Report No. 427-CE

Appraisal of the FILE COpySri LankaDairy Development ProjectJune 5, 1974

Asia Projects Department

Not for Public Use

Document of the International Bank for Reconstruction and DevelopmentInternational Development Association

This report was prepared for official use only by the Bank Group. It may notbe published, quoted or cited without Bank Group authorization. The Bank Group doesnot accept responsibility for the accuracy or completeness of the report.

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CURRENCY EQUIVALENTS

US$1 = Sri Lanka Rupees (Rs) 6-74MRs 0.01 = Sri Lanka CentRs 1 US$0.148Rs 1 million = US$148,368

WEIGHTS AND MEASURES (British System)

1 long ton 2240 lbs = 1.016 metric tons1 hundredweight (cwt) 114 lbs = 50.8 kg1 bushel (bu) 45 lbs (of paddy)1 pint 0.57 liters (1)1 acre 0.405 hectares (ha)1 mile 1.609 kilometers (km)1 gram (g) 0.035 ounce (oz)1 inch = 25.4 millimeters (mm)

ABBREVIATIONS

APHD = Animal Production and Health Division(in the Ministry of Agriculture)

CRB = Cooperative Rural BankDCS = Dairy Cooperative SocietyMPCS Multipurpose Cooperative SocietyNMB = National Milk BoardPTU = Project Technical UnitAPC = Agricultural Productivity Center

FISCAL YEAR

January 1 - December 31

/1 The Sri Lanka rupee has been tied to the poundsterling since June 1972 at Rs 15.60 per poundand has consequently been floating with it. TheUS dollar rate is thus dependent upon the cross-ratebetween the pound and the dollar. The rate ofUS$1 = Rs 6.74 was established by the Central Bankof Ceylon on December 31, 1973. Under the ForeignExchange Entitlement Certificate Scheme (FEEC's),a levy of 65% is applied to most non-food imports.Since the major items to be imported by governmentagencies under the proposed Project are subject tothe FEEC's, the exchange rate used in this AppraisalReport is US$1 = Rs 10, which is the approximateaverage FEEC rate between June 1972 and the time ofproject appraisal.

SRI LANKA

DAIRY DEVELOPMENT PROJECT

TABLE OF CONTENTS

Page No.

SUMMARY AND CONCLUSIONS ............................... i - i

I. INTRODUCTION ........ ............. .....................

II,, BACKGROUND ...................... ......................

A. General . .......................................... 1B. Agricultural Sector .............................. 2C. Milk Marketing and Processing .................... 3D. Development Support Services ..................... 4

III. THE PROJECT AREAS ..................................... 6

IV. THE PROJECT ........................................... 7

A. Description ...................................... 7B. Detailed Features ................................ 8C. Cost Estimates ................................... 10D. Proposed Financing ............................... 12E. Procurement ...................................... 13F. Disbursement ..................................... 14C. Reporting and Auditing ........................... 14

V. ORGANIZATION AND MANAGEMENT ........................... 15

A. Administration ................................... 15B. Management and Technical Services ................ 15C. Lending Operations ............................... 17

VI. MARKETING, PRICES, SUBSIDIES AND PRODUCER BENEFITS .... 18

A. Marketing and Prices ............................. 18B. Subsidies . ........................................ 20C. Producer Benefits ........ ........................ 21

VII. ECONOMIC BENEFITS AND JUSTIFICATION ....... .. .......... 21

VIII. AGREEMENTS REACHED AND RECOMMENDATION ............. ... 22

This report is based on the findings of a mission composed of R. Bailey (IDA),H. Groenewold (FAO/IBRD Cooperative Programme) and T. Haworth (Consultant)that visited Sri Lanka in June/July 1973.

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ANNEXES

1 - The Dairy Sub-Sector2 - National Milk Board3 - Pricing and Subsidies Relating to the Dairy Sector4 - Recent Legislation: Land Reform and Agricultural Productivity5 - Agricultural Cooperatives6 - The Lending Banks7 - Dairy Farm Development Projections8 - Management, Technical Assistance and Pilot Units9 - Terms of Reference for Technical Assistance Specialists10 - Terms of Reference for Milk Collection and Transport Consultancy11 - Project Costs by Investment Categories12 - Estimated Schedule of Disbur3ements13 - Financial Rates of Return14 - Economic Rate of Return

MAP

SRI LANKA

DAIRY DEVELOPMENT PROJECT

SUMMARY AND CONCLUSIONS

i. Agriculture plays a major role in the economy of Sri Lanka throughits large contribution to GNP, foreign exchange earnings, and governmentrevenue. In 1973 the agricultural sector accounted for nearly 33% of GNP,about 77% of export earnings, and 50% of total employment. While livestockfarming has considerable potential it is now of minor economic importance,contributing only about 7% of the gross value of agricultural production.

ii. The proposed Project would be the Bank Group's fourth in agri-culture in Sri Lanka and the first IDA Credit in the livestock sector. Itwould provide for on-farm development on about 42,000 acres, comprising about1,800 small (5-10 acres) and 600 larger (40-50 acres) farms in the CoconutTriangle and Mid-Country, including purchase of about 10,400 local and 3,200imported heifers. Existing milk collection and transport services of theNational Milk Board (NMB) and cooperatives would be expanded and improved.Technical assistance is also prov:lded in the form of pilot programs to developand demonstrate systems of communal calf rearing and techniques for milkproduction in the Dry Zone area, as well as for in-service training.

iii. Project cost is estimated at US$12.7 million equivalent, includ-ing working capital required during the on-farm investment phase, and coversa five-year period, from 1974 to 1978. The proposed IDA credit of US$9.0million would finance foreign exchange costs of US$5.5 million and about502 of local currency costs. Government would establish a project accountwith the Central Bank of Ceylon through which the proceeds of the IDA creditwould be channeled. The major part of the credit ($5.5 million) would be foron-farm development and milk collection and transport investments and wouldbe relent by the Borrower to two participating banks - People's Bank andBank of Ceylon - for 12 years including three years of grace with interestat 6% p.a., for subsequent relending to dairy farmers, NMB and cooperatives.The participating banks would augment these funds by contributing about $1.5million of their own resources to the financing needs of the project bene-ficiaries. Relending terms to project beneficiaries would be: (a) tofarmers at 10% p.a. for 12 years; (b) to NMB at 8% p.a. for 10 years; and(c) to cooperatives at 8% p.a. for 12 years; all including a three yeargrace period. The remainder of the credit ($3.5 million) would be forimported livestock, the Project Technical Unit and pilot operations andwould be disbursed through the Ministry of Agriculture, complemented byGovernment's contribution of about $0.5 million. Government would alsocontribute about $0.9 million in the form of pasture development subsidiesto participating farmers. Farmers would contribute about $0.9 million inlabor, cash and kind toward the cost of on-farm development and livestock.

iv. In order to ensure overall coordination, a Project Committee wouldbe established under the chairmanship of the Ministry of Planning and Econo-mic Affairs. It would include representation from all agencies and banks

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concerned in the Project. Responsibility for executing dairy farm develop-ment, livestock procurement, techuical services and pilot operations providedunder the Project would lie with PTU, which would be established in theMtinistry of Agriculture. The PTU would be headed by a Project Director whowould report to the Deputy Director of Agriculture responsible for the AnimalProduction and Health Division (APHD) and who would be supported by inter-nationally recruited personnel, including a technical director and expertson tropical pasture and calf-raising. Responsibility for milk collection,transport and marketing would lie with NMB and be coordinated through theProject Committee.

v. International competitive bidding, in accordance with IDA guide-lines, would be used for the purchase of imported milk storage equipmentand vehicles and mobile testing units to be purchased by NMB - about US$0.6million. Heifers valued at about US$1.4 million would be imported fromselected countries free from foot and mouth disease in accordance with pro-cedures acceptable to IDA. As most major vehicle manufacturers are representedin Sri Lanka, local competitive bidding would be used for purchase of importedvehicles required by PTU - about US$0.3 million. Seed and materials forpasture planting would be purchased from local suppliers. Local contractorswould be used for construction of selected buildings, and water supplyfacilities which would be of a small and scattered nature. Local cattle wouldbe procured from both Government herds and from private farm herds throughauctions organized by PTU.

vi. Participating farmers are expected to benefit from higher netincomes at full development, expected in 1981, and the smallest farmerswould more than double their incomes. Additional milk production wouldbe about 43 million pints annually, amounting to about 25% of 1972 importsof dairy products giving estimated annual foreign exchange savings of about$2.0 million. The estimated financial rate of return to the farmers' invest-ments would range from 15% to 19%. The economic rate of return for theproposed Project is estimated at 15%. The project would create new jobs forabout 1,500 people.

vii. The proposed Project would also assist the Government in its planneddiversification from marginally productive tea on 14,000 acres in the Mid-Country. In addition, the extension and research activities in pasture deve-lopment, communal calf rearing and milk production would encourage soundanimal husbandry not only on project farms but also in the surrounding areas.Moreover, the experience gained in financing development of small farmersunder the Project is expected to contribute significantly to improved andexpanded credit operations in the dairy sector.

viii. The proposed Project is suitable for an IDA credit of US$9.0 million.

SRI LANKA

DAIRY DEVELOPMENT PROJECT

I, INTRODUCTION

1.01 The Government of Sri Lanka has applied for Bank Group assistancein financing a part of its Five Year Plan (1972-76) in the dairy sector.The proposed Project would support dairy development on small to medium-sized farms, and help expand essential milk collection and transport facil-ities. The Bank Agricultural Sector Mission of October 1971 identified theProject. It was subsequently prepared by an interagency team from variousSri Lanka Government departments, with assistance from the FAO/IBRD Coopera-tive Programme.

1.02 This would be the Bank Group's fourth agricultural sector projectin Sri Lanka. Credits 121-CE' for US$2.0 million in 1968 and 168-CE forUS$2.5 million in 1969 supported irrigation and land reclamation. Loan653-CE/Credit 174-CE for US$29.0 million in 1970 supported power and irriga-tion. Although there were initial delays, progress on the three projectsis satisfactory.

1.03 This report is based on the findings of a mission composed ofR. Bailey (IDA), H. Groenewold (FAO/IBRD Cooperative Progratme) and T. Haworth(Consultant) that visited Sri Lanka in June/July 1973. Consultation with theGovernment of Sri Lanka regarding dairy pricing and other policy matters wereundertaken following the field appraisal.

II. BACKGROUND

A. General

2.01 The Republic of Sri Lanka covers an area of 25,300 sq mi and hasa population of about 13.5 million which is growing-by slightly more than 2%annually. Various governments since independence in 1948 have concentratedheavily upon a wide range of social welfare programs, expenditures for whichhave tended to depress the rate of economic growth. The real GDP growthrate, which has averaged about 4% over the period 1960-1970, dropped toless than 1% in 1971 but recovered to about 2% in 1972 and to 2.5% in 1973.Per capita income in 1971 was estimated at US$100. Activity in the privatesector remains depressed; unemployment is high, particularly among theyoung; export earnings in real terms have declined sharply in recent years,and, with increasing prices for oil and other imports, the balance of paymentsis under strong pressure.

2.02 Sri Lanka's economy is predominantly agricultural. Agriculture isthe largest productive sector, accounting in 1973 for nearly 33% of GNP,50% of total employment and 77% of all export earnings through the sale of

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tea, rubber and coconut products. In contrast, food imports, which haveaveraged about US$150 million p.a. in the past five years (over 50% of allforeign exchange earnings), have increased.

2.03 In its effort to reverse the deteriorating economic trend, Govern-ment is concentrating attention on both export expansion and import substi-tution programs, looking particularly to increasing domestic production ofrice and subsidiary food products, including meat and milk. The Bank Groupis already assisting rice production through irrigation projects and withthe proposed Project would provide effective support to development of thelagging dairy sector, aimed at increasing supplies of milk and reducingthe country's dependence on imported milk powder. In 1972 these importswere worth about US$8 million representing about 43% of the liquid milksales of NMB. Even with imports at this level, the per capita availabilityof milk is only about 45 g per day compared with about 113 g per day inIndia. This is inadequate to meet even minimal daily nutritional require-ments, estimated at about 150-200 g per capita.

B. Agricultural Sector

2.05 Sri Lanka's patterns of agricultural production are extremelydiverse, reflecting varied climat..c and topographic conditions. The Wet Zone(i.e. the highlands and the southwestern region) receives both monsoons; theannual rainfall varies from 75 to 200 inches. This Zone covers 25% of thearea and contains two-thirds of the area under permanent agriculture. TheDry Zone, the northern and eastern 75% of the island, receives 35-75 inchesof rainfall mostly during the four-month November-February period. Rainfedcrop growth is severely limited during most of the other months (Map).

2.06 Of a total land area of 16 million acres, only one-fourth isunder permanent agriculture; most of the remainder is forest or bush,natural grassland and scrub. Tree crops, mostly tea, rubber and coconut,are grown on both estates and smallholdings and cover nearly 60% of thepermanent cultivated area. Rice accounts for 30% of the cultivated areaand, along with a great diversity of other crops as well as livestock, isproduced mainly on peasant smallholdings. Farm sizes are generally small:of nearly 1.2 million total land holdings at the 1962 Census, only about6,000 were larger than the 50 acre maximum subsequently imposed by 1972land reform legislation and 85% were smaller than 5 acres (Annex 1, Table 4).

Livestock and Milk Production

2.07 Cattle and buffaloes, numbering 1.6 and 0.7 million respectively,are the most important farm animals. Most herds are very small, with theanimals kept primarily for draught and milk on widely dispersed smallholdingsthroughout the island. About 90 million lb of beef (mostly by-product), 20million lb of other meat (chiefly pork and poultry), and 225 million pintsof milk (bevond that fed to calves) were produced in 1972, accounting intotal for about 7% of the gross value of agricultural production. Consump-tion of livestock products is low, averaging about 7 lb of beef, 1.5 lb of

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other meats and 29 pints 1/ of milk (of which 12 plnts were imported) percapita in 1972. Including eggs and milk, all livestock products combinedaccount for only 6% of all food protein consumed.

2.08 Total livestock output lhas increased since 1960 at an averagerate of about 4% annually. Growth was confined to the early 1960's, however,and slaughter of all types of farm animals has increased since 1965 leadingto a considerable decline in cattle and buffalo numbers.

2.09 With only 40% of the total cattle numbers, the Wet Zone has greatpotential for dairy development. Conditions for pasture growth are suchthat it is possible to produce milk on a year round basis. Most cows in thisarea produce up to 10 pints per day during a 160-day lactation period comparedwith 2-3 pints in the Dry Zone. Basic information on pasture development inthe two main milk producing sub-zones in the Wet Zone (the Coconut Triangleand the Mid-Country) is available. The potential for increasing productionfrom these sub zones is considerable, both through the application of knownpasture technology and the greater use of crossbred and purebred Europeandairy breeds. By contrast, pasture management technology has yet to beproven in the Dry Zone.

Animal Health

2.10 Sri Lanka is free of rinderpe;t. Foot and mouth disease, hemorrhagicsepticemia, black quarter and anthrax are prevalent but are effectively con-trolled through disease control programs (Annex 1). Foot and mouth diseaseordinarily causes only a temporary reduction in performance. Hemorrhagicsepticemia is normally fatal unless animals are vaccinated at six month in-tervals. Piroplasmosis and anaplasmosis do not affect indigenous cattle,but all importations require preimmunization. Internal parasites can becontrolled by drenching. Leeches attack grazing cattle on pastures above1,200 feet elevation and cattle are customarily housed to prevent reductionin milk production. Calf mortality is a serious problem in the Mid and Up-Country where calves are normally separated from their mothers after birth,suffer from malnutrition and are made more vulnerable to disease. A pilotproject to develop techniques for collective calf rearing is proposed (para4.12).

C. Milk Marketing and Processing

2.11 About 75% of the milk produced domestically for sale is marketedlocally either directly or more commonly through middlemen who pay the farmer35-40/pint. The remaining 25% is sold through the Government-owned NationalMilk Board (NMB) which processes and markets mainly in the larger populationareas.

1/ Liquid milk equivalent of all milk products consumed.

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2.12 The role of NMB. The NMB is the biggest milk marketing organiza-tion in Sri Lanka and the only one with processing facilities. However,until May 1973 when the procurement price was increased from 40i to 60i perpint, the Board had great difficulty in obtaining regular supplies. Todaymore farmers are selling regularly to NMB through their cooperatives and itssupply position is improving. However, many potential suppliers are unableto sell to NMB because of inadequate collection facilities.

2.13 Currently NMB has about 30 milk collection centers throughout theisland with another 20 coming up by 1974. Processing capacity in NMB'sfive plants is now 281 million pints/year with the recent commissioning ofa milk powder factory at Ambewela and a heat treatment plant at Colombo in1973. At maximum operating capacity NMB could process nearly six times thequantity of milk collected in 1972.

2.14 Since late 1972, NMB has purchased milk almost exclusively fromcooperative societies which collect milk from farmers and deliver it toNMB collection centers (para 2.20). NMB pays cooperatives monthly for wholemilk delivered; cooperatives pay their suppliers one or two days later,after deducting a collection charge which by recent cabinet directive cannotexceed 5 cents 1/ per pint. Previously, collection charges ranged up to 11cents.

2.15 NMI's financial structure, management and operating performance arepresently weak (Annex 2). NMB's price policy is rigidly controlled byGovernment. The procurement price for;4% butterfat milk, which averaged 40cents per pint (extremely low by international standards) over 1970-72, wasincreased to 60 cents in May 1973. Consumer prices of NMB milk products,which historically have been set below cost, were increased by 20-85% inMay 1973, but the price of NMB's two major products, powder and condensedmilk, were reduced a few days later, due to public protest and politicalpressure, to a point above their previous level but below cost (Annex 2 andparas 5.07-5.08).

D. Development Support Services

Research, Extension and Education

2.16 The Animal Production antd Health Division (APHD) of the Departmentof Agriculture and Lands (Ministry of Agriculture) has primary responsibilityor p,licy formulation, research, veterinary and extension services in the

livestock sector. With 92 veterinarians filling most key positions on itstotal staff of 500, animal health has been given more emphasis in programsand services than has animal production, particularly with respect toextension services.

2.17 Pasture and forage research is conducted at Government farms(para 2.19), the University of Ceylon, the Coconut Research Institute and

1; Sri Lanka cent, equivalent to Rs 0.01.

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the Agricultural Research Station at Maha Illupallama. Pasture speciesadapted to conditions in the proposed Project areas have been proven andplanting materials are produced and sold by both Government and privatenurseries.

2.18 Four year B.Sc (Agriculture) and B.V.Sc degree courses at theUniversity of Ceylon have produced 30-40 graduates per year; admissionshave now been increased to 100 annually. A two-year animal husbandrydiploma course at the Kundesale School )f Agriculture graduates about100 per year, most of whom join the Department of Agriculture asinspectors, and two to six-month training courses in animal husbandryare offered on Government farms and at the APHD Training Institute atPeradeniya. While numbers of graduates are adequate to meet the manpowerrequirements for the Government services concerned, it is anticipatedthat further training of personnel to staff the proposed project willbe required and conducted by the Project Technical Unit (para 4.03).

Government Farms

2.19 Three Government farms maintain herds of improved dairy cattlefor research and training, multiplication and sale of bulls and heifersto private farmers, and for milk production to supply nearby NMB milkprocessing plants. The farms alsc serve as quarantine stations for largescale imports of cattle. More emphasis has been placed on milk productionthan on the other service functions (Annex 1).

Agricultural Cooperatives

2.20 The cooperative structure in Sri Lanka, at the primary level,

consists of 368 large sized Multipurpose Cooperative Societies (MPCSs),most of whose main activity has beeti to run consumer stores, and a numberof specialized societies including 29 Dairy Cooperative Societies (DCS)and seven coconut producers' cooperatives. Two major changes significant tothe proposed Project have occurred in the functions of the MPCSs followingcompletion of a drastic reorganization in 1971 (Annex 5). They, along withDCSs, have taken a much more active and generally efficient role in collect-ing milk for NMB (from 5% of NMB purchases in 1969 to 65% in 1973); furtherincreases are expected and encouraged by NMB. Second, a program to estab-

lish Cooperative Rural Banks (CRBs) within the MPCSs has been activelypursued, with CRBs increasing from 20 in 1967 to 350 in April, 1974. Estab-lishment of CRBs in nearly all of the 368 MPCSs (152 in the proposed Projectareas) by the end of 1974 is planned; each with deposit and agriculturallending facilities and with access to Peoples Bank for banking advances (para2.22 and Chapter IV). Details of the perfortiance of the Banks are given inAnnex 6.

Banking and Agricultural Credit

2.21 The commercial banking system in Sri Lanka consists of four localbanks and eight foreign banks. The former account for 77% of the depositsof all banks and of these, the Bank of Ceylon and the Peoples Bank are the

largest, each with deposits of about Re 1 billion. Some 10% of the advances

by the! Bank of Ceylon are for agriculture, mostly to the larger tea andrubber estates. Of the advances by the Peoples Bank, 20% are for agricul-ture, mainly to coconut farmers and cooperatives. The Bank of Ceylon, setup in 1938, is now fully state-owned, while Government and Cooperativesshare about equally in ownership of the Peoples Bank. The Central Bankof Ceylon, which exercises supervisory powers over all banks in thecountry, provides rediscount facilities to banks from its general fundsfor short-term advances, and from its Medium and Long-term Fund forlong-term (up to 15 years) advances. Interest rates vary from 8 to 12%for agricultural advances depending on collateral offered and period ofthe loan.

2.22 Two significant developments in banking and agricultural creditare in process. First, under the Agricultural Productivity Act of 1972(Annex 4), over 400 Agricultural Productivity Centers (APCs) will be built(150 open at April 1, 1974), each to include a branch or sub-branch of theBank of Ceylon. Bank of Ceylon is pressing the branch establishment program,consistent with a policy decision to participate more actively in small-holder farmer financing. Second, a network of CRBs is being establishedby cooperatives with support of Peoples Bank. Plans are for about 90 Bankof Ceylon branches (or sub-branches) and 100 CRBs to be operative in theproposed Project areas (in which both banking systems are expected to parti-cipate as on-lenders) by the end of 1974. This rapid expansion is strainingthe supply of experienced management, particularly at local (branch/CRB)level, and both banking systems are recruiting and expanding their managementtraining programs.

Bilateral and Multilateral Support

2.23 The proposed project was designed with the benefit of the ex-perience gained under the UNDP/FA0 Project (CEY 22 "Agricultural Diversifica-tion of Uneconomic Tea and Rubber Lands") which is identifying alternativeland uses including the development of improved pastures in the Mid-Country.

2.24 Dairy development is aided by various assistance programs, manyof which are a part of the International Scheme for Coordination in DairyDevelopment (ISCDD) initiated by FAO in 1969/70. Bilateral aid includesa pledge of US$2.1 million from Sweden (SIDA) for artificial insemination,vaccine production and veterinary services; technical milk processing assistanceand a soft loan for heifer imports from Denmark; US$0.2 million for pasturedevelopment fertilizer from Federal Republic of Germany; US$0.3 million an-nually from Australia for veterinary equipment and services; and in additionthe United Kingdom has indicated it would probably consider favorably arequest to finance a consultancy study of milk collection and transport forMMB (para 4.10).

III. THE PROJECT AREAS

3.01 The proposed project would be located in the Wet Zone where con-ditions for dairy farming are most favorable. It would be concentrated inthe two existing main milk producing sub zones --the Coconut Triangle andthe Mid Country. The Coconut Triangle is located along the South West Coast

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with genexally flat terrain at elevations below 1,500 feet. The Mid Countrysub zone is located to the east of the Coconut Triangle between 1,000 and3,000 feet. The terrain is generally hilly.

3.02 Coconut Triangle. The population of the Coconut Triangle is about4.3 million, including the city of Colombo. About 20% of the country'scattle and 33% of its buffaloes are located in the Coconut Triangle wherethey are used traditionally for coconut harvesting and transport purposes.They are grazed under the coconut trees by day and housed and fed cut forageby night. Traditionally, milk is produced for home consumption. Any surplusis sold either fresh or as ghee. Average yields from local dairy stock andtheir crosses with Indian dairy bulls are about 1,200 pints per lactation.

3.03 Most of the area is well served with all-weather roads and almostall the settlements have electricity. NMB has two milk processing plantsand seven collection centers in the area; three further centers are underconstruction. Presently 15 DCS and 107 MPCS are in operation. The area isestimated to have over 18,000 farm holdings of 10 to 50 acres in size.

3.04 Mid-Country The population of the Mid-Country is about 1.6 million.In this area, the Government is encouraging the replacement of marginal teaand rubber with more profitable and reliable forms of production. Milk pro-duction is an attractive alternative. The area has about 7% of the island'scattle and buffaloes. Most farmers own cattle, almost all of which are up-graded crosses of native and Indian breeds stallfed on fresh indigenousroughage and home-mixed concentrate, and produce an average of 2,400 pintsper 250 day lactation. The temperate climate is suitable for European breedsof cattle when they are given shelter against the heavy rains and externalparasites.

3.05 The area is well served with narrow but mostly sealed all-weatherroads. NMB has one milk processing plant and two collection centers in thearea; eight further centers are under construction. Six DCS and 45 MPCS arein operation. The area is estimated to contain 12,000 farms of 5-10 acresand 4,200 of 10-50 acres in size.

IV. THE PROJECT

A. Description

4.01 The proposed Project would provide an integrated program for thedevelopment of milk production on about 42,000 acres comprising about 2,400dairy farms in the Wet Zone. It would provide technical support and creditto farmer participants and would ensure adequate support for milk collectionand transport and marketing.

4.02 Specifically the following activities would be undertaken:

(a) credit and technical serrices for on-farm development includingpurchase of livestock on about 800 farms of 5-10 acres and 400

farms of 40-50 acres in the Coconut Triangle and about 1,000farms of 5-10 acres and 200 farms of 40-50 acres in the MidCountry;

(b) supply and installation of equipment for the expansionand improvement of milk collection and transport servicesallowing NMB to handle the incremental production expectedfrom the project;

(c) credit to MPCS and DCS for the construction or improvementof facilities to house milk collection equipment;

(d) establishment of a Project Technical Unit within the Ministry ofAgriculture, including technical a,isistance to help executeon-farm development and pilot operations; and

(e) establishment of pilot units to (i) demonstrate systemsof communal calf rearing through the establishment of apilot unit with a yearly throughput of 500 heads; (ii)develop pasture management systems for increasing milkproduction in the Dry Zone using existing governmentland and livestock in the region.

B. Detailed Features

Dairy Farm Development

4.03 Approximately 2,400 dairy farms would be developed by farmersselected in the Coconut Triangle and the Mid-Country. This is expected toinvolve about 42,000 acres of which about 14,000 acres in the Mid-Countryis at present under sub-marginal tea or rubber production. An essentialfeature of the development plans in both areas would be the use of improveddairy cattle to increase herd sizes and production. These would be procuredfrom local sources within and outside the project areas and through directimportation. Credit would also be provided for land clearing (in the Mid-Country), pasture establishment, buildings, fences, water supply and smalldairy equipment (details in Annexes 1 and 7).

4.04 In the Coconut Triangle, improved pastures and fodder grasses wouldhe pltnted to replace natural growth under coconut palms and domestically-procured high grade heifers would be purchased which, over a period ofherd build-up, would replace indigenous cattle with crossbreds and increaseaverage yield from the present 1,200 pints to 3,000 pints per lactation.Based on the experience of NMB'and the Animal Production and Health Division(APHD) it is estimated that development would take place on about 400 farmsof up to 50 acres in size and 800 smallholder farms of around 10 acres.Investments would be phased over three years and total about US$94 per acrefor the 50 acre holdings, and about US$80 per acre over two years for the10 acre farms.

4.05 In the Mid-Country about one-half of the 1,200 farmers expected toparticipate are now located on marginal tea and rubber lands. They aremaintaining crossbred dairy cattle on indigenous forage cut and carriedfrom wastelands and marginal tea (or rubber) gardens. Under the Projectthe original crops would be uprooted and replaced with improved foddergrasses. Herd sizes and productiiity would be increased by purchase ofpure bred (European type) heifers, half of local origin; half imported.Lactation yields would increase from the present 2,400 to 3,600 pints perlactation. It is estimated that about 200 farms of around 40 acres and 400of 8 acres in size would participate. Investments, phased over three years,would average about US$185 per acre for the 200 forty acre farms expectedto participate. Similar but less intensive investments would be phased overtwo years on the eight acre holdings and would average about US$106 per acre.These investment costs are higher than in the Coconut Triangle because of theneed for land clearing.

4.06 The remaining 600 Mid-Country farms which would participate aresmallholdings under traditional mixed tree, shrub and vegetable crops onfarms ranging around 5 acres in size. Investments in addition to grassestablishment would include purchase of one purebred heifer, shelter, watersupply and minor equipment for a total of about US$100 per acre.

4.07 The integration of high producing livestock into mixed farmingsystems is one of the most desirable forms of diversification from both thenutritional and economic aspects. The proposed investments per acre arecomparable with those for dairy development in similar environments in Thailandand Burma where pasture and breed improvement are also the two essential com-ponents.

Milk Collection and Transport

4.08 It is expected that NMB would participate under the Project as themain outlet for milk produced by farmer-participants and as a sub-borrowerfor the purchase of essential imported equipment. However, NMB's finaucialsituation is poor and measures for its improvement are to be taken, as setout in para 5.08.

4.09 The existing milk collection and storage facilities of NMB in theProject areas are hardly adequate for present levels of production. Expandedand improved facilities are needed to encourage the production of milk underthe Project. Funds would therefore be provided for NMB to purchase storagetanks and chilling equipment for about 70 new milk collection centers, twomobile milk testing units, and for about 15 bulk milk tank trucks to transportmilk from collection centers to processing plants. Funds would also be pro-vided to cooperatives for construction or improvement of buildings to housethe tanks. Tanks and equipment would be owned by NMB and maintained by thecooperatives which would manage and operate the collection centers. Thetesting units would be acquired in Project year 1 and the tankers in year 2.Construction of buildings and installation of equipment for collection centerswould be phased over years 2 and 3, coordinated with the expected flow ofmilk from participating farms. These investments will be phased following aspecial study to be undertaken by consultants to NMB (para 4.10).

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4.10 Based upon the estimated increases in milk production resultingfrom the Project, it is anticipated that about 40 of the new collectioncenters would be located in the Coconut Triangle and 30 in the Mid-Country.However, their exact number, distribution and specific locations as well asthe specification of exact transport routes and procedures would need to bebased upon the results of a comprehensive collection/transport study expectedto be financed by the Commonwealthi Fund for Technical Cooperation and to becompleted by qualified consultants employed by NMB. Terms of reference forthe consultants were discussed with NMB and are at Annex 10. Agreement wasobtained that NMB would engage these consultants, under terms of referenceagreed with the Association, not later than 60 days after Credit effectiveness.

Technical Services and Pilot Operatl ons

4.11 Project technical support would be provided under the Project to allfarmer participants to help them draw up farm investment plans and supervisetheir development programs. This would be done through a Project TechnicalUnit (PTU) (See Chapter V), which would also be responsible for setting upand demonstrating systems of communal calf retaring and of milk production inthe Dry Zone.

4.12 Facilities for the pilot calf-rearing unit would be constructednear the Veterinary Research Institute at Peradeniya. The unit would havea capacity of 500 heifer calves per year, to be purchased soon after birthfrom dairy farmers, reared on purchased feed, and re-sold prior to firstcalving. Finance would be provided for the :onstruction of buildingsand purchase of equipment, and to cover the first two years' operatingexpenses. First estimates have been made which suggest a capitalinvestment of about US$65,000 and that the unit would be self-sustainingafter the second year. Detailed planning would be a first responsibilityof the calf rearing specialist to be employed under the Project.

4.13 The pilot operation in the Dry Zone would test the feasibilityof increasing the low cattle carrying capacity under traditional Dry Zoneland use by developing a ley (rotational) farming system in which feedgrains and pulses would be rotated with grass and legume pasture for theproduction of draught animals and milk. Initial attention would concentrateon identification of suitable field crop rotations and adapted grass andlegume species for pastures, utilizing Government lands and cattle forexperimentation. Finance would be provided for buildings, land clearingand some levelling, and establishment costs.

C. Cost Estimates

4.14 Total Project cost, including participating farmers' incrementalworking capital (US$0.57 million) required during the on-farm developmentphase, is estimated at US$12.7 million (Annex 11) including contingencies andtaking into account the price rises which followed recent crude oil priceincreases . In particular fertilizer prices are about 250% of those prevailing

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at appraisal in July 1973. 1/ A physical contingency of 5% has been appliedto all items and price contingencies have been added as follows: importedcattle 5% p.a. cif; local cattle, farm deve3opment and technical services6% p.a.; and equipment, fertilizer and fuel 14% and 11% for 1974-75 and 7.5%for 1976 and thereafter. The estimated foreign exchange component is aboutUS$5.5 million, or about 43% of total Project cost. Details of investmentcosts and foreign exchange components by major categories are given in Annex11 and summarized in the following table.

Total Project Cost

ForeignCategory Local Foreign Total Local Foreign Total Exchange

-- (Rupees Million) -- -- (US$ '000)-----

Dairy Farm Devel-opment 22.9 17.0 39.9 2,288 1,700 3,988 42

Incremental WorkingFarm Capital 4.5 - 4.5 450 - 450 -

Purchased Livestock 10.8 14.5 25.3 1,081 1,447 2,528 57

Milk Collection &Transport Equipment 5.8 5.5 11.3 575 553 1,128 49

Collection CenterBuildings 0.9 0.2 1.1 92 16 108 15

Management, TechnicalServices & PilotUnits 12.5 4.8 17.4 1,252 481 1,733 28

Subtotal 57.4 42.0 99.4 5,738 4,197 9,935 42

Contingencies:Physical 2.9 2.1 5.0 294 205 499 41Price 12.2 10.8 23.0 1,219 1,082 2,301 47

Subtotal 15.1 12.9 28.0 1,513 1,287 2,800 46

Total ProJect Cost 72.5 54.9 127.4 7,251 5,484 12,735 43

1/ Reflecting a projected farm gate price for urea of US$225 per m ton.

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D. Proposed Financing

4.15 The proposed IDA Credit of US$9.0 million would finance about 702of total Project cost. ApproximateLy US$5.5 million of the Credit wouldfinance the full foreign exchange cimponent and US$3.5 million would financeabout 50% of the local currency expenditure. The Project would be financedas follows:

(Rs Million)

TotalCategory Farmers Banks Government IDA Amount

(Amount)--------- (Amount) (%)

Imported Livestock - 1.4 - 17.3 92 18.7

Local Livestock - 1.2 - 10.7 90 11.9

Dairy Farm Development 8.8 3.4 8.8 30.7 60 51.7

Incremental Farm WorkingCapital - 0.6 - 5.1 90 5.7

Sub-Total 8.8 6.6 8.8 63.8 72 88.0

Milk Collection andTransport Equipment - 8.0 7.7 49 15.7

Collection Center Build-ings 0.1 0.2 - 1.0 80 1.3

Mansnagement, TechnicalServices & PilotUnits _ - 4.8 17.5 78 22.3

TOTAL 8.9 14.8 13.6 90.0 70 127.3

4.16 Government.would establish a project account with the CentralBank through which the proceeds of the IDA Credit would be channeled. Themajor part of the Credit ($5.5 million) would be for on-farm development,including purchase of domestic.livestock, and milk collection and transport:-quipment and would be relent by Government to People's Bank and Bank of,.eylon, which would augment these funds by contributing about $1.5 millionof their own resources. Funds for on-farm development would be relent todairy farmers by both banks: by Bank of Ceylon through its branches and byPeople's Bank to Cooperative Rural Banks (CRBs) and by CRBs to farmers.Funds for milk collection and transport equipment would be relent by Bankof Ceylon to NMB, and funds for collection center buildings would be relentby People's Bank to the cooperatives (see paras 5.09-5.15 for details oflending terms and operations). The remainder of the Credit ($3.5 million)would be for imported livestock, PTU and pilot operations and would be

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disbursed through the Ministry of Agriculture, complemented by Government' scontribution of about $0.5 million. Government would also contribute about$0.9 million in the form of pasture development subsidies to participatingfarmers. Farmers would contribute about $0.9 million in labor, cash andkind toward on-farm development and livestock. Execution of subsidiaryloan agreements between the Borrower and People's Bank and Bank of Ceylon,as well as provision of acceptable forms of lending agreements betweenthese banks, CRBs, NMB, farmers and cooperatives, would be conditions ofCredit effectiveness.

E. Procurement

4.17 Contracts with an estimated value of about US$0.6 million netof contingencies would be let under international competitive bidding, inaccordance with IDA guidelines, for the purchase of milk storage and transportequipment and mobile testing units which would have to be imported by NMB.Tenders would require the suppliers of milk storage equipment to superviseits installation. Specifications for milk storage and transport equipment,the timetEble for phasing its purchase and installation and the determinationof sites for the installation of storage equipment would be set by NMBin accordance with the findings of the milk storage and transport study tobe completed by consultants (para 4.10), and would be subject to IDA approv-al. Agreement on these provisions was obtained.

4.18 Approximately 13,600 dairy heifers costing about US$2.5 millionnet of contingencies would be purchased. Of these, about 3,200 costingUS$1.4 million would be imported; 4,000, costing about US$0.5 million,would be purchased from existing Government herds; and 6,400, costing aboutUS$0.7 million, would be purchased from privately-owned herds. All purchaseof dairy heifers would be subject to the supervision and approval of the PTUProject Director and, during the first three years, the Technical Director,for quality and suitability of stock. Purchase of imported heifers fromoutside Sri Lanka would be organized by PTU. Because of the wide variationsin breeds, types and adaptability of animals available, and the diseasesituation in supplying countries, proposals would be obtained from at leastthree countries free from foot and mouth disease, that can supply heifersof the type required, in accordance with procedures acceptable to IDA. Thiswas agreed during negotiations. The allocation and sale of heifers andyoung cattle from existing Government herds to Project participants wouldbe carried out by PTU as would the organization of local cattle auctions inthe Mid and Up-Country through which sales of privately-owned cattle ofsuitable breeding to farmer participants in the Project would be conducted.

4.19 Orders for the 19 four wheel drive'vehicles and 90 motorcyclesrequired by the PTU would total less than US$200,000 and be of a piecemealnature since they would have to be coordinated with the needs of the PTUtechnical staff which would be built up and trained under a gradually expandingprogram phased over 3 years to meet increasing demands of the Project. There-fore international competitive bidding would not be appropriate and procurement

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would be by local competitive bidding. Most major manufactures of importedvehicles are represented in Sri Lanka and are competitive and offer satis-factory follow-up service facilities. PTU wiwuld incur additional costs ofabout US$0.4 million in direct expenditures on technical assistance salariesand vehicle operations. Pasture planting materials, fertilizer, buildings,water supply and other materials required for on-farm development, costingin total about US$5.3 million, would be obtained by farmers and PTU throughlocal suppliers and contractors. These goods and services would be procuredpiecemeal over 5 years and could not reasonably be bulked to allow forcompetitive bidding. However, they are readily available locally and thereis keen competition between suppliers in the Project areas. Erection of thecollection center buildings, which will be widely dispersed and of simpleconstruction, would be carried out mainly by cooperative members. Any minorcontracts required would be negotiated with domestic contractors.

F. Disbursement

4.20 The IDA Credit would be used to finance (a) the cif cost of dairyheifers and of milk storage, collection and transport equipment importedspecifically for the Project; (b) 90% of sub-loan disbursements to partici-pating farmers on new on-farm development investments approved under theProject including working capital and local cattle but excluding importedcattle; (c) 90% of sub-loan disbursements to participating cooperatives forcollection center buildings aplproved under the project; (d) the cif costof vehicles for the PTU; (e) 100% of the foreign exchange costs of technicalspecialists and calf rearing and dry land pilot operations; and (f) 80% ofall other PTU expenditures on management, technical services and pilot unitsexcept for purchases of vehicles. Disbursement requests would be supportedby the usual documents. Disbursements against sub-loans would be made onthe basis of a statement of expenditures certified by the Central Bank andparticipating banks. Detailed supporting documentation for local expenditureswould not be submitted for review, but would be retained by the Borrower andbe available for inspection by the Association during the course of projectsupervision.

4.21 Disbursement of the Credit would be over five years. The phasingof disbursements for each major investment category and the forecast ofestimated disbursements on a quarterly basis are shown in Annex 12.

G. Reportlng and Auditing

4.22 Government would maintain a Special Project Account with separateaccounts for the several components of the Project, i.e., dairy farm loans,imported livestock, purchased local livestock, milk collection and transportequipment, and PTU (management, technical services and pilot units). Itwould submit quarterly reports to IDA within 30 days of the close of thequarter. Within six months of the close of the fiscal year IDA would also

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require annual audited statements covering the Special Project Account, theentire operations of NMB and the Project-related accounts of Bank of Ceylonand Peoples Bank by independent auditors acceptable to the Association.Agreement on these procedures was obtained.

V. ORGANIZATION AND MANAGEMENT

A. Administration

5.01 Responsibility for overall coordination of the various agencyactivities related to the Project would be vested in a Project Committeeto be appointed by Government under the Chairmanship of the Ministry ofPlanning and Economic Affairs and to include representation from the Ministryof Agriculture (including the APHD), the Ministry of Finance, the Commissionerof Cooperatives, Peoples Bank, the Bank of Ceylon and NMB. It would be acondition of effectiveness that the Project Comnittee has been established.

5.02 The PTU would be set up specifically for the purpose of the Project,and its establishment would be a condition of effectiveness of the Project.It would be responsible for the execution of on-farm development, livestockprocurement and the technical services components of the project includingpilot demonstration operations. It would be established as an autonomousunit within the APHD under a Project Director who would report directly tothe Deputy Director of Agriculture in charge of APHD. Milk collection andtransport components would be executed by NMB. Coordination of theseactivities with the on-farm development program under PTU would come throughthe existing APHD representation on the NMB board and also the Projectcommittee.

B. Management and Technical Services

Project Technical Unit

5.03 The full-time Project Director would be recruited locally. He wouldprobably be drawn from the existing cadre of senior members of the APHD andwould be an experienced administrator in livestock development services. Itwas agreed that the PTU would at all times be headed by a competent ProjectDirector whose qualifications and experience shall be satisfactory to theGovernment and IDA and that his appointment would be a condition of effective-ness. He would be assisted by an internationally recruited TechnicalDirector who would be experienced in dairy farm development and the managementof pastures under tropical conditions. The Technical Director would beresponsible for training the technical staff of the PTU and participatingbanks, particularly in preparation and approval of farm plans, and for theapproval of farm plans submitted by farmers for financing under the Project.

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5.04 Two additional specialists would be recruited and attached tothe PTU staff as follows:

(a) a livestock specialist responsible for planning andoperation of the calf-raising pilot operation. Hewould also participate in the livestock aspects offarm development planning and appraisal and PTU stafftraining; and

(b) a tropical crops and pasture specialist responsible fordetermining and training PTU staff in the most suitablekinds of pasture/fodder crops, production methods andseed multiplication on Project farms. He would alsoplan and conduct the Dry Zone rotational farming/milk.roduction pilot operation and participate in the technicalaspects of a farm development planning and appraisal.

5.05 The Technical Director and two specialists would be recruited in-ternationally on terms and conditions satisfactory to IDA and agreement onthese points was obtained. Proposed terms of reference are at Annex 9. Theappointment of the Technical Director would be a condition of effectivenessand that the two specialists would be appointed within 6 months of signing ofthe Credit. Other PTU) staff would be selected largely from members of theAPHD with experience in dairy development in the Project areas. Staffrequirements are shown at Annex 8.

5.06 To ensure close contact with the farming community and successin promotion of the Project, the PTU would be decentralized with its headoffice located at Peradeniya (which is the HQ of APHD and where suitableaccomodations are available) and branch offices located at the existingAPHD Livestock Offices in Nawalapitiya, Kurunegala and Welisara.

National Milk Board

5.07 Since its formation in 1954, NMB has, with the exception of smalltrading profits in 1970 and 1971, operated unprofitably with losses coveredannually (only partially in 1972) by Government. With the May 1973 priceincreases, profits of Rs 19 million were projected for 1973 but at the sub-sequently reduced (and present) prices, losses of up to Rs 11 million may beexpected for the year. Further, at present prices and with or without theproposed Project, NMB future losses would likely be even greater (see Annex 2).

5.08 Strengthening of NMB's financial management and restoration ofthe organization to a sound financial position through, inter alia, revisionof its pricing structure are essential to its effective participation inthe Project. NMB intends to recruit a competent finance manager empoweredto achieve these goals, and appointment of a person whose qualificationsand experience are satisfactory to IDA would be a condition of effectiveness.In addition, it has been agreed that:

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(a) Government would take all measures necessary to ensure thefinancial viability of NMB and to enable NMB to realize, bythe end of its fiscal year 1977, and maintain a rate ofreturn of 8% on NMB's total capital employed. These objec-tives could be attained initially if the schedule of milkand milk product price increases introduced by Government onMay 26, 1973 but subsequently retracted, were re-establishedfully by January 1976 (see Annex 2, Table 4) with necessaryadjustments for inflation; and

(b) Government would provide NMB with the funds necessary toenable NMB, not later than December 31, 1975, to write offall its losses accumulated up to December 31, 1974, such fundsto be used by NMB to reduce its current liabilities.

C. Lending Operations

5.09 Sub-borrowers under the Project would be NMB, Cooperatives and about2,400 farmers approved by PTU. Initially the farmers in those areas nearestthe main chilling and collection centers and with established bankingservices would be brought into the Project. After the PTU and Bank staffshave been trained and had experience in these operations they will move tomore isolated areas. Both the Bank of Ceylon, through its branches, andPeoples Bank, through CRBs would serve as on-lenders of Project funds fordairy farm development. In addition, Bank of Ceylon would serve as on-lenderto NMB, and Peoples Bank would on-lend to cooperatives for construction ofbuildings to house milk collection equipment. Both Bank of Ceylon and PeoplesBank recruit and conduct training programs designed to provide competentmanagers for the 90 branches and 100 CRBs scheduled to be operative in theProject areas by end-1974. Government has undertaken to ensure the establish-ment of these banking facilities as well as any additional facilities neces-sary to carry out the project.

Procedures

5.10 Dairy Farm Development Loans. The PTU technicians would collaboratewith the participating banks and MPCS in the Project areas in the initialpromotion of the project. This is considered an essential prerequisite tosuccess, since many farmers lack familiarity with improved livestock andpasture management. However, the limited experience to date in the projectareas has shown that farmer interest in dairy development credit can be fos-tered with good promotion and advice. Farmer applications for developmentcredit (including purchase of cattle), would be submitted either to one ofthe participating banks or to a PTU farm planning technician located in theProject areas. Proceeding concurrently, the Bank would initiate investigationof the applicant's creditworthiness and, if need be, title to property offeredfor mortgage; the PTU technician, in cooperation with the applicant, wouldprepare a farm development plan for submission to the PTU Technical Director

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(or his appointed representative) for approval which would be based on lend-ing criteria as set forth in Annex 6, Appendix 1 and contingent upon assur-ance that timely payment would be made by Government to the applicant of theappropriate pasture development subsidy (para 6.08). Upon receipt of theapproved development plan from PTU the participating bank, with power ofapproval limited to the applicant's creditworthiness, would secure mortgageof property, obtain an assignment from the borrower on his sales of milkand proceed with execution and disbursement of the loan.

5.11 Equipment and Building Loans. After receiving IDA approval ofspecifications and bids, NMB would apply to the Bank of Ceylon for loans tofinance the purchase of imported milk storage, transport and testing equipment.Cooperatives would apply to Peoples Bank for loans to finance buildings tohouse collection center equipment.

5.12 Relending Terms. Relending terms for IDA funds from Government toBank of Ceylon and People's Bank would be at 6% for 12 years. Bank of Ceylonwiould relend to farmers at 10% for 12 years and to NMB at 8% for 10 years.1eople's Bank would relend part of its proceeds to CRBs at 7-1/2% for 12years and the CRBs would relend to farmers at 10% for 12 years. People'sBank would relend the remainder of its proceeds to cooperatives (MPCS andDCS) at 8% for 12 years. All relending terms include a grace period of threeyears, These terms are consistent with prevailing terms for similar loansin Sri Lanka. The interest spreads would be sufficient to cover administra-tive costs and credit risks. Agreement has been reached that the above interestrates may be increased to reflect future increases in the interest ratescharged by banking institutions in Sri Lanka on loans for agriculturalpurposes.

VI. MARKETING, PRICES, SUBSIDIES AND PRODUCER BENEFITS

A. Marketing and Prices

6o01 NMB marketed about 215 million pints of milk equivalent in 1972,equal to about half the country's consumption. About 160 million pints ofthis was reconstituted from imported milk powder while about 55 million pintsof raw milk was collected locally and sold as processed milk. The balance ofthe domestic production of about 170 million pints was sold by producersoither directly or through collection agents to local rural customers.

6.02 The demand for milk and milk products has invariably exceededsupply over recent years. Although consumer prices have been controlledat levels that have stimulated demand, domestic production has stagnated duemainly to controls on producer prices which, up to recently, offered no in-centive for commercial milk production. In addition, Government has re-stricted importation of milk powder. Over the next decade, Government plansto increase domestic production by 4-5% per year through a package of higher

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producer prices, subsidies and improved technical services. However, thisincrease, if realized, will barely keep pace with increasing demand whichGovernment estimates will increase by 5% per year. The Project incrementalproduction of 43 million pints annually would have a significant impact inreducing import requirements.

6.03 Prices paid to most milk producers did not increase between 1960and 1972 and, in fact, actually fell in the Mid and Up-Country. However,NMB raised its procurement price from 40 to 60 cents/pint (55 cents/pint netof collection charge) in May, 1973. Many small producers, having only threeto six pints to sell daily, are outside NMB's existing collection system andget 30-35 cents/pint from middlemen. In some production areas raw milk canbe retailed directly by producers at 50-55 cents/pint but most producers nowappear to turn readily to the NMB channel when accessible. However, withthe recent increase in fertilizer prices the financial benefits to the farm-ers have been so reduced that unless procurement prices are increased therewill be little incentive for investment in dairy farming. At current costsand prices the milk procurement price would need to be increased graduallyfrom 60 to about 75 cents per pint by January 1977 in order to guaranteefarmer interest. Agreement has therefore been reached that Government and NMBwould keep milk procurement prices continually under review, adjust priceswhenever necessary to ensure that production incentives for dairy farmersare maintained, and consult with IDA semi-annually on the suitability of theproduction incentives.

6.04 Consumer milk price structure tends to follow NMB's pricingsince NMB supplies half of the market. NMB's price structure is set byGovernment, and reflects the long-standing national policy of consumer(estecially foodstuffs) subsidization (Annex 3). Thus liquid milk, whichis almost exclusively consumed by the more affluent urban consumers, ispriced relatively higher than powder which, because of its keeping quality,is consumed by the urban and rural poor. However, neither product is sold atprices that cover all costs. Powder, which at present world prices costsabout 92 cents/pint equivalent to import and repack, is sold at 77 cents.The price of 91 cents/pint received by NMB for liquid milk covers directcosts but results in a substantial net loss when overheads and depreciationare deducted.

6.05 Consumer prices of milk products were adjusted upwards by from77% to 90% on May 26, 1973 but, due to public reaction and political pres-sures, prices of powder and condensed milk were brought back close to theirprevious levels and below NMB's costs. The Project requires Government toadjust milk prices and/or take such other actions as may be required toensure NMB's financial viability as specified in paras 5.08 and 8.01 (c).

6.06 With lagging domestic production of beef and imports restricted tohotel requirements, retail prices for beef have increased more rapidly thanthose of other foodstuffs. Retail prices per pound range upwards from thecontrolled price of Rs 1.75 in Government shops to Rs 2.40 in unregulatedprivate butcher stalls. To market animals legally for slaughter (through

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Government shops) proof of registration and ownership is required. However,most producers do not register their animals, hence must sell to middlemenwho arrange for the necessary documents, act as wholesalers, control suppliesand set producer prices at low (Rs 0.30-0.40/lb liveweight) levels. However,the Project animals would all be registered under the Animals RegulationsAct and surplus males or cull females could therefore be sold into thedomestic market for beef at reasonable prices.

6.07 Surplus dairy heifers are traded at about Rs 600 to 1,300 per head,depending on quality, with the prices - particularly for low producing cat-tle - reflecting beef prices. Prices of imported purebred dairy cattle tofarmers are subsidized at f.o.b. cost in country of origin -- about Rs 1,300per head for heifers, and comparable purebred heifers from Government farmsare priced at the same level. Because of the unattractive producer pricesfor milk and unorganized marketing, there has been, until recently, a lack ofenthusiasm for dairy operations. However, the incentives offered under theProject should correct this situation and Project output of surplus breedingheifers which would be available in number from about 1980 should find aready market. An increased supply of quality stock will be essential to meetthe Government plans for expanded milk production.

B. Subsidies

Producer Subsidies

6.08 Four direct input subsidy schemes are available to dairy producersin the proposed Project areas. These are described in detail in Annex 3 andsummarized as follows:

(a) Rs 500 per acre for pasture establishment in theMid-Country (for diversification from tea andrubber);

(b) Rs 120 per acre for establishrent of improvedpastures under coconut palms;

(c) 50% subsidy on pasture fertilizer cost afterestablishment of pasture in (b); and

(d) pricing of imported cattle to dairy producersat f.o.b. cost in country of origin.

6.09 The pasture development subsidies serve as an incentive to farmersto shift from traditional land uses and farming practices to the differentuses and more sophisticated technologies required under the Project.They are consistent with Government's goal of increased production of foodcrops and livestock products. Similarly, the subsidy on imported dairycattle is an incentive for farmers to change from their low producing native

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breeds to proven high producing dairy breeds and consistent with govermentpolicy for a rapid build up of a high producing dairy herd. As new technologydeveloped by the project becomes widespread, increasing the availability ofhigh quality dairy cattle, and milk procurement prices rise gradually (para6.03) the need for these subsidies will disappear.

C. Producer Benefits

6.10 Parmers participating in the Project are expected to benefitfrom higher net incomes at full development. During appraisal it was es-timated that the 600 smallest farmers, (five acres in the Mid-Country) woulddouble their incomes (from Rs 700 to Rs 1,400) at year seven, with an in-crease again to 2,400 after debt retirement in year nine. Similar financialbenefits would also accrue to the estimated 1,200 small farmers in the Mid-Country and Coconut Triangle with 8-10 acres. In the case of the 600 larger'farmers with 40-50 acres their net incomes currently derived from dairyingare mLrginal and would increase under the Project to about Rs 5,000 toRs 9,500 at full development in year 7. The financial benefits from theseinvestment models are detailed in Annex 7 and show financial rates of returnof 18% to 26%. The time required to reach full development ranges from 6 to8 years. Although no substantial cash incomes are generated until yearsfive to six for large and small farmers in the Coconut Triangle and thelarger farms in the Mid Country, experience has shown that many farmers inthe area are willing to forego higher initial incomes and rely on existingsources provided they can see that their investments will eventually resultin considerable improvement of their income and nutritional levels.

6.11 With fertilizer prices adjusted to reflect a projected farm gateprice for urea of US$225 per ton, the rates of return at the present producerprice for milk range from 7% to 11%. Phased increases of Rs 0.05 per pintper year 1975-77 (total increase Rs 0.15) in the producer price of milkwould bring the rate of return into the 15 to 19% range. For this reasonagreement has been reached that Government and NMB would keep milk procurementprices continually under review and adjust the prices whenever necessary tomaintain producer incentives (para 6.03).

VII. ECONOMIC BENEFITS AND JUSTIFICATION

7.01 The Project would assist Sri Lanka in the development of itslivestock potential and, by substantially increasing domestic milk produc-tion, help conserve scarce foreign exchange resources. At full development,expected in 1981, additional milk production from project farms would beabout 43 million pints annually, amounting to about 25% of 1972 imports ofdairy products and savings of about US$2.0 million in foreign exchange. Inaddition, meat production in the form of cull animals from project farms islikely to be 1,250 tons liveweight annually (valued at US$418,000), equivalentto about 3% of domestic production in 1971. Also, the 1,400 head of purebredand 1,350 head of crossbred surplus breeding heifers, together valued at

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US$780,000, available annually from the project will offset the number ofimported stock otherwise needed for a rapid build-up of the national herd.

7.02 Non-quantified but significant benefits would result from thesupport that the project would provide in the implementation of the Govern-ment's plans relating to milk production. In general terms, it would en-courage the integration of livestock into the farming system and the adop-tion of mixed farming which in turn would have marked effect in improvementof soil fertility and structure. Specifically, the extension and researchactivities in calf rearing and pasture management would encourage soundanimal husbandry and effective pasture management not only on project farmsbut also in the surrounding areas and improved animal husbandry and pasturetechnology adapted to Sri Lanka's tropical environment would emerge. Inaddition, the experience gained in financing development of about 1,800 smallfarmers of about 5-10 acres under the Project should contribute materially tothe improvement and expansion of credit operations for small farmers throughoutthe Island.

7.03 The Project would also assist the Government in its planneddiversification of marginally productive tea operations on 14,000 acresin the Mid-Country. Displacement of about 3,000 tons of present greenleaf tea production is expected. The Project would increase the utiliza-tion of family labor and create employment for additional 1,500 full timeworkers.

7.04 To reflect the shortage of foreign exchange, an average FEEC rateof Rs 10 - US$1 was used in the economic rate of return calculations. Localcrossbred animals were valued at the full domestic market prices as was alllabor. The value of the lost tea production is taken equal to the cost ofits production since mainly only the marginal operations are being sacrificed.All imports for and imports displaced as a result of the Project were valuedat international prices. On these assumptions the economic rate of returnfor the Project has been estimated at 18% (Annex 14). No account was takenof the recent fertilizer price increases in this calculation. When this isincluded, and assuming no change in commodity prices, the economic rate ofreturn is 15%. To test the Project against changes in investment costs andproduction results a sensitivity analysis was done. By increasing bothinvestment and operating costs by 20% without changing the operating results,the return to the economy would drop to about 13%. Similarly, by reducingbenefits by 20% without changing costs, the rate of return would be 12%.Additional sensitivity tests are given in Annex 14.

VIII. AGREEMENTS REACHED AND RECOMMENDATION

8.01 During negotiations, agreement was reached on the following principalpoints:

(a) NMB would employ, not later than 60 days after Crediteffectiveness, qualified consultants to carry out, underterms of reference agreed with the Association, a studyof milk collection and transport in the Project area

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'.r-a 4. 0, and specifications for milk storage andtransport equipment to be imported by NMB and the sitesfor the collection centers would be subject to IDAapproval (para 4.17);

(b) PTU's Technical Director, Crops and Pasture Specialist,and Livestock Specialist would be recruited internationallyon terms and conditions satisfactory to IDA, and the twoSpecialists would be appointed within 6 months after signingof the Credit (para 5.05);

(c) Goverament would (i) take all measures necessary to ensurethe financial viability of NMB and to enable NMB to realize,by the end of its fiscal year 1977, and maintain a rate ofreturn of 8% on total capital employed and (ii) provide NMBwith the funds necessary to enable NMB, not later thanDecember 31, 1975, to write off all its losses accumulated upto December 31, 1974, such funds to be used by NMB to reduceits current liabilities (para 5.08);

(d) Government would keep milk procurement prices continuallyunder review and adjust prices when necessary in light of thereview to ensure that production incentives for dairy farmersare maintained (para 6.03).

8.02 Agreement was also reached on the following as conditions ofcredit effectiveness:

(a) Subsidiary loan agreements acceptable to IDA between theBorrower and the Bank of Ceylon and the Peoples Bank hadbeen made (para 4.16);

(b) acceptable forms of the proposed lending agreements betweenthe participating banks, intermediary institutions and projectbeneficiaries have been furnished to the Association (para4.16);

(c) establishment of the Project Committee and the PTU (paras5.01, 5.02) and appointment of the Project Director (para5.03);

(d) appointment of the Technical Director (para 5.05); and

(e) appointment of the finance manager by NMB (para 5.08).

8.03 The proposed Project is financially and economically sound andwould be suitable for an IDA credit of US$9.0 million.

ANNEX 1Page 1

SRI LANKA

DAIRY DEVELOPMENT PROJECT

The Dairy Sub-Sector

Livestock In Sri Lanka Agriculture

1. Agriculture plays a major role in the economy of Sri Lanka throughits large contribution to GNP, foreign exchange earnings, and governmentrevenue. In 1973 the agricultural sector accounted for nearly 33% of GNP,about 77% of export earnings, and 50% of total employment. While livestockfarming has considerable potential it is now of minor economic importance,contributing only about 7% of the gross value of agricultural production.

2. Cattle and buffaloes are the most important farm animals, beingwidely dispersed on smallholdings and numbering about 1.6 million and 0.7million, respectively (see Table 1 for livestock numbers). In the paddyand coconut growing areas of the south-west, cattle and buffalo numbersare linked to draught power requirements. In the dry north and east,cattle and buffalo grazing is based on the communal use of natural grass-lands, and their numbers exceed the local requirements for draught power.Most cows are milked after parturition but yields are typically low. Inthe past some tea estates have used higher yielding European type cattle tosupply milk for their laborers. This type of milk production has virtuallyceased, the cattle having been transferred to small-holders and estate laborerswith milk used largely for home consumption.

3. There is no specialized beef production in Sri Lanka; all beefis the by-products of traditional cattle and buffalo husbandry for draughtand milk. Goat and sheep populations are relatively small and locatedpredominantly in the Dry Zone. Pig numbers have remained constant at about100,000, concentrated in small units on the west coast. Encouraged by gov-ernment programs including the suspension of all imports of poultry products,poultry production increased rapidly in the 1960's. A network of privatehatcheries and commercial production units around the consumption centersdeveloped, but a serious setback to the poultry industry occurred in early1973 when concentrate prices rose to an all-time high due to poor coconutharvests and the continued substantial export of dessicated coconut and ofcoconut cake (poonac).

4. Livestock output has increased since 1960 by about 4% annually,growth rates being higher in the early 1960'.. Since 1965, slaughterrates of all farm animals have increased and reportedly have caused con-siderable declines in cattle and buffalo numbers. 1972 estimates indicatethat the slaughter rate in cattle still exceeds their rate of natural

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increase, but that buffalo numbers are increasing again. Total productionof beef (including edible offal) was about 90 million lb in 1971,equivalent to about seven lb per capita per year (see Table 2 for presentlivestock production). Average consumption of all other meats is estimatedat about 1.5 lb per capita per year. Ii 1970, about 220 miilion eggswere produced, corresponding to about 17 eggs per person. It is estimatedthat at present about 610,OCO pints of milk are available daily for humanconsumption from local production. This corresponds to about 224 millonpints total production per year and, including 1972 imports of about 160million pints of fluid milk equivalent, gives an estimated average annualper capita consumption of about 30 pints. All livestock products combinedaccount for only 6% of all food protein consumed in Sri Lanka, less thanhalf as much as fish.

Milk Production

Production Systems

5. Present conditions and development potential of milk productioncan best be considered by referring to the different ecological zoues ofthe island (see Map and Tables 3 and 4).

6. The Dry Zone consists of about 11 million acres. There areabout 400,000 individual holdings covering about 1 million acres of irrigableland, 2 million acres used for shifting cultivation (chena), 2 millionacres of natural grasslands and 6 million acres of jungle. Most villagesderive their subsistence food and income from the production of rice onindividually owned lands. The Dry Zone has about 60% of the country'scattle and more than 50% of its buffaloes. Cattle herds average 10-15 headof indigenous stock. All animals are privately owned but collectivelygrazed during the day on the village or government owned natural rangesand jungle clearings around the villages. About three acres of unimprovedrangeland are required per animal but grazing is seasonal and insufficientin quantity and quality during the long dry season from March until October.No concentrates are fed. After calving, most cows are milked; with once aday morning milking they produce 2-3 pints per day over a 160 days lactation:they produce a total of no more than about 500 pints of milk for home con-sumption or for curd production, and feed their calf.

7. NMB has four milk collection centers in the area around Polonnaruwa;only about 5 million pints out of widely dispersed total annual production ofabout 95 million pints are collected. Although not much of the milk producedin the Dry Zone is available for consumption outside the area, this regionprovides the rural areas and urban populations of the southwest with largenumbers of draught and slaughter cattle.

8. The Coconut TriLangle covers about 1.6 million acres in thesouthwest of the island. An area of about 1.2 million acres is undercoconut palms, 280,000 acres on valley floors are used for paddy production.

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The area has about 20% of the country's cattle population, traditionallyused for transport work in coconut harvest, and about one-third of SriLanka's buffaloes used for paddy cultivation.

9. Grazing for the cattle is provided by the grasses, mainlyAxonopus species, and shrubs which grow under mature coconut trees. Onlarger farms cattle are grazed free during the day; on smaller holdingsthey are tethered. All cattle are housed and fed cut forage at nightwhen lactating cows are separated from their calves so that they can bemilked next morning. Average yields from indigenous stock and their crosseswith Indian dairy bulls (Sahiwal, Red Sindhi, Haryana) are about 1,200 pintsper lactation in addition to calf requirements. All cattle have traditionallybeen given substantial amounts of coconut cake and rice bran and, on average,all nutrients required for the milk produced are derived from the dailyaverage ration of about 6 lb of concentrates per cow. Improved grasses forgrazing on larger holdings and for a cut-and-carry system on smallerfarms have been planted only receatly to improve the forage supply forcattle.

10. It is estimated that about 36 million pints of milk are producedannually in the Coconut Triangle. Of this, about 6 million pints aredelivered to NMB milk collecting centers. So far, most milk deliveredto the collecting centers is from larger holdings of about 40-50 acresaverage, as the owners of smaller farms with one or two lactating cowsfind it unattractive to bring the small quantities they produce to thecollection centers and as very few cooperatives have taken up milk col-lection.

11. The Mid-Country occupies 1.3 million acres in the hill areasbetween 1,000 and 3,000 feet above sea level. The topography is generallyundulating to steep, the flat valley floors being used for paddy pro-duction. Tea is the predominant crop and occupies about 500,000 acres.Paddy and other annual crops are grown on about 130,000 acres, the remainderis taken up in about equal parts by rubber and forest gardening (mixed tree,shrub and vegetable production). The Mid-Country is the area wheregovernment policy is to replace marginal tea and rubber with more profitableland uses. This area has at present about 7% of the country's cattle andbuffalo populations.

12. Generally, all animals are housed day and night throughout theyear and stallfed with 80-100 lb of cut, fresh forage. Panicum maximumgrows freely on the edges of roads and fields, and in empty spaces of teaor forest gardens and provides sufficient amounts of fodder throughout theyear even for landless cattle owners. Most farmers own cattle, and thetypical forest gardener with about five acres of land has fresh fodder collect-ed daily in a radius up to one mile around his property, saving the moreeasily collected small amounts of fodder which grows on his own lands for festivedays. There is competition for free growing fodder. Many tea estates havebeen subdivided during the last 20 years into holdings of 5-10 acres. Mostof these farmers find sufficient fodder for their cattle on their own lands.

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Sowe of the larger, owner-managed tea farms have started to keep dairy cattlein order to make use of those lands which cannot be used for tea and arenow under indigenous or planted grasses. Lactating cows received about 5to 6 lbs. daily of a home-mixed concentrate consisting of poonac and ricebran. Most cattle area of a non-descript type, being crosses between thenative stock and Indian dairy breeds and then upgraded to importedEuropean dairy stock. Lactation yields average about 2,400 pints in 250 days.Most cows are milked without their calves at foot.

13. It is estimated that about 41 million pints of milk are producedannually in the Mid-Country. Of this, about 18 million pints are deliv-ered to NMB collection centers. Most of this milk is produced on small-holdings, particularly of the forest garden type, and is collected and sentto the NMB centers through cooperatives.

14. The Up-Country is the area above 3,000 feet occupied, typicallyby Agency-House-managed tea estates. 1/ There are about 310 tea estates inthe Up-Country. Some areas on hill tops are under grass cover (patua), someothers have been planted to wattle, pines or are still under virgin forest.The Up-Country has about 6X of Sri Lanka's cattle population.

15. Most cattle in this area are owned in units of one or two cows byestate laborers for the augmentation of family income. European type cattleof Friesian and Ayrshire descent are kept in fully enclosed sheds and fedabout 100 lb of indigenous grasses which are cut daily by family memberson the waste areas accounting for about 5% of estate lands. On a fewestates, centrally managed dairy herds are maintained. Very few pastureshave been established so far on Up-Country tea estates. All cattle receivelarge rations of concentrates; 6-7 lb of a poonac/rice bran mixture wouldbe typical for a lactating cow. Averaga lactation yields are about 2,400pints, without calf at foot.

16. Total annual milk production in the Up-Country is estimated to beabout 38 million pints. Nine-tenths of this is produced by estate laborersand about 24 million pints or 65%, is collected by NNB collecting centers.

17. Southern Wet Zone. There are about 1.6 million acres, notincluded in the Coconut Triangle and the Mid- and Up-Country, located inthe south and southwest of the island at elevations up to 1,500 feet.About 60% of this land is held in smallholdings of less than five acresfor rice and tree crop production. Most of the remaining cultivated landsare under plantation crops (rubber). This area has about 8% of the cattleand buffalo populations.

18. Cattle husbandry is generally similar to tnat in the CoconutTriangle, but because of high temperature and rainfall neither Europeanbreeds or upgraded cattle perform well. Cattle are mainly kept for

1/ Foreign owned.

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draught and lactating cows are milked once a day but with low productionand only one NHB center in the area collecting about 1 million pintsannually the bulk of the 14 million pints produced per year is for homeconsumption and processing into curd.

Cattle Breeds and Performances

19. The vast majority of cattle are of the indigenous (Bos indicus)type which thrives well under the local conditions. A number of Indiancattle have been used with limited success to increase the milk productionpotential and body size of Sinhala cattle. For a long time higher yieldingpurebred European dairy breds, mostly Friesian, Jersey, Ayrshire and Shorthorn,hav, been used on Up-Country estates. Their offspring and crosses withindigenous cattle have been passed on to the Mid-Country and, to a limitedextent, also the Coconut Triangle where they have proven to be higher yield-ing than the indigenous cattle particularly when attention is paid to theirnutrition. It is estimated that 90% of all cattle in the Up-Country and50% in the Mid-Country are of European descent and their crossbreds. Onlyabout 5-10% of cattle in the Coconut Triangle are European crossbred, buttheir number, particularly from crossing with Jersey bulls, is increasingrapidly.

20. Productivity of all cattle is low and generally less than geneticpotential, largely reflecting low levels of nutrition and management. Thecalving rate approached 50% on a national level and is about 65% in theMid- and Up-Country. Deficiency and seasonality of feeding are the majorcause of reduced fertility. Calf mortality is probably as high as 20% onthe more intensively operated dairy farms whereas adult mortality is quitenormal at about 5%. Average liveweight of mature Sinhala cattle is 700-800 lbin bulls and 500-600 in cows. First calving occurs at three years of age.

Cattle Disease Situation and Calf Mortality

21. Sri Lanka has been free from Rinderpest since 1964. Diseases ofmajor economic importance are haemorrhagic septicaemia, foot-and-mouthdisease, black quarter and anthrax. Haemorrhagic septicaemia is normallyfatal; it requires vaccination at six-monthly intervals. 0 and C type virusesare the causes of foot-and-mouth disease which normally only causes atemporary reduction in performance. Piroplasmosis and anaplasmosis arepresent. They do not affect indigenous cattle, but all importationsrequire preimmunization. Internal and external parasites are widespread.Leeches attack grazing cattle on pastures above 1,200 feet elevation,cause considerable loss of milk production through blood loss and disruptionof grazing, and necessitate housing of animals.

22. Calf mortality is a serious problem where calves are separatedfrom their dams after birth and not needed for milk let-down in theirmothers. This is normally the case in the Mid- and Up-Country, whereasin the Coconut Triangle and Dry Zone calves run with their mothers duringthe day and get some milk in the morning when they induce milk let-down.Most farmers try to sell all the milk they produce and, in the absence of

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milk replacers, many calves are subjected to malnutrition for a very criticalperiod before they become true ruminants. This malnutrition, often combinedwith Lo-hygienic and unhealthy stables, predisposes young calves to a seriesof contagious diseases, like white scours or pneumonia, which then are thefinal cause of death. Calf mortality is above 20X on many farms andrepresents a serious loss of valuable animal resources.

Forage Productivity

23. This section summarizes information obtained from discussionswith private farmers and at various research centers regarding recentexperiences with pasture/fodder production in Sri Lanka.

24. To provide cattle regularly with as much low co