Peru - Puno Rural Development Project

Document of The World Bank FILE COPY FOR OFFICIAL USE ONLY Report No. P-2722-PE REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO THE REPUBLIC OF PERU FOR THE PUNO RURAL DEVELOPMENT PROJECT February 27, 1980 Thb ouoent ia a restriced distibution and mny be used by rwipients ody in the perfonnum ofi r official dutise. Its eontents my not otherwis e disclhsed witlht Wold Dak autihorition..  CURRENCY EQUIVALENTS The exchange rate is being adjusted daily roughly in line with the difference between domestic and international inflation. The exchange rate and currency equivalents in effect on January 31, 1980, were as follows: CURRENCY UNIT = Sol (SI.) Calendar 1979 January 31, 1980 US$1 = SI. 225 SI. 255 SI. 1 = US$0.0044 US$0.0039 S/. 1,000 = US$4.44 US$3.92 FISCAL YEAR January 1 to December 31 ABBREVIATIONS ARE - Agrarian Reform Enterprise BAP - Banco Agrario del Peru (Peruvian Agricultural Bank) CENCIRA - Centro Nacional de Capacitacion para la Reforma Agraria (National Training Center for Agrarian Reform) ENCI - Empresa Nacional de Comercializacion de Insumos (National Input Marketing Company) ERP - Economic Recovery Program INIA - Instituto Nacional de Investigacion Agricola (National Agricultural Research Institute) MAA - Ministerio de Agricultura y Alimentacion (Ministry of Agriculture and Food) ORDEPUNO - Organismo Regional de Desarrollo de Puno (Puno Regional Development Organization)  FOR OFFICIAL USE ONLY PERU PUNO RURAL DEVELOPMENT PROJECT LOAN AND PROJECT SUMMARY Borrower: Republic of Peru Loan Amount: US$15.0 million equivalent Terms: Payable in seventeen years, including four years of grace, at 8.25 percent per annum. Project Description: The objectives of this project, which would be carried out in the southern Peruvian altiplano near Puno, are to improve living conditions for the approximately 29,500 rural families in the project area now at or below the relative poverty level. Of these, 170,000 families participating directly in the agricultural develop- ment components would increase their agricultural and livestock production on about 24,000 ha of the project area through the improvement and construction of irrigation systems, the provision of agricultural credit and intensive research and extension programs. The project would also include the rehabilitation of rural roads a forest plantation component for fuel and soil conservation, improvement of rural health facilities, construction of communal potable water systems, vocational training and preinvestment studies for a follow-up project. The principal risk confronting the project is its administrative com- plexity. To deal with this risk a Project Unit would be established in ORDEPUNO, the Puno Regional Develop- ment Organization, with operational control over most of the executing agencies. In addition, the project would be closely supervised by Bank staff and would receive substantial technical assistance. | This document has a restricted distribution and may be used by recipients only in the performance of e their official duties. Its contenst may not otherwise be disclosed without World Bank authorization.  - ii - Estimated Cost- Local Foreign Total (US$ millions) (a) Irrigation Works 2.3 1.3 3.6 (b) Farm Credit Program 2.7 4.3 7.0 (c) Roads, Communications 1.5 1.0 2.5 and Forest Plantation (d) Social Infrastructure 0.9 0.5 1.4 (e) Project Unit Administration and Extension and Training Services 2.8 1.2 4.0 (f) Research and Project Preparation 1.1 0.7 1.8 Baseline Costs 11.3 9.0 20.3 Physical Contingencies 0.9 0.7 1.6 Price Contingencies 3.0 2.4 5.4 Total Project Costs 15.2 12.1 27.3 Financing Plan: Local Foreign Total (US$ million) Bank 7.2 7.8 15.0 Government 7.2 4.3 11.5 Beneficiaries 0.8 - 0.8 15.2 12.1 27.3 Estimated Disbursements: 1981 1982 1983 1984 1985 (US$ millions by Bank fiscal year) Annual 1.8 3.8 3.9 3.7 1.8 Cumulative 1.8 5.6 9.5 13.2 15.0 Rate of Return: 27 percent Staff Appraisal Report: Report No. 2736-PE, dated February 12, 1980.  INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE IBRD TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO THE REPUBLIC OF PERU FOR THE PUNO RURAL DEVELOPMENT PROJECT 1. I submit the following report and recommendation on a proposed loan to the Republic of Peru for the equivalent of US$15 million to help finance the Puno Rural Development Project. The loan would have a term of 17 years, including 4 years of grace, with interest at 8.25 percent per annum. PART I - THE ECONOMY 1/ 2. A basic economic report entitled "Long-Term Development Issues: Peru" (Report No. 2204-PE) was distributed to the Executive Directors on April 13, 1979. This part is based on the report's findings as well as those of more recent economic missions to Peru. Country data sheets are attached as Annex I. Background 3. Peru, the fourth largest country in Latin America, is divided by the Andes mountains into three distinct regions: the coastal region (the Costa), with 46 percent of the population where modern economic activity is concentrated; the Sierra, with 44 percent of the country's population, which encompasses the highlands above 2,000 meters; and the sparsely populated, tropical rain forests east of the Andes (Selva). The rugged topography limits trade between the three regions. 4. Peru's natural resources include large deposits of varied minerals, particularly copper, iron, silver and zinc, located mainly in the Sierra and the southern coast. Petroleum resources, particularly in the jungle areas of the North and offshore, are believed to be substantial but their full extent has not yet been ascertained. Another major natural resource asset is the large fishing potential in coastal waters, although the magnitude of this potential is subject to sharp fluctuations. Agricultural land is limited, and most of the soils suitable for intensive agriculture are already being farmed. 1/ The section is substantially unchanged from the Petroleum Production Rehabilitation Project President's Report of February 13, 1980 (Report No. 2706-PE).  5. As a result of three decades (1930-1960) of rapidly falling mortality rates, the rate of population growth had risen. In the early 1960's, birth rates started a gradual fall, mainly caused by the urbanization process and by improved education. But as death rates continued to fall, population has continued to grow at about 2.8 percent p.a. Since death rates are expected to fall further, population growth is likely to remain at around 2.8 percent p.a. over the next 25 years, unless an effective demographic policy is adopted. Given the structure of Peru's population, the labor force is expected to grow well in excess of 3 percent per year during the next 15 years. 6. Crude oil is the dominant source of energy in Peru, supplying approxi- mately 80 percent of Peru's commercial energy requirements. Although Peru's energy resource base is relatively diverse and there is scope for expanding the role of hydropower and coal in future electricity generation, petroleum will still provide the major part of Peru's energy requirements throughout the rest of this century. After being dependent on imported crude oil for many years to meet its petroleum needs, domestic oil production increased almost threefold between 1976 and 1979, enabling Peru to export oil in substantial quantities for the first time since 1958. Despite this encouraging production trend, domestic consumption is likely to rebound after several years of stagnation so that Peru may once again become a net importer of petroleum in the mid-1980's unless new oil reserves are discovered. Past Development Policies 7. Since the military came to power in 1968, the Government has followed a development strategy directed at achieving economic growth and at narrowing the sharp differences in wealth and opportunities between population in various income classes and geographical regions. The Government has tried to correct class and regional imbalances by expanding the role of the State in the economy, changing the pattern of asset ownership, reducing foreign ownership of national resources, orienting industry and agriculture toward producing essential goods for the domestic market, stimulating the deconcentration of economic activity out of Lima, and reforming the educational system to make it more responsive to local economic and social needs. Through nationalization and creation of new enterprises, the State has taken direct control of over 150 enterprises in key economic sectors, and its share in total capital formation has risen from less than one-fourth in 1968-70 to about one half in 1974-1978. By imposing complex legislation, the Government has also strictly controlled the operations of the private sector. 8. As a result of these actions, the pattern of asset ownership in the economy has changed drastically. Through nationalization, the share of assets owned by foreigners fell sharply. A sweeping land reform redistri- buted 43 percent of the country's best farmland to workers' cooperatives benefitting some 25 percent of all rural families. Through other laws, industrial workers were given shares in the firms which employed them and, in the mining sector, a share in profits. The Government has also given a strong autarkic orientation to its agricultural and industrial sector policies and strengthened the incentives for industries outside of Lima.  - 3 - 9. The Government's programs have benefitted large numbers of Peruvians, but they have hardly reached the poorest half of the population which continues to live in abject poverty. It is estimated, for example, that about three quarters of rural families, mostly "minifundistas" (those farming less than 2 ha) and the landless seasonal workers, have not been reached by social pro- grams. The Government imposed controls on prices of a number of domestic- ally produced goods and heavily subsidized imported petroleum and foodstuffs. Most of the subsidized products, however, were more important in the consump- tion basket of high and middle-income Peruvians than in that of the poorest groups. Moreover, the maintenance of artificially low prices for some products--such as mutton and cereals--actually hurt the poor who produced these items, and affected production negatively. 10. In the final account, one of the most significant achievements of the Government was the promotion of the cultural and political integration of the country. Owing in great part to the land reform, an important segment of the rural population has become better organized and is able to communicate its priorities in a more forceful and articulate way. Unfortunately, although many of the policies and structural changes carried out since 1968 were meant to achieve rapid growth and more equality, the cost of these measures proved to be excessive and their implementation inefficient. The Economic Crisis 11. During nine years, 1968-77, the military Government followed expan- sionary fiscal and credit policies. A rapid increase in spending by the public sector (including large defense outlays) was not matched by a parallel increase in revenues. Pricing, interest rate and foreign exchange policies encouraged consumption and discouraged savings, exports and, sometimes, overall production. As a result of these policies, aggregate demand consider- ably exceeded aggregate supply. This excess demand, in turn, led to widening external gaps and to strong inflationary pressures, with a resulting loss of international reserves and a massive build-up of external debt. 12. This imbalance was aggravated by circumstances beyond the control of the authorities. Anchovies, the fishing industry's principal product, virtually disappeared as the annual catch dropped from around 10,000 metric tons in 1968-71 to an average of 2,300 metric tons in 1975-78. Between 1974 and 1978, furthermore, Peru's terms of trade worsened sharply. Export prices, particularly for copper and sugar (which together accounted for almost one- fourth of merchandise exports), fell from their very high 1974 levels at a time when import prices soared. Petroleum reserves, which in the early 1970's were predicted to lead to a quick, major expansion in export earnings, have taken much longer than expected to come on line. 13. Public sector savings dropped steadily in relation to GDP from 4.4 percent in 1970 to dissavings of 2.6 percent in 1977. A major cause for this was a massive erosion of the tax base owing to excessive tax incentives, loopholes in the tax system and weak enforcement. At the same time, there were rises in the budgetary cost of subsidies for foodstuffs and petroleum products, and sharp increases in military imports and local expenditures. Much of public investment, furthermore, was increasingly concentrated on  capital-intensive projects with long gestation periods and little immediate contribution to the growth of output or employment. 14. Inflation accelerated from 5 percent per year in 1970 to 38 percent in 1977. Interest rates on domestic banking system loans, however, remained substantially negative in real terms, discouraging financial savings and stim- ulating capital flight. Moreover, the exchange rate remained practically constant between 1968 and 1975, thus contributing to the overall disequilibrium. National savings fell dramatically from 16 percent of GNP in 1970 to 8 percent in 1977, when they financed only about one-half of investment. Following a period of rapid expansion in 1968-74 during which GDP grew by more than 6 percent per year, the growth rate dropped progressively and became negative in 1977. 15. The growing disequilibrium described above was reflected in the balance of payments. The current account deficit averaged US$1.1 billion per year in 1974-77, equivalent to nearly 9 percent of GNP. To finance this deficit, Peru accumulated a massive external debt. Peru's total private and public external debt--including short-term indebtedness--stood at almost US$8.3 billion by year-end 1977, equivalent to two-thirds of GDP and four times exports. Much of this debt was contracted on fairly short maturities with three fourths of the public sector's long-term debt--which is estimated to have totaled US$6.3 billion--scheduled to be repaid over the 1978-82 period. 16. Beginning in 1975, successive economic teams made several efforts to cope with the mounting economic crisis. A major stabilization program was initiated in June 1976, when the sol was devalued from S/. 45 to S/. 65 per U.S. dollar, fiscal and credit policies were tightened and interest rates were raised. This program was initially successful in reducing the fiscal deficit and the loss of foreign exchange. Nevertheless, it was abandoned later in the year as a consequence of strong popular opposition and a lack of consensus within the Government regarding the gravity of the financial situation. Further attempts to stabilize the economy were initiated in March, July and Septem'ber 1977 but they were not successful. A stand-by arrangement was negotiated with the IMF and approved in November 1977, but its targets were not met. While these efforts proved to be false starts, they succeeded in somewhat reducing the gap between national savings and investment from a peak of 11.5 percent of GNP in 1975 to 8.5 percent in 1976 and 7.4 percent in 1977. 17. By mid-1978 the economic crisis had reached grave proportions. The drop in GDP had intensified and inflation had further accelerated to an annual rate approaching 100 percent. Moreover, the private sector was finding it increasingly difficult to open letters of credit for new imports and the banking system's net international reserves had dropped to a negative level of US$800 million. It had become clear that the public sector was fast approach- ing the point where it would no longer be able to fully service its external debt. Peru was no longer creditworthy. Financial instability had reached the point where practically all economic activities were adversely affected. Stabilization Efforts 18. A new economic team was named in May 1978. Since then, the Govern- ment has adopted a number of important measures aimed at strengthening public  finances, stimulating exports and stemming the loss of international reserves. By means of a crawling peg, the sol was devalued from SI. 130 to the U.S. dollar in May to almost S/. 200 to the U.S. dollar by year-end 1978; since then the sol was devalued a further 28 percent. Most subsidies were elimi- nated, thus closing an important drain on public savings. Other price con- trols were re]^xed. In addition, a number of tax measures were adopted and Government expenditures were restrained. Interest rates on bank loans were raised from 16 to 31.5 percent per year. Peru reached agreement with foreign commercial banks to reschedule US$185 million of principal payments due in the second half of 1978 until January 1979. The Government also negotiated a stand-by arrangement for SDR 184 million, which was approved by the IMF on September 15. In July 1979, this stand-by was replaced by a new stand-by arrangement for SDR 285 million, (of which, SDR 232 million will be financed from the Fund's supplementary financing facility) in support of the same financial program. Peru's debt outstanding to the IMF as of June 30, 1979 was equivalent to SDR 439.8 million. 19. The Government's financial stabilization program, supported by the stand-by, has resulted in a dramatic improvement in public sector finances in 1979. Public sector current account savings rose from - 0.7 percent of GDP in 1978 to about 3.6 percent of GDP in 1979 and the overall deficit was reduced from 6.4 percent of GDP in 1978 to 2.9 percent in 1979. Central Government revenues increased by 23 percent in real terms, while current outlays declined by 6 percent. Payments for wages and salaries alone fell by some 7 percent in real terms, partly as a result of a planned reduction in excessive civil service employment. The elimination of subsidies on food and petroleum products, initiated in mid-1978, also contributed to the control of current expenditures. Defense outlays have also been cut. On the revenue side, several measures--including a 10 percent import surcharge, a higher tax on traditional exports and an increased tax on interest charged on bank loans-- help to achieve the revenue target. In spite of good fiscal performance, however, inflationary pressures remain strong, with the consumer price index rising at an annual rate of 67 percent. Debt Restructuring 20. Major debt-relief operations carried out in late 1978 enabled Peru to reduce substantially the debt-service burden for 1979 and 1980, postponing repayment to the 1982-1986 period. In May 1978, the Soviet Union rescheduled the equivalent of about US$140 million of maturities originally due in 1978-80. These amounts are to be repaid over a 10-year period including three years of grace. In November, at a Paris Club meeting, the OECD countries agreed to reschedule 90 percent of principal payments due by the public sector to governments and guaranteed suppliers in 1979 (US$250 million) and 1980 (US$263 million). These amounts are to be repaid over a period of eight years, in- cluding three years of grace. The Paris Club agreement states that 1980 maturities will be rescheduled provided that Peru agrees with the IMF, by December 31, 1979, on a financial program for 1980. (This agreement with the IMF was scheduled to be considered by the IMF Board on February 27, 1980.)  -6- The Paris Club creditors also agreed to reschedule 90 percent of the principal payments due in 1979 and 1980 (about US$30 million in each year) on private sector debt guaranteed or insured in the creditor countries. In addition, Peru has negotiated smaller amounts of debt relief with non-OECD countries. 21. As regards the large medium-term public debt to commercial banks, in keeping with an agreement concluded in December 1978, Peru has been repaying in 1979 the bulk of the US$185 million rolled over from 1978 (para 18 above). The agreement reached between the Government of Peru and the commercial banks gives the Government the option of refinancing up to 90 percent of the maturi- ties due in 1979 and 1980. The Government, however, has recently indicated that it intends to forego a large part of this debt relief, in view of the much improved balance-of-payments situation (para 25). Social Situation 22. The economic crisis has been reflected in two consecutive years of negative growth. Total Gross Domestic Income fell by 0.6 percent in 1977 and a further 3.9 percent in 1978. In this two-year period GDP per capita dropped by over 8 percent. This situation, in turn, has been reflected in incomes and employment. Nearly one half of Peru's labor force is believed to be unemployed or underemployed, i.e., earning less than the minimum wage or working less than 35 hours a week and wishing to work more. According to government estimates, the purchasing power of an average salary had fallen 40 percent by 1978 compared to 1970 and that of an average wage by over 16 percent. In these circumstances, the social situation has been unavoidably tense, and several general strikes have taken place during the past year. 23. In July, 1979 the military Government promulgated a new constitution, written by a popularly elected assembly. The Government has called for elections in May, 1980 and the transfer of authority to a civilian government is scheduled to take place in July, 1980. At present the authorities are maintaining an informal dialogue with the leaders of the major political parties in an effort to ensure the continuity of economic policies following the political transition. The Economic Recovery Program 24. With the financial stabilization program and the debt restructuring described above, the Government has brought the fiscal and external gaps under control. These efforts, however, have not yet helped much in overcoming the deep economic recession. To this end the Government conceived an Economic Recovery Program (ERP) which would reverse the decline in GDP and lay a basis for a financially sound economic recovery. The ERP includes, in addition to the above-mentioned stabilization actions, measures to open up the economy, stimulate industrial sector efficiency, promote non-traditional exports, strengthen the tax system by broadening its base, and generally improve the efficiency of resource allocation in the private and public sectors. In this connection, the Government formulated a Public Sector Investment Program that aims at redirecting public investment towards projects of clear economic priority and positive effect on production and employment. In support of the ERP, the Bank approved a US$115 million program loan in May, 1979. Progress  in carrying out the ERP is generally satisfactory with performance in some critical areas--e.g., export promotion--actually exceeding expectations. 25. The Government's program has also led to a strong balance of payments performance in 1979, which is essential for economic recovery and to restore net international reserves. This was achieved by maintainin- in export-oriented foreign exchange policy, realistic interest rates, and the prumotion of non- traditional exports, but it is also the result of low, recession prone imports. In addition, Peru benefitted from substantial price increases for silver, copper, petroleum and other commodities. The Peruvian Government also intends to improve foreign debt management by, inter alia, making greater use of aid from official bilateral and international donors to the extent possible. Much of Peru's large foreign short-term debt (estimated at over US$2 billion as of year-end 1978) is expected to be rolled over or refinanced as the gradually improving economic situation permits new trade-related credit lines to be opened. The trade balance is expected to be strengthened by favorable world prices for minerals, and by the availability of a large petroleum surplus for export amounting to some US$850 million per year over the next few years. Even though about one third of the projected gross petroleum exports would leave the country as profit remittances, this still implies a major improvement over recent years, when Peru was spending in excess of US$200 million per year on fuel imports. 26. As economic activity recovers to an annual growth of about 6.5 per cent in real terms during 1979-85 and the volume of petroleum exports stagnates and eventually declines, the value of imports is expected to outpace exports. Based on assumptions that are cautiously optimistic, the country is expected to show a strong balance-of-payments performance through the mid-eighties, with current account surpluses and a substantial build up of foreign exchange reserves in spite of heavy debt repayment obligations. The balance-of-payments situation may, however, deteriorate in the second half of the eighties (or even earlier), when the exportable surlus of oil is expected to decline. This will eventually result in increasing current account deficits, particularly if imports exceed projections as a result of the recently started import liberali- zation process. Against this background and given Peru's large overhang of external indebtedness, there is a continuing need for official development assistance, including some degree of local cost financing. Considering the expected medium-term balance-of-payments performance and assuming that the authorities continue to carry out the ERP and to maintain prudent financial policies, Peru is creditworthy for Bank lending. PART II - BANK GROUP OPERATIONS IN PERU 27. In addition to the US$32.5 million loan to PETROPERU which the Executive Directors are expected to consider in March, the Bank has approved 36 loans to Peru for a total amount of US$732.1 million, net of cancellations. About 33 percent of the Bank's lending to Peru has been for transportation (mainly highways and ports), 22 percent for agriculture, 16 percent for the May 1979 Program Loan, 12 percent for the energy sector, 11 percent for mining and industry and about 6 percent for education and urban development.  28. Of the US$279.1 million undisbursed as of January 31, 1980, almost 95 percent is attributable to the seven project loans and the program loan made since 1976. The slow start-up of the project loans--only two of which were "repeater" operations--as well as the slow progress of previous opera- tions was due, in large part, to weak project execution capacity and to a shortage of counterpart funds that worsened as the economic situation deterio- rated during this period. As a result, disbursements have averaged about US$25 million per year over the past few years (Annex II contains a summary statement of Bank loans as of January 31, 1980, and notes on the execution of on-going projects). In an effort to improve this situation: (i) the Bank has recently opened a resident mission in Peru; (ii) the Executive Directors have approved modifications in the Education and the Lima/Amazon Corridor Projects (see Annex II for further details); (iii) adequate counterpart funds have been provided by the Government for 1979 and 1980; and (iv) the Government has set up a special commission to monitor loan execution and resolve administrative problems. With these actions and since start-up problems facing some of the newer projects have now been largely overcome, the pace of disbursement is now increasing. Almost US$20 million was disbursed on project loans in the first semester of FY 1980. 29. Program Loan disbursement started slowly because of the unforeseen increase in foreign exchange availability in Peru as a result of booming exports and continued depressed import levels, as well as substantial debt rescheduling. In order to accelerate disbursements, the list of eligible imports has been expanded to include additional high priority industrial inputs. In recent months, Program Loan disbursements have increased markedly. As of February 4, 1980, US$41.2 million had been disbursed. 30. The main objectives of Bank lending to Peru have been to assist in (a) the creation of the physical infrastructure needed to sustain and foster development; (b) the expansion of productive capacity in crucial sectors; (c) the consolidation of structural and institutional changes, particularly land and education reforms; (d) the strengthening of agencies to implement and operate projects effectively; and (e) improving living con- ditions for the urban and rural poor. In the past, Bank lending concentrated on infrastructure in the transportation and power sectors. More recently, the Bank's emphasis has shifted to more directly productive fields -- mining, agriculture and industry -- to aid Peru in surmounting its balance of payments problems. Lending for social projects has also grown. 31. The next operations that would be ready for the Executive Directors' consideration include a provincial airports project, a sixth agricultural credit project, a mining operation and a highway maintenance project. 32. Bank loans constituted about 7.0 percent of Peru's total public external debt, including undisbursed, at the end of 1978, and absorbed about 3.7 percent of the country's external debt service in 1978. Assuming increased recourse to long-term bilateral and multilateral aid by Peru, the Bank's share in the country's outstanding public foreign debt by 1985 could reach 12 percent and its share of debt-service would be around 5.5 percent.  -9 - 33. IFC commitments to date have been US$29.7 million (including US$15 million to the Southern Peru Copper Corporation for the Cuajone Copper Mining Project) of which US$17.2 million is held by the Corporation. A summary statement of IFC investments as of January 31, 1980 is presented in Annex II. 34. -i other principal official agencies lending to Peru -- IDB and USAID -- are expected to continue giving special attention to agriculture with IDB emphasizing agricultural credit and small scale irrigation and AID stress- ing rural development. Total loan commitments as of October 31, 1979 by IDB and USAID were US$500.9 million and US$198.3 million, respectively, and their shares of debt service as of end-1978 were 1.0 percent and 0.5 percent, respectively. PART III - THE AGRICULTURE SECTOR Land and Water Resources 35. Peru has a limited natural reso rce base for agriculture. Of the country's total land area of 1,285,000 km , only about 2.9 percent is cultiv- able and another 17 percent is natural pastureland. Some additional land could be brought into production, but only at a high cost either for expensive new coastal irrigation schemes or by providing basic infrastructure for more remote areas, mainly in the Amazon region east of the Andes. 36. Of the country's three principal regions, the 130,000 km Costa is the major agricultural area. This region accounts for about 10 percent of the total land area and 46 percent of the country's population. Agriculture in the Costa, which consists mainly of desert terrain, is limited to river valleys where irrigation is possible. 37. The Selva region east of the Andes accounts for 64 percent of the total land area but for only 10 percent of the country's population. There is abundant water, since Peru's major river systems flow through the area and rainfall is high, but soils are generally poor--particularly in the lower Selva. In an area known as the Ceja de Selva (the foothills between the Andes and the lower Selva), soils are of better quality and agricultural and live- stock development has begun. 38. The Sierra, where the Puno project would be located, has about 44 percent of the country's populatio2 and consists of steep mountains and high valleys. Of the zone's 332,000 km, about seven percent are farmed and 52 percent are used for grazing. Because of the rugged topography and severe climate, productivity is low and there is little scope for putting new land into production. There is a potential, however, for increasing agricultural and livestock productivity through projects such as the one proposed in this report.  - 10 - Agriculture in the Economy 39. In 1978, agriculture contributed about 13 percent to Peru's GDP, employed more than 42 percent of the labor force and accounted for about 18 percent of total merchandise exports. From the mid-1960s to the mid-1970s, investment in agriculture was low mainly because of uncertainty and rural unrest during a period when a major agrarian reform was proposed and under- taken. Government price, production and marketing control policies also tended to discourage investment and production by setting low prices for foodstuffs to favor urban areas and by imposing production limits on non-food crops. As a result, the value of food production in constant prices increased by an average of only one percent per annum during this period. During the same period, population increased by an average of 2.9 percent per annum. Conse- quently, the country's dependence on imported foodstuffs grew substantially, mainly for dairy products, legumes, vegetable oils and grains such as wheat and maize. At the same time, the volume of agricultural exports--which consist primarily of coffee, cotton and sugar--declined and by 1975/76 was only about 60 percent of its 1962/63 level. A principal cause was the sharp contraction in cotton production because of erratic prices and government policies emphasizing food production. Also, the value of sugar exports was curtailed by rapidly increasing domestic consumption and low world prices. In spite of these trends, Peru continued to maintain a positive, though shrink- ing, balance of trade in agriculture through the mid-70s. In 1977/78, this positive balance grew as food imports were reduced--because of the country's economic crisis--and the value of exports grew, primarily because of the increase in coffee prices. 40. The Government has recognized that improvement of the agricultural sector's performance is critical to the country's economic progress and to the well-being of the rural population. It has, therefore, recently taken steps to stimulate production and increase producers' incomes. In 1978, farmgate prices were greatly increased, restrictions on production were relaxed and consumer subsidies on food products were reduced substantially. While there are indications that these policy changes have had a positive influence (e.g., there has been a 20 percent increase in the 1979/80 cotton crop), it is still too early to estimate their full impact on agricultural production. Agrarian Reform 41. In June 1969, the Government approved an agrarian reform law aimed at expropriation of 14,500 estates covering 10.3 million ha (43 percent of the country's area in farms). By the end of 1978, the agrarian reform was sub- stantially completed but had benefitted only about 25 percent of the country's 1.8 million rural families. 42. Rather than dividing them up among individual farmers, the agrarian reform left the large cotton and sugar estates on the Costa and cattle and sheep ranches in the Sierra intact. These agrarian reform enterprises (AREs) are now run on a commercial basis under various forms of cooperative associa- tion. By and large, they work fairly well on the Costa where the workers were already acquainted with large production units and wiLh the technologies used. Production has been maintained in most cases and the incomes of agrarian reform beneficiaries have improved somewhat.  - 11 - 43. The introduction of cooperative forms, with which the Sierra population was not familiar, has not been as successful. Member rejection has been particularly noticeable in the poor tenant-based haciendas, where coopera- tivization has been accompanies by attempts to eliminate individual plots and herds. Also, since wages and jobs for ARE members are both guaranteed, there are few incentives towards labor effort and discipline. Effe ive management is also a major problem for many of these enterprises, since - large number of the technicians and administrators previously working on the private estates left and were replaced by less qualified staff. 44. The Government recognizes that the success of the agrarian reform will depend on solving the AREs' organizational problems and increasing their efficiency. The key issue will be how to strengthen the identification of the members with the ARE to establish labor discipline. For this reason, the Government is beginning to undertake projects to increase the production and profits of the enterprise in order to provide greater benefits to participants. To begin to deal with the AREs' management problems, the Government has conditioned the granting of credit to enterprises on the hiring of qualified professional managers. With these measures and improvements in organization and supporting services, such as those envisaged in the proposed project, the AREs' management and financial situation should slowly begin to improve. 45. Altogether, about 75 percent of the rural population--mostly land- less workers and farmers with less than 2 ha--were left untouched by the agrarian reform. In a sense, these groups are now worse off than before: for the landless workers, employment opportunities on the large cooperative farms have now become more scarce, and the Government has channelled its agricultural support services almost exclusively to the AREs. To reverse this trend in the Puno area, services and credit for small farmers would be a major component of the proposed project and the employment generation envisaged should provide work for the relatively few landless laborers in the project area. Agriculture and Rural Poverty in the Sierra 46. About 75 percent of the Sierra's population depends on farming (much of which is at the subsistence level) and cottage industry; the remainder are engaged in mining, commerce and other activities. Annual farm family income in the mid-1970's was estimated at US$250 equivalent--well below the relative poverty level in Peru of US$800 per family. One of the major limita- tions on the region's economic development has been stagnating agricultural productivity. Already restrained by harsh climatic conditions and the perva- siveness of inadequate traditional practices, agricultural production in the Sierra has received little assistance from Government infrastructure or support service programs. Also, until recent policy shifts, pro-urban pricing had discouraged production. 47. Over 95 percent of the more than one million farms in the Sierra and under 20 ha in size; these account for 77 percent of the region's cropland and for about 65 percent of livestock herds. Medium-sized units (20-100 ha) and units of over 100 ha (mostly AREs) represent three and one percent, respec- tively, of the number of farms. The Sierra accounts for almost 80 percent of  - 12 - the country's cattle herds and for almost all of the sheep. Much ranching, however, is done under marginal conditions and yields are low. This is also true of crop farming, which is limited to one short growing season from about November to March. The principal crops are potatoes, barley, wheat and quinua--a native grain. The Sierra is the country's main producer of these staples. 48. Poor economic performance is accompanied by miserable living condi- tions and social and cultural impoverishment, particularly in rural areas. Most housing is primitive, with inadequate potable water and sanitary facili- ties. Few homes have electricity. Both caloric and protein intake are inadequate among Sierra residents and 60 to 70 percent of rural children under school age are malnourished. Life expectancy in the region is 35 years, mainly as a result of high infant mortality rates of over 100 per thousand live births. Infectious parasitic and respiratory diseases--owing to poor personal hygiene, lack of immunization and inadequate potable water and sewerage disposal facilities--are the leading cause of death. Health services are rudimentary or non-existent; Sierra departments average less than one health facility bed and one professional or technical staff per thousand persons--under one-half the national average--and even these are concentrated in urban centers. 49. The extreme poverty and poor living conditions of the rural Sierra have resulted in significant migration to urban areas, especially to the cities of Puno, Arequipa and Lima. The region's population is increasing at only one percent per annum, with most growth in the urban areas. Institutional Framework and Support Services 50. The Ministry of Agriculture and Food (MAA) is generally responsible for formulating and carrying out Government agriculture sector policies and activities. These include overseeing the agrarian reform, providing extension services, carrying out research and executing agricultural projects. Operations at the field level are carried out by 13 regional directorates. Training for agricultural extensionists and farmers is provided by the National Training Center for the Agrarian Reform (CENCIRA) in its local centers. Research is undertaken by the National Agricultural Research Institute (INIA) through regional stations. Both CENCIRA and INIA are autonomous entities under MAA. Generally, the MAA--at both the central and regional levels--has suffered budgetary limitations that have resulted in low salaries and consequent difficulties in retaining qualified personnel. The Government has recently raised salaries somewhat in an effort to attract experienced technicians to key positions. 51. Under the General Water Law of 1969, all water became property of the state. The MAA is now responsible for irrigation activities and the establishment of water rates. Under the 1969 law, farmers are required--in accordance with their financial capacity--to pay water charges to cover full operation and maintenance, plus a reasonable amount of the investment costs of the works. Some maintenance is carried out by water users' associations which are authorized to impose charges to pay for the work. Until recently,  - 13 - water charges imposed by the Government were nominal, effective collection was low and receipts did not cover 0 & M costs. Moreover, the monies that were collected went to the national treasurer and not to the irrigation districts where farmers could see the fees they paid invested. This situation is beginning to improve (see para. 82). 52. The Peruvian Agricultural Bank (BAP), a Government-owned institution, provides 85 percent of agricultural credit in Peru, with the balance coming from other banks. BAP has branch offices and agencies throughout the country. About 90 percent of BAP's annual lending consists of short-term production credit, mainly to AREs. BAP long-term lending has generally been financed by Bank or I1B loans. BAP has executed five Bank-financed agriculture credit loans and is acting as banking agent for the on-farm development credit component of the 1977 First Irrigation Rehabilitation Project (Loan 1403-PE) and of the 1979 Lower Piura Irrigation Rehabilitation Project (Loan 1771-PE). BAP's lending operations have grown in recent years owing to rising demand from AREs and declining participation of private banks. The volume of BAP long-term development credit has increased to a lesser degree because of BAP's lack of resources and the reluctance of individual farmers to invest. Although a high level of arrears has been a problem, BAP's financial situation has been improving recently as AREs have become better established. 53. Marketing services and provision of agricultural inputs are provided by the National Input Marketing Company (ENCI). ENCI operates storage facil- ities around the country and markets fertilizer and seeds. 54. At the local level, development activities are coordinated by regional development organizations which have been established in a number of areas over the past five years. The Puno Regional Development Organization (ORDEPUNO) is typical of such entities. The Chief of ORDEPUNO has ministerial rank and reports directly to the President. The various national ministry regional directorates (agriculture, health, education, transport, etc.) are under his control. Their budgets are established by ORDEPUNO in accordance with regional priorities and plans. Sectoral Development Strategy 55. In addition to assisting the rural poor, particularly the Indians of the Sierra, the Government's agricultural development strategy as reflected in its 1978-1982 Medium Term Public Investment Program is to: (i) continue development and rehabilitation of irrigated coastal areas where the potential for increases in production is great and large investments in irrigation infrastructure have already been made; (ii) begin to develop the potentially rich Ceja de Selva, east of the Andes; and (iii) increase development of smaller scale irrigation projects. The Government is also interested in increasing the flow of agricultural credit and strengthening its weak exten- sion service to provide better support to both small farmers and AREs. Bank Lending 56. In order to help spur Peru's agricultural development, the Bank has made 11 loans to Peru totalling US$163.5 million. Five of them, in the period 1954-1973 and totalling US$55.0 million, were for agricultural credit and were  - 14 - channelled through BAP (105-PE, 162-PE, 257-PE, 415-PE and 933-PE). In general, BAP performance has been good; disbursement of the last loan (933-PE) has been completed and preparation of a sixth loan is underway. Two loans (67-PE and 98-PE), totalling US$3 million, were for farm machinery imports. Another two (Loans 114-PE of 1955 and 418-PE of 1965), totalling US$24.5 million, financed irrigation works and land settlement in the San Lorenzo area within the Chira-Piura basin. The San Lorenzo project, financed by Loan 418-PE, is the only one in the sector that has been the subject of a Performance Audit. Although the Audit Report concluded that the project achieved its basic goals of increasing agricultural production and the incomes of rural poor, it noted the need for provision for better maintenance of works, a strong project unit, and agricultural support programs for irrigation projects. These findings were taken into account in the design of the two most recent irrigation operations: The First Irrigation Rehabilitation Project and the Lower Piura Project (Loans 1403-PE of 1977 and 1771-PE of 1979 for US$25 and US$56 million, respectively). PART IV - THE PROJECT 57. This would be the first Bank-financed integrated rural development project in Peru. After several Bank exploratory missions, project preparation was begun in mid 1977 by a working group established under the direction of the Puno regional office of the MAA. This group included representatives of the various regional agencies expected to participate in the project. A feasi- bility study for the proposed project was completed in mid-1978, with the assistance of the FAO/IBRD Cooperative Program. A Bank mission visited Peru to appraise the project in June 1979. The appraisal mission's report entitled "Staff Appraisal Report, Puno Rural Development Project" (No. 2736-PE dated February 12, 1980), is being distributed separately to the Executive Directors. Supplementary data are contained in Annex III. Negotiations took place in Washington from February 4 through 12 and the Peruvian Delegation was headed by Mr. Ulises Montoya, Deputy Director of Public Credit of the Ministry of Economy and Finance. The Project Area 58. The project area consists basically of the 8,558 sq km Juliaca micro-region in the Department of Puno, located close to Lake Titicaca on the southeastern border of Peru (see the attached map). The principal city in the area is the marketing and transport center of Juliaca, with a population of 39,000. The micro-region is mainly a plateau intersected by valleys. Most of the agricultural land is located between 3,800 m and 4,200 m. There are only about 12,000 ha in crops--about half in potatoes, one quarter in quinua, one fifth. in barley and the rest in other grains, beans and minor crops. Most of the balance of arable land is in natural pasture. There is little cultivated pasture in the project area, although about 150,000 ha are suitable for this. Lake Titicaca and four rivers in the area provide surface water resources. Although the area is semi-arid, only about 600 ha (mainly on small farms) is irrigated. Two trunk roads, both gravel-surfaced and in poor condition, cross the area. One leads to the Costa and the other serves the southern highlands of the Altiplano. The 625 km of secondary roads in the project area are also in poor condition.  - 15 - 59. The rural population of the micro-region was estimated at 118,000 in 1978, representing some 29,500 families engaged in agriculture. Of these, 12,370 or 42 percent were classified as "minifundistas". This group farmed less than two percent of the land in the project area and their farms averaged 1.1 ha. Their net income from farming (estimated at about US$70 per family in 1977) is below that required for subsistence consumption. Tr he extent possible, the "minifundistas" supplement farm income with earnings from seasonal labor and sale of artisan products. Another 13,390 families (45 percent of the total) were classified as "small farmers", with plots averaging 12 ha each and annual farming income of US$209 per family. There were also 740 medium farmers (2.5 percent of the total) with farms averaging 93 ha. The annual incomes of this group were US$577 per family. Finally, about 3,000 families were members of the seven AREs in the area which were created from former haciendas in the early 1970s. Project area AREs average over 70,000 ha in size, and are predominantly livestock enterprises based on extensive grazing of natural pastures. Although only 10 percent of the families in the project area are ARE members, they manage over half the land and have an annual family income from farming of US$548. 60. The Juliaca micro-region is one of the poorest areas of Peru, with an average income for a four member family of under US$200--well below the relative poverty level. Social conditions in the area are generally worse than those typical in the Sierra as described in paragraph 48. Project Objectives and DescriEption 61. The objectives of the project, which would be carried out over a 4-1/2 year period, are to raise incomes and improve living conditions for the 29,500 low-income rural families in the project area. Of these, 17,000 families (4,100 minifundistas, 9,400 small farmers, 500 medium-sized farmers and 3,000 families working on seven AREs) participating directly in the agricultural development components of the project would increase production and productivity on part of their holdings--20,000 ha of rainfed crop and pasture land and 4,100 ha of irrigated land. The project area's social and physical infrastructure would also be improved. This project would constitute one of the first efforts in Peru to coordinate development activities to improve the quality of life for poor rural families, including small farm- ers not associated with the agrarian reform. If, successful, this approach could be replicated on a larger scale as an important element of the Govern- ment's program to alleviate rural poverty. 62. The project would consist of: (a) the rehabilitation and construction of small irrigation systems to serve 4,100 ha; (b) an agricultural credit program to finance on-farm investments and incremental production inputs for the seven AREs in the project area and 14,000 private farmers; (c) crop and livestock extension services for beneficiaries of the credit program;  - 16 - (d) the establishment of 1,500 ha of forest plantations for soil conservation and fuel; (e) the constuction and improvement of crop, livestock and irrigation research facilities, and the establishment of training and demonstration programs; (f) the rehabilitation and upgrading of 515 km of rural roads, the acquisition of road maintenance equipment for the micro-region and the construction of six post offices; (g) the construction and improvement of 6 and 11 rural health facilities, respectively. Equipment for these facilities and the Lampa hospital would also be provided as would a nutrition program and training for rural health agents; (h) the installation of small communal potable water systems to serve some 13,250 families in 46 communities in the project area; (i) the construction and equipping of 23 vocational training centers; and (j) studies to prepare a second phase project for the Southern Altiplano. 63. Irrigation works, representing about 18 percent of project costs, would include rehabilitation of three irrigation systems (Huata-Quito, Cabanillas and Taraco) which were constructed 10 to 15 years ago. Repairs to principal canals, gates and intake works, as well as construction of secondary and tertiary distribution canals and drainage systems would permit the expan- sion of irrigated areas from 610 ha to 3200 ha, benefitting about 2,000 small farmers. 64. The project would also include the establishment of small-scale irrigation systems based on pumping from lakes, streams and wells to serve about 400 ha of the Buena Vista ARE and about 500 ha cultivated by small farmers in the micro-region. Finally, the project would include the establishment of a small machinery pool to construct minor on-farm works and to maintain the irrigation systems. 65. Agricultural credit, the project's single largest component totalling about 34 percent of project costs, would be channeled through the BAP to finance incremental production inputs and on-farm investments including irri- gation and drainage facilities, establishment of improved pastures, structures and storage facilities, farm machinery, tools and breeding animals. Altogether, about 17,000 farm families would benefit from this component. 66. The technical assistance program, representing over 16 percent of project costs, would provide crop, livestock and irrigation extension services to the families benefitting from the credit component. Utilizing the training and visit system, each extension agent would assist from two to six groups, depending upon their dispersion and the difficulty of the terrain in the area for which he was responsible. Specialists in small rural enterprise develop- ment would also be included in the Project Unit (to be set up under this operation) to identify possible projects for financing from an existing Banco Industrial del Peru credit line and to assist in preparation of investment studies and subloan applications.  - 17 - 67. The forest plantation program would be carried out on marginal lands that are not suitable for crops or livestock. In the first years, a seedling nursery would be established. Thereafter, 1,500 ha would be planted, primarily with eucalyptus trees. This program would improve soil conservation and even- tually provide an estimated 2,850 rural families with wood for fuel and sale. 68. The agricultural research and training component of the project would include the construction and equipping of an INIA crop and livestock experimental station at Illpa and the improvement of existing facilities at Tahuaco. The research program would be applicable to the Altiplano in general and to the project area. A small MAA irrigation training, demonstration and research center would also be established at Pirapi to instruct extension personnel and farmers in appropriate irrigation techniques and water use. 69. About 309 km of rural feeder roads would be rehabilitated and improved and 206 km of unsurfaced dirt tracks would be upgraded to all-weather standards so as to provide year-round access to all communities in the project area. Acquisition of equipment would be included to assure maintenance of the system. Six new post offices would be constructed to improve commun- ications in the area. This component would comprise about 9 percent of total project costs. 70. Under the rural health facilities component, six new health posts to provide ambulatory medical services would be constructed and seven existing health posts would be rehabilitated. In addition, two existing health posts would be upgraded to health centers, with four to eight beds each, and two existing centers would be rehabilitated and equipped. The small existing Lampa Hospital would also be equipped and expanded to a 20-bed facility. Regional staff and rural health promoters would receive training, ambulances and medical kits would be provided, and a small maintenance workshop for medical equipment would be established. Finally, nutritionists would be included in the Project Unit to provide training in about 40 villages in food preservation and preparation, and guidance in cultivating garden plots and raising small animals. The project would finance a study of the current nutri- tional status of the population and an annual review of program achievements. 71. Basic communal potable water supply systems would be provided for 46 communities and for project area health posts and centers currently without water. Public laundry and shower facilities would be installed in the health stations and in 30 of the communities to be served. In most cases, water would be supplied from wells equipped with small manual or windmill operated pumps. 72. Vocational training centers to be constructed in 23 villages would provide training in artisan crafts. It is envisaged that about 4,200 persons would participate in the vocational training program during project execution. Day care facilities would be included at some centers to enable greater participation of women. 73. A second phase study would be financed to prepare a possible follow-up project. Water resource development, soil and land use, agronomy and forestry, and marketing and socio-economic factors would be analyzed in the preparation of a comprehensive development plan for the project area. Some 24 man/months of international consultant services would be provided for this study. These and other consultant services under the project are expected to cost US$8,000 per man/month.  - 18 - Project Execution 74. The establishment within ORDEPUNO of a Project Unit with overall responsibility for project coordination would be a condition of the proposed loan's effectiveness (Sections 3.01(b) and 6.01(a) of the draft Loan Agreement). As a further condition of effectiveness, the Government would also enact a decree establishing regulations for ORDEPUNO (Section 6.01(f) of the draft Loan Agreement). The Project Unit, whose Director would report to the Chief of ORDEPUNO, would itself provide farm and ranch extension, nutrition and small enterprise development services. In addition, it would coordinate and supervise the carrying out of project components that would be the responsi- bility of other entities. A Project Unit Director acceptable to the Bank has been appointed and participated in negotiations. Should the Director change, his replacement's qualifications and experience would also be satisfactory to the Bank (Section 3.11 of the draft Loan Agreement). The Project Unit would have a separate budget through which all project activities, except the agricultural credit component, would be financed. As a condition of loan effectiveness, the Government would establish two project accounts. The first would be managed by the Project Unit and would contain, initially, sufficient funds to cover project expenses for three months. The second would be managed by BAP and would cover the estimated total cost of the agricultural credit component (US$8 million) (Sections 3.02(a), 3.03(a)(iii) and 6.01(c) of the draft Loan Agreement). 75. The construction, operation and maintenance of irrigation systems and the forest plantation program would be carried out by the regional office of the MAA. Training and research activities would be undertaken by CENCIRA and INIA, respectively, and the BAP would provide farm credit. The regional offices of the Ministries of Transportation and Communications, Health, Education and Agriculture would carry out the road improvement, health/potable water, vocational training and irrigation components, respectively (Schedule 6 of the draft Loan Agreement); they would be responsible for their maintenance thereafter (Section 4.05 of the draft Loan Agreement). The Government, through ORDEPUNO, would enter into agreements with the autonomous entities (BAP, INIA and CENCIRA), which would cover the preparation and execution of their work programs, procurement, financial arrangements, maintenance of records and reporting. Draft agreements, satisfactory to the Bank, have already been agreed to by the Government, BAP, INIA and CENCIRA. Execution of the agreement with the BAP would be a condition of loan effectiveness and the other two agreements would be signed within six months of loan signature, and their execution would be a condition of disbursement for the respective component (Sections 6.01(d) and 3.04 and Schedule 1 para. 4(b) of the draft Loan Agreement). Also, within six months of this loan's signature, ORDEPUNO would contract with Peru's Nutrition Institute to undertake the nutrition impact studies referred to in para. 70 (Section 3.04 (a)(iii) of the draft Loan Agreement). The remaining agencies, which are under the direct control of the Chief of ORDEPUNO, would prepare annual operating plans setting out the next year's work program. These would be consolidated by the Project Unit into an annual project investment and operating budget proposal which would be submitted to the Bank for review and approval not later than August 1 prior to the start of each year (Section 3.06(a) and (b) of the draft Loan Agreement).  - 19 - 76. Two long-term experts with international experience would be con- tracted to assist the Project Unit. One would be qualified in the execution of multisectoral rural development projects and serve as advisor to the Project Director for 36 months. The other would be hired for 24 months and assist in establishing and operating training programs for extension agents and farmers. In addition, internationally recruited short tr consultants would be hired to provide 44 man-months of assistance to the .roject Unit staff in (i) the managerial and financial analysis of ARE operations; (ii) planning, programming and budgeting; (iii) monitoring and evaluation; and (iv) identifying and preparing small enterprise projects. All consultants, including those for the second phase study, would be hired under terms and conditions and with qualifications acceptable to the Bank (Section 3.05(b) of the draft Loan Agreement). Appointment of the two long term consultants and of the ARE consultant would be a condition of loan effectiveness (Section 6.01(e) of the draft Loan Agreement). 77. A project coordinating committee would be established to set project policies and monitor execution of the project. This committee would meet at least quarterly, would be chaired by the Chief of ORDEPUNO, and would include representatives of (i) the entities involved in project execution; and (ii) the AREs and individual farmers. The Project Director would serve as a non-voting secretary to the committee (Section 3.01(c) of the draft Loan Agreement). The establishment of this committee in a manner satisfactory to the Bank would be a condition of loan effectiveness (Section 6.01(b) of the draft Loan Agreement). Project Costs and Financing 78. The total cost of the project is estimated at US$27.3 million (including taxes of US$0.1 million on civil works) of which US$12.1 million (44 percent) are foreign costs. The proposed Bank loan of US$15.0 million, representing 55 percent of total project costs, would cover the equivalent of all foreign cost and US$2.9 million of local costs (see para 26 for the local cost financing justification). The Government would provide counter- part funds of US$11.6 million equivalent, or 42 percent of project costs, and the beneficiaries would finance the equivalent of US$0.8 million, or three percent of project costs. 79. To help assure prompt initiation of the project, up to US$140,000 in retroactive financing would be provided to help finance costs incurred after January 1, 1980 for initial Project Unit Expenses (including the training of staff), completion of designs and preparation of procurement documents for irrigation system civil works, and initiation of studies of the river flows at the Cabanillas site where irrigation works would be rehabilitated under the project (para. 4 of Schedule 1 to the draft Loan Agreement). On-Lending Arrangements 80. On-farm investments and incremental production credit would be provided by the project through BAP sub-loans to individual farmers, farmer groups and AREs. BAP would continue to finance its ongoing short term credit program in the area from its own resources, but incremental production credit would be financed under the project. The BAP would grant sub-loans in Soles  - 20 - on the basis of development plans and applications prepared with the assistance of Project Unit extension agents. Where appropriate, loans to the AREs would be conditioned on the carrying out of improvement programs in management and financial administration. In accordance with present BAP procedures, sub-loans for incremental production inputs would be for up to two years with six months grace. The terms for on-farm investment credit would vary depending on the type of investment but would be for a maximum of 12 years with between three and five years of grace. Beneficiaries would contribute at least five percent of costs for sub-loans of under US$5,000 equivalent and ten percent for larger sub-loans, unless the BAP determines that for reasons of poverty the benefi- ciary cannot afford to make the minimum contribution. In such a case the BAP could lend up to 100 percent of the investment cost. Such subloans would not exceed 10 percent of the investment subloans under the project. In order to assure an equitable distribution of credit among the various categories of farmers in the project area, subloans of over US$100,000 equivalent would not exceed 15 percent of total loans and subloans of over US$5,000 equivalent (entirely for the AREs) would not exceed 50 percent of total loans under the project. The BAP Subsidiary Agreement with the Project Unit would provide that subloans be made on the terms and conditions set forth in this and the following paragraph (Section 3.03(a) and Schedule 7 of the draft Loan Agreement). 81. The minimum interest rate on short-term and development subloans would be the same as BAP currently charges--29 and 31 percent, respectively, plus a two percent commission charge. As a promotional measure for minifun- distas and small farmers who have generally not had experience with credit, first subloans for production and investment of under US$500 equivalent may bear an interest rate of 18 percent. BAP interest rates were increased substantially in 1978 when inflation was about 75 percent. Inflation was 67 percent in 1979 and is currently projected to drop to about 45 percent within the next two years. While the lending rates are presently negative in real terms, if the Government's economic recovery program continues to reduce inflation, they would become positive toward the end of the project execution period. To the extent that there is credit subsidy in the interim period it would go almost entirely to families with incomes under the relative poverty level, many of whom are engaged in subsistence agriculture. BAP would peri- odically review the lending rate in consultation with the Bank, taking account of changes in the rate of inflation and capital market conditions (Section 3.03(c) of the draft Loan Agreement). Cost Recovery 82. As noted in para. 51, in the past O&M charges collected from irrigation systems' beneficiaries have fallen far short of the actual costs. This situation is now changing. The MAA is beginning to enforce the water charge provisions of the General Water Law. In keeping with this policy, in the project area the Government would: (a) no later than June 30, 1984 and at least every two years thereafter, review and adjust the level and structure of water charges so as to ensure that they cover full O&M costs and as much as practical of the investment costs, taking into account inflation and the farmers' payment capacity; (b) by June 30, 1984 and thereafter, return to the irrigation districts fees equal to O&M costs; (c) staff and equip the irrigation district as necessary to provide adequate maintenance for systems in the project area;  - 21 - and (d) by March 31, 1984 complete a socioeconomic study, satisfactory to the Bank, on beneficiary repayment capacity as a basis for establishing a reason- able target for recovery of investment costs on the irrigation sub-projects carried out under this project (Sections 4.04 and 4.05 of the draft Loan Agreement). 83. In the case of the small-scale pumping schemes, a users' association would be organized for each system. Participation agreements would be entered into by the users' association and MAA prior to the construction of these systems, based on a model acceptable to the Bank. The Government would, by September 30, 1980 furnish this model agreement to the Bank (Section 3.07(a) and (b) of the draft Loan Agreement). 84. Cost recovery estimates are based on the assumptions that (a) farmers would repay capital costs of the irrigation schemes over a fifty year period without interest; and (b) that all irrigation O&M costs would be recovered. On this basis, the average cost recovery index for the irrigation projects is 44 percent. Procurement and Disbursement 85. Contracts for civil works whose costs are estimated to exceed US$500,000 equivalent would be let in accordance with Bank guidelines for international competitive bidding (ICB). Because of their small size, civil works for less than US$500,000 but more than US$100,000 equivalent would be let in accordance with local competitive bidding procedures (LCB) acceptable to the Bank. LCB is envisaged in the case of civil works under US$500,000 because international firms are not likely to be interested in relatively small contracts scattered over such an isolated region and because local firms have experience in such operations. Works that, because of their small scale and dispersed nature, are not likely to attract even local contractors would be carried out by force account. These would be limited to most road rehab- ilitation works (with a total cost of approximately US$1.3 million) and minor irrigation rehabilitation (with a total cost of about US$300,000). In the rare cases where the cost of such works is more than US$100,000 equivalent, prior Bank review would be required before force account proposals are approved by the Project Unit. 86. Contracts for equipment of over US$150,000 per package would be let under ICB. Qualified local suppliers and those from Latin American Free Trade Association and Cartagena Agreement member countries participating in inter- national competitive bidding would be accorded a preference representing the difference between the prevailing duty actually applicable and the duty appli- cable to goods imported from non-member countries, or 15 percent on the c.i.f. price, whichever is lower. Other contracts for equipment would normally be grouped into lots of not less than US$50,000 each and would be procured by LCB. 87. Disbursements under the proposed loan are expected to take place over a period of about five years, beginning in FY1981, and would be made against: (i) 100 percent of foreign expenditures and 80 percent of local expenditures for vehicles, machinery and equipment; (ii) 80 percent of total  - 22 - expenditures for civil works, including engineering and supervision; (iii) 80 percent of local expenditures for the salaries and operating costs of the Project Unit and the second phase studies, and of the research and forest plantation programs; (iv) 90 percent of cost of local training and 100 percent of foreign expenditures for overseas training; and (v) 100 percent for consul- tants and experts. For force account works and Project Unit operating expen- ditures, disbursements would be made on the basis of statements of expenditures. Project Benefits 88. The proposed project would substantially improve living conditions for about 29,500 poor rural families in the Juliaca micro-region. Increased crop and livestock production of some 17,000 families would, at full develop- ment, raise minifundista family net income from farm operations by 160 percent, small farmer income by 117 percent, medium farmer income by 60 percent and ARE income by over 100 percent. Also, labor demand on area ranches and farms would increase by over 2,000 man-years. Given the income level from which they are starting, however, most beneficiaries would remain below the relative poverty level. 89. There would be large improvements in productivity under the project. Although land in crops and pasture would not be significantly expanded, yields would increase through more and better use of improved seeds, fertilizer and pesticides, planting of cultivated pastures and improved farming and ranching practices. This would be supported by an efficient extension service, better irrigation and transport infrastructure and timely provision of farm production and investment credit. Improved health conditions should also promote improved productivity. Crop and livestock output is expected to more than double in most cases. Estimated yield increases have already been achieved by the more efficient farmers in the area and should be attainable with the assistance of project supported programs. The incremental net value per annum of crop production at full project development for minifundistas and small farmers would be US$2.5 million. For medium farmers and AREs, this net incremental value would reach US$400,000 per year. 90. The benefits of the physical and social infrastructure programs are difficult to quantify but would improve living conditions for a substantial part of the project area's population. The health and potable water supply components are especially critical given the extent and nature of health problems in the area. The vocational training and forest plantation programs would provide additional sources of income for area residents. 91. The project's economic rate of return (excluding second phase study costs) is estimated at 27 percent with a shadow price for labor at 70 percent of its financial cost. Sensitivity analysis indicates that the project would still have an ERR of 12 percent (the estimated opportunity cost of capital in Peru) with either benefits reduced by 37 percent, irrigation system, on-farm investment and social infrastructure costs increased by 236 percent or operating costs increased by 78 percent. Project and Environmental Risks 92. The technical risks related to the engineering and agronomic aspects of the project are similar to those faced by other projects of this sort and are acceptable. The executing agencies have experience in carrying out  - 23 - the type of works planned and the feasibility of the proposed production techniques and expected yields have already been demonstrated. There is a risk that delays may occur because of the institutional and organizational weaknesses of the public sector agencies and difficulties in retaining suffi- cient qualified agricultural extension staff. To deal with these risks, the project's size has been kept modest, a Project Unit with ad2rlte operational control would be established and training and technical assiscance would be made available to the Project Unit staff. Moreover, Bank staff would closely supervise the project's execution. 93. No environmental risks are anticipated with relation to the project, which is expected to result in improved land and water resources management. Fertilizers and agricultural chemicals, used with proper guidance, would have minimal impact on the environment. Furthermore, the forest plantation program would assist in soil conservation. PART V - LEGAL INSTRUMENTS AND AUTHORITY 94. The draft Loan Agreement between the Republic of Peru and the Bank and the Report of the Committee provided for in Article III,. Section 4 (iii) of the Articles of Agreement are being distributed to the Executive Directors separately. 95. The draft agreement conforms to the normal pattern for loans for rural development projects. The main features of the Loan Agreement are referred to in the text and listed in Section III of Annex III. Special conditions of loan effectiveness would be that (i) two project accounts be established, one for BAP for the credit component and another for the Project Unit for other components (para. 74); (ii) the Project Unit and the project coordinating committee be established in a manner satisfactory to the Bank (paras. 74 and 77); (iii) long term consultants to advise the Project Unit's Director and to establish and operate the Unit's training programs as well as the consultant to advise on ARE management be appointed (para. 76); (iv) a decree establishing regulations for ORDEPUNO be enacted (para. 74); and (v) the Government and BAP enter into a Subsidiary Agreement (para. 75). Special conditions of disbursement for the INIA and CENCIRA components would be the execution of their agreements with ORDEPUNO governing their implementation responsibilities (para. 75). 96. I am satisfied that the proposed loan would comply with the Articles of Agreement of the Bank. PART VI - RECOMMENDATION 97. I recommend that the Executive Directors approve the proposed loan. Robert S. McNamara President Attachmen s February 27, 1980 Washington, D.C.  - 24 - A12XI TASL 3A Page 1 of 5 PERU - IOCINL INDICATORS DATA RinERCP ClOU.P5 (ADnfSD AIJjGES LAND AMEA (TROUSAND SO Q-.) PUIU - MS UCE'4T ESTIMATE) - rTAL 1255.2 SAME SME EY RCEU ACUCULTURAL 1960. ObST MUCCNT GCOGCRPJIC IPCOMC . ICOQ5s - 1960 lb 1970 lb ISTIMATE /b CEGION /c GROUP /d CROUP / MNM P