Cambodia. Structural Adjustment Credit Credit Number 3323-KH Release of the Second Tranche and Waiver of Two Conditions. I.

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1 Cambodia Structural Adjustment Credit Credit Number 3323-KH Release of the Second Tranche and Waiver of Two Conditions I. Summary 1. On February 29, 2000, the Board of Executive Directors approved the Structural Adjustment Credit (SAC) for the Kingdom of Cambodia in the amount of SDR 21.9 million (US$30 million equivalent at the time of the Credit approval) to be disbursed in three tranches. The first tranche of SDR 7.3 million (US$10 million equivalent) was disbursed on May 3, The floating tranche of SDR 3.6 million (US$5 million equivalent) was released on September 11, The Kingdom of Sweden (through SIDA) is co-financing the SAC program. The second tranche release of the SIDA grant (US$1.6 million equivalent) is conditional upon the completion of the actions for the second tranche release under the SAC. 2. This memorandum summarizes recent economic developments and discusses the progress made in fulfilling the conditions for the release of the second tranche of the SAC. It concludes that the Borrower has maintained a satisfactory macroeconomic policy framework, achieved satisfactory progress in carrying out the overall program with respect to public resource management, public sector management, and enhancing governance and fighting corruption, and completed six of the eight specific actions for second tranche release as required under Part A of Schedule 2 of the Development Credit Agreement. One condition related to the Law on Investment has only been partially completed, because after a process of extensive, additional consultation with the private sector, the precise formulation for the revised Law submitted to the National Assembly was changed from the language inserted into the tranche condition. Another condition related to the social sector disbursement ratio was also only partially met because floodrelated expenditures raised non-social sector spending in an unanticipated, but appropriate, amount. The Government is continuing to support the thrusts of these two conditions by making the investment incentive regime more transparent and predictable, and by further reorienting expenditures to the social sectors. 3. In the light of satisfactory overall performance, it is proposed that waivers be granted on a no-objection basis for the above actions in order to release the second tranche of the Credit, in the amount of US$15 million equivalent. II. Background 4. After almost three decades of armed conflict, significant progress has been made since the formation of the Royal Government in 1993 in stabilizing the economy, in

2 2 restoring economic growth, and in undertaking policy reforms to transform the economy into a market-oriented one. Despite the progress made over the past several years, Cambodia still remains one of the poorest countries in Asia. Its 13 million citizens have an average per capita income of US$280, one of the lowest in the region, and poverty is pervasive across the country, in particular in the rural areas. According to the recent National Poverty Reduction Strategy (NPRS), 36 percent of the population is in poverty. 5. The SAC program has been formulated under the overarching framework of the Country Assistance Strategy (CAS) for FY IDA has been closely collaborating with the IMF which had a parallel PRGF program in place. The SAC program aimed to help push forward the Government reform agenda, with an emphasis on institutional underpinning, in the following three areas: (a) improving public resource management which includes resource mobilization and forestry management; (b) enhancing public sector management, which comprises expenditure rationalization and preparatory steps for military demobilization and administrative reform; and (c) formulating and implementing a strategy on enhancing governance and fighting corruption in economic management. 6. The IDA and IMF Boards endorsed Cambodia s Interim Poverty Reduction Strategy Paper (I-PRSP) in January 2001 and PRSP Preparation Status Report in January The Government completed the first full PRSP, called National Poverty Reduction Strategy (NPRS), in late December The full PRSP (25360-KH) was endorsed by the IDA and IMF Boards in February 2003 as a credible poverty reduction strategy that provides a sound basis for Fund and IDA concessional assistance. The CAS for , based on the full PRSP, is currently under preparation. III. Overall Conditions for the Second Tranche Release 7. Pursuant to Part (d) of Section 2.02 of Article II of the Development Credit Agreement, release of the second tranche requires compliance with overall conditions of (i) macroeconomic framework satisfactory to IDA and (ii) overall progress on the program as set out in the Letter of Development Policy (LDP) satisfactory to IDA, in addition to compliance with the specific second tranche release conditions. A. Macroeconomic Framework 8. Macroeconomic developments have been satisfactory. The IMF s Poverty Reduction and Growth Facility (PRGF) program, focusing on fiscal and financial sector reform, has been on track. The last installment of the PRGF was released in February 2003 and a new PRGF program is being considered. 9. During the SAC implementation period ( ), the economy grew at a robust rate of about 6 percent per annum, despite severe floods in , driven mainly by strong exports of garments, and also tourism and construction. GDP grew at 7.0 percent in 2000, 5.7 percent in 2001, and 5.5 percent in The economy is projected to slow down in 2003 (4.8 percent growth) due to adverse effects of anti-thai riots in January, the regional SARS outbreak in early 2003, and uncertainties in the run-

3 3 up to the national election held in July and subsequent delay in forming a new government. Table 1: Macroeconomic Indicators, SAC Implementation Period Est. Proj. Real GDP Growth (%) Inflation (end-of-period) Broad Money Growth (%) Budget Revenue (% of GDP) Budget Expenditure (% of GDP) Current Budget Balance (% of GDP) Export of Goods (US$ Mn. excluding re-export) 921 1,206 1,295 1,659 1,926 Import of Goods (US$ Mn. retained import) -1,219-1,662-1,809-2,231-2,480 External Current Account Deficit (% of GDP) Gross Official Reserves (in months of imports) Official Exchange Rate (end-of-period, Riels/US$) 3,775 3,910 3,900 3,942 4,095 Sources: Data provided by the Cambodian authorities 10. Budgetary performance continued to improve. The overall fiscal deficit (excluding grants) was limited to around 6 percent of GDP during , while the current surplus was maintained at around percent of GDP. In 2003, the fiscal deficit is projected to widen to around 7 percent of GDP in 2003 due to the revenue shortfall associated with the slowdown of the economy as explained in para 9. Despite shortfalls in customs revenue, government revenue was at around percent of GDP during , reflecting improved collection of domestic taxes and non-tax revenue. Overall expenditure was contained below budget targets, thus contributing to the avoidance of domestic financing. 11. Monetary policy was prudent. Due to strict budgetary discipline, inflation was close to zero during , and around 4 percent in 2002, and around 3 percent in External developments were on track. While there was a marked slowdown in the growth of garment exports since mid-2001, the external current account deficit was contained at around percent of GDP (excluding grants). Gross international reserves reached about 3 months of imports of goods and services. The riel continued to be stable in U.S. dollar terms. 12. Thus, the key components of the macroeconomic policy framework fiscal policy, monetary policy and exchange rate policy, are being implemented in a manner satisfactory to IDA. B. Progress in Carrying out Overall Program 13. Cambodia s progress in carrying out the overall program has been satisfactory. This is described below in respect of the broad areas that were covered by the program:

4 4 forestry management, public revenue management, public sector management, and governance diagnostics. 14. Forestry Management. Forestry is a central part of the Government s SACsupported reform program. In 1997/98, just prior to the SAC-supported program, an IDA report estimated illegal logging at 4 million cubic meters per year, a rate of exploitation that would have exhausted the forest in 5 years. Contributing to this was an inadequate forest concession system, poor enforcement, and a weak and ambiguous legal and institutional framework. The government program since then has reduced illegal logging, although illegal logging does still persist and tensions remain within the Government on the pace and specifics of the program. Government actions to crack down on illegal logging, have included, for example, cancellations of concessions, seizure of logging equipment, joint operations with the military against suspected illegal logging, and the recruitment of an independent monitor of forest crimes reporting. The forest concession system has been reduced in area from 6.4 million hectares to 2.5 million hectares and concession logging is currently under suspension as planning and reviews proceed. One million hectares of areas formerly under concession have been established as legally protected forests (Cardamom Mountains, Preah Vihear and Mondulkiri) with severely restricted access for logging. Drafts of strategic forest management plans and environmental and social impact assessments were disclosed for the first time in Cambodia, and this has enabled some public oversight over the concession process. Documents have also been released in affected districts and communes, and the Government has begun a program of more extended consultation and discussion of its plan review and consideration process. A draft model contract has been prepared and will be used as the basis for finalizing new contracts with concessionaires once the strategic forest management plans have been approved and compartment and coupe plans based on those strategic plans have been prepared. A new Forest law, designed to strengthen enforcement efforts, and Sub-Decrees on Community Forestry and Forest Concession Management have provided an institutional and legal framework required for sustainable forest management. 15. However, these achievements have taken 33 months longer than originally anticipated under the SAC-supported program. The first delays were occasioned by irregularities discovered in the management of forestry revenues. These discrepancies were discussed with the Government and in some cases mitigating measures were taken, including tightening procedures to channel funds into the Treasury. In December 2002, following a clash between police and demonstrators in front of the Department of Forestry and Wildlife, the Government announced its intention to terminate its recognition of Global Witness as independent monitor of forest crimes reporting, which was made effective in April Continued allegations of illegal logging, corruption, vulnerability of forest dependent populations and mismanagement of forest resources have persisted, and these have undermined confidence in the Government s achievements and commitment. In response to these setbacks, the SAC was extended to give the Government more time to address the specific concerns raised about its forestry program. On November 25, 2003, the Government signed a new contract with another outside independent monitor, Societe Generale de Surveillance, Sp. A. under terms of reference

5 5 reviewed by a multi-donor working group on natural resource management after an international competitive bidding process. Notwithstanding the continued complexities in reforming this sector and problems with the management of forest resources, sector reform is moving ahead with significant implementation of the framework now in place. As outlined above and detailed in paras 33, 36, and 39 below, IDA is satisfied with the progress achieved in the forestry sector reform program as spelled out in specific conditions and as described by the Government in the Letter of Development Policy. The Government has also agreed to an extension of the Forest Concession Management and Control Pilot project for 18 months (through end-june 2005) which will contribute to the implementation and sustainability of the actions supported by the SAC. A multi-donor forestry sector review is ongoing with Bank involvement and will contribute to a stronger dialogue between the Government and donors and to identification of a future assistance program for the sector. 16. Public Revenue Management. There has been satisfactory progress in increasing revenue and improving efficiency of the system. Cambodia increased the share of total revenue in GDP from 8.4 percent in to around percent in , mainly due to expansion of the tax base. This was helped no doubt by the replacement of the turnover tax with the value added tax (VAT), because the latter covered all incorporated businesses. The amendment of the Law on Investment, approved in 2003, which rationalized tax incentives, is also expected to contribute to revenue increases in future. Overall, these policy measures raised revenue and improved the efficiency of the tax system. Better use of pre-shipment inspection services also helped to improve collections and speed up shipment, but problems remain with regard to informal charges at customs and ports that shippers have to pay. However, Cambodia had less success in its efforts to improve tax administration. The Technical Cooperation Action Program (TCAP) adopted in 2001 contributed to some improvements, but the binding constraint lay in the inadequate number of professional tax and customs collectors and the incentive structure under which such personnel operated. 17. Public Sector Management. The Government sought to reorient public spending and manage it more efficiently, and there was satisfactory progress in respect of this aspect of the Government s overall program. There was significant improvement in the alignment of public expenditures with the development objectives: allocations for 4 key sectors, notably education and health, rose from 2.0 percent of GDP in 1999 to 3.6 percent of GDP in 2002 (see Table 2 in para 47). However, problems of cash management have delayed releases of these allocations, until late in the year, thereby muting somewhat the full impact of these increased allocations. Given the existing weaknesses in budgetary data systems, the Government has initiated an expenditure tracking study to trace actual spending on health and education, from the center down to the local level. To improve the effectiveness of such spending, initial steps have also been taken to improve linkages between planning and budget execution, through the development of a medium-term expenditure framework, but a good deal more remains to be done. The recent Integrated Fiduciary Assessment and Public Expenditure Review (IFAPER) completed in September 2003 has identified a substantial unfinished agenda of

6 6 reforms to improve public expenditure management and effectiveness of expenditure policy. 18. Reductions in public spending on defense and security from around 4 percent of GDP in 1998 to 2.8 percent in 2002, together with increases in revenue (as reported in para 16 above) permitted the reorientation of public spending towards priority programs. As a result of the first phase of the full scale demobilization program, the military payroll stood at just over 112,000 in September 2002, down from 164,000 before demobilization began. Those removed included over 15,000 ghost soldiers, more than 8,000 widows transferred to the Ministry of Women and Veterans, and 1,500 soldiers demobilized under the pilot project, and 15,000 mainly elderly, sick, and disabled soldiers demobilized under the first phase of the full scale program. The full scale program, which is being supported by IDA through a Demobilization and Reintegration Project, was based on a review of the experience of a pilot project carried out in full consultation with donors, NGOs and civil society. The pilot project and the discharge of the first 15,000 soldiers were completed satisfactorily. However, the second phase of demobilization under which a further 15,000 soldiers will be discharged, has been postponed pending resolution of procurement-related issues under the IDA credit, and submission of audits. The Government has stated their commitment to resolving these issues and continuing with demobilization in the near future. The Ministry of National Defense with the support of Australia (AusAID) has also completed the preparation of a white paper on long term national defense policy. 19. Governance Diagnostics and Dissemination. In addition to improving governance in respect of forestry, public revenue management, and public sector management, the program sought to prepare detailed diagnostics on governance through surveys, and to disseminate the findings of that diagnostic and the resulting action plan. This was done, as described in detail in section IV. In addition, more detailed work has been carried out in respect of how governance factors impinge on the private sector, especially exporters and investors decisions because of high unofficial payments and long delays i.e., the Integrated Framework trade diagnostics completed in 2002, and the ongoing Investment Climate Assessment that is nearing completion. Both of these show clearly what action needs to be taken in order to improve the climate for private investors and the competitiveness of Cambodian exporters, currently being undermined by governance problems. 20. Despite this significant progress in diagnosing the problems and disseminating the findings as well as in developing consensus among Cambodians and other development stakeholders on the actions needed, implementation of actions to improve governance has been relatively slow. 21. As described above and while recognizing that there has been slower than expected progress on implementation of some aspects of the program, IDA is satisfied with the overall progress on the program as set out in the LDP.

7 7 IV. Specific Conditions for Second Tranche Release 22. Pursuant to Part A of Schedule 2 of the Development Credit Agreement, release of the second tranche requires that IDA be satisfied with the following specific eight conditions in the areas of revenue mobilization, expenditure rationalization, and enhancing governance and fighting corruption. A. Revenue Mobilization 23. There are two second tranche release conditions on revenue mobilization. The first condition is as follows: The Borrower has submitted for adoption by the National Assembly an amendment to Article 14 of the Law on Investment, and introduced related measures, acceptable to the Association and in form and substance consistent with paragraph 8 of the Letter, with a view to rationalizing the incentive regime inherent in the Law on Investment and eliminating distortions thereunder. 24. According to paragraph 8 of the Letter of Development Policy, the Government was committed to amending the Law on Investment with the following main elements: (a) elimination of the special 9 percent corporate tax rate for all new investment and phasing the 9 percent rate out to the standard 20 percent under the Law on Taxation for the next five years for existing approved and operational projects; (b) elimination of the tax free reinvestment of profits and introduction of an appropriate investment allowance in the Law on Taxation at a rate to be determined, satisfactory to IDA, and applicable to all qualifying investment, new or expansion, irrespective of source of finance, without evaluation; (c) repeal of the current tax holiday provisions and the introduction of a three year tax holiday, conditional on annual certification of compliance, to all qualifying new investment, without evaluation; the use of a tax holiday will deny the tax payer any benefits available under the Law on Taxation during the tax holiday including initial investment allowance as well as accelerated depreciation allowance; all current tax holidays provided under the Law on Investment will be grandfathered; and (d) elimination of the right to the tax free repatriation of earnings and other incomes by approved enterprises. 25. Parts (a), (b), and (d) of this condition have been fully met. A waiver is sought for part (c) of this condition, which has not been met. A bill to amend the Law on Investment was submitted to the National Assembly, and subsequently adopted in February The submitted bill, and the adopted amended Law on Investment, includes the following elements regarding the conditionality: (a) The new clause A qualified investment project shall be subject to a profit tax rate after its tax exemption period as determined in the Law on Taxation was introduced, replacing the previous clause A corporate tax rate of 9% except tax rate on the exploration and exploitation of natural resources, timber, oil, mines gold, and precious stones which shall be set in separate laws.

8 8 (b) The previous clause In the event profits are reinvested in the country, such profits shall be exempted from all corporate tax was dropped. (c) The new clause A qualified investment project (QIP) shall be entitled to exemption from the tax on profit imposed under the Law on Taxation for a tax exemption period. The tax exemption period is composed of a Trigger Period + 3 years + n years (n shall be determined in the Financial Management Law). The maximum allowable Trigger Period is to be first year of profit or three years after the QIP earns it first revenue, whichever is sooner. was introduced, replacing the previous clause A corporate tax exemption of up to 8 years depending on the characters of the project and the priority of the government which shall be mentioned in a Sub-Decree. (d) The previous clause Non-taxation on the distribution of dividends or profits or proceeds of investments, whether transferred abroad or distributed in the country was dropped. 26. While the spirit of part (c) has been met, the specific proposal in the second tranche condition was to apply a 3-year tax holiday without evaluation. This was modified after extensive consultations with the private sector, prior to submission of the bill to the National Assembly. The Government wished to have some flexibility in determining the length of the tax holiday (rather than uniform 3 years) in consideration of strategic importance of each investment project based on pre-set explicit criteria. IDA concurred with it as the amended clause provides significantly enhanced transparency and predictability in investment incentives (the main thrust of the conditionality) and also as the consensus will ensure higher compliance from the private sector in the implementation of the Law. The Government is continuing its efforts to make the investment incentive system more transparent and predicable. The Bank is supporting the Government s efforts with targeted technical assistance for the preparation of the subdecree for the amended Law on Investment. 27. The related measures referred to changes to other legislation necessary for consistency and unambiguity. The obvious effected legislation is the Law on Taxation. The amended Law on Taxation was adopted by the National Assembly in February 2003, at the same time as the adoption of the amended Law on Investment. 28 The second condition on resource mobilization is as follows: The Borrower has re-established a system of pre-shipment inspection of imports, on terms and conditions acceptable to the Association, and in accordance with the policies and principles laid down in paragraph 11 of the Letter. 29. According to paragraph 11 of the Letter of Development Policy, the Government was committed to re-establishing the pre-shipment inspection (PSI) system with the following main elements: (a) extending the PSI to all imports except for a list of goods agreed with IDA; (b) using pre-shipment inspections valuations for the basis of the

9 9 import value for customs purposes; and (c) instituting a system of prepayment of customs duties and other taxes at imports for all sealed containers based on the pre-shipment inspection report, allowing in principle immediate clearance of such containers without inspection on arrival, within the framework of risk management system, whose criteria are satisfactory to IDA. 30. This condition has been met. PSI was reinstated in October 2000 with the following elements regarding the conditionality: (a) The only exemptions are for cigarettes, shipments below a threshold of $4,000 (the latter is normal in PSI contracts), imports for investment companies, diplomatic missions, as well as precious metals (e.g., gold), temporary imports. (b) Pre-shipment inspection valuations are being used for the basis of the import values for customs purposes. The only exceptions are for products where the Ministry of Economy and Finance has assigned minimum values higher than the PSI valuation for a few products--the substance of this was to avoid under-valuation. (c) Duty and taxes are paid at the time of import, based on the PSI Report of Findings. A system of prepayment is being implemented for companies with good records of law compliance and reputation within the framework of risk management system of the Customs and Excise Department. In some cases, PSI agency s Reports of Findings (ROFs) are not accurate and sealed containers do not always contain what are indicated in the ROFs. To strengthen the PSI mechanism, a PSI Steering Committee was established to address concerns, raised by importers and the service provider. B. Forestry Management 31. There are three second tranche release conditions on forestry management. The first condition is as follows: The Borrower has satisfied the Association that it has maintained its quarterly publication on forestry crime monitoring and that such publication has been made regularly available to the public, in accordance with the provisions of paragraph 13 of the Letter. 32. According to the paragraph 13 of the Letter of Development Policy, the Government was committed to continuing to report quarterly on forest crimes to the public to provide a firmer basis for further investigations and preventive actions. 33. This condition has been met. The Government established a forest crime monitoring system composed of units in the Council of Ministers, the Department of Forestry and Wildlife (DFW), and the Ministry of the Environment. Since 1999, the Government has produced regular reports on the level, type and geographic incidence of forest crimes including timber theft, arson, land encroachment, and other crimes. The publication on forestry crime monitoring has been made regularly (on a quarterly

10 10 schedule) to the public through direct distribution to the press, embassies, and others. Given these arrangements, IDA is satisfied that the specific tranche condition has been met. 34. The second condition on forestry management is as follows: The Borrower has completed a forestry concession review and taken actions based on the outcome of the review, in accordance with the provisions of paragraph 14 of the Letter. 35. According to paragraph 14 of the Letter of Development Policy, the Government was committed to carrying out a performance review of existing concession contracts and will take actions based on the outcome of the review, within the framework of Cambodian law and the existing contracts, by: (a) terminating non-performing contracts, where appropriate; (b) requiring other concessionaires to present restructuring programs, satisfactory to IDA; and (c) not awarding any subsequent contracts outside the scope, rules, and procedures set out in the Sub-Decree on forestry concession management. 36. This condition has been met. The Government completed a performance review of forty concession contracts in August 2000 and based on the outcome of the review, twenty five non-performing contracts were terminated. For the remaining fifteen concession contracts, the Government required concessionaires to present restructuring plans satisfactory to IDA. However, concessionaires were slow to engage. Accordingly in December 2001, a Prakas (regulation) of the Ministry of Agriculture, Forestry, and Fisheries suspended operations in all forest concessions pending settlement on restructuring programs to be submitted by concessionaires. As a first step towards restructuring, these concessionaires presented draft strategic forest management plans, which are in the process of being revised for final review by the Government. Based on the review of the draft strategic forest management plans, the Government has initiated actions to terminate seven concession contracts. For the remaining eight, review process is still underway. Cambodian Forest Law and the Sub-Decree on Forest Concession Management require preparation of five year compartment plans and annual operating or "coupe" plans, consultation with concerned stakeholders, and final approval by the Government before new contracts can be issued and logging can resume. In the meantime, logging and transport of logs remains under suspension in all forest concessions, except for one stump collection contract to salvage wood from already logged trees which was awarded in an area where the concession contract was terminated. In addition, the on-going monitoring under the Forest Concession Management and Control Pilot Project indicates that no subsequent forestry concessions have been granted outside of the terms and conditions of the Sub-Decree on Forest Concession Management. 37. The third condition on forestry management is as follows: The Borrower has, following full consultation with stakeholders, and in accordance with the provisions of paragraph 15 of the Letter, submitted for adoption by the National Assembly a draft law revising the Forest Law, acceptable to the Association, and

11 11 establishing clear responsibility for forest management and administration, and providing for enforcement authority, inter-sectoral oversight and public accountability. 38. According to paragraph 15 of the Letter of Development Policy, the Government was committed to adopting a new Forest Law, in full consultation with all stakeholders, which will clearly establish responsibility for forest management and administration, provide for enforcement authority, intersectoral oversight, and public accountability. 39. This condition has been met. The drafting of a new Forestry Law was initiated in 1994 with FAO technical assistance. After a hiatus, consultations were renewed in 2000/01 through several public workshops, and the draft was made available for public comment. NGOs, FAO, and other interested parties submitted comments and revisions were made. The draft law was submitted to the National Assembly in August 2001 and was signed into law in August The Law provides a sound legal basis for control, allocation, and management of the national forest estate, clarifies jurisdiction over forest areas and parks and protected areas, establishes an administrative structure for forest management, and provides recognition of customary property rights. Special efforts were made in the drafting process to ensure compatibility with the Land Law and other legislation. The Forestry Law is satisfactory to IDA. C. Expenditure Rationalization 40. There are two second tranche release conditions on expenditure rationalization. The first condition is as follows: The Borrower has presented to the Association a draft FY 2001 budget, acceptable to the Association, including budget allocations for, and contents of, the Priority Action Program (PAP) and the Accelerated District Development (ADD), and showing enhanced allocations for health, education, agriculture and rural development sectors in terms of share of total current expenditures as compared with FY 2000 budget. 41. This condition has been met. The budget plan for the 4 key sectors (health, education, agriculture, and rural development) increased from 299 billion riels to 415 billion riels in the 2001 budget. As a share of total current spending, this is up from 24.6% of current expenditure in the 2000 outturn to 29.2% of the current expenditure in the 2001 budget. The allocation for Chapter 13 (PAP and ADD) in the 2001 budget was increased to billion riels from 9.5 billion riels in As the SAC second tranche was initially envisaged to be released by March 2001, the program did not include medium-term conditions beyond However, as the SAC second tranche release has been delayed, the Government substantially has increased expenditures for the 4 key sectors over the SAC implementation period of as shown in the para 47 and Table The second condition on expenditure rationalization is as follows:

12 12 The Borrower has submitted to the Association satisfactory evidence in terms of the formula specified in paragraph 19 of the Letter of Development Policy, to show that: (a) the ratio of actual disbursements of non-wage operating expenditures for the health, education, agriculture and rural development sectors combined during FY 2000 have been not less than the corresponding ratio for the remaining sectors combined; and (b) actual disbursements for the Accelerated District Development (ADD) program during the same period have been not less than the corresponding budget allocation. 43. According to paragraph 19 of the Letter of Development Policy, the Government was committed to the following: In the past, diversions of budgeted amounts away from the priority sectors toward defense, security, and other public activities--together with continued revenue shortfalls-- have been a major reason for low implementation in the key economic and social sectors. In the years , the Royal Government will take increased measures to ensure that the budgeted amounts in these priority sectors are in fact realized to the fullest extent possible. Toward this end, the Royal Government will provide IDA with evidence showing that the ratio of actual disbursements of non-wage operating expenditures (total current expenditure minus chapter 10) to the combined budgetary allocations for key social and economic sectors (i.e., health, education, agriculture, rural development) has been no less than the corresponding ratio for the rest of the sectors combined. In addition, the Royal Government will provide IDA with evidence showing that actual disbursement in riel amounts for the ADD program has been no less than the budget allocation. 44. This condition has not been met, and a waiver is sought. The thrust of this condition was to protect the disbursement to the key social and economic sectors as compared with the budget allocation at least on par with the rest of the sectors so that, when combined with the Board condition on enhanced 2000 budget allocation for key sectors, it would contribute to expenditure reorientation toward key sectors. Regarding the element (a) of the conditionality, the ratio of actual disbursement to the budget allocation for the four key sectors combined was 83.1%, as compared with the corresponding ratio of 89.1% for the remaining sectors combined. 45. There were two main reasons for this: emergency post-flood rehabilitation needs and weak absorptive capacity. First, Cambodia was hit by severe floods in July- November 2000, the worst in 70 years. Some 30 percent of rice fields were damaged, major parts of roads and irrigation facilities were washed away, and many schools and hospitals were damaged. Total damage was estimated at around $180 million (5 percent of GDP). As a result, the Government had to divert cash from the allocated social sector outlays to the emergency post-flood rehabilitation needs. A substantial part of the postflood rehabilitation outlays were of a social expenditure nature and if they had been properly classified as the social sector outlays in the budget table, this condition could have been met outright. Second, in early 2000 the Government established the Budget Strategy and Enforcement Center (BSEC) at the Ministry of Economy and Finance as a one-stop shop to streamline the screening of bids for funding, and facilitate cash disbursement to key social and economic sectors. The role of BSEC was to facilitate the

13 13 operation of the new Priority Action Program (PAP) based on advance payment of budget allocations on a quarterly basis, with post-audit replacing pre-audit. However, PAP started almost four months late in September This was due mainly to communication problems regarding financial procedures, coordination failures, and some coordination breakdown between the BESC and the Ministry Health. Provincial department directors were very cautious and slow in using the PAP fund even when the PAP installments had been already released from the National Treasury and deposited in their accounts, as they were not familiar with post-audit system. 46. In 2002, the situation improved compared with 2000, but still the disbursement ratio for the four key sectors was 91.9% as compared with the corresponding ratio of 94.8% for the remaining sectors combined. The main reasons for this were: (i) the Government set too ambitious social sector expenditure targets in the budget; and (ii) weak capacity of line ministries to develop expenditure programs and to adopt associated regulations. 47. Although this conditionality was not met in terms of the specific quantitative indicator, the thrust of the conditionality (protection of social sectors against revenue shortfalls, and increase in disbursements to these sectors) has been satisfied. There has been significant improvement in expenditure reorientation toward key social and economic sectors since 1999 (see Table 2). Expenditure for the four key sectors was increased substantially as a ratio of GDP from 2.0% in 1999 to 2.3% in 2000, 2.9% in 2001, and 3.6% in In contrast, defense and security expenditure was decreased as a ratio of GDP from 3.9% of GDP in 1999 to 3.5% in 2000, 3.0% in 2001, and 2.8% in Table 2: Expenditure Reorientation, Outcome Outcome Outcome Outcome Budget 4 key sectors a/ (% of GDP) Defense/security (% of GDP) a/ health, education, agriculture, rural development 48. Regarding the element (b) of the conditionality, the actual disbursement for ADD in 2002 was 4,691 million riels as compared to the budget allocation of 6,000 million riels due to the reasons explained in the paragraph. 45. ADD program is for a cash advance system for district health centers. The Government introduced the Priority Action Program (PAP)--cash advance system to health and education sectors--to extend the thrust of the ADD to more comprehensive PAP with a view to enhancing disbursement to key social sectors. Spending for PAP in 2000 was 890 million riels. The combined ADD and PAP actual spending for 2000 was 5,581 million riels. The

14 14 Government is committed to continuing expenditure reorientation toward key social sectors as committed in the PRSP. The Bank is continuing the policy dialogue to ensure adequate budget disbursement to key social sectors, including the ADD and PAP programs, among others, in the context of the recently completed Integrated Fiduciary Assessment and Public Expenditure Review (IFAPER). D. Enhancing Governance and Fighting Corruption 49. The second tranche release condition is as follows: The Borrower has, following full consultations with stakeholders, and in accordance with the provisions of paragraph 34 of the Letter: (a) conducted surveys on governance and corruption, and, on the basis thereof, prepared a diagnosis and formulated a national action plan acceptable to the Association; (b) disseminated the findings of the surveys and details of the national action plan; and (c) begun implementation of the national action plan. 50. Paragraph 34 is as follows: As important steps toward these objectives, with assistance from IDA, the Royal Government carried out governance/corruption surveys involving citizens, government officials, and private enterprises. Based on the survey results, the Government will: (a) prepare a diagnosis; (b) formulate a National Action Plan based on the results of these surveys and those sponsored by other donors, in close consultation with the private sector, NGOs, and the donor community; (c) disseminate the findings of the surveys along with an action plan to the government officials, the public, and local press; and (d) begin implementation of the action plan. 51. This condition has been met. The Government commissioned a local NGO, Lidee Khmer, to carry out a diagnostic study on governance and corruption in The surveys were conducted in November/December The study included three surveys of citizens, enterprises and public officials concerning their perceptions of corruption problems in the public sector. The diagnostic surveys generated useful data to diagnose the extent of governance and corruption problems in the public sector in Cambodia. Based on the analysis of the survey results, a report was prepared in May 2000, entitled Cambodia: Governance and Corruption Diagnostic: Evidence from Citizen, Enterprise and Public Official Surveys. The Government prepared an initial draft of a Governance Action Plan (GAP) and presented it at the Consultative Group meeting in May The initial draft of GAP built on the analysis and findings of a number of studies, including the diagnostic study mentioned above, a study on governance and sustainable development carried out by the Cambodia Development Resource Institute (CDRI) with financial support from the ADB, and many other reports prepared by other donors. Since then, the Government has held extensive consultations with many donors, NGOs, and the private sector before finalization of the GAP and approval by the Council of Ministers in March The Government organized a National Forum in December 2001 to start disseminating the GAP and the diagnostic

15 15 report on governance and corruption. The forum was chaired by the Prime Minister and was attended by ministers, senior civil servants from all over the country, and external stakeholders, totaling some 700 participants. It was followed by four workshops in provinces targeting public officials (some 900 participants) and external stakeholders (donors, NGOs, academia, and the press) in the first half of The Government has begun implementing GAP since its official adoption in March While some actions have already been completed, several others are in the process of being implemented. Significant progress has been made in some areas, including public finance, but implementation in other areas, particularly for legal and judicial reform, has been slow. The progress of actions in GAP was reported to the public in the Government s biannual GAP Progress Reports in June and December The Government is currently preparing the second GAP with more focus on legal and judicial reform.