Document of The World Bank Report No: ICR00004445 IMPLEMENTATION COMPLETION AND RESULTS REPORT (IBRD-86610) ON A LOAN IN THE AMOUNT OF US$ 200 MILLION TO THE PEOPLE’S REPUBLIC OF CHINA FOR THE HUNAN FISCAL SUSTAINABILITY DEVELOPMENT POLICY FINANCING January 3, 2019 Macroeconomics, Trade and Investment Global Practice Governance Global Practice East Asia and Pacific Region i CURRENCY EQUIVALENTS (Exchange Rate Effective November 30, 2018) Currency Unit = RMB RMB 0.16= US$1 US$ = SDR 1 FISCAL YEAR January 1 - December 31 Regional Vice President Victoria Kwakwa, EAPVP EFI Practice Group Vice President: Ceyla Pazarbasioglu-Dutz, GGEVP Country Director: Bert Hofman, EACCF Senior Global Practice Director: John Panzer (Acting), GMFDR; Debbie Wetzel, GGODR Practice Director John Panzer, GMFD2; James Brumby, GGODR Sector Manager: Deepak Mishra, GMF02; Alma Kanani, GGOEA Project Team Leaders: John Litwack, GMF02; Min Zhao, GGOEA ICR Team Leader: Lorena Viñuela, GGOEW ii ABBREVIATIONS AND ACRONYMS CAS Country Assistance Strategy CCP Chinese Communist Party CFAA Country Financial Accountability Assessment CNAO DOF China National Audit Office Department of Finance DPF Development Policy Financing DRC Development and Reform Commission DSA Debt Sustainability Analysis FAI Fixed Asset Investment FYP Five Year Plan GDP Gross Domestic Product GRS Grievance Redress Service HPFD Hunan Provincial Finance Department IBRD International Bank for Reconstruction and Development IFC International Finance Corporation IMF International Monetary Fund IPO Initial Public Offering JSAN Joint Staff Advisory Note LDP Letter of Development Policy LGFVs Local Government Financing Vehicles MDGs Millennium Development Goals MOF Ministry of Finance MTEF Medium-Term Expenditure Framework MTFS Medium-Term Fiscal Strategy NDRC National Development and Reform Commission NPC National People’s Congress NPL Non-performing Loan OECD Organization for Economic Cooperation and Development PBOC People’s Bank of China PBSOE Public Benefit State Owned Enterprise PEFA Public Expenditure and Financial Accountability PER Public Expenditure Review PFM Public Financial Management PPP Public Private Partnership SDR Special Drawing Rights SPV Special Purpose Vehicle TSA Treasury Single Account UDICs Urban Development Investment Corporations UNDP United Nations Development Program WBG World Bank Group iii CHINA Hunan Fiscal Sustainability DPF TABLE OF CONTENTS DATA SHEET ................................................................................................................................... 1 A. BASIC INFORMATION ........................................................................................................... 1 B. KEY DATES .............................................................................................................................. 1 C. RATINGS SUMMARY ............................................................................................................. 1 D. SECTOR AND THEME CODES .............................................................................................. 2 E. BANK STAFF ............................................................................................................................ 3 F. RESULTS FRAMEWORK ANALYSIS ................................................................................... 3 G. RATINGS OF PROJECT PERFORMANCE IN ISRs .............................................................. 5 H. RESTRUCTURING (IF ANY) .................................................................................................. 5 1. PROJECT CONTEXT, DEVELOPMENT OBJECTIVES AND DESIGN .................................. 6 1.1 Context at Appraisal ................................................................................................................. 6 1.2 Original Project Development Objectives (PDO) and Key Indicators ..................................... 9 1.3 Revised PDO and Key Indicators, and reasons/justification .................................................. 10 1.4 Original Policy Areas Supported by the Program .................................................................. 10 1.5 Revised Policy Areas .............................................................................................................. 15 1.6 Other significant changes ........................................................................................................ 15 2. KEY FACTORS AFFECTING IMPLEMENTATION AND OUTCOMES .............................. 15 2.1 Program Performance ............................................................................................................. 15 2.2 Major Factors Affecting Implementation ............................................................................... 19 2.3 Monitoring and Evaluation (M&E) Design, Implementation and Utilization ........................ 21 2.4 Expected Next Phase/Follow-up Operation ............................................................................ 22 3. ASSESSMENT OF OUTCOMES ............................................................................................... 22 3.1 Relevance of Objectives, Design and Implementation ........................................................... 22 3.2 Achievement of Program Development Objectives ............................................................... 23 3.3 Efficiency ................................................................................................................................ 26 3.4 Justification of Overall Outcome Rating ................................................................................ 27 iv 3.5 Overarching Themes, Other Outcomes and Impacts .............................................................. 27 (a) Poverty Impacts, Gender Aspects, and Social Development .............................................. 27 (b) Institutional Change/Strengthening ..................................................................................... 27 (c) Other Unintended Outcomes and Impacts ........................................................................... 28 3.6 Summary of Findings of Beneficiary Survey and/or Stakeholder Workshops ....................... 28 4. ASSESSMENT OF RISK TO DEVELOPMENT OUTCOME................................................... 28 5. ASSESSMENT OF BANK AND BORROWER PERFORMANCE .......................................... 29 5.1 Bank Performance ................................................................................................................... 29 (a) Bank Performance in Ensuring Quality at Entry ................................................................. 29 (b) Quality of Supervision......................................................................................................... 29 (c) Justification of Rating for Overall Bank Performance ........................................................ 30 5.2 Borrower Performance ............................................................................................................ 30 (a) Government Performance .................................................................................................... 30 (b) Implementing Agency or Agencies Performance ............................................................... 31 (c) Justification of Rating for Overall Borrower Performance ................................................. 31 6. LESSONS LEARNED ................................................................................................................. 31 7. COMMENTS ON ISSUES RAISED BY BORROWER/IMPLEMENTING AGENCIES/PARTNERS ................................................................................................................. 33 (a) Borrower/Implementing agencies ........................................................................................ 33 (b) Cofinanciers......................................................................................................................... 33 (c) Other partners and stakeholders .......................................................................................... 33 ANNEX 1: BANK LENDING AND IMPLEMENTATION SUPPORT/SUPERVISION PROCESSES .................................................................................................................................... 34 ANNEX 2: SUMMARY OF BORROWER'S ICR AND/OR COMMENTS ON DRAFT ICR ..... 36 ANNEX 3: THEORY OF CHANGE ............................................................................................... 41 Map of Hunan Province ................................................................................................................... 42 v DATA SHEET A. BASIC INFORMATION Hunan Fiscal Country: China Program Name: Sustainability DPO Program ID: P157406 L/C/TF Number(s): IBRD-86610 ICR Date: 08/28/2018 ICR Type: Core ICR PEOPLE'S REPUBLIC Financing Instrument: DPL Borrower: OF CHINA Original Total USD 200.00M Disbursed Amount: USD 200.00M Commitment: Revised Amount: USD 200.00M Implementing Agencies: Department of Finance of the Hunan Province Cofinanciers and Other External Partners: B. KEY DATES Revised / Actual Process Date Process Original Date Date(s) 12/17/2015 Effectiveness: 12/31/2017 Concept Review: Appraisal: 05/05/2016 Restructuring(s): Approval: 01/10/2017 Mid-term Review: Closing: 12/31/2017 12/31/2018 C. RATINGS SUMMARY C.1 Performance Rating by ICR Outcomes: Highly Satisfactory Risk to Development Outcome: Moderate Bank Performance: Highly Satisfactory Borrower Performance: Highly Satisfactory 1 C.2 Detailed Ratings of Bank and Borrower Performance (by ICR) Bank Ratings Borrower Ratings Quality at Entry: Highly Satisfactory Government: Highly Satisfactory Highly Satisfactory Implementing Highly Satisfactory Quality of Supervision: Agency/Agencies: Overall Bank Highly Satisfactory Overall Borrower Highly Satisfactory Performance: Performance: C.3 Quality at Entry and Implementation Performance Indicators Implementation QAG Assessments (if Indicators Rating Performance any) Potential Problem Program No Quality at Entry (QEA): None at any time (Yes/No): Problem Program at any Quality of Supervision No None time (Yes/No): (QSA): DO rating before Closing/Inactive status: D. SECTOR AND THEME CODES Original Actual Sector Code (as % of total Bank financing) Public Administration Sub-National Government 100 100 Theme Code (as % of total Bank financing) Economic Policy 13 13 Fiscal Policy 13 13 Fiscal sustainability 13 13 Public Sector Management 63 63 Public Administration 63 63 Public Assets and Investment Management 38 38 Transparency, Accountability and Good 25 25 Governance Public Finance Management 50 50 Debt Management 50 50 2 E. BANK STAFF Positions At ICR At Approval Victoria Kwakwa Vice President: Victoria Kwakwa Bert Hofman Country Director: Bert Hofman Practice Manager/Manager: Deepak K. Mishra, Alma Kanani Matthew Verghis, Robert Taliercio John Litwack, Min Zhao Program Team Leader: John Litwack, Min Zhao ICR Team Leader: Lorena Viñuela ICR Primary Author: Lorena Viñuela William R. Dillinger John Litwack F. RESULTS FRAMEWORK ANALYSIS Program Development Objectives (from Project Appraisal Document) To support the Hunan Provincial Government to achieve fiscal sustainability by developing a forward-looking, comprehensive and transparent public finance framework that integrates budget, public investment and debt management. The four pillars of the DPF are: (a) Fiscal Sustainability; (b) Capital Budgeting; (c) Monitoring and Regulating Sub- Provincial Government Debt; and (d) Transparency. Revised Program Development Objectives (if any, as approved by original approving authority) N/A 3 PDO Indicator(s) Indicator 1: Share of Hunan Provincial Government public liabilities in Province GDP Value quantitative or 14.1 15.0 14.0 Qualitative) Date achieved 12/31/2015 01/11/2017 01/11/2017 Comments Achieved and surpassed. The original target was for the Hunan Government to have less (incl. % than 15 percent of GDP in public liabilities in 2016. The result was exceeded in 2016, achievement) achieving 14 percent of GDP in public liabilities, a value maintained in 2017. Indicator 2: Number of sectors covered in the integrated capital financing plan of Hunan Province Value quantitative or 0 3 7 Qualitative) Date achieved 12/31/2015 01/11/2017 12/31/2017 Comments Achieved and surpassed. The target was outperformed in 2016 with the majority of (incl. % sectors covered in the integrated capital financing plan and a total of seven a year later. achievement) Indicator 3: Interagency Committee issues opinions on the Medium Term Fiscal Strategy and Three- Year Rolling Capital Financing Plan for Transportation, Water/Irrigation, and Social Housing for 2016-2018 Value quantitative or No Yes Yes Qualitative) Date achieved 12/31/2015 01/11/2017 01/11/2017 Comments Achieved. The Hunan Government expressed its commitment to maintaining the practice (incl. % with the preparation of a new rolling plan. achievement) Indicator 4: Share of local governments satisfying annual disclosure of debt data online and fund use plans for new borrowing Value quantitative or 0 40 80 Qualitative) Date achieved 12/31/2015 01/11/2017 01/11/2017 Comments Achieved and surpassed. The target was exceeded in 2016 and again in 2017, reaching (incl. % 82 percent of local governments disclosing debt data. achievement) Indicator 5: Share of local governments classified as “red” for more than one year having not submitted a risk mitigation action plan to restore financial health Value quantitative or 100 40 30 Qualitative) 4 Date achieved 12/31/2015 01/11/2017 01/11/2017 Comments Achieved and surpassed. The number of governments classified as red without a (incl. % mitigation plan was 30 percent in 2016 and 15 in 2017. achievement) Indicator 6: Biannual comprehensive debt reports on the internet with less than four month lag from end-June 2016, end-December 2016 and end-June 2017 Value quantitative or 0 3 3 Qualitative) Date achieved 12/31/2015 10/31/2017 10/31/2017 Comments Achieved. The Government expressed its commitment to maintaining the practice going (incl. % forward. achievement) Indicator 7: Number of local governments in Hunan Province having disclosed all debt and financial information in the template on the internet platform Value quantitative or 0 10 10 Qualitative) Date achieved 12/31/2015 01/11/2017 01/11/2017 Comments Achieved and surpassed. The number of local governments disclosing all debt and (incl. % financial information online was 10 in 2016 and 12 in 2017. The Government estimates, achievement) based on its ongoing efforts, that the number will also increase in 2018. Indicator 8: Number of citizens' budget reports and budget performance reports disclosed online less than 6 months from year end Value quantitative or 0 2 2 Qualitative) Date achieved 12/31/2015 01/11/2017 01/11/2017 Comments Achieved and surpassed. Four citizen budget reports have been published since 2015 and (incl. % the Government plans to continue their annual publication. achievement) G. RATINGS OF PROJECT PERFORMANCE IN ISRs Date ISR Actual Disbursements No. GEO IP Archived (USD millions) H. RESTRUCTURING (IF ANY) Not Applicable 5 1. PROJECT CONTEXT, DEVELOPMENT OBJECTIVES AND DESIGN 1.1 Context at Appraisal 1. This World Bank Development Policy Financing (DPF) for US$ 200 million assisted the Hunan Province Government realize reforms to place its public finances on a sustainable path. This included the development of tools for debt / fiscal sustainability, a new integrated approach to medium-term capital budgeting, and improvements in the provincial-level monitoring and regulation of the financial health of local governments. Hunan Province has long been a leader among Chinese provinces in reform, and the expectation was that the experience from the operation would inform debates and policies on subnational fiscal reform throughout the country. 2. China is now a high middle-income country, and well positioned to become a high- income country in the next decade. The country’s economic transformation over the past three decades has raised living standards and made China the world’s largest manufacturer and exporter. Real per capita GDP increased 24 times over 1978–2017, and more than 850 million people have been lifted out of poverty. All Millennium Development Goals have either been reached or are within reach. While China’s exceptionally rapid growth and development in recent decades has served the country well, it has also been associated with economic, environmental and social imbalances. 3. China’s growth has gradually slowed in this period of transition, signaling what President Xi Jinping has called the “new normal.” Growth has moderated from the over 10 percent average annual rate that China experienced for three consecutive decades, falling to 6.9 percent by 2017. Against this backdrop, China’s economy has been steadily rebalancing toward more consumption-led growth concentrated in the service sector. 4. While growth in China still remains high by international standards, macroeconomic risks have increased in the last decade, including in the form of rapidly rising of subnational debt. To stimulate economic growth since the global financial crisis of 2008, subnational governments in China have rapidly accumulated debt. Although subnational governments were not allowed to incur explicit deficits or borrow funds directly until 2015, they nevertheless accumulated debt quite rapidly in off-budget local government financing vehicles (LGFVs) that carried out public investments. In recent years, a number of local governments have begun to experience financial difficulties due to this rapid build-up in LGFV debt against the backdrop of an economic slowdown and declining marginal returns from investment. 5. China’s Government recognized the seriousness of this problem, and introduced a major reform in 2014 to bring subnational debt under control and reorient subnational officials and budgetary institutions toward fiscal / debt sustainability. Strong incentives at the subnational level of government to promote growth and investment have been an important ingredient of China’s successful economic development in recent decades. The budget reform has sought to alter the incentives and constraints of subnational governments toward the additional 6 objective of fiscal sustainability, while also improving transparency in local finance. The reform prohibited local governments from acquiring additional debt or issuing guarantees through LGFVs. Simultaneously, subnational governments were granted the right to borrow explicitly through bond issuances, albeit within strict limits. A bond swap program was launched to address the stock problem of accumulated legacy debt in the LGFVs. The 2014 reform also includes measures for creating and building institutions for more efficient and effective budgeting at the subnational level, including medium-term budgeting and higher standards of accounting and transparency. 6. As part of the efforts to implement the reform, the World Bank piloted development policy financing operations focused on budget reforms to achieve fiscal sustainability at the subnational level in Hunan Province and Chongqing Municipality. China’s Government selected Chongqing and Hunan as the pilot regions for the first World Bank development policy operations in China for a number of reasons, including a strong reformist orientation and a strong demand in those regions for cooperation with the World Bank to accelerate reforms. Two separate operations were requested as pilots for both a province-level government and a sub-provincial district government. The challenges of budget reform implementation for these two different levels of government have some important differences. 7. The political and economic context for the DPF operations in Hunan and Chongqing in 2015-2016 created some challenges for project design and implementation. The primary objective of the operations was to assist local governments in placing their finances on a fiscally sustainable path through implementation of key parts of the 2014 Budget Reform. Strictly following the revised Budget Law, this would entail moving all public investment finance explicitly on budget. However, a public-investment based fiscal stimulus pursued during 2015-2016 had the effect of temporarily extending a strong role for LGFVs in financing public investment off budget. In the course of preparing these operations, it became very clear that a meaningful debt sustainability framework at the local level must unavoidably involve a careful consideration of contingent liabilities that were continuing to accumulate in the LGVFs at a very fast pace. Thus, the design of the pilot operations ended up deviating to an important degree from the prevailing instructions on Budget Reform implementation that did not yet include a framework for managing these contingent liabilities. Political pressures in favor of higher local public investment also provided a challenging context for creating and implementing fiscal consolidation programs. Nevertheless, the China’s government continued to encourage the World Bank, Hunan, and Chongqing to pursue these programs as individual pilots that could be studied to inform the reform process going forward. 8. Hunan is a province of 67.4 million people (equivalent to the size of France), covering an area of 211.8 thousand square kilometers. Hunan Province consists of 14 prefectural cities and 122 counties, with Changsha as its capital city. The Province Government directly supervises the public finance and debt management of all prefectural cities and counties. Despite high economic growth in the last decade at an annual rate of 11.5 percent, Hunan’s GDP per capita is 7 still only 83.0 percent of the China national average in 2017, and 3.6 million residents were estimated as living below the poverty line as of 2016. 9. This Development Policy Financing supported budget reform in Hunan Province in two primary ways: (i) it assisted the Provincial Government directly in restructuring its budgets and capital investment plans toward fiscal sustainability and increased efficiency; and (ii) supported innovative approaches already underway in Hunan Province to use the new provincial allocation authority over new borrowing and debt swaps to incentivize local governments toward reforms and the disclosure of key information. The program was consistent with efforts that were already underway in budget reform in Hunan that included the development of medium term budgetary plans, three-year rolling budgets, and an early warning system. The system developed in Hunan Province to improve monitoring and regulation of local governments through incentivizing local officials was also novel. As a pilot region in the context of this operation, Hunan Province went well beyond the provisions of the budget reform in anchoring its policies to a comprehensive fiscal sustainability framework that accounts for contingent liabilities and risks from public investments involving state-owned enterprises, SPVs, or PPPs. In addition, Hunan advanced further under the operation in (i) a more integrated approach to capital budgeting and (ii) transparency. 10. Several possible forms of assistance were discussed with Chi na’s Government and Hunan Province before deciding on development policy financing. The World Bank had already engaged at the subnational level in China on budgetary reforms through technical assistance in Shanghai. China’s Government and World Bank agreed that a Development Policy Financing would be an appropriate vehicle for a deeper engagement for two primary reasons. First, experience in other countries, such as Brazil and Nigeria, with development financing suggests that a DPF can be an effective instrument for World Bank support to a comprehensive policy / reform program consistent with fiscal sustainability at the subnational level that goes beyond a technical assistance program. This includes a series of development policy operations that helped the Indian state of Andhra Pradesh become a leader in subnational fiscal reform and adjustment. Development policy engagements in Lagos and Edo States in Nigeria had strong fiscal sustainability and medium-term budgetary components. A series of subnational development policy engagements in Brazil also focused on sustainable state-level finance. 11. As evidenced by the substance of this operation, the DPF has indeed provided a framework for a new level of World Bank engagement at the subnational level in China. A structured program built around prior actions and results indicators has served to focus energies and World Bank assistance on common ambitious objectives. Second, the deeper subnational engagement supported by this operation, as well as the simultaneous pilot in Chongqing Municipality, also enabled the Bank to expand its cooperation with the Central Government and other subnational governments in the areas of budget reform and fiscal sustainability. 12. A multi-tranche operation was also considered. Given that this operation supports institutional reforms that will take time to be realized, a programmatic engagement was naturally discussed. China’s Government decided that it would prefer to evaluate the results from this first 8 DPF before considering options for further support which could be to Hunan or for expanding the program to other provinces. While this operation is a stand-alone single tranche operation, cooperation between the World Bank and Hunan Province has continued beyond this initial DPF. 1.2 Original Project Development Objectives (PDO) and Key Indicators 13. The Project Development Objective of the First Hunan Fiscal Sustainability Development Policy Financing was to support the Provincial Government in achieving fiscal sustainability by developing a forward-looking, comprehensive and transparent public finance framework that integrates budget, public investment and debt management. 14. The key objectives and indicators included the following: • Pillar 1: Fiscal sustainability o Objective: To develop and employ a medium term fiscal / debt sustainability framework and budget for managing risks and achieving fiscal sustainability for Hunan Province - Share of Hunan Provincial Government public liabilities in Province GDP (Baseline: 14.1% in 2015; Target: < 15% in 2016) • Pillar 2: Capital budgeting o Objective: To develop an integrated approach to capital budgeting to improve efficiency - Number of sectors covered in the integrated capital financing plan of Hunan Province (Baseline: 1 in 2015; Target: 3 in 2016) - Interagency Committee issues opinions on the Medium Term Fiscal Strategy and Three-Year Rolling Capital Financing Plan for Transportation, Water/Irrigation, and Social Housing for 2016-2018 (Baseline: Not applicable in 2015; Target: Opinions issued in 2016) • Pillar 3: Monitoring and regulating sub-provincial government debts o Objective: To develop an effective system at the provincial level of government to monitor the financial health of local governments and incentivize them to pursue prudent debt management - Share of local governments satisfying annual disclosure of debt data online and fund use plans for new borrowing (Baseline: 0% in 2015; Target: >40% in 2017) 9 - Share of local governments classified as “red” for more than one year having not submitted a risk mitigation action plan to restore financial health (Baseline: 100% in 2015; Target: <40% in 2017) • Pillar 4: Transparency o Objective: To enhance transparency and accountability in the use of budget resources - Biannual comprehensive debt reports on the internet with less than four month lag from end-June 2016, end-December 2016 and end-June 2017 (Baseline: 0 in 2015; Target: 3 reports on line on time by October 2017) 1.3 Revised PDO and Key Indicators, and reasons/justification 15. Not applicable. 1.4 Original Policy Areas Supported by the Program 16. The single tranche stand-alone development policy financing for the equivalent of US$ 200 million supported the Hunan Provincial Government’s efforts to achieve fiscal sustainability by developing a forward-looking, comprehensive and transparent public finance framework integrating budget, public investment and debt management. The DPF had four pillars: (a) Fiscal Sustainability; (b) Capital Budgeting; (c) Monitoring and Regulating Sub- Provincial Government Debt; and (d) Transparency. 17. Pillar 1: Fiscal Sustainability. The program supported the establishment of institutional arrangements that allow Hunan Province to assess its expected financial position under various scenarios and adopt of a Medium Term Fiscal Strategy (MTFS) consistent with fiscal sustainability. To support these efforts, a debt sustainability framework—that includes the explicit Hunan budget and other sources of finance for public investments such as public benefit state owned enterprises (LGFVs), public-private partnerships, and special purpose vehicles—was developed with the technical assistance of the World Bank. Given that a large share of borrowing for public investment was occurring off budget, Hunan Province took a prudent approach of including a comprehensive measure of public liabilities (and assets) for the conduct of its debt sustainability analysis. Thus, for example, for the LGFV that builds motorways in Hunan and expects future revenues from tolls, both the expected liabilities (debts) and future expected revenues/expenditures of this LGFV are included in the Debt Sustainability Analysis (DSA). A similar approach was taken for private public partnerships (PPPs). 18. Hunan Province adopted a medium term fiscal strategy under which provincial-level public liabilities as a share of province GDP stabilize over time under baseline assumptions (official projections) and under a stress test where GDP growth is two percentage points lower 10 and revenues from toll roads are 20 percent lower than projected. This definition of “fiscal sustainability” was agreed with the World Bank. GDP growth and toll roads are two primary sources of fiscal risk for Hunan provincial finances. In the implemented strategy, 1 fiscal sustainability was to be achieved by essentially freezing aggregate province-level public investment for five years at the level of 2015, while keeping growth in current expenditures at moderate levels. Within the investment finance envelope, resources had to be reallocated toward higher priorities, including an expansion of investment in trunk roads and airports relative to motorways. The Medium Term Fiscal Strategy developed under Prior Action #1 employed a MTFS-DSA framework developed jointly with the World Bank. 19. Pillar 2: Capital Budgeting. Under the DPF, Hunan Province implemented a multi- year capital budgeting framework to ensure that priority public infrastructure needs are addressed at lower cost and risk, and that capital spending is consistent with fiscal sustainability. This was provincial initiative, as the national budget reform did not at the time prescribe the preparation of multiyear aggregate investment programs, project level capital budgeting, or investment financing plans. The reform was critical for achieving two primary goals in subnational finance in China, namely fiscal sustainability and greater efficiency in public investment. Subnational public investment programs in China are commonly executed in a rather fragmented manner, including numerous planning and implementing bodies and (usually) off- budget financing sources. A key task for improving efficiency and sustainability for subnational governments is a more integrated approach to public investment planning and finance that allows for a clear assessment of opportunity costs and implications for debt sustainability. Hunan Province achieved this goal through reforms in public investment planning and the creation of an Interagency Committee that has a gatekeeping function for assessing public investment projects and plans from the points of view of fiscal risk, and costs / benefits. 20. Hunan Province had spearheaded the integrated planning of public investment finance in China prior to the DPF. The Hunan Province Department of Finance had introduced a multi-year integrated capital budgeting process in 2014 involving selected LGFVs in the areas of rail, roads, and water/irrigation. The piloted LGFVs were required to submit 3 year rolling budget requests based on medium-term projections of revenues, recurrent expenditures (headcount and operations / maintenance), and costed implementation plans for priority investment projects. With explicit equity and/or operational subsidies from government budgets, LGFVs are required to achieve targets for financial viability and other performance 1 The Medium Term Fiscal Strategy program sought to: (i) rationalize public investment while maintaining aggregate outlays at the level of 2015; (ii) improve the debt profile by redemption of high cost debts; (ii) enhance transparency and disclosure; (iv) allocate a higher share of investment to trunk/rural roads, while decentralizing the finance and responsibility to local governments; (v) enhance accountability through improved engagement with citizens (citizens’ budget); (vi) increase the efficiency of current public expenditures, keeping their growth slightly lower than that of nominal GDP; (vii) Align revenues with expenditures, and ensure sufficient transfers to local governments to cover delegated expenditures; and (viii) improve public investment project evaluation and management. 11 objectives. Investment projects that received budget resources needed to be consistent with government development plans, be of public nature, obtain approval of sponsoring government agency(s), have completed feasibility studies, and have passed environment assessments. LGFVs were also required to maintain their liability-to-asset ratio below 60 percent (75 percent in exceptional cases). An early warning system was developed in each LGFV based on a dynamic financial analysis over a time span of 5-10 years. LGFVs required prior review from the Province Department of Finance before borrowing, and additional approval from the Province Governor for projects financed with an interest rate beyond a threshold of 7 percent. 21. The DPF supported Hunan Province in extending the three-year rolling capital budgeting plan (2016-2018) requirement to all agencies involved in major public infrastructure projects in the area of rail, roads, airports and water/irrigation. This capital budgeting plan is inclusive of both explicit budgetary and other forms of finance for public investments, including LGFVs, PPPs and SPVs, and accounts for the vast majority of provincial- level investment. The three-year rolling capital investment financing plan for 2016-2018 was been extended again to include social housing, and brought the coverage to over 90 percent of province level public investment. The actual adoption of the three-year rolling capital budgeting plan for the years 2016-2018 was postponed to May 2016 so as to synchronize this activity with the adoption of the Medium Term Fiscal Strategy. The Medium Term Fiscal Strategy specified an aggregate ceiling on the annual capital spending under which projects could be prioritized and selected. The integrated medium-term planning approach for public investment is being gradually scaled up to local governments in Hunan Province. 22. Hunan was the first province in China to institutionalize a gatekeeping function for capital projects to promote fiscal sustainability and greater efficiency. The Provincial Government put in place an interagency committee (IAC) to strengthen sustainable financing aspects of the capital investment program. This IAC was approved by the Hunan Provincial Government and reports directly to the Governor. The Interagency Committee is chaired by the Director General of the Department of Finance, and includes high level representation from the Finance Department, the Provincial Development and Reform Commission (DRC), the Transport Department, the Audit Office and the Finance Office. Close interaction with selected line departments is conducted as appropriate. The responsibilities of the IAC include: (i) reviewing the policy framework for debt management policies and regimes; (ii) reviewing medium term fiscal planning and capital budgeting; (iii) collecting information about provincial and sub-provincial debt/contingent liabilities and capital financing; and (iv) providing endorsement subject to review of the Governor for any capital projects with major financing and/or contingent risk. The effectiveness of integrated capital investment planning depends on the continual systematic review of the planning, execution, and fiscal implications of projects. This challenge is particularly acute in the Chinese institutional context, where capital investment planning has been rather disjoint from budget planning. International experience suggests the importance of creating an explicit “gatekeeping” body assigned with the task of examining and scrutinizing proposals and public projects from the points of view of fiscal sustainability and project efficiency. The interagency body 12 of this type would contribute to solidifying the new integrated approach toward public investment planning and finance. 23. Pillar 3: Monitoring and Regulating Sub-Provincial Government Debt. The DPF supported the implementation of an early warning system indicators, an allocation scheme for bond swaps, and a Debt Management Framework. The framework was adopted to strengthen regulations by: (a) establishing informational requirements for local governments, including submission and disclosure of a fund use plan for new borrowing and basic debt data; (b) requiring the submission of risk mitigation action plans from local governments classified as “red” and “orange” in the provincial early warning system; and (c) allocating new borrowing limits to local governments based on indicators set in the early warning system. 24. Hunan Province set up an early warning system to monitor local government debt ahead of many other provinces, and has extended the early warning system in an important and innovative manner under the DPF. The Budget Reform of 2014 require provincial governments to develop a system for monitoring and regulating borrowing by sub-provincial governments, which have been responsible for the majority of (mostly off-budget) accumulation in government debt in China. Hunan built an effective system to monitor and regulate local government debt, including innovations that go well beyond central guidelines. The Province’s early warning system divides local governments into categories of red, orange, yellow, and green according to fiscal risks measured by seven indicators of debt and liquidity stress. The key innovation has been incentivizing local governments to manage their finances prudently through the allocation of debt swaps and new borrowing rights under the authority of the Province administration. The DPF supported the efforts of Hunan Province in creating and expanding this monitoring and regulatory framework. 25. Hunan Province implemented distinct allocation schemes in 2015 for both bond swaps and new borrowing quotas. Hunan received a bond swap quota of 122.2 billion RMB for swapping maturing LGFV debt into explicit local government bonds. It also received a bond quota for new borrowing of 18.1 billion RMB designated for new investment projects. The Provincial Government took 27.98 billion RMB of debt swap bonds and 7.1 billion RMB in bonds for new borrowing for its own finance. This left 94.2 billion RMB and 11 billion RMB to be allocated to local governments for debt swaps and new borrowing, respectively. Two different schemes were introduced to reward more prudent local governments. 26. The Province adopted a formula that allocated a larger share of debt swaps to local governments with lower shares of non-standard debts and lower debt to revenue ratios. The size of the quota for debt swaps given to Hunan Province was based on the expected size of maturing legacy debt in 2015. The standard practice would have been for a province to swap out all of this maturing debt in a passive manner as the debts came due for repayment. Instead, Hunan Province first applied a discount factor of 70 percent in counting debts in the form of build-transfer obligations, payables, or medium-term notes considered to be sub-standard. It then applied a second coefficient for allocation between 0.8 and 1.2. Local governments with lower debt to revenue ratios 13 received a higher number. Thus, local governments with lower debt to revenue ratios and little non- standard debt could swap more than just maturing legacy debt, while more poorly performing local governments had a smaller share of their maturing debt swapped. The relative shares of legacy debt swapped varied from 62.5 percent to 118.9 percent. Local governments are strongly interested in receiving bond swaps since this decreases significantly the interest rate applied to the debts in question. 27. Quotas for new borrowing were allocated by formula based on indicators in Hunan Province’s early warning system. Of the 11 billion RMB in new borrowing quotas allocated to local governments in 2015, 1.57 billion RMB were earmarked for local projects of particularly high priority for the province and the remaining sum was divided in a manner that accounts for a number of the primary indicators in the early warning system (debt, debt servicing, debt servicing capacity, and projected growth in revenues, among others), with a significantly larger share going to local governments that have achieved the higher green or orange ratings. 28. A new Decree of Hunan Province on the debt management framework expanded the early warning system in a manner that solidifies Hunan’s role as a primary innovator in building fiscal institutions. The indicators of the fiscal risk monitoring system were expanded to account for contingent liabilities associated with the current expansion of PPP and SPV schemes. Furthermore, the Province now uses its authority over the allocation of new borrowing rights to incentivize further local governments to undertake necessary reforms and transfer information to the provincial level for more effective monitoring. The tool of linking the allocation of borrowing quotas to information requirements have helped Hunan to obtain a clearer picture of the finances of the entire province with implications for fiscal sustainability. 29. Pillar 4: Transparency. The DPF supported the publication of Citizen’s Budget Report along with additional Budget Performance Reports, including comprehensive debt reports for provincial level and consolidated province finance, to improve richness and timeliness of the Hunan Province’s information disclosure and better engage with citizens. Approved aggregated budget and budgetary outcomes have been since regularly published on the official website that was created for the disclosure of subnational debt and financial data. Through its Citizen’s Report, Hunan Province introduced an innovative approach to communicate this fiscal information in a plain language accessible to the general public. This information has been provided on an internet platform that allows for engagement with citizens. 30. Hunan Province pioneered the biannual publication of comprehensive debt reports for provincial level and consolidated province finance. The publication of this report in an agreed best practice template further boosted Hunan’s position as a leader in China in disclosure and transparency. Publishing comprehensive debt information reinforces the credibility of the early warning system supported in pillar 3, while also strengthening the creditworthiness of Hunan Province, thus lowering the cost of government borrowing—the objective supported in pillar 2. Pertinent information on debt composition and risk indicators should be periodically disseminated 14 on a biannual basis to inform citizens and minimize uncertainty amongst market players, thereby ensuring more stable financing and efficient pricing. 31. The Comprehensive Debt Report is published with a lag no greater than four months and includes information on the outstanding stock and composition of debt, including contingent liabilities. The timeliness of the debt report release eliminates a common problem in China of long delays before the release of subnational debt data. The template includes indicators for debt burden, repayment, solvency and liquidity. The debt report covers (i) Hunan Provincial Government and (ii) consolidated debt of all local governments in Hunan province. This thus establishes a landmark system of transparency that permeates across the provincial and sub- provincial administrations, and also builds on the envisaged best-practice reforms in the budgetary system. The Department of Finance benefits by establishing a focal point that deals regularly with the main debt stakeholders and produces these debt statistics and other relevant information. 32. The internet platform for local government debt created a one-stop shop for accessing debt data in Hunan Province. This is part of an effort by Hunan Province to encourage the public disclosure of debt information by individual local governments. As the Provincial Government borrows on behalf of local governments, it plays a disciplining role to ensure adequate transparency and information disclosure at the local level. This includes not only information submitted to the Province, but that disclosed by local governments to the public. For this purpose, the Provincial Government set up an internet platform with a template that can be used by local governments for the public disclosure of information relevant to debt. In the time frame of this operation, Hunan has piloted this template for 10 local governments. Thus, these local governments were expected to populate fully the template in the internet platform. 1.5 Revised Policy Areas 33. Not applicable. 1.6 Other significant changes 34. Not applicable. 2. KEY FACTORS AFFECTING IMPLEMENTATION AND OUTCOMES 2.1 Program Performance 35. The single tranche of USD 200 million was released on December 1, 2017. No waiver was requested (see Table 1). The Bank provided substantial technical assistance through multiple missions. 15 Table 1: Tranche Amount and Release Date Tranche # Amount Expected Release Actual Release Release Date Date Tranche I USD 200 million December 1, 2017 Regular 36. The prior actions are listed in Table 2. Table 2: Policy Matrix Prior Actions Status Pillar 1: Fiscal sustainability Prior action #1: Hunan Provincial Government has adopted and published a Medium Term Fiscal Met Strategy, grounded in a debt sustainability analysis, which sets a target for provincial-level public investment financing that is consistent with fiscal sustainability. Pillar 2: Capital budgeting Prior action #2: Hunan Provincial Government has instituted the annual formulation of three-year Met rolling capital financing plans for the provincial-level budget. Prior action #3: Hunan Provincial Government has adopted a three-year rolling capital financing plan Met for the provincial-level budget for transportation, water/irrigation, and social housing for the calendar years 2016-2018, itemizing project by project. Prior Action #4: Hunan Provincial Government has established the Interagency Committee for Public Met Investment Financing and Debt Risk Management. Pillar 3: Monitoring and regulating sub-provincial government debts Prior action # 5: Hunan has implemented an allocation scheme for bond swaps and new borrowings Met that rewards local governments for achieving better performance and early warning system indicators. Prior Action #6: Hunan Provincial Government has approved its Debt Management Framework to Met strengthen regulations by, inter alia: (a) establishing informational requirements for local governments, including submission and disclosure of a fund use plan for new borrowing and basic debt data; (b) requiring the submission of risk mitigation action plans from local governments classified as “red” or “orange” in the provincial early warning system; and (c) allocating new borrowing limits to local governments based on indicators set in the early warning system. Pillar 4: Transparency Prior action # 7: Beginning in year 2016, Hunan Provincial Government has started publishing Met annual Citizens’ Budget Reports and Budget Performance Reports and has set up an internet platform which allows an open engagement with citizens. Prior action #8: Beginning in year 2016, Hunan has (a) started producing and publishing biannual Met debt reports, containing debt information for the provincial level, and consolidated information for sub-provincial governments, and (b) created an internet platform for local governments for the disclosure of subnational debt and financial data. 37. At the time the program was under preparation, the financial situation of the Hunan Provincial Government was somewhat complicated. As of end-2015, the Provincial Government’s debt totaled RMB 401 billion. As shown in Table 3 about 60 percent of this consisted 16 of debt contracted by the province’s LGVFs prior to 2015.2 This debt was in the process of being transferred into local government bonds of the Province though so-called bond swaps. Another 20 percent consisted of debts that had been incurred by LGVFs after 2014—debt which, under central government policy, was officially considered commercial and therefore ineligible for bond swaps. The remaining 20 percent consisted of direct debt of the Province already in the form of government bonds. Table 3: Trends in Hunan Provincial Debt Stock (RMB bns) 2015 2016 2017 A. Official public benefit debt 315 294 299 Direct debt 79 111 200 LGFV pre-2015 debt 235 176 99 B. LGFV debt 2015 and later 86 142 183 TOTAL DEBT 401 436 482 as percent of Hunan GDP 14% 14% 14% 38. The principal aim of the project was to institutionalize a process for reducing and maintaining the provincial government’s debt at levels that were fiscally sustainable. Although the total stock of Provincial Government debt (including post-2014 debt officially considered commercial) represented only 14 percent of GDP, it was a significant fiscal burden on the Provincial Government. The Province’s discretionary revenues are limited. While Hunan received RMB 344.7 billion in revenues in 2015, it was obligated to transfer the majority of those revenues to subordinate local governments. In 2015, transfers to subordinate local governments totaled RMB 301 billion, leaving the province only RMB 44 billion in funds to pay salaries, other recurrent expenditures, and debt service. Relative to its debt servicing capacity, the Province’s debts were large. The debt situation is also difficult and complex at the local sub-provincial level. While no direct aggregated information was available on outstanding liabilities in sub-provincial local government LGFVs at the time, the World Bank team used indirect methods to estimate total outstanding public liabilities of Hunan Province, including 137 local governments and their LGFVs at 1,201 billion RMB (48 percent of Hunan GDP) as of end-2015. 39. The continual rapid accumulation of public sector liabilities in the LGFVs, despite the provision in the revised Budget Law 2016 that essentially forbid this practice, was very common for local governments in China during the fiscal stimulus pursued in 2015-2016. Quotas for new local government bond issues proved inadequate to meet political pressures for increasing levels of local public investment, and commercial banks were essentially granted permission by Beijing to continue refinancing LGFVs. The design of the DPF program therefore had to confront a fundamental challenge. In light of the Budget Reform, LGFV borrowing was no 2 Of this, almost 90 percent had been contracted by the LGVF responsible for toll roads. Another nine percent was held by the LGFV responsible for non-toll trunk roads: T-LGFV. Responsibility for the construction on non-toll trunk roads was later transferred to local (sub-provincial) governments. After 2016, debts of T-LGFV do not appear on the province’s books. 17 longer classified as government debt and therefore did not enter official debt accounting. Yet it remained the greatest challenge to the sustainability of provincial finances. In the course of project preparation, it therefore became clear very quickly that a meaningful framework for achieving fiscal sustainability in Hunan provincial government finances could not avoid the direct consideration of LGFV finances and liabilities. The design of the DPF therefore evolved from an anticipated assistance in implementing the strict provisions of the 2014 Budget Reform, as well as supporting related initiatives in Hunan Province, to a pilot that could, in part, demonstrate how a meaningful fiscal sustainability framework can be put in place that fully recognized the present reality of provincial government finance in China. It was hoped that this approach could provide important lessons for moving forward on budget reform and achieving fiscal sustainability at the subnational level throughout the country. 40. Pillar 1: Fiscal Sustainability. As noted above, the principal objective of the DPF was to help the Hunan Provincial Government place its finances on a fiscally sustainable path. The primary challenge to fiscal sustainability came from the continuing accumulation of considerable debt in the LGFVs. Three of the eight prior actions were highly relevant for this objective: the adoption of a sustainable medium term fiscal strategy for the Province, the development of three- year capital investment budgeting, and the establishment of the interagency committee to review and approve individual projects in a manner consistent with fiscal sustainability. Activities under this pillar began with an extensive process of gathering and consolidating information on Hunan provincial public sector investment, financing, debt, assets, and liabilities on and off budget. This information was consolidated to construct a debt sustainability analysis. The results of this analysis were rather sobering, and induced the Human Provincial Government to freeze growth in outlays of public investment in its Medium Term Fiscal strategy at 2015 levels as a means of placing provincial finances on a fiscally sustainable path. 41. Pillar 2: Capital Budgeting. The second pillar was intended to better integrate the planning and finance of public investment to clarify cost / benefit tradeoffs and implications for debt sustainability, as well as to impose of hard budget constraints on aggregate public investment. To better integrate the planning and financing of public investment, Prior Action 2 required the province to institute the formulation of a three-year rolling capital investment plan (CIP). At the outset, the CIP covered three sectors—transportation, water/irrigation, and social housing— covering all public investments financed directly through the provincial budget or through LGFVs. Hunan Province planned to gradually expand the sectoral coverage of the capital budgeting plan and was moving toward the preparation of a three-year capital investment financing plan that would cover 100 percent of provincial-level public investment by 2017. To institutionalize the capital planning process as a whole, Prior Action 4 required the Provincial Government to establish an Interagency Committee for Public Investment Financing and Debt Risk Management. This Committee was established by the Governor and began its operations prior to Board approval of the operation. 18 42. Pillar 3: Monitoring and Regulating Sub-Provincial Government Debt. This pillar was intended to strengthen the provincial government’s ability to monitor debt and encourage prudent financial behavior at the sub-provincial level. At the time of project preparation, recent central regulations required all provinces in China to improve their monitoring of the financial health of local governments based on seven indicators, including the size of their (explicit) debt stocks and debt servicing obligations relative to expenditures and assets. These indicators provided valuable information, but still did not account for all sources of fiscal risk at the local level. Moreover, they did not provide a mechanism for encouraging prudent local fiscal management. 43. To address the latter problem, the Province drafted and adopted a new regulatory framework for subnational debt management (Prior Action 6). This framework extended the Hunan Provincial Government innovative practice of leveraging its authority over the allocation of borrowing quotas to incentivize local governments toward prudent debt and fiscal management. Formally, Hunan Province had awarded higher borrowing quotas to local governments who maintained or generated lower debt positions. Under the DPF, the revelation of key debt and borrowing information, as well as the submission of risk mitigation plans from high risk local governments, became prerequisites for access to new borrowing rights. The first draft regulatory framework also focused on the revelation by local governments of their off budget contingent liabilities. However, central government officials were initially uncomfortable with these provisions, as official instructions at the time did not recognize off budget debts in LGFVs incurred after 2015 as government contingent liabilities for inclusion in monitoring and regulation. For this reason, these provisions were not included in the regulatory framework adopted during the DPF operation. However, given the subsequent decision of the Central Government to mandate the monitoring of these contingent liabilities, Hunan Province was able to extend its debt management framework in the aftermath of the operation to include what was initially intended. 44. Pillar 4: Transparency. Under this pillar, Hunan Province sought to increase its status as a transparent and open province in China. Provincial officials worked with World Bank experts on creating the most effective templates for the biannual reports and disclosure of information from local governments on their finances and debt. Citizens budget reports were produced and internet platforms were created. 2.2 Major Factors Affecting Implementation 45. The operation was ambitious but surpassed and went beyond the original reform agenda. The successful reform implementation required close cooperation and the support of multiple agencies, particularly the Finance Department in charge of the budget, and the Development and Reform Commission (DRC) in charge of the investment plan and economic development targets. Because it was one of the first two development policy programs in China, there was limited experience to build on and implementation risks were high. Political pressures at the time in favor of a local government investment-based fiscal stimulus also added uncertainty and risk to the implementation and sustainability of the program. 19 46. Strong political support and motivation in Hunan Province and the Central Government were essentially to successful implementation of the program’s objectives . The determination of the Hunan Government to succeed, along with World Bank technical assistance and careful framing of the policies, were important factors driving the results. Strong support in Beijing for the pilot operation, despite the challenging political climate, and subsequent changes in central policies consistent with the goals of the DPF, were also key to success. Hunan Government officials highlighted the importance of having strong high-level political support for the actions. The inclusion of actions in the DPL enabled departments to pursue reforms with greater credibility and prominence, making it easier to obtain the support from others. The inclusion of strong actions in the DPL revealed the high priority placed by the Provincial Government, with the backing of Beijing, on the proposed reforms. The high-level commitment permeated down to the working level staff. With the clear political backing, the administrators and staff responsible for each program were able to motivate and encourage other agencies and groups to participate and contribute to the success of the program. This was complemented by the presence of clear results under the DPL, which provided added incentives for all participants to adhere and support the commitments made. The commitments under the DPL were implemented despite significant political and technical challenges. The adoption by the Central Government in late 2016 and 20017 of several key policy directions consistent with the DPF program then provided a favorable context for sustaining and extending the reforms. 47. The soundness of the background analysis was also key to the successful implementation of the operation. The complexity of the economic and political situation in Hunan Province in 2015-2016, and the need for an innovative approach to achieve the objectives of the operation, required both a team with extensive background in subnational finance in China and similar countries, but also the skills to be able to assess the situation and propose a compelling program. The accumulated knowledge from previous World Bank engagements on subnational fiscal issues in China, as well a knowledge brought from the experience of other countries, proved invaluable in this respect. Designing and implementing a successful program could not have been achieved with hard collaborative work between the World Bank team and Hunan Province. 48. Achieving the objective of placing Hunan Provincial Finance on a fiscally sustainable path required a tailored design for the operation to reflect the complex reality on the ground during implementation of the budget reform in 2015-2016. The World Bank team had a primary mandate for this operation to assist the Hunan Provincial Government with a program to put its finances on a fiscally sustainable path. While it was originally envisioned that this would take the form of assisting Hunan Province with the strict implementation of key parts of the national budget reform and provincial-level initiatives already in pace, this would not have been adequate for the achievement of this central objective. In particular, the most important risks to fiscal sustainability in Hunan Province were still coming from the activities of its LGFVs and related contingent liabilities. The decision to move forward with a strong ambitious program on a pilot basis that proposed solutions for genuine current problems on the ground boosted the motivation for implementation of the program within Hunan Province. The demonstration effect eventually 20 boosted the prestige of Hunan Province and its position as a leader in budget reform in China, and fed into municipal and national reforms that proved key for the sustainability of the new arrangements. 49. The continuous presence of the Bank and the its technical assistance were important during implementation. In Hunan Province, this was particularly important for setting up the DSA model and developing capacity within Hunan Province to manage it. In addition to missions involving technical staff, Hunan Provincial Staff came to the World Bank Beijing office for training. Trained staff have subsequently helped institutionalize the new framework for fiscally sustainable provincial-level finance in Hunan Province. 50. These factors were supported by a very careful framing of the reforms that allowed the Hunan Province to go beyond the 2014 Budget Reform and continue to innovate. The Provincial Government and the Bank identified a program that was challenging and went further than what was originally anticipated. The success was positively reinforced the wide recognition that the Province is getting from Beijing and other subnational entities that are interested in replicating and scaling up the reforms. 2.3 Monitoring and Evaluation (M&E) Design, Implementation and Utilization 51. M&E Design. The monitoring and evaluation framework largely reflected prior actions of the operation that required the gathering of comprehensive information on public sector assets and liabilities, formulating a comprehensive capital investment plan, and the establishing an Interagency Committee to assess capital projects and monitor fulfilment. The day-to-day M&E was carried out by the Department of Finance, although assisted by the Interagency Committee that reflected a new level of cooperation and coordination with other relevant government bodies and the LGFVs. Monitoring the results indicators required utilizing new analytical and organizational capacities put in place under the DPF program. This includes tracking closely the evolution of comprehensive public sector liabilities and the responsiveness of local governments to the incentives offered in the new Debt Management Framework. Prior actions and results indicators in the transparency pillar were designed to naturally share M&E results with stakeholders. In virtually every case, the M&E for the DPF program represented activities that Hunan Province will sustain as part of its own management framework in the aftermath of the operation. 52. M&E Implementation. As the implementing agency, the Finance Department maintained a close dialog with the Bank. They were responsible for organizing the preparatory work for periodic supervision missions. The monitoring of the program was based on expected results for each component. There were dedicated groups that monitored the advances of the reforms in each of the results of the subcomponents. As anticipated, the Hunan Provincial Government developed new analytical capacity to collect and analyze debt and fiscal data. Performance was excellent in every respect. 21 53. M&E utilization. Part of M&E utilization was embedded in the DPL program. Once information was collected together on comprehensive public sector assets and liabilities of Provincial finance, this information was used for a debt sustainability analysis that, in turn, led to a moderation of plans in the Province for public investment outlays during the next three years. These findings were communicated to stakeholders through the publication of budgetary reports, some of which can also be associated with the DPF program. The DPF M&E has become a permanent activity within the Hunan Provincial Government with implications for the allocation of public resources. 2.4 Expected Next Phase/Follow-up Operation 54. Discussions have been held with Hunan on a follow-up operation, which could take the form of a PforR in one of the poorest prefectures (a sub-provincial jurisdiction containing a number of local governments) in the province. Hunan Province has formally submitted a request for this operation, although this request would need to be approved in Beijing by the National Development and Reform Commission (NDRC) and the Ministry of Finance. Whether or not there is a specific follow-up operation, the two pilots have helped to inform the budget reform process in China. Subsequent to the launching of this pilot, China has mainstreamed a number of elements into the reform program, including the comprehensive monitoring and management of off-budget contingent liabilities, the strengthening of subnational debt management units, and the recommended adoption of three-year rolling capital investment financing plans. The World Bank is continuing work according to a memorandum with China’s Fiscal Academy of the Ministry of Finance for programmatic work on identifying the most promising directions for the continuing budget reform, building partly on the experience of Hunan Province. 3. ASSESSMENT OF OUTCOMES 3.1 Relevance of Objectives, Design and Implementation Rating: High 55. The objectives of the operation were highly relevant for China’s development priorities and the Country Partnership Strategy. They are important for achieving fiscal sustainability and improving the efficiency of capital spending at the local level in China. These are among the most important reform directions in China for future stability and growth in the country, and, by implication, in the world economy. While China is making notable progress on implementing the Budget Reform and placing local government finance on a fiscally sustainable foundation, this difficult process is far from over, and will remain one of the most important reform directions in years to come. The operation is aligned with the previous FY2013-FY2016 Country Partnership Strategy’s theme 2: “promoting more inclusive development” (Report 67566-CN). In particular, this CPS notes the importance going forward for “integrating policies and program 22 administration” for China’s future developmental success. The China Performance and Learning Review (Report 95709-CN)) of January, 2016 noted that future IBRD lending in China may include PforR and DPO instruments. As recognized in discussions around the forthcoming new China Country Partnership Strategy, a primary focus of the World Bank program will be supporting China in mitigating remaining institutional weaknesses. Institutions for fiscal and debt sustainability remain a very constructive focus in this regard, as a rich world experience can be usefully brought to bear on assistance to China. Correspondingly, the operation fits directly in the new draft CPS Engagement Area Three, Objective 3.2: “demonstrating approaches to more effective and sustainable fiscal management and infrastructure financing.” 56. The design of the operation required an innovative approach to make it applicable and relevant for China in 2015-2016. The original intention was to assist Hunan Province in achieving fiscal sustainability through implementation of institutional changes prescribed in the 2014 Budget Law. However, accounting for the reality on the ground in China, it soon became clear that a meaningful framework for achieving fiscal sustainability would require a somewhat different approach. The fact that central government reform instructions and guidelines in 2017-2018 moved strongly in the direction of the approach taken in the DPF speaks for the high relevance of the design. A strong argument can be made that the implementation of this program had a measurable impact not only on Hunan Province, but on the World Bank policy dialog in China, and on the future course of budget reform in the country. 3.2 Achievement of Program Development Objectives 57. The program development objectives of the operation were met, sustained, and exceeded. The underlying objective of the program was to support the Hunan Provincial Government achieve fiscal sustainability by developing a forward-looking, comprehensive and transparent public finance framework that integrates budget, public investment and debt management under the four pillars (a) fiscal sustainability; (b) capital budgeting; (c) monitoring and regulating sub-provincial government debt; and (d) transparency. As a secondary objective, is was strongly hoped that the example of Hunan Province could inform budget reform policies and programs going forward in China. Hunan met, and mostly exceeded, the program targets in all of these areas. It has also sustained the institutional changes embodied in the operation. Furthermore, the subsequent adoption by the Central Government of policy directions consistent with the Hunan experience justified expectations about the relevancy of the program, and also helped provide the context to ensure the sustainability and further progress by Hunan Province in the given reform directions. 58. Fiscal sustainability. Hunan Province has sustained and scaled up the institutional changes under this pillar. The forward looking technical tools and institutional framework for controlling the Hunan Province Government’s debt are now in place. Consistent with Prior Actions 1, 2, and 3, Hunan continues to update its Medium Term Fiscal Strategy and three-year rolling capital financing plan for the provincial-level budget. The more detailed capital investment plans now 23 cover trunk roads, railways, airports, water transport, energy and public housing. The plan for 2018- 2020 will, in addition, cover education. The Interagency Committee for Public Investment Financing and Debt Risk Management continues to monitor and control the level of provincial borrowing. In 2018, the power and authority of the committee was substantially increased. The evolution of aggregate liabilities has remained below the ceilings envisioned in the three-year Medium Term Strategy developed under the operation, thus fulfilling the key program results indicator for pillar 1. 59. Results for 2016 and 2017 suggest that the Province’s fiscal sustainability has improved. Although the operation was not approved by the Board until January 2017, most of the preparation occurred in late 2015 and early 2016, with an eye toward satisfying the prior actions in 2016. Thus, it is reasonable to attribute results in both 2016 and 2017 to the program. The preparation of the Medium Term Fiscal Strategy grounded in a comprehensive debt sustainability analysis caused Hunan Province to forego plans to increase levels of public investment in 2016- 2017. The Province’s debt to GDP ratio remained roughly constant in 2016 and 2017, at just under 14 percent of GDP,3 as shown above in Table 3. This is a result that goes beyond the expectations in the DPF program, as many current expenditures on new road construction will yield expected returns (toll revenues) only in the future. For that reason, a temporary increase in comprehensive liabilities was projected, but did not materialize. As shown in Table 4, Hunan’s capital investment program for 2017-2019 now foresees an increase in capital spending in 2018, reflecting ongoing road building and railway construction projects. As a result, the Province’s debt to GDP ratio may increase temporarily in 2018. The lower level of investment spending planned for 2019 suggests that it will subsequently fall, and increases in toll revenues will also support debt reduction in future years. Hunan Province has kept growth of aggregate liabilities well within the confines of the Medium Term Fiscal Strategy prepared under the operation. Table 4: Provincial capital investment plan (RMB bns) Sectors 2017 2018 2019 Railway 6.5 6.0 6.1 Highway 25.0 36.9 18.9 Trunk roads 9.0 9.0 9.0 Water Transport 1.1 0.8 0.8 Water conservancy construction 4.4 4.2 4.0 Airport 0.3 Energy 0.5 0.5 0.5 Social housing 2.5 Total Investment 49.3 57.5 39.2 3 These figures slightly misrepresent underlying trends, however. Borrowing in 2017 was lower than expected due to a slower-than-expected pace of road construction. It is expected to increase this year (2018). 24 60. This outcome is attributable largely to the DPF. First, the DPF provided the context for requisite TA for the development of the comprehensive debt sustainability analysis tool (DSA) that underpinned efforts to achieve fiscal sustainability. It provided a framework for monitoring and managing comprehensive liabilities at a time when Central Government guidelines did not include this task. It also assisted Hunan Province in choosing institutional pilots based on world experience, including the Interagency Committee and the platform for disclosure of financial information to the public. The context of the DPF operation also provided a partial shelter from political pressures that could have undermined efforts to consolidate investment expenditures in line with fiscal sustainability. The positive demonstration effect of the operation arguable also contributed to changes in central regulations that have encouraged Hunan Province to scale up these reforms. 61. Capital Budgeting. The more detailed capital investment plans now cover trunk roads, railways, airports, water transport, energy and public housing. The plan for 2018-2020 will, in addition, cover education. The Interagency Committee for Public Investment Financing and Debt Risk Management continues to monitor and control the level of provincial borrowing. It also approves both the fiscal budget (governing primarily recurrent on-budget revenues and expenditures), the government fund budget (governing most investment spending), and the capital investment financing plan that includes public investment outlays from all sources of finance. In 2018, the power and authority of the committee was substantially increased with the addition of the provincial governor and the party secretary as ex oficio members. The committee is now termed the leadership group. Taken together, this suggests that the measures aimed at maintaining control over Hunan’s finances are sustainable. The results indicator for number of sectors included in the capital investment plan was achieved and surpassed. The results indicator for opinions issued by the Interagency Committee was also satisfied. 62. Monitoring and Regulating Sub-Provincial Debt. Hunan Province not only put in place the Debt Management Framework developed in the context of the DPF program, but significantly expanded this Framework in a direction initially intended in the DPF engagement. In particular, Hunan not only put in place arrangements to incentivize sub-provincial governments to submit and disclose direct debt information, borrowing use of funds plans, and risk mitigation plans (for debt distressed localities), but is now monitoring and incentivizing disclosure of off budget contingent liabilities. According to data from the provincial finance department, the stock of comprehensive sub-provincial debt, including such contingent liabilities, declined from RMB 783 billion in 2016 to RMB 713 billion in 2017. The results indicators for this pillar were quite ambitious. Beginning from ground zero, difficult targets were set for the number of local governments disclosing debt information and fund use plans on line, and for distressed local governments having submitted risk mitigation strategies in a timely fashion. These results indicators were all achieved and surpassed. The share of local governments classified as “red” for more than one year not submitting a risk mitigation action plan fell below 30 percent in 2017, while 82 percent of local governments disclosed their debt data and new borrowing plans. 25 63. Taken together, these results suggest that the measures supported under Pillar 3 have had the desired impact, and there is reason to believe that this impact will be sustained . The practice of using credit allocations to encourage prudent fiscal behavior at the sub-provincial level appears to have become routinized as has the coverage of reporting on sub-provincial government fiscal performance. The Bank team presumably contributed to the design of these measures, although magnitude of the direct impact of the Bank is difficult to judge. Given the competence and enthusiasm of the counterparts in Hunan, these measures might have been adopted even without the intervention of the Bank. However, the focus of the DPF program for the first time on comprehensive public sector liabilities certainly supported Hunan’s initiatives to expand the monitoring in this direction. 64. Transparency. Under the DPF program, Hunan Province took significant measures under this pillar that moved its position in an independent third-party measure of transparency that is well recognized in China from 27th to 2rd in the country. Three results indicators were used to monitor progress on the public’s access to information on the budget performance of the Provincial and the sub-provincial governments. The first tracked the publication of the proposed biannual comprehensive debt reports within the proposed time frame. Given the effort involved, specified annual deadline for the first report (for 2015) was not expected to be met. However, it was expected that subsequent reports would be published on schedule. The second indicator tracked the number of local governments that populated the template in the internet platform that Hunan Province had created. It was expected that 10 local governments would populate this platform immediately. The third indicator measured the number of citizens' budget reports and budget performance reports disclosed online with less than a six-month lag 65. Since the operation, the actions initiated by the prior actions have continued and the targets specified in the corresponding results indicators continue to be met. Citizens Budgets for 2017 and 2018 have been published, along with (ex post) budget performance reports for 2016 and 2017. A Report on the Implementation of the 2016 Budget of Hunan Province and the Draft Budget of 2017 is also on the web. Annual reports on the debt of the provincial government and the 137 sub provincial governments have been published on a timely basis—the most recent covering the period ending December 2017. The number of local governments disclosing all debt and financial information in the template developed under the operation has exceeded the target, although the number remains small. The target was ten; by end-2017, twelve had done so. It is not yet clear that these measures have resulted in greater citizen participation in the processes of government. But it is reported that the exercise has been useful in informing participants in the budget process within the government 3.3 Efficiency Not applicable 26 3.4 Justification of Overall Outcome Rating Overall Rating: Highly Satisfactory 66. Achievement of the PDOs is rated highly satisfactory, as all of the program results indicators were achieved or exceeded their targets. The operation identified seven results indicators to be attained by the end of 2017. All of these indicators were met, and 6 out of the 7 were even surpassed. The DPF played a decisive role in the adoption of a fiscally sustainable, more efficient, and more transparent budgetary framework in Hunan Province that it currently being sustained and expanded. The fact that elements of the Hunan Province approach supported by the DPF have been mainstreamed into the national reform agenda speaks for fulfillment of the program objective to inform this agenda. 3.5 Overarching Themes, Other Outcomes and Impacts (a) Poverty Impacts, Gender Aspects, and Social Development 67. The pillars of this operation were not directly related to these issues . However, this operation was relevant for achieving fiscal sustainability, more efficient budgetary outcomes, and greater transparency in subnational finance. These issues have implications for the quality of social development and poverty alleviation. (b) Institutional Change/Strengthening 68. This operation was very much about institutional change. Under the program, Hunan Province built new institutions for financial and budgetary management, which include debt sustainability analysis, a medium term fiscal framework, an integrated capital financing plan, an interagency committee for project review, a debt management framework, and higher standards of transparency. In the course of the operation, the Hunan Provincial Government has built capacity in all of these areas, and has correspondingly changed the manner in which it operates. These Institutional developments changed budgetary and planning processes, modernized organizational arrangements, created new norms and procedures, and applied new knowledge and information. Participants acknowledge that the institutional changes are well entrenched and not likely to be reversed. The program has also helped reinforce and consolidate the role of the Debt Sustainability Department, which in turn is helping build institutional capacity at the sub-provincial level, particularly through learning and results orientation. They are already creating a new culture of evaluation and analysis, along with a focus on targets, which will become part of a new institutional structure. 27 (c) Other Unintended Outcomes and Impacts 69. Hunan Province well exceeded expectations in achieving results, sustaining the institutional changes made during the DFP program, and continuing with the next stage of reforms even without a follow-up DPF. During the DPF engagement, there were concerns about sustainability, particularly given some political pressures that challenged the policy directions of Hunan Province toward public investment consolidation and achieving fiscal sustainability. However, subsequent changes in national policies served to re-enforce the DPF program and encourage Hunan Province to move forward in this manner. 3.6 Summary of Findings of Beneficiary Survey and/or Stakeholder Workshops 70. Not applicable. 4. ASSESSMENT OF RISK TO DEVELOPMENT OUTCOME Rating: Moderate 71. The original Program Document identified several possible sources of risk to the continued fulfillment of the development objectives. They were mainly related to possible deteriorating macro and fiscal conditions, governance and political issues, and technical design and implementation capacity. These risks have not yet materialized. 72. There currently remain two main risks to the sustainability of reforms. (1) policy priorities emanating from Beijing could change and (2) priorities and capacities in the Hunan Provincial Government could change. Like many other subnational governments in China, the Hunan Provincial Government commonly experiences a significant turnover in personnel and leadership. Since the implementation of the DPF, a very large number of relevant positions in the government and finance department have changed. The strong continuity of reforms under these conditions reflects encouragement by Beijing for Hunan to continue to move forward in this manner. This may also be a reason why Hunan has taken measures to ensure sustaining its own developed capacity for debt sustainability analysis even with major personnel changes. 73. As of the fourth quarter of 2018, the priorities of Beijing are again moving toward a possible fiscal stimulus to offset the headwinds brought on by the current tensions with the US. The hope is that, if a major fiscal stimulus is carried out, China will account for the lessons of 2015-2016 and not pursue it essentially as an unfunded mandate for subnational governments to increase public investment. While the scenario of a repeat of 2015-2016, which derailed the country from budget reform implementation to a significant extent, is unlikely, it cannot be ruled out. This would, in turn, challenge the ability of Hunan Province to sustain or expand its budget reforms in the spirit of the DPF, and also make more likely political changes in the Hunan Provincial Government that would lower the priority on measures to ensure fiscal sustainability relative to other objectives. Even in the event that these latter issues materialize, it is expected that this would 28 delay rather than negate the progress that Hunan continues to make in budget reform. The imperative of achieving fiscal sustainability at the subnational level in China will remain. 5. ASSESSMENT OF BANK AND BORROWER PERFORMANCE 5.1 Bank Performance (a) Bank Performance in Ensuring Quality at Entry Rating: Highly Satisfactory 74. The Bank was very responsive and worked closely with the Hunan Province Government during the preparation of the loan. Having worked closely with China’s Government for many years on interbudgetary relations and budget reform, the World Bank proved an ideal partner for this operation. Most recently, prior to the DPF operation, the World Bank partnered with the Development Research Center of the State Council on the flagship report, Urban China (IBRD, 2014), which has a chapter devoted to the reform of local government finance. The Bank had also recently gave technical assistance to Shanghai Municipality on questions of fiscal sustainability. The Bank provided substantial advisory support in the design of the DPF program. The Bank was able to act quickly because it had a close dialogue and development relationship with Hunan Province. While the context of 2015-2016 proved rather difficult for undertaking a program of this kind aimed at achieving fiscal sustainability, the exceptionally strong level of engagement with Hunan Province gave confidence to move ahead with a pioneering and highly ambitious program. The preparation work conducted by the Bank was careful and thorough and involved significant direct technical assistance from its staff to the Provincial Government. During project preparation, the Bank mobilized some of the best experts in each of the areas and brought to bear the relevant knowledge and lessons accumulated in China and other countries (Brazil, India, and Nigeria). The result was a well-focused program with strong links to the Budget Reform agenda and the broader engagement with the Central Government. The design of the project posed some challenges, as the Bank needed to come to a consensus with Hunan Province on an appropriate and meaningful framework for pursuing fiscal sustainability that did not yet find reflection in national instructions for conducting the budget reform. (b) Quality of Supervision Rating: Highly Satisfactory 75. One of the highlights of the process was the quality of the Ba nk’s supervision. The success of the program can be partly attributed to the intensive and continuous presence of the Bank throughout implementation. Continuous interaction and the supervision missions ensured more consistent progress towards achieving the result targets. There was an ongoing dialogue, as 29 evidenced by mission aide memoires, on many facets of the program. The World Bank took a total of nine missions to Hunan Province during preparation and implementation of the program. Selected experts stayed for longer periods of time for training and data analysis. Hunan Department of Finance officials sent a mission to the World Bank office in Beijing for DSA training. There has been continuing communication by phone during non-mission times. There was a focus on ensuring results and on the measures needed to move the program forward. The staff followed up on indications of difficulties and the technical needs of the Province. There is widespread recognition that the technical assistance was a source of considerable help to the Government in overcoming implementation obstacles and finding solutions to several problems. Strong supervision was present in all pillars of the program. The nature of the support provided under each component varied according to needs. The assistance covered broad policy issues, norms, regulations, and the updating of the DSA. These inputs were particularly valuable as the team had access to high level decision makers. (c) Justification of Rating for Overall Bank Performance Rating: Highly Satisfactory 76. The Bank’s performance as a whole was commendable for its close involvement during the preparation and implementation of the program supported . The Bank’s engagement and support to the Hunan Province under this operation was widely recognized by the authorities, who viewed it as crucial for their success. They appreciated not only the responsiveness at preparation, but also the quality and manner in which advice and support were provided throughout. They noted the professionalism of Bank staff and the respectful approach taken in understanding the Province’s priorities and specific needs. The authorities also pointed to the critical role of the Bank’s oversight and scrutiny. The constant inquiries by the Bank and the on-going exchange of views led the authorities to examine in greater detail the work being done and to be more self-critical. In many instances, in response to Bank’s concerns, the authorities adapted their approach to take into consideration the recommendations. 5.2 Borrower Performance (a) Government Performance Rating: Highly Satisfactory 77. The Hunan Province Government’s performance is highlighted by the continued efforts to achieve the committed results. The authorities were persistent in implementing the reforms and in showing progress. The program included many measures that required perseverance and tenacity to make them effective. Some of the measures were politically challenging. For example, the adoption of a fiscal sustainability model entailed a sharp change reduction public 30 investment beyond what was initially anticipated and encountered resistance. Eventually, it became widely accepted, and it has established a new culture in investment planning. The government had to garner the support and participation of all executing agencies, and more importantly had to begin to integrate budgeting and planning, a task that required strong persuasive powers. The authorities also placed significant efforts in dealing with the complexities and challenges of implementing a monitoring system and measuring sub-provincial entities’ fiscal risks. (b) Implementing Agency or Agencies Performance Rating: Highly Satisfactory 78. The primary responsibility for the administration of the loan rested with the Hunan Finance Department that coordinated all activities under the program and was responsible for the implementation of several of the actions. Its performance was outstanding. This team had already piloted important reforms in Hunan Province before the DPF operation, and was highly motivated to make the World Bank DPF in China a success. Strong support from the Governor of Hunan Province was also a motivating factor. The DPF had a dedicated a highly competent team from Hunan Province that supervised the compliance with the commitments under the loan. The team was central to the efficient communication that took place between the Bank staff and the Government and they also organized and facilitated the supervision missions. Hunan Province provided complete access to needed information both from the provincial government and local government financing vehicles. The undertaking was difficult and required considerable organizational capacity and political ability. (c) Justification of Rating for Overall Borrower Performance Rating: Highly Satisfactory 79. The overall performance by the borrower is considered to be highly satisfactory because of the considerable achievements in most components of the loan. All components were managed successfully. 6. LESSONS LEARNED 80. This operation demonstrates that the DPF can be a very effective instrument for facilitating deep cooperation around policies and reforms. The World Bank has long been engaged with subnational governments on budget reforms through technical assistance. Yet the TA instrument did not provide such a special context that essentially unites the Bank and client teams around the achievement of specific reforms and policies under the discipline of a time line. Hunan Province benefited from the longer-term financing from the World Bank, but money was not the most important motivating factor. Hunan Province took pride in receiving the first World Bank development policy financing in China and was highly motivated from the outset to make the 31 operation a success. This motivation increased as the program materialized in a manner that pleased Hunan for maintaining and strengthening its status as a leader in budget reform in China. 81. Fortunately, the absence of an explicit programmatic DPF did not prevent what became a necessary multi-year engagement. Given the inherent multi-year nature of the complex institutional reforms embodied in the program, a number of years were needed for the achievements of the DPF. The World Bank and Hunan Province had already been closely engaged for more than one year before the World Bank Board approved the operation in January, 2017. Close engagement on implementation of the program and strengthening the new institutions continued throughout 2017. As the national reform program began scaling up elements of the program, Hunan Province had a natural interest to remain closely engagement with the Bank team during 2018 as well. Thus, the fact that the operation was formally only a one tranche non- programmatic engagement, the high interest of the client in achieving and strengthening reforms provided the context for what became a genuine programmatic engagement. 82. This DPF also reaffirms the critical role of the Central Government for facilitating an environment where significant and valuable experimentation can occur. The Ministry of Finance in China lobbied very hard for several years for this type of operation that would link World Bank teams and subnational governments around realizing objectives in budget reform. The Ministry of Finance was important for creating conditions under which needed information could be shared with the World Bank team. Even when the directions of the operation began to deviate from current national instructions for budget reform, the Ministry of Finance continued to defend and support the operation as a pilot to be studied. The strong motivation of the central Ministry of Finance for conducting and defending the operations was essential for creating an environment where something of this nature can be achieved in China. 83. A more simplified debt sustainability assessment tool will be needed to scale up the experience of Hunan. Completing comprehensive debt sustainability assessments in this and the simultaneous DPF in Chongqing were difficult, given the current complexities surrounding subnational finance in China. While these careful and comprehensive assessments were appropriate for these initial pilots, it became clear in the course of these operations that a more simplified framework will be needed for scaling up these practices in local governments throughout China. For this reason, the World Bank team has begun work on a simplified template that could be filled out by local governments for use at the provincial level for assessing financial risks in local governments, including those coming from contingent liabilities. This is part of current cooperative work between the World Bank and the Fiscal Academy of the Ministry of Finance in Beijing. 84. This experience of this operation strongly suggest that more stability and predictability are needed in both intergovernmental transfers and expenditure mandates from higher levels of government to support high quality medium-term budgeting and debt sustainability frameworks at the subnational level. For Hunan Province and other provinces in China, this creates a high degree of uncertainty around the realization of medium-term budgeting 32 consistent with debt sustainability. This experience is helping to inform the current policy dialog between the World Bank and Central Government. 85. This operation demonstrated important potential links between World Bank projects and policy dialog with the government. The experience of this operation, as well as the one in Chongqing, improved greatly the Bank’s own knowledge of important budget reform issues at the subnational level and deepened the ability of the Bank team to engage with the Central Government on budget reform. While there is no proof of a causal relationship, a number of the practices pioneered in Hunan Province under the operation, as well as policy recommendations made by the Bank that were informed by this operation, have been echoed in budget reform initiatives of the Central Government beginning in the second half of 2016. Some of these initiatives have arguably revitalized the budget reform in China. 7. COMMENTS ON ISSUES RAISED BY BORROWER/IMPLEMENTING AGENCIES/PARTNERS (a) Borrower/Implementing agencies 86. The Hunan Province Department of Finance has highly competent staff who have command of the DSA model that underpins their Medium Term Fiscal Strategy and efforts to ensure fiscal sustainability. As other provinces in China, the majority of expenditures are carried out at the local (sub-provincial) level of government. Given limited capacity at the sub- provincial level, the DSA model used for Hunan Province and the provincial level is too complicated for implementation at the lower level. Hunan Province therefore requests follow-up work that develop and appropriate simpler tool, as well as capacity building, that could extend the results achieved under the DPF at the provincial level to the sub-provincial level. The World Bank team is currently working on this design, and a proposed follow-up operation by Hunan Province is under discussion in the Central Government. (b) Cofinanciers 87. Not applicable. (c) Other partners and stakeholders 88. Not applicable. 33 ANNEX 1: BANK LENDING AND IMPLEMENTATION SUPPORT/SUPERVISION PROCESSES (a) Task Team members Names Title Unit Responsibility/Specialty Lending John Litwack Lead Economist GMTP1 Macro-economic and Fiscal Management / Team Leader Min Zhao Senior Economist GGOEA Public Financial Management / Team Leader Christoph T F Ungerer Economist GMTE3 Debt Management Luan Zhao Economist GMTP1 Macro-economic Management Kai-Alexander Kaiser Senior Economist GGOEA Public Investment Management Lili Liu Lead Economist GGOGI Debt Management Abha Prasad Program Leader LCC3C Debt Management Jay-Hyung Kim Adviser GGOAS Public Investment Management Juan Pradelli Consultant GMTP2 Debt Management Alejandro Alcala Gerez Senior Counsel LEG Legal Regis Cunningham Senior Financial GGODZ Financial Management Management Specialist Yi Dong Sr Financial Management GGOEA Financial Management Specialist David Duarte Senior Public Private GTIAK PPP Partnerships Specialist Yu Shang Program Assistant EACCF Administrative and Client Support Lin Yang Program Assistant EACCF Administrative and Client Support Yunxia Chao Consultant GMTP1 Data Analysis Supervision 34 John Litwack Lead Economist GMTP1 Macro-economic and Fiscal Management / Team Leader Min Zhao Senior Economist GGOEA Public Financial Management / Team Leader Luan Zhao Economist GMTP1 Macro-economic Management Regis Cunningham Senior Financial GGODZ Financial Management Management Specialist Yi Dong Senior Financial GGOEA Financial Management Management Specialist William Dillinger Consultant GMTP1 Intergovernmental Fiscal Relations Lorena Vinuela Senior Public Sector GGOEW Intergovernmental Fiscal Specialist Relations Yu Shang Program Assistant EACCF Administrative and Client Support Lin Yang Program Assistant EACCF Administrative and Client Support Yunxia Chao Consultant GMTP1 Data Analysis (b) Staff Time and Cost Staff Time and Cost (Bank Budget Only) Stage US$ Thousands (including travel No. of staff weeks and consultant costs) Lending 15.19 92.27 Supervision/ICR 157.77 19.90 Total: 35.09 250.04 35 ANNEX 2: SUMMARY OF BORROWER'S ICR AND/OR COMMENTS ON DRAFT ICR In 2015, with the implementation of new Budget Law, the magnificent local government debt reform was unveiled in China. The CPC Committee of Hunan Province and Hunan Government took the fiscal reform as a major task, strictly followed the deployment of the CPC Central Committee, borrowed on the international experience and in line with local situation, implemented a series of debt management reform measures conducive for the near term and long term development and laid a foundation for the future. The development policy loan (DPL) project sourced from the World Bank under the theme of “improving provincial government debt management capacity” is undoubtedly one of most effective measures. We hereby report the implementation of specific applied work, the project influence and next-step work as follows. I. Overview of DPL implementation and government debt management reform Centered on prominent issues in Hunan provincial debt reform, upon repeated negotiation between both parties, eight prior action measures of DPL project have been confirmed as a precondition for approving the project. Strongly supported by the provincial party committee and government and the World Bank expert team, eight prior actions have been successfully implemented. Taking the DPL project as the opportunity, we actively push ahead with the government debt management reform to a higher level, in a wider range of scope and more intensively. We have achieved some positive effect. (I) Establish and improve the organizing and leadership system, establish the provincial government debt management leadership group and a joint meeting system for risk control. In the beginning of 2016, upon the approval of the provincial government, we established the joint meeting system of the budget management and risk control for the provincial government debt, with the Provincial Department of Finance as the team leader, and the NDRC Provincial Committee, Transport Department of Hunan Province, the Provincial Department of Audit and the Financial Office of the Hunan Province Government as team members. In 2018, to unify the thoughts and action on government debt management and control among departments at all levels, we established the government debt leadership group, led by major officials of CPC Committee and the government of Hunan Province, with the participation of related functional departments. Since 2018, the provincial party committee secretary, governor and deputy governor have attended the meetings dedicated to work deployment related to government debt management and control. Meanwhile, to implement the deployment of the provincial party committee and government, we further expand the leadership group of government debt management. The head of the Hunan Provincial Department of Finance select ten competent personnel from the Financial Department, Hunan Provincial Development and Reform Committee, Audit Department and Finance Office, fully responsible for province-wide debt data statistics, risk screening, monitoring illegal loan behaviors, organizing stock debt swap, issuing local government bond and other debt management work. Now, we have worked with the Provincial Discipline Inspection Commission and Provincial Inspection Office to conduct several debt inspections so as to strengthen the requirements and 36 accountability of debt management and transmit them to the governments and departments at all levels. (II) Establish stricter debt management framework in line with new concept, new trend and new requirements of government debt management. The cooperation with the World Bank brings us sophisticated international experience in mitigating debt risks. Meanwhile, with the progress of reform both extensively and intensively, the debt management in Hunan province faces new challenges and needs to be further regulated. Therefore, in February 2018, the Several Opinions of CPC Hunan Committee and Government on Strictly Controlling the Growth of Government Debts and Mitigating the Debt Risks (Xiang Fa [2018] No. 5) was issued, which requires that the city/county governments shall not rely on the upper level government to pay back the loans for them, hold a correct attitude towards performance and development, actively and stably mitigate the stock debts and prevent “disposal risk”, formulate the debt repayment and debt servicing plan, strengthen the management and control of vehicle directory, promote the market transformation, prevent illegally disguised loan through such methods as PPP, governmental procurement of services, government investment fund. This regulation directs Hunan province to regulate the government debt management, specifies requirements and strengthens current and future regulations. (III) Apply the DSA model, draft and issue the sustainable mid-term financial strategic report. The provincial debt sustainable analysis (DSA) model for Hunan is the major achievement of this project. Under the guidance and help of the World Bank experts, we comprehensively review the debt generation mechanism at the provincial level, establish the DSA model based on our prevailing system. Upon the quantitative calculation and accurate analysis, we offer a series of public finance expenditure and investment policy suggestions for provincial debt risk control and financial sustainability. The Notice of Hunan Province on Issuing the Mid-term Financial Strategic Report at the Provincial Level (Xiang Cai Yu [2016] No.53) was hereby promulgated in the end of May2016, including investment scale control, reducing administrative expenditure and paying back high-interest debts, with a view to realizing provincial debt risk control and financial sustainability. (IV) Draft the mid-term financing debt planning and implement source control on provincial government debt. In 2015, we launched the pilot program of drafting annual debt budget for major construction projects. From 2016, to improve policy planning, far-sighted significance and effectiveness, we expanded annual debt budget to the medium-term (three years) financing debt planning and issued the Notice on Drafting the Medium-Term Financing Planning for Provincial Government Public Welfare Projects (Xiang Cai Yu [2016] No. 51) to make this measure be institutionalized and long-lasting. Based on this, we drafted 2016-2018 and 2017-2019 Medium- Term Financing Debt Planning. Now, we are drafting 2018-2020Medium-Term Financing Debt Planning. When drafting the medium-term financing debt planning, we fully use the achievements of DPL project and introduce the DSA model. Based on quantitative analysis, we accurately set the financing upper limit to ensure provincial fiscal sustainability in three years and allocate the quota to various departments in need of financing. On the basis of strict integration of project planning 37 and reasonable division of expenditure obligations between the province and cities/counties, the budget control from the source applies to all construction funds in need of principal and interest repayment, including financial subsidies, creditor's rights and equity financing, covering major projects in such areas as provincial trunk road, railways, airports, waterway, water conservancy, energy and affordable housing projects. (V) Improve debt risk early warming mechanism and play an incentive and constraining role in debt quota allocation. From 2015, we have established the early warning mechanism for government debts featuring different grades and accurate management control. The debt ratio is classified into four pre-warning grades at the city and county level, including green safety, yellow alert, orange early warning and red warning. When allocating the debt quota, we will significantly reduce quota allocation in the red and yellow pre-warning regions, and ask them to submit the debt risk mitigation plan within a time limit and file with the Provincial Department of Finance. In 2018, we also significantly increase the indicator weight in the party and political performance assessment of city/prefecture governments. This figure is increased from 10points to 60points. It also becomes an important individual assessment item, to further play the directional role of pre-warning debt risks in strengthening debt risk prevention. (VI) Improve information transparency and regulate budget and debt management through information disclosure. First, we release the budget report and interpretation manual. We adhere to continuous improvement of budget report and draft system, contents and related statements, and enabling the deputies to the people's congress and republic to understand “government balance statement”. From 2015, we have further innovated the report format and drafted the interpretation manual for the budget report in animations. Through policy interpretation in graphics, data analysis, comparison and other methods, we interpret the fiscal reform, budget data and people’s welfare policy to the deputy to the people’s congress in a vivid manner. According to agreed actions, we will release these documents online completely and provide the commenting function for the public to view and offer suggestions, generating sound social effect. Second, we draft and release comprehensive debt report covering the province, cities and countries. The debt is sensitive of nature and some regions and departments are reluctant to release. Guided by the World Bank expert team, we borrow on international templates and design the comprehensive debt report in line with Hunan province’s needs. We also establish an online platform to release debt information of province and some cities and counties, available for the public to access. Thanks to effective measures in releasing budget and debt information, Hunan province ranked top among Chinese provinces in terms of financial information disclosure assessed by the Ministry of Finance and third party in 2016and 2017. II. Overall project assessment The successfully implementation of DPL in Hunan province represents that the cooperation between the World Bank and Hunan province enters a new stage from issuing infrastructure loan 38 to improving governance system and capacity building, which is significant for deepening the cooperation between the two parties and generates positive effect in multiple aspects. First, show the entrepreneurship and innovative spirit of Hunan people. Different from ordinary engineering project loans, DPL is a loan dedicated to promoting the reform, which requires the project organization with the capacity of policy understanding, project coordination and resource mobilization. The application is difficult. Now, there is a gap in this regard in the cooperation between the World Bank and China. Hunan province becomes the first successful applicant for DPL of the World Bank in China, showing the entrepreneurship and innovative spirit of Hunan people. Second, drive the government debt reform at the provincial level. To fully implement the action plan preset by both parties, we need to renovate the reform in such aspects as debt management institutional mechanism, measures and technical tools. The successful implementation of this project comprehensively improves the government debt management capacity of Hunan province. In particular, the establishment and application of DSA mode firstly introduces the concept of “quantitative analysis, accurate control and management and forward-looking plan” to the debt risk management control work, and provides effective technical measures for the provincial government to strengthen debt management, scientifically formulate the fiscal expenditure and public investment policy and ensure sustainable fiscal operation. The provincial party committee and government focus on regulating the local government debt management and mitigate major risks, preside over and coordinate the progress of debt reform and directly control the provincial debt risk level under the DSA model, fully demonstrating the important role of DPL loan project played in driving the debt management reform in Hunan province. Third, train a batch of reform talent with international vision. Hunan’s DPL project lasted for nearly two years from the application to issuing the loan, involving over ten public institutions under the provincial government and state-owned enterprises. During this period, the World Bank expert team had comprehensive and constructive communication with us. Their proficient knowledge structure, meticulous work attitudes and sharing cooperative spirit impressed us. In line with the project needs, we sent young cadres to learn at the World Bank headquarters and worked with the World Bank Beijing Office, which helped us to train a batch of reform talent with broad international vision. Fourth, form a sound demonstrative and leading role. After Hunan Province successfully applied for DPL project, the Ministry of Finance and NDRC popularize our experience to other provinces and cities across China. Guangdong and other provinces learn the application experience from us. To widely apply DPL project achievements, in 2017, we expanded the pilot scope of mid- term financing scale from the provincial level to all 14 cities, prefectures and some counties. The implementation of DPL project in Hunan province also generates sound effect in developing countries. In the end of February of 2018, the delegation from the government of the People's 39 Republic of Bangladesh visited Hunan province and learn the DPL project with a view to borrowing some valuable reference for deepening the reform of fiscal management system in their country. The benefits of DPL project are evident. Meanwhile, we face some issues for further expanding the project deliverables. For example, the DSA model is complex of nature and difficult to be implemented at the grassroots. After the project completed, we need to improve the mechanism of the World Bank “intelligent” support. We need talent with extensive professional knowledge to push ahead with the DPL project cooperation. Next step, we will jointly explore new breakthroughs for deepen cooperation on a basis of open, inclusive, sharing and win-win principles. III. Related opinion suggestion To deepen and expand DPL project achievements and further deepen the cooperation between both parties extensively and intensively, we offer the following suggestions in line with pre-stage project application experience: (I) Simplify DSA model and improve its generalizability. Now, to collect the provincial DSA model data, it involves such sources as the government debt management system, the financial statement of platform company, government budget and final accounts. The data chain stretches longer from basic data entry to synthesizing composite debt ratio. When introducing this model to the city and county level, it is subject to the capacity of local fiscal and investment system and personnel competency. Some cities and counties report their difficulty to apply the model. We suggest that both teams further strengthen cooperation, explore the methods to simplify the model and improve the application of the model in cities and counties. (II) Establish the normalized mechanism and expand cooperation intensively and extensively. After the World Bank experts leave, we will continuously push ahead with related reform alongside the route explored by both parties, such as drafting the mid-term financing planning, comprehensive debt report and citizen budget report. However, the reform of fiscal and taxation systems involves a wide range of scope. We suggest that the World Bank selects Hunan province as a long-term partner. As such, both parties could have a wide range of cooperation in reform and experience summary, enable us to stay the edge in concept, knowledge and technology and continuously deepen our cooperation both extensively and intensively. (III) Strengthen talent training and improve sustainability. To improve state governance system and modernization of governance capacity, we need a batch of professional talent with broad international version and modern economic knowledge. In the process of applying the DPL, we value this opportunity to directly work with the World Bank and put capacity building as the priority. We urge the World Bank to continuously give us support in the aspect of personnel training and international communication and laying a solid foundation for deepen the cooperation between the two parties. 40 ANNEX 3: THEORY OF CHANGE 41 Map of Hunan Province 42