The World Bank Vanuatu Disaster Risk Management Development Policy Grant with a Catastrophe-Deferred Drawdown Option (CAT-DDO) (P168749) Document of The World Bank FOR OFFICIAL USE ONLY Report No: PGD57 INTERNATIONAL DEVELOPMENT ASSOCIATION PROGRAM DOCUMENT FOR A PROPOSED GRANT IN THE AMOUNT OF SDR7.3 MILLION (EQUIVALENT TO US$10 MILLION) TO REPUBLIC OF VANUATU FOR THE Disaster Risk Management Development Policy Grant with a Catastrophe-Deferred Drawdown Option (CAT-DDO) December 4, 2019 Urban, Resilience, and Land Global Practice East Asia And Pacific Region This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization. . The World Bank Vanuatu Disaster Risk Management Development Policy Grant with a Catastrophe-Deferred Drawdown Option (CAT-DDO) (P168749) Republic of Vanuatu GOVERNMENT FISCAL YEAR January 1 – December 31 CURRENCY EQUIVALENTS (Exchange Rate Effective as of October 31, 2019) Currency Unit = Vatu (VUV) VUV 116 = US$ 1.00 US$ 1.37939 = SDR 1.00 ABBREVIATIONS AND ACRONYMS ASA Advisory Services and Analytics MDCCCs Municipal Disaster and Climate Change Committees CAT-DDO Catastrophe-Deferred Drawdown Option MFEM Ministry of Finance and Economic Management CCA Climate Change Adaptation NGO Non-Government Organization CCDRR Climate Change and Disaster Risk NSDP National Sustainable Development Plan Reduction CSO Civil Society Organization PDCCCs Provincial Disaster and Climate Change Committees DMS Debt Management Strategy PFM Public Financial Management DRM Disaster Risk Management PPG Public and Publicly Guaranteed DRR Disaster Risk Reduction PPP Purchasing Power Parity ECP Economic Citizenship Program RBV Reserve Bank of Vanuatu GDP Gross Domestic Product RPF Regional Partnership Framework GoV Government of Vanuatu SDR Special Drawing Rights IMF International Monetary Fund VMGD Vanuatu Meteorology and Geohazards Department LDP Letter of Development Policy WB World Bank . Regional Vice President: Victoria Kwakwa Country Director: Michel Kerf Regional Director: Benoit Bosquet / Hassan Zaman Practice Manager: Abhas Kumar Jha / Ndiame Diop Task Team Leaders: Artessa Saldivar-Sali, Tevi Maltali Obed, Kim Alan Edwards The World Bank Vanuatu Disaster Risk Management Development Policy Grant with a Catastrophe-Deferred Drawdown Option (CAT-DDO) (P168749) REPUBLIC OF VANUATU VANUATU DISASTER RISK MANAGEMENT DEVELOPMENT POLICY GRANT WITH A CATASTROPHE-DEFERRED DRAWDOWN OPTION (CAT-DDO) TABLE OF CONTENTS SUMMARY OF PROPOSED FINANCING AND PROGRAM .......................................................................2 1. INTRODUCTION AND COUNTRY CONTEXT ...................................................................................4 2. MACROECONOMIC POLICY FRAMEWORK....................................................................................6 2.1. RECENT ECONOMIC DEVELOPMENTS............................................................................................ 6 2.3. IMF RELATIONS ............................................................................................................................ 16 3. GOVERNMENT PROGRAM ........................................................................................................ 17 4. PROPOSED OPERATION ............................................................................................................ 18 4.1. LINK TO GOVERNMENT PROGRAM AND OPERATION DESCRIPTION .......................................... 18 4.2. PRIOR ACTIONS, RESULTS AND ANALYTICAL UNDERPINNINGS .................................................. 20 4.3. LINK TO CPF, OTHER BANK OPERATIONS AND THE WBG STRATEGY .......................................... 28 4.4. CONSULTATIONS AND COLLABORATION WITH DEVELOPMENT PARTNERS ............................... 29 5. OTHER DESIGN AND APPRAISAL ISSUES .................................................................................... 30 5.1. POVERTY AND SOCIAL IMPACT .................................................................................................... 30 5.2. ENVIRONMENTAL ASPECTS ......................................................................................................... 32 5.3. PFM, DISBURSEMENT AND AUDITING ASPECTS .......................................................................... 33 5.4. MONITORING, EVALUATION AND ACCOUNTABILITY .................................................................. 35 6. SUMMARY OF RISKS AND MITIGATION ..................................................................................... 36 ANNEX 1: POLICY AND RESULTS MATRIX .......................................................................................... 39 ANNEX 2: FUND RELATIONS ANNEX .................................................................................................. 40 ANNEX 3: LETTER OF DEVELOPMENT POLICY ..................................................................................... 44 ANNEX 4: ENVIRONMENT AND POVERTY/SOCIAL ANALYSIS TABLE .................................................. 47 This operation was prepared by an IDA team consisting of Artessa Saldivar-Sali (Task Team Leader, SEAU1), Tevi Maltali Obed (Co- Task Team Leader, SEAU1), Kim Alan Edwards (Co-Task Team Leader, EEAM2), Anna Robinson (EEAM2), Rashad Hasanov (EEAM2), William Battaile (EA1M1); David Bruce Whitehead (EEAG2), Janet Virginia Gamarra Rupa (EEAG2), Zhentu Liu (EEAR2), Rachelle Marburg (SEAS1), Darian Naidoo (EEAPV), Philip Martin (SEAS1), Leisande Otto (EACNF), Duangrat Laohapakakul (LEGES), Holly Woodcroft (LEGES), Colleen Mary Gollach (SEAU1), Karen Olivia Jimeno (SEAU1), Veronica Piatkov (SEAU1), Felix Taaffe (SEAE1), Michelle Lee (EACNF), and Danielle Okeefe (EACNF). Page 1 The World Bank Vanuatu Disaster Risk Management Development Policy Grant with a Catastrophe-Deferred Drawdown Option (CAT-DDO) (P168749) SUMMARY OF PROPOSED FINANCING AND PROGRAM BASIC INFORMATION Project ID Programmatic P168749 No Proposed Development Objective(s) The Program Development Objective (PDO) is to enhance the Recipient's regulatory framework and institutional capacity to: (i) manage and reduce the risks from natural disasters and climate change; and (ii) manage public debt. Organizations Borrower: REPUBLIC OF VANUATU Implementing Agency: MINISTRY OF FINANCE AND ECONOMIC MANAGEMENT, DEPARTMENT OF STRATEGIC POLICY, PLANNING AND AID COORDINATION PROJECT FINANCING DATA (US$, Millions) SUMMARY Total Financing 10.00 DETAILS International Development Association (IDA) 10.00 IDA Grant 10.00 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 Substantial Page 2 The World Bank Vanuatu Disaster Risk Management Development Policy Grant with a Catastrophe-Deferred Drawdown Option (CAT-DDO) (P168749) . Results Indicator Name Baseline (2019) Target (2022) Pillar A. Managing and Reducing Disaster and Climate Risk Results Indicator 1.1: Number of Provincial and Municipal Disaster and 4 PDCCCs established 6 PDCCCs established Climate Change Committees (PDCCCs, MDCCCs) established with funded annual work plans 0 MDCCCs established 2 MDCCCs established Results Indicator 1.2: Disaster Recovery Framework developed and No Yes approved for implementation by Council of Ministers Results Indicator 2.1: Subdivision Regulations integrating affordability, Regulations applied to 100 Regulations not climate and disaster resilience adopted and applied precent of Subdivision developed applications Results Indicator 2.2: Disaster and climate-risk informed Land LMPC Guidelines applied to LMPC Guidelines not Management Planning Committee (LMPC) guidelines adopted and 100 percent of Subdivision developed applied applications Pillar B. Managing Public Debt Compliance with the DMS Results Indicator 3.1: Compliance with the Debt Management Strategy concessionality condition of New external loan (DMS) condition of a minimum 35 percent grant element for any new a minimum 35 percent grant contracted in late 2018 external financing element for any new had a grant element external loan contracted below 35 percent during the term of the DMS (from 2019 to 2022). . Page 3 The World Bank Vanuatu Disaster Risk Management Development Policy Grant with a Catastrophe-Deferred Drawdown Option (CAT-DDO) (P168749) IDA PROGRAM DOCUMENT FOR A PROPOSED DEVELOPMENT POLICY GRANT WITH A CATASTROPHE-DEFERRED DRAWDOWN OPTION (CAT-DDO) TO REPUBLIC OF VANUATU 1. INTRODUCTION AND COUNTRY CONTEXT 1. The proposed SDR 7.3 million (US$10 million equivalent) Disaster Risk Management (DRM) Development Policy Grant with a Catastrophe-Deferred Drawdown Option (CAT-DDO) supports the Government of Vanuatu’s (GoV) efforts to reduce and manage disaster and climate risks and improve its management of public debt. Disasters in recent years (e.g. 2015 Tropical Cyclone Pam, 2018 Tropical Cyclone Hola, recurring volcanic activity on Ambae, Ambrym, Tanna and Gaua islands) have shown the need for a comprehensive disaster risk management framework, with well-defined institutional roles and responsibilities for preparedness, ex ante risk reduction, and management of impacts. At the same time, the rapid growth of population and assets in hazardous areas necessitates stronger disaster risk reduction (DRR) policies and regulations for resilient land and settlement development throughout the country. This proposed stand-alone operation aligns with the national priorities set forth in the Vanuatu Climate Change Adaptation and Disaster Risk Reduction Policy (2016-2030) and the objectives of the National Sustainable Development Plan (2016-2030), specifically Environment Goal 3 of a strong and resilient nation in the face of climate change and disaster risks posed by natural hazards. 2. The substantial increase in public debt after Tropical Cyclone (TC) Pam in 2015 has reduced the fiscal space available to the government to respond to future natural disasters, which were assessed by the International Monetary Fund (IMF) in its recent Article IV consultations to be the main risk to the economy looking forward. In addition to the disaster risk reduction policies and regulations outlined above, the debt management reforms supported by this operation are a key component of the government’s overall plans to consolidate its public finances and ensure fiscal resilience, including by maintaining sufficient fiscal buffers to respond to future disasters and other external shocks. 3. As a very small remote economy that is highly vulnerable to climate change, disasters and external shocks, Vanuatu is subject to many of the constraints facing other Pacific island countries. The 290,000 residents of the Republic of Vanuatu live on an archipelago of 83 volcanic islands (72 of them inhabited) with approximately 12,200 square kilometers land area, dispersed over an exclusive economic zone of about 827,000 square kilometers. The economy is characterized by a formal sector driven by tourism and agriculture, and informal subsistence activity outside the main urban centers of Port Vila and Luganville. The small size of the domestic economy (GDP was estimated at US$928 million in 2018) and its remoteness from major markets push up the costs of economic activity, as economies of scale cannot be realized in domestic production and transport costs significantly increase the cost of trade. Relatively fast population growth (due to high fertility rates and limited international migration opportunities) has meant that average annual per capita GDP growth has only been marginally positive over the past decade, with GDP per capita estimated at US$3170 in 2018. Recent infrastructure spending (including for post-TC Pam reconstruction activities) has led to a sharp increase in external public debt over the last few years, although most of this external borrowing has been at highly concessional terms and used to finance important public investment needs. 4. Vanuatu is exposed to a variety of both hydrometeorological and geophysical disasters due to its location in the South Pacific tropical cyclone basin and the Pacific Ring of Fire. Hydrometeorological hazards include tropical cyclones, floods, and droughts, whereas geophysical hazards include volcanic hazards, Page 4 The World Bank Vanuatu Disaster Risk Management Development Policy Grant with a Catastrophe-Deferred Drawdown Option (CAT-DDO) (P168749) earthquake-related hazards, and tsunamis. During the period 1980 to 2012, Vanuatu experienced approximately 53 disaster events (earthquakes - 46 percent, tropical cyclones - 35 percent) that affected around 300,000 people.1 As at 2014, the cumulative effect of disaster loss on fixed capital was estimated at approximately 24 per cent of capital investment since 1970.2 In March 2015, Category 5 Cyclone Pam struck 22 islands of Vanuatu, causing estimated economic impacts in the amount of US$450 million, equivalent to 64 percent of GDP.3 Catastrophe modeling conducted in 2010 estimated that, on a very long-term annual average, the country faces US$48 million per year in risk to assets from earthquakes and tropical cyclones alone. In any given 50-year period, Vanuatu has a 50 percent chance of experiencing a loss exceeding US$330 million, and a 10 percent chance of experiencing a loss exceeding US$540 million.4 5. The effects of climate change will exacerbate the impacts of hydrometeorological events. The Vanuatu Climate Change Adaptation and Disaster Risk Reduction Policy identifies the following climate change-related hazards: (i) by 2040, daily temperatures will increase from 1995 levels by 1.2°C; (ii) sea level rise will continue and accelerate; (iii) extreme weather events, including cyclones and storms, will increase in intensity but not necessarily in frequency; (iv) dry periods will last longer; and (v) extreme rainfall will be more frequent and intense. The associated consequences could include coastal inundation, damage to infrastructure, and loss of coastal land, among others. 6. In addition, accelerating development and concentration of people and settlements in hazardous areas is significantly increasing the country’s risk profile. Port Vila’s population is growing at a rapid 4.1 percent annually (faster than cities like Dhaka and Nairobi), from both natural population increase and rural migrants from other islands seeking prosperity and opportunity in the city. The majority of growth (74 percent) occurs outside the municipal boundary, in unplanned, un-serviced settlements in hazardous areas (a trend that is mirrored in the country’s other population centers such as Luganville). While Port Vila Municipality is estimated to have 66,000 residents, the population of Greater Port Vila -- including adjacent peri-urban areas -- is almost double at 114,000 (or about 45 percent of the national population in 2018).5 7. While the average annual risk to assets in Vanuatu is estimated at 7 percent of GDP, well-being risk6 (accounting for the disproportionate impact of asset loss on the poor) is about 10 percent of GDP.7 Even though the poor suffer only a small share of the dollar value of asset losses caused by disasters, the well-being effect across the population is magnified (as measured by the estimated drop in consumption) due to lack of capacity to cope with disasters. Using the international poverty line of U$1.90 (PPP per person per day) the headcount poverty rate in 20108 was estimated at 13.2 percent, while the rate is 39.5 percent based on the lower-middle 1 Pacific Disaster Net, 2013. www.pacficdisaster.net. 2 Global Assessment Report on Disaster Risk Reduction 2015: Making Development Sustainable: The Future of Disaster Risk Management . Geneva, Switzerland: United Nations International Strategy for Disaster Reduction, 2015. 3 World Bank Group, 2015. Tropical Cyclone Pam Post Disaster Needs Assessment. 4 PCRAFI Country Risk Profiles, September 2011. 5 Trundle et al., 2018. “Leveraging endogenous climate resilience: urban adaptation in Pacific Small Island Developing States” in Environment & Urbanization Vol 31(1): 53-74. Provided an estimate of the peri-urban population within a 10 km radius of the city boundary at the 2009 Census, extrapolated by the task team to 2018 using the Census growth rate. 6 Well-being risk is defined so that US$1 of well-being risk indicates the same impact on poor people as on the wealthy, even when their asset losses differ. 7 World Bank and Global Facility for Disaster Reduction and Recovery “Resilience Indicator”. World Bank 2017, Unbreakable. 8 The most recent poverty estimates for Vanuatu are based on the 2010 Household Income and Expenditure Survey data. A 2018/2019 Household Income and Expenditure Survey is ongoing. Page 5 The World Bank Vanuatu Disaster Risk Management Development Policy Grant with a Catastrophe-Deferred Drawdown Option (CAT-DDO) (P168749) income poverty line (US$3.2 per day). By supporting policy reform for risk reduction -- so that assets and livelihoods become less vulnerable to future shocks -- this program could help reduce overall well-being risk due to natural disasters in Vanuatu by more than 40 percent. Similarly, by enabling fast recovery through immediate liquidity -- so that people can get back to their normal life as early as possible -- the program could help reduce overall well-being risk by over 20 percent.9 8. The availability of predictable contingent financing through this proposed CAT-DDO would supplement existing post-disaster funding arrangements. In 2010 the government commenced annual appropriations of VUV25 million (approximately US$265,000) for an Emergency Fund10, which currently does not accrue and becomes expendable at the end of the financial year. Recent disasters have required supplementary budget allocations, showing that the Emergency Fund is inadequate and can be depleted even by a single event. Catastrophe risk modeling further shows that there is a 91 percent chance that disaster losses will exceed the VUV25 million provision in any given year11, which highlights the need for contingent sources of immediate liquidity to cover relief and early recovery. Year Supplementary Budget Requirement, Official Development Assistance for Emergency million US$ (A) Response12, million US$ (B) 2010 TC Vania - US$1 million 0.08 2011 0.15 2012 0.10 2013 0.00 2014 0.04 2015 TC Pam - US$2.3 million 68.77 2016 1.12 2017 Ambae volcanic eruptions -US$1.9 million 2.35 2018 TC Hola - US$0.8 million Not yet reported Ambae volcanic eruptions -US$3.9 million Not yet reported 9. The Program Development Objective (PDO) is to enhance the Recipient's regulatory framework and institutional capacity to: (i) manage and reduce the risks from natural disasters and climate change; and (ii) manage public debt. This objective will be achieved through reforms under Pillar A: Managing and Reducing Disaster and Climate Risk, and Pillar B: Managing Public Debt. The overall program risk rating is Substantial, based on substantial political and governance, macroeconomic, fiduciary, and institutional capacity risk. 2. MACROECONOMIC POLICY FRAMEWORK 2.1. RECENT ECONOMIC DEVELOPMENTS 10. Vanuatu is close to full recovery from TC Pam, which struck in March 2015, resulting in loss of life and around 75,000 people requiring emergency shelter. TC Pam inflicted substantial damage to Vanuatu’s capital 9 World Bank and Global Facility for Disaster Reduction and Recovery. World Bank 2018, Building back better: achieving resilience through stronger, faster, and more inclusive post-disaster reconstruction. Washington, D.C.: World Bank Group. 10 In 2019 the appropriation was VUV150 million (US$1.3 million). 11 PCRAFI Country Note, February 2015. 12 Source: OECD Creditor Reporting System (Open Data) Page 6 The World Bank Vanuatu Disaster Risk Management Development Policy Grant with a Catastrophe-Deferred Drawdown Option (CAT-DDO) (P168749) stock, including infrastructure, livestock, and household assets, with damages and losses estimated at around 60 percent of GDP. Because of TC Pam, GDP was broadly flat in the 2015 calendar year (compared with the pre- cyclone forecast of 4.3 percent growth), due to losses in the tourism and agricultural sectors in particular, which were only partially offset by reconstruction activity and the commencement of several large infrastructure projects. Subsequently, a recovery in tourism and agriculture combined with further ramping-up of infrastructure projects propelled growth to around 3.5 percent in 2016 and an estimated 4.4 percent in 2017. In 2018, growth is estimated to have slowed to 3.2 percent due to disruptions to agriculture caused by storms and volcanic eruptions, and weaker agricultural prices. Several large infrastructure projects, including the rehabilitation of damaged road transport infrastructure, and a port upgrade in the capital, are now nearing completion, consistent with a projected easing in construction-related economic activity. Growth is expected to stabilize at around 3 percent per year over the medium term. 11. Reflecting the high import content of infrastructure projects and limited production and export opportunities, Vanuatu has consistently recorded large trade deficits, putting downward pressure on the current account balance. Imports increased to around 40 percent of GDP in 2015 and 2016 due to cyclone reconstruction efforts, while exports declined due to damage to tourism facilities and reductions in agricultural production. Nevertheless, tourism receipts and transfers cushioned the effect on the current account, which was close to balance in these two years, and the IMF provided emergency assistance of US$23.8 million, or around 3 per cent of GDP. In 2018, the current account recorded a strong surplus of 3.5 percent of GDP, reversing a deficit of 6.5 percent of GDP the previous year. The reversal was largely driven by windfall revenues from the Economic Citizenship Programs (ECP) in 2018, as well as a pick-up in tourism receipts.13 Gross international reserves have grown steadily over the past few years, bolstered by cyclone related grants and loans from the IMF and other development partners, and currently cover 12 months of imports, well above the Reserve Bank of Vanuatu’s (RBV) minimum target level of 4 months of imports. 12. Inflation in Vanuatu has remained comfortably within the 0–4 percent range targeted by the RBV over the last few years, although it has moved to the upper half of the target band in 2017 and 2018. Reconstruction activity and infrastructure investment coupled with shortages of materials pushed inflation up to 2.5 percent in 2015 (with the decline in oil prices preventing a more pronounced acceleration), before moderating to 2.1 percent in 2016. Inflation is estimated to have quickened to around 3 percent in 2017 and 2018, reflecting the impact of increased construction activity and increased domestic demand for food, transport and education. However, a temporary VAT increase from 12.5 percent to 15 percent in January 2018 did not put substantial additional pressure on inflation as originally expected. The vatu peg to an undisclosed basket of currencies acts as an important nominal anchor – allowing Vanuatu to import low inflation from Australia and New Zealand – and continues to serve Vanuatu well in promoting stability and confidence. Despite being broadly stable in recent years, IMF staff analysis of the real effective exchange rate (REER) suggests that the exchange rate is somewhat undervalued compared to its fundamentals, and this may have had a positive impact on Vanuatu’s export competitiveness (although different exchange rate valuation methodologies yield different results). 13. The RBV’s monetary policy was accommodative after the cyclone but has shifted to a more neutral stance in recent years, though the monetary transmission mechanism is weak. After the cyclone, RBV moved swiftly to support economic recovery through a series of measures to loosen monetary policy, including lowering 13 The Economic Citizenship Programs offer Vanuatu citizenship to foreigners in exchange for a one-time financial contribution. Page 7 The World Bank Vanuatu Disaster Risk Management Development Policy Grant with a Catastrophe-Deferred Drawdown Option (CAT-DDO) (P168749) the policy rate, reducing the required reserve ratio, and activating central bank credit facilities.14 In its 2019 Article IV staff report, the IMF notes that the RBV has acted to mitigate more recent inflationary pressures by increasing banks’ statutory reserve deposit requirements and mopping up additional excess liquidity through open market operations. The continuation of a broadly neutral monetary policy stance was assessed as appropriate for the short term. Excess liquidity in the banking system and high lending rates are structural issues which weaken the monetary policy transmission mechanism. 14. Vanuatu is making considerable efforts to improve compliance with anti-money laundering/countering financing of terrorism (AML/CFT) standards in order to protect its correspondent banking relationships. In 2016, Vanuatu was placed on the Financial Action Taskforce (FATF) “grey list” due to weaknesses in its financial regulatory framework. This highlighted the vulnerability of Vanuatu’s banking sector to losing access to the correspondent banks that it needs to operate in the international financial system, a significant risk to financial stability. Vanuatu has since implemented a number of measures in response to the grey-listing, including amendments to the International Companies Act to improve access to beneficial ownership information. FATF removed Vanuatu from the grey list in June 2018 in response to this significant progress, although it remains subject to enhanced follow-up. While banks have generally maintained their correspondent banking relationships, these compliance activities have increased costs. 15. Vanuatu does not have corporate or personal income tax, which increases the relative tax burden on the poor and means that Vanuatu is reliant on non-conventional revenue-raising schemes to supplement tax revenues. Value-added tax (VAT) and other taxes on goods and services generally make up around half of domestic revenue and were estimated at 13.7 percent of GDP in 2018. Special citizenship schemes and other fees and charges have been the second most important revenue category and averaged 6-7 percent of GDP in 2016 and 2017 before increasing dramatically to 11.9 percent of GDP in 2018 (revenues from citizenship schemes actually exceeded VAT in 2018). Meanwhile, external grants spiked to 11.8 percent of GDP in 2015 following TC Pam and averaged 9.4 percent of GDP in 2016 and 2017 (compared to an average of around 3 percent of GDP over 2012-14). However, preliminary outturns indicate a substantial drop-off in grants in 2018, to around 5.6 percent of GDP. 16. The GoV carried out a comprehensive revenue review in 2017, but proposals to introduce new taxes are on hold until after the next elections in 2020. Proposals from the revenue review included introducing an income tax for individuals and for companies; removing some fees and charges which are costly to administer, and which affect the ease of doing business; and fast-tracking the removal of import duties already agreed to under PACER Plus (a regional trade agreement). Given that implementation of the income tax recommendations has been deferred, the government decided to temporarily increase the VAT rate from 12.5 to 15 percent from January 2018, to ensure sufficient fiscal headroom for new spending. The IMF’s Pacific Financial Technical Assistance Center (PFTAC) provided advice on the revenue review and has also assisted with new tax administration legislation, which was passed in December 2018. 14The Statutory Reserve Deposit (SRD) requirement was lowered from 7 to 5 percent to alleviate liquidity pressure on banks, following the government’s decision to allow members’ withdrawal of 20 percent of their VNPF retirement funds. The Secured Advance Faci lity was reactivated in March 2016, allowing banks to borrow from the RBV at a rate 250 basis points higher than the policy rate. The collateral requirement for this facility was relaxed and banks were able to use their required reserves—in addition to their holdings of government bonds and RBV notes—as collateral. The RBV also activated an Import Substitution and Export Financing facility, allowing commercial banks to borrow at 1 percent under the condition that the funds be on-lent to private firms in specific sectors at a rate capped at 5 percent. Page 8 The World Bank Vanuatu Disaster Risk Management Development Policy Grant with a Catastrophe-Deferred Drawdown Option (CAT-DDO) (P168749) 17. Vanuatu has maintained its target of keeping the recurrent budget in surplus over the medium term, despite recent public sector pay settlements which saw a 25 percent increase in the wage bill in 2018. Vanuatu ran operating surpluses (i.e. excluding capital spending) in 2016 and 2017, both before and after including donor operations. The 2018 budget as passed would have resulted in an operating deficit of 3.7 percent of GDP, mainly due to the implementation of pay settlements from the Government Remuneration Tribunal (GRT) review that commenced in 2016. The GRT determinations (designed to reflect increased cost of living and make it easier to attract and retain talent) saw compensation of employees jump by almost 40 percent in the 2018 budget compared with the original 2017 budget, bringing this expense category to VUV13.4 billion (13 percent of GDP and 50 percent of recurrent spending). A supplementary budget in 2018 also allocated a further VUV870 million to GRT adjustments. However, 2018 estimates indicate that wage and salary spending came in VUV0.9 billion under budget, at VUV12.4 billion. While the increase was nevertheless large, with the wage bill increasing by about 25 percent from 2017, it was the first increase in public sector wages since 2006, and increases of a similar magnitude are unlikely in the near future. As well as providing compensation for increases in the cost of living over the past decade, the wage increase was used as an opportunity to rationalize several public servant allowances (e.g. for housing), which have now been built into the new salary scales. This resulted in a partially offsetting decline in spending on social benefits in 2018. Meanwhile, spending on goods and services was also under budget in 2018, due in part to slower-than-expected implementation of government infrastructure projects.15 This underspending, combined with the unexpected windfall from citizenship schemes, has resulted in a large operating surplus in 2018, estimated at 10.9 percent of GDP. 18. In contrast to spending on the public sector wage bill, the ongoing Ambae Volcano emergency has had a relatively contained impact on the recurrent budget, despite having widespread humanitarian consequences. In addition to original appropriations of VUV25 million and VUV30 million for the Emergency Fund in 2017 and 2018, GoV allocated VUV200 million towards Ambae relief costs through a supplementary budget in 2017 and a further VUV440 million in 2018, but together these amounts totaled less than 1 per cent of GDP. GoV has significantly increased the Emergency Fund appropriation in the 2019 budget, to VUV150 million. 19. Post-cyclone reconstruction spending and concessional borrowing for flagship infrastructure projects have meant that capital spending has offset operating surpluses, leading to overall budget deficits in recent years. Following widespread recognition of the need to improve the nation’s infrastructure stock, GoV has implemented a number of major donor-funded infrastructure projects. This includes the construction of international wharves, new roads, inter-island shipping facilities and upgrades to the international airport, financed in large part through concessional loans. Spending on nonfinancial assets was estimated at 16.1 percent of GDP in 2015, declining to 9.9 percent and 8.8 percent of GDP in 2016 and 2017, respectively. 2018 estimates indicate a further decline in capital spending (6.1 percent of GDP) in 2018, which together with lower operating spending has resulted in an overall surplus of 4.8 percent of GDP. The surplus has been directed towards net repayments of domestic and foreign debt and increased cash balances. The 2018 fiscal results indicate that Vanuatu made net principal repayments of VUV1.4 billion (1.4 percent of GDP) during the year, including repayments ahead of schedule. 20. Recent infrastructure spending has led to a sharp increase in external public and publicly guaranteed (PPG) debt, with IMF estimates indicating an increase from 19.5 percent of GDP in 2014 to 45.2 percent of GDP 15 A further VUV3 billion was allocated to unspecified government projects in a supplementary budget in 2018. Page 9 The World Bank Vanuatu Disaster Risk Management Development Policy Grant with a Catastrophe-Deferred Drawdown Option (CAT-DDO) (P168749) in 2018 (total PPG public debt has increased by a similar margin to 52.4 percent of GDP in 2018).16 Vanuatu’s external debt tends to be long-term (20 to 40-year maturities) and relatively concessional (interest rates of 0-2 percent), with around two thirds borrowed from bilateral partners (mainly China and Japan) and one third from multilateral lenders. Despite the recent run-up in debt, Vanuatu remained at moderate risk of external debt distress in the most recent IMF-WB Debt Sustainability Analysis conducted in 2019 (see Section 2.2). Domestic PPG debt is worth around 7 percent of GDP and consists of bonds held mainly by the Provident Fund and Reserve Bank, and state-owned enterprises (SOE) guarantees. There have been no new bond issuances since 2017 and GoV repaid VUV1.8 billion worth of bonds in 2018. Guaranteed SOE debt has averaged 2-3 percent of GDP in recent years, more than 90 percent of which has been issued by Air Vanuatu, the national flag carrier. The 2019 budget introduced a target of keeping nominal public and publicly-guaranteed debt below 60 percent of GDP, in line with recommendations from the 2018 IMF Article IV consultations. 21. In November 2018, Vanuatu signed a major semi-concessional loan, after paying down external debt in the first half of the year. The CNY350 million loan (approx. US$51 million or 5.5 percent of GDP) was signed with China’s EXIM Bank for the second phase of the Tanna and Malekula Road project. Phase I of the project was approved in 2013 (at which time Vanuatu was classified at a low risk of debt distress and hence not subject to the Non-Concessional Borrowing Policy (NCBP)) and an economic analysis was conducted at the time which remains publicly available on the Ministry of Finance and Economic Management (MFEM) website. The grant element of the loan was around 28 percent, below the 35 percent concessionality threshold set by the NCBP, meaning that a waiver was requested as per the NCBP.17 The loan was also inconsistent with the concessionality requirements in Vanuatu’s Debt Management Strategy (DMS) 2015-17, though this strategy had expired at the time the loan was contracted. The loan did not cause the risk of debt distress to change (the 2019 IMF-WB DSA incorporates this loan into the projections, see below) and was consistent with the overall debt targets introduced in the 2019 budget and the DMS 2019-22 (see para 59), as well as the long-term fiscal objectives set out in the 2018 budget. 2.2. MACROECONOMIC OUTLOOK AND DEBT SUSTAINABILITY 22. GDP growth is expected to remain around 3.4 percent in 2019, and ease to 3 percent in 2020, as large infrastructure projects are completed. Nevertheless, the government’s substantial public investment and cyclone reconstruction program should ultimately help to raise the productive capacity of the economy over the medium to long term. Activity in the agriculture and tourism sectors should continue to expand over the medium- term, helping to drive continued overall growth. While construction activity associated with government infrastructure projects is projected to ease over the next few years, the effect on overall economic growth may in part be offset by increased private sector investment, particularly in the tourism sector. Inflation is expected to stabilize at around 2 to 3 percent per year, reflecting low inflation in major trading partners and the RBV’s continued maintenance of the exchange rate peg. Nevertheless, like all small, import-dependent Pacific Island 16 Work conducted as part of the preparation of the updated DMS indicates that the level of external PPG debt as at end-2018 may be 7 to 8 percentage points lower than estimated by the IMF in its recent Article IV and DSA consultations, in part because updated data has shown that disbursements of previously contracted loans were lower than previously estimated. 17 IDA considered several factors in response to this waiver request, including: (i) the loan did not trigger a downgrade in the assessed risk of debt distress; (ii) the project funded by the loan targets an important development need – improving connectivity on the islands of Tanna and Malekula and facilitating access to markets; and (iii) work is underway to further strengthen debt management policy in Vanuatu, including as supported by Prior Action 3 of this operation. In light of these considerations, IDA decided to grant an NCBP waiver to Vanuatu. Page 10 The World Bank Vanuatu Disaster Risk Management Development Policy Grant with a Catastrophe-Deferred Drawdown Option (CAT-DDO) (P168749) economies, Vanuatu remains subject to a number of macroeconomic risks related to the external environment, including a slowdown in growth in larger economies in the region, which could have a negative impact on tourism activity, FDI inflows, and/or remittances. 23. A moderation of revenue from ECP is expected to turn the current account surplus into a small deficit in 2019. The deficit is expected to widen from 2020 onwards, reflecting additional current account pressure from the purchase of airplanes as part of the Shared Vision 2030 (SV2030) program (see para 27), which aims to increase the number of holiday visitors from 87,000 in 2017 to 300,000 in 2030. On the other hand, a slow-down in infrastructure-related imports and an increase in tourist numbers as envisaged by SV2030 may offset some of these downside pressures. Downside risks include a rise in international energy prices, which could put pressure on the current account deficit, as could a continued strengthening of the U.S. dollar, to the extent that its weight in the vatu basket peg causes the real effective exchange rate to appreciate. 24. While tax revenue is projected to remain relatively strong, a decline in ECP revenues would also put pressure on the fiscal position over the next few years. Abstracting from ECP revenues, the GoV expects relatively buoyant domestic revenue collections in 2019 and over the medium-term. Compared with 2016 and 2017, VAT and excise tax collections are projected to remain relatively strong from 2019 onwards, in line with GDP growth and the higher VAT rate of 15 percent. On the other hand, non-tax revenues are expected to decline markedly over the forward estimates, due to a fall in revenues from the ECP. While these projections may be conservative in the near term (citizenship scheme revenue was more than 200 percent above budget in 2018), the government and development partners recognize these schemes are a fundamentally volatile source of revenue which should not be relied on as a sustainable source of funding over the medium to long term. Grants are forecast at around 5.4 percent of GDP in 2019, on a par with 2018 actuals, and are expected to stabilize around this level over the next few years. Though not included in the projections in Tables 1 and 2 (as a decision has been deferred until after the 2020 elections), the proposed introduction of personal and corporate income taxes would significantly expand the revenue base and improve the equity of the tax system. IMF estimates suggest that such tax reform could lead to a sustained revenue increase of about 2.5 percent of GDP. Further, if the new tax measures are compensated with a reduction of VAT back to 12.5 percent, urban poor households may benefit from reduced cost of living pressures. Nevertheless, for the approximately 80 percent of the population living in rural areas and relying on subsistence agriculture, the impact is expected to be limited. Page 11 The World Bank Vanuatu Disaster Risk Management Development Policy Grant with a Catastrophe-Deferred Drawdown Option (CAT-DDO) (P168749) Table 1: Key Macroeconomic Indicators Proj. 2016 2017 2018 2019 2020 2021 2022 Real sector 12-month percent change Real GDP (percent change) 3.5 4.4 3.2 3.4 3.0 2.8 2.8 CPI inflation (end of period) 2.1 3.3 2.6 2.6 2.2 2.5 2.6 CPI inflation (period average) 0.8 3.1 2.9 2 2.2 2.3 2.5 Fiscal percent of GDP Total revenue and grants 30.8 34.8 35.5 28.0 28.0 28.0 27.8 Domestic revenue 22.5 24.2 29.9 22.6 22.4 22.1 21.9 External grants 8.3 10.6 5.6 5.4 5.6 5.8 5.9 Expenses 24.8 26.9 24.6 25.9 25.9 25.9 26.0 Net acquisition of nonfinancial assets 9.9 8.8 6.1 5.3 5.7 6.1 5.9 Overall balance -3.9 -0.9 4.8 -3.2 -3.6 -4.0 -4.1 Total PPG debt 46.3 53.2 52.5 52.9 53.9 55.3 56.6 External 36.2 43.8 45.2 46.0 47.5 49.2 50.6 Domestic 10.1 9.4 7.3 6.9 6.4 6.1 6.0 Money and credit 12-month percent change Broad money (M2) 10.6 9.3 12.6 10.7 4.8 6.0 6.0 Private sector credit 1.3 4.7 3.0 4.1 4.1 4.1 4.1 Balance of payments percent of GDP Current account balance 0.5 -6.5 3.5 -1.2 -5.4 -4.8 -4.4 Goods exports 6.2 6.9 6.4 6.1 6.1 6.0 5.9 Goods imports -39.8 -35.9 -36.7 -36.5 -40.0 -38.8 -37.6 Trade balance -33.6 -29.1 -30.3 -30.4 -34.0 -32.8 -31.6 Services exports 37.0 34.6 38.0 40.7 40.5 40.2 39.9 of which: Tourism receipts 23.5 19.3 22.6 24.7 24.5 24.2 23.9 Services imports -18.8 -17.7 -17.4 -17.4 -17.4 -17.4 -17.4 Primary income (net) -0.3 -1.2 0.9 0.9 0.9 0.9 0.7 Secondary income (net) 16.1 7.0 12.3 4.9 4.6 4.3 4.0 Capital account 6.0 5.6 4.5 3.5 3.1 2.9 2.7 of which: Offical flows 5.7 5.2 4.2 3.2 2.8 2.6 2.5 Financial account 29.7 10.3 3.4 3.0 3.3 3.4 3.3 of which: Foreign Direct Investment 5.6 4.5 4.4 4.2 4.0 3.8 3.6 External reserves Percent of GDP, unless otherwise noted Gross international reserves (USD millions) 292.7 396.4 502.4 552.0 562.3 579.0 598.0 Gross international reserves (in months of imports) 7.5 10.1 12 13 11.8 11.8 11.8 Exchange rates Vatu per USD (period average) 109.3 107.8 108.5 .. .. .. .. Vatu per USD (end of period) 113.1 106.5 112.3 .. .. .. .. Nominal GDP (Vatu millions) 87,300 94,900 100,700 106,300 112,000 118,000 124,500 Sources: Vanuatu authorities and IMF and World Bank staff estimates and projections. Page 12 The World Bank Vanuatu Disaster Risk Management Development Policy Grant with a Catastrophe-Deferred Drawdown Option (CAT-DDO) (P168749) Table 2: Key Fiscal Indicators Proj. 2016 2017 2018 2019 2020 2021 2022 Percent of GDP, unless otherwise noted Revenue 30.8 34.8 35.5 27.9 28.0 28.0 27.8 Domestic revenue 23.7 24.2 29.9 22.5 22.3 22.1 21.9 Taxes 16.3 17.1 17.9 17.7 17.7 17.7 17.6 Taxes on property 0.5 0.5 0.5 0.6 0.7 0.7 0.7 Taxes on goods and services 12.2 12.9 13.7 13.5 13.4 13.3 13.3 Taxes on international trade and transactions 3.6 3.7 3.7 3.7 3.7 3.7 3.7 Other revenue 6.2 7.1 11.9 4.9 4.7 4.5 4.3 of which: Economic citizenship programs 4.2 5.0 9.9 2.8 2.6 2.4 2.2 External grants 8.3 10.6 5.6 5.4 5.6 5.8 5.9 Expenditure Current expenses 24.8 26.9 24.6 25.8 25.9 25.9 26.0 Compensation of employees 10.4 10.5 12.4 12.6 12.7 12.7 12.8 Use of goods and services 6.9 8.8 6.7 7.1 7.1 7.1 7.1 Interest payments 1.0 1.0 1.0 0.9 0.9 0.9 0.9 Subsidies 0.0 0.0 0.0 0.2 0.2 0.2 0.2 Grants 3.7 2.5 2.4 2.6 2.6 2.6 2.6 Social benefits 1.8 2.8 1.0 1.2 1.2 1.2 1.2 Other expense 1.0 1.3 0.9 1.1 1.1 1.1 1.1 Net acquisition of nonfinancial assets 9.9 8.8 6.1 5.3 5.7 6.1 5.9 Net lending/borrowing (overall balance) -3.9 -0.9 4.8 -3.2 -3.6 -4.0 -4.1 Primary balance -2.9 0.1 5.8 -2.3 -2.7 -3.1 -3.2 Gross operating balance 6.0 7.9 10.9 2.1 2.1 2.1 1.8 Net financial transactions -8.6 -5.0 1.3 -3.2 -3.6 -4.0 -4.1 Net acquisition of financial assets 3.5 2.5 3.4 0.1 0.1 0.1 0.1 Net incurrence of liabilities 12.1 7.6 2.1 3.2 3.7 4.1 4.2 Net errors and omissions 4.7 4.1 3.5 0.0 0.0 0.0 0.0 PPG public debt 46.4 53.2 52.4 52.9 53.9 55.3 56.6 Domestic 10.1 9.4 7.3 6.9 6.4 6.1 6.0 External 36.2 43.8 45.2 46.0 47.5 49.2 50.6 Nominal GDP (Vatu millions) 87,300 94,900 100,700 106,300 112,000 118,000 124,500 Sources: Vanuatu authorities and IMF and World Bank staff estimates and projections. Page 13 The World Bank Vanuatu Disaster Risk Management Development Policy Grant with a Catastrophe-Deferred Drawdown Option (CAT-DDO) (P168749) Table 3: Balance of Payments - Proj. Financing requirements and sources 2017 2018 2019 2020 2021 2022 US$ millions Financing requirements 56.4 -15.2 24.3 62.2 60.7 59.7 Current account deficit 51.9 -30.8 11.1 51.1 47.9 46.2 Debt amortization 4.5 15.6 13.2 11.0 12.8 13.5 Financing sources 56.4 -15.2 24.3 62.2 60.7 59.7 FDI and portfolio flows (net) 10.4 13.2 13.0 13.3 14.0 13.7 Capital grants 41.5 37.0 29.7 26.5 25.9 26.3 Debt disbursements 64.0 49.5 42.5 47.5 54.0 55.0 Other flows 34.7 -14.6 -12.6 -15.7 -17.2 -17.3 Change in reserves (-ve is increase) -94.2 -100.3 -48.3 -9.5 -16.0 -17.9 25. Despite the projected decline in overall revenues, operating surpluses are expected to continue over the medium term, but any further public sector pay settlements would put pressure on the recurrent budget and reduce the quality of spending. Operating surpluses of around 2 percent of GDP are projected over 2019 – 2021, in line with GoV’s target of a positive recurrent balance over the medium term. Compensation of employees is budgeted at 12.6 percent of GDP in 2019 and is projected to account for nearly half of recurrent expenses over the next three years. GoV has not announced intentions for further pay adjustments but this remains a risk, especially in the lead-up to elections in 2020.18 26. Debt-financed donor projects are expected to result in overall budget deficits averaging 3.6 percent of GDP from 2019 to 2021. GoV-funded acquisition of fixed assets is budgeted to remain steady at about 0.7 percent of GDP over 2019-2021. Donor-funded capital spending is expected to reach 4.6 percent of GDP in 2019 before picking up to 5.4 percent in 2020, although this may be affected by the timing of donor commitments and disbursements. Given that donor construction projects are predominantly debt-funded, the overall fiscal balance tends to be directly related to progress on project implementation. 27. Recently announced plans for an ambitious expansion of the state-owned airline could be very costly, but the government intends to limit its fiscal exposure. In February 2019, Air Vanuatu (a state-owned enterprise) signed an order for four Airbus A220 aircraft with a total list price of US$345 million (over a third of GDP), with the first plane due for delivery in June 2020. The planned acquisitions would represent a major fleet expansion and would be used to compete on new international routes, as part of the SV2030 plan, which targets an expansion in the number of tourist arrivals to 300,000 per year by 2030, from around 100,000 currently. The government has provided Air Vanuatu with VUV2 billion (approx. US$18 million) in loans to fund a down-payment for the planned acquisitions, but has indicated that it does not intend to provide Air Vanuatu with any further form of financial support for these aircraft (either in the form of further loans or government guarantees).19 Current indications are that some form of lease agreement is currently being negotiated, and Air Vanuatu reportedly intends to fund any remaining costs through a combination of internal cash flow and foreign 18 Previous elections in Vanuatu (in 2016 and 2012) have not been associated with a significant pick up in public spending, and the 2020 elections are not expected to be different in this regard. Compared with 2018, current spending is expected to increase by around 1 percent of GDP in 2019 and then stay relatively flat as a proportion of GDP over the medium term. The increase in 2019 is partly a normalization from lower-than-expected current spending in 2018 (e.g. on goods and services). 19 Air Vanuatu’s existing aircraft have been financed with US$ bank loans secured over the as sets and guaranteed by the government. Page 14 The World Bank Vanuatu Disaster Risk Management Development Policy Grant with a Catastrophe-Deferred Drawdown Option (CAT-DDO) (P168749) investment; it is therefore possible that the acquisitions will be staged according to the availability of funding. Relative to the ambitious plans envisaged in SV2030, a more measured approach to investment in aircraft, infrastructure, and marketing still has the potential to result in positive outcomes and may be more likely to be implemented in practice (given financial and capacity constraints). It should be noted that there is little publicly- available information about the planned acquisition, and there is a general lack of transparency around Air Vanuatu’s financials. The most recent published financial statements are from 2014 and show a VUV850 million loss for that year, though news reporting indicates Air Vanuatu has been profitable in more recent years. 28. The 2019 WB-IMF Debt Sustainability Assessment (DSA) assesses Vanuatu to be at moderate risk of debt distress. There are no breaches to external PPG debt thresholds under the baseline scenario (which includes assumptions on long-term climate change and the average annual cost of natural disasters), with the present value (PV) of PPG external debt expected to increase from 27 percent of GDP in 2018 to 35.6 percent in 2029, mainly because of new disbursements for infrastructure projects. Nevertheless, the baseline scenario analysis indicates that even in the absence of any significant fiscal shocks, the public debt-to-GDP ratio will breach the government’s own target of 60 percent by 2025. Under the tailored natural disaster shock (a one -off shock to the debt to GDP ratio of 10 percentage points in 2020), the debt threshold would be breached by 2024, confirming the importance of building fiscal buffers to enhance resilience against natural disasters. 29. While the overall risk of debt distress remains moderate, the DSA indicates that there is only limited fiscal space available to absorb shocks, including further natural disasters. It recommends that the authorities seek highly concessional terms for any new borrowing and pursue opportunities to rebuild fiscal buffers, including by increasing domestic revenues. It also notes that the authorities should prioritize which loans to accept and should limit guarantees to SOEs, including Air Vanuatu, to safeguard debt sustainability. In response, the authorities noted their intention to maintain a grant-element target of at least 35 percent, seek grant financing as much as possible to reduce the debt burden, and limit or avoid providing guarantees for borrowing by any SOEs in the near future. They also stressed their commitment to use strong cash reserves (attributable to unexpectedly strong ECP revenues) to make prepayments of debt, as a form of saving and to preserve fiscal space over time. Indicators of PPG debt sustainability from 2019 IMF-WB DSA* PV of external debt to GDP ratio PV of public debt to GDP ratio Page 15 The World Bank Vanuatu Disaster Risk Management Development Policy Grant with a Catastrophe-Deferred Drawdown Option (CAT-DDO) (P168749) PPG external debt service to exports ratio PPG external debt service to revenue ratio * The DSA baseline is based on a specific scenario – namely, that all financing from IDA and the ADB is provided on credit terms – given its role to inform judgment on Vanuatu’s capacity to receive credit financing. To the extent that Vanuatu in practice continues to receive 50 percent grant / 50 percent credit financing from these institutions, the projected increase in debt to GDP becomes much less pronounced (under the baseline projections, the PV of external debt would remain broadly flat, reaching 28.4 percent of GDP by 2029 rather than 35.6 percent as shown in the figure above). 30. The macroeconomic policy stance is adequate overall, though there are a number of important risks that will be mitigated in part by the policy reforms supported by this operation. Growth is expected to remain broadly resilient in the medium term and despite projections of moderate fiscal deficits in the years ahead, the risk of debt distress in Vanuatu is assessed as remaining moderate, in contrast to several other Pacific Island countries. The most recent (2019) IMF assessment noted that reconstruction efforts from TC Pam are nearing completion and that full recovery is in sight. Nevertheless, there are two overarching (and related) macroeconomic risks in the medium term: the risk of another large natural disaster, and the risk that public debt continues to accumulate at the pace seen in recent years. Both risks, if realized, would place considerable pressure on government finances in a context of limited fiscal space. Despite being provided at semi-concessional terms, the recently contracted loan for roads on Tanna and Malekula is not likely to call Vanuatu’s overall macro sustainability into question, and nor are the government loans provided to Air Vanuatu to date to fund a down- payment for planned aircraft purchases. However, a further build-up of PPG debt, including in response to natural disasters or for aircraft acquisitions, could jeopardize Vanuatu’s overall macroeconomic sustainability, particularly if new loans are contracted at non-concessional terms. These risks are mitigated by the DRM reforms supported by this operation which should help facilitate ex ante measures to reduce the costs associated with natural disasters. They are also mitigated by the approval of a revised DMS and associated ongoing reforms to improve debt policy and management, which will strengthen concessionality requirements for new borrowing and provide a framework for maintaining debt at sustainable levels, thereby helping to build GoV’s capacity to respond to future natural disasters and external shocks. The contingent financing provided by this operation will also provide an important source of additional budget support to the government in the event of a future natural disaster, thereby moderating the associated macroeconomic risk. 2.3. IMF RELATIONS 31. The World Bank and IMF collaborate closely, and Bank staff have participated in all recent Article IV missions and jointly prepare the Debt Sustainability Analysis for Vanuatu. Based on this cooperation, the Bank and IMF share a common view about Vanuatu’s macroeconomic and structural reform priorities. The most recent Page 16 The World Bank Vanuatu Disaster Risk Management Development Policy Grant with a Catastrophe-Deferred Drawdown Option (CAT-DDO) (P168749) IMF Article IV mission in April 2019 has provided macro-fiscal estimates which have been an important input to the macroeconomic assessment presented here. 3. GOVERNMENT PROGRAM 32. Disaster resilience and sound public debt management are key objectives of the National Sustainable Development Plan (NSDP) 2016-2030. Environment Goal 3 on Climate and Disaster Resilience includes the following policy objectives: (i) institutionalize climate change and disaster risk governance, and build institutional capacity and awareness; (ii) strengthen post-disaster systems in planning, preparedness, response and recovery; (iii) promote and ensure strengthened resilience and adaptive capacity to climate related, natural and man-made hazards; and (iv) access available financing for climate change adaptation (CCA) and DRM. The first Economic Goal is stable and equitable growth, including the policy objective to ensure public debt is sustainably managed and finances are directed towards projects with positive economic returns. 33. The Climate Change and Disaster Risk Reduction Policy (CCDRR) 2016-2030 articulates the country’s strategic priorities to achieve the NSDP’s resilience objectives. The strategic priorities and actions include: (i) strengthening institutional structures at provincial and municipal levels to encourage bottom-up planning and implementation, (ii) integrating and harmonizing disaster risk reduction and prevention measures into legislation (e.g. by updating the National Disaster Act of 2000) and policy frameworks (e.g. for land use planning), (iii) enhancing disaster response and recovery planning and ensuring that recovery aims to ‘build back better’, and (iv) ensuring timely access to disaster response and recovery funds. 34. The National Disaster Act of 2000 [Cap. 267] repealed the Search and Rescue Act [Cap. 89]. It established the National Disaster Committee (NDC), and provided for the following functions of the NDC (among others) to: (i) develop strategies and policies for the prevention of, preparation for, response to and recovery from disasters; (ii) ensure that such strategies and policies are implemented by the National Disaster Management Office (NDMO), other government agencies and non-government agencies; (iii) advise on the need for aid to counter the effects of a disaster, and (iv) advise on the declaration of states of emergencies. Under this Act, NDMO was also tasked to develop the National Disaster Plan, which lapsed in 2016. Page 17 The World Bank Vanuatu Disaster Risk Management Development Policy Grant with a Catastrophe-Deferred Drawdown Option (CAT-DDO) (P168749) 35. Vanuatu participated in the Pacific Catastrophe Risk Assessment and Financing Initiative (PCRAFI) in the pilot phase (2013-2015) and from 2016-2018 through the IDA-funded Pacific Resilience Program. PCRAFI is a regional, market-based parametric disaster risk insurance pool. After TC Pam in 2015, Vanuatu received a payout of US$1.9 million (under the pilot, during which the premium payments were fully funded by bilateral donors) but did not receive payouts after any subsequent disasters. As of the season commencing November 1, 2018, the government had not renewed its coverage under PCRAFI, although dialogue continues regarding the importance of layering post-disaster financing instruments under a comprehensive financial protection strategy. 4. PROPOSED OPERATION 4.1. LINK TO GOVERNMENT PROGRAM AND OPERATION DESCRIPTION 36. The Project Development Objective is to enhance the Recipient's regulatory framework and institutional capacity to: (i) manage and reduce the risks from natural disasters and climate change; and (ii) manage public debt. This objective will be achieved through reforms under Pillar A: Managing and Reducing Disaster and Climate Risk, and Pillar B: Managing Public Debt. These Pillars and the corresponding actions under the program support the NSDP’s objectives to: (i) institutionalize climate change and disaster risk governance and build institutional capacity; (ii) promote strengthened resilience and adaptive capacity to natural hazards; and (iii) ensure public debt is sustainably managed. 37. The proposed operation contributes to the achievement of Vanuatu’s commitments under the Sendai Framework for Disaster Risk Reduction 2015-2030 and its Intended Nationally Determined Contributions as a signatory to the Paris Agreement. The policy measures supported by this operation will support the GoV’s ongoing efforts to strengthen the national framework for DRM, and its priorities for integrated climate change adaptation and disaster risk reduction. The operation’s pillars, prior actions and associated result indicators are aligned with these commitments and strategic priorities, further detailed in the Vanuatu CCDRR Policy, as follows: (i) reviewing and updating legislation and policy frameworks in view of evolving disaster risk and climate change contexts; (ii) integrated CCA and DRR for more efficient service delivery; and (iii) well-coordinated and resourced recovery. 38. The program draws on lessons learned from previous operations in Vanuatu, and global experience in the design and implementation of CAT-DDOs. a. As PCRAFI insurance coverage is designed for very high-impact, low-frequency events, there have been certain disasters in Vanuatu (e.g. Tropical Cyclone Hola in March 2018) that had a significant impact but did not meet the quantitative (modeled) threshold for triggering payouts. In addition, the major disaster that the government faced in 2017-2018 was the series of Ambae volcanic eruptions, highlighting the need for post- disaster financing for hazards other than tropical cyclone and earthquake, which are covered by PCRAFI. The CAT-DDO also offers flexibility on the amount and timing of drawdown, as the instrument is based on a qualitative trigger. Importantly, it complements the World Bank’s substantial portfolio of investment projects and technical assistance in post-disaster recovery and disaster risk reduction, by providing a direct platform to promote a range of associated policy reforms. b. The design of the drawdown trigger needs to be aligned with the country’s disaster management legislation and public financial management in post-disaster situations, to ensure that the contingent financing can be utilized for the appropriate scale of disaster impact. There are several countries (e.g. Page 18 The World Bank Vanuatu Disaster Risk Management Development Policy Grant with a Catastrophe-Deferred Drawdown Option (CAT-DDO) (P168749) Philippines, Lao PDR, Romania) that, as in the case of Vanuatu, utilize the declaration of a State of Emergency sparingly, because of its broader implications (for example, on tourism). Thus, the CAT-DDOs that are either under preparation or implementation in these countries have had to carefully consider more appropriate drawdown triggers that are more aligned with the objective to provide immediate post-disaster liquidity. c. As the first stand-alone CAT-DDO in the Pacific, this program also draws on implementation experiences from other countries, which have shown that DRM policy dialogue is most effective when based on a long- standing technical engagement in priority policy areas, which is the case in Vanuatu. In terms of supporting institutional capacity building, a complementary program of technical assistance during the implementation period has also been found to be instrumental to the achievement outcomes and supporting continuous policy dialogue. d. Lessons from the Independent Evaluation Group evaluations of CAT-DDOs highlight the need to: (i) strengthen the monitoring and evaluation framework by avoiding too many result indicators and ensuring simplicity and measurability; and (ii) prioritize policy areas and actions closely related to project objectives. 39. Key features of the operation: a. Drawdown period and renewal: The drawdown period for the CAT-DDO will be three years. Accordingly, the closing date of the grant is proposed to be June 30, 2023. The drawdown period may be renewed once, for a maximum of six years in total. The adequacy of the macroeconomic framework and the satisfactory implementation of the program set out in the Letter of Development Policy will be assessed at renewal. b. Funding sources: Fifty percent of the amount requested for this operation will be funded through Vanuatu’s concessional core IDA allocation envelope, with the balance financed by IDA’s overall resources. The concessional core IDA Allocation portion of any undisbursed CAT-DDO balance may be recommitted at the end of the drawdown period. 40. Drawdown triggers. The applicable laws that are relevant to the proposed drawdown triggers are the National Disaster Act (and the relevant repealing Act, i.e. the new Disaster Risk Management Act) and the Public Finance and Economic Management (PFEM) Act. a. The National Disaster Act [Cap. 267], and the Bill for the successor Disaster Risk Management (DRM) Act, provide for the declaration by the President, on the advice of the Council of Ministers (COM), that a state of emergency exists in whole, or a specified part or parts of Vanuatu in relation to a disaster. The President must be satisfied that the disaster constitutes a significant and widespread danger to life, property or the environment in Vanuatu; and exceeds the affected community’s capabilities to deal with that disaster. b. The PFEM Act provides for a standing appropriation for a financial emergency, under the following conditions. If: i. the Minister [of Finance] is satisfied that a financial emergency exists; and ii. there is no appropriation, or an insufficient appropriation, for alleviating the financial emergency; and iii. an Appropriation Act cannot be passed by the Parliament within a reasonable time so as to make funds available for alleviating the financial emergency; the Minister may, with the prior approval of the Council of Ministers, authorize amounts to be drawn down from the Public Fund for the purposes of alleviating the financial emergency (defined as “ a situation where Page 19 The World Bank Vanuatu Disaster Risk Management Development Policy Grant with a Catastrophe-Deferred Drawdown Option (CAT-DDO) (P168749) the Government because of a lack of funding is unable to provide basic essential services to the people of Vanuatu to alleviate significant hardship”). 41. In view of the relevant provisions of the laws described above, the proposed drawdown triggers for this operation are as follows: In response to a Natural Catastrophe20: a. the Recipient’s President has issued, in accordance with the Recipient’s applicable law21, an order to declare that a state of emergency exists in the Recipient’s territory in relation to such Natural Catastrophe; or b. the Recipient’s minister responsible for finance has issued, in accordance with the provisions of the Public Finance and Economic Management Act, an order to authorize amounts to be drawn down from the public fund for the purposes of alleviating a financial emergency in relation to such Natural Catastrophe.22 4.2. PRIOR ACTIONS, RESULTS AND ANALYTICAL UNDERPINNINGS Pillar A: Managing and Reducing Disaster and Climate Risk 42. The prior actions under Pillar A, and the associated results, will fundamentally strengthen the regulatory framework and institutional capacities for multi-hazard, ex ante DRM at national and local levels, and provide a comprehensive approach to risk reduction and climate adaptation in future land and settlement development throughout the country. While the set of reforms is fundamental to managing and reducing disaster and climate risk, the realization of outcomes is a long-term process that is expected to continue beyond the lifetime of this program. The proposed results therefore represent implementation and operationalization of the supported policy reforms. 43. The Vanuatu CCDRR Policy called for a review of the National Disaster Act of 2000, based on the evolving understanding of: (i) the impacts of climate change, and (ii) management of risk, instead of treating disasters as exogenous shocks that cannot be proactively addressed. The review found that the implementation of the National Disaster Act has (in practice) focused predominantly on immediate preparedness activities (e.g. evacuations), emergency operations including those of first responders, and the provision of relief to affected people (as an indication, neither the term ‘risk’ nor ‘climate’ appear in the National Disaster Act). On this basis, the reforms embodied in the new DRM Act will enable the government to reorient its regulations and institutional system toward the full cycle of effective disaster risk management, shifting the focus from ex post emergency management and response, to risk reduction, climate adaptation, and longer- 20 For the purposes of this operation, ‘Natural Catastrophe’ is proposed to be defined as an imminent or occurring emergency situation caused by an earthquake, tsunami, cyclone, storm, flood, volcanic eruption, drought, bush fire or any other natural hazard that requires the Recipient to promptly mobilize its capacity and/or financial resources, excluding any public health-related event. The existing institutional system for emergency management and response are not (and have not historically been) deployed for health emergencies and, as such, health emergencies will not trigger a drawdown. 21 If the drawdown trigger is met before the new DRM Act is passed, the subsequent response will be based on the current National Disaster Act [Cap. 267]. The process of declaring a state of emergency remains unchanged under the new DRM Act. 22 The process for the Council of Ministers to approve authorization (via a Council of Ministers’ decision) of amounts to be dra wn down from the Public Fund for the purpose of alleviating a financial emergency are defined in the PFEM Act. The relevant COM decisions from past disasters have indicated the cause of the emergency. Page 20 The World Bank Vanuatu Disaster Risk Management Development Policy Grant with a Catastrophe-Deferred Drawdown Option (CAT-DDO) (P168749) term recovery. 44. The National Land Use Planning Policy of 2013 (Land Use Policy) calls for appropriate and effective land use planning in the face of growing population and assets in hazardous areas, compounded by the impacts of climate change. It highlights that Vanuatu is rapidly urbanizing, with population growth in urban areas (including provincial centers) nearly double that of rural areas. The Land Use Policy recognizes that, if properly planned, the economic and social benefits of urbanization can be realized in an inclusive and resilient manner. Conversely, land subdivision for development and the associated infrastructure can create new risk and vulnerability. The Land Use Policy therefore directs that risk and vulnerability assessment tools, methodologies, and information be formally integrated into the land use planning process, particularly in determining development controls and assessing development applications. The National Subdivision Policy provides the regulatory framework and institutional mandates to address these priorities. Prior Action 1: The Recipient’s Council of Ministers has approved, and submitted to the Parliament, a Bill for the Disaster Risk Management Act, which provides for an integrated approach to disaster risk reduction and climate change adaptation, disaster preparedness, response and recovery at national and local levels. 45. The DRM Act will repeal the National Disaster Act of 2000 and strengthen institutions and mandates (across levels of government) for an integrated approach to disaster risk reduction and climate change adaptation, disaster preparedness, and recovery. The Bill for the DRM Act is expected to be automatically submitted during the November 2019 Ordinary session of Parliament, together with the set of Bills that were withdrawn from the June 2019 session, when an unrelated motion of no confidence was lodged (but not carried). 46. The DRM Act will provide for development and implementation of regulations, frameworks, and plans at national, provincial and municipal levels, supporting a whole-of-society approach that is gender responsive and respectful of indigenous and traditional knowledge systems. In parallel, it enables a whole-of- government approach to ex ante disaster risk-informed development planning, and the integration of disaster risk reduction and climate change adaptation across the different sectors (including agriculture, infrastructure, water, health and education). 47. Expected Results and Outcomes. The achievement of the key results enabled by the DRM Act will strengthen institutional mandates for DRM and CCA and clarify roles and responsibilities across levels of government and sectors. The expected outcome is a fundamental reorientation of the government’s regulations and institutional system toward the full cycle of effective disaster risk management, shifting the focus from emergency management and response, to risk reduction, climate adaptation, and longer-term recovery. a. The DRM Act provides for the establishment of Provincial Disaster and Climate Change Committees (PDCCC) and Municipal Disaster and Climate Change Committees (MDCCC), which will align the DRM and CCA coordination and implementation structure with the existing government policy on decentralization. Importantly, the new Act differentiates the functions of the provincial and municipal committees, highlighting that the PDCCCs should coordinate DRR and CCA programs with national government agencies (NDMO and sectoral), while MDCCCs should coordinate DRR/CCA programs with local agencies, partners, and communities to ensure localization, build community resilience, strengthen gender responsiveness, and integrate traditional knowledge and approaches. The PDCCCs and MDCCCs will be established, membership specified, and mandates provided for under the DRM Act. This points to the importance of well-defined terms of reference and work plans for these Committees, the development of which are planned to be Page 21 The World Bank Vanuatu Disaster Risk Management Development Policy Grant with a Catastrophe-Deferred Drawdown Option (CAT-DDO) (P168749) supported with technical assistance from the Bank. b. The government recognizes that risk can never be fully reduced to zero, and that Vanuatu will continue to face recurrent disasters, requiring a Disaster Recovery Framework to institutionalize systems for more effective and efficient medium- to long-term recovery, including sectoral preparedness for recovery and continuity of services such as health and education. Major aspects of the Disaster Recovery Framework include: prioritizing actions, and providing guidance on financing, implementing, and monitoring recovery programs, including emergency procurement, post-disaster public financial management procedures, and guidelines for the use of funds. Finally, the Framework will also address longer-term DRR and CCA, through coherent programs that bridge the gap between recovery and development, including addressing disaster- resilient public infrastructure, safety nets and social assistance to improve human resilience. Prior Action 2: The Recipient’s Council of Ministers has approved a National Land Subdivision Policy, which provides for risk-informed land and settlement development, with minimum standards for disaster risk reduction. 48. Vanuatu is experiencing high population growth, with the 2009 census showing a total population of 234,023, an increase of 25.4 percent from the population of 186,678 people in 1999.23 Much of this growth has occurred in the urban and peri-urban areas of Port Vila, Luganville, and provincial centers. Urban areas experienced an average annual growth rate of approximately 3.5 percent per year between 1999 and 200924, comprising growth rates of 4.1 percent for Port Vila and 2.0 percent for Luganville.25 This population growth is primarily (74 percent) in the unplanned, peri-urban areas immediately outside the Port Vila municipal boundary, and similarly outside Luganville – which is leading to the increasing concentration of people and assets in hazardous areas. Hazard and risk mapping for the population centers of greater Port Vila and Luganville were undertaken for the 100-year mean return period, showing the following: Population and buildings exposed to Hazard High/Very High Risk Moderate Risk Greater Port Vila, Shefa Province Earthquake and Cyclones 15% 85% Coastal Inundation 6% Flooding 20% Greater Luganville, Sanma Province Earthquake 2% 98% Cyclones 99% 1% Coastal Inundation 4% Flooding 26% 49. The National Land Use Policy relates only to the uses of land, has a largely rural land use focus, and does not provide the necessary parameters for subdivision and development. As a result, subdivision development applications were being reviewed and approved in a piecemeal, slow (approximately 2 years), and opaque manner, including in highly hazardous areas such as coastal zones. Once applications were approved, land developers were not responsible for providing or maintaining roads, drainage, or other services. This has resulted in: (i) sprawl into increasingly hazardous areas, and inefficient use of land, (ii) the absence of infrastructure and service standards resulting in residential subdivisions without basic services such as water, 23 Vanuatu National Statistics Office, 2009 National Population and Housing Census – Analytical Report, Volume 2. 24 Vanuatu National Statistics Office, 2009 National Population and Housing Census – Analytical Report, Volume 2. 25 Derived from 2009 National Population and Housing Census. Page 22 The World Bank Vanuatu Disaster Risk Management Development Policy Grant with a Catastrophe-Deferred Drawdown Option (CAT-DDO) (P168749) sanitation, power, road access, and drainage (exacerbating flooding), (iii) lack of environmental, social, and disaster risk considerations in the subdivision designs; (iv) unclear institutional roles and responsibilities for regulation, and (v) lack of affordability considerations, particularly for low- and middle-income earners. 50. To address these issues, the Council of Ministers approved the National Land Subdivision Policy (Subdivision Policy) in March 2019, which applies to any land in Vanuatu that is intended to be leased/subdivided into two or more lots26 (including by customary landholders) and any public land that is to be re-subdivided into a new configuration. All land in Vanuatu is either under: (i) customary landholding (98 percent) in rural, rapidly growing peri-urban, and non-declared urban areas, or (ii) government (public) landholding (2 percent) in gazetted physical planning/urban areas. The Subdivision Policy is consistent with the approved Land Reform Act (Cap. 123), the Strata and Community Title Act (Cap. 266), and all principles of the Land Use Policy. 51. The Subdivision Policy provides the regulatory framework (and the associated instruments) for the development of land (including for the productive sectors, infrastructure networks, and most importantly human settlement). Given that around 70 percent of urban/peri-urban land uses are for residential purposes, it is worth emphasizing that the private housing sector alone accounted for higher damage and losses (VUV9.8 billion) from TC Pam than the combined infrastructure sectors (VUV9.3 billion) and half of all productive sectors (VUV18.9 billion). 52. The key DRR and CCA-related provision of the Subdivision Policy is the requirement for all land developers to prepare a concept plan based on a site assessment for the proposed subdivision area identifying: (i) the natural hazards to which the site is exposed, (ii) corresponding risk reduction measures, (iii) the suitability of the site for different income groups (especially low-income) and proposed land uses; (iv) area- wide road and infrastructure services, drainage, and buffers or zones of transition between the proposed subdivision and adjacent land uses. All development must take into consideration geohazards, flooding, erosion and landslides (among others) and the groundwater level, which are factors that may impact the proposed development and are subject to the consideration and recommendation of the Vanuatu Meteorology and Geohazards Department (VMGD) (as a member of the Land Management and Planning Committee, LMPC) in the application process. 53. Before the Subdivision Policy was in place, there was no existing policy or legislation in Vanuatu to underpin land value capture for public purposes or to provide for the costs of servicing lands in less hazardous areas for lower-income groups. As a result, subdivisions are currently either: relatively well-located and serviced, but unaffordable to lower-income groups; or located in marginal and hazardous lands without any minimum standards for basic infrastructure, services, drainage, or other risk reducing measures. The Subdivision Policy and its associated regulations will apply to existing unplanned settlements which the Ministry of Lands intends to regularize in an incremental and carefully managed manner. The Policy is explicitly aimed at encouraging the development of new lands in safer areas and restricting certain types of land use (such as high density residential uses) in less safe areas. It is not expected to result in involuntary resettlement. 54. Under the Policy, land developers are required to provide fully serviced plots including drainage and sanitation. The Policy also allows the development of smaller plot sizes with the requirement that drainage and sanitation services are also provided. This will result in more affordable new plots than currently provided by developers. The LMPC guidelines will also include detailed layout planning techniques to improve cost efficiency 26 Non-subdivided leases are for agricultural, not settlement, purposes. Page 23 The World Bank Vanuatu Disaster Risk Management Development Policy Grant with a Catastrophe-Deferred Drawdown Option (CAT-DDO) (P168749) for infrastructure services whilst protecting environmental amenity and livability. 55. Expected Results and Outcomes. The expected outcome of the National Land Subdivision Policy is to ensure that the development of land and creation of new settlements results in affordable, resilient, environmentally and socially sustainable development and an improved quality of life for residents with minimum standards of disaster risk reduction, access, health, and safety. To achieve this outcome, the Policy establishes the parameters of the regulatory and administrative processes and clarifies the regulatory roles and responsibilities of the LMPC and the respective local authorities. The Subdivision Policy provides for the development of transparent regulatory instruments to ensure that the affordability, environmental, social, DRR and CCA considerations are integrated in subdivision approval, design, and land development. The Policy mandates the development of ministerial Subdivision Regulations in full public consultation, covering appropriate land uses, development controls (including prevention of the approval of new greenfield subdivision development applications in highly hazardous areas), and other requirements to implement the Policy. The Subdivision Regulations will enable the relevant authorities to strategically guide future land development toward moderate-risk areas, and will set out transparent criteria for approval including hazard assessment, environmental impact, affordability, and alternative options considered. 56. Furthermore, guidelines will be developed for the LMPC to apply in the review and approval of subdivision applications, in accordance with the Policy’s provisions. The LMPC Guidelines will be formulated in consultation with government agencies, private sector developers and professionals and academic institutions (and supported with technical assistance from the Bank). It is anticipated that the Guidelines will specify the required components of all subdivision applications, including: (i) identification of site-specific features including topography (especially steep slopes), soil conditions, proximity to coastal zones, water bodies, known faults, or other conditions that may impact exposure to both hydrometeorological and geophysical hazards and be relevant for the affordability of the proposed development, (ii) use of all relevant hazard and/or risk maps available from the VMGD of the Ministry of Climate Change, or other government agency, and (iii) the appropriate mitigation measures (including eco-based adaptation and risk mitigation measures that work with natural systems) that will be taken in the physical planning and development of the site to adequately mitigate against the identified risks. The LMPC Guidelines will include information on hazard areas in Vanuatu and the associated requirements for building standards. The Guidelines and ongoing training (planned for support through technical assistance from the Bank) will move some of the onus for enforcing the Regulations from the LMPC to the private sector developers and the professionals advising them. Pillar B: Managing Public Debt 57. The second development objective of the proposed operation is to strengthen the government’s capacity to manage the fiscal impacts of natural disasters and external shocks. The substantial increase in public debt after TC Pam in 2015 has reduced the fiscal space available to the government to respond to future natural disasters, which were assessed by the IMF in its recent Article IV consultations to be the main (high likelihood and high impact) risk to the economy looking forward. The debt management reforms supported by this operation are a critical component of the government’s overall plans to consolidate its public finances and build the fiscal buffers it needs to respond to disasters and other external shocks. Prior Action 3: The Recipient’s Council of Ministers has approved a Debt Management Strategy 2019-2022, which contains measures to minimize the costs and risks associated with the Recipient’s public debt, and sets Page 24 The World Bank Vanuatu Disaster Risk Management Development Policy Grant with a Catastrophe-Deferred Drawdown Option (CAT-DDO) (P168749) out plans to strengthen the Recipient’s public debt management. 58. Strengthening debt policy and debt management is a key priority in Vanuatu given the rapid escalation of public debt in recent years and the need to control the associated risks and ensure sufficient fiscal space to respond to the next natural disaster. Vanuatu issued its first DMS in the aftermath of TC Pam, covering the period from 2015 to 2017. The DMS set out objectives to maintain the present value of state debt below 40 percent of GDP (although there was some ambiguity around this threshold) and limit external borrowing to loans which are highly concessional. It also included indicative procedures for processing external borrowing proposals, to ensure that selected projects and financing plans are: (i) consistent with national and sectoral priorities; (ii) evaluated based on an economic and financial analysis; and (iii) compliant with the debt management strategy. 59. As a prior action for this operation, the government has approved an updated DMS for the period 2019-2022. The updated DMS is closely linked with the government’s fiscal strategy and recognizes that with the TC Pam reconstruction phase near completion, the government now needs to focus on fiscal consolidation to control the overall level of debt and the debt servicing burden, and to ensure that the country has the fiscal space necessary to manage the next natural disaster when it inevitably strikes. Indeed, the DMS notes that “as in many Pacific Island Countries, fiscal risks are high in Vanuatu, given vulnerabilities to very sudden and costly natural disasters”, and highlights the need to ensure the government’s fiscal ability to act “promptly and sufficiently” after such disasters. The DMS works towards this objective by emphasizing the requirement to only contract external debt that is highly concessional, with at least a 35 percent grant component, as well as the requirement that loans should only be approved if they fund projects which have a minimum positive economic return sufficient to cover the interest and repayment costs. The updated DMS also sets debt thresholds that: (i) are consistent with the maintenance of overall public debt sustainability; and (ii) differentiate more clearly between the overall nominal value of total public debt and the net present value (which is the basis of debt sustainability thresholds in the joint IMF-WB DSA), as well as between overall public and public external debt.27 Taken together, these requirements help to limit the costs and risks associated with new external debt, while ensuring that overall debt remains at a level that allows room to maneuver in the event of a disaster. The DMS further provides an analysis of different types of fiscal pressure and risk associated with the public debt and guarantee portfolio – including the redemption profile of the current public debt stock, as well as the associated currency risk, interest rate risk, refinancing risk, credit risk and operational risks – and sets out some options for mitigating these risks. 60. The approval of the DMS is also the critical first step in a series of planned reforms to strengthen public debt management in Vanuatu. These include measures to provide legal backing for the key objectives of the DMS, reinforcing the basis for its implementation. The updated DMS includes a list of associated legislative, regulatory, and institutional reforms to be carried out over the three-year period and sets timeframes for each. In so doing, it provides a coherent framework and rationale for the government’s plans to: a. Amend the Public Finance and Economic Management Act to include: (i) a definition of eligible purposes for borrowing; (ii) a requirement for a COM-endorsed DMS and annual progress reporting on the DMS in the Budget; and (iii) a requirement for government to define a sustainable level for public debt and regularly report on the evolution of debt relative to this defined level. 27The DMS requires that the nominal value of total public debt remains below 60 percent of GDP, and that the nominal value of external public debt remains below 40 percent of GDP. Note this is stricter than the condition to avoid being classified at a high risk of debt distress, which is that the present value of external public debt remains below 40 percent of GDP. Page 25 The World Bank Vanuatu Disaster Risk Management Development Policy Grant with a Catastrophe-Deferred Drawdown Option (CAT-DDO) (P168749) b. Develop financial regulations under the Public Finance and Economic Management Act that: (i) require compliance with DMS concessionality requirements for new external borrowing; (ii) set out procedures to be followed for new external borrowing, the issuance of guarantees, and on-lending; and (iii) establish a National Debt Committee. 61. These reforms should help to ensure that further instances of non-concessional borrowing (see para 21) are avoided by providing legislative and regulatory backing for the key DMS provisions. The implementation of these reforms will be led by the Debt Management Unit, which was established in 2014 to help centralize debt management functions within the MFEM and has since benefited from an increased budget and the recruitment of new staff, as an indication of the government’s continued commitment to prudent debt management. The technical assistance from the World Bank on the DMS and the three-year timeframe and support for implementation provided by the CAT-DDO affords the World Bank with a solid basis to stay engaged with these reforms to the legislative and regulatory framework, which may also be directly supported by budget support operations being prepared by other development partners. As highlighted in the DMS, one specific avenue for engagement will be for MFEM to assess debt management performance in coordination with the World Bank, updating the Debt Management Performance Assessment (DeMPA) that was conducted in 2014. Together with the ongoing debt engagement, planned World Bank work on a combined Country Economic Memorandum/Public Expenditure Review will also provide an entry point for further dialogue with the authorities on macro-fiscal reforms. 62. Expected Results and Outcomes. Strengthened debt policy and management should assist in consolidating Vanuatu’s public finances over the medium term, thereby rebuilding its capacity to respond to future natural disasters and external shocks. As noted above, the government is expected to pass amendments to the PFEM Act and associated regulations which provide legislative backing for several of the provisions in the DMS, including around concessionality requirements for new borrowing and the maintenance of debt at sustainable levels. They should also establish procedures for external borrowing and guidelines for guarantees and on-lending. The expected result is compliance with the DMS concessionality condition of a minimum 35 percent grant element for any new external loan contracted during the term of the DMS (from 2019 to 2022). Page 26 The World Bank Vanuatu Disaster Risk Management Development Policy Grant with a Catastrophe-Deferred Drawdown Option (CAT-DDO) (P168749) Table 1: DPF Prior Actions and Analytical Underpinnings Prior Actions Analytical Underpinnings GoV (2017). Review of National Disaster Act 2000. Highlights the need to update the disaster management legislation to focus on risk reduction and climate change adaptation, as well as to strengthen medium- and long-term disaster recovery. Supported through technical assistance under the Increasing Resilience to Climate Change and Natural Hazards project (P112611). GoV (2016). National Sustainable Development Plan (2016-2030). Outlines the government’s goals and policy objectives to achieve resilience in the face of climate change and disaster risks posed by natural hazards. GoV (2016). Vanuatu Climate Change Adaptation and Disaster Risk Prior action 1: The Recipient’s Reduction Policy 2016-2030. Outlines specific strategic priorities in Council of Ministers has approved, line with the recommendations of the 2014 Risk Governance and submitted to the Parliament, a Assessment Report: Strengthening Climate and Disaster Risk Bill for the Disaster Risk Governance in Vanuatu. Management Act, which provides for an integrated approach to UNISDR (2015). Sendai Framework for Disaster Risk Reduction 2015- disaster risk reduction and climate 2030 adopted by the GoV at the 3rd UN World Conference on Disaster change adaptation, disaster Risk Reduction. The Sendai Framework identifies four policy priorities: preparedness, response and (i) Understanding disaster risk, (ii) Strengthening governance to recovery at national and local levels. manage disaster risk, (iii) Investing in disaster risk reduction for resilience, and (iv) Enhancing disaster preparedness for effective response, and to “Build Back Better” in recovery and reconstruction. Key activities under the Sendai Framework are being consolidated in this operation’s policy framework, including: (i) mainstreaming and integrating disaster risk reduction within and across sectors and reviewing and promoting the coherence and further development of national and local frameworks of laws, regulations and public policies28; (ii) building better from the start to withstand hazards through proper design and construction29; (iii) promoting mechanisms for financial protection in order to reduce the financial impact of disasters on governments and societies.30 World Bank (2015). Guide to Developing Disaster Recovery Frameworks. The key finding informing this prior action is that the preferable arrangement for post disaster recovery is to have pre- existing institutional arrangements for core recovery planning and 28 Sendai Framework, Section IV, paragraph 27.a 29 Sendai Framework, Section IV, paragraph 30.c 30 Sendai Framework, Section IV, paragraph 30.b Page 27 The World Bank Vanuatu Disaster Risk Management Development Policy Grant with a Catastrophe-Deferred Drawdown Option (CAT-DDO) (P168749) oversight functions, with clear mandates. GoV (2013). National Land Use Planning Policy. Highlights the need for the integration of risk and vulnerability assessment tools, methodologies, and information into the land use planning process, particularly in determining development controls and assessing development applications. Advisory Services and Analytics (ASA) on Enabling Affordable and Prior action 2: The Recipient’s Resilient Settlements (P157414), the key finding of which is that Council of Ministers has approved a unplanned urban expansion has led to piecemeal development of National Land Subdivision Policy, high-income (unaffordable) subdivisions, proliferation of unplanned which provides for risk-informed informal settlements, and settlements expanding into areas of high land and settlement development, exposure to natural hazards. The precursor Mainstreaming Disaster with minimum standards for Risk Reduction Project (P129376) supported the VMGD to develop disaster risk reduction. robust multi-hazard and risk maps for Greater Port Vila and Luganville, the two rapidly growing population centers of Vanuatu. GoV (2015). Tropical Cyclone Pam Post Disaster Needs Assessment (PDNA). The PDNA highlighted that damage to unplanned residential settlements was equivalent to that in infrastructure sectors (combined). Debt Management Performance Assessment (2014): highlights the need for a DMS to provide guidance for future financing decisions and Prior Action 3: The Recipient’s help meet the authorities’ objectives to contract debt at the lowest Council of Ministers has approved a cost and risk. Debt Management Strategy 2019- Vanuatu Debt Management Strategy (2015-17): notes the need to 2022, which contains measures to review the legal framework for debt management and prepare an minimize the costs and risks action plan to address key weaknesses. associated with the Recipient’s public debt, and sets out plans to IMF Article IV (2019): notes that the process of strengthening the debt strengthen the Recipient’s public management framework needs to be completed, including through debt management. complementary regulations and legal amendments, and that consultation with development partners could strengthen the effectiveness of such emendations. 4.3. LINK TO CPF, OTHER BANK OPERATIONS AND THE WBG STRATEGY 63. This program is consistent with the World Bank Group’s Pacific Islands - Regional Partnership Framework (FY17-FY21) [Report 120479] covering nine Pacific island countries, including Vanuatu. Specifically, it is in line with Focus Area 3: Protecting incomes and livelihoods, through its contribution to the achievement of Objective 3.1: Strengthened resilience to natural disasters and climate change; and with Focus Area 4: Strengthening the enablers of growth opportunities, through its contribution to the achievement of Objective 4.1 to develop and maintain frameworks to improve fiscal management. The program is also aligned with the Climate Change special theme of IDA18. Page 28 The World Bank Vanuatu Disaster Risk Management Development Policy Grant with a Catastrophe-Deferred Drawdown Option (CAT-DDO) (P168749) 64. Contribution to poverty reduction. While disasters impact whole societies, when they strike, the poor and vulnerable (including women, children and the elderly) are hit the hardest. Natural disasters and climate shocks also induce and exacerbate poverty. Though the asset losses of the poor account for just a small fraction of total losses in any disaster, one dollar in asset losses matters more to a poor household than to a wealthy one. Well- being risk is defined so that US$1 of well-being risk indicates the same impact on poor people as on the wealthy, even when their asset losses differ. Analytical work conducted by the Global Facility for Disaster Reduction and Recovery has found that the average annual well-being risk from disasters in Vanuatu is over 1.4 times the average annual risk to assets, reflecting the disproportionate impact of disasters on the poor, particularly in terms of the impact on transient consumption poverty.31 65. This program supports the World Bank Group’s twin goals of ending extreme poverty and boosting shared prosperity. Poorer people are typically disproportionately affected by disasters for several reasons: (i) the poor and “bottom 40 percent” typically have inadequate financial means (insurance, cash reserves, or alternative income sources) to deal with disaster events, (ii) in the face of more immediate challenges (access to food, water, or livelihood), poor people have limited settlement options and are forced to live in lower-value hazard prone areas, and (iii) people just above the poverty line and vulnerable populations (children, women, elderly) can be pushed into transient poverty when a disaster hits. Accordingly, the contingent financing can be expected to benefit the most vulnerable and impoverished communities by strengthening the financial capacity of the government to respond and recover in a timely manner following a disaster, thus allowing poor communities to recommence their livelihood activities sooner. 66. The program will also complement recently completed and active DRM and climate adaptation projects and technical assistance activities in Vanuatu. These include investment projects such as the: (i) Mainstreaming Disaster Risk Reduction Project (P129376 – closed 2017), which supported hazard and risk mapping in the Greater Port Vila and Luganville areas, (ii) Increasing Resilience to Climate Change and Natural Hazards Project (P112611 – closed 2018), which supported community-based disaster risk management and the review of the National Disaster Act of 2000, (iii) Pacific Resilience Program (P155256 – active), which funded Vanuatu’s catastrophe insurance premia from 2015-2018, and (iv) Vanuatu Infrastructure Reconstruction and Improvement Project (P156505 - active), which is reconstructing and upgrading public facilities and infrastructure in provinces affected by Cyclone Pam, as well as the Vanuatu Enabling Affordable and Resilient Settlements ASA (P157414 - closed). Targeted, grant-funded technical assistance will also be carried out by the Bank during the operation’s implementation to support the achievement of results indicators. 4.4. CONSULTATIONS AND COLLABORATION WITH DEVELOPMENT PARTNERS 67. Consultations. The overall consultation process for the actions and outcomes supported under this operation are convened by the Department of Strategic Policy, Planning, and Aid Coordination, in accordance with their mandate under the Government Act, Part 2.5, paragraphs (a)-(e), to exercise leadership authority over “strategic policy-planning…coordinating the activities of Government…. (and) overseeing the implementation of Government policy”. In terms of consultations around the specific reforms: a. Disaster Risk Management Act – the National Advisory Board for Climate Change and Disaster Risk Reduction convened the multi-stakeholder consultation process (starting in 2016) for the 31 World Bank and Global Facility for Disaster Reduction and Recovery “Resilience Indicator”. World Bank 2017, Unbreakable. Page 29 The World Bank Vanuatu Disaster Risk Management Development Policy Grant with a Catastrophe-Deferred Drawdown Option (CAT-DDO) (P168749) review of the predecessor National Disaster Act, which informed the drafting of the Bill for the Disaster Risk Management Act. Consultations involved government agencies, local governments, development partners, academia, NGOs, CSOs, the private sector, and humanitarian partners within the National Cluster system. b. National Subdivision Policy – consultations have been convened by the Ministry of Lands and Natural Resources since 2015, involving relevant government agencies, academia, private sector stakeholders, and communities. c. Technical assistance was provided by the World Bank in June and July 2019 to facilitate the preparation of the updated Debt Management Strategy, working in close collaboration with the Debt Management Unit within the MFEM, and other key stakeholders. 68. Collaboration with other development partners. The Vanuatu Climate Change and Disaster Risk Reduction Policy, which called for the review of the National Disaster Act, was supported by the Government of Australia (GoA), the United Nations Development Program, the Secretariat of the Pacific Community, and GIZ. Development partners participate in the National Cluster system for humanitarian coordination and are thus engaged in the reform area on disaster preparedness, emergency management, relief and recovery. A review of land use planning activities in Vanuatu was supported by the Secretariat of the Pacific Community, in collaboration with GIZ, which informed the National Land Use Planning Policy. Development partners including the Australian Department of Foreign Affairs and Trade, the Asian Development Bank, and the World Bank have worked to coordinate the provision of technical assistance for the debt management reforms that are currently underway. 5. OTHER DESIGN AND APPRAISAL ISSUES 5.1. POVERTY AND SOCIAL IMPACT 69. The disproportionate impact of natural disasters on the poor has been extensively documented in Vanuatu. The country faces long-term average annual asset risk of approximately 7 percent of GDP, consisting of the cost to repair or replace damaged assets including homes, schools, hospitals, roads and bridges, etc. However, these aggregated asset losses do not show how people’s livelihoods are affected, especially the prospects of the poorest and most vulnerable (well-being risk). For the poor, even small absolute values of asset loss can disproportionately affect livelihoods, reducing income and making it even harder to rebuild lost homes and productive assets. The poor have few assets, and little or no savings. They have little opportunity for risk diversification and restricted access to credit. Because of this, they are less able to cope with impacts on consumption or disruptions to income. Exogenous shocks like disasters can also increase poverty indirectly through the effects of lower economic growth, higher inflation (to which the poor are more vulnerable), and through resulting lower government spending for social services. Households living close to the poverty line can be pushed into poverty as a result. Prior Action 1 will strengthen the regulatory and institutional systems to enable more effective, faster recovery, which has been found to significantly reduce well-being risk in Vanuatu.32 70. The Post-Disaster Needs Assessment (PDNA) conducted after TC Pam found that extensive destruction of food crops seriously affected households’ food security and nutrition. A head of island cabbage, a common 32 World Bank and Global Facility for Disaster Reduction and Recovery.World Bank 2018, Building back better: achieving resilience through stronger, faster, and more inclusive post-disaster reconstruction. Washington, D.C.: World Bank Group. Page 30 The World Bank Vanuatu Disaster Risk Management Development Policy Grant with a Catastrophe-Deferred Drawdown Option (CAT-DDO) (P168749) and important vegetable in ni-Vanuatu cuisine, rose from VUV100 before the cyclone to VUV300 at the time of the PDNA. The loss of vegetables and fruits, compounded by inflated vegetable prices, placed food beyond the means of the most vulnerable households. According to custom, women eat last; with limited availability of food, there were concerns that women (particularly pregnant and lactating women) were not getting sufficient nutrition in the aftermath of the disaster. Having an efficient, properly functioning disaster risk management system at the local and national levels (as supported by Prior Action 1) will allow for faster post-disaster recovery of the poorest. Similarly, risk-informed land development enabled by Prior Action 2 will decrease the vulnerability of population settlements to disasters. 71. One of the key principles of the National Subdivision Policy (Prior Action 2) is that the regulation and approval of land subdivision applications must take into consideration the affordability of (part of) the proposed development for low-income households. Provisions are made for higher density subdivision layouts and the setting aside of land for lower-income groups to increase affordability, more cost-efficient site planning (layouts) and service provision, and appropriate minimum infrastructure service standards for all subdivision developments (including those targeted to low-income households). 72. Low-income households in Vanuatu tend to be relatively more vulnerable to any contraction in the provision of essential public services that may result from external shocks if the government lacks adequate fiscal buffers. It is thus particularly important to poor people and vulnerable groups that the government maintains the capacity to provide public services over time, which in turn depends on the maintenance of fiscal stability. The reforms to debt management and policy supported by this operation are expected to have positive impacts on the poor, to the extent that they assist the government in its efforts to consolidate its public finances and build fiscal buffers. The operation will also contribute to increased social/human resilience in particular through the Disaster Recovery Framework (Results Indicator 1.2), which will: (i) include sectoral recovery (e.g. in the health and education sectors) to reduce interruptions to provision of essential public services, and (ii) support ongoing dialogue within the GoV on culturally appropriate social protection measures for disaster- affected people. 73. Overall, the policy actions and results to be supported by this proposed operation are expected to have significant positive effects on poor people and vulnerable groups. Poverty and vulnerability to natural hazards are strongly inter-related: poverty increases vulnerability to adverse natural events, and disasters cause capital and human losses, fostering poverty and leading to poverty traps. A well-functioning DRM system relies on a comprehensive framework defining roles, responsibilities, processes and implementation modalities for both ex-ante investments and post-disaster recovery and reconstruction. Coordinated efforts and efficient management of resources to ensure that interventions reach communities are likely to reduce the unmet needs of the poorest households and most vulnerable male and female populations in the event of a disaster, and in this way contribute to poverty reduction and shared prosperity. 74. Gender. Within households, the impacts of disasters are not spread equally. Women and infant girls are often the ones who bear the brunt of impacts within the poorest households. This includes not only the direct impacts (disaster-related mortality rates are higher among women), but also the indirect impacts (negative impacts on nutrition and school performance are disproportionately high among girls). A 2016 comparative study of TC Pam by CARE International showed that while both women and men lost their agricultural produce, the extensive destruction of food and cash crops created new challenges for women’s ability both to provide adequate food and nutrition, and to generate income to support their families. Reports from humanitarian assessments indicated that women were reducing their food intake to make the remaining food last longer. The increased burden of work due to child care, because of extensive damage to kindergarten schools, also meant Page 31 The World Bank Vanuatu Disaster Risk Management Development Policy Grant with a Catastrophe-Deferred Drawdown Option (CAT-DDO) (P168749) that women had less time available for rebuilding their livelihoods. There was also a 300 percent increase in new domestic violence cases at Tanna Women Counselling Centre after two tropical cyclones hit Tafea, the southern province of Vanuatu, in 2011. The CARE report concluded that DRR activities are more effective in the face of a disaster when both men’s and women’s voices and roles are respected and actively sought. 75. While gender-responsive DRR initiatives are a policy challenge for many countries in the world, the Pacific region’s progress towards gender equality and the empowerment of women within DRR is lagging. Pacific Island Countries have made no or limited advancement in complying with the gender indicator called for by the Hyogo Framework for Action (HFA), that a ‘gender perspective should be integrated into all disaster risk management policies, plans and decision-making processes’33, with many countries struggling to address gender and social inclusion issues in their DRR efforts. Nearly all Pacific Island Countries have national disaster legislation that is completely gender blind: a review of 11 disaster laws (including Vanuatu’s National Disaster Act 2000) reveals over 80 percent are gender blind. National climate change and DRR legislation, policies and strategies are also limited in the integration of gender perspectives. 76. In HFA National Progress reporting (2011-2013), Vanuatu was one of only four Pacific Island Countries unable to report on any of the six gender indicators, revealing a large gender gap in Vanuatu’s DRM legislation. The Ministry of Climate Change’s Project Management Unit, the National Disaster Management Office, and the Department of Women’s Affairs, do not have systematic procedures for gathering sex-disaggregated data on disaster impacts34. Accordingly, disaster policies lack sufficient analysis and response needed to propel substantive reduction in the underlying vulnerability of women and girls and to ensure the needs and priorities of both women and men are considered in DRR planning processes. As a signatory to the Sendai Framework for DRR 2015-2030, which supersedes the HFA, GoV now recognizes the importance of gender dimensions in DRM and supports the calls for inclusiveness and engagement of all of society in implementing related programs and projects. 77. This operation will concretely close the gender gap specifically in legislation via the Bill for the DRM Act (Prior Action 1), which: (i) mandates the membership of a representative of the gender and protection sector of the relevant Province or Municipality in the PDCCCs and MDCCCs, to ensure that disaster risk management and climate change adaptation measures are gender responsive, and (ii) as part of the Disaster Recovery Framework (Result Indicator 1.2), establishes as a condition of endorsement by the National Recovery Committee that all disaster recovery plans (at central, provincial and municipal levels) will include monitoring mechanisms on gender and protection. In so doing, the Disaster Recovery Framework will concretely close the gender gap identified under the HFA National Progress reporting and ensure Vanuatu is able to comply with Sendai Framework data standards on gender dimensions in DRM. 5.2. ENVIRONMENTAL ASPECTS 78. The policy actions proposed under the operation are likely to have positive effects on Vanuatu’s environment, natural resources or forests, relative to the status quo. The actions, which include implementation of the DRM Act and application of the National Land Subdivision Policy, will improve risk reduction, preparedness, response and recovery from natural disasters and are not associated with activities that will impact the environment or natural resources. The DRM Act (and the resulting Disaster Recovery 33 UNISDR, UNDP and IUCN, 2009 34 UN Women 2016 Page 32 The World Bank Vanuatu Disaster Risk Management Development Policy Grant with a Catastrophe-Deferred Drawdown Option (CAT-DDO) (P168749) Framework) will clarify and harmonize oversight procedures and approvals to be applied (including those of development partners), to ensure that all recovery/reconstruction plans, programmes and projects incorporate provisions for environmental and social safeguards, in accordance with national legislation and regulations. The Subdivision Policy is expected to have positive environmental impacts associated with future development, via integration of environmental considerations in the subdivision approval, design and implementation process. 79. Through the prior actions supported under this operation, the GoV has adopted a comprehensive, multi-hazard approach that considers the range of geological and hydro-meteorological hazards to which the country is exposed. The existing vulnerability of communities is being evaluated through hazard and risk assessments conducted by the VMGD. Prior Action 1 recognizes and puts systems in place to address the impacts of climate change, particularly since this has resulted in significant changes in baseline environmental conditions. These changes affect the underlying disaster risk factors, such as exposure to storms, floods, droughts and other weather-related hazards. Through Prior Action 2, the government is adopting a risk-informed approach to development, by addressing the gaps in the regulatory environment for climate and disaster-resilient land and settlement development. 80. The GoV has in place environment and natural resources management laws that provide for sustainable utilization and conservation of the environment and natural resources. The primary legislation is the Environmental Protection and Conservation Act, administered by the Department of Environmental Protection and Conservation. The act requires environmental assessment to be undertaken for any activity likely to impact on the environment and is referred to in the National Land Subdivision Policy, as well as the Disaster Recovery Framework. The framework for environmental assessments has been mainstreamed into the development process and for specific projects (including post-disaster reconstruction), and the Strategic Environmental Assessment (SEA) is required for sectoral plans and programs. More effective environmental management, including the adoption of eco-based adaptation and risk mitigation measures that work with natural systems, will be informed by the mainstreaming of DRM in the development process through Prior Actions 1 and 2. 5.3. PFM, DISBURSEMENT AND AUDITING ASPECTS 81. Vanuatu’s public financial management (PFM) system shows mixed overall performance and is not adequate in some areas. Although some areas of PFM had several improvements in recent years, there are still weaknesses and challenges that need addressing. The 2013 Public Expenditure and Financial Accountability (PEFA) Report and 2015 Self-assessment PEFA Report both revealed main areas of strength in: (i) credibility of budget, and (ii) comprehensiveness and transparency. The main areas of weakness are: (i) budget cycle, (ii) accounting, recording and reporting, and (iii) external scrutiny and audit. The 2013 PEFA showed some improvements in half a dozen indicators. While the 2015 Self-assessment PEFA Report showed improvements in more indicators, it qualified that many of these were not a change in performance, but only a difference in assessors’ interpretation. The GoV has established a reasonably adequate level of basic fiscal controls and compliance by line ministries on budget preparation and execution, showing key progress on areas such as credibility of revenue forecasts, comprehensive and transparent budget documentation, budget credibility, timeliness and public access to in-year reporting, internal control on revenue administration and processes, and legal framework on Customs and Procurement. The budget is published each year on the website of the MFEM. However, PFM arrangements are still weak over effectiveness of the payroll controls, the quality and timeliness of annual financial statements, multi-year fiscal planning, transparency, competition and complaints mechanisms in procurement, and scope and timeliness of external audits and ministries’ response to audit Page 33 The World Bank Vanuatu Disaster Risk Management Development Policy Grant with a Catastrophe-Deferred Drawdown Option (CAT-DDO) (P168749) recommendations. 82. Institutional arrangements governing post disaster PFM waivers are not in place. There can be situations where normal PFM procedures are waived for post-disaster financing. Legislation and documented procedures for if, when, how this can be done, and the alternate procedures that are then to be followed, are not existent. Nor is there available information on the success or not, and any impact of suitability and effectiveness of the waivers or alternate procedures. 83. Vanuatu has put in place a comprehensive PFM improvement program via the PFM Roadmap 2017- 2021, however it is too early to monitor progress of implementation. The Vanuatu PFM Roadmap 2017-2021 is the first PFM reform roadmap developed for the GoV, and it identified sound PFM as a core element of good governance to ensure stability and growth as well as efficiency and transparency in the use of government resources. This vision is translated into four objectives: sustained fiscal strategy, improved performance of public investments, reduced exposure to fiscal risks and transparent performance of all public entities. The top priority action areas are: (i) procurement regulations, (ii) payroll controls, (iii) SOE reporting, (iv) reporting of debt, (v) audited financial statements, and (vi) taxation. 84. The foreign reserves control environment shows weaknesses. Vanuatu underwent an IMF Safeguards Assessment (IMF SA) in 2016. The 2019 Article IV Staff Report identified several weaknesses, and safeguards recommendations that were made, but stated that progress in implementing the safeguards recommendations has been slow. 85. The Reserve Bank of Vanuatu publishes its annual report and independently audited financial statements. The financial statements are prepared in accordance with International Financial Reporting Standards and the financial reporting provisions of the Reserve Bank of Vanuatu. The 2017 and 2018 financial statements showed unqualified audit reports; however, the 2017 statement included two Emphasis of Matters regarding comparative information being restated for 2016 and 2015. As a result, the IMF directed RBV to record all IMF-related assets and liabilities in the balance sheet, as previously only some were recorded. The impact of this is: (i) a one-time increase to equity (general reserve of VUV285 million -- a 61 percent increase of 2015 equity), and (ii) the distribution of foreign exchange gains regarding the impact on the determination of reserves available for distribution to stakeholders, as there is no definitive accounting literature in this regard, and so these items could be treated differently by other organizations. The impact of this in 2017 is nil but for 2018 the impact is 10 percent of general reserves now available for distribution, i.e. VUV100 million available for distribution. Both Emphasis of Matters did not modify the auditor’s unqualified opinion on the 2017 audit. The 2016 audit included qualified opinion. The RBV had arbitrarily allocated the movement in the fair value of the “Available for Sale” financial instrument between interest income and the fair value reserve, impacting the reported net profit or loss (overstated by VUV2.4 million); other comprehensive income (understated by VUV2.4 million) and in the fair value reserves (understated by VUV147.1 million). The audit report also included an Emphasis of Matter about the RBV recognizing realized foreign exchange gains and losses on the bases of translation of financial instruments denominated in foreign currency with original maturity of less of one year; including such realized gains and losses in the profit or loss for the year and transferred to the general reserve available for distribution, despite the fact that the underlined instruments have not settled at balance date. 86. The fiduciary risk rating for the operation is Substantial. The weaknesses noted above in Vanuatu’s PFM systems, especially relating to PFM around post-disaster financing and funds pose a substantial risk to proposed operation. This weakness is planned to be mitigated via new legislation with a Bill for the new DRM Act, where in section 42 – Guidelines for Use of Funds, the GoV will prescribe a guideline for the use of emergency funds, Page 34 The World Bank Vanuatu Disaster Risk Management Development Policy Grant with a Catastrophe-Deferred Drawdown Option (CAT-DDO) (P168749) including procedures for urgent request of funds and types of emergencies. Due to weaknesses in the central bank control environment and budget management system, the Bank has identified the below additional measures to secure acceptable fiduciary arrangements. 87. The proceeds of each disbursement will be deposited by the World Bank, at the request of the Recipient, into a dedicated Foreign Currency Deposit Account with the RBV that forms part of the official foreign exchange reserves. The funds for the partial or full disbursement of the CAT-DDO will be made available after the drawdown condition is met. The proposed operation will follow the World Bank’s disbursement procedures for development policy grants. 88. The proceeds cannot be used for ineligible expenditures and will not be tied to any specific purchases. The proceeds of the operation would not be used to finance expenditures excluded under the General Conditions for IDA Financing: Development Policy Financing (2018) (“General Conditions”). If, after being deposited in a government deposit account, the proceeds of the operation are used for excluded expenditures as defined in the General Conditions, the Recipient will be required to refund the amount directly to the World Bank. Any such amounts refunded to the World Bank shall be cancelled. 89. As a due diligence measure, within 30 days of each grant disbursement the Recipient will provide a written confirmation to the World Bank of the receipt of funds. The recipient will confirm that: (i) the proceeds were received into an account of the government that is part of the country’s foreign exchange reserves (including the date and the name/number of the government’s bank account in which the amount has been deposited), and (ii) an equivalent amount has been accounted for in the country’s budget management system (including the Chart of Accounts name/account number, the date, and the exchange rate used). 90. The World Bank will require a special audit of the dedicated Foreign Currency Deposit Account for each fiscal year in which there were receipts. The audits will confirm that the funds disbursed by the World Bank have been deposited into the Foreign Currency Deposit Account, form part of the country’s foreign exchange reserves, and that an equivalent amount has been either credited to an account of the government available to finance budgeted expenditures or used for budgeted payments made in foreign currency, and categorization of these payments. The audit opinion should also confirm the following: (i) the accuracy of the summary of the transactions, including accuracy of exchange rate conversions; (ii) that the dedicated account was used only for the purposes of the operation; (iii) that all payments out of the dedicated account were not made for any Excluded Expenditures as defined in the General Conditions; (iv) that all payments made from the dedicated account were for the government’s budget expenditures (i.e., items included in the government’s approved budget for the period) or transfers into the government’s Treasury Account; and (v) that payments from the Foreign Currency Deposit Account were transferred to an account available to finance budgeted expenditure in a timely manner (normally within 30 days of disbursement). The audit reports of the dedicated account for each fiscal year in which there were receipts, will be required to be received by the World Bank within six months of the end of the Recipient’s fiscal year in which the disbursement is made. 5.4. MONITORING, EVALUATION AND ACCOUNTABILITY 91. The MFEM is the main counterpart of the World Bank for this development policy operation, while the implementation of the policy program will be coordinated and monitored by MFEM and the Department of Strategic Policy, Planning and Aid Coordination attached to the Prime Minister’s Office. The 3-year drawdown period will coincide with the monitoring of the operation’s Policy and Results Matrix, with indicators that reflect Page 35 The World Bank Vanuatu Disaster Risk Management Development Policy Grant with a Catastrophe-Deferred Drawdown Option (CAT-DDO) (P168749) the expected outcomes of the prior actions (in line with the monitoring and evaluation framework of the National Sustainable Development Plan). Grant-funded technical assistance is planned to be provided by the World Bank at the request of the government, to support achievement of selected result indicators. 92. Policy dialogue and monitoring and evaluation of the program are shared with the relevant actors under the Policy and Results framework. The government and the Bank will maintain a close policy dialogue during the program implementation period, through periodic implementation support missions that may take place at a frequency consistent with the needs of the counterparts, but no less than every 6 months. Indicators selected to monitor progress toward achievement of the PDO reflect defined areas of action and correspond to the expected outcomes of the prior actions. They include an appropriate mix of specific qualitative and quantified targets, which are attributable, relevant, and time-bound, and are expected to be sufficient to enable effective monitoring of the project’s achievement of the PDO. Moreover, the result indicators are aligned with government priorities. 93. 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 Development Policy Operation 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 94. The overall program risk rating is Substantial, based on substantial political and governance, macroeconomic, fiduciary, and institutional capacity risk as detailed below. Sector strategies and policies pose moderate risk, as the government has shown strong leadership by integrating the DRM and CCA agenda in the National Sustainable Development Plan and convening extensive public consultations around the prior actions. The substantial risks remain to be: a. political risk, which has had an impact on the passage of the Bill for the DRM Act (submitted to the Parliament) due to unrelated motions of no confidence in December 2018 and June 2019. The impact of this risk on achievement of the operation’s objectives will be mitigated through targeted technical assistance to support progress toward achievement of the result indicators; b. macroeconomic risks related to future natural disasters and the public and publicly-guaranteed debt trajectory (though the prior actions supported by this operation help to mitigate these risks). There are also several risks related to the external economic environment, including the potential for lower-than-expected growth in the larger economies in the region, which could have a negative impact on tourism activity, FDI inflows, and/or remittances; Page 36 The World Bank Vanuatu Disaster Risk Management Development Policy Grant with a Catastrophe-Deferred Drawdown Option (CAT-DDO) (P168749) c. fiduciary risks related to post-disaster public financial management and audits, which will be mitigated by targeted technical assistance to support the development of key guidelines for the use of post-disaster funding; and d. the effective long-term implementation of reforms given constrained institutional capacity. This is being mitigated by the strong anchoring of the reforms in the Climate Change and Disaster Risk Reduction Policy, as well as the corporate plans of the relevant ministries. This agenda also has strong support from the Council of Ministers, and public pressure for better disaster risk management is significant due to the frequency and intensity of disasters in Vanuatu. The capacity of four key implementing ministries (MFEM, the Prime Minister’s Office, Ministry of Climate Change, and Ministry of Lands and Natural Resources) have been strengthened with the confirmation of key executive positions (Directors-General and Directors) in November 2018. In addition, the reforms being supported by the operation and the associated results have a strong focus on building institutional capacity to enable sustainability and implementation. 95. Risks related to the technical design of the program are moderate as this operation builds on the Bank’s long-standing engagement in DRM and strong leadership of counterparts in prioritizing the reforms. The policy areas supported under this program consolidate ongoing work and have been designed through a comprehensive technical assistance program as well as through completed and ongoing investment projects over the past decade. The program also builds on the outcomes and lessons learned from the Pacific Resilience Project. Page 37 The World Bank Vanuatu Disaster Risk Management Development Policy Grant with a Catastrophe-Deferred Drawdown Option (CAT-DDO) (P168749) Table 2: Summary Risk Ratings Risk Categories Rating 1. Political and Governance  Substantial 2. Macroeconomic  Substantial 3. Sector Strategies and Policies  Moderate 4. Technical Design of Project or Program  Moderate 5. Institutional Capacity for Implementation and Sustainability  Substantial 6. Fiduciary  Substantial 7. Environment and Social  Moderate 8. Stakeholders  Moderate 9. Other Overall  Substantial . Page 38 The World Bank Vanuatu Disaster Risk Management Development Policy Grant with a Catastrophe-Deferred Drawdown Option (CAT-DDO) (P168749) ANNEX 1: POLICY AND RESULTS MATRIX Prior Actions Indicator Name Baseline Target PILLAR A: Managing and Reducing Disaster and Climate Risk Prior action 1: The Recipient’s Council of Results Indicator 1.1: Number of Provincial and 4 PDCCCs established 6 PDCCCs established Ministers has approved, and submitted to Municipal Disaster and Climate Change Committees the Parliament, a Bill for a Disaster Risk (PDCCCs, MDCCCs) established with funded annual work 0 MDCCCs established Management Act, which provides for an 2 MDCCCs established plans integrated approach to disaster risk reduction and climate change adaptation, disaster preparedness, response and Results Indicator 1.2: Disaster Recovery Framework recovery at national and local levels. developed and approved for implementation by No Yes (Completed – December 2018) Council of Ministers Prior action 2: The Recipient’s Council of Results Indicator 2.1: Subdivision Regulations Regulations applied to 100 Regulations not Ministers has approved a National Land integrating affordability, climate and disaster resilience percent of Subdivision developed Subdivision Policy, which provides for risk- adopted and applied applications informed land and settlement development, Results Indicator 2.2: Disaster and climate-risk informed LMPC Guidelines applied to with minimum standards for disaster risk LMPC Guidelines not Land Management Planning Committee (LMPC) 100 percent of Subdivision reduction. developed guidelines adopted and applied applications (Completed – March 2019) PILLAR B: Managing Public Debt Prior Action 3: The Recipient’s Council of Ministers has approved a Debt Compliance with the DMS Management Strategy 2019-2022, which concessionality condition Results Indicator 3.1: Compliance with the DMS New external loan contains measures to minimize the costs of a minimum 35 percent condition of a minimum 35 percent grant element for contracted in late 2018 and risks associated with the Recipient’s grant element for any new any new external financing had a grant element public debt, and sets out plans to external loan contracted below 35 percent strengthen the Recipient’s public debt during the term of the DMS management. (from 2019 to 2022). Page 39 The World Bank Vanuatu Disaster Risk Management Development Policy Grant with a Catastrophe-Deferred Drawdown Option (CAT-DDO) (P168749) ANNEX 2: FUND RELATIONS ANNEX Page 40 The World Bank Vanuatu Disaster Risk Management Development Policy Grant with a Catastrophe-Deferred Drawdown Option (CAT-DDO) (P168749) Page 41 The World Bank Vanuatu Disaster Risk Management Development Policy Grant with a Catastrophe-Deferred Drawdown Option (CAT-DDO) (P168749) Page 42 The World Bank Vanuatu Disaster Risk Management Development Policy Grant with a Catastrophe-Deferred Drawdown Option (CAT-DDO) (P168749) Page 43 The World Bank Vanuatu Disaster Risk Management Development Policy Grant with a Catastrophe-Deferred Drawdown Option (CAT-DDO) (P168749) ANNEX 3: LETTER OF DEVELOPMENT POLICY Page 44 The World Bank Vanuatu Disaster Risk Management Development Policy Grant with a Catastrophe-Deferred Drawdown Option (CAT-DDO) (P168749) Page 45 The World Bank Vanuatu Disaster Risk Management Development Policy Grant with a Catastrophe-Deferred Drawdown Option (CAT-DDO) (P168749) Page 46 The World Bank Vanuatu Disaster Risk Management Development Policy Grant with a Catastrophe-Deferred Drawdown Option (CAT-DDO) (P168749) ANNEX 4: ENVIRONMENT AND POVERTY/SOCIAL ANALYSIS TABLE Significant poverty, social or Significant positive or negative Prior Actions distributional effects positive or environment effects negative Prior action #1 Yes - positive Yes - positive Prior action #2 Yes - positive Yes - positive Possibly positive, by helping to ensure the maintenance of fiscal space to fund critical public services (upon Prior action #3 No which low-income households tend to be more reliant) in the aftermath of natural disasters or other external shocks. 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