Document of The World Bank FOR OFFICIAL USE ONLY IAlJ 32Z9-/X/ Report No. 8337-HU STAFF APPRAISAL REPORT HUNGARY INTEGRATED AGRICULTURAL EXPORT PROJECT MAY 15, 1990 Agriculture Operations Division Country zepartment IV 'Europe, Middle East and i rth Africa Region This docunent has a restricted distibution and ma' be mu CURRENCY EQUIVALENT Currency Unit - Forint (Ft.) April 1987 1988 1989 1990 US$1-Ft. 47.0 50.4 60.8 63.9 WEIGHTS AND MEASURES Metric System ABBREVIATICNS AGROBER - Agricultural Construction and Engineering Firm AKI - Research Institute of Agricultural Economics BB - Budapest Bank CCB - Commercial and Credit Bank CMEA. - Council of Mutual Economic Assistance EEC - European Economic Community FSMP - Financial Sector Modernization Project HCB - Hungarian Ciedit Bank HUNGEXPO - Agency for Trade Fairs and Export Promotion KOPINT - Institute for Market Research MEM - Ministry of Agriculture MT - Ministry of Trade NBH - National Bank of Hunga#y NPV - Net Present Value NSB National Savings Bank SAL - Structural Adjustment Loan SIO - Subsector Interprofessional Organization SOE - Statement of Expenditures TTK - Hungatian Agricultural Commodity Exchange HUNGARY - FISCAL YEAR January 1 - December 31 HUNGAR INTEGRATED.AG&ICULTURAL EXPORT PROJECT Table of Contents Chapter page No. LOAN AND PROJECT SUMMARY ........................................... i - iii I. INTRODUCTION. 1 II. AGRICULTURAL POLICY UNDER TRANSITION. 2 A. Sector Background and Strategy. 2 B. Major Issues Facing the Agricultural Sector 3 C. Status of the Financial and Banking Sector. 7 III. CHANGING STRUCTURE OF FARING . .11 A. Private Sector Farms ...........................11 B. State iarms and Cooperatives ...................... 13 C. Impact of Bank Lending in Agriculture .16 IV. THE PROJECT .17 A. Concept, Design and Objectives .17 B. Proiect Descrption .18 C. Cost and Financing .................... \ ........... 20 D. Procurement ........................................ 21 E. Bank Loan Allocation and Disbursement .............. 23 F. Environmental Impact... ............................ 24 V. PROJECT IMPLEMENTATION ................................... 25 A. Organization of Implementation ..................... 25 B. Subloan Criteria and Onlending Terms ............... 26 C. Small Scale tarmer Credit Arrangements ........... 29 D. Technical Assistance and Training .31 E. Reporting, Auditing.and Supervision .34 VI. AGRICULTURAL POLICY CHANGES .36 A. Producer Prices .36 B. Subsidies .......................................... 36 C. Ownership of Assets in Farming .38 D. Rehabilitation of Low Efficiency Farms .40 E. Trade Liberalization .40 VII. ESTIMATED PROJECT RESULTS ....... . 41 ~~~~~. ........ .. . . A. Production ............ 41 B. Markets .41 C. Financial Analysis .42 This document has a restricted distribution and may be used by recipients only in the performance of their official -duties. Itis contents may not otherwise be disclosed without World Bank authorization. (ii) Pgge_ No. VIII. JUSTIFICATION AND BENEFITS ............................. 43 X A. Beefis...........i............ 43 B. Economic Analysis .44 C. Risks .45 IX. AGREEMENTS REACHED AND RECOMMENATION . .45 ANNEXES 1. Selected Documents Available in the Project File 2. Details on the Three Major Commercial Banks 3. Program for Improving tow Efficiency Large Scale Farms 4. Reiating Project Objectives with Project Components 5. Detailed Cost Tables 6. Estimated Disbursement Schedule of Bank Loan L 7. Terms of Reference M(i) Agricultural and Food Marketing (ii) Commodity Exchange bevelopment (iii) Market Information Service (iv) Subsector Interprofessional Marketing Organizations (v) Agricultural Insurance System (vi) Training Farm Managers in Business Planning and Marketing (vii) Local Consultant Industry for Business Planning (viii) Training of Private Farmers (ix) Extension Service for Private Farmeis (X) Livestock Advisory Services 8\. Indicators for Project Monitoring 9. Reassignment of Producer Prices Among Categories of Price Regime, 1988-90 10. Detailed Subsidy Reduction Program in the Agricultural and Agroprocessing Sectors 11. Assumptions for ERR Calculat.ons MAPS This report was prepared by Wayne Ringlien (Task Manager), Martin Herman, Orlando Sacay, Michel Debatisse (Bank) and Istvan Feher (C); the project was appraised in November 1989. -\; INTEGRATED AGRICULTURAL EXPORT PROJECT Loan and Project Sumary Bgrrower: National Batik of Hungary (NBH). Guarantgr: Republic of Hungary. BeTnefic aris: Private farmers, large scale farms and marketing agencies. Amount: US$100 million equivalent. Terms: Fifteen years, including a five-year grace period, at the Bank's standard variable interest rate. Onlending NBH will on-lend US$100 million equivalent in Forints to the lerms participating institutions at a maturity not exceeding 15 years including a grace period not exceeding five years, at its prevailing adjustable refinancing rate which is positive in real terms and will be adjusted from time to time to a level suffi.cierit to cover: (a) NBH's average cost of funds; and (b) the expected foreign exchange risk, which will be borne by NBH. Project (a) To provide quality food products for export; and Objectives: (b) to make agricultural producers more efficient by providing additional financial resources to private, small scale farmers and by improving agrobusiness methods and practices of managers of large scale farms. Proiect The project would provide a line of credit to be used Descrigtion: according to criteria and guidelines set by the commercial banks to finance investments by private farmers, agriultural enterprises and agroprocessing enterprises so that they may improve their operations, reduce their unit costs and increase exports. Investment funds would finance, for both large scale agricultural units and small scale farmers, planting material, breeding and fattening stocks equipment for the improvement of crop and livestock production, non-agricultural activities of agricultural enterprises such as services and manufacturing, and storage and commodity handling facilities and marketing and sales promotion services. Theproject includes important agricultural policy initiatives which support privatization ef farming assets and liberalization of prices and trade. (it) Proiect Project benefits would be derived from: (a) increased Ae_n_qf_its: earnings from exports, mainly to convertible currency markets; (b) increases in the value added of the products processed under the project; and (c) transfe! of the ownership of assets, including land, from state farms and cooperatives to farmers either organized in groups or as individuals. The beneficiaries of the project would be about 5,000 private farmers and entrepreneurs and 500 large scale state, cooperative, and joint venture enterprises engaged in agriculture and related activities. The elimination of most subsidies, and liberalization of producer prices and import licensing would improve resource allocation and efficiency in agriculture and the economy at large and would contribute to Government savings. Project Risks: The major risks of the project include inadequate implementation of the Government of the agreed policy reforms and insufficlent incentives to farm and enterprise managers so as to motivate them to carry o'-t the required restructuring. The project attempts to reu e these risks by securing agreement with Government on selected policy issues, and by including in the project, services to assist farm maragers to identify markets and to organize productiqn to meet the quantity and quality requirements of their markets. As regards the environmental impact of the project, water pollution may result from agroprocessing waste and use of farm chemicals. However, Government is strengthening its enforcement of regulations governing water pollution, and the investment proposal of each subborrower will be cleared with the Ministry of Environment. Project Costs: Local Foreign Total ---- (USS million)---- Crop Production 36 60 96 Livestock Production 46 13 59 Horticulture 27 2 29 Agroprocessing & Other 27 39 66 Trade Infrastructure 4 5 9 Training&Tech. Services 12 . 15 TOTAL 152 122 274 Financing IBRD - 100 100 _PLa_: Commercial Banks/rirH 98 107 Beneficiaries Equity 52 - 52 Government Contribution 2 - 1 OECD Donor Agencies - 14 14 TOTAL 152 122 274 - ~ ~ ~ ~~ ~ ~~- _= (iii) Estimated IBRD FY 121 1992 1292 1994 1995 1S96 Disbursement: (US$ million)- Annual 8.1 23.7 29.4 23.8 12.0 3.0 Cumulative 8.1 31.8 61.2 85.0 97.0 100.0 Economic Rate of Return: Ranges between 18% and 57%. Maps: IBRD 22071, 22072 and 22085 HUNGARY INTEGRATED AGRICULTURAL EXPORT PROJECT STAFF APPRAISAL REPORT I. INTRQDUCTION 1.01 In tandem with broader economic reform, Itungarian agricultLure is moving forward in its transition from a production system based on quotas to a farming system based on profits. The transitional phase is particularly difficult for the agricultural sector as it lags behind the manufacturing sector regarding liberalization and, thus, is required to absorb the consequences of facing high, int3rnational prices for its inputs and low, controlled prices for its output, and the resulting deterioration in the internal terms of trade over the last decade. Under these circumstances, the agricultural sector has been unable to stress its comparative advantage in higher quality products than those which it is currently producing and correspondingly shift emphasis to crops relative to livestock. The agricultural sector has also been faced with uncertainties arising from macro economic policies. 1.02 In attempting to assist the transitional process in the agricultural sector, this project not only finances investment at the farm level, but also addresses changes in agricultural policy and support for institutional strengthening. Consistent with the overall economic reform process, significant changes are also expected in the agricultural sector, in several areas including liberalized imports of major agricultural products, reducedans.ldies, liquidation of unprofitable farms, privatization of large scale farms, decentralization of decision making, increased competition among agroprocessing enterprises and other strategic actions which are expected to help progress towards a market oriented system. A major breakthrough of policy was the freeing of agricultural producer prices in January 1990. 1.03 As Hungarian agriculture competes with temperate climate countries of the northern hemisphere, it must develop quickly a functional domestic market structure which sends clear signals to the farming and agroprocessing sectors in the form of higher prices for quality products. The proposed project attempts to address this issue through (a) an extensive training program for enterprise managers in food and commodity marketing; (b) technical services for developing a commodity exchange, price information system and other institutional measures which are fundamental for the functioning of a market; and (c) the preinvestment work needed for establishing the physical infrastructure in marketing. 1.04 The concept of the project represents an integrated operation which addresses the urgent need for agricultural producers to vertically coordinate their output mix on the one hand with the capabilities of the agroprocessing sector and, on the other, with the effective demand on the AT domestic and international markets. -2- 1.05 The project was prepared by the Hungarian authorities with the advice of Bank staff who visited the country in November 1988 and March 1989 and, again,'in November 1989 to'appraise the project. Additional documents concernIng the sector and the project are listed in Annex 1. II. AGRICULTURAL POLICy UNDER TRAN§ITION A. Sector Background ant Strategv 2.01 Hungary has about 20 percent of its economically active population working on farms or in agricultural enterprises. Agriculture contributes about one-fifth of GDP and accounts for about 30 percent of convertible currency expqrts; its substantial exports to the countries which are members of the Council of Mutual Economic Assistance (CdEA) have a greater potential to be converted in a relatively short time into higher quality goods for Western markets than the output of other sectors. Agriculture is important in every phase of the economic, social and political life in the country, and its leaders recognize the vital role it plays in the successful development of the ongoing economic reform. Under these circumstances, the Bank has gradually broadened its dialogue with the Government on agricultural policy and institutional issues. Key sector issues which the Bank is currently pursuing with tie Government include: (a) clarifyirng ownership of assets in agriculture by individuals, which is essential for the development of a land market, transforma'-%n of present cooperatives to other organizational forms, and liquidation of loss-making Large scale farms; (b) reducing subsidies, particularly on production and investment; (c) reducing import licensing in the context of liberalized agricultural producer prices; and (d) developing an effective marketing system. E 2.02 While large scale farms are considered to be efficient p-oducers of field crops, e.g. wheat, corn, and sunflower, they have performed le'ss well in livestock production and have increasingly relied on private farmers for the breeding and fattening of large animals, especially, pigs, dairy and beef cattle and sheep. Large scale farms have seen their profitability decline over the last decade to some extent as a result of unfavorable world prices, but mostly because of their traditional and outmoded methods of management and marketing. Virtuallv all large scale farms have diversified into nonagricultural activities because of low profits in agriculture and because of lack of capital outlets for investing their cash. This multiprodcIt activity calls for a moder1i management system not unlike agribusiness' enterprises in Western Europe and the United States, which, in turn, points to the need for training in business planning, adoption of proven financial management methods and a decision-making-orientation of the accounting system. On the other hand, private farmers who are largely small scale producers and are efficient in the production of fruits and vegetables need access to commercial credit and supporting services such as extension and marketing in order to shift out of their present role as sha\reworkers for the large scale -3- ; farms and develop inco owner-operators of commercially-oriented farms. These are two of the most pressing challenges facing the agricultural sector as it poises to %ckd its place in the emerging market economy of Hungary. The proposed project and the accompanying policy dialogue have addressed both, these issues. B. Major Issues Facing the Agricultural Sector Government Regulation 2.03 F3r many years, Government fixed the producer prices cf major agricultural products based on the average costs of production with some notion of internal market conditions integrated into the administered prices. Under this policy accompanied by significant investment in agriculture in the 1970s, yields and output soared, particularly in field crops. That system, however, encouraged high economic costs in production and was not linked to an efficiency indicator. Furthermore, the pricing system was used to support farm incomes in areas of low quality land. This pricing policy also directly contributed to the misallocation of resources in agriculture by supporting an uncompetitive livestock industry. With declining prices on the world markets for Hungarian livestock products in the 1980s and rising prices for commercial inputs, irternal terms of trade deteriorated. Government pricing policy has gradual'o' x'olved from direct administration by the State all the way to free producer :rxces in 1990. Even the bureaucratic process of price review by the National Pricing Office was terminated and the responsibility for producer pricing policy was turned over to the Ministry of Agriculture. Currently, except for milk and wheat, all producer prices for agricultural goods are unregulated. 2.04 Until recently, Government determined through its Ministry of Agriculture the products which the large scale farms should produce, primarily by tying investment and production subsidies to specific commodities. Furthermore, the County Councils were, in effect, empowered to make the final selection of farms which would receive subsidies and distributed them directly to the farms. The County Councils, therefore, wielded formidable power in agricultural production and trade outside of Budapest, with little transparency in their selection of farms or distribution of benefits. This situation changed dramatically in 1989, in part, due to considerable discussion between Government and the Bank. Agricultural subsidy reduction targets had been set in 1988 under the Agroprocessing Modernization Project (Loan 2936-HU), but were overtaken by events. Government is now committed to further reducing expenditures on subsidies despite the short term unfavorable effects on food prices and inflation. Qwnership of Coogerative and State Farms 2.05 Based on the regulatory framework still in force, some of the actions of Government hamper cooperatives and state farms while others assist such units. As experience shows, Government agencies, Municipal and County -4- Councils, national and regional cooperative organizations, and banks interfere through a complicated network of informal ;hannels in the management and decision making of large scale farms. 2.06 CooneratlyVs. The basic condition for establishing cooperative autonomy is the definition of such autonomy and the clarification of the relationship between the Government and the cooperatives. Legal guarantees need to be provided to ensuI that cooperative members are owners of cooperativL property and are free to exercise thei functions as owners. Government should frame legislation to permit the members of the cooperative to decide on its organizational form and the disposal of its assets. How the actual distribution of farm land and assets of the cooperative occurs will depend on the scope of the legislation and the disposition of the cooperative members. Limited experience shows that successful cooperatives have diversified their product mix outside of agriculture and also experimented with variations of integration with small scale members .ho grow out pigs and poultry on their household plots as well as lease land belonging to the cooperative, functioning as a group. Experiments on insolvent cooperatives have resulted in establishing the ownership of the assets on an individual basis, on land leased from the County Council or State and the land being cultivated more as individual farms rather than as one large scale farm. The creation of diverse forms of ownership is supported, in part, by an amendment to the Cooperative Law and by the Transformation Law (1989). However, rights of individuals need greater clarification and protection than are available under current legislation and practice. 2.07 State Farms. As in the case of cooperatives, the basic cordition for increasing autonomy in state farm management is the clarification of Government's role. One of the fundamental issues facing Government concerns the creation of an owner's attitude in state farm employees. While some of the state farms or parts thereof shoulrl be privatized, others would need to be restructured to operate as profitable businesses, subject to the same regulatory framework as cooperatives and private farmers. They should have the same flexibility as cooperatives in sponsoring and setting up various organizational forms. Managers and employees of state farms have yet to transform their farms into joint stock companies, as is legally possible. 2.08 A crucial aspect of privatization in agriculture is the ownership of land by individuals. Despite the common impression that agricultural land has no value, commercial banks are regularly using land as collateral for securing loans and, under the Land Law of June 1989, large scale farms are renting and selling land to their members and workers. In the case of specialized cooperatives, of which there are 66, the existing worker members may sell land which they own to outsiders as well. The Ministry of Agriculture (MEM) has elaborated formulas which help set land rentals. However, there is little experience yet as only 4,000 ha were sold from large scale farms to the private sector in 1989. Following from the right to own farm land, private farmers and cooperatives should be able'to mortgage part of their aatets to the commercial bank to cover their loans. Currently, the fact that land has no financial or economic value under the present system totally distorts the financial position of farmers. \ ; -~~~~~~ Ax5ort and bomestic Trading Constraints 2.09 Along with the deregulation of supply and demand of agricultural goods which is in progress, the freeing of the export and domestic trading system is the central principle of a market based economy. Though the lega. constraints on enterprises to engage directly in such tr~de are being loosened, there can be little competitive export trade among firms without the transformation of their domestic trade into an open and free market operation.- 2.10 Domestic Trade Domestic trade in agriculture is at the beginning of a transition from being Government directed to becoming market determined. 'n theory, trade in Hungary is a free, multi mhannel activity regulated by various legislative me&-sures but, in rpactice, most enterprises involved in matketing agricultural produce act as official Government procurement channels, operating at low levels '.of efficiency and with little - effect on the formation of price . In this context, the decisive role of County Councils on the allocation of products within and outside counties' boundaries is still to be clarified. Wholesale and retail profit margins continue to be directly or indirectly set by Government and leave lit;xe roou. for initiative on the part of wholesele agents beyond carrying out ene most - rudimentary activities, often without storage space or trucking capacity for which they rely on the producer enterprises or on the retail companies. In addition, the few enterprises which are generally not under direct Government management have strong incentives to form new cartel-type associations in the absence of effective anti-trust legislation. Although it is difficult to prove collusive behavior, a number of examples point to the tendency for enterprises 'to cooperate' by fixing prices with or without Government support. The operation of the Meat Center which succeeded the abolished Meat Trust is a case in point. 2.11 The Government recognizes that much more needs to be done to promote trade through fair competition, and the Trade Act, which is pending in Parliament, is a step in this direction. As part of fundamental economic reform, the Ministry of Trade (NT) is likely to assume a role of fac$litating the efficient operation of the market mechanism through: (a) market supervision to ensure competition; (b) promotion of marketing services inclq.ding up-to-date price information; (c) establishment and supervision of health and quality standards; and (d) other similar functions designed to enhance the functioning of the market through a liberallied trade policy and increased access of exporters to foreign exchange. The G,vernment I.s ready to facilitate the creation of interprofessional organizations at the agricultural subsector level, which would be in charge of designing the future marketing instruments such as networks of witolesale markets, grading and inspection, standardized exchange contracts wid arbitration procedures. 2.12 Fundamental institutional changes are required vo achieve the reformvobjeNctives. In addition to the measures to reorganizE '\KT, there is a need to fin6 and employ publiis servant"-with other thar. purely-administ_-stive skills to conVract marketing services, itich would supervise the operation of the market. Moreover, other Government agencies (e.g. the Ministry of - 6 - Justice) would need to change and adopt new roles. While most domestic trade issues are common to the entire economy, agricultural trade has important special features related to its economic, legal, institutional, managerial, and technical aspects, which interact to bring about needed adjustment toward a market determined system. 2.13 \foreign Trade The Government is committed to facilitate access to foreign products through import liberalization for all items. Nevertheless, licensing of imports and exports is common, particularly for agricultural and agroprocessed goods. For example, at the level of the economy, licenses are required for 19 percent of imports, many of them food items, and for 39 percent of exports. Major issues constraining the increase of exports are: (a) monopoly power of the foreign trading companies, which have exclusive rights to trade on the CMEA market; (b) the requirement of export licenses; (c) lack of effective marketing services to small and medium sized enterpripes; and (d) lack of investment in marketing infrastructure. 2.14 The Government is gradually liberalizing import/export licenses, which will have a positive effect on expi t performance in the medium term but will create increased demands on foreign exchange outflow in the short term. In addition, the lack of effective marketing services is a serious problem for market expansion and for development of new markets, particularly in view of the passive response of Hungarian enterprises to export opportunities. For example, most exports are managed by foreign agents, wholesalers and importers who go to Hungary and seek opportunities rather than by Hungarians going abroad tc sell their products. The recent establishment of the Agromarketing Office, a limited liability company, to provide marketing information on prices, quality, timing, packaging, labelling and transportation indicates an awareness of the need, but its delivery of services is yet to be tested. The lack of pre-shipment export financing and insurance has also long been a serious constraint in the export marketing system but Government has begun to move toward establishing an institutional framework for facilitating these services. Since October 1989, preshipment export financing at preferential rates, based on export contracts, has been available. 2.15 CMEA member countries are now in the pro_ess of reviewing the options for moving the current system toward greater trade liberalization. Since about one half of all Hungarian trade, irkcluding agricultural products, is with the CMEA countries, such trade influences the extent to which enterprise managers can gear their exports toward the Western markets. CHEA trade also serves as a structural limitation on any incentive which can be built into the current enterprise system for rewarding managers for their export performance. Further, foreign trading organizations utilize their monopoly position in CMEA trade to dominate trade with the West by crowding out individual enterprises which seek to develop their own marketing channels. For example, direct enterprise trading in agriculture with the West accounted for only about 15 percent of the value of those exports in 1989 and were largely concentrated in the frozen food industry, which, today is still managed as a mini trust. At the same time, it would be unwise to exclude foreign trading companies from operating on the convertible currency markets, as they have staff experienced in trading. -7- C.' Status of the Financial and Banking Sector The Finanp0ial System 2.16 The financial system in Hungary has evolved rapidly since the establishment of the two tier banking system in 1987. The system'consists of a banking sector comprising the central bank, thirteen commercial banks, ten specialized financial instituts.ns, and four joint venture banks with foreign participation, a new securities market, four insurance companies, and the" social security system. As part of the overall economic liberalization, the Government has also embarked on a major reform of,financial policies, institutions and instruments. Monetary and credit policy is now managed through indirect int,truments. Deposits and lending' rates are largely market- based, banking services for households and enterprises are being integrated and foreign exchange operations are being decentralized. A new banking law, now under preparation for legislative approval in the third quarter of 1990, would establish a comprehensive framework for bank operations in Hungary and strengthen the banking supervisory function as well as prudential regulations for banks. Recent corporate legislation has facilitated the development of the incipient securities market, and a separate securities market law is also under preparation. 2.17 Fundamental changes have taken place in Hungary's financial system since the introduction of a number of specialized financial institutions and the establishment of the bond market iX 1984. The reform of the bankipg system in 1987, and the licencing of more commercial banks in 1988-89 are two major developments of significance. In parallel with the ongoing reforms in the real,sector, the government intetnds to conti%.e enlarging and improving the 'tervices and functions of thetfinancial system so as to enable it to efficiently support the movement towards a market economy. The medium term plan prepared for this purpose involves action in two broad areas. The first is to improve resource mobilization and allocation, an objective especially import4nt for the agricultural sector, since the elimination of subsidies is leading to shortages of liquidity and investment capital required by state farms and cooperatives. Progress in this direction will require, among others, an adequate structure ok interest rates, the \ equalization of banks' reserve requirements, the elimination of direct credit allocation and interest subsidies, and the transfer of the foreign exchange risk to the subborrowers. The second area for action implies the further development of the financial system to promote domestic and foreign private capital operations and the preservation of a performing and healthy system. This requires, bes4des the strengthening of the banking,sector, a modernization program for the securities market and the introduction of e commodities f tures transactions. It would also require the introduction of an efficient accounting and auditing system, based on internationally accepted standards, in banks and enterprises, And the establishment of an efficient supervisory system to prevent and re6uce irregularities. Also, to lessen the 3 negative financial and social'impact of restructuring the economy, and 8' reducing subsidies, it will be nedessary to establish efficient insurance and social security systems. 2.18 The Bank is providing assistance to the medium term plan for the modernization of the finaneial system through the Financial System Modernization Project (FSMP) (Loan No. 3191-HU). That project emphasizes the importance of the rehabilitation of the major banks, focussing on such crucial areas as: (i) establishing credtt policies and procedures to permit better assessment of the risk of lending operations; (ii) undertaking portfolio adjustments, based on detailed external auditIng of banks, to improve their financial standing; and (iii) improving the accounting and auditing systems so as to achieve transparency and reliability of financial statements of banks and enterprisos. It is expected that the improved banking system framework will encourage domestic private investment and the flow of direct foreign investment, and result in substantial benefit to the economy as a whole. In the long run, improvements will also have to be made in the mobilization of savings and in the establishment of an efficient capital market and efficient insurance and social security institutions as those are essential to supFort privatization and economic development. The Bank expects to continue to assist in the achievement of these objectives in future lending operatiors. The banking System 2.19 Since the formation of the two tier banking system in 1987, the National Bank of Hungary (NBH) restricts itself to traditional central banking activities. NBH is involved in the formulation and enforcement of monetary policy, and in maintaining internal and external financial equilibrium. NBH now acts as banker only for the State, for banks and for specialized financial institutions. Within the new economic and financial environment, NBH has become more independent of Government and relies on moreindirect control of eredit, through instruments such as reserve requirements, open market operations, refinancing limits, and interest rates. 2.20 Refinancing credits are provided by NBH to commercial banks for short and medium term working capital loans and also fox investment loans. The latter are mainly provided through Bank-financed agricultural, industrial and other projects. Short term refinancing credit can be obtained through an automatic overdraft facility allocated on the basis of a bank's capital or through the liquidity facility for,banks whose credit requirements exceed the established overdraft limits for lbnger periods of time. NBH has sought to control the lending behavior of the banks by varying the limits for refinancing short term working capital credits. In line with the tight monetary policy, the limits were halved between September 1987 and Septemb\er 1988. In January 1989 automatic overdrafts were limited to 50 percent of a bank's share capital and any remaining credit being met through the liquidity facility. At the same time, interest rates on overdrafts and liquidity loans were raised to 14 percent and 18 percent, respectively. The dependence of the banks on the refinancing mechanism is expected to decrease as integration bf the household and the enterprise banking sectors progresses, and commercial banks begin to accept deposits from, and issue bonds to, the household sector. \~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ 9 2.21 The interest rate structure has been reformed to mobilize more resources and to channel them more efficiently from areas of surplus to areas of shoNtage. This was achieved by deregulation of interest rates and by maintaihing positive interest rates. In the past, NBH refinancing rate has generally been kept positive in relation to anticipated domestic inflation. Refinancing rates on working capital credits were raised from 11 percent which prevai)?d fQr much of 1988, to 13 percent in November 1988 and to 14 percent in Jatiuary 1989. Measured in relation to producer prices inflation of 15 percent in 1989, NBH financing rate lost its positive real margin. Also, given the evidence of accumulated, and mounting, foreign exchange losses at the NBH, the rate did not appear anymore to provide an adequate margin to cover such losses. To counter these trends, NBH increased its refinancing rate in Decemdber 1989 by three percentage points to 17 percent per year. This rate would appear adequate to cover the foreign exchange risk and administrative costs as producer price inflation iz expected to remain at about 15 percer,t in 1990 with a declining trend thereafter. 2.22 Banks have been able to establish their own lending and deposit rates since 1987, the former principally on the basis of their cost of capital and of overheads. For investment loans such cost is mainly influenced by the refinancing rate of NBH, which is the main source of long term financing to agriculture. The rates are variable and differ from bank to bank, reflecting also the status of the portfolio, the need to establish provision for bad debts and the assessment of the risk of the operations financed, Similarly, short term rates are determined by the cost of short term resources and'of operating costs. Short term rates are variable as well and have recently been increased, due to the reduction of NBH overdraft facility to 50 percent of the borrowing bank's capital. This has obliged the banks to turn for resources to the household sector through the issuance of financial instruments such as CDs, which bear higher costs, and to the higher cost inter-bank market. Interest rates are constantly under review by the IMF and will be reviewed in the Bank from time to time under the proposed SAL and the FSMP. 2.23 NBH role in managing foreign exchange operations is also evolving as certain operations are progressively decentralized. It continues to manage gold and foreign exchange reserves and be in charge of all international borrowing activities as well as management of external debt. However, since March 1989, the commercial banks have been permitted to intermediate certain foreign \exchange transactions between domestic customers and .he NBH and to establish correspondent banking relationships with some major'international banks. Further deregulation will affect all foreign exchange activities except foreign borrowing. The commercial banks will be able to make foreign exchange payments, collect deposits in foreign exchange and extend credit for export and to small and medium sized farms and enterprises. Medium sized enterprises in the agroprocessing sector are already known to be taking V Since commercial banks would be lending Bank loan proceeds to producing farms and enterprises in a financial market which is segmqnted betweeh producers and households, the relevant price index to use' for project beneficiaries would be. the producers price index. -10- advantage of new financial instruments, svch as leasingb made available by the banks to increase their access to foreign exchange resources. The FinanMial Intermediation System 2.24 Commercial banks are registered in different legal forms and ownership structures, from budgetary institutions to joint-venture, joint- stock companies. In case of the large commercial banks, the biggest single shareholder is the State which holds up to 52 percent of share capital (except for the National Savings Bank (NSB) which is a budgetary institution, and as such, does not have a shareholding structure); the remaining shares are held by enterprises. Hungarian banks in general\,follow a Western style corporation management structure, with a chief executive chairing and reporting to a board of directors, drawn from major shareholders. They usually also have a supervisory board that reports separately to the general assembly of shareholders. 2.25 At the time of their creation in 1987, the three major commereial j banks (BB, CCB, and HCB) inherited their business portfolios from the commercial banking sections of the NBH. Until they were allowed in 1989 to participate in retail banking activities and mobilize household deposits, the commercial banks only dealt with state enterprises, local councils, large cooperatives and other entities in the socialist sector. A few are now beginning to service the small business and farm sectors. Some of the large commercial banks intend to develop into 'universal banks', involved in every aspect of retail and commercial banking. The NSB and savings cooperatives, traditionally involved in retail banking and housing finance, have also been converted to full-service commerciWl banks. The smallest and the most diverse group of financial institutiorP consista of the specialized financial institutions which evolved fzom the innovation funds set up in the early 1980s. These are full-flsPdged banks with the exception that they are not permitted to operate current, accounts. They have pioneered and developed a number of financial services in Hungary, such as leasing, hire purchase, real estate development financing, and quasi-equity profit-sharing participation instruments, and deal mostly with small cooperatives, small state enterprises and private farmers. Finally, the foreign joint-venture banks are full- service banks which engage in trade finance and leasing activities for small enterprises, cooperatives and private sector ventures. 2'.26 While all the commercial banks are active in all sectors of the economy, 'each has some initial specialization which is a reflection of the experience of their staff prior to the twro-tier banking system. For example, the Commercial and Credit Bank (CCB) was formed in 1987 out of the agriculture divisioni of the NBH and inherited several existing loans to the agricultural sector. Cons3quently, the majority of its lending is for agriculture and the food industry. About two-thirds of all cooperatives are financed by this bank. The Hungarian Credit Bank (HCB) was also founded in 1987 and is the largest commercial bank providing'credit primarily to industry. About 20 percent of its loan portfolio goes to agriculture and the food industry. It serves the credit needs of about one-fourth of all cooperatives. The Budapest Bank (BB) is the third largest commercial bank and has particular experience - 11 - In serving the needs of the energy sector. It maintains interest in expanding its involvement in agriculture although its area of coverage and branch network are still limited. 2.27 Agrobank Ltd. which has been in existence under the umbrella of the Ministry of Agriculture and Food since 19Fn became a full-fledged commercial bank in 1988. Mezobank was founded in 1986 as the national banking institution of agricultural cooperatives. The Bank for Small Ventures was organized as an affiliate of the National Savings Bank to provide credit to small businesses including agricultural ventures, but does not have a branch network. NSB is one of the oldest financial institutions and has the largest branch netwtork which caters to the general public by receiving deposits and granting loans to individuals. 2.28 Based on tle financial statements and financial indicators, the three major commercial banks appear to be in a relatively healthy financial position. However, their financial results are probably somewhat overstated due to the lack of adherence to prudent policies and procedures regarding loan classification and interest accrual, and accounting standards which are not in line with internationally acceptable accounting practices. Govern*xent is aware of these problems and has mounted programs to improve the financial position of the banks as well as to set the stage for establishing a satisfactory accounting system. Under the FSMP, selected commercial banks would undergo detailed financial audits with a view to assess their true | financial condition and the state of their portfolios. Also, special audits to be carried out in 1990 would provide a basis for developing and implementing, as appropriate, an action plan to restructure the portfolios of those banks for *which audits would revea'l need for adjustments. Annex 2 describes the more important features of the three major commercial banks and shows their summary financial statements. III. CHANGING STRUCTURE OF FARMING A. Private Sector Farms 3.01 Private, small-scale farms now produce over 60 percent of grapes, fruits and vegetables, 56 percent of pigs and 44 percent of poultry, but only 23 perceit of beef and milk. Except for milk, all of these products are exportable. With a share of only 11 percent of the area cultivated in Hungary, the small scale farming sub-sector contributes about half of total net value added in agricultural production. Grouped together as a transient form of organization at the time when lani was being collectivized, these farms have taken on increasing importance in spite of limited government support and declining land resources. This hat been possible through increased markete,orientation and specialization towards labor intensive production. The large farms find it increasingly difficult to undertake such production activities directly and prefer to transfer them to private farmers through a variety of arrangements. -12 - 3.02 Private farming activities involve some 40 percent of the Hungarian population working on 1.4 million farms and about 0.7 million even smaller "hobby farms". Table 1 shows the number and type of farming units in the country and the relative stability of their numbers over the last decade. Table 1: NU1ThER OF FARMS, 1980-88 1980 1985 1986 1987 1938 Private Small Scale Farms V ('000) 1,500 1,442 1,415 i,395 1,395 Cooperative Farms 1,338 1,270 1,260 1,262 1,253 State Farms 132 128 129 130 133 Specialized Cooperatives 61 60 60 62 66 Cooperative\Associations 42 54 58 54 64 Forestry Companies 23 25 27 29 28 Fishing Cooperatives 16 15 14 14 14 1J Estimated With an estimated average working time of 4.9 hours per day and per family, private farming accounts for about 1.2 million man-years, i.e. almost twice the labor force available in the large-scale sector.. Land rights differ for the various categories of farmers, depending chiefly on the time they work for the large farm to which they belong as cooperative members or as state farm employees. The mean cultivated area is only 0.5 ha per farm. Cooperative members are entitled to more land, but often prefer to lease part of the allocated land to the cooperative for rent payable in cash or kind. \ 3.03 Due to limited access to credit and unfavorable producer prices and policies, investments in private sector farming have been limited, particularly in fixed assets. For example, most buildings for livestock date back prior to the communist government. Only one private commercial farm in 20 has a tractor or a power tiller, and there were only 21,000 four-wheel tractors in 1986. The number of small tractors has been increasing in the past five years, but remains insufficient to meet the needs, since they remain expensive and in short supply. Until very recently, individual farmers were not allowed to buy pick-up trucks, and virtually all deliveries of farm products to city markets are still made by horse drawn carts or passenger cars. 3.04 The technology used by private, small scale farmers is inefficient with regard to labor use due to the lack of adequate eqi4pment. However, technical performance, particularly for vegetables, potatoes and fruits, is not far behind that of large-scale farms on average, and quite comparable in the case of commercially-oriented, small scale farms which normally use the same seed varieties and inputs as large farms. Due to the lack of price incentives for quality and difficult access to protein feeds until 1989, - 13 - technical ratios and meat quality in the private small farms are less satisfactory in livestock production, particularly for pigs and poultry. Technologies used by large scale farms in livestock production are often not well suited to small farms which cannot produce their own feed and are too small for mechanization. 3.05 Private farms rarely have direct access to credit, inputs. technology and markets, but depend on large scale cooperative or state enterprises for such services under some form of integration. These may vary widely from a loose system with no obligation to buy or to sell, to very tight -rrangements akin to sharecropping. The diversity and flexibility of existing at:rangements are justified by the variability in conditions. The more successful integration systems are those which benefit both the private small scale farmer and the integrator. The capacity of cooperatives to support efficiently the production activities of their small farmer members is somewhat limited because, in the absence of a clear delineation between their social and economic roles, cooperatives, particularly those located in disadvantaged areas, often undertake unprofitable activities for the sake of maintaining employment. B. State Farms and Cooneratives Larne Scale Farms 3.06 Large scale farms account for about 83 percent of the best agricultural land in Hungary and are comprised of state farms (13 percent of land) and the collective farms of agricultural cooperatives (70 percent). State farms are basically expropriated estates of private families who operated them as large tracts of land before the communist revolution. Government nationalized private estates and continued to cultivate them with the objective of increasing food production for self sufficiency on the domestic market and exporting a considerable surplus to Hungary's CMEA partners in exchange for raw materials and other needed imports. Cooperatives were formed through Government pressure on private farmers to pool their land and equipment together in exchange for Government administered prices based on average costs of production and the right of farmers to use (i) the small land area around their house and farm buildings; plus (ii) 0.6 ha on the cooperative's fields or the equivalent in corn or cash. Members of the cooperative were allowed to maintain title to their land even though it was merged into large fields under the cooperative; however, in recognition of the title, the cooperative paid a nominal, annual rental fee for the use of the land. When leaving the cooperative or on death with heirs who were not members of the cooperative, individuals were expected to return the land to the "central administrative unit", which currently controls about 63 percent of the land in cooperatives. 3.07 Large scale farms have grown considerably over tbe years, largely due to poor performance and financial losses of some farms which have been absorbed by neighboring units. As a result, there has been a continuous - 14 - increase in average farm size, from 2,000 ha in 1970 to over 4,500 ha in 1989 for cooperatives, and from 5,500 ha to 7,600 ha for state farms. The larger fa\rms seem to be experiencing diseconomies of scale as they have become too large. There is considerable scope for decentralizing these farms without affecting the large sized fields which permit the operation of 150 hp tractors and large equipment for planting, cultivating and harvesting grains and oilseeds. Yields per ha on the large scale farms are impressive for field crops; yield increases are obtained by improved varieties/breeds and techniques disseminated by "production system centers" established by leading state farms and cooperatives. Major crop yields and livestock productivity indices progressed in parallel with those of western countries from which the technology was adapted. However, since the early 1980s, yields have stagnated. 3.08 Although yields can technically further increase in many cases, it is now being realized that farms with the highest indices are not necessarily the more profitable ones. More efficient input use is now needed. Some improvement in fertilizer efficiency has already been achieved, as a result of more careful utilization following recent price increases and the expected reduction, with eventual elimination, of the fertilizer subsidy. Further yield increases may be limited by the prevailing reliance on recommendations which do not take sufficient account of specific local physical and economic farm situations, and which are still chiefly geared to maximization of yields rather than of profits. 3.09 Over the last two decades, investments in machinery have increased and resulted in a significant expansion in traction power per ha and per machine on the large scale farms. More investments in modern precision machines, such as those supported by the Bank-financed Crop Improvement Project, and for which there is a sustained demand, are necessary to further reduce maintenance costs and improve yields through better cultivation practices. Labor productivity remains low, however, compared to Western standards, particularly in livestock production, a fact which is partly due to lack of equipment and partly due to lack of incentives and reluctance to reduce the number of workers arising from Government's interest to maintain full employment. 3.10 The fact that about 50 percent of all large scale farms in financial difficulty are found in disadvantaged areas with poor soils is not necessarily evidence that profitable farming is not possible in those areas but rather reflects a failure to adjust production systems to natural resources. However, such adjustment has been made difficult by price equalization policies, which for example, subsidize cereals in particular areas where they are costly to produce. Wheat is grown in areas which would be better suited to sunflower or rye, or in some cases, should not be cropped at all but converted into grazing or forest land. Many farms have, therefore, engaged in diversified activity outside of agriculture rather than attempt to change the existing production pattern, and now derive the larger part of their income from agroprocessing, services, and manufacturing activities. Diversification has been progressing in the sector as a whole during recent years. 14on-agricultural activities noyA provide 43 percent of the total gross - 15 - output value of cooperatives, and 55 percent for state farms; they have also been the major source of their profits over the last decade. 3.11 Another way to improve farm profitability, characteristic of many cooperatives in recent years, has been to transfer those activities in which they were less efficient, essentially the labor intensive tasks, to the private small-scale farms of their members and employees. This type of arrangement has proven successful when an adequate and clear sharing of ,responsibilities has been identified, and could be further developed, but will soon find its limits if small farm labor productivity is not raised. By contrast, transfer of activities or services to private businesses is still an exception. Low Efficiency Farms 3.12 The declining profitability of agriculture experienced over the last decade has magnified the performance variations among state farms and cooperatives. Clarrently, there are about 175 large scale farms which are considered as chronic loss makers. While these farms account for only about 12 percent of the assets in agriculture, they have damaging demonstration effects on the well managed farms and require ad hoc subsidies from the central budget to pay for their losses. The causes for these losses are complex and vary from one enterprise to another. However, in general, the major factors are the following: (a) low quality management; (b) lack of earnings from non-agricultural activities; (c) the inability of the contracted private, small scale farmers to undertake labor intensive activities on the farm; (d) employment of excess labor, particularly, at the staff level; and (e) poor quality of land. Annex 3 explains how these factors influence farm performance and expands on the detail of the Government debt reduction program which is designed to permit low efficiency farms to rehabilitate (para 3.13). 3.13 In January 1987, Government initiated a debt reduction program for loss making large scale farms as well as farms which made substantial capital investments and, as a result, experienced serious cash flow problems over a rolling, three year period. Two hundred and thirty-four state farms and cooperatives were accepted into the three-year program, based on their debt position and 81 farms enrolled in the period 1987-89. The program permits the selected farms a debt write-off of 40 percent to 60 percent of their outstanding obligations to commercial banks, Ministry of Agriculture, Ministry of Finance and the National Federation of Cooperatives. As of April 1990, the total amount written off was about Ft. 855 million paid from Government's budget and Ft. 1,102 million by commercial banks. Generally, payments of Interest and principal were suspended during the three-year trial period. Under the program, 64 farms showed an average profit over the three-year period and qualified for debt reduction. The target profit level for the 64 successful farms was Ft. 434 million per year, but they exceed this target and reached an aggregate profit of Ft. 481 million in 1987, Ft. 724 million in 1988 and Ft. 799 million in 1989. This was a one time offer to farms to enable them to obtain substantial assistance for their restructuring programs as they will not be eligible for any subsequent program and would assume full responsibility for all debts and obligations if they failed to meet the agreed 16 - profitability targets. Of the 17 remaining farms, one was not included in the analysis due to exceptionally poor weather conditions over the period, 12 are expected to come to financial rescheduling and arrangements with their creditors and four are expected to be liquidated. The program is generally thought to be a successful endeavor as 64 farms were restructured with reduced staff, changed management, revised organizational structure, and new products with a higher rate of market acceptability. In addition, profit taxes (34X) paid by the successf.ul farms due to the program contributed annually about Ft. 185 million to Government revenues. 3.14 In addition to following through on the 1987-91 debt reduction program which would terminate in 1991 when the third group of farms completes its three-year testing period, Government has announced, with the cooperation of the commercial banks, a new four-year debt reduction program which will begin in 1990. Under this program, Government has allocated Ft. 3,350 million to assist some 220 farms, including p-tvate sector operations if they qualify as severely indebted enterprises based on their 1985-88 record. Details of the operational aspects of the program are not clear except that the State will not forgive debt as under the previous program but would swap debt for equity and expect a 15 percent per annum dividend on that placement. Commercial banks would negotiate with their clients in each case to determine whether the former judge the farm as a viable, profit-earning venture. The - banks would be free to reschedule principal and interest payments, reduce the D interest charged or forgive a share of the debt. C. Imnact of Bank Lending in Agriculture 3.15 Bank projects in Hungarian agriculture introduced the country to low cost, modern machinery which embodied the technology required by the agricultural sector to maintain their competitiveness in world trade. In 1983, the Bank signed the first agricultural loan to Hungary and since then, three additional loans have been effective. The Grain Storage and Farm Mechanization Project (1983, Ln. 2316) was the first Bank operation in Hungary and has been followed in the agricultural sector by three other projects: (a) Integrated Livestock Industry Project (1985, Ln. 2510); (b) Crop Production Improvement Project (1986, Ln. 2738); and (c) Agroprocessing Modernization Project (1988, Ln. 2936). As summarized in the 1989 Project Performance Audit Report (Report No. 7924), the Grain Storage and Farm Mechanization project was highly succcssful mainly because it helped to relieve critical foreign exchange constraints and because it focused Loan proceeds of US$169.3 million on farm machinerv, grain storage, and fertilizers, all of which faced critical bottlenecks. Economy and efficiency in procurement were realized, so that the subborrowers benefited from good value for their expenditures. Grain production was increased, cost of production reduced, and investment under the project yielded a relatively high return. The livestock and crop projects are being successfully implemented and achieving their objectives of increasing revenues from exports and reducing unit costs of production through improved technology both at the farm level and the slaughterhouse level. Despite a slow start-up due to country - 17 - conditions, the agroprocessing project is making a favorable imparct on increased earnings from higher valued products as well as creating efficiencies in agroprocessing and export marketing. Besides the machinery and services purchased under the loans, a policy dialogue was established between the Bank and Government which resulted in a substantial change in official thinking about agriculture, liberalizing the sector and giving it a legal framework for future privatization of assets in farming. In general, Bank involvement in the sector has resulted in: (a) incorporating economic and financial analysis in all investment decisions; (b) discontinuing highly subsidized production programs of soybeans, corn and land improvement; (c) phasing out administrative controls on producer prices; (d) reducing overall subsidies to the sector; (e) establishing export marketing services for agricultural products; and (f) breaking up of the commodity trusts in ooultry, meat and grains. IV. THE PROJECT A. Concept. Desig-n and Obiectives 4.01 The concept of the project is to encourage commercialization of the private, small-scale farming sector and modernization of large-scale farms under the umbrella of the national economic reform program. Overall reductions in Government subsidies and in regulations restricting decisions by farm managers are creating a new sense of financial responsibility in the agricultural sector. On an experimental basis, large scale farms are leasing And, in special cases, selling assets to private farmers organized in groups or as individuals under a variety of contractual arrangements. Commercial credit needs are rapidly developing to finance these new ventures, and innovative ways to secure loans from commercial banks to private operators are required. Similarly, large scale farms are restructuring their product mix according to its impact on profitability and on exports. In order to achieve an effective supply response, large scale farms require commercial credit and supporting services so as to coordinate their production with existing and planned processing capabilities and with effective market demand. 4.02 The dasign of the project focusses on managers of reso rces of the different farming units in the country and attempts to proviJe technical assistance, training, investment and working capital as means of promoting change in the production-processing-marketing system. The sequence and intensity of the changes in the way agriculture operates in relation to a market based economy are a function of the incentives and supporting services available to farm managers. However, the broad measures promoted by the economic reform at the policy level are yet to be adequately articulated and implemented in terms of operational experience at the farm and processing levels. The proposed project blends a mix of investments at these levels with changes in policy and institutions which are interrelated and follow from the on-going dialogue between the Bank and Government on agricultural policy within the framework of the economic reform program agreed with the Bank. - 18 - 4.03 The project is also designed to strengthen the system of financial institutions by improving their capability: (a) to cater to the demand for credit from a new group of farmer clientele resulting from the restructuring of the sector; and (b) to evaluate investment proposals. It also proposes to broaden the borrowing capacity of &gricultural cooperatives and of private farmers by making land mortgageable. Some commercial banks view the emerging private farmers as a profitable clientele and are equipping themselves to provide credit service to them to a larger extent than at present. 4.04 The project is based on a line of credit through the banking system. Credit is limited to agriculture because of the present needs for investment capital to restructure the agricultural sector and increase its international competitiveness. To keep segmentation of the credit system to a minimum, credit allocation within the sector will be decided exzlusively by the banks on the basis of demand and their lending policies and procedures. The project makes available investment capital to strengthen the comparative advantage of the agricultural sector with particular focus on private, small scale farmers who are entering into the commercial credit system for the first time. Such long term resources are expected to act as a catalyst for improving the efficiency of the sector and making agricultural beneficiaries more familiar with the use of commercial credit. The project is entirely financed through the banking system, because in th12 phase of transformation, the institutions outside the banking sector (,re not capable of assuring the delivery of significant amounts of investmjent funds. When the sector becomes more profitable, the capital market may be expected to become an !nportant source of funds to the private sector. The loan delivery system has been designed in accordance with the requirements of the FSMP. Interest rates reflect market rates and are determined with due consideration of the financial and operating costs of the intermediary institutions, the rate of inflation and the foreign exchange risk. 4.05 As an integral part of the production-processing chain, private, small scale farmers, who currently account for about one-half of value added in agriculture, wiil be given the opportunity under the project to have greater access to land, supporting services and commercial financing for the long term development of their agricultural activities. It is expected that such financing would flow to private farmers from commercial banks, directly, as individuals or as members of small sized cooperatives, associations or joint ventures or, indirectly, through large scale farms. B. Project DescriRtion 4.06 The project would principally consist of a line of credit defined through criteria and guidelines of the commercial banks to provide funds for investment and incremental working capital for agricultural enterprises to improve their operations, reduce their unit costs and increase their contribution towards exports. Investment funds would finance planting material, br\eeding stock, equipment for the improvement of crop and livestock - 19 - production, forestry, non-agricultural activitiesW of agricultural enterprises like servicv} and manufacturing, and storage and commodity handling facilities of both private and state owned agricultural units. The project would, in particular, finance small scale farming equipment, pick up trucks and small tractors which are designed for private farmers. Virtually all project investments would be used to produce high quality products, exportable to the convertible currency markets. Funds would also be made available to farms and marketing firms for marketing and sales promotion as well as business planning. Considerable training and technical services to be financed through grants from donors would be incorporated into the project in the areas of private, small scale farmer support, agricultural and food marketing and domestic market structure, agricultural insurance and technical services for livestock. It would also further enforce the existing regulations for environmental protection, particularly from water pollution on the proposed farms to be financed under the loan. 4.07 Potential project beneficiaries would be a wide range of clients who can be categorized into two groups. The first group includes private, usually small scale farmers, part time farmers who are members of agricultural cooperatives and employees of state farms, farmers organized into groups, contractors of farm services and rural entrepreneurs engaged in activities supporting agriculture or agroprocessing enterprises. The second group includes large scale farms and their subsidiaries, and agents engaged in the marketing and processing of agricultural products. In the interest of coordinaticn with the ongoing Agroprocessing Modernization Project (Ln.2936- HU), only farms with agroprocessing units and small scale entrepreneurs with annual sales of less than US$2 million would be serviced by this project. Nonagricultural activities of farms and rural entrepreneurs would be financed under the project up to US$500,000 per subloan; larger requests would be met under the ongoing Industrial Loans. Large scale farms would reduce unit costs and reorient their operations toward greater profitability and exports by adopting business planning which would help modernize the manner in which they identify their markets, carry out their operations and take financial decisions. Commercial banks would provide financing of investment for rehabilitated large scale farms. Private farmers would be promoted as clients for commercial credit either as individuals, groups or through the large scale enterprises. Annex 4 gives a schematic outline of how project components support the achievement of project objectives. v' Non-agricultural activities include a variety of small scale agroprocessing activities, services and small, usually labor intensive, manufactured goods such as office furniture, plastic products, and household novelties and village tourism. - 20 C. Cost and Financing Estimated Costs 4.08 The total cos: of the project is estimated at US$274 million (Ft 16,000 billion equivalent), of which US$122 million (45 percent) would be foreign exchange, as shown in Table 2. Table 2: PROJECT COST StMIARY - Total -----(Ft M) ---(US$ M)-------- 2 Foreign Base Local Foreign Total Local Foreign Total Exchange Costs A. Crc.p Productiou i.3a4 3,152 4,456 22 52 74 71 37 B. Latetot. Production 1,949 575 2,524 32 10 42 23 21 L C. lZorticlaura 1,111 107 1.219 18 2 20 9 10 D. Agroprocessing & Other 1,116 1,642 2,751 19 27 46 O0 23 E. Trade Infrestructure 186 227 413 3 4 7 55 4 F. Services & Training 510 in 638 9 2 11 20 5 Total Baseline Costs 6,178 5,830 12,008 103 97 200 49 100 Phyuical Contingencies 618 583 1,201 10 10 20 49 10 Price Contingencies 2,378 880 3,258 39 15 54 27 27 Total Pfoject Costs 9,174 7,293 16,467 152 122 27.. 45 137 NOTE: Nuimibers may not add up due to rounding. 4.09 The base costs were derived from feasibility studies, net of taxes and duties, and adjusted by the appraisal mission to prices of November 1989 at the exchange rate of 6OFt/US$. Price contingencies for foreign exchange costs have been allocated at 4.9 percent in 1990-95 and for local costs at 15 percent, 12 percent, 10 percent, 8 percent, and 7 percent in 1990-91, 91-92, 92-93, 93-94, and 94-95 respectively. Taking into account the rehabilitation of buildings and other civil works and quality differences of equipment, physical contingencies were set at 10 percent of base line costs. The project funds are expected to be committed by December 1994 and project activities completed by June 1995. See Annex 5 for detailed cost tables. 4.10 A Bank loan of US$100 million is proposed to cover about 36 percent;of total project cost and about 82 percent of the estimated foreign exchange component. The Bank loan would not finance taxes and duties. As shown in Table 3, additional financing required for project implementation would be provided by: (a) NBH and commercial banks (US$107 million or 39 percent of project cost); (b) sub-borrowers in the form of equity contributions (US$$2 million or about 19 percent of project cost); (c) Government (US$1 million or 0.4 percent of project costs); and (d) OECD donor agencies for training and technical services (US$14 million or 5 percent of project cost) and while most of the funds for this component have already been committed, the Government continues to seek donor financing and has undertaken to assure the provision of the funds required for full implementation. The Bank loan would be made to NBH for 15 years including a five-year grace period at the Bank's standard variable interest rate. -21- t SOURCES OF FINACING (US$ Millions) UB8I Camnrcial Government Project Banks Contribution Beneficiaries IBRD OECD TOTAL Squipment & services / 54 - 36 10 - 19o Civil Works 53 - 16 - - 69 Tecbnical Services _ -X _ _ 1 1 TOTAL 107 1 52 100 14 274 Percentage Distribution 392 12 192 36X 52 100l D. Procurement 4.11 Internas.ional competitive bidding (ICB) would apply for contracts greater than US$300,000 while prevailing commercial procedures which are acceptable to the 3ank and which include obtaining price quotations from at least three suppliers would apply for contracts less than US$300,000 for farms and enterprises. However, ICB and LIB procedures may be used in cases where such procedures would produce a distinct competitive advantage. Goods and technical licenses which the Bank agrees are: (a) proprietary; (b) the timing is critical for efficient project execution; or (c) needs to be compatible with other installed equipment, would be procured through direct negotiation with the proprietor on terms and conditions acceptable to the Bank. Experience from recent farm machinery and equipment procurement for large scale farms confirms that ICB procedures have had a significant impact on equipment prices. Host foreign equipment manufacturers are already repre.aented in Hungary, and competition is strong. Although prices for equipment procured through ICB are about 5-7 percent lower compared to "off- the-shelf" local shopping, it takes at least six months to arrange an ICB farm machinery package compared to a few weeks for direct purchase. However, while the number of suppliers for servicing large scale farms and enterprises is large and growing, suppliers for private, small scale farms and small agroprocessing ventures are just getting established. Distribution of equipment and supplies for the private sector is carried out by local organizations (e.g. Hermesz, AFESZ, TSKER, SKAIA, etc.). While the existing network remains inadequate, major improvements are expected shortly as many Hungarian companies, associations and cooperatives are in the midst of negotiations with foreign manufacturers to establish dealership and service networks. Also, MEM vigorously supports market entry of major manufacturers of small scale equipment and supplies. Procurement arrangements for the project are summarized in Table 4 and show approximate amounts by procurement method. All arrangements would be in eccordance with the Bank procurement guidelines. -22- Table 4: PROCUREMENT (US$ Million) Proiect Element ICB LIB Other Total Civil Works a/ - - 69 69 Eqqipment k/ 50 37 103 c/ 190 (50) (10) (40) (100) Technical Services - 15 15 TOTAL 50 37 187 274 (50) (10) (40) (100) a/ Civil works, mainly remodeling, executted by force account, not r being financed by the Bank. T/ Includes incremental working capital and services such as business planning and marketing i Standard commercial practices acceptable to the Bank. NOTE: Amount from Bank loan is in brackets. 4.12 Total amount of Bank loan funds to be used under ICB for equipment purchase is estimated at US$50 million. The equipment to be purchased under the project would include machinery and goods for private small scale farming such as small sized tractors, soil preparation, cultivating and harvesting equipment, feed mills, pick-up trucks, wagons, storage equipment', electric fencing, animal treatment handling items, manure spreaders, milking machinery, green house irrigation equipment and small chilling chambers. Also, private farmers would purchase some construction materia1s for remodelling of their facilities, which they would, most likely, 'carry out on their own. Large sca4e farms would purchase a wide variety of equipment and materials including large scale tractors with complete sets of associated implements, combine harvesters, plows, discs, diggers, harrows, drainage canal cleaners, heating systems for poultry grow out sheds, feeding storage tanks and conveyors, automatic barn cleaners, animal treatment equipments trucks, wagons, a wide variety of agroprocessin& equipment, machinery for manufacturing of small consumer goods such as office furniture, plastic products, and household novelties. Consultants and services may be retained for export m4rketing by all farms and agroprocessing enterprises including those which currently may not be undertaking rehabilitation of their farms and plants; enterprises seeking project funds may hire consultants to help prepare medium-term business plans which would form part of the documentation for subloan requests from the commercial banks. Services and goods would be made available to enterprises, farms, foreign trading organizations and other trading entities \ \,\~~~~~~~~~~~~~~~~ - 23 - for marketing, and marketing development, training and technical services. Those technical services and training (paras 5.14-5.24) which are to be financed by donor grant funds would be purchased under the prevailing guidelines of the individual donor agency. 4.13 All bid packages for equipment, supplies and technical licenses estimated to cost over US$1.0 million equivalent, and bid packages for consultant services would be subject to the Bank's prior review of procurement documentation, including pre-qualification if necessary. It is estimated that such prior review would cover about 30 percent of the total estimated value of contracts. Civil works contracts, not financed by the Bank (about US$69 million total), would be procured under prevailing commercial procedures, whichi include obtaining price quotations from at least three contractors, and are considered appropriate. Asstutancos were Siven that subloan beneficiaries would follow the stipulated procurement procedures. E. Bank Loan Allocation and Disbursement 4.14 The allocation of the proposed Bank loan of US$100 million is shown in Table 5: Table 5: ALLOCATION OF BANK LOAN (US$ Million Equivalent) Z of Expenditures _______ gateaorv _Amount to be financed Goods and consultants, 100.0 100S of foreign expenditures services for onfarm and and 100X of local expenditures marketing develnpment .ex-factory cost) for goods and 75Z of local expenditures for goods and related services procured locally; 802 of local expenditures for services of consultants domiciled wiVtin the territory of the Guarantor andJl002 of foreign expenditures for services of othpr consultants; 100X of foreign expinditures for technical licenses and marketing activities For the project components, all disbursements for contracts valued at less than US$500,000 equivalent would be oia the basis of statements of expenditure (SOB) which detail the individual transactions; existing arrangements for SOEs at the commercial bank level were found to be satisfactory. The documentation to support these expenditures would be retained by the commercial banks, audited by independent auditors acceptable to the Bank, and made available for review by the Bank upon request. Withdrawal applications against contracts of over US$506,000 equivalent will be fully documented. Two types of subloans would be made under the project. In the case of the first, the Bank loan would finance 100 percent of goods and services directly imported by the subborrowers which would, generally,' be the large scale farms and marketing agencies. In the case of the second, the Bank loan would finance 75 percent of forint-denominated subloans to private small scale farmers and -24- entrepreneurs who would then purchase goods and services through normal business channels. 4.15 To facilitate the Borrower's access to the loan, NBH will establish a special account into'which the Bank would deposit from time to time amounts determined with reference to the actual need for financial resources as estimated. Th; special account would have an authorized amount - of US$8 million which would be adequate to finance reimbursement requests from ; participating banks. A record of all contracts financed and a permanent accounting record of operations financed would be kept by NBH and be aivfilable | for review by Bank missions upon demand. Payments from the special account would only be made for eligible expenditures indicated in the Loan Agreement. An audit report by an independent auditor oai the special ac¢ount would be prepared and submitted to the Bank no later than five months after the end of each fiscal year. 4.16 It is anticipated that the Bank loan will be completely disbursed by December 31, 1995 in accordance with the disbursement schedule givet in Annex 6. Disbursement experience was quite favorable in the case of the Grain Storage and Mechanization Project which became 'ffective in August 1983 and completely disbursed by December 1986. The Crop'Improvement Project is virtually completely committed and will close on schedule. The Integrated Livestock Industry Project has been broadened in scope and the loan is now 90 percent committed and will, most likely, also close on tchedule. The suggested disbursement period for the proposed project is accelerated relative to the disbursement profile of agricultural credit projects throughout the Bank and projects in,the EMENA region which both indicate a 10-year period. In addition to the favorable couittry experience in Hungary, project disbu;sement is expected to'be completed over about 5 years because: (i) lessons learned from previous operations are incorporated in the design of this project; (ii) part of the funds will go to many private farmers who will be requesting small, but quickly disbursed subloans; and (iii) large scale farms will be able to make more direct purchases from project proceeds than under previous projects. Nodel bidding documents prepared by the Hungarian authorities in,consultation with the Bank are being used to streamline procurement under the project relative to past experience. Also, the above mentioned special account will facilitate disbursement, particularly, siubloans to private farmers. 4.18 As an incentive to participating banks making subloans to private, small scale farmers, the Bank loan would retroactively finance all such subloans contracted after January 1, 1990, which are expected to amount to less than US$10 million, 10 percent of the, ,Loan amount. F. Environmental Imnact 4.19 The potential unfavorable environmental impact ok the project would mainly consist of air and water pollution resulting from agroprocessing enterprises and ground and surface water rollution resulting from farm - 25 - chemicals. Theproject has been reviewed under the provisions of Operational Directive 4.00, Annex A, "Environmental Assessment" and placed in screening Category B. Projects in this category do not require environmental assessment; however, each of,the subproj\ects with a subloan size greater than US$150,000 to be financed under the project would be reviewed by the Ministry of Environment before approval for compliance with the relevant environmental regulations. Existing regulations for environmental protection, particularly for water pollution from the proposed farms under the project, have been reviewed and were found to be acceptable to the Bank. A Bank mission confirmed that Government places high priority on the quality of the, F environment and is implementing its laws and regulations in compliance with pollution control guidelines as set by the Ministry of Environmental Protection fot air pollution and solid waste; those guidelines were found acceptable by the Bank. Government imposes an effective graduated charge on 1 eLterntrises Waich cause pollution, and enterprises are finding it more PM economical to Install pollution control devices rather than pay the charges. Each subborrower has the responsibility of clearing his investment proposal with the Ministry of Environment before submitting his subloan application to the commercial bank. Assurances were obtained that each subproject would be undertaken in accordance with the country's safety, health and environmental standards. V. PROJECT IMPLEMENTATION A. Organization of Imnlementation 5.01 NBH will be responsible for onlending the Bank loan proceeds and monitoring the use of these funds. NBH would; (a) collect onlending information from all participating banks on a regular basis; (b) review the operations of commercial banks and, in general, review selected subloan appraisals; and (c) review and assist in the preparation of procurement documents. The Government, through MEM and tT as appropriate, will be responsible for management and supervision of technical services, training and extension (paras. 5.14-5.25) which would provide supporting services to project beneficiaries and financed by donor grant funds. These activities would include preparing terms of reference for consultants, contracting and supervising the works of consultants, and putting their recommendations into practice. In addition, project beneficiaries would directly contract productive services such as business planning (para. 5.04) and marketing services which would be finance by loan proceeds. 5.02 The key link in project implementation would be the relationship of commercial banks with investors. Both would need technical assistance as they move to commercial operations based on market principles and away from excessive Government involvement. Commercial banking operations are expected to improve considerably under the FSMP as it is to be implemented in parallel. The preparation of\\investment proposals, feasibility studies and business - 26 plans has been improving and would improve further by the entry of new consulting companies including joint ventures with foreign partners. 5.03 The MT would be responsible for the implementation of the marketing component and coordinate the work to be carried out under the project by the Agromarketing Office, a limited liability company, and the different government agencies, e.g. HUNGEXPO, KOPINT, charged with export promotion and trade. The commercial banks would be responsible for approving subloans and assuming the risk of the subloans, based on applications for large scale farms and enterprises which would include: (a) a business plan; (b) an investment feasibility study; and (c) a statement of creditworthiness. The banks would hire consultants from time to time on their own account to asslst them in undertaking assessments of potential subborrowers' business plans in those areas where special expertise is required. Subloan applications of private farmers and enterprises would include a two page U summaTy of the purpose and scope of the investment. E 5.04 Large scale farms seeking a subloan are expected to prepare a complete business plan, whose purpose is to assist the enterprise to improve its.international competitiveness by increasing its value added, improving its product quality, adjusting closely to market requirements, reducing costs of production and increasing productivity and direct export marketing and sales. Project beneficiaries may use consultants to help them prepare a business plan. As 'a result of the business plan preparation and its implementation, enterprises will be better positioned to export to the convertible currency market. A business plan would include the following elements: (a) history of the enterprise and its current situation; (b) analysis of the enterprise's product lines and marketing strategy; (c) evaluation of technological capabilities; and (d) organizational structure, management and information system. Within the context of the business plan, enterprises would also make projections of their financial statements with a view to bringing certain financial ratios, e.g. current ratio, liabilities to net worth, collection period, sales to inventory, assets to sales, and return of assets, up to the industry norm levels which will be made available by the commercial banks. B. 5.05 Nine commercial banks would initially serve as intermediary banks under the project. These are: (a) Commercial and Credit Bank (CCB), (b) Hungarian Credit Bank (HCB), (c) Budapest Bank (BB), (d) Agrobank; (e) Inter Europa Bank; (f) General Bank for Venture Financing; (g) National Savings Bank; (h) Industry Development Bank; and (i) Mezobank, which will be participating in a Bank financed project for the first time. Other banks may participate in the project provided these can meet the general requirements, based on the stipulated criteria. Under the FSNP, it has been agreed that banks that intend to participate in that project would have to meet the following eligibility criteria: - 27 - (a) sound financial performance in accordance with requirements of prudential regulations, including capital adequacy. Preparation of three years' financial projections and plans to maintain and improve performance (including attainment of key financial performance indicators);2 (b) presentation of an institutional development strategy, includirtg plans with an implementation schedule to introduce efficient management in the bank; (c) commitment by the bank to carry out an annual external audit in line with international standards by qualified auditors;! and - (d) based on the audit under (c), the participating bank would makep C the necessary adjustments to Its financial position, including the establishment of adequate loan loss reserves and provisiotus, based on - the assessment of its loan portfolio according to pr-udent loan classification criteria. These requirements will also be the criteria for eligibility of banks under the present project, and their compliance will be monitored under supervision. The overall audit of the major banks by qualified auditors has already been completed. Further, as a measure to strengthen the commercial banks, Government would monitor the carrying out of portfolio audits of the three major commercial banks (BB, CCB, and HCB), and, based on the outcome of the audits, help develop and subsequently implement an action plan to restore, as appropriate, the solvency of the banks, including the possible contribution of necessary resources to ensure theftr capital adequacy. 5.06 The NBH will pass on the Bank loar, proceeds to the participating banks for a maturity not exceeding fifteen years while loans made by the intermediary banks to the final beneficiaries will have maturities of not more than 10 years, including a maximum grace period of three years. The signing of subsidiary loan agreements between NBH and two eligible intermediary banks would be a condition for loan effectiveness. NBH would bear the risk of exchange, for which it is covered by a variable spread (currently about 9 percent), between the Bank lending risk and its refinancing rate of 17 percent (para 2.21). a Indicators were made available to NBH and Participating Banks under FSMP. A/ Audits are to be carried out according to terms of reference which were agreed under FSMP. pl The three major banks, CCB, HCB and BB, already had, by March 1990, external audits carried out by international auditors acceptable to the Bank. The financial performance of most of the smaller banks is expected to be better than the three major banks as the former did not iWherit loans from the NBH when the two tier banking system was initiated. \ \~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~K 28 - 5.07 NBH will onlend the Bank loan proceeds to the participating institutions at its prevailing refinancing rate (currently 17 percent per year), which is adjustable to reflect changing economic conditions. NBH, pursuant to its credit policy guidelines, has raised its refinancing rate regularly in the past to keep it positive in relation to anticipated it:lation. The recent increase by three percentage points would help to achieve this objective; domestic inflation as measured by the producer price index was 15 percent in 1989 and is expected to remain at that level for 1990 (para 2.21). In connection with the FSMP, the Government has agreed that, with a view to achieving a positive rate in real terms, the refinancing rate of the NBH will be so set as to be sufficient to cover: (a) the NBH's average cost of funds; and (b) the projected differential between the domestic and international inflation rates, and that these principles would continue to guidt the refinancing rete for the Bank loan in the future. Given this - assuratnce, the satisfactory adjustments by NBH in the level of che refinancinig rate in the past, and the desirability of avoiding segmentation of 4nterest rates by imposin& special onlending rates for Bank funds, proceeds of the Loan would be on-lent to the participating inistitutions at NBH's prevailing rate. Refinancing of local currency expenditures would similarly be at NBH's prevailing refinancing rate. As regards the rates charged by the participating banks on sub-loans, each of the banks has adopted a lending and investment policy statement which specifies that interest rates charged on subloans would conform to the principles of: (a) adequate margin to cover the bank's average cost of funds, administrative costs and provisions for doubtful loans; and (b) positive rates relative to inflation. The NBH will monitor the compliance with such statements through subsidiary loan agreements; the relevant data would also be made available to Bank supervision missions to confirm the continued compliance of the participating banks with these onlending principles. 5.0$ Intermediary banks would use the proceeds of the Bank loan based on their planuned requirements for funds to onlend to their clients over the disbursement period of the project. As a measure to transfer greater responsibility to irtermediary banks than under previous Bank loans, these banks would be required to pay a commitment fee on the indicated amount of Bank loan proceeds for which they bid. As the maturity of the NBH loans to the banks would be longer than that of their subloans, intermediary banks may retain the amounts received by them by way of repayments of subloans and relend such funds to eligible subborrowers for financing similar subprojects, provided that such sums are not immediately required for repayment to NBH. 5.09 Intermediary banks would employ sound financial practices and evaluation standards in implementing the project. Project beneficiaries with subloans greater than US$300,000 would be required to satisfy the following criteria: (a) subprojects must provide a projected financial rate of return - 29 - and economic rate of return of at least 12 percent0; (b) enterprises should have a satisfactory financial position as indicated by a current ratio above 1.3, a debt/equity ratio not exceeding 65/35, and a debt service coverage above 1.5; (c) enterprises would prepare business plans which would indicate their markets, operations and financing arrangements; and (d) the bulk of the output of the activities financed would be exportable for convertible currency. Subloans below the limit of US$300,000 will be evaluated according to the current procedures of the banks which were found to be satisfactory. As per current practice, the banks will review such loan requests with reference to the rates of return on the investments proposed, and the type of cultivation and production associated with the investments, and the creditworthiness of the subborrowers based on their balance sheet and income and expenditure statements, and their past repayment performance. C. Small Scale Earm rr 5.10 This component would enable private, small scale producers to engage in the production of commodities for which they have a comparative advantage. The subloans would fitance farm inputs, planting material, breeding and fattening livestock, equipment, farm machinery, building construction and other fixed investments and working capital requirements of the farm. Private farmers are expect-ed to seek subloans of an average US$10,000 equivalent of which a portion of the subloan financed from Bank sources would be used mainly for purchase of equipment but with some purchases of construction materials. The portion of the subloan financed by sources other than the Bank loan may be used for the purchase of additional land by farmers who are expanding their farm operations to go into full-time farming. A two-page farm plan and budget indicating how the investment fits into their overall farming operations would be sufficient to support the loan application. Assets to be acquired from loan proceeds would be accepted as collateral. Private individuals would be acceptable as sureties or guarantors - provided they possess the necessary assets. Marketing contracts could also be accepted as security for loans. Though no funds have been earmarked for;loans to private farmers under the project with a view to avoiding )segmentation, there are strong grounds to expect that the banks will be significantly active in financing such farmers as contemplated under the project. The banks recognize that these farmers account for 50 percent of the value added in agriculture and that because of their intensive cultivation practices, their production is of high qualitr and largely export-oriented. Their past record in respect of loan repayments is also creditable, as seen from the experiende pi ERR is a proxy for the opportunity cost of capital in the country which is estimated to be about 12 percent and, therefore, all subprojects should meet this threshold level. The FRR is also set at 12X in constant prices as it is considered adequate to provide a sufficient margin for beneficiaries to repay the principal and interest on their subloans, particularly since beneficiaries would also agree to meet the debt servici coverage rati85 of 1:5:1. 30- of the NSB which has been active in this respect. Many of the small farmers have also been finding innovative ways of operating efficiently either as members of groups or with links to large farms or joint ventures. The flexible procedures proposed under the project for lending to small farmers would also help the flow of credit to them. Taking into account these factors and tae exnected transfer of assets from the large farms which would increase the land held by the private farmers and their capital base, the banks look upon such farmers as constituting a dynamic subsector of Hungarian agriculture and are equipping themselves to serve such clientele efficiently by expanding their network of branches and related staffing. It is understood that loans of the order of US$35 million equivalent were advanced by banks to private farmers in the first quarter of 1990. 5.11 Under the Third Industrial Restructuring Project (Ln.3020-HU), provision was made for the development of the capacity of the banking system to cater to small businesses. Each participating bank was required to prepare a small business credit manual containing procedures and specific viability - criteria. To date, approval by the Bank for such a manual has been obtained by nine participating commercial banks. In addition, these banks have established special units to handle small scale loans. Assurances were obtained that intermediary banks would assign or hire a full-time qualified agricultural credit officer for each branch which has reached a level of 200 loans granted to small scale farms per year or which has reached a level of 1,000 loans in its loan portfolio. 5.12 The proposed project would utilize the existing evaluation standards and organizational structure of each intermediary bank in processing i the loan applications of small scale farmers. However, considering the relatively smaller size of these enterprises and their special characteristics, some guidelines would be suitably modified. Each, intermediary bank would prepare for their credit officers the following information: (t) activity models for selected livestock and crops which would give an indicat.on of the projected cash flow of selected activities, rough estimates of rLLeir repayment capacity and returns to family labor; (b) availability of market outlets; and (c) product prices to farmers. Assurances were obtained that a training program for 'preparing intermediary bank staff to service private, small scale farmers would be incorporated into the ongoing bank training program. The International Training Center for Bankers established in February 1989 has entered into a joint venture agreement with the Paris-based Centre Internationale de Formation de la Profession Bancaise. Its courses are aimed at the middle management levels in the banks and other financial institutions. 5.13 In evaluating the eligibility of individual borrowers, each intSrmediary bank would consider their farming experience, adequacy of assets and repaying capacity based on income from the proposed enterprise, income from other sources and taking into consideration the level of family expenditures. The subloan would be for a period of up to 10 years including a three year grace period. The lending guidelines developed by intermediary banks would be reviewed regularly in the course of Bank supervision of the project. 31- D. Technical Assistanct and Training Agricultural and Food Maiketing 5.14 The liberalization of domestic and foreign trade implies new approaches to product marketing. Large farms, cooperatives, wholesale and trading companies will hirG traders for their new commercial department. Similarly, agroprocessing firms will need product managers as well as a whole range of marketing specialists in their food marketing departments. Two different types of skills will therefore be greatly needed: (a) agricultural marketing specialists in charge of commodity type of products, on the domestic as well as the foreign markets; and (b) food marketing specialists in charge of a company's product differentiation (using a specific marketing-mix for the product) and the merchandising of it. A training program in agricultural anda food marketing has been agreed with Government to: (a) fill an educational gap - toward a market oriented economy; and (b) lay the basis for a self designed agricultural market organization by Subsector Interprofessional Organizations - (SIO) (para 5.17). Over the five year project period: (a) two hundred young executives and undergraduates will attend masters' programs in North America and West European Universities and Business Schools; and (b) another two hundred executives will participate in three to four weeks training sessions abroad. Finally, two-day seminars respectively on agricultural marketing and food marketing will be run every year in Hungary, with the participation of foreign speakers and Hungarian specialists. Commodity Exchange Development 5.15 Three major Hungarian banks and three trade companies have formed the Hungarian Agricultural Commodity Exchange (TTK). Its first task is to cdncentrate on market operations of commodities such as grains and protein feeds. When operating in a more liberal pricing environment, TTK would serve as an exchange for physical delivery of the products and also as a hedging tool against price fluctuations, i.e. future market. TTK is a non-profit organization in charge of organizing the exchange, forwarding market information and organizing training courses for brokers, commission hovtses and other professions. Consultants would be hired to help: (a) design the commodity exchange according to existing international standards; (b) establish an independent Clearing House for transactions which would guarantee deliveries and payments; (c) create an electronic monitoring and mailing system for the Exchange; (d) organize the delivery procedures including standardizing futures contracts; and (e) organize seminars in Hungary for training local operators on commodity market trading. MarketJInformation Service 5.16 MEM has recently begun the operation of a Market Information Servi.ce (MIS) whiich seeks to collect, process and publish price information about food and agricultural products with the initial efforts focussed on the fruit and vegetable whQlesale markets; sstbsequent efforts will include all the major wholesale markets at the subsector level, e.g. cereals, livestock, small 32 - animals. In the process of facilitating the development of a market oriented economy, the component would facilitate the supply of price infor¶ation to professionals operating in the agricultural marketing chains. The developmant of MIS into a full fledged operating system would require a three-year period and include hiring and training of staff with similar organizations in 1hestern Europe, improvement of the computer and telecommunication equipment, and the publication of wholesale price information (in-country as well as indicative international market prices). Subsector Interprofessional darketing Organizations (SIO) 5.17 MT will facilitate the establishment of SIOs which will include representatives of small farmers, state farms, cooperatives, wholesale trading companies and retail industries. Two or three SIOs are expected to be organized annually. The SIOs will cover all the major agricultural sub- sectors: fruit and vegetables, meat and livestock, dairy, cereals and oilseeds, sugar and sweeteners, wine, tobacco, wool andl others. They will be in charge of (a) efficient exchange systems at the wholesale level for raw products and, when applicable, for first processed products; (b) information transmiss'on and intermediation between Government and members of SIO; and o (c) generic products promotion, domestic and abroad. Technical assistance by Hungarian and foreign consultants will assist the SIOs in preparing working sessions and technical proposals. Where relevant, SIO members will visit marketing institutions abroad including (a) foreign SIOs; (b) auction markets; (c) future markets; (d) wholesale markets; and (e) retail companies. Agricliltural Insurance Scheme 5.18 Two general insurance companies, both owned by Government, offer agricultural insurance to large scale agricultural enterprises and, to a limited extent, to individual farmers. Two years ago, multi-risk coverage was discontinued, and single risk coverage is now available for hail, frost and flood to large scale farms but only for hail to private farmers. Damage due to drought is covered under a special arrangement with the Government. The companies enjoy a subsidy from the Government equal to Ft 500 million yearly to partially cover losses for frost and flood damage but this will be withdrawn by the end of 1991. They will now have to develop their agricultural operations on a commercial footing if they are to continue such operations. As a basis for determining future actions a consultant study would be commissioned. 5.19 The major objective of the study would be to assess the present stage of development of the agricultural insurance system, identify problems, recommend solutions atid propose a long range strategy to develop the system on a commercial basis. On the technical aspects, the study would assess the type of coverage offered and the procedures in underwriting, supervision and loss adjustment as well as identify the need for adjustment in actuarial calculations. On the organizational. 4spects, it would determine actuarial capability and identify the need for additional manpower and training; it would alsa determine the organizational capability for loss adjustment, considering the need to expand coverage of private farmers. In general, the - 33 - study would examine the linkage between the agricultural insurance companies and lending institutions and assess the merits of establishing a calamity fund by goveitnment to cover risks which would not normally be covered by commercial insurance. Training Farm Managers in Business Plannin& and Marketing 5.20 With a view to familiarizing a group of progressive managers of large scale farms with modern business planning and marketing, a program would be prepared for training in Hungary and abroad at an acceptable management institute. The program would be organized by HEM and the Training Institute of the Agricultural University of Godollo and would train about twenty farm managers and trainers in this material during a six week course. The program would cover the following topics: (a) strategic farm/business planning; (b) marketing; (c) economics/finance; and (d) training methods for improved management. Imail -ggNEL Indu_t1&ry for Business Planning 5.21 Due, in part, to the paucity of technical services in business planning, financial management and accounting, many farms and enterprises are not aware of the usefulness of these modern tools for managing their operations. Foreign consultants have proven to be too expensive in terms of foreign exchange needs and not always fully responsive to the special circumstances and constraints faced by Hungarian firms. Bank funds are available under the Third Industrial Restructuring Project (Ln.3020-HU) to help local firms finance joint ventures, contract foreign consultants, purchase computers and software and make other arrangements to the benefit of ri the foreign as well as the local consulting firms. Commercial banks may also be expected to extend the requirement of enterprises preparing a business plan along with their subloan application to all their loans, and not only for the World Bank supported project subloans. In order to stimulate interest among enterprising individuals and expansion of services of existing consulting companies, MEY and commercial banks would jointly hold a seminar in Budapest for local and foreign consulting companies to exchange informatlon and know- how with a view to possibly entering into joint ventures in the area of business planning, financial management and accounting. MEM and the commercial banks would also prepare a program of training for local entrepreneurs. Training of Private Farmers 5.22 The four major agricultural universities and fifteen agricultural schools would develop family sized demonstration farms which will be used as centers for training private farmers directly as well as for offering special training to those managers of large scale farms who are in charge of integration of the small scale farmers into their operations (either on a contract basis in terms of growing out animals, e.g. poultry, pigs, beef cattle, or supplying the large scale farms with produce which they, in turn, markets through their wholesale or retail network). This training would concentrate on farm management; livestock farming; crop production and farm - 34 - mechanization; and focd technology. These institutions would send a group of 30 trainers abroad for training in how to organize and implement training programs; how to set up demonstration farms and make the best use of them as teaching tools; how to teach farm management to private small scale producers; and how to strengthen the decision making tasks of small scale farmers through methods of farm planing and budgeting. Extension Service for Private Farmers 5.23 Based on initial work carried out by the Government with technical support from the rural extension service of the Ministry of Agriculture and Fisheries of the Netherlands in December 1989-February 1990, Government would carry out a study with the assistance of foreign consultants to determine the lines on which extension arrangements are to be established for private, small scale farmers. The principal beneficiaries of an extension system would be independent private farmers; integrated, small scale farms; and new groupings of farmprs in the form of specialized cooperatives. While the study is underway, several training activities will be organized and implemented to provide a running start on staffing and training extension agents. The findings and recommendations of the consultants on an extension program would be discussed in a national forum attended by different interest groups within and outside of Government, before further steps are taken. Livestock Advisory Services 5.24 The Livestock Advisory Services which were established independently of MEK in 1983 have not proven to be a profitable or responsive system. The current six regional service groups cerry out several services to livestock farmers such as artificial insemination, herd registration, animal performance testing and others. In order to improve the effectiveness and the profitability of these services, a consultant study would be undertaken to identify the weaknesses in the present organization and recommend modifications in the system including the relationship of the service centers with the newly formed Animal Breeders' Association and the Chamber of Agriculture and adoption of the success factors of similar service centers in Western European countries. The terms of reference for all the above training and technical services are found in Annex 7. E. Reporting. Auditing and Supervision 5.25 Semi-annual and ann.ual progress reports would be jointly compiled by NBH, MEM and MT. The NBH controller's office would set up a project account at the start of the project and the participating banks would keep a detailed record of all subloans extended under the project, whether financed with Bank or NBH funds. The intermediary comme-.aial banks wou3d submit summary sheets for approved subloans to NBH, indicating: (a) up-to-date project financial status, (b) the type of subloans financed, and (c) the respective sources of finance used such as 'Bank funds, NBH funds, beneficiary equity contributions and Government subsidies. In the case of subloans to - 35 - small scale producers, detailed information such as: (a) characteristics of beneficiaries, (b) type and volume of subloans financed, and (c) recovei' performance, wo4sld be summarized and reported by branch. This information would be used by NBH to monitor progress of the project. MEN and MT would provide annual reports to the Bank on the non-lending aspects of the project. 5.26 NBH would furnish to the Bank, within five months after the end of each fiscal year, a report of the project accounts, audited by independent auditors acceptable to the Bank. NBH would also retain the annual audited financial statements of institutional borrowers for Bank staff review during supervision missions. Within six months after the closing date of the Bank loan, NBH will prepare and furnish to the Bank a project completion report dealing with the implementation of the project, and the cost and benefits derived and expected to be derived. All project accounts, the revolving funds, statements of expenditure, and the financial statements of project entities receiving a subloan greater than US$1 million equivalent will be audited at the end of each fiscal year by independent auditors acceptable to the Bank. Short form annual audit reports for the preceding fiscal year will be sent to the Bank no later than the end of May each year. The annual financial statements of the intermediary banks will also be audited by independent auditors acceptable to the Bank at the end of each fiscal year. Assurances were obtained that the above-mentioned reporting and auditing requirements for the project would be carried out by intermediary banks, NBH and Government. 5.27 Project supervision would be carried out in line with the other agricultural loans to Hungary in the Bank portfolio as all these projects seek to achieve either directly or indirectly, apart from their specific objectives, increased revenues from exports and improved efficiency in the operations of farming and agroprocessing enterprises within the context of the economic reform program. There are three fundamental categories of actions to be supervised in the project: (a) onlending to project beneficiaries (para 4.07) by commercial banks; (b) technical services and trainins' financed by donor grants and managed by MEM and MT (paras 5.14..5.24); and (c) completion of agricultural policy actions (para 6.04-6.12). Regarding the onlending operations, Bank financial staff will coordinate their supervision with NBH in reviewing the interest rates charged to subborrowers, the strengthening of the commercial banks in servicing private, small scale farmers, the quality of subloans, procurement and disbursement of Loan proceeds. The supervision of technical services and training will require expertise ir marketing and market development and agricultural training. Agricultural policy changes will be monitored by Bank economists according to the dates by which specific polisy actions are to take place. Bank missions should supervise the project at six months intervals and allow for about 12 staff-weeks/year for the first two years of project implementation and, after that, the manpower requirement can be adjusted according to the need to solve problems and accelerate project implementation progress. 5.28 Monitoring of project activities will be undertaken by the commercial banks regarding the onlending operations, by the MEM and MT regarding the technical services and training components and by MEM regarding - 36 the agricultural policy actions. Annex 8 contains the formats for the monitoring of the onlending operations, including procurement, commitments, disbursements and suummary sheets of approved subprojects by commercial banks. VI. AGRICULTUAL POLUCY CHANGES A. Producer Prlces 6.01 As a result of the continuing policy dialogue which includes Bank sector work, studies on special issues carried out by Hungarian research institutes and project preparation work, several critical policy issues were identified which need to be addressed in order for the sector to proceed further toward liberalization, improved productivity and financial discipline. Some of these 'issues also form part of the proposed SAL as they are directly linked to the overall performance of the economy. Producer prices in the agricultural sector constitute a major policy issue in this perspective. 6.02 Relatively low profitability and flagging international competitiveness of Hungarian agriculture have led to a realization that producer prices need to reflect international prices as an efficiency standard. Though Government is concerned about the effect of price liberalization on consumer prices of foods, on earnings from food exports and on farmers' incomes, it is now recognized that gains from an unregulated pricing system will outweigh any unfavorable effects and accordingly, all agricultural prices except for milk and wheat were freed with effect from January 1, 1990. Annex 9 shows the evolution of price liberalization from 1988-90. B. Subsidies 6.03 Negotiations between the IMF/Bank and Government have resulted in a significant reduction in the Government budget deficit mainly caused by subsidies which accounted for 17.5 percent of GDP in 1989. The Government is committed to a progressive reduction in the level of suzbsidies, especially those that primarily benefit producers. The share of subsidies in GDP, which includes consumer, producer, investment and housing sector subsidies, is expected to be reduced from its 1989 level of 13.2 percent of GDP to no more than seven percent in 1991 and no more than five percent in 1992. 6.04 In the agricultural sector, subsidies constitute one of the instruments which Government uses to influence decisions by farm managers as well as to support investment, production and exports. However, there has been some withdrawal from Government intervention as indicated by the reduction of subsidies ii the sector at a rate which has exceeded the rate of reduction of all subsidies. Agriculture's share of subsidies is expected to decline from 3.2 percent of GDP (Ft. 57 billion) In 189 to about 1 percent in - 37 - 1992. Assurances were obtained at negotiations that Government would maintain and monitor its program for the reduction of investment, production and export subsidL.es to the agricultural sector within and consistent with the overall subsidy reduction program. By December 31, 1990, Government would reduce all agricultural subsidies by at least one third of the agricultural subsidies in effect during the 1989 calendar year calculated in current prices. Before the end of each calendar year, the Bank would review: (a) progress in achieving targeted subsidy reductions; and (b) the new target to be achieved during the next calendar year. Government would take into account the Bank's comments on such new target in preparing the final proposal for the following calendar year. After the one-third reduction in 1990, only 20X (US$ 118 million) of the remaining subsidies would be in the priority areas for further reduction, i.e. outside of export, rural infrastructure, and income support programs. Investment subsidies to farms will be eliminated and replaced with an investment tax credit which would accrue only to those farms which pay profit taxes. The intervention fund which allows Government to intervene in disrupted markets from time to time, would be eliminated. (Annex 10 gives details on Government's indicative subsidy reduction program.) 6.05 Export subsidies are the most important and the most difficult to reduce in agriculture because of the variety of supports given by Hungary's competitors in overseas markets. Agricultural trade accounts for about US$1.7 billion of Hungary's exports which is equally divided between the CMEA and the convertible currency markets. In the CMEA market, prices are used as units of account in transferable rubles based on barter trade except for "hard" goods such as meat and poultry which account for one third of the trade with the Soviet Union and are denominated in US dollars. Government taxes away the difference between the imported price in forints and the prices on sales to the domestic market and uses those funds to subsidize CMEA exports when the price of the exported good is below the domestic price in forints. Experience shows a slight surplus in the transfer of the "differential turnover tax" relative to the CMEA export subsidies. On the convertible market, particularly, in the EEC, exports face tariff barriers which require subsidies from time to time depending on the domestic situation of the EEC country. These subsidies are basically designed to offset the trade barriers and to provide incentives to enterprises to engage in convertible currency trade. 6.06 One of the long-standing issues in Hungarian agriculture is the income position of cooperatives located in resource poor areas. Government has undertaken an income support program for selected farms which have an average crown valueV of less than 19. About 90 percent of these subsidies are transferred to these farms in the form of supplemental farmgate prices but only on selected commodities which are usua.lly livestock products and 10 percent is given as a direct subsidy to the farm. The County Council administers the subsidy and selects the recipients based on Government guidelines. Prior to 1989, all cooperative managers reported to the County Z The crown value is an old concept which measures the physical features of farm land and permits land taxation of average land of over 19 crown value and subsidies to land of less than that value. \ -38 - Councils which heavily influenced the operations and the labor policies of the coopbratives. This practice has been discontinued and along with the revision of the present land tax system to be implemented in 1991, the subsidies system to resource poor areas will also be revised. Assurances were obtained that the current income support program for large scale farms located on poor quality land would be revised according to a plan of action to be adopted by December 31, 1991 and that such income support does not determine or influence the production of any specific crop and livestock at the farm level. 6.01 Government would retain the subsidy on infrastructure investment such as rural roads and electrification and honor its commitment to finish the support payments to farms for previously incurred investment expenditures. However, there have been no new direct investment subsidies to farms since January 1990, when the Government introduced an investment tax credit. This investment tax credit is primarily linked to major livestock products, of which about 50 percent are produced by private, small scale farmers. Assurances were obtained that based on a review of the results of its implementation program of investment tax credits for the agricultural sector, Government would submit to the legislature draft legislation by December 31, 1992 providing for the revision of investment tax credits in a manner that such investment tax credits do not determine or influence the production of any specific crop or livestock at the farm level like the income support subsidy (para 6.06). This transitional period would assist farmers to adjust their output mix in line with market forces. C. Ownershin of Assets in Farming 6.02 The transformation of cooperatives is different in many respects from that of state farms and state-owned enterprises. There is clearly a sense among the current leadern of the agricultural cooperatives that HEM, Federation of Cooperatives and the County Councils should no longer control the functioning of the cooperatives, and that the existing limitations and barriers should be completely eliminated by 1991 so that the future of these institutions should be wholly determined by their members. Cooperatives which account for about 65 percent of the assets in agriculture have a unique and ambiguous relationship with their members in regard to the ownership of thc commonly held assets. As regards farm land, its present distribution in the 1,253 agricultural cooperatives in the country is as follows: Commonly held land - 3.0 million ha Owned by Individuals----- 2.0 million ha Owned by State ----- 0.2 million ha Total ----- 5.2 million ha While there is little problem with the plots to which cooperative members have original title even if they are now being cultivated within a large field and the State owned land can be returned to the State or sold at an auction, it is -39- the commonly held land which has no identifiable owner that constitutes the central issue of the transformation process. 6.09 MEM is proposing legislat:on to eliminate many of the important barriers to land transfer in the sector. For example, cooperatives no longer require members who leave a them to sell their land to the "central administrative unit" at a nominal price, but would permit that individual to take his land or an equivalent plot with him if so decided by the general assembly of the cooperative. There would be no ceiling on land rentals which the cooperative pays annually to the members who own land in the cooperative. The size of the,cooperative land for private use by members has been increased from 0.6 ha to any limit which the individual cooperative general assembly stipulates. In four specific cases over the last two years, production cooperatives were liquidated, and specialized cooperatives were formed. The membership of the new cooperatives consists of individual entrepreneurs who have received parcels of the main unit and use much of the equipment in common. These cooperatives function much the same way as the Western type of supply and marketing cooperatives. However, further legislation is needed to support these privatization actions in the sector and to encourage more orderly transformation. Assurances were obtained that Government would by June 30, 1991 submit draft legislation to the legislature providing for: (a) the assignment of ownership rights in the net assets (other than agricultural land) of the cooperatives to the members of such cooperatives; and (b) the definition of ownership rights in agricultural land. 6.10 The development of the land market is a first step in privatizing state owned property. Financing of purchase of agricultural land would be incorporated into the project as an encouragement for increased land sales: but more liberal legislation is required. Under the Land Law of June 1989, about 4,000 ha of farm land has been bought by private, small scale farmers. While not significant in terms of area, it is a major step forward in the transfer of land in agriculture. The major constraints to further land sales - are: (a) the failure of the Government to recognize land as a financial asset; (b) inadequate sources of financing; (c)ythe lack of supporting services to assist private, small scale farmers in understanding the legal and financial aspects of land purchase; and (d) the absence of extension, credit and marketing services for small scale farmers. Assurances were obtained that the Ministry of Finance would by December 31, 1991 adopt regulat4ons which require all farms to include on their balance sheets, for accounting purposes, land as an asset with notional value. MEM is beginning to elaborate formulas which assist buyers and sellers set rental prices of agricultural land based on its income earning capacity. Government will establish an office of farm land which would record all transactions of purfchases and sales of farm land and make them transparent and available to the public. Government is expected m to regularize the use of land as collateral to obtain commercial bank credit, and large scale farms should be able to differentiate their land holdings and mortgage to the commercial bank only that portion of their land which is required for covering the outstanding loan amount. However, the legal, procedural and economic basis for mortgages is not clear and is currently based on a civil code as the Mortgage Law of 1927 has been rescinded. Assurances were obtained that, Government would take by June 30, 1991, all - 40 measures necessary to make agricultural land mortgageable for commercial bank loans. D. Rehabilitation of Low Efficiency Farms- 6.11 The first group of 81 cooperatives completed the debt reduction program on December 31, 1989 (paras 3.12 -3.13). Results indicate that the program has been successful In that 64 cooperatives restructured their operations, while seventeen cooperatives failed to perform and, therefore, will now be required to pay all their previously suspended debts, receive no Government subsidies and, if found insolvent, their major creditors, usually the commercial banks, may start liquidation proceedings. Assurances were obtained that Government would take all measures necessary to liquidate each large scale farm which is participating in the Government's 1987-90 debt reduction program and subsequent programs and has failed to meet the financial targets specified in such programs and has been determined to be insolvent. The Bank would review with Government by April 30 of each year, the progress achieved under such debt reduction program; the review would include, inter alia, the number of large scale farms which failed to meet the financial targets specified in such program, the farms selected for liquidation, and the progress achieved under the program for the rehabilitation of low efficiency farms. The Bank would also be involved in assisting Government improve the effectiveness of the debt reduction program. E. Trade Liberalization 6.12 A program of trade liberalization, including domestic and foreign trade in the food sector, is under way (parAs 2.12-2.17). Parliament is considering a Trade Law in 1990 which would, among other features, permit trading firms to be easily established in order to e¶gage in food handling, storage, transportation and, general trading. Meanwhile, territorial constraints for processing enterprises to purchase and sell products on the domestic market are being abolished, and procedures for registration of newly formed companies are being simplified. However, the so-called strategic products still need a special license for domestic trade and for expert or iport. Numerous agricultural and food products are still included in the lists of exception to free trade. These products mainly include: (a) for exports: cereals, feedgrains, 9ilseeds, vegetable oil, milk powder, some live animals and meat products, and poultry; (b) for imnorts: all of the above p.us agroprocessed products including beverages, canned foods and alcohol which account for about one-half of value added in agriculture; and (c) for domestic trade: cereals, feedgrain concentrates, refined spirits, tobacco, coffee, cocoa, baby foods and selected breeding animals. \Government intends to shorten the list and reduce state intervention in foreign trading activity; however, long ter% commitments with CHEA countries as well a.s specific regulations in European importing countries may slow this process. Of special importance is the liberalization of agricultural imports as producer prices -41 - for agricultural products have been freed and producers will need to face import competition in the medium term. Presently, imported temperate climate products are not competitive with local products but freeing of imports is needed to prevent market distortions and manipulations. Assurances were obtained that the Government would adopt a plan of action for the gradual reduction of the licenses on the imports of agricultural products. The plan would include the use of tariffs on the imports of agricultural products in accordance with the General Agreement of Tariffs and Trade (GATT) negotiations to protect domestic agricultural producers from the effects of below market pricing by foreign competitors. VII. ESTIMATED PROJECT RESULTS A. Production 7.01 Although agricultsral production and the supply of food to the domestic and export markets will increase as a result of project investments, increased quality and greater efficiency of production, storage, processing and distribution of food, resulting from project inv.stments would be even more important. The project would also stimulate g eater diversity in the supply of food by responding through project inves aents to increasingly diverse consumer demand both on the domestic and port markets. In most cases, final consumer food products would contain a higher value added than that currently available on the market. B. Markets 7.02 Market analysis for project products was carried out under two ongoing projects [Livestock Industry Development (Loan No. 2510-HU) and Agroprocessing Modernization (Loan No. 2936-HU)]; these studies indicated adequate market possibilities for selected Hungarian agricultural and agroprocessed products. Agricultural products with the best export prospects are differentiated pork, beef and sheep products, fresh and cut poultry, fresh and frozen vegetables, fruits and fruit juices and related wines. The market research studies carried out also demonstrate the need for a basic marketing strategy, irrespective of product or market and point to the weak state of marketing in Hungary. This is particularly true for agricultural commodities at the wholesale level (i.e. raw and first processed products). At this level, with only a few exceptions such as flowers or some fruits and vegetables, all marketing activities were formerly centrally adpinistered. Relatively high returns can be expected from the improvements in the 'software" aspects of marketing as better performance in the marketing chain will reduce costs of handling the products from the farm gate to the final user. The'establishment - 42 - of new wholesale market networks will improve allocation of products over distance, time and quality. Further, price information which will result from it will improve the decision-making process from the producer to the consumer. C. Financial Analysis 7.03 The principal financial benefits of the proposed project derive from fundamental restructuring of agriculture alcng free market principles. With further liberalization of the economy and the sector, enterprises would become more concerned with profitability rather than with volume of production. This would bring about greater product diversity, higher quality standards, and higher production volume in cases of short supply. Imported equipment and technology would reduce operational costs, increase labor productivity, and minimize adverse environmental impact. Moreover, greater integration into the world economy would help realize more effectively Hungary's comparative advantage in agriculture, which would result in additional exports. Also, Hungary would be better positioned to take advantage of access to Western markets. 7.04 Feasibility studies have been prepared and have provided the basis for financial analysis. Details on projections of investment and operating costs, revenues and cash flows are presented in the project file. Investments would be more diverse and smaller than under previous agricultural projects; they would also bear relatively higher rates of return and faster implementation periods. In all cases considered, the financial analysis of net incremental benefits indicates that the expected investments would be financially viable with satisfactory financial rates of return (FRR) ranging from 15 percent to 40 percent (para 8.06). 7.05 In general, the financial situation of a sample of possible investors is satisfactory from the standpoint of creditworthiness. Many are likely to have borrowed under ongoing Bank projects for similar investments, most of which are already successfully completed. Current ratios in almost all cases are above the 2:1 standard. The debt service coverage ratio averages 2.3 which indicates a satisfactory level of financial resources to meet current and long term financial obligations. Moreover, balance sheets of farms do not reflect the value of land which if included would highlight the fact that agriculture is substantially underleveraged. Private investments in agriculture and related activities are expected to increase substantially during project implementation as indicated in surveys conducted by several commercial banks. FRRs for a sample of possible subprojects to be undertaken by private investors are about 25 percent, which indicates strong potential interest. - 43 - VIII. JUSTIFICATION AND BENEFITS A. Benefits 8.01 Project benefits would be derived from: (a) increased earnings from exports, mainly to convertible currency markets; (b) increases in the value added of the products processed under the project; and (c) transfer of the ownership of assets, including land, from the state farms and cooperatives to farmers either organized in groups or as individuals. The project is expected to generate substantial incremental tax revenues, to contribute significantly to export revenues and to provide new permanent and seasonal jobs on the farm as well as in wholesale and retail food trade. Furthermore, the project would continue to support the transfer of advanced technologies and modern management techniques. The elimination of most subsidies, and liberalization of producer prices and import licensing would improve resource allocation and efficiency in agriculture and the economy at large and would contribute to Government savings. Market prices and market interest rates are expected to improve investment efficiency and benefit investors and commercial U banks as well as consumers. The project would support the development of a cohesive, domestic, product market which allocates resources based on supply and demand; it would also help carry out preinvestment work for future market infrastructure development. Finally, the project would provide for various technical services (costing about US$15 million) to support the development of wholesale and retail trade facilities, institutions, advanced trade information systems, and private farmer training, all of which v'ould facilitate progress towards a market economy. 8.02 The project would expand the role of the private sector, by supporting an estimated 5,000 private farmers and entrepreneurs. A number of new private farms and agroprocessing ventures would be based on the restructuring of loss-making state and cooperative enterprises. Other beneficiaries of the project would be about 500 large scale state, cooperative, and joint venture enterprises engaged in agriculture and food processing. Project beneficiaries would be strengthened in ter\ms of their financial position and their technical level of production and they would become more competitive by the exposure to the market. 8.03 Non-quantifiable benefits of the project would include: (a) institution-building effects such as training and studies related to project implementation; (b) improved domestic and extort marketing including penetration of new markets and enhanced assortment and greater quality of food products on the domestic market; (c) improved farm management; and (iv) greater competition on the domestic market resxtlting in reduced food price inflation. - 44 B. Economic Analysis 8.04 A sample of the most likely investments under the project has been selected to indicate economic viability. Economic benefits of the project include incremental production, including improvement in product quality. Economic costs include incremental operating costs, investment costs, and in some cases, incremental working capital. The average economic life was estimated at 15 years for all the selected investments. Replacement investment was not included in the calculation of the Economic Rate of Return (RRR) or Net Present Value (NPV). The shadow discount rate or opportunitj) cost of capital was estimated at 12 percent, the cut-off rate for acceptable economic rates of return which will result in optimal utilization of investment capital. 8.05 The MEM carried out a major effort in the preparation of crop budgets and farm models for a variety of large and small scale farms as well as private farmers integrated into large scale farms. The economic rates of return (ERR) for the sample of selected investments range from 18 percent to 57 percent. In all cases considered, the analysis indicates that the expected investments would be economically viable. The sensitiv-'ty analysis indicates that the sample investments are about equally sensitive to operating costs and benefits but they are more resilient in regard to changes in investment costs and delays in benefits. Annex 11 gives the assumptions used to calculate the ERRs of crop budgets and farm models. 8.06 The assumptions used for the selected economic models rely on experience with the implementation of previous projects (Ln. 2510-HU, Ln. 2738-HU, and Ln. 2936-HU), which showed that they met appraisal expectations. In addition, the economic analysis of the farm machinery and grain storage components dtraws on results of the PCR for the Grain Storage and Mechanization Project (Ln. 2316-HU). The results for the sel'cted models by component are presented in Table 6. Table 6: FINANCIAL AND ECONOMIC RCR, NPW AND SWITCHING VALUtS Financial Analysis Economic Analysis FRR NPV (12X) ERR NPV (12X) Switching Values (2) Ft '000 CX) Ft '000 Total Total Costs Benefits Cron Produttion Farm Machinery 31 8.010,990 21 3,613,a00 32 -24 Grain Storage 15 234,500 18 187,600 14 -12 Livestock Production Beef Fattening I/ 29 1,155 23 916 26 21 Pia Fattening / 28 32,400 17 19,670 17 -15 AaronrocessinR Poultry 36 352,020 23 206,800 5p -35 Wine 40 40,335 57 57,400 135 -57 &/ Private farmers and owner-operators. * Integrated farming operation with smaU scale farmers fattening feeder pigs which were raised by the large scale farm. 45- C. Risks 8.07 The major risks of the project include inadequate implementation by the Government of the agreed policy reforms and insufficient incentives to managers of large scale farms and agroprocessing enterprises so as to motivate them to carry out the required restructuring of their farms and enterprises. Besides political will and determination, these issues involve policy formulation and implementation capacity of the Government, and institutional strengthening and business planning at the encerprise level. The potential unfavorable environmental impact of the project would mainly consist of air and water pollution resulting from agroprocessing activities\and ground and surface water pollution resulting from farm chemicals. The project attempts to reduce these risks by addressing selected policy issues which are also being pursued under the proposed Structural Adjustment Loan, and by including in the project, technical services to assist farm managers in identifying markets and organizing production to meet their quality and quantity requireme'lts. The project also provides the opportunity for the large farms to develop business planning as a tool for adopting modern financial, commercial and management practices at:d to small farmers to become effective owner-operators by providing them with incentives such as access to credit, export marketing services and technical services. Government is strengthening its enforcement of regulations governing air and water pollution, and each subborrower will be required to clear its investment proposal under the Loan with the Ministry of Environment. IX. A.;REEKENTS REACHED AND RECOMEATION 9.01 The signing of subsidiary loan agreements between NBH and at least two,eligible intermediary banks would be a condition of Bank loan effectiveness (para 5.06). 9.02 Assurances were obtained from Government at negotiations that: (a) it would maintain and monitor its program for the reduction of investment, production and export subsidies to the agricultural sector within and consistent with the overall subsidy reduction program. By December 31, 1990, Government would reduce all agricultural subsidies by at least one third of t*le agricultural subsidies in effect during the 1989 calendar year calculated in current prices. Before the end of each calendar year beginning in 1990, the Bank would review: (a) progress in achieving targeted sxbsidy reductions; and (b) the new target to be achieved during the next calendar year. Government would take into account the Bank's comments on such new target in preparing the final proposal for the following calendar year (para 6.04); - 46 - (b) the current income support program for large scale farms located on poor quality land would be revised according to a plan of action to be adopted by December 31, 1991 and that such income support does not determine or influence the production of any specific crop and livestock at the farm level para (6.06). (c) based on a review of the results of its implementation program of investment tax credits for the agricultural sector, it would submit to the legislature draft legislation by December 31, 1992 providing for the revision of investment tax credits in a manner that such investment tax credits do not determilie or influence the production of any specific crop or livestock at the farm level like the income support subsidy (para 6.07); (d) it would by June 30, 1991 submit draft legislation to the legislature providing for: (a) the assignment of ownership rights in the net assets (other than agricultural land) of the cooperatives to the members of such cooperatives; and (b) the definition of ownership rights in agricultural land (para 6.09); (e) it would by December 31, 1991 adopt regulations which require all farms to include on their balance sheets for accounting purposes land as an asset with notional value (para 6.10); (f) in order to make possible the use of agricultural land as collateral for commercial bank credits, Government would take by June 30, 1991, all measures necessary to make agricultural land mortgageable for commercial bank loans (para 6.10); (g) it would take all measures necessary to liquidate each large scale farm which is participating in the Government's 1987-90 debt reduction program and subsequent programs and has failed to meet the financial targets specified in such debt reduction program and has been determined to be insolvent. The Bank would review with Government by April 30 of each year, the progress achieved under such debt reduction program; the review would include, inter alia, the number of large scale farms which failed to meet the financial targets specified in such program, the farms selected for liquidation, and the progress achieved under the program for the rehabilitation of low efficiency farms (para 6.11); and (h) it would adopt a plan of action for the gradual reduction of the licenses on the imports of agricultural products. The plan would include the use of tariffs on the imports of agricultural products in accordance with the General Agreement of Tariffs and Trade (GATT) negotiations to protect domestic agricultural producers from the effects of below market pricing by foreign competitors (para 6.12). - 47 - 9.03 Assurances were obtained from NBH at negotiations that: (a) each subproject would be undertaken in accordance with the country's safety, health and environmental standards (para 4.19); (b) intermediary banks would assign or hire a full-time qualified agricultural credit officer for each branch which has reached a level of 200 loans granted to small scale farmers per year or which has reached a level of 1,000 loans in its loan portfolio (para 5.11); aud (c) a training program for preparing intermediary bank staff to service private, small scale farmers would be incorporated into the ongoing bank training program (para 5.12); 9.04 On the basis of the above mentioned agreements and the staff appraisal, rhe project is considered suitable for a Bank loan of US$100 million for 15 years, including five years grace, at the Bank's standard variable interest rate. The loan will be made to the National Bank of Hungary and guaranteed by the Republic of Hungary. I \ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~~~~~~~~~~~~~~~~~' I~~~~~- 48 V . j~~~~~~~~~~~~~~NNEX I Page 1 of 3 HUNGARYV INTEGBATED AGRICULTURAL WXORT PROJECT §elected Documents Available in the Proiect File A. Selected Reports apd Studies on the Agricultural SeXtor A.l Agricultural Sector Strategy for Policy and Structural Change (in two volumes), August 1, 1989, vol 1 pp. 65, vol 2 pp 161. This is the first overall review of the sector by the Bank which was approved by Goverrment; although dated, it contains a wealth of basic information on the sector particularly regarding economic and policy issues. It addresses the particular issues of pricing, taxes and subsidies; priorities for subsector development; international trade and marketing; enterprise restructuring, competition and management of large scale farms; support services for agricultural production; development of disadvantages areas; and environmental implications of agricultural development and growth. The report 4lso contains a section on recommendations and investment opportunities. A.2 Agricultural Policy Analysis: A Position Paner on Selected Issues, September 1, 1989, pp 65. 'This report focuses on six major policy issues in the sector which are included in the SAL policy matrix to form an integral part of SAL conditionality. The report was shared with the Hungarians to inform them of the Bank's view on the background and recommendations on the issues. They included the following: property ownership and transformation of cooperatives; land market development; low efficiency large scale farms; constraints and recommendations for improving the operation of domestic trade and msrketing; criteria for setting agricultural producer prices; and subsidy reduction program. All ok these issues were discussed with Government during the appraisals of the Integrated Agricultural Export Project in November 1989 and, the SAL in February 1990. Agreements were reached with Government on all six issues. B. Selected ReRorts and Stud=es Relating to the Project B.1 Factors in the Mana8ement of the Loss-Making Large Scaie Farms and the Main Instruments of Establishing Rrofitable management in Agriculture, October 1988, pp.175. This report was prepared by STAGEK, an institute for economic analysis within the Ministry of Agriculture (MEM). It is a statistical study on the situation of the loss making, large scalq farms and deals with the following subjects: characteristics of the large scale farms; special internal features of loss making cooperatives; regional characteristics of loss making farms; use of factors of production 49 - ANNEX I Page 2 of 3 in the loss making cooperatives; and the main tasks to be achieved in order to turn the loss makers around. B.2 Development PotentialT and Trends in Economically Backward Regigns, June 1989, pp.140. Report written by the Research Institute for Agricultural Economics (AKI) for three areas: Tab, located in the southwest and south of Lake Balaton in the province of Somogy; Nyirseg, located in the east along the Soviet border in Szaboles-Szatmar county; and Zemplen and Hegykoz, located in the northeast along the Slovak border in rhe county of Borsod-Abaul- Zemplen. The study looks into the nat4ral resource endowments, capital stock and labor of each area, comments on the international competitiveness of some agricultural products which could be grown or raised in the areas, and suggests ways to make farming profitable through restructuring and integration of manufacturing and other nonagricultural activities. It contains a section of conclusions and recommendations. B.3 Possible Prospects for the Development of the Agricultural Small Scale Production, December 1988, pp.167. Study prepared by STAGEK, the institute of economic analysis of MEM and includes the following information: the ideological justification of the small scale agriculture within the communist system; the role of small scale production n the agricultural sector; production capacity and Government regulation of the small scale sector; Income of small scale farmers; comparative benefits of small scale production and its related characteristics; organizational and financial issues related to the further development and prospects of small scale farming. B.4 Development in the Economic Position of Certain Important Agricultural Products on Large Scale Farms and Their Interrelations with the Intearation of Small Scale Producers, June 1989, pp. 320. Study prepared by STAGEK and is divided into three major areas of interest: first, the procuction possAbilities of the large scale farms; second, the system of integration of the small scale farmer within the large scale farm and the Qrganizationat and financial implications for both the income of the small scale farmers as well as the benefit to the large scale farm; and third, machinery requirements for commercial small scale farmers and its availability for future expansion of the sector B.5 Investments in Seed Production and Processing Industry, September 1988, pp. 13. Study prepared by Agrober deals with the present situation in the seed processing industry, the need for improving the quality and diversity of seed production, domestic and export sales potential, need for streamlining of the seed industry, areas of promising investment and their financial and economic evaluation., - 50 - Page 3 of 3 B.6 Planned Content and Financiaal AnaA4s, pp. 219, November 1989. Study prepared by Agrober presents investnmnt models in: (i) pig; (ii) beef; (iii) amall animals; (iv) sheep; (v) horse; (vi) agriculture; (vii) fish; (viii) selected food processing models; (ix) grain storage; (x) forestry; (xi) horticulture; and (xii) farm mechanization. B.7 ExDort Oriented Development of Maior Integrat2d Production Subsectors, p. 141, December 1989. Policy work done by the Agricultural Economic Research Institute (AKI) which concentrates on the exportability of major product lines in agriculture and agroprocessing. It describes the contractual relationships among the private , small scale farmer and the large scale\farms, reviews export market contacts of foreign trading companies and identifies areas for efficiency improvement In the vertical coordination within product lines. It contains conclusions and a summary. \~~~~~~~~~~~~~~~~~~~~~- ANNEX 2 Page 1 of 17 HUNGARY INTEGRATED AGRICULTURAL EXPORT PROJECT Details on the Three Maior Commercial Banks ' I. Budapest Bank A. Introduction 1.01 Background. Budapest Bank (BB), Hungary's third 'Largest commercial bank, was created on January 1, 1987 by merging the operations of the Budapest Credit Bank, the State Development Bank an. certain lending departments of the National Bank of Hungary. It is a joint-stock company whose shareholders are the Government, enterprises, and institutional investors. At the end of 1988, the Government held 49.4% of the share capital, with the rest being held by 586 shareholders. 1.02. Business Activity. At the end of 1988, the bank had 30 bran-hes and offices throughout the country. The branch offices have major responsibility for customer relations, disbursement and repayment of loans, and maintaining deposit accounts. Head office staff are responsible for mobilization and management of resources, planning and budgeting, and credit administration, personnel and accounting activities. 1.03. BB has\ over 4,000 clients, including some 400 large or medium size companies, 2000 cooperatives that are mostly small-scale, and some 1,500 private firms. Thus far, the client base has proven stable -- in 1988, BB gained a net 344 company and cooperative clients, and over 1,500 private enterprise clients. Customers include two of Hungary's largest industrial conglomerates -- OKGT (National Gas and Oil Trust) and MVNT (Hungarian Electricity Board). Although to \date the bank has operated exclusively as a commercial bank for enterprises, it has recently begun entering the retail banking and international trade financiig fields. Thus far, the bank has primarily been involved in lending to the mining, chemicals, machinery and oil subsectors. Bt has also been involved in co-financing international business undertakings in Hungary. Two recent projects, to produce float glass and polystyrene were recently cofinanced, one with a foreign bank, and the other with the IFC. BB is the leading institutional player among the banks in Hungary's securities market, accounting for some 40% of total transactions. In 1988, the bank won a tender issued by the Ministry of Finance to conduct the issuing, organization and trading of treasury bills\ on a nationwide level. Reflecting the expansion in the bank's activities, BB's staff increased 0% in 1988, to over 1,200, and in 1989, grew further to 1,330. k 1.04. Involvement in Bank Groun Projects. Since 1987, BB has been involved in onlepding World Bank funds to the industrial sector under three industrial restructuring projects, the Technology Development Project, as well as several projects in the agriculture sector. BB has also served as guarantor in two IFC 52 - A iNEX 2 Page 2 of 17 projects, and in 1990, is expected to serve as the agency for an IFC line of credit to finance small and medium-sized projects in the private sector. B. Institutional Asgects (i) Institutional Strategy 1.05. BB is currently forming its strategic plan and has drafted a document outlining its basic objectives, products and markets, strengths and weaknesses, and development objecti7es in five key strategic areas. In the meanwhile BB is taking actions to strengthen its financial position, increase liquidity, improve the balance sheet, improve its credit portfolio, diversify lts customer base, lend on a more selective basis, and to strengthen other areas. The Bank carried out a diagnostic review of BB, which highlights the need for BB to identify its most critical strategies and focus adequate resources on successfully executing those strategies, build an analytical justification for new markets and products, and develop a sound financial plan linked to the strategic plan. (ii) Organization Structure 1.06. BB is headed by a chief executive who also serves as Chairman of the Board of Directors. The 13-member board pf directors represents the major shareholders of the bank. The Board has sole responsibility for establishing the business statutes of the bank, and for approving the bank's business rules and policies. BB also has a 16 member supervisory committee which oversees management of the bank and polices violations in, the legal provisions and the charter of the bank. 1.07. BB's organization structure is being modernized in phase with its strategic plan. It has established an asset/liability management council, added new functions, and the six Budapest lending units are being formed into branch-like units.m However, there is a need to focus its orientation more clearly on business results rather than activities; to develop operational policies and procedures, internal controls and standards; to effectively manage the branch network; and to correctly size each unit to accomplish its required results. (iii) Status of Human Resources 1.08. BB has wide skill development requirements. Actions have been taken to build recruiting sources, to hire college graduates and to acquire experts from NBH. A mediim and long-term training plan, focusing initially on delivering basic banking training to young graduates and the majority of existing staff over the next three years, is being developed. BE is also planning to send people for training to yhe International Training Center for Bankers, to organize language training, to send some staff members to foreign banks for training in special areas, as well as to copduct internal training. BB needs to fully define skill requirements and prioritize skills shortfalls so that it can build priority internal training progr\amg, select external programs, and organize on-the-job training. - 53 - 'ANNEX 2 Page 3 of 17 (iv) Key Banking Functions 1.09. Credit. BB is following a selective lending policy, taking active measures to reduce its proportion of doubtful debts and diversifying its customer base to reduce the impact of its number of very large customers. A new system for classifying customers and loans is being implemented and decisions on credit allocation and follow-up of doubtful debtors are being based on this system. However, BB still needs to build a comprehensive set of policies and procedures and to develop effective internal controls. Further, it needs to sharpen its credit system with respect to assessing and dealing with credit risk, and monitoring and following-up on overdue payments and arrears. 1.10. Treasury. B's treasury function makes decisions on allocation of funds, use of excess funds, borrowings, reserves, interest rates, and other matters. BB is developing procedures, considering establishing a full treasury groutp, and planning an automated treasury information system. Until this system is on line, however, an interim system will be necessary. BB also needs to build treasury skills among managers and technical staff in the liqulidity council and in the business policy department. l.ll.\ Planning. budgeting and Derformance measurement. BB currently prepares a one-year plan which is the basis for certain actions of functional units xnd for the plans of the branches. The branch-level plans cover deposits, loans, securities sales, and improvement of the loan portfolio. Branch managers can earn significant bonuses based on results. Profitability is monitored quarterly. Profitability management systems ate being developed and applied for the branches and for several major business areas of the Bank. 'BE still peeds to develop a planning process, and a budgeting process that fits the plaiming proce;s. The process must establishk performance measures and goals for the bank overall, as well as individually by'staff and line unit. 1.12. pranch operations. BB's branch system has expanded quick-y from 18 br¶nches to 3u. emd a number of 40 branches was targeted by end-il989. Further expansion is planned, based on market opportunities and budget considerations. BB has developed a\model for a branch and will start to implement it in Budapest. 1.13. Automation. Automation is required for sound bank management, competitivenes4, and efficiency. The bank has retained outside consultants to help develop an automation plan which will include general ledger applications, domestic banking applications, and some international applications. 1.14. Management information systems (MIS). A considerable portion of iKts management information is now provided through the NBH computer system. However, a new and more comprehensive MIS is needed. The Bank is currently trying to meet some MIS requirements internally, while other information is being provided by customers, and some MIS requirements will be met through 'automation. Management's needs for information have not yet been clearly defined. Such definition is a necessary pre-requisite to the development of a MIS. 54- ANNEX 2 Page 4 of 17 1.15. Internal audit. BB's 'Auditing Department reports directly to the Chief Executive and to the Supervisory Committee and checks the books of the branches at year end. Visits are also made to some branches to check principal and interest payments. BB needs to build a complete and modern internal audit function - with skilled auditors to conduct frequent and comprehensive audits of branches and headquarters units, with sufficient audit tools, and with an internal environment conducive to effective audits. C. Financial Structure and Performance, 1.16. The following tables provide an overview of the key elements of BB's financial structure, and of key indicators of financial performance. (Summary financial statements and key performance indicators are contained in Appendices 1 and 2). Budanast Bank Changes in Financial Position 1987 1988 Z Change ----(Ft. BiLlion)---- Total Assets 84.5 80.9 -4.2 Total Loans 53.5 51.9 -3.0 Total Refinancing 31.3 26.9 -14.0 Total Deposits 35.0 29.S -Z5.0 Capital 6.6 8.9 +3o.7 Operating Expenses 0.7 2.6 +263S2 Net Income 1.2 1.1 -4.7 Budanest Bank Financial Performance Indicators 1987 1988 -(----Percent)---- Loans/Deposits / 64.1 84.7 Loans/Borrowed Funds 74.7 80.1 Capital/Assets 7.0 9.1 Return on Assets 1.5 1.3 Return on Equity 23.2 14.4 Net Int. Margin/Avg. Assets 2.7 3.9 Op. Costs/Avg. Assets 0.9 3.1 f Loans are adjusted for NBH refinancing. 1.17. Structure. The 4% reduction in BB's total assets in 1988 was caused mainly by a significant fall in the principal sources of funding -- refinancing through the NBH, and deposits. Refinanced loans amounted to Ft26.9 bilXion, and were predominantly long term. 1he Ft4 billion fall in refinancing between 1987- 88 was caused by a sharp decrease in short term refinancing credits, reflecting tightening of credit by the monetary authorities. Enterprise demand deposits fell 20X in 1988, largely as the result of liquidity problems that followed the introduction of a profit tax and further reductions in Government subsidies. V It should be noted that the financial statements of Hungarian banks have not been prepared according to ipternationally accepted accounting principles. Also, until a portfolio audit is completed and new prudential guidelines\ for loan classification are in place, the correct level of substandard loans, required provisions, cessation of interest accrual, and eonsequently, valid earnings, will be not be known. - 55 - \ ~~~~~~~~ANNEX 2Z Page 5 of 17 1.18. Liguidity. BB's liquidity position deteriorated between 1987 and 1988. Deposits fell faster than loans, leading to a worsening of the loan- deposit ratio, to 85%. While this is slightly higher than the desirable level of 70%, with careful monitoring of the situation and assiduous deposit mobilization, BB should be able to improve the situation. 1.19. CaRital Adeguacy. BB's capital to assets ratioZJ improved in 1988, to 9.1%, due primarily to a Ftl.l billion increase in share capital. While this figure appears to exceed the desirable level of 8%, it should be kept in mind that capital may be significantly overstated since BE is as yet inadequately provisioned against doubtful debts, and since loan classification standards for doubtful debts, as well as policies on interest accrual, are weak and arbitrary. 1.20. Earnings Performance. BB's interest income increased by over 401 in 1988. A sharp rise in short-term lending rates, and possibly the accrual of penalty interest on substandard loans, helped increase the net interest margin. Also, BB's large volume of short-term lending increased commitment fee income substantially. The resultant increase in overall income was partially offset by higher operating expenses, due to the branch expansion program and increases in staffing. As a result, however, operating expenses jumped from 0.9X to 3.1X of average assets, and need to be closely monitored. Also, had BB made adequate provisions in 1988 -- to reach the level recommended,by the State Banking Supervision Agency (SBS) -- income would have been substantially reduced. Despite the increased interest and fee income, net income after tax was about the same in 1988 as in 1987, due to. the higher operating costs and provisioning. Return on average capital dropped in 1988, mostly due to the rapid increase of equity and reserves. Return on average assets also dropped, but marginally. Both these ratios are acceptable provided the earnings figures on which they are based are valid. BB declared dividends of 171 and 12% in 1987 and 1988, respectively. 1.21. Loan Portfolio Ouality. In 1987, when the commercial banks were created, BB inherited a number of problem loans, the highest among the three large banks. At end-1987, substandard loans totalled 260% of capital (including reserves). By the end of 1988, the situation had improved, and substandard loans amounted to 130% of capital. The improvement resulted from a fall in substandard loans, due in part to write-offs, and a 351 increase in capital. 1.22. The loan portfolio is potentially further weakened because of the extent of connected lending and concentration of sectors and borrowers. BB's ten largest borrowers hold 61 of the share capital, and account for 461 of the outstanding loan portfolio, equivalent to 2651 of the bank's capital. Poor performance on the part of these borrowers could therefore have serious implications for the bank's financial viability. BB's loans are also heavily concentrated by sector. The top 5 subsectors in the portfolio account for over 75X of the portfolio, making BB vulnerable to downturns in these areas. Given the ongoing economic restructuring in Hungary, there is a need for BB to diversify its portfolio rapidly to decrease potential instability. 1/ Adjusted to exclude risk reserve. - 56 - ANNE4 2 Page 6 of 17 1.23. Loan_Loss ResVrves. BB's loan loss reserves, the "risk reserve fund", amounted to Ftl.4 billior. in 1988, or 2.5X of gross loans. This was an improvement over 1987, when the risk reserve fund was FtO.7 billion, equivalent to 1.1 of gross loans. The risk reserve fund amounts to only half the level prescribed by 1987 SBS regulations, primarily because BB has funded the reserve only to the limit allowed out of pre-tax profits, and has not supplement the reserVe from after-tax profits. 1.24. Financial Viability. The future financial viability of Budapest Bank will depend upon a number of issues. First, the true conditic.i of the loans will be revealed by the forthcoming portfolio audits, both in terms of ar\earage, and in terms of the financial condition of the debtor enterprises. This, in turn, will provide an indicator as to whether the level of reserves is adequate. Second, the annual audit will reveal the extent to which interest is being accrued beyond prudential limits, casting light on whether the earnings, -reserves, and capital are real or not. The new guidelines and prudential regulations on loan classification and provisioning that the SBS is expected to put in place shortly, and a potentiAl Government program-to restructure the portfolios of the three large commercial banks, would enhance BB's financial viability in the lone run. 11, Commercial and Credit Bank A. 1Introduction 2.01 Background. Commercial an4 Credit Bank (CCB) is Hungary's second largest commercial bank. It wts created on January 1, 1987 out of the agricultural and food industry departments of the National Bank of-Hungary. It is a joint-stock company whose shareholders are the Government and enterprises. At the end of 1988, the Government held 71% of the share capital, with the rest being held by 1,308 shareholders. By mid-1989, the Government shareholding had been reduced to 52X. 2.02 Business Activity, At the end of 1988, the bank had 58 branches and offices throughout the country, including the headquarters and two branches in Budapest. The branch offices are responsible for appraisal of projects, di bursement and repayment of loans, administration of deposit accounts, and branch office-accounting. CCB's clients include state farms and cooperatives, industrial and agro- industrial companies, and trading firms. The bank's customer base grew from 3,880 clients in 1987 to over 5,500 in 1988. The Enumber of small enterprise clients grew by X,100 to 4,100, and net growth in large corporate customer accounts was 64. Although until recently the bank has operated exclusively as a commercial bank for enterprises, it has now begun entering the rekail banking field. Thus far, lending ha; been concenlrated in the agriculture, commerce, and field/forestry subsectors. Reflecting the increase in the bank's activities, bank staff grew from 1,837 in 1987 to 2,350 in 1988. Of these, 430 are located in headquarters, and the rest are in the branch - 57 - ANNZX 2 Page 7 of 17 network. In April 1988, CCB established a wholly-owned subsidiary, Merkantil Bank, to undertake lease-financing, debt factoring, bond sales, and import licensing. 2.03 Involvement in Bank Group Projects. Since 1987, CCB has been involved in onlending World Bank funds to the industrial sector under three industrial restructuring projects, and the Technology Development Project, as well as several projects in the agriculture sector. During 1988, 45Z of all investment loans made, representing Ft2.5 billion, were for Bank-related projects. B. Institutional Asvects (i) Institutional Strategy 2.04 CCB has made a good start in developing its institutional development strategy. In June 1988, CCB developed a mission statement, identified strengths and weaknesses, prepared tentative goals and action plans for both strategy and institutional develapment, and assigned responsibilities for completing each task within targeted deadlinas. Since then, target markets and services have been identified, and thie organization, product development, human resources and other areas have been further developed. The Bank has recently conducted a diagnostic review of CCB, which highlights the need for CCB to identify its most critical strategies and focus adequate resources on successfully executing those strategies, build an analytical justification for new markets and products, and develop a sound financial projection of the outcomes of the strategic plan. (ii) Organization Structure 2.05 CCB is headed by a chief executive who also serves as Chairman of the Board of Directors. The 14-member Board of Directors represents the major shareholders of the Bank. ;CB also has a 12-member Svperv'sory Board which oversees management of the bank. Its day-to-day operations are managed by the Chairman, assisted by management committees which are composed of the heads of major departments. The bank underwent a reorganizatic,n in March of this year. Ies new organization structure establishes important new functions, groups its head office functions into logical clusters for management purposes, clarifies the role of each department, and generally follows sound organization principles. However, there is a need to focus the bank's orientation more clearly on business results and to effectively manage the branch network. (iii) Status of Human Resources 2.06 CCB has launched several institutiohal development Xactivities in the human resources area - in recruiting, staffing, training, performance appraisal, rewards, and other areas, and its branch rationalization program will define optimal branch staffing levels. ', CCB needs to fully define skill requirements for each category of job, assess incumbents against skill requirements, ide4tify and prioritiz. skill shortfalls, and build the plans and resources necessary to meet priority \skill shortfalls within the quickest 0 . l~~~~~~~~~~~~~~~~~ - 58 - ANNEX 7 Page 8 of 17 practical time. This will enable CCB to build internal training programs, select external programs, and conduct on',the job training. (iv) Key Banking Functions 2.07 Credit. CCB is developing its credit system. It has prepared a credit manual, outline credit procedures, developed a client-qualification system, and developed an extensive base of credit officers. The bank is also foeusing on problem loans and on extending new loans to only the most creditworthy customers. CCB needs to further develop its credit system, focussing on building itternal controls to assess and deal with credit risk and to classify, monitor and follow up on overdue payments and arrears. Credit skills will also need to be developed rapidly to correctly utilize the new policies and procedures. 2.08 Treasury. A Liquidity Directorate has been established to manage the liquidity position, reserves level, borrowings and placing, maturities, and interest rate risk. However, as automated treasury informatiton will not be available for another two years, a manual system must be developed for use in the interim. Sufficient treasury skills must also be developed among managers and technical staff in the relevant Directorates. 2.09 Planning. bud eting and vgrformance measurement. CCB currently prepares a one-year plan and a one-year budget. There is an overall bank budget. In addition, each branch has a budget, and numerous indivfdual categories of head office expenses are budgeted. Results against budget in the branches are measured quarterly against several key performance areas. CCB needs to develop a suitable planning process at all levels, and a budgeting process that fits the planning process. It also needs a procsss that establishes performance measures and goals for the bank overall, as well as for staff and line units. 2.10 Branch onerations. As part of its branch r4tionalization program, COB is building model branches which will modernize and standardize work procedures, forms, organization, and job descriptions, and prepare the branch for automation. After evaluation by senior management, the pilots will be rolled out to all branches. CCB still needs to improve on the diffused system of branch management and achieve a greater degree of standardization. 2.11 Automation. CCB has retained a data processing (DP) expert, organized a DP directorate, prepared an aLitomation plan, and moved ahead in several areas,\ whith include building infrastructural elements of the DP directorate, implementing a crash program to become operational in foreign exchange by year-end, and developing internal systems to meet interim needs that cannot be handled by the NBH system. Once CCB's strategic plan is finalized, it needs to review its automation development plan to ensure congruence. 2.12 Management information systems. CCB is curtently thinking through its MIS requirements. A considerable part of its information is provided through the NBH system. However, since many areas are not covered at all, a new MIS is needed. Some MIS requirements will be iet internally, and others through the planned automation program. Management's needs for information have not yet been -59- Page 9 of 17 clearly defined. Such definition is a necessary pre-requisite to the development of a MIS. 2.13, Internal audit. CCB has established an independent Internal Control Department reporting directly to the Chairman. The department plans to conduct general audits of the branches once every two years and annual audits of head office operational units. Audit compliance is perceived as being good, managers are receptive and post-audit follow-up is conducted by the audit team to ensure correction of deficiencies. An audit manual incorporating sound audit policies, and practical audit procedures is needed. Also, audit skills need to be upgraded and expanded. C. Financial Structure and Performance 2.14 The followLig tables provide an overview of the key elements of CCB's financial structure, and of key indicators of financial performance. (Summary financial statements and key performance indicators are contained in the attachment to this annex).? Commercial and Credit Bank Changes An Financial Position 1987 1988 X Chanae ----(Ft. BilUon)…----- Total Assets 160.9 119.8 425.5 Total Loans 122.2 94.1 -23.0 Total Refinauncig 87.5 55.2 -37.0 Total Deposits 45.6 37.6 -17.6 Capital 12.9 18.2 +41.0 Operating Expenses 0.7 1.3 +88.2 Net Income 1.9 2.0 +17.1 Commercial and Credit Bank Financial Performance Indicators 1987 ----(Percent)---- Loans/Deposits _/ 91.0 143.4 Loans/Borrowed Funda 93.2 110.7 Capital/Assets 8.0 14.5 Return on Assets 1.2 1.4 Return on Capital 19.1 12.9 Net Int. Margin/Avg. Assets 2.8 3.9 Op. Costs/Avg. Assets 0.5 0.9 a_/ Loans are adjusted for NBH refinancing. ; 2.15 Structure. The 25% reduction in CCB's total assets in 19188 was caused mainly by a significant fall in the principal sources of funding -- It should be noted that the' financial statements of Ilungarian banks hav not been prepared according to internationally accepted accounting principles. Also,. until a portfolio audit is completed and new prudential guidelines for loan classification are in place, the correct level of substandard loanp, required provisions, cessation of interest accrual, and consequently, valid earnings, will be not be known. -60- ANNEX 2 Page 10 of 17 refinancing through the NBH, and deposits. Short term refinancing credits fell almost Ft3O billion from 1987 levels, reflecting tightening of credit by the monetary authorities. At the same time, demand and short term deposits from enterprises fell by over Ftll billion, largely as the result of liquidity problems that followed the introduction of a profit tax and further reductions in Government subsidies. 2.16 LiSuiditv. CCB's liquidity position deteriorated sharply between 1987 and 1988. Deposits fell faster than loans, leading to a worsening of the loan-deposit ratio, to 143%. This is much higher than the desirable level of 701 and CCB needs to take immediate steps, including assiduous deposit mobilizstion, to improve the situation. 2.17 CaRital Adequacy. CCB's capital to assets ratiof improved sharply in 1988, to 14.5%, due primarily to a Ft3.0 billion increase in share capital. While this figure apparently exceeds the desirable level "of 81, it should be kept in mind that capital may be significantly overstated since CCB is as yet inadequately provisioned against doubtful debts, and since loan classification standards for doubtful debts, as well as policies on interest accrual, are weak and arbitrary.Y 2.18 Earnings Performance. Despite the reduction in the overall loan portfolio, CCB's interest income increased some 15% in 1988. A sharp rise in short-term lending rates, and possibly the accrual of penalty interest on substandard loans, helped increase the net intetest margin. The increase in income was partially offset by higher operating expenses due to increases in staffing. Operating expenses doubled, from 0.5X to 0.91 of averqge assets. As competition among the banks accelerates, however, expenditures on staffing and marketing will increase, and would need to be closely monitored. Also, had CCB made adequate provisions in 1988 -- to reach the level recommended by the State Banking Supervision Agency (SBS) -- income would have been substantially reduced. Return on average capital dropped in 1988, mostly due to the rapid increase of equity and reserves. Return on average assets increased marginally, due mostly to the reduction in assetsl. Both these ratios are acceptable, provided the earnings figures on which they are based are valid. CCB declared dividends of 12% and 131 in 1987 and 1988, respectively. 2.19, Loan Portfolio Ouality. In 1987, when the commercial banks were created, CCB inherited a number of problem loans. At end-1987, substandard .~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ Adjusted to exclude risk reserveI fund. Under the accounting practice followed by CCB, it does not pay taxes or dividends, nor allocate provisions from gross profits, until the first quarter of the following year. As a result, the entire figure for gross profit is shown as retained earnings, which are therefore seriously overstated, as is net worthi. A rough calculation, adjusting for items to be expended from gross profits, including taxes, dividends, and other allocations, yields a capital to assets ratio of 5.5% in 1987 and 10.6X in 1988. 61 - ASNNEX , Page 11 of 17 loans totalled 150% of capital (including reserves). By the end of 1988, substandard loans had increased 21% in absolute terms but, due to the large increase in capital, the ratio of substandard loans to capital improved to 130X. 2.20 The loan portfolio is potentially further weakened because of the existence of connected lending, and concentration of sectors and borrowers. CCB's ten largest borrowers hold 7.5% of the share capital, and account for 28% of the outstanding loan portfolio, equivalent to 145X of capital. Poor performance on the part of a few borrowers could therefore have serious implications for the bank's financial viability. CCB's loans are also heavily concentrated by sector. Overall, over 50% of the portfolio is in the agricultural sector, and over 40% i'. the industrial sector. The top 5 subsectors in the portfolio account for over 90% of the portfolio, making CCB vulnerable to downturns in these areas. Given the ongoing restructuring in the Hungarian economy, it would be prudent for CCB to diversify its portfolio to desrease potential instability. 2.21 Loan Loss Reserves. CCB's loan loss reserves, the "risk reserve fund", amounted to Ft2.6 billioni in 1988, or 2.8% of gross loans. This was an improvement over 1987, when the risk reserves were Ftl.O billion, equivalent to 0.9% of gross loans. In 1988, CCB allocated 30% of pre-tax profits to its risk reserve fund, up from 20% in 1987. The risk reserve fund- amounted in 1988 to less than half the level prescribed by 1987 SBS regulations, primarily because CCB has funded the reserve only to the limit allowed out of pre-tax profits, and has not supplemented the reserve from after-tax profits. 2.22 Financial Viability. The future financial viability of Commercial and Credit Bank will depend upon a number of issues. First, the true condition of the loans will be revealed by the forthcoming portfolio audits, both in terms of arrearage, and in terms of the financial condition of the debtor enterprises. This, in turn, will provide an indicator as to whether the level of reserves is adequate. Second, the annual audit will reveal the extent to which interest is being accrued beyond prudential limits, casting light on whether the earnings, reserves,, and capital are real or not. The new guidelines and prudential regulations on loan classification and provisioning that the SBS is expected to put in place shortly, and a potential Government program to restructure the portfolios of the three large commercial banks, would enhance CCB's financial viability in the long run. III. Hungarian Credit Bank A. Introduction' 3.01 Background. Hungarian Credit Bank (HCB), Iungary's largest commercial bank, was created on January 1987 from the industrial credit section of the Nationl Bank of Hungary (NBH). HCB is a joint-stock company whose shareholders are the Government of Hungary, lnd Hungarian enterprises and cooperatives. At the end of 1988, total share capital of the bank was Ft 14.0 - 62 - ANNEX 2 Page 12 of 17 billion with the Hungarian state holding 49.41 and the rest held by some 900 enterprises.P 3.02 Business activity. At the end' of 1988, the bank had 54 branches and directorates, a staff of 3,100 of which 20X were college graduates. It has over 4,700 clients (borrowers) and held the current accounts of more than 3,000 state enterprises and cooperatives. The total production value of HCB's depositors is approximately 50X of GDP and 50 of the exports of Hungary. The services of the bank ate extetlded to non-account owners as well and in 1988, the bank provided services to 1,500 of such clients. Although the bank has operated virtually exclusively as a commercial bank for enterprises, in 1989 it entered the retail baivking market by offering certificates of deposits to the general population. HCB has been ptimarily involved in lending for industrial and infrastructure projects and beginning 1988, special emphasis has been given to small- and medium-sector of the economy. HCB has given special emphasis to encouraging foreign capital investment in Hungary. Some examples of such venture in which HCB has equity holding are: Soviet-Hungarian trading company involved in trade between the companies in the two countries, as well as in the developing countries and East-West Real Estate Development Company with the partuership of Swedish Skanska AB. A pioneer in transforming state enterprises to international sharehplding companies, in 1988 it bought most of the shares of Tungsram Co., and with the assistance of the Austrian Girozentrale A.G., offered and sold 40Z of the shares in West European stock markets. The main competition to HCB is currently from the other two major banks, but as it moves into the retail mobilization business it will have to compete with NSB and PostaBank as well. 3.03 Involvement in Bank GrouR proiects. Since 1987, HCB has been involved in on-lending World Bank loans to the industrial and agricultural sector lines of credit, such as the three industrial restructuring projects, Technology Development Project, Agroprocessing Modernization, Crop Production Improvements, I-tdustrial Energy Conservation II, Fine Chemicals and Integrated Livestock. B. Institutional Aspects (i) Institutional Strategy 3.04 HCB's strategy is in the early stages of development. The current strategic situation focusses on expanding beyond existing products and markets, growing in size, and improving profitability. The bank is undertaking considerable growth in its branch system. Starting with 23 regional directorates and no branches, it now has 25 regional directorates and 27 branches; 20 additional branches are being added and more are planned. Retail and international businesses are being built and foreign exchange, securities and other services are being added. as As of end 1988, Bebolna Agriculture Co-operative, was the largest single shareholder after the Government, with a holding of 7,81 of total share capital. 63 ANNEK 2 Page 13 of 17 3.05 In terms of a strategy, further development should focus on building a strategic plan, i.e., HCB's mission, objectives, strategies and action plans that will distinguish HCB from other financial institutions and guide its development over the next few years. The plan should discuss target markets, products and services, identify how HCB will serve these markets, and how HCB will maintain or achieve competitive advantage. Moreover, to furnish a credible basis for specific actions, the plan should be analytically based, i.e., quantified. (ii) Organization Structure 3.06 The chief executive is the chairman of 'the 17 member board of directors, representing the stockholders of the bank. The board has sole responsibility for the conduct and monitoring of the ordinary business of the bank. A 23-member supervisory committee oversees management compliance with the charter of the bank as well as policies and legal provisions. 3.07 Earlier this year, HCB implemented a new organization structure to meet its near term needs. This structure is intended to be transitional until a more permanent structure can be adopted, along bankholding company lines. This new structure still has some problems. Further changes are planned in March 1990. The new organization structure should be oriented toward enhancing business results, independent internal control functions, and lead to effective branch management. (iii) Human Resources 3.08 The Personnel Division and line managers of HCB recognize that the bank faces a major challenge in building the needed scope and depth of skills across the bank. Actions have been taken to conduct more effective recruiting, organize and deliver new training programs, and, 'otherwise, build skill levels. The bank is moving in the right direction and in further development of its persoinel skill; it must fully define skill requirements, assess incumbents against skill requirements, and identify, prioritize and plan how to meet skill shortfalls. (iv) Key BankingaFunctions 3.09 Credit. The credit system is being developed by HCB. The bank is following a selective lending policy, taking active measures to reduce its proportion of doubtful debts, and changing its cutstomex mix to build a stronger loan portfolio. Several tools and techniques are being designed and implemented to help improve credit decisions and other actions. For example, a new system for classifying customers and lo"ns has been designed and implemented. Decisions on credit allocation and;follow up of doubtful debtors are being made based in part on this system. The bank is taking active steps to continue modernizing and strengthening its credit system.' Arrartgement has been made to purchase a financial analysis system for credit purposes. Experts are studying Western credit systems for potential adoption. The bank intends to move toward the samel loan appraisal methods and credit risk management system as Western banks. Page 14 of 17 3.10 Treasury. The bank's new organization establishes a Liquidity Department and a Liquidity Committee to conduct basic, treasury functions. The Liquidity Department is improving its information base and its analy.ical support for the Committee. Plans for further development include establishing an asset/liability management system, an interest rate system, improving short term planning and adding functions in securities dealing. Special attention should be given to building treasury skills within the Liquidity Department and the Liquidity Committee. 3.11 Planning. budgeting and nerformance measurement. The bank currently prepares an annual business plan each year, and a more general three-year plan. The annual plan becomes the basis for the annual budget. Each' regional directorate prepares a budget. And, there is an aggregate budget for headquarter units, which focuses on budgeting specific classes of items, such as salaries. The business plan and budget serve as part of basis for performance requirements and measurements. Other operational performance measures are monitored regularly well. The bank is moving towards a system of "profit centers", within which full income and costs will be allocated to each unit. Further improvements in this area will be required to develop planning, budgeting and performance measurement as a basic tool for HCB management. 3.12 Branch operations. HCB is expanding its branch syptem rapidly. Starting in 1987 with Z3 regional directorates and no branches, HCB now has 25 regional directorates and 27 branches, with 20 more branches being added. Further expansion is being considered, based on market opportunities, competitive factors, and budget considerations. Standards for branch operations need to be further developed. 3.12 Automation. Automation is clearly needed for sound bank management, competitiveness, and efficiency. HCB has retained outside consultants to help develop an automation plan for the bank. Their draft recommendations should be completed by November 1989. This plan will likely include basic general ledger applications and customer accounting, plus some business application in lending, retail and international. When the Bank's strategic plan ii developed, its organization structure finalized, and its information requirements identified, the automation plan will need to be reviewed to fully support and fit with these demands. ' 3.12 Management information system (MIS). HCB is currently developing its management information systems requirements. Development of MIS was recently assigned to the Economics Department. A considerable portion of current management information is provided through the NBH computer system. However, some important areas are not covered by this system. In other areas, only fragmentary information is provided, and some information is redundant. A new management information system is\therefore needed. Some priorities have been identified but considerable further development must be conducted. 3.14 Internal audit. The Internal Audit Unit is not fully independent; it is combined with other'functions and probably too small. The department now conducts a series of focused audits in the regional directorates every 6 to 12 "onths, and regular (full) audits ,every three years. Audit compliance is 65 - ANNEX 2 Page 15 of 17 considered to be good. In headquartezs, periodic audits are conducted of certain areas, e.g., accounting, cash box, the business directorates, inventory, other valuables and internal investments. The department has regulations that provide some guidelines for conducting audits. Because there is little tradition of bank auditing in Hungary, further skills development is needed, and audit policies, procedures, and techniques shoul4 be improved. C. Financial Structure and Performance 3.15 The following tables provide a view of the key elements of HCB's financial structure and performance. (Suilmmary financial statements and key performance indicators are contained in the attachment to the annex) .71 Rungarian Credit Bank Change in Financial Position 1987 1988 X Chanae -----(Ft Billion)----- Total Assets 210.3 193.7 -7.9 Total Loans 158.4 137.5 -13.2 Total Refinancing 107.2 88.4 -17.5 Total Deposits 66.6 50.3 -24.5 Capital 16.1 23.9 48.4 Operating Expenses 1.5 1.3 -13.3 Net Income 2.3 2.4 4.3 Bunrarian Credit Bank v Financial Performance Indicators - 1987 198 --(Percent)-- Loans/Deposits 9/ 98.4 124.7 Loans/Borrowed Funds 94.7 102.8 Capital/Assets \ 7.7 12.0 Return on Assets 1.2 1.2 Return On Equity 24.1 0.9 Net Interest Margin/ Average Assets 3.2 3.0 Op. Costs/Avg. Assets 0.8 0.6 g/ Loans are adjusted for HBH refinancing. 3.16 Financial structure. Total assets of HCB declined by 81 in 1988, and loans by 13X. This reduction can be attributed to the sharp reductions in NBH refinancing and deposits which are the main sources of funding, accounting for 461 and 26X of total assets in 1988. The Ftl8.8 billion decline in NBH refinancing was the result of the tight monetary policy of the Government, especially in regards to the availability of short-term refinancing. The deposit decline appears mainly related to the liquidity problems in the enterprise V It should be noted that the financial statements of the Hungarian banks have not been prepared according to internationally accepted accounting principles. Also, until a portfolio audit is completed and new prudential guidelines for loan classification are in place, the correct level of substandard loans, required provisions, cessation of interest accrual and consequently, valid earnings, will not be\known. - 66 - ANNE 2 Page 1i of 17 sector, partly caused by the introduction of the new profit tax in 1988, as well as further reductions Government subsidies. As expected, on the assets side, short-term loans and liquid assets were most affected. Based on preliminary mid- 1989 figures, HCB seems to have improved its funding apd lending activities significantly. 3.17 Liquidity. HCB has experienced a sharp deterioration in its liquidity position. Deposits declined much more sharply than loans, leading to the worsening of the loan to deposit ratio1 to 125X in 1948, which is much worse than the desirable level of 70X. This short fall is being financed from bonds and in interbank markets and the remaining with capital. The more dependence on capital is\evident from the worsening of the loans to deposits and borrowed funds. 3.18 Capital adeauacy. The capital (net of risk reserves) to assets ratio improved to 1211 in 1988, which is substantially above the desirable level of 81. Although this figure could be overstated due to the lack of a satisfactory interest accrual policy, lack of write-offs, and doubts about the quality of the portfolio, and therefore the appropriate level of provisioning, it shouid be noted that share capital represented a healthy 60X of total capital due to the offering and sale of Ft5 billion of shares in 1988. 3.19 Earninns nerf_ormance. Despite the reduction in the loan portfolio in 1988, interest revenues grew by 15.41. This growth could be explained by the increase in the short-term lending rates, an possible accrual of interest on substandard loans which would normally include a penalty rate of 61. The net interest margin to total average assets declined slightly to 3.01 in 1988, 'which is below the desirable level of 4X. This decrease points to the increasing costs of funding for HCB. The net interest margin was augmented by the fee income of 1.81 of average total assets. Reported operating expenses ,eem to be well below the acceptable levels. This, however, could be understated, since there was an actual reported reduction from the 1987 levels. Return on average assets stayed the same at 1.21 in 1988, but because of the fast build-up of equity the return on average equity dropped to a low level of 9.91-- which provides a negative return on capital in teal terms. 3.20 Portfolio situation. Based on the reported figures at the end of 1988, the portfolio situation of H1B had slightly improved from the previous year was due to 211 reduction in substandard loans (substandard loans amounting to 9.11 of loans and 531 of total capital). This decrease is due to repayments, as well as active rescheduling and write-offs. The qu4iity of the HCB loan portfolio, like the other banks, is adversely affected by the concentration by sector and borrower, as well as connected lending. In 1988, the loans to top 25 borrowers of HCB accounted for over 2001 of the capital of the bank. These Total loans (net of NBH refinance)/Total deposits (net of trade). 11 In its published reports, HCB follows the practice of transferring pre- tax profits to retained earnings. After adjustment fori\taxes and after- tax deduction the ratio is an approximate 10.51. ANNEX 2 Page 17 of 17 borrowers at the same time held 11% of the share capital. This represents a very high concentration of risk for the bank. Also, 48X of the loan portfolio was concentrated the three sectors, which would make the bank vulnerable to downturns in these areas, 3.21 Loan loss reserve. HCB has allocated a sum of Ft 2.8 billion to risk reserves in 1987 and 1988 (2.02 of loans outstanding). This amounts to 67X of the level prescribed by SBS. 3.22 Financial viability. The future financial viability of HCB will depend on a number of issues. First, the true condition of the loans will be revealed by the forthcoming portfolio audits, both in terms of the quality of loans and in the financial condition of the debtor enterprises. This, in turn, will provide an indicator as to whether the level of risk reserves is adequate. Second, the annual audit will reveal the extent to which interest is being accrued beyond prudential limits, casting light on whether the reserves are real or not. The new guidelines and prudential regulations on loan classification and provisioning that the SBS is expected to put in place shortly, and a potential government program to restructure the portfolios of the three large commercial banks, should enhance HCB's financial viability, in the long run. Lu -68- ANNEX 3 Page 1 of 5 INTEGRATED AGRICULTURAL EXPORT PROJECT PROGRAM FOR IMPROVING LOW EFFICIENCY LARGE SCALE FARMS Income Position of Agricultural Cooperatives 1. Contrary to the experience of the 1970s when the internal terms of trade favored agriculture over industry, the 1980s showed a marked deterioration of the income position of cooperatives. The returns per unit of operating expenditures on basic agricultural activities declined by 62 percent from 1981 to 1987. While the returns from supplementary activities were maintained at a relatively higher level, they too experienced some decline. At the enterprise level, operating income declined by 12 percent during this period. The declining profitability of agriculture had a greater negative impact on the loss making cooperatives as compared to the profitable cooperatives.1f Overall, the business operation of loss making cooperatives became a losing proposition while the better cooperatives, despite the declining profitability of agriculture, managed to double their incomes. Ironically, because of the system of allocation, a larger proportion of subsidies was received by the profitable cooperatives. 2. The quality of land owned and cultivated by the cooperatives had an influence on the profitability of agricultural production. Sixty five percent of the chronic loss making cooperatives operated land with a crown value of less than 19.V While land quality is a factor affecting the profitability of basic agricultural activities, it becomes less important in determining the overall enterprise profitability especially for cooperatives which have been able to overcome limitations in land quality. About 47 percent of the profitable cooperatives have poorer quality land with a crown value of below 19. These cooperatives were able todiversify their operations out of basic agriculture into more profitable activAties and were, in part, 11The returns from basic agricultural activities for loss making cooperatives not only started out low at the beginning of the decade i (Ft.2,.4/Ft.100 of expenditures in 1980/81) but turned negative by 1986/87 (Ft. - 4.7/Fi.100 of expenditures). The returns from supplementary activities of loss making cooperative also declined during this period (from Ft.6.7 to Ft.3.0). In contrast, the profitable cooperatives managed to maintain their high returns from basic agricultural activities (Ft.17.3 in 1980/81 to Ft.16.8 in 1986/86). The returns from supplementary activities further increased (from Ft.16.3 to Ft.18.00). VFor cooperatives operating poorer land with a gold crown value of below 19, it was reported that the returns from basic agricultural activities per Ft.100 of expenditure declined from an average income of Ft.4.36 in 1980/81 to a loss of Ft.3.95 in 1986/87. In spite of a subsidy of Ft.8.45, the itcome of cooperatives with poorer land averaged only about 56 percent of tte income of cooperatiyes with a gold crown value of above 19. - 69 - ANNEX 31 Page 2 of 5 able to vertically integrate their operations forward through processing and marketing. The share of basic agricultural production relative to total operating income declined, and production from supplementary activities increased including a significant growth in food processing. In contrast, the loss making cooperatives continued their dependence on basic agricultural activities, their supplementary enterprise production increased only slowly but profitability declined. The prospects for loss making cooperatives to improve their financial condition will, to a large degree, depend on the extent to which they can diversify their operations by changing their product m mix and by undertaking profitable non-agricultural services and manufacturing/processing activities. 3. In general, cooperatives have shifted the prodiction of labor intensive commodities to small scale producers who are mostly part-time farmers. A significant proportion of the latter products were sold to cooperatives, making up 26 percent of the cooperative sector's sales revenue; the share of small scale farmers production marketed through cooperatives shows an increase of 66 percent between 1980-87. The profitable cooperatives managed to increase the value of goods and services supplied to farmers to a far greater extent than the less profitable cooperatives. It is becoming apparent that a factor determining the level of profitability is the extent to which cooperatives are able to integrate small scale farmers into their, production systems by providing financing for auxiliary services such as supply of inputs, farm machinery services, processing and marketing. This in turn depends on the extent to which land is released by cooperatives and credit is granted by commercial banks to small scale producers. 4. The cumulative effect of the deteriorating situation of loss making cooperatives has led to their inability to replace depreciated assets and, much less, to generate new investment. There is a widening gap in the 1ivel of fixed assets among the cooperatives. By i989, the profitable cooperatives' value of fixed assets per unit area was 69 percent higher than that of the loss making cooperatives. This situation explains the inability of the loss making cooperatives to increase productivity and diversify i-ito more profitable ventures. 5. Efficiency of production has become a major determinant of the profitability of cooperative enterprises. Production per unit area of loss making cooperatives is less, than one-half of total production value of the profitable cooperatives. The improvement in the quality of manpower is more evident among the latter. Loss making cooperatives had relatively higher labor costs, which often exceeded the amount of ther gross income less subsidies, and higher banking charges and overhead costs. Without subsidies, the loss making cooperatives could not even recover direct costs. Enterprise production grew by 44 percent from 1980 to 1987 in the case of loss making cooperatives compared to 76 percent for the profitA4le cooperatives. 6. The social responsibility of coopetatives to keep their active and retired members and permanent workers employed have contributed to the perpetuation of the loss making condition of cooperatives. Land not otherwise well suited to agricultural production could not, be taken out of production -70 ANN-EX-3 Page 3 of 5 until recently without considering its effects on unemployment.W Likewise, loss making cooperatives continued unprofitable lines of supplementary activities for the sats - purpose. The high labor component and relatively large number of pensioners constitute evidence that social considerations havt affected the viability of cooperative enterprises. Prospects for the improvement of the financial status of loss making cooperatives depend on the extent to which they could be relieved of this social burden. 7. Solutions to turn around the majority of the loss making pooperatives will require a commitment by Government and the new management of these cooperatives to match their resources with effective market demand at high levels1of productivity. In order to accomplish this goal, several supporting conditions must prevail in their favor: (a) available incentives such as ,bonuses and housing for new management teams; (b) debt write down programs such as those underway in selected counties; (c) formal restructuring through the legal process of liquidation proceedings; (d) access tolong term commercial credit through, perhaps, the use of guarantee funds and the right to mortgage land to the banks; and (e) the right of cooperative members to change the organizational structure of their cooperative. Debt Reduction Prograa for Low Efficiency Farms 8. In January 1987 the Government passed a decision to reduce the debt burden of large scale farms. Two hundred and thirty-four large scale farms (18 state farms and 116 cooperatives) were enrolled in the program scheduled over a three-year period; the Ministry of Agriculture and Food (NEM) and the Ministry of Finance (MOF) concluded contracts with the applicants based on the overall indebtedness, whereby the financial benefits were made subject to'the improvement of profit at the farms. In the first year ¢4ntracts were concluded in the disadvantaged areab or with indebted farms that were able to show the fastest improvement. In the second year, 1988, low efgiciency and indebted farms operating under disadvantaged circumstances were contracted and in 1989 the remair,ing farms were included. During the time between preparing applications and signing the contracts a liquidation process was started at four farms (Arlo, Cigand, Recse, Botpalad) and two farms merged with the neighboring farms, which had also applied for participation. 9. The purpose of the debt reduction program is : (1) to increase efficiehey of the participating firms; (ii) to increase the income generating ability; and (iii) to restructure their operations. If the planned profit is 8 produced after three years, the state writes off the liabilities and the commercial banks part of their loans or swaps these loan balances into Government grants. In case the conditions of the contract are not fulfilled, all obligation become due together with their accumulated interest. However, if there is a financial loss through natural disaster (flood, inland waters, frost, etc.) and its extent is such that Government assistance is required, VUntil 1989,. managers of large scale farms were required by the county councils to'plant field crops on all cultivated land irrespective of its level of loss to the financial position of the Earm. -71- ANE3 Page 4 of 5 the sahnctions are modified according to the particular case. 10. The Government (MOF and MEM) suspended during the three year period, the payment of debt servicing in the obligations included in the debt reduction package. Commercial banks suspended the repayment of existing investment and working capital loans in the timount and according to the schedule negotiated, while Government paid the banks 50X of the interests due of outstanding loans. 11. Of the 234 farms enrolled in the program, only 53 of them have no outstanoing loans with commercial banks, but are heavily indebted to state programs and have shown consistently poor financial performance over the years. Most of the farms with outstanding loans are clients of the Commercial and Credit Bank (92) and the Hungarian Credit Bank (71). Table 1 indicates only those obligations to Government which are included in the debt reduction program; in addition to these obligations, farms are responsible for the payment of accrued taxes and special transfers. 'The total amount of Government and commercial bank debt which would be possible to write off by the farms if they would all meet the agreed financial targets over the rolling three year period is estimated at Ft. 3.4 billion or US$66 million. Repayable loans or equity contribution from Government which add to Ft. 512 million are from the following schemes: (a) ad hoc transfers due to looses on their income statements over time; (b) supplements to investments that are in addition to the investment subsidies; and (c) refundable state equity contribution to onfarm investments. Commercial banks would offer to write off ' Ft. 2.8 billion in outstanding debts of which Government would reimburse them for Ft. 1.4 billion. In addition, other grants equal to Ft. 485 given to farms for various purposes would also be forgiven under the program. j,a 1: O=STANDImG OBLIGATIONS OF FARMS mEoLLED II DEBT REL-ICTION PPGX (In thousands of Forints in Currijut Prices) RWepayable Nuraber of Loans or Cc ercial Bank Loans Other Commercial Large Scale Equity from Principal Paid by Remaining Obligations Bank Farms Goverrment Baduction Government of Bank Loan Forgiven Budapest Bank 18 - 196 203 23 Hungarian Credit Bank 71 197 425 355 39 6S CoinnerciaL and Credit Bank 92 125 760 846 117 66 Without Bank Loan 53 358 IOTAL 234 512 ',381 1,404 179 485 Source: MM, Department of Cooperatives 12. The evaluation of contracts concluded in the first year of the debt settlement program - in 1987 - is taking place at the beginning of 1990. According to prelimin#ry data about 65-75X of the farms fulfill the U - 72 - ANNEX 3 Page 5 of 5 conditipns. About 10 cooperati-res are expected to be failures in terms of the program and those farms will hav6 to assume all suspended debt and obligations prior to entering into the program. If their creditors, particularly the commercial bank so decides, the cooperative would go into liquidation proceedings. The debt reduction program studied is different from the earlier similar programs, but cannot be considered a panacea for solving all problems, its novelty is its enterprise orientation and it appears to be based on mutual responsibility. It is having a favorable effect at those farms first of all, where the debts were primarily caused'not by unfavorable characteristics or by the disadvantaged area, but because they made significaht investments in the eighties. Thus their investment and working capital loans increased, and their profit,1due to a reduction of subsidies and the increase of input prices, significantly decreased. The debt settlement eliminated this unfavorable temporary circumstance, especially in those cases where the H management was sufficiently business oriented, well organized and utilized the assets efficiently. 13. In the case of chronic loss-making farms, which operate under unfavorable conditions and their level of management is not always satisfactory, the debt redAuction is sufficient only to finance the accumulated losses, but they can use only limited financial resources for restructuring, and they need such further funds which assist the rehabilitation process. These farms do not enjoy the trust of commercial banks, even if they transform into a new economic association. The future of large scale 'farms which have not succeeded (30X) is uncertain. They would be submitted for liquidation which may result in: (i) formation of a new organization, mostly specialized cooperatives; (ii) sale of assets including land in an auction. However, the liquidation process raises Aeveral issues including (a) land valuation methods, (b) social and welfare considerations, (c) mortgageability of their, land, (d) ownership and collateral, (e) access to commercial bank credit, and "(f) support services. New Rehabilitation Proartm for Low Efficiency Farms 14. The Government has reserved Ft. 3.3 billion for the payment of farm liabilities for the four-year debt reduction (1990-94). The number of large scale farms concerned is 200-250, of these 15-20 are state farms and the rest are agricultural cooperatives. These farms include 70-75,000 people and another 45-50,000 retired people.. They comprise an agricultural area of 700- 800,000 hectares and are related to 500-600 villages. The new application system is open to any large scale farm which strictly complies with the issued criteria of the invitation, on the basis of their 1985-1988 balance sheet data. 15.- The farms' undertakings will be appraised annually. In the netr system the obligations and benefits undertaken are distributed among four years in equal proportions. If in one year the obligation is not met, the next year's benefit'will be omitted, anq if in further years the undertaking is proportionally over-fulfilled, the benefit can be given in proportion to thatl .l~ ' Psge I of 3 MXARY INIIEGRATED ACRICULTURA PROJECT RELATING PRJECT OBJECTtVES WITH PROJECT CWllEltTS Covefiue Po60P lcies Institutlonal Strenotheninv Enterarise snr anoamit 1. Increase exp rts Expwd diret foreign trading lip-ave preshipent export leprove the export marketing lsrve locat transportation Initiate a five-year trainingi proia thruh higher qualtity rights tm redc obtiptory financing. services. I.e. Inform.tion on wd storage facilites. to edcate 200 executlves in mater's pro*ets ar limpoving export lieeses for specific prices, qualities, packogIng, Program In US and western Eurpean wasting and sales. product grows. abtering, tronsprtatfon, aniversities and business schools and storaeg of existin agencies amnother 200 executives in 3-4 week to better service direct training sesslwu abd on - _ - enterprises. agricultural. rd food mrketing. #ake foreign exchange readfly Facilftate export Insurance to -valvlable to exportars for exporters. -lportirg primry and intermdiary goots for reexport. Liberalize ibports of Ssbloans from crrciat bwans corinrclat inputs to the woutd also be detemoined by egricultural sector. the exportable orientation of the proosed prtdiction. Nrewte direct foreign Investment in joint vern,uva with foreign fire. It. Efficiency galins Nnitor the fe domestic fesipo cdity exchange Stremi the agricultur{a Reptace deteriorated and Apt mde buslnes plwming through chtwing traditional prices of agriculturat goods according to Internationel crop Insurance system to the outmed equlipent with high methods I.e. strategie mrket fam Into modern, so that they bectxe In tine stads mlth delivery requirments of Wgribwsinesi techotcgy products from vest targeting. _nngwnt infotr ftion egribsiness enterprises with interrationat prices. prdouces fnclutifng enterprwic. through comwercal credit. syptem modern finucael __agment standardsed future ;-eatices. EtRa wd cash flow constraints. projectiln of inted Invetmts. facititate the transformetfon Expwd tihe rentty Provide for a locat censulttnt Purdse cooputers and Begin to vertically integrate special of cooper tives to other estalished farket Inforemtion itrustry for busine am roprlate software for product tines in order to achieve corporate forme through Service to preside timety plaoning, finencitl n_gment ipovd business mnageunt. economies of scale w.a secialization modifications in cuments to price erd quality Information end accornting. of products for export. the cooperative Loaw the land to professionals operating In tam and the trenaformation merketing chains.. Accelerate the devetopasnI of Create iusector Crciel banks would readily Strengthen non-agriculturat Sell off loss-asking activities to the lotd mnrket by Interprotessional accept land as collateral for activitles throush new produt specialized firm or individuals. facilitating saltes n organitations by product developnt loans to farcers. devel%epent Where compatible purchases. groups WAich would set the with agricultural production. guideaines for an efficient wholesale or-ket, provide inforration between Government and trade and promote generic products both at homr end abroad. i ~ ~ ~ ~ ~ ~ ~ ~ f AW11" 4 Reduce subsidies a-d texea to Set ontending criterife ior the sector and make the cowercial bank loaos to rI ning subsidies pftout agribssiness enterprise4. neutrat. Requira .1t farm to, inctule Atter the current output six In term landsn a nationat asset an of Podto and improv the ovrerll ther- beltance sheets and quality of producto. ackoe_wnt of its owortance and for future ld evatuation. 111. Efficiency Gsins Facilitate the purchase of ailk accessible comerciel Provide irpAt upptlies fran Provide turds for pirchase of throu(;h Prtion of Our- farm lard to mall scale lines of credit to scmL-scale camercial sources approprlate equipment, Opertors in Farming ftr ers through passa of farmers. cpltemntin the err#angmnts aterials srd vehicles. legislation which mawtes the between large and setl-scole right of property o rship. ftars. Create a line of credit for PYblish 4rutes of thul faor private indlviduals to take setting the base price for credit for purchase of agricultural lond. agricultural land. Provide credit for contracts to purchase equipment tl work land, cultivate end harvest for priveate farers. Provide guideltnes for the Formatize contracts between Provide infometion services lwrova training courses for smit transfer of assets of lage-stale wd smtl-scale to seit-wcate foroers scate forgers with speciat cournes for egriculturaI cooperatives to farming. c'mcerning purcae of land tm farnm d young ien, who their aars. and achinery. witt work an the frm. C-eate a revtving fund of project proceeds within participating crcialt bans for linking toam to private farmers. Assist etml-scale faming llaie mavlable export throwgh farm system ra-erch serketing services, eptcially and extermion. to small-scale farms producing high valued produce. Set antending criteria for Pr. ome the organization of caemricel bw* losffto smIt-scele cooperatives private farsars. services tnctuding purchase of irpta and marketing of products. ., ~ ~ ~ ~ ~ ~ ~ ~ ~~E l /~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ Page 3 of I IV. Turn Loss-Nakiri Contimea debt rrutlon Restructw. thosM ceoweratlves Develtop a garian business Prowidlu fws in foreign tooporatives Into Profitable progrn of lENIM. end ahia participate in the debt plavring consultnt tdastrv. eachne to assist Entpeim cosreiat banks warte off procroo (nt8n4a) bi cooperatives in restructuring; developing caiste bainess ofte working capital weitable ptl. with the preofessonal bosed an their projected cash assistarne of epactottued flow. ccrsult In busirnesa planning. 7 Cive new rnnepmp ter of Encourage -rciel banks to 1aoro the seevices of the Restructure the prodtf dix of the restructured coeprative or of loan fresh cash to l1iqudation proceedings in cooperatives in tiae uit! effective voperoative uwd the debt restructured cooperative With order to assist cooprative rrket drd e.g. shift from field write off progrW persa GoverrCent gwrantees for pert and state feasr to erops to pasture and from pture to inrentives e.g. adequate or at1 of the toans. restructure. torestry. heuing wnd boms, fn order to ake ecooperatives profiteble. Permit third parties to inoest 4n cooepratives end benefit from profits or returns from sates. Designato agriculturat land Bra an asset for cooperatives aAich can be used as cottaterat for cmerciat bank leans. .~~m ANNEX 5 -76- Page 1 of 3 Integrated Agriculture Export Project Table 1. Crop Production Detalled Cost Table (Ft N) Base Costs Totals Including Contingencies 90/91 91/92 92/93 93/94 94/95 Total 90/91 91/92 92/93 93/94 94/95 Total l ~~~~~~~~~~...... ......................... ........ ...................... 1. INVESTMENT COSTS ............... A. Fqrm Nachinery 446 891 1062 788 240 3427 506 1075 1357 1063 341 4341 S. Drying,Sorting,Storing 50 101 120 89 27 388 59 129 167 133 43 531 C. Land tqnrevnnt 31 63 75 55 17 241 37 83 109 88 29 346 D. other 52 104 124 92 28 400 61 137 180 145 47 570 ..... .... .... .... ...... ...... .... ...... ..... ...... .... ..... Total INVESTMENT COSTS 579 1159 1381 1025 312 4456 662 1423 1813 1429 460 5788 ---uu a----- -uu a= Sn=z = inua 33 C== C t=C= 3W = Total 579 1159 1381 1025 312 4456 662 1423 1813 1429 460 5788 - Values scaled by 1000000.0 1/19 '1990 15:32 HUNGARY Integrated Agriculture Export Project Table 2. Lfvestock Production Detailed Cost Table (Ft N) Base Costs Totaels Including Contingencies 90/91 91/92 92/93 93/94 94/9 5 Total 90/91 91/92 92/93 93/94 94/95 Total ..................... .................... .......................................... 1. INVESTMENT COSTS A. Beef 32 64 76 57 17 246 38 85 112 90 29 353 8. Dairy 30 59 71 52 16 228 34 76 99 79 26 315 C. Pig 110 221 263 195 59 850 129 289 379 304 99 1201 D Poultry 79 158 188 139 42 606 92 204 266 213 69 843 E. Other 7n 154 184 137 42 594 90 202 265 213 69 839 ...... ..... .... ...... ...... ...... ..... ..... .... . . .... . ..... ...... Total INVESTMENT COSTS 328 656 782 581 177 2524 384 856 1120 899 293 3551 m _m smm Cm =m mm!z ==C u u m=2= mm se ms = S m Total 328 656 782 581 177 2524 384 856 1120 899 293 3551 - Values scated by 1000000.0 1/1990 15:32 . AD1NEX 5 - 77 -Page 2 ot 3 HUNGARY Integrated Agriculture Expo.et Project Table 3. Horticulture Detailed Cost Table (Ft M) Base Costs Totals Including Contingencies ONCss= 3=33=32=33S=3= now COCCuU COMMU=ZZO 90/91 91/92 92/93 93/94 94/95 Total 90/91 91/92 92/93 93/94 94/95 Total .......................................... ------------------------------------------................. .. ... ...................................... . .... 1. INVESTMENT COSTS A. Orchards 40 79 95 70 21 305 47 106 139 113 37 441 B. Vegetabwes 42 83 99 74 22 320 49 110 145 117 38 459 C. Wine and Grapes 44 87 104 77 23 335 51 115 152 122 40 481 D. rthver 34 67 80 60 18 259 40 89 117 95 31 372 ... ... .. ....... . ......... ........... ...... ......... ...... ......... ...... ......... ...... . .......... Total INVESTMENT COSTS 158 317 378 280 85 1219 187 421 554 447 146 1754 ----3 3----- ---33=--- -- - 5Y 33 3=3==3= aY== CZ=CZY Cce=Z CCCCZZ; t== 55=3 Total 158 317 378 280 85 1219 187 421 554 447 146 1754 333333=3=5535=33333333-=3353 555=s5s=s5 - 5 =3X - 55s=3a =3N=33=3 =-=CCCZZ=3 Values scaled by 1000000.0 1/19/1990 15:32 HUNGARY Integrated Agriculture Export Project Table 4. Agroprocessing and Other Detailed Cost Table (Ft M) Base Costs Totals Including Contingencies 90/91 91/92 92/93 93/94 94/95 Total 90/91 91/92 92/93 93/94 94/95 Total I. INVESTMENT COSTS A. Food Storage 0 0 130 275 95 500 0 0 174 393 144 711 S. Meat Processing 0 0 141 298 103 542 0 0 190 431 158 779 C. Grain Processing 0 0 120 254 88 462 0 0 161 363 133 657 D. Fruit and Vegetables 0 0 120 254 88 462 0 0 159 359 131 650 E. Forestry 3 5 6 5 1 20 3 6 8 7 2 26 F. Game 2 4 5 4 1 17 3 6 8 6 2 25 G. Other 0 0 196 415 143 755 0 0 263 593 217 1074 ...... ........ ..... ....... ........ ....... ...... ......... ._........ ...... ......... ...... ........ ................... . Total INVESTMENT COSTS 5 10 719 1505 520 2758 6 12 964 2152 788 3922 Total 5 10 719 1505 520 2758 6 12 964 2152 788 3922 - Values scaled by 1000000.0 1/19/1990 15:32 5 - 78 - Page 3 of 3 HUNGARY Integrated Agriculture Export Project Table 5. Trade Infrastructure Detailed Cost Table (Ft N) Base Costs Totals Including Contingenies UI C= C-:.uuuauZuunnuu 33 33==:3:2=3n-S3a:s=3 3333 s32=s 90/91 91/92 92V93 93/94 94/95 Total 90/91 91/92 92/93 93/94 94/95 Total .......... ....................................... ......................... ......................................... .......... 1. INVESTMENT COSTS ................ A. Trade Infrastructure Wholesale 20 40 48 35 11 154 23 50 65 51 17 205 Retail 20 40 48 35 11 154 23 50 65 51 17 205 Warehouses 8 16 19 14 4 62 9 20 26 21 7 83 Other 6 11 13 10 3 43 6 14 18 14 5 S7 ;z .......... ;i ... ..... ....... .. ....... ..... ...... .... ..... ..... ....... ........ ..... Sub-Total 54 107 128 95 29 413 62 135 173 137 44 551 ... ... ... ;i ----- --.; ....... ..... ..... ..... ... . . ...... ........ . .... Total INVESTMENT COSTS 54 107 128 95 29 413 62 135 17 137 44 551 *-= aCC - I S - = C ---- ----:s Cw=z C=r. -- -----> am-- -----1 ----= Total 54 107 128 95 29 413 62 135 173 137 44 551 _= = = w~~=3=33333=333333333=3==33333S:-t:=#C=_3== IS::--3=3==53=3---333=333===33SI - Values scaled by 1000000.0 1/19/1990 15:32 H:NGARY Integrated Agriculture Export Project Table 6. Technical Services, Education, and Training Detailed Cost Table (Ft M) Base Costs Totals Including Continger-les 90/91 91/92 92/93 93/94 94/95 Total 90/91 91/92 92/93 93/94 94/95 Total ...... ......... v................... ........ .................. ....... 1. INVESTMENT COSTS .... .... .. .. A. Technical Services 21 43 51 38 12 165 25 56 74 59 19 233 B. Education 21 43 51 38 12 165 25 56 74 59 19 233 C. Training 40 80 95 71 22 308 47 105 137 110 36 435 . ... i.. . .... .... .....i ....... ... ....... ...... ..... ..... ... iz..... Total INVESTMENT COSTS 8 166 198 147 45 638 97 217 284 228 74 902 =0= *-m C== =*- *-- -- 0 -- - - ---- == Total 83 166 198 147 45 638 97 217 284 228 74 902 - Values scaled by 1000000.0 1/19/1990 15:33 - 79 - ANiE]X 6 INTEGRATED AGRICULTURAL EXPORT PROJECT Estimated Disbursement Schedule of bank Loan Estimated Schedule Calendar Year Percentage and Month-ending Cumulative of Total Semester Fiscal Year Amount Amount (X) (US Million) Dec. 31, 1990 FY91 3.0 3.0 3 June 30, 1991 FY91 5.1 8.1 8 Dec. 31, 1991 FY92 10.0 18.1 18 June 30, 1992 FY92 13.7 31.8 32 Dec. 31, 1992 FY93 14.0 45.8 46 June 30, 1993 FY93 15.4 61.2 61 Dec. 31, 1993 FY94 13.8 75.0 75 June 30, 1994 FY94 10.0 85.0 85 Dec. 31, 1994 FY95 7.0 92.0 92 June 30, 1995 FY95 5.0 97.0 97 Dec. 31, 1995 FY96 3.0 100.0 100 \~~~~~~~~~~~~~~~~~~~~~~~ 80- Page 1 of 30 HUNGARY INTEGRATED AGRICULTURAL EXPORTYPROJECT AGRICULTURAL AND FOOD MARKETING Terms of Reference I. BACKGROUND:- I\ , . E A large training program in agricultural and food marketing has been agreed\upon (a) to fill an educational gap toward a market-oriented economy; and (b) to lay the basis for a self-designed agricultural market organization by the Subsector Interprofessional Organizations (SIO). Two types of marketing specialists would be in great dem4nd in the next decade: (a) agricultural marketing specialists: traders, sellers and buyers of raw agricultural commodities (cereals, oilseeds, live animals, fruit and vegetables, etc.) or first procossed products (flour, animal carcasses or packed cuts, sugar, protein meal, vegetable oil, etc.); and (b) food marketing specialists: product managers and merchandisers for the processing firms. II. OBJECTIVES: Over a five-year period of time, the training program would provide the Hungarian food and agriculture sector with the following specialists: (a) on the medium term: about 100 (50 in agricultural marketing and 50 in food marketing) future professors, trainers in charge of executive programs and senior executives would graduate in agricultural marketing and business (majoring in marketing) in both North American and West European Uhiversities; aftd (b) on the short term: young and experienced executives who would specialize in marketing related questions. A total of 125 of them would follow short training sessions abroad (100 in agricultural maFketi\g and 25 in food marketing). In addition, 5 to 6 foreign specialists would visit each year Hungary to participate ifi short seminars on agricultural and food marketing. III. TRAINING PROGRNS: The project unit would be in charge of the setting and the follow-up of the training activities. This would include, short seminars to be organized in Hungary and two types of education and training programs to be run abroa! !U V . .... \~~~~ - - 81 - Page 2 of 30; (a) education at a master level in agricultural marketing ('master programs'): this would be organized for young executives and undergraduates (about one-year programs) dua to become professors, trainers and senior executives in Hungary; and (b) three weeks session\s for executives of large farms, processing companies or cooperatives, staff and members of the Boards of SIO, etc. The project unit would advertise about the different programs and make the proper decisions to facilitate their implementation over the five year period of time. The project unit would report each yeag about the running of the training component. IV. TRAINING COMPONENT IN AGRICULTURAL MARKETINrG Master programs in agricultural marketing: each year, about twenty participants would follow master programs in agricultural marketing, half of them in North American Universities and half in Western Europe (Bank would provide tentative list of Universities running such programs). The training would include attendance to lectures, seminars, and writing of a thesis. The following topics should be studied: (a) Agricultural marketing (see details in Appendix 1); (b) Markets analysis (preferably including an econometric approach); (c) International economics; (d) Agricultural and Trade Policies (e) Futures and options trading; (f) Agricultural cooperatives management; (g) Money and banking techniques; (h) International finance. Three weeks sessions: each year, two groups of about twenty executives each would convene respectively in North America and in the European Community to follow three weeks of intensive training and technical visits of regional marketing facilities. This wouldcbe prepared by the project unit, on a contract basis with fore.gn Universities or similar institutions (Bank will provide a tentative list). The sessions should cover the following major topics: (a) agricultural marketing techniques; (b) price formation ind market analysis; (c) impact of agricultural and trade policies on markets equilibrium; (d) risk mafiagement on futures and option markets; and (e) visits of commodity exchanges (auction and other wholesale markets, commodity futures exchanges and,-where possible, electronik markets), handling fac9llties, trading companies, mar4eting cooperatives, trade - 82 - ANNEX 7 Page 3 of 30 associations, procurement departments of processing companies, brokerage firms. Lectures and visits *would be alternatively run by professors and local professionals. Two-ddays seminars would be run in Hungary (one per year), by Hungarian specialists, unIer the supervision of the project unit, on domestic agricultural marketing. Three specialists from foreign countries would be invited each year. V. TRAINING COMPONENT IN FOOD MARZETING The training programs in food marketing (see Appendix 2 for tentative - list of subjects) would follow a similar format than the one on agricultural marketing. However, these programs would only be run in Western Europe: (a) master programs (for 5 young executives or undergraduates per year over five years); and (b) three weeks sessions (one per year) for twenty executives over five years). A tentative list of educational organization would be drafted by the Bank. In addition, two-days seminars on food marketing would be run in Hungary, by Hungarian specialists. Three specialists from foreign countries would be invited each year. VI. TIMETABLE: The above-mentioned program would be run on a yearly basis, starting no later than january 1991. VII. ESTIMATED COSTS: The training program in agricultural and food marketirng would have over the five year period of time, an estimated total cost of US$ equivalent 5.3 million (13.21 in Forints, 86.8% in foreighn currency) broken down as follow: 83 ANNEX 7 Page.4 of 30 Cost table (US$ 1,000 equivalent) Domestie Foreign Total * Agricultural marketing: - Administration of the program 30 - 30 - Master programs (*) 40 2,100 2,140 - Three-weeks sessions (*) 200 800 1,000 - Seminar in Hungary (**) 150 150 300 *Food marFketina: - Administration of the program 20 - 20 - Master progtams (*) 10 1,000 1,010 - Three-weeks sessions (*) 100 400 500 - Seminar in Hungary (**) 150 300 Total 74600 5.300 **) travel, cost of living, tuition & fes (**) taavel, cost of living, fees l~~~~~~~~~~~~E \ \~~~~~~~~~~~~~~~~~~~~~~~~ - 84 - AEX 7 Page 5 of 30 APPENDIX 1 AGRICULTURAL MARKETING Tentative Program of Training A. INTRODUCTION TO AGRICULTURAL MARKETING: (a) 0hrerview of the interdependence in the food and fiber marketing chain; (b) The institutions involved in agricultural marketing (private and publis); (c) The functions performed in marketing: (i) exchange functions (buying and selling); (ii) physical functions (storage, handling and transportation, processing); (iii) 'facilitating' functions (standardization, financing, marketing intelligence gathering, risk bearing; (d) Marketing at the micro-level: operations involved on the standpoint of the agents in the marketing chain. B. MARKET ANALYSIS: price formation and the competitive environment. C. SPACE. TIME AND QUALITY ASPECTS OF MARKETING: (a) Price formation over space: (i) price relatironships between delivery places; (ii) optimization of flows of prod;ts between production and consumption places; (iii) arbitrage between delivery places; (b) Price formation ;-ver time: (i) price differentials over time for seasonal, non-seasonal and storable, non-storable commodities; (iii) arbitrage trading over time; (c),Price formation over quality: (i) trading by description; (ii) grading and quality; (iii) problems related to grading; (iv) price differentials between qualities; (v) minimization of procurement cost under quality constraints in the food and feed industries; D. PRICING kNSTITUTIONS: Mechanisms for discovering agricultural prices; private contracts (direct or through brokers); auction markets; electronic markets; futures markets; administrative pricing (interprofessional or public). E. COMMODITY FUTURES AND OgTIONS MAMRKES (introduction): - ' GRO ~ TURSKEY JANUARY 1 . . .. V _%~ . .L*I~dIJ4~ 18RD 2 - \ H U N G A R Y -G A R. INTEGRATED AGRICULTURAL EXPORT PROJECT V I .saoo'co-.. i CF¶TABILITY OF AGRICULTURAL COQPERATIVES BY COUNTY CZECHOSLOVAKIA I4WC ACIRO7OS U. S S. R. RROFITABILiTY.OF AGRICULTURAL COOPERATIVES BY COUNTY - MOTORWAY 80BO50-APAUJ- HIGH INCOME (BETWEEN 115 150Y Pf THE AVERAGE) MAIN ROADS j6 , AVERAGE INCOVE (BETWEEN 85 - 115% OF THE AVERAGE) - RAILROADS BELOW AVERAOE INCOME (BETWEEN 5S 85% OF THE AVERAGE) , CANALS ,ua- LOW INCOME (NOT REACHING 50% OF THE AVERACE) RIVERS J *-.AI 4 ;4,; NATIONAL CAPITALLCY @ MEOYE CAPITALS ICSIgrr1' 2 -. - _ _ MEGOE (COUNTfl ROUNOARIES 0ESo -.-INTERNATIONAL BOUNDARIE -'R'IIA AUSTRIA I To V~~~~~~~~~~~~~~~~~c M&h6n4~~~~~~~~~~~~~~SAT ViS 0EV < o !w W t 1 §4 . ROMANIA 2AM \p.iorcos 10~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~N M--S IS -0 !R I 1 Sz ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~~~~~~~~*~EHSOKA ~ pts,~~~~~~~~~~~~~~~~~~~~~~~~ Cog ~ ~ ~ ~ ~ ~ ~ ~ BLAI Koposv MILES 0 to 20~~~~~~~~~20GR 3 ANUAo k -~~~~~~~~~~~~~~~~~~ N I,~ ~ ~ ~ ~~~~~~~~~~~f , 2 I IEGD 0)B INTG~AhD HUNGARY z*~ INTEGkATED AGRICULTURAL EXPORT PROJECT X , LOCATION OF PRIVATE SECTOR FARMERS CZECHOSLOVAKIA / - r'Hia""* . U. S. S. R. LOCATION OF PRIVATE SECTOR FARMERS' MOTORWAY = MOST POPULATED COUNTIES M- MAIN ROADS . BAW - AVERAGE POPULATED COUNTIEI - - RAILW)ADS EN LEAST POPULATED COUNTIES CANLs 'NOTE; Ro-4 fo oR c-nok.la A6.RIER - P*pO ol.iion i; ATgEiOu,e -nd Sto-k of Pig, NATIONAL CAPITAL ) IS&onnfo,n (i) ~~MEGYE CAPITALS uj6 MEGTE (COUiNTY) RUORR AUSTRIA r - INTERNATIONAL RONAIS(8to.4i N~y6 VES ~~~~~~~~~SAMA' kE-d -~~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ . A4k 'io'' \ ' ' \ ' _ 'oh NOOY*ARiRI'O~ ~ ~ ~ ~~7 RILOMITIRS 0 to 20 30 40 50 ES 70 MILRS 0 tG 20 30 do RCHO>~~~~~(SA~~~~ U. S. S.P AUSTRIAN* ~HUNrARY/ OTY ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~~ ~~~~~~~~~~~~~~-ROMANJIA YUGOSLAVIA YU~~~~~a4GOSLAVI ~ ...' K -, ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~~~~~~~~~~~~~~~~~~~~ ~~~~~~BULGARIA JANUARY