Sri Lanka - Smallholder Rubber Rehabilitation Project

Document of The World Bank FOR OFFICIAL USE ONLY FILE COPY Report No. P-277 7-CE REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A PROPOSED CREDIT TO THE DEMOCRATIC SOCIALIST REPUBLIC OF SRI LANKA FOR A SMALLHOLDER RUBBER REHABILITATION PROJECT April 16, 1980 This document hes . restricted dntstibution end mys be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed wvithout World Bank autbioriz tbon  CURRENCY EQUIVALENTS US$1 = Rs 15.5 1/ Rs 1 = US$0.064 Rs 1 million = US$64,102 WEIGHTS AND MEASURES 1 acre (ac) = 0.405 hectare (ha) 1 mile (mi) = 1.609 kilometers (km) 1 square mile (sq mi.) = 640 ac (259 ha) 1 foot (ft) = 30.5 centimeters (cm) ABBREVIATIONS AND ACRONYMS ARTI - Agrarian Research and Training Institute ASD - Advisory Services Department CPD - Commodity Purchase Department DRC - Department of Rubber Control GPC - Group Processing Center JEDB - Janatha Estates Development Board MPI - Ministry of Plantation-Industries PCU - Project Coordination Unit RPPU - Rubber Policy and Planning Unit RPRC - Rubber Policy Review Committee RRISL - Rubber Research Institute of Sri Lanka RSS - Ribbed Smioked Sheet SPC - State Plantations Corporation FISCAL YEAR January 1 - December 31 1/ At the time of appraisal. Current exchange rate is US$1 = Rs 16.30.  FOR OFFICIAL USE ONLY SRI LANKA SMALLHOLDER RUBBER REHABILITATION PROJECT Credit and Project Summary Borrower: The Democratic Socialist Republic of Sri Lanka. Amount: US$16 million equivalent. Terms: Standard. Project Description: The project aims to increase rubber production in Sri Lanka through the acceleration of an ongoing program of replanting over-aged, low-yielding smallholder rubber. It would strengthen the agencies involved in smallholder rubber production and provide adequate replanting inputs and incentives. The project also includes improvement in rubber processing standards, expanded training facil- ities and technical assistance. The project faces no major risk. The problem of constrained implementation capacity has been addressed by building up replanting targets slowly over the project implementation period. Estimated Cost: 1/ US$ Million Equivalent Local Foreign Total A. Replanting Costs 9.0 3.5 12.5 B. Institutional Support Advisory Services Department (ASD) 1.8 1.0 2.8 Department of Rubber Control (DRC) 0.5 0.1 0.6 Subtotal 2.3 1.1 3.4 C. Training and Technical Assistance 0.2 0.3 0.5 D. Processing and Research 0.2 0.2 0.4 E. Project Coordination and Evaluation 0.1 0.1 0.2 Base Cost 11.8 5.2 17.0 Physical Contingencies 0.4 0.1 0.5 Price Contingencies 8.4 2.1 10.5 Total Project Cost 20.6 7.4 28.0 1/ Includes taxes and duties of US$0.25 million equivalent. 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.  Financing Plan: IDA 8.6 7.4 16.0 Government 12.0 - 12.0 Total 20.6 7.4 28.0 Estimated Disbursement: IDA FY 1981 1982 1983 1984 1985 1986 Annual .8 1.3 1.9 2.6 3.9 5.5 Cumulative .8 2.1 4.0 6.6 10.5 16.0 Economic Rate of Return: 23% Staff Appraisal Report: No.2827-CE, dated April 15, 1980  INTERNATIONAL DEVELOPMENT ASSOCIATION REPORT AND RECOMMENDATION OF THE PRESIDENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED CREDIT TO THE DEMOCRATIC SOCIALIST REPUBLIC OF SRI LANKA FOR A SMALLHOLDER RUBBER REHABILITATION PROJECT 1. I submit the following report and recommendation for a proposed development credit to the Democratic Socialist Republic of Sri Lanka for the equivalent of US$16.0 million on standard IDA terms to help finance a smallholder rubber rehabilitation project. PART I - THE ECONOMY 1/ 2. The most recent economic report, "Development in Sri Lanka: Issues and Prospects" (Report No. 1939-CE, March 22, 1978) was distributed to the Executive Directors on March 23, 1978. An economic mission visited Sri Lanka in December 1979 to prepare an economic report which is scheduled for distri- bution in May 1980. This section draws on the preliminary findings of that mission. Country Data are provided in Annex I. 3. After several years of relative stagnation, Sri Lanka's economy is experiencing rapid growth and unprecedentedly high levels of savings and investment. This remarkable turnaround is explained by the Central Bank of Ceylon as the "spontaneous reaction of a long repressed economy to its liberalization by the new economic policies initiated in 1977." Until 1977, Sri Lanka's growth performance was below both need and potential. Although GDP growth in the 1960s, at 4.4% per annum, was above the average for low income countries, growth slackened sharply in the 1970-77 period to 2.9% per annum, just below the average for low income countries. Through much of this period, the terms of trade deteriorated steadily, eroding even these modest gains: as a consequence, per capita gross national income rose by a mere 0.9% per annum during the 1960-76 period. The slowdown in economic growth in the 1970-77 period is attributable to a combination of factors, including inadequate investment, poor management of the economy and a policy environ- ment unconducive to growth and investment, which were compounded by bad weather and a sharp rise in the cost of imported food and fuel. 4. The three tree crops--tea, rubber and coconuts--which are still the mainstay of the economy, suffered from low replanting and inadequate in- centives. These problems were exacerbated by a dual exchange rate, introduced in 1968, that discriminated against these crops, and by the uncertainties surrounding a protracted nationalization (1972-75) of the larger estates. After the exceptional output growth of the 1960s, rice yields and cropping 1/ This part is substantially the same as Part I of the Report and Recommen- dation of the President to the Executive Directors on a proposed credit to the Democratic Socialist Republic of Sri lanka for a Road Passenger Transport Project, Report No. P-2721-CE dated February 27, 1980.  - 2 - intensities declined in the 1970s due to poor institutional support. Invest- ment in manufacturing was low, and the inefficiency of most public and private sector firms nurtured in a highly protected environment resulted in industrial growth of less than 2% per annum. The only bright spots were subsidiary food crops and industrial exports which benefited from good incentives. 5. An inadequate public savings effort, caused by inelastic revenues and an uncontrolled increase in recurrent expenditures, inhibited public investment. Private savings and investment were constrained by an unfavor- able policy environment. The high incremental capital output ratio in the 1970s (5.5 as against 3.5 in the 1960s), reflected the fact that the invest- ment that did take place was both inefficient and highly capital intensive. 6. The poor growth rates and the slow changes in the structure of output matched neither the jobs nor the changes in employment structure that the labor force required. Slow output growth, the excessive capital intensity of investment, the mismatch between the job aspirations of those with post- primary education and the jobs available to them, the post war demographic bulge, and rising female participation rates contributed to a massive increase in open unemployment, estimated at over 1 million, or nearly 20% of the labor force in 1977. 7. In sharp contrast to this poor economic performance, Sri Lanka's social achievements in relation to per capita income have been outstanding. Sri Lanka has about one and one-half times the life expectancy, almost thrice the literacy, one-quarter the infant mortality and half the birth rate that would be expected for a country at its per capita income level. Nutrition levels have been adequate, and in the 1960s there were parallel gains in income distribution. 8. Improvements in the quality of life, in particular the rise in health standards, the spread of education and the availability of subsidized food, have been important factors in the decline in mortality. The increasing age of marriage, the spread of female education and employment, and a vigorous family planning program, have also contributed to a sharp decline in fertility. As a consequence, the growth rate of population has dropped from 2.6% per annum in the 1953-63 intercensal period to 2.0% per annum in the 1963-73 period. Allowing for net migration, population is currently increasing at only 1.7% per annum. 9. The gains in the social field were made possible by favorable initial conditions. Compulsory primary education was introduced as early as 1901. The food ration was introduced in 194:2. Thus, at the time of Independence in 1948, Sri Lanka already enjoyed high levels of adult literacy and life expectancy. These initial gains were consolidated and expanded in the post-Independence period through large expenditures on social services and the food subsidy, which accounted for two-fifths to one-half of government revenues in the 1960s and early 1970s. These expenditures were traditionally financed by harnessing the surpluses of Sri Lanka's three major tree crops (tea, rubber, and coconut), which provided the Government with both an easy revenue source and foreign exchange earnings. These surpluses began to disappear in the late 1960s as government policies discriminated against these crops and the terms of trade  -3 - deteriorated. With growth in other productive sectors in the economy also decelerating in the 1970-77 period, the budgetary resources available for social programs were squeezed by inelastic revenues and rapid inflation. As a consequence, expenditures on social services other than the food subsidy began to decline as a proportion of total current expenditures and GDP, threat- ening the hard-won gains in health and education. In sum, the economy was no longer generating the resources needed to sustain a large program of welfare expenditures. Moreover, the very size of those programs reduced the scope of policy makers to shift resources to development. 10. The policy changes introduced in 1977, following the election of the United National Party, were intended to break this vicious circle. The new Government identified its objectives as the revival and resuscitation of the economy and increased employment through (i) increased capacity utili- zation in the productive sectors, (ii) stimulation of savings and investment, and (iii) efforts to encourage exports and import substitution in foodgrains. A program of policy reforms was developed in close consultation with the IMF. Its principal aim was to dismantle controls over resource allocations and initiate price adjustments with a view to establishing more realistic relative prices. These reforms were supported initially by an IMF standby arrangement covering 1978 for SDR 93 million. On January 26, 1979, the Fund's Executive Board approved an SDR 260 million Extended Arrangement covering the 1979-81 period. 11. The following broad policy reforms have been introduced: Exchange Rate Reform: The exchange rate was unified on November 16, 1977 at a depreciated rate of Rs 16 = US$1.00 and allowed to float. This implied a depreciation of 46% against the official rate prevail- ing prior to unification, 11.2% with respect to the Foreign Exchange Entitlement Certificate rate, and 29.5% with respect to a transactions- weighted average rate of the two markets. 1/ Import Liberalization: The trade and payments regime was liberal- ized. With the exception of foodgrains and petroleum products, public sector import monopolies were terminated. Prior licensing of imports was abolished for all but a handful of commodities. The tariff structure was revised and simplified. Interest Rate Reform: To encourage financial savings and discourage speculative imports, interest rates were raised sharply. Price Controls: These ended for most commodities. Budgetary Policies: The unification and depreciation of the exchange rate caused tree crops export tax revenues and the cost of food, fertilizer and petroleum subsidies to rise sharply. Business Turnover 1/ Prior to unification, all exports other than tea, rubber and coconut products and all imports other than food, fertilizers and drugs were channelled through the certificate market. Since November 1972, the FEEC rate was maintained at a 65% premium over the official rate.  - 4 - Tax rates were substantially lowered and rationalized to be con- sistent with the new import tariff and exchange rate. To limit the increase in cost of food subsidies, rice and sugar rations were initially confined to the poorer half of the population, and the subsidy on imported wheat flour was reduced through a series of adjustments in the domestic price. On September 1, 1979 the Gov- ernment introduced a system of food and kerosene stamps for families with monthly incomes less than Rs 300 to replace specific food sub- sidies and rationing, and to target benefits to the poorest. Ini- tially about seven million persons were issued with food and kero- sene stamps. To offset the adverse impact of these changes on real incomes, public sector wages have twice been adjusted upwards, and in February 1978 an income supplement was introduced at Rs 50 per month to benefit the poorest households in which one or more persons had no gainful employment. Public corporations were asked to pass on cost increases, except in the case of fertilizer, petroleum, milk and public transport, where price increases were initially deferred to cushion the impact on consumers. The Government has subsequently made sizable adjustments in flour, rice and sugar prices, bus fares, and petroLeum prices. The burden of subsidies and transfers has, as a consequence fallen from around 9% of GNP in 1978 to around 5% in 1980. These changes, taken together with higher aid receipts, have permitted a sizable step up in capital expenditures. Tax Reform: The tax structure has been rationalized and simplified with a view to increasing the elasticity of revenues. The burden of personal and company taxation has been lowered. Agricultural Pricing Policies: The domestic procurement price for rice was increased by 21%. With the related increase in flour prices, incentives for paddy and other flour substitutes benefited. Fresh coconut prices have also been increased by 30% and the export duty on coconut products has been appropriately adjusted. While the uni- fication of the exchange rate ended formal discrimination against tree crops, the export duty on tea was initially set at a level which effectively siphoned off most of the benefits to the Government. As tea prices fell and production costs rose in 1978-79, the Government responded to the reduced producer margins by a lowering of taxes on tea. Further adjustments in both the structure and level of tea taxation will be needed to maintain and improve incentives. 12. The economic reforms have been accompanied by a major effort at stepping up public investment. The Government's capital expenditures jumped from 6% of gross national product at market prices in 1977 to an average of 13% in 1978 and 1979, as government departments responded to an improved budgetary resource position by embarking on long overdue replacement invest- ments and new projects that had been shelved earlier for lack of resources. The Government has also embarked on four major new programs which are to be the lead projects in a five-year rolling public investment program. These are: (i) Accelerated implementation of the Mahaweli Ganga Development Program, by  - 5 - far the largest multi-purpose river basin development ever undertaken in Sri Lanka; (ii) a 200 square-mile free trade zone north of Colombo under a newly constituted Greater Colombo Economic Commission which has established the first Investment Promotion Zone near Colombo's international airport, Katuna- yake, and is planning others, and has approved some 92 proposals involving a total investment of US$176 million by December 1979; (iii) a massive housing and urban renewal program with its main focus on the Colombo metropolitan region; and (iv) the construction of a new capital complex at Kotte, a suburb of Colombo. 13. These four programs will together cost an estimated Rs 25 billion, or 43% of the projected Rs 60 billion public investment program over the 1980-84 period. The Government's tentative macro-economic scenario envisages public investment taking one-half of total investment which is expected to average an ambitious 23% of GNP in 1980-84 as against 16% in the early 1970s. To enable this increase to materialize, gross domestic savings are expected to average 16.3% of GNP, and net external inflows nearly 7%. This implies a substantial increase in external inflows which averaged 2.3% of GNP in the 1970-76 period. Official development assistance is to finance 54% of public investment. 14. The underlying public investment strategy is to balance the large investment requirements of the Government's high priority programs against the urgent rehabilitation and fresh investment needs in other sectors. The main thrust of the public sector program is to lay the foundation for longer term development, both by improving the efficiency of use of existing infrastructure investments and by expanding the longer term growth capacity of the economy. The strategy thus implicitly relies on the private sector to respond to the economic reforms and the stimulus of the public sector investment program, and provide much of the short-term growth. 15. The initial response of the economy to the policy reforms and the accompanying acceleration in public investment has been encouraging. Economic growth between 1977 and 1980 is estimated at an impressive 6.7% per annum. This growth has been shared by almost all sectors of the economy, with the most dynamic sectors being construction, mining and quarrying, electricity, gas and water and manufacturing. The only major exception has been the tree crop sector. This impressive performance is due to a number of factors including the improved availability of inputs following import liberalization, an increased role for the private sector in distribution, and the removal of price controls. 16. Domestic savings reached 15% of GNP in 1978 and 1979, well above historical levels. Financial savings, as measured by fixed and savings deposits, have responded dramatically to the change in interest rates. Public and private investment have also risen sharply, bringing total invest- ment to 20% of GNP in 1978 and 25% in 1979. This has been reflected in a four-fold increase in capital goods imports from $84 million in 1977 to an estimated $350 million in 1979. Much of the investment reflected pent up demand for replacement of antiquated equipment in industry and transport. Investment approvals in 1978 and 1979 for manufacturing reached record levels; those involving foreign collaboration totalled $300 million, of  - 6 - which over one-half were in the new free trade zone. Although there is little data available on employment, the Central Bank estimates a sizable (102,000) increase in the public sector and organized private sector employ- ment in 1978 as against an increase of 40,000 in 1977. This would have contributed to the fall in open unemployment from an estimated one million to 900,000, or 16% of the labor force. 17. The exchange rate adjustment, other policy induced price increases and related wage increases, and the removal of price controls contributed significantly to inflationary pressures in 1978 and 1979. However, these pressures were moderated in 1978 by a bumper paddy harvest, increased capacity utilization in the economy, increased availability of imports and the benefi- cial effects of competition from iimports and in domestic distribution. Thus average annual inflation was held to 9% in 1978. There was a marked deterior- ation in 1979 - average annual inflation rose to 18% (32% on December 1978 to December 1979 basis) due to an acceleration in money supply expansion on account of the continued buildup in gross external assets and the rapid domestic bank credit expansion, and to a sharp increase in construction sector costs, as the increase in investment levels led to shortages of construction materials and skilled labor. 18. Not surprisingly, the current account deficit in the balance of payments rose sharply to $150 million in 1978 and $360 million in 1979. After a strong surge in 1978, merchandise imports rose by a further 41% in 1979 to $1,450 million, or twice 1977 levels, reflecting sizable increases in the cost of petroleum imports, and substantial real increases in non-food consumer goods, intermediate and investment goods imports. Exports rose by a more modest 18% to $900 million in 1979. However, as in 1978, the current account deficit was more than offset by non-monetary capital inflows, resulting in an increase in net foreign exchange reserves by a further $46 million. Gross reserves rose by $121 million to $519 million at end 1979, due largely to drawings on the Extended Fund Facility. Reserves are currently equivalent to about four months imports. Preliminary balance of payments projections for 1980 suggest a further marked deterioration in the current account deficit to $600 million, due in part to the sharp rise in the cost of petroleum imports. Net petroleum imports as a percentage of non- petroleum exports will rise from 14% in 1979 to 26% in 1980. At currently projected aid levels, net reserves are likely to fall by nearly $60 million in 1980. 19. Success in attaining the Government's medium-term development objectives is conditional on a number of factors. The Government will need to carefully continue reviewing the content of its public investment program. As presently proposed, it will severely strain the domestic availability of skilled manpower and construction materials. To the extent that this forces a greater reliance on imports, it will further strain the balance of payments, which is already under severe pressure on account of the oil price increase and other factors that will result in a deterioration in the terms of trade. Moreover, domestic production and exports will need to increase at a rapid rate to ensure the required level of import substitution and export promotion implicit in the Government's macro-framework. This, in turn, will require further efforts to improve price and export incentives, and the quality of management in the public sector, and particularly in the tree crop sector.  - 7 - A further essential precondition is an adequate level of public savings to generate the required resources for public investment without infringing on the financing needs of the private sector. While the Government has already undertaken a number of important resource mobilization measures, this will need to be an area of continuing vigilance. However, success will ultimately be contingent on larger aid flows which are needed to ensure that an ambitious development program, with a strong rehabilitation component, can be implemented within the framework of a liberalized import regime. The Government is antici- pating that aid flows will finance over one-half of the public investment pro- gram, including considerable local cost financing. In this way, the Govern- ment's own considerable resource mobilization efforts will be supplemented, A while at the same time providing strong balance of payments support during this period of economic transformation. 20. Aid donors have responded enthusiastically to the new policy environ- ment in Sri Lanka. Aid commitments in 1978 from members of the Sri Lanka Aid Group totalled US$362 million, an increase of 60% over 1977. Aid commitments in 1979 totalled a massive $660 million, including $220 million for the accel- erated Mahaweli Program. The grant element of aid commitments is currently around 63% and is expected to improve further. The debt service ratio in 1979, excluding Fund repurchases, stood at around 8.0%, declining from 15.0% in 1977 and 10.0% in 1978, due to improved export earnings and the decline in outstand- ing short- and medium-term borrowings. PART II - BANK GROUP OPERATIONS IN SRI LANKA 21. Since the beginning of its operations in Sri Lanka in 1954, the Bank Group has made eight loans totalling US$72.9 million (net of cancellations) and 21 credits totalling US$266.5 million (net of cancellations and exchange adjustments) in support of 27 projects. About 44% of Bank Group assistance has been for agriculture (irrigation, agricultural, and dairy development), 17% for power, and the remainder for development finance company operations, highways, a program credit (mainly involving the import of raw materials for industry), water supply, road transport, small and medium industries and technical assis- tance. Eight loans and eight credits have been fully disbursed so far. During FY80, IDA credits for a total of US$56.0 million have been approved for a Technical Assistance project and a Road Passenger Transport project. Annex II contains a summary statement of Bank Group operations as of February 29, 1980, together with notes on the execution of ongoing projects. 22. An IFC equity investment of about US$100,000 equivalent in the Devel- opment Finance Corporation of Ceylon (DFCC) and an IFC non-revolving line of credit of US$2.0 million to the government-owned Bank of Ceylon for on-lending to private small- and medium-scale industrial enterprises were approved in FY78. IFC also approved an investment of US$2.32 million in a synthetic textile mill, and US$986,000 in a polypropylene bag manufacturing plant in FY79. IFC has very recently approved an increase in equity investment of about US$51,000 equivalent in DFCC. 23. The Bank Group's current strategy is focused on the agricultural sector to support Government efforts to increase food production and reduce its dependence on food imports, and to raise productivity, employment, incomes  - 8 - and living standards of the rural population in Sri Lanka. Projects to sup- port industry and basic infrastructure are also included. In addition to providing financing for the ongoing Mahaweli Ganga Development Project II, the Bank Group is assisting the Government of Sri Lanka in accelerating the implementation of the Mahaweli Ganga Development Program (para 12) principally through the coordination of external assistance for project preparation and implementation. It is expected that significant investment opportunities for IDA and other Aid Group members will flow from this effort. Projects in water supply and sewerage, rural development, power transmission, and telecom- munications also are being prepared for possible IDA financing. 24. The Bank Group presently accounts for 10.3% (IBRD, 3.3%; IDA, 7.0%) of Sri Lanka's total debt outstanding and disbursed, and 6.5% (almost totally IBRD) of debt service. It is projected that the Bank Group's share in total external debt will increase to 19% by 1985 (with the IBRD's share declining to 0.7%). The Bank and IDA shares in the debt service are expected to decline to about 4% by 1985. PART III - AGRICULTURE AND THE RUBBER SECTOR The Role of Agriculture in the Economy 25. Agriculture dominates Sri Lanka's economy, accounting for 39% of GDP, over 50% of total employment, about 80% of export earnings, and a large share of public revenue. Approximately 80% of the country's total population lives in rural areas. Thus, economic growth in the country depends largely upon the performance of the agricultural sector. During the 1960s, food production increased as the Government pursued a policy of reducing dependence on food imports. Paddy production grew at an impressive 7.4% per annum during 1964-70 but growth declined to a mere 0.7% per annum during the 1970-77 period. Apart from generally poor weather, the decline in yields and cropping intensities is attributable principally to a sharp deterioration in institutional support for production programs. 26. In the early 1960s, the tree crop subsector accounted for over 90% of the value of merchandise exports (against about 80% today). During thle 1960s, production grew slowly at only 1% per annum, and that mainly from rubber which was reaping the benefit from a substantial replanting program in the early 1950s. However, after Llhis increase, rubber production stagnated in the 1970s. Tea and coconut output has in fact been declining steadily from the mid-1960s. Erratic weather conditions, declining profitability associated with low prices and high taxes, and uncertainties associated with the Govern- ment's long, drawn-out land reformn (1972-75) depressed producer incentives and hence investment and production. 27. In the foreseeable future, tree crops exports will continue to be the main source of foreign exchange earnings. Furthermore, they will continue to play a vital role in all aspects of the economy, including generation of employment and Government revenues. Rubber alone accounts for over one-sixtl of the value of the country's merchandise exports.  -9- The Rubber Industry 28. Rubber production in Sri Lanka rose from 97,000 tons in 1960 to a peak of 159,000 tons in 1970. During the last decade (1969-78), production fluctuated around 150,000 tons which is about 4% of the world total. The total area currently under rubber is estimated at 193,000 ha and has declined by about 16,000 ha since 1972. In 1953, the Government initiated a Rubber Replanting Scheme with an annual target of about 6,000 ha based on replace- ment of 3% of the rubber area annually. Under the scheme, replanters receive advice, and replanting payments financed by an export cess on rubber compris- ing replanting inputs and some financial assistance to compensate for labor inputs. The replanting payments have not always been sufficient to provide adequate incentives for smallholders to replant. 29. A rubber smallholder having title to registered rubber which is either over 20 years old, or low-yielding because of disease, damage or inherent genetic reasons, is eligible to participate in the rubber replanting scheme and receive replanting payments. The objective of replanting payments is to induce and encourage the rubber growers to undertake capital expenditures involved in replanting overaged rubber plants. An analysis of past trends in replanting rates and payments indicates a strong positive correlation between the two. The replanting payments have not always been sufficient to provide adequate incentives for smallholders to replant. These increased from Rs 2,470/ha in 1953 to the present level of Rs 16,050/ha (introduced in November) and are now considered satisfactory. The payments are spread over a six-year period. 30. The initial operation of the scheme was very successful. During the first ten years, 76,000 ha were replanted. However, for reasons outlined above (para 26) annual replanting declined continuously during 1963 to 1976, from 6,400 ha to 2,550 ha improving to 3,200 ha in 1978. The adequacy of replant- ing payments appears largely to explain the decline in replanting rates during 1963-1976 and subsequent improvement. 31. Much of the current rubber acreage is either over-aged or in need of rehabilitation to make good the damage which occurred in recent years due to lack of fertilizers and chemicals. The present backlog of replanting is estimated to be about 55,000 ha of which 41,000 ha are in the private sector. Despite the annual replanting target of 6,000 ha set by the Government and a national need to achieve about 10,000 ha a year, there has been little improve- ment in rubber replanting in the last two years. 32. Under the Land Reform Acts of 1972 and 1975, ownership of all private rubber holdings over 20 ha was vested in the State. The Government established two corporations -- State Plantations Corporation (SPC) and Janatha Estates Development Board (JEDB) -- to manage the nationalized tea and rubber estates, exceeding 100 ha. Holdings between 20 and 100 ha are also controlled by the State which controls about 35% of the rubber area in Sri Lanka. Thus the majority of the rubber land (65%) has remained private, mostly (71%) in the hands of small producers (less than 4 ha). After an uncertain start, the two state corporations have embarked on a replanting program in order to catch up with the backlog by 1985. There is an urgent need to implement a similar program on private holdings.  - 10 - 33. The Department of Rubber Control (DRC) was created in 1934 to control the planting and production of rubber. Its current functions include: registration of rubber holdings and producers; licensing of dealers, manufac- turers and nurseries; collection and collation of industry statistics; and operation of the Rubber Replanting Scheme, including the inspection of small- holdings and distribution of planting materials and fertilizer. The operation of the Replanting Scheme has been criticized by many smallholders for its cumbersome and slow-moving administrative procedures and for its failure to provide necessary replanting inputs on time and at easily accessible places. The Rubber Research Institute of Sri Lanka (RRISL) is responsible for all aspects of research in rubber husbandry, production and processing. The Institute has conducted good quality research work in the past and main- tained links with research in other countries including Malaysia. The Advisory Services Department (ASD), currently operating as a department under RRISL, is responsible for extension work including dissemination of research findings to smallholders and medium sized estates. ASD officers also assist the Replanting Scheme through inspection and authorization of replanting payments at the request of DRC. ASD is grossly understaffed to carry out these operations. All three main rubber development agencies (DRC, RRISL and ASD) come under the Ministry of Plantation Industries (MPI) which is responsible for overall planning and development of the rubber industry. At present MPI does not have the policy and planning capability that would be required to adequately plan for the rubber industry and to formulate policies on such questions as levels of producer margins, replanting payments, cess and duties, and marketing strategies. 34. The rubber growing area is generally well-served with facilities for processing latex. About 50% of smallholder latex production is processed by independent private operators, 40% by smallholders themselves, about 8% directly by factories, and only 2% in Group Processing Centers (GPC). About 100 GPCs have been established under the supervision of ASD staff, using Government grants and loans. About 20 to 100 smallholders join together to collectively process latex into ribbed smoked sheet (RSS) in the GPCs, using modern equipment and techniques. GPCs are run and operated by a committee elected by members. Despite low throughput and poor management, GPCs provide a potentially valuable forum for smallholder rubber development by providing a center for quality processing and extension activities directed to a group rather than the individual. 35. Over 90% of smallholder rubber production is marketed as RSS and scrap. The Commodity Purchase Department (CPD) under the Ministry of Trade and Shipping buys RSS from growers and markets it internationally. There are more than 2,000 licensed rubber dealers and a significant number of unlicensed dealers, who handle the marketing of about 75% of RSS for delivery to author- ized shippers in Colombo. CPD handles about 20% of RSS, while about 5% is marketed through unauthorized middlemen (4%) and cooperatives (1%). CPD fixes the daily price of all grades of RSS based on the Singapore daily price. These prices are announced over the national radio network and in daily newspapers. The announced prices are binding on all CPD depots and serve to establish a floor price. The co-existence of CPD depots and a wide network of private dealers has resulted in a relatively efficient marketing system.  - 11 - PART IV - THE PROJECT 36. The project would assist the Government in increasing future rubber production in Sri Lanka through its support for the acceleration of an ongoing Government program to replant the backlog of over-aged, low-yielding small- holder rubber. It would strengthen the agencies involved in smallholder rubber production and provide adequate replanting inputs and incentives. The project area is located in the lowland wet zone of southwestern Sri Lanka and consists of the three administrative districts of Kegalle, Kalutara and Ratnapura. Rubber is the most important crop in the area, accounting for about 49% of the total land under cultivation (142,000 ha). Coconuts account for 18%, paddy 16%, tea 15% and minor crops 2% of the agricultural land. 37. The principal features of the six-year project are summarized below: (a) replanting of 18,800 ha with high-yielding rubber on about 27,000 smallholdings (below 20 ha). This will replace about 70% of project area's and 45% of the entire island's privately owned over-aged rubber. The project would provide replanting inputs, including planting material, fertilizer, cash payments and technical advice to smallholder replanters. Where technically feasible, the project would also encourage intercropping in order to provide smallholders with addi- tional income during the immature period; (b) strengthening of the two major implementing agencies: (i) Advisory Services Department (ASD) and (ii) Department of Rubber Control (DRC) through additional staff, training, technical assistance and equipment. In addition, a Project Coordination Unit will be created in the MPI for implementing the project; (c) construction of three regional offices for DRC/ASD staff, three regional fertilizer stores and 78 houses for field level ASD staff. All field level staff would also be supplied with vehicles to ensure mobility and reduce time lost through use of public transport; (d) improvement of smallholder processing standards through establishment of a Processing Advisory Division within ASD which would service private processors and 67 existing Group Processing Centers (GPCs), and, subject to attain- ment of satisfactory operating norms for existing GPCs, establishment of 50 new GPCs; (e) support for research directed particularly to smallholder rubber production. Vehicles and equipment would be provided to the Rubber Research Institute of Sri Lanka to enable it to serve the smallholders more effectively;  - 12 - (f) support to the Agrarian Research and Training Institute (ARTI) to conduct surveys and case studies aimed at evaluat- ing the project's impact on smallholders. The evaluation would comprise an initial baseline survey and subsequent case studies which should result in a better understanding of the smallholder's viewpoint and help design a more efficient and attractive replanting scheme; and (g) expanded training and technical assistance for training, project evaluation, and improved procedures for the adminis- tration of the replanting program. About 15 manmonths of consultants' services would be provided at an estimated manmonth rate of US$3,500 and manmonth cost of US$6,000 which includes salary, allowances, and travel and transport expenses. A training center would be constructed and equipped to provide training to the staff. The center would run both pre-service and inservice training courses. Organization and Management 38. The entire institutional structure of the rubber industry has been reviewed by the Rubber Masterplan in November 1979 under UK technical assistance. Pending the review of the Masterplan by the Government and IDA, major changes in the umbrella or apex organization for the industry are not proposed under the project. However, the project would bring about minimum organizational changes required for implementing the project. These organi- zational changes would be consistent with the Masterplan recommendations. 39. The project would establish within MPI, a Project Coordination Unit (PCU), which would be responsible for coordination of all aspects of project implementation. The specific responsibilities of PCU would include: (a) assistance to DRC and ASD in the preparation of annual work plans and budgets for project activities; (b) assistance to DRC and ASD in procurement; (c) monitoring project implementation; (d) preparation and submission of applications for withdrawal of proceeds from the credit on behalf of the implementing agencies; (e) collation of progress reports and project accounts from the implementing agencies; and (f) liaison with ARTI in respect of project evaluation. 40. The Project Coordinator (PC) would serve as the PCU executive officer. He would be responsible and report to the Chairman of the Steering Committee, and subsequently to the Rubber Policy Review Committee (para 43) which would provide the forum for coordination of decisions on project imple- mentation. The Steering Committee, which was established to coordinate the preparation of the proposed project and to guide the Masterplan team comprises: the Secretary of MPI as Chairman; representatives of DRC, ASD and RRISL; a representative from the Treasury; a representative from the Ministry of Finance and Planning; and representatives of SPC/JEDB. 41. The Advisory Services Department (ASD) now operates as a depart- ment of RRISL. By January 1, 1981, it would be established and adequately staffed as a department directly under the Ministry of Plantation Industries (Development Credit Agreement (DCA, Section 3.07 (a)). In addition to its  - 13 - role in advising rubber growers on all aspects of rubber husbandry and pro- cessing, ASD would be responsible for all field-level contacts with rubber replanters. Its revised responsibilities would include: inspection of holdings for replanting permits; inspection of replantings for authorizing replanting payments and inputs; distribution of planting materials and fertil- izers; and quadrennial checks on registration of rubber holdings. In order to enable it to perform the expanded duties effectively, ASD professional staff would be increased from the present 56 to 154 under the project. No difficulty is likely to be faced in finding qualified persons for these additional positions. The proposed training center at Nivitigalakele would be equipped to train the existing and additional staff. a 42. DRC would relinquish its present responsibilities for inspection of rubber holdings, authorization of replanting payments, production of planting material, and distribution of replanting inputs. The Rubber Policy and Plan- ning Unit (RPPU), to be established within MPI, would take over the present DRC responsibility for setting replanting payments and cess levels. DRC would continue to collect and maintain industry statistics relating to area, produc- tion and processing and marketing; register holdings; issue replanting permits; and make cash payments on authorization from ASD. ASD would inspect and on the basis of inspection, advise DRC that the replanter is eligible for payment; DRC would disburse payments on the basis of such authorizations. DRC would develop simpler procedures for the administration of the replanting program. A consultant would be retained to assist in this effort. 43. The success of the project requires that producer margins and replanting payments are maintained at an adequate level to keep rubber pro- duction attractive to producers. The replanting targets should also be set by a body able to take an overview of the industry and with an awareness of the industry's contributions and costs to the economy as a whole. A Rubber Policy Review Committee (RPRC) would be established not later than January 1, 1981 to fill in the abovementioned role (DCA, Section 3.07 (c)). The existing Steering Committee would form the basis of RPRC. The Committee would comprise: Secretary, Ministry of Plantation Industries as Chairman; representatives of Ministries of Finance, Trade, Industry, SPC and JEDB; heads of DRC, ASD and RRISL; and representatives of private estates, smallholders and rubber traders/ processors. In order to service RPRC, a Rubber Policy and Planning Unit (RPPU) would be set up in MPI with adequate staff and finance, not later than January 1, 1981 (DCA, Section 3.07 (b)). The functions of RPPU would include, inter alia, advising RPRC on the levels of industry cesses, duties, and replanting payments; replanting targets; and marketing strategies. It would also carry out research for the purpose of policy formulation. Project Cost and Financing 44. The total project cost is estimated at about US$28 million equiv- alent, including taxes and duties of US$0.25 million equivalent, with a for- eign exchange component of US$7.4 million. Physical contingencies have been applied to the base cost estimate in the following manner: 15% for planting  - 14 - material; 5% for fertilizer; and 10% for civil works. Price contingencies have been estimated assuming annual inflation of 21% for 1980, 15% for 1981, 12% for 1982 and 10% thereafter for domestic costs; and 10.5% for 1980, 9% for 1981, and 8% for 1982 and 7% thereafter for foreign costs. The proposed IDA credit of US$16 million equivalent would cover the full foreign exchange cost and about US$8.6 million equivalent or 42% of local costs, and thus would finance 58% of total project costs, net of taxes and duties. The rather large financing of local cost is justified in the context of Government's recent increased domestic resource mobilization measures (para 11), which has been carried out in the face of Sri Lanka's deteriorating terms of trade, and a considerable need for local cost financing in support of a higher investment effort (para 19). In order to ensure an early start to the project, some pre-project expenditures incurred after April 1, 1979, would be retroactively financed out of the proposed credit. Such expenditures would amount to a maximum of US$0.2 million equivalent. 45. Rubber replanting payments are financed by a Replanting Fund which is financed by a replanting cess levied on rubber exports and administered by DRC. The Fund has not run into deficit in the past but the proposed accel- eration of replanting during the project period would lead to a substantial cash deficit in the Fund. This deficit could be met by budgetary intervention or by increasing the replanting cess. However, an increase in cess would require a careful analysis of its effects on the producers' margins. The Gov- ernment would annually review the financial resources of the Replanting Fund and provide the Fund with necessary budgetary resources to finance the deficits in implementing the project, and continue the Replanting Scheme at a mutually agreed rate (DCA Section 4.04). Procurement and Disbursements 46. Replanting activities wrould be carried out by individual small- holders. Replanting payments would cover the costs of (a) planting materials and fertilizer which would be provided in kind to the planters; and (b) the cost of other required inputs, including labor. The planting materials would be supplied by the two public corporations (SPC and JEDB). These corporations have the expertise and facility to produce high quality planting material. Fertilizer would be purchased by the project authorities at Government rates from either of the two Government corporations dealing with fertilizer or imported directly. Separate tendlers for the fertilizer requirements would not be practicable since rubber fertilizer has to be produced by mixing several inputs; nor would it be in the interest of economy since the corporations, by tendering for much larger quantities, obtain better prices. ASD would be responsible for distributing planting materials and fertilizer to the small- holder replanters. 47. GPCs offer a potentially useful means for improving smallholder returns in areas not adequately served by latex processing factories or pri- vate processors. In view of thei.r potential, the project would assist in their improvement, and, following the achievements of satisfactory operating norms, in their expansion. The efficient operation of GPCs requires that they have a legal basis for their operation including satisfactory by-laws, as well as sufficient commitment on the part of potential members. Therefore all existing GPCs within the project area would be established and organized  - 15 - under a legal framework by March 31, 1981 and no new GPCs would be established within the project area unless pledges were obtained from members that they collectively would provide not less than 100 kg of latex per day (DCA, Section 3.06). 48. Contracts for vehicles and equipment costing more than $100,000 each would be awarded on the basis of international competitive bidding. All other contracts, including contracts for civil works, which would be small and dispersed, would be awarded on the basis of local competitive bidding, follow- ing procedures acceptable to IDA. 49. Disbursements under the Credit would be made as follows: (a) 80% 4 of local expenditures on replanting payments to rubber replanters; (b) 80% of expenditures on civil works; (c) 100% of foreign expenditures on directly imported or 100% of local expenditures (ex-factory) on locally manufactured or 80% of expenditures on locally procured vehicles, equipment and materials; and (d) 100% of expenditures on technical assistance and overseas training. Disbursements against replanting payments would be made against certified statements of expenditures. Disbursements for small contracts for civil works costing less than SLRs 100,000 (US$6,450) and other procurement involv- ing expenditures of less than SLRs 100,000 for vehicles and equipment would also be made against statement of expenditures. All other disbursements would be fully documented. The institutional capabilities of the implementing agencies for this purpose are adequate and satisfactory. However, the current staff strength is inadequate. Therefore, additional accounting staff required for project implementation would be appointed by the Government by January 1, 1981 (DCA, Section 4.03). DRC, ASD and RRISL would keep separate accounts of expenditures made under the project. Cost Recovery 50. While providing smallholders with suitable remuneration and incen- tives, the replanting scheme would also provide Government with an adequate financial return. Government contribution to the replanting scheme would take the form of replanting payments and administrative overheads. Its revenues would include export cesses and duties levied on project rubber output. These revenues would be sufficient to recover all costs by project year 16 and thereafter annual surpluses would be about US$15 million. Over the life of the project (30 years) the financial rate of return to Government would be about 14%. Production and Marketing 51. At full development, the project would increase the annual output of rubber by about 25,000 tons. The incremental production represents about 15% of Sri Lanka's current rubber production. The demand outlook for elas- tomers, including both natural and synthetic rubber, is bright. Also, the competitive position of natural rubber relative to oil-based synthetic rubber is favorable. Unless investment in natural rubber production increases within the next few years, growth in consumption of natural rubber will be severely constrained by supply and in response the synthetic rubber industry will expand  - 16 - its capacity to produce polyisoprene rubber instead. Projections indicate continued rapid growth in demand for elastomers with associated high prices. The present world demand for rubber of about 13 million tons annually (of which 4 million tons is natural rubber) is expected to grow at 4.9% per year between 1980 and 1990 while world market prices are expected to increase by about 15% during the same period. The incremental project output of 25,000 tons/year at full development would represent about 0.4% of the projected world demand for natural rubber and about 0.5% of projected world exports in 1990. Consequently, Sri Lanka should face no difficulty in exporting the additional project output. Project Benefits and Risks 52. The project's major economic benefit would be the increased pro- duction of rubber resulting from the replanting of over-aged rubber in the project area, and improvement in the quality of rubber resulting from improve- ments in processing. Increased exports would strengthen Sri Lanka's balance of payments with additional foreign exchange earnings of about US$28 million (in constant prices) at full development. Exports would also improve Govern- ment budgetary position through increased levies which would bring an esti- mated surplus to Government revenue of US$16 million at full development. The balance of revenue from rubber exports would accrue to 27,000 smallholders whose earnings from rubber alone would eventually quadruple with the result that almost two-thirds of the 47% of smallholders currently in the poverty income group would be elevated out of that group. The economic rate of return (ERR) of the project is estimated to be 23%. Even with a 20% decrease in rubber yields and prices, the project would yield an ERR of 20%. 53. The project faces no major risk. The economic rate of return is relatively insensitive to variations in the key parameters such as rubber yields, prices and production costs. The techniques and inputs for replant- ing and maintenance are all proven. There is, however, a risk that the proj- ect may over-extend the implementation capacity of the concerned institutions. Should this occur, replanting targets would not be met and both benefits and costs would be reduced. The project would, nonetheless, remain viable under such circumstances. The problem of constrained implementation capacity has been directly addressed in designing the project. Firstly, it has been accepted that some 30% of the over-aged rubber now awaiting replanting would have to be excluded from this first project. Secondly, the annual replanting targets build-up slowly giving time for the institutions to recruit staff and to implement the new procedures. Thirdly, the institutions themselves would be strengthened under the project and their activities would be coordinated and monitored by PCU. Finally, some 70% of project disbursements are directly tied to actual replanting achievements providing a strong incentive for the Government to ensure that implementation capacity does not become a constraint. PART V - LEGAL INSTRUMENTS AND AUTHORITY 54. The draft Development Credit Agreement between the Democratic Socialist Republic of Sri Lanka and the Association, and the Recommendation  - 17 - of the Committee provided for in Article V, Section 1(d) of the Articles of Agreement are being distributed to the Executive Directors separately. 55. Special Conditions of the credit are listed in Section III of Annex III. The following events of suspension have been added, namely: a change in the Subsidy Act, the Control Act and any other legislation or regulation governing the rubber sector so as to materially and adversely affect the Replanting Scheme, the Replanting Fund or the Project (DCA, Section 5.01). 56. I am satisfied that the proposed credit would comply with the Articles of Agreement of the Association. PART VI - RECOMMENDATION 57. 1 recommend that the Executive Directors approve the proposed credit. Robert S. McNamara President by Ernest Stern Attachments April 16, 1980 c  -18- Annex I Page 1 of 6 pages TAELB 3! SRI LANKA - SOCIAL INOICATORS DATA SKEEET EflRflcR GRoUPS (ADJUS5T0 A LGES tLAND0 AREA (THOUSAND SQ. IN.) SRI - XQCST REC