Philippines - Sugarlands diversification study

Report No. 6042-Pi The Philippines Sugarlands Diversification Study May 30, 1986 Projects Department East Asia and Pacfic Regional Office FOR OFFICIAL USE ONLY Document of the World Bank This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents ma-, not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS P 1 = US$0.054 (Average floating exchange rate in 1985) US$1.0 = P 18.50 FISCAL YEAR. January I to December 31 WEIGHTS AND MEASURES 1 picul = 63.25 kilogram 1 kilogram (kg) 2.2 pounds (lb) 1 metric ton (tonne) 2,205 lb I hectare (ha) = 2.47 acres ABBREVIATIONS AND ACRONYMS CB _ Central Bank of the Philippines DBP - Development Bank of the Philippines EPD - Economic Analysis and Projections Dept., World Bank GDP - Gross Domestic Product MAF - Ministry of Agriculture and Food MTI - Ministry of Trade and Industry NASUTRA - National Sugar Trading Corporation NEDA - National Economic and Development Authority NFA - National Food Authority NIA - National Irrigation Administration PCARRD - Philippine Council for Agriculture and Resources Research and Development PD - Presidential Decree PHILSIUCOM - Philippine Sugar Commission PHILSUCOR - Philippine Sugar Corporation PHILSUMA - Philippine Sugar Marketing Corporation PNB - Philippine National Bank PS/Ha - Piculs of Sugar per Hectare PS/TC - Piculs of Sugar per Tonne of Cane RPB - Republic Planters Bank SDT - Sugar Development Technologist UPLB - University of the Philippines at Los Banios  FOR omCAL USK ONLY PHILIPPINES SUGARLANDS DIVERSIFICATION STUDY Tabte of Contents Page No. PREFACE EXECUTIVE SUMMARY .............. . - , , 0 Vii I. OVERVIEW OF THE SUGAR SECTOR AND ITS PRESENT "ITUATION .......... 1 Sector Background............................................* 1 Role of the Sector in Exports............................... 1 Value Added and Employment ...... ............... ... .... . 1 Area and Production ................. I ..... .. 1 Regional Characteristics, Structure and Yields.............. I Milling..... ......................... .... ................ .... .. 2 Domestic Consumption .............. .... 2 Institutional Organization.................................. 2 Causes and Effects of the Sugar Industry Decline................. 2 The Problem of Negros................................... .... 3 Government Response to the Industry Crisis....................... 4 II. ELEMENTS OF SECTOR ADJUSTME.T.. . ............... 5 Rationalization ........ 6 Projected World Prices ....................... * 6 Domestic Cost of Production ..... 6 US Sugar ..............................................-.... 7 Projected Domestic Demand .............. 7 Sugar Stocks8.............................. ............ ...... 8 Desirable Sugar Production Level............................ 8 Sugar Mill Capacity Rationalization and Production Quotas ...................................... 9 Product Diversification (Ethanol)................................ 12 Crop Substitution and Diversification ............................. ...... 13 Sugarcane-Based Diversification......................... ... 16 Crop Substitution.... .......... .... 17 Improving Sector Efficiency ...................................... 21 Farm Productivity ...................................................... 22 Input Use, Farm Size and Cost of Production ............ 22 Ratoon Culture and Yielts.............................. 23 Irrigation.**...................................... 24 Sugar Research and Extension........................... 26 Cane Harvesting, Loading and Transport....................... 27 Technical Processing Efficiency............................. 28 This document has a estricted distibution and may be usd by recipients onbl in the peffomance of theit official duties. Its contents may not otherws be disclosed without World Dank authoriation.  -.2i Page No. III. POLICIEs AND PRoCRAMS FOR SECTOR ADJUSTMENTo...................... 28 Short-Term Government Assistance Measures......................... 29 Recommendations Supporting Crop Substitution and -Diversification ..... *9*.................. .... * .... ............... 29- Land Distribution Policy.................... ............. .... 29 Irrigation Policy and Program......... 32 Pricing and Marketing Policies for Alternative Crops in Sugar1ands04**&* ............................... 33 Government Programs for Crop Substitution and Recommendations Supporting Sugar Sector Rationalization and Efficiency Improvement .......... , 35 Sugar Financing Policy ...... .... 35 Trade and Pricing Policies for S 38 - Marketing Policy for Sugar.................................. 41 Planter-Miller Revenue Sharing Arrangements ................. 46 Institutional Adjustment and Strengthening .................. 48 Proposed Government Programs to Improve Sugar Sector Efficiency ..................................... 49 Action Prga ................................50 ANNEX A Draft Terms of Reference for a Study of the Viability of Sugar Mill Districts ANNEX B Draft Terms of Reference for a Study of Sugar Financing and Loan Arrearages ANNEX C List of Background Papers ANNEX TABLES Table 1: Area Harvested, Sugar Production and Yields per Hectare (1947/48- 1985/86) Table 2: Area Harvested, Productivity and Sugar Production by Mill District (Average 1979/80-1983/84) Table 3: Dacline in Area under Sugarcane Table 4: Sugar Production in 1984/85 vs. 5-year Average (1979/80-1983/84) Table 5: No. of Sugarcane Planters by Farm Size Table 6: Sugarcane Area by Farm Size Table 7: Sugarcane Productivity by Farm Size Table 8: Utilization of Mill Rated Capacities (Average 1979/80-1983/84) Table 9: Utilization of Mill Rated Capacities (1984/85) Table 10: Regional Cost of Production (On-Farm) of Sugar Table 11: Domestic Resource Cost Estimate by Sugar Region Table 12: A - Crop Budget (1 ha) for Plant Cane Table 12: B - Crop Budget (1 ha) for Ratoon Cane Table 13: Cane Yields of Selected Countries Table 14: Productivity and Cost of Production of Major Sugar Producing Countries Table 15: Sugar Production Costs for Different Farm Sizes Table 16: Production Characteristics of Mill Districts (1983/84) Table 17: Distribution of Sugarcane Area by Productivity Level  MAPS IBRD 19441 - Philippines - Ainfall and Cyclones IBID 19442 - Philippines S Sugar Mills and Refineries  PREFACE Beginning in 1984, the sugarcane area and sugar production in the Philippines have suffered a drastic decline due to the country's acute finan- cial problems and the sharp drop in world sugar prices. As a result, sugar workers have been facing serious unemployment and underemployment. The objective of this report is to review the present problems of the country's sugar sector and recommend to the Government policies and programs to facili- tate and manage the sectoral adjustment process now under way. The recommen- dations take into account the need for productivity and income growth and sound environmental management in the sugar areas. This report is based on the findings of a mission which visited the Philippines in June,'July 1985, consisting of Messrs. S.Z. Husain (Leader - Economist), E. Lutz (Agricultural Economist), C. Bevan (FAO/CP - Agronomist), D. Kraatz (FAO/CP - Irrigation Engineer), L. Doherty (FAO/CP Consultant - Marketing), E. Rosario (Consultant - Sugarcane Agronomy) and H. Idehara (Consultant - Sugarcane Processing). Ms. S. Kulsrethsiri collaborated in the analysis of sugar financing. Editorial assistance was provided by Ms. P. Brereton. The draft of this report (dated March 6, 1986) was discussed with various Government officials and sugar industry representatives in the later part of April 1986 in Manila. The report incorporates new information which came to light during those discussions. References in the report to Govern- ment performance, decisions and agreements are to those of the previous Government; the new Government, which came to power in February 1986, is specificaily referred to, wherever relevant.  - vii - EXECUTIVE SUMMARY Sector Background 1. The sugar sector has played a significant role in the Philippine economy. During 1973-82, sugar exports averaged some 1.4 million tonnes p.a.-- 'which were about 601 of total domestic production) and accounted for an average 12% of the total value of merchandise exports. During this period, the sugar industry employed some 500,000 workers in production and processing. In 1983, sugar accounted for about 4% of the gross value added of the agricultural sector. 2. During 1979/80-1983/84 the sugarcane area averaged about 442,000 ha with production of about 2.4 million tonnes p.a. Since thent however, owing to financing constraints caused by the country's tight liquidity situation and a decline in the world price of raw sugar, both the sugar area and sugar- production have dropped sharply. In 1984-85 sugar covered some 385,000 ha producing some 1.7 million tonnes and projections for 1985-86 indicate a further decline to about 321,000 ha producing about 1.3 million tonnes, or a decrease of about 28% in the sugar area and 45% in production compared to the five-year average through 1983-84. 3. Of some 30,000 sugarcane growers in the country, about 77% have small farms below 10 ha, 18Z medium-sized farms of 10 to 50 ha and 5% large units of above 50 ha. In terms of the total sugarcane area, however, small farms account for only about 22% while medium and large farms account for about 35% and 43%, respectively. Land distribution is thus highly skewed. There are 41 sugar mills in the country (38 currently operating) with a total milling capacity of about 3.5 million tonnes of raw sugar per year. The five- year average (1979/80-1983/84) capacity utilization was 70%. The figure for 1984/85 is only about 50%. 4. World raw sugar prices averaged about 5 US cents/lb in 1985 and are projected to remain below 9 US cents/lb in 1985 constant dollars for at least the next three years. At these prices, the Philippines will not be able to profitably export raw sugar except under the US quota which is 210,000 tonnes in 1986. Export of refined sugar, which commands a premium of only 2 US cents/lb over raw sugar, is also not profitable at current prices. At present, except in marginal sugarcane areas and on very inefficient farms where the cost could be higher, the maximum on-farm cost of producing sugar in the Philippines is an estimated 5 US cents/lb equivalent (at an exchange rate of P 18.5 = US$1). With the very low sugar milling capacity utilization in 1985, the total processing cost is estimated to range from 5 US cents/lb for some old mills to about 25 US cents/lb for some new mills which have high finance charges on their outstanding debts. Operating costs are estimated to range from 2 to 6 US cents/lb. If only operating costs were to be covered, then some mill districts could export at a FOB Manila price of about 9 US cents/lb. If capacity utilization of the more efficient old mills returned to their 1983-84 levels and consequently their processing cost declined to about 3 US cents/lb, they could cover all their costs (including finance charges) and export at a FOB Manila price of about 10 US cents/lb. Prospects for  -viii-~ Philippine raw sugar exports should be better by 1990 when the world price is projected to increase to 14 US cents/lb in 1985 constant dollars. Thereafter, prices are expected to decline once more. 5. Given the inability of the sugar industry to profitably export at the prevailing world price, the decline in both the sugar area and sugar production was inevitable. The adjustment, however, has been sudden and disorderly and has entailed high economic costs, mainly due to the decline in financing available to the industry since early 1984. The financing constraint was brought on by several factors including the liquidity squeeze in the economy resulting from the Government's macro-economic stabilization program; the closure of the Central Bank (CB) rediscounting window which was the major source of credit for the sugar sector; the instability and uncertainty of Government's sugar marketing policy which made some banks reluctant to lend for sugar; and the inability of some planters to repay their 1983/84 loans owing to drought and the cQnsequent refusal of banks to approve new loans. 6. With much of the released sugarcane land remaining idle, over 100,000 sugarcane workers are either unemployed or underemployed. The employment problem has been particularly severe on the Island of Negros, which in the past accounted for over 501 of the country's sugarcane area and over 200,000 of its workers, and specifically in the Province of Negros Occidental, where over 70% of the total cultivated area was devoted to sugarcane and where alternative employment opportunities for workers are very limited. The highly skewed distribution of the sugarlands intensified the employment problem -- if the industry had been dominated by small farmers, who are mostly self-financed and cannot afford to leave their lands idle for long, crop substitution and consequently provision of alternative employment would have occurred much faster. 7. Since its inception in 1977, the Philippine Sugar Commission (PHILSUCOM) has been responsible for policy-making and regulation in the sector. During most of 1977-85, the National Sugar Trading Corporation (NASUTRA) had been the sole agency involved in domestic trading and export of sugar. In late 1985, in an attempt to rationalize the industry, the Govern- ment announced the establishment of the Philippine Sugar Marketing Corporation (PHILSUMA) as the single buying and selling agency to replace NASUTRA, the planned closing of six sugar mills and a production quota allocation for the remaining mill districts for the 1986-87 crop year. These decisions were, however, soon reversed, and free domestic trading of sugar was allowed side by side with PHILSUMA. Instead of mill closure and the production quota, market forces were allowed to determine the direction and speed of the adjustment process. The Government also agreed with the Bank and the IMF under the IMF standby program, henceforth referred to as the Bank/IMF program, to implement several important institutional changes that would have contributed to the sector's streamlining and adjustment. After the new Government came to power in February 1986, a Sugar Industry Advisory Council, composed of representa- tives of sugar planters and millers, was created. The Council has submitted some important proposals to the Government for reorganization and reform of the sugar industry. The proposals are largely in line with the Bank/IMF program and the recommendations of this report. The most significant proposal  - ix - is to dissolve PHILSUCOM and instead create three separate bodies viz. a regulatory body to be named Sugar Board which would be under the Ministry of Trade and Industry, a private Research and Development (R&D) Foundation and a private Socio-Economic Foundation. Consideration is also being given to phasing out PHILSUMA after the ^urrent milling season. Recommended Strategies for Sectoral Adjustment 8. Given bleak world sugar price forecasts for at least the next three years and the high economic costs of the market-induced adjustment so far,-the critical issue is how to achieve a reduction in sugar output and at the same time minimize short-term economic costs and provide for longer-term producti- vity and income growth in the sugar areas. Four principal strategies are proposed to bring about the orderly adjustment of the sugar sector: (a) effi- cient rationalization (contraction) of sugar production capacity; (b) product diversification, principally through the use of cane to produce ethanol; (c) crop substitution and diversification in sugarlands; and (d) improvement of sugar sector efficiency to enhance the medium- to long-term competitiveness of the Philippines in the world sugar market. The rationale for the four strategies and particular problems to be addressed by each strategy are dis- cussed below, followed by recommended policies and programs to effect the desired changes. 9. Rationalization (Text paras. 2.11-2.20). With the viable export market for at least the next three years restricted to the US quota, production of sugar in the Philippines has to be predominantly for the domestic market. Current estimates of annual domestic demand ranga from 0.9 to 1.1 million tonnes. Annual production of raw sugar should, therefore, be 1.1-1.3 million tonnes for 1986/87, with the lower end of the range probably more appropriate. Maximum raw sugar production should be about 1.4 million tonnes by 1990. With sugar production of 1.1-1.4 million tonnes, about 170,000-230,000 ha would be released from sugarcane and become available for crop substitution. Up to 80,000 ha less would be released if the proposed ethanol program proves viable (para. 14). 10. Given the present installed processing capacity of 3.5 million tonnes of raw sugar per year, the desirable production level of 1.1-1.4 million tonnes would represent a mill capacity utilization level of only 31- 40Z, assuming all sugar mills were operating. At such levels, unit processing costs are extremely high and mills can only remain viable if prices are artificially supported. This is not a desirable alternative. Since the ethanol program geared to the domestic market would only marginally improve the average capacity utilization level, some mills will have to close. The issue is whether the present policy of letting the market process adjust the capacity of the sugar industry (para. 7) should be continued or some form of Government intervention is desirable. As part of agreements under the Bank/IMF program, the Government was to review by July 31, 1986 its decision not to close any mills and the need for a quota system. The need for this review remains.  ll. By the above date, the results of the current milling sea will be available. In addition, the Government wil_ want to take into acco. the following considerations. As an agro-ind-.try, sugar is most depen nt on milling capacity and, therefore, changes in the total area and location of sugarcane production and adjustments in processing capacity have to be closely linked. Since the estimated sugarcane acreage and sugar production in 1985/86 are close to the desirable level (paras. 2 and 9), it may appear that on-farm rationalization of sugar has already occurred. However, the cutback is not in response to price signals: it is probably a temporary phenomenon resulting from the financing problem (para. 5). Processing capacity rationalization (mill closzres) has not happened so far and'all the mills are operating, albeit at unviable capacity utilization levels. The market process has not yet led to closure of mills because of rigidities in the sugar processing sector. Half of the sugar mills are now in the public sector, heving been taken over by Government banks for failure to repay loans. These mills are being implicitly subsidized, since the Government banks are repaying the mills' foreign debts and little or none of-the local currency debts are being repaid by the mills. The large size of investments in sugar processing and very low sale value of the mills, given the current low world sugar prices, are additional factors causing rigidities. As a result, rationalization through the market process could be protracted and the economic costs high in the form of continued operation of mills at unviable capacity utilization levels and/or closure of even efficient private milLs which may not be able to compete with mills now in the public sector. 12. Under the Bank/IMF program, the Government agreed to divestiture of mills now in the public sector and transfer of these to an Asset Management Trust pending their divestiture. However, the need for closure of some of those mills will remain and Government intervention may be needed to assist the market process. Short-term Government intervention could be through provision of incentives for voluntary closure of some public and private sector mills, forced closure of some public sector mills, imposition of production quotas on surviving mills and improvement of sugar financing arrangements. The Government should first offer compensation to mill districts which voluntarily announce by August 31, 1986 their decision to close. If none comply, a forced closure of some public sector mills would be necessary. The Government then would need to announce a program well before the next planting season begins in October 1986. To assist in this process, it is essential that the Government immediately initiate a study of the viability of mill districts, to be finalized by the end of July 1986. A compensation scheme for mill districts which will go out of sugarcane should also be formulated. The most expedient alternative in the short-term appears to be a levy on sugar production in the remaining mill districts, with Government infrastructural investment programs considered for these mill districts in the medium- to long-term. 13. A more complex issue is whether, even after mill closures, produc- tion quotas will be necessary, considering that there will be some excess processing capacity to take care of a possible ethanol program and some future world market exports. There are two arguments against production quotas at this stage: (a) once mill closures have taken place, the market process should determine sugar prices and production; and (b) since the financing  - xi - problem appears to have become worse and the 1986/87 sugarcane crop is now projected by some sugar produce.s to be even less than the desired level, there is no need for production quotas. However, once again, the short-term problems in the sugar industry have to be taken into account. It appears that commercial banks are over-cautious about financing sugar at present due to the uncertainty about the domestic trice level of sugar (see paras. 34 and 39) which in turn is due to lack of reliable information on current sugar stocks and domestic demand level on the one hand and the huge excess sugar processing capacity and absence of production quotas on the other. These uncertainties are an inevitable result of the sudden change from a single buying and selling agency (NASUTRA), which guaranteed to producers and banks a minimum liquidation price (see para. 34), to a free domestic market where the price level is difficult to predict. The short-term uncertainties could be considerably reduced if the Government were to work out a rational production target, taking into account confirmed data on sugar stocks in the country and the actual sugar consumption in 1985, and allocate quotas to planters based on their average production in the last few years. This would be extremely useful to banks in taking their financing decisions regarding individual planters. Once the free domestic market processes are generally understood and prices can be anticipated, there may not be any need for production quotas and the market process could efficiently determine sugar prices and production. The need for production quotas in the short-serm should be reviewed over the coming months, so that a decision can be taken in good time before the next planting season. If a system of quotas is introduced, quotas should be transferable among and within mill districts. 14. Product Diversification (Text paras. 2.21-2.23). Ethanol is presently the most significant available product diversification option. The Government envisaged the eventual production of 600 million liters of alcohol per annum from sugarcane, equivalent to about 800,000 tonnes-of raw sugar; of this, 300 million liters were expected to be exported. A detailed feasibility study of this program has reportedly been completed but not yet released. Preliminary findings indicate that the prospects for exports are limited and that initially the Philippines would have to concentrate on the domestic market. Since the installation and start-up of the distilleries would take at least 18 months, and more probably two to three years, the program's benefits would not be felt in the short term and would not address the current employment problem. If the ethanol program is found feasible, the most appropriate course of action would be to encourage private sector investment in distilleries. 15. Crop Substitution and Diversification (Text paras. 2.24-2.41). Both crop substitution (in areas wniich have gone out of sugarcane) and sugarcane- based diversification (development of complementary production activities with sugarcane as the main crop) could have an immediate significance for over- coming ur,employment and underemployment in the sugar industry. The prospects for sugarcane-based diversification currently appear somewhat limited, hov- ever, at least in the medium-term. Two possibilities have been identlfea intercropping with mungbeans and peanuts, and livestock integration. Since the available varieties of mungbean and peanut have been developed for monoculture, shade-tolerant varieties suitable for intercropping would have to be bred. Furthermore, the domestic market for both crops appears to be small,  - xii - although peanut oil might be exported, using the presently sizeable unused capacity in coconut oil processing. This, however, needs to be investi- gated. The integration of ruminants in sugar areas has been suggested in view of the availability of sugarcane by-products which can be used as feeds. The dairy industry and cattle fattening for sale have some prospects. But a shortage of improved animal stock, insufficient familiarity with dairy tech- nology and low domestic prices of dairy products as a result of cheap imports are major problems for producers. Furthermore, previous estimates of domestic resource costs show import substitution of dairy products in the Philippines to be highly uneconomic. The economics of these ventures thus needs further review before significant Government investments are made in establishing herds and training farmers. 16. The identification of economically efficient crop substitution op- tions in sugarlands is difficult, particularly for Negros, because of the pau- city of land capability data. A land capability survey of Negros should, therefore, be undertaken as soon as possible. On the basis of the data that do exist, the following crop )ptions are available. 17. Rice is the most significant alternative crop in the sugarlands. However, the Philippines is now almost self-sufficient in rice and if any ma- jor increase in rice production occurs over the next few ,..ars, the disposal of rice surpluses would become an issue. The world rice price would have to increase by at least 25% from its present level before the Philippines could enter the export market. Rice pricing and marketing policies need to be reviewed to facilitate rice export in the coming years (para. 31). 18. Corn has attractive prospects as an import substitute for animal feed. Although domestic demand for feed has been depressed by the economic recession, it is expected-to resume as the economy recovers. Exports in the medi tm term are, however, unlikely at current and projected world prices. The Government's extension and financing programs for corn expansion in sugarlands should, therefore, be carefully monitored keeping in view the feed demand recovery. 19. Small domestic markets also exist for mungbeans, peanuts, sweet potato, and cassava. Substantial scope for import substitution of soybean cake for animal feed exists, but the technological package for soybean needs further development. The results of the Soybean Pilot Production Program of the Philippine Council for Agriculture and Resources Research and Development (PCARRD) should be reviewed before a significant expansion of soybean acreage is encouraged. Consideration should be given to assisting PCARRD to establish a legume research and development center similar to the one already existing for root crops. 20. The best perennial crop options are coconut, rubber and cocoa. For rubber and cocoa in particular, the existing infrastructure in sugar mill districts and the familiarity of farmers with arrangements for centralized processing provide an excellent basis for nucleus estates. Ipil-ipil tree cultivation offers another possibility, particularly on the marginal slopes in Negros. Ipil-ipil stalk for firewood and leaf for animal feed have a good domestic market and leaf meal has an attractive export market in Japan.  - xiii - 21. Improvement of Sector Efficiency (Text paras. 2.42-2.66). The fourth major strategy for sectoral adjustment, that of improving sugar sector efficiency, is of a -longer-term nature. Compared to many major sugar pro- ducers in the world, the Philippines has low on-farm productivity and techni- cal processing efficiency. Both average yields of cane and sugar per ha (53 tonnes and S tonnes, respectively) are low. However, it is the cost of production rather than yield per ha which is important. The factors causing both low cane yields and high production costs in the Philippines are: (a) the use of marginal land for an estimated 25-30% of the sugarcane area; (b) poor quality seedcane material; (c) poor ratoon yields of the most commonly planted variety; and (d) uneven distribution of rainfall in many areas and provision of irrigation for only about 92 of the sugarcane area. These factors should be addressed in the proposed productivity improvement program (pars. 44).- 22. Average technical processing efficiency of sugar in the Philippines is also.low compared to that in Australia, South Africa and the US. This is caused by equipment imbalances (inconsistent capacities at various processing stations) and managerial inefficiencies in both old and new mills. At present little incentive is provided to increase mill efficiency by the prevailing fixed revenue sharing between planters and millers (paras. 42-43). Low quality of incoming cane and long periods of insufficient cane supplies resulting in high factory downtime also contribute to low technical processing efficiency and high processing costs. Policies and Programs for Sectoral Adjustment 23. To address the severe unemployment and underemployment problem in Negros, some short-term, emergency measures are being carried out by Govern- ment. These include a rice loan program and a food-for-work type program which is assisted by WFP/UNDP/ILO. These measures need to be complemented with the medium- to long-term programs and policies for sectoral adjustment discussed below. Crop substitution and diversification are the most crucial needs and should be encouraged through land redistribution; expansion of irrigation, particularly on Negros; a review of rice pricing and marketing; and investment programs for research, extension, market infrastructure, surveys and studies. To facilitate sector rationalization and improved efficiency (which have significant interrelationships), the important measures include: improvement in sugar financing arrangements; linkage of trade and pricing policies-for sugar with long-run world prices; further liberalization of sugar marketing; the direct purchase of cane; and investment programs for sugar research, extension and mill district planning. Measures needed for ethanol production should be defined once results of the ethanol program feasibility study (para. 14) are available. Policies and Programs for Crop Substitution and Diversification 24. Farmers have thus far been slow to change their cropping patterns because,-given present relative prices, sugarcane is still the most profitable rainfed annual crop to grow in most sugar areas. Many farms have, therefore, been left uncultivated in the expectation that the financing situation will improve and the lands can again be planted to sugarcane. In addition, many  - xiv - farms which have been foreclosed by the banks due to unpaid loans have not yet been sold and remain uncultivated. Other reasons for slow crop substitution are: (a) although an existing Presidential Decree exempts all sugarlands from the land reform laws pertaining to rice and corn, there is an apprehension among many large planters that land reform may be introduced if they diversify into rice and corn on a large scale; (b) many planters, particularly in Negros, are-relatively unfamiliar with the commercial production of annual crops other than sugarcane or, owing to high interest rates, are unwilling to invest in perennial crops with long gestation periods; (c) given the law and order situation, particularly in Negros, pilferage is a possible problem, particularly of rice and corn; (d) availability of credit for other crops remained a constraint, though not of the same magnitude as for sugar, in 1984 and 1985; and (e) a shortage of post-harvest facilities, particularly for - corn, is a constraint in some areas. The following policies and programs would serve to address these problems and accelerate the movement into new - crops. However, the choice of alternative crops should be market-determined. 25. Land Distribution (Text paras. 3.03-3.08). Concentration of land ownership appears to have slowed down the crop substitution and diversifica- tion process (paras. 6 and 24). Since the cost of production per unit of sugar output is estimated to be generally lower on small farms than on larger farms in the Philippines, land redistribution is unlikely to reduce the country's long-run cost competitiveness in sugar. In particular, there appears to be no rationale for exempting from land reform sugarlands taken out of sugarcane as a result of industry rationalization. However, a general redistribution of sugarlands at this time would create serious instability and merely compound the already severe problems of the industry. Therefore, a limited land reform currently seems practicable. 26. A land redistribution policy in sugarcane areas based on the following four elements to be considered by the Government: (a) voluntary granting of agricultural lease-hold by landowners to workers and other voluntary land sharing arrangements to be encouraged on all sugarlands; (b) sale of lands foreclosed by the banks to the sugarcane workers, who previously worked on these lands and who have the financial means to buy or, alternatively, sale of these lands to the Government for resale to workers over a period of time; (c) for mortgaged sugarlands with arrears but which have not yet been foreclosed, granting of agricultural leasehold to workers on a part of the land as a condition for any debt rescheduling; and (d) land reform on sugarcane lands not planted to any crop for (say) three consecutive years starting in 1985-86. The latter measure is likely to create pressure on large planters to accelerate crop substitution and diversification. 27. A task force should be set up to prepare the land redistribution program as well as a detailed financing plan for the purchase of land and crop production inputs by land reform beneficiaries. Implementation of this -program would be a major step towards restructuring the sugarlands, particu- larly on Negros, besides being an important poverty alleviation measure since sugarcane workers have remained a major poverty group in the country and the recent problems of the industry have only worsened their situation.  - xv - 28. Irrigation (Text paras. 3.09-3.10). The Government, through the National Irrigation Administration (NIA), focussed its irrigation strategy on attaining self-sufficiency in rice through the provision of irrigation facilities to small farmers. Given this emphasis, NIA has not ventured into sugarcane irrigation, and its presence in Negros has, therefore, been very limited. 29. Irrigation of the sugarlands would serve several purposes besides increasing cane yields. By increasing the productivity-of farms and thereby reducing the total cropped area, irrigation would lower the cane transport cost which is currently a major cost in sugar production. Moreover, irrigation can be an important step towards diversification in sugarlands since it provides an incentive for farmers, particularly small farmers who have no fear of land reform, to switch to rice, which is more profitable than sugarcane under irrigated conditions. 30. The provision of irrigation facilities would be particularly effective in helping to restructure and diversify the agricultural economy of Negros. Plans for this development should be geared to a cropping system that includes sugarcane, paddy and specialized crops such as soybeans and cotton. Initially, four prefeasibility studies prepared by NIA several years ago for Negros should be updated, and if these investments appear viable, irrigation in Negros should be included in the country's limited program of new investments in irrigation i. the next few years, to the extent that this is consistent with the present emphasis on nation-wide rehabilitation and improvement of existing irrigation systems. Irrigation projects in Negros should include watershed management and reforestation components to reverse the deterioration that has taken place as a result of uncontrolled logging activities and shifting cultivation. 31. Rice Pricing and Marketing (Text paras. 3.11-3.12). It would be desirable to review the pricing and marketing policies for major alternative crops in sugarlands, including the paddy support price policy of the National Food Authority (NFA). If rice surpluses build up (para. 17) and the NFA continues to buy these surpluses, the issue of their disposal would have to be faced. One possibility is export of rice. However, since the current NFA paddy support price of P 3.50/kg (approximately equivdlent to about US$350/tonne of rice delivered wholesale Manila) is substantially higher than the current and projected world prices of rice, the NFA would incur significant losses in its rice operations and this could have budgetary implications. The paddy support price policy should, therefore, be reviewed along with other policy issues in the light of rice production ana consumption trends in the near future. With future rice exports in view, possibilities of improving rice quality should also be studied. 32. Other Government Programs for Crop. Diversification (Text paras. 3.14-3.16) . In addition to studies (para. 15), a land capability survey of Negros (para. 16), legume research (para. 19) and irrigation (paras. 28-30), the Government should consider: (a) designation of the Ministry of Agricul- ture and Food (MAF) as the lead agency for extension in sugarcane areas and strengthening of the MAF extension services for this purpose; (b) establish- ment of an effective market information service in the MAF; and (c) improve-  - xvi - ment of market infrastructure in some sugar areas through construction and rehabilitation of farm-to-market roads. In mill districts expected to go out of sugarcane, the MAF should provide technical assistance to the planters' associations and miLlers to utilize the existing mill-site infrastructure for establishment of centers of post-harvest facilities for annual crops as well as nucleus estates for perennial crops. Adequate financing is now available for these private sector investments. Policies and ?Sograms for the Rationalization and Improved Efficieney of the Sugar Sector _ 33. Sugar Financing PoLicy (Text paras. 3.17-3.20).- Although crop loans for 1986-87 sugarcane plantings may be drawn from the Agricultural Loan Fund (ALF), which has external financing from the World Bank (Loan 2570-PH), few sugar planters would be eligible for the ALF owing to high arrearages of many planters on their past sugar loans. Moreover, both of the major financial intermediaries in the sugar sector, the Philippine National Bank and Republic Planters Bank are in serious financial trouble due to non-repayment of a major part of their past loans. Other private financial intermediaries appear very cautious about financing sugar for reasons explained in para. 13. An in-depth review of the financial situation of the sector, including arrearages with Government and other banks and analysis of alternative solutions, is urgently needed. Under the Bank/IMF program (para. 7), the Government agreed to complete this review by December 31, 1985. However, this was not done. The review should be completed by the end of July 1986. It is also recommended that the pol:.y of basing loans to planters on the producer price of sugar be changed and that sugar crop loans be based on estimated cash costs of produc- tioni of efficient producers and repayment prospects. 34. Trade and Pricing Policies for Sugar (Text paras. 3.21-3.29). Through 1985, NASUTRA as the single buying and selling agency for sugar implemented the Government pricing policy for sugar producers. The producer price for sugar (called the composite price) was determined as a weighted average of domestic liquidation price and export and reserve sugar liquidation prices (the last two consisting of an initial liquidation price and a final differential based on actual export receipts). Estimates of production costs prepared by PHILSUCOM staff provided the basis for determining the sugar pro- ducer price. With the abolition of NASUTRA, establishment of PHILSUMA and freeing of the domestic merketing of sugar in late 1985 (further discussion in paras. 38-41), the earlier policy of a controlled producer price was replaced by one of a target producer price which PHILSUMA was expected to support. The target composite price was P 300/picul (about 11.7 US cents/lb) for the 1985/86 crop year. While PHILSUMA has secured financing for its export opera- tions, so far it has not been able to obtain funds for its domestic market operations. It appears at this stage that PHILSUMA will not be able to purchase any sugar in the domestic market to support prices. The domestic wholesale consumer price of raw sugar equivalent to about 13.5 US cents/lb is 1/ Mill closures and production quota allocations for the rationalization of the industry were discussed in detail in paras. 9-13.  - xvi i tWo to three times the prevailing world price. Consumers are'thus subsidizing producers. 35. The issue of an appropriate trade and/or pricing policy for sugar in the Philippines is a comp._cated one since the world market for sugar is distorted by very high protection in major industrialized countries. No country in the world has a cost of production of sugar as low as the prevail- ing world price of 5-6 US cents/lb. Open market sugar has had the most vola- tile price of all major commodities. Given such price volatility, the world sugar price in any given year is an inappropriate reference for domestic pric- ing policies. Either the long-run average world market price or the long-run average cost of efficient world producers could be used, although both have problems. An advantage of long-t.erm price projections is that they are up- dated frequently by tne Bank in the light of changing circumstances and provide-a quick reference. If these were to be chosen as a reference, a ten- year period would be appropriate as it covers at least one whole cycle of peaks and lows of sugar prices. The Bank's projected world raw sugar pri'ce - for 1986-95 of 10.3 US cents/lb is close to the historical average of the last decade. Based on this projected world price, the raw sugar wholesale consumer price (import parity) in Manila would be about 13-13.5 US cents/lb as at pre- sent. However, if the Philippines is to remain an exporting country, its domestic prices should be closer to export parity prices. In this case, the Manila wholesale consumer price for raw sugar should be 9.5-10 US cents/lb equivalent and the producer price 8.5-9 US cents/lb equivalent. 36. At the above producer price, few, if any, mill districts in the Philippines would now be able to produce raw sugar profitably (para. 4). Domestic production would fall far short of domestic demand, and importation would be required. It is, therefore, essential that the Government take steps to increase average capacity utilization (paras. 10-13) and introduce other efficiency improvements (para. 44) to lower production and processing costs to a level where Philippine sugar exports are once again profitable. Given the current uncertainties in the domestic sugar market (see para. 39), the present policy of indicating target composite prices should be continued in the short- term but the target prices should be lowered in real terms in line with implementation of the cost reduction measures recommended above. 37. With the freeing of the domestic marketing of sugar, the role of trade and commercial policies in influencing domestic prices has become impor- tant. The current blanket ban on sugar imports does not give the Government any means of keeping domestic prices within limits and thus exert pressure on the domestic sugar industry to remain efficient and competitive in the long run. To set an upper limit on the extent to which domestic prices could be raised, it appears desirable that the import ban should apply only as long as wholesale consumer prices in the Philippines do not exceed long-run average world sugar prices. Beyond this (currently estimated at 13-13.5 US cents/lb equivalent), imports should be allowed. 38. Sugar Marketing Policy (Text paras. 3.30-3.42). Instability and shortcomings in marketing arrangements have aggravated the problems of the sugar industry, and it is essential that a stable marketing policy be formu- lated and implemented as soon as possible. The controversy has essentialLy  - xviii - centered 'in the merits of the ,re-1974 policy of private sector trading against those of the post-1974 policy of a single buying and selling agency. Given the segmentation of the world sugar market (only about half of world exports are at current prices and the rest are under bilateral arrangements or long-term contracts), there are argumer - in favor of a single buying and selling agency, and several sugar-prodt.ing countries follow this marketing policy. However, in the specific context of the Philippines, this policy involves serious problems since some producer groups have bitterly criticized the role and accountability of NASUTRA over the last few years. So far sugar producers have not voluntarily subscribed to PHILSUMA's share capital, though PHILSUMA was envisaged to be owned by all sugar producers. 39. The previous Government hid proposed that PHILSUMhA have exclusive responsibility for sugar exports; compete with private traders and producers in the domestic sugar market; and hold reserve stocks of sugar to stabilize producer prices. To analyse the justification of the above functions, a distinction is necessary between the short-term and the longer-term needs of the sugar industry. With uncertainties- rega.ding the magnitude of sugar stocks and consumer demand in the country (para. 13) and the reported under- capitalization of private sugar traders, there were fears that the 1985-86 crop might not be easy to sell and producer prices might drop sharply. This uncertainty is likely to continue until sugar industry rationalization (paras. 10-13) is completed. There is some justification, therefore, for PHILSUKA to perform a short-term role as a buyer of last resort and in preventing producer prices from falling too sharply. To perform this function effectively, PHILSUMA would need profits from the US quota exports as a cushion. However, when sugar industry rationalization is completed and the financing situation improves, it may be desirable to minimize PHILSUMA'S role as discussed below. 40. Once the short-term problems of the sugar industry (para. 39) are resolved, the desirability of PHILSUMA'S export monopoly should be reviewed. Since sugar is likely to be exported only under the US quota for the next few years, there may not be any rationale for a single agency continuing to handle this, particularly if the agency is not a parastatal, does not have the voluntary support of all producers (para. 38) and its price stabilization function is no longer important (see para. 41). Under the circumstances, consideration should be given to allow private traders and producers to export sugar for the US quota, as was the system before 1974. In this regard, several alternatives such as auctioning of quotas, tenders or direct alloca- tion of quotas to mill districts could be considered by the Government. Moreover, to provide an incentive to efficient mill districts, consideration should also be given to allow private traders and producers to export sugar to the world market so that they can take advantage of any rise in prices. 41. Beyond the short term, there may not be any need for the envisaged producer price stabilization role for PHILSUMA. Once processing capacity has been rationalized, adequate trade financing is available and an appropriate trade policy adopted (para. 37) to protect domestic producers and consumers from world price fluctuations, a reasonably stable domestic price level for sugar is expected even without intervention from any agency. If PHILSUMA survives as a private trading agency, it could hold operational stocks as a  - xix - normal trade practice. But if the Covernment intention is to hAve PHILSUMA hold stocks for contingencies, it should be re-exmined. Maintaining a contingency stock of sugar would be costly. Sugar imports would generally be a lower-cost alternative in years of shortages: in about seven out of ten years in the past, imports would have been cheaper than domestic sugar. 42. Planter-Miller Revenue Sharing (Text paras. 3.43-3.48). Under the prevailing law, planters receive payment for cane delivered to the factory in shares of the sugar manufactured and other marketable by-products produced. The shares vary by mill district and range from 60Z to 70% in favor of planters. This system has several major disadvantages: (a) the planter's incentive to deliver high quality, clean cane is weakened since his share is determined by weekly sugar recovery which in turn is dependent on the condition of the factory whenu the cane is milled and the quality of cane from other A4anters; (b) the miller is disinclined to improve sugar processing since he gets only about one-third of the direct returns to such investments; and (c) since raw sugar is the basis for the sharing arrangement, the system does not encourage product diversification, 43. It is recommended that the revenue sharing system be changed and sugar mills allowed to purchase cane directly from planters, based on a price formula which takes into account the time of delivery, sucrose content and cleanliness of cane. The country's present cane weighing, sampling and analysis system has all the elements necessary for a direct payment system and no technical problems are foreseen. Measures to ensure financing for the mills for cane purchases should be examined in the course of the recommended review of sugar financing (para. 33). 44. Government Programs to Improve Sector Efficiency (Text paras. 3.49-3.55). In addition to the policy changes discussed above, the following Government programs are recommended to promote sector efficiency. First, the phasing out of marginal areas should be encouraged. The process would be assisted by the recommended move toward lower sugar prices (para. 36) and by allowing transfer of quotas among and within mill districts, if produc- tion quotas are to be allocated in the future (para. 13). Preparation of individual mill district plans and crop zoning should also be undertaken on a pilot basis to identify marginal areas,-encourage alternative farming systems for these areas and implement other productivity improvement measures such as irrigation, drainage and improved transportation. Second, establishment of seed treatment plants annexed to sugar mills and seedcane nurseries to be owned by the planters' associations should be undertaken to address the poor seedcane problem, with PRILSUCOM assisting in this process. Third, improved ratoon yields and culture appear to be the best means of reducing costs, even in the short term. Better ratooning varieties are available in the Philip- pines but have not been widely adopted. PHILSUCOM should, therefore, launch a major campaign to promote them. Fourth, the feasibility of public irrigation facilities for sugarcane should be seriously investigated. Fifth, a project to strengthen sugar research is recommended. In the meantime, research priorities should be reoriented to emphasize ratoon culture and management; incremental yield benefits from irrigation and drainage; breeding of cane varieties for other uses (alcohol, feeds, etc.); development of site-specific production technologies; and sugarcane-based-farming systems.  -Mx- Action Program 45. In summary, two types of Government intervention have been recom- mended in this report to help recolve the problems of the sugar sector. The first set of interventions (listed in paras. 47 and 48) would be designed to accelerate the process of crop substitution and diversification in sugar areas and improve sugar sector efficiency: it would include land redistribution, irrigation, research, surveys, studies, transportation infrastructure and market information. These are generally accepted areas of Government inter- vention. The second set of proposed interventions would aim to rationalize the industry and improve its efficiency. These interventions (listed in para. 46), which are more debatable, would include mill closures, production quota aLlocations, improvement of the sugar financing situation and improve- ment of the incelntive environment through appropriate trade, pricing, market- ing and planter-miller revenue-sharing policies. The general thrast of these recommendations is to enlarge the role of the market as the resource allocat- ing mechanism. However, in view of-certain short-term problems, specific- Government interventions are considered desirable to assist the market process in overcoming market failures and distortions, and to minimize economic costs. The short-term problems have resulted from the economic recession and financial crisis since early 1984; rigidities in the process of sugar milling capacity rationalization (para. II); and the sudden change from a single buying and selling agency for sugar (NASUTRA) to free domestic trading which has created uncertainties regarding the price level of sugar and in turn has made commercial banks reluctant to lend for sugar. 46. The principal recommended measures in the second set of interven- tions mentioned above are highlighted below (the first two have urgency): (a) A study of the viability of mill districts as a basis for a decision on mill closures and production quota allocation in the short term and formulation of a compensation scheme for mill districts which will go out of sugarcane (para. 12); (b) Resolution of the present sugar financing problems, particularly sugar loan arrearages (para. 33); - (c) Adoption of a direct cane purchase system in place of the present sharing system to improve the incentive environment (para. 43); (d) Continuation of the present policy of indicating target prices instead of controlling prices but lowering the target prices in real terms (para. 36); (e) Linking of the ban on sugar imports to long-run average world sugar prices instead of the present blanket ban on sugar imports (para. 37); (f) Reconsideration of PHILSUMA's assigned roles with a view to enlarge the scope of market processes once the short-term problems of the sugar industry are resolved (paras. 40-41); and (g) review of rice pricing and marketing policies (para. 31).  - xxi - All the above recommendations except (a) would enlarge the role of the market and bring the country's trade and pricing policies more in line with the pre- sent and projected situation in the world market. Recommendation (a) takes into account the specific short-term problems of the sugar industry (paras. 11-13) and is intended to assist the market process in the longer- term. 47. Both sets of Government interventions mentioned in para. 45 have been recommended primarily to increase employment and income of sugar workers, directly through measures to accelerate crop substitution and diversification in sugar areas and indirectly, in the medium- to long-term, through measures to improve sugar sector efficiency. In addition to ('a), (b) and (c) in para. 46,'the following recommended measures have high priority: Short-term Government Assistance Measures: Continuation and effective implementation of Government's short-term program to help displaced sugar workers (para. 23); Land Reform: (i) Limited land reform in sugarlands (para. 26); and (ii) Formation of a task force to prepare the land redistribution program and a detailed financing plan for land reform beneficiaries (para. 27); Sugar Financing: A change in the basis for granting sugar loans (para. 33); and Extension: Designation of MAF as the lead agency for extension in all sugarcane areas (para. 32). 48. Other recommendations in the report are listed in text para. 3.57. The main ones are: Irrigation: Updating by NIA of four prefeasibility studies for sugarcane and paddy irrigation in Negros and consideration given to expanding the overall irrigation program in Negros (para. 30); Survey and Studies: (i) A land capability survey in Negros (para. 16); (ii3 Investigation of the feasibility of peanut oil exports (para. 15); and (iii) Review of prospects for the dairy and meat products industry (para. 15); Research, Extension and Market Information: (i) Assistance to PCARRD for augmentation of legume research and review of the PCARRD Soybean Pilot Production Program (para. 19); (ii) Preparation of a sugar research project and reorientation of PHILSUCOM research priorities (para. 44); (iii) Initiation of PHILSUCOM programs for improvement of sugar sector efficiency (para. 44); and (iv) Establishment of an effective market information service in MAP (para. 32).  I. OVERVIEW OF THE SUGAR SECTOR AND ITS PRESENT SITUATION Sector Background 1.01 Role of the Sector in Exports. The sugar industry has been one of the major foreign exchange earners in the Philippines. During 1973-82, sugar exports averaged 1.4 million tonnes annually (about 60% of total domestic production) and accounted for an average 12X of the total value of merchandise exports. With declining world prices, the value of sugar exports fell to about US$300 million in 1983 or about 6Z of the total value of exports. In the 1970s, the Philippines accounted for about 2.5Z of world production and about 5% of world exports of centrifugal sugar. Significant exports of refined sugar from the Philippines started in 1980. Over 1980-83, refined sugar accounted for about 15% of Philippine sugar export tonnage. Through 1974, almost all Philippine sugar exports were to the USA. Since 1975, the USA, Japan, the USSR and the Republic of Korea have been the major importers of Philippine sugar. 1.02 Value Added and Employment. During 1973-82, sugar contributed about 6.5% to the gross value added of the agricultural sector (including livestock, fisheries and forestry) in 1972 constant prices. The contribution declined to slightly over 4% in 1983. Through 1983-84, about 500,000 workers were annu- ally employed in sugarcane production (90%) and processing (10%). Given -n average family size of 6 members, approximately 3 million people out of an estimated 1985 total population of 55 million have thus depended on the sugar industry. Sugarcane workers are mainly employed by large planters. Of these workers, about 73% live and work regularly on farmst about 25% live in nearby villages and are employed seasonally and about 2% are migrant seasonal yprkers called secadas and found mainly on large farms in the Island of Negros., 1.03 Area and Production. In 1975-76, the sugarcane area and total sugar production reached a peak of about 550,000 ha and 2.9 million tonnes (45.5 million piculs), respectively (Table 1). During 1979/80-1983/84, the sugarcane area averaged 442,000 ha, with annual sugar production of about 2.4 million tonnes (Table 2). In 1984-85, both area and production declined significantly to an estimated 385,000 ha (Table 3) and 1.7 million tonnes (Table 4), respectively. Further declines are projected for 1985-86 to 321,000 ha (Table 3) and 1.3 uillion tonnes, respectively, or about 28% and 45% below the respective 5-year averages through 1983-84. 1.04 Regional Characteristics, Structure and Yields. About 70% of all sugarcane is grown in the Visayas (Panay and Negros Islands), with the remain- der in Luzon (25%) and Mindanao (5%). The heaviest concentration of sugarcane 11 These figures refer to "the off-milling season." Therefore, the proportion of seasonal workers, especially sacadas, is underestimated for tthe whole crop year (World Bank, Aspects of Poverty in the Philippines: A Review and Assessment, Repo-rt No. 2984-PH, December 1, 1980, Vol. II, p. 71)  -2- is in the province of Negros Occidental where over 7V% of the total cultivated area has been devoted to sugarcane. Of the 30,000 sugar growers in the country (Table 5), about 77% have small farms (below 10 ha), 18Z medium-sized farms of 10 to 50 ha and 5% large units of above 50 ha. in terms of the total sugarcane area, however, small farms account for only about 222 while medium and large farms account for about 35% and 43%, respectively (Table 6). Land distribution is thus highly skewed. Of the total sugarcane proJuction, small farms account for-about 20%, while medium and largc farms account for 20X and 601, respectively. As the data indicate, sugarcane yields per ha are much higher on small and large farms compared to those on medium-size farms. (Table 7). The highest average yield was about 76 tonnes/ha on farms above 100 ha (average 1978/79-1980/81). The countrywide average yield is about 53 tonnes/ha. 1.05 Milling. The Philippines has 41 sugar mills (Map IBRD 19442) with a tctal milling capacity of about 184,500 tonnes of cane per day, equivalent to about 3.5 million tonnes of raw sugar per year. Capacity utilization averaged 701 in 1979/80-1983/84 (Table 8) and fell to an estimated 501 in 1984/85 (Table 9). Eight refineries also operate in the country (Map IBRD 19442) with a total capacity of about 4,000 tonnes per day. 1.06 Domestic Consumption. Domestic sugar consumption in 1983 was about 1.1 million tonnes. Over 1977-83, the Philippines' annual per capita consump- tion of centrifugal sugar was about 23 kg. Of the 40X of total sugar produc- tion normally consumed domestically, about 601 is by households and 40% by industrial users. 1.07 Institutional Organization. Since its inception in 1977, the Philippine'Suiar Commission (PHILSUCOM), a Government body, has been respon- sible for policy-making and regulation in the sector, including the allocation of sugar for export, domestic consumption and reserves and the fixing of raw sugar buying prices. Throughout 1977-85 (except for a brief period from June 1984 through early March 1985), the National Sugar Trading Corporation (NASUTRA) had been the sole agency involved in the domestic trading and export of sugar. Credit for the sugar industry has been provided largely by the Republic Planters Bank (RPB) and the Philippine National Bank (PNB).- Causes and Effects of the Sugar Industry Decline 1.08 The contraction of the sugar industry since 1984-85 (para. 1.03) can be traced primarily to the decline in financing available to the industry since early 1984, the deteriorating law and order situation in Negros and, since late 1984, when NASUTRA's long-term export contracts expired, the inability of the Philippines to export sugar profitably since its cost of production (para. 2.06) exceeded the average world price of raw sugar in 1985 (about 5 US cents/lb). The financing problem has been particularly severe and made the industry contraction very disorderly. New loans to the sugar industry in 1985 were estimated to be about one third of those in 1983. The major factors respo.a*ible for the decline in financ'ing since early 1984 include: the liquidity squeeze in the economy resulting from the  -3- macroeconomic stabilization program;2/ the closure of the Central Bank (CB) rediscounting window which was the largest source of credit for the sugar sector; reluctance of some banks to lend for sugar owing to the instability and uncertainty of Government sugar marketing policy viz., operation of NASUTRA as a single buying and selling agency until mid-1984, followed by liberalization of domestic marketing, followed again by the single buying and selling agency system in February 1985; and the inability of some planters to repay their 1983/84 loans owing to drought and the consequent refusal of banks to approve new loans. Delayed payments by NASUTRA for sugar bought in and after March 1985, largely because NASUTRA lacked the required funds, has exacerbated the planters' cash flow problem. - 1.09 The sudden and disorderly contraction in the sugar industry has entailed high economic costs for the country. Many good sugarcane lands, which could be used for other crops, are still lying idle and because of this, it is estimated that over a 100,000 sugarcane workers are-either unemployed or seriously underemployed. This does not include the decline in 14bor demand owing to higher than normal ratooning (instead of new planting)-1 and lower than normal input use, which have recently been widely observed. In addition, the serious decline in mill capacity utilization (para. 1.05) has led to increased processing costs (para. 2.05). 1.10 The Problem of Negros. The unemployment and underemployment problem is particularly serious on the Island of Negros, which has accounted for over 50X of sugarcane acreage in the country and employed over 200,000 sugarcane workers. The most severely affected province is Negros Occidental, which, owing to its almost exclusive dependence on sugarcane (para. 1.04), offers very limited alternative employment opportunities for workers. Crop diversi- fication has thus become a major issue in Negros. It is not an issue in other sugar areas since, overall, sugarlands account for less than 5% of total cul- tivated area in the Philippines and, in half of the areas growing sugarcane (outside Negros), sugarcane itself can be regarded as a diversified crop as these areas formerly grew rice and other crops. In essence, monocropping of sugarcane in Negros is a problem if it produced largely for the world market where prices fluctuate sharply (para. 3.24) inducing severe instability in production and employment. Monocropping would not be a problem in Negros if it were to produce only or predominantly for the domestic sugar market, which, as in the past, could be shielded from the severe world price fluctuations through appropriate trade and pricing policies. The domestic market is expected to grow steadily except in periods of severe economic recession and Negros has the capacity to meet the entire domestic demand for sugar. The issue then is whether Negros has a comparative advantage in supplying the 2/ For details, see World Bank, The Philippines: An Agenda for Adjustment and Growth, Report No. 5258-PH, November 30, 1984. 31 Ratoon cane is the regrowth from the root structure of the previous crop. The first ratoon is the crop after plant cane is harvested. The second ratoon is the second crop after plant cane and so on (see further paras. 2.48-2.49 for a discussion-of ratooning).  -4- entire domestic market, relative to other regions in the country. Available estimates of regional cost of production (Tables 10 and 11) show that Negros does not have an overall cost advantage compared to other regions in the country, though some mill districts in Negros may. There is thus a strong case for some mill districts in Negros to diversify out of sugarcane. 1.11 The unemployment and underemployment problem in Negros and other sugarlands has been aggravated by the highly skewed land distribution (para. 1.04). If land distribution had been less skewed, the problem would not have emerged at its present scale, despite the financing problem, since small farmers would be mostly self-financed. Moreover$ given the need for sugar industry contraction, crop substitution and the provision of alternative employment opportunities would have occurred much faster on smaller farms since, unlikc large planters who usually have other sources of income, small farmers cannot afford to leave their lands idle for long. Government Response to the Industry Crisis 1.12 In response to the industry's rapid decline and the consequent effects on incomes and employment, Presidential Decree (PD) 1971 was issued on February 21, 1985, to initiate a major restructuring of the sector and its institutions. The Decree "declared a grave national emergency in the sugar industry, necessitating its revitalization by way of an industry rationali- zation program to be promulgated by the Philippine Sugar Commission, subject to the approval of the President." The Decree had four main features: changes in the PHILSUCOM Board membership with private sector majority; establishment of the Philippine Sugar Marketing Corporation (PHILSUMA) as a single buying and selling agency to replace NASUTRA; cost plus pricing of sugar; and authority given to PUILSUCOM to "mothball" excess milling capacity. 1.13 Other sector changes were called for in a study of the sugar industry undertaken by the country's National Economic and Development Authority (NEDA) with financing from the Bank-supported Agricultural Sector/ Inputs Project (Loan 2469-PH). The study, completed in February 1985, covered farm production, processing, institutional arrangements, marketing and financ- ing of the sector. The recommendations made in the study and some other proposals were discussed by the Internatonal Monetary Fund (IMF), the World Bank and the Government in the context of the IMP standby program. Some im- portant agreements reached in late 1985 under the program, henceforth referred to as the Bank/IMP program, were: (a) restructuring of the PHILSUCOM Board to ensure majority Government representation and establishment of a subcommittee at the Cabinet level to which PIILSUCOM will report its plans, programs and operations; (b) divestiture of PHILSUCOM and Philippine Sugar Corporation (PHILSUCOR) assets; (c) full public accountability and transparency of PHILSUCOM through independent auditing and publication of its financial state- ments; and (d) free domestic marketing of sugar rather than having PHILSUMA as the country's single buying and selling agency. A new PD i984, amending PD 1971 and introducing "a new policy of free enterprise trading for the sugar industry" was issued for the purpose of allowing private traders to operate alongside PHILSUMA. The earlier Government decision to close six sugar mills and impose production quotas on the remaining mill districts with a production target of 1.6 million tonnes for the 1986/87 crop year was reversed and the  open market was allowed to determine the direction and speed of the adjuatment process. 1.14 After the new Government came to power in February 1986, a Sugar Industry Advisory Council, composed of representatives of sugar planters and millers, was created. The Council has submitted some important proposals to the Government for reorganization and reform of the sugar industry. The proposals are largely in line with the Bank/IMF program and the recommenda- tions of this report. The most significant proposal is to dissolve-PHILSUCOM and instead create three separate bodies viz. a regulatory body to be named Sugar Board which would be under the Ministry of Trade and Industry (MTI), a private Research and Development (R&D) Foundationwar. a private Socio-Economic Foundation. Another significant proposal is to phase out PHILSUMA after the end of the current milling season. For the Sugar Board, the proposal is to have seven members, with the Chairman appointed by the President of the Philippines and the planters and millers represented by four and two members respectively, thus giving the private sector majority in the Board. However* as the regulatory body for sugar, the proposed Sugar Board should have a Government majority, as was agreed for the PHILSUCON Board under the Bank/IMF program (para. 1.13). Moreover, it would be desirable to have the Government representation large enough to ensure that the Sugar Board's decisions fully reflect the Government's views and that the complex decisions, which would be needed for the sugar industry in the near future and which would involve several Government ministries and agencies, could be taken by the Sugar Board expeditiously. The ministry under which the Sugar Board will be placed should have effective control of the Board and the private sector members of the Board should be truly representative of the sugar industry. The relationship of the proposed Sugar Board with the proposed R&D and Socio-Economic Founda- tions needs to be spelled out clearly. Moreover, the proposen R&D Foundation, which is currently proposed to have only one representative of the Ministry of Agriculture and Food (MAE) but ten private members, should make full use of expertise and ongoing research in othe research organizations and, in parti- cular, forge close links with the Philippine Council for Agriculture and Resources Research and Development (PCARRD) and the University of the Philippines at Los Banos (UPLB) in developing sugarcane-based farm systems research (see further paras. 3.50-3.54). II. ELEMENTS OF SECTOR ADJUSTMENT 2.01 Given the pessimistic world sugar price forecasts for at least the next three years (para. 2.03) and the high economic costs of the market- induced adjustments so far (para. 1.09), the critical issue is how to achieve a reduction in sugar output and at the same time minimize short-term economic costs and provide for longer-term productivity and income growth in the sugar areas. Four principal strategies are proposed here for the industry's short and long-term adjustment: (a) efficient rationalization (contraction) of sugar production capacity; (b) product diversification (principally the use of- cane to produce ethanol); (c) crop substitution and diversification in sugarlands; and (d) improvement of sugar sector efficiency. If efficiently managed) this adjustment will overcome the problem of unemployment and  -6- underemployment in sugarlands, particularly in Negros; improve the competitive position of the Philippines in the world sugar market in the medium to long term; and improve efficiency of land use and increase incomes in sugarcane areas. This Chapter discusses the particular problems to be addressed by these strategies while Chapter III discusses the specific policies, institu- tional changes and Government investments needed to facilitate an efficient sugar sector adjustment. Rationalization 2.02 Rationalization of the sugar industry will entail contraction of both production and processing capacity. The scope of rationalization will be determined by the interaction of various factors including projected world prices of sugar, the domestic cost of production, US sugar quota, projected domestic demand, the desired stock level and product diversification possibil- ities (diversified uses of cane). Because of its importance. the use of cane for ethanol production is discussed separately (paras. 2.21-2.23) while the use of cane as livestock feed is discussed in para. 2.33. All other factors are discussed below. 2.03 Projected World Prices. The world price for raw sugar is expected to remain depressed dring the next few years. Bank projections, which may be somewhat optimistic,_t indicate a price below 9 US cents/lb. in 1985 constant dollars for the next three years. Prices are projected to increase to 14 US cents/lb. about 1990 but then to decline again. At projected prices for the next three years, the Philippines will not be able to profitably export raw sugar, except under the lucrative US quota. This also applies to exports of refined sugar which at present commands a premium of only 2 US cents/lb. over raw sugar. The projected 1990 world price would, however, make possible Philippine sugar exports. 2.04 Domestic Cost of Production. A national average cost of production of sugar in the Philippines is difficult to derive, given wide variations in on-farm costs (owing to differences in farm sizes, soil and climatic suitabil- ity, technologies used and management efficiency) and processing costs (owing to major differences in finance costs between old and new mills). Avaiiible estimates of national average costs are inconsistent and contradictory.- However, taking all available estimates of on-farm costs into account, a maximum on-farm cost of about P 130 per picul is likely, except in marginal sugarcane areas (para. 2.44) and on very inefficient farms where productivity and, consequently, the costs of production could vary widely. This estimate excludes hauling costs, which are mostly reimbursed by mills, but includes rent and a finance charge of 302, which was the interest rate on sugarcane production loans in July 1985. The national average (excluding marginal areas 4/ For a detailed discussion, see Background Paper 6. 5! For a detailed review and analysis of available estimates of sugar production costs in the Philippines, including PHILSUCOM estimates, see Background Paper 5.  -7- and extremely inefficient farms) is-likely to be much lower, considering the significant proportion of low-input, mostly self-financed and lower-cost farms in the country (para. 2.45) and high ratooning in some areas (para. 2.49). The maximum figure of P 130 per picul is equivalent to about 5 US tents/lb. of raw sugar at an exchange rate of P 18.5 - US$1.00. 2.05 Total hauling and processing costs in 1983-84 (including deprecia- tion and finance charges but net of receipts from molasses sales) ranged from 1.9 US cents/lb. equivalent for an old mill to 21.6 US cents for a new mill. For old mills, finance charges are low but owing to greatly reduced capacity utilization in 1984-85 (Table 9), total hauling and processing costs are esti- mated to be at least 5 US cents/lb. equivalent in 1985. Operating costs (that is, costs excluding depreciation and finance charges) in 1983-84 ranged from 1.8 to 4.0 US cents/lb. equivalent. Once again, owing to low capacity utili- zation in 1984-85, they are estimated to range from 2.0 to 6.0 US cents/lb. equivalent in 1985. 2.06 On the basis of these estimates, if only operating costs were to be covered, some mill districts in the Philippines could export at a FOB Manila price of 9 US cents/lb. (assuming on-farm coits of 5 US cents, factory operating costs of 2 US cents and storage, transportation and port charges of 2 US cents/lb.). If capacity utilization of some old mills were to return to the 5-year average through 1983-84 (Table 8), these mills could cover all their costs (including finance charges) at about 3 US cents/lb. and could export at a FOB Manila price of about 10 US cents/lb. 2.07 US Sugar Quota. Given the estimated cost of production in the Philippines and pessimistic world sugar price forecasts for at least the next three years, Philippine sugar exports would have to be restricted to the US quota. The quota has declined from 310,000 tonnes for 1984/85 (14-month period) to 210,000 tonnes for 1985/86 (10-month period). Whether the quota would be reduced further in the future cannot be predicted with any certainty. 2.08 Projected Domestic Demand. With the viable export market for at least tie next three years restricted to the relatively small US quota, pro- duction of sugar in the Philippines has to be predominantly for the domestic market. The domestic average annual consumption of sugar over the 1979-83 period has been about 1.1 million tonnes, with virtually no growth from year to year (in fact, there was a small decline in 1980 and 1982). The actual consumption figure for 1984 is not available. The decline in GDP in 1984 is estimated to be 62 and the growth rate in 1985 could be zero or negative. In addition, real wages, particularly in the urban sector, are estimated tg-have declined significantly in 1984 and 1985 and unemployment has increased.'/ Whether these factors have adversely affected domestic consumption of sugar and, if so, by how much, is not known (available estimates of income and price elasticities for sugar in the Philippines are 0.5 and -0.2, respectively). Some private sector estimates of domestic demand for sugar in 1985 are as low as 0.9 milLion tonnes. However, the previous Government estimated a level of 6/ See Background Paper 6 for details.  1.1 million tonnes (presumably on the assumption that the adverse income effects of the economic recession may have been counterbalanced by the population growth of 2.5% per annum). Taking into consideration the decline in GDP and real wages anid increase in unemployment, the 1985 domestic demand for sugar was presumably no more than 1.0 million tonnes. The domestic demand is expected to grow in future at a rate of 3X to 41 p.a. to reflect population growth and income effects. 2.09 Sugar Stocks. Estimates of contingency stocks of sugar desired by the Government range from 110,000 to 200,000 tonnes. lyovisional estimates made by United States Department-of Agriculture (USDA)_ show stocks of about 433,000 tonnes beginning September 1985 and also ending August 1986, on the assumption of a domestic production of 1.4 million tonnes, domestic cQnsump- tion of 0.9 million tonnes and export of 0.5 million tonnes (for the US quota and other outstanding long-term contractual obligations) in 1985-86. On the basis of the USDA estimate, the current and projected August 1986 stocks are far in excess of the level desired by the Government (for a discussion of the desirability of a contingency stock policy for sugar, see para. 3.42). 2.10 Desirable Sugar Production Level. The Government's announced production target for 1986/87 was l.f million tonnes including an estimated 1.1 million tonnes for domestic cons.mption, 0.2 million tonnes of stock and 0.3 million tonnes for the US export luota. This production target is too high. The US quota has already been reduced to 0.2 million tonnes for 1986 (para. 2.07). Moreover, there is presumably no need for any further stocks; instead, if USDA estimates (para. 2.09) are correct, current stocks have to be reduced substantially. Therefore, with domestic demand estimated to grow from 1.0 million tonnes in 1985 to about 1.1 million tonnes in 1987 (para. 2.08), an assumed US quota of 0.20 million tonnes and reduction of the sugar -stocks by at least 0.2 million tonnes, the desirable raw sugar production level for 1986/87 would be 1.1 million tonnes. However, if sugar stocks are substan- tially less than those estimated by USDA (para. 2.09), the raw sugar produc- tion target for 1986/87 would be closer to 1.3 million tonnes. By 1990, the desirable raw sugar production level would be 1.4 million tonnes if US quota stayed at 0.2 million tonnes and 1.2 million tonnes if the US quota dis- appeared. With these raw sugar production levels, about 170,000-230,000 ha would be released from sugarcane (assuming an average yield of 53 tonnes/ha and 1.5 piculs of sugar per tonne of cane) and become available for crop substitution. However, if the ethanol program of 300 million liters (paras. 2.21-2.23) is successfully implemented over five years, it would require about 80,000 ha and the net area available for crop substitution would be 90,000-150,000 ha. The area-to be released from sugarcane will be known more precisely when actual data on the sugar stock level and domestic sugar consumption in 1985 are available. 7/ There is a great deal of uncertainty about the present level of sugar stocks in the country. Data on these are not officially available from the Government. A foreign consultant team, which was appointed to determine NASUTRA's stocks, submitted its report to the Government, but the findings are not known.  -9- 2.11 Sugar Mill Capacity Rationalization and Production Quotas. With the present installed processing capacity of 3.5 million tonnes, the desirable production level of 1.1-1.4 million tonnes (para. 2.10) would represent a capacity utilization level of only 31Z to 40X, if all of the country's 41 sugar mills were operating. This is not a viable situation. Even if the ethanol program were implemented, requiring the equivalent of 0.4 million tonnes of raw sugar, capacity utilization would still be very low at 43% to 51%. Seme mills, therefore, have to close. 2.12 The expansion of the sugar sector in the 1960s and 1970s was not entirely based on the consideration of comparative advantage. Some mills were established in unsuitable areas based on political considerations and their viability was questionable from the start. Most of the new mills obtained their local currency loans from the Government banks viz. PNB and Development Bank of the Philippines (DBP), and had their foreign currency loans also guaranteed by these banks. These loans were not repaid and, as a result, almost all the new mills were taken over by PNB and DBP. In 1984, 14 of these mills were transferred to PHILSUCOR, which is also a public sector entity. In addition, seven old mills, which have run into serious financial problems, are heavily indebted to Government banks. The sugar industry is thus highly distorted in She sense that approximately half of the country's sugar mills are now in the public sector (Appendix to Annex A) and being implicitly subsi- dized (see para. 3.19). Under the Bank/IMF program as well as a proposed reform program for Government financial institutions, the Government had agreed to a divestiture of PHILSUCOR assets (para. 1.13) and transfer of these to an Asset Management Trust pending their divestiture. Further, the Government intended to review by July 31, 1986 its decision not to close any mills, the effects of domestic market liberalization and the need for a quota system to bring about an orderly and efficient adjustment of the sugar industry. 2.13 The main issue is whether the policy of letting the market process achieve rationalization of the sugar industry (para. 1.13) should be continued or some form of Government intervention is necessary. It is difficult to provide a definite answer to this question without first reviewing the results of the 1985/86 milling season, which is still continuing. The target date of July 31, 1986 (para. 2.12), when the results of the current milling season will be available, is, therefore, more appropriate for a detailed review. However, based on trends so far, some aspects of sugar industry rationaliza- tion can be noted and guidelines prepared so that a sound Government decision can be taken and implemented before the next planting season begins in October 1986. 2.14 Sugar is an agro-industry that is most dependent on milling capacity and a clear distinction is, therefore, necessary between on-farm rationaliza- tion (acreage and production of sugarcane) and rationalization of processing capacity. Since the estimated sugarcane acreage and sugar production in 1985/86 are close to the desirable level (para. 1.03 and 2.10), it may appear that on-farm rationalization of sugar has already occurred. However, the cutback is not in response to price signals: it is probably a temporary phenomenon caused by the financing problem (para. 1.08) and, as a result, the locations where production and acreage reductions have taken place are not  - 10 - necessarily the-ones where it should have happened. Moreover, while for many agricultural commodities on-farm rationalization is all that is required for industry contraction, it is not enough in the case of sugar unless accompanied by processing capacity rationalization. This has not happened in the country so far and, according to the latest information, 38 of the 41 mills in the country are milling (2 private mills had closed at the start of 1984/85 and one mill heavily indebted to PNB closed at the start of 1985/86). Almost all of these mills appear to be operating at unviable capacity utilization levels. The issue, therefore, is to synchronize on-farm rationalization (total area and location} with processing capacity rationalization so that surviving mills run at viable capacity utilization levels. 2.15 The market process has so far not led to rationalization of process- ing capacity (closure of mills) because of implicit subsidization of half of the mills in the country by Government banks (paras. 2.12 and 3.19), the large size of investments in sugar processing and very low sale value of the mills given the current low world sugar prices. Moreover, since the milling of most of one year's sugarcane crop takes place after the planting of next years' crop, a sudden closure of a mill would represent a complete loss of income for farmers who have standing crops in the field. A mechanism to ensure adequate notice of intended closure is, therefore, essential. The above factors have caused rigidities in the process of sugar milling capacity rationalization in the country. Market pressures would eventually lead to rationalization; however, given the rigidities noted above, this process could be protracted and, in the meantime, the economic costs could be high in the form of continued operation of mills at unviable capacity utilization levels and/or closure of even efficient private mills which may not be able to compete with mills now in the public sector. Even after the mills now in the public sector are transferred to an Asset Management Trust (para. 2.12), the need for closure of some of those mills will remain given the negligible possibilities of their profitable divestiture. Government intervention, may, therefore, be needed in the short-term to assist the market process by removing the rigidi- ties in the sugar processing sector and to minimize economic costs. 2.16 The short-term Government intervention for sugar industry rationali- zation could be through provision of incentives for voluntary closure of some public and private sector mills, forced closure of some public sector mills, imposition of production quotas on surviving mills and improvement of sugar financing arrangements. The sugar financing issue is discussed in detail in paras. 3.17-3.20 and briefly mentioned in paras. 2.19-2.20 below. The Government should first offer compensation (see further para. 2.18) to mill districts which voluntarily announce by August 31, 1986 their decision to close. It is possible that none of the mill districts will voluntarily come forward. In that case, a forced closure of some public sector mills would be necessary. The Government then would need a factual and analytical basis to formulate a sound rationalization program and announce it before the next planting season begins in October 1986. For this it is essential that the Government immediately initiate a study of the viability of mill districts. Ideally, all mill districts in the country should be studied. However, given the time constraint, a comprehensive national study is not recommended at this stage. Instead, a phased approach is desirable. The first phase of the study should include some mills (indebted to Government banks) which are obvious  - II - candidates for closure based on their recent financial performance. The private mills not indebted to Government banks should be excluded in the first phase since (a) they are asssumed to have some comparative advantage as evidenced by their long existence without subsidization; (b) if they are inefficient they will close eventually due to market pressures (as happened in the case of two mills in 1984/85); and (c) if the Government ordered their closure it may get bogged down in complicated legal problems. 2.17 To ensure that the closure decision maximizes benefits to the economy, both financial and economic criteria should be included in the study recommended above. The proposed criteria are the folloving: (a) cost of processing (including haulage) per picul; (b) cost of haulage per tonne of cane; (c) operating surplus/loss; (d) an assessment of whether on-farm costs of producing sugarcane are likely to be high in the mill district, considering the climate, soils and terrain; (e) an assessment of whether conclusions of the ethanol feasibility study would make any diff-erence to the viability of the mill district; and (f) a similar assessment of the impact of existing refineries on viability of respective mill districts. Hill districts should be ranked based on the above criteria. The period 1983/84-1986/87 should be covered. The study should be carried out by independent consultants to ensure utmost objectivity and be supervised by NEDA with the cooperation of PHILSUCOMN MTI, MAF, PNB, DSP and other relevant agencies. The study should be finalized by the erd of July 1986. Draft terms of reference for the study are included at Annex A. 2.18 The closure of some mills will generate externalities in the form of improved capacity utilization, lower unit costs and larger surpluses for surviving mills. As such there is a strong case for compensation to mill districts-which will go out of sugarcane and a compensation scheme should, therefore, be formulated by the Government. Several mechanisms such as a levy on sugar production in remaining mill districts; Government investment programs in irrigation, transport and market infrastructure; special financing programs for crops other than sugar; etc. could be considered. Since special financing programs inevitably introduce distortions, the most expedient alternative in the short term appears to be a levy on sugar production, with Government infrastructural investment programs considered for these mill districts in the medium to long term. 2.19 A more complex issue is whether imposition of production quotas would be required even after milling capacity has been rationalized. It is clear that quotas are not a substitute for mill closures since they would not resolve the problem of unviable capacity utilization levels. Quotas could only be complementary since even after mill closures there would be some excess processing capacity in the country to take care of a possible ethanol program (paras. 2.21-2.23) and some future world market exports. There are two arguments against production quotas at this stage: (a) once mill closures have taken place, the market process should determine sugar prices and produc- tion; and (b) since the financing problem appears to have become worse and the 1986/87 sugarcane crop is now projected by some sugar producers to be even less than the desired level, there is no need for production quotas.  - 12 - 2.ZO Both of the above arguments have merits; the first, in particular, is the recommended Government policy in the medium to long term. However, once again the short-term problems in the sugar industry have to be taken into account. Though adequate details of the latest sugar financing situation are not available (further discussion in para. 3.18), it appears that commercial banks are over-cautious about financing sugar at present due to the uncer- tainty about the price level of sugar in the domestic market (see para. 3.22); this uncertainty is in turn due to lack of reliable data on the present sugar stocks in the country (para. 2.09) and the domestic demand level (para. 2.08) on the one hand and the huge excess sugar processing capacity and absence of production quotas on the other. These uncertainties are an inevitable result of the sudden change from a single buying and selling agency (NASUTRA), which guaranteed to producers and banks a minimum liquidation price (see further para. 3.21), to a free domestic market where the price level is difficult to predict. It can be argued that these short-term uncertainties can be considerably reduced if the-Government were to work out a production target, taking into account confirmed data of sugar stocks in the country and the actual sugar consumption in 1985, and allocate quotas to mill districts based on their average production in the last few years. It is true that, given a free domestic market, these quotas may not be fully enforceable, but the existence of a rational overall production target and quota allocation to individuai mill districts may be extremely useful to banks in taking their financing decisions regarding individual planters. Once the free domestic market processes are generally understood and prices can be anticipated, there may not be any need for production quotas and the market process could efficiently determine sugar prices and production. The need for production quotas in the short term should be reviewed before the next planting season in the light of the previling financial situation. If a system of quota allocation is introduced, quotas should be transferable among and within mill 4istricts so that the more efficient producers can buy quotas from the less efficient and, in consequence, rationalization proceeds according to comparative advantage. Product Diversification (Ethanol) 2.21 An important element in the restructuring of the sugar sector is the- proposed ethanol program, which is presently the most significant available product diversification option. In 1985, the Government began to examine the potential for ethanol and envisaged the eventual production of 600 million liters of alcohol per annum (equivalent to about 800,000 tonnes of raw sugar); of this, 300 million liters were to be exported. A new Alcohol Corporation (with equity from the Government and foreign partners) was to be established to oversee the program and, if necessary, to own, manage and operate alcohol distilleries throughout the country. A detailed feasibility study of the ethanol program was undertaken, supervised by the MTI. According to informa- tion received from the Government, the feasibility study team was composed of members from both the public and private sectors. The public -sector was represented by the Board of Investments, Philippine National Alcohol Commis- sion, PHILSUCOM and National Development Company. The private sector was represented by Marubeni Corporation of Japan and Pilipinas Shell. The study is reported to have been completed but has not yet been released by the new Government.  - 13 - 2.22 The ethanol program is not an answer to the short-run crisis caused by unemployment and underemployment in the sugar areas Cpara. 1.09), since start-up of the ethanol distilleries will not take place for at least 18 months or more probably two to three years. Furthermore, looked at from the point of view of efficiency, the most appropriate course of action would be to encourage private sector investment in distilleries. There is already considerable private sector experience in alcohol production in the country and the installed capacity is close to 50 million liters per annum. Given a supportive policy environment-, private sector investment in the ethanol program should be expected. 2.23 Based on peeliminary findings of the ethanol program feasibility study, there is no scope for major exports of anhydrous ethanol as an octane enhancer to Japan. Export possibilities to other countries are also limited, given competition from Brazil. It appears that the Philippines would have to initially concentrate on the domestic market with a gradual replacement of lead additives and an ultimate blend of 20Z ethanol with gasoline as an octane enhancer. The Government enacted legislation for the gradual elimination of lead from gasoline used in the country, recognizing the health nazards of lead additives. The five-year program reportedly formulated by the feasibility study team envisages the upgrading and expansion of existing private distil- leries annexed to sugar mills in the early years of the program. By the third year, new distilleries are envisaged to be built and annexed to selected sugar mills, if found feasible. The program target is to bring about "lead phase- down" through the use of a 1OX blend alcohol in gasoline by the third year. The objective after the third year is to bring about a total phase-out of lead. The economic analysis of ethanol production presents complex problems as evidenced in several recent studies in Latin American and Caribbean countries. The feasibility study would have to be reviewed carefully before a decision is taken to launch an ethanol program in the country. The falling oil prices, in particular, raise doubts about the economic viability of ethanol production. On the other hand, given the considerable sunk costs in sugar mills in the country, the economic costs of production of ethanol in annexed distilleries could be quite low. These factors, among others, should be weighed during the review of the feasibility study. Further, if the ethanol program is found feasible, the breeding and propagation of-high- yielding alcohol cane varieties, which have been introduced in Brazil in particular, would have to be given a high priority and the "energy cane" concept evaluated. The concept refers to sugarcane that is managed as an energy crop for its total-growth potential rather than sugar and necessitates changes in agronomic management practices including selection of high tonnage varieties, improved land preparation, increased fertilization especially nitrogen, adequate irrigation at all times, maximization of growth until harvest and inclusion of cane tops and leaf trash in the final tonnage. Crop Substitution and Diversification 2.24 The third major strategy for the economic adjustment of the sector is the substitution of appropriate crops for sugar in areas where the latter is no longer economically viable. While the market process will eventually determine the cropping pattern in sugarlands, the Government will have to provide some assistance, at least in-the short term, because of (a) lack of  --14 - knowledge in many areas, particularly those such-as Negros where sugarcane has been traditionally grown, of the best alternative crops based on agronomic and marketing suitability; (b) problems associated with the existing land distri- bution pattern; and (c) insufficient market infrastructure. Without any Government intervention, crop substitution may entail trial and error and a high economic cost. 2.25 Crop diversification would likewise need some Government assist- ance. Diversification, as opposed to crop substitution, refers to the development of complementary production activities with sugarcane as the main crop. Sugarcane-based diversification is not strictly necessary. However, it is desirable as it increases the income of sugarcane producers per unit of land under sugarcane and reduces underemployment of sugarcane workers in the off-season. It is particularly helpful when sugarcane prices decline since it provides some stability to producers' incomes. 2.26 Thus far, crop substitution and diversification have proceeded slowly, largely because, given present relative pri-es, sugarcane is still the most profitable annual crop to grow in most of the sugarlands as shown below. These results are based on farm budgets for plant and ratoon cane.jn Tables 12A and B and farm budgets for other crops in Background Paper 8., Net revenue per ha before rent and finance charges (P) High input/output Low input/output Sugarcane - plant 14,055 6,492 - ratoon 13,253 5,826 Paddy 9,340 3,543 Corn 7,613 3,097 Soybean 4,420 1,810 Sweet potato 5,483 2,590 Cassava 6,520 2,225 Mungbean 5,075 1,710 Peanut 6,124 2,020 Vegetable (Onion) 18,640 12,360 Pasture and cattle fattening 4,165 3,043- The above analysis is based on a single crop per ha per year, which is the case in most of the sugarlands, given climatic characteristics. Though vegetable growing is more profitable than sugarcane, soil and climatic 8/ The results for both high input/output and low input/output cases in the table are averages for high cost and low cost areas as detailed in farm budgets in Background Paper 8.  -15- requirements and marketing problems render vegetables a very limited crop substitution option in sugarlands. The major annual crop superior to sugar- cane is rice under irrigated conditions where two or three crops can be grown in a year compared to only one crop of sugarcane. However, only about 9X of the sugarlands is under irrigation (para. 2.50) and irrigated rice is, there- fore, also not a significant option. 2.27 Given the relative profitability of sugarcane, as shown in the table above, many large planters have not changed their cropping pattern and have preferred to leave large sugar areas idle in the hope that the financing situation will improve and these lands will be planted to sugarcane again. Some lands have been foreclosed by the banks (para. 3.06) and have remained unsold and uncultivated. Other reasons for land having been left idle are the following: (a) even though an existing Presidential Decree exempts all sugarlands from the land reform laws pertaining to rice and corn (maximum per- missible holding of 7 ha), many large planters are apprehensive that the land reform laws may become applicable at a future date if they diversified into rice and corn on a large scale; (b) planters, particularly in Negros, are relatively unfamiliar with commercial production of annual crops other than sugarcane, are reluctant to face the marketing uncertainties associated with large volumes of production and have avoided investment in perennial crops with long gestation periods owing to the high interest rates; (c) given the prevailing law and order situation, particularly in Negros, the large planters expect widespread pilferage 't harvest time, particularly if they grew rice and corn; (d) availability of credit for other crops remained a constraint, though not of the same magnitude as for sugar, in 1984 and 1985; and (e) owing to the heavy concentration on sugarcane in Negros and some other areas, private sector investments in post-harvest facilities for alternative crops, particularly corn, have been limited and the shortage of such facilities is a constraint to crop substitution and diversification. However, once industry rationalization is achieved and demand for post-harvest facilities for paddy, corn, etc. is perceived as stable, private sector investments are likely. 2.28 Crop substitution has also been proceeding unevenly among the different islands and farm sizes. Substitution seems more rapid in areas which formerly had a very diversified cropping pattern (such as Panay where the sugarcane area in 1985/86 declined by about 58Z over 1983/84 owing to substitution of mostly rice and corn; the decline in area in Negros was only 26%) and on smaller farms. 2.29 There are three main issues related to crop substitution and diversification. First, what are the crop substitution-and diversification options which are economically efficient considering the country's resource  - 16 - base, availability of technology, availability of markets and current and projected long-run relative prices? Second, will these economically efficient options be adopted by sugarcane farmers fast enough to provide alternative employment opportunities to the large number of sugarcane worbers who are currently unemployed and underemployed? And third, if not, what policies and programs are required from the Government to accelerate the process? 2.30 Taking the second question first, it is clear that the progress is unsatisfactory so far (para. 2.27). Were it not for the pressing problem of unemployment and underemployment of sugarcane workers, questions two and three would lose their urgency. This is because, unlike some other countries, there is no problem of allocation of good land in the Philippines to sugarcane as against foodcrops. A near self-sufficiency in rice and corn, the two major staples, has been reached and there is thus no conflict between sugareane growing and food self-sufficiency. Given the negative answer to question two, question three has to be addressed. The recommended policies and programs to accelerate crop substitution and diversification are discussed in Chapter III and the main crop options are discussed below. 2.31 It is somewhat difficult to make specific recommendations for crop substitution and diversification at this stage since the sugarcane areas are located throughout the country and have varied resource bases and climatic characteristics. With the freeing of the domestic market for the 1985-86 crop year (para. 1.13), it cannot be predicted which mill districts will go com- pletely out of sugarcane and how much hectarage will be devoted to sugarcane in the mill districts that survive. If the earlier decision of the previous Government to close some mills and impose production quotas on the remaining mill districts (para. 1.13) had been implemented, a more concrete program for crop substitution and diversification could have been developed. 2.32 Sugarcane-Based Diversification. For areas remaining under sugarcane, the available options and prospects for diversification appear limited in the medium term. There are two main possibilities: (i) inter- cropping with mungbeans and peanuts; and (ii) livestock integration. The technology of intercropping (with plant cane) is well-established, particu- larly for legume intercrops which have been shown to have no detrimental effect on sugarcane yields. Yields of intercrops are about 50Z lower than monoculture yields. PHILSUCOM embarked on a national campaign to encourage intercropping of sugarcane with legume crops in the late 1970s but this slackened considerably when the world price or sugar improved. Among the problems encountered in intercropping were difficulty in marketing the produce, inadequate post-harvest facilities and pilferage. Present constraints include the low yield and uncertain market prospects of intercrops. The available varieties for intercropping were developed for monoculture and thus lack the desired adaptability to intercropping. There is consequently a need to breed intercrop varieties which will be shade tolerant. In addition, there is a need to re-examine the traditional system of cane cultivation to adapt it to multicropping if the benefits of intercropping were to be maximized. For instance, it has been shown at the UPLB that modifying row arrangements to a double row scheme can easily double the intercrop yield without reducing the sugarcane yield. As for market pros- pects, available data show the domestic market for mungbeans and peanuts to be  - 17 - small. There is a possibility of utilizing the presently sizeable unused capacity in coconut oil processing for production and export of peanut oil. However, the profitability of peanut oil exports needs to be analyzed (see further para. 2.38). 2.33_ Integration of ruminants (cattle, carabao, goats, etc.) offers another possiblity in view of the availability of sugarcane by-products which can be used as feeds, namely, sugarcane tops, bagasse and molasses. Whole sugarcane can also be fed to livestock. The dairy industry and cattle fatten- ing for sale are possibilities (also for mill districts such as Cagayan, if they were to go completely out of sugarcane), given the significant scope for import substitution. However, a shortage of improved animal stock, insuffi- cient familiarity with dairy technology and low domestic prices of dairy products as a result of cheap imports (mainly from the European Economic Community (EEC) which subsidizes its exports) are major problems for the producers. Previous estimates of domestic resource costs show Jimpor ,substi- tution of dairy products in the Philippines to be highly uneconomic.Z The economics of the dairy and meat products industry, therefore, needs further review b-efore significant Government investments are made in establishing herds and training farmers. 2.34 Crop Substitution. The crop substitution options in sugarlands are more difficult to analyze. Adequate land capability data are required for mill districts and marginal areas within mill districts which will go out of sugarcane. The MAF has reportedly completed zoning data for 39 of the country's 73 provinces to supply farmers with a list of suitable crops based on soil and climate. The remaining zoning surveys are expected to be completed by mid-1987. A land capability survey is at present being under- taken in Mindanao. For Negros, the most important sugarcane area, scattered land capability data are available but have never been integrated. A land capability survey is, therefore, a high priority for Negros. 2.35 Based on available information, the crop substitution and diversifi- cation options in sugarlands are presented in a tabular form on pages 18-19. The advantages/disadvay8ges and areas of suitability of identified crops and enterprises are shown.- The market prospects for these crops and enter- prises are discussed in detail in Background Paper 9. 2.36 Rice and corn are obvious alternatives in sugarlands. Through 1987, rice is the most significant alternative. The Philippines is now almost self- sufficient in rice and during 1977178-1983/84 small quantities of rice were exported. The drought in 1982/83 reduced domestic production considerably, depleted stocks of the National Food Authority (NFA) and made imports necessary in 1984 and 1985. With a tood crop in 1984/85 (owing to exception- ally good weather), self-sufficiency was regained. The NFA is replenishing 9/ World Bank, Philippines - Agriculture: Issues in Pricing Policy, July 10, 1984 (Table 8, page 33). 10/ For details, see Background Paper 8.  SIICUNS DIVRISIFICtAflO S?IDP Crop/Knterorise tub etituctoa Otiona Ctosjgntarpriss Advnagemp ieadvntag.e Rest apprOpriate loeCation A. Annul Crops 1. RIce - Traditolnal crop of the country - breSt *ulted to low-lyig and/or - throughout coutty in low/flat *teas - Va11 suited to climate and coil. tlrtgated ar e - S_s1 (< 10.0 ha) ferm., whtch cen - Pro"" produettia technology evwtleble - Labor tntenetv provide labor cad mnagq nt - lthrat profp eot good - Aequiree goot manement to schldv - Produetion credit available high ytilda - Production an large etates tobibtod by fear of land reform. 2. Corn (mime) - Comneraly suited to cliatet acd soils C_rop requires good emangoveat _ Througbout country, but e micilaly in - traditional crop, especially in - Post-harvet factlittes (ehtllere, indatino, on gently-tolllg land that mindenco - dryere, *torage) inadequate ts vll drained - Phtlippines io an Iw4rter - Production on large tUtate inhibited - Smll (< 10.0 he) faras Ikely to be by fear of lend reform east appropriate 3. ung 1 leans - Crows mell In most augarcane oreas - Current supplr and demand appear to be - Throughout the country - Very *hort grownag period (< 90 days) In balance and domeseic sorket unlikely enablee up to 3 trope a yJar to be to ebvorb igniftcint ncrementa grown in goae areas production - intercrops veil With asie a*nd eugarcane 4. Sweet Fotato - Ytields well with good nagemeat and - Cost* of prodOction stetlar to thoee of Viayes eand central Luzon rainfall (k 15 tlha) asie but net returna lows - Relattwely short growing period (* 110 - Zarkets ltatted to areas in prozimity days) facilitates at least 2 crope a to a feed ill in pig producing area. year - Shortege of tained extentien staff - Proven production teehnology end - Shortage of pt-harvest facUitties cultivara voailable S. Ceecaw - Well suited to dry areas that have - Long growing season (10 monthe) Dry ereae of Visaye pronounced dry season (> 4 months) - Limited market de_md a4s hbn food; - Requires only Moderate anagement to feodstuff outlets limited to areas with yield 1St/ha a pig todustry - Froven production technology available - Sbortage of aeedstock likely to alew up introduction - Lack of traitnd extension staff - Shortage of post-barveet facilities 6. Soybean - Philippines a malor importer - Rainfall too erratic ti many area to Parts of Ittndanco facilitate do _ managemt of crop - Tields achieved to date very low (< 0.5/ha) - ors dovelopment work required to determine appropriate faruar produetoan practices 7. Peanuts - Sotl and cliate of sugarland euitable - Significant problew of pests and Mest *ugarcans areas for the crop disease, weeds, costly harvesting, and - Can be intercropped with eugarcnfe Inadequate eveilability of iproved - Producttio technolegy available aeeds and storase facilitie. - Domestic market mall; cost coapetitivense of peanut oil exports not yet eastablihed I. prenntl,ICrope 1. r - Can be equally well produced on large - t S year to productton Nhrginal lands and sall (1.0 ha ) farms - Cn only be lntercropped In the first 2 iainly in Nivdano - Doem not require existeuce of neighbor- years. therefore, special financing hood procesiSng and handling failities arrang_ats required - Trading tnfrastructure already ests - Shortage of budded rubber tree may ta sea areas (0. Cetabeto, I.e. Site Inhibit expansion of area Psinby) - Resonably good doesetic and export erkato  - 1Q - Cropsllnterprtee Advnteages pigdvaiitegot appropitate locations 2. Coconuts - traditional crot. no tec1ntcs1 problms tWag tim to maturity ( 7 ye4rs) 7hrehout Pbilppines anticipate - digh cost of etsbistdm"nt - Goao opFortfutitea for tntareropptin ( 1anne in first 5 years tollowed by cocoa) 3. OIl Psis - Crop *hould grow wetl in socm 4rodW -tqutree the est*blaent of nWMliog Not likely t eho en epprepriate eubatitute - Export eavrnis potentislly good ad proceseing t factttea, best og- fot cane. am area requtied too large aised on a plontattoan estate basoi. - Itreover pfficient tlad to aot avail- able tn lat* suou_h parcelt to attract posSible investo. - to local trettin of oal pals tn the country; therefore. ms$or managqemt en4 training effort needad 4. Cnou - Grove wel, especially under coconuts - Lo cuttivar Ausceptible to vascular Nindonao - ts known by farmers diseae ne cultivate rquired Stt euttd to deelopmt in @xietiSn - fphlppines to an tporter - Atl crop c.te coats very bigh due to cocenut patations, or uder ne coconut - yields bestn in 3 years of pesticide spraing regie plantip eaiablitaheat - Cood crop innsgsmm tequtred (pruning. weeding. etc.) 5. Coffee - Ytiets dequately (robasta) - Unlikely to be suttable for substitute throughout Philippines - PhlIppines nct yet elsufeufticient planting of large ex-cane areae Small fare - an be gron by weall famrs- 6. Reasn - Troditional crop of tindao - Local ret pefttrs locl varieties, Kindenoo (plaetation and amll holder) best produced on a backyard bsie - - xport opportunittes Utnted to ipros selected ultivare whibch can beat be produced under estate/plentetion conditions and not by smll farmer. 7. Pineapple - Ttadittonal crop (smll productr and - tocal market l supplied Trougbhout Philipptnes plantation) - later-tiland sales ititd due to production In most provincea - po-irt opportunities litmted to procesed pineapple which would requtre - eonetructton of procesinSg plant S. Ctttus/Sungoe - t4cal *ad export markets exist - Long (* 6 years) period to produacton Viyae - Better suited to ell dratined btlly cress - Mango difftcult to intercrop S. IPil-lpil - Grows well where soils are not too - nltivtely low financial returns fSrtnl (hilly) augarlanda acidic - Can be usd as a source of todder or a*e a source of fuelmeod - Goad doestic nd export arkets C. Livestock and Aluncultuce 1. Cattilfti7 -ung on - Philippines tie e at nd dairy - no speciftc production adventages in possible opportunity in CgaySS Valley of Pasturestaangelnds products tIporter most ares N eon - Pasture production technoloa well- - Ltw stock ntbr at pree nt; there- known fore. btuid up of a saimeala erd(so - use of Cottle mnure tao fortilizer. woud take a tons tie and/of be llowetr tbe total value of nutrients expensive supplied by cattle manure ts relew. - Vary ltmtted tradition of cettle On average, dried cattle anure rearnug contfins 2.02 nttrogen - Cottle burnese is high risk (disteee, 1.52 phoephete teft. etc.) and the lose ef a nle 1.52 total potash aninel could bankrupt smell producert if they relied on cattle *loe for an incoms -A major fatteningdairy program would requre meseire Government support to establits herds and train fartre eand provide fincial escurity - CAttle raising ehld be aeen as a mediun to log tela objective to be schierd by GOvennt incntites to local producers 2. Aquaculture - Profitable where land peritos chep - elatively bib catal coat beyond througbout country construction of ponds. etc. means of moat growrs  - - 20 - its stocks through purchases of domestic paddy. Exports of rice, therefore, appear unnecessary at least through 1987. However, if any major increase in rice production occurs (e.g., through large-scale conversion of sugarlands to rice), disposal cf rice surpluses would become an issue. At the current world price of US$225/tonne (FOB Bangkok, 5Z broken), the Philippines cannot compete in export markets. With the high interest rates now prevailing in the country, the average FOB cost of rice (roughly estimated) would be about US$250/tonne (at P 18.5 = US$1) for 25-30% broken. Even if interest rates were to decline significantly, the FOB cost would be about US$225/tonne for rice of a much lower quality than Thai rice. The world rice price would have to increase by at least 25X from its present level before the Philippines could enter the export market. If the projected 1990 world rice price of -US$332/tonne (in 1985 constant dollars) materialized, there may be attractive export opportunities for Philippine rice. However, the domestic rice pricing and marketing policies in the Philippines need to be reviewed (see paras. 3.11-3.12). 2.37 The next important alternative crop is corn. Until 1984, yellow corn was an attractive import substitution crop as about 300tO00 tonnes (equal to about 20% of domestic consumption of yellow corn) were being imported for animal feed. With a good crop in 1984-85, which also coincided with a decline in demand for yellow corn from feedmillers (for the poultry and livestock industry) caused by the economic recession, the deficit has been considerably reduced. Corn exports appear unprofitable in the short to medium term. The average FOB Manila cost of corn is roughly estimated at US$150/tonne. If domestic interest rates were to decline, the average FOB cost would be-about US$130/tonne. At the current world price of US$115-120/tonne (FOB Gulf ports) and the projected 1990 world price (in 1985 constant dollars) of US$111/tonne, it is unlikely that the Philippines can become a corn exporter, unless major technological breakthroughs or farm efficiency improvements take place. How- ever, domestically, a resurgence of feed demand, as a result of the expected economic recovery, would provide a significant scope for yellow corn import substitution. The Government's extension and financing programs for corn expansion in sugarlands should be phased, taking into account the pace of feed demand recovery (see further para. 3.13). 2.38 Other possible annual crops include mungbeans, peanuts, sweet potato, cassava and soybeans. Available d indicate only small domestic markets for each of these except soybeans. Peanut could be an important export crop and deserves further investigation. Both the climate and soils of the sugarlands are generally well suited to peanut; production technology is known; peanut can be intercropped with sugarcane; and suitable varieties are available to make possible adequate yields of about 2 tonnes/ha (unshelled). The presently substantial unused capacity in coconut oil processing can be- used to produce peanut oil which would have to be exported, since the domestic market for peanut oil is negligible. The processing costs of peanut oil and the financial viability of exporting peanut oil, however, need to be investigated. 11/ For details, see Background Paper 9.  -21- 2.39 The domestic market for soybeans is substantial as about 400,000 tonnes of raw bean equivalent of soybean cake are annually imported for-animal feed. However, full import substitution of this amount through domestic raw bean production would generate a large quantity of soybean oil which cannot be absorbed by the domestic market and would have to be exported. The financial viability of this needs to be investigated. Moreover, the present domestic processing capacity is inadequate for this quantity of raw bean. The volume of imports, which could be substituted by using available domestic processing facilities, is about 35,000 tonnes. Even this considerably exceeds present domestic raw bean production of about 8,000 tonnes. But the primary problem with soybean expansion is the technological package, which needs further devel- opment. The results of the Soybean Pilot Production Program of the PCARRD should be reviewed before a significant expansion of soybean acreage is encouraged. Assistance to PCARRD should be considered for establishment of a legume research and development center similar to that existing for root crops. 2.40 Among perennial crops, the best would appear to be coconut, rubber and cocoa. Coconut has the disadvantages of a long gestation period (seven years), given the present high interest rates on bank credit, and of an uncer- tain export market outlook, bl. it has the advantage of being a traditional crop in the country and has good opportunities for intercropping (annuals in the first five years, followed by cocoa) to compensate for the long gestation period. Rubber has the disadvantage of a long gestation period of five years (and it can only be intercropped in the first two years), but the advantage of a reasonably good domestic and/or export market. Cocoa has the advantage of both a short gestation period (three years) and a reasonably good domestic market. The existing infrastructure (offices, houses, roads, mill premises, etc.) in mill districts and the familiarity of farmers with arrangements for centralized processing provide an excellent basis for nucleus estates growing perennial crops. The infrastructure could also facilitate establishment of centralized post-harvest facilities. Private firms, existing planters' asso- ciations in mill districts and millers should be provided technical assistance by the Government to establish nucleus estates for perennial crops or centers of post-harvest facilities for annual crops in mill districts which go out of sugarcane. Adequate financing is available for these private sector investments. 2.41 Ipil-ipil tree cultivation offers another possibility, particularly on the marginal slopes in Negros. Ipil-ipil stalk for firewood and leaf for animal feed have a good domestic market and leaf meal has an attractive export market in Japan. Limited possibilities also exist for fruits such as mangoes, bananas and pineapples; acquaculture; and miscellaneous minor crops. Projec- ted acreages of alternative crops in sugarlands are shown in para. 3.15. Further discussion of these alternatives is in Background Papers 8 and 9. Improving Sector Efficiency 2.42 The fourth major adjustment strategy is of a longer-term nature: that of increasing sugar sector efficiency. Compared to many major sugar producers in the world, the Philippines has low on-farm productivity and tech- nical processing efficiency. In terms of sugar production costs, while some  - 22 - mill districts appear competitive with other efficient producers in the world, the national average cost is high due to the cultivation of some high-cost marginal areas, inefficient management of some farms, some mills with high operating costs and others with extremely high financial costs (para. 2.05) and low capacity utilization of mills (para. 1.05). There is thus a need to reduce average national costs of sugar through appropriate policies and pro- grams and by concentrating production in reasonably efficient mill districts. 2.43 Farm Productivity. Average yields of 53 tonnes of sugarcane and 5 tonnes of sugar per ha in the Philippines are low compared to almost all ma- jor producers in the world (Table 13), except for Brazil which has yields si- milar to those in the Philippines (Table 14). Brazil is, however, a lower- cost producer. Factors which merely cause low yields have to be distinguished from those which cause both low yields and high costs since it is the cost of production rather than the yield per ha which is important. 2.44 The following major factors appear to cause low cane yields in the Philippines: (a) a relatively low input level provided on most small farms (mainly low fertilizer use and in some cases animal rather than tractor land preparation); (b) use of land which is marginal for sugarcane (clayey soils, hilly areas, poor drainage, etc.) but accounts for some 25-30% of the sugar- cane area; (c) poor quality seedcane material owing to the use of cane tops which become relatively dessicated in the dry season and are sometimes infec- ted with borers; (d) poor ratoon yields of the variety most commonly planted in the country; and (e) an uneven distribution of rainfall in many areas and provision of irrigation on only a small proportion of the sugar area. Exten- sion and research for sugar have not been strong enough to overcome some of the above farm productivity problems. 2.45 Input Use, Farm Size and Cost of Production. Of the above, the first factor, i.e. low input use, does not necessarily result in higher costs per unit of output even though it leads to lower yields. Low input use is a rational decision made mostly by small farmers to minimize costs and maximize profits in view of their limited access to credit and weather uncertainties. Some small farmers do, of course, have high input-output levels. Available evidence shows that the cost of production per ha and per unit of output on low input/low output small farms is generally lower than on larger farms with higher inputs. This is illustrated in Tables 12-A and 12-B and validated by the results of a PHILSUCOM survey (Table 15) and estimates from the PHILSUCOM research station at La Granja (details are in Background Paper 5). The conclusion is further supported by-data in Table 7 which show that the variation in yield of cane per ha between small farms (below 5 ha) and large farms (above 100 ha) is not very significant except for South Negros and Panay. In South Negros, it is 88% and in Panay, 47%. In all other regions (accounting for about 67% of the country's sugar area), the yield variation is from 7% to 27%. It appears that, on large sugarcane farms in the Philippines, higher yields in general do not fully compensate for the increased costs per ha resulting from a much higher level of mechanization, fertilizers and other inputs, overhead costs and finance charges compared to those on small farms. 2.46 An interesting point that emerges from Tables 12-A and 12-B is that net returns per ha would be higher with increasing input levels if a certain  - 23 - level of yield increase were achieved. This appears logical as otherwise there would be no incentive to use higher input levels. Therefore, the larger the farm size and/or easier the access to credit, the greater the tendency to use higher input levels as long as financing is available. However, marginal sugarcane areas and those with inefficient management may not show the input- output relationships in Tables 12-A and 12-B and higher input levels may not, therefore, result in higher net returns per ha. 2.47 All the other factors mentioned in para. 2.44 as causing low yields also tend to increase costs and should be addressed in any productivity improvement program. A complex set of policies and programs including pric- ing, marketing and financing of sugar and improved extension and research would be needed. The phasing out of marginal areas would be encouraged by appropriate sugar trade and pricing policies (paras. 3.26-3.27) and,-if production quotas are to be allocated in the future (para. 2.20), by quota transferability among and within mill districts. Preparation of individual mill district plans and crop zoning would also help in this respect (see further para. 3.55 (d) and, for details, Background Paper 2). Establishment of seed treatment plants annexed to sugar mills and seed cane nurseries to be owned by planters' associations should be undertaken to address the poor seedcane problem. PHILSUCOM should assist in this process. 2.48 Ratoon Culture and Yields. Improved ratoon yields and culture appear to be the best means to decrease costs even in the short term. The ratoon cost per ha is lower than that of plant cane since no land preparation is generally involved. Data from PHILSUCOM show ratoon cost per ha to be about 202 to 26% lower than the plant cane cost. Moreover, the lower ratoon yield does not neutralize the cost advantage. PHILSUCOM's research station at La Granja estimates that the cost per picul of ratoon cane is about 15-20% lower than that of plant cane (further details are in Background Paper 5). Compared to Brazil, which appears to have many features similar to those in the Philippines including a very small irrigated sugarcane area, the lower on-farm cost in Brazil (despite the reportedly higher labor costs) may primarily be due to fairly high ratooning (4 to 5) with reasonably high ratoon yields compared to only 1.5 ratoons in the Philippines (Table 16) with low average ratoon yields. Improved, high-yielding sugarcane varieties are avail- able in the Philippines and yield over 100 tonnes/ha on some farms. However, about 52% of the country's cane area uses a Philippine-bred variety, Phil 56-226, which is a medium-tonnage, relatively early maturing (10-12 months) variety that is highly susceptible to smut disease and, therefore, performs poorly when ratooned because of poor cane stand. Planters remedy the problem by growing plant cane yearly or minimizing the number of ratoons. Despite the lower ratoon cost per ha and per picul, the low ratoon yields result in a lower net return per ha than that from plant cane (Tables 12-A and 12-B). Therefore, if financing is not a constraint (and it was not in the past), planters will choose plant cane rather than ratoon cane. 2.49 Varieties such as Phil 6607, Phil 6723, VMC 67-611 and VMC 71-238, which have better ratooning ability than Phil 56-226, have not been adopted widely by planters for a variety of reasons including lack of pressure in the past to reduce costs; inertia of farmers to switch from an old, familiar and tested variety like Phil 56-226 to new varieties; and inadequate extension and  - 24 - field demonstration trials by PHILSUCOM for the new varieties. However, some areas of the country have a fairly high number of ratoons. Thus Mindanao had 4.5 and Panay 3.4 ratoons in 1983-84 compared to the national a-erage of 1.5 (Table 16). Improper ratoon culture has also contributed to low annual aver- age sugarcane yields in the Philippines. Ratoon operations such as stubble shaving, fertilization and cultivation are usually delayed by planters. As a result, the first ratoon yields 10-20% less than the plant cane, the second ratoon 25-302 less and the third ratoon 40-50Z less though, with adequate inputs and proper care, the first and second ratoons should yield about the same as plant cane. A major campaign by PHILSUCOM to promote better ratooning varieties and improved ratoon culture are needed to reduce costs. 2.50 Irrigation. It is estimated that about 41,000 ha of sugarcane are currently under irrigation. This represents about 9% of the total sugar area of 442,000 ha in 1983-84 and about 131 of the projected 321,000 ha under sugar in 1985-86. Compared to many major sugar-producing countries in the world, the proportion of irrigated sugarcane in the Philippines is extremely low. Moreover, some irrigated sugarcane areas do not receive water throughout the growing season. While the average annual rainfall in the sugarcane-growing areas is more than adequate at about 200 cm (Map IBRD 19441), the distribution of rain in most mill districts is uneven, causing water stress during cane growing periods and thus lower cane yields. Irrigation would resolve this problem and help increase yields. 2.51 However, the research base to quantify the impact of irrigation on incremental yields of sugarcane and the cost of production is very weak in the Philippines. A PHILSUCOM estimate shows that, conservatively, an incremental yield of 22 tonnes of cane per ha might be produced from 2.5 rounds of irriga- tion. But experiments on the yield response of sugarcane to irrigation con- ducted by UPLB in early 1974 showed discouraging results. In absolute figures, the yield response to irrigation under experiment station conditions ranged to a maximum of 12.5 tonnes of cane per ha and under l)eld trials to a maximum of 3 tonnes of cane per ha over rainfed cane yields,- The actual incremental yields attributed to irrigation by planters in various mill disjj cts in July 1985 were mostly in the range of 20 to 27 tonnes of cane per 2.52 The irrigation strategy of the Government was to lay the basis for rice self-sufficiency through provision of irrigation facilities to small farmers. At present about 95% of the irrigated area in the country is devoted to paddy cultivation. Given its preoccupation with rice irrigation and since most sugarcane areas are owned by large farmers, the National Irrigation Administration (NIA) has not embarked upon any public sugarcane irrigation scheme so far. Moreover, since Negros is mostly devoted to sugarcane growing, NIA's presence there has been very limited. Only four national irrigation. -12/ NEDA, Sugar Industry Study Report (pp. 9-10 of the volume relating to the Farm Production Sector), 1985. 13/ See Background Paper 3 for details. -  - 25 - systems, two in the-west and two in the east and covering only 13,000 ha, are operating in Negros Island. 2.53 Evidently, some sugar millers have also been apprehensive that if public irrigation facilities were provided in sugarcane areas, planters, particularly smalt planters, will switch to rice (as reportedly happened in parts of Southern Luzon and Negros) since two to three crops of irrigated rice grown in a year provide substantially higher incomes than sugarcane (para. 2.17). Even with a cropping intensity of 1.5 (which is now roughly the national average), irrigated rice would be more profitable than sugarcane. 2.54 Several years ago, NIA carried out pre-feasibility studies for surface-irrigated projects for sugarcane and paddy in four of the largest river basins in Negros, i.e., Cadiz, Hilabangan, Kalogo and Binalbagan. At that time, roughly estimated economic rates of return for these projects ranged from about 131 -to 17X. These studies are now out of date, hovever, and detailed feasibility studies are needed, taking into account the latest pro- jections for world prices of sugar and rice. Moreover, serious watershed degradation has taken place in Negros as a result of uncontrolled exploitation of the natural forest through logging and shifting cultivation and this is having marked deleterious effects on water availability, erosion and flood- ing. Any major surface scheme in Negros should thus have a watershed protec- tion, management and reforestation component. Of all the sugarcane-growing regions, Negros appears to have the greatest potential for surface irrigation, considering rainfg}l patterns, topographic suitability and availability of water resources.- 2.55 In determining the incremental benefits of irrigation for sugarcane, several other benefits in addition to incremental yields should be consid- ered: (a) irrigation, by increasing farm productivity, would reduce the total cropped area and lower the cost of cane transport, at present a major cost in sugar production; (b) with the guarantee of adequate water input, even small farmers would be expected to apply greater quantities of other inputs than they do in rainfed cropping, thus maximizing their net returns per ha (para. 2.46); and (c) irrigation would facilitate tractor mechanization of land preparation which is generally considered to be a yield-increasing factor for sugarcane. The absence of irrigation leaves only a short period for land preparation and planting when weather is favorable. Small planters dependent on tractor rental services for land preparation are often unable to get these services when needed and must often resort to animal traction. The pressure on tractor rental services and the problem of timely mechanized land prepara- tion could also be alleviated significantly through increased ratooning (paras. 2.48-2.49). 2.56 Drainage. There are no detailed studies to indicate the proportion of sugarcane areas with drainage problems. A rough estimate is 10-15%. Some of the waterlogged areas were once planted to rice but were converted to cane during the sugar boom. Some farmers in these areas are now returning to paddy 14/ See Background Paper 3 for details.  - 26 - cultivation, but the process is slow owing to the fear that the lands will be subjected to land reform. While the switch back to paddy cultivation will take care of a large part of the drainage problem, the Government should con- sider carrying out drainage works, where needed, within good sugarcane zones, to improve production efficiency. 2.57 Sugar Research and Extension. Research and extension services for the sugar industry are handled by the Research ani Development Office of PHILSUCOM. Research is carried out mainly at the La Granja Experiment Station and also at the Luzon Experiment Station. Funding for research and extension, which have had annual budgets averaging P 25 million over the last few yearst is provided from the 3X production tax on-sugar. 2-.58 Sugar research made some important contributions to the industry in the past although more could have been done, particularly to bridge the gap between the research recommendations and their translation a'nd adaptation to the conditions of the various sugarcane areas and the economic realities of the time. PHILSUCOM's limited progress in developing site-specific tech- nologies has caused many planters to lose their respect for the service. There have been several weaknesses in the research program in recent years. crop nutrition studies have concentrated on laboratory analysis of the availability of major nutrients in soils and prediction of lime requirements from pH measurement, the recommendations being based on theoretical nutrient levels required to achieve maximum yields without analysis of economic thres- hold levels of application. This partly resulted from the abolition of the research service's economics division. The field verification trials (major nutrients and lime) and micronutrient studies appear inadequate. Agronomic work in recent years has concentrated on time of planting, population density and intercropping studies and herbicide trials. Most of the work done in support of the breeding program was to determine the agronomic characteristics of new varieties. While this was essential work, the range of investigations appears limited. In particular, studies were needed to determine appropriate practices to prolong ratoon yields. The agricultural engineerinA section has done some good work, particularly on the benefits of mechanical cultivation and harvesting, but a major weakness in the program has been the paucity of data on the incremental yields from irrigation and drainage. Other important areas that need greater attention are the technical and economic prospects of sugarcane area diversification and sugarcane-based farming systems. 2.59 The major problems with sugar research appear to be a lack of strong technical leadership as evidenced by the absence of a well-planned and coord- inated research program; uncertainty as to PHILSUCOM management's commitment to research; inadequate direct expenditure on research (the overall budget is sizeable but is mostly consumed by salaries and fringe benefits) resulting in a shortage of equipment and insufficient mobility of research staff; lack of merit promotion and incentives for professional growth; and centralized fund management hampering flexibility of research operations. 2.60 PHILSUCOM's extension function is carried out b,-sugar development technologists (SDTs) assigned to the various mill districts. On average, each SDT covers an area of 2,000 to 3,000 ha. Based on comments from planters, it appears that the SDTs are unable to provide any significant assistance to the  - 27 - planters, particularly now when the latter need advice on reducing costs and improving production efficiency. This results largely from the SDT8 lack of farm experience coupled with inadequate support from the research group for site-specific studies. Better trained SDTs ar., therefore, needed if the extension service is to be of any value. 2.61 The thrust towards sugarcane diversification also poses a problem for PHILSUCOM extension services since the SDTs' specialized training in sugar renders them unable to advise planters on what alternative crops to grow and the technology required. The planters are instead directed to the MAF for assistance and this has unduly burdened the Ministry whose staffing does not take into account the requirements of sugar areas. 2.62 Cane Harvesting, Loading and Transport.*