ASIAN DEVELOPMENT BANK PPA:SRI 24320

PROGRAM PERFORMANCE AUDIT REPORT

ON THE

SECOND AGRICULTURE PROGRAM (Loan 1127-SRI[SF])

IN

SRI LANKA

August 2002

CURRENCY EQUIVALENTS

Currency Unit – Sri Lanka Rupee/s (SLRe/SLRs)

At Appraisal At Program Completion At Operations Evaluation (October 1991) (October 1997) (March 2001) SLRe1.00 = $0.0241 $1.00 = SLRs41.28

SLRe1.00 = $0.0167 $1.00 = SLRs59.85

SLRe1.00 = $0.0117 $1.00 = SLRs85.27

ABBREVIATIONS

ADB – Asian Development Bank APL1 – First Agriculture Program Loan APL2 – Second Agriculture Program Loan CFC – Ceylon Fertilizer Corporation COFC – Ceylon Oil and Fats Corporation IMF – International Monetary Fund JEDB – Janatha Estates Development Board KMIL – Kiriya Milk Industries Ltd. LMFL – Lanka Milk Foods Limited MILCO – Milk Industries of Lanka Company Ltd. MOA – Ministry of Agriculture MOF – Ministry of Finance MPPI – Ministry of Policy Planning and Implementation OEM – Operations Evaluation Mission PCR – program completion report PPAR – program performance audit report PSEL – Pelwatte Sugar Enterprise Ltd. SDR – special drawing right SLSCL – Sri Lanka Sugar Company Ltd. SLSPC – Sri Lanka State Plantations Corporation SOE – state-owned enterprise TA – technical assistance USAID – United States Agency for International Development

NOTES

(i) In this Report, "$" refers to US dollars. (ii) The fiscal year of the Government and the Central Bank of Sri Lanka ends

on 31 December.

Operations Evaluation Department, PE-575

CONTENTS

Page

BASIC DATA ii EXECUTIVE SUMMARY iii

I. BACKGROUND 7

A. Rationale 7 B. Formulation 7 C. Objectives and Scope at Appraisal 8 D. Financing Arrangements 9 E. Aid Agency Coordination 9 F. Program Completion Report 10 G. Operations Evaluation 10

II. IMPLEMENTATION PERFORMANCE 11

A. Policy Reform Measures 11 B. Procurement and Disbursement 14 C. Organization and Management 15 D. Effectiveness of Technical Assistance 15 E. Compliance with Loan Covenants 16 F. Monitoring 16 G. Use of Counterpart Funds 16

III. PROGRAM RESULTS 10

A. Performance Indicators 10 B. Institutional Development 19 C. Socioeconomic Impact 19 D. Gender and Development 20 E. Environmental Impacts 20 F. Gestation and Sustainability 20

IV. KEY ISSUES FOR THE FUTURE 21

A. Revitalizing Agriculture 21 B. Self-Reliance versus Commercialization 21 C. Complexity of Agro-Divestiture 22 D. Sustainability of Policy Reform 15

V. CONCLUSIONS 24

A. Overall Assessment 24 B. Program Rating 25 C. Borrower and ADB Performance 25 D. Lessons Learned 25 E. Follow-up Actions 26

APPENDIXES 20

BASIC DATA Second Agriculture Program (Loan 1127-SRI[SF])

PROGRAM PREPARATION/INSTITUTION BUILDING TA No. TA Name Type Person-Months Amount Approval Date 2315-SRI Support to Public

Enterprises Reform in the Agriculture Sector

SSTA 4 $100,000 29 March 1995

KEY PROGRAM DATA ($ million)

As per ADB Loan Documents

Actual

ADB Loan Amount/Utilization (SDR equivalent) 60.00 (44.06) 30.14 (21.69) ADB Loan Amount/Cancellation (SDR equivalent) 32.27 (22.37) KEY DATES Expected Actual Fact-Finding 24 June-5 July 1991Appraisal 11-23 August 1991Loan Negotiations 21-23 October 1991Board Approval 26 November 1991Loan Agreement 20 December 1991Loan Effectiveness 19 March 1992 24 February 1992Loan Closing 30 June 1994 31 December 1996Months (effectiveness to completion) 27.4 58.3 BORROWER: Government of the Democratic Socialist Republic of Sri Lanka EXECUTING AGENCY Ministry of Finance1 MISSION DATA Type of Mission No. of Missions No. of Person-Days Fact-finding 1 36 Appraisal 1 65 Inception2 1 13 Project Administration Review3 7 73 Program Completion 1 30 Operations Evaluation4 1 24

ADB = Asian Development Bank, SDR = special drawing right, SSTA = small-scale technical assistance, TA = technical assistance. 1 Later renamed the Ministry of Finance and Planning. 2 In conjunction with the fact-finding for the Pigeonpea Adaptation and Production Studies (Phase II). 3 In conjunction with the review of TA 1735-SRI: Study on Policy Impact of First Agriculture Program; fact-finding

for the Tree Crop Plantations Project; and inception mission for Loan 1462-SRI(SF): North Central Province Rural Development Project.

4 The Operations Evaluation Mission comprised Chi-Nang Wong, Sr. Evaluation Specialist/Mission Leader and Steve Tabor, Staff Consultant.

EXECUTIVE SUMMARY

The Second Agriculture Program Loan (APL2) was follow-on assistance from the Asian Development Bank (ADB) to the first Agriculture Program Loan.1 The objectives of APL2, approved for $60 million on 26 November 1991, were to support the Government of Sri Lanka’s agriculture program to increase productivity, help the Government in introducing agricultural reforms, sustain policy reforms and institutional strengthening begun under the first Agriculture Program Loan, and assist the Government in meeting the continued need for imports of agricultural inputs. The overall implementation of policy reform measures under APL2 was partly effective. Despite three extensions to the loan closing, the Government’s failure to comply with some policy conditions, particularly the divestiture of several fertilizer and sugar companies and the removal of fertilizer subsidies, led to the cancellation of the second tranche. A few of the important policy conditions have remained unfulfilled to date because of a combination of waning political support, legal challenges, civil war, and labor disputes. The most significant results were the elimination of export and turnover taxes on the plantation crops, and the restructuring and preparation of the two large state plantation companies for privatization. The Ceylon Fertilizer Corporation was restructured into five companies, two of which were divested to the private sector. About half of its fertilizer retail stores and two of its regional fertilizer distribution stores were privatized. The Ceylon Oil and Fats Corporation and Lanka Milk Foods Limited were privatized. The Milk Industries of Lanka Co., Ltd., the largest state dairy company, was twice privatized and twice repossessed by the Government in the 1990s. The State Sugar Corporation was divided into three companies, one of which was privatized during the APL2 period. Two agricultural seed farms were also privatized. Noncompliance with loan covenants on major policy reforms relates to the failure to privatize enough state sugar factories, state fertilizer companies and fertilizer storage facilities, seed farms, and livestock farms. The Government’s failure to remove fertilizer subsidies or to reach an agreement with the International Monetary Fund on their removal was a critical setback. The lack of quarterly monitoring reports was another area of noncompliance with loan covenants. In recognition of the institutional constraints to privatization during APL2 implementation, ADB provided a small-scale technical assistance grant to help strengthen the institutional capabilities of the Public Enterprise Reform Commission. This technical assistance was highly effective and generated the design that was ultimately used in the privatization of 20 state plantation companies. The most significant impact of APL2 was the revitalization of the plantation crops subsector. The elimination of distortionary taxes and the privatization of government plantations have catalyzed a massive effort to rehabilitate the plantations and allowed tea production and exports to reach historical highs. Other notable accomplishments include a doubling of the private sector’s share in the domestic fertilizer trade. The benefits, however, appear to be confined to these subsectors only. Agriculture grew by just over 2 percent per annum in the 1990s, much the same rate as in the 1980s. Agricultural incomes have tended to stagnate while rural poverty remains high. Macroeconomic distress, adverse trends in global commodity

1 The first loan for $80 million, approved on 28 November 1989 and closed on 14 August 1991, was rated partly

successful.

markets, and incomplete implementation of market-oriented reforms have limited the spread and intensity of APL2 benefits.

The elimination of distortionary taxes on tree crops exports and the privatization of government plantation companies have proceeded beyond the point at which reforms are likely to be reversed, though this is not attributed to APL2 alone. By contrast, sustainability of reforms in the agriculture sector that are oriented toward the domestic market is a concern. Since 1994, the Government has reversed its policy on eliminating fertilizer subsidies. The sugar companies, the former Milk Industries of Lanka Co. Ltd., and some fertilizer companies have reverted back to the Government. Little progress has been made in divesting state seed farms or commercial livestock farms, putting in place a more liberal agro-technology trade regime, or commercializing livestock services. The extension service remains fragmented, supply driven, and administered by an unwieldy array of central and local government ministries and agencies. The 2001 Budget announced the Government’s desire to increase agricultural protection and to establish new state agricultural marketing companies. A key issue in Sri Lanka’s agriculture sector is that its performance is constrained by a wide range of policy, institutional, infrastructure, and structural impediments that are too large to be overcome by APL2 on its own. Another issue is that divestiture is a complex process, which takes longer to accomplish than allowed for under a quick-disbursing program loan. A third issue is that Sri Lanka’s agriculture sector remains divided by policy objectives that promote commercial, market-oriented development on the one hand, and self-reliance on the other. This, plus a tendency for the Government to intervene heavily in the food markets to ensure that food is available at a price that government administrators regard as reasonable, contributes to policy inconsistency and volatility. A fourth issue is the great difficulty of forging bipartisan political support for market-oriented agricultural policies, and hence sustaining policy reforms in a fluid political arena. APL2 is rated as partly successful considering its design, implementation performance, results and sustainability, and achievement of its objectives. While the elimination of distortionary taxes on plantation crop exports and the privatization of the government plantation companies led to the revitalization of the plantation crops subsector, policy reforms relating to domestic-oriented agriculture were not satisfactorily implemented. Failure to comply with some important policy conditions led to the cancellation of the second tranche. Sustainability of some APL2 reforms remains doubtful. A lesson learned is the need to address the broad policy, institutional, and infrastructure constraints to agricultural development in a holistic and integrated manner. A lack of consistent goals and objectives for the sector has led to inconsistency in agricultural policy reforms and contributed to implementation slippage. Another lesson learned is that realistic time-frames and procedural considerations should be incorporated into the program design, particularly if complex agro-enterprise divestitures are involved. A third lesson is that a focus on sound and transparent divestiture, rather than speedy divestiture, may generate more durable results. In terms of follow-up actions, the Government should continue to implement the divestiture agenda identified under APL2 and should review its agricultural policies with the aim of deepening the transition to a more market-oriented environment. ADB should support this process through policy dialogue and technical advisory support for a thorough review of agricultural policies and the divestiture process.

I. BACKGROUND

A. Rationale

1. Despite record commodity prices, agricultural production in Sri Lanka stagnated in the mid-1980s. This occurred notwithstanding the continuing efforts at liberalizing the economy that began in 1977. Faced with mounting budget deficits, a widening current account deficit, and sluggish agricultural growth, the Government requested, in 1989, the multilateral assistance community to help it produce a set of macroeconomic and sectoral reform programs. These programs were aimed at stabilizing the macroeconomic environment while increasing the economy’s capacity for efficient, export-oriented growth. The Asian Development Bank (ADB) responded by providing a loan to support the Agriculture Program (APL1), which was implemented from 1989 to 1991.1 The major objectives of APL1 were to (i) revitalize productivity and growth in the agriculture sector; (ii) achieve rice self-sufficiency; (iii) enhance export earnings from plantation crops and other export crops;2 and (iv) promote agro-industries. APL1 was considered successful upon completion since the objectives as set out at appraisal were substantially met. At postevaluation in 1996,3 APL1 was rated partly successful owing to the reversal of policies on the elimination of fertilizer subsidies and on decreasing the involvement of the Paddy Marketing Board in the paddy and rice trade. 2. To continue one of the policy measures under APL1 (i.e., the phased reduction of export duties and ad valorem sales tax on tea, rubber, and coconut, and phasing out of other agricultural export crop subsidies), support the Government’s agricultural investment programs, and assist in introducing further extensive policy reforms in the agriculture sector, the Second Agriculture Program Loan (APL2) was formulated. It was approved in November 1991, almost immediately following the completion of APL1. The rationale for APL2 was premised on the relative success of APL1 at the time of its completion and on the need to focus on another area of policy reform, namely, divestiture of government interests in commercial agriculture. The mode of lending was guided as much by the intent to have a follow-on program to encourage agriculture policy reforms as the desire to have a quick-disbursing mechanism for funds that the Government badly needed at a time of macroeconomic instability.

B. Formulation

3. APL2 was formulated in line with the Government’s macroeconomic and sectoral objectives, economic stabilization and adjustment programs, the agricultural programs as reflected in the 1990-1994 Public Investment Program, policy reforms implemented under APL1, the findings and recommendations of various technical assistance (TA) studies financed by ADB,4 and the policy dialogue conducted between the Government and ADB. APL2 was an integral part of the Government’s overall strategy to undertake economic adjustment programs

1 Loan 994-SRI (SF): Agriculture Program Loan, for $80 million, approved on 28 November 1989. 2 Plantation crops, in the context of Sri Lanka, refer to tea, coconut and rubber, which are major exports. Other

export crops include coffee, cocoa, cinnamon, etc., which are mainly grown by smallholders. 3 PPA: 994-SRI: Agriculture Program Loan December 1996. 4 TA 1166-SRI: Sugar Sector Rationalization Study, for $387,000, approved on 16 June 1989; TA 1213-SRI:

Agricultural Extension Rationalization, for $350,000, approved on 30 October 1989; TA 1478-SRI: Rationalization of the Fertilizer Marketing System, for $97,000, approved on 9 February 1991; and TA 1540-SRI: Livestock Sector Policy Review, for $350,000, approved on 18 July 1991.

to foster a greater role for the private sector in the market economy, enhance exports, and promote a more outward-looking and internationally competitive economy. The Government’s commitment to undertake such reforms was strongly expressed in its development policy letter to ADB at the time of loan approval, though the letter clearly stated that the first goal in agriculture was to optimize the production of basic foods to achieve a high degree of self-reliance in such foods. The implication of this policy was apparently not fully understood at appraisal or else it was glossed over even if understood, as the government regime at the time did apparently display a strong commitment to reforms, particularly in the aftermath of APL1. The change in government in 1994 could not have been predicted. A comprehensive participatory approach was not in evidence during the formulation of APL2. Farmers and workers in state-owned enterprises (SOEs) were apparently not consulted, leading to strong support for the Government’s later pledge to reverse the removal of fertilizer subsidies and to disputes between management and labor of SOEs after they were initially removed from government control. With hindsight, it would have been advisable to allow some time to lapse after the completion of APL1 before APL2 was introduced. It would appear that APL2 was formulated with undue haste and that the necessary preparation for government divestiture was not done.5

C. Objectives and Scope at Appraisal

4. The main objectives of APL2 were to (i) support the Government’s agriculture programs to increase productivity in agriculture, (ii) help the Government’s endeavor in introducing extensive reforms in the agriculture sector, (iii) sustain the policy reforms and institutional strengthening implemented under APL1, and (iv) assist the Government in meeting the continued need for imports of agricultural inputs required for agricultural investment. 5. The policy reforms covered seven broad categories: (i) phased reduction of export duties and ad valorem sales tax on tea, rubber, and coconut, and phasing out of other agricultural export crop subsidies; (ii) rationalization of sugar pricing and privatization of three state-owned sugar companies; (iii) rationalization of agriculture extension services; (iv) rationalization of the fertilizer marketing system and privatization of three state-owned fertilizer companies; (v) rationalization of the livestock subsector, including privatization of three state-owned livestock companies; (vi) restructuring of the Janatha Estates Development Board (JEDB) and the Sri Lanka State Plantations Corporation (SLSPC); and (vii) streamlining of the agricultural seeds subsector. In 1996, as part of the third extension of the APL2 closing date, the Government and ADB agreed that fertilizer subsidies would either be eliminated or a plan for their eventual elimination would be agreed with the International Monetary Fund (IMF) before the second tranche could be released. The inclusion of the removal of the fertilizer subsidy as a second tranche condition was subject to much internal debate in ADB as the condition was not originally part of APL2.

5 The original expected loan closing date of APL1 was 30 June 1992. The actual date was 14 August 1991,

apparently brought forward to accommodate APL2, which was approved on 26 November 1991 and made effective on 24 February 1992, nearly one month ahead of the planned effectiveness date of 19 March 1992. The program completion date for APL1 was expected to be 31 December 1991 but APL1 was deemed completed only in November 1992 when the last policy reforms under APL1, but carried over for implementation under APL2, were accomplished. These reforms included policy recommendations made on crop production incentives and extension services.

D. Financing Arrangements

6. ADB approved a loan amounting to SDR44.057 million (equivalent to $60 million) from the Special Funds resources to support APL2. The size of the loan was determined by the requirements for agricultural inputs to sustain sector development and the adjustment cost arising from implementation of APL2 reforms. The proceeds of the loan were to be used to finance the foreign exchange costs of eligible imports. The loan was to be released in two equal tranches: the first tranche after loan effectiveness, and the second on 30 November 1992, provided satisfactory progress was made by the Government with the policy reforms and eight specific conditions.6 APL2 made a small, but timely contribution to closing Sri Lanka’s external resource gap. From 1991 to 1995, Sri Lanka’s average external financing gap was just in excess of SDR1 billion ($1.35 billion) per annum. Gross official disbursements of external assistance averaged SDR481 million ($649 million) per annum, while net official transfers to Sri Lanka averaged SDR123 million ($165 million) per annum during the same period (see Appendix 1). Counterpart funds, on the other hand, were to be used to finance the local cost requirements of agricultural development projects. The Borrower was the Government, with the Central Bank of Sri Lanka as the depository of loan proceeds. The Ministry of Finance7 (MOF), the Executing Agency, in cooperation with the Ministry of Policy Planning and Implementation (MPPI), was to coordinate with other ministries, agencies, and sector-specific entities in implementing APL2.

E. Aid Agency Coordination

7. Coordination with other aid agencies during the processing of APL2 involved extensive consultations, particularly with the World Bank, IMF, and the United States Agency for International Development (USAID). Coordination was important as some of the agencies were also involved in activities similar to those fostered under APL2. The World Bank had substantial involvement in the restructuring program for the state plantation corporations, plantation crops taxation policy, agriculture extension, and land reform. USAID was involved in agriculture extension rationalization and the Government’s seed policy. The World Bank had in fact initially requested ADB not to include specific conditionalities on plantation crops export taxes for fear that its position and future dialogue with the Government would be greatly compromised if the Government were to agree with ADB on specific plantation crops taxation measures. The World Bank was then carrying out various studies on plantation crops taxation. Close consultation among ADB, the World Bank, and the Government helped resolved the matter, on the understanding that reductions in tea and rubber taxation up to 30 June 1992 would follow measures specified in APL2, while subsequent further reductions would be discussed and agreed with both the World Bank and the Government based on the World Bank’s study of the restructuring program for the state plantation corporations. USAID was critical of ADB’s study on agriculture extension rationalization that provided the basis for APL2’s policy measures on such rationalization. USAID claimed that the study was inadequate and poorly coordinated with the efforts of other aid agencies. Nevertheless, USAID supported APL2, after exchanging correspondence with ADB. While ADB had discussed and provided the consultant’s draft report for comments to interested parties including USAID prior to finalization, the fundamental problem was one of approach to the whole idea of agriculture extension. The World Bank provided a loan for agriculture extension designed to empower extension workers as agents of

6 Loan Agreement, Schedule 3, Attachment 2. 7 Later renamed the Ministry of Finance and Planning.

change rather than just technical advisors during the implementation of APL2. ADB and the Government tended to view the primary function of extension workers as providing technical expertise to farmers. As it turned out, the use of extension workers as agents of change did not prove workable. The World Bank cancelled its second agricultural extension loan before the completion of the project.

F. Program Completion Report

8. A program completion report (PCR), prepared by the Agriculture and Rural Development Division West, was circulated on 26 March 1998. The PCR presented the objectives and scope of APL2, and an objective and fair evaluation of its components as well as APL2 performance and its benefits. At the time of loan approval, it was envisaged that the proceeds of the loan would be disbursed by 31 December 1993. However, due to delays in compliance with the requirements for the release of the second tranche, the loan closing date of 30 June 1994 was extended three times. Eventually, the second tranche was cancelled and the loan was closed on 31 December 1996. The PCR could have placed greater emphasis on the fundamental conflict in government policy regarding export-oriented agriculture and domestic-oriented agriculture. The PCR has rated APL2’s performance as partly successful.

G. Operations Evaluation

9. This program performance audit report (PPAR) deals with the key aspects of APL2 and presents the findings of the Operations Evaluation Mission (OEM) that visited the country from 19 to 30 March 2001. The PPAR presents an assessment of the effectiveness of APL2 in achieving its objectives, generating benefits, and sustaining its impact. 10. The PPAR is based on a review of the PCR, the Report and Recommendation of the President, materials in ADB files, government reports, and discussions with ADB staff, MOF, other concerned agencies of the Borrower, and representatives of multilateral agencies and the private sector. Copies of the draft PPAR were provided to the Borrower, MOF and other agencies concerned, and ADB staff for review and comment. Comments received were considered in finalizing the PPAR.

II. IMPLEMENTATION PERFORMANCE

11. APL2 was most successful in reducing distortionary taxes on Sri Lanka’s main agro-exports and in launching the privatization of the plantations sector.8 Divestiture of sugar processing companies, fertilizer marketing companies, the national dairy company, state seed and livestock farms, the rationalization of the extension service, and the removal of fertilizer subsidies had mixed results. Major factors hindering completion of APL2 reforms included the change of government in 1994, civil conflict, labor disputes, limited institutional capacity to undertake privatization, long-gestating legal challenges to selected divestitures, the adverse initial impact of structural reforms on low-income farmers, and the Government’s concern for “reasonable” pricing to both consumers and producers. The last factor reflected the fundamental conflict between the need to offer protection to producers (and consumers) and the Government’s aspiration to have a commercially viable agriculture sector. The specific APL2 reforms and their status at the time of the PCR and OEM are detailed in Appendix 2.

A. Policy Reform Measures

Reduction of Export Duties and Ad Valorem Sales Tax on Tea, Rubber, and Coconut, and Phasing Out of Other Agricultural Export Crop Subsidies 12. Since 1980, the Government had been reducing the tax burden on the export crops sector. This process was accelerated under APL2 because of a steep fall in international commodity prices in 1990 and 1991 and evidence that Sri Lanka was rapidly losing market share to Kenya in tea production and to Thailand and Indonesia in rubber. To help bolster competitiveness, plantation crop export duties and ad valorem sales taxes were fully eliminated in December 1992. Likewise, plantation crop exports were exempted from the value-added tax and the security levy. Under APL2, plantation crops replanting and crop promotion subsidies were to be narrowed and phased-down. This was partly accomplished. The same concern to provide relief to smallholders, leading to dismantling of export taxes, also provided the reason for the slow withdrawal of the various subsidies. Promotion and replanting subsidies were concentrated on a smaller range of crops. The real value of these subsidies declined over the 1990s. A small export cess (or specific tax) to provide resources for services (i.e., research and market promotion) that are operated quasi-commercially remained and is closely supervised by industry. Rationalization of Sugar Pricing and Privatization of Three State-Owned Sugar Companies 13. Sri Lanka’s sugar industry operated under a high degree of trade protection in the 1980s. In the 1990s, as trade protection was gradually withdrawn, the industry became less able to compete. This, combined with labor disputes and nontransparent privatization, weakened the industry and led ultimately to a reversal of efforts to increase private participation in the sector. The Government was required to rationalize sugar pricing, commercialize and then privatize Sri Lanka Sugar Company Ltd. (SLSCL), and restructure the financing arrangements of the Pelwatte Sugar Enterprise Ltd. (PSEL).

8 Privatization of plantation companies under APL2 was primarily in the form of private management contracts

granted by the Government, which then made it possible for fuller divestiture of ownership under subsequent Loan 1402-SRI: Plantation Reform Project, for $60 million, approved on 9 November 1995.

14. Refinancing of the foreign loan of PSEL was satisfactorily completed in June 1992, and at the same time, the Government eliminated the Agreed Sugar Price agreement with PSEL. This was initially replaced by a uniform ex-factory sugar purchase price of $500 per ton, which was then superseded by import tariff protection for all factories in 1997, set initially at 18 percent. The import tariff was raised in 1998 to 25 percent and has now been replaced by a specific import duty set at SLRs3,500 ($41.00) per ton. SLSCL was commercialized by putting its assets in three separate companies—Sevenagala, Hingurana, and Kantale. Sevenagala was privatized in 1992, Hingurana in 1993, and Kantale in 1994. Subsequently all three factories were repossessed by the Government due to labor disputes and mounting factory losses. In 1998, the Government also assumed ownership of PSEL. At present, the Kantale and Hingurana factories are out of operation and are slated for liquidation. The Sevenagala and PSEL factories produce only 10 percent of the country’s requirements and were operated by the Government at a loss estimated at SLRs65million ($813,000) in 2000. Except for Kantale, all the factories were placed under new management this year. Rationalization of Agriculture Extension Services 15. Under APL2, the extension service was to become more unified and integrated through several planning committees and staff skills were to be upgraded. Unforeseen at appraisal, a combination of devolution, severe fiscal constraints, and the proliferation of central government ministries, agencies, and authorities with agricultural program responsibilities eroded extension effectiveness and hindered efforts to rationalize the service. Efforts made to rationalize and unify the extension service under the World Bank’s Second Agricultural Extension Project did not succeed. Separate extension services remain in effect for various commodity groups. With devolution, national extension coordinating mechanisms have been abolished and those introduced at the regional level have become largely defunct or ineffective. Continued involvement in subsidy administration and a shift in the extension orientation toward community empowerment activities diverted the focus of the extension service away from diffusion of improved agricultural technology. Funding shortfalls, weak links between agricultural research and extension, and limited private sector involvement have reduced the effectiveness of the extension effort. In 2001, management of minor export crops extension was contracted out to three private firms on a pilot basis under an ADB loan and TA grant, to instill a greater market-orientation into the delivery of advisory services.9 The effectiveness of such an approach is yet to be proven. Rationalization of the Fertilizer Marketing System and Privatization of Three State-Owned Fertilizer Companies 16. The Government was required to privatize three major fertilizer companies, including the Ceylon Fertilizer Corporation (CFC). Together with the abolition of fertilizer subsidies (supported under APL1), such privatization was intended to introduce competition and provide scope for private sector involvement in the fertilizer industry. With the change of government in 1994, political support for further divestiture of the fertilizer industry diminished and strong political commitments were made to re-introduce fertilizer subsidies. State fertilizer marketing and fertilizer subsidies were re-introduced as part of the nation’s safety net to help small farmers bear the adjustment costs arising from trade liberalization and other structural reforms.

9 Loan 1552-SRI(SF): Second Provincial Perennial Crops Development, for $40 million, approved on 25

September 1997 and TA No. 2877-SRI: Privatization of Extension Services for Perennial Crops, for $550,000, approved on 25 September 1997.

17. In 1992, CFC was converted into five limited liability companies, resulting in seven fertilizer companies to be privatized. Of the seven fertilizer companies, four were sold. The Colombo Commercial Fertilizer Limited was repossessed by the Government. The Janatha Fertilizer Enterprise Ltd. was not privatized due to labor disputes. These last two companies are on the list of public firms slated for liquidation. Some 16 of the 34 district fertilizer stores previously operated by CFC were sold. Those that were not sold include five stores in the north and northeast parts of the country, where the civil conflict would render their privatization impracticable. The National Fertilizer Secretariat continues to oversee fertilizer subsidies and is charged with administering the National Fertilizer Act. The removal of fertilizer subsidies in January 1990 led to a near-doubling in fertilizer prices and a modest reduction in fertilizer utilization. In 1994, the Government restored fertilizer subsidies at a cost to the budget of SLRs630 million ($12.8 million) in 1994 and SLRs1,234 million ($24 million) in 1995. Fertilizer subsidies were capped at SLRs1.5 billion ($18.75 million) per annum until 2000, resulting in lower fertilizer subsidies in real terms over time. For 2001, fertilizer subsidies have been budgeted at SLRs2.2 billion ($25.8 million). Starting in 1997, price subsidies have been confined to urea to maintain uniform national urea prices. Rationalization of the Livestock Subsector Including Privatization of Three State-Owned Livestock Companies 18. Under APL2, the Government aimed to privatize its holdings in Ceylon Oil and Fats Corporation (COFC), Lanka Milk Foods Limited (LMFL), and Milk Industries of Lanka Company Ltd. (MILCO); establish an appropriate milk-pricing policy; and create more scope for private sector livestock support services. All of the equity in LMFL was divested in 1991 and 60 percent of the equity in COFC was sold in 1992. MILCO, the largest state dairy company, was in fact privatized twice during the early 1990s, but both efforts ended in failure. A lack of institutional experience in preparing the company for privatization, selecting suitable investors, and structuring an appropriate privatization arrangement contributed to the failure. Legal and labor disputes have ultimately sidelined this process. The lack of proven approaches and limited political support for privatizing livestock support services have contributed to a lack of progress in increasing private sector participation in these areas. The assets of MILCO were transferred to Kiriya Milk Industries Ltd. (KMIL), which was acquired by a joint venture of the national Government and the National Dairy Development Board of India. KMIL was repossessed by the Government in 2000 following labor disputes. There are no plans currently to privatize it. 19. No statutory milk pricing formula was put into effect, although KMIL did establish a system of quality-based milk prices. Tariff reforms have created greater scope for private sector involvement in the livestock sector, particularly in feed and poultry production. Tariff protection for powdered milk products has been progressively reduced. The Government has moved cautiously to reduce its role in providing livestock support services. Restructuring of the Janatha Estates Development Board (JEDB) and the Sri Lanka State Plantations Corporation (SLSPC) 20. In the early 1990s, the state plantation companies were operating at huge losses. The state banks were no longer willing to roll over their loans and the budget could no longer accommodate the losses. The plantation unions were well aware that the plantation workforce could face massive layoffs if the state plantation companies were forced into bankruptcy. The Government, banks, unions, and the private sector recognized their common interest in accelerating the divestiture of the state plantation companies. The Government restructured the two large plantations sector state companies, JEDB and SLSPC, injecting SLRs780 million ($15.70 million) into these two SOEs between 1992 and 1996 to cover past losses and prepare them for privatization. Some 450 out of 500 plantations were handed over to 23 regional private

companies, initially under five-year management contracts. In 1995, together with an ADB loan and a TA grant, the Government privatized the regional companies by selling their equity and extending lease terms to 50-year leases with renewal options.10 Twenty of the 23 companies have been privatized. Some residual marketing and warehousing facilities remain with JEDB and SLSPC. Plans are being discussed for the eventual liquidation of these assets and for the eventual use of nonviable plantations, but the Government has yet to announce specific plans. Streamlining of the Agricultural Seeds Subsector 21. During the APL2 period, the Government published an expanded list of approved seed varieties for import; three seed farms were divested in 1993 and a committee was established to review the seed import permit system. In March 1997, a new Seed and Planting Material Policy Statement was issued. Import restrictions for planting material were eased as part of the tariff reforms of 1998 and 1999. The assets of the Hingurakgoda Paddy Seed Farm were sold in 1998. The introduction and domestic multiplication of hybrid maize seeds by the private sector, using an out-cropper arrangement, was made possible by the easing of seed import requirements. A new Seed Law was submitted to Parliament in 2000, clarifying the role of the Government in seed production, inspection, and quality control. 22. Despite the progress made, complex quarantine regulations and an elaborate seed inspection procedure continue to inhibit private sector involvement in the domestic seed industry. The Government continues to dominate the production and sale of improved paddy and other food crop seeds, which are sold with a subsidy, though the government prices for seeds have been increasing. A committee of representatives from the private and public sectors has been established to revise the seed and planting material prices of the Department of Agriculture, which has plans to phase out its commercial seed production activities. However, limited progress has been seen in opening-up the seed sector to private sector participation because of the distribution of subsidized, publicly provided seeds to smallholders and because of the Government’s fear that greater private sector involvement could degrade the integrity of Sri Lanka’s seed and planting material supply.

B. Procurement and Disbursement

23. The loan of $60 million was scheduled to be disbursed in two equal tranches of $30 million equivalent, the first tranche to be made available following loan effectiveness and a second tranche after a number of policy reform conditions were satisfied. The conditions for the first tranche were met quickly and the loan was declared effective on 24 February 1992. The conditions of the second tranche were not fully satisfied despite three extensions to the closing date. The actual cost of APL2 was therefore $30.14 million (SDR21.684 million). 24. Procurement contracts were made in accordance with government procedures acceptable to ADB. A positive list was used for financing eligible imports from the foreign exchange proceeds of the loan. The loan proceeds were used for the procurement of items for agriculture or agriculture-related industries from ADB member countries. Some 97 percent of the loan proceeds were used for the import of fertilizers, of which $23.56 million were imports registered by two public sector firms. Other imports were disinfectants, insecticides and fungicides (2 percent of the loan proceeds), plywood tea chests (0.76 percent), and jute bags

10 Loan 1402-SRI(SF): Plantation Reform, for $60 million, approved on 9 November 1995; and TA2315-SRI: Support

to Public Enterprise Reform in the Agriculture Sector, for $100,000, approved on 29 March 1995.

(0.1 percent). Four years were required to secure a clean audit of the utilization of the first tranche proceeds and that only after much follow-up action from ADB.

C. Organization and Management

25. MOF as the Executing Agency, in cooperation with MPPI, was responsible for implementation of APL2 together with the ministries, agencies, and parastatal bodies concerned. While MOF did have some capable staff, these few staff were swamped by the extent of policy measures and covenants they had to coordinate and monitor, in addition to their regular work. Lack of timely response from ministries or agencies concerned contributed to the problem of coordination. MOF failed to provide quarterly monitoring and progress reports to ADB, notwithstanding constant reminders. An effective monitoring and evaluation system as required under APL2 would have facilitated the production of such reports and contributed to effective policy dialogue during APL2 implementation. 26. Lack of clear and consistent sector policies, limited capacity to design and manage complex public enterprise divestitures, limited stakeholder consultation, and lack of public awareness of APL2 reforms all hampered program implementation. Legal challenges and labor disputes inhibited completion of several planned divestitures. The Government did not provide sustained support in rationalizing the extension service, fostering private sector participation in the seeds sector, providing livestock support services, and completing the privatization of the fertilizer industry. The devolution process complicated efforts to streamline and rationalize agricultural support services. That, together with a fragmentation of responsibilities for agriculture and natural resource management among several ministries, complicated the pursuit of policy dialogue.

D. Effectiveness of Technical Assistance

27. ADB provided the TA (footnote 10) when it was apparent that attempts at divestiture were not progressing well. The TA funded 90 days of international advisory services and several months of domestic expert services on plantation privatization. While the TA was originally intended to help resolve constraints to privatizing agro-enterprises identified for divestiture under APL2, it focused instead on accelerating the privatization of the regional plantation companies. The TA helped to develop a long-term privatization strategy, formulate divestiture procedures, and devise the legal framework for eventual plantation privatization. The resulting strategy was a success, in terms of stemming operating losses, transforming long-term ownership rights to the private sector, and securing political, labor union, and public support for this immense privatization effort. Without the TA, there would have been a significant risk that progress could have been reversed in the contracting-out of the management of the JEDB and SLSPC estates.

E. Compliance with Loan Covenants 28. The major loan covenants were partly complied with (Appendix 3). MOF did not provide quarterly progress reports and made no final impact assessment. With respect to the policy reform conditions, a lack of satisfactory progress in privatizing state-owned sugar, fertilizer, and dairy companies, and divesting an adequate number of seed farms, and the failure to abolish fertilizer subsidies were the main reasons for the three delays in the closing date and were the eventual cause for the cancellation of the second tranche.

F. Monitoring

29. No monitoring and evaluation system was in place at the beginning of APL2. MOF and MPPI were charged with monitoring and evaluating progress made under APL2, but the Government failed to provide resources to undertake formal monitoring or to execute an impact assessment. Program management was led by the Director, Agriculture from the National Planning Division, MOF. On ADB’s part, monitoring was conducted through a series of field visits, of which 11 were fielded from fact-finding in July 1991 to program completion in October 1997. The Government’s program completion report was provided in February 1998 but in rather inadequate fashion comprising of only a matrix of policy conditions and their status of compliance with no analysis or detailed clarification of the circumstances of compliance, lessons learned, etc. Under the terms of the loan, the Government was required to provide an impact assessment to ADB, but did not. Instead, it submitted a request to ADB for consultant assistance to undertake an impact evaluation study. In light of the limited number of agreed policy reforms that had been fully completed and sustained and the failure to have a monitoring and evaluation system that could provide the benchmark data for comparative purposes, an impact assessment would have been of limited value. ADB’s PCR suggested that this request for a TA to undertake the impact evaluation study should be taken up during the preparation of the PPAR. The OEM believes that adequate expertise is available in the current Ministry of Plan Implementation and Parliamentary Affairs, which has been the recipient of past TAs from ADB on evaluation-related work11 and that there is no need for ADB to fund a TA.

G. Use of Counterpart Funds

30. The counterpart funds generated from the loan proceeds were used, as agreed, to meet the local currency cost requirements of ADB-financed agricultural development projects and other such projects. An amount of $11.4 million was released during 1992-1993 to finance the local currency cost of ADB projects, with the balance utilized to fund other agricultural development projects.

11 TA 1579-SRI: Strengthening Post-Evaluation Capability of the Ministry of Policy Planning and Implementation, for

$100,000, approved on 17 October 1991 and TA 2810-SRI: Strengthening Project Performance Evaluation Capability of the Ministry of Plan and Implementation, Ethnic Affairs and National Integration, for $350,000, approved on 16 June 1997.

III. PROGRAM RESULTS

A. Performance Indicators

31. APL2 was designed to help the Government raise agricultural productivity and growth and support the implementation of its market-oriented agricultural policy reforms. Launched during a period of balance-of-payments stress, APL2 aimed to assist agricultural imports and augment budget resources for agricultural development projects. It was expected that a series of measures aimed at rolling back the role of the State in commercial activities, reducing the tax burden on export-oriented agriculture, and liberalizing access for private sector investment would trigger a revitalization of agricultural growth and development. However, no mechanism, such as a logical framework, was prepared at appraisal that would identify the relationship between the proposed policy reforms and the social and economic objectives, nor were the key performance indicators identified. The degree to which policy change was accomplished, rather than the impact of that change on investment or sector performance, became the default indicator of APL2 performance. 32. The abolition of export and turnover taxes for the plantation crops marked the culmination of a 15-year process aimed at reducing the tax burden on Sri Lanka’s main commodity exports. Returns to tea, rubber, and coconut producers have been 10 percent higher each year since 1992 than they would otherwise have been had 1990s export taxes been maintained. Revenues lost through distortionary plantation crops export taxes have been offset by the adoption of a value-added tax. Tea production increased by 33 percent during the 1990s to reach a record 300,000 tons in 2000, though this could not be attributed to APL2 alone as other factors, including tighter management control of privatized plantations, were in play. In value terms, tea exports peaked at $780 million in 1998, compared to $500 million in 1990. Despite weak global market prices, rubber and coconut output has remained stable. 33. The transfer of the public plantations to private companies has led to a revival in the plantation crops subsector. Prior to privatization, the plantations were losing close to SLRs500 million ($10 million) per month. With privatization, government fiscal support to the subsector has been reduced to very low levels, productivity and product quality have increased, the profitability of plantation companies has increased, new investments have been made to upgrade field stands and modernize the factories, and wages have been increased for plantation workforces. 34. After a decade of attempted sugar industry divestiture, the Government now owns a greater share of domestic production capacity than it did at the start of the process. Privatization and tariff reforms in the sugar industry have, perhaps inadvertently, revealed more clearly the degree to which Sri Lanka does not have a comparative advantage in producing sugar, especially at quite modest rates of trade protection. Only two of the sugar factories are now in operation, and are kept this way for social reasons. Sugar recovery rates at the PSEL and Sevenagala sugar factories are about 8.5 percent, nearly a third lower than those obtained in India. With a decline in trade protection and factory closures, resources have been reallocated to more productive uses. In the areas in which the factories have closed, farmers have reallocated their lands to paddy and other irrigated crops. Domestic sugar production meets just 10 percent of total supply requirements, compared to 19 percent at the start of the decade.

35. In terms of fertilizer marketing, APL2 reforms have increased the scope for private sector initiatives. Four of the largest fertilizer manufacturers and importers are now under private sector management. Fertilizer use has steadily increased from 453,000 tons in 1991 to 612,000 tons in 1999. Urea use has increased from 191,000 tons in 1993 (prior to subsidies being reinstated) to 280,000 tons in 1999 (postsubsidy). The private sector's share of total fertilizer market sales increased from 18 percent in 1990 to 65 percent in 2000. Quality control remains, however, a concern, with nearly a quarter of all fertilizer sold estimated to be adulterated. Both bulk and bag facilities for fertilizer imports are available, albeit without a special terminal for the latter as was intended during APL2 formulation. 36. The resumption of fertilizer subsidies in 1994 was aimed at fulfilling an election promise and boosting paddy output. The subsidy is now confined to urea and its cost exceeds $25 million per annum. Before the fertilizer subsidy was restored, fertilizer consumption in paddy fell from 208,000 tons in 1992 to 148,000 tons in 1993. With the subsidy restored, fertilizer consumption in paddy doubled between 1993 and 1999, in what appeared to be a retreat into subsistence-oriented rice production in the mid- 1990s. Further, the subsidy appears to be contributing to nutrient imbalance problems, with farmers overusing urea relative to other fertilizers. 37. As a result of dairy sector reforms, the private sector has become more involved in producing milk and diary products, but largely by importing and reconstituting powdered milk rather than through promoting domestic dairy activity. Domestic dairy production meets 22 percent of total consumption requirements, with the bulk supplied by imports of powdered milk. Price controls have been replaced by tariffs, and protection rates steadily declined during the 1990s. The privatization of COFC has tended to increase its market dominance in the domestic feed industry. 38. The extension service has witnessed a number of reorganizations but there is no evidence of any improvement in the relevance, impact, or effectiveness of the outreach effort. The extension effort continues to be fragmented, serves under a confusing array of central and local administrative authorities, is hardly integrated to research, exhibits few signs of client responsiveness, has limited private sector involvement, and makes but minimal use of modern communications technology. Erosion in the quality of the public agriculture extension effort has stimulated efforts to search for new approaches to delivering agricultural information. 39. As for performance in the seeds subsector, the Government continues to dominate the market for improved paddy and food crop seeds, with publicly produced seeds sold at a nominal price to the farm community. Subsidized seed sales tend to discourage private participation in the industry. While trade restrictions on seeds and planting varieties have been eased, access to a wide range of planting material continues to be restricted under the Quarantine Act. Importation of planting materials is subject to complex permit and inspection procedures that raise costs and discourage private initiative. The proposed national Seed Law, however, is a major step forward in clarifying the regulatory role of government in establishing and certifying the quality of improved seeds.

B. Institutional Development

40. Outside of the reforms supported for agriculture extension, APL2 did not specifically provide for institutional capacity building in the public sector. It was, however, recognized by ADB and the Government early on during the implementation of APL2 that institutional capacity constraints limited both the pace and quality of the divestiture effort. ADB responded by providing a TA to strengthen the Public Enterprises Reform Commission established in 1995 (footnote 10). That body has developed the capacity to lead a more professional and transparent divestiture effort. Through reforms undertaken under APL2, the private sector has developed the institutional capacity to manage the large state plantations, play a greater role in fertilizer marketing, manufacture dairy products under more competitive conditions, and start domestic seed production activity. In several agriculture subsectors, the Government has developed the capacity to assume more of a policy oversight and regulatory role, with the private sector taking the lead in providing commercial services.

C. Socioeconomic Impact

41. There is no evidence that APL2 has triggered a revitalization of the agriculture sector. The sector grew by some 2.3 percent per annum in the 1990s, almost exactly the same rate of growth achieved in the 1980s. In per capita terms, agricultural incomes rose by some 10 percent over the decade, while economy-wide incomes increased by 65 percent. APL2 did not specifically target poverty reduction. Between 1990 and 1996, poverty levels (measured using the higher poverty line) increased from 33 percent to 39 percent of the total population, of whom some 88 percent lived in rural areas. While 1996 was a drought year, it would be difficult to conclude that APL2 reforms made a positive contribution to rural poverty reduction. Indeed, some of the APL2 reforms may initially have contributed to higher rates of rural poverty. The handover of the government plantations to the private sector was accompanied by a decline in the quality of social services, particularly in reduced access to health facilities, and availability of drugs previously provided by the plantations. The closure of two sugarcane companies contributed to some hardship for an estimated 14,000 cultivators formerly supplying those mills. However, the elimination of plantation crop export taxes raised the gross returns of smallholder tea, coconut, and rubber cultivators by nearly 10 percent per annum, and in so doing, made a positive contribution to rural poverty reduction. 42. The main fiscal impact of APL2 was the loss in revenues, equivalent to some SLRs2.5 billion ($62.4 million) in 1990, when export and turnover taxes on tea, rubber, and coconut were eliminated. Under that tax regime, plantation losses were approaching SLRs4 billion ($99.8 million) per annum, financed through the banking system. The Government reversed the losses in the plantations sector and mobilized nearly SLRs8.8 billion ($154.7 million) between 1993 and 1999 from the divestiture of firms under APL2, of which SLRs7.5 billion ($131.8 million) was realized from the sale of state plantations. Fiscal pressures on agriculture would likely have been more severe had APL2 not provided the resources that it did. The first tranche released in 1992 financed 2.1 percent of the nation's external resources gap and reduced the Government's domestic borrowing requirements by 7 percent.

D. Gender and Development

43. APL2 did not have a component dealing directly with gender issues. Nevertheless, women are the main employees in the tea industry, which has responded positively to an environment of improved incentives. High returns to tea have contributed to wage hikes in a sector traditionally dominated by female labor.

E. Environmental Impacts

44. Some improvement in land use has been induced thanks to a lower plantation crop tax burden and by reversing the neglect of state plantation lands under the public enterprises. Private sector managers tend to keep marginal plantation lands out of production, which contributes to reduced soil erosion.

F. Gestation and Sustainability

45. APL2 reforms have contributed to the process of curtailing the role of the State in agriculture and creating greater scope for private sector initiatives. Some of the most important APL2 reforms, such as lowered plantation crops export taxes and divestiture of the state plantations, are bound to realize substantial benefits only with a considerable lag. Under private management, product quality and productivity can be substantially boosted and much more value can be added by exporting more processed plantation crops products. 46. Several of the APL2 reforms have been reversed, particularly those in regard to the divestiture of the Government’s interest in SOEs. In some cases, the appropriate solution for uneconomic ventures is liquidation rather than sale. For others, a lack of government commitment to handing-over responsibilities to the private sector is apparent. Fundamentally, the domestic agriculture subsector faces a constraint arising from the Government’s priority for self-reliance and policy of ensuring “reasonable” prices for producers and consumers. Such a constraint translates into a potentially greater incidence of substituting administrative judgment for market forces in smallholder agriculture. On the other hand, the tax burden on the plantation crops subsector, and in fact on all export-oriented agricultural activities, has been significantly reduced. The plantation crops subsector has been virtually transferred into private ownership and the link between the budget and the plantations has been severed. Recent public statements by the Minister of Plantation Industries and the Chairman of JEDB and SLSPC regarding possible repossession of the regional private companies, however, make the private sector nervous. The private sector has come to dominate fertilizer marketing and the sale of liquid milk. Lower tariff protection has encouraged a shift of resources out of sugarcane production, a sector in which Sri Lanka appears not to be globally competitive.

IV. KEY ISSUES FOR THE FUTURE

A. Revitalizing Agriculture

47. The divestiture strategy has paid off in export agriculture. The plantations have a new lease-of-life and nontraditional agro-export sectors, such as high-value horticulture, are showing signs of steady growth. But three fourths of Sri Lanka's agriculture is domestic-market oriented and sluggish progress in domestic agriculture is the main reason that agriculture grew by just 2.3 percent per annum during the 1990s compared to 5.6 percent for the economy as a whole.

48. Administrative judgment continues to act in the place of market forces in smallholder agriculture. State ownership of some 80 percent of the land, restrictions on technology imports and land use, heavy subsidies for imported wheat, pervasive fertilizer and credit subsidies, together with high rates of effective tariff protection and frequent changes in agricultural trade policies, all stifle innovation, discourage diversification, and promote inefficient resource use. A comprehensive analysis of the policy and institutional barriers to improved agricultural performance is needed to identify the full range of constraints and the inconsistencies likely to impede the ambitious objective of revitalizing agriculture before any program of policy reforms can be realistically designed. For example, more attention should have been accorded in the design of reforms to safety nets for small farmers and workers, and to temporary measures aimed at ensuring that the provision of essential marketing, agro-input, and technology services remained in place for small farmers while greater scope for private sector initiative was created.

B. Self-Reliance versus Commercialization

49. Reversal of a number of the APL2 reforms, including those related to fertilizer subsidy, and the persistence of subsidized rural credit can be traced to the Government’s desire to increase domestic self-reliance in food production. For more than three decades, the Government has followed a food self-reliance policy centered on ensuring that about 90 percent of local rice consumption requirements were met from domestic production. Self-reliance targets have been set for sugar, dairy, and a number of minor food crops. Public investment and support services have been focused on achieving self-reliance goals. The 2001 budget speech called for Sri Lanka to enhance self-reliance in domestic food production and invoked trade protection, agro-input subsidies, state marketing of agricultural commodities, and increased state seed production as strategies for achieving this goal. Despite input subsidies and tariff protection, the profitability of paddy production has been on a declining trend for more than a decade. Paddy farming is characterized by low asset endowments and low returns on assets. A case may be made that the paddy monoculture bias to ensure food security works against the Government’s efforts to reduce poverty in rural areas. Implementation of the food self-reliance policy so far has been inconsistent with the reforms advanced under the APL2, a design weakness of APL2 that may have been perceived as such at APL2 formulation. ADB was encouraged by the performance of APL1. It might have assumed that the long-standing policy of self-reliance was more rhetoric than substance. Nevertheless, agricultural growth and rural income generation may be better served by encouraging farmers to shift their limited land resources out of low-value food crops. As long as government policy in agriculture is driven by such contradictory objectives—i.e., self-reliance and competitive commercial development—

mixed signals are sent to the private sector and reform progress will be difficult and possibly fleeting.

C. Complexity of Agro-Divestiture

50. The durability of the divestiture effort hinges very much on the quality of the divestiture approach. Privatizing commercial agro-industries was considerably more complex than envisaged at appraisal. Inadequate enabling regulation; lack of company accounts and transparency in privatization procedures in the early 1990s; investor recourse to the courts to delay divestiture; costly financial restructuring; limited scope for public consultation, confidence-building, and securing political support; and noncompetitive market conditions all contributed to delays in the divestiture process. In retrospect, a two- to three-year program period was far too short for mounting a complicated and controversial agro-privatization effort, but that was typically the time period for a quick-disbursing program loan. A single well-designed privatization conducted by the Public Enterprise Reform Commission normally requires two to three years from start to finish. Adequate consideration should have been accorded by ADB and the Government at the start of APL2 to the Government’s capacity to manage divestitures, with TA resources immediately provided to prepare the necessary procedural and legal framework and to ensure that sound and transparent privatization practices were adopted. An accompanying investment project (as was subsequently provided through ADB’s Plantation Reform Project) would have facilitated the divestiture process. Given the risk that privatization sales can be challenged in the courts, and hence effectively placed outside of government control, it would have been more appropriate to design divestiture conditionality in terms of a share of the total net asset value privatized from a set of firms (or other state assets) rather than a set of specifically-identified companies. Further, privatizing uneconomic ventures is not an appropriate strategy, for it only delays the inevitable day of reckoning. Sri Lanka's sugarcane operations were known to be uneconomic at appraisal, yet privatization rather than closure was the chosen reform strategy. Likewise, KMIL was repossessed in 2000, to avoid closure. Such SOEs are now slated for liquidation; their asset base deteriorated in the 1990s. The Government should be encouraged to facilitate the closure of uneconomic industries, rather than impeding this process by re-nationalizing privatized firms.

D. Sustainability of Policy Reform

51. A fiscal crisis provides a timely opportunity to introduce policy reforms, but they take many years to fully implement. Outside of the plantation crops subsector, agricultural policy reform momentum has slowed with the closing of APL2. Changing and inconsistent government policies, a proliferation in the number of central government ministries with responsibilities for agriculture, and the legal devolution of agricultural development responsibilities to provincial governments diffused sectoral responsibilities and made it increasingly difficult to obtain a consistent and coherent vision for agricultural reform. APL2 did not include sufficient TA resources to assess agricultural progress, foster continued re-assessment and revision of agricultural reform strategies, or guide sustained policy and institutional reform. As a result, the policy dialogue during APL2 focused on meeting conditionalities, rather than on defining and advancing a more robust agricultural reform agenda. Continued policy and institutional reforms will be needed to revitalize agriculture, but there is neither the analytical base nor political consensus in place to support more sustained reform. Agriculture suffers from being driven by an internally inconsistent combination of self-reliance and commercialization policies. Government leaders are aware of these internal contradictions, but achieving consistency is

difficult due to the fragmentation of responsibilities for agriculture within government. A commitment by ADB (and other agencies) to a new generation of sector strategy, public consultation, and greater awareness efforts is needed to define and build support for continued policy and institutional reforms in agriculture.

V. CONCLUSIONS

A. Overall Assessment

52. Program appropriateness and relevance. A major thrust of APL2 was to phase out government intervention in the agriculture sector. Rolling back the commercial role of the Government and creating greater scope for private sector initiatives in agriculture were appropriate reform thrusts, given fiscal pressures and the need to mobilize private investment to trigger higher agricultural growth. The general thrust of APL2 was relevant at the time of its design, though some design elements such as the divestiture measures in the sugar industry were inappropriate. The prerequisites for successful privatization in a number of the subsectors were lacking. Divesting the commercial role of the State, and creating greater scope for market forces and private sector investment in agriculture were necessary, but insufficient, to revitalize agriculture. Many other structural constraints impede agricultural growth and development in Sri Lanka. There is a potential conflict of any reform measure with the longstanding policy of self-reliance that was underestimated during APL2 formulation. A failure to address these constraints in an integrated manner, and to provide a supportive macro-economic environment, partly explains the sluggish response of the sector to a more private-sector-oriented policy regime. 53. Program impact and efficacy. APL2 exceeded its targets set for export trade liberalization and divestment of the public sector in the case of the plantation crops and state-plantation subsectors. It was less effective in achieving the targets set for divestment of the public sector in domestic agriculture (as opposed to export-oriented agriculture) and in the privatization of the fertilizer and domestic dairy industry. APL2 targets were not met in the case of reforms in agriculture extension, the seeds subsector, fertilizer subsidies, and the sugar industry. Notwithstanding progress achieved in opening all of these subsectors to some private sector participation, APL2’s efficacy was moderate. 54. Program sustainability. The sustainability of APL2 reforms on the whole is doubtful. Plantation privatization has proceeded beyond the point at which reforms can readily be reversed as the subsector has to remain competitive in the export market. Despite a difficult fiscal situation, the Government has not re-imposed export or turnover taxes on plantation crops. By contrast, the Government has neither sustained the divestment of the sugarcane factories, MILCO, and various fertilizer factories, nor continued to privatize livestock farms and some seed farms slated for divestment. The urea subsidy conflicts with a market-oriented pricing environment in the fertilizer industry. Reforms in the dairy and sugar subsectors have resulted in a considerable increase in the nation's reliance on imported sugar and dried milk powder. While this may be a more efficient outcome, it hardly suggests that reforms have been sufficient to inspire or sustain domestic productivity growth. The 2001 budget speech reinforced the Government’s emphasis on food self-reliance and signaled the establishment of a National Agricultural Produce Marketing Authority to help organize farm trade. There is a risk that a growing role will be accorded to state enterprises in fostering smallholder agricultural development.

B. Program Rating

55. The Program is rated partly successful considering its design, its implementation performance, results and sustainability, and achievement of its objectives.12 Considerable progress was made in reducing the tax burden and boosting private sector participation in the plantation subsector. This led to the revitalization of plantation crops. Similarly, some progress was made in encouraging private sector participation in fertilizer marketing. Relative to their sectoral impact, these were the most important reforms to be addressed. However, less progress was made in divesting the public sector role in the fertilizer, dairy, and sugar industries. The reversals in the divestment of the companies in these industries underscore the problem of sustainability. Failure to comply with some policy conditions, particularly the divestiture of a number of fertilizer and sugar companies, and the removal of fertilizer subsidies, led to the cancellation of the second tranche. No apparent progress was made in enhancing the quality of the extension service and private sector involvement in seed production. Privatization of livestock services has yet to begin in earnest. Sustainability of the limited reforms achieved in domestic agriculture remains uncertain given the divided policy objectives in agriculture that promote commercial, market-oriented development on the one hand, and self-reliance in food crops on the other. The commitment to APL2 reforms appeared to diminish with the change of government in 1994.

C. Borrower and ADB Performance

56. Even though it failed to provide regular reports to ADB, performance by MOF was satisfactory under the prevailing circumstances, especially in the aftermath of a change in government when it had to oversee a highly complex reform effort involving more than 12 different ministries. MOF exerted leadership reforms and sought to secure continued political support for highly contentious divestitures, notwithstanding staff constraints. Support from other government entities was more mixed. Several line ministries were reluctant to divest public enterprises or cede control to the private sector for agricultural services provision. Indeed, the Ministry of Agriculture (MOA) mobilized political support for a reversal of several key APL1 and APL2 reforms. A failure to have a full-time program director weakened the ability to monitor and report on APL2 progress, but this was compensated for by the attention that senior MOF officials accorded to APL2. ADB performance was satisfactory, but frequent staff turnover complicated the policy dialogue. The re-linking of fertilizer subsidy removal to second tranche conditionality was perhaps unrealistic, and did not take into consideration the sharp decline in paddy production and farm welfare between 1990 and 1993. Despite the frequent staff turnover, ADB's close supervision did help maintain forward momentum in implementing APL2 reforms. Moreover, timely provision of the small-scale TA to strengthen the Public Enterprise Reform Commission (footnote 10) was essential for Sri Lanka's privatization process.

D. Lessons Learned

57. Need to address the basic causes of agricultural stagnation. Higher agricultural growth can be realized in Sri Lanka by encouraging smallholders to diversify from low-value paddy to higher value activities. In conjunction with efforts to enhance the private sector's role,

12 On a rating scale of highly successful, successful, partly successful, and unsuccessful.

more attention needs to be given to structural barriers to sluggish agricultural performance including state ownership of 80 percent of the land and practically all irrigation facilities, an under-performing research and development system, high-cost market infrastructure, and an inward-oriented agriculture protection regime. A more holistic and integrated approach showing the main sectoral goals and objectives and the linkages between those and the reforms supported, will result in a more robust reform agenda. 58. Stakeholder consultations during design and implementation. Obtaining continued support from stakeholders for policy reforms is essential for sustaining the reform process. While consultations are necessary during the formulation of a policy reform program, such a program should also provide the resources for continued consultation and social safety nets. Ensuring that safety nets and other temporary measures are in place to cushion the effects of structural change on smallholder incomes and performance is important to fostering widespread support for the reform process. The vulnerability of policy reform momentum to political change needs to be understood and addressed in the program design. 59. Sound and transparent, not rapid, divestiture. Divestiture programs are inevitably time-consuming and require considerable up-front investigation and preparation to be sustained. The rapid divestiture of government interests in SOEs within the short span of a program loan tends to sacrifice transparency and sound practices of due diligence, and to impair durability. Establishing realistic divestiture targets, and encouraging use of good practices for divestiture, will help achieve better results. Linking divestiture targets to a share of net asset values rather than to the sale of specific firms is more appropriate given the risk that specific transactions could face legal challenge. Promoting orderly closure, rather than privatization of uneconomic agro-industries, is a more appropriate design in noncompetitive sectors. Efforts to advance divestiture should be accompanied by clear, well-defined subsector policies. 60. Necessity to monitor the program and macro-setting. Monitoring the changes in the macro-environment and in the agriculture sector would have alerted ADB and the Borrower to the need to make mid-course corrections in a number of the policy reforms. Failure to monitor the evolving incentive environment for private sector initiatives in agriculture contributed to a focus on simply implementing agreed reforms rather than achieving desired results and impacts.

E. Follow-up Actions

61. Government policy in agriculture is torn between a desire to be more competitive and commercial, on the one hand, and to provide fair and reasonable prices to protect poor consumers and foster greater domestic self-reliance, on the other. The Government needs to resolve this contradiction to give clear signals to the private sector and to apply a consistent agricultural policy framework. The Government needs to re-examine agricultural policies to identify opportunities for progressing toward a more competitive agriculture sector. It should be encouraged to carry out within the next two years a review of public policies affecting agriculture, and to ensure consistency and clarity in its policy reforms. Such a review should be undertaken at the highest government level with the initiative appropriately taken by MOF and MOA. 62. ADB should continue to advocate through policy dialogue the divestiture of state enterprises, farms, and agro-services that were slated for privatization under APL2, and provide assistance if necessary. The Resident Mission should maintain such dialogue, supported by relevant operational departments in the course of current and future projects. Assistance could

include preparation and introduction of the procedure and legal framework specifically tailored to effect privatization for these enterprises and farms which operate in different circumstances from the plantations. The Government should also be encouraged to seek an orderly liquidation of uneconomic state agro-enterprises. The policy dialogue should also take up the matter of adverse fiscal and agronomic impacts of fertilizer and wheat subsidies. The dialogue should move away from fertilizer subsidies per se, toward promoting the adoption of a more market-oriented food policy. During the country programming mission in 2002, ADB should consider providing advisory TA to help the Government examine opportunities for further agricultural policy reforms.

APPENDIXES

Number Title Page Cited on (page, para.)

1 Financing of Sri Lanka’s External Resources Gap 21 2, 6 2 Policy Reform Matrix 22 4, 11 3 Status of Compliance with Major Loan Covenants 35 9, 28

Appendix 1

Financing of Sri Lanka’s External Resource Gap, 1991-1995(SDR million)

Item 1991 1992 1993 1994 1995External Resource Gap 1,115 1,036 1,032 1,264 1,008Financed by:Central Government 633 443 449 427 451of which:Grants 148 130 115 117 107Project Aid 422 215 255 281 285

IMF Drawings 56 112 56 56 —

Note:Net Official Transfers 148 130 115 117 107

IMF = International Monetary Fund, SDR = special drawing right, — = not available.Source: Central Bank, Annual Report, 1996 and 1997.

POLICY REFORM MATRIX

Policy Area andObjective

Measures to be Taken Target Date forAccomplishment

DateAccomplished Status at Time of PCR Status at Time of PPAR

1. Tree Crop TaxationPlantation crops (tea,rubber, and coconut)are subject to exporttaxes (export duties andad valorem sales tax)and income tax. Thisdouble taxation is notconducive to the long-term development ofplantation cropproduction.

MajorThe Government has agreed to furtherreduce the export duties on tea, rubber,and coconut as well as phasing out thead valorem sales tax as hereunder:

(i) Export DutyBulk Tea: from SLRe1.00/kg to

SLRe0.50/kgPacketed Tea: from SLRe0.50/kg to zeroTea Bags: from SLRe0.50/kg to zeroInstant Tea: from SLRs6.00/kg to

SLRs4.50/kgRubber: from SLRe1.00/kg to zero

31 Dec 1991

30 Jun 1992

30 Jun 199230 Jun 199230 Jun 1992

1 Oct 1991

7 Nov 1992

22 Dec 19927 Nov 19927 Nov 1992

22 Dec 1992

Complied with.All export duties and advalorem sales tax on exportcrops removed on dates asshown.

Complied with.No export duties and advalorem sales tax on exportcrops through 2001.Exports are also exemptfrom the security levy.

Desiccated Coconut:from SLRs2,500/ton to SLRs1,000/tonfrom SLRs1,000/ton to SLRs500/tonfrom SLRs500/ton to zero

31 Dec 199131 Dec 199231 Dec 1993

12 Nov 199112 Nov 199122 Dec 1992

Complied with.No export duties and advalorem sales tax on exportcrops through 2001.Exports are also exemptfrom the security levy.

(ii) Phased reduction of ad valoremsales tax (currently 50 percent) asfollows:

Bulk Tea: 40 percent

The threshold price (currently atSLRs65/kg) over which the sales tax iscalculated will be reviewed and adjustedas required during the above period.

31 Dec 1991 12 Nov 1991

Complied with.No export and ad valoremsales tax on export cropsthrough 2001. Exports arealso exempt from thesecurity levy.

Rubber: from current 50 percent to 30percent.

The threshold price on which sales tax iscalculated will be reviewed and adjustedas required during the above period.

1 Oct 1991 1 Oct 1991 Complied with.No export duties and advalorem sales tax on exportcrops through 2001.Exports are also exemptfrom the security levy.

PCR = program completion report; PPAR = program performance audit report.

Appendix 2, page 1

Policy Area andObjective

Measures to be Taken Target Date forAccomplishment

DateAccomplished Status at Time of PCR Status at Time of PPAR

Rubber: from current 50 percent to 30percent.

The threshold price on which sales tax iscalculated will be reviewed and adjustedas required during the above period.

1 Oct 1991 1 Oct 1991 Complied with.No export duties and advalorem sales tax on exportcrops through 2001.Exports are also exemptfrom the security levy.

Coconut Oil, Desicated Coconut, andCopra: raising the threshold price fromSLRs20,000/ton to SLRs25,000/ton (31Dec 1991) and phasing out the advalorem sales tax (currently 50 percent)as follows:

40 percent30 percent20 percent10 percent 0 percent

31 Dec 1991

31 Dec 199131 Dec 199231 Dec 199331 Dec 199431 Dec 1995

31 Dec 1991

12 Nov 19926 Nov 199221 Dec 199221 Dec 199231 Dec 1992

Complied. Complied with.No export duties and advalorem sales taxes onexport crops through 2001.Exports are also exemptfrom the security levy.

After 31 December 1991, the thresholdprice will be reviewed and adjusted asrequired.

Not applicable. Not applicable

OthersTea:(i) Grants to selected companies forbrand promotion to be abolished.

31 Dec 1991 6 Feb 1992 Complied with.50 percent subsidy nowrestricted to promotion ofLion Logo linked to teabrands in certain markets.Cess funded.

Complied with. Totalpromotion budget for LionLogo limited to 30-35percent of advertising cost.Total promotion budget is$250,000 per annum and isfunded from a SLRs2.5/kgcess.

(ii) Interest rate subsidy (at 75 percent)for purchase of tea-bagging machinery tobe gradually phased out and eventuallyeliminated.

31 Dec 1994 Not complied with.Subsidy reduced to 50percent; reverted to 75percent from 1 November1995. Applies to new loansfor purchase of new tea-bagging machines. Cessfunded.

Complied with.Interest subsidy removed in1999.

Appendix 2, page 2

Policy Area andObjective

Measures to be Taken Target Date forAccomplishment

DateAccomplished Status at Time of PCR Status at Time of PPAR

(iii) Infilling subsidy to be graduallyreduced and eliminated.

31 Dec 1995 1 Jan 1991 Partly complied with.Infilling subsidy reinforcedin 1993 for block infixing oftea lands. Smallholdersonly. Cess funded.

Partly complied with.Infilling subsidy forsmallholders only withmonitoring by smallholdergroups. Cess funded.

RubberCess under the Medical WantsOrdinance (SLRe0.0165/kg) to beabolished

31 Dec 1991 - Not complied with.Rubber cess continued tobe collected underordinance. Ministry ofHealth considering repealof ordinance andintroducing new bill tocover state worker’s health.

Complied with.Rubber cess abolished.

Coconut(i) Subsidies for underplanting andrehabilitation (except for moistureconservation) to be abolished(subsidies to be limited to coconutreplanting, intercropping with approvedagricultural export crop, pasture andrehabilitation for moisture conservation).

31 Dec 1991 27 Jan 1992 Partly complied with.Subsidies remain forreplanting, new planting,rehabilitation, intercropping,and the installation ofirrigation facilities. Field“development” subsidiesalso available for newplanting and replanting.Cess funded.

Complied with.Subsidies for replanting atSLRs15,000/acre and fielddevelopment atSLRs16,000/acre arefinanced from theconsolidated fund.

Other Agricultural Export Crops

(i) Replanting subsidy will be limited tococoa, cinnamon, and cardamom (out ofeight crops).

31 Dec 1991 1 Jan 1992 Complied with.Revised replanting subsidyscheme, 1997, applies asfollows:cocoa – SLRs26,750/ha,cinnamon – SLRs40,000/ha,cardamom – SLRs25,000/ha, andjava citronella –SLRs10,000/ha.

Complied with.Replanting subsidy remainslimited to cocoa, cinnamon,cardamom, and citronella.

(ii) New planting subsidy to coffee andpepper to be limited.

31 Dec 1991 1 Jan 1992 Complied with.Revised new plantingsubsidy scheme, 1997,applies to pepper –SLRs30,000/ha, andcoffee – SLRs25,000/ha,under a four-year pilotproject.

Complied with.

Appendix 2, page 3

Policy Area andObjective

Measures to be Taken Target Date forAccomplishment

DateAccomplished Status at Time of PCR Status at Time of PPAR

(iii) Fruit crop subsidy will be limited tocitrus (orange and lime) and mango (outof 10 crops).

31 Dec 1991 1 Jan 1992 Complied with.Funds (approx. SLRs10million/annum) allocated toprovincial councils, whichdistribute free plantingmaterial to farmers fromnurseries.

Complied with.

2. Sugar IndustryThe sugar industry inSri Lanka has beenreviewed under theADB-assisted TA onSugar SectorRationalization Studycompleted in June1990.

Major(i) To eliminate the agreed sugar price(about $1,000 equivalent per ton ofsugar) applied for Pelwatte SugarEnterprises Ltd. (PSEL) and applyuniform purchase price equivalent tolong-term international price currentlyestimated at $500 per ton of sugar.

30 Jun 1992 10 Jun 1992 Complied with.Uniform purchase pricenow abolished in favor ofduty protection, currentlyset at 25 percent.

Complied with.Uniform purchase priceabolished in favor of dutyprotection, initially set at 35percent, brought down to17 percent and now set ata flat rate duty ofSLRs3,500 ($40) per metricton.

(ii) Conversion of PSEL’s foreigncurrency loan to rupee loan.

30 Jun 1992 10 Jun 1992 Complied with. Complied with.

(iii) to privatize three companies asfollows:

- establishment of a TenderCommittee.

1 Oct 1991 1 Oct 1992 Complied with. Complied with.

(a) Privatize Sevanagala SugarIndustries Ltd.

31 Dec 1996

The main findings andrecommendations of thestudy include(i) rationalization ofsugar pricing;commercialization of theSri Lanka SugarCompany Ltd. (SLSCL);and (iii) recapitalization/refinancing of foreignloan of the PelwatteSugar Enterprise Ltd.(PSEL).

- completion of valuation andpreparation of a time-bound actionplan for capital restructuring as apreparation for privatization.

30 Jun 1992 23 Feb 1992 Complied with. Complied with.

- divestiture of at least 51 percent of itsequity1

31 Dec 1992 Public Enterprise ReformCommission proposes toreadvertise the sale ofSevanagala after courtdecision given on case filedby Great Industries of HongKong, China.

Hingurana, Pelwatte andSevanagala sugarcompanies wererepossessed by theGovernment. Factorylosses were subsidized atSLRs65 million in 2000.

1 Additional condition for the release of second tranche agreed upon between ADB and the Government in 1994.

Appendix 2, page 4

Policy Area andObjective

Measures to be Taken Target Date forAccomplishment

DateAccomplished Status at Time of PCR Status at Time of PPAR

(b) Private Hingurana Sugar IndustriesLtd. By divestiture of at least 52percent of its equity.

31 Mar 1993 22 Jan 1993 Repossessed by theGovernment in 1996. Tobe readvertised for saleeither by tender ornegotiated sale. Companyneeds to be restructured tobe viable.

Hingurana not in operation.

(c) Privatize Kantale Sugar IndustriesLimited by divestiture of at least 51percent of its equity.

30 Jun 1993 21 July 1994 A court injunction is still inforce. Attempts will bemade to settle the issue outof court through theintervention of the AttorneyGeneral.

Kantalai factory notprivatized.

Kantalai and Hinguranafactories not in operation.Companies are on theliquidation list.

3. Agriculture Extension RationalizationThe report (June 1991)of ADB-assisted TA onAgricultural ExtensionRationalizationreviewed the currentstatus of agriculturalextension in Sri Lankaand produced severalrecommendations toimprove and rationalizeexisting services.

Major(i) Field-level extension services will becarried out by agricultural instructors forthe crop sector and livestockdevelopment instructors/technicians forthe livestock sector. They will bedesignated as divisional extensionofficers and function technically underthe respective provincial directors ofAgriculture and Animal Production andHealth and perform administrativelyunder assistant government agents.

31 Oct 1992 Single line ofcommand toagriculturalinstructors underProvincial Directorof Agricultureeffected mid-1993.Memo from Ministryof AgriculturalDevelopment andResearch tolivestockdevelopmentinstructors/techniciansapproved byCabinet on 3 Dec1994.

Complied with.Institutional structure fordelivery of extensionservices revised underWorld Bank-funded SecondAgricultural ExtensionProject (SAEP).

Partly complied with.Extension system remainsfragmented withresponsibilities to morethan 14 central government“agriculture” ministries, andprovincial councils.Separate services remaindue to overlapping fundingand oversight. Differentextension approaches bydifferent commoditygroups.

Others(i) Establishment of a nationalagricultural extension group (NAEG).

31 Mar 1992 14 Sep 1992 Complied with. NAEG defunct; now anannual national extensionmeeting.

Appendix 2, page 5

Policy Area andObjective

Measures to be Taken Target Date forAccomplishment

DateAccomplished Status at Time of PCR Status at Time of PPAR

(ii) Establishment of a provincialextension management unit (PEMU).The PEMU will serve as the coordinatingbody responsible for integrating in-service training, provision of advice, andtechnical supervision for field staff; willperform duties under the chairmanship ofthe Provincial Secretary of Agriculture.

31 Mar 1992 Dec 1993 Complied with. PEMU defunct; provincialworking group and aregional technical workinggroup took over under theResearch System.

(iii) Rearrangement of the RegionalTechnical Working Group will cover, inaddition to its existing activities, animalproduction and health, coconut, otheragricultural export crops and forestry.

31 Jul 1992 23 Mar 1992 Complied with. Complied with.

(iv) Introduction of a modularized andprogressive in-service staff trainingprogram to upgrade competence of staffin the following fields: training, planning,management, delivery and methods, andorganizational and management skills.

31 Oct 1992 Jun 1993 Complied with. Complied with.Perennial crops extensionservices contracted out tothree private companies inFebruary 2001.

MajorThe Government will take the followingmeasures:(i) establish a Tender Committee;

(ii) privatize Ceylon FertilizerCorporation (CFC);

(a) complete valuation and capitalrestructuring of CFC as apreparation for privatization;

1 Oct 1991

30 Jun 1992

28 Jan 1991

15 Jul 1992

Complied with.

Complied with.

Complied with.

Complied with

4. Fertilizer MarketingOn 9 February 1991,ADB approved technicalassistance for the studyof Rationalization of theFertilizer MarketingSystem. Consideringthat the fertilizersubsidies have beencompletely removedsince 1 January 1990,there is need to take afresh look at thefertilizer marketingsystem including therole of the government-owned fertilizercompanies.

(b) divest the district fertilizer stores ofCFC;

30 Jun 1992 Partly complied with.Of the 34 district fertilizerstores operated by CFC, 13have been sold, eight arenow run by CFCL on behalfof other agencies, sevenremain with CFC, five arenot functional, and one wastransferred to the originalowner.

Partly complied with.Of the 34 district fertilizerstores operated by CFC, 16have been sold.

Appendix 2, page 6

Policy Area andObjective

Measures to be Taken Target Date forAccomplishment

DateAccomplished Status at Time of PCR Status at Time of PPAR

(c) divest the regional warehousecomplexes of CFC; and

30 Jun 1992 14 Sep 1992 Complied with.The five regionalcomplexes were divestedto the five companiesresulting from restructuringof CFC.

Partially complied with.Three regional complexeswere sold when CFC wasrestructured. Two wereretained by CFC.

(d) privatize (divestiture of at least 51percent of equity in) CFC (theHunuputiya complex and the headoffice;

31 Dec 1992 - CCFL is currently awaitingMinistry concurrence toproceed with itsprivatization possibly in1998.

CCFL was closed in 1997after labor problems.Operated by the Ministry ofAgriculture and is on theliquidation list.

(iii) privatize (divestiture of at least 51percent of equity in) ColomboCommercial Fertilizer Limited (CCFL);

31 Dec 1992 29 Jul 1994 Repossessed by theGovernment in 1996.Company books of accountbeing reconstructed byErnst and Young. Underconsideration for sale in1998.

CCFL functioning underauthority of the Ministry ofAgriculture.

(iv) private (divestiture of at least 51percent of equity in) Janatha FertilizerEnterprise Limited (JFEL); and a

31 Mar 1993 Public Enterrpise ReformCommission to readvertisethe company. Anunsolicited expression ofinterest has been receivedfrom a Norwegian firm. Thisfirm is expected to be anactive participant in the up-coming divestiture process.

JFEL not privatized buthandles only local fertilizersales. It is on the liquidationlist.

(v) privatize (divestiture of at least 51percent of equity in) Rajaratha Agro-Fertilizer Enterprise.

18 July 1996 July 1996 Complied with. Complied with.

Others(i) to streamline the National FertilizerSecretariat (NFS) through the followingmeasures: redefining its role andimplementation of staff deployment;

30 Nov 1991/30 Jun 1992

30 Jun 1992 Complied with. Complied with.NFS focusing onimplementation of theRegulation of Fertilizer Act.

a Additional conditions for the release of second tranche agreed between ADB and the Government in June 1994.

Appendix 2, page 7

Policy Area andObjective

Measures to be Taken Target Date forAccomplishment

DateAccomplished Status at Time of PCR Status at Time of PPAR

(ii) to establish a bulk fertilizer handlingfacility at Colombo Port, in line withfollowing principles: the facility operatorshall not be a fertilizer importer; the portcontinues to handle bagged fertilizerimports; and arrangements forappropriate port handling charges forbulk fertilizer imports, and the chargesfor bagged fertilizer, will remain the sameas that for other bagged cargoes.

Nov 1992 Partly complied with.Contract for facility (2,000tons/per day) signed on 10Nov 1992. Facility operateduntil 1994/95 at high unitcost and with lowutilization. Facility nowremoved.

Complied with.Facility closed due to a lackof demand andtechnological difficulties.Fertilizer importers can usebulk handling facilitiesavailable for cement atColombo port.

5. Livestock SectorIn line with governmentpolicy to deregulate thelivestock sector, there isconsiderable

Major(i) To establish tender committees forprivatization of COFC, LMFL, andMILCO.

1 Oct 1991 20 Jun 199020 Aug 199026 Jun 1990

Complied with. Complied with.

(ii) To privatize (divestiture of at least 51percent of equity in) COFC and LMFL.

30 Jun 1992 9 Jan 1992 (COFC)25 Oct 1992

(LMFL)

Complied with. LMFLclosed due to labordisputes. No longerprocures fluid milk and onlyprocesses imports.

(iii) To privatize (divestiture of at least 51percent of equity in) MILCO.

31 Dec 1992 3 Sep 1997 Assets transferred to newcompany, Kiriya MilkIndustries, in May 1996.New company acquiredunder joint venturearrangement between theGovernment (49 percent)and National DairyDevelopment Board ofIndia (51 percent). NewBoard and Managementappointed. Companycommenced operations inSep 1997.

Kiriya Milk Industries wasrepossessed by theGovernment in 2000; nowunder the management ofthe Ministry of LivestockDevelopment and EstateInfrastructure. Kiriya is onthe list of firms to beliquidated.

opportunity fortransferring a number ofservices traditionallyprovided byGovernment to theprivate sector. TheCeylon Oils and FatsCorporation (COFC),Lanka Milk Foods Ltd.(LMFL) and MilkIndustries of LankaCompany Ltd. (MILCO)are government-ownedcompanies that have tocompete with theprivate sector in themanufacture,distribution, and sale oflivestock feeds andother inputs, and in thecollection, processing,and marketing of milk(products).

(iv) To formulate an appropriate milkpricing policy under ADB-assisted TA.Recommendations to be discussed andimplemented as appropriate.

31 Dec 1992 3 Sep 1997 Complied with.Government involvement inprice setting removed bythe sale of LMFL andMILCO. Prices aredetermined by marketforces.

Complied with.Only import tariffs onpowdered milk (10 percent)and high-fat powdered milk(25 percent) influence fluidmilk prices.

Appendix 2, page 8

Policy Area andObjective

Measures to be Taken Target Date forAccomplishment

DateAccomplished Status at Time of PCR Status at Time of PPAR

While the threecompanies operatewithout governmentbudgetary support,profitability andoperational efficiencyare severely hamperedby government controlson purchase and salesprices and inflexibility inmanagement. Theirprivate sectorcounterparts, CeylonGrain Elevators Limited,Anchor Foods (Pte)Ltd., and Nestle LankaLtd. operate with moreflexibility, which givesthem a competitiveadvantage.

OthersPossible privatization of a number ofgovernment facilities and services suchas livestock farms, and veterinary andartificial insemination centers andservices to be reviewed and examinedunder ADB-assisted TA and therecommendations thereof will bediscussed and implemented asappropriate after completion of the studyexpected in May 1992.

31 Dec 1992 1 Oct 1997 Partly complied with.Under the current policy,privatization of theseactivities and others hasbeen identified. Importrestrictions and tariffstructure for animal feedshave been rationalized andgreater competitionfacilitated in animal feedand poultry industries.Three new ultra heattreatment (UHT) milk plantsnow operational. Dairysector is being developedunder cooperative model.

Partly complied with.Import restrictions onanimal feeds have beenabolished and tariffsrationalized. Competitionhas increased in animalfeed and poultry industries.Two National LivestockDevelopment Board farms(New Zealand andAmbewela) were identifiedfor divestiture in 1999. Bidswere evaluated and asuitable firm was identified,but no contract wasawarded due to landencroachments andopposition to staffdownsizing. Veterinary andother services remain in thepublic sector, althoughplans exist for theircommercialization.

6. The State Plantation CorporationMajorA. The Government has agreed to takefollowing steps:

(i) Split up the regional boards of JEDBand SLSPC into more than 20independent public companies.

In accordancewith a schedule tobe agreed onbetween theGovernment andthe World Bank

30 Jun 1992 Complied with. Complied with.

The state plantationsector comprising theJanatha EstatesDevelopment Board(JEDB) and the SriLanka State PlantationsCorporation (SLSPC) isa major player in theeconomy of Sri Lanka.However, its less thansatisfactoryperformance—productivity being 30—40 percent lower thanthat of the tea andrubber estates in othercountries—has resultedin declining contributionto the economy over thedecade.

(ii) JEDB and SLSPC will be managed byprivate management companies or otherprivate sector entities undermanagement contracts.

30 Jun 1992 Complied with. Complied with. 20 manage-ment companies provided50-year contracts andequity sold between 1995and 1998.

Appendix 2, page 9

Policy Area andObjective

Measures to be Taken Target Date forAccomplishment

DateAccomplished Status at Time of PCR Status at Time of PPAR

(iii) Segregate the nonviable estates tobe retained by JEDB and SLSPC. A planwill be drawn up for the best use of theseestates.

30 Jun 1992 Complied with. Complied with.No buyers for one companyand management contractwithdrawn from two(coconut) companies.

(iv) Segregate the marketing andwarehousing divisions of JEDB andSLSPC into separate commercial entitiesand privatize them.

Partly complied with.Remaining marketing andwarehousing activities ofJEDB and SLSPC areoperating commercially andaccessible to the privatesector. Possible furtherprivatization beingconsidered.

Partly complied with.Remaining marketing andwarehousing activities ofJEDB and SLSPC are inareas with little privatesector demand due to thesecurity situation. Noimmediate privatizationplans.

Major(i) Prepare and publish an expandedimport list of approved varieties.

31 Mar 1992 31 Mar 1992 Complied with. Complied with.

(ii) Prepare a divestiture program of atleast five agricultural farms.

31 Mar 1992 31 Mar 1992 Complied with. Complied with.

7. Agricultural SeedTo encourage andsupport the privatesector in theimportation, production,and marketing of high-yielding varieties ofagricultural seeds andplanting materials.

(iii) Examine the import permit systemand recommend improved importprocedures.

31 Dec 1992 Mar 1997 Complied with. Complied with.

(iv) Prepare a seed industrydevelopment program.

31 Dec 1992 Sep 1992 Complied with.New Seed and PlantingMaterial Policy Statementissued in March 1997,promoting greater privatesector involvement in theindustry.

Complied with.Draft Seed Law Submittedto Parliament in 2001.

(v) Divest at least five agricultural farms. 31 Dec 1992 Partly complied with.Three farms leased in Mar1993. Ministry ofAgriculture to decidewhether two other farmsare to be privatized.

Partly complied with.Two seed farms divested inMarch 1993. Assets of theHingurakgoda Paddy SeedFarm sold in 1998.Department of Agriculturecontinues to sell paddy andvegetable seeds atsubsidized prices.

Appendix 2, page 10

Policy Area andObjective

Measures to be Taken Target Date forAccomplishment

DateAccomplished Status at Time of PCR Status at Time of PPAR

Additional Issues During Program ImplementationThe fertilizer subsidy,which was abolished in1990 under the FirstAgricultural ProgramLoan, was reintroducedby the Government inDecember 1994 to helpfarmers reduce the costof rice production.

The Government shall remove thefertilizer subsidy, or enter into anagreement with the InternationalMonetary Fund under its EnhancedStructural Adjustment Facility thatincludes, among others, the removal ofthe fertilizer subsidy.

12 Dec 1996 On 1 October 1997, theGovernment removedsubsidies on all fertilizersexcept urea. The fertilizersubsidy will decline in realterms.

Until 2000, the fertilizersubsidy was capped atSLRs1.5 billion. For 2001,subsidy increased toSLRs2.2 billion. Nominalurea prices fixed since1994. Subsidy has beenconfined to urea since1997.

Submit an independentaudit certification andsupporting documentson the loan utilization ofloan proceeds under thefirst tranche.

31 Aug 1996 21 Aug 1996 Complied with. Complied with.

Appendix 2, page 11

Appendix 3, page 1

STATUS OF COMPLIANCE WITH MAJOR LOAN COVENANTS

Covenant Reference inLoan A greement Status at Time of PCR Status at Time of

PPAR

1. The Borrower shall maintain, or cause tobe maintained, records and documentsadequate to identify the eligible itemsfinanced out of the proceeds of the Loanand to record the progress of theProgram.

Section 4.04(a) Complied with. Complied with.

2. The Borrower shall furnish, or cause tobe furnished, to the Asian DevelopmentBank (ADB) quarterly reports on thecarrying out of the program and on theaccomplishment of the targets andcarrying out of the actions set out in thePolicy Letter.

Section 4.05(b) Not complied with. Not complied with.

3. Promptly after the closing date forwithdrawals from the Loan Account, butin any event not later than three (3)months thereafter or such later date asmay be agreed for this purpose betweenADB and the Borrower, the Borrowershall prepare and furnish ADB a reporton the execution of the Program,including its cost, the performance by theBorrower of its obligations under thisLoan Agreement, and theaccomplishment of the purposes of theLoan.

Section 4.05(c) A partially completedreport was submitted tothe ADB PCR mission on30 Sep 1997. The finalreport was submitted toADB on 27 Feb 1998.

Complied with.

4. The Borrower shall establish with theCentral Bank of Sri Lanka (CBSL),immediately after the effective date, animprest account, which shall bemanaged and liquidated in accordancewith terms and conditions satisfactory toADB and consistent with ADB’s“Guidelines on Imprest Fund andStatement of Expenditures Procedures”and subject to detailed implementationarrangements agreed upon between theBorrower and ADB.

Schedule 3,para. 5

Complied with. Complied with.

Appendix 3, page 2

STATUS OF COMPLIANCE WITH MAJOR LOAN COVENANTS

Covenant Reference inLoan A greement Status at Time of PCR Status at Time of

PPAR

5. Separate accounts and records inrespect of the Imprest Account shall bemaintained in accordance withconsistently maintained soundaccounting principles and shall beaudited annually by independent auditorsacceptable to ADB in accordance withsound auditing standards.

Schedule 3,para. 6(a)

Partially complied with.1 Complied with.

6. Promptly after the preparation, but in anyevent not later than six (6) months afterthe close of the fiscal year to which theyrelate, or not later than six (6) monthsafter the date of the closing of the LoanAccount, as the case may be, certifiedcopies of such audited accounts andrecords shall be furnished to ADB.

Schedule 3,para. 6(a)

Delayed compliance. Delayedcompliance.

7. No withdrawals shall be made from thesecond tranche unless ADB shall besatisfied, after consultation with theBorrower, that (a) sufficient progress hasbeen achieved by the Borrower in thecarrying out of the Program, and inparticular, (b) the Borrower has fulfilledthe conditions for the release of thesecond tranche.

Schedule 3,para. 6(a)

The second tranche wascancelled. The Borrowerwas able to fulfill many butnot all the conditions for itsrelease.

Borrower unableto meet divestitureand fertilizersubsidy removalconditions.

8. Except as the Borrower and ADB mayotherwise agree, the Ministry of Finance,in cooperation with the Ministry of PolicyPlanning and Implementation (MPPI),shall be responsible for coordination ofthe Program among the variousconcerned ministries and agencies of theBorrower, and CBSL shall beresponsible for the effectiveadministration and disbursement of theproceeds of the Loan.

Schedule 5,para. 1

Complied with. Complied with.

9. The counterpart funds shall be used tofinance the local currency costs of ADB-financed agricultural developmentprojects and other agriculturaldevelopment projects.

Schedule 5,para. 2

Complied with. Complied with.

1 Following recommendations made by the Auditor General’s office, the accounts, records, and documents relating to withdrawals

from and replenishments to the imprest account were properly maintained.

Appendix 3, page 3

STATUS OF COMPLIANCE WITH MAJOR LOAN COVENANTS

Covenant Reference inLoan A greement Status at Time of PCR Status at Time of

PPAR

10. By 30 September 1992, ADB shall carryout a review of (i) progress in theimplementation of the policy reforms asset out in the Policy Letter, and (ii) theimpact of these and earlier reforms onthe development of the agriculturesector.

Schedule 5,para. 6

Complied with. Complied with.

11. The National Planning Department(NPD) of MPPI shall, upon completion ofthe Loan, evaluate the benefits of theProgram in accordance with such timeschedule and terms of reference as shallbe agreed upon between NPD and ADB.

Schedule 5,para. 7

Not complied with.Timetable yet to be agreedbetween the Governmentand ADB.The Government hasasked for technicalassistance to assist in animpact study. The PCRmission considered it oflittle relevance for thestudy undertaken at thetime of PCR preparation.

Not complied with.Impactassessment notcritical due toseveral reformreversals andincompleteimplementation.Moreover, theGovernment hasadequate capacityto conduct theimpact studywithout technicalassistance fromADB.