Document of

The World Bank

FOR OMCAL USE ONLY

MICROFICHE COPY

Report No. P- 5736-BD Type: (PR) Report No. P-5736-BDWESTIN, R./ X80426 / D9 095/ SAlCI

REPORT AND RECONMENDATION

OF THE

PRESIDENT OF THE

INTERNATIONAL DEVELOPMENT ASSOCIATION

TO TIHE

EXECUTIVE DIRECTORS

ON A

PROPOSED CREDIT

IN THE AMOUNT OF SDR 109.3 MILLION

TO

THE PEOPLE'S REPUBLIC OF BANGLADESH

FOR A

PUBLIC RESOURCE MANAGEMENT ADJUSTMENT CREDIT

APRIL 3, 1992

This document has a restricted distribution and may be used by recipients only in the performance oftheir official duties. Its contents may not otherwise be disclosed withOut World Bank authorization.

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CURRENC' EQUIVALENTS

The external value of the Bangladesh Taka (Tk) is fixed in relation to abasket of reference currencies, with the US Dollar serving as the interventioncurrency. The official exchange rate as of January 1, 1992 was:

US$ 1 = Tk 38.80Tk 1 = US$ 0.0258

In this report, US$ is sometimes abbreviated to $.

List of Abbreviations and Acronyms Used

ADB - Asian Development BankADP - Annual Development ProgramBOI - Board of InvestmentBPDB - Bangladesh Power Development BoardCAG - Comptroller and Auditor GeneralCORBEC - Committee on Reforms in Budgeting and Expenditure ControlCONTASA - Convertible Taka Special AccountERD - Economic Relations DivisionESAF - Enhanced Structural Adjustment FacilityECNEC - Executive Committee of the National Economic CouncilFFW - Food For WorkFFYP - Fourth Five-Year PlanFIAS - Foreign Investment Advisory ServiceIMED - Implementation Monitoring and Evaluation DivisionIPC - Import Program CreditISAC-2 - Second Industrial Sector Adjustment CreditKfW - Kreditanstalt fur WiederaufbauNBR - National Board of RevenueNGO - Non-Governmental OrganizationO&M - Operations and MaintenanceODA - Overseas Development AdministrationPFP - Policy Framework PaperPRMAC - Public Resource Management Adjustment CreditRAL-II - Second Board Report on Adjustment LendingTYRIP - Three-Year Rolling Investment ProgramTA - Technical AssistanceUNDP - United Nations Development ProgramUSAID - United States Agency for International DevelopmentVAT - Value-Added TaxVGD - Vulnerable Group DevelopmentWID - Women in Development

FISCAL YEAR (FY)

July 1 - June 30

FOR OMCIL USE ONLY

BANGLADESH

PUBLIC RESORCE NANAGDIENT ADJUSTMENT CREDIT

TABLE OF CONTENTS Page Number

CREDIT SUMMARY

PART I. COUNTRY POLICIES AND BANK GROUP'S ASSISTANCE STRATEGY ....... .. 1

A. Background ............................................................. 1B. Macroeconomic Framework ..... .. . ............................. 3C. Public Resource Management .......................................... . 5D. Stimulating the Productive Sectors .................................. 7E. Addr3ssing Social Development Concerns ............................... 10F. The Bank Group's Assistance to Bangladesh ................. *..... 11G. External Financing Requirements .......... ..... .. .. ... . ...... 14H. Sunt ary Assessment and Performance Indicators ........ ............ 15

PART II. THE CREDIT ....................................... .................. 16

A. Background to the Credit ..................................................... . 16B. Description of the Major Policy Actions . ....................... 18

(i) Macroeconomic Framework ........................... .......... . 19(ii) Tax Reform ................ ...... *... .... ..... ................. 9(iii)Expenditure Prioritization ................................... 22(iv) Aid Utilization ....................................................... 28(v) Institutional Strengthening .............................. .... 31Summary of Actions for the Second and Third Tranches .. 32

C. Structure of the Credit ................ ....... 36D. Rationale for IDA Involvement ............................... . .......39

PART III. RECOMMENDATION ......... ........ .**o . .......... 41

LIST OF SCHEDULES

Schedule A: Major Economic Indicators . ..................... ... ..... 42Schedule B: Timetable of Key Processing Events .......................... 45Schedule C: Matrix of Policy Actions ................... 46Schedule D: The Status of Bank Group Operations in Bangladesh ......... 54Schedule E: Letter of Development Policy . ....................... 56

Map IBRD 20726R

This document has a restricted distribution and may be used by recipients only in the performaiceof their official duties. Its contents may not otherwise be disclosed without World Bank authoriz n

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BANGLADESH

PUBLIC RESOURCE MANAGEMENT ADJUStMENT CREDI!

Credit Sumnry

Borrower X People's Republic of Bangladesh

Amount t SDR 109.3 million (US$ 150 million equivalent)

Terms I Standard, with 40 years maturity.

Description X The proposed credit would support the implementation of aprogram of fiscal reforms designed to increase publicinvestment and savings, including tax reform, prioritizationof the public expenditure program, improvements in aidutilization procedures, and strengthening of institutionsinvolved in fiscal management. The objectives of the creditare closely linked to the macroeconomic program described inthe Policy Framework Paper for 1991192 - 1993194, and themonitoring of the reform program would be coordinated withthe DWF's ESAP program.

Disbursemen.s9% The proposed credit would finance approximately 1 percent ofBangladesh's gross import requirements for the three-yearperiod covered by the reform program, 1991/92 to 1993194.It would be available in three equal tranches linked toactions in three successive government budgets, therebyreflecting the need to introduce fiscal reforms over amedium-term horizon. The Federal Republic of Genrmny wouldprovide DM 30 million in parallel financing to support theproposed credit., and the United Kingdom Overseas DevelopmentAdministration and the United Nations Development Programwould provide technical assistance in support of taxadministration and institutional development. The closingdate for the credit would be June 30, 1994.

Benefits s The proposed credit draws on a major program of economic andsector work, including three grey cover economic reports(Bangladesh: An Agenda for Tax Reform, Report No. 7196-BD,December 15, 1989; Bangladesh: Public Expenditure Review,Report No. 7545-BD, March 13, 1989; and Bangladesh: Povertyand Public Expenditures, Report No. 7946-BD, January 16,1990), as well as two recent country economic memoranda witha specific focus on public resource management (Bangladesh:Managing the Adiustment Process - An Appraisal, Report No.8344-BD, March 16, 1990; and Bangladesht Managing PublicResources for Higher Growth, Report No. 9379-BD, April 19,1991). Approval of the credit would provide a tangibledemonstration to the donor coamunity that issues that have

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dominated the country economic dialogue over the past fewyears are being addressed by the Government in a sound andresponsible fashion.

Risks s As the credit would provide support for a major part of themacroeconomic program of the Government, the principal risksregarding the achievement of the objectives of the creditshould be judged on a country basis. Bangladesh has arecord of reasonably sound financial management, and therecent mid-term review of the ESAP program indicates thatthe macroeconomic program is basically on track. Many ofthe most important structural reforms to be supported by thecredit have already been introduced in the 1991/92 budget,and the credit would provide a framework for monitoring theimplementation of the reform program over the next twofiscal years. The risks inherent in an operation as broadas the proposed credit are therefore fully justified on thebasis of the prior actions of the Government.

Malp IBID 20726R

REPORT AND TION OF TU PSIEOF IDA TO THE ECUTI DICTORS

ON A PROPOSED CREDIT TOTHE PEOPLE' S REPLIC OF IAN SU

FOR A PUBLIC RESOURCE )IANAGDIENT ADJUSTHMENT CRbDIT

1. I submit for your approval the following report and recommendation on aproposed development credit to the People's Republic of Bangladesh forSDR 109.3 million, the equivalent of US$ 150 million, on standard IDA termswith a maturity of 40 years to finance a Public Resource Management AdjustmentCredit.

2. A Country Economic Memorandum entitled 'Bangladesh: Selected Issues inExternal Competitiveness and Economic Efficiency," (Report No. 10265-BD) wasdistributed to the Executive Directors on March 16, 1992.

PART I. COUNRRY POLICIES AND BANK GROUP'S ASSISTANCE STRATEGY

A. Background

3. With a per capita GNP of around US$190, Bangladesh is one of the poorestcountries in the world. Efforts to reduce its widespread poverty have beenhampered by several physical and structural constraints. With an estimatedpopulation of 107 million in an area about the size of Greece, Bangladesh hasa population density of 741 persons per square kilometer, ten times that ofGreece and three times that of India. This limits the ability of theagriculture sector to contribute to raising incomes and absorb the rapidlygrowing labor force. Although the land is fertile, frequent floods andcyclones cause severe damage to infrastructure and make agricultural outputsubject to high variability. Other than natural gas, Bangladesh has virtuallyno mineral resources and limited physical infrastructure. Its labor forcelacks the education, health and nutrition neeeed to make a rapid transition tofaster industrial and export-led growth. Its weak public administration,inefficient public enterprises and frail financial system have limited thecountry's capacity to mobilize resources efficiently, implement developmentprojects, and deliver public services effectively.

4. Despite these constraints, Bangladesh made generally good progressduring the early to mid-1980s9. Sustained stabilization policies supportedby the International Monetary 1'und (IMF) and IDA helped to reduce the externaland fiscal deficits from 10-12 percent of GDP in the early-1980s to about 7percent of GDP by FY86, while inflation was brought down to around 10 percent. vReal GDP increased by approximately 5 percent p.a. between FY81-86, due toincreases in foodgrain production, construction and services. Improved

I A table of major economic indicators is attached as Schedule A.

t Bangladesh maintains a fiscal year beginning on July 1; the symbol FY86therefore refers to the fiscal year from July 1, 1985 to June 30, 1986.

2-

exchange rate management helped to increase non-traditional exports by roughly20 percent p.a., although from a very limited base. Policies were introducedto stimulate domestic production by providing incentive prices to farmers,simplifying private investment sanctioning procedures, and denationalizingpublic enterprises. Development of domestic comercial energy supplies,especially natural gas, increased rapidly, enabling relatively high growth inthe power and fertilizer sectors and significant Import substitution forpetroleum products.

5. Growth fell sharply beginning in FY87, however, due to a combination ofnatural disasters (including major floods in FY88 and FY89), a deteriorationin the quality of macroeconomic management, and the cumulative impact offalling investment levels over the past decade. To a large extent, thedecline in investment was due to inappropriate fiscal policies, as publicinvestment fell from 9.4 percent of GDP in PY81 to 6.1 percent in FY91, whileprivate investment fell from 6.5 percent of GDP in FY81 to 5.6 percent inFY91. At the current level of gross investment, estimated at 11.7 percent ofGDP in FY91, it is likely that Bangladesh is approaching the margin of itscapital replacement requirements, let alone contributing to a net increase inproductive assets. The Government set targets in the annual Policy FrameworkPapers (PFP) beginning in FY87 to reverse this situation by increasingdomestic revenues and restraining current expenditures, but performance inachieving the targets was generally unsatisfactory, in large part because theGovernment was unwilling to make politically difficult choices needed toincrease revenues and restrain the growth of current expenditures. As aresult, the Government resorted to large cuts in local funding for the AnnualDevelopment Program (ADP) in order to meet its fiscal targets, which had amultiplier effect on public investment because of the resulting inability toutilize available commitments of foreign aid. Following a period of near-financial instability during FY90, IDA delivered a highly critical assessmentof the Government's performance at the annual Aid Group meeting in April 1990,which resulted, inter alia, in a reduction in donor pledges to $1.8 billion ascompared to $2.2 billion in the previous year. As a result, the Governmentagreed to review its performance on the basis of an Action Program for PolicyReforms during a special Hid-Term Review meeting in Dhaka in November 1990. Amacroeconomic policy framework was prepared with the assistance of the IMF andIDA, backed-up by a three-year ESAF program, and IDA assisted the Governmentin establishing short-term targets for structural reforms in the areas coveredby the Action Program. At the Hid-Term Review meeting, it was determined thatfinancial stability had been largely restored and a promising start had beenmade in many aspects of the structural reform program (such as financialsector reforms), but performance in establishing a sound basis fo: medium-termfiscal management needed to be strengthened. This theme was repeated in IDA'sassessment of performance at the May 1991 Aid Group meeting, which recognizedthat the Government had made significant progress in the intervening period inpublic revenue and expenditure management policies.

B. Macroeconomic Frcework

6. Following approval of the ESAF program by the IMP in August 1990,financial management has been basically sound, despite a variety of inter.Aaland external shocks over the past year. The Gulf crisis resulted in thereturn of almost 70,000 workers, as well as higher oil prices and a loss ofexports to Iraq and Kuwait. The Government took prompt actions to manage thesituation, including an increase in domestic petroleum prices, restraints oncurrent expenditures, and a reduction of imports, as well as mobilizingadditional assistance from donors and the 1MF. In December 1990, escalatingpolitical unrest forced the resignation of the President, and democraticelections in February led to the restoration of a parliamentary form ofgovernment, a process that was completed in October 1991. On April 29 1991, amassive cyclone struck the southeastern coast of Bangladesh, killing anofficially est!inated 139,000 people and severely damaging the second largestcity, Chittagong. Due to additional cyclone-related relief expenditures inthe final two months of the fiscal year as well as some reduction in revenuesattributable to the cyclone, the Government was not able to fully achieve itsfiscal targets for FY91, which otherwise would have been on track. Economicgrowth fell to 3.3 percent for FY91 and continued at a generally depressedpace throughout the first half of FY92, due in part to slow implementation ofthe Annual Development Program because of uncertainties related to the longperiod of political transition and a slow start-up of cyclone rehabilitationactivities. As a result of lower import growth (exports have remainedgenerally on target) and additional inflows of concessional assistance forcyclone relief, foreign exchange reserves increased to approximately $1.3billion at the end of December 1991 (equivalent to four months coverage of thereduced level of imports), a situation that is expected to moderate aseconomic activity picks up and cyclone reconstruction accelerates with the endof the monsoon season. Moderate-to-heavy flooding occurred in northwesternBangladesh in August-September 1991, which destroyed approximately 500,000tons of grain, although overall foodgrain production for FY92 is now expectedto reach record levels (in excess of 20 million tons) due to continuing stronggrowth in production in the rest of the country. Finally, military unrestbroke out near Bangladesh's southern border in January 1992, which resulted ina large influx of refugees into a region of the country still struggling torecover from the recent cyclone. Thus, the new Government has been subjectedto an extraordinary series of shocks during its first year, in addition tohaving to maintain a very tight macroeconomic program.

7. The macroeconomic program outlined in the second-year ESA" program seeksto restore a moderate rate of economic growth during the current year whilemaintaining the momentum of the structural adjustment program. With regard tothe fiscal framework laid out in the PFP, the Government has specified thefollowing objectives for FY92:

(a) Increase revenue mobilization by 0.5 percent of GDP, in line withthe overall ESAP target of increasing total revenue collectionsfrom 9.2 percent of GDP in FY90 to at least 10.7 percent of GDP inPY93;

- 4 -

(b) Restrain the growth of current expenditures to less than thegrowth of nominal GDP; and

(c) Increase public investment in real terms and prioritise the publicinvestment program on the basis of a rolling three-year programthat is consistent with the macroeconomic framework.

In addition, the Government has reaffirmed its commltment to a broad range ofpolicy measures affecting agriculture, industry, the financial sector, socialsectors and poverty alleviation. This program, which was outlined at the AidGroup meeting In May 1991, received strcng endorsement by the donors asindicated by the increase in pledges to $2.3 billion for FY92.

8. One of the most important reforms in the FY92 budget was theintroduction of a value-added tax (VAT), which is the centerpiece of the taxreform program reconmended by IDA and the IHF. This action generatedsubstantial public opposition, and while the Government maintained itsconmmitment to the VAT, it introduced exemptions which compromised some of tLebroad-based nature of the tas. The Government committed itself during the PFPdiscussions to tight restraints on public sector wage increases; however,political pressures for implementation of the recommendations of a recentNational Pay Commission subsequently became insurmountable. In August, theGovernment announced a two-year program for adoption of the pay awards. As aresult, the PFP was delayed by IDA and the IMF until assurances were receivedthat the Government would introduce offsetting revenue measures andexpenditure cuts to fully cover the additional cost of the pay increases, andthe PFP and the associated ESAF program were approved by the Committee of theWhole for IDA and by the DMh Board in late September 1991. The Governmentsubsequently came under pressure from labor unions to extend the pay iacreasesto employees of public enterprises, and a Wage Commission has been establishedto review the wage structure for public enterprises and consider an increasein the minimum wage that would apply to employees in private sectorenterprises as well. In spite of these pressures, the mid-term review of theESAP program in early February 1992 determined that the Government is largelyon track in achieving its financial targets for FY92 (with the possibleexception of the public investment program, where implementation in the firsthalf of the year has been well behind schedule); and ample leeway is availablewithin the current targets to accelerate growth by speeding-up implementationof the public investment program.

9. As regards the broader macroec-nomic framework in the PEP, theperformance of the agricultural sector has been very good during the pastseveral years, due in large part to policies which significantly expanded therole of the private sector in the distribution of agricultural inputs. Incontrast, the industrial sector performed poorly throughout the 1980s in termsof production, investment and job creation, and the Government has placed highpriority on achieving rapid industrial growth through liberalization of thepolicy environment and promotion of the private sector, as well as reducingthe drain on the economy due to poorly performing public enterprises. Exceptfor a brief period during 1989, the Government has maintained generally soundmanagement of external trade flows, and the current account balance has

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remained in the range of 6-7 percent of GDP, almost all of which has beenfinanced by concessional aid inflows. The Government follows a flexibleexchange rate policy that is generally appropriate for maintaining externalfinancial stability, although a more aggressive exchange rate policy incombination with structural reforms (e.g., trade liberalization) may bedesirable in the future in order to maintain external competitiveness. TheGovernment's external borrowing policies have been realistic, with a projecteddebt-service ratio of 18 percent of export earnings in FY92. Monetarypolicies have been supportive of a decline in the rate of inflation to 8.9percent in PY91 and 5.5 percent during the first halt of FY92 (due in largepart to good performance in foodgrain production). In this situation, recentBoard papers on adjustment lending (e.g., RAL-Il W) recognize that fiscalpolicy should be the primary instrument for addressing low levels of savingsand investment.

C. Public Resource Management

10. As mentioned above, the stagnation of public investment over the pastdecade can be attributed in large part to inappropriate fiscal policies. Themajor factors that contributed to this situation were:

(i) Stagnation of Domestic Resource Mobilization. Revenue mobilizationhas remained virtually unchanged as a percentage of GDP, accounting for9.4 percent of GDP in FY81 and 9.3 percent in FY90. The tax structureis heavily dependent on taxation of trade flows, with consequentproblems of low revenue elasticity and high implicit costs in terms ofeconomic distortions. Tax administration is weak, and there is a highdegree of tax evasion, due in part to a wide degree of administrativediscretion in tax enforcement.

(ii) Rapid Growth in Current Expenditures. Current expendituresincreased from 5.6 percent of GDP in FY81 to 9.0 percent in PY91. Majorcontributing factors include increases in wage and salary payments, adeterioration in the financial position of Bangladesh Railways,increased subventions for teachers' salaries in private secondaryschools, and excessive staffing levels in local gc.ernmentadministration. While subsidies declined over much of the FY81-89period, there was a sharp increase in subsidies during PY90, rising to14 percent of total current expenditures. Expenditures for essentialoperations and maintenance and the social sectors have been generallyunder-funded. These figures do not fully capture the implicit fiscalcost of large and increasing losses by public sector enterprises (suchas jute and power) that have been covered by access to loans from public

a Adjustment Lending Policies for Sustainable Growth", World Bank CountryEconomic Department, September 1990.

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sector financial institutions, growing arrears to suppliers, and non-payment of debt-service obligat.,ono.

(iii) Weak Prioritization of the Public Investment Program. TheGovernment adjuated to financial instability in the early 19809 throughsharp cuts in the public investment program. Following this exercise,relatively little was done to maintain the investment program within arealistic resource envelope, despite the emergence of seriousimplementation problems due in part to constraints on the availabilityof local counterpart funds. This problem was aggravated by weakprioritization, with approximately one-half of local resources beingallocated to locally-financed projects and block grants, often for verylow priority purposes. Donors compensated for growing shortages inlocal funding by increasing their share of project financing, includingfunding a portion of recurrent costs, and by providing balance-of-payments support. Despite this, the increase in donor financ3'ng sinceFY84 was fully offset by a reduction in the Government's own fundingcontribution to the investment program, with the result that publicinvestment remained static in real terms throughout most of the period.

(iv) Cumbersome administrative procedures. Donor disbursements havebeen further hampered by cumbersome administrative procedures, leadingto a build-up in the outstanding pipeline of project aid commitments to$5.1 billion at the beginning of FY92. Implementation problems relatedto delays in project approval, technical assistance, procurement ofgoods and services, land acquisition, and project staffing, havecontributed to a high frequency of time and cost overruns, therebysignificantly reducing the productivity of public investment. Obsoleteadministrative procedures for planning, budgeting and accounting havemade it difficult for central government agencies concerned withbudgetary management to monitor and control the pattern of publicexpenditures.

11. IDA has made a major effort over the past several years to focusattention on needed reforms in public resource management. This has includedthree grey cover ESW reports -, as well as an emphasis on public resourcemanagement issues in the last two country economic memorandaY Thesereports have demonstrated that improvements in public resource management areessential for achieving higher economic growth, as well as to improve thedelivery of poverty alleviation programs such as primary education, primaryhealth and family planning. As Chairman of the Bangladesh Aid Group, IDA took

-V Bangladesh : An Agenda for Tax Reform, Report No. 7196-BD, December 15,1989; Bangladesh s Public Expenditure Review, Report No. 7545-BD, March 13,1989; and Bangladesh s Poverty and Public Expenditures, Report No. 7946-BD,January 16, 1990.

v Bangladesh : Managing the Adjustment Process - An Appraisal, Report No.8344-BD, March 16, 1990; and Bangladesh : Managing Public Resources for HigherGrowth, Report No. 9379-BD, April 19, 1991.

a strong stand on the need to establish clear investment priorities -ndimprove aid utilization, an approach that nas been backed fully by otherbilateral and multilateral donor agencies. IDA has taken a leading role atthe sectoral and institutional level to help prioritize the public Investmentprogram and to identify needed improvements in aid utilization procedures.During the past year, the Government has taken a number of important steps tointroduce reforms in public resource management recommended by IDA, includingthe introduction of the value-added tax in the PY92 budget, preparation of athree-year prioritized public investment program, and various improvements inaid utilization procedures. These actions demonstrate substantial up-frontcommitment by the Government to the reform program, and the Public ResourceManagement Adjustment Credit would provide a logical continuation of IDA'sdialogue with the Government in this critical area of economic management.

D. Stimulatint the Productive Sectors

12. Expanding the Role of the Private Sector. Higher economic growth rat*Tswill only be possible if there is an increase in investment led by a morevibrant private sector. The Government has taken a number of measures toimprove the economic, financial and regulatory climate for the private sector.Perhaps the most notable success has resulted from the removal of restrictionson the participation of the private sector 4n the distribution of agriculturalinputs, which has increased the availability of minor irrigation equipment andfertilizer and lowered costa to the farmer through more efficient distributionsystems and a greater range of technological choices. The gradual removal ofimport restrictions over the past several years and liberalized access toforeign exchange has also provided the private sector greater scope to competeeffectively in the industrial sector. At the same time, the Governmentrecognizes that further actions are required to improve the incentivestructure for private investment and rationalize the regulatory framework forindustry. A program of prtvatization has been announced, and this needs to becarried through in close _.anjunction with continuing efforts at publicenterprise reform.

13. Agricultural Policies. The Government's objective is to raise theagricultural growth rate to 3.5-4.0 percent annually over the medium term. Toachieve this, the Government intends to rely on greater private investment inminor irrigation and increased use of improved seeds and fertilizers. TheGovernment removed all restrictions on the importation, distribution andsiting of low horsepower irrigation equipment and power tillers in FY88 andFY89, and private distributors were allowed direct access to bulk purchases ofchemical fertilizers starting in FY89. These measures contributed greatly tothe record FY90 harvest and to continuing strong agricultural growth duringFY92. The Government intends to support these reforms through increasedinvestment in minor irrigation equipment by the private sector, expandeddrainage and flood control, intensified command area development, and improvedresearch and extension services. Better transportation infrastructure is alsoimportant to improve farmers' access to major markets.

14. As Bangladesh approaches self-sufficiency in rice production, theGovernment needs to reexamine its food policies. IDA recently prepared a FoodPolicy Report that recommended a variety of measures to improve the efficiencyof foodgrain operations through further liberalization of input markets,expanded involvement of the private sector in foodgrain marketing, andallowing market forces to have a greater influence on output/input prices. Inthe long run, policies that bring domestic rice prices into line with thelong-run trend in world prices should produce a more efficient rice sector,resulting in lower prices to the consumers.

15. Industrial and Trade Policies. Economic diversification, relyingprimarily on private sector-led industrial development, is essential to createnon-farm employment for the rapidly growing labor force. Given the limitedscale of the domestic market due to widespread poverty, industrial growthshould be based on export-oriented activities as well as efficient importsubstitution. Such a strategy would require, at a minimum, a stablemacroeconomic environment, improved regulatory framework, rationalization ofthe trade regime, and an improvement in the operation of public industrialenterprises.

16. Measures to achieve these policy objectives were announced in theIndustrial Policy for FY92. To facilitate private inves'ment, the sanctioninglimits of financial 'nstitutions have been increased to US$2.5 million, andwithin this limit, equal treatment has been provided to domestic and foreigninvestment. Guidelines on foreign direct investment have also been updated.The Government is discussing a further program of trade liberalization withIDA that would involve the elimination of all bans and restrictions on importsezcept for those required for reasons of religion, health, security, andperhaps a small number of items which the Government considers to besensitive. In addition, tariffs for a wide variety of items (other thanluxury goods) would be lowered to a maximum of 75 percent over the next twoyears, with further reductions to 50 percent where revenue considerationspermit.

17. Because public enterprises play a significant role in the country'sindustrial development, their ganerally poor performance and excess capacityhave stifled industrial growth and drained budgetary resources. The mostcritical problems involve firms in the jute sector. With appropriatepolicies, jute could continue to play an important role in industrial exports,despite weak external demand. A Jute Development Project is under discussionwith TDA that would involve the phasing out of excess production capacity andlabor in the existing mills, modernization and rehabilitation investments inviable public and private sector mills, financial, organizational andmanagerial restructuring, and eventual privatization of public sector mills.

18. Financial Sector Reform. Rapid growth of the financial system in themid-1980s without due regard to enforcement of loan recoveries undermined theviability of the financial sector. In addition, the administered interestrate structure virtually eliminated price competition and made priority sectorlending and mobilization of term deposits commercially unattractive.Recognizing these deficiencies, the Government is undertaking a program of

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financial sector reforms vith IDA support which seeks to enhance efficiencythrough greater reliance on market competition, reduction in direct Governmentintervention, interest rate liberalization, strengthening of the nationalizedcommercial banks, and an improved legal framework for debt recovery. TheGovernment has introduced a more market-oriented approach to interest ratedetermination, discontinued subsidized refinancing facilities through theBangladesh Bank, imposed new regulations with respect to accounting policiesfor provisioning of bad debt and suspension of interest, and institutedfinancial loan courts to improve debt recovery. Continuing difficulties inthe financial performance of the nationalized commercial banks, however, couldaffect the sustainability of the reform program unless they are promptlyresolved.

19. The Role of Infrastructure. Well-planned investments in infrastructuregenerally achieve high economic rates of return in Bangladesh despiteimplementation delays, and there have been significant achievements in severalsectors (for example, Bangladesh's dependence on imported petroleum declinedfrom 68 percent of export earnings in FY81 to 19 percent in FY90 due to thedevelopment of domestic natural g's supplies). The major factor constraininggreater investment in infrastructure is the weak financial and operatingperformance of most sector agencies, although there are some importantexceptions (for example, the Rural Electrification Board is generallyconsidered to be an efficient and well-managed organization). The mostserious problems involve the Bangladesh Power Development Board (BPDB), whichinitially achieved improvements as part of the FY89 Energy Sector AdjustmentCredit supported by IDA but subsequently experienced a very seriousdeterioration in its financial performance. As a result, all major donors,including IDA, have suspended new lending for power development during FY91.and IDA has suspended disbursements for an ongoing power operation until theGovernment makes substantial progress in restructuring BPDB and reducingsystem losses and accounts receivable. The Government has recently takensteps to resolve this situation, including establishment of Dhaka ElectricitySupply Authority as an independent entity on October 1, 1991, and it is hopedthat sustained progress in reducing system losses and accounts receivable willallow IDA to resume disbursements and preparation of new investments in thenear future. The natural gas sector has also experienced serious problemsrecently, including contract delays and lack of progress in resolving pricingissues. While IDA is not active in the railway sector, Bangladesh Railways isconsidered to be a major problem due to high losses and poor operatingperformance. In the road sector, IDA was not active for an extended periodduring the 1980s due to lack of agreement with the Government on the priorityof road maintenance. This problem has now been resolved and IDA has resumedlending for roads, and a major Transport Sector Review was prepared by IDA inFY91 to provide a strategic framework for future investments in the transportsector. The report also helped provide a framework within which IDA hastentatively agreed to support the proposed Jamuna multipurpose bridge,provided that the project gains support from other potential cofinanciers.IDA has been active in supporting investment in other infrastructure sectorsas well, such as ports, inland water transport, urban water supply and urbandevelopment; in almost all cases, however, the binding constraint on furtherinvestment is the limited absorptive capacity of the sector institutions.

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R. Addressing Social Develoument Concerns

20. Population. Rapid population growth constitutes one of the most seriousobstacles to poverty alleviation efforts. Since independence in 1971,Bangladesh's population has increased by 35-40 million people. This increasehas created a large expansion in the number of rural landless households andhas increased the number of urban poor through rapid rural-urban migration.Population growth has over-stretched the social services and worsened theimpact of natural disasters through encroachment on marginal lands. Areduction in fuelvood availability is causing rural households to useagricultural residues and animal dung as energy sources, contributing to soildepletion and reduced fodder availability for draft animals.

21. The Government has had an active family planning program since 1975which has been successful in increasing the contraceptive prevalence rate from8 percent in 1975 to 31 percent in 1989 and reducing the total fertility ratefrom above 7 in the mid-1970s to below 5 in 1989. An IDA-led consortium ofdonors is providing support for the sector through the Fourth Population andHealth Project approved in FY91. Efforts are being made to strengthen thelinkages of family planning to maternal and child health care activities, aswell as to the health seztor in general. It is increasingly recognized thatprograms aimed solely at the supply of family planning services will not besufficient to achieve the desired reduction in fertility. Greater efforts areneeded to promote the general status of women in society, as well as to extendfamily planning services to the population in greatest need, for example, byincluding population education in the primary and secondary school curriculum.

22. Human Resource Development. Human resource development as measured interms of literacy, health and nutrition, is extremely low in Bangladesh. Theadult literacy rate (about 29 percent) is one of the lowest in the world, andprimary and secondary school enrollment rates (about 58 percent and 27 percentrespectively) are significantly lower than in comparable countries. With thesupport of other donors, IDA is providing assistance for the expansion ofprimary education and improvements in educational quality through the GeneralEducation project approved in FY90. Programs are also under preparation toexpand educational access to disadvantaged groups, for example, through non-formal literacy programs administered by NGOs.

23. Women in Development. The majority of women in Bangladesh are caughtbetween two different worlds - one determined by culture and tradition thatconfines their activities inside family homesteads, sad the other shaped byincreasing landlessness and poverty that forces them into wage employment foreconomic survival. Ill-prepared for the outside world, women have limitedeconomic opportunities. Bangladesh would benefit significantly in terms ofincreased productivity, enhanced family welfare, and a reduced populationgrowth rate by focussing on the development potential of its women. IDA hascontributed to drawing attention to issues affecting women through its recentStrategy Paper on Women in Development completed in FY90, which is beingfollowed-up by integrating WID issues into the General Education Project and

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the Fourth Population and Health Project, as well as preparation of theproposed Female Secondary School Assistance Project.

24. a vironmental Issues. The floods of 1987 and 1988 and the cyclone of1991 have heightened interest in improved environmental management. IDArecently completed an Environment Strategy Review, which will be discussedalong with other environmental documents at a forthcoming meeting in Dhaka.Particular attention is being paid to forestry issues (because of thedepletion of Bangladesh's forests and sources of biomass), industrial andagricultural pollution control (because of the threat to water supplies andfish), and biodiversity (because Bangladesh is home to a number of endangeredspecies). Flood management and cyclone protection are particularly importantenvironmental concerns, and IDA has taken a lead role in coordinating interna-tional action on flood management. IDA's Action Plan for Flood Control wasendorsed at a conference of donors in London in December 1989, and is nowbeing implemented by the Government with the support of 15 donors, includingIDA. IDA has played a major role following natural disasters in coordinatingthe donor response for rehabilitation and reconstruction activities, and IDAis supporting programs to rehabilitate coastal embankments and expand thecyclone shelter system.

25. Efforts to Reduce Poverty. The elimination of pervasive poverty remainsone of the principal objectives of public policy, and the mixed outcome of theGovernment's efforts in reducing poverty remains a major concern. The mostrecent data indicate that close to 50 percent of the population does not earnenough income to afford a basic diet considered to be the minimum necessary byinternational standards. The Government recognizes that improvedmacroeconomic policy and economic growth are not sufficient to improve theprospects of the poor. It has therefore undertaken to expand employmentopportunities through programs such as Food for Work (FFW) and to targetincome transfer programs to the lowest income groups through the VulnerableGroup Development (VGD) program; these two programs reached approximately fivemillion poor beneficiaries in recent years. The Government has establishedthe independent Palli Karma Shahayak Foundation for poverty alleviation tosupplement these efforts. The objective of the foundation is to supportincome generating programs by NGOs and public sector agencies involved ingenerating employment for the very poor through the provision of credit.

F. The Bank Group's Assistance to Bangladesh

26. Lending Level and Composition. As of December 31, 1991, cumulative BankGroup commitments to Bangladesh totalled US$ 5395.3 million equivalent, net ofcancellations. The distribution of lending as of December 31, 1991 is givenin Table 1 below. In PY90. US$540 million was committed for five operations,and in FY91, $459.7 million was committed for 6 operations. IDA grossdisbursements to Bangladesh totalled US$331 million during FY91, while debt-service payments of US$50 million were received (US$17 million foramortization and US$33 in interest payments), resulting in a net transfer toBangladesh of US$281 million.

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Mfb 1: 0_8h d 1ak fa 8_0b%11072110

Ournualv LO PaondinSector Amount (U886 milan)

Agutue rIgAo wnd Rural Develpmet 11s.7 20

P"r and Ene 10O3&0 18

bxks*y 804.4 14

Educ6ton 400.8 7

Tansportio and T_bccmmvA*adcm 419.5 7

6w_y Pehablltaton 188.6 3

WM b_uluobue 141.7 2

Ppuation and HedhU 905.0 5

Teclhrdca MSleMs 8O5 1

Ad,urn and ir Non.PrWCt Csd 1t257.3 22

Toal __ __ __ _ __ __ __ _ t009

27. For the PY92-95 period, the IDA lending program is planned to continueat a level of around US$450-500 million a year. Of this amount, approximately15-20 percent represents planned adjustment lending, which would materializeonly if the pace of the policy reform process is maintained. Excludingadjustment lending, roughly 22 percent of the remaining amount would go foragriculture, irrigation and rural development, 30 percent for power andenergy, 23 percent for transportation, 15 percent for education and technicalassistance, 5 percent for urban infrastructure, 3 percent for population andhealth, and 2 percent for industry and finance. L

28. IDA's lending program is closely linked to the development strategyoutlined in the preceding sections. The major adiustment operations duringthe FY92-95 period would include the Public Resource Management AdjustmentCredit and the proposed Second Industrial Sector Adjustment Credit, as well asproposed operations for restructuring the jute manufacturing industry and

v The relatively low percentage for population and health reflects theapproval of the Fourth Population and Health Project in FY91 (total projectcost of $600 million, of which IDA will contribute $180 million and bilateraldonors $356 million), which is expected to provide the bulk of resources forthis sector over the next five years.

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improving the foodgrain management system, which would be brought into thelending program if the Government is prepared to commit itself to majorreforms. As regards the lending program for agriculture and water resources,we are planning several lending operations in support of the Flood ActionPlan, including two projects to improve cyclone protection (through roads,coastal embankments, early warning systems, etc) and construct cycloneshelters in high risk areas. We are also planning operations in support ofsustainable forestry management and agricultural research, although furtheroperations in support of agricultural credit have been temporarily shelveduntil we reach a clearer agreement with the Government on priorities in thisarea. Concerning investment in power and energy development, the recentreduction in lending as a result of donor dissatisfaction with the financialand operating performance of the sector agencies has led to growing imbalancesin the investment program that may result in increasingly severe problems ofservice delivery during the next few years. If the performance of the sectoragencies improves substantially, we foresee a need to increase investment overthe next few years in order to restore a balanced program for the developmentof the energy sector. In the transportation sector, the choice of newprojects will be guided by IDA's recent Transport Sector Review. The largestproject in the portfolio is the Jamuna multipurpose bridge, which wouldprovide the first direct transportation link between the eastern and westernsections of Bangladesh, as well as providing supporting infrastructure forpower transmission and a possible gas pipeline in the future. Other potentialprojects in the sector include a continuation of the ongoing roadrehabilitation and maintenance program, improvements in rural access roads byconstructing structures (bridges, culverts, etc) that are not provided by theFood for Work program, and possible projects for port development and roadferry improvements. In the education sector, we anticipate a follow-onoperation to the General Education project in FY95, as well as innovativeoperations for expanding female school enrollment at the secondary level andencouraging non-formal education programs for hard-to-reach children.Operations in urban infrastructure are expected to concentrate on water supplyand sanitation in major urban areas (Dhaka and Chittagong), provided thatagreement is reached on actions to improve the financial and operatingperformance of the sector agencies. In the area of population and health, themajor share of funding for the sector will be provided through the ongoingFourth Population and Health project, and possible new operations during thenext few years will concentrate on programs to stimulate demand for familyplanning services and expand nutrition programs targeted at high risk mothersand children. We currently anticipate relatively limited direct lending tothe industrial sector. However, we are devoting a major share of ESWresources to examining issues involving the incentive structure for industrialdevelopment, promotion of private sector activities, and restructuring ofpublic enterprises, and we expect that additional operations may materializeas a result of this effort.

29. Project implementation. The efficient utilization of IDA resources isseriously constrained by the limited absorption capacity of most sectoragencies. Between FY82 to FY89, the disbursement ratio for project aid as apercentage of outstanding commitments remained in the range of 12-15 percent.Disbursements have improved during the past two years to nearly 20 percent of

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outstanding commitments due to more intensive supervision and restructuring ofproblem projects; however, the quality of the IDA portfolio remainsdisappointing (32 percent of IDA projects are currently rated as experiencingmajor implementation problems), and further actions will be needed to sustainthe recent improvements in disbursement performance. Many of the genericproblems affecting the portfolio would be addressed as part of the PublicResource Management Adjustment Credit. Additional actions are being taken atthe sector level to address implementation problems affecting specificagencies, such as the Bangladesh Water Resources Board and the BangladeshPower Development Board. IDA has made a major effort to improve aidcoordination activities, so that uncoordinated investments by donors do notoverload the implementation capacity of sector agencies. IDA has alsoindicated to the Government that project implementation performance will be amajor factor in determining the level of aid recommendations to the donors atthe annual Aid Group meetings in Paris.

30. Role of IMP, IPC and MIGA. IDA and the IMF have worked closely inBangladesh, especially in connection with the preparation of Policy FrameworkPapers in support of SAF operations during FY87-89 and an ESAF operation forFY9l-93. IDA has coordinated with the IMP in pxeparing adjustment operationsin the financial and industrial sectors.

31. The IFC has increased promotional activity considerably in the last yearand is currently pursuing investment opportunities in general manufacturing,services and capital markets. During FY91, IFC invested in a textile spinningmill. In order to maintain market presence, IFC has been willing to acceptinvestments smaller than it typically considers. In the capital markets area,IFC is focusing its efforts on non-banking financial institutions such ashousing finance, bill discounting and asset finance companies. IFC is alsowilling to play an active role in the Government's privatization initiativeand has expressed this interest to the Government on several occasions.

32. During FY91, MIGA provided an investment guarantee for an export-oriented fertilizer factory in Bangladesh. Following up on work started in1987 by IFC, FIAS has been providing technical assistance to improve thestructure and functioning of the Government's Board of Investment (BOI). InFY91, a 2-year program to strengthen the BOI was agreed upon. Work on thisprogram has recently started and has resulted in the formulation of proposa.sfor reorganization and restructuring of BOI. FIAS is also working with IDA ona deregulation and incentives study in connection with the proposed SecondIndustrial Sector Adjustment Credit.

G. External Financing Requirements

33. Bangladesh can achieve a growth rate in excess of 5 percent over themedium term if it follows the policy framework described above. To supportsuch growth and finance the necessary investment, Bangladesh will have tocontinue to rely on external assistance. Total external aid commitments toBangladesh are currently about US$2 billion a year, of which IDA's share isin the range of 20-25 percent. Even with improvements in public savings,

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Bangladesh will continue to face a savings/investment gap of around 6.5percent of GDP and a budget deficit of about the same amount, which ismirrored in the balance of payments. Given that exports are only two-fifthsof imports and jute prices and volumes are not expected to increase, thecurrent account deficit is expected to remain at around 6.5 percent of GDPdespite the rapid growth of non-traditional exports. Allowing for maintenanceof foreign exchange reserves and amortization payments, aid flows (excludingshort-term financing and the IMF) will need to be maintained at present levelsover the medium term.

34. The bulk of the required aid flows should come from disbursements fromBangladesh's aid pipeline, which stood close to US$5.6 billion at thebeginning of FY92. The balance of the resource requirements would need tocome from new commitments averaging US$1.9 - 2.1 billion p.a. Of this amount,about one-third would need to come from food and commodity aid commitments,reflecting Bangladesh's continued reliance on such aid for fiscal and balance-of-payments support.

35. Bangladesh's outstanding medium and long-term external debt is expectedto increase from US$11.4 billion at the end of FY91 to US$13.0 billion by end-FY93. Because the bulk of the debt is contracted at highly concessionaryterms, the debt-service ratio to GDP is low at 1.8 percent, while the debt-service ratio to exports, excluding IMF repurchases, is manageable at 15.2percent. These ratios are projected to decline to 1.5 percent and 12 percentrespectively by FY95, provided that GDP and export growth are maintained.

R. Summary Assessment and Performance Indicators

36. The Government and IDA are largely in agreement on the key policy issuesfacing the Bangladesh ecor,omy, and differences of viewpoint typically involvethe timing and sequencing of specific policy actions. The highest prioritypolicy indicators for the medium term are summarized in the PFP policy matrix,which was endorsed by the Committee of the Whole on September 26, 1991.Macroeconomic performance is monitored closely by the IMF and IDA in thecontext of the PFP/ESAF program, and various aspects of the macroeconomicprogram are monitored by IDA in greater detail through specific adjustmentoperations (such as fiscal policy in the context of the proposed PublicResource Management Adjustment Credit and financial sector reforms in thecontext of the ongoing Financial Sector Adjustment Credit). IDA's countryeconomic memorandum provides a mechanism for reviewing progress on a broadrange of policy reforms with the donor community at the annual Paris Aid Groupmeeting, while policy matters affecting particular sectors are generallymonitored in the context of specific investment operations. IDA has played amajor role in coordinating the efforts of donors in various sectors, includingtwo IDA-led consortia that are providing support for the expansion of primaryhealth and family planning and primary education. The World Bank ResidentMission forms the focal point for coordination of donor programs at the locallevel, and IDA maintains extensive contact and collaboration at the workinglevel with staff of the Asian Development Bank. Thus, donor coordination on

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policy issues is broad-based and generally effective in the context ofBangladesh.

37. The Government has been reasonably successful in maintaining financialstability over the past several years. However, economic growth has beengenerally disappointing, and serious structural problems need to be resolvedin order to achieve higher growth in the future. The most importantindicators that IDA will use in assessing the Government's performance inaddressing these issues are the followings

* Continued sound macroeconomic management, including agreed fiscal andmonetary targets in the context of the PFPIESAF program, and flexibleexchange rate management.

* Substantial improvements in public resource management (includingactions to be supported by the attached credit) focusing on tax reform,prioritization of the public investment program, restraint of currentexpenditures, and streamlining of aid utilization procedures.

* Improved incentives for efficient industrial investment through tradelib. alization, restructuring of public enterprises (includingprivatization) especially in the jute sector, continued progress infinancial sector reforms, and improvements in the regulatory environmentfor industry.

* Vigorous action to reduce losses and improve performance in keypublic enterprises, especially Bangladesh Power Development Board,Bangladesh Railways, Petrobangla, and Dhaka and Chittagong Water andSanitation Authorities.

* Continued liberalization of agricultural inputs, expanded role forthe private sector in foodgrain management, and restructuring ofBangladesh Agricultural Development Corporation.

* Implementation of the Flood Action Plan, including cyclone protectionand shelter programs, and improvement of project implementation andmaintenance by the Bangladesh Water Development Board.

* Strong support for human resource development in the context of theGeneral Education project and the Fourth Population and Health project.

* Continued support for women in development, including expansion ofeducational programs for women at the secondary level.

PART TI s THE CREDIT

A. Background to the Credit

38. Obiectives of the Credit. The Public Resource Management Adjustment(PRMAC) would support the Government's program as outlined in the recentPolicy Framework Paper to achieve a substantial and sustainable increase in

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public savings and investment over the medium term and to ensure that theavailable resources are utilized efficiently in support of high priorityprograms. In order to achieve this objective, the PRMAC would monitor policyreforms in the following aressa

(i) Fiscal TarRets: Establish realistic and achievable multi-yeartargets for increases in public savings and investment within asound macroeconomic framework;

(ii) Structural Reforms: Support comprehensive structural reformof the tax system and prioritization of the public expenditureprogram to improve the efficiency and buoyancy of revenuemobilization and ensure that the available resources are used forthe highest priority activities; and

(iii) Institutional Development: Assist the institutions withprimary responsibility for fiscal management and policy tostrengthen their internal operating procedures, reduceadministrative impediments to efficient aid utilization, andimprove coordination with sectoral agencies responsible forexecuting the public expenditure program.

39. Coordination with the IMP. The PRMAC has been prepared in closecooperation with the IMF, and there is full agreement on priorities for fiscalreform (for example, the introduction of the VAT was a structural benchmarkfor the ESAF program as well as a prior action for appraisal of the PRMAC, andthe IMF provided a technical adviser to the Government for two years to assistin the preparation of the VAT). The macroeconomic framework to be used by thePRMAC will be prepared jointly with the IMF in the context of the annualPolicy Framework Papers (PFP), and the monitoring of the PRMAC will becoordinated with the DMF during various ESAF tranche reviews, PFP discussions,etc. While the reform program supported by the PRMAC therefore forms animportant part of the ongoing ESAF program, the PRMAC will set more specificperformance targets in each of the main areas of structural reform included inthe credit (e.g., tax administration, prioritization of the public investmentprogram, etc.).

40. Justification for Balance of Payments Support. As recognized in recentreports to the Executive Directors on adjustment lending, substantialincreases in savings and investment will be an essential part of a sustainableadjustment strategy for the large majority of countries. For a low-incomecountry such as Bangladesh, improvements in fiscal policies are expected toplay a leading role in stimulating investor confidence and expandingopportunities for productive investments by the private sector in industry,agriculture and services. In the initial stage of the fiscal adjustmentprocess, however, there is greater scope for expanding public investment morerapidly than public savings, both because of the critical need for additionalpublic investment in social and economic infrastructure and because sustainedincreases in revenues are difficult to achieve in the short term and need tobe backed up by longer-term improvements in tax administration. The majorshare of increased public investment should be (and generally is) financed

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directly through increased project aid, but there are limits on the extent towhich this approach can be productive, both because the availability of localcounterpart funds is often a critical constraint on the investment program andbecause project aid does not address the general import requirements of theeconomy stemming from a multiplier effect as a result of the increase ininvestment. Thus, the PRMAC can play an important role in assisting with thetransition to a high-growth, high-savings economy by providing balance-of-payments support for the additional import requirements resulting from thereform program and by generating local counterpart funds to assist with theimplementation of the public investment program.

41. Since the measures to be supported by the PRMAC therefore form anintegral part of the Government's overall reform program, the balance-of-payments justification for the credit should be viewed in terms of the broadercontext of the structural adjustment program being pursued by the Government.Medium-term economic projections prepared in the context of the PFP indicatethat even with a vigorous structural adjustment program, the current accountdeficit is expected to remain in the range of 5.5 - 6.5 percent of GDP for theforeseeable future in order to support a higher level of investment needed tomaintain rapid economic growth. In order for this economic scenario to besustainable, the Government will need to undertake policies aimed at achievinghigher export growth and efficient import substitution, such as the program oftrade liberalization currently being discussed with IDA in the context of theSecond Industrial Sector Adjustment Credit. Within this context, the PRMACwould be the first adjustment credit supported by IDA that combines all theelements of a comprehensive fiscal reform program needed to achieve asustained increase in public savings and investment in the medium term, and ittherefore fully satisfies the criteria provided in recent Board reports tojustify the use of adjustment lending.

B. Description of the Maior Policy Actions

42. The policy reforms to be supported under the PRMAC can be classifiedinto the following five categories:

(i) Macroeconomic Framework;(ii) Tax Reform;(iii) Expenditure Prioritization;(iv) Aid Utilization Procedures; and(v) Institutional Strengthening.

The PRM&C has been designed as a three-tranche adjustment operation timed tocoincide with the introduction of fiscal reforms in three successive annualbudgets. The appraisal of the PRMAC (November-December 1991) took placefollowing the introduction of major elements of the reform program in the FY92budget, especially the introduction of the value-added tax and the preparationof a prioritized three-year rolling investment program (TYRIP). The secondtranche of the PRMAC would support reforms associated with the FY93 budget(which is also the third year of the ESAF program) and would focus primarily

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on direct tax reforms, improvements in tax administration, furtherprioritization of the public expenditure program, and monitoring theimplementation of aid utilization improvements. The third and final trancheof the PRMAC would support reforms associated with the FY94 budget (the natureof IMF involvement beyond the current ESAP program has not yet beendetermined, although it is expected that the IMF will continue to monitor themacroeconomic situation), and it would focus on expanding the base for directand indirect taxes, further improvements in tax administration, expenditureprioritization, aid utilization, and extension of the institutionaldevelopment components of the PRMAC. By adopting the framework of severaltranches tied to reforms in three successive budgets, the PRMAC recognizes theneed to implement fiscal reforms over a medium-term horizon and to match thepace of disbursements under the credit with the timeframe needed to ensurethat the reforms are fully institutionalized. Moreover, by linking the secondand third tranches to preparation of the PFP and the presentation of theannual budget, the PRMAC seeks to avoid potential problems resulting fromconflicting signals and/or multiple negotiations with separate agencies thatcould interfere with the efforts of the Government to prepare and implement acoherent set of fiscal policies.

(i) Macroeconomic Framework

43. A sound macroeconomic framework is essential in order to establishrealistic targets for improvements in public savings and investment.Agreement on a satisfactory macroeconomic framework will continue to takeplace within the PFPIESAF process, and the following fiscal targets (which areconsistent with the PFP) will be monitored as part of both the ESAF and PRMACprograms:

Mi) annual increase in revenues by 0.5 percent of GDP;(ii) rate of growth cf current expenditures not to exceed the rate of

growth of nominal GDP; and(iii) realistic increase in the Annual Development Program (ADP)

consistent with the above targets.

Release of the second and third tranches will be based on a satisfactoryreview of performance in achieving the targets for the previous fiscal yearand the preparation of a realistic budget for the coming fiscal year thatfully meets these targets.

(ii) Tax Reform

44. Due to ch'ronic problems of low revenue elasticity and economicdistortions resulting in part from the tax structure, IDA mounted a majortechnical assistance mission to Bangladesh in 1986 to develop a medium-to-longterm program of tax reform. The recommendations of the mission are summarizedin the 1989 report on tax reform referred to earlier. The report provides aframework for tax reform that is consistent with the recent review paper,Lessons of Tax Reform', that was discussed by the Board of ExecutiveDirectors on April 16, 1991; in fact, the Bangladesh study provided one of themajor inputs for the preparation of the Board paper. The PRMAC would

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represent the first adjustment credit to provide support for a broad-basedprogram of tax reform drawing on the recommendations of the Board paper.

45. Indirect Taxation. As recommended in the recent Board paper on taxreform, the cornerstone of the reform effort is the introduction of a value.added tax, which became effective on July 1, 1991. The VAT has been levied ata uniform rate of 15 percent at the manufacturer-cum-import level. Togetherwith trade-neutral supplementary excise duties, this system largely replacesthe earlier structure of differentiated sales taxes on imports and excisetaxes on domestic goods. Despite the intense initial public resistance to theVAT following its introduction, the VAT has performed well, and its revenueyield during the first six months of FY92 exceeded initial expectations by asubstantial margin. Over the longer run, the VAT is expected to improverevenue elasticity by broadening the base of indirect taxation, as well asreducing economic distortions through elimination of the cascading of taxationthrough succeeding stages of production and moderating the anti-export biasimplicit in the previous structure of excises and sales taxes. Thepreparation of the VAT was assisted by the posting of an IMF technical adviserto the National Board of Revenue (NBR) for the past two years. Follow-upassistance to NBR is being provided through a UNDP technical assistance grant,including the posting of a resident VAT adviser to assist with impl6mentationproblems.

46. The PRMAC would provide support for the introduction of the VAT in theFY92 budget and would monitor its implementation and extension over the nexttwo years. As the first stage in this process, IDA and NBR have agreed on anaction plan for improvements in VAT administration during FY92, includingspecific measures to expand the number of registered traders and verify theaccuracy of the VAT register, increase the rate of submission of VAT returnsto at least 80 percent of registered traders (as compared to 60 percent atpresent), improve internal documentation of VAT administration, expandmanagement training programs, and improve computer cell integration betweenNBR and the field level collectorates. A detailed action plan providingsimilar targets for FY93 would be prepared for implementation as part of thesecond tranche. Actions have also been identified to expand the base of theVAT during the next two years. Measures to be included in the FY93 budgetinclude a limitation on the exemption for small and cottage industries so thatit applies only to enterprises with annual turnover below the threshold forthe turnover tax, inclusion of contractual processing services in the VAT, andinclusion of items currently subject to excise (including at least natural gasand cigarettes) within the VAT. NBR is currently reviewing the administrativefeasibility of expanding the VAT register during FY93 to include, inter alia,all commercial importers and exporters, and wholesalers serving manufacturers,so that they become subject to the VAT in the FY94 budget. A study will becarried-out with IDA assistance to examine appropriate taxation regimes foryarn and textiles (these items were exempted from the VAT during the recentbudget discussions), and taxation will be introduced for yarn and textiles inthe FY94 budget based on the results of this study. Assurances have beenreceived that there will be no further substantive exemptions to the VAT inthe FY93 and FY94 budgets, and all remaining items currently subject to excisetax will be included in the VAT in the FY94 budget.

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47. In addition to the introduction of the VAT (which would be supportedunder the PRMAC), the Government is considering rationalization of theremaining structure of import taxation by lowering the maximum tariff rate,eliminating concessions based on the type of importer or user, replacing highduty rates with trade-neutral supplementary excise duties, and introducingpre-shipment inspection of imports to improve revenue collections. Thesechanges form part of a program of trade policy reforms (including theelimination of most quantitative restrictions on imports and improvements ininvestment sanctioning and export promotion procedures) that would besupported by IDA's proposed Second Industrial Sector Adjustment Credit (FY93).

48. Direct Taxation. 'While the VAT is expected to provide the foundation ofthe revenue system, reforms in direct taxation are needed to improve revenueelasticity and provide a greater degree of progressivity in the tax structure.As demonstrated in IDA's report on tax reform, the current structure of directtaxes is characterized by low revenue elasticity and a high degree of inequitybetween taxpayers because of excessively generous allowances and deductionswhich allow the majority of individuals and corporations to avoid payingtaxes, as well as problems of weak administration that contribute to a highdegree of tax evasion. As a result, income taxation accounted for only 13percent of total tax reven.es in FY90, of which almost two-thirds resultedfrom the company income tax. Some reforms have recently been introduced as aresult of IDA's recommendations, including the introduction of withholdingtaxes on interest in FY91 and dividends in FY92, inclusion of entertainmentallowances in the tax base in FY92, withdrawal of tax exemptions for capitalgains on assets subject to the investment allowance in FY91, reduction of theceiling for the investment allowance to Tk 100,000 in FY92, and a limitationof the time period for granting company tax holidays to 1995 in the FY92budget. The actions to be taken in the FY93 budget include replacement of thecurrent filing threshold for the personal income tax with an exemption limitand replacement of the personal investment allowance with an investment taxcredit, accompanied by additional measures (if needed) to ensure that theoverall package of direct tax reforms is at least revenue neutral. Inaddition, a study will be initiated to prepare an alternative package of taxincentives for companies to replace tax holidays after 1995, with the resultsof the study to be implemented beginning with the FY94 budget.

49. The changes described above would do a great deal to improve equity andefficiency by replacing the current direct tax structure, which ischaracterized by a narrow base and overly-generous allowances and deductions,with a broader-based system that is less susceptible to tax avoidance andevasion. At the same time, improvements in tax administration are consideredessential in order to benefit from the structural changes. The Governmentrecently approved the creation of more than 1000 new posts in the direct taxwing to be spread over a period of three years (filled by a combination ofstaff rotation and new hires), which will permit the establishment of almost100 new tax offices. At the same time, it is important for staff to be usedmore effectively by redeploying existing and addition*. manpower into priorityareas. With this objective in mind, the coverage of the self-assessmentscheme for the personal income tax will be expanded in the FY93 budget to

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cover the majority of assessees in Categories II and III (assessees withincome of Tk 80,000 or less), so that tax enforcement efforts can concentrateon Category I assessees (income greater than Tk 80,000) who currently accountfor approximately 80 percent of revenues generated by the personal income tax,as well as selective screening of taxpayers filing returns under the self-assessment program. Targets have been established for increasing the numberof registered taxpayers by 10 percent during FY92 and 12 percent during FY93,with the proportion of Category I assessees increasing to 4 percent of thetotal in FY92 and 5 percent in FY93, as well as a reduction in outstanding taxarrears (including disputed payments) by Tk 1 billion in each of the next twoyears.

(iii) Expenditure Prioritization

50. Public Investment Program. Despite growing evidence during the latterpart of the 1980s that the public investment program was substantiallyovercommitted (as demonstrated by declining project aid disbursement rates aswell as IDA's public expenditure review mentioned above), the Goverment wasunable to address the problem in any consistent fashion, in large part becauseof political constraints. As a result, the donors began to question theability of the Government to take on major new commitments and implement themefficiently, including several high visibility activities such as the JamunaBridge, the Flood Action Plan, and major programs for the expansion of primaryeducation and primary health and family planning. Following the April 1990Aid Group meeting which brought these issues into sharp focus, the Governmentundertook efforts to prioritize the public investment program in order toaddress the donor's concerns. A high-level committee was established toreview all ongoing projects in order to determine the scope for possible costsavings, which resulted in a reduction in locally-financed block grants in theFY91 budget by 60 percent, the immediate closure of almost 100 ongoingprojects (mc.r of them relatively small), and the identification of potentiallonger-term cost savings in the remaining projects amounting to 20 percent ofprojected costs over the coming five-year period. Drawing on this exercise,the Planning Commission began the preparation of a three-year rollinginvestment program (TYRIP) to integrate the funding requirements for ongoingand proposed projects into a consistent macroeconomic framework. This processwas highly contentious, as the Planning Commission had just issued (October1990) the final version of the Fourth Five-Year Plan (FFYP) that was based ona projected resource envelope roughly 30 percent larger in real terms than themore realistic resource envelope envisioned in the TYRIP. The preparation ofthe TYRIP therefore required the sectoral ministries to reconcile the highlyambitious investment objectives outlined in the FPYP with a more realisticassessment of resource availability. The TYRIP has undergone a number ofrevisions over the past year, a process in which IDA participated in aninformal advisory capacity. It was circulated to donors at the end of October1991, and the Planning Commission has compiled the comments of donors as aninput for reviewing the TYRIP during preparation of the FY93 budget and AnnualDevelopment Program (ADP).

51. The prioritization exercise has resulted in the following changes in thepublic investment program to date:

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(a) Sectoral Allocations. One of the primary objectives of the TYRIPis to ensure adequate funding for high priority projects,especially in the social sectors. Sufficient funding has beenprovided in the FY92 ADP to fully support priority activitiesbeing undertaken as part of the General Education Project and theFourth Population and Health Project. In addition, there has beena major increase in the allocation for investment in natural gas(from 4.6 percent in the FY91 ADP to 8.3 percent in the FY92 ADP)in order to address chronic implementation problems due to localfunding constraints. At the same time, the allocation for theindustrial sector has been reduced from 10.5 percent in the FY91ADP to 5.2 percent in FY92, due in part to a decision to deferlower priority projects.

(b) Reductions in Locally-Financed Projects. The allocation forlocally-financed projects and block grants in the FY92 ADP hasbeen reduced to 27 percent of available local resources, ascompared to 50 percent in the FY90 ADP. This was achieved bycutting the number of locally-financed projects from 385 in FY90to 218 in FY92 and by sharp reductions in block grants for localdevelopment projects. This effort will be continued in subsequentbudgets to ensure that the total allocation for locally-financedprojects and block grants does not exceed 25 percent of theavailable local resources. As a result of the pruning exercise aswell as more careful budgeting for higher priority projects, theavailability of local counterpart funds, which previously wasconsidered to be a major implementation constraint for a largenumber of donor-assisted projects, is no longer a significantproblem in the FY92 ADP, although other implementation problemshave resulted in relatively low disbursement rates so far thisyear.

(c) Pruning of Lower-Priority Projects. A number of lower-priorityprojects have been dropped or scaled-back to token allocations inthe TYRIP, partially in response to queries raised by IDA andother donors regarding project prioritization. For example, theTYRIP has identified 18 out of 26 locally-financed projects in thehealth sector to be closed in FY93, for an estimated annualsavings of Tk 0.3 billion. Moreover, a number of projects,including many in the agricultural sector, have been identified ashaving lower priority in the TYRIP, and these projects areexpected to absorb the burden of funding reductions if the amountof resources is less than originally expected.

52. While the TYRIP is generally regarded as providing a useful frameworkfor prioritizing the investment program, it has not yet been fully integratedinto the budget cycle. Moreover, the TYRIP needs to be backed-up byinstitutional changes within the Planning Commission to establish a strongerrole for macro-level management of the public investment program. Untilrecently, the Planning Commission focused on the screening of individualinvestment projects as well as preparation of the five-year development plans.

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Vhile the five-year development plans have been useful in articulating long-term objectives (such as the recent focus on human resource development andpoverty alleviation in the Fourth Five-Year Plan), the macroeconomic frameworkfor the development plans has tended to be overly ambitious, and they have notprovided a realistic guide to the allocation of scarce development resources.The TYRIP is intended to overcome this problem by providing a realisticframework for programming investment projects that is linked to themacroeconomic projections in the PFP. At the same time, the guidelines forproject preparation and approval have been modified to delegate responsibilityto the sectoral ministries for the preparation of investment projects, whilethe Planning Commission has taken on greater advisory responsibilities assecretariat to ECNEC (Executive Committee of the National Economic Council),especially as regards the overall composition of the investment program andthe consistency of investment projects with sectoral strategies. The variousactions to be supported by the PRMAC are intended to continue strengtheningthe role and capacity of the Planning Commission in providing these essentialinputs into the investment programming process.

53. The following actions will be monitored as part of the PRMAC:

(a) Preparation of the TYRIP and ADP. As part of the annual budgetprocess, the Planning Commission will update the TYRIP, with the ADPserving as the first year of the TYRIP, so that it meets the followingcriteria:

{i) the resource envelope should be consistent with themacroeconomic framework in the PFP;

(ii) adequate allocations should be provided for high-priorityprojects, including sufficient local funds; and

(iii) the amount of funding provided for locally-financedprojects and block grants (excluding block grants for landacquisition and payment of custom duties and value-added tax onproject-related imports) should not exceed 25 percent of the localfunds available for the ADP in any given year.

(b) Strengthening the Project Pipeline. Up to now, the TYRIP has beenapproached primarily as a financial programming exercise. In somesectors such as power and natural gas, donors have worked closely withthe Government to develop medium-term priority investment programs thathave been useful in identifying imbalances in the infestment program,such as the need to increase investment in power transmission anddistribution facilities as compared to generation. In other sectors,however, project selection is still approached in an ad hoc manner. TheGovernment intends to use the TYRIP to strengthen the pipeline ofpriority projects in selected sectors. In order to initiate thisprocess, the Planning Commission has identified three sub-sectors,(fisheries, natural gas and health) for which investment strategy reviewpapers will be prepared by the relevant agencies working in cooperationwith the appropriate sector divisions of the Planning Commission, to be

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completed prior to the second tranche of the PRMAC. These papers willbe discussed with the relevant donors and reviewed by the PlanningCommission, for submission and approval by ECNEC as the basis forstrengthening the project pipeline over the medium term. Following thisexercise, at least three additional sub-sectors (including moredifficult sectors such as crop agriculture) will be identified for thepreparation of investment strategy review papers prior to the thirdtranche of the PKMAC.

(c) Restructuring of Lower Priority Projects. The project pruningexercise carried out in FY91 and the various revisions of the TYRIP haveresulted in a large number of ongoing and proposed projects beingdropped from the investment program because of lower priority. Whilethe overall quality of the public investment program is generallyadequate, there are still a fair number of projects in the TYRIP wheresignificant differences of opinion exist as to their expected benefits,cost-effectiveness, and/or priority in terms of overall selectoralobjectives. As part of the PRMAC, the Planning Commission hasidentified ten relatively large ongoing projects that will be reviewedwith the objective of restructuring the projects (including the optionsof continuation on a revised basis or possible termination) to improvetheir economic and/or financial viability and their implementationperformance. The list of ten projects includes several that havegenerated substantial controversy in recent years, including the TeestaBarrage, Seed Development Project, Barind Integrated Area DevelopmentProject, Establishment of an Aluminum Rod Mill, and High Voltage Cableand Conductor Manufacturing Plant. A timetable and action plan forreviewing each project is being prepared, with satisfactoryimplementation of the restructuring plans to be initiated prior to thethird tranche of the PRMAC.

(d) Introduction of Project Pruning on a Continuous Basis. While theproject pruning exercise in FY91 was an effective means for deleting alarge number of lower priority projects from the investment program andreleasing funds for use by other projects, past experience indicatesthat the benefits of this exercise will be relatively short-lived unlesscontinuing attention is given to pruning lower priority and/or poorlyperforming projects on a regular basis. As part of the PRMAC, theImplementation Monitoring and Evaluation Division (IMED) will prepare alist of potential projects for pruning and/or restructuring, includingthose that require increased funding allocations, which will beconsidered by the Programming Cormittee of the Planning Commission inmaking the allocations for projects in the ADP. The first such reportwas completed in February 1992 and recommended reduced allocations for162 projects (of which 46 would be dropped entirely from the FY93 ADP),for a total savings in local counterpart funds of Tk 2.5 billion.(Notes revisions in project aid requirements were not quantified as theresources are not fungible.) In addition, 82 projects were identifiedas requiring increased local funding allocations amounting to Tk 4.0billion in order to support prompt implementation, with the net increase

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in local funding to be provided from unallocated block grants in theADP.

(e) Improved Monitoring of High Priority Proijects. The IMED maintainsan extensive monitoring system for ongoing in-estment projects, whichhas been used primarily to estimate the actual level of ADP expendituresand prepare project completion reports. As part of the PIMAC, IHED hasagreed to introduce a more action-oriented monitoring system on a trialbasis that will provide fast-response information to decision makers onimplementation problems for a selected subset of high priority projects.The Planning Commission and IMED have identified an initial group offorty priority projects for intensive monitoring, and IMED has developeda monthly reporting format oriented at identifying criticalimplementation issues. These reports will be reviewed on a regularbasis with the sector ministries and the Planning -aommission in order toidentify follow-up actions and improve inter-agency coordination forcritical approval procedures. DMED will redeploy its staff to ensurethat all of the identified priority projects are visited at leastquarterly. This system was introduced on a trial basis on March 1, 1992(following a period of training for the sector agencies), and it will befully implemented in July, 1992.

(f) Short-term Improvements for Honitoring ADP Expenditures. The IMEDmonitoring system is currently the major source of information on actualexpenditures for the ADP. Because of various reporting difficulties anddefinitional problems, it has not been possible to reconcile the IMEDestimates with other estimates of actual ADP expenditures provided fromother sources (e.g., the cash flow estimates based on accountsmaintained by Bangladesh Bank). In the longer term, this situation canbe resolved by improving the expenditure reporting system maintained bythe Comptroller and Auditor General (see para. 60), but this effort willnot be fully operational for several years. In the meantime, a stud