The World Bank THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING (P164321) Document of The World Bank FOR OFFICIAL USE ONLY Report No: PGD49 INTERNATIONAL DEVELOPMENT ASSOCIATION PROGRAM DOCUMENT FOR A PROPOSED DEVELOPMENT POLICY GRANT IN THE AMOUNT OF SDR 3.7 MILLION (US$5.0 MILLION EQUIVALENT) TO THE DEMOCRATIC REPUBLIC OF SÃO TOMÉ AND PRÍNCIPE FOR THE THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING November 19, 2019 Macroeconomics, Trade and Investment Global Practice Africa Region This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization. . The World Bank THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING (P164321) Democratic Republic of São Tomé and Príncipe GOVERNMENT FISCAL YEAR January 1 – December 31 CURRENCY EQUIVALENTS (Exchange Rate Effective as of October 31, 2019) Currency Unit = São Tomé and Príncipe Nova Dobra (STN) STN 22.06 = US$1 SDR 0.72495813= US$1 ABBREVIATIONS AND ACRONYMS AfDB African Development Bank AGER Autoridade Geral de Regulação de São Tomé e Príncipe (General Regulatory Authority of São Tomé and Príncipe) AML/CFT Anti-Money Laundering/ Combating the Financing of Terrorism AQR Asset Quality Review BCSTP Banco Central de São Tomé e Príncipe (Central Bank of São Tomé and Príncipe) CEM Country Economic Memorandum CIT Corporate Income Tax COSSIL Gabinete de Coordenação e Seguimento de Licitações (Office for Coordination and Support of Procurement) CPS Country Partnership Strategy CRC Central de Registro de Crédito (Public Credit Registry) DGA Directorate General of Customs DGE General Directorate of Environment DI Directorate of Taxation DPF Development Policy Financing DPO Development Policy Operation DSA Debt Sustainability Analysis DSM Demand Side Management ECF Extended Credit Facility EMAE Empresa de Água e Electricidade (Water and Electricity Company) ENCO Empresa Nacional de Combustíveis (National Fuel Company) EU European Union FDI Foreign Direct Investment GDP Gross Domestic Product GoSTP Government of São Tomé and Príncipe GRS Grievance Redress System HDI Human Development Indicator HFO Heavy Fuel Oil HIPC Heavily Indebted Poor Countries IBRD International Bank for Reconstruction and Development ICBP World Bank Institutional Capacity Building Project IDA International Development Association IFMIS Integrated Financial Management Information System IMF International Monetary Fund IPP Independent Power Producer KPIs Key Performance Indicators LCPDP Least Cost Power Development Plan LCU Local Currency Unit LDP Letter of Development Policy LED Light Emitting Diode MFD Maximizing Finance for Development MIP Management Improvement Plan MIRNA Ministry of Infrastructure, Natural Resources, and Environment MIS Management Information System MTEF Medium-Term Expenditure Framework MTSFFP Ministry of Employment, Solidarity, Family, and Vocational Training NAP Norma de Aplicação Permanente (Permanent Rule) NDP National Development Plan NIPD Carteira Nacional de Projectos (National Investment Portfolio Database) NIR Net International Reserves NPLs Non-performing Loans PEFA Public Expenditure and Financial Accountability PENPS Política e Estratégia Nacional de Proteção Social (National Policy and Strategy for Social Protection) PER Public Expenditure Review PFM Public Financial Management PIM Public investment management PIT Personal Income Tax PLR Performance and Learning Review PRSP Power Sector Recovery Project PV Present Value SDR Special Drawing Rights SME Small and Medium Enterprise SNIP Sistema Nacional de Investimento Público (National Public Investment System) SNP National Planning System Law SOE State-Owned Enterprise SP Social Protection SSA Sub-Saharan Africa STN São Tomé and Príncipe Nova Dobra STP São Tomé and Príncipe TA Technical Assistance VAT Value-Added tax WB World Bank WBG World Bank Group . Regional Vice President: Hafez M. H. Ghanem Country Director: Abdoulaye Seck Global Practice Director: Marcello De Moura Estevão Filho Practice Manager: Francisco Galrao Carneiro Task Team Leader: Rafael Chelles Barroso The World Bank THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING (P164321) DEMOCRATIC REPUBLIC OF SÃO TOMÉ AND PRÍNCIPE THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING TABLE OF CONTENTS SUMMARY OF PROPOSED FINANCING AND PROGRAM .......................................................................3 1. INTRODUCTION AND COUNTRY CONTEXT ...................................................................................5 2. MACROECONOMIC POLICY FRAMEWORK....................................................................................7 2.1. RECENT ECONOMIC DEVELOPMENTS............................................................................................ 7 2.3. IMF RELATIONS ............................................................................................................................ 19 3. GOVERNMENT PROGRAM ........................................................................................................ 19 4. PROPOSED OPERATION ............................................................................................................ 19 4.1. LINK TO GOVERNMENT PROGRAM AND OPERATION DESCRIPTION .......................................... 19 4.2. PRIOR ACTIONS, RESULTS AND ANALYTICAL UNDERPINNINGS .................................................. 20 4.3. LINK TO CPF, OTHER BANK OPERATIONS AND THE WBG STRATEGY .......................................... 46 4.4. CONSULTATIONS AND COLLABORATION WITH DEVELOPMENT PARTNERS ............................... 48 5. OTHER DESIGN AND APPRAISAL ISSUES .................................................................................... 48 5.1. POVERTY AND SOCIAL IMPACT .................................................................................................... 48 5.2. ENVIRONMENTAL ASPECTS ......................................................................................................... 50 5.3. PFM, DISBURSEMENT AND AUDITING ASPECTS .......................................................................... 50 5.4. MONITORING, EVALUATION AND ACCOUNTABILITY .................................................................. 52 6. SUMMARY OF RISKS AND MITIGATION ..................................................................................... 53 ANNEX 1: POLICY AND RESULTS MATRIX .......................................................................................... 56 ANNEX 2: IMF RELATIONS ANNEX ..................................................................................................... 60 ANNEX 3: LETTER OF DEVELOPMENT POLICY..................................................................................... 63 ANNEX 4: ENVIRONMENT AND POVERTY/SOCIAL ANALYSIS TABLE .................................................. 71 Page 1 The Third Strengthening Growth and Fiscal Policy Development Policy Financing was prepared by an IDA team consisting of Rafael Chelles Barroso (Task Team Leader and Senior Country Economist, EA2M2), Melanie Trost (JPO, EA2M2), Mazen Bouri (Program Leader, EA2DR), Valéria Salomão Garcia (Senior Financial Sector Specialist, EFNFS), Carlos Leonardo Vicente (Sr. Financial Sector Specialist, EA1F2), Denise Dias (Microfinance Specialist, EFNFS), Maria do Céu da Silva Pereira (Senior Financial Sector Specialist, EFNFI), Zenaida Uriz (Senior Private Sector Development Specialist, EA2F2), Eric Zapatero Larrio (Senior Social Protection Specialist, HAFS2), Jordi Jose Gallego-Ayala (Social Protection Specialist, HAFS2), Kjetil Hansen (Senior Public Sector Specialist, ELCG2), Joseph Kizito (Lead Financial Management Specialist, EA2G2), Nicolas Jean Marie Sans (Hydropower Specialist, IAFE4), Nashi Fiifi Eyison (Senior Energy Specialist, IAFE4), Jacqueline Veloz Lockward (Counsel, LEGLE), João Tinga (Financial Management Specialist, EA1G2), Laurent Mehdi Brito (Sr. Procurement Specialist, EA2RU), Nelson Tisso Miezi Eduardo (Economist, EA2M2), Emmanuel Skoufias (Lead Economist, EA1PV), Claudia Rocio Manrique (Program Assistant, EA2M2), Pinar Baydar (Operations Analyst, EA2M2), and Nadia Gabriel Bilale (Environmental Specialist, SAFE3). Guidance was received from Francisco Carneiro (Practice Manager, EA2M2), Norbert Fiess (Lead Economist, EA2M2), and Elisabeth Huybens (EFI Regional Director, EA2DR). The peer reviewers are Rohan Longmore (Senior Economist, ELCMU), Yadviga Semikolenova (Senior Energy Economist, IEEES), and Julian Casal (Senior Financial Sector Specialist, EA1F2). The World Bank THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING (P164321) SUMMARY OF PROPOSED FINANCING AND PROGRAM BASIC INFORMATION Project ID Programmatic If programmatic, position in series P164321 Yes 3rd in a series of 3 Proposed Development Objective(s) The objective of this operation is to help the government introduce growth-enabling reforms in the financial sector, business environment, and infrastructure; generate fiscal resources and savings; and improve quality of expenditures. Organizations Borrower: MINISTRY OF PLANNING, FINANCE, AND BLUE ECONOMY Implementing Agency: MINISTRY OF PLANNING, FINANCE, AND BLUE ECONOMY PROJECT FINANCING DATA (US$, Millions) SUMMARY Total Financing 5.00 DETAILS International Development Association (IDA) 5.00 IDA Grant 5.00 INSTITUTIONAL DATA Climate Change and Disaster Screening This operation has been screened for short and long-term climate change and disaster risks Overall Risk Rating High . Page 3 The World Bank THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING (P164321) Results Indicator Name Baseline (2015) Target (2020) Result Indicator 1: Number of banks below the Central Bank’s 3 0 minimum Capital Adequacy Ratio (12 percent). Result Indicator 2: Share of the population with access to formal 39 percent 45 percent financial services (e.g. bank accounts). Result Indicator 3: Share of real estate properties and mortgages 0 percent 70 percent registered and digitized in the Public Notary Registry. Result Indicator 4: EMAE’s operational profit/loss (in million LCU). -224.9 -194.7 Result Indicator 5: Number of complaints received by EMAE. 6,542 3,000 Result Indicator 6: Tax revenues, except custom duties on oil (in 831.1 1050.0 million LCU). Result Indicator 7: Number of SOEs’ performance monitoring 0 2 systems in place. Result Indicator 8: Share of ongoing and finalized projects with basic information included in the National Investment Portfolio 0 percent 95 percent Database. 4,000 (of which 50 Result Indicator 9: Number of beneficiaries enrolled in the three percent has received core social protection programs and receiving regular payments as 0 payments through the set in law. formal financial system). . Page 4 The World Bank THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING (P164321) IDA PROGRAM DOCUMENT FOR A PROPOSED GRANT TO THE DEMOCRATIC REPUBLIC OF SÃO TOMÉ AND PRÍNCIPE 1. INTRODUCTION AND COUNTRY CONTEXT 1. The proposed Third Strengthening Growth and Fiscal Policy Development Policy Financing (DPF) aims to support São Tomé and Príncipe (STP) in its efforts to promote private-sector-led growth and macroeconomic stability for growth and poverty reduction. This proposed operation, in the amount of SDR 3.7 million (equivalent to US$5 million), is the third in a programmatic series of three development policy operations (DPOs). The objective of the operation is to help the government introduce growth- enabling reforms in the financial sector, business environment, and infrastructure; generate fiscal resources and savings; and improve the quality of expenditures. The reforms of the proposed operation are aligned with the International Monetary Fund’s (IMF) new Extended Credit Facility (ECF), which was approved by the IMF Executive Board in October 2, 2019. 2. STP is a low middle-income and small-island country that faces challenges typical of small states. It consists of two main islands in the Gulf of Guinea, has a surface area of 1,001 sq. km, and is administratively divided into six districts, in addition to the Autonomous Region of Príncipe (Região Autonóma do Príncipe, RAP). STP is a multiparty democracy and a unitary state, and its total population is approximately 200,000 people, with 42.6 percent of the population at or below the age of fourteen. In 2018, the country’s per capita gross national income was estimated at US$3,430 in purchasing power parity (PPP), and its per capita gross domestic product (GDP) was US$1,890. As a small island country, STP is characterized by: (i) a small population; (ii) a small land area; (iii) remoteness; and (iv) a high fixed cost of public goods—all factors that affect the country’s public sector capacity, trade, fiscal accounts, and human development. 3. Poverty reduction appears to have been rather stagnant in STP since 2010. Poverty numbers from the latest survey in 2017 are not yet available. But estimates based on growth and distribution assumptions indicate that around one-third of the country’s population lives on less than US$1.90 (2011 PPP) per day in 2019, a decline of roughly 2 percentage points relative to 2010. The change in poverty has been mainly attributed to economic growth (increases in the mean value of household income) rather than the redistribution of income across the population, and inequality in STP remains high for international standards (Gini index of 56.3 in 2017). Additional welfare indicators such as the Human Development Index (HDI), at 0.59 for STP lags the average for peers (at 0.62). Moreover, STP’s total fertility rate is 4.5 births per woman, and its adolescent fertility rate is 96.3 per 1,000 women aged 15-19. The unemployment rate in STP is 8.9 percent in 2017, with females having an unemployment rate 3 times higher than that among males (14.5 performance among females compared to 5 performance among males). 4. The October 2018 elections and the subsequent change in administration reset the policy dialogue on critical reforms to the DPO. STP held parliamentary and local elections in October 2018, which yielded a coalition government that took office in the end of November. Coalition governments are historically unstable in STP and have difficulty in advancing reforms. The change of governments also led to a reshuffle in most government positions. In addition, some expenditure and borrowing made in the end of 2018 delayed a thorough assessment of the macroeconomic picture. The new administration needed time to familiarize itself with the macroeconomic condition it had inherited as well as with the Page 5 The World Bank THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING (P164321) ongoing policy reforms. These developments, together with the lapse of the previous IMF program, delayed the preparation of the third operation relative to the originally proposed schedule, as the World Bank team had to reassess the adequacy of the macroeconomic policies and the suitability of the reform program, and to engage with the new administration to ensure that the program remains aligned with the new government program. The new administration has gradually gained understanding of the difficult macroeconomic situation and gained ownership of the program, supporting and acting on strong measures such as value-added tax (VAT) introduction and fuel price hikes. 5. Economic growth, which has been overly reliant on public expenditure, has been declining due to reduced government funding (external loans, grants, and own-source revenues), and more recently due to the energy crisis. The country’s GDP growth rate slowed from an average of 4.9 percent in 2010- 15 to 2.7 percent in 2018. In the same period, public investments dropped from an average of 22.1 percent of GDP to 9.0 percent, while grants declined from an average of 15.2 percent of GDP to 8.2 percent in 2018. Tax revenues also declined by about three percentage points of GDP between 2010-15 and 2018. As a result, public debt increased significantly, reaching 118 percent of GDP as of June 2019. The rise in public debt was further propelled by a build-up of government and state-owned enterprises’ (SOEs) arrears, which increased domestic debt. While the agriculture and tourism sectors—where most private -sector-led growth originates—grew in the last 10 years, they have not been able to replace the government as the economy’s main growth driver. The combination of a weak private sector and strained public sector has reduced economic growth, and has brought about energy outages, a liquidity crunch, and high exposure of banks to the public sector. 6. The new administration of STP has reiterated its commitment to make the private sector the country’s leading driver of economic growth. The new administration has acknowledged that STP’s macroeconomic situation is fragile, that the public sector bureaucracy is too large and inefficient, and that future growth will have to be led by the private sector. This operation aims to address these challenges by supporting reforms that will enable higher levels of private-sector growth and restore macroeconomic stability. For example, the supported financial sector reforms aim to reduce risks from a banking crisis while providing companies and consumers with tools to have more access to credit. The supported energy reforms aim to increase the supply of low-cost and reliable energy, relieving private companies from the burden of relying on power generators. Finally, the proposed fiscal measures aim to increase tax revenue and improve public investment spending and the efficiency of SOEs, which will help policymakers achieve balanced budgets and provide the public services needed to increase private-sector growth. 7. The macroeconomic situation remains challenging, but recent government measures and the new IMF program have been addressing some of the imbalances. The government has acknowledged the severity of the country’s current macroeconomic situation. The approved 2019 budget promotes fiscal consolidation of more than 1 percentage point of GDP. The recently approved IMF program for a total of US$19 million focuses on fiscal consolidation, SOE reform, and monetary tightening to support the country’s currency peg. Although the macroeconomic imbalances have deteriorated since the approval of the second operation, the government has taken measures to address these imbalances; the proposed DPO program, complementary World Bank engagements, and the ECF will ensure that critical reforms such as the VAT implementation and SOE reform remain on track. 8. The risk of the proposed operation is high due to (i) political and governance; (ii) macroeconomic; (iii) fiduciary; and (iv) institutional capacity for implementation and sustainability risks. These risks emanate from the short tenure of the current government, its coalition nature, the need for support from Parliament to implement some reforms, vulnerability to domestic and external shocks Page 6 The World Bank THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING (P164321) and their potential impact on program objectives, and the complex design of the operation. 9. The operation is aligned with the World Bank Group (WBG) Maximizing Finance for Development (MFD) framework and the recently adopted Africa Regional Strategy. The operation supports MFD-enabling reforms, including achieving macro-financial stability; improving the business climate; implementing SOE reforms; and regulating the energy sector. It is also aligned with the Africa Regional Strategy, as it aims to create sustainable and inclusive growth (through increased domestic resource mobilization, improved public investment management, and higher financial inclusion) and strengthen human capital (by expanding social protection (SP) coverage). 2. MACROECONOMIC POLICY FRAMEWORK 2.1. RECENT ECONOMIC DEVELOPMENTS 10. A decline in government expenditure and foreign direct investment (FDI), a slowdown in agriculture and tourism, and energy shortages, have slowed GDP growth. The country’s GDP growth rate averaged 5 percent from 2001 to 2014 – STP’s golden growth era - before starting to gradually decline, reaching an estimated 2.7 percent in 2018. The economy’s main growth drivers, public spending—mainly public investment financed by grants and loans—FDI, tourism, and agriculture, have declined or slowed growth in recent years.1 Public investments have declined due to a reduction in loan and grant disbursements. Grants dropped from an average of 15.2 percent of GDP in 2010-2015 to 12 percent in 2016-2018. While FDI peaked in 2010 and 2011 during the initial oil licensing round, it declined when no oil reserves were discovered. In recent years, the tourism sector, which generated US$61 million in 2018, has grown at a slower pace, and both the volume and value of agricultural products have fallen slightly. For example, the value of the country’s cocoa exports dropped by 5 percent between 2016 and 2018, and the total value of its agricultural production declined by 11.7 percent between 2014 and 2016, according to the latest data available. Disruptions in weather patterns and agricultural pests were the main reasons for the decline in production. 11. The economy was also adversely affected by the elections, political uncertainty, and the energy crisis in the second half of 2018 with waning effects in 2019. The 2018 elections and the long transitioning period led to an overspending and overborrowing in the domestic market, which affected the private sector by draining their liquidity – through delayed government payments to suppliers – and crowding out bank financing. Meanwhile, STP experienced a severe energy crisis in late 2018. STP’s energy production capacity dropped from 20 MW to as low as 7 MW as diesel generators systematically failed, a result of inadequate infrastructure maintenance. The water and energy company, Empresa de Água e Electricidade (Water and Electricity Company EMAE), responded by cutting the electricity supply, leaving parts of the country with energy access for only a few hours a day and other areas without energy for several days. The ensuing protests and widespread popular discontent led to roadblocks that constrained fuel distribution in the country. Both the electoral period and the energy crisis caused a significant slowdown in economic activity that led to lower tax collection, a scarcity of goods, higher inflation, and lower foreign exchange inflows. The government still has not been able to settle the payment arrears to suppliers or the bank loans taken to pay salaries. On the energy side, STP was able to bring energy production back to 16 MW, reducing and rationalizing the blackouts. A 9 MW-diesel fired generator for São Tomé and a 0.7 1 STP does not produce national accounts from the demand side. Page 7 The World Bank THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING (P164321) MW diesel fired generator for Príncipe were donated by British Petroleum, which will allow energy supply to be reestablished to the full demand level and conduct proper maintenance of the other generators. On the other hand, Empresa Nacional de Combustíveis (National Fuel Company, ENCO), the fuel supplier has reduced the quantity of fuel imported and raised fuel prices to EMAE due to the growing arrears from EMAE to ENCO. 12. Public revenues—especially tax revenues—have been declining and reached a new low in 2018 due to the elections and the energy crisis. One of the main causes of STP’s fiscal fragility is its low capacity to mobilize domestic revenues. Despite some raises in tax rates, especially on alcoholic beverages, tax revenues have been falling since 2015 due to the following reasons: (i) an excessive dependency on import taxes—particularly on fuel;2 (ii) arrears from large taxpayers – including from the fuel importer (ENCO); (iii) an inadequate tax policy; and (iv) a very low tax administration capacity. Tax collection efforts were also negatively affected by the sluggish economy. As a result, tax revenue as a share of GDP dropped from 14.6 percent of GDP in 2015 to 12.5 percent of GDP in 2018. 13. Current expenditures are not excessively high and have generally been under control, leaving low tax revenue as the main source of budget imbalances. STP’s current expenditures are not high for a small island country and have been managed relatively well, except for some slippages that were recorded in 2017 and 2018 in relation to IMF program targets. Current expenditures averaged 18.1 percent of GDP from 2010 to 2015, before declining to an average of 16.5 percent of GDP in 2016-2018. The domestic primary deficit increased from 1.6 percent of GDP from 2010 to 2015 to 3.3 percent of GDP from 2016 to 2018, despite that primary expenditures declined by 1.5 percentage points of GDP from 2015 to 2018, signaling that the persistence of the budget deficit is mostly credited to underperforming tax revenues. Overall budget deficits have been reduced since 2010, but this is mostly credited to reduced public investments financed by grants and not to fiscal policy decisions per se. 14. Public debt has been increasing since STP had its debt forgiven in 2008 due to external borrowing, budget deficits, loss-making SOEs, energy subsidies, and government arrears. The total debt- to-GDP ratio increased significantly from 58.5 percent in 2008 (when it completed the Heavily Indebted Poor Countries (HIPC) program and the Multilateral Debt Relief Initiative) to 113.4 percent in 2015. A large part of the public investment that boosted growth from 2001 to 2014 was paid for by external loans, leading to an increase in public debt. The debt also increased during part of this period due to lower fuel prices in STP than abroad, creating a fuel subsidy that was assumed by the government in the form of debt with the fuel supplier. This subsidy has been reverted since 2016 as domestic prices are now higher than international prices and the difference is being used to reduce this debt. From 2015 to 2018, debt growth tapered off due to lower external loan disbursements, the forgiveness of pre-HIPC debt from China, and higher domestic fuel prices that allowed the country to amortize debt related to past fuel subsidies. However, domestic debt increased. The previous administration expanded the electricity grid, providing access to energy to more people in both islands. Greater access, however, came with higher public debt since EMAE is a loss-making SOE, whose debt is guaranteed by the government and with tariffs set on average at half of its costs. The decline in budget revenues has led the government to fail to pay its suppliers on time, accumulating arrears with EMAE, the telecom company (CST) and other suppliers, and most recently with domestic banks, which have financed investments from SOEs, autonomous and sovereign agencies, but also financed the government payroll. 2Revenues from custom taxes on fuel increased on 2017 and 2018 mainly because of the settlement of arrears from ENCO. They declined by 60 percent until June of 2019. Page 8 The World Bank THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING (P164321) 15. STP’s public external debt is of low risk, but the government arrears pose heightened risks to the economy. STP’s total debt, which includes pre-HIPC debt, a contested debt with Nigeria, government arrears, and SOE debt, was US$500.4 million, or 118.1 percent of GDP, in June 2019. If debt contracted before the HIPC program, as well as the disputed debt, is excluded on the assumption of debt forgiveness following the LIC-DSF guidance, the country’s debt-to-GDP ratio drops to 94.2 percent in 2019. STP’s overall debt profile is of low risk since the average time to maturity of the external debt is 11.6 years and the average debt cost is 1.2 percent. The risk, however, is greater for the domestic debt, which has shorter maturity and especially for the government arrears to suppliers, whose terms of payments have not been agreed, which could lead to immediate supply cuts in fuel and telecommunication services and demand for outright payment in full. 16. Inflation is anchored by a fixed exchange rate peg and external account sustainability is determined by financing availability. STP enjoys a fixed exchange rate peg at the rate of STN 24.5 per euro, which decreased its inflation rate substantially from 10.4 percent in 2012 to 4 percent in 2015.3 The peg is supported by a credit line up to an amount of 25 million euros (US$27.5 million) from the World Bank of Portugal, which can be used only when net external assets are below three months of imports. The high inflation differential and large current account deficit might be a threat to the peg, however, the literature and empirical evidence suggest that the benefits of fixed exchange rate outweigh the costs for small countries4 and that the sustainability of the peg is ensured by the availability of financing.5 Given the country’s fixed exchange-rate regime and its underdeveloped interbank market, the ability of the Banco Central de São Tomé e Príncipe (Central Bank of São Tomé and Príncipe, BCSTP) to conduct independent monetary policy is limited. 17. Inflation has moderated in 2019, after fuel prices, weather, and supply shocks caused inflation to peak in 2018. Inflation peaked at 10.2 percent in October 2018, ending the year at 9.0 percent—1.3 percentage points higher than in 2017. Inflation increased due to higher fuel prices, heavier-than-usual rainfall, the energy crisis, and scarcity among some common consumer goods. The government increased fuel prices in June 2018 in response to higher international prices, resulting in higher transportation costs. This, in turn, increased the price of consumer goods, as most goods in the country are transported by trucks. In the second half of 2018, STP recorded heavier-than-usual rainfall, preventing fishermen to venture out to sea, which raised the price of fish. Excessive rainfall also reduced cereal and pepper production, leading to higher prices. Moreover, the energy crisis led many households and businesses to lose their perishable products, causing the supply to drop and prices to increase. Finally, STP experienced a rice shortage in 2018, doubling the price of rice, which also affected substitute goods such as taro and yam. Inflation moderated in 2019, reaching 7 percent as of August. Inflationary pressures are concentrated on domestically produced goods, resulting from weather shocks (lemon and pepper) and 3 Despite the currency peg, the inflation rate has not converged fully to the euro area. The reason for the non-convergence are threefold: (i) large structural differences between the economies such as STP’s remoteness and the development of the non- tradable sector that reflect different composition of CPI baskets; (ii) policy differences in the labor market (i.e., existence of wage indexation), differences in tax policy (i.e., different tax rates), barriers to trade (including tariff and non-tariff barriers), and transportation costs or price indexation; and (iii) differences in the external environment, such as oil price fluctuations and its transmission process to the local economy. 4 Open and Nimble: Finding Stable Growth in Small Economies (World Bank) summarizes the discussion on the choice of exchange- rate regimes for small economies (pages 61-64). It explains the theoretical and empirical arguments that favor fixed exchange rate regimes in small countries. 5 The counter-intuitive response of the trade balance to the real appreciation of the STN suggests that the current account deficit is not being driven by declining international trade competitiveness, but rather by STP’s fiscal deficits, which are in turn enabled by foreign aid flows. This causality is common among EMDEs (Chinn & Prasad, 2003; Duarte & Schnabl, 2015). Page 9 The World Bank THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING (P164321) from the energy shortages that increased the price of substitute goods (wood and charcoal) and the price of fish, since boats are propelled by diesel. Expansion of monetary aggregates, which was an enabling factor to inflation in 2018 has been reversed. The M2 and M3 money supply, which grew by an annual rate of 19.4 percent and 15.2 percent respectively in 2018, are now at 16.6 and 9 percent as of July 2019. 18. The trade balance and the current account have improved in recent years. The trade deficit narrowed from 34 percent of GDP in 2015 to 28 percent in 2018. As exports, excluding re-exports, only slightly declined from 2.9 percent to 2.2 percent of GDP in the same period, the improvement in the trade balance was primarily attributed to a reduction in imports, which fell from 37.4 percent to 31.7 percent of GDP. The reduction in imports was registered across all categories, except for capital goods, which were already at a low level in 2015. The surplus in the services balance fell due to lower growth in the tourism sector and lower service imports. As a result, STP’s current-account deficit, excluding official transfers, narrowed from 24.8 percent of GDP in 2015 to 18.9 percent in 2018. 19. Despite reduced external financing needs in 2018, international reserves dropped due to lower capital inflows, being only partially reestablished in 2019. While the country’s lower current-account deficit has translated into lower external financing needs, existing financing needs have not been met since capital inflows have declined significantly. This led to a loss of 38.6 percent in net international reserves (NIR) in 2018. At its lowest point in March 2019, NIR totaled US$27.4 million, which was equivalent to a mere 1.7 months of imports. STP’s low level of international reserves has created difficulties for both companies and people to access foreign exchange. The BCSTP currently reports a backlog of nearly US$10 million in unfulfilled foreign exchange requests due to low international reserves. Some grant disbursements from China and European Union (EU) allowed STP to partially rebuild its reserves, which now stands at US$39.2 million or 2.5 months of imports. 20. The banking sector continues to face stability challenges, although authorities have taken important steps to better assess risks and strengthen the resolution framework. While the average reported capital adequacy ratio was 31.5 percent in June 2019, and all banks met the regulatory minimum ratio of 12 percent, non-performing loans (NPLs) remained high at 27 percent. NPLs could further rise and capital positions could erode as banks reclassify loans and create additional provisions in line with the recommendations of the recently concluded asset quality review (AQR) of the entire banking system. STP’s banking system is liquid, reflecting a lack of lending opportunities in an environment of persistently high NPLs. The country’s banks have increased their holding of Treasury bills (which totaled 8 percent of assets in September 2018) and lending to SOEs, directly exposing themselves to government arrears. After the failure of Bank Equador in 2016, the BCSTP revoked the license of Banco Privado in June 2018, following the bank’s protracted breach of prudential norms. Both banks are currently being liquidated. To deal with emerging risks, the BCSTP continues to strengthen the supervisory and resolution framework, focusing on the development of a resolution manual and the introduction of risk-based supervision. 21. Financial depth and intermediation have been declining, reflecting banks’ increased risk aversion and the closure of some banks. The size of STP’s financial sector (by assets) declined from 79 percent of GDP in 2012 to an estimated 50 percent of GDP as of September 2018,6 making it one of the smallest financial systems in the world. As of September 2018, credit to the private sector was estimated at 21 percent of GDP, down from a peak of 39 percent in 2011. In the same period, loans accounted for only 34 percent of total banks’ assets, and the credit-to-deposit ratio declined to 58 percent, from 63 6 As of September 2018, total assets were estimated at US$220 million. Page 10 The World Bank THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING (P164321) percent in September 2017. This means that banks are channeling much less credit to STP’s private sector. Indeed, the Financial Inclusion Survey completed in 20177 showed that 39 percent of adult population had access to financial services and only 3 percent of the country’s micro, small, and medium-sized enterprises had access to credit. Overall, low levels of access to finance underscore the urgency of implementing secured transactions reforms to mitigate small and medium-sized enterprises’ (SMEs) lack of immovable collateral, as well as upgrading the credit registry to improve the availability of information on borrowers and allow banks to better access risks. 22. The government has recognized the country’s difficulties and is taking measures to address macroeconomic imbalances. It has communicated to the population that the macroeconomic situation of the country is acute and has asked international financial institutions to be as candid as possible in their assessments. It increased debt transparency by conducting a thorough analysis of government arrears, which were included in the debt stock for the first time. Authorities have also demonstrated a willingness to take hard, but needed, measures starting with the new IMF program, the introduction of VAT with a tax rate of 15 percent, and the increase in fuel prices to generate resources to pay down the debt with ENCO. Moreover, the government has agreed to increase taxes, suspend civil servants’ benefits, and contain the growth of the wage bill. The government has made clear that it will not contract new external loans that cannot be sustainably repaid by the country and that the country’s development will have to come from the private sector. Other long-term and more structural measures such as bank supervision improvements and modernization of the property and land registry are progressing as well. 7 BCSTP, 2018. Inquérito à Inclusão Financeira (draft). Page 11 The World Bank THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING (P164321) Table 1. Selected Economic Indicators (2015-2022) 2015 2016 2017 2018 2019 2020 2021 2022 Projected Real Economy Percentage of GDP GDP at constant prices 3.8 4.2 3.9 2.7 2.5 3.0 3.5 4.0 GDP deflator 5.1 5.1 2.0 4.7 4.7 5.0 4.1 2.8 Consumer prices End of period 4.0 5.1 7.7 9.0 6.6 8.7 5.3 4.3 Period average 5.3 5.4 5.7 7.9 7.8 8.4 6.9 4.7 Fiscal Accounts Total revenue 28.9 29.3 28.0 23.7 20.3 23.3 22.8 23.5 Tax revenue 14.6 12.7 12.8 12.5 12.2 13.0 13.6 14.0 Non-tax revenue (excl. oil) 1.4 1.4 1.1 0.6 0.9 0.9 0.9 0.9 Grants 12.1 14.2 13.5 8.2 6.6 8.7 7.9 8.0 Total expenditure 37.3 35.3 33.1 26.6 22.9 23.2 22.5 22.2 Of which: Domestic primary expenditures 17.8 16.7 17.2 17.5 15.2 15.6 15.6 15.3 Current expenditure 17.1 16.1 17.1 16.4 15.9 16.1 16.1 15.9 Capital expenditure 18.2 17.9 14.7 9.2 5.5 7.1 6.4 6.4 Of which: financed by the Treasury 1.2 1.1 0.6 1.5 0.3 0.4 0.3 0.3 Financed by external sources 17.0 16.9 14.1 7.7 5.1 6.7 6.1 6.1 HIPC Initiative-related social expenditures 0.6 0.2 0.3 0.1 0.2 0.2 0.2 0.1 Overall balance (8.4) (6.1) (5.1) (1.8) (1.0) 0.0 0.3 1.2 Domestic primary balance, excl. oil (1.7) (2.6) (3.3) (4.1) (2.1) (1.6) (1.1) (0.4) Public debt 112.7 108.2 111.4 108.9 113.9 111.6 109.3 107.0 Selected Monetary Accounts Annual Percentage Change Base money 37.5 5.0 (9.6) 0.8 (0.5) 2.6 7.1 7.6 Credit to the economy 3.8 8.3 2.5 (1.6) (6.7) 0.6 6.6 7.1 Central Bank reference interest rate (percent) 10.0 10.0 9.0 9.0 N.A N.A N.A N.A Average bank lending rate (percent) 23.3 19.6 19.6 19.8 N.A N.A N.A N.A External sector Percentage of GDP Current account balance (incl. official transfer) (11.8) (7.1) (13.4) (10.9) (11.9) (8.0) (7.2) (5.5) Current account balance (excl. official transfer) (24.8) (20.5) (24.4) (19.4) (18.5) (16.7) (15.1) (12.7) Foreign direct investments 8.1 6.0 11.0 6.8 9.1 9.0 8.9 8.9 Net international reserves Millions of U.S. dollars 56.3 49.7 46.8 28.6 28.8 30.2 31.8 33.3 Months of imports 5.9 3.1 2.9 1.8 2.1 2.1 2.0 2.0 Exchange rate (new dobras per US$, annual average) 22.1 22.1 21.7 20.7 21.7 21.6 21.4 21.3 Exchange rate (new dobras per US$, end of period) 22.4 23.4 20.5 21.5 21.3 21.1 19.1 21.4 Memorandum item Gross Domestic Product Millions of new dobra 7.031 7.698 8.154 8.763 9.402 10.167 10.954 11.714 Millions of U.S. dollars 318.3 347.5 375.0 422.6 433.0 470.5 510.7 549.8 Per capita (in U.S. dollars) 1.627 1.739 1.836 2.022 2.033 2.158 2.290 2.410 Sources: São Tomé and Príncipe Authorities and WB and IMF staff estimates and projections: October 2019. Page 12 The World Bank THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING (P164321) Table 2. Central Government Operations and Financing Needs (2015-2022) % of GDP 2015 2016 2017 2018 2019 2020 2021 2022 Projected Total revenue 28.9 29.3 28.0 23.7 20.3 23.3 22.8 23.5 Tax revenue 14.6 12.7 12.8 12.5 12.2 13.0 13.6 14.0 Income tax 2.1 3.6 3.1 2.8 2.8 3.0 3.4 3.6 Import tax 8.1 5.1 4.8 5.5 5.3 5.1 4.9 4.7 Other 4.4 4.1 4.9 4.2 4.1 4.9 5.3 5.7 Non-tax revenue (excl. oil) 1.4 1.4 1.1 0.6 0.9 0.9 0.9 0.9 Grants 12.1 14.2 13.5 8.2 6.6 8.7 7.9 8.0 Total expenditure 37.3 35.3 33.1 26.6 22.9 23.2 22.5 22.2 Current expenditure 17.1 16.1 17.1 16.4 15.9 16.1 16.1 15.9 Payroll 8.9 8.8 9.1 9.1 9.2 9.2 9.1 8.9 Interest Payments 0.6 0.4 0.5 0.4 0.7 0.8 0.8 0.8 Goods & Services 2.6 2.2 2.7 3.0 2.6 2.5 2.4 2.3 Subsidies & Transfers 5.0 4.7 4.7 3.9 3.4 3.7 3.9 3.9 Capital expenditure 18.2 17.9 14.7 9.2 5.5 7.1 6.4 6.4 Overall fiscal balance (commitment basis) -8.4 -6.1 -5.1 -1.8 -1.0 0.0 0.3 1.2 Net change in domestic arrears -1.2 0.0 0.1 0.9 0.0 -0.6 -0.7 -0.6 Float and statistical discrepancies 0.1 0.0 -0.7 -0.3 0.0 0.0 0.0 0.0 Overall fiscal balance (cash basis) -9.4 -6.1 -5.7 -1.3 -1.0 -0.6 -0.4 0.6 Financing 9.4 6.1 5.7 1.3 1.0 0.6 0.4 -0.6 Net External 10.1 6.5 4.3 0.9 0.1 -0.7 -0.2 -0.4 12.8 of which program financing (loans) and disbursement (projects) 8.0 5.5 1.6 1.7 0.8 1.2 1.0 of which scheduled amortization -2.7 -1.5 -1.2 -0.7 -1.5 -1.5 -1.4 -1.4 Net domestic -0.7 -0.4 1.4 0.4 0.8 1.3 0.7 -0.2 Net bank credit to the government -0.7 -0.4 1.4 0.4 0.8 1.3 0.7 -0.2 -0.6 of which banking system credit (excluding National Oil Account) -0.1 1.3 2.4 0.6 1.2 0.5 -0.2 of which National Oil Account -0.1 -0.4 0.1 -2.0 0.2 0.2 0.2 0.1 Nonbank financing 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 Financing gap 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 Sources: São Tomé and Príncipe Authorities and WB and IMF staff estimates and projections Sources: São Tomé and Príncipe Authorities and WB and IMF staff estimates and projections: October 2019. Page 13 The World Bank THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING (P164321) Table 3. Balance of Payment Financing Requirements and Sources (2015-2022) US$ Million 2015 2016 2017 2018 2019 2020 2021 2022 Projected Gross financing requirements -96.6 -66.3 -91.7 -70.1 -88.2 -92.1 -90.9 -83.0 Current account, excluding official transfers -78.9 -71.4 -91.5 -82.0 -80.1 -78.7 -76.9 -69.8 Financial account -8.4 -4.6 -4.3 -3.5 -6.6 -7.4 -7.5 -7.5 Scheduled amortization -7.5 -3.7 -4.3 -3.1 -6.2 -7.1 -7.2 -7.2 IMF/MDRI repayments -0.9 -0.9 0.0 -0.4 -0.4 -0.3 -0.3 -0.3 Change in external reserves (-ve=increase) -9.2 9.7 4.1 15.4 -1.5 -6.0 -6.5 -5.7 Available funding 96.6 66.3 91.7 70.1 88.2 92.1 90.9 83.0 National Oil Fund (net) 2.1 1.9 2.7 1.8 3.6 3.7 3.5 3.2 Oil signature bonuses 2.5 3.2 2.3 10.2 2.8 2.8 2.5 2.8 Saving (-ve=accumulation of oil reserve fund) -0.4 -1.3 0.4 -8.4 0.8 0.9 1.0 0.4 Expected disbursements 72.2 55.7 58.1 40.1 35.2 47.7 47.8 52.5 Multilateral HIPC interim assistance 6.0 2.9 3.1 1.6 3.4 3.3 3.3 3.3 Grants 32.6 46.4 47.6 32.9 25.2 37.8 37.0 40.7 Concessional loans 33.6 6.4 7.4 5.6 6.6 6.6 7.5 8.5 Private sector (net) 22.3 8.7 30.9 28.2 49.4 40.7 39.6 27.3 Financing gap 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 Sources: São Tomé and Príncipe Authorities and WB and IMF staff estimates and projections: October 2019. Box 1: The Energy Sector and Reforms at the EMAE STP has the third highest cost of energy in SSA. This partly reflects the challenges faced by energy systems in small island countries such as small-scale operation and the lack of interconnectivity between systems, but it also reflects problems in the outdated transmission and distribution system, an energy generation mix highly dependent on costly fuel, and the poor management of the utility company EMAE. EMAE has been registering large losses and accumulating arrears with suppliers. After an expansion of the electricity network, EMAE’s annual losses surged to about 4 percent of GDP during 2016-2018, compared to an average of 1.5 percent of GDP in SSA. The losses mainly reflect high technical and commercial losses (totaling 33 percent of the energy produced). Meanwhile, the collection rate (91 percent in 2018), including from public institutions, is suboptimal. The losses have been predominantly financed by accumulating arrears to the fuel supplier – the oil company ENCO, which reached about 23 percent of GDP by mid-2019 (Figure 1). The World Bank’s Power Sector Recovery Project (P166805) supports a long-term structural improvement of the EMAE and STP’s energy sector. The project, co-financed by the European Investment Bank, has four main activities that are also supported through the DPO: (i) improving the physical infrastructure, including the rehabilitation and expansion of the main hydropower plant, rehabilitation of the electricity grid, and installation of meters; (ii) developing sectorial planning, particularly development of a Least Cost Power Development Plan (LCPDP) (DPF 3 Prior Action #6); (iii) improving the regulatory framework and strengthening the capacity of the regulator AGER (DPF 3 Prior Action #7); and (iv) implementing a Management Improvement Plan (MIP) of EMAE (DPF 3 Prior Action #6). The goal is to achieve cost recovery over the medium term by reducing production costs and distribution losses, as well as by protecting revenue through improving billing and collection and reducing commercial losses. Addressing operational inefficiencies (mainly transmission and distribution losses and bill collection) could reduce losses to below 1 percent of GDP. Without a drastic change in the cost of production or compensating measure, the EMAE’s financials will continue to worsen in the short-to-medium term. Short-term measures are required to reduce the fiscal burden from the energy sector, including:  Switch from an expensive energy mix dominated by diesel generation to a more affordable mix, consisting Page 14 The World Bank THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING (P164321) of heavy fuel oil (HFO), hydropower, and solar energy, as recommended by the LCPDP. The elimination of diesel would also end the challenge of rampant diesel theft. The government should seek to attract reputable private-sector developers that are interested in developing an IPP for an HFO plant on the island through a competitive process. The development of generation options is well outlined in the LCPDP.  Accelerate the implementation of the MIP to reduce non-technical losses and improve billing and collection, which is key to promoting the sustainable development of the power in the medium term. The first strategic step was the development of the MIP for EMAE, together with the definition of a clear concession contract, with indicators for operational efficiency and accountability, which will entail the launch of a sustainable plan for tariffs and finding a financial equilibrium in its current operation.  Implement demand-side management (DSM) measures to suppress peak electricity demand and overall electricity consumption. An electricity demand study showed that 68 percent of the evening peak demand is related to residential consumption, and lighting accounts for about 70 percent. As of today, lighting requirements are mainly met by inefficient incandescent lighting (74 percent of households), or moderately efficient compact fluorescent lamp bulbs (29 percent of households). A government-led DSM program that exchanges inefficient lighting with more efficient light emitting diode (LED) bulbs for residential consumers could significantly reduce peak demand as well as overall electricity demand. Ideally, the DSM program should be combined with a prohibition on incandescent bulbs. Furthermore, all government agencies should implement the LED program and ensure efficient energy use.  Enforce payment discipline. Measures include (i) installing pre-paid meters for all non-essential public consumption, disconnecting electricity services due to non-payment; and pre-paying for the consumption of essential services from the central budget; (ii) agreeing on arrears clearance plans with large private consumers, SMEs, and residential consumers, or disconnecting services due to non-payments; and (iii) conducting a communication campaign to explain that collective action is needed to improve electricity services and penalize, through the judicial system, customers found to be illegally accessing electricity services. In addition to supporting long-term structural improvement of EMAE and the energy sector, this DPO also supports short-term measures to improve the financial standing of EMAE and reduce the fiscal burden from the energy sector. Reforms in the third operation include energy saving measures – a light bulb exchange program (DPF 3 Prior Action #5). Figure 1: Cumulative Payment Arrears, EMAE to ENCO and Treasury to EMAE, 2010-2018 (% of GDP) 25.0 20.0 15.0 10.0 5.0 0.0 2010 2011 2012 2013 2014 2015 2016 2017 2018 Debt treasury to EMAE (% GDP) Debt EMAE to Enco (% GDP) Source: EMAE, Ministry of Finance, and Word Bank estimates, October 2019 Page 15 The World Bank THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING (P164321) 2.2. MACROECONOMIC OUTLOOK AND DEBT SUSTAINABILITY 23. GDP growth rates are expected to gradually recover as the energy supply is fully restored, weather shocks are absorbed, grant inflows increase, and the tourism sector resumes its growth momentum. The country’s energy supply has been partially reestablished, but the acquisition of new generators will allow STP to reestablish power generation to the level of the demand early in 2020. Therefore, GDP growth rates should not be constrained by energy shortages anymore. The effects of weather-related shocks on the agriculture sector and the fishing industry have abated, and the tourism sector growth is picking up, benefiting from an increase in the number of seats available on airplanes due to large airplanes operating in the flights from Accra and Lisbon and the re-establishment of the air connection with Cabo Verde. Grant inflows are also expected to increase following the approval of the IMF program and the continuation of the government. 24. Strong fiscal consolidation is expected in 2019 and beyond as the government implements the new IMF program. The IMF program includes a robust and front-loaded fiscal consolidation that are expected to reduce STP’s domestic primary balance from 3.2 percent of GDP in 2018 to 1.7 percent of GDP in 2019 and bring it below 1 percent in the long-run. Also, the absence of the factors that depressed tax collection in 2018—the elections and the energy crisis—will likely result in a rebound in corporate tax revenue, which would aid the government’s fiscal consolidation efforts. Moreover, the DPO series is supporting the implementation of the government’s strategic policies related to fiscal consolidation through measures to implement a VAT (DPF 3 Prior Action #8), reform SOEs (DPF 2 Prior Action #9), and improve the efficiency of public expenditures (DPF 2 Prior Action #10). 25. Inflation is expected to fall as shocks dissipate and growth in monetary aggregates is contained. Inflation in 2018 was propelled by shocks such as excessive rain, energy black-outs, and higher external oil prices that are not expected to be seen again in 2019. However, inflation in 2019 will experience some negative effect from the fuel price increase. The implementation of a new monetary policy tool to shore up excess liquidity will constrain inflation and reduce the impact of any pass-through from potential shocks. The main risks to inflation are: (i) weather-related shocks that have become more frequent due to climate change; and (ii) increases in fuel prices or tax rates that will eventually be needed to balance the budget. The introduction of the VAT in 2020 will trigger a one-off increase in prices. In the worst-case scenario, inflation would reach 12 percent in 2020, subsiding to 6 percent in 2022. 26. STP’s external account will continue to improve as oil prices stabilize, energy efficiency improves, and grants and tourism receipts increase. The current-account deficit is expected to be financed through grants and concessional loans as well as tourism receipts. Increased financial assistance in the form of grants and concessional lending is expected from official donors in 2020 onwards, as some donors halted disbursements due to the elections and the lapse of the IMF program. The government is seeking to establish new donor relationships and strengthen the currents ones. The government is also making a significant effort to attract private investments, which should yield benefits in the medium term. 27. STP remains in debt distress due to prolonged unsettled external arrears, but debt can be deemed sustainable under programmed policies. STP is in debt distress because of the regularization of STP’s post-HIPC sovereign arrears (to Angola, Brazil, and Equatorial Guinea, totaling around 2.6 percent of GDP) is still ongoing. The Governments of STP and EQG reached an initial agreement to clear the loan in arrears and the renegotiation of the loan with Brazil is pending parliamentary approval by the lender country. The government is also working to curb the increase in domestic debt by regularizing payments to suppliers and utilities as well as aggreging on a settlement plan for past arrears. Under the baseline Page 16 The World Bank THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING (P164321) scenario, the present value (PV) of the total PPG debt-to-GDP ratio breaches the benchmark, mainly because of the inclusion of EMAE’s arrears to ENCO and newly identified government arrears to private suppliers. Hence, staff assesses that total PPG debt is sustainable provided EMAE’s planned reforms are implemented and the country continues to borrow externally only at concessional terms at a measured pace. All the three total PPG debt ratios (PV of debt-to-GDP, PV of debt-to-revenue, and debt service-to- revenue) are most sensitive to a primary balance shock. 28. While the macroeconomic situation is difficult, the government is actively taking measures in the right direction to address the problems, which deems the macroeconomic framework adequate for this operation. The current macroeconomic framework is consistent with domestic and external balance, since the exchange-rate peg serves as an anchor to inflation and the government is showing commitment to restore fiscal and external balances. Some of the factors that affected the economy in 2018 have already been addressed, such as electoral uncertainty and the energy crisis. The government is making important efforts and taking tough decisions, such as increases in fuel prices and the introduction of the VAT, to make things right. The macroeconomic program, supported by the IMF ECF, sets performance criteria (floor) for the domestic primary balance and NIR and establish a ceiling for government borrowing and guarantees (both domestic and external). Moreover, the IMF program contain structural benchmarks for the VAT, bank supervision, and energy sector reforms. STP’s macroeconomic risks include the government’s inability to sustain fiscal consolidation, a deterioration in the banking sector, higher international prices of fuel and food, and a sudden reversal in external financing flows that would weaken support to the peg. Given the context, the government is making important efforts and taking tough decisions to make things right. Even if several things are expected to align appropriately, and the short- term outcomes may not be brilliant, that set of policies make a sustainable and credible medium-term framework. Page 17 The World Bank THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING (P164321) Figure 2: Debt Sustainability Analysis Page 18 The World Bank THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING (P164321) 2.3. IMF RELATIONS 29. STP has a new IMF program, which supports fiscal consolidation and the stability of the exchange-rate peg. The new program was approved by the IMF Board of Directors on October 2, 2019. The three-year program is extended under the ECF modality for a total of US$19 million. It focuses on fiscal consolidation and monetary tightening to support the exchange rate peg. The IMF program is aligned with the overall work program of the World Bank and has several structural benchmarks that are rooted in World Bank projects, reflecting World Bank-IMF coordination on VAT implementation and financial sector development. 3. GOVERNMENT PROGRAM 30. The Government of São Tomé and Príncipe (GoSTP) program is composed of its medium-term National Development Plan (NDP) 2017-2021 and the XVII government program. There are sectorial strategies for the country’s financial and energy sectors, human capital, and SP. The XVII Government program is the most relevant since it was done by the current government. The NDP 2017-2021, which was developed by the previous government, will be revised as required by law and aligned with the current administration’s objectives. Nonetheless, no big changes are expected since neither the NDP nor the XVII Government program have major disagreements. The NDP 2017-2021 sets out three main development objectives for STP: (i) accelerate economic growth; (ii) poverty reduction; and (iii) environmental protection. Meanwhile, the XVII government program defines two main objectives for the country: (i) create the basic conditions to reach an average growth rate above 7 percent, sustained by private investment, electric power generation, and infrastructure development; and (ii) strengthen social cohesion by improving the effectiveness of the public sector. The XVII program is composed of four strategic axes and twenty-two strategic policies. The four axes are: (i) strengthen democracy and rule of law; (ii) achieve robust economic growth and increase job creation; (iii) improve the quality of health and SP; and (iv) implement a development-oriented foreign policy. The program’s strategic policies include measures to build solid institutions; a service-led growth model that is sustained by investment in human capital; a sound macroeconomic policy (e.g., fiscal consolidation, improvement in the business environment, and an increase in bank credit and microfinance); development of infrastructure (i.e., urbanization, energy, and water), and social assistance programs and a conditional cash transfer program (Rendimento Mínimo de Inserção Social). The XVII government program represents an improvement from previous plans, as it has a simpler structure and excludes highly ambitious infrastructure projects. Nonetheless, some ambitious aspirations remain, such as turning STP into a provider of financial and health services. The program, however, lacks bottom-up costing and a clear financing plan. 4. PROPOSED OPERATION 4.1. LINK TO GOVERNMENT PROGRAM AND OPERATION DESCRIPTION 31. The proposed operation aligns with the government´s objectives by supporting the second and third axis of the XVII government program. Specifically, the operation will support the government’s strategic policy objective of developing the financial sector by strengthening the BCSTP’s supervision and intervention capacity (Prior Action #1). It also includes measures to develop the national payment system, the microfinance sector, and the property registry system (Prior Actions #2, #3, and #4, respectively), which will support bank credit expansion and increase access to finance. Reforms of public water and Page 19 The World Bank THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING (P164321) energy utilities (Prior Actions #5, #6, and #7) also aim to leverage the development of infrastructure and improvement in the business environment. Moreover, DPO reforms will support the implementation of the government’s strategic policies related to fiscal consolidation through measures to implement the VAT (Prior Action #8). Finally, the proposed operation will support the government´s objectives to reduce poverty through the tracking of payments under SP programs (Prior Action #9). 32. The objective of the proposed DPO is to support the implementation of growth-enabling reforms in the financial sector, business environment, and infrastructure; generate fiscal resources and savings, and improve the quality of expenditures. These reforms will address the main obstacles to economic development in STP and are expected to promote financial development and inclusion, attract investors, develop more efficient and accessible infrastructure, and foster fiscal sustainability and private- sector-led growth in the medium term. The operation is organized around two pillars, each including several policy actions: Pillar A: Introduce growth-enabling reforms in the financial sector, business environment, and infrastructure. Policies under this pillar aim to support the BCSTP to effectively address vulnerabilities in the financial sector by improving bank supervision and financial soundness. They also aim to develop a national payment system and the microfinance sector, as well as improve the registry of properties, which will increase the availability of credit, accelerate financial inclusion, and improve the tourism sector. Additionally, Pillar A will support policies aimed at expanding infrastructures and improving public service delivery. Pillar B: Generate fiscal resources and savings and improve the quality of expenditures. This pillar includes policies aimed at strengthening fiscal sustainability and protecting poor and vulnerable households. Lessons Learned 33. The design of the proposed operation incorporates lessons learned from previous DPOs in STP. The three main lesson learned from the last DPO series were: (i) close and constant follow up with public authorities and development partners is crucial to obtaining accurate and timely information concerning government actions that affect macroeconomic stability; (ii) implementing agencies need the capacity to move forward and follow up on status indicators; and (iii) resource effectiveness needs to be improved. Based on these lessons learned and the increase in the World Bank’s budget allocation to STP, this DPO benefits from a potentially larger World Bank team focusing on STP and exploring synergies with other operations. The large resource envelope allowed the World Bank to conduct analyses and provide technical assistance (TA) that underpin and strengthen the DPO. Finally, this DPO will mainly work with agencies that were involved in the previous operation—such as the BCSTP, the Ministry of Finance, and the Minister of Employment and Social Action—and have a long experience working with the World Bank. 4.2. PRIOR ACTIONS, RESULTS AND ANALYTICAL UNDERPINNINGS 34. The policy matrix supported by this programmatic series has been modified to sharpen the focus on growth-enhancing reforms and strengthen the links between this proposed DPO and the World Bank’s support to the energy sector. This operation is also closely aligned with the recently concluded Country Economic Memorandum (CEM, 2019) that identified six key challenges for STP’s development, out of which four are addressed by this DPO: (i) the twin budget and current account deficits; (ii) credit constraints; (iii) uncertainty surrounding property rights and land tenure; and (iv) poor quality infrastructure. Page 20 The World Bank THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING (P164321) Table 4. Summary of Changes in Prior Actions from DPF 2 to DPF 3 Trigger Prior Action Explanation for Change In order to obtain more reliable The Recipient, through BCSTP, has The team decided to drop the second information on banks’ financial approved the Report for the STP part of the prior action on the soundness, the Recipient, through Banking System Asset Quality implementation of recommendation its Central Bank, has carried out a Review, as part of its efforts to of the AQR (on loan reclassifications, review of the quality of banking improve financial soundness of bank provisions) due to the time sector assets (Asset Quality Review- commercial banks. needed for the BCSTP to carry out AQR) and mandated banks to adjust this task in a satisfactory manner. Non-Performing Loans The implementation of the classification and provision recommendations of the AQR is accordingly. further a structural benchmark under the IMF program for end- 2019. In order to expand the range of Dropped. This prior action was assets that can be pledged by dropped since more time is required borrowers and strengthen the to coordinate this ambitious legal quality of collaterals, thereby change between the Ministry of improving access to credit, the Justice, central bank, and the agents Recipient has submitted to the involved. parliament a new law on guarantees that: (i) introduces the concept of a functional approach to secured transactions; (ii) widens the range of assets that can be used as collateral; and (ii) allows for the establishment of a movable collateral registry. In order to increase the Dropped. This prior action was information available to lenders dropped due to time required in for assessing borrower’s procuring the upgrades of the CRC. creditworthiness, which would improve access to credit, the Recipient, through its Central Bank, has improved the Public Credit Registry (Central de Registro de Crédito, CRC) by: (i) instituting back-up procedures; (ii) instituting real-time update procedures; and (iii) expanding the scope of information. In order to implement the key The Recipient, through BCSTP, has No changes. provisions of the microfinance law, passed key regulations which the Recipient, through its Central establish the minimum entry, Bank, has passed the regulations, operation requirements, risk which establish the supervisory management minimum and reporting procedures for requirements, and supervisory and microfinance institutions. reporting procedures for microfinance institutions. The Recipient, through: (i) its The new prior action guarantees the Page 21 The World Bank THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING (P164321) National Assembly, has passed the implementation of the new Payment legal framework for payment Services Law (SNP) that was services providers and payment supported under DPO2 and entered system operators, which outlines into force in November 2018. the oversight framework, and duties and powers of BCSTP; and (ii) BCSTP, has passed the key implementing regulations under the National Payments System Law, which provide for the legal protection of the electronic transfer of funds and the licensing and supervision of payment institutions and payment system operators The Recipient, through its Council The new prior action complements of Ministers, has approved the the implementation of the new institutional structure for enabling property registration code and public interoperability between the land notary code that was supported property register (Registo de under DPO2. These new codes laid Propriedade) and the cadaster the foundation for improvements (Registo Cadastral) and upgrades in the land registration system such as digital registries, interoperability, and joint titling. In order to allow for a more Dropped. The prior action was efficient and accurate billing and dropped due to delays in public reduce potential for tender for the metering system with underreporting of consumption, remote metering. The metering the Recipient, through EMAE, has system will be financed by the EIB. introduced a new remote metering system connected to the management system that will allow for automated metering and billing. In order to reduce arrears from The Recipient, through the The prior action was changed to the government to EMAE, the President of the Republic, has support measures that reduce Recipient has taken the following instituted an energy demand demand for energy and therefore actions: (i) condition the budget management program, which more immediately impact EMAE’s transfer to autonomous institutes includes the exchange of low performance. Reduction and on the timely payment of energy efficient bulbs with higher clearance of arrears are being bills; (ii) agree on payment plans efficient ones. supported through the for overdue energy bills for each implementation of EMAE’s MIP, the autonomous agency; and (iii) give increase of domestic revenue priority to energy bill payments mobilization and the increase in just after payroll and debt service. domestic fuel prices. In order to structurally reduce the The Recipient, through its Council The team added the approval of the cost of energy and promote long- of Ministers, has approved: (a) a MIP for EMAE in the prior action to term private investment, the Least-Cost Power Sector ensure high-level support for its Recipient, through its Council of Development Plan, which provides implementation. The MIP will help Ministers, has approved the Least- the basis for a competitive reduce non-technical losses and Cost Power Development Plan. process for all power generation improve billing and collection, which Page 22 The World Bank THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING (P164321) activities; and (b) a Management is key to setting the power sector on Improvement Plan for EMAE, a more sustainable path in the which aims to improve EMAE’s medium term. operational performance. In order to improve the quality of The Recipient, through AGER, has No changes. service, the Recipient, through signed a concession contract with AGER, has signed a concession EMAE, which stipulates the contract with EMAE including all obligations of the Recipient and the company’s obligations including the licensee, including rules on rules on tariffs and sanctions. tariffs and sanctions. In order to broaden the tax base The Recipient, through the The prior action was strengthened to and generate more own-source National Assembly, has passed the reflect the criticality of having the revenues, the Recipient has Value Added Tax Code, which sets law approved rather than only submitted to parliament a draft forth provisions aimed at submitted to parliament. law to implement a VAT. broadening the tax base and generating more own-source revenues. In order to improve accountability Dropped. The World Bank of the SOE management, the Institutional Capacity Building Recipient, through its Council of Project (ICBP) provides support for Ministers, has established a the implementation of the SOE performance monitoring system reform plan, the first step being the with financial and non-financial hiring of an advisor to support the targets for all SOEs, with clear implementation of the plan, incentives for compliance. including the establishment of a performance monitoring system. SOE sector reform is critical, and the government’s commitment for the continuation of the reform is outlined in the letter of development policy. In order to increase transparency Dropped. This prior action was and ensure accuracy of SOE’s dropped in an effort to streamline financial position, the Recipient the matrix; this reform is also has published accounts audited by supported by the ICBP and the World an external and independent Bank team has received pre-audits auditing company for its main (audit reports done by external public owned SOEs (EMAE, ENASA auditors, but without an opinion and ENAPORT). from the accountant) for all SOEs. In order to improve selection of Dropped. Work on public investment public investment projects, the management (PIM) is supported by Recipient, through its Council of World Bank TA through the Korean Ministers, has established a Trust Fund and the Institutional National Investment Portfolio Capacity Building Project. Through Database, (Carteira Nacional de the TA, the authorities and DPO team Projectos, NIPD) to serve as the realized that there is a need to pass a single source for public investment law before implementing the NIPD: a projects, from which all public law on the National Public investment projects will have to be Investment System (Sistema Page 23 The World Bank THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING (P164321) sourced to be executed through Nacional de Investimento Público, the Public Investment Program SNIP). This prior action has been (Programa de Investimentos dropped since the submission/ Públicos). passing of the law will require more time. The government’s commitment to SOE reform is outlined in the letter of development policy. In order to allow for tracking and The Recipient, through the Ministry No changes. reconciliation of funds allocated to of Finance, has instituted a financial SP payments, the Recipient has system-based (non-cash) payment instituted a predominantly mechanism to allow for the tracking financial system-based formal and reconciliation of funds payment mechanism for SP allocated to SP payments. programs. Table 5. Summary of Changes in Results Framework from DPF 2 to DPF 3 Previous results indicator Current results indicator Explanation for Change Result Indicator 1: Number of banks Result Indicator 1: Number of banks No changes. below the Central Bank’s minimum below the Central Bank’s minimum Capital Adequacy Ratio (12 percent) Capital Adequacy Ratio. (12 Baseline (2015): 3 percent) Target (2020): 0 Baseline (2015): 3 Target (2020): 0 Result Indicator 2: Score on Doing Dropped. This results indicator was Business indicator “Getting Credit”. dropped since the corresponding Baseline (2015): 0 out of 20 prior action (law on secured Target (2020): 10 out of 20 transactions) was also dropped. The team and the client agreed that stakeholders needed more time to understand the implications of the law. Result Indicator 3: Result Indicator 2: Share of the The baseline and the target were Share of the population with access population with access to formal changed to reflect the findings of to formal financial services (e.g. financial services (e.g. bank recently conducted financial bank accounts). accounts). inclusion survey. The previous results Baseline (2015): 53 percent Baseline (2015): 39 percent indicators were based on Target (2020): 65 percent Target (2020): 45 percent administrative data, that were found to have overestimated financial inclusion. The new target is ambitious yet feasible and takes into account the recent trends in access and the long gestation for reforms to be implemented. Page 24 The World Bank THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING (P164321) Result Indicator 4: Share of real Result Indicator 3: Share of real The target was slightly reduced to estate properties and mortgages estate properties and mortgages take into account the actual pace of registered and digitized in the registered and digitized in the digitalization at the Public Notary Public Notary Registry. Public Notary Registry. Registry. Baseline (2015): 0 Baseline (2015): 0 percent Target (2020): 90 percent. Target (2020): 70 percent. Results Indicator 5: EMAE’s non- Result Indicator 4: EMAE’s The new results indicator will technical losses. operational profit/ loss (in millions capture the impact of short-term Baseline (2015): 26.4 percent LCU). measures to improve the financial Target (2020): 23.8 percent Baseline (2015): - 224.9 million LCU standing of EMAE (contain losses, Intermediate (2017): 23 percent Target (2020): -194.7 million LCU avoid new arrears, introduce energy Results Indicator 6: Amount of saving measures), including the Public Sector Arrears to EMAE. demand side measures (PA#5) and Baseline (2015): 36.4 billion the approval of the MIP (PA#6). It is Target (2020): 12 billion a very challenging target based on experience from utility reforms implemented in the past in SSA and other regions. Results Indicator 7: Energy cost of Dropped. The World Bank Power production Sector Recovery Project supports a Baseline (2015): 8,545.22 STD/Kwh long-term structural improvement of Target (2020): 8,300.00 STD/Kwh the energy sector, including a reduction in the energy production costs. The reduction in overall generation cost is, however, not feasible before 2020. Result Indicator 8: Number of Result Indicator 5: Number of No changes. complaints received by EMAE complaints received by EMAE. Baseline (2015): 6,542 Baseline (2015): 6,542 Target (2020): 3,000 Target (2020): 3,000 Result Indicator 9: Tax revenues (as Result Indicator 6: Tax revenues Revenues from custom duties on oil a share of GDP) except custom duties on oil (in were excluded due to their volatility Baseline (2015): 14.6 percent millions LCU). and the fact that the DPO-supported Target (2020): 15.8 percent Baseline (2015): 831.1 million LCU revenue measures do not impact Target (2020): 1050.0 million LCU custom duties on oil. Also, the indicator is in nominal LCU to isolate from GDP swings. Result Indicator 10: Percentage of Result Indicator 7: Number of SOEs’ The results indicator was changed to performance targets achieved – performance monitoring systems in accommodate the delay in average for SOEs. place. implementing the SOE reform plan, Baseline (2015): N.A. Baseline (2015): 0 as a result of the change in Target (2020): 50 percent Target (2020): 2 government and represents a coverage of 50 percent of the SOE sector. Result Indicator 11: Share of Result Indicator 8: Share of ongoing Small change in target to ongoing and finalized projects with and finalized projects with basic accommodate for eventual technical basic information included in the information included in the difficulties to reach 100 percent. National Investment Portfolio National Investment Portfolio Database. Database. Page 25 The World Bank THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING (P164321) Baseline (2015): 0 Baseline (2015): 0 percent Target (2020): 100 percent Target (2020): 95 percent Result Indicator 12: Number of Result Indicator 9: Number of No changes. beneficiaries enrolled in the three beneficiaries enrolled in the three core SP programs and receiving core SP programs and receiving regular payments as set in law. regular payments as set in law. Baseline (2015): 0 Baseline (2015): 0 Target (2020): 4,000 (out of which Target (2020): 4,000 (of which 50 50 percent has received payments percent has received payments through the formal financial through the formal financial system). system). 35. While the results are expected to be achieved only in 2020, some results indicators have shown considerable progress. In 2019, the BCSTP reported that all banks were above the minimum capital adequacy ratio. Following an effort to install meters in residencies, the number of complaints to EMAE dropped to less than 4,000 in 2018. Finally, the government has registered almost 90 percent of the target population for the core SP programs. Pillar A: Introduce growth-enabling reforms in the financial sector, business environment, and infrastructure Objective A.1. Introduce growth-enabling reforms in the financial sector and business environment 36. STP’s financial sector has persistently faced multiple vulnerabilities, including high levels of NPLs, a concentration of loan portfolios, foreign exchange shortages, and a deficient credit infrastructure. NPLs totaled 24.6 percent of all bank loans in December 2018, despite declining from a peak of 29.8 percent in 2015. A high level of NPLs and a lack of business opportunities8 have lowered banks’ profitability and constrained their ability to generate internal capital. For example, only one in five banks were profitable as of June 2018. Due to the small size of the economy, a few clients represent a large portion of loan portfolios, exposing banks to liquidity and solvency risks in case of default. The banking sector is concentrated but it is a structural feature of the financial systems in small economies, and the concentration is not in itself a binding constraint. Moreover, shortages of foreign exchange continue to constrain the ability of banks to engage in international trade and foreign exchange trading, which are usually significant sources of income and profitability. Finally, a costly and uncertain enforcement of loan agreements and collateral due to an inefficient court system and the absence of alternative dispute resolution mechanisms continue to be a burden on banks, which partly explains their reluctance to lend and inability to resolve NPLs. The financial sector reform in STP initiated with a financial sector development strategy, financed by a TA from the FIRST Initiative, which continued to support financial sector reform in STP in the three areas supported by this DPO series: financial sector supervision, payments systems, and microfinance. 8Regional banks entered the STP market between 2000 and 2013 amid expectations of potential of offshore oil revenue and expanding business opportunities that did not materialize. Page 26 The World Bank THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING (P164321) PA#1: Financial sector supervision Rationale 37. Improving the regulation, supervision, and resolution of banks is key to reduce financial sector vulnerabilities and for enabling the banking sector to support economic growth. Only well-supervised and capitalized banks can efficiently mobilize and allocate savings to productive investments, while providing other critical financial services such as payments. A high level of NPLs has been a drag on lending, as it has reduced bank incentives to assume more risk. Reducing vulnerabilities and increasing the soundness of banks will require not only efficient regulations and supervision to ensure that banks operate prudently but also a strong resolution framework to facilitate the orderly exit of failed banks. 38. The government has implemented various measures to enhance the stability of the financial sector and enable it to contribute to economic growth. Policymakers in STP passed a new banking resolution law in 2017, which gave the BCSTP ample powers and tools to resolve distressed financial institutions in timely and orderly manner. They also adopted complementary regulations to be applied in the resolution of failing financial institutions and in preparation and adoption of recovery plans by banks. In addition, the BCSTP has finalized a resolution manual to facilitate the implementation of the new legal and regulatory framework for the financial sector. Moreover, the authorities are revising the BCSTP law and the financial institutions law, among other laws, to ensure their alignment with the resolution law. They also plan to upgrade the credit registry, with support from the ICBP to improve the quality and scope of information to facilitate banks’ risk management. With support from the IMF, the BCSTP is also strengthening its supervisory framework through the introduction of risk-based supervision mechanisms, and it is encouraging banks to step up their loan recovery efforts. 39. Previous reforms in STP have provided the BCSTP with the tools needed to conduct effective bank supervision and resolution. In 2015, authorities initiated an ambitious reform program to strengthen financial stability, with TA from the IMF and World Bank. This DPO series supported the passage of the country’s banking resolution law, which gave the BCSTP the power and authority to deal effectively with distressed financial institutions by facilitating early intervention and providing additional policy instruments to address vulnerabilities (Prior Action #1 for DPF1). Following the passage of the resolution law, authorities issued regulations on two key provisions of the law: (i) bank resolution measures (i.e., bank sale, recapitalization, and unilateral merger); and (ii) the minimum content of the bank recovery and reorganization plan (Prior Action #1 for DPF2). The BCSTP used the new framework to initiate the resolution of two banks, mitigating immediate risks to financial stability. DPF 1 Prior Action #1: The Recipient, through its National Assembly, has approved a banking resolution law (Medidas Especiais de Saneamento, Resolução e Liquidação de Instituções Bancárias) that provides the Central Bank with the power and authority necessary to deal effectively with distressed financial institutions by facilitating early intervention and providing additional policy instruments to address vulnerabilities. DPF 2 Prior Action #1: In order to strengthen the bank resolution framework, the Recipient, through its BCSTP, has adopted regulations implementing the Recipient’s financial institutions resolution law, which set out: (i) the measures to be applied by the BCSTP in the resolution of distressed financial institutions; and (ii) the requirements for the elaboration and adoption of recovery and resolution plans. DPF 3 Prior Action #1: The Recipient, through BCSTP, has approved the Report for the São Tomé and Page 27 The World Bank THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING (P164321) Príncipe Banking System Asset Quality Review, as part of its efforts to improve financial soundness of commercial banks. Results Indicator #1: Number of banks below the Central Bank’s minimum Capital Adequacy Ratio (12 percent). Baseline (2015): 3. Target (2020): 0 Substance and criticality 40. The AQR is critical to financial sector stability because it exposes gaps in loan classification and provision, determines the need for bank recapitalization, and identifies supervisory gaps. This operation supports the completion of an AQR to help the BCSTP obtain more reliable information on banks’ financial soundness (Prior Action #1 for DPF 3). Funded by the ICBP, the AQR took stock of banks’ asset classification and provisioning practices, identified deviations from BCSTP’s guidelines and international norms, and recommended necessary adjustments to ensure compliance. The AQR also determined shortfalls in loan losses provisioning and capital levels. Where applicable, the BCSTP will require banks to reclassify loans, make additional provisions, and develop recapitalization plans to ensure compliance with minimum requirements. Recapitalizations will be key to ensuring that the AQR effectively contributes to the soundness and stability of STP’s financial sector. Moreover, the findings of the AQR will inform the development of plans to close supervisory gaps, such as limited enforcement of prudential norms and weaknesses in banks’ risk management practices and internal controls. While the BCSTP has yet to finalize an action plan to guide the implementation of the recommendations of the AQR, banks have already reclassified some loans and increased provisions, following BSTP’s instructions based on the AQR findings. The BCSTP is also discussing the adoption of the AQR methodology to value collateral of loans – mainly real estate – in a phased manner. The World Bank and IMF are supporting the BCSTP with TA on the implementation of all the findings and recommendations of the AQR, which is a structural benchmark under the IMF program for end-2019. 41. The expected result from these reforms is to have all banks comply with the minimum capital adequacy ratio. The reforms supported by this operation aim to enhance the stability of the banking sector. In particular, the AQR will propose adjustments to banks’ provisioning levels and capital positions, and in case of capital shortfalls, the BCSTP will require banks to recapitalize to be in compliance with the minimum capital requirements. In tandem, the resolution framework already allows the BCSTP to resolve problem banks and protect depositors. The DPO’s reforms will be evaluated by the number of banks below the minimum capital adequacy ratio of 12 percent (Results Indicator #1). PA#2: Payment systems Rationale 42. The deficient payment infrastructure in STP constrains economic development, especially in the tourism industry. The country’s limited payment infrastructure and access channels limit the access to payment services— in particular, in rural areas and on the island of Príncipe, including the payment and collection of taxes, the payment of utility bills and wages, and disbursement of welfare benefits. The current payment infrastructure is not reliable – employees spend most of their time fixing manually problems created by system errors – and therefore bank cards and electronic transactions are used less and less in STP. The African Development Bank (AfDB)is financing an upgrade of the payment system, but the project is severely delayed, and thus the payment system remains a major constraint. The absence of an adequate national payment infrastructure (comprising all the relevant clearing, switching, and settlement systems), the lack of connectivity of the local payment system with international card Page 28 The World Bank THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING (P164321) networks (e.g., VISA, Mastercard, etc.)9, and the high costs of international transactions significantly impair economic activity. This is especially relevant for the development of the tourism sector since tourists cannot use their international credit cards in STP, restricting the revenues generated by the tourism activity in the country. 43. Mobile payment services in STP are extremely underdeveloped, underscoring the need for the recently concluded update of the legal and regulatory framework, increasing capacity, and upgrading the payment infrastructure. Current electronic retail payment instruments rely on banks and bank accounts. Mobile phone coverage is available in all seven districts, access to mobile cellular phones increased from 58 phones per 100 people in 2010 to 91 phones in 2017, and the number of internet users as a percentage of the total population increased from 19 percent to about 28 percent in the same period.10 However,11 there are currently no mobile payment products available to unbanked clients in STP. Payment system reforms aim to support the development of payment solutions and attract private investments for mobile service providers and new products and services. 44. The approval of the new payment service law, the creation of the new directorate, and reforms supported under previous DPOs marked the initial steps in establishing an efficient, safe, reliable, and modern national payment system. As a first step in the reform process, the BCSTP has created, operationalized, and staffed a new directorate (Direção de Sistemas de Pagamento) to better align the mandate and responsibilities of the payment systems oversight team at the BCSTP with international standards and best practices, in particular the CPMI-IOSCO Principles for Financial Markets Infrastructures (Prior Action #2 for DPF1). The role of the restructured department is to oversee the development and supervision of new non-bank payment services providers (payment institutions), as well as new retail payments products and services. The government submitted to the parliament a new Payment Services Law (RJSNP) that was approved by Parliament on November 2018. The RJSNP (Prior Action #3 for DPF 2) provided a comprehensive framework for payment services, including clear rules for the provision of payment services, operation of payment systems, and market entry. The RJSNP also grants BCSTP adequate powers and tools for effective oversight and supervision of the financial sector; it also promotes competition by allowing the entry of new payment service providers in the market, such as payment institutions and the use of agent networks. DPF 1 Prior Action #2: The Recipient, through its Central Bank, has created, operationalized and staffed a new directorate (Direcção de Sistemas de Pagamentos) to consolidate in the same unit all responsibilities related to oversight, policy formulation and development of the national payment system. DPF 2 Prior Action #3: In order to expand the outreach of the banking system and support financial inclusion through the usage of mobile financial services, the Recipient, through its Council of Ministers, has approved and submitted to the Parliament the proposed National Payment Systems Law, which sets forth the statutory level principles for regulation on modern payment methods, such as agent banking, mobile money, and electronic payments. 9 The World Bank and the AfDB are supporting the technical work and financing the purchase of equipment needed to modernize the national payment system and its connection with the international credit card network. 10 IEG Project Performance Assessment Report Cameroon, Chad, Central African Republic, São Tomé e Príncipe: Internet and Mobile Connectivity. Central African Backbone Program (APL 1A and APL 2), June 4, 2018. 11 IEG Project Performance Assessment Report Cameroon, Chad, Central African Republic, São Tomé e Príncipe: Internet and Mobile Connectivity. Central African Backbone Program (APL 1A and APL 2), June 4, 2018. Page 29 The World Bank THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING (P164321) DPF 3 Prior Action #2: The Recipient through: (i) its National Assembly, has passed the legal framework for payment services providers and payment system operators, which outlines the oversight framework, and duties and powers of BCSTP; and (ii) BCSTP, has passed the key implementing regulations under the National Payments System Law, which provide for the legal protection of the electronic transfer of funds and the licensing and supervision of payment institutions and payment system operators. Results Indicator #2: Share of the population with access to formal financial services (e.g. bank accounts). Baseline (2017): 39 percent. Target (2020): 45 percent. Substance and criticality 45. A safe and efficient national payment system, combined with a sound legal and regulatory framework, is critical for economic development, as it allows for greater competition, cost reduction, and a wider choice for end users by offering a broader scope of payment instruments and channels. The World Bank, under the FIRST Project, has worked closely with the BCSTP to develop all supporting regulatory framework for the RJSNP, namely the Decree-Law on the Legal Framework on Payment Services Providers and System Operators and regulations (Norma de Aplicação Permanente, NAP) on Electronic Fund Transfers (Prior Action #3 for DPF3) and on authorization of payment institutions (such as mobile payments providers) and operators, as well as the activation of the National Payments Council. 12 Improving the existing national card switch and associated infrastructure is a priority to preserve and enhance public trust in the use of electronic payment instruments. This will facilitate future introduction of other solutions in mobile financial services with potential for financial inclusion of the unbanked in both rural and urban areas. 46. A modern national payment system will yield several benefits including on financial inclusion, social safety nets, digital economy, and tax collection. Beyond supporting financial inclusion, a safe and efficient national payment system is the backbone of the financial sector and is critical to financial stability and economic growth. It is also a pre-requisite for the digital economy, facilitates tax collection and the application of Anti-Money Laundering/ Combating the Financing of Terrorism (AML/CFT) and anti- corruption laws. Furthermore, SP programs of the GoSTP would benefit from an efficient national payment system and increased use of electronic payment instruments as they enable better identification of beneficiaries, faster and more efficient payment execution, and easier and safer access to benefits. Expected results of this reform will be measured jointly with the Prior Action #2 on the microfinance law, please see below (Results Indicator #2). The team will also try to isolate and report on the effect of improved payment system infrastructure on tourism exports from the Balance of Payments data. PA#3: Financial inclusion Rationale 47. There is a small unregulated microfinance sector in STP that, if well regulated, could contribute to expanding access to finance. Few informal lenders currently provide short-term, high-interest loans, but these are not under the supervision of the BCSTP. While these institutions could provide valuable 12National Payment Councils are an internationally recognized best practice and have been implemented in many countries. The NPC would bring together a broad range of relevant actors from public and private sides, including representatives of payment services users and providers (banks but also future non-banks providing payment services), various BCSTP Departments, Telecom Regulator, SPAUT- current Switch Operator, and other relevant authorities. This would ensure effective mobilization and commitment around common goals, and effective consultation of all relevant parties. Page 30 The World Bank THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING (P164321) services to people who do not normally have access to bank credit or savings, they could also harm consumers by not following good business practices and adopting abusive sales and debt collection strategies that take advantage of clients. Therefore, the BCSTP is seeking to regulate this emerging industry and formalize microfinance providers. Establishing a legal, regulatory, and supervisory framework for microfinance, together with reforms already underway for modernizing the national payment system and strengthening the banking sector, could improve the overall stability, integrity, and development of STP’s financial sector and protect the rights of consumers. The government approved in 2018 the first law on microfinance (Prior Action #2 for DPF2). DPF 1 Prior Action #2: The Recipient, through its Central Bank, has created, operationalized and staffed a new directorate (Direcção de Sistemas de Pagamentos) to consolidate in the same unit all responsibilities related to oversight, policy formulation and development of the national payment system. DPF 2 Prior Action #2: In order to develop the microfinance sector and promote the offer of microfinance services, the Recipient, through its Council of Ministers, has approved and submitted to Recipient’s Parliament a draft law on microfinance. DPF 3 Prior Action #3: The Recipient, through BCSTP, has passed key regulations, which establish the minimum entry, operation requirements, risk management minimum requirements, and supervisory and reporting procedures for microfinance institutions. Results Indicator #2: Share of the population with access to formal financial services (e.g. bank accounts). Baseline (2017): 39 percent. Target (2020): 45 percent Substance and criticality 48. The upgrade of the payment infrastructure is not sufficient to increase access to finance - proper regulation of the microfinance sector is also critical for access to finance . Due to the underdeveloped payments system infrastructure, policy initiatives in support of financial inclusion depend on reforms to improve and modernize the current infrastructure, strengthen and improve the legal and regulatory framework with the objective to promote the entry of new payment service providers, use of alternative channels, promote digital retail payments, and improve consumer protection and financial literacy. Proper regulation including on consumer protection is needed to support the development of the microfinance sector and increase access to finance. This operation now supports the implementing regulation - supervision and reporting requirements for microfinance institutions (Prior Action #3 for DPF3). As for the payments area, the World Bank FIRST project has provided extensive TA for review of legal framework for payments. 49. Support for the implementation of a new national payment system and microfinance law, which has been recently approved, will yield several benefits including on financial inclusion, social safety nets, digital economy, and tax collection. The expected results are an increase in the quality and quantity of payment services provided by banks and the entry in the market of new payment service providers, increasing competition and offer of new digital financial services. The new landscape will meet the needs of the banked and unbanked population, particularly in terms of affordability and accessibility. This will promote financial inclusion, allow for the growth in tourism and tourism revenues, and support economic transactions and the digital economy. This set of reforms will be evaluated by the share of the adult population with access to formal financial services (e.g. transaction accounts) (Results Indicator #2). Page 31 The World Bank THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING (P164321) PA#4: Business environment and property registry Rationale 50. The absence of a functioning land information system in STP constitutes a major constraint on the government to perform sustainable land governance operations. The possibility to record, store, and manage data related to land is essential for land governance efforts.13 The government needs access to accurate and updated land information to assign and protect land rights, value and tax property, manage the use of resources, and implement dispute resolution mechanisms, all of which are essential objectives of sustainable land governance. A lack of access to land information also hinders the emergence of functioning land markets, which hampers private investment in land-related sectors. 51. The country’s property registries and cadasters are deficient and outdated, and there is no unique identification number for land parcels, which prevents the existence of an interoperable information system. Property registries in STP are paper-based and require manual bookkeeping, increasing errors and generating risks in terms of security, transparency, and legal certainty. Land transactions, including cadaster and property registration functions, are distributed among various government agencies, reducing the efficiency in data production processes and affecting the quality of information. Finally, the country’s land information systems lack a unique identification number, preventing their interoperability with other systems like the tax registry, rendering all land management efforts inefficient. The lack of interoperability of the country’s information systems results in data fragmentation and increased transaction costs, prevents economies of scale, and affects the quality of information to inform policy formulation. 52. The GoSTP has made efforts to reduce the cost of registering properties and mortgages and improve the effectiveness of land information systems to improve the business environment. Under this DPO series, the bank has supported the government in reducing the cost of registering mortgages (DPF 1 Prior Action #3) and reviewing and approving a new property registration code and public notary code (DPF 2 Prior Action #4). These new codes laid the foundation for upgrading land registration systems, such as digital registries, improving the interoperability of databases, and allowing joint titling. DPF 1 Prior Action #3: The Recipient, through its Council of Ministers (Conselho de Ministros), has reduced legal fees (i.e. taxes and registry fees) associated with the registry of mortgages. DPF 2 Prior Action #4: In order to reduce costs and simplify procedures to register property, therefore improving its ability to serve as loan collateral and foster access to finance, the Recipient, through the Council of Ministers, has approved and submitted to the recipient’s Parliament (i) the proposed Property Registration Code; and (ii) the proposed Public Notary Code. DPF 3 Prior Action #4: The Recipient, through its Council of Ministers, has approved the institutional structure for enabling interoperability between the land property register (Registo de Propriedade) and the cadaster (Registo Cadastral). Results Indicator #3: Share of real estate properties and mortgages registered and digitized in the Public 13See: Food and Agriculture Organization of The United Nations (FAO) (2012). Voluntary Guidelines on the Responsible Governance of Tenure of Land, Fisheries and Forests in the Context of National Food Security. Rome and; Deininger, Klaus; Harris Selod, and Anthony Burns (2012). The Land Governance Assessment Framework Identifying and Monitoring Good Practice in the Land Sector. World Bank, Washington DC. Page 32 The World Bank THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING (P164321) Notary Registry. Baseline (2015): 0. Target (2020): 70 percent. Substance and criticality 53. The third operation supports the first steps toward the interoperability of the country’s land information systems14 (DPF 3 Prior Action #4). This will be ensured by the creation of a cadaster and registry technical committee, comprised of the General Directorate for National Registry and the Direction of Geographical and Cadastral Services, to foster collaboration around land transactions and property demarcation and registration, as well as facilitate periodic meetings to resolve operational bottlenecks. 54. Expected results include an improvement in the effectiveness of property registration. Results will be measured by the share of real estate properties and mortgages registered and digitized in the new public notary registry (Results Indicator #3). Objective A.2. Introduce growth-enabling reforms in the infrastructure sector 55. STP’s energy supply does not meet its demand15 and is unreliable16 and costly. As a result, the electricity grid suffers from frequent outages, especially during periods of peak demand. The fragility of the energy sector became evident in 2018, when a combination of an expanded power grid and generator capacity based on inadequate planning and maintenance led to an energy crisis that cut supply by as much as 75 percent. STP has the third-highest energy supply costs in SSA.17 This is partly due to challenges faced by energy systems in small island countries, including small-scale operations and a lack of interconnectivity between systems due to insularity. However, STP’s energy sector also suffers from an outdated transmission and distribution system, an energy generation mix highly dependent on costly fuel and difficulties in managing the EMAE. Moreover, most of the country’s energy comes from low-efficiency thermal generators, leading to high fuel consumption and aggravating the structurally high cost of energy. 56. EMAE is financially unsustainable, has historically underinvested in maintenance, and has large payment arrears with fuel supplier. Despite high energy tariffs, the EMAE is not able to recover its costs; the average cost of service (0.27 US$/KWh) is above the average tariff (0.23 US$/KWh).18 As a result, the EMAE’s own capital is negative at €63 million in 2018 and its costs exceeded revenues by €11 million in 2018—equivalent to 3.1 percent of GDP. Faced with insufficient tariff revenue, the EMAE has been unable to honor payment agreements and has accumulated arrears with suppliers, especially the fuel supplier, ENCO, in the amount of €91 million—approximately 23 percent of GDP. In addition, a lack of financial resources has prevented the EMAE from properly maintaining its assets, resulting in a degradation and 14 Currently, there are two main cadasters: the property registry at the Ministry of Justice and the land registry at the Ministry of Infrastructure, with no correspondence between them. 15 The total nominal installed capacity in the country is 30 MW, but only 15 MW is guaranteed. The energy mix consist of diesel- fueled generators (95 percent), with the remaining energy coming from a hydropower plant (around 1.9 MW). 16 There are no available statistics on standard industry measures for energy interruptions, but the index on reliability of supply and transparency of tariff from the Doing Business survey is zero in STP. 17 STP has third highest cost of electricity service in 2014 U.S. dollars per kWh billed after Comoros and Sierra Leone. Operating costs of power utilities in SSA are twenty times higher in island countries than in non-island countries, and that operating costs for small systems (less than 150 MW) are six times higher than for larger systems (>1000 MW). Source: Trimble, Chris et al. “Financial Viability of Electricity Sectors in Sub-Saharan Africa: Quasi-Fiscal Deficits and Hidden Costs” World Bank Policy Research Working Paper 7788, The World Bank Group, Washington D.C: 2016. 18 Based on EMAE 2017 figures. Page 33 The World Bank THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING (P164321) loss of assets, low-quality services, and high customer dissatisfaction. The major commercial challenges faced by the EMAE include inadequate metering and billing and overdue bills from public and private clients. Client arrears reached €12.6 million in 2018—equivalent to 92 percent of the EMAE’s annual revenue in the same year.19 PA#5: EMAE’s commercial losses Rationale 57. The EMAE could significantly improve its finances through reducing commercial (non-technical) losses. Commercial losses are significant in the EMAE. Total transmission and distribution losses (T&D losses), which are comprised of technical and commercial losses, amount to 34 percent (vis-à-vis 15 percent from comparators20), of which 23 are commercial. Commercial losses in the EMAE are caused by underpricing, inefficient billing and collection (bill collection rate at 89 percent, vis-à-vis 93 percent from comparators21) and large payment arrears from clients, over-staffing, electricity and diesel theft. 58. This DPO series supports EMAE’s efforts to improve energy billing and collection, to reduce commercial losses, and to generate more revenue. The first measure to improve its billing and collection was the introduction of a revised system of prepaid energy services that allows for accurate metering and invoicing (DPF 1 Prior Action #4), followed by a campaign to raise public awareness of the importance of paying energy bills on time to avoid service disconnection (DPF 2 Prior Action #5). The electricity utility is also addressing arrears accumulated by the government, its largest client. Public clients pay the highest energy tariff, they make up 36 percent of the EMAE’s revenues and 50.3 percent of bills in arrears. A metering campaign will be rolled out in January 2020, with the aim to better monitor actual consumption of public customers and the possibility to implement cutting off policy for nonpayment. The GoSTP has concluded an inventory of its energy and water bills and is working on a new arrear settlement plan with the EMAE. DPF 1 Prior Action #4: The Recipient, through EMAE, has introduced a revised system of pre-paid energy services that will allow for accurate consumption metering and invoicing, as well as eliminating the risk of non-payment. DPF 2 Prior Action #5: In order to promote transparency and incentivize timely payments, the Recipient, through EMAE, has published its policy to improve billing collection and launched a public awareness campaign through public TV and radio. DPF 3 Prior Action #5: The Recipient, through the Presidency of the Republic, has instituted an energy demand management program, which includes the exchange of low efficient bulbs with higher efficient ones. Result Indicator #4: EMAE’s operational profit/ loss (in million LCU). Baseline (2015): - 224.9 million LCU. Target (2020): -194.7 million LCU. 19 Please refer to Box 1 on the energy sector and reforms at EMAE in the macroeconomic policy framework section for more financial and operational information on the EMAE. 20 Weighted average value across 39 SSA countries. 21 Median value across 39 SSA countries. Page 34 The World Bank THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING (P164321) Substance and criticality 59. The third operation supports energy efficiency measures to reduce overall electricity consumption and therefore reduce EMAE’s losses. Electricity DSM – measures that seek to manage or decrease overall electricity consumption – can have significant economic, reliability and environmental benefits, while reducing the overall electricity system expenditures. Since EMAE is a loss-making SOE, less energy demand means reduced losses in the EMAE. An electricity demand study for STP showed that 68 percent of the evening peak demand is related to residential consumption, of which lighting accounts for about 70 percent. As of today, lighting requirements are mainly met by inefficient incandescent lighting (used by 74 percent of households), or moderately efficient compact fluorescent lamp bulbs (29 percent of households). 60. The energy demand program will promote the adoption of more efficient lighting and gradually ban the import of less efficient ones. The government will implement a DSM program that exchanges inefficient lighting with more efficient LED bulbs for residential consumers at no additional cost ( DPF 3, Prior Action #5). Under this program each household will be giving LED lamps in exchange for the return of low-efficient incandescent light, which will be discarded according to good environmental practices. The program will also gradually ban the importation and use of low energy-efficient incandescent lamps in order to ensure sustainability of the gains over time, which is a structural benchmark in the IMF program. This is expected to significantly reduce peak demand as well as overall electricity demand. Considering a reduction in peak demand only, the annual electricity demand could be reduced by about 10 percent, which is close to the annual demand growth (7 percent). The DSM program would also reduce energy consumption and bills of residential customers, and thus mitigate the risk of new arrears accumulation. The light bulb exchange will take nine months, will be completed in 2020 and be financed by grants. It will also be designed in way to ensure that poor households benefit equitably from it and will include a sensitization strategy to promote energy efficiency and use of low consumption LED lights. 61. Expected results include an improvement in EMAE’s operational results. The DSM program is expected to reduce the electricity system expenditures for the EMAE. This should in turn reduce commercial losses and improve the EMAEs operational result (Results Indicator #4). PA#6: Energy planning Rationale 62. The high cost and unreliable supply of energy are the direct result of insufficient planning in the expansion of the system by EMAE. Historically, the EMAE has based investment decisions on the availability of financing and equipment for quick deployment, rather than on long-term environmental and cost considerations. This has resulted in an inefficient and fragmented energy system with high production costs. Moreover, the energy sector suffers from various management problems at the EMAE, including inefficient billing and collection systems, the absence of an integrated management system, a lack of consistent accounting practices, and non-existent internal control mechanisms.22 The second operation addressed this lack of planning by binding any power generation decision to the LCPDP (DPF2 Prior Action#6). 22For instance, the pre-audit report commissioned in 2018 showed that some accounts in EMAE’s balance sheet could not be reconciled. Also, some wages and benefit payments were not recorded through the payroll system, thus circumventing internal control mechanism. Page 35 The World Bank THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING (P164321) DPF 2 Prior Action #6: In order to structurally reduce the cost of energy, increase the share of renewable sources, and promote long-term private investment, the Recipient, through its Council of Ministers, has ruled that any capacity expansion of the power sector will have to follow the prescriptions of the integrated Least-Cost Power Development Plan, and that any exception would need to obtain the approval of the Recipient’s Minister of Infrastructure, who shall have to provide the rationale for such exemption and publish said decision. DPF 3 Prior Action #6: The Recipient, through its Council of Ministers, has approved: (a) a Least-Cost Power Sector Development Plan, which provides the basis for a competitive process for all power generation activities; and (b) a Management Improvement Plan for EMAE, which aims to improve EMAE’s operational performance. Results Indicator #4: EMAE’s operational profit/ loss (in million LCU). Baseline (2015): - 224.9 million LCU. Target (2020): -194.7 million LCU. Substance and criticality 63. Better energy sector planning and management at the EMAE are critical to reduce energy costs, improve the reliability of the country’s energy supply in the long term, and reduce commercial losses. This DPO series, together with the Power Sector Recovery Project (PRSP), has been supporting better sector planning and management at the EMAE. The LCPDP is a planning mechanism that selects the optimal combination of power generation and transmission at the lowest cost, while complying with reliability standards and other policy commitments, such as environmental standards and the target to generate at least half of the energy supply from renewable sources. Since its approval, the LCDP has been the basis for discussions with various donors and private players on options for long term generation capacity addition in STP. 64. Inefficiencies at the EMAE will be addressed by the Management Improvement Plan (MIP). The MIP, which was supported through the World Bank’s PRSP, assessed the EMAE’s business processes with the objective to improve efficiency, transparency and accountability in operations in all business areas. The MIP provides detailed action plans for the reduction of commercial losses, including for the establishment of a loss reduction unit to address payment arrears; and the modernization of billing and installation of pre-paid and smart meters. The MIP suggests specific key performance indicators (KPIs)to monitor and evaluate the implementation of the plan. One main activity from the MIP, which already being implemented is the recruitment of an HR firm to competitively recruit all directors working under the EMAE CEO, based on clear job description and with contracts including KPIs, linked to the objectives of the MIP. This operation foresees the formal endorsement by the Council of Ministers of (i) the LCPDP, which promotes a competitive process for all power generation activities; and (ii) an MIP for the EMAE, (DPF 3 Prior Action #6), which will empower government agencies to implement these plans. 65. Expected results include an improvement in EMAE’s operational results. The adoption of the LCPDP and MIP are expected to reduce commercial losses and improve the EMAE’s operational result (Results Indicator #4). The ongoing PSRP will also monitor the implementation of both plans. Page 36 The World Bank THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING (P164321) PA#7: Energy regulation Rationale 66. An adequate regulatory framework is needed to improve the quality of service and foster private investment in the energy sector. In order to improve service quality, the EMAE’s service standards need to be defined and agreed upon between the EMAE and the GoSTP in the form of a concession contract, overseen by the sector regulator, Autoridade Geral de Regulação de São Tomé e Príncipe (AGER23). Additionally, standards must be overseen by an independent regulator that has the authority and ability to impose credible sanctions on the EMAE. An independent regulator with the relevant sectoral expertise would also ensure that electricity prices are set and adjusted according to the principle of cost recovery and based on a sound and transparent methodology. This in turn could increase price predictability and attract private sector interest in operating and investing in STP’s electricity sector. 67. This DPO series supports reforms in energy regulation to improve the quality of service. The first DPO established a customer complaint redress system at the EMAE for the mediation of conflicts between citizens and the EMAE, overseen by the AGER (DPF 1 Prior Action #5). The second DPO supported the publication of minimum quality criteria for energy services through the AGER ( DPF 2 Prior Action #7). DPF 1 Prior Action #5: The Recipient, through AGER, has mandated EMAE to: (i) establish a comprehensive customer complaint redress system, for the mediation of conflicts between citizens and EMAE, as well as representing the interests of the public, receiving feedback, complaints, information requests and suggestions for improvement of service; and (ii) send to AGER monthly reports of complaints received from customers. DPF 2 Prior Action #7: In order to improve the reliability of energy supply, the Recipient, through AGER, has published the minimum quality criteria for the provision of services in the electricity sector. DPF 3 Prior Action #7: The Recipient, through AGER, has signed a concession contract with EMAE, which stipulates the obligations of the Recipient and the licensee, including rules on tariffs and sanctions. Result Indicator #5: Number of complaints received by EMAE. Baseline (2015): 6,542. Target (2020): 3,000. Substance and criticality 68. A concession contract between the government and the EMAE, overseen by the AGER, constitutes a cornerstone of regulation and is critical for improving service quality. While the contract is included in the energy law as an obligation, it has never been implemented. The third operation supports the establishment of a concession contract between the GoSTP and the EMAE (DPF 3 Prior Action #7). The contract aims to formalize the framework and conditions applicable to service delivery by the concessionaire (rights and obligations, economic and service quality regulations, regime for monitoring performance, electricity tariff setting procedures and enforcing compliance, etc.) will last for 20 years. The contract foresees also the establishment of performance indicators, infrastructure 23AGER is a multi-sector regulator in STP, responsible for the regulation and supervision of the telecommunications, postal services, water and electricity sectors. Page 37 The World Bank THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING (P164321) investment commitments, and minimum supply levels. The contract has been made public in the official gazette. 69. Expected results include an improvement in the quality of energy services. This improvement will be reflected in a more reliable energy supply and better customer service, which will be measured by the number of complaints received by the EMAE (Results Indicator #5). Pillar B: Generate fiscal resources and savings and improve the quality of expenditures Objective B.1: Generate fiscal resources and savings PA#8: Revenue mobilization 70. STP’s level of tax revenue is low and insufficient to meet the country’s growth and development needs. Tax revenue reached 12.6 percent of GDP in 2018—among the lowest in the world. There is compelling evidence that a tax revenue ratio of 15 percent of GDP is the minimum threshold for a state to function effectively. Therefore, strengthening domestic revenue mobilization became an IDA18 policy commitment. The World Bank’s latest Public Expenditure Review (PER) for STP revealed that the GoSTP can increase domestic revenue by 3 to 5 percentage points of GDP by reforming its tax policy and improving the country’s tax administration. Rationale 71. The country’s revenue underperformance is the result of an outdated tax policy and inefficient tax administration. Tax revenue relies heavily on indirect taxes, mainly customs duties. Instead of a general and broad-based consumption tax on goods and services, STP has a series of specific consumption taxes. STP is one of only eight African countries (out of a total of fifty-five) that do not have a VAT. It does have a stamp tax, which is levied on many transactions. Revenue from direct taxation comes mainly from the personal income tax (PIT), while corporate income tax (CIT) revenue has been declining over the past years. Moreover, current tax administration practices are inefficient: customs duties and taxes are managed by different offices—the Directorate of Taxation (DI) and the Directorate General of Customs (DGA)—which makes coordination difficult and results in additional administrative costs. Tax audits are also inaccurate, labor intensive, and lack a risk-based approach. The DI and DGA have no specific strategic planning units, which weakens their capacity to monitor activities and performance assessments, and lack accountability. The DI’s information technology (IT) capacity is also low, and there is an urgent need to replace the current system. Finally, the collection of tax arrears is poorly monitored, and collection enforcement is a lengthy and costly process due to STP’s inefficient judicial system. 72. The GoSTP aims to broaden the tax base by reforming the country’s tax policies. Policymakers have approved several changes in the tax legislation in recent years. In the first DPO, the tax structure for the PIT and CIT was adjusted and simplified. The amount of the minimum tax paid (presumptive taxation) was also increased for the first time since 1995, and a cumbersome structure with six taxation thresholds was simplified to one threshold (DPF 1 Prior Action #6). A key element to broadening the tax base in STP and increase long-term revenue is to adopt a VAT. The GoSTP has taken steps to implement a VAT with support from the World Bank, the IMF, and the AfDB. Also, the previous administration submitted a VAT law to Parliament in May 2018. However, the law had to be resubmitted to Parliament in 2019 due to end of the legislative session. A precondition for the successful introduction of the VAT is the adoption of necessary regulations for fiscal invoicing and supporting accounting and tax information from taxpayers (DPF 2 Prior Action #8). Page 38 The World Bank THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING (P164321) DPF 1 Prior Action #6: The Recipient, through its Council of Ministries, has simplified the tax structure and updated the threshold values of tax brackets for presumptive income taxation. DPF 2 Prior Action #8: In order to generate the tax and accounting information needed to implement the VAT, the Recipient, through its Council of Ministers, has adopted the legal framework for fiscal invoices and similar documentation, whereby it legally mandated companies to issue fiscal invoices, set out said invoice’s minimum content and time requirements for storing them. DPF 3 Prior Action #8: The Recipient, through the National Assembly, has passed the Value Added Tax Code, which sets forth provisions aimed at broadening the tax base and generating more own- source revenues. Result Indicator #6: Tax revenues excluding except custom duties on oil (in million LCU). Baseline (2015): 831.1 million LCU. Target (2020): 1050.0 million LCU. Substance and criticality 73. The implementation of the VAT requires a combination of policy, legal, and administration reforms, including (i) improving IT systems; (ii) recruiting new staff; and (iii) training new and existing staff. The DI has provided a list of activities leading to the implementation of the VAT. These activities will be supported by the World Bank (through the ICBP), the AfDB, and the IMF. Project components include the enhancement of physical infrastructure and logistics; the development of a new IT system; capacity building of tax administration staff; education of taxpayers; and a communication campaign on the VAT. 74. To formalize the legal framework for the VAT, the GoSTP has approved the VAT law, which is based on TA from the World Bank and IMF (DPF 3 Prior Action #8). The adoption of the VAT law is a structural benchmark under the new IMF ECF. The VAT law will allow the GoSTP to transition to a VAT regime in 2020. With TA from the World Bank and IMF, the government will also adjust related regulations—including the harmonization of the VAT with other consumption taxes—and strengthen the operational capacity of the taxpayer administration to ensure the successful roll-out of the VAT. 75. Expected results include the implementation of reforms to broaden the tax base and generate a stable source of public revenue. These will be evaluated by revenue performance outcomes and measured by the tax revenue amount, excluding custom revenues on oil (Result Indicator #6). The introduction of the VAT is expected to drive the modernization of the tax administration by improving operations—including a new IT system—and other tax administration areas such as direct taxation. Potential adverse effects of the implementation of the VAT, including price increases and less income for poor households, are mitigated by exempting agricultural goods from the VAT and introducing a targeted cash-transfer program. SOE management 76. STP’s SOEs, which operate in the critically important infrastructure sector, are hindered by inefficient management practices. The GoSTP controls four fully-fledged SOEs in the electricity, water and sanitation (EMAE), airport (ENASA), ports (ENAPORT), and postal services (Correios) sectors. These companies are vital for the economy and the country’s ability to attract tourists and export cocoa and other goods. The efficient operation of these SOEs is therefore of strategic importance to STP. Page 39 The World Bank THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING (P164321) Rationale 77. SOEs face several challenges related to efficiency, financial viability, and transparency. The four majority-owned SOEs have incurred significant losses in recent years. They are thinly capitalized, unable to finance themselves, and heavily reliant on the state or international donors for their investments. Moreover, the quality of SOE services ranges from uneven to poor. Due largely to their deteriorating financial performance and inability to run their operations autonomously, SOEs have been facing serious operational problems, hampering their ability to provide quality services. Their loss-making positions and liquidity problems have prevented the government from deriving any significant revenues from these enterprises in the form of taxes or dividends. Instead, SOEs have accumulated significant arrears with suppliers and creditors. 78. Corporate governance of SOEs is weak. While the legal and regulatory framework for SOEs is mostly adequate, state ownership arrangements are unclear, which results in a significant administrative burden and limited operational autonomy. Accountability mechanisms are also unclear: despite being obligated to follow general principles of efficiency and effectiveness, SOEs are not bound by fiscal or financial outcomes. There is no established mechanism for monitoring the performance of SOEs or its managers, and the financial reporting of SOEs is inadequate. 79. Reforms targeting SOEs have so far progressed very slowly, despite a consensus that poorly managed SOEs are a burden on the country’s economy and public finances. The previous government acknowledged that SOEs were nearly bankrupt. In January 2017, the Council of Ministers requested an MIP for the country’s main SOEs and decided to freeze personnel expenses until SOEs were financially sound. However, those initiatives were never implemented. The World Bank is supporting SOE reforms through several instruments. Its PSRP supports management reforms at the EMAE—the largest SOE—and the recent PER carried out a diagnostic of the management and control of SOEs, which formed the basis for the government’s SOE reform plan. The reform plan was approved in the second DPO ( DPF 2 Prior Action #9) and aims to strengthen SOE governance and performance and reduce SOE-related fiscal risks. The PRCI also supports the implementation of the government’s SOE reform plan. Furthermore, the GoSTP has conducted, with World Bank guidance, external pre-audits 24 of its three main SOEs. 80. The new administration is committed to SOE reform, as outlined in the letter of development policy. The ongoing ICBP (P162129) provides support for the implementation of the SOE reform plan. The first step is the hiring of an advisor to support the implementation of the plan, including the establishment of a performance monitoring system. At the same time, the government is hiring with World Bank support an external accounting audit of all SOEs. 81. Expected results from the reforms include improvements in SOE management, oversight, and performance. The approval of the SOE reform plan, and its operationalization through the establishment of a proper monitoring system, will strengthen SOE monitoring and accountability. This in turn would drive both financial and non-financial improvements of SOEs (Result Indicator #7) and improve their quality of services. The monitoring system is also expected to improve the SOEs’ internal controls and enhance the quality of their financial reporting. Furthermore, aggregate SOE reports, annual financial statements, and audit reports should increase the transparency of the SOE sector. 24Pre-audits report on (i) misstatements in financial statements that will be subject to review and (ii) significant weaknesses in accounting policies, practices, and procedures and internal control during the preparation of financial statements. Page 40 The World Bank THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING (P164321) DPF 2 Prior Action #9: In order to improve SOE’s financial and non-financial performance, the Recipient, through its Council of Ministers, has approved an SOE reform plan that established a performance monitoring system with financial and non-financial targets for all SOEs and incentives to ensure compliance. Result Indicator #7 Number of SOEs’ performance monitoring systems in place. Baseline (2015): 0. Target (2020): 2. Objective B.2: Improve the Quality of Expenditures Public investment management 82. STP needs to improve the efficiency of public investments to compensate for the rapidly declining public investment ratio. The country’s public investment as a share of GDP almost halved over the last six years due to a decline in grants—the main source of investment financing. As a share of GDP, STP has a high public capital stock compared to its structural peers. However, this is not reflected in the quality of infrastructure, as STP suffers from a large infrastructure gap in energy, transport, and water and sanitation. With grants expected to play a smaller role in financing future investments, improving the efficiency of public investments—including those of SOEs—to better use existing resources and support national priorities is crucial for the future development of STP. Rationale 83. The country’s PIM practices are weak. STP lacks credible strategic guidance for public investment to ensure they are focused on the country’s development goals. While the Vision 2030, the NDP, and the XVII government program provide strategic guidance, these documents are very broad and fail to provide effective guidance.25 There are also no formal project appraisal mechanisms in place to assess the technical feasibility and the potential impact of projects, and criteria for project selection are unclear.26 Moreover, project implementation suffers from low planning capacity—cost and time overruns are common—and procurement practices are inefficient. Also, there are no completion and evaluation reviews available that assess the quality of completed projects. A large portion of donor-funded public investments is managed separately from domestically funded Public Investment Projects (PIPs). As a result, the preferences and financing of donors and lenders are important to implement specific interventions in the country. 84. The GoSTP has taken the first step to improve PIM by approving the National Planning System Law (SNP) in 2018. The SNP, which establishes the broad framework for national plans and capital expenditure, was approved in the second DPO (DPO 2 Prior Action #10). The law focuses on transparency, public consultation, monitoring and evaluation, the harmonization between different planning instruments, and the connection between planning and budget instruments through a medium-term 25 The country’s strategy for reaching its development goals needs to be re-considered, in particular regarding the large infrastructure projects with dubious viability. While important infrastructure gaps remain, the government continues to pursue projects with little prospects of commercial viability, which if carried out would drain resources from much needed investments in more viable enterprises. An example is the government’s aspiration to turn the country into an air transport hub by expanding the current airport’s runway. These projects have little technical backing and risk the investment’s financial sustainability. 26 The Directorate of Planning is not involved in the selection, and the Directorate of Budget does not have any formal role in selecting projects. Page 41 The World Bank THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING (P164321) expenditure framework. The World Bank supports PIM activities through trust funds and the ICBP. Project components include (i) creating a comprehensive public investment portfolio database; (ii) developing a project prioritization and investment programing tool; (iii) creating a project management cycle framework; (iv) performing TA to improve the legal framework; and (v) setting up software applications. 85. The new administration is committed to PIM reform, as outlined in the letter of development policy. With TA from the World Bank, the GoSTP will create the legal framework for establishing a national investment portfolio database (NIPD). Once the Council of Ministers pass the SNIP, the project database will be set up with guidance from the World Bank. The Directorate of Planning will update the database regularly and create a comprehensive project database, which will include data on project finances, outcomes, and outputs, as well as other indicators. The database will include projects in the pre- investment phase, both domestically funded and donor-financed programs, concluded projects, and other information needed for government agencies to monitor investment spending. 86. Expected results. This set of prior actions and triggers will be evaluated by the number of investment projects that are included in the public investment database ( Result Indicator #8). DPF 2 Prior Action #10: In order to improve the efficiency and Value for Money of public investment, the Recipient’s Parliament has enacted a National Planning System Law (SNP) that harmonizes planning and budget tools and lays the foundation for the appraisal and selection of public investment projects. Result Indicator #8: Share of ongoing and finalized projects with basic information included in the National Investment Portfolio Database. Baseline (2015): 0. Target (2020): 95 percent. PA#9: Social protection 87. STP’s SP programs are ineffective due to fragmentation, low coverage, underfunding, and lack of staff, leaving poor and vulnerable households with little protection. Specifically, SP programs are fragmented, have low coverage, offer low benefits, and fail to deliver timely and regular transfers to the extreme poor. In 2016, the GoSTP spent less than 0.7 percent of GDP on SP and assistance—well below the African regional average of 1.2 percent of GDP and among the lowest in the region. There are currently eleven SP programs,27 including three core social safety net programs.28 Program coverage is either unknown or below 30 percent of the target population, and benefits are low. There is also uncertainty regarding the programs’ financial resources, which reduces the efficiency of the SP framework. Moreover, several programs are partly financed by external aid, including the school feeding program, which increases uncertainty related to funding and continuity. Finally, the SP system suffers from operational constraints due to underfunding and understaffing, which undermines program implementation and supervision. The constraints mentioned above resulted in an inefficient, low transparency and low accountability of the SP programs in their different steps along the delivery chain from the intake, registration, and enrollment of the beneficiaries to the delivery of cash to the beneficiaries. These constraints also contributed to the irregular payments of the cash transfers to the beneficiaries. 27Excluding higher education scholarships. 28 The first program is a conditional cash-transfer program for families in extreme poverty (vulnerable families’ program). The second is a non-contributory pension program for the poor elderly, handicapped, and chronically ill (social pension program). Finally, the third program is a labor-intensive public works and community service program. There are also higher education scholarships, which are not counted as social protection programs. Page 42 The World Bank THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING (P164321) 88. Nonetheless, STP has made significant progress in SP in recent years. In 2014, the GoSTP approved the National Policy and Strategy for Social Protection (Política e Estratégia Nacional de Proteção Social, PENPS). The strategy is implemented through the Ministry of Employment, Solidarity, Family, and Vocational Training (MTSFFP) and aims to establish a SP system that protects the Santomean population, especially poor households and children, against natural and idiosyncratic shocks, and in turn, contribute to poverty reduction. The strategy has five objectives: (i) eliminating extreme poverty through conditional cash transfers and activities promoting human capital development; (ii) developing a robust mandatory contributory SP system; (iii) promoting employability of vulnerable groups like the youth, women, and the disabled; (iv) developing adequate delivery systems for the implementation of SP programs; and (v) defining adequate coordination mechanisms for the SP sector. Additionally, the PENPS supports three core social safety net programs, including conditional cash transfers for families in extreme poverty (vulnerable families’ program, VFP). 89. The World Bank has provided TA to the GoSTP over the last five years to establish the building blocks of a coherent and efficient SP system.29 Through the actions carried out in the previous DPO, it has been possible to strengthen the efficiency, transparency and accountability of the SP programs. With support from the World Bank, the GoSTP has registered all SP beneficiaries in a single registry, which was a prior action for the second DPF operation (DPF 2 Prior Action #11).30 World Bank support to SP also included the establishment of a social registry and the development of an operational manual with a targeting methodology and eligibility criteria for the VFP. DPF 2 Prior Action #11: In order to coordinate and harmonize social protection and poverty reduction policies, the Recipient has registered in the Recipient’s social registry all the beneficiaries of the three core social protection programs defined by the Recipient’s Social Protection Policy and Strategy. DPF 3 Prior Action #9: The Recipient, through the Ministry of Finance, has instituted a financial system-based (non-cash) payment mechanism to allow for the tracking and reconciliation of funds allocated to social protection payments. Result Indicator #9: Number of beneficiaries enrolled in the three core social protection programs and receiving regular payments as set in law. Baseline (2015): 0. Target (2020): 4,000 (of which 50 percent has received payments through the formal financial system). Substance and criticality 90. The approved World Bank Social Protection and Skills Development Project (P163088) will support the operationalization of STP’s core SP delivery systems and strengthen the government’s capacity to ensure the effective management of safety net programs. The project includes activities to support the GoSTP in its efforts to scale up conditional cash transfers, behavioral change activities, and entrepreneurial skills training. It will also provide conditional cash transfers to 2,570 households in 2019, equivalent to 91 percent of all households living in extreme poverty.31 29 Rapid Social Response Trust Fund: Project P149534 in 2014 “Building Blocks for the Social Protection System in São Tomé e Principe” and Project 163445 in 2017 “Development of Effective Delivery Systems for Social Protection.” 30 This has generated fiscal savings since 10 percent of beneficiaries did not exist. In future, the government will have to exclude beneficiaries identified as non-poor and registry-eligible beneficiaries based on the new household survey. 31 The cost of the conditional cash-transfer program amounts to US$1 million, or 0.2 percent of GDP, annually, which the GoSTP will fund going forward. Page 43 The World Bank THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING (P164321) 91. The current payment delivery system for existing safety net programs is, however, inefficient and not transparent. The MTSFFP currently uses a manual cash payment system to deliver subsidies to program beneficiaries through its district offices. In practice, this means that cash is withdrawn from the government account and transported and delivered physically to beneficiaries. This inefficient method has led to delays in payments to beneficiaries and limited financial reconciliation, as there are no fiduciary mechanisms for transferring funds from the central to the district level. The GoSTP recognizes the need for institutional reforms to ensure that social safety net payments are made in a reliable, efficient, and transparent way. 92. This DPO supports the establishment of a predominantly financial system-based formal payment mechanism for SP programs through a third party ( DPF 3 Prior Action #9). This will allow the payments delivered through the banking system will allow to reduce the cash transfer costs and deliver the cash in a more transparent and accountable way that will also allow a “real time” reconciliation of the payments to the beneficiaries. The GoSTP will contract a financial institution that will be responsible for transfers to beneficiaries.32 To support the implementation of the new payment mechanism, the MTSFFP will adjust its management information system (MIS) and conduct a communication campaign for beneficiaries. 93. The expected results include increased transparency and control as well as more timeliness and predictability in the disbursement of benefits. The establishment of a formal payment mechanism is expected to improve the timeliness and predictability of social safety net payments to program beneficiaries. Increased transparency of payment delivery mechanisms and an improved MIS for the monitoring and reconciliation of funds should increase the effectiveness of the SP system. This should also increase the number of beneficiaries enrolled and receiving regular payments in the three core SP programs (Result Indicator #9). Finally, the use of electronic payment instruments and basic transaction accounts for beneficiaries to receive payments also includes a component focused on improving financial inclusion. Table 6. DPO Prior Actions and Analytical Underpinnings Prior actions Analytical Underpinnings Pillar A: Introduce growth-enabling reforms in the financial sector, business environment, and infrastructure 32 Although the Government is actively working to create a new legal framework that will allow for the modernization of STP’s financial system (see Prior Action #1 DPF 3), there are currently no alternative payment service providers to banks (i.e., post office, mobile network operators, or microfinance institutions). Page 44 The World Bank THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING (P164321) Prior Action #1: The Recipient, through BCSTP, has The GoSTP. “Financial Sector Development approved the Report for the São Tomé and Príncipe Implementation Plan: 2016–2020”, Washington D.C: self- Banking System Asset Quality Review, as part of its published, 2016. efforts to improve financial soundness of commercial The WBG, “Upgrading the Credit Registry Platform in the Republic of São Tomé and Principe” (unpublished banks. manuscript, June 2017), Microsoft word file. The WBG. “STP – Secured transactions law and practice: legal and institutional diagnosis study” (unpublished manuscript, July 2017), Microsoft word file. Beck, Thorsten. “Microfinance- A critical literature survey” IEG Working Paper 2015/4, The WBG, Washington D.C: 2015. Deloitte Consultores S.A. “Relatório Preliminar da Qualidade dos Ativos” (unpublished manuscript, March Prior Action #2: The Recipient, through: (i) its 2019). National Assembly has passed the legal framework Basel Committee’s Guidance on the Application of the for payment services providers and payment system Basel Core Principles for Effective Banking Supervision to operators, which outlines the oversight framework, the Regulation and Supervision of Institutions Relevant to and duties and powers of BCSTP; and (ii) BCSTP, has Financial Inclusion, CGAP Guide to Regulation and passed the key implementing regulations under the Supervision of The Joint WBG and the Committee on National Payments System Law, which provide for Payments and Market Infrastructures (CPMI) Payments the legal protection of the electronic transfer of Aspects for Financial Inclusion Task Force Report the funds and the licensing and supervision of payment Committee on Payments and Market Infrastructures institutions and payment system operators (CPMI) – International Organization of Securities Commissions (IOSCO) Principles for Financial Market Infrastructures. The main recommendation of the Financial Sector Development Strategy is to update or introduce new regulatory frameworks to strengthen financial sector supervision, increase financial inclusion, and improve financial infrastructure. Prior Action #3: The Recipient, through BCSTP, has passed key regulations, which establish the minimum entry, operation requirements, risk management minimum requirements, and supervisory and reporting procedures for microfinance institutions. Prior Action #4: The Recipient, through its Council of Direcção Geral dos Registos e Notariado. Plano Estratégico Ministers, has approved the institutional structure dos Registros e Notariado 2017-2019. São Tomé: October for enabling interoperability between the land 2016. property register (Registo de Propriedade) and the Lamb, Tony; Endo, Victor; Stanley, Victoria. cadaster (Registo Cadastral). 2016. Systematic property registration: risks and remedies (English). Washington, D.C.: WBG. The absence of a proper land information system and a weak land governance framework are identified as the major constraints to development. Page 45 The World Bank THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING (P164321) Prior Action #5: The Recipient, through the The WBG. “Power Sector Recovery Project” Washington Presidency of the Republic, has instituted an energy D.C: self-pub, 2016. demand management program, which includes the The WBG. “Beyond Connections: Energy Access exchange of low efficient bulbs with higher efficient Redefined” Washington D.C: self-pub, 2015. ones. Trimble, Chris et al.,” Financial Viability of Electricity Sectors in SSA: Quasi-Fiscal Deficits and Hidden Costs” World Bank Policy Research Working Paper 7788, The WBG, Washington D.C: 2016. Prior Action #6: The Recipient, through its Council Mundi Consulting. “Memorando do Sistema de Controlo of Ministers, has approved: (a) a Least-Cost Power Interno e Aspetos Contabilísticos EMAE 2015 e 2016”, Sector Development Plan, which provides the basis São Tomé e Príncipe: 2018. for a competitive process for all power generation Ricardo Energy and Environment. “Least Cost activities; and (b) a Management Improvement Plan Development Plan Report for STP (Final Draft)” São Tomé for EMAE, which aims to improve EMAE’s operational e Príncipe: 2018. performance. The PSRP project describes several problems of the energy sector in STP including the following: (i) chronic Prior Action #7: The Recipient, through AGER, has underinvestment, (ii) constrained supply, (iii) old and signed a concession contract with EMAE, which poorly maintained transmission and distribution network, stipulates the obligations of the Recipient and the (iv) inadequate metering equipment, (v) large technical licensee, including rules on tariffs and sanctions. and non-technical losses, and (vi) scarce regulatory and planning capacity. Pillar B: Generate fiscal resources and savings and improve the quality of expenditures Prior Action #8: The Recipient, through the National The WBG. “STP: Public Expenditure Review”, Washington Assembly, has passed the Value Added Tax Code, D.C: self-pub, 2018. which sets forth provisions aimed at broadening the IMF. “STP: Towards a Slim VAT – simple, local and tax base and generating more own-source revenues modern”, IMF/ FAD Technical Assistance Report, Washington D.C: self-pub, 2016 The PER laid out low domestic revenue mobilization as the main reasons behind the chronic fiscal deficits and pointed to VAT as a more modern and efficient way of taxation that was lacking in STP. Prior Action #9: The Recipient, through the Ministry The WBG. “Building Blocks to the social protection system of Finance, has instituted a financial system-based (P149534)” (non-cash) payment mechanism to allow for the This report concluded that the coverage and transfers of tracking and reconciliation of funds allocated to assistance program are very low, payments irregular, and social protection payments. have limited impact on the well-being of the beneficiaries. The selection criteria of the beneficiaries are not clearly defined and there is no targeting mechanism for the different programs. Basic subsystems as a registry of beneficiaries, a targeting system, or a MIS do not exist, and low and declining resources are being allocated to social assistance programs in recent years. 4.3. LINK TO CPF, OTHER BANK OPERATIONS AND THE WBG STRATEGY 94. This operation reflects the priorities and objectives of the WBG Country Partnership Strategy Page 46 The World Bank THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING (P164321) (CPS) FY2014-2018 (Report No. 83144), which has been extended to FY2020. The CPS supported STP’s Second Poverty Reduction Strategy Paper (2012-2016), which focused on ways to boost growth and job creation to achieve poverty reduction. The CPS was extended for two years to incorporate the results of the Performance and Learning Review (PLR) and the NDP 2017-2021. The previous two focus areas have been streamlined and aligned with the new government’s priorities and now focus on: (i) supporting macroeconomic stability and inclusive growth; and (ii) strengthening human capacity and reducing vulnerability. Objectives under the first focus area include: (i) increased fiscal revenue and improved quality of public expenditures; (ii) strengthened governance of SOEs and extractive industries and improved transparency; (iii) improved performance of the infrastructure sector (i.e., ICT, energy, and transport); and (iv) an improved business environment, focusing on the tourism sector and SMEs. Objectives under the second focus area include: (i) enhanced education quality and skills; (ii) improved poverty targeting and access to social safety nets; and (iii) increased adaptive capacity of coastal communities. Gender, partnerships, and capacity building are elements that cut across all the proposed engagements. 95. The DPO series will contribute to both focus areas of the CPS. For instance, the operation’s prior action on banking supervision will strengthen the stability of the financial sector, which is aligned with the first CPF focus area to support macroeconomic stability. Reforms of the property registry and prior actions on payment systems and financial inclusion will help improve the business environment and support inclusive growth. Also, the prior action on VAT will increase fiscal revenue and help achieve a more sustained budget balance position, while prior actions focusing on the SOE sector and PIM will improve the quality of public expenditures and strengthen SOE governance and transparency. Moreover, energy- related reforms will support the long-term structural improvement of the EMAE and the energy sector. They will also foster macroeconomic stability by containing the SOEs’ losses and associated fiscal risks in the short term. Finally, the prior action on SP is closely related to the objective of increasing access to social safety nets under the CPS’ second focus area by streamlining SP programs, expanding coverage, and improving the targeting of the SP policy framework. 96. The DPO will also directly and indirectly contribute to the WBG twin goals. The revision of the SP policy framework and the expansion of fiscal space (through measures to increase revenue mobilization) would allow for an improvement in the targeting and coverage of SP programs. Policies supported by the operation are likely to boost shared prosperity. Also, the revised SP policy will focus not only on the extreme poor but also on other poor and vulnerable groups. Moreover, policy changes to improve the credit market are expected to increase access to credit and market opportunities for households in the bottom part of the income distribution. Finally, affordable and increased access to energy are also associated with reduced poverty and greater shared prosperity. 97. This DPF series follows a two-pronged approach in which the DPO supports the policy reforms, while the IPFs and other World Bank interventions provides the TA needed for reform implementation and sustainability. In the energy sector, the World Bank is supporting an investment financing project (P157096) that will increase the reliability of the power supply, help reduce the cost of energy, improve the management of the utility company, and strengthen the regulatory framework. The DPF operation will support policymakers to improve regulations in the energy sector and the management and oversight of SOEs. Furthermore, the World Bank Social Protection and Skills Development project (P163008) will support the operationalization of the GoSTP’s core SP delivery systems and strengthen its capacity to ensure the effective management of safety net programs. Several DPO reforms are also supported by the World Bank’s Institutional Capacity (P162129) and FIRST (P159937) projects, including reforms focusing Page 47 The World Bank THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING (P164321) on the financial sector, the property registry, the VAT, and SOEs. Also, the DPF series is supported by ongoing and recently completed advisory services and analytics in SP (P149534) and the financial sector (P150418). Other World Bank reports that inform the DPO series include the latest PER (P161140), which focuses on STP’s tax policy and administration, SOEs, and PIM, and the ongoing country economic memorandum (P164180). 4.4. CONSULTATIONS AND COLLABORATION WITH DEVELOPMENT PARTNERS 98. Government programs and supported policy reforms have undergone public consultations. Policymakers consulted with the public during the formulation of the NDP, which is aligned with reforms supported by this operation. Consultations with stakeholders in the financial sector were also conducted throughout the formulation of the financial sector’s development strategy. Similarly, there were various rounds of public consultations during the formulation of the PENPS (e.g., the PENPS established a formal council on SP). Moreover, reforms of the public notary and property registration codes were created by a committee with members from the country’s courts, the public prosecutor’s office, and university law schools. The drafting of the new national planning law was also preceded by consultations with key stakeholders. Both the diagnostic of the SOE sector and the SOE reform plan were shared with the management of all SOEs and high- and mid-level government officials before they were completed and approved. Also, public consultations were carried out during the development of the LCPDP. 99. This DPF series is coordinated with STP’s main developing partners. The policies supported by the proposed operation complement and leverage the support provided by development partners. For example, the IMF is providing TA focused on the country’s revenue administration and tax policy, including the implementation of the VAT and banking resolution. The AfDB is supporting an investment lending project in the energy sector and financing the infrastructure for the payment system upgrade. Moreover, the EU is financing a public expenditure and financial accountability (PEFA) assessment that will guide its TA in public financial management (PFM) in the coming years. The European Investment Bank is supporting the modernization of STP’s energy sector through investment lending. Finally, Portugal has been providing TA to STP’s justice sector, which will facilitate the implementation of a property registry reform and reforms in the financial and banking sector. 5. OTHER DESIGN AND APPRAISAL ISSUES 5.1. POVERTY AND SOCIAL IMPACT 100. Overall, the proposed DPO supports policy and institutional changes that are expected to have poverty-reducing effects in the medium - to long-term ; however, there will be distributional effects in the short-run that should be addressed. The main poverty-reducing effects from this DPO come from the support to introduce cash transfer to poor and vulnerable families, the energy demand program that will distribute for free more efficient light bulbs for all households, and the reforms on the payment system and microfinance. The short-term negative effect on poverty comes from the introduction of VAT. 33 However, the introduction of the VAT will help improve the fiscal position of the government and to improve macro-stability and economic growth in the medium to long term. In turn, this could help prevent 33 This DPO does not support energy tariff revision or increases of any sort. Page 48 The World Bank THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING (P164321) economic crisis-induced increases in poverty. 101. While the introduction of the VAT will not affect income concentration, it is expected to increase the poverty headcount between 1.5 and 3.0 percentage points. The simulation of the impact of the VAT was done by taking into account direct and indirect effects using consumption data from the 2017 household survey. It reveals the VAT will not affect income concentration, as measured by the Gini coefficient, in a significative way, even when different sets of exemptions are introduced. However, the implementation of the VAT is expected to increase the poverty headcount by between 1.5 and 3.0 percentage points. Moreover, the poverty impacts of the VAT appear to be mitigated by exempting food, small producers, and health and education expenditures (exempting health and education spending will be more significant in urban areas). Taking into consideration the early stage of the social safety net system in the country, there are limited prospects at this stage, for using cash transfers to mitigate the negative impacts of VAT on the poor or any other sub-population group with precision. 34 Nonetheless, the deployment of cash transfers program as supported in prior action 9 will mitigate some of the effects of VAT, even though that is not the primary purpose of the program. Fortunately, as it is confirmed by the simulations of the impacts of a VAT exempting food, small producers, and health and education expenditures, the approved VAT law reducing the tax burden on food staple items by 50 percent, seems to be contributing significantly at mitigating the negative impacts of the VAT. It is also reassuring that the analysis reveals that 51 percent of the VAT collection will be paid by the richest decile of the population. 102. Improved financial inclusion and a more resilient financial system will benefit the poor . Modern development theory sees lack of access to finance as a cause of persistent income inequality and slower growth. Small enterprises and poor households face greater obstacles with access to finance, especially in developing countries. The 2017 household survey and the 2017 survey on financial inclusion show that poor people are excluded from banking, financial transactions, and credit. Poverty rates are higher (70 percent) among the group who declare not having a bank account compared to those who do (43.8 percent). Only 38.7 percent of the population has banks accounts, with a significant gender and rural gap; 58.7 percent of women and 60 percent of rural population do not have a bank account. The expansion of the payment system network and the use of other delivery channels such as mobile banking could have a relevant impact on poverty since near 70 percent of the population receives their income in cash or check. In addition, 75 percent of the population does not have any bank credit and 89 percent of the SMEs had credit requests denied. 103. Poorer households tend to use less electricity, yet electricity spending is more of a financial burden. The 2019 survey on energy access based on the Multi-Tier Framework found that while nearly 50 percent of the households in the first quintile of the income distribution use less than 100 kWh per month, 47.5 percent of these households spend more than 10 percent of their budget on electricity. In addition, the same survey reported that affordability was the main hindrance for households not being connected to grid with 42 percent pointing to the one-time cost of the connection and 15 percent pointing to the monthly fees. Therefore, the energy demand program, which will replace for free the low efficient light bulbs for higher-efficiency ones, will reduce the cost of energy for the population. This will be particularly beneficial to the poorer households, which spend a larger share of their income on electricity. 34For example, the recent Poverty Assessment for Sao Tome & Principe (2019) confirms that, holding all else equal, female- headed households have the same likelihood of being poor as male-headed households. Page 49 The World Bank THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING (P164321) 5.2. ENVIRONMENTAL ASPECTS 104. Specific policies supported by the DPO series are not expected to have a significant negative effect on STP’s forests, water resources, habitats, or other natural resources. The country has a legal and institutional framework to manage and respond to environmental challenges. The General Directorate of Environment (DGE), under the Ministry of Infrastructure, Natural Resources and Environment (MIRNA), is the central institution responsible for environmental management. It oversees all projects expected to have a potential positive or negative impact on the environment. Even though an institutional and legal framework is in place, the inconsistent monitoring, compliance, and enforcement of environmental laws and regulations are of concern, and some prior actions to be implemented under this DPF are likely to have environmental effects and therefore need to be scrutinized and closely supervised. 105. The exchange of low efficient incandescent bulbs to higher efficient LED can bring environmental benefits (Prior Action #5). Positive environmental impacts on deployment of LED bulbs are related to its lifecycle environmental impacts, which are significantly less in comparison to the traditional incandescent bulbs. Moreover, the use of LED bulbs can contribute to significant energy savings, lower local pollution, and reduce greenhouse gas (GHG) emissions. 106. A reduction in the cost of energy and an increase in the share of renewable energy can bring environmental benefits (Prior Action #6). The Least-Cost Development Plan, which has identified hydropower as a priority source of energy to attain National Development Contribution targets, will guide stakeholders in how to develop sub-sector plans that meet the country’s energy and development needs at the least cost to the economy and environment. All activities related to capacity expansion of the power sector will have to follow the prescriptions integrated in the LCPDP, which includes compliance with environmental standards. In addition, environmental clauses will be included in the bidding documents and contractual arrangements. Current and upcoming operations in the energy sector will dedicate resources to improve coverage and effectiveness of the current ESIA systems, especially enforcement and compliance monitoring. Participation of civil society in the process of preparing ESIA, and dialogues about environmental policies will incrementally increase accountabilities in environmental and social management activities and ensure proper oversight. 5.3. PFM, DISBURSEMENT AND AUDITING ASPECTS 107. The GoSTP has undertaken some reforms to improve PFM practices, and authorities are committed to continuing these. This commitment is exemplified by the progress in implementing reforms supported by the last DPF series and the creation of an overall PFM action plan that was published in 2016. Previous PFM reforms focused on areas related to the comprehensiveness and transparency of budget documents, medium-term fiscal planning, public financial reporting, and external auditing, including the submission of the 2013 and 2015 public financial statements to the supreme audit institution. While the last PEFA review conducted in 2013 concluded that the GoSTP has made progress on PFM reforms in several areas, there were various challenges that public authorities still needed to address. The review noted that the government had made improvements in the scoring, which demonstrated broad engagement on reforms, and there was a strong public commitment to continue the implementation of reforms. The PEFA also acknowledged advances in PFM performance, including (i) clearer and more comprehensive instructions (budget circulars) for the preparation of budget proposals; (ii) more transparent and comprehensive budget information available to the public and the availability of budget documents through printed forms and the websites of Parliament and the Ministry of Planning, Finance, and the Blue Economy; (iii) some improvements in the preparation of the Medium-Term Page 50 The World Bank THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING (P164321) Expenditure Framework (MTEF); (iv) more legislative scrutiny of the annual budget law; (v) the establishment of a treasury single account, resulting in greater control over bank accounts and deposits in commercial banks; (vi) the implementation of an integrated financial management information system (IFMIS); and (vii) positive trends in internal controls and tax management. However, the review also revealed that ongoing reform efforts had not yet addressed the key challenges facing PFM in STP, including: (i) low budget credibility; (ii) the absence of the structural and institutional reforms needed to strengthen tax management; (iii) a lack of effectiveness of the IFMIS; and (iv) insufficient follow up on the findings of the audit and monitoring process. These challenges and continuing weaknesses in the PFM environment are a result of constraints in technical capacity, human resources, and available skills, affecting the key institutions responsible for all stages of the PFM cycle, including the General Inspectorate of Finance, which is responsible for internal audit functions, and the supreme audit institution ( Tribunal de Contas). Nevertheless, the GoSTP’s PFM action plan appears adequate to address these challenges over the next few years. 108. STP complies with the World Bank minimum standards on budget transparency for DPOs. STP has published the budget laws both at proposal and approval stage since 2010 and since 2016 the government has been publishing the budget formulation directives as well. The budget proposal is published on the Ministry of Finance’s website on the same day it is sent to parliament or with very little delay. The same happens with the approved budget. Despite complying with the World Bank minimum standards on budget transparency for DPOs, the preliminary PEFA report points that transparency could improve by including more information on budget documents such as medium-term budget forecasts, fiscal risks, and include more budgetary information from autonomous government agencies. 109. There has been an improvement in the country’s public procurement functions, although challenges remain in the implementation of procurement regulations. A procurement supervisory body and a coordination and assistance procurement cabinet Gabinete de Coordenação e Seguimento de Licitações (Office of Coordination and Support of Procurement COSSIL) was created in 2009 to centralize procurement information, assist decentralized procurement units, and ensure uniformity and quality across units. COSSIL may suspend, cancel, or invalidate contractual procedures that are not in accordance with applicable legislation. The main challenges in implementation of procurement regulations include the following: (i) procurement law and regulations are old and do not capture recent innovations in the sector (sustainable procurement, framework contracts); (ii) lack of standard bidding documents leading to use of different instruments by the procuring entities and use of less competitive methods; (iii) large turnover of staff in procuring entities making difficult to maintain a core staff of public procurement practitioners in the public administration and SOEs; (iv) limited information collected on procurement in order to have a clear picture and implement mitigation measures; and (v) no procurement audit of government entities (central and local level) and SOEs (there is an ex-post audit by “Tribunal de Contas” on public accounts but have not a specific procurement component). The World Bank is supporting the improvement of the public procurement system through the revision of legislation, capacity building of COSSIL’s staff and procurement units, the preparation of a strategic public procurement plan, and the set- up of a dedicated website to improve transparency. All these actions are included in the ongoing Institutional Capacity Building project (P162129). 110. The BCSTP is responsible for ensuring STP’s strong foreign exchange control environment. The IMF’s second ECF review and the authorities’ request for waivers for nonobservance of performance criterion and modification of performance criteria were made public in December 2016. These documents indicated that the BCSTP still faces capacity constraints, including in the independent oversight of audit Page 51 The World Bank THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING (P164321) mechanisms, internal controls, and financial reporting. While external audits conducted by a reputable audit firm continue to serve as a critical safeguard, ongoing institutional development will be needed to strengthen capacity and bolster the safeguard framework. The IMF concluded in its review that the BCSTP is committed to strengthening the control environment. 111. Although the fiduciary risk is substantial, STP’s PFM environment is adequate to support the proposed operation since ongoing reforms will address some of these risks. In addition, the GoSTP’s development strategy and its previous actions to implement reforms demonstrate its commitment to improving the PFM environment. However, the IDA retains the right to request an audit of the dedicated account if it concludes that some risks were not addressed. 112. SDR 3.7 million (equivalent to US$5 million) will be disbursed upon grant effectiveness and following the Recipient’s request for withdrawal of grant proceeds. The grant will follow IDA’s standard disbursement procedures for DPOs. IDA has informed the GoSTP that there can be no withdrawals unless it is satisfied that the program is being carried out (a) by the Recipient and (b) with the appropriateness of the Recipient’s macroeconomic policy framework. Once the operation is approved by the WBG Board of Directors and becomes effective, and following the GoSTP’s request for withdrawal of proceeds, IDA will disburse the grant to a dedicated foreign currency account at the BCSTP. The proceeds of the grant will then become part of STP’s official reserves. Within 30 days of the receipt of the deposit, the Recipient will provide confirmation to IDA that (a) the grant proceeds were deposited into a public account that is part of the country’s foreign exchange reserves (including the date, name, and number of the government’s bank account); and (b) an amount equivalent to the grant proceeds has been credited in the Recipient’s budget management system within 5 working days of receipt, indicating the exchange rate applied, where applicable. The conversion from foreign to the local currency will be based on the prevailing exchange rate on the date that the funds are credited in the budget management system. The BCSTP will not impose any charges or commissions on the Recipient for these transactions. 113. Based on the level of fiduciary risk associated with this operation, IDA reserves the right to request an audit of the dedicated account on terms acceptable to IDA. If the right were to be exercised, the GoSTP would have the dedicated account audited by an independent auditor acceptable to IDA, with the audit assuring that: (a) the funds have been received and deposited into the account; (b) the funds received in the dedicated account were, within five working days of receipt, converted into local currency and transferred to the consolidated fund account (Treasury Account) of the GoSTP to finance budgetary expenditures; and (c) the amount received has been appropriately accounted for in the government’s financial management system. If the proceeds of the grant were to be used for ineligible purposes, as defined in the financing agreement, IDA will require the recipient to promptly, upon notice from IDA, refund an amount equal to the payment to IDA. Funds refunded to IDA, upon such request, shall be cancelled. The administration of this proposed grant will be the responsibility of the MPFBE. 5.4. MONITORING, EVALUATION AND ACCOUNTABILITY 114. The Ministry of Finance will be the coordinating agency for monitoring and evaluation of the program implementation and progress towards the achievements of the results. The MPFBE has created a dedicated macro and fiscal unit that will coordinate the program implementation and will serve as the main point of contact with international financial organizations. The unit will develop a brief monitoring and evaluation manual with the sources and the methodology for calculating each result indicator. The MPFBE has coordinated several externally financed projects and is the main counterparts of the GoSTP in dealing with international financial organizations, therefore it has experience and adequate institutional Page 52 The World Bank THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING (P164321) capacity to monitor the DPO program implementation. 115. Data availability and quality are appropriate to monitor progress of the DPO program . The results of the operation will be monitored by standard indicators or based on data already produced by the GoSTP. Standard indicators include the number of banks with capital adequacy ratios below recommended levels or tax revenue ratios. When such indicators are not adequate, the results will be measured by indicators already used by the client. Moreover, monitoring measures will use figures that have been published by the government or data produced by the government that the World Bank has historically used, such as the EMAE’s balance sheet. 116. Grievance Redress. Communities and individuals who believe that they are adversely affected by specific country policies supported as prior actions or tranche release conditions under a World Bank DPO may submit complaints to the responsible country authorities, appropriate local/national grievance redress mechanisms, or the WB’s Grievance Redress Service (GRS). The GRS ensures that complaints received are promptly reviewed in order to address pertinent concerns. Affected communities and individuals may submit their complaint to the WB’s independent Inspection Panel which determines whether harm occurred, or could occur, as a result of WB non-compliance with its policies and procedures. Complaints may be submitted at any time after concerns have been brought directly to the World Bank's attention, and Bank Management has been given an opportunity to respond. For information on how to submit complaints to the World Bank’s corporate Grievance Redress Service (GRS), please visit http://www.worldbank.org/GRS. For information on how to submit complaints to the World Bank Inspection Panel, please visit www.inspectionpanel.org. 6. SUMMARY OF RISKS AND MITIGATION 117. The overall risk of the proposed operation is high. The rating is attributed to: (i) political and governance; (ii) macroeconomic; and (iii) fiduciary risks; as well as (iv) risks related to the country’s institutional capacity for implementation and sustainability. While the technical design of the program and related fiduciary risks are rated as substantial, all other categories are rated as moderate. 118. While political risk is high due to the change of government, its coalition nature, and the need for Parliament support for some reforms, it is mitigated by a new IMF program and efforts to reach out to the legislature. Political and governance risks are rated high because the operation will be implemented by a new government formed by a coalition of parties, which has historically been unstable in STP. The government will also need the approval from Parliament to implement key measures such as introducing a VAT and supporting fiscal consolidation. Low transparency and accountability at the tax office compound the high-risk rating. Mitigating measures include the IMF program, the government’s effort to reach out to Parliament and stakeholders from opposition parties, and the World Bank dialogue with parliamentarians to inform them on the World Bank’s supported program in STP. 119. Macroeconomic risk is high due to the country’s vulnerability to domestic and external shocks and their potential impact on program objectives, although the new IMF program together with the DPO-supported reforms mitigate this risk. Macroeconomic instability can derail program objectives by reducing the revenue potential of tax measures, the ability to clear arrears in the energy sector, and the impact of measures in the financial sector on stability and access to finance. The country is also vulnerable to domestic shocks such as weather-related shocks that impact inflation and energy supply shocks that affect economic growth and tax collection. STP’s vulnerability to external shocks is also high, as high oil prices can lead to higher inflation and SOE losses. Also, less grant proceeds can lead to lower public Page 53 The World Bank THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING (P164321) investments, which in turn could result in lower economic growth. The new IMF program serves as mitigating measure by including a higher quota volume as well as more widespread and candid communication between relevant stakeholders on the acute macroeconomic situation facing the country. 120. The risk stemming from the program design is substantial due to the multisectoral nature of the operation. The program design is complex because it contains nine prior actions that encompass five different sectors. In addition, the GoSTP has a tradition of working in compartmentalized way, with information not flowing freely from one ministry to the other. The World Bank has reduced the number of prior actions from the second to the third operation as a mitigating measure. It is also engaged in all sectors included in the DPO with analytical work and/ or TA. 121. Institutional capacity risk is high due to low implementing capacity. Technical capacity is low due to a lack of formal intergovernmental cooperation mechanisms, the government’s poor track record of following-up on its own decisions, and an insufficiently empowered coordination unit. The operation’s mitigating measures include TA and investment operations from both the World Bank and development partners in the energy and financial sectors, tax administration, SOE supervision, and Financial Management Information System. 122. Finally, the fiduciary risk is substantial because of weak internal and external audit functions and major weaknesses in the financial management system, especially in terms of the mismatch between cash flow and budget execution. The World Bank is providing TA through the ICBP to improve the financial management information system, to strengthen IT capacity and the accountancy profession. The EU is financing a new PEFA for STP, which has received comments from the World Bank and will originate a new PFM reform plan. Table 6: Summary Risk Ratings Risk Categories Rating 1. Political and Governance  High 2. Macroeconomic  High 3. Sector Strategies and Policies  Moderate 4. Technical Design of Project or Program  Substantial 5. Institutional Capacity for Implementation and Sustainability  High 6. Fiduciary  Substantial 7. Environment and Social  Moderate 8. Stakeholders  Moderate 9. Other Page 54 The World Bank THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING (P164321) Overall  High . Page 55 The World Bank THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING (P164321) ANNEX 1: POLICY AND RESULTS MATRIX Prior Actions Results Prior Actions under DPF 1 Prior Actions under DPF 2 Prior Actions for DPF 3 Pillar A: Introduce growth-enabling reforms in the financial sector, business environment, and infrastructure Objective A.1: Introduce growth-enabling reforms in the financial sector and business environment Prior Action 1: The Recipient, through its Prior Action 1: In order to strengthen Prior Action 1: The Recipient, through Result Indicator 1: Number National Assembly, has approved a the bank resolution framework, the BCSTP, has approved the Report for the STP of banks below the Central banking resolution law (Medidas Especiais Recipient, through its BCSTP, has Banking System Asset Quality Review, as Bank’s minimum Capital. de Saneamento, Resolução e Liquidação adopted regulations implementing the part of its efforts to improve financial Adequacy Ratio (12 de Instituções Bancárias) that provides Recipient’s financial institutions soundness of commercial banks. percent) the Central Bank with the power and resolution law, which set out: (i) the Baseline (2015): 3 authority necessary to deal effectively measures to be applied by the BCSTP in Target (2020): 0 with distressed financial institutions by the resolution of distressed financial facilitating early intervention and institutions; and (ii)the requirements for providing additional policy instruments to the elaboration and adoption of address vulnerabilities. recovery and resolution plans. Prior Action 2: The Recipient, through its Prior Action 2: In order to expand the Prior Action 2: The Recipient, through: (i) Result Indicator 2: Central Bank, has created, operationalized outreach of the banking system and its National Assembly, has passed the legal Share of the population and staffed a new directorate (Direcção support financial inclusion through the framework for payment services providers with access to formal de Sistemas de Pagamentos) to usage of mobile financial services, the and payment system operators, which financial services (e.g. bank consolidate in the same unit all Recipient, through its Council of outlines the oversight framework, and accounts). responsibilities related to oversight, policy Ministers, has approved and submitted duties and powers of BCSTP; and (ii) Baseline (2017): 39 percent formulation and development of the to the Parliament the proposed Target (2020): 45 percent BCSTP, has passed the key implementing national payment system. National Payment Systems Law, which regulations under the National Payments sets forth the statutory level principles for regulation on modern payment System Law, which provide for the legal methods, such as agent banking, protection of the electronic transfer of mobile money, and electronic funds and the licensing and supervision of payments. payment institutions and payment system operators. Prior Action 3: In order to develop the Prior Action 3: The Recipient, through microfinance sector and promote the BCSTP, has passed key regulations which offer of microfinance services, the establish the minimum entry, operation Recipient, through its Council of requirements, risk management minimum Page 56 The World Bank THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING (P164321) Prior Actions Results Prior Actions under DPF 1 Prior Actions under DPF 2 Prior Actions for DPF 3 Ministers, has approved and submitted requirements, and supervisory and to Recipient’s Parliament a draft law on reporting procedures for microfinance microfinance. institutions. Prior Action 3: The Recipient, through its Prior Action 4: In order to reduce costs Prior Action 4: The Recipient, through its Result Indicator 3: Share of Council of Ministers (Conselho de and simplify procedures to register Council of Ministers, has approved the real estate properties and Ministros), has reduced legal fees (i.e. property, therefore improving its ability institutional structure for enabling mortgages registered and taxes and registry fees) associated with to serve as loan collateral and foster interoperability between the land digitized in the Public the registry of mortgages. access to finance, the Recipient, property register (Registo de Notary Registry. through the Council of Ministers, has Propriedade) and the cadaster (Registo Baseline (2015): 0 percent approved and submitted to the Cadastral). Target (2020): 70 percent. recipient’s Parliament (i) the proposed Property Registration Code; and (ii) the proposed Public Notary Code. Objective A.2: Introduce growth-enabling reforms in the infrastructure sector Prior Action 4: The Recipient, through Prior Action 5: In order to promote Prior Action 5: The Recipient, through the Result Indicator 4: EMAE’s EMAE, has introduced a revised system of transparency and incentivize timely Presidency of the Republic, has instituted operational profit/loss (in pre-paid energy services that will allow for payments, the Recipient, through an energy demand management program, millions LCU). accurate consumption metering and EMAE, has published its policy to which includes the exchange of low Baseline (2015): - 224.9 invoicing, as well as eliminating the risk of improve billing collection and launched efficient bulbs with higher efficient ones. million LCU non-payment a public awareness campaign through Target (2020): -194.7 public TV and radio. million LCU Prior Action 6: In order to structurally Prior Action 6: The Recipient, through its reduce the cost of energy, increase the Council of Ministers, has approved: (a) a share of renewable sources, and Least-Cost Power Sector Development promote long-term private investment, Plan, which provides the basis for a the Recipient, through its Council of competitive process for all power Ministers, has ruled that any capacity generation activities; and (b) a expansion of the power sector will have Management Improvement Plan for EMAE, to follow the prescriptions of the which aims to improve EMAE’s operational integrated Least-Cost Power performance. Development Plan, and that any exception would need to obtain the approval of the Recipient’s Minister of Infrastructure, who shall have to provide the rationale for such Page 57 The World Bank THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING (P164321) Prior Actions Results Prior Actions under DPF 1 Prior Actions under DPF 2 Prior Actions for DPF 3 exemption and publish said decision. Prior Action 5: The Recipient, through Prior Action 7: In order to improve the Prior Action 7: The Recipient, through Result Indicator 5: Number AGER, has mandated EMAE to: (i) reliability of energy supply, the AGER, has signed a concession contract of complaints received by establish a comprehensive customer Recipient, through AGER, has published with EMAE, which stipulates the EMAE complaint redress system, for the the minimum quality criteria for the obligations of the Recipient and the Baseline (2015): 6,542 mediation of conflicts between citizens provision of services in the electricity licensee, including rules on tariffs and Target (2020): 3,000 and EMAE, as well as representing the sector. sanctions. interests of the public, receiving feedback, complaints, information requests and suggestions for improvement of service; and (ii) send to AGER monthly reports of complaints received from customers. Pillar B: Generate fiscal resources and savings and improve the quality of public expenditures Objective B.1: Generate fiscal resources and savings Prior Action 6: The Recipient, through its Prior Action 8: In order to generate Prior Action 8: The Recipient, through the Result Indicator 6: Tax Council of Ministries, has simplified the the tax and accounting information National Assembly, has passed the Value revenues except custom tax structure and updated the threshold needed to implement the VAT, the Added Tax Code, which sets forth duties on oil (in millions values of tax brackets for presumptive Recipient, through its Council of provisions aimed at broadening the tax LCU) income taxation. Ministers, has adopted the legal base and generating more own-source Baseline (2016): 831.1 framework for fiscal invoices and revenues. million LCU similar documentation, whereby it Target (2020): 1050.0 legally mandated companies to issue million LCU fiscal invoices, set out said invoice’s minimum content and time requirements for storing them. Page 58 The World Bank THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING (P164321) Prior Action 9: In order to improve Result Indicator 7: number SOE’s financial and non-financial of SOEs’ performance performance, the Recipient, through monitoring systems in its Council of Ministers, has approved place. an SOE reform plan that established a Baseline (2015): 0 performance monitoring system with Target (2020): 2 financial and non-financial targets for all SOEs and incentives to ensure compliance. Objective B.2: Improve the quality of public expenditures Prior Action 10: In order to improve Result Indicator 8: Share of the efficiency and Value for Money of ongoing and finalized public investment, the Recipient’s projects with basic Parliament has enacted a National information included in the Planning System Law that harmonizes National Investment planning and budget tools and lays the Portfolio Database. foundation for the appraisal and Baseline (2015): 0 percent selection of public investment Target (2020): 95 percent projects. Prior Action 11: In order to coordinate Prior Action 9: The Recipient, through the Result Indicator 9: Number and harmonize social protection and Ministry of Finance, has instituted a of beneficiaries enrolled in poverty reduction policies, the financial system-based (non-cash) the three core social Recipient has registered in the payment mechanism to allow for the protection programs and Recipient’s social registry all the tracking and reconciliation of funds receiving regular payments beneficiaries of the three core social allocated to social protection payments. as set in law. protection programs defined by the Baseline (2015): 0 Recipient’s Social Protection Policy and Target (2020): 4,000 (of Strategy. which 50 percent has received payments through the formal financial system). Page 59 The World Bank THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING (P164321) ANNEX 2: IMF RELATIONS ANNEX IMF Executive Board Approves New US$18.2 Million Extended Credit Facility Arrangement for the Democratic Republic of São Tomé and Príncipe October 2, 2019  The Extended Credit Facility arrangement aims to support São Tomé and Príncipe’s economic and structural reforms.  Structural reforms should help mobilize revenue, enhance control over public spending, reduce contingent liabilities from SOEs, improve financial stability, and promote sustainable and inclusive growth to reduce poverty, including through empowering women economically.  The Executive Board decision allows an immediate first disbursement of US$2.6 million to São Tomé and Príncipe. On October 2, 2019 the Executive Board of the International Monetary Fund (IMF) approved a new 40-month arrangement under the Extended Credit Facility (ECF) for São Tomé and Príncipe in the amount of SDR 13.32 million (about US$18.2 million) in support of the country’s economic and structural reforms.[1] It will enable an immediate disbursement of about SDR 1.9 million (about US$2.6 million). The remaining amount will be phased over the duration of the arrangement, subject to semi-annual reviews. The ECF arrangement aims to support the authorities’ economic reforms, macroeconomic stability, and private-sector led inclusive growth. It also seeks to alleviate balance of payments pressures and restore fiscal and external sustainability over the medium term. Following the Executive Board’s decision, Mr. Mitsuhiro Furusawa, Deputy Managing Director and Acting Chair, issued the following statement: “The ECF arrangement supports the authorities’ economic reforms to restore macroeconomic stability, reduce debt vulnerability, and alleviate balance of payment pressures to provide the foundation for strong economic growth. It could also help catalyze additional development support. “The government plans to undertake sustained fiscal consolidation and reforms to reduce debt vulnerability. To this end, the authorities aim to broaden the tax base and ensure equitable tax burden-sharing, including by introducing a value-added tax and strengthening tax administration. Public expenditure will be restrained, made more efficient, and prioritized to protect essential social services. They are also committed to borrowing only at concessional terms and at a measured pace and to enhance debt management capacity. Page 60 The World Bank THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING (P164321) “Monetary policy will be tightened to encourage savings, ease demand for foreign exchange, and contain inflation. A new payment system allowing credit card transactions is being developed, which will stimulate tourism and raise foreign exchange receipts. Financial sector supervision will be strengthened. “Comprehensive structural reforms will also be pivotal in promoting private-sector led inclusive growth and safeguarding macroeconomic stability. Key reforms include implementing the Tourism Development Strategy, publishing a codified procedure for the approval of private investments, rehabilitating the energy sector including EMAE, and promoting women’s economic empowerment and financial inclusion. The IMF program is complemented by a World Bank social protection program of $10 million to protect the most vulnerable households.” Recent Economic Developments São Tomé and Príncipe is a fragile, small island-state with limited resources and capacity. The economy has a very narrow production base and depends heavily on imports and foreign aid. Exports of goods amount to only four percent of GDP. While offshore oil exploration continues, no commercial production is expected in the near term. Tourism, agriculture, and fisheries have potential for growth but require better infrastructure and private-led investment. While tourism grew significantly in recent years, local value-added of the sector is very low due to high import content. São Tomé and Príncipe faces pressing constraints. In 2018, lower external inflows, election-related disruptions, higher fiscal spending, and severe power outages contributed to a fall in real growth to 2.7 percent from 3.9 percent in 2017 and a sharp decline in gross international reserves by $16.3 million (1.5 months of imports). Higher international oil prices and shortages of local produce led to an increase in inflation to 9.0 percent, up from 7.7 percent at end-2017. Preliminary data suggest economic activity remained sluggish in the first half of 2019, and fuel and power shortages weighed on the economy. The fiscal position deteriorated significantly in 2018. Unbudgeted increases in personnel and capital spending and failure to cut utility consumption as planned contributed to overspending of almost 3.5 percent of GDP. Consequently, the domestic primary deficit reached 4.1 percent of GDP, 2.8 percent of GDP above the target. Furthermore, some government entities were allowed to spend off-budget, effectively loosening the fiscal stance further and raising the public debt by close to 1 percentage point of GDP. Meanwhile, EMAE accumulated arrears to its fuel supplier of close to $16 million (more than 3.5 percent of GDP), and total public debt rose to over 95 percent of GDP at end-2018. A new coalition government took office in December 2018 following parliamentary elections. The government’s reform program seeks to restore macroeconomic stability and unlock growth potential. Page 61 The World Bank THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING (P164321) Program Summary The 40-month program seeks to restore macroeconomic stability, bring the debt down to a sustainable path, and unlock growth potential. Fiscal consolidation supported by debt restructuring and monetary tightening will address pressure on foreign reserves and restore fiscal and external sustainability over the medium term. Structural reforms aim to mobilize revenue, enhance control over public spending, reduce contingent liabilities from SOEs, improve financial stability, and promote inclusive growth to reduce poverty, including through empowering women economically. A floor on pro-poor spending, along with a World Bank social protection program, will protect the most vulnerable. The Fund-supported program will also play a catalytic role and provide positive signals to stakeholders. [1] The ECF program is a lending arrangement that provides sustained program engagement over the medium to long term in case of protracted balance of payments problems. IMF Communications Department MEDIA RELATIONS PRESS OFFICER: GEDIMINAS VILKAS PHONE: +1 202 623-7100EMAIL: MEDIA@IMF.ORG Page 62 The World Bank THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING (P164321) ANNEX 3: LETTER OF DEVELOPMENT POLICY Page 63 The World Bank THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING (P164321) Page 64 The World Bank THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING (P164321) Page 65 The World Bank THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING (P164321) Page 66 The World Bank THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING (P164321) REPÚBLICA DEMOCRÁTICA DE SÃO TOMÉ E PRÍNCIPE Unidade – Disciplina – Trabalho MINISTÉRIO DO PLANEAMENTO, FINANÇAS E ECONOMIA AZUL GABINETE DE MINISTRO Letter of Development Policy Your Honor David Malpass World Bank Group President 1818 H Street, NW Washington, DC. 20433 USA Ref . ______ / GM / 201 9 São Tomé, October 23, 2019 Mr President, On behalf of the Government of the Democratic Republic of São Tomé and Príncipe, I am pleased to submit to your high consideration the document for the third operation of the program in support of the strengthening of growth and fiscal policy of São Tome and Príncipe (STP). This operation and its respective grant are a continuation to the World Bank's support the to the country's efforts to implement reforms conducive to economic growth, mobilization of own-resources for development financing, and the improvement of quality of public spending. The current government took office in December 2018, after a parliamentary election that led to power a coalition of parties, which were opposed to the previous government. The program of the XVII government is based on four strategic axes: deepening of the democratic rule of law; robust economic growth and accelerated job creation; improvement in health quality and social protection; and foreign policy at the service of development. All actions of the 17th Government aim to achieve two objectives: to create the conditions for the relaunch of an average economic growth of more than 7%, and to strengthen social cohesion. Nonetheless, the government has a much more urgent task facing given the terrible macroeconomic reality with visible social impacts found after taking office. In 2018, São Tome and Príncipe faced an energy crisis Page 67 The World Bank THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING (P164321) that at its peak reduced the country's energy production by up to 75%. The energy crisis has drastically reduced the country's level of economic activity and food availability with serious consequences for tax collection, inflation, and the well-being of the population. In addition, the actual government found a lot of expenses that were made by the previous government without the necessary financial backing or resorting to bank loans to pay even the payroll and that were not properly recorded in government accounting. As a result, this government spent one considerable amount of time earlier this year only to get a true picture of the real macroeconomic situation of the country. And believe me, this photograph was not pretty. The current government has since been trying to gradually solve the problems inherited. Inflation declined from over 10% at its peak in October 2018 to 7% in July 2019. And monetary aggregates’ growth, which partially explained inflation, fell from growth rates of 15-20% to values near zero or negative. International reserves have been partially restored, and tax revenues are already showing slight growth in 2019. The government has resumed payments on its energy and telephone bills and has been trying to curb public spending. This task, however, is proving extremely difficult given the country's absolute low level of public expenditure, the volume of overdue expenses, and salary increases approved by the previous government to take effect in 2019. The public debt-to-GDP ratio rose not because of new loans, but due to the recognition of debts due to payments in arrears to suppliers, bank credit, and debt to the water and electricity company (EMAE) and the fuel supply company (ENCO), which for the first time were incorporated into the public debt stock as a way of giving greater transparency to public debt. This government is committed to a sound macroeconomic policy and has not hesitated to take tough measures to achieve fiscal balance such as raising fuel prices, raising existing taxes and introducing the value added tax, which is one of the actions supported by this operation (Prior Action #8). The Tax Directorate has been preparing for the introduction of VAT through international expert missions, study tours, and hiring new staff. With the approval of the law, the Directorate will now engage in the communication campaign, systems development, and employee training. As a result of this work, the government has not resorted to bank loans to pay wages. It is also a commitment of this government not to borrow in excess of its repayment capacity, but above all to make the private sector the engine of economic growth. In recognition to this effort, the International Monetary Fund recently approved a new program to STP, which will allow the release of other grants from international partners. It this spirit the Government of São Tome and Príncipe requests the World Bank support for the third development policy operation. The first policy area of this operation is the financial sector. The Central Bank of STP has been developing a fruitful partnership to improve banking supervision and avoid any macro- fiscal problems arising from poorly managed banks (Prior Action #1), and to improve financial infrastructure to support private sector development, mainly tourism, financial inclusion, and development of social programs (Prior Action #2). This partnership also supported the development of the entire legal framework for the microfinance sector (Prior Action #3), aiming at financial inclusion and overcoming the credit constraint on private sector development. Reviewing the quality of the assets of the commercial banks has enabled the Central Bank to see gaps in its supervisory activity and to verify the main vulnerabilities of the banking system, which are already being addressed by the bank supervision area. The partnership with the World Bank has allowed us to structure the Central Bank's payment system area, create all the legislation that now allows us to address system failures, and create the infrastructure necessary for its modernization such as the connection to the international credit card network and for financial inclusion. Page 68 The World Bank THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING (P164321) The recently concluded Country Economic Memorandum rightly pointed to the uncertainty of land rights ownership as one of the constraints to private sector development, particularly in the areas of tourism and agriculture. In addition, the legal framework on land ownership has a major implication on gender issues, especially in a country like STP where most marital unions are informal. In this sense, this operation, together with other Bank operations, will allow the inter-operability of the main property and land cadasters in the country and safeguard women's land ownership rights (Prior Action #4). The government is digitizing all registry files, which is the first step towards interoperability that will be achieved with the new system that is under construction. Energy is a critical issue in STP. The current government managed to gradually restore the energy production capacity to 85% of the demand. In 2020, the government will install more power generators that will allow EMAE to restore power production to meet demand, ending the power cuts, and allowing the government to make the regular maintenance of generators without the need for cuts. The government understands that this is a temporary and short-term solution and that the long-term solution requires the participation of the private sector and the use of renewable energy. In this regard, the government recently approved the least- cost power development plan (Prior Action #6), which was supported by the World Bank, to guide expansion and private investment in the energy sector. The government is also aware that attracting the private sector to the energy sector requires a financially and operationally sound energy company. To this end, EMAE prepared a management improvement plan that has been approved by the Council of Ministers (Prior Action #6) and the government is committed to settle its overdue accounts with the company and the fuel supplier (ENCO). The increase in fuel prices aimed to recompose the positive differential between domestic and international prices in order to generate resources to amortize the debt with ENCO. Negotiations to sustainably pay off these debts are also underway. Another step being taken to reduce EMAE financial losses in the short term is to decrease costs by improving efficiency in electricity consumption for the end-user through a government program to encourage the use of efficient LED light bulbs (Prior Action #5) and the gradual ban on the importation of inefficient incandescent light bulbs. The government is working on the technical specifications of the program such as numbers of lamps per household and its types and logistics for rapid deployment. Currently, over 70 percent of the current electricity generation in São Tomé and Príncipe (STP) is consumed for meeting the need for lighting across various consumer categories. The implementation of a demand side management (DSM) program based on large-scale LED bulb deployment in STP will be the quickest way to address power shortages, improve the financial viability of the electricity sector and also help create climate co-benefits through the reduction of green-house gas emissions. This program is expected to reduce the demand by 8 MW and 15 GWh of energy consumption, that is, 15 percent of EMAE’s current generation by the summer of 2020. Finally, the government has been working to improve energy sector regulation. The most recent progress has been the approval of the concession agreement between Government and EMAE (Prior Action #7), which aims to formalize the framework and conditions applicable to service delivery by the concessionaire (rights and obligations, economic and service quality regulations, regime for monitoring performance and enforcing compliance, etc.). Such contracting will improve the planning of the regulatory agency oversight activities and will also serve as guidance for EMAE’s improvement. On the fiscal side, the government has been working on a series of measures to increase revenues such as the aforementioned introduction of the VAT, but also to improve the management of public enterprises and public investments. Although actions relating to these two areas are no longer in the policy matrix of the third Page 69 The World Bank THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING (P164321) operation, the government remains committed to them. It was recently selected an international consultant to support the implementation of the state-owned enterprises reform plan, and the team from the Directorate of planning has been working on the revision of the legal framework and forms and methodologies for evaluation of public investment. Finally, I would like to highlight the importance of providing the country with a modern social protection system with focused programs and payments permanently made through the banking network and electronic means (Prior Action 9) in order to ensure the integrity of the program and foster financial inclusion. The government has already registered almost all beneficiaries and payments will start shortly. In short, these are the reforms for which we would like to have the support of the World Bank. I believe that the tough macroeconomic measures taken are concrete examples of our commitment to macroeconomic stability. I also renew my commitment to keep you informed of any action of the government to interfere in the program or not our engagement with multilateral institutions. Aware of your attention, I renew my protests of high esteem and distinguished consideration. The minister _________________________ Osvaldo dos Santos Vaz Page 70 The World Bank THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING (P164321) ANNEX 4: ENVIRONMENT AND POVERTY/SOCIAL ANALYSIS TABLE Prior actions Significant positive or negative Significant poverty, social or environment effects distributional effects positive or (yes/no/to be determined) negative (yes/no/to be determined) Pillar A: Introduce growth-enabling reforms in the financial sector, business environment, and infrastructure Prior Action #1: The Recipient, through No significant positive or No BCSTP, has approved the Report for the São negative environmental effects Tomé and Príncipe Banking System Asset are expected. Quality Review, as part of its efforts to improve financial soundness of commercial banks. Prior Action #2: The Recipient, through: (i) No significant positive or Yes its National Assembly, has passed the legal negative environmental effects framework for payment services providers are expected. and payment system operators, which outlines the oversight framework, duties and powers of BCSTP; and (ii) BCSTP, has passed the key implementing regulations under the National Payments System Law, which provide for the legal protection of the electronic transfer of funds and the licensing and supervision of payment institutions and payment system operators. Prior Action #3: The Recipient, through No significant positive or Yes BCSTP, has passed key regulations, which negative environmental effects establish the minimum entry, operation are expected. requirements, risk management minimum requirements, and supervisory and reporting procedures for microfinance institutions. Prior Action #4: The Recipient, through its No significant positive or Yes Council of Ministers, has approved the negative environmental effects institutional structure for enabling are expected. interoperability between the land property register (Registo de Propriedade) and the cadaster (Registo Cadastral). Page 71 The World Bank THIRD STRENGTHENING GROWTH AND FISCAL POLICY DEVELOPMENT POLICY FINANCING (P164321) Prior Action #5: The Recipient, through the Yes. Positive environmental Yes Presidency of the Republic, has instituted effects are expected because the an energy demand management program, deployment of LED bulbs can which includes the exchange of low contribute to significant energy efficient bulbs with higher efficient ones. savings, lower pollution, and reduce GHG emissions. Prior Action #6: The Recipient, through its Yes. Positive environmental No Council of Ministers, has approved: (a) a effects are expected. Power Least-Cost Power Sector Development generation activities shall to Plan, which provides the basis for a follow the prescriptions competitive process for all power integrated in the Least Cost Power generation activities; and (b) a Development Plan including Management Improvement Plan for the compliance with environmental EMAE, which aims to improve EMAE’s standards. operational performance. Prior Action #7: The Recipient, through No significant positive or No AGER, has signed a concession contract negative environmental effects with EMAE, which stipulates the are expected. obligations of the Recipient and the licensee, including rules on tariffs and sanctions. Pillar B: Generate fiscal resources and savings and improve the quality of expenditures Prior Action #8: The Recipient, through No significant positive or Yes the National Assembly, has passed the negative environmental effects Value Added Tax Code which sets forth are expected. provisions aimed at broadening the tax base and generating more own-source revenues. Prior Action #9: The Recipient, through the No significant positive or Yes Ministry of Finance, has instituted a negative environmental effects financial system-based (non-cash) are expected. payment mechanism to allow for the tracking and reconciliation of funds allocated to social protection payments. Page 72