Report and Recommendation of the President to the Board of Directors. Proposed Grant Nepal: Capital Market and Infrastructure Capacity Support Project

Transcription

1 Report and Recommendation of the President to the Board of Directors R4b Sri Lanka Project Number: March 2011 Proposed Grant Nepal: Capital Market and Infrastructure Capacity Support Project

2 CURRENCY EQUIVALENTS (as of 28 March 2011) Currency Unit Nepalese rupee/s (NRe/NRs) NRe1.00 = $0.01 $1.00 = NRs71.47 ABBREVIATIONS ADB Asian Development Bank FCGO Financial Comptroller General s Office GDP gross domestic product MOF Ministry of Finance NPC National Planning Commission NRB Nepal Rastra Bank PDMO Public Debt Management Office PMCO Project Management and Coordination Office PPP public private partnership PSP private sector participation SEBON Securities Board of Nepal NOTES (i) (ii) The fiscal year (FY) of the Government of Nepal ends on 15 July. FY before a calendar year denotes the year in which the fiscal year ends, e.g., FY2010 ends on 15 July In this report, "$" refers to US dollars. Vice-President X. Zhao, Operations 1 Director General S. H. Rahman, South Asia Department (SARD) Director B. Carrasco, Public Management, Financial Sector and Trade Division, SARD Team leader Team members Peer reviewers J. Romero-Torres, Financial Sector Specialist (Capital Markets and Infrastructure), SARD Y. Acharya, Economist, Nepal Resident Mission (NRM), SARD N. Bertsch, Young Professional, SARD G. Bhatta, Principal Public Management Specialist, SARD J. Ghimire, Counsel, Office of the General Counsel V. Rao, Senior Finance Specialist (Public Private Partnership), SARD S. Shrestha, Senior Economist, SARD R. Tuladhar, Senior Programs Officer, NRM, SARD N. Akamatsu, Deputy Head, Office of Regional Economic Integration G. Hauber, Principal Private Sector Development Specialist, SARD In preparing any country program or strategy, financing any project, or by making any designation of or reference to a particular territory or geographic area in this document, the Asian Development Bank does not intend to make any judgments as to the legal or other status of any territory or area.

3 CONTENTS Page PROJECT AT A GLANCE I. THE PROPOSAL 1 II. THE PROJECT 1 A. Rationale 1 B. Impact and Outcome 4 C. Outputs 4 D. Investment and Financing Plan 6 E. Implementation Arrangements 6 III. DUE DILIGENCE 7 A. Economic and Financial 7 B. Governance 8 C. Poverty and Social 8 D. Environmental and Social Safeguards 9 E. Risks and Mitigating Measures 9 IV. ASSURANCES 10 V. RECOMMENDATION 10 APPENDIXES 1. Design and Monitoring Framework List of Linked Documents 14

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5 I. THE PROPOSAL 1. I submit for your approval the following report and recommendation on a proposed grant to Nepal for the Capital Market and Infrastructure Capacity Support Project. The project aims to address key impediments to infrastructure development in Nepal through the creation of an enabling environment for the generation of long-term financing and active private sector participation (PSP) in infrastructure. II. THE PROJECT A. Rationale 2. Nepal is in the process of reconciliation, rehabilitation, and reconstruction after its decadelong conflict. Key stakeholders reached a comprehensive peace agreement in 2006, and successfully held constituent assembly elections in The macroeconomic environment has improved and gross domestic product (GDP) grew at 3.5% in FY2010. The restoration of peace augurs well for the revival of the country s development and poverty reduction agenda. However, the post-conflict political transition has been complex and challenging, with a protracted peace and constitution drafting process. 3. Nepal faces continuing, daunting development challenges across all sectors. Poverty is still widespread in the country and economic growth remains uneven. Poor infrastructure is a critical constraint to inclusive economic growth in Nepal. The infrastructure sector is grossly underdeveloped, with large sections of the population lacking access to basic services. More than 18 million people are still without access to electricity, mainly in the rural areas and remote districts. 1 The persistent energy shortages disrupt economic activity and impose hardship, especially on the poor. Poor physical connectivity, resulting from underinvestment in roads, significantly increases costs of production and trade as well as access to basic social services. 4. Nepal needs to invest an estimated $40 billion in infrastructure for to achieve its target GDP growth rate of 7%. 2 Investment requirements have risen rapidly due to delayed investment and damage to infrastructure during the conflict. 3 Nepal spends less than 1% of total GDP on infrastructure, which is significantly less than other countries in the region. 4 Public financing is already constrained by the high cost of post-conflict reconstruction efforts and limited fiscal space, and cannot generate the needed level of infrastructure investment. Private sector investment is needed to bridge the infrastructure financing gap critical to Nepal's development and poverty-reduction efforts, but PSP in infrastructure in Nepal has been low due to the lack of an enabling environment to attract larger investments in this sector. 5. Initial efforts by the Government of Nepal to introduce policies and incentives for infrastructure financing have been ad hoc and fragmented. Infrastructure financing in Nepal remains impeded by multiple and interlocking constraints resulting from the (i) absence of a well- 1 Asian Development Bank, Department for International Development, and International Labour Organization Country Diagnostic Studies. Nepal: Critical Development Constraints. Manila. 2 The 7% desired rate of growth was specified in the Brussels Programme of Action for Least Developed Countries (an outcome of the Brussels Declaration in May 2001), and will help Nepal meet its Millennium Development Goals. Feedback Ventures Feasibility Study and Business Plan for Setting Up an Infrastructure Financing Institution in Nepal. Kathmandu (August). 3 It is estimated that $129.6 million worth of physical infrastructure was damaged during the conflict in Nepal. (Footnote 1). 4 India spent roughly 4.8% of total GDP on infrastructure in 2007 and It is estimated that South Asian countries need an annual investment in key infrastructure subsectors of about 6% 7% of their GDP to achieve their growth targets. (

6 2 developed capital market for raising long-term funds, such as bond and equity financing; (ii) inadequate policy and regulatory framework, which is not conducive to PSP in infrastructure; and (iii) lack of viable projects and capacity for project structuring to attract private sector investments. The challenging political transition 5 has an adverse impact on investor sentiment that exacerbates these constraints. 6. The current political uncertainty and subdued investment climate augurs in favor of an incremental approach to capital market development in Nepal, and in the absence of any major policy reforms, any intervention supporting capital market development must build on tangible, piecemeal achievements. 7. Underdeveloped bond market. Long-term committed funding for infrastructure projects is best supported by a mature and vibrant bond market, but Nepal's bond market remains constrained, accounting for just 12.6% of GDP at the end of The government issues most (90%) of Nepal s debt securities, in the form of treasury bills and bonds which are largely held to maturity. There is no coherent public debt management strategy to guide decisions on the volume and maturity of each issuance, which are done on an ad hoc basis, primarily to meet short-term financing needs. From a macroeconomic perspective, additional effort is required to strengthen economic fundamentals to develop a low inflation and stable interest rate environment. 8. The Nepalese institutional investor base is too narrow to support an active bond market. Commercial banks are the largest investors in government securities, and invest mainly to meet statutory liquidity requirements. Having primary dealers serve as agents for the sale of government securities can contribute significantly to trading of these securities in the secondary market, but such a provision and practice does not exist in Nepal. Secondary trading is negligible due to the lack of investor base and inadequate clearing and settlement systems. Processing of information takes days and securities are issued in paper form, which is subject to human error and fraud. 9. The lack of a reliable issuance calendar, minimal government securities, trading volume, and negligible liquidity in the secondary market all contribute to the lack of a liquid sovereign benchmark yield curve that is essential for pricing corporate bonds and long-term debt financing instruments. Moreover, the absence of a credit rating agency in the country limits the ability of investors to make informed investment decisions. Consequently, corporate bond market activity is almost non-existent. 10. Attention needs to be given to improve the laws, regulations, and supervision for bond market development. Nepal s financial regulators, the Nepal Rastra Bank (NRB) and the Securities Board of Nepal (SEBON), have overlapping roles in securities market regulation. While the Securities Related Act, 2007, provides the legal basis for SEBON, it provides inadequate independence and enforcement powers; when coupled with SEBON s capacity constraints, this renders it unable to effectively fulfill its market development and regulation mandates. 11. Weak policy and institutional frameworks. The government is undertaking initiatives, with support from Asian Development Bank (ADB) and other development partners, to promote public private partnerships (PPPs) in various infrastructure subsectors. 6 However, both public and private sectors share the view that a robust regime of policy, institutional, and regulatory 5 The constituent assembly s extended tenure ends May A new government under Prime Minister Jhala Nath Khanal was sworn in on 6 February The political situation can be expected to remain uncertain for some time as concluding the ongoing peace process remains challenging. 6 Summary of Ongoing ADB Technical Assistance on Public Private Partnerships in Nepal (accessible from the list of linked documents in Appendix 2).

7 frameworks conducive for investment in infrastructure sector in Nepal is absent. There is no central apex body to formulate PPP policies and national strategies. The project pipeline suitable for PPPs remains thin, and while a number of line ministries are pursuing various PPP projects, they are doing so without a uniform approach, and none of the projects have reached successful financial closure to date. Key constraints include the (i) absence of a national PPP policy framework, (ii) weaknesses in key policies and legislation, 7 (iii) lack of information and guidelines on appropriate risk-sharing mechanisms between public and private sectors needed to support PSP, and (iv) lack of reliable independent dispute resolution system. 12. Lack of PPP experience and capacity. Project financing and PPPs are relatively new concepts in Nepal. At present, key line ministries (e.g., the Ministry of Physical Planning and Works, Ministry of Energy, and Ministry of Local Development) are pursuing PPP ventures, but lack a uniform approach. Understanding of PPPs and how they can be used to spearhead infrastructure development interventions in various sectors is limited. PPP projects are being initiated by some line ministries, but to date none have attracted private sector interest. Commercial banks and public sector entities in Nepal lack the technical and commercial skills needed to identify, appraise, and structure projects, even if suitable infrastructure lending was available. 13. Opportunities. Accelerated economic growth supported by high quality infrastructure is a critical priority of the government s Three-Year Interim Plan, FY2008 FY2010, and the Three-Year Plan Approach Paper, FY2011 FY ADB s country partnership strategy, , 9 and the 2009 country assistance program evaluation 10 for Nepal are closely aligned with the government s development plans, and highlight the importance of infrastructure in Nepal's development and poverty reduction efforts. However, the interim plan concluded without demonstrable progress against its infrastructure goals, and economic development in Nepal remains slow. The interim plan, the approach paper, and the country partnership strategy all recognize the need for innovation and diversification in Nepal s financial sector 11 in order to promote much-needed private sector investment in infrastructure development. The country assistance program evaluation recommends prioritizing assistance to infrastructure, including through a longer-term approach that promotes private sector investments and PPPs. 14. Opportunities for capital market development and infrastructure financing are included in the measures initiated by the government in support of the interim plan and the approach paper priorities, which include: (i) undertaking a feasibility study for the establishment of an independent debt management office, separate from the monetary functions of the central bank; 12 (ii) establishing a central depository system for both bonds and equities, with support from the Government of India; 13 and 3 7 Including for example, amendments to the Private Financing in Build and Operation of Infrastructures Act, 2006 (commonly referred to in Nepal as the BOOT Act). 8 Government of Nepal, National Planning Commission Three-Year Interim Plan, FY2008 FY2010. Kathmandu; Government of Nepal, National Planning Commission Three-Year Plan Approach Paper, FY2011 FY2013. Kathmandu. 9 ADB Country Partnership Strategy: Nepal, Manila. 10 ADB Country Assistance Program Evaluation: Nepal Delivering Assistance in a Challenging Environment. Manila. 11 ADB Report and Recommendation of the President to the Board of Directors: Proposed Sector Development Program Cluster Loans, Asian Development Fund Grant, and Technical Assistance to Nepal for the Rural Finance Sector Development Program (Subprogram 2). Manila. 12 Separating public debt management from the conduct of monetary policy would establish clear accountability and responsibility for debt management. At present, the NRB is the debt manager for the government. It is also the regulator of government securities market and advises the government on the formulation of annual borrowing program. As the debt manager for the government, the NRB manages the maturity profile, timing of issue, composition of debt, and type of instruments issued.

8 4 (iii) establishing PPP cells in some line ministries for project-specific transactions, and prioritizing PPPs in its development strategies. 15. Lessons. Lessons from ADB experience have been incorporated in the project design. A recent special evaluation study 14 of ADB support for capital market development noted the need to develop realistic assistance strategies that take into account country-specific conditions. Given Nepal s political uncertainty and the limited absorptive capacity and resources of public institutions, development interventions must be modest and realistic building on incremental achievements. Nepal s capital market is in a nascent state and sector institutions are weak; consequently, the project focuses on fundamental aspects of financial sector development and PSP (i.e., developing the basic regulatory and institutional framework and market infrastructure). The project places a strong emphasis on basic but key aspects of capacity development that will ensure the sustainability of reforms essential for further sector development. The project builds on past ADB support (i.e., the Corporate and Financial Governance Project), 15 which helped develop the basic building blocks by supporting (i) the development of key financial sector legislation, (ii) establishment of public sector accounting and auditing standards, and (iii) improvement of legal enforcement capacity and infrastructure. The project design also benefited from past technical assistance on public debt management 16 and ongoing technical assistance projects for PPPs (footnote 6). B. Impact and Outcome 16. The impact will be greater availability of infrastructure services. The outcome will be greater private sector investment in the infrastructure sector. (Appendix 1) C. Outputs 17. Nepal needs to address prevailing inadequacies in the financial and infrastructure sectors while also progressing the infrastructure development agenda. The three project outputs aim to bridge the significant and growing gaps in infrastructure financing. 18. Output 1: Regulatory and institutional framework for bond market development. Given the lack of bond market development in Nepal, there is a need to first create an enabling environment for the successful development of government securities market that will set the stage for development of corporate debt securities. (i) Strengthening the institutional capacity for public debt management. This will be achieved through (a) developing an effective institutional arrangement for debt management; (b) drafting appropriate regulations for establishing a dedicated and professionally managed Public Debt Management Office (PDMO); (c) installing appropriate information technology platforms and analytical tools, including maintenance and updates of the computer-based debt management system; (d) implementing training programs, including links with debt management entities 13 As part of the technical assistance agreement (signed in January 2010) between the Central Depository Services (India) Limited (CDSL) and Nepal Stock Exchange Limited, CDSL will also provide support for (i) finalizing operating instructions; (ii) preparing business requirement specifications, evaluation and selection of vendors for hardware and networking; and (iii) carrying out User Acceptance Training for the implementation of the central depository system. 14 ADB ADB Assistance for Domestic Capital Market Development. Manila. The special evaluation study covered ADB assistance for capital market development in Indonesia, Mongolia, Pakistan, the Philippines, Sri Lanka, and Viet Nam during ADB Report and Recommendation of the President to the Board of Directors: Proposed Loan and Technical Assistance Grant to the Kingdom of Nepal for the Corporate and Financial Governance Project. Manila. 16 ADB, Technical Assistance to the Kingdom of Nepal for Strengthening Institutional Capacity for Public Debt Management. Manila.

9 5 (ii) (iii) (iv) and training institutes to build the capacity of public debt management staff at the Ministry of Finance (MOF), the Financial Comptroller General s Office, and NRB; (e) developing an operational plan for PDMO, including addressing sustainability and the provision of physical, human, and financial resources; and (f) supporting the start-up and operation of PDMO. Developing a government securities issuance strategy and market access. As part of its efforts to establish the PDMO, the proposed project will assist in establishing a sovereign yield curve as a benchmark for pricing private sector borrowings by (a) helping develop a reliable issuance calendar that specifies the volume and maturity of government securities by the PDMO; and (b) helping establish a primary dealer system by enforcing a licensing requirement, developing a code of conduct for primary dealers, and developing a system of incentives for primary dealers to play a market-making role. Developing the bond market infrastructure. A central depository system is currently being developed (footnote 13); however, further support will be needed to draft necessary components for the establishment of a legal framework for the system. Building the institutional and regulatory capacity of SEBON. To enhance the autonomy, enforcement powers, and capacity of SEBON, the project will (a) draft relevant regulations and amendments to key regulations, including developing best regional practice governance norms for listed companies; and (b) implement incountry capacity-building programs for SEBON and the Nepal Stock Exchange, and build links with good-practice regulatory and training institutions and other relevant agencies. 19. Output 2: Enabling policy and institutional framework for greater private sector participation in infrastructure. This component continues ADB s ongoing support to the government for creation of an enabling PPP policy framework, including the inputs provided for strengthening the draft report on the Nepal PPP White Paper The project will support establishing and institutionalizing a central PPP cell within the National Planning Commission and provide capacity building for (i) developing a comprehensive national PPP policy framework outlining the government's policies, strategies, and approach to mainstreaming PPPs across line ministries; (ii) conducting an inventory and suitability assessment of laws and regulations for enabling PPP transactions, and providing recommendations for amendments, revisions, or additions to such laws and regulations; (iii) developing PPP manuals and a process handbook, including an environmental management and social safeguards framework; (iv) building the operational and information technology capacity of the central PPP cell; (v) developing a coordination mechanism with each line ministry PPP cell; and (vi) implementing PPP training programs with links to PPP training institutes (e.g., in India and the Republic of Korea). 20. Output 3: Development of a public private partnership demonstration project. The project will provide technical support to the government in identifying and developing a pilot PPP project (prioritizing a potential project of modest scope and complexity) from conceptualization to bid stage, including by (i) identifying, screening, and short-listing appropriate candidate PPP projects; (ii) undertaking pre-feasibility assessment of the candidate project based on a set of agreed criteria; (iii) selecting a demonstration project based on priorities and cost allocation; (iv) conducting a feasibility study (including financial, technical, and commercial structuring of the 17 In December 2010, the ADB project team reviewed and provided extensive comments on the draft report on the Nepal PPP White Paper 2010, which was prepared by a consulting team supported by UNDP and submitted to the National Planning Commission for its approval (ADB Preliminary Comments on the Draft Report on Nepal Public Private Partnerships White Paper 2010, accessible from the list of supplementary documents in Appendix 2).

10 6 selected demonstration project); (v) conducting stakeholder consultations; (vi) preparing project documents and contracts; and (vi) preparing bid documents. D. Investment and Financing Plan 21. The project is estimated to cost $6.25 million (Table 1). Table 1: Project Investment Plan ($ million) Item Amount A. Base Cost a Output 1: Regulatory and institutional framework for bond market development 2.77 Output 2: Enabling policy and institutional framework for greater private sector participation in 0.95 infrastructure Output 3: Development of a public private partnership demonstration project 0.48 In-country training and knowledge-sharing programs b 0.16 Taxes and duties 0.57 Project administration and logistics 0.68 Subtotal 5.61 B. Contingencies c 0.64 Total Cost 6.25 a In mid-2010 prices. b To be provided by specialized training institutes and relevant agencies. c Physical contingencies are approximately 16% of consultancy package and training. Price contingencies are approximately 13% of the information technology package. Total contingencies are estimated at 10% of total project cost. Source: Asian Development Bank estimates. 22. The government has requested a grant not exceeding $5.0 million equivalent from ADB's Special Funds resources to help finance the project (Table 2). The grant from ADB will finance (i) capacity building for bond market development, (ii) PPP policy framework development, and (iii) technical assistance for developing a demonstration PPP project. Government counterpart contributions will be mostly in-kind and will cover counterpart staff salaries, office expenses, training, local travel, and other costs. Table 2: Financing Plan Source Amount ($ million) Share of Total (%) Asian Development Bank Government Total Source: Asian Development Bank. E. Implementation Arrangements 23. The implementation arrangements are summarized in Table 3 and described in detail in the project administration manual. 18 Table 3: Implementation Arrangements Arrangements Aspects Implementation period 1 June May 2014 Estimated completion date 31 May 2014 Management (i) Oversight body Project Steering Committee chaired by the MOF secretary; and comprising the secretary, MPPW; secretary, NPC Secretariat; financial comptroller general, FCGO; chairman, SEBON; deputy governor, NRB; and project director/joint-secretary, MOF, as member secretary 18 Project Administration Manual (accessible from the list of linked documents in Appendix 2).

11 7 Aspects (ii) Executing agency (iii) Key implementing agencies (iv) Implementation unit MOF Output 1: MOF, NRB, SEBON, FCGO Output 2: NPC Output 3: NPC Arrangements Project Management and Coordination Office (in the MOF) Project director (joint secretary) from MOF A representative each from the NPC Secretariat, NRB, SEBON, FCGO, and the line ministry responsible for PPP demonstration project. Project management specialist (one national consultant supported by the project) Procurement expert (one national consultant supported by the project) Accounting and auditing expert (one national consultant supported by project) Procurement Output 1 International competitive bidding 1 contract $2.00 million Output 2 National competitive bidding 1 contract $0.10 million Consulting services Quality- and cost-based selection International National Output 1, 2, and 3 75 person-months 100 person-months $2.10 million Disbursements a The grant proceeds will be disbursed in accordance with ADB's Loan Disbursement Handbook (2007, as amended from time to time) and detailed arrangements agreed upon between the government and ADB. ADB = Asian Development Bank, FCGO = Financial Comptroller General s Office, MOF = Ministry of Finance, MPPW = Ministry of Physical Planning and Works, NPC = National Planning Commission, NRB = Nepal Rastra Bank, PPP = public private partnership, SEBON = Securities Board of Nepal. a Subject to final identification of the PPP project for demonstration, the responsible line ministry will be the implementing agency. Source: Asian Development Bank. 24. Overall policy direction and project implementation oversight will be provided by a high-level project steering committee with representation from the executing agency and all implementing agencies (Table 3). A project management and coordination office (PMCO) will be established in the MOF, which will be the executing agency for the project. The PMCO will be headed by a fulltime project director and will include representatives from each implementing agency. The PMCO will be supported by a project manager, procurement expert, and accountant. The PMCO's main responsibilities include (i) reviewing and endorsing procurement of goods and services for all project components, (ii) day-to-day project management and coordination among implementing agencies and other stakeholders, (iii) providing timely feedback to the project steering committee and ADB on matters that may hamper project implementation, (iv) preparing quarterly progress reports and a project completion report, (v) consultant selection and procurement in line with ADB policies, and (vi) ensuring full compliance with ADB's Safeguard Policy Statement (2009). III. DUE DILIGENCE A. Economic and Financial 25. By improving the availability and quality of infrastructure over the longer term, the project will contribute directly to inclusive growth and poverty reduction in Nepal. Reduced costs and higher profitability resulting from improved infrastructure will enhance private sector investment, and thereby expand employment opportunities. Improved transport connectivity and access to electricity and urban services will boost economic activity and significantly improve quality of life, especially for the poor, who are particularly impacted by the lack of infrastructure services. 26. A significant increase in infrastructure outlay is warranted if Nepal is to meet its growth and poverty reduction targets. Due to limited fiscal space, public financing alone will not be able to generate the level of investment needed to improve infrastructure facilities. Enhancing private sector infrastructure investments and minimizing the government's borrowing cost through the

12 8 PDMO will create fiscal space for additional social infrastructure investment. The project is designed to promote the commercial viability of infrastructure projects by creating an enabling environment to support long-term financing for infrastructure projects, and promote greater PSP through a robust PPP policy framework and structured project development process. Further, the support for development of demonstration PPP projects will help to gradually overcome the lack of experience and technical and commercial skills required for identifying, appraising, and structuring PPP projects. This will complement ADB efforts to promote PSP, including through PPPs in the transport, urban, and energy sectors. 27. Through bond market development, the project will help increase the competitiveness, efficiency, and stability of Nepal s financial system by (i) reducing overreliance by the public and corporate sectors on short-term bank loans and foreign borrowings by mitigating maturity and currency mismatches in their portfolios and thereby enhancing the stability of the financial system; (ii) enabling long-term capital for long-term investments and asset creation, such as infrastructure, to be raised efficiently; and (iii) facilitating efficient financing of the government budget from nonbank sources and thereby improving risk management of public debt. The development of a broad-based financial sector through capital market development will reduce vulnerability to financial crises, which often have significant adverse growth and poverty impacts. B. Governance 28. Project-specific governance risks have been analyzed by carrying out a governance risk assessment in line with the requirements of ADB's Second Governance and Anticorruption Action Plan. 19 In recent years, the government has taken a number of initiatives to address corruption, including the Promoting Market Competition Act, 2006; Right to Information Act, 2007; Special Court Act, 2002 (amended in 2007); and Anti-Money-Laundering Act, The government has also passed the Public Procurement Act, 2007, and the Public Procurement Regulations, 2007; which are both generally acceptable to ADB and encompass best international procurement practices. The government has also established a procurement watchdog in the form of the Public Procurement Monitoring Office under the Office of the Prime Minister and Council of Ministers. Furthermore, it has established the National Vigilance Centre under the direct supervision and control of the Prime Minister to control corruption through preventive measures. The project support for bond market development, private infrastructure investments, and capacity building will also enhance governance in the respective fields. Corruption risks in the project are not expected to be severe. 29. ADB s Anticorruption Policy (1998, as amended to date) was explained to, and discussed with, the government and the executing and implementing agencies. The specific policy requirements and supplementary measures are described in the project administration manual. 20 C. Poverty and Social 30. The project is classified as one of general intervention. It will help create an enabling environment policy, regulatory, and institutional for increased investments for infrastructure development with an aim to attract private sector investments through PPPs. Development of priority infrastructure, such as hydropower, transport, and water supply will not only promote overall economic growth (which is critical for poverty reduction) but will also help improve access to economic and social services. Greater business opportunities from increased public and private 19 ADB Second Governance and Anticorruption Action Plan. Manila. The action plan focuses on risks in public financial management, procurement, and anticorruption (A Risk Assessment and Risk Management Plan is accessible from the list of linked documents in Appendix 2). 20 Project Administration Manual (accessible from the list of linked documents in Appendix 2).

13 investments will generate employment opportunities and contribute to poverty reduction, thereby benefiting the poor, women, and excluded sections of the population. D. Environmental and Social Safeguards 31. The project is classified as category C for environment, involuntary resettlement, and impact on indigenous peoples. Adverse impacts of the proposed policy and regulatory reform and capacity building activities in the project are unlikely. However, although no direct environmental and resettlement implications are expected, there could be future impacts through the proposed development of PPP infrastructure projects. Consequently, the project will help the line ministries responsible for the development of the selected PPP projects (i) address the potential environmental and resettlement issues arising from investments in the infrastructure projects in line with the safeguard policies of ADB and the government; and (ii) internalize and streamline these issues in the project activities, particularly in the training programs, operational manuals, and business plans. E. Risks and Mitigating Measures 32. The overall implementation risk of the project is considered low if appropriate mitigation measures are in place. Although the ongoing political transition and associated instability are apparent risks to reform and development in any sector, risks to this project are limited. All political parties in Nepal consider financial sector reforms and infrastructure development important to achieving growth and poverty reduction. The implementing agencies in the project are the MOF and the financial regulators (NRB and SEBON), and therefore there is significant government ownership of, and commitment to, the project. ADB will engage with the government to ensure that its commitment to relevant reforms remains high. Other risks and their mitigating measures are summarized in Table 4 and are described in detail in the risk assessment and risk management plan. 21 Table 4: Summary of Key Risks and Mitigating Measures 9 Key Risks Weak project implementation and the lack of coordination across relevant agencies. The project covers three components with activities involving a number of implementing agencies having capacity constraints. There is also a risk that there may not be close coordination during implementation. Lack of institutional capacity and skills base required for project sustainability. The institutional capacity in financial and public debt management in Nepal is low and availability of local expertise is limited. The government may also not be able to allocate the required level of resources for the needed reforms. The capacity constraint constitutes a type-1 risk to the project a Mitigating Measures Project implementation oversight and coordination will be provided by a high-level project steering committee, with a PMCO established in the MOF as well. The PMCO will be headed by a full-time project director supported by national consultants to support and build capacity with the EA and IAs. The PMCO will also be tasked with advising on proper sequencing of reforms and capacity-building activities in the project. The project team will also engage in regular dialogues with IAs to monitor progress and management of expected deliverables. The project focuses on capacity building throughout all three components. Consulting services will be primarily for hands-on work and helping in implementation as well as transferring knowledge to local counterparts (and only to a lesser extent for additional studies and review). Knowledge-sharing, training, and certification programs will be developed through linkages with reputable training institutions. ADB will engage with the government to ensure that resources and reforms are adequate. 21 Risk Assessment and Risk Management Plan (accessible from the list of linked documents in Appendix 2). The plan also briefly discusses the review of the peace filter, and that of the disaster and climate change screening tool, with respect to project design.

14 10 Key Risks Mitigating Measures Lack of proper sequencing of PPP policy, The project design allows for possible delays in implementation of institutional, and regulatory reforms. Proper the policy reform actions envisaged in the project due to possible sequencing of reforms is critical for creating an political disruptions, and provides adequate time for reform actions. enabling PPP environment and successful Most of the reform actions do not require approval of the legislature, development of the proposed demonstration PPP which can be time-consuming in the current environment. Activities project as well as other projects in the future. relating to the demonstration PPP project development (component Without the proper PPP framework in place, 3) have been carefully sequenced with related policy reforms under transactions on demonstration projects may not component 2. materialize. ADB = Asian Development Bank, EA = executing agencies, IA = implementing agencies, MOF = Ministry of Finance, PMCO = project management and coordination office, PPP = public private partnership. a Type-1 risks must be addressed through specific risk-mitigation strategies that are in place prior to project implementation. Source: Asian Development Bank. IV. ASSURANCES 33. The government and the Ministry of Finance have assured ADB that implementation of the project shall conform to all applicable ADB policies including those concerning anticorruption measures, safeguards, gender, procurement, consulting services, and disbursement as described in detail in the project administration manual and grant documents. 34. The government and the Ministry of Finance have agreed with ADB on certain covenants for the project, which are set forth in the grant agreement and project agreement. V. RECOMMENDATION 35. I am satisfied that the proposed grant would comply with the Articles of Agreement of the Asian Development Bank (ADB) and recommend that the Board approve the grant not exceeding $5,000,000 to Nepal from ADB s Special Funds resources for the Capital Market and Infrastructure Capacity Support Project, on terms and conditions that are substantially in accordance with those set forth in the draft grant and project agreements presented to the Board. 28 March 2011 Haruhiko Kuroda President

15 Appendix 1 11 DESIGN AND MONITORING FRAMEWORK Design Summary Impact Greater availability of infrastructure services Outcome Greater private sector investment in the infrastructure sector Performance Targets and Indicators with Baselines 1 At least 3 infrastructure projects having private sector, foreign direct investments, or commercial financing by 2017/18 (2009 baseline: nil) At least one PPP project reached financial closure by 2014/15 (2011 baseline: nil) Data Sources/Reporting Mechanisms Reports and statistics from MOF, NRB, MOPPW, MOE, and NPC IMF and World Bank country reports and publications ADB's Asian Development Outlook Reports from MOF, NRB, NPC, and SEBON Assumptions and Risks Assumption Continued commitment from the government to deliver its infrastructure program Risks Political and macroeconomic instability, including that resulting from exogenous shocks Government commitment to private sector development may wane Assumptions Reforms are sequenced with capacity building and other requirements Consultations with private sector participants and development partners Associated reforms (e.g., in the labor sector) are implemented simultaneously Risk Institutional capacity to encourage greater private sector participation not sustained Outputs 1. Regulatory and institutional framework for bond market development A dedicated Public Debt Management Office within the MOF established (2011 baseline: separate debt management functions in MOF, FCGO, and NRB) Regular issuance calendar to promote a benchmark sovereign yield curve (2011 baseline: no such benchmark in place) Eligibility criteria and regulation of primary dealers improved (2011 baseline: no established primary dealer system) Reports from SEBON, FCGO, NRB, and MOF Assumptions Timely adoption of key legislation NRB and MOF are aligned to the sequencing of relevant reforms in bond market development Risk High staff turnover in executing agency and implementing agencies Amendments to Securities Related Act, 2007, submitted to legislature (2011 baseline: relevant amendments being drafted) 1 By end of project period, unless mentioned otherwise.

16 12 Appendix 1 Design Summary 2. Enabling policy and institutional framework for greater private sector participation in infrastructure Performance Targets and Indicators with Baselines 1 National PPP policy and strategy adopted (2011 baseline: draft PPP white paper prepared) Central PPP Cell within National Planning Commission established (2011 baseline: no cell in place, only a focal point identified) Recommendations for the amendment of the BOOT Act, 2006, or draft PPP bill submitted to legislature (2011 baseline: BOOT Act, 2006, contains numerous weaknesses) Data Sources/Reporting Mechanisms Reports from PPP Cell of NPC FNCCI reports Assumptions and Risks Assumptions Timely formulation of PPP policy Other government entities adopt the recommendation of the PPP Cell Risk Trained staff are not retained in the central PPP Cell 3. Development of a PPP demonstration project Model PPP concession developed (2011 baseline: no draft in place) Viable PPP project identified (2011 baseline: list of potential PPP projects prepared) Bid stage preparation achieved for the demonstration PPP project (2011 baseline: no PPP project prepared) Reports from PPP Cell of NPC and concerned line ministry Project progress report Assumptions Continued government priority placed on infrastructure development through PPPs Internal capacity in concerned line ministries to prepare and negotiate PPP projects There is sufficient number of viable PPP projects Risks Lack of adequate private sector interest in PPP investment due to deterioration of the political and security environment Delay in putting in place a conducive PPP policy and institutional framework Activities and Milestones 1. Regulatory and institutional framework for bond market development 1.1 Stocktaking of key legislation and regulations pertinent to the securities market (Q4 2011) 1.2 Submit amendments to relevant legislations, including the Securities Related Act, 2007, and the Companies Act, 2006, to legislature, and draft regulations for governance norms for listed companies and for the central depository system (Q3 2012) 1.3 Submit Public Debt Management Bill to legislature (Q3 2012) Inputs Asian Development Bank: $5 million Output 1: $2.77 million Output 2: $0.95 million Output 3: $0.48 million Training: $0.16 million Contingencies: $0.64 million

17 Appendix 1 13 Activities and Milestones 1.4 Establish Public Debt Management Office with appropriate mandate, reporting and support structure, coordination arrangements with MOF, NRB, and FCGO, and resources (Q2 2013) 1.5 Implement capacity building and training for debt management and capital markets ( ) 1.6 Adopt eligibility criteria and regulations for primary dealers (Q1 2014) 1.7 Disseminate revised legislation, policy, and regulations to potential borrowers and investors ( ) Government of Nepal: $1.25 million Taxes and duties: $0.57 million Project administration and logistics: $0.68 million 2. Enabling policy and institutional framework for greater private sector participation in infrastructure 2.1 PPP white paper approved by cabinet (Q3 2011) 2.2 Adopt PPP policy and national strategy as approved by cabinet (Q4 2011) 2.3 Establish centralized PPP Cell for PPP policy coordination within NPC and across line ministries (Q1 2012) 2.4 Submit recommended amendments to the Private Financing in Build and Operation of Infrastructures Act, 2006 (BOOT Act, 2006) or draft PPP bill to legislature (Q3 2012) 2.5 Draft PPP concession or template agreements (Q3 2012) 2.6 Draft documentation for bidding processes, request for proposals and request for qualification (Q4 2012) 2.7 Develop PPP guidelines and manuals (Q4 2012) 2.8 Capacity building of PPP Cell ( ) 3. Development of a PPP demonstration project 3.1 Assess a long list of potential PPP projects as provided by Government of Nepal (Q2 2012) 3.2 Create a short list of candidate projects and conduct pre-feasibility assessments based on a set of agreed criteria (Q3 2012) 3.3 Select a demonstration PPP project based on priorities and budget available (Q4 2012) 3.4 Conduct feasibility study on demonstration project including financial, technical, and commercial structuring; and environmental and social safeguards (Q1 2013) 3.5 Stakeholder consultations and issue stakeholder consultation report (Q1 2013) 3.6 Draft suite of project contracts (Q2 2013) 3.7 Prepare bidding documents (Q2 2013) 4. Project supervision and management (continuous during project) 4.1 Establish project steering committee (by April 2011) 4.2 Engage consultants for project activities (starting April 2011, and as needed) 4.3 Conduct reviews: (i) steering committee review (once every 3 months), and (ii) ADB review missions (once every 6 months, or as needed) 4.4 Prepare and submit (i) project inception report (August 2011), (ii) interim reports (every 6 months after inception report), (iii) draft project final report (3 months before project ends), and (iv) project tripartite and final report (6 months after the project ends) ADB = Asian Development Bank, BOOT = build own operate transfer, FCGO = Financial Comptroller General s Office, FNCCI = Federation of Nepal Chambers of Commerce and Industry, GDP = gross domestic product; IMF = International Monetary Fund; MOE = Ministry of Energy; MOF = Ministry of Finance, MOPPW = Ministry of Physical Planning and Works, NPC = National Planning Commission, NRB = Nepal Rastra Bank, PPP = public private partnership, SEBON = Securities Board of Nepal. Source: Asian Development Bank.

18 14 Appendix 2 LIST OF LINKED DOCUMENTS 1. Grant Agreement 2. Project Agreement 3. Sector Assessment (Summary): Multisector 4. Project Administration Manual 5. Contribution to the ADB Results Framework 6. Development Coordination 7. Economic and Financial Analysis 8. Country Economic Indicators 9. Summary Poverty Reduction and Social Strategy 10. Risk Assessment and Risk Management Plan Supplementary Documents 11. Overview of Nepal s Public Debt Management 12. Summary of Ongoing ADB Technical Assistance on Public Private Partnerships in Nepal 13. ADB Preliminary Comments on the Draft Report on Nepal Public Private Partnerships White Paper 2010