Uganda - Cotton Subsector Development Project

Document of The World Bank FOR OFFICIAL USE ONLY Report No. 11970-UG STAFF APPRAISAL REPORT REPUBLIC OF UGANDA COTTON SUBSECTOR DEVELOPMENT PROJECT APRIL 15, 1994 Agriculture and Environment Operations Division Eastern Africa Department Africa Region This document has a restricted distribution and may be used by reipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS Currency Unit = Uganda Shillings (UShs) US$1 = USh.1200 (at appraisal) SDRI US$1.39 (as of March 28, 1994) WEIGHTS AND MEASURES Metric System GOVERNMENT FISCAL YEAR July I - June 30 ABBREVIATIONS AND ACRONYMS ADB - African Development Bank AEP - Agriculture Extension Project APC - Agricultural Policy Committee ARTP - Agricultural Research and Training Project ARP - Agricultural Rehabilitation Project AS - Agricultural Secretariat ASAC - Agricultural Structural Adjustment Credit ASAP - Agricultural Sector Adjustment Program BOU - Bank of Uganda BPA - Bukalasa Pedigree Albar CDO - Cotton Development Organization CSDP - Cotton Subsector Development Program DFCU - Development Finance Corporation of Uganda DFI - District Farm Institute EADB - East African Development Bank EU - European Union (formerly EEC) EDP - Enterprise Development Project EIB - European Investment Bank ERP - Economic Recovery Program ERR - Economic Rate of Return FSAC - Financial Structural Adjustment Credit GTS - Ginning Training School ICB - International Competitive Bidding Procedures IDA - International Development Association IFAD - International Fund for Agricultural Development IFC - International Finance Corporation IMF - International Monetary Fund IPM - Integrated Pest Management KfW - Kreditanstalt fuer Wiederausbau LCB - Local Competitive Bidding Procedures LMB - Lint Marketing Board LMCL - Lint Marketing Co. Ltd. MAAIF - Ministry of Agriculture, Animal Industry and Fisheries MOFEP - Ministry of Finance and Economic Planning MTI - Ministry of Trade and Industry NAEP - National Agricultural Extension Plan NARO - National Agricultural Research Organization NGO - Non Government Organization NRM - National Resistance Movement NRS - Namulonge Research Station NYTIL - Nyanza Textile Industries Ltd. NRP - Northem Rehabilitation Project PCU - Project Coordination Unit PIU - Project Implementation Unit PS - Permanent Secretary CSSC - Cotton Subsector Steering Committee SAC - Structural Adjustment Credit SATU - Serere Action Type Uganda SCRP - Smallholders Cotton Rehabilitation Project SIDA - Swedish International Development Agency SMS - Subject Matter Specialist SRS - Serere Research Station SWRARP - South West Region Agricultural Rehabilitation Project USAID - Unites States Agency for International Development UCB - Uganda Commercial Bank UGIL - Uganda Garment Industry Ltd. UTC - Uganda Technical College VTC - Variety Trial Center  FOR OFFICIAL USE ONLY REPUBLIC OF UGANDA COTTON SUBSECTOR DEVELOPMENT PROJECT Credit and Project Summary Borrower: Government of Uganda (GOU) Beneficiaries: Agricultural producers, cotton ginning industry, marketing agents, Cotton Development Organization, Ministry of Agriculture, Animal Industry and Fisheries (MAAIF) and National Agricultural Research Organization (NARO) Amount: SDR 10.0 M (US$14.0 M equivalent) Terms: Standard, with 40 years maturity Cofinancier: IFAD (US$12.5 M equivalent) Project Objectives: The project would support Government's strategy to revive cotton production and exports through increased competition in cotton processing and marketing and improved supporting services. The specific objectives of the project are: (a) improved performance in the cotton industry through liberalization of cotton processing and export marketing; establishment of an efficient regulatory framework for the cotton industry; and improved managerial, technical and operating efficiency in a creditworthy ginning industry; (b) improved efficiency and impact of supporting services through support for national research and extension programs; and (c) improved delivery mechanisms and availability of credit and seeds. These objectives would contribute to the broader sectoral objective of increased agricultural growth and diversification. Project Description: The project would provide financial assistance to support three broad sets of activities: (i) restructuring the cotton industry through (a) revision of the legal framework, liquidation of Government regulatory and marketing agency and establishment of an industry based regulatory body, and support of operations of the regulatory body; (b) transformation of Cooperative Union owned ginneries into creditworthy operators, including strengthening management and technical training to the industry; and (c) support of Government oversight of the subsector reforms; (ii) improved supporting services through support for national research and extension programs; and (iii) improved delivery mechanisms and availability of credit and seeds through provision of short and medium term credit and distribution of quality seed to farmers. |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.  - ii - Benefits: The project is expected to have a significant impact on the organization and management of the industry involving: (a) creditworthy ginnery ownership, which would make prompt payment to farmers a reality; (b) efficient ginnery management, which would encourage seed cotton production by farmers and facilitate marketing of their output; and (c) improved quality of ginning and marketing to raise the ginning percentage and lint value and make it possible to raise prices to farmers; and (d) increased production through improved extension services and availability of credit. There would be additional benefits, if the ginneries, following their restructuring, would become involved in the overall vertical integration of the industry including seed and input supply, ginning and marketing. These changes, complemented by the revival of ox ploughing, would lead to an increase in the numbers of farmers growing the crop and consequently an increase in area planted and in the national output. Overall cotton production would increase from 55,000 bales in 1993 to about 160,000 bales by 1999, equivalent to US$44 M in export value. This projected output is only about 34% of the peak level of 470,000 bales achieved around 1970. Risks: The project is subject to policy and financial risks. Safeguards against these risks have been included in project design as well as in other supporting operations. The major policy risk relates to GOU's commitment to implement the debt relief and associated restructuring programs for Union-owned ginneries and the willingness of the Unions to restructure their businesses. A new cotton legislation has been promulgated which would pave the way for restructuring and diversified ownership. Modalities for the Unions debt relief and restructuring have been agreed. The modalities carry a threat of foreclosure by the creditor banks of ginneries which fail to restructure their businesses. The book value of the debts and the extent of debt relief that have also been determined. The transfer of at least 100,000 bales of ginning capacity to creditworthy and viable operators would be a condition of release of the second tranche of SAC II. Financial risk relates to accessibility to credit by both ginnery operators and cotton producers. A problem is likely to be the ability of ginnery operators to satisfy the lending criteria and access available credit lines. The project therefore would provide business advisory services to assist operators in preparing viable business plans and in obtaining access to financing. At the producer level, credit accessibility is constrained by weak delivery mechanisms. The savings and credit program under the ongoing IFAD financed Smallholder Cotton Rehabilitation Project (SCRP) has fallen behind schedule due to institutional capacity constraints and delays in obtaining technical assistance. The proposed project is expected to continue and expand these programs through the ginneries and would include a pilot to test an alternative delivery mechanism, using a well-experienced non-government organization (NGO). The alternative mechanisms and experiences would be reviewed at the mid-term review of the SCRP in April 1995.  iii Project Costs: a/ Component Local Foreign Total % Foreign % Total (US$ Million) Exchange Base Cost A. Restructuring Cotton Industry 2.6 3.2 5.9 54.8 22.9 B. Improved Supporting Services 3.2 3.5 6.7 51.6 26.1 C. Credit and Seed Program 7.0 6.0 13.1 46.0 51.1 Total Base Costs 12.9 12.7 25.6 49.6 100.0 Physical Contingencies 1.3 1.3 2.6 49.5 10.0 Price Contingencies 2.1 1.3 3.3 35.1 12.8 Total Project Cost 16.3 15.1 31.4 48.1 122.8 a/ Numbers may not add due to rounding. Financing Plan (US$ million): Local Foreign Taxes Total IDA 5.9 8.1 - 14.0 IFAD 5.5 7.0 - 12.5 CDO 2.5 - - 2.5 COMMERCIAL 0.5 - 0.5 BANKS GOU 0.2 - 1.7 1.9 TOTAL 14.6 15.1 1.7 31.4 Estimated IDA Disbursement (US$ Million) IDA Fiscal Year 94 95 96 97 98 99 2000 Annual 1.1 2.5 4.1 2.7 2.2 1.0 0.4 Cumulative 1.1 3.6 7.7 10.4 12.6 13.6 14.0 Economic Rate of Return: 24% Poverty Category: Not applicable Maps Nos: IBRD 25455: Cotton Growing and Seed Multiplication Areas IBRD 25456R: Cotton Ginneries   REPUBLIC OF UGANDA COTTON SUBSECTOR DEVELOPMENT PROJECT TABLE OF CONTENTS I. BACKGROUND .............................................. I A. Economic Setting ......................................... I B. Agriculture Sector ....................................... 3 Sectoral Background .................................... 3 Agricultural Growth .................................... 3 Competitiveness in International Markets ......................... 4 Bank Role in Structural Adjustment in Agriculture .................. 4 C. The Cotton Subsector ....................... , 5 Current Status ........................................ 5 Key Constraints ....................................... 7 Market Prospects ...................................... 8 Future Development Strategy ............................... 9 1I. PROJECT BACKGROUND ...................... 9 A. Development Framework .................................... 9 B. Project Strategy ......................................... 11 Ginning Industry ...................................... II Improving Cotton Quality ........ ........................ 13 Finance Systems ...................................... 15 C. Support Services to the Cotton Subsector ......................... 16 Cotton Research ...................................... 16 Extension Services .................................... 17 D. The Role of Women in Cotton Production ........................ 18 E. Country Assistance Strategy and Rationale for IDA Involvement ... ....... 18 III. THE PROJECT ........ ......................... 19 A. Objectives and Main Features ................................ 19 This report is based on the findings of an appraisal mission in June 1993. The mission was led by K. Loganathan (Sr. Financial Analyst, Uganda Resident Mission/Task Manager), and included V. Mackrandilal (Sr. Economist), T. Sharif (Sr. Financial Analyst), J. Matovu (Operations Offlicer, Resident Mission), N. Ofwono (Operations Officer, Resident Mission), Stephen Carr (Consultant, Agriculturalist), F. Gillham (Consultanit, Cotton Agronomist), D. Parish (Consultant, Private Sector Development Specialist), S. Postma (Consultant, Project Analyst), M. Naur (Consultant, Women in Development), and J. Rwampwanyi (Consultant, Ginning Enginieer). S. Mustata (Consultant, Agronomist) participated on behalf of IFAD. Contributions based on previous mission and subsequent review were also made by Aloysius Ordu (Economist), Agi Kiss (IPM Specialist), J. Cameron (Consultant, Cotton Expert), A. Low (Consultant, Cotton Agronomist), C. Sarvaas (Consultant, Gender and Credit), and Ms. C. Jones (Operations Analyst). l'he Director and staff of the Agricultural Secretariat, Bank of Uganda, also contributed to the preparation of the report. The peer reviewers were Hamdy Eisa (Sr. Agriculturalist) and A. Spurling (Pr. Agriculturalist). Ms. S. Ganguly and Mr. F. Colaco are Managing Division Chief and Department Director, respectively. Mmes. Enid Kyomugisha, Agnes Kaye, Sarah Nsibirwa, Edith Ekwaro, Maxine Gunawardane and Minerva Naldo provided assistance in editing and document processing.  B. Project Components ................................................. 20 Restructuring the Cotton Industry .............................. 20 Legal and Regulatory Framework ................................ 20 Policy Coordination and Support ................................ 20 Restructuring the Ginning Industry ....... . . . . . . . . . . . . . . . . . . . . . . . . 21 Ginneries Management and Technical Training ...... . . . . . . . . . . . . . . . . . . 21 Improved Supporting Services ........................................ 22 National Research Program ........................... 22 National Extension Services ................................... 22 Extension Training Program ................................... 22 Credit and Seed Programs .......................................... 23 Production Credit .......................................... 23 Medium-Term Credit ....................................... 23 Rehabilitation of Animal Holding Grounds ...... . . . . . . . . . . . . . . . . . . . . 23 Studies and Pilot Activities.. ............... ... 23 Seed Procurement, Dressing and Distribution ....... . . . . . . . . . . . . . . . . . . 23 C. Project Costs and Financing ............................................. 24 Project Cost ................................................... 24 Proposed Financing .............................................. 25 D. Procurement ......... .............................. 26 E. Disbursement ..................................................... 27 F. Accounts and Audit .................................................. 28 IV. ORGANIZATION AND IMPLEMENTATION ARRANGEMENTS ...... . .......... . . . . . . . . 28 A. Overall Project Arrangements ........................................... 28 Cotton Improvement and Seed Multiplication and Distribution .................... 29 Credit Programs ................................................ 30 Cotton Development Organization ..................................... 31 Ginneries Restructuring and Debt Relief Program ............................ 31 B. Monitoring and Reporting .............................................. 32 Mid-Term Review ............................................... 33 V. BENEFITS, JUSTIFICATION AND RISKS .................. ....................... 34 A. Main Benefits and Beneficiaries .......................................... 34 B. Financial Analysis .................................................. 36 Farm Budget .................................................. 36 Ginning Industry ................................................ 36 Cotton Development Organization ..................................... 36 C. Economic Analysis .................................................. 37 Comparative Advantage and Competitiveness of Cotton ........................ 37 Rate of Return ..................... .. 37 D. Project Risks ..................................................... 38 E. Environmental Impact ................................................ 39 VI. ASSURANCES AND RECOMMENDATION ................. ...................... 40 A. Agreements and Assurances Obtained ....................................... 40 B. Recommendation ................................................... 41 LIST OF ANNEXES 1. Cost Tables 2. Activities under the PPF 3. Estimated Disbursement Schedule 4. Implementation and Supervision Plan 5. Economic Analysis 6. Letters of Development Policy 7. Documents in Project File  REPUBLIC OF UGANDA COTTON SUBSECTOR DEVELOPMENT PROJECT I. BACKGROUND A. Economic Setting 1.1 Uganda is well endowed with natural and human resources. It has abundant, fertile land and favorable climatic conditions for agricultural growth and it once had a relatively well- developed manufacturing sector and an effective transportation system. 1.2 The first few years after independence in 1962 clearly demonstrated the economic potential of the country. GDP grew by about 6 percent annually from 1963 to 1973. However, starting in 1970, political turmoil and economic mismanagement threatened to arrest the progress. As a result, real GDP declined by about 20 percent during the 1970s. In early 1981, the Government initiated a recovery program with the assistance of donors, including the World Bank and the International Monetary Fund (IMF). The recovery was short-lived and, beginning in 1984, a renewed cycle of instability escalated fiscal deficits, accelerated inflation and overvalued the currency, leading to further reductions in GDP. A military coup in 1985, followed by civil war, eventually brought the economy to a standstill. 1.3 The National Resistance Movement (NRM) Government which assumed power in January 1986, inherited an extremely poor infrastructure, a grossly under-utilized manufacturing sector, rampant inflation and a huge external debt. After a gradual return to political stability, the Government initiated an Economic Recovery Program (ERP) in 1987, backed by a Structural Adjustment Facility from the IMF, an Economic Recovery Credit (Cr. 1844-UG) from the International Development Association (IDA) and other donor financing. In 1989, the Government obtained an Enhanced Structural Adjustment Facility from the IMF and a Second Economic Recovery Credit from IDA to accelerate the reforms. The IMF program supported demand-management initiatives, while the IDA credit supported further structural measures, particularly those that promoted stability and growth objectives. 1.4 Continued support for the ERP is being provided under a Structural Adjustment Credit (SAC), approved by IDA in November 1991. The two primary goals of SAC are to: (a) remove the remaining constraints on the private sector and create an environment in which private initiatives can flourish and thus enable Uganda to realize its comparative advantage; and (b) improve the effectiveness and efficiency of public expenditure. 1.5 The performance of the economy under the ERP has been good. Over the past year and a half, the Government has made significant progress in macroeconomic management, private sector development and public sector management. 1.6 These actions have begun to show good results. In this regard, FY93 proved to be a major turning point in the Government's fight against inflation. Year-on-year inflation decelerated sharply during the year, reaching minus 0.5 percent in June 1993. Good weather, with its favorable impact on food supplies and prices, was undoubtedly an important factor behind this impressive performance. However, not less important was the firm control that the Government exercised over expenditure.  - 2 - 1.7 The trend towards low inflation has had a salutary effect on the exchange rate which has remained quite stable, fluctuating narrowly around USh 1,200/US$ over the past year. Owing to lower inflation, nominal interest rates started to fall, but rather slowly. The commercial bank interest rate on savings deposits came down from 21 percent at the end of December 1992 to 15 percent at the end of June 1993, while the interest rate on most loans dropped from 33 percent to 27 percent during the same period. The spread between lending and deposit rates has, however, remained the same (12 percentage points), but real interest rates have turned strongly positive as inflation has dropped. The banks have been slow to reduce interest rates because of the weakness of their balance sheets, their high operating costs, the general lack of competition in the industry and, perhaps, lingering inflationary expectations. 1.8 Uganda has also put in place a very liberal exchange and trade system which has greatly improved incentives for exports. However, the prospects for coffee, the main export, remain poor. Production has recovered somewhat from 122,154 metric tons in FY91 to about 130,000 mt in FY93, while prices have remained depressed at around US$0.85/kg (prices have, however, begun to increase after the introduction of the "Coffee Retention Scheme" in October 1993 by the Association of Coffee Producing Countries, including Uganda). Consequently, coffee export earnings slumped from over US$360 million in FY87 to US$101 million in FY93. Uganda would have fared even worse than this if it had not adopted far-reaching liberalization measures in the coffee subsector. The main measures include the abolition of the Government marketing agency's -- Coffee Marketing Board -- monopoly on exports, the freeing of farmgate prices, the elimination of the coffee export tax, and the conversion of coffee export proceeds into local currency at the market exchange rate. 1.9 Uganda has made considerable progress towards the achievement of macroeconomic stability. It has adopted important structural policies that have resulted in the creation of free markets and some improvement in public sector management. In spite of this progress, major challenges still remain. Macroeconomic stability remains fragile and needs to be consolidated. The social indicators (infant mortality, life expectancy, etc.) are very poor and need to be improved through a combination of faster growth and increased and better-targeted public expenditure in the social sectors. The tax base remains extremely narrow and tax administration is in need of further improvement. The financial system is inefficient and fragile. The civil service is short of professional and managerial skills, the pay is meager and productivity is, not surprisingly, very low. Against this background, the Government's basic medium-term macroeconomic objectives are: achievement of a GDP at an annual growth rate of at least 5 percent; maintenance of low and stable inflation; a reduction on the overall fiscal deficit (excluding grants) to 10 percent in 1994/95 from 12 percent in 1992/93; and, a steady improvement in the external payments position. 1.10 While Uganda will, for sometime, be preoccupied with consolidating financial stability, poverty reduction remains the overriding goal of development policy. Poverty is being attacked on two fronts: one, through accelerated economic growth, with its implications for the expansion of income and employment opportunities, and two, through investment in human capital and the targeted delivery of key public services needed to ensure that the poor are able to participate in growth. Of primary importance to raising the growth rate will be actions to promote private investment, backed by actions to increase domestic savings and achieve higher literacy rates and improved health.  - 3 - 1.11 The Government is reducing direct state involvement in production (with the support of the IDA Enterprises Development Project - EDP) and adopting policies to promote private enterprise. To make privatization politically palatable, it must make an effort to involve more local investors in the privatization process. A broad range of policies and programs to promote private sector development are now in place and are leading to a perceptible increase in private investment. In agriculture, the Government will have to strengthen the delivery of research and extension services, improve the security of access to land, liberalize cotton ginning and marketing, and complete the deregulation of the coffee subsector. Rapid private sector development is also contingent upon early and effective reform of the financial sector which at present is not able to provide long-term finance and meet working capital requirements. 1.12 In seeking to promote economic growth and provide public services, the Government will have to pay more attention to women's issues. To empower women to contribute more fully to economic and social development, actions are required in the following areas: legislative reform to establish legal rights and protection, enabling women to benefit from their own labor and have greater access to and control over economically productive resources, particularly land; investments in literacy and education aimed at countering the bias against female education; investments in health care, responsive to the wide range of women's health concerns; investments in targeted programs aimed at improving women's access to credit, extension services, technology and inputs; and programs that take specific account of female users' needs for labor-saving technologies. B. Agriculture Sector Sectoral Background 1.13 Agriculture is the mainstay of the Ugandan economy. Eighty-nine percent of the population is rural. The sector accounts for 51 percent of GDP (1991) and over 90 percent of exports, and employs 80 percent of the employed household population. Agricultural output comes almost exclusively from about 2.5 million smallholders -- 80 percent of whom have less than 2 ha each. Only tea and sugar are grown on large estates, which total 50,000 ha. The predominance of smallholder farming implies that the benefits from sectoral growth will be equitably distributed. Income per capita in 1990 was estimated at US$140 using the market exchange rate. 1.14 Food crop production dominates the agricultural sector in Uganda -- totalling 71 percent of agricultural GDP, followed by livestock production contributing another 17 percent (average 1989-91). Export crop production is only 5 percent of agricultural GDP; the fisheries subsector accounts for 4 percent; and, forestry for 3 percent. Only one-third of food crop production is marketed, compared with two-thirds of livestock production, and all export crop output. Agricultural Growth 1.15 The Agriculture sector has grown rapidly in recent years, achieving a 4.9 percent average annual growth rate between 1986 and 1991. This has been due to an expansion in cultivated area, rather than an increase in yields. The area under cultivation -- 4.6 M ha -- is still below the level of the late 1970s. Food crop cultivation, at 4.3 M ha, is at the levels of the early 1970s. Cash crop cultivation at 0.3 M ha is less than half the level of the 1970s, and is mainly due to the  - 4 - decline of cotton. Agricultural land, while not limiting growth for the country as a whole, is a constraint in certain, high-potential, high-population regions in the Southwest and Northeast. There is a gradual inter-regional migration, from the most densely populated areas to less- populated regions of good potential. Reestablishing peace north of Lake Kyoga will make large under-utilized areas available for cultivation. The area currently under cultivation, while utilizing the regions of highest potential, is still less than 30 percent of potentially cultivable areas. Competitiveness in International Markets 1.16 There have been dramatic changes in the international prices of Uganda's traditional export crops; coffee, tea, and cotton face much lower prices in real terms now than in the early 1970's. Prospects for price improvements are limited. Profits and rents from these crops, most of which were captured by the Government, have been severely reduced to keep the country competitive in international markets. Successful international competition now requires continued increases in the efficiency of export production and processing, with little margin for taxation. Uganda, due to its excellent agricultural resources, is a low-cost producer in these three crops and, with improved efficiency in the processing industries, can expect to profitably sell all it can produce. 1.17 The regional market for food, especially maize and beans, can be expected to increase. Given the conditions of drought that have persisted in the neighboring countries in the past several years, Uganda's landlocked status and reliable rainfall provide it with the opportunity to supply food cheaply to several of its neighbors. Growth in this market depends, however, on the annual food import requirements of a country in a given poor agricultural year, and may not go beyond 300,000 to 400,000 tons of food per year. Bank Role in Structural Adjustment in Agriculture 1.18 The Government's efforts to reform the production and marketing arrangements in agriculture since 1980 have received support from two IDA funded projects supporting sectoral adjustment: (a) the Agricultural Rehabilitation Project (ARP), Cr. 1328 - UG of February 1983; and (b) Agricultural Sector Adjustment Credit, (ASAC), Cr. 2190-UG of December 1990. Under the ARP, the physical rehabilitation of export processing facilities in the cotton, coffee and tea sub-sectors was financed. The ARP also financed a large share of imports of agricultural inputs between 1983 and 1992, when it closed. Perhaps the most important contribution was support for the newly established Inter-ministerial Agricultural Policy Committee (APC) and its executive arm, the Agricultural Secretariat (AS) in the Central Bank of Uganda (BOU). Through this structure, the Government monitored production and incentive problems facing farms and processing industries, and was able to implement ARP conditionality which required that farmgate prices for export crops be adjusted to maintain production incentives. While still administered by the Government, prices and margins for export crop purchase and processing were adjusted upwards during the early 1980s to maintain production and export incentives within a monopolistic, state controlled system. There was some response in the coffee, tea, cotton, and tobacco sub-sectors, which was subsequently dampened by security problems in the mid 1980s, the collapse of commodity prices on international markets and a decline in real farmgate prices. 1.19 ASAC was designed in 1990 to support the Government Agricultural Sector Adjustment Program (ASAP). It complemented the Government macroeconomic and cross sectoral policies to promote ARP's stabilization and growth objectives. The program has two objectives. The first is  - 5 - to support financial stabilization (by controlling credit expansion through improved institutional arrangements for financing coffee crop procurement and restructuring marketing intermediaries). The second objective is to promote agricultural growth (by creating competitive systems for processing and marketing export crops through institutional reforms, and enhancing coffee export incentive through price and tax reform). ASAC's main focus was on coffee subsector reforms. In addition, funds were provided to improve policy making in the agricultural sector and strengthen agricultural research and extension capacity. The project has been successful and provides a model for how to proceed in the liberalization of other export crop marketing systems. Also, ASAC provides support for the promulgation of a new land law which would extend freehold tenure. 1.20 There is still a remaining agenda for structural change in agriculture. Rapid increases in output in the cotton subsector should result from changes in ownership and the introduction of more efficient management in ginneries, improved access to credit, and increased competition amongst ginneries and export marketing agents. Adjustment in the cotton subsector will be fairly complex and cumbersome, however, given the dispersed location and ownership of ginneries, and the significant changes in ownership, management and finances involved. Reforms in the tea subsector are underway: the Government has divested its interest in tea estates owned by the Agricultural Enterprises Ltd; ownership claims for tea estates held by the Custodian Board have been resolved; and restructuring of factory ownership and management in the smallholder tea subsector is underway. 1.21 The quickest gains from structural change have already been captured. The constraints to growth now facing the agricultural economy will not be so easy to deal with. Continued growth in agriculture will have to come from improvements in: technology generation and dissemination; the responsiveness of the capital market, and the availability of long-term finance; access to hitherto under-utilized areas; the re-establishment of peace and security North of Lake Kyoga; and, land tenure security and the establishment of freehold tenure. The gradual release of constraints to growth in these areas will result from improvements in the effectiveness of the Government in the provision of essential public services and establishment of indirect regulatory mechanisms. All these efforts require a long-term commitment to slow, steady change. C. The Cotton Subsector Current Status 1.22 Cotton was introduced into Uganda in 1902 by the colonial Government. The ginning and marketing of cotton in Uganda was open to free competition until 1907, when hand gins were prohibited, and the licensing of ginneries began. Ginning and marketing of cotton were progressively restricted by the Government, through the establishment of the Cotton Control Board in 1921, culminating into a Cotton Commission in 1929. The restrictive recommendations of this Commission led to the Cotton Zone Ordinance of 1933, which carved the country into fourteen zones, and allocated an area to each ginnery where it became the monopoly buyer. A minimum pricing scheme was set up by the Government, in agreement with the ginneries, and the competition between ginneries for the cotton crop and the movement of prices according to supply and demand were finally ended. This system of controlled marketing and prices to growers has lasted to the present day.  - 6 - 1.23 Production grew rapidly until the mid-1930s, when coffee began to compete in the cash crop market. Cotton output and area continued to grow at a slower rate until around 1970, when the area under cultivation peaked at some 900,000 ha, and production reached 470,000 bales (86,900 tons) of lint. From this point on, the industry declined steadily. Output in 1990 was about 31,900 bales (5,900 tons) of lint, and the area under cultivation was estimated at 70,000 ha. 1.24 Ugandan cotton is a rainfed annual crop of medium staple, grown using low input-low output methods. The use of fertilizers and pesticides is small. It is grown at less than 1,500 m, above sea level, and requires a rainfall regime of over 800 mm/annum. It competes mainly with annual food crops. At the peak of production in 1970, it was grown mainly north, east and southeast of Lake Kyoga, and in the Kasese area in the West. Yields varied between 200 and 450 Kg/ha of seed cotton. 1.25 Two varieties have been used since the mid 1960s, supporting the two ecological zones which grow cotton: the northern and eastern dry areas, which are served by the Serere Research Station (SRS), grow the variety SATU (Serere Albar Type Uganda) and the southern and western wet areas, served by the Namulonge Research Station (NRS), grow the variety BPA (Bukalasa Pedigree Albar). (IBRD Map No. 25455) Based on existing production systems, cotton growers may be categorized into three groups: Category 1 - those who give priority to cotton as a commercial crop, plant early and spray 3-4 times in order to achieve optimum yields; about 60 percent of the growers in Kasese District fall into this category but only 5 to 15 percent in most other districts; Category 2 - those who plant cotton a little later (at or just before the onset of the second rains), generally because they lack land-preparation capability and have given priority to establishment of food crops. These farmers commonly include those preparing cotton land from fallow and who may spray once or twice but do not tend the crop as intensively as Category 1; Category 3 - those who plant late, sometimes after the harvest of a first rains crop, and regard cotton mainly as a conditioning crop for millet or as a "catch" crop after a more profitable early food crop. Little or no spraying is undertaken by this group. 1.26 The ginning and marketing of cotton are currently regulated under the Cotton Act, revised in 1964, and the Lint Marketing Board Act of 1959, amended in 1976. The Government marketing agency -- Lint Marketing Board (LMB) -- had, until recently, the right to purchase all cotton for export. Ginneries are free to sell lint to the two domestic mills. Traders in cotton lint and seed had to be licensed by the Ministry of Trade and Industry (formerly the Ministry of Cooperatives and Marketing). Profits from cotton trading by the LMB were transferred to a Cotton Price Assistance Fund. The Cotton Act provided for the zoning of cotton production, the setting of fixed seed and cotton lint prices, restrictions on the importation or trade in cotton, and the licensing and setting of ginneries. This Act was used to allocate "areas of influence" to each ginnery, prevent the use of hand ginneries, and confine ginning activities to the Cooperative Unions (Unions), which now own and operate all ginning capacity in the country. In late 1991, the Government declared its intention to liberalize the ginning and marketing of cotton.  - 7 - 1.27 The installed ginning capacity in Uganda exceeds demand. There exist some 38 ginneries with some 740 gin stands, and an installed capacity of 330,000 bales per season, assuming 120 days ginning season and operating two eight hour shifts per day. This is what remains from the peak number of 50 ginneries, with an installed capacity of 500,000 bales per season. In spite of rehabilitation programs in the 1980s (para 1.18), many ginneries are still in poor condition, and actual operating capacity is some 170,000 bales per season. The rehabilitation programs of the mid-1980s were financed by lines of credit provided through the Uganda Commercial Bank (UCB) and the Cooperative Bank under the IDA and African Development Bank (ADB) financed projects. Recently, the Government has been working through the LMB to provide finance, technical assistance, and spare parts to key ginneries, in an attempt to increase production further. These efforts have been moderately successful. Farmgate prices have been raised. The production response has been strong, but is not matched by operating capacity of the monopsonistic Unions, which have been unable to purchase and gin the available cotton due to financial and managerial problems. Key Constraints 1.28 The cotton industry in Uganda collapsed when international prices were high. Exports dropped from 65,000 tons of lint in 1973 to 10,000 tons in 1977. This dramatic decline was due in part to the dislocation in the ginning and export industries and in part to the decline in real prices paid for seed cotton. 1.29 Price Factors. The decline in production after 1973 closely followed the decline in real farmgate prices. The ratio of the seed cotton price to that of "next best" cultivation alternatives, such as millet, maize, or cowpea, shows a similar trend. During the early 1980s, the Government raised real cotton prices substantially, in an effort to restore output levels. There was an output response, although slight when compared to the changes in the real farmgate price. The lack of significant response in the production of lint, can be attributed to "nonprice" factors. 1.30 As was the case with coffee, farmgate prices for cotton provided the farmer with a relatively low share of the international price, especially when valued at the market rate of exchange. As of 1990, the Government allowed the earnings from cotton exports to be valued at the market exchange rate, raising industry earnings. In 1991, the farmer received about 55 percent of the world price for lint, which while, not out of line for Africa, is below international levels. 1.31 The elasticity of supply with regard to the price of seed cotton can be quite high. Response elasticities of over 2.0 have been estimated for Kenya and Nigeria. In Uganda, however, the supply response elasticities which have been estimated are much lower at 0.2-0.7, suggesting that other nonprice factors inhibit rapid increases in output in the country. 1.32 A key nonprice factor is vertical integration -- which is more important in the cotton industry than in coffee. This is because a market only exists for the cotton lint and maybe for seed, the final products of the cotton ginning process. Picked seed cotton (as with greenleaf tea or sugarcane) cannot be transported too far before transport costs become prohibitive. Ginneries are thus located near producers. Should any links in the chain fail, the intermediate product has little value, and the production effort to that point is wasted. Lack of competition among ginneries and exporters is believed to be the main source of the institutional problems facing the  - 8 - cotton industry. Both ginning and exporting have had, until recently, monopsony buyers -- Unions and LMB -- working with captive clients on a predetermined margin. 1.33 Key reasons for the failure to respond to price incentives include late payments to farmers, problems with input availability, particularly quality seeds, and ginnery malfunctions. Late payments to farmers for seed cotton deliveries to primary societies reduce the effective price received. These late payments result from the difficulty of obtaining crop finance at the Union level, because of outstanding bad debts to the LMB or the commercial system, and the administrative inefficiency at the Union or primary society where the payments are made. 1.34 Any attempt to raise cotton yields above the 400 kg/ha level will depend on early planting and the use of insecticides (fertilizer use has not been profitable). An important and profitable input to facilitate early planting is the use of ox-drawn ploughs, which have been used extensively in the North and Northeast. The insecurity and cattle rustling have, however, depleted the animal stock in the North and Northeast. The timing of the first two weedings coincides with the harvest of early planted crops, which means that labor must be hired. All these measures to raise yields require financing, yet direct access to formal finance is very hard for the farmer. Finance and the inputs are most efficiently provided by the marketing entity -- the Union. The financial insolvency of the Unions, however, has severely restricted the provision of production finance. Even though finance is available to some extent from informal sources, the market in agricultural inputs is haphazard and poorly developed. 1.35 In addition, the quality of another input, seed, has deteriorated. Seed is cleaned, dressed and distributed free of charge by the LMB through the ginneries. This service has been poorly run, and there is no private sector involvement in marketing seeds. Due to low yields and insecurity in the North, the SATU variety has practically disappeared. It has also been mixed with BPA. The mixture has led to poor genetic purity and low germination rates. 1.36 Finally, ginnery malfunctions are a serious problem, with a lack of spares and qualified mechanics contributing to long delays in the ginning of cotton stock. This reduces cotton quality and increases production costs. The cotton classification system used is based on "hand-pulling" methods, which is inadequate for the world market. More comprehensive and accurate methods would allow Uganda to charge a premium -- where warranted -- for its product, while generating confidence in its quality. Market Prospects 1.37 Given the current slim margins, efficiency at all levels of the industry will have to be promoted to keep Uganda competitive in the international market. Uganda will be trying to revitalize its cotton industry at a difficult time in the cycle of world cotton prices. International cotton prices are lower in real terms than in the early 1970s. As with coffee, real prices are unlikely to return to their former pre-1984 levels. The depression in international cotton prices in 1986 caused a rapid resurgence in demand, and substitution of natural for synthetic fibers in North America and Europe. The subsequent rise in prices peaked at about US$1.85/Kg in early 1991. Since then prices have fallen to about US$1.24/Kg (February 1992) due to the record world crop in 1991. Prices are projected to remain low in 1992 and 1993, and to return to 1991 levels -- in-real terms -- by 1995. The long-term forecasts for the cotton market do not predict any major changes from the current low real prices.  - 9 - 1.38 Domestic demand comes from two textile firms: Nyanza Textile Industries Ltd (NYTIL) and Uganda Garment Industry Ltd (UGIL), currently operating at about 14 percent of capacity. They produced some 8,150 square meters of cloth in 1990, down from 11,750 the previous year. Domestic purchases of lint in 1990 totaled some 1,300 bales by UGIL, and roughly 20,000 bales by NYTIL. Demand from local mills could be a useful market, estimated, assuming full capacity utilization by existing mills, at 70,000 bales. Once the limits of the domestic market have been reached, the regional market for clothing could also be tapped by Uganda, if quality improves sufficiently to compete successfully with Kenyan products. Future Development Strategy 1.39 The country is at a crossroads on cotton development strategy. The nonprice factors are severely restricting sector response. Production levels continue to be low, in spite of increased "minimum" prices from 1986 to 1991. The existing institutional structure, under which ginning and marketing of cotton are controlled, has to be changed. 1.40 Changes to the institutional structure forms, inter alia, the subject of this proposed project. II. PROJECT BACKGROUND A. Development Framework 2.1 During 1990 and 1991, the Ugandan Government's APC set up specialized working groups to examine the causes of the severe decline in cotton production that occurred through the late 1970s and the 1980s, and to prescribe Government action that could restore the cotton subsector to its former eminence as a major domestic industry and a significant export earner. As a result of the policy committee's efforts, a cotton subsector strategy evolved, which incorporated the policies of the Government, and also advocated a Cotton Subsector Development Program (CSDP). 2.2 The CSDP is an integral part of the Government ASAP presented in the Government's letter of Agricultural Policy, dated November 23, 1990, supported by ASAC. The ASAC supported primarily the reform of the coffee subsector (Para 1. 19). In the context of reforming regulatory and business climates, the reform of the cotton subsector is one of the key themes of the Structural Adjustment Program proposed for support by IDA under the Second Structural Adjustment Credit (SAC II). Extracts from the Government Letter of Agricultural Policy and the draft letter of Development Policy in support of SAC II are in Annex 7. 2.3 The Development Prograin advocates liberalizing cotton processing and export marketing, with each layer of the industry competing for raw materials and exports. Pricing, down to the farmgate, would be determined by market forces. Ginneries would compete for seed cotton. Export companies would compete for lint. Research by Government institutions would continue, possibly with industry funding. A central regulatory agency would set quality standards and collect statistics. The proposed structure existed when cotton production was successfully started in Uganda early in the century. A similar model has been followed, with a fair degree of success, for the Ugandan coffee industry. This approach would benefit from the incentives provided by competition and profit-seeking at every stage of the process. It diversifies against the risk of collapse or default of a centralized organization. It makes the industry responsible to  - 10 - international market conditions. By keeping units small, the system links cost elements directly to profits, leading to efficiency in investment decisions. Such a system accepts that cotton production will be on an extensive, low-input, low-output basis. 2.4 A small regulatory body would be established in place of the current LMB, to set quality standards, maintain production and export statistics, administer a small cess on exports to fund cotton research, and oversee seeds multiplication and distribution. The LMB would be restructured into a trading organization and privatized, with shares sold eventually to the private sector. On the production side, extension advice would continue to be available from MAAIF extension service, backed by the research establishments of Namulonge and Serere. Reintroduction of ox-drawn ploughing would be promoted. Ginneries could finance inputs and labor for farmers. Decentralized input supply and credit mechanisms would be developed domestically to serve all sectors, including cotton. 2.5 An important aspect of the development strategy in the industry will be to focus on ginneries, in an effort to solve their financial, managerial, and technical problems, and return output to full capacity. The Government would take the lead in this effort, marshalling the Government, donor, and private resources to get the industry started again. In the context of a competitive industry, interested banks, private export trading concerns, and investors would help the Unions to resolve their bottlenecks. Self-financing credit and technical assistance agreements would be crafted, for example, between a Union, a foreign trading concern, and a bank, to enable operations to begin and expand. 2.6 To implement the Cotton Subsector Development Program, the Government has, after agreeing with IDA, tabled before Parliament, the National Resistance Council (NRC), a Bill -- the Cotton Development Bill, 1993 -- which by repealing the Cotton and Lint Marketing Board Acts removes the monopoly of Unions over cotton processing and that of LMB over export trading. LMB would be dissolved, and a regulatory agency, the Cotton Development Organization (CDO) would be established. Licensing of ginneries would be removed, but registration of ginneries and traders in lint and zoning of cotton production would be continued. 2.7 With the removal of 'regulatory' functions from LMB, the Government proposes transferring LMB's export trading activities to an enterprise -- Lint Marketing Co. Ltd. (LMCL)-- to be registered under the Companies Act. Consistent with its policy to restrict public sector investment in trading activities, the investments in the new enterprise will be restricted to transfer of existing assets with LMB required for trading operations. 2.8 Since April 1993, the Government has also begun implementing a three year IFAD-funded Smallholders Cotton Rehabilitation Project (SCRP), which aims to purify existing cotton planting seeds, reinstate seed multiplication, and promote greater use of oxen. The Government is also taking advantage of the European Union's (EU's) Stabex program to support the cotton sub- sector. So far, the EU has permitted the use of Stabex funds to provide crop finance to LMB and to Cooperative Unions which have been permitted to enter the export trade. This is in response to the Government decision to permit selected enterprises to enter cotton processing and export trading, pending formal liberalization of processing and marketing. The EU is also supporting these Cooperative Unions to establish their export marketing agency. The EU has also agreed in principle to assist the Government in settling claims on LMB, against export contracts not honored. This would remove the embargo by overseas arbitrators on cotton exports directly  - 11 - by LMB, or any other Government agency involved in trading. Finally, the EU would also finance payment of compensation to LMB staff who would be retrenched. B. Project Strategy 2.9 The Development Framework proposed by the Government requires, for its implementation, clarification in three key areas. These are addressed in this section. Ginning Industry 2.10 The Government proposes to open cotton processing and trading to competition. The assumption is that cotton production will be best encouraged by the creation of a ginning industry where individual ginneries are, in the medium-term, under the operational control of creditworthy investors, and where they are obliged to operate in a competitive environment. 2.11 As virtually all the country's ginning capacity is in the hands of the Cooperative Unions, a key issue that must be resolved through the reform process is the debt burden on the Unions. The Unions owe, on account of rehabilitation loans obtained from 1974 to 1981 and in 1983, an equivalent of about US$44.5 M to the Cooperative Bank, UCB and LMB, the latter on account of crop finance extended (Para 1.27). The rehabilitation loans are denominated in foreign exchange and as such have grown with the devaluation of the Uganda shilling. This level of debt greatly exceeds the value of the ginneries. The amounts involved are disputed by the creditor banks, which acted as the Government's agent in on-lending funds from external financiers (ADB and IDA), and by the Unions, which were the ultimate beneficiaries of the loans. 2.12 The proposals for reform, set out below, are designed to resolve the debt burden of Unions through a two stage process. First, steps will be taken through a debt relief programn extended to the Unions to create an enabling environment for private sector participation. This will be followed by a program of actions designed to make private participation a practical reality, with technical assistance support to enable the program to proceed smoothly. 2.13 The modalities and institutional arrangements for the Unions' debt relief and restructuring program, which have been agreed with IDA and notified by the Government to the creditor banks, LMB, and the Unions, are described below: (a) Debt relief, on outstanding rehabilitations loans extended by UCB and Cooperative Bank, and on advances from LMB, would be offered to Unions which put forward business plans, satisfactory to lending institutions, to restructure their businesses in support of their request for credit facilities. (b) The business plan should provide for the restructuring of Unions' ginning operations, either to be operated by the Unions as a separate business or for leasing or outright sale to the private sector, with details of external financing requirements. (c) The lending institution, from which a Union would seek financing for restructuring, would decide on the adequacy of the business plan provided.  - 12 - (d) Only those Unions which succeed in securing the required credit facilities to operate their restructured businesses would be entitled to the debt relief. (e) The debt relief would take the form of a substantial writing off of the outstanding loan and freezing of repayment of the reduced debt, with no interest accruing until an agreed date to commnence repayment. Such a repayment would be based on the business plan and repayment terms on the new credit facilities that the Unions would secure from lending institutions. Those Unions which fail to restructure their businesses will not be entitled to the debt relief and will be called upon by the creditor banks to repay the outstanding loans. In the event of non-payment, the creditor banks would be called upon to foreclose on the Unions and acquire the ginneries. (f) The amount to be written off -- debt relief -- against outstanding loans would be the difference between the book value of the debt per existing loan agreements and a fair value of the debt. (g) For purposes of determining the book value of the debt, an independent team, comprising a financial analyst, a lawyer and a ginning engineer under the responsibility of a firm of auditors, will determine the present dues of the Unions to commercial banks and LMB, per existing agreements. (h) For dues to the creditor banks, a fair value of the debt would be the value of the ginnery on a going concern basis, after adjusting for remaining works to be undertaken to complete the rehabilitation. Such a fair value would be determined by the team led by a firm of auditors. (i) For dues to LMB, a fair value of the debt would be the book value, after adjusting for interest that accrued when LMB delayed collecting the lint and payment against export proceeds. This would also be determined by the audit team. (j) The written down value of the debts would form the redeemable value of the loans. (k) The audit team would submit its recommendations to APC which in turn will give its formal recommendation for approval by the Government (Minister of Finance and Economic Planning). Such an approval by the Governnent would require NRC's authority. After obtaining NRC's authority, the Government would signify its acceptance to the debt relief by agreeing to offset reductions in the debt to the creditor banks by similar reductions in the amounts owed by the banks to the Government. LMB or its liquidators will signify similar acceptance. In the case of LMB, the amount written off would be taken into account in its liquidation proceedings. (I) The creditor banks and LMB's liquidators will agree to subordinate repayments of the agreed value of the loan. Such repayments will be based on Unions agreed expectations of future activities in cotton as reflected in their business plans. The project would provide an appropriate advisory service, comprising a business management expert, financial analyst, and legal advisor, to the Unions to develop business plans, and to facilitate their negotiations for debt relief, for restructuring their business, negotiations with prospective buyers/joint venture partners, and for seeking credit facilities.  - 13 - 2.14 As a condition of the debt reduction program, the Unions will be asked to establish their cotton ginneries as independent profit centers in the Union's books of account. This will facilitate private sector involvement in ginnery management and ownership. It will also ensure an arnms length relationship between the Union and the ginnery so that there is transparency in pricing and clear measurement of financial performance. There are a number of ways in which this could be accomplished. 2.15 The clearest separation would be achieved by setting up the ginneries as independent companies in the Union's ownership. This would give the greatest scope for private sector involvement in the ginneries and is probably the easiest way to establish the ginneries as creditworthy entities in the eyes of banks. However, a Union in a strong financial position might prefer simply to establish the ginnery as an internal, but separate, profit center. 2.16 A company structure would also offer the possibility of making farmers shareholders in the ginneries. This could be by distribution of shares (preferably tradeable vouchers), for free, representing their equity interest in the ginnery, to all farmers registered in the books of primary societies of the Union. The arrangements for such a distribution would need to be considered carefully. The rationale for this recommendation is to establish the ownership over the ginneries and to transfer it to the ultimate owners (farmers). This would also give the option to the farmer to realize his or her investment, if he or she so desires. Moreover, this would be a first step towards establishing a "Stock Exchange". 2.17 In addition, Unions may be given the opportunity to walk away from their ginneries, if they wish, and surrender the titles to the creditor banks. The banks would then sell the ginnery on the best terms that can be obtained and apply the funds to debt repayment. 2.18 In many cases it is likely that private sector support will be the only viable option for operating the ginneries successfully. Private sector involvement in the ginneries may take a number of forms, ranging from sale or leasing arrangements to joint ventures and management contracts. There are advantages and disadvantages to each of these options. Once an option has been selected, contracts must be negotiated. The Unions currently lack the skills to choose the most appropriate option for their circumstances or to negotiate effectively with a private sector operator. 2.19 The Unions will, therefore, require advice in these areas. Such advice would be coordinated under the proposed project through technical assistance. Experts would advise Unions effectively on the preparation of business plans, on the most appropriate course of action for their particular circumstances, and on the factors to be considered in negotiating contracts. The role would be advisory. It is important that the Unions themselves prepare business plans as experience shows that few organizations are capable of carrying out such plans if they cannot first prepare them. Improving Cotton Quality 2.20 Uganda has established a reputation for a particular quality of cotton which has won a specific share of the market and a premium price for its lint. With a fairly weak world market for cotton, it is important for Uganda to retain its special share of that market. At the samne time, both farmers and the national economy will benefit if Ugandan lint can again claim the premium  - 14 - which it once commanded. Several factors are involved in achieving these goals. Those which are significant to the proposed project are: (a) the genetic qualities of the variety or varieties being released by the research station; (b) the effectiveness of the control over seed multiplication and distribution; (c) the degree of cotton mixing at ginneries; and (d) the standards of management of the ginneries. 2.21 There are two technical and practical issues which need to be addressed in relation to the revitalization of cotton research. These are: (a) The justification for two varieties; and (b) the most suitable center for cotton breeding. 2.22 The justification for having two varieties in the past was based on ecological factors and was rendered possible by strict control over the buying and ginning of the crop. This latter factor has been absent in recent years with a resulting mixing of varieties and a consequent loss of quality and value. With a liberalized marketing system, it will become increasingly difficult to control the movement of seed cotton. The consequent mixing of both lint and seed would make it difficult for Uganda to regain its reputation for quality. There is an urgent need to consider whether the liberalized industry would be better served by a single variety which would avoid the danger of mixing. Both agronomic and quality factors will have to be considered in making this decision, but uncontrolled marketing mitigates against more than one variety. 2.23 Cotton breeding work is presently carried out in the research stations at Namulonge and Serere. Pending a decision to breed one variety or two, the National Agricultural Research Organization (NARO) has decided that breeding work be centered at Serere (with Variety Trial Center's (VTC's) in all cotton growing regions) whilst retaining the quality laboratory and some agronomic or adaptive research at Namulonge. 2.24 Another factor to be considered in relation to cotton breeding is the justification for introducing a short-season cotton variety which would provide higher yields for farmers who have to plant later in the season. Such varieties are available elsewhere, but their quality is different to BPA and SATU and the introduction of such a strategy would lead to inevitable mixing and loss of quality. In consequence, every effort should be made to improve on the performance of the current material when planted late, but it would not be wise to introduce a separate short-season variety, without controls on where it is ginned. 2.25 Whether the Government decides to concentrate on one variety or two in its breeding program, the benefits of such work will be lost if there is no effective control and organization of seed production. This involves the supervision of all stages beyond the production of breeder seed, which includes the production of foundation seed, the maintenance of segregated areas, and the supervision of seed multiplication in the segregated areas. The CDO will coordinate these activities in full cooperation with both the research and extension staff of MAAIF. The SCRP would provide support for this strategy over three years.  - 15 - Finance Systems 2.26 Uganda's once well-developed formal financial system has deteriorated. The rural financial system within the overall financial system has also declined. The marketing intermediaries, such as the ginneries, which provided credit for cash crops are not creditworthy and are unable to raise funds even for their working capital. The only credit available in rural areas, outside crop finance for procurement of cash crops -- mainly coffee, are occasional lines of credit funded by foreign donors. There are institutions involved in quasi-finance, such as savings and credit societies and non-government organizations (NGOs). Their overall impact is small, but their experience in attempting different approaches to rural lending can be instructive in designing measures to extend the frontiers of the financial system. The essence of the NGO programs is the use of groups (often women groups) to foster financial savings; reduce transaction costs associated with savings, lending and supervision; and, increase repayment incentives through joint liability and penalty arrangements. 2.27 Following the reforms under ASAC, improved institutional arrangements are in place for financing coffee crop procurement and export finance. These are largely provided by commercial banks, but prevailing interest rates are high at about 26 percent. The BOU is extending support for export finance through foreign exchange denominated loans, at interest rates ranging between 8 percent and 10 percent. Similar facilities are also extended by the Development Finance Corporation of Uganda (DFCU) and the East African Development Bank (EADB), but their resources, like BOU, are limited. 2.28 There are various programs extending term-finance for rehabilitation of existing enterprises and for new enterprises. The IDA-financed Enterprises Development Project (EDP), with substantial resources, is extending, through accredited commercial banks, loans designated in local currency, with interest rate pegged to the development finance rate, currently at 24 percent. This facility does not seem attractive to enterprises as interest rates are high and BOU's re- financing requirements are stringent. Facilities extended by DFCU, through lines of credit from the European Investment Bank (EIB) and Kreditanstalt Fuer Wiederausbau (KfW), though with limited resources, are popular among enterprises. Loans are designated in foreign currency, with interest rates at about 10 percent. Complementary working capital finance and venture capital, from finances made available by the United States Agency for International Development (USAID), are also available from DFCU. 2.29 The Bank, under its Financial Sector Adjustment Credit, is closely working with the Government to address the problems underlying the financial system. Five major problems have been identified and are being addressed: lack of confidence in the financial system; lack of control of credit expansion by BOU; internal and external constraints facing BOU; and the high risk of financial instability arising out of solvency problems of the two largest commercial banks, UCB and the Cooperative Bank. 2.30 It would be sometime before the financial sector is restructured and poised to support the rural financial markets. Meanwhile, targeted credit can act as a catalyst to overcome such obstacles, thus opening market access to previously excluded groups and sectors, such as micro- enterprises, small farmers, and women. 2.31 There are three targeted credit programs being implemented at present under the South- West Region Agricultural Rehabilitation Project (SWRARP), SCRP and Northern Reconstruction  - 16 - Project (NRP). These programs have, however, a serious draw back. The credit is extended direct to the farmer, bypassing the marketing intermediaries, and results in difficulties in recovering the advances. The financial intermediaries under these programs, the Cooperative Bank and UCB, act merely as administrators of the programs; they have partial responsibility for appraising loan applications and assume no credit risks. The loans are approved by District Loan Committees constituted by the Government. Funds are distributed by the financial intermediaries from project funds deposited by the Government. Bad debts are written off by the banks from their books if the borrower fails to meet repayment on the due date. Therefore, recovery of the bad debts is the responsibility of the District Loan Committees. These arrangements require to be revised to permit financial intermediaries to assume full responsibility for loan appraisal and to assume the credit risk. The program should also encourage participation by other commercial banks, rather than restricting it to the two public sector owned financial institutions (UCB and Cooperative Bank). Other commercial banks, mostly foreign owned, do not, however, have extensive branch networks in the rural areas. In such cases, NGOs could be used as intermediaries by those banks. 2.32 While directed credit can help to overcome constraints in lending to certain borrowers, market finance may not, however, be forthcoming if the policy and other factors inhibiting it have not been properly identified and eliminated. For the cotton industry, appropriate intermediaries for extending credit to farmers would be the ginneries in pursuit of their raw material requirement. A key factor inhibiting the development of market finance is that the ginneries are not creditworthy. Once the ginneries are in the hands of creditworthy operators, they would be in a position to raise the required resources to make available the production inputs to the farmers. 2.33 A major specific support is required for rural financial markets. One approach, followed under SCRP and NRP, based on experience under the IDA-financed Agricultural Development Project (ADP) and the IDA/IFAD financed SWRARP, is to advocate a "saving based" approach, utilizing the existing commercial financial system. SCRP has set aside about US$0.5 M for short- term credit for inputs and US$1.5 M for medium-term credit for acquisition of draught oxen. Similarly, NRP has provided US$1.4 M for short-term credit for inputs, but it also covers requirements for crops other than cotton. C. Support Services to the Cotton Subsector Cotton Research 2.34 With no donor support since the mid-1970s and a scarcity of Government funding for research, the cotton research program has, until recently, been undertaken at a maintenance level only. In 1991, the Government with IDA support adopted a National Agricultural Research Strategy and Plan. The strategy for achieving an institutional framework for the efficient and sustainable administration, operation and financing of all agricultural research includes: the establishment and transfer of research responsibilities to the semi-autonomous National Agricultural Research Organization (NARO); determination of national research priorities, subject to routine assessment; improving conditions of service in agricultural research organizations; rehabilitation of research institutions, providing vehicles and equipment and meeting recurrent operating costs; improving linkages among research, extension and academic institutions, and enhancing the coordination of donor funded agricultural research activities.  - 17 - 2.35 The national strategy is being supported for a six year period by the IDA-financed Agricultural Research and Training Project (ARTP) which became effective in early 1993. ARTP provides financing for ongoing high-priority research programs in nine commodities, including cotton, and will thus complement the support provided by IDA under ASAC (Para 1.19). Whilst ARTP would indirectly benefit the cotton research program through rehabilitating the Serere Research Station (SRS), the direct funding for cotton would be from the IFAD-supported SCRP, which became effective in April 1993. 2.36 The Smallholders Cotton Rehabilitation Project (SCRP) is intended, as a three year pilot program, to re-establish an effective seed multiplication system and to initiate a revitalized national program of cotton research and animal traction development. In the research program, particular emphasis would be given to: (a) an initial reselection within SATU and BPA, leading to further releases and continued breeding for their eventual replacement with superior varieties; (b) the development of practical Integrated Pest Management (IPM) techniques, incorporating pest and insect scouting based spraying programs; and for cototn seed procurement, dressing and distribution; and c) development of animal traction techniques, emphasizing post-ploughing operations. 2.37 Cotton research would be financially supported by SCRP at both SRS and NRS, through the provision of staff training, vehicles, laboratory equipment and supplies, staff allowances and incremental recurrent operating costs. The LMB's Fibre Testing Laboratory at NRS would be supplied with specified replacement equipment to provide the needs of an enlarged breeding program. Support for animal traction would receive similar assistance, but only at SRS. Recognizing the paucity of experienced cotton researchers, SCRP would provide 154 person months of technical assistance, including 36 months of a cotton breeder and 30 months of a specialist in IPM. Extension Services 2.38 A multiplicity of extension approaches has, until recently, caused management problems for MAAIF; impact has been less than optimal and there has been duplication of effort. A National Agricultural Extension Plan (NAEP) was prepared in 1990 with funding support from IDA. 2.39 ,The extension approach to be adopted nationally is compatible with the T&V system of management, and extension focuses on a unified extension approach in which parallel services would be minimized at the farm level. Thus each agricultural extension worker at the field level will be responsible for crop and animal production, agro-forestry and fish pond aquaculture. The extension workers would live in the parishes in which they work and would operate through farmer groups which would be visited according to a pre-arranged work schedule. Technical support would be provided through a cadre of Subject Matter Specialists (SMS) at the district level, covering crop production, plant protection, livestock production, women's groups and, depending upon the district requirements, fisheries production. District Farm Institutes (DFI) would play a key role in farmer training and demonstration of improved techniques. 2.40 The NAEP has been endorsed by the Government and a number of actions towards its implementation have been taken. The main agricultural ministries have been merged and reorganized, and a directive has been issued on a structure for the unified extension system. Activities were started on a pilot scale in selected counties in four districts with funding from  - 18 - ASAC. Under the IDA-supported Agricultural Extension Project (AEP), which became effective in 1993, expansion is expected into 16 districts out of the total of 38. Provided that satisfactory progress is made by a Mid-Term Evaluation in late 1994, a rapid expansion to cover all districts is expected. D. The Role of Women in Cotton Production 2.41 In Uganda, women farmers play a significant role in the production of all agricultural crops, including cotton. More than 90 percent of women in Uganda are engaged in crop production and contribute to the bulk of farm labor. Only a fraction of the women engaged in agriculture own land. 2.42 Although women contribute most of the farm labor, over 80 percent use rudimentary tools. Many do not have a hoe, panga or axe. The tools they use are borrowed. Only a few have tractor hiring services available and very few of them can afford these services. There is little knowledge about farm inputs, such as spray pumps, weed killers, animals' feeds, insecticides, and fertilizers. A few know about mulching and the use of improved seeds. 2.43 Decision making concerning farm operations is often made by husbands and relatives. Also disappointing to the women is lack of access to credit. A majority of the women find the prospect of approaching a bank and applying for a loan very difficult. A high rate of illiteracy adds to their problem of understanding and using the banking system. The low percentage of women owning land also adds to their problem of obtaining credit. About 10 percent of the women sell crops in the markets, but only just over one quarter of that group make decisions on how to use the money from their sales. In addition to farm labor, most farm women are expected to prepare food, care for the home, and look after the family -- making their role and workload difficult and heavy. 2.44 These findings are applicable to women involved in cotton production. Moreover, in the cotton areas, civil strife and the loss of cattle (for animal traction) have extended the roles of women in the agricultural system and increased their work burdens. Another problem facing women in the drier areas of the North (which are also major cotton-growing areas) is the acute shortage of water. Several donors (in particular UNICEF and the Danish aid agency, DANIDA) are involved in the provision of water in these areas, but the needs exceed the implementation capacity, and it will be some time before a major impact can be realized. The proposed project would, mainly through the national extension services, support and expand actions initiated under AEP, SCRP and other projects to address the issues facing women in agricultural production generally, and cotton growing in particular. E. Country Assistance Strategy and Rationale for IDA Involvement 2.45 The proposed project supports the Country Assistance Strategy (CAS) approved by the Board in May 1993, which emphasizes economic growth, poverty reduction and increased exports. Agriculture is vital to attaining these goals. With its focus on an export crop (cotton) which is grown by smallholders and has the potential for substantial growth, the proposed project supports the CAS objectives. IDA has been supporting GOU's economic recovery program and, in the agricultural sector, these reforms have been deepened under ASAC. The proposed project  - 19 - is further underpinned by a thorough analysis in the Agricultural Sector Memorandum of March 1993, and would broaden the policy reforms and investments aimed at maintaining strong agricultural growth. IDA's continued presence is essential to encourage GOU to bring about the difficult reforms in the legal, policy and institutional framework. These reforms are necessary to assure competitiveness of the cotton production system, to increase the productivity and incomes of smallholders, and to contribute to the diversification of the export base. There is strong commitment on the part of GOU as evidenced by its success in licensing private firms to lease ginneries and compete with LMB in lint export, and its willingness to have the enabling legislation that would establish a level playing field in this vital industry. Further, GOU recognizes that, as a profitable annual crop, cotton has the potential to be the main engine of growth, especially in the northern and eastern regions of the country. The project supports several IDA initiatives such as poverty alleviation, private sector development, and capacity building. It would complement existing projects in the agricultural sector such as the ARTP, AEP and the IFAD-financed SCRP. III. THE PROJECT A. Objectives and Main Features 3.1 The project would support the Government's strategy to revive cotton production and exports through increased competition in cotton processing and marketing and improved supporting services. The specific objectives of the project are: (a) improved performance in the cotton industry, through liberalization of cotton processing and export marketing, establishment of an efficient regulatory framework for the cotton industry, and improved managerial, technical and operating efficiency in a creditworthy ginning industry; (b) improved efficiency and impact of supporting services through support for national research and extension program; and (c) improved delivery mechanisms and availability of credit and seed. These objectives would contribute to the broader sectoral objective of increased agricultural growth and diversification. The project would provide financial assistance to support three broad sets of activities: (i) restructuring the cotton industry through (a) revision of the legal framework, liquidation of Government regulatory and marketing agency and establishment of an industry based regulatory body, and support of operations of the regulatory body, on a declining basis; (b) transformation of Cooperative Union owned ginneries into creditworthy operators, including strengthening management and technical training to the industry; and (c) support to APC's oversight of the subsector policy reform and inter-agency coordination responsibilities through the Agricultural Secretariat; (ii) improved supporting services through support for national research and extension programs; and (iii) improved delivery mechanisms and availability of credit and seed through provision to farmers of short-and medium-term credit through intermediaries (e.g. ginneries and NGOs), as well as improved quality seed.  - 20 - B. Project Components 1/ 3.2 Chapter II outlined the strategies initiated by the Government to revive cotton production and exports, as well as ongoing Government initiatives, particularly those assisted by the IFAD- financed SCRP and the IDA-financed AEP, ARTP, and NRP, supporting the subsector. Project components designed against this background are summarized below (Details in Project File). Restructuring the Cotton Industry (US$5.9 M) 3.3 Legal and Regulatory Framework (US$2.8 M). IDA has reached agreement with the Government on a legal framework for the liberalization of the subsector (para 2.6). A Bill satisfactory to IDA and which provides for the liquidation of LMB and establishment of CDO, has been tabled at the NRC for approval. The CDO would be formally established on passage of the Bill (Para 4.16). 3.4 The CDO would be an autonomous agency, with a Board of Directors representing the industry and Government agencies which provide support to the industry. The objectives of the organization would be to promote and monitor cotton production and marketing. It would register all participants in processing and marketing, set quality standards for seed cotton and lint, and facilitate agricultural extension and research when its income from cess so justifies. It would be headed by a Managing Director, with a lean organization of technical and administrative staff. 3.5 The project would provide technical assistance for the liquidation of LMB and the establishment of CDO and LMCL. For CDO, vehicles to facilitate mobility of staff and office equipment would be provided. Provision would also be made for staff training. The Bill provides that the operating cost of the Organization be met from cess, not exceeding two percent, on lint produced by ginneries. During the early stages of the project, revenue from cess would not be adequate to cover the entire operating costs. The project would, therefore, finance, on a declining basis, the operating costs, including staff salaries and allowances, for a period of four years, by the end of which CDO will have become an autonomous industry-based organization. The project would also finance the rehabilitation of Fibre and Spinning Test Laboratory transferred to CDO from LMB. This would primarily be used for commercial fiber testing. 3.6 Policy Coordination and Support (US$1.5 M). On the Government's behalf, APC is responsible for implementing ASAP, supported under ASAC (Para 1.19). The Committee, which reports to the Presidential Economic Council, has served as the Government's agricultural policy advisory body since 1982. Its membership includes the Permanent Secretaries from the Ministries of Finance and Economic Planning (MOFEP) (Chairman); MAAIF; Trade and Industry; Land, Housing and Urban Development; Prime Minister's Office; and Natural Resources, as well as the Governor, BOU; the Managing Directors of UCB, the Coffee Marketing Board Ltd, and Uganda Coffee Development Authority; the General Secretary, Uganda Cooperative Alliance; and the Director, Agricultural Secretariat, who also functions as the Secretary. Since revitalizing cotton production is a key element of ASAP, APC will need to be informed on progress or constraints in implementation of the subsector development program so that appropriate policies may be formulated and analyzed, as necessary. The APC is supported by a secretariat, Agricultural 1/ All figures in current dollars, excluding contingencies.  - 21 - Secretariat (AS), housed at BOU with a Director and a Deputy Director, supported by three key departments - Sector Policies and Natural Resources, Finance and Marketing and Statistics - and two consultants, a Financial Advisor and an Economist. Operational support to APC and its secretariat, provided under ASAC, would close by December 31, 1994. The project would provide support for technical assistance, staffing, logistic facilities and operating costs from January 1995 for a further three years; this includes technical assistance support provided under a Project Preparation Facility (PPF) for project preparation. For purposes of monitoring and evaluation of the constraints and impact of cotton development on target groups, a study to fill data gaps in the districts of Kumi and Soroti has been completed under SCRP. This study would be expanded under the project to cover other cotton growing districts. 3.7 Restructuring the Ginning Industry (US$0.4 M). The Government has agreed with IDA on a restructuring plan to transform Cooperative Union owned ginneries into creditworthy operators (para 2.13). The project would provide technical assistance support to implement the program. This would include a team led by a firm of auditors to determine the extent of debt relief each Union would be entitled to receive, and provision of advisory services to Unions to develop business plans to restructure their businesses. 3.8 Ginneries would require credit, both seasonal for working capital, and medium-term to restructure their businesses, including rehabilitation of ginneries. About 38 ginneries are expected to become operational during the project period. Assuming production to increase from 55,000 bales in 1993 to 160,000 bales by the end of the project, peak credit requirements are estimated at US$14.0 M for working capital, and US$4.0 M for medium-term loans. These are expected to be met by commercial banks, DFCU, EADB, ongoing donor assisted projects, particularly the IDA-financed EDP, and from new lines of credit which EIB, KFW, and the International Finance Corporation (IFC) are expected to establish to support the development of the ginning industry. Ginneries, in addition to their existing investments, would need to provide incremental equity for their operations. The proposed line of credit from EIB would provide a part of the equity by way of venture capital. 3.9 Ginneries Management and Technical Training (US$1.2 M). It is envisaged that, in the coming years, there would be a considerable demand for skilled ginnery managers, fitters, mechanics and other technicians to meet the needs of the Ugandan cotton ginning industry. The Ginnery Training School (GTS), a department at Uganda Technical College (UTC), Lira, would be rehabilitated and strengthened, ensuring that the ginning industry has a firm base upon which to build. The project would provide for conversion and renovation of an existing building at the UTC, and purchase of vehicles, tools and equipment. A ginning management specialist and an engineering specialist would be provided to make short-term visits over a three-year period to re- establish the school. The engineering specialist would be assisted by two locally recruited counterpart training engineers. The first priority of the school would be to run a series of short courses of instruction and awareness for ginnery managers, fitters, mechanics and other technicians. Curriculum development would be a special responsibility of the training specialists and in this function they will liaise closely with both the Principal of UTC and the Technical Section of the Ministry of Education. Provision has also been made for attendance of students at local workshops, and visits to related cotton industry locations in countries within the region. The project would also finance incremental operating costs, including staff salaries and allowances, and field allowances.  - 22 - Improved Supporting Services (US$6.7 M) 3.10 The project would provide incremental support to the national research and extension programs which are supported by ARTP and AEP. 3.11 National Research Program (US$2.1 M). Comprehensive support for cotton breeding, animal traction development program, and Integrated Pest Management Program (IPM) will be provided under SCRP for a three year period. With few exceptions, the project activities supporting cotton-systems research would commence in PY3 (1996/97). Such a support would be in the form of incremental financing for the Cotton research program, identified as an integral part of the national research program. This would support the rehabilitation of laboratories, offices, and staff quarters, vehicle replacement, farm and laboratory equipment, operating costs including field trials and staff allowances, short-term technical assistance, and training and study tours, according to national priorities. 3.12 National Extension Services (US$2.2 M). Under AEP, the coverage of the national unified extension services has been extended to 23 districts, compared with 16 districts envisaged at the time of appraisal. Four additional districts are expected to be covered under NRP. The project would provide support to extend the program to the three remaining cotton growing districts of Arua, Kasese and Kamuli, which are not covered either under AEP or NRP, and incremental support services, over and above those provided under SCRP, for seed multiplication in segregated areas. As under AEP, the project would provide vehicles, office and field equipment. In addition, a limited number of staff quarters would be constructed for field staff, mainly in remote areas. Vehicles would be restricted to bicycles for Field Extension Workers and motorcycles for County Officers. Incremental operating costs, including staff, travel, and housing allowances would also be provided (US$1.3 M). 3.13 Extension Training Program (US$2.4 M). AEP training of extension staff and the farming community is carried out at MAAIF Agricultural Colleges. AEP provides for improving the training capacity at one of the colleges, but they all require additional support. The project would provide support to colleges at Arapai, Busitema and Bukalasa, by way of rehabilitation of facilities, equipment and incremental operating costs, including curriculum development, staff allowances, and training costs. Short-term technical assistance support will also be included. The aforementioned would support actions initiated under AEP to implement a National Training Plan under preparation and to facilitate increased enrollment of women at the colleges and improved access for qualified young farmers (of both gender). The training program would also assist farmers in the complexities of management and marketing of cash crops at both farm and group levels. In addition, pilot projects would be designed and tested to demonstrate new technologies to relieve labor bottlenecks and generate additional income. These pilot demonstrations would be designed with a primary focus on the issues facing women farmers (paras 2.41 to 2.44). These proposed activities would compliment the existing interventions and initiatives under the national extension program to address the constraints faced by women-farmers. The project would also support the completion of an ongoing study on the legal constraints facing women by the Ministry of Women in Development, Youth and Culture (MWDYC), funded by the Swedish International Development Agency. This would bring about a close collaboration between MAAIF and MWDYC in addressing the issues concerning women and youth.  - 23 - Credit and Seed Programs (US$13.1 M) 3.14 Production Credit (US$3.9 M). Appropriate intermediaries to extend seasonal credit to farmers would be the ginneries (para 2.32). Once the ginneries are in the hands of creditworthy operators, they would be in a position to raise the required resources to make available the production inputs. Considering that ginneries would be able to meet the credit requirements of farmers only by the last year of the project, credit requirement over the first four years of the project is estimated at about US$4.8 M. Available support, specifically for cotton, from SCRP and NRP would be about US$0.9 M. Support from EDP for seasonal credit needs of farmers is not available. The project would, therefore, provide the remaining requirements. 3.15 Medium-Term Credit (US$4.3 M). The Government strategy envisages increase in cotton production mainly through expansion of area under cultivation. More than 60 percent of the area expansion is expected to come from east and north of the country, comprising Kumi, Soroti, Apac, Lira, Gulu, and Kitgum districts. The project would support a livestock restocking program in these six districts. Kumi and Soroti would receive support under SCRP over a three year period. The project would extend similar support in the remaining districts -- Apac, Lira, Gulu and Kitgum -- and in Kumi and Soroti over the fourth and fifth year of the project through provision of medium-term credit to groups of farmers for the acquisition of their requirements of oxen, heifers and bulls; supply of animals would be from local cattle markets or from imports by private sector, for which direct project support would not be required as adequate resources are available to the private sector from ongoing programs and from foreign exchange freely available in the country. The project would also provide medium-term credit for the acquisition of equipment such as sprayers, and on a pilot basis for other income generating activities by farmers, particularly women. 3.16 Rehabilitation of Aninal Holding Grounds (US$ 0.5 M). To facilitate imports of animals by the private sector, the project would provide incremental support to veterinary quarantine services and holding grounds, for imported animals, provided by the Government. This would include rehabilitation of six identified cattle holding grounds, by provision of perimeter and paddock fencing, water facilities, tick control facilities, rehabilitation of farm houses, and stock handling facilities. The project would also support incremental operating costs. 3.17 Studies and Pilot Activities (US$ 0.2 M). The project would finance studies to facilitate delivery mechanisms and availability of credit. A rapid appraisal of rural finance and ongoing credit programs, particularly those under SCRP, would be carried out to assist in the re-design of ongoing credit programs under SWRARP, SCRP and NRP and to develop a pilot credit program incorporating the recommendations of the rapid appraisal. Training to lenders and borrowers would also be included. 3.18 Seed Procurement, Dressing and Distribution (US$4.1 M). Seed maintenance would begin on the research stations, which would be responsible for providing breeder and foundation seed. Further multiplication would be by farmers over three seasons in segregated areas. The MAAIF will provide extension support to farmers. The project would provide support for procurement of seed cotton from farmers, ginning for seed by ginneries, seed dressing, and distribution of dressed seed to farmers. Financing would be on a declining basis over the first four years of the project.  - 24 - C. Project Costs and Financing Project Cost 3.19 The total project costs are estimated at US$31.4 M, of which about US$15.1 M or 48 percent is foreign exchange cost. As a proportion of base costs, investment costs amount to 63 percent and incremental recurrent costs 37 percent. The project baseline costs, estimated in the Preparation Report, were updated to July 1994 using historical and projected local and international inflation rates. Physical contingencies account for 10 percent of baseline costs. Price contingencies, equivalent to 13 percent of baseline cost, reflect projected local and international inflation rates, and a continuous adjustment of the exchange rate in line with maintaining a constant purchasing parity exchange rate. Project costs are exclusive of direct duties and taxes on imported goods, against which the Government issues credit notes. Indirect duties and taxes are estimated at US$1.7 M, or 5 percent of total costs. A project cost summary is in Table 3. 1, with details in Annex I. Table: 3.1 PROJECT COST SUMMARY a/ (US$ M) COMPONENT LOCAL FOREIGN TOTAL % FOREIGN % TOTAL EXCHANGE COSTS A. RESTRUCTURING COTTON INDUSTRY 1. Regulatory Framework 1.6 1.2 2.8 41.4 10.9 2. Policy Coordination & Support 0.5 1.0 1.5 64.8 5.7 3. Gin. Restr. & Debt Relief 0.3 0.2 0.4 34.2 1.7 4. Ginneries Technical Training 0.2 1.0 1.2 82.6 4.5 SUB-TOTAL 2.6 3.2 5.9 54.8 22.9 B. IMPROVED SUPPORTING SERVICES 1. National Research Program 0.9 1.2 2.1 56.6 8.3 2. National Extension Program 1.4 0.7 2.2 33.7 8.5 3. National Ext. Training Program 0.9 1.5 2.4 63.5 9.2 SUB-TOTAL 3.2 3.5 6.7 51.6 26.1 C. CREDIT AND SEED PROGRAMS 1. Credit Programs & Studies 3.5 4.9 8.4 58.3 32.9 2. Rehabilitation of Animal Holding Grounds 0.2 0.3 0.5 52.7 2.1 3. Seed Procurement Dresing & Distribution 3.3 0.8 4.1 19.8 16.0 SUB-TOTAL 7.0 6.0 13.1 46.0 51.1 TOTAL BASELINE COSTS 12.9 12.7 25.6 49.6 100.0 Physical Contingencies 1.3 1.3 2.6 49.5 10.0 Price Contingencies 2.1 1.2 3.3 35.1 12.8 TOTAL PROJECTS COSTS 16.3 15.1 31.4 48.1 122.8 a/ Numbers may not add due to rounding.  - 25 - Proposed Financing 3.20 External sources would finance the equivalent of US$26.5 M, representing 89 percent of project costs, net of duties and taxes, meeting all foreign exchange costs and 78 percent of local costs; to ease the financing of local costs in the early years of the project, external financiers would finance 90 percent of selected local expenditures. CDO through a cess recovered on lint production and internal cash generation, would finance the equivalent of US$2.5 M (8 percent of the total project costs, net of taxes). The Government contribution would be US$1.9 M, including duties and taxes estimated at US$1.7 M. 3.21 The proposed IDA credit of US$14.0 M would finance the project components covering Restructuring of Cotton Industry, Improved Supporting Services (with the exception of Seed Procurement, Dressing and Distribution), and Rehabilitation of Animal Holding Grounds. This level of financing would cover 47 percent of project costs, net of duties and taxes. The International Fund for Agricultural Development (IFAD) would co-finance the project with a loan of US$12.5 M. Effectiveness of the IFAD loan would be a condition of credit effectiveness. 3.22 An advance from IDA Project Preparation Facility (PPF) of US$1.2 M has been approved to complete project preparation and to undertake key start-up activities, before the IDA Credit is declared effective. Activities to be funded under the PPF are in Annex 2; they include technical assistance for project preparation and start-up activities for the Unions' debt relief and restructuring program, as well as for the liquidation of LMB, establishment of CDO, and seed distribution costs in FY94. 3.23 Table 3.2 summarizes the proposed financing plan by component and external financiers. Table 3.2: PROPOSED FINANCING PLAN a/ (US$ M) COMPONENT IDA IFAD CDO/CLBS GOU TOTAL A. COTTON INDUSTRY 1. Regulatory Framework 2.4 - 1.0 0.1 3.5 2. Policy Coordination & Support 1.6 - - 0.1 1.7 3. Gin. Restructuring & Debt Relief 0.5 - - 0.0 0.5 4. Gin. Technical Training 1.2 - - 0.2 1.4 SUB-TOTAL 5.7 - 1.0 0.4 7.1 B. SUPPORTING SERVICES 1. National Research Program 2.2 - - 0.4 2.6 2. National Extension Program 2.4 - - 0.3 2.7 3. National Extension Training Program 2.5 - - 0.4 2.9 SUB-TOTAL 7.1 - - 1.1 8.2 C. CREDIT AND SEED PROGRAMS 1. Credit Programs and Studies - 9.8 0.5 - 10.3 2. Rehabilitation of Animal Holding Grounds 0.5 - - 0.2 0.7 3. Seed Proc. Dressing & Distribution 0.7 2.7 1.5 - 5.1 SUB-TOTAL 1.2 12.5 2.0 0.2 16.1 TOTAL PROJECT COSTS 14.0 12.5 3.0 1.9 31.4 a/ Numbers may not add due to rounding.  - 26 - D. Procurement 3.24 Items to be financed by IDA under the proposed Credit would be procured through arrangements as summarized in Table 3.3 and described below, where applicable. Procurement of project items to be financed by IFAD would be arranged in accordance with the procurement procedures and guidelines of that agency. Table: 3.3 SUMMARY OF PROCUREMENT ARRANGEMENTS a/ (US$ M) ICB LCB Other b/ NBF c/ All Sources Vehicles, Machinery 3.0 - 0.5 - 3.5 and Equipment (2.6) - (0.4) (3.0) Civil Works 1.0 1.2 - - 2.2 (0.8) (0.9) (1.7) Short-Term & Med. - - - 10.1 10.1 Term Credit - - - - Technical Assistance - - 3.7 - 3.8 and Training - - (3.5) (3.5) Incremental Recurrent - - 7.6 4.3 11.8 Costs (5.8) (5.8) 4.0 1.2 11.8 14.4 31.4 (3.4) (0.9) (9.7) (14.0) a/ Figures in parenthesis are estimated amounts to be financed under the proposed IDA Credit. b/ Includes procurement of consultant services following IDA guidelines, and local procedures involving supporting quotations and direct order and for incremental recurrent cost. c/ Non Bank Financed. 3.25 Individual contracts for civil works above a value of an equivalent of US$0.5 M and totalling about US$1.0 M would be awarded through International Competitive Bidding (ICB) procedures. The other contracts for civil works, lower in value than an equivalent of US$0.5 M and spaced in time, totalling about US$1.2 M, would be awarded through Local Competitive Bidding (LCB), in accordance with procedures satisfactory to IDA. Procurement of vehicles, equipment, and supplies totalling US$3.0 M would be grouped wherever possible into bid packages of at least US$0.1 M for procurement through ICB procedures. Contracts for procurement of an item or group of items having a value of the equivalent of US$50,000 or less, aggregating to about US$0.5 M, would be procured either through the UN's Inter Agency Procurement Services Office (IAPSO) or through direct competitive shopping based on at least three quotations. A limited number of vehicles, office model computers, and office equipment, will be procured by local shopping to assure the availability of essential facilities for commencement of implementation of works by the implementing agencies. Consultancy contracts  - 27 - aggregating to about US$1.2 M, excluding those financed under PPF (details in Annex 1) would be procured in accordance with IDA Guidelines for the Employment and Use of Consultants. Overseas and local training (US$0.8 M) would be by direct placement, in consultation with IDA, based on agreed training programs. Procurements (if any) needed under Incremental Recurrent Costs (US$7.5 M) would be small in value and would follow local Government procedures satisfactory to IDA. 3.26 Contract Review. The Bank's standard bidding documents and contracts for goods, works, and consulting services would be used for all procurement where applicable. All bidding documents for procurement packages estimated to cost in excess of US$0.1 M each for goods and US$0.2 M each for works would be subject to prior IDA review. This would result in a coverage of about 70 percent of the total estimated value of contracts that would be financed by IDA. The balance of contracts would be subject to random post review after contract award. 3.27 The individual project implementing agencies (MAAIF, NARO, CDO, and AS) will be responsible for procurement of goods, works and services for the respective project components assigned to them. The MAAIF has developed in-house expertise for procurement management and contract administration of all on-going projects. A procurement specialist engaged under AEP is available to provide support as necessary. The NARO has also developed in-house expertise. The procurement specialist and the financial management specialists engaged under the ARTP are available to provide support. The AS has long experience in implementing projects and is equipped with staff trained under ASAC. The CDO is yet to be established, and it will receive assistance from AS. The implementing agencies will be preparing tender documents, for the items identified in their procurement packages by grouping these suitably for bidding in the formats of IDA Standard Bidding Documents and Contracts. The listing of tender documents (including invitation of proposals for consultancies) for ICB and procurement schedule have been agreed at Credit negotiations. E. Disbursement 3.28 The US$14.0 M IDA Credit would be allocated among disbursement categories and disbursed as outlined in Table 3.4. Table 3.4: SUMMARY OF DISBURSEMENT SCHEDULE (US$ M) CATEGORY AMOUNT OF CREDIT % OF EXPENDITURE TO BE FINANCED Civil Works 1.5 75% Vehicles, Equipment and Supplies 2.9 100% of foreign; 85% of local Technical Assistance and Training 2.2 100% Incremental Recurrent Costs 4.7 90% up to US$1.0 M, and 50% thereafter PPF Refinancing 1.2 Unallocated 1.5 TOTAL 14.0  - 28 - 3.29 The IDA Credit is expected to be effective on July 1, 1994. Disbursements would be made over a period of seven years, including PPF disbursement in FY 94. The disbursement projection is in Annex 3; it is shorter than the historical profile of nine years for agriculture and rural development projects in Uganda. The seven year disbursement period is considered realistic because the key agencies (MAAIF and AS) responsible for assisting in the implementation of the project are formally in place and experienced. 3.30 To facilitate project implementation and expedite disbursements, MAAIF, NARO, CDO and AS would open and operate separate Special Accounts in a commercial bank on terms and conditions satisfactory to IDA. Initial deposits to the Special Accounts would be US$300,000, US$200,000, US$100,000, and US$75,000 respectively, being the estimated requirements for three months. 3.31 All withdrawals from the Credit will be against full documentation, except for incremental recurrent expenditures and for contracts less than US$50,000 or equivalent, which would be made under IDA procedures covering disbursements against Statements of Expenditures (SOEs). F. Accounts and Audit 3.32 Comprehensive financial and accounting guidelines would be prepared by the AS and included in the Project Implementation Manual. The Agricultural Secretariat would assist project implementing agencies in following the guidelines, as appropriate. Separate project accounts would be prepared by each implementing agency, for their respective components. 3.33 The project accounts of each implementing agency (para 3.30) would be audited by independent auditors, satisfactory to IDA, appointed by the Auditor General. For each implementing agency, the auditor's opinion shall cover: (a) whether the annual accounts/financial statements present a true and fair view of the financial position in accordance with generally recognized international accounting and auditing standards; (b) that the movement of funds in the Special Accounts was strictly for the purposes of the project; and, (c) that where expenditures were disbursed through the use of Statements of Expenditure (SOEs), such expenditures were properly incurred for the purposes intended under the project. The audited accounts of each implementing agency, together with the auditor's opinion, would be submitted to IDA annually no later than six months after the end of its financial year. Assurances were be obtained during negotiations that the above arrangements would be followed. IV. ORGANIZATION AND IMPLEMENTATION ARRANGEMENTS A. Overall Project Arrangements 4.1 Individual ministries and agencies will be responsible for implementing their relevant project components, including financial management and procurement aspects. The APC, in its role as the agricultural policy coordinating arm of the Govermment (see the Government Letter of Agricultural Policy dated November 23, 1990 in Annex 6), will be responsible for coordination of all policy matters and inter-agency coordination issues. The AS will provide secretariat and executive services to the APC on these matters. An APC Management Committee chaired by the Permanent Secretary (PS), Ministry of Trade and Industry, comprising representatives from all implementing agencies and assisted by the AS,  - 29 - will handle on a day-to-day basis all inter-agency coordination issues. The APC will meet every six months to review reports prepared by the AS on policy and inter-agency issues relating to the cotton subsector. 4.2 The project components covering extension services and research programs would be integrated into the existing organizational framework of MAAIF and NARO. MAAIF would be responsible for the integrated extension program, including support for seed multiplication in segregated areas, and the rehabilitation of animal holding grounds for the restocking of oxen. The heads of departments (Commissioners) in MAAIF would be responsible for the implementation of their respective programs, under the overall coordination of the Permanent Secretary. NARO, through its research institutes, would be responsible for the research components. The Serere Research Institute would be the pritne institute responsible for cotton breeding. 4.3 CDO will facilitate the implementation of the Seed Procurement, Dressing and Distribution and Ginning Management and Technical Training components of the project. CDO would manage the funds provided for procurement of seed cotton from farmers, including payment of premium to contract growers, ginning at private ginneries, including payment of premium to ginneries at dressing plants previously owned by LMB and now vested in CDO, and distribution of seeds to farmers through private transport contractors. The MAAIF will assist in registering contract growers. Implementation and coordination arrangements will be as provide in the Cotton Development Bill. An inter-agency committee, comprising representatives from CDO, NARO, MAAIF, ginneries and farmer groups, will facilitate coordination arrangements. The Ginning Training School would operate as a department of UTC, under the overall control of the Principal, UTC. A representative of CDO would be invited to serve on the Board of Governors of UTC. The Ministry of Education and Sports (MES) through UTC will be responsible for implementing the technical training program. CDO will be responsible for managing the funds provided under the project. 4.4 An APC Sub-Committee, chaired by the PS, Ministry of Trade and Industry, will be responsible for implementing the ginneries restructuring and debt relief program. The Sub-Committee will include the Secretary General, UCA, and representatives from MOFEP, the Attorney General, BOU, UCB, and the Cooperative Bank. The Director, AS, will act as Secretary to the Sub-Committee. 4.5 The credit programs will be managed by the Development Finance Department (DFD) of BOU. The AS will provide technical and analytical back-up support to DFD. Cotton Improvement and Seed Multiplication and Distribution 4.6 The national research system is being restructured and strengthened under the ARTP (para 2.35). Organizational arrangements, including responsibilities assigned to each of the research stations involved (para 2.23), have been broadly defined for the national cotton program, but a number of key issues are yet to be resolved. The breeding strategy and objectives need to be agreed upon (para 2.22). Project support for cotton research is expected to commence in 1996/97 when funding for priority programs under the SCRP will cease. A condition of disbursement for the support to the national cotton research program under the project will be that NARO would finalize: (a) its cotton research program within the framework of its national research program; and (b) satisfactory terms of reference for a study to determine the future cotton breeding policy. 4.7 The organizational arrangements for the extension program are described in paras 2.39 - 2.40 and 4.2. A condition of disbursement against the extension program would be that MAAIF finalize a work  - 30 - program for the implementation of the extension and training programs, including support for seed multiplication in segregated areas, that would be financed under the project, SCRP and AEP, and of the project component covering rehabilitation of animal holding grounds. 4.8 Seed growers and ginneries would receive a premium of 20% and 5%, respectively, of seed cotton price. Seeds would be distributed free during the first three years of the project, and thereafter 40% of the cost would be recovered during the fourth year and 100% from the fifth year onwards. A condition of disbursement for the IFAD Loan against the Seed Procurement, Dressing and Distribution component would be that CDO finalize implementation and coordination arrangements for the seed multiplication and distribution program, satisfactory to IDA and IFAD. Credit Programs 4.9 Currently, farmers can access funds for seasonal agricultural inputs through a number of donor financed, savings-based credit programs, including one under the IFAD-funded SCRP. (Funds from the IDA financed EDP are not available for short-term credit needs). All these credit programs are managed by MAAIF, with funds channeled to the farmers through a commercial bank. (The commercial bank, however, acts merely as an administrator, and does not bear the credit risk.) Disbursements under these credit programs have, however, been slow, and the ginneries are currently not in a position to provide agricultural inputs to farmers in their command area. Therefore, it is proposed that a rapid appraisal of rural finance be carried out shortly to refine and improve credit delivery mechanisms and processes. Pending the completion of the rapid appraisal of rural finance, it is proposed that farmers meet their short-term credit needs from ongoing credit programs managed by BOU. Alternative mechanisms for final delivery to smallholders would be evaluated and tested. The ginneries would be one mechanism for short-term credit. Another mechanism, based on a successful model such as the Grameen Bank in Bangladesh, could be one (or more) well experienced NGO, acting as a sub-agent for a commercial bank and operating through peer groups. The alternative mechanisms and experiences would be evaluated at the mid-term reviews of the SCRP and of the proposed project, and the necessary adjustments will be made. 4.10 The short-term credit extended to ginneries or NGOs will be in Uganda shillings, following procedures similar to those under EDP, with on-lending through commercial banks. Deposit and interest rates have been liberalized. The re-financing rate will be pegged to the interest rate applicable to time deposits with commercial banks, presently 10%. The interest rate applicable for the ultimate borrower would be on prevailing interest rates applicable for development loans, currently 22%. The difference between the lending and the re-financing rate would be the margin, about 12% at the present levels, to be shared between the lending institutions and the ginneries/NGOs to cover their credit risk and administration cost. The repayment period will not exceed one year. 4.11 Any commercial bank or credit institution accredited for participation under the EDP credit program will be eligible to seek re-finance. The lending institutions will be entitled to establish their own criteria for a sub-borrower (ginneries or NGOs) to be eligible to borrow under this program. It is envisaged that the lending institutions will offer the credit to ginneries under this program as complementary advances to the term-finance they may extend for the rehabilitation of ginneries and short- term advances for working capital. 4.12 The sub-loans (advances to ginneries or NGOs) will primarily be for the purpose of financing farmers who would be registered with ginneries as suppliers of raw materials (cotton). Farmers would be encouraged by ginneries to form savings groups to seek access to the facility.  - 31 - 4.13 The medium-term credit for animal traction and agricultural equipment would also be extended through ginneries or NGOs, on terms and conditions covering to those of short-term credit. The repayment period will not exceed 5 years. Terms and conditions covering both the short and medium credits and details of refinancing arrangements are in the Project File. It would be a condition of disbursement for the IFAD Loan against the medium-term credit component that financing and management agreement, satisfactory to IFAD, be entered into between the Government and BOU based on the findings of the rapid appraisal of rural finance. 4.14 Pilot projects would be designed and tested under the project to demonstrate new technologies for income earning activities. Farmers, particularly women, who wish to adopt these new technologies would be provided with medium-term credit. Details will be worked out at the rapid appraisal. 4.15 The credit requirement of ginneries for their working capital and rehabilitation needs would be met from ongoing (such as the one from EDP) and new programs, proposed to be financed by EIB, KfW and IFC. The additional facilities are expected to be in place by the time the proposed Credit becomes effective. Lending criteria and participation of commercial banks as financial intermediaries would follow the criteria applicable to EDP, but interest rates would be competitive, with facilities to raise dollar designated loans. Under the Unions' restructuring and debt relief program, the existing loans to the Unions would be restructured, with grace periods allowed for interest and repayment of principal, based on business plans (para 2.13). Cotton Development Organization 4.16 The APC has appointed two Sub-Committees to oversee the liquidation of LMB and the establishment of CDO and LMCL. The Sub-Committees, assisted by the AS, would provide recommendations for transfer of LMB's assets to CDO and LMCL and for the recruitment of staff for CDO. The NRC has approved the Cotton Development Bill. The President has given his approval to the Statute, enabling the establishment of CDO. The formal establishment of CDO, with the appointment of its Managing Director, would be a condition of Credit Effectiveness. Ginneries Restructuring and Debt Relief Programn 4.17 The modalities for the restructuring and debt relief program have been developed and agreed with IDA (para 2.13), and the Unions, LMB, and the creditor banks have been notified of these modalities by the Minister of Finance. By acknowledging receipt of the notification and furnishing the required information relating to the debt and the status reports on the ginneries rehabilitated using the proceeds of the loans, the Unions, LMB and creditor banks have signified acceptance of the modalities proposed. The APC has appointed a Sub-Committee assisted by a team of consultants, led by a firm of auditors, to determine the extent of Unions' debt for which relief would be available if certain conditions are met. 4.18 Available rated ginning capacity in the country, owned by Unions, is over 400,000 bales. Ginneries with a rated capacity of 300,000 bales are now operational, but they require rehabilitation to improve their efficiency. By late 1994, cotton production is expected to reach about 70,000 bales, but the crop would be thinly spread over the country. Therefore, assuming 50% capacity utilization, nominal ginning capacity required to handle the expected crop would be about 140,000 bales. The project objective would be to create an enabling environment for the transfer of Union-owned ginneries to creditworthy operators. The Government would, however, have no direct control over the number of ginneries that would be transformed as creditworthy operators. An assurance was obtained that the  - 32 - Government would, by March 31, 1995, take the following actions to ensure the transfer of ginneries, with a total ginning capacity of at least 100,000 bales, to creditworthy operators: (i) engage auditors (financed under the PPF) to determine the book value and the fair value of the Unions' debts to UCB, Coop Bank and LMB; (ii) the auditors will make recommendations to APC regarding the extent of debt relief to be offered, the relief being the difference between the book value and the fair value; (iii) APC will recommend for the Finance Minister's approval in principle the extent of debt write-down for each Union; (iv) the Finance Minister based on NRC's approval, will authorize in principle the debt relief to be offered to each Union; (v) each Union will prepare a business plan for restructuring the management and operations of its ginnery, with assistance, if requested, from the business advisory services (financed under the PPF); (vi) Unions which require credit facilities will submit their business plans to lending institutions. Once the credit facility has been approved, a Union will submit a formal request for debt relief to APC. A Union which does not require credit facilities will submit a formal request for debt relief, together with a business plan, directly to APC; (vii) APC will recommend to the Minister of Finance to grant debt relief; (viii) the Finance Minister's approval of the debt relief in respect of a ginnery will signify the completion of actions needed to facilitate the transfer of a ginnery into the hands of creditworthy and viable operators, or the restructuring of the operations of that ginnery; and, (ix) where a Union fails to seek debt relief within 280 days of the date of offer of the debt relief (para 4.18 (iv)), GOU, as the original lender, will, through the Minister of Finance, request the creditor banks, as subsidiary lenders, and LMB to demand full repayment of outstanding loans, and to foreclose on defaulting Unions; foreclosure will signify completion of the actions needed to transfer, by sale, lease or management contract, of a ginnery into the hands of creditworthy and viable operators. 4.19 The book value of the debts and the extent of debt relief that would be offered to each Union has been determined. Formal offer by the Minister of Finance and Economic Planning to each Union of the amount of the debt relief would be a condition of Credit effectiveness. B. Monitoring and Reporting 4.20 Each implementing ministry/agency would, at least one month before the beginning of the fiscal year, submit its annual work program and budget to APC and IDA for review and approval, respectively. It would be the responsibility of each implementing agency to manage its  - 33 - program, with IDA approval for procurement and disbursements as appropriate. Quarterly progress reports on the program, and on the implementation of the investment components, would be submitted by each agency to APC and IDA, in a format acceptable to IDA, within one month after the end of each three month period. APC would monitor the implementation and impact of policy measures to liberalize ginning and decontrol cotton marketing, including restructuring of the marketing agency, to assess whether the Government policy actions are effective in meeting its liberalization and growth objectives, and to identify obstacles in a timely manner. Assurances on the above were obtained during negotiations. The AS will assist in preparing a Project Implementation Manual, including guidelines for planning, budgeting, and financial management. The finalization of the Project Implementation Manual, based on agreement reached at negotiations, would be a condition of Credit Effectiveness. 4.21 The program would also be closely monitored under the proposed Second Structural Adjustment Credit (SAC II). It would be a condition of second tranche release of funds under SAC II that the Government facilitate the transfer of ginneries of a total ginning capacity of at least 100,000 bales to creditworthy operators. 4.22 The existing Monitoring and Evaluation Unit of the MAAIF, built up under ADP and supported under SCRP, would design and institute a monitoring system involving periodic reporting of selected indicators of project performance relating to production aspects of the project (extension programs, including support for seed multiplication), and its impact on the target group. The Director General, NARO, Managing Director, CDO, and Director, AS, would be responsible for designing and instituting similar monitoring systems for their respective components. 4.23 IDA missions to review project implementation would be scheduled to coincide with the review of key steps in the implementation of the Program (Project Implementation Schedule and Supervision Plan are in Annex 4). As the project would require relatively frequent missions, it is likely to be supervised by the Bank Resident Mission in Kampala. Because of the strong links to the macroeconomic program, staff from the Country Operations Division would participate in at least one key mission per year. Mid-Term Review 4.24 With few exceptions, cotton production related components would commence in PY3 and would continue, after the closure of SCRP, for the remaining two years of the project. The project components have been designed, assuming satisfactory progress under SCRP. A mid-term review of SCRP is scheduled for April 1995. The production related components would, therefore, be restructured, if necessary, based on the findings of SCRP's mid-term review. 4.25 The mid-term review of the project itself would be carried out at the end of the third project year, by June 30, 1997. The review would be carried out jointly by the Government and IDA, with the AS responsible for preparatory arrangements and coordination. The main purpose of the review will be to assess progress towards opening cotton processing and marketing to competition, aimed at assessing the project's impact on cotton production and exports.  - 34 - V. BENEFITS, JUSTIFICATION AND RISKS A. Main Benefits and Beneficiaries 5.1 The project is expected to have a significant impact on the organization and management of the cotton industry through the involvement of the private sector in: (a) ginnery ownership, which would make prompt payment to farmers a reality; (b) ginnery management, which would ensure a steady flow of seed cotton from villages and make it possible to have ease of marketing at village level; and (c) improving the quality of ginning and marketing to raise the ginning out-turn and value of lint and make it possible to raise prices and incomes of farmers. There would be additional benefits if the ginneries, following their restructuring, were to become involved in the overall vertical integration of the industry, including seed and input supply, ginning and marketing. These changes, complemented by the introduction of ox-ploughing, would lead to an increase in the numbers of farmers growing the crop and consequently an increase in area planted and in the national output. The debt relief program would also facilitate the Government's efforts in restructuring the two largest indigenous commercial banks in Uganda (UCB and Cooperative Bank). 5.2 The project would continue the work on seed production, research and extension initiated under SCRP, ARTP, and AEP so that full benefits can accrue to these components. Seeds of existing approved material should become widely available to farmers by about 1999 (end of PY5), but it may take another year or so for the buyers to be confident in the general quality of Ugandan lint and restore its full premium. If the seed production program continues on course, there should be marked improvement in yields and the comparative price of cotton. 5.3 The research program will focus on four main activities. These are: (a) Breeding. This is an important activity but its impact is long-term. Past plant breeding (1939 to 1972) had no doubt brought about genetic improvement in the crop and more specifically maintained the gains made in the quality of Uganda cotton. However, adverse agronomic and socio-economic factors over the years prevented the full realization of the impact of such research effort. Future research may be able to raise yield and ginning percentage without sacrificing quality. This is too conjectural to provide a basis for a benefit stream. The main focus of this activity is likely to be on regaining the stability of Ugandan cotton's quality and pest and disease resistance; (b) Seed Multiplication. Continuation of SCRP efforts on production and distribution of seeds in segregated areas will replace present impure seeds distributed in all cotton growing zones. This will restore quality of Ugandan lint in the local market; (c) Pest Control. Research will focus on increasing the efficiency of pesticide use whilst attempting to reduce the quantity of chemicals applied to a given area. This work could result in yield gains in areas under cultivation by Categories I and II farmers (para 1.25); and (d) Ox Plough Planting and Weeding. If this revitalized program is able to achieve a technical break through which has eluded past researchers, this component could have an impact on both the area under cotton and its yield, as well as areas under food crops, besides reducing the drudgery of farm work.  - 35 - 5.4 The focus of extension activities would be to graduate farmers in lower categories of the farming system to the higher categories: Category I: The focus on this highest category (where cotton is the main cash crop and is planted on time, and where farmers have access to family and hired labor) which is currently producing average yields of 800 kg/ha and would benefit from the use of pesticides, would be on optimizing the use of these inputs and in developing appropriate crop protection strategies. Yields would increase to about 830 kg/ha, and the percentage of farmers in this category would increase from 15 percent to 20 percent. Category II: In this farming system, cotton is planted late because of competing demands in labor requirements for food crops. Average yields are presently at 400 kg/ha. The focus of extension would be on ways to overcome labor bottlenecks, permitting these farmers to adopt Category I practices. Yields for this category would increase to 480 kg/ha and the percentage of farmers in this category would increase from 35 percent to 50 percent. Category III: This system utilizes cotton as a land opening crop. Cotton is planted very late, receives essentially no inputs, and the average yield is about 200 kg/ha. Extension effort would be towards overcoming labor bottlenecks and, with the ready availability of ox for ploughing, would aim at graduating a majority of farmers in this category to the higher category. Yields for this category would increase to 240 kg/ha, and the percentage of farmers in the category would decline from 50 percent to 30 percent. 5.5 Overall, cotton lint production would increase from the present level of 55,000 bales to about 160,000 bales, equivalent to US$44 M in export value. The area under cotton would increase from 88,000 to 190,000 ha, benefitting about 500,000 farmers, who constitute about 20 percent of the total Ugandan farming community. Average yield is expected to increase from 350 kg/ha to 470 kg/ha. About 38 ginneries would be operational, all in the hands of creditworthy operators, resulting in enhanced utilization of ginning capacity (about 90 percent by the end of the project), increased ginning out-turn, prompt payment to farmers and improved farmgate prices (from USh. 330/kg to USh. 430/kg). 5.6 Cotton production is dispersed, with smallholder farmers producing both food for own consumption and the cash market, and cash crops. The structure of cotton production is also based on the use of large numbers of farmers, each of whom produces small quantities of the crop for delivery to a processing center. The implication is that, once the processing industries become competitive, growth in exports will carry with it strong backward linkages to the rural population. For this reason, there is a close relation between measures that produce agro-based export growth and those that will contribute towards a reduction in rural poverty. The project would also have forward linkages by promoting domestic textile, edible oil, livestock feed, and soap industries. 5.7 Some aspects of the project are likely to have an effect on gender differences. The use of rural women's groups in the design of the rural savings and credit schemes would help incorporate women into the financial system, and provide finance for trade and food production, activities that rural women specialize in. The proposed study on legal constraints to the economic empowerment of women (para 3.14) would further help in this regard. Women farmers would also benefit from improved production technologies and implements, particularly oxen, which would reduce labor bottlenecks and drudgery of farm work.  - 36 - B. Financial Analysis Farm Budget 5.8 Cotton now faces competition from several other cash crops for which there was no significant market in the 1960's. These vary from one region to another, but the main competitors are maize, beans, simsim, millet, sorghum, groundnuts, beans, rice and vegetables. Farm budgets with and without project have been prepared for the Northern and Eastern regions and for the Kasese district. Details are in Annex 5. Without the project, returns from food crops are higher than from cotton. With the project, income from Cotton in the Northern region for Category II farmers using pesticides and hand hoes would substantially increase, with further increase for Category I farmers using ox cultivation. For Category I farmers, there would be increase in area cultivated, both in cotton and food crops. Similar increases are seen for farmers in Eastern region and Kasese district, with much higher increases for farmers in Kasese using partial mechanization. Ginning Industry 5.9 Of a total of 44 ginneries in the country, 21 are operational, 17 require major rehabilitation, and 6 remain closed. A total of 38 ginneries are expected to become operational under the project. Rehabilitation cost for the 38 ginneries, which are expected to become operational, is estimated at US$4.3 M. 5.10 On average, a Union-owned ginnery has 20 gin stands, with a ginning capacity of 8,640 bales. Its existing rehabilitation loan is estimated at an equivalent of US$2.75 M. Based on a revaluation, on a going concern basis, and net of future rehabilitation cost, estimated at an equivalent of about US$110,000, a ginnery is expected to qualify for debt relief of an equivalent of US$1.6 M. In addition to this concession and term loan requirement of US$110,000 for rehabilitation (assuming 75 percent borrowing to finance rehabilitation), a ginnery would require working capital (for crop and export finance) of about US$1.9 M, excluding a base minimum working capital of about US$250,000, which would be financed by the Unions from their equity contribution. 5.11 A status report on existing ginneries and an analysis of investment requirement and return on investment of a model ginnery are in the Project File. Ginning capacity utilization is projected to reach about 35 percent in year 2, by which time the ginnery would have a positive cash flow, leading to a return on its equity of about 40 percent. The internal rate of return is estimated at 36 percent. Cotton Development Organization 5.12 A cash flow statement covering the project period has been prepared based on CDO's investment and recurrent costs, and costs of services to the industry and farmers. It has been assumed that seeds would be distributed free of charge during the first three years, and that in year four, there would be a 60% cost recovery, increasing to full cost recovery by year five. With the expected increase in crop and hence exports, it is expected that CDO would reduce its cess on lint from 2.0 percent to 1.5 percent by PY3, and to 1.0 percent by PY5. By PY5, CDO is expected to be self financing. External financing would be required during the first four years of the project to cover 30 percent of its recurrent cost and 60 percent of cost of seeds distribution (Project File).  - 37 - C. Economic Analysis Comparative Advantage and Competitiveness of Cotton 5.13 A recent study identifies crops that have the greatest potential profitability under a liberalized export regime 2/. Using Domestic Resource Cost (DRC) analysis, 3/ the study develops an index of theoretical comparative advantage and profitability for different crops. Using this type of analysis, at current economic values, all of Uganda's traditional export crops, such as coffee, tea and cotton have a DRC ratio of less than one, and are hence theoretically competitive; tea is more attractive than cotton, while coffee (Robusta) is less attractive than cotton. Also, under this economic analysis, maize, groundnuts, soyabeans, and rice cannot compete effectively in the international market, although there may be regional market opportunities. Products such as hides and skins, cashew nuts, sesame, and other non-traditional exports appear to have export potential, at economic values. 5.14 The Bank Agriculture Sector Memorandum (April 1993), evaluated family labor costs -- the largest production input -- in its economic analysis in terms of their opportunity cost in staple food production. The economic opportunity cost of labor was 20 to 30 percent above the going-financial- wage at the time of the analysis (January 1990). Production and processing efficiencies are those which existed at the time of the analysis. Since yields and processing efficiencies were comparatively low, especially for cotton, there is substantial room for improving competitiveness through better processing efficiency. Rate of Return 5.15 The economic rate of return (ERR) of the project is estimated to be 24 percent (Annex 5). This relatively high rate of return for a cotton project at a time when cotton prices are generally depressed arises from the relatively low cost of the ginneries restructuring program, from which substantial benefits are expected. 5.16 Without project situation is difficult to quantify in terms of patterns and net returns to the existing ginneries and adjoining farm lands. It has been assumed that without the proposed project, yields would stagnate, but with moderate increases in areas planted and in ginneries output. Similarly, it has been assumed that use of farm lands for food production would gradually expand. 5.17 Valuation of Costs and Benefits. All identified benefits have been quantified. The project would also benefit from ongoing activities under AEP and SCRP. On the basis that research, seed multiplication and extension efforts under the project and SCRP are targeted towards cotton, all costs under the project and SCRP, relating to research, seed multiplication, and extension services have been taken into account. Similarly, ginneries' credit requirements expected to be financed by other 2/ Bank of Uganda, Agricultural Secretariat, "Comparative Advantage and Competitiveness of Uganda's Agricultural Exports," Kampala, January 1990. 3/ Domestic resource cost analysis compares the net returns to domestic factors of production valued in foreign exchange--(after the cost of imports has been deducted--to their domestic "scarcity value." The DRC ratio is the scarcity value of domestic factors of production divided by the foreign returns to these factors--both in domestic prices. The ratio's size depends on the exchange rates, with distortions removed, to establish a benchmark. The lower the DRC ratio, the more competitive a country's exports. A DRC ratio of one or less means that--at the official exchange rate--the product can compete effectively on the world market.  - 38 - programs have also been taken into consideration. In addition, existing investments in ginneries, valued on a going concern basis, net of rehabilitation costs, and on the basis that prospective investors would take over the ginneries from the Unions, together with the existing debts, net of the debt relief, have been included as project cost. Farm outputs are based on farm budgets "with" and "without project" for the three categories of farming system. Ginneries' outputs are based on the assumption that transformation of ginneries to creditworthy operators will keep pace with ginning requirement, based on farm output. 5.18 Sensitivity Analysis. Estimates of cost and benefit streams under both "with" and "without" project scenarios unavoidably involve uncertainties affecting ERR on project investments. Switching value analysis, however, show the ERR to be relatively insensitive to changes in costs and start-up delays. But, the ERR is sensitive to changes in benefit streams, particularly yields, area under cultivation, and delays in implementing the ginneries restructuring program. With respect to cotton prices, the analysis shows that the project is comparatively less sensitive to changes in international cotton prices. D. Project Risks 5.19 The project is subject to policy, financial, institutional and production risks. Safeguards against these risks have been included in project design as well as in other supporting operations. The major policy risks relate to GOU's commitment to implement the debt relief and associated restructuring programs for the Union-owned ginneries. Financing has been provided under the PPF for consultancy services to assist in preparation of the restructuring program and for administrative arrangements involved in its implementation. A new cotton legislation has been promulgated which would pave the way for restructuring and diversified ownership (para. 2.6). Agreement has been reached on the modalities for the debt relief and restructuring program; formal agreement by the Government with the Unions, LMB and the creditor banks on these modalities has been concluded. The book value of the debts and the extent of debt relief have also been determined. The formal offer of debt relief by the Government to the Unions would be a condition of credit effectiveness. The transfer of ginneries, with at least 100,000 bales of ginning capacity, to creditworthy and viable operators, would be a condition of release of the second tranche of SAC II. 5.20 The financial risk relates to accessibility to credit by both ginnery operators and cotton producers. These risks pose the greatest threat to successful project implementation in both market improvements and expansion of production, as, in the latter case, medium-term credit for the livestock restructuring program is the vital determining factor in the proposed area expansion under the project. Availability of credit is not likely to be a problem for ginnery operators. A line of credit is available under the IDA-financed EDP, and additional funding is expected to be provided by the EIB, KfW, and IFC. A major problem is likely to be the willingness of the Unions to restructure their businesses. The modalities for the restructuring program carries the threat of foreclosure by the creditor banks of ginneries which fail to restructure and take advantage of the debt relief program. Another problem is likely to be the ability of ginnery operators to satisfy the lending criteria and access the funds under the various credit programs. The project would, therefore, provide business and advisory services to assist operators in preparing viable business plans and in obtaining access to financing (para 3.7). The problems are more intractable at the producer level. Disbursements under existing savings and credit programs have been slow. A rapid appraisal of rural finance will be carried out shortly to refine and improve credit delivery processes and mechanisms (para 4.9).  - 39 - 5.21 Insufficient institutional capacity is another potential risk which has been addressed in project design. CDO, as the main coordinating body in the subsector, would be strengthened with technical assistance and training (para 3.5). Some support is being provided to APC and its secretariat to further facilitate coordination (para 3.6). Provisions have also been made to strengthen the research and extension services, including training capacity (para 3.13). Project implementation would also benefit from the measures under the AEP, ARTP and SCRP for the institutional strengthening of MAAIF and NARO. Further institutional strengthening of agricultural support services is expected to be addressed in a proposed Agricultural Sector Investment Project. 5.23 At the production level, the major risks derive from: poor prices, late payments, cultivation bottlenecks, and insufficient seed. These risks have been partly mitigated through the measures to address policy, financial and institutional risks described above. Additional measures include quarantine and other supporting services for the livestock restocking program (para 3.17), and support for the improved quality seed distribution program (para. 3.18). E. Environmental Impact 5.24 The project is expected to have a beneficial impact on the environment. The SCRP will provide significant support for IPM research and development, including technical assistance, direct support for research, and testing and demonstrations in the field. The extension messages under the national extension program would focus on: proper husbandry and soil management practices; crop rotation; education of farmers on effects of uncontrolled erosion; and integrated pest management practices, including use of biological control methods combined with judicious use of chemical pesticides through the use of indicators of the economic threshold level of pests. The technical assistance advisor on IPM under SCRP is on site working with the research team. An assurance was obtained at negotiations that an IPM research program, satisfactory to IDA, will be developed, together with an appropriate extension program. 5.25 With the resources (short-term credit) provided under the project for procurement of pesticides by the farmers, escalation of pesticide use is bound to occur prior to IPM development and adoption. Farmer education and training under the extension program would, to some extent, mitigate the environmental and health risks. But as pesticide procurement and distribution would be carried out by the private sector, there is also a need for direct control and regulation. The Government is regulating procurement through clearance procedures for procurement of chemicals. These procedures would follow Bank procedures established under the import support program, financed under the Structural Adjustment Credit and ASAC. The Government has also enacted legislation (Control of Agricultural Chemicals Statute, 1989) and recently issued a statutory order (Statutory Instrument No. 23 of December 31, 1993) regulating all stages of distribution, including packaging, labelling, advertising, storage and disposal. The Bank would support the implementation of such regulations under the National Environmental Action Plan currently being prepared with the assistance of IDA and other donors. 5.26 There are no other environmental issues in the project. It is classified as Category B.  - 40 - VI. ASSURANCES AND RECOMMENDATION A. Agreements and Assurances Obtained 6.1 During negotiations, the following assurances were obtained: (a) annual audited project accounts of each implementing agency, together with the auditor's opinion from independent auditors, satisfactory to IDA, would be submitted to IDA no later than six months after the end of the financial year (para 3.33); (b) the Government would ensure the transfer, by March 31, 1995, of ginneries, with a total ginning capacity of 100,000 bales, to creditworthy operators (para 4.18); (c) annual work program(s) and quarterly progress reports on the implementation of the Cotton Subsector Development Program and investment components of the project would be submitted by each implementing agency (para 4.20); (d) a Mid-Term Review would be carried out by June 30, 1997 (para 4.25); and (e) an IPM research program, satisfactory to IDA, will be developed (para 5.24). 6.2 During negotiations, the draft Project Implementation Manual and Standard Bidding Documents to initiate procurement were reviewed and agreed upon (paras 3.27 and 4.20). 6.3 The following would be conditions of Credit effectiveness: (a) all conditions precedent to the effectiveness of the IFAD loan agreement, other than those related to the effectiveness of the IDA credit, have been fulfilled (para. 3.21); (b) formal establishment of the Cotton Development Organization, and the appointment of its Managing Director (para 4.16); (c) formal offer by the Minister of Finance and Economic Planning to each Union of the amount of the debt relief (para 4.19); and (d) finalization of a Project Implementation Manual satisfactory to IDA (para 4.20). 6.4 The following would be conditions of disbursement: (a) for support to the national cotton research program, NARO would finalize: (i) its cotton research program within the framework of its national research program; and (ii) satisfactory terms of reference for a study to determine the future cotton breeding policy (para 4.6); and (b) MAAIF would finalize work programs for the implementation of the extension and training programs, including support for seed multiplication in segregated areas, that would be financed under the project, and of the project component covering rehabilitation of animal holding grounds (para 4.7).  - 41 - B. Recommendation 6.5 Based on the above conditions and agreements, the project is suitable for a Credit to the Republic of Uganda of SDR 10.0 million (US$14.0 million equivalent) on standard IDA terms with 40 years maturity.  U G A N D A Cotton Sub-Sector Development Project Projects Conponents by Year Totats Including Contingencies Totals Inctuding Contingencies USh uss 1994/95 1995/96 1996/97 1997/98 1998/99 Total 1994/95 1995/96 1996/97 1997/98 1998/99 Total ==5=========