Report and Recommendation of the President to the Board of Directors

Transcription

1 Report and Recommendation of the President to the Board of Directors Project Number: November 2009 Proposed Program Loan, Technical Assistance Loan, and Technical Assistance Grant Republic of the Maldives: Economic Recovery Program

2 CURRENCY EQUIVALENTS (as of 4 November 2009) Currency Unit rufiyaa (Rf) Rf1.00 = $0.078 $1.00 = Rf12.80 ABBREVIATIONS ADB Asian Development Bank BPT business profit tax DIR Department of Inland Revenue EA executing agency GDP gross domestic product IMF International Monetary Fund MIA Maldives International Airport MMA Maldives Monetary Authority MOFT Ministry of Finance and Treasury MTFF medium-term fiscal framework PEMEB Public Enterprise Monitoring and Evaluation Board PMU project management unit PSIP Public Sector Investment Program SDR Special Drawing Rights SOE state-owned enterprise STELCO State Electric Company Limited STO State Trading Organization TA technical assistance TPMU thematic project management unit W&MA ways and means advance NOTES (i) The fiscal year (FY) of the Government and its agencies ends on 31 December. FY before a calendar year denotes the year in which the fiscal year ends, e.g., FY2009 ends on 31 December (ii) In this report, "$" refers to US dollars.

3 Vice-President X. Zhao, Operations 1 Director General K. Senga, South Asia Department (SARD) Directors B. Carrasco, Country Coordination and Regional Cooperation Division, SARD A. Sharma, Financial Sector, Public Management and Trade Division, SARD Team leaders Team members A. Hussain, Principal Economist (Results Management), SARD K. Shin, Senior Economist (Financial Sector), SARD G. Bhatta, Principal Public Sector Management Specialist, SARD T. Hayashi, Economist, SARD R. Nagpal, Senior Counsel, Office of the General Counsel In preparing any country program or strategy, financing any project, or by making any designation of, or reference to, a particular territory or geographic area in this document, the Asian Development Bank does not intend to make any judgments as to the legal or other status of any territory or area.

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5 CONTENTS Page LOAN AND PROGRAM SUMMARY i I. THE PROPOSAL 1 II. THE MACROECONOMIC CONTEXT 1 III. THE SECTOR 3 A. Sector Description and Analysis 3 B. Issues and Opportunities 4 IV. THE PROPOSED PROGRAM 6 A. Impact and Outcome 6 B. Policy Framework and Actions 7 C. Creation of Apex Program Management Unit 11 D. Important Features and Lessons 11 E. Cost and Financing Plan 11 F. Implementation Arrangements 13 G. ADB s Coordination with Other Development Partners 15 V. TECHNICAL ASSISTANCE 15 A. Technical Assistance Loan (Project Loan for Capacity Development for the Program) 15 B. Technical Assistance Grant (Institutional Strengthening for Economic Management) 17 C. Implementation Arrangements for TA Loan 18 D. Implementation Arrangements for TA Grant 19 VI. PROGRAM BENEFITS, IMPACTS, ASSUMPTIONS, AND RISKS 19 A. Expected Benefits and Impacts 19 B. Risk Analysis 20 VII. ASSURANCES 20 A. Specific Assurances 20 B. Conditions for Loan Effectiveness 21 VIII. RECOMMENDATION 21 APPENDIXES 1. Design and Monitoring Framework Sector Analysis 29 3 Development Partner Coordination and Assistance Development Policy Letter and Policy Matrix Summary of Poverty Reduction and Social Strategy Procurement Plan List of Ineligible Items Summary Governance Risk Assessment Cost of Adjustment Detailed Cost Estimates (TA Loan and TA Grant) 61

6 SUPPLEMENTARY APPENDIXES (available on request) A. Governance and Anticorruption Risk Assessment B. Gender and Development C. Public Expenditure and Financial Accountability Assessment D. IMF Stand-By Arrangement (highlights) E. Consultants' Terms of References F. Government Reform Measures G. Medium Term Fiscal Framework H. Roadmap for Modernization of Department of Inland Revenue

7 LOAN AND PROGRAM SUMMARY Borrower Classification Environment Assessment Program Description Rationale Republic of the Maldives Targeting Classification: General intervention Sector (subsectors): Public sector management (public expenditure and fiscal management, economic and public affairs management, public administration) Theme (subthemes): Economic growth (promoting economic efficiency and enabling business environment, promoting macroeconomic stability); private sector development (private sector investment, privatization); capacity development (institutional development) Climate change: climate change mitigation Location impact: National (high impact) Category C The proposed Economic Recovery Program is part of a broad emergency program of the Government of the Maldives supported by several international financial institutions, including an International Monetary Fund (IMF) Stand-By Arrangement. The Government's emergency program seeks to correct deep-rooted economic imbalances and restore the economy to a sustainable growth trajectory over the medium term. To achieve these objectives, the Program will support specific reform initiatives, including (i) rationalizing, prioritizing, and aligning public spending with available resources; (ii) broadening the tax base; (iii) reducing economic subsidies; (iv) supporting privatization of state-owned enterprises (SOEs); (v) strengthening internal audit functions; and (vi) changing the role of the Government in the economy from a provider of all services to an enabler of sustainable and equitable growth. The tsunami of late 2004 brought to the fore some underlying structural problems in the economy of the Maldives. These include a narrow and concentrated economic base, an inelastic taxation system, continued subsidization of social services, a rapidly growing civil service, and the lack of a clear strategy for the divestment and privatization of SOEs. In addition, human resource capacity constraints, especially at mid to low level, including government functionaries, have made effective implementation of development assistance projects difficult. These structural constraints have weakened macroeconomic fundamentals and made the economy more vulnerable to external shocks, including increases in prices of imported food and refined oil products. They also have an impact on the main driver of the economy tourism. The increasing reliance on public spending,

8 ii together with the Government's inability to reduce its role in the economy, has led to a large fiscal deficit (13% of gross domestic product [GDP] in 2008). To finance this large deficit, the authorities have had to resort to monetization of the deficit through the ways and means advances. This has led to additional pressure on inflation, increases in the real effective exchange rate, and pressure on the currency peg. This process of monetization is also placing further strain on Maldives Monetary Authority's (MMA's) balance sheet. Large current public spending has led to increasing demand for imports by virtue of the openness of the economy and rapid growth of the current account deficit (52% of GDP in 2008), a rapid increase in public debt (54% of GDP) and increasing pressure on the international reserves position. The Government recognizes the magnitude of the economic crisis and has begun reforms to arrest its deteriorating fiscal position. At the same time, it has agreed to take further economic reform measures under this Asian Development Bank (ADB) Program and under the IMF Stand-By Arrangement The Government, which inherited a legacy of unaddressed structural issues, realizes the costs of delaying corrective measures. It has seen its net foreign exchange reserves drop to $53 million at the end of August 2009, a significant increase in the fiscal deficit, and a contraction of economic growth. Tourism, fisheries, and construction the three main drivers of economic growth have been adversely affected by the global economic slowdown and weaknesses in domestic economic management. Accordingly, the country is now in recession, with GDP expected to contract by nearly 4% in Impact and Outcome The proposed Program will support recovery and sustainable growth of the economy over the medium term by removing the distortions that have led to the large economic imbalances. By supporting long overdue structural reforms, the Program will move toward a more broad-based and sustainable development framework that reduces the country's vulnerability to external shocks and prepares it for scheduled graduation by the United Nations to middle-income country status on 1 January The key end-of-program outcomes of the Program will be the creation of greater fiscal space in the Government budget by diversifying the tax base and rationalizing expenditures, improving debt management, and enhancing the privatization of SOEs. The issuance of Treasury bills and bonds will deepen the financial market (given that the Government and the MMA have reached an agreement that the deficit will no longer be monetized, but will be financed by open-market operations of the MMA). Specific outcomes of the Program include (i) improved fiscal

9 iii discipline and predictability; (ii) enhanced value of the budget as a policy tool; (iii) synchronization of the budget preparation process with available resources; (iv) diversification of the tax base; (v) expenditure rationalization; (vi) better monitoring and management of internal and external debt; (vii) a sounder footing for Government finance, avoiding inflationary domestic finance; (viii) deeper financial markets through the issuance of Treasury bills and bonds, and provision of a market-based instrument for liquidity management to MMA; (ix) better project management and development effectiveness; (x) a transparent privatization process for SOEs; and (xi) a stronger internal audit mechanism. Financing Plan ADB will provide a loan in various currencies equivalent to SDR21,912,000 ($35 million equivalent) from ADB's Special Funds resources. The loan will have a term of 24 years, including a grace period of 8 years, and an interest charge of 1.0% per annum during the grace period and 1.5% per annum thereafter. ADB will also provide a technical assistance (TA) package of $4.5 million in support of the Program. This will consist of (i) TA grant of $3.0 million in support of various institutional strengthening initiatives, from ADB's Technical Assistance Special Fund (TASF-IV), and (ii) a TA loan in various currencies equivalent to SDR939,000 ($1.5 million equivalent), for supporting capacity development and privatization initiatives, from ADB's Special Funds resources, which will have a term of 32 years, including a grace period of 8 years, and an interest charge of 1.0% per annum during the grace period and 1.5% per annum thereafter. Program Period and Tranching Executing Agency Implementation Arrangements The Program will be completed by December The loan will be released in two tranches SDR11,269,028 ($18 million equivalent) upon effectiveness of the loan and fulfillment of agreed conditions for the first tranche, and SDR10,642,972 ($17 million equivalent), which is expected to be disbursed 18 months after loan effectiveness upon satisfactory fulfillment of agreed conditions for the second tranche (or earlier than 18 months if the conditions have been met). ADB will monitor the progress of the Program at regular intervals. Ministry of Finance and Treasury (MOFT) A steering committee will be responsible for overall coordination, implementation, monitoring, and policy approvals. It will be chaired by the state minister of MOFT and will include representatives from the President's Office, Privatization Committee, MMA, and senior officials from MOFT (including the heads of Public Enterprise Monitoring and Evaluation Board, Internal Audit Unit, Budget Division, Debt Division, Department of Inland Revenue, and Department of National Planning). ADB will participate in the committee as an observer.

10 iv Procurement and Disbursement Program Benefits Consultants to be financed from the TA loan and grant will be recruited in accordance with ADB s Guidelines on the Use of Consultants (2007, as amended from time to time). Consultancy contract packages using the quality- and cost-based selection method and consultants qualification selection will be utilized for selection of consultants, based on technical proposals, for specific subcomponents. Procurement of any goods or services shall be carried out in accordance with ADB s Procurement Guidelines (2007, as amended from time to time). The Program is expected to result in higher tax collection and better expenditure management systems that, combined with the divestment and privatization of SOEs, should lead to a reduction in economic imbalances, including fiscal and current account deficits, and improvements in macroeconomic management. The Program is also expected to lead to better resource management from domestic and external sources. In particular, over the medium term, it is expected that the apex project management unit (PMU) at the Ministry of Finance and Treasury and two thematic project management units (TPMUs) at the Ministry of Housing, Transport and Environment, and Ministry of Economic Development, respectively, will improve the project performance ratios, including portfolio performance indicators, thereby improving aid effectiveness. Strengthening the macroeconomic profile, improving alignment between development spending and sector priorities and programs, introducing new taxes, rationalizing expenditures, and progressing toward divestment and privatization of SOEs will expand the economic base and support more broad-based economic growth. The Program will equip government agencies with modern analytical tools to manage the development process, facilitate an inflow of foreign direct investment, and smooth Maldives' transition to middle-income country status. Risks and Assumptions There are many risks to the effective implementation of the Program. On the political front, there have been difficulties in obtaining agreement on policy reforms, particularly on fiscal management and, specifically, expenditure cutbacks. These risks are mitigated to a significant degree by the strong upfront actions. In contrast to previous reform efforts, the Government has strong ownership of the Program and the reform agenda at all levels. The President himself has been a leading champion of the reform process. The Government has been candid about the comprehensive nature of the economic reforms it needs to undertake. This will serve to mitigate the political risks and also expedite legislative approval.

11 v Risks to privatization will be mitigated by the provision of a TA to the Government. A Government and IMF program will set forth the macroeconomic and fiscal framework and support complementary policy measures over the medium term. Technical Assistance A TA package of $4.5 million will be provided under the Program. This will comprise (i) TA grant of $3.0 million in support of various institutional strengthening initiatives, and (ii) a TA loan of $1.5 million in support of capacity development initiatives and the eventually income-generating privatization initiatives. The TA grant will be primarily used for (i) strengthening the MOFT capacity in budget, expenditure, tax, cash management, internal audit, and (ii) supporting apex PMU, and the TPMUs in two key ministries and related capacity development. The TA loan will (i) enhance training and capacity building for government officials and related stakeholders; and (ii) enhance capacity to support privatization policies and procedures, the privatization process for targeted SOEs, and develop the capacity of the Privatization Committee, Invest Maldives, and develop a public private partnership framework.

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13 I. THE PROPOSAL 1. I submit for your approval the following report and recommendation on (i) a proposed program loan for the Economic Recovery Program (the Program); (ii) a proposed technical assistance (TA) loan for Capacity Development for Economic Recovery Project (the Project), both to Republic of the Maldives. The report also describes proposed TA for Institutional Strengthening for Economic Management. The design and monitoring framework is in Appendix 1. II. THE MACROECONOMIC CONTEXT 2. Socioeconomic development. Generally, sound macroeconomic management combined with favorable external conditions and strong donor support have led to average annual gross domestic product (GDP) growth of 6.6% during in the Maldives. Tourism has been the engine of growth and it has driven economic expansion in other sectors, including construction, transport and communications, and wholesale and retail trade. Strong and sustained economic growth has led to a rapid increase in income per capita. The Maldives has gone from being one of the poorest countries in South Asia in the 1970s with a per capita income of less than $100 to the country with highest per capita income in the region (per capita income of almost $3,000 by the end of 2008). The Maldives will be graduated by the United Nations to a middle-income country on 1 January Social indicators have also improved. Primary education is nearly universal. Illiteracy declined from about 18% in the 1970s to about 1% in Infant mortality decreased from more than 100 per thousand in the 1970s to 14 per thousand in Average life expectancy rose from 47 years in 1977 to 71 years in While income inequality remains an issue, partly reflecting the characteristics of a small population scattered across vast distances, this is expected to decline slowly as distant atolls are integrated with the formal economy in Malé and its surroundings. 3. Small, open economy. The Maldives is a small, open economy and is therefore vulnerable to potential shocks, including changes in tourism flows, fluctuations in the prices of key commodities such as food and fuel (both of which are mainly imported), and capital inflows. The country s revenues and foreign exchange reserves are directly or indirectly tied to the performance of tourism and any changes to tourism arrivals as in the aftermath of the tsunami and after the start of the global economic crisis can undermine macroeconomic stability. The economy needs to be properly managed so these vulnerabilities can be addressed. In view of the limited role of monetary policy reflecting a dollarized economy with a fixed exchange rate to the dollar and a money market in its infancy fiscal policy has the potential to play a greater role in driving demand management and economic stabilization measures. 4. Rising budget imbalance. The December 2004 tsunami wreaked havoc on the lives of people in the Maldives and created a disaster of national proportions. There was widespread infrastructure damage, including shelter, in most of the inhabited atolls, but the capital, Malé home to about half of the country s population escaped relatively unscathed. Total damage was estimated at about $470 million, close to 60% of GDP. With generous external assistance, almost all of the tsunami-related damage has been repaired to a higher design standard. Beginning with the 2005 and 2006 budgets, the incumbent Government started increasing recurrent expenditures with an eye toward the next elections. These mainly consisted of (i) a large increase in the size of the civil service, (ii) an increase in public sector wages, and (iii) maintenance of power and water subsidies, especially in the politically important capital, where power tariffs have remained unchanged since Cumulatively, these recurrent expenditures meant that fiscal expenditure reached 62% of GDP by the end of 2008 (compared

14 2 with 36% in 2004). At the same time, unrealistic revenue projections, reflected in successive budget proposals, failed to materialize and, as a result, the fiscal deficit increased from 1.6% of GDP in 2004 to 12.6% by the end of Total public debt increased from 43% of GDP in 2004 to 54% by the end of Domestic borrowing to finance the deficit drove debt accumulation. External debt to GDP rose from 42.7% in 2004 to 76.9% in Deteriorating balance of payments. Given the Maldives' high import dependency, its expansionary fiscal policy has resulted in a deterioration of the balance of payments current account. The deficit increased partly because of an increase in imports to pay for tsunami reconstruction but mostly because of (i) strong domestic demand led by new resort construction, (ii) large government expenditures, and (iii) soaring food and oil prices from Reliance on external capital inflows. Capital inflows have financed the large balance of payments current account deficit. The main items have been the external investment inflow for resort development, greater lending by Malé-based branches of two foreign commercial banks (by obtaining funds from their overseas headquarters), and domestic borrowing by the Government to finance rising expenditures. As the foreign bank liabilities are in the form of short-term borrowing, the short-term external debt had increased to $498 million (40% of GDP) by the end of Impact of the global crisis. Since the onset of the global economic crisis in September 2008, foreign banks in Malé have sharply curtailed their lending, which has led to a shortage of dollars in the domestic market. Withdrawals from dollar-denominated accounts are paid out in either rufiyaa or in a combination of dollars and rufiyaa. The recession in the developed world has also affected tourism. Bed-nights dropped by almost 9% year-on-year during January September The international liquidity crunch will make it harder for the Maldives to roll over its short-term borrowing. This represents a risk for the Maldives balance of payments and the currency peg with the US dollar. The Maldives Monetary Authority (MMA) has continued to intervene in the foreign exchange market to maintain the peg, which has led to a steady decline in reserves. Although a credit line of $100 million from India, including $50 million of budgetary support, was agreed to in early 2009, it provided only temporary relief from the pressure on international reserves. Due to the nascent nature of the financial system in the Maldives, the volume of financial inflows on capital account or portfolio investment has been low. Gross international reserves have shown a steady depletion and, on a net basis, were some $53 million at the end of August Political change. The Maldives now has a new constitution, and a new President who was elected through universal adult suffrage in a free and fair election in October 2008, bringing to an end the 30-year-long rule of the previous administration. The new Government is strongly committed to political and economic reforms and its election manifesto included reducing the size of the Government to a lean and efficient administrative machinery, reducing the state s role in economic activity by privatizing state-owned enterprises (SOEs), and improving public governance. 9. Inherited economic legacy. By the time the new administration assumed office in November 2008, the economy had deteriorated significantly; from an estimated GDP growth of 5.8% in 2008, the most recent official projection for 2009 is 3.9%. The economy continues to be adversely affected by progressively higher budget and balance of payment deficits, which has forced the authorities to resort to monetize the deficit through the ways and means advances (W&MA), i.e., an overdraft facility with the central bank. However, in May 2009, the Government obtained parliamentary approval for a revised 2009 budget. The overriding

15 3 objective is to adjust the budget so it is in line with the policies of new government sworn in November 2008, and to align expenditure 71% of GDP in the original budget with available resources. Under the revised budget, total expenditures are projected to decrease to 67% of GDP, and the budget deficit was projected to decline significantly, largely because of the proposed privatization of Malé International Airport (MIA). 10. The way forward. As noted in the Government's development policy letter (Appendix 4), the neglect of long-standing structural issues by the previous administration and the impact of the expansionary fiscal policy over the past 3 years have resulted in a marked deterioration in the economy. In order to restore macroeconomic stability and return the Maldives to its highgrowth trajectory, the Government has decided to implement a far-reaching economic reform program. For this purpose, it has sought assistance from Asian Development Bank (ADB) and other development partners, including International Monetary Fund (IMF) and World Bank (see Para 57). III. THE SECTOR A. Sector Description and Analysis 1. The Challenge 11. Since the tsunami in late 2004, the Maldives economic performance has rapidly deteriorated. While the tsunami-related damage is being restored, the deterioration in macroeconomic indicators continues. This reflects the then Government's failure to undertake much-needed reforms to address longstanding structural issues, including a rapidly expanding civil service and public sector wage increases, unsustainable subsidies on economic services (including that of power in Malé, the country's most affluent region), and a system of revenue generation that relies on advance payments of public assets, such as advance lease payments for tourism resorts, and for financing recurrent expenditures at the detriment of future generations. The Maldives' expenditure to GDP ratio is one of the highest in the region and one of the highest of island economies. 12. The economic base remains narrow and relies disproportionately on the performance of tourism, and to a lesser degree on that of fisheries and construction. There are 39 SOEs, of which a minority transfer any meaningful dividend income to the treasury. The remainder represents a net drain on the budget. As the Maldives is an open economy and highly dependent on imports, these structural constraints have weakened macroeconomic fundamentals and rendered the economy much more vulnerable to external shocks, including a rise in international food and fuel prices as well as the impact from the global economic downturn. The increasing reliance on large public spending has led to a large fiscal deficit, which is at the source of the economic ills facing the country and has resulted in rapid accumulation of public debt. The share of current expenditure to total expenditure increased from 70% to 80%. The authorities have had to monetize the deficit through W&MA. This has fueled inflation, increased the real effective exchange rate, and exerted pressure on the currency peg. Debt monetization is also placing increasing pressure on MMA's balance sheet. Large public spending has increased demand for imports by virtue of the openness of the economy and resulted in rapid growth of the current account deficit. For a more detailed sector analysis, see Appendix 2.

16 4 2. Government Measures Taken to Address the Problem 13. The Government is aware of these increasing fiscal constraints and associated external imbalances, and has started reforms to address them. However, it does not have the resources to implement many of these measures and has approached its development partners to support its economic reform program. 14. The Government has initiated measures to (i) curtail expenditures; (ii) broaden the revenue base, (iii) streamline Government functions; (iv) address the issue of SOE circular debt; (v) reduce its borrowings from the Central Bank to finance the budget deficit, and (vi) strengthen the institutional framework for privatization and national planning. It has also announced its intention of rationalizing the civil service by reducing it by a third, increasing power tariffs in Malé, and also instituting a power tariff formula linking power tariffs to cost of inputs including international petroleum prices. Details of these measures are in Supplementary Appendix F. B. Issues and Opportunities 1. Issues a. Revised 2009 Budget and the Medium-Term Fiscal Framework Remain Ambitious 15. Budget deficit. Although the revised 2009 budget aims to compress the fiscal deficit to 7.4% of GDP, revenues are uncertain most are projected to come from the privatization of MIA, which is not likely in 2009, and from the introduction of an increase in the airport passenger service charge (airport tax), business profits tax, and tourism goods and services tax. As of the end of June 2009, the budget deficit was 16% of GDP, and, with the measures described in the Program, the year-end budget deficit is projected to be 28%, 1 and to decline to 14% by the end of The credibility and predictability of the budget formulation and implementation process needs to be significantly enhanced. "Expenditure brakes" need to be introduced if revenue and expenditure deviate from the projected adjustment path. Given the increasing uncertainty over revenues aggravated by volatility in the global economy monthly statements of expenditure and receipts and significant deviations (outside seasonal factors) should be closely monitored and expenditure brakes quickly triggered across the board. b. Lack of Capacity Could Hinder Revenue and Expenditure Measures 17. Revenue generation. The medium-term tax and expenditure containment measures underpinning the revised 2009 budget may not achieve the fiscal targets within the stipulated timeframe. For proposed revenues to reach their target, significant preparatory work needs to be undertaken and capacities developed to introduce two major taxation initiatives (a business profits tax and a tourism goods and services tax) within a relatively short period. On the spending side, fiscal policy remains expansionary, and there needs to be a clear articulation of a mechanism to synchronize power tariffs with input costs and reduce the wage bill for the public sector. Smaller capital inflows to finance new resort construction and declining tourist arrivals because of the global economic crisis would affect projected government revenue in To 1 Without the Program, the 2009 year-end budget deficit is projected to be 33% of GDP.

17 5 strengthen the Government s revenue base, the introduction of broad-based taxes is essential. However, if these are to be successful, the associated capacities need to be developed. 18. Expenditure management. Expenditures have risen rapidly in recent years. The growth has been in recurrent expenditures, mostly because of increases in the civil service wage bill, and continued subsidization of economic services, including power tariffs in Malé. 19. Debt management. Debt management is an integral part of sound fiscal management. Although an External Resource Management Division was set up in the Ministry of Finance and Treasury (MOFT) to act as the focal point for debt management, the Government currently does not have an overall strategy to reduce debt to prudent levels over the short to medium term. 20. Circular debt. The State Electric Company Limited (STELCO) owes the State Trading Organization (STO) accumulated debt of Rf400 million (some $31 million) as of August 2009 (the circular debt). Currently, MOFT is accruing liabilities on behalf of STELCO, and this liability is planned to be transferred to MOFT in As the Government plans the privatization of SOEs, MOFT will need to recognize their liabilities and account for them as a part of the Government's contingent liability. c. Need to Improve Deficit-Financing Mechanisms by Treasury Bills 21. MOFT does not have a framework for analyzing monthly Treasury cash flow to support MMA's liquidity forecasting. As MMA purchases of Treasury bills on its own account have been discontinued (to decrease the cost of Treasury bill financing) a system of Treasury bill auctions, including primary dealers and brokers to support trading in the secondary market is contemplated. d. Internal Audit Function Faces Capacity Constraints 22. Although the Public Finance Act 2007 and its regulations have been enacted, the regulations do not cover accounting standards. Consolidated financial statements are currently not prepared and are therefore not audited. 2 A task force has been set up to analyse the International Public Sector Accounting Standards to see how draft financial regulations can be made consistent with international standards. The intention is to begin by implementing cash accounting standards (which is historically how governments have accounted) and then progressively implement accrual accounting standards. 3 However, the internal audit team is understaffed and will need training in and exposure to technology and project management. None of the current staff is capable of assuming the role of an information technology auditor. e. Privatization Lacks Clear Policy and Procedure 23. The Maldives lacks a formal privatization policy. A clear policy is critical particularly in the absence of a privatization act to explain the Government's objectives and to establish clear principles for the privatization process, including checks and balances. The policy is particularly needed in view of the difficulties that have been encountered in the privatization of MIA (the first flagship privatization attempt by the new Government). 2 IMF Public Expenditure and Financial Accountability Assessment for the Maldives. Washington, DC. 3 The accrual method of accounting is the internationally agreed best practice and the method most governments are progressively implementing.

18 6 24. For efficient and effective privatization, the Government needs to issue regulations to implement the comprehensive SOE privatization reform initiative. Areas that need to be addressed include (i) the basis for determining which SOEs identified for reforms should be retained, restructured, privatized, or closed; (ii) guidelines for financial restructuring detailing the procedure for implementing the financial restructuring plan; and (iii) a redundancy program, covering eligibility criteria and severance compensation. f. Deficiencies in Utilizing External Assistance 25. Capacity constraints affect all stages of the economic management process, including timely utilization of external assistance. As a result, all development partners are experiencing significant delays in the completion of their projects and programs. These increase costs and deprive the intended beneficiaries. Project implementation units are usually severely understaffed and staff are often underqualified. There is no systematic review of project performance, and no mechanism in place to reward good performers and penalize poor performers. Coordination within Government is weak and it takes an inordinate amount of time to resolve normal development problems. As a result, projects are usually 3 4 years late. These delays impose a high opportunity cost and undermine the projects' development effectiveness. 2. Opportunities 26. There is an urgent need to realign public spending within a realistic revenue envelope. This is a prerequisite to reducing economic imbalances and restoring a sustainable growth trajectory over the medium term. The Government has initiated reforms to strengthen its fiscal position and, as the country nears middle-income status, the Government plans to reduce its direct role in the economy, and to facilitate a greater role for private sector. To promote the reform initiatives, the Government has requested ADB assistance. With net international reserves down to $53 million in early August 2009, a significant contraction in the 2009 growth rate and a large financing gap, this is the time to undertake sustainable remedial actions. The Program is consistent with the strategic thrust of the country partnership strategy 4 and ADB s Strategy 2020, 5 represents ADB s responsiveness to an economic emergency, and reflects close coordination with development partners. IV. THE PROPOSED PROGRAM 27. The Program has five major components: (i) strengthening fiscal policy and bolstering budget formulation and implementation; (ii) implementing revenue, expenditure, and debt management measures to strengthen fiscal policy; (iii) strengthening mechanisms for financing the budget; (iv) facilitating privatization of SOEs; and (v) strengthening internal audit operations. A. Impact and Outcome 28. The impact of the Program will be an enhanced recovery and sustainable growth of the economy over the medium term by removing the distortions that have led to the current large economic imbalances. By supporting long overdue structural reforms, the Program will move toward a more broad-based sustainable development framework that reduces the country's vulnerability to external shocks and prepares it for scheduled graduation to middle-income 4 ADB Country Partnership Strategy ( ): Maldives. Manila. 5 ADB Strategy 2020: The Long-Term Strategic Framework of the Asian Development Bank, Manila.

19 7 country status on 1 January The Program takes into account the remedial actions either already taken by the Government or planned for the coming months. It outlines subsequent actions that will need to be undertaken to deepen the reform process and return the economy to a sustainable growth trajectory. 29. The medium-term outcomes of the Program include (i) enhancing the realism and value of the budget as a policy tool; (ii) improving fiscal discipline and predictability; (iii) moving the budget preparation process from a needs to an availability basis; (iv) ensuring that a results framework is used to track overall development performance and measure progress toward achievement of the Millennium Development Goals; (iv) facilitating timely implementation of development assistance from ADB and other development partners to enhance development effectiveness; (v) improving monitoring and management of internal and external debt and retain them at sustainable levels; (vi) putting Government finances on a sounder footing and avoiding inflationary domestic finance; (vii) deepening financial markets by issuing Treasury bills, and providing the MMA with a market-based instrument for liquidity management. The design and monitoring framework is in Appendix 1. B. Policy Framework and Actions 1. Component 1: Strengthening Fiscal Policy and Bolstering Budget Formulation and Implementation 30. Strengthening policy framework. The Program seeks to improve the fiscal policy framework and budget preparation process to ensure a commitment to fiscal discipline and macroeconomic stability. Sound fiscal discipline is critical to small, open economies such as the Maldives, where fiscal prudence and stabilization of inflation are essential to ensure effective macroeconomic management and smooth adjustment to potential external shocks. To establish an overall framework for fiscal consolidation, a fiscal responsibility act will be drafted during the Program period. This will stipulate budget deficit targets that cannot be exceeded, and make it a legal requirement for future budgets to be linked to the medium-term fiscal framework (MTFF). The draft act should be submitted for parliamentary approval by June The MTFF in the revised 2009 budget will be strengthened and will continue to describe a realistic path to fiscal consolidation. The MTFF will develop rolling revenue and expenditure projections over a 3-year period, based on underlying assumptions such as GDP growth, inflation, exchange rates, interest rates, tourism inflows, and external trade. The MTFF will anchor the preparation of the budget and will be updated regularly. Its assumptions and projections will generate a fiscal position and borrowing requirement that are consistent with the Government's overarching fiscal and debt strategy. 31. The adoption of MTFF will move away from the current project-based approach to development assistance. While the assistance may be for specific sectors or projects, the resources made available will become part of well defined sector strategies supporting overall government development policies. Furthermore, there will be an increasing integration between development and recurrent budget taking into account recurring costs (i.e., operations and maintenance) resulting from fixed capital formation. The Government will soon approve a new National Development Strategy (NDS), based on the Government's election manifesto and close stakeholder consultation. It includes a preliminary costing of programs and a resultsbased monitoring framework. The United Nations Development Programme is assisting the Government with the NDS.

20 8 32. The Program will support various MOFT actions related to the MTFF. First, MOFT will develop medium-term sector road maps based on NDS goals. These will have clear objectives and policies and a results-based monitoring framework to measure how programs can effectively meet sector objectives. Second, MOFT will develop a budget programming framework to ensure that expenditure on the development budget follows sector objectives, policies, and programs. Third, MOFT will issue budget circulars requiring line ministries to align proposed development expenditures closely with sector goals and policies. Fourth, MOFT will develop project selection criteria for the PSIP budget and ensure recurrent costs are reflected in annual budgets. Fifth, MOFT will introduce, on a pilot basis, principles of results- or performance-based budgeting in three key sectors (transport, health, and education). Sixth, MOFT will develop a monitoring framework for budget implementation to allow for (i) alignment with the MTFF, (ii) ex-post evaluation of how closely actual development spending was aligned with the budget, and (iii) an assessment of the contribution to sector outcomes. Finally, MOFT will migrate and reconcile 2009 revenue and expenditure accounts into public accounting system-compatible format, and prepare the 2011 budget based on public accounting system reporting requirements. 2. Component 2: Implementing Revenue, Expenditure, and Debt Management Measures to Strengthen the Fiscal Policy 33. Revenue measures. In parallel with the Government's efforts to strengthen fiscal policy and budget preparation, it will continue to strengthen the revenue base and to rationalize expenditures, leading to a progressively lower budget deficit. On the revenue side, the Program will facilitate the diversification of the tax base and increase revenues through higher tax collection. In addition to the business profit tax (BPT) and tax administration bills, the Program requires the MOFT to submit the tourism goods and services tax bill to Parliament by the end of Subsequent to Parliamentary approval for enhancing the airport passenger service charge (airport tax) from the current $12 to $18.5 per ticket, MOFT will issue a circular to transfer the proceeds of the airport tax from Maldives Airport Company Limited to the Treasury. While these actions are to be completed in 2009, the Program envisages extension of the goods and services tax to non-tourism sectors by submission of a bill to Parliament by June The BPT will be more complex than other taxes administered by the Department of Inland Revenue (DIR) and will require intensive preparatory work, including registering taxpayers, undertaking tax survey work, and reviewing audited statements, compliance assessment, and post-tax audits. As part of the measures to strengthen DIR, the TA grant will help to build tax administration capacity, including developing a large taxpayer unit focusing on the collection of BPT for the largest 50 companies; approving operations manuals, auditing manuals, and taxpayer guides; and collecting other information to prepare for the actual collection of BPT. As part of the upgrading of the DIR, the Government will strengthen the staffing of the revenue administration. Automation of the DIR will also enable effective management of the tax base. A computerized database will help in effective risk assessment and in planning an appropriate audit strategy. It will also provide the department with a tool to institutionalize performance management within the department. ADB has already initiated the transformation of DIR through the preparation of a Roadmap on the modernization of revenue administration (Supplementary Appendix H). 35. Expenditure measures. In order to align expenditure with revenues, the Government is finalizing a human resource management plan, setting out the principles and criteria for downsizing the civil service and constituting the framework for implementation of the redundancy program. The first phase of a redundancy program will be implemented by the end

21 9 of 2009, resulting in a reduction of at least 2,000 staff in Government and SOEs. The second phase will be completed in 2010 with a further reduction of a minimum of 3,000 civil servants and followed by another 3,000 by June Along with the reduction in the civil service, the Government plans to reduce and then eliminate power subsidies and linking power tariff adjustments, on a biannual basis, to cost of inputs. 36. Debt management measures. Previous ADB support to strengthen the Government's debt management capacity 6 needs to be built upon. The need to develop an effective and comprehensive debt monitoring and management system is underscored by the recent build-up of debt. As the Maldives moves toward middle-income country status, its debt will be increasingly priced on commercial terms and strong debt management practices will result in significant savings for the Treasury. Various measures under the Program will support debt management. The Government will develop and approve a debt strategy, which will allow better planning of its borrowing strategy and introduce regular debt sustainability analysis to monitor debt and manage the associated risks. The debt strategy's objectives will include achieving consistency with the objectives of the MTFF, improving debt management, undertaking the first debt sustainability assessment, and finalizing a framework to monitor external private debt. 37. Regarding the contingent liabilities originating from SOE debt, MOFT will prepare a study that identifies the stock of outstanding liabilities on SOE balance sheets (with a focus on STELCO and STO) by the end of Further, by end 2009, the Government will issue bonds or make other arrangements to retire the outstanding circular debt owed by STELCO to STO. 3. Component 3: Strengthening the Mechanisms for Financing the Budget 38. To reform the mechanisms for efficient financing of fiscal deficit, liquidity forecasting will be strengthened at MOFT. A framework will analyze monthly Treasury cash flow and will be used to support liquidity forecasting by the MMA. A progressive reduction of the outstanding balance on W&MA will be achieved and greater reliance will be placed on open market operations using Treasury bills, including the eventual conversion of outstanding W&MA. MMA will prepare a study on a system of primary dealers and brokers for auctioning Treasury bills and subsequent trading in the secondary market. It will also establish a framework to replace the fixed rate tap system with a variable rate Treasury bill auction system to develop competitive bidding and trading in Government securities. The W&MA ceiling will not be breached and public sector borrowing will be mobilized in the domestic market, thereby reducing liquidity injections and containing inflationary pressures. By June 2011, MOFT and MMA will revisit the memorandum of understanding dated 30 August 2006 with the objective of further reducing the ceiling on W&MA. In the medium term, the Program anticipates that Treasury bill and bond issuances, and their eventual trading will contribute to deepening of financial markets and providing MMA with a market-based instrument for liquidity management. The development of tradable securities at the short end of the market will also serve to enhance the conduct of monetary policy. For this purpose, MMA will arrange the trading of Treasury bills in the secondary market, including open market operations. To enhance demand, MMA will include Treasury bills as eligible items under its minimum reserve requirements for commercial banks and will allow non-institutional investors to participate in the Treasury bills market. 6 ADB Technical Assistance to the Republic of the Maldives for Strengthening of Debt Management. Manila (TA 4196-MLD, approved on 14 October).

22 Component 4: Facilitating Privatization of State-Owned Enterprises 39. The privatization of SOEs forms a core plank of the Government's economic reform agenda. It has established an independent Privatization Committee to oversee the implementation of the privatization policy. Invest Maldives under the Ministry of Economic Development is the implementation agency for privatization, in close consultation with the Public Enterprise Monitoring and Evaluation Board (PEMEB) under MOFT. Invest Maldives has posted following SOEs for privatization on the Government website: Maldives National Shipping; Malé Water and Sewerage; Maldives Industrial Fisheries (for joint venture partnerships in fish freezing, fish canning, and aquaculture); Waste Management; STELCO; Maldives National Broadcasting; MIA; Thilafalhu Development in the Greater Malé Region; and Regional Utility Services. As a part of the Government's efforts to privatize selected SOEs, a formal privatization policy is being prepared that will establish clear principles underlying the privatization process, including the necessary checks and balances. 40. Development partners have been supporting the privatization program. ADB has been working with PEMEB to develop a monitoring framework to assess the performance of SOEs and has supported possible reforms to STELCO, building on a new business model. Further work is needed to develop (i) a framework that will categorize SOEs into those to be retained and restructured under Government ownership, those to be privatized, and those to be closed; (ii) guidelines for financial restructuring, detailing the procedure for implementing a financial restructuring plan for loss-making entities; (iii) a redundancy scheme for employees of SOEs; (iv) enforcement of the institutional structure for SOE reforms under the Privatization Committee (to address issues that arise from individual SOEs being sponsored by different ministries); and (v) guidelines on the privatization process to ensure that the Government shares in those SOEs identified for privatization are divested through a fair, transparent, and objective bidding process. The International Finance Corporation has been hired as a lead manager in the privatization of MIA. 5. Component 5: Strengthening Internal Audit Operations 41. ADB has assisted the Government's efforts to put in place appropriate institutional arrangements, systems, and procedures to discharge internal audit functions, including the development of a strategic management plan. Human resource development and model operating procedures were developed during this first phase. ADB's follow-up assistance will be taking account of the recommendations made by the IMF under its recent public expenditure and financial accountability assessment. The IMF's work on strengthening budgetary mechanisms and debt management will be synchronized with ADB's support for debt sustainability assessments. 42. The approval of the strategic management plan will usher in the start of the Program's second phase, during which auditing standards and registration requirements will be developed, together with model reporting requirements. Comprehensive internal audit manuals will also be completed. Capacity development will be an integral part of this phase. The third phase will comprise the carrying out of risk-based audits in a diligent, consistent, and effective manner and in full compliance with the Public Accounting Act of The internal audit function will roll out into budgetary agencies on a pilot basis.

23 11 C. Creation of Apex Program Management Unit 43. As noted in ADB's 2007 country partnership strategy (footnote 4), capacity constraints severely affect the optimization of all externally-assisted projects and programs. The practice of establishing project-specific PIUs has not worked well, as they have never been properly staffed. As a result, projects are completed 3 4 years late, undermining their development effectiveness. Under the Program, ADB and the Government have agreed that an apex project management unit (PMU) will be established at the MOFT and two thematic project management units (TPMU) will also be established in the Ministry of Housing, Transport, and Environment; and the Ministry of Economic Development. These will not only monitor the implementation of ADB-assisted projects, but also those of other development partners. The apex PMU will meet every quarter, identify timely remedial measures, and publish the minutes of its meetings on the MOFT website. The creation of these PMUs will result in cost efficiencies and allow them to be staffed appropriately. ADB will support the creation of the PMUs as well as their functioning during the program period. The performance assessment of the PMUs will be an integral part of the overall implementation assessment of the Program. It is envisaged that other development partners may also contribute to the funding of such PMUs. D. Important Features and Lessons 44. The lessons in processing the Program are twofold: (i) the authorities' failure to address structural issues in a timely manner adds to costs and makes the adjustment path steeper; and (ii) institutional weaknesses, manifesting itself in poor macroeconomic management, highlights the need to build the capacity to manage an open, import-dependent economy, and to have systems in place that provide timely signals for the Government. Complacency and undue reliance on tourism need to be avoided through long overdue structural reforms (although admittedly these will have to be addressed in an adverse global economic environment). The process of privatizing selected SOEs needs to be carefully managed to ensure that the process is conducted transparently according to well-defined rules. 45. The Program has a high degree of political ownership from the Government, and the legislative assembly (the Majlis). The scale of reform measures approved by the Majlis in 2009 suggests that the economic reform program enjoys bipartisan support. Unlike in the past, the Government has been very transparent about the objectives it wants to achieve with the Program and forthcoming about its likely costs. It has listed a menu of reform measures that it will pursue. The Program is being developed in close consultation with the Government and other development partners such as IMF and World Bank. In the run-up to the Program, many joint missions were fielded, and, given the nature of the support, a holistic approach has been pursued. ADB has shared the policy matrix with the IMF and the World Bank and has coordinated closely with them in the final design. E. Cost and Financing Plan 1. Cost 46. Policy reform adjustment costs are estimated at $231 million (Table 1). The bulk of the costs are associated with the implementation of the redundancy program, payment of the Government's share of the accrued pension liability (after passage of the 2009 Pension Act), retirement of existing circular debt owed by SOEs like STELCO, and services related to the introduction of taxes and capacity development.

24 12 Table 1: Indicative Program Adjustment Costs for the Economic Recovery Program ($ million) Outputs and Areas for Support Costs 1. Civil service redundancy package SME loans (for redundant civil servants) Higher education loans (for redundant civil servants) TVET (for redundant civil servants) TVET capital costs (related to redundancy program) Accrued government pension liability Three-year interest cost of converting $40 million circular debt into Government 8.5 of Maldives bonds 8. Interest cost of conversion of Rf1.6 billion W&MA to a 3-year bond issue at % Subtotal TA loan Assistance for strengthening the privatization process 2.0 Total SMEs = small and medium-sized enterprises; TA = technical assistance; TVET = technical, vocational, and educational training; W&MA = ways and means advances Note: Work relating to green tax, business profits tax and institutional strengthening of the Bureau of Inland Revenue will be covered under the proposed TA grant with a cumulative value of $2.0 million. Source: Asian Development Bank and Government of the Maldives estimates. 2. Financing Plan 47. ADB will provide a loan in various currencies equivalent to SDR21,912,000 ($35 million equivalent) from its Special Funds resources. The program loan will have a 24-year term including a grace period of 8 years, and an interest charge of 1.0% per annum during the grace period and 1.5% per annum thereafter. ADB will also provide a technical assistance (TA) package of $4.5 million in support of the Program, comprising (i) a TA grant of $3.0 million, from ADB's TA Special Fund (TASF-IV), in support of various institutional strengthening initiatives; and (ii) a TA loan in various currencies equivalent to SDR939,000 ($1.5 million equivalent) from ADB's Special Funds resources in support of capacity development and privatization initiatives. The TA loan will have a term of 32 years, including a grace period of 8 years, with an interest charge of 1.0% per annum during the grace period and 1.5% per annum thereafter. ADB support will cover 15% of the adjustment cost while the Government will cover 36%. The remainder will be funded by other development partners (although the nature of the IMF s Stand-By Arrangement and the World Bank s Development Support Facility is accounted differently from budget support). Table 2: Financing Plan for the Economic Recovery Program Source Amount ($ million) Share (%) Asian Development Bank Government a Other Development Partners b Total a Includes in-kind contribution of office space, counterpart staff, and administrative support. b The IMF is providing $92.5 million under a Stand-By Arrangement and the World Bank $24 million possibly under a Development Support Facility. Source: Asian Development Bank estimates.

25 13 F. Implementation Arrangements 1. Program Management 48. The MOFT will be the Executing Agency (EA) of the Program. A steering committee will be established to ensure effective and timely implementation of the Program by monitoring performance and coordinating efforts across various implementing agencies. It will be chaired by the minister of state for finance and will include representatives from the President's Office, MOFT, the Privatization Committee, Department of National Planning, PEMEB, and MMA. ADB will participate as an observer. In consultation with ADB, the Government will appoint a secretary of the committee. The committee will meet at least once every quarter to discuss implementation progress and address any outstanding issues. The secretary will officiate as the program director and will be responsible for coordination efforts across the five program components. Quarterly progress reports will be sent to ADB highlighting the achievements and potential problem areas to be addressed by the committee. In addition, the apex PMU at MOFT will be responsible for overseeing Program implementation as part of its broader agenda to enhance development effectiveness. 2. Program Period and Tranching 49. The Program is expected to be completed in 36 months, from January 2010 to December The loan will be released in two tranches: (i) SDR11,269,028 ($18 million equivalent) upon fulfillment of agreed conditions for the first tranche and following effectiveness of the loan, and (ii) SDR10,642,972 ($17 million equivalent) upon confirmation of compliance with all agreed conditions for the second tranche release. It is estimated that the second tranche will be disbursed within 18 months of loan effectiveness. 3. Procurement and Disbursement 50. The Program proceeds will be used to finance the full foreign exchange costs (excluding local duties and taxes) of imports produced, and procured, in ADB member countries, excluding ineligible items and imports financed by other bilateral and multilateral sources (Appendix 7). The Government will certify its compliance with this formula with each withdrawal request. Otherwise, import documentation under existing procedures will be required. The Program proceeds will be disbursed to the Government in accordance with the provisions of ADB's disbursement procedures. 4. Counterpart Funds 51. The local currency generated from the proceeds of the Program will be used to finance adjustment costs under the Program. 5. Anticorruption Policy and Governance Risks 52. Governance and corruption risks in the Program can be categorized broadly as those evident in the broader political economic context, and those that are program-specific. The broader risks include weakening Government commitment to necessary reforms; impending political changes, creating an environment of policy uncertainty; lack of consensus among stakeholders on needed policy reforms and on how far to push the reform envelope; and negative exogenous shocks (both economic and otherwise). Program-specific risks include (i) continued capacity constraints in key economic and financial agencies; (ii) continued inability

26 14 of the Government to formulate and commit to a suitable fiscal consolidation policy and strategy; and (iii) an inability to deepen civil service reforms. For further risk analysis, see Appendix 8 and Supplementary Appendix A. 53. ADB s Anticorruption Policy (1998, as amended to date), as well as the Second Governance and Anticorruption Action Plan, was explained to and discussed with the Government and the EA. Consistent with its commitment to good governance, accountability, and transparency, ADB reserves the right to investigate, directly or through its agents, any allegedly corrupt, fraudulent, collusive, or coercive practices relating to the Program and the Project. To support these efforts, relevant provisions of ADB s Anticorruption Policy are included in the Loan Agreement and the bidding documents for the Project. In particular, all contracts financed by ADB in connection with the Project shall include provisions specifying the right of ADB to audit and examine the records and accounts of the EA and all contractors, suppliers, consultants, and other service providers as they relate to the Project. 6. Accounting, Auditing, and Reporting 54. The Government will maintain records and accounts for the Program and the Project, in accordance with sound accounting principles, and will have such accounts and records audited annually by auditors acceptable to ADB. To ensure proper fund management, ADB retains the right to audit the use of program and project loan proceeds. The accounts will be managed, operated, and liquidated in accordance with terms satisfactory to ADB. The Government will ensure that submission of reports, audited accounts, and financial statements are in compliance with ADB s guidelines. Audited annual accounts by independent auditors acceptable to ADB will be submitted to ADB within 6 months of the reporting period (i.e., within 6 months of the end of the fiscal year). The annual audit for the Project will provide a separate audit opinion on the soundness of (i) the statement of expenditure operations, and (ii) the imprest account operations. The Government was advised of ADB s requirement of timely submission of audited accounts and financial statements, and was advised about suspension and acceleration sections. 7. Program Monitoring 55. Program monitoring, in the first instance, will be done by the steering committee, supplemented by the apex PMU of MOFT and will be complemented by periodic ADB review missions. These will (i) confirm the fulfillment of policy actions for tranche releases; (ii) confirm the release of adequate funds from the Government for program activities; (iii) monitor the continued applicability of the assumptions underlying the Program, as well as specific risks and their mitigating measures; and (iv) advise on actions to maintain effective implementation within the program period. Relevant baseline indicators and targets have been incorporated into the design and monitoring framework (Appendix 1). 8. Program Review 56. The Government and ADB will review program implementation at least three times a year. The reviews will evaluate the program scope, implementation arrangements, consultations with the MOFT and the program director, progress with the policy reform agenda, and capacity development measures. ADB will also field regular review missions, including a midterm review mission and a program completion review mission 3 months after completion. The review missions will assess progress and identify any necessary changes in program and project

27 15 design, the implementation schedule and/or implementation arrangements, and compliance with the terms of conditions of the loan agreements. G. ADB s Coordination with Other Development Partners 57. ADB s close coordination with IMF, the World Bank, and other development partners is described in Appendix 3, Table A3.2. The Program is being parallel financed by IMF and World Bank. ADB and IMF staff have been cooperating closely to develop an economic recovery package, and IMF has endorsed the policy matrix of the Program. IMF reached a staff-level agreement with the Government in August 2009 for a Stand-By Arrangement of SDR67 million (about $88 million). IMF board approval is envisaged in early December The Stand-By Arrangement supports stabilization measures based on a macroeconomic and fiscal framework and is in line with resources to ensure overall debt sustainability. It will include policy actions to improve the fiscal and balance of payments position and to strengthen the financial sector. Apart from balance of payments support, IMF is providing assistance for better management of Treasury bills system and open market operations, as well as for drafting the fiscal responsibility legislation. World Bank support is expected to cover pension and civil service reforms. In addition, the International Finance Corporation is providing advisory support for the privatization of SOEs, and the United Nations Development Programme is providing assistance to the Government to transform its political manifesto into a national development plan. V. TECHNICAL ASSISTANCE 58. The country partnership strategy recognized that human resource deficiencies are a significant binding constraints on the Government's economic management. Given that a number of new economic measures are to be pursued under the Program, technical support needs to be provided to ensure the Government can implement these initiatives successfully. A TA package of $4.5 million is therefore proposed. This will comprise (i) a TA loan of $1.5 million for supporting capacity development and privatization initiatives, and (ii) TA grant of $3.0 million from ADB's TA Special Fund-IV for institutional strengthening initiatives. Details of the various packages under both the TA loan and TA grant are in Appendix The primary outcome of the TA package will be significant capacity development in government institutions responsible for economic management in general and implementation of the Program in particular. A key objective of the TA package is to enable the Government to comply with all policy actions under the Program in a timely manner. A. Technical Assistance Loan (Project Loan for Capacity Development for the Program) 1. Impact and Outcome 60. The impact of the TA loan will be to enhance the Government's capacity to accomplish the policy and institutional reforms supported by the Program. The outcomes will be (i) capacity development of the EA and the implementing agencies by training large numbers of officials by consultants in conjunction with local training institutions; and (ii) capacity development of the Privatization Committee and Invest Maldives to expedite ongoing privatization of SOEs. Advance action on this TA will support targeted tranche reform measures under the Program within the implementation period. 7 7 The Government has been advised that such advance action does not commit ADB to finance the TA.

28 16 2. Outputs 61. Deepening overall capacity. One component of the TA loan will be the strengthening of capacity and professional skills of the EA. This will include support for implementing agencies to enable them to carry out the policy reforms and actions specified in the Program s policy matrix. TA support will be provided for institutional and human resource capacity building to develop skills in management, leadership, facilitation, negotiation, and conflict resolution, as well as training to implement policy and procedural actions under the Program. To ensure the efficient training of large numbers of officials, trained consultants will be recruited in conjunction with local training institutions. 62. Strengthening privatization framework. Another component of the TA loan will focus on capacity building of the Privatization Committee and its secretariat, Invest Maldives. This will include the following activities: (i) preparation of the framework on the basis of which the SOEs identified for reforms will be categorized into those to be retained and restructured under Government ownership, those to be privatized, and those to be closed; (ii) preparation of guidelines for financial restructuring detailing the procedure for implementing a financial restructuring plan for loss-making entities; (iii) preparation of a redundancy package for employees of SOEs, (iv) assisting the Government to enforce the institutional structure for SOE reforms under Privatization Committee to address issues that arise from individual SOEs being sponsored by different ministries; and (v) preparation of guidelines on the privatization process for ensuring that the Government ownership shares in SOEs identified for privatization are divested through a fair, transparent, and objective bidding process. 63. The privatization component will assist the Government in conceptualizing, preparing, and developing projects that involve private companies on a public private partnership basis. The TA Project will recommend the optimum project structure to attract competitive bids from the private sector, form the basis of a contract between the private sector and the Government, and bring the projects to financial closure. 3. Cost and Financing 64. The TA loan in various currencies equivalent to SDR939,000 ($1.5 million equivalent) from ADB's Special Funds resources will have a term of 32 years, including a grace period of 8 years, and an interest charge of 1.0% per annum during the grace period and 1.5% per annum thereafter. The amount equivalent to $0.3 million for in-kind support will be borne by the Government. The detailed cost estimates are in Appendix 10 (the terms of reference for consulting services and other details are in Supplementary Appendix E). Table 3: Financing Plan for the Technical Assistance Loan Source Amount ($ million) Share (%) Asian Development Bank Government Total Source: Asian Development Bank.

29 17 B. Technical Assistance Grant (Institutional Strengthening for Economic Management) 65. The outputs of the TA grant will be: (i) (ii) (iii) (iv) strengthening administration of new taxes introduced under the Program; developing capacity of MOFT for implementing new revenue measures, debt management, budget formulation, and expenditure rationalization; strengthening MOFT s internal audit unit; and providing support for the apex PMU and two TPMUs. 66. Even with the passage of the proposed new tax bills, significant work needs to be undertaken to enforce the legislation, especially the BPT, which will be directly implemented by DIR. The TA grant will therefore help to build DIR's capacity to introduce the new taxes smoothly. Other taxation-related activities will include (i) reviewing the reform strategy and manuals previously prepared by ADB, 8 (ii) assessing capacity constraints to ensure effective tax administration within DIR, and (iii) recommending organizational restructuring. In addition, the TA grant will assist in developing and conducting surveys, workshops, and public awareness campaigns for the taxpayers, and preparing a road map and a list of large taxpayers. Further, the TA grant will assist in developing staff instructions, and providing training on tax audit techniques, reviewing and assessing automation at DIR, and recommending suggestions on hardware and software. 67. The TA grant includes capacity building of MOFT through (i) a study on SOE outstanding liabilities, i.e., circular debt; (ii) a framework for cash flow projections on both revenue and expenditure, (iii) support for the debt management component of the Program, and (iv) continued capacity building of the Internal Audit Unit of MOFT (which has already begun under ongoing ADB TA 9 funded by the Australian Agency for International Development, and (v) developing budget programming frameworks, including performance-based budgeting, monthly and ex-post evaluation of budget implementation. 68. Timely implementation of the portfolios of ADB and other development partners is critical to avoid cost overruns, strengthen results orientation, and enhance development effectiveness. The TA grant will support fully staffed apex PMU and functional TPMUs at two ministries, including institutionalizing mechanisms for quarterly portfolio performance. Systemic issues beyond the remit of the TPMUs will be discussed at the apex PMU, and if necessary, raised at the level of Department of National Planning. Table 4: Financing Plan for Technical Assistance Grant Source Total ($ million) Share (%) Asian Development Bank Government Total Source: Asian Development Bank 8 ADB Technical Assistance to the Republic of the Maldives for Revenue Diversification. Manila (TA MLD, approved on 26 September). 9 Technical Assistance to the Republic of the Maldives for Enhancing Internal Audit in Maldives. 2007, funded under ADB Proposed Technical Assistance for the Development Partnership Program for South Asia. Manila (TA 6337-REG).

30 18 C. Implementation Arrangements for TA Loan 69. TA management and implementation period. The MOFT will be the EA of the TA loan. The Ministry of Economic Development will be the implementing agency for component 1 and the MOFT will be the implementing agency for component 2 (Appendix 6). The TA loan is scheduled to commence following the loan effectiveness of the Program, and completed by December Procurement and consulting services. Consultants to be financed will be recruited in accordance with ADB s Guidelines on the Use of Consultants (2007, as amended from time to time). Consultancy contract packages using the quality- and cost-based selection method and consultants qualifications selection will be used to recruit consultants, based on technical proposals, for specific subcomponents under the TA. Procurement of any goods or services shall be carried out in accordance with ADB s Procurement Guidelines (2007, as amended from time to time). Goods such as equipment or training material will be purchased using shopping procedures. 71. Disbursements. The TA loan proceeds will be disbursed in accordance with the Loan Disbursement Handbook (2007, as amended from time to time). The Government will certify that the loan proceeds will be used as agreed in a manner satisfactory to ADB. 72. To facilitate implementation, an imprest account will be set up with MMA and will be managed by MOFT. The imprest account will be denominated in US dollars. The initial advance to be deposited to the imprest account will not exceed either 6 months of estimated expenditures for TA loan to be financed from the imprest account, or 10% of the TA loan amount, whichever is lower. To expedite funds flow and simplify documentation process, the statement of expenditures procedure will be used by MOFT for reimbursement, liquidation and replenishment of the imprest account for eligible expenditures not exceeding $50,000 per individual payment. Payments in excess of statement of expenditures ceiling will be liquidated or replenished based on full supporting documentation process Governance and corruption risks. Governance and corruption risks in the TA loan will be covered as mentioned above under the Program loan implementation (paras ). 74. Accounting, auditing, and reporting. The accounting, auditing, and reporting will be maintained as mentioned above under the program loan implementation (para. 54). Further details are in Supplementary Appendix A. 75. Monitoring and evaluation. The Government and ADB will periodically review TA loan implementation. The reviews will include evaluation of project scope, implementation arrangements, consultations with the EA, progress on the policy reform agenda, and progress on capacity building measures. The Government and ADB will conduct TA loan reviews in conjunction with program review as mentioned above under the program loan implementation (paras ). 10 Given that an imprest account is proposed under the TA loan, the bank charges will be financed from the TA loan resources, as required by ADB Cost Sharing and Eligibility of Expenditures for ADB Financing. Operations Manual. OM Section H3/BP. Manila.

31 19 D. Implementation Arrangements for TA Grant 76. TA management and implementation period. MOFT will be the EA and the Implementing Agency of the TA grant. The TA grant will commence following loan effectiveness of the Program, and be completed over 3 years. 77. Procurement and consulting services. Consultants to be financed from the TA grant will be recruited in accordance with ADB s Guidelines on the Use of Consultants (2007, as amended from time to time). Consultancy contracts packages using quality and cost based selection method and consultants' qualification selection will be utilized for selection of consultants, based on technical proposals, for specific subcomponents under the TA. Procurement of any goods or services shall be carried out in accordance with ADB s Procurement Guidelines (2007, as amended from time to time). Goods, e.g., equipment or training material, will be purchased using Shopping procedures. 78. Disbursements. The TA grant proceeds will be disbursed in accordance with applicable ADB's Technical Assistance Disbursement Handbook Monitoring and evaluation. Institutional strengthening through results-based capacity development is a necessary condition for policy ownership and effective management of the economy. The Government and ADB will periodically review TA grant implementation based on quarterly reports of the apex PMU and the two TPMUs, as well as consultant reports. The reviews will include evaluation of the scope, implementation arrangements, consultations with the EA and TPMUs, progress with the policy reform agenda, and capacity building measures and progress. The Government and ADB will conduct TA grant review in conjunction with the program review. 80. Accounting, auditing, and reporting. The accounting, auditing and reporting will be maintained as mentioned above under the program loan implementation (para 54). VI. PROGRAM BENEFITS, IMPACTS, ASSUMPTIONS, AND RISKS A. Expected Benefits and Impacts 81. The Program will remove the distortions in the economy that have led to significant economic imbalances and will thereby support recovery and sustainable growth over the medium term. By undertaking long overdue structural reforms, the Program will move the Maldives toward a more broad-based sustainable development framework that reduces its vulnerability to external shocks and prepares it for scheduled graduation to middle-income country status on 1 January The key end-of-program outcomes will be greater financial flexibility and improved management of the Government budget through a more diversified tax base, more rational expenditure, and better debt management. The Program will support the privatization of SOEs and deepen the financial market through the issuance of Treasury bills and bonds. 82. The Program is expected to increase tax collection, improve expenditure management systems, and support the Government to divest itself of SOEs. These measures should lead to a reduction in macroeconomic imbalances, and improvements in macroeconomic management. 11 ADB Technical Assistance Disbursement Handbook. Manila.

32 20 Over the medium term, it is expected that project performance ratios, including portfolio performance indicators, will strengthen significantly thereby improving aid effectiveness. 83. Strengthening the Maldives' macroeconomic profile, improving the alignment between development spending and sector priorities and programs, introducing new taxes, rationalizing expenditures, and making progress toward the divestment and privatization of SOEs will expand the economic base to support more broad-based economic growth, and equip government agencies with modern analytical tools to manage the development process, facilitate the inflow of foreign direct investment, and smooth the transition to a middle-income country status. B. Risk Analysis 84. By their nature, economic reform programs carry risks, including political risks. In this case, the political risks are mitigated to a significant degree by the strong prior actions that have been taken. In contrast to previous practice, the Government has strong ownership of the Program and the reform agenda at all levels. The President himself has been a leading champion of the reform process. The Government has been candid about the comprehensive nature of the economic reforms it needs to undertake. This will help to mitigate the political risks and expedite the legislative approval process. 85. The budget financing gap remains large and there is a risk that it may deteriorate further, given the uncertainty of realizing privatization proceeds. However, a Government IMF program will set out the medium-term macroeconomic and fiscal framework and support policy measures that will contribute to the timely implementation of the reforms. 86. There is limited capacity across government, including in the area of procurement. The Program includes the implementation of new taxes, strengthening of internal audit, and commencement of the privatization process, all of which require specialized expertise. The Program addresses these constraints by providing capacity building TA as a part of package that will mitigate the risks that arise during the procurement and administrative procedures. VII. ASSURANCES A. Specific Assurances 87. In addition to the standard assurances, the Government has given the following assurances, which will be incorporated into the legal documents: (i) (ii) (iii) The Government will promptly adopt the policies and take the actions as specified in the development policy letter and the policy matrix, and ensure that such policies and actions continue in effect during and after the period of the Program; The Government will ensure that the policies adopted and actions taken prior to the Program as described in the development policy letter will continue in effect for the duration of the program period and subsequently; The Government will keep ADB informed of policy discussions with other multilateral and bilateral aid agencies that may have implications for the implementation of the Program, and will provide ADB with an opportunity to comment on any resulting policy proposals;

33 21 (iv) (v) (vi) (vii) (viii) (ix) (x) The Government will use local currency funds generated by the program loan to meet the program expenditures and associated costs of reforms; and ensure that necessary budgetary allocations are provided to meet the recurrent costs under the technical assistance; Within 1 month of the effective date of the program loan, the Government will cause MOFT to set up a steering committee, designate the minister of state for finance as a chairperson, and appoint a secretary of the steering committee in consultation with ADB as the program director; Within 2 months of the effective date of the program loan, MOFT will ensure that the first meeting of the steering committee is convened; The Government will use its best efforts to reduce staff turnover in MOFT (Budget, Economic Affairs and Policy, External Resources Management, Treasury and Public Accounts, Finance and Treasury Management, and Public Enterprise Monitoring and Evaluation), DIR, MMA, and Invest Maldives; Within 4 months of the effective date of the program loan, the Government will cause MOFT to establish a program performance monitoring system acceptable to ADB; The Government will cause the apex PMU to monitor program progress as part of its broader development management process related to implementation of externally assisted projects; and The Government will undertake mitigation measures to ensure good governance, accountability, and transparency consistent with the findings of governance assessment carried out by ADB under its Second Governance and Anticorruption Action Plan. B. Conditions for Loan Effectiveness 88. The following are the conditions for program loan effectiveness: (i) (ii) Compliance with all the first tranche policy actions as set out in the policy matrix; and Establishment of a fully staffed apex PMU under MOFT for monitoring of externally assisted development projects. VIII. RECOMMENDATION 89. I am satisfied that the proposed program loan, technical assistance (TA) loan, and TA grant will comply with the Articles of Agreement of the Asian Development Bank (ADB) and recommend that the Board approve (i) the program loan in various currencies equivalent to Special Drawing Rights of 21,912,000 to the Republic of the Maldives for the Economic Recovery Program from ADB s Special Funds resources with an interest charge at the rate of 1.0%

34 22 per annum during the grace period and 1.5% per annum thereafter; a term of 24 years, including a grace period of 8 years; and such other terms and conditions as are substantially in accordance with those set forth in the draft Loan Agreement presented to the Board; (ii) (iii) the TA loan in various currencies equivalent to Special Drawing Rights of 939,000 to the Republic of the Maldives for Capacity Development for Economic Recovery Project from ADB s Special Funds resources with an interest charge at the rate of 1.0% per annum during the grace period and 1.5% per annum thereafter; a term of 32 years, including a grace period of 8 years; and such other terms and conditions as are substantially in accordance with those set forth in the draft Loan Agreement presented to the Board; and the provision of the TA grant not exceeding the equivalent of $3,000,000 to the Government of the Republic of the Maldives for Institutional Strengthening for Economic Management. 18 November 2009 Haruhiko Kuroda President

35 Appendix 1 23 DESIGN AND MONITORING FRAMEWORK Design Summary Impact Support the Government's development objectives by (i) reducing economic imbalances and restoring the economy to a sustainable growth trajectory over the medium term, (ii) assisting the Government's structural reforms; and (iii) reducing the country's vulnerability to external shocks Performance Targets and Indicators Year-on-year increase in the economic growth (2009 baseline: 3.9%) a Year-on-year inflation (2008 baseline: 12.3%) b Year-on-year reduced fiscal imbalance (2008 baseline: 12.59% of GDP) c Number of privatized state-owned enterprises (2008 baseline: one) Data Sources and Reporting Mechanisms MAA and MOFT reports and statistics on macroeconomic indicators, mid-year fiscal position, bulletin of monthly expenditure and revenues, annual public expenditure, and intrayear budget allocation Findings from IMF Article IV consultations Debt sustainability assessment reports ADB review missions Assumptions and Risks Assumption Government remains committed to continued fiscal reforms Risks Natural disasters and global recession may cause disruptions in the tourism inflows Increasing oil prices may add to the balance-of-payment deficit and put pressure on gross international reserves Outcome Creation of greater fiscal space in the budget, and financial flexibility through a more diversified tax base and rationalized expenditure, better debt management, and more efficient privatization of SOEs as well as deepening the financial market with the issuance of Treasury bills and bonds Improved transparency and accountability of the budget process consistent with the MTFF (2008 baseline: no consistency between the budget process and MTFF) Improved ability to link resource allocation with the medium-term fiscal policy objectives (2008 baseline: no linkage between resource allocation and MTFF policy baseline) Budget speech and budget documents (MTFF, PSIP) MOFT and MMA reports and statistics Auditor general s annual report Official gazette ADB review missions Assumption Line ministries collaborate with MOFT in preparing the MTFF and budget Risk Limited political will to carry through and implement reforms proposed under the program Year-on-year tax revenue increase through diversification of tax (2008 baseline: $265 million) d Current expenditure as a share of total expenditure (2008 baseline: 79.7%) e Debt to GDP ratio (2008 baseline: 53.9%) f Completion of projects without cost overruns/ Improved portfolio ratings (2008 baseline: frequent

36 24 Appendix 1 Design Summary Performance Targets and Indicators cost overruns) Progressive reduction in the number of privatized SOEs (2008 baseline: one) Data Sources and Reporting Mechanisms Assumptions and Risks Outputs 1. Strengthening Fiscal Policy and Bolstering Budget Formulation and Implementation Reformulated 7th National Development Plan becomes the new Poverty Reduction Strategy, and results framework facilitates monitoring of Plan objectives and targets (2008 baseline: none) Fiscal Responsibility Act is operational (2008 baseline: not operationalized) MOFT fiscal statistics Budget document including MTFF Official gazette Government circulars ADB review missions Risk Limited political will to carry through and implement reforms proposed under the program Align expenditure and budget deficit with the 3- year rolling budget framework (2008 baseline: no alignment) Fiscal deficit is reduced down to 15% of GDP in 2010 (2009 baseline: 28% of GDP) 2. Implementing Revenue, Expenditure and Debt Management Strengthened cash balances projections and estimates for the year (2008 baseline: weak cash balances projects and estimates). GST to be implemented by 2012 (2009 baseline: no GST) Official gazette Government circulars Assumption Debt strategy is consistent with MTFF. Measures to Strengthen the Fiscal Policy Revenue augmentation through improved tax collection (2008 baseline: 47.1% as percentage of total revenue collection for the year) ADB review missions Debt strategy reports Risk Limited political will to carry through and implement reforms proposed under the program Maintenance of public debt at sustainable level (2008 baseline: $679

37 Appendix 1 25 Design Summary Performance Targets and Indicators million) g Data Sources and Reporting Mechanisms Assumptions and Risks Approval of the Government's human resource management plans (2008 baseline: no human resource management plans) Approval of redundancy program and its implementation (2008 baseline: no redundancy program) Finalization of Debt Strategy and publication of Debt Strategy reports (2008 baseline: no debt strategy and no relevant reports) Guidelines on tariff setting measures for utility services providers as a pilot (2008 baseline: no tariff setting measures) 3. Strengthening the Mechanisms for Financing the Budget Outstanding Treasury bills and operationalized open market operation (2008 baseline $56.8 million) h The W&MA ceiling is observed (2008 baseline Rf 1.6 billion): Convert all of W&MA in excess of Rf1.6 billion to Treasury bonds by end A new ceiling to be agreed between MOFT and MMA further reducing the outstanding threshold of W&MA in 2010 MAA and MOFT reports and statistics ADB review missions Assumption The Government and MMA collaborate for better mechanisms for financing the budget Risk Low level of demand for Treasury bill in the market Progressively higher use of Treasury bills as a monetary instrument (2008 baseline: T-bill was not used as a monetary instrument)

38 26 Appendix 1 Design Summary Performance Targets and Indicators Increasing volumes of Treasury bills are actively traded in the secondary market (2008 baseline: no Treasury bills were traded in the secondary market) Data Sources and Reporting Mechanisms Assumptions and Risks 4. Facilitating Privatization of SOEs Government regulations on privatization classification, financial restructuring and redundancy program (2008 baseline: no regulations) Privatization of major SOEs (e.g. STELCO, MNSL, etc) by end 2010 (2008 baseline: one privatized SOEs) Official gazette Government circulars ADB review missions Assumption Employers in SOEs agree to privatization Risk Limited political will to carry through and implement reforms Privatization of targeted SOEs (2008 baseline: one privatized SOEs) 5. Strengthening Internal Audit Operations Preparation of framework for producing periodic and ad hoc internal audit reports (2008 baseline: framework does not exist) Implementation of internal audit manual pursuant to standard financial accounting (2008 baseline: internal audit manual does not exist) Roll out the internal audit function as a model into other line ministries and agencies (2008 baseline: independent audit function does not exist) Official gazette Government circulars ADB review missions Risks Limited political will to carry through and implement reforms proposed under the program Vested interests within the Government may delay initiating necessary steps to implement an effective internal audit mechanism Implementing new financial regulations in line with international public sector accounting standards (2008 baseline: none exists) Receiving regular

39 Appendix 1 27 Design Summary Performance Targets and Indicators information technology audit reports (2008 baseline: none exists) Major activities with Milestones under the Program Data Sources and Reporting Mechanisms Assumptions and Risks Inputs 1. Strengthening Fiscal Policy and Bolstering Budget Formulation and Implementation 1.1 Approve a medium-term macroeconomic and fiscal policy framework (by end 2009) 1.2 Implement a 3 year rolling budget framework and unify public sector investment program (PSIP) (by end 2009) 1.3 Introduce a periodic monitoring of monthly statements of actual revenue and expenditure (by end 2009) 1.4 Submit fiscal responsibility legislation to Parliament (by June 2011) 1.5 Develop medium term budget programming framework (MTBF) (by December 2010) 1.6 Develop project selection criteria for the public sector investment program (by June 2010) 1.7 Introduce on a pilot basis principles of results or performance-based budgeting in three key sectors (by December 2010) 1.8 Prepare 2011 budget based on PAS reporting requirements (by December 2010) Program loan ADB: $35 million ADF TA grant and loan ADB: $4.5 million Policy Reforms and Outputs 2. Implementing Revenue, Expenditure and Debt Management Measures to Strengthen the Fiscal Policy 2.1 Announce the introduction of BPT and TGST, and submit these bills to Parliament (by end 2009) 2.2 Tax collection across BPT, TGST and Passenger Service Charge (Airport Tax) (by June 2011) 2.3 Proposal for extending TGST to non-tourism sector is submitted to Parliament (by June 2011) 2.4 Implement the first phase of a redundancy program resulting in reduction of 2,500 staff in 2009 (by end 2009) 2.5 Approve Government's human resource management plans (by end 2009) 2.6 Implement the second phase of the redundancy program resulting in a reduction of 3,000 civil servants (by December 2010) 2.7 Implement new tariff program based on the targeted subsidies to lower income households (by December 2010) 2.8 Prepare a study identifying the stock of outstanding liabilities on SOE balance sheets with a focus on STELCO and STO (by end 2009) and retire outstanding debts (by June 2011) 2.9 Obtain cabinet approval for a Debt Strategy targeting at reducing debt reduction over the medium term consistent with MTFF (Dec 2010) and implement the strategy (by June 2011) 3. Strengthening the Mechanisms for Financing the Budget 3.1 Convert the outstanding advance on the W&MA to Treasury bonds (by end 2009) 3.2 Develop and implement a framework to analyze monthly Treasury cash flow management to be used to support liquidity forecasting (by end 2009) 3.3 Replace the fixed rate tap system with a variable rate Treasury bill

40 28 Appendix 1 Design Summary Performance Targets and Indicators Data Sources and Reporting Mechanisms auction system (by end 2009) 3.4 Arrange the trading of Treasury bills in the secondary market and to include open market operations (by December 2010) 3.5 Include Treasury bills as eligible items under MMA's minimum reserve requirements for commercial banks and allow non-institutional investors to participate in the Treasury bills market (by June 2011) Assumptions and Risks 4. Facilitating Privatization of SOEs 4.1 Present to cabinet a formal privatization policy for SOEs (by end 2009) 4.2 Publish orders on privatization including the categorization framework of SOEs, guidelines for financial restructuring and framing of a redundancy package (by end 2009) 4.3. Announce 19 SOEs for privatization (by October 2009) 4.4 Prepare STELCO business plan based on a revised business model (by end 2009) 4.5 Strengthen functions and organization structure of the Public Enterprise Monitoring and Evaluation Board (by December 2010) 4.6 Bring to the point of sale at least three SOEs identified in the list of SOEs to be privatized (by June 2011) 5. Strengthening Internal Audit Operations 5.1 Operationalize internal audit function by revising existing internal audit internal guidelines (by end 2009) 5.2 Complete draft accounting standards in line with the enacted PFA and international public sector accounting standards (by end 2009) 5.3 Complete a comprehensive internal audit manual (by June 2010) 5.4 Roll out the internal audit module under the public accounting system (by June 2011) 5.5 Implement pilot internal audits of at least two budget agencies (by June 2011) ADB = Asian Development Bank, BPT = business profit tax, GDP = gross domestic product, GST = goods and services tax, IMF = International Monetary Fund, MMA = Maldives Monetary Authority, MNSL = Maldives National Shipping Limited, MTFF = Medium Term Fiscal Framework, MOFT = Ministry of Finance and Treasury, PAS = public accounting system, PFA = Public Finance Act, PSIP = Public Sector Investment Program, SOEs = state-owned enterprises, STELCO = State Electric Company Limited, STO = State Trading Organization, TGST = tourism goods and services tax, W&MA = ways and means advances. a GDP at current market prices for Source: Statistical Year Book of Maldives, b Consumer price index for 2008 (index base: June 2004 = 100). Source: Statistical Year Book of Maldives c Overall budget deficit including grants. Source: Statistical Year Book of Maldives d Tax revenue for Source: Statistical Year Book of Maldives e Statistical Year Book of Maldives Malé. f MMA Monthly Statistics for August Malé. g Total outstanding debt for Source: Monthly Statistics for August MMA. Malé. h Total Treasury bill outstanding at the end of December Source: Monthly Statistics for August 2009, Maldives Monetary Authority. Malé. Source: Asian Development Bank.

41 Appendix 2 29 A. Overview of Fiscal Situation SECTOR ANALYSIS 1. The Maldives pursued an expansionary fiscal policy after the tsunami in The Government included large reconstruction outlays in the budget, but also pushed up current spending, both to raise public sector wages and to maintain subsidies in Malé especially for power generated by oil-fired generating plants. Total expenditure jumped to about 60% of gross domestic product (GDP) in 2008 from 40% in Revenue increased with the help of tsunami reconstruction grants and import growth, but not enough to cover the expenditure. The fiscal deficit escalated to 13% of GDP in 2008 from below 5% in Structural constraints have weakened macroeconomic fundamentals, resulting in both domestic and external imbalances. The large fiscal deficit exerted significant pressure on the balance of payments. The economy is particularly vulnerable to the global slowdown as tourism accounts for more than a quarter of GDP and has significant knock-on effects on aggregate demand in the economy. 3. In 2008, the Maldives faced revenue and foreign exchange shortfalls and as a result two planned major infrastructure projects totaling $190 million were not awarded. The Government wanted to fill the revenue gap by tendering leases for new resorts on 30 islands, as well as by a 20% reduction in budgeted expenditure for the last few months of However, it did not proceed with the tenders and instead found alternative revenue from bilateral and commercial external sources. 4. The new government elected in November 2008 revised the 2009 budget in May 2009 to reflect its political manifesto. The revised budget is a first attempt to rationalize expenditure within the constrained resources available and to decrease expenditure. However, it is not certain whether the measures in the revised budget will take effect in Faced with a revenue shortfall, the Government may need to decrease expenditure further to avoid a large fiscal deficit. Export-Import Bank of India will provide a loan facility of $300 million, of which $50 million will be included to the government budget. This will give temporary financial relief. Table A2.1: Summary of Government Finance (% of GDP) Item Total Revenue and Grants Current Revenue Capital Revenue Grants Expenditure and Net Lending Current Expenditure Capital Expenditure Net Lending (0.3) (0.2) (1.8) (2.0) (1.2) (1.0) (0.9) (1.1) Overall Balance (4.7) (4.9) (3.4) (1.6) (10.9) (6.8) (4.7) (12.6) Foreign Financing Domestic Financing (1.3) (2.5) Total Debt (end of period) Foreign Domestic ( ) = negative, GDP = gross domestic product. Source: Maldives Monetary Authority.

42 30 Appendix 2 B. Structure of Revenue and Expenditure 5. The Maldives' public finances depend on a narrow revenue base. Tax revenue, which accounts for about half of domestic revenue, is concentrated on import duties and tourism tax. Tourists are subject to an $8 per-person per-night tourism tax. This is collected by the tourist resorts and has given resorts an incentive to focus on high-end market. Rent from leasing resorts and dividends from state-owned enterprises (SOEs) are the principal sources of nontax revenue. SOEs are engaged in a wide range of economic activities, including utility services such as water and power, transport, communications, trading, construction, and finance. Table A2.2: Current Revenue Item Rf million (%) Rf million (%) Tax Revenue 2, , Import Duty 2, , Tourism Tax Bank Profit Tax Others Nontax Revenue 3, , Net Sales of SOEs , Resort Lease Rent 1, , Others Current Revenue 6, , SOE = state-owned enterprise. Note: 2008 data are based on the revised estimate. The data follow government finance statistics format. Source: MOFT Government Budget in Statistics. Malé. 6. Since 2005, higher public sector wages and power subsidies in Malé and tsunami reconstruction outlays pushed up fiscal expenditures. In fact, the increase in current expenditure outstripped that of capital, raising the current expenditure share by 10% of total expenditure. Figure A2.1: Breakdown of Total Expenditure 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Current Expenditure Capital Expenditure Source: MOFT Government Budget in Statistics. Malé

43 Appendix 2 31 C. Public Debt Outstanding 7. As fiscal balance has deteriorated since 2005, outstanding public debt increased to over 50% of GDP. The recent increase was driven mainly by domestic debt: about 60% of outstanding public debt is denominated in foreign currency. 8. An assessment by the International Monetary Fund (IMF) concluded that the sustainability of the public debt depends largely on the strength of adjustment efforts, including a significant fiscal retrenchment and possible arrangements with international financial institutions. Without such adjustments, the public debt ratio will increase substantially to an unsustainable level over the medium term. Figure A2.2: Public Debt Outstanding 60% 50% 40% 30% 20% 10% 0% Source: Maldives Monetary Authority. Foreign Domestic Total Debt D. Impact on External Sector Imbalances 9. As the economy is driven by the public sector (fiscal expenditure accounts for 67% of GDP in 2009), fiscal expansion has a substantial impact on aggregate demand and widens external imbalances. Imports for reconstruction and new resort development, a general demand increase, and higher international commodity prices in 2008 have increased the trade deficit substantially. With only moderate growth in tourism receipts, the current account deficit widened sharply to 51.7% of GDP in 2008 from 15.8% in Although there were still large net inflows driven by resources for resort development (other investment), the overall balance of payments moved into deficit (a negative 5.4% of GDP) in As the global financial crisis deepens and the capital inflow dries up, there will continue to be balance-of-payments risks. Table A2.3: Summary of Balance of Payments (% of GDP) Item Current Account (9.8) (5.6) (4.5) (15.8) (36.4) (33.0) (41.5) (51.7) Balance on Goods (net) (39.5) (33.1) (37.9) (49.4) (65.9) (64.5) (69.9) (70.7) Balance on Services (net) 40.9 (39.3) 45.0 (45.1) Balance on Income (net) (6.2) (5.5) (5.5) (4.5) (4.1) (4.5) (6.4) (5.1)

44 32 Appendix 2 Item Current Transfers (net) (5.0) (6.2) (6.1) (6.9) (1.3) (4.1) Capital Account Financial Account FDI (net) Portfolio Investment (net) Other Investment (net) Net Errors and Omissions (0.8) (1.1) Overall Balance (5.0) (2.3) (5.4) ( ) = negative, FDI = foreign direct investment, GDP = gross domestic product. Source: Maldives Monetary Authority. E. Revised 2009 Budget and Medium Term Fiscal Framework 10. The medium-term tax and expenditure containment measures underpinning the revised 2009 budget may not achieve the fiscal targets by the stipulated target date. The revised budget included a projected revenue increase from the privatization of the Malé International Airport (capital revenue), which is not likely to occur in The Government is committed to diversifying revenue away from import duties and has introduced legislation in the parliament for (i) levying a tourism goods and services tax (TGST) in lieu of existing fixed bed tax, (ii) business profits tax, and (iii) increasing passenger services charge (airport tax) from $12 to $18.5 per ticket. Further, in 2011, the Government plans to extend the TGST to non-tourism sectors of the economy. Significant preparatory work needs to be undertaken at an early stage to introduce the new taxes, especially the BPT. There is a concern that the country may not have the capacity to introduce these within a relatively short period of time. 11. On the spending side, fiscal policy remains expansionary in It is unclear how fiscal consolidation will be achieved against a backdrop of the rather ambitious and costly development agenda announced by the President. The MTFF needs to show a clear articulation of a power tariff adjustment mechanism, synchronized with international oil prices and the composition of the wage bill for the public sector. Table A2.4: Medium-Term Fiscal Framework (% of GDP) Item Total Revenue and Grants Current Revenue Capital Revenue Grants Expenditure and Net Lending Current Expenditure Capital Expenditure Net Lending (1.1) 0.0 (0.1) (0.2) Overall Balance (12.6) (7.4) (3.1) 2.6 Foreign Financing (0.5) Domestic Financing 8.8 (1.5) 2.2 (2.2) ( ) = negative, GDP = gross domestic product. Source: MOFT Government Budget in Statistics. Malé.

45 Appendix 3 33 DEVELOPMENT PARTNER COORDINATION AND ASSISTANCE A. DEVELOPMENT COORDINATION MATRIX 1. The Economic Recovery Program is part of the Government's broad emergency program supported by the international financial institutions and underpinned by an International Monetary Fund (IMF) Stand-By Arrangement. The Stand-By Arrangement will include policy measures to bring public finances back to a sustainable footing, halt financing from the Maldives Monetary Authority to the Government, and take measures to strengthen financial sector performance. The Program includes support for privatization and internal audit, on top of support for strengthening fiscal policy. Table A3.1: Development Partners' Work on Program-Related Areas Sector ADB Development Partners' Work Fiscal Policy and Budget Formulation Framework Component 1 (Strengthening Fiscal Policy and Bolstering Budget Formulation and Implementation) International Monetary Fund (IMF) Support preparation of a fiscal responsibility act Revenue, Expenditure and Debt Management Mechanisms for Financing the Budget Privatization of SOEs Internal Audit Financial Sector Component 2 (Implementing Revenue, Expenditure and Debt Management Measures to Strengthen the Fiscal Policy) Component 3 (Strengthening the Mechanisms for Financing the Budget) Component 4 (Facilitating Privatization of SOEs) Component 5 (Strengthening Internal Audit Operations) IMF Stand-By Arrangement a Reducing public spending to bring public finances back to a sustainable footing, through a restructuring of wages, allowances, and the government payroll, and cuts in other expenses. IMF Stand-By Arrangement a Tightening monetary policy, including by halting financing from the Maldives Monetary Authority to the central government IMF Currently preparing a Public Expenditure and Financial Accountability Assessment (to be completed in 2009) World Bank Public accounting modernization project Reforms in public procurement and external audit Country financial accountability assessment (2000) and a public expenditure review (2002) Technical assistance to support the introduction of an integrated financial management information system IMF Stand-By Arrangement a Strengthening the financial sector ADB = Asian Development Bank, SOE = state-owned enterprise, TA = technical assistance. a Based on Staff-Level Agreement with Maldives on Stand-By Arrangement (20 August 2009).

46 34 Appendix 3 Table A3.2: Nature of Coordination with Development Partners ADB Development Partners ADB attended the Development Partnership Forum in the Maldives in March 2009 and held discussions with key development partners, including (i) the World Bank, (ii) Japan International Cooperation Agency (JICA), (iii) Islamic Development Bank, (iv) Commonwealth Secretariat, (v) United States Agency for International Development (USAID), and other bilateral development partners. ADB IMF An ADB mission worked closely with an International Monetary Fund (IMF) World Bank mission on debt sustainability assessment by participating in the mission and follow-on activities for the preparation of the report. ADB was invited to attend the public expenditure financial assessment mission, but could not participate due to staffing constraints. However, ADB provided comprehensive comments on the draft public expenditure financial assessment. An ADB mission worked closely with IMF missions in the field on two occasions, including an Article IV mission and a mission to prepare the Stand-By Arrangement. Preliminary policy frameworks and other information were shared. ADB World Bank The South Asia Country Coordination and Regional Cooperation Division director has visited the Maldives on three occasions with a World Bank counterpart. In September 2009, ADB staff attended World Bank country retreat discussions in Malé in preparation for the next country assistance strategy. ADB JICA An ADB mission visited the JICA office in Colombo, following an earlier cofinancing mission to JICA, Tokyo, to explain the nature of the Economic Recovery Program and potential of cofinancing. ADB = Asian Development Bank, IMF = International Monetary Fund, JICA = Japan International Cooperation Agency, SAOC = Country Coordination and Regional Cooperation Division, USAID = United States Agency for International Development. B. LOANS AND TA IN THE SECTOR AND RELATED AREAS Table A3.3: External Assistance Donor Program Amount Date of Approval Objective ADB Capacity Building for the Maldives Public Accounting System (TA 3320-MLD) $600,000 2 December 1999 The TA aims to improve the public accounting system to enable the development of an effective fiscal operation and macroeconomic policy.

47 Appendix 3 35 Donor Program Amount Date of Approval Objective ADB ADB ADB ADB ADB World Bank ADB World Bank Capacity Building for the Maldives Customs Service (TA 3496-MLD) Strengthening of the Public Accounting System (TA MLD) Revenue Diversification in the Maldives (TA 3925-MLD) Strengthening of Debt Management (TA 4196-MLD) Capacity Building for National Statistical System (TA MLD) Public Expenditure Management (TA MLD ) Strengthening Project Management and Monitoring for the Ministry of Finance and Treasury (TA 4623-MLD) Strengthening of Procurement Regulatory Framework (TA MLD) $824,000 5 September 2000 $150, December 2001 $415, September 2002 $412, October 2003 The TA s objective is to strengthen the valuation capacity of MCS to enable it to successfully adopt and apply the WTO valuation rules in , and thus to enhance transparency and accountability of MCS. The objective of the TA is to prepare a proposed public accounting system project implementing a computerized, double-entry, cash-based, public accounting system with a central ledger and a check production unit under the control of MOFT. The main objectives of the TA are to assist the Government in (i) devising an implementation plan for the BPT and the PRVT, and (ii) supporting the enactment of relevant legislation and regulations. The aim is to facilitate sound management of the existing debt portfolio, and provide input on new borrowings vis-à-vis the country s repayment capacity and development framework. $350,000 2 May 2003 The TA aims to prepare (i) a human resource plan; (ii) a draft statistics act; (iii) the design of a diplomalevel training program in statistics; and (iv) a technical report on improving the national accounts indicators. $240, The TA aims to develop a Government Finance Statisticsbased MOFT budget ledger and supports the development of fiscal programming. $295, July 2005 The TA will support MOFT (i) in developing a system, including an MIS, for effective management and monitoring of projects funded by international financing institutions, and (ii) in strengthening the capacity of the staff of the ERM section and senior officials of MOFT in financial planning, and project management and monitoring to support the line ministries. $300, The TA aims to create a nodal agency for facilitating procurements.

48 36 Appendix 3 Donor Program Amount Date of Approval Objective World Bank IMF ADB European Union ADB ADB World Bank World Bank Institutional Development and Capacity Building of the Office of the Auditor General (TA MLD) Developing the Treasury bills market (TA MLD) Strengthening of Public Service Division (TA MLD) Strengthening of the Public Accounting Systems Project SME Development Project (TA 4745-MLD) Private Sector Development Project Proposed Mobile Phone Banking Project Public Accounting System Project Additional Financing $380, The TA aims to strengthen systems and procedures in the Auditor General s Office. $295, December The TA's objective is to assist in preparing the legal, policy, and operational requirements to issue Treasury bills in the Maldives. The TA aims to help the PSD (i) develop a performance-oriented strategic reform plan; (ii) increase the knowledge and improve the skills of its staff, and the staff of ministries, regarding modern human resource management and organizational development concepts and processes; and (iii) prepare guidelines for establishing the PSTC and developing its curriculum. $6 million 2006 The project aims to strengthen financial management of the Tsunami Relief and Reconstruction Fund. $600, December 2005 The objective of the TA is to develop MSME in selected regions and targeted sectors, resulting in enhanced business activities, employment, and reduced poverty through accelerated growth of MSME. $7.5 million 20 June 2008 The overall objective of the proposed project is to promote the expansion and growth of a vibrant MSME sector and to encourage private sector development for broad-based, sustainable, and inclusive economic growth and employment. $6.8 million Q The project aims to provide an automated banking and payment system through mobile phones leading to reductions in transaction costs. Q The project addresses the procurement of software, installation and training.

49 Appendix 3 37 Donor Program Amount Date of Approval Objective World Bank UNDP Pension and Social Security Project Support for Public Service Reforms $14 million 2008 The project supports the establishment of a new pension system to provide old age income security. $1 million to $2 million 2008 The project aims to develop capacity in PSD to strengthen the functions of government. ADB = Asian Development Bank, BPT = business profit tax, IMF = International Monetary Fund, MCS = Maldives Customs Service, MLD = Maldives, MOFT = Ministry of Finance and Treasury, MSME = micro, small, and medium-sized enterprises, PRVT = property rentals value tax, PSD = Public Service Division, PSTC = Public Service Training Center, TA = technical assistance, UNDP = United Nations Development Programme, WTO = World Trade Organization. Source: Asian Development Bank.

50 38 Appendix 4 DEVELOPMENT POLICY LETTER

51 Appendix 4 39

52 40 Appendix 4