Sri Lanka - Key development issues in the 1980s (Vol. 2 of 2) : Agricultural producer incentives

Report No. 2955-CE Aluc cop Sri Lanka: Cp Key Development Issues in the 1980s Volume II: Agricultural Producer Incentives May 29, 1980 South Asia Programs Department FOR OFFICIAL USE ONLY Document of the World Bank This document has a restricted distribution and may be used by recipients only in the performance of ti ,ir official duties. Its contents may not otherwise be disclosed without World Bank authorization.   FOR OFFICIAL USE ONLY SRI LANKA: KEY DEVELOPMENT ISSUES IN THE 1980s Volume II: Agricultural Producer Incentives Table of Contents Page No. I. INTRODUCTION ............................................ 1 II. PADDY ................................................... 4 Production and Price Trends ............................. 4 Official Procurement and the Role of the Public Agencies ....................................... 8 Returns to the Farmer ................................... 10 Marketing Costs and Margins ............................. 13 Border Price Equivalents ................................ 17 The Level of Prices and the Role of the GPS .... ......... 19 III. MINOR FIELD CROPS ....................................... 22 Output and Price Trends ................................. 22 Role of the Floor Price ................................. 25 IV. COCONUTS ................................................ 28 Producer Returns ........................................ 28 Recommended Farmgate Prices ............................. 30 V. TEA AND RUBBER .......................................... 33 Tea Producer Margins .................................... 33 Fiscal Recommendations .................................. 34 Rubber: The Importance of the Replanting Scheme .... .... 36 VI. CONCLUSIONS ................ 40 LIST OF TABLES IN THE TEXT Table 1: Paddy Production: 1972/73-1978/79 and 1979/80 Target ................................... 5 Table 2: Per Capita Supplies of Foodgrains, 1970-1978 .... ... 6 Table 3: Annual Averages: Retail and Producer Prices .... ... 7 Table 4: Seasonal Price Variations for Raw Rice and Paddy ... 7 Table 5: Trends in Procurement, Imports and Issues by Food Commissioner ............................. 9 Table 6: Net Returns to the Paddy Farmer: Maha 1972/73 - Maha 1979/80 ........................... 12 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.  Table of Contents (continued) Page No. Table 7: Structure of Public Sector Paddy/Rice Prices as of February 1, 1980 ........ .......................... 14 Table 8: Structure of Public Sector Rice Prices as of February 1, 1980 ........ ......................... 15 Table 9: The Structure of Rice Prices: 1979/80 Crop Year and Projections for 1980/81-1982/83 ......... 18 Table 10: Production and Import Data: Food Crops .... ........ 23 Table 11: Producer Prices: Minor Field Crops .... ............ 24 Table 12: Basis for Establishing Floor Prices for Minor Field Crops ...................................... 26 Table 13: Net Returns to Coconut Farmers, 1973-1980 .... ...... 29 Table 14: Structure of Prices for Coconuts, 1978-1985 ........ 31 Table 15: Tea Net Producer Returns, 1973-1979 ................. 34 Table 16: Fiscal Impact of Alternative Tea Taxes .... ......... 36 Table 17: Rubber Prices and Net Returns ...................... 38 LIST OF ANNEXES Annex I: Returns to the Paddy Farmer ..... ................... 43 Annex II: Returns to the Coconut Farmer ..... ................. 67 GLOSSARY ARTI - Agricultural Research and Training Institute Asweddumized - Levelled and bunded land, suitable for paddy cultivation Bushel - 20.87 kg or 46.02 lbs Chena - Slash and burn cultivation CMB - Coconut Marketing Board CWE - Cooperative Wholesale Enterprise DOA - Department of Agriculture FC - Food Commissioner GPS - Guaranteed Price Scheme Jaggery - Unrefined brown sugar Maha - Northeast monsoon, October-February Manioc - Cassava PMB - Paddy Marketing Board Poonac - Copra cake Yala - Southwest monsoon, May-September  VOLUME II AGRICULTURAL PRODUCER INCENTIVES I. INTRODUCTION 1.01 The policy changes introduced by the Government on coming to power were designed inter alia to increase capacity utilization in the productive sectors. The aim was to dismantle controls over resource allocation and, by establishing realistic relative prices and strong producer incentives, ensure production increases over the medium term, in particular in the private sector (but also on the public estates). Such productive growth would provide directly for rising incomes and help generate the resources required for the Government's ambitious investment program. Investment would in its turn ensure continued growth into the future. 1.02 For the agricultural sector, this strategy was a response to the disappointing growth in output during the early and mid-1970s, and the belief that capacity utilization in the sector had been well below its potential. Annual value-added growth during the 1960s was 3.4% per year, whereas between 1970-77 this had declined to 2.0%--about the rate of growth of the popula- tion. Coconuts had fared particularly poorly, during both the 1960s and 1970s, but tea production had also declined since the mid-1960s and rubber production had still to exceed its 1970 peak. Even paddy output, which had grown at more than 6% per annum during the 1960s (particularly during the second half cf the decide) rose at only 0.6% annually during the first seven years of the 1970s. (nly for subsidiary food crops was 1970-77 a relatively successful period, and this could be attributed to the virtual cessation of imports due to foreign exchange constraints and the resultant high domestic prices. 1.03 The initial response to the new policy initiatives was encouraging. While the recovery in the paddy crop in 1977 was largely due to weather factors (and the first results of the Mahaweli Program), the 10% increase in agricultural value added was followed by a further 5% increase in 1978--the first sustained increase since the late 1960s. Paddy accounted for most of this increase, and was undoubtedly helped by the Guaranteed Price Scheme (GPS) price increase in November 1977, but production of rubber and coconuts also recovered and there was major growth in minor export crops. Although growth was still up to the average of the early 1970s, the agricultural sector received a setback in 1979. Again, adverse weather conditions largely explained the lack of growth in paddy, while tree-crop production continued to suffer from past neglect. 1.04 The restoration of producer returns played an important role in the policy reforms initiated in 1977, and it will be clearly important to maintain or enhance these in the face of continued inflation if the promising recovery in the agricultural sector during the last three years is to be sustained. This volume, therefore, reviews trends in producer returns in order to throw light on the measures that might be necessary to maintain incentives. It summarizes the conclusions reached in Annexes I and II with respect to paddy and coconuts, and draws on Bank staff reviews of the tea and rubber master plans (Annexes D and E in Volume I). In particular, it discusses:  (i) Possible adjustments to the GPS price, and its role in maintaining paddy incentives (Chapter II). (ii) Minor field crops and their response to trade and pricing policies, including the recently established floor price scheme (Chapter III). (iii) The adverse effects of coconut taxation and pricing policies not only directly on coconut output, but also on the promotion of substitute crops (Chapter IV). (iv) The erosion of tea margins in comparison with those of rubber which have benefitted from high world prices (Chapter VT) (v) Possible modifications to the exceptionally high fertilizer subsidies, given price prospects for the major crops (Chapter VI). 1.05 Particular emphasis has been given to paddy, which has been treated at greater length than the other crops. This reflects not only its great importance to the domestic economy, but also the considerable changes that are currently taking place in the structure of rice marketing. An attempt has been made in Chapter II to review producer returns in the context of these changes while a detailed discussion of returns to the farmer per se is given in Annex I. 1.06 This volume concentrates on producer incentives. These are impor- tant, and a necessary condition for medium- (and longer-) term growth in production. They are not, however, necessarily a sufficient condition. Investments in expanding the asweddumized area will continue to contribute importantly to growth in paddy production, in particular once the Accelerated Mahaweli Program takes effect. However, yield improvements due to increased fertilizer use (especially in the early years), water management, and varietal improvements could also be significant provided the necessary incentives are ensured. 1/ A fair appreciation suggests that growth rates in production of about 4-5% per year are possible, with yield and area effects contributing about equally--yield effects being more important in the early years (so long as incentives are provided) and area effects more important once the Accelerated 1/ The problems being encountered in the supply of agricultural credit will continue to affect the success of these programs, in particular the increased use of fertilizer. These problems date from the unfortunate decision taken in 1977 to greatly expand the credit available, with the consequent breakdown in recoveries. While the strict enforcement of credit restrictions on 1977 defaulters was undoubtedly necessary to reintroduce a sense of credit discipline, it appears now that these restrictions should be partially eased in order to support increased production. It is difficult to over-emphasize the need to re-establish the role of a creative agricultural credit sector, and in the meantime it will be all the more important to ensure adequate producer incentives to compensate for the lack of institutional credit.  Mahaweli Program achieves results. Adequate producer incentives and supporting services could also lead to productivity improvements in minor field crops (possibly at about 1-2% per year). More important, however, are potential area effects; acreage could double provided the necessary incentives and security of land tenure are assured. 1.07 For tree crops, short-term increases in production are likely to be limited (and may in fact be adversely affected by necessary replanting programs, especially in rubber). However, increased fertilizer application (especially in the smallholder coconut and tea sectors) represents a promising strategy, while management improvements are clearly of vital importance in the public estate sector. For the longer term, production increases will depend crucially on replanting, infilling, underplanting and other appropriate investments. Given their great potential and economic profitability, high priority must be given to providing the necessary encouragement to such investments. On the one hand this requires supporting them with appropriate producer incentives (in particular by ensuring that heavy export taxes do not discourage interest in these crops), and on the other it requires direct action to encourage such investments and to improve the management and effic- iency of appropriate schemes. 1.08 For the smallholder sector this may well need primarily to take the form of direct replanting and similar grants, given the long immature periods and the improbability of smallholders being able to generate their own resources or being able to obtain credit (the returns to smallholder rubber replanting are particularly high, although the same is true to a lesser extent for tea and coconuts). In the corporate sector (in particular, the tea industry which is 70% owned by the public sector), the strategy needs to concentrate on ensuring that the industry can generate its own resources for investment without excessive direction and intervention from outside. As in the case of shorter-term production increases (notably from increased ferti- lizer use), this depends crucially on maintaining producer margins and improv- ing management practices. Given the unpromising outlook for world tea prices, this will involve changes in the rates of taxation on tea exports. Similarly, despite substantial price increases, producer margins for coconuts are still depressed by export taxes which insulate the domestic market from higher world prices. In contrast, rubber margins have been buoyed by high world prices while minor export crops have been greatly helped by the abolition of export taxes. Nevertheless for both rubber and minor export crops also, it will be important to keep producer incentives under review. 1.09 As stated above, this volume concentrates on producer incentives, which are one aspect--though a very important aspect--to maintaining growth in production. Where relevant, interactions between the prices of different crops are discussed (in relation both to specific crops as well as to their substitutes). No attempt is, however, made to estimate the physical supply response to alternative pricing policies in any other than qualitative terms. Quantitative analysis should, of course, be given high priority and would undoubtedly strengthen and modify the recommendations made below; the data for such analyses, however, do not appear at present to be available.  -4- II. PADDY 2.01 This chapter reviews the returns to the paddy farmer in the context of the major changes currently taking place in the structure of rice marketing in Sri Lanka. It begins with a summary of recent trends in production and prices. These trends are then related to the public sector procurement and distribution system; in particular, its evolution from being primarily a system of distribution to meet ration requirements to being one of market regulation through the operation of a buffer stock. This is followed by a discussion of the three main factors that will need to be taken into account in setting the floor and ceiling prices required to operate such a buffer stock: (i) the returns to the farmer and incentives for production; (ii) marketing costs and margins (that is, the real costs incurred between the farmer and the consumer); and (iii) the cost of imports to Sri Lanka (that is, the economic value of additional domestic production). The chapter ends with a review of the present level of prices, and makes recommendations for the near future taking into account likely trends in world prices and domestic inflation. Production and Price Trends 2.02 Paddy production during the last three years has reached record levels, and prospects for the current year also appear to be very good. A breakthrough came in 1977 when output is estimated to have risen by more than 30% to 80.4 million bushels. Comparisons with 1975 and 1976 are a little misleading given the very adverse conditions prevailing in those years. Nevertheless, production in 1977 was still 24% above the average of the previous ten years (a period during which there were sharp variations about a fairly stagnant trend). More importantly, there was a further increase in 1978 (to 90.6 million bushels) and this was broadly maintained in 1979, 1/ despite a drought-affected Yala crop. With 90% of the 1980 Maha crop harves- ted, unofficial estimates suggest a total of 70 million bushels or more: Yala plantings appear also to be good and, although the official target of 105 million bushels for the two crops together may be optimistic, a good outturn appears very probable. 1/ The official estimate shows a further increase to 91.6 million bushels. However, this was affected by a number of improvements in the statistical procedures followed, the most significant of which related to the esti- mation of 'net area harvested.' In the past, this was derived by applying a standard 15% 'correction factor' to the estimates of gross area. As from the 1978 Yala crop, however, individual correction factors based on survey results have been used for 18 districts (15% is still used for the remainder). The weighted average on an asweddumized area basis has come down to about 12%, with the result that production (the yield multiplied by the net area) appears to be higher (90.6 and 91.6 million bushels in 1978 and 1979, compared to 89.7 and 88.6 million bushels on the old basis). In other words, and taking no account of other changes (e.g., improved field supervision of crop cutting surveys, the change from cultivation committees to cultivation officers as the source of area estimates, etc.), past production was probably understated, and a slight decline (from a higher true level) probably occurred in 1979.  - 5 - 2.03 After a period of adverse conditions, therefore, there appears to have been a marked improvement in the paddy sector. Even so, this needs to be put in perspective and does not necessarily imply that these rates of increase can be maintained indefinitely. The average production during 1976/77-1978/79 was about 25% higher than in 1968/69-1971/72, but in terms of annual increase, this was only 2.4% per annum. Although a more rapid increase can be expected in the future (reflecting the effects of the Accelerated Mahaweli and other programs), 1/ this will almost certainly in the long term be significantly lower than the average achieved since 1976. Table 1: PADDY PRODUCTION: 1972/73-1978/79 AND 1979/80 TARGET (million bushels) % change in three Cultivation Year Maha Yala Total year moving average 1972/73 42.0 20.9 62.9 -7.1 1973/74 52.6 24.2 76.8 +5.1 1974/75 34.5 20.9 55.3 -3.7 1975/76 42.3 17.8 60.0 -1.5 1976/77 54.8 25.6 80.4 +1.9 1977/78 /a 61.6 29.0 90.6 +18.1 1978/79 /a 66.6 25.0 91.6 +13.6 1979/80 Tfarget) 75.0 30.0 105.0 + 9.4 /a See footnote to para 2.02. Source: Dfpartment of Census and Statistics 2.04 The improzement in the paddy sector has been assisted by increased fertilizer use, an expansion in the irrigated area (including the impact of Mahaweli developments), and generally more favorable climatic conditions. Trade liberalization and the expansion of private trade have also undoubtedly played a major part: (i) by improving the supply and timeliness of farm inputs, in particular fertilizer, (ii) by providing the farmer with greater choice of when and to whom he sells, this being reinforced by transport, milling, and related improvements, and (iii) indirectly, by increasing the availability of consumption goods and thus encouraging the commercialization of paddy farming. These factors so far seem to have outweighed the erosion in real net return since 1977 (see below) and may help explain the continued increase in production expected in the current year. 2.05 Prices have also risen since 1977 although, as shown below, the upward drift in farmgate prices has in recent years been considerably more than offset by rising farm costs. The major influence on the level of farm- gate prices was the sharp increase in the GPS price (from Rs 33 to Rs 40 per bushel) in November 1977. Prices have also, however, been influenced by seasonal supply conditions, import policies and trends in retail prices: (a) Between 1971-76, free market prices for paddy remained well above the GPS price, reflecting severe droughts in 1971-73 and 1975, low per capita availability of foodgrains (Table 2), and severe restrictions on private trade. The free market was 1/ See para 2.11 in Volume I.  - 6 - as a result of these restrictions a very narrow one (effectively a black market, given the regulations forbidding movement and trade in rice). They were designed to maintain high procurement by the Paddy Marketing Board (PMB)--an objective that was on the whole achieved up until 1975 when the poor harvest sharply curtailed the marketable surplus. (b) Increased availability of foodgrains in 1976 and 1977 (initially due to higher imports, especially of wheat flour, but subsequently due to the record 1977 rice harvest) led to declines in the free market price which fell significantly below the GPS price during the 1977 Maha season. Prices rose during 1978, following the increase in the GPS price, but still lagged behind the latter at the harvest period. PMB purchases, therefore, recovered dramatically, causing considerable storage and related problems, these being further aggravated by the demand shift to the free market following major reduction in early 1978 in the numbers eligible for the ration. (c) The levelling off in production during 1979, and in particular the setback to the Yala crop, together with the continued demand shift to the open market, led to further increases in free market prices and ultimately to reduced PMB procurement. Adjustments to official retail prices in early 1980 helped maintain prices above the GPS price despite the expectation of a bumper Maha crop, and, in consequence, PMB purchases in the current year appear to be falling off even more sharply than in 1979. Table 2: PER CAPITA SUPPLIES OF FOODGRAINS /a: 1970-1978 (kilograms per annum) Rice Domestic Imports Total Wheat Flour /b Others Total 1970 66.6 42.5 109.1 29.5 2.9 141.5 1971 75.1 28.1 103.2 23.4 1.9 128.5 1972 70.6 21.3 91.9 33.2 1.7 126.8 1973 62.1 27.4 89.5 34.3 2.7 126.5 1974 74.8 24.2 99.0 32.6 3.1 134.7 1975 49.0 33.4 82.4 38.6 3.6 124.6 1976 60.7 33.3 94.0 40.6 3.4 138.0 1977 65.6 43.4 109.0 43.0 4.0 156.0 1978 78.4 18.8 97.2 45.0 2.8 145.0 /a After allowing for changes in stocks of rice and wheat flour, and uses other than food (animal feed, seed, waste, etc.). /b Including flour equivalent of wheat grain imports. Source: Department of Census and Statistics: Food Balance Sheets.  2.06 In sum, farmgate prices for paddy have risen significantly since the low point reached during the 1977 Maha, when prices fell well below the average for that year (Table 3). The increase in free market prices was pronounced in 1978, although still lagging behind the sharply increased GPS price. Since then, they have continued to drift upwards and, despite the bumper Maha crop, appear now to be above the GPS level. Whi'- they have weakened recently in response to the new crop, they have been supported by upward adjustments to official retail prices (from Rs 1.60/lb to Rs 1.78/lb for locally procured rice, and from Rs 1.80/lb to Rs 2.17/lb for imported rice) and are significantly higher than a year earlier. These price developments are summarized in Table 3, while seasonal variations in retail prices and (where available) producer prices are given in Table 4. Table 3: ANNUAL AVERAGES: RETAIL AND PRODUCER PRICES Retail Prices: Rs/lb Producer Prices: Rs/bushel Raw Rice Parboiled Rice Free Market lb GPS (Maha) 1976 1.50 1.54 37.4 33.0 1977 1.43 1.44 35.2 33.0 1978 1.60 1.58 40.7 40.0 1979 /a 1.73 1.71 41.8 /c 40.0 /a Provisional 7b Annual average - price at the peak Maha season tends to be signi- ficantly lower. Farmgate prices in 1977 were particularly low relative to the GPS price. /c Central Bank of Ceylon estimate. Source: Department of Census and Statistics. Table 4: SEASONAL PRICE VARIATIONS FOR RAW RICE AND PADDY Jan-Mar. Apr-Jun. Jul-Sep. Oct-Dec. Average /b Retail Prices: -Rs/lb 1976 1.57 1.41 1.51 1.52 1.50 1977 1.61 1.42 1.37 1.38 1.43 1978 1.52 1.58 1.65 1.65 1.60 1979 1.72 1.62 1.72 1.88 /a 1.73 /a Producer Prices:- Rs/bushel 1979 43.3 39.5 41.9 42.5 41.8 /a Provisional. 7W Provisional estimate for January-March 1980: Rs 1.91/lb. /c Provisional estimate for January-March 1980, based on average for three surplus districts (Amparai, Polonnaruwa and Anuradhapura): Rs 43.3 per bushel. The national average will tend to be higher (it was 3% higher than in these three districts between September 1978-March 1979). Source: Department of Census and Statistics (Retail Prices); Central Bank of Ceylon (Producer Prices).  - 8 - Official Procurement and the Role of the Public Agencies 2.07 Table 5 summarizes trends in official procurement, imports and distribution which broadly reflect the production and price trends discussed above. Up till 1979, the principal objective of Government procurement was to supply the official rationing system, under which eligible households (until early 1978, all households) were entitled to a pre-determined weekly supply of rice (free or at subsidized prices). 1/ To ensure supplies to the PMB, the private sector's role was restricted (both directly and indirectly), and this also reflected a distrust of the role of the private trader as a useful economic agent. To offset poor harvests, additional imports were arranged (both of wheat flour and paddy) and these again were distributed through the public distribution system. 2.08 On September 1, 1979, however, the Government introduced the Food Stamps Scheme 2/ under which eligible households receive "food stamps" which can be used to purchase rice, paddy, flour, bread, sugar, selected milk foods and dried fish: "The administered prices of these goods, which were hitherto influ- enced by government policy, were thereafter expected to reflect true market conditions and the object of the food stamps was to initially compensate the truly indigent families for the higher cost of basic food items.... Thus, the Government was able to extricate itself from the dual stranglehold of guaranteed supplies of food and of price subsidization, irrespective of the income or wealth of beneficiaries." 3/ 2.09 As a result of the introduction of the Food Stamps Scheme, there was a further significant shift in demand to the open market and away from public supply points, reinforcing the trend initiated by the restrictions on ration eligibility in early 1978. This shift to the private sector (brought on not only by the Food Stamps Scheme per se but also by associated price developments favorable to the private traders and by quality improvements in private milling) has major implications not only for the share of the harvest passing through the public sector agencies, but also for the roles that they should play. This is well analysed in the 1979 Annual Report of the Central Bank (page 30): "In this new situation, the role of the PMB (Paddy Marketing Board) and the FC (Food Commissioner) has changed dramatically from mere purchasing-cum-distributing agencies to that of market regulation, the PMB holding the market 'floor' for farmers' paddy and the FC holding the 'ceiling' for consumers' rice (and substitute wheat flour) by importing the shortfall in supplies. It appears that these two functions, in the new context, are best performed by one organization. As much as the PMB should not measure its achievements by the pro- portion of the annual harvest it purchases from the farmers, but by its ability to stabilize the paddy rice market to the farmers, the FC should not feel obliged to stand by to exchange food stamps for food items at pre-determined prices, but to stabilize the consumer market by efficient supply management at the wholesale level." 1/ Table 10.3 of the Statistical Appendix, Volume I). 2/ See Annex A in Volume I. 3/ Central Bank of Ceylon, 1979 Annual Report, page 30.  Table 5. TRENDS IN PROCUREMENT, IMPORTS AND ISSUES BY FOOD) COMMISSIONER Procurement Imports Issues Procurement Imports Lssues as % as % of s % of Million bushels '000 tons '000 tons of Production Consumption Consumption 1970 26.2 534 640 33.9 39.0 46.7 1971 32.4 334 879 48.4 27.2 71.7 1972 26.4 262 792 42.0 23.2 70.1 1973 22.9 338 685 36.4 30.6 62.1 1974 20.9 297 558 27.3 24.4 45.9 1975 11.6 450 617 21.0 40.5 55.5 1976 12.9 419 624 21.9 35.4 52.8 1977 24.5 534 711 30.5 39.8 52.9 1978 32.3 167 660 35.7 19.3 46.8 1-9 79-/1 25.8 208 520 28.2 14.5 36.3 ai Procurement in January - April 1980 amounted to 8.3 million bushels compared to 13.5 million bushels in the same period of 1979. >.urce: Food Commissioner and Ministry of Finance and Planning. Further details given in Table 7.2, Statistical Appendix, Volume I.  - 10 - 2.10 This analysis points the way to major reform of the public sector agencies to establish a single effective institution to stabilize the market and operate a buffer stock. In general, the policy objective should be to expand the role of the private sector in the rice market while concentrating public sector activities on stabilizing the market within acceptable limits of seasonal variation in price. Critical to the success of such policies is the need to set the range between the floor and the ceiling prices in such a way that it provides adequate scope to the private sector without adversely affect- ing producer and consumer interests. For this it is clearly necessary to establish floor and ceiling prices in relation to each other as well as in relation to (a) desirable levels of net returns to ensure adequate incentives to the farmer, and (b) factors affecting the retail price, notably the pre- vailing cost of imports. 1/ The following sections discuss, therefore, the three main considerations involved in setting the floor and ceiling prices: (i) the returns to the farmer, (ii) marketing costs and margins which set a minimum range between the two prices, and (iii) expected border price equiv- .cIlttb Lor local rice. Returns to the Farmer 2.11 The GPS price was last increased (from Rs 33 to Rs 40 per bushel) in November 1977, and this was followed by the marked upswing in the free market price of paddy described above. Since then, and despite the continued upward trend in free market prices, returns to the farmer have been eroded by general inflation, in particular by the rapid increase in the costs of farm power and rural labor. This is shown in Table 6 which summarizes Bank staff estimates of farmer returns (based on fixed assumptions concerning technological rela- tionships) over the period Maha 1972/73 to 1979/80 in four districts selected to represent the range of technologies applied in Sri Lanka (see Annex I). The assumption of fixed technical relationships is, of course, an over- simplification designed to provide evidence of pure price effects on net returns. In practice, these relationships will be affected by such factors as lower yields in drought years, changes in fertilizer use in response to rela- tive prices, etc. Overall, the estimates probably overstate the deterioration in actual incomes after 1977 since these other factors have generally improved. 2.12 These estimates also assume that the farmer receives the GPS price. In many cases this is effectively true, in particular when free market prices are relatively low in relation to the GPS price as they were in Maha 1977 and 1978. 2/ With the rise in free market prices since then, however, sales to the PMB have declined markedly, and, therefore, for this reason also Table 6 overstates the actual decline in a weighted average of farm incomes. However, 1/ As argued below, the present range between the floor (the GPS price) and the effective ceiling (the price of imported rice) appears to be too wide. In effect, the decision to sell imports on a cost plus basis would allow a substantial increase in farmgate prices while still providing room to the private sector and without threatening the likely (seasonal high) retail price (see paras 2.22 to 2.27). 2/ Although actual prices received by the farmer may be lower by the costs of transport to the collection center.  - 11 - even at the free market price prevailing during the first quarter of 1980 (Rs 43/bushel--see footnote to Table 4), net returns would still be lower than the comparable estimate (assuming fixed technical relationships) at the GPS price in 1977. 2.13 Current rates of inflation are more than usually hi-h. To take this into account, Annex I concludes that farmgate prices would need to rise to Rs 50 to Rs 52/bushel by mid-1980, and Rs 58 to Rs 60/bushel by mid-1981, if net farm incomes (discounted at the Colombo cost-of-living index) are to equal in real terms the average achieved between 1973-79. 1/ If the fertilizer prices were also to be increased to their full border price equivalent (see Annex I), prices would need only to rise by an additional Rs 4/bushel by mid-1981. The relatively minor impact of much higher fertilizer prices on net income is an important reason for suggesting reductions in the fertilizer subsidy (although attention still needs to be given to ensuring incentives for fertilizer use and to the effect on other crops). 2.14 Even with such an increase in the farmgate price, it is still un- certain whether producer incentives would be fully restored. The Colombo cost-of-living index may understate inflation; farm costs are increasing as a proportion of gross return which will add to the variability--and hence risk of paddy cultivation; returns to family labor have narrowed relative to prevailing wage rates (see Table 6), increasing the attractiveness of alter- native occupations; and finally, major changes in relative costs may also influence productivity. Returns to family labor and management remain, however, substantially higher than the average wage rate. 2/ There is, therefore, no real danger of paddy land being unnecessarily left fallow. However, farmers will tend a priori to economize on land preparation, reduce labor intensive activities such as transplanting, and substitute water--which remains essentially free to those who can get it--for both farm power (lead- ing to delays in Maha sowing) and hand weeding. The returns from additional 1/ This index almost certainly understates inflation rates in urban areas. The position in rural areas is more difficult to assess since this period coincided with a possible shift in the terms of trade in favor of the agricultural sector as a whole and rural areas were also less affected by increased costs of housing and similar items. The impact on surplus- producing farmers of increases in rural wages and farm power costs (in part themselves a reflection of the shift in the terms of trade) has already been taken into account in the estimates of net return. Never- theless, the real value of the latter has also been affected by inflation. On balance, and for want of a better alternative, it has been assumed that the Colombo cost-of-living index gives a reasonable picture of the rise in prices for consumer goods purchased in rural areas--and may be closer to the actual position than in the case of urban areas. 2/ Which may help explain the continued growth in production despite the erosion in net returns, and suggests that other factors may have been a constraint on growth in the past, e.g., availability of inputs and marketing facilities, and the weather.  - 12 - Table 6: NET RETURNS TO THE PADDY FARMER: MAHA 1972/73 - MARA 1979/80 a/ 1972/73 1973/74 a/ 1974/75 1975/76 197t/77 1977/78 b/ 1978/79 1979/80 Net Return c/: Current Prices: Rs/acre Polonnaruwa 824 1,689 1,655 1,578 1,536 1,949 1,631 1,423 Hambantota 594 1,231 1,180 1,117 1,081 1,389 1,137 969 Kandy 647 1,292 1,266 1,217 1,215 1,572 1,369 1,261 Colombo 417 834 784 746 731 924 734 634 Net Return c/: 1972/73 Prices: Rs/acre d/ Polonnaruwa 824 1,504 1,380 1,301 1,229 1,415 1,105 796 Hambantota 594 1,096 984 921 880 1,009 770 542 Kandy 647 1,150 1,056 1,003 989 1,142 927 706 Colombo 417 743 654 615 595 671 497 360 Net Return: Rs/manday of Family Labor e/ Polonnaruwa 41 84 83 79 75 97 82 71 Hambantota 40 82 79 74 72 93 76 65 Kandy 15 30 30 29 29 37 32 30 Colombo 14 28 26 25 24 31 24 21 Average Wage Rate: Rs/manday f/ Polonnaruwa 6.50 7.00 7.50 8.25 9.50 11.25 13.50 16.00 Hambantota 6.50 7.00 7.50 8.25 9.50 11.00 13.00 15.50 Kandy 5.50 6.00 6.50 7.25 8.00 9.00 10.50 12.00 Colombo 6.00 6.50 7.00 7.75 9.25 12.00 15.00 17.50 a/ Assuming fixed technical relationships and that the farmer gets the GPS price. b/ Jump in net return due to adjustments in GPS price. In real terms, the increase in the GPS price in 1977 failed to reestablish the real returns achieved in 1973/74 valued at the GPS price. To the extent farmers obtain the free market price, the decline in net return between 1976/77 and 1974/80 will be significantly overstated (see text). c/ Assuming no cost for family labor. d/ Deflated at the Colombo consumer cost of living index. This may understate true rate of inflation. e/ Return per manday of family labor after deducting hired labor and other costs from gross return. (See Annex I, Table C for assumptions relating to family labor inputs.) f/ May understate average real wages since it excludes payment in kind and fails fully to take account of sharp seasonal differences. Source: Bank staff estimates--See Annex 1.  - 13 - (cheap) fertilizer use may, therefore, be limited by the lack of complementary farm inputs and adverse effects of relative prices on water discipline. These considerations suggest not only that farmgate prices for paddy should be allowed to rise but also that adjustments to the fertilizer price would encour- age a more balanced use of farm inputs. Marketing Costs and Margins 2.15 Under the newly evolving situation, the GPS price will effectively function as the floor. The retail ceiling price will clearly have to exceed this floor at least by the costs (including credit charges) and margins involved in paddy and rice marketing if the private sector is to expand its operations and the public sector is to cover its costs. 2.16 In the public sector, the PMB normally purchases paddy through an agent, usually a cooperative. The paddy is stored in PMB warehouses and milled (mainly by private millers on behalf of the PMB) to be supplied as rice to the Food Commissioner (FC) at a fixed transfer price as and when required. 1/ The FC in his turn retails the rice through the cooperative system at another fixed price (previously at the ration price, but now at a price that more than covers his costs--see below). Imports are also scheduled and purchased by the FC, who negotiates with foreign suppliers, stores imported rice as appro- priate, and supplies the local market largely through the cooperative system (in the past at the ration price, but now at a separate price which since February 1980 has been designed to cover import costs). 2.17 Tha various costs and margins allowed to the PMB, FC and their agents are periodicall.y reviewed. Tables 7 and 8 summarize the price struc- ture for locally procured rice that has been effective since February 1, 1980. Without comparable estimates for the private sector, a comparison between the public and private sectors is difficult. Nevertheless, the large expansion in the private trade now taking place suggests that the margins indicated in Tables 7 and 8 are sufficient to encourage private participation: 1/ The PMB also has some direct outlets at which rice is sold at a discount, and is increasingly pressing to be allowed to retail directly through cooperatives, especially in surplus growing areas, thus bypassing the additional stage of the FC. This appears to be a desirable trend, and could be facilitated by the reforms recommended by the 1979 Central Bank report (para 2.09 above).  - 14 - Table 7: STRUCTURE OF PUBLIC SECTOR PADDY/RICE PRICES AS OF FEBRUARY 1, 1980 (Rs/100 lbs of paddy or paddy equivalent) Raw Rice Parboiled Rice (66% Extraction) (68% Extraction) GPS Price (for 2.17 bushels equivalent) 87.00 87.00 Variable Costs Handling and Transport 1.07 1.07 Agent's Commission 1.60 1.60 Interest (3% for 4 months) 1.00 1.00 Storage Losses (1%) 0.90 0.90 Total 4.57 4.57 Fixed Costs Storage Overheads 0.93 0.93 Depreciation /a 1.38 1.38 Head Office Overheads lb 1.28 1.28 Inter-regional Transport 1.00 1.00 Total 4.59 4.59 Total price: ex-store 96.17 96.17 Milling Charges 4.50 6.00 Transport to Mill: Paddy 0.89 0.89 Transport to FC: Rice 0.49 0.55 Profit to PMB 1.03 1.05 Transfer Price to FC /c 103.08 104.66 /a Gunny bags, equipment, etc. /b Including regional stores and offices. /c Equivalent to Rs 1.562/lb for raw rice at 66% extraction rate and Rs 1.539/lb for parboiled rice at 68% extraction - see Table 8. Source: Paddy Marketing Board.  - 15 - Table 8: STR'U- :s.-E OF PUBLIC SECTOR RICE PRICES AS OF FEBRUARY 1, 1980 (Rs/lb of rice or rice equivalent) Raw Rice Parboiled Rice (66% Extraction) (68% .xtraction) GPS Price 1.318 1.279 PMB Costs 0.228 0.244 PMB Profit 0.016 0.016 Transfer Price to FC 1.562 1.539 FC Costs 0.095 0.095 FC Profit 0.023 0.046 Transfer Price to Coops. 1.680 1.680 Coop Margin 0.100 0.100 Retail Price 1.780 /a 1.780 /a /a This compares with the current retail price for imports of Rs 2.17/lb which is some 22% higher. Source: Paddy Marketing Board and Food Commissioner. (a) Costs. The involvement of two major public entities (the PMB and FC) as well as their agents (for purchasing, milling, transport, and retailing) inevitably creates heavy overhead costs, which would not necessarily be incurred by the more efficient private sector. In relative terms, these costs will rise even further during a period of contraction (as at present) since staff and facilities are likely to be maintained despite the decline in procurement. However, in two respects the tables appear to understate the costs which the private sector would have to cover: (i) financial charges, and (ii) investment costs. (b) Financial Charges. The PMB obtains concessional finance from the banking system (3% per annum up to 6 months, fully refinanced at this concessional rate by the Central Bank) to cover its paddy stocks. In contrast, the banks are reluctant to lend to the private sector on the security of paddy stocks, charge relatively high interest rates (up to 20% or more) and provide credit over a limited period. (c) Investment Costs. Investment in storage and processing facili- ties for the PMB and FC are largely financed under the Govern- ment's capital budget, whereas private sector interests would need to finance these out of their profits.  - 16 - (d) Profits. Since February, both the PMB and the FC have been allowed a small margin of profit, and profits are also included in the margins allowed to their agents. A somewhat higher profit margin would be required for a healthy private sector, although this might decline with time and as greater competition improved efficiency. Without more detailed information, however, it is difficult to provide a satis- factory estimate of what would be needed. (e) Quality Differences. On balance, the private sector supplies higher quality rice than the public sector, and quality differ- ences are reflected in a substantial price range in the market. Quality differences make it difficult to make satisfactory comparisons. In general, the change to the Food Stamps Scheme has shifted demand towards higher quality rice, a trend initi- ated in early 1978 when the ration was withdrawn from upper income groups: previously consumers put up with lower quality in order to obtain their (free or subsidized) ration. (f) Extraction Rates. A reduction in the extraction rate for PMB supplies (from 68% to 66%) was agreed early in 1980. Although in theory this should encourage quality improvements (and was associated with an increase in the specified degree of polish), in practice it may partly represent a further hidden cost (if in fact the extraction rate was to be maintained at 68% without any quality improvement, the GPS price equivalent for raw rice would be Rs 1.272/lb of rice, giving an additional margin of Rs 0.046/lb of rice to the PMB--see Table 8). A higher extraction rate in the private sector (quality being equal) would be a factor improving its ability to compete. 2.18 The balance of these various factors is difficult to determine, but clearly at present prices the private sector can compete even though it has paid prices somewhat above the GPS level and received a retail price which appears comparable to (and, allowing for quality differences, perhaps lower than) the official price for local rice (Table 4). This is despite its lack of access to finance and despite its generally weak position following a period when the public sector has dominated the market. This implies not only that there are considerable inefficiencies in the public sector, 1/ but also that the efficiency benefits for consumers from the shift to the private sector could be further increased by providing a stable environment and adequate support, e.g., through the banking system. One possibility might be for the banks to divert credit that might otherwise have been directed to the PMB (but which will not be required due to reduced PMB purchases) to the private sector on the security of paddy stocks at appropriate rates of inter- est. Another possibility would be for the PMB and other public sector agencies to hire out surplus storage and other facilities to the private sector. 1/ These inefficiencies have undoubtedly increased since, despite the reduced role of the public sector, there have yet to be any significant reductions in PMB and FC staff or facilities.  - 17 - Border Price Equivalents 2.19 The previous section showed that the official price for domestically procured rice is currently being set to cover public sector costs and ensure a small profit. In other words it is being set in relation to the GPS price establishe as long ago as November 1977, and bears no direct connection to the current level of production costs and needed incentives nor to the (fluctu- ating) level of world market prices. It thus differs significantly from the retail price for imported rice which was raised to Rs 2.17/lb in early 1980, the price required to avoid subsidies on imports ordered towards the end of 1979 for delivery during 1980. In other words, the Government has raised the retail price for imported rice to its border price equivalent on the local market while keeping public supplies of domestic rice at a significantly lower price. 2.20 This is shown in Table 9 which summarizes estimates of border price equivalents (both retail and farmgate) for 1979/80 as well as giving projec- tions for 1980/81 to 1982/83. The basis for these estimates is explained in the footnotes to the table. The cost structure assumed is that for the public sector institutions (Tables 7 and 8) which may overstate costs for the (more efficient) private sector (but this may be offset by the other factors dis- cussed in para 2.17). A number of conclusions can be drawn from Table 10: (a) The current farmgate border price equivalent (Rs 51.9/bushel) is substantially higher than both the GPS (Rs 40/bushel) and the prevailing free market price (Table 4). If obtained by the farmer, however, it would provide a net return approximately equal to the average achieved between 1973-79 in real terms (para 2.13). (b) On the basis of World Bank projections, a substantial increase in world market prices is expected over the next few years. Even if farmgate prices rose to Rs 58-60/bushel by mid-1981 (the price needed to maintain real net return--see para 2.13), they would still lag behind the expected border price equivalent. (c) The expected increase in world prices would also require sub- stantial increases in the retail price of imports if the Government's policy remains one of avoiding budgetary subsidies.  - 18 - Table 9: THE STRUCTURE OF RICE PRICES: 1979/80 CROP YEAR AND PROJECTIONS FOR 1980/81-1982/83 Actual Projections 1979/80 1980/81 1981/82 1982/83 $ per metric ton: Rice FOB Bangkok /a n.a. 325 358 412 Freight, etc. /b n.a. 27 30 32 CIF Colombo /c 281.5 352 388 444 Rs per lb: Rice CIF Colombo /d 1.99 2.49 2.74 3.14 Add: Harbor Dues, etc. /e 0.03 0.04 0.05 0.05 FC Costs /e 0.05 0.06 0.07 0.08 Retailing Costs /e 0.10 0.12 0.14 0.16 Retail Price 2.17 2.71 3.00 3.43 Rs per bushel: Paddy Retail Price /f 65.9 82.3 91.1 104.1 Less: Retailing Costs /e -3.0 -3.6 -4.2 -4.7 FC Costs /e -3.6 -4.4 -5.0 -5.6 PMB Costs7e -7.4 -8.9 -10.3 -11.5 Farmgate Equivalent 51.9 65.4 71.6 82.3 /a World Bank projections for milled 5% broken, adjusted by a factor of 0.7 to allow for quality differences. The World Bank calendar year figure is assumed to correspond to the delivered price in the following crop year. /b Inflated at World Bank projections of international prices, assuming a freight rate of $25 per metric ton in 1979/80. /c For 1979/80, actual delivered price on the basis of contracts signed in last quarter of 1979. For 1980/81-1982/83, as estimated under Line 1. /d Assuming an exchange rate of US$1 = Rs 15.6. /e Based on public sector costs (including profits) for early 1980, inflated at Bank staff estimates of domestic inflation. See Tables 7 and 8 for details of costs and margins. /f Assuming 46 lbs = 1 bushel, and an extraction rate of 66%. Source: Bank staff estimates.  - 19 - 2.21 The projections given in Table 9 are, of course, tentative. The Food Commissioner expects world prices (c.i.f. Colombo) to be lower than suggested in the table. Even so, some upward movement of prices appears inevitable and, for the longer term, World Bank projections suggest that the international rice prices will continue to rise in real terms throughout the 1980s. Given this outlook, it is all the more important zo ensure that farmers receive adequate price incentives, while there appears to be little risk that higher farmgate prices (e.g., in the range Rs 55-60/bushel by mid- 1981) will be out of line with subsequent world price movements (in particular given the prospect for continued world inflation). The Level of Prices and the Role of the GPS 2.22 It has been argued above that the range between the GPS price and the current retail price appears to have been sufficient to encourage major private sector participation in the rice market. However, the true ceiling is not the official price for local rice (which broadly corresponds to current retail prices) but the price for imports--that is the price at which the public sector will balance supply and demand on the local market. 1/ This price will become effective sometime during the lean season (say December- February) and, as discussed above, has been established at a level (Rs 2.17/lb) which will cover the public sector's costs for imports delivered in 1980. 2.23 Retail prices are currently significantly lower than this ceiling, due presumably to the abundant harvest and the relatively low GPS and official retail prices for domestic rice. Financial weaknesses in the private sector may also be a factor, given the costs and difficulties of financing rice stocks over long periods. Nevertheless, prices are bound to rise markedly during the second half of the year as the price of imports (which must set the ceiling price so long as domestic production fails to meet demand) becomes effective. 2/ Seasonal fluctuations are, of course, normal, and the prospect 1/ This assumes that the 1980 crop will fall short of domestic requirements-- even if the (optimistic) production target is achieved. Such a shortfall is likely for the foreseeable future--in particular since a shift away from wheat flour is to be expected as a result of the higher flour price. 2/ Although official prices influence the market, demand is currently being met largely by the private sector. The PMB expects to enter the market from about June to stabilize retail prices, but current estimates of procurement suggest that its supplies will be exhausted fairly quickly. Not surprisingly there is at present virtually no demand for FC imports--a fact which is causing storage problems--but demand will shift to imports when domestic prices rise. It may in fact be preferable to withhold PMB stocks and allow the price to rise from June onwards so as to offload FC imported stocks earlier. This would relieve the FC's storage problems which may become acute as further imports are delivered. Moreover, PMB stocks are usually held in the form of paddy which preserves its quality better than raw rice.  - 20 - of high prices will tend to raise the farmgate price, especially for the Yala crop. However, it seems likely that the price increase this year will be greater than can be attributed to normal seasonal factors, and there is a danger that the relatively low GPS price will continue to hold down farmgate prices, despite the prospect of a relatively high lean s!ason retail price. In other words, it appears that the range between the floor and the ceiling prices is currently too wide. 1/ 2.24 It is recommended, therefore, that a GPS price of at least Rs 50/ bushel be announced before the next Maha sowing season. Such a price, if received by the farmer, would still be insufficient to restore average net returns in real terms during 1981 to the average received in recent years (see para 2.13). However, a significantly higher floor price, without an adjustment to the ceiling price, might run the risk of adversely affecting the shift to private marketing (given the costs incurred between the farm and the retail outlet--see Tables 7 and 8). Provided this shift in the structure of rice marketing works as expected, it is to be hoped that actual free market farmgate prices next Maha will in fact be above the newly-established floor price and that, therefore, net farm incomes will come closer in real terms to past levels. To achieve this objective, sufficient financial and other support will need to be given to the private sector to promote efficient operations and to encourage increased competition. Although an increase in the GPS price would have only a minimal effect on lean season retail prices (given that these are already determined by the price at which imports will be sold), it would tend to reduce the fall in retail prices during the next Maha harvest. This, however, appears to be an acceptable outcome and would allow the Government to stabilize prices in a range determined by the retail price of imports. 2.25 The main objective of announcing an increase in the GPS price before the Maha sowing season would be to have a positive impact on producer incentives. For this, the new price would need to become effective only in February 1981 when the harvest begins. Given the peculiar conditions of this year, however, there is a reasonably strong argument for making the new price effective before the Yala crop comes in. It is true that the increase could not affect production (virtually all Yala sowing is already complete). However, it would ensure that the farmer gets the price implied by the (cer- tain) retail price expected when the FC enters the market with imported rice. As argued above, the farmgate price will in any case tend to rise and a formal increase in the GPS price should not in any way be seen as an attempt by the PMB to recapture supplies. However, besides its direct effect on farm incomes, a decision to make the increase in the GPS price effective immediately would provide further confidence to the farmer and might also put additional financial resources into his hands before the next Maha planting season. 1/ Since what is now the floor price was established as long ago as November 1977, while the ceiling price was established recently in the light of world price developments, this is perhaps not surprising. Certainly, the floor and the ceiling have not been set directly in relation to each other as would normally be desirable in the operation of a buffer stock system.  - 21 - 2.26 Further increases in the floor price will undoubtedly have to be envisaged for the longer term. Much will depend on how import prices behave and what policies are followed in setting the retail price for imports. If world prices rise as expected (Table 9), and the Government continues to sell imports on a cost-plus basis, 1/ then--by analogy with the arguments given above--further substantial increases in the floor price will become possible without adversely affecting the shift to private marketing. If world prices do not rise as expected, or the Government fails to adjust retail (ceiling) prices fully in line with rising world prices, it will still be essential to ensure adequate producer returns while providing continued scope to the private sector. Moreover, more detailed analyses (e.g., of producer returns and marketing costs) will be vital for establishing an optimum range between the floor and the ceiling in order to achieve these objectives, and this would also be facilitated by a reorganization of the public sector institutions along the lines suggested in the Central Bank's annual report. 2.27 Finally, there is the question of how far the Government should in fact follow world prices in setting the ceiling price. Clearly, for such a sensitive item as rice, no government would be willing to follow slavishly any and all world price changes - the international rice market is a narrow one relative to world production and this inevitably results in major short- term price swings. Nevertheless, there is obviously a case (both on economic and public finance grounds) for broadly adjusting retail prices in line with long-term trends in the world market. Whether the farmer should receive the full border price equivalent is perhaps debatable given: (i) the need to have a range between the floor and ceiling prices; (ii) the subsidies the farmer receives on inputs; aid (iii) the inadequacy of alternative taxes on agricul- tural incomes. Howevzr, the farmer also needs to be provided the correct price signals as an incentive to production. The more closely inputs are priced at their economic level, and the more progress is made in evolving appropriate forms of rural taxation, the stronger will be the argument for passing on the full border price equivalent to the farmer. For the foresee- able future, the appropriate border price equivalent will remain that for imports, but if Sri Lanka is able to achieve self-sufficiency, then the appropriate price would be the (relatively lower) long-term price for exports. 1/ Such a policy would also open up a role for the private sector in imports, thus further reducing the role of the public sector. In principle, pri- vate sector imports have been permitted since February 1980, but so far only small amounts of high quality rice have been privately purchased. However, this could change. Private import trade during the 1950s was both large and efficient.  - 22 - III. MINOR FIELD CROPS Output and Price Trends 3.01 These crops are taken to include minor cereals (maize, sorghum, millets); roots and tubers (manioc, sweet potatoes, potatoes); pulses (green gram, black gram, cowpea); oilseeds (soya, groundnuts, sesame); chillies, onions and sugarcane jaggery. With some exceptions, they are grown under rainfed conditions, in small patches around the house or under upland (often shifting or chena) cultivation. In contrast to paddy, it is planted area rather than yields that primarily responds to financial incentives since cultivation practices have changed little and yield variations largely reflect rainfall patterns. The exceptions are crops such as chillies and onions, which are grown under intensive irrigated conditions, especially in the north of the country. 3.02 Basic information on these crops is inadequate for a full review of farmer returns. Nevertheless, a general picture of trends emerges from a review of production, trade and price data. Production estimates (see Table 10) suggest that output of most of these crops rose markedly during the mid-1970s but that many received a setback in 1978. According to Ministry of Agriculture data the area under twelve of the most important crops declined by 15% in that year (to 475,000 acres), the lowest level since 1973. Data for 1979 have yet to be made available; national accounts estimates suggest value added rose by only 3%. 3.03 Much of the increase in production during the mid-1970s can be attributed to reduced per capita availability due primarily to curtailment of imports; the subsequent price increases which were in some cases dramatic (see Table 11); and the lack of alternative employment opportunities (reflected, for instance, in stagnant rural wage rates). In contrast, the trade liberalization initiated in 1977 largely reversed these developments. Supplies were expanded through imports; prices levelled off or even declined; general inflation further reduced returns in real terms; and greatly expanded job opportunities were associated with a sharp increase in rural wages. Field crop cultivation has, therefore, become increasingly unattractive relative to other opportunities open to family labor.  - 23 - Table 10: Pu iitCTION AND IMPORT DATA: FOOD CROPS ('000 Metric Tons) 1972 1973 1974 1975 1976 1977 1978 CEREALS Maize: Production 13.2 13.7 23.9 34.6 31.1 42.0 35.3 Sorghum: Production ... 1.1 3.1 6.4 1.7 2.0 0.5 Kurakkan: Production 4.6 19.5 22.2 24.5 23.5 21.6 21.1 Other grains: Imports ... 0.7 ... 0.1 2.4 23.4 3.2 Wheat flour: Imports a/ 402.0 436.9 495.2 528.2 479.5 605.0 693.6 Rice: Total availabillty a! 1,851.4 1,833.2 2,052.1 1,735.1 1,938.0 2,404.4 2,191.8 ROOTS AND TUBERS Manioc: Production 313.2 663.0 851.4 768.4 684.2 548.5 497.8 Other: Production 87.5 118.0 184.0 248.0 214.3 156.8 162.2 PLULSES Green gram: Production 1.3 3.0 5.9 5.9 4.6 7.8 8.4 Cowpea: Production 1.2 0.6 2.0 7.6 11.9 21.2 22.6 Black gram: Production ... 0.5 0.7 1.0 2.4 11.7 8.7 Pulses: Imports 30.6 10.4 ... ... ... ... 17.1 OILSEEDS AND NUTS Groundnuts: Production 5.5 9.3 7.4 7.6 6.1 6.6 7.5 Soya: Production ... 0.2 1.0 1.2 0.7 1.1 2.9 Sesame: Production 7.2 4.6 4.9 5.9 8.6 7.4 9.7 Coconuts (shelled): Production a/ 1,013.6 665.7 695.4 879.4 747.6 619.5 750.8 SUGAR Sugar: Production 6.6 11.9 19.2 18.0 22.9 22.0 25.0 Jaggery: Production 2.0 3.0 6.2 12.0 28.0 18.0 15.0 Sugar: Imports 213.7 190.5 42.0 61.4 45.9 97.7 167.6 OTIIER Chillie.. Production 12.1 19.5 18.4 16.4 36.4 32.0 28.2 Chillies: Imports 19.8 1.2 ... ... ... 1.0 7.1 Onions: Production 62.3 63.3 71.1 72.4 78.4 66.5 72.2 Onionrs Imports 1.1 ... 0.5 3.6 ... na na a/ Data on wheat flour, rice and coconuts are included for the sake of comparison, demonstrating in particular that output of the minor field crops represents only a small part of total food supplies. Source: For production data - Ministry of Agricultural Development and Research For import data - Department of Census and Statistics, Food Balance Sheets.  - 24 - Table 11. PRODUCER PRICES: MINOR FIELD CROPS 1972 1973 1974 1975 1976 1977 1978 1979 Cereal: Rs/bushel Maize 15.1 19.0 50.8 43.1 31.3 31.9 36.1 34.4 Sorghum 20.0 12.4 67.6 70.6 42.7 50.4 28.0 n.a. Kurakkan (millet) 13.8 34.3 66.5 48.9 35.2 33.8 29.4 35.2 Roots & Tubers:Rs/Cwt Manioc 14.4 26.7 43.4 31.3 26.5 27.9 29.7 39.2 Sweet Potatoes 18.0 31.9 48.6 37.3 31.4 36.2 39.4 60.5 Potatoes 83.3 97.0 122.3 117.9 143.8 159.2 204.5 321.4 Pulses: Rs/bushel Green gram 77.0 108.3 134.0 166.1 146.3 154.0 147.1 n.a. Cowpea 28.0 40.8 86.8 98.6 115.5 95.0 108.6 n.a. Oilseeds: Rs./bushel Groundnuts 29.3 37.5 55.5 64.5 66.1 122.1 112.4 n.a. Sesame 32.8 57.3 77.3 81.4 108.4 112.0 139.1 201.2 Other: Rs/Cwt Chillies 768.6 941.6 1,112.6 1,307.7 1,388.2 1,175.0 907.7 1,019.2 Onions 106.4 117.8 107.5 142.4 112.3 205.6 165.1 169.1 Source: Department of Census and Statistics (1972-78) and Central Bank of Ceylon (1979). 3.04 The Government has sought to offset these trends in a number of ways: (i) A floor price scheme was announced in October 1979 for eight crops (maize, sorghum, black gram, soya, groundnuts, sesame, chillies and turmeric). These are all crops which, in theory, could be exported, and which were selected so as to avoid difficulties such as those encountered by the PMB in 1978 when it found itself with unsaleable stocks of cowpea. In April 1980, however, the floor prices were revised and extended to include both cowpea and green gram-crops for which it would be difficult to find a satisfactory export outlet. (ii) Prices of competing commodities are to be adjusted to remove distortions in relative prices. The sharp increase in the price of flour, and upward shifts in rice prices, should help some crops (e.g. millets, manioc) and a higher sugar price could stimulate the production of jaggery. Nevertheless, so long as export taxes keep prices for coconut products well below world prices, it is inevitable that many crops which  - 25 - compete with coconuts will continue to suffer. This applies not only directly to oilseeds (groundnuts, soya) but also to crops for animal feed which have to compete with heavily sub- sidized poonac. (iii) T ading policies, notably imports through the Cooperative Wholesale Establishment (CWE) are designed in theory to be on a cost plus basis. In practice, however, imports have frequently responded to consumer needs, there appears to have been some cross subsidization in the CWE accounts, and, for instance, arbitary price reductions have been announced at festivals. Despite import duties on some commodities, domestic prices have suffered notably in respect of those commodities for which CWE remains the sole importer (chillies, onions, potatoes, and masoor dhal which competes with local pulses). (iv) Legislation has been enacted to legalize encroachers on up- land areas and to distribute land currently in public hands (most of which was taken over under land reform). These are ambitious programs covering very large areas. Security of tenure undoubtedly represents an important step towards longer-term programs designed to establish higher produc- tivity for these crops, whose yields are now frequently very low. Complementary programs to stabilize upland and chena cultivation, as well as increased emphasis on these crops in agricultural research and extension programs, are also important. Role of the Floor Price 3.05 Some confusion and uncertainty surrounds the role of the floor price scheme. Initially the floor prices were set in relation to estimates of the costs of production and were, therefore, regarded as providing the farmer with an insurance against loss. The price levels selected were thus relatively low and in practice PMB purchases since the introduction of the scheme have been minimal. As pointed out in a recent note by the Market Reseach Unit 1/ however, the role of a floor price scheme, as against a guaranteed price, should primarily be to influence the market in such a way that the farmer obtains on average a higher share of the overall return: "The basic problem is the unduly low market price of these crops during the harvesting and immediate post-harvesting weeks when the growers sell most of their produce. Thereafter the market rises sharply, by about 35-50%. The floor price should thus aim specifically at strengthening the market when it is lowest. This would mean the adoption of a price that is higher than the (other- wise expected) 'bottom price' in the market." 1/ "A Note on the Specific Aims of the Floor Price Scheme and on Criteria for Determining Floor Prices", Market Research Unit, Agricultural Research and Training Institute (undated).  - 26 - 3.06 Table 12 summarizes the basis for the floor prices adopted as of May 1, 1980. As in the case of the evolving paddy marketing structure, the aim of setting these prices should not be to expand the public sectors' role in marketing but to influence the private market in a way favorable to the producer while still providing adequate scope to the private sector. It is particularly important to avoid major public involvement, given the inadequacy of the logistical (transport, storage, etc.) facilities available to the PMB and their lack of experience in handling these crops. Such logistical inade- quacies are, of course, also a factor in the private sector (and help explain the sharp seasonal price variations). Support to the private sector will, therefore, be an important element in any programs to promote these crops, e.g., through the banking system and through complementary infrastructural investments. Table 12. BASIS FOR ESTABLISHING FLOOR PRICES FOR MINOR FIELD CROPS (Rs per lb) 1980 1979 Prices Anticipated Floor Highest Lowest Lowest /a Price Maize 0.86 0.54 0.60 0.75 Black Gram 3.00 1.15 1.75 1.60 /b Cowpea 2.49 1.81 2.00 2.15 Green Gram 3.67 2.62 2.80 3.00 Dried Chillies 10.32 7.70 8.25 9.50 Sorghum 0.60 0.50 0.55 0.60 Soya Bean 2.69 2.19 2.25 2.25 /b Turmeric 13.10 8.75 9.25 7.50 7T Groundnuts (unshelled) n.a. 2.00 2.10 2.25 Sesame (gingelly) 3.64 2.59 2.75 3.00 /a Anticipated 'lowest prices' in 1980 are in the absence of an effective floor price (although part of the difference between the floor and 'lowest' prices is accounted for by the higher costs to the farmer of selling to a PMB purchasing center). Such 'lowest prices' are however assumed to be higher than in 1979 due to inflation, increased flour prices and the cur- tailment of chena cultivation. /b The floor prices for black gram, soya bean and turmeric were set lower than recommended by the Market Research Unit. Source: Market Research Unit, ARTI (op. cit.). 3.07 Without adequate financial incentives, production of these crops will continue to stagnate, despite the considerable potential represented by the available land resources. Given the ready availability of rice and wheat flour, subsistence crops such as kurakkan (millet) and manioc may have limited potential (despite higher prices), although higher prices for flour in partic- ular should encourage some increase in production and new markets may emerge (e.g. alcohol production or animal feed). Rapid inflation seems likely to  - 27 - undermine further the returns from commodities such as chillies, onions and pulses which can be readily imported. At the very least, import schedules need to be arranged in a way that pays greater regard to producer interests, while a general adjustment to the cost of imports (e.g. through protection) may be necessary to maintain local production. So long as coconut prices remain below world prices, vegetable oil milling based on of'er oilseeds will remain unprofitable and incentives for these crops, and for animal feeds which compete with poonac, will remain unattractive. Upland versus irrigated production of sugar is currently the subject of a Bank-financed consultancy study which may result in pricing proposals designed to encourage the former. 3.08 The outlook for these crops is, therefore, mixed. The contribution they made to agricultural growth in the mid-1970s was associated with the conditions of the time and is unlikely to be repeated. Nonetheless, there is considerable physical potential for stabilized upland cropping in the longer- term, as well as for introducing these crops into irrigated rotations as a means of maximizing returns from limited Yala water supplies (e.g. as proposed for free draining soils in some Mahaweli project areas). Provided the Govern- ment moves further towards the removal of price distortions (especially in relation to coconut products) and an open economy, then substantial production increases for some of these crops in line with Sri Lanka's comparative advant- age are achievable. Given the paucity of data and analysis, however, it is difficult to be certain which of these crops should receive priority and in what regions of the country should they be promoted. It is important, there- fore, that institutions such as the recently established Market Research Unit in the Agricultural Research and Training Institute (ARTI) are given continued support in order to establish a more satisfactory basis for adopting policies for these crops.  - 28 - IV. COCONUTS Producer Returns 4.01 Coconut production has declined over the last two decades. The decline has been erratic due to weather and other conditions but averaged about 1% per year between 1960-64 and 1975-79. Many factors have been identified as contributing to this decline, including acreage reductions (from about 1.15 million acres in 1962 to 1.12 million acres in 1973 and perhaps 1.07 million acres by 1979); aging of the coconut palms due to inadequate replanting (at best the age composition has remained static); land reforms which created uncertainty and reduced the size of the (relatively efficient) estate sector; adverse rainfall conditions during recent years (although no scientific analysis of changes in moisture conditions has been attempted); and declining fertilizer application (which fell markedly between 1970 and 1977, and which--despite a substantial recovery since then--remains well below recommended levels). 4.02 A number of the factors (notably fertilizer use and replanting rates) are clearly related to producer returns, both in the short and in the longer term. Table 13 summarizes estimates of producer margins for three levels (low, medium and high) of productivity over the period 1973-80 (details are given in Annex II). Coconut prices are essentially set by overall supply and demand, within a framework of export controls and taxation. While the latter has maintained farmgate prices well below border equivalent prices, these have been allowed to increase considerably in recent years. Actual market prices have risen from about Rs 240-580 (1972-76) to Rs 800-950 per 1,000 nuts (1977-79) but with considerable variations from year to year and between seasons. Farm costs rose in 1974 due primarily to higher fertilizer prices 1/, but remained fairly constant between 1974 and 1977. Since 1977, however, they have risen rapidly. This was more than offset by the doubling in farmgate prices that occurred as a result of the policy changes in 1977, but since 1977 producer margins have been eroded. Estimates for 1980 suggest net returns will average about 6-10% less than in 1977 in current terms, and 36-38% less when discounted at the Colombo cost-of-living index, 2/ assuming prices remain at the indicative level. The evidence suggests, however, that prices in early 1980 were in fact higher--in the region of Rs 1,100-1,200/1,000 nuts--while poonac prices have also increased. 4.03 Regular fertilizer use can raise production significantly, and is the major factor contributing to the difference between the low and the high productivity alternatives illustrated in Table 13. Fertilizer off-take during 1972-77 was, however, sufficient to cover only 11% of the total area at recom- mended levels of application. A greater area than this undoubtedly receives fertilizer at sub-optimum levels, but data on this is scarce and unreliable (as are the acreage estimates themselves). Clearly, however, most coconut 1/ No fertilizer is assumed in the low productivity alternative. 21 See para 2.13 for a discussion of the appropriateness of this index.  Table 13: NET RETUINS TO COCONUT FARMERS: 1973-80 1973 1974 1975 1976 1977 1978 1979 1980 Net Return: Current Prices - Rs/acre Low Productivity 318 610 286 446 1,000 852 983 936 Medium Productivity 604 1,146 495 810 1,927 1,553 1,815 1,733 Highi Productivity 1,021 1,875 829 1,340 3,132 2,534 2,973 2,870 Net Return: 1973 Prices a/ Rs/acre Low Productivity 318 543 239 368 814 619 666 524 Medium Productivity 604 1,020 402 668 1,568 1,128 1,229 969 High Productivity 1,021 1,669 673 1,104 2,549 1,840 2,013 1,605 Net Return: Rs/manday Low Productivity 23 39 17 26 58 44 48 37 ttedium Productivity 27 46 18 30 70 S0 55 43 High Productivity 36 60 24 39 91 66 72 57 Ratio of Net Revenue/Cost of Fertilizer Application 1.33 2.09 1.35 1.90 4.13 1.96 2.16 2.04 a! Deflated at the Colombo Consumer Cost of Living Index; this may understate actual inflation. Source; Bank staff estimates - See Annex II.  - 30 - holdings receive no fertilizer and correspond, therefore, to the low alterna- tive in Table 13. This table includes estimates of the ratio of net revenue to cost of fertilizer during this period which largely explain the low levels of offtake. Clearly, the returns to fertilizer use on coconuts have been far less than comparable estimates for paddy. Assuming a 3:1 ratio is desirable to encourage fertilizer use, 1/ returns from fertilizer application were in- adequate in all years except T977 (when prices doubled while fertilizer costs declined). To re-establish a ratio of 3:1 in 1980, farmgate prices would need to rise to at least Rs 1,365/1,000 nuts, and an even larger increase might be desirable--in particular if fertilizer prices were also to increase. Such an increase in the farmgate price would also be sufficient to ensure net returns (discounted at the Colombo cost-of-living index) exceeding the peak reached in 1977. Recommended Farmgate Prices 4.04 Table 14 summarizes Coconut Marketing Board (CMB) estimates of the structures of prices, together with Bank staff projections of border price equivalents for the period 1980-85 (see Annex II for details). The CMB's in- dicative price (the price the farmer theoretically obtains for a given duty structure) was raised twice between August 1978 and November 1979. Actual prices were in fact higher in 1978 than the 1978 indicative price, reflecting shortages on the local market at that time. Although this can occur, the indicative price more normally acts as a ceiling since any higher price to the farmer results in a loss to the exporter (assuming the various margins are fixed on an actual basis--to the extent that these are overstated, there is a margin which can be reduced if competitive conditions ensure this). It does not, however, necessarily fix a floor price since quantitative restric- tions 2/ can result in a seasonal glut on the local market (especially during April-July). A way to tackle this problem would be to maintain export duties/ levies at a level which ensures (desired) incentive levels while removing all quantitative restrictions. This would remove the rigidities of Government intervention and should make the 'indicative' price effective. It would also, of course, lead to higher retail prices for coconuts and coconut producers. 4.05 According to CMB estimates for end-1979, the farmgate price of coconuts was only about 50% of its border price equivalent, with the distor- tion for poonac (about 30% of the border price) considerably greater than for coconut oil (about 60%). Since then, coconut oil prices appear to have fallen considerably on world markets and in fact exports have been suspended since they fail to earn the minimum price set by the CMB. However, this is almost 1/ A ratio of at least 3:1 appears desirable given that the sector is dominated by smallholders, there is a response time lag of up to two years and risks associated with changing rainfall conditions are substantial. 2/ Exports of coconuts and poonac are normally forbidden, while those of coconut oil and copra are controlled. The maintenance of both a fixed specific duty and a variable levy effectively insulates the local market from world price changes.  - 31 - Table 14: STRUCTURE OF PRICES FOR COCONUTS 1978-85 CMB: Financial Prices Bank Staff Projecti.ns: Border Price Equivalent Aug. Jan. Feb. 1978 1979 1979 1980 1981 1982 2985 Coconut Oil: Rs/metric ton Export Price 9,525 13,050 13,311 13,770 a/ 16,100 a/ 16,460 a/ 19,820 a/ Customs Duty (fixed) 1,650 1,650 1,650 n.a. n.a. n.a. n.a. Admin. Levy (variable) 2,175 -4,300 2,711 n.a. n.a. n.a. n.a. Industrial Dev. Fund 100 100 100 n.a. n.a. n.a. n.a. Shippers Margin 100 100 100 120 c/ 140 c/ 155 c/ 205 c/ Coconut Oil Price 5,500 6,900 8,750 13,650 15,940 16,305 19,615 Poonac: Rs/metric ton Export Price n.a. n.a. n.a. 3,110 b/ 3,970 b/ 4,090 b/ 5,470 b/ Shippers Margin n.a. n.a. n.a. 120 c/ 140 c/ 155 c/ 205 c/ Poonac Price 800 1,200 800 2,990 3,830 3,935 5,265 Composite: Rs/8,000 nuts equivalent d/ Composite price 5,900 7,500 9,150 15,145 17,855 18,275 22,250 Millers Cost and Margins 350 350 700 845 c/ 975 c/ 1,090 c/ 1,450 c/ Copra Curing Costs 350 350 450 545 c/ 625 c/ 700 c/ 930 c/ Implicit Price/Border Price 5,200 6,800 8,000 13,755 16,255 16,485 19,870 Indicative Price: Rs/1,000 nuts 650 850 1,000 1,720 2,030 2,060 2,485 a/ Equivalent to 95% of World Bank projection for Philippines/Indonesia cif Europe, assuming no change in the exchange rate. Actual prices in early 1980 appear to be below the World Bank projections. b/ Equivalent to 90% of World Bank estimate for Coconut Pellets in 1979, projected at rate of increase for soya meal. c/ Inflated at expected domestic inflation rate. d/ 8,000 nuts equivalent to 1 metric ton of oil and 0.5 metric ton of poonac. Source: Coconut Marketing Board (CMB) and Bank staff estimates.  - 32 - certainly a temporary phenomenon and, given the distortions that have been typical in the past, it is not surprising that competing oilseeds and animal feed products face unattractive returns (see para 3.07). Although prices of oilseeds have continued to rise in line with those of coconuts (and in con- trast to most other minor field crops - see Table 11), they are still only about 50% of world price levels. Their expansion, and that of associated milling facilities, will continue to be retarded so long as they have to compete with the low prices of coconuts, for which capital investment has already occurred (in the form of palms and processing facilities) and for which the marginal costs of harvesting are minimal (as shown by the return to labor which has consistently been much higher than the prevailing wage rate--see Table 13). 4.06 Table 14 shows that a major increase in coconut prices would be required in order to bring them into line with border price equivalents. A farmgate price of at least Rs 1,365/1,000 nuts (as suggested above) would still fall within the border price equivalent expected 1/ in 1980 (assuming no change in poonac prices and the expected low world price for oil), although actual prices may be lower, given the recent declines on the world market. Oil prices are, however, expected to recover in 1981 which would allow for higher export duties as would an increase in the price of poonac. Further increases in farmgate prices will, however, certainly be required to take account of inflation and, for instance, any increase in fertilizer prices. It is clear, therefore, that if adequate incentives are to be restored to the coconut producer, a substantial readjustment to relative prices will be required, with prices approaching their border price equivalent. Such a structural change would also open up opportunities for competing crops, and is among the most important price readjustments that it would be desirable for the government to undertake. 4.07 The extent to which such an increase in prices occurs will depend on the Government's assessment of the balance between consumer and producer interests, since coconuts are both a major direct consumption item (see Annex II) and also influence the price of other items (e.g. that of milk through the very low poonac price). An adequate relationship between farmgate coconut and fertilizer prices is, however, the most direct instrument for reversing the downward trend in coconut production, and it is, therefore, strongly recommended that the indicative price be raised. Even so, the production potential from the existing coconut palms is necessarily limited. For the longer term, adequate producer incentives will need to be complemented by other schemes such as the various rehabilitation, replanting, under-planting and intercropping programs operated by the Coconut Cultivation Board. Given the predominantly smallholder nature of coconut holdings, it is inevitable that farmers will find it difficult to generate their own .;nvestment resources no matter how high current net returns are. Subsidy scheme., will, therefore, play a crucial role in any overall policies designed to reve.se the long-term downward trend in production. 1/ To ensure the survival of the desiccated coconut industry, similar adjustments would need to be made to desiccated coconut duties.  - 33 - V. TEA AND RUBBER Tea Producer Margins 5.01 . in the case of rubber and coconuts, the policy reforms intro- duced in 1977 shifted the burden of tea export taxation from reliance on the dual exchange rate system back to export duties. In contrast to rubber, however, the main source of revenue established then was a fixed export duty (currently Rs 4.77/lb) which accounted for 80% of total export taxes on tea in 1978 and is expected to remain at about 83% of the total during 1980-84, assuming World Bank price projections and no change in the duty structure. So long as the exceptionally high 1977 prices prevailed, producer margins remained high. However, prices have declined in 1978 and 1979, significantly eroding producer margins and demonstrating that the principal outcome of heavy reliance on the fixed export duty is that the burden of any increase in tea export prices or increase in costs of production is borne fully by the industry producers. In addition to the fixed duty, there is an ad valorem tax (20% of the excess monthly average price over Rs 7.27/lb) and a Tea Board cess (Rs 0.41/lb). Even after the reduction in the various duties to their present levels in November 1979, 1/ the tax burden remains at about 33% of the export unit value (by comparison the equivalent tax burden in Kenya is nil). Ironically, the 1980 budget proposal on tea taxation, which raised the trigger level, and lowered the rate, of ad valorem tax, has effectively made the fixed export duty even more prominent than before. 5.02 For over a decade, excessive taxation of the tea industry kept net producer margins at low levels in the face of generally declining export prices and increasing costs. Table 15 summarizes trends since 1973. Except for 1977, net producer margins have been below Rs 2.00/lb since 1969 and, on a number of occasions, have been negative. Towards the end of 1979, producer margins were estimated at Rs 0.20/lb despite the July and November reduction in taxes, reflecting increased wages and other factors. As a consequence of this level of taxation, there has been a chronic shortage of investible surpluses both for regular upkeep and maintenance and for medium- and longer- term development. 1/ For details of changes in tea taxation system, see Annex A in Volume I.  - 34 - Table 15: TEA NET PRODUCER RETURNS, 1973-1979 (Current Rs/kg) 1973 1974 1975 1976 1977 1978 1979 Export Price (fob) 6.2 7.7 9.0 10.6 18.9 33.3 30.4 Export duty, cess, exporter charges, sales tax 2.0 2.0 2.9 2.6 5.5 21.6 17.4 Net sale price (average) 4.2 5.9 6.2 7.7 13.4 11.7 13.0 Production costs 4.4 5.5 6.6 7.1 7.9 9.5 12.8 Net producer return -0.2 0.4 -0.4 0.6 5.5 2.2 0.2 Net return/acre /a (Rs) -120 240 -240 360 3,000 1,200 120 /a Assuming yield of 545 kg/acre. Source: Central Bank of Ceylon. Fiscal Recommendations 5.03 With heavy taxation constantly assailing tea producer margins and industry financial viability, the Government has instituted various subsidy measures, currently numbering nine in all. The administration of such a large number of different measures is cumbersome, and their rationale appears questionable given the characteristics of the tea industry. In contrast to rubber and coconuts, 70% of the tea sector is publicly owned. The corporations running the public estates have suffered from inadequate management incentives both in relation to adopting recommended cultural practices and to longer-term rehabilitation programs. Productivity has declined and with it morale, which the subsidy schemes have failed to reverse. Not only have they failed to have the impact on replanting, infilling and new planting that was hoped for, but in some cases they have had adverse unintended consequences (e.g.. the guaranteed minimum price scheme for smallholder green leaf which promoted low grade tea production, depressed prices, created storage problems and led to abuse). 5.04 Given this background, both the Government and Bank staff have considered the need to re-establish corporate responsibilities and incentives as the primary requirement for the tea industry. This lies behind the recent reorganization of the industry as well as behind the fiscal measures recom- mended by Bank staff. 1/ These emphasize the need for the industry itself to generate the necessary investment funds within the context of overall plans to revitalize the industry. The tax changes introduced in the November 1979 budget were a step in the right direction, in that producer margins were restored at least for the time being. By continuing to place heavy reliance on a fixed specific export duty, the new tax level is, however, still unre- sponsive to changes in market prices and production costs. The projections contained in Table 16 suggest that a continuation of current tax levels would result in a substantial erosion of producer margins over the coming years. This would again result in the industry being starved of funds and lead to low levels of reinvestment. A more desirable tax structure would be one that would incorporate as much automatic responsiveness to industry profitability 1/ In the context of discussions on sector issues in response to the Tea Master Plan proposals (see Annex D in Volume I).  - 35 - as possible. Given Sri Lanka's resource constraints, and the contribution that taxes on tea make to government revenues, the Bank's recommendations would not substantially affect net revenues accruing to the Government (that is after allowing for subsidies and the losses which are to be expected under the present tax system). They would, however, reduce gross revenues, in the medium- and long-term, and return control over investment f --is to the corpora- tions. In the longer-term, consideration should be given to changing the tax collection mechanism solely to company income tax. For the immediate future, however, Bank staff suggestions take into account administrative convenience as well as the need to ensure remunerative producer margins in the face of changing sales prices and costs of production, and government revenue require- ments. Specifically, the proposed fiscal system would consist of: (i) A low specific export duty to ensure minimum inflow of revenue from the tea industry. At present and anticipated future average export prices, a duty of about Rs 4.40/kg has been suggested. Provided this duty is maintained at a low level, it may help induce production of good quality tea. (ii) An ad valorem sales tax levied at auction point, as at present, but which would be relatively more important given the lower incidence of the specific duty. Of great impor- tance is the need to vary the level at which the tax become operative to take into account changing production costs. A rate of 70 to 75% of the difference between these costs and the sales price has been suggested. (iii) As at present, a cess on tea exports to cover costs of the Tea Research Institute and the Tea Promotion Board, and corporation income tax levied at the standard rate (50% of net surpluses on incorporated enterprises) with public corporations returning any after tax profits to Government in the form of dividends. (iv) The rationalization of subsidy programs through elimination of some measures and merging of others. Given the expected decline in tea margins (even if the above taxation changes are introduced, see below), the private sector (and parti- cularly smallholders) will still probably require additional incentives to remain in the industry, and a practical and cost-effective way of realizing investment targets for infill- ing and replanting would be to retain appropriate subsidies to the private sector. These would need to be adjusted periodically to account for price escalation. 5.05 These fiscal measures could be instituted with minimal legal and administrative preparation since they are conceived within the existing tax framework. Table 16 projects their impact on producer returns and compares this with the effect of maintaining the existing system. The existing system would result in falling margins due to rising real costs and expected declines in real prices. With the existing taxation system, gross government revenue during 1980-84 would be about Rs 13,500 million, whereas, during the same  - 36 - period, the proposed taxation system would generate gross revenues of about Rs 13,300 million--a difference of about Rs 40 million in average annual revenues. Under the proposed fiscal arrangements, however, producer margins would be partially protected against falling real prices and rising costs, thereby obviating the need for budgetary support to the industry. Table 16: FISCAL IMPACT OF ALTERNATIVE TEA TAXES 1980 1984 1980-84 (Annual Average) Cur- Sug- Cur- Sug- Cur- Sug- rent gested rent gested rent gested Export Price (f.o.b.) Rs/kg 31.48 31.48 40.66 40.66 35.96 35.96 Taxes and Other Charges /a Rs/kg 14.22 14.72 16.53 15.05 15.29 14.90 Cost of Production Rs/kg 14.45 14.45 23.39 23.39 18.77 18.77 Producers' Margin Rs/kg 2.81 2.31 0.74 2.22 1.90 2.29 Production million kg 210 210 226 226 218 218 Industry Profits /b Rs million 590 485 167 502 410 499 Subsidies Rs million 33 10 120 36 75 23 Industry Investment Rs million 229 229 639 639 412 412 Surplus (deficit) after Investment /c Rs million 394 266 (352) (101) 73 110 Net Government Revenue /d Rs million 2,506 2,634 2,786 2,605 2,627 2,639 /a Export duty, cess, ad valorem tax and exporters' charges. /b Producers' margin times production. 7c Industry profits plus subsidies less industry investment. 7d Government revenues from export duty, cess, ad valorem tax and corporate income tax less subsidies. Source: Appendix 3, Annex D, Volume I. Rubber: The Importance of the Replanting Scheme 5.06 World market prices for natural rubber have shown a strong upward trend since 1975 (at least partly due to the increasing supply price for oil- based synthetics) and present forecasts are for continuing high prices. While this provides strong justification for replanting (the internal rate of return is estimated at about 25%, well above the opportunity cost of capital), it does not necessarily ensure adequate incentives for undertaking replanting. This is particularly true for smallholders who are faced with heavy export taxation and lack working capital, technical expertise and appropriate planting material. Under these circumstances an effective replanting scheme is crucial  - 37 - and recent analyses 1/ suggest this is of much greater significance than producer returns in ensuring adequate rates of replanting. Together with the effectiveness of the technical assistance provided, the adequacy of replant- ing payments appears largely to explain both the decline in replanting rates between 1961-76 (from 18,700 acres to 6,300 acres) and the subsequent improving t-end since 1976. 5.07 In contrast to tea, therefore, the objective of high replanting rates to replace the large stock of over-aged rubber in Sri Lanka is best served by a suitable replanting scheme rather than by measures designed to generate investment resources within the industry (although this is, of course, desirable in the corporate sector). Adequate producer margins are essential to ensure continued tapping and to provide general support for replanting programs. However, these are currently fairly high and there is no immediate need for a structural adjustment in the level of prices as in the case of coconuts. Of more importance than the appropriateness of the 55% government levy on rubber exports is, therefore, the question whether or not the combined taxes and subsidies for the rubber sector result in an adequate package of incentives to produce and invest. 5.08 Table 17 summarizes broad estimates of producer margins for rubber between 1975-85. It is clear that the increase in prices between 1975-79 more than offset the impact of cost increases on net return--despite the substantial increase in the proportion of the unit export price going to the Government in the form of export taxation. The return to labor in 1979 is estimated to have been about Rs 19/manday, somewhat above the prevailing wage rate. Such a ma gin appears desirable given the high priority attached to the rubber sector, and the need to ensure continued tapping of low produc- tivity trees. Export taxes need to be adjusted, therefore, to ensure that producer prices rise in line with costs, and to ensure that real incomes are maintained at a level which continues to exceed those prevailing in alternative occupations. However, current incomes from low yielding holdings must not be so high as to discourage replanting (incomes from replanted rubber will, of course, be very much higher than implied by Table 17), since it is only through replanting that output can be significantly increased and Sri Lanka can take advantage of strong world prices. 5.09 Recent prices for an average grade mix have been about Rs 19/kg f.o.b. Colombo. At this price, Government levies amounted to about 55% of the f.o.b. price which is substantially higher than in say Malaysia (where they were about 27% of the fob price) or Thailand (25%). There is, therefore, considerable potential for adjusting export duties to ensure a margin is maintained over rising real income levels elsewhere in the economy, while still ensuring substantial budgetary revenues. 1/ Multiple correlation analysis undertaken in the context of the proposed World Bank Rubber Replanting Project suggests that 90% of the variation in rates of replanting between 1960-74 was explained by replanting pay- ments, producer margins and factors associated with land reform of which no less than 70% was explained by replanting payments alone.  Table 17: RUBBER PRICES AND NET RETURN, 1973-1985 Estimates Projections 1973 1974 1975 1976 1977 1973 1979 1980 1981 1982 1985 Rupees/kilogram FOB Price: All Rubber a 3.7 5.7 4.1 6.5 6.8 14.6 18.5 18.8 20.2 22.9 28.4 Colombo Market Price a/ 2.6 2.8 2.5 4.3 4.5 6.1 8.1 8.2 8.8 10.0 12.4 Marketing Charges b/ 0.2 0.3 0.3 0.4 0.5 0.- 0.6 0.7 0.8 0.9 1.2 Producer Prices 2.4 2.5 2.2 3.9 4.0 6.2 7,5 7.5 8.0 9.1 11.2 Input Costs b/ 0.5 0.6 0.7 0.8 0.9 1.0 1.2 1.4 1.7 1.9 2.5 Net Return to Producer 1.9 1.9 1.5 3.1 3.1 5.2 6.3 6.1 6.3 7.2 8.7 co Net Return/ha c/ 1,425 1,425 1,125 2,325 2,325 3,900 4,725 4,575 4,725 5,400 6,525 Net Return/ha: l973prices d/1,425 1,269 938 1,917 1,892 2.832 3,199 2,560 2,290 2,346 2,130 Net Return/manday c/ 5.7 5.7 4.5 9.3 9.3 15.6 18.9 18.3 18.9 21.6 26.1 a Projected according to index based on World Bank price projections. Assuming no change in the exchange rate or in the export duty structure. Based on 1979 Bank staff estimates, adjusted by rubber production cost index (1973-79), and Bank staff projections of inflation (1980-85). c/ Assuming average yield 750 kg/ha and 250 manday input per ha. d/ Deflated at Colombo cost of living index (1973-79) and Bank staff projections of inflation (1980-85). Source: Bank staff estimates.  - 39 - 5.10 The export taxes shou-d not, however, be viewed in isolation, since the Sri Lankan producer also benefits from government assistance in the form of replanting subsidies which are currently quite reasonable, and from fer- tilizer subsidies which are high. Indeed, replanting subsidies have doubled in real terms since 1977 and fertilizer subsidies are currently about 70% of the retail prices. If these are maintained at their present levels, it can be estimated that under an active replanting program 65% of Government revenue is returned to the rubber sector (40% in the form of replanting grants and 25% in the form of subsidies on fertilizer), while a further 15% is spent on services to the rubber industry (mainly in the form of technical advice and administra- tion of the replanting scheme). Thus, only 20% of total levies on rubber (or 11% of the f.o.b. price) would be available to government general revenues for investment in other sectors of the economy, 5.11 In contrast to tea, there is no fixed duty, and there is an element of progressiveness in the variable duty which rises from about 45% if the price is Rs 12/kg to 50% if the price rises to about Rs 18/kg. 1/ At lower prices, export taxation still represents a more severe real burden to the producer. However, world prices are expected to maintain their high 1979 levels in real terms in the longer term (although they are expected to weaken a little over the period 1980-85). The aim should, therefore, be to maintain the level of producer returns at least at their 1979 levels rather than make a structural change in relative rubber prices (as has been recommended for coconuts). If fertilizer prices are increased, this would require a corres- ponding adjustment to export duties to maintain producer margins. Similarly it will be vital also to link the value of replanting payments to smallholder replanting costs. In general, however, provided the incentive package is maintained at or close to current levels in real terms, this should permit the Sri Lanka rubber producer to enjoy substantial profits in the years ahead, and through these incentives promote the desired rehabilitation and development of the rubber sector. 1/ In addition, there is a 2.5% cess.  - 40 - VI. CONCLUSIONS 6.01 This volume has reviewed agricultural production incentives in the context of the policy changes initiated under the present government. A number of recommendations have been made designed to maintain or enhance incentives, some of which could have significnt budgetary implications while others may have an impact on the general level of prices. With the exception of the budgetary impact of recommended tax changes in the tea sector, these implications have not been analyzed in any detail. They will, however, clearly affect the degree to which any or all of the recommendations can be implemented immediately, and it will therefore be necessary to phase any changes in the light of general macro-economic developments and concerns. With this qualifi- cation in mind, the conclusions reached in relation to particular crops can be summarized as follows: (i) Paddy margins have been eroded by rapid cost inflation, in particular by increases in rural wages and farm power costs. The continued growth in production suggests that other positive factors have so far offset this trend. Nevertheless a substantial increase in the farmgate price is required if incentives are to be maintained and the adverse consequences of major changes in relative costs and returns are to be avoided. How such an increase is to be effected will need to reflect the major changes in the structure of rice marketing that are currently taking place. Margins between the GPS and retail prices have been suffi- cient to encourage a major shift to the private sector, and the role of Government agencies is evolving towards one of market regulation and away from pure distribution. It will be important to preserve these developments. Nevertheless, trading margins should not be allowed to widen excessively at the expense of the farmer, a possibility threatened by the decision to price imports on a cost plus basis while retaining the GPS price at the level established as long ago as 1977. An increase in the GPS price before the next Maha sowing season to at least Rs 50/bushel should provide assurances to the farmer, and allow ample scope to the pri- vate sector, without putting serious pressure on retail prices during the lean season (which will be determined by the price for imports). Under these conditions, the GPS price would act as a floor and the official price for imports as a ceiling, with actual farmgate prices during the harvest season being determined by market conditions, ideally at a level above the floor. (ii) Many minor field crops have been affected by import policies and, despite the great physical potential for these crops, their outlook appears mixed. Provided trading policies are implemented in a non-discriminatory fashion and provided prices for competing crops (notably coconuts) are adjusted  - 41 - to reflect more closely their border price equivalents, opportunities for a number of these crops will undoubtedly emerge. The recent substantial increase in the price of flour will also have a favorable impact on production. However, it will be important to identify more clearly --hich of these crops accords with Sri Lanka's comparative advantage, and to support those crops selected with an appropriate floor price scheme and complementary research, extension, and land stabilization policies. (iii) Export taxation of coconuts has adversely affected incentives for fertilizer use, contributed substantially to declining output and discriminated against a number of competing crops. Despite a number of adjustments designed to increase the farm- gate price in recent years, further significant increases appear desirable. At present fertilizer prices, a farmgate price of at least Rs 1,350-1,400/1000 nuts would be necessary to expand fertilizer use significantly, and a major price increase would probably be the most direct means of reversing the long-term decline in output. If fertilizer prices are increased, then a correspondingly higher farmgate price would be required. The recent decline in world coconut oil prices may make such adjustments more difficult in the short term, but this decline appears to be temporary and in any case prices for other coconut products provide sufficient scope for effecting the necessary changes. Given the smallholder characteristics of most coconut farmers, any increase in farmgate prices will still need to be complemented by replanting and similar subsidy programs to ensure the continued long-term health of the sector. (iv) Export taxes on tea have similarly depressed producer margins and affected the adoption of satisfactory cultural and management practices. Unlike coconuts, tea pricing has not adversely affected competing crops. However, it has undoubtedly seriously affected investment levels in the corporate sector which the operation of a complex set of official subsidy programs has failed to offset. Tax changes designed to pro- tect tea margins against both declining real world prices and rising costs are essential if the necessary funds are to be generated to provide both for regular up-keep and maintenance and for medium- and longer-term development. Provided this is achieved, and provided substantial management improvements are effected, many of the subsidy programs for the estate sector can be substantially modified. Such programs will, however, continue to be necessary for the private smallholder sector which is unlikely to be able to generate its own investment resources even if producer margins prove to be more favorable. (v) While export taxation on rubber has also in the past kept producer margins low, the recent increase in world prices has raised them to adequate levels. It will be important  - 42 - to maintain them, if necessary through adjustments in export duties, in order to ensure continued tapping and to provide a continued margin over returns in alternative wage labor opportunities. Export taxes should not, however, be viewed in isolation since the producer also benefits from replanting and other subsidies. The returns from replanting are very high, and this is clearly the principal strategy for taking advantage of the promising outlook for world prices. In contrast to tea, however, the rubber sector is dominated by private smallholders who will be unable to generate their own resources for investment. A replanting subsidy program will, therefore, continue to be crucial, indexed to the costs of smallholder replanting costs. Provided the incen- tive package as a whole is maintained at or close to current levels this should provide adequate incentives for the smallholder to produce and invest. 6.02 Finally, the differences in returns from fertilizer use for the different crops face Sri Lanka with a dilemma in setting fertilizer prices. Whereas current incentives for fertilizer use in paddy appear excessive, and may distort the pattern of input use, those for coconuts are marginal. (and possibly also for tea and rubber). Given the very great cost of the (unnecessary) subsidy on fertilizer for paddy, some increase in average fertilizer prices is desirable. To the extent possible, this should dis- criminate against paddy (e.g., by raising the relative price of urea), but this can be taken only so far and involves issues related to the new urea factory which have not been discussed here. From the point of view of the paddy farmer, provided farmgate prices for paddy move as suggested above and provided agricultural credit is made available on a satisfactory basis, fertilizer prices in the longer term could approach their border price equiv- alent. The extent to which this proves possible will, however, depend on movements in associated tree crop fertilizer price ratios and at least a value-cost ratio of 2.5:1 for coconuts would need to be maintained.  - 43 - ANNEX I RETURNS TO THE PADDY FARMER Introduction 1. This annex reviews returns to the paddy farmer over the period 1972/73-1979/80 with a view to throwing light on price incentive policies. The analysis considers: (i) changes in relative farm costs; (ii) changes in real purchasing power of the farmer surplus; and (iii) ways in which farmer returns have varied in relation to prevailing wage rates. The annex concludes with a broad assessment of adjustments that might be made to the official pro- curement price in order to maintain farmer incentives. No attempt is made to estimate the supply response of alternative pricing policies, although some general conclusions are drawn, in particular through a discussion of relative fertilizer-output price relationships. Nor does the annex discuss the signi- ficant changes currently occurring in the rice marketing system - a subject which is dealt with at some length in Chapter II of this volume. 2. In order to structure the analysis, four differing technologies have been defined, corresponding broadly to the rice cultivation practices followed in Polonnaruwa, Hambantota, Kandy and Colombo districts respectively. These have been chosen partly because of the availability of published farm survey data, and partly because they provide a reasonable picture of the range of technologies followed in the country as a whole. Of course, even within dis- tricts, there are very considerable differences from farmer to farmer, depend- ing on such factors as land ownership, soil conditions, water supply, labor availability, and farmer knowledge and preference. The specified technologies should be seen, therefore, as being representative rather than as being an exact reflection of average practices in the districts concerned. 3. The procedure followed has been to define a standard package of technical relationships for each alternative and, assuming these remain fixed, to test the impact that past price changes would theoretically have had on farmer returns. Of course, just as technical relationships vary from farmer to farmer, so do they vary for a particular farmer over time, for instance in response to variable weather conditions, changes in relative prices, or the adoption of higher-yielding practices. However, the purpose here is not so much to simulate actual past experience as to develop a basis for assessing alternative pricing policies. By abstracting from unpredictable changes, such as those due to weather, it is possible to assess the pure price effect on income, while by defining alternative technologies it is possible to evaluate theoretically predictable changes (e.g., those in response to price changes or technical opportunities) in terms of the incentives for moving from one technical level to another. Such a procedure would be valid, although some- what more difficult to interpret, even under conditions of rapid technical progress. However, during the period under review there was in fact rela- tively little persistent technical change and, despite considerable variations from year to year, yields, varieties, and fertilizer use were not markedly different towards the end of the period as compared to the levels towards the beginning. This is shown by the district data derived from official sources and summarized in Table A.  -44 - ANNEX I Table A: PADDY YIELDS, VARIETAL AND FERTILIZER USE 1972/73 1975/76 1976/77 1977/78 1978/79 Paddy Yields (bushels/acre) Polonnaruwa 78 81 80 79 70 Hambantota 53 59 64 59 67 Kandy 67 55 58 60 62 Colombo 35 43 41 40 40 All Island 46 47 52 53 55 Area Under Improved Varieties (% of total) Polonnaruwa 86 87 97 94 n.a. Hambantota 87 85 n.a. 94 n.a. Kandy 85 96 91 82 n.a. Colombo 60 82 n.a. 67 n.a. All Island 73 83 89 83 n.a. Fertilizer Issues (lb/acre) Polonnaruwa 72 173 200 213 n.a. Hambantota 35 71 93 158 n.a. Kandy 71 122 158 207 n.a. Colombo 61 130 104 104 n.a. All Island 44 82 89 122 n.a. Source: Central Bank of Ceylon. Technical Relationship Assumptions 4. The definitions of the four alternatives were based in the first instance on the estimates given in an Agrarian Research and Training Institute (ARTI) survey of paddy farmers in the four districts during the 1976/77 Maha season. 1/ These were modified taking into account an earlier survey by ARTI, 2/ surveys undertaken by the Department of Agriculture (DOA), 3/ the published estimates given in Table A, and by a short exercise commissioned by the Bank's economic mission and undertaken by an ARTI researcher. 4/ 1/ A.S. Ranatunga and W.A.T. Abeysekera: "Profitability and Resource Characteristics of Paddy Farming", Agrarian Research and Training Institute, 1977. 2/ K. Izumi and A.S. Ranatunga: "Cost of Production of Paddy Maha 1972/73," Agrarian Research and Training Institute, 1974. 3/ K. Sathasivampillai and G.A.C. De Silva: "Farm Business Management", Dry Zone 1973/74, Wet Zone 1973/74 and Dry Zone 1974/75, Department of Agriculture 1976/77. 4/ W.A.T. Abeyesekera, Unpublished Mimeo Tables.  - 45 - ANNEX I 5. Table B summarizes data derived from the 1973 Agricultural Census to indicate land ownership patterns in the four districts, and Table C sum- marizes the physical input and output assumptions used in this paper. The four alternatives can be described briefly as follows: (a) Polonnaruwa. This district has yields that are among the highest in Sri Lanka, reflecting fairly secure water supplies in well-established Dry Zone settlement schemes. It is repre- sentative of high intensity, commercial (surplus-producing) farming. Yields have been taken to be 80 bushels/acre (4.1 metric tons/hectare), with relatively high inputs of labor, farm power and fertilizer. Labor is predominantly hired, with migrant labor coming from outside the district at peak periods. Ownership of farm power sources (especially buffaloes) is fairly widespread, reflecting the fact that the typical farm is above average size (earlier settlers received more than the 2.5 acres given for instance under the Mahaweli scheme), and is operated by its (relatively prosperous) owner. Transplanting is common, and while this tends to increase labor requirements, it reduces seed inputs and is consistent with relatively high yields. (b) Hambantota. This Dry Zone district is also a significant surplus-producing area. However, both yields and input-use intensities are lower than in Polonnaruwa, reflecting largely the less secure water supplies. Yields are taken to be 60 bushels/acre (3.1 metric tons/hectare). Labor requirements are assumed to be 75% of those in Polonnaruwa but, as for the latter, the majority is hired with migrant labor coming from the Wet Zonf at peak periods. Farm power is fully mechanized, reflecting the more extensive nature of the agriculture and the limited effort put into agricultural practices. Similarly, transplanting is fairly infrequent, and seed requirements are high. Average operational size is somewhat lower than in Polonnaruwa, but tenancy is fairly common, and the average area owned by landowners is probably as high as in Polonnaruwa. Table B: OPERATIONAL LAND HOLDING SIZE /a (% of holdings) Polonnaruwa Hambantota Kandy Colombo All Island Size of Holding Less than 0.5 acre 4.5 9.4 34.1 54.0 30.2 0.5 - 1.0 acre 5.4 10.6 21.8 16.3 15.2 1.0 - 2.0 acre 15.2 24.0 20.1 15.0 19.3 2.0 - 3.0 acre 13.7 18.9 9.7 5.8 11.4 3.0 - 5.0 acre 24.9 19.0 8.6 4.3 12.1 More than 5.0 acre 36.3 17.4 5.8 4.6 11.9 Memorandum Items: Average size (acres) All holdings 3.98 2.97 1.71 1.46 2.34 Paddy holdings 3.09 2.34 0.95 0.96 1.78 /a Components may not add to 100.0 due to rounding off. Source: Census of Agriculture, 1973.  - 46 - ANNEX I (c) Kandy. This district is representative of high intensity sub- sistence Wet Zone agriculture. Average farm sizes are low reflecting high population pressure. This also gives rise to fairly widespread tenancy (as in Hambantota but for different reasons). Yields are taken to be 60 bushels/acre (3.1 tons/ hectare). This is not particularly high since physical inputs (farm power and fertilizer) are limited by financial constraints, and yields in the Wet Zone tend to be lower due to climatic con- ditions (offset in terms of overall farm incomes by higher Yala cropping intensities). Labor inputs are high, reflecting trans- planting, the use of labor in land preparation and other labor intensive practices. Perhaps surprisingly, in view of population pressure, both the ARTI and DOA surveys are agreed that hired labor (mainly at peak periods) represents about 50% of the total. Farm power is confined to (largely hired) buffaloes and manpower, with the use of human labor in land preparation a reflection of the financial constraints facing the farmer. (d) Colombo. This district is representative of low intensity, sub- sistence Wet Zone cropping. Flooding is fairly common, and the general lack of water control leads the farmer to adopt practices which minimize inputs, including labor. Yields are taken to be 40 bushels/acre (2.1 metric tons/hectare). Both tractors and buffaloes are used as sources of farm power, but inputs of these as well as of labor are fairly low. Many farmers supplement their income with laboring activities, often outside agriculture, using their paddy holdings as a source of subsistence rice production. Table C: PHYSICAL INPUT AND OUTPUT ASSUMPTIONS Polonnaruwa Hambantota Kandy Colombo Yield (bushels/acre) 80 60 60 40 Labor (mandays/acre) Hired 50.0 37.5 42.5 20.0 Family 20.0 15.0 42.5 30.0 Total 70.0 52.5 85.0 50.0 Farmpower (hours/acre) 4-wheel tractors 4 3 - 1 2-wheel tractors - 10 - 4 Buffalo pairs 40 - 60 30 Material inputs Seed: bushels/acre 1.5 2.0 1.5 2.0 Urea: lb/acre 140 112 112 84 Basal: lb/acre 140 112 112 84 Source: Bank staff estimates.  - 47 - ANNEX I 6. It is perhaps worth repeating that the physical input and output assumptions given in Table C are representative of the wide range of farming practices followed in Sri Lanka rather than being a completely accurate picture of those followed in the districts concerned. The incentives governing how far a farmer is likely to vary these relationships in response to changes in relative prices are discussed below, following a discussion 'fI past price trends. Price Trends: 1972-1979 7. Output prices: The basis for estimating trends in fertilizer and paddy prices is somewhat more satisfactory than is the case for labor and farm power. For paddy, the price taken in the analysis provided in this annex is the Government procurement (GPS) price. It is true that regional variations in paddy prices exist, reflecting such factors as the local supply/demand situation, competitive conditions in the private sector, and transport costs. Similarly, open market prices as a whole can rise above the GPS when overall supply shortages appear as a result of an unexpected harvest failure, govern- ment controls or problems with scheduling imports, while prices can fall under the influence of excess supplies at harvest. Nevertheless, the Government continued to procure a substantial proportion of the marketable surplus through most of this period, and for many farmers the GPS price effectively determined the farmgate price. 1/ 8. Table D summarizes data from the Department of Census and Statistics on actual trends in open market prices between 1973 and 1979 and compares these with the GPS price prevailing at the time of the Maha harvest. Unfortunately, the district information from this source is only available up to 1977, but the table also includes data for 1979 from an exercise initiated in September 1978 by the Central Bank of Ceylon. The table suggests that open market prices tend to be lower than the national average in Kandy, and higher in Colombo, but in the two Dry Zone districts they tend to follow the national average fairly closely. This probably reflects the narrowness of the market- able surplus in the Wet Zone areas, and consequently the influence of local retail prices. Trends over time can be discussed as follows: (a) Between 1971-75 the free market was heavily curtailed. In this narrow market, prices for paddy remained well above the GPS price, reflecting the low per capita availability of foodgrains at this time. The restrictions on private trade were designed to maintain high procurement by the PMB - an objective that was on the whole achieved up until 1975 when the poor harvest sharply curtailed the marketable surplus. 1/ In practice the farmer tends to get a lower price than the GPS even when selling to a PMB agent since the latter (usually a cooperative) incurs transport and other costs which may be deducted from the farmer's price.  - 48 - ANNEX I (b) Increased availability of foodgrains in 1976 and 1977 (initially due to higher imports, especially of wheat flour, but subsequently due to the record 1977 rice harvest) led to declines in the free market price which fell significantly below the GPS price during the 1977 Maha season. Prices rose during 1978, following the increase in the GPS price. Nevertheless, they still lagged behind the latter at the 1978 harvest period with the result that PMB purchases recovered dramatically, causing consider- able storage and related problems. (c) The levelling off in production during 1979, and in particular the setback to the Yala crop, led to further increases in free market prices and to reduced PMB procurement. Adjustments to official retail prices in early 1980 helped maintain prices above the GPS price despite the expectation of a bumper Maha crop, and in consequence PMB purchases during the current year appear to be falling off sharply. 9. In summary, farmgate prices for paddy have risen significantly since the low point reached during the 1977 Maha. The increase in free market prices was pronounced in 1978, although still lagging behind the sharply increased GPS price. Since then, they have continued to drift upwards and, despite the bumper 1979/80 Maha crop, appear now to be above the GPS level, and are being supported by higher retail prices. Although the latter have weakened recently in response to the new crop, they have been supported by upward adjustments to official prices (from Rs 1.60/lb to Rs 1.78/lb for locally procured rice, and from Rs 1.80/lb to Rs 2.17/lb for imported rice) and are significantly higher than a year earlier. 10. In theory, these price trends should be taken into account in esti- mating changes in net returns, for instance, through a weighted average of GPS and open market prices at the farmgate. Similarly the changing role of the GPS price itself (from a procurement price to a floor price) should also be taken into account. However, to simplify the analysis, and to concentrate on farm incomes at the time of the Maha harvest (when procurement is at its height) the analysis is presented in terms of the GPS price while recognising the influence of the open market price trends discussed above. The changing role of the GPS price is also mentioned below but is discussed in greater detail in the context of the overall changes in the rice marketing structure described in Chapter II of this volume.  - 49 - ANNEX I Table D: PRODUCER PRICES FOR PADDY: 1973-79 (Rs/bushel) /a Average Open Market Prices - GPS Price Polonnaruwa Hambantota Kandy Colombo All Island April-June 1973 27.0 31.3 23.7 25.4 24.2 18.0 1974 n.a. n.a. n.a. n.a. 41.2 30.0 1975 41.3 34.7 39.2 45.6 41.8 33.0 1976 37.7 38.4 36.2 40.5 37.4 33.0 1977 34.3 37.3 34.6 36.2 35.2 33.0 1978 n.a. n.a. n.a. n.a. 40.7 40.0 1979 41.4 41.9 39.1 49.2 41.8 40.0 /a Prices during the Maha harvest would tend to be significantly lower than the annual average. Source: Department of Census and Statistics: 1973-78; Central Bank of Ceylon: 1979. 11. Production Costs. Tables E, F and G summarize estimates of unit costs for inputs in paddy production for the period 1972/73-1979/80. These estimates apply to those prevailing during the main Maha crop season and can be discussed as follows: (a) Labor: Farm survey data show a fairly slow increase in wages in the informal sector between 1972-76 1/. Pressure on wages was restrained by stagnant production, few alternative job opportu- nities and the effect of constant ration prices which shielded wage earners from the worst effects of price increases. Since 1977, however, a much more rapid increase has occurred, as wage good prices have risen, and alternative job opportunities have been created by the Government's development projects and the general increase in economic activity. The increase has been particularly marked in the Colombo area, but it has also affected Dry Zone areas dependent on migrant labor. Wages in paddy cultivation in such Wet Zone districts as Kandy are lower than in the Dry Zone and the increase in recent years has been less marked. Table E: ESTIMATED WAGES RATES, Maha 1972/73-1979/80 (Rs per manday equivalent) Polonnaruwa Hambantota Kandy Colombo Maha 1972/73 6.50 6.50 5.50 6.00 1973/74 7.00 7.00 6.00 6.50 1974/75 7.50 7.50 6.50 7.00 1975/76 8.25 8.25 7.25 7.75 1976/77 9.50 9.50 8.00 9.25 1977/78 11.25 11.00 9.00 12.00 1978/79 13.50 13.00 10.50 15.00 1979/80 16.00 15.50 12.00 17.50 Source: Bank staff estimates. 1/ In contrast, wages in the estate sector were adjusted up significantly from a low base - see the official Minimum Wage Index (Statistical Appendix 9.1 in Volume I).  - 50 - ANNEX I (b) Farm power costs have risen more consistently than those of labor, although again there has been a particularly rapid rise over the last few years. The draught animal population has declined, and this has been reflected in, for instance, fairly consistent increases in the price of buffaloes (160% between 1972 and 1978), meat and milk. The increase in petroleum and capital goods import prices between 1972-74 was reflected in a more than doubling of the local price of diesel and rapid increases in the purchase price of tractors. Although international inflation moderated in 1975, there has been renewed acceleration since 1977, compounded domestic- ally by policies designed to pass on the full costs to the local market. The price of diesel rose from Rs 5.25/gallon in 1977 to Rs 13.50/gallon by the end of 1979, and tractor costs have also risen rapidly. These trends are reflected in the estimates given in Table F, which take into account the cost estimates per hour presented in the recent FAO Farm Power Study. According to the 1976/77 ARTI survey, farm hire costs were higher in Polonnaruwa than in either Hambantota or the two Wet Zone districts. To take this into account, a 10% premium is added to farm power costs in Polonnaruwa. Table F: ESTIMATED FARM POWER RATES /a Maha 1972/73-79/80 (Rs per hour) Buffalo 2-Wheel Tractors 4-Wheel Tractors Maha 1972/73 1.7 6.0 19.5 1973/74 2.0 6.9 22.3 1974/75 2.4 8.6 27.9 1975/76 2.8 10.7 34.8 1976/77 3.1 12.4 40.4 1977/78 3.5 15.0 48.8 1978/79 /b 4.3 18.9 61.3 1979/80 5.4 24.0 78.0 Hours/acre Ic 32.5 8.0 4.0 Hours/day /c 5.0 8.0 8.0 /a Including cost of operator. /b 90% of FAO Farm Power Study estimates for mid-1979. /c Based on FAO Farm Power Study assumptions of 80 hrs/ha, 20 hrs/ha and 10 hrs/ha respectively. Source: Bank staff estimates, and FAO Farm Power Improvement Project, AG:DP/SRL/77/012, 1980.  - 51 - ANNEX I (c) Material costs. Selling prices for Government certified seed paddy have moved broadly in step with the GPS price, as shown in Table G. Only a minority of farmers use certified seed, and these tend to be confined to the larger more commercially-oriented farmers. To reflect this, seed costs in Kandy and Colombo are taken to be 90% of tf'ose given in the table. Table G also includes official retail selling prices for fertilizers used in paddy production. While there are minor variations by region, in practice a fairly uniform price has been maintained, with government agencies absorbing differences through cross-subsidization, and the overall level being set by government subsidy poli- cies. Prices of chemicals used in disease and pest control have risen rapidly, broadly reflecting trends in overall international prices. Table G: ESTIMATED COSTS OF MATERIAL INPUTS USED IN PADDY CULTIVATION: Maha 1972/73-79/80 Certified Seed Fertilizer/ Retail Prices Index of Paddy /a VI Basal Urea Chemical Prices Rs/Bushel Rs/cwt Rs/cwt 1972/73=100 Maha 1972/73 18.0 18.9 20.1 100 1973/74 30.0 26.1 26.6 120 1974/75 45.0 84.0 94.0 170 1975/76 45.0 72.9 94.0 180 1976/77 45.0 64.0 52.9 190 1977/78 45.0 56.3 50.4 230 1978/79 52.0 80.3 93.2 280 1979/80 52.0 66.0 49.8 350 /a Price prevailing in October-November period. 7T Price prevailing in October-December period. Source: Department of Agriculture, Department of Agrarian Services and Bank staff estimates. Overall Returns to the Farmer 12. Based on the physical relationships for the four alternatives estab- lished in Table C, and the price trends estimated in Tables D-G, it is possible to estimate overall returns from paddy production for the period Maha 1972/73 to 1979/80. These are summarized in Tables H to K. Because of the infrequency of adjustments to the GPS price, these tend to be fairly large (67% in 1973/74, and 21% in 1977/78). They, therefore, create, a series which is typified by a sudden increase in net returns, which are subsequently eroded by general cost inflation. This erosion has been particularly rapid over the last three years, reflecting the overall acceleration in the rate of inflation, although the effect of this on net farm incomes is probably overstated in the tables, given the upward drift in open market prices.  Table H: PADDY CROP BUDGET: POLONNARUWA (Rupees/acre) Quantity 1972/73 1973/74 1974/75 1975/76 1976/77 1977/78 1978/79 1979/80. GRuzi n_ 80 bushels 1440 2400 2640 2640 2640 3200 3200 3200 FARM COSTS Seed 1.5 bushels 27 45 68 68 68 68 78 78 Fertiliser: Basal 1.25 cwt 24 33 105 91 80 70 100 83 Urea 1.25 cwt 25 33 118 118 66 63 117 62 Pest and Disease Control - 25 30 43 45 48 58 70 88 Farm Power: Buffalo 40 hrs 75 88 106 123 136 154 189 238 2 wheel tractor - - - - - - - - 4 wheel tractor 4 hrs 86 98 123 153 178 215 270 343 Hired Labor 50 M/day 325 350 375 413 475 563 675 800 Other 5% 29 30 47 51 53 60 70 85 Total Farm Costs - 616 711 985 1,062 1,104 1,251 1,569 1,777 NET RETURN - 824 1,689 1,655 1,578 1,536 1,949 1,631 1,423 Net Return/manday of Family Labor 20.0 M/day 41 84 83 79 75 97 82 71 Net Return: 1972/73 prices a/- 824 1,504 1,380 1,301 1,229 1,415 1,105 796 a/ Deflated by the Colombo Cost of Living Index Source: Bank staff estimates.  Table I; PADDY CROP BUDGET: HAMBANTOTA (Rupees/acre) Quantity 1972/73 1973/74 1974/75 1975/76 1976/77 1977/78 1978/79 1979/80 GROSS RETURN 60 bushels 1080 1800 1980 1980 1980 2400 2400 2400 FARM COSTS Seed 2 bushels 36 60 90 90 90 90 104 104 Fertiliser: Basal 1 cwt 19 26 84 73 64 56 80 66 Urea 1cwt 20 27 94 94 53 50 93 50 Pest & Disease Control - 25 30 43 45 48 58 70 88 Farm Power: Buffalol 2 wheel tractor 10 hrs 60 69 86 107 124 1SO 189 240 n 4 wheel tractor 3 hrs 59 67 84 104 121 146 184 234 Hired Labor 37.5 M/days 244 263 281 309 356 413 488 581 Other 5% 23 27 38 41 43 48 55 68 * Total Farm Costs - 486 569 800 863 899 1,011 1,263 1,431 NET RETURN - 594 1,231 1,180 1,117 1,081 1,389 1,137 969 Net Return/manday of Family Labor 15.0 M/days 40 82 79 74 72 93 76 65 Net Return 1972/73 Prices aZ - 594 1,096 984 921 880 1,009 770 542 a/Deflated by the Colombo Cost of Living Index Source: Bank staff estimates.  Table J: PADDY CROP BUDGET: KANDY (Rtupees/acre) Quantity 1972/7i 1973/74 1974/75 1975/76 1976/77 1977/78 1978/79 1979/80 GROSS RETURN 60 bushels 1,080 1,800 1,980 1,980 1.980 2,400 .2.400 2,400 FARM COSTS Seed 1-5 bushels 24 41 61 61 61 61 70 70 Fertiliser: Basal 1 cwt 19 26 84 73 64 56 80 66 Urea 1 cwt 20 *27 94 94 53 50 93 50 Pest & Disease Control - 13 15 21 23 24 29 35 44 Farm Power: Buffalo 60 hrs 102 120 144 168 186 210 258 324 1 2 wheel tractor - - - - - - 4 wheel tractor - - - - - - - _ _ Hired Labor 41.5 234 255 276 308 340 383 446 531 Other 5% 21 24 34 36 37 39 49 54 Total Farm Costs - 433 508 714 763 765 828 1,031 1,139 NET RETURN - 647 1,292 1,266 1,217 1,215 1,572 1,369 1,261 Net Return/manday of Family Labor 42.5 M/day 15 30 30 29 29 37 32 30 Net Return: 1972/73 647 1,150 1,056 1,003 989 1,142 927 706 Prices a a/ Deflated by the Colombo Cost of Living Index. Source: Bank staff estimates.  Table K: PADDY CROP BUDGET: COLOMBO (Rupees/acre) Quantity 1972/73 1973/74 1974/75 1975/76 1976/77 1971/78 1978/79 1979/80 GROSS RETURN 40 bushels 720 1,200 1,320 1.320 1,320 1,600 1,600 1,600 FARM COSTS Seed 2 bushels 32 54 81 81 81 81 94 94 Fertiliser: Basal .75 cwt 14 20 63 55 48 42 60 50 Urea .75 cwt 15 -20 71 71 40 38 70 37 Pest & Disease Control - 13 15 21 23 24 29 35 44 Farm Power: Buffalo 30 hrs 51 60 72 84 93 105 129 162 2 wheel tractor 4 hrs 24 28 34 43 50 60 76 96 4 wheel tractor 1 hr 20 22 28 35 40 49 *61 78 Hired Labor 20 M/days 120 130 140 155 185 240 300 350 Other 5% 14 17 26 27 28 32 41 46 Total Farm Costs - 303 366 536 574 589 676 866 957 NET RETURN - 417 834 784 746 731 924 734 643 Net Return/manday of Family Labor 30.0 M/day 14 28 26 25 24 31 24 21 Net Return' 1972/73 Prices Al - 417 743 654 615 595 671 497 360 a/ Deflated by the Colombo Cost of Living Index Source: Bank staff estimates.  - 56 - ANNEX I 13. As might be expected, returns vary substantially, both over time and from area to area. Deflated by the Colombo cost-of-living index, the net return estimated for the current Maha (assuming a 20% increase in the index) ranges between 54 and 62% of that obtained in Maha 1977/78, the year after the last adjustment to the GPS price. This index almost certainly understates inflation rates in urban areas. The position in rural areas is more difficult to assess since this period coincided with a possible shift in the terms of trade in favor of the agricultural sector as a whole and rural areas were also less affected by increased costs of housing and similar items. The impact on surplus-producing farmers of increases in rural wages and farm power costs (in part themselves a reflection of the shift in the terms of trade) has already been taken into account in the estimates of net return. Nevertheless, the real value of the latter has also been affected by inflation. On balance, and for want of a better alternative, it has been assumed that the Colombo cost-of-living index gives a reasonable picture of the rise in prices for consumer goods purchased in rural areas - and may be closer to the actual position than in the case of urban areas. 14. The recent deterioration in real net return for surplus-producing farmers has clearly been substantial, even if - as suggested above - this tends to be overstated in these estimates in view of the upward movement in open market prices since 1977. For the subsistence sector, interpretation of Tables J and K is less straight-forward. Nevertheless, subsistence farmers have clearly faced increasing costs, particularly in Colombo. The manday equivalent required in alternative employment in order to finance these costs has declined in Colombo (from 65 mandays per acre in 1972/73 to 51 in 1979/80) since the wage rate has risen rapidly, but has increased in Kandy (from 79 man-day per acre in 1972/73 to 91 in 1979/80) where wages have risen at a more moderate rate. 1/ 15. Another way of presenting these results is by comparing the apparent return to family labor from paddy cultivation with the prevailing wage rate. This is shown in Table L. While the returns from paddy cultivation are still higher than from wage labor, the differential has declined and in the case of Colombo appears to be fairly narrow. The apparent returns to family labor given in Tables H to K in effect also include returns to land and management, and should presumably also cover any risk premium. It is not, therefore, unreasonable that they should be significantly higher than the returns from wage labor, and this is in any case almost certainly necessary in order to encourage the adoption of high return (but high cost) agricultural practices. 1/ Of course, labor also migrates from Wet Zone areas and, to the extent that wages received are higher than obtainable locally (Table E), these manday requirements may be overstated.  - 57 - ANNEX I Table L: RATIO OF RETURNS TO FAMILY LABOR FROM PADDY CULTIVATION- COMPARED TO PREVAILING WAGE RATE Polonnaruwa Hambantota Kandy Colombo 1972/7" 6.3 6.2 2.7 2.3 1973/74 12.0 11.0 5.0 4.3 1974/75 11.1 10.5 4.6 3.7 1975/76 9.6 9.0 4.0 3.2 1976/77 7.9 7.6 3.6 2.6 1977/78 8.6 8.5 4.1 2.6 1978/79 6.1 5.9 3.1 1.6 1979/80 4.4 4.2 2.4 1.2 /a Defined as the ratio of net return excluding costs of family labor to family labor manday input. Source: Bank staff estimates. 16. Major changes have occurred in the burden of relative costs (Table M). In 1974/75, fertilizer is estimated to have accounted for about 24% of farm costs (excluding family labor), but this had declined to about 9% by 1979/80. In contrast, the shares of hired labor (from 35% to 42%) and farm power (from 23% to 32%) have increased fairly sharply. During the same period, total farm costs (excluding family labor) rose from a level equivalent to about 40% of gross return to about 55%. In other words, the risks asso- ciated with paddy far ning have increased, and pressures are growing on the farmer to minimize costs, in particular those of labor and farm power. The effect of this on average yields is hard to assess, but presumably there will be a tendency for the high-yielding practices represented by the Polonnaruwa alternative to give way to less intensive agriculture, for instance, by econo- mizing on land preparation or by substituting broadcasting for transplanting. 17. Given the very low fertilizer prices, there will be a tendency to offset the effects of less intensive labor and farm power practices with the use of additional fertilizer. Table N summarizes various ratios of fertilizer profitability, all of which suggest that at present price levels fertilizer use is exceptionally profitable. They can be compared with the value:cost ratio of 3:1 normally considered adequate to encourage the spread of fer- tilizer use 1/, 2/ and to a somewhat lower ratio (2.5:1) which may be accept- able under conditions where fertilizer has generally been accepted. Thus, 1/ That is the cost of fertilizer should be about a third of the value of the additional rice output that can be attributed to the use of the fertilizer in order to offset the credit charges, risk and other factors that are involved in fertilizer use. 2/ The Report of the Fertilizer Promotion Project (Agrarund Hydrotechnik GMH, February 1978) suggests somewhat higher ratios of 4:1 for commercial farmers and 5:1 for smallholders.  - 58 - Table !I: STRUC-URE OF FARM COSTS: MAHA 1972/73 to 1979/80 - of Total Costs) 1972/73 1973/74 197.4175 1975/76 1976/77 1977/78 1978/79 19-9/80 Polonarruwa: Seed 4 6 7 6 6 5 5 4 Fertilizer 8 9 23 20 13 11 .14 a Peast and Disease Control 4 4 4 4 4 5 4 5 Farm Poer 26 26 23 26 28 29 29 33 Hired Labor 53 49 38 39 43 45 43 45 Other 5 5 5 5 5 5 5 5 Total Farm Costs 100 100 100 100 100 100 o00 :0 Total as X of Gross Return 43 30 37 40 42 39 49 56 Hatbantota: Seed 7 11 11 10 10 9 8 7 Fertilizer 8 9 22 19 13 10 14 a Pest and Disease Control 5 5 5 5 5 6 5 6 Farm Power 24 24 21 24 27 29 30 33 Hired Labor 50 46 35 36 40 41 39 41 Other S 5 5 5 5 5 5 5 Total Farm Costs 100 100 100 100 100 100 100 :00 Total as 1 of Gross Return 45 32 40 44 45 42 53 60 S3ed 6 8 9 8 8 7 7 5 Fertilizer 9 10 25 22 15 13 17 Pest and Disease Control 3 3 3 3 3 4 3 4 azP Pover 24 24 20 22 24 25 25 Is Mired Labor rI. lo L.An .4 LA 47 Other 5 5 5 5 5 5 5 5 Total Farm Costs 100 100 100 100 100 100 100 !00 Total as of Gross Return 40 28 36 39 39 35 43 _d Colombo: Seed 11 15 15 14 14 12 11 :0 Fertilizer . 10 11 25 22 15 10 15 9 Pest and Disease Control 4 4 4 4 4 4 a 5 Farm Power 31 30 25 28 31 32 31 35 Hired Labor 40 36 26 27 31 36 35 37 Other 5 5 5 5 5 5 5 5 Total Farm Costs 100 100 100 100 100 100 100 ;30 Total as %of Cross Raturn 42 31 41 43 45 42 54 60 Source: Tables R to K.  - 59 - ANNEX I while it is true that average fertilizer use remains well below recommenda- tions, the present high fertilizer subsidies almost certainly represent an unnecessary financial burden 1/ in terms of encouraging its further spread, and may well induce overuse and waste. /a Table N: VALUE COST RATIOS- FOR FERTILIZER USE Fertilizer Promotion Study Assuming Grain: Nutrient Assumptions/b Ratio is 7:1/c 1972/73 11.7 7.0 1973/74 14.5 8.8 1974/75 4.7 2.8 1975/76 5.0 2.8 1976/77 7.2 4.9 1977/78 9.6 6.2 1978/79 5.8 3.4 1979/80 8.9 6.3 /a The ratio of the additional value of rice output to the additional cost of fertilizer inputs. The net additional value would be slightly reduced by the higher harvest labor that would be required. /b Taken to be equivalent to 1.5 cwt of urea and 1.25 cwt of VI basal dressing yielding an additional 35 bushels per acre. /c For urea. Source: Bank staff estimates. 18. The combined effect on yields of increased fertilizer use together with reduced labor and farm power inputs cannot be satisfactorily assessed on the basis of the evidence available. A priori, the farmer will be tempted to substitute water for both farm power (Teading to delays in the Maha crop and reduced Yala intensities) and hand weeding (which would be aggravated by higher weed-inducing fertilizer applications). The returns from additional fertilizer may well, therefore, be limited by the lack of complementary farm inputs and the adverse effects of relative prices on water discipline. Such a result may be less marked in Wet Zone subsistence areas, since a greater proportion of labor inputs are supplied by the farmers' family. Nevertheless, as discussed above, the farm survey evidence suggests that even in these areas considerable hired labor and farm power are employed, with fertilizer account- ing for a small share of the total, so that the a priori argument remains essentially the same as in Dry Zone areas. 1/ The high subsidy on urea is in part due to the desire to make full use of the urea factory once it comes into operation during 1980.  - 60 - ANNEX I Farmgate and International Price Levels 19. The evidence presented above suggests that an adjustment to the GPS price is overdue and that the present distortions in the cost structure need to be corrected in order to encourage the balanced use of farm inputs. In assessing how large an increase is desirable, it is necessary to review not only the returns to the farmer, but also the relationship of the procurement price to import prices and to prices facing the consumer, and to the changing role of the GPS price in maintaining farmgate prices. 20. Table 0 summarizes projections of the structure of prices for the period 1979-82, based on World Bank projections of international prices and applying expected inflation rates to costs other than the rice base. The basis for these estimates is explained in the footnotes to the table and discussed in greater detail in Chapter II of this volume. The rapid projected increase in world rice prices provides considerable scope for increasing the farmgate price without distorting economic incentives in an absolute sense in favor of rice.  - 61 - ANNEX I Table 0: THE STRUCTURE OF RICE PRICES 1979/80 CROP YEAR AND PROJECTIONS FOR 1980/81-1982/82 Actual Projections 1979/80 1980/81 1981/82 1982/83 $ per metric ton: Rice FOB Bangkok /a n.a. 325 358 412 Freight etc. /b n.a. 27 30 32 CIF Colombo /c 281.5 352 388 444 Rs per lb: Rice CIF Colombo /d 1.99 2.49 2.74 3.14 Add: Harbor Dues, etc. /e 0.03 0.04 0.05 0.05 FC Costs /e 0.05 0.06 0.07 0.08 Costs of Retailing /e 0.10 0.12 0.14 0.16 Retail Price 2.17 2.71 3.00 3.43 Rs per bushel: Paddy Retail Price /f 65.9 82.32 91.1 104.1 Less: Costs of Retailing /e -3.0 -3.6 -4.2 -4.7 FC Costs /e -3.6 -4.4 -5.0 -5.6 PMB Costs /e -7.4 -8.9 -10.3 -11.5 Farmgate Equivalent 51.9 65.4 71.6 82.3 /a IBRD projections for milled 5% broken, adjusted by a factor of 0.7 to allow for quality differences. The IBRD calendar year figure is assumed to correspond to the delivered price in the following crop year. /b Inflated at IBRD projections of international prices, assuming a freight rate if $25 per metric ton in 1979/80. /c Actual delivered price 1980 on the basis of contacts signed in last quarter of 1979. /d Assuming an exchange rate of US$1 = Rs 15.6. /e Based on public sector costs (including profits) for early 1980, inflated at Bank staff estimates of domestic inflation. See Tables 8 and 9 for details of costs and margins. /f Assuming 46 lbs = 1 bushel, and an extraction rate of 66%. Source: Bank staff estimates.  - 62 - ANNEX I 21. Table P summarizes estimates of the farmgate price that would be required to ensure returns to the farmer equivalent in real terms to that achieved after the last adjustment to the GPS price in 1977 and to the average achieved over the period 1973/74-78/79. The estimates are given for three separate cases: (a) 1979/80, assuming farm costs are as estimated in Tables H to K. An increase for the current Maha would not significantly affect production, although it would maintain farm incomes and divert supplies to public procurement. To ensure incomes were equal to the average achieved in real terms over the period 1973/74- 78/79, the farmgate price would need to be increased to Rs 50-52/bushel. (b) 1980/81, assuming costs other than fertilizer rise at the general inflation rate, but that fertilizer prices remain constant. In this case, the farmgate price for the 1981 Maha crop would need to be about Rs 58-60/bushel to maintain average real farm incomes. (c) 1980/81, assuming costs other than fertilizer rise at the general inflation rate, but that fertilizer prices are tripled to bring them into line with expected border price equivalents (see below). In this case, the farmgate price would need to rise to about Rs 62-64/bushel to maintain real incomes in 1981. Table P: FARMGATE PRICES REQUIRED TO MAINTAIN REAL FARM INCOMES 1979/80 /a 1980/81 /b 1980/81 /b No Change in No Change in Threefold Increase Fertilizer Prices Fertilizer Prices in Fertilizer Prices To Equal Real Incomes in 1977/78 Polonnaruwa 53.8 63.5 67.1 Hambantota 53.9 61.7 65.6 Kandy 53.0 60.7 64.5 Colombo 53.9 61.7 66.0 To Equal Average Real Incomes in 1973/74-1978/79 Polonnaruwa 51.8 61.1 64.7 Hambantota 52.0 59.5 63.3 Kandy 50.1 57.4 61.2 Colombo 52.0 59.5 63.9 /a Assuming farm costs as in Tables H to K. /b Assuming an inflation rate of 15% for all costs other than paddy and fertilizer. Source: Bank staff estimates.  - 63 - ANNEX I 22. The farmgate prices suggested in Table P are within the limits set by expected border price equivalents (Table 0). In other words, real farm incomes could be increased beyond those obtained in recent years without exceeding border prices. 23. The increase in fertilizer subsidies implemented in late 1979 was in part designed to offset the impact of inflation in other inputs on net farm returns. However, its impact was fairly limited (see Tables H to K) and, as argued above, it distorted relative prices. Table Q provides projections of the structure of fertilizer prices over the period 1979/82. Assuming the new urea factory comes on stream as planned, the appropriate border price for urea corresponds to the commodity as an export. Even so, the farmgate equivalent price in 1980 is three times the current price. Expected farmgate equivalent prices for T.S.P. are similarly expected to be about three times the current price (Rs 67.7/cwt) and a similar ratio probably corresponds to the VI basal dressing for which no World Bank commodity price projection is available. Table P shows that, if fertilizer prices were increased to their full border price equivalent, then the farmgate price would need to be about Rs 4/bushel higher in 1980/81 to maintain real incomes. At a farmgate price of Rs 62/ bushel, the ratio of the value of increased output to fertilizer costs (assuming a grain:nutrient ratio of 1:7) would still be 3.2:1 for urea if the latter price was increased three-fold. The ratio would be a little less favorable for basal dressing but the overall incentives would probably be sufficient to encourage fertilizer use. At the expected border equivalent price for paddy, the incentives for fertilizer use would, of course, be very favorable even if fertilizer prices were at the full border equivalent price themselves.  - 64 - ANNEX I Table Q: STRUCTURE OF FERTILIZER PRICES: 1979-82 1979 1980 1981 1982 Urea $ per ton CIF Equivalent /a 173 196 218 241 Freight etc. /b 29 32 35 37 FOB Colombo 144 164 183 204 Rs per ton FOB Colombo 2,304 2,624 2,928 3,264 Harbor dues, etc. /c 75 91 104 117 Economic Price: Colombo 2,329 2,533 2,824 3,147 Rs per cwt. Economic Price: Colombo 118.6 128.9 143.8 160.2 Transport and Retail /c 17.8 21.6 24.8 27.8 Economic Price: Farmgate 136.4 150.5 168.6 188.0 T.S.P. $ per ton FOB Gulf /a 146 162 188 215 Freight /b 37 41 45 48 CIF Colombo 183 203 233 263 Rs per ton CIF Colombo 2,928 3,248 3,728 4,208 Harbor dues, etc. /c 75 91 104 117 Economic Price: Colombo 3,003 3,339 3,832 4,325 Rs per cwt. Economic Price: Colombo 152.9 170.0 195.1 220.2 Transport Retail /c 20.4 24.6 28.3 31.7 Economic Price: Farmgate 173.3 194.6 223.4 251.9 /a World Bank commodity projections /b Inflated at World Bank projections of international inflation. /c Inflated at Bank staff estimates of domestic inflation. Source: Bank staff estimates  - 65 - ANNEX I Conclusions 24. From the point of view of returns to the paddy farmer, an increase in the farmgate price is undoubtedly overdue. The analysis given above sug- gests that to maintain incomes from paddy production, the farmgate price would need to rise at least to Rs 50-52/bushel by mid-1980 and to Rs 58-60/bushel by mid-1981. If an increase in the fertilizer price also occurs, then the farmgate price by the same criteria would need to rise by up to an additional Rs 4/bushel depending on the extent to which the fertilizer price approaches the world price equivalent. In order to have an incentive effect on the next Maha crop, the expected mid-1981 farmgate price would need to be established before the next Maha sowing season. These estimates are based on the assump- tion that the Colombo cost-of-living index reflects actual consumption goods inflation rates facing the farmer. To the extent that this index tends to understate the true rate of inflation, they are on the conservative side. 25. In the analysis given in this annex, the GPS price has been taken as a proxy for the farmgate price, and under the conditions prevailing during much of the past decade, this has been realistic. Official procurement at the GPS price has regularly accounted for a large part of the marketed surplus, even if farmgate prices at non-peak periods and away from the main surplus areas have on occasion exceeded the GPS price. 26. However, the role of the GPS price is changing from that of a fixed procurement price to that of a floor price in a market increasingly dominated by the private sector. The changes involved are discussed in Chapter II where, taking into account the various issues involved, it is recommended that the GPS price should be increased to at least Rs 50/bushel to be announced before the next Maha sowing season. Such a price, if received by the farmer, would be insufficient to restore average net return in real terms during 1981 (see Table P). However, a significantly higher floor price, without corresponding adjustments to retail prices, might run the risk of adversely affecting the shift to private marketing. Provided this shift in the struc- ture of rice marketing works as expected, it is to be hoped that actual free market prices next Maha will in fact be above the newly-established floor price and that, therefore, net farm incomes will come closer in real terms to past levels.   - 67 - ANNEX II RETURNS TO THE COCONUT FARMER Introduction 1. This annex reviews returns to the coconut producer over the period 1972-79, relating these to trends in production and to the outlook for the sector. It assesses possible changes in the structure of export taxes with a view to reversing the long-term downward trend in production, but recognizes that coconut output is unlikely to expand rapidly, and that the most that can be hoped for is a slow recovery in the industry. Background 2. The area under coconuts is about 1.06 million acres, approximately equal to the combined area under tea and rubber. It contributes about 14% of agricultural value added and is the third largest export. Its contribution to exports has, however, been declining (from 13% in 1972 to 7% in 1978), largely reflecting declining production and increased domestic consumption which now accounts for 60-70% of total output. Coconut growing is essentially a small- holder activity and surveys suggest that 70-75% of all holdings are below 10 acres. Most smaller coconut holdings are operated on an owner-cultivator basis, but wage labor is more important on the larger farms. The dualistic ownership/ management structure, coupled with the part time nature of such involvement in coconuts, seriously limits the development potential of these lands. 3. Production of coconuts is estimated by adding an assumed domestic consumption of fresh nuts (90 nuts per capita per year--derived from the 1969/70 Socio-economic Survey) to the nut equivalent of production of copra, desiccated coconuts, coconut oil etc. Output estimates are, therefore, very uncertain. Table R suggests a decline of about 16% between 1960-64 and 1975- 79, an annual average of about 1%, but with considerable oscillation about this trend in response to weather conditions. Many variables have been asso- ciated with this decline, including: (a) Acreage. Annual acreage of coconut cultivation is not available, but according to one estimate, the area under coconuts was 1.15 million acres in 1962. The Agricultural Census, 1973, indicated a figure of 1.12 million acres, implying a decline of 3% over an eleven year period. Since then, further loss of acreage has occurred on account of housing, construction of roads, electric distribution network, and damage by droughts. The cyclone in November 1978 completely destroyed nearly 30,000 acres in the dis- tricts of Amparai, Batticaloa and Polonnaruwa. In all, about 50,000 acres (4.5%) may have been lost during the 1973-79 period, thus bringing down coconut acreage to around 1.07 million acres by 1979. 1/ The decline in acreage, 1/ Loss of coconut acreage on account of housing is estimated at 14,000 acres (at 3 coconut palms per household of 5 persons) and another 6,000 acres from other sources. With cyclone damage of 30,000 acres, total loss comes to 50,000 acres since 1973.  - 68 - ANNEX II though significant (7.5%) during the 1962-1979 period, cannot explain the large drop in output which was quite substantial (20.5% for the same period). Other factors must also have contributed in a big way. 1/ (b) Age Composition. According to a survey conducted in 1970, the percentage of trees in the age group 60 years or more was about 5% of the total. Another 15.3% were in the age group 46-60 years. By 1979, about 64% of the trees in this age bracket would have reached the age of 60 years or more, thus raising the percentage of old trees (60 and more) in the total stand from 5% in 1970 to 15% in 1979. According to the same survey, the area underplanted was estimated at 15.3%. Given the time lag of 10-14 years before newly planted palms come into full bearing, a maximum replacement of 11.5% is possible. 2/ If allowance is made for seedlings/ palms which may not have proved to be viable (15-40%), an effective replacement of 8-10% is estimated. 3/ This would mean that, at best, the age composition of coconuts has stayed at the same level (i.e. 15% minus 10% = 5%) as in 1970, or possibly deteriorated slightly (15% minus 8% = 7%). 4/ This may have contributed to a slight decline in output levels. (c) Land Reforms and Ownership Pattern. Land Reform (under Land Reform Law No. I of 1972) affected the coconut sector in two important respects. First, the estate sector, accounting for 27% of the acreage and a much larger share in production, may have been neglected in anticipation of Land Reform and the various uncertainties attached with it. Secondly, the lands taken over by the State (112,500 acres) were divided up between various institutions and organiza- tions, which significantly reduced the relative size of the generally well managed and high productivity estate sector. Thirdly, the new organization failed to enlist the experienced managers from the private estate era. These factors seem to have accelerated the process of deterioration in output levels. (d) Rainfall Conditions. It is generally held that rainfall condi- tions have deteriorated during the last 15 years or so, adversely 1/ Especially if loss of acreage has been concentrated on low productivity lands. 2/ A time lag of 12 years is assumed. During 1970-79, only 75% of the area newly planted or replanted would be in bearing. 3/ No precise figures on the rate of failures/non-viability of replanting are available. It is generally believed that the failure rate is quite high due to neglect and reluctance of smallholders to remove the original trees in time. 4/ Seedlings issued (11.2 million) during the 1970-79 period are not taken into account as they are unlikely to be in bearing, during the same period.  - 69 - ANNEX II affecting coconut production. Not only have droughts become more common, but seasonal rainfall distribution has also shown signs of more unevenness. No scientific analysis has, however, been attempted to demonstrate whether this has in fact affected moisture conditions and reduced production. (f) Fertilizer Application. As shown in Table R, fertilizer offtake started falling from a level of about 64,000 metric tons in 1970, declining to a low of 27,000 metric tons in 1975. Consumption stagnated at around 30,000 metric tons (or half the 1970 level) in 1976 and 1977. Fertilizer consumption seems to have recovered in 1978 and 1979. Year by year correlation of coconut production with fertilizer consumption is complicated by the lagged effect of fertilizer use on productivity and variations in rainfall. Other things being equal, however, the decline in fertilizer consumption seems to be the single most important factor associated with low coconut production in the 1970s. Some of the reasons generally mentioned for the drop in fertilizer consumption are: (i) reduction in the size of the estate sector (which used the bulk of the fertilizer); (ii) poor fertilizer availability during most of the 1970s; (iii) poor rainfall conditions and repeated droughts; and (iv) unfavorable trends in the economics of fertilizer application. This last cause may, in fact, have been the most decisive factor. Table R: COCONUT PRODUCTION AND FERTILIZER OFFTAKE Period Estimated Production Fertilizer Offtake (million nuts) ('000 metric tons) Five Year Averages 1960-64 2,645 44 1965-69 2,517 56 1970-74 2,394 50 1975-79 2,230 36 Annual Data 1970 2,510 64 1971 2,668 58 1972 2,818 48 1973 1,946 39 1974 2,030 39 1975 2,398 27 1976 2,330 31 1977 1,821 30 1978 2,207 42 1979 2,393 49 1980 (Forecast) 2,200 - Source: Central Bank of Ceylon and Ceylon Fertilizer Corporation  - 70 - ANNEX II Producer Returns and Production Incentives 5. An attempt is now made to identify various cost components involved in the cultivation of coconuts and to estimate financial return on coconut land over the period 1972-1980. Three broad categories of farmers/lands are assumed: low productivity (1,000-1,500 nuts/acre); medium productivity (2,000-3,000 nuts/acre); and high productivity (3,000-5,000 nuts/acre) - in order to differentiate (as far as possible) costs and returns on different types of lands and management practices. The position, as estimated in Tables S and T, can be discussed as follows. (a) Coconut prices are essentially determined by overall supply and demand conditions within a context set by heavy export duties and quantitative export restrictions (see paras 11-15). Largely as a result of adjustments to these, the domestic farmgate price for coconuts rose substantially between 1975-77. Since then, prices have remained within the range of Rs 800-1,000/1,000 nuts on average, although with signi- ficant seasonal variations reflecting the glut (May-October) and lean (November-April) periods, respectively. Prices in early 1980 appear to have been somewhat higher (Rs 1,100- 1,200/1,000 nuts) and this may be maintained or exceeded later in the year if, as expected, the Government allows an increase in the indicative price. (b) Cultivation costs are a fairly small proportion of gross returns, with labor and fertilizer costs representing the main components. Trends in unit costs are summarized in Table U. Wage rates in the period 1973-77 increased only modestly, but have since risen substantially. Fertilizer costs jumped in 1974 and 1978 when fertilizer prices were revised in response to changes in world prices. In the case of medium and high productivity lands (for which fertilizer costs are substantial), costs of production increased by 128% and 144% respectively between 1973 and 1979 (Rs 246 to Rs 560/acre and Rs 339 to Rs 827/acre). About 80% of the costs for lower productivity lands are for labor and, therefore, increased more slowly (by 91% from Rs 107 to Rs 204/acre). (c) Return per acre. Figures on operating surplus (market value of coconuts minus cultivation costs) show that returns per acre were highest in 1977 (Rs 1,000/acre on low productivity land, compared to Rs 1,927/acre and Rs 3,132 per acre on medium and high productivity lands, respectively), when costs had not risen to the present high level. As compared to 1977, returns per acre declined in 1978, but recovered slightly in 1979 as coconut prices improved. In real terms, however, discounted at the Colombo cost-of-living index (which may understate the true level of inflation), net returns were substantially (about 20%) lower in 1979 than in 1977. Tables S and T suggest further declines in 1980, assuming no change in farmgate prices. However, on the basis of trends established in early 1980, this may be overly pessimistic and a significant price rise during the year seems likely.  - 71 - Table S: ESTLDtATED AVTERAGE COST OF COCONUT PRODUCTION AND FINANCIAL RETTRN. ({,R|na^/acr.) 1973 1974 1975 1976 1977 1978 1979 1980 1. Lo' Productivity Land (Av. 1.250 nuts/acre) A. Costs Noarmal maintenance 54 58 58 59 64 90 106 131 Fertilizer application - - - - - - - - Weeding, soil and moisture conservation 31 34 33 34 36 50 60 74 Harvesting 16 17 17 17 19 27 32 40 Land tax 6 6 6 6 6 6 6 6 Total: 107 115 114 116 125 173 204 251 Labor 84 90 90 90 97 139 167 210 Materials 11 12 12 14 15 19 22 24 Others 12 13 12 12 13 15 15 17 3. Xevenue Gross income 425 725 400 562 1.125 1,025 1,187 1,187 C. O7erating Surplus 318 610 286 446 1,000 852 983 936 II. Medium Productivitv Land (Av.2,500 nuts7acre) A. Costs Normal maintenance 99 109 109 115 122 167 196 234 Fertilizer application 65 108 109 112 106 198 208 2:7 Weeding, soil and moisture conservation 51 54 54 55 60 84 100 123 Harvesting 25 27 27 27 29 42 50 62 Land tax 6 6 6 6 6 6 6 S Total: 246 304 305 315 323 497 560 6'2 Labor 135 146 146 146 157 224 269 336 Materials 62 106 106 111 105 195 203 '09 Others 49 52 53 58 61 78 88 97 3. Revenue Gross income 850 1,450 800 1,125 2,250 2,050 2,375 2,375 C. Operating Surolus 604 1,146 495 810 1,927 1,553 1,815 1,733 III. High Productivitv Land (Av.4,000 nuts/acre) A. Costs Normal maintenance 114 125 130 132 141 192 223 267 Fertilizer application 129 217 218 224 214 397 416 434 Weeding, soil and moisture conservation 60 65 65 66 72 101 120 i48 Harvesting 30 32 32 32 35 50 60 i5 Land tax 6 6 6 6 6 6 6 6 Total 339 445 451 460 468 746 327 930 LAbor 169 182 182 182 197 281 337 -21 Materials 121 210 210 219 207 385 399 .10 Others 49 53 59 59 64 80 91 99 B. Revenue Price(Rs./thousand nuts) 340 580 320 450 900 820 950 950 Gross income 1,360 2,320 1,280 1,800 3,600 3,280 3,800 3,300 C. Operating surnlus 1,021 1,875 829 1,340 3,132 2,534 2,973 ',830 "euorandum iten: Price of cocennuts ('a/thouaand units). 340 580 320 450 900 S20 950 950 Source: Estim.ates for the various cost components for che year 1979 were prepared on the basis of information provided by the Ministry of Coconut Industry and Coconut Development Authority. For other years, estimaces were based on the actual fertilizer prices and indices ror wages and materials (shown in 'able 9) Price of coconuts taken from the Central 3ank publicatton Economic & Social Statistics of Sri Lanka. For 1979 and 1980 estimates based on current 2arket prices.  Table T: NET RETURNS TO COCONUT FARMERS: 1973-80 1973 1974 1975 1976 1977 1978 1979 1980 Net Return: Current Prices - Rs/acre Low Productivity 318 610 286 446 1,000 852 983 936 Medium Productivy 604 1,146 495 810 1,927 1,553 1,815 1,733 High Productivity 1,021 1,875 829 1,340 3,132 2,534 2,973 2,870 Net Return: 1973 Prices-/ Rs/acre Low Productivity 318 543 239 368 814 619 666 524 Medium Productivity 604 1,020 402 668 1,568 1,128 1,229 969 High Productivity 1,021 1,669 673 1,104 2,549 1,840 2,013 1,605 - Net Return: Rs/manday Low Productivity 23 39 17 26 58 44 48 37 Medium Productivity 27 46 18 30 70 50 55 43 High Productivity 36 60 24 39 91 66 72 57 Ratio of Net Revenue/Cost b/ of Fertilizer Application 1.33 2.09 1.35 1.90 4.13 1.96 2.16 2.04 a/ Deflated at the Colombo Consumer Cost of Living Indexi this may understate actual inflation. F/ Prom Table V . Source: Bank staff estimates  - 73 - ANNEX II Table U: FERTILIZER PRICES, WAGE RATES AND OTHER COST ITEMS Fertilizer - Wage Rates - Other Costs - Year Rs/ton Index Rs/man-day Index Index 19g3 320 100 6.00 100 100 1974 618 193 6.50 108 112 1975 618 193 6.50 108 111 1976 641 200 6.50 108 124 1977 590 184 7.00 117 131 1978 1,170 366 10.00 167 171 1979 1,194 373 12.00 200 197 1980 1,194 373 15.00 250 238 /a Actual price data supplied by the Ceylon Fertilizer Corporation. In the case of price changes, the prices relevant to the Maha season were used. The costs are for coconut mixtures and differ from those used in relation to paddy in Annex I since they were heavily subsidized in the mid-1970s. /b Based on assumed average wage rates prevailing in the major cocounut producing areas, being broadly comparable to assumptions for paddy. /c Wholesale price index for intermediate goods prepared by Central Bank of Ceylon. Source: Bank staff estimates and as specified in notes to table. 6. With falling operating surpluses, producer margins and, hence, pro- duction incentives, are being eroded. This will adversely affect production as farmers would tend to reduce current inputs (such as fertilizer application and other inputs essential to good management practices). Probably the key input which affects production levels is fertilizer. Regular use of fertilizer (at the rate of 7-10 lbs/palm) can raise production by 1,000 nuts/acre which is almost 50% of the national average productivity level. Fertilizer off-take during the 1972-77 period was only sufficient to cover 11% of the total acreage. By taking into account problems of moisture and the financial position of farmers, regular fertilizer use should be possible on at least 50% of the total acreage, implying a potential consumption of 160,000 metric tons. Although, fertilizer consumption has picked up more recently (over 50,000 tons in 1979), it is still much below the achievable potential. For any rational production strategy, enhanced use of fertilizer should receive top priority. Whether farmers would actually be interested in increasing fertilizer applica- tion depends, however, on the economics of fertilizer use. 7. Table V shows the costs and returns per acre of fertilizer use for the 1973-80 period. The ratio of net revenue to total costs of fertilizer application during the period 1973-76 averaged only 1.95. The ratio of gross revenue to total costs of fertilizer was 2.81 (this corresponds more directly to the estimates for paddy -- see Annex I, Table N). In 1978 and 1979, these  Table V: ESTIMATED RETURN ON FERTILIZER USE ON ONE ACRE OF (AVERAGE) COCONUT LAND (Rupees) 1973 1974. 1975 1976 1977 1978 1979 1980 A. Cost Fertilizer 92 177 177 183 167 334 341 341 Transport 2 2 2 2 3 4 5 6 Labor cost for application 35 38 38 38 41 58 70 88 Total 236 217 217 223 211 396 416 435 B. Additional Output (nuts/acre) 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 C. Market price (Rs./nut) 0.34 0.58 0.32 0.45 0.90 0.82 0.95 0.95 D. Value of Additional Output 340 580 320 450 900 820 950 950 E. Plucking & Handling costs 25 27 27 27 29 42 50 62 F. Net Revenue (Rs./acre) 315 453 293 423 871 778 900 888 G. Ratio of (net) revenue/cost of fertilizer application 2.44 2.09 1.35 1.90 4.13 1.96 2.16 2.04 H. Ratio of gross revenue/costs of fertilizer 3.70 3.27 1.81 2.45 4.91 2.46 2.79 2.79 Source: Based on actual prices of fertilizer and Bank staff estimates of labor and other costs.  - 75 - ANNEX II ratios were at or above the average 1/. This, coupled with better avail- ability of fertilizer, led to a recovery in fertilizer off-take (average of 46,000 metric tons as against 37,000 metric tons during the 1972-76 period). Table V suggests a slight deterioration in 1980 due to rising costs of labor and transport - this is, however, likely to be offset by the higher prices actually now expected (see above). 8. If fertilizer application in the coconut sector is to be increased to cover a large part of the area, a return of three rupees is probably desir- able for every rupee spent on fertilizer use. An adequate return is partic- ularly important in view of the fact that the sector is dominated by small- holders and the impact of fertilizer on output is felt after a lag of two years, while changing rainfall conditions can enhance risk of causing large variations in productivity. If this is accepted as the basis for determining adequate levels of incentives for farmers, coconut prices for 1980 would need to be at least Rs 1,350-1,400/1,000 nuts at the farmgate or a market price which is perhaps 10% higher. 9. If fertilizer prices increase, then the farmgate price for coconuts would have to be correspondingly higher. If fertilizer prices were to increase three-fold to approach their border price equivalent, as suggested in Annex I, then the farmgate price in 1980 for coconuts would have to be no less than Rs 3,400/1,000 nuts to maintain a ratio of net revenue to total costs of 3:1 (Rs 2,850/1,000 nuts for a ratio of 2.5:1). Such a large increase in farmgate price would be unsustainable and would exceed the border price equivalent (see below). Nevertheless, fertilizer use would still be justified on national economic costs since benefits at border prices would still exceed the cost of fertilizer, even if such returns are substantially lower than the comparable returns for paddy (see Annex I, Table N). 10. The differences in returns for paddy and coconuts (and the other major tree crops - tea and rubber - given heavy export taxation), provides a dilemma in setting fertilizer prices. To some extent, prices for coconut mixtures can be set lower than those for paddy. Differentiating fertilizer prices in this way has been attempted in the past, but there are inevitable limits to which this can be effective. Other schemes, such as the specialized credit scheme for coconut fertilizer, could also play a part. In practice, full border pricing of fertilizer is unlikely to be implemented immediately. What is important from the point of view of coconut production is that any increases in fertilizer prices are compensated by further hikes in the farmgate price and that the ratio of net returns to total cost of fertilizer application (Table V) remains at least as favorable as, say, 2.5:1. 1/ The ratios for 1977 were probably favorable, but were quite unusual.  - 76 - ANNEX II Export Policies and the Structure of Duties 11. Current export policies have been designed to achieve two goals: (i) to maintain adequate domestic availabilities of coconuts and essential coconut products at reasonable prices to the consumer; and (ii) to maximize foreign exchange earnings, and contribute to budgetary revenues, by main- taining the export price at a level which has been substantially higher than the domestic cost of production. In implementing these policies, the export of coconuts and poonac have usually been totally restricted, while exports of coconut oil and copra are controlled. In addition, important coconut pro- ducts, such as desiccated coconut, coconut oil, and copra, are subject to heavy export duties (both specific export duty and a levy) which completely insulate the domestic market from international influences at any given point of time. Any increase in world prices is absorbed in the variable levy, and the price to the shipper is, therefore, effectively fixed. 12. Table W summarizes Coconut Marketing Board (CMB) estimates of the structure of coconut oil/poonac prices, assuming the coconut oil is exported and the poonac is sold on the domestic market at the official price. Table X summarizes comparable estimates by the CMB for desiccated coconut. No allowance is made for returns from the non-kernel products (coir and shell) and to this extent the value of the coconuts to the farmer is understated.  - 77 - ANNEX II Table W: ESTIMATED STRUCTURE OF PRICES FOR COCONUT OIL/POONAC August 1978 January 1979 November 1979 Coconut Oil: Rs./metric ton Export Price 9,525 13,050 13,311 Less: Customs Duty (fixed) -1,650 -1,650 -1,650 Admin. Levy (variable) -2,175 -4,300 -2,711 Industrial Dev. Fund -100 -100 -100 Shippers Margin -100 -100 -100 Coconut Oil Price 5,500 6,900 8,750 Poonac: Rs./metric ton Poonac price 800 1,200 800 Rs per 8,000 nuts equivalent /a Composite price to miller 5,900 7,500 9,150 Less: Millers Cost and Margins -350 -350 -700 Copra Curing Costs -350 -350 -450 Implicit Price 5,200 6,800 8,000 Rs per 1,000 nuts Indicative Price 650 850 1,000 Border Price Equivalent /b 2,140 2,140 2,260 /a 8,000 nuts is equivalent to one metric ton of coconut oil and 9.5 metric tons of poonac. /b Assuming poonac export price equivalent to Rs 3,000/metric ton (see Table Y). Source: Coconut Marketing Board and Bank staff estimates.  - 78 - ANNEX II 13. The CMB estimates demonstrate the burden of export duties. These were adjusted in January 1979 and again in November in order to allow an increase in the indicative price to the farmer (the price the farmer the- oretically obtains for a given duty structure). Actual prices were in fact higher on the local market in 1978 than the 1978 indicative rice (see Table S), reflecting shortages on the local market at that time. Although this can occur, the indicative price more normally acts as a ceiling since any higher price to the farmer results in a loss to the exporter (assuming the various margins are fixed on an actual basis). It does not, however, necessarily fix a floor price since quantitative restrictions can result in a seasonal glut on the local market (especially during April-July). A way to tackle this problem would be to maintain export duties/levies at a level which ensures (desired) incentives while removing all quantitative restrictions. This would remove the rigidities of Government intervention and should make the 'indicative' price effective but would also, of course, lead to higher retail prices for coconuts and coconut products. 14. While the fixed duty accounts for a larger proportion of the total tax in the case of desiccated coconut, the overall duty structures for coconut oil and desiccated coconut are both set to obtain the same theoretical indica- tive price. Whether they do depends not only on local competitive conditions Table X: ESTIMATED STRUCTURE OF PRICES FOR DESICCATED COCONUT August 1978 January 1979 November 1979 April 1980 Rs./metric ton Export price 15,000 20,250 21,420 21,726 Less: Customs Duty -6,450 -6,450 -6,450 -6,450 Admin. Levy -2,250 -6,320 -6,020 -6,326 Industrial Dev. Fund -100 -100 -100 -100 Shippers Charges -880 -880 -1,250 -1,250 Desiccated Coconut Price 5,320 6,500 7,600 7,600 Rs per 6,700 Nuts Equivalent /a Millers Fund -200 -200 -200 -200 Millers Margin -300 -300 -400 -400 Millers Costs -200 -200 -200 -200 Implicit Price 4,620 5,800 6,800 6,800 Rs per 1,000 Nuts Indicative Price 650 850 1,000 1,000 /b Border Price Equivalent 1,929 2,730 2,834 1,871 /a 6,700 nuts is equivalent to one metric ton of desiccated coconut. /b Actual market prices were in the range of Rs 1,100-Rs 1,200. Source: Coconut Marketing Board and Bank staff estimates.  - 79 - ANNEX II (including seasonal effects which for a bulky commodity like coconuts can be considerable), but also on whether the margins and costs allowed reflect the true position. Those for desiccated coconut appear to be more generous and the CMB argues that this is so because of the riskier nature of the business. This justification is uncertain. There is a danger that Government interven- tion in this way may distort relative incentives within the industry and the effect of quantitative restrictions may well have a similar effect. This argues for a more flexible system, including (as suggested above) the aboli- tion of quantitative restrictions. 15. Table Y summarizes World Bank projections of the structure of prices for coconut oil/poonac 1/ (assuming the latter was also allowed to enter world trade). The current indicative price -- even after adjustments in 1978 and 1979 -- is well below the border price equivalent. Oil prices are expected to weaken during 1980, (and preliminary information suggests that in early 1980 they were even lower than expected), but even so on the basis of these expectations are 72% higher than an indicative price of Rs 1,000/1,000 nuts. Thereafter, both oil and poonac prices are expected to strengthen and the gap will thus widen. A farmgate price of Rs. 1,350-1,400 nuts (as suggested above) would be within the border price equivalent expected in 1980, even if oil prices prove lower than expected, since this is likely to be offset in part by higher prices of poonac. Further increases in subsequent years would certainly become necessary to take account of inflation and any increase in fertilizer prices, but again the scope for such increases in relation to the border price is likely to be considerable. The official domestic price of poonac (Rs. 800/metric ton) is particularly out of line with world market prices, although local free market prices of poonac are already substantially higher. 1/ The corresponding export price projections for desiccated coconut are not available.  - 80- ANNEX II Table Y: STRUCTURE OF PRICES FOR COCONUT OIL/POONAC, 1979-1985 1979 1980 1981 1982 1985 Coconut Oil: Rs./metric ton Export Price /a 15,680 13,770 16,100 16,460 19,820 Less: Shippers Margin /c -100 -120 -140 -155 -205 Coconut Oil Price 15,580 13,650 15,940 16,305 19,615 Poonac: Rs./metric ton Export Price /b 3,000 3,110 3,970 4,090 5,470 Less: Shippers Margin /c -100 -140 -140 -155 -205 Poonac Price 2,900 2,990 3,830 3,935 5,265 Rs per 8,000 Nuts Equivalent /d Composite Price 17,030 15,145 17,855 18,275 22,250 Less: Millers Costs' Margins /c -700 -845 -975 -1,090 -1,450 Copra Curing Costs /c -450 -545 -625 -700 -930 Implicit Price 15,880 13,755 16,255 16,485 19,870 Rs per 1,000 Nuts Border Price Equivalent 1,985 1,720 2,030 2,060 2,485 /a Equivalent to 95% of World Bank projection for Philippines/Indonesia cif Europe. 1979 actual average price for coconut oil. /b Equivalent to 90% of World Bank estimate for Coconut Pellets in 1979, projected at rate of increase of soya meal. /c Inflated at expected domestic inflation rate. /d 8,000 nuts is equivalent to one metric ton of coconut oil and 0.5 metric tons of poonac. Source: Bank staff estimates Conclusions 16. Adequate incentives for fertilizer use are the most direct instru- ment for reversing the downward trend in coconut production. If fertilizer prices remain at the present level, it has been suggested that as a minimum coconut prices to the farmers should be allowed to increase to Rs. 1,350/1,000 nuts. This would provide a ratio of net revenue to additional costs of fer- tilizer of about 3.0:1. It would be desirable to associate such an increase with the abolition of quantitative restrictions on coconut products to ensure greater effectiveness to the indicative price. Although this might lead to exports during the glut season, and greater scarcities during the lean season, the Government could take complementary measures to offset this (e.g. by allowing imports of competing oils or extending its buffer stock operations). A review of the costs and margins in the different processing sectors is also desirable to ensure that the duty structure does not discriminate between the differing products.  - 81 - ANNEX II 17. In the longer term, further adjustments in farmgate prices will un- doubtedly become necessary and if the distortions relative to substitute crops are to be removed, and fertilizer prices to the paddy farmer (Annex I) are to be increased, then it may be necessary to allow them to approach the border price equivalent. The guiding principal might be to ensure that the ratio of net revenue to costs of fertilizer application remains at least at 2.5:1 and, preferably, at 3:1. 18. The extent to which such an increase in prices occurs will depend on the Government's assessment of the balance between consumer and producer interests, since coconuts are both a major direct consumption item and also influence the price of other items (e.g. that of milk through the very low poonac price). Adjustments to the price of both fresh coconuts and coconut oil would have a direct adverse impact on the real incomes of all consumers. An adjustment to the poonac price would cause an outcry by the livestock industry (as it did the last time poonac prices were allowed to increase) and would require corresponding increases in milk prices, again with adverse effects on consumers. 1/ Such increases may, therefore, have to be imple- mented cautiously, even if they are necessary to restore coconut incentives, and to remove distortions in the promotion of competing crops. 19. For the longer term, adequate incentives will be a necessary but not a sufficient condition for growth in coconut production. Given its predominant- ly smallholder characteristics, the industry is unlikely to be able to generate sufficient investment funds to ensure the long-term health of the sector. The Government operates a range of subsidy programs designed to assist the small- holder in undertaking such investments including (i) the coconut rehabilita- tion program; (ii) the coconut replanting and underplanting programs; (iii) the intercropping programs, including promotion of pastures under coconuts; and (iv) the supply of subsidized seedlings, especially for houseplots, etc. This annex has concentrated on the incentive issue. This is not, however, intended to suggest that longer-term subsidy programs are not equally important to ensuring the future viability of the coconut sector. 1/ The most recent information is that poonac prices have in fact been allowed to increase, but that milk prices have not been adjusted.