Document of The World Bank FOR OFFICIAL USE ONLY STAFF APPRAISAL REPORT PARAGUAY AGRICULTURAL CREDIT PROJECT. May 16, 1983

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1 Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Document of The World Bank FOR OFFICIAL USE ONLY STAFF APPRAISAL REPORT PARAGUAY AGRICULTURAL CREDIT PROJECT May 16, 1983 Projects Department Latin America and the Caribbean Regional. Office Report No. 4382a-PA This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.

2 CURRENCY EQUIVALENTS Local Currency Unit Guarani (G) Official Exchange Rate US$1 = G 126 WEIGHTS AND MEASURES Metric System GLOSSARY OF ABBREVIATIONS AD - Agriculture Department (BNF) BNF - National Development Bank CAH - Small Farmer Rehabilitation Credit Agency CB - Central Bank CREDICOOP - National Credit Cooperative, Ltd. DIAF - Department of Agricultural and Forestry Research DRP - Debt Recovery Program FECOPROD - Federation of Producers Cooperatives FG - Livestock Fund IBR - Rural Welfare Institute KfW - Kreditanstalt fur Wiederaufbau MAC - Ministry of Agriculture SEAG - Agricultural Extension Service TAP - Technical Assistance Program GOVERNMENT OF PARAGUAY FISCAL YEAR January 1 to December 31

3 PARAGUAY FOR OFFICIAL USE ONLY AGRICULTURAL CREDIT PROJECT Staff Appraisal Report Table of Contents Page No. I. LOAN AND PROJECT SUMMARY... 1 II. PROJECT OBJECTIVES AND PERFORMANCE INDICATORS. 3 A. Project Objectives B. Performance Indicators. 3 BNF's Performance Indicators and Goals. 3 BNF's Agricultural Department Performance Indicators and Goals. 4 Agricultural Production Indicators. 4 III. THE AGRICULTURAL SECTOR... 4 A. General Characteristics... 4 Agriculture in the Economy... 4 Land Tenure and Use. 5 Institutional Framework... 6 Agricultural Credit. 7 Marketing and Prices. 7 B. Bank Strategy and Previous Bank-financed Projects. 8 IV. THE PROJECT. 8 Background.. 8 Objectives and Description.. 9 The Project Executing Agency.. 9 Project Execution Lending Terms and Conditions.. 14 Project Cost and Financing.. 15 Procurement and Disbursement.. 15 Accounts and Auditing.. 16 Monitoring and Evaluation Financial and Economic Justification.. 17 Project Justification Project Risks V. AGREEMENTS REACHED AND RECOMMENDATION This report is based on the findings of an appraisal mission which visited Paraguay during November The mission comprised Messrs. J. Bazo (Mission Leader), H. Floyd (Agriculturist), and R. Hanan (Ag. Economist) (Bank) and G. Gomez (Consultant). This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.

4 - i~i - Page No. ANNEXES 1. Agricultural Credit and BNF A. Agricultural Credit B. Agricultural Lending of BNF C. Sources of Funds... a D. BNF's Portfolio Arrears and Collections E. BNF's Balance Sheets and Income Statements.. 29 Table 1 - Loans Made by BNF's Agricultural Department..33 Table 2 - BNF's Portfolio under A rrears. 34 Table 3 - Consolidated Balance Sheets for Fiscal Years Table 4 - BNF's Income Statements, Table 5 - Consolidated Financial Statements - BNF..37 Table 6 - Historical and Projected Income Statements - BNF 38 Table 7 - BNF/Results and Profitability D a t a 39 Table 8 - Income and Costs Statement Without Project.. 40 Table 9 - Actual and Projected Income Statements With Project Farm Models and Financial and Economic Justification Farm Budgets, Rates of Return and Cash Flow Tables 1 and 2 - Model 1 (120 ha farm) Tables 3 and 4 - Model 2 (80 ha farm) Tables 5 and 6 - Model 3 (40 ha farm) Tables 7 and 8 - Model 4 (15 ha farm) Table 9 - Farmgate Prices for Financial and Economic Analyses BNF's Technical Assistance Program (TAP) Statement of Operating Policies and Procedures List of Selected Documents and Data Available in the Project File 69 SUPPORTING TABLES Table 1 - BNF's External Resources for Small-farmer Loans Table 2 - Institution-Building Component Table 3 - BNF's Project Lending Program MAP IBRD No

5 PARAGUAY AGRICULTURAL CREDIT PROJECT I. LOAN AND PROJECT SUMMARY Borrower: The Republic of Paraguay. Beneficiaries: Government; National Development Bank (BNF). The ultimate beneficiaries would be about 5,000 small- and medium-scale crop farmers receiving project subloans from BNF. Loan Amount: Loan Terms: Relending Terms: US$40.0 million (including US$0.10 million front-end fee). 17 years, including four years of grace, at the standard variable interest rate. The proceeds of the loan would be made available to BNF in local currency under arrangements to be covered by a subsidiary agreement between the Government and BNF. Execution of the subsidiary agreement, satisfactory to the Bank would be a condition of loan effectiveness. BNF, in turn, would relend to project sub-borrowers at an effective rate of interest of at least 18% per annum, with repayment terms of up to 10 years, including a grace period of up to three years. Project Description: The project's main objectives would be to increase agricultural output, including production of export crops for which Paraguay enjoys a comparative advantage, and to help small- and medium-scale farmers to increase their earnings and thereby improve their living conditions. To attain these objectives, the project would provide funds to BNF to alleviate the scarcity of long-term resources for financing such development. It would also continue efforts initiated under the Bank-financed Industrial Credit Projects (Loans 1419-PA and 1866-PA) to strengthen BNF's institutional capability. The project would include two components. The major one would consist of a lending program of long-term credit for financing on-farm investments, as well as short-term credit for incremental operating costs. The minor component would finance a program to strengthen BNF's staff capabilities and expand the office equipment and vehicles used in its agricultural credit operations. Benefits: The project is expected to have a significant impact on agricultural development, raising standards of living of the rural population, increasing foreign exchange earnings and savings, and improving the operational capacity of the principal lending institution for the agricultural sector of Paraguay.

6 -2 Risks: Credit demand under the project is highly dependent on prices paid at farm level for soybeans and cotton. Because of the depressed international market, prices for these two crops were, till recently, unattractive to the bulk of farmers in Paraguay. However, according to the Bank's commodity price forecasts, world prices for soybeans and cotton are expected to improve in 1983 and beyond. Estimated Costs: Components Local Foreign Total (US$ million equivalent)- Credit Program 31.0 a/ a/ (on-farm investment) BNF's Institution Building Total Financing Plan: Local Foreign Total (US$ million equivalent)---- Estimated Disbursements: Bank loan BNF Project Beneficiaries Total Bank FY: Annual Cumulative Economic Rate of Return: not applicable. Appraisal Report: Report No. -PA, a/ Includes US$14.0 million of project beneficiaries' contribution.

7 II. PROJECT OBJECTIVES AND PERFORMANCE INDICATORS A. Project Objectives 2.01 The project's main objective is to improve the income of small- and medium-scale farmers, mainly through increased production of soybeans and cotton. Most of the increased production would result from increasing the area under cultivation, though some increase would also result from improved yields. Much depends on farmers' investment and borrowing decisions. These, in turn, will be influenced by international prices, exchange rate policy, and marketing and climatic conditions. However, based on present price exp~ectations, soybean and cotton production would be attractive enough to stimulate on-farm investment in the foreseeable future. The other objective of the project is to strengthen the National Development Bank (BNF) in its financial and operational aspects, so that it may serve as an efficient and expanding source of institutional credit for agricalture in Paraguay. B. Performance Indicators 2.02 The indicators shown in the tables which follow are based on the present situation in regard to BNF's agricultural lending and the contemplated increase in its operations and improvement in aspects such as loan recovery, cost reduction and financial strengthening. BNF's Performance Indicators and Goals Actual Projections Annual growth of net loan portfolio - % 26.4% 22.4% 19.6% 17.4% 15.4% 15.3% 2. Portfolio under arrears at end of fiscal year - % 16.9% 15.5% 15.2% 14.7% 13.7% 13.5% 3. Earnings over net loan portfolio - % 15.0% 16.0% 16.3% 16.4% 16.5% 16.5% 4. Operating costs over gross portfolio ratio 7.8% 7.6% 7.4% 7.0% 6.7% 6.5% 5. Net growth of deposits from private sector - % 9.6% 12.0% 12.0% 12.0% 12.0% 12.0% 6. Liquidity ratio at year end

8 - 4 - BNF's Agricultural Department Performance Indicators and Goals Actual Projections Annual growth of net loan portfolio - % 25.7% 20.3% 18.6% 16.5% 14.5% 14.5% 2. Portfolio under arrears at end of fiscal year - % 16.6% 15.6% 15.3% 15.0% 14.0% 14.0% 3. Earnings over net loan portfolio - % 14.2% 15.2% 15.4% 15.6% 15.7% 15.7% 4. Operating costs over gross portfolio ratio 5.2% 5.1% 5.0% 4.8% 4.6% 4.5% Agricultural Production Indicators 2.03 Estimated yields of main commodities developed under the project are expected to increase as follows: Before Project Incremental At Full Development Production (tons) Soybeans ,000 Wheat ,000 Cotton ,000 III. THE AGRICULTURAL SECTOR A. General Characteristics Agriculture in the Economy 3.01 Agriculture is the most important economic activity in Paraguay, contributing about 31% of GDP, over 95% of the country's total exports, and near half of the employment. In 1980, 70% of the total population lived in rural areas. The sector supplies most of the products needed for domestic consumption, except for wheat, dairy products and fruits, which are imported from neighboring countries. The country is divided by the Paraguay river into two distinct areas: the Chaco to the west and the Eastern region. The Chaco, with about 25 million ha and approximately 3% of the country's population of three million, is dry and short of water resources and generates only about 1.5% of the agricultural production, mostly from extensive livestock ranches. The Eastern region accounts for over 97% of the population and of the GDP and comprises forested areas and plateaus, with good soils and well distributed rainfall, Crop production is essentially limited to this region.

9 During the decade of the 1970s, the value of agricultural production grew in real terms at a cumulative annual average rate of 7.5%. This increase resulted mostly from expansion of cropped areas in the eastern part of the Eastern region. Area covered by the principal crops, mainly cotton and soybeans, rose from about 500,000 ha in 1972 to approximately 1.5 million ha by the end of This development has been supported by a large immigration of capable and aggressive farmers from Brazil, who have made an important technological contribution, and by farmers who came from the central areas of the country, characterized by eroded soils and minifundia. Other important factors supporting this development are the construction and improvement of roads in the Eastern region, attractive international prices for cotton and soybeans, and the demand originating from the construction of Itaipu dam. Future production expansion will depend on farmgate prices, the availability of investment capital, and the public sector's ability to improve roads and technical services. These are the main factors which would facilitate and accelerate the transition from subsistence to commercial agriculture. The Bank and other international agencies have been helping this process by financing a number of integrated rural development projects designed to upgrade the technological and economic status of existing smallholder settlements and to support new settlers. Land Tenure and Use 3.03 The number of farm units in Paraguay has increased by 53% over the past 10 years, from about 162,000 in 1971 to about 249,000 in / Over 70% of the farms are exploited by owner-operators, another 12% by tenants, and the remaining 18% by farmers, who, though lacking land titles, may have established users' rights. As to farm size, for the 14 departments within the Eastern region which account for 244,000 of the country's 249,000 farms, over 40% had less than 5 ha, 24% had between 5 and 10 ha, 27% had 20 to 50 ha, and 4% were between 50 and 200 ha. Farms larger than 200 ha accounted for about 1.5% of the total number. Of the total area included in the census, the distribution is highly skewed, with 95% of the farms occupying only 23% of the total farming area of about 10 million ha. These figures, however, also reflect considerable variability in land productivity There is little reliable data on land use. With land being increasingly cleared for crops, the situation is changing rapidly. Of the total 10 million ha of farming area in Eastern Paraguay, only 1.5 million ha is cropped; the remainder is in pastures, woodlands and wasteland. Cotton and soybeans occupy 50% of the crop area. According to the census, in the strata of 5 to 50 ha, 25% of the farm area is cropped, while in the strata of 50 to 200 ha, the comparable figure rises to about 30%. Increase in crop land is at the expense of forest land. In the majority of cases, farmers, mainly small scale, manually cut down and burn the forest after removing the most valuable timber. After some years of cropping among the stumps and felled trees, many medium-scale farmers clear the stumps with heavy machinery or animal power. Cotton is a typical non-mechanized activity of small-scale farmers, who generally plant less than 5 ha, due to labor shortages. Wheat and sorghum are about the only alternatives for cropping during the off season. 1/ Source: preliminary data from the 1981 agricultural census.

10 -6- Institutional Framework 3.05 The Ministry of Agriculture (MAG) is responsible for policy formulation and for administering support services for the sector. Its most important activities are agricultural extension (through its Agri'eultural Extension Service - SEAG), research (Department of Agricultural and Forestry Research (DIAF)), marketing, collection of agricultural statistics, and land reform. Various autonomous entities carry out related program3. The National University of Asuncion provides most of the agricultural education and some research, while the Rural Welfare Institute (IBR) is responsible for land distribution, mainly through the establishment of settlements. There are only two research centers and six substations for agricultural research and three livestock research substations, with a total staff of 73 professionals, 14 of them working in the central office of the Ministry of Agriculture. Though the national research program is handicapped by a shortage of trained scientists and funding, there have been some successes. For example, with the participation of French Government Technical Assistance, DIAF has produced high-yielding varieties of cotton, which have been widely adopted by farmers over the past 10 years. SEAG, with some 300 technicians, faces many of the same problems as DIAF. The staff that is linked to specific development projects financed by the Bank and other foreign sources work under much better conditions than their associates, but the impact of their work is limited to the project areas. BNF, with 93 agricultural technicians who at the 45 branch offices help farmers prepare on-farm investment programs, also provides some extension services. Moreover, there is a joint SEAG/BNF program (PAC) under which extension staff from SEAG assist BNF's small-scale farm customers in preparing farm plans and credit applications in specified areas of the country. The Livestock Fund (FG), strengthened by financial support from the Bank, maintains a task force of professionals, which, besides helping ranchers prepare investment plans and loan applications, provides technical assistance Suppliers of insecticides and other production inputs and the merchants who purchase farm produce, are actively involved in technology transfer. In the case of certain crops (cotton, tobacco), the buyers supply seed and most also provide production credit, as well as participate in extension programs organized by SEAG. This gives them considerable influence with farmers. Some soybean merchants have agents who make production contracts with farmers, arrange credit, supply inputs, observe and advise on crop production problems and supervise harvesting. The role of private intermediaries in technology transfer may thus be as important as that of official agencies The IBR, established in 1963, has organized public settlements and sponsored private ones, settling some 3,000 families per year, mostly from the "minifundia" areas around Asuncion. It normally provides plots of about 15 to 20 ha of undeveloped land to each family, concentrating its efforts on settling large numbers at low cost, basing its program essentially on the self-reliance of the settlers. IBR also provides land titles, which are required as collateral for agricultural credit from BNF. In Bank-supported rural development projects, specific titling targets have been laid dowrn and generally achieved, though sometimes with delay.

11 -7- Agricultural Credit 3.08 Institutional agricultural credit in Paraguay is provided by the general banking system (except Central Bank (CB)) and certain specialized entities. The banking system consists of the CB, the Government-owned BNF and 22 private commercial banks, while the specialized public credit entities comprise FG and the Small Farmer Rehabilitation Credit Agency (CAH). Farmer associations and cooperatives which are affiliated either with the National Credit Cooperative, Ltd. (CREDICOOP) or the Federation of Producers Cooperatives (FECOPROD) also act as credit intermediaries. Non-institutional sources are important in providing seasonal production credit and consumption credit to smallholder producers of cash crops BNF is by far the main source of institutional credit to crop and mixed crop/livestock farmers in Paraguay (paras 4.06 to 4.13 and Annex 1). in 1981 BNF accounted for 51% of the US$200 million total agricultural institutional lending in Paraguay, serving about 15% of the farmers and financing 30% of the area under cash crops. Over 80% of the 30,000 to 40,000 borrowers served with such credit annually were small-scale farmers who constituted the main target group of all its externally financed credit programs. Significant numbers of small-scale farmers are provided with credit in areas such as those covered by integrated rural development projects where adequate support services are available and where farmers can be reached with the services. Private banks finance mainly marketing of crops and livestock, with funds channelled through middle men, cotton gins, rice and sugar mills, and soybean exporters, but they also provide short-term credit for cattle fattening and marketing. FG, established in 1969 as an independent branch of CB, has developed into an expanding source of investment credit for livestock, thanks to the financing and institution building provided for under a series of Bank-financed projects. CAH's main objective is to provide credit and other types of assistance to the poorer small-scale farmers who lack land titles or other collateral, and, hence, do not satisfy the criteria for credit from other institutional sources. It aims at improving the economic and social status of these farmers, so that they may eventually qualify as regular customers of the banking system. Marketing and Prices 3.10 In general, the marketing of agricultural products in Paraguay has been free from Government regulations, and the prices for most products are determined by domestic supply and demand and market conditions abroad, especially in Argentina and Brazil. The only exceptions are the guarantee price for wheat payable at the mills and certain reference prices for sugar and cotton payable at the refineries and gins, respectively. However, MAG's limited institutional and financial capability does not permit it to exercise effective control on the prices received by the farmers, which are usually lower than these reference prices, especially at harvest. The policy of supporting the wheat price has been in force for several years; it is intended to shield the producer against competition from imports at the official exchange rate. The guarantee price at present is about 50% above import parity prices at the official exchange rate and about 20% below at the free market rate. The Paraguayan authorities have attached importance to domestic production of wheat on grounds of food security and the

12 -8- complementarity of wheat to soya. The issue of maintaining a guaranteed price for wheat in the context of the overall incentive system for agricultural production will be discussed with the Government in the forthcoming Bank sector study. B. Bank Strategy and Previous Bank-financed Projects 3,11 The Bank's agricultural lending strategy is to help sustain and broaden the growth process, begun in the 1970s. To this end, the Bank is supporting efforts to: (a) expand the agricultural frontier, while protecting the country's rich national resources, and (b) promote and support intensification of production through the provision of credit and support services to aid the use of modern inputs. At the same time, the Bank has endeavored in these efforts to emphasize assistance to small-scale farmers so as to enable them to participate in, and contribute to, agricultural development. This strategy is in line with the Government's policy and constitutes a suitably balanced effort to meet the economic and social objectives of the sector. It is complemented by assistance from other lending institutions, notably the idb and USAID, and from the Governments of Japan and the Federal Republic of Germany in the fields of agricultural marketing, research, extension, agricultural statistics, and specific commodity programs The proposed project would be the twelfth Bank/IDA-supported agricultural project in Paraguay. These projects comprised a general-purpose agricultural project in 1951, followed by five livestock projects, four rural development projects, and a livestock and agricultural development project. Experience with the execution of the agriculture projects in Paraguay underscores the importance of expanding credit and technical services for agriculture, including transport infrastructure, in order to accelerate the realization of production potential and to meet the development needs of lower income people. The bulk of recent Bank lending to Paraguay in this sector has, accordingly, been directed to supporting small-scale farmers, mostly through rural development projects which combine the provision of services such as credit, land titling and extension to aid production, rural roads, and community and health facilities. In general, the experience with the rural development projects has been satisfactory, and, despite implementation delays, they have been contributing to increased agricultural production and incomes and improved rural roads and comunity and health facilities. The Project Performance Audit Reports available so far relate to livestock projects except for the one recently issued on the Small Farmer Credit and Rural Development Project (Credit 509-PA), completed in The PPAR concludes that the project achieved most of its physical, economic and social objectives and resulted in increased yields for cotton, maize and soybeans but points out that delays encountered led to a cost overrun of 25%. IV. THE PROJECT Background 4.01 The proposed project was prepared by the Government and BNF, assisted by an FAO/CP mission that visited Paraguay in August/September A Bank mission appraised the project in November 1982,

13 -9- Objectives and Description 4.02 The project aims at increasing agricultural output--including production of export crops for which Paraguay enjoys a comparative advantage--and helping medium- and small-scale farmers to increase their earnings and thus improve their living conditions. As the existing and proposed external lines of credit available to BNF are all focussed on small-scale farmers (Table 1), the proposed project would seek, especially, to meet the credit needs of medium-scale farmers, for which funding is inadequate. With a view to supporting progress toward these objectives, the project would provide funds to increase the resources available to BNF for financing on-farm development and to continue BNF's ongoing institutionbuilding program initiated with Bank/UNDP assistance in The project would include two components. The main one would consist of a lending program for financing medium- and long-term credit for on-farm investments and short-term credit for incremental operating costs. The other would finance part of a program to strengthen and expand staff andphysical facilities related to the broader institution-building effort for streamlining BNF's agriculture credit operations (Table 2) The Lending Program. Over a three-year investment period, the project would finance some 5,000 farmers throughout the country, a majority of them being crop and mixed crop/livestock farmers in the Eastern region. Project beneficiaries would include small-scale farmers located in areas of the country not assisted under other Bank or internationally financed BNF projects and medium-scale farmers with up to 200 ha of crop land. In both cases, the conditions of eligibility for project financing would be that the farm be operated by the farmer and his family and that his major source of income be derived from farm production. Medium- and long-term credit for on-farm investments would finance mainly mechanized destumping of fields; farm machinery, mostly tractors, tilling implements and soybean harvesters; farm installations; on-farm roads; and soil conservation practices. Short-term credit would finance the production of annual crops, which would be mainly soybeans, cotton and subsistence crops (mainly cassava, maize and beans). The principal items financed by short-term credit would be seeds, fertilizer, pesticides and equipment operating costs (Annex 2) Institutional Development. To help improve BNF's operational efficiency and services to farmers, the project would provide financing for: vehicles for field staff which would enhance mobility and frequency of contact with farmers and office equipment which would expedite processing of loan requests and supervision. This would be complementary to phase II of the Technical Assistance Program (TAP) whicti BNF is implementing (Annex 3). The program is designed to strengthen accounting and computing services, financial management and the administration of its lending operations and is presently being financed by BNF from various sources,including funds available under the Bank's Second Industrial Credit Project. The Project Executing Agency 4.06 BNF, which would be responsible for executing the project, functions as an autonomous institution under the organizational structure of the Ministry of Finance, with a mandate to promote and finance general

14 programs and specific projects for the development of agriculture, livestock, forestry, industry and commerce. BNF provides credit and other banking services through three departments--agriculture (AD), Development (Industrial) and Commercial--each with independent capital and sources of funds and specific operating guidelines, and supported by BNF's general administration, financial and service units. BNF operates in accordance with the Statement of Policies and Procedures (SPP) issued by its Board of Directors (Annex 4). Financing of agriculture is the most important role of BNF, particularly its assistance to small-scale farmers Prior to 1976, BNF participated in a wide range of activities and financed some unsound investments, which resulted in Large losses and a weak financial position. However, under post-1976 management, an overall rehabilitation plan was worked out and implemented within the framework of two Bank-supported industrial credit projects. Under the first project (Loan 1419-PA), BNF started implementation of a UNDP/Bank Technical Assistance Program, called TAP, to strengthen BNF's institutional capability. The program began in September 1977 and during the following three years assisted BNF in improving its financial administration, industrial project appraisal and supervision, programming of agricultural loans, computing activities, telecommunications between headquarters and branches, loan portfolio management, and human resources. Encouraged by its initial achievements, BNF authorities, at the end of 1981, decided to continue and expand its TAP with special emphasis on AD's operational efficiency. During the course of the following year, BNF detached 20 professionals from its different departments to work full time on the second phase of its TAP, which was institutionalized as a permanent BNF office, headed by a Coordinating Committee assisted by an expatriate consultant hired by BNF. The TAP Second Phase (shown in Annex 3), with an estimated cost of US$3 million, is financed largely by BNF, and, to a small extent, with resources from Bank loans (Industrial and Caazapa projects/loans), IDB and UNDP. As a result of these efforts, the collaboration and interest of the Government and the assistance provided by international agencies, BNF's overall financial situation and operational performance have continued to improve from year to year Financial Situation. 2/ After incurring losses for 12 consecutive years, BNF has since 1977 been making annual profits, which increased steadily from about US$0.5 million to US$2.2 million in However, there has been a setback since 1980, mainly as a result of higher operating and financial costs (Annex 1, Tables 6 and 8). The BNF had begun to make some progress in reducing operational costs, following the commencement of the first phase of TAP but the trend began to be reversed in 1981, mainly reflecting staff expansion, salary increases and the general impact of inflation. Considering that it is a multi-purpose development bank with a large branch system and given the need to recruit and retain staff of good quality, BNF has administrative costs that are not unduly high, compared with similar banks in other countries. This is particularly true of its agricultural lending, as it consists largely of small-scale farmer credits which are admittedly costly to process and supervise. The situation would 2/ Annex 1 and supporting tables provide more detailed information.

15 improve as the volume of operations grows over the years and AD's operational efficiency is raised as a result of the implementation of TAP in its various aspects. However, BNF, at the Bank's request, has agreed to present to the Bank an analysis of the causes for the recent increase in costs and an action program for checking this trend. Financial costs, expressed as a proportion of average liabilities, also increased from 6.2% to 7.4% between 1979 and 1981, mainly as a result of the increased cost of funds in the world market. In order to offset this trend BNF increased the interest rate on loans for agriculture from 13% to an effective annual rate of 18% in As a consequence, BNF's interest income over total average portfolio grew from 13.8% in 1978 to 15% in Portfolio Arrears. In 1976, during the appraisal of the first Bank Industrial Project/Loan (1419-PA), a major concern of the Bank, as well as of the new administration of BNF, was the high proportion (22%) of arrears in BNF's loan portfolio. Serious efforts made to deal with this problem in the intervening years had led, by 1981, to a significant reduction of arrears (to 16.9%) and an expectation of further improvement in the following years. Portfolio in arrears, from 30 days to over five years, amounted to US$35 million on December 31, Of this total, amounts overdue for over two years amounted to US$14.9 million (43%), of which US$11.2 million corresponded to old loans. Such loans had, in most cases, been made by the Agricultural Department in support of Government-sponsored programs (such as the National Wheat Program), under which lending decisions were based predominantly on political rather than technical-economic grounds. Provision for possible loan losses amounted to US$10.5 million, or 70% of the amount under arrears for over two years at the end of December Debt recovery for current dues of agricultural loans has improved from 82% in 1977 to 90% in 1981 and under the total BNF portfolio, from 81% to 90%. Recovery of loans in arrears also improved from 21% for agricultural loans and 25% for all BNF loans in 1977 to 34% and 35%, respectively, in December 1981 (Annex 1) The actual andcexpected improvement of BNF's portfolio quality is, in large part, due to measures taken under the TAP (para 4.07). In compliance with the first Industrial Project Loan Agreement, and within the framework of the TAP, BNF adopted a debt recovery program (DRP) which established debt collection goals based on the amount and length of arrears as well as the procedures and schedules for achieving the goals. A Portfolio Control Committee, composed of the directors of BNF's departments, was established to supervise the DRP and to upgrade portfolio quality. BNF has achieved debt recovery targets set in connection with the Bank's first and second industrial loans BNF's agricultural lending is handled by its Agriculture Department through three separate programs, identified by source of funds and specific beneficiary targets. These are: (a) the Agricultural Promotion Program, basically a countrywide small-scale farmer credit program financed since the mid-1960s by five IDB loans already disbursed, as well as by BNF funds and rediscounts from CB; (b) the Agricultural Enterprises Program, which finances mainly mechanized medium- and large-scale farming enterprises and is funded with limited BNF resources plus occasional loans from foreign banks and suppliers' credits; and (c) the Regional Projects Program, which

16 handles mainly the small-scale farmer credit components of the rural and area development projects and is financed by loans from the Bank, IDB and the Federal Republic of Germany (KfW) Volume of agricultural credits granted annually by BNF has risen from about US$40 million in 1978 to about US$76 million in 1981, or at an average annual rate of about 25% in current prices and 16% in real terms (Annex 1 provides further information about BNF's operations). Over twothirds of these amounts were advanced under the two programs, which have small-scale farmers as target groups. Credit for these farmers would be further augmented by a countrywide credit program to be financed by a new loan being proposed by IDB and by rural development projects being prepared for external financing. Moreover, such farmers can be advanced credit on a satisfactory basis only if there is in place an adequate system of support services and facilities (extension and input supplies, and the like), as in areas served by rural development projects, which would ensure the productive use of such credit. The emerging credit requirements of small-scale farmers, within the limits set by these constraints, can be expected to be adequately met by the existing and proposed external lines of credit which are available to BNF and almost wholly designated for such beneficiaries Statistics show that BNF's short-term lending for agriculture has been growing at a faster rate (18%) than medium- and long-term lending (12%) in real terms between 1978 and This has been caused mainly by the scarcity of long-term funds for the Agricultural Enterprises Program, under which investment loans grew at an annual rate of only 6%, compared with 38% for short-term loans. BNF's existing lines of external credit are all focussed on small-scale farmers throughout the country (as with the IDB's existing and proposed Agricultural Promotion Program) or those covered by area development projects under which the necessary supporting services, extension, land titling, and such are being built up (as with credit lines for rural and area development projects supported by the Bank, IDB, IFAD and KfW (Table 1). Funds are, however, needed for meeting the credit requirements of the numerous medium-scale farmers who are also important from the point of view of agricultural production, but can be assisted only under the Agriculture Enterprises Program which depends almost entirely on limited BNF resources. It is this group which the proposed project would principally aim to help, along with certain small-scale farmers for whom other funds are not available. Project Execution 4.14 The Government of Paraguay would be the borrower and would assume the foreign-exchange and the interest rate variability risks of the Bank loan. The proceeds of the loan would be made available to BNF in local currency under arrangements to be covered by a subsidiary agreement between the Government and BNF. Execution of the subsidiary agreement between the Government and BNF, satisfactory to the Bank, would be a condition of loan effectiveness The lending program component of the project would be administered by BNF's AD, while BNF's coordinating committee for its TAP would administer the institution-building component, with support from an agricultural credit

17 consultant to be financed under the Caazapa Area Development Project (Loan 2087-PA). Under the Bank-financed Second Industrial Credit Project (Loan 1866-PA), BNF is to implement the second phase of its TAP (para 4.07) and is required to draw up a second debt recovery program (the first has already been implemented). At negotiations, assurances were obtained that both the second phase of the TAP for further improvement and strengthening of BNF, as well as the new debt recovery program, would be implemented, as reviewed and agreed to between BNF and the Bank, not later than the end of June each year BNF needs to augment its medium-term resources so as to be able to increase its investment loans under programs financed from its own financial resources, provide counterpart funds for externally financed credit projects, and cushion the impact on its liquidity of agricultural loan arrears caused by adverse crop conditions or declining commodity prices. Taking these requirements arising from the steadily expanding volume of BNF's agricultural credit operations into account, as well as the need to compensate BNF for losses on its earlier lending in pursuance of Government agricultural programs, Government has been contributing to BNF's equity over the last few years, partly in compliance with conditions of the Bank's industrial credit projects. As a result of such Government share capital contribution, amounting to US$54.5 million since 1977, and its own increasing profitability, BNF has improved its own funds position over the last few years and achieved a comfortable debt-equity ratio of 3.1:1, in 1982 as compared with the permitted maximum of 8:1 under the Second Industrial Credit Project. However, the financial projections of BNF envisage a substantial expansion in the level of its lending operations over the four-year period ( ) to be covered by the proposed project, as is illustrated by the proposed increase from US$68 million to US$130 million per annum of short-term lending and from US$27 million to US$54.5 million per annum of medium/long-term loans. In this situation, BNF's original projections for financing counterpart funds for the lending program (about US$25 million) were based on the assumption that the Government would continue contributing to BNF's equity at an annual rate (10% over previous year's capital and reserves) as during the past five years. However, during negotiations, the Paraguayan delegation indicated that, because of recent growing budget deficits and restrictive monetary policy, the Government could not assume the obligation to provide the counterpart funds on this basis. Therefore, certain actions were agreed to that would make it possible for the bulk of the counterpart funds to be generated by the project itself, as follows: (a) the farmers' contribution to the project cost under the on-farm development component was increased from an estimated average 10% to 20% (para 4.18) and, consequently, the lending program was reduced from US$60 million to US$55 million; thus, the proportion of Bank disbursement over the value of subloans increased from 62% to 70%; and (b) the Bank would front-load disbursements at the rate of 80% for the first US$20 million of subloans made by BNF and falling to 64% for the balance of US$35 million of subloans, a formula under which the average Bank disbursement would remain at 70% of the total value of subloans. Projections show that, under this arrangement, BNF would

18 have to contribute no more than US$4 million equivalent from its own resources and that funds generated by the project would be sufficient to sustain the project lending program over the five-year implementation period (Table 3). Nevertheless, given the sensitivity of projections, various uncertain factors, assurances were obtained during negotiations that, no later than September 30 of each year, the Borrower would exchange views with the Bank and BNF, on BNF's financial requirements for carrying out the project in the following fiscal year. Lending Terms and Conditions 4.17 Project subloans, as well as other similar loans made by the AD, would bear interest and other charges at an initial effective rate of no less than 18% per annum during the lifetime of the subloans. This rate is positive in real terms and covers the AD's financial and operating costs (inflation in 1982 was 5.1%). In line with the BNF policy statement requiring that it conduct operations in a manner which would ensure a reasonable return sufficient to maintain the real value of its capital, assurances were obtained at negotiations that interest rates on new subloans would be reviewed periodically. This review would be undertaken once a year by BNF in consultation with CB and the Bank, and, if necessary, BNF would modify the interest rate and commission charges on new project subloans and all other medium- and long-term loans made by AD with funds from other sources, so that (a) they would be sufficient to cover the operating costs of BNF's loan portfolio, and (b) BNF would maintain a positive real interest rate vis-a-vis the annual inflation rate, as measured by the variation of the Consumer Price Index for the previous calendar year. If these consultations fail to produce an agreement within the following 180 days, BNF would abstain from making any further commitment out of the proceeds of the loan until such agreement is reached. This approach concerning interest rates charged by BNF is consistent with that adopted in previous agricultural and industrial projects financed by the Bank in Paraguay. Assurances were obtained during negotiations that BNF would comply with the provisions described above in regard to the interest rates to be charged on its subloans Subloans made to project beneficiaries would follow standard norms and procedures currently applied by the AD. Investment subloans would be processed and approved on the basis of farm plans demonstrating the technical, financial (including cash flows) and economic feasibility of the proposed investment and short-term production subloans on the basis of projected cash flows. The subloans would finance up to 90% of the total cost of farm investment/production plans approved for beneficiaries with farms of up to 40 ha of cropping land, 80% irn cases of farms with more than 40 ha but no more than 80 ha; and 70% in cases of farms with more than 80 ha and up to 200 ha. Subloans for on-farm investments would have repayment terms of up to 10 years, including grace periods of up to three years; within these limits, the amortization schedule would be established for each subloan on the basis of the cash flow projections of the investment plan to be financed. Similarly, short-term subloans for the production of annual crops would have repayment terms in accordance with the crop cycle of the specific crop, plus a reasonable time for harvest and marketing. In general, these loans would be for a period of one year.

19 Assurances were obtained at negotiations that any subloan or subloans made to any individual beneficiary would not exceed, in the aggregate, US$150,000 equivalent. This covenant, as well as the other lending terms and conditions specified in the previous paragraphs, would also be incorporated into the subsidiary loan agreement to be entered into by the Government and BNF (para 4.14). Project Cost and Financing 4.20 Total project cost is estimated at US$72.0 million equivalent, with a foreign exchange component of US$40.0 million, or about 55% of total cost. The proposed Bank loan of US$40.0 million would finance the full foreign exchange component which is net of taxes and duties. BNF would provide US$18.0 million (25%). Project beneficiaries would contribute the remaining US$14.0 million (20%) The costs have been estimated and the financing proposed under the following assumptions and considerations: (a) the core of the project would be the lending program, amounting to US$56.0 million, to be financed with US$39.0 million (70%) from the proceeds of the Bank loan and US$17.0 million (30%) by BNF; (b) of the US$56.0 million, about US$40.0 million (70%) is expected to be used for long-term investment subloans and US$16.0 million (30%) for short-term subloans, which would be complementary to the investment subloans; (c) the estimated number of subloans and the estimated commitment period are subject to variation, depending on the investment climate during the period 1983 to 1986 (no price contingency is included, in view of the possibility of a follow-up line of credit after this is exhausted and additional funds are needed); (d) the contribution of beneficiaries is estimated at US$14.0 million (20% of the on-farm investment program) and represents an average of the minimum contributions required from farmers seeking subloans; (e) the BNF institution-building component, amounting to US$2.0 million, would be financed in equal parts by the Bank and BNF. It has been budgeted to finance vehicles and office equipment (described in Table 2) and includes price contingencies over a three-year period on foreign and local costs, based on the following inflation rates: 1983=8%, 1984=7.5% and 1985=7%; and (f) project costs, in general, were estimated on the basis of November 1982 prices escalated to May Procurement and Disbursement 4.22 Project beneficiaries (about 5,000), using the proceeds of subloans, would purchase (over a four-year period) on-farm development inputs

20 (US$39.0 million) from established local agents, who represent a broad spectrum of international and local suppliers. The use of international competitive bidding would not be practicable. However, local agents for tractors, farm machinery, fertilizer and chemicals represent Bank member countries and provide satisfactory services. Vehicles and office equipment for BNF (US$1.0 million) would be procured through locally advertised competitive bidding procedures, which are satisfactory. However, as far as possible, the requirements would be so grouped as to make the quantities sufficiently large to attract bids from foreign firms. Thore are nc fcr^zign exchange or other restrictions on the procurement of any of the items to be financed under the project The proceeds of the Bank loan are expected to be disbursed over a period of five years. This estimate takes into account the past experience with agricultural projects in the country, which indicates that, in general, credit projects have not suffered disbursement delays as a result of the type of constraints which have affected multicomponent rural development projects. The allocation of loan amounts and the percentage of expenditures to be reimbursed by the Bank are as follows: Amount Allocated Category (US$) % of Expenditures to be Financed (1) Project Subloans (a) First Phase 16,000,000 80% of amounts disbursed by BNF (b) Second Phase 22,900,249 64% of amounts disbursed by BNF (2) Vehicles and Office Equipment 1,000, % of foreign expenditures and for local expenditures, 70% for vehicles, and 50% for office equipment (3) Front-end Fee 99,751 amount due 40,000,000 Disbursements for subloans under the agricultural credit component would be made against certified statements of expenditures. The internal audit and control arrangements within the BNF are adequate for the adoption of this procedure. The loan is expected to be fully committed by December 31, 1987 and disbursed by June 30, Accounts and Auditing 4.24 Separate project accounts, records and documentation would be kept by BNF. Financial statements for BNF as a whole and those for the project would be audited annually by independent auditors, satisfactory to the Bank. The audit would include financial information supporting statements of expenditures used to claim reimbursements from the Bank. The auditor would