Colombia - Trade and Agricultural Policy Loan Project

Document of The World Bank FOR OMCAL USE ONLY Repmt No. P-4195-CO REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTER!;ATIONAL BANK- FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED L')AN IN AN AMOUNT EQUIVALENT TO US$ 250 MILLION TO THE REPUBLIC OF COLOMBIA FOR A TRADE AND AGRICULTURAL POLICY LOAN March 27, 1986 This documeut b a reted distio. ad may be ose by recipients only in the perfoanance of ther effidl dudes Its coot.- -ay u thdmewise be dbeloed witbout Worltd Bmck aborizon.  CURRENCY EQUIVALENT Currency Unit = Colombian Peso (Col$) Col$142.5 = US$1.00 (1985 average) Col$178.1 = US$1.00 (March 1, 1986) Col$1.00 = US$0.006 (March 1, 1986) WEIGETS AND EWASURES Metric System FISCAL YEAR January 1 - December 31 GLDSSARY OF ABBREVIATIONS BOR - Banco de la Republica (Central Bank) BONOS DE PRENDA - Storage credit CAJA AGRARIA - Caja de Credito Agraria, Industrial y Minero (Agricultural, Industrial and Mining Credit Bank) CERT - Certificado de Reembolso Tributario (Tax Reimbursement Certificate for Exporters) CPI - Consumer price index DNP - Departamento Nacional de Planeacion (National Planning Department) DRI - Programa de Desarrollo Rural Integrado (Integrated Rural Development Program) FEDERACAFE - Federacion Nacional de Cafeteros de Colombia (National Federation of Colombian Coffee Growers) FFAP - Fondo Financiero Agro.-cuario (Agricultural Financial Fund) HIMAT - Instituto de Hidrologia, Meteorologia y Adecuaciones de Tierras (Institute for Hydrology, Meteorology and Land Improvement) ICA - Instituto Colombiano Agropecuario (Colombian Agricultural Institute) IDEMA - Instituto de Mercadeo Agropecuario (Agricultural Marketing Institute) INCOMEX - Instituto de Comercio Exterior (Foreign Trade Institute) INCORA - Institutc Colombiano de la Reforma Agraria (Colombian Institute for Agrarian Reform) INDERENA - Instituto Nacional de los Recursos Naturales Renovables y del Ambiente (National Institute for Renewable Natural Resources and the Environment) MOA - Ministry of Agriculture OPSA - Oficina de Planeamiento del Sector Agropecuario (Planning Office, Ministry of Agriculture) PLAN VALLEJO (PV/SIEX)- Import duty drawback and exemption schemes for exporters PROEXPO - Fondo de Promocion de Exportaciones (Export Promotion Fund) TPED - Trade Policy and Export Diversification TAP - Trade and Agricultural Policy  FOR OFFICIAL USE ONLY COLOMBIA TRADE AND AGRICULTURAL POLICY LOAN SUMKARY Borrower: Republic of Colombia Executing Agency: Ministry of Agriculture and INCOMEX Amount: US$250 million equivalent Terms: 17 years, including four years of grace at the standard variable int'erest rate. Project Description: The operation provides further support to Colombia's medium-term, growth-oriented, structural adjustment pro- gram by: (i) deepening reforms in the macroeconomic, trade and public investment areas; and (ii) reducing trade and sectoral distortions in agriculture. These efforts are expected to provide a sounder basis for export- oriented growth. The reviews in the context of the loan assist in monitoring the economic program and in promoting the participation of the external financial community in the program. The loan would: (a) support trade liberal- ization, including a further reduction of export restric- tions, a progressive reduction of import restrictions and duties, and improvements in the use of duty exemptions for exporters; (b) rationalize trade and price intervention policies in agriculture; (c) support coffee policy in balancing the incentives between coffee and non-coffee agriculture; (d) support reforms to improve agricultural credit availability at more realistic interest rates; and (e) review efficiency in public investments in the agri- cultural and rural sectors, and provide institutional support to the Ministry of Agriculture. Project Risks: Import liberalization of agricultural inputs may hurt domestic producers who are unable to adjust to the change. This risk, however, is minor considering that the domestic producers would also benefit from the liberaliza- tion of imported raw materials; moreover, the contribution of this subsector to employment is relatively small. Measures affecting protection for the import-competing commodities could potentially hurt small farmers special- izing in these categories; but the policy changes are gradual and provide for offsetting cost reductions and increased investments. Finally, there are the usual risks of continuity in policies, especially regarding incentives for minor exports even in the event of a sizeable expan- sion in export earnings from coffee, petroleum and coal. This document has a restricted distribution and may be used by recipients only in the performance | of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  - ii - The understandings for the loan's second tranche, and the Government's awareness of this issue in the light of the experience with the previous coffee boom should minimize this risk. Estimated Disbursements: Out of a first tranche of US$125 million, US$25 million would be released to an export account upon loan effec- tiveness. The remaining US$100 million would be available upon effectiveness to be disbursed by reimbursing 30Z of import payments for imports of agricultural inputs, machinery and equipment. The second tranebe of US$125 million would be released provided the review of the economic program, trade and agricultural policies in November, 1986 demonstrates satisfactory implementation of the agreed program. Appraisal Report: This is the combined President's and Staff Appraisal Report. Nap: IBID No. 18370  INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT REPORT AND RECOMMENDATION OF THE PRESIDENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO THE REPUBLIC OF COLOMBIA FOR THE TRADE AND AGRICULTURAL POLICY LOAN 1. I submit the following report and recommendation on a proposed loan to the Republic of Colombia for the equivalent of USS250 million to help finance a Trade and Agricultural Policy Loan. The loan would have a term of 17 years, including four years of grace, with interest at the Bank's standard variable rate. PART I - THE ECONOMY 2. An economic mission visited Colombia in July 1982 and its report (4444-CO) was distributed to the Executive Directors in August 1983. A mission to review the external sector and agriculture visited Colombia during April/May 1983, and its report (4981-CO) was distributed to the Executive Directors in April 1984. A review of macroeconomic developments was con- tained in the President's Report for the Trade Policy and Export Diversification Loan (P-4055-CO) of May 1985. Country data sheets are presented in Annex I. A. Background 3. The Colombian economy has made considerable progress since the early 1950s, evolving from a largely agricultural and rural base into one that is more open, integrated and industrialized. The growing economic activity, rapid rural-urban migration, increased participation of women in the labor force, and expanded public services have contributed to reductions in poverty and improvements in income distribution. Financial and capital markets have evolved pari passu with the growing needs of the economy, and the country has become an active participant in international capital markets. State enterprises are few, follow, on the whole, adequate pricing policies, and many have some form of private sector participation. The country's energy balance has been changing in recent years and Colombia is expected to become a net petroleum exporter this year and, increasingly, an exporter of thermal coal. 4. Export promotion has been a concern of Colombian authorities for some time. Beginning in 1967 the authorities adopted an outward-looking development strategy, expanding and diversifying exports. Export promotion policies, including frequent small devaluations of the peso, export tax rebates and other incentives were introduced. The authorities also began lowering tariffs somewhat and relaxing domestic capital market controls as a means of raising efficiency and increasing the competitiveness of Colombian goods in external markets. These measures were successful in relieving foreign exchange constraints and stimulating growth and employment.  -2- B. Economic Performance During the 1970s 5. In the mid-1970s the economy faced strong inflationary pressures from a sharp increase in world coffee prices. The increased coffee export receipts, together with some official surrender of foreign exchange from illegal exports, caused a turn-around in the balance of payments. Incomes rose rapidly stimulating aggregate demand, and inflation accelerated. Economic growth also rose, and unemployment fell substantially in rural and urban areas. Largely as a consequence of increased coffee tax revenues, the public finances generated surpluses averaging about 1% of GDP during 1976-78 and, by the end of 1979, net official international reserves had risen to about US$4.1 billion, nearly eleven months equivalent of that year's imports of goods and services. 6. While beneficial in many respects, the foreign exchange boom had some negative effects. The rate of currency devaluation was slowed and the conversion of export receipts into pesos was delayed to moderate the growth of domestic demand, with adverse effects on non-coffee exports. The Government also sought to check inflation by maintaining high reserve requirements and expanding controls over credit thereby reducing, in real terms, the financing available to the private sector through the formal capital market. 7. The 1977-79 economic program was partially successful in restrain- ing aggregate demand growth, but relatively high inflation persisted. In response to the increasing restraint on aggregate demand, troublesome finan- cial market distortions and disincentives to non-coffee exports from the exchange rate appreciation, the authorities began in late 1979 to -djust the program. The rate of peso devaluation was advanced somewhat, and in early 1980 credit restraints were relaxed. At the same time, interest -ates on certificates of deposit--and on lending therefromr-were freed from controls. To offset the inflationary effects of these measures, the authorities further liberalized import payments and adopted the policy of not expanding the sub- sidized selective credit operations of the Central Bank in excess of the resources captured from private savings for this purpose. Real GDP growth decelerated to 4% in 1980 from an average of almost 6% since 1960, unemploy- ment started to creep up, and inflationary pressures continued. C. Recent Economic Developments 8. During 1981-83 the economic situation took a turn for the worse in part on account of external factors, with real GDP growth slowing down to 2.3% in 1981 and 1.2% on average in 1982-1983. Agricultural output was hard- hit as a result of low international prices, reduced input use from declining profitability and adverse weather. Industrial activity deteriorated on account of depressed aggregate demand, and unutilized capacity continued to increase, particularly in manufacturing. Unemployment reached almost 14% of the labor force at the end of the year, up from about 7% at the end of 1981. Inflation, however, slowed down in 1983 to a 20% average for the year, down from 28% in 1981 and 25% in 1982. 9. After experiencing a surplus for six years, a deficit of about US$1.5 billion emerged in the resource balance in 1981 and it increased to an average of about US$2.2 billion in 1982-83. These deficits resulted mainly  from a drop in exports at constant prices: in addition to domestic factors, major reasons were the slowdown in world demand, large devaluations and import restrictions in neighboring countries, and the reduction of Colombia's coffee exports from their previous high levels. Net foreign exchange reserves declined by about US$1.8 billion in 1983 to about US$3.1 billion, equivalent to about five months of imports of goods and services in that year. On the fiscal side, a slowdown in revenue growth, together with increased current expenditures resulting from automatic transfers to depart- ments and municipalities and large infrastructure investments in energy and transport led to growing deficits: the Central Government cash deficit grew from 2.1% of GDP in 1980 to 4.1% in 1983, while that of the consolidated public sector rose from 3.6% to 7.6%. 10. In 1983 the Government introduced policies to stimulate aggregate demand and expand non-coffee exports. The rate of peso devaluation was accelerated; housing construction was provided with incentives to mobilize more resources; and selective credit operations to the productive sectors were expanded. Temporary import restrictions were introduced for balance of payments stabilization, ir- addition to measures to reduce the fiscal deficit and to ease distortions in the financial system. These efforts were insuffi- cient to reverse the deteriorating balance of payments trends particularly in view of the tight international capital market. Colombia, unlike some other Latin American countries, has not had a debt problem because of a relatively low debt-level, the high share of debt from multilateral institutions in total debt outstanding, and the term structure of such debt. However, the Latin American debt problem produced a sharp reduction in the credit lines available to Colombia and difficulties in obtaining medium-term loans for ongoing projects, which contributed to further declines in foreign exchange reserves and to strains in the financial system. 11. During 1984-85 Government policy began to focus increasingly on: additional revenue and expenditure measures to contain the fiscal deficit and monetary expansion: acceleration of the exchange rate devaluations and further increased incentives to exports; measures to improve the profitabil- ity of the commercial banking and to resolve the external debt problems of the private sector. The policy reforms began to take hold during the second half of 1984. Real GDP growth increased to 3.2%, the unemployment rate fell to 13% of the labor force at year's end from its increased levels during 1983-84, while inflation was brought down to 16.4% on average in 1984. Merchandise exports grew at about 12%; the current account deficit in the balance of payments was reduced by nearly US$1 billion to 5.3% of GDP, and reserves remained at about US$1.8 b,llion at year end (about three and one- half months of 1984's imports of goods and services). 12. Macroeconomic policy reforms were deepened in 1985. The economic program has contributed to a sharp and sustained adjustment thus far. The current account in the balance of payment registered a significant impr9ve- ment in 1985 declining to a deficit of nearly 4.0% of GDP. Inflation remained under control in 1985 at less than 23%, while economic growth con- tinued at a modest rate below 3%, although the unemployment rate remained higher than in recent years. In contrast with a US$1.3 billion fall in 1984 and a previously projected fall of US$50 million in 1985, net reserves increased by US$271 million in 1985.  -4- D. Growth and Balance of Payments 13. With further policy improvements (see Part II), Colombia's growth prospects for the rest of the decade would be good. At this stage, projec- tions are made difficult by the recently emerging international coffee situa- tion, which could mean a foreign exchange boom of additional receipts depend- ing on the severity of the Brazilian drought and production shortfall. Pre- liminary calculations suggest, however, that the medium-term scenarios would not be affected substantially: 1986-and possibly 1987-on the other hand, should witness a greater reserve accumulation and increased debt repayments. According to present projections, the current account deficit of the balance of payments would average some US$800 million per year (less than 2.5% of GDP), and real GDP growth nearly 3.5% during 1985-86. By end-1986 net official international reserves would be over four and one-half months of 1986 imports of goods and services. Total investment would need to be main- tained at about 19% of GDP to complete energy and mining projects, and gross national savings about 17.3% of GDP compared to 14.3% during 1981-84, with the public sector generating a significant part of the additional savings. Beyond 1986 real GDP growth should resume at near historical rates, averaging 4.0-5.0% per year during 1986-90. The current account deficit should remain modest as a result of increasing export proceeds from new non-traditional exports (particularly crude petroleum and coal), declining to less than 2% of GDP by 1990. 14. Total gross external medium- and long-term capital requirements are projected to total about US$6 billion for the 1985-86 period. Net foreign investment is expected to account for about US$1.0 billion during 1985-86, most of which would be to complete existing energy projects. About US$2.5 billion is expected from multilaterdl, bilateral and other official sources. A similar amount is expected from private sources during 1985-S6, including about one-half of the US$1 billion new money signed with the com- mercial banks in December 1985 mainly to complete petroleum and coal projects for export. At the end of 1984 Colombia's public and publicly guaranteed M&LT external debt, disbursed and outstanding, amounted to US$8.0 billion (21% of GDP). The Bank share of this external debt (excluding non-guaranteed private) was 22.8% in 1984 which is expected to reach an average of about 25% during 1987-90. The public debt service ratio in 1984 was 23.5% and, based on assumptions of the current program, it is expected to peak at about 30% in 1987 and then decline below 30% after 1990. The Bank's share in M&LT public debt service (excluding non-guaranteed private) was 25.3% in 1984 and it is expected to average aboi 23% during 1987-90. With sound management and the new export activities referred to above, Colombia is expected to maintain its creditworthiness through and beyond 1985-90. E. Medium-Term Policy and Bank Strategy 15. The country's medium-term prospects would be related co the relaxa- tion of key developmental constraints. Central to rapid growth and employ- ment generation would be diversification of exports and production that can be achieved through the execution of an outward-looking strategy. Government policy and public sector management have been addressing these issues. Bank presence in Colombia seeks to underpin a sound macroeconomic program for adjustment with growth, and support policy improvements at the sectoral  level. A three-pronged approach is envisaged, of providing assistance through policy-based macroeconomic operations, sector loans and the more traditional projects. The policies and financing are expected to support a revitalization of export-oriented growth over the medium-term. 16. Support for the economic program was initially provided through the Bank's Trade Policy and Export Diversification (TPED) Loan. The present pro- posal is a follow-up operation as part of a financing package to help imple- ment the program. This loan deals with three policy areas: (i) macro- economic policy; (ii) general trade reform; and (iii) trade and agricultural policy. The second tranche of the TPED Loan was released on March 27, 1986, thereby enabling the release of a part of the US$1 billion from the commer- cial banks. This loan also will be released in two tranches, one upon effec- tiveness and the second following a review of policy in November 1986. Future operations are envisioned to follow-up further on agricultuiral policy reform, and extend the impact of macroeconomic improvements in other sectors such as energy and transport as well. PART II - THE ADJUSTMENT PROGRAM A. Macroeconomic Measures 17. The Government has been reorienting trade policies towards outward- looking growth and revising public investments and pricing policies. Key elements of this program, supported by the TPED Loan for 1985-86, would be extended through 1986 and 1987 and supported by this loan (also see Annex 4). The 1985 program was successful in achieving adjustment with growth, and the targets of the Colombian program being monitored by the IMF have been met. The figures below for 1986 reflect the macroeconomic program the Government has discussed with the IMF and the Bank. Selected aspects of past performance, recent policy adjustments and future outlook are highlighted in Table 1. 18. Fiscal Policy. The 1985-86 program includes: measures to elimi- nate deductions in the income tax, a broader base for the value-added tax, an increase in stamp taxes, and an additional temporary 8% import tax. Together, these measures are estimated to have resulted in additional net revenues for the Central Government of 43% during 1985. Public sector salaries approved for 1985 implied an average salary reduction of about 13% in real terms. Public sector subsidies in transport were reduced and a scaling down of the investment program was initiated. As a result of these measures, fiscal performance strengthened substantially and the overall public sector deficit as a percentage of GDP was reduced by more than one- third to 4.6% in 1985. These policies are envisaged to stay in place in 1986. Settlements of public sector salaries and minimum wages for 1986 seem to have avoided real increases for this year. A further reduction of the public sector deficit to about 2.2% of GDP in 1986 and a similar level for 1987 are envisaged, in part due to increased coffee revenues. 19. Monetary Policy. A rapid decline in the Central Government cash deficit allowed for a reduction in monetary financing to the public sector in 1985 from the high 1984 level of about Col$150 billion. Central Bank  - 6 - financi&g of the deficiL was kept to dabouee Col$35 billion in 1985, and it is expected that the Central Government would require no Central Bank financing in 1986. This would permit the banking system to expand credit to the private sector in line with the growth in nominal GDP. Such an outcome would reduce the pressure in the growth of the monetary base during a period when reserves will be recovering. With a fiscal policy as discussed above and a moderate expansion of credit to the private sector, the growth in the monetary base and money supply should be in line with the expected growth of nominal GDP. 20. Exchange Rate Policy. With the acceleration of the crawling peg devaluation starting in 1983, Colombia achieved a significant real deprecia- tion of its exchange rate. However, at the end of 1984, the trade-weighted real exchange rate index still stood at only 82 compared to the 1975 .equilibrium" base (the highest level achieved in several decades). The 1985 program envisaged a recovery of the 1975 real level by the end of the year. Towards this goal, the Government sharply accelerated the rate of the crawl- ing peg to 51.3% in 1985, as compared to 27.8% during 1984. Exchange rate policy was ext-;emely successful during 1985; as inflation was contained to 22.6% during the 12 months ending December and with the weakening of the U.S. dollar vis-a-vis other major currencies during the second half of 1985, the real exchange rate index increased to 7% in excess of the 1975 base level, i.e., a 30.5% real depreciation of the peso. Current Government policy is to maintain the real rate reached in December 1985 even in the event of sizeable increases in export earnings from coffee, petroleum and coal. Performance of non-coffee exports in 1986 in response to the signific- antly depreciated peso should provide evidence on the adequacy of the present real exchange rate and the basis for any further adjustment in real terms. 21. Investment and Borrowing Program. Reviews of the investment pro- gram were initiated in early 1985 utilizing the criteria of encouraging quick-yielding investments with significant and positive impact on produc- tion, resource mobilization and the balance of payments. A scaling down of the investment program has been necessary, including the postponement or cancellation of all new large scale power generation and a number of large transport projects. The revised program, which implies containing public sector investment to less than 10% of GDP during 1985-87 compared to 10.5% during 1983-84, consists largely of projects which are already in execution or for which loans have been contracted. The investment program is dominated by the mining and power sectors. The mining investments of nearly US$1.8 billion inclu'e ECOPETROL's (National Petroleum Company) petroleum production and development program in association with foreign partners, and CARBOCOL's (Public Company for Coal Resources) ongoing El Cerrejon Coal project, a joint venture with EXXON. Both should contribute to a significant increase in export earnings from 1986 onwards. 22. Even with reductions in the current account deficit and the modest scaling down of the share of public investment in GDP, gross medium- and long-term capital disbursements (including net foreign investment) are expected to average about US$3 billion p.a. in 1935-87 compared to about US$2 billion in 1980-84. As part of these overall capital requirements, a loan for US$1 billion was signed at the end of 1985, about one-half of which is expected to be utilized in 1986 and the rest available in 1987 if needed. The country would require maintenance of the short-term credit lines from its  Table Is COLONBIA: ECONOMIC PERFORIMCE, ADJUSTMIET AkD CRaOVr, 1970-1987 (annu I averages) Record of the 1970s Early 1950s The Nld-ISBUs Export-Led Coffee EconomIc Beginning of Beginning of Growth Boom Sat-back Policy Concern Adjustnt Adjustmnt wIth Growth 1970-7S 1976-SO 1981-63 1983 1984 19S5 * 1986 p 1987 p 1. Perormnene IndIcators Aversa Growth Rate a/ GOP, conmtant price 5.7 5.5 1.3 1.6 3.2 2.9 4.0 4.6 Experts CUIWS), constant 6.9 7.4 -5.2 -I1.9 9.1 13.9 22.1 5.8 price Inports CGSNFS), constant 2.2 1".1 3.2 - 8.4 -7.0 0.8 2.5 1.1 price Inflation (CPI, average) 17.1 24.5 24.9 19.8 16.4 22.6 22.0 18.0 Average Ratio (percent) Current Account/COP -2.9 1.2 -6.5 -7.3 -5.3 -3.9 -1.0 -3.2 Year-end Reserves (USsn) 360 3,000 4,533 3,079 1,795 2,066 2,966 3.366 Months, Imports of C S t2.7) (8.1) (7.9) (5.0) (3.1) (3.5) (4.6) (4.8) Total Debt Service Ratio b/ 22.7 14.7 31.1 36.9 37.2 38.2 31.6 37.4 Public Debt Service RatIo 13.2 10.4 16.8 21.2 23.5 27.0 24.2 30.0 Total Investnt/G0P 19.1 I6.4 20.3 19.9 I.7 19.2 19.4 19.5 II. External Factors Nominal Coffee Price C/ (1970-100) B4 133 88 89 98 99 Jac 12S Net Capital Inflow CUSsm5)d/ 284 543 1.699 1,014 710 1,576 1.239 1,594 OECO Growth Rate a 2.3 3.6 3.3 2.3 4.7 3.0 3.0 3.0 III. Domstc PeolIcy Real Excbhnge Rte (1975 - 100) / 89 85 75 75 82 107 g9 ..9/ Money Base Growth 23 35 18 14 18 27 28 24 Central Covern_nt DafIcIt/q;OP 1.1 0.4 3.9 4.1 5.0 2.8 1.7 1.5 Overall Pub.Snctor Oeficith/ 3.0 5.5 6.8 7.6 7.6 4.6 2.2 2.0 CWFS ImportsGCOP IS IS 17 16 14 16 17 17 * - preliminary estimate p - projection &/ Note that average growth rates Include the rates In the and years. b/ Includes non-guaranteed and short-tern debt. c/ World Bank figures as of January 1986. d' Capital account balance, Including errors and omissions. eo For 1970 - 1975 figure. growth rate for 173 - 1975 was taken from IMF's World Economic Outlook, 1982; 1975-83 figures were derived from World Bank's World Dovelop_ent Report, 1982; and 1984-86 aro from OECD3 Outlook. f/ The calculations ucs 1975-84 estimated non-coffee trade weIghts; the 1983 and 1984 figures utlIze estimated weighted average exchange rates and Inflation rates for Venezuela. g/ MaIntain reaI exchange rate and revlew Its adequcy In view of balance of paymnts evidence. h/ Central Government plus docentralized agencles. Source: M1inIstry of Finance, lIF and World Bank estlmtes  -8- major external bank creditors at least at levels prevailing at end-1984, roughly US$1.5 billion; the Government is satisfied with developments and prospects in this respect. B. Trade Policy 23. As a result of actions during 1983-84 in response to a worsening foreign exchange situation, the trade regime became more restrictive than in a long period of time. Few items remained in the free license regime, while the share of items under import licensing and prohibition increased sharply; the tariff regime was characterized by increasing average levels and disper- sion, while export restrictions remained in effect. The trade policy changes of the adjustment program have been three-fold: (i) reduce import prohibi- tions, licences, tariff dispersion arnd tariff levels, build in substantial automaticity and uniformity in the access to export incentives and eliminate restrictions to exporting; and (ii) initiate more detailed studies of the impact of trade policies and incentives on export performance providing the basis for a medium-term action program; and (iii) put together a policy and financial package in support of exports, fostering the resumption of commer- cial bank flows to Colombia. 24. The adjustment program has produced results in gradually opening up the import and expcrt regimes and strengthening trade performance. The share of imports that can be freely imported has been rising, first including increasing magnitudes of inputs and raw materials in this share and subse- quently selected finished products as well. The tariff regime has been in the process of being rationalized and the access to export incentives improved. Together with the significant depreciation of the real exchange rate, export performance has been strengthened. Although it might be early for an evaluation, recent policies seem to have contributed to improved export performance. Non-coffee exports are estimated to have risen by nearly 14% in 1985 after a poor performance in the early 1980s and picking up in 1984; preliminary indications suggest that a process of diversification in exports is underway. 25. As will be detailed in Part IV, the present loan supports the extension of trade actions by: (i) increasing free imports; (ii) further rationalizing tariffs; and (iii) reducing further biases against exports. These reforms would carry forward the process of liberalizing the export and import regimes, in a manner that can be sustained and deepened over time, giving Colombia a significantly st:engthened external sector. Based on the findings of studies underway, a medium-term action program is expected to be formulated later this year which could serve to guide future policy. The Government envisages continued attention to issues of liberalization of exports and imports, effective protection and efficiency.  9 PART III - TRADE AND AGRICULTURE A. Policy Issues 26. Key areas for policy improvements in the general trade area over the medium-term include import restrictions, tariff reform and export incen- tives. First, quantitative controls on imports have varied substantially over time, and policy reversals have often left the import regime restric- tive. At the end of 1984 only 23 items (out of a total of 5,011 customs positions) belonged to the free license regime. The reform program has been addressing this problem. Imports needed for exports under the special export schemes are already freely imported, although further improvements can be made in streamlining procedures. The Government has been transferring more items to the free license regime; imports of raw material and intermediate inputs have been generally liberalized; the next steps are to reduce further the discretionary element in the import regime through a steady and sustained increase in the share that can be freely imported. Inclusion of progres- sively more finished products would provide greater competition to domestic production. 27. Second, the level and variation in tariffs represent another area for reform. In 1984 tariff dispersion amounted to a standard deviation of 29%, and the weighted average tariff rate was 36%. Actions already taken have reduced the average tariff levels, and their dispersion. A maJor com- ponent in the tariff incidence concerns a surcharge of 8% which was temporar- ily introduced in 1984. Complementary to the envisaged phasing out of this surcharge in 1986-87, a full evaluation of remaining tariffs would be needed, beginning with the November 1986 review. 28. Third, a key element of the medium-term strategy would be the elimination of restrictions and disincentives to export. The performance of non-coffee exports has fluctuated significantly in the past hurting the long- term performance of the external sector. The reasons have partly been export restrictions and other disincentives, and partly exchange rate overvaluation particularly in periods of high coffee earnings. While significant progress has been made, elimination of export restrictions, except those on non- economic grounds related to national security, cultural heritage, environment and similar, and minimization of administrative approval procedures are needed reforms. 29. In addition to these general trade reforms, agriculture requires special attention. Colombian agriculture has considerable potential with favorable soil and climatic conditions, proximity to major international markets and a resourceful rural population. While yields of crops such as rice, sugar and coffee are high by international standards, there is substan- tial potential in a variety of other products which can be realized through investments in technology, infrastructure and marketing, and through policy improvements. The sector accounts for 20% of GDP, provides about 25% of total employment, and contributes some two-thirds of the export revenues, including one-half of total exports constituted by coffee. Imports of agri- cultural products represented 7.5% of total imports in 1983, following a growing trend from 1970, approximately 30% of which imports are accounted for by wheat. Within non-coffee agriculture, an export-oriented segment (bananas, flowers, sugar, tobacco, rice, cotton, etc.) accounts for roughly  - 10 - 28% of agricultural GDP and covers 19% of the area under cultivation; an import substitution part (mainly cereals) contributes approximately 18% to agricultural GDP and uses more than 25% of the area under cultivation, and a domestic sector (potato, yucca, plantain, etc.) produces mostly for home consumption. 30. In addition to coffee policy (Annex 8), government interventions in the sector have included: (i) export restrictions, import policies and price supports for import-competing products; (ii) import and price policies for inputs; (iii) credit policy; and (iv) public investments and institutional aspects. Export restrictions have been in effect, although they have been in the process of being lifted over the past year. Import substitution crops enjoy protection through the import controls of the Government's marketing agency, IDEMA, which until recently has had a monopoly in their international trade. IDEMA also sets minimum guaranteed support prices for several import crops, which has led to financial costs ultimately covered by the Central Government. 31. Agricultural machinery, fertilizers, pesticides and seeds are largely imported and represent more than 40% of farm budgets for some crops such as sorghum, rice, cotton and potato. Approximately two-thirds of the total costs of compound fertilizers and pesticides are imported materials. Installed capacity of compound products and most urea imports are controlled by two companies, and some 50% of their distribution by Caja Agraria and FEDERACAFE. Over 70% of production and distribution of pesticides is con- trolled by six firms, reflecting the internationally oligopolistic structure of the industry. Import duties involving a tariff for each category (around 20% on average in 1984) plus a surcharge of up to 18%, and licensing for the agricultural inputs and machinery provide additional protection to the domestic industry. Importers have also incurred additional fiaiancial charges (about 8% p.a. of the c.i.f. import price) due to an obligatory system of delayed import payments (minimum of six months for fertilizer and pesticides and three years for capital goods in 1984) at the exchange rate prevailing at the time of payment. 32. Agricultural credit has been made available during recent years via a system of forced credit under which private banks are required to contrib- ute to an agricultural fund (FFAP) receiving interest rates well below market rates. Financial intermediaries can draw from this fund for agricultural lending at rates which were often negative in real terms until recent reforms. The Government has also made available subsidized interest rates for storage of agricultural commodities (bonos de prenda). These subsidies, in contrast with FFAP subsidies, are partially financed by direct monetary emission, and are enjoyed by a small number of producers and processors. 33. The participation of public investment directly or indirectly bene- fitting agriculture in total public investment has decreased dramatically since 1970. Agriculture-related public investment as a proportion of total public investment was 25% in 1970, 12% in 1975 and only 8% in 1985. At the same time important increases in personnel took place, implying lower levels of capital funds available for each job created. The Ministry's capacity to direct agricultural investments and policy is also at issue.  - 11 - B. Constraints to Performance 34. After expanding at satisfactory rates of above 4% during most of the seventies, the growth rate in agriculture fell to only 1.3% during 1980-84. While in the seventies export growth was a very important source of growth, in the more recent period export performance has had a negative impact. During the first half of the seventies agricultural growth was based on the dynamism of non-coffee exports which expanded at an average annual rate of nearly 10% in real terms. In the second half of the seventies the coffee boom became the driving force while non-coffee exports decreased its expansion to less than 7% per annum. In contrast, during 1981-84 coffee exports have been greatly affected by negative factors depressing the inter- national markets while non-coffee exports have shown a negative growth rate. The decline of coffee and non-coffee exports explains almost 80% of the fal'. of agricultural GDP growth that took place in the 1981-84 period. 35. Three sets of forces explain the decline in exports and overall performance and provide bases for medium-term adjustments. First, unfavor- able international conditions for agricultural commodities implied a rather dramatic fall in prices of commodities exported by Colombia. Coffee exports suffered a drastic decline in 1981 as indicated earlier. Sugar exports have declined substantially mainly because of prevailing protectionist policies in the USA and European Community countries. Exports of cotton fiber and fresh meats have also suffered large reductions in the early 1980s due in part to unfavorable external market conditions. Second, macroeconomic policies in the latter part of the seventies led to a significant appreciation of the exchange rate and to a reduced emphasis on export promotion. 36. Third,. trade and agricultural policies described in the previous section have had a critical impact especially on the export-oriented sector. Export restrictions, aimed inter alia at assuring minimum domestic availability, have hurt the export potential of certain crops such as rice and cocoa. Inadequate supply of imported inputs and capital goods and lack of access of agricultural exports to export promotion schemes have also impaired the development of agricul- tural exports. Import restrictions and support prices for the import substituting crops have provided some incentives to the sector, although these efforts have meant price distortions in favor of import substitution, and import inflexibility contributing to inflation. The degree of such distortion and its coverage in Colombia, however, has been moderate compared to other countries. Support prices in 1985 for various commodities were between 25% and 45% above international c.i.f. prices including port charges and transportation, although market prices represent somewhat higher protection via the import controls. Coffee policy and incentives have affected the relative profit- ability of other products. Following the 1976-80 coffee price boom and the technological advances in coffee production, the implied incentives for non-coffee exports have been an area of concern. Future non-coffee development would depend on coffee incentives being kept within reasonable levels--given international market prospects for coffee-and on direct incentives for diversification;  -12- recent international events, however, have made domestic price increases for coffee inevitable. Given the interest rate subsidy for the FFAP funds, excess demand and arbitrary allocations among agricultural producers of these resources and increased administrative costs for banks and other financial intermediaries result. Furthermore, the situation com- bined with the lack of dynamism of Caja Agraria (an institution designed to serve small producers), has implied that small pro- ducers have been mostly unable to obtain adequate credit. Another problem is related to the lack of flexibility of the agricultural credit system which has caused credit to be concentrated in short- term loans (approximately 60%), largely because interest rates for long-term loans are required to be constant throughout the period of the loan. Finally, evidence from the 1970-84 period suggests that the storage credit subsidy, originally intended to induce greater price stability, might have actually exacerbated commodity price fluctuations. The notable reduction of government investments in agriculture since the mid-1970s and inadequate institutional capacity of the Ministry of Agriculture to direct these investments have had a detrimental effect on production conditions. A significant reversal of this trend would be justified in view of the sector's potential to contribute to growth and employment generation. The composition of investment would also require more careful reviews than in the past. The Ministry's institutional capacity for policy analysis and execution need to be significantly strengthened. PART 1V - THE LOM A. Loan History and Objectives 37. The loan continues support of the Government's macroeconomic and trade adjustment program spelt out in Part II. It helps to extend the adjustment process in the trade and agriculture area, and to address the medium-term issues raised in Part III. Discussions with the Government have i-._l-ed issues affecting trade and agricultural development (Report No. `93i-CO dated April 20, 1984) and agricultural strategy (Report No. 4275-CO dated January 31, 1983). The loan was appraised in September 1985. Negotia- tions were held in Washington in December, 1985. The Colombian delegation was led by Jorge Ospina Sardi, Director of DNP. Supplementary loan data are provided in Annex 3. 38. This operation would underpin policy reforms at a critical point in the adjustment process when its effects on resource allocation are being felt, and when temporary increases in coffee earnings need to be handled. The loan is intended to reinforce a package of actions by the Government (Annex 7) and to support policy monitoring and the mobilization of external private financing for Colombia. Envisioned is a deepening of reforms previously 7nitiated in trade policy and macroeconomic management, and an extension of the program to the sectoral level through reforms in agriculture designed to restore the sector's competitiveness. In addition to adjustments  - 13 - in fiscal, monetary, exchange rate, investment and external borrowing, and medium-term trade policies discussed in Part II, the following trade and agricultural areas are addressed: (a) import liberalization; (b) tariff reform; (c) export policy; (d) agricultural input trade policy; (e) agricultural output trade policy; (f) coffee policy; (g) credit policy; (h) public investment in the sector; and (i) institutional strengthening. B. Measures Supported by the Loan (Annex 4) 39. Import Liberalization. The number of items under the free license regime was increased by 1,135 during the course of 1985. With these actions the share of free imports reached 56% of the total value of imports in December 1985 from just over 30% at the beginning of the year. (Free imports include imports under the free license regime, imports under export promotion schemes, imports under international agreements, e.g., Andean Group, and through free ports, and non-reimbursable imports primarily goods financed by medium- and long-term foreign loans and private investment). Subsequently, an additional 653 items have been moved to the free license regime of which more than half belong to the finished category. Consequently the share of free imports in the total has reached 67Z by February. This share is expected to increase to 69% by April and it is envisaged to be maintained and reviewed in November 1986 for further actions. During the recent process of liberalization the number of prohibited items has declined from 828 (17% of the total) at the beginning of 1985 to 119 at effectiveness of the TPED Loan and to 69 (1.4% of total) at present. 40. In line wwith the gradual liberalization of the import regime the real depreciation of the exchange rate and the improvement of the foreign exchange situation, the level of import approvals was increased during 1985. Initially, the monthly budget for approvals of imports that are not extern- ally financed was set at US$250 million per month, implying an annual import level, inclusive of externally financed imports, of US$4.0 billion, the same as in 1984. The monthly budget for approvals was increased to US$300 million from about the middle of the year. In all, total import approvals, including externally financed imports, reached close to US$4.7 billion in 1985, or 17% more than in 1984. Given the lag between approvals and importation, import arrivals were only slightly above the 1984 level, while import payments were lower than in 1984 because of a requirement introduced at the end of 1984 to maintain a minimum period before credit repayment. With the strengthening of the foreign exchange situation and the normalization of commercial credit lines, this requirement has been abolished effective January 1, 1986. For 1986, non-oil imports are expected to increase by about 15% over the 1985 level. 41. Tariff Reform. The import tariff regime was significantly rationa- lized in the course of 1985. Through the reduction of peak tariffs and the elimination of many ad hoc tariff discounts, tariff dispersion was reduced to a standard deviation of 16% in 1985 (from 29% in 1984) while the weighted average nominal tariff level was reduced to 28% in 1985 (from 36% in 1984). Import tariff surcharges, including a temporary component of 8%, currently amount to up to 18% on top of the 28% tariff level. Actual collections of .duties, inclusive of surcharges, however, amounted to only close to 20% of total value of imports. Inefficiencies of customs and the exemption from  * - 14 - duties and surcharges of most public sector imports explain the divergence between nominal rates of duties and surcharges, and collections as a share of total imports. Further rationalization of the duty regime and strengthening of customs administration would be required if Colombia is to successfully move further in reducing dependence on the license regime to protect domestic industry. Progress in these areas would be assessed in the course of the supervision of the TAP Loan and during the November 1986 review. 42. Export Policy. The Government has been simplifying the access to duty concessions on imports for exports, and significantly reducing the restrictions to exports. In 1985 the number of items subject to restric- tions, including prior approvals (vistos buenos), has been reduced from 729 to 175. (Within this total, the number of explicitly prohibited items was reduced from 93 to zero). Most of the remaining restrictions represent non- economic concerns. The Government has agreed in principle to take the following further actions. For the 70 items subject to prior approval of the environmental agency, INDERENA, a permanent register of producers and exporters would be established rather than requiring prior approval for each export transaction. The list of items subject to prior approval by the Ministry of Agriculture (31) would be significantly reduced. Finally, in the case of rice and cotton, which are subject to export quotas, complete liberalization could have unacceptable fiscal implications since both have relatively high levels of CERT (indirect tax rebates for exporters); the Government agrees in principle, subject to further review of legal implica- tions, to allow these crops to be exported freely in excess of established quota levels without CERT payments. At the end of 1985, the Government reduced the average of CERT rates applicable to exports, reducing both dis- persion and the number of rates applied from 7 to 4 levels. This measure was justified by the sigificant real depreciation of the exchange rate achieved during 1985. Even with the lower CERT rates, the real effective exchange rate (i.e., including the export incentive) is estimated to roughly equal the 1975 level. 43. The Government has also extended access for farmers to the PV/SIEX schemes, which allow import duty exemptions and drawback and automatic access to imported raw materials and intermediate goods used in export activities. In practice, since in agriculture this has been implementable only in cases where the importer and exporter is essentially the same entity, a large part of agriculture was excluded on account of the complex linkages between importers and exporters. Only banana and flower producers with a continuous export record have benefited from the scheme. A more liberal interpretation of procedures established by INCOMEX in 1985 has now begun to allow more export-oriented crops, especially rice and cotton in addition to bananas and flowers, to benefit by enabling producers' associations who import the inputs and export the products to access these schemes. 44. Agricultural Inputs. In 1985 about 85% of fertilizer imports were freed from licensing as opposed to none previously. Total import duties (tariffs plus surcharges) were also reduced for fertilizers from a weighted average of 23% to 13% of the c.i.f. value mainly via an exemption from the 8% surcharge. For pesticides total duties were reduced from a weighted average of Z9% to just over 23%. For agricultural machinery the decrease was from a weighted average of 36Z to 32%. Finally the requirement of having minimum periods for repayment of external credits has been eliminated. These measures reduce effective protection to local producers of agricultural Inputs. At the same time, trade barriers are being reduced both for raw  - 15 - materials to supplier industries and for finished fertilizers, pesticides and agricultural imaplements. During 1986 a study will examine the effects of changes in import restrictions on the effective protection of industries supplying agricultural inputs (see Annex 6) to guide further adjustments to tariffs and import licensing. Beginning in 1986 the Government intends to phase out the 8% surcharge on imports imposed by Law 50, 1984. 45. Output Pricing. As a first step, the Government has terminated IDEMA's monopoly in wheat imports, while interventions have been reduced in the cases of barley and soya. The private sector can now import the bulk of these commodities directly within global quotas. Support price increases announced for the first semester of 1986 have been substantially less than the domestic inflation rates. The annual rate of growth of the support price for wheat announced for the first semester of 1986 was 16% versus 36% for the second semester of 1985, for soybeans 9.7% versus 41%, for corn 15.5% versus 33% and for barley 16% versus 36%. Domestic wholesale prices of commodities subject to import quotas, however, were still growing faster than domestic inflation and above peso international prices in the first semester of 1985. Wholesale prices of soybeans, corn and barley, for example, increased at an annual rate of approximately 35% while dry beans prices increased more than 80% annual rate; the wholesale price of wheat increased by only 20%. Support prices announced for the second semester of 1986 are below the inflation rate. 46. Given their existing level of protection, domestic prices of the import-competing crops would not increase in real terms on account of import and price support policies. Understandings for the second tranche envisage that the 1986-87 support prices would not, by and large, increase beyond the rate of inflation. Imports would be allowed by private importers for all commodities (in addition to wheat, barley and soya) subject to global quotas, if necessary. Import quotas would be adjusted so as to avoid real price increases for wheat, beans, barley, soybeans and sorghum. Import quotas would be distributed among importers in a less discretionary and more market- based manner than at present: the private sector would import, directly or indirectly, at least 80% of the quota, which would be negotiated by the traders amongst themselves with minimal government intervention. IDEMA would continue to reduce its participation in domestic purchases and storage. 47. Coffee Policy. Under the Agricultural Diversification Loan (2453-CO) an understanding was reached with FEDERACAFE on the incentives for diversification. Since then a consensus has been established with the Federation and the Government inter alia on not raising the domestic real prices of coffee (see Annex 8). World coffee prices, however, have increased very sharply in recent months, and it appears that they will remain high during 1986 in view of shortfalls in the Brazilian production. This alters the assumptions on which the previous consensus on domestic prices was based. In view of this new situation the Federation has decided to raise the internal price by about 37% in real terms during the 1986 coffee year. Given the increase of international prices and the rapid peso depreciation, never- theless, the share of the domestic producer in the external price is still below 45%, one of the lowest shares historically. Other measures carried out to maintain a balance between coffee and non-coffee production are: (i) elimination of the subsidy for fertilizers and for coffee plantings to coffee growers; (ii) incentives for stumping the high yielding caturra variety, both to postpone output modestly and to protect long term yields; and (iii)  - 16 - increase funds for coffee d versification. The domestic price increases were necessary inter alia to prevent large-scale smuggling and the consequent loss of participation of the Federation in the market arising from a large diver- gency between domestic and international prices. 48. In order to avoid price signals for overproduction, a temporary variable bonus scheme has been introduced, linking the temporary bonuses over and above the guaranteed price in a proportion to any further increases in the external price. The policy of a variable bonus if strengthened and implemented, could make price policy more flexible in allowing downward adjustments in coffee receipts of producers when world prices fall. The National Coffee Fund is expected to remain self-financed and unsubsidized; the Federation would lend to and borrow from the Government according to the cycles of coffee revenues. Under the proposed loan the Federation has pre- sented the key elements of coffee strategy and has agreed to follow-up on this matter periodically. Current policies in handling increased coffee revenues are satisfactory, and continued vigilence on the part of the Govern ment in sustaining incentives for non-coffee activities in the future would be needed. 49. Credit Policy. The Bank and the Government have been analyzing the financial sector policies. In agriculture the following measures have been analyzed with a view to reducing distortions: (a) increase the average rates of interest associated with the agricultural fund (FFAP loans) to approach gradually market rates; (b) introduce partially variable interest rates; (c) improve the margins of financial intermediaries; and (d) reduce the subsidy to interest rates for -bonos de prenda (storage). While an across-the-board approach is eventually necessary to improve credit policies, two policy changes have been carried out immediately as a first step towards reducing reliance on forced credit. First the average rate of interest on FFAP to borrowers has been raised by 1.5X on average, and thus the effective rate became positive in real terms. Second, a system of partially variable interest rates, linked to the market CDT rates, has been introduced on most medium- and long-term FFAP loans. The second tranche would seek adjustments of the FFAP and other agricultural rates to make them more competitive. Sub- sequent operations in agriculture are envisaged to address further the issue of phasing out the system of forced credit and improving the access to credit for small farmers. 50. Public Investments. The Government plans to upgrade public invest- ments in agriculture, to strengthen institutions and carry out studies. Based on experience of the past decade an investment program for the subsec- tors has been agreed upon. The 1986-87 public investment budget would regain its 1983 level in real terms. The 1986-87 program has been found satisfac- tory based on economic criteria, and it gives priority to: (a) projects already underway; (b) high-priority projects for which implementation is about to begin; (c) a few selected projects currently under negotiation; (d) priority investments under the National Rehabilitation Plan, a multi-sectoral program to increase investments in neglected rural areas; and (e) some resources to enhance the investment and operations of the decentralized agencies of the MOA. This program can be implemented without significant increases in personnel-as human resources are presently underutilized for lack of funds--and many of the investment activities, especially in infra- structure, will be subcontracted with the private sector.  - 17 - 51. The 1986-87 program gives priority to irrigation rehabilitation and small-scale irrigation development by HIMAT, agricultural research by ICA, and land titling, colonization, and agricultural credit for agrarian reform beneficiaries by INCORA. Additional funds would be allocated to the multi- sectoral activities of the Regional Development Corporations, the DRI, and to improve agricultural statistics, and better control of pests and animal and plant diseases. No major new investments would be started in 1986 that are not already appraised and financed, and those in 1987-88 would be reviewed before the second tranche, in accordance to the criteria indicated in the previous paragraph. A three-year investment program is envisioned to be reviewed by mid-1987. 52. Institutionatl Strengthening. The Government has decided to streng- then agricultural planning by establishing a national agricultural policy board chaired by the Minister of Agriculture. It would be supported by a technical unit of high level staff and be responsible for periodically reviewing the medium-term agricultural strategy, including the following areas: agricultural credit, public sector investment, marketing of agricul- tural products, and price policy. The Government has decided to upgrade the planning and policy analysis capabilities of the MOA, and its capacity to identify, prepare and monitor projects. Before the second tranche release, the Government would develop a plan to reorganize the OPSA of the MOA. In addition, measures would be taken to improve the financial efficiency of MOA's decentralized agencies and their budgetary, monitoring and control capabilities. OPSA and the DNP would contract international consultants for strengthening policy analysis and for arranging short-term training courses and international study visits for their staff. A schedule of actions was finalized during negotiations. 53. Part of the loan (US$2 million) has been set aside for the above- mentioned technical assistance component and to finance specific studies to be completed by OPSA and the DNP before second tranche release (see Annex 6). The studies are: (a) analysis of demand and supply elasticities for agricultural products and inputs to estimate the response of the sector to policy changes; (b) possibilities of increasing the internally-generated resources of public agricultural institutions; (c) a feasibility study on a line of credit for agricultural marketing and processing; (d) the cost of production of selected crops; and (e) effective protection of selected agri- cultural inouts. These more detailed studies are necessary in order to understand -more quantitatively the potential for deepening the policy reforms currently proposed. The method of selecting consultants, timetable and fees were reviewed during negotiations. Selected staff of the MOA and DNP would participate in these studies so as to receive on-the-job training. C. Expected Effects of Policy Changes 54. Lower Farm Costs. Given the high import dependence of agricultural inputs, the reduction of import harriers would reduce prices to the farmer. Lower tariffs, more liberal import licensing and the elimination of foreign credit payment periods are expected to reduce prices on the order of 15% on average for agricultural inputs. Cost reductions are expected to be passed on to farmers given that: (a) internal distribution of agricultural  - 18 - machinery is competitive; and (b) price controls in fertilizers and pesti- cides would take into account reductions in producers' costs, which should not increase given the excess capacity in these industries. Furthermore, introduction of competition from imported finished agricultural inputs is likely to reduce prices further. 55. Increase Production and Employment. Productivity gains are also expected from an acceleration of coftee diversification, a reduction in dis- tortions against agriculture, the recuperation of public investments and the depreciation of the real exchange rate. For reasonable supply elasticities, the indicated fall in the average cost of production alone could increase agricultural growth by over 2% on an annual basis. Despite some offsetting effect of the increased use of farm machinery, the effect of increased output on employment could be of the order of 25-30 thousand additional jobs (0.2% of the labor force). 56. Lower Food Prices and Inflation. This is expected to result from lower farm costs and a change in the import policy of food commodities. A reduction in the monopoly of IDEMA and a change in support price policy should reduce the price of wheat and at least stabilize the price of other cereals and legumes. Assuming an agricultural supply elasticity of 0.5 and a food demand elasticity of -0.3, the reduction in the cost of production and the other measures indicated above should decrease the food prices by 4Z and thus the overall CPI by close to two percentage points. 57. Exports and Balance of Payments. The adjustment of the exchange rate and changes in agricultural commodity pricing are expected to increase the relative profitability of exports. Increased imports of inputs would lower input prices and stimulate exports. The net effect of the measures, including increased export earnings and increased importation of inputs and machinery, is expected to be significantly positive during 1986-88 (Annex 5). 58. Social Costs and Benefits. Expected social benefits would be sig- nificant since improved agricultural performance would assist the poorer com- munities in Colombia as producers and consumers. Small producers (farmers with less than 20 hectares) constitute an important proportion of the farm population (around one million producers), and they mainly produce import substitutes and traditional crops such as potatoes and other tubers. Some of the proposed policies may reduce the protection currently afforded to these producers, which could cause a reduction in their income if shifting resources to other activities is difficult. This problem, however, would be mitigated by employment-generation expected from export-oriented activities and the increase in investment and cost reductions. Another potential cost for the farm labor force may be associated with increased mechanization that will occur as a consequence of increasing imports of agricultural machinery. The expansion of production, however, should compensate for this substitution effect. D. Risks 59. Import liberalization of agricultural inputs, implements and machinery could reduce the protection to the domestic producers of these  - 19 - goods, and hurt producers who are unable to adjust to the change. This risk, however, may be minor given the prospect that the domestic producers would also benefit from the lower cost of imported raw materials; moreover the con- tribution of this subsector to employment is relatively small. Furthermore, lower input prices would expand demand, thus enabling a more efficient utilization of excess capacity present in the pesticides and (to a lesser extent) the fertilizer industries. 60. A potential risk could also concern the economic and social effects of the measures affecting the import substituting crops produced by small farmers. This possible risk, however, would be mitigated by the gradual nature of the proposals and the prospect that the loan would induce lower costs of production through lower input prices and more government investments. 61. There are the usual risks concerning continuity in policy given that a new Government will take office next year. The mechanism of two tranches and possible future policy loans address this risk. A sizeable expansion of foreign exchange from petroleum, coal and coffee could votentially reverse the current export orientation for other products. The authorities, however, believe that export incentives should not be hurt by temporary booms of specific commodities, particularly in light of the experience with the previous coffee boom. In the wake of recent coffee price increases, debt prepayment is being planned for, and the real exchange rate is being protected. E. Loan Features and Operations 62. A US$250 million Bank loan is proposed based on the estimated incremental foreign exchange requirements for inputs, machinery and equipment for the agricultural and rural sectors during 1986-87. US$198 million would be used to finance these categories for the agricultural and rural sectors; US$50 million would be channelled through the export account established under the TPED Loan to finance inputs for exporters that participate in the PV/SIEX export promotion schemes, and the balance--US$2 million-to finance technical assistance. 63. Contracts for the procurement of import of inputs, intermediate and finished goods for agricultural production estimated to cost the equivalent of US$5.0 million or more would be awarded through ICB in accordance with Bank guidelines as in the TPED. Equipment for the technical assistance com- ponent, estimated not to cost more than US$100,000 in total, would be through local shopping in accordance with Bank guidelines. All other goods would be awarded on the basis of normal commercial procurement procedures of the pur- chasers of goods. Consulting services would be contracted in accordance w-th Bank guidelines. 64. The Government of Colombia would be the Borrower of the proposed loan. The proceeds of the loan would be made available to and administered by BOR, except tor the technical assistance component which would be made available to the MOA and the DNP. BOR will maintain separate accounts to record and monitor loan disbursements against payments for eligible imports for the agricultural sector. These accounts will be audited each fiscal year  - 20 - in accordance with sound auditing principles by independent auditors accept- able to the Bank. The Government would maintain a separate account to record the use of counterpart funds for investment. 65. The loan proceeds would be disbursed in two tranches. The first tranche of US$125 million would be available upon loan effectiveness and would comprise: (i) US$25.0 million as an initial deposit into the Export Account for imports for exporters under the export promotion schemes; (ii) US$99.0 million for direct and indirect imports of inputs and machinery for the agricultural and rural sectors to be disbursed by reimbursing 30% of payments of imports of the relevant categories, which is equivalent to the estimated incremental imports of those categories in 1986. Of this amount up to US$25 million would represent retroactive financing of eligible imports incurred between January 1, 1986 and the date of lorn signing in view of policy reforms that are in place, and the 1986 import and investment program underway; and (iii) US$1.0 million for studies and the technical assistance component. The second tranche of US$125 million would be released upon a satisfactory review of second tranche conditions in early 1987, utilizing the same criteria as in the first tranche. All disbursements under the two tranches would be made against certified statements of expenditures. The corresponding documentation would be retained by BOR and periodically reviewed by Bank staff, except for the documentation pertaining to the Export Promotion Schemes that will be periodically forwarded to the Bank. F. Monitoring 66. To monitor the trade and macroeconomic variables under the adjust- ment program, the Social-Economic Committee of the Cabinet (CONPES), headed by the President of the Republic and comprising Cabinet ministers, will meet regularly to review progress, and to decide on appropriate actions to ensure timely implementation. The agricultural policy reforms, the measures for institutional strengthening and the agricultural investment program will be periodically reviewed by OPSA and the DNP. 67. The monitoring of the export promotion measures for agricultural products would be based on a report to be prepared by INCOMEX at the end of the first year of the loan regarding the use of such schemes for agricultural exports. INCOMEX plans to report on the number of final agricultural imports whose inputs are liberalized as well ax on the raw materials for domestic input production set on the free list. For those products still subject to import quotas, the value of their imports would be used to determine whether additional imports availabilities have been adequately allocated between finished inputs and raw materials. 69. IDEMA would provide annual progress reports concerning its decreas- ing participation in purchases and storage in regions of commercial agricul- ture and on the level of imports of agricultural products. A biannual con- trol of support prices would be made to verify that these do not increase beyond the overall inflation rate. A monitoring of the FFAP interest rates would be implemented. The investment program would be followed by periodic progress reports to be issued by the MOA, and the CY1987 public agricultural investment program and recurrent expenditures would be reviewed before the second tranche release, relating performance and expenditures to objectives and targets.  - 21 - 70. Under the two tranche releases the Bank plans to review and monitor: (1) the adequacy of the 1986-87 macroeconomic program; (ii) the specific agreements on trade and agricultural policy reforms; and (iii) agreement on the public sector investment and external borrowing program (Table 2, pages 14-15). The assessment of the macroeconomic program would take into account the findings of the IMF on stabilization, particularly as it relates to targets on net international reserves, total credit of the Central Bank, net credit of the Central Bank to the public sector and the level of public sector external debt on a quarterly basis. As part of this process, the Government would prepare and send to the Bank two reports, summarizing the status of implementation of the program, the first in October 1986 and the second in June 1987. The first status report should also serve as a basis for a mid-term review which in turn would form the basis for the release of the second tranche of the loan. PART V - BANK GROUP OPERArIONS IN COLOMBIA 71. The proposed loan, the 119th to be made to Colomlia, would bring the total amount of Bank loans to Colombia to US$5,455.2 million (net of cancellations). Of this amount the Bank held, as of September 30, 1985, US$3,758.3 million; IDA made one credit of US$19.5 million for highways in 1961. Disbursements have been completed on 72 loans and the IDA credit. Before 1979, disbursements averaged US$86 million equivalent per year, but had increased to US$286 million in FY84 and to US$591 million in FY85, reflecting in part the higher level of commitments in the late 1970s and efforts to build the pipeline. While disbursements in Colombia have been slower than those recorded in the Latin American Region for similar projects, concentrated efforts to overcome problems to initiate project execution have resulted in a significant increase in disbursements during FY84 and FY85. Improving performance of social sector institutions in the execution of Bank- financed projects, the gradual containment of inflationary pressures and the effects of the recently-introduced fiscal reforms, which should improve counterpart funding, all point to a higher level of disbursements for pro- jects in the future. IFC has made investments and underwriting commitments of US$144.2 million in 29 enterprises and as of September 30, 1985, it held US$67.3 million. Annex Ti contains a summary statement of Bank loans, the IDA credit and IFC investments as of September 30, 1985. 72. Since the initial loan in 1949, Bank lending to Colombia has become quite diversified. Although through the mid-1960s, 88% of the loans made were for power or transport, since then the Bank has broadened its participa- tion in lending for agriculture and industry, and initiated lending for irrigation and watershed management, education, water supply, telecommunica- tions, urban development, petroleum development, export diversification, nutrition and health. By the late 1970s, 53% of the loans made to Colombia were for projects other than transport and power. Of the loans made since 1978, 37% were for power and transport, 15% for industry, 18% for agriculture and irrigation, 9% for water supply, 6% for urban, 4% for telecommunications, 2% each for petroleum development and export diversification and 7% for education, nutrition, health and multipurpose projects. The diversification was indeed a desirable aim as it helped provide close contact with a broader range of Colombia's development problems. The experience gained has served  - 22 - to identify areas in which the Bank's role can only be a marginal one and, thus, to enable lending to be focussed upon sectors in which the Bank's presence can have a meaningful impact. 73. The Bank's dialogue with the Government has focused upon the need to mobilize additional domestic resources, to diversify and expand exports, to develop rapidly the country's energy resources, and to free the economy from excessive controls. The discussions involved fiscal, interest rate and pricing policies, as well as incentives for exports and reduction in the level of effective protection. Positive results have been obtained parti- cularly in the power sector, where power rates were increased sharply and a least-cost expansion was formulated and launched. Similar results have been achieved in respect of some other public services, including appropriate charges for water for irrigation and domestic use and petroleum prices. 74. The Bank has been supporting the Government's efforts to increase economic growth and exports with financial stability, raise utilization of domestic energy sources, provide key infrastructure, and improve the living conditions of the poor. More recently, in response to Colombia's adjustment process the thrust of the Bank's support has shifted towards loans to finance directly productive activities, such as agriculture and industry, support efforts to raise productivity, income and employment, increase and diversify exports and help develop renewable sources of energy through lending for hydropower and arranging associated cofinancing. Loans recently approved by the Board and in advanced stage of preparation reflect the emphasis on: (i) increasing output rapidly; (ii) reorienting production towards exports and efficient import-competing goods; (iii) supporting quick-yielding infrastruc- ture investments, particularly those that enable the use of existing facili- ties more intensively; and (iv) increasing resource mobilization. 75. The Bank's lending in FY85 consisted of loans for agricultural diversification, small-scale industry, petroleum, development banking, water supply and sewerage and trade policy and export diversification totalling US$707.5 million. The TPED Loan is designed to support the first phase of trade policy adjustments in Colombia. In addition to the loan presented in this report, the current program comprises the already approved loans for public health, port rehabilitation, electricity distribution, water supply and sewerage, rural transport and irrigation rehabilitation. Work is under- way on projects for power and energy sector development, agricultural technology transfer, and financial and public sector management. In infra- structure, the Bank is stressing rehabilitation, modernization and a more intensive use of the existing facilities in port improvement, water supply and highways maintenance. Finally, several projects in preparation will also support the Government's efforts to help the poorer segments of the popula- tion. Proposed lending for further rural development, agricultural credit, and water supply and waste, will help improve the standard of living of the poor, while being designed to make better use of existing capacity and reduce losses. 73. While IBRD, IDB and bilateral sources provided about 75% of total external financing to Colombia in the 1961-72 period, their share has decreased since then to some 49% for the 1975-82 period and is expected to decline further to about 40% of external capital requirements during the eighties. IDB has given increased emphasis to energy-related projects, in  - 23 - addition to those for low-cost housing, urban and rural development, agrarian reform, university education, water supply, rural electrification and land erosion control, which are aimed at improving living standards of the lower- income population. In the future, it proposes to assist Colombia in develop- ing sources of domestic energy and in expanding productive sector activities to help generate increased employment. USAID has supported programs in education, rural development and small farm development, but is phasing out its program in Colombia. The Government of Canada, the Federal Republic of Germany and the Netherlands have also provided concessional financing for basic needs and regional integration projects. ART VIn - UCOMqED&TTION 74. I am satisfied that the proposed loan would comply with the Articles of Agreement of the Bank and recommend that the Executive Directors approve the proposed loan. A. W. Clausen President Attachments Washington, D.C. March 27, 1986  - 24 - AMUEX I L*.LLLJ, ?ata 1 of 6 ,w IM : mA NN.,a usc NL t 91131.3 11".9 111.9