Sri Lanka - Tree Crop Rehabilitation (Tea) Project

Document of FIL E CoPY The World Bank FOR OFFICIAL USE ONLY Report No. P-2331 -CE REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A PROPOSED CREDIT TO THE REPUBLIC OF SRI LANKA FOR A TREE CROP REHABILITATION (TEA) PROJECT May 19, 1978 This document hbs a restricted distribuwtn and may be used by recipients only in the performance of their ofcial duties. Its contents may not otherwise be disclosed without World Bank autborization.  CURRENCY EQUIVALENTS US$1 = Rupees (Rs) 16.00 Rs 1 US$0.06 WEIGHTS AND MEASURES 1 kilometer (km) = 0.62 miles 1 meter (m) = 1.09 yards 1 kilogram (kg) = 2.2 pounds 1 hectare (ha) 2 2.47 acres 1 square metre (m ) - 10.76 square feet ABBREVIATIONS AND ACRONYMS DCA - Development Credit Agreement GOSL - Government of Sri Lanka ICB - International Competitive Bidding JEDB - Janatha Estates Development Board LRC - Land Reform Commission MPI - Ministry of Plantation Industries PA - Project Agreement PC - Project Coordinator PCC - Project Coordinating Committee SPC - State Plantations Corporation TSDA - Tea Small-holdings Development Authority TRI - Tea Research Institute GLOSSARY Broken Orange Pekoe (BOP), BOP Fannings (BOPF), and DUST I are among top tea grades. They are listed in descending order of particle size. Ability to vary grade proportions permits responsiveness to changing market conditions. Clonal or vegetatively propagated tea gardens outyield seedling tea because the bushes are identical and selected from superior mother bushes; seedling tea is heterogeneous and contains poor yielding bushes. GOVERNMENT OF SRI LANKA Fiscal Year January 1 - December 31  701 OFFXCL u ONLY SRI LANKA TREE CROP REHABILITATION (TEA) PROJECT Credit and Project Summary Borrower: Government of Sri Lanka. Beneficiaries: State Plantation Corporation (SPC) Janatha Estates Development Board (JEDB) Private estate owners About 180 small-holders Private transporters. Amount: US$21.0 million Terms: Standard Relending Terms: Government through the Central Bank will on-lend up to US$17.2 M of the credit to the Bank of Ceylon (BOC) at a rate of interest of: (i) 8.5% per annum, to be on-lent for project purposes at 12% per annum to SPC, JEDB, private truck operators, private growers, and factory owners; and (ii) 6.5% per annum, to be on-lent to SPC, JEDB, and private growers at 10% per annum for estate labor housing expenditure. Maturities would be: factory machinery, 10 years; vehicles, 5 years; field development, 15 years, with one year of grace; and estate labor housing, 15 years, and 5 years of grace. The Bank of Ceylon shall repay its loans from the Central Bank within the same term as the relevant subloans. Project Description: The project would assist the Government of Sri Lanka in improving the economic efficiency of the tea industry by lowering production costs and improving tea quality in the project area, as well as in stem- ming the decline in output of tea through: expanded programs of tea replanting and infilling; strengthen- ing the two major Government corporations involved in estate management; reduction in total number of factories, and expansion and rehabilitation of the remainder; provision of vehicles for personnel, green leaf and made-tea transport; and rehabilitation of soil conservation works. The project would also assist private estate owners and approximately 180 small-holder producers, and would provide improved housing and medical facilities for estate laborers. The project faces no special risks, but realization of full benefits will depend mainly upon the manage- ment performance of the two Government corporations involved. Thu document has restricted distribution and may be uied by recipients only in the performance of their official duties. Its contents may not otherwise be discloed without World Bank authorization.  - ii. - Estimated Cost: The table below summarizes the total cost of the project. (Numbers may not add due to rounding). US$ Million Equivalent Local Foreign Total Field works 3.6 1.2 4.8 Field and Nursery Equipment .4 .3 .7 Vehicles 1.1 2.0 3.1 Housing 6.3 2.1 8.4 Factory Equipment 2.6 1.7 4.3 Medical .2 .2 .4 Training - .2 .2 Support .1 .1 .2 Total Base Costs 14.2 7.7 22.0 Physical Contingencies .7 .4 1.1 Price Contingencies 6.2 1.5 7.7 Total Costs 21.1 9.7 30.8 Estimated $ Million Disbursements: Bank Fiscal Year 1980 1981 1982 1983 1984 1985 Annual 3.0 4.5 4.5 3.5 4.5 1.0 Cumulative 3.0 7.5 12.0 15.5 20.0 21.0 Rate of Return: 25% Staff Appraisal Report: No. 1892-CE, dated May 12, 1978  INTERNATIONAL DEVELOPMENT ASSOCIATION REPORT AND RECOMMENDATION OF THE PRESIDENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED CREDIT TO THE REPUBLIC OF SRI LANKA FOR A TREE CROP REHABILITATION (TEA) PROJECT 1. I submit the following report and recommendation on a proposed development credit to the Republic of Sri Lanka for the equivalent of US$21.0 million on standard IDA terms to assist the Government of Sri Lanka in improving the efficiency of the tea industry by lowering production costs and improving tea quality in the project area, as well as in stemming the decline in output of tea. Up to US$17.2 million of the credit would be relent to the Bank of Ceylon (BOC) at: (i) 8.5% per annum to be relent for project purposes at 12% per annum for 10 years for factory equipment, 15 years for field development with a one year of grace and five years for vehicles; (ii) 6.5% per annum to be relent for estate labor housing at 10% per annum for 15 years with five years of grace. The Bank of Ceylon would repay the loans obtained within the same term as the relevant sub-loans. PART I - THE ECONOMY 1/ 2. The latest economic report, "Development in Sri Lanka: Issues and Prospects" (Report No. 1937-CE, March 22, 1978) was distributed to the Execu- tive Directors on March 23, 1978. Country Data are provided in Annex I. 3. Sri Lanka has achieved social progress far beyond of that of other countries with comparably low per capita incomes. Literacy, health, and life expectancy are high; nutrition is adequate, and mortality and pop- ulation growth rates have been declining. These impressive gains have been achieved despite generally low output and employment growth. Per capita GDP growth was only 0.9% per annum in the 1948-60 period; it accelerated to 2.1% in the 1960s and then declined to 1.3% per annum in the 1970s. Through- out the 1960s and the 1970s, these modest output gains were eroded by adverse terms of trade trends. This disappointing performance has been accompanied by a disturbing increase in the level of open unemployment. In the 1970s, while the labor force has been growing at about 125,000 per year, employment has been rising by about 85,000, much of it in unproductive jobs. The number of unemployed has, therefore, been rising, and open unemployment is estimated at over one million or 20% of the labor force. 4. The gains in the social field were made possible by favorable initial conditions. Compulsory primary education had been introduced as early as 1901. The food ration was introduced in 1942. Thus, at the time of Independence in 1948, Sri Lanka already enjoyed high levels of adult literacy and life expectancy. These initial gains were consolidated and expanded in the post-Independence period through large expenditures on social 1/ This part is the same as Part I under the Tree Crop Diversification (Tea) Project.  -2- services and the food subsidy, which have accounted for two-fifths to one-half of government revenues in the 1960s and 1970s. These expenditures have been financed by harnessing the surpluses of Sri Lanka's three major tree crops, tea, rubber, and coconut, which provided the Government with both an easy revenue source and the foreign exchange earnings needed to pay for food imports required to meet consumption requirements. 5. There are both measurable and non-measurable economic benefits flow- ing from these improvements in health, nutrition, and education. Of these, the most important ones are the decline in fertility and the relatively low rate of urbanization. At the same time, there have been some significant costs arising from the firm commitment of successive governments to maintain- ing these social gains. The fiscal burden of these expenditures has imposed a high degree of inflexibility on Sri Lanka's policymakers in their attempts to accelerate long-term growth. That inflexibility has increased over time as growth slowed down and in particular, the ability of the tree crop sub- sector to provide resources weakened as commodity prices kept falling and productivity suffered due to inadequate incentives. Moreover, the gains in education have had a negative impact in the form of large numbers of educated unemployed who have posed a challenge to the established political order. With political parties competing against each other to offer inducements to the electorate, it has proved difficult for governments to focus social ex- penditure programs more narrowly on specific groups living in poverty. 6. In the 1960-77 period, gross domestic product at constant prices rose by 3.8% per annum, slightly above the 3.5% per annum recorded in the first 12 years after Independence. This impressive performance masks a marked deceleration in the growth of the productive sectors of the economy between the 1960s and the 1970s. GDP growth slowed down from 4.4% per annum in the 1960s to 3.0% in the 1970-77 period. Growth fell from 3.4% to 1.9% in agri- culture; from 6.2% to 2.3% in manufacturing. 7. The key to the slowdown in GDP growth lies largely in the slow growth of agriculture, which accounts for over one-third of GDP and four-fifths of export earnings. Tea and coconut output has been declining steadily from the mid 1960s; rubber, after showing a rapid increase in the 1960s, stagnated in the 1970s. Poor weather, declining commodity prices, a rising effective tax burden, and low producer returns combined with the uncertainties caused by a long, drawn-out land reform (1972-75) depressed producer incentives and, hence investment and production, to new lows. These problems were aggravated by a dual exchange rate, introduced in 1968, which discriminated against tra- ditional exports and in favor of food imports. 8. Paddy production, which grew at 7.4% per annum in the 1964-70 period, slowed down to 0.7% per annum in the 1970-77 period. The decline in yields and cropping intensities that this reflected is attributable to a series of droughts and a sharp deterioration in the institutional support for production programs. The only bright spot on the agricultural scene has been the rapid increase in output of subsidiary food crops in the 1970s. This represents gains in acreage rather than yields and is in response to the improved incen- tives arising from a ban on imports of this foodstuff, introduced in 1970.  9. The slowdown in manufacturing output in the 1970s was due to the cumulative impact of declining investment levels, severe foreign exchange shortages that necessitated import rationing (with serious consequences for a sector in which imported raw materials account for 70% of the value of raw materials used), the exhaustion of import substitution possibilities, and inefficiencies in management of the public sector, which now acco-nts for 66% of the gross value of production in organized industry. 10. In general, economic growth was constrained by a persistent foreign exchange shortage throughout the 1960s and 1970s, inadequate levels of saving and investment, and the low efficiency of resource use. Sri Lanka's terms of trade have deteriorated steadily since the early 1960s and worsened sharply in the mid 1970s following increases in the price of imported food, fertilizer, and petroleum. The share of these three items in Sri Lanka's total imports jumped from about 50% in 1972 to 70% in 1975. This sharp increase has, to some extent, offset the improvement in export prices (particularly of tea) since 1973. Trade policies that discriminated against exports and encouraged import substitution caused a slow growth in exports of 2.5% per annum between 1960 and 1976, which acted as a significant constraint on growth for an econ- omy in which exports accounted for 30% of GDP in 1960, and, at 22%, are still substantial today. 11. The share of consumption in GDP has remained relatively stable and high (at 86%) over the last decade and a half. Domestic savings, when adjusted for the dual exchange rate, fell from 11.5% of GDP in 1966-70 to 9% in 1971-76. This deterioration in savings performance is largely explained by a decline in public savings. Public savings averaged a mere 1% of GDP in the 1960s, shrink- ing rapidly in the 1970s, and eventually becoming negative. This poor perform- ance is attributable to the large and growing burden of subsidies and transfers, which worsened in the 1970s because of the increasing disparity between import and officially determined prices. Savings levels were also adversely affected by the large hidden subsidy burden implicit in the failure to recover costs from beneficiaries of irrigation and other infrastructure projects. Private savings were adversely affected in the 1970s by political uncertainties, a confiscatory tax burden, and falling real interest rates. 12. Gross investment has averaged 16% of GDP at current market prices in the 1960-1976 period. In real terms, investment has been declining, and there has been persistent failure throughout this period to raise the level of public investment (around 6-7% of GDP) while private investment in produc- tive activities was, on the whole, not being given much encouragement. The efficiency of investment has also been rather low due to both a misdirection of investment and a failure to exploit the full potential of past investments. Thus, much of the investment in agriculture has been directed to paddy, to the neglect of replanting in the tree crop sub-sector, resulting in an erosion of the latter's production base. Even within paddy, the strategy pursued emphasized costlier, more visible extensive development of the Dry Zone to the neglect of cheaper, but less intensive, development. In the manufacturing sector, capital-intensive import substitution was pursued to the neglect of labor-intensive export-oriented production. Utilization of the potential  already established is uniformly low. This is reflected in low cropping iitensities and yields in the agricultural sector, and low-capacity utiliza- tion in manufacturing. 13. In the elections of July 1977, the eighth since Independence, the United National Party won a large majority. In the relatively short period it has been in office, it has embarked on a number of changes in the struc- ture of Government and economic policies. On February 4, 1978, Sri Lanka shifted from a Westminster style parliamentary system to a Presidential sys- tem of government. In parallel, reorganization of local administration is also under way. On the economic front, the Budget for 1978, introduced on November 15, 1977, contains a number of policy initiatives designed to "pro- vide a basis for strong and sustained growth." The explicit objectives identified by the Government are a revival and resuscitation of the economy, increased capacity utilization in the productive sectors, increased employ- ment opportunities, the stimulation of savings and investment, and an improve- ment in the balance of payments over the medium term. These objectives are to be achieved through a shift in emphasis from direct controls to reliance on the price mechanism, together with a restructuring of relative prices, and an increased role for the private sector. 14. The main thrust of the comprehensive economic reforms, in support of which the IMF granted, in December 1977, a Stand-by Arrangement in the amount of SDR 93 million, is to dismantle administrative controls over the allocation of resources and to set realistic relative prices. On the external front, this involved a major liberalization and restructuring of the external trade and payments system supported by a reform of the exchange rate. Most public sector monopolies in ir-lorts (with the exception of food and refined petroleum) have been terminated. Prior licensing of imports has been reduced to a short list of items. Most exchange controls over invisibles transactions have been relaxed. In order to ease the task of managing the external pay- ments position and reduce the bias against tree crop exports in favor of food imports, the exchange rate has been unified and allowed to float, on the basis of underlying market forces, at an initial level of Rs 16 = $1.00. 15. Import liberalization and the reform of the exchange rate required corresponding adjustments of indirect taxes. A new import tariff structure has been introduced. The Business Turnover Tax rates have been substantially lowered and rationalized to be consistent with the new import tariff and ex- change rate. Export duties on traditional tree crops have been increased to mop up the bulk of the additional receipts flowing to this sector as a result of the unification of the exchange rate. 16. In order to reduce the drain on resources caused by the sharp in- crease in the cost to the budget of the food subsidy following the unification of the exchange rate, the rice subsidy has been confined to households with a monthly income of Rs 300 ($19). This implies that roughly half the popula- tion will no longer be entitled to the ration and will have to rely on the open market. To compensate those adversely affected, wages and salaries have been increased, provision was made for a dole of Rs 50 per month for the un- employed (which has so far not been put into effect), and the procurement  - 5 - price of paddy has been raised by 21%. Further, price adjustments arising from the new exchange rate and wage increases have been deferred in the case of wheat flour, fertilizer, petroleum, public transport, and infants' milk food. However, price controls have ended for most commodities, and public corporations are to be allowed more autonomy in pricing and distribution policies. 17. The reform of the exchange rate, combined with corresponding adjust- ments in import and export tax rates, is expected to result in a substantial increase, by 75%, in Government revenues in 1978 over 1977 levels. Expendi- tures have also risen, partly due to the exchange rate unification and to increased subsidies and transfers designed to cushion consumers from the impact of the increases in prices resulting from the exchange reform, the reduction in scope of the rice subsidies, and the removal of price controls over a wide range of goods. The combined impact of the various budgetary measures has resulted in a current account surplus of about Rs 650 million, permitting the Government to increase allocations to the capital budget. 18. An adequate response of investment, production, exports, and employ- ment to the major realignment of relative prices introduced in the Budget of 1978 is contingent on a well-thought-out medium-term development strategy. This is recognized by the Government which is beginning the process of iden- tifying the steps necessary to tackle the constraints facing agricultural out- put, industrial efficiency, and exports. The capital budget for 1978 repre- sents a determined effort to raise the level of public investment. Although the sectoral allocations in the budget mainly reflect the momentum of conti- nuation works, the process of allocating financial and manpower resources to three new key programs has already begun. These are: (i) a significant acceleration in the pace of implementation of the Mahaweli Ganga River Devel- opment Master Plan, (ii) a new export processing zone north of Colombo, and (iii) urban renewal for the Greater Colombo Metropolitan Area. 19. The Government has also begun the process of integrating these policies and programs into a medium-term investment program. In order to streamline the machinery for planning, the Ministry of Planning and Economic Affairs has been merged with the Ministry of Finance. The enlarged Ministry has been entrusted with the task of preparing a medium-term investment program by the autumn of 1978. A review of sector programs and policies is also under way. Project preparation capabilities, which have been a major weakness in the past, are to be bolstered by a new UNDP technical assistance Umbrella Project with IDA as Executing Agency. There are a number of parallel bilateral programs involved in similar efforts. 20. The ability of the Government to manage this period of transition in economic policies is greatly enhanced by a relatively strong short-term economic situation. GDP in 1977 rose by 4.4%. This was due mainly to a 9% increase in agricultural output and a 4% increase in manufacturing and services. Paddy production reached a record high of 82 million bushels due to favorable weather conditions. Tea production recovered from a low of 433 million lbs in 1976 to 460 million lbs in 1977. Rubber production also rose to 370 million lbs from 345 million lbs. However, coconut output fell in  -6- 1977, reflecting the delayed impact of drought in 1976. With money supply expanding rapidly (33% annual growth through June 1977), prices have remained under pressure despite the improvement in supplies. However, there has been a substantial improvement in the external accounts. Export earnings in 1977 rose by a record 37%. This was due in the main to a 69% increase in earnings from tea, brought about by record tea prices. Rubber and coconut exports also benefited from higher unit values, and there was a further encouraging growth in non-traditional exports. Despite various import-inducing policies, such as the March 1977 revaluation and record food imports, imports grew much more slowly. As a result, a current account surplus emerged for the first time since 1965. With a substantial net foreign exchange inflow, gross foreign exchange reserves have risen sizably from $92 million at the end of 1976 to $290 million at the end of December 1977. Part of this reserve build up represents a $64 million drawing against the SDR 93 million IMF Stand-by Arrangement. 21. The task of external management will be greatly eased in the short- term by the buildup in reserves and the relatively favorable prices for tra- ditional exports. However, Sri Lanka's current account deficit is likely to widen sharply in the coming years for four seasons. First, the new policy of import liberalization will permit industry and trade to replenish depleted stocks and meet some of the large unsatisfied demand for imports of consumer goods intermediates and spare parts. Second, the substantial rehabilitation requirements of the economy will gradually begin to be addressed. Third, as the Government implements its medium-term investment program, major new in- vestment efforts will place an additional burden on the balance of payments. Finally, the increased volume of imports will be set within a background of deteriorating terms of trade in the medium-term, as tea prices decline in real terms and foodgrain import costs rise. The success of the program of economic reforms instituted in November 1977, thus depends heavily on an increase in aid flows. Such an increase will help discourage excessive speculative im- ports, by strengthening in the eyes of speculators, the Government's ability to persist with its import liberalization policy. It will also enable the Government to desist from more costly forms of borrowings. Most important, increased concessional aid will be needed to supplement the Government's efforts at domestic and external resource mobilization in support of higher levels of investment spending. In this context, local financing will be needed to support this effort, particularly in the early years, when domestic resource mobilization efforts begin to gather momentum. 22. Sri Lanka's dependence on foreign aid has risen substantially in recent years. Net aid transfers have gone up from about $40 million in 1970 to $139 million in 1977, with gross aid rising from $63 million to $199 mil- lion. About four-fifths of net aid comes from member countries and institu- tions of the Sri Lanka Aid Group (at the fourteenth meeting of the Aid Group in May 1978, aid pledges amounted to about $342 million). Despite the improve- ment in export earnings, the debt service ratio (inclusive of short-term bonds and IMF repurchases) remains at around 21%. However, it is expected to decline sharply in 1979 as amortization and interest payments reflect the fall in the last two years in short- and medium-term borrowings.  PART II - BANK GROUP OPERATIONS IN SRI LANKA 23. Since the beginning of its operations in Sri Lanka in 1954, the Bank Group has made eight loans totalling US$73.4 million (net of cancellations) and thirteen credits totalling US$120.3 million (net of cancellations and exchange adjustments) in support of 19 projects. About 30% of Bank Group assistance has been for power, 50% for agriculture (irrigation and agricul- tural and dairy development), and the remainder for Development Finance Company operations, highways, a program credit (mainly involving the import of raw materials for industry), and water supply. Three early power loans, the Mahaweli Ganga Development credit, and the program credit together with the recently completed Lift Irrigation and Drainage, and Land Reclamation Credits have been satisfactorily completed and fully disbursed. Of the two DFCC loans, US$6.8 million of the US$12.0 million available was cancelled by DFCC due to a sudden deterioration in the private investment climate resulting from a change of governments in 1970. Under an ongoing IDA credit of US$4.5 million made to the DFCC in 1975, sub-projects for the total credit have been approved. A second IDA credit to DFCC and an equity investment by the IFC, of about US$199,000 equivalent, in the DFCC were approved by the Board early in FY78. An IFC non-revolving line of credit of US$2.0 million to the government-owned Bank of Ceylon for on-lending to private small- and medium- scale industrial enterprises has also been approved in FY78. At the request of the Borrower, a loan/credit for highways was cancelled in 1970, after disbursement of US$0.8 million of the credit, following the Goverrnent's decision to make major changes in the scope of the project. An IFC investment of US$3.25 million to the Pearl Textile Mills, Ltd. (Ceylon) was approved by IFC's Board of Directors in January 1970, but cancelled the same year because Government approval for the project was withdrawn. Annex II contains a sum- mary statement of Bank Group operations as of April 30, together with notes on the execution of ongoing projects. 24. The Bank Group's current strategy is focused on the agricultural sector to support Government efforts to increase food production and reduce its dependence on rice/flour imports, and to improve productivity in the tree crops sub-sector. Projects to support industry and basic infrastructure are also included. The Bank Group has agreed to assist the Government of Sri Lanka to accelerate the development of the Mahaweli Ganga Catchment Area by helping to develop an implementation strategy and to coordinate external assistance for project preparation and implementation. It is expected that significant investment opportunities for IDA and other aid donors will be associated with this effort. A proposed project for diversification of crops on marginal lands now under tea has been appraised and is expected to be pre- sented to the Board shortly. Appraisal has been largely completed for an integrated rural development project for the Kurunegala District, and pre- paration is under way for a road maintenance project. In addition, pro- jects in other fields, including irrigation and drainage and rainfed farming, are being prepared for possible IDA financing. 25. The Bank Group presently accounts for nearly 13% (Bank, 3%; IDA, 10%) of Sri Lanka's total external debt outstanding, and about 5% (almost totally  - 8 - Bank) of debt service. It is projected that the Bank Group's share in total external debt will increase to about 17% by 1982 (with the Bank's share declining to about 2%). The Bank and IDA shares in the debt service will show a slight decline. PART III - AGRICULTURE AND THE TEA SECTOR The Role of Agriculture in the Economy 26. Agriculture plays a major role in Sri Lanka's economy, accounting for 37% of GDP, over one-half of total employment, over four-fifths of export earnings, and a large share of public revenue. Approximately 80% of the country's total population lives in rural areas. Thus, economic growth in the country depends largely upon performance in the agricultural sector. During the 1960s, considerable progress was made in increasing food pro- duction as Government pursued a policy of reducing dependence on imports. Paddy production expanded from 840,000 tons to 1.6 M tons (6.5% per year), as a result of area expansion (175,000 ha), increasing yields (from 725 kg/ha to 1,050 kg/ha), and increased cropping intensity. After 1970, area expansion continued at a similar rate but yields and cropping intensity declined so that production grew at only 0.7% per year. Apart from generally poor weather, the major reason for the fall off in productivity was the sharp deterioration in institutional support programs aggravated by farm power and fertilizer shortages arising from foreign exchange constraints. 27. In the early 1960s, the tree crop sub-sector accounted for over 90% of the value of merchandise exports. During the 1960s production grew at only 1% per annum, and that mainly from rubber which was benefiting from the substantial replanting in the early 1950s. Since 1970, conditions in the tree crop sub-sector have further deteriorated, with output of tea, rubber, and coconut all tending downward although in 1977 there was an increase in tea and rubber production (para 20). Declining quality has also been evident, especially in the tea industry. The disappointing production trends in the tree crop sub-sector, although also influenced by drought, were primarily a reflection of declining profitability, associated with lower prices and high taxes, the uncertainties associated with Government's land reforms, and in- adequate foreign exchange allocations for vital inputs such as fertilizer and spares and replacements for machinery and vehicles. 28. The importance of the traditional export crops (tea, rubber, and coconut) lies not only in the fact that, in the foreseeable future, they will continue to be the main source of foreign exchange earnings but also in their vital role in all aspects of the economy. These three crops account for 70 to 90% of export earnings, about 45% of agricultural employment, 40% of the value added in the agricultural sector, and in addition, are expected to con- tribute about 50% of government revenues according to the 1978 Budget. Tea alone accounts for approximately one-half of the value of the country's total merchandise exports.  -9- Land Reform 29. The first phase of land reform, initiated in 1972, limited private holdings to: (i) 25 acres (10.12 ha) if exclusively paddyland or (ii) 50 acres (20.24 ha) if not exclusively paddyland, with paddyland not to exceed 25 acres. In the first-phase takeovers, implemented in 1973 through 1975, about 225,000 ha of land were vested in the Land Reform Commission (LRC). Of this, about 60% was under tree crops which included about 23% of the total tea area, 15% of the rubber area, and about 10% of the coconut area. The State Plantations Corporation (SPC), under the Ministry of Plantation Industries (MPI), was given about 40 of the larger, well-maintained tea and rubber estates, covering about 10% of the tree crop land taken over. The management of most of the remainder was placed in the hands of cooperatives. 30. In the second phase, initiated in October 1975, all land owned by Sri Lankan and foreign companies, which included the country's major tea and rubber estates, was vested in the LRC. About 65,000 ha were assigned to SPC and nearly 95,000 ha to the Janatha Estates Development Board (JEDB) which was established under the Ministry of Agriculture and Lands (MAL) for the purpose of operating these estate lands. The compensation terms for foreign-owned plantations were agreed in 1976, and payments have commenced. Compensation negotiations for rupee company and private estates are still in progress. 31. As a result of the second phase of the Land Reform, about 60% of the tea estate land, 30% of the Rubber estate land, and 10% of the coconut estate land is now vested in the LRC. In late 1977 the management of much of this land was significantly rationalized. JEDB was transferred from MAL to MPI, and several organizations and cooperatives which had mismanaged the estates they received under the first phase of the Land Reform were disbanded and their estates divided between JEDB and SPC. Of Sri Lanka's 240,000 ha total tea area, nearly 135,000 ha (56%) are vested in the LRC. Now, over 75% of these tea estate lands are managed by government corporations, with most of the remainder still managed by various cooperative groups. In addition, tea small-holders own 48,000 ha (average holding 0.39 ha) and 42,000 ha are owned by individuals with an average holding of 15 ha. The Tea Industry 32. Tea production in Sri Lanka rose from 100 M kg in 1933 to a peak of 228 M kg in 1965 averaging 223 M kg over the four years 1965 to 1968. Since 1969, production has never exceeded 218 M kg and in the last three years (1974-76) has averaged 205 M kg. This deterioration in output is partly attributable to drought, but mostly to the lack of proper attention by the Government to the sector, which has resulted in inadequate replanting, fertilization and weeding, and other poor management practices. Fertilizer use, for example, declined steadily from 43,000 tons of nutrients in 1965 to 24,000 tons in 1973, and then recovered slightly to 30,000 tons in 1975. This low usage was due to pre-nationalization uncertainties, rising fertilizer costs, low returns, the transfer of fertilizers from tea to other crops, and persistent drought. Although fertilizer use should improve, inadequate re- planting will continue to affect production adversely over the next decade. Thus, even on an optimistic calculation, 70% of the tea bushes in Sri Lanka in 1985 will be over 50 years old, and as much as 50% will be over 70 years old.  - 10 - 33. Nearly 90% of the country's tea' lands are planted to seedling tea. The rate of replanting with higher-yielding clonal tea has fallen from a peak of 2,770 ha in 1970 to 890 ha in 1976 in spite of subsidies, because of land reform uncertainties and temporarily higher prices which discouraged uprooting of old tea. The Government's replanting goal of 3,000 ha per year is not like- ly to be realized before the early 1980s, and tea output in 1995 is expected to be in the region of 227.0 M kg, still below the 1965 peak of 228.2 M kg. 34. The Sri Lanka Tea Board was created in 1975 with wide powers includ- ing: sales promotion; advising government on tea policy; administering tea subsidies; collecting and collating industry statistics; and, through its agency, the Tea Research Institute, carrying out tea research. The Chairman is appointed by the Minister, MPI and the Secretary of the Ministry is an ex- officio Board member. A Tea Small-holdings Development Authority (TSDA), established by MPI in 1976, is responsible for overseeing tea growers who do not have their own manufacturing facilities. Its major functions are to pro- vide extension advice and to ensure that small-holders receive fair treatment from greenleaf buyers. However, it is poorly staffed and has barely started work. 35. SPC and JEDB between them manage 105,000 ha of tea estates (SPC, 45,000 ha; and JEDB, 60,000 ha). Their chairmen are appointed by, and respon- sible to, the Minister of Plantation Industries. Policymaking, marketing, financial control, and input supply functions are centralized in Colombo, while responsibility for day-to-day management is decentralized to regional offices. Largely because of recent high tea prices, it is projected that the 1977 trading profit for SPC will be about Rs 77 M (US$5.0 M) and for JEDB, Rs 106 M (US$7.0 M). 36. Over 90% of Sri Lanka's tea production is sold at the Colombo auc- tions (the world's largest), with the remainder mainly sold at the London auctions. All the major buyers are represented in Colombo, and the marketing system operates well. The only problem of any significance has been the delay sometimes experienced in transporting tea from the estates to Colombo; delays occur because transport contractors cannot provide satisfactory service, being unable to obtain spares and replace vehicles. 37. Most SPC and JEDB managerial staff, prior to the Land Reform, were employed by private estate owners or agency houses. After land reform, some were employed on terms poorer than they had before, while the majority were employed on their previous terms, but only on a temporary basis, resulting, generally, in poor staff morale. The Government has recently introduced new staff terms, but staff reaction to them is not known as yet. 38. Tamil workers continue to be the majority of the labor force on the estates, especially in higher areas. With the continuing program of Tamil repatriation to India and the difficulty of attracting Sinhalese into the industry, some estates in high areas are now short of labor during peak periods. Major disincentives to potential new workers are the generally lower health and welfare standards on the estates, particularly the overcrowded and primitive housing. GOSL, however, intends to redress this imbalance.  - 11 - 39. The tea industry is subject to heavy taxation, mostly sales and export taxes. On the other hand, it benefits from subsidies on tea chests and fertilizer and for replanting. The system of taxation and subsidization is costly to administer, but its overall impact on the industry is unknown. A "Tree Crop Incentive Study," a component of the Agricultural Development Project (Credit 595-CE), is presently being undertaken to provide the Govern- ment with a policy framework, to enable Government to use resources economic- ally, and to examine the trade-off between production and export earnings on the one hand, and Government revenues (taxation and subsidies) on the other. 40. To formulate future policies for the tea industry on such questions as, inter alia, desirable production levels, organization, management, diver- sification, replanting, and marketing strategies, Government, at IDA's sug- gestion and with the assistance of the Canadian International Development Agency (CIDA), began work in January 1978 on an overall Tea Master Plan ex- pected to be completed in early 1979. The Master Plan is to develop recom- mendations on industry structure, fiscal policy, and investment programs and priorities. Financing of Tea Development in Sri Lanka 41. Under existing Bank Group policy, as stated in my memorandum to the Executive Directors of August 17, 1973 (Document No. R73-206), no further financing of projects involving tea production is to be undertaken, except: (i) "financing for increases in output in countries with no investment alter- natives yielding an acceptable rate of return; and (ii) financing for reha- bilitation involving no increase in output (this implies reduction in acreage and encouragement to diversification)." 42. It would be difficult to establish that alternative projects "offer- ing an adequate rate of return" do not exist or cannot be developed in Sri Lanka. The proposed project, however, qualifies under the second exception (para 12 of the policy paper): "Financing for replanting or a rehabilitation project could be considered if the project does not lead to increased production in the near or medium term. Such projects would lead to increases in yield, and these would have to be offset by shifting the acreage saved to other purposes. Tea bushes last, with slowing declining yields, for 75 years and more. Since the alternative to replanting or rehabilitation is usually to allow old bushes to continue their slow decline, the principal result of such projects is the long-run extension of the period of production. The discounted present value of their effects upon world tea prices is, therefore, likely to be very small. The purpose of such a policy would be to give encouragement to diversification. The Bank is prepared to provide financing for this purpose." (emphasis added). 43. Sri Lanka is the only major tea-producing country suffering a long-term structural decline in its tea production; its share of the world production declined from an average of 18.6% in the late 1960s to about 12.2% in 1976. The primary purpose of the proposed project would be to support a  - 12 - replanting program designed to prevent further decline in Sri Lanka's pro- duction rather than to increase output over its historic peak levels. Tea production in 1995 in Sri Lanka, including the proposed project, is estimated to be about 227 M kg, still below the peak reached in 1965 (para 32); at this level, Sri Lanka's share of the world production would still be expected to decline further to about 8.6%. This estimate does not take into account any diversification of tea lands to other uses which might be undertaken by the Government. 44. The Government has an ongoing diversification program and has assigned to the Agricultural Diversification Division in the Ministry of Agriculture and Lands the tasks of: (i) preparing an inventory of lands suitable for diversification; (ii) assigning development priorities to the inventory; and (iii) preparing future diversification projects. The Govern- ment has also requested IDA support to finance an initial project in the Kandy area which will diversify 4,800 ha of marginal tea to spices and food crops, dairying, and forestry. This project was appraised concurrently with the project now proposed and is expected to be presented to the Board shortly. PART IV - THE PROJECT 45. The proposed project was prepared by the Government of Sri Lanka with assistance from the Canadian International Development Agency and was appraised in October/November 1977. A staff appraisal report entitled "Tree Crop Rehabilitation (Tea) Project" (No. 1892-CE, dated May 12, 1978) is being distributed separately. Supplementary project data are provided in Annex III. Negotiations were held in Washington from April 10-14, 1978, with a Sri Lankan delegation led by Mr. B. Weerakoon, Secretary, Ministry of Plantation Industries. 46. The project would assist the Government in improving the economic efficiency of the tea industry by lowering production costs and improving tea quality. Though its incremental impact on Sri Lanka's tea output would be small, the project would help to slow the decline in production evident over the past decade. The project would strengthen the two major government corporations involved in estate management, assist private estate operators and approximately 180 small-holder producers, and provide improved housing and medical facilities for estate laborers. An additional benefit would derive from the control of soil erosion in the catchment area of the country's most important hydro-electric stations. 47. The project area is located about 80 km east of Colombo, in the planting districts of Maskeliya and Upper and Lower Dickoya in the north- western portion of the administrative district of Nuwara Eliya. The area includes about 18,000 ha of tea, managed by the SPC (10,000 ha in 30 estates), JEDB (7,600 ha in 29 estates), private estates and small-scale producers (300 ha owned by about 180 individuals). Neither soils nor topography in the project area are well suited to land uses other than tea, forestry, or pasture. The area also embraces large portions of the watersheds of the Castlereigh and  - 13 - Maskeliya Reservoirs which serve hydro-electricity stations currently supply- ing about 90% of the island's power. 48. The principal features of the proposed five-year project are sum- marized below: (a) The program of replanting with clonal tea on the JEDB estates, which is currently less than that on SPC estates, will be expanded by about 550 ha. In addition, 6,500 ha of existing seedling tea will be infilled with high-yielding clonal tea of which 3,000 ha and 3,500 ha would be on JEDB and SPC estates, respectively. Small-holders will be assisted with modest replanting and infilling programs, 15 ha and 40 ha, respectively. (b) Soil conservation structures would be completely renovated in replanted and infilled areas and would be repaired on 16,000 ha of seedling tea scheduled for future infilling. (c) To help remedy the fuelwood shortage, JEDB and SPC would plant 340 ha and 250 ha, respectively, of fuelwood on land unsuitable for tea. (d) 42 factories (JEDB, 17; SPC, 22; and 3 private) would be rehabilitated and expanded while 15 factories owned by the two public corporations would be closed in a rational- ization program. Completion of an estate and factory rationalization study would be required before implemen- tation of this component (para 70). (e) Trucks, tractors, and trailers would be provided for green leaf transport to improve plucking efficiency and ensure that leaf arrives in top condition at factories. Personnel transport would be provided to improve estate management efficiency and bowsers would be supplied to improve herbi- cide and fuel transport. Trucks would be made available to private contractors to improve made-tea transport. (f) SPC and JEDB would each establish a workshop in the project area to undertake vehicle and factory machinery maintenance and minor repairs. (g) In order to improve living conditions for labor on JEDB, SPC, and private estates, which are markedly below the national level, 6,600 new houses will be constructed, 6,700 more would be rehabilitated, and water supplies would be improved. (h) Statistics show that the health level of the estate workers is poorer than the national average; therefore, health services in the project area will be improved and an investment plan developed to improve health care on estates nationwide.  - 14 - (i) Government would be assisted in establishing a National Institute of Plantation Management and provide overseas training visits for senior estate staff. (j) Assistance would be provide for updating tea area statistics, mainly through use of Landsat data. Organization and Management 49. Land Reform (paras 29-31) substantially changed the ownership and management structure of the tea industry, and now, after two years of post- reform operational experience, the entire institutional structure is in need of a detailed review to determine its suitability. Such a review is the Tea Master Plan Study (para 40), to be completed in early 1979. Pending the outcome of this study, major institutional and fiscal policy changes are not proposed under the project. However, since any such changes would affect the project, it was agreed (DCA, Section 3.11) that the findings of the Master Plan and the Tree Crop Incentive Study (para 39 and 40) and any institutional changes which would materially affect the execution of the project would be disussed with IDA prior to their implementation. 50. A Project Coordinating Committee (PCC) has been established which will provide a forum for coordination of all aspects of project implementation between all concerned organizations. The PCC comprises: the Secretary of MPI as Chairman; the Chairmen or General Managers, JEDB and SPC; the Hatton Regional Managers of both JEDB and SPC (para 52); the Director General of the Tea Board; the General Manager, TSDA; and a representative of the External Resources Department, Ministry of Finance and Planning. The Project Coordinator (para 51) will serve as PCC executive officer. The PCC will meet regularly to re- view project progress, discuss and approve an annual development plan and budget for the project, and, on the basis of the recommendations of the Project Coordinator, award all contracts for the supply of goods and services. 51. The position of Project Coordinator (PC) has been established at the level of Senior Assistant Secretary of MPI. In addition to serving as the executive officer for the PCC, the PC would, in conjunction with the two Hatton Regional Managers, prepare and submit to the PCC and IDA annual plans and budgets for the project. They would be prepared at least six months in advance of each financial year so that they could be incorporated in SPC and JEDB budgets. The PC would also, in consultation with the Supply Managers and the Regional Managers of the two corporations, arrange preparation of tender documents (with IDA approval where appropriate), issue tenders, open and evaluate bids, and make recommendations for award. Monitoring project progrv.7s and submitting half yearly reports to the PCC and IDA would also be a resp:nsibility of the PC. Assurances were obtained that the position of Proje > Coordinator would, at all times, be filled by a person with qualifi- cations and experience satisfactory to IDA (DCA, Section 3.04). 52. Both the SPC and JEDB have similar organizations (para 35) with control of field operations decentralized to seven regional offices; the project area comprises virtually all of the Hatton Region of both corpora- tions. Since the regional managers of both corporations would have key roles  - 15 - in project implementation, it was agreed that these posts would be filled over the life of the project with persons with qualifications and experience acceptable to IDA (PA, Section 2.07). Although day-to-day financial control of the estates in the regions is adequate, monthly estate reporting would be improved through the introduction, by December 31, 1978, of a common reporting format for both corporations (PA, Section 3.05). 53. SPC and JEDB estates are managed by superintendents, assisted where necessary by assistant superintendents, the rate of staffing being about one officer per 140 ha. Visiting Agents, selected from senior superintendents within SPC and JEDB, are used to intensify supervision by regional management over corporation estates through preparation of comprehensive tri-annual reports on each estate, and through contributions to the development of estate budget estimates. It was agreed (PA, Section 2.06) that SPC and JEDB would, until completion of the project, continue to maintain the Visiting Agent system in the project area. Although experienced staff did leave the industry as a result of land reform, a sufficient number remained to form a core of experienced personnel and staffing of the corporations, at least in project- related areas, is generally good. A Government Commission has examined, and made recommendations on, terms and conditions, and Government announced new terms in March 1978. It is too early to judge whether the new terms will enable the corporations to attract and retain staff of requisite quality. Because their ability to do so is essential to the future of the industry, an assurance was obtained that staff conditions and terms of service would be reviewed with the Association by December 31, 1979 (PA, Section 3.06). As part of a general effort by Government to alleviate the serious problem of unemployment in the country (para 3) by offering more jobs in the public sector, SPC and JEDB together absorbed 45,000 new employees in the period August 1977 to January 1978. The Government has decided since, that employment in public corporations should not be expanded at the expense of a decline in their profitability, and agreement was obtained that Government would not implement any major programs for increasing personnel in SPC and JEDB which are inconsistent with their financial viability (DCA, Section 3.14). 54. The Government recognizes that SPC and JEDB must be given a large measure of financial autonomy if they are to be able to effectively discharge the functions assigned to them in managing and developing the tea industry whose viability is vital to the economic future of the country, and it intends to institute policies and procedures accordingly. Most generally, the aim will be to ensure that: (i) the production of tea is sufficiently profitable to induce the corporations to manage and develop their lands in an economically optimal fashion and to enable them to do so without recourse to general bud- getary funds; and (ii) the corporations have the requisite powers to manage their affairs, within the general framework of objectives and policies of the Government but without detailed intervention by Government, including, in particular, the use of funds. In order to accomplish this, the financial structure and operations of the corporations need improvement. The asset base of SPC and JEDB remains undecided because decisions regarding transfer of ownership of nationalized estates from the Land Reform Commission to the corporations have yet to be taken. Agreement was obtained (DCA, Section 3.12) that measures, satisfactory to IDA, would be taken by December 31, 1978,  - 16 - to transfer ownership of the nationalized estates to the corporations. In ijer that these assets may be properly valued, Government intends to com- plete revaluation of the estates by 1982. These steps will provide the basis fot sound financial planning and management and will enhance the credit worthi- ness of the corporations, a factor which would be important in view of the large increase in bank borrowing envisaged. 55. Profitability is not, at the moment, an acute problem due to the high level of tea prices and the net effect of the exchange reform of November 1977; indeed, nominal profits have been at a level sufficient to enable the two corporations to cover their capital expenditure in full from internal cost flow. However, if tea prices decline as now projected, profitability would become a problem unless remedial measures are taken. Thus, it was agreed (DCA, Section 3.07) that duties, taxes, cesses, and subsidies in respect of tea would be adjusted as necessary to maintain profitability at the level established when such duties, taxes, cesses, and subsidies were set in the budget of November 1977. It was agreed further (DCA, Section 3.13) that the two corpo- rations will be permitted to retain in their investment reserves a sufficient amount of their net surpluses to enable them to finance no less than 25% of their investment programs. Funds in these reserves would be placed in short- and medium-term securities in accordance with the corporations' overall invest- ment plans. Finally, under the project the corporations would come under the financial discipline of the commercial banks from which they will have to obtain a substantial share of their long-term capital requirements. However, such financial operations of the corporations are presently constrained by the Finance Act of 1971, which controls public corporations. Under this Act, prior approval of the concerned Minister and the Minister of Finance and Planning is required for: (i) commitments of capital expenditure in excess of Rs .5 M (about US$32,000); (ii) appropria:ions for write-offs; and (iii) transfers to and from reserves. Agreement, therefore, was obtained that the Government would, by December 31, 1978, take measures satisfactory to the Association to exempt SPC and JEDB from the above-mentioned provisions of the Finance Act (DCA, Section 3.05). 56. A factor that could greatly affect the profitability of the tea industry in future is the cost of providing adequate housing for estate labor. Housing for estate labor at present is generally poor and of standards that would be unacceptable to Sri Lankan labor that will have to replace departing Tamil labor (para 38). Thus, substantial investments will need to be made in order to enable the industry to attract such labor. The alternative would be a decline in the labor force which would mean a fall in production. While it is difficult to estimate what the decline in production would be, two sets of analyses were undertaken in conjunction with the proposed project with a view to assessing broadly the implications of the housing problem. In the first set, the investment package was defined as comprising the full project cost of replanting and infilling, but only that part of the investment in housing that would be needed to provide for the labor engaged in work on the acreage to be improved. That portion of housing costs was taken as 40%, equivalent to the portion of land to be replanted and infilled under the project (7,000 ha) to the total area under tea in the estates covered by the project (18,000 ha). The financial rates of return on such a package are estimated at 14.5% and  - 17 - 12.5% for JEDB, suggesting that the gains in productivity from the project would make such investment financially attractive, despite the substantial investment in housing associated with it. The second set included the total investment in housing in the investment package. Because the income stream is the same as in the first set, the financial rates of return to SPC and JEDB in this ca e are estimated at only 8.5% and 8.0% respectively. Since the second set of analyses probably approximates the situation confronting the tea industry in general more nearly than the first, it is evident that the large investment in housing, that appears to be required, will have a considerable effect on operating cost and thus on profitability, unless remedial measures are taken. Government recognizes this problem and has directed that the Tree Crop Incentive Study (para 39) should pay particular attention to the financial burden imposed on the industry by the labor housing improvement program. In order to establish sufficient incentive for invest- ment, a minimum financial rate of return of 12% on investment would also be established as an objective in all analysis under the study. 57. Reliable data on small-holder yields, production costs, and returns are not available, and the proposal to assist the approximately 180 small- growers in the project area would be essentially in the nature of a pilot scheme. The Tea Small-holdings Development Authority (TSDA), which admin- isters subsidies and provides extension advice to small-holders, will place a regional officer with a small support staff in the project area to organize small-holder development activity. Only the more productive small-holders would be encouraged to undertake replanting and infilling programs. Such programs are expected to be modest in scale since on a small-holding achieving only average yields, replanting depresses income for several years even when credit and subsidies are available. It is estimated that only about one- quarter of the 180 small-holders eligible will participate in replanting ar.u!1 infilling (15 ha and 40 ha, respectively). Project Cost and Financing 58. The total project cost is estimated at about US$31 million equivalent, including taxes and duties of US$0.5 million, with a foreign exchange component of US$9.7 million (30%). Physical contingencies have been applied to the base cost estimate in the following manner; 7.5% for housing construction, 5% for factory equipment and field works, and 2.5% for the support components. No physical contingencies have been included for vehicles, field, nursery, health, and training equipment. The proposed IDA credit of US$21.0 million equivalent would finance 70% of total project costs, net of taxes and duties, and would cover the full foreign exchange cost and about US$11.3 million equivalent of local costs (para 21). Consultants will be employed to assist in developing the nationwide estate-health investment plan (12 man-months; US$25,000) and to provide technical assistance to the National Institute of Plantation Manage- ment (30 man-months; US$100,000). 59. It is now the Government's policy that Government-owned corporations should operate according to commercial practices and thus SPC and JEDB should obtain the funds they need to finance their investment in the first instance from their own, internally generated resources and the balance through borrow- ing from commercial banks (para 55) rather than the Government as was lIinely  - 18 - the practice in the past. Therefore, the Government through the Central Bank would on-lend up to US$17.2 million of the Credit to the Bank of Ceylon, which would in turn on-lend this amount, plus US$1.9 million of its own resources, to the two corporations, private factory owners and tea growers (including some small-holders, para 57) and to private truck operators. These sub-borrowers would contribute from their own resources no less than 25% of the total cost of the investment. The balance would be available from the Bank of Ceylon on terms in line with present commercial banking practices (para 1). The Central Bank of Ceylon, in turn, would refinance 90% of the amount lent by the Bank of Ceylon, at an interest rate that would allow the Bank of Ceylon a margin of 3.5% which would be sufficient to cover administrative expenses and risks and allow a reasonable profit. Procurement and Disbursements 60. With the exception of fluid bed driers, and fuel and herbicide bowsers and trailers, all factory equipment, tractors, and vehicles for the corporations (US$5.9 million) would be procured through international com- petitive bidding (ICB) in accordance with IDA guidelines. Bids from domestic manufacturers would receive a margin of preference -- 15% or the prevailing customs duty, whichever is lower -- in the evaluation of bids from competing foreign suppliers. Fluid bed driers (US$0.2 million) are patented and manu- factured by only one firm, located in Sri Lanka, and would be purchased direct. Prices for these driers are considered reasonable, and the firm is capable of meeting estimated demand. Fuel and herbicide bowsers and trailers for the corporations (US$0.6 million) would be procured on the basis of competitive bidding advertised locally, following procedures acceptable to IDA, since procurement would be in small lots not expected to attract international tenders. All equipment and vehicles for private tea producers, and trucks for made-tea transport (US$0.6 million) would be purchased directly by private operators on the basis of customer preference because purchases would be in small lots not suitable for ICB. Civil works (housing) would consist of many small individual units constructed over a five-year period and would not, therefore, be suitable for ICB. 61. Contracts for construction of new cottages (US$4.3 million) would be awarded on the basis of competitive bidding advertised locally, following procedures acceptable to IDA. The Project Coordinator's office may undertake bulk procurement of such items as cement, iron sheets, and timber for small contractors. In this instance, procurement would also be on the basis of competitive bidding advertised locally following procedures acceptable to IDA. To encourage small contractors, tenders would be invited for multiples of five cottages. Rehabilitation of existing estate housing (US$4.0 million) would be undertaken by estate labor on force account, with provision for outside con- tractors for those instances where estate labor does not have the necessary capacity. Field development works (US$4.8 million) would be undertaken by estate labor on force account. Water pipe and tanks, workshops, and office and field dispensary and nursery equipment (US$0.8 milllion) consist of many small items that would not be suitable for ICB and would be procured on the basis of local shopping. Domestic manufacturers and local agents of foreign manufacturers are present in sufficient number to ensure competitive prices. Civil works for hospitals and civil works and equipment for the Training  - 19 - Institute (US$0.2 million) would be procured on the basis of competitive bidding advertised locally following procedures acceptable to IDA. Vehicles and equipment for hospitals and polyclinics included under the health com- ponent would be purchased from suppliers to ensure standardization with those already in use by the Ministry of Health (US$0.14 million). 62. Disbursements will be made directly against project expenditures and not against the sub-loans to borrowers under the project. In the event that the corporations are able to finance from their own resources more than the minimum of 25% of the total cost of their investment (para 55), this provision would prevent disbursements from the credit falling short of the intended share of IDA financing in total project cost. Disbursements will be made as follows: (a) 100% of foreign expenditures for directly imported vehicles and equipment, or 100% of local expenditures (ex-factory cost) if manufactured locally or 75% of expenditures for imported goods procured locally. (Completion of an estate and rationalization plan is a condition of disbursement for factory equipment (para 70); (b) 55% of the total cost of civil works carried out by local contractors and civil works performed under force account by SPC and JEDB estate labor; (c) 55% of the total cost of the training and medical components; and (d) 50% of total estate field development expenditures on replanting, infilling, soil conservation works and timber planting. The disbursement schedule is given in the Credit and Project Summary. Project Benefits and Risks 63. The project's major benefit would derive from increased efficiency in production and better quality of tea through replacement of obsolete machinery and equipment. Incremental production from the project (4.4 M kg after 20 years) would be marginal in Sri Lanka's total tea output (para 43), but would help to arrest the currently declining production trend. It would still leave the country's total production below the peak reached in 1965. 64. About 25,000 estate labor families would benefit from improved housing, water, and health services. In addition, some 15,000 man-years of incremental employment would be created during the investment period. 65. The project would diversify marginal tea land into timber which would provide locally significant quantities of fuelwood for estate labor and factory use. Rehabilitation of soil conservation drains throughout the project area, together with diversification of marginal land, would reduce soil erosion, thus protecting a large portion of the catchment area of the country's most important source of hydro-electricity generation.  - 20 - 56. The economic rate of return (ERR) of the project is estimated to be 2ziZ. An increase or decrease of 10% in tea prices from the level projected would change the ERR by about one and one-half points either way. An equiva- lent increase or decrease in costs would change the ERR by about two percent- age points either way. 67. Apart from the unpredictable, but temporary, impact of adverse weather, the technical risks of the project are no greater than would normally be associated with operations of this type. The major risks are organizational and managerial in nature. As a consequence of land reform, the tea industry in Sri Lanka has been subject to significant changes in recent years. In particular, there are now two large corporations handling the work that pre- viously was the responsibility of a large number of private tea agency houses. The corporations have encountered problems, but their performance has been improving with experience. Furthermore, the ongoing Tea Master Plan is examin- ing the institutional structure of the industry and is expected to make recom- mendations for its further improvement. In the meantime, the organizational/ managerial structure, as strengthened under the project (paras 50-55), is ade- quate, in view of the limited areas of operation, for project implementation. PART V - LEGAL INSTRUMENTS AND AUTHORITY 68. The draft Development Credit Agreement between the Republic of Sri Lanka and the Association, the draft Project Agreement between the Association and the State Plantation Corporation and the Janatha Estates Development Board, and the Recommendation of the Committee provided for in Article V, Section l(d) of the Articles of Agreement are being distributed to the Executive Directors separately. 69. Special conditions of this credit are listed in Section III of Annex III. Additional conditions of effectiveness for the IDA credit include (i) the execution of the Project Agreement on behalf of the State Plantation Corporation and the Janatha Estates Development Board (DCA, Section 5.01 (a)), and (ii) the execution of a satisfactory subsidiary loan agreement between the Government of Sri Lanka and the Bank of Ceylon (DCA, Section 5.01 (b)). 70. Completion of an estate and factory rationalization plan satisfac- tory to the Association would be a condition of disbursement for tea factory equipment (DCA, Section 2.02). 71. I am satisfied that the proposed development credit would comply with tle Articles of Agreement of the Association.  - 21 - PART VI - RECOMMENDATION 72. I recommend that the Executive Directors of the Association approve the proposed credit. Robert S. McNamara President Attachments May 19, 1978 Washington, D.C.   Annex 1 fae of 4 pages SRI LANKA - SOCIAL INDICATORS DATA SHEET LAND AREA (THOU KM2 ---- -- -- -- -- - - - - - - -- - ------- SRI LANIA * REFERENCE COUNTRIES (1970) TO1AL 66.6 MOST REcENT AGrIC. 24.2 1960 197t. ESTIMATE TANZANIA PHILIPPINES MALAYSIA*ff GNP PER CAPITA (USS) 80.0 130.0 200.0)a 100.0* 230.0* 7 440.0* ____________________ POPULATION AND VITAL STATISTICS POPULATION (MID-YR. MILLION) 9.9 12.5 13.8)a 12.0)6. 36.9 10.8 POPULATION DENSITY, PER SQUARE KM. 151.0 191.0 210.0)a 14.0 .123.0 33.0 PER SO. KM. AGRICULTURAL LAND 507.0 518.0 57nln)a 25.0 375.0 185.0 VITAL STATISTICS CRUDE BIRTH RATE (/THOu. AV) 37.6 33.1 28.2 50.5 44.2 42.2 CRUDE DEATH RATE (/THOU.AV) 10.7 B.0 7 . 23.0 13.2 12.9 INFANT A3RTALITY RATE (/THOU)t 52.0 S1.0 5 .U , 165 0 91.0 40.8)a LIFE EXFECTANCY AT BIRTH (YRS) 60.5 65.8 67.8 41.9 5.56 56.7 GROSS REPRODUCTION RATE 2.5 2.3 2.2 3.2 3.3 2.6)a POPULATION GROWTH RATE (%) TOTAL 2.8 2.4 1.7 3.0)6 3.0 2.9 URBAN 4.6 4.5 3.7 5.6 4.0 3.0 URBAN POPULATION (S OF TOTAL) 17.9 22.0 24.3 5.5 )b 27.6 26.9 AGE STRUCTURE (PERCENT) 0 TO 14 YEARS 41.5 ) 40.0 39.0)a 44.4 )b 45.6 44.7) a 15 TO 64 YEARS 54.3 )a' 56.0 6V8>a 53.0 )D 51.6 52 65 YEARS AND CVER 4.2 )a 4.0 4.2)R 2.6 )b 2.8 3.2 AGE DEPENDENCY RATIO 0. ). 0.8 0.8)0 09 0.9 0.9 ) a ECONDRA1C DEPENDENCY RATIO 1.5 1.4 1.2)D 1 2asab 1.5 1.6) FAMILY PLANNING ACCEPTORS (CUMULATIVE, THOU) ,. 215.3 431.5 .. 320.0 222.2) USERS (% OF tNARRIED WtEN) .. 7.0 9.9 .. 2.0 8.0)a EMPLOYMENT TOTtL LABOR FORCE (THOUSAND) 3500.0 141000 4800.0 5600*0),t2400 0 3600.0 LABCR FORCE IN AGRICULTURE () 49Q)& S2. a( Ss.50)c 91.0)a,b 55:.0)a 49.5 UNEMPLOYED C% OF LABOR FORCE) 4.0)a,b 9.oSb I d 7.6 7.0 INCOME DISTRIBUTION % OF PRIVATE INCOME REC'D BY- HIGHEST 5% OF HOUSEHOLDS 26.4) 18.9 1a.6 33.5 28.3 HIGHEST 20% OF HOUSEHOLDS 52.1.) 45.6 42.8 63.3 54.0. 56.0 LOWEST 20% OF HOUSEHOLDS 4,51 7.4 7.3 *2.3 3.6 3.5 LOWEST 40% OF HOUSEHOLDS 13.7) 17.9 19.3 7.8 11.7 11.2 DISTRIBUTION OF LAND OWNERSHIP % O.X\LO BY TOP 10% OF OWNERS .. .. .. % OWNED BY SMALLEST 10X OWNERS .. .. .. .. HEALTH AND NUTRITION POPULATION PER PHYSICIAN 4600.0.C . 3980.8 ) 21570.0) POPULATION PER NURSING PERSON 4170.0 2730 0)C 2280. )a 4890.0'a POPULATION PER HOSPITAL BED 290.0) 330.0)c 330.0)a 700.0 650.0 270,0)a PER CAPITA SUPPLY OF - CALORIES (% OF REQUIREMENTS) 92.0 101.0 97.0 73.0 93.0 110 0 PROTEIN (GRANIS PER DAY) 45.0 50.0 45.0 43.0 45.0 49,00b -OF WHICH ANIMAL AND PULSE 15.0 16.0 15.0 23.0 22.0 20.0)b 5.5 DEATH RATE (/THOU) AGES 1-4 .. .. 16.8 ,, 6.6 EDUCATION ADJUSTED ENROLLMENT RATIO PRI'.:ARY SCHOOL 95.0 35.0 113.0 8s.)6 SECONDARY SCHOOL 27.0 5i.Q)d s9.O)f 3.0 49.0 .34.0)a YEARS OF SCHCOLING PROVIDED (FIRST AND SECOND LEVEL) 12.0 12.0 12.0 t3.0 10.0 13.0 )a VOCATIONAL ENROLLMENT (I OF SECONDARY) ,, i.o)d 1.0)f 10.0)C 6.0)b 3.0 )a ADULT LITERACY RATE (%) 61.0)a .. 76.1 .. .. 55.0 )a HOUSING PERSONS PER ROOM (URBAN) 2.1 )a 2.7 )g 2.3)a OCCUPIED DWELLINGS WITHOUT PIPED WATER (%) 80.9 )a . 77.5)g 30.o)b,d 76.0 65.0)a,c ACCESS TO ELECTRICITY (I OF ALL DWELLINGS) 7.5 )a 9.0 )g ,. 23.0 43,0)a RURAL OWELLIN-S CONNECTED TO ELECTRICITY (%) 2.3 )a 2.8)R , 7.0 30.0 )a CONSUL!PTION ___________ 37.0 RADIO RECEIVERS (PER THOU POP) 36.0 -. 11.0 72.0 41.0 PASSENGER CARS (PER THOU POP) 9.0 7.0 ^7.0 3.0 8.0 27.0 ELECTRICITY (KWH/YR PER CAP) 31.0 65.0 SZ.8 31.0 235.0 382.0 NEWSPRINT (KG/YR PER CAP) 1.2 1.5 0.5 0.1 2.0 4.0 SEE NDTES AND DEFINITIONS ON REVERSE  ANNEX 1 Page 2 of 4 pages NOTES Unless otherwise noted, data for 1960 refer to any year between 1959 and 1961, for 1970 between 1968 and 1970, and for Most Recent Estimate between 1973 and 1975. * GNP per capita data are based on the World Bank Atlas methodology (1974-76 basis). ** The selection of Malaysia as an objective country is based on its ability to combine a high rate of economic growth with an adequate level of wel- fare making it a suitable objective for policymakers in Sri Lanka. SRI LANKA 1960 a/ 1963 *b/ Registered applicants for work. c/ 1962 1970 a/ As a percentage of employment b/ Registered unemployed c/ Government only d/ Between 1965 and 1970 the duration of general secondary education was increased from 4 to 7 years. Data on vo- cational education refer to technical institutes attached to the Ministry of-Education only. X Technical institutes attached to the Ministry of Education only. 1/ 1971 Most Recent Estimate: a/ 1976 b/ Ratio of population under 15 and 65 and over to total- labor force. c/ As percentage of employment d/ Registered unemployed e/ 1972 f/ Between 1965 and 1970 the duration of general secondary education was increased from 4 to 7 years. Data on vocational education refers to X. Tanzania 1970 a/ Mainland Tanzania b/ 1967 c/ 1965 d/ As percentage of urban households Philippines 1970 a/ As percentage of employment b/ Not including private vocational schools or vocational short-term school. Nla2.agig 3970 a! Peninsular Malaysia b/ 196 4- 66 c/ Piped water insiLle  Annex I Page 3 of 4 Pages COUNTRY DATA - SRI LANKA AREA POPULATION 1/ DENSITY 65,607 sq km 13.8 millien (mid 1976)- 210 per rq km (1976) Rate of Growth: 1.7% (from 1971 to 1976) 554 per sq km of agricultural land (1974) POPULATION CHARACTERISTICS (1976) HEALTH (1976) Crude Birth Rate (per '000): 27.4 Population per physician: 6,107 Crude Death Rate (per '000): 7.9 Population per hospital bed: 330 Infant Mortality (per '000 live births): 51 (1974) INCOME DISTRIBUTION (1973? DISTRIBUTION OF LAND OWNERSHIP % of national income, highest quintile: 45 % owned by top 10% of owners ** lowest quintile: 13 % owned by smallest 10% of owners ** ACCESS TO PIPED WATER (1971) ACCESS TO ELECTRICITY (1971) % of population - urban: 77 % of dwelliAgs - uroan- 9 - rural: 5 - rural: 3 NUTRITION (1973) EDUCATION (1973) Calorie intake as % of requirements: close to 100 Adult literacy rate: 78% Per capita protein intake (grams per day): 45 Primary school enrollment: 86% 2/ GNP PER CAPITA in 1976: US$200 GROSS DOMESTIC PRODUCT IN 1976 ANNUAL RATE OF GROWTH (%. constant prices) US$ Mn % 1960-65 1965-70 19'0-76 GDP at Market Prices 3,114 100.0 3.6 5.3 2.7 Investment, 495 15.9 ** ** ** Domestic Saving 430 13.8 ** ** ** Current Account Balance -65 -2.1 * * * Exports of Goods, NFS 628 20.4 3.8 -0.6 -0.8 Imports of Goods, NFS 679 22.0 -8.4 3.5 -5.0 OTPUT, EMPLOYMENT, AND PRODUCTIVITY IN 197f Value Added Empleymeit-/ V. A. Per Worker us$ M Mn. % S$ u I Agriculture 1,053 36.1 2.029 50.1 519 73 Industry 4/ 468 16.3 0.389 9.6 1,203 171 Services 1,343 46.9 1.632 40.3 823 110 Unallocated * * * Total/Average 2,864 T100. 4.050 ioO2TY 707 100.0 GOVERNMENT FINANCE Central Government (Rs mn) % of GDP 1976 1970-72 1976 Current Receipts 5,837 21.0 18.8 Current Expenditure 5.925 23.1 19.1 Current Surplus -88 2.1 -Z03 Capital Expenditures 2,030 6.4 6.5 External Assistance (net) 1,050 2.7 3.4 1/ Provisional estimates. 2/ The per capita GNP estimate for 1976 is taken from the World Bank Atlas. Per capita adjusted GNP in 1977 (see Annex C) at the new exchange rate is $160. All other conversions in this table are at the average official exchange rate prevailing during the period. 3/ The sectoral distribution was assumed to be the same as for 1971. 4/ Includes mining. Note: As described in "The Economy" section of this report, Sri Lanka has introduced a number of major changes in domestic and external policies. The implications of these policies for the future have been reviewed in the Country Economic Report entitled "Development in Sri Lanka: Issues and Prospects," dated March 22, 1978 (Report No. 1937-CE). In consultation with the Government, work on detailed projections of the major macro-economic parameters, and the balance of payments is currently under way. ** not available * not applicable  Annex 1 Page 4 of 4 pages COUNTRY DATA - SRI LANKA September MONEY, CREDIT, AND PRICES 1971 1972 1973 1974 1975 1976 1977 (end of period) Money and Quasi Money 3,379 3,916 4,093 4,504 4,712 6,521 7,795 Bank Credit to Public Sector 2,738 2,709 2,600 2,468 2,497 3,580 3,016 Bank Credit to Private Sector 1,736 2,117 2,133 3,188 3,363 3,919 5,222 (Percentages or Index Numbers) Money and Quasi Maney as % of GDP 26.6 28.7 24.8 20.9 19.6 23.7 - General Price Index (1970 - 100) 102.7 109.2 119.7 134.4 143.3 145.2 146.21/ Annual percentage changes in: General Price Index +2.7 +6.3 +9.6 +12.3 +6.6 +1.3 +1.3L/ Bank credit to Public Sector +8.3 -1.1 -4.0 -5.1 +1.2 +43.4 -13.0 Bank credit to Private Sector +8.6 +21.9 +0.8 +49.5 +5.5 +16.5 +34.8 BAIANCE OF PAYMENTS MERCHANDISE EXPORTS (1977) 1976 1977i2/ US$Nn 7 (US$ Million) Tea 419 53.6 Exports of Goods, NFS 627 864 Rubber 109 14.0 Imports of Goods, NFS 679 809 Coconut Products 38 4.9 Resource Gap (deficit = -) -52 +55 Interest Payments (net) -20 -17 All other cosodities 215 27.5 Workers' Remittances - - Total 781 T0'W Other Factor Payments (net) - - Net Transfers +7 +7 EXTERNAL DEBT, (US$ Million)-/ Balance on Current Account -65 +*45D December 1976 December -1977 Direct Foreign Investment 1 -1 Total Outstanding 1,102.6 1,124.0 Net MLT Borrowing 83 74 Disbursements (111) (122) Total Outstanding Amortization (28) (48) and Disbursed 702.3 784. Subtotal 83 Capital Grants 58 62 DEBT SERVICE RATIO for 1977-/ 22.8% Other Capital (net) 44 1 Other items n.e.i. +4 2 Increase in Reserves (+) 5/ +67 +183 Gross Reserves (end year) 92 292 Net Reserves (end year) -67 +116 RATE OF EXCHiiNGE IBRD/IDA LENDING, December 31, 1977 (USS Millioni 1967 - 1471 __ID U s 5.9 IBRD IDA US$