Ecuador - Agriculture Sector Program Project

Document of The World Bank FOR OMFCIAL USE ONLY Rqnrt No. P-4126-EC REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN IN THE AMOUNT EQUIVALENT TO US$100 MILLION TO THE REPUBLIC OF ECUADOR FOR AN AGRICULTURE SECTOR PROGRAM October 2, 1985 Ths doumut h. a res&Jui dubm md nay be and by redjieis ony in th pe _dome d du ofiddates lb ats am otherwibe disla_"d witbou World Bunk mduinm.  CURRENCY EQUIVALENTS Currency Unit: Sucre (SI.) Calendar 1984 September 1985 Currency Unit (average multiple rates) (unified rate) US$1 = SI. 79 = S/. 96.5 S/. 1 = US$.0l = US$.0l SI. 1,000 = US$12.66 = US$10.36 FISCAL YEAR January 1 to December 31 ABBREVIATIONS BNF - Banco Nacional de Fomento (National Development Bank) ENAC - Empresa Nacional de Almacenamiento y CDmercializacion (National Enterprise for Storage and Marketing) ENPROVIT - Empresa Nacional de Productos Vitales (National Enterprise for Essential Products) FAD - Food and Agriculture Organization of the United Nations IDB - Inter-American Development Bank SOE - Statement of Expenditure UNDP - United Nations Development Programme USATID United States Agency for International Development  FOR OFFICIAL USE ONLY ECUADOR AGRICULTURE SECTOR LOAN Table of Contents Page LOAN AND PROJECT SUHOHARY ...............I........*******.**** i I. THE ECONOMY ..*...... ....................................... 1 Background .................................................. I The Impact of Petroleum ...................... 2 Recent Events .................. ******.*** ****************** 3 Outlook ........ * . 4 II. BANK GROUP OPERATIONS IN ECUADOR ............................ 5 III. THE AGRICULTURAL SECTOR .................................... 8 General 8..................................................... 8 Importance and Potential of the Agricultural Sector ......... 8 Performance of the Sector .................*...... 9 Agricultural Trade and Pricing Policies ...................... 9 Public Enterprises in Agriculture ............................ 11 Agricultural Credit..............o...................... oo ...... 12 Current and Planned Public Investments in Agriculture......... 13 Government Policy Objectives ...................... e0**SSU@... 13 Recent Actions Taken ............ ............................ 14 Constraints to Further Actions ... .... O...... 14 IV. PROPOSED AGRICULTURAL SECTQR LOAN ........ 15 Action Taken Prior to Board Presentation ..................... 15 Proposed Conditions for Disbursement of Second Tranche ...... 16 Policy Monitoring under the Sector Loan ..................... 17 Technical Assistance and Studies ....... ..................... 18 Studies of Public Enterprises in Agriculture ................ 19 Procurement ..*.....**.........* .......................... .. 20 Disbursenent ................................. 20 Benefits, Impact and Risks ........................*......... 21 V. RECOMMENDATIONS ............................................. 24 This report is based on the findings of a mission composed of Messrs. 0. Knudsen (Mission Leader), J. Fernandez (Agricultural Economist), and 0. Ruiz (Consultant), which visited Ecuador from April 22 to May 10, 1985. Messrs. M. Ahmad (DRDSU), A. Meeraus (DRDSU), and G. O'Mara (AGREP) generously gave assistance in the computer modeling of the ugricultural sector. This document h2s a restricted distbution and may be used by _iPients on in the performat of tber offcal dute Its COntents may not otherwise be disclosed without World Bank authonzation.  - ii - Table of Contents (continued) Page ANNEXES I. Social and Economic Indicators ...... ge.... .**........e...... 25 II. The Status of Bank Group Operations in Ecuador ............. 31 III. Supplementary Pzoject Data Sheet ........................... 33 IV. Ecuador: Agricultural Sector Policy ....................... 35 V. Draft Development Policy Letter ............................ 37 VI. Documents Available in Files .e ...... ................ 40  ECUADOR ACEIULTU SKcIO PRUAK WhI AND PROIECr SUARY BDrrower: Republic of Ecuador _mt: US$100.0 million equivalent. Ter : Repayable over 17 years including 4 years of grace, at the Bank's standard variable interest rate. Pro ect Description: The proposed project would support the Government's program to reform policies in the agricultural sector, which emphasizes the liberalization of commodity pricing and interest rates and the reduction of public sector interventions. The specific additional steps supported by the loan would be to improve terms of trade of agriculture relative to other sectors of the economy; remove remaining support prices and subsidies; maintain positive interest rates; and unify lending rates for the agricultural sector. Institutional strengthening in the area of sectoral policy analysis would also be supported. The proposed loan would finance the general imports of agricultural inputs. Risks: As a policy adjustment effort, this project runs the risk of political unsustainability of the proposed reforms. To date, the Government has sustained progress towards its policy objectives and would be supported in this effort by policy analysis developed by the Ministerial units receiving assistance under the loan. Future trends in international prices and export incentives are also sources of risk. Commodity price projections for Ecuador's potential non-traditional agricultural exports are favorable. The exchange rate is being monitored via a Government-IMF dialogue.  - li - (US$ Millions) Loan Components: Imports of Agricultural Inputs 97.5 Institutional Strengthening 2.5 Total 100.0 Estimated Disbursements: 1986 1987 USS millions by Bank Fiscal Year Annual 50.0 50.0 Cumulative 50.0 100.0 Rate of Return: u.a. Staff Appraisal Report: No Staff Appraisal Report has been prepared for this project.  INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPNSNT REPORr AND RECOMNENDATION OF THE PRESIDENT OF THE IBRD TO THE EXECTIVE DIRECTORS ON A PROPOSED LOAN TO THE REPUBLIC OF ECUADOR FOR AN AICULTURE SECTOR PROGRAM 1. I submit the following report and recommendation on a proposed loan to the Republic of Ecuador for the equivalent of US$100 million to help finance an agriculture sector program. The loan would be repayable over 17 years including 4 years of grace, at the standard variable interest rate. PART I - THE ECONOMY 1/ 2. The most recent economic report on Ecuador, Report No. 5094-EC entitled 'Ecuador: An Agenda for Recovery and Sustained Grouth- was distri- buted to the Executive Directors on October 5, 1984. The subsequent para- graphs reflect the findings of that report as well as those of a Bank mission which visited Ecuador in November 1984 to analyze the public investment pro- gram. Annex I provides the main social and economic indicators. 3. Ecuador entered the 1970s as one of the least developed Latin American countries. In 1967, petroleum was discovered in Ecuador's Anazon region and in 1972 the country became a net oil exporter. In 1973 world oil prices quadrupled and Ecuador's export earnings doubled. During the 1970s, Ecuadorian income and output expanded rapidly, perhaps at a rate unprece- dented in its history. At constant 1983 prices, per capita GNP increased from US$1,190 in 1972 to US$1,430 in 1983, placing Ecuador firmly among the Bank's middle-income borrowers. 4. Between 1960 and 1980, much social progress was made. Life expec- tancy increased by ten years; death and infant mortality rates dropped by more than 40 percent; and school enrollment expanded rapidly. By 1980 virtually all children were attending primary school, and a third of the relevant cohort attended schools of higher education. Today's citizens are better educated, in better health, and better fed than at any other time in Ecuador's history. Nevertheless, owing to the low level from which Ecuador started, Ecuador's social indicators lag behind those of other countries with similar levels of per capita income. Moreover, the benefits of growth were not evenly distributed. While a sizeable middle class emerged, about 40 percent of the urban and 65 percent of the rural population live in absolute poverty. 5. Highly concentrated ownership of productive resources and unequal access to public services explain much of Ecuador's skewed income distribu- tion. For example, 60 percent of the country's farmers derive their livelihood from only 11 percent of the arable land. Their farms are 1/ Part I is substantially the same as Part I in Report No. P-4006-EC of March 28, 1985.  small-less than 5 ha-and tend to be of the poorest quality. Low levels of education, primitive cultivation techniques, scarce use of technical inputs, and limited access to credit and to commercial marketing channels contribute to low farm productivity and incomes. But uneven distribution of the oil income also accounts for the disparities in social conditions. Thus, during the 1970s only about a quarter of total public investment was channeled to the rural areas, where 56 percent of the population and most of the poor live. 6. Like many other Latin American countries, Ecuador is now beginning to emerge from a severe recession. In 1984, real GDP grew by about 3.4 percent. For the years 1982-83, however Ecuador not only suffered from declining international oil prices and suspension of commercial bank lending, but also from the ravages of the Nino current which, in 1983, practically wiped out cocoa exports (a major source of foreign exchange), severely damaged the countryside, and forced the country to import foodstuffs. Normally domestic production meets the country's food needs. Per capita income dropped in 1982; in 1983 it dropped again, this time by more than 5 percent. While statistics are scarce, it is clear that unemployment has increased, some business have gone bankrupt, and Ecuador's financial and industrial sectors have severe liquidity problems. The Impact of Petroleum 7. While the immediate causes for Ecuador's economic downturn may be traced to falling oil prices and suspension of commercial bank lending, these factors only exacerbated pending problems, as the country had embarked on an unsustainable economic course. After the initial burst of oil exports in 1973, the country's volume of exports remained practically constant; export earnings increased mainly because the international price of-oil went up, and the country's income increased because the terms of trade turned sharply in its favor. By 1980, the increased income made available since 1975 by rela- tively higher export prices was adding 8 percent to Ecuador's yearly income. The increased expenditures of the public sector-through which much of this income passed-were partially responsible for the improvement in the nation's living standards and physical infrastructure, as well as for accelerated industrial production. 8. Unfortunately, this income also had three adverse effects. First, it slackened efforts to collect taxes from the non-oil portion of the economy. Thus, while petroleum revenues doubled relative to GDP between 1973 and 1983, non-oil taxes, including social security contributions, fell from 17 percent of GDP in 1973 to 10 percent in 1982, and total revenues, relative to GDP, stagnated. 9. Second, because oil taxes were painless for the Ecuadorian con- sumer, there was an incentive to earmark them for various subsidies-imports, housing, roads, and education-and to keep domestic petroleum product prices frozen at the 1972 level. By 1980, the Ecuadorian consumer was paying only US$0.10 for a gallon of gasoline. The subsidy implicit in the difference between world prices and domestic prices was equivalent to about 8 percent of 1980 GDP.  -3 - 10. Third, the abundance of revenues and their ease of collection dimin- ished incentives to control the growth of public expenditures. Current expenditures went up from 16 percent of GDP in 1973 to 24 percent in 1982. Public sector savings decreased to such an extent that the public sector surplus of 1973 (equivalent to 3 percent of GDP) became a deficit equivalent to 8 percent of GDP by 1982. Because of its status as an oil exporter, Ecuador was able to finance this deficit abroad with ease, but at a price. The public external debt more than doubled between end-1979 and end-1983; economic adjustment was deferred until Ecuador found its access to foreign funds severely limited. The abundance of oil income also affected Ecuador's exchange rate, allowing it to appreciate in real terms without causing financial problems. This made imports cheaper for Ecuadorian industrialists and consumers, but it also meant that non-oil exports suffered. With the important exception of shrimp, non-oil exports grew slowly in volume after 1974. Like the public sector, the external sector would also have encountered problems after 1980 had it not been for recourse to large external borrowings. 11. M4onetary policies complemented both exchange rate and fiscal poli- cies. Negative real interest rates led to a decline of financial savings relative to GDP. But Ecuador's financial system expanded credit rapidly in nominal and real terms, despite poor domestic resource mobilization, because foreign banks provided the Central Bank with increased resources. The external sector, with a fixed exchange rate, gave vent to what otherwise would have been inflationary pressures by increasing the supply of goods to the economy through imports. Copious external borrowing provided the needed foreign exchange. Financial institutions, then, like the public and external sectors, became dependent on petroleum (through the Central Bank) and ultimately on external borrowing, through guarantees. They too encountered severe problems when, in 1982, petroleum receipts stagnated and Ecuador's access to external funds became severely limited. Recent Events 12. During 1981/82, the terms of trade turned against Ecuador as oil prices declined. Export earnings fell by about 8 percent in 1982. Despite a reduced volume of imports, the current account deficit of the balance of pay- ments exceeded US$1 billion, about 9 percent of GDP. To finance it, the authorities borrowed short-term and used up about US$460 million of the country's international reserves, almosL depleting them in the process. When the economic downturn worsened in 1983, Ecuador had to manage with severely limited financial resources as foreign banks restricted their net, new lending to US$430 million. To make matters worse, the Nino current's climatic shifts, which had inflicted some damage in 1982, continued to ravage the countryside with floods. 13. The authorities' attempts to deal with the crisis have been, for the most part, prompt and in the right direction. First, they dealt with the exchange rate. In 1982, the sucre was devalued for the first time since 1971  - 4 - and thereafter was adjusted frequently. It now stands at a rate which is as attractive for exporters as it was in 1970, before the oil boom allowed it to appreciate. Second, they dealt with the liquidity crisis by temporarily prohibiting or limiting many imports and renegotiating principal on the external private and public debt. Negotiations with the commercial banks for a multi-year rescheduling covering maturities falling due in 1985-1989 were concluded in the first quarter of 1985; a Paris Club agreement was reached in April 1985 to reschedule official debt falling due between 1985-1987. Temporary import restrictions were eliminated as the liquidity of the Central Bank improved. 14. A fiscal austerity program was put in place by 1983 in cooperation with the IMF. The public sector deficit was reduced from about 8 percent of GDP in 1982 to about 1.4 percent in 1983 and virtually eliminated in 1984. Ecuador also complied with the rest of the IMF program. Partly as a result, inflation was more than halved in 1984, to about 23 percent; the balance of payments was practically brought into equilibrium, and growth resumed. An IMF program-a one year SDR 105.5 million stand-by-for 1985/1986 is now underway. Among other things, this program anticipates a public sector surplus equivalent to 2.2 percent of GDP for 1985 to be achieved by raising revenues and holding down expenditures. Another key feature is the unification of the exchange rates of the official and intervention markets (see para. 54). Additionally, the program addresses the need to reduce inflation. 15. Finally, decisions taken prior to the crisis began to bear fruit in 1983. For example, owing to positive results of exploration efforts under- taken as far back as 1980, and the implementation of a secondary recovery program, oil production and oil exports rose 11 percent and 39 percent, respectively, in 1983. Outlook 16. The present Administration which took office in August 1984, is the second one to be democratically elected after nearly a decade of military rule. The Government's economic philosophy essentially supports the market as an efficient resource allocation mechanism, with minimal Government intervention in economic affairs. Since coming to office, the Administration has taken a number of important and politically difficult corrective measures: it again devalued the sucre and later unified the multiple exchange rate markets; it raised domestic petroleum products prices; it improved the interest rate structure; it successfully obtained a multi-year rescheduling of its external debt; it liberalized trade; -.a it moved to free prices in the agricultural sector. These are important utilization of resources and stimulate exports, agricultural production and 17. Owing to the devaluations of the sucre in the past two years, which have raised the price of oil in sucre terms, oil exports now amount to 18 percent of GDP. Virtually all of this income accrues to the public sector. Present prospects indicate that in future years, the oil sector  - 5 - will at least maintain its importance in the economy. Realization of the country's growth potential requires extremely careful management of this income. In particular, it will require continuation of frugal fiscal policies and tight monetary policies, very much along the lines of the 1985-86 program agreed with the IMF. A public sector surplus channelled to the private sector via the monetary system may be required to avoid inflationary pressures and to maintain an adequate flow of resources to the private sector, partially substituting for the foreign borrowings of previous years. This delicate balance between public and private sector needs underscores the importance of good public sector management. 18. This balance is all the more important because Ecuador is likely to continue facing a shortage of foreign exchange in the next few years, espe- cially if oil prices continue to decline. In addition, Ecuador, like many other developing countries, will face greater difficulty than in the past in obtaining financing for its development effort from commercial sources. Yet, the country has abundant resources. With a good public investment program, continued improvement of sector policies, and tight monetary policies, the exchange rate should remain attractive for exporters. Under these conditions Ecuador could grow some 3-4 percent per year on average in 1985-1990 and attain equilibrium in both its overall fiscal and external accounts, remaining, therefore, creditworthy for Bank lending. Both the Bank and the Fund are supporting attainment of these objectives. Recent Bank dialogue has focused on ensuring a sound public investment program; the Bank lending program supports the improvement of sector policies and the ongoing IMF agreement directs specific attention to the monitoring of fiscal policies and exchange rate policies. PART II - BANK GROUP OPERhFI0NS IN ECUADOR 19. Bank Group operations in Ecuador date back to 1954 when a loan was sade for a first highway project. Altogether, the Bank and IDA have extended 31 loans and six credits to Ecuador totalling US$626.8 million net of can- cellations. As of March 31, 1985, US$439 million of this amount had been disbursed. The IFC has invested in five firms in Ecuador, including a large textile company, a sugar mill, a cement company, a mining enterprise and a development finance company. As of March 31, 1985, commitments for these operations amounted to US$28 million, of which IFC held US$8 million. Annex II contains a summary statement of Bank loans, IDA credits and IFC operations as of March 31, 1985. 20. Execution of Bank Group financed projects has often been hampered by weaknesses in Ecuador's implementation capacity, reflecting the insuffi- ciency of the country's public sector managerial and technical resources-a constraint that is still a serious obstacle to Ecuador's economic and social development. In recent years, the Government and Bank staff have worked together to step up disbursement of Bank loans. Among other initiatives, a  Special Action Program for the country provided for revolving funds in five projects. As a result of these general efforts, disbursements rose from US$26 million in FY83 to US$42 million in FY85. The country has recently set up a monitoring committee for all externally financed projects which should reinforce efforts to accelerate disbursements. The Bank plans annual port- folio implementation reviews to detect and resolve specific obstacles to execution of Bank-financed projects. Ecuador's average disbursement rate for 1981-1984 has been higher than the average for Latin American countries. 21. Bank and IDA lending in Ecuador was originally concentrated in transport and power, where there were substantial bottlenecks to be over- come. To date, approximately 30 percent of Bank Group lending has been for infrastructure. Seven of the nine loans and credits extended for transport were to improve the country's road network and two were to help finance the expansion of the port of Guayaquil. Three power operations aimed at improving generation and distribution facilities in Quito. The first livestock development loan, approved in FY67, marked the beginning of a diversification in the Bank Group's lending program away from infrastructure. Since then, the Bank Group has made nine other loans and credits for agriculture and fisheries, seven loans to support industrial development, and two for pre-investment studies. These productive sector loans comprise 52 percent of total Bank lending to Ecuador. Bank Group support for social sectors--education, water supply and urban development--now accounts for about 18 percent of total Bank lending. 22. Presently, there are three ongoing projects in agriculture: Tungu- rahua Rural Development (Ln. 1644-EC) for US$18 million; Puerto Ila-Chone Rural Development (Ln. 1991-EC) for US$20 million; and Esmeraldas Rural Development (Ln. 2044-EC) for US$17 million. An Agricultural Credit Project was fully disbursed by September 1985, with a small balance cancelled. The three rural development projects are progressing slowly due to complexity of project design, inadequate institutional capacity and lack of counterpart funding, with disbursements lagging behind appraisal estimates. To accelerate project works, a restructuring of the Tungurahua Project became effective in 1985. In addition, the Puerto Ila-Chone and Esmeraldas Projects are being reprogrammed to expedite project implementation. 23. The Bank has carried out extensive sector work id Ecuador. On the basis of the latest sector work, a Green Cover Report-Agriculture: An Assessment and Direction for Development--was issued in August 1983. The report has been reviewed by the Government's Economic Team and various key public agencies, and the Government has endorsed the recommendations outlined in the report, as stated in the letter of September 25, 1984, from Mr. Marcel Laniado, Minister of Agriculture and Livestock, to the Bank (Annex V). Other background papers prepared for the sector loan and recent agriculture sector studies are included in the project file (see Annex V).  24. Turning to the future, the Bank strategy is to support Government initiatives in macroeconomic and sector reforms over the medium term. Bank lending would build on a core program for industry, agriculture and infra- structure to meet the following objectives: (a) completion of a physical and social infrastructure base capable of fostering development; (b) expansion of productive capacity in crucial sectors; and (c) strengthening of agencies to implement projects effectively. Additional projects would support policy improvements in energy, agriculture, industry and the general development framework. In addition to the design and adoption of adequate sector poli- cies, Bank lending will emphasize the generation of exports and employment. Besides the Agriculture Sector Loan recommended in this report, the Bank is preparing an industrial finance operation and an agricultural credit operation. These operations, as well as a small scale enterprise project, have been designed so as to support in a consistent and coordinated fashion the financial and trade reforms sought by i.le Government to reduce subsidies and protection and encourage investment in these productive sectors. These operations would also increase incomes and improve employment prospects for the population. In addition to Bank lending, the IFC is analyzing several possible operations, principally in agribusiness and fisheries. 25. Substantial development financing has also been provided to Ecuador by the Inter-American Development Bank (IDB), the U.S. Agency for Interna- tional Development (USAID) and, to a lesser extent, by other bilateral sources. IDB has been the single largest lender to Ecuador. Loans outstand- ing (including undisbursed) from IDB to the country as of December 31, 1984, totalled about US$985 million equivalent. Past IDB lending has been concentrated in the power, agriculture, industry and transport fields. Most of IDB's loans to the country have come from the Fund for Special Operations and normally carry concessional terms. It is likely that IDB will remain Ecuador's major development lender in the immediate future with power, agriculture and socially-oriented projects continuing to account for a large share of its lending program. By December 1984, USAID had about US$105 million in outstanding loans to Ecuador (including undisbursed). Its program concentrates on urban development, agriculture, health and the private sector. In addition to maintaining close contact with USAID, IDB and other aid agencies to assure compatibility of programs, Bank staff have undertaken a full public sector investment review which could serve as the basis for a Consultative Group Meeting of Ecuador's creditors, possibly by mid-1986. 26. As of December 31, 1984, the public and publicly-guaranteed medium- and long-term external debt of Ecuador (including undisbursed) totaled about US$8.1 billion, of which US$1.3 billion was undisbursed. Of the former sum, the Bank group provided 5.5 percent; the IDB 12.2 percent and USAID 1.3 percent. Through 1988, the Bank's share of Ecuador's outstanding and disbursed public foreign debt is expected to remain below 7 percent, and the Bank's share of total public foreign debt service is projected to remain between 3 percent and 4 percent.  - 8 - PART III - TUE AGRICDLTJURAL SECTDR General 27. Before petroleum dominated the economy during the 1970s and 1980s, agriculture was Ecuador's leading sector in growth and export earnings. Although it still remains important to the economy, discriminatory and often contradictory policies, combined with inefficiency in delivery of support services, have prevented agriculture from achieving its potential in terms of income growth, export earnings, and employment. As a consequence, it has not become a major force in reducing poverty and inequality in Ecuador. However, the new Government has proposed to reform agricultural policy through liber- alizing prices and trade and return agriculture to being a leading sector in economic growth and poverty alleviation. It has requested the Bank to assist in supporting this policy reform and in easing the consequential sectoral adjustment process. baportance and Potential of the Agricultural Sector 28. Despite a decade of policies favoring industry and discriminating against agriculture, the agricultural sector remains important to Ecuador's GDP and foreign exchange earnings, accounting for 14 percent of GDP and about 16 percent of export earnings. If the value added from agro-industry is included, then its contribution to the economy increases to about 29 percent of GDP and nearly 30 percent of export earnings. Agricultural products, including forestry and fishery exports, constitute 98 percent of non-petroleum export earnings. 29. Because agricultural production is labor intensive, generally requiring unskilled labor, agriculture's importance to employment, especially for the poor, is even more substantial than its contribution to GDP. Despite high rural-to-urban migration, the agricultural sector still employs about half of Ecuador's economically active population. If agro-industry is included, employment provided directly and indirectly by agriculture increases to over 60 percent of the active work force. With rural incomes substantially below urban levels and under-employment in rural areas by some estimates 50 percent of the available labor, agricultural growth is essential to increasing the employment and the incomes of Ecuador's poor. 30. Despite its importance to the economy and rural welfare, agricul- ture's potential has not been fully developed. Although Ecuador has a favor- able climate for growing most crops, agricultural land remains under- exploited: Ecuador is utilizing only about 44 percent of its land suitable for cropping and about 62 percent of its pasture land for cattle. Except for bananas and palm oil, average yields have not increased for major crops, remaining at levels 30 to 75 percent below those obtained by advanced farmers using improved technology and having access to extension and credit.  - 9 - 31. Although agriculture is a major source of foreign exchange earnings, the potential for increased exports of agricultural products has not been exploited. While the comparative advantage of Ecuador's traditional exports-coffee, cocoa, and bananas-remains strong, domestic resource cost calculations indicate that Ecuador also has a comparative advantage in the production of rice, hard corn, cotton and soybeans, products which are cur- rently imported or only occasionally exported in years of surplus. An attractive exchange rate and policies that encourage agriculture investment could stimulate production and eventually lead to sustained exports of these non-traditional export crops. Performance of the Sector 32. Except for livestock production, forestry, and the shrimp industry, agriculture has grown slowly. The growth rate of real value added for the major export crops-bananas, coffee, and cocoa-has been about 1.7 percent p.a. from 1970 to the early 1980s. The other traditional crops which constitute Ecuador's food production have grown at only 0.6 percent p.a., well below the rate of population growth of 2.5 percent. As a consequence, food imports have been increasing rapidly, rising at an average annual rate of 13 percent; food now constitutes 53 percent of total imports. Wheat is the major food import, reaching about 330,000 tons in the 1983/84 crop year. Wheat production remains stagnant at about 25,000 tons, despite high support prices, while consumption continues increasing at over 5 percent per year. Because of increasing food imports and lower export prices, the agricultural trade surplus has declined, falling from a peak of US$547 million in 1979 to US$231 million in 1982. gZricultural Trade and Pricing Policies 33. The poor performance of agriculture can be largely attributed to past Governments' trade and pricing policies. Ecuador's foreign trade policies have been characterized by high and highly variable protection of its import substituting industry through tariffs and qulantitative restric- tions, overvalued exchange rates, selected taxation of exports and subsidization of imports. For instance, a 1983 Bank economic mission esti- mated effective rates of protection of about 100 percent for some textile products, 200 percent for some domestic electrical appliances, and 300 percent for other industrial products, while agricultural commodities had generally low or negative effective rates of protection. Effective rates of protection have also been calculated based upon actual tariff receipts and thus represent lower limits (as quantitative restrictions would raise protection). For industry, these rates are 26 percent (1975), 20 percent (1980), and 61 percent (1983), while for agriculture they are -1.3 percent (1975), -1.6 percent (1980) anid 4 percent (1983). 34. During the 1970s and early 1980s, the overvaluation of the exchange rate compounded the discriminatory effect on agriculture of trade and pricing policies. While industrial final products became practically non-exported because of the high protection afforded them, the agricultural sector, pro- ducing mostly tradeable commodities, became continually more discriminated  - 10 - against as the official exchange rate remained fixed until 1982. During this period, based upon an import-weighted and export-weighted basket of curren- cies, the official exchange rate became overvalued by between 40 percent and 48 percent. This caused declines in the real competitive returns to banana and coffee exporters, and would have similarly affected cocoa exporters, had not two major competitors (Ghana and Nigeria) suffered worse appreciation of their exchange rates. 35. Until September 1985, when the rates were unified, multiple exchange rates and controls were used to indirectly subsidize a few agricultural products (wheat, flour, and milk) and agricultural inputs (fertilizers and agro-chemicals) that could be imported at a low exchange rate of 67 sucres/US$1. Other imports were, since September 1984, subject to an official intervention exchange rate of 97 sucres/US$1 while a parallel free market' rate of about 110-120 sucres/US$1 also existed for tourism and capital movements. 36. While exchange rate policy generally discriminated against agricul- ture by permitting subsidized imports of commodities that competed with domestic products, the Government further reduced incentives to the sector through export taxes on coffee, cocoa, bananas, and additional financial subsidies on imported wheat and milk powder. Although a high support price for the small amount of domestically produced wheat, a minimum price on milk, and the fertilizer subsidy tended to somewhat counterbalance the import subsidies, the net negative effect remained as Ecuador continued to attempt to provide low-cost food to urban consumers. 37. This combination of policies penalized agriculture in several ways. First, the high protection and, in many cases, import prohibitions granted to the industrial sector in the past 10 years worsened the terms of trade between agriculture and the rest of the economy, distorted the flow of resources between the two sectors and induced an overgrowth of the urban economy. Second, the past overvaluation of the exchange rate diminished the incentives to develop exportable surpluses and further depressed producer prices of exported crops. Third, the subsidization of the imports of certain agricultural products such as wheat and milk powder through a preferential exchange rate and at times direct subsidies by the Government discouraged production of their consumption substitutes, such as rice and fresh milk. 38. Agricultural production has further been hampered by the distortion in relative prices brought about by the operations of public enterprises, controls on wholesale and consumer prices, and trade restrictions. On the input side, the subsidization granted through the preferential exchange rate to imports of fertilizers, seeds, and pesticides has been vitiated by lack of availability at critical times and inefficient use. This has been caused in part by over-participation in the delivery of these inputs by overstaffed and poorly managed publicly controlled enterprises and by licensing controls on imports. 39. On the output side, the attempt at providing piecemeal compensation (through procurement and price controls) to individual crops, for the overall policies of discrimination against agriculture has induced distortions of relative prices. These compensations have been attempted through legally  - 11 - mandated "minimum' wholesale prices and procurement by public enterprises and processing facilities, and maximum retail prices. Although many of the price controls and interventions have been ineffective or, at least, only arbitrar- ily enforced, they have contributed to increased uncertainties about price levels and, in some cases, produced relative price distortions as compared to international price ratios. Despite the fact that agricultural inputs were subsidized when multiple exchange rates existed, effective rates of protection for most agricultural products remained negative. Public Enterprises in Agriculture 40. Public enterprises in the agricultural sector are either fully Government-owned, or mixed enterprises in which private parties own stock, most frequently on a minority basis. The two most important fully Government-owned enterprises are: National Enterprise for Storage and Marketing (ENAC), a state enterprise with the objective of stabilizing market prices at the producer level, and National Enterprise for Essential Products (ENPROVIT), a state enterprise with the objective of distributing food at minimum prices to the poor. Together with trade controls, ENAC and ENPROVIT were the major instruments in implementing domestic price policy. 41. ENAC. ENAC, controlling about 27 percent of the agricultural storage capacity in Ecuador, is authorized to purchase locally or import, store, and distribute basic items such as rice, sugar, corn, wheat, and cotton. It also has exported surpluses according to local conditions of supply and demand and supervised wholesale markets, commodity exchanges, and market information systems. Through these controls and procurements, the Government attempted to influence producer and wholesale prices. However, limited storage and financial capacity restricted its influence on prices. As a result, ENAC purchased mostly from large growers while smaller producers had to sell in the open market at lower prices. Because of its price support activities, ENAC accumulated deficits of about US$35 million. Recently, the Government restricted ENAC to supporting 'incentive' prices only for hard corn and rice. 42. ENPROVIT. While ENAC addressed producer prices, ENPROVIT attempted to control consumer prices at retail markets through about 300 outlets in five regions of the country, 31 supermarkets in some major cities, and 13 warehouses. Retail sales averaged about US$50 million; about 30 percent of its operating budget were co'rered by Government subsidies. Outstanding debt is about US$12 million, and lines of credit to ENPROVIT were recently suspended. The current Administration intends, in the short term, to limit ENPROVIT's growth, and in the medium term, to explore alternatives to improving the food intake of the poor. 43. Other Public Enterprises. Agro-industrial enterprises that are partially Government-owned range from a fertilizer company and a seed company to various food processing enterprises, including milk, tea, cattle slaughtering, sugar, and citrus juice plants. Their financial position,  - 12 - inventories, and other basic information are generally unknown by the Govern- ment. The new Administration intends to divest some of these enterprises but, without the most basic financial information, it is unable to make realistic assessments of the consequences, or even the feasibility, of priva- tization. Agricultural Credit 44. About 14 percent of the credit from the banking system in Ecuador is extended to the agricultural sector. The National Development Bank (BNF) is the main source of financing for the sector, providing 88 percent of all formal sector credit. Although between 1978 and 1982 actual lending by BNF declined by 11 percent in real terms, lending increased in 1983 and 1984 by an annual average of 30 percent in real terms. 45. BNF has been virtually the only formal source of credit for small farmers; 60 percent of its loans are directed to this group. However, an analysis of the volume of BNF lending in agriculture indicates a focus on livestock, traditional export crops, and a few selected non-traditional crops. Its interest rates have generally been negative in real terms, and have varied depending on source of funds, and the crop intended to be supported. Short-term credit, which averaged over 60 percent of the total lending in the last five years, also favored a few commodities, mainly rice, corn, and cotton. 46. The lending by BNF to agriculture has been impaired by cumbersome procedures for subloan appraisal and approval and by legal requirements. BNF has taken steps to strengthen its operations and to improve its credit and accounting procedures. In particular, under technical assistance from FAO, BNF has reduced its operating costs and rescheduled a number of overdue loans. 47. Although still solvent, BNF has a weak financial position. Its margin between cost of funds and on-lending rates has not been adequate to cover operating costs, bad debts, and equity loss caused by inflation. As a result, it has been decapitalized at an average annual rate of more than 10 percent over this period. 48. Interest rates on most deposits, and loans are regulated by the Monetary Board. After nearly a decade of fixed interest rates, adjustments were made in 1981, 1983, and 1984. Savings rates range from 18 percent to 21 percent and lending rates in agriculture, excluding fees and commissions, ranged from 18 percent for small producers to 23 percent for medium and large producers. In 1984, inflation was about 25 percent, making real savings, and lending rates somewhat. negative. Inflation in 1985 is currently running around 21 percent. 49. While lending rates have been simplified, there has been no formal mechanism for periodic adjustments of interest rates. In August, a new law was approved which provides for adjustable interest rates on medium- and long-term loans. Furthermore, in practice, loans in arrears are rescheduled as new loans at current interest rates, and commercial banks have, for some time, arranged even their longer term lending on a short-term basis so as to enable an annual revision of interest rates.  - 13 - Current and Planned Public Investments In Agriculture 50. Public investment in agriculture has amounted to 10 percent of total public investment, or 0.7 percent of GDP. The current Administration emphasizes further reducing inefficient public sector interventions in agriculture and increasing the attractiveness of the sector for private investment. About 80 percent of public agricultural investment has been channelled to infrastructure-irrigation, roads, and water supply. Planned investments follow the same pattern, with the bulk directed to irrigation - works and, in particular, to two major irrigation projects: Daule-Peripa and Tahuin. Investments associated with integrated rural development emphasize roads, water supply and schools and amount to 16 percent of the investment plan in agriculture. Only a small proportion (7 percent) is allocated to research and extension services. 51. The Daule-Peripa project, a large multi-component irrigation, drainage, and hydroelectric power project, would absorb about 74 percent of the total public investment in irrigation and 54 percent of total public investment in agriculture and thus is the most important project in the sector. The Inter-American Development Bank (IDB), which has provided financing for the project, conducted a detailed review of it in 1984. Based upon the ongoing experience with the project, IDB estimated that the overall project would have a rate of return of about 9 percent; if costs incurred prior to 1985 are deducted from total investment costs, then the rate of return increases to 12 percent. 52. A recent updating of this cost-benefit analysis within the Bank found that the rates of return calculated by 1DB are now most likely under- stated because (a) sunk costs would have to include all of 1985 costs and possibly more before work could be stopped; and (b) cancellation costs were omitted from the -without project- case. A November 1984 Bank Public Investment may be more costly to stop it than to complete the second phase irrigation works where most of the potential benefits lie. Together with this conclusion, the Public Investment Review Mission also recommended continuing with all research, extension and forestry, and most rural development and irrigation works currently underway or planned (96 percent of proposed public investments in the sector). Goveruzent Policy Objectives 53. The Government elected last year has proposed policies for the agricultural sector which are decidedly more market-oriented than past administrations (see Development Policy Letter in Annex V on the intent of Government policies). The objectives of the policies include: (a) improvement of the internal terms of trade of agriculture in relation to other sectors of the economy; (b) liberalization of prices, including reduction of the number of commodities covered by controlled producer and consumer prices; (c) reduction of tariffs and quantitative restrictions to trade; (d) divestment of selected enterprises owned fully or partially by the Government;  - 14 - (e) increased provision and improved efficiency in the distribution of agricultural credit at non-subsidized rates of interest; and (f) improved efficiency of the Ministry of Agriculture and ancillary institutions. Recent Actions Taken 54. The Government has already begun to implement policies to support these objectives (see the Policy Matrix in Annex IV for a summary of recent actions taken and additional actions to be implemented). Foremost, the Government has devalued the sucre substantially. In 1984, it began transferring transactions from the official market (fixed at 66.5 sucres per dollar) to the intervention exchange rate (96.5 sucres per dollar). By September 1985, all trade was unified at the intervention rate (except for some transitional measures for existing contracts, and limited tourist access to a free market). The Government has eliminated most of the quantitative restrictions put in place in 1982 and 1983, somewhat reducing the distortions between agriculture and industry. Subsidies (via use of the preferential official exchange rate) on the imports of wheat and milk powder have been eliminated and procurement by ENAC has been reduced to two commodities, rice and hard corn. Likewise, the number of commodities covered by maximum official prices has been reduced to five, three of which are agricultural (the remaining two are salt and banana packing boxes). A graduated scale of export taxes based on international prices has been raised so that export taxes effectively have been eliminated except for a nominal tax which is earmarked for reinvestment in the export crop. Constraints to Further Actions 55. Despite these actions, the Government still faces severe political, technical, and financial constraints to the further implementation of its policies. In an economy accustomed to highly interventionist policies, economic interest groups have formed and continue to resist liberalization. Although competent professionals can be found within and outside the Ministry of Agriculture, their numbers are few and salaries are insufficient to attract more experienced and competent personnel to assist in policy anal- ysis. Also, funds are limited for supporting monitoring of policy effects and studies on policy reforms and public institutions and enterprises. On the financial side, a policy of restricting imports through licensing and delayed payment to suppliers remains as the Government attempts to ration foreign exchange and generate increased surpluses on its current account. Ar agricultural production depends on imported inputs, especially fertilizers and pesticides, foreign exchange availability remains an important constraint to agricultural growth. 56. Therefore, despite the need to move even more decisively in liber- alizing prices and trade as well as reorganizing and improving the efficiency of the public sector and public investments, the Government is limited in the actions it can realistically undertake without foreign exchange and technical assistance. It is the objective of the proposed Agriculture Sector Loan to assist in providing the resources necessary to support the Government in the implementing of its policy intentions with respect to the sector.  - 15 - PART IV - PROPOSED sE(coR LOM 57. Over two years, the proposed Agricultural Sector Loan would: (a) assist in implementing a set of further policy reforms in the area of agricultural pricing, trade and interest rates while ensuring that the dismantling of industrial protection proceeds; (b) provide foreign exchange for importing agricultural inputs (fertil- izers, agro-chemical products, pesticides, seeds, agricultural machinery, silos, processing equipment, large trucks) necessary for supporting the expansion and diversification of agricultural pro- duction; (c) finance technical assistance for supporting the analysis of agri- cultural policies and investment criteria through assisting in strengthening a policy group responsible for monitoring the effects of policy reforms and advising the Government on other policy initiatives in the agricultural sector; and (d) finance a set of studies of public enterprlses which could lead to the divestiture of some enterprises, the improvement in efficiency of others, and the building of a policy framework for implementing policies with respect to public enterprises. 58. The proposed loan of US$100 million would finance about a quarter of Ecuador's projected 1986/87 imports of agricultural inputs, including storage and transportation equipment. Disbursement of the Loan is proposed to be in two tranches based upon the fulfillment of two sets of conditions which are important for encouraging agricultural growth and efficiency and on which the Government is prepared to take action. The first tranche of US$50 million would be available for disbursement upon loan effectiveness. The second tranche of US$50 million would be available for disbursement following completion with the second set of policy actions defined in the program. The first set of policy actions which took effect prior to Board consideration of this program was primarily oriented to liberalizing internal pricing and to achieving positive interest rates along with unifying most rates unless differences were justified by transaction costs including arrears. The second set continues price liberalization and progress on real rates of interest while focusing on trade policy and on improvement of inter-sectoral terms of trade. It also provides for policy reviews on export incentives, inter-sectoral terms of trade, public investment in agriculture, and for satisfactory progress on a set of studies financed under the loan. Actions Taken Prior to Board Presentation 59. Prior to Board Presentation, the following actions took place: (a) Purchases by ENAC and other public enterprises in order to support minimum prices of agricultural commodities were eliminated, except for two products; during the up-coming winter harvest, ENAC will continue to procure hard corn and rice. In order for the Government to maintain its credibility with producers, limited purchases of rice and hard corn by EN&C would continue until the second tranche since procurement prices have already been announced for the winter crop (harvested in November and December in normal years).  - 16 - (b) Official "maximum" consumer prices on all agricultural products except for wheat flour were eliminated and the sales of food at ENPROVIT outlets at minimum prices in poor areas were restricted to no more than three staple commodities (wheat flour, milk, and sugar). In order to avoid excessive windfall gains by owners of stored imported wheat, the Government needed to continue price controls on wheat flour at the consumer level after the exchange rates had been unified until existing stocks have been sold. However, the Government intends to adjust the maximum price level upward during the transition period and then eliminate controls. The three staple commodities would continue to be distributed at floor prices in poor areas in order to partially protect the food security of the urban poor. The loan would finance a study of ENPROVIT and of alternative schemes of ensuring adequate food intake by the poor in order to determine a cost-effective means of achieving this objective. (c) Agricultural lending rates were unified except for differences justified by transaction costs, at 21 percent for all agricultural loans with maturities of 90 days or more. Industrial lending rates are currently satisfactory at 26-27 percent effective nominal rates (for the purposes of the Loan, positive rates are defined to be lending rates including commissions and other related charges that are zbove a seasonally adjusted index of the previous six months inflation or, alternatively, 85 percent of a market-based certificate of deposit rate; currently, the inflation indicator reflects a 21 percent annual rate.) Proposed Conditions for Disbursement of Second Tranche 60. The conditions for disbursement of the second tranche would be the following: (a) Elimination of quotas and other quantitative restrictions on the imports of agricultural products and inputs and substitution by generally uniform tariffs at levels to be agreed to by the Bank aad to be determined from the internal terms of trade study (para. 6 M) and international long-term price forecasts. Although tariffs would be required to be generally uniform, some variability in tariffs would be permitted to compensate for short- term price deviations from long-term international prices. This would be necessary for instance in the case of milk powder and sugar where current prices are considerably below long-term projected prices. (b) Elimination of the maximum consumer price on wheat flour. By the time of the second tranche, the need to maintain price controls on wheat will have ended. (c) Elimination of purchases of hard corn and rice by ENAC or other public enterprises to support minimum wholesale prices. This would end Government procurement to support minimum prices of agricultural products. The future role of ENAC would also be studied under the program (para. 65).  - 17 - (d) Satisfactory progress on studies of public enterprises (para. 65) and inter-sectoral terms of trade (para. 61). Satisfactory pro- gress would be defined against a schedule of actions and targets spelled out in the terms of reference. Ten specific public enterprises-those most important in asset size--would be included in the initial survey. (e) Satisfactory progress in improving policies affecting inter- sectoral terms of trade and export incentives as determined through a joint review with the Government to take place no later than September 30, 1986. Although the recent devaluations have eased the bias against tradeables, the incentive to export agricultural and industrial products is significantly reduced due to the high protection offered to the industrial sector. Therefore, a policy that encourages trade and price liberalization in agriculture needs to be balanced by a gradual dismantling of protection for industry. A significant reduction of the number of coinmmodities covered by quantitative trade restrictions, and a lowering of the level and dispersion of tariffs on industrial commodities would thus be one condition required for achieving satisfactory progress. The Ministry of Industry has proposed an acceptable first step for tariff reform including almost total elimination of prior authorization to import except for commodities requiring restrictions due to health and sanitary reasons, a lowering of the maximum tariff from 220 percent to 125 percent, and a reduction of tariff dispersion such that 75 percent of commodities imported would have tariffs of 70 percent or lower. The adequacy of export incentives would be determined through net returns to crops Cbananas, coffee, cocoa, rice, hard corn, soybeans, cotton) as based upon an agreed-upon methodology for crop financial models. At least four of the seven crops mentioned would have to have (or continue to have) a positive net financial rate of return. The review of export incentives and internal terms of trade would be coordinated with the Bank's industrial lending operations and continuing dialogue with the Governmeat on trade reform. (f) Continued positive interest rates on lending, including commissions, and other related charges for the agricultural and industrial sectors as described in para. 59 (c). (g) Satisfactory 1986 public investment program for agriculture deter- mined through a joint review. As the current investment program is largely satisfactory, this condition would serve to identify any potentially poor new investments and to focus on the work of the policy analysis group on investment criteria (para. 62). Policy Monitoring under the Sector Loan 61. With technical assistance and analysis provided under the loan, a newly established Agricultural Policy Analysis Group reporting directly to the Minister of Agriculture would be strengthened to monitor the reforms under the loan. The following monitoring would be undertaken: (a) Differential Protection. Differential protection between agricul- ture and the rest of the economy would be monitored by estimating  - 18 - nominal and effective rates of protection for commodities produced in the two sectors. The Agricultural Policy Analysis Group, using technical assistance financed under the project, would conduct farm surveys on costs of production and make estimates of the effective rates of protection for agriculture. Monitoring of effective rates of protection for industry is currently being undertaken by the Central Bank. (b) Internal Terms of Trade. In conjunction with estimates of effec- tive protection, domestic terms of trade between agriculture and the other sectors of the economy would be periodically estimated to ensure that the agricultural sector is not unduly penalized by any of the multiple market intervention policies of the Government in other sectors. These estimates are well within the capabilities of the Ecuadorian Government, since its system of national accounts includes a yearly updated input-output matrix. Since terms of trade vary with the income and cost structure of the subsector and/or the population groups concerned, they should also be esti- mated for the main agro-economic regions of the country. The same group currently estimating industrial effective protection in the Central Bank would take responsibility for these estimates in con- junction with the Agricultural Policy Analysis Group. Technical assistance for the terms of trade studies would also be financed by the proposed loan. xc) Price Ratios. Exchange rate and trade policies and the dismantling of control prices would be expected to gradually bring domestic price ratios towards long-term expected international price ratios. Systematic comparisons between domestic and international price ratios taking into account transport and handling cost dif- ferences for all crops could be developed by the Agricultural Policy Group. 62. General Policy Analysis. In addition to the above specific anal- ysis, the Agricultural Policy Analysis Group with technical assistance financed by the proposed loan, would develop the capability to: (a) estimate gains and losses of alternative policy courses and of different degrees of departure from international price ratio parity; (b) monitor objectives and instruments of agricultural policies; (c) estimate financial and economic returns to various crops; and (d) establish investment criteria for public investments in agriculture. Technical Assistance and Studies 63. Technical Assistance. To support and implement the new policy framework of the Government, about US$1,000,000 of the Sector Loan would be allocated to the following technical assistance (draft terms of reference were agreed during negotiations). (a) Technical Assistance for the Policy Analysis Group within the Ministry of Agriculture would consist of (i) two micro-economists (for 18 man-months); (ii) one macro-economist (for five man- months); and (iii) short-term consultants (for 12 man-months).  - 19 - (b) Technical Assistance for policy analysis on terms of trade and exchange rates within the Central Bank would consist of a series of short-term consultants (for 4 man-months). (c) A series of short-term consultants (for 4 man-months) to the Ministry of Agriculture, for analysis of selected issues such as marketing and storage. 64. The Agricultural Policy Analysis Group as well as the Central Bank Unit in charge of disbursing the loan would also require limited micro- computers and software, included in the above total cost. Studies of Public Enterprises in Agriculture 65. In order to enhance the efficiency and improve the finances of the public sector, the Government intends to divest itself of several public enterprises, improve the efficiency of others, and change the principal activities of still others. However, to classify enterprises according to the suitability for action in these areas, the Government requires basic information on the financial, managerial, and technical status of the enterprises and estimates on the budgetary and economic implications of divestiture. It also requires proposals on steps to Improve the efficiency or to reform the functions of some public enterprises. To support the Government in carrying out its intentions with respect to public enterprises, the loan would finance three studies. (Draft terms of reference were agreed during negotiations): (a) The first, a broad-based study, would (i) identify and collect data on inventories, financial records, asset values, and status of plant and equipment of public enterprises; (ii) identify specific problems impeding the performance of these public enterprises and give an estimate of the impact that these enterprises have on the Government budget, internal and external debt, and foreign exchange earnings or payments; (iii) identify how Government policy, e.g., pricing, import quotas, etc., affect the performance of these enterprises; and (iv) establish criteria and recommend enterprises for possible divestiture and determine the policy framework that would be needed once divestiture has taken place. (b) The second set of studies would be an in-depth analysis of enter- prises recommended for divestiture including necessary preparations for their sale. For enterprises to be retained either fully or partially by the Government, the study would recommend systems for management and financial control and necessary upgrading of plant and equipment. (c) A third set of studies would proceed with respect to two enter- prises which have been identified as requiring Immediate in-depth attention. These studies would be on ENAC, to determine a future role for the enterprise including possible divestiture, and ENPROVIT to improve its delivery of food to the poor or determine an alternative, more cost effective means to achieve the objective of increased food intake of the poor. The estimated financing of these studies under the loan is US$1,500,000.  - 20 - Procurement 66. Sector Imports. Contracts for the procurement of goods estimated to cost the equivalent of US$5 million or more would be awarded following international competitive bidding (ICB) in accordance with Bank guidelines. Private sector imports under contracts below US$5 million would follow normal commercial practices. Contracts of lesser value by the public sector would be purchased following normal procurement procedures of the Government. 67. Technical Assistance and Studies. Locally and internationally recruited consultants acceptable to the Bank would be selected following Bank Guidelines for the Use of Consultants. To assure timely contracting of con- sultants for projects, the Government has decided to contract with UNDP's Office of Project Execution to recruit and administer contracts for indi- vidual consultants and firms to carry out studies. Disbursement 68. The proposed loan would reimburse 100 percent of the foreign exchange costs of eligible imports (para. 57(b) lists agricultural inputs to be financed) and 100 percent of the costs of technical assistance and studies. Disbursements would be made against the cost and freight of eligible imports subject to documentary evidence that expenditures had been incurred after the loan signing. They would be made against Statements of Expenditures (SOEs) certified by the Central Bank and only for expenditures made within 120 days of arrival of the goods within the country for the first tranche and within 30 days for the second tranche.2/ Contracts of less than US$50,000 would not be eligible for disbursement. The Central Bank would be responsible for collecting relevant documents in support of eligible imports, technical assistance and studies, and for preparing and forwarding withdrawal applications to the Bank. The supporting documentation of SOEs would be identified and filed by the Central Bank and made available to Bank missions for review. In order to facilitate disbursements, a Special Account with an initial deposit of US$20 million equivalent will be established with the Central Bank following standard Bank procedures. Both the SOEs and the Special Account would be subject to audits carried out by independent auditors acceptable to the Bank. 2/ The reduction in the number of days for payments to suppliers is to avoid delayed payments by the Central Bank, a practice conducted in the past to assist in rationing of foreign exchange. With the loan and the use of a Special Account, undue delay in payments would not be required.  - 21 - Benefits, Tpact and Risks 69. The policy reforms recently undertaken by the Government and the additional actions proposed under the loan with respect to the agricultural sector represent a fundamental change in the direction of policy from one of price controls and import substitution to one of price liberalization and export promotion. They represent a recognition that the agricultural sector has the potential to return to being a leading sector in the long-term growth of the economy and is fundamental to assuring improved living conditions for the country's poor, the majority of which live and work in the rural areas. 70. Benefits. In order to determine the benefits of the policy reforms of the loan, an agricultural sector model was constructed. The model divides the agricultural land area into six zones, each consisting of small, medium, and large farmers (one large public farm was also included). Farm models for each zone and farm type are estimated based upon actual and potential crop processes. Production possibilities are constrained by land, labor, and fertilizer availability. Changes in farm incomes, employment, and production are simulated for the removal of import constraints on fertilizer imports (a proxy for removal of foreign exchange constraints on imports of agricultural inputs) and the liberalization of agricultural commodities prices. The effects of import tariffs on some agricultural commodities--wheat, rice, cotton, and hard corn-are also estimated. Although the model is not explic- itly able to estimate the time required for these effects to be manifested, it is anticipated that these are medium-term adjustments, that is, within five years. Longer-term effects (10 to 20 years), for example from new plantings and rehabilitation of coffee and cocoa plantations, have not been estimated. Table 1 summarizes the results of the simulations. Table 1: Simulated Effect of Policy Reforms Policy Outcomes Policy Reforms Farm Incomes Agricultural Gross Value of Small Medium Large Employment Production Percentage Change from 1984 Base Levels-- Removal of Fertilizer Import Constraint -4 7 45 31 38 Plus Liberalization of Prices 26 26 58 28 48 Plus Import Tariff of 10% 48 43 70 27 59 of 25% 74 75 91 15 71  - 22 - 71. The removal of the constraint on fertilizer imports (constrained in the model to 1984 levels) through provision of foreign exchange for imports by the loan has a substantial effect on agricultural production and employ- ment with production increasing by 38 percent and employment by 31 percent. Without prices liberalized, the major benefactor would be large farms which have the resources to purchase fertilizer and grow high valued, fertilizer- intensive crops. With agricultural product prices liberalized, the benefits are spread more evenly because the higher prices permit more use of fertili- zers by small- and medium-size farms. Employment declines slightly from the without-price-liberalization scenario as production is diverted to less labor-intensive crops on small- and medium-size farms but remains 28 percent above the base case. Imposing an import tariff of 10 percent further increases farm incomes while only marginally affecting employment. Increas- ing the .mport tariff to 25 percent, although continuing to raise farm incomes especially small- and mediumr-size farms, substantially reduces employment from the level obtained under a 10 percent tariff. This occurs because the crops (e.g. wheat, soybeans, and barley) that are protected by the proposed tariff, and therefore, became more profitable, are less labor- intensive. Therefore, the balancing of the internal terms of trade between agriculture, and the rest of the economy through import tariffs on agricul- tural commodities must be done with moderation in order to aroid reducing the employment increases that are gained from removal of import and price constraints. 72. The effect of this increase in agricultural production on export earnings and substitution for imported agricultural products depends on other critical variables, such as the exchange rate and the growth of domestic income (and hence demand), which are outside of the model. However, some broad estimates are possible. If aggregate income growth in Ecuador is in the range of 3-4 percent p.a., per capita income growth would be in the range of 0.4 to 1.4 percent, implying an increase in food demand of 1-2 percent p.a. According to the estimates from the model, agricultural production would increase at a rate of nearly 8 percent p.a. under the reform program and with continued availability of foreign exchange for imports of agricul- tural inputs. Therefore, the reforms undertaken under the loan would gen- erate substantial surpluses available for export, or in the case of imported agricultural commodities, for import substitution. 73. Impact on Urban Consumers. A policy reform of this fundamental nature is not without costs. Although there will be a substantial benefit of the policy reforms to the rural poor, the removal of consciner price controls, along with the unification of the exchange rate, will raise the price of food to urban residents by 10-20 percent. Without compensating interventions, this rise in food prices would initially result in a decline in food intake of 2-4 percent for some of the urban poor. However, the maintenance of ENPROVIT operations and the general economic growth induced in part by agri- cultural growth (an increase in the income of the poor by 4-8 percent will fully compensate for the price rise) will assist in buffering the impact of these price increases on many of the urban poor. In addition, the loan would focu.; the operation of ENPROVIT on three essential commodities and finance a study to improve its delivery of food to the poor and to explore alternatives of achieving increased food intake of the poor.  - 23 - 74. Risks. The major risks of the project depend on the political sustainability of these reforms, the future trends in international prices for agricultural commodities, and the maintenance of an attractive exchange rate for export promotion. Although the policy reforms proposed under the Sector Loan can be implemented without legislative action, the Government will be under continuing pressure to modify or reverse its policy reform. So far, the new Government has maintained its original policy objectives despite resistance to liberalization. 75. As the agricultural sector becomes more directly connected with international markets, the price and international market prospects for agricultural commodities become critical in determining to a large extent the growth of the sector. According to a recent report on price prospects for major primary commodities and the Bank's commodity price forecasts, export volumes of commodities important to Ecuador's agricultural sector are pro- jected to increase modestly for traditional exports and more vigorously for non-traditional exports, while prices are anticipated to mostly decline or rise modestly (except for rice). Table 2: Projected World Export Volumes and Price Changes, 1985-95 Real Value Commodity World Export Volumes Price Change Increase (1983 Constant US$) (- decrease) (Percent Per Annum) Coffee 1.4 -0.46 0.94 Cocoa 1.9 -0.45 1.45 Bananas 1.7 -3.08 -1.38 Corn 3.4 -0.92 2.48 Rice 3.3 3.58 6.88 Soybean Oil 4.8 -1.16 3.64 cotton 1.1 0.29 1.39 76. As shown in Tabte 2, although price prospects are less favorable than the prospects for growth in world export volumes, these projections indicate that if Ecuador achieves a growth in export volumes at least equal to world export volumes, a growing trend in export earnings could be sus- tained for non-traditional exports-rice, coarse grains, soybeans, and cotton. Much less sustainable prospects are for the traditional exports facing rather inelastic demand, such as coffee, cocoa, and especially bananas. A diversification of agricultural exports and an expansion of market shares are thus necessary for growth in agricultural export earnings of 3-6 percent p.a. 77. Critical to entering non-traditional export markets and expanding traditional markets is avoiding an overvaluation of the sucre. Currently, the parallel market rate is about 18 percent above the intervention exchange rate, which has not been devalued since September 1984, despite an inflation  - 24 - rate of 25-30 percent p.a. Although the sucre appears not to be currently overvalued compared to 1970 levels, the rates of inflation indicate that the effective exchange rate is deteriorating and that the sucre could become overvalued in the near term. The IMF is monitoring this situation and the Bank and Fund have coordinated their analyses of export incentives so that positions of the two institutions are consistent. However, under the loan, rates of return to agriculture would be monitored and required to maintain satisfactory progress in improving export incentives, one of which is of course the adequacy of the exchange rate. This issue will continue to receive high priority. PART V - CONHENDATIONS 78. I am satisfied that the proposed loan would comply with the Articles of Agreement of the Bank and recommend that the Executive Directors approve the proposed loan. A. W. Clausen President Attachments October 2, 1985 Washington, D. C.  - 25 - ANNEX I ECUADOR - AGRICULTURE SECTOR LOAN Page 1 of 6 SOCIAL AND ECONOMIC INDICATORS sausol - SoesAL 101 w 1 ? 3 2 b uc <~~~aeu , H KDOKA 19601 10701b U3 rA LA?. MCh & CAR Zu1309 10L *1 283.6 263.6 263.6 47. "A 63.3 ,. 3 CI (0 .. .. 1420.0 1873.6 21*4.3 - mmwu m coirn cm co,I or 0oL sunVAu 131.0 223.0 571.0 993.6 l119.$ POFULATION.ID-!U CTUOSAM) U422A0 3364.0 8216.0 324 PiU.A!S0N CZ ofAvo 34.4 39.3 44.4 67.7 0*3s POIULTUN nwNOIIEI OULIU In 1 2W0 (KU.) 12. T*Z3 oIULaTZoS CHILL) 23.0 i0hU1*ZCU fONO= 1.9 IOIULATON 011011t 13 sq. U. 13.6 20.7 29.0 46.0 64.7 M SQ. is. h-t, LAW 9.1 120.8 L22.3 91.1 166.9 POFU=OI J SA ICTUUZ CZS) 0-14 as 44.4 43.3 43.8 36.3 31.2 13-6 u3 1.I 30.6 32.7 37.1 61.3 63AM ADM5 3. 3.6 3.4 4.2 7.2 IOPULATIW 01093 34r5 CZS) TOTAL 2.9 2. 2.6 2.4 1.6 URBN 4.J 4.2 3. 3.6 3.7 CRUDD ZZ1121 CPU 46.6 43.2 37.0 30.9 23.4 con UME RaTn CPU 2300611) 16.6 12J 0 .1 8.0 6.9 C038 I0R0UCI 3M 3.4 3.2 2. 2.0 1.3 ACCI08. ANUAL (C9110) .. 9.0 32.3 / 33Z CS 0 ufl .. .. 40.0 45.3 1M OF NO PROD. M CAPITA (L91371-100) 104.0 101.0 62.0 10.6 109.1 MU CIPIT so111801 C4O3 CS CZ o8r )NIT) 76.0 89.0 97.0 113.2 131.3 133O36 Ca lS "a 1) 48.0 2.0 30.0 69.4 92.4 of 93C AUfLAM PUL S 23.0 27.0 26.0 34.2 34.3 CILD CMS 1-I4) DgT 3 26.2 17.J 7.0 4.6 *.7 Lin 1cc. AT m (13A3) 50.7 33.9 62.6 64.6 67.2 i- anT 1mr. 3m (5 90158) 140.0 107.3 76.0 59.7 53.3 :ACS 7'0 $M US CMS) TOTAL 12.3 JfL 36.0 45.0 /a 65.3 70.2 03JA1* 32.J Mif 76.0 82.0 7: 76.3 89.4 NaSAL 1.9 idj 7.0 16.07 - 4.2 37.0 ACCESS TO 57AK 313P06A1 Cs of POULATIO) TAL .. 22.4 25.0 56.3 59.6 RAXI .. .. 39.0 73.4 65.9 ul .. .. 14.07 23.3 47.6 PU3ULATOIW M P 1UZCXAN 2670.0 2320.0 760.0 1909.7 1070.6 10. 152 3U 2 1233 2340. if L380.0 570.0 506.2 746.5 Pto. MU IUTAL 32U TOTAL 530.0 620.0 500.0 362.0 324-3 ORMAN 300.0 f 300.0 .. 422.0 201.9 322*1. .. 4440.0 .. 2716.7 4319.7 AMaSSI M3 STAL 3 .. 17.1 .. 27.3 20.0 A133RA3 SIZZ OF HOUSEHOLD TOTAL 5.1 /f 3.2 -^l .. .. . .. URL .. ....