Colombia - External sector and agriculture policies for adjustment and growth (Vol. 1 of 2) : Main Report

Report No. 4981-CO Colombia: External Sector and Agriculture Policies for Adjustment and Growth (In Two Volumes) Volume 1: Main Report April 20, 1984 Latin America and the Caribbean Regional Office FOR OFFICIAL USE ONLY 'Uz Document of the World Bank 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.  CURRENCI EQUIVALENTS Currency Unit = Colombian Peso (Col$) Exchange Rate As Of January 1, 1984 US$1 = Col$88.770 Col$I = US$O.O1127 Average Exchange Rate 1980 1981 1982 1983 US$1 = Col$47.280 US$1 = Cc1$54.491 US$1 = Col$64.102 US$1 = Col$78.861 Col$1 = US$0.0212 Col$1 = US$0.0184 Col$1 = US$0.0156 Col$1 = US$0.0127 WEIGHTS AND MEASURES Metric System GOVERNMENT OF COLOM31A FISCAL YEAR January 1 - December 31  FOR OFCIAL USE ONLY This report is based on the findings of a mission which visited Colombia during April/May 1983. The mission comprised of Nessrs. Vinod Thomas (Chief of Mission), Sebastian Edwards, John Nash (consultants), Mateen Thobani, German Rioseco and Ms. Ai Chin Wee. The mission benefited from a paper prepared by Jorge Garcia-Garcia and the contribution of Jose' Sokol. I ldocumnht buaz *i d dionbm and maybe uued by rdpits 0* in tbe cofOfW Of ictbir offid dufi Its conuts mqr not otbwi be adbcoed wkbout World Iban autborizaXo.  COLOMBIA: EXTERNAL SECTOR AND AGRICULTURE POLICIES FOR ADJUSTAENT DN GBROWTR GLOSSARY OF AUBREVIATIONS ABOCOL = Abonos Colombianos S.A. (A Colombian Private Sector Fertilizer Company) ACOSEMILK = Asociacion Colombiana de Productores de Semillas (Colombian Association of Seed Producers) AGD = Almacenes Generales de Deposito (General Storage Facility) ALADI = Asociacion Latino Americana de Desarrollo y Integracion (Latin American Association for Development and Integration) ALMAGRARIO = Almacen Agrario (Agricultural Storage) ALMAPOPULAR = Almacen Popular (Popular Storage) ASOCANA = Asociacion de Cultivadores de Caina de Azucar de Colombia (Sugar Mills Association of Colombia) ASOCOLFLORES = Asociacion Colombiana de Productores de Flores (Colombian Association of Flower Producers) BANCO GANADERO = Livestock Bank BOLSA = Bolsa Nacional Agropecuaria, S.A. (National Stock Exchange for Agriculture) BOR = Banco de la Republica (Central Bank) BP = Bono de Prenda (Subsidized Storage Credit) CAJA = Caja de Credito Agrario, Industrial Y Minero (Agricultural, Industrial and Mining Credit Bank) CAT = Certificado de Abono Tributario (Tax Credit Certificate) CECORA = Central de Cooperativas de La Reforma Agraria (Cooperative Center of the Agrarian Reform) CERT - Certificado de Reembolso Tributario (Tax Reimbursement Certificate) CD = Certificado de Deposito (Term Certificate of Deposit) COFIAGRO = Corporacion Financiera de Fomento Agropecuario y de Exportaciones (Financial Corporation for Agricultural and Export Development) COLPUERTOS - Puertos de Colombia (Colombian Port Authority) CONPES = Consejo Nacional de Politica Economica y Social (National Economic and Social Policy Council) CORABASTOS = Corporacion de Abastos de Bogota 'Whci esale Market of 1Rn4gots  -2- CVC - Corporacion Autonoma Regional del Valle del Rio Cauca (Autonomous Regional Corporation of Rio Cauca Valley) DANE - Departamento Administrativo Nacional de Estadistica (National Department of Statistics) DNP - Departamento Nacional de Planeacion (National Planning Department) DRI (IRDP) - Programa de Desarrollo Rural Integrado (Integrated Rural Development Program) EEC - European Economic Community EMCOPER - Empresa Comercializadora de Productos Perecederos (Enterprise for Marketing of Perishable Products) ERP - Effective Rate of Protection FAO - Food and Agriculture Organization FEDEARROZ - Federacidon Nacional de Arroceros (National Rice Producers' Federation) FEDEGAN - Federacion Colombiana de Ganaderos (Colombian Cattle Owners' Federation) FEDEPALMA - Federacion Nacional de Cultivadores de Palm Africana (National Federation of African Palm Growers) FEDEPAPA = Federaci6on Colombiana de Productores de Papa (Colombian Producers of Potato) FEDERACAFE = Federaci6n Nacional de Cafeteros de Colombia (National Federation of Colombian Coffee Growers) FEDERALGODON = Federaci6on Nacional de Algodoneros (National Cotton Producers' Federation) FEDESARROLLO = Fundacio'n para la Educaci6n Superior y el Desarrollo (Foundation for Higher Education and Development) FENALCO = Federaci6on Nacional de Cooperativas (National Federation of Cooperatives) FFAP - Fondo Financiero Agropecuario (Agricultural Financial Fund) GATT - General Agreement on Trade and Tariff HIMAT - Instituto de Hidrologia, Meteorologia y Adecuaciones de Tierras (Institute for Hydrology, Meteorology and Land Improvement) ICA - International Coffee Agreement ICA - Instituto Colombiano Agropecuario (Colombian Agricultural Institute) ICO - International Coffee Organization IICA - Instituto Interamericano de Ciencias Agrfcolas (Inter-American Institute for Agricultural Sciences) IDB - Inter-American Development Bank IDEMA - Instituto de Mercadeo Agropecuario (Agricultural Marketing Institute) IFS - International Financial Statistics INCOMEX - Instituto de Comercio Exterior (Foreign Trade Institute)  - 3 - INCORA - Instituto Colombiano de la Reforma Agraria (Colombian Institute for Agrarian Reform) INDERENA - Instituto Nacional de los Recursos Naturales Renowables y del Ambiente (National Institute for Renewable Natural Rtesources and the Environment) LDC - Less Developed Countries LP - Licencia Previa (Prior Licensing) NCF X National Coffee Fund NER - Nominal Exchange Rate OECD - Organization for Economic Cooperation and Development OPSA - Oficina de Planeamiento del Sector Agropecuario (Agricultural Sector Planning Office) PAN - Plan Nacional de Alimentacion y Nutricion (National Food and Nutrition Plan) PLANIA - Plan Nacional de Investigacion Agropecuario del ICA (National Agricultural Research Plan for ICA) PLANIF - Plan Nacional de Investigacion Forestal (National Plan for Forestry Research) PLAN VALLEJO - Import Duty Drawback for Exporters PRODESARROLLO - Programa de Diversificacion y Desarrollo de Zonas Cafeteras (Program of Development and Diversification of Coffee Areas) PROCANA - Productores de CaZa (Cane Producers) PROEXPO - Fondo de Promocion de Exportaciones (Export Promotion Fund) Also denotes (Export Promotion Agency) RER - Real Exchange Rate REER - Real Effective Exchange Rate SAC - Sociedad de Agricultores de Colombia (Colombian Farmers' Association) SEA - Special Exchange Account SENA - Servicio Nacional de Aprendizaje (National Apprenticeship Service) SITUADO FISCAL - Revenue Earmarking USDA - United States Department of Agriculture  COL4OBII: EXTERNAL SECTOR AND hORICULTURE POLICIES FOR ADJUSTNENT MNJ GROWTH TABLE OF CONTENTS Page No. VOLUME I - THE MAIN REPORT COUNTRY DATA SUMMARY AN) CONCLUSIONS i-xxd PART I MACROECONOMIC POLICY AND AGRICULTURE I. AN OVERVIEW OF TRADE AND AGRICULTURE POLICIES .................... 1 A. Introduction... ...**..***...*...*......**... ......... 1 B. Long-Term Performance and its Sources........................ 2 Sectoral Contributions to Growth............................ 3 Components of Total Demand ....o@60ooo g@ .0 .0.0. ........ 5 C. Trade in Agriculture..ooo..o...oo. ......................... 6 Trade Orientationoo.o...o...0.0000000.0.00................................ 6 Trade Surpluso............oo, .................oo.o. ooo.ooo 7 D. The Recent Downturn and Some Explanations..................... 8 External Factorso.o.o..00.00.000000osoo.................................. 8 Evolution of Internal Relative Prices.................... ..6. ,,,.,, 10 E. Coffee, Macroeconomic Policy and Inflation................... 13 Monetary Growth and Inflation ................... 13 Fiscal Deficit and Inflation ..............................,., 13 Summary of Macroeconomic Developments.... ..........o,,,..,, 14 F. Current Outlook ............... ...... 15 G. A Policy Overviewoi... o.oo............0...............0..... 18 The Role of Coffee.........................00....0...... 18 Economic Adjustment. .......o.............. o. ..... ...... 19 II, TRADE POLICY AND EXPORT PROKOTION.. ........... .............o.o.... 21 A. Introduction............................ 21 B. Factors Affecting Policy Choice.o..o.o..oo....00............. 21 C. Past Policies and Exports.s..o.............. .........o........... 23 The 1967 Trade Reforms........00000........................ 23 Developments in the 1970s.o. ...o.o.o.o.o....... o. oo.o...o 25 Recent Developments and Outlook.. ........................ 25 D. Competitiveness and the Real Exchange Rate...... t.o..o...... 26 Some Conceptso n ce.p ts.... ...oo..... ooo.... oe......o.ooso 26 Estimates of the Real Exchange Rate..o ......... ......... 27 Effect of Special Incentives............................... 30 Exchange Rate Depreciation vs Special Incentives..oo.o.ives 30 E. Stimulating Non-Coffee Exportsx.p...oor ts.o....o. eo. oe...o.. 31 Current O u t l o okeeoe..oo.oooooooooooo. 31 Non-Coffee Exports and the Exchange Rate. a te...oo.soosooo. 33 F. Addressing the Appreciation of the Peso.,.oossoooo.oossoo. 34 Role of Wages. .............00.00........................ 34 Interest Rate Effects..ooooo..... ....eo..o. oo. o ...... 34 Impact of Monetary Disequilibrium ...ooo..,..o..... o....o 36  -2- Page No. G. Export Promotion Efforts .................... ......... . 36 Role of PROEXPO .............*......................*.....* 36 Foreign Investment ..... ............................... . ..... . 37 H. Conclusions and Policy Suggestions .......................0 .... 37 Exchange Rate and Inflation .......................................... . 38 Interest Rate Effects ................................ ..... . 38 Export Promotion and Capital Inflows ....................... 39 III. IMPORT POLICY FOR GROWTH AND STABILITY .......................... 40 A. Introduction ............. ............. 0......................... 40 B. Long-Term Policy Directions .. .............................. .0. 41 Historic Patteru .............. 0...................... ............ 41 Opening-Up of Imports in the 1970s ......................... 41 Effect of Import-Substitution .............................. 42 C. Long-Term Development of Imports ............................. 42 Structure and Trends ....................... ........................ 42 Agriculture and Imports .. .. ....................... . . 43 D. Recent Developments ............................................... . 45 Import Tariffs .................................................. 45 Import Licenses .... ............... . ...................... .. 48 Other Restrictions to Trade ................................ 49 E. Policy Implications of Recent Developments ................... 50 Increasing Trade Restrictions .............................. 50 The Use of Import Licenses ................................ . 51 F. Conclusions and Policy Suggestions ..................... 53 Import Liberalization and Phasing .......................... 53 Improving on Licensing Methods ............................ 53 PART II AGRICULTURAL PRICE POLICY IV. PRICE INTERVENTIONS, COMPETITIVENESS AND INCENTIVES .............. 54 A. Introduction ....................................................... 54 B. Government Interventions in Agriculture ...................... 54 Major Interventions ........................................ 54 IDEMA's Policy ....................O..*.................... ......... 56 Level of Price Support ................................................. . 56 Effect of Policy ...... ................................... O......... 58 C. Protection and Efficiency in Agriculture ..................... 58 Exports vs Import-Competing Products ........... ....... ..... 59 Protection and Efficiency ................ .. .. ..... . 59 A More Precise Estimate of Protection ..................... . 60 Evaluating Protection: The Case of Wheat ...............** 62 IDEMA's Interventions .... ............................................ . 63 IDEMA's Problems ..... ............................... ...... . 64 D. Production Incentives for Major Conmodities .................. 64 Protection and Competitiveness ............................. 64 External and Internal Factors .............................. 65 E. Trends in Relative Prices for Agriculture ........ O............ 67 F. Conclusions and Policy Suggestions ............ ..............0 ... 69 Agricultural Protection .... .................... ........... . 69 Price Support .. ............................ .0 ....... . 70 Competitiveness .................... a.......... ........ ............. 71  -3- Page Nc,. V. PRICE STABILIZATION IN AGRICULTURE ............................... 72 A. Introduction .................................................... 72 B. Some Basic Considerations .......... ..... ........................... . 73 Concerns over Price Instability ................. ...... ....... 73. Evaluating Interventions for Greater Stability ............. 731 C. Addressing Year-to-Year Instability ....... .......... 75 General Observations ............. ........................ . 75 Export Price Stabilization................................... ,'5 Futures Market ........................................... '77 D. Seasonal Price Fluctuations .............. ... ... ..... . . . . 80 Subsidized Credit for Storage .............................. 81 Costs of Subsidized Credit ............. ... *............ ..... . 84 Reforms of the System ............................ .......... 85 IDEMA's Role in Storage..... ..... ........... .............. .... 87 E. Conclusions and Policy Suggestions ........................... 92 Futures Market ....... ..... ....... ............. ... ....... 92 Agricultural Storage.* ..... ..... a ..... ... ............. ...... 92 IDEMA's8 Role.* ..... .....a.............................. ....... 93 VI. COFFEE POLICY UNDER CHANGING PRICES AND TECHNOLOGY ............... 94 A. Iutroduction ..... ................................. ........... 94 B. Colombia's Coffee Economy ...................... . ......... . 94 Structure and Trends ....... ........... ........... ..... .. . 94 Coffee Technology ............. . ..... ....... .................. . 95 Coffee's Changing Fortunes.. ....... . .. ............ ...... 97 The Federation of Coffee Growers .......... o................. .. 99, C. Structural Adjustment in the Coffee Economy ........... ....... o. 1O(' Past Stabilization and Effects ............. ........ 101) The Stock Problem and Related Considerations...o...... ...... 132 Policy Options ................................ .0 ............... 13.4 D. Coffee Price Policy .......... . . 105 Policy Instruments ...... 0.............................................. 1C05 Price Policy and Exports ....................................... . . . . . . . . 1(X5 Price Policy and Revenues .........................16...... o. 106 E. Technology and Yields ............................... .... ............. . 108 Traditional vs New Technology-....................- .....-- 108 Pruning ..................................................... 109 Planting of Shade Trees.-* ................... .......... ... 1.09 F. Coffee Diversification ....................... . ............... . )10 Social vs Private Benefits .............. ...* . .......... 10 O Private Benefits and Costs ............................ ... . 112 FEDERACAFE's Benefits ..... ......... . ............ ....... 113 Need for Diversification ... . .. . ............. .......... 114 F. Conclusions and Policy Suggestions ........................... 114 Adjustment in the Coffee Economy ........................... 114 The Federation's Leadership .............................. 115 Coffee Diversification .......................... . .......... 115 Coffee Production and Exports ................. .... 116  -4- Page No. PART III PRODUCTION POLICY IN AGRICULTURE VII. INVESTMENT IN AGRICULTURE .............. 117 A. Introduction ............... 117 B. Public Sector Expenditures. ..... .... ..................... ....... 118 Long-term Trends .................... .......... 118 Problems in Public Sector Investment ....................... 120 C. Private Expenditures..................... .................. 126 Size and Compositionu. e.................................... 126 Major Producer Organizations...... ............o........... 127 Agricultural Borrowing.o.o.... o. .. o.o ................... ... 128 D. Current Government Efforts......e.o..o ......o.o.. . . . . . . . . . . . . . ..... 129 E. Conclusions and Policy Suggestions ......e.o... o............ 130 Private Sector Role........................................ 130 Trends in Government Investment....eo......e.oo.......... 130 Allocacion of Public Investmenteo.......................... 131 Public Sector Reforms............... ....................... 131 VIII. AGRICULTURAL TECHNOLOGY, INPUT POLICY AND MARKETING.. ........... 132 A. Introduction .o.....o.o.e.o..*.Oooe..O.oo.o..0........................ 132 B. Trends and Problems in Input Adoption...o.................. 132 C. Technology and Infrastructures.o..o.o...o........oe........ 135 Research and Technology............................................. 135 Irrigation Development Management.o..oeo.o ................ 136 Conservation of Renewable Natural Resources.........0.... 138 D. Input Pricing Issues......................................... 139 Rural Labor and Income.................. . ........... .... 139 Fertilizer ................................................. 140 Credit Policy .................................... 141 E. Agricultural Marketing.o ..........o ...... o..... ... o..o .... 145 Marketing Magn ................................145 Institutional Issues....................................... 147 F. Conclusions and Policy Suggestions........................... 149 Research and Extension.... ..0,00 .... 0..0.0 ............... 149 Water Useo.oe..* -.*.e.o.e oo... oe.....o..o....o...o....o........... 149 Natural Resources ... o ...-.........0.000..............., 149 Input Costso.......................o.oo.o.... o..o.....e. 150 Agricultural Marketing... ...oeos*. ..... .... ............ 150 Agricultural Credit.o ......o............. .o.... . .o 151 MAPS (IBRD Nos. 10103R, 10117R, and 10190R) PART IV (In VOLUME II) TECHNICAL ANALYSES (See separate Table of Contents)  Pap I of 2 CuWM 1DTA - CZIBIA AIWA R W ATL0N 6ENSflY 1.13B,900 .ij. (total) 26.9 mllion (Wf1982) 23.6 per sq.km. 232,000 sqJk. (arable) Rate Ef grwrh: 2.CX (fron 1975 to 1982) 116.2 per aqk. of anbi laned ]PMLAT aOMRAUsTS I/ HEAUH 1/ Crde bLrth rarte (per i,a006 30 16puiiatln per ptysr1an 1,967 Crude death mie (per 1,000) 8 Populatio per hospLtal bed 619 Ilart tortality (per 1,000 live blrths) 2/ 56 UU) D=INIT1O (1978) DlSIMX.ON OF lAND aFICIIP (1971) Z of nationl income, highet IC 40 Z woed by top 10% of awner 80.0 lost 2fX 5 2 aAd by aallst IOZ of mnmem 0.2 AGS 7D SAFE WAm 2/ A 0M 8. ECIICrTY (1973) Z of poplaritn - ur1m 73 Xof paoplation - urba 87.3 - ural 46 - nwal 13.2 - total 64 Caloric Intake a Z of requireents 98 Ailk literay rate (1973) 80.8 Per cepLta protein irtrke (grans per day) 49 Prilry sdwol enrolhnert ratio 2/ 128.0 CM FIR CAP iN 1581 3/ lSSl,380 oWe Wmcsw i'w Di 1982 4/ ANIAL WE CF GKJ (C, Cautmt Prices) LES tin. 2 1960-65 1965-70 1970-75 1975-80 1982 GIP at Market Pris 38,969 100.0 4.5 5.5 6.6 6.0 1.4 Gros Dthzrc Investusit 10,224 26.2 1.8 8.1 1.3 10.3 - 3.1 Grss Natimal Savlf 7,981 20.5 2.1 10.8 6.5 10.5 - 2.5 Wsirt Acchut Balance - 2,243 - 5.8 . . apOrts of GOods, NES 4,679 12.0 2.1 4.1 4.4 7.3 - 6.0 TIports of Goods, NFS 6,444 16.5 1.9 10.2 0.8 11.9 - 9.0 m'. LAVJ FORCE AID NricnvrLr I4n 1980 Value Added labor Fomr 2/ VA. per Worcer US$b. Z Un. __ USS Z Agrialture 8,181 27.6 2.3237 25.8 3,521 106.9 lmlwths 9,108 30.7 1.9094 21.2 4,770 144.8 Orher 12 381 41.7 4.7737 53.0 2 594 78.7 Total Wedgted kAW67 100.0 9.0068 100.0 100 Pbiic Sector Cuntrl CoVEr101it (CatS Gl n) Z of GDP (CS Pan) Z of OW 1981 1981 1976-1980 1981 1981 1976-1911 arreQt RevePa 56U,634 23.0 24.5 261,499 13.0 14.3 Garret Fameture 398.919 19.9 17.0 98,474 4.9 7.8 arreat Accat- Surplus 162,715 8.1 7.5 163,025 8. 6.5 Captal EVen1rr 148,933 7.4 7.1 90,914 4.5 3.9 ternzl &orrwdzi (net) 35,091 1.7 1.3 I/ Betm 1978 m1 1982. 2 Bezm 1978 sal 1980. 3 el per capita Qi es te is colatel by rho zxmexsim tkerique In the Wrld Bwk Adas. Odher acoverIons w dalam in thiB table are at tie averag emdax rare preal11zr d6zdu tie period coveved. 4/ Pxeliizry. NIt applicable. .It avalable. BEST COPY AVAILMLE  Pap 2 of 2 (aNMn am - LIDUIA MU, GEM AND H 1976 1977 1978 1979 1980 19B1 1902 I/ (Bil1i7wf GdLS c3awiilg mit priod) lbu adt Q_11 lbuy 105.1 140.7 180.0 223.0 323.3 43.6 530.8 Bzk CdIt tD the Ihic Sector 14.9 19.2 14.4 -7.3 -17.5 -.1.8 49.3 Banr Cradit to tle Pziwe Sector 109.2 142.3 149.3 181.6 259.3 3&6.4 442.3 (Persrntq or ltle mmuie.) bney ad Qml ?bs - Z of GMl 19.7 19.6 19.6 18.7 20.3 21.6 20.9 (terom) Co.mer Pice ha (Seamier 69.5 85.7 10040 124.9 158.9 203.6 253.7 1978-100) Anal perFtaF dm in: CGo er Price Indec 19.9 34.7 16.7 24.9 27.2 2.1 24.6 lMEy ad QuI mony 33.9 33.9 27.9 23.9 45.0 35.7 21.0 Bk Credit w tih Iblic Sector -6.1 28.9 -25.0 -150.7 -139.7 32.6 517.8 Sn* Credit to thm Pimste Sector 23.3 30.3 4.9 21.6 4B.3 3L3 24.1 BUNCE CF PAW=S (Xi]I. US$) mSmisE EIRlRS (Aera 197942) 1979 1960 1961 1982 I/ MSmin Exports of Cood, HFS 4,658 5.677 4,606 4,679 Cfee 1.838 51.0 bpois of Goods, MS 3.939 5.494 6,078 6,444 Mmjor NotGoEfee Agrlolte 527 13.7 FAmve (op (Dtfi - -) 719 183 -1,472 -1,765 Major Mmufa=rvd Goodk 651 16.1 etzrol SerivtL 115 5.7 FAtor Servi eIcme (not) - 255 - 210 - 4B - 701 All Other Good. 572 13.5 RecEipts (U7) (494) (647) (496) PAYnsta (522) (704) (1.075) (1,197) Toted 3,703 100.0 Net Tkazfers 98 164 242 223 Bularce Crre AccGt ME 1D3 -1,h58 -2,243 ~JL r. 0h> 31. 198l2 1/ Dlrect For* lutmt 104 52 22 a88 Not HLT Drorg 609 779 1,450 1.168 115 lI. DIbb_emit (1,102) (1.156) (1,972) (1,610) Amtztim (-493) (-377) (-522) (- 442) Itbbic Debt, Ircludiug 6.211 Cqitsl n.e.l. (net) - 38 200 92 1 girautead -_cruine In Rmerv t-) 2/ N.37 -1,168 - e amted P dime Debt 1.21b Gltal Outat:uilw ad Dlsbnued 7 Goons linen. (erd ye.r) 3/ 4.113 5,420 5,633 4,894 NHt Rmrvm (ed year) ,r 4,106 5,416 5,630 4,892 KMJIC DM* 11Q im NM 191124/ X twztIofl 6.5 lnteret 11.2 RZ CIF ENWGMZ U3/M WSD, (1bw_ 31, 1932) OflhlioI USS) Deber 31, 1981 M 1551.00 - C*1359.07 ColSI.00 - US0.0169 Outstidlig ed Disbais 1,346 20 Wkdisbused 1 512 _ I,omie 31.1962 OlCtanmdj 1nc1udI. hUibaue US$1.OD - QalS70.29 Col$1.00 - U0.0142 1/ Pxeliry data. 2/ Of the ReBI Syati. 3/ Of tie Ceetral Bi 4/ Ibtlo E RAb-c Debt Seioee to Fiqorm of Gooda ad an Ser.vci. ..Bt CABlable. BEST COmPY AVIUBI  COLOMBIA: TRADE AND ACRILT POLICIES FO ADUSTKMNT AIND GROWI SUNHARY ADD CONCLUSIONS I. Introduction i. This report represents a development of some major themes that have emerged from the World Bank's ongoing economic and sector work on Colombia. A central issue addressed in the study concerns the recent downturn in the economy's performance after a long period of rapid expansion. The econoic record has beer closely associated with success in the agriculture sector. Agricultural and other exports have been the mainstay of favorable outturns in the external accounts in the past and a significant source of economic growth. At the same time, a proximate cause of the recent difficulties has been the setback in the external sector, particularly that relating to the poor performance of agricultural and other exports. For these reasons, a primary objective of this work is to consider ways and means for stabilizing Colombia's external sector and revitalizing growth, in particular by enlarging the net foreign exchange contribution of agriculture. ii. A previous reportl/ noted the connection between macroeconomic and agricultural developments. The present study extends the analysis by focus- ing explicitly on this interrelationship. Macroeconomic developments have been strongly influenced by the fortunes of agriculture, particularly by the sector's external performance. In turn, the sector's record has been sub- stantially affected by macroeconomic policies. In view of these links, a part of this work is devoted to an analysis of trade-related macroeconomic policy, which has a major bearing on agricultural performance. After establishing this broader perspective, we narrow the focus to study sectoral policies that directly affect agriculture, and then to even more specific financial issues. The sectoral initiatives that are investigated include price interventions, most importantly price support and import controls for import-competing commodities, storage and price stabilization measures for cereals, tax policies in the case of coffee, and credit subsidies that affect most products. iii. Taken together, the various pieces of analyses seek to shed light on considerations for achieving stability and accelerated growth of the external sector, particularly as they involve incentives to produce and export agricultural commodities. The domestic prices of traded commodities relative to others are determined not only by international price trends but also by domestic policies toward the exchange rate, production costs and, more generally, the rate of inflation within Colombia. Inducements to produce and export also derive from various export promotion and import 1/ World Bank, Colombian Agriculture: Selected Issues and Some Directions for Strategy, Report No. 4275-CO, 1983.  - ii - policies. In addition, a variety of policies that are confined to agricul- ture can alter output and input prices, and in turn affect farm incentives. Finally, microeconomic production considerations involving yields and farm budgets influence the production environment and affect actual performance. iv. With this framework in mind, the full report is structured in four parts, with this Summary and Conclusions following the same sequence. Part I discusses trade-related macroeconomic policies, paying special attention to their link with agriculture. Chapter 1 begins with an overview of issues and the impact of macroeconomic policy on the agriculture sector. The next chapter reviews export policy, focusing on export incentive management, while Chapter 3 considers import policy alternatives. Part II of the report assesses price policies in agriculture, 2/ including price support and import restrictions (Chapter 4); price stabilization issues (Chapter 5); and policies regarding coffee production and pricing, and issues related to agri- cultural diversification (Chapter 6). Part III examines non-pricing issues that influence the production environment in agriculture, including public and private sector investment in agriculture (Chapter 7) and direct policies aimed at increasing agricultural productivity (Chapter 8). Part IV (in Volume II) contains technical analyses supporting some of the conclusions and policy suggestions. II. Past Performance and Recent Problem v. The Colombian economy has experienced a rapid and sustained growth In output and employment since the mid-1950s. Even in the past decade while most other countries in the region suffered significant declines in growth, Colombia's GDP has risen at a trend rate of 4-5% p.a.; combined with an annual growth rate of population of about 2Z, this has resulted in a respect- able long-term growth in per capita output. For much of the 1970s, the country enjoyed a substantial balance of payment surplus, and prudent manage- ment of the external sector has contributed significantly to the confidence shown by international financial markets in Colombia's creditworthiness. On the domestic front, the country realized an extraordinary employment boom and improvements in real wages during most of the 1970s, which accompanied the rapid expansion of labor-intensive production and exports. Although fortuitous external circumstances have been helpful, it is also true that a fa-orable policy environment that has prevailed over the long-term has been instrumental in producing these results. vi. Although manufacturing and services have registered higher long- term growth rates, the contribution of agriculture to growth has been just as sizable in view of the sector's larger share in GDP, and the sector has been the mainstay of economic performance since the mid-1970s.3/ Agriculture currently accounts for nearly a quarter of GDP, some two-thirds of export earnings and over one-third of total employment in the economy. The sector 2/ This work focuses on crop production although many of the policy directions would be relevant for the important livestock sector as well. 3/ During 1970-82 agriculture contributed, on average, about one-fifth of the increase in GDP.  - iii - continues to influence major macroeconomic trends, not only through its contribution to foreign exchange revenues and import capacity, but also directly through its impact on employment and incomes in both agricultural and non-agricultural activities. vii. Vigorous economic growth in Colombia has been positively related to the development of exports. The country's success in raising exports during the 1967-75 period was based on an outward-looking orientation which resulted in part from significant domestic inducements for export promotion. Activism in export orientation has diminished significantly since the mid-1970s, partly on account of the increase in foreign exchange earning accompanying the commodity price boom (1976-79). Rapid increases in external demand for the country's agricultural produce were the most significant aspect of this period, with the demand for coffee and illegal drugs leading the rest of exports. viii. Recent economy-wide developments, however, have not been favor- able because of both internal and external factors. The rate of economic growth has been falling in the 1980s. Colombia's external sector has been in serious difficulty, in part because of the economic and debt problems of Latin America (para. ix). Although a major source of long-term growth, agri- culture has suffered a sharp downswing in recent years, attributable to weak export demand and low international prices, and to domestic developments. To understand this process better, it is useful to disaggregate agriculture into two categories-coffee and the rest. This enables us to see that the country has exhibited the symptoms of the -booming-sector syndrome" experienced elsewhere in the world, where the rapid growth of a few primary exports and the resulting inflow of foreign exchange have been coupled with a real appre- ciation of the exchange rate4/ causing major changes in labor deployment and resource use which have hurt other productive sectors by drawing resources into the booming sectors. In Colombia, the coffee and drug export windfalls in the second half of the 1970s produced these adverse effects on non-coffee agriculture and the rest of the economy, and the impact has persisted even after the end of the commodity boom period. Growth in non-coffee exports (agricultural and others) has been decelerating since the mid-1970s, first as the relative producer prices in the domestic markets for these commodities worsened, and later as international export conditions became increasingly unfavorable. ix. The connection between Colombia's current troubles and those of its Latin American neighbors is noteworthy. Exports to Mexico, Argentina, Brazil, Ecuador, Costa Rica and Chile, which had expanded significantly during 1970-1982, have fallen since 1982. The speculation against the Colombian peso following the 1983 Venezuelan devaluation and the ensuing tight import restrictions in Venezuela have exacerbated Colombia's problems. At present, the Colombian peso is significantly appreciated with respect to the currencies of a number of Latin American countries, and particularly to 4/ A fall in the number of Colombian pesos paid per unit of foreign currency is defined as a nominal apreciation of the peso. However, after adjustments are made for differential movements in price levels in Colombia and externally, a measure of real movements in the exchange rate is obtained.  - iv - the Venezuelan Bolivar. Venezuela used to account for about 25% of Colombia's exports of goods and services and for most of the transfers received from abroad. In 1984 foreign exchange receipts from these sources are expected to be less than a fifth of what they were in 1982. The external debt problems of other Latin American countries has been a proximate cause for the pressure on the capital account also. The availability of external commercial bank financing has shrunk, and terms and conditions of the loans have hardened. x. The emerging difficulties of the non-coffee economy were hidden during the period of the coffee boom.5/ In the 1980s, however, a further deterioration in the performance of non-coffee commodities has been accom- panied by a precipitous decline in real coffee earnings (to levels existing at the beginning of the coffee boom). The current account of the balance of payments has swung into deficit during 1981-83. In 1983 this deficit amounted to 6Z of GDP, and the country lost US$1.8 billion of international reserves. The evolution of the present difficulties in the external sector calls attention to the changed international conditions and to the need for a systematic adjustment in domestic policies to permit an increase in exports and a resumption of rapid growth (see the following section). At the same time, vigorous and timely corrective actions are needed-as recognized by the Government-to overcome the current balance of payments problems satisfactor- ily (paras. xiv through xvi). As elaborated below, problems in the macro- economic area regarding the exchange rate, export promotion, the fiscal deficit and capital inflows must be addressed promptly and continue to be reviewed, in addition to pursuing coffee diversification and investments for reducing production costs and improving yields in agriculture. III. The ia_-roecxnuxy and Agriculture The Role of Coffee Xii. The main link between the macroeconomy and agriculture that is established in this report operates through the effect of coffee production and exports; an important impact may have been exercised by illegal drugs also.6/ These commodities have contributed significantly towards raising the aggregate supply of output in Colombia. Less obvious, but equally important, has been their impact on increasing the money supply, aggregate demand and inflation, in causing an appreciation of the real exchange rate, and in hurting the performance of non-coffee production sectors. Increases in the price of coffee resulted in higher disposable incomes in Colombia and an increase in the demand for all goods; since the domestic price of trade- ables is to a significant degree determined by their world price and the exchange rate, this rise in incomes tended to raise aggregate demand and, consequently, the relative prices of non-tradeables. This shift in relative 5/ There was also rapid growth in illegal drug trade, although an adequate assessment of its impact remains difficult. 6/ Although there are parallels, the monetization of export receipts and the fiscal impact of drug exports which are illegal would be quite different from those of coffee. Of course, the domestic social and sociological aspects of coffee and drug exports are worlds apart.  - v - prices was reinforced by the impact of accelerated foreign exchange inflows on the domestic supply of money, which contributed strongly to the higher inflation rates (average over 25%) witnessed in the second half of the 1970s. xii. Macroeconomic management in Colombia has been found to be especially difficult when coffee prices fluctuate sharply. This arises from the uncertainty attached to assessments of the duration of price increases and, consequently, the degree of adjustment in macroeconomic variables that is required. During the coffee price boom, alternative means for stabiliza- tion were pursued to varying degrees and effectiveness. To some extent, the increases in reserves were neutralized by monetary policy actions and some increase in imports. The real exchange rate was also allowed to appreciate as a stabilization measure. A smaller peso appreciation could have been viable if supported by an even larger inflow of imports than the actual to absorb the increased domestic demand. It should be noted, however, that a major liberalization in the face of an already appreciated peso could exacer- bate adjustment problems of import-competing domestic industries. Temporary protection for non-coffee exports in the form of special export incentives might be necessary for a short period of time, as actually done to a small extent. Once the price boom is diagnosed as transitory, however, a reversal of the peso appreciation-even if the exchange rate might have represented an adequate level during the boom-would normally be the right approach to take. In this respect, the adjustment of the Colombian economy-in lowering inflation, improving the real exchange rate for non-coffee categories, and shifting resources into non-coffee production-could perhaps have been more timely. Economic Adjustment xiii. The differential between domestic and external inflation during 1975-83 was high, with domestic prices measured at the official exchange rate rising by 115%, compared to a 42% increase in one index of external prices (Table 2.2). Partly as a result, the producer prices of non-coffee trade- ables (which, as mentioned earlier, are strongly influenced by international prices) have been falling relative to the price of domestic goods and services in this period. Since agricultural output has a higher share of tradeables than the rest of the economy, this fall in relative producer prices has been especially adverse for the sector. Unfortunately, the shift of incentives in favor of non-tradeables has not produced any significant output response from this domestic sector (for example services) as a whole, so that there. has been little offset to the production and employment losses which resulted from slower growth in the tradeable goods sector. xiv. Colombia now faces real coffee prices that are roughly comparable to those that existed in 1974-75 but below the average real price for the first half of the 1970s. The country's terms of trade today correspond roughly to the level of the mid-1970s. The direction of macroeconomic policy at present should consist inter alia of a depreciation of the peso in real terms to reach an equilibrium level as soon as possible and a reduction of domestic inflation through fiscal and monetary measures--which are the present Administration's goals-and additionally, a gradual opening-up of imports as exports respond to improved incentives. A target could be to bring down the Central Government's fiscal deficit from a level of some 42 of GDP in 1983 to the historical level of about 1% over the near term. These  - vi - steps aimed at reducing inflation and improving the real exchange rate would in general be favorable to agriculture, reducing the pressure to provide special price incentives directly to the sector. xv. The Government would also have to execute more forcefully a strategy of return to export promotion which will be needed to absorb any major shift in the domestic supply of agricultural products. It should include: an adequate general incentive system for Colombia's non-coffee exports to regain competitiveness; a gradual reduction of effective protec- tion across sectors; and an assurance to exporters of rapid access to foreign exchange and imports needed to produce exports. The 1983-84 increases in import restrictions are likely to have some negative effect on exports despite the duty drawback provided by Plan Vallejo:7/ in 1983 about one-half of non-coffee exports did not or could not take advantage of this scheme. A reorientation of the free trade zones towards export promotion and attraction of foreign investment in export industries are also needed. Finally, PROEXPO's (the Export Promotion Agency) activities need to be increasingly redirected towards aggressive export development, rather than purely export- financing. xvi. A balance of payments scenario consistent with growth recovery through the 1980s indicates also the need to step up significantly net capital inflows in the short-term. (Additional capital inflow can induce an appreciation of the real exchange rate, which should be offset by accompany- ing exchange rate policy.) In the first four months of 1984, Colombia has been a net exporter of capital, a situation that needs to be reversed rapidly. A major bottleneck at present is the reluctant international capital market in the face of the economic and debt problems of Latin America. The country also needs to simplify its procedures of borrowing, speed up disbursements of external loans and put together a program for addi- tional, rapidly disbursing, external financing. xvii. This study suggests that both the world economic recession and an adverse shift in relative producer prices in domestic markets have been sig- nificant in explaining the performance of non-coffee exports (agricultural and others) .8/ A product-by-product and country-by-country examination is needed of external demand and of institutional and other arrangements re- quired to break into new markets, supported by efforts to improve yield, quality, processing and marketing. A major aspect of agricultural adjustment revolves around the problem of coffee overproduction and the need to restrain the internal real price of coffee and to induce a shift of resources into non-coffee activities. A good part of diversification is likely to be in additional food output, domestic expenditure on which contributes nearly 40% of the consumer budget. The demand for non-coffee agricultural products 7/ The scheme Plan Vallejo provides duty drawback on imported products that are needed as inputs into exports. Its efficiency and additional needed measures, as well as the question of the treatment of domestically provided inputs for export production, need to be studied. 8/ Even with a faster world recovery, Colombia's success in raising exports might be predicated on its ability to take into account the exchange rate adjustments of its competitors.  - vii - (food and non-food combined) is projected to grow sufficiently to absorb a significantly higher output level--by about 3% (domestic and external combined) in the 1980s under one set of "moderate" assumption of a world recovery and improvements in Colombia's competitiveness (Report No. 4275-CO, oP~ cit.). IV. Exchange Rate and Export Promotion A Measure of Peso Appreciation xviii. Colombia's crawling peg has by and large been a successful 'olicy instrument over the long term, although at present (first quarter 1984) the real exchange rate (RER) is significantly appreciated. The period 1974-76 could be a satisfactory base for measuring changes in the RER for a combina- tion of reasons: commodity prices and the terms of trade on average were not "abnormal" and (in contrast to the present) the current account deficit was modest and in line with trends in net capital inflows.9/ While Colombia's crawling exchange rate is pegged to the US$, it would be appropriate to measure the RER against a basket of currencies of the trading partners in addition to examining the Col$/US$ real rate. When the dollar has appre- ciated against other major currencies (as in recent years), this RER measure has accordingly reflected a smaller improvement. If the US$ depreciates against the basket (as may be expected in the near term), it might be essential to pay attention to the Col$/US$ real rate: a good part of exports are denominated in US$, and the U.S. market may be crucial for the future growth of agricultural and industrial exports from Colombia. A direct com- parison may also be necessary with exchange rate movements of Colombia's export competitors, particularly taking into account the recent sharp currency depreciation of its neighbors.10/ xix. In 1983 (on average) the Colombian RER measured against the basket was some 24% below the 1974-76 average. As international reserves have been falling, and the real money supply contracting somewhat, the rate of infla- tion also declined; with a 23% average depreciation against the US$ and average domestic inflation of 19.8%, a gain was made in 1983 with respect to the US$ and a marginal improvement against the basket. The Government's policy is to continue an accelerated peso depreciation in order to correct the RER lag: the measures presented here indicate the need for significant and timely action to correct the accumulated lag up to 1983 plus the addi- tional inflation differential in Colombia after 1983. Recently, special export incentives have been increased, including which the peso appreciation (i.e. of the real exchange rate adjusted for export subsidies) in 1983 would be 17% compared to the 1974-76 base. However, these calculations ignore changes in export incentives in other countries; furthermore, increases in 9/ Colombia was still self-sufficient in petroleum so that there was no significant oil price effect. 10/ The exchange rate in real terms depreciated by an estimated range of some 30% to over 50% between 1981 and 1983 in Ecuador, Chile, Brazil, Argentina and Mexico, although it remains to be seen how much of these on= rj,l^ Ia. tnrne in !S3l term in he future. The mar-kt exchange rate in Venezuela has depreciated in real terms even more significantly.  - viii - such incentives in Colombia are neither efficient nor viable over the long- term, and sufficient exchange rate adjustment may be sought that can permit an elimination of such subsidies. Exchange Rate and Inflation xx. In principle, a nominal depreciation will raise the RER only if: either there is a price variable such as nominal wage that is not tied to the nominal exchange rate; or if the nominal money supply is not fully adjusted to accomodate the higher level of prices; or if there are accompanying reduc- tions in some component of aggregate demand such as government expenditures. Nominal wages are neither rigid nor completely flexible in Colombia; this means that real wages can be flexible, and a nominal peso depreciation can, in principle, produce a real depreciation. Negotiations in 1983 have resulted in an increased the nominal minimum wage by 22% for 1984 in the urban areas and 28% by mid-1984 in the rural areas, which are significantly above the 1983 and projected 1984 inflation rate (about 20%) and ahead of productivity improvement at least in the case of the rural wage. Wage setting will need to be fully cognizant of a potential inflationary impact through cost push mechanisms or by creating inflationary expectations, unless closely tied to productivity increases. Additionally, since the prices of non-tradeables are (moderately) flexible, a reduction in the Government's fiscal deficit would be essential. Policymakers would need to lower the fiscal deficit, thereby ameliorating the impact of excess demand pressures on aggregate prices. Such fine-tuning to affect nominal prices of non- tradeables, while by no means easy, appears to be feasible in Colombia as the 1983 experience has shown to some extent. Interest Rate Effect xxi. With the domestic nominal interest rate estimated to move broadly in- line with the world interest rate plus expected peso depreciation, an increase in the rate of the crawl can tend to cause a higher nominal rate of interest domestically. Our statistical analysis indicates that the rate of depreciation is relatively quickly translated into an equi-proportional increase in the domestic nominal interest rate; if inflation is successfully reduced (as in 1983), this can mean some increase in the real interest rate as well. During a period of acceleration of the peg, therefore, real interest rates can increase and hurt the growth of domestic sectors such as construction and industrial activities with high debt/equity ratios, and possibly contribute to higher inflation through a cost-push mechanism. Up to a point while the exchange rate is highly overvalued, hDwever, these costs might be offset by the positive production impact of a higher RER on tradeables. xxii. A higher rate of the crawl can affect the expected rate of depreciation, and result in higher interest rates during the period of acceleration of the crawling peg. It is possible that a one-step devalua- tion, if perceived by the public to be large enough, can remove expectations of higher rates of devaluation, leaving the domestic interest rate unaffected. However, if the public is not convinced by the magnitude of such a one-step devaluation (which has usually been the case in Latin American countries), there may be no such mitigating effect. The Government's present preference is for an acceleration of the crawl based in part on its good track record in Colombia and the recent success in depreciating the peso in  - {x - real terms with this method. The greater the lag, however, the more the public is likely to expect increases in the acceleration of the peg which would exacerbate the interest rate problem, and the authorities might con- sider a maxi-devaluation. This alternative, however, would have to be closely coordinated with, and linked to, fiscal, monetary and income policies in order to ensure success in improving the RER and raising non-coffee exports. V. lMport Policies for Growth and Stabillty xxiii. Import policy has been largely effected through quantitative restrictions (consisting of licensing) and import tariffs. The rate of effective protection in Colombia has been determined not only by the level and coverage of nominal tariffs and other import taxes and the extent and structure of quantitative restrictions within the import license regime, but also by the exchange controls that allocate foreign exchange for authorized imports, and the real exchange rate of the peso that has varied substan- tially. During 1967-82 as a whole, tariffs were gradually reduced, and a large number of items were moved from the prohibited and prior license lists to the free imports list. On the whole, a modest import liberalization took place over the long term although measured as a proportion of GDP the increase in legal imports has not been significant. xxiv. Towards the end of 1982 there was a clear move to higher controls: even though the increase in nominal tariffs has been relatively minor, the structure of the import licenses system has increased dramatically. The major objective for the most recent changes (1983-84) has been to arrest the decline in international reserves, rather than to provide additional protec- tion to the domestic industry. By May 1983, roughly 56% of the positions in the import list were under prior licensing; by March 1984 about 85% of the positions accounting for some 70% of the value of imports are estimated to be under prior licensing. These changes may be expected to affect not only domestic inflation but also the country's ability to produce and export. Import Liberalization and Phasing xxv. A reversal of the recent restrictive measures would be desirable as export policies begin to show results. Liberalization may need to proceed in stages in order to ameliorate adjustment costs to domestic producers and short-term employment problems. In particular, a major liberalization while the exchange rate is appreciated can be problematic from the point of view of the domestic industry; and it will need to be tied to a depreciation of the peso to reach an equilibrium level. xxvi. In the meantime, it would clearly be desirable to utilize controls that are temporary in nature, easy to apply, and relatively cost-effective. Studies in other countries have demonstrated that tariffs (if applied fairly uniformly across sectors) are preferable to quantitative restrictions, since they (the tariffs) allow the volume of international trade to respond with greater flexibility to changes in domestic demand and supply. At the same time the flexibility of the control instruments ultimately depends on the ease of making changes, given Colombian administrative and legal procedures. xxvii. Even though there are no infallible answers, for the present Colombian case it seems advisable to reduce imDort restrictions as the real  - x - exchange rate reaches an equilibrium and exports respond to the improvements in the real exchange rate. In the short-term, however, if there is no way to induce quick real exchange rate adjustments, it may be advisable to undertake a temporary tariffs-cum-export subsidies policy in addition to the exchange rate depreciation. if this policy is adopted, it is essential that: (a) the newly imposed import restriction policies are temporary, and (b) that the public is made clearly aware of the temporary nature of these policies. Improving on Licensing Methods xxviii. It would be desirable to rely on a system that maximizes the probability that recent increases in import restrictions will be temporary. If it is decided that licenses are best suited for this purpose, their allocation should be made in a way that captures different parties' willingness to pay for them. In view of the problem with international reserves, one criterion for licensing at present is the availablity and terms of external financing for imports. In general, however, licenses are, in good measure, fairly arbitrarily allocated; their recipients gain the implied rents. Auctioning the licenses would increase the efficiency of the system and transfer the rents to the Government. The approach of auctioning licenses could be adopted initially for selected products on a pilot basis in order to refine its functioning in the Colombian context. xxix. The Government could periodically (say every three months) announce through INCOMEX (Foreign Trade Institute) the auctioning of a certain number of licenses for selected commodities. Interested parties would then submit bids that would specify unit prices they are willing to pay for different numbers of units. These bids would be added up, and the clearing price-- consistent with the amount to be auctioned--would be determined. This procedure will allow the Central Government to capture the rents derived from licenses, and would avoid income distribution and efficiency problems. Ideally this scheme should be supplemented with the possibility of licenses being transacted in the open market. Additional preparatory work is needed before such a proposal can be put into effect; it might also need to proceed in stages, initially focusing on selected commodities. VI. Agr1cultural Price Interventions xxx. Four types of direct government interventions may be distinguished in Colombian agriculture, the first two operating in the external sector, and the remaining two in the domestic agricultural sector: (i) agricultural trade restrictions including import tariffs, and import/export licensing; (ii) agricultural export subsidies, and in the case of coffee, export taxes; (iii) output price supports; and (iv) price fixing in output and input markets. Agricultural Protection xxxi. An important intervention-in addition to credit subsidy (para lxiv)--is represented by import restrictions complemented by IDEMA's (Agricultural Marketing Institute) price supports, provided mostly to cereals and other food crops, which in general do not appear to enjoy a comparative advantage (with the exception of rice). The import-competing component is a  - xi - relatively small part, so that despite substantial levels of protection to this segment, overall production incentives and international competitiveness have been diminishing since the mid-1970s. The policy inference, however, is not that the levels of import protection should be raised further: protec- tion levels are already high and they impose a cost on consumers while it has, on the whole, been rather ineffective in stimulating production. xxxii. Exports of agricultural products, on the other hand, have in the past been usually subject to a limit determined by available 'surpluses" after meeting domestic demand, with the possible exception of flowers, banana and tobacco. Only when the domestic market demand has been satisfied and an estimated surplus remains, permission to export has been granted. In general, it appears that crops which can be developed as export crops and are able to compete successfully in international markets (example, rice and barley) have not been stimulated but implicitly taxed by macroeconomic policies. Only when export crops develop problems in external markets have support measures been established as in the case of cotton and more recently, rice. Price Support xxxiii. If IDEMA's objective is to protect domestic producers of import- ables, import restrictions might already achieve that goal without price supports, unless the market is completely monopolistic. Even if some price supports are to be provided, a lowering of the support prices in areas further removed from consumption centers to account for transport cost increases would be desirable from an efficiency viewpoint. On the other hand, income distribution goals might be particularly important in such removed areas, and alternative redistributive mechanisms might need to be devised. As discussed subsequently, reforms of IDEMA's seasonal price stabilization and a separation of the price support operations from the storage functions would be helpful. xxxiv. While the benefits from import controls and price supports have been small, their economic costs also have not been large compared to sectoral GDP. The allocative efficiency losses from policy are not very large in the case of wheat according to this report. Nevertheless, these interventions bear a significant financial cost, particularly in comparison to the public sector operations in agriculture. At least from this point of view, efficiency improvements in pricing policy would merit attention. Competitiveness xxxv. International conditions have undoubtedly contributed to the problems of Colombian agriculture: terms of trade for non-coffee agricul- tural exports have declined since the mid-1970s, as international prices for these products fell in real terms. However, the country could have main- tained greater competitiveness abroad with more adequate macroeconomic policies. Despite low and falling protection, as measured by domestic and external price ratios for traded commodities, the international competitive- ness of Colombia's non-coffee agriculture was stronger during 1970-75 com- pared to the post-1975 period. Declining competitiveness despite rising protection since 1975 has been at least in part on account of high rates of domestic inflation and an appreciating exchange rate. In general terms, policy emphasis in the 1980s could be on establishing a more neutral macro- economic framework which does not prejudice incentives to agriculture. In  - xii - addition, export promotion could replace import protection as a development strategy. A favorable export climate within Colombia would be essential in order to regain external markets, and to restore exporters' confidence in the Government's intentions concerning export promotion. xxxvi. A recent study1l/ considers the range of price distortions (including protection to agriculture and manufacturing, pricing of capital and labor) moderately low during the 1970s in Colombia in a comparison of groups of high, moderate and low-distortion countries. The study reports nominal protection coefficients during the 1970s for a few agricultural pro- ducts, which have been high for maize, moderate for cocoa, and low for rice and beef. The fact that agricultural prices have not been unduly distorted in the last decade has also oeen related to the sector's good long-term record.12/ Consistent with these observations, the needed shifts in agri- cultural pricing policies suggested in this report are modest. VII. Price Stabilization Within Agriculture xxxvii. Year-to-year and seasonal instability of domestic prices is con- sidered by sources in and out of Government as a major problem for producers and consumers of agricultural commodities in Colombia. However, stabiliza- tion of year-to-year price variations through often proposed schemes such as 'buffer stocks may not lead to income stabilization, which might be the objec- tive of policymakers. Some of the advantages and disadvantages of the recent policy change to a variable subsidy scheme for exports (CERT) are noted in this report. IDEMA's price interventions and the storage system affect seasonal price spreads, although their net economic benefits are questionable. Futures Market xxxviii. The alternative of allowing hedging in international futures markets would reduce price uncertainty for several imported and some exported products, but at a lower cost than many proposed government policies. If importers and exporters could be encouraged to use international futures markets, it would provide the benefits of risk reduction directly to them, and indirectly to domestic producers and consumers to the extent that domestic prices move with international. In the absence of a viable domestic futures market, the Government might seriously consider taking steps to remove the obstacles to participation in international futures markets. xxxix. First, legitimate hedging might be exempted in some ways from rules governing other foreign exchange transactions. So long as the futures market activity is truly hedging (i.e., coupled with a transaction for the physical commodity), the possibility of significant losses in foreign exchange are remote. General rules could be developed for this purpose, ensuring that 11/ The World Bank, World Development Report 1983, (New York: Oxford University Press, 1983). 12/ M. Urrutia, Winners and Losers in Colombia's Recent Growth Experience, the World Bank (forthcoming).  - xiii - futures markets are not used for speculation but leaving potential users enough flexibility to hedge effectively. Such rules might: (a) limit the above exemption from exchange controls to agents who actually deal in the commodity; (b) limit futures market transactions to one set (buying and sell- ing) per transaction in the physical commodity; and (c) limit the size of the futures market transaction to the size of the transaction in the physical commodity. xl. Second, a commitment might be needed to exempt hedging from changes in trade policy during the period of the transaction. This step would eliminate the risk that a policy change would prevent a hedger from consumma- ting the part of the transaction involving the physical commodity, changing the hedger's position to that of a pure speculator. Third, futures market activity might be substituted for government control of domestic prices for reducing producer uncertainty. While governmentally guaranteed prices remove the incentives for hedging, the former are less efficient and more costly to the Government and perhaps no more effective in reducing producer uncer- tainty. Fourth, import restrictions on agricultural commodities might be gradually eliminated which could encourage hedging in more commodities. Agricultural Storage xli. Storage permits the transfer of consumption from periods of low marginal value (i.e., low price) to periods of high marginal value. Storage is costly, however, and therefore the optimal amount of storage is less than that required to make prices constant throughout the year. In fact, the optimal storage should be much less than this in an economic environment such as Colombia, where the economic cost of storage is high because of the high returns on alternative investments. In general, market signals would be sufficient to give incentives for the optimal level of storage, and storage subsidies (represented by the 'bonos de prenda', the subsidized credit system) are likely to be unnecessary over the medium term. xlii. The "bonos de prenda" system subsidizes storage of different crops at unequal rates with no apparent economic rationale for the differences, other than special circumstances and problems of individual products and the disparate ability of various benficiaries to exert political pressure. It causes income transfers from savers, investors and holders of cash to a relatively small number of large producers, and creates an undesirable link- age between storage and the monetary base. If it were necessary to give a subsidy to storage, it would be better to include it as a line item in the federal budget, and administer it as a direct rebate to anyone-producers, distributors, or manufacturers--who store agricultural commodities. The amount of the rebate could be determined as some fixed fraction of the financial cost of storage (i.e., the opportunity cost of funds tied up in the stored commodity), based on the crop's true market value at the time of storage and the market rate of interest. IDEMA's Role xliii. IDEMA has been expected to carry out such widely divergent and con- flicting objectives as assuring high prices for producers and low prices for consumers, holding price increases over the course of the year to the targetted inflation rate, making private storage profitable, and supporting  - xiv - itself financially. Its role needs to be redefined to include only those goals that are consistent, and alternative means of achieving those objec- tives evaluated. If IDEMA's primary goal is to support producer prlces, this goal might be met through import adjustments alone rather than through the elaborate purchasing program now used in addition; if Income distribution Is sought to be improved through price support-which may not be an efficient instrument for this purpose--such impact might be evaluated, explicitly recognized and financed separately by the Government. xliv. Policies regarding price increases between harvest periods must be changed if private storage is to become financially feasible on a larger scale, and if IDEMA's financial losses are to be controlled. First, IDEMA should not be expected to help control inflation by its pricing pollcies, not only because of the inefficiencies generated but also because Inflation is mostly a macroeconomic phenomenon. Second, IDEMAL should retain Its goal of allowing prices to rise at a rate sufficient to cover storage costs, but Its estimates of these costs need to be reconsidered. It would appear that the costs (financial and nonfinancial) of storage are slgnificantly under- estimated at present. Probably the best guide to true storage costs would be the average historical rates of price increase durlng periods of minimal out- side intervention. These figures for different crops could be considered along with direct cost estimates to decide upon wore realistlc target rates of price Increase. VIII. Coffee Policy Under Changing World CIrcuiatances xlv. For more than 50 years FEDERACAFE (the Coffee Federation) has been charged by the Government with administering coffee policy and has received remuneration from the latter for Its services. The Federation's most import- ant tasks have been to support Incomes of coffee growers by facilitating the marketing of coffee at a guaranteed minimum price, and in addition Investing in coffee diversification and in projects of health, education and Infra- structure in the coffee zones. Coffee taxes have stablllzed domestic prices in comparison to external prices, and in addition, domestic producer prices have ranged from 38-63% of world prices during 1970-83. Comparing the end years of the period, the farmer's share of the export price has not varied, although since 1981 the trend has been downwards. The Federation's presence is strong in the coffee zone, reachlng down to the village level through Its many projects, some of which (such as rural electriflcation) are not directly related to coffee production. Adjustment In the Coffee Economy xlvi. Colombia's efficiency in capitalizing on favorable world prices of coffee has contributed enormously to the country's generation of exports, incomes and employment. Over one-fifth of agrlcultural growth since 1970 can be attributed to this com-odity. With the current problem of overproduction, however, the focus has shifted to finding ways and means to minimize the pro- duction and storage costs of supplying the country's export quota under the International Coffee Agreement (ICA) and any additional sales. In 1981/82 Colombia held 19% of world coffee stocks compared to its export share of 14X; by end 1982/83 (crop year; October 1, 1982 - September 30, 1983) Colombia stored 112Z of lts total exports. During the crop year 1982/83 domestlc  - xv - production is estimated to have declined, although in the calendar year 1983 it is estimated to have increased significantly: poor climatic conditions in 1981/82 and good weather instrumental in producing good crops in 1983, as well as significant internal price increases during October-December 1983 inducing higher sales (which are accounted as registered production), have been contributing factors. High stocks might serve a strategic purpose in the export negotiations, which, nevertheless, are unlikely to justify the financial and economic costs of the range of stocks held at present. In recognition of the need to bring down coffee production, credit is being given for the pruning of coffee trees, in addition to that for coffee diver- sification (para. xlviii). xlvii. During the coffee boom, yield improvements were the major source of additional production, as farmers rapidly switched to the high-yielding pro- duction system containing the use of the high-yielding caturra variety with high plant density, high fertilizer application and intensive pruning techniques. This system constituted 36Z of the total coffee area in 1981/82. (The full impact of the response to price changes normally takes 4-6 years to manifest in terms of production changes.) While most of the needed adjustments in cropping patterns in the future may be expectel to be initiated by the coffee producers, the compliance with ICA implies that domestic prices have to be kept below international levels to discourage overproduction.13/ Taking into account transitory versus more enduring changes in international prices, domestic price policy would need to continue to avoid translating temporary increases in international prices into higher domestic prices, particularly since the latter are not easily reversible. If coffee demand recovers, reasonable additions to Colombia's export quota might be met from stocks without increasing production. Between October 1982 and March 1984 the internal coffee price has not increased in real terms. An on- going analysis14/ suggests that real production prices during 1983-95 may have to be more than 10Z lower than 1982 levels to achieve a meaningful pro- duction reduction. (This analysis does not take into account the potential detrimental effect of the recent appearance of coffee rust.) The Federation's Leadership xlviii. The Federation might also provide--as it currently does to varying degrees-non-price encouragement to reduce coffee production growth and to develop non-coffee commodities. This report reviews several options: dis- couraging new technology in coffee production, pruning of coffee trees to postpone harvest, planting of shade trees such as banana to reduce coffee yields, and coffee diversification. The obstacles to diversification are partly psychological--producers are reluctant to forsake their 'tried and true' coffee crops for other activities which to them are yet unproven. They are also partly based on the farmers' inadequate knowledge of cultivation techniques and markets for non-coffee products such as fresh fruits and 13/ The full report sets out the way in which the elaborate existing pricing mechanism works, tracing how price and tax changes affect the Federation's finances and the coffee economy. 14/ T. Akiyama, Possible Effect of Real Producer Prices on Coffee Production in Colombia", mimeo., the World Bank, September 9, 1983.  - xvi - vegetables. Most importantly, the Federation's assured market for coffee at a guaranteed price makes other alternatives less attractive particularly for the small farmers. This report indicates that while the social benefit/cost ratio of diversification is large, the ratio from the private farmer's point of view is significantly less attractive given the alternative of an assured coffee price. Coffee Diversification xlvix. FEDERACAFE is acutely aware of the emerging difficulties, and is financing a diversification program. The program has been less successful in inducing coffee reduction than in encouraging other crops. At the same time, since the decline in the real internal price of coffee has made coffee pro- duction only marginally profitable relative to other activities in some areas, this might be a propitious time to encourage some coffee substitu- tion. The recent outbreak of the disease roya has made coffee production riskier, which might make diversification more attractive. More of the funds-instead of being used to cultivate new crops-might be used to subsi- dize the substitution of old coffee trees, particularly in the medium-sized and larger farms, with other crops; and to promote marketing and processing, thereby creating greater price assurance for the non-coffee commodities. New loans or grants under the program might be increasingly linked to coffee stabilization and reduction, or alternatively farmers might be reimbursed for the value of, perhaps, one year of coffee output reduced. 1. The structure of incentives governing the distribution of funds to the regional committees of FEDERACAFE might be reconsidered. Currently, the share of the budget to each committee for improving its region is determined by that region's share in coffee production. It may not be in the interest of an individual committee to give its full cooperation to a program such as coffee substitution in its region, as this would decrease the ensuing budget allocations made from the Coffee Fund. Finally, the Federation's practice of providing subsidized fertilizer for coffee growers could be abandoned. Coffee Production and Exports li. Even if production were to be stabilized at current levels, stocks would in all likelihood continue to accumulate: a FEDERACAFE projection was that, assuming recent trends, stocks could reach 15.5 million 60-kg bags by the end of the 1987/88 crop year compared to exports of about 9.2 million bags in 1982/83. Circumstances under which such stock levels will be economical are not likely to arise. Production reduction is therefore needed, and the Federation's objective, agreed upon at the 1983 Coffee Congress, is to bring the output down in coming years. The options for pro- duction reduction, such as switching to shade techniques, pruning and diver- sification, retain adequate flexibility for farmers to raise coffee yields and output when required. lii. Finally, greater attention might continue to be given to increasing total exports of coffee. However, Colombia has little control over world demand, and only limited control over its quota share under the ICA; the issue of raising its exports to non-member importing countries remains, and it might be handled within an agreement among member exporters.  - xvii - IX. Role of Agricultural Investmmt Private Sector Role liii. It is widely recognized that the private sector in Colombian agri- culture is dynamic and responsive to incentives. Private investments have taken the lead in promoting agricultural growth, partially offsetting a decline in public sector investments in the last decade. The able steward- ship of private producers' organizations is attested to in this report. The efforts of FEDERACAFE, FEDEARROZ (National Rice Producers' Federation) and ASOCANA (Sugarcane Association) in research and infrastructural development are examples. Recent declines in estimated private expenditure in real terms may have stemed inter alia from insecurity in the rural areas and falling incentives in the sector. Macro-economic policies to reverse agricultural disincentives can be expected to stimulate agricultural investment. Trends in Government Investment Uiv. The public sector has a crucial role in the provision of key infra- structural developments such as rural roads and irrigation, and supporting facilities which have more general applications for a wider constituency than that of specialized producer or interest groups, which would indirectly support private initiatives. In the period 1970-1981, however, total public expenditures, and particularly long-term investments, in agriculture are estimated to have decreased sharply in real terms and as a proportion of total national budget allocations. A number of limitations of estimation and caveats to the measures currently available are noted in the report. But the broad result concerning a falling trend in public investment holds, and the particularly significant decline in agricultural investment since the second half of the 1970s coincides with the downturn of the non-coffee agricultural economy, although no clear causality has been established. Allocation of Public Investment lv. The bulk of the public expenditures have been on commercial and marketing services--mostly in support of IDEMA's operations. About a third of the allocations have been loosely classified as 'transfers and debt services", resulting from ad hoc transfers of funds throughout the financial year because needs were not fully anticipated and prioritized in the planning stage. Such cross-transfers between agencies are hard to trace, especially as the uses are often loosely classified under 'investment' or 'operating' expenditures, terms which have yet to be defined in any standard fashion between different agencies. Investments in drainage and irrigation and supporting programs for research and extension have typically only received between 3-5% of the budget up to 1981. The creation of agencies such as the 'autonomous' Regional Corporations (which nonetheless require substantial government funding to get started) have complicated somewhat the old division of duties among the main agencies, by assuming some of the functions on a regional basis.  - xviii - Public Sector Reforms lvi. This review has noted a number of areas for improvements regarding public sector expenditures in agriculture. Admittedly, the identification of problems in this respect is easier than the finding of solutions. A general difficulty that affects other sectors as well concerns the growing dependence of the public agencies on budgetary allocations and on transfers. Towards better efficiency in management, there is need for public agencies to generate more revenues to meet their own financial requirements. The increase in the number of public agencies at different levels of government seems to have compounded the problem of transfers. A related issue concerns the inflexibility of budget allocations for investments, derived in part from the earmarking of revenues for a variety of current expenditures. In this respect, recent efforts to free more resources for investment should be noted, although their impact is yet to be fully assessed. In agriculture, the precarious financial problems of Caja Agraria (Agricultural, Industrial and Mining Credit Bank) and IDEM& have further constrained resource avail- ability for investment. lvii. Budgetary procedures appear to create considerable uncertainty regarding actual resources that will be available to the sector. The process spanning initial authorization, additional appropriations and actual alloca- tions is characterized by the government practitioners as rather complex and cumbersome. Streamlining the procedures would seem to have high pay-offs: a better system of matching revenues and expenditures may be necessary to releave the uncertainty of project funding and reduce delays in execution. X. Agricultural Inputs, Technology, and Marketing lviii. The annual growth in the use of fertilizer and other inputs in non- coffee agriculture diminished significantly since the mid-1970s when expan- sion in production also showed a distinct downturn-an association worthy of further investigation. Recent studies have revealed the scope for signific- antly raising input use in non-coffee agriculture. While Colombia has achieved competitive levels of yields in crops such as coffee, rice, cotton and sugarcane, there may be considerable potential to improve the yields of crops such as barley and maize. Available evidence points to mounting farm production costs outstripping the combined effects of yield improvements and output price increases. The structure and evolution of farm budgets need further study, but current indications are that unless input costs can be lowered and yields improved it would be difficult to absorb any major increase in supply domestically or through exports. Research and Extension lix. Research and extension have suffered from relative neglect in the 1970s, and current efforts to reverse this trend deserve full support. The decrease in funding for ICA (Colombian Agricultural Institute), the over- burdening of institute with regulatory functions and loss of first-rate scientists are problems to be overcome. Ongoing efforts in upgrading research need to be quickly linked to extension which has also suffered in the past from the fragmentation of the agricultural extension services in the  - xix - country and inadequate funding and policy orientation. A project is under preparation to assist the Government in executing a national plan to improve and coordinate all forms of technical assistance in agriculture. Water Use lx. Additional irrigation and drainage are of high priority in selected areas where water is the constraint to higher yields and to obtaining two crops a year. In particular, public Investment for flood control and drain- age could be effective in converting pastures into land suitable for intensive cropping. Irrigation rehabilitation is also justified in general on cost effectiveness criteria. Expansion of agricultural production on new land with new irrigation facilities is generally a more costly option. Several irrigation projects are under preparation by HIMAT (Colombian Institute for Hydrology, Meteorology and Land Improvement). Natural Resources lxi. A rapid reduction in Colombia's rich forest resources, soil erosion and conservation problems and increasing siltation of water reservoirs are serious policy concerns. A greater capacity to execute programs in natural resource use needs to be developed, which will clearly require greater public awareness of the problems. INDERENA's (National Institute for Renewable Natural Resources and the Environment) institutional capabilities for policy execation needs to be strengthened, and conservation education programs need to be stepped up. A program of research and base-line studies on critical areas is called for to enable INDERENA to evaluate policies and projects, funding for which might need to be sought externally. The ad-hoc approach to forestry development needs to be replaced by a more systematic policy. In particular: the execution of pilot projects, such as the Upper Magdalena Pilot Watershed Management Project, and the follow-up of larger-scale projects should be placed within the framework of a national forest and natural resources development program. Input Costs lxii. The most significant element of estimated farm budgets is labor costs, contributing 40-50% of variable costs. Policy intervention consists mainly of minimum wage legislation, arrived at through negotiations between the Government and the agricultural unions. Negotiations for 1984 have resulted in a 28% increase in the minimum wage by mid-year, which is expected to far outstrip the inflation rate adjusted for productivity gains. The pressure this could put on the average wage costs can be serious. lxiii. Farmgate prices in Colombia are about double the c.i.f. prices for urea which is predominantly imported, except perhaps for coffee in which case the input price is somewhat lower than in other crops. The sources of this mark-up are high internal transport and port-handling costs, and to a lesser extent financial costs and import duties. Improvements in the functioning of COLPUERTOS (the Port Authority) would be vital for achieving long-term cost reduction for farmers. Efforts to lower internal transport costs could include measures to: reduce high tariffs on agricultural equipment and tran- sport vehicles; lower the unduly restrictive entry and low capacity capacity  - xx - utilization in trucking; increase the transport of fertilizer in bulk; expand the use of port facilities at Buenaventura on the Pacific, which is closer to key farm production centers such as those of the Cauca valley. lxiv. In the case of composite fertilizers, domestic industry is the main supplier, using imported or domestic inputs. More analysis is needed on the present level of protection and subsidy to the industry, its efficiency and pricing policy. If industry requires protection, ways and means to lower their input costs should be explored before domestic output sales prices (i.e. of the composite fertilizers) are raised. For the first trimester of 1984, the price that the domestic industry can charge the buyers has been raised on average by 8.4%: such price increases in future need to be evaluated under the criterion of its impact on agricultural production. Agricultural Marketing lxv. Long-term improvements in wholesale marketing are evidenced by an estimated decline in the wholesale margins measured as percentage of the pro- ducer price or consumer price. These margins, nevertheless, are considered to be large by some recent reviews, implying the scope for marketing improve- ments as has been the experience under the programs of PRODESARROLLO (Coffee Diversification Program of FEDERACAFE) and DRI/PAN (Integrated Rural Development and the Food and Nutrition Plan). Retail margins seem to have increased during the 1970s. These increases in margins, however, might partly represent quality mprovement and increa ed shares of processing and packaging in the final products in response to real income increases over time, and perhaps lags in transferring consumer price increases to wholesale and producer levels. Inadequate improvements in the face of increasing customer demand for greater marketing services might be another part of the explanation. There have been recent proposals for marketing projects intended to lower marketing margins and to bring about institutional improve- ments; a clear concept of how these efforts would contribute to agricultural development, however, is yet to emerge. Agricultural Credit lxvi. The estimated annual cost of institutional credit is about 11X of production costs for 12 major crops including coffee. The rates on institu- tional credit, currently positive in real terms, are estimated to be as low as 55% of the market rate. (As already noted, a reason for 'high' real market rates is the acceleration of the crawling peg.) The 45% credit subsidy implies a credit cost saving to farmers of about 9% of annual produc- tion costs. Removing the subsidy would raise the production costs by less than 9% if, as expected, it would lead to increased credit availability, lower market interest rates and farmers obtaining credit from both sources. In comparison, fertilizer constitutes about 12.5% of production costs while machinery rental accounts for about 14%. While the subsidy component of the credit cost is not insignificant, it could eventually be substituted by other measures: an adequate exchange rate and reductlon in costs of other inputs (by a further reduction in tariffs and increased efficiency in transportation and port handling). The present estimates, however, may understate the full credit costs to the farmer, including non-financial costs of the institu- tional credit and the cost of non-institutional credit. Additional sector  - xxi - work is proposed to analyze the sources of institutional and non-insti- tutional credit, the efficiency of existing arrangements and their benefi- ciaries, and how the system can successfully cope once policy reforms in other areas lead to increased input demand. lxvii. The financial situation of Caja Agraria, the largest bank in Colombia in terms of geographical coverage and number of staff, continues to be critical. In the past, Caja's financial shortfalls have been managed through special rediscount lines from the Central Bank, the paying of relatively low interest rates on savings deposits, and periodic government contributions to replenish Caja's capital. A consensus is emerging, however, that these problems have to be dealt with systematically through structural changes. The costs of the social function of Caja need to be identified and quantified separately from those arising from any inefficiencies. The Government, through specific periodic allocations suitably monitored, would need to assume responsibility for the social costs and try to lower these costs. On the other hand, Caja should assume responsibility for improving its operational efficiency: Caja's credit and input functions might be split with a view to achieving greater financial accountability in each of these distinct areas.  PART I NAQOECOUKIKC POLICY SD SRMICULTMIRE I,.  Chapter 1 AN OVERVIEW OF TRADE AND AGRICULTURE POLICIES A. Introduction 1.01 This report represents a development of some major themes that have emerged from the World Bank's ongoing economic and sector work on Colombia. A central issue addressed in the study concerns the recent downturn in the economy's performance after a long period of rapid expansion. The economic record has been closely associated with success in the agriculture sector. Agricultural and other exports have been the mainstay of favorable outturns in the external accounts in the past and a significant source of economic growth. At the same time, a proximate cause of the recent difficulties has been the setback in the external sector, particularly that relating to the poor performance of exports. For these reasons, a primary objective of this work is to consider ways and means for stabilizing Colombia's external sector and revitalizing growth, in particular by enlarging the net foreign exchange contribution of agriculture. 1.02 A previous reportl/ noted the connection between macroeconomic and agricultural developments. The present study extends the analysis by focus- ing explicitly on this interrelationship. Macroeconomic developments have been strongly influenced by the fortunes of agriculture, particularly by the sector's external performance. In turn, the sector's record has been sub- stantially affected by macroeconomic policies. In view of these links, a part of this work is devoted to an analysis of trade-related macroeconomic policy, which has a major bearing on agricultural performance. After establishing this broader perspective in some detail, we narrow the focus to study sectoral policies that directly affect agriculture, and then to even more specific financial issues. The sectoral initiatives that are investigated include price interventions, most importantly price support and import controls for import-competing commodities, storage and price stabilization measures for cereals, tax policies in the case of coffee, and credit subsidies that affect most products. 1.03 Taken together, the various pieces of analyses seek to shed light on considerations for achieving stability and accelerated growth of the external sector, particularly as they involve incentives to produce and export agricultural commodities. The domestic prices of traded commodities relative to others are determined not only by international price trends but also by domestic policies toward the exchange rate, production costs and, more generally, the rate of inflation within Colombia. Inducements to produce and export also derive from various export promotion and import policies. In addition, a variety of policies that are confined to agricul- ture can alter output and input prices, and in turn affect farm incentives. Finally, microeconomic production considerations involving yields and farm budgets influence the production environment and affect actual performance. 1/ The World Bank, Colombian Agriculture: Selected Issues and Some Directions for Strategy, Report No. 4275-C0, 1983.  -2- 1.04 With this framework in mind, the report is structured in four parts, with the first three parts included in this volume. Part I discusses trade-related macroeconomic policies, paying special attention to their link with agriculture. This chapter begins with an overview of external and agri- culture sector issues, and sets the stage for the rest of the report. The main findings relate to the sources of the long-term success and the more recent downtrend in agricultural and overall performance. A contribution of the present analysis is to bring out the role of coffee, inflation and relative producer prices in affecting the recent trends, in addition to external conditions and non-price factors which have been emphasized in previous work. 1.05 The next chapter reviews export policy, focusing on export incen- tive management, while Chapter 3 considers import policy alternatives. These chapters have relevance for all sectors, although the suggestions originate, in the first place, from considerations to boost agricultural performance. Part II of the report assesses price policies in agriculture,2/ including price support and import restrictions (Chapter 4); price stabTlization issues (Chapter 5); and policies regarding coffee production and pricing, and issues related to agricultural diversification (Chapter 6). Part III examines non- pricing issues that influence the production environment in agriculture, including public and private sector investment in agriculture (Chapter 7) and direct policies aimed at increasing agricultural productivity (Chapter 8). Part IV presented in Volume II contains technical analyses and additional tables supporting some of the conclusions and policy suggestions. B. Long-Term Performance and its Sources 1.06 The Colombian economy has experienced a rapid and sustained growth in output and employment since the mid-1950s. Even in the past decade while most other countries in the region suffered significant declines in growth, Colombia's C-DP has risen at a trend rate of 4-5Z p.a.; juxtaposed with an annual growth rate of population of about 2%, this has resulted in a respect- able long-term growth in per capita output. For much of the 1970s, the country enjoyed a substantial balance of payment surplus, and prudent manage- ment of the external sector has contributed significantly to the confidence shown by international financial markets in Colombia's creditworthiness. On the domestic front, the country realized an extraordinary employment boom and improvements in real wages during most of the 1970s, which accompanied the rapid expansion of labor-intensive production and exports. Although fortui- tous external circumstances have been helpful, it is also true that a sanguine policy environment that has prevailed over the long-term has been instrumental in producing these results. 1.07 Recent economywide developments, however, have not been favorable because of both internal and external factors. The rate of economic growth has been falling in the 1980s. Colombia's external sector has been in serious difficulty in part because of the economic problems of its neighbors and the debt problems of Latin America. Although a major source of long-term 2/ This work focuses on crop production although many of the policy direcrions would be relevant for the important livestock sector as weil.  - 3 - growth, agriculture has suffered a sharp downswing in recent years, attributable to weak export demand and low international prices, and to domestic developments. Growth in non-coffee exports (agricultural and others) has been decelerating since the mid-1970s, first as the relative produce prices in the domestic markets for these commodities worsened, and later as international export conditions became increasingly unfavorable.3/ The emerging difficulties of the non-coffee economy were hidden during the period of the coffee boom.4/ In the 1980s, however, a further deterioration in the performance of non-coffee commodities has been accompanied by a precipitous decline in real coffee earnings (to levels existing at the beginning of the coffee boom) producing high deficits in the current account of the balance of payments. 1.08 The evolution of the present difficulties in the external sector calls attention to the changed international conditions and to the need for systematic adjustments in policies to permit an increase in exports and a resumption of rapid growth (see Section G). At the same time, vigorous and timely actions are needed--as recognized by the Government-to overcome the current balance of payments problems satisfactorily (sections F and G). As elaborated in sections D through G, problems in the macroeconomic area regarding the exchange rate, export promotion, the fiscal deficit and capital inflows must be addressed promptly and continue to be reviewed, in addition to pursuing coffee diversification and investments for reducing production costs and improving yields within agriculture. Before turning to these policy options, this section and the following one focus on some of the elements of the long-term success, paying special attention to agriculture and trade. Sectoral Contributions to Growth 1.09 From the late 1960s through much of the 1970s output growth averaged a sizeable 6%, although the second half of the decade witnessed a deceleration. An even sharper turning point was at the beginning of this decade when the growth rate in GDP began to dip (Table 1.1). Agriculture has over the long term grown at about 1.5 percentage points below the economy's average. Although manufacturing and services have registered higher long- term growth rates, however, the contribution of agriculture to growth has been just as sizable in view of the sector's larger share in GDP, and the sector has been the mainstay of economic performance since the mid-1970s. During 1970-82 agriculture contributed, on average, about one-fifth of the increase in GDP. Agriculture currently accounts for nearly a quarter of GDP, some two-thirds of export earnings and over one-third of total employment in 3/ In the 1980s, the recession in Venezuela and increasing import restriction in that and other neighboring countries have seriously hurt Colombian exports. 4/ There was also rapid growth in drug trade, although its assessment remains difficult. In R. Junguito and C. Caballero, 'La Otra Economia,' Coyuntura Economica (Bogota, 1978), drug exports were estimated to have grown from about US$300 million to US$850 million between 1974 and 1977. This growth would be equivalent to an additional 0.4% average annual growth in GDP in that period, or nearly 10% inCrease in t'i growtu raLe of that period.  - 4 - the economy. The sector continues to influence major macroeconomic trends, not only through its contribution to foreign exchange revenues and import capacity, but also directly through its impact on employment and incomes in agricultural and other activities. Table 1.1 COLOMBIA: TOTAL AND SECTORAL GROWTH RATES,a/ 1960-82 (in percentage) Time Selected Total Periods Agricultureb/ Manufacturing Servicesc/ GDP 1960-67 2.9 5.4 5.6 4.6 1967-75 4.5 7.8 7.7 6.4 1975-80 4.5 5.2 6.5 5.5 1975-82 3.8 3.4 4.8 4.6 Long-Term 1960-82 4.1 6.0 6.4 5.5 - Contributiond/ (21.1) (22.8) (19.5) (100.0) Short-Term 1980-82 1.2 -1.0 0.3 1.9 - Contributiond/ (16.2) (-10.9) (2.7) (100.0) a/ Growth rates are for GDP at factor cost, calculated by least squares method. b/ Including fishing, hunting and forestry. c/ Commerce, banking, finance and insurance. d/ Sectoral contributions to growth measured as sectoral growth rates weighted by corresponding sectoral shares in GDP. These do not add to 100 because some sectors are excluded. Source: Annex Table 4. 1.10 Manufacturing grew at an unaccustomed rate during 1967-75, result- Ing in a sectoral contribution of over 23% to GDP increment in that period compared to the much smaller impact in the following period. The sector's vitality has weakened markedly since the mid-1970s as a consequence of a number of factors: a declining real exchange rate for exports In the face of the coffee bonanza; the slowdown in domestic economic activity; lagging technological progress In the highly protected domestic industrial sector; and, more recently, the downturn in the world economy. During 1980-82 manufacturing growth has averaged -1.0% p.a., which has accounted for a good part of the domestic recession. Services supporting the productive sectors sustained a fairly steady and high growth rate, accompanying high growth rates either in manufacturing or in agriculture. Over the long term, this sector's contribution to GDP increment has been about the same as that of  - 5 - agriculture or manufacturing. Since the late 1970s, however, as both agri- culture and manufacturing suffered setbacks, the growth in services has also dipped.5/ Components of Total Demand 1.11 Previous work has tried to disaggregate the components of aggregate demand and relate them to economic performance. The signficant contribution of increases in exports to aggregate demand has been noted; in particular, the contribution of expor s to growth and employment generation in manufac- turing has been analyzed._/ An earlier report discussed the broad relation of agricultural performance to export growth, indicating that outward-looking strategies have contributed positively to the sector's record (see World Bank Report No. 4275-CO, o2. cit.). The period 1970-75 witnessed a growth rate of about 5% p.a. in noncoffee agriculture compared to about 4% since 1075. There was a distinct switch in emphasis from external demand driven growth to domestic demand based expansion between the periods as depicted in Table 1.2. The contribution of exports to total demand fell sharply while that from import substitution turned negative between the two periods. The slow- down in domestic activity in recent years is in part attributable to the downswing in world economic expansion. Additionally, the inward looking nature of development in agriculture in the latter half of the 19709 compared to the previous half has also been associated with a slowdown in non-coffee growth. 1.12 Although Colombia is only moderately open by international standards (based on a criterion of the trade shares in total output), a finer disaggregation of economic activity makes it immediately apparent that for most of the period under consideration trade has, indeed, been a major source of growth in the economy. While t may be true that much of the export-led development of the second half of the 1970. was the result of fortuitous external circumstances, it is equally true that the establishment of an outward-looking policy environment in the 1967-75 period was instrumental in creating the basis for a dynamic response to external market conditions. As a result values of total exports and imports have increased significantly in real terms since the mid-1960s, producing a modest increase in their (goods 51 For a more detailed discussion of the economy see World Bank, Colombia: Economic Development and Policy under Changing Conditions, Report No. 4444-CO, 1983. It should be noted that some of the calculations in Report No. 4444-CO and the present one involving national accounts data obtained from the Central Bank differ somewhat from the newly published data of DANE (the National Department of Statistics). In future reports, the data base of DANE could be increasingly used. 6/ See G. Montes and R. Candelo, -El Crecimiento Industrial y la Generacion de Empleo en Colombia: Entre le Subtitucion de Importaciones y la Promocion de Exportaciones", Aevista de Planeacion y Desarrollo, 1981; and F. Thoumi, 'International Trade Strategies, Employment and Income Distribution in Colombia", in Trade and Employmuent in Developing Countries, (ed.) A. Kreuger, et. al., Vol. 3, (Chicago: University of Chicago Press, 1981).  -6- and n.f...) shares of CDP over the long-term.7/ In view of these findings, we provide below an overview of the role of trade within agriculture, which is of special interest in thls report. Table 1.2 (OoXDBA; 9IAES IN QUiWl OF GOM9=IES OF ACRICmRAJL SAGWd1E MND, 1970-75, 1976-1 5/ (In peromntWa) Daoitic De1md aerenal Dovrd Sub tituttw Total Intenuediate Fixe ChQqo Csonsqptiw TIn Intersdiate FirNl Capital in Sub for Sub- Perlod Comupwic CQ Iptlon Foziutimi Stocis Total Exxnt Exports Toal 1970-75 43.0 24.5 2.3 -1.2 68.6 7.4 16.8 24.2 7.2 100.0 1976-8 43.0 32.6 0.8 10.6 87.0 34 15.9 19.3 -6.3 100 a/ he metbod usd to mtlste the period aezage OaItr1but1o of the spocues of total &t.iI is sqx2a1ni in G. Monts aid L Candelo, Revift de Plmuaclg y D sniUn, Val. XIII, No. I and 2, Bogota Jamary-June 1981, pp. 87. Sowmr: CP (the Nationl PLaFmfix Dqartumnt) calclation using WME data. C . Tade I. Agricalture Trade Oriercation 1.13 As a whole, agriculture has had a strong trade orlentation, in great measure accounted for by the role of coffee. In 1982 agricultural exports represented some 66X of total exports, which roughly correspond1 to the 'expected' behavior of a country with Colombia's per capita Income. / During 1970-82, the share of agricultural commodity etports averaged some 332 In agricultural GDP. Excluding coffee this proportlon (i.e. non-coffee agri- cultural exports over non-coffee agricultural GDP) falls to about 92, which is about one percentage point above the share for non-agriculture (see Annex Tables 5 through 7). In the same period agricultural Imports constituted only 3Z of sectoral GDP compared to about 18Z in the -est of the economy. Undoubtedly, exports have been a far more significant component than Imports 7/ Details of this and other trade-related observations can be found in Annex Tables 1 through 10. 8/ See R. Junguito and D. Pizano, 'Primary Products in Latin America", in Latin America and the Ne, International Order, (eds) R. Ffrench-Davis and Ernest Tironi (London: MacMillan, 1982).  -7- of GDP in agriculture with or without coffee.9/ Consequently, the net foreign exchange position of the agriculture sector has been strongly positive over the long-run. 1.14 An alternative approach to measuring trade orientation in agricul- ture is demonstrated in a recent review which attempts to estimate the share of tradeables (i.e. exportables and importables) in agriculture, defined as the total value added in domestic production of categories that have been or are exported and imported.10/ The purpose of this estimation is to show the full size of value added of a category (in addition to the actually traded part) that would be affected by an export or import intervention. Including coffee, total exportable and importable agricultural commodities are estimated to comprise 70Z of sectoral output, 60% being exportables and 10% importables (mostly food items). The remaining 30% is comprised mostly of food items for domestic consumption. Excluding coffee, agricultural trade- ables are estimated to constitute 40-45% of (non-coffee) agricultural output. 1.15 In contrast, the rest of the economy is characterized by a larger proportion of non-tradeables: over 50% of non-agricultural production is derived from fully non-tradeable sectors such as transportation, communica- tion, commerce, banking, and public services. Additionally, not all of the value-added of sectors such as industry is tradeable. The conclusion is that agriculture contains a larger tradeable component than the rest of the economy on average, and in that sense trade policies can influence agricul- ture more than they can affect the rest of the economy on average. Further- more, because of the higher share of exports than imports in agricultural GDP, incentives to agricultural exports--given a satisfactory demand environment--would have a more significant effect on the balance of payments than a comparable protection given for import-substitution in agriculture. 1.16 During 1970-82 as a whole, agricultural exports have grown at 5% p.a. in constant prices, coffee growing slightly above this average and other exports slightly below. During the past decade, flowers, banana, fresh meat, hides and skins and tobacco have grown at impressive rates albeit from small bases. It is noteworthy, however, that after a growth of 5% p.a. in constant prices during 1970-75, non-coffee agro-based exports grew at only 2.3% during 1975-82, and even with the recent decline, coffee has been the mainstay of 9/ The main agricultural export commodities, other than coffee, are cotton, sugar, banana, flowers, leaf tobacco, livestock products, fish and rice. Agricultural imports are defined here as outputs of agricultural origin, and they exclude processed foods and beverages as well as agricultural inputs such as fertilizer. 10/ See J. Garcia-Garcia, -Aspects of Agricultural Development in Colombia: 1970-81-, mimeo, Bogota, April 1983. Exportables are defined as coffee, rice, sugarcane, leaf tobacco, beans, banana, sesame, cotton fiber, flowers, bovine cattle and sugar. Importables consist of nonr-rice cereals, green peas, other- vegetables, 'other- fruits, soybean, cocoa and milk products. Domestic commodities are brown sugar, tubers, tomato and other vegetables, plantains, oilseeds, nonr-cotton fibers, hogs, sheep, horses, poultry and eggs.  export growth. Agricultural imports have grown steadily although at a rate below the average for the rest of the economy: in 1970-82 agricultural imports grew at 5% (the same rate as the sectoral exports), compared to 6.3% outside the sector. The larger part of increases in agricultural imports have come from increased domestic consumption of imported food categories. These increases in agricultural imports have not been quantitatively very significant in affecting the balance of payments. The sharp decline in the contribution of exports from the sector (growth rates of -9% in 1981 and 2% in 1982 in non-coffee agricultural exports in constant terms) is a more serious source of concern. Trade Surplus 1.17 Agriculture's position as a net exporter is true regardless of whether coffee Is included or not. Including coffee, the trade surplus during 1970-82 was about 30% of sectoral GDP. For non-coffee commodities, exports and imports have been fairly small proportions of domestic produc- tion, and during 1970-82 the trade surplus of this (non-coffee) portion was some 5% of value added of the same category. The country has remained a net exporter of food products also, steadily registering a small trade surplus. With this trade surplus, food production has been slightly above net domestic supply in all years since 1975. The net supply of food is estimated to have grown by roughly 4% p.a. in constant pesos. The gross value of food output is about 65% of the agricultural total, and it is a highly diversified output whose growth can contribute enormously to the domestic food supply. Fears of undue reliance on international markets for food, and expectations of benefits from heavy protection of domestic food production or from export controls are somewhat misplaced in view of the trade surplus and the small share of agricultural imports in GDP and in total imports. D. The Recent Downturn and Some Explanations 1.18 We turn now to the problem highlighted at the outset of the deceleration of economic activity and problems in the external accounts since the mid-1970s, particularly in the 1980s. The subject has focused on the international recession and the difficulties of other Latin American countries, which have undoubtedly hurt Colombia's growth and exports. In addition, internal developments have also contributed to emergence of the present problems. To understand this process better, it is useful to disaggregate agriculture into two categories--coffee and the rest. This enables us to see that the country has exhibited the symptoms of the "booming-sector syndrome' experienced elsewhere in the world, where the rapid growth of a few primary exports and the resulting inflow of foreign exchange have been coupled with a real appreciation of the exchange ratell/ causing major changes in labor deployment and resource use which have hurt other 11/ A fall in the number of Colombian pesos paid per unit of foreign currency is defined as a nominal apreciation of the peso. However, after adjustments are made for differential movements in price levels in Colombia and externally, a measure of real movements in the exchange rate is obtained.  - 9 - productive sectors by drawing resources into the booming sectors (see section E). In Colombia, the coffee and drug export windfalls in the second half of the 1970s produced these adverse effects on non-coffee agriculture and the rest of the economy, and the impact has persisted even after the end of the commodity boom period. These external and internal factors are discussed below in turn. External Factors 1.19 The connection between Colombia's current troubles and those of its Latin American neighbors is noteworthy. Exports to Mexico, Argentina, Brazil, Ecuador, Costa Rica and Chile, which had expanded significantly during 1970-1982, have fallen since 1982. The speculation against the Colombian peso following the 1983 and 1984 Venezuelan devaluations and the ensuing tight import restrictions in Venezuela have exacerbated Colombia's problems. At present, the Colombian peso is significantly appreciated with respect to the currencies of a number of Latin American countries, and particularly to the Venezuelan Bolivar. Venezuela used to account for about 25% of Colombia's exports of goods and services and for most of the transfers received from abroad. In 1984 foreign exchange receipts from these sources are expected to be less than a fifth of what they were in 1982. The external debt problems of other Latin American countries has been a proximate cause for the pressure on the capital account also. The availability of external commercial bank financing has shrunk, and terms and conditions of the loans hardened. 1.20 In general, domestic performance has been positively associated with growth in world production and trade. During 1965-73 export volumes grew at an estimated 8.7% compared to only 4.9% in 1973-80, directions of change which were also broadly true for Colombia. The downturn in the world economy during 1980-82, when the growth of industrial countries averaged barely 1% p.a., has-by dampening international demand for Colombian exports--undoubtedly hurt Colombia's performance. In general the country's terms of trade have been positively related with domestic performance. Since the midl960s Colombia's terms of trade have gradually improved. After fall- ing between 1974 and 1975, they improved during 1975-79 because of sharply rising coffee prices, more than compensating for the decline in real prices of non-coffee exports during 1977-79. After 1979 n n-coffee export prices began to recover in real terms, partly offsetting the fall in coffee prices. The overall terms of trade today are above the level of 1975, having regained its 1974 level (Table 1.3). Excluding coffee, in fact, the terms of trade show an improvement compared to 1975. For non-coffee agriculture alone, however, they are yet to regain the 1974-75 level (Chapter 4). 1.21 Coffee exports are determined in part by special arrangements under the International Coffee Agreements (ICA) while domesti incentives for coffee production and exports are provided in a manner quite distinct from those for other commodities (Chapter 6). The value of coffee exports has risen (1978-80) and fallen (1980-82), following the ups (1976-78) and downs (post 1979) in world coffee prices. Although domestic prices for coffee were considerably stabilized, the higher producer prices in 1976-78 induced a dramatic increase in production. The higher prices were the main reason for increased export values in 1976-77. The record export sales in 1978-80 on the other hand resulted both from higher prices and higher volumes. During  - 10 - 1981-83, export volumes have declined from the 1978-80 levels and stabilized at levels which, nevertheless, are above the 1970-75 average. The decline in the 1981-83 export values have also been on account of the fall in prices. 1.22 Non-coffee exports in real terms (i.e. total value adjusted by its price index) have fallen since 1979, after a modest increase in the second half of the 1970s. The fall in an index of international real prices of these commodities b&tween 1977-79 has contributed to the poor export perform ance. Furthermore, coffee prices remained high in this period, producing a fall in the price of these commodities relative to coffee in the interna- tional markets. Quantities exported of these non-coffee commodities may have slackened (with a lag) in the 1980s in response to depressed prices. External prices, however, cannot fully explain the declining export trend since world prices and the overall terms of trade have improved. Within agriculture alone, a fall in external prices has been a more serious impedi- ment than in the case of the rest of the economy, as will be elaborated in Chapter 4. In general, however, domestic price developments and non-price factors have also to be accounted for in explaining recent trends. Table 1.3 COLOMBIA: REAL PRICES OF EXPORTS, IMPORTS, AND THE TERMS OF TRADE, 1970-82 a/, b/ (1975 = 100) Non-Coffee All Terms of Year Coffee c/ Exports d/ Exports e| Trade f/ 1970 139.9 86.6 113.5 99.0 1971 112.0 88.1 100.0 92.5 1972 116.0 87.0 101.9 97.3 1973 126.6 88.6 107.4 103.6 1974 108.2 123.9 115.0 108.1 1975 100.0 100.0 100.0 100.0 1976 189.6 102.1 143.8 140.3 1977 266.5 130.9 195.1 194.6 1978 174.2 103.0 138.3 145.3 1979 154.7 89.9 122.1 129.8 1980 139.3 110.8 125.8 132.0 1981 105.4 135.0 118.2 111.3 1982 116.6 123.6 119.7 108.1 a/ For more details of agricultural prices (external and domestic) see Chapter 4. b/ These exports are prices deflated by a World Bank estimate of US dollar price of manufactured exports from developed to developing countries. c/ New York price for Colombian coffee; line 76e in International Financial Statistics (IFS) Yearbook 1982. d/ Calculated from coffee and all export indices weighted by their respective shares. e/ From IFS, line 74d. E/ IFS Supplement on Trade Statistics, pp. 159. Source: IFS, World Bank and mission estimates.  - 11 - Evolution of Internal Relative Prices Economy-Wide 1.23 Prices of exports and imports relative to those of non-traded commodities in the domestic market reflect the degree of competitiveness of the traded goods. Between 1975 and 1977 when the relative price of coffee was rising, the internal relative prices of both non-coffee exports and imports with respect to non-tradeables declined, and this reduction continued in 1978 (Table 1.4). Between 1979 and 1980 this tendency was reversed, with the relative price of coffee dropping, and the relative price of non-coffee exports and imports increasing. In 1981 and 1982, the relative prices of coffee and non-coffee traded goods fell significantly. These price develop- ments would be expected to erode the incentives to produce non-coffee export- ables and import-competing commodities, which is what has happened in recent years. Table 1.4 COLOMBIA: INTERNAL RELATIVE PRICES a/ OF EXPORTS AND IMPORTS, 1975-82 All Coffee Non-coffee Exports Exports b/ Exports Imports 1975 100.0 100.0 100.0 100.0 1976 120.6 165.1 90.6 91.9 1977 135.4 235.6 83.6 82.2 1978 111.2 151.7 78.9 77.0 1979 97.0 110.9 83.1 78.5 1980 102.4 111.9 93.6 80.2 1981 85.0 80.2 89.2 77.5 1982 82.5 85.1 80.4 72.3 a/ Relative prices in this table are defined as the ratio of implicit prices of exports and imports to implicit GDP deflators. b/ Coffee export price divided by the GDP deflator this is not the real internal price of coffee in Table 6.6. Source: Computed from DANE data by J. Garcia-Garcia, po. cit. Agriculture 1.24 The increase in the world coffee price by raising disposable incomes and spending increased non-traded categories not only with respect to coffee, but also with respect to the other (non-coffee) traded categories (see section E).12/ In view of the high traded component in agriculture, 12/ The measures of relative prices for exports and imports would by and large be representative of the trends for exportables and importables respectively as well. Therefore, often a finding concerning the competi- tiveness of traded goods is generalized for tradeables in this report.  - 12 - this effect of falling relative prices was felt particularly in this sector (Table 1.5). The relatively high rate of domestic inflation coupled with a low rate of peso depreciation during 1976-1982 further reduced the degree of competitiveness of non-coffee traded goods. The higher world price of coffee in 1976-79 generated a dramatic increase in international reserves, higher rates of growth of high-powered money and a tendency towards higher infla- tion. The Government responded by implementing a stabilization policy and sterilizing (neutralizing) a part of the additional reserves and thus con- trolling other sources of inflation. No significant liberalization of imports was attempted during the bonanza to absorb the growing liquidity, although towards the end of 1979, import restrictions were significantly eased (Chapter 3). Meanwhile for stabilization, the rate of depreciation of the crawling peg was reduced, 13/ and the real exchange rate was allowed to appreciate significantly, contributing to a lowering of the competitiveness of non-coffee traded categories. The role of coffee in this process is elaborated in the next section. Table 1.5 COLOMBIA: INTERNAL RELATIVE PRICES OF AGRICULTURAL EXPORTS AND IMPORTS, 1975-82a/ Agriculturalb/ 'Broad' Agriculturalc/ Agricultural Exports Exports Imports d/ 1975 100.0 100.0 100.0 1976 94.3 147.4 87.8 1977 99.3 212.6 93.4 1978 90.2 148.4 58.3 1979 93.4 113.7 81.5 i980 81.4 107.0 89.2 1981 85.4 84.5 83.7 1982 96.6 89.2 79.7 a/ Agricultural prices relative to the implicit price deflator for the non- agricultural economy. b/ This column excludes processed coffee and processed sugar. c/ -Broad' agriculture includes-in addition to pergamino (unprocessed) coffee, other crops and livestock-the sectors dealing with coffee processing and sugar processing. d/ Imported agricultural commodities within the 'broad" agriculture sector. Source: Ibid. 1.25 Falling producer prices in agriculture relative to the rest of the economy since the mid-1970s have hurt non-coffee agriculture. In addition, sector price interventions and non-price development have also contributed to the sector's performance, as Parts II and III will elaborate. Government interventions in the sector have sought to provide special inducements to 13/ See "Evaluacion de la Estrategia de Exportaciones Nuevas 1979-1982" PROEXPO (the export promotion agency), Bogota, 1982.  - 13 - agricultural production, mostly through import controls, domestic price supports for selected commodities and credit subsidies (Chapters 4, 5 and 8). Import policies only help the small proportion of these importables, and thus have been rather ineffective and often inefficient. Furthermore, addi- tional import controls indirectly constitute a tax on exports, further eroding incentives in the part of agriculture that produced exportable commodities. The period of falling agricultural incentives (since 1975) also coincided with declining government efforts in agricultural investment (Chapter 7). The private sector has taken the lead in investments, although a declining government contribution in key areas such as research, extension and infrastructure development has been detrimental to sectoral development. Meanwhile, agricultural production costs have mounted and yields of only certain products have increased significantly. Investments in a number of areas-research, extension, irrigation, input supply--together with improve- ments in credit provision and marketing can make a significant contribution to raising yields and lowering production costs (Chapter 8). E. Coffee, Macroeconomic Policy and Inflation Monetary Growth and Inflation 1.26 The increase in the coffee price resulted in higher disposable incomes, and in an increase in the demand for tradeables and non-tradeables. Since the price of other (non-coffee) tradeables is, to a significant extent, given by the world price and the exchange rate, this income effect resulted in a higher relative price of non-tradeables (Annex 1 in Volume II). More importantly, the increase in the price of coffee tended to generate a balance of payments surplus and an accumulation of international reserves. Since this increase in international reserves was not'fully sterilized, the monetary base also increased. Additional spending induced by the higher coffee earnings raised the demand for credit and probably increased velocity, and inflation tended to accelerate in the short run. A fairly close statis- tical relationshiy between inflation and monetary growth has been documented in previous work. 4_ Another avenue through which higher coffee price affected the real exchange rate was discussed in paragraph 1.23. The monetary authority, worried about higher inflation, reacted to a higher price of coffee by trying to use exchange rate policy for stabilization and reducing the rate of nominal depreciation of the crawling peg. 1.27 Thus, income, inflation and exchange rate effects were felt during the coffee boom. As confirmed by the statistical analysis in Annex 2, the higher coffee price was associated with an increase in the monetary base, which was positively related to a rise in the rate of domestic inflation and a fall in the real exchange rate. An additional development during 1980-82 was the growing fiscal deficit of the Central Government, which rose from 1% of GDP in 1980 to 2%, 3.5% and an estimated 4% in 1981, 1982 and 1983 respec- tively. These inflationary developments combined with the inadequate 14/ J. Hanson, -Inflation and Imported Input-Prices in Some Inflationary Latin American Economies-, mimeo, World Bank, 1982; L. Currie, 'La Demanda de Dinero y la Velocidad Ingreso de la Moneda en Colombia 1960-80', in Desarrollo y Sociedad, (Bogota, July 1981).  - 14 - exchange rate adjustment have meant a reduction of the relative prices of non-coffee tradeable goods and a consequent loss in their competitiveness. Together with the recent world recession, this loss in competitiveness has caused the poor performance of the non-coffee tradeables and contributed to balance of payments difficulties. Fiscal Deficit and Inflation 1.28 With the decline in real coffee prices since 1979, the trends in the international reserve position and the size of the monetary base have been reversed. These tendencies should be expected to bring down the rate of inflation, and ceteris paribus improve the real exchange rate. In the 1980s, however, the growing fiscal deficit has been a source of the upward pressure on domestic prices. The Government has been increasing--albeit from relatively low levels-eexpenditures that need to be financed by borrowing from private savings and from money creation. A part of the government deficit is financed by money creationl5/ and not met by a concomitant increase in aggregate supply. Since 1980 there has been a sharp decline in the contribution of international reserves growth to the money base, while deficit financing assumed increasing importance and contributed to infla- tion. The rising deficit has also meant a diversion of a part of investible funds from private savings for government current expenditures, thus lowering the availability of such funds for the rest of the economy. Finally, the fiscal deficit has also reduced the degree of freedom that Government has with respect to balance of payments deficits management, given the need to finance a part of the budget deficit from commercial external financing by reducing foreign reserves. 1.29 Annex 2 shows the positive empirical relationship between the government deficit and the rate of inflation. Such a positive association, however, may be difficult to discern by merely considering particular years without separating out the simultaneous effect of other important variables. It is possible in a given year for the deficit to increase while the rate of inflation declines. A recession can diminish tax revenues thus increasing the deficit, while simultaneously putting a lid on the rate of inflation. In 1983, the reserves dropped drastically, holding the expansion in the rate of growth of the money supply and inflation in check without any decrease in the fiscal deficit. These observations, however, do not negate the partial posirive effect of deficits on inflation. 1.30 Another implication of the foregoing is that under recessionary circumstances, an increase in the deficit may not raise inflation in the very short term. As the economy recovers, however, the inflationary impact would be evident, other things remaining the same. The results depend on monetary policy as well. The inflationary effect of higher deficits can be offset by a tight monetary policy, but this could lead to higher interest rates which may arrest economic growth. Since 1983 the real monetary base has been 15/ See World Bank Report lHo. 4444, op. cit.; J.C. Jaramillo and A. Montenegro, -Cuenta Especial de Cambios: Descripcion y Analisis de au Evolucion Reciente-, in Ensayos Sobre Politica Economica, (Bogota, September 1982); and J.A. Ocampo and A. Perry, La Reforma Fiscal 1982-83", in Coyuntura Economica, FEDESARROLLO, (Bogota, March 1983).  - 15 - reduced, mainly on account of falling reserves, which in the face of a rising budget deficit, has exercised an upward pressure on the interest rate. The determination of interest rate is also heavily influenced by the expected depreciation of the peso (Chapter 2). Summary of Macroeconomic Developments 1.31 The data in Table 1.6 support the more formal empirical analysis in Annex 2 establishing the statistical link between the price of coffee, the rate of growth of high-powered money and inflation in Colombia. The statis- tical analysis also brings out the position association between the fiscal deficit and inflation). Together, the findings confirm some of the charac- teristics of the Dutch-disease type model:16/ ceteris paribus, a higher price of coffee has led to a higher rate of inflation and a downward pressure on the real exchange rate. A growing fiscal deficit has aggravated the inflationary tendency, further exerting a downward pressure on the real exchange rate. 1.32 The net result has been to hurt the performance of the non-coffee tradeables. On the other hand, there has not been any significant output response from the non-tradeables which experienced an improvement in their relative prices. The coffee boom hid the negative impact on the non-coffee tradeable economy. With a fall in non-coffee prices in the 1980s, a lower rate of inflation and an improvement in the real exchange rate ought to be expected. The decline in the rate of inflation has been slow up to 1982, however: the continuing increase in the fiscal deficit combined with increases in real wages and the slow pace of economic recovery have kept increases in aggregate demand higher than aggregate supply. F. Current Outlook 1.33 During 1980-82 GDP grew at an average of only 2% p.a.,17/ and largely by virtue of agriculture's contribution. Nonrcoffee exports fell in constant pesos in 1981 and 1982.18/ Combined with the fall in coffee revenues, this has meant a sizeable decline in commodity exports in constant pesos in the 1980s (Table 1.7). Commodity imports, in the meantime, 16/ A Dutch-disease type of model is formally explained in Annex 1. See W. M. Corden and J. P. Neary, -Booming Sector and De-industrialization in a Small Open Economy', Seminar Paper No. 195, Institute for International Economic Studies (University of Stockholm, 1982); A. C. Harberger, 'Dutch-disease: How much sickness, How much Boom?-, mimeo., University of Chicago, 1981; and S. Edwards and M. Aoki, 'Oil Export Boom and Dutch-disease: A Dynamic Analysis", Resources and Energy (forthcoming). 17/ See, for a discussion, E. Gutierrez Castro, "Presentacion ante el Congreso Nacional Sobre la Emergencia Economica', mimeo, Bogota, 1983; see Annex Table 9 also. 18/ See Annex Table 7. If dollar receipts are deflated by the declining international price index for manufactured goods in 1981 and 1982, however, no significant change is indicated in constant dollar terms.  - 16 - increased in constant terms in 1981 and 1982 which, combined with the slump in exports have produced deficits in the trade and resource balances during 1981-82 for the first time in seven years. The current account of the balance of payments has swung into deficit during 1981-83. In 1983, this deficit amounted to 6Z of GDP, and the country lost US$1.8 billion of inter- national reserves. The urgency for stimulating agricultural and other exports derives from both its expected impact on growth and as a means to avoid serious balance of payments problems. In the domestic sector in the meantime, the rise in the fiscal deficit has turned out to be a major problem restricting the Government's flexibility in policy management. With several strains in the external accounts, a reduction in the fiscal deficit and a review of the Government's investment program are urgently required. Table 1.6 CDIMXBI: SaECD IKCa WONEC VARTABES, 1970-8B Rate of Central Groith Governmet Average of Cash Rate of Rate of Real Real Price TeDDs of Mbaey Deficit Infla DevaluEr- EThdWae of Coffea/ Trade/ Baseb/ as X tiond/ tione! Ratet/ (1974-100T (197441T) (X) of GDEc/ (Z) (Z) 1974-TOO 1970 139.9 99.0 19.8 1.0 6.7 6.5 79.7 1971 112.0 92.5 8.8 1.1 11.6 8.1 83.2 1972 116.0 97.3 25.4 2.0 13.8 9.7 85.9 1973 125.6 103.6 31.1 1.2 22.0 8.1 90.0 1974 108.2 108.1 18.8 0.9 25.2 10.3 95.1 1975 100.0 100.0 31.7 0.3 23.2 18.7 100.0 1976 189.6 140.3 41.6 -1.1 19.9 12.2 97.0 1977 266.5 194.6 40.1 -0.7 34.7 6.0 84.2 1978 174.2 145.3 35.2 -0.7 16.8 6.3 85.7 1979 154.7 129.8 30.4 0.2 24.9 8.8 84.1 1980 139.3 132.0 28.8 1.2 27.2 11.1 83.8 1981 105.4 111.3 21.8 2.0 28.1 15.3 77.8 1982 116.6 108.1 17.7 3.4 24.6 17.6 72.8 1983e 105.3 110.0 13.5g/ 4.0 19.8 23.0 734 e Preliixfray estiute. a/ From Table 1.2. b/ Cuorrey in the haxds of public plus reserves held by commercial barks in noninal terms, see World Bank Report No. 4444-COD, . cit., Vol. II, Table 6.1. c/ Report No. 4444, Vol. I, Table VI.1. d/ Frm IFS; chage in period averages. e/ Report No. 4444, Vol. II, Table 6.1. f/ Measured against a trade weighted basket as explained in Table 2.3. / The 1983 figure is a Der-December estimate; it reflects the effect of the sharp fall in iternational reserves in 1983. Mj (airrency plus denmrd deposits) increased by a yearly average of 20.4Z and DeUe b e-Deber 25.6%. Soume: Ba deo de la Republica, DMF, and mission calolations.  - 17 - 1.34 The economic situation continued to be depressed in 1983. A modest reactivation of agriculture, resulting from higher yields and some increase in acreage, was partly offset by an estimated fall in manufacturing output (by some 2%). In seven major cities, the unemployment rate in 1983 was estimated to be 11.9Z on average compared to 9.2% in 1982. GDP in real terms is estimated to have increased by less than 1% in 1983. Commodity exports and imports are estimated to have fallen in 1983 as shown below. (Coffee exports are estimated to have fallen by 4% in nominal dollars and other exports by 13%.) A large current account deficit is estimated for 1983, only marginally lower than the deficit in the previous year. Net capital inflow has significantly declined causing a 37% drop in international reserves during 1983. In addressing these immediate problems, an increase in net capital inflows is urgently needed. Table 1.7 COLOMBIA: THE BALANCE OF PAYMENTS SITUATION, 1970, 1975, 1978-83 (US$ million) 1970 1975 1978 1980 1981 1982 1983e Exports a/ 1,000 2,165 4,039 5,676 4,606 4,680 4,135 Imports T/ 1,149 2,030 4,131 5,494 6,078 6,444 5,552 Current Account Balance -339 -98 357 136 -1,658 -2,242 -2,162 % of GDP -4.8 -0.7 1.5 0.4 -4.4 -5.7 -5.8 Net Reserves 152 547 2,482 5,416 5,630 4,891 3,077 (year-end) Equivalent Months of Imports 1.6 3.2 7.2 11.8 11.1 9.1 6.7 e preliminary estimate a/ Goods and n.f.s. Source: Banco de la Republica and mission estimates. Near-Term Prospects 1.35 The near-term outlook remains difficult. In the first three and a half months of 1984, the country lost an additional US$880 million in reserves. If a recovery in exports and a further fall in imports can be achieved during the rest of the year (Annex Table 10), the current account deficit can be reduced in 1984. Furthermore, with prompt government action to secure a significant increase in net capital inflow, the rate in the fall of reserves can be reduced. The medium-term outlook is predicated on the speed of recovery of the world economy and the management of the domestic  - 18 - economy. A base-case or moderate"9/ scenario assuming world economic recovery and good domestic policies (some of these are discussed in this report) envisages that, with a significantly faster rate of depreciation of the real exchange rate (than in 1983) combined with a vigorous export drive backed by efforts to strengthen aggregate supply, rapid economic growth could be resumed in the mid-1980s. The balance of payments could also improve sub- stantially and stabilize. G. A Policy Overview The Role of Coffee 1.36 The main link between the macroeconomy and agriculture that is established in this report operates through the effect of coffee production and exports; an important impact may have been exercised by illegal drugs also. / These commodities have contributed significantly towards raising the aggregate supply of output in Colombia. Less obvious, but equally important, has been their impact on increasing the money supply, aggregate demand, and inflation, in causing an appreciation of the real exchange rate and in hurting the performance of non-coffee production sectors. Increases in the price of coffee resulted in higher disposable incomes in Colombia and an increase in the demand for all goods; since the domestic price of trade- ables is to a significant degree determined by their world price and the exchange rate, this rise in incomes tended to raise aggregate demand and, consequently, the relative prices of non-tradeables. This shift in relative prices was reinforced by the impact of accelerated foreign exchange inflows on the domestic supply of money, which contributed strongly to the higher inflation rates (average over 25Z) witnessed in the second half of the 1970s. 1.37 Macroeconomic management in Colombia has been found to be especially difficult when coffee prices fluctuate sharply. This arises from the uncertainty attached to assessments of the duration of price increases and, consequently, the degree of adjustment in macroeconomic variables that is required. During the coffee price boom, alternative means for stabiliza- tion were pursued to varying degrees and effectiveness. To some extent, the increases in reserves were neutralized by monetary policy actions and some increase in imports. The real exchange rate was also allowed to appreciate as a stabilization measure. A smaller peso appreciation could have been viable if supported by a larger inflow of imports to absorb the increased 19/ The base case assumes inter alia good OECD growth, and a set of good domestic policies in the exchange rate, monetary, fiscal and financial areas and in external debt management. 20/ Although there are parallels, the monetization of export receipts and the fiscal impact of drug exports which are illegal would be quite different from those of coffee. Of course, the domestic social and sociological aspects of coffee and drug exports are worlds apart.  - 19 - domestic demand and if borrowing did not increase sharply as occurred during 1978-80. It should be noted, however, that a major liberalization in the face of an already appreciated peso could exacerbate adjustment problems of import-competing domestic industries. Temporary protection for non-coffee exports in the form of special export incentives might be necessary for a short period of time, as actually done to a small extent. Once the price boom is diagnosed as transitory, however, a reversal of the peso appreciation-even if the exchange rate might have represented an adequate level during the boom--would normally be the right approach to take. In this respect, the adjustment of the Colombian economy--in lowering inflation, improving the real exchange rate, and shifting resources into non-coffee production--could have been more timely. Economic Adjustment 1.38 The differential between domestic and external inflation during 1975-83 was high, with domestic prices measured at the official exchange rate rising by 118Z, compared to a 42% increase in one index of external prices. Partly as a result, the producer prices of non-coffee tradeables (which, as mentioned earlier, are strongly influenced by international prices) have been falling relative to the price of domestic goods and services in this period. Since agricultural output has a higher share of tradeables than the rest of the economy, this fall in relative producer prices has been especially adverse for the sector. Unfortunately, the shift of incentives in favor of non-tradeables has not produced any significant output response from this domestic sector (for example services) as a whole, so that there has been little offset to the production and employment losses which resulted from slower growth in the tradeable goods sector. 1.39 Colombia now faces real coffee prices that are roughly comparable to those that existed in 1974-75 b- t below the average real price for the first half of the 1970s. The country's terms of trade today correspond roughly to the level of the mid-1970s. The direction of macroeconomic policy at present should consist inter alia of a depreciation of the peso to reach an equilibrium level as soon as possible and a reduction of domestic infla- tion through fiscal and other measures--which are the present administra- tion's goals--and additionally, a gradual opening-up of imports as exports respond to improved incentives. A target could be to bring down the Central Government's fiscal deficit from the level of some 4% of GDP in 1983 to the historical level of about 1% over the near term. These steps aimed at reducing inflation and improving the real exchange rate would in general be favorable to agriculture, reducing the pressure to provide special price incentives directly to the sector. 1.40 The Government would also have to execute wore forcefully a strategy of return to export promotion which will be needed to absorb any major shift in the domestic supply of agricultural products. It should include: an adequate general incentive system for Colombia's non-coffee exports to regain competitiveness; a gradual reduction and equalization of effective protection across sectors; and an assurance to exporters of rapid access to foreign exchange and imports needed to produce exports. The increase in import restrictions are likely to have Rome negative impact on  - 20 - exports despite the duty drawback provided by Plan Vallejo:21/ in 1983 about one-half of non-coffee exports did not or could not take advantage of this scheme. A reorientation of the free trade zones towards export promotion and attraction of foreign investment in export industries are also needed. Finally, PROEXPO's (the export promotion agency) activities need to be increasingly redirected towards aggressive export development, rather than purely export-financing. A balance of payments scenario consistent with a recovery of growth through the 1980s indicates also the need to significantly step up net capital inflows in the near term. The country needs to speed up disbursements of external loans and put together a program for additional, rapidly disbursing, external financing. 1.41 Chapter 2 suggests that both world economic conditions and an adverse shift in relative producer prices in domestic markets have been sig- nificant in explaining the performance of non-coffee exports (agricultural and others)._2/ A product-by-product and country-by-country examination is needed of external demand and of institutional and other arrangements required to break into new markets, supported by efforts to improve yield, quality, processing and marketing. Within agriculture, domestic price policies can perhaps play only a rather limited role in efficiently boosting incentives to produce and export (Chapters 4 and 5). A major aspect of agri- cultural adjustment revolves around the problem of coffee overproduction and the need to restrain the internal real price of coffee and induce a shift of resources into non-coffee activities (Chapter 6). A good part of agricul- tural diversification is likely to be in additional food output, expenditure on which contributes nearly 40% of the consumer budget. The demand for non- coffee agricultural products (food and non-food combined) is projected to grow sufficiently to absorb a slgnificantly higher output level-by about 3% (domestic and external combined) in the 1980s under one set of 'moderate' assumption of a world recovery and improvements in Colombla's competitiveness (Report No. 4275-CO, M. cit.). Efforts to lower production costs and increase yields (Chapters 7 and 8) will permit a better alignment of addi- tional supplies with future demand. 21/ The scheme Plan Vallejo provides duty drawback on imported products that are needed as inputs into exports (Chapter 3). Its efficiency and additional needed measures, as well as the question of the treatment of domestically provided inputs for export production, need to be studied. 22/ Even with a faster world recovery, Colombia's success in raising exports might be predicated on its ability to take into account the exchange rate adjustments of its competitors (Chapter 2).  - 21 - Chapter 2 TRADE POLICY AIND EXPORT PROMDTION A. Itroduction 2.01 This chapter is concerned with trade policies that influence export performance significantly. The superior performance of outward-oriented economies has been related both to competitive exchange rates, and to other incentives such as access to duty-free imported inputs for exporting firms. Successful outward-looking economies have been known for their policies to ensure equal incentives to production for export and home markets. Equally important have been quality control and prompt delivery, and flexibility of changing product composition in response to major variations in foreign demand. Furthermore, where import protection is not heavy, domestic produc- tion has had to compete with imports either for domestic sales or eventually for exports.l/ 2.02 Export incentives in Colombia usually involve inter alia exchange rate management, export loans, subsidies and special facilities, as well as import -:.licy. Setting aside import considerations for Chapter 3, we take an indepth look at how these incentives have varied over time. An important area of this analysis is the exchange rate, which since 1967 has been based on a crawling peg. We examine how the exchange rate has varied in order to stimulate exports (the 1967-75 period), how it has been utilized for stabili- zation purposes (1976-80), and what options are available in the 1980s to adequately restore its function of export promotion. B. Factors Affecting Policy Cholce 2.03 In evaluating exchange rate policy, it is essential to distinguish between short-term fluctuations around long-term "equilibrium levels and persistent disequilibrium levels. While short-term variations can be problematic, of greater concern are persistent deviation from a long-term or fundamental equilibrium. Purchasing power parity suggests that changes in the nominal exchange rate should be in accordance with differentials between domestic and external inflation, but it does not indicate the base exchange rate level for comparisons. Measures of changing competitiveness as guides for the appropriate exchange rate are also arbitrary because they require choosing base years when the country's costs and prices are considered to be in reasonable balance and when a basic equilibrium may be considered to have 1/ On the Colombian experience with trade policy and the performance of manufacturing, see D. Morawetz, -why the Emperor's New Clothes are not made in Colombia", the World Bank, (Johns Hopkins University Press, 1981). A review of the relationship between the outward-oriented strategy and performance in LDCs is provided by P.K. Mitra, -World Bank Research on Adjustment to External Shocks", Research News, the World Bank, Vol. 4, No. 3, Fall/Winter 1983; the successful experience of Korea, Thailand, Malaysia, Indonesia and the Philippines in the 1970s is documented in P. Hasan, Growth and Structural Adjustment in East Asia, World Bank Staff Working Paper No. 529, 1982.  - 22 - existed. One alternative is to examine "normal" years2/ when the real exchange rates permitted the matching of current account balances with trends in capital flows.3/ The rate would have to provide sufficient incentives to productive sectors to allow a reasonable growth rate in a framework of balance of payment viability given external conditions and domestic fiscal and monetary conditions. 2.04 Wide fluctuations in the country's external terms of trade have made it difficult to determine and maintain a long-term equilibrium exchange rate in Colombia. These changes have resulted mostly from variations in world prices of coffee (comprising some 56% of goods exported during 1970-82), which in turn have affected the level of th' exchange rate the authorities consider sustainable for non-coffee commodities. During the 1950s and through the mid-1960s multiple exchange rates were used, with rates for non-coffee exports (sometimes separate ones for imports and for petroleum and other products) at times floating and ofte- pegged at a level different from that for coffee. Instability and unpredictability of world coffee prices have also been reasons that discouraged policy makers in the past from seeking long-term equilibrium rates, and utilize instead import controls, and export subsidies for non-coffee commodities. Since 1967 multiple rates have been abandoned, and the approach to an equilibrium rate has been more successful, although not always without difficulties. 2.05 With the trade reforms initiated in 1967 (para. 2.07), the peso depreciated significantly to reach an equilibrium by the mid-1970s. The balance of payments were in reasonable equilibrium during 1974-76. Commodity prices were not abnormal in that period, and Colombia was still self-sufficient in petroleum so that there was no significant oil price effect. In fact, the terms of trade were about the same at that time as in 1983 (Table 2.1). The current account deficit at present, on the other hand, is much larger both in absolute terms and relative to GDP than during 1974-76, and net capital inflows have yet to reach levels that can sustain such deficits over time. 2.06 During 1975-82 domestic prices measured at the official exchange rate rose much faster than international prices, which has been in contrast to the 1970-75 experience. This has meant a sharp appreciation of the real exchange rate. The authorities believe that a significant peso depreciation would be needed to achieve a substantial increase in exports and improve the balance of payments. Considerations given in the previous paragraph would seem to support the authorities' use of the mid-1970s as a broad guide for peso depreciation, although this will clearly need to be a flexible policy to be revised upon new evidence. 2/ That is, excluding years with unusual commodity prices, oil stocks, or other such special circumstances. Clearly basic changes in the domestic or world economy (such as major variations in domestic productivity, the availability of a new resource at home, or permanent changes in a country's terms of trade) can change the equilibrium level. 3/ See, for example J. Williamson, The Exchange Rate System, Institute for International Economics, (Washington D.C., September 1983).  - 23 - Table 2.1 a)UIUJA: INDIDCRS CF PRf N(X IN THE EEIL SE=, 1970-84 Tems of Relative Prie Real ExmdhanW Current Account Net CapitaL (Change in Tradeal/ Colnbia/ b/ RateC/ Balance d/ TnElow d/ Reserves d/ (Ixdces, 1975=100) (in US$ milion) Year X of C)P 1970 99.0 141.2 79.7 -339 -4.8 345 -2 1971 92.5 134.7 83.2 -484 -6.4 319 -75 1972 97.3 127.0 85.9 -214 -2.5 293 L92 1973 103.6 120.5 90.0 -80 -0.8 279 225 1974 108.1 108.9 95.1 -384 -3.0 35 -364 1975 100.0 100.0 100.0 -98 -0.7 200 139 1976 140.3 104.9 97.0 210 1.4 135 562 1977 194.6 123.0 84.2 449 2.3 178 852 1978 145.3 114.6 85.7 357 1.5 122 610 1979 129.8 117.7 84.1 562 2.0 562 1,237 1980 132.0 124.5 83.8 136 0.4 699 1,168 1981 111.3 145.2 77.8 -1,658 -4.4 1,866 112 1982 108.1 157.1 72.8 -2,242 -5.7 1,662 -806 1983e 110.0 141.3 73.4 -2,162 -5.8 624 -1,812 e Preliminary estimate. a/ Unit export price divid3 by unit import price (IM data). W rie blue-co/ar coKsumer price itdex divided by the M f r unit value ilex (IBRD estimte) coDnverte at the officia exhange rate. cl Mesured a1gaint a tralevelghted bascet of currernies; see Table 2.3. 41 From Annex Table 8; a ndms signifies a drop in reserues. Source: Bamxo de la Republica, IMF and! mission estimates. C. Past Policies and Exports The 1967 Trade Reforms 2.07 During the 1950s and through the mid-1960s, the peso was chronIc- ally overvalued from the point of view of competitiveness of now-coffee exports, effectively constraining export diversification.4/ Although isolated attempts at stimulating exports had been undertaken before, it was not until 1967 that a coherent set of measures was implemented to promote non-traditional exports (i.e. exports other than coffee and petroleum). The most important element of the new policies was the introduction of a crawling 4/ World Bank Reports 4444-CO and 4093-CO, op. cit.; C.F. Diaz-Alejandro, Foreign Trade Regimes and Economic Development: Colombia, NBER, (New York: Colombia University Press, 1976).  - 24 - peg exchange rate system.5/ A package of export incentives was also intro- duced, including: (a) fiscal incentives (CATS-Certificados de Abono Tributario); (b) concessionary credits for export-related activities from the Export Promotion Fund (PROEXPO credit); and (c) an expanded and more effective import/export regime (Plan Vallejo). The new policies represented an attempt to compensate for the relative price distortions generated by the import-substitution effort. Together with a favorable development of world trade, this shift in policy emphasis led to impressive results. Effect on Exports 2.08 Between 1968 and 1974 manufactured exports in current prices increased from US$58 million to over US$390 million, and their share in total exports rose from 8% to 28%. Industrial value-added increased by 7% p.a. in real terms, and the growth in manufacturing employment of 8.5% p.a. reached unprecedented levels, largely as a result of the relatively more labor-inten- sive nature of the leading export subsectors-textiles, apparel, footwear, and leather products. This growth of manufactured and other minor exports also succeeded in easing the foreign exchange problems which had plagued the economy in prior years. 2.09 About one-third of Colombia's export growth during 1967-75 was mainly attributed to the sharp expansion in world trade of manufactured goods, and the remaining two-thirds to the increased competitiveness of Colombian industry in international markets (Report No. 4093-CO, op. cit.). This has in turn been linked to real exchange rate adjustments to reflect the effective value of CAT export subsidy, the effective value of subsidized PROEXPO credit, and the conditions of the import duty drawback scheme (Plan Vallejo). A variety of products took advantage of these incentives, and several new commodities entered the export market. A number of impressive results may be cited: Colombia's textile exports grew faster than that of Taiwan, Hongkong and Singapore during 1970-75; exports of cut flowers, beginning from negligible levels in the mid 1960s registered a dramatic climb, reaching US$19 million in 1975 and US$112 million in 1982; Colombia became the world's leading exporter of children's books by 1978 with US$58 million exports compared to US$2 million in 1970. 2.10 Several developments through the 1970s might not have been predicted at the beginning of that decade: cheese, banana, frozen shrimps, footwear products, refrigerators and stoves, workers' gloves, and false teeth are some of the products that by 1980 reached impressive levels of exports. These examples suggest that a favorable export climate can produce remarkable results, not all of which may be anticipated. Exports to the Andean Group have been roughly 15-16% in recent years and this proportion has not changed significantly since the mid-1970s (see para. 3.07 also). Protection for agricultural imports in other countries is a potentially limiting factor con- cerning Colombian exports of individual commodities to individual countries or groups of countries. In the aggregate, however, there would appear to be 5/ A detailed discussion of the exchange rate and other trade reforms is provided in World Bank, Colombia: Manufacturing Sector Development and Chaes in Foreign Trade and Financial Policies, Report No. 4093-CO., 1983.  - 25 - the 'head room' to raise Colombia's exports; the issue of export markets, however, needs to be examined further. Impact on Efficiency 2.11 Non-primary exports benefited more fromi the exchange regime established during 1966-70 than did natural resource-based products but both were encouraged to take advantage of a rapidly growing world market. This approach was continued into the 1970-74 development plan as well. The resultant growth reflected the utilization of excess capacity created during the 1962-66 period of substantial investment and a judicious use of expan- sionary exchange rate and aggregate demand policies. However, growth also reflected an improvement in resource allocation. For example, no new and expensive import-competing projects were initiated. Growth in agriculture, particularly of export-oriented commodities, accelerated while output of relatively inefficiently-produced crops--such as wheat-fell sharply. These production effects, particularly the Improvement in agricultural performance, also contributed to lowering inflation. Developments in the 1970s 2.12 The overall thrust of the 1967 reforms have been largely maintained in subsequent years, but their effectiveness has varied with changes in world conditions and occasional delays in policy responses. Soon after the mid- 1970s, an externally-generated increase in the money supply gave rise to higher rates of inflation: world coffee prices almost doubled, unrecorded exports and net capital inflows grew rapidly, while imports fell as a percentage of the GDP, and aggregate real purchasing power rose nearly 8Z. The 1974-78 administration initiated a stabilization package in January 1977, consisting of sharp rises in reserve requirements, including those for foreign borrowing; the reimposition of prior deposits for imports to reduce the money base; the use of exchange certificates to delay the monetization of export receipts; a further tightening of fiscal policy; and a reduction in the rate of peso depreciation: there was qualified success in containing inflation. An even more rapid increase of selected imports than actually occurred6/ could have, in addition to absorbing the risirg liquidity allowed the country to grow faster and enjoy efficiency benefits of liberalization, although the timing of such a policy during a coffee boom is not without problems, as discussed in Chapters 1 and 3. Recent Developments and Outlook 2.13 While international coffee prices began declining from their post- World War II peaks of 1977, the Government's budget deficit began to climb steadily in the second half of the 1970s, contributing to inflation. Public investment and expenditures had been reduced during the 1974-78 administra- tion's stabilization efforts, and the new administration (1978-72) sought to reverse this trend. Both current and capital expenditures grew in 1979 and 1980, but these contributed to increasing the fiscal deficit, in the absence of a matching tax effort. A large part of this deficit was financed by the use of the Special Exchange Account, a part of it representing money creation 6/ Smuggled imports, by all accounts, did increase.  - 26 - (Report No. 4444-Co op. cit.). The Central Bank's deficit financing opera- tions were estimated to account for over 90% of the expansion in the money base in 1981, a sharp change from the previous five years when public sector borrowing had been negligible. Once the reserve accumulation was reversed in the 1980s, the rising deficit became a reason for high inflation. A growing government deficit squeezes out private sector from the domestic credit market, which has particularly serious effects in the present difficult circumstances of the international financial markets. 2.14 The recession has hurt world-wide exports which grew by 1.5% in 1980, stagnated in 1981 and declined by some 2% in 1982. Only a few develop- ing countries have managed to increase exports (mainly of manufactured goods) in this period through improving productivity and quality.7/ Colombia's exports have also declined in constant prices in 1981 and 1982. Non-coffee agricultural exports fell from US$419 million in 1981 to approximately US$350 million in 1982. Although a small increase in non-coffee agricultural exports has been estimated for 1983-as a result of expanded markets and good prices for flowers and bananas, in addition to Colombia being able to export its surplus rice stocks albeit at prices well below production costs- total non-coffee exports have been estimated to have fallen. A recovery of the world economy and a depreciation of the exchange rate and export promo- tion efforts will be vital to Colombia's export performance. D. Competitiveness and the Real Exchange Rate Some Concepts 2.15 Alternative measures of competitiveness try to capture changes in a country's production costs--evaluated at a suitable nominal exchange rate (NER)--compared to the changes internationally. In this section we present estimates of how domestic and international inflation have differed over time, recognizing that the measures presented would capture changes in pro- duction costs only in a broad sense. In addition, estimates of the real exchange rate (RER) are also presented. The RER captures the effect of nominal exchange rate changes in offsetting the differential between domestic and external inflation. Internal and External Inflation Differential 2.16 Colombia's crawling peg is defined in terms of the Col$/US$ exchange rate. Traditionally, RER calculations have used comparisons of the Col$ and US$, adjusting the nominal rate by the differential between domestic and U.S. inflation. A more comprehensive procedure would be to compare domestic inflation with an average inflation rate for the relevant trading partners--rather than just using the U.S. inflation rate. Such comparisons, however, would still have to be modified to the extent that the peso is 7/ The spectacular performance of some of the East Asian economies in the 1980s is worth mentioning. GDP growth in Korea and Singapore ranged from 6Z-10Z p.a. in the 1980s, and similar results were obtained in Malaysia and Thailand. Exports from Korea, Thailand, and Singapore have been increasing substantially in real terms during this decade.  - 27 - floating with respect to the US$ even as some of the other principal currencies have also been floating vis-a-vis the dollar. Depending on the relationship between the US$ and these currencies, a particular change in the RER, as indicated by the Col$/US$ exchange rate, may or may not be reflected by a similar change of the Col$ vis-a-vis these other currencies. In particular, when the US$has appreciated against other currencies--as it has recently--the peso has also, ceteris paribus, tended to appreciate in real terms against these currencies. A government policy to depreciate the Col$/US$ rate in this case may not depreciate the peso vis-a-vis a basket of all the relevant currencies. The exchange rate movements in real terms against these currencies can be accomplished by constructing an index of the RER with respect to a basket of currencies of the trading partners, taking into account their inflation rates as in Table 2.3. Estimates of the Real Exchange Rate 2.17 Between 1970 and 1975, the rise of Colombian prices in US$ terms was significantly slower than the external prices. Using 1970 as a base, Table 2.2 shows a 43% increase in domestic prices (in US$) during 1970-75 compared with 102% inflation externally. The opposite has been true since 1975. From 1975, a 115% increase took place in domestic prices compared with a 42% increase externally contributing to Colombia's declining competitive- ness in the international markets. 2.18 In the indices of the RER in Table 2.3, period average weights have been used as it is difficult to choose a representative year for this purpose.8/ The calculations have included eight mDst important partners using average trade-weighted changes in their respective currencies. Three measures have been used: export weights (index bl), import weights (index b2) and trade (i.e. export and import) weights (index b3). The trade- weighted index perhaps captures the changes affecting the external sector more fully than the other two measures. Two of the more traditional measures of the RER are also presented, both measuring the Col$/US$ exchange rate, one using U.S. inflation (index el) and the other using an average inflation for the industrialized countries (index e2). 2.19 The 1975-82 appreciation is less serious if based on the US$/Col$ measure of RER (el). Furthermore, the 1983 depreciation is substantial with respect to this traditional index. The measure against the basket (b3), how- ever, shows a more serious level of appreciation through 1983, which is clearly an account of the recent appreciation of the US$ against other major currencies. 8/ For previous studies on the subject, see F. Montes, 'Principales Determinantes de Comportamiento de la Cuenta Corriente Durante la Decada", in Ensayos Sobre Politica Economica, No. 2, (Bogota, September 1982); and FEDESARROLLO, Coyuntura Economica (Bogota, March and September, 1983).  - 28 - Table 2.2 COLOMBIA: A COMPARISON WITH INTERNATIONAL PRICE MOVEMENTS, 1970-83 (measured in US dollars) Consumer Official Consumer Price Index EXchange Price Index International in Col$ a/ Rateb/ in US$ Price Index c/ (1970-100) (1970-100)(1975-100) (1970-100)(1975-100) 1970 100.0 18.4 100.0 69.4 100.0 49.5 1971 111.6 19.9 103.3 72.2 108.1 53.6 1972 127.1 21.9 106.9 74.7 118.6 58.8 1973 155.1 23.6 121.0 84.6 141.7 70.2 1974 194.2 26.1 137.0 95.8 177.7 88.0 1975 240.0 30.9 143.0 100.0 201.8 100.0 1976 287.4 34.7 152.8 106.8 205.5 101.5 1977 387.9 36.8 194.1 135.7 222.6 110.3 1978 452.7 39.1 213.2 149.0 262.4 130.0 1979 565.2 42.6 244.3 170.8 292.9 145.1 1980 718.8 47.3 279.9 195.6 317.1 157.1 1981 920.8 54.5 311.1 217.4 302.1 149.2 1982 1,146.9 64.1 329.5 230.3 295.8 146.6 1983e 1,374.0 78.8 321.2 224.5 286.3 141.9 e preliminary estimate a/ Blue collar, period average. bi Period average; 1983 assumes 26.5% depreciation over 1982 average. Z/ Unit value index of manufactured exports (MNU) from developed to developing countries on a c.i.f. basis. Source: DANE, IFS, World Bank data. 2.20 With respect to 1974-76, the average peso appreciation in 1982 against the basket was 24.6%, and with the 1983 improvement, 24%. The average 1983 appreciation against the US$ with respect to the same base period is lower than the-above estimate if the U.S. inflation is used, and higher if the MUV is used. In the near term, a depreciation of the US$ against the other major currencies would mean that the peso would depreciate more vis-a-vis the basket for any given depreciation against the dollar; the authorities might wish to consider the impact on growth of Colombian exports to U.S. in such a situation. The use of a trade-weighted basket in compari- sons will need to be flexible, in view of the fact that a large proportion of exports are denominated in US$ and the importance of future trade with the U.S. Finally, a comparison with exchange rate mDvements in countries Which compete with Colombia for export-markets would also be necessary (para 2.41).  - 29 - Table 2.3 COLOMBIA: INDEXES OF REAL EXCHANGE RATE OF THE PESO, 1970-1983 (1975 - 100) Against Currency Basket Against US$ e Index b1f Index bZ/ Index b3f/ Index el_/ Index eZ/ 1970 79.1 80.4 79.7 103.3 70.9 1971 83.0 83.6 83.2 104.3 74.3 1972 85.6 86.2 85.9 103.9 78.6 1973 89.7 90.3 90.0 97.7 83.1 1974 94.4 95.7 95.1 95.4 91.6 1975 100.0 100.0 100.0 100.0 100.0 1976 96.9 97.1 97.0 99.0 95.2 1977 84.4 83.8 84.2 83.0 81.2 1978 85.9 85.3 85.7 81.3 87.2 1979 84.8 83.3 84.1 78.8 84.8 1980 84.4 83.2 83.8 78.2 80.2 1981 76.7 78.6 77.8 77.7 68.8 1982 72.3 72.1 72.8 77.8 63.6 1983e 76.3 75.3 73.4 82.5 63.2 e Preliminary estimate; bl, b2 and b3 are based on data available for the first three quarters of 1983 and mission projections for the fourth quarter; el and e2 assume yearly averages of 23% nominal depreciation of the Col$; 19.8Z domestic inflation; 3.2Z U.S. inflation (consumer price index); and -3.2% in the NUV. a/ Export weights are: U.S. - .40; Germany - .24; Japan - .05; Italy - .04; Netherlands - .07; France - .07; Venezuela - .10; Ecuador = .06. The weights as presented here do not add up exactly to 100 because only two decimal places are shown. b/ Import weights are: U.S. - .56; Germany - .11; Japan - .14; Italy - .04; Netherlands - .01; France - .05; Venezuela - .06; Ecuador - .03. c/ Trade weights are: U.S. - .47; Germany - .17; Japan - .10; Italy - .04; Netherlands - .04; France - .05; Venezuela - .08; Ecuador - .05. In all trade-weighted indices, a foreign country index of WPIs was used to reflect external inflation, and the Colombian CPI was used for domestic inflation. d/ Measured against the US$, applying the U.S. inflation rate (consumer price index). e/ Against the US$, using World Bank estimate of the MUV. Source Computed from IFS data.  - 30 - Effect of Special Incentives 2.21 The provision of special incentives for exports (CAT and more recently CERT--see Chapter 5--and PROEXPO credit) has increased since 1975 in order to offset a part of the appreciation of the RER. It is estimated by the mission that during 1975-81 the REER against the US dollar-including changes in CAT--declined by 19.8% while RER (excluding the CAT) against the US dollar fell by 22%, implying that the export incentives raised the REER over the RER by about two percentage points. In 1983 and 1984 CAT rates and the new CERT rates were significantly increased as shown below (Table 2.4). The mission has calculated that with the CAT increases applicable by 1983 on average, about 7 percentage points of the appreciation may have been corrected the exporters' viewpoint.9/ After accounting for this compensa- tion, the 1983 average appreciation against the basket with 1974-76 base might have been reduced to some 17%. However, these calculations have not accounted for changes in export incentives in other countries. Other limita- tions of considering additional special incentives are noted below. Table 2.4 COLOMBIA: AGGREGATE WEIGHTED AVERAGE FOR CAT/CERT RATES, 1978, 1981, 1983-84 Weighted Average Rate Year Total Agriculturea/ (in percentage) 1978 3.7 n.a. 1981 3.5 n.a. 1983b/ 11.3 9.8 1984C/ 12.3 10.6 19849/ 15.0 n.a. a/ Percentage of export value, excluding coffee. b/ Before the August 1983 increase. c/ After the August 1983 increase, effective 1984; a rough estimate based on projected total additional fiscal expenditures on CAT and 1982 value of non-coffee exports. d/ An estimate of the average rate of CERT, which in 1984 has, by Ley 48, replaced CAT. Source: Table 5-1 and 5-2 in Annex 5. Exchange Rate Depreciation vs Special Incentives 2.22 A policy of faster exchange rate depreciation differs from one of higher export subsidies in several respects. First, a nominal peso 9/ For other studies see J. Ospina Sardi and N. Carrizosa Serrano, .Evolucion y Perspectiva del Certificado de Abono Tributario (CAT)', in Revista Nacional de Agricultura, No. 856, SAC, (Bogota, November 1981); Coyuntura Economica, FEDESARROLLO (Bogota, December 1983).  - 31 - depreciation that succeeds in generating a real depreciation raises the relative prices of all tradeables as a group-exportables and importables-- compared to the non-tradeables. An increase in the export incentives alone excludes the import-competing industries. To avoid the latter effect, import tariffs can be raised, but only at some welfare cost as will be discussed in Chapter 3. Differential rates of export subsidies and import tariffs can produce substantial inefficiencies and welfare losses. Second, export incen- tives promote only merchandise trade, while a real exchange rate increase affects invisibles as well. Third, commercial policies (export subsidies and import tariffs) do not directly affect the peso value of foreign assets, whereas a peso depreciation would raise it. Finally, an expected faster rate of the crawl which is the stated government policy1 or a step-wise devalua- tion wil"l tend to raise the nominal interest rate.LO/ Commercial policies do not produce such effects on the interest rate. 2.23 Clearly there are alternative considerations affecting the choice between a faster crawl and the provision of additional export incentives. In practical terms, further increases in export subsidies may not be feasible in view of various trade agreements. These incentives also have significant and negative consequences for public finance. Where the diagnosis points to an overvaluation of the exchange rate, the primary policy tool would need to be the exchange rate, and accompanyirg policies should seek to offset potential side effects such as the ones on the external debt and the interest rate. Therefore, once the REER (including the special incentives) attains an equilibrium level, special incentives might gradually be substituted by a further depreciation of the peso. E. Stimulating Non-Coffee Exports Current Outlook 2.24 While non-coffee exports expanded by 5Z p.a. in constant pesos during 1970-75, they increased by only 2Z during 1975-82. In agriculture, the share of non-coffee exports has gradually increased from 18% in 1970 to 24% in 1982. In dollar terms, the most important agricultural export items are banana, flowers, cotton, sugar and livestock products constituting about 23Z, 21Z, 17Z, 14% and 10% respectively of the non-coffee agricultural export value; less important exports are tobacco, rice and fish. The World Bank's projections as of January 1984 (Table 2.5) indicate little improvement in coffee prices in constant dollar terms through the rest of this decade, although projected 1985-90 prices still represent a large increase over the 1975 level. For the rest of the 1980s, banana prices are projected to show little improvement from the average levels that have existed since 1975. Both sugar and cotton prices are projected to rise significantly from their depressed 1982-83 levels, with substantial price increases expected in the case of sugar. Tobacco price is projected to fall in the rest of this decade while a substantial price recovery is expected in the case of rice. Food prices are projected to remain well below the levels registered during the 1970s (particularly 1970-77). 10/ Given the option of invest:ng externally, a broad equivalence has been observed over time between the Colombian interest rate adjusted for the expected rate of peso depreciation.  - 32 - Table 2.5 COLOMBIA: PRICE PROJECTIONS FOR MAJOR AGRICULTURAL EXPORTS, 1975, 1980-90 (1981 constant dollars; $/HT unless otherwise indicated) Actuala, Projection 1975 1980 1981 1982 1983 1985 1990 Coffee (c/kg.) 216 326 283 315 306 295 265 Banana 370 361 401 382 453 392 326 Cotton (c/kg.) 183 196 187 164 197 189 206 Sugar 672 602 374 189 197 303 372 Beef 199 263 248 244 258 284 250 Tobacco 2,271 2,191 2,350 2,459 2,666 2,391 2,158 Rice 544 413 483 299 294 281 425 Foodb/ 98 98 87 73 80 81 84 a/ These are not actual prices for Colombian exports, but the World Bank's estimated averages for the commodities. b/ A weighted index with 1977-79 as base. Source: The World Bank, as of January 1984. 2.25 These projections suggest modest price increases in the 1980s for the agricultural products presently exported by Colombia. The country can continue to expand banana exports rapidly, and capture additional shares of the cotton and sugar markets. Significant increases in cattle and beef are not unreasonable to expect, along with efforts to take advantage of the pro- jected recovery in rice prices. The industry believes, for good reasons, that a continued expansion in flower exports is possible despite recent increase in U.S. import duties on this category. A tentative review of various agricultural commodities on a product-by-product basis suggests that while coffee exports in constant dollars may increase by about 1Z annually, during 1983-90, non-coffee agricultural exports could expand by about 5% annually. These projections, however, do not account for a faster rate of the crawl in the exchange rate than at present, nor for the development of non-traditional exports with favorable export climate in the country.ll/ Fruits and vegetables could become future exports on a significant scale, with improved processing, packaging and marketing and establishment of sus- taining export relations abroad. The excellent environmental conditions for the growth in Colombia and the country's large reserves of tropical hardwood forests indicate that the country might have a comparative advantage in pro- ducing and exporting tropical hardwood products (lumber and plywood). The small level of current exports of these categories and their decline in the past decade draw attention to examine this potential closely (see Chapter 8 also). 11/ Korea has shown great flexibility in raising its exports and capturing additional export markets, even while external conditions have turned unfavorable. Between 1979-83, Korea's exports are es:imated to have increased by some 50% in constant dollars.  - 33 - Non-Coffee Exports and the Exchange Rate 2.26 This study has tried to empirically separate out the effect of some key variables including the real exchange ratel2/ on the non-coffee exports using quarterly data for 1970-81 (see Annex 3). While the world's economic growth has a stronger long-term effect, our results show that the impact of changes in the level of the real exchange rate upon the volume of non-coffee exports is significant.13/ It is also noteworthy, however, that real changes in the value of the exchange rate are needed, which means that in order for a nominal depreciation to be effective, it should not be accom- panied by exactly commensurate increases in the domestic price level. Colombia's exports depend strongly on the commercial policies of its trading partners. The protectionist behavior of some industrialized countries neighboring countries (Ecuador and Venezuela) can critically affect possibil- ities for expansion of non-coffee exports. A careful study of the room left for additional exports needs to be carried out on a product-by-product and country-by-country basis. Some Estimates 2.27 The results suggest that the long-term elasticity of the volume of non-coffee exports in Colombia, with respect to the real exchange rate lies between 1.2 and 1.7, which narrow down previous estimates. The different estimates suggest different behaviors of the lag structure of this elasticity. While some estimates indicate a higher short-run response, others suggest a more even distribution of export response. At this stage it is not possible to know precisely which of these lag structures is mare adequate, and a more definite answer will require additional work. 2.28 The long-term elasticity of the volume of Colombian exports with respect to the world level of activity is typically large: ranging from 5 to 9. Even though this is a wide range, it does suggest that to a large extent the recovery of Colombia's external sector will depend on the world economic situation, provided Colombia's exchange rate movement match those of countries that compete for same markets. These results indicate that both domestic exchange rate policy and world economic activity will be important to export performance. Finally, the long-term elasticity of exports with 12/ On the relationship between exports and the exchange rate, see for example, FEDESARROLLO, Coyuntura Economica, Vol. 13, No. 1, (Bogota, March 1983); J.A. Ocampo, -Politica Economica Baja Condiciones Camblantes del Sector External," in Ensayos Sobre Politica Economica. (Bogota, 1982); and M. Carrizosa, 'El Futuro de la Balanza Comercial" in La Economia ColombIans en la Decada de los Ochenta, FEDESARROLLO, (Bogota, 1979); and J.J. Echavarria, 'La Evolucion de las Exportaciones Colomblanas y sus Determinantes, Revista del Banco de la Republica," (Bogota, 1980). 13/ The statistical analysis used a Col$/US$ real exchange rate as the relevant explanatory variable. This was done in order to be able to compare the present result to previous studies. However, if an exchange rate deflned relative to a basket of currencies is used, similar results are obtained.  - 34 - respect to the domestic level of activity, holding external activity constant, is, as expected, negative. In most cases its coefficients are not significant, suggesting that changes in Colombia's real income does not affect the performance of non-coffee exports in an important way. 2.29 The regression analysis indicates that a real depreciation of the peso of 10% against the US$, holding constant the relation of the US$ to the basket, could be expected to increase non-coffee exports in real terms in the order of 10% above what they would otherwise be over the long-term. A world economic recovery, without exchange rate improvements by Colombia, on the other hand, may not ensure a revitalization of Colombian exports in the face of exchange rate depreciations by Brazil, Mexico, Chile and other countries which produce similar exportables (see para. 2.52). F. Addressing the Appreciation of the Peso 2.30 While some observers suggest that the appreciation should be 4 corrected by accelerating the rate of depreciation of the crawling peg,14/ others have recommended the devaluation of t2ie peso in a once-and-for-all way.15/ These alternative approaches can have quite different effects on factor prices, and they in turn can affect the success in achieving a change in the real exchange rate. In resolving this issue, the role of real wages, expectations, intermediate goods and the interest rate in determining the effect of changes in the NER on the RER (Annex 4) need to be considered. A tentative line of addressing this issue is offered at the end of this chapter (paras. 2.44 through 2.46). Role of Wages 2.31 Even when all factor costs are held constant, a higher NER would Increase the price of tradeables in nominal domestic currency terms, and the cost of non-tradeables would be increased to the extent that they contain tradeable input components. The higher the share of these tradeable components in nontradeable production, the more will domestic prices rise and the less the effect of a higher NER on actually raising the RER. More realistically, when prices of factors and inputs are allowed to adjust at least partially, the change in RER would generally be smaller than other- wise. The importance of wage adjustments would depend on the share of the wage bill in total production costs, and in the type of existing wage negotiations that affect the rate of wage increases in the face of a devaluation. Interest Rate Effects 2.32 The relation between devaluation and the domestic interest rate has been a subject of concern. The analysis in Annex 3 recognizes that Colombia 14/ See J.A. Ocampo, -En Defensa de la Continuidad del Regimen Cambiario' Coyuntura Economica, XIII, 1, FEDESARROLLO, (Bogota, March 1983). 15/ See A. Montenegro, 'La Sobrevaluacion del Peso', mimeo, CEDE, UNIANDES, (Bogota, April 1983).  - 35 - is a semi-open economy, and that, consequently, open economy and/or closed economy models are inappropriate. Three alternative formulations for the determination of the interest rate in a semi-open economy were developed and tested using quarterly data for 1968-82. The results obtained are remarkably good, and indicate that: (a) discrepancies between the domestic (nominal) interest rate and the world interest rate plus expected devaluation will be eliminated through time. The estimates indicate that in one quarter, between one-third and one-half of a unitary discrepancy between the domestic rate and the world rate plus the expected rate of devaluation will be corrected. (b) In six quarters an acceleration of the rate of devaluation of the crawling peg will be almost completely translated into an equivalent increase in the domestic rate of interest. (c) An excess supply of (real) money will exercise significant negative pressures on the nominal interest rate (i.e. there is a liquidity effect). Empirical Evidence 2.33 Annex 6 suggests that an increase in the rate of depreciation of the crawling peg will be relatively quickly translated into an equi-propor- tional increase in the domestic nominal rate of interest. Moreover, if this faster rate of crawl results, as is desired, in a higher real exchange rate, the domestic rate of inflation will increase by less than the acceleration of the peg, and produce an increase in the real interest rate. During the period of the expected acceleration of the crawl, the interest rate effect can hurt in particular non-tradeable industries such as the construction sector, in addition to industries with high debt/equity ratios. With respect to the tradeable goods sectors, the higher rate of the crawl will produce effects that will then work in the opposite direction. To the extent that a higher crawl results in a higher real exchange rate, on the other hand, the level of activity of these tradeable sectors would increase, possibly dominating any depressing effect from the higher interest rate. 2.34 The domestic nominal interest rate is observed to move broadly in line with the world interest rate plus expected devaluation in Colombia (Annex 6). Therefore, an increase in the rate of the crawl may be expected to result in a higher nominal rate of interest, affecting the cost of capital (i.e. rental rate of capital) and exerting upward pressures on the price of non-tradeable goods; to that extent, there will be a tendency for the acceleration of the crawling peg to be less effective. Some observers have taken the view that the rising interest rates will generate a higher rate of inflation through the cost-push mechanism: such an effect is possible in the face of persistent stickiness of certain costs and prices. An empirical investigation of this issue in the Colombian context needs to be done. 2.35 The main aspect of this interest rate problem is that a higher rate of the crawl can affect the expected rate of depreciation, and result in higher interest rates during the period of acceleration of the peg. It is possible that a large one-step devaluation, if perceived by the public to be large enough, can remove expectations of higher rates of devaluation, leaving the domestic interest rate unaffected. However, if the public is not con- vinced by the magnitude of such a one-step devaluation (which has usually been the case in Latin American countries), there may be no such mitigating effect.  - 36 - Impact of Monetary Disequilibrium 2.36 The analysis presented until this point has focused exclusively on cost aspects, ignoring demand considerations. However, the real effect of a nominal devaluation will also depend, among other things, on the behavior of monetary policy. In particular it is expected that an excess supply for money will be translated into an excess demand for non-traded goods which then exert an upward pressure on their prices. In that sense the effect of a nominal devaluation on the RER could also be offset by an easy monetary policy that would result in an excess supply of money, and in an increase in the nominal price of non-tradeables. In order to have a devaluation that affects the RER, special attention should be given to both wages and monetary behavior. G. Export Promotion Efforts 2.37 Although coffee dominates exports, Colombia sells a wide range of commodities abroad. Excluding coffee, manufactured products are about twice the value of (non-coffee) agro-based commodities, and these two categories combined have gradually increased their share in total exports. Colombia exports to a large group of countries. North America's share in Colombian sales has declined from 35% in 1970 to 24% in 1982, while Europe's share has fallen from 49Z to 45% in the same period. Developing countries have been buying increasing amounts and by 1982 Central America and the Caribbean claimed 6.5Z and Asia (including Japan) 4.4% of Colombia's exports. Role of PROEXPO 2.38 PROEXPO (the Export Promotion Agency), following policy guidelines of the National Council of Economic and Social Policy (CONPES), is in charge of export promotion activities. An autonomous institution ascribed (subsidiary) to the Central Bank, PROMEPO is able to maintain independence from the majority of other public institutions. The agency has a key role in the implementation of export promotion policies, particularly those concerned with the provision of export credits. The central executing agency dealing with most trade-related policies, however, is INCOMEX (the Foreign Trade Institute). This institution directs the execution of government policies concerning imports and exports, through instruments such as provision of licenses for importing and exporting. 2.39 Apart from reimbursements received from its past credits of 16 years of operation, PROEXPO's budget benefits from receipts of a 5Z import tariff: the total annual budget is roughly US$800 million. About 92% of expenditures consists of credit provision for exporters and investments in a variety of activities. A number of services is also offered: identification of exporters, of exportables, of export markets, and provision of technical assistance. 2.40 In the area of administration, a better definition of functions and areas of responsibility and improved internal coordination of activities of PROEXPO are needed. The agency could make better use of the commercial attaches abroad, and reduce its excessive dependence on the Central Bank. Statistical information needs strengthening as well. In general, promotional activities need greater attention, channeling some of the efforts away from  - 37 - pure financing of exports by the Government to (non-price) export promotion activities. Support to exporters' needs to be stepped up through more studies of export potential, a strengthening of relationships with the export community, better coordination of Colombia's commercial offices, and a more active role in the development of new export lines by PROEXPO. On the policy side, a gradual elimination of import restrictions (that are currently constraining the supply of inputs needed for exports) and reduction of effective protection across the board will be needed to sustain rapid export growth. A part of the increased import restrictions is likely to hurt export activities despite the import duty drawback provided by the Plan Vallejo: in 1983 about one-half of non-coffee exports did not or could not take advantage of this scheme. A reorientation of the free trade zones towads export promotion and the attraction of foreign investment in export industries would be helpful initiatives. Foreign Investment 2.41 Historically, natural resource development has not played a major role in growth despite the country's rich agricultural and mineral base. This lagging development was partly caused by the lack of processing indus- tries, partly by high transport costs, and partly by the authorities' unwill- ingness to fully support investment projects of either private or foreign participation in these areas. Traditionally, the country has had a lukewarm attitude towards foreign investment. In addition, Colombia was self-suffi- cient in petroleum until 1976, reducing the need to come to grips with foreign investment in this area. The oil crisis and the need to import pet- roleum during the second half of the 1970s changed that situation substan- tially, and Colombia now is seeking development of its hydrocarbon and petro- chemical resources as well as coal and non-fuel minerals with significant foreign participation. Moreover, recent government policy actions, parti- cularly those related to allowing increased profit remittances across the board and to the gradual dismantling of regulations on private sector borrow- ing from abroad, signal a policy shift towards allowing increased foreign private sector participation. H. Conclusions and Policy Su&ggestions 2.42 Colombia's crawling peg has by and large been a successful instru- ment over the long term, although at present (first quarter 1984) the real exchange rate (RER) is significantly appreciated. The period 1974-76 could be a satisfactory base for measuring changes in the RER for a combination of reasons: commodity prices and the terms of trade on .-erage were not abnormal and (in contrast to the present) the current account deficit was modest and in line with trends in net capital inflows. While Colombia's crawling exchange rate is pegged to the US$, it would be appropriate to measure the RER against a basket of currencies of the trading partners in addition to examining the Col$/IUS$ real rate. When the dollar has appre- ciated against other major currencies (as in recent years), this RER measure has accordingly reflected a smaller improvement. If the US$ depreciates against the basket (as may be expected in the near term), it might be essen- tial to pay attention to the Col$/US$ real rate: a good part of exports are denominated in US$, and the U.S. market may be crucial for the future growth of agricultural and industrial exports from Colombia. A direct comparison may also be necessary with exchange rate movements of Colombia's export  -38 - competitors, particularly taking into account the recent sharp currency depreciation of its neighbors.' / 2.43 In 1983 (on average) the Colombian RER measured against the basket was some 24% below the 1974-76 average. As international reserves have been falling and the real money supply contracting somewhat, the rate of inflation also declined; with a 23Z average depreciation against the US$ and average domestic inflation of 19.8%, a gain was made in 1983 with respect to the US$ and a marginal improvement against the basket. The Government's policy is to continue an accelerated peso depreciation in order to correct the RER lag: the measures presented here indicate the need for significant and timely action to correct the accumulated lag up to 1983 plus the additional infla- tion differential after 1983 in Colombia. Recently, special export incen- tives have been increased, including which the peso appreciation (i.e. of the real exchange rate adjusted for export subsidies) in 1983 would be 17% com- pared to the 1974-76 base. However, these calculations ignore changes in export incentives in other countries; furthermore, increases in such incen- tives are neither efficient nor viable over the long-term, and sufficient exchange rate adjustment may be sought that can permit an elimination of such subsidies. Exchange Rate and Inflation 2.44 In principle, a nominal depreciation will raise the RER only if: either there is a price variable such as nominal wage that is not tied to the nominal exchange rate; or if the nominal money supply is not fully adjusted to accomodate the higher level of prices; or if there are accompanying reduc- tions in some component of aggregate demand such as government expenditures. Nominal wages are neither rigid nor completely flexible in Colombia: this means that real wages can be flexible, and a nominal peso depreciation can, in principle, produce a real depreciation. Negotiations in 1983 have resulted in an increase in the nominal minimum wage by 22% for 1984 in the urban areas and 28Z by mid-1984 in the rural areas, which are significantly above the 1983 and projected 1984 inflation rate (about 20Z), and ahead of productivity improvement at least in the case of the rural wage. Wage set- ting will need to be fully cognizant of a potential inflationary impact through cost push mechanisms or by creating inflationary expectations, unless closely tied to productivity increases. Additionally, since the prices of non-tradeables are (moderately) flexible, a reduction in the Central Govern- ment's fiscal deficit would be essential. Policymakers would need to lower the fiscal deficit from its 1983 of 4% of GDP to the historic level of about 1%, thereby ameliorating the impact of excess demand pressures on aggregate prices. Such fine-tuning to affect nominal prices of non-tradeables, while by no means easy, appears to be feasible in Colombia as the 1983 experience has shown to some extent. Interest Rate Effect 2.45 With the domestic nominal interest rate estimated to move broadly in line with the world interest rate plus expected peso depreciation, an increase in the rate of the crawl can tend to cause a higher nominal rate of interest domestically. Our statistical analysis indicates that the rate of 16/ The RER depreciated by an estimated range of some 30% to over 50% between 1981 and 1983 in Ecuador, Chile, Brazil, Argentina and Mexico, although it remains to be seen if this impact in real terms will be maintained. Venezuela's market exchange rate has depreciated in real terms even more significantly.  - 39 - depreciation is relatively quickly translated into an equi-proportional increase in the domestic nominal interest rate; if inflation is successfully reduced (as in 1983), this can mean some increase in the real interest rate as well. During a period of acceleration of the peg, therefore, real inte- rest rates can increase and hurt the growth of domestic sectors such as con- struction and industries with high debt/equity ratios, and possibly increase inflation through a cost-push mechanism. However, while the peso is signi- ficantly appreciated, these costs might be offset by the positive production impact of a higher RER on tradeables. 2.46 A higher rate of the crawl can affect the expected rate of depre- ciation, and result in higher interest rates during the period of accelera- tion of the crawling peg. It is possible that a one-step devaluation, if perceived by the public to be large enough, can remove expectations of higher rates of devaluation, leaving the domestic interest rate unaffected. How- ever, if the public is not convinced by the magnitude of such a one-step devaluation (which has usually been the case in Latin American countries), there may be no such mitigating effect. The Government's present preference is for an acceleration of the crawl based in part on its good track record in Colombia and the recent success in depreciating the peso in real terms with this method. The greater the lag, however, the more the public is likely to expect increases in the acceleration of the peg which would exacerbate the interest rate problem, and the authorities mighit consider a maxi-devaluation, closely coordinated with fiscal, monetary and income policies. Export Promotion and Capital Inflows 2.47 The world's economic conditions and the RER have significant statistical effects on non-coffee exports. Exports from agriculture have been hit in recent years by low international prices and surplus stocks. Furthermore, penetrating into agricultural markets and crossing trade barriers in the case of a number of important commodities are problematic. At the same time, the country needs to return to a more aggressive export promotion strategy. Additional sector work is proposed to examine con- straints in domestic policy; institutional and legal frameworks to rapidly increase exports; market conditions and impediments to entering new areas. 2.48 In addition, a gradual elimination of import restrictions and reduction of effective protection across the board will also be needed to sustain rapid export growth (see Chapter 3). Improvements are needed in the actual functioning and efficiency of Plan Vallejo (the duty drawback for exporters' imported inputs). Also, domestic providers of inputs, even if efficient, are not currently placed on the same footing as the importers. A reorientation of the free trade zones towards export promotion and the attraction of foreign investment in export industries would be helpful initiatives. A variety of reforms have also been noted in this chapter intended to re-orient PROEXPO's activities more towards export promotion rather than just export financing. 2.49 Finally, projections of the balance of payments consistent with a recovery of growth indicate the need to significantly step up net capital inflows in the near term, in addition to export promotion. (A substantial increase in capital inflows by itself can tend to cause an appreciation in the RER, which needs to be anticipated in determining the crawling peg.) The country needs to speed up disbursements of existing external loans and secure additional rapidly disbursing external financing.  - 40 - Chapter 3 EMPORT POLICY FOR GROWH AND STABILITY A. Introduction 3.01 This chapter analyzes how import regimes in Colombia have changed over time, focusing on the most recent increases in import restrictions and associated economic problems. Import restrictions-consisting mainly of import licensing and tariffs--have been periodically increased in the past in order to protect domestic producers in agriculture and other sectors, or to prevent a worsening of the balance of payments, or for both these purposes. The utilization of tariff increases as a tool for financing public sector deficits has also been an important consideration governing import policy: recently tariffs were raised to finance the deficits of public sector agencies in agriculture. On the other hand, additional import restrictions have raised the level of domestic prices, caused inefficiencies in resource allocation and produced welfare losses to consumers. In recognition of these, a policy of opening up imports has been periodically followed, particularly during periods of high growth. 3.02 After a period of moderate liberalization since 1967, however, a drastic increase in restrictions has taken place since the third quarter of 1982 raising the level of import controls above what existed prior to the last major opening up of 1979. In early 1983 import licensing and exchange controls were significantly raised mainly to reduce the loss of international reserves. Even before the 1982-83 measures, roughly a third of imports were subject to prior license, and estimates of effective protection-unadjusted for quantitative restrictions--showed fairly high average levels (44X) and dispersion (a standard deviation of 40%).'/ The full impact of the recent measures is yet to be assessed; for now, a significant decline in imports is projected for the near-term which can hurt production and exports in agricul- ture and non-agriculture sectors. On the other hand, these recent measures partly offset the disadvantages to import-competing sectors from the peso appreciation. 3.03 There is considerable empirical evidence concerning the net benefits from import liberalization.2/ A distinction concerning liberaliza- tion is worth making at the outset :.n the case of Colombia. Often imports have been opened up for stabilization (example, additional car imports or 1/ See World Bank Report No. 4093, op. cit. 2/ See, for instance, Anne 0. Krueger, Foreign Trade Regimes and Economic Development: Liberalization Attempts and Consequences, NBER, (Washington D.C., 1978); B. Balassa, "The Policy Experience of Twelve Less Developed Countries, 1973-78" World Bank Staff Working Paper No. 449; and -Structural Adjustment Policies in Developing Economies", in World Development, Vol. 10, No. 1: pp. 23-38; J. Bhagwati and T. N. Srinivasan, Trade and Development' in R. Dornbusch and J. A. Frenkel (eds.), International Economic Policy: Theory and Evidence, (Johns Hopkins University Press, 1979).  - 41 - food imports), and such measures have been short-lived. Import liberaliza- tion for speeding up growth and improving efficiency has been carried out on a more modest scale over the long-term, which was reversed by the recent measures. B. Long-Term Policy Directions Historic Pattern 3.04 Major policy tools have been quantitative restrictions consisting of licensing,3! prior deposit requirements, and import tariffs. The rate of effective protection has been determined not only by the level and coverage of nominal tariffs and other import taxes and the extent and structure of quantitative restrictions within the import license regime, but also by the exchange controls that allocate foreign exchange for authorized imports, and the real exchange rate of the peso that has varied substantially. 3.05 Severe import controls used in the 195OS and through much of the 1960s attempted to foster industrialization by giving high protection to the domestic production of manufactured goods. In 1966 many of the tariff barriers and quantitative controls on imported inputs and investment goods required to produce export goods were reduced or removed. Unfortunately, these measures were not accompanied by improvements in the real exchange rate and the real interest rate, and as a result the balance of payments was hurt and controls were eventually reimposed. Under the two development plans during 1966-70 and 1970-74, a vigorous export promotion policy was pursued, which eventually permitted a reduction in import controls through most of the 1970s. The gradual move towards opening the economy favored employment by encouraging labor-intensive exports.4/ Opening-Up of Imports in the 1970s 3.06 By the mid-1970s, a process of liberalizing and simplifying the import regime had been initiated. Since then, its implementation and effects have varied widely in response to changing economic conditions and con- straints imposed by Andean Pact arrangements. During 1967-82 as a whole, tariffs were gradually reduced, and a large number of items were moved from the prohibited and prior license lists to the free imports list. Further- more, between 1967 and 1982 varying importance was attached to the prior deposit required before getting the import permit: they were eliminated in 3/ Imports fall under (i) free registration or (ii) prior import licensing. Items under the former can be freely imported without quantitative limit- ations, after a procedure of administrative registration is fulfilled. Quantitative restrictions in Colombia are imposed through the latter which requires specific approval for each import permit. INCONEX (the foreign trade institute) is responsible for administering these controls, and in practice, uses its discretion to exercise control even over commodities in the free registration category. For example, if it con- siders the price for a free registration item too low, the permit can be denied on grounds that the declared price does not correspond to the actual price. 4/ See M. Urrutia, op. cit.; and F. Thoumi, op. cit.  - 42 - early 1976, reimposed in mid-1976, increased in 1977 and 1979, reduced in early 1982.5/ The Andean Pact 3.07 Colombia's participation in the Andean Pact has limited its ability to attract foreign investment and, to a lesser extent. reduce protection. Andean Pact Decision 24 limits foreign investment except for major energy and mining projects. As a consequence, there has been a relatively small contri- bution of foreign investment to the country with the exception of the petroleum sector and a few scientific mining projects. On the side of trade restrictions, Colombia's tariffs in many goods had fallen to roughly the average of the Andean Pact's common minimum tariff by 1979. Further reduc- tions in protection were inhibited somewhat by the Pact. On the other hand, Colombia did benefit from a rapid expansion of manufactured exports to Venezuela and Ecuador since the Pact's initiation although much of this growth can be attributed to the petroleum booms in the latter two countries. Effect of Import-Substitution 3.08 In general, import-substitution has stimulated the economy when output was depressed below normal levels. However, import-substitution has come into conflict with export-promotion particularly as production capacity became more fully utilized, and both sectors began to compete for the same scarce resources and bid up costs and prices. In sum, a variety of costs of a generalized policy for import substitution may be noted. A reduction in imports, while benefiting a specific, import-competing industry, has raised costs and prices in other industries which use the import as an input.6/ On balance, import-substitution tended to increase prices in the aggregate and to slow output growth in the long run. Moreover, non-traditional, non- resource based exports have been more labor-intensive in Colombia than import-competing industries. Thus, with growth returning to a normal level along a long-term trend, continued dependence on an import-substitution strategy has reduced the long-run demand for labor as well as the growth rate, compared to a development strategy that would concentrate new invest- ment and resources in those industries in which the country has a comparative advantage in exporting or import substitution, as occurred in the 1967-74 period. C. Loug-Term Development of Imports Structure and Trends 3.09 Colombian merchandise imports have increased over sixfold, from US$800 million in 1970 to US$5.2 billion in 1982. The acceleration was especially pronounced since the mid-1970s (Annex Table 9). The growth in imports during the 1970s was significantly above that registered in the 5/ See S. Clavijo, 'Los Depositos Previos de Importacion', Revista del Banco de la Republica, 1981. 6/ See World Bank Report No. 4444-Co., op. cit.  - 43 - 1960s; imports expanded at 5.7% annually during 1970-80 compared to 2.7Z during 1960-70. If related to the growth of the domestic economy, however, the growth in legal imports would not appear significant. Legal imports as a percent of GDP fell from 16.2% in 1970 to 14.6% in 1982 (Annex Table 1). Thus, compared to the level of economic activity, no significant long-term change in role of imports can be said to have taken place since 1970. Not included in these official statistics, however, is a substantial amount of contraband. Smuggled imports of textiles in some recent years have been estimated to as much as 20% to 25% of the value of local production; 10 of official imports has been estimated import smuggling (World Bank Report No. 4093-CO, op. cit.). 3.10 The shares of the broad categories--consumer, intermediate and capital goods--have not undergone any major change since 1975. In 1982 the category of raw materials and intermediate goods constituted 50% of total imports, followed by capital goods (37%) and consumer goods (13%), which are not significantly at variance from the proportions recorded in 1970. Industrial inputs represented some 35% and industrial equipment 21X of total imports in 1982, while non-durable consumer goods were only 6%. Food and agricultural outputs and inputs have constituted relatively small proportions as elaborated below. Table 3.1 COLOMBIA: IMPORTS BY ECONOMIC CATEGORY, 1970, 1975, 1980-82 1970 1975 1980 1981 1982 Consumer Goods 10.9 11.3 13.3 12.8 12.6 Raw Materials and Intermediate Goods 43.4 52.2 52.7 52.0 50.6 Capital Goods 43.6 36.1 34.0 35.2 36.8 Unclassified 2.1 0.4 - - - TOTAL 100.0 100.0 100.0 100.0 100.0 Source: Annex Table 10. Agriculture and Imports 3.11 Imports of agricultural commodities as a proportion of agricultural value-added are rather small, although they have risen from about 2.2X in 1970 to about 3.7% in 1982. As a proportion of total imports, the share of agricultural imports was less than 5% in 1982. Imports of certain categories, however, are more important than what these aggregate measures suggest: in 1981, roughly 15% of the gross value of domestic output cereals and nearly 10% of vegetables were imported. Wheat, maize, sorghum and barley are major cereal imports estimated at 467, 120, 82 and 50 thousand tons of imports in 1982. In the case of wheat, roughly 90% of domestic consumption is met by imports. Aggregate estimates of agricultural imports, neverthe- less, contradict widely held beliefs concerning the relative importance of agricultural imports and their impact on the domestic economy.  - 44 - Government Interventions 3.12 Nominal tariffs on foods, beverages, vegetables, oil and livestock products currently range from 17% to 38%, which on average are below the rates on non-agricultural commodities (see Annex Tables 10 and 11). More importantly, several potential and actual imports are controlled by IDEMA (the Agricultural Narketing Institute) which has a monopoly on certain agricultural imports, and as a result these products receive higher nominal rates of protection than what the tariff rates would imply. As elaborated in Chapter 4, a combination of import controls and price supports by IDEMA helps to maintain domestic prices of several agricultural commodities at levels significantly above international levels. IDEMA is exempt from import tariffs and it enjoys a monopoly on licenses to import certain commodities. It is noteworthy that domestic support prices are significantly above international prices for maize, wheat and sorghum for which the country does not seem to have a comparative advantage, while the opposite is true for rice and barley which could potentially compete in international markets. The domestic producer prices are broadly in line with the support prices for these crops, notwithstanding year-to-year variations. 3.13 High and rising agricultural production costs have been related to rural real wages and to the cost of agricultural inputs which incur high port-handling and domestic transport costs, in addition to the import tariffs and restrictions which some inputs face. For fertilizer and some other inputs, while import tariffs are low (3-7Z), other port and transport costs raise domestic prices well above border prices (see Chapter 8). Transport vehicles face high tariffs, while the incidence on agricultural equipments varies depending on whether they are domestically produced also. The net effect is to raise effective protection from levels implied by the nominal tariff rates: i.e. effective protection (the ratio of value added of domestic and border prices) is greater than nominal protection (which measures this ratio for only the output price). Exportables, on the other hand, face the inflated import cost of inputs but no other protection. Policy Implications 3.14 In the aggregate, a drive to protect agriculture from imports is unlikely to produce any major quantitative impact on the balance of payments or on domestic production, and such an effort wili be particularly unneces- sary as the real exchange rate is improved. Over the long-term, the foreign exchange savings from any major import substitution effort of principal agri- cultural imports is likely to be modest. Wheat, maize, sorghum and soybean are currently imported in significant amounts, but as shown in Table 3.2 below, while world prices of these commodities are expected to increase from their depressed 1982 levels, they are not projected to exceed levels existing in 1975 in real terms. Therefore continued imports of these commodities at existing levels ought not to be viewed with alarm. One area for import-substitution, however, might be forestry products. The trade deficit in all forestry products in 1980 was estimated to be over US'l08 million. Most of the deficit was accounted for by pulp and paper imports which grew to US$113 million in 1980 and US$157 million in 1981. The possibility of increasing pulp and paper production might be explored under the proposed National Forestry Research Plan (Chapter 8) and FEDERACAFE's (the Coffee Federation) reforestation plan under its diversification program (Chapter 6).  - 45 - Table 3.2 PRICE PROJECTION OF AGRICULTURAL IMPORTS, 1975, 1980-90 (1981 constant dollars, $/MT) Actuala/ Projection 1975 1980 1981 1982 1983 1985 1990 Wheat 271 182 196 170 179 156 190 Maize 179 119 131 112 143 121 142 Grain Sorghum 168 123 126 111 136 116 137 Soybean Oil 927 569 507 457 554 539 648 a/ See Table 2.4 for an explanation. Source: The World Bank, as of January 1984. D. Recent Developments 3.15 The tendency to liberalize imports observed since 1967 has been reversed during 1982-83. In 1982, Resolution 39/82 (September 7) moved a number of luxury items" from the free imports list to the prior license list. Decree 3080/82 (October 28), on the other hand, raised the level of import tariffs of most import items by about 20X of existing levels for many items. The basic criteria behind these measures was to protect the domestic industry, both barring 'luxury' imports, and by granting a higher level of protection to domestically-produced goods. These measures-together with the increase in export incentives--were intended to partially compensate for the real exchange rate appreciation. 3.16 On April 19, 1983, by Resolution 015/83 it was decided to move 684 additional items from the free imports list to the prior license list. The main difference between this measure and the previous ones (Decree 3080/82 and Resolution 39/82) was that now the criteria for moving items from one list to the other was not motivated by the need to protect the domestic industry, but by the attempt to reduce the level of total imports. In fact, the items with higher value of imports were generally the ones to be moved from the free to the prior license list. (There were some exceptions to this rule, like fertilizer.) The Government hoped that these measures would arrest the ongoing depletion of international reserves. On May 16, Resolution 030/83 moved an additional one hundred products, considered to be luxury items, into prior licensing. By this time roughly 56% of positions in the import list were under prior licensing. In October another 103 items- mostly intermediate goods in production such as chemicals--were added to the list. In mid-1983, a further tariff increase took place, raising the rates by about 10% over the existing levels. The recent changes do not violate agreements under GATT and the Andean pact. Import Tariffs Nominal Tariffs 3.17 The weighted average nominal tariff was 29.02% in the first quarter of 1983, nearly three points higher than its 1981 value (26.11%), and about 32% by the third quarter of 1983; there has been an increase in the basic  - 46 - tariff rate by two percentage points in early 1984. These estimates exclude certain other duties for PROEXPO and general purposes and do not take into account various exemptions relevant for government imports, for imports from the Andean Group (about 6X of imports) and ALADI (another regional grouping), and others. Table 3.3 presents the evolution of the weighted average nominal tariff for 1979-1983, using weights for the relative importance of imports in each section of the tariff schedule for 1980.7/ This increase in the weighted average tariffs between 1981 and 1983 only represents an increase of 4.4Z in the impact of the tariff, defined as one plus the tariff rate, which -barring changes in quantitative restrictions and transport costs- determines the internal price of importable goods, together with changes in the exchange.8/ Table 3.3 COLOMBIA: WEIGHTED AVERAGE NOMINAL TARIFF, 1979-83 (percentage) Weighted Average 1979 (Ist Quarter) 27.62 1981 (2nd Quarter) 26.11 1983 (lst Quarter) 29.02 1983 (3rd Quarter)e 32.00 1984 (lst Quarter)e 34.00 e preliminary estimate. Source: Constructed from data obtained from Giraldo 2p. cit., DNP, and Arancel de Aduanas Legis. 3.18 To investigate the evolution of import tariffs across sectors, weighted averages for the different chapters and sections of the tariff schedule were constructed. An annex provides the average nominal tariff for the 99 chapters for the first quarter of 1979-just before the last generalized tariff reduction in mid-1979,9/ and the first quarter of 1983. In 1983 the average tariffs are higher than in 1981 for 96 of the 99 chapters 7/ The concept of weighted average tariff is tricky because the higher the tariff the lower the amount imported of a good and thus the lower its weight. In the extreme case a prohibitive tariff would have a weight of zero. Annex Table 15 sets out the weights used here. 8/ PM = PM* (1It)e, where PM is domestic price; PM* a world price; (1+t) the impact of the tariff; and e the nominal exchange rate. 9/ G. Giraldo, -La Estimacion de la Proteccion en Colombia-, Revista de Planeacion y Desarrollo, DNP, (Bogota, 1979).  - 47 - of the tariff schedule. Also, for 71 out of the 99 chapters, nominal tariffs are higher In 1983 than in the first quarter of 1979, when the last major step towards liberalizlng the imports sector was taken. 3.19 Weighted averages for the 21 sections into which chapters are aggregated were also constructed and are presented in Annex Tables 12 and 13. At thls level of aggregation, tariffs between 1981 and 1982 have increased in 20 out of the 21 sections. With respect to 1979, however, tariffs are now higher in 14 of the 21 sections. These tables show that even though the recent increase in the level of tariffs has been fairly generalized, affecting most sectors, the magnitude of the tariff increases have been very modest. On the other hand, available evidence also suggests that the increase In protection is fundamentally based on the increase in the coverage of import licenses, rather than tariff increases. Effective Protection 3.20 A number of studies have been concerned with the degree of protec- tion granted to value added, or effective rates of protection (ERPs). Even though there is informatlon on the level and structure of effective protec- tion for 1979 through 1981, there is no information for the wore recent perlod. Slce data on the historical behavior of ERPs (up to 1981) in Colombia is available in a number of publications and reports,LO/ Table 3.4 only contains the overall averages, standard devistions, maximti and minimum rates of ERPs for 1979, 1980 and 1981. The average rate of effective protec- tiou had declined steadily up to 1981 as a result of successive liberaliza- tion measures. In 1981, however, its dispersion, measured by the standard deviation was higher than in 1979 and 1980. Table 3.4 COLOMBIA: RATES OF EFFECTIVE PROTECTION, 1979-81 (percentage) 1979 1980 1981 Average 47.55 43.79 38.66 Standard Deviation 43.42 40.31 55.26 Maximum Rate 397.90 399.51 606.26 Minimum Rate -48.65 -45.78 -160.84 Sources: Giraldo, o2. cit., and DNP. lO/ See, for example, T.L. Hutcheson and D.M. Schidlowsky, -Colombia' in B. Balassa, Development Strategy in Semi-Industrial Economies (Johns Hopkins Press, 1982); G. Giraldo, op. cit.; J.A. Ocampo, -Politics Economica Bajo Condiciones Cambiantes de Sector Externo,' in Ensayos Sobre Politica Economica, 1982; and World Bank Report No. 4093-CO, a. cit.  - 48 - Public Sector Imports 3.21 At present import tariffs are not paid on most public sector imports (roughly one-quarter of all Imports Including petroleum) In Colombia, introducing an element of discrimination between the treatment of the public and private sectors. This policy also encourages the public sector to use a mix of inputs heavily based on imports. In practice, however, publlc sector agencies must apply for import duty exemption to the Industrial Dlvision of DNP, and about 30X of applications are rejected, causing some conflicts with- in the public sector. In principle, it may be preferable to elimitiate the present provision that exempts the public sector from the payment of import tariffs. This step would also help to achieve uniformity in the protective structure. Import Licenses 3.22 Import licenses have traditionally been an important tool for con- trolling the volume and composition of Imports. Between 1974 and ald-1982, and as a result of the liberalization process, the mumber of items subject to prior Import licenses declined steadily. In late 1982 and early 1983, how- ever, this tendency was reversed, as many items were moved from the free imports list into the prior licenses list. 3.23 The fact that a particular good is in the prior licenses list means that any person and/or agency that wants to import a certaln amount of that good has to apply for a license to INCOMEX. As INCONEX does not have recent experience in processing numerous applications, it takes between one and two months for a decision regarding any given application to be reached. At the present time the criteria for decidlng when to grant a license, to whom and for what amount has not been fully decided although some guidelines exist. It is not unlikely that if the foreign exchange situation is not improved in the near future, the government will attempt to revive the old practice of allocating a monthly quota of foreign exchange to INCOMEX, which, would then decide how to allocate it among different applications. 3.24 Table 3.5 presents informatioD on the proportion of goods within each section of the tariff schedule whIch were subject to prior licenses in 1979, 1980 and the first quarter of 1983. The major change in the second quarter of 1983, not shown in the table, is that most of the products in sections 1 through 4 have been moved into prior licensing. In addition, the October change has increased the prior licence coverage, particularly in Chapters 29, 39, and 41. These figures have been constructed as weighted averages, whereby the importance of each chapter has been weighted by relative imports to construct the averages. (Annex Table 13 gives the names of these sections.) In the agricultural goods sections--Section 1 (live animals and related products), and Section 2 (vegetables and related goods)- the number of items subject to prior licenses has increased significantly, when compared both with 1980 and 1979. This is especially the case for Section 1 where since April 1983, 92Z of imports are subject to prior licenses. The coverage has also increased for processed food sections (Sections 3 and 4). The change is especially dramatic when the coverage of prior licenses for Section 4 (food, beverages, alcoholic beverages and tobacco) is compared between 1980 and 1983.  - 49 - 3.25 For the rest of the sections (i.e. non-agriculture and non-food), the change in the coverage of the Prior License System is less drastic when compared with 1979. It is clear, however, that at the present time the amount of goods (weighted by their relative importance) subject to prior licenses has increased significantly with respect to 1980. Additional infor- mation regardin! the distribution of imports by regime is given in Annex Table 14 which presents disaggregated data at the chapter level for 1979, 1980 and 1983. Table 3.5 COLOMBIA: IMPORTS BY REGIME, 1979-831/ (Percentage under licensing; weighted average) 1st Quarter Section Chapter 1979 1980 19832/ 1 1-5 78 54 92 2 6-14 82 79 90 3 15 71 65 89 4 16-24 51 20 90 5 25-27 72 53 51 6 28-38 74 22 20 7 39-40 45 30 48 8 41-43 68 19 38 9 44-46 99 74 60 10 47-49 53 38 59 11 50-63 45 45 81 12 64-67 68 18 69 13 68-70 28 15 54 14 71-72 74 0 24 15 73-83 51 46 63 16 84-85 50 48 45 17 86-89 80 76 84 18 90-92 22 18 31 19 93 100 100 100 20 94-98 90 62 96 21 99 100 100 100 l/ For a description of goods included in each section, see INCOMEX, Arancel de Aduanas Legis. 2/ Subsequent changes in May and October 1983 have essentially - raised the percentage for Chapters 1 through 24 to 100. Sources: Annex Table 14, and weights presented in Annex Table 15; L.P. refers to prior licensing. Other Restrictions to Trade 3.26 In addition to tariffs and licenses, there are a number of minor taxes to imports that also play a role in restricting trade. The following are some of the most important ones:  - 50 - (a) Prior Deposit. According to Resolution 2/82 of the Junta Monetaria, the importation of a number of goods is subject to a 1OZ prior deposit payable before the nationalization of a commodity. This deposit does not yield any interest, is not negotiable and can only be used to pay a portion of the import of that particular good. Under some exceptional cases these deposits can be used to pay imports of other goods (Resolution 16/82 of the Monetary Board). All these restrictions, however, were eliminated by Resolution 99 of 1983, which also eliminated the maximum payment period of imports and prior deposit for transport cost. (b) Five Percent Tax. According to Article 229 of Decree 444 of 1967 all imports into Colombia are subject to a 5% tax over their CIF value. The proceeds of this tax are used to finance PROEXPO. (c) One and a Half Percent Tax. According to Article 20 of Decree 688 of 1967 all imports into Colombia are subject to an additional 1-1/2 percent tax. The proceeds of this tax are used to finance general purposes under the government budget. E. Policy Inplications of Recent Developments Increasing Trade Restrictions 3.27 Towards the end of 1982 there was a clear movement away from the tendencies to open up the economy observed since 1967. Even though the increase in the level of nominal tariffs has been relatively minor, the coverage of the import licenses system has Increased dramatically. By May 1983, roughly 562 of the positions on the impoxt list were under prior licensing: by March 1984, some 85% of the positions accounting for some 70Z of the value of imports are estimated to be under prior licensing. It is important to consider how the wider coverage of import licenses will affect Colombia's external sector. 3.28 The reversal of the trend towards trade liberalization can be expected to affect both the structure and level of production. First, the increase in the level of protection (i.e. higher tariffs and/or more restric- tive licenses) will help to partly compensate the present overvaluation of the peso, and will result in a higher real effective exchange rate for importables (i.e. import-competing goods, see Chapter 1); to that extent, the degree of competitiveness of this group of goods will increase and its pro- duction will tend to expand. However, where tariffs and licenses are used, as in this case, a serious problem is that the recovery of the importable sector will partially take place at the expense of the exportable sector. The higher real effective exchange rate for importables will mean a lower real effective exchange rate for exporters ini relative terms. This policy of using commercial policy to promote importables is equivalent to imposing a tax on exportables.11/ Consequently, while tariffs will tend to generate an increase in the level of activity of importables, they will also tend to produce a decline in the level of activity of non-coffee exportables (especiall; non-traditional exports). 11/ The symmetry between import tariffs and export taxes holds in both a world with and without non-tradeables goods.  - 51 - 3.29 Furthermore, the increase in protection would tend to affect the overall level of activity of the economy. It has been extensively documented that export-promotion oriented economies tend to outperform import- substitution economies in terms of growth, income distribution and employ- ment.12/ To the extent that the new commercial policies result in an implicit tax on exports, a slowdown in overall growth could be expected. Recently the authorities have recently also raised export subsidies. If the increase of tariffs and export subsidies are sufficiently large, this com- bined policy could generate an effect on relative prices similar to that of a devaluation. However, this does not seem to have happened in Colombia as the increased imports restrictions have dominated the additional export incen- tives. This means that the export-tax effect discussed earlier is likely to result from the recent policies. Use of Import Licenses 3.30 From an economic point of view, the Colombia import licenses system is similar to a quota, or quantitative restriction system. The main differ- ence, however, is that in the case of licenses the quantity of any particular good that can be imported in any period of time is not known a priori by the public. Also, this quantity can be easily altered by the authorities, in response to different circumstances. In a sense then, it may be said that the Colombia licenses system are equivalent to a -flexible' quota system. This import licenses system has two basic economic effects: (a) it restricts the amounts of a good that is imported; and (b) it produces an increase in the domestic peso price of licensed goods, over and above what it would be in the absence of the license. (This means that the domestic price of the imported good will exceed the foreign price plus the tariff, transport costs and other normal adjustments). From an efficiency point of view, and to the extent that the allocation of licenses is administratively decided by the authorities without the possibility of resale of licenses, this system can potentially lead to corruption and welfare costs that would exceed those of an equivalent import tariff. Moreover, to the extent that the allocation of licenses is arbitrary, there will be income distribution effects associated with the scheme, where those parties that obtain the quotas would get the related rents, while consumers will get losses associated with the higher prices they would have to pay. Effect on Imports 3.31 At present, it is not possible to know with any degree of certainty the effects that the 1983 increase in the prior licenses coverage will have on domestic prices of importable goods. By the nature of these licenses, the final outcome concerning the volume of imports, will depend on how applica- tions will actually be approved by INCOMEX. The effect of this policy on domestic prices will depend on: how restrictive the license will actually be; the elasticity of demand for imports of those goods; and the process by which the licenses are allocated. 12/ At this stage the evidence suggesting that in terms of growth, liberal- ized export-oriented economies outperform inward-looking economies is overwhelming. See Krueger, op cit; Bhagwati and Srinivasan, op. cit.; I.M.D. Little, T. Scitowsky and M. Scott, Industry and Trade in Developing Countries, (Oxford University Press, 1970).  - 52 - 3.32 With respect to the level of restrictiveness of licenses, the his- torical evidence available indicates that at least for agricultural goods, licenses have been fairly restricting, having a fairly considerable effect on prices. Domestic prices of some agricultural goods have significantly exceeded world prices (corrected for tariffs, taxes, and estimated transport costs). In the absence of import licenses, it is probable that the domestic price of an imported good (Pd) will be equal to the international price adjusted for the tariff and other taxes and domestic transport costs.'3/ The difference between the prices observed when import licenses are in effect, and Pd can then be attributed to the effect of the import licenses. The available information on the price elasticity of the demand for imports refers to fairly aggregated categories of goods. The studies that have empirically analyzed the subject have found price elasticities of demand for imports that range from -0.17 for capital goods to -1.52 for con- sumption goods,__/ which would imply that a significant price increase can result from additional import restrictions. Tariffs vs Licenses 3.33 If it is intended that increased protection should be temporary, it would be desirable to compare the merits of tariffs or licenses as alterna- tive means to achieve it. The disadvantages of licenses-both from a welfare and administrative point of view--are well known. From a pure efficiency perspective tariffs would be preferred over licenses.15/ However, in the present case of Colombia, one should take into account an additional con- sideration: which of the two systems (tariffs or licenses) is more likely to be temporary, or which of these two measures will be easier to reverse once the exchange rate problem is solved. Licenses are determined by a high level Ministerial Advisory Committee for the External Sector and a resolution is signed by the Minister of Economic Development. The recommendation for a tariff change is made by a Vice Ministerial Comittee to the President and the Minister of Finance, and a decree is signed by the President. It is not clear which of the two--tariffs or license--is more temporary on institu- tional grounds. A point that favors licenses as temporary protective measure, is that by their own nature they can easily become non-binding if everyone who applies for a license would immediately get one. F. Conclusions and Policy Suggestians Import Liberalization and Phasing 3.34 The major objective for the most recent changes (1983-84) has been to arrest the decline in international reserves, rather than to provide 13/ Pd - P*[(1+t) + T] + r, where P* is the cif world price, t is the tariff, T are other taxes, and r are domestic transport costs. 14/ See, for example, A. Brillembourg, -Specification Bias in the Demand for Imports: The Case of the Colombian Countries', IMF, 1975; K. Marwah, -An Econometric Model of Colombia', Econometrica, 1969; A. R. Husalem, Dinero, Inflation Y Balanza de Pagos: la experiencia de Colombia, Banco de la Republica, 1971; M. S. Kahn, -Import and Export Demand in Developing Countries", IMF Staff Papers, (1974). 15/ See, for example, Krueger, op. cit. and J. N. Bhagwati, Anatomy and Consequences of Exchange Control Regimes, (Ballinger, 1978). Tariffs are particularly superior in the case where licenses cannot be resold.  - 53 - additional protection to the domestic industry. A gradual reversal of the recent restrictive measures would be desirable from the point of view of the production sectors as export policies begin to take effect. Liberalization may need to proceed in stages in order to lower the adjustment costs to domestic producers and the short-term employment impacts. In particular, a major liberalization while the exchange rate is appreciated can be problem- atic, and it will need to be tied to a depreciation of the peso to reach an equilibrium level. 3.35 In the meantime, it would clearly be desirable to utilize controls that are temporary in nature, easy to apply, and relatively cost-effective. Studies in other countries have demonstrated that tariffs (if applied fairly uniformly across sectors) are preferable to quantitative restrictions, since they (the tariffs) allow the volume of international trade to respond with greater flexibility to changes in domestic demand and supply. At the same time the flexibility of the control instruments ultimately depends on the ease of making changes, given Colombian administrative and legal procedures. 3.36 Even though there are no infallible answers, for the present Colombian case it seems advisable to reduce import restrictions as the real exchange rate reaches an equilibrium and exports respond to the improvements in the real extz2ange rate. In the short-term, however, if there is no way to induce quick real exchange rate adjustments, it may be advisable to undertake a temporary tariffs-cum-export subsidies policy in addition to the exchange rate depreciation. If this policy is adopted, it is essential that: (a) the newly imposed import restriction policies are temporary, and (b) that the public is made clearly aware of the temporary nature of these policies. Improving on Licensing Methods 3.37 It would be desirable to rely on a system that maximizes the prob- ability that the recent increase in protection will be temporary. If it is decided that licenses are best suited for this purpose, their allocation should be made in a way that captures different parties' willingness to pay for them. In view of the problem with international reserves, one criterion for licensing at present is the availability and terms of external financing for imports. In general, however, licenses are, in good measure, fairly arbitrarily allocated; their recipients gain the implied rents. Auctioning the licenses would increase the efficiency of the system and transfer the rents to the Government. 3.38 The Government could periodically (say every three months) announce through INCOMEX the auctioning of a certain number of licenses for selected commodities. Interested parties would then submit bids that would specify the unit price they are willing to pay for different numbers of units of a commodity. These bids would be added up, and the clearing price-consistent with the amount to be auctioned--would be determined. This procedure will allow the Central Government to capture the rents derived from licenses, and would avoid serious income distribution and efficiency problems. Ideally this scheme could be supplemented with the possibility of licenses being transacted in the open market. Additional work is needed before such a pro- posal can be put into effect; it might also need to proceed in stages, initially focusing on selected commodities on a pilot basis. Annex 7 pro- vides some background information and a bibliography on the subject.  PART H AGICULTURAL PRICE POLICY  - 54 - Chapter 4 PRIRC IlTmVKUTIONs COI1EMESS AND DiCZENIQVS A. Introduction 4.01 This chapter is concerned with sectoral price interventions, and their effects on profitability, incentives and efficiency in agriculture.l/ As set out in Chapter 1, since the mid-1970s the Impact of macroeconomic policies on non-coffee agriculture has on balance been negative, while coffee benefited from a price boom during 1976-80. Sectoral policies, on the other hand, have been intended to directly boost agricultural production and income. These policies include price incentives effected through price supports, import protection and export subsidies, and non-price inducements by way of the Government's efforts in agricultural investments, input supply, research, extension and transfer of technology. These interventions favor agriculture, and, to varying extents and degrees of efficiency, have helped to offset some of the (unintended) disincentives from macroeconomic policies, thereby improving the profitability of agricultural production. 4.02 A major intervention is represented by protection to Importables, effected by a combination of import controls and price supports. These levels of protection in Colombia are generally considered high (section C below), and tend to more than offset the appreciation of the exchange rate. However, only about 1OZ of agricultural output (Chapter 1), the degree of protection cannot be considered pervasive. The levels of protection declined somewhat during the first half of the 19709 and increased thereafter, so that during the 1970s as a whole no significant trend can be observed. The com- petitiveness of import-competing products as well as export items is influenced also by exchange rate changes and the rate of inflation. 4.03 More generally, incentives in agriculture as a whole are influenced by the levels and changes in product prices in agriculture--consisting not only of exportables and importables but also of the large group of domestic products (30X of agricultural output)-relative to the rest of the economy. These relative prices are affected by government interventions as well by market forces. The discussion of price supports and import restrictions will therefore be complemented by analyses of measures of competitiveness and relative prices in agriculture, and the extent to which government policies may be significant in these respects. B . Governent Interventiozo in Agriculture Major Interventions 4.04 Four types of direct government interventions may be distinguished in Colombia agriculture, the first two operating in the external sector, and the remaining two in the domestic agricultural sector: (i) agricultural trade restrictions including import tariffs, and import/export licensing; 11 Previous discussions include R. Junguito Bonett, -Agricultural Incentives in Colombia", mimeo., the World Bank, 1982; E. Sarmiento Palacio, Inflacion, Produccion y Comercio Internacional, CFEDESARROLLO, (Bogota, 1982).  - 55 - (ii) agricultural export subsidies, and in the case of coffee, export taxes; (iii) output price supports; and (iv) price fixing in output and input markets. Direct price controls are set by the Ministry of Agriculture (MoA) for cocoa, sugar and sisal, and for fertilizers and pesticides, although the Ministry (through IDEMA, the Agricultural Marketing Institute) intervenes directly in the market to buy or sell only sisal and some sugar. Producer price supports for wheat, barley, corn, soybean, sorghum, sesame, beans and rice are set by IDEMA, and the Ministry (see paras. 4.06 and 4.09 below). 4.05 Price support policy is closely linked to import licensing. Imports of all food crops are controlled by INCOMEX (the Foreign Trade Institute). Permission to import is only granted after INCOMEX is satisfied that a deficit for the crop exists at the prevailing price level. Thus, the support price can in principle be maintained without a subsidy even when the international price may be lower. Other than coffee, the major agricultural exports from Colombia include sugar, flowers, banana, cotton, rice and tobacco, each of which is eligible to receive the subsidized PROEXPO credit. In addition, several products currently receive CERT (the export incentive) of 20%-25% (example, 25% for rice and livestock, 20% for cotton).2/ As a member of the Sugar Exporters' Association, Colombia faces a quota on its exports of sugar. The domestic price of sugar is fixed by the MoA after negotiations with the Sugar Growers' Association (PROCANA) and the Sugar Mills Association (ASOCANA). This price takes into account the cost of pro- duction and the level of international prices. Cotton and rice currently receive a variable export subsidy over and above CERT, depending on the level of international prices. 4.06 The main instruments of protection to agriculture are tariffs and quantitative restrictions on imports, and subsidies to exports. In Colombia, exports of agricultural products has been usually subjected to a quota, with the possible exception of flowers, banana and tobacco. Priority has been given to first supplying the domestic market; when this requirement has been satisfied and a surplus remains, permission to export has been granted. In the case of coffee, export quotas have been set in recent years by the International Coffee Organi7ation (see Chapter 6). Domestic producers and consumers of cotton have been obliged to reach an agreement on quantity as well as price before the Government decides on export permits; as is to be expected, this provides more leverage to domestic consumers (i.e. the texvile industry) than to producers. Rice export permits have been granted only if a production surplus is expected. In the case of imports, most purchases are made by IDEMA; and INCOMEX normally does not grant an import license without prior consultation with IDEMA and the MoA. As a result, the protection granted to the production of a particular product does not constitute the legal tariff rate or export subsidy alone, but may be significantly higher. The combined effect of tariffs and quantitative restrictions is nevertheless reflected by nominal protection rates measured by a comparison of the domestic and international prices (see section C). 2/ Chapter 2 spells out differentials in export incentives for various products. Although much of the differentials have been eliminated, the degree to which exports of different agricultural products benefit from these subsidies varies. Flower exports to the U.S., for instance, receive only a 1% CERT on account of objections by the U.S., compared to 20% in the case of those to other countries.  - 56 - IDEMA's Policy 4.07 The main functions of IDEMA are to buy, sell, and distribute certain agricultural products; to maintain adequate operating stocks; to import and export certain other products and intervene in the marketing of strategic agricultural commodities. One of IDEMA's main tools is the provi- sion of support prices for wheat, barley, corn, sorghum, sesame, beans and rice. The purpose of the price supports--announced twice a year at the beginning of the planting seasons--is to guarantee that domestic producers can recover production costs or realize a minimum level of income per unit of output.3/ Price support and import policies are closely related and IDEMA attempts to supply short-term deficits by imports and to build up stocks to tide over periods of short supply. 4.08 In addition, import policy seeks to at least equate prices of the imported products with the support prices plus distribution costs.4/ Most of IDEMA's imports and sales involve raw materials and intermediate produc- tion inputs. Various reasons are given for this emphasis: domestic produc- tion of raw materials falls short of domestic consumption (this is true of wheat, sorghum, corn, soybean cake and milk, all of which IDEM& imports); the market structure for raw materials is imperfect; and the share of imported raw materials in the production costs of food for direct human consumption is high. More significantly perhaps, IDEtA's interventions in general help the Government to appropriate economic rents from import controls which would otherwise go to private industry, and also help to protect the domestic pro- ducers of agricultural raw materials.5/ Level of Price Support 4.09 In principle, price supports take into account estimated farm pro- duction costs and international prices. In practice, imports are kept under prior licensing (with global import quotas by product and by semester), and buyers of the products imported by IDEMA continue to pay IDEMA. the full difference between the domestic support price and the cost of importing. Support prices have increased at a rate approximately equal to the rate of inflation from a base determined in the early 1970s, and the real value of support prices has not changed on the average since 1970 (See Tables 4.1 and Annex Tables 16 and 17). However, after 1975 the real peso value of price supports declined--with the exception of rice--following steady increases in the value of the index during 1970-1975. In the second half of the 1970s, the general intervention also declined except for sesame and wheat. This reduced level of intervention resulted partly from the precarious financial situation faced by IDEMA as a result of the huge losses which it incurred in the period 1970-1974 and continued to accumulate since then. 3/ L. F. Londono Capurro, Politica Agropecuario 1981-1982 (Bogota, 1982), p. 26; IDEMA, Filosofia de 'os Precios de Sustentacion, mimeo., November 1982, p. 4; E. Sarmiento, Objetivos del IDEMA, mimeo., pp. 8 and 84. 4/ A. Ramirez Ramirez, IDEMA: Dos Anos de Labores 1980-1981 (Bogota, 1982), p.31. 5/ IDEMA, La Intervencion del IDEMA en el Mercado de Alimentos y Materias Primas mimeo., January 1983, p. 8.  - 57 - 1w1a 4.t- mm R aRNG ACiD m E Plll/ 190-1D64 (In peea/tn.) 1980 191 1982 l983 l984 I II II I I I U I II UFT Swport Price 12,00 14,000 15,500 17,500 19,000 20,600 22,500 24,750 26,730 29,50 itt Preice - 13,500 14,86 1.5,960 138L 19,037 20,534 22,340 - Ia Funalse Prie 11,925 14,744 15,887 17,825 19,129 21,401 23,114 25,45 - - UM Pard.ha_/ 85.* 29.4 49.51 41.72 91.7 50.1Z 80.72 - - - CM b/ support Prie 9,600 11,680 14,040 15,986 18,20 20,246 22,965 23,980 26,380 27,700 tolt Price - 13,825 13,465 14,200 16,354 19,172 21,144 23,810 - - UtF PFrdse Prie 8,950 11,480 13,52 14,95B 17,642 18,863 21,997 22,7W9 - - INtA FPrdtan 0.3Z 2.8Z 2.1Z 3.22 3.52 6A6 3. - - - SM 9-nrt Price 14,930 16,000 21,200 24,000 27,600 30,300 33,000 35,475 39,40D 43,340 Iqi let Price - 19,150 21,3W0 24,000 27,634 31,1% 34,000 37,213 - - MDt PFrdae Prce - - 20,325 23,625 27,168 30,245 30,44W 35,504 - - lm artia - - 0.1Z 6.72 2.(1 Om 0.1L - - - sport Price 8,645 9,800 11,500 13,200 15,000 16,7W0 17,900 19,240 20,780 22,440 toket Price - 11.436 12,22 13,269 14,1M 16,971 17,585 19,320 - - MU Purdim Pric 8,32 9,568 11,182 12,624 14,730 16,189 17,463 18,611 - - t Burdmis 3.32 24c 7.5Z 12Z 19.7z 8.62 6.72 - - - suppot Price 23,820 23,820 29,820 31,000 32,000 35,000 36.200 42,020 46,220 58,240 ;oilet Prim - 29,800 24,500 28.000 30,500 40,000 40,00D 44,6A - - It E baSis Prce 29,554 23,65L 29,53 30,611 31,568 34,275 37,310 41,406 - Ut dme 93.s 18.1Z 89.s 10.3Z 33A4 4.42 3*M - - M- SapDrt Price 30,000 37,500 40,500 45,000 46,000 52,000 58,300 64,130 69,900 85,000 toilt Prie - 40,000 44,000 52,500 60,800 63,500 67,700 69,50 - - MMt ordns Prce - - 30,666 36,173 - - 41,5e 63e4,2 - - Ut lwdas d - - 2.1Z 02Z - - OS3 - - - Om C/ Support Price 9,957 li,777 12,720 14,500 16,200 18,100 19,900 21,700 24,180 25,390 Moet Price - - 10,860 13,250 14,790 14,550 7,137 17,605 - - UMlt Prde Pric 9,27 10,418 10,647 12W97 13,460 14,882 16,344 17,6 - - mmN PEzduW 5A4 10.9Z 0.2Z 1.9Z 1.42 17.12 10.1Z - - - aWM Support Price 9.800 10,500 13,000 15,000 16,800 18,600 20,100 22,5W 24,750 3,500 toilet Price - 12,5W0 14,50 14,000 15,438 17.450 18,50 21,500 - - ItM ordimse Price - - - - - 15.750 - 19,840 - - IUtEPrd.. - - - - - 2.1: - - - - Not: 2. n-Irt prim is am fwr a certain graie af th crap, ally a suprior a. a so tie aFv pm Wid by Tt is tyLclly lone. 2. te prlce is tUe naticwl meie fnrte price. - tbt mUlle. a! As a prportion of ttt pndctlio . b(Weifght a 9 for Sake and ye1m corn. A feor faM 7, 8, 9, tetiCe ar Oryzics. 9-Ut. BEST COPY AVAILABLE  - 58 - 4.10 The price support increases in 1983 were fairly uniform and corresponded closely to inflation levels. For example, the increases announced for semester I of 1983 ranged from 7X to 9% for all crops which do not reflect the initial gap between domestic and international prices for these crops. Similarly, while IDEMA claims to be concerned with stock levels, last semester's support price for rice was raised by 9%. This occurred even though IDEMA had large stocks of rice from the previous year which it could not profitably export and, according to IDENA's own estimates, costs of production increased by only 5% during the semester. Thus it appears that changes in IDEMA's support prices are based primarily on the rate of inflation. This implies an attempt to ensure that farmers' returns for a crop do not drop below previous levels in real terms rather than an attempt to alter the production mix. Effect of Policy 4.11 IDEMA's support price is offered for a certain grade that is usually higher than average, and the support price is therefore typically higher than the average price actually paid by IDEMA (Table 4.1). The support price for a commodity is uniform across the country. Both the announced support price and the average price actually paid by IDEMA are usually above what the market price would have been in areas located far from consumption centers, but lower than the average open market price in the country (see Annex Tables 18 and 19). Consequently, IDEMA manages to purchase only a small fraction of output for most crops. In general the total value of IDEMA's purchases does not exceed 1% and 3% of the total value of agricultural output in non-coffee agriculture. The major exceptions to this are wheat and sesame where IDEMA has purchased 49% and 43% respectively of the total annual production during the last 3 years. Therefore, while IDEMA has a strong influence in stimulating production and raising farm incomes for some products in some regions, its price support role is not a major policy tool for stimulating production nationwide. C. Protection and Efficiency in Agriculture 4.12 A comparison of domestic prices with international prices (Annex Table 20) provides a measure of the extent to which domestic production is protected from external competition. Annex Table 21 contrasts the f.o.b. prices of major traded commodities with Colombian prices at the official exchange rate during 1970-82. Admittedly, these comparisons are rough. No quality adjustments are made in comparing external and internal prices. The use of the official exchange rate does not account for the overvaluation of the peso that has occurred since the mid-1970s. As a result, any Implicit tax on exports (i.e. domestic price being below the external) would be under- estimated, and protection to imports (i.e. external price being below the domestic) would be overestimated. Finally, a more correct price comparison for import competing commodities would be between the farugate price and the Colombia c.i.f. import price plus port and transport charges to the consump- tion center, less transport cost from the farm to the consumption center. In the case of exports, the Colombia f.o.b. price would be compared to the farm- gate price plus all transport and port charges (see para. 4.19). The present comparisons may only be used to suggest broad differences in the treatment between imports and exports, and general trends over time.  - 59 - Exports vs Import-Competing Products 4.13 Export agriculture in general is implicitly taxed, and import-com- peting agriculture is protected (Annex Table 21). For most export commodi- ties (rice, coffee, banana, tobacco, cotton, sugar), the ratio of domestic to international prices (f.o.b.) is significantly less than one, no matter whether the export crop is food (such as rice) or non-food (such as cotton).6/ Even after adding international transport costs to the Colombian prices most of these price ratios would appear to be less than one. In the case of import-competing crops (barley, corn, wheat, sorghum, soybeans and butter), the domestic to international price (f.o.b.) ratio is significantly higher than one, suggesting that one government objective is to achieve food self-sufficiency, although this aim may not be intended for each specific crop. 4.14 Food self-sufficiency, however, is being pursued at a high cost for many import-competing products, as the nominal protection granted these pro- ducts at times reach levels of between 50% and 100%, as in the case of corn, wheat and sorghum. Moreover, the implied costs from protection has increased in the last two years as protection levels have gone up significantly. For animal products such as beef and milk, and parlicularly butter, there appears to be some measure of protection. The rates of nominal protection for beef and milk, however, have to be interpreted with particular care, since the domestic price of beef seems to be the average of different qualities of meat, while the international price of meat is for the best quality of meat.7/ 4.15 The pattern of protection during 1970-1982 as a whole has been rather stable-export crops remaining implicitly taxed during rhe entire period, while import-competing food crops were being protected at the official exchange rate, and even after accounting for the growing overvalus- tion of the peso since the mid-1970s. One export crop which exhibits a wide variability in its index of nominal protection is sugar; at times it appears heavily taxed, while at others it seems to be heavily protected. The reason for such volatility rests on the goal of keeping prices in the internal market relatively stable, in the face of highly volatile international prices. Protection and Efficiency 4.16 The levels of nominal protection have been positively related to the inefficiency in production for a s all group of food crops such as wheat, corn, sorghum and soybeans. This conclusion is based on comparisons of average production costs with their international peso price (see Annex Tables 22 and 23). Production of corn and wheat would appear to be 6/ Beef seems to be protected as shown in Annex Table 16. However, the difference between the domestic and international price is probably absorbed by the marketing margir from producer to wholesaler. 7/ Also, the international price used when making th- price comparison for milk is the U.S. producer price (as supplied by the Central Bank) for lack of a better indicator, while the quality of Colombian and US milk is quite different.  - 60 - inefficient by international standards and the levels of nominal protection received barely serve to cover the high costs of production. The production of soybeans and sorghum is less inefficient when compared with international standards, and the corresponding levels of nominal protection these products receive are smaller than for wheat and corn. Cotton and rice seem to be com- petitive but historically they have been implicitly taxed; recently Increased CATs and a variable subsidy have sought to offset the disincentives from an appreciated exchange rate and declining domestic competitiveness. 4.17 In general, it appears that crops whichl can be developed as export crops and are able to compete successfully in international markets (example, rice and barley) are not stimulated but taxed. only when export crops develop problems in external markets are support measures devised and imple- mented, as in the case of cotton and more recently, rice. On the other hand, import-competing crops which do not have a chance of standing up to external competition have received ample protection, but little has been achieved in terms of increasing their output. Most of the protection granted to import- competing crops has gone to food crops, particularly cereals, which, in general, do not appear to enjoy a comparative advantage, with the exception of rice.8/ A blore Precise Estimate of Protection 4.18 Strictly speaking, for importables the farmgate price should be compared to the c.i.f. import price plus port and transportation charges to the consumption point less transportation charges from the farm to the con- sumption point. Data on port and transportation cost, however, are not readily available. If it is assumed (as done below) that the sum of port charges and transportation costs from the port to the consumption point is equal to the transportation costs from the farm to the consumption point, a direct comparison of the c.i.f. price with the farmgate price would be possible. Since port charges in Colombia are high, this simplifying assump- tion would lead to an overestimation of the nominal rate of protection. In a sense, the resulting estimate gives a measure of protection both from policies of import restrictions (including tariffs), and from the "natural' protection in the form of high port charges. The nominal rates of protection thus calculated for five major import crops are given in Table 4.2. The high nominal rates of protection imply that the bulk of the importable crops receive a production subsidy in the sense that they could have been imported more cheaply. The protection rates implicitly impose a consumption tax since retail prices are based on mark-ups from the protected farmgate prices. The distortion suggests possible gains from lowering import restrictions. 8/ On the matter of comparative advantage and domestic resources costs see Econometria, Ventajas Comparativas de Productos Agropecuarios en Colombia, Volumen I (October 1982), a report prepared for DNP.  - 61 - Table 4.2 ODLOMBIA: NOMINAL RATES OF PROTECTION FOR SELECTED IMPORTABLE CROPS, 1980-82a/ (Percentage) 1980 1981 1982 Wheat 36 45 91 Corn 87 67 79 Soybean 37 46 85 Sorghum 67 57 110 Beans 42 186 106 a/ Measures the percentage difference of farmgate over international prices (c.i.f. Colombian ports). Source: IDEMA, DNP and mission estimates. 4.19 Calculating nominal rates of protection for Colombia's exportable crops is difficult for two reasons: (i) the comparison must now be made between the Colombian f.o.b. price and the farmgate price plus the sum of transportation costs to the port and port charges-the earlier simplifying assumption on transportation and port charges can nc longer be made; (ii) Colombia's exportables such as sugar, cotton, rice, flowers and tobacco, unlike the importables, have significant processing costs before they can be exported. One way to circumvent these problems is to compare the f.o.b. price to the domestic wholesale price on the assumption that the wholesale price approximates the farmgate price plus processing and transportation costs. However, the problem with port charges remains as well as the differ- ences in quality between domestically-consumed exportables and actual exports. For these reasons a more precise estimate of protection rates for exportables has not been attempted. However, nominal rates of protection for exportables are expected to be significantly lower than for importables, and may be negative at least for some crops in severa: years. 4.20 Another measure of the degree of protection for a crop is given by the effective rate of protection (ERP). The ERP can be thought of as the subsidy to value-added / and is, therefore, in principle a better measure of the incentive given to a farmer. It takes into account both distortions in the output price and In the prices of traded inputs. If the inputs receive the same degree of protection as outputs, the nominal and effective rates would be equal. Since agricultural inputs in Colombia receive much lower protection than outputs, especially importables, the ERP would exceed the nominal rates given earlier. Therefore, importables unambiguously receive high rates of protection- T.,e ERP expzirtables, however, is more difficult to determine for the same reasons mentioned in the case of the nominal rates. 9/ See E. Tower, Understanding Shadow Prices, Second-Best Tariffs, the Effective Rate of Protection and Domestic Resource Cost from the Perspective of Simple General Equilibrium Models,' World Bank uimeo, July 1983.  - 62 - Evaluating Protection: The Case of Wheat 4.21 The stated purpose of the protection given to farmers, at least for wheat, is not so much to stimulate domestic production (in which IDEMA has had limited success since over 80X of the Colombian consumption of wheat is still imported) as to increase farm incomes in certain regions. The concerns are the cost of this policy in terms of net efficiency loss and the impact of this policy on farm incomes, consumer welfare and government revenues. In considering elimination or reduction of the high protection to wheat, con- sideration should also be given to the fact that certain other commodities which are substitutes or complements for wheat in either consumption or pro- duction face import tariffs or receive export subsidies. Removing all dis- tortions from wheat alone would lead to resources moving into the production of say, barley, which is protected. Assuming that barley is a perfect sub- stitute for wheat in production, the second-best policy would be to equate wheat's ERP with that of barley, while equating the tariff for wheat with that of its substitute good in consumption.10/ 4.22 Calculating the welfare cost of protecting wheat from the support prices-cum-import restrictions when price supports or import restrictions for all other crops remain unchanged is therefore not adequate. This is because the welfare loss is likely to be negligible since wheat's major substitutes in production, barley and livestock, and its major substitute in consumption, corn also have fairly high levels of protection. The more interesting case is to calculate the potential welfare gain if IDEMA were to lower its support prices for all its imported crops to an optimal level but all other distor- tions remain unchanged. The optimal price level for each crop in this case will be the c.i.f. price plus the average distortion on its substitute goods in consumption and production. Thus the second best optimal policy would be to remove all licensing requirements and impose a tariff equal to the average distortion on its substitute goods in production and consumption. 4.23 The welfare impact on consumers, producers and the Government associated with moving to this optimal level is shown in Annex 8 for the case of wheat under three different scenarios: the average distortlon on the sub- stitute goods is 10%, 15% or 20% implying optimal tariff levels for wheat of 10%, 15% or 20% respectively. The distortion level is based on the assump- tion that the resources diverted from wheat production and consumption are used to purchase or produce an average' bundle composed of exportables, importables and non-traded goods. The range for the distortion from 10% to 20% depends on plausible parameters for various combinations of the distribu- tion of importables, exportables and non-traded goods coupled with average levels of import tariffs and export subsidies. Based on an analysis of producer and consumer surplus, the results show that it is the consumer who would stand to gain most from the policy whereas the Government and IDEMA would lose the most. The net efficiency gain varies from Col$163 to $226 10/ In reality, of course, even if the land used in wheat can only otherwise be used for barley, it is not likely to be true for all factors of production (labor may migrate) and so one cannot think of perfect substitutes. Instead one needs to think in terms of a series of substitute goods in production (consumption) with different weights given to their ERPs (tariffs) depending on how close a substitute the good is.  - 63 - million depending on the distortions in the rest of the economy. The net efficiency loss is modest as compared to the value of consumption (less than 1%). Even when the elasticity of supply was increased from a short-run value of 0.6 used in the analysis to a long-run elasticity of 1.2, the efficiency gain as a percentage of GDP increases to only slightly over 1% in the 10% distortion case. IDEMA's Interventions 4.24 A comparison of IDEMA's support prices with international prices (Annex Table 24) shows a tendency to protect the production of those com- modities for which the country does not appear to enjoy a comparative advant- age such as corn, sorghum, wheat 2nd soybean, while it does not promote the production of those products such as rice and barley in which the country is able to compete in international markets. In addition, the elements and pattern of protection has varied since 1970. While the ratio of support to internationail prices declined in 1970-1975, it increased in 1976-1982. The reason is that during 1970-1975, the increase in costs that had to be covered by higher support prices was smaller than the rise in the peso value of the international price, thereby accomplishing the double objective of a more efficient agriculture and of increasing the real incentives to domestic agri- cultural production; the opposite behavior of costs and the peso value of international prices occurred during 1976-1982, and it is for this reason that an increasing level of protection resulted. As regards those commodi- ties for which the country seems to enjoy a comparative advantage and for which IDEMA's support prices are lower than international prices, the reasons for IDEMA to intervene are to build up working stocks and to support pro- ducers when bumper crops result at the regional level. IDEMA's Impact - 4.25 In certain regions there may be a production impact, but nationwide it is not significant. Only in the case of paddy rice and wheat have support prices been higher than average nationwide producer prices during 1970-1982; for all other products-sesame, barley, beans, corn, sorghum and soybean- average nationwide producer prices have in general been higher than support prices. Thus only in the case of wheat and sesame, price supports may have been an effective incentive to boost output, both because support prices are higher than producer or international prices and because the participation of IDEMA's purchases in the market for these products is rather large. It is doubtful whether intervention for the rest of the products has any signific- ant impact either in raising production or in guaranteeing a minimum return to the producer: the Institute's intervention in these cases is to be looked upon rather as a help to producers at times when excess production problems arise at the regional level or for building up stocks to complement the Institute's function as a distribution entity. 4.26 The support prices for most importables can be maintained above their international prices because imports are restricted. INCOMEX must approve the import of every crop whose price is supported by IDEMA. It grants a license only after consulting with IDEMA and the MOA and after con- firming that a deficit for the crop exists. This is to ensure that consumer prices do not fall below IDEMA's support prices. IDEMA may import the commodity without paying any tariffs, whereas other importers must pay  - 64 - between 15.5% and 24.5%. While IDEMA's domestic purchase price may be higher than its import purchase price, the price at which IDEM& subsequently sells is based on its domestic purchase price.ll/ Thus IDENA obtains all the rents from the system of tariffs and licenses. For example, the farmgate price of wheat in 1982 was 91% higher than its c.i.f. price. Even after accounting for differences in the costs of transportation from the port to Bogota versus Pasto, the major wheat growing region, to Bogota, the farmgate price remains about 70% higher than its import parity price. Since tariffs on wheat in 1982 were only 16.5% until October (when they were raised to 18.5%) and IDEMA does not pay tariffs anyway, the 70X differential constitutes rents to IDEMH and port charges. Port charges have been estimated to be very high in Colombia and are likely to have elements of rent. IDEMA's Problems 4.27 IDEMA's accumulated losses (estimated at about US$200 million in 1983) pose serious financial and economic dilemmas for the Government. Basic issues concern the objectives IDEMA. is expected to achieve, and the cost- effectiveness of its policy instruments. Preliminary analysis of IDEM&'s 1983 operation reveals a distinct pattern the institution makes a gain on its imports, but incurs a heavy loss on its domestic purchases. For example, it is estimated that on domestic purchases costing some Col$17,539 million of agricultural commodities, an operating loss of about Col$2,936 million (or 16.7% of the cost of purchases) was incurred. At the same time imports cost- ing some Col$5,100 million produced a gain to the institute of Col$1,794 million (35% of the cost of purchases). Combined, total purchases costing about Col$22,639 million led to losses of about Col$l,142 million (or 5% of cost). Including losses on other operations, a total loss of Col$1,361 million is estimated for 1983. D. Production Imeentives for Major Commodities Protection and Competitiveness 4.28 Despite the high levels of protection for importables and increases in these protection levels during the second half of the 1970s, production incentives of Colombia's traded (i.e. exports and import-competing) agricul- tural commodities have declined on average since 1975. Evidence is provided by an index of the real peso value of international prices for selected agri- cultural commodities (Annex Tables 25 and 26). This index is the product of the international price in dollars times the average exchange rate for each year divided by the implicit GDP price deflator for that year, thus combining the conditions prevailing in international markets (international prices) with domestic economic policies and conditions (exchange rate and interu-al price level). To the extent that the G^P Litflator reflects trends in domestic iroduction costs, this index indicates broad patterns in inter- national competitiveness of Colombian agriculture. For 12 out of 15 products 11/ IDEMA's selling price is much higher than its import price plus transportation and handling costs and is only feasible because of a government policy of restricting imports via licensing. Thus the support price policy and import restrictions policy go hand in hand.  - 65 - chosen for the exercise, the index fell by 25% to 50% between 1975 and 198212/ and for two of these products (butter and beef) no clear trend exist-s. This behavior differs remarkably from that experienced during the years 1970-1975 when the index rose for most of the products showing rather substantial margins in some cases. 4.29 Among the products chosen for the exercise, the country produces and imports butter, barley, corn, wheat, palm oil and soybeans. The index for butter varied moderately during 1975-1982 and no clear trend can be deduced. The 1982 value of the index for barley was 35% lower than in 1975, but the index had reached a bottom level in 1978, recovering thereafter. For w*eat, corn, soybeans and palm oil, the index has been falling sharply. Among export products the index was constructed for beef, rice, sugar, coffee, banana, tobacco and cotton. The index for all these products decreased significantly since 1975. In the case of cotton, the loss of international competitiveness has been so high that area planted and output fell to one-third their size after 1975. External and Internal Factors 4.30 The conditions prevailing in international markets, particularly the low international prices, have been often cited as the main cause of the loss of competitiveness in agriculture. International economic conditions have undouotedly had an impact on the trend and the level of the index for several products. It is worth noticing, however, that the international price in real terms for coffee, banana, beef, tobacco, barley and butter was higher in 1981 and 1982 than it was in 1975. If domestic conditions had remAined unchanged (with prices and exchange rate constant), the index of the real peso value of international prices of agricultural exports for the products should have been higher in 1982 than in 1975. High rates of inflation and worsening real exchange rate have been important reasons for the loss of competitiveness of agricultural exports. In addition, this fall is substantial when the index of international prices (which is the index of the real peso value of international prices with stable prices and stable exchange rates) is compared to the actual index of the real peso value of international prices. 12/ The 15 products analyzed are butter, beef, barley, corn, rice, wheat, sugar, palm oil, coffee, sorghum, soybeans, bananas, tobacco, cotton and sisal.  - 66 - Table 4.3 COLOMBIA: INTERNATIONAL PRICES FOR SELECTED AGRICULTURAL EXPORTS, 1970-82 (in constant pricesa/, 1975 = 100) Year Coffeeb/ Cottonc/ Sugard/ Bananae/ Ricef/ Beefg/ Tobaccoh/ 1970 140.0 110.1 36.8 137.2 91.5 172.3 157.0 1971 91.7 119.2 41.4 106.9 85.4 192.7 132.1 1972 116.0 116.3 60.9 112.2 88.1 226.9 131.1 1973 126.7 166.7 66.5 95.9 134.9 260.8 114.7 1974 108.3 139.5 166.4 85.5 150.7 245.5 104.5 1975 100.0 100.0 100.0 100.0 100.0 100.0 100.0 1976 189.6 143.5 56.0 103.7 72.4 104.3 100.1 1977 266.5 121.7 36.2 101.1 72.1 123.3 100.5 1978 174.4 104.3 29.7 90.0 73.3 104.0 91.9 1979 154.7 100.2 32.8 91.6 62.8 154.1 89.5 1980 139.3 112.5 89.7 97.5 75.4 159.5 87.5 1981 104.7 105.7 55.6 106.0 90.2 144.6 103.3 1982 116.6 93.2 28.0 104.4 59.7 112.4 120.1 a! Nominal prices divided by index of manufacturing unit value (MUV) from World Bank data. b/ New York price for Colombian coffee. ci Liverpool index. d/ Caribbean (New York). e/ Latin America (U.S. Ports). _/ United States (New Orleans). so Argentina (frozen). h/ United States (all markets). Source: IHF, International Financial Statistics Yearbook, 1983, and IBRD. 4.31 The above conclusions are also obtained when the index of competi- tiveness is generated on the basis of the ratio of the peso value of the international price to the average production costs for some selected agri- cultural commodities-rice, corn, sorghum, soybean, wheat and cotton (Annex Table 27). The pattern observed is similar to that of the previous index (index of the ratio peso value of international price/GDP implicit price deflator), although the levels vary somewhat. Using the index which incorporates production costs, it is seen that rice, corn, sorghum and soy- bean have suffered a greater loss in international competitiveness than has cotton and wheat. However, the general trend observed in all of these commodities is the same: there has been a loss of international competitive- ness in agricultural production in Colombia since 1975, following a period of substantial gains (1970-1975).  - 67 - Table 4.4 COLOMBIA: INTERNATIONAL PRICES FOR SELECTED AGRICULTURAL IMPORTS, 1970-82 (in constant prices 1975 = 100) Year Wheatb/ Corn C/ Barleyd/ Sorghum_/ Soybeansf/ Butterg/ Palm Oilh/ 1970 68.8 98.6 87.5 100.2 107.5 93.7 122.4 1971 77.1 91.0 75.0 88.6 108.9 122.0 113.6 1972 79.6 79.8 119.2 86.1 108.2 127.9 86.3 1973 133.8 116.5 126.4 126.1 188.4 87.5 125.3 1974 137.7 126.0 95.5 128.4 143.1 83.6 177.2 1975 100.0 100.0 100.0 100.0 100.0 100.0 100.0 1976 87.5 92.4 85.1 91.9 103.1 104.2 93.1 1977 62.7 72.4 79.0 71.6 115.0 105.9 113.8 1978 65.8 65.0 56.7 66.2 93.7 116.8 107.6 1979 74.0 66.9 79.9 72.5 93.0 124.9 105.0 1980 73.6 67.0 74.5 84.2 85.9 133.7 86.5 1981 78.3 73.1 102.3 86.0 87.5 130.5 88.8 1982 77.6 62.7 97.4 75.0 76.0 123.5 70.8 a! Nominal prices divided by index of manufacturing unit value (MWUV) from World Bank data. b/ United States (U.S. Gulf Ports). c/ Yellow No. 2 (U.S. Gulf Ports). d/ c.i.f. Colombia, from DANE. e/ United States (Rotterdam) El United States (Rotterdam). V New Zealand (London). h/ Malaysia (Europe). Source: Ibid. E. Trends in Relative Prices for Agriculture 4.32 The internal relative prices13/ of agricultural production14/ have varied significantly since 1970. As shown in Table 4.5, the domestic price of agricultural output rose relative to that in the rest of the economy in the early 1970s, fell in the mid-1970s, recovered again for a brief time between 1976 and 1977 and declined continuously thereafter. The direction of change in these price movements for agriculture as a whole has been connected with price changes in commodities internationally traded by Colombia. Comparing the terms of trade of traded goods--i.e., ratio of implicit price 13/ The relative price between two activities refers to the ratio of the implicit price deflator of gross output for these activities. When no mention is made to the contrary, the term 'relative price' refers to domestic relative prices. 14/ In these measures agriculture is defined to include sectors 01, 02, 03, 08 and 12 in DANE's classification of national accounts. The rest of the economy comprises sectors 04, 05, 06, 07, 09, 10, 11 and 13 through 35.  - 68 - deflators of peso exports to peso imports both in agriculture and the economy as a whole (Table 4.6) with the producer price of agricultural commodities relative to the rest of the economy (Table 4.5), a fairly close correlation in the directions of change can be observed. 4.33 The movements in Colombia's terms of trade have been dominated by coffee prices, and changes in producer prices in agriculture relative to the rest of the economy have been stronger for coffee than for non-coffee agri- culture. As a result of the sharp fluctuations in the international price of coffee, and its dominance in the terms of trade and the domestic price of agricultural output relative to the rest of the economy, however, a clear distinction must be wade between coffee and non-coffee agriculture. The domestic price of coffee relative to the rest of the economy has followed the same pattern as that of the terms of trade for coffee: both reached a peak in 1977 and declined continuously thereafter. The variations in domestic relative prices for coffee have been less pronounced than in terms of trade, which will be further elaborated upon in Chapter 6. 4.34 The terms of trade for non-coffee exports as a whole have experienced relatively small variations since the mid-1970s, and as noted in Chapter 1 their levels in 1982 were hardly different from 1974-75. Within the agricultural sector also, the terms of trade for non-coffee exports have experienced smaller fluctuations than for coffee, but since the mid-1970s-- with some exceptions--a downward trend can be observed. International price variations have differed significantly from product to product as will be discussed in the following section; what is indicated in Table 4.6 is only an aggregative picture. The falling terms of trade for Colombia's non-coffee agricultural exports can be discerned from international price trends. With efforts to hold the country's competitiveness, export performance could have been better despite this international price fall. Within the domestic economy the fall in the price of non-coffee agriculture relative to others has been stronger than the decline in the terms of trade. 4.35 Two sub-periods emerge with clear trends: 1970-74 and 1975-82. During the first period there is a clear improvement in the relative price of non-coffee agriculture, but no clear trend appears for coffee. On the other hand, there is no defined pattern in the terms of trade either for coffee or for non-coffee agriculture during 1970-74. The improvement in domestic terms of trade for non-coffee agriculture can be explained by a move to liberalize trade and promote exports that took place between 1970 and 1974 in the form of lower nominal tariffs and lesser quantitative restrictions. These permitted an increase in the real exchange rate that was then transmitted to the non-coffee agricultural sector.15/ During 1975-82, the trend in domestic relative prices has been one of deterioration for non-coffee agriculture, with the exception of 1977 when a serious shortfall of domestic production pushed prices of agricultural products upwards. Other than movements in the terms of trade, domestic factors also significantly explain the fall in the internal relative price of non-coffee agricultural production since 1975. 15/ The average nominal tariff was reduced from 70% in 1970 to 30% in 1974. See R. Junguito and C. Caballero, Problemas y Perspectivas del Proceso de Integracion Andina, FEDESARROLLO (Bogota, 1974). The liberalization process between 1970 and 1974 is documented in J. Garcia Garcia. The Effects of Exchange Rr.tes and Comercial Policies on Agricultural Incentives in Colombia: 1953-1978, IFPRI Research Report No. 24 (Washington D.C., June 1981), Chapter 6.  - 69 - Some of these considerations were analyzed in Chapter 1: improvements in the terms of trade of coffee; lag in exchange rate adjustment; a growing fiscal deficit; and inadequate use of import policy to offset inflationary pressures. Table 4.5 COLOMBIL: PRODUCER PRICES IN AGRICULTURE RELATIVE TO THE REST OF THE ECONOMY, 1970-82a/ (Indices of Price Ratios; 1975=100) Total Non-Coffeed/ Agricultureb/ CoffeeC/ Agriculture Rest Rest Rest 1970 95.7 112.4 92.8 1971 92.0 95.8 93.9 1972 96.7 105.4 97.4 1973 106.3 120.3 105.1 1974 103.6 103.0 106.8 1975 100.0 100.0 100.0 1976 111.0 150.8 98.0 1977 126.4 201.3 103.4 1978 103.2 149.0 93.9 1979 89.1 112.3 88.9 1980 85.7 106.8 85.8 1981 75.9 82.6 83.3 1982 75.8 83.3 83.2 a/ Based on price deflators of GDP components bl Broad definition; see Chapter 1 and para. 4.04. _J Coffee consisting of pergamino and processed _l i.e., Sectors 02, 03 plus 12 Source: Garcia-Garcia op. cit., based on DANE data. F. Conclusions and Policy Suggestions Agricultural Protection 4.36 An important intervention-in addition to credit subsidy (Chapter 8)-is represented by import restrictions complemented by IDEMA's price supports, provided mostly to cereals and other food crops, which in general do not appear to enjoy a comparative advantage (with the exception of rice). The import-competing component is a relatively small part, so that despite substantial levels of protection to this segment, the competitiveness and production incentives have been diminishing since the mid-1970s. The policy inference, however, is not that the levels of Import protection should be raised further: protection levels are already high and they impose a cost on consumers while it has, on the whole, been rather ineffective in stimulating production.  - 70 - Table 4.6 COLOMBIA: PRICES OF EXPORTS RELATIVE TO IMPORTS, 1970-82 (1975 - 100) Coffee NonrCoffee Agriculturala/ Non-Coffee Exports/ Exports/ Exports/ Exports/ Agricultural Year Imports Imports Imports Imports Exports/Imports 1970 107.3 135.0 82.6 176.8 132.5 1971 99.0 115.9 84.6 137.1 93.5 1972 109.4 132.9 93.2 155.3 110.8 1973 122.1 150.1 103.6 128.7 117.0 1974 113.3 111.4 114.8 90.9 122.5 1975 100.0 100.0 100.0 100.0 100.0 1976 131.3 179.7 98.6 171.3 91.7 1977 164.8 286.7 101.7 234.2 101.4 1978 144.5 197.1 102.5 271.4 87.7 1979 123.5 141.3 105.8 154.3 87.5 1980 127.7 139.6 116.7 142.8 101.2 1981 109.7 103.5 115.1 119.6 97.3 1982 114.2 117.7 111.2 133.6 86.7 a/ Broad definition including sectors 01, 01, 03, 08, and 12 in DANE's classification. Source: Ibid. 4.37 Exports of agricultural products, on the other hand, have in the past been subject to a quota, with the possible exception of flowers, banana and tobacco.. Only when the domestic market demand has been satisfied and an estimated surplus remains, permission to export has been granted. In general, it appears that crops which can be developed as export crops and are able to compete successfully in international markets (example, rice and barley) have not been stimulated but implicitly taxed. Only when export crops develop problems in external markets have support measures established as in the case of cotton and more recently, rice. Price Support 4.38 If IDEHIA's objective is to protect domestic producers of import- ables, import restrictions might already achieve that goal without price supports, unless the market is completely monopolistic. Even if some price supports are to be provided, a lowering of the support prices in areas further removed from consumption centers to account for transport cost increases would be desirable from an efficiency viewpoint. On the other hand, income distribution goals might be particularly important in such removed areas, and alternative redistributive mechanisms might need to be devised. As discussed subsequently, reforms of IDEMA's seasonal price stabilization and a separation of the price support operations from the storage functions would be helpful.  - 71 - 4.39 While the benef its from import controls and price supports have been small, their economic costs also have not been large compared to sectoral GDP. The allocative efficiency losses from policy are not very large in the case of wheat according to this report. Nevertheless, these interventions bear a significant financial cost, particularly in comparison to the public sector operations in agriculture. At least from this point of view, efficiency improvements in pricing policy would merit attention. Competitiveness 4.40 International conditions have undoubtedly contributed to the problems of Colombian agriculture: terms of trade for non-coffee agricul- tural exports have declined since the mid-1970s, as international prices for these products fell in real terms. However, the country could have main- tained greater competitiveness abroad with more adequate macroeconomic policies. Despite low and falling protection, as measured by domestic and external price ratios for traded commodities, the international competitive- ness of Colombia's non-coffee agriculture was stronger during 1970-75 compared to the post-1975 period. Declining competitiveness despite rising protection since 1975 has been at least in part on account of high rates of domestic inflation and an appreciating exchange rate. In general terms, policy emphasis in the 1980s could be on establishing a more neutral macro- economic framework which does not prejudice incentives to agriculture. In addition, export promotion could replace import protection as a development strategy. A favorable export climate within Colombia would be essential in order to regain external markets, and to restore exporters' confidence in the Government's intentions concerning export promotion. 4.41 A recent study16/ considers the range of price distortions (including protection to agriculture and manufacturing, pricing of capital and labor) moderately low in Colombia during the 1970s in comparison to groups of high, moderate and low-distortion countries. The study reports nominal protection coefficients during the 1970s for a few agricultural products, which have been high for maize, moderate for cocoa, and low for rice and beef. The fact that agricultural prices have not been unduly distorted in the last decade has also been related to the sector's good long- term record.17/ Consistent with these observations, the needed shifts in agricultural pricing policies supported in this report are relatively modest. 16/ The World Bank, World Development Report 1983, (New York: Oxford University Press, 1983); R. Agarwala, Price Distortions and Growth in Developing Countries, World Bank Staff Working Paper No. 575. 17/ M. Urrutia, Mp. cit.  - 72 - Chapter 5 PRICE STABILIZ&TION IN AGRICULTURE A. Istroduction 5.01 This chapter is devoted to the issue of price variation and its effect on agricultural performance. Instability of domestic prices is con- sidered by sources in and out of Government as a major problem for producers and consumers of agricultural commodities in Colombia. Greater price stabil- ity is often recommended on various grounds (paras. 5.03 through 5.05), and for this purpose some policies have been put into effect, and others have been proposed. Policies connected with stabilization concern two distinct but interrelated aspects: year-to-year price variation and seasonal intra- year price fluctuations. These two types of price instability are discussed in turn, and existing and proposed policies and other alternatives are evaluated in this chapter. 5.02 FEDERACAFE (the Coffee Federation) reduces domestic price changes of coffee in the face of volatile variations in international markets. OPSA (the Planning Office of the Ministry of Agriculture) sets producer prices, usually once a year, for sugar, cocoa, sisal and fiber, and intervenes in the negotiations of cotton prices between producers and cotton manufacturers, but the agency may not be an effective price stabilizer since it does not actually buy or sell any of these products. IDEMA sets support prices for producers and influences consumer prices through its sales and imports of major staples such as rice, wheat, maize, barley, beans, sesame, sorghum and soya. Many of these are seasonal crops, and therefore the agency's purchase, import, storage, and sale policies affect seasonal price variations. In addition, the government policy of subsidized credit for storage has import- ant implications, as discussed subsequently. IDEMA's nationwide contribution to seasonal and annual price stabilization may be limited, however, since--in the view of its financial constraints--it intervenes substantially only In a few markets as shown below. Table 5.1 COLOMBIA: IDEMA'S PURCHASE AS PERCENT OF NATIONAL PRODUCTION OF EACH CROP, 1980-81 Product Purchase Beans 0.6 Corn 2.3 Rice (paddy) 4.4 Sesame 64.7 Sorghum 4.2 Soybeans 0.9 Wheat 41.6 Source: IDEM&.  - 73 - B. Some Basic Considerations Concerns over Price Instability 5.03 A concern of policymakers is that high seasonal prices of food items hit poor consumers who spend a high fraction of their income on such categories. This notion confounds the conceptually distinct issues of the average price level and the variations of the price over the year. Stabil- izing the price would imply a lower price in some seasons and a higher price in others than currently exist. Clearly, compared to a regime of unstable prices, consumers are better off in the former seasons and worse off in the latter. On balance, over all seasons, consumer welfare may actually be reduced by price stabilization.1/ 5.04 It is believed by some observers that price uncertainty, annual or seasonal, leads producers to make the wrong production decisions. Producers, being uncertain about the future price, base decisions on the current price, leading to alternate booms and busts. If producers learn from experience, however, they would find that high prices one year tend to be followed by low prices the following year, and therefore would make the appropriate adjust- ment in planning decisions, leading to a leveling-out of prices. It is especially difficult to understand why producers would base planting decisions on current prices in cases where IDEMA publishes future support prices far enough in advance to base plans upon them. Another consideration is that reduction of agricultural risks could be expected to promote invest- ments, expand production a.ad reduce consumer prices. 5.05 Concerns regarding the macroeconomic effects of price instabil- ity2/ assume that consumers and producers have different marginal propensi- ties to consume. Thus, it is often argued that when agricultural price and production fluctuations cause income shifts between the two groups, the demand for individual products, and aggregate demand, also fluctuate, destabilizing the rest of the economy. It should be noted, however, that if incomes of producers of different crops are not highly correlated, large shifts of income from agricultural producers as a group to consumers or vice versa would be rare, since the shifts in some crops in a given year would tend to be offset by the opposite shifts in other crops. Evaluating Interventions for Greater Stability 5.06 It is seldom clear in discussions of stabilization whether the objective of actual or proposed policy is to stabilize price, income or some other variable. Additionally, sometimes the task involves insulating domestic markets from international price variations, whereas in other cases the source of variations is instability in domestic production. In all instances, the impact of government intervention per se and its costs are inadequately evaluated. This study has only initiated an analysis of these 1/ B. F. Massell, -Price Stabilization and Welfare," Quarterly Journal of Economics, May 1969, 83, pp. 285-298. 2/ See for instance, Y. Castro Forero, 'Precios agricolas y Su Incidencia Economica', Revista Nacional de Agricultura, February 1983.  - 74 - issues, and results provided in the rest of this chapter on seasonal and annual price variation are quite partial and tentative. Risk and Uncertainty 5.07 The mission has computed indexes of variability and of differences between realized and predicted values of three variables for different crops: prices, profit (net income/ton and gross income/ton, if yearly cost figures were unavailable) and annual return on land Investment (see Annex 9 for details). In the case of price, domestic prices at the producer and consumer levels are more stable and predictable than are international prices for the crops considered, viz. coffee, rice, sugar, wheat, cotton, corn, barley and potato. It is not clear whether this result on average is obtained from government intervention, or is the consequence of farmers' and traders' own storage and other efforts, or both. In the case of coffee, the stabilization program of FEDERACAFE has had a major impact. There may also be some addi- tional fragmentary evidence on the price stabilization impact of government policy: in the case of potato (with little or no government intervention), variability of domestic prices is not much less than the international varia- tion, whereas in the other cases, as already noted, price variation is less domestically than internationally. 5.08 On the other hand, price is perhaps not as good an indicator of risk/uncertainty as income and profitability. It is well-known that stabilizing price does not necessarily stabilize income or profitability. An example is a product with random production and a demand elasticity of unity. In such a case, although production fluctuates from year to year, low production is offset by high prices and vice versa, so income is stable in the market without any intervention. On the other hand, in this case if the price is stabilized by an external agency, producer income fluctuates with production, with price stabilization destabilizing income. For potato, total income and income per hectare seem to be more stable in domestic than in international prices by about the same amount as other crops. Judged by these criteria, therefore, little credit can be attributed to government programs in stabilizing farm income. Government Impact 5.09 In any event, for all crops including potato, but except cotton, producer prices and incomes vary less if evaluated at domestic prices than at international prices. In selected cases such as coffee, domestic price stabilization can be attributed to policy, but such a relation is less clear in other cases. Furthermore, income stabilization appears to be achieved, at least in the case of potato, with much less price stabilization than in the other cases. It appears that with or without government intervention, domestic variables tend to be less volatile and to a lesser extent, more pre- dictable than international variables. It is not clear why this should be true, though one might conjecture that the reason is simply that domestic prices are 'sticky' for institutional reasons.  - 75 - C. Addressing Year-to-Year Instability General Observations 5.10 Any plan which solves the microeconomic problem of production risk by breaking the link between producer income and consumer expenditure may exacerbate the macroeconomic destabilization problem. With no stabilization plan, agricultural production and price shifts cause income transfer between producers and consumers of agricultural commodities. In years when pro- ducers' incomes are low, and their expenditures on non-agricultural commodi- ties are consequently low, consumers' expenditures on agricultural products are low, and their expenditures on non-agricultural commodities high. Thus, the overall demand for the non-agricultural commodities tends to stay at a constant level, although it may fluctuate somewhat due to differences in marginal propensities to consume between agricultural producers and con- sumers. But suppose the link between producer income and consumer expend- iture is broken, for example in a case where producer income is stabilized by the provision of counter-cyclical credit, with concessionary credit being made available to producers in bad years. Consumer expenditure on non-agri- cutural products would be high as before, but this would no longer be offset by a fall in producers' expenditures on these products. Shifts in total expenditures would be more pronounced, and the net effect of stabilizing pro- ducer income would be destabilization of non-agricultural demand. Annex 10 explains that the same can be true of buffer stock schemes. Export Price Stabilization 5.11 For internationally traded crops, domestic prices may be stabilized by import or export taxes or subsidies without breaking the link between pro- ducer income and consumer expenditure. A law approved by the Congress facilitates the use of variable export subsidies to stabilize domestic prices of exportables. With the CAT system, changes in an export subsidy rate were made administratively, but only once a year. Under the new system CERT, the rates (five levels with a maximum of 25Z announced by Decree 637 of 1984) are expected to be changed more often, greatly increasing the flexibility of the system. When the world price of a product increases, its subsidy rate can be decreased quickly, thus preventing its domestic price from rising very much, and conversely when its world price falls. As noted, this kind of plan has the advantage that consumer expenditure is still linked to producer Income, avoiding the macroeconomic side-effects of some other stabilization plans. It is also probably less burdensome on the economy than many alternatives, such as direct import management by the Government, or quotas. However, it has two limitations and three disadvantages. 5.12 One limitation is that its scope of coverage is limited to exports. It is, of course, possible to expand the coverage to importables, such as the European Economic Community (EEC) does with its 'variable levies-, but in any case it cannot be used for non-traded items. The second limitation is that the size of the export subsidies are limited by GATT. (In fact, the main purpose of the flexible plan is to allow subsidies to be changed quickly if other GATT signatories complain; the price stabilization function is secondary.) As a practical matter, this may not be very import- ant for some crops, but may be a real limitation on the ability to stabilize prices of others.  - 76 - 5.13 One disadvantage of this sort of plan is that there is a temptation to use it to increase distortions of production incentives beyond what they otherwise would be. For example, the EEC has used its variable levy system not only for stabilization, but also for protection. Certainly, it is possible to stabilize price without increasing average protection of a good beyond existing levels, but it is probably politically difficult. For an import with no current protection, this would involve taxing imports in years of low world prices and subsidizing them when world prices are high. It may be quite difficult to subsidize imports in the face of domestic producer opposition. If the stabilization efforts result in increased protection from foreign competition, the economic costs may be high. 5.14 The second disadvantage is the economic inefficiency involved in failing to react to world market signals. For example, economic efficiency demands that an export product be produced and exported at a level such that its marginal cost is equal to its price. But, if producers are insulated from world prices, the price on which they base production decisions is not the price which reflects the true social value of the product. If producer prices are stabilized, when world prices are high a country will not export enough of an export product to take full advantage of the good prices, and it will export too much when world prices are low. Rough estimates of these kinds of efficiency or welfare costs3/ are presented for several crops in Table 5.2 below. (Annex 11 explains the method used to compute these numbers.) While the annual costs for any single crop are not overwhelming, the cumulative value of these yearly costs into the indefinite future can be substantial. It should be noted, however, that these are welfare losses from perfect price stabilization. To the extent that a price stabilization scheme does not make the price perfectly stable, the costs will be correspondingly less. Table 5.2 COLOMBIA: WELFARE COST OF DOMESTIC PRICE STABILIZATION FOR SOME IHPORT AND EXPORT CROPS (millions of 1975 pesos) Crops Annual Welfare Cost Net Present Value of Cost a/ Wheat 59.4 848.6 Corn 60.9 870.0 Barley 0.9 12.9 Rice 231.7 3,310.0 Cotton 108.6 1,551.4 Potato 126.3 1,804.3 a! Net present value of an infinite stream of the annual cost, evaluated using a 7% real interest rate. Source: Mission estimates (see Annex 11 to this chapter). 3/ Defined as the sum of loss in producer and consumer surpluses in comparison with a situation without interventions.  - 77 - 5.15 The third disadvantage is that it requires that government offi- cials make judgements about whether observed world price movements are tran- sitory or part of a long-run trend. If the movements are part of a trend, but are thought to be transitory, then the CERT rate will be adjusted in the expectation that it will be readjusted when the price returns to its previous level. Since the price will never return to this level, the CERT adjustment becomes a permanent change in protection of the good. This disadvantage could be mitigated to some extent by basing the CERT adjustment on the devia- tion from the long-run price. This long-run price would be recomputed each year as a moving average of previous years. When the price moved to a new level as part of a long-run trend, this would appear to be a large deviation at first, leading to a large compensating adjustment in CERT. But, as the price remained at its new level, it would be seen as less and less of a deviation, and the CERT adjustment would become smaller each year. Futures Market 5.16 Colombia might consider diminishing the risks involved in agricul- tural production and processing by allowing producers and processors access to futures markets. Hedging in futures markets does not stabilize incomes, but it does eliminate uncertainty about price, which is one of the problems the Government is justifiably concerned about. Eliminating risk in this manner can be, by and large, costless to the Government, and is free of any efficiency costs as well, differing in both respects from the support price policy of IDEMA and price stabilization plans like CERT. On Hedging 5.17 Hedging as a means of risk reduction involves the buying and sell- ing of futures contracts in such a way that movements in the value of the contracts offset the movements in the price of the commodity that the hedger will buy or sell in the future. For example, an idealized hedging transac- tion might proceed as follows:4/ An importer of wheat who wlll need to buy wheat on December 1 buys a fut~ures contract on a US commodity exchange call- ing for delivery of wheat on that date, paying US$150 a ton. The contract is an enforceable agreement, and if he wanted, the importer could accept delivery of the wheat. But, for any of several reasons, the Importer may not wish to buy the wheat through the futures market and need not accept delivery to relieve himself of the risk of paying a price different from US$150. Suppose, for example, that on November 30, the spot price of wheat (i.e., the price for Immediate delivery) is US$160 a ton. Then his futures contract (which on this date is essentially a contract for immediate delivery) is worth US$160. The importer could sell his contract for US$160, making a US$10 profit on his transaction in the futures market. He can then apply this profit to buying wheat from another source for US$160, paying US$10 more than he expected to pay. He ends up paying an effective price (excluding his US$10 futures market profit) of US$150. (Note that if the price of wheat 4/ The mechanics of the transaction are actually somewhat different from those outlined below, but the example captures all of the essential ideas. A more detailed discussion is contained in A. Fuentes Hernandez Participacion de Colombia en los Mercados de Futuros', Revista Nacional de Agricultura, No. 863, June 1983, pp. 97-106.  - 78 - from this source is not US$160, then the effective price he pays is not exactly US$150. But, so long as the prices of wheat from his source are well correlated with prices in the U.S. market, the profits or losses in futures market transactions will tend to offset movements in his prices, and decrease his risk accordingly.) 5.18 Similarly, an exporter of, say, cotton could reduce his risk by hedging. If the exporter wishes to sell cotton on December 1 at an assured price, he can sell a futures contract for delivery on that date at the going price for such a contract - say, US$0.80/lb. On December 1, if the actual price he receives for his crop is US$0.70/lb, he nevertheless receives an effective price of US$0.80, because he can liquidate his position in the futures market (i.e., -buy back the contracts he sold for US$0.80) at a price of US$0.70, making a profit of US$0.10/lb. Other Advantages 5.19 In addition to the advantage of giving importers and exporters5/ the opportunity to reduce risk from price fluctuations, participation in futures markets would have an important concomitant advantage. The spread between the current spot price and the futures contract price provides valu- able information on how the market expects the price to move, since the futures contract price is a good predictor of what spot price will prevail at the date the contract matures. This kind of information is valuable in making storage and inventory control decisions. (Working argues that this function of futures markets is of more value than the reduction of price uncertainty.i6 Policy Problems 5.20 While the value of futures markets, especially as they relate to risk reduction, has been widely recognized by academic and government sources, their use by Colombians has been rare. In fact, it appears that only three economic agents have ever used futures markets.7/ There are several reasons for the lack of participation. First, and perhaps foremost, government exchange controls have made participation difficult. The govern- ment has, to some extent, been reluctant to authorize the use of foreign 5/ While the examples are discussed in terms of Importers and exporters, since they are the economic agents most closely linked to international markets, other agents (e.g., producers and consumers in domestic markets) could also reduce risks by hedging in international futures markets, to the extent that domestic prices are correlated with international prices, or by hedging in a domestic futures market. 6/ Holbrook Working, -Futures Trading and Hedging, American Economic Review, June 1953, p. 314-343. 7/ See A. Fuentes Hernandez, op. cit., Part 2, Revista Nacional de Agricultura, August 1983, pp. 109-120. This article is the source for much of the information in this section on the institutional framework and historical background of futures markets in Colombia.  - 79 - exchange for this purpose for fear that hedgers will begin to speculate and require large quantities of foreign exchange to pay their losses. Even in those instances where it is willing to do so, the licensing procedure is time-consuming and does not allow hedgers much flexibility in the timing of purchases and sales of contracts. 5.21 Second, the strict controls on imports decrease the usefulness of hedging. As implied by the examples above, for maximum risk reduction the physical commodity must be purchased in the same market as the futures con- tract. (Otherwise, even on the contract maturation date, the value of the contract may differ from the value of the commodity.) Import controls make the purchase of commodities in world markets more difficult. Of course, some risk reduction is still possible, to the extent that world and domestic prices are well correlated, but the effectiveness of hedging is reduced. Similarly, for goods imported by IDEMA, or whose imports are licensed by IDEMA, hedging is made less effective in risk reduction by the fact that decisions are made a very short period of time before the importation actually occurs. 5.22 Third, the unpredictability of government trade policy makes hedging more risky. For example, if an importer hedges in the futures market planning to import a commodity, and the government then puts the import on the prior licensing list, the importer is effectively changed from a hedger to a pure speculator, and his risk increased manifold. Fourth, for some agents hedging is not very useful because prices are controlled by the government, a policy which makes the prices fairly predictable. This is true of producers of crops whose future support prices are fixed and announced before planting time. This will also be true of export crops to the extent their domestic prices are fixed by the CERT plan. This factor appears to have played a major role in causing one cloth manufacturer to quit hedging after the government began fixing domestic cotton prices. Finally, inade- quate information about the value of futures markets may also help explain why they are rarely used. 5.23 Some of these problems would be mitigated by the development of a domestic futures market. In the long run, it is possible that the Bolsa Agropecuaria can develop into a domestic futures market. In fact, contracts are now available through the Bolsa which call for delivery (in 150 days) of crops which are non-existent when the contract is signed. But since these contracts are not tradeable, risk transfer to speculators is not possible. The Bolsa also has very limited market participation--only about 2Z of Colombia's agricultural output is sold through the Bolsa-and is completely dominated by IDEMA, which participates in 70Z-80% of the total transactions (73Z in 1982). The Bolsa is still young (only 3 years old), and is struggling to work out a number of problems which prevent it from attracting greater participation. In time, it may succeed in attracting a sufficient number of participants to make IDENA a relatively small part of the Bolsa, and to develop the economies of scale that are necessary to make a futures  - 80 - market function efficiently,8!/ but until this occurs, there is little chance that it can function effectively as a futures market. In the meantime the Government might remove obstacles to participation in international futures markets. D. Seasonal Price Fluctuations 5.24 One of the Government's objectives is to ensure that food prices do not rise unduly in the periods between harvests. Such seasonal stabilization can in principle be facilitated by varying the timing and quantities of imports and exports of agricultural products. ln practice the country's internal storage system plays an equally important role in assuring adequate supplies and moderating prices in the non-harvest months. This section focuses upon the impact of storage policies, paying particular attention to two issues: first, whether the existing system of subsidized loans for storage called the -bonos de prenda' (BP) is desirable and efficient, and second, whether IDEMA's sales policies tend to discourage private storage activities. 5.25 Considerable storage capacity is owned by IDEMA, industrial processors, producers' associations, and twelve general facilities, called 'Almacenes Generales de Deposito" (AGD), which are subsidiaries of private banks.9/ Identifiable onr-farm storage capacity (excluding coffee planta- tions) in 1977 was only 0.91% of the total.0!/ This figure probably under- states the available capacity, but field observations suggest that on-farm capacity may be rather limited. Most individual storers utilize space rented in AGDs, generally owned by banks at which those individuals do business. Since some banks specialize in their clientele, for example, by catering to the needs of growers of particular crops, these banks also specialize in the storage of particular commodities. When an individual stores a commodity in an AGD, a deposit certificate or, 'certificado de deposito' (CD) is received, 8/ One of the necessary conditions for the smooth functioning of a futures market is that it must be cheap to purchase and sell contracts, thus encouraging sufficient buying and selling to establish a legitimate market price at all times. This, in turn, means that brokerz' commissions must be low. Unless market participation is quite heavy, brokers will not receive a competitive return on their labor, commissions will be raised, participation will fall further, etc., until the market collapses. In addition to insuring that each broker makes a large number of transactions, participation must be heavy for another reason; that is, to support a large number of brokers so that collusion is impossible and a competitive market operates. 9/ Exceptions are ALM&GRARIO and ALMAPOPULAR which are also such general facilities, but are partially owned by IDEMA and consequently, are considered "semi-official" rather than private. Almacafe is also an exception since it is owned by FEDERACAFE, and not by a private bank. 10/ According to a report of the Division de Regulacion Tecnica of the Ministry of Agriculture, "Capacidad Instalada de Almacenamiento y Secamiento en Bodegas y Silos".  - 81 - specifying the quality and quantity of the merchandise. This certificate then becomes a title to the property and can be bought and sold in the market. It may be returned to the bank as collateral for a loan under the BP system, which is described below. Subsidized Credit for Storage: Bonos de Prenda System (BP) 5.26 Under the BP system, a bank may make a loan at a subsidized interest rate, using the CD as collateral, and rediscount part of the loan through the Central Bank. Only certain crops qualify for loans under this system, but the list is fairly extensive: African palm oil, sesame, cotton fiber, cotton seed, anise, paddy rice, cacao, coffee, barley, sisal, beans, powdered milk, corn, potatoes, sorghum, soybeans, tobacco, wheat, and pro- ducts for export. A serious limitation is that only growers, processors, and IDEMAL are eligible for loans under this system, thus excluding wholesalers and other 'middle-menu. In general, the loans can be up to 80% of the value of the stored crop,l/ evaluated using a "basic price" established by the Monetary Board. This fraction is known as the discount margin. 5.27 The subsidy element in the BP loans can be substantial, and has changed quite a bit over time. Table 5.3 below displays relevant information for comparing the market interest rate with the subsidized rate from 1970 to 1981. Of course, the -subsidy' is not measured strictly by the difference between the market rate and BP rate, because the subsidized loan is only made on 80% of the value, based on the 'basic price", which may deviate substan- tially from the market value. That is, using the BP system is as if a storer incurred all of the normal storage costs, but received a rebate in the amount of 0.8 PbQ(rm-rs) per year, where Pb is the "basic price', Q is the quantity stored, rm is the real market interest rate, and r5 is the real subsidized rate.l/ This subsidy element depends as much upon Pb as it does on the difference between rm and rs. Pb may vary over time and over crops; there- fore, the subsidy element is different among different years and crops. Annex Table 28 shows the evolution over time of the ratio Pb/Pm for different 11/ This fraction is 70%, rather than 80%, for palm oil, sisal, and wheat and 75% for export products. 12/ Obviously, for the crops only eligible for a 70% or 75% loan, the 0.8 should be replaced accordingly.  - 82 - crops, where Pm is the market producer price of the product. The above sub- sidy can be written as a fraction of the crop's market value.13/ Table 5.3 COLOMBIA: MARKET INTEREST RATES AND BONOS DE PRENDA RATES, 1970-81 Year Market Rate of Real market Interest Rate Bonos de Prenda Interesta/ Inflationb/ Interest (ex post) Nominalc/ Real (ex post) 1970 13.3 7.2 6.1 10.0 2.8 1971 16.4 12.6 3.8 10.0 - 2.6 1972 15.6 14.1 1.5 10.0 - 4.1 1973 20.3 22.1 - 1.8 10.0 -12.1 1974 30.4 25.2 5.2 15.0 -10.2 1975 23.8 17.5 6.3 17.0 - 0.5 1976 22.4 25.4 - 3.0 17.0 - 8.4 1977 22.9 27.5 - 4.6 17.0 -10.5 1978 25.9 19.7 6.2 17.0 - 2.7 1979 36.5 26.5 10.0 17.0 - 9.5 1980 41.5 24.5 17.0 24.0 - 0.5 1981 52.5 25.6 26.9 28.8 3.2 a! CAT, 120 day maturity, average annual rate. b/ Consumer price index. c; Average discount rate. Source: Calculations DNP/UEA/DC based on Banco de la Republica, Resoluciones de la Junta Monetaria, Asobancaria. 5.28 Table 5.4 below shows the value of the subsidy element as a percent of market value for several crops in 1980 and 1981, the last years for which full information is readily available. (Where appropriate, the 0.80 was 13/ 0.8 PhQ(rm-r.) = 0.8 (Pb/Pm)(rm7rs) Throughout this analysis, computations assume that the interest rates are rates paid on the full amount of the loan. That is, it is assumed that a 25% rate of interest means the borrower pays $25 interest on a $100 loan. On some Colombian loans, the interest is taken out of the principal, so the interest rate understates the true rate. For example, on a loan at 25%, the borrower would receive only $75 ($100-$25), leading to a true rate of 33% (25/75). Computation of interest in this way would not alter the qualitative results of the analysis, although it would change the numbers. For example, if interest is computed in this way, the subsidy as a fraction of market value should be the following: 0.8 (Pb/Pm)(rmnrs)/(l-rm)(l-rs).  - 83 - adjusted to 0.70 or 0.75.) These figures have the dimension of percent per year and are thus directly comparable to the financial cost of storage. For example, storing barley with a subsidy of 12.05% and a market interest rate of 41.5% is exactly as costly as storing barley when the market rate of interest is 29.45% (- 41.5% - 12.05%) but no subsidy is given. So, one can consider the BP system in 1980 and 1981 as being equivalent from the view- point of storers to a reduction in the market interest rate by the amounts shown in Table 5.2. The subsidy rates vary from a low of 5.12% (palm oil in 1980) to a high of 17.26% (barley in 1981), with unweighted averages of 9.65% and 13.55% for the two years. Table 5.4 COLOMBIA: VALUE OF SUBSIDY TO STORERS, AS PERCENTAGE OF MARKET VALUE OF STORED CROPS, 1980-81 Subsidy (Z) a/ Crop 1980 1981 Barley 12.05 17.26 Beans 6.41 11.35 Cocoa 10.91 13.43 Corn 7.17 12.86 Cotton Fiber 14.32 14.28 Cotton Seed 10.30 14.09 Palm Oil 5.12 14.53 Rice (Paddy) 10.29 12.45 Sesame 13.23 13.27 Sorghum 8.44 12.14 Soybeans 8.47 15.67 Wheat 8.98 11.32 Unweighted Average 9.64 13.55 a/ S = 0.8 (Pb/Pm) (ra - rs), where S subsidy per year, Pb = basic price, Pm - market price, rm = market interest rate, rs - subsidized bonos de prenda discount rate. For wheat and palm oil, 0.8 in this formula was replaced by 0.7. Source: Computed from Table 5.3 and Annex Tables 28 and 29. 5.29 The fraction of the loan which may be rediscounted at the Central Bank (the 'margin of rediscount'), as well as the interest rate charged on the rediscount, are set by the Monetary Board. As of July 29, 1981, the "margin of rediscount- was 40% and the interest rate on the rediscount was 25%. At the same time, the discount rate on the BP was 30Z and the margin of discount 80% for most crops. That is, for every $100 worth of stored crops, evaluated at the official basic prices, a storer could borrow $80 from the commercial bank at an interest rate of 30%; the bank could then rediscount $32 (40% of $80) at the Central Bank at an interest rate of 25%. The bank's effective rate of return on its loan can be computed as 0.30 - (0.25)(0.40). 0.33. 1-(0.40)  - 84 - This effective rate of return is shown for several years in Annex Table 29, along with the market rate of interest. It is clear that in recent years, the incentive for banks to make loans through BP rather than through normal market channels has fallen substantially. This is one reason for the decline in the real volume of such loans. 5.30 There are two questions regarding BP which are considered in turn. The first is whether the general concept of subsidizing storage activity is worth the cost. The second is how this particular system could be improved. Costs of Subsidized Credit 5.31 The program is costly in two senses. First, it is costly to the Government and to lending institutions to subsidize loans to storers. Annex Table 30 shows the total cost of the program for each major product in 1981, and how the cost is divided between banks and the Government.14/ Although the exact ratio varies from crop to crop, depending on the ratio of discounts to rediscounts, in general private banks bear at least as much of the cost of subsidizing crop storage as does the Government, and much more of the cost of subsidizing manufactured and export goods. 5.32 It is worthwhile to inquire into the nature of the transfer implied by these numbers. First, who are the recipients of the subsidy? The main recipients are a few large firms in concentrated industries. In 1978, the last year for which these data are readily available, one firm used 18.6% of the total loans rediscounted, the largest four firms used 46.6Z, and the largest eight firms 59.1%.l5/ This tendency is even more striking in certain industries: in cotton fiber, barley, tobacco, and cocoa, four firms used between 85% and 100% of the loans rediscounted. While one would normally expect that a subsidy on an industry's cost of production would be passed along in the form of lower consumer prices, it is doubtful that the benefits are passed along to consumers when the subsidy is concentrated in so few firms. The use of the subsidy by growers (including growers' associa- tions) was only 1% of the total, so it is clear that the subsidy does not benefit growers. 5.33 And who are the ultimate bearers of the cost of the subsidy? If the banking system is more or less competitive, the portion of the cost borne by it--1/2 or more-would be ultimately passed on to savers (in the form of lower interest paid on deposits) and borrowers (in the form of higher 14/ The cost in Annex Table 30 may be a slight under-estimate for the following reason: the interest rate used as a market rate is the rate in the CAT market, and is thus essentially a risk-free rate of interest. To the extent that BP loans are risky, the 'true' market rate for them would be higher and the computed subsidy greater. However, since these loans are well secured, it is doubtful that the risk premium on them would be very large in a free market. 15/ A. Silva, R. Monsalvo, and G. Montes, 'E1 Almacenamiento de Productos Agropecuarios en Colombia", Revista de Planeacion z Desarrollo, Vol. XI, No. 3, September - December 1979, p. 100. Excluding IDEMA, the four largest firms used 43.0% of the total.  - 85 - interest charged on loans). It is not possible to estimate the relative mag- nitudes of these burdens without a detailed analysis of elasticities of supply and demand for loanable funds. The portion of the cost paid in the first instance by the Government is ultimately financed by an 'inflation tax". The rediscounts of the BP by the Central Bank are financed by money creation. This can cause a rise in the general price level, effectively ta ing the holders of cash balances, whose purchasing power declines. This inflation tax, then, transfers purchasing power from holders of cash balances to the recipients of the subsidy. In general, we vould expect the inflation tax to be regressive; that is, the rate of taxation (as a percentage of wealth) declines with the absolute level of wealth, because the poor hold a larger fraction of their wealth in the form of cash. On balance, therefore, the BP system operates to transfer resources from savers, investors, and holders of cash to a relatively small number of industrial firms. 5.34 The second type of cost involved concerns efficiency. The usual economic analysis of subsidies might apply here. The system subsidizes firms' storage activities, and by doing so, it encourages the diversion of investment from other activities to storage, to such a degree that the true social marginal value of the storage is less than the marginal value of alternative investments. It is difficult to estimate a magnitude of the efficiency loss without a detailed analysis of elasticities. However, the size of the distortion is certainly large enough to create a large loss, especially for certain crops (see Table 5.2 above). Of course, it is possible that the subsidy to storage could be optimal In the presence of other distortions. This does not seem likely, however, because the type of distortions which would make this subsidy optimal--subsidies of a similar size for other investment activities of the firm--are not generally present. Reforms of the System 5.35 In view of the costs of the BP system, a second issue is how the system could be improved. Three revisions in the system might be conr- sidered. First, if the Government desires to encourage agricultural storage, it could do so in a way which benefits all storage activity. There does not seem to be any legitimate reason for excluding middle-men from the subsidy, especially since the alternative beneficiaries at present are primarily large processing firms. 5.36 Second, the subsidy should be divorced from the money supply func- tion of the Central Bank. As mentioned earlier, rediscounts of BP are financed by direct expansion of the monetary base. This linkage between storage and the money supply has two peculiar effects. One is that increases or decreases in agricultural production (and the consequent demand for storage) to some extent tend to result in fluctuations in the money supply. This tends to remove control of the supply from the monetary authorities on a year-to-year basis and to introduce a seasonality into the monetary base. The seasonal nature of the rediscounts is demonstrated in Annex Table 31. While this problem could be serious if the rediscount formed an important part of the monetary base, it is probably not serious at the present because  - 86 - that fraction is only around 0.8Z.16/ If BP rediscounts ever again form a significant fraction of the monetary base, (e.g., 8.4%, as in 1974), this would be a source of concern. 5.37 The more serious effect at present is the linkage which runs the other way; changes in monetary policy tend to have a direct impact on storage activity. That is, in periods of tight monetary policy, the rediscounts available for BP tend to be contracted, discouraging storage, as discussed below. In one sense, this is as it should be; tight money always raises interest rates, raising the cost of storage. However, when monetary policy affects storage through its intermediate effect on interest rates, it also affects other competing investment activities (private and public) in the same way. Given the way in which the BP system is structured, it is not possible to assure this result; BP rediscounts may be affected in a major or minor way vis-a-vis alternative investments by monetary changes, depending on political decisions. 5.38 Perhaps a better system would be to include interest subsidies for storage as a line item in each year's budget. When an individual took out the type of loan currently eligible for BP he would be charged a non-subsi- dized rate of interest by the bank, but would then be reimbursed for some fraction of his interest cost directly by the Government, perhaps using the bank as an administrative agent. Presumably the fraction would remain constant over time. In this way, storage would always be given the same advantage relative to other investments, but its cost would rise or fall as it should along with the cost of other investments as monetary or real factors in the economy caused the interst rate to rise or fall. An addi- tional advantage to this type of scheme is that it would finance the Government's share of the subsidy from general revenues, rather than by money creation, thus avoiding the possibly regressive inflation tax. The share of the subsidy currently financed by the banks could be taken over by the Government (and perhaps financed by a tax on the banks) or could be left with the banks by mandating that they give storers a rate which is higher than the discount rate now (since banks would no longer be partially reimbursed by subsidized rediscounts), but below the market rate. 5.39 Third, the mechanism for allocating credit among different crops might be changed. Currently, the amount of credit available to a storer depends on the "basic prices" set for each crop by the Monetary Board. These prices are used to establish a value for the physical quantity stored, and this value is the basis for the size of the subsidized loan available. These basic prices have little connection to market prices, but rather, to a large extent, are set on the basis of political considerations. As one might guess, the basic prices are the subject of lobbying efforts by producers' associations.17/ Consequently, the ratio of basic prices to market prices 16/ However, the impact on monetary stability is greater than this figure would imply because changes in BP rediscounts are reflected peso-for-peso in changes in the monetary base. Changes in the base, in turn, change the money supply through a multiplier effect. Thus, for each peso by which BP rediscounts vary, the money supply changes by several pesos. 17/ Silva, et al, op. cit., p. 92-93.  - 87 - (and the subsidy element) vary widely among products, with the products with weak producers' associations generally losing out. The contrast between the subsidies available for cotton, with a strong producers' association, and beans, an important food crop with a relatively weak producers' association can be seen in Table 5.2 above. This distortion tends to cause inefficiency by encouraging storage of some crops more than others, with no apparent rationale for the bias. 5.40 As Table 5.2 demDnstrates, the size of the bias tends to change over time. For example, when the ratio of basic to market prices is compared for cotton and beans, cotton always has an advantage, but its magnitude varies from 1% (in 1976) to 223% (in 1980). This bias could easily be eliminated by setting the ratio of basic to market price at the same level across crops. The overall ratio could be adjusted each year as a means of controlling the demand for subsidized credit. Alternatively, the ratio could be set at unity every year, and the credit could be rationed by changing the rediscount interest rate or the margin of rediscount. Of course, this rationing would all be unnecessary if the whole scheme were revised in such a way that basic prices would be set at the same level as market prices each year, and the demand for storage loans each year would be determined by a uniformly subsidized interest rate. The average demand over time, of course, would be determined by the size of the subsidy offered. IDEMA's Role in Storage 5.41 IDEMA is the single most important agricultural storage agent in Colombia. It is full owner of 10.7Z of total storage capacity, partial owner of another 5.6Z (Almagrario and Umapopular), and sometimes rents space from privately owned AGDs.18/ It is much more important in the storage of some crops-especially rice, wheat, zorn and sorghum. Table 5.5 shows IDEMA's share of total stocks (that is, of stocks either held by IDEHA or in AGDs) of these crops, as of June and December of 1979, 1980, and 1981. In these products, IDEMA's policies regarding storage and sales can obviously have a great impact on market conditions. Consequently, it is worth investigating what effect these policies are likely to have, and in particular, how they are likely to affect private storage activity. 5.42 IDEMA's policies can have an impact upon private storage to the extent that the policies increase or decrease the profitability of storage activity. The profitability of storage is determined by the price spread-- the difference between the price at which the commodity is purchasedl9/ and the final price at which it is sold after storage--relative to the costs of storage. In a competitive storage industry, storage each year would be 18/ Figures are for 1979, the most recent year for which information is readily available. Source: -Informe Estadistico sobre la Capacidad Instalada en Colombia para Almacenamiento de Productos Agricolas", OPSA, July 1980. 19/ If goods are stored by the producer, not by a third party who purchases them for later re-sale, the -purchase price' is to be interpreted as the market price at the time the goods are placed in storage, e.g., the opportunity cost.  - 88 - sufficient to ensure that, 'or the marginal firm or the marginal units, the expected price spread Is just sufficient to cover the costs. IDEMA has a potential impact on storage particularly because of its policies regarding the price spread. Table 5.5 COLOMBIA: IDEMA'S SHARE OF TOTAL STOCKS OF SELECTED CROPS, 1979-81 (percentage) Date White Rice Wheat Imported Corn and Sorghum 1979 June 32 89 21 December 22 16 19 1980 June 29 42 11 December 39 32 59 1981 June 38 56 51 December 14 52 47 Source: Computed from Cuadro No. 12, p. 42 of IDEMA: Dos Anos de Labores, 1980-1981 IDEMA's Goals and Policies 5.43 IDEMA's pricing policies are rooted in what it perceives to be two of its primary purposes (in addition to supporting producer prices): to keep consumer prices low and to aid in the Government's fight against inflatinn. In the past, these goals have caused IDEMA to pursue completely unrealif&tic pricing policies. After buying and storing commodities, IDEMA would sell them for little if anything more than it paid. In doing so, it consistently failed to cover its own costs of storage and consequently lost a great deal of money and had to borrow heavily. It has a new policy which is an attempt to operate on a more financially sound basis, while still meeting the same goals. It comprises the following three operational rules: (i) the selling price will not exceed an amount equal to the purchase price plus carrying cost of 3.5Z per month; (ii) the selling price will not rise by more than 20% per year, in any case; (iii) if market conditions at any time are such that the market price is lower than the price that would be indicated by rule (i), IDEMA will sell at the prevailing market price. Rule (i) reflects the goal of financial responsibility, (ii) reflects the goal of fighting inflation, since 20% is the Government's inflation target, while (iii) reflects the goal of assuring low consumer prices. Clearly, there is considerable potential for conflict among these rules and goals, and it is too difficult to judge how the rules are actually applied in practice. Some preliminary judgements are, however, possible regarding probable effects.  - 89 - Effects of IDEMA 's Policies 5.44 To the extent the policy outlined above is effective, it Is likely to have a negative effect on private storage, for several reasons. First, even if prices always rose at 3.5% per month, this would be insufficient to cover private storage costs. IDEM& calculated the cost of storage an 3.5Z by uslng the subsidized BP rate of interest as the financlal cost of storage, then adding its other costs (physical spoilage, etc.). However, BP loans are only available to cover 80% (or less) of the value of the stored crops, evaluated using the basic prices. The remaining 20Z must be financed at the market rate. In addition, since the ratio of the baslc prlce to the market price is less than one for almost all crops, and differs substantially among crops, the true financial cost of storage is always higher than the BP rate, and differs from crop to crop. It also changes with variations in the market interest rate. 5.45 Table 5.3 showed the direct interest subsidy equivalents of the BP system in 1980 and 1981. That is, with the schedule of basic prices In those years, and market and BP rates as shown In Table 5.3 and Annex Tables 29 and 30, the effective financial cost of storage was reduced by the amount shown in Table 5.3 for each crop. For example, rice, with a subsidy equivalent of 10.29% had an effective simple annual financial storage cost of 31.21% (41.5Z-10.29Z) In 1980, or since the interest is compounded bi-monthly, a true cost of about 36% per year or 3X per month. IDEM& sources suggest that when the BP rate is 24Z (as it was in 1980), the financial cost of storage might be 2.31% per month. This may be a substantial underestimate of the true cost, and the underestimate is even more serious for other crops Whose subsidy equivalent Is smaller. Obviously, the magnitude of the underestimate becomes smaller as the market interest rate approaches the BP rate, but there wili always be an under-estimate unless the two are equal. In addition, the 3.5% figure seems to be an estimate of IDEMA's marginal cost; that Is, it does not include fixed costs such as construction cost of storage facilities, nor does it adequately cover other non-financial costs, as discussed in Annex 12. Consequently, storage will be uneconomical for private storers (and, indeed, for IDEMS also) if IDES& succeeds in limiting the price Increase to 3.5% per month. 5.46 Second, even if 3.5% per month were adequate to cover storage costs, the 20Z per year ceiling on price increases would mke falrly lorng- term storage uneconomical ln a perlod of 20% general inflatlon. (And, pre- sumably, it is because lnflatlon is expected to be 202 or greater that the 20% ceilling was chosen as an antL-Lnflation tool.) The fundamental reason for thls is that the price of the stored crop must rlse ln real terms (that is, at a rate greater than the rate of inflatlon) ln order to cover the cost of storage. Consider the case most favorable to a policy of limited price increases, a hypothetical crop which ls harvested almost year-round and only has to be stort4 for consumptlon for a short time; even so, a 20% ceiling is insufficlent. Suppose, for example, the crop's harvest ls fairly evenly spread out over nlne months of the year, so that consumption must come from storage for only three months. In a period of 20% annuAl lnflatlon, the prlce of the crop would rlse during the nlne months of harvest by about 15Z because of the general lnflatlon. After the end of the harvest, when con- sumption must come from stocks, suppose that IDESA regulates lts stocks so that the prlce rises 3.5Z per month. At the end of one month and one week of  - 90 - storage, the price will be 20% higher than it was at the beginning of the harvest about ten months earlier. If IDEMA then holds price constant, storage will be a losing proposition for the rest of the year. 5.47 In general, if the underlying inflation rate is about 20%, the price will rise 20% from the beginning of one harvest to the beginning of a harvest one year later. But, this does not mean that the price during the year should not rise to a level higher than 20Z over the original price. It must rise to a higher level in order to make it profitable to carry stocks, even though it will fall when the new harvest begins. That is to say, on average the price would behave as shown by the solid line in Figure 1. If marginal consumption must come out of storage beginning at to + 9, storers must be reimbursed for the real costs of carrying stocks (real interest costs, physical losses, etc.) over and above the nominal gains in the value of their stocks due to inflation. To place a 20% ceiling on price increases is to make storage unprofitable for the last two months of the year. 5.48 Finally, in addition to the two problems cited earlier, the inter- action of rules (i) and (iii) tend to make storage unprofitable on average. These rules ignore the fact that profits from storage are qul-e stochastic. Storage decisions are normally based on expectations about futu::e prices at which the stored crop will be sold. When the crop is actually taken out of storage and sold, the price may be higher than expected, in which case profits are made, or the price may be lower, in which case losses are incurred. In a competitive market, the profits in some years balance the losses in other years, so that on average, costs of the marginal firm or marginal unit are just covered. But, IDEN&'s rule (i) guarantees that price will never rise rapidly enough to do more than cover costs, even in the best of times. And rule (iii) guarantees that in times when prices are lower than a firm's expectations, it will lose money. On average, then, these two rules acting together tend to discourage storage. 5.49 There is fairly convincing prima facie evidence that IDEM& has suppressed the rate of price increase in at least one crop - rice - below what it must be to make private storage profitable. Alvaro Castillo Nino examines the evidence from 1978-1982, and concludes that frequently prices after harvest have risen at a rate such that private storage would not generally have been profitable.20! Of course, there is the possibility that this result was due to the choice of an unrepresentative sample of years - for competitive storage to exist, it is not necessary that costs be covered by price rises every year, but only on average. Nonetheless, given our other reasons for suspecting that IDEM4&s policies suppress price increases, if they are successful, the most obvious explanation of the evidence is that they do indeed succeed to some extent. 20/ A. Castillo NiZo, Inestabilidad de los Precios Agricolas", mimeo., Bogota, 1983.  - 91 - Figure 1: COLOMBIA: INFLATION, SEASONAL PRICE RISE AND STORERS' PROFITABILITY Price ln(1.28 PO) *--_