AND THE AND THE FOR. April 4,2006

Transcription

1 Public Disclosure Authorized Document of The World Bank Group For Official Use Only Report No PAK Public Disclosure Authorized INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT AND THE INTERNATIONAL DEVELOPMENT ASSOCIATION AND THE Public Disclosure Authorized INTERNATIONAL FINANCE CORPORATION COUNTRY ASSISTANCE STRATEGY FOR THE ISLAMIC REPUBLIC OF PAKISTAN FOR THE PERIOD FYO6-09 Public Disclosure Authorized April 4,2006 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not be otherwise disclosed without World Bank authorization.

2 The last Country Assistance Strategy for Pakistan (Report No PAK) was discussed on June 11, 2002 and a Country Assistance Strategy Progress Report (Report No PAK) was discussed on April 20, 2004 CURRENCY AND EQUIVALENTS Currency Unit = Pakistan Rupee US$1 = PKR FISCAL YEAR July 1 - June 30 ABBREVIATIONS AND ACRONYMS AAA Analytical and Advisory Activities IDI Long Distance and International ADB Asian Development Bank LL LocalLoop ADR Alternative Dispute Resolution MDG Millennium Development Goals AIDS Acquired Immunodeficiency Syndrome MIGA Multilateral Investment Guarantee Agency AJK Azad Jammu Kashmir MTBF Medium Term Budget Framework BMOs Business Membership Organizations MTDF Medium Term Development Framework CAE Country Assistance Evaluation NBP National Bank of Pakistan CAS Country Assistance Strategy NEPRA The National Electric Power Regulatory Authority CAS-PR Country Assistance Strategy Progress Report NEAS National Education Assessment System CBR Central Board of Revenue NGOs Non-Governmental Organizations CFAA Country Financial Accountability Assessment NWFP North West Frontier Province CGA Controller General of Accounts PDF Pakistan Development Forum CWIQ Core Welfare Indicators Questionnaire PEP-MENA Private Enterprise Partnership for Middle DCC Donor Coordination Cell East and North Africa DFID Department for International Development (UK) PFM Initial Public Offering DPL Development Policy Loan PIFRA Project to Improve Financial Reporting and EAD Economic Affairs Division Auditing EBP Enterprise Benchmarking Program PIHS Pakistan Integrated Household Survey ERRA The Earthquake Reconstruction and PPAF Pakistan Poverty Alleviation Fund Rehabilitation Authority PPPS Public-Private Partnerships FSAP Financial Sector Assessment Program PRSC Poverty Reduction Support Credit GDP Gross Domestic Product PRSP Poverty Reduction Strategy Paper GEF Global Environment Facility PSCB Public Sector Capacity Building GoP Government of Pakistan PTCL Pakistan Telecommunications Limited GTZ German Agency for Technical Cooperation PSLSM Pakistan Social and Living Standards HIES Household Income and Expenditure Survey Measurement Survey HIV Human Immunodeficiency Virus QAG Quality Assurance Group IBRD International Bank for Reconstruction and SAC Structural Adjustment Credit Development SME Small and Medium Enterprise ICR Implementation Completion Report TATF Technical Assistance and Trust Funds IDA International Development Association TMAs Tehsil Municipal Authorities IEG Independent Evaluation Group USAID United States Agency for Int'l Development IFC International Finance Corporation WAPDA Water and Power Development Authority IMF International Monetary Fund WEF World Economic Forum IPO Initial Public Offering WHO World Health Organization IPP Independent Power Producer WTO World Trade Organization JBIC Japan bank for International Cooperation WSS Water Supply and Sanitation The World Bank Vice President Praful Patel, SARVP Country Director John W. Wall, SACPK Task Manager Torm Buckley, SACPK The International Finance Corporation Vice President Declan Du CIOVP e Country Director Michael Essex, CMERC Task Manager Torek Farhadi, CMEHQ

3 TABLE OF CONTENTS EXECUTIVE SUMMARY... COUNTRY CONTEXT AND DEVELOPMENT CHALLENGES...1 A. Political and Social Context B. Social Progress and Poverty Profile C. Development Challenges... 2 D. Economic Developments and Outlook II. PAKISTAN'S POVERTY REDUCTION STRATEGY A. The PRSP Strategy III. BANK GROUP ASSISTANCE STRATEGY A. Implementation of the Last CAS and Lessons Learned...12 B. Context and Engagement Principles C. World Bank Group Program Priorities IV. DELIVERING THE WORLD BANK GROUP PROGRAM...33 A. The World Bank Program...33 B. The IFC Program...38 C. MIGA Portfolio and Program...40 D. Partnerships and Harmonization...40 E. Communications and Outreach...41 F. Monitoring and Evaluation G. Managing Risks TABLES Table 1: Progress on Selected Social Indicators...3 Table 2: Competitiveness Rankings...3 Table 3: Medium Term Outlook - Key Indicators...9 Table 4: Pakistan's PRSP Targets and Alignment with Millennium Development Goals...11 Table 5: Bank Portfolio Indicators Table 6: Selected Health Indicators Table 7: Public Spending on Select Safety Net Programs Table 8: Key Policy Performance Benchmarks for RD Lending Table 9: Pakistan Credit Rating by Standard & Poor's ih.o... a...36 Table 10: Maximum Projected IBRD Exposure Table 11: AAA - Indicative Key Outputs by CAS Theme... 37

4 FIGURE Figure 1: Recent Economic Performance... 8 Box Box 1: Impact of the October 8 Earthquake ANNEXES Annex I: CAS Results Framework Annex II: CAS Completion Report Annex III Private Sector Strategy Annex IV: Country Financing Parameters Annex V: Other Donor Activities Annex VI: CAS Consultation Process Annex VII: Guidelines for EBRD Lending Annex B 1: Country at a Glance Annex B2: Indicators of Bank Portfolio Performance and Mgt Annex B3: IBRD/IDA Program Summary Annex B3: IFC/MIGA Program Summary Annex B4: Summary of Non-lending Services Annex B5: Poverty and Social Development Indicators Annex B6: Key Economic Indicators Annex B7: Key Exposure Indicators Annex B8: Operations Portfolio (TBRD/IDA and Grants) Annex B8 (IFC) Statement of IFC Held and Disbursed Portfolio

5 EXECUTIVE SUMMARY i. The FY06-09 Country Assistance Strategy (CAS) has been prepared at a time of great opportunity for Pakistan. Since the beginning of the new millennium, Pakistan has managed a remarkable turnaround. During the 1990's Pakistan's progress in reducing poverty and improving the welfare of its people was not very encouraging as economic growth slowed and progress in improving social indicators stagnated. Beginning in 2000, the Government initiated a wide-ranging and ambitious reform program resulting in a dramatic turnaround. The FY03-05 CAS period witnessed the consolidation and acceleration of this turnaround with sustained implementation of a program of stabilization and wideranging structural reforms. Yet Pakistan's development challenges remain formidable. While provisional poverty estimates suggest that poverty declined between 2001 and 2005, the proportion of the population below the poverty line remains high. And despite recent indications of improvement, social and living standards remain well below countries with similar incomes and growth rates. Development Challenges ii. The key challenge for Pakistan is now to sustain its recent growth performance in order to generate significant poverty reduction. Sustained growth will require continued sound macroeconomic management along with further improvements in the investment climate. Pakistan's infrastructure platform needs significant investment in order to support Pakistan's growth and service delivery goals. For the poor to participate in and benefit from growth Pakistan needs to accelerate human development. While Pakistan is making progress, analysis suggests that it will be challenging to achieve the MDGs for infant mortality, child malnutrition, primary completion, and elimination of the gender gap in primary enrolment. Looking beyond the MDG's, enhancing competitiveness in an increasingly globalized and technology driven world economy will require a growing pool of workers with leading edge skills pointing to the need for increases in the level and quality of secondary, vocational and higher education. Thus, continued concerted efforts to address poor human development outcomes are important not only to improve equity but also as an integral part of achieving Pakistan's growth objectives. Pakistan's Poverty Reduction Strategy iii. Pakistan's poverty reduction strategy paper (PRSP) sets forth a broad-based strategy for addressing poverty in its various dimensions including human development, governance, and vulnerability and builds on the economic program first articulated in the fall of 1999 and further elaborated in the I-PRSP of The PRSP emphasizes policies to sustain rapid growth as the main vehicle for poverty reduction and is grounded on four pillars: (i) achieving and sustaining a high growth rate while maintaining macroeconomic stability, translating this higher growth into lower poverty, and bridging the social gap; (ii) improving governance and consolidating devolution, both as a means of delivering better development results and ensuring social and economic justice; (iii) investing in human capital, with a renewed emphasis on effective delivery of basic social services; and (iv) targeting the poor and vulnerable to bring marginalized sections of the population and backward regions into the mainstream of development, and to make marked progress in reducing existing inequalities. The PRSP's targets are fully aligned with the MDGs. Bank Group Assistance Strategy iv. In line with Pakistan's recent performance and the Government's request for increased Bank Group support, this CAS proposes a substantial increase in the volume of lending to Pakistan during the next four years.' The immediate priority will be to assist in addressing the impact of the October 2005 earthquake - up to US$1 billion in IBRD/IDA commitments will be used to support reconstruction and recovery (US$840 million in new commitments have already been approved). In addition, based on the 1 In this report, the "Bank Group" refers to IBRD, IDA, IFC, and MIGA while the "Bank" refers to IBRD/IDA.

6 - ii - Government's priorities for sustaining growth and accelerating poverty reduction, the CAS envisions an expansion in lending in infrastructure (primarily energy, water, and transport) and human development. Bank Group program priorities will retain considerable continuity with the FYO3-05 CAS, focusing on the areas which are most critical for poverty reduction. The three inter-linked and mutually reinforcing pillars of the CAS correspond to the strategic priorities of the PRSP: (i) sustaining growth and improving competitiveness; (ii) improving government effectiveness and service delivery; and (iii) improving lives and protecting the vulnerable. Pillar I: Sustained Growth and Improved Competitiveness v. The focus of this pillar of the CAS will be to support the investments and reforms needed sustain rapid, private sector-led growth. To help maintain the hard-won benefits of macroeconomic stability the Bank will provide support to help the Government strengthen economic management through improving the composition and effectiveness of public expenditures and supporting tax reforms. In agriculture, the focus of the Bank's work will initially be to support the preparation of a rural strategy, integrating issues related to agriculture, natural resource management, the rural non-farm economy, infrastructure, rural finance and the need for targeted interventions. In irrigation the Bank will support a combination of institutional reforms and investments throughout the system including major investments in rehabilitation of critical assets and reforms to improve the quality, efficiency, and accountability with which irrigation services are delivered. Recognizing that sustaining the current high rates of economic growth requires globally competitive production in an increasingly demanding world market, the Bank Group will also support reforms to improve the business environment. vi. Infrastructure bottlenecks pose a significant threat to Pakistan's ability to sustain rapid growth. In the power sector the Bank Group will support further strengthening of sector governance to improve performance and attract private investment while at the same time helping to address a significant backlog in investment, particularly to address technical losses. In telecommunications the Bank will support adoption of measures to strengthen the policy and regulatory environment and possible investment support for accelerating the provision of rural telecommunication infrastructure. In transport, the Bank and the government will adopt a strategic approach focusing first on the National Trade Corridor linking Pakistan's major ports in the south with its major cities and trade corridors to the North. The key outcome sought would be significant reductions in the time and cost of moving goods through the Indus corridor. Investment and policy-based lending for highways, trade facilitation, ports and railways will be considered, with an emphasis on increasing private sector participation in operation and management. In the financial sector, the Bank Group will support further financial sector reforms to increase access to finance (especially for microcredit borrowers) and support further reforms with the aim of increasing the availability of longer term savings instruments. Pillar II: Strengthened Governance and Service Delivery vii. Improving government effectiveness is a central theme of the PRSP. Priorities in this area will be to support further reforms and investment to increase efficiency, transparency and accountability in the use of public resources. In public financial management, full implementation of the Project for Improved Financial Reporting and Auditing (PIFRA) will be the focus along with analytical support to assist in defining the agenda for further reforms in financial management at the federal and provincial levels. The Bank will also support the achievement of transparent and efficient public procurement through development policy lending, policy dialogue and capacity building. Working across sectors, the Bank Group will continue to support cross-cutting reforms to increase capacity and accountability of those responsible for service delivery; empower communities and clients through enhanced access to information on finances and performance; and build the capacity of both communities and governments. Work will also include support to further civil service reform and devolution as well as a stepped-up engagement in the urban sector to improve municipal service delivery, especially in the larger cities.

7 - i1 - Pillar III: Improved Lives and Protection of the Vulnerable viii. The PRSP recognizes that increased investment in human capital leading to significant improvements in education and health will be necessary to build the skilled, healthy work force necessary to sustain recent growth performance. The Bank strategy in education will continue to be focused on the provinces, using development policy credits to support policy and systemic changes as well as the other areas linked to education reform including decentralization and governance reforms. In health, at the national level, the Bank will concentrate on encouraging the Government to focus on public health functions (such as surveillance, quality control, monitoring and evaluation, and public information) while supporting the development and implementation of program and management reforms in the Lady Health Worker program as a way of expanding access to primary health care and family planning. The Bank Group will also support the piloting and evaluation of new approaches for service delivery and demand side interventions. Recognizing that a major focus of efforts in health must be at the provincial and local level, we will support major system reforms through planned provincial Development Policy Credits, beginning in NWFP. ix. The PRSP recognizes that protection for the poor and vulnerable is a cornerstone of any poverty reduction program. The Bank's assistance for social protection will include support for safety nets that help the chronic poor cope with and, where possible, escape poverty, and help families and individuals cope with seasonal shocks and natural disasters. The Bank will also provide support for social security via improving formal sector pensions and consider innovative approaches to micro-insurance to address life cycle risks. Pakistan's PRSP recognizes that while rapid growth will be the main driver of poverty reduction, targeted interventions and community-based approaches to rural development are also required to address the immediate needs of the poor and vulnerable, especially in drought prone and flood stricken areas, and help them share in economic growth. The Bank will continue to support implementation of the Community Investment Programs in NWFP and AJK and look for possible expansion and replication opportunities. The Bank will also support the Government's newly announced program for rural poverty alleviation through social mobilization. Delivering the World Bank Group Program x. IBRD/IDA Lending. Pakistan's demand for World Bank financial support has grown to meet the needs of its growth and poverty reduction strategy and to address the impact of the October earthquake. To meet this demand a flexible IBRD/IDA lending program of up to US$6.5 billion (approximately US$3.1 billion IDA and US$3.4 billion IBRD) is proposed in order to support implementation of the PRSP. Pakistan's IDA allocation has been increased under IDA 14, with the three-year envelope set at SDR 1.5 billion (equivalent to about US$725 million per year). In addition Pakistan will have access to additional IDA on hard terms estimated at SDR 130 million. The scale of IBRD financial support will be determined by the strength of the GoP's policy performance and macroeconomic management. The upper bound of the proposed IBRD lending range for FYO6-09 is $3.4 billion of which up to $1.3 billion could take the form of development policy loans. Annual lending could increase to as much as $1 billion per year with up to $500 million in DPLs within this envelope. xi. The IFC and MIGA Programs. In the upcoming CAS period, IFC will be increasing its investment with the target range of US$ million for the period. IFC will also explore opportunities in pre-privatization investment. It furthermore plans to make more equity investment and intends to be a catalyst for and mobilize private equity in the country. IFC activity will focus on three main sectors: financial, SME and infrastructure. With the recent creation of Private Enterprise Partnership for Middle East and North Africa region (PEP-MENA), IFC has initiated a substantial TA program in Pakistan to build capacity and address constraints of the SME, infrastructure and financial sectors. MIGA's outstanding portfolio in Pakistan consists of 10 contracts of guarantee with a total gross exposure of US$136.8 million and a net exposure of US$106.8 million. An application seeking coverage for a US$20.8 million equity investment in a hydropower project in Pakistan is currently pending.

8 - 1v - xii. Partnerships and Harmonization. The Bank Group's work in Pakistan is coordinated with and reinforced by the efforts of other donors in a wide variety of areas. The international response to the October earthquake has also served as an opportunity to substantially deepen donor harmonization and coordination. The Government leads coordination of policy dialogue and donor support within the framework of the PRSP, using the Pakistan Development Forum (PDF), held annually in Islamabad, as the principal forum for discussion with and among donors. A Donor Coordination Cell (DCC) has been created in the Economic Affairs Division (EAD). Formal donor group meetings are also held, at least two to three times a year, to discuss implementation of the government's PRSP. Under the leadership of the Government of Pakistan, the Bank Group is increasing efforts to strengthen partnerships and improve harmonization of activities among donors in line with the Paris Declaration on Aid Effectiveness. During the next four years we expect an increasing share of analytical activities to be carried out jointly with partners. Managing Risks xiii. The proposed CAS program poses a number of risks, the greatest of which is that of possible policy reversal due to shifting priorities or political changes. There are also implementation risks relating to both the Bank and Pakistan. The Bank will seek to pro-actively manage these risks by actively addressing capacity constraints while seeking to build and sustain support for further reforms. We will continue to rely on the self-regulating nature of the programmatic approach wherein the volume and pace of lending will match the pace of reforms. Issues for Board Discussion xiv. The following issues are suggested for Board discussion: a) Does the proposed program adequately support Pakistan's strategy for poverty reduction and achievement of MDGs? b) Is the planned increase in the scale of World Bank Group support for Pakistan appropriate? c) Is mix of instruments and activities consistent with the focus of the strategy?

9 A. Political and Social Context I. COUNTRY CONTEXT AND DEVELOPMENT CHALLENGES 1. The FYO6-09 Country Assistance Strategy (CAS) has been prepared at a time of great opportunity for Pakistan. Since the beginning of the new millennium, Pakistan has managed a remarkable turnaround. During the 1990's Pakistan's progress in reducing poverty and improving the welfare of its people was not very encouraging. Economic growth slowed and progress in improving Pakistan's social indicators stagnated. Successive governments initiated reforms, but with only modest results. Beginning in 2000, the Government initiated a more wide-ranging and ambitious reform program resulting in a dramatic turnaround. The FYO3-05 CAS period witnessed the consolidation and acceleration of this turnaround with sustained implementation of a program of stabilization and wide-ranging structural reforms. Economic growth accelerated from the average of 3.3 per cent during to 6.4 per cent in 2003/04 and 8.4% in 2004/05. Public debt fell to 61% of GDP from almost 90% in 2000/01. Improved fiscal performance and growing fiscal space resulting from savings on interest expenditures, generous external support and improved revenue administration have enabled the government to exceed targets for education spending. In short, Pakistan moved from crisis to growth, laying the groundwork for sustained growth and significant poverty reduction. 2. Yet Pakistan's development challenges remain formidable. While provisional estimates for suggest that poverty has declined compared with , the proportion of the population below the poverty line remains high. And despite recent indications of improvement, social and living standards remain well below countries with similar incomes and growth rates. For example Pakistan's gross female primary enrolment rate is 33 percent below and its infant mortality rate is 27 per thousand above that of countries with the same per capita income. Moreover, there remain substantial disparities in opportunity, particularly for the rural poor and women. 3. Politically, Pakistan is benefiting from a period of relative stability compared with the turmoil of the last decade. The past six years have been marked by consistent policies and sustained implementation of the government's reform program. Elections in 2002 restored the National and Provincial Assemblies and despite occasional slowdowns in implementation, the reform program has been carried forward under the elected government. The prospects are good for continued stability and maintenance of the government's pro-reform orientation. General elections are due to be held in The decentralization initiative has started the process of transferring responsibility and resources for public service delivery to local governments, laying the groundwork for more responsive and accountable government at the local level as well as improved services. Recent local government elections in 2005 were an important milestone in the institutionalization of the new local government system. 4. Internationally, relations with India have steadily improved over the past two years, although the conflict in Afghanistan and international terrorism continue to have serious repercussions for Pakistan. Relations with India have improved markedly under the comprehensive dialogue launched in early 2003 and trade between the two countries is growing strongly, although from a low base. President Musharraf visited India in late April 2005, and he and the Indian Prime Minister, Manmohan Singh, agreed to increase transport links between the divided parts of Kashmir. The response to the October 8 earthquake has served as an opportunity to expand peaceful interaction across the divided territory, demonstrating the potential for cooperation and constructive engagement in the region. However, Pakistan's efforts to deal with the spillover of post-9/11 conflict in Afghanistan and to cooperate in international efforts to combat terrorism continue to bring it into conflict with militant groups, particularly in remote border region. Clashes between law enforcement agencies and militants-many of them foreign-have resulted in significant casualties.

10 -2- B. Social Progress and Poverty Profile 5. The most recent household survey from which poverty estimates can be derived is now 4 years old, dating from 2000/01, when economic growth was depressed and much of the country's rural areas were suffering severe drought conditions. A definitive evaluation of whether the economic turnaround of the past few years has translated into lower poverty will have to await the release and analysis of the results of the Household Income and Expenditure Survey which is expected in 2006; however, provisional estimates released by the Government indicate that the incidence of poverty which rose above 30% in 1998/99, and rose further in 2000/01, fell to below 30% in 2004/05.2 The results of the 2000/01 Pakistan Integrated Household Survey (PIHS) convey the characteristics of poverty in Pakistan and highlight the challenge of attaining the Millennium Development Goal of halving the proportion of population below the poverty line between 1990 and Based on the PIHS, disaggregated poverty headcounts by province (using the official poverty line) show that NWFP and Balochistan are the poorest provinces and that poverty is far more widespread in rural areas. Poverty is highest among unskilled labor in the informal sector and their condition became worse between and Ownership of livestock and agricultural land are also closely associated with rural incomes. While the poorest quintile of the rural population accounted for only 10 percent of the total estimated value of livestock in , the top quintile accounted for 36 percent. Households with no land constituted 60 percent of the rural population in , but accounted for 76 percent of those in the bottom quintile; and poverty incidence among landless households actually increased from to Vulnerability is a key feature of poverty; approximately 41 percent of the population is concentrated in a small range of 75 to 125 percent of the poverty line implying that, for a very large share of Pakistan's population, unanticipated shocks such as illness/disability, death, or natural disaster can result in poverty. 7. Poverty is also characterized by low level of human capability, manifested in poor outcomes in education, health and lack of connectivity to basic services and facilities. Here there is recent data to suggest that Pakistan's reform program is beginning to pay off. Preliminary findings from the recently completed Pakistan Social and Living Standards Measurement survey, measuring outcomes as well as access, satisfaction and usage of public services both at the household and facility level, are encouraging. The preliminary results show significant improvement in a range of indicators including primary enrolment and immunization coverage (See Table 1). Nevertheless, across a range of indicators, Pakistan's social indicators continue to lag behind those of similar countries. C. Development Challenges 8. The key challenge for Pakistan is now to sustain its recent growth performance in order to generate significant poverty reduction. Pakistan's recent growth performance is encouraging, but its continuation is by no means assured. Sustained growth will require continued sound macroeconomic management along with further improvements in the investment climate. Notwithstanding the economic recovery, investment rates are insufficient to sustain high rates of growth needed to reduce poverty. Foreign direct investment, while recovering from the very low levels of the late 1990's remains low compared to more dynamic economies in Asia. Sluggish rates of investment reflect continued weaknesses in the investment climate; despite the recent successes in reducing state intervention in the economy and improving the regulatory framework for private business, firms continue to face significant policy, regulatory, and infrastructure constraints. Security concerns and political uncertainty have also combined to deter investors, both foreign and domestic. The impact of these constraints is reflected in the results of 2 The government has established a joint committee made up of donors, experts and officials to evaluate and analyze the most recent data and carry out a detailed analysis of poverty incidence. The provisional estimates are subject to change based on the results of this analysis.

11 -3- the World Economic Forum's (WEF) Competitiveness Report which indicate that in 2005, of the 116 countries covered, Pakistan ranked 66th in 'business competitiveness' (see Table 2). Table 1: Progress on Selected Social Indicators Reported data Indicator Poverty Poverty incidence (%) Demographics Population (millions) Education Adult literacy rate: 15+ years (%) Female literacy rate as percent of male literacy (%) Net enrollment rate (NER): grades 1-5 (%) Female NER as a percent of male: grades 1-5 (%) Health Life expectancy at birth (year) Infant mortality rate 0-12 months (per 1000 live births) na Under-five mortality rate (per 100,000 live births) na Fully immunized children, age months (%) Percentage of pregnant women using pre-natal care Sources: PIHS , , Preliminary estimates from PSLM * Provisional estimate. 9. Pakistan's infrastructure Table 2: Competitiveness Rankings platform needs significant Business Competitiveness Index investment in order to support Countries investmnts inwh ad evc (116 countries) (103 countries) (102 countries) Pakistan's growth and service delivery goals. Infrastructure Singapore services including electricity, paved India roads, municipal services, and Thaia telecommunications reach a Turkey relatively low proportion of the China population. Moreover, inefficient Pakistan operations in key sectors, like Philippines power and transport, adversely SriLanka affect competitiveness. The power Bangladesh sector is characterized by high Source: World Economic Forum, Global Competitiveness Report losses and unreliable supply, forcing 2006; World Economic Forum, Global Competitiveness Report many large firms to invest in 2004 captive generators. Much of the road network is in poor condition and the railways are carrying only a small fraction of the nation's freight due to inefficiency. Delays at Pakistan's ports are also hurting cost competitiveness of Pakistan's exports. Each day of delay in shipment is currently raising unit costs, on average, by over 0.5 percent of f.o.b. prices of exports. 4 At the same time, improvements in basic infrastructure are critical to improving WEF's 'Business Competitiveness' index incorporates indicators of the 'quality of the national business environment' and of the 'company operations and strategy'. For details, see: World Economic Forum, Global Competitiveness Report " The World Bank, Global Economic Prospects:- Trade, Regionalism, and Development- 2005, page 80.

12 -4- human development outcomes. Approximately 40 percent the population lacks access to power and about 75% of all rural health, education and market facilities are accessible only by earth tracks. Similarly, water and sanitation services which are critical to achieving human development outcomes suffer from poor quality and limited availability. 10. The infrastructure challenge is particularly acute with respect to water as Pakistan relies on the largest contiguous irrigation system in the world for 90% of food production and 25% of GDP. Agriculture is the single most important source of employment and irrigation represents more than 95% of the total consumptive use of water. However, this massive infrastructure is deteriorating and in need of rehabilitation along with reforms to improve the allocation of water as well as the efficiency of its use. The capacity of existing reservoirs is diminishing as the result of siltation and no new reservoirs have been built since Moreover, competition for water is growing among the provinces and across the varied needs for irrigation, industrial and domestic use, and the environment. Pakistan has already begun ramping up its investments, beginning with the urgent rehabilitation of barrages. Yet there remains a need for significant new investment, not only in irrigation but in other uses of water as well, including power generation and urban-industrial and domestic supplies (50% of the population is not served by a formal supply system and sanitation and water treatment reaches less than 10% of the population). At the same time there is uncontrolled pollution of surface and groundwater from agriculture, industry and rapidly growing cities. 11. For the poor to participate in and benefit from growth Pakistan needs to accelerate human development. International experience suggests that no country can hope to compete in the global economy without an educated and healthy work force. Indeed, the lack of skilled manpower and lower labor productivity are often cited as constraints to raising productivity, strengthening competitiveness, and achieving sustained high economic growth by both business leaders and policymakers in Pakistan. While Pakistan is making progress, analysis suggests that it will be difficult to achieve the MDGs for infant mortality, child malnutrition, primary completion, and elimination of the gender gap in primary enrolment. 5 Looking beyond the MDG's, enhancing competitiveness in an increasingly globalized and technology driven world economy will require a growing pool of workers with leading edge skills pointing to the need for increases in the level and quality of secondary, vocational and higher education. Thus, continued concerted efforts to address poor human development outcomes are important not only to improve equity but also as an integral part of achieving Pakistan's growth objectives. 12. Pakistan's poor social indicators are not due solely to poverty or lower rates of economic growth; Pakistan significantly underperforms when compared to other countries at similar levels of per capita income, and when compared to countries at similar levels of development. For example, Pakistan has 36 percent fewer births attended by trained personnel, an infant mortality rate that is 27 per thousand higher, and a gross primary enrollment rate that is 20 percent lower than countries with similar income levels. Similarly, growth in Pakistan appears to have less of an impact on social indicators than in other countries-between 1960 and 1998, as per capita GDP more than doubled in Pakistan, infant mortality declined by 43 percent, as compared to a decline of 73 percent in a group of low income countries that on average grew at the same rate. 13. Pakistan's relatively slow progress in improving human development reflects both low public expenditures on education, health, water and sanitation and other key sectoral expenditures as well as weaknesses in public service delivery which limit the effective use of scarce resources. As a result of the debt burden, which reached a peak in the late 1990's, social sector spending was squeezed, with education and health expenditures declining from 2.2 and 0.7 percentage of GDP in 1987/88 to 1.7 and 0.5 percentage of GDP by 1999/00. Despite having risen since then, public expenditure on health and education remain low by international standards. Within sectors, resources have been poorly allocated World Bank, Attaining the MDGs in Pakistan (Washington, DC, 2005).

13 -5- with emphasis on spending for new hiring and facilities at the expense of providing resources for operations and maintenance. Weaknesses in management of public services also stem from capacity constraints and in some cases lack of clarity about the roles and responsibilities of various levels of government. Moreover, social services are subject to, inter alia, high absenteeism rates of service professionals (25 percent for teachers), poor quality of inputs and materials, low community involvement and limited participation of the poor. 14. It is also important to note that a number of factors weaken the link between growth and poverty reduction in Pakistan. One such factor is the skewed structure of ownership and access to factors of production (land, water and credit) in rural Pakistan, which limits the impact of agricultural growth on the incomes of the rural poor. Landless agricultural laborers and non-agricultural rural poor households account for 61 percent of the rural poor (and nearly 30 percent of the rural population). Another factor is the ineffective targeting and delivery of government programs which reduces the benefits of increased government spending. Strong social and cultural norms restrict access to public services and reduce the economic opportunities of women and girls. Together these factors create obstacles for the poor and vulnerable to partake in the benefits of economic growth, highlighting the importance of interventions that address chronic poverty and vulnerability, and help the disadvantaged groups, including women, participate in economic growth. 15. Large gender inequalities represent a critical constraint to improvements in human development outcomes. Since the late 1990s, the Government of Pakistan has launched programs designed to increase girls' school enrollments, enhance female access to health care, and facilitate women's participation in the public arena. Some progress has been made, but much more is needed. For example, legislation mandating reservation of seats for women in local governments, as well as in provincial and national assemblies, has substantially increased women's political representation. However, although more girls are in school, a substantial gender gap in enrollment remains and worsens significantly as girls transition from primary to middle school. Although gender differentials in child immunization have declined, considerable gender differentials persist in other aspects of health care. The use of reproductive health services is low, and maternal mortality ratios remain high. In the labor market, lower educational attainment coupled with social norms that restrict mobility confine women to a limited range of employment opportunities and low wages. The achievement of Millennium Development Goals (MDGs) will require significant reductions in these gender gaps. Policy interventions directed specifically at gender inequality in these public domains are needed. 16. Pakistan's population is predominantly rural and dependent on agricultural lands, rangelands and forests. Natural resources and their sustainable management are therefore central to Pakistan's economic growth and to people's livelihoods. Salinization and waterlogging of land, increasingly polluted agricultural drainage (partly due to excessive pesticide use), and loss of important ecosystem functions from diversion of flows and from pollution are reflected in disappointing development outcomes and compromised agricultural yields. Degradation of rangelands continues and the rate of deforestation is relatively high (although the level of remaining forest cover is already low). The poorer rural dwellers suffer most from these trends. Urbanization is increasing at a rapid rate and the provision of basic environmental services in these areas has not matched the pace of growth. In both rural and urban areas there are problems of public health related to the lack of water, sanitation and other services and also to high levels of air pollution (in rural areas, this is related mainly to indoor air from use of poor quality fuels). Addressing these problems is a necessary adjunct to a sustainable growth and poverty alleviation strategy.

14 -6- Box 1: Impact of the October 8 Earthquake The October 8, 2005 earthquake left widespread destruction in its wake, killing at least 73,000 people, severely injuring another 70,000, and leaving 2.8 million people without shelter. The affected areas suffered extensive damage to economic assets and infrastructure, with social service delivery, commerce, and communications either severely weakened or destroyed. Beyond the human toll, the overall costs associated with the earthquake are significant. A Joint Damage and Needs Assessment put the value of the direct damage sustained due to the earthquake at US$2.3 billion while resulting indirect losses are estimated at US$576 million. The estimated costs for relief, livelihood support for victims, and reconstruction cost are estimated at approximately US$5.2 billion. The earthquake is expected to have an adverse impact on the economy, most notably on the fiscal deficit. The impact on economic growth will be modest as the affected regions account for a very small part of the country's GDP; growth at the national level is expected to decline by 0.4 percentage points in 2005/06. However, a large share of reconstruction costs, including restoration of social and physical infrastructure and government assistance to households to rebuild livelihoods and homes, will fall on the Government. Fiscal deficits during FYO6-08 are expected to increase by 0.5 to 0.9 percent of GDP per year. While the impact on exports is projected to be limited, relief and reconstruction needs have increased import demand due to higher demand for fuel and steel. These pressures could pose difficulties for Pakistan's macroeconomic balances and have the potential to compromise the achievement of its long-term development goals. Whether and to what extent this occurs will depend on the response of the Government and the international community. The Government intends to absorb a part of the budgetary impact of the earthquake by making cuts in low-priority expenditures and by raising additional domestic revenue while protecting priority expenditures needed to improve health, education, and public infrastructure. The decision to delay the purchase of new military aircraft indicates the Go%ernmenCs seriousness in this regard. Implementation of outstanding revenue and spending measures also need to be accorded high priority. However, even with such measures (which are needed in any case), given the magnitude of resources needed for rehabilitation of earthquake-affected areas, it is unlikely that the government will be able to fully absorb the fiscal impact of the earthquake without significantly affecting public sector development activities. Moreover, it is important that the poor in areas not affected by the disaster (the vast majority) not lose out due to increased allocation of public resources to the earthquake-affected areas at the expense of the rest of the country. Ensuring the dual objectives of rehabilitating and rebuilding earthquake affected communities and accelerating Pakistan's development will require additional resource mobilization by Pakistan and the international community. For the country assistance strategy, the main impact is on the lending program, particularly the use of IDA resources. While Pakistan's long-term development challenges and poverty reduction strategy have not been fundamentally changed by the earthquake, its immediate financing needs have greatly increased. To help meet these needs while protecting implementation of the PRSP reform program, the Bank has already made available $740 million in new IDA commitments and $100 million in IBRD lending. Overall earthquake-related financing may reach $1 billion. This has significantly front-loaded the use of IDA 14 resources with expected FY06 IDA commitments totaling over half of the three-year IDA allocation. In consultation with the Government, the CAS lending program has been re-prioritized accordingly; some planned IDA operations have been reduced in size and additional IBRD lending is planned, consistent with creditworthiness considerations. To the planned AAA program we have added dialogue and advisory activities to assist the Government in the development of a comprehensive hazard risk management strategy. 17. Addressing governance challenges and combating corruption are critical for improving the investment climate and strengthening the delivery ofpublic services. Public institutions delivering social services, law and justice and economic services suffer from inadequate capacity and ineffective internal and external accountability. Moreover, while reliable data is scarce, surveys cited in the Government's

15 -7- National Anti-Corruption Strategy indicate that corruption is a serious challenge. 6 The civil service suffers from weak capacity as a result of many years of rapid turnover, patronage-based employment at lower levels and inadequate compensation at senior levels. Accountability has been further weakened by lack of effective client voice, made worse by the over-centralization of power at higher levels of government. Together these weaknesses represent a major impediment to improving service delivery and the investment climate. 18. Improving governance and combating corruption is one of the pillars of Pakistan's poverty reduction strategy. Key elements of the strategy include: (i) reducing opportunities for corruption by redefining and refocusing the role of the state through privatization and de-regulation; (ii) reforming the civil service; (iii) establishing local government as an effective system of governance, participation and accountability; (iv) supporting reforms in public financial management and procurement in order to promote prudent and accountable management of public resources while reducing opportunities for corruption; and (v) strengthening enforcement mechanisms and the administration of justice. 19. Significant progress has been made in these areas. Local governments have been created to increase responsiveness and accountability for provision of key public services. The tax administration system has been redesigned to reduce interaction between taxpayers and tax officials. The Government's privatization program accelerated during the previous CAS period; over the last two years the government realized US$4.35 billion in proceeds through 27 transactions compared with US$600 million during the previous three years. Privatization of state-owned banks coupled with stronger regulation under a revitalized State Bank of Pakistan has reduced politically-motivated lending and non-performing loans. Progress has been made in improving public financial accountability through modernization of financial reporting systems and auditing, while the institutions of accountability like the Auditor General and the Parliamentary Public Accounts Committees have been revitalized. The national power utility is being unbundled to de-monopolize the industry, improve its transparency and efficiency and prepare for privatization. The National Accountability Bureau was created, successfully prosecuting cases of highlevel corruption. Nevertheless while this progress has been encouraging, most observers believe that a great deal more needs to be done to address the deep governance challenges faced by Pakistan. D. Economic Developments and Outlook Recent Economic Developments and Prospects 20. Since the last CAS, Pakistan's economy has continued its strong recovery. Growth has accelerated from 3.1 percent in FY2001/02 to 8.4 percent in 2004/05. The recovery was driven by a strong rebound in exports of manufactures and, more recently, favorable weather conditions leading to a strong pick up in agricultural production. Large scale manufacturing grew by 18.2% in FY2003/04 and by 15.4% in 2004/05. Fiscal performance has been sustained, despite limited progress in improving revenue collections and reducing power sector losses. Due primarily to increases in non-tax revenues and savings on the interest bill, the overall fiscal deficit (excluding grants) declined from 6.6 percent of GDP in 1999/2000 to about 3 percent of GDP in 2004/05. Moreover, despite this rapid fiscal adjustment, socialand poverty-related expenditures were raised by over 1 percentage point of GDP over the last three years, or by over 30 percent in real per capita terms, although they remain low in comparison with other developing countries. 21. The balance of payments turned around with strong export growth and sizable remittances, and international reserves were rebuilt to cover about five months of imports of goods and nonfactor services and over 250 percent of short term external liabilities (up from 11 percent in 1999/2000) at end 2004/05. 6 Government of Pakistan, National Anti-Corruption Strategy, Islamabad Pakistan, 2002 (

16 -8- However, the external situation has deteriorated somewhat over the past 18 months. Exports and workers' remittances have performed well, but with imports growing even faster, the current account moved into deficit in 2004/05. The trade deficit during FY05 rose sharply to US$ 4.3 billion and is projected to increase further to over US$7 billion in FY06. This reflects the rapid increase in imports which rose by nearly 38% to US$18.8 billion due to strong import demand for a wide range of consumer and investment goods (including automobiles and machinery), agricultural and chemical goods (fertilizer), and to high oil prices. Exports increased by 13.8% to US$14.1 billion. Gross reserves fell by about US$800 million in 2004/05 to US$9.8 billion at end-june The current account deficit is projected to reach 3.9% of GDP in FY06. Figure 1: Recent Economic Performance % Economic Growth Balance of Payments and Reserves Geoss int'l reserves in billions Real GDP at factor cost capital GDP er Current accoun t excluding official transfer (% of GDP) / / / / / / / / / / /05 % Total and External Debt Fiscal Trends Expenditure Crosspablic debt (% of GP) , Revenue Total public & publicely guaranteed external debt Budget balance (excl grats) / / / / / / / / / / / / Pakistan's public debt burden has declined sharply in the past four years. Although the stock of debt remains high, it has declined faster than expected, and its net present value has been reduced. Thanks to rapid growth, availability of grants and concessional finance, debt cancellation and fiscal consolidation, total government debt as a percent of GDP declined from 80% in 2001/02 to 61% in 2004/05. Total external public and publicly guaranteed debt declined from 296 percent of exports of goods and services in FY2001/02 to 203 percent in FY2004/05 while debt service fell from 34 to 19 percent of exports of goods and services. Interest payments have fallen from 5.6% of GDP in 2001/02 to 3.2% in FY2004/ The response to the October earthquake-arguably the most debilitating natural disaster in Pakistan's history-is expected to have an impact on fiscal outcomes during the current fiscal year and for at least the next 3 years. The deficit, which had already been projected to grow as the result of increases in civil service salaries and a growing public investment program, is expected to rise further, reflecting the costs of rebuilding infrastructure and government services and of subsidies to restore livelihoods and housing in the earthquake-affected areas. The FY06 fiscal deficit before grants is expected to increase by around 0.6% of GDP, to 4.4% of GDP (see Table 3), which remains consistent with a stable macroeconomic framework and the Fiscal Responsibility and Debt Limitation Law. However, the increase in public expenditures due to the earthquake may result in a slowdown in the pace of debt reduction. The extent to which it does depends not only on the Government's efforts to reprioritize

17 -9- expenditures, but also the pace at which grants pledged at a November 2006 donors' conference materialize. The government has indicated that it is reprioritizing expenditures and strengthening revenue efforts so as to minimize the impact of the earthquake on fiscal balances. The latter is particularly important since revenue performance suffered in FY05 due to a reduction in petroleum taxes (a move designed to cushion consumers from the impact of rising international oil prices), reductions in customs duties and special regimes for particular sectors. Some administrative reforms also may have contributed to a temporary dip in collections. However, collections during the current fiscal year are improving markedly. Table 3: Medium Term Outlook - Key Indicators Projections 2002/ / / / / / /09 (in percent of GDP, unless indicated otherwise) Output and Prices Real GDP at factor costs (percent change) Consumer prices (period avg. percent change) Consolidated Government Budget Balance Excluding grants Net ofearthquake Impact Public Debt Total government debt Domestic debt External debt External Sector Current Account Balance Gross Reserves (US$ millions. IMF definition) 10,251 10,621 9,985 10,549 12,157 13,117 14,079 Reserve cover to imports of GNFS (months) Sources: 2002/03 to 2004/05 - Government of Pakistan; 2005/06 to 2008/9 projections - World Bank Staff estimates. 24. The Government's fiscal policy aims to contain the deficit and continue to reduce the debt burden while increasing public investment and social spending. These commitments are embodied in the Fiscal Responsibility and Debt Limitation Bill approved by the National Assembly and subsequently passed into Law in The Law specifies that the revenue deficit be reduced to zero by June 30, 2008, and a surplus maintained thereafter; that total public debt be reduced by 2.5% of GDP per year; that PRSP expenditures be at least 4.5% of GDP in any year; and that debt guarantees be limited to 2 percent of GDP. An additional important clause introduced in the Law by the Assembly is the requirement that education and health expenditures, as a percentage of GDP, be doubled over the next ten years. Meeting these targets will depend in large part on the government's ability to improve revenue collection while continuing to reduce the losses of state-owned enterprises, particularly in the power sector. The Government fiscal framework for 2006 through 2009 is expected to remain consistent with the Fiscal Responsibility and Debt Limitation Law. 25. Prospects for rapid growth to be sustained over the next 3 years are good, provided that political and macroeconomic stability are maintained, that the momentum of structural reforms and investments to reduce the cost of doing business is sustained, and that domestic savings and public and private investment continue to increase The Government is targeting a more ambitious growth path than the Medium Term Outlook table estimates, with growth projected to rise gradually to 7.8% of GDP by Emerging risks on the external sector can be mitigated by gradually reducing demand pressures. The Medium Term Outlook presented above assumes that the measures necessary to reduce inflationary pressures and the growing external and fiscal imbalances will be taken by the central bank and the Government of Pakistan. Economic growth for FY06 is projected to remain strong and broad-based. Led

18 by strong domestic demand, industrial growth remains strong in the automobiles and consumer durables sub-sectors. The textile sector continues to perform well, in spite of the end of the Multi-Fiber Agreement, and exports of textile products have remained strong. Agricultural output in FY06 is projected to be average, below last year's record-breaking levels. Foreign Direct Investment is continuing to increase, as investor confidence is strengthening. II. PAKISTAN'S POVERTY REDUCTION STRATEGY 26. The positive developments outlined above have set the stage for accelerating poverty reduction in Pakistan. Pakistan's poverty reduction strategy paper (PRSP), which was presented on December 31, 2003, sets forth the broad-based strategy for addressing poverty in its various dimensions including human development, governance, and vulnerability and builds on the economic program first articulated in the fall of 1999 and further elaborated in the I-PRSP of 2001.' Since the PRSP was prepared, the Government has continued to develop and refine its program for implementing the PRSP agenda which is embodied in the five-year Medium Term Development Framework (MTDF), adopted along with the FY2005/06 Budget. While the PRSP continues to serve as an overall framework for the poverty reduction strategy, the MTDF refines the strategy, taking into account recent developments, and updates the targets while providing further details on implementation strategies. The Government is also in the process of preparing a new PRSP which is expected to be finalized in Taken together, the PRSP and the MTDF constitute a comprehensive poverty reduction and growth strategy. The PRSP emphasizes policies to sustain rapid growth as the main vehicle for poverty reduction and is grounded on four pillars: (i) achieving and sustaining a high growth rate while maintaining macroeconomic stability, translating this higher growth into lower poverty, and bridging the social gap; (ii) improving governance and consolidating devolution, both as a means of delivering better development results and ensuring social and economic justice; (iii) investing in human capital, with a renewed emphasis on effective delivery of basic social services; and (iv) targeting the poor and vulnerable to bring marginalized sections of the population and backward regions into the mainstream of development, and to make marked progress in reducing existing inequalities. The PRSP's targets are fully aligned with the MDGs (see Table 4:). A. The PRSP Strategy 28. Pillar One: Accelerating economic growth while maintaining macroeconomic stability. The PRSP focuses on accelerating poverty reduction and improving social indicators through rapid, privatesector and export-led growth and more effective and equitable delivery of health, water and sanitation, and education services. The PRSP also emphasizes enhancing competitiveness in the era of globalization through higher investment and knowledge inputs. It recognizes that, while a great deal has been accomplished in terms of restoring growth and addressing external vulnerabilities, considerable challenges remain to improve the efficiency of resource use and raise factor productivity. The key source of poverty reduction and employment is expected to be rapid growth and job creation in the manufacturing and service sectors, which are already responding well to economic reforms. The PRSP projects a substantial increase in private sector investment and the continued expansion of private sector activity in order to sustain growth. To increase private investment, the PRSP outlines a set of structural reforms to increase productivity and reduce the cost of doing business in Pakistan. Overall, the strategy aims to expand the role of the private sector in the development process by the strengthening the enabling role of the government through policy direction and creation of a supportive regulatory environment. 7 The Bank-Fund Joint Staff Assessment (JSA), discussed by the Board on March 11, 2004, endorsed the PRSP and indicated it provides a good policy framework for the implementation of a strong reform program. Pakistan, Joint StaffAssessment of the Poverty Reduction Strategy Paper, Report PK, February 12, 2004.

19 Pillar Two: Improving governance. The PRSP recognizes that continuing to improve governance in Pakistan matters critically for economic growth and the development of human capital. The MTDF reinforces this emphasis. Key elements of the Government's strategy include accelerating civil service reform, furthering devolution, improving access to justice, police reforms, accelerating improvements in public procurement and financial management, and additional measures to accelerate progress on fiscal and financial transparency and reduce opportunities for corruption. In addition to these areas, the MTDF also highlights the importance of strengthening corporate governance, enhancing the quality and coverage of data and statistics, and making greater use of participatory approaches in order to improve program and project outcomes. Regarding civil service reform, the government's strategy highlights a flatter structure, merit-based recruitment and promotion criteria, performance based compensation, and incentives to innovation. There is also a proposal to restructure the civil services in order to break free of some of the structural rigidities resulting from the current cadre system. The government also indicates its intention to implement further pay and pension reforms. Table 4: Pakistan's PRSP Targets and Alignment with Millennium Development Goals Goals and Indicators actual Eradicate Poverty and Hunger - Overall poverty level (% of population) Poverty gap ratio Achieve Universal Primary Education - Literacy rate of years old (%) Gross Enrollment* Promote Gender Equality and Empower Women - Ratio of literate females to males of years (%) Proportion of Seats held by women in the Parliament: National Assembly (%) Senate (%) Local Councils (%) Reduce Child Mortality - Infant mortality rate Proportion of fully immunized children months 25% 53% 82% 90% >90% - Under five mortality rate Improve Maternal Health - Maternal mortality rate/100, Total fertility rate LHW coverage of target population n/a 45% 77% 90% 100% 6. Combat HIV/AIDS, Malaria and Other Diseases - Incidence of TB/100,000 n/a Ensure Environmental Sustainability - Sustainable access to safe water 82% 86% 90% 93% - Population with access to sanitation 28% 51% 55% Source: Government of Pakistan, Poverty Reduction Strategy Paper, *A sub-committee headed by Director, PIDE is engaged in reconciling PIHS and NEMIS data. 30. Pillar Three: Investing in human capital. In Pakistan, social development lagged even when growth was robust and the incidence of income poverty declined. The Government's PRSP acknowledges that without a considerable improvement in social indicators, especially for women, Pakistan will be unable to sustain high rates of economic growth. Education is seen as the most important factor

20 distinguishing the poor from the non-poor. The PRSP, therefore, includes increased allocations for education, health, water and sanitation, and rural infrastructure. The MTDF reflects a large increase in resources for education with the total public allocation for education expected to increase to 3.6 percent of the GDP by 2010 with private sector expenditure adding another 1.5 percent. 31. In health, the PRSP recognizes the need to increase financing and enhance efficiency of spending through organizational and management reforms. Furthermore, the PRSP focuses on reorganization of district health structures, strengthening of district and tehsil hospitals, improving hospital administration through greater autonomy, and regulation of the private sector. On the programmatic front, the strategy is to continue and strengthen the shift from curative services to preventive and primary health care. The strategy prioritizes control of communicable diseases, reproductive health, child health and nutrition. In health, the Federal Ministry would focus on development of a public health surveillance system and on gradually devolving preventive care programs, which would increasingly be designed and not only implemented by provincial and local governments. The PRSP acknowledges that the achievement of key PRSP goals in health depends also on policies and developments outside of the health sector such as literacy, access to drinking water and adequate sanitation. 32. Pillar Four: Targeting the poor and the vulnerable. Targeting the poor and the vulnerable through social protection programs is one of the integral pillars of the strategy. There are several social protection programs in Pakistan, which have as their objective improving the welfare of the poor and vulnerable groups. The programs include cash transfers through the Zakat and Bait-ul-Maal programs, in-kind assistance through, for example, the school meals pilot program (Tawana Pakistan), and programs to reduce the prevalence of child labor (stipend/schools for working children and their families). In addition to cash and in-kind transfers, Khushali Bank and a number of NGOs provide microfinance to low-income households. There is also a social security system for workers in the formal sector. A modest number of facilities provide institutionalized care or special education to specific vulnerable groups such as the disabled or child laborers. III. BANK GROUP ASSISTANCE STRATEGY A. Implementation of the Last CAS and Lessons Learned FYO3-05 Actual lending, portfolio management, and IFC program 33. While new lending slowed during FY03 following the October 2002 elections, it picked up thereafter and overall CAS lending volume was close to that envisioned in the high-case lending scenario of the FYO3-05 CAS. New lending commitments during the CAS period totaled US$2.033 billion, including US$404 million of IBRD, or 15% below the CAS high case lending scenario of US$2.4 billion including US$600 million in IBRD borrowing. The shortfall in IDA commitments was due in large part to delays in development policy lending for the provinces of Sindh and NWFP as well as a shortfall in overall IDA 13 resources. Total EBRD commitments were one-third less than the high-case scenario total. A detailed comparison of planned and actual lending is included in the CAS Completion Report. Just over half of IDA and IBRD commitments were fast disbursing development policy loans, compared with the 65% share projected in the CAS, again reflecting the delay in planned development policy lending for the provinces. 34. With respect to the ongoing portfolio, performance throughout the CAS was generally good (see Table 5). Starting from a low point at the beginning of the CAS period, the portfolio has grown from 12 to 16 projects reflecting the increase in lending over the previous CAS. Despite the growing volume of lending, the portfolio remains relatively small, a reflection of the substantial proportion of single tranche development policy credits in the program (about one-third of the operations approved during the CAS period). Performance indicators showed sustained strong performance with 100 percent realism and

21 pro-activity and a disbursement ratio well above regional and Bank-wide averages. The percentage of projects at risk remained low, although it rose somewhat in FY05. This increase is being watched closely and managed intensively in consultation with the GoP (see para. 106). Table 5: Bank Portfolio Indicators. Indicator FY02 FY03 FY04 FY The CAS emphasis on knowledge transfer was reflected in Number of Projects the AAA program. Core diagnostic Projects at Risk (%) reports completed include a Public Commitments at Risk (%) Expenditure Review (rated highly Realism (%) satisfactory by QAG), a Poverty Proactivity (%) Assessment, CFAA (complemented Disbursement Ratio by three provincial financial accountability assessments), an FSAP, and a Country Gender Assessment. Customized, high impact informal AAA such as the trade policy notes and power sector policy notes were used to support high level policy dialogue and catalyze implementation of reforms. A series of in-depth provincial economic reports was launched, beginning in FY04 with the Punjab Economic Report, followed by the NWFP Economic Report in FY05. By design, the AAA program has put less emphasis on delivery of discrete outputs and teams have been encouraged to transfer knowledge through policy dialogue and non-lending TA. Major (or flagship) ESW Reports have been limited to no more than three a year to ensure quality and adequate managerial attention. 36. The IFC Program over the previous CAS period included investments and significant increases in technical assistance and advisory service. Commitments during the three year period totaled US$187 million. Total exposure now stands at US$314 million in 32 companies including US$62 million in equity, down from US$442 million in 48 companies at the time of the CAS. Liquidity in the local financial markets led IFC to reassess its approach and provide more value-added instruments and put greater emphasis on TA. The focus during this period was on the financial sector, SMEs infrastructure, and targeted industrial interventions. IFC's investments supported expanded container capacity in Karachi's port, the first investment in information technology, Islamic financing in the leasing sector, and a linkage initiative in the textiles sector. TA included initiatives in all major pillars of the Private Enterprise Partnership for the Middle East and North Africa (PEP-MENA) facility: financial sector, SMEs, business enabling environment, and privatization or public-private partnerships. IFC's TA program in Pakistan included a corporate governance program for banks, institution building in housing finance, and SME and microfinance, training in alternative dispute resolution, support for business membership organizations, and advice in the water sector. Moreover, during the last CAS period, IFC Technical Assistance and Trust Funds Program (TATF) completed a feasibility study in the health sector as well an analysis of the competitive positions of the country's leasing companies and investment banks. IFC's Environmental Opportunities Facility (EOF) completed a study to help optimize a wastewater treatment facility in the textile manufacturing industry. Lessons learned from IEG evaluations, client survey, and the CAS Completion Report 37. The Country Assistance Strategy (CAS) for FY builds on the lessons learned during implementation of the FYO3-05 CAS and the messages heard during consultations with stakeholders as well as the results of a client survey. In addition, recent formal reviews of the Bank's work in Pakistan include (i) the Independent Evaluation Group (IEG) Country Assistance Evaluation covering FY94-FYO3; (ii) the FYO3-05 CAS Completion Report; (iii) Recent IEG Project Performance Assessment Reports; (iv) ICRs of projects closed during the CAS period; and (v) a QAG review of AAA work.

22 Results of the Client Survey. The survey of 351 stakeholders drawn from government, national and provincial assemblies, the private sector, media and academia yielded a number of insights on the Bank's contribution to Pakistan's development. Stakeholders reported that the greatest development challenges are poverty reduction, education and law/justice, with education emerging as a critical issue consistently throughout the survey-and an area where respondents believe the Bank can play a more profound role. In addition, stakeholders emphasized infrastructure as an area that is critical for successful development-and an area where the Bank's work receives some of the highest ratings from stakeholders. The Bank's role as a provider of knowledge was also particularly valued. The Bank's greatest weaknesses were considered to be imposing technocratic solutions without regard to political realities and not exploring alternative policy options. A consistent and important message from both the survey and consultations is that the Government of Pakistan values its partnership with the World Bank. 39. Lessons from the CAS Completion Report. The CAS Completion Report (Annex 2) reviews the Bank Group's effectiveness over the past three years and indicates that the Bank's strategy was appropriate and succeeded in making a significant contribution toward the achievement of some of the outcomes targeted in the FY03-05 CAS. In particular, targets for macroeconomic stabilization (including debt reduction) and increases in poverty-related expenditure were met and milestones in governance reforms in financial management and tax administration were achieved. While outcomes in several areas were not met, the Bank program helped in the development and implementation of reform programs to which the government remains committed, even if the pace of reform has not been as rapid as envisioned in the CAS. With respect to development outcomes, there is now preliminary data to suggest that the reforms of the past three years are beginning to yield measurable improvement, although in some cases less than targeted in the CAS. Taken together these reviews and feedback suggest that while the Bank has made a valuable contribution to Pakistan's development, there is significant potential to increase our development impact. The chief lessons relevant to formulation of the CAS are: * A programmatic approach provides the flexibility to support reforms while managing risk. The use of annual single tranche adjustment operations at both the provincial and national level helped to support reforms while providing a mechanism to adjust the lending program to match the pace of reforms. This approach strengthened the link between borrower performance and the Bank lending program. * Projects need to be focused and scaled to fit the capacity of the implementing agency, in terms of both project scope and the pace of implementation. While reinforcing the emphasis on the key role of "client pull," the experience of a number of projects that closed during the CAS, especially the multi-province umbrella projects, highlights the need for focused projects that are readily "implementable" with realistic schedules and clear ownership. In particular, governance reforms often took longer than planned. Realistic assessment of technical and political implementation challenges need to be reflected in project designs which should exhibit a strong bias towards simplicity. * Greater attention to capacity building is needed. As indicated above, weak implementation capacity is a widespread concern affecting project design and implementation. The Bank has begun to increase its capacity building programs with the approval of the Public Sector Capacity Building (PSCB) project in FY04 and the designation of Pakistan as a focus country for WBI programs beginning in FY05. The Bank will also continue its support for civil service reforms through policy dialogue, the PSCB project and PRSCs. During the coming CAS, projects will have a greater emphasis on building institutional capacity. * The program needs to continue to strengthen its focus on results. To address weak M&E systems and capacity within the GoP and implementing agencies, the Bank needs to support the strengthening of statistical capacity and monitoring and evaluation as part of institution strengthening. At the same time, the Bank needs to do a better job of focusing on developing

23 solid project-level results and indicators and incorporating the monitoring of these results into the supervision process. The results-based CAS offers an opportunity to identify and focus on key strategic outcomes at the country level and provide a framework for joint monitoring and evaluation of the overall country program with the Government. 40. The IEG Country Assistance Evaluation. IEG's Country Assistance Evaluation (CAE) rates the overall outcomes of the Bank's assistance program as moderately unsatisfactory. 8 During the period covered by the IEG review ( ), IEG found that the outcomes of Bank support for macroeconomic management and growth achieved success, especially in the last few years. However, outcomes of the Bank's assistance were found to be unsatisfactory in poverty reduction and social sector development, governance, agriculture and natural resource management, fixed infrastructure, and revenue mobilization and expenditure management. Taken together, therefore, IEG rated the overall outcomes of the Bank's assistance program as moderately unsatisfactory. Although the CAE primarily covers the decade prior to the beginning the FYO3-05 CAS, some of its findings and recommendations are applicable to the new CAS and have been discussed by the Country Team and are reflected herein. The key recommendations of the CAE are: (i) the Bank should continue its strong support of analytical work while translating analysis into implementable actions taking into account political economy constraints; (ii) Bank interventions should have a greater focus on building sustainable institutional capacity; (iii) projects should be more focused and scaled to fit the capacity of implementing agencies; and (iv) the Bank should invest additional effort into improving donor relations. 41. A more recent IEG Project Performance Assessment 9 drawing lessons from the provincial development policy loans for Sindh and NWFP has also informed the development of this CAS. In particular, the PPAR notes that sub-national development policy lending can make a significant contribution in terms of improving service delivery. In the context of devolution, the PPAR also notes the importance of clarifying the respective roles and financial relationships of various levels of government. Finally like the CAE, the PPAR notes the importance of taking capacity constraints into accountespecially at the local level-and recommends greater attention to capacity building in future operations. B. Context and Engagement Principles 42. While highlighting areas in need of strengthening, the review of our assistance and lessons learned outlined above also confirm the value of the Bank's strategic partnership with Pakistan. The Bank has come to be seen by the Government as a trusted development partner, valued not only as a major source of development finance but also as a source of global knowledge based on international experience. At the same time, the Bank has gained significant credibility as a catalyst for reform through its willingness to exercise selectivity, lending only in the presence of strong ownership of, and commitment to, reform and where there is clear evidence that the Bank adds significant value. The Bank is therefore uniquely positioned to play a key role in helping Pakistan to sustain its recent strong performance and accelerate poverty reduction. Moreover, in light of its recent successes, Pakistan is well positioned to make real progress in poverty reduction and has requested a significant increase in the scale of Bank financial support. For the Bank, this represents an important opportunity to increase the impact of our work in Pakistan by significantly scaling up our program over the FY06-09 period. 43. In this context, the Bank's work will continue to be guided by the following strategic engagement principles: Pakistan - Country Assistance Evaluation (CODE ; /1), June 29, The Pakistani authorities agree with the CAE's analysis in some areas, but note that the report did not emphasize adequately recent improvements and was too critical of outcomes in agriculture and privatization. 9 IEG, Project Performance Assessment Report. Report No , December 19, 2005.

24 - 16- * The Bank will commit resources only in the presence of strong "client pull" to ensure that scarce resources are applied only where there is a high probability of success. Evidence of client demand for Bank support will include the leadership of committed reform champions who have demonstrated the willingness and ability to carry out needed reforms. At the project level, client demand will be reflected in the establishment of adequate institutional arrangements and readiness for prompt implementation. * The Bank's program will reflect strategic selectivity, targeting Bank resources where they can be most effective. A principle consideration will be demonstration of client pull as outlined above. In addition, while the program will span a wide range of instruments and sectors, we will maximize impact by seeking replicate or scale-up approaches that have already been shown effective. We will continue to maintain a close dialogue with the Government and other partners to harmonize and reinforce our efforts and to target our activities in the areas where the Bank has the greatest comparative advantage. * This new CAS will have an even greater focus on outcomes. The Bank's program for Pakistan will be guided by the CAS results framework (Annex 1) which identifies: (i) long-term national development goals; (ii) associated CAS outcomes that the Bank can directly help to realize; and (iii) the mix of Bank Group products and services that best contributes to these CAS outcomes. An integral part of the shift toward a results-based CAS will be the strengthening of the CAS M&E architecture. The CAS results framework also identifies indicators to monitor progress toward the achievement of CAS outcomes as well as implementation of World Bank Group CAS programs and will therefore serve as a mechanism for monitoring progress in CAS implementation. * Programmatic approaches will continue to form the core of the Bank program. The experience of the FYO3-05 CAS supports the continued used of a programmatic approach to provide sustained, flexible, and predictable support to medium-term reform programs. Experience has also shown that programmatic approaches are effective in strengthening ownership while accommodating the uncertainties inherent in medium-term reforms. Increasingly we will provide a range of services-a combination of dialogue, capacity building, expenditure review and technical assistance along with IDA resources-aimed at building effective service delivery systems at the local government level. Programs will seek to link inputs to outputs, be integrated into medium-term budget frameworks and include an effective monitoring system. 44. In line with Pakistan's recent performance and request for additional Bank support as well as application of the strategic principles outlined above, the Bank will seek to deliver a substantial increase in its volume of lending to Pakistan during the next four years. The immediate priority will be to assist in addressing the impact of the October 2005 earthquake; up to US$1 billion in IBRD/IDA commitments will be used to support reconstruction and recovery (US$840 million in new commitments have already been approved). In addition, based on the Government's priorities for sustaining growth and accelerating poverty reduction, the expansion in lending will be primarily in infrastructure (primarily energy, water, and transport) and human development. Cross-cutting reforms, both at the national and provincial level will remain a key focus and a substantial share of IDA lending will take the form of PRSCs and provincial development policy credits to support, inter alia, fiscal/financial management improvement, transparent and efficient public procurement, power sector reforms, actions to improve the investment climate and cross-cutting initiatives to improve service delivery. Investment lending devoted to strengthening and reform of the key governance institutions (e.g., tax administration, financial management, land records, and statistics) will also continue to make up a significant portion of the lending program.

25 While the Government's request for additional financing for infrastructure will lead to an increase in investment lending, policy-based fast disbursing lending will continue to account for a significant share of total lending. Policy-based lending instruments are well-suited to supporting the Government's poverty reduction strategy which emphasizes second generation policy and institutional reforms. The experience of the FYO3-05 CAS has demonstrated the effectiveness of flexible, performance-based assistance in supporting policy reforms and crosscutting actions needed to improve service delivery. Annual PRSCs will form the core of the Bank's support for implementation of Pakistan's poverty reduction strategy at the national level. Province-level development policy operations will feature prominently where mediumterm reform programs have advanced to the stage where Bank support can assist in their implementation. As in the previous CAS province level development policy operations will couple fiscal and financial management reforms to improve financial sustainability with actions to improve the effectiveness of service delivery. IBRD development policy lending will be considered to support reforms in urban management, irrigation, and transport, in conjunction with investment lending, policy dialogue and technical assistance. In each case, the choice of development policy instruments will be driven by the strength of medium-term reform programs and the capacity and track record of counterparts. 46. The proposed assistance program will be aligned with the respective responsibilities of national and provincial governments in Pakistan and tailored to meet the needs of the individual provinces. Provinces and local governments bear most of the responsibility for delivering public services including irrigation, education, health, and water supply and sanitation, but have very limited "fiscal space" to provide these services. In the FYO3-05 CAS, the Bank's strategy was to focus on those provinces-sindh and NWFP-that had embarked upon comprehensive reform programs to support those programs through a series of development policy credits. In addition the Bank provided programmatic support for education reforms in Punjab, beginning in FY04. Provincial reform programs in Punjab and Balochistan were supported through the Asian Development Bank's Resource Management Program loans. During the coming CAS period we will continue to support provincial reform programs in these provinces and maintain a dialogue with all provinces based on in-depth provincial economic reports for each province. We will seek a balanced approach with lending and analytical services geared to the specific challenges and unique opportunities (e.g., the mineral sector in Balochistan) in each province. 47. At the national level, policy-based and investment lending will focus on areas that are the mandate of the federal government. The PRSC program will focus on the critical policy and institutional reforms to improve governance and the investment climate. Much of the planned increase in investment lending will be for national-level programs, including national highways, ports, railways, power, and water. C. World Bank Group Program Priorities The Strategic Framework 48. The Bank Group' program priorities will retain considerable continuity with the FYO3-05 CAS. The World Bank program for FYO6-09 will support the continuation and consolidation of many of the reforms initiated in previous years including cross-cutting governance reforms initiated in current and earlier CASs (financial management, procurement, tax administration, devolution and civil service reform). We will also assist in strengthening the institutions governing the market economy and continue to encourage reforms in the incentive and regulatory regimes for infrastructure, finance, trade and manufacturing to further improve the business climate. Working with the federal government and the provinces we will seek to improve the quality of and expand access to basic services for the poor, including health, education and safety nets. 49. The Bank Group will focus its program on the areas which are most critical for poverty reduction. The three pillars of the CAS correspond to the strategic priorities of the PRSP: (i) sustaining growth and

26 - 18- improving competitiveness; (ii) improving government effectiveness and service delivery; and (iii) improving lives and protecting the vulnerable. The pillars of the CAS are inter-linked and mutually reinforcing. Sustaining high and broad-based growth is necessary to create employment and incomegenerating opportunities. Addressing poor human development outcomes is a critical element of the strategy to enable the poor to take part in and benefit from growth. Improving governance cuts across the entire strategy - it is important both to improving the investment climate to support growth and to strengthening the delivery of services to the poor. Within the three pillars of the CAS, the Bank has identified a selected number of outcomes that will be pursued during the CAS period. The rest of this section explains the main issues and constraints in the areas of the CAS pillars and how the proposed outcomes to be supported by the Bank Group program will assist Pakistan in tackling these constraints. Pillar I: Sustained Growth and Improved Competitiveness 50. Strengthened macroeconomic management and allocation of resources. Maintaining the hardwon benefits of macroeconomic stability will be critical to sustaining growth during the CAS period. While recent performance has been good, particularly with respect to growth, rising inflationary pressures and limited progress in improving revenue mobilization represent challenges. With the increased spending made necessary by the costs associated with earthquake recovery, there is an even more acute need for further prioritization of expenditures to maximize the benefit of available fiscal space. Key priorities include reducing the drain on the budget caused by losses of state-owned enterprises, improved management of the public investment program, and strengthened debt management. 51. With the conclusion of the IMF poverty reduction growth facility program, the Bank's macroeconomic monitoring and advice will occupy a more central role in our dialogue 0 In addition, the Bank will continue to provide support to help the Government strengthen macroeconomic management through (i) improving the level and composition of expenditure; (ii) improving the effectiveness and impact of public expenditures through the preparation of a Medium Term Budget Framework (MTBF) and the formulation of sector strategies and sector investment programs; and (iii) continuing ongoing tax reforms aimed at improving tax payer services while increasing the tax-to-gdp ratio. PRSCs and province-level development policy lending will help to bolster these reforms while planned AAA will include reviews of the Public Sector Development Program, a Public Expenditure Review, technical assistance in pension reform, and analytical support for tax policy reforms. 52. Improving Pakistan's low tax-to-gdp ratio will continue to be a major focus of our work aimed at addressing weaknesses in the current system including: (i) inefficient tax administration; (ii) a narrow tax base - only 1.53 million taxpayers out of 39.4 million employed; (iii) a complex and cumbersome tax system; and (iv) corruption and tax evasion. Recent reform initiatives have had a positive impact on tax management and in improving revenues - for the first time over the last two years, the Government was able to achieve its revenue targets, although this cannot be attributed to tax administration measures alone as strong growth has also contributed to rising revenue. Successful implementation of the FY05 Tax Administration Reform project will be the centerpiece of our efforts. The main challenges will include implementing organizational and management reforms, re-engineering of operational processes that are likely to affect staffing levels and introducing automated risk-based systems that reduce contact between tax payer and tax officials to minimize corruption. In addition, with the end of IMF program, ad-hoc and inconsistent tax policy changes have started to constrain expansion of the tax base. Tax policy support, 10 A 3-year PRGF arrangement was approved in November 2001 and concluded in December All PRGF disbursements were made available upon completion of program reviews although the GoP elected not to draw the final tranche in light of its improved external position. Compliance with structural performance criteria and macroeconomic conditionality was better than average for Fund-supported programs. See, IMF, Pakistan 2005 Article IV Consultations and Ex Post Assessment of Longer-Term Program Engagement, November 2005.

27 - 19- including a Tax Policy Study, is planned and PRSC III will support tax policy measures to increase revenue mobilization. 53. Increased diversification and exports in agriculture. The Government intends to accelerate agricultural growth by promoting the diversification of agricultural production into high value products (including crops, livestock and fisheries) and agro-processing, improvement in factor productivity, and better integration of supply chains. The Government has made good progress over the last couple of years with respect to liberalization of the domestic wheat trade (removing restrictions on transport), liberalizing wheat imports and maintaining a reasonable level of strategic reserves. However, the Government remains involved in the procurement of some 20% of local production at a heavy cost. Long-term agricultural growth and poverty reduction are constrained by the structure and performance of key rural factor markets including land, water, and credit as well as a degrading resource base, in particular soil and water. Given the constraints on land and productivity, the poor will benefit from agricultural growth only if the increase in productivity is translated into lower real prices of food and higher employment-to include the rural non farm poor, who together account for 61% of the rural poor-and higher rural wages. 54. The focus of the Bank's work in this area will initially be to support the preparation of a rural strategy, integrating issues related to agriculture, natural resource management, the rural non-farm economy, infrastructure, rural finance and the need for targeted interventions. The strategy will also include analytical work on supply chains and World Trade Organization (WTO) issues, to understand the potential market access for agriculture through the opening up of international markets and agribusiness networks. It will analyze and discuss the potential for increased public support through agricultural research, extension services, and technology transfers with an emphasis on adapting technology for rainfed areas and livestock. The Bank will also support policy and institutional reforms in land administration beginning with the Punjab Land Records Management Project. In addition we will seek to support reforms in the research and extension system to introduce more demand-driven participatory approaches based on public-private partnership. 55. Irrigation and drainage. Pakistan's extensive irrigation system is under growing stress as the result of growing demand, deteriorating infrastructure and poor governance. Building on the recently completed water strategy, the Bank will support a combination of institutional reforms and investments including: (i) major investments in rehabilitation of critical assets (including barrages), and will help put in place Asset Management Plans which will set priorities for asset rehabilitation and maintenance, make explicit the requirements for public and user financing, and develop institutional arrangements for rehabilitating and maintaining this infrastructure; (ii) development of capacity at the provincial and federal levels for improving water and associated natural resource management; (iii) efforts to improve the quality, efficiency, and accountability with which irrigation services are delivered; and (iv) investments in on-farm services (land leveling, watercourse lining, introduction of new technologies) for increasing the productivity of water use. Bank support will be provided through a range of instruments including development policy lending in support of key reforms as well as through investment lending to finance infrastructure and institutional development. Governance and communication improvements will be a central theme as poor governance and low trust are among the key underlying factors behind the poor performance of the irrigation system and low productivity. Finally, given the major scientific, policy and implementation challenges ahead, the Bank, with support from the Government of the Netherlands, will provide analytical and technical support to the federal and provincial governments. 56. While Pakistan recognizes the importance of improving the efficiency of water use, the Government's water strategy also assigns high priority to augmenting water storage capacity, both to offset the declining capacity of existing reservoirs (due to siltation) and to meet growing demand. Indeed, compared with other countries Pakistan has relatively little water storage capacity and substantial untapped hydropower potential, indicating a potentially high payoff from new reservoirs. The GoP has recently announced a Presidential initiative under which it intends to build up to five new dams by 2016.

28 Given the importance of such an investment for addressing long-term water issues, the Bank will consider providing technical assistance for this work. Looking further ahead, should the proposed project prove technically and economically sound, the Bank would be prepared to respond favorably to a government request to help finance construction, provided the project is designed and implemented in conformance with international standards for social and environment safeguards. 57. Improving the business environment for trade and investment Recognizing that sustaining the current high rates of economic growth requires globally competitive production in an increasingly demanding world market, policy makers are focused on strengthening international competitiveness through rising productivity to support higher wages, a strengthened currency and increased returns to capital. Macroeconomic stability and the removal of price distortions have eliminated impediments to productivity growth but will only translate into rising productivity if accompanied by a more conducive business environment. There is consensus among policy makers, academics and the business community that improvement in Pakistan's competitiveness derives in part from success in three "second generation" areas which impact firm-level productivity and thus have become important priorities for Pakistan. First, economic governance to instill market discipline and provide certainty in investment returns poses a particular challenge, encompassing such entrenched factors as efficiency and effectiveness of government and autonomous institutions, quality of regulation, policy uncertainty, and the rule of law. Second, efficiency of factor markets to foster flexibility and fluidity represents a major constraint to good resource allocation and ease of entry, particularly in the case of land and labor. Third, the degree to which entrepreneurs find it easy to do business has a major impact on international competitiveness. Many reforms were initiated in these areas in recent years, and a number of indicators of 'doing business' have improved as a result. 58. During the CAS period, the Bank Group will support the following: (i) strengthening the institutions and legal/regulatory frameworks in support of a competitive market economy by updating corporate law and building the capacity of courts and monopoly control authorities; (ii) lowering the burden of government bureaucracy and regulation to ease entry and business operations, particularly for SMEs; (iii) improving labor market flexibility through legislative reform (employment and industrial legislation is currently being revised); (iv) improving tax administration; and (v) further reduction of trade protection. In addition, as provincial governments have a role in improving their local investment climate, the Bank Group will work with provincial authorities to address areas within their domain such as improving management of industrial estates and improving the functioning of land markets. 59. Ongoing analytical work in this area includes studies on 'Growth and Competitiveness', 'Value Chain Analysis', and 'The Labor Market.' This work will be followed by National and Sub-national Doing Business & Investment Climate Assessments and additional Provincial Economic Reports. The Public Sector Capacity Building Project (PSCBP) will be implemented along with an IDF grant for the Securities and Exchange Commission of Pakistan. Capacity building for other institutions charged with government markets will also be deployed, such as efforts to strengthen the framework for fair and open competition. Annex 7 outlines in greater detail the World Bank Group Private Sector Strategy. 60. Improved infrastructure to Support Rapid Growth. Infrastructure bottlenecks pose a significant threat to Pakistan's ability to sustain rapid growth. During the next CAS period the Bank will focus on three areas: (i) supporting reform processes, including privatization and private sector participation in public utilities, technical assistance and capacity building to strengthen institutions in specific sectors; (ii) working closely with the IFC and MIGA to increase private investment in infrastructure; (iii) developing the legal and institutional framework to encourage private-public partnerships and (iv) undertaking IBRD investment operations where reforms have advanced sufficiently to make public investment effective. 61. At present, the power sector is not up to the challenge of meeting growing electricity demand efficiently and reliably and extending service to underserved areas and poorer segments of the population.

29 -21 - Challenges include high technical and commercial losses (over 20 percent in a number of distribution companies and in some cases as high as 40 percent), bottlenecks in transmission and distribution, substandard quality of supply, underinvestment, high costs, and inadequate tariffs. About 30 percent of population has no access to power. There are large cross-subsidies in the tariff structure, with industrial and commercial consumers subsidizing residential ones. Government subsidies to the sector total about US$1 billion annually. 62. In recent years the Government has made significant progress in implementing its power sector program first initiated in the late 1990s. The reform program includes unbundling, corporatization, commercialization, and privatization of the industry," establishment of an independent regulatory agency; institutional strengthening in policy, governance, and corporate management; and mobilization of resources from the private sector to meet the power sector's technical, financial and human resource needs. Although much remains to be done, progress has been made: a new legal framework for the sector was adopted, an independent regulatory agency (NEPRA) established, WAPDA was unbundled, privatization of several companies in generation and distribution has been completed or is underway, and a Policy and Implementation Cell in the Ministry of Water and Power established. 63. The Bank has been deeply engaged in the power sector. Strategic and policy advice, supported by development policy lending including SAC II and PRSC I, was instrumental in restructuring the sector. Although progress in improving financial performance has been disappointing, implementation of the overall restructuring strategy for the sector has laid the groundwork for improved performance and opened the way for investment lending. Further strengthening of sector governance is required to improve performance and attract private investment. There is a significant backlog of investment, particularly in reducing the high technical and commercial losses in the distribution systems. In addition to continued support for policy, governance and regulatory reforms through the PRSC, planned investment lending includes support for distribution and transmission, investment in hydropower (including possible largescale hydropower), and the expansion of rural access. A programmatic approach is planned, with a sequence of investment loans and guarantees to address investment priorities as implementation of the reform program proceeds. In the context of expanding rural access, there is good potential for the mobilization of Global Environment Facility (GEF) and carbon finance to support "low-carbon" growth in the sector. In developing options for affordable and sustainable provision of power in rural areas-and in particular in NWFP and Balochistan where grid penetration is currently limited-the Bank will consider alternative investment and institutional approaches to rural electrification, including options for decentralized autonomous grids. 64. During the previous CAS period, the Bank supported Pakistan's telecommunication reforms through policy dialogue and lending, including PRSC I and the Telecommunication Regulation and Privatization Support project. As a result of the reforms, sector performance has begun to improve markedly as indicated by the increase in aggregate telecommunications density (fixed and mobiles) from 4.6 telephones lines per 100 inhabitants in June 2003 to about 17.8 by December Key reforms included (i) strengthened institutional and regulatory arrangements under the Ministry of IT and Telecommunications and the Pakistan Telecommunications Authority; (ii) full liberalization of the local loop (LL) and long distance and international (LDI) markets resulting in numerous new companies providing services at competitive rates; (iii) approval of a new cellular mobile policy in January 2004 leading to licensing two new additional cellular mobile operators, rapid growth in penetration, and a dramatic reduction in prices; (iv) successful privatization of Pakistan Telecommunications Limited (PTCL) generating US$2.6 billion in proceeds and leaving the telecommunications sector fully managed 1 The Water and Power Development Authority (WAPDA) has been responsible for electricity generation, transmission, and distribution in all areas of Pakistan with the exception of Karachi, where Karachi Electricity Supply Company (KESC) has played that role. The unbundling and restructuring elements of the reform program applied to WAPDA only, as the dominant monopoly; the other elements of the reform applied to the entire industry.

30 by the private sector. IFC made a very successful investment in TRG, (a call center company), with a strong demonstration effect. 65. In spite of this success, telecommunications services fall well short of their potential compared to comparator countries. One important gap is between rural and urban users; as of March 2005 about 50% of Pakistan's 50,000 villages have no access to telecommunications services and very few villages have access to the Internet. The Bank will support over the CAS period (i) adoption of additional measures to strengthen the policy and regulatory environment, including establishing pro-competitive licensing, interconnection and tariff regimes, addressing quality of service and other consumer issues, and improving the management of limited resources such as the radio spectrum and numbers; (ii) policy dialogue and advice; and (iii) investment support for accelerating the provision of rural telecommunication infrastructure including e-services and broadband connectivity. In addition, IFC will support the expansion of services by the private sector. 66. Pakistan's transport sector is inefficient, imposing additional costs on Pakistani business and threatens to become a serious obstacle to sustained growth, as well as an impediment to achievement of the MDGs. It is estimated that this inefficiency already costs 4-6% of GDP per annum, constrains economic growth and diversification, reduces export competitiveness, and hinders social development. Key issues are: (i) poor rural mobility with 75% of all rural health, education and market facilities accessible only by earth tracks; (ii) urban congestion and inadequate public transport which are raising the cost of doing business, crowding out the urban poor, and increasing the health and safety hazards faced by passengers, pedestrians and residents; (iii) Pakistan Railways' financial and operating performance remains weak and as a result it carries barely 5% of total cargo traffic, far less than its potential; (iv) costly port systems and inadequate trade facilitation are imposing high costs and delays on shippers. 67. Reflecting the high priority assigned to supporting growth and competitiveness, the Bank and the government are in the process of developing a strategic approach to the transport sector focusing first on the National Trade Corridor linking Pakistan's major ports in the south with its major cities and trade corridors to the North. Together the ports, road and railways along this corridor handle 95 percent of external trade and 65 percent of total land freight serving the regions of the country which contribute 80-85% of GDP. Corridor utilization is more than 80% of existing capacity and projected growth will double demand by 2015, and require much higher levels of service. The objective is to develop an integrated approach to planning, investing and managing the National Trade Corridor transport logistics system. The key outcome sought would be significant reductions in the time and cost of moving goods through the Indus corridor. The GoP has already initiated reforms, reducing entry fees at Karachi port while seeking to reduce port dwell times. The Government is also targeting improved trade and transport connectivity with China, Central Asia and Western Europe as a means of promoting economic activity throughout the region and is seeking World Bank support in this endeavor. The Bank has provided and will continue to provide analytical support to develop the frameworks to guide sub-sector policies (for highways, railways, ports and trade facilitation), including pricing, regulation and enforcement, medium term budgetary frameworks, restructuring and progressive commercialization of public entities and strengthening of institutions (NHA, Pakistan Railways, etc.). An ongoing transport competitiveness study will help highlight priorities for investment lending and institutional reforms. 68. Pakistan's investment needs in transport are enormous. There is a significant maintenance backlog and current government investment in the sector is as much as 5 times less (as percent of GDP) than countries in East Asia. It is estimated that modernization of the Indus Trade Corridor alone will require investment of about US$1 billion per year over the medium term. In addition, critical road links were destroyed or damaged in the October earthquake and their repair is an urgent priority. The Bank is currently supporting rehabilitation of the national highway network through the Highways Rehabilitation Project (with additional financing to address the effects of the earthquake) and assisting in modernizing trade and transport facilitation under the Trade & Transport Facilitation Project. There is strong demand

31 from government for increased lending in the transport sector during the coming CAS period. Follow-on investment lending for highways and trade facilitation is expected along the Indus Trade Corridor with an emphasis on increasing private sector participation in operation and management. In railways, a combination of development policy lending and investment projects may be considered should the government commit to a medium term reform program to revitalize Pakistan Railways by creating a separate, professionally managed, commercial freight business with its own rolling stock and staff. In the port sector the Bank will support a move towards port corporatization and professional management combined with a modem institutional and legal framework for port operations that would open the way for investment lending to upgrade port infrastructure. 69. While the emphasis is on supporting growth, the Government also recognizes that transport, especially in rural areas is important to improving development outcomes. Surveys have shown that healthcare for all, and above-primary educational opportunities for girls are particularly hard hit by mobility constraints. During FY03-05 the Bank prepared a Rural Access and Mobility Study focusing on options for the sustainable provision of a core rural access network at the district level under the country's devolution framework. During the coming four years we will continue to explore options for providing assistance to this sub-sector including possible implementation of pilot projects through the Pakistan Poverty Alleviation Fund. 70. Support for reform and development of the oil and gas sector has been a strategic priority for the World Bank assistance program since During the last CAS, the Bank continued to provide policy advice and technical assistance supported by development policy lending (SAC II and PRSC I). Good progress has been made in the deregulation of the petroleum market, pricing and regulation of natural gas, conversion of power plants from fuel oil to natural gas, and acceleration of exploration activities. However, gas tariffs continue to be distorted by cross subsidies among different classes of consumer (particularly the very large and poorly targeted "lifeline" tariff slab and the low cost of gas for the fertilizer sector) and implementation of the gas price adjustment mechanism has been erratic. Similarly, in 2004 the government elected only partially to adjust domestic petroleum product prices to reflect international oil prices, resulting in a fiscal cost of Rs. 8 billion (US$130 million). 71. Looking ahead, a key priority is to address looming gas shortages; while all gas is currently domestically produced, given the combination of rapid growth in demand and depleting reserves, gas imports will become necessary, possibly as soon as With this in mind, the Bank will continue to provide policy and technical advice and encourage further appropriate de-regulation and privatization in the industry while helping the government to build necessary capacity to engage in international gas import transactions. Possible investment lending or guarantees would support the expansion of infrastructure for the importation, storage and distribution of gas. In addition, IFC is expected to support private participation in the oil, gas and mining sectors. 72. Pakistan's infrastructure investment needs are as high as US$3.5 billion per year, far greater than can be financed by the public sector. The Government recognizes that public-private partnerships (PPPs) can play a key role in increasing resources and improving efficiencies by helping the country access not just finance, but also managerial expertise, new technology, better project design and implementation, and more efficient use of resources. Past efforts to attract private investment, in particular in the power sector, have shown both that these investments can be realized, but also that strong oversight is needed to ensure that these are priority projects and that consumers and the government have the capacity to pay for them. 12 Regardless of sector or level of government, PPPs should be pursued where they represent priority projects, are affordable to the government and consumers, and represent value-for-money, i.e. a better approach than would be delivered through public procurement. 12 Fraser, Julia M. Lessons from the Independent Private Power Experience in Pakistan. Energy and Mining Sector Board Discussion Paper No. 14. May 2005.

32 The Bank Group will support the government's efforts to encourage PPPs through: (i) advisory support in developing the national PPP policy and, where needed, provincial policies and legal frameworks for PPPs; this would also cover strengthening oversight of the fiscal costs of PPPs; (ii) technical assistance for the development of the institutional framework (including financial and subsidy support to PPPs) and to develop pilot PPPs ready for procurement and implementation within the next months; and (iii) lending to support subsidies to address affordability issues for PPPs and for longterm finance for PPP service providers. 74. Improving access to market-based finance. Pakistan has undertaken major reforms in recent years in the financial sector that have resulted in a sound and more efficient system. A major achievement has been the transformation of a pre-dominantly state-owned and weak banking system into a healthier, market-based system, owned primarily by the private sector (nearly 80% percent of sector assets are now under private ownership compared with 34 percent in 1999, and just 8% percent in 1990). This has been facilitated by the restructuring of major banks, ongoing consolidation of the sector, strengthening of regulatory capacity, and improvements in transparency, corporate governance, and credit culture. This has helped improve access, and credit to the private sector has grown significantly over the past three years. These achievements have been endorsed by the findings of a joint Bank-IMF Financial Sector Assessment that was concluded in Despite these impressive accomplishments, important reforms remain to be done, and a large segment of the economy continues to operate with little formal credit. A significant number of financial institutions are still under government control including the National Bank of Pakistan (NBP), State Life Insurance, the largest open end mutual fund, and a few large specialized banks. The legal framework needs to be strengthened to address banking laws, the Public Debt Act, the Insurance Ordinance, as well as laws pertaining to insider trading and take over of companies, bankruptcy/insolvency, payments systems, credit information and Anti-Money Laundering. Enforcement of financial contracts remains weak pending clarification of the Financial Recoveries Ordinance While there have been extensive reforms of capital markets, under-development of contractual savings has inhibited development; insurance penetration remains very low relative to other countries at Pakistan's income level, reflecting weak consumer protection and awareness. The pension system is also weak - both civil service system and Employees Old Age Benefits Institution are fiscally unsustainable. Finally, the stock market has performed well but it remains shallow and narrow with inadequate investor protection systems. Leveraged financing of share transactions coupled with weak supervision of market intermediaries pose a threat to systemic stability. 76. During the next CAS period the Bank Group will support further financial sector reforms in the following areas: increasing the number of microcredit borrowers (especially in rural areas), restructuring and privatization of the remaining state owned financial institutions, non-bank financial companies and other specialized institutions; continuing the revision of the legislative framework to facilitate effective regulation and enforcement; aligning rates on National Savings Scheme (NSS) instruments more closely with market yields; strengthening and further deepening capital markets (including equities, bonds and swaps) with the aim of increasing the availability of longer term savings instruments, e.g. by establishing a comprehensive legal and regulatory framework for private pensions, reviewing the role and strategy for state owned insurance companies; and improving financial markets infrastructure and legal framework. New areas of involvement will include expanding financial services-consumer financing, mortgage loans, SME financing, agriculture credit-through expansion of banks' retail. Following on the recent Financial Sector Assessment and the approval of the Banking Sector Development Policy Credit, future work will center on policy dialogue, and technical assistance, particularly to provinces as well as economic and sector work on access to finance. Lending operations to support technical assistance for the State Bank of Pakistan and for capital market development will also be considered. The IFC will

33 selectively invest in the financial sector to support the development of housing finance, SME finance and microfinance, in addition to providing TA through its PEP-MENA facility. Pillar II: Strengthened Governance and Service Delivery 77. Improving government effectiveness remains a hallmark of the Government of Pakistan's reform program. As discussed earlier, inadequate and poorly targeted government spending on services and investment are only part of the problem; delivery of government services is hampered by the weak capacity and lack of accountability of service providers. Addressing these weaknesses is critical for achieving most if not all of the Government's poverty reduction goals. Far reaching reforms to improve the performance of key government institutions including financial management, tax administration, and the civil service are underway in parallel with the government's decentralization initiative. Many of these have been and will continue to be supported by the Bank Group. 78. Greater efficiency transparency and accountability in use of public resources. The government has been pursuing far-reaching reforms in public financial management since The Bank has been deeply engaged in this process and significant progress was made during FY03-05 CAS period. Under the Bank-funded Project for Improved Financial Reporting and Auditing (PIFRA), a new computerized accounting system and a new chart of accounts is being implemented nationwide. The new systems being introduced under PIFRA will eventually allow for the automated consolidation and reconciliation of all the civil accounts of the government, thereby greatly improving the timeliness, comprehensiveness, and accuracy of financial data. Legislative oversight has improved with the re-establishment of Public Accounts Committees at the federal level (a PRSC 1 prior action), as well as in the provinces. The federal Public Accounts Committee has made good progress in reviewing audit reports, and in tracking and monitoring cash recoveries from public officials in government departments and other public institutions. The Controller General of Accounts (CGA) organization has been strengthened, and the timeliness of reporting and reliability of public accounts and audit reports has improved substantially. 79. Remaining challenges include full implementation of the PIFRA system. In addition, the backlog in the review of audit reports and audited accounts remains substantial, due in large part to the poorer quality of the older audit reports that resulted in a large number of audit paragraphs being placed before the Committee. In the case of accounting, the Government needs to clarify the roles, responsibilities and reporting relationships of various players (e.g., Controller General (Accounts), Provincial Accountant Generals, District Accounts Officers and Treasury Officers) in the light of devolution. Support for these reforms will continue to be a priority. The follow-on PIFRA-2 project, which was approved in September 2005, will extend the computerization to remaining sites across the country. An IDF Grant has recently been approved to strengthen the capacity of the Public Accounts Committee at the federal level. The Bank will also work on supporting the improvement of the accounting and auditing oversight arrangements following up on the Accounting and Auditing ROSC exercise, conforming corporate accounting and auditing practices to international standards. IFC's PEP-MENA facility will launch a comprehensive corporate governance project in Pakistan to support private sector companies. 80. Building on the 2003 CFAA, the Bank will continue to provide analytical support to assist in defining the agenda for further reforms in financial management. The Bank will work with the Government and international partners (including DFID and ADB) to carry out public financial management and accountability assessments based on the PEFA PFM performance measurement framework approved in A similar exercise, using the December 2004 PEFA Consultative Draft was conducted in FY 2005 for Punjab. The assessments will be carried out at the federal and provincial levels in order to identify the strengths and remaining weaknesses in the accountability framework and provide the basis for drawing up comprehensive action plans that focus on areas most in need of action to mitigate shortcomings. The action plan will not only aim at further improving public financial management but will also support transparency, competition, value for money and controls in procurement.

34 Procurement irregularities have been a significant problem in Pakistan, in large part due to a weak regulatory framework that discouraged due diligence in contract awards and stifled open competition. Specific problems have included inadequate bidding documents, inadequate response time to bidders, prequalification as a means of restricting competition, price negotiations, lack of independent complaints handling process, and irregularities in inspections or measurements. During the CAS, the Bank will support the achievement of transparent and efficient public procurement at federal and autonomous bodies levels. The Bank will support the Government in: (i) developing a implementing regulations for the recently notified public procurement rules; (ii) developing credible complaints handling process; (iii) developing rules for the selection of consultants; (iv) introducing reporting requirements and a credible enforcement mechanism; and (v) capacity building for the Pakistan Public Procurement Regulatory Authority; and (vi) harmonizing audit and procurement procedures. Procurement will also be an integral part of the PFM Performance Measurement assessments planned during the CAS period. 82. Enhanced service delivery. The need to dramatically improve service delivery to Pakistan's citizens-with particular attention to programs in health, education, water and sanitation, and safety nets-is essential to the achievement of Pakistan's poverty reduction goals. Working across sectors, the Bank Group will continue to support reforms to increase capacity and accountability of those responsible for service delivery; empower communities and clients through enhanced access to information on finances and performance; and build the capacity of both communities and governments. 83. Improving the quality of public administration is critical for making public expenditures more effective, and for improving service delivery. While the size of the civil service in Pakistan is not problematic, improving its performance is recognized by the Government as a key challenge for improving service delivery. The key problems are: (i) systemic rigidities that make it difficult to recruit and move staff between departments as needed; (ii) compensation is insufficient to attract skilled entrants at the higher levels but may be too generous at lower levels; (iii) inadequate training which has led to an erosion in the quality of civil service and critical gaps in technical skills. Implementation of a comprehensive civil service reform is proceeding slowly, although there are very important pieces of the reform going forward. The best progress has been made on merit recruitment, training, pay and pensions and capacity building of selected government line and regulatory agencies. However, improvements in overall public service delivery require progress across a broader front in the civil service program as well as in the devolution agenda. Over the coming CAS period, the Bank will continue to support development and implementation of a long-term strategy for public sector employment, which would include: further implementation of merit-based recruitment and promotion; structural changes to support devolution; further pay and pension reforms; and continued capacity building through effective national and international training. 84. Pakistan's devolution initiative is a cornerstone of the government's strategy for improving service delivery by making the public sector more accountable to citizens and more efficient at delivering basic services. Creation of the political structure for devolution began in 2001 with the creation of a new local government structure consisting of over 6,400 new elected local governments. New local governments were sworn in following local government elections in August However, while political devolution has moved rapidly, fiscal and administrative devolution have not advanced as well, creating obstacles for local governments and weakening incentives of local government staff to improve service delivery. Local governments are also facing a number of problems linked to capacity constraints, including lack of strategic planning, poor financial management, lack of skills and finance. Decentralization reforms need to be completed through a meaningful devolution of administrative and fiscal powers and supported with capacity building assistance. This needs to include a greater share of resources going to the provinces through National Finance Commission (NFC) awards-and to the districts-through the Provincial Finance Commissions and, to a lesser extent, conditional grants;

35 reassignment of tax bases from the center to local governments (e.g. agriculture income tax); and the transfer of functions and administrative authority to local governments. Pakistan's PRSP also recognizes that devolution will not be complete until there is some transfer of responsibility from the federal to the provincial governments as well. The January 2006 Amendment to the NFC award was a positive step in this regard as it increased the provinces' share of revenues and should alleviate some of the fiscal pressures being faced by provincial and local governments. 85. The Bank has worked to support of devolution, both at the provincial and local levels, through analytical and capacity building support. A major study on progress in implementing devolution was undertaken jointly with the ADB and DfID. During the next four years, Bank support for devolution, much of which will be provided in the context of ongoing operations, will feature: (i) analytical support to assist in the rationalization and clarification of roles and responsibilities under the devolved framework; (ii) support for citizens participation through social mobilization, community driven approaches, and other mechanisms to strengthen the linkages between local governments and communities in order to increase their responsiveness and accountability; (iii) capacity building support for local governments. We will also ensure that the design of lending operations reinforces the local government system. 86. With over a third of its population living in urban areas, Pakistan is currently the most urbanized country in South Asia and urbanization growth rates are twice the rate of the overall population increase. But cities suffer from severe infrastructure bottlenecks, service deficiencies (roads, water, and waste removal), poor local governance, and distortions in land and housing markets. While the urban sector was an area of limited engagement during the previous CAS, devolution has created opportunities for deeper engagement and the Government of Pakistan has accorded greater priority to urban development with a particular focus on the "mega-cities" of Karachi and Lahore. Devolution has transferred to municipalities (Tehsil Municipal Authorities - TMAs) the responsibility for services such as water supply, sewerage, sanitation, waste collection, urban transport and land management. 87. The Bank's strategy is to assist the Government's urban reform agenda by helping to address the weaknesses in policies and administrative structures that undermine service delivery in cities. Recent analytical work has highlighted the fragmentation of service provision, weak financing and management of urban service delivery, especially water and sanitation, and dysfunctional land and housing policies. Two projects are currently being prepared. The Punjab Municipal Services Improvement Project (PMSIP) will build capacity and provide for grants for investments to improve service delivery in the smaller municipalities of the Punjab Province. The Punjab Large Cities Development Policy Loan (DPL) will support implementation of reforms to improve the functioning of the Punjab's seven large cities. Reforms will focus on four broad areas: (i) governance and institutional reform; (ii) municipal finance and service delivery; (iii) urban planning and land management; and (iv) urban transport. The Bank is also conducting economic and sector work to help shape our future involvement in the urban sector. With the support of PPIAF/GPOBA financing, the Bank is undertaking a detailed study of eight major cities in Punjab to investigate options for improving the efficiency of WSS service providers. A variety of alternatives are being considered, including public-private contractual mechanisms (management contract, concession), financial incentives, and regulatory reform with possible downstream Bank and IFC project financing. A similar investigation of solid waste management issues is also underway. Finally, building on preliminary work carried out with the support of the Italian Government through the Italian Trust Fund for Culture and Sustainable Development, the Bank will support development of Pakistan's cultural heritage and tourism. 88. Experience in Pakistan has shown that there is considerable potential for improving access to and quality of public services through the adoption of alternative service arrangements and by empowering communities to monitor providers and influence resource allocation. In health, Pakistan has begun to experiment with contracting of public services to private providers to circumvent weak administrative capacity of the public sector and expand coverage. Initial results of contracting out management of

36 primary health facilities in twelve districts of Punjab to an NGO (the Punjab Rural Support Program) indicates significant improvement in utilization of services. The Punjab education program has begun to expand public-private partnerships to tap into low cost private schools while strengthening School Councils to increase parental involvement and influence. In Balochistan, the planned Primary Education Project will focus on strengthening community-run schools. During the CAS we will continue to pilot and scale up such initiatives. 89. Policy makers have also fostered private provision of services in Pakistan in order to allow greater provider choice (and competition) to the population, and this has enabled the better off (but also the poor) to bypass the low quality public system. In education, the private sector has already demonstrated its potential with private schools accounting for a growing share of total enrolments, in many cases with higher quality and lower costs than government schools. However, private sector providers need to be held accountable to particular standards (e.g., in education) and may need to be regulated (e.g., in the case of health). Pillar III: Improved Lives and Protection of the Vulnerable 90. During the next 5 to 10 years, in addition to the measures outlined below, improving social indicators is likely to require strong economic growth, effective public sector management, a motivated and well managed civil service, increased pro-poor spending and more effective allocation of resources. At the same time increased investment in human capital leading to significant improvements in education and health will be necessary to build the skilled, healthy work force necessary to sustain recent growth performance. Improved delivery of health and education services 91. The achievement of universal primary education, with a particular emphasis on promoting girls' schooling, has been a government priority since the early 1990s. Resources for education have increased by over 60% over the past four years and a range of programs to increase enrolments, especially for girls, have been put in place. These efforts appear to be starting to bear fruit; preliminary results of a national household survey are encouraging and show an increase in the net primary enrolment rate from 42% in 2001/02 to 52% in 2004/05. Nevertheless, meeting Pakistan's goal of increasing the net primary enrolment rate to 100% by 2015 remains a major challenge. The issues affecting the performance of the sector include inadequate resources, systemic weaknesses in public service delivery including overcentralization and weak public sector management, and poor performance of the education system in terms of access, governance and quality. 92. Reflecting the lessons of the Social Action Program of the 1990s and the requirements of devolution, the Bank strategy has focused efforts at the provincial level using development policy credits to support policy and systemic changes as well as the other areas linked to education reform including decentralization and governance reforms. Under the Punjab Education program the Bank is supporting free tuition and books, upgrading school facilities, stipends for girls in backward areas and public funding of the rapidly growing non-government-independent low-cost private-education sector. Results so far have been promising. The Bank will continue to support these reforms through education development policy credits in Punjab with annual tranches linked to outcomes; annual Development Policy Credits in other provinces, beginning in NWFP, with a special focus on education; and investment projects for regions where sector investment projects are a more viable option such as Balochistan. Gradually the focus of reforms will shift from primary to higher levels of education. 93. At the national level, policy dialogue on financing, governance, demand side interventions, improvements in quality of learning, inclusive education for the disabled, and service delivery issues, will be backed by analytical work, including an education sector review and evaluations of the impact of

37 -29- different education sector reforms and policies. Annual PRSCs will continue to support reform in education. The ongoing National Education Assessment System (NEAS) project will develop a baseline and monitoring system for measurement of learning outcomes. We will also provide advice and technical support to the government's vocational/technical and higher education reforms which are needed to provide the skilled labor force needed to support sustained growth. 94. Given its far-reaching importance for reaching all of the MDGs, gender equity in education will remain a high priority. Building on the findings of the recent Gender Assessment, the Bank will assist the government in developing strategies to address gender gaps in education. Recent analysis suggests that the practice of restricted female mobility plays a large role in perpetuating gender gaps in school enrollments. As a result, school attendance for girls is very sensitive to school proximity. Girls are much more likely to attend school if a school is available within the settlement they reside in. This sensitivity to school proximity worsens as girls grow into adolescence. Qualitative studies suggest that concerns over safety and norms of female seclusion are the primary factors behind the precipitous drop in enrollment beyond age 12. This concern is also evident in the rising expenditure on transportation to school reported for older girls. A similar concern makes it difficult to attract female teachers to schools in remote areas. 95. While Pakistan has made Table 6: Selected Health Indicators some progress in improving health Fertility Infant Child Maternal outcomes for the poor, the pace has rate 2003 Mortality Mortality mortality been slow. Poor health outcomes and high fertility remain obstacles to Pakistan economic growth and contribute Bangladesh significantly to high levels of poverty. India In particular reducing fertility rates SriLanka would contribute to: (i) improved Sources: World Development Indicators (2005), except MM: WHR women's health and reduced overall maternal mortality by reducing the number of high order births; (ii) reduced infant mortality rates by increasing the time between births; (iii) helping empower women by providing them choices about when and how many children to have; and (iv) providing a necessary condition for sustained and rapid economic growth. Recent research has found quite a large impact on economic growth from lower dependency ratios brought about by lower adult mortality and fertility rates. There is a continuing burden of malnutrition and increasing burden of hepatitis infections. Utilization of essential maternal health services is low, especially in rural areas. Pakistan also faces a real threat from AIDS; recent assessments found HIV epidemic among certain populations; for example, 27% of injecting drug users and 7% of male sex workers in Karachi were found to be HIV-positive. The government is committed to increasing public health expenditure and has taken steps in that direction but the overall strategic allocation of public resources should be focused towards achieving better health for the poor and addressing the most urgent priorities, such as maternal and child health. In addition key constraints to effective utilization of increased resources include: (i) limited management capacity; (ii) lack of high quality data and program impact evaluation for decision making; (iii) lack of a well-developed human resource development strategy; (iv) inadequate use of the private sector for national goals; (v) lack of focus on quality of care; and (vi) lack of clarity on the roles and responsibilities of the three levels of government. 96. During the past three years, IDA lending to the health sector consisted of an H /AIDS Prevention Project and US$41 million to support polio eradication. Multi-sectoral policy-based loans (a PRSC and provincial structural adjustment credits) have supported HNP policy reforms as well. Recent analytical work has highlighted the potential for public-private partnerships (e.g. contracting with NGOs to deliver services) to improve basic health services. For example, one district in the Punjab (Rahim Yar Khan) contracted the management of its 104 health units to an NGO and witnessed a doubling in the number of outpatient visits and increased client satisfaction. Such successful efforts must be scaled up.

38 Looking ahead, at the national level, the Bank will concentrate on: (i) encouraging the Government to focus on public health functions (such as surveillance, quality control, monitoring and evaluation, and public information), through analytical support and national level development policy lending; (ii) supporting the development and implementation of program and management reforms in the Lady Health Worker program as a way of expanding access to primary health care and family planning; (iii) supporting increases in overall health expenditures as envisioned in the PRSP; and (iv) supporting the piloting and evaluation of new approaches for service delivery and demand side interventions. Recognizing that a major focus of efforts must be at the provincial and local level, we will support major system reforms through planned provincial Development Policy Credits, beginning in NWFP. Initially, the focus of these credits will be on increasing access and coverage of maternal health services, improving the functioning and utilization of first level care facilities, and targeting underserved areas. Overall, Bank lending and analytical support in health will be guided by the following principles: (i) a focus on the poor and underserved areas; (ii) promoting testing and rigorous evaluation of innovations by local governments; (iii) increased accountability, particularly at the district level; and (iv) increased integration of services at the grassroots level. 98. Improving the health outcomes of the poor will also depend on complementary interventions outside of the health sector. Recent research has highlighted the strong effects on infant and child mortality from improved maternal education and basic infrastructure services, such as access to sanitation, piped water, clean cooking fuels and electricity. The Government has recently announced a major initiative to expand access to clean water by building water treatment facilities at the local level. In light of this, water supply and sanitation will continue to feature in the Bank's lending and analytical work, in both the urban sector and through support for community infrastructure, especially in rural areas. 99. Current analytical work on the health and economic costs associated with air and water pollution has confirmed the high impacts, with losses estimated to be more than 2% of GDP. The Bank is deepening its engagement with the Government on environmental management to address these issues. The recently approved National Environment Policy provides the framework and the Bank is supporting the Government at federal and provincial levels in the identification and preparation of priority interventions. Key areas for action in relation to health issues will be urban air quality in the major cities, protection of water supplies and management of increasing amounts of industrial and hazardous waste. Reducing vulnerability and poverty through effective safety nets and targeted programs to reach the poor 100. The PRSP recognizes that protection for the poor and vulnerable is a cornerstone of any poverty reduction program and Pakistan has a range of programs which aim to improve the welfare of the poor and vulnerable including microfinance, old age security, public works, cash and in-kind transfers, and programs for child laborers, the disabled, and other highly vulnerable groups. However, these programs are severely under-funded, covering only a very small fraction of the poor and vulnerable (see Table 7 for details). Total spending is equivalent to 0.5% of GDP, substantially lower than the levels found in other developing countries. Moreover, there are severe shortcomings in the existing safety net programs: (i) there is no program (such as workfare) to help the rural poor cope with chronic or seasonal underemployment; (ii) formal social security covers only the small minority employed in the formal sector; (iii) existing programs do too little to protect the human capital of the vulnerable--efforts to use safety net measures to support health, nutrition, and education of the poor are in their infancy; and (iv) the size of benefits is often negligible. Other issues include the weak administration, targeting, and delivery mechanisms, lack of coordination between agencies, and poor monitoring and evaluation.

39 The Bank's Table 7: Public Spending on Select Safety Net Programs assistance for assitane social soialbudget fo / spending Number of protection will include (in Rs. Billion) Beneficiaries support for safety nets Wheat subsidy 8.00 (untargeted) that (i) help the chronic Bait-ul-Mal (Food Support and other) ,250,000 poor (e.g. widows, Tawana (mid-day meals for girl students) ,000 disabled, and the elderly Zakat (cash transfers and other) ,733,000 with no means of Employees Old Age Benefits (EOBI) ,000 livelihood) cope with Total ,363,000 poverty, and, where possible, (ii) help the poor escape poverty, e.g., via conditional cash transfers and other demand side interventions, (e.g., inclusive education) aimed at increasing access to basic social services for the poor and marginalized; and (iii) help families and individuals cope with seasonal shocks and natural disasters (e.g., via workfare). We will also provide support for social security which helps mitigate risks, via improving formal sector pensions, and consider innovative approaches to microinsurance to address life cycle risks. Building on ongoing analytical work and policy dialogue, the Bank is helping the government develop a comprehensive social protection strategy to guide policy reform in this area over the medium and long term. Reforms will be supported through the PRSCs, a stand alone Social Protection operation, support for persons with disabilities in the earthquake affected areas as well as social protection components in provincial DPCs and emergency operations. Technical assistance will include support for strategy development, design of new social protection interventions (workfare, demand-side incentives for health and education, etc), program implementation, e.g. improved targeting methods, administration, and evaluation. The Bank will also broaden its work on pensions to cover oldage security mechanisms in their entirety, and continue and deepen its work on inclusive education that seeks to mainstream disability in the education sector Pakistan's PRSP recognizes that while rapid growth will be the main driver of poverty reduction, targeted interventions and community-based approaches to rural development are also required to address the immediate needs of the poor and vulnerable, especially in drought prone and flood stricken areas and help them share in economic growth. The Bank is supporting the Government through a series of analytical and advisory services in the definition of a rural development strategy that would look in an integrated way at farm and non-farm opportunities as well as policy and institutional issues. The Government has announced a major increase in its pro-poor public works program and has asked for Bank's support for the continuation of a drought/flood assistance program (DERA). The Bank will continue to support implementation of the Community Investment Program in NWFP and AK and look for possible expansion and replication opportunities. A major focus of these efforts will be to strengthen the partnership between communities and local governments by supporting citizen participation in identifying priorities for public investment and by building the capacity of local governments. At the same time, the Bank would support the Government's newly announced program for rural poverty alleviation through social mobilization. Such program would be critical in fostering organizations of the poor and their access to income generating activities as well as in enhancing accountability mechanisms and the effectiveness of Government programs. These investments yield not only better project outcome but also help in the longer term to build communities that are better organized and in control of their own development. The Bank will seek to build on the successful experience of the Pakistan Poverty Alleviation Fund (PPAF) which has already reached 6,500 communities through micro-credit and community driven physical infrastructure projects. The experience of the PPAF has also shown that the impact of targeted interventions is enhanced through up-front investments in social capital formation that build ownership and increase sustainability.

40 Reducing Pakistan's Vulnerability to Natural Disasters 103. The Government, with support from the international community has responded capably to the October earthquake and its aftermath. The Army, with support from UN agencies and bilateral donors, led a massive and largely successful relief campaign to provide shelter and food for the displaced. Despite the extremely difficult conditions with many affectees in inaccessible regions subject to severe winter a feared "second disaster" of mass freezing and starvation did not materialize. By mid-february the government had managed to provide immediate cash relief to some 543,000 households (over 90 percent of those declared eligible), with payments made through individual bank accounts to reduce potential for leakage. Arrangements for assisting households with housing reconstruction are progressing with government partnering with local NGOs to mobilize assistance and inspection teams to administer relief and provide technical support. Reconstruction of major highways commenced in mid-march with the onset of favorable weather. Donors pledged a total of US$6.5 billion at the November 19th donor's conference. Of this total, US$3.1 billion has been committed and US$1 billion disbursed as of mid- February. A key challenge now is to complete institutional arrangements linking The Earthquake Reconstruction and Rehabilitation Authority (ERRA) with local and provincial governments and to complete detailed reconstruction strategies in some sectors, particularly for education, health and public administration The October earthquake highlighted the vulnerability of the poor to natural disasters and the importance of hazard risk management. This is an issue of continuing concern since in addition to being in an earthquake prone area, Pakistan frequently experiences weather-related hazards, resulting in significant economic losses from localized and seasonal floods, landslides and droughts. Pakistan has been identified as being among the more vulnerable countries in the world on the basis of mortality and economic risks induced by such hazards. " Lack of enforcement of building codes, unsafe land use patterns, and poor construction practices contribute to high economic and human losses. To address such issues, hazard prevention and mitigation strategies are relevant and integral to Pakistan's national development framework Effective hazard risk management should be mainstreamed as part of Pakistan's poverty reduction strategy with the purpose of reducing future losses of lives and livelihoods, protecting infrastructure and investments and promoting a stable foundation for private sector investment. At present, Pakistan has an ad hoc approach to hazard risk management. Interventions are primarily focused on relief and response with insufficient ex ante mitigation measures. Given its social and economic vulnerability to natural disasters, it is essential that Pakistan improve its approach to hazard risk management. Following the relief period, Pakistan needs to develop a strategic approach to hazard risk management based on five key pillars: risk identification, risk reduction, capacity building, emergency preparedness, and risk transfer mechanisms, to achieve a sustainable recovery program and build in-country capacity for hazard risk management. Beginning with the ongoing Emergency Recovery Credit the Bank will assist in the process of developing Pakistan's hazard risk management strategy. The Bank plans to continue to work with government and other partners to develop the capacity to carry out this strategy and to integrate risk management into development programs. 13 Dilley, Maxx and others Natural Disaster Hotspots: A Global Risk Analysis. Washington, D.C: The World Bank.

41 IV. DELIVERING THE WORLD BANK GROUP PROGRAM A. The World Bank Program Portfolio management strategy 106. The key to maintaining strong portfolio performance will be continued attention to good quality at entry and timely attention to implementation issues through joint portfolio monitoring. The planned increase in investment lending, especially in large-scale infrastructure projects, will pose a challenge in sustaining current good portfolio performance. To meet this challenge we will continue to closely scrutinize new lending and apply "readiness filters," screening new projects for ownership, adequacy of institutional and policy frameworks, and implementation capacity. This is being reinforced by Regional management by requiring a formal "decision meeting" prior to project appraisal in order to institutionalize a formal review of project readiness. For projects that have already been approved, we will jointly establish with the GOP key portfolio indicators for each year (e.g., portfolio riskiness; disbursement etc.) which will be jointly monitored on a regular basis. Quarterly joint portfolio review meetings will continue to serve as a forum for discussing portfolio performance and for elevating and resolving project issues. The CAS results framework will also serve as the foundation for monitoring the portfolio for outcomes. Starting in FY07, we will undertake a yearly joint review of progress in achieving CAS outcomes and adjust the lending and AAA programs accordingly Portfolio Fiduciary Risk Management. Taking into account the result of reforms implemented over the past five years, including recommendations from the CFAA and provincial financial accountability reviews and implementation of PIFRA, overall Bank portfolio fiduciary risk has fallen from an average rating of 'substantial to high' during the CAS to an average of 'moderate to substantial'. The strategy for managing this risk will emphasize project design and capacity building. Projects will be designed with increased participation of beneficiaries in projects (e.g., CDD projects and enhancing the role of school management committees in education projects) and generation and public dissemination of project performance information including information generated through third party validation exercises. Project readiness filters will include assessment of the adequacy of fiduciary arrangements. A risk-based approach to financial management and procurement will guide the Bank's fiduciary team, both in project design and supervision. Intensive supervision and enhanced procurement arrangements will be put in place in selected projects where fiduciary risks are deemed to be highest Continued strengthening of government financial management and audit capabilities will be a key element of the strategy. The Bank recognizes the Supreme Audit Institution (Office of the Auditor General of Pakistan) as the independent auditor for Bank-financed operations implemented by most government entities. 14 Bank financing is fully integrated into federal and provincial budgets and disbursements for Bank-financed operations flow through the State Bank of Pakistan to the nominated account of the projects and programs to ensure that Bank funds are accounted as part of the overall funds flow of the Government. Successful roll-out of PIFRA to the provinces will enable the timely preparation of reliable and comprehensive financial reports as well as timely, high quality audits, not just for Bank projects but also for the entire government. We will also continue to work with government to strengthen procurement practices at the federal and provincial level (see paras ). Supporting the improvement of country systems and the overall control environment will support planned development policy lending and enable mainstreaming of investment lending operations using government PFM systems. While over 90% of project financial statements are received on time, due to uneven quality of presentation and content of the statements, about 25% of the statements are unacceptable at first submission. Capacity 14 Bank-financed projects that are implemented by corporatized entities are audited by independent firms of Chartered Accountants whose acceptability will continue to be assessed by the Bank on a case-by-case basis.

42 building of project financial management teams in financial reporting will therefore also be an important area of Bank intervention during the CAS. FY05-09 lending scenarios and triggers 109. IBRD/IDA Lending. As indicated above, Pakistan's demand for World Bank financial support has grown to meet the needs of its growth and poverty reduction strategy and to address the impact of the October earthquake. To meet this demand a flexible IBRD/IDA lending program of up to US$6.5 billion (approximately US$3.1 billion IDA and US$3.4 billion IBRD) is proposed in order to support implementation of the PRSP."s In light of the extraordinary demands posed by the earthquake and the need to protect implementation of the PRSP program, the Government of Pakistan is seeking additional concessional financing from the donor community. The proposed program is consistent with Pakistan's financing requirements, IDA allocation, debt management strategy, and the Bank's exposure guidelines IDA will account for about half of Bank Group support to Pakistan. Pakistan's IDA allocation has been increased under IDA 14, with the three-year envelope set at SDR 1.5 billion (equivalent to about US$725 million per year). In addition Pakistan will have access to additional IDA on hard terms estimated at SDR 130 million. 6 Annual IDA availability is therefore expected to be in the range of an average of $785 million per year. It is expected that the full IDA allocation would be utilized provided Pakistan continues to maintain a policy environment conducive to growth and PRSP implementation while making further progress in implementing reforms. A dramatic deterioration in performance including, for example, failure to maintain a sound macroeconomic framework, reversal of governance reforms in public financial management and procurement, and inappropriate reductions in poverty-related expenditure would warrant a review of the overall strategy and could preclude full utilization of the IDA 14 allocation. In assessing performance, the Bank will focus on progress in achieving key outcomes tied to PRSP reforms and CAS program priorities Priorities for IDA resources include support for second generation structural reforms to facilitate private sector growth, improve governance and continue to expand PRSP-related expenditures. In addition, the demands placed on IDA have risen dramatically as a result of the October 8 earthquake with incremental IDA commitments of $740 million already approved. As a result, utilization of IDA will be front loaded; over half of the three year IDA allocation will be committed by end-fyo6 and the full IDA allocation could be exhausted by end FY-07. Other priorities for IDA support include support for policy reforms and institution building to help reach MDG targets as well as financing for pro-poor targeted programs such as micro-credit, social protection and community-driven infrastructure. Annual Poverty Reduction Support Credits will serve as the foundation of our support for PRSP implementation at the national level. These will be complemented by development policy lending for the provinces to support service delivery and improve human development outcomes. IDA will also continue to be used to finance governance-related institution building (tax administration, financial management, land administration) The scale of IBRD financial support will be determined by the strength of the GoP's policy performance and macroeconomic management. Continued good policy performance and sound macroeconomic management leading to continued improvements in IBRD creditworthiness would form the basis for IBRD lending of up to $400 million per year, of which no more than $200 million would be in the form of development policy loans. The upper bound of the proposed IBRD lending range for FYO6-09 is $3.4 billion of which up to $1.3 billion of IBRD lending could take the form of development policy loans. Annual lending could increase to as much as $1 billion per year with up to $500 million in 1 Four-year IDA access is estimated on the basis of IDA 14 allocation. 16 IDA hard-term lending allocations are additional to regular allocations under IDA14. The hard-term IDA allocation for Pakistan in FY06 is SDR 62 million. The allocation for FYO7/08 is indicative and subject to change based on implementation of the IDA 14 grant component.

43 DPLs within this envelope. Reaching this upper bound would take place only in the context of strong performance as demonstrated by reaching the key benchmarks set forth in Table 8. In the event of policy reversals resulting in the macroeconomic framework going off-track, the Bank would seek to limit its exposure by suspending IBRD lending. Although recent macroeconomic performance has been good, rising inflation, earthquake-related increases in the fiscal deficit, and a growing current account deficit reflect increased pressure and the need for continued vigilance. Table 8: Key Policy Performance Benchmarks for IBRD Lending Lending IBRD lending up to $1.6 billion Total IBRD lending up to $3.4 billion ($400 million per year) (up to $1 billion per year) * Maintenance of a sound macroeconomic framework and no e Continued improvement in fiscal substantial decline in fiscal discipline. performance and debt management as Macroeconomic [as demonstrated by public debt to demonstrated by achieving in each Management and GDP ratio at or below FY05 level and year all targets for the revenue deficit Debt Reduction foreign exchange reserves equivalent and debt reduction in the Fiscal to at least 3 months offollowing fiscal Responsibility and Debt Limitation year's projected imports of Goods and Act of Non actor Services] No substantial deterioration in the * Continued improvement in the Promoting business environment, business environment t ahrough [as evidenced by no substantial movesby enn privatehsectorb toward protectionist or interventionist a t b governmin ofefsl or reversal offinancial sector Rpolicies legstions and e mpoimtiont reforms] ervices] * Implementation of modernized " Continued conmmitment to financial accounting and auditing systems Promotcapturing 65% of the federation's aeene expenditure budget by June 2007 and Governance 80% by June 2009 Notification t of regulations to support implementation of the national procurement rules. * Satisfactory implementation of national procurement rules to reduce procurement irregularities The level of IBRD lending will also reflect the extent to which sectoral policies and governance arrangements are conducive to effective Bank engagement. The Government of Pakistan's priorities for IBRcD financing are in infrastructure, primarily water, power, transport and urban development. In each of these areas the viability of investment lending will depend on the establishment of a policy environment conducive to project implementation and to the achievement of targeted outcomes. In some cases, the conditions necessary for increased lending have already been met while in others key policy actions are required before expanded investment lending can take place. Reaching the upper end of the proposed lending range would require strong progress across the board in implementing the sector reforms necessary to ensure that IBRD investments lead to the achievement of GAS outcomes. Annex 7 summarizes key sector reforms that would serve as indicators to guide IBRD lending Actual lending amounts will also depend on the ability to prepare high quality operations as well as continued satisfactory portfolio performance. As indicated in the GAS Progress Report, work has already begun to meet the demand for stepped-up IBRD support and the pipeline of IBRD projects is growing. Nevertheless, given the fact that this new lending is in sectors where Bank has lending has been limited in the recent past, the scale-up will take some time. At present, with concerted effort on the part of both the Bank and GoP counterparts, we expect IBRD lending to reach US$850 million in FY07.

44 However, reaching this level would require a considerably strengthened pace of project preparation and strong implementation capacity The level of policy based lending will depend on several factors. Continued sound macroeconomic management will continue to be a pre-condition for development policy lending as will satisfactory implementation of PRSP reforms. Similarly, development policy operations at the province level will take place in the context of fiscal and financial management reforms aimed at increasing fiscal space and ensuring sustainability of reform programs. Within the context of a sound macroeconomic environment, the use of DPOs will be driven primarily by the appropriateness of the DPO instrument vis- A-vis alternatives (see para. 45). In addition, the share of IDA-funded development policy lending in the overall IDA lending program will be managed in the context of commitments on the Bank-wide share of policy-based lending under the IDA 14 agreement Due to its rapid economic turnaround, Pakistan is far more creditworthy than at the time of the last CAS. Total government debt outstanding is 61 percent of GDP in 2004/05 (compared with 74 percent in 2002/03) and is projected to decrease to 47 percent by 2008/09. Debt service has fallen from 26 percent of exports of goods and services in 2002/03 to 15 percent in 2004/05. Recent debt sustainability analysis suggests that public and external debt are projected to continue to decline over the medium term and sensitivity analysis indicates that this downward trend is not likely to deteriorate significantly under a variety of shocks to the baseline scenario. Pakistan's improved creditworthiness is also reflected in improved ratings on its sovereign bonds (Table 9), although the country's rating remains several grades below minimum investment grade. The Government of Pakistan's first Table 9: Pakistan Credit Rating by Standard & Poor's international Islamic 'Sukuk' bond Local Currency Foreign Currency offering (this is the GoP's second Date Sovereign Credit Sovereign Credit bond offering, following last year's Rating Rating Eurobond US$500 million issue) JulY 9, 1999 B/Stable/B SDNM/SD attracted subscriptions worth US$1.2 Dec.21,1999 B+/Stable/B B-/Stable/B billion for a bond issue of US$600 Dec.12,2002 BB-/Stable/B B/Stable/B million on January 18, TheBB-/Positive/B B/Positive/B authorities have also indicated that Sou. Sa r & PorS. they intend to initiate further bond offerings on an annual basis IBRD lending of up to the maximum of US$3.4 billion over the FY06-09 GAS period would increase total 11BRD exposure to Pakistan from the current US$2.5 billion, or 2.3% of the portfolio to US$3.3 billion in FY10, about 3% of the IBRD portfolio. Bank Group exposure guidelines limit the ratio of IBRD debt service to public debt service to no more than 20%, and the ratio of IBRD debt service to exports of goods and services to no more than 4%. Even if total IBRD lending reaches US$3.4 billion over the CAS period-the upper end of the proposed range-neither of these limits would be breached. Pakistan does have a high share of external debt owed to preferred creditors and the preferred credit ratio (debt service to preferred creditors as a percent of total public debt service) is above the 35% recommended by IBRD exposure guidelines. But this risk is mitigated by bilateral debt rescheduling and Pakistan's debt reduction strategy which has emphasized the retirement of expensive short term debt and increased reliance on multilateral concessional debt, including IDA. In combination these factors have served to reduce both the stock of external public debt and the associated debt service.

45 Table 10: Maximum Projected IBRD Exposure Projected FY05 FY06 FY07 FY08 FY09 FY10* IBRD Debt Disbursed and Outstanding 2,464 2,149 2,192 2,571 2,835 3,293 Preferred creditor ratio Share of Total IBRD Portfolio (%) IBRD Debt Service as % of Total Debt Service IBRD Debt Service as % of Exports of GNFS * FY10 Exposure projected on the basis of continued lending at the upper end of the FYO6-09 CAS lending range. Knowledge Services: AAA and Building Capacity 118. AAA and capacity building will be integral to the Bank Group program. Consistent with our focus on outcomes, ESW and TA will be programmed on the basis of their contribution to achieving CAS outcomes, recognizing that knowledge transfer, often without financing, can be instrumental in achieving results. The AAA program will also provide the analytical underpinning of the lending program. Based on the FY04 QAG review of the Pakistan AAA program, we will invest more in dissemination and outreach. Table 11: AAA - Indicative Key Outputs by CAS Theme FY06 FY07 FY08 FY09 Sustained Growth * Sindh Economic * Balochistan Economic * Banking Sector a Access to Finance and Improved Report Report NLTA * Skill Competitiveness * Growth and Export * Investment Climate * Development Development & Competitiveness Assessment Policy Review Labor Market TA * Rural Development * Poverty Update * PPP for Agric. Report * Tax Policy Study Technology and * Transport Services Competitiveness Strengthened * Provincial * Monitoring and * Land Market * Statistical Governance and Procurement Evaluation NLTA Administration Strengthening TA Service Delivery Assessment NLTA * Urban NLTA * Devolution TA * Civil Service Pension Report Improved Lives * Safety Net Report * Public-Private * Education Sector * Education TA and Protection of Partnerships in Review the Vulnerable Education * Pension Reform * Health Sector Review NLTA Crosscutting/Core * Strategic Country * Integrated Public * Poverty Diagnostic Environment Financial Assessment Assessment Management and Accountability Assessments (CFAA/CPAR/P ER) 119. Based on the lessons learned in implementing the last CAS as well as the recommendations of the CAE, the FYO6-09 CAS has been designed with greater emphasis on capacity building and ensuring that capacity constraints are adequately addressed in project design. The Public Sector Capacity Building

46 project, approved in May 2004, is revitalizing civil service training and building the capacity of key ministries and regulatory agencies that are in the forefront of design, implementation and monitoring of reforms. With the designation of Pakistan as a focus country, the World Bank Institute will also play a greater role in building capacity in support of operations. For example WBI has provided training in municipal management feeding directly into the capacity building component of the Punjab Municipal Services project. The partnership between WBI and country operations has been strengthened with the appointment of regional coordinator located in Dehli. WBI activities are expected to focus primarily on governance, including decentralization, urban management and parliamentary oversight of spending At the project level, projects will have a stronger emphasis on building institutional capacity. Projects will be designed with capacity issues in mind and capacity considerations will play a greater role in appraisal of projects' readiness with an explicit requirement that projects not proceed to negotiation unless institutional issues are resolved and project management capacity is in place. The proposed guidelines for IBRD lending address capacity constraints as well as policy reforms and therefore will help serve as a "capacity filter" for judging project readiness. Capacity building will also increasingly be incorporated in project design with provision for associated technical assistance included in projects. Country Financing Parameters 121. The country financing parameters pursuant to the Bank's policy OP-BP 6.00, Bank Financing were established in November 2004, and reviewed during the preparation of this CAS (see Annex IV). This framework allows the Bank to finance expenditures needed to meet the development objectives of the operations it supports within a framework that addresses country risks related to fiscal sustainability and appropriate use of Bank resources. The policy has added flexibility in the use of Bank financing for a number of expenditures. To implement this policy, the Bank and Government have agreed upon country financing parameters for Pakistan. Under these financing policy parameters, the Government of Pakistan will have flexibility in allocation and management of resources in the following areas: overall cost sharing; local cost financing; recurrent expenditures; and financing of taxes and duties. Application of the policy is not expected to have an adverse impact on fiscal sustainability. The above policy is based the Government's five-year track record of stable and prudent fiscal management and debt reduction coupled with a sound medium term fiscal framework, approval of a Fiscal Responsibility and Debt Limitation Bill, and commitment to implement its development program with all donor assistance fully integrated into the budget The financing parameters for cost sharing, local and recurrent costs, and taxes and duties will be applied on a project-by-project basis, depending upon the type of operation, to ensure efficient implementation and sustainability after project closure. This will not impact the overall cost sharing of the Bank, and the magnitude of financing in any individual project would be limited by the total available IDA and IBRD resource envelope; the flexible financing arrangements in some projects will be offset by other projects, depending upon the nature, type and sectoral intervention. Periodically, the financing parameters and cost sharing for individual projects, will be reviewed with the Government and the Bank to ensure that overall Bank financing remains within the total IDA/IBRD envelope and funding is consistent with the Government's PRSP and availability of local resources. Details can be found in Annex IV. B. The IFC Program 123. Over the last CAS period, IFC helped existing clients to restructure and strengthen their financial position and provided financing for new projects in infrastructure, manufacturing, and the financial sector to support small and medium enterprises (SMEs). IFC committed a total of US$187 million in 16 projects in Pakistan from FY03 to FY05. IFC's committed portfolio in the country as of July 31, 2005 was US$314 million in 32 companies, including US$62 million in equity. The largest exposure is in the power

47 sector, representing 37% of the portfolio in five independent power producer (IPP) projects, with the remaining portfolio spread across the financial and industrial sectors During the previous CAS period, local banks became active providers of longer term financing at competitive rates, driven by strong liquidity inflows and the increased efficiency of the recently privatized commercial banks. The business environment in the country also benefited from recent government private sector policies (visible in the improvements in the Doing Business indicators), which have spurred investment activity. Therefore, IFC was selective in its investments during this period and did not compete with local banks In the upcoming CAS period, IFC will be increasing its investment with the target range of US$ million for the period. IFC will also explore opportunities in pre-privatization investment. It furthermore plans to make more equity investment and intends to be a catalyst for and mobilize private equity in the country. In addition EFC will increase technical assistance (TA) activity in Pakistan. IFC activity will focus on three main sectors; financial, SME and infrastructure. With the recent creation of Private Enterprise Partnership for Middle East and North Africa region (PEP-MENA), EFC has initiated a substantial TA program in Pakistan to build capacity and address constraints of the SME, infrastructure and financial sectors In the financial sector, opportunities include: microfinance; SME lending; support for recently privatized banks and those expected to consolidate; and long term lending and securitization for housing finance. IFC will also continue to support the expansion of trade finance for SMEs, and expansion of the asset management sector where it has played a pioneering role in the country. TA will complement the investment program. PEP-MENA will focus on strengthening financial markets and on expanding access to finance for micro, small and medium-sized enterprises, improving corporate governance practices, and expanding access to affordable housing for low and middle-income citizens. PEP-MENA will launch a training and advisory project for the housing sector and will work with individual banks to improve internal credit and risk systems, policies and procedures to promote affordable housing finance IFC expects to support innovative financing to promote funding to SMEs from local banks and to help meet the funding needs of SMEs, specifically in health and education. To help enhance the country's business enabling environment, PEP-MENA is supporting commercial dispute settlement through its alternative dispute resolution (ADR)/mediation pilot project in Karachi. The project will establish a pilot mediation center for SMEs to provide training on mediation for judges, lawyers and the private sector. It is expected that the pilot will result in a decline in court litigation, which is particularly burdensome for SMEs, and could eventually be replicated in other provinces. PEP-MENA is also providing support to business membership organizations (BMOs) to improve services and support to their SME members. PEP-MENA will also launch its business management training tool, Business Edge, in Pakistan to support business development service providers through train-the-trainer workshops. This management training tool is to provide SMEs greater access to business development, management training and advice IFC intends to increase its investments in infrastructure and housing finance activities in order to address financing gaps in these sectors. In the infrastructure sector, the country is addressing constraints in power generation and distribution. IFC is developing a number of investment proposals to address these challenges. IFC is pursuing opportunities to further develop the country's natural gas resources, where clients value IFC's political risk mitigation. In addition, IFC lending and advisory services are expected to support the expansion of the private telecom industry, which is growing strongly after the privatization of Pakistan Telecommunications Limited (PTCL) and after the rapid expansion in mobile telephony and value added telecommunication services As to the development of housing finance sector, a key driver for stimulating the growth in the mortgage market would be for originators to have access to long term local currency financing. This

48 would be led by the development of the local capital market, via securitizations and other capital market instruments, which mobilize domestic capital to support funding for mortgage finance. Some legal and regulatory framework needs to be changed to ensure that the environment for securitization is enhanced. PEP-MENA is exploring ways to support the GoP to enhance the legal regulatory framework. IFC will explore ways to support pilot securitization efforts with some local financial entities that could be developed in tandem with some of the changes in the legal and regulatory infrastructure In privatization and public-private partnership (PPP) development, PEP-MENA will support the GoP's regulatory bodies and its infrastructure privatization efforts. IFC currently has two advisory mandates in Pakistan: (i) structuring a PPP for Lahore Water and Sewerage Agency; and (ii) privatization of Faisalabad Electric Supply Company. IFC is working with Global Partnership on Output Based Aid (GPOBA) and Infrastructure Department of the Bank on other PPP-related transactions and on the institutional framework in support of PPPs. C. MIGA Portfolio and Program 131. MIGA's outstanding portfolio in Pakistan consists of 10 contracts of guarantee-four in the financial sector, five in the infrastructure sector and one in the services sector-with a total gross exposure of US$136.8 million and a net exposure of US$106.8 million. An application seeking coverage for a US$20.8 million equity investment in a hydropower project (Laraib Energy Ltd.) in Pakistan is currently pending. In FY07 MIGA intends to implement an Enterprise Benchmarking Program (EBP) Survey in South Asia, and Pakistan is expected to be one of six or seven countries that will participate. The EBP will provide detailed investor-focused information to assist Pakistan's investment promotion efforts. D. Partnerships and Harmonization 132. The Bank Group's work in Pakistan is coordinated with and reinforced by the efforts of other donors in a wide variety of areas. The Government leads coordination of policy dialogue and donor support within the framework of the PRSP, using the Pakistan Development Forum (PDF), held annually in Islamabad, as the principal forum for discussion with and among donors. The PDF has allowed the Government (federal and provincial) to actively participate and present their policy reforms to the donor community. This has enabled the development partners to learn first hand from key policy makers and implementers, about the country's economic reforms and to experience the ownership of the program at all levels of the government. To follow-up on the PDF in a systematic manner, a Donor Coordination Cell (DCC) has been created in the Economic Affairs Division (EAD). Formal donor group meetings are also held, at least two to three times a year, to discuss implementation of the government's PRSP. Provincial governments have also continued to engage development partners in the implementation of their provincial reform programs. Building on the positive experience of the provincial development forum meetings in Sindh and NWFP, a Punjab development Forum was held in 2005, and another NWFP Development Forum is planned in Under the leadership of the Government of Pakistan, the Bank Group is increasing efforts to strengthen partnerships and improve harmonization of activities among donors in line with the Paris Declaration on Aid Effectiveness. Analytical activities are increasingly being prepared jointly; during the last CAS five ESW reports were prepared as joint products with the support and participation of the Bank, IMF, ADB, the EC and the UK Department for International Development. During the next four years we expect an increasing share of analytical activities to be carried out jointly. A comparison between the World Bank's and ADB procurement rules was undertaken in 2004 as part of the harmonization exercise and as a result, harmonized procurement documents are available for use. A similar exercise is underway in the area of financial management where DFID and ADB will be working jointly together on the planned PFM Performance Measurement assessments for the federal government, Punjab and NWFP. A

49 -41- similar PFM assessment for Punjab was carried out jointly by the World Bank, DFID, and the EC in Discussions are underway with a number of donors including the US, UK and EC to harmonize program support and we will continue to seek opportunities for harmonization of budget support, both at the national and provincial level, under common policy frameworks. Details of partner activities can be found in Annex V The international response to the October earthquake has served as an opportunity to substantially deepen donor harmonization and coordination. The Preliminary Damage and Needs Assessment was the product of a multi-agency mission led by the Asian Development Bank (ADB) and the World Bank including experts from the government as well as international organizations, including the European Union, the United Kingdom's Department for International Development (DFID), the German Agency for Technical Cooperation (GTZ), the German KfW, the Japan Bank for International Cooperation (JBIC), the Japan International Cooperation Agency (JICA), the United States Agency for International Development (USAID), the World Health Organization (WHO), and UN Agencies." A core group of seven donors including the ADB, DFID, the European Union, Japan, UN, USAID, and the World Bank has continued to meet on a near-weekly basis to coordinate activities by designating lead agencies and develop common approaches, including assisting in development of sector reconstruction strategies to guide government and donor efforts over the coming months. During the CAS we will seek to build on this mechanism to institutionalize and deepen donor coordination. E. Communications and Outreach 135. An important complement to partnership and coordination efforts is the Bank Group's overall outreach. Accordingly, the Bank has increased its interactions with the different levels of government, the media, civil society, and business community to establish partnerships based on a shared vision for Pakistan's development. The Bank Group has intensified efforts to build the local media's capacity, and will continue to conduct training programs for business and economic journalists in collaboration with local universities and WBI. In keeping with the Bank's goal of sharing knowledge, increasing transparency, and enhancing accountability, the Bank Group's web site not only provides information about Bank operations in Pakistan but also provides real time access to stakeholders allover the world on annual events like the Pakistan Development Forum. The web site and other web-based communications channels like virtual meeting rooms and discussion space have played a great role in donor coordination during the recent earthquake in Pakistan. Additional efforts will be made to extend the Bank Group's outreach through more periodic dialogue with stakeholders. This will be done through wider dissemination of the Bank Group's reports and disclosure of project documents (especially in local languages), greater engagement with civil society organizations and opinion makers. The Bank will continue also its highly effective consultative process in the preparation of specific projects. F. Monitoring and Evaluation 136. Successful implementation of the results-based CAS will require further improvements in monitoring and evaluation. At the level of the country program, the CAS results framework establishes the specific results which the Bank Group aims to assist the Government to achieve (Annex 1). Progress toward the achievement of these objectives will be monitored and jointly reviewed on an annual basis. This process will be supported by activities to improve government systems to collect, analyze and disseminate data. To supplement the data available from household surveys, beginning in 2005, the Federal Bureau of Statistics (FBS) has begun conducting a Pakistan Social and Living Standards Measurement Survey (PSLM). This survey consists of a Core Welfare Indicators Questionnaire (CWIQ), which for the first time is gathering data at the district level, and a Household Income and Expenditure 1 Pakistan: 2005 Earthquake Preliminary Damage and Needs Assessment. SecM /IDA/SecM , November 18, 2005.

50 Survey (HIES), which is provincially representative. Together with household surveys, the CWIQ and the HIES provide information on intermediate and final development outcomes as well as on satisfaction with government services and provide decision makers with annual feedback on the results of government programs which can be used to assess effectiveness and make needed adjustments. The Bank will also support the strengthening of administrative reporting systems with independent cross-checks provided by third party validation surveys, an approach that is already being implemented in the Punjab Education program Like several other South Asian countries, Pakistan boasts a strong statistical system with a long time-series of household surveys with extensive data on economic, demographic, and social trends. Already a participant of the General Data Dissemination System, the GoP has announced its intention to adopt the Special Data Dissemination Standard. Further, as the country moves forward in implementing its poverty reduction strategy, increasing information demands are being placed on its statistical system. Recognizing the importance of timely and reliable statistics for policy analysis and public debate, the GoP has embarked on an ambitious plan to restructure existing statistical agencies and develop a long-term plan to strengthen its system of official statistics to meet these challenges. The World Bank is providing technical assistance to the GoP to help prepare a strategic plan for the merger of the various statistical agencies into one organization, to help draft a new statistical law specifying the respective roles and responsibilities of various actors in the revamped statistical system, as well as to develop an implementation plan to strengthen the overall system, including training and motivation of staff and the strengthening of the statistical infrastructure. In addition, the Bank has also helped the Federal Bureau of Statistics carry-out the CWIQ survey in 2004/ Improvements in monitoring and evaluation will also be a focus of efforts at the project and portfolio level. Based on the results of a recent portfolio monitoring and evaluation review, there is scope for improving the M&E focus of projects by enhancing projects-level results frameworks, strengthening the selection of measurable outcome indicators, and strengthening M&E information channels at the project level. We will continue to build the capacity of the Planning Commission for evaluation and monitoring of development projects. Further support, including lending and technical assistance for implementation of the statistical restructuring plan, will also be considered during the CAS period. G. Managing Risks 139. The greatest risk faced in the new CAS is the risk of policy reversal due to shifting priorities or political changes. While the government has shown itself able to sustain its reform program over an extended period, the period leading up to elections in 2007 could bring greater uncertainty. In this context, a slowdown in decision making is possible as are shifts in government policies and priorities. While the Bank's ability to mitigate this risk is limited, we will seek to build and sustain support for further reforms, using our AAA work as appropriate to help make the case for reform in public and to strengthen the hand of reformers in policy debates. The government is also sensitive to this risk and has launched a variety of initiatives which aim to spread the benefits of growth and reform as widely as possible, particularly among the poorer regions in the country. In this way, the government seeks to build popular support for continued reform. We will support these efforts. Finally, we will continue to rely on the self-regulating nature of the programmatic approach: the volume and pace of lending will match the pace of reforms Recent macroeconomic developments including rising inflation and a growing current account deficit suggest an increase in the risk of macroeconomic slippage. On the fiscal front, expenditure pressures are evident due in part to the October 2005 earthquake and associated claims on the federal government's finances. Disbursement of grant donor funding pledged at the November 19, 2005 Conference in Islamabad has been slower than planned. There is also a risk of increased external vulnerability as shown by the rapid increase in the current account deficit during FY05 and the first half

51 of FY06. These risks are offset to some extent by the Government's track record over the past five years in managing the economy coupled with its strong commitment to sound macroeconomic management as embodied in the Fiscal Responsibility Law. The Bank will seek to further mitigate this risk through its engagement in macroeconomic policy dialogue and in the context of the PRSCs and other development policy operations, as well as technical assistance and capacity building Despite some favorable trends over the past several years, Pakistan will remain vulnerable to security risks which may affect implementation of the strategy. While the peace process with India remains on track, the threat of violent conflict persists. Some episodes of violence in Balochistan and in the border regions near Afghanistan over the past year have caused disruption in project or program implementation. Moreover, it is likely that security concerns have acted as a constraint on the effectiveness of Pakistan's reform program by dampening somewhat the private sector's response to the rapidly improving investment climate. While the Bank cannot address security issues directly, its engagement can have a demonstration effect and help to "crowd in" private investment. We will mitigate the security risk to Bank operations by continuing to closely monitor developments and by responding quickly to safeguard staff while maintaining our engagement The October earthquake has highlighted Pakistan's vulnerability to exogenous shocks, including natural disasters. Pakistan is subject to earthquakes as well as weather-related hazards including floods, landslides and droughts, all of which were experienced during the last CAS period. The response to the earthquake has also demonstrated Pakistan's capacity to weather such shocks, as well as the need to improve hazard risk management practices in Pakistan. This risk will be mitigated by ensuring the Bank's readiness to provide necessary support-resources, AAA and leadership-to assist in responding to emergencies. In addition we will work with the Government to strengthen hazard risk management strategies and capacity The IBRD exposure risk is deemed to be acceptable based on Pakistan's improving debt sustainability indicators and growing access to international financial markets. Nevertheless, IBRD lending at the upper end of the proposed range will take place only in the context of further improvements in creditworthiness. In consultation with the IMF, the macroeconomic situation will be monitored closely and I3RD lending adjusted accordingly. Moreover, application of the guidelines for IBRD lending will serve to modulate the lending program based on policy performance at the sector level There are implementation risks relating to both the Bank and Pakistan. As outlined earlier technical and institutional capacity constraints, particularly at the local level, could delay implementation of reforms or slow the preparation of new projects. On the Bank side, the planned increase in infrastructure lending poses risks related to the timeliness and effectiveness of Bank support as we re-engage in sectors where there has been little or no lending during the previous CAS. Portfolio risks will also be more prominent as we scale up infrastructure lending. As outlined above, we will aim to increase our support for capacity building, both through stand-alone operations and as an integral part of new activities. We will also apply a "capacity filter" to new operations to ensure that projects proceed only with adequate capacity in place or with a clear strategy for building it. To address the environmental and social risks associated with scaling-up and programmatic support, particularly in the infrastructure and water/irrigation sectors, the Bank will increase efforts, working with our clients, to identify at an early stage the critical issues affecting the potential sustainability of the programs and to put in place appropriate mechanisms to address them. To mitigate the implementation risks on the Bank side will require a concerted effort to streamline project preparation and ensure timely attention to implementation issues on the part of both the Bank Group and GoP.

52 Page I of 8 ANNEX I: PAKISTAN FYO6-09 CAS RESULTS FRAMEWORK Pakistan's Development Agenda World Bank CAS Pillar 1: Sustaining High and Broad-based Growth and Improving Competitiveness 1. Strengthened Macroeconomic Management and Utilization of Resources * Poverty incidence reduced Macroeconomic * Fiscal deficit (before grants) at or a Satisfactory implementation of the Fiscal Lending: from 32% in 2001 to 28% vulnerabilities: (i) low below 4.5%; Tax-to-GDP ratio Responsibility and Debt Limitation Bill * PRSCs in and 22% in revenue mobilization, (ii) increased to at least 11.5% by e Progress in restructuring CBR and 9 Provincial DPCs 2011 high costs of power sector, implementing improvements in * Average real GDP growth (iii) pension liabilities * Improved organizational management, HR and revenue operations e Public Sector Capacity rate of 6.5% from I nefficient tax efficiency and effectiveness of 9 The share of pro-poor expenditures rises Bidn rjc * Macroeconomic stability administration, narrow tax the Central Board of Revenue from 4.8% in 2004/05 to 6.8% in 2008 with maintained base, skewed tax structure, * Strengthened capacity for monitoring and evaluation mechanisms to AAA * Stock of public debt and evasion macroeconomic, poverty and track progress * Tax Policy Study reduced to 50% of GDP * High debt and low social monitoring * Adoption of a strategic plan for * TA for pensions reform by creditworthiness reorganization of statistics function under a * Growth and Competitiveness elow savings, and public new statistical law. report and private investment insufficient to support sustained high growth 2. Increased Diversification and Exports in Agricultural *increased exot leas no1.%nb e Poverty Assessmnt b Statistical strengthning TA * Monitoring and evaluation (TA) " Increase in agriculture 9 Distortions due to 9 increased productivity and Preparation of an action plan for the LENDING productivity/competitiven subsidies on inputs and diversification at the farm level revamping of the Ag. R&D system OFWMP in NWFP and ess (including livestock) some commodity prices o Better functioning of land 9 Automated land records management Sindh " Improved functioning of Stagnant yields and limited * markets system implemented in Punjab province. Punjab Land Records Mgt rural factor markets: access of small farmers to e Increased horticulture production (07) Water, Land, Credit improved technology 9 nrae xoto o-aaa Shallow land, credit and * traditional crops. * Rural DPR (06) water markets hinderm access by the poor restructuringicbr High transaction costsrevenueoperati m

53 Page 2 of8 Pakistan's Development Agenda World Bank CAS Isue an Costait facing small scale farmers and inefficiencies in the marketing chains Iitnc,.' Ban Gru * Livestock review (07) TA * Workshops/TA on land markets administration 3. Efficient and Sustainable Irrigation and Drainage Infrastructure and Service Delivery * Efficient, transparent and e Inefficient water use and o Improved management of * Asset Management Plans prepared with * Punjab Barrage accountable water and water shortages irrigation and drainage increased funding provided for maintenance Rehabilitation and irrigation sector e Supply-driven system non infrastructure and rehabilitation Modernization (07) supporting increased responsive to farmers' 9 Improved irrigation service e Number of FOs created and at least 40% of * Sindh Water sector agricultural production needs delivery through increased abiana collection is transferred to them in improvement (07) infrastructure degradation cost recovery in irrigation and modernized and an action plan for (07) * Lack of transparency and * Transparent and more equitable water infrastructure development is * Punjab Irrigation DPL equity in the water water allocation and distribution prepared (annual beginning FY06) allocation and monitoring of water * Drainage master plan and drainage accord 9 Workshops/TA on irrigation system concluded among provinces sector institutional reforms 4. Improving the Business Environmentfor Trade and Investment *CompetitionmLawgamproved w Inter-provincial water allocation agreement (05) and related monitoring system in place * Reduced water losses in irrigation system in OFWM canal commands Strengthened * Labor market rigidities 9 Enhanced labor market flexibility Existing labor laws amended * PRSC competitiveness, hinder enterprise * Strengthened legal framework for - Increases in DB index of hiring and firing * Labor Market Study increased productivity and adjustment and factor competition flexibility Competition Policy TA improved investment mobility the water climate * Inadequate legal and ncompetition Li annoued institutional arrangements to promote competition.m Government regulations pose barriers to entry and business operations * Modernized Legal and e Underdeveloped Established and operational New laws, regulations, and procedures Policy dialogue; Capacity Regulatory Framework framework for private Mineral Rights Cadastre introduced building reform using PHRD investment in exploration Ia

54 Page 3 of 8 Pakistan's Development Agenda World Bank CAS Long Term GOP-MDG. Outcomes the Bank expects to Intermediate milestones/indicators to track I Goals issues and Constramts influence during the CAS period implementation towards CAS outcomes for the mineral sector and development of * Functional Cadastre with trained staff Grant, PSRCs minerals * Basic geo-information used to promote * Mineral Sector TA Loan (FY exploration and develop investment 5. Improved Delivery and Efficiency of Infrastructure Services A financially self- * Poor technical and * Power sector corporatized into * Notification of tariffs for individual * Transmission and sustaining power sector commercial efficiency, independent generation, corporate entities; transfer of assets, Distribution Improvement capable of supporting service quality, and transmission and distribution liabilities and staff; adoption of trading Loan (FY07) economic growth and reliability entities by region rules and mechanisms for independent * PSCB providing reliable services * Inadequate tariffs with * Improved performance of the financial flows to existing and new substantial cross subsidies regulatory framework * Investment in transmission and distribution consumers * Under-investment and lack * Reduced fiscal costs of the sector. * Reduced technical and commercial losses of maintenance * Expanded use of * Poor sector performance as * Increased fixed, mobile, and rural * Develop and implement the Universal * Support to telecommunications evidenced by: (i) limited teledensity Service Strategy by using private operators Telecommunications services access especially in rural * Strengthened legal and policy to deliver services Regulator (PTA) through the areas, where teledensity is framework and improved * MOITT policy-making capacity and PTA's PSCB Project less than 1%; (ii) long performance of the regulatory regulatory regime strengthened * Rural Telecom project waiting time for telephone regime (FY08) connection and (ii) poor performance of PTCL and * Increase in delivery of e-services * IFC/MIGA support to private... the cellular operators for citizens * A more efficient, safe and 9 Long travel times and Improved Traffic Flow on * Rehabilitation of highways under the e National Trade Corridor reliable transport system congestion National Trade Corridor as National Highway Improvement Program Project moving people and goods e Limited access and poor measured by operating costs and e Road Maintenance Account operational and * Transport Competitiveness more effectively and condition of netork travel times financing Annual Maintenance Program Study safely Prvtsetrpriiainn * Inadequate investment in P Satisfactory progress in implementing system maintenance. road transport increased agreed NHA institutional reform program * Lack of private sector 9 Reduction in communities lacking basic participation in road access to transport services: 10% transport sector A competitive Oil and * Government intervention Percentage of households using * implementation of pricing regimes for oil * Policy dialogue Gas sector, providing and price controls gas as cooking fuel increases and gas * Analytical work on open quality products in an e Mis-targeted and non- from 30% to 40% * P0 and NRL privatized by FY07 access, strategic storage, efficient and costs

55 Page 4 of 8 Pakistan's Development Agenda World Bank CAS 6. Improving Access to Market-Based Finance uneconomic allocation of through imports FY o7 * Advice on gas imports scarce resources * IFC support to private mining and gas field dev. operators oa strong and diversiiedatcot of financial in ing aents syste, DIt * PRC Nce o va financial sector withand amd improved capit Market Tr equitable access operatingin the give * t r or eve d eled * B ai sect or A under sound regulation controlgoeraneen Srve DeNvedy * Under-development of * Strengthened *ifraewnt numer ofpadnbf public e n to cerdasctr l pial HuigFnneT contractual savings has oouanaemntereitofetansato covered u ne a PIF. TA fmiinstitutiondlglsk inhibited capital markets I e i cdernizedinan reotng adudit o IF forufede P a developmentity of financial * Gaps in the legislative Ti ine a de lo ani framework pose (B n IA)eHuigFnneT *ddtoofaa Repoiing astasured banks reoni * PRSC nwp DPc instii f gtoenmiden audisse c e b a m c m *re * NtinaSvigsSchmeretrctr ofrdt subivtzed wihnoeya MFaamety andot o inomaindusotimelins governmentn fiania AM Provinedcial FaAtisrmn D f* Strengthened legalfavew for Public f* Debt Act,cInsurance O i n law * Cpita lty TAs instituta andsegal riskspotn fe i overign htn public expenditure p eran n to over smesrdb f co rcniitinp s and S weakesss inimpovedquaity nd imelnes benhmaks (00%by 209)* IFCegtchn bic asitanca *ccountable Isefpbli goerntm e c* Role of trainct,dp nt Offies ndi *IFAC ae1f m Weakened ia amtitutise reconcilpillar l v 2: Strngteneadit Goenne nd% Trery Servi Delie fic clarii ihnoeyar Mngmnn * Tracklog pogras u evelo pt edra udelite * 7. GraerEfcinylTasanys inanacouabilityeintteed epublie esourcescoutbiiysssmet r s ( eli mi and a y e n FYo in7ia n A *ecredible,otransparent andcepniue oe fdsrctacutofcsan CA/PRPR * Weaked capailt v nauyofce lrfe overnmet accounting-eie edpstfeealaui reconciliationby nd Y0

56 Page 5 of 8 Pakistan's Development Agenda World Bank CAS Long Term GOP-MDG Outcomes the Bank expects to Intermediate milestones/indicators to track Goals influence during the CAS period implementation towards CAS outcomes * Efficient and transparent * Non- transparent 9 Improved transpareney and a 100% of federal procurement eondueted * Provincial Procurement public procurement procedures at Federal, efficiency in public procurement under modernized regulation by FY Assessments Provincial, Municipal and at Federal, Provincial, Municipal. Establishment of appeals procedure * PSCB capacity building Autonomous bodies level and Autonomous bodies level * Lack of implementing e Improved credibility of bidding e Procurement Regulations for implementing * Punjab Education SAC Regulations and clear Procurement rules notified. Procurement e PRSC 11, 111 (FYs 06,07) intttoa ragmns process Law enacted 9 NWFP SAC Ill (FY06) institutional arrangements for public procurement 9 Alignment between PPRA and o Monitoring and reporting mechanism * Sindh SAC 11 and Ill (FY06, " akofefrcmn,auditor Generals Of Pakistan established to provide statistics on public 07 * Lack of enforcement, monitoring and appeals procurement handling process o Engagement of Auditor Generals Office in * Weak capacity of the development and implementation of procurement officials Procurement Rules, Regulations and Procedures; conduct of annual audit 8. Enhanced Capacity for Service Delivery and Public Sector Management e Efficient, accountable * Low levels of competence Professional qualifications of * FPSC capacity strengthened and PRSC civil service staffed by in policy and operational civil servants increased responsibility for recruitment process Devolution TA/Policy Notes highly qualified management * Civil service compensation reaffirmed PSCB project individuals * Weak accountability reformed to reflect market e National Executive Service created realities District and Local Government Services * Civil service restructured to created further devolution i Pay compression ratio reduced from 1:10 e Civil service pensions reformed * Increased proportion of senior civil servants with internationally recognized training * HRMIS system made operational *Accountable and efficient *Incomplete fiscal and *Increased transfer of national *Districts given full APT authority over all e TA local governments, administrative devolution fiscal space to provincial and staff at grades 19 and below CIP Projects SLack of clarity about roles local governments *Share of overall government resources Capacity building for lucal and responsibilities of Administrative and Fiscal e provided to provinces/districts government through the various tiers of devolution completed * Greater Federal/Provincial and Devolution Trust government Strengthened links between local * Provincial/District tax reassignments. " Fiscal imbalances among governments and community e Increased utilization of local development tiers organizations (COs) resources " Limited capacity of local Increased capacity of COs to Number of Community OrganizationsP * P

57 Page 6 of 8 Pakistan's Development Agenda World Bank CAS Long Term GOP-MDG Issues and Constraints Outcomes the Bank expects to Intermediate milestones/indicators to track, Goals sseancosrms influence during the CAS period implementation towards CAS outcomes governments participate in development created 9. Improved Municipal Service Delivery * Weak links between planning communities and local governments * Improved quality of life in * Rapid urban transition Improved quality, efficiency and 9 improved urban land management system e Urban Non-lending TA the urban areas and e Weak urban service access to urban services in implemented in 6 TMAs * Punjab Municipal Services increased contribution of delivery as a result of selected municipalities e Adoption of clearly articulated vision and Improvement Project urban areas to growth and fragmented improved urban planning and policy framework for urban development (PMSIP) poverty reduction responsibilities, weak management frameworks by provincial governments e Punjab Large Cities capacity and limited implemented in selected * Implementation of capacity building Development Policy Loan accountability of public municipalities activities and development grants through (DPL) sector institutions *Increased access to water, the Punjab Municipal Development Fund a IFC support for municipal * Uneconomic pricing and sanitation, transport and other Company water and sewer operators inefficient public service urban services in selected delivery mechanisms. municipalities * Poorly performing land *Improved quality and condition markets of intra-city roads and o Inadequate regulation and transportation enforcement --~~~~~~~~~~... _-... ~ ~ ~ Pillar... 3: Improving ove quaity Lives effiienc and Protecting and... the Vulnerable 10. Improved Delivery ofhealth and Education Services Education *Limited client voice in *Gross primary enrolment e National Learning Assessments conducted LENDING " Increased leaning improving the quantity and increases from 72 to 104 percent. twice during the CAS period Provincial DPCs achievement of primary quality of service delivery * Gross enrollment rate for middle Improved teacher attendance a Punjab PEDPC school students *Weak management, school increases from 41 percent 9 Results of annual survey based assessments * Balochistan Ed. Loan (06) " Gender gap in literacy including lack of focus on: in to 52 Percent in 2009 of providers show marked increase in e IFC support for private reduced: ratio of literate (i) information-outcome e Increase in gross enrollment of quality of service provision education female/males increases based policy making, (ii) girls in primary school from 61 in - Increased non-salary recurrent expenditures e Higher Education Reforrm from 65 percent in 2005 standard setting regulation; percent to 85 percent in in education to 93 percent by 2015 (iii) monitoring and 2009 * itray ae f 5-4 evaluation * Successful implementation of education a Education Sector Report ea o rasie icenti o * Increase gross enrollment of girls stipend program for girls in selected Private Sector Participation eiin middle school from 35 in districts 58% in 2001 to 78% in providers that link percent to 45 percent in in Punjab 2011 autonomy with 2009 Higher Education Policy

58 Page 7 of 8 Pakistan's Development Agenda World Bank CAS Long Term GOP-MDG Issues and Constraints Outcomes the Bank expects to Intermediate milestones/indicators to track Goals influence during the CAS period implementation towards CAS outcomes Improve post-primary accountability * Increase enrollments in Higher Note access and quality * Limited opportunities for Education (particularly for TA public-private partnership bottom 20 percent of the * Skill development/labor population) market TA * HD Monitoring and Evaluation TA Improved Health Weak management: Contraceptive prevalence rate e Increase in LHW (and skilled birth 9 Partnership for Polio Outcomes compounded by (i) poor increased from 28% to 34% by attendants) from 84,000 to 110,000 by Eradication (FY06) * Under 5 mortality rate accountability of service FY09 FY09 e Lady Health Workers (FY07) reduced from 103 to 60 providers and managers, *Proportion of births attended by * Timely availability of polio vaccines and e National HIV/AIDS Control (per 1,000 live births) (ii) limited autonomy, and skilled health personnel rises increased SIA coverage of targeted children project (FY03) * Maternal mortality rate (iii) lack of performance- from 31% to 38% to at least 80% in polio endemic provinces reduced from 450 to 250 based incentives * National Public Health (per Lack of focus on Pn/ Surveillance and Monitoring (pe brts)months) 10,00liv fully immunized contracted to deliver services to high-risk System (08) * Polio eradicated information-outcome increased from 77% to 85% groups rises from 7 to at least 26 based policy making, (ii) e Health sector review * Spread of HIV infection monitoring and evaluation 9 HIV prevalence remains below including assessment of the reduced 5% of female sex workers and c aiitstabilizes securiaeptiy assistance and instrumeninrease social among male sex and responsibilities for workers, truckers, fo 2% ppvalncerat jail o inmates 34%r (byto oio rgasipoea * IFC support for private different levels of and IDUs providers government 11. Reduced vulnerability and Improved livelihoods of poor communities through effective safety nets, targeted interventions; and hazard risk management adminiteredsocia Uncleerar offiaftyinetsfncroles Vulnerability reduced * Lack of national strategy Increased school attendance e SP strategy and approved by Government Lending through implementation for social protection among poor children (bottom 2 e Pilots for safety net reforms (CCTs) * Social Protection (FY08) of well targeted, e Limited, ad hoc, and quintiles) and among disabled implemented and scaled up e PRSCs, Provincial DPCs, financially viable, and unevaluated use of safety children Safety net targeting mechanism developed Emergency Recovery well nets and social security and administrative capacity to deliver and Operations (06-09) seuiyporm Existing safety net 2 quintiles) e Civil service pension reforms enacted; * Safety net Report (FY06) programs not designed to * Reduction in fiscal liabilities of reforms of other formal/informal pensions help poor cope with the civil service pensions design ed/agreed, and reforms initiated (FY06)rvc Pnio epr shocks/natural disasters p rise or build human capital safetinesinpndgonovrytgeted * Pension Report/ TA (FY07- Social Protection programs f 308) are under-funded and have e Micro-insurance Report low/poor coverage (FY08) * Weak implementation *HIVpreval

59 Page 8 of 8 Pakistan's Development Agenda World Bank CAS capacity leading to inefficient administration *Improved livelihoods and LiieacestbaiInraecomnt InraereitainoComntBsd *PAF adii services for poor services and infrastructure participation in the decision Organizations (CBOs) (from 120 in June * Kushall Pakistan/Social communities and drought hinder opportunities for making process and partnership 2004) prone areas economic activities and between municipalities and * Number of community infrastructure Mobilization 9 NWFP CIP 1 income generation for the CBOs on service delivery projects launched and number of rural rural poor Improved delivery of services, communities reached. * AJK CIP * Weak community based and productive and social * Number of active microcredit borrowers. organizations and rural infrastructure institutions Increased access to credit, * The poor (esp. in rural including microcredit areas) lack access to credit *Areas affected by October e High risk of natural *Vulnerable populations provided e Number of houses restored/rebuilt to * Earthquake Emergency 2005 earthquake disaster including livelihood support during post- earthquake resistant standards. Recovery Credit rehabilitated earthquake, floods and earthquake period Number of communities/households Earthquake Emergency to hazards drought * Basic CVulnerability services and public benefiting from livelihood support Response package reduced through increased e Ad hoc approach to infrastructure restored in payments preparedness dealing with Hazard Risk earthquake affected area Development of National Emergency Management (HRM) Owner driven housing Management Plan Undeveloped institutional framework and limited capacity for disaster response and limited i reconstruction complete in selected areas * Strengthened GoP capacity to manage and minimize the impact of future disasters rrm

60 Pakistan: CAS Completion Report Page 1 of 30 ANNEX II: CAS COMPLETION REPORT Country: Pakistan Date of CAS: June 24, 2002 Date of CAS Progress Report: April 28, 2004 Period covered by the CAS Completion Report: July June 2005 CAS Completion Report completed by: Thomas Buckley, Senior Country Officer Date: May 27, This CAS Completion Report evaluates the effectiveness of the World Bank's Country Assistance Strategy for Pakistan (FY ). It is a self-evaluation by the country team of the extent to which expected CAS outcomes were achieved and the extent to which Bank performance was satisfactory in helping to design and implement the CAS toward outcomes, with a view toward longer term strategic goals. The purpose of the report is to identify the lessons relevant to the design and implementation of the new results-based CAS. Completion of this report coincides with the completion by the Independent Evaluation Group (IEG) of a Country Assistance Evaluation covering FY which, although it covers a different period, offers additional lessons relevant to the new CAS. 2. This report evaluates the CAS against the outcomes established in the FY2003 CAS. The report assesses: (i) the alignment of the CAS with Pakistan's goals and expected development results; (ii) the degree to which CAS outcomes were achieved during the CAS period; and (iii) the Bank's performance during this period. Since the CAS was presented to the Board in June of 2002, a CAS Progress Report was discussed in April Progress in achieving CAS outcomes is summarized in Annex-1 while annexes B and C compare planned and actual deliveries of lending and non-lending support over the CAS period. Overview 3. From independence through the 1980s, Pakistan's economy grew at a respectable rate - always over 5 percent after the 1950s and in the 1980s over 6 percent per year. In the 1990s, however, growth slowed while public debt accumulated rapidly and poverty increased. The imposition of sanctions following the 1998 nuclear tests exposed the vulnerability of the economy, leading to severe balance of payments difficulties, spending cuts, import restrictions, tax increases and external debt service arrears. 4. The government which assumed power in 1999 succeeded in turning this situation around; Pakistan's macroeconomic performance has improved significantly and more rapidly than expected. Sustained implementation of the Government's stabilization and economic reform program, along with the generous support from the World Bank and other donors, has resulted in macroeconomic stability and accelerating growth, laying the foundations for poverty reduction. Economic growth has increased from the average of 3.3 per cent during to the average of nearly 6 per cent during Against the target of 5.3% for FY04, GDP growth was recorded at 6.4%, the highest rate in 8 years. For FY05, despite the impact of rising oil prices, growth reached 8.4%. 5. There has been significant progress in implementing a wide ranging program of structural reforms with deep World Bank engagement. The banking sector has been strengthened through

61 Pakistan: CAS Completion Report Page 2 of 30 privatization, a strengthened legal and regulatory environment, and significant improvements in transparency, corporate governance, and credit culture. There has also been progress in de-regulating the economy so as to reduce the cost of doing business in Pakistan. The regulatory and policy framework for the telecommunications sector has been improved to establish a competitive telecommunications market. There has been progress in implementation of the oil and gas reform agenda, in particular in the petroleum downstream sector. Governance reforms have continued to advance including: (i) reforms in public financial management and public procurement to increase fiscal transparency, accountability, and value for money; (ii) restructuring of the Central Board of Revenue to strengthen tax administration; (iii) a devolution initiative aimed at improving the delivery of public services by creating more accountable local governments; and (iv) reform of the civil service to improve incentives and accountability. A. Longer Term Strategic Goals 6. The 2002 CAS and June 2001 CAS Progress Report reflected and supported the program which the government had formulated starting in Soon after the military coup, the new government issued a seven-point agenda to revive the economy, address endemic corruption, depoliticize state institutions, devolve power to the grass-root level, and improve checks and balances and democratic processes in society. In December 1999, following national consultations, the government announced its development strategy which focused on: (i) strengthening governance and the integrity of the civil service; (ii) creating opportunities through accelerating growth of agriculture, small and medium scale industries, information technology, and oil and gas sectors; and (iii) reducing poverty through revival of growth and re-orienting public expenditure towards human development and poverty reduction. 7. Later, these goals became the basis of the government's Interim Poverty Reduction Strategy Paper which was completed in November of The CAS outlined a Bank program in support of the I-PRSP.I The I-PRSP specified five main goals: engendering growth, reforming governance, creating income generating opportunities (specifically for the poor), improving human development, and reducing vulnerability to shocks (at the microeconomic level). While not explicitly linked to the MDGs, the I-PRSP was closely aligned to them. The full PRSP (discussed in greater detail below), which was completed in December 2003, went on to make the link between the MDGs and Pakistan's poverty strategy explicit, setting targets for poverty reduction, education, health, and gender equality that are fully aligned with the MDGs. In addition, both the I-PRSP and the PRSP included M&E frameworks to track progress toward the MDGs as well as intermediate indicators to guide policymakers and program managers. 8. During the CAS period, the government's longer term objectives underwent a process of refinement and elaboration, but remained fundamentally unchanged. Parliamentary elections were held in October 2002 leading to the formation of a government under the leadership of an elected Parliament and Prime Minister. The civilian government has largely adhered to the policy priorities of the military government. Many key ministers have remained in place and President Musharraf has continued to exercise considerable influence on policy matters. Mr. Shaukat Aziz has remained Finance Minister throughout the CAS period while also being elevated to Prime Minister in The PRSP prepared in December 2003 outlined a policy which continued and built upon the I-PRSP. Pakistan's PRSP is grounded on four pillars: (i) achieving sustained high and broad-based economic growth, focusing particularly on the rural economy, while maintaining macroeconomic stability (ii) improving governance and consolidating devolution; (iii) investing in human capital; and (iv) targeting the poor and vulnerable. The I-PRSP and Joint Staff Assessment were discussed by the Board on December 4, Pakistan: Interim Poverty Reduction Strategy Paper and Joint IDA-IMF StaffAssessment, Report PAK, November 15, 2001.

62 Pakistan: CAS Completion Report Page 3 of Overall, Pakistan has made substantial progress towards the longer term goals set in the I-PRSP. As outlined above, growth has resumed, macroeconomic stability has been restored, and fiscal adjustment has been successful, creating fiscal space for increased spending on poverty-related programs. Governance reforms were launched including the devolution initiative, financial management improvements and tax administration reforms. Some progress has been made in each of these areas and there are early indications of success as shown by increasing timeliness and accuracy of government financial reporting, and improved customer satisfaction by the Central Board of Revenue. With respect to devolution, the new devolved political structure is fully in place, but the fiscal and administrative aspects of devolution have yet to be fully implemented creating obstacles for local governments seeking to improve delivery of public services. There has been less progress in civil service reform. Nevertheless, given the long term nature of governance reforms this is a respectable track record, even though in some respects it falls short of the goals set in the CAS. 11. Public expenditure has been reoriented toward human development, a shift made possible by a dramatic reduction in interest expenditures brought about by successful implementation of a debt reduction strategy. Poverty related expenditures have increased substantially, exceeding in some cases the targets set in the I-PRSP. However, public spending on health and education remains low by international standards and it is too early for a full assessment of whether additional expenditures have led to significant increases in the quality and availability of services, let alone outcomes. Nevertheless, there are examples of increased access in several areas. Improvements in the effectiveness, as well as the level, of social spending will be necessary to reach the MDGs. Consequently, the government's governance reform agenda is a key ingredient of a strategy for improving human development outcomes. Additional resources have been targeted toward social safety nets, but here too the government recognizes the need to improve the targeting and efficiency of these programs and has launched efforts, supported by the World Bank, to do so. B. CAS Outcomes 12. The CAS was designed to support Pakistan's pursuit its I-PRSP goals through a Bank program organized around three pillars corresponding to major areas of the government's reform program: (i) strengthening macroeconomic stability and government effectiveness; (ii) improving the business environment for growth; and (iii) improving equity through support for pro-poor and pro-gender equity policies. For each of these pillars, a set of country outcomes and associated indicators or milestones were identified in the CAS program matrix. The CAS triggers also included specific performance criteria for assessing progress in the main areas of the CAS. 13. The results framework established in the 2003 CAS program matrix has some weaknesses when compared to the approach now developed for use in a results based CAS. Some objectives, such as improved performance of CBR lack specificity, although milestones in the CBR reform program are reflected in the CAS and these are expected to lead to improved performance. Other objectives, such as higher private investment represent longer term country goals and don't have a clear link to the CAS program, representing instead a medium-term outcome expected to come about as the result of the overall government reform program to strengthen the environment for private sector investment. In some cases, performance indicators were identified without baselines or targets. Nevertheless, despite these limitations, the CAS and its program matrix together present an adequate monitoring and evaluation framework for assessing progress toward CAS outcomes. The CAS Progress Report updated the program matrix and assessed progress against the objectives in the program matrix as well as the CAS triggers. Progress in achieving CAS objectives is discussed in the following sections.

63 Pakistan: CAS Completion Report Page 4 of 30 MACROECONOMIC STABILITY AND GOVERNMENT EFFECTIVENESS 14. This pillar of the CAS embodied two key elements of the I-PRSP: consolidating recovery from the macroeconomic crisis of the late 1990's while reversing the long term deterioration in governance. The I-PRSP and CAS were based on two premises: first, the economic growth essential for poverty reduction required in the first instance correction of macroeconomic imbalances and maintenance of a sound macroeconomic framework. Second, that low growth and rising poverty were in part a reflection of poor governance requiring concerted efforts to improve government performance and restore confidence in state institutions. Macroeconomic Stability 15. Upon coming to power in 1999, the Musharraf government moved quickly to stabilize the economy and restore confidence. By the time of the 2002 CAS, considerable progress has been made and for the first time in its history Pakistan had successfully concluded an IMF Stand-by arrangement. Nevertheless, the macroeconomic situation remained perilous and the outlook was made more uncertain by the impact of 9/11. The I-PRSP set targets for further fiscal consolidation, accelerating growth, and management of debt. The CAS incorporated these targets as well as the targets in the PRGF arrangement with the IMF. Overall, progress has been impressive, particularly with respect to restoration of growth (see table 1). With respect to the PRGF program, targets were mostly met or exceeded and structural reforms measures were largely followed through, though in some cases with delays. 2 All PRGF disbursements were made available upon completion of program reviews although the authorities elected not to draw the final tranche in light of the improved external position. Table 1: Key Indicators: I-PRSP vs. Actual Real GDP Growth I-PRSP Target Actual/proj Inflation I-PRSP Target Actual/proj Budget Balance (excl. grants) I-PRSP Target Actual/proj Development Expenditure I-PRSP Target Actual/proj PRSP Expenditure I-PRSP Target Actual/proj * For comparability with I-PRSP targets, figures above do not reflect 2005 GDP re-basing. 16. The instruments employed to support Pakistan's stabilization program consisted of a series of one-tranche development policy credits to the federal and provincial governments. These supported policy reforms while assisting in the restoration of financial equilibrium. This strategy was carried out in partnership with the IMF which took the lead in assisting in the adoption of supportive monetary and exchange rate policies. A 3-year PRGF arrangement was approved in November 2001 and concluded in December Other donors also provided significant budget support. The Bank development policy lending program constituted a multi-year commitment of budget support tied to fiscal and governance reforms keyed to the pillars of the I-PRSP. The first of these, SAC I, was approved in 2001 while the 2 IMF, Staff Report for the 2004 Article IV Consultations, Ninth Review Under the Poverty Reduction and Growth Facility, and Request for Waiver of Performance Criteria, November 16, 2004

64 Pakistan: CAS Completion Report Page 5 of 30 second, SAC II was approved along with the CAS in June of SAC III, which was expected to be approved in FY03, was delayed as a result of a slowdown the reform program following the elections and political transition in late Reform accelerated in 2003 and 2004 opening the way for resumption of development policy lending which came in the form of a Poverty Reduction Support Credit (PRSC I) which was approved in September The CAS recognized that there were acute fiscal imbalances at the provincial as well as the national level. The provinces and local governments in Pakistan bear most of the responsibility for delivering public services including education and health, but have very limited fiscal space to provide these services. Therefore, the CAS initiated a program of single tranche development policy credits to provide performance-based budget support to enable the provinces restore financial equilibrium while undertaking reforms. The resources provided an immediate means to address the imbalance between the provinces' responsibilities and their fiscal capacity while the fiscal management reforms supported under these credits were designed to improve fiscal sustainability through increased revenue mobilization at the provincial level. The provincial credits also supported governance reforms and service delivery improvements to address the governance problems that historically limited the effectiveness of spending increases. 18. A first round of provincial development policy credits-for Sindh and NWFP-was approved in FY03. As in the case of the federal government, the elections in 2002 and resulting political transitions slowed implementation of the provinces' reform programs. As a result, planned follow-on credits were delayed. In the case of NWFP, a second NWFP credit was approved in June A principal objective in the CAS for provincial development policy lending was to restore the provinces fiscal space and allow them to increase spending on social services by undertaking reforms. In this respect, the provincial SACs were effective, allowing the provinces to re-profile their debt and reduce interest costs while re-orienting expenditures, including very large increases in development spending on education and health. As a result the government of NWFP has been able to increase the share of PRSP spending from 29% to 38%. Provincial tax revenue has grown by 14%. In Sindh, the SAC-supported provincial reform program resulted in substantial increases in provincial revenues and development spending as well as an increased share in the budget for health and education. However, given the provinces' overwhelming reliance on fiscal transfers from the federation, sustainability of these fiscal reforms and maintenance of adequate fiscal space at the provincial level depends in large part on the (still pending) outcome of the National Finance Commission which will establish the formula for allocating federal revenues among the provinces and federal government. 19. The development policy lending program was complemented by policy dialogue and economic and sector work. The CAS was based on a Development Policy Review, a Poverty Assessment, and a Country Procurement Assessment. During the CAS period the Bank completed work on a Public Expenditure Review, Country Financial Accountability Assessment and an FSAP and the Bank annually conducted reviews of the Government's Public Sector investment program. A series of trade policy notes was prepared during FY04. The Bank also worked closely with the Fund, providing advice and technical support in the implementation of the I-PRSP/PRSP program. Governance Reforms 20. The Bank's support for improving the effectiveness and accountability of state institutions focused on the following areas: (i) reforms in public financial management and procurement to increase fiscal transparency and accountability; (ii) restructuring of the Central Board of Revenue to strengthen tax administration; (iii) a devolution initiative aimed at improving the delivery of public services by creating more accountable local governments; and (iv) civil service reforms. The specific CAS outcomes

65 Pakistan: CAS Completion Report Page 6 of30 supported by the Bank took the form of milestones in the institutional reform processes as well as, in some cases, indicators of improved performance. 21. In public financial management and procurement, the focus of the CAS was on improvements in government accounting, auditing, and legislative oversight along with the adoption and implementation of modern public procurement laws and regulations. The strategy was to assist in modernization and computerization of the government accounting system coupled with strengthening of the audit function and revitalization of the external oversight process. The centerpiece of the Bank's support was the Project to Improve Financial Reporting and Auditing (PIFRA) which was approved in FY97 and closed in FY05. SAC II and PRSC I also supported these reforms with prior actions related to expenditure reconciliation targets and establishment of the Federal Public Accounts Committees as well as the notification of new Public Procurement Rules. Non-lending assistance took the form of policy dialogue, a Country Financial Accountability Assessment, and provincial financial accountability assessments for the Sindh, NWFP and Punjab provinces. 22. Overall, there was steady advance in the government's financial management reform program. The CAS Progress Report described substantial progress as demonstrated by improvements in timeliness and reliability of financial statements as well as progress in launching of computerized accounting sites under PIFRA. The CAS Progress Report also described improvements in the timeliness of audits, the launch of an Annual Audit Program, and recruitment of qualified auditors to develop district level auditing capacity. Nevertheless, in several areas progress fell short of the benchmarks set in the CAS. The CAS targeted extension of PIFRA reforms to the district level which ultimately was delayed as overall PIFRA implementation proved slower than anticipated, with PIFRA reforms extended to 30 of a planned 56 districts. Full Roll-out of PIFRA systems to the district level will be completed in the next generation PIFRA II project which will be approved in FY06. The CAS also set an ambitious target for the public accounts committees to eliminate the backlog of unreviewed audit reports and remain current in the review of audits under the new government. This could not be achieved as a result of delays in reconstituting the PACs following the October 2002 elections. In procurement, adoption of new procurement rules did not take place until July 2004 and implementation remains a concern. 23. The CAS identified improvements in tax administration as critical for improving the business climate and enhancing revenue mobilization. The government's two-pronged strategy-approved in November called for changes in tax policy coupled with tax administration reform to improve the efficiency of tax collection. Both the Bank and the Fund provided advice on tax policy reforms supported through policy lending and PRGF performance benchmarks. The CAS also targeted Bank support toward the restructuring of the Central Board of Revenue over a three-year period. CAS outcomes were keyed to achievement of key milestones in this process, including organizational changes, adoption of revised HR policies, and measures to increase transparency. The Bank supported the CBR reform process through both development policy and investment lending. Approval of the reform program was a prior action under SAC II and the Bank financed preparation of the detailed reform program, leading to approval of the Tax Administration Reform project in December Additional support to CBR was also provided under the Public Sector Capacity Building TA project. 24. The restructuring program for the Central Board of Revenue (CBR) progressed well during the CAS, although more slowly than anticipated. A new recruitment policy has been put in place for key staff in order to attract specific skills while incentive and merit based remuneration and promotion mechanisms have been adopted on a pilot basis. The improved organization structure for tax collection has been piloted in the form of a Large Taxpayers Unit and a Medium Taxpayer Unit and similar pilots are underway in the area of customs administration and sales tax. Performance indicators including revenue targets and changes in policies are published on a quarterly basis and are also available on the CBR website. While some measures to broaden the tax base were implemented, including the withdrawal of

66 Pakistan: CAS Completion Report Page 7 of 30 tax exemptions and extension of sales tax to additional categories, a significant widening of the tax base has yet to be accomplished and the revenue-to-gdp ratio remains low by international standards. 25. Pakistan's devolution initiative is an integral part of the GOP's strategy for improving service delivery by making the public sector more accountable to citizens and more efficient at delivering basic services. The Bank supported devolution by providing analytical support focused on areas where the Bank had a comparative advantage; a number of Pakistan's development partners were also supporting the devolution program. The targeted outcomes related to devolution represented key milestones in implementing the initiative, especially those that affected the ability of the districts to deliver public services. These included promulgation of Provincial Finance Commission awards transferring resources to districts, and implementation of capacity building programs at the district level. Provincial DPLs targeted fiscal reforms designed to increase resources for basic service delivery. 26. A major ESW report on devolution was completed in FY04 which outlined the progress and remaining challenges facing Pakistan in implementing its devolution strategy. The provincial development policy credits for NWFP and Sindh (3 of the planned 6 operations were approved) included prior actions related to enhanced transfers of resources and responsibilities to district governments through formula-based provincial finance commission awards. Assistance in financial management improvements through PIFRA and development policy lending also aimed at strengthening local government capacity. By providing performance-based conditional grants to district governments willing to commit to reforms in education, the Punjab Education Sector Adjustment Credits (approved in FY04 and FY05) also served as a means of helping to increase financing for local government delivery of education. 27. The CAS Progress Report reported that Pakistan's progress in implementing devolution was substantial with respect to putting in place the new local government political structure. However local government autonomy, both financial and managerial remains limited. District governments face significant obstacles caused by incomplete administrative and fiscal devolution as well as severe capacity constraints. In some cases these constraints are exacerbated by political rivalries. 28. Civil Service Reform. The I-PRSP recognized the importance of improving the quality of the civil service in order to increase the effectiveness of its poverty reduction programs and set out an agenda of restructuring, recruitment reform, enhanced training, and pay and pension reform. The CAS outcomes for civil service reform were to (i) strengthen merit recruitment and promotion; (ii) launch pay and pension reforms; (iii) implement a civil service training plan; and (iv) improve the composition of the workforce which is highly skewed toward lower grades. The instruments to support civil service reform were the federal and provincial development policy operations which supported recruitment and pay and pension reforms. In addition, the Public Sector Capacity Building (PSCB) TA project is financing civil service professional development and capacity building in key agencies, ministries, and regulatory bodies. 29. The government has made some progress in implementing these reforms. The Federal and provincial public service commissions (responsible for civil service recruitment) have been strengthened and changes in the promotion system have been introduced to make evaluations more objective, increase transparency in promotion, and to link promotion to higher grades to required training. Pay reforms were instituted in January 2002 which restored about 75 percent of the lost purchasing power of wages (which had not been increased since 1994) and introduced important structural reforms in pension and pay scales. Further pay increases were implemented in July 2003 and July 2004 in the form of interim across-theboard salary increases. This has improved compensation somewhat but the wage structure remains severely compressed. The compression ratio (of top to bottom salaries) is 1:10. It was 1:46 in the 1960's. As a result, the higher echelons of public servants have significantly lower compensation than comparators, making it difficult to recruit high-caliber staff. Options for further pay reforms designed to

67 Pakistan: CAS Completion Report Page 8 of 30 tighten the link between compensation and responsibility are under discussion as are proposals for structural changes in the civil service. Civil service training is being revamped under the PSCB project, but this process is still at an early stage. There has been a modest improvement in the ratio of professional to support staff. Taken together, these reforms represent a promising start, but are only the beginning of the more far reaching reforms needed to address the challenge of developing a strong civil service in Pakistan. Assessment/Lessons Learned 30. In retrospect, the mix of instruments in the CAS was appropriate to support the reform program in this pillar of the CAS. The use of development policy operation supported both macroeconomic stabilization and a broad array of structural reforms targeting the key weaknesses in government effectiveness. The government's macro strategy called for rapid fiscal adjustment; sizable external financing on concessional terms was a key ingredient in its debt reduction strategy, allowing it to reprofile high interest debt. Given the severity of the debt problem, this emphasis was appropriate. Complementary investment lending was used when government reforms had progressed sufficiently and where targeted assistance was needed to reinforce reforms. Investment lending advanced institutional modernization and capacity strengthening, as in the case of public financial management, (PIFRA) tax administration reform (Tax Administration Reform Project) and government capacity building (Public Sector Capacity Building TA). The use of a series of single tranche operations was appropriate to take into account Pakistan's uneven track record and the uncertain political and security environment, enabling the Bank to match its support to the pace of the reform program - when the pace of reforms slowed, so did Bank financial support. 31. With respect to macroeconomic stabilization, the government reform program, supported by the Bank, the IMF and other donors effectively supported the government reform program and made significant progress with respect to engendering growth. Improvements under SAC II and PRSC I include a continued acceleration in growth, from 3.1% in FY01/02 to over 8% in FYO4/05, and major improvements in the fiscal and current accounts. Fiscal outcomes improved significantly in FY03 and FY04. The fiscal deficit fell from 6.7% of GDP in FY02 to 4.6% of GDP in FY03, falling below 5% for the first time in more than 25 years. It fell further to less than 3% of GDP in FY04 despite continued low levels of revenue mobilization and high losses by public sector enterprises before rising to 4.1% in FY05. Pakistan's debt service burden has fallen significantly from 34% of export earnings in 2001/2002 to 25% in 2004/05. With respect to governance, results have been more modest; the government has launched ambitious reforms in tax administration and devolution, but implementation has been slower than expected and the expected results are not likely to be seen until the next CAS. Implementation of ongoing financial management reforms was also delayed. 32. Exogenous factors had significant impacts, both positive and negative, on the achievement of CAS objectives under this pillar. Throughout the CAS period, security concerns were prominent as a result of events both inside and outside of Pakistan including the war in Afghanistan and its effects, the war in Iraq, and the confrontation with India in On the negative side, risk perceptions and increased defense expenditures were a negative factor for the investment climate and fiscal balance, while rising oil prices put significant pressure on the budget and balance of payments. On the positive side, Pakistan's geopolitical role led to increased grant aid, debt restructuring on highly concessional terms, and expanded textile quotas. The post-9/1 1 tightening of money-laundering regulations resulted in largescale repatriation of holdings abroad and growing remittances, accelerating the accumulation of reserves. The growing rapprochement with India, beginning in 2003, has greatly reduced tensions and over the longer term holds the prospect for increased trade and economic integration.

68 Pakistan: CAS Completion Report Page 9 of Pakistan's performance contributed significantly to meeting CAS objectives. As reported in the CAS Progress Report, Pakistan's performance in implementing reforms put it in the high case and the macroeconomic turnaround was dramatic. On governance reforms, there were areas where the pace was slow such as in financial management, procurement and civil service reform. In some cases this reflected challenges in implementing a complex modernization and reform program while in others, proposed reforms faced formidable institutional and political obstacles, making the pace of change foreseen in the CAS too optimistic. STRENGTHENING THE ENABLING INVESTMENT CLIMATE 34. This pillar of the CAS was aligned with the I-PRSP which emphasized the importance of creating a favorable environment for trade and investment. The PRSP continued this emphasis, outlining measures to deregulate and open additional sectors to private sector activity and competition while increasing public sector investment, for example to address infrastructure bottlenecks. The CAS was designed to support the achievement of the following objectives: (i) improving the incentive and regulatory regime, (ii) privatization, (iii) financial sector reform, and (iv) accelerating rural growth. CAS performance benchmarks related to adoption of measures to modernize trade and industrial regulations and enforcement practices; complete selected privatization transactions; undertake reforms in power, oil, gas and transport; and implement reforms in water management and irrigation. The CAS also targeted improvements in related indicators such as growth in FDI, trade, and private investment, although baselines and specific levels were not targeted. 35. These outcomes were supported through development policy lending at both national and provincial levels as well as investment lending and AAA. SAC II and PRSC I supported actions in privatization, adoption of trade and regulatory reforms, and reforms in power, oil and gas. The provincial adjustment credits also set targets for the adoption of regulatory and other reforms designed to improve the business climate for growth in Sindh and NWFP. Banking Sector reforms were financed with development policy lending and investment lending including the Banking Sector Restructuring and Privatization project, the Technical Assistance to the Banking Sector project and the Banking Sector Development Policy Credit. In infrastructure, the Ghazi Barotha Hydropower project and the Telecommunications Regulation and Privatization Support Project were completed and closed during the CAS period while the National Highways Rehabilitation project was approved in FY04. AAA support included an Investment Climate Assessment and the Doing Business surveys, as well as policy dialogue and IDF support to the Committee on Reforms in Regulatory Legal and Policy Environment. A Financial Sector Assessment Program (FSAP) report was prepared in FY04. In trade, the Trade and Transport Facilitation Project (FY01) was completed while trade policy notes were prepared in FY04 and FY With respect to rural growth, the CAS strategy was to target next generation reforms to address the unequal opportunity and capacity to access assets and markets - land, water, credit, technology and output markets. The instruments to support these reforms included both lending and AAA. Lending in water and irrigation consisted of the National Drainage Program project (FY98-05) and On Farm Water Management projects in NWFP (FY01) and Sindh (FY04). PRSC I also supported agriculture and water sector reforms including further liberalization of wheat and sugar markets and further development of national water and drainage policies. Ongoing policy dialogue was supplemented by ESW reports on Rural Factor Markets and a Water CAS. The Public Expenditure Review also dealt extensively with irrigation and water issues. A planned Rural Development Policy Review originally planned for FY03 is now planned in FY06.

69 Pakistan: CAS Completion Report Page 10 of 30 Incentive and Regulatory Environment 37. The Government implemented a range of measures to improve the incentive and regulatory environment. A number of laws and regulations governing industrial relations were consolidated and promulgated in the Industrial Relation Ordinance In addition, the Drug Act 1976, long considered to be a deterrent to the healthy development of a pharmaceutical industry, was revised with input from stakeholders and promulgated as the Drugs Ordinance Additional reform of laws concerning industrial relations and labor protection is also proceeding and revised legislation is expected to be presented in 2006 including: (i) Amendment to Industrial Relations Ordinance 2002; (ii) Conditions of Employment Act; (iii) Wages Act; (iv) Occupational Safety and Health Act; (v) Human Resource Development & Control of Employment Act; and (vi) Labor Welfare and Social Security Act. Reforms to business registration procedures were undertaken in 2002 cutting the time for business start-up by more than half, from 53 to 22 days while provincial authorities in Sindh and NWFP reformed factory and business inspections to reduce harassment. 38. In trade, the CAS targeted increased exports, lower levels of effective protection and improved trade facilitation. Pakistan is one of the more open countries in South Asia. The maximum tariff rate is 25% and the number of tariff bands is four. The Government has eliminated quantitative restrictions, regulatory duties, para-tariffs, and several other measures that restricted trade in the past (with the exception of trade with India). During the CAS period, the government sustained the momentum of tariff reductions and weighted average tariffs continued to decrease from 14.2% to 13.4%. Agriculture has the lowest tariff rates in the region (13.1 %, down from 13.9% last year). In the FY05 budget, duties on cars were reduced from the range of 75%-150% to 50%-100%. The Trade and Transport Facilitation Project was completed satisfactorily in 2005, having contributed toward bringing Pakistan's traditional trade and transport practices in line with international best practices. 39. Financial Sector Reforms. The FSAP conducted in FY04 concluded that banking sector reforms have been effectively implemented and have significantly improved the soundness and efficiency of the financial system by reducing state intervention and improving the environment for banking. Privatization of large state-owned banks during the CAS period (Habib Bank and United Bank Limited) substantially changed the structure of the banking sector and nearly 80 percent of sector assets are now controlled by private banks as compared with 34 percent in 1999, and just 8 percent in As a result access to finance has improved and credit to the private sector has witnessed significant growth during the past three years. Last year alone private sector credit showed an increase of over 30 percent. A large part of the success of the reforms stems from the improved legal and regulatory framework and enhanced corporate governance as a result of the reduced role of the government and the enhanced role and capacity of the regulators, especially the State Bank of Pakistan which is being supported through the Banking Sector TA loan (FY03). Profitability and liquidity indicators for the commercial banks have shown a marked improvement. The banking sector has also become considerably more competitive and responsive. Efforts by the SBP are also underway to further strengthen the payment system to enhance its transparency and efficiency. 40. Power Sector Reforms. The CAS made improvement in the performance of the state-owned power sector a major focus. In part this reflected recognition that Pakistan needed expanded, more reliable supplies of power at reasonable costs to support its growth objectives. At the same the sector's considerable drain on the budget was seen as a threat to successful fiscal adjustment. In coordination with the Fund PRGF program, SAC II supported sector reforms and set targets under a financial improvement plan. However, progress in improving the financial performance of the main power utilities, WAPDA and KESC, fell short of expectations. The financial improvement plan agreed under SAC II was not fully implemented as the tariff increase approved was smaller than forecast and electricity rates were subsequently reduced despite continued high losses. Moreover, little progress was made in reducing

70 Pakistan: CAS Completion Report Page 11 of 30 public sector arrears and technical losses. Nevertheless, the program achieved a number of positive steps, particularly in laying the groundwork for the corporatization and eventual privatization of the sector. In addition, a top priority-the privatization of KESC-has moved ahead with successful bidding in January of Reforms in infrastructure. The I-PRSP and PRSP identified telecommunications reform as a key element of the reform program because of its linkages to other sectors. Progress in reforms has been strong, emphasizing enhanced competition within a supportive regulatory framework. In January of 2004, Pakistan de-regulated the sector, allowing free entry of new fixed-line private operators to compete with the state-owned Pakistan Telecommunications Company Limited (PTCL). PTCL was privatized in A new mobile telephone policy was also been approved to introduce further competition and additional cell phone licenses have been issued under a competitive bidding process. 42. Progress in implementation of the reform agenda in oil and gas was mixed as the Government's success in privatizing state-owned assets, increasing supplies, and improving regulation was offset by inability to adjust consumer prices as foreseen in the CAS. In FY05 the Government temporarily suspended its policy of automatic fortnightly petroleum price adjustments based on global oil prices, a setback which had a significant cost to the budget. Even though overall gas tariff collections met policy goals, implementation of the six-monthly gas price adjustment mechanism was also inconsistent and the government did not make progress in rationalizing the abnormally low gas tariffs maintained for the fertilizer industry. Accelerating Rural Growth 43. There was only incremental progress in achieving the CAS outcomes targeted in this area, namely improved land and water markets and improved efficiency of institutions in irrigation and drainage. Moreover, agricultural growth has been disappointing, averaging 1.7 percent per annum during the last seven years, though this is in large part attributable to drought; with favorable weather conditions, FY05 agricultural growth rebounded strongly, reaching 7.5%. The National Drainage Program (NDP) was the centerpiece of Bank projects to support implementation of institutional reforms in water, including decentralization and management transfer of irrigation and drainage systems in the Provinces. The NWPF On-Farm Water Management project (approved in FY01) and the Sindh On-Farm Water Management project (approved in FY04) also targeted enhanced water management and agricultural productivity through improved governance and investment in secondary and tertiary irrigation infrastructure. Implementation of the Sindh On-Farm Water Management project is in its earliest stages, progress in implementation of the NWFP On-Farm Water Management project has been slow. 44. Relative to its stated objectives and program targets the achievements of NDP were disappointing and its overall performance unsatisfactory, although there is now much greater ownership for its reform objectives. Notwithstanding its overall unsatisfactory rating, the project yielded several positive outcomes. First it helped clear the backlog of deferred maintenance of the existing irrigation and drainage system. Second although the institutional reform component has had mixed performance, the need, strategy, and decision to carry out the reforms have been endorsed at the highest levels of the GOP and Provinces. Third it was instrumental in the completion of key policy and sector studies that have paved the way for introduction of a National Water Policy and a drainage sector strategy for the country. Fourth the project improved the knowledge base by financing research, learning and international advice. Fifth, the project organized 223 farmer organizations covering an area of approximately 2 million hectares in which farmers are now responsible for the operation and maintenance of the irrigation system. Finally the project provided the studies, technical discussions, and the general forum for the discussion of long-term options for the sustainable development of the Indus river basin and as a consequence has raised awareness of the importance of sound environmental planning and management.

71 Pakistan: CAS Completion Report Page 12 of30 Assessment/Lessons Learned 45. The mix of lending and non-lending activities for this pillar of the CAS was satisfactory and contributed to the achievement of some of the outcomes sought. Policy dialogue and AAA were successful in helping the government to refine and articulate its reform vision and contributed to the adoption of a variety of measures. In particular, the use of development policy lending was well suited to supporting the very wide range of reforms that the Government of Pakistan was trying to implement. Development policy lending also provided financial incentives to undertake reforms and helped reformers advance their agenda within Pakistan. In areas where results fell short of expectations as in the power sector and in irrigation, the reforms sought were perhaps overly ambitious and resistance to adopting them was underestimated. An additional challenge, relevant to the water sector, was the difficulty in implementing a national level program in an area of provincial responsibility and where the provinces have adopted alternative approaches. 46. However, as noted by IEG with respect to the FY94-03 period, the range of activities in the rural sector could have been broader. The Bank's agenda for rural growth was limited mainly to policy dialogue on removing distortions in pricing trade and taxes (most of which had been removed by 2002) and work on reforming the irrigation system. Consequently there was a lack of strategic focus on agriculture and therefore key constraints to agricultural growth were not addressed. 47. Exogenous factors played an important role in determining CAS outcomes. Drought conditions which prevailed during reduced agricultural output while significantly worsening the financial situation of the power sector due to the need to import oil to make up for diminished hydropower availability. The rapid run-up in oil prices in 2004 clearly made it difficult for the government to continue to implement the oil pricing policy as originally envisioned. 48. Borrower performance in the Investment Climate pillar was generally satisfactory with a few exceptions. The Government's reform program was high quality and had the attention and support of the President, Prime Minister (once in place) and Finance Minister. Significant achievements were made in implementing reforms-particularly in the financial sector-and their impact in terms of increased exports and investment is now apparent. However, it is likely that these early results are in large part the result of the macroeconomic turnaround rather structural reforms. Further, second generation reforms, will be needed to maintain higher rates of growth and investment. 49. In some areas the pace of reform did not match the timelines envisioned in the CAS. This was principally due to an overall slowdown following the elections of 2002 and the lengthy transition thereafter. There were also delays in implementing investment projects, for example NDP. In some areas, particularly energy pricing, the Government found itself unable to carry out pricing measures that turned out to be more politically difficult than anticipated. In addition, some of the assumptions behind the government's reform program (for example with respect to reducing technical losses in the power sector) proved unrealistic. Nevertheless, in view of the accomplishments, the summary judgment is that borrower performance was satisfactory. SUPPORTING PRO-POOR AND PRO-GENDER EQUITY POLICIES 50. This pillar of the CAS reflected two elements of the I-PRSP and later the PRSP: (i) investing in human capital, and (ii) targeting the poor and the vulnerable. Recognizing the urgency of addressing the challenge posed by Pakistan's lagging social indicators, the I-PRSP outlined a strategy for improving delivery of health and education services through a combination of additional expenditure and improved governance to increase the effectiveness of social sector spending. The PRSP maintained this emphasis,

72 Pakistan: CAS Completion Report Page 13 of 30 noting that without considerable improvement in social indicators, including for women, Pakistan will be unable to sustain growth and poverty reduction. Since health and education are primarily sub-national concerns, with the bulk of expenditure taking place at lower levels of government, the GoP's devolution strategy represented the core policy action to address weaknesses in governance and improve the effectiveness of spending. At the same time, the provincial governments implemented other measures to strengthen management while scaling up promising approaches in health and education. 51. The Bank's strategy in Education was to support implementation of the Government's Education Sector Reform (ESR) program which was designed to improve access to and quality of education through investments in: (i) infrastructure; (ii) curriculum and textbook revision; (iii) teacher training; and (iv) establishment of a national education assessment system. The CAS aimed at a few intermediate outcomes including meeting the I-PRSP targets for increased expenditure on education, successful transition to district based delivery of education, and launching of the National Education Assessment System (NEAS), a sample-based national assessment of student learning, with standardized tests conducted at grades 4 and 8. The CAS indicated that these intermediate outcomes were intended to move Pakistan toward the MDG goal of universal primary education by 2015 with a goal of reducing the gender gaps in primary and secondary education by The latter goal was not met and no intermediate target was set for primary education outcomes. 52. The Bank program targeted both the federal and provincial governments recognizing their respective roles and responsibilities. At the federal level, engagement focused on supporting increased education expenditure in line with the I-PRSP and launching of the NEAS. Initially, the broad-based provincial DPLs in NWFP and Sindh were key instruments to support the provinces' education reform programs by opening up fiscal space at the provincial level to increase financing while supporting the implementation of reforms. However, the CAS also envisioned a more targeted instrument in the form of sector adjustment lending. This took the form of the Punjab Education Reform DPC, the first in a series of one-tranche education DPCs which was delivered in FY04 and which also supported devolution by strengthening incentives for improved service delivery at the local government level. A second credit was approved in FY05. The Northern Education project (approved in FY98) closed in FY04. The AAA program in support of education included a study of public and private partnerships in education and an MDG assessment, outlining the critical constraints and strategies for achieving the MDGs in Pakistan. 53. The CAS outcomes targeted for education were partly achieved. Financing for education has increased in line with I-PRSP targets with consolidated federal and provincial education spending rising from 1.5 percent of GDP in FY2001/02 to 1.8 percent of GDP in FY2003/04. The FY05 education sector allocations in the budget are consistent with the PRSP targets at 2.1% of GDP. The NEAS initiative was launched with Bank support in the form of a TA loan approved in FY03 and pilot testing of Grade 4 students in Language and Mathematics was conducted throughout the country in April 2004, although overall the NEAS project is behind schedule. 54. At the provincial level, reforms have moved forward at different speeds in the various provinces. In Sindh and NWFP a variety of education initiatives were supported through the provincial DPCs. Despite delays in follow-on rounds of these loans, budget allocations for education have been increased, additional teachers recruited, facilities rationalized and enrolments have increased. In Punjab, most targets under the education reform program have been exceeded. Education spending in FY04 was in line with program targets and the FY05 budget projects a further 15% increase. Free textbooks were distributed on time to 90% of primary school students and approximately 175,000 girls have received regular installment of monthly stipends to encourage retention and to increase enrolments in elementary grades. Preliminary school census data suggests significant increases in enrollments during the first year of the program.

73 Pakistan: CAS Completion Report Page 14 of Pakistan continues to make progress in improving key health and population outcomes, but the pace of progress has been slow. The health status of Pakistan's population remains well below countries in the region with similar or lower levels of income. The fertility rate remains much higher than its South Asian neighbors and a serious impediment to sustained economic growth. The PRSP recognizes the need to further increase financing and enhance the efficiency of spending and calls for the doubling of resources for the health sector over the next three years. The Government's priorities in health are to strengthen public health programs-immunization, communicable diseases, maternal and child health and family planning-while improving the quality of care at district and sub-district hospitals. 56. The CAS outcomes related to health included strengthening of key public health programs including Lady Health Workers, tuberculosis control, the Expanded Program of Immunization, polio eradication, malaria control, HIV/AIDS, and family planning and reproductive health. In line with the I-PRSP, increased expenditure on health was targeted along with an increased share of non-salary expenditures. Indicators to measure improved service delivery included increases in the percent of births attended by trained providers, access to Lady Health Workers, coverage of pre-natal care, contraceptive prevalence, and immunization coverage. Country outcome indicators for reductions in infant and child mortality and total fertility were drawn from the I-PRSP. 57. The Bank's strategy in health was to support reforms in health through a combination of development policy and investment lending as well as AAA. Both SAC II and PRSC I included actions related to increasing expenditure on health while implementing reforms to increase the effectiveness of spending, including expanding service delivery through NGOs and developing demand side interventions. Similarly, the provincial DPLs in Sindh and NWFP targeted increased health spending and improved management of health care facilities. An HIV/AIDS project was approved in FY03. Under an innovative partnership with the Gates Foundation, an IDA credit of $20 million was approved in FY03 to finance polio vaccine procurement for use in subsequent rounds of vaccination aimed at eradicating polio in Pakistan by Supplemental funding of $21 million was approved in FY05. AAA instruments included the MDG Assessment and a report on the public health surveillance system to assist in the development and implementation of a Public Health Surveillance and Response System. 58. The CAS outcomes targeted in the area of health were only partly achieved. Public health expenditures have increased, but not as rapidly as foreseen in the PRSP. Consolidated health expenditures have increased by 18% from Rs 22.4 billion in FY03 to 26.6 billion in FY04. However, as a percentage of GDP expenditures (using old GDP numbers) are estimated to have increased from 0.56% in FY03 to 0.59% in FY04, well short of the target of at least 0.7% of the GDP set in the PRSP. Strengthening of the immunization program for children has been launched and immunization coverage for children has increased from 49 percent in (1998/99) to 77 percent in (2004/05). Good progress was made towards polio eradication through supplemental immunization campaigns with the number of polio cases decreasing from 119 in 2001 to 53 in In 2005, only nineteen cases were reported through September. Pakistan has made significant progress in expanding TB DOTS program to 93% of the population with treatment success rate of 78%. However, the TB case detection rate is only 43%, indicating the need for enhancing demand for services. The Lady Health Workers (LHW) Program has been expanded to 92,000 LHWs, covering 56% of the population against a target of 70% mainly in rural areas. It is apparent that the program is having an effect on some important indicators but there is still significant room for improvement in many important areas, such as immunization and family planning. The national HIV/AIDS control program was launched in The Government has started to contract NGO to provide services to vulnerable populations; however the process has experienced delay. 59. Pro-Poor Targeted Programs. Targeting the poor and the vulnerable was an integral pillar of the I-PRSP and remains so in the full PRSP. The government's strategy was based primarily on expansion of safety net programs such as microfinance, public works programs, and transfer programs like Zakat and

74 Pakistan: CAS Completion Report Page 15 of 30 food support. The PRSP recognized the need to improve the targeting and delivery of these cash and in-kind benefit and other poverty alleviation programs in order to increase their coverage and reduce the leakage of benefits. The CAS also aimed to bring about strengthened governance and improved delivery of basic infrastructure services at the local level along with a deepening of the rural asset base. No specific indicators were identified for assessing progress in achieving these outcomes. 60. The CAS focused the Bank's role in this area toward a strategy of directly targeting rural poverty through rural community-based infrastructure projects and micro-credit, building on approaches which had been introduced in the previous CAS. At the same time, SAC II and PRSC I supported measures to scale up and strengthen existing safety net programs. The NWFP Community Infrastructure Project was underway at the time the CAS was prepared and a follow-on project was approved in FY04. The AJK Community Infrastructure Project (CIP) was approved in early FY03. Similarly, the Pakistan Poverty Alleviation Fund project was underway and a $238 million credit was approved in FY04 to extend additional support to this highly successful project which supports NGO-implemented infrastructure and micro-credit schemes. To help the government develop a strategy for strengthening safety net programs, the Bank prepared a detailed study of existing programs proposing reforms to improve their effectiveness and targeting, as well as enhancing the monitoring and evaluation of programs. 61. The outcomes in this area of the CAS are being achieved, though in some cases more slowly than anticipated. To date, the PPAF has surpassed most project targets and its poverty reduction programs have helped more than 2 million poor in all four provinces, extending loans to 122 thousand clients with an estimated average recovery rate of around 95 percent. Implementation of CIP projects has progressed somewhat more slowly than planned. The government has formed a Social Protection Working Group to discuss the progress of the work on social safety net reform in Pakistan. 62. The Bank assistance program in this pillar of the CAS reflected the trade-offs inherent in trying to improve delivery of social services in Pakistan in the context of devolution. The use of development policy lending was appropriate as a means to support the needed fiscal, policy and systemic changes. However responsibility for implementation rested with local governments having limited capacity and thus broad based federal and provincial development policy lending was less effective in supporting sector reforms. The more focused approach of using a sector DPC as in Punjab seems to have been more effective than the broader approach taken with the Sindh and NWFP SACs, although other factors, including an extraordinary degree of high-level commitment and ownership were also at work. In retrospect, greater use of TA to complement development policy lending might have been useful to help the authorities, especially at the provincial and local level to implement and monitor reforms adopted under the SACs. More in-depth analytical work at the provincial level might also have been helpful to strengthen the provincial reform programs. With completion of the Punjab Economic Report in FY04, and initiation of Economic Reports for Sindh and NWFP in FY05, this need is now being addressed. 63. Borrower performance under this pillar of the CAS was hampered by shifting responsibilities and capacity constraints. Specifically, provincial governments need to strengthen their policy formulation capabilities to ensure that well crafted departmental policy proposals, together with their financial implications are submitted for cabinet review and discussion during budget formulation. Similarly, the ongoing transition to district based service delivery has been accompanied by some hiccups such as delayed release of funds to districts. Some investment projects including HIV/AIDS, NEAS, and community infrastructure projects have experienced slow or delayed implementation. SUMMARY ASSESSMENT OF CAS PERFORMANCE 64. During the FYO3-05 period, the Bank program in Pakistan was for the most part successful in either achieving or making substantial progress toward the achievement of the outcomes set in the CAS.

75 Pakistan: CAS Completion Report Page 16 of 30 As described above and in summary table in Annex 1, many of the intermediate outcomes representing milestones in implementation of the reform program were met. While a number of outcomes were not met, the underlying reform programs are in place and government commitment appears strong, even if the pace of reform has not been as rapid as envisioned in the CAS. To the extent that data is available, final outcome indicators show some promising trends toward improvement. 65. Sustainability. The sustainability of the CAS outcomes is likely, although Pakistan's longer-term track record as an intermittent reformer suggests that this cannot be taken for granted. The CAS is well aligned with Pakistan's own reform agenda and continued commitment to the reform program appears likely. President's Musharraf's tenure in office will continue until at least The Prime Minister, Mr. Aziz, is a strong reformer. There is a high level of support from the international community. Despite occasional slowdowns, the government has shown the ability to sustain reforms in the face of significant challenges and political pressures. 66. Institutional impact. Bank assistance under the 2002 CAS has contributed to institutional development but this is an area where additional attention is needed. Key government institutions were targeted for modernization including the Central Board of Revenue, State Bank of Pakistan, Controller General, Auditor General, regulatory bodies, and key economic ministries. Capacity building assistance has been provided through investment lending and most have demonstrated improved performance. However, as observed in the CAE, institutional capacity is a widespread concern. Recognizing that institutional development and capacity building represent a cross-cutting challenge for Pakistan, a Public Sector Capacity Building Project was developed and approved in FY04 to support institutional development and capacity building in key ministries and regulatory bodies. C. Measuring Bank Performance Quality of Products and Services 67. IEG's FYO3-05 performance ratings for Pakistan show that of the eleven projects that exited during the CAS period which were reviewed by IEG, one had a highly satisfactory outcome, four had satisfactory outcomes, three had moderately satisfactory outcomes, two had moderately unsatisfactory outcomes and one was rated unsatisfactory (see Table 3, page 20). The latter project, the highly ambitious Social Action Program project, approved in FY1998, was the subject of an intensive learning Implementation Completion Report (ICR) which identified key lessons which are being used to guide the formulation of future Bank interventions in the social sectors. 3 A QAG panel carried out a Quality at Entry Assessment for the FY03 Sindh Structural Adjustment Credit. The panel rated the operation satisfactory overall, citing specific aspects as highly satisfactory including implementation arrangements, the degree of borrower ownership during preparation, and the quality of the Task Team. The panel also gave a rating of Satisfactory for Bank inputs and processes 68. In early FY04, the Quality Assurance Group (QAG) carried out a Country AAA Assessment for Pakistan. The report assessed the quality of a sample of AAA products from FY01-03 as well as the overall AAA program within the context of the strategic framework. While part of the sample related to work undertaken prior to the FYO3-05 CAS, several FY03 tasks were evaluated and the overall conclusions are applicable to this completion report. Overall, QAG found the Pakistan AAA program to be satisfactory. Of the sample reviewed, four tasks were completed during the CAS period and of these two were rated highly satisfactory and two were rated satisfactory. However, QAG also noted the strong emphasis of the program on macroeconomic management and recommended further work on other, growth-related, sectors including rural development, trade, and infrastructure as well as more attention to Implementation Completion Report, Second Social Action Program Project, Report No: 26216, June 25, 2003.

76 Pakistan: CAS Completion Report Page 17 of 30 the sub-national level. QAG also found that greater attention is needed in the areas of dialogue and dissemination in order to increase the impact of the AAA program. 69. Portfolio Performance. The World Bank's active portfolio in Pakistan, on June 30, 2005, comprised 16 projects with loans/credits amounting to $990 million (net of cancellation). Also included in the portfolio are two Grant projects-gef- Protected Areas Management ($10 million); and the Montreal Protocol Phase-Out of Ozone Depleting Substances ($13 million). About $561 million remained undisbursed. The disbursement ratio remained well above the target of 18 percent throughout the CAS period (see Table 2).4 Table 2: Portfolio Indicators Actual Performance Indicator FY02 FY03 FY04 FY05 Number of Projects Projects at Risk (%) Commitments at Risk (%) Realism (%) Proactivity (%) Disbursement Ratio Portfolio Management. The portfolio has grown somewhat over the CAS period after reaching a low at the end of FY 02 (the beginning of the CAS). The earlier reduction reflected the results of an aggressive portfolio improvement program under which 32 projects were closed. This trend has since been reversed as lending has picked up although the substantial proportion of single tranche development policy credits in the program (about one-third of the operations approved during the CAS period) has meant that the size of the portfolio has grown only modestly. Portfolio management has continued to emphasize good "quality at entry" and close collaboration with the Government of Pakistan to ensure project readiness and adequate management attention to emerging issues. To avoid delays in project startup, new projects have been subjected to close scrutiny to ensure that they exhibit strong client ownership and are ready for implementation prior to approval. Over the past three years, 100 percent pro-activity has been maintained. This process has been facilitated by country office leadership of project teams (50 percent of projects in the active portfolio are managed in the country office) and decentralization of many of the regional core services functions to Pakistan and regional hubs in the South Asia region. 71. Despite these efforts, a number of portfolio issues have begun to reemerge. Several projects in the current portfolio are slow moving and facing implementation issues; most of these relate to: (a) delayed project start-up, which has often led to slower progress subsequently during implementation; and (b) weak capacity to effectively implement projects according to agreed plans. Besides project specific implementation issues, key generic factors contributing to slow implementation include lack of adequate staff and funds for start-up activities, delays in obtaining routine clearances for loan negotiation/signing as well as opening of accounts, and delays in initiating the procurement process. These issues are being addressed intensively with the GoP in order to prevent a deterioration in portfolio performance. As it relates to Bank performance, these findings indicate that there is room for improvement on the part of Bank teams in developing simpler, more readily "implementable" projects with realistic timetables that reflect the time consuming nature of institutional reforms and decentralized approaches. 4 Disbursement ratio represents disbursements as a percentage of undisbursed balances at the beginning of the fiscal year, for investment lending only.

77 Pakistan: CAS Completion Report Page 18 of There is also a need to improve the results focus of the portfolio. The Bank recently undertook an Monitoring and Evaluation (M&E) Review of (i) its on-going portfolio; and (ii) Government systems for project M&E. The report found that due to weak M&E systems and inadequate capacity within GoP and implementing agencies, there is limited focus on monitoring of outcomes and results in many projects. At the same time, Bank teams need to do a better job of focusing on developing project-level results and indicators and incorporating the monitoring of these results into the supervision process. Country Dialogue and Aid Coordination 73. The Government has taken the lead in donor coordination under the leadership of the Economic Affairs Division (EAD), under the Ministry of Finance, which is responsible for development assistance coordination. Donor meetings resumed in 2001 and the Pakistan Development Forum (PDF) has been held on an annual basis since then, with all but one meeting taking place in Islamabad. Civil society and private sector representatives have participated in the PDF. The Bank's strategy has been to play a facilitating role in the government-led coordination process by supporting the PDF and actively sharing information and facilitating partnerships among donors and the GoP. 74. These efforts have been paying off as external partners have been increasingly aligning their strategies to the PRSP and making greater use of cooperative approaches in their assistance programs. For example, the UK and the US have begun to align their budget support with the Bank's PRSCs. In addition, the Bank has undertaken more joint analytical work in partnership with the Government and other donors. In 2003 the World Bank, DFID, and ADB completed jointly a CFAA. Two economic reports-- the Devolution in Pakistan (District Assessment) Report and the Punjab Economic Report-- were prepared as joint products of the World Bank, ADB, and DFID. The upcoming NWFP Economic Report is being prepared in collaboration with DFID and the Sindh Economic Report is being prepared in collaboration with the ADB. Nevertheless, IEG found that a number of donors expressed dissatisfaction with their interactions with the Bank. Among issues raised were inadequate consultation; lack of continuity of Bank staff interacting with donors; intermittent participation of senior staff at donor meetings; and poor information flow to donors and NGOs. 75. There are now strong efforts to harmonize with country systems, with a large percentage of development assistance disbursed as budget support once a year following the approval of the national budget. There have been efforts to improve the procurement and financial management systems of some line ministries and at the provincial level. A comparison between the World Bank's and ADB procurement rules was undertaken in 2004 as part of the harmonization exercise and as a result, harmonized procurement documents are available for use. A similar exercise is underway in the area of financial management. In addition, external partners have agreed to put together a joint "Portfolio Issues Paper" focused on key generic portfolio management issues faced by externally financed projects, for discussion with the Government. D. Key Lessons for the Next CAS 76. Based on the preceding analysis and the CAE, the following are the key lessons learned and recommendations for the next CAS. * Projects should be as simple and realistic as possible. The experience of a number of projects that closed during the CAS, especially the multi-province umbrella projects, highlights the need for focused projects that are readily "implement-able" with realistic schedules and clear ownership. In particular, governance reforms often took longer than planned. In the context of development policy lending, there is a need to guard against over-optimism as the difficulty of

78 Pakistan: CAS Completion Report Page 19 of 30 implementing reforms, especially those with wide impact and high visibility was at times underestimated. * The CAS program should give greater emphasis to capacity building. The CAE and a number of ICRs completed during the CAS identify weak implementation capacity as a critical constraint, especially at the local government level. This will require more TA in the program and in projects, building on the Public Sector Capacity Building Project approved in FY04. Civil service reform and institution building should continue to receive attention. Projects will also have to be designed to take capacity constraints into account, being realistic about both the scope and pace of implementation given those constraints. * A programmatic approach provides the flexibility to support reforms while managing risk. The use of annual single tranche adjustment operations at both the provincial and national level helped to support reforms while providing a mechanism to adjust the lending program to match the pace of reforms. This approach strengthened the link between borrower performance and the Bank lending program. * The program needs to continue to strengthen its focus on results. To address weak M&E systems and capacity within GoP and implementing agencies, the Bank needs to support the strengthening of statistical capacity and monitoring and evaluation as part of institution strengthening. At the same time, the Bank needs to do a better job of focusing on developing solid project-level results and indicators and incorporating the monitoring of these results into the supervision process. The results-based CAS offers an opportunity to identify and focus on key strategic outcomes at the country level and provide a framework for joint monitoring and evaluation of the overall country program with the Government.

79 Pakistan: CAS Completion Report Page 20 of 30 Table 3: Projects Closed During the CAS Period ICR Rating for: IEG Rating for: Institutional Closing Approval Institutional Date FY Outcome Dev Sustainability Outcome Dev Sustainabili Social Action Program 11 Jun U M L Unsatisfactory Modest Non-Evaluable Moderately Structural Adjustment Credit II Dec S M L Satisfactory Modest Likely Moderately Sindh Structural Adjustment Credit Dec S M L Unsatisfactory Modest Unlikely Moderately NWFP Structural Adjustment Credit Dec S M L Satisfactory Modest Likely Telecom Regulation & Privatization Jun S M L Satisfactory Modest Likely Moderately NWFP Community Infrastructure June S SU L Unsatisfactory Modest Unlikely Northern Education Sep S SU L Satisfactory Substantial Likely Moderately Ghazi Barotha Hydropower Project Oct S M L Satisfactory Modest Likely Punjab Education Sector Adjustment Credit Sep S SU L Satisfactory Substantial Likely National Drainage Program Dec ## Highly Poverty Alleviation Fund Dec S SU L Satisfactory Substantial Likely Banking Sector Restructuring and Privatization Dec HS # HL Satisfactory Substantial Likely Pakistan PRSC I NWFP SAC II Dec S L M Dec S M L Improving Financial Reporting and Auditing May S SU L HS=Highly Satisfactory, MS=Moderately Satisfactory, S=Satisfactory, MAS=Marginally Satisfactory, MS=Marginally Unsatisfactory, MU=Moderately Unsatisfactory, U=Unsatisfactory; HL=Highly Likely, L=Likely, UN=Unlikely, HUN=Highly Unlikely, HU=Highly Unsatisfactory, H=High; SU=Substantial, P=Partial, N=Negligible, NRT=Not Rated, UNC=Uncertain

80 Pakistan: CAS Completion Report Page 21 of30 Key issues/ Diagnostic ANNEX A: PAKISTAN COUNTRY PROGRAM RESULTS MATRIX (FYO3-05) CAS Strategic Objectives & Status at FY04 CAS Progress Report Update at end-cas Outcome Indicators Macroeconomic Stability Despite good macroeconomic Macroeconomic Stability as Achieved; external balances have met or exceeded PRF PRGF successfully concluded with quantitative targets met management, the external and demonstrated by achieving targets trom targets, inflation remains subdued and foreign exchange Economic growth has continued to accelerate and external domestic public debt are both I-PRSP for fiscal consolidation, reserves have risen to a comfortable level and domestic imbalances have been brought to sustainable quite large and hence there are domestic savings, debt levels. However inflationary pressures have grown still concerns over the fragility of the external position and future Tax1GDP ratio has risen from 12.9% in FY01 to 13.6% in Limited progress overall. FY03104 Tax1GDP ratio was 13.6%, growth prospects. The o Higher Tax/GDP ratio FY03. FY04105 programmed at 13.8% ("old" GDP). September 11 shock has also increased the risks to the balance of payment position by e Reduced Fiscal DeficitYGDP Fiscal deficit (excluding grants) declined from 6.7% to 4.5% FY03104 fiscal deficit 4. 0% of GDP,- FY04105 fiscal deficit was making more uncertain an early of GDP. 4.1% of GOP which is broadly consistent with the PRSP fiscal resumption of long-term private capital inflows as well as increased access to * Sustainable current account deficits > Achieved; FY03 current account surplus of 4,4% of GDP. Achieved. FY03u04 current account balance was 1.4 percent of GDP surplus; FY0405 balance was -1.e6% international capital markets * Provinces fiscal space restored Provinces have expanded own revenue collection while Provinces, particularly NWFP and Punjab have substantially using donor resources to re-profile debt and reduce interest costs. The upcoming National Finance Commission Award is expected to include a substantial increase in the provinces' share in overall revenue, framework. increased fiscal space through debt management and increased revenue collection. However inability to reach agreement on NFC award leaves provinces' share of resources unresolved and makes sustainability uncertain. SContinued tight management of )o> Evident in primary surplus and progress in debt reduction. External government debt has fallen from 35% of GOP in external borrowing Pre-payment of high cost debt and increased reliance on 2002/003 to 28.2%% in New external borrowing concessional financing have reduced interest expenses has been weighted toward official sources on soft terms. from 37% to 31% of government expenditure. A4Debt Policy Coordination Office has been established to sustain implementation of strict controls. Sound financial position of WACDA c While there has been some progress in sector restructuring this has yet to result in a significant improvement in WAP A finances

81 Pakistan: CAS Completion Report Page 22 of 30 Key issues/ Diagnostic CAS Strategic Objectives & Status at FY04 CAS Progress Report Update at end-cas Outcome Indicators Restoring the Integrity and Accountability of State Institution *At the core af the poor *Improvement in government >Difficult to assess comprehensively, but promising steps in Reforms ate still being developed. Further rest ructutingan governance problem in effectiveness at federal, provincial, and civil service reform and in key reforming agencies apparent. pay/pension reforms are being developed to improve efficiency and support devolution Pakistan is the leadership's district levels abuse of state institutions, widespread corruption, and Transparent budgetary processes and MTBF is still in a pilot phase with expansion to cover the entire disregard for the separation improvement in overall quality of federal budget not expected until 2010/2011 of powers and respect for the financial management thru the MTBF rule of law "Improved public sector, accounting, Substantial progress. Expenditure reconciliation increased Though less than planned, there was substantial progress in auditing, and reporting capacity, to 99% in FY03 Modernized chart of accounts and introducing modernized systems under PIFRA I (closed in automated accounting system being introduced, though at FY05), laying the groundwork for further improvement under a slower pace than envisioned. Timeliness and quality of PIFRA (FY06). About 40 percent of financial and fiscal audits improving. transactions of government expenditures are covered by PIFRA-modernized systems. * Promulgation of a Procurement Ordinance National Procurement Progress has been slow. GoP has created a procurement Government notified new procurement rules conforming to Authority established regulatory authority (the PPRA), but is still in the process of international best practice in However, implementing preparing revised guidelines. The NWFP government has regulations, monitoring systems and enforcement approved a modern procurement ordinance and is in the mechanisms remain to be established process of issuing regulations to implement it, * Improved CBR performance Functional reorganization of CBR underway. Pilot Large Progress continues to be satisfactory. Additional Large and and Medium Taxpayer units functioning with improved Medium Taxpayer units have been established. Tax customer satisfaction ratings. Administration Reform Project approved in FY05 automated acontn syste beingn inroucd thugea * Ad-hoc Public Accounts Committees (PACs) have cadt botte o Limited progress. Ad-hoc PACs reduced, but did not The Federal PAC has now been established along with the FedAs hand Pcal levelsh the eliminate the backlog. These have now been disbanded to Provincial PACs. It has made good progress in reviewing audit Federal ofit Repors tye be replaced by regular PACs under the auspices of elected reports and tracking and monitoring cash recoveries from reviewed ofandi taeaport follow- national and provincial assemblies. However, while the public officials. It is still devising a strategy for addressing the acion provincial governments have reconstituted PACs, the backlog of audit reports with capacity building assistance up ifederal govement has yet to constitute its PAC. The new under an F grant and with WI support. The backlog is due PACs will need time to address the remaining backlog of in part to the poor quality of the audit reports resulting in a reports. very heavy volume of audit findings accutabrilit tro Freel Proceedings se of the ad-hoc federal and provincial PACs See above on functioning of PACs. Federal PAC proceedings Iccunformaiit, etih futo of te were open to the public. Phase 1M CFAA was published in are open to the public and a Freedom of Information Publrmtic Ac n, ctve omm ies, ofthe December 2003; implementation plan is being developed. Ordinance was enacted in October 2002 and implementing Pubic Agreement s the NAB organization and legal basis are under review rules were passed in June The Ordinance provides a

82 Pakistan: CAS Completion Report Page 23 of'30 Key issues/ Diagnostic CAS Strategic Objectives & Status at FY04 CAS Progress Report Update at end-cas Outcome Indicators outcomes of the second phase of the legal right to access public records. NAB organization and CFAA, and the establishment of a legal basis are still under review. lasting institutional basis for the National Accountability Bureau. * Better performance evaluation, meritbased promotions, and training > Reforms in the promotion system have been introduced to Government has appointed a Pay and Pensions Committee to programs, as well as the make evaluations more objective, increase transparency in develop recommendations to reform civil service implementation of the reforms of the promotion, and to link promotion to higher grades to compensation. Its recommendations were issued in pay and pension systems required training. Two rounds of pay increase have been Civil service training is being revamped under the Public implemented but pay scales remain highly compressed. Sector Capacity Building Project. Strengthening the Enabling Investment Climate a Heavy burden of tax *Low tax and regulation compliance >Investment Climate Survey carried out and results According to the 2005 Doing Business indicators, the cost to administration and regulation, costs Lower compliance costs reported disseminated through workshops. Business registration start a business fell from 70 percent of gross per capita and related corruption in business environment surveys, procedures reformed, cutting the time for business start-up income in 2002 to 47 percent in 2003 and further to 36 percent in half, from 53 to 24 days. The GoSindh has streamlined in Government is in the process of revising labor * Unstable, distorted industrial business inspections from 23 to 7, with all to be done on legislation to improve labor market flexibility and reduce policies one day. discretion of government inspectors. Administrative Barriers to * Anti-export policy bias investment study has been completed, identifying turther * limited availability of financing actions. from weak financial sector to the particular disadvantage of * Increased availability of domestic Credit to private sector increased from 107 Rs.B (July02- the SME sector financing for private investment Mar03) to 362 Rs B (JulyO43-AprO5) a High regulatory and policy risks for private investment in 9 Greater private provision of ptne n orderlto extractive industries and infrastructure regulatory framework for public-private encourage greater private provision of infrastructure. These infrastructure * Development of extractive industries efforts are starting. * Lower levels of effective protection Good progress in streamlining tariff schedule and reducing Pakistan continues to liberalize the trade regime. The barriers to trade. The simple average tariff rate declined 2004/05 budget reduced tariffs on capital goods and lowered from 51 percent in 1995 to 17 percent in Numerous the average customs duty to 14.9%. quantitative restrictions, regulatory duties and other paratariffs eliminated. Statutory regulatory orders and related exemptions also reduced. * Higher FDl > FD remains low, but is increasing, rising to $800 million in FD grew by 60% in FY05 to reach $1.5 billion FY03, vs. $485 million in FY02.

83 Pakistan: CAS Completion Report Page 24 of 30 Key issues/ Diagnostic CAS Strategic Objectives & Status at FY04 CAS Progress Report Update at end-cas Outcome Indicators * Higher exports : Exports grew 19 percent in Continued strong growth; Pakistan's exports reached $ 14.4 billion in FY05, growing by 15.9 percent over the FY04. * Higher private investment > Private investment has started to increase, but remains low Investment has risen, but further improvements in by historical standards. microeconomic fundamentals are needed to encourage additional increases in investment. * Increase in output and employment in > Data not yet available. SME sector contributed 30% to GDP and generated 25% of SMEs manufacturing sector export earnings. * WAPDA corporatization completed > Corporatization complete "on paper" by end December Further progress achieved. NEPRA has issued cost reflective 2003, but this has not yet resulted in managerial and tariff determinations, however notification is still pending and financial independence needed to give the newly formed the newly independent entities have not yet been made entities the incentives to improve service financially autonomous. * Effective regulation thru NEPRA > Performance of NEPRA (the power regulator) continues to Difficulties in completing the tariff determination process improve as reflected in the timeliness and quality of tariff indicate that NEPRA needs further strengthening to fully determinations and support to the corporatization and assume its role. privatization processes through the timely issuance of operating licenses. * KESC Privatized > Not done. Brought to point of sale but limited investor Met. Kanooz Al-Watan of Saudi Arabia/ Siemens consortium interest prevented sale. successfully bid to acquire 73% of shares in early 2005 e Rehabilitated highways, improved NHA > Bank supported Highways Rehabilitation Project underway. Highways Rehab project is progressing satisfactorily. Trade financial management, and improved Improvements in NHA financial management include facilitation reform has not yet streamlined the systems; it still trade facilitatnion. adoption of Medium-Term Budgetary Framework and takes an average of 17 days to clear an import container operation of a Road Maintenance Fund to help ensure through customs. sustainable delivery of a productive and efficient national highway network. IDA supported Trade and Transport Facilitation program under implementation. Accelerate Rural Growth Acceerat HgherRurl GrwthRural Rual Gowt e growth increased from -0.1 % in FY01 to 4.2%. Average * Skewed land distribution and *" Higher Skwedlanddisribuionandfor Rural Growth GAS period is projected to be 4.3% vs. -0/9% for previous low agricultural productivity GAS period, due mainly to drought * Weak link between rural growth and reduction of rural * Improved efficiency of institutions in Irrigation and drainage infrastructure remains underdeveloped poverty irrigation and drainagerelative to Pakistan's needs and water markets are Smrv dainxagdedirgtoan undeveloped. Additional water storage capacity is also Irrigationan drainage infrastructure neemainsficincyderdevelopedslow * Improved and expanded irrigation and

84 Pakistan: CAS Completion Report Page 25 of 30 Key issues/ Diagnostic CAS Strategic Objectives & Status at FY04 CAS Progress Report Update at end-cas Outcome Indicators * Strengthened community/farmer Community/farmer organizations have been strengthened in organizations some areas. Overall institutional reforms are still in early stages, and advancing in select areas. * Full implementation of institutional and > Irrigation reforms in the Nara Canal are well advanced. Institutional reforms have been fully put in place and physical physical rehabilitation reform in 1 major rehabilitation begun. These efforts will be deepened and canal command (Nara Canal). expanded in the follow-on Sindh Water Sector Improvement Project * Improved land and water markets > Reforms in water markets are advancing in a limited area Institutional reforms in water management are being extended and will need to be implemented more broadly to increase and deepened in Sindh while similar reforms have begun in efficiency of water use. Land markets reforms in initial Punjab. The Bank is supporting improvements in land stages registration systems to improve land market functioning. * Reduced vulnerability to drought. > Some progress through DERA project implementation Improved hazard risk management being pursued * Update knowledge on rural > Rural Factor Markets Study underway Rural Factor Markets Study completed. Rural DPR underway development * Devolution and Delivery of Rural > Too early for comprehensive assessment Rural services The legal framework and administrative structures for Services devolved, but transitional issues are affecting delivery. devolved delivery of rural services are in place but funding and NWFP CIP/l project will support rural service delivery while administrative capacity are lacking at the local government addressing local government capacity. level and links between local governments and communities need to be strengthened. Education * Education service delivery mproved access to, quality of, and Primary net enrolment reported to have reached 60 percent in system in crisis equity in primary education, moving 2004 vs. 43% in 2001/02. Nevertheless, it appears unlikely towards the MDG goal of universal that the country will achieve the MDG of full primary * Low enrollment, poor primary enrollment by 2015 completion by achievements, poor quality of education Closing of the gender gap in primary Female enrolment as a percent of male enrolment rose from Very poor governance * and secondary education by % to 85% from 2001/02 to With sustained efforts it is possible to eliminate gender disparities in primary enrolments by 2007 * Implementation of Education Reform The federal ESR program is under imp/ementation and its Strategy elements are reflected in the full PRSP and in the federal

85 Pakistan: CAS Completion Report Page 26 of 30 Key issues/ Diagnostic CAS Strategic Objectives & Status at FY04 CAS Progress Report Update at end-cas Outcome Indicators budget. A remaining challenge is to ensure that ESR priorities are fully reflected in provincial and local education programs. Health, Nutrition and Population * Development of a reliable monitoring > Largely achieved with poverty outcomes monitored through The first results from the CWIQ Survey were released in system for HD outcomes. strengthened Pakistan Integrated Household Survey. December 2005 and the results of a full household survey are Intermediate outcomes are monitored through a CWIQ expected in 2006 survey. Full PRSP outlines comprehensive monitoring system under Federal PRSP Secretariat. * Successful implementation of district > Under devolution districts have assumed responsibility for National and provincial governments' sector reforms are based delivery of education services delivery of education but more work is needed to increasingly aligned to the devolved delivery system. strengthen their capacity and ensure their fiscal and administrative autonomy in order to fulfill their role. * Improved governance in social service Too early to tell. Some promising early signs of improved delivery governance resulting from provincial education reforms under devolution, but comprehensive assessment is not yet possible. * Low public spending and poor * Country Outcomes in the IPRSP, tobe MR has decreased from 83 per 1000 live births to 76 per value for money because of achieved by include: to reduce 1000 live births in 2003 (Pakistan Demographic Survey) TFR governance and management the MR to 65/1000, to reduce child of 4.1 meets I-PRSP target; MR target likely not met weaknesses mortality to 17/1000, to reduce the TFR to 4.1 children per woman, The I-PRSP * Weak capacity in the public also sets targets in terms of improved sector for policy formulation, coverage of water and sanitation, programming, implementation, and M&E " Poor quality of private health 0 Strengthened and expanded key public Increased resources have been provided for each of these The programs have been strengthened and expanded care services and consumer health programs, including Lady Health programs. Progress mixed with LHW, Polio and TB Dots although overall spending has increased by less than planned. abuse Workers, TB-Dots, EPI, polio making significant progress and immunization program eradication, malaria, HIcVAIDS, and showing modestly positive results, although significant * Important factors outside the family planning/reproductive health. challenges remain. health sector include poverty, lack of education especially of - Increase in the % of births attended by >Likely to be achieved, FY01102 actual was 24% increasing Achieved. Skilled birth attendance has increased to 31 %, up women, environmental trained providers to 25% by from baseline of 19% from 23% in 2001 and 18% in 1998 factors, and many households lacking access to * Increase in the % of fully immunized Modest progress; FY01102 coverage was 53%, rising from Immunization coverage reached 77% in 2004/05 safe water and sanitation children to 85% by

86 Pakistan: CAS Completion Report Page 27 of 30 Key issues/ Diagnostic CAS Strategic Objectives & Status at FY04 CAS Progress Report Update at end-cas Outcome Indicators * Increase in the coverage of prenatal > Modest progress; FYO1/02 coverage increased from 31% to Achieved. Pre-natal care coverage has increased to 50% care to 50% by %. * Increase in the % of population with > 56% of population has access to LHWs, increasing from Not met: 65% coverage achieved in FY003/04. The LHW access to Lady Health Workers (LHWs) baseline of 40%. - target revised to 70% of population program continues to expand and improving access to PHC to 90% by targeting mainly rural population. Revised target likely to be and FP services as envisaged in the PRSP. The program has achieved by end FY05. expanded to 92,000. * Increase in the CPR to 39% by > Updated data since last CAS not yet available. (Projected Latest estimate: 32% in CPR estimated at 32%) * Increase in public expenditure on > Increases achieved inline with 1-PRSP targets from 0.5% of Public health expenditures have increased, but not as rapidly health and nutrition as a percentage of GDP to 0.6% of GDP. Further increases programmed as foreseen in the PRSP. Budget allocations have been GDP. under full PRSP. increased, but utilization has lagged. While health expenditures increased in nominal terms by on average 18% annually, as a percentage of GDP they grew only marginally from 0.44% in FY02 to 0.48% in FY05. * Increase in the share of non-salary > Data not yet available Data not yet available expenditures in total government health expenditure * Increase in the share of government > Data not yet available. Data not yet available subsidy in health services accruing to the poor Pro-Poor Rural Infrastructure and Services and Social Protection * Very poor rural infrastructure * Community driven development of local and social service delivery service provision systems * High vulnerability of rural poor to idiosyncratic shocks Implementation of PPAF and Community Infrastructure Projects has resulted in improvements in project areas, but there is a need to scale-up these efforts through enhanced * Strengthened governance and > Comprehensive assessment not yet possible. Progress varies across provinces and sectors, but overall improved delivery of basic Improvements in governance and service delivery at the there are signs of improvement. infrastructure services at the local level, local government level are beginning to show, but further

87 Pakistan: CAS Completion Report Page 28 of 30 Key issues/ Diagnostic CAS Strategic Objectives & Status at FY04 CAS Progress Report Update at end-cas Outcome Indicators progress in adapting to the devolved local government framework is needed for widespread improvement. Pro-Poor and Pro-Gender- Equity Policies * Rural asset base deepened through > Bank supported community infrastructure project (CIP) rural community-based infrastructure underway in AJK. Recently completed CIP in NWFP projects and spread of micro-credit. delivered community infrastructure projects in 90 communities. PPAF project supported over 3,000 smallscale infrastructure projects in villages. * Significant gender gaps in * National Resettlement Plan Policy > A Resettlement Ordinance has been prepared, but awaits No further progress both literacy and health status action. * Institutional and attitudinal * Resolution of outstanding Resettlement Satisfactory progress in addressing outstanding cases. Resettlement cases associated with Bank projects resolved discrimination against women cases * National Gender Policy > Government issued a National Policy for the Development and Empowerment of Women in SChanges in Laws to promote gender > Electoral reservation system has been instituted, Changes in laws to promote gender equity have been ein dramatically expanding women's political participation. Little proposed, but not acted upon by Parliament equity progress in amending discriminatory statutes.

88 Pakistan: CAS Completion Report Page 29 of 30 Annex B: Pakistan - Planned Lending Program and Actual Deliveries CAS Plans (May 15, 2002) Progress Report (March 26, 2004) S(M) Status $( FY Project IBRD IDA IBRD IDA 2002 Drought Emergency Recoverye Actual Banking Sector Restructuring/Privatization Actual AJK Community Infrastructure 20.0 Forwarded to 2003 Banking Sector TA 26.5 Forwarded to 2003 Structural Adjustment Credit II Actual Sindh Structural Adjustment Credit (SAC) Forwarded to 2003 Total Total AJK Community Infrastructure 20.0 Banking Sector TA 26.5 Sindh SAC NWFP Provincial Adjustment Credit 90 Actual 90.0 Highways Rehabilitation 100 Forwarded to 2004 (now actual) HIV/AIDS Prevention 20 Actual 37.1 National Education Assessment System 5 Actual 3.6 Education Reform SAC 150 Forwarded to 2004f Tax Administration Reform 100 Forwarded to 2005 Provincial Adjustment Credits (Sindh, 110 NWFP forwarded to 2004 (now actual); NWFP) Sindh dropped Economic Reform TA 25 Additional Actual Projects: Partnership for Polio Eradication 20.0 Total Total Progress Report (March 26, 2004) Completion Report $(MS M) FY Project IBRD IDA Status IBRD IDA 2004 Poverty Alleviation Fund II Actual Highways Rehabilitation Actual Punjab Education Sector Reforms Actual Public Sector Capacity Building TA 52.0 Actual 55.0 Sindh On Farm Water Management 61.0 Actual 61.1 NWFP Community Basic Infrastructure 37.0 Actual 37.1 Poverty Reduction Support Credit Forwarded to 2005 Additional Actual Projects NWFP SAC II 90.0 Total Total PRSC I Improving Financial Reporting and 80.0 Forwarded to 2006 Auditing Tax Administration Reform Actual Balochistan Irrigation 25.0 Forwarded to 2006 Infrastructure Development Actual (Changed to Taunsa Barrage Rehabilitation) Banking Sector Adjustment Credit Actual Poverty Reduction Support Credit Forwarded to 2006 NWFP SAC II 90.0 Approved in 2004 Additional Actual Projects Partnership for Polio Eradication II 21.5 Punjab Education Development II Total Total Reallocation from already committed IDA resources - not counted as new commitments. Project changed to Punjab Education SAC

89 Pakistan: CAS Completion Report Page 30 of 30 Annex C: Pakistan - Non-Lending Services: Planned and Actual Deliveries (FYO3-05) FYO3-05 CAS Plans Status: CAS Progress Report FY Product Type Status 2003 Investment Climate Rpt Completed Provincial Economic Reform Rpt Forwarded to FYO4-06 Policy Note to New Government Pol Completed JSA - PRSP Rpt Completed CFAA II Rpt Completed CPAR II Rpt Dropped Oil & Gas Sector Review Rpt Completed Financial Sector Assessment Rpt Forwarded to FY04 CAS Progress Report CAS Forwarded to FY04 Public Expenditure Review Rpt Completed Rural Development Policy Review Rpt Forwarded to FY06 Power Sector Review Rpt Forwarded to FY05 Sindh Rural Development Policy Review Rpt Dropped Social Risk Assessment Rpt Dropped Additional Actual Products: FYO4-05 CAS Progress Report 2004 District Assessment/Devolution Rpt Completed Punjab Economic Report Rpt Completed Poverty Update Rpt Completed Trade Policy Notes Pol Completed Rural Factor Markets Rpt Completed Power Policy Notes Pol Completed Textile & Clothing Policy Note Pol Completed Financial Sector Assessment Rpt Completed Urban Development Non-Lending TA TA Forwarded to FY06 Mineral Sector Development Pol Ongoing 2005 Water Sector Strategy Rpt Completed NWFP Economic Report Rpt Completed Country Gender Assessment Rpt Completed Public-Private Partnership in Education Rpt Forwarded to FY07 Pakistan MDG Assessment Rpt Ongoing JSA - PRSP Progress Report Rpt Completed Labor Market Policy Note Pol Forwarded to FY06 Social Protection NLTA Rpt Changed to Report/Forwarded to FY06 Pakistan-India Trade Study Pol Dropped Sindh Economic Report Rpt Forwarded to FY06 Agriculture Output Market Rpt Dropped

90 Page I of 16 ANNEX III: PAKISTAN PRIVATE SECTOR STRATEGY 1. This note describes progress in implementation of the World Bank Group's (WBG) Private Sector Strategy for FYO3-05, reviews the current challenges and outlines a Bank Group Private Sector Strategy for FYO6-09 taking into account changing market conditions and the evolving agenda emanating from the continuous process of multi-level economic reform. Economic Context 2. Following some of the lowest growth, highest debt and fastest growing poverty in South Asia during the 1990s, the early part of the new millennium represented a key period of transition in Pakistan's recent economic history. At the beginning of the decade, policy makers fundamentally adjusted the development policy toward unleashing the power of the private sector. Reforms which addressed macroeconomic imbalances, opened the economy to trade, reduced regulation and began transforming the role of the state as an owner/operator were complemented by a buoyant world economy, significant capital and remittance inflow and improved market access. Macroeconomic stability was achieved, debt dynamics reversed and policy credibility was re-established leading to a positive economic response of higher output, more predictable market signals and a growing confidence within the business community. Economic growth returned to over 6 percent and, helped by a strong agricultural season accelerated to over 8 percent in Despite this early success investor response has so far been muted as investment's share in GDP has fallen from 16 to 13 percent over the last few years. Rapidly increasing competition in global markets for Pakistan's traditional exports has added uncertainty to long term growth prospects and sustained the economy's dependence on lower value added activities. There is growing awareness among stakeholders of the need for entrepreneurial dynamism, technology adoption and a business-friendly policy environment to raise productivity growth and improve international competitiveness. The challenge is enormous, given Pakistan's historical legacy of stagnant world market shares concentrated in low value added products (Box 1). The World Economic Forum's competitiveness benchmarks capture the myriad influences on national productivity and show Pakistan's relatively low, but increasing position in global and regional rankings.' Progress Since the Last CAS 4. The Government's interim Poverty Reduction Strategy Program, was operationalized in the FY Country Assistance Strategy. For private sector development, the CAS emphasized Government undertaking near term actions to foster a more favorable business environment while embarking on the long, difficult process of converting the State's role as owner operator to business facilitator and regulator. This conversion required stable policies, improved infrastructure, modernization of business regulations, improved tax administration, trade liberalization, privatization of public sector enterprises, reduced barriers to entry by new and smaller entrepreneurs, deepened financial sector reform, and expanded access to finance for new and under-served sectors. Specifically, the private sector strategy envisioned (i) building the knowledge base in PSD; (ii) strengthening Pakistan's investment climate, (iii) conversion of the role of government; and, (iv) adequate provision of infrastructure services. Good progress was achieved in many of the strategic areas as described below. 1 Pakistan's 2004 rankings in the Growth Competitiveness, and Business Competitiveness indicators were 91 and 75 respectively out of 104 countries while the Heritage Economic Freedom Index placed Pakistan at 153 out of 176. In 2005, these ranking rose significantly, with the Growth and Business Competitiveness indicators at 83 and 66, respectively and the Herigage Economic Freedom Index improving to 110 out of 153.

91 Page 2 of 16 Box 1: Pakistan's Starting Point: The Challenge of Growth in a Global Economy (GOP, Towards a Prosperous Pakistan. A Strategy for Rapid Industrial Growth, March 2005) Industrialization and export orientation outcomes over recent years reveal the challenge Pakistan faces in moving to a more globally competitive and dynamic set of economic activities. Key facts cited below underscore the challenges inherent in Pakistan's starting point. * Lagging industrialization. Over the past three decades, the share of manufacturing value added in GDP increased from 14 percent in the 1970s to around 18.4 percent today while the share of exports to GNP increased from 8 to 17 percent over the same period (with 3 percentage points added in the past three years) - a much lower supply response to globalization than that witnessed in East Asia. * Stagnant global market share. Pakistan's share of world exports has been stagnant over the past 25 years while the share of manufacturing exports from Malaysia, Mexico and Thailand have doubled and the share from China has tripled. * High concentration of low value added production. Two thirds of manufacturing value added is accounted for by textiles, leather, sugar, food, beverages and tobacco, pharmaceuticals, industrial chemicals, minerals, and basic metals while three quarters of exports derive from 5?? product groups: cotton based yam, textiles and garments, rice, leather and leather products and sports goods. Within cotton based textiles, fabrics, knitwear, bed wear and cotton yam account for half. * Low share of dynamic exports. In 2002, 31 percent of exports were considered "dynamic" where Pakistan achieved an increasing market share of a growing world market. In 40 percent of products, Pakistan is losing market share. * Technological sophistication is low. With much lower resource based exports over the past two decades, the share of low technology products increased from 54 to 76 percent of total exports while medium technology products increased from 7.8 to 8.4 percent. High tech products remained negligible at 0.6 percent of total exports in Note: Low tech products have stable, well diffused technologies, and include textiles, garments, footwear, other leather, simple metal and plastic, furniture and footwear. Barriers to entry are low and competition is based on price. Medium tech products are heavy products like autos, industrial chemicals, machinery and standard electrical goods. These products require complex, stable technologies with moderate R&D but advanced engineering and design skills, and large scale production. Barriers to entry tend to be high due to capital requirements and strong learning effects in operation and design. High tech products are complex electrical, pharmaceuticals, aerospace, precision instruments, and fine chemicals. These products have fast-changing technologies and complex skill needs and therefore have the highest barriers to entry. * Building the knowledge base in PSD. Two important firm level surveys took place during the period which underscored the 'micro-level' impediments that have constrained Pakistan from fully enjoying the benefits of global integration. 2 A number of policy notes assessed the effectiveness of trade reforms and encouraged stronger export-oriented growth. Finally, an IDF grant implemented by the Ministry of Industry and Special Initiatives (MOI&SI) examined a range of areas in support of economy wide regulation and strategy formulation. 4 2 The Investment Climate Assessment (PK-ICA, 2003) demonstrated that productivity can be enhanced by improving key elements of the country's investment climate. The Administrative and Regulatory Cost Survey Study (ARCS, 2004) examined the official and unofficial costs associated with administrative barriers. 3 These include a TariffRationalization Study and Implications ofabolition of the Textile and Clothing Quotas. ' The areas studies included, labor legislation, the Drug Act, regulation at the level of SMEs, anti-competitive behavior and company registration studies in support of an industrial strategy.

92 Page 3 of 16 * Strengthening the enabling Investment Climate. Based on the initial analytical work, the key areas of reform initially address focused on the business-government interface in the areas of labor, tax, customs and business entry. The investment climate agenda was mainstreamed into federal and provincial level policy based operations, including the NWFP and Sindh SACs as well as the PRSC. Implementation support in the areas of tax and customs was supported by capacity building for the Central Board of Revenue while the revision of the labor code was initiated with the deregulation grant. * Conversion of state's role from owner/operator. The enormous challenge of fundamentally transforming the state's role from owner-operator to facilitator-regulator across many key economic activities was accelerated. Privatization of finance, utilities, and industrial enterprises made great progress, the opening of controlled markets in telecommunications, media and ICT was initiated and has been accelerating, and legal and regulatory frameworks along with independent regulatory oversight have been strengthened. Policy reforms and performance triggers were supported under SAC II and PRSC I while directed support has been provided to government and independent agencies carrying out new roles.' * Infrastructure. In addition to ownership, regulatory and governance improvements attention to other challenging areas of infrastructure in power, telecom, and gas and transport, including tariff policies in power and gas, the financial viability of key public sector entities like WAPDA and the elimination of losses throughout the power system. Transport issues include poor rural mobility, urban congestion, inadequate financial and operational performance of Pakistan railways and costly port systems and inadequate trade facilitation. Bank operations in power, telecommunications and oil and gas have been focused on strategic and policy advice supported by development policy lending through SAC II and PRSC I and in telecommunications, complemented by the Telecommunications Regulation and Privatization project. In addition to a strong program of analytical work, the Bank is supporting rehabilitation of the highway network (through the Highways Rehabilitation Project) and assisting in modernizing trade and transport facilitation under the Trade and Transport Facilitation Project. * Access to finance. Similarly, ownership, soundness and regulatory strengthening in the financial sector will go far to expand access to finance for formalized commercial activities. A Banking Sector Adjustment Credit approved in 2005 is supporting sustained soundness of the newly privatized banking sector while the Banking Sector TA in providing continued support for operational strengthening of the State Bank of Pakistan. In addition, along with commercial banking reforms, efforts to widen access were supported by the Bank under PPAF and other banking operations, including expanding micro-finance to the bankable poor, widening prudential regulations to cover SME, consumer, and micro-finance lending and establishing private credit information services * IFC's program during the last CAS period. Over the past three years, IFC introduced new financial products and a greater focus on key strategic sectors, including financial markets, small and medium-sized enterprises and infrastructure. IFC has also put greater emphasis on technical assistance and advisory services in addition to traditional investment operations. o Investment operations. During the period, US$187 million in sixteen new investments were committed in infrastructure, information technology, the financial sector, textiles, and pulp and paper. Particular examples of groundbreaking investments include: Including through the Telecom Regulation and Privatization project, the Banking Sector Adjustment and Technical Assistance Loans and the Public Sector Capacity Building Project.

93 Page 4 of 16 * Pakistan International Container Terminal to upgrade the port of Karachi, including civil works, container handling equipment and expansion of capacity in the-container yard. * TRG, which demonstrated the viability of Pakistan as a location for call centers. The company became the largest of its type in the country and is expanding operations throughout the region. * First UDL Modaraba where an Islamic financing product was used in the leasing sector. * Dewan Salman Fibre Limited where the introduction of preference shares, the provision of a local currency product and a linkage program with its small suppliers complemented an investment to expand its production capacity and restructure its balance sheet. o Technical Assistance Trust Funds (TA TF) During the period, two studies were completed: (i) a feasibility study on the country's private health care industry, including an assessment of the market for general and specialized services; and (ii) an analysis of the competitive positions of the country's leasing companies and investment banks. Foreign Investment Advisory Service (FIAS) completed a private sector development strategy for the Northwest Frontier province. o PEP - MENA. An extensive technical assistance and ramped up advisory program focused on supporting (i) improvements in the business enabling environment (BEE), (ii) financial sector, (iii) SMEs and (iv) challenging advisory assignments addressing privatization issues and public-private partnerships. Particular examples include: Strategic Objectives * Financial markets support covering a range of activities, such as corporate governance, institution-building in housing finance, women's banking, and micro and SME finance. * Business enabling environment including (i) assistance to the Pakistani Securities and Exchange Commission in efforts to de-mutualize the countries three stock exchanges, (ii) the introduction of alternative dispute resolution to promote mediation for SMEs. * General support to SMEs in the form of work with business membership organizations to assist them in supporting SMEs in their industries including work focused on the automotive supplier sector and the introduction of its "Business Edge" program, which provides a platform for Training of Trainers for SMEs. * Advisory and Public-private Partnerships including the initiation of a program to (i) advise on the privatization of the Faisalabad Electric Supply Company, and (ii) bring private sector operators into the water sector through work on the Lahore Water publicprivate partnership. 5. The Government's objectives for private sector development are based not only replacing the state in commercial activities, but on becoming globally competitive through cost minimization and innovation. As Pakistan moves from a focus on macroeconomic stability and restoring growth to one of productivity growth and sustained private investment, innovation through FDI and technology development will be needed to enable further gains and economic diversification. To accomplish this, the economy will require lowering the cost of doing business, stronger domestic competition with easier entry and exit, better infrastructure and wider access to finance, including equity, fixed income and project based. Therefore, PSD objectives seek: * An environment which fosters a dynamic manufacturing sector and entrepreneurial activity within an export-oriented policy framework based on improved competition in product and factor

94 Page 5 of 16 markets, innovation and skills upgrading, greater diversification and participation in global supply chains; * An investment-friendly policy stance for all enterprises, large and small, through continued reorientation of the state's role, strengthened economic governance, improved infrastructure and better law and order; * Improving the financial sector environment for intermediation, the legal framework and judicial process for enforcing financial contract, the depth of capital markets, the quality of financial infrastructure and access to financial services,- and * Development of rural areas where most of the poor live based on productivity gains in agriculture and non-farm activities from improvements in policies and rural infrastructure. Current Policy Challenges 6. Policy makers increasingly recognize that sustaining the current high rates of economic growth requires globally competitive production in an increasingly demanding world market. Therefore, based on considerable progress in stabilizing and reorienting the economy, policy makers are focused on strengthening international competitiveness through rising productivity in order to support higher wages, a strengthened currency and increased returns to capital. Macroeconomic stability and the removal of price distortions have eliminated impediments to productivity growth but will only translate into rising productivity if accompanied by a conducive business environment. 7. Notwithstanding Pakistan's notable policy achievements and company level strengths, there is a consensus among policy markers, academics and the business community that improvement in Pakistan's competitiveness derive from success in three "second generation" areas which impact firm level productivity. First, economic governance to instill market discipline and provide certainty in investment returns poses a particular challenge, encompassing such entrenched factors as efficiency and effectiveness of government and autonomous institutions, quality of regulation, political uncertainty, corruption and the rule of law. Second, efficiency of factor markets to foster flexibility and fluidity represents a major constraint to good resource allocation and ease of entry, particularly in the case of land and labor. Third, physical infrastructure and transport logistics have a major impact on international competitiveness and have become important priorities for Pakistan. 8. In addition to these, two specific areas are of interest to Pakistan's policy makers, concerned with ensuring that growth is sustainable and broad based. First, issues reflecting technology adaptation represents the new frontier for Pakistan business in an increasingly globalized market. Second, sub-national differences are particularly poignant in Pakistan as a federation of four vastly different provinces with growing urban - rural divide. 9. Economic Governance. A driving force behind firm-level productivity is an environment of open and fair competition which encourages low costs, high efficiency and innovation to survive. Minimized cost of regulatory compliance, ease of entry, expedient exit and institutional protection of property rights and fair competition are key components of a supportive policy regime. Not surprisingly, institution building is a long, difficult process for the executive, judiciary and independent regulators. As a result, the consistency, certainty, and predictability of the economic governance framework - including the laws and regulations, the adjudication mechanisms and their enforcement agencies - still fall short of minimal standards as reflected in a recent deterioration in governance indicators. 6 6 In 2004, Pakistan ranked in the bottom 20 percent in four of six indicators with the other two in the bottom third During the , the ratings fell for three of the six indicators and did not change for two others (Kaufmann, Kraay Mastruzzi, Governance Matters IV. Governance Indicators for , The World Bank, May 2005.

95 Page 6 of Entry and Post - Entry Regulation. Starting and running a business in Pakistan has become easier in recent years due to concerted effort across a range of regulatory processes, but key challenges remain in terms of land acquisition, site development, construction licensing, and utility hook up, all of which carry a high degree of administrative burden and are governed by provincial and local authorities. A significant source of government-business interface stems from compliance processes involved with tax, customs and labor regulation.' In all of these areas, the Government is undertaking comprehensive programs with the explicit objectives of lowering the compliance burden while improving the effectiveness of government oversight. Legislated efforts are being driven at the federal level and a range of implementing agencies are undergoing capacity building and process re-engineering to ensure better government - business interface, focusing initially on federal tax administration, customs facilitation and labor protection Court Efficiency. Without the credible threat of an efficient and effective insolvency, adjudication and dispute resolution mechanism, risk taking by businesses is suppressed and innovation forgone. Court processes, judicial capacity and supporting institutions (advocates, registries, accountancy and related professions) have been notoriously ineffective in enforcing contracts and protecting property rights in Pakistan. Just over a third of businesses surveyed in 2002 expressed confidence in the judiciary as commercial parties increasingly use the courts to delay and or stop transactions through stays and continuances. Case backlog-around half of which concern cases of commercial nature-in the High Courts of Sindh and the Punjab number over a hundred thousand, and for the lower courts, in the millions. When cases do go forward, it takes, on average, 46 steps, more than a year and almost a third of the contract value to enforce a contract. 10 Standardized indicators comparing the average time (2.8 years) and cost (4 percent of the estate), to close a firm are not excessive by international standards, but legislated restrictions in labor law, the company law and its associated insolvency procedures are cumbersome and inadequate. Adjudication of commercial cases, already a lower priority in the courts, will become even more inadequate as new legal frameworks are introduced for foreign investment, insolvency, monopoly regulation, anti-money laundering, insider trading and corporate governance. 12. Competition Policy. Pakistan lacks effective legal framework to govern fair competition and an associated institutional framework to promote competition within the domestic market. At a time when privatization, utility deregulation and economic restructuring are radically changing the competitive landscape, the extent of domestic competition, industrial concentration and barriers to entry in the economy is not well understood in Pakistan.. However, with the opening of previously uncontestable markets, large scale privatization and anecdotal evidence citing concentration in primary sectors such as cement and fertilizer, Pakistan has recorded low rankings for local competition." At the same time, sectors such as power, oil and gas, telecommunications and electronic media are opening to private sector competition and are experiencing some of the natural challenges associated with rapidly transforming regulatory landscape in technically difficult areas. Cite Pakistan's 2006 DB Rankings. Recent surveys detail the process of business start-up, demonstrating that the process to initiating business operations can take more than a year. Accordingly, the World Economic Forum's indicator, "Administrative Burden for Startup," fell from 7 2 nd in the world in 2003 to 9 2 nd in An indication of the regulatory impact on formal firms' cost of doing business is that Pakistani managers, on average, spend 10 percent of their time dealing with Government regulation; higher than other comparator countries apart from China and India, (The World Bank, Investment Climate Database). 9 For example, federal tax and customs authorities are undergoing institutional restructuring and process reform. For labor inspections, provincial governments are experimenting with different approaches, including combining visits and pre-announcing (Sindh), self-regulation (Punjab) and exemptions for low risk firms (NWFP). 10 The high number of steps to enforce a contract may be a contributor to the perception that the judiciary is one of the most corrupt institutions in the country. " For example by The World Economic Forum, Global Competitiveness Report.

96 Page 7 of Factor Market Conditions. Well functioning markets for land, labor and capital enable optimal resource allocation and maximum factor productivity growth. Pakistani authorities have taken bold steps to improve the banking sector, but deficient labor and land markets continue to be viewed as major constraints in Pakistan's investment climate. 14. Labor Market and Skills. Pakistan's labor market efficiency ranks low by international standards due, in part, to antiquated and restrictive regulations governing maximum hours, overtime conditions, length of temporary contracts, remuneration rates, welfare contributions and retrenchment procedures which impact bilateral market relationships and cause real wages to diverge from productivity levels, preventing efficient resource allocation and harming competitiveness. The discretionary approach of provincial inspectors, labor tribunals and wage authorities in enforcing requirements and adjudicating disputes adds considerable uncertainty to labor market outcomes. The result is that many, if not most, firms circumvent labor laws to some degree, most often by using contracted or piece rate labor on a very short term basis and often hired through intermediaries, suppressing investment in labor skills 1 2 and sustaining concentration on low value added activities. 15. Land Market and Industrial Estates. Access to land markets and the use of land as loan collateral is fraught with difficulties, involving a multitude of public agencies at the federal, provincial and state level which own, manage, tax and regulate commercial land. For transactions which do occur in the private sector, the inherent weaknesses of the system of registering prevent certainty of property rights. These include the multiple agencies involved in land registration, complex and opaque records keeping and sale transactions taking place without valid conveyance documents. These legal inadequacies and procedural deficiencies prevent indisputable land title and is one of the primary causes of the case backlog in the courts. Moreover, without clear property rights, lenders will not consider collateral as loan security without an original sale deed in the bank's possession. The resulting "dead capital" and lack of site access, hinders leveraged investment, firm level entry and efficient resource allocation. The rapid rise in land prices throughout Pakistan has made the situation even more constrained as hoarding is encouraged, underreporting for tax purposes is rising, and a new cadre of speculative players has entered the market. 16. Federal and provincial governments have countered problems with land access and site development by making available plots on government owned land in industrial estates with mixed success. 13 Reason include (i) inappropriate selection of location; (ii) poor quality of infrastructure and support services; (iii) insufficient land in prime business locations; (iv) rigid government rules regarding eligibility of investment; and (v) inadequate stakeholder participation in estate management. The Federal Government is piloting new models of public-private partnerships to locate, develop and manage new industrial estates, drawing on the Sundar experience in Punjab. 17. Financial Markets. The past five years witnessed considerable deregulation, liberalization and privatization in the financial sector. Starting from three quarters of banking assets controlled by the public sector in the late 1990s, almost 80 percent of assets are now under private control. Reforms were initiated to strengthen the regulations and the regulator, reform the National Savings Scheme (NSS) to rationalize interest rates, strengthen enforcement of financial contract; rationalize the tax structure and foster greater disclosure and transparency. Still, the supply of longer term finance and capital market development remains limited. Among other implications, this constrains the development of nascent financial markets such as housing and leasing which depend on the availability of long term funding in the banking sector. The insurance and pension system is small, dominated by public institutions, invests 12 Pakistan's basic education and skills indicators are at the lower end of global rankings and have been falling. A survey of the 35 principal industrial estates across the country reveals a stock of more than 17,000 plots, two thirds of which have been allotted. The survey also reveals the low occupancy rate for most estates apart from 100 percent occupancy in SITE in Sindh, and Raiwind and Kot Lakhpat in Punjab Ministry of Industry, Production and Special Initiatives, A Prosperous Pakistan, 2005.

97 Page 8 of 16 in government assets, and is highly taxed. The 700 companies listed on the Karachi stock exchange4 are capitalized at around 24 percent of GDP as compared with 50 and 130 percent in Mumbai and Kuala Lumpur, respectively. The legal system for enforcement of financial contracts is partly untested and is faced with problems at the execution level, 1 5 and credit bureaus are at an early stage of development. The lack of a tested secured transaction regime as well as the nascent private credit information system limits access. 18. Infrastructure Development. In addition to low penetration density and coverage ratios, the performance.of infrastructure services has been relatively poor, particularly in the area of power. At the same time, the conditions of the roads, railways and ports hinder Pakistan's competitiveness by preventing adequate logistical linkages among firms and with their customers 19. Power. The principal infrastructure issue facing the business community, particularly larger established firms, is access to reliable power both at the business start-up phase, in terms of obtaining electricity connections, and during business operations, in terms of having reliable supply. In addition, the sector's pricing structure involves cross-subsidization with the burden falling particularly hard on industry, adversely impacting investment decisions and competitiveness enhancement. Current challenges include (i) the high technical and commercial losses in the system, increasing from 23 to 27 percent of total output between 1995 and and in some cases reaching as 40 percent; and (ii) the extension of services to underserved areas as estimates indicate that almost of third of the population has no access to power. 20. Telecommunications. In the global market with growing connectivity requirements, telecommunications represents a key determinant of the country's investment climate. Pakistan has taken significant steps to (i) end the state monopoly for fixed lines resulting in numerous companies providing services at competitive rates; (ii) privatize the public telephone company leaving the sector fully managed by the private sector; and (iii) approve a cellular mobile policy in January 2004 leading to two additional cellular mobile operators being licensed. These initiatives have led to a complete liberalization of the sector and significant foreign investments. Low penetration rates are increasing rapidly, as telecoms density has increased from 4.6 to 9.8 lines per 100 inhabitants between 2003 and 2005 and the sector as seen a dramatic reduction in prices. Connection time is improving and the sector now has the potential to be a strength in Pakistan's investment climate. However, there is a significant lag in rural telecommunications access, as the positive developments and impact in the sector are mostly confined to the urban and semi-urban areas. The difference in penetration between rural and urban users is quite high, as half of Pakistan's 50,000 villages have no access telephones or the internet. This is primarily due to its lack of commercial viability and penetration is at a meager 1 percent. Facilitating rural telecommunications access will enable e-government and e-services to be delivered to rural areas and assist in overall economic development of the country. 21. Oil and Gas. Representing 41 and 36 percent, respectively of the total commercial energy consumption, the Government's long-term goal for Oil and Gas is to institute a largely privatized sector. Beginning with a fundamental policy shift in 2000, the Government began to focus more on policy issues, state enterprises were slated for privatization and natural monopolies were entrusted to an autonomous regulatory body. Progress in the reform agenda has been mixed. The movement toward Government divestment and improved regulation has proceeded relatively well. On the demand side, the domestic price mechanisms continue to be distorted by cross subsidies among different classes of consumers and the mechanism for adjusting gas price has been erratic. In 2004, petroleum prices were prevented from 14 KSE lists all companies on the Lahore and Islamabad stock exchanges apart from five companies listed in Lahore. 15 The Financial Recoveries Ordinance 2001, has been effective for several years but has been used sparingly due to recent judicial challenges. It will only become fully effective once it is upheld by the supreme court of the country. 16 The World Bank, World Development Indicators, 2005.

98 Page 9 of 16 adjustmenting to reflect world market conditions, creating pressure on private suppliers and distortions in consumption and investment patterns. 22. Transport: Roads, Railways, Ports. Pakistan's potential competitive position is highly dependent on the quality and cost of its internal and external transport systems. However, the sector is inefficient and so far has been unable to overcome the competitiveness disadvantages of both long sea and land transport links. Major markets are located at considerable distances from Pakistan and the location of its main production center is over 1,000km from the sea. The sector faces further cost disadvantaged in terms of scale, since total import/export flows are relatively small. Key sector issues are: (i) poor rural mobility;" (ii) urban congestion;" (iii) ineffective state railways monopoly carrying 3 percent of the total cargo traffic; and (iv) costly port systems and inadequate trade facilitation. 23. Innovation, Globalization and FDI. Policy makers and the business community recognize that improved processes and increased efficiency at the firm level will require appropriate technology adoption and a drive for innovation. Effective demand for new technology by commercial enterprises will rise as they participate in vibrant competitive markets exposed to global prices and driven by sophisticated consumer demand. The adaptation process also requires (i) an educated workforce; (ii) positive incentives for risk-taking; (iii) integration between academic/government sponsored research and business applications; and (iv) a spillover of knowledge transfer which comes from participation in the global economy, through integration with inward FDI and participation in global supply chains requiring producing to world standards of price, quality and delivery time. 24. Though a rapidly developing ICT infrastructure, is undoubtedly having a positive impact on telecommunications and innovation, the challenge for Pakistan to develop into a more knowledge based economy are morebasic, given the education and labor skill outcomes described above. In addition inadequate technical expertise to support innovation, 19 a limited amount of risk capital along with a low degree of globalization 20 and low levels of inward FDI, despite one of the more liberal regimes in the world 21 is limiting Pakistan's ability to capture productivity gains emanating from innovative ways to do business. 25. Provincial Role in the Investment Climate. As a highly diverse federation, significant differences in the investment climate are seen across provinces, attributable in part, to variances in political, security, and economic management issues. 22 Due to the increasing importance of vertical integration and inter-firm linkages in the global marketplace, such regional differences become an issue of national competitiveness. While inter-provincial competition can be healthy for reform, the creation of policy induced location advantages and differences in perceptions of security, crime and political stability can adversely affect efficient resource allocation. Moreover, as provincial governments and increasingly local authorities are responsible for much of the business interface with regard to labor and other type of business inspections, tax administration, license approval, land and site development issues and judicial enforcement, the nature of a firm's investment climate depends on good implementation and coordination with Federal policies. 17 Particularly as 45 percent of unpaved roads are mostly in rural areas. 1 Particularly in Karachi and Lahore, which support close to a third of Pakistan's GDP. 19 Science and technology indicators as well as higher education outcomes have fallen over the past decade and currently lag most other comparator countries (The World Bank, Knowledge Assessment Database, 2005). 20 Pakistan's ranks in the bottom ten out of 62 countries for four globalization dimensions economic, personal, technological and political (AT Kearney / Foreign Policy Globalization Index, 2004),and ranks 144 out of 163 countries in FDI as a share of GDP for the period (World Bank, World Development Indicators, 2005). 21 The government liberalized the foreign investment regime in the 1990s by opening strategic sectors to foreign ownership, reducing required approvals, expanding profit repatriation and providing national treatment and legal protection. Seedy dispute resolution and a further opening of the service sector was legislated in Pakistan ranks 81s in the world according to the WEF indictor "Regional Disparities in the Business Environment".

99 Page 10 of Public-Private Dialogue. By establishing close connections to the local business community, provincial governments have mobilized private sector initiative to play an important role in activities traditionally considered exclusively as within the public sector's domain. Areas where the private sector is increasing getting involved include strategy formulation and policy advice (Sindh, NWFP), industrial estate management (Punjab, Sindh, NWFP), vocational training (NWFP), and privatization transactions (Sindh). Increasingly, the private sector will be able to play more substantive roles in providing public services through more sophisticated public-private partnerships in municipal services particularly water and sewage, road building, information technology and knowledge development. 27. Entry and Post-Entry Regulation. To achieve a favorable impact from reforms addressing business start-up, labor regulation, and tax administration, federal reforms require complementary implementation efforts at the provincial level. In addition, there are other pre- and post entry regulations solely within the purview of provincial governments that need to be reviewed to ensure that barriers to entry are minimized and the cost of doing business is comparable with other countries. Implementation should be at a harmonious pace across Pakistan to avoid perceptions of permanent policy induced location advantages Factor Markets. As market mechanisms for land, labor and capital, are only starting to be addressed, provincial governments have an important responsibility in the development of land markets which in turn will support improved access to finance. In the interim, improved management of industrial estates can provide increased access to publicly held land and utilities In addition, as they are responsible for enforcement of labor legislation, provincial governments have a key role in breaking long standing market rigidities. As Federal legislation is being reformed, provincial governments will need to re-tool their implementation mechanism to enable real wages to better reflect productivity, supporting competitiveness and improving resource allocation. 29. Judicial Efficiency. Property rights are weak in Pakistan generally, with contract enforcement and land disputes based more on negotiated settlements than rule of law and judicial enforcement. Provincial governments can directly contribute to improvements in judicial processes in three ways. First, improved governance and better performance of government officials in implementing regulations would lessen the crowding out of purely commercial disputes. Second, efforts to improve the functioning of land and labor markets would remove a second source of taxation on court time. Finally, ensuring adequate capacity and a rational structure at lower court levels while simultaneously working toward filling vacancies and improving procedures for commercial cases at the High Court, would significantly contribute to the certainty and predictability of property rights. 30. Security and Crime. Issues outside the normal parameters of economic management have been shown to significantly affect investment climates around the world, 24 but are perhaps more important for Pakistan than for other economies. Perceptions of security risks as well as local crime, though hard to quantify, have clearly had an adverse impact on investment and growth. Perception of political instability at the regional political arena, even if constrained to the local region, has been a clear deterrent to investment throughout Pakistan, as well. Together local issues of crime and political stability, can infect the entire country and contribute to a short term corporate view and suppresses investment by the business community. 23 Doing Business Pakistan, 2004 shows significant regional differences in the legislated cost and time associated with a number of business procedures, including opening a business, contract enforcement, and property and collateral registration. 24 For example, Ayyagari, Demirgtig-Kunt and Maksimovic, How Important Are Financing Constraints? The Role of Finance in the Business Environment, (Forthcoming) shows that "maintaining political stability, keeping crime under control, and undertaking financial sector reforms are likely to be the most effective routes to firm growth."

100 Page II of 16 The Way Forward 31. Economic Governance. As the economy increasingly opens up to international trade and investment, attention has turned to regulatory and institutional reform to create a more certain and predictable environment for commercial transactions. Good progress is being made in tax, customs, financial, labor and utility regulation as the first areas to be tackled with the next round focused on: * Risk based approaches emphasizing self-assessment will be deepened through tax and customs administration reform and will be expanded to labor inspections under the planned new labor code and prudential regulation of the financial sector under Basel II. * Business laws will have their own program of modernization, particularly in areas covering insolvency, corporate governance, and competition law. In addition the Securities and Exchange Commission of Pakistan (SECP) will be strengthened and complemented by an activation of a credible competition authority. * Expeditious adjudication of commercial cases is being actively pursued. Implementation of the pending legal reform bill will limit procedural delays (stays, continuances, etc.) and introduce formalized alternative dispute resolution. More fundamental reform is under consideration including a commercial court, commercial benches, streamlined and summary procedures, and systems of registries, accountancy, and enforcement. * In all areas the principal of strengthening enforcement agencies to implement strengthened legal frameworks, along with a credible system of operational rules, procedures and monitoring systems will be pursued. * Process reengineering would be a central part of capacity building efforts with an expansion of existing pilot e-government initiatives to improve the business-government interface. 32. Efficient Factor Markets. Efforts to improve the functioning of factor markets are a central pillar of Pakistan's drive for economic restructuring. Deepening financial sector reforms, expanding efforts to improve labor markets and initiating a more rational approach to land markets will involve: * Codifying, rationalizing and liberalizing antiquated legislation governing labor compensation, industrial relations, working conditions, health and safety requirements and human resource development. 2 5 * Initiating a two tracks system to develop land markets: (i) develop a new, clean system of land titling for new transactions to ensure sovereign backing, easy transferability, and rational taxation; and (ii) begin carrying out the complex and delicate parallel activity to establish property rights in the face of ownership disputes. In the interim, in order to feed and provide credibility to the new land titling system, federal and provincial authorities would inventory underutilized land to be auctioned and transferred according to the newly introduced system. * In the interim, provincial governments will observe implementation of the various models of public-private partnership in industrial estate development and management such as SITE, Ltd in Sindh and Sundar in Punjab to formulate "best practice" guidelines for estate management. 25 Laws are being redrafted to replace federal and provincial laws and regulations covering employment conditions, labor welfare, health and safety and human resource development. The first act, Services and Employment, recognizes piece-rate contract workers in the legislation, expands the weekly hours and overtime hours, particularly for women and reduces the compliance cost on business.

101 Page 12 of 16 * To deepen financial sector reforms and improve term transformation, the remaining large public sector commercial bank, specialized financial institutions and insurance companies will be privatized, regulatory constraints on investments by insurance and pension/ provident funds will be rationalized and corporate governance will be strengthened. Further deepening of the financial sector through analytical and advisory assistance and operational investment in key finance sectors such as housing finance, leasing, SME finance and microfinance will have positive spillover effects on the rest of the economy by spurring household and entrepreneurial savings and investment spending. * Access to credit will increase with improvements in the legal framework and judicial processes for enforcement of financial contracts (such as a modem secured transactions regime for movable collateral) and an expansion of private credit registry coverage. 33. Infrastructure. Government efforts to provide better infrastructure have been intensive in recent years and characterized by successes in telecommunication and oil/gas and slow progress in power sector reform. Therefore, the near term agenda in infrastructure includes: * In power, strengthen implementation of the Government's Sector Recovery Plan, which aims at (i) completing the unbundling of Water and Power Development Authority (WAPDA) into separate transmission and distribution companies; (ii) accelerated privatization in generation and distribution; (iii) aggressive cost and loss reducing measures throughout the system; and (iv) improved tariffs and subsidies, for distribution companies to enable better targeting of subsides and enhance operational and financial performance. Implementation delays are causing more losses in the system, further complicating the challenge. Based on the investment backlog in the sector, investment lending would support distribution and transmission, hydropower and rural access. * In telecommunications, continue to implement the 2003 deregulation policy and 2004 mobile cellular policy by (i) strengthening the policy and regulatory environment for licensing, interconnection and tariff regimes; (ii) completing the privatization of the state-owned monopoly as an integrated company; (iii) continue opening the cellular market to further competition by selling additional licenses; and (iv) accelerating rural telecommunication and broadband connectivity. Under this new competitive, open regime, capacity enhancement is needed both for the Ministry as a policy making body as well as the regulator. * In oil and gas, domestic prices should reflect fully world market conditions. Gas tariffs, are priced close to long run costs on average but are still below opportunity costs for households and for the fertilizer industry. Over time, pricing decisions will be made by the Gas Regulator (ORGRA) rather than the Cabinet, but with rising demand and depleting reserves, imports will begin in the coming y ears. On the oil side, efforts to unbundle and privatize the large enterprise (Pakistan State Oil, Oil and Gas Development Company and Pakistan Petroleum Limited) will be strengthened as world petroleum prices are increasingly passed through to the consumers. * In transport and trade logistics, develop a strategic approach to the sector focusing first on the Indus trade corridor linking the major ports with the major city and corridors in the North with an objective of developing an integrated approach to planning, investment and managing the Indus transport logistics system. There is a significant maintenance backlog in the sector requiring maintenance of $1 billion per year. Continued high-level commitment and support will help accelerate reform initiatives in the Pakistan Railways. Capacity constraints at the National Highway Authority of Pakistan will be addressed to avoid delays in new highway construction. Finally, delays in finalization and adoption of laws, rules, and procedures that were developed

102 Page 13 of 16 under the trade and transport facilitation program will be eliminated. As a particular emphasis, transport in rural areas will be pursued under the country's devolution framework. * The institutional framework for Private Public Partnerships (PPP) in infrastructure needs immediate attention to attract private financing to transport, urban services, energy and other infrastructure areas. The immediate steps will be to prepare and issue a PPP policy to identify sectors, the institutional framework (PPP unit) and funding mechanism while in tandem pilot projects are pursued to demonstrate the viability of the PPP framework, for example with highways or municipal services. 34. Innovation, Technology Improvement and FDI. To help capture productivity gains from advances in business processes, improved techniques and increased technology content of production, public and private initiatives will aggressively seek competitive markets at home, participation in the global economy and development of the human and financial resources required for innovation, including: * A globalization driven, outward-orientation is needed in firm level business strategy to benefit from a broader set of markets, resources and technologies. However, to participate, domestic firms require a competitive operating environment at home which rewards firm-level innovation, investment in skills, improved industrial organization and risk taking. * Pakistan needs to offset perceived risks of foreign direct investors stemming from perceptions regarding security, stability, and corruption with an aggressive program to attract foreign investors. Recognizing the lingering reputation risk from high profile disputes with private companies, passing legislation to recognize international arbitration would be a strong and a positive signal to foreign investors concerned with unpredictable contract enforcement. * Government's role in knowledge development is to focus on the basics, including (i) improved education outcomes and coverage, (ii) better telecommunications infrastructure; (iii) programs to subsidize connectivity for disadvantaged sectors of society; and (iv) improving science and technology at home through support for basic R&D; and (v) leveraging the Pakistan Diaspora to foster linkages between business, research institutions and academia. 35. Provincial Role in Determining the Investment Climate. As the Federal government deepens its reform agenda into institution building, regulatory reform and legal modernization, and as devolution restructures economic relationships, provincial governments will play an increasingly active role in a number of key areas, including, * Establish public-private policy and reform-related dialogues - create institutions to encourage dialogue, e.g. investor council, consultative mechanisms, etc. Contributing to greater publicprivate activity, but also helping to raise the level of awareness and understanding of the private sector amongst ministries and staff. and ultimately will develop a PPP Framework * The new coordinating body in the Federal Government will encourage provincial governments to implement reforms through active consultation, monitoring and domestic benchmarking, to encourage a unified and competitive approach to implementation of provincial regulations. * The high level of business sophistication and large numbers of specialized business associations and chambers around the country can be leveraged through public-private partnerships to strengthen inter-firm supply chains.

103 Page 14 of 16 Role of the Bank Group 36. The World Bank Group has provided support to the Government's objectives through a number of avenues, grouped into analytical work, non-lending technical assistance, policy support and investment operations. 37. Analytical Work. As policy makers develop comprehensive plans for the next round of strategic policy decisions, contemporaneous, rigorous and informed analysis will assist in directing efforts toward the binding constraints to improved microeconomic efficiency. The previous CAS sought the building of a strong analytical basis to advise the Government on various dimensions of private sector development. Since then a number of studies were launched. The Growth and Competitiveness flagship report sets the integrates microeconomic factors into growth modeling in order to provide an in depth analyses of constraints to sustained rapid economic growth. The yearly benchmarking of Pakistan at the global, regional and sub-national levels using the Doing Business methodology provides insight and monitoring for economic governance issues. Studies covering administrative barriers, labor markets, access to finance, and transport competitiveness will examine specific dimensions of the investment climate. Sector studies on retail, construction and tourism will look at sector specific issues. Four provincial economic reports and the rural growth strategy will shed analytical light on sub-national dimensions and a value chain study of particular products will provide specific case studies to illustrate competitiveness issues. Finally, investment climate assessments at the federal and provincial level will synthesize this body of work and complement it with international benchmarking and productivity analysis. 38. Lending Support for Policy Reform. Supporting one of the pillars of the PRSP, key elements of the Government program of private sector led growth have been supported by policy lending at the federal and provincial levels during the previous CAS and will continue for the coming CAS period. At the Federal Level, the PRSC dialogue has supported reforms in infrastructure, particularly power, a new labor code, privatization transactions and financial sector reform. Future policy lending in the private sector will continue to focus on regulatory reform, infrastructure and privatization and will expand to further development of institutions for a market economy. The Development Policy Credit for NWFP is supporting an emerging private sector orientation by the provincial government. 39. Non-Lending Technical Assistance. Small scale capacity building support to regulatory agencies will assist in strengthening regulatory and oversight agencies. A World Bank IDF grant was approved to support the Securities and Exchange Commission. In cooperation with DFID the Bank is also providing technical assistance to help government design a new competition policy, law and agency. In terms of promoting new foreign investment, MIGA is willing, if requested by the government, to provide practical capacity building support for the Board of Investment and is seeking to build the South Asia Enterprise Benchmarking Program, an example of an operational diagnostic study with key outputs being marketing profiles, outreach and promotion activities and product development to assist each participating country to promote itself more effectively for foreign investment. 40. Public Investment Lending. Lending in areas which support private sector development has generally taken the form of technical assistance and capacity building, or large infrastructure investments. The Tax Administration Reform Project, a major program aimed at improving federal tax and customs administration will be implemented during the CAS period and may require a repeater activity. Components of the Public Sector Capacity Building program are aimed at strengthening utility regulators and will help with infrastructure services. A series of projects aimed at infrastructure development, particularly the power sector are being developed. In the future, projects will be pursued which focus on institutions for a market economy and combine public investment with technical assistance to enhance international competitiveness and develop capital markets. In the financial sector, future lending by the

104 Page 15 of 16 Bank will build on first generation reforms and focus on term transformation investments that increase access to long term funds for household and entrepreneurial activities such as housing, leasing and domestic capital investments. 41. IFC Priorities for FYO6-FYO9. In the coming CAS period, IFC will build upon the efforts to support strategic sectors, particularly the financial sector, SMEs and infrastructure. IFC will also look for opportunities to provide value-added to industrial clients. IFC will broaden the scope of technical assistance and advisory work, both linked to investment and on a stand-alone basis. The focus of IFC efforts will be to provide a package of services and financing aimed at addressing the specific needs of our clients. 42. During the upcoming CAS period, IFC expects to increase its investment with the target range of US$ million for the period. IFC will also explore opportunities in pre-privatization investment. It furthermore plans to make more equity investment and intends to be a catalyst for and mobilize private equity in the country. In addition IFC will increase technical assistance (TA) activities through the PEP- MENA program. The two pronged approach of investment and TA will allow for synergies between the programs. For example, in the financial sector, IFC can provide TA to develop microfinance institutions, while at the same time providing investment for nascent institutions, which in turn provides such funds to entrepreneurs. Work to support the microfinance sector is seen as a particularly effective way to spread the benefits of development to a broader segment of society. Microfinance institutions are set up outside the reach of traditional financial institutions and therefore can support entrepreneurs in more remote areas. Also in the financial sector, PEP-MENA TA to banks will be aimed at the next size of enterprises - efforts to help banks develop their ability to assess risks of SMEs can be accompanied by credit lines. Other priority areas in the financial sector include housing finance, leasing, and trade finance. Housing finance efforts can help increase the availability of affordable housing, and improve the opportunity for people of middle income and even lower income to buy their own homes. IFC's efforts in this sector can include institution building TA and investment to provide long-term lending and securitization for housing finance. Work with banks and other institutions will include TA to improve internal credit risk systems, policies and procedures, and upgrade training of staff. IFC through PEP-MENA will work with banks to develop Corporate Governance practices. 43. In the SME sector, beyond the financial component, IFC will continue to provide TA support through "Business Edge" and work with business membership organizations to improve services for the support of their SME members. IFC believes that there are opportunities to support SMEs in strategic sectors such as health and education, both with TA and investment. 44. In infrastructure, IFC will focus on the energy sector, including power, gas and utilities, and telecommunications through investment operations supporting the Government's strategy. There is a particular need to improve the physical infrastructure in the country to allow for the efficient flow of goods, people and energy. Without improvements in this vital area, the long-term benefits of Pakistan's liberalization will be stifled. IFC expects to have an investment program in infrastructure where it is open to the private sector. IFC will also put emphasis on advisory work for privatization and will support public-private partnerships to improve the management of these facilities. IFC's recent efforts in the water and sanitation sector will continue in the upcoming CAS period. IFC could consider new investments in power, building upon its extensive experience in the sector. Advisory mandates will also be pursued, particularly those which address constraint in power generation and distribution. IFC can assess opportunities to invest in the development of the country's natural gas resources, where clients look for political risk mitigation. In the telecommunications sector, IFC could consider opportunities following privatization in the sector and the expansion of mobile networks as well as value-added services. IFC will focus on efforts to improve the business enabling environment to ease constraints and address needs of the private sector. This will include work to improve the legal and regulatory environment.

105 Page 16 of On the industrial side, IFC will look for niche opportunities, including supporting Pakistani corporations as they embark on south-to-south expansions. IFC will also look for ways to support the development of linkage programs to involve local SME suppliers to larger companies. IFC's ability to provide innovative financing tailored to the needs of clients will be pursued selectively where there is clear value-added. 46. Political Risk Insurance. MIGA will advance its marketing and promoting for foreign investment in key sectors, working with key public agencies and private sector bodies (Chambers, etc.) to identify opportunities for using political risk insurance to support FDI into Pakistan. In addition, subnational risk mitigation has become an important aspect of the MIGA political risk insurance product and it is considered important in the breach of contract coverage. MIGA's new Small Investors' Program (SIP) offers a streamlined, simplified and more cost effective political risk insurance program to support foreign investment into SMEs.

106 Page ] of I ANNEX IV: PAKISTAN - COUNTRY FINANCING PARAMETERS Item Parameter Explanation/Remarks Cost Sharing: Limit on the proportion of Up to 100% individual project costs that the Bank may finance The Bank's financing percentage in each project would be determined on a case-by-case basis, depending upon project type, sector, etc. In many projects, the practice of requiring government counterpart funding would continue. In general, low to moderate contribution by Government (federal/provincial), beneficiaries and others are expected in CDD-type projects and water sector projects. Moderate contribution by Government (federal/provincial) is expected in infrastructure projects. 100% Bank financing could occur in pro-poor projects, such as social sector projects and projects in poor and remote areas. 100% Bank financing may also occur in capacity building projects with moderate to high in-kind contribution by the Government (such as staff time, office space and equipment). Recurrent Cost Financing: Any limits No country- In determining Bank financing of recurrent costs in that would apply to the overall amount of level limit individual projects, the Bank will take into account recurrent expenditures that the Bank may sustainability issues at the sector and project levels. finance Financing of recurrent costs will be carefully assessed, particularly financing of Government staff salaries, which the Bank will only finance for specific purposes. For example, where our support is primarily programmatic (such as in the education sector), there may be need to finance recurrent costs and for a longer duration (as long as program continues) to support achievedent of program objectives. Recurrent cost financing may also be allowed to support cost of managing project implementation and to ensure sustainability of project activities. Local Cost Finance: Are the requirements Yes The two criteria are met. Therefore the Bank may finance for Bank financing of local expenditures local costs in any proportion needed in individual projects. met, namely that: (i) financing requirements for the country's development program would exceed the public sector's own resources (e.g., from taxation and other revenues) and expected domestic borrowing; and (ii) the financing of foreign expenditures alone would not enable the bank to assist in the financing of individual projects Taxes and Duties: Are there any taxes and No Taxes and duties in Pakistan are generally reasonable. Also duties that the Bank would not finance? taxes and duties are not discriminatory against Bankfinanced projects. At the project-level, the Bank would consider whether taxes and duties constitute an excessivel high share of project cost.

107 z 7l rr- ff5 Partner Growth and Investment Financial Sector Energy Transport -Agriculture & Rural Dev. XHealth, Nutrition Education Environment Water & Sanitation Social Protection Public Sector Management Judicial & Legal Reform Devolution

108 Page ] of 3 ANNEX VI: CAS CONSULTATION PROCESS 1. Preparation of the CAS benefited from consultations with Federal and Provincial governments, the private sector, donors and civil society. Consultations were carried out using a two stage process consisting of: (i) a two-part client survey to solicit input on Pakistan's development challenges and the role of the World Bank in Pakistan, and, (ii) stakeholder consultations with provincial governments, the private sector, and civil society to obtain feedback on the proposed strategy. Highlights of the feedback given during the consultation process are summarized below. Client Survey 2. The Client Survey was carried out in October 2004 through February About 800 stakeholders of the World Bank in Pakistan were asked to fill out a mail-in survey. Respondents were asked to indicate: (i) their overall attitudes toward the Bank; (ii) which of the broad areas of the World Bank's economic and social development activities bring the greatest value to the country; (iii) the importance of specific areas of the Bank's work and the Bank's effectiveness in those areas; and (iv) their level of agreement with a series of statements about the way the World Bank does business. Respondents were also asked to indicate which of a list of general development issues facing Pakistan was of highest priority and the level of impact a variety of challenges have on development. In addition, respondents were asked about the Bank's communication and outreach efforts in Pakistan. 3. Survey participants were drawn from the federal government, members of Parliament, provincial government officials, members of provincial assemblies, district/tehsil Municipal Administration (TMA) government offices or staff, union councilors, bilateral and multilateral agency staff, private sector businesses or organizations, civil society organizations, the media, and members of academia. The majority of respondents were federal government officials, indicating that the results of the survey reflect primarily the views of the Bank's government counterparts. 4. In sum, the Client Survey results show that the World Bank's work is appreciated on a number of levels, as are certain aspects of the Bank's relationships with clients and stakeholders in Pakistan. However, there are certain areas of the Bank's efforts that may require additional focus and attention. 5. Respondents overwhelmingly (80 percent) indicated that they felt that Pakistan was headed in the right direction. Poverty reduction emerged as the top development priority with over half of all respondents identifying it as either the most important or second most important development priority. Respondents also cited education, government effectiveness, and improving the effectiveness of the law and justice system as priorities for Pakistan. 6. Respondents were also asked to assess the impact of various development challenges. Inadequate access to quality education and inadequate infrastructure development were considered to have the most significant impact on development in Pakistan. Health issues were considered to have the least impact on development. 7. Across all respondents, the Bank's overall effectiveness in Pakistan received a 5.6 rating on a 10- point scale, with 1 being very unfavorable and 10 being very favorable. Respondents from local government, federal government officials, and provincial government officials gave the highest favorability ratings of the Bank. In contrast, respondents from academia, other organizations, and the media gave significantly lower favorability ratings. Respondents saw the Bank as most effective in helping to develop physical infrastructure, helping to develop water resources, and helping to improve the performance of the energy sector, all receiving mean ratings of 3.3 on a 5-point scale with 1 being not effective at all and 5 being very effective. The Bank's role as a financier of development projects was seen as most important. Respondents felt that the Bank's greatest weakness was imposing technocratic solutions without regard to political realities. Stakeholders' views of the Bank's effectiveness in some

109 Page 2 of 3 areas considered top priorities by stakeholders were not terribly positive: poverty, government effectiveness and growth. 8. Across all respondents, there was a solid level of agreement that the Bank is a good source of knowledge; the Bank's effectiveness in producing knowledge (studies, analyses) that is useful and technically sound both received the ratings of 3.9 on a 5-point scale with 1 being not at all effective and 5 being very effective. There was less agreement, however, that the Bank was able to adapt its knowledge to Pakistan's needs, receiving a mean rating of Overall relationships are somewhat strong; stakeholders perceive the Bank as relatively accessible, straightforward, and responsive. However the survey revealed that usage of the Bank's website is lower in Pakistan than in other SAR countries surveyed last year. This finding is being examined with a view to developing strategies to increase usage. Usage of the Public Information Centers is also low in Pakistan, due in large part to security requirements limiting access to the Bank office in Islamabad. As PICs and websites are important tools for engagement with broader audiences-including "tomorrow's leaders" (e.g., students)-following up on these finding will be a priority. As a first step, full public access to the PIC in Islamabad was restored in March The initial quantitative survey was followed by a qualitative survey using more focused, in-depth interviews with a subset of respondents in order to probe survey responses and get a better sense of the views and opinions behind the results of the quantitative survey. These follow-up interviews were carried out by an independent opinion research firm to provide assurances of anonymity. 11. Results of the qualitative follow-up reinforced the relevance of the Bank's poverty reduction mission while highlighting the importance of demonstrating results. Respondents unanimously ranked poverty as the greatest challenge facing Pakistan. At the same time some, particularly in the media, expressed skepticism about the benefits of the recent economic turnaround which they believed was benefiting only a narrow segment of society. A clear message was that economic growth is not by itself an adequate measure of success and respondents want to see clear indications of concrete improvement in the lives of the poor. These findings highlight the importance of targeted interventions that reach the poor as well as the continuing need to strengthen capacity to generate reliable, timely data on development outcomes both to guide policymakers and to help build support for poverty reduction programs. 12. On the role of the Bank, the in-depth survey showed that a majority held a positive view of the Bank's effectiveness. However there was a range of views about the areas where the Bank is most effective. There was a strong consensus that the Bank should play a supporting role, allowing the Government to set the agenda and providing support as requested. A majority felt that such a supporting role is especially important in the areas of governance and corruption where the government must be in the lead. A critical role of the Bank in this regard is to monitor the use of resources. A majority of respondents appreciated the role of the Bank in generating and disseminating knowledge, but they urged greater attention to dissemination. A number of respondents highlighted the need for the Bank to simplify its procedures and reduce the administrative burden of Bank lending. Stakeholder Workshops 13. A series of consultation meetings were held in Islamabad and the four provincial capitals during January Meetings were held with provincial governments, the private sector, Parliamentarians donors and civil society groups. On the whole, there was endorsement of the general thrust of the CAS, especially of its strategic principles and program priorities. In particular, there was strong support for the renewed emphasis on infrastructure lending. The CAS was also endorsed by provincial governments which endorsed the overall thrust of the CAS and welcomed the proposed World Bank engagement at the provincial level. Each of the provinces urged the Bank to take into account their respective unique challenges and accomplishments and to tailor the Bank program accordingly. There was specific

110 Page 3 of 3 endorsement of the move away from umbrella multi-province projects in favor of provincial lending. A common theme among the provinces was the need to be mindful of capacity constraints at the local government level. 14. Consultations with representatives from the private sector were held in Lahore and Karachi. The private sector representatives welcomed the emphasis on infrastructure, especially transport and power. Education was also mentioned as a priority by the private sector with representatives citing the difficulty of finding literate workers for manufacturing work. They voiced strong support for targeted poverty programs and governance, citing problems related to land titling and litigation and the need for stronger regulatory agencies. Financial sector development also emerged as a priority with representatives concerned about access and interest rate fluctuations. There was strong support for an enhanced role for IFC. 15. A civil society stakeholder consultation workshop was held in Islamabad and attended by representatives of various organizations from throughout Pakistan. While participants agreed with the thrust of the CAS, they expressed concern that the benefits of growth are not yet reaching the poor and that the Bank should emphasize activities directly targeting the poor. They urged the Bank to use its influence to help ensure that the needs of the poor are reflected in Government priorities. They also stressed the importance of timely accurate demographic and social data and urged the Bank to give priority to ensuring that accurate data is publicly available. Finally, several representatives mentioned the importance of addressing gender issues.

111 Page ] of 2 ANNEX VII: GUIDELINES FOR IBRD LENDING The following guidelines for IBRD lending in various sectors set out key sector-specific reforms that would be needed to establish conditions necessary for successful scaling-up of Bank lending. Sector Power Water/irrigation Highways Railways Guidelines for New Lending In addition to support for power sector reforms in PRSCs, investment lending in the power sector will be accompanied by the following key reforms: * Satisfactory progress on corporatization of the Water and Power Development Authority with establishment of legally and financially independent distribution companies operating under competent and stable management * Establishment of a fully functional and institutionally properly placed Central Power Purchase Agency (CPPA), operating under transparent and efficient rules for power trading and financial settlement; * Well defined and sustainable government subsidy policy * Well performing regulatory framework, with independent regulator (NEPRA) and separation of the regulatory, policy, and ownership functions. At the provincial level, investment and development policy lending in the water and irrigation would require commitment to and in some cases up-front actions to: * Increase transparency of water allocations and entitlements; * improve the quality of irrigation service delivery though greater user participation, and formal contractual arrangements between bulk water providers and users; and * enhance on-farm productivity and water use efficiency. At the national level, investment lending for major new Indus Basin storage infrastructure would require: * Consensus among the provinces * an explicit, transparent agreement for implementing the 1991 Water Accord and sharing the benefits equitably * an agreed Environmental Flow allocation to the Indus Delta * Commitment to institutional reforms and investments at the provincial, canal command and farms levels to ensure more equitable, efficient use of water Scaled-up investment lending in the highways will require commitment to increase private sector orientation and enhance management and implementation capacity in the National Highways Authority (NHA) as demonstrated by: * Increased private sector membership on NHA Executive Board; * induction of adequate professional staff in the Planning, Design and Procurement sections; * introduction of project management consultants under Project Directors In addition, satisfactory progress in the implementation of existing projects including the Highway Rehabilitation Project, including progress in fulfilling financial covenants would also be necessary. Lending in the railways sector would require government commitment to a medium term reform program to revitalize Pakistan Railways (PR) as demonstrated by: * Appointment of a professional, private sector CEO to head PR reform, with support of a dedicated reform team in PR; * GOP endorsement of a medium term reform program which would, inter alia, create a professionally managed, commercial freight business with its own rolling stock and staff and transfer non core activities and businesses to a separately managed holding company outside PR; * Restructuring the governance of PR (possibly as a state corporation) under an autonomous and restructured Board; * Separation of policy function (to be carried out by the Ministry of Railways) and operational functions (to be carried out by the restructured PR).