Document of The World Bank

Transcription

1 Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Document of The World Bank FOR OFFICIAL USE ONLY IMPLEMENTATION COMPLETION REPORT (SCL-46520; IDA-36170) ON A CREDIT IN THE AMOUNT OF SDR 40.5 MILLION (US$50 MILLION EQUIVALENT AND A LOAN IN THE AMOUNT OF US$50 MILLION TO INDIA FOR KARNATAKA ECONOMIC RESTRUCTURING LOAN/CREDIT II Poverty Reduction Economic Management Unit South Asia Region 06/13/2003 Report No: This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.

2 CURRENCY EQUIVALENTS (Exchange Rate Effective ) Currency Unit = Rupees (Rs.) Rs.1 = US$ US$ 1 = Rs FISCAL YEAR April 1 March 31 ADB ATL BATF BATF BWSSB CAF CAS CII CSO DDPER DES DMTFP ESCOM FDI GoI GoK GSAP GSDP HDI IBRD IC ICR IDA IDFC IEG KERC KERL Asian Development Bank Anti Power-Theft Law Bangalore Agenda Task Force Bangalore Agenda Task Force Bangalore Water Supply and Sewerage Board Combined Application Form Country Assistance Strategy Confederation of Indian Industry Central Statistical Organization Department for Disinvestment and Public Enterprise Reform Department of Economics and Statistics Departmental Medium Term Fiscal Plan Electricity Supply Company Foreign Direct Investment Government of India Government of Karnataka Governance Strategy and Action Plan Gross State Domestic Product Human Development Index International Bank for Reconstruction and Development Investment Climate Implementation Completion Report International Development Association Infrastructure Development Finance Corporation Institute for Economic Growth Karnataka Electricity Regulatory Commission Karnataka Economic Restructuring Loan/Credit ABBREVIATIONS AND ACRONYMS KERP KIFB KPCL KPTCL KSRTC LDP MOP MTFP NGO NSS O&M OED OUP PAC PDS PEs PHCs PHDMS PSAL PSU QAG RBI RTI SME UNDP VAT VRS UP Karnataka Economic Restructuring Program Karnataka Industries Facilitation Bill Karnataka Power Corporation Limited Karnataka Power Transmission Corporation Limited Karnataka State Road Transport Corporation Letter of Development Policy Memorandum of the President Medium Term Fiscal Plan Non Government Organization National Sample Survey Operations and Maintenance Operations Evaluation Department Oxford University Press Public Affairs Centre Public Distribution System Public Enterprises Primary Health Centers Poverty and Human Development Monitoring System Programmatic Structural Adjustment Loan/Lending Public Sector Unit Quality Assurance Group Reserve Bank of India Right to Information Small and Medium-sized Enterprise United Nations Development Program Value Added Tax Voluntary Retirement Scheme Uttar Pradesh Vice President: Country Manager/Director: Sector Manager/Director: Task Team Leader/Task Manager: Ms. Mieko Nishimizu Mr. Michael F. Carter Mr. Sadiq Ahmed Mr. Stephen Howes, Lead Economist Ms. Paramita Dasgupta, Economist

3 INDIA KARNATAKA STRUCTURAL ADJUSTMENT LOAN II CONTENTS Page No. 1. Project Data 1 2. Principal Performance Ratings 1 3. Assessment of Development Objective and Design, and of Quality at Entry 2 4. Achievement of Objective and Outputs 4 5. Major Factors Affecting Implementation and Outcome Sustainability Bank and Borrower Performance Lessons Learned Partner Comments Additional Information 43 Annex 1. Key Performance Indicators/Log Frame Matrix 54 Annex 2. Project Costs and Financing 58 Annex 3. Economic Costs and Benefits 59 Annex 4. Bank Inputs 60 Annex 5. Ratings for Achievement of Objectives/Outputs of Components 61 Annex 6. Ratings of Bank and Borrower Performance 62 Annex 7. List of Supporting Documents 63

4 Project ID: P Team Leader: Paramita Dasgupta Project Name: KARNATAKA STRUCTURAL ADJUSTMENT LOAN II TL Unit: SASPR ICR Type: Core ICR Report Date: June 16, Project Data Name: KARNATAKA STRUCTURAL ADJUSTMENT L/C/TF Number: SCL-46520; IDA LOAN II Country/Department: INDIA Region: South Asia Regional Office Sector/subsector: Sub-national government administration (73%); General industry and trade sector (18%); Health (3%); General education sector (3%); Roads and highways (3%) Theme: Administrative and civil service reform (P); Other economic management (P); Public expenditure, financial management and procurement (P); Other accountability/anti-corruption (S); State enterprise/bank restructuring and privatization (S) KEY DATES Original Revised/Actual PCD: 11/13/2001 Effective: 03/19/ /19/2002 Appraisal: 01/08/2002 MTR: Approval: 03/14/2002 Closing: 09/30/ /30/2002 Borrower/Implementing Agency: Other Partners: Government of India/Government of Karnataka STAFF Current At Appraisal Vice President: Mieko Nishimizu Mieko Nishimizu Country Director: Michael F. Carter Edwin R. Lim Sector Manager: Sadiq Ahmed Sadiq Ahmed Team Leader at ICR: Stephen Howes Paramita Dasgupta Lili Liu Stephen Howes ICR Primary Author(s): Stephen Howes Paramita Dasgupta 2. Principal Performance Ratings (HS=Highly Satisfactory, S=Satisfactory, U=Unsatisfactory, HL=Highly Likely, L=Likely, UN=Unlikely, HUN=Highly Unlikely, HU=Highly Unsatisfactory, H=High, SU=Substantial, M=Modest, N=Negligible) Outcome: S Sustainability: L Institutional Development Impact: SU Bank Performance: S Borrower Performance: S QAG (if available) ICR

5 Quality at Entry: Project at Risk at Any Time: No S 3. Assessment of Development Objective and Design, and of Quality at Entry 3.1 Original Objective: Karnataka s Reform Program. Karnataka is India s 8th largest state with a population of about 53 million. It has benefited significantly from India s process of liberalization since Karnataka has embarked on a major program of fiscal and governance reform, under the label of the Karnataka Economic Restructuring Program (see 3.3 for a summary). The strategy is two-pronged, aiming to (i) rationalize and refocus the role of the state and (ii) enhance the effectiveness, transparency and accountability by which the state performs this role. Sectoral reforms have also been initiated in the power, roads, water, health, education, transport, urban and agriculture sectors. World Bank Assistance Strategy to Karnataka. Support to reforming states has been an important part of the Bank s Country Assistance Strategy to India since The Bank has been supporting comprehensive reforms in Karnataka since late The Bank s program of assistance to Karnataka has three important features: (i) it is aligned to the Government of Karnataka s (GoK s) own reform program; (ii) it is focused on poverty reduction, with particular focus on the poorer, arid regions of the state; and (iii) it is programmatic in nature, with a sequence of interventions designed to further government reforms and goals. The overall program consists of analytical work, technical assistance, investment lending and adjustment lending. Loan/Credit Objective. The latest CAS, discussed by the Board on April 5, 2001, reflects a higher emphasis on fiscal and governance reforms and increased reliance on programmatic adjustment lending. The recent CAS update (November 2002) endorses this strategy. So far, sub-national loans have been made to the states of Uttar Pradesh, Andhra Pradesh and Karnataka. The objective of both the First and the Second Karnataka Economic Restructuring Loan/Credit (KERL1 and KERL2) was to support GoK s efforts to stabilize its fiscal position, improve governance, and foster an enabling environment for structural reforms and sectoral investments under the Karnataka Economic Restructuring Program. In keeping with the focus on programmatic lending, KERL1 was envisaged as the first in a series of adjustment loans/credits (i.e the first loan in a Programmatic Structural Adjustment Loan series or PSAL) to help the state implement and finance KERP. In particular, although the KERL1 President s Report (the Memorandum of the President or MOP) identified that the financing requirement for 2001/02 was US$250 million, KERL1 only provided US$150 million equivalent. (The reason for this split was a perception that the reform program was still at an early stage. In particular, in the power sector, the government had deferred an agricultural tariff increase ordered by the electricity regulator.) Upfront actions were specified in the KERL1 MOP for a second loan/credit, KERL2, which was designed in such a way that, provided good progress was made with the reform agenda, the loan/credit could also be disbursed in the GoK 2001/02 fiscal year. Good progress was indeed made, performance under KERL1 was rated satisfactory in the KERL1 ICR (a verdict endorsed by OED), and KERL2, in the value of US$100 million equivalent, was approved by the Board on March 14, 2002, and the Rupee equivalent was disbursed by the Government of India (GoI) to GoK prior to the close of the Indian 2001/02 fiscal year. KERL3 was originally planned for the Indian FY03 fiscal year (ending March 2003), subject to good reform progress. However, two factors have caused a delay in KERL3. First, Government of India sought a review of the Bank s state adjustment lending, and a pause until new guidelines were in place, which took - 2 -

6 till December, (The new guidelines make adjustment lending a facility any state can apply for to support a multi-year reform program aimed at fiscal consolidation.) Second, once the go-ahead was given to the Bank in December 2002 to prepare for KERL3, the Bank s assessment in January, 2003 was that Karnataka did not then qualify for KERL3, for reasons explained later in this report. Scope of the ICR. This Implementation Completion Report is an evaluation of KERL2. KERL2, like KERL1, was based on upfront policy actions, all of which were completed prior to loan approval and none of which have been reversed. To provide an adequate assessment of KERL2, this ICR, like the KERL1 ICR, goes beyond certification of compliance with upfront actions to include an assessment of progress in KERP reforms post-approval of KERL2. The reason for this is the lack of progress following approval of a loan would indicate weak program design and/or ineffective implementation. In addition, this ICR, unlike the KERL1 ICR, includes additional information (in Section 10), with a summary in Box 4, providing an assessment of development outcomes achieved in Karnataka. The reason for this is that, with Bank support for Karnataka s reform program now about three years old, it is worth taking a step back and looking at the outcomes actually achieved on the ground in Karnataka. Not all the outcomes can be linked to Karnataka s reforms, still less to the Bank s support for these reforms. However, it is very important to have a broader sense of whether, to what extent, and in what areas Karnataka is succeeding. 3.2 Revised Objective: Not applicable. 3.3 Original Components: As per the Government s Letter of Development Policy for KERL2, the various components of Karnataka s fiscal and governance reform program (the Karnataka Economic Restructuring Program or KERP), can be summarized as follows. The fiscal and public expenditure reforms include a multi-year framework for fiscal adjustment, as well as reforms to improve fiscal transparency, tax and expenditure policies, public expenditure management, financial accountability, and transparency in public procurement, with the objectives of restoring the state s financial health, creating additional fiscal space for high priority development expenditures, and promoting more efficient and transparent management of the government s financial resources. Administrative reforms focus on civil service reforms, freedom of information, service agency reforms, anti-corruption initiatives, decentralization, and e-governance, with the objectives of improving the efficiency and transparency by which government conducts its business and delivers services. The private sector development component focuses on improving the business environment through deregulation and privatization or closure of public sector undertakings. The poverty monitoring and statistical strengthening component supports the better use of data in policy making, through the development of a poverty and human development monitoring system, increased emphasis on program evaluation, and strengthening of the state s statistical system. There are also two sectors recognized by both GoK and the Bank as being of particular importance to KERP, the power sector and the education sector. The power sector is important because, as it currently functions, it is a huge fiscal drag and constraint on industrial growth. (In Karnataka, like many other Indian states, the power sector has a large, negative fiscal impact.) The education sector is important to promote human development, a key strategic challenge facing this fast-growing state. Focus on the education sector - 3 -

7 came after KERL2 approval. Focus on the power sector came right from KERL1 preparation, and was manifested in two ways. One, a consolidated fiscal target was defined which included the losses of the power sector and other important off-budget liabilities as well as the traditional budgetary deficit. Since program targets required reduction in this consolidated target, this implied reduction in the financial losses of the power sector, separate targets for which were agreed on. Two, in terms of structural reforms in the power sector, although these were not formally specified as triggers in the way that the fiscal and governance triggers were, benchmarks for progress were agreed on in the documentation for both KERL1 and KERL2, and subsequently closely monitored. 3.4 Revised Components: The addition of education as a key sector of importance to the KERP was the major extension of the programme, which took place in the course of Quality at Entry: QAG assessed KERL1 as highly satisfactory for quality at entry, but did not assess KERL2. The KERL1 ICR and OED assessed KERL1 as satisfactory for quality of entry, and this ICR proposes the same rating for KERL2. While the design of KERL2 was largely defined at the time of KERL1, three years of experience have also confirmed the appropriateness of the design of the overall Karnataka Economic Restructuring Program. Some of the lessons learnt in KERL1 were applied in the development of KERL2 (e.g. in relation to the power sector where a lot more attention was given to limiting aggregate supply). There was some risk in moving ahead with KERL2 on the basis of fiscal estimates for 2001/02, but these estimates turned out to be reasonable overall. Reality on the ground at the time of loan approval was worse than expected in two regards: the volume of civil service transfers; and collection efficiency in the power sector. These are discussed in more detail in the text. 4. Achievement of Objective and Outputs 4.1 Outcome/achievement of objective: KERL2, like KERL1, included a set of triggers -- upfront actions -- on which approval of the loan/credit was based (shown in Box 1 below). The final KERL2 triggers were very similar to those set out in the KERL1 MOP as indicative triggers. Only one trigger agreed at the time of KERL1 was not achieved, and that was the notification of the Right to Information Act, something which the Bank agreed to allow more time for, and which was done by July By design, all of these measures were implemented prior to Board approval and subsequent disbursement of the loan/credit. None have been subsequently reversed, although one could note that the Corruption Prevention Committee, though established, has never really become active. Achievement of this trigger (#8) has thus not really served any purpose

8 Box 1. Activating Triggers for the Second KERL Fiscal Policy and Public Expenditure Management 1. Progress towards agreed fiscal targets, as indicated by: (I) actuals for 2000/01; (ii) monthly fiscal accounts data for 2001/02; and (iii) progress in implementation of revenue and expenditure reforms. 2. Further development of the Medium Term Fiscal Plan (MTFP), including: (I) approval of the draft MTFP to guide budget approval; (ii) development of 4 departmental MTFPs (education, health, roads, and rural water); and (iii) greater use of performance evaluations. 3. Draft Fiscal Responsibility Legislation. 4. Establishment of Central Procurement Cell, and approval of an Action Plan to implement agreed recommendations of the Karnataka Procurement Assessment. Administrative Reforms 5. Drastic reduction in number of civil servant transfers. 6. Implementation of pilot reforms to reduce elapsed time in government administrative transactions. 7. Completion of functional reviews for major departments to rationalize the government administration. 8. Establishment of the Corruption Prevention Committee to monitor and publicly report on the Government s anti-corruption program. 9. Roll out of pilot agency reforms to other parts of the state. 10. Notification of rules for, and effectiveness of, Right to Information Act. Private Sector Development 11. Implementation of reform measures in the Karnataka Policy Paper on Deregulation of the Business Environment. 12. Closure or sale of 3 Public Enterprises. In addition to these fiscal and governance triggers, key upfront actions were also required in the power sector to show progress against the benchmarks identified in the KERL1 project documentation. These measures included: Initiation of metering of irrigation pump-sets (IP sets) Passage of Anti-Power-Theft Act Implementation of an agricultural tariff increase of 80% which had been ordered by the Regulator in January 2001, but deferred by the Government. Filing of a second tariff order (for 30% increase) during 2001/02. A more detailed evaluation of performance under each component, as well as in the two important sectors of power and education, follows in 4.2. In general, one can see that Karnataka s reform program has come a long way over the last few years. As documented in 4.2, it has taken significant steps forward across a range of reform areas, including in the areas of fiscal adjustment and reform, governance reforms, public enterprise reforms, poverty monitoring and education. Before going into this specifics, however, we make a more general evaluation, based on three types of consideration: (i) broad strengths and weaknesses of the reform program; (ii) the environment for reform; and (iii) a broader analysis of the success of Karnataka in improving development outcomes. Taking first a broad view of the reform program, it can be argued that it has displayed two cross-cutting strengths: an openness to participation in reforms and government activity by the private sector, NGOs and citizens groups (which are vibrant in Karnataka); and the adoption of a legislative approach to reform. On the former, Karnataka has benefited from having an active private sector and civil society willing to work with the government, and from having a government willing to involve the private sector and NGOs. Public-private partnerships have evolved in a range of disparate areas, as outlined in Box 2 below

9 On the latter issue of a legislative approach to reform, more than any other reforming state, Karnataka has attempted to take this route. Seven pieces of legislation underpin the state s reform efforts: in the power sector, the Electricity Reform Act and amendments to the Electricity (Supply) Act to strengthen penalties for the theft of electricity (the so-called "Anti-Power-Theft" Act) ; to improve transparency, the Right to Information, and the Transparency Act in the Public Procurement Act; to strengthen fiscal discipline, the Ceiling on Government Guarantees and Fiscal Responsibility Act; and to deregulate business, the Industries Facilitation Act. As shown by Table 1 below, no other state has passed this raft of laws. One should not overstate this achievement. The list below is not comprehensive (e.g. Maharashtra has passed an act to mandate PSU privatization and closure). And laws themselves may or may not be implemented. At the same time, it is hard to deny that legislative backing is extremely important in a country such as India with a well-developed legal framework. Certainly, in Karnataka, its reform legislation is having an impact. Table 1: Legislation Passed by Reforming States Karnataka AP Maharashtra Delhi TN Rajasthan Electricity Reform Act Anti-Power-Theft Act Right to Information (RTI) Act Transparency in Public Procurement Act Ceiling on Government Guarantees Act Fiscal Responsibility Act Industries Facilitation / Single Window Clearance Act Notes: The Maharashtra Fiscal Responsibility legislation has been tabled but not passed; the TN RTI Act is regarded as flawed. The Anti-Power-Theft Act is actually an amendment to the Electricity (Supply) Act. On the negative side, progress has been slower than expected and some important milestones have not been achieved in the areas of business deregulation, and power sector reforms. The latter in particular is an important shortcoming, given the overall importance of this sector. In fact, the Bank ruled that it was largely on account of inadequacies in power sector reforms that Karnataka did not qualify for KERL3 in FY03. (KERL3 has its own triggers defined at the time of KERL2. This ICR does not extend to a formal analysis of progress against KERL3 triggers. It suffices to say here that several of the power sector reform benchmarks have not been achieved, including targets for collection efficiency.) Box 2: Examples of public-private partnerships in Karnataka External feedback to Government. Karnataka is fortunate to have organizations such as the Public Affairs Centre (PAC) to provide feedback and pressure for reform. It has carried out two surveys ( report cards ) for various government services in the Bangalore area, and, more recently, a similar exercise for all of India. The most lowly-ranked service in the 1999 Bangalore survey, the Bangalore Development Authority, asked PAC for assistance after the results were out, and it is now widely-regarded as having turned around its performance. The Government has been receptive to PAC s feedback, and has itself commissioned work from the organization. While PAC has clearly been a pioneer, there are now other organizations playing a similar role, both in cities other than Bangalore, and, though the challenges are obviously greater, in rural as well as urban areas. GoK has also encouraged the provision of participant feedback on its schemes and programmes by launching the independent evaluation initiative under which government departments are encouraged to finance external evaluations of their programmes, usually by academic institutes or NGOs. So far, about 30 of these evaluations have been completed

10 Urban services. In late 1999, the Government institutionalized a role for citizen involvement in Bangalore by issuing a Government Order to set up the Bangalore Agenda Task Force (BATF) headed by a prominent business leader, with a largely non-government membership, but a government secretariat, and with a mandate to work with city agencies to improve the quality of life in Bangalore. Over the last few years, BATF has played a number of very useful roles: it has annually and publicly monitored the performance of major city agencies; it has helped with specific reforms, such as the reform of property tax, and the introduction of fund-based accounting in Bangalore; and it has helped nurture other citizens groups with an interest in service delivery. Both the BATF concept and the reforms it has helped spawn in Bangalore are now spreading to other cities in the state as well as in other states (Maharashtra, UP). Education. The Azim Premji Foundation, based in Bangalore, and financed by one of India s software giants, has a mandate to work for universal education. It is playing a unique role in improving the delivery of education services in Karnataka. The Foundation has already piloted the introduction of computer facilities in rural schools (on a self-funding basis). It has now started a scheme to incentivize better school performance. Any school in the backward north-east region of the state is now entitled to a Rs 20,000 grant provided it can show: (i) 100% enrollment, (ii) 90% attendance, and (iii) 60% student competence. Given that the annual discretionary expenditure of a typical school in Karnataka is only less than Rs 3,000 it is perhaps not surprising that some 6,000 schools have applied to participate in this scheme, perhaps India s first attempt to move towards a performance-based allocation system in the school education sector. Infrastructure and contracting out. Karnataka has farmed out the maintenance of its core road network to the private sector for the last three years. Bangalore has contracted out solid waste management to private sector firms. IDeCK, a joint venture company between GoK and IDFC was set up in 2001 to develop infrastructure projects with private sector participation. Karnataka is one of four states to be participating in the ADB Private Sector Infrastructure Project. Agriculture. Karnataka is India s first state to amend its Agricultural Produce Marketing Act to allow private-sector marketing of agricultural produce. A one-time exemption was provided to establish a large, non-government vegetable, fruit and flower market, which is expected to be opened in Bangalore around the middle of Karnataka has also taken a lead in promoting contract farming, seen as a private-sector solution to the support needs of small farmers. Task forces. Karnataka set up several task forces that have prepared reports covering almost every conceivable subject from administrative reforms, to sector issues, to womens empowerment and regional divides. Both these reports and their implementation are of variable quality, yet the reports ensure that there is a constant flow of new ideas entering the public policy debate. Turning now to the environment for reform, the second factor entering into our overall assessment, as Box 3 summarizes, there can be no doubt that this has been negative over the last two years, each of which has recorded the lowest rainfall in the state for the last 20 or 30 years, and accordingly has led to a significant decline in agricultural Gross State Domestic Product (GSDP) and a considerable degree of both rural distress and political agitation. Box 3 Rainfall and Growth in Karnataka, was a good year in terms of economic growth and rainfall for Karnataka, with the only real problem being low prices for some agricultural products. However, 2001/02 and 2002/03 were both low rainfall years. As the figure below shows, the rainfall shortage in each of these two years was the worst since 1980 (1970 for 2002/03). Correspondingly, these were years of negative agricultural growth and low GSDP growth, as the table below indicates, with a cumulative decline in agricultural production of about 17% over the two years. Industrial and services growth continued to be fairly high, with the latter estimated at around 13% for each of the two years, and the former at an average of 7.5%.While these are early estimates, and while one might expect some exaggeration of agricultural distress in the official figures, econometric analysis suggests that a cumulative fall in agricultural output of about 15% would not be unexpected given the shortfall in rain. Agriculture is notoriously - 7 -

11 volatile in Karnataka due to a low proportion of irrigated to cultivated land, and single-year declines in food grain production by 10% or 20% are fairly common. Deviation in Annual Rainfall in Karnataka, Growth and Inflation in Karnataka, 2000 to % deviation 30% 20% 10% 0% -10% -20% -30% -40% GSDP growth (real) Agricultural growth (real) Foodgrain production (kg) growth Inflation Note: Deviation is from average for period Year for rainfall is the calendar year Quick Estimate, Advance Estimate. Source: DES, GoK. Apart from leading to a growth slowdown, and causing rural distress (e.g. drinking-water shortages), the rain shortfall of the last two years has also had a negative financial impact on the power sector in various ways: (i) increased pumping (at subsidized tariffs) by farmers to substitute for lack of rain; (ii) increased power supply costs due to reduced availability of hydro-power; and (iii) a reluctance to take harsh measures, such as implementation of tariff increases or collection of tariff dues. Given the huge impact of the power sector on the fiscal position, this made the task of fiscal adjustment much more difficult than expected. The final input to our overall assessment of performance should be, as mentioned, a broader analysis of the success of Karnataka in improving development outcomes. This issue is gone into in some detail in Section 10, the main results of which are summarized in Box 4 below. Essentially, Karnataka shows rapid improvement across a range of indicators. The fastest-growing state in India, it has a relatively good investment climate, and an increasing ability to attract private investment. With above-average growth, there is a marked decline in poverty. Social indicators are also improving, and Karnataka shows relatively good and, to the extent that there is evidence to judge it, improving service delivery. Yet, for all this progress, in terms of fundamental outcomes, as measured by poverty and basic social indicators, Karnataka still appears to be a rather average state, with slightly worse-than-average levels of poverty, and slightly better-than-average human development indicators. Rates of improvement in basic social indicators have also roughly been average by Indian standards. The challenges for Karnataka in the coming years are twofold: (i) to maintain if not accelerate the 8% growth rate achieved in the last half of the nineties; and (ii) to achieve the human development standards of its southern neighbours, first Tamil Nadu and ultimately Kerala. Box 4. Development Outcomes in Karnataka: Progress in Recent Years (summary of Section 10) Growth. Karnataka is India s fastest growing state. Its growth rate picked up from 5.3% in the eighties (below the national average) to 7.4% in the nineties. Growth in all three sectors of the economy was above the Indian average. Poverty. Using the now-widely-accepted Deaton-adjusted poverty estimates, rural poverty in Karnataka fell from 37.9% in 1993/94 to 30.7% in 1999/00 (compared to an all India decline from 33% to 26%) and urban poverty fell from 21.4% in 1993/94 to 10.8% in 1999/00 (compared to an all India decline from 18% to 12%). Thus there was a slightly-above-average reduction in rural areas and a greatly-above-average reduction in urban areas

12 Investment climate. Karnataka s investment climate was ranked fourth in the country by the World Bank-CII multi-state firm-level competitiveness survey of 10 states. During the second half of the 1990s, Karnataka became the third largest recipient of FDI among major Indian states, accounting for nearly 19 percent of FDI approved to the top six recipient states (and 9% of total approvals in the country). Human development. Karnataka s performance in human development indicators is improving, though rather average. The nineties saw a eleven percentage point improvement in literacy, a slow down in population growth, and above-average improvement in infant mortality. Yet Karnataka has a long way to go to catch up to the comparator states of Tamil Nadu and Kerala, as well as Maharashtra and, on the issue of population growth, Andhra Pradesh. Service delivery. State governments in India are responsible for the provision of basic social services. The independent and well-respected Public Affairs Centre (PAC) has recently conducted a nationwide survey to examine how well states perform on service delivery based on user feedback. The results show that Karnataka emerges in third place out of 22 states. As to whether public service delivery has been improving in Karnataka, evidence is not available for the whole state, but evidence from Bangalore suggests it has been. The Public Affairs Centre conducted two surveys in 1994 and 1999 of satisfaction with government services among Bangalore residents. For the six public utilities covered in the survey, and on average the proportion of satisfied users rose from 9% to 32%, while the number of dissatisfied users fell from 41% to 19%. There is also information on individual services which suggests positive improvements. Improvements in specific services o Education: A large number of initiatives have been launched to ensure universal enrollment, and the number of out-of-school children since 2001 has been halved. o Government hospitals: The system of government hospitals has been overhauled resulting in a massive increase in utilization of the system: the number of occupied beds and day-patients each more than doubled between 1996 and 2002, the number of surgeries increased eleven-fold, the number of lab-tests increased more than thirty-fold, and so on. o Land records. About 5 million farmers a year request the government for a copy of or change in their land records. Karnataka has now computerized its 20 million land records. Whereas land record issuance took 3-30 days under the manual system it is now done immediately. Feedback from farmers has been positive. o Public transport. About 7 million passengers uses public (government) buses in Karnataka every day. On-time departures for the Karnataka s largest bus company on main routes have increased from 92% in 1998/99 to 99% in 2002/03, and a range of customer-friendly initiatives adopted. o Transport regulatory services. In Karnataka, some 260,000 people a year receive licenses a year, and some 30,000 vehicles are registered annually. The Regional Transport Offices in Bangalore, as well as now a few outside Bangalore, have been fully computerized. An independent survey found that 41% of driving-license applicants reported paying a bribe in the non-computerized setting, but only 3% in the computerized setting. Taking all of the above considerations into account, overall our assessment of GoK's achievement of reform objectives under KERL2 is that it is satisfactory, even though it was not sufficient to proceed to KERL3 in 2002/03. This is based on: the achievement of the KERL2 upfront actions; the progress made since KERL2, despite an adverse environment for reforms, in a range of areas, which is impressive even if inadequate to qualify for KERL3 in 2002/03; the important underlying strengths of the reform program outlined above; and the good progress in recent years improving basic development outcomes in the state. 4.2 Outputs by components: For the reasons mentioned in Section 3.1, we examine progress both prior to approval of KERL2, and post-approval. This section reviews first progress under the four individual fiscal and governance components of KERL2 (see Section 3.3) and then under the two sectors of power and education. The - 9 -

13 original policy matrix milestones were contained in GoK s Letter of Development Policy dated 8th February, For an assessment of the program against performance benchmarks, see Annex 1. (i) Fiscal and Public Expenditure Reforms. This component includes sub-components relating to fiscal adjustment, revenue and expenditure reforms, and reforms in the areas of public financial accountability and public procurement. (a) Fiscal Adjustment Karnataka probably has the best fiscal position of any of the major Indian states. It has the highest credit rating of those states which are rated. It is the only major state not to have relied on RBI s overdraft facility in the recent past: its use of this facility in 2001/02 was zero compared to about 130 days for the major states (up from 30 days in 1997/98, which was the last year before the current state-level fiscal crisis). Karnataka also probably has the most flexibility in its expenditure structure of all the major states, with a relatively low ratio (about 60%) of committed expenditure (salaries, pensions and interest) to total revenue. Karnataka s fiscal position has, however, been deteriorating. To avert a crisis, fiscal reform commenced in Karnataka in 2000/01 and fiscal targeting began the following year, the first year a Medium Term Fiscal Plan was produced. 1 The target consolidates important off-budget liabilities, such as power sector losses, with budgetary liabilities. While Karnataka achieved its fiscal targets for 2001/02 in nominal (Rupee) terms falling short by just Rs 1 billion or 1.4% of the target -- the lower economic growth for that year has meant that the fiscal deficit in fact rose slightly as a percentage of GSDP to 6.2%. The primary deficit, however, did fall slightly, and it stood in 2001/02 at 2.6% of GSDP compared to the 3.0% observed prior to the commencement of fiscal reform in 1999/00 (Table 2). 2 For 2002/03, the latest estimates show a drop in the fiscal deficit to 5.4%, on target and a fall in the primary deficit to 1.4% in 2002/03, better than targeted, even with lower-than-expected nominal growth. The 2003/04 budget targets further deficit reduction (Table 2). It does now appear that Karnataka is on the path of fiscal adjustment. In particular, the following encouraging signs are now evident: Consolidated borrowing has fallen to below 5%. The achievement of the mandated Fiscal Responsibility Act target of a fiscal deficit of 3% by 2005/06 appears to be in reach provided the deficit continues to fall. Slow down in interest growth. Consolidated interest has grown annually at about 20% for the last five years, but is budgeted to grow at only 6% in 2003/04, resulting in a decline in the interest/gsdp ratio for the first time since the fiscal deterioration began. Debt stabilization. The rate of increase in the debt-stock has slowed and, if Karnataka sticks to its MTFP, the debt-gsdp ratio will peak this year (2003/04), and thereafter start falling. Off-budget borrowing by special-purpose vehicles is on the decline, as per GoK's stated announcement to abolish such borrowing by

14 Table 2: Consolidated Fiscal Indicators for Karnataka, 1997/98 to 2003/04 Consolidated Borrowing Consolidated Primary Deficit GSDP growth Target Actual/est. Target Actual/est. Assumption Actual/est. Rs. Bn.% GSDP Rs. Bn.% GSDP Rs. Bn.% GSDP Rs. Bn.% GSDP Rs. Bn.% growth Rs. Bn.% growth Pre-fiscal-reform % % % % % % % % % Fiscal reform % % % % % % % % % (r.e) % % % % % % (target) % % % Note: Consolidated borrowing includes budget borrowing, off-budget borrowing by special purpose vehicles, and power sector borrowing defined as the financing requirement of the transmission and distribution sectors net of budgetary support. The consolidated primary deficit is consolidated borrowing minus consolidated interest payments figures are based on revised estimates. Targets as % of GSDP are divided by the assumed GSDP growth at the time of target setting. The paragraphs following provide some further detail on Karnataka s fiscal adjustment over the last two years. Current deficit. One area where Karnataka has not done as well on fiscal reform is in relation to its current (revenue) deficit. GoI monitors the current deficit, and notes in its comments attached to this ICR that this variable deteriorated in 2001/02. This is for three reasons: (i) As GoI notes, this was largely due to GoK paying its power sector subsidy obligation in full in 2001/02 unlike in earlier years, on account of which budgetary support to power sector went up Rs 23.0 billion from Rs. 8.6 billion. This change is in the nature of bringing an off-budget liability on budget, and should be adjusted for in any comparison over time. (ii) For both 2001/02 and 2002/03 revenue growth has not been rapid, requiring expenditure cuts to meet the budget targets. These have naturally fallen on capital projects. (iii) A rapidly mounting interest burden, which has grown by 40% in the last two years, makes it very difficult to reduce the current deficit. But while acknowledging limited progress on the revenue deficit front, overall it does seem that Karnataka is now on the path of fiscal adjustment. Fiscal targets under KERP. Experience under KERL1 indicated the difficulty of monitoring a target which includes borrowing from the public accounts as the fiscal deficit conventionally defined does. These accounts proved to be quite volatile (especially between revised estimates and actuals) and, on closer analysis, to be largely in the nature of book adjustments with no corresponding expenditure or creation of actual liability. 3 The KERL1 ICR highlighted this problem and noted that Targeting of the fiscal deficit excluding borrowings from those public accounts where no debt liabilities are involved may also be advisable. This decision has since been implemented. Thus a consolidated borrowing variable is now targeted, defined as the sum of three elements: (i) budget borrowing defined as an increase in public debt, and so excluding non-debt public accounts; 4 (ii) off-budget borrowing defined as borrowing by special purpose vehicles largely for infrastructure projects the servicing of which will fall on the budget; (iii) power sector borrowing, defined as the financing requirement of the transmission and distribution sectors net of budgetary support

15 Overall fiscal performance in 2001/02: actuals v. estimates and targets. Table 3 compares fiscal targets for 2001/02 (KERL1 targets) with the estimate for 2001/02 at the time of the KERL2 MOP (February 2002), with the ICR estimate (June 2002), and with actuals. It can be seen that the final outcome of Rs billion was Rs 1 billion above the KERL1 target and almost identical to the estimate at the time of KERL2 approval. However, it was above the KERL1 ICR estimate, which was only a partial update of the KERL2 forecast and turned out to be too optimistic. (Learning from this, an attempt has been made in this ICR to provide a prudent estimate of the 2002/03 fiscal outturns.) In 2001/02, the fiscal (budget) deficit turned out to be Rs 58.7 billion against the KERL1 target of Rs 51.3 billion (and revised estimates of Rs 51 billion). This large difference of Rs 7.4 billion is mainly due to much larger than budgeted use of non-debt public accounts (which, as explained earlier, is now not part of the fiscal targeting): Rs 4.5 billion of the increase is explained by this. The increase in net budget borrowing was about Rs 3 billion above target, an excess which was offset by a reduction in off-budget borrowing. Table 3: Fiscal Targets, Estimates and Actuals KERL1 Target KERL2 Est. (Feb. 2002) ICR est. (June 2002) Actuals % % % % Rs bn GSDP Rs bn GSDP Rs bn GSDP Rs bn GSDP A Net budget borrowing % % % % B=B1-B2 Net off budget borrowing % % % % B1 Gross borrowing % % % % B2 Principal repayments % % % % C=C1-C2 Net power sector borrowing % % % % C1 Power sector financing requirement % % % % C2 Government support % % % % D=A+B+C Consolidated borrowing % % % % D-interest Consolidated primary deficit % % % % Memo Fiscal deficit % % % % GSDP (and growth rate) % % % % Notes: Definitions are as per Table 2. Note that some figures may not be comparable with those in earlier documents due to change in definition relating to budget borrowing as discussed above, plus a change in definition C2 (government support) due to a different treatment of pension funding. Overall fiscal performance in 2002/03. KERL2 targeted a deficit reduction in 2002/03. Table 4 compares the latest estimate for 2002/03 with the KERL2 target. It seems likely that the target will be achieved. The power sector financing requirement has been exceeded due to higher unit power purchase costs (low hydro due to the drought), and higher than expected interest costs (due to lower than expected power subsidy payments forcing KPTCL to borrow off budget; in turn the lower power subsidy payments were due to lower-than-budgeted resource availability, in particular the non-receipt of KERL3 in 2002/03 as budgeted). From the perspective of consolidated borrowing, however, this has been offset by below-target borrowing both on- and off-budget. (More detail in the power sector is presented in 4.2(v).)

16 Table 4: Fiscal Adjustment in 2002/03: Performance Against Targets Target RE/est Rs bn. % GSDP Rs bn. % GSDP A Net budget borrowing % % B=B1-B2 Net off budget borrowing % % B1 Gross borrowing % % B2 Principal repayments % % C=C1-C2 Net power sector borrowing % % C1 Power sector financing requirement % % C2 Government Support % % D=A+B+C Consolidated borrowing % % D-interest Consolidated primary deficit % % Memo GSDP (and growth rate) % % Fiscal deficit % % Notes: As per Table 3. Targets from GoK 2002/03 MTFP and power sector cash flow targets. Institutional reforms for fiscal adjustment. Karnataka has made good progress in implementation of its fiscal institutional reform agenda. In August 2002, Karnataka became India's first state to enact a Fiscal Responsibility Act, which binds the states to achieving a fiscal deficit of 3% by 2005/06, consolidating with off-budget or SPV borrowing, with reduction to this target every year, among other targets. This has had a strong demonstration effect, and three states have since passed similar Acts; others are expected to follow soon. Karnataka's Act became effective as of April 1, Karnataka also published its second Medium Term Fiscal Plan in August 2002, thus institutionalizing an annual cycle of MTFP updation. 5 Fiscal transparency. One of the aims of the fiscal reforms is to promote fiscal transparency. Further steps have been taken in the last twelve months in this direction by: (i) putting a larger amount of material on to the Finance Department Website (tax and borrowing information, as well as monthly accounts); (ii) providing information to the Centre for Monitoring the Indian Economy to bring out a monthly report on Karnataka, which includes detailed fiscal as well as economic data. However, it should be noted that in 2002/03 the Website data was not updated as frequently as it was in 2001/02. (b) Revenue and Expenditure Reforms Revenue reforms. Karnataka has made significant progress in relation to both tax reforms and increases in user charges. With respect to tax reforms, an agenda was provided for the Government by the Tax Reforms Commissions whose two reports (delivered in 2000 and 2001) provided a road-map for the Government. Many of its recommendations have since been implemented, including: In sales tax, abolition of the turnover tax, and infrastructure cess, and reduction in scope of the entry tax. Important administrative reforms have also been introduced such as self-assessment, and a system of advance rulings. Karnataka is one of the better prepared states for VAT introduction

17 On transport taxes, a shift to ad valorem taxes, rationalization of rates, and introduction of a green tax, penalizing old polluting vehicles. Taxes on property transactions have been cut as of April 1, 2003 from 13.5% to 9% of property value. The main tax reform challenge facing Karnataka now is the successful introduction of VAT. While the state has passed VAT legislation and made extensive preparations for VAT introduction, at the time of writing the timing of the introduction of VAT is uncertain due to the breakdown of the national consensus for VAT introduction in April With respect to user charges, the Government has brought about major increases in utility charges: Bus charges have been increased by 30% since late Power tariffs have been increased by about 34% since end-2000; 6 Urban water charges for Bangalore residents were increased by 45% in Irrigation charges have been doubled. Higher education charges have been increased by 20%, and are set to increase 10% every year. These charges have at times been controversial and difficult to implement. Government has also had difficulties collecting increased charges in rural areas. Revenue performance. Revenues grew strongly in 2000/01 (by 15%) but growth has slowed in the last two years to 7% in 2001/02 and an estimated 6% in 2002/03. Own-tax performance has been reasonable with growth of 17%, 9% and 7% (estimated) for each of the last three years. While own-tax growth has been lower in the last two years due to the economic slowdown, the own-tax/gsdp ratio has also risen from 8.1% in 1999/00 to 8.6% in 2000/01 to 9.0% in 2001/02, falling slightly to an estimated 8.9% in 2002/03. There were two main reasons for the slow-down in own-tax growth in the last two years. Excise (alcohol) tax growth slowed to zero in 2002/03 on account of the drought which reduced demand. And commercial taxes, the most important, showed two years of slow growth, perhaps partly related to the slow growth in Karnataka over the last two years, and partly due to the increasing impact of sales tax concessions (no longer given to new projects, but still impacting revenue through projects in operation). Karnataka has launched a compliance drive in 2003/04 to boost revenues in both commercial taxes and excise. Revenue forecasts. One area where Karnataka has suffered has been through reliance on unrealistic revenue forecasts. 7 For the period 1996/97 to 2001/02, Karnataka s own-tax revenues have been on average only 92% of budget estimates. Non-realization of unrealistically high revenue estimates has led to the need for large expenditure cuts and difficultt in achieving fiscal targets. This problem was highlighted in the KERL1 ICR, and is one area in which no improvement is evident over the last three years, apart from 2000/01, when very strong revenue growth made 96% achievement of budget estimates possible. Karnataka would certainly benefit from adoption of a more prudent approach to revenue forecasting. Expenditure reforms. High-priority development expenditures, defined as elementary and secondary education, health, roads and rural water supply, and non-wage O&M for irrigation and public buildings, are targeted to be first protected and then expanded under the Restructuring Program. With good revenue growth in 2000/01, high-priority expenditures were expanded in that year with real growth of about 7%, despite containment of the fiscal deficit. With relatively slow growth in revenue over the last two years, expenditure growth has correspondingly been constrained. In 2001/02, excluding interest payments, power sector subsidy, and the debt-servicing of off-budget liabilities, budget expenditure grew by only 6%