Philippines - Agricultural sector strategy review (Vol. 2 of 2) : Annexes

Report No. 6819-PH Philippines Agricultural Sector Strategy Review (In Two Volumes) Volumne II: Annexes 1 13 October 21, 1987 Asia Region FOR OFFICIAL USE ONLY Document of the World Bank This report lies 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.  FOR OFFICIAL USE ONLY ABBRSVIATIO-NS AND ACRONYMS ADB - Asian Development Bank AFT - Agricultural and Food Technician ALRP - Accelerated Land Reform Program APST - Agricultural Policy and Strategy Team, authors of the Agenda for Action for the Philippine Rural Sector AR(' - Agricultural Research Office ASSP - Agricultural Support Services Project ATI - Agricultural Training Institute BACOD - Bureau of Agricultural Cooperatives Development BAEcon - Bureau of Agricultural Economics BAR - Bureau of Agricultural Research BFD - Bureau of Forest Development BPI - Bureau of Plant Industry BPP - Barangau Pilot Production BS - Bureau of Soils BSW - Bureau of Soils and Water Management CALF - Consolidated Agricultural Loan Fund CB - Central Bank CEDP - Community Employment Development Program CIS - Communal Irrigation System CLSU - Central Luzon State Univeraity CGIAR - Consultative Group on International Agricultural Research DA - Department of Agriculture DAR - Department of Agrarian Reform DBM - Department of Budget and Management DBP - Development Bank of the Philippines DENR - Department of Environmental and Natural Resources DOST - Department of Science and Technology DPWH - Depertment of Public Works and Highways DTI - Department of Trade and Industry EC - European Commission EDS - Extension Delivery System FAO - Food and Agriculture Organization FNRI - Food and Nutrition Research Institute FPA - Fertilizer and Pesticide Authority FRG - Federal Republic of Germany FSDC - Farm Systems Development Corporation FSSRI - Farm Systems and Soil Resources Institute FY - Fiscal Year GDP - Gross Domestic Product CIA - Grant-in-aid GNP - Gross National Product GVA - Gross Value Added HYV - High-Yielding Varieties IA - Irrigation Association IADP - Integrated Area Development Project IFPRI - International Food Policy Research Institute IOSP - Irrigation Operation Support Project IRR - Internal Rate of Return IRRI - International Rice Research Institute 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 - ISF - Irrigation Service Fee ISNAR - International Services for National Agricultiral Research LBP - Land Bank of the Philippines MAO - Municipal Agricultural Officer WACIAD - National Council on Integrated Area Development NAFC - National Agricultural and Fisheries Council NAPHIRE - NationLal Post Harvest Institute for Research and Extension NASUTRA - National Sugar Trading Comamission NCIP - National Coconut Intercropping Program NDC - National Development Company NEDA - National and Economic Development Authority NEP - National Extension Project NFA - National Food Authority NGO - Non-Governmental Organization NIA - National Irrigation Authority NIS - National Irrigation System NPC - National Power Corporation NRDP - National Research ari- Development Program NRO - NEDA Regional Office NSTA - National Science and Technology Authority OLT - Operation Land Transfer O&M - Operations and Maintenance OP - Open-Pollinated PAO - Provincial Agricultural Officer PAID - Private Agricultural Investment for Development PCA - Philippine Coconut Authority PCAMRD - Philippine Council for Aquatic and Marine Research and Development (established March 1987) PCARRD - Philippine Council for Agriculture, Forestry and Natural Resources Research and Deve'Lopment (previously Philippine Council on Agriculture and Resources Research and Development) PCGG - Presidential Commission on Good Government PD - Presidential Decree PDB - Private Development Bank PHILPHOS - Philippine Pho3phatic Fertilizer Corporation PHILSUCOM - Philippine Sugar Commission PHILSUMA - Philippine Sugar Marketing Authority PIP - Public Investment Program PIS - Pump Irrigation Systems PNB - Philippine National Bank PNOC - Philippine National Oil Company PTA - Philippine Tobacco Authority PVTA - Philippine Virginia Tobacco Authority PTVT - Provincial Technology Verification Team RB - Rural Bank RBRRC - Rural Banking Rehabilitation Review Committee RDC - Regional Development Council R&D - Research and Development R&E - Research and Extension RIARS - Regional Integrated Agricultural Research Stations SCU - State Colleges and UJniversities  - iii - SMS - Subject Matter Specialist SRA - Sugar Regulatory Administration TA - Technical Assistance TBAC - Technical Board for Agricultural Credit TG - Technology Generation TOR - Terms of Reference T&V - Training and Visit system of extension TV - Technical Verification UCPB - United Coconut Planters Bank UMDP - United Nations Development Program UNICOM - United Coconut Oil Mills UPLB - University of the Philippines at Los Banos US - United States USAID - United States Agency for International Development USM - University of Southern Mindanao VISCA - Viscaya's State College of Agriculture  - iv - PHILIPPINES AGRICULTURAL SECTOR STRATEGY REVIEW VOLUME 2: ANNEXES T&ble of Contents Page No, ANNEX 1 Trends in Agricultural Employment, Incomes and Poverty... 1 ANNEX 2 Non-Bank Evaluations of the Sector......................o 12 ANNEX 3 Coconuts ................ 22 ANNEX 4 Sugar...................... . .0 ANNEX 5 Grains Pricing Policy Including a Suggested New Approach to Protection.,... 0o,....o.................. 34 ANNEX 6 Irrigation..... ...................................... 49 ANNEX 7 Rural Credit ................ 77 ANNEX 8 Fertilizer ........................................ ..... 86 ANNEX 9 Research and Extension... . ........... ... .so 90 ANNEX 10 Sector Institutions... ..... ... .. 115 ANNEX 11 Public Expenditures in Agriculture...................... 120 ANNEX 12 Policy Changes 1984-87 ......... 0....,. .@*@00*0*@00@ 140 ANNEX 13 Statistical Tables ..... ..*,O ***....... 143  ANNEX 1 Page 1 PHILIPPINES AGRICULTURAL SECTOR STRATEGY REVIEW TRENDS IN AGRICULTURAL EMPLOYMENT, INCOMES AND POVERTY Employment and Incomes 1. Between 1970 and 1986 the Philippine population grew from 37 million people to 56 million, an average increase of 2.5% p.a. During the same peri- od, total employment grew from just under 11 million to just over 20 million, an average increase of 4.4% p.a. Total agricultural employment increased from 5.6 million to 10.1 million, an 80% rise that works )ut to an annual growth of 4% p.a. In 1970, total agricultural employment (i.e. including fisheries and forestry) provided just over 50% of national employment; by 1985 agriculture's share of total employment had fallen to a little less than 50% of the total. What these figures imply is that agriculture was providing nearly half of all new employment in the economy--approximately eight times as many jobs as manufacturing and two and half as many as either commerce or "other services", the three next-largest sectors. 2. In a vigorously growing economy one would not expect agricultural employment to be growing nearly 50% faster than population and nearly as fast as total emplcyment. Non-agricultural growth wouid be draining off people from agriculture. The fact that this has not happened over the past decade and a half reflects the general weakness in the economy, forcing more people to remain in agriculture than would have done so had employment expanded vigo- rously in other sectors. With the value of total sector output groting at 3.9% over this period (1970-86), simple arithmetic (employment growing faster than income) tells us that average agricultural incomes had to fall. Figures on poverty trends and on real agricultural wages confirm the picture of falling average incomes. Government figures show a fall in the real wages of daily laborers of 11% in sugarcane, 15% in palay, and 19% in corn between 1970-82; only in coconuts was there a marginal increase (1%). Since 1982, the downward trend of wages has, if anything, accelerated. The implication of these income trends for rural poverty is explored in the paragraphs that follow. Rural Poverty 3. The measurement of poverty in the ?hilippines, the identification of poverty groups, and the foundation of policies and programs to alleviate po- verty are all handicapped by data problems. Measures of absolute and relative poverty in the Philippines are based on household surveys that are thought to  -2 ANNEX Page 2 be not wholly reliable or comparable over time. A more serious problem is that there is no agreed definition of poverty nor of the methodology for mea- suring it. Thus estimates of the extent of poverty vary considerably, depending upon the analyst's concept. For example, estimates of the poverty line in 1971 vary from a low of P 360 per capita to as much as P 1l102. Even the two Bank reports on the subject use different methodologies.- 4. For the purposes of this report, we use the definition of the poverty line used by the 1985 Bank report. It set the poverty line at P 7,363 for the average rural family and P 10,584 for the average urban family. According to this definition, these amounts of purchasing power were just enough to provide the needed food and nonfood items. The threshold of extreme poverty was defined as the income level which provides necessary calories only, equal to 16 kg of rice per head per month. 5. Despite deficiencies in data, there is broad agreement on the following basic conclusions: (a) poverty in rural areas is a problem that needs to be addressed urgently; (b) the uncertain prospects for the Philippine economy in general and for agriculture in particular will further blunt the impact of a growth-oriented strategy for poverty alleviation; (c) many specific poverty-oriented programs have been largely ineffective, either because of faulty design or lack of political commitment; and (d) there is therefore a need for a much more systematic and determined strategy for attacking poverty. 1/ The first Bank report on Poverty, Aspects of Poverty in the Philippines: A Review and Assessment was prepared at the request of the Consultative Group and issued in December, 1980. It was the first systematic attempt by the Bank in the Philippines to measure the extent of poverty, to assess trends in poverty and income distribution and to anialyze the causes of poverty. It also analyzes the policy issues facing the government in trying to alleviate poverty. The second report, The Philippines: Recent Trends in Poverty, Employment and Wages, issued in June, 1985, was muchi narrower in scope. It analyzed the trends in poverty, income distribution, employment, and wages, critically reviewed the data on which the estimates were based, and offered detailed recom- mendations for improving the data base. Unlike the 1980 report, however, it did not analyze either the causes of poverty or the strategic options open to the Government in reducing poverty or income inequality in the future.  - 3 - ANNEX 1 Page ' 6. This Annex draws on available studies to briefly indicate the mag- nitude of the problem, identify the poor, and assess the causes of poverty. It then reviews past poverty programs and some of the current proposals for future action. In so doing, it suggests a possible conceptual framework for formulating a strategy for alleviating rural poverty. Scale of the Problem 7. While data problems seem to preclude accurate measurement, the general dimensions of the poverty problem are fairly clear: (a) The incidence of poverty in the Philippines is relatively high for a middle income country. Using the 1985 Bank report's definition of poverty, some 40% of families in the country felt below the pove:ty line in 1983, of which about a fifth were in extreme poverty. (b) The distribution of income is highly inequitable. In 1983, the bottom 20% of families received 3% of total income and the bottom 40% less than 10%. The top 20% received over 58% of total income. (c) Poverty is heavily concentrated in rural areas and in agriculture. According to the 1985 Bank report, the incidercc of poverty in rural areas was 45% in 1983 (compared with 26% in urban areas), of which one third was extreme poverty. Over 80% of the poorest (lowest 30%) Philippine families were in agriculture, where a high incidence (50- 60%) of poverty occurs among families primarily dependent on corn, coconut and sugar cane, among small-scale fishermen, and among agri- cultural laborers (see paras. 10-12 below). (d) The incidence of poverty varies significantly across regions. In 1983 the highest rates (about 50%) were found in Western and Central Visayas where over half of the nation's sugar industry is concen- trated. Extensive poverty was also often found in inaccessible, resource-poor areas. Relatively high rates of poverty incidence (around 40%) were also observed in Ilocos, Cagayan Valley, Bicol, Western and Northern Mindanao. The most favored areas, Central Luzon, Southern Tagalog, Southern Mindanao and Central Mindanao, had rates around 20%. 8. The extent of poverty in the Philippines is also reflected in the nutritional level of the people. The Second Nationwide Nutrition Survey undertaken in 1982 showed that about one third of Filipino households had inadequate energy intake levels (less than 80% of recommended daily levels). Adequacy levels were closely correlated with household incomes and the educational level of the meal planner, and negatively correlated with size of household. Nutritional deficiencies showed up particilarly among high-risk, pre-school children: about 10% of children aged 0-6 years were found to be suffering from either chronic or acute miialnutrition. The 1982 survey results showed significant gains over the first survey undertaken in 1978. Never- theless, it is clear that major nutritional problems remain.  - 4 - ANNEX 1 Page 4 9. In certain important respects, the poverty and income distribution situation seems to be getting worse, rather than better: (a) the total number of poor families increased during the period 1971- 83, despite an 80% real increase in GDP; (b) the incidence of poverty, after falling for many years, has probably risen again since the economic crisis of 1984 and 1985, when average per capita income fell by about 15% in real terms; (c) income distribution has become more inequitable since 1971; the share of income going to the lowest 40% of families fll from 12% in 1971 to less than 10% in 1983, while the share going to the top 20X increased from 53% to 59%; (d) average family incomes have increased more than twice as fast in urban areas than in rural areas since 1975, resulting in a further widening of rural/urban income differentials; (e) agricultural incomes have fallen further behind incomes in other sectors, primarily due to poorer terms of trade for agriculture; and (f) while no data are readily available, it is probable that malnutri- tion has increased since 1978, particularly since per capita income fell. Who are the Poor? 10. This report is concerned with the rural poor only. In 1983 there were estimated to be some 2.8 million rural families living in poverty. Most cf them depended on agriculture for their primary source of income: Farming 31% Farm labor 16% Fishing/livestock/forestry 11% 58% But a surprising proportion of the rural poor were dependent mainly on non- agricultural sources of income: "Dividends, rents, pensions" 20% Non-agricultural labor 14% Wholesale/retail trade 3% Other 5% 42% Thus it is clear that (i) the problem _f rural poverty is not confined to agriculture and (ii) that agriculture alone cannot be expected to solve rural poverty (let alone national poverty).  ANNEX 1 Page 5 11. A systematic classification of the major poverty groups might be a useful first step towards identifying more specific poverty prigrams. The 1980 Bank report identified six particular groups of poor families in agriculture: (a) Rice/corn farmers, estimated to be the largest single group in the agricultural sector. (b) Rice/corn farm laborers, who were t;.ought to be the poorest single group. (c) Small coconut farmers and laborers (over 50Z of whom are poor). (d) Small sug&r farmers and laborers (poverty rate high, especially among the landless labor). (e) Farmers in upland/remote/marginal areas (estimated at about 1 mil- lion farm families). (f) Coastal ("municipal") fishermen and their laborers. 12. This chapter continues to use this typology for convenience . How- ever, a more detailed breakdown of poverty groups would be required as a first step in formulating a systematic poverty alleviation strategy. In particular, it would seem desirable to recognize that: (a) There are important differences within the majot poverty groups. (For example, within the rice/corn farm group, it would be useful to distinguish betrfeen irrigated farms, rainfed farms in lowland areas, and upland areas). (b) Many poor families will fall into more than one category (for example, a rice/corn farmer may also grow coconuts or be employed as a parttime laborer.) It would be useful to know more about the range of economic activities available to poor families. (c) It would be desirable to identify other distinct farm labor categor- ies (not just rice/corn labozers), since their problems and needs are different. In particular, it would be desirable to distinguish between landless laborers and laborers who also farm (i.e. small- holders or tenants with off-farm labor income). (d) More information is needed about families in upland areas; these would appear to be both the largest poverty group (estimates go as high as 3 million families) and the most vulnerable. Why Are They Poor? 13. A strategy for poverty alleviation needs to attack the basic causes of poverty. For those families who depend upon agriculture for their main income, there seem to be five main determinants of poverty:  - 6 - ANNEX 1 Page 6 (a) Limited Access to Resources. The most important resource is land. The primary reason agricultural households are poor is because they operate very small farms, or have no land at all. Accori,ing to the 1980 Agricultural Census, 50% of farms were less than 2 ha in size, and 23% were less than 1 ha. The gross inequality in access to land is shown by the fact that the 50% smallest farmers cultivated only 16% of the land. At the other end of the scale, the 3% of farmers with holdings in excess of 10 ha cultivated 26% of the land. Some examples of the proble. of small size within major poverty groups include: (i) 50% of rice/corn farmers have holdings of 1-3 ha and 15% have less than 1 ha. Depending upon their access to irrigation and technology, many of these farms would be too small to provide an acceptable income level; tii) 50% of coconut holdings are less than 1 ha; and (iii) 60% of sugar holdings are less than 5 ha, and account for only 12% of total area. However, the poor also typically have poor access to the other resources that might intensify their land use (such as credit or extension) or that might impr.ve their quality of life (such as health and other public services). (b) Low Productivity. High-Yielding Varieties (HYVi technology has done much to increase incomes on many farms, mainly in irrigated rice- growing but also in bette:-endowed rainfed areas. Nevertheless, yields of all major crops are still low, compared with other countries, and (in the case of rice, coconuts and sugar) compared with technology available in the Philippines. Poverty is doubly likely when low productivity is combined with sub-marginal land holdings. (c) Depressed Prices. During the 1975-82 period, the internal terms of trade for agriculture declined by sume 30%, offsetting much of the gain from the adoption of improved technology. This was largely due to a set of prize controls, tariffs and taxes that discriminated against agriculture in favor of manufacturing (and the consumer). Externally, net terms of trade fell by nearly 60% between 1974 and 1985. (d) Lack of Employment Opportunities. Non-agricultural employment expanded faster than agriculture in the period 1970-85 mainly due to the growth of the service sector. Nevertheless, agriculture still accounted for some 60% of new employment during this time, many being absorbed as unpaid family workers, Nationally, the number of unemployed increased more than threefold between 1970 and the cnd of 1985.  - 7 - ANNEX 1 Page 7 (e) Catastrophic weather and/or pest attacks. The poor family is likely to be particularly vulnerable to periodic catastrophies--to the extent of possibly losing their land or jobs and being pushed further into poverty. Past Poverty Programs 14. Overall Assessment. In its 1985 review of government policies affecting low-income families in agriculture, the National and Economic Development Authority (NEDA) differentiated betwee. (i) the indirect impact of macroeconomic policies/programs on the poor, (ii) specific agricultural/rural development programs, and (iii) policies and programs specifically targeted at the poor. There is general consensus (Bank, NEDA, APST Report) that the past macroeconomic policy framework, far from helping to alleviate poverty, had a generally negative impact on the rural poor. 15. In reviewing specific agricultural/rural development programs, the APST report identifies three types of programs: (a) The old community development approach of the 1950s and 1960s, now generally discredited. (b) The single-commodity approach which, being primarily production- oriented, was not well focussed on poverty target groups (and in NEDA's judgment excessively "top-down" in approach). (c) Integrated area development programs which, while located in poor areas, did not qualify as poverty programs since they did not "deliberately target the poor communities as program beneficiaries." 16. One of the best reviews of past programs for alleviating poverty is by Rahman Sobhan, Chairman of the Bangladesh Institute of Development Studies, who was retained by the Food and Agriculture Organization (FAO) to review rural poverty in the Philippines.21 He concludes that, despite declared objectives of combining growth with equity, the emphasis of previous government development plans has been on promoting economic growth through industrialization, exports, and agricultural development. Successive plans all declared war on poverty. But while they identified specific targets for increasing esmloyment, incomes and services, "there was no clear conceptual or programmic linkage between the goals of attacking mass poverty and the investments and programs" within the plans. 17. According to Sobhan, there was an "implicit assumption that target groupa of the poor can be reached through the development process without having to redistribute wealth or access to resources." The main thrust of the 1983-87 Plan, for example, was to "equate poverty alleviation with the increase in employment opportunities and to in turn relate this to the accele- 2/ Rural Poverty and Agrarian Reform in the Philippines, FAO (undated, circa 1983).  - 8 - ANNEX 1 Page 8 ration of development expenditure." There was an implicit assumption that increased production would absorb labor and that iypropriate technologies and incentives would be available for this to happen.-. 18. More precise attempts to target the poor were made through invest- ment programs in backward areas, targeted at marginal groups in fishing, forestry or upland agriculture. Again, it was assumed that such programs would stimulate employment and incomes for the poor, although there was no mechanism to ensuire that they would reach their target beneficiaries. Sobhan concludes that such broad spectrum programs (including social services) failed to reduce poverty because they had no built-in components to identify and reach the poorest groups and to ensure that resources were allocated in favor of the poor (and not the privileged groups). 19. Agrarian Reform. The agrarian reform programs, particularly since 1972, were among the more precisely targeted poverty programs. While it is not certain how reliable the data are, the programs seem to have been modera- tely successful, in terms of their original (limited) objectives. There is no doubt that these agrarian reform programs, in spite of the delays in their execution, have increased the incomes of a substantial group of poor families. They are also probably the most successful and visible program for tackling social inequity in the Philippines. Yet as anti-poverty programs the agrarian reforms have some major defects: (a) First is the limited scope of past programs. Rice/corn tenant farms account for only about 40% of farmers or 15% of the total agricul- tural labor force. The program did nothing for other major poverty groups, such as the landless or tenants in crops other than rice or corn. Nor did it recognize the needs of the subtenants who were excluded from the program. (b) Second, the program redistributed but did not necessarily increase rural incomes. In principle, if not always in practice, the lease- hold program, for example, reduces the landlord's share by half and distributes it to the tenant. Although it may be too early to judge, there seems to be no evidence so far that total production, income or employment has increased in areas where land reform has been in process. (On the contrary, there is some evidence that, at least in the short term, production may suffer when the new owner is cut off from the services previously supplied by the landlord that public sector institutions cannot immediately make up for.) (c) Third, it appears that the ongoing agrarian reform program cannot by itself overcome the poverty of even those tenant farms it reaches, never mind the majority of rural poor it cannot reach. It is suggested that limited access to land, rather than land tenure, is the primary cause of poverty (see para. 13 above). But the major 3/ But it did not materialize because of capital-intensive investments and distorted incentives.  9 - ANNEX 1 Page 9 land reform programs of the past have not given more land to the poor; most of the farmers are still dependent on very small holdings. Nor have the programs tackled another major cause of poverty--low productivity* Yet without such programs, many holdings are too small to be viable, whatever the legal status of the cultivator. 20. The Government has proposed a program to accelerate the implementation of the existing agrarian reform program and to extend it to a much larger area of land. This ambitious program seeks to address most of the criticism of the previous programs cited above. In particular, it proposes to: (a) greatly accelerate the rate of implementation in rice/corn areas; (b) extend the land reform programs to other areas, most notably those under sugar and coconut; (c) make available various categories of land that are expropriatable under existing law; (d) legitimize the de facto occupation of large areas of public land; and (es provide follow-up services, particularly extension and credit, to new owners or settlers to help them make good use of their land. 21. This program has been reviewed by a recent Bank mission, which made important recommendations for accelerating and improving the program and for reducing its cost.-' Many details of the program have still to be worked out, and it is not yet clear what the impact on rural poverty will be. In the short-term, there will be an immediate increase in production and incomes to the extent that presently unused land is brought back under cultivation. On the other hand, where land already under cultivatiorn is being transferred to tenant or labor ownership, there may well be a fall in production. In the case of large scale commercial operations, there could be a significant disruption, and in Volume I it is suggested that this risk be carefully studied (see Appendix 1 to Volume 1). In the long run, we expect the program to have a very dynamic effect in increasing production and income and in bringing about a more equitable distribution of incomes. 22. However, as the recent Bank report pointed out, even an accelerated land reform program will not by itself solve rural poverty. It is to be hoped that the strong political appeal and large financial cost of the program will not therefore obscure the need for a wider and more integrated approach to rural poverty alleviation. 4/ See Agrarian Reform Issues in the Philippines: an Assessment of the Proposal for an Accelerated Land Reform Program, Report No. 6776-PH, May 12, 1987.  - 10 - ANNEX 1 Page 10 What Can Be Done? 23. The limited progress made in the past in eradicating poverty is at least partly explained by the poor policies and doubtful commitment to reform of previous political regimes. The new administration has given a high prior- ity to poverty alleviation in its official statements, and has already shown itself willing to take forceful actions--as for instance in correcting price distortions and liberalizing fertilizer importation and distribution. How- ever, while the new administration has been quick to point out the deficien- cies of previous policies and programs, it has still to formulate a coherent strategW,for eradicating poverty or to determine how to proceed on land reform.- 24. There is clearly uto single, simple solution to poverty in the Philippines. Since poverty is heavily concentrated in agriculture, a large burden of responsibility falls on agricultural development strategy, policies and programs to seek out and help the poor. Much of the general strategy for accelerated agricultural growth outlined in Volume I, while aimed at the whole sector, also contains key elements of any anti-poverty strategy. These programs include most major agriculture services, such as research, extension, credit, irrigation and rural infrastructure, including those specifically targeted at agrarian reform areas. 25. But a sharper focus on poverty will be required in the future, since it cannot be assumed that a general growth-oriented strategy will necessarily reach the poor. There are two additional approaches that might be followed: (a) Volume I suggests that if development programs are to have a greater impact on the poor, then poverty impact should be a major, and perhaps paramount, criterion of program design. If this principle were applied to agriculture, it would mean that every development program should be reviewed for its poverty impact and, where necessary, redesigned to more effectively reach and benefit the poor. Some of the more obvious questions that might be asked are: 5/ The new Government's Draft Development Plan, 1987-92, makes poverty- reduction a major objective, with rural poverty to be reduced from 64% of all rural families today to 47% by 1992 (56% fell below the poverty line in 1971). The main instrument for combatting poverty, apart from land reform, appears to be vigurous growth of the agriculture sector. Overall growth of GDP is targeted at 6.3%, with agriculture to grow at 5.0%, industry at 7.0%, and services at 6.4%. Apart from questions about the effectiveness of a high-growth 3trategy for attacking poverty, there seems a basic inconsistency in the plan's 5.0% growth target for agriculture since none of the major subsectors is targeted to grow faster than 3.9% (crop production 3.9%, livestock and poultry 1.9%, and fish production 3.4%).  - 11 - ANNEX 1 Page 11 (i) In research: Is there sufficient emphasis on cropping systems to improve poor families' incomes, health and nutrition? Can poor farmers afford recommended inputs, and if not, is there enough work being done to develop low-cost technology? Does the scientific community have an appro- priate technology for each identified poverty target group or is working to develop one? Do recommended practices give enough emphasis to labor-intensive technology? (ii) In Extension: Are the extension services reaching the poor and disadvantaged families, including those in remote areas, sub-marginal holdings, women? Is the advice being offered relevant to the poor? How can the extension service better reach the poor (particularly when the extension workers lack transport)? (iii) In Irrigation: The provision of (subsidized) water has great potential for raisiTtg farm incomes; is this being used to narrow income differentials, or do the better-off farmers benefit most? Can the irrigation design/water management system be skewed to give a large share of available water to small farmers? Are irrigation service fees appropriate from a poverty point of view? What is the potential for low-cost individual water systems to increase productivity on small holdings (see Appendix 1 to Volume 1). (iv) In Inputs and Credit: Do poor farmers have ready access to the modern inputs they need to increase productivity and incomes? If not, why not, and what needs to be done to ensure they do? (see Appendix 1 to Volume 1). (b) In addition, agricultural policy makers could draw up comprehensive programs for reaching specific poverty target groups such as smallholders in coconut areas (primarily through extension of intercropping), upland farmers in specific locations, or municipal fisherman. 26. It must be recognized, however, that neither agrarian reform nor agricultural programs, by themselves, can overcome rural poverty. A major theme of this report is therefore the need for development in ocher sectors of the economy to take up the slack, and in particular to draw off a large proportion of the expanding labor force from the land. This subject is discussed at some length in Volume I.  - 12 - ANNEX 2 Page 1 PHILIPPINES AGRICULTURAL SECTOR STRATEGY REVIEW Non-Bank Evaluations of the Sector 1. People interested in the sector have an unusually large number of recent studies on which to draw in addition to the Bank's own work. Those done by the Bank are not summarized but are listed in Annex 9; this annex summarizes five non-Bank studies completed in 1985-87. The studies covered are the following: (a) Afenda for Action for the Philippine Rural Sector, prepared by a 20- member Agricultural Policy and Strategy Team drawn from the University of the Philippines at Los Banos and the Philippine Institute for Development Studies. Six chapters (volumes) plus four annexes (October 1986). (b) Price and Investment Policies for Food Crop Sector Growth in the Philippines, by M. Rosegrant, L. Gonzales, H. Bouis, and J. Sison of the International Food Policy Research Institute of Washington, D.C. (one volume, January 1987). (c) Agricultural Cooperation with the Philippines, by Joseph Ertl, Uwe Otzen, and Richard Peters (Federal Republic of Germany). One volume (September 1986). (d) Private Sector Opportunity Assessment (Agricultural Sector): An Overview of the Philippines and Its Agricultural Sector, AYC Consultants, Inc. (three volumes, November/December 1985). (e) Crop Diversification in Rice-Based Agricultural Economies: Conceptual and Policy Issues, by Prof. C. Peter Timmer (draft, December 1, 1986, 65 pp.). The Agricultural Policy and Strategy Team (APST) Report 2. This Agenda for Action is probably the best single document for a comprehensive introduction to the sector. It was prepared at Government request by a 20-member team lead by Dr. Cristina David and composed of 16 professors mainly from the University of the Philippines at Los Banos (UPLB) plus four other experts. The study is impressive not only for its analyses and specific policy recommendations but equally for the richness of the historical, institutional, and statistical information which it provides. Each chapter also includes a bibliography. 3. The report's six chapters are entitled "An Agenda for Policy Reform", "Addressing Rural Poverty", "Traditional Food Sectors", "Agricultural Exports", "Rural Credit, Agricultural Inputs and Services", and "Research, Extension and the Delivery of Government Services to Agriculture." The four  - 13 - ANNEX 2 Page 2 (relatively short) annexes deal with (i) the National Agricultural Investment Company and the Agricultural Incentives Act of 1986, (ii) the case for removal of export taxes on agricultural products, (iii) rural organizations (mainly non-governmental organizations, NGOs), and (iv) alternative procurement and release prices for rice and their impact on the operations of the National Food Authority (NFA). 4. The rural poverty chapter assembles much good data, although the data-bases for both poverty-mapping and land reform appear relatively weak. The prescriptive advice on how the Government should pursue anti-poverty goals suggests that much further work remains to be done before good intentions are converted into implementable programs. Similarly, the land reform objectives are not spelled out very clearly. The chapter on traditional food sectors covers rice, corn, livestock and animal feeds, fisheries, and upland agricul- ture (including forestry). The coverage of rice, fisheries, and upland agriculture is particularly good (despite weakness in the recommendations for .,le). The coverage of corn is better on white corn (used for human consump- thp, on yellow corn (used for animal feed). The livestock/feedstuffs K iai weak. Not surprisingly, the chapter is stronger at problem- idet ifil. lon than on policy advice and program recommendations (this is in cont ~st to the IFPRI study summarized below). The chapter on agricultural expor4s focuses on coconuts, sugar, and nontraditional exports (conventionally defined as individual exports totalling less than US$5 million in 1968). The general view of coconuts and sugar is that they are not "sunset industries" but can be brought back to viability with suitable reforms. The difficult but crucial problem of the market outlook for coconut products is not handled with much depth; supply-side reforms are given more attention. Sugar will have to become smaller, be exposed to world markets, and undergo land reform. The report's coverage of nontraditional exports reflects a strong bias against transnational corporations and large-scale plantations and a belief that small private farms and small-scale traders can provide the healthiest institutional basis for growth, with Government concentrating on the prcvision of infra- structure and information. Chapter V on credit, inputs, and services covers credit, irrigation, pesticides, fertilizer, and postproduction systems for grains and perishables. The latter section is particularly effective in highlighting nontechnical factors that might improve quality and reduce waste (considerable emphasis is put on the development of quality premiums in the price structure). The final chapter, on research, extension, and government services, is especially usieful on institutional material; the section on the Department of Agriculture (DA) organization is less clear and convincing (the main thrust is to shift from the Ministry's present commodity organization to a functional organization). 5. The report's policy advice is divided into six longer-tei-m "principal thrusts" and a dozen "immediate steps" that the Government should take. The longer-term policy imperatives are to: (a) adopt an anti-poverty focus in rural areas; (b) implement comprehensive land reform;  - 14 - ANNEX 2 Page 3 (c) eliminate the bias against agriculture to induce growth and efficiency in the rural economy; (d) strengthen support services to increase productivity, improve market efficiency, and expand market size. (The key services are irriga- tion and infrastructure, credit, -iiput supplies, research, exten- sion, training, and post-harvest technology); (e) protect lo:2g-term agricultural potential by strengthening conservation policies; and (f) increase the effectiveness of government agricultural institutions and promote the participation of NGOs. The "immediate steps' recommended are: (a) launch a massiz'c rural infrastructure program; (b) implement land reform immediately in the poorest areas; (c) restore the availability of production credit by using monetary policy to bring interest rates down generally (but not selectively in favor of agriculture); (d) continue the dismantling of government-supported monopolies; (e) maintain the domestic prices of rice, corn, and sugar "close to long-run world price levels;" (f) abolish export taxes on all products except logs; (g) remove the P 10 surcharge on fertilizer; (h) relax the ban on interprovincial transport of carabaos and the slaughter of male carabaos; ti) mobilize research and extension systems, with greater roles for regional state colleges and universities, NGOs, and farmers' organizations; (j) reduce constraints on seed supplies, particularly for open- pollinated corn; and (k) abolish the Agricultural Incentives Priorities Plan (which benefits only large agribusiness and promotes capital-intensive production). 6. In general, the APST report is strongly in favor of free enterprise and market guided decision-making. The main exception is the need to maintain minimum prices (but close to estimated long-run world prices levels) for rice, corn, and sugar (at the time of report writing, world prices of these commodilies were 30-50% below their long-run trend levels).  - 15 - ANNEX 2 Page 4 The 1987 IFPRI (International Food Policy Research Institute) Study 7. This simulation study investigates what changes would have to be made in government price and investment policies and in national cropping patterns, if the recent rate of agricultural growth (3.2%) is to rise to the 4% level judged necessary for agriculture to play a lead role in economic recovery and growth. It is an impressive study, not least because of the clarity with which its methodology and policy recommeniations are explained. The work was commissioned by ADB as part of a 15-country study; although primarily a modelling exercise, the study draws heavily on empirical work done in a Phase I study which IFPRI did jointly with IRRI in 1983/84. 8. The study uses estimates of domestic resource costs (DRCs) of 29 crops to establish whether or not the Philippines has a comparative advantage in each crop. Excluded from the study are coconuts and sugar. The country is found to have enough of a comparative advantage in rice, corn, soybeans, and cottof so that it can compete iith imports at modera17 levels of protection, even at the low world prices of 1985 and early 1986.- But costs are not low enough to permit competition in export markets for any of these crops. Of the 19 other crops examined, only four showed good export potential: tobacco, garlic, onions, and abaca (all are current exports, although their volume is small). Six additional crops show high farm-gate profitability at world prices but lack export potential (string beans, sweet peas, tomatoes, water- melon, turnips, and pineapple). Achieving the target 4% growth rate will depend on what happens in rice, corn, and livestock production, since the combined weight of all other crops (including coconuts and sugar) is rela- tively small compared to the staple grains and livestock (which consists of pork, poultry, and eggs--cattle are relatively unimportant). Consequently the study's main attention is on pricing and investment policy as they affect the three key subsectors (rice, corn, and irrigation). 9. The following four quotations contain the study's major recommendations (Bank views are not fully in agreement with them): (a) On irrigation: "The current irrigation program by the National Irrigation Authority (NIA) is inadequate to meet growth in domestic demand. Substantial increases toward the level in the 1983 NIA plan would be appropriate. Increase in levels of investment should be concentrated on new system construction, which in general provide more production for a given level of investment compared to rehabilitation. Finally, results are supportive of an increased emphasis on investment in low productivity regions. The results indicate that investments in these regions can improve regional equity without reducing the impact on production growth." 1/ Because of a further drop in world market prices for corn and rice in the second half of 1986, high tariff protection wps required to maintain competitiveness with imports.  - 16 - ANNEX 2 Page 5 (b) On protection: "The basic strategy for growth is to maintain moderate protection of rice and corn in the short term, sharply increase investment in technology-enhancing projects and programs, and reduce price protection on a phased basis as productivity increases. Reduced prices in turn boost domestic demand and real incomes, generating further incentives for agricultural production. The key elements of the strategy are price policy, technology development policy, and irrigation investment policy." (c) On technology priorities: "Rapid technological change is the key to generating agricultural growth sufficient to induce price declines adequate to boost consumption, while maintaining producer incentives with lowered cost per unit of output. A major effort must be made to maintain long-run growth rates in rice yields, and to sharply increase the growth rate in corn yields." (d) On corn productivitiy: "Generating increased productivity for corn is likely to be more difficult than for rice. The research, extension, and seed production and distribution systems for corn are much less developed than for rice. Improved varieties of corn cover only about 10% of total corn area, compared to nearly 90% for modern varieties of rice... Based on the results of the policy impact model, in order to reath about 4% annual growth in production, the area devoted to improved varieties would need to reach 40-60% of total corn area harvested by 2000, depending on the balance between hybrids and improved yellow open-pollinated (OP) varieties. This effort would require sharp increases in funding for research, extension, and seed production and distribution for corn. Research on corn has been too low, with the percentage of total agricultural research funds devoted to corn only about half the percentage of corn in gross agricultural value added. Funding of seed production and distribution programs is even more inadequate. The current corn seed production and distribution system can meet only about 10% of potential demand for improved seed." 1986 Federal Republic of Germany (FRG) Study of German/Philippine Agricultural Cooperation 10. This summary report provides an excellent overview of the sector's problems and potential. Despite favorable natural conditions and a well- developed research network, the sector is found to have three serious struc- tural weaknesses (skewed land distribution, a weak marketing system, and weak agricuitural services) plus a recent policy environment that has resulted in "skimming off" surpluses for the benefit of the industrial and urban sectors (this was done through marketing monopolies, product-specific levies, the taxation of agricultural exports, price controls, export quotas, and an over- valued exchange rate). Yields are relatively low, the credit system has "virtually collapsed", and agricultural incomes have fallen since 1980 while rural malnutrition has increased. But the sector does have the potential of achieving a 4% growth rate, and can regain its function of being the No. 1 employment-generator, if reforms are made in nine specific areas. The overall key to reform is "liberalization" (greater reliance on market forces); the  - 17 - ANNEX 2 Page 6 Aquino Government has already taken, or is preparing, a number of steps in this direction (e.g., liberalization of agricultural imports, abolition of taxes on agricultural exports except logs, and abolition of foreign trade monopolies in coconuts, sugar, maize, soya flour, wheat and rice). 11. The nine key areas where reforms are believed needed are the following: (a) Centralization of sector planning. There is a history of ill- defined, conflicting responsibilities among the multiple agencies involved in decentralized sector planning. (b) Agricultural pricing policy: The Central Bank's liberalization of almost all agricultural imports has met with resistance in thie MAP which wants to maintain protection and price supports for rice and corn. Fertilizer prices are being forced down by removal of import restrictions. (c) Agrarian reform. The Marcos Government did not accomplish more than half its first-phase 1972 program of distributing holdings of over 25 ha. of rice and corn lands to tenants; very slow progress was made in the second-phase program of giving tenants on smaller properties secure tenure arrangements. Nor was any serious consideration given to redistributing large holdings of land under sugar, coconuts, pineapple, or bananas. (d) Agricultural credit. The virtual collapse of the formal credit system for agriculture has led to a rapid expansion of private or informal money-lending (which now accounts for 60Z of outstanding credit, with concentration among smallholders). (e) Food processing and marketing. Raw material shortages have led to underutilization of capacity. Poor storage capacity is partly to blame. Government favors expansion of contract farming arrangements. Expansion of the presently weak co-ops could help. (f) Training, Extension and Applied Research. Although the applied research institutions are quite good, the tradition of product- specific extension workers is unsound. The pay and morale of the 12,900 field agents are low, and their number too high. Government plans to shrink their nuw er through attrition and to raise their pay from P 1,600 to about P 3,000 per month. (f) Protection of Agricultural and Fisheries Resources. Timber resources have been rapidly depleted as the result of predatory practices; "drastic legiolattion" is needed to end these. There is an obvious need for widespread reforestation. There has also been much destructive fishing (e.g. the dynamiting of coral reefs). (g) Sugar: structural reorganization. The distress in the sector following the price collapse of 1981/82 has led to reorganization proposals from the World Bank (most are embodied in the Sugar  - 18 - ANNEX 2 Page 7 Rehabilitation and Diversification Project, soon to be appraised), as well as a series of private and local-government proposals for Negros, the most seriously affected island. But those local proposals need the support of a national land reform program. (h) Coconut reorganization. Over one-quarter of the country's cropped area is under coconuts, which have typically contributed 17-20% of total export earnings. Until recently, coconut export earnings covered 80-90% of the country's debt service requirements. The present depressed state of the industry, plus the change in Government, has stimulated proposals for recovery. Increasing productivity and much wider adoption of intercropping appear essential. But there is a question about how large a replanting program would be wise. 12. The last third of the report assesses the prospects for German/ Philippine cooperation in the sector, with emphasis on the market prospects for Philippine exports to the FRG and the European Community (EC). The outlook for sugar and coconut oil/cake/meal is unfavorable; the only hope (not a significant one) lies in the development of processed products. Tropical fruits look more promising but the long distance to Europe makes dried fruits, and fruit juices, better prospects. Cashew nuts hold promise. Coffee, already fairly well established and with the export quota recently doubled, has good prospects, particularly if it can find a place in FRG imports. Cocoa, a fairly recent introduction, will have difficulty competing with longer-established suppliers but may find a modest market in import substitution. With good growing conditions, the country's large net imports of pepper suggest an import-substitution opportunity; ginger might grow well also. Ramie, the textile fiber that does well in cotton and synthetic blends, can probably expand moderately. Tobacco can probably hold its present export markets but cannot look forward to much expansion in world consumption. Carrageenane, an algae extract used as a jellying agent, will continue to do well as a Philippine company is the market leader in Asia, the center of world demand. Timber and its products are likely to diminish in export volume because of falling supplies. The dairy industry deserves exploration as a substitute for the present large dairy imports, but there will need to be much attention to technical factors to establish economic feasibility. Meat and its delicatessen products deserve study, with special attention to decentralized abattoirs specializing in finished products. Feedstuffs "could play an increasingly important role, possibly even advancing to the export stage..." Finally, fish and marine products are a subsector that has not suffered much from the depression. The municipal (inshore) sector serves the domestic market; the commercial (offshore) sector is already well organized-- it is almost exclusively a tuna industry; the biggest potential probably lies in aquaculture for raising shrimp, prawns, mussels, and oysters. A big need is cheap fishfood (a potential product of the animal feed industry). 13. According to the study the most promising area for increased FRG/Philippine cooperation may be FRG help in reviving agricultural cooperatives. Only about 7,200 of the 17,179 registered co-ops are active and there is a big need for the functions they could perform. "Entry points" for direct private German investment are noted--"primarily in the processing and  - 19 - ANNEX 2 Page 8 packaging of agricultural produce for export, refrigeration (refrigeration chain), the domestic and ex;ort marketing of marine products, and the production of feedstuffs (basic products and protein concentrates." Additional possibilities exist in ti,nber, meat processing, and the silo industry. The 1985 USAID-Sponsored Study by AYC Consultants, Inc. 14. This three-volume report is part of a larger multi-sector assessment of investment opportunities in the private sector. The core of the report is a detailed assessment of the performance of 72 crops in each of the country's 12 regions. "Performance" was assessed in terms of (i) past profitability, yields, and regional specialization, (ii) past and potential markets, both domestic and foreign, and (iii) linkage potential. The result is a weighted ranking of the 72 crops with respect to future promise, both nationally and in each region. The four existing major crops (rice, coconuts, sugar, and corn) did well, mainly because of their present size and consequent ability to affect rural development. Of the remaining crops, 36 showed "strong potential" in different regions; three of these are examined in some depth (corn, coffee, and cacao). 15, Establishment of a new Philippine company is proposed for channelling US aid (and other funds) to the private agricultural sector. The new program/institution (PAID--Private Agricultural Investment for Develop- ment) might lend to entrepreneurs, take equity positions, or make direct investments on its own account for eventual resale to private investors. Similar institutions are said to have been established in Jamaica, the Dominican Republic, and Costa Rica. 16. The regional data assembled for the 72 crops are useful (especially those on corn) and the results of the rankings are su}gestive. But the methodology appears somewhat simplistic (especially the market analyses and agronomic assessments) and the results therefore unconvincing. Prof. Timmer on: Low Commodity Prices and Diversification 17. The decline in what appear to be long-term prices of agricultural commodities has strengthened Bank interest in crop diversification. To help it assess the possibilities and instruments for achieving greater diversi- fication, the Bank's Agriculture Department has commissioned a number of consultant studies. One that focuses specifically on Southeast Asia is a paper by Prof. C. Peter Timmer of Harvard, "Crop Diversification in Rice-Based Agricultural Economies: Conceptual and Policy Issues" (draft, December 1, 1986). The paper reviews experience with rice price policy in the leading rice-growing countries of the region, including Japan. Timmer's general view is that regional governments have acted sensibly in using rice price stabili- zation schemes to insulate farmers and consumers from the swings of world prices, made volatile by the thinness of the international market. This policy has succeeded in expanding domestic production of the staple cereal grain, decreasing or eliminating the need for rice imports and releasing foreign exchange for other imports of higher development priority. Diversifi- cation was not much of an issue while countries were still net importers; the  - 20 - ANNEX 2 Page 9 diversification issue has arisen only since self-sufficiency has been attained and surpluses (actual or potential) have emerged. 18. Faced with this new situation, Timmer's advice is to continue with price stabilization programs but to avoid 'i) setting floor prices too much above world prices or (ii) continuing such support too long. If support is "too high" or "too long" the strain on the budget will become intolerable. Thus price stabilization should be viewed as a short-run policy. For the long run, diversification must be encouraged. Successful diversification is not likely to result from government attempts to "pick winners" among possible alternative crops, however. No one can know enough to pick winners. A much surer route to successful diversification is to think of the process as a gradualistic adjustment to market forces. This means trial-and-error changes in cropping patterns by farmers kept under pressure by rice stabilization programs that provide only a minimal "safety net." The most effective help governments can provide is to allow market signals to function and to provide cost-reducing infrastructure improvements that will expand farmers' access to new market opportunities. Timmer puts great emphasis on infrastructure improvements (especially roads) and on strengthening research and extension, areas which are of special importance for the Philippir.es. 19. Prof. Timmer's analysis makes several points that are relevant to Bank appraisal methodology and policy advice. Among the more important of these points are the following: (a) It is impossible to forecast the future world price of rice with any confidence. Neither econometric models nor attempts to read trends from past price data provide good enough guides to future prices to justify using their results for project justification or policy- setting. The best one can do, he writes, is to use current market prices. (b) Tie expansion of off-farm income opportunities is the surest way to compensate for low rice prices, He says little about how to stimulate such opportunities; the expansion of rural infrastructure programs would certainly seem one way--perhaps the fastest, surest way. (c) The concept of "comparative advantage is not a very useful concept for discussinig crop diversification." Timmer defines comparative advantage only "as it is traditionally used by economists"--a qualification that excludes some economists, who overwhelmingly use the term as a synonym for competitive advantage. (d) Although market forces are the surest guide to successful diversification, markets do not always work efficiently or fairly. Policy-makers need to understand more about how markets work and the roles and needs of private actors, including "disfranchised elements" such as small farmers, the rural landless, and the urban poor. After warning against policies that reflect a "cozy relationship between large corporations and a handful of government officials", Timmer also suggests that much of the nationalistic  - 21 - ANNEX 2 Page 10 rhetoric against multinational companies is unhelpful, since those firms can sometimes offer the easiest access to external markets. And without markets, he notes, there can be no diversification. (e) As noted, Timmer gives his blessing to price stabilization pr^grams (at least for rice; he is silent on how many additional crops, if any, he would also protect). He relies on pragmatism, not formal economic principles, to determine the level of support. The dominant consideration is bound to be the potential drain on the budget. To encourage diversificaiton, support prices should not deviate "too much from border prices for too long a time, where 'too much' and 'too long' cain be determined only relative to budgetary flexibility and the seriousness of any spillovers from zice price stabilization to other commodities or other countries." (f) Japanese experience carries lessons for other Asian countries. Until 1960. Japan's rice farmers were competitive with imports, which were permitted. After that date, the government decided to link returns from rice farming to industrial wages; this was done by tanning imports and guaranteeing farmers a support price. The formula used included the cost of land--a "mistake" that spilled over into the whole sector as higher rice prices made land more valuable, which further pushed u? rice prices, etc. As rice production and prices both rose, consumers began to eat less rice and a rice surplus emerged. The surplus stocks could be exported only by subsidizing them; this was costly to the budget and to Japan's relations with other rice exporters. So the government turned to diversification from rice. Pork and poultry expanded successfully, and without protection, so long as feed grains were available at international prices (those quasi-industrial products need cheap feed more than they need land). But attempts to move into other products (e.g. wheat, soybeans, barley, hay) required large subsidies since these are land-based crops and land (built into the rice price formula) had become very expensive. While the rice surplus fell, the budgetary burden from alternative crops remained. To ease that burden the government promoted beef and oranges, using high protection to make consumers, not the budget, pay the high costs. Thus "the secondary effects of rice price policy continued to haunt the cost structure of nearly all of Japanese agriculture. Protecting rice farmers from foreign competition causes extensive spillovers into the competitiveness of other crops." "Poorer countries", he warns, "cannot afford the budget costs or the resource misallocations of the Japanese model." Timmer then cites, much more briefly, Thailand's success with diversification, a market-produced result that has received relatively little explicit policy support from the government,  - 22 - ANNEX 3 Page 1 PHILIPPINES AGRICULTURAL SECTOR STRATEGY REVIEW Coconuts 1. With some 3.27 million ha of coconuts in 1985 21 (about a third of the total farm land area), the country is the world's largest producer and exporter of coconut products. Although this accounts for over two-thirds of combined world exports of copra and coconut oil, it amounts to less than 5% of the world's fats and oil market. Because of the lower production costs in other countries of competing vegetable oils such as palm, soy bean and rapr.seed oil, the outlook for Se coconut sector is not promising. There is thus a distinct need for increat.lng the productivity of standing trees and for improving crop area productivity through diversification and intensification by intercropping with annuals and perennials. 2. Area and Yield.!' Between 1950 and 1970 the total coconut area doubled from 905,000 to 1,884,000 ha, then increased to 2,200,000 ha in 1975 and 3,126,000 ha in 1980, with little growth in the 1980-85 period. About 1/3 of the trees were planted since 1975. It therefore appears that the often quoted area of senile trees (a third) may be overestimated. Production (yield) statistics are for a mix of copra, dessicated coconut, and fresh nuts and are therefore difficult to interpret. Based on these statistics there was a significant yield increase between 1965 and 1980 from 956 kg/ha to l,462 kg/ha, but a decline to about 905 kg/ha in 1985. In the Landell Mills' Oils and Oilseeds report of March 1987, the 1985 copra yield was shown as 570 kg/ha, indicating that about 60% of the yield will be in the form of copra. Declining yields in the last few years are due to low prices which induced a deteriorating crop management (almost no input use in even the most favorable years) and indicate that substantial production increase is possible if it becomes worthwhile for farmers. 3. Regional growth has been strongest in Mindanao, while the Luzon coconut area has declined quite sharply since the late seventies as indicated in Table 1l 1/ Area and yield statistics are from the 1986 Philippine Statistical Yearbook, issued by NEDA. The total-area of coconuts in that document is shown to be larger than that obtained by the Philippine Coconut Authority (PCA) from aerial photography, which indicates that the total area may not exceed 2.8 million ha.  - 23 - ANNEX 3 Page 2 Table 1: REGIONAL COCONUT AREA ('000 ha) Region 1960 1978 1983 Luzon 589 747 298 Visayas 398 407 527 Mindanao 495 918 1,661 Source: Philippines Statistical Yearbook, various issues. There are also regional differences in production per tree. In 1982 Mindanao palms averaged 47 nuts/tree, while the rest of the country averaged only 34 nuts/tree/year. Coconuts are a major crop in 64 of the country's 72 prov- inces, with greatest concentration in coastal areas. The number of holdings and holding size distribution is provided in Table 2 for a total area of 2.8 million ha. Table 2: NUMBER AND SIZE DISTRIBUTION OF COCONUT FARMS Under 5 ha 5-20 ha Over 20 ha Total No. of holdings 653,380 (91%) 50,300 (7%) 14,300 (2%) 718,000 Total area (ha) 915,600 (33%) 628,300 (22%) 1,256,100 (45%) 2,800,000 Source: Philippines Statistical Yearbook, various issues. Over 90% of the holdings are thus below 5 ha and occupy a third of the coconut area. Some 45% of the coconut area is held by 2% or 14,300 large owners, with an average of 87.8 ha/holding. The average farm size of 3.9 ha disguises a skewed holding size distribution where farmers in the category under 5 ha average only 1.4 ha/holding, in the 5-20 ha category the average is 12.5 ha, and the over 20 ha category averages a large 87.8 ha/holding. 4. It has been estimated that each farm provides, on average, income for about two families, divided between owners, resident workers/share croppers, and laborers. Most of the larger coconut farm owners have substantial off-farm incomes and do not live on the property. The corporate farm area has been increasing and with it the number of hired laborers. The tenurial status of the coconut subsector is complex as indicated in Table 3 (from a comprehensive 1978/79 NEDA survey):  - 24 - ANNEX 3 Page 3 Table 3: COCONUT FARM TENURE STATUS, 1978 Average Farms Area area/farm (x) (Z) (ha) Owned and operated 71.0 60.0 3.3 Share tenanted (operator shares crop with owner) 22.3 25.0 4.5 Partly owned (operator cultivates both owned and tenanted parcels) 4.2 5.0 4.4 Lease tenanted (operator pays fixed rent to the owner) 0.3 1.0 8.3 Managed (usually plantations supervised by person other than owner) 0.8 6.0 29.0 Others 1.4 3.0 8.2 All farms 100.0 100.0 3.9 For many owners, coconut farming involves no more than arranging for harvesting by contract laborers, drying the copra and selling it. They employ "caretakers" who protect the crop from pilferage and may share in the harvest. Caretakers sometimes sharecrop non-coconut areas of a farm and annual crops interplanted between rows of coconut palms. It is probable that the percentage of share tenants and area under tenancy is higher than indicated because both partly-owned and managed farms often have part of their land under tenancy arrangements, and because many landowners, fearing the possibility of land reform, refuse to recognize a tenancy relationship between themselves and their workers. Thus the actual share of tenanted farms varies from 50:50 to 90:10 (in favor of the landlord). In some of the more isolated areas a de facto land reform is in progress with the New People's Army extorting "taxes" from tenants, although the owners, mostly living in the cities or overseas, retain official title. 5. The annual income of a coconut farm was P 7,640 (US$546) in 1983. Divided among two families this income was below the 1983 rural poverty line. Since 1983 copra prices have declined to a very low level in 1986, but have somewhat increased since then. Early (1983) data indicated that some 57Z of coconut farming families fell below the poverty line, and this situation has continued or even worsened. It is therefore extremely important to increase the productivity and incomes in coconut areas. This is possible by (a) improving the nutritional standard of the trees by nitrogen and chloride application as indicated by foliar analysis; (b) intercropping annuals, biennials (e.g. pineapple) or perennials (coffee, cocoa, black pepper, etc.); and (c) under grazing with sheep or goats. Farmers or share croppers usually are reluctant to fertilize their trees although there is experimental evidence that it is possible to increase production and income. Therefore increased productivity and incomes can most likely be generated from intercropping which  - 25 - ANNEX 3 Page 4 is possible due to the general wide spacing and a high leaf canopy for trees older than 20 years. Presently nearly 20% of all coconut farms have both annuals and perennials as intercrops, which indicates the possibility for expanding the area of intercropping or "multistorey" cropping. Recently planted hybrid semi-dwarf palm stands are generally not suitable for intercropping once shading becomes excessive. 6. The Governmer.t is already actively promoting intercropping and grazing under coconuts which also leads to coconut yield increases (from soil aeration and fertilizer application). At present, there are two small credit schemes available: (a) PCA's National Coconut Intercropping Program (NCIP) which reached only some 2,035 farmers (owners or tenant farmers with a written consent of the landlord) in 1985. The loan amount is based on actual costs for establishing the intercrop (P 2,100 for mung bean, P 5,400 for hybrid corn, P 15,100 for black pepper and P 16,800 for cacao (over a 4-year period for perennials)). For 1986 some 7,000 participants averaging about one ha per intercropped area were anticipated (funds from PCA are available). (b) The Countryside Economic Development Program, piloted in 1987 for organized groups of farmers, with the participation of a trader and the Coconut Development Officer. This program is jointly sponsored by the United Coconut Planters Bank (UCPB) and PCA. Eligibility, range of crops, and loan amounts are similar to that under the PCA program. 7. Commercial plantations in Mindanao have introduced intercropping already on a significant scale, in particular cocoa and coffee. Attracted by high raw fiber prices in 1986, a large number of smaller farmers, in the most evenly distributed rainfall areas of Mindanao, have recently introduced ramie, a good quality fiber intercrop (which may compete with palms, much the same as grasses do, for nutrient uptake). There are substantial smallholder coconut areas in Cavite province (south of Manila) where successful intercropping and multistorey cropping can be observed. This indicates that there is much potential for these practices if the market is available. DA's cropping system research on farms, and Farm Systems and Soil Resources Institute's (FSSRI's) work, together with research by other SCUs, has provided a base for making crop and methodology recommendations with a considerable degree of confidence. Despite these ongoing efforts there remains a very large area of underutilized coconuts, where productivity and incomes could be greatly increased. However, one of the most potent reasons that this is not being exploited is the tenancy problem. Large areas of coconut lands are owned by absentee landlords and it is difficult to arrange formal cropping or share arrangements. Moreover, due to the isolation of many coconut areas, it may be difficult to arrange for substarlLial areas of intercropping there unless the peace and order situation improves.  - 26 - ANNEX 3 Page 5 8. Based on presently available credit schemes (para. 6) for intercropping (or under grazing), costs (excluding labor costs for crop maintenance and harvests) and benefits are estimated as follows: Table 4: INnICATIVE INTERCROP PRODUCTION COSTS AND BENEFITS Available Annual credit amount returns for crop es- Intercrop Producer before labor tablishment yield price Annual costs for and immature at full early production crop mainte- maintenance production 1987 cost /a nance & harvest (p) (kg/ha) (P/.g) (P/ha) (P/ha) Cocoa 169800 750 25 6,000 12,750 Coffee 11,800 600 30 4,500 13,500 Black pepper 15,100 1,000 50 4,000 46,000 Ramie 23,000/b 1,600 30 27,500/c 13,500 Grazing 4,300 250/d 20 2,000 3,000 Upland rice 2,600 1,400 3 2,860 1,340 Mung bean 2,100 50 12 2,310 3,690 /a Inclusive of credit repayments. 7i No credit scheme--actual establishment cost in Mindanao in 1986/87. Th Four harvests per year of 400 kg/ha brushed fiber. 73 Live weight gain per year. Grazing goats is preferred in coconut areas. In addition to the benefits from the intercrop, copra yields would also increase from intercropping by about 100 kg/ha/year, resulting in an additional income of about P 2,700/ha/year (before additiotzal labor costs). 9. From Table 4 it is clear that intercropping perennials can result in significantly increased income if markets are available. Before substantial. investments are made in intercrops with a long immature period a careful market analysis should be uone. Olt hilly terrain preference should be given to perennials to avoid soil erosion losses. Annuals are less profitable and require new plantings each season, and should therefore be mostly considered in food deficit areas. With average coconut yields of some 800 kg/ha at P 2.70/kg, providing a gross benefit of P 2,160/ha, all intercrops except upland rice would out-perform the base crop coconuts. 10. The following possibilities for increasing the area of intercropping coconuts with long-term crops should be urgently pursued: (a) Evaluate PCA's ongoing NCIP and, if found viable and in need of additional funding, support the program. Evaluate the potential impact of UCPB and PCA's Countryside Economic Development Program  - 27 - ANNEX 3 Page 6 and determine if there are technical, organizational and financing constraints. The above efforts support both individual and organized groups of coconut farmers; and (b) Review private proposals for financing Nucleus Estate type opera- tions for producing high quality coffee and cocoa and possibly other crops such as spices, ramie, etc. by farmer cooperatives with participation of a so-called anchor-firm. The latter would be established jointly by private investors and the cooperative, which would set up clonal nurseries, provide technical assistance, arrange for credit, establish post-harvest processing facilities (wet- processing and drying of coffee and fermentation/drying of cocoa, ramie decortication and degumming, etc.) and contract to purchase from participating growers all produce for final processing and sale. A proposal for intercropping coffee in the Calinan-Baguio District in the Davao City area appears to be a model for review and possible adoption. 11. The Nucleus Estate type of development appears particularly appro- priate and attractive since it organizes farmers to produce and process a high quality product while sharing in the full benefits on an agreed basis. However, it is not clear how areas with various ownership-tenancy arrangements can participate, and this should be a clear target for further investigation. One of the attractions of a Nucleus Estate type of development is that it will also increase coconut production (as a side effect of fertilizing and tending the intercrop) and it should increase copra quality through using the central drying facility. 12. If another 20% of farmers/property owners on farms larger than 5 ha would participate in intercropping perennial crops over a 10-year period, an additional area of about 380,000 ha could be covered. With a distribution of 40% cacao, 30% coffee, 10% ramie, 10% spices (black pepper and others), and 10% miscellaneous crops and grazing, incremental production at full production would amount to some 142,000 mt cocoa, 68,000 mt coffee, 60,000 mt ramie fiber, 19,000 mt of spices (pepper equivalent) and some 6,000 mt of meat. At early 1987 prices this could then amount to an incremental annual benefit of P 8.5 billion at full production. Recommendation 13. The Government should arrange for a review of present and proposed coconut intercropping operations, and possible new initiatives, within the next six months by a team comprising an agro-economist, a land-tenancy expert, and a tree crop/processing expert. In particular the tenancy problems should be addressed, and an indication should be given of the area of coconut land that could become available in reasonable homogeneous blocks for intercropping on a nucleus estate or cooperative farming basis within the next 5-10 years. This review may then lead to the preparation of either a coconut development project or a subsector loan based on an agreed development/on-lending proposal.  - 28 - ANNEX 3 Appendix 1 Page 1 Cocodiesel 1. The possibility of long-run increases in world petroleum prices and long-run decreases in the world price of coconut oil are a double source of concern for the Philippines, or should be. If, however, coconut oil can become a substitute for some petroleum products, the country may be able to convert adversity into an advantage. Work on this possibility began about 1981, when the petroleum price was still above US$30/bbl.; the fall of coconut oil prices from their 1981 historic peak, with ensuing domestic gluts, inten- sified Philippine interest in finding new outlets for coconut oil. But when world oil prices also fell, and copra prices improved somewhat, interest in promoting cocodiesel weakened. Today, only a weak effort remains (mainly as a minor program in the Philippine National Oil Company's (PNOC's) Nonconven- tional Energy Center). 2. The possibility of substituting coconut oil for petroleum (either diesel, bunker C, or industrial fuel oil) depends on relative prices and on solving certain technical problems. These problems are linked. The main technical problem has been the development of fungal bacterial growth when crude coconut oil is mixed directly with diesel. The fungal contamination interferes with proper performance of the cocodiesel mixture, contributing to clogging of the injection jets, degradation of the engine's lubricating oil, and injury to motor gaskets. If an economic biocide can be found that will kill the bacteria, these problems will either disappear or be open to much simpler solution (i.e. not all the technical problems arise from fungal contamination). An alternative, more expensive solution is to refine crude coconut oil into an esther, which does not suffer from fungal contamination. Partial estherification (refining the crude into "kuchin" oil) adds roughly 50% to the crude price; complete refining adds another 10-15%. In early 1987, the pump price of motor diesel (including all taxes) was P 4.76/ltr; crude coconut oil was P 3.97, but fully-refined coconut oil was P 6.29 (kuchin oil fell somewhere between the P 4.76 and 6.29 figures). These are financial or market prices, which may not measure the true value of imported petroleum or coconut oil to the Philippine economy ("economic" prices). 3. The Government's earlier interest in promoting a cocodiesel program resulted in the launching of a national program in the fall of 1982. A pilot project the year before had proved the feasibility (if not the popularity) of using a 30% coconut oil 70% diesel blend. The program was seen primarily as a way of helping the coconut oil milling industry rather than as an energy development program. A Presidential Decree issued on 1 September 1982 made the cocodiesel program part of the rationalization program of the coconut industry. The production of intermittent exporters of coconut products and the excess production of those primarily producing for the domestic market was supposed to be channeled to the cocodiesel program. To implement the directive, PCA promulga-t d rules and regulations and indentified the oil mills and desiccators that should participate in the program. The program did not succeed, however, and was virtually shelved four months after it began. The main reason appears to have been resistance to cocodiesel by its intended users (whether their objections stemmed from problems associated with fungal contamination is unknown). One other program appears to have been much more  - 29 - ANNEX 3 Appendix 1 Page 2 successful; this was the use of crude coconut oil (preheated but reportedly used without mixing) in power generation by the National Power Corporation. There appeared to be far fewer technical problems in using crude coconut oil as a boiler fuel than as an automotive fuel. But even at the low coconut oil prices that ruled during that (brief) period, the product had to be subsidized to make NPC willing to use it. 4. There has been one evaluation of the cocodiesel program (by Aramas and Clyde, in September, 1984); they concluded that "the volume of expected foreign exchange foregone due to the use of coconut oil in the cocodiesel program seems large enough to question the economic wisdom of the project." That judgment and the analysis on which it is based appear questionable, however, as the authors worked entirely with market prices in a fairly narrow range. What seems needed is a more broad-based analysis of various options of a program whose costs are low but whose potential benefits could be sizeable if and when petroleum product prices experience sizable increases.  - 30 - ANNEX 4 Page 1 PHILIPPINES AGRICULTURAL SECTOR STRATEGY REVIEW Sugar 1. The sugar subsector has long played a significant role in the Philippine economy. During 1973-82, sugar exports averaged some 1.4 million tonnes p.a. and accounted for an average 12% of the total value of merchandise exports. This declined to 5% in 1983 and 1984 and to 4% in 1985. Until 1984 the sugar industry employed about 500,000 worker3 annually in sugarcane production (90%) and processing (10%). Given an average family size of six members, approximately three million people out of the estimated 1985 population of 55 million have thus depended on the sugar industry. 2. Beginning in 1984, world sugar prices dropped sharply. At about the same time, the country's acute financial problems emerged. The Philippines' lucrative long-term export contracts for sugar also expired in late 1984. All these problems led to a drasti: decline in sugarcane area and production in the country. Compared to the five-year average (1979/80-1983/84) sugarcane area of 442,000 ha (harvested) and raw sugar production of 2.4 million tonnes, the area and production in 1984-85 declined to 384,000 ha and 1.7 million tonnes respectively and to 321,000 ha and 1.5 million tonnes, respectively, in 1985-86. The projection for 1986-87 is 310,000 ha and 1.4 million tonnes re3pectively, a decline of 30% in area and 42% in production over the five- year average through 1983-84. 3. There are some 30,000 sugarcane growers in the country, of which 77% operate small farms (below 10 ha), 18% operate medium-sized farms of 10 to 50 ha and 5% operate large farms (above 50 ha). However, small farms account for only about 22% of the sugarcane area while medium and large farms account for 35% and 43%, respectively. Land distribution is thus highly skewed. Currently 38 sugar mills are operating with a total annual milling capacity of about three million tonnes of raw sugar. The five-year average (1979/80- 1983/84) capacity utilization was 70%, declining to about 50% by 1985/86 and a projected 47% in 1986/87. 4. The Philippines, which was exporting about 60% of its total raw sugar production in the 1970s and early 1980s, cannot profitably export sugar (except under thI US quota of about 160,000 tonnes) at current world prices of 6-7 US cents/lb.- The adjustment in sugarcane area and production (para. 15) is thus in the right direction. However, several problems have emerged in the adjustment process, some of which entail high economic and social costs. Some of the problems are: 2/ The average cost of production of raw sugar in the Philippines is estimated at 14-15 US cents/lb.; however, some efficient mill districts can profitably export at 9-10 US cents/lb.  - 31 - ANNEX 4 Page 2 (a) A serious unemployment/underemployment problem has emerged, involving about 100,000 sugarcane workers who were already part of a major poverty group; (b) Some sugarcane land is lying idle; (c) Sugar mills are operating at low capacity; and (d) Crop loan arrears have increased. 5. In the period 1977-1986, the Philippine Sugar Commission (PHILSUCOM) had been responsible for policy-making and regulation in the sector. During most of 1977-85, the National Sugar Trading Corporation (NASUTRA) had been the sole agency involved in domestic trading and export of sugar. In late 1985 the Government established the Philippine Sugar Marketing Corporation (PHILSUMA) as the single buying and selling agency to replace NASUTRA. Also, the Government, agreed under the IMF standby program to implement several important institutional changes that would have contributed to the sector's streamlining and adjustment. Specifically, it committed itself to undertake audits of NASUTRA and PHILSUCOM, prepare a p; of divestiture of PHILSUCOM's subsidiaries, issue operating guidelines for ".ILSUCOM, and issue mandatory guidelines to PHILSUCOM and PHILSUMA on public disclosure requirements. However, no significant progress was made on any of these commitments under the old administration. 6. Since early 1986 the new Government has introduced a number of institutional and policy changes. The new Government abolished the export monopoly of PHILSUMA and consequently export marketing has been liberalized, except for allocation of the US export quota by the Sugar Regulatory Administration (SRA). The new Government also dissolved PHILSUCOM, established SRA as the regulatory agency, and attached it to DA. The SRA com?rises three members (including a Chairman), two representing planters and one representing millers. The Government is considering what SRA's functions should be, particularly whether it should handle research and extension, as PHILSUCOM did; its staffing, funding and organizational structure; and what should be done about the retrenchment/redeployment of PHILSUCOM staff. 7. The institutional and policy changes made so far are clearly in the right direction. They have resulted in reduced regulatory control and a lesser degree of Government intervention. However, further changes are required to support longer-term productivity and income growth in the subsec- tor. These have been discussed with Government in connection with a Bank sector report "Philippines Sugarlands Diversification Study" (Report No. 6042- PH, May 30, 1986) and a proposed policy-based lending operation. 8. The proposed Bank loan (appraisal scheduled for August 1987) would address various adjustment problems in the subsector. It specifically would support policies and plans to: (a) rationalize sugarcane production and pro- cessing; (b) resolve the problem of sugar loan arrearages; (c) initiate sugar- lands agrarian reform; (d) facilitate crop substitution/diversification; (e) improve efficiency through measures including introduction of a direct cane purchase syste; and (f) restructure institutional arrangements for the sugar subsector, including research and extension.  - 32 - ANNEX 4 Appendix 1 Page 1 Ethanol 1. Before the energy crisis of 1973-74 the Philippines was highly dependent on foreign energy sources (over 95%). The crisis created an impetus to start diversifying its energy sources and developing indigenous supplies. The second round of world oil price increases of 1979-80 encouraged those developments further. The energy program of 1982-87 published in April 1982 stated that among the renewable energy sources, ethanol offers the highest potential contribution. An alcogas program was launched in 1982 but it was soon frozen at existing levels as petroleum prices started falling. 2. In 1985, the Government began to re-examine the potential for ethanol and envisaged the eventual production of 600 million liters of alcohol per annum (equivalent to about 800,000 tonnes of raw sugar); of this, 300 million liters were to be exported. The primary reason for the re-considera- tion was the depressed price for sugar; attempting to diversify energy sources is currently a secondary reason. A new Alcohol Corporation (with equity from the Government and foreign partners) was to be established to oversee the program and, if necessary, to own, manage and operate alcohol distilleries throughout the country. A detailed feasibility study of the ethanol program was undertaken, supervised by the Department of Trade and Industry (DTI). The feasibility study team was composed of members from both the public and private sectors. The public sector was represented by the Board of Investments, Philippine National Alcohol Commission, PHILSUCOM and National Development Company. The private sector was represented by Marubeni Corporation of Japan and Pilipinas Shell. 3. Based on the findings of the ethanol program feasibility study, there is no scope at present for major exports of anhydrous ethanol as an octane enhancer to Japan. Export possibilities to other countries are also limited, given competition from Brazil. The feasibility study team, therefore, recommended that the Philippines initially concentrate on the domestic market with a gradual replacement of lead additives. The three-year (1987-89) program envisages a countrywide 10% blend of ethanol with gasoline as an octane enhancer. However, the economic viability of the program is in doubt and MTI and NEDA are presently re-evaluating the economics of ethanol. 4. If, for health reasons, the lead level in gasoline is to be reduced, a least cost analysis, which takes into account the economic cosL of substitutes other than ethanol (such as MTBE, Toluene, etc.), is the proper approach. In connection with the preparation of the Sugar Diversification Project, Bank staff are following this approach in their evaluation of the ethanol program. The study will be finalized shortly.  - 33 - ANNEX 4 Appendix 1 Page 2 (a) A serious unemployment/underemployment problem has emerged, involving about 100,000 sugarcane workers who were already part of a major poverty group; (b) Some augarcane land is lying idle; (c) Sugar mills are operating at low capacity; and (d) Crop loan arrears have increased. 5. In the period 1977-1986, the Philippine Sugar Commission (PHILSUCOM) had been responsible for policy-making and regulation in the sector. During most of 1977-85, the National Sugar Trading Corporation (NASUTRA) had been the sole agency involved in domestic trading and export of sugar. In late 1985 the Government established the Philippine Sugar Marketing Corporation (PHILSUMA) as the single buying and selling agency to replace NASUTRA. Also, the Government, agreed under the IMF standby program to implement several important institutional changes that would have contributed to the sector's streamlining and adjustment. Specifically, it committed itself to undertake audits of NASUTRA and PHILSUCOM, prepare a plan of divestiture of PHILSUCOM's subsidiaries, issue operating guidelines for PHILSUCOM, and issue mandatory guidelines to PHILSUCOM and PHILSUMA on public disclosure requirements. However, no significant progress was made on any of these commitments under the old administration. 6. Since early 1986 the new 1overnment has introduced a number of institutional and policy changes. The new Government abolished the export monopoly of PHILSUMA and consequently export marketing has been liberalized, except for allocation of the US export quota by the Sugar Regulatory Administration (SRA). The new Government also dissolved PHILSUCOM, established SRA as the regulatory agency, and attached it to DA. The SRA comprises three members (including a Chairman), two representing planters and one representing millers. The Government is considering what SRA's functions should be, particularly whether it should handle research and extension, as PHILSUCOM did; its staffing, funding and organizational structure; and what should be done about the retrenchment/redeployment of PHILSUCOM staff. 7. The institutional and policy changes made so far are clearly in the right direction. They have resulted in reduced regulatory control and a lesser degree of Government intervention. However, further changes are required to support longer-term productivity and income growth in the subsec- tor. These have been discussed with Government in connection with a Bank sector rrport "Philippines Sugarlands Diversification Study" (Report No. 6042- PH, May 30, 1986) and a proposed policy-based lending operation. 8. The proposed Bank loan (appraisal scheduled for August 1987) would address various adjustment problems in the subsector. It specifically would support policies and plans to: (a) rationalize sugarcane production and pro- cessing; (b) resolve the problem of sugar loan arrearages; (c) initiate sugar- lands agrarian reform; (d) facilitate crop substitution/diversification; (e) improve efficiency through measures including introduction of a direct cane purchase system; and (f) restructure institutional arrangements for the sugar subsector, including research and extension.  - 34 - ANNEX 5 Page 1 PHILIPPINES AGRICULTURAL STRATEGY SECTOR REVIEW Grains Pricing Policy Including a Suggested New Approach to Protection Background 1. Yields of both rice and corn have increased in recent years, although they remain low by South-east Asian standards (average palay yield is around 2.5 tons/ha vs. 3.3 tons for Asia; average corn yields are slightly below 1.0 tons/ha vs. around 1.5 tons for Asia). 2. Rice is the most important food commodity in the Philippines, with per capita consumption just under 100 kg in 1980. Between 1970 and 1985 production expanded at a rate of about 3% p1i., from 5.2 million tons of unmilled rice ("palay" in the Philippines) - to 8.2 million tons, slightly faster that the population growth rate (2.5% p.a.). The rapid increase in production after the early 1970s was partly due to a government rice production program called "Masagana 99" which promoted new high-yielding varieties and increased fertilizer usage and made subsidized credit available to farmers. Initially, this helped in the adoption of new technology, but because of debt collection problems, it undermined the solvency of the majority of the rural banks. 3. The increase in production during the 1970s permitted the country to become self-sufficient. Imports decreased from over 600,000 mt in 1972 to 24,000 mt in 1977, and from 1978 to 1982 the country was able to export small quantities. Because of drought conditions in 1982, some imports, undertaken by NFA, were required. The main harvest in the fall of 1985 was large, and with normal weather conditions experienced in 1986, no imports were necessary in 1986. 4. The "Maisagana" program for corn was the Government's counterpart program to "Masagana 99," the rice program. It started in 1982 and was also encouraged by the extension service and with subsidized production credits. Even before the program started production expanded with the use of improved varieties and production technology. Total production expanded from 2.5 million mt in 1975 to 3.3 million mt in 1984; i.e., on average the expansion was about 3% p.a.--about the same as that for rice. Because of the sharp increases in the use of yellow corn as a feed input, yellow corn imports have increased from about 1,000 mt in 1970 to a high of 528,000 m in 1983 in spite of the increase in production. However, imports for 1985 were down to 250,000 mt and were largely undertaken during the first half of the year. An excellent main harvest from July 1985 to December 1985 eliminated the need for imports during that time and for 1986. 1/ One ton of palay corresponds to about 0.6 tons of milled rice.  - 35 - ANNEX 5 Page 2 5, The January, 1987, IFPRI report 2/ concluded that rice and corn production should be protected with a moderate tariff of about 20% for effi- cient domestic producers to remain competitive with 3imports and to keep domestic prices in line with long-term world prices- . Their competitive advantage analysis indicated that at those levels Philippine -ice and corn were competitive with imports uling border prices of the first half of 1986. The border prj,re for rice in the first half of 1986 was about US$235, for corn about US$115 pe Adding the 20% tariff would result in import prices of US$282 and US$138 for rice and corn, respectively. The authors of the IFPRI report further state that protection below what was advocated would result in substantial shifts out of rice and corn production and in large-scale importation. On the other hand, if protection was above 20%, production would be stimulated, domestic demand would be reduced, and surpluses would arise that could be disposed of only through (subsidized) exports. 6. Since the IFPRI aralysis was done, corn prices have dropped to even lower levels, not expected at the time. Since August 1986 cif prices have hovered around US$65 to 70 per ton, a price that undoubtedly reflects "dumping". Under these circumstances a fixed tariff of 20%, as proposed, would not protect domestic producers adequately. On the other hand, a ban on imports, which is currently in place, can be costly to the consumers and the feed milling industry when there is a shortfall in production. A compromise proposal--the introduction of a reference price connected with a variable tariff--which grants some protection to both producers and consumers, is outlined below. Government's Overall Policy with Regards to Pricing and Marketing 7. Prices for agricultural commodities and inputs (except rice and corn) are determined by the free interplay of supply and demand. All price controls have been abolished. For traded commodities the Government's trade/tariff policy determines the relationship between world and domestic prices. A wide variety of policies exists from zero tariff cases (where world prices determine the level and variability of domestic prices) to the cases of explicit bans which result in complete segmentation of the domestic from the world market. 2/ M.W. Rosegrant, L.A. Gonzales, H.E. Bouis, and J.F. Sison: "Price and Investment Policies for Food Crop Sector Growth in the Philippines", IFPRI, Washington, D.C., January 20, 1987. 3/ According to the latest Bank projections in Report No. 814/86 (October 1986), rice prices (fob) in constant 1985 dollars are projected to vary within a range of $206 per ton to $233 per ton between 1988 and 2000. Corn prices (fob) are projected to be $104 in 1988 and to slowly decrease to $94 by the year 2000. 41 The present low price of rice reflects in part the success of several countries in expanding rice production as well as protection and export subsidies in some industrial countries.  - 36 - ANNEX 5 Page 3 8. Government's overall policy is that marketing is the task of the private sector. The private sector is indirectly being supported by infra- structure development and the provision of various services. An exception to the overall policy that makes marketing the exclusive domain of the private sector has been made for rice and corro, where a price stabilization policy has involved government in a residual role in domestic marketing and a monopoly or licensing role in imports and exports. Rice and Corn: The Exception to the Overall Marketing Policy 9. There has been government intervention in the marketing for rice and corn since the establishment of the National Grains Authority (which later became NFA) some decades ago. The general objectives are: (a) Objective 1: To provide remunerative prices for producers; (b) Objective 2: To provide a secure supply of the two main staple foods at reasonable prices for consumers; (c) Objective 3: To limit "exploitation" by traders; and (d) Objective 4: To hold reserve stocks for food security purposes. To carry out its functions, NFA has three main policy instruments: (a) Policy Announcements/Dissemination of Information. Policy announcements concerning the support price for the next crop could have an effect on production decisions. However, in the Philippine context, they are of little relevance since the record of achieving the support price is poor (see below). Announcements of importation decisions on the other hand result in an immediate market reaction; (b) Purchases, Storage and Sales of Grains. The main limitations of this instrument arise from financial constraints of NFA; and (c) Decisions Concerning Imports. Judging by its past record, a matter of fact, NFA has been biasci in favor of consumers and has therefore tended to overimport. But tven assuming the absence of any biases and a specific domestic price target, it is not possible for the best of bureaucrats to accurately predict supply and demand and the deficit which needs to be covered by imports. Imports will inevitably be either too high or too low. Effectiveness of NFA in Achieving its Objectives 10. It is not easy to determine NFA's overall effectiveness in achieving its goals partly because the two main objectives are conflicting. Farmers are interested in high prices and consumers low prices. A third group--the traders--are interested in wide price bands and limited and predictable intervention by NFA.  - 37 - ANNEX 5 Page 4 11. Effectiveness of Maintaining Floor Prices (Objective 1). To analyze thist one needs to distinguish between two main situations: (a) surplus situation; and (b) deficit situation. When a surplus situation exists, purchases by NFA have a limited effect on market prices unless NFA can export some quantities (at a loss). Exporting at a loss is constrained by NFA (and/or Government) financial capabilities. In a deficit situation the quantity and terms of imports are more crucial to domes- tic price formation than NFA purchases. Since past Government and NFA poli- cies were more concerned with ensuring low rice and corn prices for consumers/ feedmillers than with ensuring the achievement of the support price for pro- ducers, NFA tended to overimport and thereby undercut its own attempts (as ineffective as they have been) to achieve the support price for farmers. As a result actual farmgate prices for rice have often been below the support price. 12. With regard to NFA's ability to maintain a floor price certain misconceptions exist. It is often stated that "if NFA had enough financial resources it could buy more which in turn would raise market prices." What tends to be overlooked is the fact that in a closed economy framework, with no export subsidization, whether NFA buys 5% or 15% of production, the impact on the average national market price is marginal. It simply changes the proportion of stocks held by the private and public sectors, and it benefits some more (favored) farmers in the provinces where NFA is buying at the expense of a higher budget deficit. 13. Ftphle Supply and Low Prices for Consumers (Objective 2). The objective of a stable supply and reasonable prices has been achieved. The retail price ceilings over the years were assured by NFA selling (at a loss, because of small margins between tne purchasing and selling price) and/or by importations. The absolutely lowest prices for consumers would, of course, have been achieved by a free importation policy which, however, would have seriously threatened the production sector and which therefore would not have been acceptable. 14. Limit "Exploitation" by Traders (Objectives 3). The frequent stat- ing of this objective (generally by officials of the previous Government) reflected a particular attitude toward the private sector rather than a real economic problem. If Government sets the overall policies (which have consis- tency) and if the trading sector is competitive (with large numbers of market participants and no restrictions to entry) private traders, by attempting to maximize their own profit, will together achieve a competitive situation that is optimal for the economy as a whole. If there was a problem in this area in the past it was (a) the uncertainty created by ad-hoc NFA interventions/ decisions; and (b) by the licensing of traders, which may have been somewhat restrictive. 15. In the past NFA price bands (between purchase and selling price) have probably been too narrow. The margins were probably smaller than real  - 38 - ANNEX 5 Page 5 NFA costs (which, however, one may not be able to easily determine because of NFA's accounting system that does not permit costing on an activities' basis). To ttie extent that NFA was effective in enforcing its priceband it squeezed out some private sector firms and created uncertainties. 16. Holding Reserve Stocks (Objective 4). This objective has generally been over-achieved, at a high cost. NFA stocks te..led to be too high. (It is questionable whether a largely self-sufficient country should hold reserve stocks over and above normal working stocks particularly when world prices are- lower than domestic prices and when prices are projected to remain low.) Some Basic Trade Policy Options 17. Since Government purchases to support and/or stabilize prices have been of limited effectiveness and were costly, one must recognize the relative importance of the trade and tariff policy. Some basic options are outlined below. 18. Import Ban. For commodities where an import ban has been imposed, domestic supply and demand determine domestic prices; and the latter bear no relationship to world prices (to the extent that the ban is effective; i.e., that no smuggling is taking place). An import ban is currently in effect for rice and corn. Such a ban benefits producers whereas consumers incur welfare losses. 19. Quantitative Restrictions. Under such a system NFA grants import licenses to private sector firms for specific amounts or imports on its own account. Amongst other problems, such a policy tends to lack consistency as ad hoc decisions have to be made. 20. Free Trade Policy. Under a free trade policy domestic prices would vary with world prices. Given the low current and projected prices, producers would incur serious welfare losses whereas the consumers would gain. 21. Fixed Tariff Policy. With a fixed import tariff domestic prices would be higher than the world prices but they would fluctuate with world market prices. 22. Variable Tariff Policy. Variable import levies are used in many countries or trading blocks, such as the EC. A domestic reference price is first determined and then an import tax is assessed which makes up the difference between the imports at world prices and the reference price. The policy protects producers from low and fluctuating prices. Consumers incur some welfare losses compared to a free trade policy, but in case there is a shortfall in domestic production consumers are protected because imports will prevent prices from rising above the domestic reference price. The Cu:rent Policy 23. Import bans for rice and corn are currently in effect in the Philippines. The bans are not absolute, i.e., when domestic prices start rising, political pressures for making exemptions start building, and it is up  - 39 - ANNEX 5 Page 6 to the Government to determine if and when imports of a certain size are permitted. As stated earlier, NFA's past policies were biased in favor of consumers. The current import ban policy can be seen as a reaction to those policies in order to benefit producers. Past biases should no doubt be corrected, but one should avoid over-correction that does not assure a certain ceiling price to consumers, at which, e.g., imports would be permitted. 24. Benefits of the import ban policy cre: (a) administratively it does not require anything (except enforcement against smuggling); and (b) it benefits the farm sector, particularly in years of production shortfalls. Drawbacks of the import ban are: (a) if there is a shortfall in domestic production, consumers and traders do not know at which price level the rising prices will stop; and (b) when prices rise, political pressures for ad-hoc importation decisions building up. Two options exist: (i) Government grants an import exemption. Based on limited information the size of the imported amounts must be determined, which is a discretionary decision whose precise impact on prices is not known. Also, by the time imports actually arrive, the situation may have changed. Even under this option some smuggling may be induced if the difference between the world price and the domestic price becomes sufficiently large. (ii) Government holds -n to the ban without making exceptions. In a shortfall situation this means that prices will rise to where demand and supply intersect. This benefits producers at the expense of consumers. Again, as the differenct between the domestic prices and world prices becomes large, smuggling is likely to be induced. When smuggling takes place, the government does not get any revenues, whereas under a tariff scheme it would. A Proposed Reference Price/Variable Tariff Scheme 25. The advantages of a variable tariff scheme would be that it would: (a) protect domestic producers from imports belcw the reference price; provide greater reliability of pre-planting price forecasts; (b) assure consumers that domestic prices will not rise beyond the reference price (plus marketing margins) in case of a shortage;  - 40 - ANNEX 5 Page 7 (c) result in a lower overall price variability than the import ban or a fixed tariff policy; and (d) results in tariff revenues for Government when imports are undertaken. 26. The reference price should be determined based on the long run average world price plus a protection margin. The long run average world price could be determined by a trend line or (perhaps more objectively) by a multi-year moving aBerage price., At the cif level the five-year moving average world price is called, for our purposes, the "world reference price" for the year in question. To this price one should add a protection margin;61 this is determined, like any other tariffs, by a number of considerations, including the production costs of efficient domestic producers, extent of export subsidization by industrial countries, etc. The "protection margin" is not what importers would pay as tariff (see para. 61). 27. Three options of how 7eference prices could be determined are shown in Tables 1, 2 and 3 for corn. All of them assume a protection margin of 20%. Table 1 shows a 5-year moving average, Table 2 a 3-year moving average and Table 3 a 3-year moving average where the most recent years have a higher weight. (A fourth option, not shown in a Table, would be a moving average that includes projected prices. The Bank's latest estimate for 1)87 is US$72 per mt and the projection for both 1988 and 1989 is US$123.1. At the cif level, a 5-year moving average 1984-88 would be US$116.8 and a 5-year moving average 1985-89 would be US$114.0.) 28. If option one (from Table 1) was used the world reference price for corn for 1987 at the cif.devel would be the average for 1982 to 1986 which is $127.8 per mt. Adding a 20% margin would result in $153.4 per mt. At an exchange rate of P 20.4/$ this would equal P 3.13/kg (at the port of entry). No ad hoc bureaucratic decisions would be required during the year about whether to import or how much. It should be noted that, had a reference price/variable tariff scheme as proposed above been in effect in 1986, the 5/ The purpose of this is to even out price fluctuations and thereby to reduce domestic adjustment cost. 6/ According to Government policy all imports are to be taxed by a tariff of 10% to 50%. Instead of using a fixed tariff of say 20% we are suggesting that a variable tariff, which averages out at 20% over the years, is superior. 7/ One could of course determine a reference price each year simply on the basis of political considerations. But following an explicit method, such as the one proposed here, would be preferable because it would make the process more transparent and objective. Nevertheless, a reference price determined politically once a year would still be preferable to a ban or to quantitative restrictions being determined on an ad hoc basis.  Table 1: A PROPOSED REFERENCE PRICE/VARIABLE TARIFF SCHEME FOR CORN WITH A 20% PROTECT;ON MARGIN AND A 5-YEAR MOVING AVERAGE World refer- Domestic reference FOB price ence price price at CIF level Domestic Implicit variable tariff Yellow =(1)x1.1O = 5-year including 20% Exchange referen-e (annual averages No. 2 CIF moving aver- protection margin rate price $/ton % Gulf price age of (2) = (3) x 1.20 (P/$) (P/kg) -(4)-(2) =(7):(2) (1) (2) (3) (4) (5) (6) (7) (8) 1970 58.4 64.2 1971 58.4 64.2 1972 56.0 61.6 1973 98.0 107.8 1974 132.0 145.2 1975 119.6 131.5 88.6 106.3 7.2 0.76 0.0 0.0 1976 112.4 123.6 102.1 122.5 7.4 0.91 0.0 0.0 1977 95.3 104.8 113.9 136.7 7.4 1.01 31.9 30.4 1978 100.7 110.8 122.6 147.1 7.4 1.09 36.3 32.8 1979 115.5 127.0 123.2 147.8 7.4 1.09 20.8 16.4 1980 125.3 137.8 119.5 143.4 7.4 1.08 5.6 4.1 1981 130.8 143.9 120.8 145.0 7.9 1.15 1.1 0.8 1982 109.3 120.2 124.9 149.9 8.5 1.27 29.7 24.7 1983 136.0 149.6 127.9 153.5 11.1 1.70 3.9 2.6 1984 135.9 149.5 135.7 162.8 16.7 2.72 13.3 8.9 1985 113.2 123.4 140.2 168.2 18.6 3.13 44.8 36.3 1986 87.6 96.4 137.3 164.8 20.4 3.36 68.4 71.0 1987 72.0/a 79.2 127.8 153.4 (20.4) 3.13 74.2 93.7 /a Estimate. Iin  Table 2: A PROPOSED REFERENCE PRICE/VARIABLE TARIFF SCHEME FOR CORN WITH A 20% PROTECTION MARGIN AND A 3-YEAR MOVING AVERAGAE World refer- Domestic reference FOB price ence price price at CIF level Domestic Implicit variable tariff Yellow =(1)x1.10 = 3-year including 20% Exchange reference (annual average) No. 2 CIF moving aver- protection margin rate price $/ton % Gulf price age of (2) (3) x 1.20 (P/$) (P/kg) =(4)-(2) =(7):(2) (1) (2) (3) (4) (5) (6) (7) (8) 1970 58.4 64.2 1971 58.4 64.2 1972 56.0 61.6 1973 98.0 107.8 63.3 76.0 7.2 0.55 0.0 0.0 1974 132.0 145.2 77.9 93.5 7.2 0.67 0.0 0.0 1975 119.6 131.5 104.9 125.9 7.2 0.91 0.0 0.u 1976 112.4 123.6 128.2 153.8 7.4 1.14 30.2 24.4 1977 95.3 104.8 134.4 161.3 7.4 1.19 56.5 53.9 1978 100.7 110.8 120.0 144.0 7.4 1.07 33.2 30.0 1979 115.5 127.0 113.1 135.7 7.4 1.00 8.7 6.9 1980 125.3 137.8 114.2 137.0 7.4 1.01 0.0 0.0 1981 130.8 143.9 125.2 150.2 7.9 1.19 6.3 4.4 1982 109.3 120.2 136.2 163.4 8.5 1.39 43.2 35.9 1983 136.0 149.6 134.0 160.8 11.1 1.78 11.2 7.5 1984 135.9 149.5 137.9 165.5 16.7 2.76 16.0 10.7 1985 113.2 123.4 139.8 167.8 18.6 3.12 44.4 36.0 1986 87.6 96.4 140.8 169.0 20.4 3.45 72.6 75.3 1987 72.0/a 79.2 123.1 147.7 (20.4) 3.01 68.5 86.5 /a Estimate.  Table 3: A PROPOSED REFERENCE PRICE/VARIABLE TARIFF SCHEME FOR CORN WITH A 20% PROTECTION MARGIN AND A WEIGHTED 3-YEAR MOVING A'JERAGAE World refer- Domestic ence price reference price FOB price weighted* at CIF level Domestic Impltcit variable tariff Yellow =(l)x1.10 3-year including 20% Exchange reference (annual average) No. 2 CIF moving aver- protection margin rate price $/ton 7 Gulf price age of (2) = (3) x 1.20 (P/$) (P/kg) =(4)-(2) =(7):(2) (1) (2) (3) (4) (5) (6) (7) (8) 1970 58.4 64.2 1971 58.4 64.2 1972 56.0 61.6 1973 98.0 107.8 62.9 75.5 7.2 0.54 0.0 0.0 1974 132.0 145.2 85.1 102.1 7.2 0.74 0.0 0.0 I 1975 119.6 131.5 119.5 143.4 7.2 1.03 11.9 9.0 1976 112.4 123.6 132.2 159.2 7.4 1.18 35.6 28.8 1977 95.3 104.8 129.6 155.5 7.4 1.15 50.7 48.4 1978 100.7 110.8 115.4 138.5 7.4 1.02 27.7 25.0 1979 115.5 127.0 110.6 132.7 7.4 0.98 5.7 4.5 1980 125.3 137.8 118.0 141.6 7.4 1.05 3.8 2.8 1981 130.8 143.9 129.9 155.9 7.9 1.23 12.0 8.3 1982 109.3 120.2 139.2 167.0 8.5 1.42 46.8 38.9 1983 136.0 149.6 131.2 157.4 11.1 1.75 7.8 5.2 1984 135.9 149.5 138.5 166.2 16.7 2.78 16.7 11.1 1985 113.2 123.4 .45.1 174.1 18.6 3.24 50.7 41.1 1986 87.6 96.4 136.4 163.7 20.4 3.34 67.3 69.8 1987 72.0/a 79.2 113.8 136.6 (2G.4) 2.79 57.4 72.5 /a Estimate. * The following weights were used: 50% for most recent year; 35% for second most recent year; and 15% for third most recent vear. Ln  - 44 - ANNEX 5 Page 11 implicit variable tariff would on average have been 71% for a 20% protection level over the base price. This is because of the unusual, sudden drop in world prices to levels not experienced for over a decade. 29. Using a 5-year moving average for rice the reference price for 1987 would result in a price of US$323.5 per ton (Table 4). Whatever the protection margin would be for rice, it should be somewhat higher for wheat and even higher for flour, preferably the max Tum of 50%t in order to limit the degree of substitution of wheat for rice.- 30. If domestic prices stayed below the domestic reference price no imports would be undertaken since imports coming in at the reference price (actual cif price and variable tariff) would not be competitive. If domestic prices start moving above the reference price, the private sector would start bringing in imports and domestic prices would remain around the reference -:ce (plus marketing margins). Import licensing by NFA would not be necessary and should be abolished. Instead, any importer would be required to provide documentation (copy of contract, bill of lading, proof of payment) to Customs. The amount of variable tariff to be assessed for each shipment would be the difference between the reference price and the actudl cif price of the shipment (this amount, divided by the year's world reference price, would give the tariff in percentage terms). Imports would be undertaken only during shortage periods, and the number of shipments would not be large. Administratively it should not be a problem for Customs to be able to collect the variable duty. With a fixed tariff of say 20% the Customs official collects a duty of 0.2 times the cif price; in the case of a variable tariff he imposes whatever tariff is needed to bring the cif price up to that year's domestic reference price. To avoid over-invoicing, Gc ernment way want to require customs to provide the import documentation to NFA for a check wL. whether the prices paid are realistic in the sense of whether the' are in line with spot prices on the day of purchase. Graphical Conceptualization and Summary of Major Options 31. Three supply scenarios are presented by S , S2, and S3 (Figure 1). D is the domestic demand schedule. Pw is the actual world price, which may be above or below the five-year moving average price. P ef is the reference price. P2 is the market clearing price in situation e , when an import ban is in effect. With the same production schedule and a reference price/variable tariff scheme, imports amounting to GF would enter the country, thereby reducing the domestic price to Pref* If domestic production is S2 the market clearing price would be P1. Buying by NFA at market prices in a one-period model would not raise prices unless some exports were undertaken on a 8/ It should be noted in this connection that wheat-based products are mainly consumed by higher income groups.  Table 4: A PROPOSED REFERENCE PRICE/VARIABLE TARIFF SCHEME FOR RICE WITH A 20% PROTECTION MARGIN Domestic Domestic World reference reference price reference Implicit FOB price = 5-year at CIF level price at cif variable tariff price CIF moving average including 20% Exchange level in pesos (annual average) thin 5% price of (2) protection margin rate (4)x(5) S/ton % broken (2)-(1)xl.08 $/mt (3) x 1.20 (P/$) (P/kg) (4)-(2) (7):(2) (1) (2) (3) (4) (5) (6) (7) (8) 1970 144.0 155.5 1971 129.0 139.3 1972 147.0 158.7 1 1973 350.0 378.0 1974 542.0 585.4 Le 1975 363.1 392.1 283.4 340.1 7.2 2.45 0.0 0.0 1976 254.5 274.9 330.7 396.8 7.4 2.94 121.9 44.3 1977 272.2 293.9 357.8 429.5 7.4 3.18 135*6 46.1 1978 367.5 396.9 384.9 461.9 7.4 3.42 65.0 16.4 1979 334.2 360.9 388.6 466.3 7.4 3.45 105.4 29.2 1980 433.9 468.6 343.7 412.4 7.5 3.09 0.0 0.0 1981 482.8 521.4 359.0 430.8 7.9 3.40 0.0 0.0 1982 292.9 316.3 408.9 489.6 8.5 4.16 173.3 54.8 1983 276.9 299.1 412.8 495.5 11.1 5.50 196.4 65.7 1984 252.1 272.3 393.3 4711. 16.7 7.88 199.6 73.3 1985 215.9 233.2 375.5 450.6 18.6 8.38 217.4 93.2 1986 210.5 227.3 382.5 394.2 20.4 8.04 166.8 73.4 1987 210.0/a 231.0 269.6 323.5 (20.4) 6.60 92.5 40.0 /a Estimate. rn  -46- ANNEX5 Page 13 FIGURE 1: Three Production Scenarios and Major Policy Options P Pref P1c t-- - - -- - - - _7___I E A 3 K L C D D o  - 47 - ANNEX 5 Page 14 subsidized basis.9/ To raise the price to Pref a quantity of IE would have to be exported with a subsidy of KLEI. The export subsidy of KLEI results in welfare losses for consumers of (P1EFPre ) and the welfare gains for producers of (PlENPr f). Considering consumers and producers together there would be net gain 01 ENF which is smaller than the export subsidy. Therefore, usin), equal welfare weights for producers and consumers, the export subsidy results in a (small) net social loss. Nevertheless, if it could be established that corn and/or rice producers have a higher incidence of poverty than the average consumer, and if therefore Government assigned slightly higher welfare weights to the producers, the export subsidy could be justified on (net) welfare grounds. S3 implies a surplus situation where domestic prices fall to the world market price level. In that situation no kind of tariff policy is effective and neither is any NFA buying. The private sector would export quantity CD. Again, the only policy that would keep domestic prices above the world market floor would be an export subsidization policy. Implications for the Role of NFA 32. The three main points made above have significant implications for NFA's future role: (a) The recognition that increased buying by NFA, when there is a surplus of rice or corn, does only marginally increase the average domestic price. It increases NFA stocks and decreases privately held stocks. It benefits a few additional favored farmers in the provinces where NFA is buying and increases the NFA operating costs and deficits. Point(a) does not imply any critisicm of NFA, which is an effective agency with a highly dedicated staff; it simply recognizes the limits of public price intervention in a closed economy framework; (b) A reference price/variable tariff scheme as proposed above reduces price fluctuations (by eliminating price peaks); it protects producers from import competition below the reference price and guarantees that consumers/feedmillers etc. will get their commodi- ties at prices no higher than the reference price if there is a shortfall in production; and (c) There is little justification for a country to hold reserve stocks-- particularly large ones--when the country is basically self- sufficient, when world market prices are lower than domestic prices, and when world prices are expected to remain at low levels (the present situation). 9/ Buying at prices higher than the market rate would marginally increase average prices.  - 48 - ANNEX 5 Page 15 33. If these threy0yoints are accepted they would suggest a smaller role for NFA for the future. Even if the import ban was not replaced by a variable tariff scheme as proposed above, the implications for NFA would remain the same (because of the limited effectiveness of Government intervention in a closed economy framework when the trading is fully competitive). Retrenchment is always difficult for any organization, but NFA has shown that a retrenchment can be made without undue turmoil for the organization and hardship for individuals. In the fill of 1986, permanent NFA staff was reduced from about 7,000 to about 5,500," Good severance pay packages were offered to induce staff to leave voluntarily and according to reports most of those who left have adjusted well to their career changes. 34. If Government agrees with the thrust of the arguments above and their implications for NFA's future role, Government may want to create a task force to precisely define NFA's role and to make operational proposals of how the restructuring/retrenchment could be undertaken in the most efficient, fair and least disruptive way. 10/ This coincides with the view expressed in the APST report where it was stated that "NFA must be slimmed down" (p. 11). 11/ As a result of divestiture of non-grain activities.  - 49 - ANNEX 6 Page 1 PHILIPPINES AGRICULTURAL SECTOR STRATEGY REVIEW Irrigation 1. The development of irrigation infrastructure in the last two decades has been impressive. Irrigated area expanded from 702,000 ha to 1.4 million ha since 1968. This contributed significantly to the expansion of palay pro- duction by 3.0 million MT during the past 18 years and enabled the Philippines to achieve self-sufficiency in rice. Despite this impressive progress, the subsector faces today several issues and problems which have significant im- plications for the productivity and efficiency of the systems as well as for their financial viability. This section addresses two of the major issues. The first issue addressed is the proposed shift in the investment priorities toward increased emphasis on rehabilitation of existing systems and the empha- sis on smaller scale systems. The economic viability of the various options and the implications in terms of the appropriateness of the investment program in irrigation and the rice supply situation are analyzed. A second important issue is the financing and pricing policy in irrigation. As a result of the economic crisis and the cutbacks in the Government's budget there was a drastic fall in Operation and Maintenance (O&M) expenditures in irrigation. Because of that, .requently less than two-thirds of the planned service area are effectively irrigated, resulting in low cropping intensity. The problem is related directly to the sources of finance of irrigation and the cost recovery of irrigation water. This issue is also examined here. Review of Irrigation Development 2. Irrigation in the Philippines ia gentgezlly categorized into three types of systems: national systems (NIS), communal irrigation systems (CIS), and pump irrigation system (PIS). The National Systems are either reservoir or run-of-river gravity systems. They are built, operated and maintained by the National Irrigation Administration (NIA). In terms of command areas, they range in size from about 100 ha to over 100,000 ha. Currently there are 127 NISs covering nearly 600,000 ha. Communal Systems are small gravity, mostly run-of-river type, owned and operated by the farmers themselves. The roughly 6,300 CISs (as of December 1986) account for about 50% of total irrigated area and about 40% of irrigated rice production. CISs vary in size froni a few hectares to as large as 4,000 ha, but over 70% of systems are smaller than 100 ha. The CISs are constructed under NIA supervision with farmers contributing labor and locally available materials. The systems, after completion, are turned over to the farmers, through their respective farmer associations, who assume full responsibility for the operation and maintenance of the system. Pump systems may be government or privately owned. The large surface pumps have a service area of more than 100 ha and are generally installed, operated and maintained by NIA. The medium pumps cover a service area of 20-100 ha and are operated and maintained by either NIA or the Farm Systems Development Corporation (FSDC). Small pump units are privately owned by individual farmers, and have a command area of less than 20 ha.  - 50 - ANNEX 6 Page 2 3, The implementation of the program to generate new areas for irriga- tion was vigorously pursued over the past 10-15 years. This raiszd the ser- vice area of operating irrigation systems from about 742,000 ha in 1972 to about 1.45 million ha in 1986, or about 47% of total potential irrigable area. The irrigation investment activities had their peak during the period between 1973 and 1980, when service area increased on average by 58,940 ha per annum. That expansion slowed down in the period 1983-85 due to the financial crisis. The growth in service area by system between 1972 and 1986 is presented in Table 1. Total irrigated area during that period increased at a rate of 4.6% per year. The rate of increase was greatest for CIS (6.1%) and lowest for NIS (3.0%). By location, 67.2% of the irrigated area is in Luzon, 12.6% in the Visayas and 20.2% in Mindanao (see Appendix Table 1). Table 1: SERVICE AREA BY SYSTEM 1972-1986 Annual increase Type of 1972 1981 1986 1972-86 System (ha) (%) (ha) (%) (ha) (%) (X p.a.) National 379,200 51.1 482,200 39.2 595,259 40.8 3.0 Communal 293,800 39.6 599,000 48.6 710,009 48.7 6.1 Pump 69,400 9.3 150,000 12.2 152,128 10.4 5.4 Total 742,400 100.0 1,231,000 100.0 1,457,396 100.0 4.6 Source: NIA Table 2: SERVICE AND IRRIGATED AREA, 1986 (ha) Irrigated Cropping Irrigated Area, Rice Total Other Intensity /a Service Area Wet Season Dry Season Rice Crops (x) Storage (NIS) 103,280 81,450 78,220 159,670 8,070 162 Diversion (NIS) 491,979 367,030 247,510 614,540 31,540 131 Communal and Pump 862,137 N/A N/A 1,062,913 32,873 127 Total 1,457,396 1,837,123 729483 131 /a (Total irrigated rice and other crops) * Total service area. Source: NIA  - 51 - ANNEX 6 Page 3 4. Total irrigated areas in the NIS in 1986 reached 789,807 ha, consis- ting of 777,195 for rice and the rest for other crops (Table 2). Communal and pump systems combined account for a total irrigated area of 1,095,787 ha. In terms of irrigated cropping intensity the storage systems exhibited the highest value. On average storage systems had in 1986 cropping intensity of 162% compared to 131% for diversion systems and 127% for Communal and Pump. Overall, the cropping intensity values are low, reflecting, among others, inadequate and highly variable water supply, particularly in the dry season; poor system maintenance; and the incompatibility of system design and loca- tion-specific conditions. The low cropping intensity in communal systems is partly attributed to the overdesign of systems relative to availability of water supply. This is also reflected in rice yields. These are shown in Table 3 where the NIS system, particularly the storage ones reveal their lead over the communals. Table 3: YIELDS BY SYSTEM, 1984 (MT/ha) Wet Season Dry Season Storage 3.7 4.0 NIS (Diversion) 3.7 3.7 CIS 2.9 2.8 PIS 3.8 4.1 Lowland rainfed 1.9 Source: NIA, IFPRI Investment, Rehabilitation and Operation and Maintenance 5. There are several important questions facing Philippine planners when it comes to the investment program in irrigation. What should be the emphasis: rehabilitation or new investment? What share of resources should be devoted for O&M? If new projects are required should large scale or small scale systems be constructed? Several studies in recent years have concluded that the Philippines should place greater emphasis on rehabilitation invest- ment and on investment in small scale, less capital intensive communal irrigation schemes. The Bank's 1982 Irrigation Review recommended greater emphasis on rehabilitation and less in extending the irrigated area than the Govermnent had in mind. The Bank report, Philippines: Public Investment Program (5677-PH, August 1985), cites a study of ten projects financed by the Asian Development Bank (ADB) indicating that converting from rainfed to  - 52 - ANNEX 6 Page 4 irrigation costs 50-80% more per incremental ton of paddy than rehabilitation of existing systems. Thus, the report recommends, future activities in the sector need to focus on rehabilitation investment, increasing O&M expenditures, and the completion of on-going projects. Starting new large projects should receive low priority. An ADB study completed in May 1984,1 recommends reallocation of investment from large storage systems to communal systems or national diversion systems. The new report by IFPRI (January 1987), however, recommended that more new investment is required and relatively tess emphasis be put on rehabilitation. 6. This section reviews these questions. The economic viability of the various investment options is assessed in the context of present and projected low world rice prices, the fact that the Philippines is at or around rice self-sufficiency, and the limited prospects of rice exports from the Philippines, given world rice market conditions and the low quality of Philippine rice. 7. Returns to New Investment and Rehabilitation by System. The estimates of returns to new investment are based on existing system performanc. and projected performance of six representative systems. Two large scale systems, two medium scaJ7 systems, and two small scale systems were used as sources of basic data.- Data from three representative systems was used to assess the rates of return to rehabilitation. These systems vary in size (2,500 ha, 8,170 ha and 15,000) and in their geographical location. 8. The estimates for economic rates of returns derived here should be treated only as indicative results. Because of various limitations, such as aggregation across different systems and data availability, the results reported here represent general orders of magnitudes only. Nevertheless, these estimates provide a relatively clear picture as to the potential viability of the various investment options in Philippine irrigation. 9. All costs used are constant 1985 prices; all farm inputs and outputs are estimated at present and projected 1995 farm-gate prices expressed in 1985 constant prices. The prices for rice and fertilizers are based on the Bank's commodity price forecast of January 1987. The price structure assumed for rice is provided in Appendix Table 2. For the next 15 to 20 years (given the planned investment program in irrigation), the Philippines would fluctuate around rice self-sufficiency with a surplus in the early years turning into E deficit toward the second part of the period (see section on rice supply and demand). As a result, the economic viability of irrigation is assessed under two trade regimes: import substitution regime (import parity) and rice surplus regime (export parity). The average economic farmgate pricr used in 1/ "Assessment of Food Demand/Supply Prospects and Related Strategies for Developing Member Countries of ADB" IFPRI-ADB, May 31, 1984. 2/ The systems are Apayao-Abulog (15,000 ha), Baco-Bucayao (8,170 ha), Sta. Cruz (3,725 ha), Libmanan-Cabusao (3,427 ha), Padada (2,500 ha) and Inarihan (1,305 ha).  - 53 - ANNEX 6 Page 5 the import substitution case is P 2.3/kg and in the surplus case the price used is P 1.9/kg. 10. In the case of new projects, it is assumed that the area "without project" is utilized for rainfed rice. With the project, cropping intensity increases gradually to 80-90 in the wet season and to about 60Q in the dry season. These intensities depend, of course, on many factors: adequate system design, sufficient water supply and adequate operations and maintenance of the system, among other things. Rainfed paddy yields are 1.7 MT per ha increasing in the future to 2.5 MT/ha. With irrigation, yields are assumed to reach 4 MT/ha in the wet season and 4.2 MT/ha in the dry season. Inputs, services and labor costs are adjusted according to cropping intensity, cropping activity (i.e., rainfed, irrigated dry season, irrigated wet season), and by system location. Benefits from irrigation increase gradually as cropping intensity increases, and are assumed to reach full development levels on the fourth year after the completion of the system. Benefits derived from nonrice crops during the dry season are excluded from irrigation net benefits. 11. Construction costs of irrigation systems were estimated based on data from various ongoing and recently completed projects. These were differentiated by size: large-scale (7,000 ha +), medium-scale (2,500-7,000 ha), and small-scale (up to 2,500 ha). Construction costs vary by size and type of system from about P 29,000 per ha for smaller scale, mostly locally funded pSqjects, to over P 48,000 per ha for the larger scale systems (1985 prices). In addition, assuming adequate O&M expenditures, these systems were assumed to require only minor restsration work every 11-12 years. The appropriate levels of O&M expenditures are assumed to be provided throughout the systems life. This level varies by system but averages about P 400 per ha (1985 prices). Recurrent costs also include the purchase of O&M equipment during the systems' life. 12. In the case of rehabilitation, the cost of rehabilitation of existing systems was estimated at P 13,115 per ha (1985 prices). The required level of O&M expenditures is provided under both the "with" and "without" project. Benefits from rehabilitation are assumed to come only from improve- ments in cropping intensity. As a result of rehabilitation, cropping 3/ Very large variations from system to system (in the same size category) make estimation of construction costs of a "typical" system quite difficult (also the differentiation by size is arbitrary). For example, costs of large scale projects vary from US$1,900 per ha to about US$5,000 per ha. Furthermore, the experience in the Philippines has been that large and medium scale projects are more expensive (per unit area) than smaller scale ones. This is not only because of different technology but also because systems covering large development areas encounter an assortment of problems arising from varied topography such as flood problems, major drainage problems, varied soil characteristics, etc. Also, larger scale projects typically include training, studies and health components, which make them more expensive.  - 54 - ANNEX 6 Page 6 intensity gradually increases from an average of 50% to 80-90% in the wet season and from 30% to about 60% in the dry season. This of course depends critically on adequate supply of water and appropriate O&M levels. No increase in yields as a result of rehabilitation is assumed; and, cropping intensity in the "without project" case does not decrease over time (this can be justified by the provision of appropriate O&M expenditures). These are quite conservative assumptions but are made here to illustrate the economic viability of rehabilitation. 13. The estimated levels of the economic rates of return by system are summarized in Table 4. The results clearly show that O&M improvements and rehabilitation are economically viable under both import substitution and rice surplus regimes. New investments in irrigation are viable for small scale run-of-river systems and for communal irrigation systems. This is the case for both trade regimes. Investments in large- and medium-scale run-of-river and storage systems, on the other hand, are not economically viable according to these estimates. Table b : ESTIMATED ECONOMIC INTERNAL RATE OF RETURN - BY SYSTEM TYPE AT 1985 PRICES (x) Rice regime Import substitution /a Surplus /b Rehabilitation (3)/c 15.8 12.7 O&M improvement /d 25-35 18-25 New Investment Run-of-River Systems Large (2) 9.9 7.0 Medium (2) 10.5 7.3 Small (2) 17.3 13.3 Communal systems 18-21/e 15-16 Storage systems 3.7/e 2.7 /a Economic farmgate price of P 2.3/kg based on CIF Manila of US$216/MT (with 20% discount for quality). See Table 2 in Appendix. /b Economic farmgate price of P 1.9/kg based on FOB Manila of US$173/MT (with 20% discount for quality). /c Figures in parenthesis are number of systems from which weighted averages of internal rates of return (IRR) were derived. /d IOSP preparation estimates. Te IFPRI report. Source: Staff estimates except where noted.  - 55 - ANNEX 6 Page 7 14. Communal systems exhibited the highest returns (18-21%), mostly because of the substantially lower capital investment requirement per ha of benefitted area. Small scale systems exhibited relatively high rates of return (17.3%) even for the export regime (13.3%) due to lower cost and higher benefits per ha. Large- and medium-scale run-of-river and storage system exhibited low returns reflecting the impact of the very high per ha capital investment costs. Storage systems have been estimated to yield returns as low as 3%. 15. Rehabilitation of existing systems and O&M improvements are econo- mically viable. Rates of return to rehabilitation for the three systems analyzed vary between 14.3% and 16.5% in the import substitution case and between 10.4% and 13.4% in the export regime. This despite the very conserva- tive assumptions on the net benefits from rehabilitation. Improvement of O&M activities also prove to be viable with rates of return ranging between 25-35%. Table 5: RATES OF RETURN - SENSITIVITY ANALYSIS (Import substitution regime, %) 10% 10% decline 10% yield construction 10% decline in rice decline cost increase in areas price Rehabilitation 14.3 14.6 13.0 14.2 Run-of-River Systems Large 8.2 9.0 8.4 8.5 Medium 8.1 9.6 9.1 9.1 Small 14.6 16.0 15.8 15.9 16. The rates of return to rehabilitations are very sensitive to declines in the cropping intetnsity (Table 5). A 10% decline in the wet and dry season irrigated area reduce the IRR to 13.0% (import substitution) and 10% (export parity). These declines are smaller in the case of yield and price declines. New construction of all system sizes, on the other hand, is most sensitive to declines in yields and in rice prices. However, under the import substitution regime small scale systems are still viable under all scenarios. Under the export regime, declines in yield and rice price make small scale systems marginally viable (10-12%). 17. These results give a strong indication that the Philippines should devote increasing resources to the improvement of O&M activities in irrigation as this will provide the highest returns. The economic rates of return estimates also show that rehabilitation of existing systems should receive preference in the investment program, subject to careful choice of the systems  - 56 - ANNEX 6 Page 8 with respect to water availability and system design. On the other hand, the satisfactory performance of small run-of-river national systems and communal schemes, confirm that those are the more viable alternative schemes to follow when considering new area expansion. The next section reviews in some detail the O&M issue. The review of the proposed investment program in irrigation (para. 21) will evaluate its appropriateness and particularly its composition, in relation to the results obtained above. 18. Operation and Maintenance. The present level of O&M expenditures is inadequate. O&M expenditures, on the system level, were P 187/ha in 1985 and P 226/ha in 1986 (constant 1984 prices) compared to the required level of P 340/ha (Table 6). The levels of O&M expenditures adversely affect the performance of the systems and reduce the benefits derived from past irriga- tion investment. For example, recent experiences in system rehabilitation show that rehabilitation investment, in some cases, did not improve system performance. One of the factors cited was the inadequate level of O&M after the rehabilitation. In order to achieve the full benefits from rehabilitation the proper level of O&M expenditures must be provided. Another example is the cropping intensity in the NISs. For the period 1980-85, NIA reports that the area in NISs actually irrigated during the wet and dry season averaged 73% and 58% respectively, of total service area, for an aggregate cropping intensity of 1.31. This is due to deterioration of canals and structures, defective diversion work, and inadequate drainage. For the most part these problems are attributed to the low level of O&M. If continued, this low level of expendi- ture will cause continuous reduction in system efficiency resulting in a decrease in cropping intensity and service area. Table 6: NIS-O&M COSTS AND ISF COLLECTION (P Million) Year O&M expenditures ISF collection O&M per ha /a (pesos) 1979 66.15 46.78 235 1980 85.75 51.67 259 1981 103.45 58.57 280 1982 108.14 58.43 254 1983 100.99 72.56 231 1984 132.34 100.80 188 1985 171.10 150.64 187 /a Actual, inadequate levels of O&M expenditures. Constant 1984 prices. Source: NIA.  -57- ANNEX 6 Page 9 19. O&M of national irrigation systems has always suffered from shortage of funds. As can be seen in Table 6, nominal O&M releases have been increas- ing except for 1983. Ir real terms, however, the funds available for O&M have declined from P 280/b n 1981 to P 187/ha in 1985 (in 1984 constant prices). Actual O&M per ha in real terms was consistently below the optimal level of P 340 per ha. A combination of inadequate revenue from ISF, a sharp decline in Government equity contribution, and the requirement that NIA meet its debt- service obligations from 1982 onwards, resulted in a drastic reduction in NIA's operating expenditures. As a result, the divergence between actual and required O&M levels per ha has increased steadily since 1982-83. 20. The decline in Government budgetary support to NIA forces NIA to em- phasize cost recovery through Irrigation Service Fees. This is having an interesting effect on the level and quality of O&Me NIA in its efforts to improve cost recovery has deputized almost all of its field staff as collectors. In addition, special financial incentives are provided to the collectors. Since effective collection can be done only immediately after harvest, and this is also the time to maintain the systems, NIA field personnel are busy collecting the irrigation service fee (ISF) at the expense of maintenance work. While cost recovery of ISF is important, it is clear that this activity cannot come at the expense of the actual operation and maintenance of the system. The first problem seems to be the deputation of the technical staff as collectors. A related problem seems to be the system of incentives which encourages collection work over maintenance work. NIA must ensure that after harvest time, when the systems should be tended to, sufficient effort be devoted to their maintenance. Irrigation in the Philippine Development Plan, 1987-92 21. A medium term development plan 1987-1992 was issued in December 1986. The irrigation component of the plan seeks to support the objectives of self-sufficiency in rice in line with population growth, reduce regional im- balances in rice supply and demand, and extend irrigation to crops other than rice. To achieve these objectives the plan targets the coverage of an addi- tional irrigated area of about 206,200 ha, thus increasing the area covered by irrigation facilities to 1.66 million ha or about 53% of total irrigable area. The plan also targets the rehabilitation of some 723,100 ha (more than half the area now covered by national and communal systems). The physical targets and estimated expenditures are given in Table 7. A total investment of P 19,008 million (US$ 927 million) over the 6-year period is needed, according to the plan.  - 58 - ANNEX 6 Page 10 Table 7: IRRIGATION DEVELOPMENT PROGRAM-PHYSICAL TARGETS AND FINANCIAL REQUIREMENTS, 1987-92 ('000 ha) Total 1987 1988 1989 1990 1991 1992 1987-92 New Areas 55.9 46.2 29.1 25.8 22.2 27.0 206.2 National 41.3 29.6 11.2 10.3 6.5 10.5 109.4 Communal 14.6 16.6 17.9 15.5 15.7 16.5 96.8 Rehabilitation Improvement 167.2 174.3 173.9 66.2 75.9 65.6 723.1 National /a 124.5 130.2 127.9 16.1 20.9 7.2 426.8 CommunaL 42.7 44.1 46.0 50.1 55.0 58.4 296.3 Projected Expenditures (Million P, current 2,474 2p927 3,166 3,437 3,657 3,347 19,008 prices (Million Pp constant 2,474 2,318 2,729 2,801 2t689 2,214 15,225 1987 prices) /a Includes for 1987-1989 the area expected to be covered by the IOSP which is an O&M improvement project. Sources: Medium Term Philippine Development Plan, 1987-92, December 1986. 22. The plan recommends a shift in emphasis, compared to the 1970s, from new irrigation projects to the rehabilitation of existing facilities. There- tore, about 60% of total investment will be used to support rehabilitation, with the remaining 40% allotted to new irrigated areas under the national and communal syster. Specifically, the order of priorities for the coming years is as follows.- - Completion of ongoing projects: The completion of ongoing projects will take precedence over any project. - Development of small scale irrigation =wojects: The development of small scale irrigation projects, particularly communal irrigation projects will be continued. - Strengthening of Operation and Maintenance (O&M): Increase O&M expenditures to a sufficient level to stem further deterioration of irrigation infrastructure. 4/ Source: Philippine Development Plan 1987-2000: NIA submission.  - 59 - ANNEX 6 Page 11 Rehabilitation of existing irrigation systems: To minimize invest- ment losses and maintain efficient irrigation service, rehabilita- tion and improvement will be pursued. - Implementation of limited high-priority multipurpose projects: Multipurpose projects will be implemented sequentially to enhance irrigation, power, flood control, and other purposes. 23. On the basis of the above order of priorities and the physical targets specified in the Development Plan, a marked decrease in the annual generation of new service area is noted. For the period 1987-92, new area generation sill average only 26,100 ha per year, and for the period 1993-96, the average will go down further to about 14,300 ha per year. These targets are lower than the average of 39,900 ha per year experienced in the last two decades. On the other hand, the plan calls for the rehabilitation on average of 120,000 ha per year (compared to 429500 ha per year during 1980-86). However, two clarifications are required regarding these rehabilitation figures. One, these figures include the areas to be covered by the Irrigation Operation Support Project (IOSP) proposed for Bank financing. While some minor rehabilitation will take place under the IOSP, the project is actually an O&M Improvement Project. Thus, the rehabilitation figure in Table 7 should be lower. Second, as the IOSP, if approved, would start in 1988, the schedule for rehabilitation presented in Table 7 should move back one year. 24. About 96,800 ha of the 206,200 ha of new areas to be generated during 1987-92 will be from communal irrigation projects. The increased emphasis on communal systems is also reflected in the 1987 budget as the budget allocates P 400 million for communal projects, compared to P 75 million in the appropriations bill. Also, the new service areas generated in 1987-92 will come mostly from ongoing projects. Only about 31,000 ha will be generated from projects yet to be started, and these are mostly communal systems. 25. Four new projects are included in the new irrigation investment pro- gram (Table 8), with a total cost estimated at P 6.7 billion (constant 1986). This compares to P 9.1 billion expected expenditure for the completion of on-going projects. The IOSP aims to arrest the decline in, and gradually increase, O&M expenditures in the NISs. Under the plan, O&M expenditures per ha would increase to P 460 ha (constant 1986 prices), systems will undergo minor rehabilitation and Irrigation Associations (WAs) will be developed to encourage the participation of farmers in the operation and maintenance of the systems. Another component of the project would be to develop a new policy and strategies to improve cost recovery in irrigation.  - 60 - ANNEX 6 Page 12 Table 8: IRRIGATION INVESTMENT PROGRAM (P million, 1986 constant prices) Total 1986 1987 1988 1989 1990 1991 1992 1987-92 Ongoing 1,931 1,971 2,042 1,723 1,354 1,124 930 9,143 Total of new projects 0 385 603 998 1,460 1,729 1,556 6,721 Balog-Balog 0 27 295 466 806 917 727 3,238 IOSP 0 328 278 305 346 345 201 1,812 Pampanga Delta 0 20 20 227 230 311 315 1,123 Second Irrigation 0 0 0 0 78 156 314 548 Total 1,931 2,346 2,644 2,721 2,814 2,853 2,487 15,865 26. While the IOSP is an O&M project, the other three involve the con- struction of new service areas and some rehabilitation of existing systems. The proposed Balog-Balog project is a multi-purpose storage system meant to provide irrigation in the Tarlac and Pampanga area. A feasibility study undertaken in 1981 estimated a rate of return of 13.5%. The other major irri- gation project is the Pampanga Delta Development Project. The project, pro- posed to start in 1989, is to generate 11,000 ha of irrigated area also in the Tarlac and Pampanga areas. The internal rate of return for the project was estimated at 9.9%. The fourth new project is the Second Irrigation Sector Project planned for Mindanao. It involves the construction of 23,000 ha of new areas and the rehabilitation of 4,000 ha., as a continuation of the ADB's First Irrigation project. 27. The thrust of Governm'ent strategy in the irrigation sector is appropriate. In particular, as demonstrated by the economic rates of return derived earlier, the order of priorities which puts first, improving O&M; second, rehabilitation; and only third, new construction, is the right one. Also justified, when expanding irrigated areas, is the emphasis on communal irrigation systems and small scale national systems. There are doubts, however, whether the composition of the new investment program presented in Table 8 is the appropriate one. 28. There is no doubt that even with emphasis on rehabilitation and O&M, some new investment in irrigation areas should take place. However, there are some questions as to the specific projects in the new investment program. Particularly questionable are the Balog-Balog and the Pampanga Delta projects. The feasibility studies completed in the early 1980s show that these projects exhibited only marginal internal rates of return (13.5% for Balog-Balog and only 9.9% for Pampanga). Since construction cost increased sharply and the world price of rice declined dramatically since the completion  - 61 - ANNEX 6 Page i3 of the studies, there is no doubt that these projects are economically questionable at best. Furthermore, the regional distribution of the irrigation program--both projects are in the Tarlac and Pampanga regions-- raises some questions as to the choice, particularly when compared to the Government goal of regional equity. Finally, both projects are large scale in size (Balog-Balog is even a storage system) going against the declared emphasis on smaller scale systems. The issues of size and regional equity combined with questionable economic viability imply thaty at the least, a very close look by Government into these projects is warranted. Discussions with NEDA revealed that it is well aware of the questions raised by these two projects. It was understood that all the irrigation projects from 1988 onward would be reviewed to determine their viability. These reviews would be in- house reviews conducted by the Department of Public Works and Highways (DPWH) and by NIA. 29. The Second Irrigation Sector Project raiAes different types of questions, This project is due to start in 1990 as the second phase of an ongoing ADB project. However, the First Irrigation Project is only now starting after long implementation delays. 30. Finally, it was shown earlier that rehabilitation is economically viable, subject to: (a) careful choice of systems to be rehabilitated; and (b) provision of adequate O&M after rehabilitation. However, it should be pointed out that out of 127 NISs only 18 systems were not rehabilitated recently. Most of the systems underwent rehabilitation in the last 5-6 years. Therefore, there is no urgent need to embark on a massive rehabilita- tion effort in the next 4-5 years. In the early part of the 1990s another round of rehabilitation would most likely have to commence. However, again, if the required levels of O&M would be provided from the present onward, the rehabilitation required in the future would be in the nature of relatively inexpensive minor restoration works. Rice Supply and Demand: 1985-2005 31. The investment program in irrigation described in Table 8 has, of course, important implications on the rice supply/demand situation to the end of the century. The Philippines attached in the past much significance to the attainment of rice self-sufficiency. Now that that has been achieved the emphasis is on maintaining this. This section provides some rough indicative estimates of the link between the irrigation investment program and the rice self-sufficiency target. 32. Demand Projections. The future growth of domestic rice consumption has been estimated on the basis of the expected population growth, national income growth and income elasticity of demand for rice. Total rice consump- tion in the base case for the period 1985-2005 is given in Table 9. The specific assumptions used in estimating future dEmand foi rice in the base case are as follows: (a) population growth rate is projected to decline from 2.9% to about 2% p.a. for the period 2000-2005; (o) average national income growth to 1990 is assumed to be 5.1% p.a. increasing to 5.5% p.a. from 1990 onwards. With population growth declining, the per capita income growth rate is assumed to rise from an average of 2.5% to 3.5% between 1990 and 2005; (c)  - 62 - ANNEX 6 Page 14 the income elasticity of demand for rice has been assumed at a constant 0.1x; and (d) in the base case relative rice prices are assumed constant. Table 9: RICE DEMAND PROJECTIONS 1985-2000 - (BASE CASE) 1986 1990 1995 2000 Population Growth /a 2.9 2.6 2.4 2.2 Population (millions) 56.1 62.2 70.0 78.0 National Income Growth a - 5.1 5.5 5.5 Per Capita Income Growth /a -- 2.5 3.1 3.3 Income Elasticity of Demand 0.1 0.1 0.1 0.1 Per Capita Rice Consumption -- 0.25 0.31 0.33 Growth (% p.a.) Per Capita Rice Consumption (kg) 94 95 97 98 Total Rice Consumption 5,273 59917 6,766 7,669 ('000 MT) /a % p.a. over the past five years. 33. The annual increase in per capita rice consumption is expected to rise from 0.25% to 0.35% over the next two decades. Per capig rice consump- tion will rise accordingly from 94 kg to about 98 kg in 2000._ Based on these estimates total rice consumption is expected to increase from 5.1 mil- lion MT in 1985 to an average of 7.7 million MT for the period 1995-2000, a 50% rise in the next 15-20 years. 34. Supply Projections. The growth of rice production has been calcu- lated on the basis of expected changes in area irrigated as a result of the new irrigation investment program and the yields of irrigated, rainfed lowland and upland palay. Table 10 summarizes the results of the base case. The irrigated areas in the wet and dry season are based on the projected increase in irrigated areas included in the Medium Term Investment Plan 1987-92. The increase in irrigated area is assumed to come from rainfed lowland areas. The annual decrease in rainfed lowland areas in a given year is taken as the pro- duct of the increase in service area in all types of systems and the irrigated cropping intensity for the wet season in that year. In the upland, NIA's 5/ This is quite low compared to Thailand (207 kg) and Indonesia (170 kg).  - 63 - ANNEX 6 Page 15 estimate of 156,000 ha was adopted. The projection is, therefore, that by year 2000 total irrigated area in the wet season would be 1.66 million ha and in the dry season 1.12 million ha. Thus total irrigated area is expected to increase by 46% between 1986 and 2000. Yield levels have been differentiated according to the season (wet and dry) and by area of production (irrigated, lowland rainfed, upland rainfed) based on Bank's projections (IOSP prepara- tion). Irrigated yield represent weighted averages of national, communal and pump system yields. The disappearance rates of seed, feed and waste are assumed to remain constant at 10.5% (IFPRI estimate), but milling recovery rates have been marginally raised from 0.66 to 0.67 (1.5%) to reflect expected improvements in milling plants. Table 8: RICE SUPPLY PROJECTIONS 1986-2000 (BASE CASE) 1986 1990 1995 2000 Area ('000 ha) Irrigated WS 1,141 1,335 1,596 1,665 DS 772 895 1,050 1,123 Lowland Rainfed /a 1,264 1,070 850 740 Upland Rainfed 156 156 156 156 Yield (MT/ha) Irrigated WS 3.3 3.5 3.7 3.9 DS 3.4 3.6 3.8 4.0 Lowland Rainfed 1.9 2.0 2.1 2.1 Upland Rainfed 3.0 1.1 1.1 1.2 Production ('000 MT) 9,139 10,230 11,764 12,720 Less: Seed, Feed, Waste 959 1,074 1,235 1,336 (10.5%) Palay available for Consumption 8,180 9,156 10,529 11,385 Milling Recovery Ratio 0.66 0.66 0.66 0.67 Total Rice Supply 5,399 6,043 6,949 7,628 Total Rice Demand (from Table 4) 5,273 5,917 6,766 7,669 Surplus/Deficit ('000 MT) 126 126 183 -41 /a Does not take into account possible improvements in rainfed cropping intensity.  - 64 - ANNEX 6 Page 16 35. Based on the demand and supply projections presented in Table 9 and 10, it appears that the Philippines will be virtually self-sufficient in rice to the end of the century, it will maintain a rice surplus ranging from 126,000 MT to 183,000 MT a year during the period 1986-1995. Towards the end of the century, as the generation of new irrigated area slows down in the 1990, a very small deficit of 41,000 MT is projected to develop. 36. These results are highly sensitive to the assumptions on cropping intensities and yield growth of irrig#led rice on the supply side, and to the income elasticity on the demand side." Table 11 illustrates the results of sensitivity analyses with respect to these variables. A lower growth in yield in irrigated rice would eliminate the surplus and produce a small deficit in the 1990s and a much larger one in the year 2000. A 10% decline in the cropping intensity also brings about a situation of deficit. An increase ir the income elasticity of demand for rice will reduce the surplus in the 1990s but not eliminate them. Table 11: SENSITIVITY ANALYSIS OF RICE SUPPLY AND DEMAND PROJECTIONS ('000 MT) Surplus/Deficit 1990 1995 2000 Base Case 126 183 -41 Lower cropping intensity -64 -47 -311 Lower yield in irrigated area -6 -68 -543 Increased elasticity of demand 87 85 -216 Sources: Annex Tables 2-3. 37. The last Bank estimates of rice supply and demand were presented in The Philippines: Irrigation Program Review (2425-PH, December 15, 1982). That report projected surpluses of between 600,000-800,000 MT between 1985- 1990 and of about 300,000 MT in the year 2000. Those projections now appear optimistic. In 1985-86 the country is just about self-sufficient and will probably remain so for the rest of the decade. The reason for the lower pro- duction than projected stem from lower growth in both yields and area irri- gated. First, the drought of 1982-83 interrupted the growth of both yields 6/ Since these are only indicative estimates and for the sake of simplicity, sensitivity with respect to own or substitute crop prices was not undertaken.  - 65 - ANNEX 6 Page 17 and area irrigated. Second, the slowdown in project implementation during the crisis years (1983-85) adversely affected the growth of service areas. Cost Recovery and Financing of Irrigation 38. NIA's ability to implement the ongoing investment program and to provide adequate O&M are severely curtailed by its financial situation. Financially, NIA is on the verge of bankruptcy. Its difficulties, caused by an imbalance between expenditures and income flows, stem from: (a) existing irrigation pricing policies; (b) absence of an effective mechanism to enforce ISF collection; and (c) recent government measures to deal with the country's fiscal problems, including a sharp reduction in government equity contribu- tions to NIA and the requirement that NIA meet its foreign debt-service obligations fromi 1982 onwards from its own resources. NIA's financial diffi- culties have direct implications for its ability to implement its irrigation investment program as well as to rehabilitate and maintain existing NISs. In 1986 NIA was able to implement its program by utilizing its cash reserves (now exhausted). However, NIA will require increasing contributions from the Government from 1987 onward ur.less there are fundamental changes in irrigation pricing and collection. NIA's difficulties have already brought about a slow- down in implementation of ongoing projects, a real decline in the level of O&M expenditures (see para. 5), and, as a result of cost-saving measures, a decline in its physical and technical capacity to implement future irrigation projects. 39. Irrigation Financing. The principal financing mechanism for obtain-. ing resources from beneficiaries of irrigation has been irrigation service fees (ISF). NIA earns secondary income from equipment rental, from interest on construction funds held on deposit, and from management fees which it charges to supervise construction of foreign-funded projects. The distribu- tion of income from various sources is provided in Table 12. Total irrigation fees collected in 1986 amounted to P 215 million accounting for 51.5% of NIA's income. This represents a drastic increase from 1983 *hen ISF accounted for only 22%. Total indirect income, particularly from interest (37.1%) and management fees (25%) greatly exceeded the revenues derived from ISF. This income more than offset the shortfalls in ISF collections and NIA, therefore, was able to support its operating budget from its various sources of income. However, as a result of the financial crisis and the decline in interest income and management fees, NIA was forced to improve cost recovery of ISF in order to support its activities. The investment program in irrigation, on the other haiid, has been financed with Government equity contributions. These have ranged from P 1.4 billion in 1980 to P 1.7 billion in 1982, with Government shouldering the servicing of all foreign loans for irrigation.  - 66 - ANNEX 6 Page 18 Table 12: NIA SOURCES OF INCOME, 1983 AND 1986 1983 1986 Income Z of Income x of (P mln) total (P mln) total Irrigation service fee 72.7 22.2 215.1 51.5 Equipment rental and pump amortization 29.8 9.1 48.0 11.5 Interest income 121.8 37.1 69.7 16.7 Management fee 81.2 24.7 57.6 13.8 Other 22.4 6.8 26.9 6.4 Total 327.9 100.0 417.3 100.0 Source: NIA. 40. The economic crisis in 1983-84 and subsequent measures and policies instituted by the Government had a significant adverse impact on the financial situation of NIA, affecting both its investment program and its operating budget. The last three years saw a sharp decline in equity support of the Government to NIA. From a peak level of P 1.7 billion in 1982, equity releases went down to P 205 million in 1984. In 1985, the Government released only P 149 million of P 330 million equity programmed. For 1986, NIA received only P 140 million (out of P 590 milijon in local counterpart funds required to continue the irrigation program).- Foreign exchange availability went down from $112 million in 1981 to $64 million iA 1984. Furthermore, since 1982 NIA has been required to shoulder the debt-servicing of all loans contracted from 1982 onwards. To date, NIA has to service loans totalling $250 million for 10 foreign-assisted projects. These amounts will increase sharply beginning in 1988 reaching a peak of P 592 million in 1990 (assuming an exchange rate of $1 = P 20.50). 41. The sharp decline in equity contributions and the need to service foreign loans out of its operating budget forced NIA to cut down drastically on its operating expenditures. Annual operating expenditures declined from P 244.73 million in 1981 to P 182.41 million in 1983 (current pesos)--a 38% decline in real terms. Thus, the level of O&M, which was already inadequate because of poor collection and low fees, was reduced even further. On the investment side, delays and cutbacks in local fund releases have sharply reduced NIA's income from management fees, slowed down implementation of ongoing projects, forced cutbacks in NIA's staff and reduced NIA's capacity to implement new irrigation projects. 7/ With declining levels of equity contribution, the level of management fees also falls, reducing further the income NIA generates outside irrigation fees.  - 67 - ANNEX 6 Page 19 42. Outlook. Without a change in government policy regarding irrigation fee levels, and without a marked improvement in ISF collection efficiency, NIA cannot be financially viable in the long run (even if the Government will assume the servicing of NIA's foreign debt). Unless current ISF levels are increased, NIA will be able to finance its deficit from its cash reserves in 1986 gly. In 1987, the deficit is likely to be in the order of P 197 mil- lion.t- This would leave NIA with a negative cash balance of P 170 million, i.e., the agency will have exhausted its cash assets, liquidated all its short-term investments, and will have no working capital to continue opera- tions unless it can borrow from banks. In the medium term, assuming modest improvements in government support price for palay (in nominal terms) and in irrigation fee collection, NIA would require additional funds in the order of P 600-700 million a year to be able to support the planned investment program. These deficits could not be overcome by improvements in irrigation fee collections and other sources of operating income of NIA only. Effectively, therefore, NIA will not be able to undertake new investments. It will not be able to open new irrigated areas nor provide for rehabilitation and proper O&M of existing systems. Since most of NIA's administrative overheads are met from management fees, declining levels of government equity would force NIA to reduce further its staffing which has already been cut considerably during the last few years. 43. ISF. According to the national irrigation policy adopted in 1978, NIA is authorized to charge ISF on NIS land to cover the cost of O&M and insurance, and to recover initial investment costs (without interest) in no more than 50 yeav, provided that such charges are within the beneficiaries' capacity to pay., Current ISF rates for rice are given in Table 13. Since 1975, the irrigation fees paid by farmers have been di-nominated in terms of paddy. This has provided a degree of indexation against inflation. The farmers may either pay in kind or the equivalent amount in cash, based on the Government support price of paddy. The ISF rates vary according to type of system and by wet and dry season. 8/ These calculations assume government equity of P 150 million in 1986, and P 400 million in 1987. 9/ Farmers in communal irrigation system are expected to pay a fee to cover capital costs, excluding the costs of roads and NIA's engineering and overhead costs. Most IAs collect fees in kind based on area irrigated. Fees range from 0.5 to 4.5 cavans of palay per ha per year.  - 68 - ANNEX 6 Page 20 Table 13: CURRENT IRRIGATION SERVICE FEES /a (Cavans per hectare) Rice and other Short Season Crop /b System Wet Dry Third crop Gravity Reservoir 2.5 3.5 3.5 All other national systems 2 3 3 Pumps Bonga Pump 1 to 2 8 12 12 Solana-Tuguegarao 9 12 12 Angat-Maasim 3 5 /a 1 cavan = 50 kg of paddy 7b ISF rates for diversified crops, other than annual crops, are 60% of thoue for rice. 44. Current ISF rates, established in 1975, prior to adoption of the national irrigation policy, are insufficient to recover full investment and O&M costs even assuming 100% collection efficiency. In spite of the automatic indexation, the ISF rates have declined by about 25% in real terms between 1979 and 1984. However, as a result of the sharp increase in palay support price in 1985, the ISF level in real terms has increased substantially but it is still below 1979 levels. Using Table 13 as a benchmark, Table 14 permits a comparison between current ISF and other pricing options based on 100% collec- tion efficiency (for discussion of collection problems, see para. 48). The discussion differentiates between storage systems which involve very high investment costs, and run-of-river diversion systems which have relatively small investment costs. Tt .ee options for setting rates are presented (a) to recover required O& 5nly; (b) to recover required C&M plus direct construction costs;-0