Madagascar - Second Agricultural Credit Project

Document of The World Bank FOR OMCAL USE ONLY C a. /o- F Report No. P-4234-MAG REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A PROPOSED DEVELOPMENT CREDIT OF SDR 8.0 MILLION (US W1A.0 MILLION EQUIVALENT) TO THE DEMOCRATIC REPUBLIC OF MADAGASCAR - FOR A SECOND AGRICULTURAL CREDIT PROJECT April 24, 1987 This document has a restricted distribution and may be used by recipients only in ;he peaformance or their official duties. Its contents may not otherwisc be disclosed without World Bank authiorization.  CURRENCY EQUIVALENTS Currency Unit = Malagasy Franc (FMG) 1 US $1.00 = FMG 752 FMG 1000 = US $1.33 SDR 1.00 = US $1.25 2 WEIGHTS AND MEASURES Metric system GLOSSARY OF ABBREVIATIONS AND ACRONYMS ADB African Development Bank BFV Banky Fampandrosoana Ny Varotra (Commercial Bank) BNI Bankin' Ny Indostria (Industrial Bank) BNM Banque Nationale Malgache de Developpement (National Development Bank for Madagascar) BTM Bankin' Ny Tantsaha Mpamokatra (Rural Development Bank) CCCE Caisse Centrale de Cooperation Economique (France) FOFIFA National Center for Applied Research on Rural Development FMR Financement du Monde Rural (Rural Credit Program) MPAEF Ministere de la Production Animale et des Eaux et Forets (Ministry of Livestock, Fisheries and Forests) MPARA Ministere de la Production Agricole et de la Reforme Agraire (Ministry of Agricultural Production and Agrarian Reform) 1/ The Malagasy Franc is pegged to a basket of currencies of Madagascar's major trading partners and the rate of exchange is adjusted quarterly. The exchange rate prevailing in September 1986 has been used in this report. 2/ Rate as of February 28, 1987.  FOR OMCIL US ONLY GOVERNMENT ADHMINISTRATIVE UNITS Fokontany = Village-level local govermment Firaisana = Second tier local government - group of Fokontany Fivondron8na = Third tier local government - group of Firaisana Faritany Fourth tier local government - Region GOVERNMENT AND BTM FISCAL YEAR January 1 - December 31 This document has a rstricted distibution and may be used by rcipets only in tb peff .ns of their offciad duties. Its contents may not otherwie be discosed without Wold Duk aurmlCm.  MADAGASCAR SECOND AGRICULTURAL CREDIT PROJECT CREDIT AND PROJECT SUHMARY Borrower: Democratic Republic of Madagascar Beneficiary: The National Rural Development Bank (BTM). Amount: SDR 8.0 million, (US $10.0 million equivalent) Terms: Standard IDA terms. Relending Terms: (i) The Government would transfer the IDA credit proceeds to BTH as an equity contribution to its capital. (il) Sub-borrowers will have the option of borrowing sub-loans under the following alternative terms and conditions: (a) the IBRD lending rate at the time of approval plus 4Z p.a., the foreign exchange risk to be borne by the sub-borrower; or (b) BTM's prevailing lending rate and commissions for local currency lending, plus a front-end fee of 1OZ of the proposed sub-loan, and a fee of 3S p.a. on the outstanding amount of the sub-loan. Interest rates will be reviewed with IDA twice a year to ensure that they are positive in real terms. Repayment periods on sub-loans extended by BTM would be established on the basis of cash flow projections of each sub-project and on the type of asset to be financed. The repayment periods would not exceed the average useful life of assets being financed nor vuld they exceed a maximum period of 15 years including a three year grace. Proiect Objectives and The project would cover the foreign exchange costs of Description: new investments and rehabilitation and expansion of existing ventures in agriculture (production and primary processingJmarketing)v and would contribute to institutional development of BTM. The project would have two components: (i) a line of credit of US $8 million equivalent to finance, with an approximately two and half year commitment period, the foreign exchange costs of eligible sub- projects; and (ii) an institution-building component of US $2 million equivalent which would help finance BTM's purchase of computer equipment, and meet the costs of a pilot credit  -ii - management project, project audits, consultancy services for sub-project preparation, management and training, and a study to assist BTH and the Government in formulating a suitable agricultural credit policy for Madagascar. Benefits: By reducing two serious constraints in the Madagascar agricultural sector (i.e. lack of foreign exchange and lack of term funds), the project woild help increase production and processing of crops and would allow an increase in foreign exchange earnings through increased exports. It %iould create new employment opportunities for Malagasy natSonals. Through its institution- building component, the project would improve BTM's capacity to support development in agriculture. Risks: BTM may find it difficult to develop in full its development banking capacity, which has been underutilized in recent years. Being called on to play a double role as both a commercial bank and development bank, it might continue to emphasize short term commercial activities, to the detriment of its development lending. If the current banking sector crisis continues, BTH's financial situation may also deteriorate. Finally, the project faces a risk that the Government might falter in its efforts to improve the environment for agricultural development. Safeguards against these risks have been built into the design of the proposed project, including measures necessary to strengthen BTH's financial position. BIT will increase agricultural lending and will not make new loans to public enterprises in financial difficulties. Increased Central Bank supervision of the banking sector and the strengthening of BTM's institutional capacity would act to offset these risks. Finally, the Government has reaffirmed its policy of cooperation with the Bank and the IMF; this overall posture, and continued adjustment lending, should lead to accelerated improvement of the agricultural sector.  - iii - Estimated Cost: Local ForeiRn Total .......... M lio ).. ...........(SMllo) Credit Component 7.90 8.00 15.90 Institution Building Component 1.43 2.00 3.43 Total Financing Required 9.33 10.00 19.33 Z of Financing Plan: Local Foreign Total Total cost ............. (USSillion) .. IDA --- 10.00 10.00 52 BTM 6.15 --- 6.15 32 Investors 3.18 --- 3.18 16 9.33 10.00 19.33 100 Estimated Disbursement: (USSMillions) IDA FY FY88 FY89 FY90 FY91 FY92 FY93 FY94 Annual 0.56 1.48 3.16 1.68 1.36 1.20 0.56 Cumulative 0.56 2.04 5.20 6.88 8.24 9.44 10.00 Staff Appraisal Report: SAR No. 6040 MAG of April 7, 1987 MM: IBRD 19406  INTERNATIONAL DEVELOPMENT ASSOCIATION REPORT AND RECOMMENDATION OF THE PRESIDENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED DEVELOPMENT CREDIT TO THE DEMOCRATIC REPUBLIC OF MADAGASCAR FOR A SECOND AGRICULTURAL CREDIT PROJECT 1. I submit the following report and recommendation on a proposed IDA credit of SDR 8.0 million (US $10.0 million equivalent) to the Democratic Republic of Madagascar on standard IDA terms to help finance a Second Agricultural Credit Project. The Government would transfer the IDA credit proceeds to BTM as an equity contribution to its capital. PART I - THE ECONOMY 2. A report entitled Current Economic Situation and Prospects (Report No. 5996-MAG) was distributed to the Executive Directors and to participants in the Madagascar Consultative Group in March 1986. Its conclusions as well as the results of IMF negotiations on a Sixth Standby Program are reflecued below. Country data sheets are provided in Annex I. 3. With a population of 10 million and a per capita income of US$250 In 1985, Madagascar-is one of the poorest countries in the world. The country is sparsely settled, with a population density of about 17 inhabitants per square kilometer. While generally well endowed with natural resources and a variety of soils, there are large regional variations in ecology and climate. Agriculture is the mainstay of the economy, providing employment for 85 percent of the population, creating two fifths of GDP and generating more than 80 percent of export earnings (coffee, vanilla and cloves). 4. The years following 1972 marked a turning point in Madagascar's political and economic development. The government that took office in 1972 emphasized national control of the economy. It introduced inward- looking policies aiming at self-sufficiency in industry and agriculture, nationalized most of the larger private companies (which were essentially foreign-owned), and established direct or indirect state control over the greater part of agricultural marketing. A new system of regional and local government (the fokonolona system) was introduced, intended to provide for decentralization within a framework of centralized control. The present regime, which came to power in 1975, intensified, extended, and codified these policies. Pricing policies became biased in favor of urban consumers. Fiscal and external economic policy remained cautious through most of the decade, and the level of public external debt was extremely low. In 1978, however, Government decided to diversify the economy, taking advantage of Madagascar's borrowing potential, and adopted a policy of  -2- -all-out investment." Many new parastatal companies were created. Unfortunately, many of the projects selected made very little contribution to GNP, exports, or debt-servicing capacity, so that by 1980 the debt service ratio was rising sharply. 5. From 1973 to 1982, real per capita GDP fell by an estimated 28 percent. The main factors behind this decline were: (a) the persistent climate of uncertainty within the private sector created by the nationalizations of the mid-1970s, combined with the rapid expansion of an ineffiCient and unmanageable public sector; (b) excessive market regulation, through price fixing and controls that favored urban consumers, restrictive licensing legislation, quantitative import restrictions and exchange controls, and the establishment of national and regional marketing monopolies (cereals, agricultural inputs, basic commodities, road and sea transport, financial institutions); and (c) the neglect of smallholder agriculture in favor of import-substitution manufacturing, including enterprises of dubious economic value. 6. The financial crisis that started in 1980 was the result both of inappropriate policies and of external shocks. While export prices flagged and international oil prices doubled, GDP and export volumes continued to decline, the budgetary deficit rose to 18 percent of GDP, domestic inflation reached 30 percent per year, external debt service obligations (before rescheduling) relative to exports escalated from about 4 percent in 1978 to a peak 90 percent in 1985, and the current account deficit of the balance of payments reached 18 percent of GDP. As resource constraints tightened, domestic investment plummeted. Under the impact of heavy external payment obligations, declining export earnings, and reduced creditworthiness, severe foreign exchange shortages prevailed. Import constraints, the severe rationing of foreign exchange, and an overvalued exchange rate contributed to a sustained decline in industrial and agricultural production. 7. Faced with an unsustainable external current account gap, Government began to implement stabilization measures in 1981 with IMF assistance. From 1983, aggregate expenditure was steadily reduced and gross domestic savings increased. Among the notable measures taken to control demand were the abolition of consumer subsidies and tight monetary management. Sustained austerity combined with measures to boost revenues helped reduce the budget deficit and inflation. Measures were also taken to restore production incentives. Throughout 1982-85, the FMG underwent a real depreciation of 25 percent vis-a-vis the SDR, and a further 20 percent depreciation was implemented in August 1986. Public sector tariffs were increased, while a program of liberalization of prices and markets was undertaken in the agricultural, industrial, and transport sectors. 8. Between 1980 and 1985, agricultural output fluctuated. Production of rice remained at around 2 million metric tons of paddy per year. Madagascar had to continue importing rice throughout the period, although the volume Imported declined steadily from a peak 356,000 metric tons in 1982 to about 105,000 metric tons in 1985. The decline in rice imports,  -3- h',wever, was due to foreign exchange scarcity rather than any marked increase in domestic self-sufficiency. Production of other food craps (v'aize, potatoes, cassava, sweet potatoes) grew steadily and significantly, following higher demand for these crops as a result of increased rice prices. Coffee exports since 1982 averaged 50,000 tons per year, compared to 70,000 tons in 1980. The decline was the result of low producer prices, shortages of inputs and transportation bottlenecks. Cotton production grew rapidly in response to increased producer prices and, with the support of a project financed by IDA and France, Madagascar became a net exporter of cotton fiber. The production of other industrial and export crops generally stagnated (e.g., tobacco and pepper) or declined (e.g., groundnuts) due to inappropriate pricing and marketing policies which reduced incentives to producers and traders. The output of two other principal export crops, vanilla and cloves, was stagnant in the face of limited world market demand. 9. Industrial output declined sharply between 1980 and 1984 with a modest recovery in 1985 and 1986. Industrial manufacturing capacity has- been heavily underutilized in recent years owing to shortages of domestically supplied and imported inputs and spare Farts. The construction industry also remained slack. On the policy front, Government initiated positive changes, easing pricing controls, improving the administration of foreign exchange allocation, and legislating a new Investment Code aimed at attracting foreign private investors. A liberalized import regime is being implemented which will elimunate quantitative restrictions on about 15 percent of merchandise imports. 10. Owing to the slow growth of agriculture and industry, transport activity also stagnated. Costs escalated due to the dilapidated state of the transport system. Low administered tariffs reduced incentives to private transporters, thus further discouraging the provision of services. To improve the transport system and the policy environment, Government selected an 'economic network" of about 10,000 kms of primary and secondary roads for priority rehabilitation; established a road fund for maintenance; and permitted tariff increases for the roads, railways, and the national airline. A national transport plan is now being prepared with IDA support. 11. Public Finance. The 'all-out investment" campaign of the late 1970s caused an unprecedented growth in public capital expenditures. It was largely financed by external loans and substantial budget deficits, leading to the accumulation of arrears. Between 1981 and 1985, the bulk of the fiscal adjustment was accomplished by cutting capital expenditures, reducing general Government activity, containing the expansion of the payroll, and phasing out budgetary subsidies to parastatals (many of which subsequently became indebted to the banking system). Given the low level of activity of the economy, attempts to increase revenues were generally less successful. The magnitude of the overall budgetary deficit, which stood at 18 percent of GDP in 1980, was reduced to 4.5 percent in 1985.  - 4 - Current budgetary deficits were eliminated from 1983 on, so that the Government was in a position to contribute to development expenditures. Nevertheless, the size of the current surplus remains small relative to public investment needs, so that the execution of a number of foreign- financed projects is stifled due to the lack of local cost financing. 12. Monetary developments during 1980-85 -were generally in line with fiscal developments, reflecting implementation of stabilization measures. Throughout the period, the growth of credit to Government was reduced and, beginning in 1982, credit to the non-government (i.e., parastatal and private) sectors generally expanded faster than credit to the Government. Domestic inflation was reduced, from about 30 percent in 1981 and 1982 to approximately 11 percent in 1985. The reduction of inflation during the period was all the more remarkable in that it occurred at a time when the Malagasy Franc was depreciating. 13. Madagascar's balance of payments remained weak throughout 1980-85, despite substantial annual reductions in the volume of imports to the point of adversely affecting economic activities. The position remained weak owing to poor export performance and heavy debt service payments. Stabilization efforts throughout the period led to steady and marked improvements in the resource and current balances. In 1985, the resource gap (US$140 million) and current account deficit (US$258 million) had fallen to 25 percent and 45 percent of their respective 1980 levels. 14. Based on the external debt portfolio at end 1986 and after taking itto account pipeline disbursements, Madagascar will need gross capital inflows of about US$450 million per year during the 1987-90 period to cover current account deficits, meet scheduled debt repayments, and maintain a modest amount of gross reserves. The country will therefore continue to need increased financial assistance from the international community in the form of grants, concessional b?rrowings and debt relief. The conditions under which Madagascar is able to obtain new finance and reschedule the debt are of crucial importance and will determine whether the country will be able to overcome present external payment constraints, even with a high- quality policy program. 15. Financial Strategr. Since the emergence of the debt crisis at the beginning of the 1980s, Madagascar has managed the balance of payments by cutting imports, through the demand management measures described above, complemented by substantial debt rescheduling. These measures are very costly, involving disruption of economic activity and refinancing of some originally concessional loans at less concessional terms. Even more important, they have yet to lead to a viable balance of payments, which can only be achieved by restoring growth in export earnings. Madagascar now has probably reached a limit to further cuts in Imports as these -_e down to bare essentials. While the count..y's creditors may continue to accord debt rescheduling, to generate significant amounts of debt relief the  -5- rescheduling arrangements would need to be more concessional than previously. In the future, therefore, Madagascar must attempt to boost export earnings as a means of strengthening the balance of payments and reducing the debt burden. Concessional balance of payments support will continue to be needed. 16. Relationship with the IMF. The Government complied with the performance criteria of the Fifth Standby Agreement s'gned in April 1985. Most of the important program targets were achieved. A Sixth Standby Program was approved by the Fund Executive Directors in September 1986, and the first review of it was completed by the Fund Board in March 1987. While continuing measures to stabilize the economy, the program emphasizes the promotion of economic growth by means of further liberalization of the external account, the rehabilitation of selected parastatals, improved domestic producer prices and marketing systems, and a substantial step devaluation of the FMG. Madagascar is eligible for IMF Structural Adjustment Facility resources, and a medium-term program is being formulated with the help of the Bank and the IMF. 17. The third meeting of the Consultative Group for Madagascar took place on April 25 and 26, 1986. The participants agreed that the Government's program of policy reforms was on the right path and it was urgent that it be pursued and developed further. It was recognized that if Government's efforts were to succeed, Madagascar needs substantial external support. This would be provided by a combination of higher official development assistance, particularly in the form of quick disbursing aid, and debt rescheduling. Agreement on rescheduling was reached at a meeting of the Paris Club on October 25, 1986, and the Consultative Group is expected to meet again in late 1987. PART II- BANK GROUP OPERATIONS IN MADAGASCAR 18. Overall Lending Levels and Sectoral Composition. As of March 31, 987, IDA credits to Madagascar amounted to US$615.11 million (including US$29.9 million from the Special Fund and US$53.0 million from the Special Facility for Africa). Bank Group assistance to Madagascar has been concentrated on infrastructure, including urban and social infrastructure (48 percent of lending), agriculture and industry (41 percent), and energy (11 percent). IFC has four investments in Madagascar, in textiles, footwear, -and fisheries. Annex II contains a sun-mary statement of past loans and IDA credits as of March 31, 1987. 19. Agricultural Lending. The Bank has supported 15 agricultural projects, of which five have been completed. This has included projects in livestock development (three), irrigation (four), agricultural institution development (two), forestry (two), agricultural credit (one), rice intensification (one), and cotton development (one). An Agricultural Sector Adjustment Credit, with complementary Special Facility for Africa and Special Joint Financing resources, was approved in May 1986.  20. Energy lending. The energy sector has received growing Bank Group attention. In 1978, IDA participated with several co-lenders in the financing of the large Andekaleka hydroelectric project, which was successfully completed in June 1982. The Petroleum Exploration Promotion Credit (US$12.5 million) and the Tsimiroro Heavy Oil Exploration Credit (US$11.5 million) approved respectively in 1980 and 1982, have both supported Government's efforts in attracting foreign oil companies for exploration development. 21. Infrascructure Lendint. The Bank has supported eleven transport projects with IDA credits totaling US$205.9 million. Six credits (US$147.2 million) were for the construction, maintenance, and rehabilitation of highways; two (US$27.7 million) in 1970 and 1986 to improve Madagascar's main port of Toamasina and sector institutions; and three (US$31.0 million) to support the railway's modernization efforts in 1974, 1979, and 1986. Out of the eleven projects, seven have been completed. Urban infrastructure development benefited in 1980 from a Water Supply and Sanitation Credit for the capital city of Antananarivo (US$20.5 million) and an urban development project (US$12.8 million) in 1984. In 1984, IDA responded to the need to reconstruct cyclone dsmage with a US$15 million credit. A supplemental credit of US$10 million, following the March 1986 cyclone, was signed in August 1986. 22. Other Lending. In 1980, a US$5 million credit was made to the Industrial Development Bank of Madagascar. An Industrial Sector Adjustment Credit of US$40 million became effective in August 1985, and a Supplemental Credit of US$20 million from the Special Facility for Africa was approved in December 1985. In the social sectors, education has been the major recipient of Bank assistance, with two credits in 1967 and 1976 totaling US$11.8 million. A credit of SDR 9.4 million (US$11.5 million) for an accounting and audit training project was approved in 1981; and a second credit of US$10.3 million for management and accounting training in February 1986. 23. Implementation Problems. Problems encountered in the execution of a number of projects included mainly delays, cost overruns, deficiencies in management, and inadequate financial performance. Current problems center on difficulties linked to the country's economic crisis, notably the acute shortage of foreign exchange and budget funds, and institutional problems with the parastatal system. The Bank has addressed generic issues in part through Country Implementation Reviews, technical assistance and secondment staff. The Government has been responsive and there have been improvements in Government portfolio management. 24. Project Evaluation. Eight completed projects have been audited by the Operations Evaluation Department. Audit Report No. 1622 of December 1976 on the first Lac Alaotra project concluded that the project was generally successful. However, the Impact Evaluation Report No. 3600 of August 1981 concluded that earlier assessments of project performance had been over-optimistic, and that the actual rate of return was probably  negative. Audit Report No. 1143 of April 1976 of the first Education Project concluded that the education and manpower training objectives were satisfactorily achieved. Report No. 2143 of July 1978 concluded that the Third Highway project was well justified and had a satisfactory rate of return despite substantial cost overruns. Report No. 2299 of December 1978 concluded that the physical objectives of the Tamatave Port project were satisfactorily achieved, but pointed out that the institutional objective was not accomplished during project implementation because of inadequacies in the staffing of the port authority. Report No. 5434 of January 29, 1984, on the first Railway Project concluded that due to overruns and delays, the scaled-down project had an estimated rate o; return of less than 10 percent. Report No. 5403 of December 28, 1984, covered two agricultural projects: the Morondava Irrigation and Rural Development Project was a profoundly disappointing operation, but the Village Livestock and Pural Development Project contributed to laying the groundwork for more effective services for traditional livestock owners, with good prospects for sustainability. 25. Bank Strategy and Future Pro2ram. The Bank strategy is to support the Government's efforts to rehabilitate and restructure the economy by: (a) promoting policies and programs aimed at reforming incentive structures, setting a more favorable climate for private sector initiative and investments, and providing financial and other support for appropriate policy programs; (b) supporting sectoral strategies aimed at rehabilitating productive infrastructure and establishing conditions for long-term growth, and providing financial and technical assistance for these programs; (c) strengthening the institutions responsible for sectoral policy formulation and management; and (d) helping Madagascar to mobilize and to make effective use of donor financial and technical support. 26. Lending ProuRram Development. On the assumption of continued Government responsiveness, the Bank plans to support Government adjustment efforts with sectoral and, possibly, structural adjustment lending. Further sector adjustment operations in industry and trade, as well as in agriculture, are planned. These would support continued market deregulation, export promotion, cost recovery, private investment, parastLtal reform, and rehabilitation of productive and economic assets. The program would also address longer term issues in human resource development, health, agricultural research, and forestry/environmental degradation. Overall, future lending would concentrate mainly on agriculture, industry, and transport. 27. The main vehicle for aid coordination has been the Consultative Group (CG). An important element of the Bank country assistance strategy has been to make the CG a more effective means of addressing Madagascar's economic and financial problems, with a belief that donor and creditor support of a comprehensive financing strategy, combined with a sound Government program to stimulate real growth, would offer the best prospects for future development.  -8- 28. Economic and Sector Work. The Baxk Group economic and sector work program for the next three years is intended to support the identification of future adjustment measures, as vell as donor coordination within the CG framework. It is directed at parastatal reform, improvement in sector planning and public investment program formulation, and development of a core medium-term lending program. UNDP/IBRD technical assistance projects to assist the Directorate-General for Planning in investment planning and aid coordination have recently een signed. A study of the population and health sector has recently been carried out. The Bank Group is also providing technical assistance in policy analysis and selective institution-building; two Bank staff members have been seconded to assist the Gover.ment (in public investment programming and in the management of the livestock sector). The Bank's,Resident Mission has been strengthened by a resident economist. PART III - THE AGRICULTURAL SECTOR An Overview 29. Sector Outline - Agriculture is Madagascar's dominant economic sector; it employs 85% of the labor force and accounts for more than 80% of export earnings. Production and farming systems vary widely, with many commodities produced, but production in value terms is dominated by paddy (30%) and beef (16%). A small group of important export crops (notably coffee, cloves, and vanilla) accounts for about 151 of production, but some three-quarters of merchandise exports. Industrial crops, including sugar and cotton, contribute about 72 of agricultural production value. About 80% of total production comes from smallholder activity, and small farmers (in the 1 to 2 ha. range) are the backbone of Madagascar's agricultural economy. Over half of agricultural production by value is for subsistence and the share of subsistence production has been slowly increasing over the past decade. 30. ARroindustries and Marketing. Activities concerning processing and marketing of agricultural products extend over a wide area, including processing of rice, sugarcane, oilseeds, pepper and other fooderops, vineyard and wood products. Processing plants are owned by parastatal as well as private investors, with the latter's share tending to increase in the past several years. The proposed project will benefit largely the private investors, many of whom are active also in exporting of their processed products. 31. Recent Performance - Performance of the agricultural sector has been poor since the mid 1970s. Between 1979 and 1983, agricultural production did not grow at all, and in the 1975-78 and 1984-86 periods, production growth was insufficient to keep up with population growth. The position has been aggravated due to: (a) the stagnation in rice and serious decrease in edible oils production, and (b) a decline in coffee  exports (40X of merchandise exports) by about a third from peak quantiti , uncompensated by increased exports of other commodities. One of the few bright spots in this picture has been increased cotton production between 1983 and 1986, in response to higher producer prices and availability of inputs, but the price decline in world markets has recently led to marketing difficulties. 32. Constraints to Growth. The causes of this disappointing performance are mixed and include structural as well as short term factors: (a) the expansion of Government control in the 1970s over production, processing and marketing functions, which discouraged private sector participation. Public sector enterprises proved generally too weak in management to perform their roles, becoming a heavy drain on the budget; (b) pricing policies for major products, favoring urban consumers but discouraging farmers from producing for the market; (c) over-valued exchange rates, together with a deteriorating balance of payments situation, which led to acute foreign exchange shortages; I (d) a public investment policy heavily weighted against productive agricultural activities; and (e) unavailability of credit for agriculture. Aggravated by worsening general economic conditions in the country in 1979- 80, and shortages of local budgetary funds and foreign currency for agriculture, these factors led to the breakdown of essential services to farmers in many rural areas, limited availability of production inputs, and left inadequate incentives for increasing output. The Government Obiectives and StrateRV 33. The crisis in the agricultural sector, especially the decline in marketed output of food and industrial commodities, led to a fundamental rethinking of Government strategy in the early 1980s. A new policy framework was developed which was formally announced at the April 1983 Consultative Group (CG) Meeting and subsequently confirmed at the April 1986 CG meeting. The Government's new objectives are to increase production of foodcrops (above all, rice and edible oil) in order to reduce 'mports; revive production and improve the quality of traditional export crops; and diversify agricultural exports. Better integration of the agricultural and industrial sectors has become an important medium-term objective. IDA lending operations and sector analysis have solidly supported these objectives. The strategy to achieve these objectives recognized that (i) small and larger farmers are the main agricultural producers and that Government policy and investments must create an  - 10 - environment to stimulate production by them, and (ii) the private sector has an important role to play in the process of economic and agricultural development. The practical consequences of this approach were: (i) moving towards a free market system as a means of improving producer incentives; and (ii) withdrawing Government services from activities better performed by others. Public investments in the sector over the medium term have to be limited to rehabilitation and systematic efforts to program and manage them better. 34. The Government has been making progress in implementing this strategy, as indicated by the removal of agricultural pricing and marketing control on rice, and pulses; and significant price increases for cotton and selected export crops. On resource management, the Government has prepared and reviewed with IDA multi-year public investment programs for agriculture, and is establiqhing procedures to update programs annually. The Government has also begun to redress the bias against the private sector which has been evident in credit policy and foreign exchange allocation. Parastatal ventures are being subjected to profitability tests and are to be restructured to assure self-financing; selected divestitures have been undertaken. The Government is reinforcing extension and research while withdrawing from direct production and some commercial activities. The agricultural ministries, the Ministry of Agricultural Production and Agrarian Reform (MPARA) and the Ministry of Animal Production and Forestry (MPAEF), have been substantially reorganized and programs to strengthen their managements have been launched. Large personnel reductions have been undertaken to position these agencies to play a more dynamic but less interventionist role. Bank Group Support 35. Agricultural lending accounts for a large share of the Bank Group's portfolio in Madagascar (para 19). Lending has been primarily concentrated on priority commodities, such as rice, livestock, and cotton, and the Bank/IDA have sought to address the critical sector issues through these operations. Since 1983, Bank/IDA lending has become more directly program and policy oriented. 36. Current agricultural lending is focussed on support of the Government's agricultural adjustment program (para. 33). The project proposed in this report is the third in a trio of operations, which are designed to achieve the following objectives: (a) to support agricultural policy adjustment program aimed at increasing production over both the short and long-term; increasing the return to agricultural investment by shifting towards a more competitive, market-oriented economy; promoting exports; strengthening resource management and farmer services; and using existing assets more efficiently;  - 11 - (b) to provide part of the foreign exchange for inputs and investment; and (c) to help prepare the next phase of the reform program (1988- 90) through policy analysis, review of alternatives for further gains in efficiency and production, and preparation of related action programs. 37. The lead operation in this process is the Agriculture Sector Adjustment Credit (Cr. 1691-MAG and A16-MAG, 1986) involving lending of US $60 million equivalent to support the adjustment program, the funds going through commercial channels to provide needed imports for agricultural inputs, veterinary products and animal protection materials, tractors and transport equipment, and incentive goods for rural areas. The adjustment program to which the credit is tied comprises the following main elements: (a) actions to improve market efficiency through continued liberalization and development of the private sector; (b) strengthening producer incentives by relying increasingly on market forces, and, in parallel, making the Government's remaining intervention in pricing more efficient; (c) setting up an effective management program for rice imports, ending the Government's marketing monopoly in the two zones which produce a substantial rice surplus; (d) rationalizing public spending, notably through better choice of agricultural investments and; (e) helping to prepare the next phase of the agricultural reform program. 38. The Government's agricultural adjustment program has shown impressive progress in a number of areas: the liberalization of rice marketing; the operation of the rice market intervention stock; the elimination of subsidies on inputs; and the conversion of input marketing from a Government to a commercial activity. The agreement on 1987 rice imports and prices puts Madagascar much further along the road to rice self-sufficiency, and is consistent with achievement of the Government's 1990 rice self-sufficiency target. Administrative delays have, unfortunately, slowed down disbursements on the credit. 39. During the period of the agricultural sector adjustment process, support to sector institutions and to policy analysis will be provided under the Second Agricultural Institutions Development Proiect (Cr. 1709- MAG; 1986). This project follows on from the successful first-phase project (Cr. 1249-MAG; 1982) which provided institution-building support  - 12 - and studies for sector institutions notably the MPARA and the MPAEF. It provides technical assistance (short term consultants and training) and study tours for the ministries' staff involved in agriculture, as well as for the research organizations' staff. Specific objectives are: to improve resource management, to strengthen policy analysis capability, and to develop management capacity for key Government services - extension, research, data collection and analysis, and market information. Recruitment of consultants for management strengthening and for the natural resource inventory, is underway, and the parastatal monitoring and privatization planning activities have started. In addition, specific policy studies will be undertaken to prepare the way for the next phase of the reform program. 40. The third operation is the project proposed in this report, to provide investment funds needed to help entrepreneurs respond to Government's policy and to create economic opportunities in the agriculture sector. It will also provide funds to support further institutional strengthening of the National Rural Development Bank (BTM) (para. 64) and complement efforts to support a reform of the banking sector under the forthcoming Industry and Trade Policy Adjustment Credit which is scheduled for Board consideration in the current fiscal year (para. 47). PART IV - THE NATIONAL RURAL DEVELOPMENT BANK (ETM) General 41. The BTM is one of the three Government-owned banks in Madagascar, which were created in 1977 following the Government's nationalization of all private banks and reorganization of the country's banking system. BTM's history, and some of its current management and banking policies, are closely linked to the other two Government-owned banks: the Industrial Bank (BNI) and the Commercial Bank (BFV). The following paragraphs, therefore, while focused mainly on BTH pertain also to all three banking institutions. The Banking Sector - Structure, Policies, Reform 42. The Banking Sector Reortanization. Before 1975, the banking sector in Madagascar consisted of four commercial banks (largely foreign- owned or affiliated to foreign financial institutions), plus a national development bank, the Banque Nationale Malgache de Developpement (BNM), and the Central Bank. The Government nationalized the four commercial banks in 1975 and two years later in 1977, thoroughly reorganized the banking sector. Commercial banks and the BNM were reorganized into three government-owned banks, each of which was to be responsible for a sector of the economy: agriculture, industry and commerce. The banks thus established were the BTM for agriculture, the BNI for industry, and the BFV for commerce and trade.  - 13 - 43. ManaRement. The three banks are classified as parastatals under the Ministry of Finance. Although the establishing legislation called for a broad Policy Council and separate Board of Directors for each bank, in practice, the Policy Council has not been established and, until November 1986, all three banks were governed by a single board. In connection with the sixth IMF standby arrangement, separate Boards of Directors have been established for each bank. 44. Lending Operations. Sight and time deposits are the principal sources of funds for the banks, which compete in collecting deposits and, also, in extending credit to individuals or enterprises out-side their designated sector of specialization. The three banks also often pool their resources in consortium loans to meet corporate financing needs. Short- term loans to public and private enterprises constitute a major share of their lending, reflecting the limited role of the banking sector in financing development. All three banks are required to have liquid assets to cover 70% of their short term liabilities, and equities equivalent to 8% of their loan portfolios. The banks are inspected by the Central Bank through the banking control commission. There is need to improve the effectiveness of controls over banks. At present the Central Bank is not adequately equipped to: (a) define minimum rules regarding write-offs, classification of loans and debtors, and accounting practices for the treatment of interest due on doubtful loans; (b) ensure that the bank audits are prepared and their results presented in a consistent fashion; and (c) decide in cases of disagreement between auditors and banks over the classification of a loan or a debtor. Under the credit proposed in this report the Government would adopt rules and procedures satisfactory to IDA for bank supervision by December 31, 1988. 45. The Banking Sector Crisis. Following the reorganization, the banking sector in Madagascar lived through several years of extreme economic dirigism. Bank portfolios gradually accumulated parastatal "paper". From about 1982, two processes coincided to the detriment of the sector. First, the Government, constrained by ceilings on public sector spending, was no longer able to offer financial support to the parastatal sector, much of which was running heavy losses and in need of transfusions of working capital to keep it going. The banking sector was required by the Government to allow parastatals to run up short term borrowings which were not serviced and quickly occupied a large share of the banks' portfolios. Second, the economic crisis hit enterprise profits, and more and more loans failed to perform. Together, these two processes produced a banking sector crisis of major proportions. The auditors of BNI, for example, considered over half of BNI's portfolio at December 1983 to be doubtful; more recent reports indicate that 802 of total loans of the banks are non-performing in the sense that interest is not being paid. While BTM's position is better than BNI's, it is nonetheless difficult. 46. In the face of the crisis, BTM, ahead of the other two banks, commissioned portfolio reviews by internationally-recruited auditors based on 1983 year-end data and has agreed to the following actions: (i) maximum transfer to bad debts reserve each year consistent with retaining depositor  - 14 - confidence (i.e. the bank still shows a small profit and transfers it to reserves, with no distribution of profits); (ii) overhaul management procedures to improve the quality of new lending; and (iii) review of parastatal borrowers, starting with the worst cases, in order to work out means of generating repayments (paras. 54-55). 47. Banking Sector Reform. Until recently the receptiveness of the Government to proposals for reform in the banking sector was limited. Although a beginning is being made under the sixth IMF standby, more significant reforms are necessary in respect to the three banks. The Government has formulated a preliminary program of reforms of the banking sector which has been reviewed by IDA and found satisfactory. A key feature of this program is the adoption, by December 31, 1988, of rules and procedures satisfactory to IDA for the Central Bank's supervision of commercial banks. Futhermore, the Government undertook to maintain positive interest rates in real terms. The current excess liquidity of all three banks, as a result of tight credit ceiling enforcement of the Central bank, has negatively affected the profitability of all three banks. As part of the program mentioned at the beginning of this paragraph, to alleviate this excess liquidity (now and in the future), the creation of monetary instruments such as special issues of short-term treasury bills is being investigated. Finally, the program includes a study to address the following questions: (a) the capacity of existing financial institutions to respond fully to the needs of the economy; (b) any need to allow additional financial institutions to enter the sector, or to introduce private capital--local and/or foreign--into the existing three banks once the financial restructuring is completed; (c) adequacy of the legal framework in which the banks operate, including the possibility of calling guarantees, foreclosing on companies, and selling off pledged assets; (d) the adequacy of credit ceilings, rediscounting facilities and credit supply; (e) the improvement of financial services to include export financing, leasing, and housing finance; (f) mobilization of savings; and (g) degree of application of the 'liberalized' interest rate structure. 48. Interest Rates. The Central Bank has the authority to set the rediscount rate as well as maximum and minimum interest rates on bank credits. Interest rates, which remained constan'- between 1974 and 1981, were increased in June 1982 and February 1983. Central Bank controls on interest rate structure were simplified in April 1985 and all interest rates except the Central Bank's rediscount rates and the deposit rate for 6-12 months, were liberalized. At the same time, the Central Bank lowered its rediscount rate by 1.5Z to 11.5% (the standard rate). In line with this, the three banks reduced their interest rates to levels ranging from 13.5% to 21Z p.a. on short term credits; and to 14.5% to 15.5Z p.a. for medium-term loans. The rate of inflation in Madagascar, which was 1OZ in 1984-85, accelerated in 1986 (reaching 17.5Z). Effective January 1, 1987, the Central Bank raised its preferential rediscount rate (for advances on export bills and on agricultural products) to 11.75% p.a. and the standard rate (for all other credits) to 152 p.a. Accordingly, BTM raised its  - 15 - interest rates to 15Z-24% p.a. on short term credits and to 18% to 19% p.a. for medium term loans. For long term lending, en additional 0.25Z spread is charged. On deposits, interest rates vary depending on duration, from 1.5% to 3Z for demand deposits, to 20.50% p.a. for six-year term deposits. 49. Credit Policy. At present, the main objective of the Government's credit policy is to limit credit expansion to a level consistent with internal and external financial stability, while increasing the share of credit for production and for export. As a part of its Sixth Standby arrangement with the IMF, the Government also wants to restrict the growth of bank lending to public enterprises. To meet these objectives, the Central Bank relies in part on quantitative controls, consisting of an overall target on credit growth which is set with the IMF. Credit growth is controlled in part through the credit ceilings, which are revised quarterly for each individual bank on the basis of its liquidity position and its expected needs. The Central Bank sets a global ceiling ("plafond global") and subceilings on specific categories of credit ('encadrement du credit"). The global ceiling applies to all credit regardless of maturities or sectors of the economy, with the exception of short-term export financing. Its purpose is to control the expansion of bank credit. The various subceilings are selective; they are designed to ensure adequate financing of production and export of agricultural and mining products. There are also qualitative controls, including a prior authorization requirement by the Central Bank for all credit extensions and renewals above FMG 100 million (about US $133,000 equivalent) and the determination of interest rates for Central Bank rediscounting. The goal of the prior authorization procedure is to give the Central Bank the means to monitor the final uses of bank credit and to ensure that these uses are consistent with the Government priorities. The Government is currently reviewing these instruments with a view towards adopting a more comprehensive and coherent credit policy. Its work on the overall credit policy, started a few years ago, is to be completed under the second review of the Sixth IMF stand-by, to be carried out in the next several months. 50. ARricultural Credit Policy. Madagascar has not had a coherent agricultural credit policy for some years. In practice, banks (including BTM) have directed the bulk of their lending to the industrial and ccmercial sectors because they have been more profitable. In the agricultural sector, banks have extended development and seasonal credit mostly to large farmers and to Government institutions and companies. Credit for small farmers as" been very limited, with the exception of certain development projects with a smallholder credit component. One of the objectives of the creation of BTM in 1977 as a rural development bank was to foster seasonal and term lending to agriculture. Although BTM expanded its network of rural branches and undertook credit schemes with a specific smallholder orientation, term lending to agriculture has never been a large part of its activities. The major reasons for this, aside from the Government's decision until recently to divert bank resources to parastatals, include the lack of incentives, and a weak capital base; all these factors go back to the lack of a coherent Government agricultural  - 16 - credit policy. Provision would be made under the proposed project to assist in the formulation of such a policy and system, extending over topics such as development of smallholder credit; provision of term funds to BTM for agricultural lending; and guarantee and promotion (risk capital) funds for agriculture (para. 70). In its new Policy Statement BTM is committed to increase its new lending to agriculture and not to make any new loans to public sector enterprises in financial difficulties. The objective of this policy is to change BTM's portfolio structure so that agricultural loans will represent a majority. Progress towards this objective will be reviewed annually with IDA. The National Rural Development Bank (BTM) 51. Constitution, Capital structure. Management and Staff. Following the banking sector reorganization (para. 42), BTM took over the physical facilities of the Banque Nalgache d'Escompte et de Credit, and the loan and investment portfolio of the agricultural credit departments of the former Banque Nationale Malagasy de Developpement (BNM). Most of BTM's professional staff came from these two institutions. At present, BTM has a share capital of FMG 2 billion (US $2.66 million) of which 90% is owned by the Government and the remainder by the Central Bank. The BTM board, which w-as appointed in November 1986, has 12 members, including two who are active in the private sector. It is chaired by the Minister of Finance. The General Manager, appointed by decree of the Prime Minister, chairs the Credit Committee and is responsible for the administrative and financial performance of the institution. BTM has 44 branches and 22 field offices, and slightly less than two-thirds of its total personnel of close to 1,500 are stationed outside the BTM headquarters in Antananarivo. Overall, staff quality is good and the BET management has been responsive to the staff training needs. With support of IDA technical assistance under the first BNM project over the last three years, BTM has improved its internal organization, tightened credit review and appraisal procedures, and developed a good training program, a computer master plan, and capability for periodical assessment of its loan portfolio. To strengthen BIM's Planning and Rural Development and Operations and Credit Departments, BTM requires seven an! three additional local staff, respectively. Qualified employees for these ten positions would be assigned by the end of September 1987. 52. Loan Portfolio and Financial Position. ETM's loan portfolio, as of December 31, 1985, amounted to FMG 111 billion net of reserves (US $148 million), including loans to industry and commerce (60%), agriculture (36%) and individuals (42). Short-term loans (notably marketing loans) made up 88% of the total. As at year-end 1985, BTM's auditors estimated the bank's "non-performing' loans and guarantees at FMG 78 billion (US $104 million) or 52% of BTM's total Commitment of about FMG 150 billion, including FMG 44 billion (US $59 million) classified as very poor risks. Of the latter, over half comprised loans made to public enterprises in precarious financial position. At the end of 1985, BTM loans made to Government-owned ventures amounted to FMG 32.8 billion (US $44 million), or 30% of the total  - 17 - loans outstanding (as compared with 34% at the end of 1984 and 37Z at the end of 1983). Of this amount, FMG 2.5 billion (US $3.3 million) or only 8% was covered by Government guarantees. Provisions made by BTM against doubtful loans and guarantees totalled FMG 22 billion (US $29 million) and BTM intends to increase this provision by FMG 7 billion (US $9.3 million) per year during the next three years (para. 54). In the meantime, the BTM management will be cautious in adding new loans to Government-owned ventures. Indeed, under the sixth IMF standby arrangement, specific credit ceilings have been stipulated by the Central Bank for public enterprises; the national budget, rather than the three State banks, will finance their losses. In addition, prediagnostic studies for the rehabilitation of 16 selected public enterprises (accounting for about 40 percent of outstanding bank credit to public enterprises) were completed as part of the sixth IMF stand-by arrangement. Nine of these enterprises are BTM's clients and when their rehabilitation is completed, it is expected that they will repay part of their loans hitherto classified as irrecoverable by BTM's auditor. 53. Since its 1981-83 involvement in the Government-imposed intervention to cover public enterprises' losses, BTH's financial position has been considerably weakened. BTM's net earnings after tax are low (return on equity in 1985 was 1%), its equity base is small (equity to total liabilities was 10% at the end of 1985); and the quality of BTM's portfolio remains poor (para. 52). For certificates of deposit (CD) issued without an owner designation, BTM has been paying taxes out of its own revenues rather than collecting them out of maturing CD holders' accounts. As in the case of the two other banks, BTM's lending resources come largely from (i) deposits (75% demand deposits and CDs), (ii) equity, and (iii) external lines of credit (by IDA, CCCE, Cooperation Suisse, and ADB). These three sources, at the end of 1985, accounted for 73Z, 1OZ and less than 2% of the total BTM liabilities, respectively. The Government's insistence on collecting taxes and dividends on what are non-existent ETM profits (which amounted to the equivalent of US $1.8 million in 1984 and US $1.1 million equivalent in 1985) has been further straining BEM's finances and slowed down growth in its equity base. In the face of these difficulties, the Government agreed in 1983 that BTM would: (i) suppress its dividends to reduce its tax obligation, (ii) progressively increase its provision for bad debts so as to equal 100% of such debts over a five-year period; (iii) examine, with the other two banks, a means of liquidating parastatal obligations to the banking sector, and (iv) hire qualified auditors and consultants to give support to BTM's management in the implementation of these measures. These ongoing measures constitute parts of the BTM Action Plan" (paras. 54-55). 54. The 'Action Plan". In the face of this difficult situation, BTM and the Government, worked out in 1983 and are implementing an Action Plan that, when completed, should put BTM back in a sound financial position. In this context, BTM has adopted a program under which it has been making maximum bad debts provisions to cover doubtful debts over a five-year period (1984-88). The Action Plan provides for: (i) periodical inventories of substantial non-performing loans and assessments of the risk on these  - 18 - loans; these have been completed each year 1983 through 1985; the 1986 inventory is in progress; (ii) the establishment of a management information system aimed at better portfolio management and improved monitoring of current transactions; this is under implementation; and (iii) a rapid growth of reserves against bad debts; this is also being implemented; during 1984 and 1985, BTH's reserve against bad debts increased substantially, totalling FMG 22 billion or 50% of the high risk portfolio by year-end 1985 (para. 52). However, more time is needed to augment the reserves to the necessary levels. 55. While the results of the Action Plan implementation have so far been quite positive and its implementation in full will place BTM on a sound footing financially, additional measures are now needed by the Government and BTM to accelerate this process. Towards this end: (a) Government would pay BTM to hc.ior its past guarantees on irrecoverable loans to paras._atals, totalling FMG 2.5 billion (para. 52). A first payment was made by the Government on schedule in September 1986, and the full payment would be a condition of effectiveness of the credit proposed in this report; (b) BT would not pay any dividends until its doubtful loans as determined by the auditors as of December 31, 1985 are fully covered by adequate provisions; and BTM would continue with satisfactory provisions thereafter; and (c) BTM would (i) continue to retain an international firm of auditors; (ii) withhold taxes on interest to holders of CDs directly on CD holders' accounts instead of paying these taxes to the Government out of its own revenues; (iii) establish a system of loan portfolio analysis that would include aging of receivables, effective September 1987; and (iv) improve loan (principal and interest) collection (excluding collection of loans which are classified by BTM's auditors as irrecoverable) so as to achieve a loan recovery rate of 802 by end 1988 and 95% by end 1989 and thereafter. Each year, BTM would review with IDA its specific plans to attain this target. Irrecoverable loans would be fully covered by BTK's bad debt provision under (ii) above. BTM would make provisions for bad debt of at least FMG 7 billion per year, adequate to cover over the next three years the full amount of irrevocable loans determined by auditors at end 1985. In addition BTM undertook to reinforce its internal organization to emphasize loan recovery. A Loan Recovery Division has been created to implement a more stringent recovery policy and an experienced lawyer appointed as chief of its Legal Division. 56. With these steps, BTH's financial condition is projected to improve considerably by 1988. Its equity/assets ratio would exceed 11Z, as BTM's equity base will be reinforced with retained earnings and the  - 19 - retention of the proceeds of the proposed IDA credit as equity (para. 61). The debt service coverage ratio would also improve from the current insufficient level of 1.8, to 2.3 by 1988. The present BTM management and organization, with some additions to local staff and technical assistance as provided under the proposed project (paras. 51 and 64), are capable of implementing the proposed project satisfactorily. Experience with the First Agricultural Credit Project (Cr. 1064-MAG; 1981) 57. The first BTM project has had mixed results. While much progress has been made in the area of the institutional strengthening of BTM , the project's smallholder credit component remained largely inoperative, and had to be modified to respond to greatly altered conditions in the agriculture sector. The solution adopted, i.e. financing of urgently needed imports of agricultural inputs, offered a pragmatic approach to support the agricultural sector at a time of extreme balance of payment difficulties. This proved successful in easing the input constraint during a difficult transitional period. Through these difficulties, the BTM management has acted cautiously and prudently, directing the institution's limited development lending resources towards support of the most productive areas of investment in agriculture. Further detailed information and analysis on this subject is presented in Annex IV. PART V - THE PROJECT Proiect Objectives 58. The proposed project, a part of an IDA-supported broader agricultural reform program (paras. 36-40), would respond to several major country development strategy concerns: need to reduce state involvement in the economy, to give greater emphasis to market forces, to increase efficiency of resource utilization, and to strengthen key institutions. Within the context of this broad program, the project would have the following specific objectives: (a) to contribute to further institutional development of BTM, and (b) to meet foreign exchange costs of new investments, and expansion and improvement of existing ventures in agriculture (production and primary processing/marketing). 59. Under the proposed project, efforts would be made to strengthen BTM's financial condition and to improve its operational efficiency, thus completing a process started under IDA's first BTM project (para. 57). This objective is important particularly because BTM is essentially a commercial bank, which gets its funds from deposits and current accounts bought in the market and, therefore, has to remain competitive and  2 20 - profitable. To attain this objective, BTM would: (a) concentrate incremental agricultural lending to its most solvent clients, i.e. primarily medium and large size enterprises in the private sector; (b) continue lending cautiously to small farmers, as such operations on a larger scale are under current conditions, likely to be too costly (para. 70); and (c) not make new loans to those borrowers classified as poor risks by BTM's auditors (mostly public enterprises) excepting self-liquidating and well-secured operations. A Policy Statement for BTM in this sense has recently been adopted by BTH's board (para. 66). 60. The proposed project would focus BTM lending basically on medium and larger size borrowers. Hence, there would not be any substantial smallholder rural credit financing. As the lack of smallholder credit is a major shortcoming in Madagascar, however, the project would (a) continue to finance the incremental cost of a pilot credit management project started (but not yet completed) under the first project, which aims at improving recovery of rural credit through tight supervision (Annex IV, para. 1); and (b) finance a study by consultants to formulate a long term agricultural credit policy and system for Madagascar which would aim at identifying the basic constraints to smallholder lending, together with proposals for their removal (paras. 50 and 70). Prolect Components 61. The proposed IDA credit of US $10 million equivalent would be made to the Government of Madagascar, on standard terms, for the benefit of BTM. In view of BTM's weak long-term resource base and portfolio, and the difficulty of attracting new medium-term funds on the local market (para. 53), the Government would--in support of the 'Action Plan" (paras 54-56)-- transfer the IDA credit proceeds to BTM as an equity contribution. Such a transfer is justified in view of the illiquidity of BTM's portfolio and the Government's current difficulty to make cash transfers to BTM to strengthen the latter's equity base. The project would have: (i) a line of credit component of US $8 million equivalent, and (ii) an institution building component of US $2 million equivalent. 62. The Line of Credit Component. This component would meet the foreign exchange costs of BTH sub-projects for new investment as well as for rehabilitation or expaswion of existing ventures in agricultural production and primary processing/marketing. Agriculture would be broadly defined to include, also, livestock, fisheries and forestry. The IDA credit proceeds would cover the fixed investment needs, notably purchase of -zachinery, equipment, and spare parts. There would be no upper limit on the total cost of individual sub-projects but, in order to ensure a wide distribution of benefits, the IDA contribution would be set at a maximum of US $500,000 equivalent per sub-project (with a minimum amount of US $20,000 equivalent). The necessary counterpart funds for sub-projects would be provided by the investors and through loans from BTM's other resources (Annex IV, para. 4). Shortage of foreign exchange continues to be a major I  - 21 - constraint for investment in the agricultural sector, and at present there is considerable demand for loans in foreign exchange, notably by private agroindustries. BTM has a fairly sizable list of potential borrowers being screened for lending. The proposed project will respond to their pressing needs. 63. BTM would lend the IDA credit proceeds at positive real interest rates. Assurances were obtained at negotiations that (i) Government would pass on to BEM funds from the IDA credit as equity contribution; and (ii) BTM would lend the proceeds of IDA credit to its clients at positive real interest rates. Sub-borrowers will have the option of borrowing under the following alternative terms and conditions: (a) the IBRD lending rate at the time of approval plus 42 p.a., the foreign exchange risk to be borne by the sub-borrower: or (b) BTM's prevailing lending rate and commissions for local currency lending (para. 48), plus a front-end fee of 10 of the proposed sub-loan, and a fee of 3% p.a. on the outstanding amount of the sub-loan. BTM's local currency lending not related to the project would be made at its current interest rates which are higher than present levels of inflation. To protect BTM's income and recapitalization effort, it is important that its future interest rates also remain positive. BTH would therefore review its intei:est rates twice a year with IDA, including lending rates under the proposed project, to ensure thut they are positive in real terms. Repayment periods on sub-loans would be established by BTM on the basis of cash flow projections of each sub-project and on the type of assets to be financed. These periods would not exceed the average useful life of assets being financed nor would they exceed a maximum period of 15 years, including three years of grace. BTM would cover its risk through mortgages on the investors' assets. 64. The Institution-buildinz Component. This component would allow f*r: (i) extension of current technical assistance to BTM's training and computer services divisions; (ii) use of short-term consultants' services to train BTM staff in project promotion and appraisal; (iii) continued financing of assistance by an internationally-recruited firm already helping BTH, to audit BTM accounts and to continue assistance in institution-building; (iv) financing of incremental costs of a pilot field- Jevel credit management project aimed at reviving smallholder credit operations; (v) consultancy services to assist potential entrepreneurs with project ideas that are prima facie viable at the identification stage; (vi) consulting services for formulation of a future agricultural credit policy and system for Madagascar; and (vii) procurement of computer hardware and development of specialized banking and operational software. This last item, which would cost about US $1.2 million equivalent, is urgently needed by BTM to initiate and monitor effective portfolio analysis and follow-up under the Action Plan (paras. 54-55) and in conduct of other banking operations. It would complement the actions taken under the previous projecr.  - 22 - Proiect Costs and Financing Plan 65. The total project cost, on the basis of a commitment period of two and a half years, from September 1987 to February 1990, is expected to be about FMG 14,543 million (US $19.33 million equivalent) of which about US $10 million equivalent (or 52%) would represent foreign exchange costs. Project costs are estimated at March 1987 prices; local costs, which include taxes, are to be covered by BTM and the investors. The proposed IDA credit of US $10 million equivalent (FMG 7,527 million) would finance the foreign exchange costs. BTM and the investors would contribute about FMG 7,016 million (US $9.33 million equivalent). Of this, the investors' share would be FMG 2,393 million (US $3.2 million equivalent), or about 20Z of the sub-project costs which amount to FMG 11,966 million (US $15.90 million equivalent). Proiect Implementation 66. Role of BTM. The project would be implemented by BTM, within the framework of annual work programs which would be submitted to IDA each year for its review and approval (paras. 67-68). IDA would approve BTM sub- loans over US $150,000 equivalent, prior to commitment of IDA credit proceeds for them (para. 69). BTM would be responsible for all aspects of sub-p-oject identification and promotion, assistance in preparation, appraisal and supervision. In selection of subprojects, BTM would use economic, financial and technAcal selection criteria included in its current appraisal procedures, 4hich are acceptable to IDA. These criteria are embodied in a sound new Policy Statement for BEM lending for development projects which was approved by BTM's Board in March 1987. 67. Annual Work Programs and ProRress Reports. BTM would prepare for its activities each year a draft annual work program which would include information regarding: (i) the pipeline of sub-projects identified, those being prepared, appraised, approved, or implemented, together with an implementation schedule and comments on each sub-project; (ii) BTM's staff recruitment and training programs under the IDA project; (iii) the project budget; (iv) projected commitments and disbursements under the project, indicating projected IDA disbursements, BTM's loan or equity contributions, investors' contributions, together with an arrears analysis and loan collection data; (v) a comprehensive description of expenditure related to the IDA project's institution-building component; (vi) Bm's projected balance sheet, operating accounts'and profit and loss statement; and (vii) discussion of foreseen problems and planned or current actions to deal with them. These annual work programs would be submitted to IDA, with copies to the ministries concerned (Ministry of Finance, MPARA, MPAEF), by end of October each year (for the following year) for review and approval. IDA's approval of the work programs would be a condition for its approval of new sub-loans in the year concerned. The BTM work program for 1987 has been reviewed and approved.  - 23 - 68. Each year, BTM would send to IDA, with copies to the Ministries concerned (Ministry of Finance, NPARA, MPAEF), quarterly progress reports covering all items of the annual work program. These reports would include a sumnary of operations, financial statements, resource position, statement of arrears, collection ratios and information on sub-projects in difficulty. These reports would also include details of the sub-loans approved and committed and a summary analysis of the status of implementation and performance of sub-projects financed under the credit. Copies of the auditors' progress reports to BTM concerning the implementation of the "Action Plan' would be enclosed with these progress reports. 69. Selection of Sub-Proiects. Sub-projects to be financed under the proposed project will be of high economic priority, justified on the basis of a full economic and financial analysis, including calculation of an economic rate of return (ERR) and a financial rate of return (FRR) for projects costing above the equivalent of US $100,000 equivalent (roughly FMG 75 million). The minimum ERR would be 12Z while the minimum FRR would be 3 points above BTM's lending rate. A free limit' for sub-loans on the IDA credit would be set at the equivalent of US $150,000 (roughly EMG 113 million). Up to this free limit', BTM will have the right to approve sub- loans without prior reference to IDA. (The first ten BTH sub-loans under the -project would be subject to prior IDA approval irrespective of their amount.) The aggregate free 14mt would be the equivalent of US $3.2 million equivalent (roughly FMG 2,400 million), accounting for about 40 percent of the total amount of the project line of credit component. 70. Formulation of Atricultural Credit Policy for Madagascar. BTM would arrange for a study by consultants to formulate an agricultural credit policy for Madagascar, with particular attention to the needs of smallholder farmers (prra. 50). This study would supplement the ongoing study by the Central Bank concerning the country's overall credit policy (para. 49). BTM would make arrangements, satisfactory to IDA, with the Central Bank, the agricultural and finance ministries and the other two commercial banks, so that their views on this matter will receive due consideration. The scope of the study, including an outline of the terms of reference, were agreed with the Government and BTM. BTM would submit the recommendations of the study to IDA for its review and approval by June 30, 1988; the Government would implement the agreed recommendations not later than December 31, 1988. Procurement and Disbursement 71. Procurement. Procurement for sub-projects financed under the project's line of credit component would be on the basis of competitive quotations from domestic or foreign suppliers. Given the relatively modest size of procurement packages for sub-projects, there is little scope for international competitive bidding. Computer equipment for BTH would be procured through international competitive bidding. Technical assistance under the project would be open to international recruitment, in accordance with Bank/IDA Guidelines.  - 24 - 72. Disbursement. The proposed credit would be disbursed on the basis of: (a) for BTM sub-loans: OOZ of the cif cost of imported goods and OOZ of internationally procured services; and (b) for BTM institution-building: 100% of the foreign cost of goods and services. 73. A special account of US $400,000 equivalent (the estimated average disbursement of funds over a four-month period) would be set up in the Central Bank on terms and conditions, acceptable to IDA. The account would be replenished when the balance is below US $200,000 equivalent. All credit withdrawals, apart from those for computer procurement, would be financed from the special account unless otherwise agreed with IDA. Withdrawal applications for replenishment of the special account would be accompanied by a statement which would reflect all prior transactions. Loan disbursements would be made on the basis of Statements of Expenditure (SOEs). The documentation for withdrawals made under SOEs would be reviewed by BTM's auditors and be available for examination by IDA missions. Disbursements under the Institution Building Component would be fully documented. 74. Disbursements under the proposed credit are estimated to be completed by June 30, 1994. This period would correspond to the Region's standard profile for financial intermediary loansJcredits. Project Accounts and Audit 75. BTM's annual accounts are audited by an independent local firm, with support from an international firm. During the project implementation period both project accounts and the accounts of BTK as a whole would be audited by an independent international auditing firm acceptable to IDA. The cost of the international audit would be paid out of the IDA credit. The audited accounts with auditor's report would be submitted to IDA within six months after end of each fiscal year. BTM would maintain separate accounts adequate to show utilization of the project funds and keep development funds separate from the rest of its business. Pro4ect Benefits and Risks 76. Benefits - The benefits of this project would accrue through entrepreneurs to the economy as a whole, and to BTM as an institution. The former would come from alleviation of two key constraints, lack of foreign exchange and lack of term funds, and from advice and technical assistance provided to entrepeneurs by BTM and its consultants. With the project's support, production and processing of crops such as rice, oilseeds, pepper, vineyard, and fish would increase and contribute to increased domestic sales and exports. While total benefits can not be quantified accurately  - 25 - at this stage, their lower limit would be the minimum acceptable ERR for eligible projects, which would be set at 12Z (para. 69). Benefits to BTM will come through the institution-building component, which will strengthen its capacity to function effectively as a development bank. By improving its project appraisal capabilities, as envisaged inder the poject, BTM would be able to expand and diversify its operations in the rural development field. The project would enable BTh to create new investment and employment opportunities for Malagasy nationals by promoting and financing of agricultural undertakings, including agroindustries. 77. Risks. Under the project, BTM would be called on to play the role of a development bank, in addition to its main function as a commercial bank. So far, the commercial bank business has absorbed practically all of BTM's energy and resources. There is a risk that the same tendency in future will cause BTM's management to over-emphasize short-term commercial activities and not take sufficient interest in development lending. Technical assistance, training, and sub-project support have, however, been designed under the proposed project to rebuild that capacity. Against this risk BTM will have the required trained staff for the conduct of its development lending under the proposed project, and it will keep development funds separate from the rest of its business. BTM will increase agricultural lending and will not make any new loan to public enterprises in financial difficulties. As a further risk, if the banking sector problems intensify (para. 45), BTM's financial situation may deteriorate further. The current actions to redress BTM's situation should provide some assurance that BTM's financial condition would be restored nonetheless. Finally, the project faces a risk that the Government might falter in its efforts to improve the environment for agricultural development. Careful supervision of evolution of the banking sector and of the progress of the project institution-building component for BTM will be essential. Finally the Government has reaffirmed its policy of cooperation with the Bank and the IMF; this overall posture, and continued adjustment lending, should lead to accelerated improvement of the environment for agricultural development. Overall, the risks involved are within acceptable limits in view of the safeguards provided for and the importance of enabling investors in the agriculture sector to take advantage of recent sector policy reforms and thereby contribute to the growth of productive activities. PART VI - RECONMENDATION 78. I am satisfied that the proposed credit would comply with the Articles of the Association and recommend that the Executive Directors approve the proposed credit. Barber B. Conable President Attachments April 24, 1987  -26- ANNEX I nfbkaRom - CINMM Volo~pagelIof 3 ill For Colts @e to Mel m A. 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