Nepal - First Poverty Reduction Support Credit Project

Documentof The World Bank FOR OFFICIAL USEONLY Report No. 26556-NEP INTERNATIONAL DEVELOPMENT ASSOCIATION PROGRAMDOCUMENT FOR A PROPOSEDFIRST POVERTY REDUCTIONSUPPORT CREDIT INTHE AMOUNT OFSDR51MILLION (EQUIVALENT TO US$70MILLION) TO THE KINGDOMOFNEPAL October 15,2003 Poverty Reductionand Economic Management South 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 be otherwise disclosed without World Bank authorization.  CURRENCY EQUIVALENTS (Exchange Rate Effective October 15, 2003) Currency Unit =NepaleseRupees(NRp) US$1.0=74.50NRp FISCAL, YEAR July 15 -July 14 ABBREVIATIONS AND ACRONYMS ADB Asian Development Bank APP Agriculture Perspective Plan CIAA Commissionfor the Investigationof Abuse of Authority CFAA Country Financial Accountability Assessment CPAR Country Procurement AssessmentReport CWIQ Core Welfare Indicators Questionnaire DAP Development Action Plan DFID Department f or InternationalDevelopment DIDO District Infrastructure Development Office DHS Demographic Health Survey EHSP Essential Health Service Package IAP ImmediateAction Plan ICD InlandContainer Depots IDA InternationalDevelopment Association IMF InternationalMonetary Fund HMGN H i s Majesty's Government of Nepal LSGA Local Self Governance Act MDG MillenniumDevelopment Goals MTEF MediumTermExpenditure Framework NBL Nepal Bank Limited NEA Nepal Electricity Authority NGO Non-GovernmentalOrganization NOC Nepal Oil Corporation NRB Nepal Rastra Bank NTA Nepal Telecommnunications Authority PAF Poverty Alleviation Fund PIS Personnel Information System PRSP Poverty ReductionStrategy Paper PRSC Poverty Reduction Support Credit RBB RastriyaBanijya Bank RTS Rural Telecommunications Service SMC School Management Committee SHPS Sub-Health Posts VDC Village Development Committee WTO World Trade Organization Vice President: Praful Pate1 Country Director: KenichiOhashi Sector Director / Manager: Sadiq Ahmed / Ijaz Nabi Task Team Leaders: HassanZaman / Roshan Bajracharya  FOROFFICIAL USEONLY TABLE OF CONTENTS I Overview 1 I1 Country Context andDevelopmentPerformance .. ............................................................................................................................................................. ........................................................................................... 3 Poverty and Social Context............................................................................................................................... 3 Economic Context............................................................................................................................................. 4 PoliticalContext................................................................................................................................................ 5 I11 Nepal's Poverty ReductionStrategy 7 IV ReformsSupportedby the ProposedCredit .. ................................................................................................................ ................................................................................................... 9 Reforms to Restore Broad-based Growth......................................................................................................... 9 Reforms to Improve Service Delivery ............................................................................................................ 18 Reforms to Promote Social Inclusion............................................................................................................. 20 Reforms to Improve Governance.................................................................................................................... 21 V The ProposedCredit . ......................................................................................................................................... 24 The World Bank's Assistance Strategy .......................................................................................................... 24 Credit Design and Fiduciary Issues ................................................................................................................ 27 Poverty and Social Impact Monitoring........................................................................................................... 29 Benefits and Risks........................................................................................................................................... 31 LIST OF TABLES Table 1:RegionalDisparities. Nepal. 1995/96.......................................................................................................... 3 Table 2: SelectedEconomic Indicators 1997/98-2002/03......................................................................................... 4 Table 3: MediumTerm Fiscal Framework.............................................................................................................. 13 Table 4: PRSC Themes and Partnerships with Other Donors ................................................................................. 26 LIST OF BOXES Box 1:PotentialSources of Growth.......................................................................................................................... 9 Box 2: Fiscal Sustainability Scenarios .................................................................................................................... 10 Box 3: Key Recommendations from the Country FinancialAccountability Assessment (CFAA) ......................... 21 Box 4: Prior Actions for PRSC Iand Indicative Prior Actions for PRSC I1........................................................... 29 LIST OF FIGURES Figure 1: The PRSC Program and AAA Underpinnings ATTACHMENT Attachment 1:Letter of DevelopmentPolicy LIST OFANNEXES Annex I: Nepal Medium Term Policy Reform Matrix Annex 11: Analysis of the Potential Impact of Removing the Kerosene Subsidy Annex 111: Poverty inNepal Annex IV: Public Financial Management and Accountability inNepal Annex V: NepalAt a Glance Annex VI: Social Indicators Annex VII: Key Economic Indicators Annex VIII: Key Exposure Indicators Annex IX: IMFPublic InformationNotice 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.  Task Team HassanZaman, Senior Economist and TaskLeader; RoshanBajrachaiya, Senior Economist and co-Task Leader; Rajib Upadhya,Senior External Affairs Oficer; RobertP. Beschel,Lead Public Sector Management Specialist; Bigyan Pradhan, Senior Financial Management Specialist; Ismail Radwan, Private Sector Development Specialist; GiovannaPrennushi, Lead Economist; Rajendra Dhoj Joshi, Senior Education Specialist; Lynn Bennett, Adviser; Surendra Govinda Joshi, Senior Transport Specialist; Shyam Sundar Ranjitkar, Senior Irrigation Engineer; Tashi Tenzing, Senior Sanitary Engineer; Asif Faiz, Operations Adviser; Masami Kojima, Lead Energy Specialist; Nawaf Al-Mahamel, Counsel; Tara Vishwanath, Lead Economist; Tirtha Rana, Senior Health Specialist; Jagmohan Kang, Senior PHN Specialist; Ahmad Ahsan, Lead Economist; Sabin Shrestha, Financial Sector Specialist; Donna Thompson, Senior Financial Management Specialist; Geeta Sethi, Senior Economist; Syed Mahmood, Senior Private Sector Development Specialist; Bala Bhaskar Naidu, Research Analyst; Narayan Sharma, Consultant; Ram Chandra Mishra, Consultant; Nuru Lama, Summer Intern, Shahnaz Sultana Ahmed, Program Assistant; Kiran Gautum, Program Assistant and Neena Shresta,Program Assistant. Peer Reviewers: Sudhir Shetty, Sector Manager; Ritva Reinikka, Research Manager; ShantayananDevarajan, Chief Economist.  KINGDOMOF NEPAL FIRST POVERTYREDUCTIONSUPPORT CREDIT CreditandProgramSummary Borrower: The Kingdomof Nepal Amount: SDR 51million (US$70millionequivalent) Terms: Standard IDA terms; 40-year maturity with 10-yeargrace period Description: The proposed credit supports the implementation of the Government's Poverty Reduction Strategy Paper (PRSP), which focuses on: Generating economic growth: The PRSP argues that higher growth will require greater productivity of the agricultural sector and a recovery in manufacturing, tourism and exports. Inadditionto describingthe important exogenousfactors that determine Nepal's growth, the PRSP also identifies key barriers to growth that public policy can influence. Restoring peace will clearly prove a boon to the overall investment climate and to the tourism industry in particular. Maintaining macro-economic stability, greater efforts at domestic resource mobilization, expenditure prioritization and better financial management will create the fiscal space to spend on maintaining and creating public assets. Improving the investment climate will require a reduction in transport costs, significant strengthening of the financial system, more reliable power and telecom services and greater flexibility inlabor markets. 0 Zmproving service delivery: The PRSP outlines the importance of improving service delivery through a gradual process of decentralization, greater empowerment of local communities and greater involvement of the private sector in the management of social services. This shift away from a `Kathmandu controlled' systemto one where key decisions are made at the local level stems from a recognition by key decision-makers that in a diverse country like Nepal, devolving authority to the grassroots is essential to improving the quality of services and overcoming the prevailing disillusionment with Government services. This process has begun inawide range of sectors includingeducation, health, water, agriculture androads. 0 Promoting social inclusion: The PRSPrecognizes that promoting social inclusionwill require fundamental policy and institutional changes - particularly in the way services are delivered and in the gender, ethnic and caste composition of the civil service. In addition, in order to enhance the flow of resources to excluded groups inthe short run,the PRSP outlines the need to have targeted programs for the hard-core poor, ethnic minorities, people living in remote areas, female-headed households and women. The strategy discusses the importance of using the new Poverty Alleviation Fund to target communities in conflict-affected areas as well as introduce scholarship programs for girls and ethnic minorities to improve access to schooling. 0 Zmproving governance. Recognizingthat governance improvements are essential if reforms to stimulate pro-poor growth and improve service delivery are to have their desired impact, the PRSP develops both cross-cutting and sector-specific governance improvement strategies. Cross-cutting themes include: (i)improving the effectiveness of the civil service; (ii) strengthening anti-corruption institutions; (iii) improving the functioning of key agencies and  (iv) improving financial management. These will be complemented by tackling governance issues in key areas such as the financial sector, infrastructure, health and education. Benefits: The PRSC program supports selective key reforms that will directly contribute to pro-poor growth by (i) creating fiscal space for, and improving the effectiveness of, growth enhancing public investments and (ii) improving the investment climate. The PRSC program also supports Nepal's track record of meaningful reforms in improving service delivery by assisting HMGN in developing annual benchmarks consistent with the broad reform objectives and by providing the fiscal and technical resources necessary to accelerate the reform momentum. The PRSC process supports Nepal's efforts to promote social inclusion by (i) improving the effectiveness of targeted programs (ii) improving access to schooling for excluded groups and (iii) encouraging civil service diversity. The PRSC program also supports HMGN's strategy to improve governance by (i) improving the effectiveness of the civil service (ii)strengthening anti-corruption and accountability institutions (iii) improving the functioning of key agencies and (iv) improving financial management and procurement practices. The improvements in governance that are supported by the PRSC Iare designed to bring about a more accountable, efficient and less corrupt government that will create a more favorable investment climate and lead to better service delivery. Risks and Mitigation Strategy: There are several risks associatedwith the PRSC: (i)returnto a prolongedperiod of conflict a would dampen growth prospects and the impact of structural reforms on poverty; (ii) prior to and following national elections the efforts of reform minded technocrats may be crowded out by political interference and threaten the sustainability of reforms; (iii) implementation capacity may not be sufficient to sustain a broad reform agenda; (iv) a further worsening of global economic conditions may undermine the impact of growth-enhancing reforms. These are real risks and there i s no guarantee that risk mitigation measures could overcome the joint effect of these forces should they materialize. The risk mitigating measures partly lie in an on-going process of bringingthe delivery and management of resources closer to the people (by devolving authority from the center in education, health, water and extension services) and using targeted programs to provide opportunities and services for particularly marginalized groups and in the most deprived districts. Many of the reforms outlined in this document have a wide degree of support across the political spectrum and from civil society, as they have been based on consensus-building exercises and stakeholder consultations. Recognizing the risk of capacity limits derailing the reform process, the reform program embedded in the PRSP and supported by the PRSC sets realistic implementationtargets. The Immediate Action Plan (IAP) process plays an important role inthis regard, in identifying an annual list of high priority reform actions. While the above risk mitigation measures should provide adequate comfort that these risks are manageable, as an added risk-mitigation measure, the Bank will provide a loan acceleration clause that would allow the Bank to demand immediate repayment of the proposed loan by the Borrower in case reforms are reversed or materially changed. EstimatedDisbursement: SDR 51million ($70 million equivalent) disbursed ina singletranche upon credit effectiveness. Project ID Number: PO74685  IDA PROGRAMDOCUMENT FOR A PROPOSEDPROGRAMMATIC STRUCTURALADJUSTMENT CREDIT TO THE KINGDOMOFNEPAL I.Overview 1. Thirteen years after the establishment of a multi-party democracy and the start of rapid economic liberalization, Nepal is in the midst of a somewhat unnoticed but important "id- course correction.' The aspirations of the Nepali people for better and more inclusive governance and public services have become increasingly frustrated over the years. The armed rebel movement, which sharply escalated in2001, was the starkest reflection of the risingtensions. Wide disenchantment with ineffective and corrupt government, however, has also created a strong internal pressure for reform. In parallel with the political process that i s focusing on restoring peace and a more effective democracy, a renewed drive has been underway to buildthe economic and social foundation for sustainedpeace and poverty reduction. Much of the reform centers around creating a high-performance state that delivers public services efficiently and inclusively and supports broad-basedeconomic growth. 2. Although some important progresswas made inthe 1990s, Nepal remains one of poorest countries in the world. Economic liberalization in the early 1990s spurred respectable growth, averaging 5% per annum in the 1990s.However, growth in the past two years has been more modest due largely to the insurgency and the effects of the global economic slowdown. Certain social indicators such as infant and child mortality, total fertility, and life expectancy, have also improved significantly over the past decade. Nonetheless, widespread poverty has persisted, as the impact of growth has been dampened by high population growth and the Kathmandu centered growth pattem. Large inequities prevail across ethnic and gender lines, fueling the conflict. 3. The foundations for a lasting peace lie in improving service delivery, promoting social inclusion and reducing corruption: In late January 2003, a cease-fire was agreed upon by His Majesty's Government of Nepal (HMGN) and the rebels that lasted until August 2003. Conflict has since resumed following a breakdown of talks. Key policymakers in Nepal are now acutely aware of the need to make public services and economic growth more inclusive in order to arrive at a lasting peace, and suchawareness i s reflectedinthe PRSP. 4. Important reforms that have taken place over the last eighteen months are restoring the credibility of the Government. These reforms focus on improving the delivery of basic services complemented by far-reaching structural and governance reforms. Key reforms include: (i) revamping the expenditure management system to focus resources on priority development activities; (ii) handing over management of public schools and sub-health posts to local management committees; (iii) strengthening the legal power of the anti-corruptionauthority (which usedthis authority to file charges in high profile corruption cases); (iv) bringing the two largest loss-makingcommercial banks under external management teams; (v) increasing private sector participation in power and telecom with provisions for rural services; (vi) setting up an independent Roads Board to improve road maintenance; (vii) passing legislation that improved women's legal rights to parental property and (viii) significantly reducingthe number of civil service transfers. 5. These reforms are being championed largely by technocrats who have been given the space to carry out critical reforms. As the crisis in Nepal deepened over the past two years, an increasing number of reform-minded individuals (mostly at the technocratic level but some at the political level) have begun to take determined actions to face up to the challenge. Strong reform  champions have emergedina number of central agenciesas well as line ministries. The recent changes in administration has not hampered their efforts, for in most cases they are simply implementing the strategies and policies that had been adopted before and enjoy strong public support. If anything, the preoccupation of politicians with power politics has given the reformers more space. 6. Nepal's future reform agenda is articulated in the PRSP. The poverty reduction strategy has been prepared through a highly consultative process. The PRSP rests on four key pillars: (i) generating economic growth; (ii) improving service delivery; (iii)promoting social inclusion and (iv) improving governance. Recognizingthe constraints to implementation capacity, HMGNhas prepared an `Immediate Action Plan 2003' to ensure that a selective set of key reforms under the PRSP are implemented. 7. HMGN has requested financial support from the World Bank and IMF to help implement the PRSP. Inresponse, the IMFi s preparing a PRGF and we propose to support the PRSP through the PRSC process. A Joint Staff Assessment (JSA) of the PRSP i s being undertaken. The PRGF and the proposed PRSC Iare being closely coordinated and a Board presentation of mid November i s envisaged for both operations along with the PRSP and accompanying JSA. 8. Bank support to HMGN at this time is critical to strengthen the reform process. Reformers have now reached a critical mass and have a higher profile than inthe past. This presents an opportunity for the Bank to provide the fiscal and technical support that i s required to sustain the reform momentum. For several years the Bank restricted its financial support, thus strengthening its credibility and creating the incentives for reform ina fiscally constrained environment. By recognizing a strong track record of change, the Bank will strengthen the reformers' will to move ahead with their agenda inthe face of opposition from the quarters that standto gain from maintainingthe status quo. It will give a clear signal that future reforms will also be duly supported and help protect the space requiredfor reformers. Moreover, timely financial support would createfiscal space inthe next budget to expand financing of priority public services. 9. The risks underlying reform implementation can be mitigated and are balanced by the opportunity to strengthen the reform momentum. There are several key risks: (i) the breakdown of the peace process dampens the impact of reforms (ii) to and following national elections the prior efforts of reform minded technocrats may be crowded out by political interference; and (iii) implementation and monitoring capacity constrains progress. The basic risk mitigation measure i s in the design of the reforms itself. The reformers are trying to use `quick-win' reforms to deliver wide benefits and broaden the support for reforms. They are also using the Immediate Action Plan to set realistic implementation targets in line with capacity. Moreover, these risks are balanced by the benefits that can be brought about by continued progress on the reform agenda. It would be no exaggeration to say the future of Nepal depends on the success of this process. 2  11. Country Context andDevelopment Performance Poverty and Social Context 10. Nepal remains one of the poorest countries in the world - per capita income i s about $250, around half the children under five are malnourished and progress towards Millennium Development Goal (MDG) targets remains slow. Growth in the 1990's has been respectable, averaging 5% but its impact on poverty has been dampened by high population growth, by being concentrated inthe Kathmandu valley and the escalation of the conflict over the past two years. 11. The incidence of consumption poverty stood at 42 percent in 1995/96; trends over the last few years will be assessedin 2004 when the secondround of the Nepal Living Standards Survey, currently in the field, will be completed. However, the main characteristics of the poor are unlikely to have changed substantially since 1995/96. There are significant geographical differences, (see table 1) - in general the poor live inrural areas and engage in subsistence agriculture on small plots of land, often of low quality; they have limited access to roads, markets, healthand education services, often because of remoteness; and rely on seasonal migration and remittances to cope with downturns. Indigenous ethnidcaste groups continue to lag behind in their income and asset levels, educational achievements, and human development indicators. Table 1: Regional Disparities, Nepal, 1995/96 Poverty Poverty Gap Illiteracy Incidence (percent) Nepal 42 0.121 64 Urban 23 0.070 37 Rural 44 0.125 67 UrbanKathmanduValley 4 0.004 24 Other Urban 34 0.109 45 Terai 42 0.099 69 Hills 41 0.136 58 Mountains 56 0.185 75 12. The evidence of changes in social indicators presentsa mixed picture. Data from the 1996 and the 2001 Nepal Demographic and Health Survey indicate that the infant mortality rate has fallen from 79 per 1000 in 1996 to 64 in 2001 and child mortality from 43 to 29 per 1000. The improvement can be largely attributed to better immunization coverage -- the percentage of children fully immunized has increased by 67 percent in the last five years. Total fertility has declined from 4.6 to 4.1 births per woman and life expectancy has increased from 56 years to 59 years over these five years. On the other hand, there appears to have been little improvement in the nutritional status of children, with 50 percent of children under five years of age stunted, 48 percent underweight, and 10 percent wasted (thin for their age). The gender gap in education has not narrowed, with a 13 percentagepoint difference at the primary level and an 8 percentagepoint difference at the secondary level (see Annex I11for further details of the poverty profile inNepal). 3  Economic Context 13. Export-led growth in Nepal averaged 5 percent per annum inthe 1990's. Macroeconomic management strengthened during the mid 1990s, inflation was kept low and stable, and exchange rates-pegged to the Indian rupee-depreciated gradually to maintain stability and export competitiveness. Economic liberalization in the early 1990s' and successful stabilization of the economy in the mid 1990s helped to create an enabling environment in the non-agriculture sector, which accounted for 75 percent of growth during this period. The rapid manufacturing growth was primarily export-led; the value of exports doubled between 1994/95 and 1999/00 (in U S dollar terms) with increased demand from the US and Germany and even more rapid growth in the Indian market. Exports to India grew at a spectacular average rate of 42 percent between 1998 and 2002, largely due to a five-year old bilateral trade treaty, whereby Nepali goods were allowed into India essentially duty and quota-free. The rapid growth of tourism was also a significant determinant of non-agricultural growth - the number of tourist arrivals grew by 51% between 1994 and 1999. Agricultural growth rose in 1999/00 and 2000/01 due to favorable weather and expanded fertilizer and irrigation use, though its overall contribution to growth inthe 1990s has been modest (around one-fourth). Table 2: Selected Economic Indicators 1997198-2002lO3 1997/98 1998/99 1999/00 2000/01 2001/02 2002/03 Prelim GDPgrowthrates RealGDPat factor cost 2.9 4.5 6.1 4.8 -0.5 2.3 Agricultural GDP 0.9 2.8 4.9 5.5 2.2 2.1 Non-agriculturalGDP 5.0 5.6 6.8 4.3 -2.1 2.5 Manufacturing 3.4 5.3 7.2 3.8 -10 0.4 Other Sectors 5.3 5.7 6.8 4.4 -0.6 2.9 Govemmentbudget (percentof GDP) Totalrevenue 10.5 10.2 10.7 11.4 11.5 12.3 Total expenditure 16.7 15.4 15.7 17.6 17.2 16.3 Current expenditure 9.2 9.4 9.6 11.2 11.6 11.6 Capital expenditureandnet lending 7.5 6.1 6.1 6.4 5.7 4.7 Overalldeficit beforegrants 6.2 5.2 5.0 6.2 5.7 4.0 Overalldeficit after grants 4.4 3.9 3.5 4.5 4.3 1.9 Domesticfinancing(net) 0.5 1.4 0.9 2.7 2.9 1.2 Inflation - CPI(average) 8.3 11.4 3.4 2.1 2.9 4.7 Currentaccountbalance (excludinggrants) -2.8 0.5 0.5 1.2 2.6 -0.9 Gross official reserves(in months of importsof goods and services) 5.3 4.9 5.6 7.0 6.7 6.9 Extemaldebt/GDP (inpercent) 49.7 50.3 48.2 49.9 52.9 52.2 Debt service brcent of exports of goodsandservices) 5.1 5.3 4.7 6.1 7.5 7.4 Source: IMF ' Liberalization measures included: (i) reform o f investment regulations, including easing of entry barriers; (ii) and trade financial sector reforms that facilitated the supply of raw materials, intermediate and capital goods; and (iii) regulatory reforms that allowed private sector participationininfrastructure. 4  14. Growth has slowed sharply in recent years: Due to a combination of factors, growth in 2001/02 slumped to -0.5%, though preliminary estimatesfor 2002/03 suggests that a modest recovery i s underway. The Insurgency (through increased insecurity, destruction of physical assets/infrastructure, strikes and loss of business confidence) and the global economic slowdown ledto a contraction inmanufacturing output by 10% in2001/02 compared to the previous year. The value of merchandise exports i s estimated to have declined by 15 percent in 2001/02 after growing by 21 percent on average during the previous three years. The impact of September 11" and the deteriorating domestic security situation ledto a 22% decline inthe number of tourist arrivals in2001. Excessive monsoon rains also caused agriculture growth to slow to 2.2% in2001/02. However, growth in2002/03 is projected at 2.4%. The improved security situation inthe second half of the fiscal year appears to have led to an increase in tourist arrivals (25% increase between August 2002 and August 2003) restored normality inthe transport and service sectors and contributed to arebounding of certain manufacturing exports, particularly garments. 15. Nepal has maintained a prudent fiscal stance. The fiscal deficit after grants has not exceeded 4.5% of GDP over the past decade and has been largely financed by concessional foreign financing. Concerns over a growing share of domestic borrowing in financing the deficit in recent years were allayed in 2002103 as domestic borrowing was lower than expected. Revenue collection fluctuated little between 1994/95 and 1999/00 averaging 10.5% of GDP. Following the implementation of tax reforms, revenues rose significantly to 12.3% of GDP in 2002/03. Total expenditures declined in 2002/03 due largely to shortfalls in development expenditure in light of the security situation. 16. Balance of payments developments have been broadly positive. Preliminary estimates for 2002/03 suggest that the overall balance of payment i s expected to remain in surplus though a rebounding economy has raised the level of imports to the point where the current account deficit i s approximately 1percent of GDP. Remittances have grown steadily over the past few years-and now exceed merchandise exports-reflecting a rapid increase inthe number of Nepali workers in Malaysia and the Middle East. Gross official reserves stood at over $1billion, covering almost seven months of imports. While reserves are comfortable, they are not at a level where HMGNcan afford to draw down reserves to finance budgetary expenditures, given Nepal's vulnerability to exogenous shocks. The external debt service ratio (debt service as a proportion of exports of goods services and private transfers) is around 7.4% and interest payments on foreign debt has averaged around 0.5% of GDP in recent years (see Box 2 on `Fiscal sustainability scenarios'). PoliticalContext 17. In 1990, the Jana Andolan (People's Movement) restored multi-party democracy and in a mere six weeks, the party-less Panchayat systemthat ruled Nepal for thirty years was gone. The fall of the Nepali Congress majority government in 1994, pulled down by a faction of its own party in Parliament, marked the beginning of intensely fractious politics. Between then and 2001, all three major political parties split (although two have come back together again). Two general elections were held and there were ten changes in government, with the average life of each government being 9.5 months. During these years, ideology increasingly took a back seat as coalitions were blatantly made and broken along vested political and personal interests. Political interference in the day to day runningof the administration becamemore of the rulethan the exception. 18. Capturing the disenchantment with democracy as it was practiced since 1990, a rebel movement took up arms in 1996. After a failed attempt for peace talks in 2001, the insurgency escalated sharply and led to a growing climate of fear and insecurity in rural areas. Considerable 5  damage has been done to infrastructure-over one-third of the country's 3,900 Village Development Council buildings have been damaged or destroyed, thirteen out of seventy five districts are without phones, five hydroelectric plants are out of action, 250 post offices have been destroyed and six airports have been closed. Security concerns led to the postponement of local and national elections creating further political uncertainty. 19. Despite the deepening national crisis, frequent changes in Government continued in 2002. Following the dissolution of the Parliament in May 2002, Prime Minister Sher Bahadur Deuba continued as caretaker prime minister and announced general elections for November 2002. In late- September, however, concluding that the insurgency was too big a security threat to ensure free and fair elections, Mr.Deuba recommended deferment of the election by over a year. Determiningthat Mr. Deuba's recommendation amounted to incompetence, the King dismissed Mr.Deuba and temporarily took over all executive powers. King Gyanendra made it clear that the government 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. 20. On October 4, 2002, veteran politician Mr. Lokendra Bahadur Chand was appointed by the King as the new Prime Minister and head of a cabinet composed of technocrats and leaders of the smaller political parties. The Chand government was given a five-point mandate: (i) restoring peace; (ii) thesuspendedelections;(iii) corruption; (iv)improvingservicedelivery; and(v) holding fighting maintaining good relations with neighbors. However, the larger political parties refused to recognize the Chand government, declaring it unconstitutional, and instead chose to agitate for the revival of Parliament or formation of an all party government with full executive authority in order to limit the King's powers. Eight months into office, Mr. Chand stepped down on May 30, 2003, in a bid to narrow the rift between the Palace and the political parties. Inspite of the political turmoilthat marked histenure, implementationof reforms continued unabated. 21. On June 4, 2003, the King appointed Mr.Surya Bahadur Thapa as Prime Minister -- Nepal's twelfth in seven years and fifth since the 1999 elections. Thapa's appointment was accompanied with an executive order, vesting full executive powers in him. Thapa, also a veteran from the erstwhile Panchayat era as well as founder president of the Rastriya Prajatantra Party (RPP), currently heads a seven member `minicabinet' which he hopes to expand if and when the political parties agree to join. Thapa's appointment with full executive powers i s widely seen as a signal of King Gyanendra's withdrawal from overt political activity which his critics describe as unbefitting for a constitutional monarch. The appointment of Dr.Prakash Chandra Lohani as Finance Minister augurs well for reform implementation. Lohani has held the finance portfolio in the past and was the chief architect of stabilization and structural reformpolicies inthe mid-eighties.He enjoys an excellent rapport with the Prime Minister. 22. The rebel movement and HMGNdeclared a ceasefire on January 29" 2003, and signed a code of conduct in March. Two rounds of formal peace talks were held before the rebels called off the cease-fire on August 27&, 2003, ignoring a far-reaching agenda for political and socio-economic change proposed by the Government side during the negotiations. Key rebel demands include an all- party conference, an inclusive national government and elections to a constituent assembly to frame a new constitution. Prime MinisterThapa maintains that peaceful resolution of the conflict and a return to a functional multi-party polity based on parliamentary elections at the earliest, remain his top priority inline with the wishes of the general public who clearly want peace. 23. While there i s substantial political uncertainty, a key recent development in Nepal i s the emergence of a broad coalition of like-minded reformers comprising of technocrats, intellectuals, 6  business leaders and civil society representatives who are pushing forward with a change agenda that i s likely to stay its course even if the political process falters. There seems to be growing hope that the on-going reforms may raise the standards for public sector performance and set new norms at the level of the political leadership. Inshort, this period may turn out to be a positive mid-course correction in the evolution of Nepal as a modem state. 111.Nepal's Poverty Reduction Strategy 24. Nepal's reform agenda revolves around the PRSP's four key pillars: (i) generating economic growth; (ii)improving service delivery; (iii)promoting social inclusion; and (iv) improving governance. There is by now a broad social and political consensus in Nepal, supported by analytical work2, that progress inthese areas will be critical to building a lasting peace, speedingup development and catching up for the years lost to the conflict. The poverty reduction strategy, a product of wide national participation, captures this consensus. The following extract from the PRSP illustrates the importance given by the poverty reduction strategy's four pillars in tackling many of the underlying causes of the recent conflict: "There is little doubt that persistent poverty and inequalities in the Mid and Far Western regions have provided a fertile breeding ground for the insurrection. The reasons for the disaffection are well known: (i) The Democracy movement of 1990 created new hopes for change among the ethnic communities who perceived themselves as marginalized; but the results of various development activities hardly reached these groups; (ii) Thefailure of governments to deliver adequate and quality basic social services outside urban areas; (iii) Increasing corruption and leakages, and with them lack of accountability in the govemment; and, (iv) The slow pace of decentralization and the lack of community involvement probably added to thefrustration" (pg 39). 25. Generating economic growth: The PRSP argues that higher growth will require greater productivity of the agricultural sector and a recovery inmanufacturing, tourism and exports. While the global economic slow-down and restrictive trade practices by trading partners are essentially exogenous growth-dampening factors, there are other impediments to growth that HMGN can influence. Conflict in rural areas, heavy dependence on rain-fed agriculture, high transport costs, unreliable power and telecom services, a weak financial sector, a rigid labor market and the limited effectiveness of public investments currently constrain growth in Nepal. HMGN's growth strategy focuses on relieving each of these impediments. Restoring peace i s particularly critical as it will prove a boon to the overall investment climate and to the tourism industry in particular. Maintaining macro- economic stability, greater efforts at domestic resource mobilization and expenditure prioritization will create the fiscal space for growth enhancing public investments. Improving the effectiveness of irrigation, rural transport and power sector investments through public-private partnerships are key components of the PRSP's agricultural growth strategy. The PRSP also argues that improving the productivity of domestic manufacturing to promote export-led growth will require greater flexibility in labor markets, significant strengthening of the financial system and more reliable telecom and power services. 26. Zmproving service delivery: The PRSP outlines the importance of improving service delivery through a gradual process of decentralization and greater empowerment of local communities in the management of social services. In education, the key objectives are to improve primary completion rates, increase access for girls and ethnic minorities and raise the access to post-primary education. HMGNhas begunto implement the requiredreforms designed to achieve these objectives. A process DFID(2002) `EconomicAspects of the Insurgency in Nepal' 7  of devolving primary school management to communities has begun and represents a fundamental shift in approach from the current centrally managed system. Targeted scholarship programs for girls and ethnic minorities will also be implemented. In health, the Government has developed a sector strategy that will focus on implementing an Essential Health Care package focused on a range of critical preventative care, maternal and child health and family planning interventions. Improvements in service delivery are also expectedto occur through a process of devolving sub-health posts to local communities. The PRSP elaborates on the importance of access to clean water for healthoutcomes and aims to increase access in rural areas from 71% to 85% of the rural population by 2006. The key actions needed to achieve this are to focus on rehabilitation and maintenance of existing projects and to develop new projects using the demand driven user group approach supported by the Rural Water Supply and Sanitation FundDevelopment Board. Urban water supply management will be contracted out to the private sector over the next few years. 27. Promoting social inclusion: The PRSPrecognizes that promoting social inclusion will require fundamental policy and institutional changes - particularly in the way services in critical sectors like education and health are delivered and in the gender, ethnic and caste composition of the civil service. Inaddition, inordertoenhancethefollow ofresourcestoexcludedgroupsinthe shortterm, thePRSP proposes targeted programs for the hard-core poor, ethnic minorities (Janjatis), occupation castes (Dalits), people living in remote areas, female-headed households and women. The strategy reviews the weaknesses of such efforts in the past and discusses usingthe new Poverty Alleviation Fund as well as analytical tools, such as poverty mapping data, to improve the effectiveness of the proposed initiatives. The PRSP also stresses the need for `quick results' in order to gain the confidence of those who have thus far been left behind by development efforts. As a result the PRSP proposes to implement an integrated infrastructure development program (drinking water, small irrigation, schools, health posts, and trails) in remote areas through local Government, community groups and NGOs in light of the capacity constraints of the central Government. The PRSP discusses how gender issues will be mainstreamed in various sectors. Girls education will be promoted through scholarship programs and greater hiring of female teachers. The Essential Health Care package will have a strong focus on maternal and reproductive healthand the community user group approachto expand drinking water has explicit provisions for the involvement of women. Similarly, programs to promote the inclusion of marginalized ethnic groups will be developed within each sector's main programs. 28. Zmproving governance: Recognizing that governance improvements are essential if reforms to stimulate pro-poor growth and improve service delivery are to have their desired impact, the PRSP develops both cross-cutting and sector-specific governance improvement strategies. Cross-cutting themes include: (i) improving the effectiveness of the civil service; (ii)strengthening anti-corruption and accountability institutions; and (iii)improving the functioning of key agencies; and (iv) improving financial management and procurement practices. These economy-wide governance improvement efforts will be complemented with measures in core sectors including the financial sector, infrastructure, health and education. The progress made in tackling governance concerns in the financial sector (see below for further details) i s a testimony to HMGN's commitment to move steadily on this front. 29. As a strategic document, the PRSP is far more credible than the past plan documents. Although it stands on the extension of the traditional five-year plan process, there are at least three things that distinguish this strategy from recent five-year plans. First, although the underlying Tenth Plan is voluminous, HMGN was able to use the PRSP to extract only priority issues and programs. This sense of priority reflects muchstronger concerns about poverty reduction and social inclusion, no doubt sharpened by the experience of the insurgency. Second, the PRSP i s linked with the Medium- TermExpenditure Framework (MTEF) which was introducedin 2002/03. The MTEFi s now accepted 8  by line ministries as a serious prioritization framework with a strong focus on performance and will thus help focus public resources on PRSP-driven priorities. Third, in 2002, HMGN adopted the "Immediate Action Plan" (IAP), to bolster its track record of reform implementation. HMGN's success in using the first IAP to focus on the implementation of a few key measures has set a precedent of developing realistic annual targets that are necessary for the implementationof the PRSP inthe years ahead. IV. ReformsSupportedby the ProposedCredit Reforms to Restore Broad-based Growth 30. HMGNhas embarked on a reform agenda that will boost various possible sources of pro-poor growth. The key reforms relate to: (i) maintaining macro-economic stability and increasing the fiscal space for growth enhancing and pro-poor expenditures and (ii) improving the investment climate for private-sector led growth. Increasing fiscal space will generate greater public investment in key growth-enhancing sectors and improve the returns to private investment. Improving the investment climate will lead to greater private investment in both the rural economy as well as in the manufacturing and services sector. Peace is clearly critical for sustained growth. The implementation of the reform agenda will also contribute to gains in total factor productivity and boost long term growth prospects. The key drivers of pro-poor growth are expected to be through improved agricultural productivity, investment in the non-farm rural sector, light manufacturing exports and tourism (see Box 1). e peaceprocesswill .Remittanceshave 9  Creating Fiscal Space 31. Creating the necessary fiscal space to increasepublic investments in growth-enhancing sectors as well as improving the effectiveness of these investments is a key government priority. Inorder to create this fiscal space, HMGN has maintained a prudent macro-economic stance (see Economic Context section), increased domestic revenue mobilization efforts, pruned unnecessary expenditures, improved expenditure management (see Governance reform section on improving public financial management) and taken steps to limit the fiscal burden caused by public enterprises. A fiscal sustainability exercise, carried out by the IMF, suggests that public debt dynamics would remain manageableunder various plausible macro-economic scenarios (see Box 2). Inorder to ensure that the composition of external debt remains concessional, HMGN's Foreign Aid Policy bans all new suppliers credits. 32. Domestic revenues have increased by 1.6% of GDP between 1999/00 and 2002/03. This increase i s due to measures to improve domestic resource mobilization including (i)the implementation of the 2000 Income Tax Act, (ii) broadening the income and VAT tax base, (iii) expansion of ASYCUDA for customs and (iv) the creation of an integrated Inland Revenue Department. A Fiscal Commission was established in late 2002 to devise measures to streamline taxation procedures, promote exports and reduce the personal income tax burden at lower income levels. Key reforms that were proposed by the Commission and implemented in the 2003/04 Budget include: (i) eliminating VAT exemptions for edible oils; (ii)reduction in import duty rates (consistent with WTO accession requirements) offset by increases in excises; (iii) elimination of export service charges and reduction in export taxes; and (iv) an increase in the income tax exemption threshold together with a widening of the lowest tax bracket. 33. Following on from the recommendations of the Public Expenditure Review Commission, Nepal has taken the first steps towards the development of a credible Medium Term Expenditure Framework (MTEF).The main focus in 2002/03 was in the prioritization of the development budget into three `priority categories' - P1, P2 and P3 projects. The significance of the priority classification i s that high priority projects (60% of the development budget in FY03) will now receive first priority in the allocation of funds. HMGN intends to extend the expenditure prioritization process over the medium run by further cuts in low-priority projects. The MTEF process will also be extended to prioritize recurrent expenditures, although this distinction i s somewhat blurred currently in Nepal, given that a sizeable share of development projects include recurrent expenditures. 34. Inorder to create more roomfor pro-poorprojects, HMGNdropped 160low priority, HMGN- funded projects from the development budget in 2002/03. This redressed the sharp growth in the number of projects inthe development budget -from 423 in 1993/94 to 770 in 1998/99 -that resulted in too many projects chasing too little money. Overall, the share of education, health and drinking 10  water increased from 21% of public expenditures in 1998/99 to 24% in 2003/04. The prioritization exercise has also led to a shift towards greater pro-poor programs within sectors. For instance, within the education sector budget, the share of primary education increasedfrom 44% in 1999/00 to 55% in 2002/03. In the health sector, the share devoted to preventative health care increased from 26% in 2001/02 to 40% in 2002103. Ina context where security spending has had to increase, by about 1%of GDP in the past two years, it is noteworthy both that pro-poor spending has been protected and that the share of security spending inthe Budget is still far below most neighboringcountries. 35. Budgetary transfers to Nepal's parastatalshave averaged 1.8 percent of GDP for the last three years. HMGN has moved to reduce the fiscal burden of public enterprises by establishing a hiring freeze. HMGN intends to progressively reduce its level of budgetary transfers over the next few years. Inan effort to improve corporate governance, HMGNhas removed many political appointees from public enterprise management and begun to replace them with professional managers recruited from the private sector. An arrears reconciliation exercise took place between Government and three parastatals (telecoms, electricity and water) in 2002/03 with a partial clearing of arrears. The remaining stock of arrears is expectedto be cleared by HMGNin2003/04. 36. The privatization process has gained some momentumwith the privatization of ButwalPower Company in early 2003. HMGNhas also slated a further eight parastatalsfor privatizatiodliquidation and has started the liquidations of Hetauda Textiles, Nepal Coal and Cottage Handicrafts. The Birgunj Sugar Mill and the Agricultural Tool Factory have been dissolved under the Privatization Act and HMGNis off-loading its shares inHimal Cement Factory. HMGNintends to buildon this momentum inthe coming years and has announcedthe privatization of the Bhaktapur Bricks Factory, the Nepal Foundry, and the Pokhara Milk Supply Scheme. Bidding documents have also been prepared for Hetauda Cement, Lumbini Sugar, and Nepal Rosin and Turpentine Factory and a decision on their privatizationis expected shortly. 37. The total costs of adjustment in the first wave of eight parastatals, i s estimated to be in the order of US$47.4 million, composed of severancerelated costs of US$18.5 million and other liabilities of US$28.9 million. Current uncertainty over these estimates will be resolved through increased audits. HMGNintends to complete an annual audit inevery parastatal and has gradually increased the number of annual public enterprise audits from 16 in 1998 to 27 in 2002 out of a total of 43 parastatals.This measurewould allow government to finally get an accurateestimate of the contingent liabilities involved in adjustment. The ADB i s supporting this process of public enterprise reform through a budget support operation. 38. InMarch2003, HMGNdecided to brave the political consequencesof raisingfuel prices, to levels comparable to those in India, in order to stem the potential impact of the Nepal Oil Corporation's (NOC) losses on the Budget.At the time, the retail prices were not covering the import, transportation, distribution, and other supply costs of the petroleum products. Further, because the retail prices inNepal were lower than those in India,3 a significant amount of products was smuggled back to India, exacerbating NOC's financial problem. As a result, NOC, which made a profit of 2.9 billion rupees in 2001/02, reportedly suffered a loss of 4 billion rupees (almost 1percent of GDP) in the one year prior to the price increase. NOC used its reserves to fund these losses and took out commercial loans. The timely price hikeprevented an imminent fiscal bail-out. Prior to the March2003 fuel priceincrease, kerosenewas pricedat the equivalent of 28 rupeesper liter in Indiaand only 17 inNepal-dieselwas pricedat 26.5 rupeesinNepalandthe equivalent of 33 Nepalirupees inIndia. 11  39. While the immediate fiscal concern may have been tackled, there remains an unfinished medium run reform agenda in the petroleum sector. HMGN introduced a dual price system for kerosene. Experience in other countries suggests that the dual price system i s most likely to lead to significant leakage, diverting rationed kerosene intended for household use to the automotive diesel sector and nominally inflating its demand. On the positive side, the price gap between market and rationed kerosene has been narrowed. While there i s no immediate fiscal concern in the petroleum sector at present, a medium term concern would be that, should the border prices rise to those observed in April 2003, NOC could again suffer a significant financial loss. Hence the dual kerosene price structure needs to be phased out over time. An analysis o f the poverty impact of eliminating the kerosene subsidy (see Annex 11) shows that an increase o f Rs. 4 per liter (the price difference between subsidized and market kerosene in June 2003) i s anticipated to have a negligible impact (about 0.3 percent) on the household budget o f the bottom three deciles. In 2003/04, HMGN will move to an automatic price adjustment mechanism using a transparent pricing formula, as in Pakistan and Sri Lanka. In the medium to long term, the government will liberalize the sector and introduce competition by issuing an Act for sector deregulation and establishing an independent regulatory agency4. 40. The medium term fiscal framework i s based on the discussion above and i s based on the understanding reached with a joint IMF-World Bank mission in September 2003. Table 3 below i s premised on the following assumptions: 0 Higher capital and current expenditures: Development spending i s projected to increase over the medium term in line with PRSP priorities. The Government may also initiate new development projects and expand or fully implement existing ones if relative peace returns quickly5. Hence, development spending i s projected to rise by 1.4% of GDP by 2005/06, compared to estimated levels for 2002/03. Current spending i s also projected to increase by 1.5% o f GDP in 2003/04 compared to the previous year in light of higher recurrent spending inhealthand education; higher wage allocation for security personnel; and allocations for the clearance o f utility arrears and contingent liabilities o f public enterprises. 0 Increased development spending combined with structural reforms can help in moving towards MDG goals: An initial attempt at costing the MDG goals i s underway and preliminary results, suggesting that there i s need for a significant increase in resource mobilization to meet these targets, are in line with recent cross-country estimates6. However, these estimates are also very sensitive to assumptions regarding the poverty elasticity o f growth, income distribution and the incremental capital output ratio, which in turn are affected by structural reforms. The medium term fiscal framework presented in Table 3 envisages an increase in development spending commensurate with Nepal's implementation capacity and assumes that structural reforms to improve the investment climate and reduce exclusion will improve the efficiency by which this additional spending i s translated into development outcomes. 4Anumber of issues would need to be carefully considered in preparing the bill and accompanying regulations: competitive procurement o f petroleum products, the future of the infrastructure facilities currently belonging to NOC, requirements for market entry, and anti-trust regulations, to mention a few. For instance implementation of road constructionprojects was slow due to the concerns of storing and using explosives during the conflict. See Devarajan, Miller and Swanson (2002) "Goalsfor Development: History, Prospects and Costs." World Bank, Policy ResearchWorking Paper. 12  Reduced domestic borrowing and higher foreign financing: The medium term framework envisages a reduction in domestic borrowing to 0.6% of GDP in 2005/06, compensated by a larger share of foreign financing. 0 Higher domestic revenue effort: The medium term framework envisages a 1.1%increase in domestic revenue, as a share of GDP, by 2005/06 (from 12.3% in 2002/03 to 13.4% in 2005106). This target is based on revenue administration reforms and rationalization of VAT and customs exemptions, described earlier. Table 3: MediumTermFiscalFramework 2002/03 2003/04 2004/05 200306 Budget Estimate Staff Projection (Inpercentof GDP) Total revenue 11.9 12.3 12.4 12.8 13.4 Tax revenue 9.8 9.4 9.9 10.7 11.3 Nontax revenue 2.1 2.8 2.5 2.0 2.1 Grants 3.1 2.2 2.7 3.1 2.8 Total expenditure 18.4 16.3 18.7 18.5 18.2 Current 13.0 11.6 13.1 12.5 12.1 Ofwhich: Interest payment 1.7 1.5 1.6 1.6 1.6 Capital andnet lending 5.4 4.7 5.6 6.0 6.1 Overallbalancebefore grants -6.5 -4.0 -6.3 -5.7 -4.8 Overallbalanceafter grants -3.4 -1.9 -3.6 -2.6 -2.0 Financing 3.4 1.9 3.1 2.6 2.0 Net foreign loans 1.4 0.7 1.4 1.3 1.4 Gross disbursements 2.6 1.9 2.6 2.7 2.7 Ofwhich: IDA budget support 1.1 Net domestic financing 2.1 1.2 1.7 1.3 0.6 Sources: IMF Improving the Investment Climate 41. A lasting peace will help attract investment as all sectors have been disrupted due to the conflict. In addition to insecurity, a recent Investment Climate Assessment7also pointed to: (i) high transport costs; (ii) deficiencies in access to power and telecom services; (iii)weak financial sector; a (iv) rigid labor laws and (v) excessive government bureaucracy and corruption as impediments to increasing investment. Below, we review the issues that constrain the investment climate for both agricultural and non-agricultural growth (transport costs, power, the financial sector and telecommunications), discuss proposed reforms in the delivery of agricultural services and finally move onto one specific constraint on the manufacturing and service sector - labor regulations. The section on governance discusses measures to reduce corruption and improve the effectiveness of key public agenciesthat will also contribute to improving the investment climate. Biggs et al(2000) `The Business Environment and Manufacturing Perfoimance in Nepal' World Bank1Federationof Nepalese Chambers of Commerceand Industry. 13  42. Broad-based growth will require raising the productivity of agriculture and stimulating off- farm employment. The three-pronged strategy to do so, articulated in the PRSP, aims at removing the bottlenecks that constrain the investment climate in the rural sector (e.g. poor physical infrastructure, limited access to credit, unreliable power supply), improving the effectiveness of agricultural services (extension, research and irrigation) and strengthening public expenditure management in the agricultural sector (see sections on `creating fiscal space' and `governance'). This follows a series of first generation reforms that have liberalized input and output markets and greatly reduced policy distortions. On the agriculture input side, the subsidy on urea was completely phased out in 1999while subsidies on other fertilizer types were removed earlier in 1997. More importantly, the relinquishment of the government monopoly on fertilizer transport and distribution to the private sector has led to greater fertilizer use8.However, fertilizer use is sharply correlated with distance to markets as are crop sales, crop diversification and the use of modern technology. The level of commercialization and the productivity of Nepal's agro-processing industry is also low by regional standardsg.Hence improving access to physical infrastructure, improved power supply and greater access to telecom services i s an essentialpart of a pro-poor rural growth strategy. 43. Improving the effectiveness of agricultural services: There is also a clear need to improve the effectiveness of extension, research and irrigation services. Extension services are beingdecentralized to the district level and contracting-out pilots are in place for both extension and research services. HMGNexpects to expand the contracting out of these services to the private sector and NGO's, with greater involvement of farmer's groups, in line with its Agriculture Perspective Plan (APP). HMGN will also scale up its programs that promote crop diversification and more intensive farming practices through appropriate water management and extension activities - for instance the `On Farm Water Management' program will be expanded from the current nine districts to twenty districts. Agriculture researchi s being administered by a newly createdNational Agricultural Development Fundwhich will be given autonomy in 2003104 and made more demand-driven. Only 15 percent of Nepal's cultivable land is under year-round irrigation partly due to poor recovery of operations and maintenance costs in surface irrigation systems. HMGN is in the process of revising the current Irrigation Regulations in order for water users to impose sanctions on irrigation water charge defaulters. A process of contracting out the management of mediudlarge scale irrigation projects to the private sector will be initiated by mid 2004. Moreover the subsidy for shallow tubewells was eliminated in 2000 but they remain for deep and mediumsized tubewells. Inorder to ensure rational investment decisions HMGN will review the existing incentive structure for irrigation. 44. Nepal has taken important steps to increase trade and competitiveness. Nepal has one of the most liberal trade regimes inthe region - the average tariff, after a decade of reductions, stands at only 14% (and a top rate of 30%) compared to 40% in 1990and 32%, currently, in India. Along with trade liberalization, important steps to promote domestic competitiveness has contributed to the respectable export-led growth rates witnessed in the 1990s (see Economic Context section). The industrial sector has been largely deregulated, reductions in corporate and trade taxes have taken place and private sector participation in infrastructure provision i s encouraged. The Government has taken impressive steps over the past year to accelerate the procedures for market entry". A new Bankruptcy Bill i s being drafted to facilitate exit. In September 2003, Nepal completed negotiations to join the World Trade Organization (WTO). Fertilizer use increasedfrom an average of 28kghectare for a four year periodprior to 1997 to an average of 43 kghectare between 1998-2000. See F.Shilpi (2003) `Nepal'sAccession to WTO: Constraintsand Optionsfor Improving Agricultural Competitiveness' World Bank (draft) loDiscussions with the private sector confirm that the registration process i s no longer a major obstacle to doing business in Nepal-most businesses are registered within ten days. 14  45. However, despite these reforms, productivity remains low in Nepal and the external environment i s becoming increasingly challenging. Nepal will have to improve its competitiveness to cope with the imminent withdrawal of the Multi-Fibre Arrangement quotas and cope with WTO accession issues. Recent analytical work on trade and competitiveness" point to constraints found by the Investment Climate Assessment (transports costs, access to power and telecommunications, the financial sector and labour rigidities) that are discussed below. In addition, there are certain trade- specific constraints; a key one being the need to addressing delays in customs and transshipment to Kolkata port. It i s clear that piecemeal reform in Customs will not be effective given the nexus between governance, infrastructure and customs procedures in reducing these delays. Hence, HMGN i s embarking on a multi-faceted program of customs reform by: (i) introducing more selectivity in customs inspections; (ii) harmonizing its trade classification with the Indian EDIFACT system to facilitate transshipment; (iii) re-drafting the Customs provisions to make them consistent with WTO provisions; (iv) developing a code of conduct specific to Customs employees; and (iv) creating a post- entry valuation section. 46. Lowering transport costs: Nepal's landlocked and mountainous terrain mean that high transport costs are a key constraint to agricultural productivity and manufacturing exports". While the density of the road network i s still very low (0.1 km per square km), significant rehabilitation work, has resulted in a strategic road network that has been brought up to a maintainable condition. Hence the establishment of the National Roads Board in late 2002 i s a critical and timely reform as cross- country experience shows that the quality of the road maintenance expenditures improves with this form of institutional arrangement. This is particularly important in the case of Nepal, as the PER highlighted the significant under-fundingof operations and maintenance inthe road sector. Inorder to carry this process forward it i s important that the fuel levy receipts are channeled to the Roads Board in a timely manner. However, while improving road maintenance is critical, increasing the road network is equally important for both rural farm and off-farm activities and further development of tourism. In this context, HMGN has developed a sequenced plan to connect all district headquarters and responsibilities for local road and trail development are being devolved to the district level. In addition to a more extensive, better maintained road network, a recent study13 highlighted the importance of Inland Container Depots (ICDs) in reducing the cost of transport for Nepali exports. Two inland container depots are now managed and operated by private terminal operators and by mid 2004 it is expected that the Sirsiya ICD, with a direct link to the Indian railway system, will also begin operations contributing to lowering the cost of international transit. 47. Improving access and reliability of power: In view of Nepal's physical characteristics and abundance of water resources, hydropower is a key potential source of growth for Nepal. However, less than 2% of Nepal's hydropower generation capacity has thus far been de~eloped'~.Around 25% of the populationhave access to electricity but disparities are stark with over 90% of urban households connected incontrast to an estimated 14% in rural areas. Another key issue inthe power sector i s the relatively high cost of electricity inNepal compared to its South Asian neighbors - this is due both to technical factors, notably the capital intensive nature of hydropower development involving high upfront costs15and to inefficiencies within the Nepal Electricity Authority (NEA). It i s clear that the l2 The share of transports costs inexports are around 50% more than other competitorcountries - see 'Nepal Tradeand 'Nepal: Integrated Framework Study' (HMGNI World Bank2003). Competitiveness Study' (World Bank 2003) for more details. l3 Subramanianandh o l d (2001) 'Forging SubregionalLinks inTransportationandLogisticsinSouthAsia' l4 Out of ahydropower generationcapacity estimatedat 43,000 MW, only about 522 MW havebeendevelopedwith around 119MW underconstruction. l5 About 80% of power generationi s hydro-basedwhich is significantly more expensivethan thermal generation; small size of generationunits andthe lack of inter-connectionsall contributeto highcosts. 15  investment requirements to significantly expand access to power i s beyond the capacity of HMGN or the NEA. Hence, Cabinet approval of the Hydropower Development Policy in 2001 was an important step as it paved the way for private sector operators inelectricity generation and distribution - there are now three Independent Power Producers operating in Nepal. In order to promote micro hydropower projects in isolated rural communities, HMGN provides a one-off subsidy to private entrepreneurs. Actions expected to take place in 2004 include the establishment of the Power Development Fundto promote greater private sector investment, and the development of guidelines for rural electrification schemes through cooperatives. By 2005 an independent regulatory body i s expected to be in place and around ten community based micro-hydro schemes operational. The internal unbundling of NEA through signing of performance contracts between the NEA managementand generation, transmission and distribution centers -to improve the independence, authority and accountability of managers at all levels of NEA s inprocess and i s expectedto be completed inthe short term. Improved efficiency of - i NEA combined with the implementation of the Electricity Theft Control Act ought to reduce the current system loss of 23.4% to roughly 21% by the end of 2005, contributing to the reduction in the cost of power. 48. Improving the effectiveness of the financial sector: The two largest commercial banks, Rastriya Banijya Bank (RBB) and Nepal Bank Limited (NBL), accounting for close to 50% of banking sector assets, have an estimated negative net worth amounting to 7-9 percent of GDPbecause of large non-performing assets. HMGN has made it clear in its Financial Sector Strategy Statement (2001) that the State will withdraw its ownership stake (100% in RBB and 40% in NBL)from these two banks by seeking to fully privatize them. The road-map to achieving this `end-game' will require HMGN deciding whether these Banks will be merged or whether they will seek private sector participation as two separate institutions. IDA i s providing technical advice on this issue through its Financial Sector TechnicalAssistance Project. 49. A key reform that overcame fierce resistance was the appointment of external management teams at NBL in mid-200216 and in RBB from January 2003. Lending by these banks was often politically-motivatedor involved insider dealing and hence reform initiatives were resisted not only by the banks' boards (and employee unions) but also by many well-connected borrowers. The management teams have signed performance contracts with HMGN. Key performance benchmarks that are being implemented are (i)improved accounting systems and compliance with disclosure requirements (ii) implementation of a retrenchment program and a revised remuneration package and (iii) aggressivepolicy,includinglegalaction,againstloandefaulters.Asasignofthecontinuityof an the reform process, one of the first significant steps taken by the new Government was the formation of a Loan Recovery Tribunal effective from July 16, 2003. The Tribunal i s expected to speed up the loan recovery from the identified major defaulters in the banking sector. The current process of cost restructuring, being implemented by the new management, is an important step towards the next phase of balance sheet restructuringwhich will be done at the point of sale. The exact fiscal cost of bringing these two banks to an internationally acceptable level of capital adequacy cannot be determined precisely yet, as the balance sheet position i s being determined. However, it is clear from the very approximate negative net worth estimates that HMGNwill not be able to carry the full burden of re- capitalizationand external assistance, including from IDA, will be needed. 50. Strengthening the ability of the Central Bank to carry out its core functions is also critical. The new Nepal Rastra Bank (Central Bank) Act increases the independence and authority of the central bank and gives NRB greater authority to supervise commercial banks, including severely punishing l6 take To over managementof the majority privately-ownedNBL, the CentralBank invokedprovisionsof the new NRB Act andsuspendedthe NBLboard. 16  irregularities by bank officials. The Central Bank is being restructured and a process of shedding excess labor i s currently being implemented. Further improvements in the legislative framework are required and the Banking and Financial Institutions Ordinance, which will tighten regulatory rules governing all deposit-taking bodies, i s expectedto be enacted shortly. 51. Access to micro-finance and agricultural credit is an important element of rural farm and off- farm growth. HMGN has introduced a number of important legislative changes recently to facilitate the growth of the micro-finance sector (e.g. the Development Banking Act and the revisions to the Financial Intermediaries Society Act). However, important reforms remain inthis sector. It i s expected that Government representation will be withdrawn from the Boards of the Grameen Bikas Banks and professionals appointed in their place. In the medium run, the Cooperatives Act will be amended to address its shortcomings". 52. Improving access to telecom services: The development of a competitive telecom sector, with wide outreach, i s important to reduce the costs of doing business and improving access to relevant market information. The telecom sector reform program has made significant progress over the past year with the establishment of a regulatory body, the Nepal Telecommunications Authority (NTA), and the undertaking of various initiatives to introduce competition such as the licensing of over 70 VSAT, radio paging, and internet service providers. It is also expected that inthe next few months, a new board of directors will be appointed in order to convert the Nepal Telecommunications Corporation into a Company under the Company Act. In January 2003, HMG and NTA made the decision to re-launch the licensing of the Rural Telecommunications Service (RTS) to a private operator for 534 rural VDCs - i.e. roughly one-fourth of all communities currently without access to telephones. A private operator was selected in September 2003 and it i s expected that operations will commence inthe next few months. 53. Relieving the labor law bottleneck: A flexible labor market is important for Nepal's export and tourism led growth prospects. Industries such as garments, hotels and restaurants need to adjust to fluctuations in demand and require high service standards which in turn requires the ability to lay off workers without excessive red tape and the ability to set performance based pay. The Nepalese labor market is currently definedby some of the most rigid laws in the region that are a key impediment to investment, dilutingthe progress made inreducingthe barriers to starting a new business. 54. The 1992Labor Act grants "permanent" status to workers who have completed more than 240 days in a business with over ten employees. Dismissing permanent workers and/or closing failing ventures requires the consent of the Department of Labor, a costly, lengthy and often arbitrary process. The Act discourages informal businesses from becoming formal and/or growing beyond ten workers. It also encouragesemployers to hire and fEe workers before they can become permanent and/or recruit Indian workers who are unable to enforce their rights. The labor law also mandates the payment of wages basedon hours worked, and specific job descriptions as well as annual increments which limits transfer of employees and reduces the incentives for increased productivity. Moreover, having five different minimum wages for different occupational categories also limits labor mobility including from one enterprise to another within the same holding company. l7Amendment to the Cooperatives Act need to include: (i) formation of more than one savings and credit cooperative per the district; (ii) permission for RMDC to lendto sound cooperatives that meet RMDC's lending criteria; (iii) permission for the formation of women-only cooperatives and (iv) permit cooperatives to work in more than three VDC's. 17  55. HMGN has committed itself to increase labor market flexibility by amending the relevant legislation.** However, these are sensitive issues in Nepal and will require a consensus building exercise between government, the employers and the unions. Although there was an earlier move to amendthe labor laws by ordinance, all parties agree onthe need for constructive dialogue and the need for parliamentary approval of any proposed amendments. Tripartite discussions are ongoing brokered by the L O . As part of the process, an appropriate safety-net will have to be developed; hence the earliest feasible time-frame for an amendment of the relevant laws i s mid 2004. Reforms to Improve Service Delivery 56. Improvements in service delivery are taking place through a gradual process of decentralization, greater empowerment of local communities inthe management of social services and increased private provision of social services. Greater control of resources and an improved `voice' in local service delivery issues are important in improving the quality of local services and eventually development outcomes. In Nepal's context, greater control of resources by communities has the added benefit of partly addressingthe disenchantment inrural areas that fueled the insurgency. 57. Strengthening the decentralization framework: During the past decade Nepal has taken significant steps towards decentralization. In 1992, through separate Local Government acts for villages, municipalities and district bodies, Village Development Committees (VDCs), District Development Committees (DDCs), and Municipalities were created. The Local Self-Governance Act (LSGA) came into effect in 1999 and two years later a Fiscal Commission was created to design and implement an intergovernmental fiscal system. The key concern with the current state of affairs i s that the terms of Local Governments have expired and elections have not been held because of security issues. Civil servants are currently carrying out the administrative functions in the DDCs and VDCs. InSeptember 2003, HMGNdecided to bolster implementationcapacity at the local level by filling mayor and DDC chairmen posts on an interimbasis untillocal elections are held. 58. However, even during this interim period the reform agenda to strengthen decentralized service delivery i s likely to move ahead. First, the government has identified 23 sectoral acts conflicting with the LSGA. Of these, 14 acts have been redrafted and it i s important that this exercise be given priority since service delivery functions have already begun to be channeled through local entities. Second, local governments inNepal currently have limited capacity infinancial management, auditing, budgeting, and disclosure of information. Hence, a capacity building programneeds to be in place along with measures to improve transparency. Third, current block grants do not address inter- jurisdictional inequalities, compromising the potential role of fiscal transfers in reducing regional disparities and inequality. Hence by mid 2004, it i s expected that HMGN will prepare a fiscal framework in accordance with the LSGA and that piloting of this fiscal framework i s likely to take place in2-3 districts by mid 2005. 59. Improving the quality of education services: There has been modest progress in primary enrollment rates and literacy over the past decade, but the quality of education remains poor. Drop-out and repetition rates are high in primary and pass rates inpublic schools are significantly lower than in private schools. In an effort to improve the quality of education, the 7* Amendment of Education Act 2001 provided for the devolution of school management to communities, represented by School Management Committees (SMCs). Experience in other countries suggests that decentralization to school management committees i s an effective mechanism to improve education quality particularly Relevantlegislationincludes:Labor Act 1992, LaborRules 1993,Labor Court Laws 1997,TradeUnionAct 1995,Bonus Act 1971, IndustrialTrainingAct 1982,ForeignEmploymentAct 1985 andthe CompaniesAct. 18  when there are cohesive communities and motivated teachers". The guidelines for schools transfer to communities or VDCs/municipalities were adopted by the Cabinet in September 2002 and thus far over 270 schools have been transferred. These committees will oversee teacher recruitment, monitor attendance as well as make decisions on resource utilization, all measures that are likely to improve the quality of education, reduce drop-out rates and improve test scores. While these transfers are small inrelation to the total number of schools inNepal (around 26000 primary schools), the importance of these initial transfers lies in the shift in mindset that they symbolize. This `shift' away from a `Kathmandu controlled' system to one where key decisions are made at the local level stems from a recognition by key decision-makers that in a diverse country like Nepal, devolving authority to the grassroots i s essential to improving the quality of services and overcoming the prevailing disillusionment with Government services. The process of school transfers is expected to pick up pace over the next two years2'. The Bank and HMGN are in the process of launching an assessment of the impact of school decentralization on educational quality and outcomes which will provide feed-back into the design of the transfer process. 60. However, it is clear that transferring schools to communities i s only part of a wider effort to improve education quality and redress gender, caste and ethnic disparities. Measures are being developed to: (i) increasethe primary scholarship amount for the first child of households from which no member has completed primary school and none are currently attending primary school; (ii) provide free education for first girl and first Dalit child of households from which none have completed lower secondaryhecondary schools and none are attending lower secondary/secondary school; and (iii) provide an incentive grant for schools recruiting female teachers and bilingual teachers. 61. Improving the quality of health services: Nepal has significantly improved child survival rates, reduced fertility and achieved gains in communicable disease control in the nineties". However critical challenges remain, including a high maternal mortality rate of 539 per 100,000 live births, widespread malnutrition and wide disparities in health outcomes across regions22.Weak institutional capacity, inadequate public financing and inefficient spending, limited coverage and poor service quality, poor value from private health spending and a difficult topography, all impact health services and outcomes. HMGN has developed a Health Sector Strategy in 2002 to address these issues. Key elements include (i) decentralizing service delivery; (ii) introducing an Essential Health Care Package that focuses on reproductive health, child health, communicable disease control and improved outpatient services; (iii) public-private partnerships. 62. HMGN has already initiated action on decentralizing service delivery by handing over the management of some 460 Sub-Health Posts (SHps) to the SHp Management Committees in eight districts. Implementation of the Essential Health Care Package (EHSP) in twelve pilot districts in l9See for example the experiences of Nicaragua and Pakistan (Rawlings, Laura B., 2000. "Evaluating Nicaragua`s School- Based Management Reform." and Sedlacek, Guilheme and Pamela Hunte, 2000, "Evaluating the Impacts of Decentralization and Community Participation on Educational Quality and the Participation of Girls in Pakistan". In Michael Bamberger, ed., "lntegrating Quantitative and Qualitative Methods in Development Research" World Bank, Poverty Reduction and Economic Management Network, Gender Division, Washngton, D.C.) 2oB y mid2004, it is expected that there will be an additional 1,000primary schools, 200lower secondary schools and 100 secondary schools transferred to community management. By the end o f FY 2005, the transfer of an additional 2000 primary schools, 400 lower secondary schools and 200 secondary schools to community management i s expected to take place. 21Between 1990 and2000, infant mortality declined from 107 to 64 per 1000live births and fertility rate by over a child from 5.6 to 4.1 children per woman. Effective TB treatment is available in about 90% o f the country, and polio i s almost eradicated. 22For example, life expectancy at birthranges from 74 years in Kathmandu to only 37 years in the mountainous Mugu district. 19  2003/04 will precede a wider roll-out in subsequent years. HMGNintends to improve the management of hospitals by contracting out two district hospitals to the private sector by 2004 and another four by 2005. 63. Improving the effectiveness of drinking water services: The PRSP estimates the national water supply coverage at about 71% and sanitation at 25% with considerable regional variations. One of the key constraints facing the sector is a multitude of service delivery actors23and HMGNi s inthe process of revising the Rural Water Supply and Sanitation Policy to clarify the various roles and responsibilities in line with the emphasis on decentralized service delivery. A draft Act i s also being prepared to make the Rural Water Supply and Sanitation Fund Development Board an autonomous agency. Inorder to redress the poor management of urban water supply inKatmandu, the Government has revised the Nepal Water Supply Corporation Act which paves the way for a private operator to manage water supply and sanitation operations in the valley. Once a private operator i s in place in Kathmandu, HMGN will take the necessary steps to introduce private sector participation in towns outside the valley. The formulation of a new Municipal Service Act to establish a National Regulatory Board and a KathmanduValley Water Authority i s also inprogress. Reforms to Promote Social Inclusion 64. The reforms neededto improve social inclusion inNepal and promote greater equity in access to resources, opportunity and voice, are structural innature. They reflect a shift in deep seated gender, ethnic and caste-basedsocial hierarchies and they cannot be expectedto occur with the stroke of a pen. But since the reinstatement of democracy in 1990there is greater openness to a diverse array of civil society voices - includingthose of historically marginalized groups. Moreover, the steady critique of the old "feudal" system coming from the armed rebels has createdconsiderable public momentumfor change. Evidence for this is inrecent (September 2002) amendment to the `Mulki Ain' (national code) inheritance laws which, though still not fully equitable to women, did widen the conditions under which they can inherit parental or spousal property. There was a fierce battle in Parliament over this, but compromises were made and some important changes have materialized in women's access to productiveresources. 65. This momentum for change i s strongly reflected in the PRSP and the range of strategies it proposes for overcoming the culturally embedded barriers to equity of access which are increasingly seen by reformers in government as perpetuating the basis for violent conflict. Among the specific measures outlined are targeted programs that will be implemented to improve access to education for girls and children from minority households (see section on `improving education quality' for further details). Women and ethnic minorities are also under-representedinthe civil service. HMGN, with the support of donors such as UNDP, and ADB are in the process of developing an Affirmative Action Planto improvethe gender diversity inthe civil service. 66. A key element in the overall approach to social inclusion is the Poverty Alleviation Fund (PAF). The PAF can be seen as a direct targeted effort to reverse the vicious cycle of social exclusion poverty and conflict. HMGNenvisages the PAF to: (i) fund community projects with an emphasis on 23The principalpublic sector institutionsare the Department of Water Supply andSewerage (DWSS), the NepalWater Supply Corporation(NWSC) and the RuralWater Supply andSanitationFundDevelopmentBoard(the Board)reportingto the Ministry of PhysicalPlanningandWorks (MPPW).A recent additionto the institutional frameworkis the District InfrastructureDevelopmentOffices(DIDO) inthe Ministry of Local Development set up to assist District Development Committees (DDCs) inproviding communitybased water supply and sanitation services. Thus, with DIDO officesin75 districts there are now 150CentralGovemmentofficesinthe sector.Moreover,there are many non-govemmentalagencies (VNGOs)programsproviding ruralwater supply and sanitationservicesandthe sector has over twenty donors. 20  conflict-affected areas; (ii) a single instrument where different development partners can come create together in a coordinated manner; and (iii) demonstrate to the numerous stakeholders innovative and effective ways of reaching poor and excluded groups. To achieve the above objectives, the PAF will target some of the poorest villages inNepal and will be implemented by communities themselves with the support of NGOs. The PAF ought to contribute to the harmonization agenda as donors can come together in a coordinated fashion to support targeted anti-poverty programs inNepal. 67. International experience has shown that social fund type institutions operate effectively with an autonomous board, with limited government representation and the draft PAF ordinance provides for such an arrangement. The PAF would operate through a lean structure with limited staff on competitive salaries. HMGN has approved the draft ordinance and appointed the Executive Vice- Chairmanof the new autonomousboardrecently. Reforms to Improve Governance 68. There i s a wide consensus that improving governance i s a crucial requirement for improvements in pro-poor growth and in service delivery. HMGN's strategy to improve governance includes: (i) improving financial management and procurement practices; (ii)strengthening anti- corruption and accountability institutions; (iii) improvingthe effectiveness of the civil service; and (iv) improving the functioning of key agencies. These components are clearly inter-linked; for instance technical measures to improve the financial management system need to be reinforced with incentives and sanctions that ensure compliance by strengthening the civil service and enhancing the credibility of anti-corruption bodies. 69. Public financial management: A joint HMGN-IDA Country Financial Accountability Assessment (CFAA) was carried out in 2001/02 and HMGN has begun implementing its key recommendations (see Box 3), monitoredregularly by a high-level committee chaired by the Financial Comptroller General. The CFAA indicates that although there are significant weaknesses in Nepal's public financial accountability system, the foundations for reform are in place. Nepal has an impressive legal and regulatory fiduciary framework but fiduciary risk in Nepal remains high primarily due to the lack of compliance with existing regulations. The reforms discussed below, and elaborated in Annex IV, are part of an integrated strategy to strengthen the financial management systemas well as the incentives for compliance. 21  70. Tying budgets with perj4omzance: A far-reaching reform that started in 2002/03, stemming from the CFAA, is the development of detailed work-programs and physical performance targets for each project in the development budget. The extent of physical progress, the amount of money spent and the priority level of the project i s now usedas the basis for the subsequent trimester's fund release. This has instituteda clear rule for fundrelease, replacing the ad-hoc politically influenced fundrelease system that the 2000 PER describes as `)perhaps the most significant procedural factor affecting project implement~tion"~~. Moreover, this form of monitoring will facilitate the preparation of reimbursement claims to donor agencies and help improve aid disbursements. 71. Improvingfinancial transparency: HMGNis committed to publicly sharing budgetary data in the public domain and in this spirit discussed the 2002/03 mid-year Budget review with the media. At the local level, District Development Offices have started publishing their annual work programs, budgets and amount spent. An expenditure tracking survey was piloted by HMGN for the education sector in 2002/03 and the results have recently been discussed with the education sector. HMGN plans to expand the number of sectors covered under future expenditure tracking surveys and will make theman integralpart of the PRSPmonitoringprocess. 72. Improving accounting and auditing practices: HMGN i s in the process of creating an autonomous Financial Accounting Standards Board and Board of Auditing Standards that will formulate appropriate accounting standards inorder for the public and private sectors to move towards internationally recognized accounting standards. A new Chart of Accounts i s being designed in line with the I M F ' s General Financial Statistics classification and i s expected to be piloted from the 2004/05 Budget. The Auditor General's accounts will be audited by a reputable external auditor and an external audit of the Central Bank will be carried out in2003/04, in line with the recommendations of the IMF Safeguards Assessment. 73. Procurement reform: Greater transparency in public procurement is also an essential part of improving financial management. A recent Country Procurement Assessment Report (CPAR) was conducted and while waiting for the new Procurement Law to be drafted and approved, the Financial Administrative Regulations were amended in September 2003 in order to: (i) include sufficient time for bid advertisement and preparation; (ii) prohibit post bid negotiations with any bidder and (iii) ensure that the lowest evaluated bidder be awarded a contract based on criteria that includes not only price, but also experience, capacity etc. Mediumrun measures are expected to include: (i) enactment of a new Procurement Law based on the UNICTRAL, model law for procurement; (ii) the creation of an independent procurement agency with functions to be defined by the new Procurement Law; and (iii) widespreadprocurementrelatedtraininginthecivilservice. more 74. Anti-corruption measures: HMGN has taken significant preventive measures to stem corruption. New legislation, particularly the Prevention of Corruption Act, has given the Commission for the Investigationof Abuse of Authority (CIAA) the power to initiate cases against all top officials, including the Prime Minister and his Cabinet, without the need to secure permission. The CIAA is enjoying increased status and prestige and, empowered by the recent legislation, has recently initiated a number of high-profile anticorruption cases.25Over the last two years, the number of complaints coming to the CIAA has increased by 194percent, and the disposal of cases has increased by over 300 percent. The number of new court cases filed on corruption related charges has increased by over 12 times (albeit from a very low base) and i s set to double again this year. In order to enhance its 24World Bank (2000) `NepalPublic Expenditure Review', Volume 1page 18. 25The CIAA has filed charges against three former ministers, 22 MoF civil servants, the Executive Directorof the national airline and the Joint Secretary of the Ministry of Physical Planning. 22  effectiveness, the CIAA i s developing an electronic database to track complaints and monitor action; improving training for its officers (mostly on deputation from other Ministries) in interrogation and prosecution techniques; and trying to secure better facilities by mid-2004. The CIAA has recently produced a five year strategy to guide the agency's expansion. Future priorities will include strengthening the CIAA's presence at the district level and addressing the backlog of earlier cases currently pending within thejustice system. 75. HMGN has also recently established a National Vigilance Center (NVC) located within the Prime Minister's Office, which i s tasked with advancing the anticorruption agenda within HMGN. The NVC has broad responsibilities, ranging from strengthening prevention and raising public awareness to monitoring the performance of corruption prone departments. A newly-constituted inquiry commission, headedby a supreme courtjudge, has been given sweeping powers to investigate the property of political leaders and bureaucrats. It has ordered about 500 public office holders- includingthe PrimeMinister and other Ministers-to disclose details of properties they own. 76. Civil service reform: The core civil service in Nepal comprises 106,000 positions, or roughly 0.4 civil servants per hundred population, which in per capita terms is one of the smallest in both South Asia and the developing world. The actual numbers are even lower, as the estimated vacancy rate is around 16 percent. The composition of Nepal's civil service is particularly skewed towards the lower tiers, with a much smaller number of senior administrative staff than in India and relatively more civil servants at the lowest Classless level (e.g. peon, driver, guard, etc). 26 Accountability mechanisms have historically been weak, performance and productivity low, and political interference indaily operations achronic problemoftentranslating into frequent transfers of staff. 77. Inorder to improve the efficiency and accountability of the civil service, the government has taken several important actions. A complete Personnel Information System (PIS) has been developed with support from the ADB. In spite of resistance from various ministries, Cabinet ordered the elimination of approximately 7,500 vacant positions in late 2002 out of a total of 17,000 (as of September 2003, over 6000 of these positions had actually been eliminated.) A partial decompression of salaries took place in mid 2000, though the salary structure remains very compressed. There have also been significant steps towards reducing politically-motivated transfers in government and as a result the number of transfers has almost halved inthe last three years2'. 78. Further actions planned include connecting the PIS to the payroll system to create a comprehensive human resource database (essential for tracking posts, vacancies, transfers, and forecasting future salary and pension liabilities). The PIS will shortly be expanded to cover the approximately 106,000 teachers and eventually extended to cover the police and armed forces. HMGN i s currently considering an ordinance that will delineate more clearly the roles of civil servants and politicians in administration, thereby reducing the scope for political interference. It i s also taking measures to make the "advisor" function more transparent. Outsourcing of selected support activities; a position reclassification exercise to permit greater decompression of salaries; and selective elimination of remaining vacant positions are planned by mid-2004. Transfer data will be publicly reported inorder to promote greater transparency in 2004. Various measures to enhance the ethnic and gender balance of the civil service are also under consideration (see section on `Promoting social inclusion'). 26 Source: IMF (2002) `The Civil Service Sector :Key Issues and Reform Plans' Nepal Selected Issues Paper. 27 The number of transfers has been substantially reduced inthe last three fiscal years: from4.497 in FYOO to 2967 in FYOl and2553 inFY02(Source: ADB Governance ReformProgram). 23  79. Agency reform: The government has also taken action to improve the functioning of key agencies. Govemance Reform Units (GRUs) have been established in three ministries to advance reforms in individual line departments, and they will be expanded to other ministries over the course of the next year. In the Income Tax Department, for example, the assessment, collection, and audit functions have been separated to prevent all three tasks from being concentrated in the hands of a single officer, as was the case earlier. The Income Tax Department has introduced a citizens' charter but this needs to be revised based on stakeholder consultation to reduce the time-limits for receiving refunds, tax-payer identity cards, and to clarify grievance redressal procedures2*.Other agencies with large public interface where service delivery gains could be made by mid 2004 are in land and property registration as well as passports. Improvements in other functions of district administration are expectedby mid2005. 80. Access to information: Major measures introduced to promote transparency include the passage of a Political Party Law in 2002 requiring the Auditor-General to audit the accounts of all parties; a decision to open up FM radio programming to both private and community participation; and the establishment of a National Vigilance Center in the Prime Minister's Office. These steps will be furthered by public reportingof audit findings relatingto political parties; creating a web-portal for HMGN (initially with links to other departments, forms, information on schemes and programs, and an official directory) by end 2003; drafting Freedom of Information (FOI) legislation, based on wide public consultation, by mid2004; and institutional strengthening of the National Vigilance Center also by mid2004. V. TheProposed Credit The World Bank's Assistance Strategy 81. A Country Assistance Strategy Progress Report (CAS-PR) for Nepal was discussed at the Board in December 2002. The CAS-PR outlined the rationale for remaining in the low case of IDA lending since the time of the previous full CAS in 1998 and proceeded to argue the case for moving Nepal to a base case lending scenario. This shift to the base case was endorsedby the Board in light of the significant reform initiatives taken by HMGN over the past twelve months (see previous section for details) and the consequent achievement of the majority of base case triggers. 82. The CAS-PR confirmed that the key elements of the earlier full CAS remain valid with the Bank continuing to act as a change agent to: (i)catalyze the necessary policy reforms required to generate growth and improve service delivery through greater emphasis on programmatic lending and relevant analytical work; (ii) strengthen the focus on creating an improved governance framework both through policy dialogue and as conditions for accessing IDA resources; and (iii) build human and physical capitalthrough an appropriate mix of technical assistanceand investment projects in selective sectors where IDA has a comparative advantage. 83. A full CAS i s currently under preparation and will be discussedat the Board at the same time as the proposed PRSC. The full CAS articulates the importance of moving towards a more "programmatic" approach inresponse to HMGN's request for budgetary assistanceto help implement its reform program. In addition, the strategy envisions the continued use of traditional investment lending for community-based projects and for piloting/testing new instruments--e.g., a Second Rural Water Supply and Sanitation Project using a community-demand driven approach in poor rural areas, a Nepal Community School Support Project to support the devolution of schools, a Health Sector 28There i s a weekly public hearing to resolve issues but the current charter makes no reference to it. 24  Program Project to support the implementation of the Essential Health Care package and a Poverty Alleviation Fund Project to channel resources to the poorest of communities. Moreover, through a number of on-going operations - such as the Rural Infrastructure Project, Rural Water Supply and Sanitation, and Irrigation Sector Development - community-driven approaches have been tested, local capacity strengthenedand valuable lessonslearnt towards improving service delivery at the local level. 84. Analytical work: The reforms underway draw on a wide variety of formal and informal analytical sources. World Bank involvement in analytical work includes an Investment Climate Assessment (2000) and a Trade and Competitiveness Study (2003) that contribute to the understanding of the growth agenda. A 2000 Public Expenditure Review, a 2002 Country Financial Accountability Assessment (CFAA), a 2002 Country Procurement Assessment Report (CPAR) and on-going support to the MTEF process form the basis of reforms in public expenditure management and improved accountability. A 1999 Poverty Assessment and a 2001 Demographic and Health Survey report form the basis of the knowledge on poverty and changes inliving standards.A full household survey (NLSS 11)is currently inthe field (data collection hasbeendelayeddue to the civil conflict) and a fullPoverty Assessment is planned once the clean data set is available. As part of this work, the Bank will provide technical support and capacity building in poverty analysis and more broadly, monitoring and evaluation issues. Preliminary work has also been done for a Country Social and Gender Analysis that will examine the causes and consequences of gender, caste and ethnic social exclusion in Nepal and develop strategies to support government, civil society and donor efforts to overcome these barriers. With support from the ADB, a civil service census was carried out in 2000-01 that provides data on civil service size and composition. Analytical work is beinginitiated by the Bank (Nepal country team and DECRG) incollaboration with local analysts to better understand the political economy of reform in Nepal and provide guidance to the Bank's operational engagement inpolicy reform. Moreover, an assessment of the impact of decentralization of school management to school committees will also be launched. A policy note on agriculture that will provide further guidance on the future policy reform agenda inthe sector is also underway incollaboration with FAO. This note will also lay out the type of support the Bank can provide through a combination of investment lending, budgetary support and technical assistance. Finally, a Development Policy Review i s planned for 2003/04 and will help to refine the policy agenda for 2004/05 and beyond. Figure 1 in Annex 1 illustrates the link between analyticalwork and the proposed PRSC lendingprogram. 85. Coordination with ZMF and other donors. The Bank i s working closely with the IMF on macro-economic and structural issues and the PRSC and PRGF processing schedules have beentightly coordinated. A Joint Staff Assessment (JSA) of the PRSP i s also in progress. The ADB has recently approved a budget support operation that focuses on privatization and civil service reforms issues - there has been close coordination on these issues between the preparation teams of both the IDA and ADB credits. IDA and DFIDarejointly supporting the MTEFwork andreforms ingovernance, health and privatization, supported by the PRSC, benefit from DFID's long-standing dialogue and technical assistance. Finally, a coordinated donor effort in Kathmandu--including the Bank, IMF,ADB, DfID, Denmark, Japan and Norway --has been supporting the implementation of HMGN'sImmediate Action Program(IAP). Table 4 summarizes the key policy themes being supported by the PRSC and the key donors involved ineach sector. 25  Table 4: PRSCThemesand Partnershipswith OtherDonors IBroad-Based Economic Growth Macroeconomic stability IMF . _ _ _ _ ~ _ _ _ . _ _ _ - ~ Fiscal reforms IMF,ADB _--________ UK,Denmark, Germany IMF,ADB UK,Germany _. Financial sector . . __ __ . . SOE restructuring ADB UK Agriculture I irrigation ADB, FAO, IFAD, Australia, Canada, Denmark, OPEC Fund, EU Finland, Germany, Kuwait Fund,India, Japan, Norway, Saudi Fund, Switzerland, UK,US Trade IMF,UNAgencies, Norway, UK WTO - ~- ____ ____ -I I ____ __ Labor . . Roads Germany, India, Japan. Switzerland, UK,US Power Canada, Denmark, Finland, Agencies IGermany, Japan, Norway, Sweden, US Improving Service Delivery __ ADB, UNAgencies_ _ _ _ _ ~ Denmark, Norway, UK, US ~ ________ - ~ _ _ _ Education ADB, EU,_UN Canada, China, Denmark, Agencies Finland, Germany, India, Japan, Norway, Switzerland, . .. UK EU,UNAgencies Auitralia, __China,-Germany, __ --__. .- India, Japan, Norway, Germany, Switzerland, UK, I Drinking water and sanitation 1 ADB, us UNAgencies Finland, Japan, Norway, UK Poverty Alleviation Fund UK ImDroving access to schooling ADB, EU,UN Denmark, Finland, Japan, I I Agencies Norway, Netherlands: UK Improving civil service diversity ADB, UNAgencies Canada, UK I I t k-1 Good Governance Civil service reform ADB, UNAgencies UK I _ _ _ _ _ ~ Anti-corruption Canada, Denmark, Norway, . - Switzerland UK,-US - - - Financial management Germany, Denmark, 26  Credit Designand Fiduciary Issues 86. The proposed Poverty Reduction Strategy Credit (PRSC) program i s based on the PRSP, linked to the CAS objectives and built on appropriate structural, social and fiduciary analysis. The PRSC Iaims to: (i) support Nepal's reform champions in implementing far-reaching reforms that revive growth, improve service delivery, promote social inclusion and improve governance; and (ii) contribute to maintaining a sound macro framework and inprotecting high priority programs by filling part of Nepal's financing gap. 87. Credit design: We propose to support Nepal's reform program with a $70 million PRSC I, that will be the first slice of a multi-year programof support for the PRSP. Upon approval by the Bank Board, the PRSC Iwill be disbursed in the second quarter of FY04 based on the significant reforms undertaken over the past eighteen months including the implementation of all prior actions agreed during the PRSC Ipreparation process. Box 4 as well as Annex Isummarize the completed prior actions for the PRSC Ias well as indicative prior actions for PRSC 11. The amount of the credit is related to the intensity of the reform effort and the medium term macro-economic framework discussedearlier. 88. The PRSC Iactions form the first part of a larger medium-runreform agenda laid out above and in Annex I. The program supported by future PRSCs will retain sufficient flexibility to support a reduced core part of the overall program with a smaller loan amount should the full set of proposed reforms not take place. Moving forward with the proposed PRSC Iin Nepal i s important in order to: (i) meaningfulreformsthatwillassistinrevivinggrowth, reducepoverty andprovidethe support foundations for sustainedpeace; (ii) maintainthe credibility of the Bank and of `change-agents' within Government; and (iii)provide the fiscal resources to protect pro-poor expenditures in formerly conflict-affected areas, limit domestic borrowing and maintain macro-economic stability. 89. The medium term program's objectives, described above, will be monitored using specific outcome and intermediate indicators. The implementation of the growth strategy i s expected to gradually revive growth to 5.5% by 2005/06. This will be achieved by creating fiscal space for growth-enhancing public investments and through an improvement in the investment climate. Hence the intermediate indicators that will be monitored include (i) the share of highpriority projects in the Budget; (ii) access to basic infrastructure (roads, power, telecoms) services and (iii) greater reduced costs of doing business. The medium term strategy also aims to improve social indicators. Access to, and the quality of, education, health and drinkingwater services will be improved through a process of community involvement and private sector participation in social services. Access to these services will also be made more inclusive and the proportion of women and minority households that benefit will rise significantly. User surveys will also be used to measure improvements in governance and the quality of public services and will reflect the extent that the foundations for sustainedpeace have been laid (see Annex Ifor details on the medium term outcomes and monitoring indicators). 90. Fiduciary issues: The disbursements under the proposed PRSC program will be closely aligned with HMGN's budget cycle, in order to improve resource predictability. The PRSC Iwill follow the Bank's simplified disbursement procedures for adjustment operations. An important mitigating factor for the high fiduciary risks i s the government's commitment and demonstrated progress in the implementation of its public financial management reform agenda. The Government will open and maintain a Deposit Account with the Nepal Rastra Bank (NRB) into which the proceeds of the Credit will be disbursed. Disbursement will not be linked to any specific purchases and procurement will follow normal Government policies and procedures. If any portion of the Credit is used for ineligible purposes as defined by the Development Credit Agreement, IDA will require the 27  government either to returnthat amount to the Deposit Account for use for eligible expenditures or to refundthe amount to IDA. 91. The NRB will provide the required information on the receipt and use of the Credit funds and will prepare annual financial statements, upto and including the fiscal year in which the balance inthe Deposit Account is zero. The financial statements of the Deposit Account will be audited by independent auditors acceptable to IDA under terms of reference in accordance with acceptable international standards of auditing. 92. Environmental issues: The main environmental challenges in Nepal pertain to the sustainable use of natural resources and adequateintegration of environmental planning indevelopment programs and their implementation. HMGN has responded to the environmental challenges by incorporating conservation activities in sectoral plans and programs. Furthermore, environment-related provisions have been incorporated in various actsz9.Despite these efforts to address environmental management, weak institutional capacity and poor coordination has constrained the implementation of various environmental policies and programs. There i s also a significant gap between the content of the international environmental conventions and their implementation at the national level. With a large donor and NGO presence in this area, the CAS proposes that Bank involvement in the environmental agenda be highly selective, focusing on helping HMGN articulate an effective strategy for environmental conservation, management and capacity building. 93. There are three types of policy reforms supported by the PRSC that may potentially have an environmental impact: (i) SOE reform; (ii) out of the kerosene subsidy and (iii) phasing expanding access to electricity. In cases where SOE's are leased or sold to the private sector, HMGN would retain liability for any past irreversible impacts (stemming from land use changes and air pollution emissions). Assets that are sold would be operatedunder existing environmental regulations pertaining to soil excavation and control of industrial emissions. The phasing out of the kerosene subsidy is also unlikely to lead to any significant increaseinfirewood consumption as it is mainly usedfor cooking in urban areas and among the relatively well-off. Hence the environmental impact i s expected to be negligible. Finally, the reforms to increase access to electricity in rural areas center around the promotion of small and medium scale hydropower projects that will replace the need for fossil fuel based power generation plants. Moreover, the expansion of grid connected electricity will reduce the demand for keroseneusedfor lighting thereby reducing the impact of kerosene subsidy elimination on poor households. 29Environmental provisions feature in the Local Self-Governance Act (1998),the Forest Act (1992),the National Parks and Wildlife Conservation Act (1973 and amended in 1993),the Environment Protection Act (1996). 28  DX 4: Prior Actions for PRSCIand Indicatii Objectives PRSC Z PRSC ZZ (Indicative actions expected by Sevtember 2004) Pro-poor 2002/03 development budget scaled down and Draft relevant legislation to make labor growth prioritized [Done - 160projects dropped and employment andretrenchment laws more remaining project classified into high, mediumand flexible. low priority] Rationalize incentives for imgation to Adjust retail petroleum prices to cover the cost of promote greater private sector investment purchase, transport and distribution inorder to inimgation. reverse large petroleum-relatedlosses [Done] Transfer fuel levy receipts to Roads Board Establish new autonomous Road Board and take ina timely manner to ensure regular necessary steps to beginoperations of Road Board. resources for road maintenance. [Done] Makethe Birgunj ICDoperational through Dissolve Boards, introduce new professional finalizing the (Nepal-India) railagreement management teams at the two maincommercial and appointing a terminal management banks, Rastriya Banijya Bank and Nepal Bank operating company through competitive Limited[Done] tender. Service Transfer 600 primary schools, 100 delivery . Implement scheme to rationalize excess staff at NRB,NBL and RBB. 1 Transfer 150public primaryschools to School Management Committees to demonstrate effective secondary schools and 200 lower secondary commencement of HMGN's school decentralization schools to community management. strategy. [Done] 1 Make RuralWater Board autonomous to m Handover 400 Sub-Health Posts (SHP) to district improve effectiveness of community based level Management Committees (MCs) [Done] . drinking water services Implement Essential Health Care services in 14districts, prioritizing those with poor health indicators. Social . Enact PAF Act through an ordinance and take . Begin implementation of scholarship inc1usion necessary steps to establish new independent PAF package for girls and Dalit children in board. [Done] secondary schools. Governance . Prosecute high-profile corruption cases [Done - = Ensure adequatetenure at senior civil . corruption charges filed against three former service level, strengthen capacity of Public ministers, 22 tax officials and a senior civil servant] Service Commission to oversee transfers Revise Financial Administrative regulations inline andpublicly report transfer data. with Country Procurement Assessment Report . Prepare and enact a new Procurement law recommendations [Done] andbeginimplementation. Halve the numberof civil service transfers from the levels prevailing in 2000. [Done] Poverty and Social Impact Monitoring 94. The reform program supported under the PRSC i s part of the proposed actions under Nepal's PRSP. The PRSP outlines the institutional arrangements that will be implemented to monitor Nepal's poverty reduction strategy. The proposed framework will seek to coordinate and unify the efforts of a range of actors to ensure that a more systematic assessment of Nepal's progresstowards the MDG's i s produced. 29  95. Strengthening the monitoring of public expenditures is a key priority. Fiscal reports on overall aggregates and on high priority expenditures will be produced and disseminated widely every trimester. Annual work-plans and physical performance targets for development projects have been introduced; these will be monitored and publicized to improve accountability. The extent and use of funds that have been channeled to VDC's and DDC's will also be posted outside their offices to improve transparency. Expenditure tracking surveys will be periodically carried out by an independent thirdparty and the results made publicly available. HMGNhas already carried out a pilot survey and will be working towards scaling up and institutionalizing this process. 96. Monitoring the impact of investment climate reforms i s also important. Preliminary discussions have been held with HMGN on the type of indicators that could be monitored, the data sources required and relevant agencies. The type of indicators could include the time taken to obtain investment approvals, clear customs, obtain tax refunds and close an enterprise. The Ministry of Industry and Commerce in conjunction with the National Planning Commission are likely to take the lead role in monitoring. The private sector have also expressed a willingness to be an integral part of this monitoring system. Further discussions on this topic is envisaged as part of the PRSC I1 preparation. 97. The monitoring of long-term outcome/impact indicators that relate directly to MDG's, and those that can be used to assess the poverty impact of reform, will to a large extent be achieved through the Nepal Living Standards Survey (the next round, NLSS 11, i s scheduled to be completed in 2004). The NLSS I1will be comparable to the 1995/96 NLSS which was the basis for the ex-ante impact analysis of a petroleum price increase (see Annex 11). Demographic and Health Survey's (DHS) will also play an important role in monitoring outcomes/impacts; the most recent Nepal DHS was carried out in 2001. HMGNalso proposes, inthe PRSP, to use the 2001 Census data for a poverty mapping exercise to facilitate the targeting of anti-poverty programs and improve the allocation of public resources3o.The above-mentioned surveys needto be complemented by information on changes in `intermediate' variables that affect outcomes such as teacher absenteeism, availability of drugs etc. In the coming year, HMGN will identify the key set of intermediate indicators, assess existing data bases inrelation to these indicators, and finalize the data needs, including modifying existing surveys to address the lacunae, including the areas for capacity building to support the implementation of an integrated monitoring framework. 98. The monitoring of the PRSP will be coordinated by two sets of committees - the National Development Action Committee (NDAC), chaired by the Prime Minister, will review progress every four months while the Ministerial Development Action Committee (MDAC) will assess progress in their respective sectors every two months. A new section for coordinating poverty and social indicators monitoring and analysis will be formed in the National Planning Commission. The new Poverty Monitoring Unit will work closely with the Central Bureau of Statistics, that will continue to be responsible for carrying out household surveys and assembling national account statistics. The PRSP stresses that significant capacity building assistance will be sought from development partners to enhance monitoringand evaluationcapacity at the central, line ministry and local levels. 30 This work i s beingsupportedby the StatisticalCapacity Building Trust Fundfrom the World Bank. 30  Benefitsand Risks Benefits 99. The reformprocess supported by the proposed PRSC program i s expected to reduce poverty by stimulating pro-poor growth. Sustained peace will arguably be the single most important factor in reviving growth given its importance in attracting tourists and the boon it will provide to development activity in the conflict-affected rural areas where the majority of the poor reside. The PRSC supports selective key reforms that will directly contribute to improving pro-poor growth by: (i) creating fiscal space for, and improving the effectiveness of, growth enhancing public investments and (ii) improving the investment climate. 100. Efforts to improve service delivery and implement targeted programs are critical to reduce the social exclusion and sharp disparities in access to basic services that have been key causes of recent conflict. Improvements in service delivery are taking place through a gradual process of decentralization, greater empowerment of local communities inthe management of social services and through the private provision of social services. Targeted programs such as the Poverty Alleviation Fund are critical in targeting conflict affected areas with basic community built projects. The PRSC program supports Nepal's track record of meaningful reforms in improving service delivery by assisting HMGNindeveloping annual benchmarks consistent with the broad reform objectives and by providing the fiscal and technical resourcesnecessaryto acceleratethe reform momentum. 101. The proposed PRSC program supports HMGN's strategy to improve governance by: (i) improving the effectiveness of the civil service; (ii) strengthening anti-corruption and accountability institutions; (iii) improving the functioning of key agencies; and (iv) improving financial management and procurement practices. The improvements ingovernance that are supported by the PRSC program are designedto bring about a more accountable, efficient and less corrupt government that will create a more favorable investment climate and improved service delivery. Risks 102. There are several risks associated with the PRSC program: (i)the recent break down in the peace process leads to a sustainedperiod of violence that dampens growth prospects and the effects of reforms in service delivery on poverty and social exclusion; (ii) prior to and following national elections the efforts of reform minded technocrats may be crowded out by political interference and the sustainability of reforms may be threatened; (iii) implementation capacity may not be sufficient to sustain a broad reform agenda; and (iv) a further worsening of global economic conditions may undermine the impact of growth-enhancing structural reforms. These are real risks and there i s no guarantee that risk mitigation measures could overcome the joint effect of these forces should they materialize. The reformers in Nepal, however, are well aware of these risks and are designing the reforms in such a way to counter the risks. The purposefulness of this reform process has been uncommon. As an external development partner that has consistently encouraged a home-grown reform initiative, the Bank needs to be preparedto take these risks and to fulfill its part of the bargain by rewarding a strong track record of meaningful change and giving a clear signal that future reforms will also be duly supported. 103. Risks and mitigation measures associated with the peace process: In a scenario where hostilities resume for a sustained period, there is risk that the government loses credibility and the level of distrust between the two sides as well as between political parties will rise. Elements of the 31  Government's program designed to address the underlying causes of the conflict could be constrained in a sharply polarized political environment and hindered by poor security and low morale. On the other hand, the reformers' resolve may stiffen and they may be given even more space to implement reform, at least in the roughly two thirds of the country that HMGN controls. The risk mitigating measures partly lie in an on-going process of bringing the delivery and management of resources closer to the people (by devolving authority from the center of education, health, water and extension services) and using targeted programs to provide opportunities and services for particularly marginalized groups (e.g. scholarships for Dalit children) and in the most deprived districts (e.g. targeting resources using the Poverty Alleviation Fund). 104. Risks and mitigating measures associated with crowding out of reformers and opposition from vested interests: Implementation of some of the more politically contentious `prior actions' (e.g., regular adjustment of petroleum prices) could face delays in the run-up to elections. The continuity and sustainability of reforms could be threatened if national elections result in bringing to power a critical mass of politicians who want to slow down, or reverse, the reform process. Moreover, there could be significant opposition to the reforms from powerful vested interests. For instance improving the performance of the banking sector entails taking action against wealthy private sector individuals who have powerful patrons in Government. Taking action to stem fuel adulteration and reduce corruption are also clearly likely to be met with resistance. 105. The broad-based support for the reforms i s the best counter weight to these pressures.Many of the reforms outlined inthis document have a wide degree of support across the political spectrum and from civil society, for they have been based on consensus-building exercises and stakeholder consultations. The legislation creating the Road Fund i s an example of how popular support for the reform drawn from an extensive consultative process helped overcome the political forces that wanted to water down the legislation. Measures to fight corruption, too, enjoys very strong popular support. Moreover, certain actions are, by nature or because of legislative change, difficult to reverse, e.g., introduction of foreign management teams at RBB and NBL, and legal amendment to strengthen CIAA. 106. Certain reforms have a built-inmechanism to expand the support base for the change rapidly, thereby reducing the risk of a reversal. For instance, transfer of public primary schools and sub-health posts to community management will quickly turn those communities into strong constituencies to defend the reform, as they tend to feel the benefits immediately. Similarly, the Poverty Alleviation Fund and scholarships for disadvantaged children can be expected to develop a momentum of their own as they get underway. The benefits that the liberalization of telecom services has brought interms of improved cellular services and greater internet access will also be difficult to reverse. 107. Risks and mitigating measures associated with implementation and monitoring capacity. The reform agenda i s comprehensive and will stretch the capacity of both central and district level officials. The challenge will be significant for the few senior officials in central ministries who are responsible for the overall coordination and monitoring of the reform program. Line ministries will also be stretched. For example the pace at which schools are devolved may be constrained by capacity constraints at the central ministry level inprocessing the school devolution applications. At the district level, the capacity of DDC's and VDC's to cope with increased responsibilities will be put to the test. Moreover, the monitoring functions set up as part of the PRSP process will need significant support. Recognizing the risk of these capacity limits derailing the reform process, the reform program embedded in the PRSP and supported by the PRSC sets realistic implementation targets. The IAP process plays an important role in this regard, in identifying an annual list of high priority reform actions. Further, significant technical assistance i s provided by donors in support of these reforms. For 32  instance the ADB has focused on building the institutional capacity to implement civil service reform measures and DFID and IDA are jointly providing support to the MTEF process. Finally, efforts at greater donor coordinationare also helping to reduce the demands on Government officials. 108. Risks and mitigating measures associated with exogenous shocks. Nepal is vulnerable to erratic weather patterns and fluctuating world demand for its key exports. These factors, along with a depressed investment climate due to the conflict, have contributed to poor growth over the past two years. The growth-enhancing reforms supported by the PRSC aim to create a more favorable investment climate that should lead to diversification inthe economy and reduce vulnerability to these shocks. Nevertheless, in the short run, sharp exogenous shocks do have the potential to depress growth. 109. While the above risk-mitigationmeasuresshould provide adequate comfort that these risks are manageable, as an added risk-mitigation measure and to strengthen the hands of the reformers, the Bank will provide a loan acceleration clause that would allow the Bank to demand immediate repayment of the proposed loan by the Borrower incase reforms are reversed or materially changed.31 31Article VI1 `Acceleration of Maturity' in the General Conditions Applicable to Development Credit Agreements Dated January 1, 1985 (as amended through October 6, 1999) 33   ATTACHMENT   Attachment 1 Page I of I O KINGDOMOF NEPAL LETTER OFDEVELOPMENT POLICY Date,-  Attachment 1 Page 2 of 10 Poverty RerlectioilrsStrategy r Oar?:BroadBasedGrowth 2  Attachment 1 Page 3 of 10 3  Attachment 1 Page 4 of 10  Attachment 1 Page 5 of 10  Attachment 1 Page 6 of 10 ti  Attachment 1 Page 7 of 10  Attachment 1 Page 8 of 10  Attachment 1 Page 9 of I O  Attachment 1 Page 10 of 10 Sincerely,  ANNEXES   3 4   ; h e: h Y Y ex s2 5 x .e Y .- -w Y e,  'c 0 8 e?     a E .A V F 3  h C 0, s 4   I 4 . . 4 I .. . .  Annex I1 Page 1 of I Analysis of the PotentialImpact of Removingthe Kerosene Subsidy What impact would the removal of the subsidy on kerosene have on the poor? It i s claimed that kerosene i s a "fuel of the poor" and i s used predominantly for cooking. Data from the 1995/96 Nepal Living Standards Survey (NLSS) and the 2000/01 Rural Consumption Survey (RCS) can be used to check whether these claims are true (both surveys were conducted by the CBS and the data are available). The 1995/96 shows that in fact most households did not use kerosene for cooking, but rather firewood. Only 4.6 percent of the householdsusedkeroseneas their main source of cooking fuel (two thirds of these were in urban and one third in rural areas). Some households used it as a secondary cooking fuel, so in total 7 percent used this fuel. Of these, 4.3 were in urban areas and 2.8 inrural areas (60 percent of urban households and 3 percent of rural households). The households that used kerosene for cooking were not among the poor. Seventy-two percent of those using kerosenefell inthe fifth consumption quintile (that is, those who had consumption levels among the top twenty percent), and another 16 percent were in the fourth quintile. So kerosene i s by no means a "fuel of the poor." However, most households did use kerosene for other uses, primarily lighting, so that 90 percent of households reported some expenditures on kerosene. But lighting does not require much kerosene. Households who purchased kerosene for uses other than cooking consumed on average almost five times less than those who used it for cooking-29 liters a year compared to 133 liters (quantities estimated based on prices reported inthe NLSS community survey). As a result, expenditures on kerosene were on average a small, thoughnon-negligible share of total consumption: about one percent. The above observations are based on the data from the 1995/96 survey, which i s now 7-8 years old. More recent data can be found in the 2000/01 Rural Consumption Survey, although the survey i s confined to rural areas. It shows a slight increase in kerosene use for cooking, from 3 to 6.4 percent. On the other hand, the number of households reporting use of oil, electricity, and kerosene (unfortunately they are all lumped together inthe question) declined slightly from 84 percent to 81percent. How would an increase of, say, NRs 4 per liter (going from the subsidized price of Rs. 20 per liter to the market kerosene price of Rs. 24, prices effective in June 2003) affect the budgets of those in the bottom decile? Since household consumption data are available only for 1995/96, to obtain an estimate for 2002/2003 we assume that it grew at the same rate as private consumption from the national accounts (10.3 percent per year in nominal terms). In the absence of more recent data, the quantities of kerosene consumed (which in turn depend on consumption by individual households and the percentage of households using kerosene, especially for cooking) are assumed to be the same as those observed in 1995/96. A price increase of NRs 4 per liter would amount on average to an increase of 0.3 percentage point of total household consumption inthe bottom decile and of 0.2 percent inthe top decile.  Annex I11 Page 1of 4 Poverty inNepal Poverty Remains Widespread A few indicators give a sense of the depth of poverty in Nepal, ranked 142 among 173 countries in the 2002 Human Development Index. Forty-two percent of its people were considered poor in 1995/96 in terms of a national poverty line based on minimum food and non-food consumption. Forty percent of adult males and 65 percent of females are illiterate; infant and child mortality are around 64 and 95 percent respectively. Women and girls suffer even more. Female life expectancy continues to be slightly lower than men's -- a rare occurrence since women tend to live longer -- because of highmaternal mortality. One adult woman in three and one young woman in two is illiterate double the rate for men. Fewer girls than boys attend school. Women and girls are also less likely to seek or receive health care when ill.Women carry a greater burden from onerous household activities such as collecting water and wood. They are not well representedinpolitical and social life and are disadvantagedinfront of the law. The Poor are Predominantly in Rural Areas and Engage in SubsistenceAgriculture The last poverty assessment for Nepal was completed in 1998 and was based primarily on data from the 1995/96 Nepal Living Standards Survey I(NLSS I).32 data are now several years old, it i s While these unlikely that the geographical, occupational, and social profile of the poor has changeddramatically. The 1998 poverty assessment found that the incidence of consumption poverty was much higher in rural than in urban areas (44 versus 23 percent) and that the urban Kathmandu Valley was significantly better off than the rest of the country (with an incidence of poverty of 4 percent compared to a national average of 42 percent). Poverty rates were higher inthe more remote areas -- inthe mountains (56 percent), and in the Mid- and Far-Western Development Regions (53 percent in the Terai and 72 percent in the hills and mountains). Table 1reports figures on the incidence of poverty, poverty gap, and illiteracy by region, from the 199996 survey. The vast majority of the Nepali people draw their livelihood from agriculture, and the poor are no different (See table 2 on sources of income by consumption quartile). But the poor farm land of poorer quality, do not have access to irrigation, credit, marketing, and agricultural services, and make limited use of fertilizers. Thus, they end up growing "poorer" crops -- potato, maize, barley -- mostly for their own consumption, and achieve lower yields. Wage work in agriculture provides a way to supplement income from cultivation, but the poorest of the poor have limited access to wage-earning opportunities, partly because of remoteness and isolation. Off-farm employment opportunities are limited in rural areas, and migration to the Terai plains represents a coping strategy for many poor households. Illiteracy hinders progress in agricultural production and represents a formidable barrier to getting better employment opportunities outside agriculture. 32 A poverty update, basedon information from various other surveys, is underway and a full poverty assessment will be conducted when the data from the NLSS I1become available inmid-2004.  Annex I11 Page 2 of 4 Table 1: RegionalDisparities, Nepal, 1995/96 Nepal 42 0.121 64 Urban 23 0.070 37 Rural 44 0.125 61 UrbanKathmanduValley 4 0.004 24 Other Urban 34 0.109 45 RuralEastemTerai 42 0.095 62 RuralCentralTerai 38 0.082 I1 RuralWestemTerai 40 0.092 69 RuralMid- andFar-West.Terai 53 0.132 12 RuralEastemHills/Mtns 28 0.068 59 RuralCentralHillsMtns 61 0.108 66 RuralWestemHills/Mtns 40 0.128 54 RuralMid- andFar-West.Hills/Mtn 12 0.281 13 Terai 42 0.099 69 Hills 41 0.136 58 Mountains 56 0.185 15 Source: NepalLiving Standards Survey 1995/96. Table 2: Sources of Income by Consumption Quartile Bottom 25 percent 50 5 35 10 25-50 percent 48 7 30 15 50-75 percent 49 8 27 16 Top 25 percent 43 11 22 23 Average 47 8 28 16 Source: NepalLiving Standards Survey 1995/96. The reach o f infrastructure i s very limited in rural areas, despite significant efforts made since the 1950s, when there was no road outside the Kathmandu Valley, and no road link to the rest o f the world. In 1995/96, the average rural household lived more than five hours away by foot from a paved road and more than three hours from a vehicle-passable dirt road. Virtually no one outside o f urban areas had a private telephone, and only nine percent o f rural households had access to electricity. Needless to say, access by the poorest was even lower (for instance, only three percent o f all households in the bottom 25 percent, including those inurban areas, had access to electricity) (see Table 3).  Annex I11 Page 3 of 4 Table 3: Access to Infrastructure by Consumption Quartile Bottom 25 percent 3 10 3 15 25-50 percent 3 12 6 14 50-75 percent 5 15 11 23 Top 25 percent 19 43 32 37 Average 8 22 14 23 Source: NepalLiving StandardsSurvey 199996. Indigenous ethnidcaste groups lagged behind intheir income and asset levels, educational achievements, and human development indicators. People belonging to occupational castes and to marginalized and minority ethnic groups, such as the Tharu in the Terai and the Tamang in the hills, had higher poverty rates and lower social indicators in 1995/96. Recent Progress has been Mixed Some progress has been made in recent years on social indicators. Net primary school enrollment rose from 69 to 73 percent between 1996 and 2001, according to the Nepal Demographic and Health Survey (NDHS), primary completion rates have increased and average school going years has doubled for females. Literacy rates are rising, though the gender gap remains unacceptably high (table 4). Table 4: Gender Disparities inKey HumanDevelopment Indicators, 1996 and 2000 Source: Nepal Human Development Reports, 1996and 2001 Data from the same surveys indicate that the infant mortality rate has fallen from 79 to 64 per 1000 between 1996 and 2001, and under five mortality from 107 to 91 per 1000. This i s partly the result of successful immunization campaigns - the percentage of children fully immunized has increased by 67 percent in the last five years. Total fertility has declined from 4.6 to 4.1 births per woman. But malnutrition rates remain high, with 50 percent of children under five years of age stunted (short for their age), 48 percent underweight, and 10percent wasted (thinfor their age). As mentioned, new data to assess trends in consumption poverty will be available only in a year's time, but some data are available for rural areas. Published data point to an increase in rural consumption with respect to 1995/96, but these need to be revised to take into account differences in data collection and analysis methodology. While good rains and substantial inflows of remittances in the second half of the 1990s may explain an improvement in rural consumption levels, the lack of progress in reducing malnutrition calls this into question.  Annex I11 Page 4 of 4 A simple exercise of projecting the incidence of poverty forward from 1995196 to 2001/02 using actual GDP growth rates as a proxy for private consumption growth and population growth rates based on the 2001 Census shows that the projections done in the 1998poverty assessment, which showed a decline in poverty incidence, were broadly on track. But inequality may have changed during this period, (for example if growth has been faster in urban than in rural areas), so the projections need to be taken with great caution.  Annex IV Page 1of 3 PublicFinancialManagement andAccountability inNepal 1. The 2002 Country Financial Accountability Assessment (CFAA) indicates that although there are significant weaknesses inNepal's public financial accountability system, the foundations for reformare in place. Fiduciary risk in Nepal i s considered high - the level similar to that found in many developing countries -primarily due to the lack o f compliance with existingregulations. 2. The strengths o f Nepal's public financial accountability system, as identified in the CFAA, include an impressive legal and regulatory fiduciary framework, comprised inpart by these four elements: + The Financial Procedures Act (1999) and Financial Administration Regulations (1999) specify very detailed provisions for budget preparation, accounting and reporting on budget implementation, internal control procedures, and annual consolidated financial statements for the entire government. To increase accountability, the Ministry o f Finance submits a detailed annual report to Parliament just prior to budget presentation comparing achievements with targets for each line ministry. + The Local Self-Governance Act (1999) clearly specifies roles and responsibilities, including those for financial management, for local government committees and councils. + The Office o f the Auditor General has complete legal and professional independence. + The Public Accounts Committee (PAC) discusses the annual Auditor General's report and recommendations and forwards them to the Government with an implementation directive. PAC meetings, which are open to the public and the press, are held year round to address most aspects o f public sector financial management. However, in light o f the current interim administration, PAC has been disbanded until the new Parliament i s elected. 3. However, despite this impressive legal and regulatory fiduciary framework in Nepal, the CFAA indicated that the lack o f compliance and poor implementation o f regulations i s the single most important problem that affects public sector accountability. CoreIssues 4. The CFAA identified eight public financial accountability areas which are in need of reforms: i) complying with constitutional, statutory, and regulatory framework by tying budgets and case releases to results and outputs, ii)improving Nepalese public sector accounting and auditing standards and practices, iii)strengtheninglocallevelfinancialaccountability,iv)strengtheningtheindependenceandcapacityof the Office of the Auditor General, v) strengthening the Public Accounts Committee and the Commission for the Investigation of Abuse of Authority, vi) reducing fiduciary risk on projects, vii) strengthening private sector accounting and auditing standards, and viii) strengthening the regulation and monitoring o f NGOs. 5. The proposed PRSC will support financial management reforms and capacity building measures under the "improving governance pillar". Four priority areas were identified to address some of these financial management deficiencies: + Budgeting: The diagnostic work indicates that budget releases are not tied to demonstrated results. Moreover, the budget classification i s not sufficiently detailed to isolate key  Annex IV Page 2 of 3 expenditures and the presentation i s not consistent with IMF's General Financial Statistics (GFS) format. + Accounting and Financial Reporting: The chart of accounts does not meet financial and management reporting needs. Revenue and expenditure figures are not accurately tracked and reported to identify gaps between financial progress and physical outputs. Compliance with internal controls i s also weak. + Auditing: There i s not sufficient guidance to the Auditor General's office regarding audit scope and selection o f agencies; risk-based auditing i s not in place. Moreover, the performance of the Auditor General's office i s not reviewed by an independent entity. + Transparency and Oversight:: Fiscal transparency is currently limited as accurate information related to revenues, expenditures, and physical performance o f projects i s not publicly disseminated. Reform Strategy and Expected Results 6. Promoting a culture o f accountability requires strong political will and an enforceable incentive and disincentive structure. Hence, improvements in financial management are closely related to civil service reform and anti-comption efforts. These issues are elaborated in the main text and the rest of this annex describes HMGN's efforts to implementing the CFAA recommendations. Actions Takenand Underway 7. HMGN is in the process of reforming its budget processes based on recommendations in the CFAA. The government has formally constituted a Reform Monitoring Committee chaired by the Financial Comptroller General with members representing appropriate public and private sector agencies. Actions underway include: + Releasing budget resources inFY03 based on: i)priority for P1projects and ii)new performance based criteria usingthe first two trimester fiscal reports + Reconciling Government arrears to public utilities + Piloting an expenditure tracking survey for education by the Financial Comptroller General's office Designinga new Chart o f Accounts to align with I M F ' s General Financial Statistics classification + Creating an autonomous Financial Accounting Standards Board and Board o f Auditing Standards + SubmittingFY03 Auditor General's accounts to a reputable external auditor. ProposedActions 9. B y the end of the three-year PRSC period, HMGNexpects to: + Publish FY04 and FY05 revenue and expenditure figures each trimester and physical performance o f all P1 projects. Fiscal transparency will be extended to the local level with revenue and expenditures o f DDC's and VDC's publishedinfront of their offices.  Annex IV Page 3 of 3 +Adopt accounting and auditing standards inline with international standards +Implement expenditure tracking surveys and publicly disseminate results. +Pilot new Chart o f Accounts inline with I M F ' s General FinancialStatistics classification. +Adopt a risk-based audit approach and increase selectivity. Expand audit scope based on materiality considerations and risk-based assessments. + Submit FY04 and FY05 Auditor General's accounts to an external auditor + Conduct an external audit o f the Nepal Rastra Bank and implement key recommendations o f the I M F ' s Safeguards Assessment.  Annex V Page I of 2 At A Glance 10/7/03 POVERTY and SOCIAL South LOW- Nepal Asia income 1 Development dlamond' 2003 I Population,mid-year(million) 24.2 1,401 2,495 GNI per capita (Atlas method, US$) 240 460 430 Life expectancy `GDP per capita (US$) 238 GNI (Atlas method, US$ billion) 5.7 640 1,072 T Average annual growth, 1997-03 Population (%) 2.2 1.8 1.9 Gross Labor force PA) 2.6 2.3 2.3 primary Most recent estimate (latest year available, 1997-03) nrollment Poverty (% of population below nationalpovertyline, 7996) 42 I Urban population ("A of totalpopulation) 13 28 30 Life expectancyat birth (years) 60 63 59 Infant mortality (per 7,000 live births) 66 71 81 Child malnutrition ("A of children under 5) 48 Access to improvedwater source Access to an improvedwater source (% ofpopulation) 88 84 76 Illiteracy("A ofpopulation age 75t) 55 44 37 Gross primary enrollment (% of school-agepopulation) 118 97 95 Male 128 108 103 -Nepal - - - - - - Low-incomegroup Female 108 89 87 KEY ECONOMIC RATIOS and LONG-TERMTRENDS 1983 1993 2002 2003 GDP (US$ billions) Economic ratlos' 2.4 3.7 5.5 5.7 (in percent) Gross domestic investmenffGDP 19.6 22.6 24.6 26.1 Trade Exportsof goods and services/GDP 10.2 18.4 16.1 14.6 Gross domestic savingdGDP 8.5 12.2 11.8 11.3 T Gross national savings/GDP 10.7 14.5 25.7 25.6 Currentaccount balance/GDP -7.4 -8.1 2.6 -0.9 Domestic Investment Interest paymentson external debVGDP 0.2 0.8 0.4 0.4 savings Total external debt/GDP 18.5 54.9 52.9 51.8 Total debt service/exports 6.5 8.8 4.6 5.2 I Present value of debffGDP (2001) 28.1 Presentvalue of debffexports(2001) 74.0 Indebtedness 1983-93 1993-03 2002 2003 2003-07 (average annual growth) GDP 5.1 4.3 -0.5 2.3 4.8 -Nepal - -- Low-incomegroup GDP per capita 2.7 2.0 -2.7 0.1 2.2 STRUCTURE of the ECONOMY 1983 1993 2002 2003 ("A of GDP) Growth of GDP (%) Agriculture 60.3 41.3 39.6 39.6 I L T Industry 12.8 20.2 20.9 20.7 Manufacturing 4.6 8.6 8.1 7.9 Services 26.9 38.4 39.5 39.7 Privateconsumption 81.3 79.3 78.1 78.2 General governmentconsumption 10.1 8.5 10.0 10.5 Importsof goods and services 21.3 28.8 28.8 29.3 I -GDP 1983-93 1993-03 2002 2003 (average annual growth) Agriculture 3.4 3.3 2.2 2.1 Industry 9.2 4.9 -3.3 2.3 Manufacturing 10.1 4.2 -10.0 0.4 Services 4.7 5.5 -1.4 2.7 Note: 2003=2002/03. * The diamonds show four key indicators in the country (in bold) compared with its income-groupaverage. If data are missing,the diamond will be incomplete.  Annex V Page 2 of 2 PRICES and GOVERNMENT FINANCE 1983 1993 2002 2003 Domestic prices Inflation(%) (% change) 15T Consumer prices 14.0 9.9 2.9 4.7 I ImplicitGDP deflator 12.3 11.2 3.2 3.5 Government finance (% of GDP, includescurrentgrants) Current revenue 11.5 12.3 -I 98 99 A 01 Id: Current budget balance -0.1 -4.0 Overall surplus/deficit -5.7 -4.0 -GDP deflator ' 0 - C P I TRADE 1983 1993 2001 2003 (US$ millionsj Exportand Import levels(US$ mill.) Total exports (fob) 82 379 942 782 ~2.000T Food 65 Pulses 56 Manufactures 256 Total imports(cif) 457 860 1,773 1,707 Food 101 81 97 98 99 00 01 02 03 Fueland energy 84 338 Capitalgoods 169 312 EExports EImports BALANCEof PAYMENTS 1983 1993 2002 2003 [US$millions) Currentaccount balanceto GDP (%) Exportsof goods and services 249 675 1,060 949 Importsof goods and services 483 1,053 1,687 1,821 110T Resourcebalance -233 -378 -626 -872 Net income 12 8 -7 -6 5 Net currenttransfers 36 75 777 a25 Currentaccount balance -185 -295 143 -53 Official transfers 4 77 143 161 0 99 00 01 02 Financingitems (net) 137 380 -323 -143 Changesin net reserves(-=increase) 44 -162 36 -123 Memo: Reservesincludinggold [US$ millions) 571 1,055 1,184 Conversionrate (DEC,local/US$j 13.8 48.0 75.9 77.8 EXTERNAL DEBTand RESOURCEFLOWS 1983 1993 2002 2003 [US$ millions) Compositionof 2002 debt (USS mill.) Total debt outstandingand disbursed 453 2,010 2,933 2,975 IBRD 0 0 0 0 ~5 G 3 6 IDA 172 832 1,156 1,185 Total debt service 20 69 88 96 IBRD 0 0 0 0 IDA 2 10 26 30 Compositionof net resourceflows Official grants 94 77 143 161 Official creditors 68 156 4 Privatecreditors 1 -10 0 0 Foreigndirect investment -1 6 -4 -2 Porlfolioequity 0 0 0 0 World Bank program Commitments 45 0 23 97 A IBRD - E - Bilateral Disbursements 31 69 38 27 6 . IDA D. Other multilateral F Pnvate - Principalrepayments 0 4 18 21 C IMF . G. Short-term Net flows 31 66 20 6 Interestpayments 1 6 8 9 Net transfers 29 60 12 -3 ~~ DevelopmentEconomics 10/7/03  Annex VI Social Indicators Page 1of 1 ~~ ~~~ Latest single year Same regiodincome group South Low- 1970-75 1980-85 1995-2001 Asia income POPULATION Total population,mid-year(millions) 13.1 16.2 23.6 1,377.8 2,505.9 Growth rate ("hannual average for period) 2.0 2.1 2.4 1.8 1.9 Urbanpopulation(Yoof population) 5.0 7.8 12.2 27.8 30.8 Total fertility rate (birthsper woman) 6.2 5.9 4.2 3.2 3.5 POVERTY ("7of population) Nationalheadcountindex 42.0 Urbanheadcountindex 23.0 Rural headcountindex 44.0 INCOME GNI percapita (US$) 120 170 250 450 430 Consumer price index(1995=100) 17 35 141 Food price index (1995=100) 33 143 INCOMEKONSUMPTION DISTRIBUTION Gini index 36.7 Lowest quintile (% of income or consumption) 7.6 Highestquintile (% of income or consumption) 44.8 SOCIAL INDICATORS Public expenditure Health ("hof GDP) 0.9 1.o 1.1 Education ("%of GDP) 1.5 2.7 3.7 2.5 2.8 Social security and welfare ("hof GDP) 0.1 0.1 0.4 Net primary school enrollment rate ("7of agegroup) Total 72 Male 77 Female 67 Access to an improved water source ("7of population) Total 88 84 76 Urban 94 94 90 Rural 87 80 70 Immunization rate ("7under 12months) Measles 34 71 58 60 DPT 32 72 65 61 Child malnutrition("hunder 5 years) 69 48 Life expectancy at birth (years) Total 45 51 59 63 59 Male 46 52 60 62 58 Female 44 50 59 63 60 Mortality Infant(per 1,000 live births) 149 117 66 71 80 Under5 (per 1,000live births) 223 170 91 99 121 Adult (15-59) Male (per 1,000 population) 482 376 314 252 312 Female (per 1,000 population) 476 395 314 202 256 Maternal (modeled,per 100,000 live births) 830 Births attended by skilled healthstaff ("h) 10 12 42 Notes:0 or 0.0 means zero or less than half the unit shown. Net enrollmentrate:break in series between1997 and 1998 due to changefrom ISCED76to ISCED97; ratios exceeding100 indicatediscrepanciesbetweenthe estimatesof school-agepopulation and reported enrolment data. 2003 World DevelopmentIndicatorsCD-ROM,World Bank  Annex VI1 Page 1of 2 KeyEconomicIndicators As of 10/8/2003 Actual Estimate Projected Indicator 98/99 99/00 00101 01/02 02/03 03/04 04/05 05/06 Nationalaccounts(as % of GDP) Gross domestic producta 100 100 100 100 100 100 100 100 Aaculture 40.1 39.6 38.4 39.6 39.6 38.7 38.1 37.4 Industry 21.2 21.5 21.3 20.9 20.7 22.7 23.0 23.3 Services 38.7 38.9 40.3 39.5 39.7 38.6 38.9 39.3 Total consumption 86.4 84.8 85.1 88.2 88.7 88.4 87.6 87.1 Gross domestic fixed investment 19.1 19.3 19.0 19.3 19.2 20.0 20.5 21.5 Governmentinvestment 7.0 7.0 7.6 7.6 7.0 7.5 7.9 8.1 Privateinvestment 12.1 12.4 11.4 11.7 12.1 12.5 12.6 13.4 Exports(GNFSY 22.8 23.3 22.4 16.1 14.6 16.0 18.3 18.1 Imports(GNFS) 29.7 32.4 31.5 28.8 29.3 30.9 32.9 32.7 Grossdomestic savings 13.6 15.2 14.9 11.8 11.3 11.6 12.4 12.9 Grossnationalsavings 20.6 24.6 27.2 25.7 25.6 24.9 25.2 25.2 Memorandum items Grossdomesticproduct 5034 5494 5582 5549 5739 6408 6812 7311 (USSmillionat currentprices) GNIper capita (US$,Atlas method) 230 240 240 230 240 250 260 280 GDPper capita (US$) 228 243 242 235 238 259 270 283 Realannualgrowthrates (%, calculatedfrom 1985prices) Gross domesticproductat marketprices 4.5 6.1 4.8 -0.5 2.3 3.5 4.6 5.4 Realannualper capitagrowthrates (%, calculatedfrom 1985 prices) Grossdomesticproductat marketprices 2.2 3.8 2.4 -2.7 0.1 1.2 2.3 3.0 Balanceof Payments(US$millions) Exports(GNFSf 1270 1433 1359 1060 949 1022 1246 1322 MerchandiseFOB 763 971 942 754 633 680 883 935 Imports(GNFS~ 1595 1922 1984 1687 1821 1982 2243 2389 MerchandiseFOB 1390 1713 1773 1496 1630 1777 2024 2155 Resourcebalance -325 -489 -625 -626 -872 -960 -997 -1067 Netprivatetransfers 338 497 680 777 825 867 891 912 Current accountbalance 25 28 64 143 -53 -107 -121 -169 Officialtransfers 137 133 108 143 161 243 252 248 Long-termloans (net) 157 148 96 38 45 13 16 27 Official 89 97 60 58 74 47 37 -41 Private 68 52 36 -20 -29 -34 -22 68 Other capital(net, incl.errors &omissions) -7 61 -86 -213 133 166 166 193 Changeinreserves -183 -240 -80 36 -123 -77 -70 -65 Memorandum items Resourcebalance(% of GDP) -6.5 -8.9 -11.2 -11.3 -15.2 -15.0 -14.6 -14.6 Annual growthrates (inUS$terms) Merchandiseexports (FOB)(excludingre-exports) 18.0 37.3 4.6 -18.1 2.4 7.4 5.9 6.0 Merchandiseimports(CIF) -10.4 23.3 3.5 -15.6 9.0 9.0 13.9 6.5  Annex VI1 Page 2 of 2 KeyEconomicIndicators (Continued) Actual Estimate Proiected Indicator 98/99 99/00 00101 01/02 02/03 03/04 04/05 05/06 Publicfinance(as % of GDP at marketprice$ Total revenues 10.2 10.7 11.4 11.5 12.3 12.4 12.8 13.4 Totalexpenditure 15.4 15.7 17.6 17.2 16.3 18.7 18.5 18.2 Current expenditures 9.4 9.6 11.2 11.6 11.6 13.1 12.5 12.1 Capitalexpenditureandnet lending 6.1 6.1 6.4 5.7 4.7 5.6 6.0 6.1 Overalldeficitbeforegrants 5.2 5.0 6.2 5.7 4.0 6.3 5.7 4.8 Overalldeficit after grants 3.9 3.5 4.5 4.3 1.9 3.6 2.6 2.0 Domestic financing(net) 1.4 0.9 2.7 2.9 1.2 1.7 1.3 0.6 Foreignfinancing (net) 2.5 2.6 1.8 1.4 0.7 1.4 1.3 1.4 Monetaryindicators M21GDP 44.7 49.0 52.3 53.2 55.3 55.6 Growthof M2 (%) 20.8 21.8 15.2 4.4 8.3 11.1 Privatesector credit growthltotalcredit growth(%) 90.9 109.6 88.0 59.2 132.1 107.4 Priceindices Realexchangerate (eop; percentagechange-=depreciation) 1.3 -2.2 3.8 -9.2 -1.3 Consumer priceindex (% change) (FY85=100) 11.4 3.4 2.4 2.9 4.7 5.4 4.6 4.2 GDPdeflator (% change)(FY85=100) 8.8 4.6 3.2 3.2 3.5 4.9 4.6 4.6 a. GDP at factor cost. b. "GNFS" denotes "goodsandnonfactorservices." c. Includesnetunrequitedtransfers excludingofficial capitalgrants. d. Includesuseof IMFresources. e. Consolidatedcentralgovernment.  Annex VI11 Page I of I KeyExposureIndicators As of 10/6/2003 Actual Estimate Projected Indicator 98/99 99/00 00/01 01/02 02/03 03/04 04/05 05/06 Total debt outstandingand 2,702.0 2,848.0 2,786.0 2,933.0 2,993.0 3,022.0 3,054.0 3,097.0 disbursed(TDO) (US$mIa Net disbursements(US$mla 141.0 146.0 -62.0 147.0 60.0 29.0 32.0 43.0 Total debt service (TDS) (US$m)a 84.0 83.0 84.0 88.0 96.0 114.0 120.0 125.0 Debt anddebt serviceindicators (%) TDOKGS~ 162.6 141.8 131.5 152.9 160.9 152.5 136.7 132.6 TDO/GDP 53.7 51.8 49.9 52.9 52.2 47.2 44.8 42.4 TDSKGS 5.1 4.1 4.0 4.6 5.2 5.8 5.4 5.4 Concessional/TDO 97.5 98.4 97.7 IBRDexposureindicators(%) IBRDDS/publicDS 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 PreferredcreditorDS/publicDS (%)' 61.5 64.9 72.3 73.1 74.1 74.8 75.9 75.9 IBRDDSKGS 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 IBRD TDO (us$mId 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 Shareof IBRDportfolio(%) 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 IDA TDO (us$mld 1,107.0 1,123.0 1,102.0 1,156.0 1,185.0 1,193.0 1,204.0 1,217.0 IFC Loans(US$m) 56.8 57.3 56.0 54.0 Equityandquasi-equity (US$m)e 3.4 3.4 3.7 3.2 MIGA MIGA guarantees (US$m) 33.0 33.0 19.1 30.1 a. Includespublic andpubliclyguaranteeddebt, privatenon-guaranteed,use of IMFcredits and net short-termcapital. b. "XGS" denotesexports of goods and services,includingworkers' remittances. c. Preferredcreditors are defined as IBRD,IDA, the regionalmultilateraldevelopmentbanks,the IMF, andthe Bank for InternationalSettlements. d. Includespresentvalue of guarantees. e. Includesequity andquasi-equity types of bothloan andequity instruments.  Annex IX Page 1of 4 EXTERNAL Public Information Notice RELATIONS DEPARTMENT Public Information Notice (PIN) No. 03/110 InternationalMonetary Fund 700 19' Street, NW September 5,2003 Washington, D.C. 20431 USA IMFConcludes2003Article IV ConsultationwithNepal On August 22,2003, the Executive Board of the International Monetary Fund (IMF) concluded the Article lV consultation with Background Nepal remains among the poorest countries in the world with almost 40 percent of the population living in poverty due to insufficient growth and inadequate targeting of the poor. During the 1990s, macroeconomic conditions remained broadly stable and the fiscal position was manageable, but growth was constrained by financial sector weaknesses, weak public sector management, and poor governance. Inthe financial sector, Nepal Rastra Bank (NRE3) oversight is still weak, and intermediationi s inadequate largely due to a banking environment in which loan default is endemic, especially by well-connected borrowers. Partly as a result of this, the two largest commercial banks now have large nonperforming assets. Similar problems exist at two large development banks. In the public sector, investment has been spread thinly over projects and enterprises suffer from weak management and accountability. More recently, intensified security problems and adverse external developments contributed to lower growth and the fiscal position has deteriorated since 2000/01. The ceasefire agreed in January 2003 with the insurgents has renewed hopes for peace and efforts have been madeto sustainthe reform momentum. Progressin achieving lasting peacewould facilitate poverty reduction and implementation of policies contained in the government's Poverty Reduction Strategy Paper (PRSP). However, political uncertainties persist as major political parties continue to maintainthat the appointment of governments by the King since the dissolution of parliament i s unconstitutional. The parties have also refused to join the peace talks. GDP growth i s estimated to be 2 percent in2002103. The ceasefire has helped restore some normality in the transport and service sectors and the decline in tourism may have halted. There are also signs that some 33 Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On retum to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views o f Executive Directors, and this summary i s transmitted to the country's authorities. Washington,D.C.20431 Telephone202-623-7100 Fax 202-623-6772 www,imf,org  Annex IX Page 2 of 4 exports and manufacturing production are rebounding. Inflation, which rose to about 7%percent inmid-May (12-month basis) reflecting price developments inIndia, administrative price changes, and supply factors, i s expected to moderate by early 2003/04. The 2002/03 budget met revised targets set in a mid-termreview. Based on weak revenue performance due to lower activity during the first half of the year and external aid shortfalls relative to the initial budget targets, the authorities revised the budget at mid-year. Specifically, the tax revenue target and external financing were revised down. To compensate for these shortfalls, total expenditure was also revised down and the revised budget set a net domestic financing target of 2 percent of GDP. Following the announcement of the ceasefire, economic activity picked up and revenue performance improved. However, capital spending was below the revisedbudget, reflecting continued implementation constraints at the local level. As a result, domestic financing was around 1%percent of GDP. Monetary policy has been accommodative and the real effective exchange rate has depreciated. To help economic recovery, the NRB lowered cash reserve requirements by 1percentage point in August 2002 and maintained a refinancing facility for lending to "sick" industries. Aided by the recovery in activity and monetary easing, private credit appears to have revived and higher remittances contributed to a rise in banking system foreign assets. However, reserve money growth has been curtailed, due largely to lower net credit to the government. Lending and deposit rates have declined somewhat. The Nepalese rupee has depreciated in real effective terms since early 2002, reflecting the peg to the Indian currency which has appreciated only somewhat against the weakening US dollar. Balance of payments developments turned favorable in mid-2002/03 and external reserves are adequate. Large and increasing remittances helped buoy the current account. Garment exports began recovering in late 2002, while recorded exports to India declined, carpets and pashmina exports continued to stagnate, and imports increased with the recovery. The current account (excluding official transfers) i s expected to move into a deficit of about % percent of GDP, but with higher aid and other inflows official foreign exchange reserves are expectedto rise to US$1billion (6%months of imports of goods and services). In2002/03, significant progresswas madeinfinancial sectorreformimplementation. TheNRl3took stepsto reduce staffing through a voluntary retirement scheme (VRS). Progress was made in restructuring the two largest commercial banks, which had external management teams installed. The teams have prepared management plans, made progress in assessing the banks' financial status, and proposed VRSs to reduce overstaffing. Some improvements have already taken place with success in loan recovery and branch rationalization, although loan recovery from well-connected borrowers continues to be difficult. Prioritization of budgetary spending improved, anti-corruption efforts were boosted, and public enterprise reform implementation and governance reforms progressed. To improve prioritization, a Medium Term Expenditure Framework was introduced with World Bank assistance to help align development spending with national and sectoral priorities. Administered price increases for petroleumproducts were announced in March 2003, although some price increases were rolled back under public pressure. Liquidation procedures were initiated for four public enterprises; preparations for the privatization of one enterprise were brought to an advancedstage. Governance reforms progressed and anti-corruption efforts were boosted. The cabinet approved in September 2002 the elimination of 7,500 vacant civil service positions. To tackle corruption in public life, the Commission for Investigation of Abuse of Authority and a newly established Judicial Commission  Annex IX Page 3 of 4 initiated investigations against politicians and revenue officials perceived to have accumulated unaccountable assets. The Anti-Corruption Strategy was adopted. Executive BoardAssessment Executive Directors stressed that to address the pervasive level of poverty in Nepal, growth needs to be raised significantly over the medium term through vigorous implementation of structural reforms, particularly in the financial and public sectors. In this regard, Directors welcomed the authorities' Poverty Reduction Strategy Paper (PRSP), which i s founded on broad-based growth, social sector development, targeted programs for the poor and deprived groups, and improved governance. Directors looked forward to considering a Joint Staff Assessment of the PRSPinthe near future. They encouragedthe authorities to reach early agreement on a programthat could be supported by the Poverty Reductionand Growth Facility to help achieve PRSP goals. Directors welcomed the ceasefire agreement with the insurgents reached in January 2003. They underlined that continued peace was essential to help sustain the economic recovery currently under way. Directors also noted that progress in the peace talks and the build up of confidence should help relieve budgetary pressures for security spending. Directors commended the authorities' for maintaining broad fiscal stability to create conditions to support economic growth. Looking forward, Directors endorsed the authorities' fiscal strategy based on revenue mobilization, expenditure prioritization, and a reduction indomestic borrowing. They welcomed the 2003/04 budget as the first step in implementing this strategy. However, Directors called for a determined effort to meet the revenue targets and to resist spending pressures.To raise revenue over the medium term, Directors suggested cuts in exemptions, improvements in tax and customs administration, and increases in the VAT rate. Directors welcomed the steps taken to prioritize development spending to help achieve poverty reduction goals, including the introduction of a medium-term expenditure framework, and encouraged the extension of such efforts to all expenditures. Directors noted that the envisaged reductions in domestic borrowing would help maintain fiscal sustainability over the mediumterm, especially in view of potentially large contingent liabilities from financial sector and public enterprise reforms. Continued technical assistance inthe fiscal area will help address capacity constraints. Directors agreed that monetary and exchange rate policies should remain geared to supporting the exchange rate peg to the Indian rupee, stressing that the peg had served Nepal well given its close links with India. Looking forward, they noted that prospective external developments, such as the phasing out of the Multi- FibreAgreement, would likely have implications for external competitiveness andthe appropriate choice and level of the peg. Directors pointed to the need for policy measures to ensure that remittances are sustained, as well as for efforts to diversify Nepal's export base. They also noted that external competitiveness could be enhancedby measures to raise labor productivity and lower transport costs. Directors commended the authorities for progress in financial sector reforms, but noted that much remained to be done. They stressed the need for strengthening Nepal Rastra Bank (NIB) supervision of the financial sector. The NRB should also improve performance incentives for skilled personnel, while encouraging separations at lower levels. Directors welcomed the appointment of external managers at the two largest insolvent commercial banks, and noted recent steps taken by the new managers to improve the financial condition of the banks. To help support these efforts and, more generally, to create a sound banking  Annex IX Page 4 of 4 environment, Directors noted the authorities' intention to phase out priority sector lendingrequirements, and emphasized the effective implementation of recently adopted debt recovery mechanisms, including the Debt Recovery Tribunal and blacklistingof loan defaulters. Directors welcomed ongoing public sector reforms, including the elimination of vacant positions, the introduction of merit-based promotions, the decompression of the wage scale, as well as improvements inthe public procurement process. Looking forward, Directors recommended the adoption of civil service accountability in order to improve policy implementation. They welcomed the public enterprise reform efforts that would lower government ownership in the economy and increase the enterprises' net budgetary contribution-through privatization and restructuring of viable enterprises and liquidation of unviable ones. Several Directors stressed that due regard should be paid to the pace and sequencing of these reforms. Also, an appropriate compensation scheme could help smooth implementation of workforce reductions. Directors welcomed recent efforts to combat corruption, but emphasizedthe need to pursue forcefully those responsible for the misuse of public funds. Directors supported the authorities' plans to increase decentralization to enhance service delivery. However, they noted that the implementation of these measures should be accompanied by improvedpublic sector governance and capacity buildingat the local level. Directors supported measures to improve the business climate for private sector development through legal reforms and streamlining of administrative procedures to facilitate trade. They recommended revisions to labor legislation to make labor hiringmore flexible and modifications to the Company and Insolvency Acts to allow more orderly andtimely exit of unviable f m s . Directors commended Nepal for its open trade regime, and welcomed the authorities' efforts to gain early World Trade Organization (WTO) accession. Directors welcomed the elimination of the exchange restriction arising from quantitative limits on payments for personal travel. Directors encouraged the authorities to further improve statistics to enhance policy formulation and monitoring. They urged full implementation of Fundtechnical assistance recommendations. Public Information Notices (PINS)are issued, (i) the request of a member country, following the at conclusion of the Article IV consultation for countries seeking to make known the views of the IMFto the public. This action is intended to strengthen IMFsurveillance over the economic policies of member countries by increasing the transparency of the I M F ' s assessment of these policies; and (ii)following policy discussions in the Executive Board at the decision of the Board. The Staff Report for the 2003 Article IV Consultation with Nepal is also available.   , MAP SECTION