Document of The World Bank Report No: 28830 IMPLEMENTATION COMPLETION REPORT (TF-27863 IDA-33230) ON A CREDIT IN THE AMOUNT OF SDR 21.9 MILLION (US$30.0 MILLION EQUIVALENT) TO THE KINGDOM OF CAMBODIA FOR A STRUCTURAL ADJUSTMENT OPERATION June 30, 2004 Southeast Asia and Mongolia Country Unit Poverty Reduction and Economic Management Unit East Asia and Pacific Region CURRENCY EQUIVALENTS (Exchange Rate Effective June 2004) Currency Unit = Cambodian Riel (KHR) 1 KHR = US$ 0.00025 US$ 1.00 = 3990 KHR FISCAL YEAR October 1 September 30 ABBREVIATIONS AND ACRONYMS ADB Asian Development Bank ADD Accelerated District Development AFTA Asian Free Trade Association ASEAN Association of Southeast Asian Nations BSEC Budget Strategy and Enforcement Center CAS Country Assistance Strategy CDC Council for the Development of Cambodia CPIA Country Policy and Institutional Assessment CPP Cambodia People's Party CVAP Cambodia Veterans' Assistance Program DFW Department of Forestry and Wildlife FAO Food and Agriculture Organization of the United Nations FIAS Foreign Investment Advisory Service FUNCINPEC National United Front for an Independent, Neutral, Peaceful and Cooperative Cambodia GAP Government Action Plan LOI Law on Investment MEF Ministry of Economy and Finance METR Marginal Effective Tax Rate MTEF Medium Term Expenditure Framework NBC National Bank of Cambodia NGO Non-Government Organization NPRS National Poverty Reduction Strategy PAP Priority Action Program PER Public Expenditure Review PIMS Public Investment Management System PIP Public Investment Program PRGF Poverty Reduction and Growth Facility PSI Pre-Shipment Inspection SEDP Socioeconomic Development Plan SWAp Sector-Wide Approach UNDP United Nations Development Programme UNTAC United Nations Transitional Authority of Cambodia VAT Value-Added Tax WTO World Trade Organization Vice President: Jemal-ud-din Kassum, EAPVP Country Director Ian C. Porter, EACTF Chief Economist and Sector Director Homi Kharas, EASPR ICR Task Manager: Thang-Long Ton, EASPR KINGDOM OF CAMBODIA STRUCTURAL ADJUSTMENT CREDIT CONTENTS Page No. 1. Project Data 1 2. Principal Performance Ratings 1 3. Assessment of Development Objective and Design, and of Quality at Entry 2 4. Achievement of Objective and Outputs 8 5. Major Factors Affecting Implementation and Outcome 22 6. Sustainability 23 7. Bank and Borrower Performance 24 8. Lessons Learned 25 9. Partner Comments 26 10. Additional Information Annex 1. Key Performance Indicators/Log Frame Matrix 43 Annex 2. Project Costs and Financing 44 Annex 3. Economic Costs and Benefits 45 Annex 4. Bank Inputs 46 Annex 5. Ratings for Achievement of Objectives/Outputs of Components 47 Annex 6. Ratings of Bank and Borrower Performance 48 Annex 7. List of Supporting Documents 49 Project ID: P058544 Project Name: KH - Cambodia SAC Team Leader: Su Yong Song TL Unit: ECSPE ICR Type: Core ICR Report Date: June 30, 2004 1. Project Data Name: KH - Cambodia SAC L/C/TF Number: TF-27863; IDA-33230 Country/Department: CAMBODIA Region: East Asia and Pacific Region Sector/subsector: Central government administration (55%); Forestry (27%); General industry and trade sector (9%); Other social services (9%) Theme: Public expenditure, financial management and procurement (P); Tax policy and administration (P); Conflict prevention and post-conflict reconstruction (S); Other accountability/anti-corruption (S); Rural services and infrastructure (S) KEY DATES Original Revised/Actual PCD: 10/14/1999 Effective: 03/28/2000 03/28/2000 Appraisal: 12/23/1999 MTR: Approval: 02/29/2000 Closing: 06/30/2002 12/31/2003 Borrower/Implementing Agency: GOVERNMENT OF CAMBODIA/MINISTRY OF ECONOMY AND FNANCE Other Partners: Swedish International Development Agency, Sweden STAFF Current At Appraisal Vice President: Jemal-ud-din Kassum Jean-Michel Severino Country Director: Ian C. Porter Ngozi Okonjo-Iweala Sector Director: Homi Kharas Homi Kharas Team Leader at ICR: Su-Yong Song Su-Yong Song ICR Primary Author: Thang-Long Ton 2. Principal Performance Ratings (HS=Highly Satisfactory, S=Satisfactory, U=Unsatisfactory, HL=Highly Likely, L=Likely, UN=Unlikely, HUN=Highly Unlikely, HU=Highly Unsatisfactory, H=High, SU=Substantial, M=Modest, N=Negligible) Outcome: S Sustainability: L Institutional Development Impact: M Bank Performance: S Borrower Performance: S QAG (if available) ICR Quality at Entry: S Project at Risk at Any Time: Note on the Ratings: While the "Outcome" is rated as "satisfactory," we would like to qualify it as "moderately satisfactory" as the PDS system only allow four possible rankings. Similar qualification should be applied to the rating for "Sustainability" as "moderately likely" given its only four possible rankings Please see Sections 4 and 6 for the detailed discussion on outcome, its ratings, and the prospects for sustainability. 3. Assessment of Development Objective and Design, and of Quality at Entry 3.1 Original Objective: 3.1.1. Background. After almost three decades of armed conflict, Cambodia embarked on a program of reforms with the support of the international community to rehabilitate the country, stabilize the economy, and begin reforms to transform the economy into a market-oriented one with sustainable growth. The reform program, however, depended very much on the political climate in Cambodia with its ebbs and flows. Unsettled politics still shaped policy and economic performance of the country, accentuated by a weak human resources base and low absorption capacity. It was in this environment that the Bank's assistance to the country was formulated and implemented. 3.1.2. In late 1998, a new government took office and renewed reform efforts with some notable policy actions, including the implementation of the value-added tax (VAT), curtailing illegal logging and canceling forest concessions that violated their terms of contracts, eliminating ghost soldiers and initiating military demobilization, and amending the Implementing Regulations for the Law on Investments to tighten exemptions further. In addition, Cambodia officially became a member of the Association of Southeast Asian Nations (ASEAN) in 1999. All these activities created a new momentum for reform to address in a systematic way the country's underlying governance and economic management problems to position Cambodia further on the path toward a market economy with sustainable growth. The government's medium-term program focused on achieving lasting improvements in the structure of public finances and in public resource management, with particular attention to forestry. 3.1.3. Objectives. To implement this medium-term program, the government aimed to push forward the reforms in the above-mentioned areas in close cooperation and coordination with the IMF's program supported by the Poverty Reduction and Growth Facility (PRGF) and the World Bank through a reform program supported by a Structural Adjustment Credit (SAC). The Bank's SAC was formulated and prepared under the framework of a three-year Country Assistance Strategy (CAS). Its objectives covered the three following areas: · Assistance to improve public resource management, including resource mobilization and forestry management; · Enhancement of public sector management that comprises rationalization of public expenditures and preparatory steps for military demobilization and administrative reform; · Assistance in formulating a strategy on enhancing governance and fighting corruption in economic management and its implementation. - 2 - 3.2 Revised Objective: 3.2.1. There was no revision to the objective. 3.3 Original Components: 3.3.1. The SAC supported the government's reform program which consisted of three principal components with emphasis on institutional underpinning. Each component included several sub-components as described below. Public Resource Management: 3.3.2. Revenue Mobilization: Poor governance, inadequate enforcement of the Law on Taxation, generous tax exemptions granted under the Law on Investment, ad hoc tax and customs duty exemptions, weak collection of forestry revenues, and limited capacity in tax, customs, and non-tax administration limited revenue collections. To address these weaknesses, a series of steps were undertaken to reduce the number of loopholes in tax collection and tighten its tax policies. 3.3.3. Taxation. The government aimed to strengthen the revenue system since the adoption of the Law on Taxation in 1997. Specifically, it was expected to adopt the Sub-Decree on the implementation of the value-added tax (VAT) (adopted on December 24, 1999) to replace the various "parkas" (regulation) with no full legal standing under the Law of Taxation. The government would maintain its policy to disallow exemptions to the VAT other than those specified in the Law of Taxation. It would undertake efforts to reduce the backlog of refunds and to ensure expeditious refunds as a matter of policy. To further the rationalization of the tax regime, the government envisaged phasing out the minimum tax and undertaking reforms in customs duty on capital goods in the context of a broader reform that would put revenues on a surer footing. 3.3.4. Law on Investment (LOI). The program sought to effect an amendment to the LOI to correct the provisions in Article 14 which caused distortion to the overall tax policy framework and were detrimental to the effort to improve revenue mobilization. The provisions for tax exemptions in this article were too generous (long tax holidays, duty exemptions, etc.), given the low ranking of tax incentives on the list of major determinants of investment flows ­ compared with other high-ranking items on this list such as political and economy stability, a sound legal environment, and adequate basic infrastructure ­ according to a survey of other countries' experiences. The SAC's second tranche release condition required the submission for adoption by the National Assembly an amendment to Article 14 of the LOI. The amendment would introduce related measures in form and substance with a view to rationalizing the incentive regime inherent in the LOI and eliminating distortions thereunder. 3.3.5. Tax and Custom Administration. To strengthen the administrative tax law, the government aimed to continue with all means available under the provision of the Law on Taxation to improve compliance and enforcement to ensure proper implementation of rules and procedures of tax law and regulations. The system of information exchange between the Tax - 3 - Department, Customs Office, State Property Department and the Council for the Development of Cambodia (CDC) would be strengthened to help monitor the activities for firms approved under the LOI more efficiently. Concurrently, the government aimed to develop a new audit strategy to allow for the selective audit of tax returns in all years open to investigation, especially the current tax year. In addition, a methodology was to be developed for measuring maturity of outstanding arrears, maintaining a data base on the total amount of assessments issued each year, assessment amounts paid and those still outstanding, with monthly updates. 3.3.6. Further, the government aimed to enhance the effectiveness of the pre-shipment inspection system introduce in 1995 and to address problems arisen therein. The government would reestablish a system of pre-shipment inspection (PSI) of imports in order to realize its potential in raising import duty revenue and in facilitating speedy import clearance through better coverage of imports and corresponding improvements in port clearance procedures. 3.3.7. Forestry Management. There was evidence of pervasive corruption and serious (1) governance problems in this sector. Illegal logging had reached alarming levels. The SAC supported an orderly and transparent management system of forestry resources in order to help bring in significant revenues -- given that forests are Cambodia's most developmentally important natural resources ­ and to establish an environmentally sustainable, socially responsible, and economically viable forestry sector. The government would pursue a set of policy actions in the following areas: forest crime monitoring, concession management, and forest law. (1) It reached 4 million cubic meters in 1997 ­ ten times above the level of exploitation estimated to be sustainable. Corresponding revenue losses were estimated to be about 2 percent of GDP. 3.3.8. Forest Crime Monitoring. The government committed to crack down on illegal logging with the involvement of the military forces, the police, provincial authorities, civil society, and the cooperation of neighboring countries. A comprehensive program for a forest crime monitoring system was to be prepared and implemented by the Department of Forestry and Wildlife (DFW) with the participation of the Ministry of Environment and the Council of Ministers. The government would also undertake to publish a quarterly publication on forestry crime monitoring to be made available regularly to the public, beginning in February 2000. 3.3.9. Concession Management. An overhaul of the concession management and its regulatory framework was to be undertaken including concession contract review, with appropriate actions taken to mitigate abuses, irregularities and corrupt practices. As part of this process, the government was committed to review alternative mechanisms for timber royalties with more transparent and market-based pricing principles and to subsequently establish and apply appropriate mechanisms in the renegotiation of the contracts based on the concession contracts review process. 3.3.10. In addition, the government was expected to support "community forestry" as part of a comprehensive approach to rural and forest concession management. It aimed to prepare and implement regulation in the form of a sub-decree that would define a community forestry policy following appropriate consultations with all stakeholders. - 4 - 3.3.11. Forest Law. To strengthen and regularize the legal framework for forestry resource administration and management, the program supported the preparation of a draft law to revise the Forest Law for submission to the National Assembly. The draft law would clearly establish responsibility for forest management and administration, and provide for enforcement authority, inter-sectoral oversight, and public accountability. Public Sector Management 3.3.12. Expenditure Rationalization. To enhance the effectiveness of public expenditures toward better program and service delivery, the government would undertake a reorientation of its spending with a view for more efficient management in service delivery and a spending composition with maximum development impact. 3.3.13. Expenditure Reorientation. As part of the reform program on expenditure reorientation, a Priority Action Program (PAP) was introduced to identify critical expenditures that need to be protected (primary education, basic health, rural roads, etc.) and to extend the Accelerated District Development (ADD) program for district health centers so that local program managers would have greater certainty in the level of available budget funds and greater flexibility in their use. The SAC supported a government plan to increase expenditures for key social and economic sectors over the next three years with subsequent measurable results in budget outcomes for these sectors. The government would undertake to implement the budgetary framework for 2000-2002, especially for key sectors. It would seek to enhance the effectiveness of spending in these key social and economic sectors in order to ensure improved quality service and delivery while addressing the policy and institutional issues in the health and education sectors as (2) recommended by the Bank's Public Expenditure Review (PER). (2) World Bank, Cambodia - Public Expenditure Review: Enhancing the Effectiveness of Public Expenditures, Report No. 18791, Volumes 1 and 2, January 1999. 3.3.14. Expenditure Management. The SAC supported a government's program to the (3) implement of the recommendations in the Cambodia budget process made by the PER. These included: (i) ensuring the integrity of the budgetary process; (ii) strengthening the public investment management system; and (iii) improving the performance of spending units. (3) Op. cit. 3.3.15. Procedures to ensure budgetary process integrity were initiated within the context of the Budget Law of 2000. The government aimed to establish a budget strategy and enforcement center at the Ministry of Economy and Finance (MEF) with adequate mandate, staffing and procedures as a one-stop shop to streamline the procedures to screen the bids for funding and facilitate cash disbursements to key social and economic sectors at the central and provincial levels. Monthly reports to MEF were also planned that would cover monthly allocations and actual disbursements, variances between these items and their reasons, and measures to correct - 5 - them. A long-term program would be developed to strengthen the capacity of core budget institutions for budget preparation, implementation, and monitoring and reporting. 3.3.16. The government envisaged measures to strengthen the Public Investment Management System in order to address the weak linkage between the public investment program (PIP) and the annual budget. It was committed to initiating a medium-term expenditure framework (METF) for the health sector as a pilot project which also included the preparation of the Sector-Wide Approach (SWAp) for coordinating donors. 3.3.17. In order to improve the performance of spending units, a review of the experience with Accelerated District Development (ADD) would be conducted with recommendations on improvements and steps to resolve any impediments. These recommendations and steps would subsequently be extended in the ADD within the Ministry of Health and piloted at the Ministry of Education. 3.3.18. Preparatory Signs for Military Demobilization and Administrative Reform. 3.3.19. Military Demobilization. The government aimed to complete the identification and registration of soldiers and the formulation of a pilot demobilization and reintegration program, including provisions for independent financial and technical audits of the program. The government was committed to achieving satisfactory progress toward the implementation of the pilot phase of this program. It aimed to be in full consultation with stakeholders and conduct an interim review of the program and develop a proposal for the general demobilization and reintegration program based on the results thereof. 3.3.20. Administrative Reform. The quality of the civil service acted as a constraint on the government capacity to formulate and implement economic management and development programs. While many measures in administrative reform have been undertaken, much more remained to be done to achieve the government's vision of a lean state whose role was to deliver basic social and economic services for its citizens in areas where the private sector was not expected to intervene and to ensure sound macroeconomic management and implement policies which encouraged private sector development. The program aimed to help the government to carry out preparatory steps towards implementing administrative reforms and to realize this vision. These would include the preparation of a comprehensive action plan for rationalization of the size and function of the civil service, based on the findings of the extension of the computerized payroll system to all ministries, the implementation of a census of civil servants covering their personnel data, education, skills and experiences, and a functional review of all ministries. Enhancing Governance and Fighting Corruption 3.3.21. Corruption was perceived as widespread in Cambodia and undermined the country's development efforts. The government aimed to formulate a strategy to address the issues of governance and corruption in economic management and to implement it. The government's commitment to combating corruption and strengthening governance would need to be translated - 6 - into a practical and transparent strategy with concrete follow-up actions. It was expected at the conclusion of the SAC that the government would have conducted surveys on governance and corruption, and based on the findings thereof, prepared a diagnosis and formulated a national action plan to address these issues in concrete terms. The government was also committed to disseminating the findings of the surveys and details of the national action plan whose implementation would be initiated. 3.3.22. To further provide an enabling environment for the private sector in Cambodia, the government aimed to establish the rule of law to create clarity and transparency in economic transactions and a level playing field between economic agents. The government was committed to reforming the legal framework to correct a number of flaws and inconsistencies and in areas where laws and implementing regulations did not yet exist. Toward this end, the government intended to establish a complete and modern commercial code and adopt implementing regulations and required sub-decrees in full consultation with the relevant business and professional community. To improve the environment for foreign direct investment in Cambodia, the government also committed to submit to the National Assembly the ratification act related to the Convention on the Recognition and Enforcement of Foreign Arbitral Awards and adopt appropriate implementing regulations in a timely manner. 3.4 Revised Components: 3.4.1. No revisions were made to the above components. 3.5 Quality at Entry: 3.5.1 The "quality of entry" of the operation is rated by the ICR as satisfactory. Cambodia was at a critical stage in the transition toward sustained economic development. This credit supported basic reforms in the public sector that were urgently needed to enhance the management and administration in Cambodia. It helped the country address governance and fiscal issues for efficient use of scarce public resources, especially critical expenditures for key social and economic sectors, to consolidate the traditional role of the government while the political situation and national security were improving, but still evolving and not yet stabilized. The SAC was a logical follow-up to the Bank's underpinning ESW activities such as the PER and a series (4) of lending operations between 1993 ­ 1995 to support the then newly formed government and its reconstruction and reform program after a decade of armed conflict. (4) They are as follows: (i) Emergency Rehabilitation Project (approved in October 1993); (ii) Technical Assistance Project (approved in December 1994); (iii) Economic Rehabilitation Credit (approved in September 1995); 3.5.2 The SAC recognized the high risk nature of a policy-based operation in Cambodia's politically volatile environment. Major risks to the operation were accurately assessed and highlighted in the preparation of the program, including deterioration in political stability due to the fragmented political parties and their popular support after a long period of conflict, insufficient political will, weak institutional capacity among government agencies; and weak governance environment that may adversely affect the flow of funds of the project that might be - 7 - diverted away from intended purposes. 4. Achievement of Objective and Outputs 4.1 Outcome/achievement of objective: 4.1.1 The overall outcome of the program in terms of achieving its objectives is assessed by the ICR as moderately satisfactory given a very challenging environment in the country, both political and economic. A weak government and slow progress on the governance front meant that Bank supervision and monitoring were more crucial for such an adjustment operation. Indeed, the operation was extended five times at the government's requests for a total of 18 months to allow for the implementation of reforms -- including meeting the conditionalities for the second tranche release -- and to ensure continuing progress in the reform program. (5) The overall outcome of the activities achieved so far is strenuous and fragile at best with some possible risks for backtracking, especially in expenditure management, forestry sector management, and governance and fighting corruption. As the long conflict has destroyed Cambodia's basic fabric for good governance and government, including skills for public resources management, and public sector services, the achievements under the SAC marked just the beginning of the country's path toward the development and building of a functioning public sector to meet the challenges of a modern, market-oriented economy. Given the current challenging environment, these fragile achievements would need to be continually nurtured and strengthened so that the momentum will not be lost. (5) The five extensions are as follows: September 30, 2002, December 31, 2002, January 31, 2003, June 30, 2003, and December 31, 2003. 4.1.2. The coalition nature of the government in Cambodia also constituted a challenge in carrying out the reform program due to the political interests of the two political partners, the Cambodian People's Party (CPP) and the National United Front for an Independent, Neutral, Peaceful and Cooperative Cambodia (FUNCINPEC) whose partnership is based on a fragile dedication to reforms and development of the country into a market-based economy. The implementation period of the SAC was also accentuated by the preparation and holding of the communes elections in 2002 and the national election in July 2003. These events diverted the attention of the economic managers and decision makers from focusing on the reform program and adversely affected the implementation of the activities supported by the SAC. 4.1.3. At the conclusion of the credit, the government completed six of the eight specific actions for the second tranche release and requested the Bank's Board for waivers on a no objection basis to the other two conditions in December 2003. One condition, related to the LOI, was only partially completed because after a process of extensive, additional consultation with the private sector, the precise formulation for the revised LOI submitted to the National Assembly was inconsistent with the language inserted into the tranche condition (see detailed discussion under this condition). Another condition, related to the social sector disbursement ratio, was only partially met because of the flood-related expenditures increased non-social sector spending in an unanticipated amount. The government, however, is committed to supporting the essence of and - 8 - the emphasis on these two conditions in making the investment incentive regime more transparent and predictable, and by further reorienting expenditures toward the social sectors. 4.1.4. During the implementation of the project, there were two periods when the project was rated unsatisfactory in terms of its implementation as recorded by the project status reports in August 2002 and May-November 2003. Both unsatisfactory ratings were due to the lack of progress in forestry management and issues concerning the LOI. In August 2002, the National Assembly returned the draft LOI on technical ground. In early 2002, irregularities were discovered in the management of forestry royalties (see para. 4.2.9). These were resolved (6) through a constructive dialogue with the government. The rating was upgraded to satisfactory in December 2002. In early 2003, however, the implementation progress rating was downgraded to unsatisfactory to reflect the deterioration in the progress with respect to forestry management and broad dissatisfaction among the international community on the reforms in the forestry sector. (7) Toward the end of 2003, however, improvements and progress were made in the forestry sector. A new independent monitor was hired in November 2003; the sub-decree on community forestry was adopted; a multi-donor forestry review for the medium-term sector reforms was underway while a workshop on forestry management and implication for the SAC second tranche release was organized in November 2003. The rating was upgraded accordingly and the second tranche was release at the end of December 2003. (6) The draft LOI was resubmitted to the Parliament. The government conducted an audit of the forestry royalties and submitted the audit report. The Forestry Royalty Task Force was established whose terms of reference included review of all relevant legislation and guidelines on budget process and preparation of an analysis to identify weaknesses and needs for reforms in this area. (7) The government terminated the contract with Global Witness as the independent monitor. An action plan which was agreed with the government earlier was unlikely to be implemented in a timely fashion. 4.1.5. The two periods described above highlighted the especially fragile progress achieved in the public management of the forestry resource and underscored the government's weak performance in managing this national resource which has been under the influence of deeply entrenched special interests. A series of efforts initiated by the government and donors were undertaken to strengthen the management of the forestry sector. A forestry review mission ­ a multi-donor mission ­ was formed to review progress on the overall forestry management program under the auspices of the working group on natural resources management. The Bank has contributed to the reform in this sector to address serious weaknesses in the government's approach to forestry and help implement a strategy involving the development of an improved regulatory and legal framework. The Forest Concession Management and Control Pilot Project, approved by the Board in June 2000, aimed to establish a comprehensive set of forest management and operational guidelines and control procedures in selected provinces and forest concession areas and to establish an effective forest crime monitoring and prevention capability. 4.1.6. The Bank also addressed the weak capacity of the civil service through the Economic and Public Capacity Building Project, approved by the Board in June 2002, to enhance the capability of the public sector to perform critical tasks more effectively, to coordinate efforts to shift civil - 9 - service incentives to a sustainable basis and to create a system of accountable and transparent governance. 4.1.7. On several fronts, although a lot of challenges still lay ahead to maintain and consolidate the still fragile results thus far obtained, progress was tangible and evident in the way public resource management and public sector management were being administered. Beyond the specific conditions of the credit, the government has started to use bank records for public expenditure monitoring, for example. It has increased the budget amounts going to social sectors, and it has provided a better framework for new investments. The activities and results are discussed below in details, grouped under the three broad components of the program, in addition to the discussion of the macroeconomic context within which the credit was implemented. 4.2 Outputs by components: Macroeconomic Framework 4.2.1 The Cambodian economy has demonstrated its resilience and its performance was satisfactory during the implementation period (2000-2003) despite some significant challenges from many fronts. The GDP recorded a growth rate of about 6 percent per year during this period, driven by strong exports of garments, tourism, and construction. GDP growth in 2003 was, however, lower than expected at 4.8 percent due to the adverse effects of the anti-Thai riots and the SARS outbreak in the spring. There were also uncertainties on the eve of the national election in July and the subsequently delay in forming a new government for the rest of the year. Despite these setbacks, however, Cambodia achieved a major accomplishment with its accession to the World Trade Organization in September 2003. Economic prospects for 2004 are positive, with an expected recovery and a projected growth rate of about 5.5 percent, led by construction, tourism, and garment industries. 4.2.2 In 2003, GDP growth was supported by a strong 15 percent gain in exports of goods, underpinned by the continued strength of garment exports. At the same time, prudent monetary policy contributed to continued expansion of net foreign assets, a stable exchange rate and a low annual average inflation rate of 1.2 percent (0.5 percent for end-of-period rate). The anti-Thai riots, SARS, and the gridlock resulting from the July 2003 elections affected Cambodia's fiscal situation, with total revenue reaching only 88 percent of the budget target. Budget revenue dropped to 10.4 percent of GDP in 2003 from 11.2 percent in 2002. Weak revenue performance reflected a drop in trade taxes in spite of efforts to strengthen customs administration and increases in excises on beer and selected petroleum products. Further, there was an erosion of the tax base due to tax exemptions and the signing of contracts with private firms to provide certain government services which reduced transfers to the Treasury. This resulted in an estimated increase in the overall budget deficit of 7.1 percent of GDP (from 6.8 percent in 2002). Overall expenditure was however contained below budget targets, contributing to the avoidance of domestic financing. Inflation was low thanks to strict budgetary discipline. The external current account deficit was contained at around 11-13 percent of GDP and financed by inflows of concessional loans and grants. Gross international reserves were about 3 month of imports and the riel maintained its stability vis-à-vis the US dollars. - 10 - Table 1: Cambodia -- Macroeconomic Indicators, 1998-2003 SAC Implementation Period 1999 2000 2001 2002 2003 Prel. Real GDP Growth (%) 10.8 7.0 5.7 5.5 4.8 Inflation (average, %) 4.0 -0.8 0.3 3.3 1.2 Budget Revenue (% of GDP) 10.2 10.4 10.7 11.2 10.4 Budget Expenditures (% of GDP) 14.1 15.3 16.3 17.9 18.1 Current Budget Balance (% of GDP) 1.6 1.3 1.1 1.0 0.1 Export of Goods ($ million) 1,129 1,401 1,571 1,750 2,003 Import of Goods ($ million) -1,591 -1,939 -2,094 -2,314 -2,601 Current Account Balance (% of GDP) -13.2 -11.8 -9.4 -9.0 -11.7 Gross Official Reserves (mos. of imports) 2.9 2.6 2.8 3.0 2.7 Source: Data provided by the Cambodian authorities. Public Resource Management 4.2.3 Resource Mobilization. Satisfactory progress, albeit moderate, has been made in increasing revenue and improving efficiency of the system. Overall, recent policy measures helped increase revenue and improve the efficiency of the tax system for better resource mobilization. Between 2000-02, there was about one percentage point increase in the share of revenue in GDP, from 10.4 percent in 2000 to around 11.2 percent in 2002. In 2003, revenue was estimated to reach only 10.7 percent of GDP, however. This fact highlights the fragile performance of resource mobilization and the government will need to focus more attention and effort to maintain the progress made so far in this area. 4.2.4 Taxation. The VAT replaced the turnover tax, expanding the tax base. The government passed the Sub-Decree on VAT, fulfilling the Board presentation condition. The Tax Department moved ahead with the expansion of the VAT coverage by the Large Taxpayer Unit to provincial offices, strengthening the overall compliance and improve revenue collections across all taxes. The government was committed to maintaining a VAT refund policy ensuring all refunds are made available to the VAT taxpayer within 15 days of approval by the Tax Department. The SAC supervision mission in 2000 found that there was significant improvements in the VAT refund process. Continuing efforts to reduce the processing time were being undertaken by streamlining further the paperwork requirements after the approval was given. 4.2.5 Law on Investment (LOI). The amendment of the LOI was approved by the National Assembly in February 2003, rationalizing tax incentives. It is anticipated that this would contribute to revenue increases in the future and an investment climate more conducive to growth. 4.2.6 Tax and Custom Administration. Better use of pre-shipment inspection services has helped to improve and speed up shipments at the Customs Department. However, there remains reported persistent problems with regard to informal charges at Customs Offices and ports that - 11 - (8) shippers have to pay. (8) Transport and import clearance charges were reportedly range from 54 percent to 64 percent of total cost. World Bank and Global Development Solutions, Value Chain Analysis, June 2003. 4.2.7 The government has less success in its efforts to enhance and improve tax administration. The bottleneck remains in the inadequate number of professional tax and customs collectors and the incentive structure for these officials. 4.2.8 Forestry Management. There has been reduction in illegal logging, but it still persists and tension remains within the government on the pace and specifics of the program. The government has cracked down on illegal loggings through measures at its dispositions, such as concessions cancellation, seizure of logging equipment, joint operations with the military against illegal logging and the recruitment of an independent monitor of forest crimes reporting. Forest ( 9) concession areas were reduced to 2.5 million hectares from 6.4 million hectares. Concession logging is currently suspended while the government proceeds with planning and reviews. The government has disclosed for the first time drafts of strategic forest management plans and environmental and social impact assessments, enabling some public oversight on the concession process. It has begun a program of extended consultation and discussion of its plan review and consideration process. A draft model contract has been prepared and will be used for finalizing new contracts with concessionaires once the strategic forest management plans are approved and other related documents are prepared. A new Forest Law with strengthened enforcement efforts and Sub-Decrees on Community Forestry and Forest Concession Management have provided an institutional and legal framework for sustainable forest management. (9) One million hectares (Cardamom Mountains, Preah Vihear and Mondulkiri) that were formerly under concession have been designed as legally protected forest with restricted access for logging. 4.2.9 However, the government has taken a longer time to complete these activities than originally envisaged. The delays were due in part to the discovery of irregularities in the management of forestry revenues in early 2002 and the issue with the independent monitor of forest crime reporting in 2003. Irregularities were discovered on the transferring of forest royalties to compensate for the claims presented to the government by several forest concessionaires outside the channel of the state budget at the Ministry of Agriculture, Forestry, and Fisheries (MAFF). The government took measures to rectify the six reported operations and to ensure that MAFF would strictly comply with existing financial and budgetary procedures, according to its letter to the Bank in June 2002. In April 2003, the government terminated its recognition of Global Witness, an NGO, as the independent monitor of forest crimes reporting, as the two sides were unable to work cooperatively. These actions, along with persistent allegations of illegal logging, corruption and mismanagement in the forestry sector undermined the confidence in the government to manage efficiently and effectively the country's forestry resources. Amid these uncertainties, the SAC was extended to allow the government more time to address concerns raised about its forestry program. 4.2.10 In November 2003, the government signed a new contract with another independent - 12 - monitor, Societe General de Surveillance, Sp.A., under the terms of reference reviewed by a multi-donor working group on natural resource management after an international competitive bidding process. The government requested an extension of the Forest Concession Management and Control Pilot project for 18 months through June 2005, which would contribute to the implementation and sustainability of the actions supported by the program. Despite the continued complexities in reforming this sector and difficulties with the management of forest resources, reforms continue to move ahead with significant implementation of the framework of the sector as agreed. A November 2003 workshop on forestry in Phnom Penh for donors, NGOs and government officials discussed forestry achievements; there was a consensus among the participants that much has been achieved on the forestry front, despite that many problems still remain to be addressed. Furthermore, there was also a consensus that the achievements in the forestry sector could be attributed, in no small part, to the Bank's engagement via the SAC vehicle. A multi-donor forestry sector review in on-going with the Bank's participation and would contribute further to a stronger dialogue between the government and donors and identification of a future assistance program for the sector. However, this sector poses special management challenges to the government and the donor community. Public Sector Management 4.2.11 Expenditure Rationalization. There was satisfactory progress, albeit tenuous, in the government's efforts to reorient public expenditures and to manage it more efficiently. The journey toward better expenditure rationalization, however, would require a great deal more efforts and management skills from the civil servants. The recent Integrated Fiduciary Assessment and Public Expenditure Review completed in September 2003 has identified a substantial unfinished agenda of reforms to improve public expenditure management and effectiveness of expenditure policy. 4.2.12 Expenditure Reorientation. The government had made some positive steps in the alignment of public expenditures with the development objectives. The allocation for four key sectors ­ especially education and health ­ increased significantly to 3.3 percent of GDP in 2002 from 1.8 percent of GDP in 1999 and an estimated 3.5 percent of GDP in 2003. Nevertheless, cash management problems delayed the release of these allocations until the end of the year, thereby muting somewhat the full impact of these increased allocations. 4.2.13 Expenditure Management. The government has initiated an expenditure tracking study to trace actual spending on education, from the center to the local level. The study on health will follow suit. Steps have been undertaken to improve linkages between planning and budget execution with the development of a medium-term expenditure framework (METF). 4.2.14 The budget strategy and enforcement center (BSEC) at MEF was established (Board presentation condition) as one-stop shop to streamline the procedures to screen the bids for funding and facilitate cash disbursements to key social and economic sectors (health, education, agriculture, and rural development), both at the central level and provincial departments. Monthly reports from provincial treasuries have also been reported to MEF on a regular basis. However, BSEC was largely unsuccessful and was subsequently disbanded. Cash management problems - 13 - continued and in fact worsened in 2003. A more comprehensive reform program beyond the SAC would be necessary to alleviate and help to eventually resolve the perennial cash management problem in Cambodia. 4.2.15 The conditionality on expenditure policy did not achieve the intended result as it was a quite inadequate means in an environment such as Cambodia. This is not surprising, because: (i) expenditure and financial management is poor, (ii) sectoral policy itself is not actually efficiently as pro-poor as it could be (e.g., benefit incidence results are disappointing), and (iii) government policy, even when it is good, is not yet effectively linked to the budget for the most part. Thus, even as the country strives for the implementation of a better overall expenditure policy (less on military expenditures and more on priority sectors, in relative terms), the current outcomes demonstrate that the road toward fulfilling this objective is quite long with a lot of challenges and difficult obstacles to overcome. 4.2.16 Preparatory Signs for Military Demobilization and Administrative Reform 4.2.17 Military Demobilization. Public spending on defense and security has been reduced to 2.8 percent of GDP in 2002 and an estimated 2.3 percent in 2003, from a high of around 4 percent in 1998. As a result of the first phase of the full-scale demobilization program, the military payroll fell to 197.1 billion riels in 2003, from a high of 206.3 billion in 2000 (before the demobilization). Over 15,000 ghost soldiers were removed; more than 8,000 widows were transferred to the Ministry of Women and Veterans; 1,500 soldiers were demobilized under the pilot project; and 15,000 elderly, sick and disabled soldiers were demobilized. The second phase of the demobilization is postponed pending resolution of misprocurement-related issue under an IDA-financed project and the submission of audits. 4.2.18 Administrative Reform. The preparatory activities toward administrative reforms are still in the initial stages during this period and further work would need to be dedicated to this area in the medium and long term to help the government move toward building an efficient and capable civil service. Enhancing Governance and Fighting Corruption 4.2.19 The government commissioned a local NGO, Lidee Khmer, to prepare a detailed diagnostics study on governance and corruption through surveys in 1999-2000. This report entitled "Cambodia: Governance and Corruption Diagnostic: Evidence from Citizen, Enterprise and Public Official Surveys," on the extent of governance and corruption problems in the public sector in Cambodia was available in May 2000. Subsequently, the government prepared an initial draft of a Governance Action Plan (GAP) and presented it at the Consultative Group meeting in May 2000. The initial draft GAP built on the analysis and findings of a number of studies, including the diagnostic study mentioned above, a study on governance and sustainable development carried out by the Cambodia Development Resource Institute (CDRI) with financial support from the ADB, and many other reports prepared by other donors. Extensive consultations were held with many donors, NGOs, and the private sector before finalization of the GAP and approval by the Council of Ministers in March 2001. A National Forum was organized - 14 - in December 2001 to start disseminating the GAP and the diagnostic report on governance and corruption. This forum was chaired by the Prime Minister and was attended by ministers, senior civil servants from all over the country, and external stakeholders, followed by four workshops in provinces targeting public officials and external stakeholders (donors, NGOs, academia, and the press) in the first half of 2002. 4.2.20 The government has begun implementing GAP since its official adoption in March 2001. Significant progress has been made in some areas, such public finance, but implementation in general, particularly for legal and judicial reform, has been slow. The progress of actions in GAP was reported to the public in the government's biannual GAP Progress Reports in June and December 2001. 4.2.21 Detailed work ­ the 2002 Integrated Framework Trade Diagnostics completed in 2002 and the on-going Investment Climate Assessment in Cambodia ­ focused on the analysis of how governance factors impinge upon the private sector, especially exporters and investors' decisions due to high unofficial payments and long delays. A study on Cambodia's competitiveness showed that around 60 percent of the cost of transport and import charges were attributed to "unofficial (10) charges," making it the most expensive countries for business. A survey on corruption perceptions highlighted the fact that corruption remained the top-ranked concern of the private sector. These studies clearly show that governance problems still undermine the climate for investors and the competitiveness of Cambodian exporters. (10) "Value Chain Analysis," World Bank and Global Development Solutions, op. cit., 2003. 4.2.22 Although there was progress in diagnostics and dissemination of findings and in building consensus among Cambodians and other development stakeholders on the required set of actions, the improvement in governance has been relatively slow and full of challenges. While the legal framework for fighting corruption has been in place, implementation has been noticeably weak, with sporadic investigations not followed up with legal actions. Weak institutions, consolidation of power and lack of governance all contribute to an environment that allows a high level of corruption. The governance agenda, as presented in the GAP, aims to undertake a broad range of initiatives, but does not recognize that the absence of a capable administrative capacity would make it difficult to achieve fundamental and systematic reforms. While GAP is being carried out, the implementation of crucial activities such as anti-corruption legislation and legal and judicial reform have been slow. Cambodia will need a long lead time to improve governance and for both the government and the governed to internalize the principles of public services and the privileges as well as the duties of the governed. Brief Review of Specific Conditions undertaken under SAC 4.2.23 The SAC has seven Board presentation conditions, one floating tranche release condition, and eight second tranche release conditions. These are briefly summarized in the following section (Annex 7 presents detailed discussions for each of the conditions). 4.2.24 All the seven Board presentation conditions were met in time, enabling the project to be - 15 - discussed and approved by the Board on December 29, 2000. The activities covered the following areas: · Taxation -- approval of VAT Sub-Decree and speedy refunds once approved by the Tax Department; · Tax and Custom Administration -- initiation of a transparent and competitive tendering process for a pre-shipment inspection (PSI) and use of the PSI database for custom valuation in the interim period; · Forestry -- implementation of a work program to establish forestry crime reporting and monitoring capacity for the Department of Forestry and Wildlife (DFW), the Ministry of Environment, and the Council of Ministers and publication of a quarterly on the forest crime monitoring to the public; adoption of the Sub-Decree on forestry concession management and provision for the DFW with an appropriate level of independence from political interference in enforcement. · Expenditure Reorientation ­ a detailed plan to increase expenditures for the key social and economic sectors (i.e., health, education, agriculture, rural development) over the next three years was prepared: the 2000 budget for health (9 percent of total current expenditure), education (14 percent of total current expenditure), and agriculture and rural development (3 percent of total current expenditure) showed improvement over the 1999 budget in terms of share in total current expenditure. Satisfactory budget allocations and contents of the Priority Action Program (PAP) for health and education and also for the Accelerated District Development (ADD) program were presented. · Expenditure Management -- The Budget Strategy and Enforcement Center (BSEC) at MEF was established as one-stop shop to streamline the procedures to screen the bids for funding and facilitate cash disbursements to key social and economic sectors (health, education, agriculture, and rural development), both at the central level and provincial departments. Monthly reports from provincial treasuries have also been reported to MEF on a regular basis. However, despite these efforts, BSEC was largely unsuccessful and was subsequently disbanded. Cash management problems remain. · Military Demobilization -- In full consultation with donors, NGOs, and civil society, the government completed the identification and registration of soldiers; and formulated a pilot demobilization and reintegration program, including provisions for independent financial and technical audits of the program. 4.2.25 Floating Tranche Release. The government carried out the condition on demobilization and reintegration, thus securing the release of the Floating Tranche in September 2001. These included (i) satisfactory progress in the implementation of the pilot phase of the demobilization and reintegration program, (ii) interim review of the program with participation from all stakeholders; and (iii) a full program of demobilization and reintegration program prepared in consultation with donors, NGOs and civil society. 4.2.26 Second Tranche Release. Six of the eight conditions were completed within the original timeframe. However, the government could not meet the remaining two conditions, necessitating five extensions totaling 18 months and the request for two waivers and their subsequent approval. These two covered (i) the amendments of the Law of Investment (LOI) and (ii) the evidence on - 16 - expenditure rationalization. 4.2.27 Condition on the Law on Investment (LOI). The government will have submitted for adoption by the National Assembly an amendment to Article 14 of the Law on Investment, and introduced related measures, acceptable to IDA and in form and substance consistent with paragraph 8 of the Letter of Development Policy, with a view to rationalizing the incentive regime inherent in the Law on Investment and eliminating distortion thereunder. The government was committed to amending the LOI with the following components: (i) elimination of the special 9 percent corporate tax rate for all new investment and phasing the 9 percent rate out to the standard 20 percent under the Law on Taxation for the next five years for existing approved and operational projects; (ii) elimination of the tax-free reinvestment of profits and introduction of an appropriate investment allowance in the Law on Taxation at a rate to be determined, satisfactory to IDA, and applicable to all qualifying investment, new or expansion irrespective of source of finance, without evaluation; (iii) repeal of the current tax holiday provisions and the introduction of a three year tax holiday, conditional on annual certification of compliance, to all qualifying new investment, without evaluation; the use of tax holiday will deny the tax payer any benefits available under the Law on Taxation during the tax holiday including initial investment allowance as well as accelerated depreciation allowance; all current tax holidays provide under the LOI will be grandfathered; and (iv) elimination of the right to tax free repatriation of earnings and other incomes by approved enterprises. 4.2.28 For this condition, Parts (i); (ii) and (iv) were fully met. The waiver was sought for ­ and approved by the Board -- Part (iii) that was not met. The amendment to LOI was (11) submitted to the National Assembly, and was subsequently adopted in February 2003. While the spirit of Part (iii) had been met, the specific proposal in the second tranche condition was to apply a 3-year tax holiday without evaluation. This was modified after extensive consultations with the private sector, prior to the National Assembly's submission. The government preferred some flexibility in determining the length of the tax holiday in consideration of strategic importance of each investment project based on pre-set explicit criteria. Bank staff concurred with this as the amended clause provided significant transparency and predictability for investment incentives (the main focus of the conditionality). Also, the consensus among the stakeholders would ensure higher compliance from the private sector in the implementation of the Law. The "related measures" referred to changes to other legislation necessary for consistency and unambiguity. (11 ) The submitted bill and the adopted amended LOI include the following elements on conditionality: (1) The new clause "A qualified investment project shall be subject to a profit tax rate after its tax exemption period as determined in the Law on Taxation" was introduced, replacing the previous clause "A corporate tax rate of 9 percent except tax rate on the exploration and exploitation of natural resources, timber, oil, mines gold, and precious stones which shall be set in separate laws"; (2) The previous clause "In the events profits are reinvested in the country, such profits shall be exempted for all corporate tax" was dropped; (3) The new clause "A qualified investment project (QIP) shall be entitled to exemption from the tax period. The tax exemption period is composed of a Trigger Period + 3 years + n years (n shall be determined in the Financial Management Law). The maximum allowable Trigger Period is to be the first year of profit or three years after the QIP earns its first revenue, whichever is sooner" was introduced, replacing the previous clause "A corporate tax exemption of up to 8 years depending on the characters of the project and the priority of the government which shall be mentioned in a Sub-Decree." (4) The previous clause "Non-taxation on the distribution of dividends or profits or proceeds of investment, whether transferred abroad or distributed in the country" was dropped. - 17 - 4.2.29 Condition on Expenditure Rationalization. The government will have submitted to IDA satisfactory evidence in terms of the formula specified in paragraph 19 of the Letter of Development Policy, to show that: (a) the ratio of actual disbursements of non-wage operating expenditures for the health, education, agriculture and rural development sectors combined during the year 2000 have been not less than the corresponding ratio for the remaining sectors combined; and (b) actual disbursements for the Accelerated District Development (ADD) program during the same period have been not less than the corresponding budget allocation. 4.2.30 This condition was not met and a waiver was requested and granted. The thrust of this condition was to protect the disbursement to the key social and economic sectors as compared with the budget allocation at least on par with the rest of the sectors so that, when combined with the Board condition on enhanced 2000 budget allocation for key sectors, it would contribute to expenditure reorientation toward key sectors. Regarding the element (a) of the conditionality, the ratio of actual disbursement to the budget allocation for the four key sectors combined was 83.1 percent, as compared with the corresponding ratio of 89 percent for the remaining sectors combined. This was due to the emergency post-flood rehabilitation needs and weak absorptive capacity in the aftermath of severe floods in July-November 2000, the worst in 70 years, with total damage estimated at around 5 percent of GDP. As a result, the government had to divert cash from the allocated social sector outlays to the emergency post-flood rehabilitation needs. A substantial part of the post-flood rehabilitation outlays were of a social expenditure nature and if they had been properly classified as the social sector outlays in the budget table, this condition could have been met outright. Second, in early 2000 the government established the BSEC at the MEF as a one-stop shop to streamline the screening of bids for funding, and facilitate cash disbursement to key social and economic sectors. The role of BSEC was to facilitate the operation of the new Priority Action Program (PAP) based on advance payment of budget allocations on a quarterly basis, with post-audit replacing pre-audit, which was, however, almost four months late in September 2000. This was due mainly to communication problems regarding financial procedures, coordination failures, and some coordination breakdown between the BESC and the Ministry of Health. Provincial department directors were very cautious and slow in using the PAP fund even when the PAP installments had been already released from the National Treasury and deposited in their accounts, as they were not familiar with post-audit system. In 2002, the situation improved compared with 2000, but still the disbursement ratio for the four key sectors was 91.9 percent as compared with the corresponding ratio of 94.8 percent for the remaining sectors combined. This is due to (i) too ambitious social sector expenditure targets in the budget; and (ii) weak capacity of line ministries to develop expenditure programs and to adopt associated regulations. Although this conditionality was not met in terms of the specific quantitative indicator, the thrust of the conditionality (protection of social sectors against revenue shortfalls, and increase in disbursements to these sectors) has been satisfied. There has been significant improvement in expenditure reorientation toward key social and economic sectors since 1999. Expenditure for the four key sectors was increased substantially as a ratio of GDP from 1.8 percent in 1999 to 2.3 percent in 2000, 2.9 percent in 2001, and 3.3 percent in 2002. In contrast, defense and security expenditure decreased as a ratio of GDP from 3.9 percent of GDP in 1999 to 3.5 percent in 2000, 3.0 percent in 2001, and 2.8 percent in 2002. - 18 - 4.2.31 Regarding the element (b) of the conditionality, the actual disbursement for ADD in 2002 was 4,691 million riels as compared to the budget allocation of 6,000 million riels. ADD program is a cash advance system for district health centers. The government introduced the Priority Action Program (PAP)--cash advance system to health and education sectors -- to extend the thrust of the ADD to more comprehensive PAP with a view to enhancing disbursement to key social sectors. Spending for PAP in 2000 was 890 million riels. The combined ADD and PAP actual spending for 2000 was 5,581 million riels. The government is committed to continuing expenditure reorientation toward key social sectors outlined in the PRSP. The Bank is continuing the policy dialogue to ensure adequate budget disbursement to key social sectors, including the ADD and PAP programs, among others, in the context of the recently completed Integrated Fiduciary Assessment and Public Expenditure Review 4.2.32 The six completed conditions covered the following areas: · Customs Administration ­ The PSI was reinstated in October 2000 with the requested (12) elements. A system of prepayment was implemented for companies with good records of law compliance and reputation within the framework of risk management system of the Customs and Excise Department. In some cases, PSI agency's Reports of Findings (ROFs) were not accurate and sealed containers did not always contain what were indicated in the ROFs. To strengthen the PSI, a PSI Steering Committee was established to address concerns, raised by importers and service provided. (12) PSI was reinstated with the following elements regarding the conditionality: (a) The only exemptions are for cigarettes, shipments below a threshold of $4,000 (the latter is normal in PSI contracts), imports for investment companies, diplomatic missions, as well as precious metals (e.g., gold), temporary imports; (b) Pre-shipment inspection valuations are being used for the basis of the import values for customs purposes. The only exceptions are for products where the Ministry of Economy and Finance has assigned minimum values higher than the PSI valuation for a few products--the substance of this was to avoid under-valuation. (c) Duty and taxes are paid at the time of import, based on the PSI ROFs. · Forestry Management. Emphasis was made on transparency and the quarterly publication on forestry crime monitoring has been available since 1999. A performance review of 40 concession contracts was completed in 2000. Subsequently 25 non-performing contracts were terminated. For the remaining 15 concession contracts, the government has initiated actions to terminate seven, while the remaining eight have been under review. The Cambodian Forest Law and the Sub-Decree on Forest Concession Management require the preparation of five year compartment plans and annual operating or "coupe" plans, consultation with concerned stakeholders, and final approval by the government before new contracts can be issued and logging can resume. In the meantime, logging and transport of (13) logs remain under suspension in all forest concessions. The on-going monitoring under the Forest Concession Management and Control Pilot Project indicates that no subsequent forestry concessions have been granted outside of the terms and conditions of the Sub-Decree on Forest Concession Management. (13) Except for one stump collection contract to salvage wood from already logged trees which was awarded in an area where the concession contract was terminated. · Forest Law. Consultations for the drafting of a new Forestry Law, initiated in 1994 with - 19 - FAO technical assistance, were renewed in 2000/01 with the public, NGOs, FAO, and other interested parties. The law, which was signed into law in August 2002, provides a sound legal basis for control, allocation, and management of the national forest estate, clarifies jurisdiction over forest areas and parks and protected areas, establishes an administrative structure for forest management, and provides recognition of customary property rights. Special efforts were made in the drafting process to ensure compatibility with the Land Law and other legislation. · Resource Management ­ Expenditure Rationalization. The budget plan for four key sectors (health, education, agriculture, and rural development) increased from 299 billion riels in 1999 to 512 billion riels in the 2002 budget. As a share of total current spending, this was up from 25 percent of current expenditure in the 1999 to 32 percent of the current expenditure in the 2002 budget. The allocation for Chapter 13 (PAP and ADD) in the 2001 budget was increased to 76.1 billion riels from 9.5 billion riels in 2000. As the SAC second tranche was initially envisaged to be released by March 2001, the program did not include medium-term conditions beyond 2001. However, the government has substantially increased expenditures for the four key sectors over the implementation period of 2000-2003. · Governance and Fighting Corruption. A series of activities as set out in the reform program to improve the environment for fighting corruption and governance. A diagnostic study on governance and corruption was carried out by a local NGO in 1999-2000 based on surveys of citizens, enterprises and public officials concerning their perceptions of corruption problems in the public sector, with the publication of May 2000 Report on "Cambodia: Governance and Corruption Diagnostic: Evidence from Citizen, Enterprise and Public Official Surveys." A government's initial draft of a Governance Action Plan (GAP) was presented at the Consultative Group meeting in May 2000, building on the analysis and (14) findings of a number of studies. Extensive consultations were held with many donors, NGOs, and the private sector before finalization of the GAP and approval by the Council of Ministers in March 2001. A National Forum chaired by the Prime Minister took place in December 2001 to start disseminating the GAP and the diagnostic report on governance and corruption, followed by four workshops in provinces in the first half of 2002. The government has begun implementing GAP since its official adoption in March 2001. Progress has been uneven, with advance made in some areas, such as public finance, but implementation in other areas, particularly for legal and judicial reform, has been slow. The progress of actions in GAP was reported to the public in the government's biannual GAP Progress Reports in June and December 2001. However, concrete progress is difficult to measure and there are considerable challenges ahead for the government in this area while perception on corruption in Cambodia persists. (14) Including the diagnostic study mentioned above, a study on governance and sustainable development carried out by the Cambodia Development Resource Institute (CDRI) with financial support from the ADB, and many other reports prepared by other donors. 4.3 Net Present Value/Economic rate of return: - 20 - 4.3.1. Not applicable. However, the project would improve the efficiency of resource allocation and hence returns on investment generally. 4.4 Financial rate of return: 4.4.1. Not applicable. However, the project would yield significant returns by augmenting the Cambodian government's institutional capacity. 4.5 Institutional development impact: 4.5.1. The program has introduced basic changes in the government to enhance its resources management and public sector management that improve and enhance the way the public sector operates, moving the government further toward its vision for an efficient and responsive public sector. Through the SAC vehicle, the government has also instituted lasting impact in the legal framework of the country, including the Sub-Decrees on the VAT, the amendment for the LOI, the strengthening of the administrative tax law, measures in the tax and custom administration, forestry management and forestry law. These have helped to make the public sector more transparent and accountable. However, the results are still tenuous and the government will need to continue its efforts to ensure that these results take firm roots. Challenges are still ahead and there are many difficulties and obstacles against the reforms, for example the BESC was disbanded as it was not successful in its mandate on expenditure control and cash management has deteriorated further after the SAC. 4.5.2. The policies under the reform program have contributed to better resource mobilization with the VAT as the main vehicle for tax collection for the government. Implementation of the VAT has also improved and the expansion of the VAT coverage is expected to increase in the future, ensuring the sustainability of the government's objective for better revenue collection. The activities in rationalizing public expenditures would lead to better program and more efficient service delivery, especially in the key social and economic sectors (health and education). These would contribute to the government's effort toward poverty reduction. However, given the weak capacity of the government, difficulties remain and continue to seriously challenge the reform efforts to ensure better allocation of resources and long-lasting effects in resources management. 4.5.3. In the forestry sector, while there were delays in the implementation of the reform measures, public awareness has been raised with the publication of the forestry monitoring crime, one step in the direction of public involvement in managing this valuable resource. The disclosure of drafts of strategic forest management plans and environmental and social impact assessments contributes to openness and transparency in the management of public resources. These serve as building blocks toward better governance and provide effective tools to fight corruption in the public sector, yet with modest and fragile results that need to be nurtured further if Cambodia is to embark firmly on better resource management for the forestry sector. 4.5.4. The pilot project for demobilization serves as the first irreversible step toward better control of the defense and security budget while effecting the government's move toward peace time administration. However, similar to the other activities, the challenge still lays ahead to implement the demobilization and reintegration program. - 21 - 5. Major Factors Affecting Implementation and Outcome 5.1 Factors outside the control of government or implementing agency: 5.1 Factors Outside the Control of Government or Implementing Agency: 5.1.1. The most important factor outside the control of the government is the political situation in Cambodia, which could be at time volatile and unstable, making the reform activities uncertain and the commitment to reform subject to the convenience of political groups. 5.1.2. The weak civil service acts as a brake on the intention of the government to keep up with the reform momentum, especially when the measures to improve revenue and administration require the civil servants to have more skills and level of education to perform complicated tasks, whether in administering the VAT, its refunds or the PSI in the Customs Department. 5.1.3. The activities involving the National Assembly may not be under the government control, given the independence of the NA and its own legislative calendar. 5.2 Factors generally subject to government control: 5.2.1. Most of the measures in the SAC program were under the government's control. However, the government has to work with the National Assembly in order to obtain approval for all the needed legislations under this program. 5.3 Factors generally subject to implementing agency control: 5.3.1. The MEF was responsible for the coordination between its department and the relevant ministries and agencies to carry out the activities under the SAC program. Measures under the public sector management and public resources management were under the direction and control of the ministry. However, MEF had to coordinate with the MAFF on the measures covering the forestry sector. MEF also had to coordinate with the National Assembly and its agencies on the submission of amendments to the LOI and other legislation. 5.4 Costs and financing: 5.4.1. The original credit amount was SDR 21.9 million (US$ 30 million equivalent). At the end of the project on December 31, 2003, the project was fully disbursed at SDR 21.9 million (US$ 30.4 million equivalent) in three tranches: the first tranche amounted to SDR 7.3 million was disbursed at the declaration of effectiveness in 2000, the floating tranche (SDR 3.6 million) was disbursed in September 2001, and the second tranche (SDR 11 million) was disbursed in December 2003 at the project's closure. 5.4.2. The credit term is on standard IDA terms, with a maturity of 40 years with a grace period of 10 years. The service charge on the credit was the standard IDA rate of 0.75 percent. The Swedish International Development Agency (SIDA) of Sweden cofinanced the credit with a contribution of US$ 5 million equivalent. - 22 - 6. Sustainability 6.1 Rationale for sustainability rating: 6.1.1. The sustainability of the achievements made under the program is rated as moderately likely, albeit with some qualifications due to the fragile and tenuous nature of the progress achieved and the challenging environment within which the SAC was implemented. The government was keenly aware of the need to improve macroeconomic policies, mobilize revenue and financial resources for investment, rationalize expenditures to ensure adequate spending for key social and economic sectors, and address governance and corruption problems in economic management, especially in the forestry sector so as to better position the country towards the path for sustainable growth. However, it took enormous efforts to carry out the activities supported by the project to the desirable end. 6.1.2. The completion of the project activities provides a clear, albeit strenuous, path for the government to continue to improve its capability for public resource management, to enhance public sector management, and to formulate and implement a strategy on governance and fighting corruption in economic management. On the positive side, the achievements under the SAC enabled the government to continue to build on the activities thus far accomplished and ensured that the risks for backtracking are minimized. The changes put in place for revenue mobilization, expenditure rationalization, forestry resource management, and governance practices would serve as concrete building blocks for further reforms. However, the fact that government took a longer time to complete these activities and the weak human resource base in the public sector could still act as an impediment to maintaining the momentum of reform in the management of public resources with improved governance and fighting corruption practices. The unsettled political situation of the country which was inherited from a long period of armed conflict and deep hostility among political groups, could again hamper the movement toward deeper and more extensive reform in the public sector, similar to an earlier period. Thus, the sustainability of the reforms accomplished through the SAC remains at best fragile and this fragility in turn poses serious challenges to maintain the reform momentum. 6.2 Transition arrangement to regular operations: 6.2.1. The project was built on the achievements of the previous three lending operations. As Cambodia continues on its path toward a market-oriented system, further policy lending would be necessary. The SAC, as policy-based lending, is now however being superceded by the Bank's new, Poverty Reduction Support Credit (PRSC). PRSCs are in turn based on Poverty Reduction Strategy Papers (PRSPs), a government document which outlines its strategy for economic development and poverty reduction. Cambodia has developed a satisfactory National Poverty Reduction Strategy (NPRS) and the reform process will be supported through PRSCs in the future, thus ensuring sustainability of the SAC reform efforts. The Interim PRSP (I-PRSP) was completed in October 2000. A PRSC will be prepared, following the successful completion of the country's NPRS in December 2002, and once a new CAS will have been adopted in the Fall of 2004. PRSCs would be more tailored to Cambodia's needs and circumstances, as the development of the PRSC program is based on the country's initiative and ownership outlined in its NPRS. - 23 - 6.2.2. The SAC has been followed by a Forest Concession Management and Control Pilot Project, a Demobilization and Reintegration Project, and an Economic and Public Sector Capacity Building project. All of these were designed by the Bank to contribute to reinforcing the gains achieved under the reform program and to carry the reforms in Cambodia further toward the path of sustained development and growth. 7. Bank and Borrower Performance Bank 7.1 Lending: 7.1.1. The Bank's performance in the project preparation is rated as satisfactory. Bank staff have carried out an extensive economic dialogue with the authorities along with the IMF. The Bank also benefited from the experience of the previous three emergency lending operations and focused appropriately on the reform in the public sector as the priority for Bank's policy-based assistance. 7.2 Supervision: 7.2.1. The Bank's performance in the supervision of the project is rated as satisfactory. The presence of the same Task Manager throughout the life of the operation provides the continuity which is crucial to the implementation of the program, in the guiding and monitoring of the measures to be undertaken, especially to fulfill the second tranche condition. The Bank's resident staff strengthens the dialogue and contact with the government officials. The presence of an engaged Country Director and the direct participation of the Chief Economist and Sector Director, as well as the Country Manager, ensure the support and weight needed for smooth implementation of the project. 7.3 Overall Bank performance: 7.3.1. The Bank has satisfactorily played an active advisory role to the country through its economic dialogue with the authorities and responded timely to their request for help in implementing the reform program and in dealing with the issues requiring numerous extensions of the project. With the weak civil service and a fragile political situation, Bank staff provided needed assistance for monitoring and guiding the implementation of the project to its successful closure. Borrower 7.4 Preparation: 7.4.1. The government played an active role in the preparation of the credit, despite being hampered by political uncertainty. There was strong commitment from the senior officials to the development objectives of the project. 7.5 Government implementation performance: 7.5.1. The government performance is rated as satisfactory with some qualification. While the - 24 - senior officials agreed and committed themselves to the objectives of the project, the country's institutional capacity was weak and required additional time and efforts to translate these objectives into reality. This has complicated and exacerbated the difficulties arisen during implementation stage as many issues were required to be addressed among the ministries and agencies involved in carrying out the agreed conditions, resulting in the delay of the forestry component and the need for many extension requests. 7.6 Implementing Agency: 7.6.1 The performance of MEF, the main agency responsible for the implementation of the project, was satisfactory, given its efforts to undertake and coordinate the various measures required by the project. MEF was learning by doing in the implementation of the project despite its weak administrative capacity and the serious challenge on coordination with other ministries and agencies to fulfill the conditions in the SAC. 7.7 Overall Borrower performance: 7.7.1. Overall borrower performance is rated as satisfactory, albeit moderately. The government has brought the project to a satisfactory closure in a very challenging environment and with weak civil service, slow progress on governance, and fragile reforms in public resource mobilization and management. 8. Lessons Learned 8.1. The major lessons are: · A stable political environment would be beneficial, in fact a prerequisite, for successful implementation of macroeconomic and structural reforms. The political stability was a major factor in fulfilling the conditions of the SAC in Cambodia and remains a critical factor in structural adjustment reform of the country. · While the ownership of the project resided with the senior officials, it was apparently less so among the ministries and technical staff involved in the program. An effective vehicle would need to be instituted to involve mid-level and technical staff in the preparation of structural adjustment program. l The SAC program in Cambodia dealt across ministries and agencies without proper and effective mechanism to enhance its implementation. For the overarching adjustment lending operation, there is a critical need for a specific inter-ministerial steering group dedicated to assume the leadership of the operation and a secretariat with representatives from affected ministries and (15 ) agencies for the day-to-day implementation of the operation. These two groups could help the PMU to overcome some of the bottlenecks due to the country's weak civil service and to deal with potential rivalries among agencies. . (15 ) There was an Inter-ministerial High-Level Committee for Economic and Financial Policies chaired by the Minister of Economy and Finance and composed of various ministers and vice ministers, this Committee did not focus its attention on the SAC and was not effective in guiding the specific activities supported by the SAC. - 25 - · A weak civil service adversely affects the implementation of the structural reform program. Thus availability of technical assistance from donors and strong Bank team support are extremely crucial in low-income country with weak technical working level capacity. · Close working relations between the Bank and the government counterparts would improve the quality of the Bank assistance. Continuity of Bank staff, especially the task manager, working on Cambodia and careful transition period between Bank managers contribute to ensuring fruitful implementation of the project. · The project benefited from related operations, those that were being prepared and those that were being implemented. These strengthened and deepened the dialogue with the government on interrelated issues in the overall reform program and facilitated the implementation of the SAC program. · When addressing deeply entrenched special interests, especially corrupt officials or interests allied with corrupt officials or the military, specific provisions may be needed (i.e., Intersectoral Steering Committees or Public Advisory Commissions) to help maintain and retain the momentum of reform. · Close attention is needed to the legal draftsmanship of conditionalities and consistency between the Letter of Development Policy, the Development Credit Agreement, and the Policy Matrix, especially in reference to performance expectations involving third parties (concessionaires) and qualitative actions (restructuring, consultation). l Conditionality in the SAC should be crafted to reflect the quality of the reforms measures and to ensure their contribution to the overall progress and direction of the reform program instead of specific or quantitative benchmark and precise language which could act as inflexible barriers during project implementation. · The multi-tranche release credit presents a challenge to the government in fulfilling the conditions for the floating tranche and the second tranche releases, due to the need to maintain the momentum built up during the preparation of the operation and the continuity required throughout the whole life of the credit, given the fragile political reality in the Borrower country. · Transparency in the management of public resources would contribute to better public discipline and help to overcome the weak capacity of the civil service force. l Finally, the reform process in Cambodia would be better met by the new lending instrument, PRSC. PRSCs provide customized support to country-development and country-owned reform programs following extensive consultations among all stakeholders. PRSC program would be more tailored to the Borrower's needs and circumstances, as the development of the PRSC program is based on the country's initiative and ownership outlined in its NPRS. 9. Partner Comments (a) Borrower/implementing agency: - 26 - - 27 - - 28 - - 29 - - 30 - - 31 - - 32 - - 33 - - 34 - (b) Cofinanciers: Assessment from the Swedish International Development Cooperation Agency (SIDA), Kingdom of Sweden. - 35 - - 36 - - 37 - - 38 - - 39 - - 40 - - 41 - (c) Other partners (NGOs/private sector): 10. Additional Information - 42 - Annex 1. Key Performance Indicators/Log Frame Matrix Please see Annex 7 for the review of the activities/conditionalities under this project. - 43 - Annex 2. Project Costs and Financing Project Cost by Component (in US$ million equivalent) Appraisal Actual/Latest Percentage of Estimate Estimate Appraisal Component US$ million US$ million IDA 30.00 30.00 100 Cofinancier: SIDA 5.00 5.00 100 Total Baseline Cost 35.00 35.00 Total Project Costs 35.00 35.00 Total Financing Required 35.00 35.00 Project Financing by Component (in US$ million equivalent) Percentage of Appraisal Component Appraisal Estimate Actual/Latest Estimate Bank Govt. CoF. Bank Govt. CoF. Bank Govt. CoF. Budget 30.00 5.00 30.00 5.00 100.0 100.0 - 44 - Annex 3. Economic Costs and Benefits Not applicable. - 45 - Annex 4. Bank Inputs (a) Missions: Stage of Project Cycle No. of Persons and Specialty Performance Rating (e.g. 2 Economists, 1 FMS, etc.) Implementation Development Month/Year Count Specialty Progress Objective Identification/Preparation October 1999 4 2 Economists, 1 Forestry S S Specialist, 1 Public sector specialist Appraisal/Negotiation December 1999 5 1 Task Team Leader, 1 S S Economist, 1 Forestry Specialist, 1 Legal advisor, 1 Public sector specialist January 2000 6 1 Task Team Leader, 1 S S Economist, 1 Forestry Specialist, 1 Legal advisor, 1 Public sector specialist, 1 Senior Advisor Supervision June 2000 1 1 Task Team Leader (TTL) S S August 2000 1 1 TTL S S December 2000 2 1 TTL, 1 Forestry Specialist S S March 2001 2 1 TTL, 1 Economist, 1 Forestry U S Specialist, 1 Public sector specialist, November 2001 1 1 TTL S S June 2002 2 1 TTL, 1 Forestry Specialist U S November 2002 2 1 TTL, 1 Forestry Specialist U S March 2003 2 1 TTL, 1 Forestry Specialist U S September 2003 1 1 TTL U S November 2003 2 1 TTL, 1 Forestry Specialist S S ICR 1 1 Economist S S (b) Staff: Stage of Project Cycle Actual/Latest Estimate No. Staff weeks US$ ('000) Identification/Preparation 18 67.4 Appraisal/Negotiation 50 182.8 Supervision 60 207.8 ICR 8 24.0 Total 136 482.0 - 46 - Annex 5. Ratings for Achievement of Objectives/Outputs of Components (H=High, SU=Substantial, M=Modest, N=Negligible, NA=Not Applicable) Rating Macro policies H SU M N NA Sector Policies H SU M N NA Physical H SU M N NA Financial H SU M N NA Institutional Development H SU M N NA Environmental H SU M N NA Social Poverty Reduction H SU M N NA Gender H SU M N NA Other (Please specify) H SU M N NA Private sector development H SU M N NA Public sector management H SU M N NA Other (Please specify) H SU M N NA - 47 - Annex 6. Ratings of Bank and Borrower Performance (HS=Highly Satisfactory, S=Satisfactory, U=Unsatisfactory, HU=Highly Unsatisfactory) 6.1 Bank performance Rating Lending HS S U HU Supervision HS S U HU Overall HS S U HU 6.2 Borrower performance Rating Preparation HS S U HU Government implementation performance HS S U HU Implementation agency performance HS S U HU Overall HS S U HU Note: For the "Government Implementation Performance" and for the "Overall Performance", the ICR ratings are qualified as moderately satisfactory. - 48 - Annex 7. List of Supporting Documents Review of Conditionalities Board Presentation Conditions. All Board Presentation conditions were met, enabling the project to be presented to the Board in February 2000 for its approval. Taxation. The government has (i) passed the Sub-Decree on VAT, satisfactory to IDA, (ii) continued its policy disallowing exemptions to the VAT other than those specified in the Law on Taxation; and (iii) reduced the backlog of refunds to those no more than 15 days old following the approval of refunds request and maintained a refund policy that will ensure that all future refunds were made available to the VAT taxpayer within 15 days of approval by the Tax Department. The Sub-Decree on VAT was passed and the government is committed to maintaining the policy on exemptions and on ensuring that all refunds are made to the VAT taxpayer with 15 days of approval by the Tax Department. SAC supervision missions confirmed significant improvements in the VAT refund process. Tax and Custom Administration: The government has (i) initiated a tendering process in a transparent and competitive manner for a pre-shipment inspection (PSI) agency, with provisions for achieving the elements and objectives set out in the second tranche release condition; and (ii) used the already established PSI database as a basis for determining customs valuation during the interim period. All activities were completed. Forest Crime Monitoring. The government has (i) developed and implemented a work program for establishing forestry crime monitoring capacity of the Department of Forestry and Wildlife, the Ministry of Environment, and the Council of Ministers, including procurement, staffing, training, and budgeting, satisfactory to IDA, and (ii) reported quarterly on the forest crime monitoring to the public, including the first full report made available in early February 2000. The government fulfilled these measures to enhance all the activities required for forest crime monitoring. The quarterly reports have been made public. Concession Management. The government has adopted the Sub-Decree on forestry concession management, satisfactory to IDA, by encompassing the main provisions from a set of Codes of Practices and providing the Department of Forestry and Wildlife with an appropriate level of independence from political interference in enforcement, after consultations with concessionaires and NGOs. The Sub-Decree on forestry concession management has been adopted and satisfactory to IDA. Expenditure Reorientation. The government has presented to IDA a plan for increasing expenditures for the key social and economic sectors (i.e., health, education, agriculture, rural development) over the next three years, satisfactory to IDA. As an initial phase of the plan, the Government has presented to IDA the 2000 budget for health (9 percent of total current expenditure), education (14 percent of total current expenditure), and agriculture and rural development (3 percent of total current expenditure), showing improvement over the 1999 budget in terms of share in total current expenditure, as agreed with IDA. In addition, the Government has presented to IDA the budget allocations and the contents of the Priority Action Program (PAP) for health and education and also for the Accelerated District Development (ADD) program, as agreed with IDA. A plan for increasing expenditures for key social and economic sectors were prepared and satisfactory to IDA. Expenditure Management. The government has established a budget strategy and enforcement center at MEF, with adequate mandate, staffing, and procedures, satisfactory to IDA, as a one-stop shop to streamline the procedures to screen the bids for funding and facilitate cash disbursements to key social and economic sectors (health, education, agriculture, and rural development), both at the central level and provincial departments. The Government has also requested provincial treasuries to provide monthly reports to MEF on the variance between the monthly allocations and actual disbursements to key social and economic sectors, the reasons for the variance, and measures to be taken to compensate for the variance, and provide the monthly reports to IDA. The BSEC was established as one-stop shop to streamline the procedures to screen the bids for funding and facilitate cash disbursements to key social and economic sectors (health, education, agriculture, and rural development), both at - 49 - the central level and provincial departments. Monthly reports from provincial treasuries have also been reported to MEF on a regular basis. Military Demobilization. In full consultation with donors, NGOs, and civil society, the Government has: (a) completed the identification and registration of soldiers; and (b) formulated a pilot demobilization and reintegration program, satisfactory to IDA, including provisions for independent financial and technical audits of the program. These activities were completed. Floating Tranche Release Condition Preparatory Signs for Military Demobilization and Administrative Reform: In accordance with the provisions of paragraph 28 of the Letter of Development Policy, the Government will have: (a) achieved progress satisfactory to IDA in the implementation of the pilot phase of the demobilization and reintegration program; (b) in full consultation with stakeholders, conducted an interim review of the progress of the program; and (c) based on the results thereof, developed a proposal, acceptable to IDA, for the demobilization and reintegration program. This condition was met, enabling the release of the Floating Tranche in September 2001. Second Tranche Release Conditions Law on Investment. The government will have submitted for adoption by the National Assembly an amendment to Article 14 of the Law on Investment, and introduced related measures, acceptable to IDA and in form and substance consistent with paragraph 8 of the Letter of Development Policy, with a view to rationalizing the incentive regime inherent in the Law on Investment and eliminating distortion thereunder. The government was committed to amending the LOI with the following components: (1) elimination of the special 9 percent corporate tax rate for all new investment and phasing the 9 percent rate out to the standard 20 percent under the Law on Taxation for the next five years for existing approved and operational projects; (2) elimination of the tax free reinvestment of profits and introduction of an appropriate investment allowance in the Law on Taxation at a rate to be determined, satisfactory to IDA, and applicable to all qualifying investment, new or expansion irrespective of source of finance, without evaluation; (3) repeal of the current tax holiday provisions and the introduction of a three year tax holiday, conditional on annual certification of compliance, to all qualifying new investment, without evaluation; the use of tax holiday will deny the tax payer any benefits available under the Law on Taxation during the tax holiday including initial investment allowance as well as accelerated depreciation allowance; all current tax holidays provide under the Law on Investment will be grandfathered; and (4) elimination of the right to tax free repatriation of earnings and other incomes by approved enterprises. Parts (1); (2) and (4) of this condition were fully met. The waiver was sought for ­ and approved by the Board -- part 3 of this condition that was not met. The bill to amend the LOI was submitted to the National Assembly, and was subsequently adopted in February 2003. The submitted bill and the adopted amended LOI includes the following elements on conditionality: (1) The new clause "A qualified investment project shall be subject to a profit tax rate after its tax exemption period as determined in the Law on Taxation" was introduced, replacing the previous clause "A corporate tax rate of 9 percent except tax rate on the exploration and exploitation of natural resources, timber, oil, mines gold, and precious stones which shall be set in separate laws." (2) The previous clause "In the events profits are reinvested in the country, such profits shall be exempted for all corporate tax" was dropped (3) The new clause "A qualified investment project (QIP) shall be entitled to exemption from the tax period. The tax exemption period is composed of a Trigger Period + 3 years + n years (n shall be determined in the Financial Management Law). The maximum allowable Trigger Period is to be the first year of profit or three years after the QIP earns its first revenue, whichever is sooner" was introduced, replacing the previous clause "A corporate tax exemption of up to 8 years depending on the characters of the project and - 50 - the priority of the government which shall be mentioned in a Sub-Decree." (4) The previous clause "Non-taxation on the distribution of dividends or profits or proceeds of investment, whether transferred abroad or distributed in the country" was dropped. While the spirit of part (3) has been met, the specific proposal in the second tranche condition was to apply a 3-year tax holiday without evaluation. This was modified after extensive consultations with the private sector, prior to the National Assembly's submission. The government preferred some flexibility in determining the length of the tax holiday in consideration of strategic importance of each investment project based on pre-set explicit criteria. IDA concurred with this as the amended clause provided significant transparency and predictability for investment incentives (the main focus of the conditionality). Also, the consensus among the stakeholders would ensure higher compliance from the private sector in the implementation of the Law. The government continues to make investment incentive system more transparent and predictable. IDA is supporting the government in preparing the Sub-Decree for the amended LOI. The "related measures" referred to changes to other legislation necessary for consistency and unambiguity. The amended Law on Taxation was adopted by the National Assembly in February 2003. The government will have re-established a system of pre-shipment inspection of imports, on term and conditions acceptable to IDA, and in accordance with the policies and principles laid down in paragraph 11 of the Letter of Development Policy. In this paragraph of the LDP, the government was committed to re-establishing the pre-shipment inspection as follows (1) extending the PSI to all imports except for a list of goods agreed with IDA; (2) using PSI valuations for the basis of the import value for customs purposes; and (3) instituting a system of prepayment of customs duties and other taxes at imports for all sealed containers based on the pre-shipment inspection report, allowing in principle immediate clearance of such containers without inspection on arrival, within the framework of risk management system, whose criteria are satisfactory to IDA. This condition was met. PSI was reinstated in October 2000 with the requested elements as stated in the Letter of Development. A system of prepayment is implemented for companies with good records of law compliance and reputation within the framework of risk management system of the Customs and Excise Department. In some cases, PSI agency's Reports of Findings (ROFs) are not accurate and sealed containers do not always contain what are indicated in the ROFs. To strengthen the PSI mechanism, a PSI Steering Committee was established to address concerns, raised by importers and the service provider. Forestry Management The government will have satisfied IDA that it has maintained its quarterly publication on forestry crime monitoring and that such publication has been made regularly available to the public, in accordance with the provisions in paragraph 13 of the Letter of Development Policy. This condition was met. The government established a forest crime monitoring system composed of units in the Council of Ministers, the Department of Forestry and Wildlife (DFW) and the Ministry of Environment. Since 199, the government has produced regular reports on the level, type and geographic incidence of forest crimes including timber thefts, arson, land encroachment, and other crimes. The publication on forestry crime monitoring has been made regularly (on a quarterly schedule) to the public through direct distribution to the press, embassies and others. The government will have completed a forestry concession review and taken actions based on the outcome of the review, in accordance with the provisions of paragraph 14 of the Letter of Development Policy. This condition was met. The Government completed a performance review of forty concession contracts in August 2000 and based on the outcome of the review, twenty five non-performing contracts were terminated. For the remaining fifteen concession contracts, the Government required concessionaires to present restructuring plans satisfactory to IDA. However, concessionaires were slow to engage. Accordingly in December 2001, a Prakas of the Ministry of Agriculture, Forestry, and Fisheries (MAFF) suspended operations in all forest concessions pending - 51 - settlement on restructuring programs to be submitted by concessionaires. As a first step towards restructuring, these concessionaires presented draft strategic forest management plans, which are in the process of being revised for final review by the Government. Based on the review of the draft strategic forest management plans, the Government has initiated actions to terminate seven concession contracts. For the remaining eight, review process is still underway. Cambodian Forest Law and the Sub-Decree on Forest Concession Management require preparation of five year compartment plans and annual operating or "coupe" plans, consultation with concerned stakeholders, and final approval by the Government before new contracts can be issued and logging can resume. In the meantime, logging and transport of logs remains under suspension in all forest concessions, except for one stump collection contract to salvage wood from already logged trees which was awarded in an area where the concession contract was terminated. In addition, the on-going monitoring under the Forest Concession Management and Control Pilot Project indicates that no subsequent forestry concessions have been granted outside of the terms and conditions of the Sub-Decree on Forest Concession Management. Forest Law. Following full consultations with stakeholders, and in accordance with the provisions of paragraph 15 of the Letter of Development Policy, the government will have submitted for adoption by the National Assembly a draft law revising the Forest Law, acceptable to IDA, and establishing clear responsibility for forest management and administration, and providing for enforcement authority, inter-sectoral oversight and public accountability. This condition was met. The drafting of a new Forestry Law was initiated in 1994 with FAO technical assistance. After a hiatus, consultations were renewed in 2000/01 through several public workshops, and the draft was made available for public comment. NGOs, FAO, and other interested parties submitted comments and revisions were made. The draft law was submitted to the National Assembly in August 2001 and was signed into law in August 2002. The Law provides a sound legal basis for control, allocation, and management of the national forest estate, clarifies jurisdiction over forest areas and parks and protected areas, establishes an administrative structure for forest management, and provides recognition of customary property rights. Special efforts were made in the drafting process to ensure compatibility with the Land Law and other legislation. The Forestry Law is satisfactory to IDA. Public Sector Management Expenditure Rationalization The Government will have submitted to IDA satisfactory evidence in terms of the formula specified in paragraph 19 of the Letter of Development Policy, to show that: (a) the ratio of actual disbursements of non-wage operating expenditures for the health, education, agriculture and rural development sectors combined during the year 2000 have been not less than the corresponding ratio for the remaining sectors combined; and (b) actual disbursements for the Accelerated District Development (ADD) program during the same period have been not less than the corresponding budget allocation This condition was not met and a waiver was granted. The thrust of this condition was to protect the disbursement to the key social and economic sectors as compared with the budget allocation at least on par with the rest of the sectors so that, when combined with the Board condition on enhanced 2000 budget allocation for key sectors, it would contribute to expenditure reorientation toward key sectors. Regarding the element (a) of the conditionality, the ratio of actual disbursement to the budget allocation for the four key sectors combined was 83.1%, as compared with the corresponding ratio of 89.1% for the remaining sectors combined. There were two main reasons for this: emergency post-flood rehabilitation needs and weak absorptive capacity. First, Cambodia was hit by severe floods in July-November 2000, the worst in 70 years. Some 30 percent of rice fields were damaged, major parts of roads and irrigation facilities were washed away, and many schools and hospitals were damaged. Total damage was estimated at around $180 million (5 percent of GDP). As a result, the Government had to divert cash from the allocated social sector outlays to the emergency post-flood rehabilitation needs. A substantial part of the post-flood rehabilitation outlays were of a social expenditure nature and if they had been properly classified as the social sector outlays in the budget table, this condition could have been met outright. Second, in early 2000 the Government established the Budget Strategy and Enforcement Center (BSEC) - 52 - at the Ministry of Economy and Finance as a one-stop shop to streamline the screening of bids for funding, and facilitate cash disbursement to key social and economic sectors. The role of BSEC was to facilitate the operation of the new Priority Action Program (PAP) based on advance payment of budget allocations on a quarterly basis, with post-audit replacing pre-audit. However, PAP started almost four months late in September 2000. This was due mainly to communication problems regarding financial procedures, coordination failures, and some coordination breakdown between the BESC and the Ministry of Health. Provincial department directors were very cautious and slow in using the PAP fund even when the PAP installments had been already released from the National Treasury and deposited in their accounts, as they were not familiar with post-audit system. In 2002, the situation improved compared with 2000, but still the disbursement ratio for the four key sectors was 91.9% as compared with the corresponding ratio of 94.8% for the remaining sectors combined. The main reasons for this were: (i) the Government set too ambitious social sector expenditure targets in the budget; and (ii) weak capacity of line ministries to develop expenditure programs and to adopt associated regulations. Although this conditionality was not met in terms of the specific quantitative indicator, the thrust of the conditionality (protection of social sectors against revenue shortfalls, and increase in disbursements to these sectors) has been satisfied. There has been significant improvement in expenditure reorientation toward key social and economic sectors since 1999. Expenditure for the four key sectors was increased substantially as a ratio of GDP from 2.0 percent in 1999 to 2.3 percent in 2000, 2.9 percent in 2001, and 3.6 percent in 2002. In contrast, defense and security expenditure was decreased as a ratio of GDP from 3.9 percent of GDP in 1999 to 3.5 percent in 2000, 3.0 percent in 2001, and 2.8 percent in 2002. Table 2: Expenditure Reorientation, 1999-2003 1999 2000 2001 2002 2003 prel. Four Key Sectors: 2.0 2.3 2.9 3.6 3.8 health, education, agriculture, rural development Regarding the element (b) of the conditionality, the actual disbursement for ADD in 2002 was 4,691 million riels as compared to the budget allocation of 6,000 million riels due to the reasons explained in the paragraph. ADD program is for a cash advance system for district health centers. The Government introduced the Priority Action Program (PAP)--cash advance system to health and education sectors -- to extend the thrust of the ADD to more comprehensive PAP with a view to enhancing disbursement to key social sectors. Spending for PAP in 2000 was 890 million riels. The combined ADD and PAP actual spending for 2000 was 5,581 million riels. The Government is committed to continuing expenditure reorientation toward key social sectors as committed in the PRSP. The Bank is continuing the policy dialogue to ensure adequate budget disbursement to key social sectors, including the ADD and PAP programs, among others, in the context of the recently completed Integrated Fiduciary Assessment and Public Expenditure Review (IFAPER). The government will have presented to IDA a draft year 2001 budget, acceptable to IDA, including budget allocations for, and contents of the Priority Action Program (PAP) and the ADD, and showing enhanced allocations for health, education, agriculture and rural development sectors in terms of share of total current expenditures as compared with the year 2000 budget This condition was met. The budget plan for the 4 key sectors (health, education, agriculture, and rural development) increased from 299 billion riels to 415 billion riels in the 2001 budget. As a share of total current spending, this is up from 24.6% of current expenditure in the 2000 outturn to 29.2% of the current expenditure in the 2001 budget. The allocation for Chapter 13 (PAP and ADD) in the 2001 budget was increased to 76.08 billion riels from 9.5 billion riels in 2000. As the SAC second tranche was initially envisaged to be released by March 2001, the program did not include medium-term conditions beyond 2001. However, as the SAC second tranche release has been delayed, the government substantially has increased expenditures for the 4 key sectors over the SAC implementation period of 2000-2003. - 53 - Enhancing Governance and Fighting Corruption Following full consultations with stakeholders, and in accordance with the provisions of paragraph 34 of the Letter of Development Policy, the Government will have: (a) conducted surveys on governance and corruption, and, on the basis thereof, prepared a diagnosis and formulated a national action plan acceptable to IDA; (b) disseminated the findings of the surveys and details of the national action plan; and (c) begun implementation of the national action plan. This condition was met. The Government commissioned a local NGO, Lidee Khmer, to carry out a diagnostic study on governance and corruption in 1999-2000. The surveys were conducted in November/December 1999. The study included three surveys of citizens, enterprises and public officials concerning their perceptions of corruption problems in the public sector. The diagnostic surveys generated useful data to diagnose the extent of governance and corruption problems in the public sector in Cambodia. Based on the analysis of the survey results, a report was prepared in May 2000, entitled "Cambodia: Governance and Corruption Diagnostic: Evidence from Citizen, Enterprise and Public Official Surveys." The Government prepared an initial draft of a Governance Action Plan (GAP) and presented it at the Consultative Group meeting in May 2000. The initial draft of GAP built on the analysis and findings of a number of studies, including the diagnostic study mentioned above, a study on governance and sustainable development carried out by the Cambodia Development Resource Institute (CDRI) with financial support from the ADB, and many other reports prepared by other donors. Since then, the Government has held extensive consultations with many donors, NGOs, and the private sector before finalization of the GAP and approval by the Council of Ministers in March 2001. The Government organized a National Forum in December 2001 to start disseminating the GAP and the diagnostic report on governance and corruption. The forum was chaired by the Prime Minister and was attended by ministers, senior civil servants from all over the country, and external stakeholders, totaling some 700 participants. It was followed by four workshops in provinces targeting public officials (some 900 participants) and external stakeholders (donors, NGOs, academia, and the press) in the first half of 2002. The Government has begun implementing GAP since its official adoption in March 2001. While some actions have already been completed, several others are in the process of being implemented. Significant progress has been made in some areas, including public finance, but implementation in other areas, particularly for legal and judicial reform, has been slow. The progress of actions in GAP was reported to the public in the Government's biannual GAP Progress Reports in June and December 2001. The Government is currently preparing the second GAP with more focus on legal and judicial reform. - 54 - - 55 -