Philippines - Fourth Rural Credit Project

Document of The World Bank FOR OFFICIAL USE ONLY Report No. P-2021-PH REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO THE CENTRAL BANK OF THE PHILIPPINES WITH THE GUARANTEE OF THE REPUBLIC OF THE PHILIPPINES FOR A FOURTH RURAL CREDIT PROJECT March 24, 1977 This document has a restricted distribution and may be used by recipients only In the performance of their officia duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS US$1.00 = Pesos 7.50 US$133.00 = Pesos 1,000 US$133,000 Pesos 1,000,000 ABBREVIATIONS CB - Central Bank DRBSLA - Department of Rural Banks and Savings and Loan Associations of the CB UPLB - University of the Philippines at Los Banos AMTESP - Agricultural Machinery Testing Evaluation and Standardization Project DA - Department of Agriculture SSLA - Stock and Savings and Loan Association THE REPUBLIC OF THE PHILIPPINES FISCAL YEAR 1975: July 1, 1974-June 30, 1975 1976: July 1, 1975-December 31, 1976 From 1977: January 1-December 31  FOR OFFICIAL USE ONLY REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPM.ENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO THE CENTRAL BANK OF THE PHILIPPINES WITH THE GUARANTEE OF THE REPUBLIC OF THE PHILIPPINES FOR A FOURTH RURAL CREDIT PROJECT 1. I submit the following report and recommendation on a proposed loan to the Central Bank of the Philippines for the equivalent of $36.5 million to help finance a Fourth Rural Credit Project. The loan would have a term of 15 years, including four and one half years of grace and an interest rate of 8.5% per annum. The Central Bank would relend $35.7 million of the proceeds of the loan to participating rural banks and stock savings and loan associations (SSLAs) at an interest rate of 9% per annum. However, the portion of tke proceeds to be used for subloans to land reform beneficiaries would be relent to the same institutions at an interest rate of 7% per annum. Repayment to the Central Bank would substantially reflect the aggregate of the repayment schedules of subloans made by the rural banks and SSLAs. The Central Bank would pass on $300,000 of the proceeds of the loan to the Department of Agriculture to finance an Agricultural Machinery Testing, Evaluation and Standardization Project and would utilize the balance of $500,000 to finance vehicles, studies and staff training. PART I - THE ECONOMY /1 2. An economic mission visited the Philippines in April/May 1975 and its report, "The Philippines: Priorities and Prospects for Development, Basic Economic Report" (No. 1095a-PH of May 5, 1976) was distributed to the Executive Directors on May 18, 1976 (SecM/76/366). Paragraphs 3-16 below are an updated summary of that report. Annex I contains country economic data. 3. During the 1960s, the economy grew in real terms at an annual rate of about 5-6%. However, the rate of growth was less than the level that might have been achieved if the considerable natural and human resources of the Philippines had been exploited more effectively. Moreover, the benefits of growth were distributed relatively unevenly. As the population and labor force continued to grow rapidly, unemployment rose. Low levels of taxation accentuated these problems and resulted in inadequate public invest- ment in necessary infrastructure and social services. A relatively weak export performance combined with a failure to reduce the import dependence of domestic industry resulted in a steady deterioration in the balance of payments position. 4. During 1970-72, the authorities adopted policies of monetary and fiscal restraint in order to lay a firm basis for future growth. With /1 This is the same discussion of the economy as that in the President's Report for the Jalaur Irrigation Project (P-1973-PH of January 5, 1977) with minor updating. 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.  assistance from the Consultative Group for the Philippines, they succeeded in improving substantially the maturity structure of the external public debt. Real GNP during that period increased at about 5% a year. In 1972, the Government initiated a series of social and economic reforms including an agrarian reform program, tax reforms, and an administrative reorganization. 5. In 1973, there was a sharp increase in the level of economic activity in the Philippines and the growth in real GNP doubled to 10%. This upsurge was led by the international commodity boom, which resulted in higher export incomes, a strong recovery in agricultural and industrial production for the domestic market, and an expansion in public and private investment. 6. Like most countries, the Philippines was profoundly affected by the events in the world economy that began with the marked increase in the prices for food and petroleum in late 1973. With international trade the equivalent of almost half of its GNP, the Philippines was quite vulnerable to the impact of world inflation, the increase in oil prices, and the prolonged recession in the industrialized countries. While adverse effects of the recession were cushioned somewhat in 1974 by a modest improvement in the external terms of trade, the Philippines was more seriously affected in 1975 by the continued rise in import prices and reduced demand for Philippine exports. While the international economic situation has made it difficult for the Government to realize its objective of accelerating the rate of development, GNP in 1974, 1975, and 1976, nevertheless, grew in real terms at an annual rate of about 6%. 7. Agricultural production has grown at an average rate of 3.2% per year during the 1970s, a period which has been characterized by unusually adverse weather conditions. Rice production increased by 25% in 1973/74, but because of damage by typhoons, grew by only 1% in 1974/75; the Government had to import 200,000 tons in the first half of 1975 to ensure adequate stocks. However, the rice harvest in 1975/76 was very good due to favorable weather conditions and during this period the Philippines was virtually self-sufficient in rice. The Government continues to give the highest priority to further increasing agricultural production and has initiated a number of programs designed to expand the use of fertilizer, irrigation and supervised credit. It has also intensified efforts to expand the social services needed in rural areas, including rural electrification, health and family planning services, and village road and small-scale irrigation projects. 8. Although progress has been slower than initially planned, the Government has made some progress with its agrarian reform for the nation's one million tenant farmers who grow rice and corn. By September 30, 1976, the Government had issued Certificates of Land Transfer to 224,000 of the 424,000 tenants on holdings of over 7 hectares; thus, title to 390,000 ha of the total 825,000 hectares of farms occupied by such tenants has been transferred. The Government has raised the cash portion of the compensation package to landlords to reduce their resistance to land reform, but strong administrative efforts will be necessary to ensure continued progress in the implementation of the program. 9. Industry accounts for almost 30% of net domestic product, one third of total fixed investment and 15% of total employment. Industrial production, which grew by 12% in 1973, was adversely affected in 1974 and 1975 by the  - 3 - worldwide economic slowdown and the depressed demand for Philippine exports. As a result, industrial production increased by only 4% in 1974 and 5% in 1975. Stepped-up public sector spending for infrastructure development and other priority projects has contributed significantly to sustaining the higher level of domestic activity in 1976, especially in the construction industry. The longer term prospects for industrial growth are favorable because of the natural and human resource endowment of the Philippines and a very active private sector. 10. The Government has made significant progress in increasing public investment. The ratio of public investment to GNP is currently over 4%, having risen from 1.8% in FY72. /1 The Government has also implemented a series of long needed tax reforms and improvements in tax administration. These reforms, aided by the increased economic activity, the boom in export incomes, and domestic inflation, resulted in a 36% increase in national government tax revenues in FY73, and an estimated 47 percent in FY74. The ratio of national government tax revenues to GNP has increased from an average of 9% in the early 1970s to about 12% during the period FY74-76. 11. Significant financial reforms have also been introduced. At the beginning of 1976, the Central Bank issued circulars designed to help ration- alize the level and structure of deposit and lending rates; deposit rates were raised for the second time in 18 months; long-standing statutory ceilings on the long-term lending rates of banking institutions were increased from 12-14% to 19% per annum; and the ceilings on short-term lending rates were raised. Efforts were also made to control short-term money market operations and to strengthen the organized banking institutions. These actions should help to improve the mobilization and allocation of domestic resources in the Philippines. 12. In the latter part of 1973, inflation emerged as a major problem in the Philippines. The increase in prices was caused by the large increase in liquidity that came with the export boom in 1973/74, and by a number of cost-push factors, including the higher rate of world inflation. To deal with this problem, the Government adopted contractionary monetary and fiscal policies, and attempted to reduce the impact of inflation on consumers by subsidizing such essential goods as wheat, imported rice, and cooking oil. The annual inflation rate fell from 35% in 1974 to 8% in 1975 and 6% in 1976. 13. On the external side, Philippine's balance of payments benefited considerably from the international commodity price boom during 1973. High prices for the country's chief exports, including coconut products, sugar, copper and wood products, resulted in a 70% increase in export earnings and a current account surplus of about $550 million. Since mid-1974, the external trade position has deteriorated, due to the sharp increases in the prices of oil and other imports, less favorable prices for Philippine exports, /1 Fiscal year July 1 to June 30.  and reduced volume of some exports resulting from the downturn in the econo- mies of the Philippines' main trading partners. As a result, current account deficits of about $900 million in 1975 and about $1,000 million in 1976 were incurred. The current account deficits have been offset by direct foreign investment, inflows of medium- and long-term loan capital, the use of IMF facilities and some short-term borrowing by the Central Bank. External reserves were about $1.2 billion at the end of 1976, equivalent to four months' imports. Assuming continued sound debt management and the mainten- ance of a reasonable maturity structure of foreign borrowings, the overall level of external debt of the Philippines is expected to remain within reasonable limits, as the ratio of debt service payments to exports and nonfactor services would average about 16-17% during the rest of this decade. At present, the Bank/IDA share in total debt outstanding is about 17% and its share in debt-service is about 4%. These shares are expected to increase somewhat in the years ahead. 14. Substantial foreign assistance will be essential to help finance the large investment expenditures which will be necessary for the country's develop- ment. In order to ensure that disbursement of external assistance reaches levels commensurate with the level of development expenditures which will be required during the latter part of the decade and that debt service obligations remain within reasonable limits, total commitments of official assistance will need to be maintained in real terms at least at the annual level of about $500 million which was achieved in 1974. The Consultative Group for the Philippines at its meeting in Paris on June 15 and 16, 1976, agreed that it would be reasonable for the Philippine Government to seek official aid commitments of about $600 million in 1976 and $700 million in 1977. Total new commitments of public and private medium- and long-term capital are estimated to have reached $2 billion in 1976 and need to be maintained at approximately this level through 1980. 15. Despite the slowdown in the growth of the economy, which is pri- marily a result of worldwide economic conditions, the Government remains committed to regaining the growth momentum, which began in 1973, to provide for a continued increase in incomes and employment. Both the Philippine Government and the Bank's Basic Economic Report estimate that it should be possible in the longer term for the Philippine economy to grow in real terms at a rate of about 7% per annum provided that good economic management continues and international economic conditions improve. High priority must be accorded to expanding employment opportunities, because unemployment and underemployment are still high and the labor force continues to grow at 3% a year. Continued attention must also be given to expanding the Government's effective family planning program to reduce the rate of growth of the population and the labor force. 16. The Government is pursuing a development strategy which focuses on rural development with emphasis on food production, accelerated industriali- zation, both in capital-intensive resource based industries and labor-intensive export industries, and a substantial expansion in public sector investment in infrastructure to support the growth of the productive sectors. In support of these objectives, the Government plans to continue its efforts to increase public revenues, to strengthen the capacity of public sector agencies and to  -5- foster the growth of exports. The Government recognizes that the increased cost of petroleum and other imports cannot be financed indefinitely by borrow- ing abroad, and it is actively encouraging both local and foreign investors to expand productive investments. It will, however, take time for Government programs to have an impact on the balance of payments, and the Government is, therefore, seeking increased support from the international financial community to assist in the financing of its development effort. The Government's development program will continue to require foreign resources in addition to the capital which would become available for the financing of the foreign exchange component of development projects. Some financing of local costs is justified, especially for projects of economic and social importance which need only limited amounts of foreign exchange. PART II - BANK GROUP OPERATIONS 17. By February 28, 1977, the Philippines had received 41 Bank loans /1 (of which two were on Third Window terms) and three IDA credits for a total of $1,052.2 million, net of cancellations. About 40% of Bank lending ($401 million) has been for infrastructure projects in power, transportation, and water supply and one third ($318 million) has been for agriculture. Of the remainder, about $250 million has been for industry and about $83 million has been for social sector projects in education, population and urban devel- opment. There has been a marked improvement in the execution of Bank-financed projects in the last four years compared with experience in the 1960s, when there were serious problems caused by a shortage of peso counterpart funds and poor administration. All ongoing projects are now being implemented reason- ably well. Annex II contains a summary statement of Bank loans, IDA credits and IFC investments as of February 28, 1977 and notes on the execution of ongoing projects. 18. The Bank's lending program has been designed to continue to support the Philippine development effort with its emphasis on agriculture and infra- structure and its growing attention to the needs of lower income groups. About one third of Bank lending planned for the next few years would be for agriculture and rural development projects and another third would be for needed basic infrastructure projects, mainly in the fields of transportation and power. The amount of lending for social sector projects, including education, population and urban development, is expected to continue to grow rapidly and account for nearly 20% of future lending. The balance of future lending would be for industrial development, where growing attention is being given to the needs of small and medium industries with high employ- ment potential. The rapid growth in public revenues during the past five years has allowed for a significant expansion in public investment and both the ambitious Philippine development program and the Bank's growing lending program have been designed to make good past neglect and to meet future /1 An additional loan of $25 million for the Fourth Education Project was approved on March 1, 1977. It has not yet been signed.  -6- needs. Bank lending totalled $165.1 million in FY74, $208 million in FY75 and $268 million in FY76 compared to about $30 million a year in the preceding five years. 19. This is the fourth loan to be presented to the Executive Directors in FY77. Other loans which may be ready for presentation within a few months are for irrigation, land settlement, power and water supply projects; a smallholder tree farming/forestry project and a rural infrastructure project are also under consideration and are well advanced in the appraisal cycle. A primary objective of most of these projects is to help the Government meet its objective of increasing the productivity and incomes of the poorer segments of the population. 20. As of February 28, 1977, IFC has made commitments in the Philippines totalling $79 million for investment in 14 projects in the fields of devel- opment banking, power, telecommunications, ceramic tiles, paper, petroleum products, nickel mining and refining, chemicals and synthetic fibres and edible oils. Of these investments, $26.6 million had been sold, cancelled and repaid, leaving a net portfolio of $52.4 million, including $1.9 million undisbursed. PART III - THE RURAL CREDIT SECTOR The Rural Sector in the Philippines 21. Agriculture is the predominant sector in the Philippine economy, accounting for about one-third of gross national product, one-half of total employment, and nearly three-quarters of commodity export earnings. Over 70% of the 9 million hectares of land under cultivation is currently used for the production of cereals, of which rice and corn are the most important. The remaining land is taken up by the major export crops: sugar, coconut, abaca, pineapple, and tobacco. 22. Although there has been a substantial change in the terms of trade in favor of agriculture in recent years, the problems of poverty and income distribution continue to be particularly acute in rural areas; of the 15 million people in the bottom 40% of the income scale, 12 million live in rural areas. The Government is aware of these problems and has initiated a number of programs designed to assist the rural poor. These includ the Masagana 99 and Masaganang Maisan credit programs to support rice and corn production, respectively, increased production of commercial crops for export, expanded irrigation, development of forest resources, and livestock and fisheries production programs to reduce imports and raise local nutrition levels. The success of many agricultural programs will depend on increased use of high yielding seed varieties, fertilizers and agro-chemicals, and the provision of adequate credit and other supporting services. The performance of the agricultural sector will be crucial in determining whether the drive towards rapid and more equitable income expansion succeeds.  -7- The Agricultural Credit System 23. Agricultural credit provided by institutions (both governmental and private) probably accounts for only about one-third of all agricultural credit; the remainder is provided by traditional noninstitutional sources. Inadequate coverage by credit institutions in rural areas, collateral requirements, and the traditional bonds between landowner and tenant have slowed the development of a modern credit system to serve rural people. Although noninstitutional sources have some advantages for the small farmer (such as flexibility in repayment periods), the interest rates are very high. The Government has been developing a more modern credit system in the rural areas by encouraging the formation of private rural banks, providing production credit to small farmers without collateral through the Masagana programs, and extending the coverage of government-owned financial institutions. 24. Government institutions have been providing about 20% of all insti- tutional credit to agriculture. The Philippine National Bank (PNB) with 170 branches and 120 mobile banks is the largest of these institutions; about 30% of its total lending in 1975 was for agriculture, the vast bulk of which was in the form of short-term credit under the Masagana programs and for commer- cial agriculture. The Development Bank of the Philippines (DBP) has become an important lender of term credit for a wide range of enterprises in the rural sector and 28% of its lending in 1975 was for agriculture. The Land Bank of the Philippines (LBP) has been revitalized and is expected to play a growing role in lending to smaller farmers, while the future role of the Agricultural Credit Administration (ACA), which provides only about 2% of Government agricultural credit, is uncertain. Of the private institutions, commercial banks provide 55% of all institutional agricultural credit and are the most important source. The Central Bank requires that a minimum of 25% of all commercial bank lending go to agriculture. While only 30 commercial banks lend directly to farmers, mainly for seasonal credit for commercial agriculture, many commercial banks purchase Central Bank bonds, which are then used to refinance agricultural lending by other institutions. Coopera- tives play only a small role in providing credit now, but their importance, especially in providing credit assistance to land reform beneficiaries, is likely to grow rapidly, because of government's present emphasis on coopera- tive development. 25. Rural banks are the other important source of agricultural credit and provide about 20% of all institutional credit. Since 1952, the Govern- ment has actively encouraged the establishment of privately owned rural banks to provide rural areas with banking facilities. The rural banking system, consisting presently of over 800 individual banks (compared with 300 in 1965 and over 700 in 1974), has the most extensive network of banking institutions in the country. Establishment of rural banks is authorized by the Monetary Board and the Government may at the time of establishment assist them by subscribing in the form of preferred shares up to an amount equal to shares subscribed by private individuals. At the end of 1975, shares held by the Government accounted for 26% of paid-in capital; this percentge has been decreasing in recent years as a result of progressive sales by government of shares to private shareholders. The Central Bank provides rural banks with training for management and staff, technical assistance in lending and administration, and funds through Special Time Deposits and rediscounting facilities. It also supervises and examines their operations.  26. As of December 30, 1975, rural banks' total resources were E 2,749 million (US$377 million), consisting of P 276 million (US$38 million) in paid- capital; P 150 million (US$20 million) in surpluses, reserves and undistrib- uted profits, P 678 million (US$93 million) in deposits, and E 1,489 million (US$204 million) in borrowing, mostly from the Central Bank. In the past three years, total liabilities more than tripled from P 694 million at the end of 1972 to F 2,323 million at the end of 1975. This increase was primarily due to the introduction of the Masagana 99 and Masaganang Maisan food grain production programs and to increased disbursements under the Bank-financed rural credit projects. 27. The loan portfolio of rural banks increased rapidly in recent years from P 770 million (US$103) at the end of 1972 to P 2,324 million (US$310 million) at December 31, 1975; an increase of over 200%. More than 90% of these loans were to agriculture and the average loan size in 1975 was P 2,220 (US$296). Medium- and long-term financing, limited almost entirely to the credit program supported by the Bank-financed rural credit projects, accounts for less than 10% of rural bank loan portfolios. 28. The rural banks are experiencing unsatisfactory levels of arrears. As of December 31, 1975, arrears accounted for 21.4% of the outstanding port- folio of the rural banks, a significant increase from 16.7% on December 31, 1974. The main reasons for this increase are the rapid expansion in port- folios as a result of agricultural programs providing large numbers of loans to small farmers, heavy typhoon damage in 1974 and 1975 and inadequate technical support for the credit programs. A more detailed analysis of a sample of 268 rural banks indicated that, as of March 31, 1976, arrears amounted to 36% on a demand basis (arrears as a percentage of the sum of principal and interest due during the preceding twelve months plus amounts due at the beginning of the period). The Government is very concerned about this problem and is taking a number of steps to improve collection perfor- mance. 29. The Government is taking steps to improve the arrears situation. A National Commission for Countryside Credit and Collection (NCCC), chaired by the Central Bank's Governor, has been established to review the existing large overdues, to assist banks in their collection efforts, and to formulate education programs to improve repayment habits. A Presidential Instruction has also been issued which provides for strict loan enforcement procedures, including stronger and more effective legal sanctions for nonpayment, auto- matic salary deductions for Government employees who are in default and a substantial increase in the collection staff of rural banks. In addition, as of November 30, 1976 rediscounting facilities of the Central Bank had been denied to 257 rural banks which had arrears in excess of 25% of their total portfolio. The Central Bank has recently conducted an extensive survey of the rural banks and has agreed to rescheduling in the case of loans which are overdue as a result of natural calamities. As a result, many of the affected rural banks are expected to requalify for limited additional rediscounting facilities.  - 9 - 30. The 44 Stock Savings and Loan Associations (SSLA) supplement the coverage of the rural banking system. They are registered as stock corpora- tions by the Government and can accept deposits from and make loans to the public. As of December 31, 1975, the total paid-up capital of all SSLA was P 54.4 million ($7.3 million)? The main source of funds is savings and time deposits collected from the public. In the past, SSLA lent primarily for commercial and housing purposes, but their lending for agriculture has increased from 13% in 1974 to 31% of their total lending in 1975. The collection perfor- mance of SSLA is satisfactory. Government Strategy for the Agricultural Credit Sector 31. In September 1975, the inter-agency Presidential Committee on Agricultural Credit (PCAC) and its working group, the Technical Board on Agricultural Credit (TBAC), were established to address the issues and problems surrounding the future of the sector. Among the priority issues which have emerged so far, and which the Bank has discussed with the Govern- ment, are: the need for improved methods of assisting small farmers; arrears in agricultural credit lending; the roles of the various types of banks providing rural credit, especially for land reform beneficiaries; new sources of funds for agricultural credit; the financing of improved marketing facili- ties; and the possibility of introducing a crop insurance scheme. The Government and the Bank plan to hold further discussions on the outcome of initial work on these issues later in 1977. Experience Under the Previous Rural Credit Projects 32. The three previous rural credit projects supported by the Bank played an important role in increasing the supply of term credit in rural areas. The first loan (Loan 432-PH, $5.0 million) was made in 1965 to assist the rural banking system in beginning to channel medium and long-term credit to farmers and fishermen. The second loan was made in 1969 (Loan 607-PH, $12.5 million) and financed basically the same subloan categories as the first, but also included storage and processing facilities and on-farm transportation equipment. Demand for term credit during the initial stage of project implementation was low due to the effects of peso devaluation and of poor weather conditions; consequently, disbursements were completed only in June 1974, a delay of 18 months from the projected date. 33. Under the third project (Loan 1010-PH of June 17, 1974 for $22.5 million), additional sub-loan categories added were farm machinery repair shops, reconditioned trucks, fishmeal plants, woodcraft plants, fishpens, and small dairy farming. Stock savings and loan associations were brought into the project for the first time to provide additional channels for lending to project beneficiaries. Demand for tractors and power tillers continued to be strong, and project funds were fully committed in December 1975, about 18 months ahead of schedule..  - 10 - 34. The first three rural credit projects have been successful in pro- viding a substantial increase in term credit to the rural areas, contributing to expanded agricultural production, and assisting the Central Bank in devel- oping the rural banking system along viable commercial lines. Under the three projects, about 11,500 subloans were made totalling P 420 million ($56 mil- lion). At the same time, there have been a number of problems and short- comings identified by Bank supervision and appraisal missions and in reports of the Operations Evaluation Department (OED). These concerns are discussed below along with arrangements under the proposed project to help remedy them. 35. High loan arrearages have been a persistent problem. To reinforce its existing efforts to reduce the arrearages position of rural banks, the Central Bank has agreed that only rural banks whose arrears do not exceed 25% of total portfolio would be eligible to participate in the project. In addition, the Central Bank's Rules and Regulations under which the project would be carried out, state that a rural bank, in order to participate, would have arrears on medium and long-term loans of not more than 30% of "demand" (defined as the sum of principal and interest falling due during the preceding 12 month period plus overdues at the beginning of that period). This maximum level of allowable arrears on medium and long-term loans would be reduced to 25% of "demand" as of January 1, 1978, and to 20% of "demand" as of July 1, 1978. Any change either from the agreed maximum levels of allowable arrears or in the agreed timetable for their introduction would require the prior approval of the Bank. The Government has also agreed to undertake a study of the causes of arrears, prepare an action plan for reducing arrears, and submit copies of these documents to the Bank for comment by December 31, 1977 (Section 4.02 of the Guarantee Agreement). 36. Aside from the question of very high loan arrearages, one of the most intractable problems noted by the Project Audit Report/l has been the need to increase the number of smaller farm beneficiaries reached by the projects. Beneficiaries usually owned farms of between 5-50 ha. The main impediments to increasing lending to small farmers include the existing heavy indebtedness of small farmers, their need for production rather than term credit, and the fact that rural banks are commercial institutions, which are often reluctant to accept the financial risks associated with term lending to small farmers. Many of the project components have been designed to meet the needs of smaller farmers. For the purposes of the project, smaller farmers have been defined either as subborrowers who earn less than F 7,500 ($1,000) a year, or derive at least 75% of their earned income from a farm smaller than 7 ha, a fishpond or fishpen smaller than 5 ha, a fish- ing boat of less than 5 tons, or a cottage or agro-industry with fixed assets of less than P 100,000 ($13,300). The Central Bank would endeavor to ensure that at least $11 million of the proceeds of the loan would be made available to beneficiaries in this target group (Section 3.06 of the Loan Agreement). In addition, a separate project to help the Land Bank of the Philippines design an effective lending program to reach land reform beneficiaries is being discussed with the Government. /1 Project Performance Audit Report: Philippines Second Rural Credit Project, August 18, 1976, p. 16.  - 11 - 37. The financing of four-wheel tractors accounted for a much larger percentage of lending under the previous projects than was foreseen during appraisals. Among the reasons for this were strong demand from medium and relatively large farmers, the attractiveness of tractors as collateral, a well organized dealer network, and the scarcity of technical assistance needed to support other types of sub-projects. Although there is a general concern that mechanization may lead to a displacement of unskilled labor, the evidence presently available suggests that mechanization in the Philippines has actually increased labor requirements by facilitating double cropping and expansion in the area under cultivation. The Operations Evaluation Report on the second project noted that, "The World Bank's project has not resulted in any significant labor displacement and has enabled large numbers of farmers to increase the productivity of their labor."Ll Moroever, the report noted that the common practice in the Philippines of using tractors for custom hire services, usually for smaller farmers, has spread the benefits of tractor investments to large numbers of rural people. Nonetheless, the effect of mechanization on rural employment and the most appropriate type of mechaniza- tion in the Philippines have not yet been fully studied and more information is needed on this subject as a basis for future government policy. 38. The proposed project has been designed to assist the Government and the Central Bank to develop policies with respect to farm mechanization. It has been agreed that the Central Bank would submit a preliminary draft of a study on farm mechanization to the Bank for comment not later than December 31, 1979 (see Section 3.09 of the Loan Agreement). This study would be pre- pared by the Central Bank with the assistance of consultants to be financed under the proposed loan with qualifications and terms and conditions of employment satisfactory to the Bank (Section 3.05 of the Loan Agreement). In order to ensure that adequate attention is given to other components of the project, the amount of the loan used for tractor financing would be limited to $16.5 million. Under the Third Project, tractor financing was limited to tractors of 80 h.p. or less. But this limit did not slow the trend towards purchase of larger horsepower tractors in the Philippines which has resulted in excess power and reduced cost effectiveness of tractor investments, particularly in rice and corn areas. The ceiling would be therefore further reduced to 68 h.p. within 18 months of the signing of the of the Loan Agree- ment, or after the financing of the first 1,000 units of more than 68 h.p., whichever comes first; not more than 450 of these units would be for use on sugar farms (Section 3.07 of the Loan Agreement). 39. Four-wheel tractor and imported tiller prices have increased rapidly in recent years. While this is partly a result of additional manufacturing costs in the countries of origin, it also reflects inadequate price competi- tion and very high dealer margins which have been passed on in the form of high costs to farmers. The cost of imported power tillers to farmers has also been very high in relation to their contribution to increasing productivity. Factors contributing to high machinery prices have been the Central Bank's ceiling price policy which has allowed for relatively high prices, quite often a close relationship between rural Bank shareholders and local agricul- tural machinery dealers and inadequate supervision of machinery procured under the Bank-financed rural credit projects. /I Op. cit. p.76.  - 12 - 40. In order to ensure more appropriate pricing of the tractors and imported power tillers financed under the project, the Central Bank has lowered the ceiling prices on these items provided for under its price guide- lines. The revised guidelines are expected to result in a reduction of about 11% in retail prices of tractors and about 15% in the retail price of imported tillers. For contracts of more than FL 10,000 ($1,340), subborrowers would also be required to obtain three price quotations before making purchases under the project, which should help to reduce costs (see para. 49 of this report). The work of the Agricultural Machinery Testing, Evaluation and Standardization Project, which is included in the project, would also assist farmers in selecting farm machinery which is most appropriate to their needs. PART IV - THE PROJECT Background 41. The project design takes into account the lessons learned from the previous rural credit projects and has been carefully defined to assist the Government in achieving its longer term objectives of improving the country's agricultural credit system, increasing production, and providing for more equal income distribution in rural areas. The proposed project would provide medium and long-term credit to about 15,000 farmers and rural entrepreneurs through qualified rural banks and savings and loan associations. 42. The project was prepared by the Central Bank of the Philippines. It was appraised in May/June 1976 and negotiations were held in February 1977. The leader of the Government negotiating team was His Excellency, Eduardo Z. Romualdez, the Philippines' ambassador to the United States. The Appraisal Report (No. 1415a-PH) on the project is being criculated separately to the Executive Directors. Annex III of this report contains a loan and project summary and Annex IV contains a supplementary project data sheet. Project Description 43. The project would include the following: (a) Farm Mechanization. This category would finance about 1,775 trac- tors with implements, 240 additional implement packages, 7,800 power tillers, 400 small irrigation units, 600 portable threshers, and a small amount for other items such as back-pack sprayers. (b) Transportation. About 400 light trucks would be financed, which would be owned by small entrepreneurs and used mainly by farmers to market produce and to transport inputs to their farms. The financing of heavy and medium trucks would not be continued under this project because other sources of financing are available.  - 13 - (c) Cottage and Agro-4ndustries. This category would include about 225 sub-projects over a wide range of subsectors, such as rice milling, farm implement manufacturing, woodworking, handicrafts and concrete products. These investments would provide off-farm employment opportunities and would also enable rural banks to diversify their portfolios. (d) Coastal and Inland Fisheries. This category would include about 45 small coastal fishing boats and 1,200 inland fishponds and fishpens covering a total area of about 6,000 ha. The maximum size of boat eligible would be 40 gross tons, and the average size of fishponds and fishpens would be 5 ha. (e) Small-Scale Livestock Development. About 3,240 small-scale poultry., pig and cattle breeding and fattening sub-projects would be financed to provide for the construction of pens, sheds, and purchase of initial stock, feed and other inputs. (f) A Study of Farm Mechanization. The study, which would be undertaken by the Central Bank, would assess the financial, social and economic impact of farm mechanization in the Philippines. (g) An Agricultural Machinery Testing, Evaluation and Standardization Project (AMTESP). A unit would be established at the University of the Philippines at Los Banos to set performance and quality standards for agri- cultural machinery, and to test various makes of machinery against these standards. (h) Training. The project would augment the ongoing training program of the Central Bank for its own staff and staff of rural banks and SSLAs. This component would also finance courses on evaluation of cottage and agro- industry projects, and on-farm budgeting and planning. In addition, a Credit Handbook would be prepared for use by the staff of the Central Bank, rural banks and SSLA. (i) Service Vehicles. The project would also finance about 60 vehicles to meet the growing needs of CB field staff, which has more than doubled in number since 61 units were financed under the second project in 1969. Project Execution and Institutional Objectives 44. As under the previous three projects, the Central Bank through its Department of Rural Banks and Savings and Loans Associations (DRBSLA),would administer the credit program financed under the project. The DRBSLA, has a staff of 700, and is well managed by a Director and an Associate Director assisted by three Assistant Directors, each responsible for lending in a major region of the country. Each Assistant Director is responsible for the Agricultural Credit Supervisors and Loan Teams working in his region. Support functions are separately managed. The Technical Support and Evaluation Unit, established under the Third Project, is a separate group in the Office of the Director which carries out monitoring and technical support work for all of the Central Bank's rural credit programs. It has functioned well to date. It is the intention of the DRBSLA to decentralize its operations to the regional offices of the Central Bank to expedite loan processing and improve the supervision of accounts of the rural banks. Also, the regional loan  - 14 - teams will be upgraded gradually to provide program management and technical advice to the rural banks instead of the present direct involvement in subloan applications. Concurrently, selected qualified rural banks would begin to undertake their own subloan appraisals. The banks would be selected by the Director, DRBSLA on a case by case basis taking into account the management capbility and project evaluation and supervision capability of each rural bank to be considered for selection. Approval authority for specific types of subloans would be subject to technical support and post- appraisal audit by the loan teams (see Section 3.04 of the Loan Agreement). 45. The Technical Support and Evaluation Unit, in addition to its normal monitoring and technical support work, would monitor progress in lending to smaller beneficiaries and in improving the geographical distribution of lending (see Section 3.03 of the Loan Agreement). The Central Bank also plans to establish by December 31, 1977 a Management Advisory Unit (MAU) to provide special assistance to rural banks in areas of management where weaknesses are critical or widespread, such as cash management, sub-loan supervision, collection procedures, and deposit solicitation (see Section 3.08 of the Loan Agreement). The MAU, with a staff of about twelve, would be headed by an Assistant Director who would report to the Director, DRBSLA. The Central Bank also plans to prepare a training manual for field staff of the Central Bank and of participating lending institutions with the assistance of consultants whose qualifications and terms and conditions of employment would be satisfactory to the Bank (Section 3.05 of the Loan Agreement); a preliminary draft of the manual would be submitted to the Bank for comment not later than March 31, 1978 (Section 3.09 of the Loan Agreement). 46. The Agricultural Machinery Testing, Evaluation and Standardization Project would be established not later than March 31, 1978 at the University of the Philippines at Los Banos in a manner acceptable to the Bank, and the Government would send draft plans and specifications for the Project to the Bank for approval not later than October 31, 1977 (Section 3.03 of the Guarantee Agreement). The project would be operated as a distinct unit of the Department of Agricultural Engineering of the University of the Philippines at Los Banos (UPLB). It would be governed by an advisory council consisting of the representatives of the University of the Philippines at Los Banos, the Department of Agriculture, other relevant Government agencies, the International Rice Research Institute and the Agricultural Machinery Dealers Association. The Project would be managed by the University of the Philippines at Los Banos, which would appoint a full time director from its Department of Agriculture Engineering. Project Cost and Financing 47. The total cost of the project is estimated to be $91.3 million with an estimated foreign exchange cost of $29.4 million. The cost estimates include price contingencies amounting to 13.7% of the base cost estimate to take into acount the effects of expected international and domestic price increases. The cost estimates also provide for 14 man-years of local consul- tant services for the farm mechanization study and the preparation of the credit manual with an average man-month cost of about $4,000. The proposed  - 15 - loan would finance $36.5 million, or 40% of the total project cost, including $7.1 million of local costs. The justification for local cost financing in the Philippines is set out in para. 16. The Central Bank would finance another 40% of the total cost, the beneficiaries 10%, and the participating rural banks and SSLAs 10%. 48. The proposed loan would be made to the Central Bank and would have a term of 15 years, including a grace period of 4.5 years, and an interest rate of 8.5% per annum. The Central Bank would relend the equivalent of $35.7 million of the proceeds of the loan and an equivalent amount of its own resources to qualified rural banks and SSLAs in the form of special time deposits at an interest rate of 9% per annum. However, the portion of the proceeds which would be used for sub-loans to land reform beneficiaries would be relent to the same institutions at an interest rate of 7% per annum./l Repayment to the Central Bank would substantially reflect the aggregate of the repayment schedules of subloans made by the rural banks and SSLAs. The participating institutions would relend the funds to ultimate beneficiaries at 14% per annum except to land reform beneficiaries who would pay an interest rate of 12% per annum. Sub-loan repayment terms would vary from three to ten years depending upon the purpose and include an appropriate grace period. The 5% spread retained by the participating institutions is considered reasonable in view of the high administrative costs and relatively high risks associated with small, term loans. Sub-loans would be committed over three years and disbursed over three and a half years. The terms and conditions under which project funds would be disbursed are set out in the Central Bank's Rules and Regulations governing this program; they provide for eligibility criteria for participation of the rural banks and SSLAs in the project, the categories of investment to be financed, the terms and conditions of subloans and procedures for loan processing. Any changes in these Rules would be subject to prior approval by the Bank (Section 5.01 of the draft Loan Agreement). The proceeds of the loan to be used for the Agricultural Machinery Testing, Evaluation and Standardization Project ($300,000) would be passed on by the Central Bank to the Department of Agriculture on the basis of arrangements satisfactory to the Bank, to help finance construction and to equip the unit (See Section 3.01 (b) of the Loan Agreement and Section 3.05 of the Guarantee Agreement). The balance of the cost of the unit would be met by the Department of Agriculture. The balance of $500,000 of the loan would be retained by the Central Bank to help finance the cost of vehicles, training and the studies included in the project. The Central Bank would bear the foreign exchange risk on the Bank loan. Procurement 49. As in the Third Project and as is customary in rural credit projects, machinery, equipment and civil works needed for subprojects would be procured through normal commercial channels from local or foreign firms represented in the Philippines. Equipment and machinery firms are located throughout the LI For the same reasons noted in para. 36, a relatively small amount of the proceeds of the loan (less than 5% of the total loan amount) is likely to be used for sub-loans to land reform beneficiaries.  - 16 - Philippines, and service and repair facilities are satisfactory. There are also a large number of construction firms in the Philippines and there would be adequate competition for civil works contracts for boats, buildings and other minor works. Procurement of equipment, materials and civil works under subprojects would not be suitable for international competitive bidding because of the small size of each contract and bulk- ing of contracts would not be practicable because they would be widely dis- persed geographically and phased over time. The Central Bank would ensure that at least three price quotations are obtained for contracts in excess of P10,000 ($1,340), except in remote areas where suppliers are not well repre- sented, in which case a certified statement to that effect would be required from the participating institution. Procurement of service vehicles by the Central Bank ($400,000) and of equipment and civil works contracts of more than $20,000 for the Agricultural Machinery Testing, Evaluation and Standar- dization Project ($500,000) would be through competitive bidding advertised locally in accordance with Government procedures, which are acceptable to the Bank. Foreign vehicle manufacturers are well represented in the Philippines and they would be eligible to participate provided that they could provide satisfactory repair facilities and after-sales service. Items of less than $20,000 for the testing and evaluation project would be procured through the Government's normal procedures which are acceptable to the Bank. Disbursements 50. The proposed loan would be disbursed to the Central Bank for 45% of the amount of subloans to be made by rural banks and SSLAs against certified statements of expenditures. For service vehicles, the Bank would disburse 100% of the c.i.f. cost of directly imported vehicles, 100% of the ex-factory cost of domestically manufactured vehicles or 40% of the retail price of imported vehicles procured locally. In addition, the Bank would disburse 100% of foreign expenditures or 40% of the total costs of consultant services and training and 66% of the cost of civil works and equipment contracts for the Agricultural Machinery Testing, Evaluation and Standardization Project. Documentation of disbursements certified by Central Bank loan officers would be retained on file at the Central Bank or a designated local depository for inspection by Bank staff in the course of project supervision. Economic Justification and Project Risks 51. Investments under the project would result in substantial increases in the production of a number of agricultural commodities, principally rice but also corn, sugar, poultry, pork, beef and fish products. These would help to generate additional income for small farmers and to improve nutritional standards in the rural areas. Investments in cottage and agro-industries would expand production of a range of small capital and consumer goods for domestic and export markets, while transport and farm machinery investments would provide needed services in rural areas. The value of annual incremental production generated by the project at full development is estimated to be about $50 million. Financial rates of return on subproject investments range from 13% to over 100% on components other than power tillers. The financial return for power tillers is 8%, but this does not take into account the  - 17 - benefits they provide in the form of higher reliability and more certain land preparation capability in comparison to draft animals. The rates of return on fixed assets for poultry, cattle and cottage and agro-industry subprojects are relatively high but net cash flows are reasonable when viewed in terms of capital at risk and the labor input of the entrepreneur. The overall weighted average economic rate of return for the project is estimated to be 21%. An increase in operating costs of 10% would reduce the economic rate of return to 16%. The economic rates of return on individual components of the project are slightly higher than the financial rates of return because duties and taxes are netted out of initial investment costs while no other price adjust- ments were considered appropriate. 52. Investments financed by the project are estimated to create about 10,600 jobs directly as well as substantial additional indirect employment. The great majority of these would be unskilled jobs and therefore available to the lowest income groups in rural areas. The project would result in net foreign exchange savings of about $9 million a year. 53. The project has been designed to ensure insofar as possible that a substantial proportion of the benefits accrue to smaller borrowers. The esti- imated total annual incremental income accruing to the approximately 10,000 smaller farmers would be $7.2 million per year at full development, or an average of $725 per borrower. In addition, the majority of the 310,000 ha per year of custom hire services generated as a result of the project would be rendered on farms of less than 7 ha. 54. Since this would be the fourth in a series of projects implemented by the Central Bank and the rural banks, and the second in which SSLAs have participated, we do not envisage any procedural difficulties in project implementation. However, realization of the objectives of the project will depend on strong efforts on the part of project institutions to increase their effectiveness in assisting smaller borrowers, improve subloan appraisal and supervision capability and strengthen collection performance. The Government and the Central Bank have agreed to take the necessary steps to make rural credit policies and programs more effective and responsive to needs, but continuing commitment and effort will be essential to ensure the full success of the project. Bank staff will monitor developments closely in forthcoming supervision missions and assist in making any policy or program adjustments, which the Government decides are required. PART V - LEGAL INSTRUMENTS AND AUTHORITY 55. The draft Loan Agreement between the Bank and the Central Bank of the Philippines, the draft Guarantee Agreement between the Republic of the Philip- pines and the Bank, the report of the Committee provided for in Article III, Section 4 (iii) of the Articles of Agreement of the Bank and the text of a draft resolution approving the proposed loan are being distributed to the Executive Directors separately. Features of the Loan and Guarantee Agreements of particular interest are referred to in paras. 35, 36, 38, 40, 44, 45, 46 and 48 of this report.  - 18 - 56. I am satisfied that the proposed loan would comply with the Articles of Agreement of the Bank. PART VI - RECOMMENDATION 57. I recommend that the Executive Directors approve the proposed loan. Robert S. McNamara President By J. Burke Knapp Attachments March 24, 1977  TAILCIA h ith pe PNllpPlNCs - SOCIAL lNDICATORS DATA ISNET LAND AREA ITHOU tH2) .. . - - - - - ...................................... ----'--------- - PNILIpPINES REFRENCC CouNTRIEs t(It?* TOTAL 300.0 OUST RECENT. AGRIc. 116.3 1960 19t0 ESTINATE )NAILAN0 TURREYT HCREA.. V ~~~~~~~~~~~~~~~~~..... ......._.. __... __ ......... . .._ ........ _.... _ BR? PER CAP?IA cUSs) t*@.@ 230.0 310.0 210.0 40.0 270.0 ,,,,,,.,,._.___..... POPULATION AD VITAL STATISIICS POPULATION (NIO-fR. MILLION) 27.4. 36.9 4Z.5 36.3 35.7 31.4 POPULATION OEh9SIIY PER SOUARE xN. 91.0 123.0 1*2.0 71.0 46.0 319.0 PER 50. KM. AGRICULTURAL LAND . 219.6 326.0a ,, 67.0 1320.0 VIT4L STATISTICS AVERAGE GIRTH RATE (JTHOU) 45.1 44.2 43.- 44.3 40.6 35.0 AVERAGE DEATH RATE ITHOU) 11.9 13.2 10.5 IS.t 14.4 11.4 INFANT NORIALITY RATE (THOUI .. 60.0 68.0 j 60.0 145.0 LIFE EXPECTANCY AT GIRTH (TRS) 49.4 55.6 51.4 55.5 54.4 57.7 U.0SS REPRODUCTION RATE 3.54 3.3 3.3 1.2 2.6eiaa Z.6 POPULATION GROWTH RAtE C1Z TOTAL 3.0 3.0 2.9 3.1 2-5 2.3 URBAN 4.0 4.0 4.0 4.9 4.2 6.4 URBAN POPULATION (z of TorAL) Z5.5 21.4 f9.0 is 0 31.2 41.z AGE STRUCTURE (PERCENTI 0 TO 14 TEARS 4s.7 45.6 Ii.0 *5:41.0 41.6 42.i 15 lo 64 WEARS 51.6 51.6 s.0 52.0 13.9 54.6 65 YEARS AND OVER Z.r 2.8 2.0 I3.0 4.3 3.3 AGE OEPENDENCY RATIO 0.9 0.9 0.9 0.9 0.9 0.8 ECONOMIC DEPEhOENCI RATIO 13- 1.5 t.415 1.1 1.1 1.4 FAtILT PLANNIhG ACCEPTORS (CUMULATIVE, THOU) .. 354.0 2872.5 470.0 USERS (I OF NARRICD WOMEN) . 2.0 19.0 10.0 6.2 42.0 EMPLOOYMENT .... d --- TOTATL LABOR FORCE (THOUSAMo) 10100.0 12300.0