Technical Assistance Consultant's Final Report

Project Number: 38662 February 2008

PRC: Shanxi Integrated Agriculture Development Project

Prepared by:

Cardno Acil Pty Ltd., Australia This consultant’s report does not necessarily reflect the views of ADB or the Government concerned, and ADB and

the Government cannot be held liable for its contents. (For project preparatory technical assistance: All the views expressed herein may not be incorporated into the proposed project’s design.)

CURRENCY EQUIVALENTS (as of 31 January 2008)

Currency Unit – yuan (CNY)

CNY1.00 = $0.1321 $1.00 = CNY7.5695

ABBREVIATIONS

ADB – Asian Development Bank ACWF – All China Women’s Federation CAPE – country assistance program evaluation CPMO – county project management office CSP – country strategy and program DRC – Development Reform Commission EA – executing agency EIRR – economic internal rate of return EMP – environmental management plan FAO – Food and Agriculture Organization of the United Nations FIRR – financial internal rates of return FMA – financial management assessment FSR (‘s) – feasibility study reports FYP – 11th Five-Year Plan GAP – good agricultural practice GDP – gross domestic product IFAD – International Fund for Agricultural Development HACCP – hazard analysis and critical control point IA – implementing agency ICB – international competitive bidding IEE – initial environmental examination IPM – integrated pest management ISO – International Standards Organization IT – information technology JBIC – Japan Bank for International Cooperation LIBOR – London interbank-offered rate MPMO – municipality project management office MRL – maximum residue limit NDRC – National Development Reform Commission OCR – ordinary capital resources O&M – operation and maintenance PADO – Poverty Alleviation and Development Office PBC – People’s Bank of China PCR – project completion report PDRC – Provincial Development Reform Commission PLG – Project Leading Group PPMO – provincial project management office PPMS – project performance management system PPTA – project preparatory technical assistance PRC – People’s Republic of China

PSGA – poverty, social and gender analysis RCC – rural credit cooperative RP – resettlement plan RRP – Report and Recommendations to the President SAB – Shanxi Agriculture Bureau SEPB – Shanxi Environmental Protection Bureau SEPA – State Environmental Protection Agency SERF – shadow exchange rate factor SFB – Shanxi Finance Bureau SIADP – Shanxi Integrated Agriculture Development Project SIEE – summary initial environmental examination SPFD – Shanxi Province Finance Department SPG – Shanxi Provincial Government SME – small and medium enterprise SOCB – state-owned commercial bank TA – technical assistance TOR – terms of reference USDA – United States Department of Agriculture WACC – weighted average cost of capital WB – World Bank WTO – World Trade Organization

WEIGHTS AND MEASURES

ha – hectare

kg – kilogram m2

– square meter 1 ha – 15 mu t – ton mu – traditional land measure

NOTES

(i) The fiscal year (FY) of the Government and its agencies ends on 31 December. FY before a calendar year denotes the year in which the fiscal year ends, e.g., FY2007 ends on 31 December 2007.

(ii) In this report, "$" refers to US dollars.

CONTENTS Page

I. THE PROPOSAL 11 II. RATIONALE: SECTOR PERFORMANCE, PROBLEMS, AND OPPORTUNITIES 11

A. Performance Indicators and Analysis 11 B. Analysis of Key Problems and Opportunities 13

III. THE PROPOSED PROJECT 24 A. Impact and Outcome 24 B. Outputs 25 C. Special Features 30 D. Project Investment Plan 31 E. Financing Plan 32 F. Loan Funds Flow 33 G. Implementation Arrangements 34

IV. PROJECT BENEFITS, IMPACTS, ASSUMPTIONS, AND RISKS 38 A. Farm Investment and Incomes 38 B. Financial Analysis of Agro-enterprises 40 C. Economic Benefits 41 D. Environmental Benefits and Impacts 41 E. Employment and Training 42 F. Poverty Impact 42 G. Gender and Development 42 H. Risks and Mitigation Measures 43

APPENDIXES 1. Design and Monitoring Framework 2. Shanxi Agriculture Sector Analysis 3. Problem-tree Analysis 4. Marketing Systems and Market Demand 5. External Assistance 6. Distribution of Project activities by Counties & Municipalities 7. Criteria for Selection of Components, Sites and Activities 8. Eligibility Criteria for Selection of Agro-enterprises 9. Gender Action Plan 10. Detailed Cost Estimates 11. Flow of Funds 12. Implementation Schedule 13. Procurement Plan. 14. Summary of Consulting Services 15. Economic and Financial Analysis 16. Summary Initial Environmental Examination 17. Summary Poverty Reduction and Social Strategy SUPPLEMENTARY APPENDIXES (available on request) A. Agriculture Sector Analysis B. Farm Investment and Income Analysis C. Past Experience and Lessons Learned

D. Detailed Description of Project Components and Activities. E. Institutional Analysis F. Detailed Economic Analysis G. Initial Environmental Examination

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LOAN AND PROJECT SUMMARY Borrower People's Republic of China Classification Targeting classification: Targeted intervention

Sector: Agriculture and natural resources Subsector: Agriculture production, agro-processing, and agribusiness Themes: Environmental sustainability, sustainable economic growth, private sector development Subthemes: Developing rural areas, natural resources conservation, and public-private partnerships

Environment Assessment

Category B. An initial environmental examination (IEE) was undertaken, and a summary IEE is in Appendix 16. The IEE is in Supplementary Appendix E.

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Project Description The Project will promote adoption and expansion of environmentally sound modern technologies in the production of high value agricultural products driven by the market that will result in the production of safe agricultural products and ensure better returns for poor farmers, agro-enterprises, and consumers. Project outputs comprise (i) expansion in the production, processing and marketing of high value perennial crops, annual crops, and livestock through adoption of technologies and practices that ensure increased value-added at the farm level; (ii) improved farmer-market linkages, and (iii) strengthened technical support services and Project management. Under the improvement of high quality perennial crops, an area of 12,500 ha will be planted to fruit crops that include walnut, Chinese dates, apples, crispy pear, prickly ash, and asparagus. In addition, 900 ha will be planted with poplar for production of timber and pulpwood. An area of 500 ha will be devoted to Chinese herbal medicinal plants. Annual crops in greenhouses will be raised 7,500 household level units. Yellow millet will be planted over 2,200 ha. To facilitate on-farm processing, four cold storage warehouses and 100 drying facilities will be built for management by farmers. Under the livestock production component, production of pigs, beef cattle, mutton sheep, Cashmere goats, and poultry will be supported. The Project will also assist in increasing the cold storage and processing capacity of five ago-enterprises to facilitate expansion market outlets for participating farmers. Five farmers associations will be strengthened through training for organization and management of associations, and provision of office equipment. Skills training to farmers will be provided in the practices of modern and environmentally sound technologies. Provincial, municipality, and county technical agencies, and institutions staff will receive capacity building support through training and workshops focusing on (i) improved crops and livestock production, (ii) efficient irrigation systems, (iii) integrated pest management, (iv) environmental monitoring, and (v) water balance monitoring. Actual farm and agro-enterprise investments to be implemented under the Project will be demand driven. Although Project preparation has identified a range of investments that are viable and for which demand is expected to remain strong for several years, investments will reflect market conditions prevailing at the time the investment proposal is appraised for financing. This necessitates flexibility in the approach to implementation, and the capacity and willingness to consider alternative farm and agro-processing investment opportunities.

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Rationale The problem of resource degradation, a major cause of poverty in the province, primarily results from inappropriate land use practices. These practices, among others include cultivation of steep slopes which results in accelerated in soil erosion; excessive use of limited irrigation water through wasteful irrigation practices such as flood irrigation; over use of chemical fertilizers to address declining soil fertility; excessive use of agrochemicals to treat pests and diseases; and absence of proper disposal of agricultural waste especially solid waste resulting from livestock production. An obvious corollary is continued environmental decline, thereby adversely impacting the life and well being of the people. Reversal of these resource degrading practices through adoption of modern environmentally sound technologies will lead to enhanced productive potential of the resource base, thereby facilitating production of value-added high quality agricultural crops and livestock. For the majority of farmers, their willingness to adopt modern and environmentally sound technologies will, in the short term, depend not only upon satisfactory financial incentives, but a demonstration of better returns. Since the financial benefits of adoption of modern technologies are not readily visible, the need for extension and demonstration of such technologies cannot be overemphasized. On-farm demonstration of appropriate farming practices would facilitate dissemination, promote interest in new technologies, and encourage adoption by farmers. Adoption of modern technologies will also ensure sustainability of production and can result in net savings to the farmer. These new and improved technologies that will ensure net savings to the farmers, among other things, include use of high yielding varieties of seeds, use of efficient irrigation systems that result in significant savings in terms of water consumption and energy needed for operation of the irrigation system, phasing out of fertilizer and other agrochemicals that have an adverse impact on soil properties in favor of organic manure and compost and integrated pest management (IPM), cultivation of perennial crops on terraced slopes over 25 degrees to reduce water and soil losses through runoff and erosion, rotational grazing and stall feeding for livestock production to ensure sustainability of grassland resources, adoption of appropriate prevention and control measures against outbreaks of pests and diseases, and other pollution-free production techniques, both of crops and livestock. These are the only options that many farmers (especially poor farmers) in the Project area have for increasing household income. Alternative strategies—such as increasing farm size, obtaining off-farm employment, or exiting agriculture altogether—are not viable options.

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Value-added production of crops and livestock through improvements in production technologies will require significantly better access by farmers to stable markets and improved support services. While contractual arrangements with enterprises, traders, or the options to sell produce directly to the markets exist, there is a need for farmers’ to organize themselves in groups, cooperatives, or associations to enhance their access to markets, increase their bargaining power and obtain better prices for their products, enhance their ability to access and adopt new and improved technologies, and be in a position to better respond to markets and price incentives. In view of the limited access that farmers (especially women) have to formal credit, and the obvious need for investments in adopting new and improved technologies at the farm level, government intervention through finance bureaus may be the only option available for addressing these constraints and providing an opportunity to farmers to get out of poverty. At the farm level, technical support to demonstrate and extend improved and modern environmentally sound technologies, and enhance farmers’ knowledge base must be assured. Farmers’ access to support services is currently limited by the low quality and limited outreach of extension services, and the limited outreach of agricultural information services. Given the scale of operation and limited resources at the disposal of various government agencies responsible for technical support, there is an obvious need for enhancing the skills of these agencies so they can provide the required assistance to the farmers. The opportunity exists to improve both the skills and outreach of advisory and information services through public-private partnerships in which local, more readily accessible and more sustainable private sector services are established through linkages to existing public sector systems.

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Impact and Outcome The anticipated impact of the Project is enhanced production of high quality agricultural products for domestic and international markets through adoption of modern appropriate and environmentally sound technologies and practices. This includes the use of modern technologies and latest varieties in response to market demand, efficient use water resources, conversion of land over 25 degree slops to perennial crops and forestry, measurable reduction in accelerated erosion, and phasing out of chemical fertilizers and adoption of IPM techniques. The outcome of the Project will be sustainable and higher income, and reduced poverty that will be measured by (i) extent of increase in household income through expansion of a market-driven mechanism for enhanced agricultural productivity in higher value livestock, perennial crops, and annual crops; (ii) assured markets through expansion of production bases and collaboration with agro-enterprises; (iii) savings in water and electricity through installation of efficient irrigation systems for production of crops; (iv) provision of expanded cold storage facilities for agricultural products; and (vi) increased employment opportunities in agricultural production and processing for men and women; and phasing out of chemical fertilizer and pesticide use.

Project Investment Plan The Project investment cost is estimated at $222.8 million,

including taxes and duties of $17.4 million, contingencies of $19.3 million, and financial charges during implementation of $18.4 million.

Financing Plan A loan of $100 million (one hundred million united states dollars)

from the ordinary capital resources of the Asian Development Bank (ADB) will be provided under ADB’s London interbank offered rate (LIBOR)-based lending facility. The loan will have a 26-year term including a grace period of six years, an interest rate determined in accordance with ADB’s LIBOR-based lending facility, a commitment charge of 0.1% per annum, and such other terms and conditions set forth in the draft loan and project agreements.

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Allocation and Relending Terms

The Government of the People’s Republic of China (PRC) (the Government) will relend the loan proceeds to the Shanxi provincial Government. The Shanxi Finance Department (SFD) will on-lend loan funds to each of the five municipal finance bureaus (MFBs) in the participating municipalities. The MFBs will on-lend to the respective county finance bureaus (CFBs). The CFBs in participating counties will on-lend funds to final borrowers subject to loan approval by appropriate authorities. The on-lending of funds between finance bureaus and between finance bureaus and final borrowers will be subject to separate loan agreements. On-lending from MOF to SFD, MFBs and CFBs will be subject to the same terms and conditions as the ADB loan to PRC. On-lending to final borrowers (farmers and agro-enterprises) will be subject to the condition that the rate of interest charged will be no lower than the prevailing commercial rate of interest for equivalent types of loan. MFBs and CFBs will bear the foreign exchange and interest rate risk relating to loan proceeds provided to them, except for loans made to agro-enterprises in which the agro-enterprises will bear these risks. The margin between the cost of funds from ADB and the final borrower will be retained by the finance bureau responsible for the loan to the final borrower to cover administration costs and credit risk. The sum of all loans to agro-enterprises will not exceed 10% of the ADB loan amount.

Period of Utilization Until March 2015 Estimated Project Completion Date

30 September 2014

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Implementation Arrangements

The Poverty Alleviation Department Office of SPG will be the executing agency (EA) for the Project. The EA will coordinate and supervise all implementation activities through a Leading Group chaired by the Vice Governor of Shanxi Province, with the deputy director of the Provincial Development and Reform Commission, deputy director of the Shanxi Finance Department (SFD), and director of PADO as Vice Chairpersons. The deputy director, Provincial Department of Water Resources, deputy director, provincial Department of Agriculture, deputy director, provincial Department of Land and Resources, deputy director, provincial Department of Forests, deputy director, provincial Department of Audit, and deputy director, provincial Environmental Protection Bureau (EPB) will be the members. Municipal and County leading groups will also be constituted. The SPG will set up the Project Management Office (PMO), based in Taiyuan. The PMO, together with the Fund Administration Unit (Division of International Capital Management) of SFD will coordinate and oversee implementation of all activities on a day-to-day basis. The PMO’s major tasks include (i) organizing, coordinating and guiding the related departments in Project municipalities and counties for implementation of the Project; (ii) drawing up the annual work program and budget; (iii) organizing procurement; (iv) maintaining consolidated accounts, including developing PMS to track all financial transactions with sub-borrowers; (v) preparing and submitting to ADB Withdrawal Applications and Statements of Expenditure (SOEs) through SFD; (vi) monitoring physical and financial progress, including benefit flow to intended beneficiaries, and submitting reports to the provincial government and ADB; and (vii) liaising with the SPG through SFD for reporting to Ministry of Finance, and ADB. The municipality and county PMOs, one in each of the five municipalities and 26 counties, will assist the PMO. These PMOs will be the implementing agencies (IAs) for all Project components and responsible for day-to-day implementation under the overall guidance of PMO. The provincial EPB will be responsible for monitoring compliance with national environmental standards, rules, and regulations.

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Procurement All procurement will be undertaken in accordance with ADB Guidelines for Procurement. Contracts for goods estimated to exceed $1.0 million and contracts for works estimated to exceed $10.0 million shall be procured using international competitive bidding (ICB) procedures. Contracts for goods and works estimated to cost equal or less than the above ICB values but more than $100,000 shall be procured through national competitive bidding procedures in accordance with the PRC Tendering and Bidding Law (1999), subject to modifications agreed with ADB. Contracts for goods and works estimated to cost $100,000 or less shall be procured using shopping procedures. For farm inputs, procurement will be undertaken through shopping by the respective borrowers in accordance with the established private sector or commercial practices which, based on an assessment carried out during special review mission immediate after loan negotiation, are acceptable to ADB. More details are provided in Appendix 13, Procurement Plan. The relevant sections of ADB’s Anticorruption Policy (1998, as amended to date) will be included in all procurement documents and contracts.

Consulting Services The Project will provide 54.8 person-months of national consulting

services. National consultant person months will be contracted to: (i) study project area farmer-market linkages and to establish and promote best practices in marketing for agricultural products to be supported under the Project (5.9 person months); (ii) provide capacity building in crop and livestock associations (9.0 person months), (iii) provide training to provincial level technical service bureaus (agriculture, livestock, environment protection, water resources, etc) in participatory approaches, gender analysis, training of trainers in crop technologies, and training in trainers in livestock technologies (a total of 0.9 person months), (iv) deliver provincial level workshops in monitoring agricultural product quality and safety, monitoring soil quality, monitoring water resources and water quality, monitoring treatment of animal waste, and environmental impact assessment (for a total of 0.9 person months), (v) provide support to provincial project management in implementation preparation, project monitoring and supervision, preparation and management of bidding and procurement, mid-term review, and project completion and evaluation (for a total of 36.3 person months), (vi) provide support to municipal project management in preparation and management of bidding and procurement, and mid-term review (for a total of 1.2 person months), and (vii) provide monitoring and evaluation training to project management (0.6 person months). Contracts for consulting services will be engaged in accordance with ADB’s Guidelines on the Use of Consultants (as amended from time to time). A Summary of Consulting Service inputs is given in Appendix 14.

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Project Benefits and Beneficiaries

The major benefit of the Project will be reversal of resource degradation though adoption of modern and environmentally sound agriculture production practices to facilitate higher value production. These practices will be employed for the production of high quality perennial crops on 12,500 ha, poplar on 900 ha, Chinese herbal medicinal plants on 500 ha, annual crops in greenhouses in 7,500 household level units, and yellow millet over 2,200 ha. To facilitate on-farm processing, four cold storage warehouses and 100 drying facilities will be built for management by farmers. Under the livestock production component, production of pigs, beef cattle, mutton sheep, Cashmere goats, and poultry will be supported and expanded. The Project will generate incremental employment through all of the productive activities proposed. Within farm-based activities (crops, on-farm processing and livestock), based on the incremental labor requirement expected for each activity and assuming 300 days per year, a total of approximately 10,900 person years of employment will be generated annually at full development, with more than half benefiting women. Of these, 7,600 are expected to be in perennial crop cultivation, 630 in greenhouse vegetables and annual crops, 40 in on-farm processing, and 2,700 in livestock activities. In addition to this permanent employment creation, there will be approximately 23,000 person years of temporary employment required to establish investment activities. Of this, 20,000 will be required for establishing perennial crops since these investments will require labor inputs over a number of years. About 300,000 man days of training will be provided to enhance farmers’ technical knowledge, which will include about 200,000 women. With enhancement of farmers’ capability (training and technical instruction) the Project will directly improve about 40,000 poverty households and about 25,000 low-income households, and the average income of almost 170,000 poor people will rise to CNY 2,000, and the average income of about 110,000 low-income people will rise to CNY 2,200.

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Risks and Assumptions The principal risks associated with the Project relate to the maintenance of a stable macroeconomic environment and the effective implementation of the provincial government's declared policy on the maintenance of private sector agriculture production, addressing sustainability in agriculture, and the reduction of poverty in rural areas. The constraint related to current failure of the financial sector to provide access to investment capital for production and agro-processing activities which would be a potential risk is being addressed in the short term through the Project. In the longer-term, further improvements in agricultural productivity and sustainability will be constrained unless a supportive financial sector environment develops. Policies relating to the financial sector must facilitate the expansion of lending into agriculture and rural areas. This will require that rural financial markets remain competitive and free from non-market interference and that an enabling legal and regulatory environment is maintained. Protection of financial institutions’ interests in respect of loan default and foreclosure on collateral must be protected and enforceable by law. Without this, the risk that financial institutions continue to limit their lending to agriculture and that the sector continues to be starved of investment capital will be considerable. At the Project level, the ability and willingness of Project participants to respond to market signals and the opportunities presented by the Project will be critical to its success. The risk will be addressed through extensive promotion and training among participant groups, particularly in respect of developing effective farmer-market linkages. A further risk is that the current level of demand, and the preference for domestically-grown produce of increasingly higher quality and safety will not be maintained, thereby undermining the potential for increased productivity. Risks relating to the marketing of fresh and processed products are limited, given the strong domestic and global demand and prices for PRC's agricultural produce. Finally, the success of the Project will also, to a large degree, depend upon effective implementation by the Project management offices at provincial, municipal and county levels of government, and monitoring by ADB to identify potential problems and initiate remedial measures at an early stage. This risk is mitigated to the extent that Project management offices are already established at each level government, and have experience of other integrated agricultural development projects.

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I. THE PROPOSAL

II. RATIONALE: SECTOR PERFORMANCE, PROBLEMS, AND OPPORTUNITIES A. Performance Indicators and Analysis1 1. China’s agriculture is characterized by scarce land, abundant labor and small-scale production using little mechanization. The overwhelming majority of crop production originates from small farms averaging 0.65 ha. While a large part of livestock production also comes from small, part-time “backyard” operations, full-time “specialized” household operations and commercial operations have grown rapidly.2 While the contribution of agriculture sector to total GDP in China is not significant in comparison to industrial and service sectors (12.6% in 2005), it continues to be the major source of employment, accounting for about 340 million persons, including 300 million rural persons.3 2. In response to the reforms, average growth rate of China’s agricultural gross output stands at 6.5 percent, though the highest 12.3% was recorded in 1984, which surpassed the world’s average for the same period. By 1999, agriculture sector development in China showed remarkable progress and the outputs of grain, cotton and oil-bearing crops were 508.39 million tons, 3.83 million tons and 26.012 million tons, respectively, increases of 66.7, 76.7 and 400 percent over 1978; the output of meat amounted to 59.61 million tons, or seven times that of 1978; and that of aquatic products 41.224 million tons, an increase of 8.8 times over 1978. As a result, the chronic shortage of major agricultural products was finally overcome. 3. The per capita total rural income rose more than three-fold between 1980 and 2000 to CNY 4,631 in 2005. 4 During the same period, the per capita income from labor was CNY 1,013 up by 21%, which includes the contribution of CNY 583 from employment in local enterprises, an increase of 19%. The overall rise of incomes in rural areas, including those in poor areas, has led to a dramatic fall in poverty.5 However, the pace of rural income growth has lagged behind urban income growth, resulting in widening income differentials between rural and urban areas and between the eastern region, and the central and western regions of the country. 4. The extraordinary growth of China’s agriculture sector derives from reforms introduced in 1978, which consisted of (i) increasing procurement prices for grains, (ii) allowing farmers to sell above quota production at market prices, (iii) lowering grain quotas, (iv) increasing grain imports, and (v) expanding private inter-provincial trade. The most important feature of the reforms was the household responsibility system, in which collective land was assigned to households for up to fifteen years and local governments transferred production decisions and profits from communes to households. Economic reforms also encouraged the establishment of township and village enterprises, and dragonhead enterprises, which are now an important part of the industrial structure and major source of non-farm employment for off-season rural labor. 1 ADB. 2007. Technical Assistance to the People’s Republic of China for Preparing the Shanxi Integrated Agriculture

Development Project. Manila. 2 OECD Policy Brief. October 2005 3 China Statistical Yearbook 2006 4 China Statistical Yearbook 2006 5 Using China’s standard of income below USD 0.6-0.7 per day, the number of people living in poverty fell from 250

million in 1978 to 29 million in 2003. In other words, the proportion of the rural population affected by poverty fell from 31% to 3% during the period. Based on the World Bank definition of poverty (income of USD one per day), the number of people living in poverty in rural China was still high at 88 million in 2002, but the progress in eliminating poverty is still remarkable, with about 400 million people rising above the poverty line between 1979 and 2002.1

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5. There has also been a shift in emphasis from crops to livestock: between 1985 and 2005, the share of crops in farm output fell from 70% to 50%. The share of maize (for animal feed) has increased, though, and the area sown to vegetables and oilseeds has also expanded considerably. Exports have increased by 70% in the last decade alone, although the share of agricultural exports in total exports has been declining (3.6% in 2005, compared with 8.2% in 1995). There is a trend towards the export of higher-value products, such as horticultural and animal products, with a corresponding decline in exports of bulk commodities such as grain. 6. Shanxi province is located in the middle reaches of Yellow River and eastern part of the Loess Plateau.6 In the east of Shanxi stand Taihang Mountains where the Loess Plateau and the North China Plain meet. Shanxi consists of mountain areas in the east, plateaus in the west, and basins in the middle. The mountains, hills, and plateaus account for 35.7%, 44.6%, and 19.7% of the total land area of Shanxi, respectively. Because loess soils are high in nitrogen, potassium and phosphorus, and because they retain water effectively, they are productive despite the region’s seasonally dry climate. The Yellow River, which flows over rapids and through deep gorges, forms the western border and traverses along the southern border of the province. Roughly rectangular in shape, the province is bordered Hebei province in the east and the Shaanxi province across the Yellow River in the west. Hunan province lies in the south. The autonomous region of Inner Mongolia is situated across the northern border. Shanxi has as its economic focus the Fen River valley, which widens to form the fertile and centrally located Taiyuan Basin. This strategic location of Shanxi province places it at a significant economic advantage, especially in terms of the marketability of its produce. The capital, Taiyuan, is the largest city and chief industrial center. 7. Shanxi has an area of about 60,200 square miles (156,000 square kilometers) and population of about 33 million (2003 estimate). There are 119 agriculture counties in Shanxi, 57 of which are classified by the province as ‘poor’. Of these 57 poor counties, 11 are among the 26 counties proposed to be part of the Project. Of these 11, six are included in the 35 Shanxi counties on the list of national priority poor counties in China, as determined by China’s State Council. However, there are significant areas of rural poverty with both national level (35) and provincial level (22) poverty counties. 8. The Shanxi province is richly endowed with natural resources, especially coal, coal bed methane, bauxite, refractory clay, pearlite, and gallium. In 30 years of reform up, significant progress has been made in agricultural processing, transportation, industrial production, development of production bases, and the development of an agricultural service system, farmers’ capacities and women’s social participation. However, extensive, scattered small scale agriculture has not changed fundamentally. Farmer cooperatives, farmer associations and other rural economic organizations have just emerged.7 However, these developments could not meet the need for building modern agriculture and farmers’ capacities. In Daning County and Jiaokou County for example, 5% farmers have high school education, 65% middle school education and 30% elementary school education. In addition, women’s participation is inadequate, and their rights in social resources are usually ignored. The rate of female

6 Loess plateau is the highland area in north-central China, covering much of Shanxi, northern Henan, Shaanxi, and

eastern Gansu provinces and the middle part of the Yellow River basin. Averaging about 4,000 feet (1,200 meters) in elevation and covering some 154,000 square miles (400,000 square km), it is the world's largest loess plateau. The loess is particularly susceptible to erosion by water, and ravines and gorges crisscross the plateau.

7 The Government promulgated the Law on Farmer's Specialized Cooperatives in July 2007. The law is one of several policies related to the agricultural sector development that stipulates requirements and support instruments for the creation of farmers' association to ensure the provision of sound agricultural support services and to promote the development of the agricultural sector.

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employment to total employment ratio in Houma is 35%, 15% in Jiaocheng and 12% in Zhongyang. 9. Despite limited cultivable land, the agriculture sector has retained its place as the major source of employment, employing about 64 million persons in 2005, highest among all sectors.8 In 2005, agriculture in the province contributed CNY 26.2 billion to its GDP compared to CNY 23.5 billion for secondary industrial sectors and CNY 15.6 billion for tertiary industrial sectors. These figures indicate the importance of coal and related industries on the provincial economy. 10. China’s national priority poverty county list is based on a standard that identifies a person as ‘poor’ if income per head is below CNY 680 per annum, and as ‘low-income’ at less than CNY 1,000/head/year. The county level poverty lists, in contrast, typically define ‘poor’ as applying to persons with an annual income of not more than CNY 1,000, and ‘low-income’ at less than CNY 1,600. The standard applied by Shanxi Province to identify its 57 priority poor counties was CNY 2,100/person/year in 2006. Even this much more generous poverty line, however, is below the international standard of $1/person/day, which equates to an annual per capita sum of almost CNY 2,700, at the current exchange rate of CNY 7.4=1$US. 11. In the poorest counties in Shanxi, average net disposable income per person languishes at well below CNY 1,000 per year, which is about two-thirds below the international poverty line of approximately CNY 2,700 per person per year. The plight of poor households in poor counties notwithstanding, it would be wrong to conclude that there is no poverty in counties that are not listed on either the national or the provincial poverty list. There are poor people in every province and county in China, despite the dramatic success in reducing poverty. B. Analysis of Key Problems and Opportunities9

1. Limited and deteriorating resource base 12. Arable land resources in the province are in short supply, and in general the quality of arable land and productivity is low. Within the arable lands, around 25% are high and stable productivity, around 75% are middle-low productivity, and more than 70% are dry land whose organic matter content is less than 1%. Low rainfall, high evaporation, frequent natural disasters, water loss, and soil erosion and other natural conditions lead to instability in agricultural production. From 1997 to 2005, the area available for crops has been reduced by 603,830 ha on account of infrastructure development, the reversion of agriculture land from farming to forestry, grassland, and orchards. 10In response to the policy of converting all agricultural land over 25 degrees slope to perennial crops and forestry, there has been a noticeable increase in the area available for perennial crops and forests, and a reduction in accelerated erosion. This has increased the land base somewhat, and allowed for enhancing production of fruit crops, perennial Chinese herbs on terraced land, and establishing forest plantations. It is estimated that 241,000 ha are on slopes with gradient of more than 25 degrees, where only perennial crops, soil binding trees and shrubs are permitted. 13. Being located in the Loess Plateau, and being cultivated over centuries, soils in Shanxi are vulnerable to accelerated erosion. The estimated area subject to water and soil erosion

8 Source: China Statistical Yearbook 2006. 9 See Appendix 2 for a brief overview of the Agriculture Sector, Supplementary Appendix A for and detailed

analysis and Appendix 3 for problem tree analysis. 10 Shanxi IADP PMO Feasibility Study. December 2007.

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accounts for 59.5% of total land area. The average erosion rate is 3,000 ton/km2 and 12 of the 26 Project counties are in the priority list for treatment of accelerated soil erosion in the country.11 14. Water resources have been declining since 1956. From 2000 to 2005, there was a sharp increase in the run off and water resources decreased more rapidly. It as been estimated that from 2000 to 2003 the total amount of water resource in the province decreased by 4.9% annually, from 8.149 billion m3 to 6.951 billion m3, a net loss of 1.198 billion m3. The proportion of water available for irrigation decreased from 95% in 1950s to 59% at present.12 15. The 26 proposed Project counties have a total of 2.461 billion m3 of water, accounting for 30% of the province. The total consumption and use of water in the Project area is estimated to be 1.599 billion m3, accounting for 28% of that in the province. Irrigation water used in Project sites is estimated at 1.396 billion m3, accounting for 87.3% of that in the province. The per capita water resource availability is estimated at 321.6 m3, 28% higher than that of the province as a whole. In all 26 Project counties, 59% of the total available water is used for irrigation. It is over 50% in 16 counties, over 70% in 13 counties, and over 90% in Wenshui and Yanhu counties.13 16. Low utilization ratio of water due to severe waste of the water resources is another factor contributing to reduced water availability. Flood irrigation is the most common practice employed in the province. In 2000, 3,533 m3 of water was used for irrigating one ha, which is 3-7 times of the water used in drip irrigation and other water-saving irrigation methods. 17. High-density coal mining is a major cause of degradation of arable land, rendering it unsuitable for cultivation. During the last ten years, an area 26,700 ha potentially irrigable land has become dry because of coal mining. Coal mining also causes land subsidence, and coal waste covered arable land, reducing its productivity or making it unsuitable for cultivation. It has been estimated that the production of crops in such areas has been reduced by 250 kg per ha, or a total production loss of over 6,650,000 tons per year. 18. Water pollution is another cause for degradation of arable land. The main factors which lead to the water and soil pollution, wastage of resources, and degradation of arable land include discharge of contaminants, uncontrolled use of agrochemicals, and non-recycling of non-degradable agricultural waste such plastic mulch. Over use, and low efficiency in use drainage of agrochemicals contributes to pollution of water resources and arable land, and at the same time, increases production costs and decreases output. The utilization ratio of nitrogenous fertilizers has been estimated to be around 30%, 20% lower than most industrialized countries. 19. Coal mining is also a major contributor to reduction of water resources in the province. It has been estimated that 2.48 m3 of water are required for processing one ton of coal. At the present level of coal mining, estimated to be around 600 million tons each year, 1.488 billion m3 of water, or one fifth of the total water resources in the province, are required. The consequent economic loss caused by coal mining has been estimated to be CNY4.59 billion, which is 2.8% of the province’s GDP.

11 Shanxi IADP PMO Feasibility Study December 2007. 12 Shanxi IADP PMO Feasibility Study December 2007. 13 Shanxi IADP PMO Feasibility Study December 2007.

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20. Contamination of water by pollutants which renders it unsuitable for agriculture also contributes to a shortage of quality water. In 2001, water quality in rivers of the province was observed to suffer from severe water pollution, and as a consequence, human and livestock in over 1,000 villages faced difficulties in securing quality water. Contamination of ground water is exacerbated by the use of chemical fertilizers, which constitute a major source of pollution of ground water. The push for green agriculture and pollution-free crops can reduce the pollution from agricultural chemicals, although the application of these policies is often superficial. More efficient use of water and fertilizers, more effective use of agrochemicals and a greater understanding by farmers and technicians could increase the effectiveness of environmental efforts. Chemical control is still the main method to control pests and diseases of most vegetable crops, and these are used in large quantities and frequently. As a consequence, maximum residue levels (MRLs) are usually above Chinese national standards, making integrated pest management (IPM) a high priority.

2. Support Services 21. Technical support and extension services to farmers and AEs are the primary responsibility of technical line agencies at the provincial, municipality, county and township levels. There are 56, 175, and 148 senior professionals at the provincial, municipality, and county levels, respectively, in various line agencies. The corresponding numbers of professionals at Elementary, Intermediate, and Technical levels are about 100, 1,000, and over 2,000 in the provincial, municipality, and county line agencies. Despite the large numbers of technical staff at all these levels, adequate support to farm households and AEs is constrained by capacity and skills needed to address problems, extension and outreach of modern farming practices, prevention and control of new and emerging pests and diseases of crops and livestock, practices of pollution free farming, and IPM. Additional constraints are imposed by operational budget that limits the mobility of the staff. The problem is exacerbated at the township levels where capacity for technical support is far from adequate. 22. Regarding financial services for agriculture, lending by PRC's major commercial banks and financial institutions is concentrated on urban areas and non-agricultural sectors. The traditional sources of agricultural and rural credit, the Agricultural Bank of China (ABC), the rural credit cooperatives (RCCs) and the Agricultural Development Bank of China (ADBC), which have branches in about half the counties in the province, are gradually moving away from rural to the urban sector. These financial institutions have less than half of their lending geared to agriculture and about 80% of the loans directed to state-owned enterprises. ABC in particular is withdrawing from the agricultural sector based on the Government directive that it become more commercial and private-sector oriented. In addition, ABC has been primarily involved in short and medium-term policy lending in areas such as grain, edible oil and cotton. Such lending is not relevant to the needs of the Project area. 23. The Provincial Development Reform Commission (PDRC) also finances cash for work projects for poor farmers. In certain cases, the Poverty Alleviation and Development Office (PADO) provides small loans to farmers. Additional lending capacity (savings) is transferred to developed urban areas where the demand for credit is much greater. China Postal Savings Bank opened business in March 2007 and although have become an important part of the rural financial service system there is no indication that they will become heavily involved in lending to farmers or enterprises. 24. The principal source of formal short-term credit for individual farmers is the RCCs that operate in 95% of the province’s 996 townships and have sub-branches in 3,939 villages. As lenders, RCCs are in aggregate comparable in size to ABC, but are primarily retail lenders with

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much smaller loan sizes (CNY500 to CNY2,000), and a large number of farmer borrowers. They do, however, have an impressive 95% recovery rate. RCCs and Micro Credit Companies (MCCs) are not willing to participate in lending to farmers because of the perceived risks. Moreover, the RCCs recently withdrew from the People's Bank of China (PBC) microfinance program because the cost of funds (3.55%) was considered too high. This is, however, significantly below the expected cost of project loan funds, suggesting that RCCs would be unwilling to participate in the Project to borrow funds to on-lend to Project area farmers. 25. Farmers (especially women) and small businesses are disadvantaged in terms of access to formal credit. In addition, it is estimated that around one-third of the lending designated for agriculture does not actually reach farmers. Most farm expenditures are financed by farmers' savings, and most loans are obtained from informal sources (e.g., relatives, friends, money lenders, and pawnbrokers). The small size and short term of most agricultural finance precludes investment in assets that have a long payback period. Also, lending by state-owned commercial banks and credit cooperatives is still largely guided by government policy. According to PBC, on average, only a third of rural households have access to formal sources of credit. 26. The failure of the financial sector to function effectively in support of agriculture and agribusiness development means that market opportunities—and the associated introduction of more economically and environmentally sustainable agricultural production— are not being realized. Unless this financing gap is filled, there is a risk that PRC's farmers and agro-enterprises will lose their share in international markets in the face of increasing competition from other fruit-producing and processing countries. 3. Opportunities to reverse environmental degradation 27. The province possesses 16.407 million mu (over one million ha) of natural grassland and capacity to produce five billion kg of dry maize straw every year. The province has a long history of livestock breeding, and many well know brands have been developed during the process, such as Jinnan Cattle and Pingyao Beef. From 2001 onwards, the number of beef cattle has steadily increased and cattle for sale have increased by 40,000 heads yearly as well, an annual growth rate of 4.5%. In 2005, pig output in Shanxi was 5.75 million heads, 1.01% of the national total. Shanxi has 122 large scale pig farms, 217 slaughterhouses, and in 2005, 3.23 million pigs were slaughtered and processed, producing 276,000 tons pork. 28. In the sheep subsector, by the end of 2000, Shanxi province had 11,869,200 heads of sheep (7,061,000 head of sheep and 4,808,200 head of goats). Of these, 6,448,400 heads of sheep were slaughtered and 94,600 tons of mutton was yielded, each sheep producing 14.66kg/sheep on average. 29. Shanxi has abundant forage grass and long history of raising Cashmere goats. In 2006 that there were 4.77 million Cashmere goats, up 2% year on year; annual Cashmere output was 785 tons, up 1.5% year on year. Total trade volume CNY seven million, with average unit price of CNY 380/kg. 30. Poultry eggs output was 568,700 tons in 2005. In the first half of 2007, Shanxi exported 110 million eggs to Hongkong, worth US$55.2 million US dollars and became the third largest poultry eggs exporting province, after Liaoning and Hubei. In 2005, gross poultry production was worth CNY3.13 billion, 42% of the gross production of livestock, with poultry meat output of 41,800 tons and poultry numbering 125 million.

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31. Within the province, environment places serious limitations on agriculture due to low rainfall, elevation, erodible soils and long term degradation caused in part by overuse and poor management of the resources. Recent attempts at improving environmental conditions have led to significant and visible improvements such as tree and vegetation cover on hills, road sides and within urban areas. Improvement in coal production and cleaning technology and the closure of older mines has also led to a reduction in pollution levels at many sites. 32. To address the widening income gap between rural and urban areas and between eastern region, and the central and western regions of the country, the Government plans channelling significant investment at village and farm level to promote the introduction of high value crops and livestock as a means of increasing rural incomes and reducing poverty. Processing and marketing of such increased production will be carried out by private sector enterprises with access to favourable finance for expansion of processing facilities. 14 33. Fodder grass and crop straw are an important foundation for the development of livestock production industry. In the 13 counties in the province where livestock production is practiced, a total area of 290,000 ha of grazing land is available. This includes about 120,000 ha of natural grassland, 6,400 ha of improved grassland and 18,620 ha of planted grassland. Total dry grass production is estimated to be 2.474 million tons each year: 525,900 tons from planted grassland, 264,700 ton from natural grassland, and the rest from improved grassland. The total feed straw available from crop production is 1.684 million tons. In addition, other resources such as seeds, residue from breweries, husk, and leaves are also used for fodder. 34. As in rest of China, agricultural restructuring in Shanxi is taking on faster pace, with a series of policies being successively implemented to encourage the development of special beef industry to enhance agricultural industrialization. In response to the national 11th Five Year Plan (EFYP), the Shanxi Provincial Government (SPG) and the Committee of the Communist Party of Shanxi (CCPS), decided to support 59 counties in two economic zones (North Shanxi and Central and Southern Shanxi) to promote socioeconomic development in rural areas and to improve farmers’ incomes particularly in poverty identified counties. In the 11th five-year Development Plan for Provincial Economy and Social Development, it is clearly articulated to strategically strengthening agricultural infrastructure, fully developing fruit & forest industry, animal husbandry and vegetable industry, and construct a province with big livestock industry. The agricultural sector development plan for Shanxi proposes (a) defining agricultural production zones, (b) maintaining the production base of essential commodities, (c) fast-tracking the introduction of high value annual and perennial crops and breeding livestock, (d) improving the productivity of appropriate farmland areas with irrigation, (e) upgrading technical services to support proposed changes to farm cropping patterns, and (f) promoting awareness of environmental mitigation measures. 35. In the rural areas, increased incomes can be achieved by a shift to higher valued crops and livestock production. For the poorer farmers, this will require government intervention in the form of the supply of planting material, irrigation infrastructure, and breeding stock. In the absence of effective alternative rural financing institutions, government through its finance bureaus will need to provide investment finance for the purchase of such inputs. Development of groundwater irrigation to support the shift to higher value cropping at the village level can be justified on the basis of supplying a public good to support the proposed intervention.

14 Shanxi IADP PMO Feasibility Study December 2007.

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36. For a poor farmer household, assurance of a reasonable price for farm products will be achieved by competition from local processing agro-enterprises (AEs) and local traders supplying processing AEs in other provinces. It is therefore difficult to justify government assistance to such AEs except to ensure that they are able to cater for any increase in supply and can remain competitive with processors from other provinces. This may require favourable financing arrangements, again through county finance bureaus, to expand and upgrade processing lines. 37. Technical support to farmers to acquire the knowledge base must be assured. This support will not only require the use of government technical services, with advanced knowledge and skills, but the assistance of experts outside of the government. Of particular concern is the development of better on farm water usage were experienced consultants need to be engaged at government/Project expense, to train water users and distribution managers. 38. This strategic geographic location of Shanxi province places it at a significant economic advantage, especially in terms of the marketability of its produce. The mountains, hills, and plateaus and the consequent climatic variability provide an appropriate environment for diversified agricultural production, using modern, appropriate and environmentally neutral technologies. These may include cultivation of perennial crops on terraced slopes over 25 degrees, phasing out of fertilizer and other agrochemicals in favor of organic manure and compost and integrated pest management (IPM), water conservation, adoption of cleaner production technologies in coal mining to reduce water pollution, rotational grazing and stall feeding for livestock production, and other similar practices. The province therefore has the potential to be fully responsive to the agricultural sector development plan, referred to above. 39. Experience in the production of livestock, crops and vegetables, exists at both, the farmer, and at the AE level through collaboration in production bases. The AEs either have in-house technical capacity or engage professionals from technically qualified institutions to assist farmers in producing clean and safe vegetables, devoid of any residual pesticides, and certified livestock products. Since there is a premium in the market for production of clean and safe vegetables and fruits as well as organic livestock products, potential exists for expansion of these technologies and practices to farmer households not within the collaborative arrangements with agro-enterprises. This would require technical support form various government institutions and agencies, many of which need strengthening to fully respond to the needs, and strengthening of farmer-based associations to act as a conduit both in the extension of modern technologies and for marketing of agricultural products to ensure better prices for farmer households. This will also require access to appropriate financing arrangements through county finance bureaus, to expand capacity and upgrade processing lines.

4. Farmer-Market Linkages

40. There is a wide range of agricultural marketing channels in existence in Shanxi which operate at varying levels of effectiveness and competitiveness (See Appendix 4 and Supplementary Appendix B). There are around 270,000 farmer agents within the five municipal cities of the Project area. Of these, 4,500 are reported to be larger scales (having a turnover of over CNY100, 000, US$14,000) which regularly deal with 30,000 farmers. There are also 1,220 registered intermediary agencies such as farmers' associations, 18,000 farmer cooperatives (with 220,000 members), 355 supply and sales cooperatives, 611 registered technical associations, 92 wholesale markets, and 146 rural markets. Finally, there are 575 agro-enterprises engaged in the processing of agricultural products. Of these, 195 have established production bases supplying product. Around 250 agro-enterprises have turnovers in excess of

19

CNY1 million (US$140,000). At the county level, there are 243 agro-enterprises, 71 agro-enterprises connected to production bases, 440 registered intermediary agencies, and 95,000 farmer agents. There are, therefore, a variety of options for farmers to access outlets either through direct contact with agro-enterprises and markets, or through intermediaries (agents and associations). Their effectiveness, however, varies both geographically and by product or product grouping. 41. Within the Project area, a farmer survey conducted during Project preparation revealed that all Project area counties have specialized farmers' organizations, and there exist such organizations for all the products to be supported under the Project. Their level of development and effectiveness varies. In some counties, 50% or more of all farmers belong to such an organization, while in others membership is below 10% of all farmers. For individual products, farmer agents (brokers) who collect product from farmers and sell to wholesale markets or direct to agro-enterprises are important in the marketing of walnuts (around 50% are reportedly sold in this way), apple, pear, Chinese date, asparagus, Chinese herbs, vegetables, and all livestock products (with the exception of eggs which farmers tend to sell directly to wholesale and retail markets and agro-enterprises. For all products, however, farmers also sell directly to wholesale markets, retail markets, and agro-enterprises. There is no universal marketing system for any product or in any location within the Project area. 42. Farmers throughout the Project area are aware of the significant demand for agricultural products and, therefore, the potential for increased financial returns, but in certain areas expressed concern that their access to such market opportunities is constrained by the low level of development of marketing channels through farmers' associations, brokers, agro-enterprises, etc. Establishing links with agro-enterprises was the most common concern express across all product types. A further constraint expressed, and allied to the lack of farmer collaboration through associations, etc, is limited access to market and price information. Limitations relating to the availability of transport infrastructure were also identified as a constraint. These constraints affect farmers in different ways and to varying degrees according to products produced, geographic location, etc. They all affect the willingness of farmers to diversity into or expand the cultivation of crops which they believe they will find difficult to sell easily and at reasonable prices. This also limits the adoption of improved technologies and practices, and therefore environmental sustainability of production systems.

5. Realization of Market Opportunities 43. PRC is the world’s largest producer of cereals, vegetables, fruits, eggs, meat and aquatic products. It is also one of the world’s largest consumers of food. PRC's annual consumption accounts for 51% of the world’s production of pork, 33% of rice, 19% of ice cream, 19% of poultry, and 12% of beef. Though just 30% of the food consumed is now processed, compared to 80% in industrialized countries, the market for processed foods is growing, especially in urban areas. Urbanization and increasing urban incomes have brought about significant increases in demand for agricultural products, and a shift in demand towards a wider range of higher quality and safer agricultural produce. This includes increased demand for fruit and other perennial crops, both fresh and processed, and livestock products. For many food products (particularly processed fruit, vegetables and meat products), Shanxi Province is a net importer from other provinces within PRC. There are, however, a number of niche markets in which the province has out-performed PRC as a whole in respect of export growth. Exports of fruit products from Shanxi have grown dramatically in recent years, increasing from 32,540 tons in 2003 to 82,000 tons in 2006, an average annual growth rate of 36%. By comparison, PRC exports of fresh apple (the predominant fruit export) grew at 9.7% from 609,045 tons in 2003 to

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804,226 tons in 2006. PRC's apple exports are projected to grow to over 943,000 tons by 2015. This represents an annual average growth rate of 3.8%. With the development of Chinese infrastructure in rural areas, and the high quality of Chinese apples, the international competitiveness of Chinese fresh and processed apple products will be strengthened. This will provide an opportunity for continued expansion in provincial production and exports. Irrespective of the growth in PRC's exports of food products in recent years, there are significant opportunities for farmers and agro-enterprises to meet provincial consumers' demand currently met from imports from other provinces, given their greater proximity to and better understanding of local market conditions. 44. The realization of these opportunities will depend to a large upon the ability of provincial producers to adjust to the shift in demand to high-value, safe food products. This will increasingly require the adoption of good agricultural practices both to eradicate chemical residues in food products and to promote sustainability in production systems.15 For export markets, compliance with the standards required of membership of the World Trade Organization is critical. While there are increased costs associated with meeting the needs of increasingly discerning domestic and international consumers, there are equally significant potential price premiums to be earned for provincial farmers and agro-enterprises prepared to make the requisite investment in upgrading their technologies.

6. Government Policies and ADB’s Country Strategy 45. In the Eleventh Five-Year Plan 2006–2010 (the Plan), the Government shifts the emphasis of PRC’s economic and social development policies away from the growth orientation of previous plans, and instead emphasizes sustainability, based on broader and more inclusive rural development and social programs, in the context of an increasingly market-oriented economy. The objective of the plan is to achieve greater balance between (i) urban and rural areas; (ii) geographic regions; (iii) economic sectors; (iv) economic and social development; and (v) economic growth and protection of the environment. Continuing the emphasis on the development of the agriculture sector, the Government published its Number 1 Policy Document on Modern Agriculture in January 2007.16 This initiated the "New Socialist Countryside" concept to address the slow rate of development of rural areas, and the slow growth in income and poor socioeconomic conditions of PRC's 750 million farmers. The Document recognizes that the persistent decline in natural resources and the deteriorating environment need to be addressed by changing the nature of agricultural growth. The Plan is in line with Asian Development Bank’s (ADB) existing strategic objectives and operations in PRC (i.e., the Country Strategy and Program Update 2007–2008, approved in 2006).17 Accordingly, the Government’s in its New Socialist Countryside Policy prioritises investment in (i) improving rural growth, (ii) increasing farm productivity to raise rural incomes, and (iii) environmentally sustainable production. 46. ADB’s future operations in PRC will focus on rural development, environment, energy conservation, urban development, and regional cooperation. ADB will mobilize more resources and develop diversified instruments to meet the demand for balanced development among

15 To address these concerns and promote good agricultural practices, PRC has initiated the ChinaGAP

program, which will eventually match the standards laid down for certified producers supplying global markets (GlobalGAP). This will complement compliance with international standards already achieved by agro-enterprises through hazard analysis and critical control point (HACCP) and International Standards Organization (ISO) certification.

16 Communist Party of China Central Committee. 2007. Vigorously Developing Modern Agriculture and Steadily Promoting the Construction of a New Socialist Countryside. Beijing. 17 ADB. 2006. People’s Republic of China: Country Strategy and Program Update 2007–2008. Manila.

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regions, and between rural and urban areas. ADB will contribute to strengthening of knowledge in policy, law, and governance reform.

7. External Assistance 47. The World Bank has been the largest donor to the agriculture and natural resources sector in the PRC, followed by ADB, with a total financing of $1.477 billion for 19 projects. Japan Bank for International Cooperation (JBIC) has provided assistance to the sector in PRC for seven projects, focusing on environment, education, public health, infrastructure, and forestry. World Bank assistance to Shanxi province has included support for poverty alleviation, agricultural and natural resources development, small-holder cattle development, river basin development, watershed rehabilitation, environment, health and sanitation, transport and communications, and social infrastructure. ADB’s assistance to the province has included projects in environmental improvement, thermal power, and transport and communication sectors. Germany has provided grant assistance for two projects in the sector in the province. IFA has a small grant-funded project currently under implementation in the province. Major projects in the sector supported by external assistance are listed in Appendix 5.

8. Lessons Learned 48. Salient features and common elements of experience and lessons learned from relevant Projects include: (i) strong commitment of the project proponents to achieving target outputs and demonstrated ownership of the Project by all concerned parties including the provincial and local governments, reflected in the provision of adequate financial and staff resources; (ii) thorough and comprehensive analysis of the institutional capability of the implementing agencies and adequate support to ensure effective implementation; (iii) close adherence to guidelines and procedures; (iv) effective supervision, monitoring, and cost control during implementation; (v) adequate planning and preparation to ensure timely availability of required funds; (vi) flexibility in project design to respond to changes as implementation progresses; (vii) a properly administered bidding process, supported by detailed technical design and bid specifications, resulting in generation of advantageous bids; (viii) technical support and partnership with the Project Management Office (PMO) to guide on-lending decisions; (ix) an appropriate risk-sharing mechanism; (x) in case of private enterprise involvement, demonstrated specialist commercial and technical knowledge and experience in crop production, processing, and marketing; and an appropriate project performance monitoring system (PPMS) at the outset to obtain adequate information needed for taking timely corrective measures when required. 49. With specific reference to agro-enterprises, ADB's recent country assistance program evaluation (CAPE)18 identified a number of issues, which are relevant to the Project. These include (i) agro-industrial and agro-processing projects have had to rely on the capacity of untested private enterprises; (ii) there is a reluctance on the part of the Government to borrow for agricultural projects on ordinary capital resources terms, due to insufficient financial rates of return and difficulties in servicing the debt; and (iii) the failure of on-lending through financial institutions has required the channeling of funds through agro-enterprises. While the CAPE does not provide reasons for less than satisfactory performance agro-processing projects, the Project Completion Report (PCR) of the Fujian Soil Conservation and Agriculture Development Project referred to a number of problems common to such projects, including (i) changing market trends; (ii) location problems in relation to raw material supply; (iii) the weak financial

18 ADB. 2007. People's Republic of China: Success Drives Demand for More Innovative and Responsive

Services. Manila.

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position of subproject proponents; and (iv) inappropriate financing terms, which (a) failed to reflect agro-enterprise cash flow and required loan repayments to start immediately (prior to full operation of the facilities installed with project loan funds), (b) included an interest spread for the finance bureau, which drove the resulting end-borrower interest rate above domestic market rates, and (c) neglected the need for arrangements for complementary working capital finance to be in place. 50. ADB’s technical assistance (TA) report19 identified a number of similar lessons, specifically, that (i) viable enterprises can succeed with commercial funding, and (ii) the use of ordinary capital resources or other commercial resources for funding agro-industry is not contentious. However, where financial market failure exists, donors and governments can address this through the creation of specific financial facilities (loans, equity, and guarantees) that assist SMEs, or more specifically private agro-industry. There is often a particular need for long-term capital, because of the lead-time to full production of agricultural SMEs. The provision of long-term capital should not be subsidized for this reason. Instead, the terms and conditions of the financing should be related to a realistic repayment schedule for the enterprise. 51. To address these issues, the Ministry of Finance announced Directive 38 in 2006, resulting from an audit of 100 donor projects. This regulation requires much more involvement of the Ministry of Finance at all levels down to and including the county level. The finance bureaus are to take a more active role in the design and monitoring of projects. While not changing the project approval process, Directive 38 requires finance bureaus to carefully review project designs and undertake monitoring of funds flow and procurement. 52. The World Bank’s Water Conservation Project,20which was implemented in 27 counties from the provinces of Hebei and Liaoning and the municipalities of Beijing and Qingdao recommended that: (i) innovations in water resource management should be tested through a demonstration project, and then scaled up; (ii) a comprehensive approach giving priority to farmer incentives can increase farmer incomes and reduce water consumption; (iii) success of water users association stems, in part, from the clear establishment principles adopted: democratic self organized Associations based on hydraulic boundaries, measuring and charging for water on a volumetric basis; (iv) flexibility in approach and adaptation to local social, economic and political conditions; (v) incentives framework, with farmers in Associations seeing their incomes rise significantly faster; (vi) targeting reduction in consumptive water use based on magnitude of evapotranspiration for water management in conditions of extreme water stress. 53. Where appropriate, these lessons have been incorporated in the design of the Project. These include: (i) establishing strict criteria for the selection of Project components and agro-enterprises that satisfy financial, economic, environmental, and social criteria, including demonstrated specialist commercial and technical knowledge and experience by agro-enterprises in crop production, processing, and marketing; (ii) a thorough analysis of the proposed investments under the Project during project preparation to ensure that these are viable; (iii) adequate provision for capacity building of provincial technical support agencies, the PMOs and Finance Bureaus at various levels including support to guide on-lending decisions; (iv) inclusion in the cost estimates an adequate provision for operational funds to ensure effective management by PMO and implementation at various levels in the province; (v) removal

19 ADB. 2000. Technical Assistance to the People’s Republic of China for A Study on Ways to Support Poverty

Reduction Projects. Manila. 20 WB. 2007: Implementation Completion and Results Report: Loan IBRD-45890: Water Conservation Project:

2000 – 2006

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of an interest spread for the finance bureaus at the provincial, municipality and county levels; (vi) reasonable and achievable targets, with built-in flexibility to respond to changing markets; (vii) expansion of production to ensure adequate supply of quality raw material to AEs; (viii) an appropriate performance monitoring system (PMS); (ix) ensured technical support to farmer households to ensure effective and timely implementation, adherence to financial discipline, and on-time repayment. Moreover, in-depth discussions of various aspects of project implementation, financing, disbursement procedures and the PMS have been held with the PMOs and the concerned Finance Bureaus. See Supplementary Appendix C for details. 54. Production of value-added high quality agricultural products in an environmentally sound manner depends primarily on the willingness of farmers to adopt new and improved technologies under a household responsibility system of production. For the majority of farmers, their willingness in the short term will depend not only upon satisfactory financial incentives, but a demonstration of better returns through adoption of environmentally friendly technologies. Since the financial benefits of adoption of modern technologies are not readily visible, the need for extension and demonstration of such technologies cannot be overemphasized. Adoption of modern technologies will also ensure sustainability of production and can result in net savings to the farmer. These new and improved technologies that will ensure net savings to the farmers, among other things, include use of high yielding varieties of seeds, use of efficient irrigation systems that result in significant savings in terms of water consumption and energy needed for operation of the irrigation system, phasing out of fertilizer and other agrochemicals that have an adverse impact on soil properties in favor of organic manure and compost and integrated pest management (IPM), cultivation of perennial crops on terraced slopes over 25 degrees to reduce water and soil losses through runoff and erosion, rotational grazing and stall feeding for livestock production to ensure sustainability of grassland resources, adoption of appropriate prevention and control measures against outbreaks of pests and diseases, and other pollution-free production techniques, both of crops and livestock. These are the only options that many farmers (especially poor farmers) in the Project area have for increasing household income. Alternative strategies—such as increasing farm size, obtaining off-farm employment, or exiting agriculture altogether—are not viable options. In addition, many farmers will need to retain some area under food crops in order to satisfy household consumption needs. 55. Value-added production of crops and livestock through improvements in production technologies will require significantly better access by farmers to stable markets and improved support services. While contractual arrangements with enterprises, traders, or the options to sell produce directly to the markets exist, there is a need for famers’ to organize themselves in groups, cooperatives, or associations to enhance their access to markets, increase their bargaining power and obtain better prices for their products, enhance their ability to access and adopt new and improved technologies, and be in a position to better respond to markets and price incentives. Participating AEs, on the other hand would have assured supplies of raw materials to enable them to realize the growing market potential for processed agricultural products. However, the ability of AEs to provide the expand their production bases and provide necessary incentives and support to farmers and realize market opportunities is constrained by limited access to investment finance for the necessary expansion in processing capacity. Until the financial sector is able to provide such finance, there is a need to support AEs in expanding their capacity. 56. Given the limited access that farmers (especially women) have to formal credit, and the obvious need for investments in adopting new and improved technologies at the farm level, government intervention through finance bureaus may be the only option available for addressing these constraints and providing an opportunity to farmers to get out of poverty.

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57. At the farm level, technical support to demonstrate and extend improved and modern environmentally sound technologies, and enhance farmers’ knowledge base must be assured. Farmers’ access to support services is currently limited by the low quality and limited outreach of extension services, and the limited outreach of agricultural information services. Given the scale of operation and limited resources at the disposal of various government agencies responsible for technical support, there is an obvious need for enhancing the skills of these agencies so they can provide the required assistance to the farmers. The opportunity exists to improve both the skills and outreach of advisory and information services through public-private partnerships in which local, more readily accessible and more sustainable private sector services are established through linkages to existing public sector systems.

III. THE PROPOSED PROJECT A. Impact and Outcome 58. The anticipated impact of the Project is enhanced production of high quality agricultural products for domestic and international markets through adoption of modern appropriate and environmentally sound technologies and practices. This includes the use of modern technologies and latest varieties in response to market demand, efficient use water resources, conversion of land over 25 degree slops to perennial crops and forestry, measurable reduction in accelerated erosion, and phasing out of chemical fertilizers and adoption of IPM techniques. This will be measured by (i) the number of farmer households and agro-processing enterprises that adopt environmentally sound technologies and modern practices for production of higher value agricultural commodities; (ii) the quantity of agricultural products that include livestock, perennial crops, and annual crops that meet national and international quality standards; (iii) extent of irrigated land and the number of farmer households that use irrigation systems that demonstrate efficient use of limited water resources; (iv) the increase in the utilization of land areas over 25 degree slope for production of perennial crops and forestry; (v) the reduction in accelerated erosion on sloping land; (vi) the reduction in the use of agrochemicals and their replacement by organic manure and compost and adoption of IPM; (vi) the complete elimination of non-point source pollution, primarily resulting from livestock, evidenced by use of agricultural waste for production of biogas, manure, and compost by farmer households; (vii) the change from open grazing to rotational grazing and stall feeding; (ix) the safe disposal of affluent by agro-processing enterprises; and (x) the increase in tree cover. 59. The outcome of the Project will be sustainable and higher income, and reduced poverty that will be measured by (i) extent of increase in household income through expansion of a market-driven mechanism for enhanced agricultural productivity in higher value livestock, perennial crops, and annual crops; (ii) assured markets through expansion of production bases and collaboration with agro-enterprises; (iii) savings in water and electricity through installation of efficient irrigation systems for production of crops; (iv) provision of expanded cold storage facilities for agricultural products; and (vi) increased employment opportunities in agricultural production and processing for men and women; and phasing out of chemical fertilizer and pesticide use. 60. Facilitated by enabling policy environment, the integrated approach to the production of high quality agricultural products and adoption of environmentally sound production technologies will ensure increased access to growing national and international markets, without further degradation of natural resources. Provision of an adequate level of technical support services will facilitate better land use and efficient practices resulting in reduction of accelerated

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erosion, and savings in the use of limited water resources, thereby addressing natural resource degradation and promoting the long-term sustainability and profitability of agriculture production and processing. This approach is fully consistent with both national and local economic and social development policies and the Plan. Promoting inclusive growth and environmental sustainability has also been one of ADB’s major strategic thrusts, in order to address natural resources management and poverty reduction. 61. The Project Area includes 26 counties and districts in five municipalities, 12 of which are poverty counties. Total population in selected Project counties is 7.63 million, 6.07 million (80%) of which are rural. The rural population in Project area accounts for 26.6% of rural population in the province. Out of 305 townships in the 26 Project counties, 185 (61%) will participate in the Project. Of the 5,445 administrative villages in the Project area, 3,258 (60%) will participate in the Project. The number of participating households is estimated to be about 70,000 of the total number of 1.72 million households in Project area. The total beneficiary population is estimated to be about 300,000.21 See Appendix 6 for Distribution of Project activities by counties and municipalities and Supplementary Appendix D for detailed Description of Project Components and Activities. B. Outputs 62. The Project will promote adoption and expansion of environmentally sound modern technologies in the production of high value agricultural products driven by the market that will result in the production of safe agricultural products and ensure better returns for poor farmers, agro-enterprises, and consumers. Project outputs comprise (i) expansion in the production, processing and marketing of high value perennial crops, annual crops, and livestock through adoption of technologies and practices that ensure increased value-added at the farm level; (ii) improved farmer-market linkages, and (iii) strengthened technical support services and Project management. 63. Under the improvement of high quality perennial crops, annual outputs at full development are estimated to be about: 16,500 tons walnuts, 24,000 tons red jujube, 100,000 tons apples 16,000 tons crispy pear, 1,100 tons prickly ash, 15,000 tons Asparagus, 1,100 m3 of poplar, and 21,500 kg Chinese perennial medicinal herbs. Under the improvement of annual crops, the outputs are estimated at 880 tons yellow millet, 126 tons annual crop Chinese herbal medicine, and 73,000 tons vegetables in greenhouses. The Project will also assist in the building of four farmer-groups cold storage warehouses and increase capacity by 600 tons, and increase red-date drying capacity by construction and operation of 100 24- ton drying rooms. In terms of livestock production, annual production of 4,700 sows and 213,500 fattened pigs, 140,000 pigs for sale, 5,800 cows for breeding and 4,300 calves for fattening, 36,000 cattle for sale, 14,000 ewes, 15,500 mutton sheep, 36,700 Cashmere goats and 11,000 kg Cashmere, 28,000 tons of eggs, and three million chicken. 64. In addition, the Project will result in increasing the cold storage and processing capacity of five ago-enterprises to facilitate expansion market outlets for participating farmers. Five farmers associations will be strengthened through training for organization and management of associations, and provision of office equipment. Skills training to farmers will be provided in the practices of modern and environmentally sound technologies. Provincial, municipality, and county technical agencies, and institutions staff will receive capacity building support through training and workshops focusing on (i) improved crops and livestock production, (ii) efficient 21 PMO Feasibility Study December 2007.

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irrigation systems, (iii) integrated pest management, (iv) environmental monitoring, and (v) water balance monitoring. 65. Actual farm and agro-enterprise investments to be implemented under the Project will be demand driven. Although Project preparation has identified a range of investments that are viable and for which demand is expected to remain strong for several years, investments will reflect market conditions prevailing at the time the investment proposal is appraised for financing. This necessitates flexibility in the approach to implementation, and the capacity and willingness to consider alternative farm and agro-processing investment opportunities. Selection of components and sites will follow the agreed criteria as detailed in Appendix 7.

1. Improving Agricultural Value-added

a. Higher Value Perennial Crop Production 66. This subcomponent will focus on perennial crops such as fruits, nuts trees and selected Chinese herbs, among others. It will provide farmer households with access to the materials and technology needed to plant higher value crops, increase the production and value-added of crops and provide farmer households support in the form of farm investments and inputs. When groundwater use is involved (as would be the case with many fruit tree crops), water conserving technology would be promoted and participating farmers would be given advice and training in optimum water use as well as the safe use of other inputs. To provide a poverty focus to the component, initiatives would also be made in rainfed areas where the level of poverty is typically high. This would be through the promotion of hardy, higher value dryland crops such as Chinese medicinal herbs, and walnuts. 67. Under this component, support will be extended to 20 counties in five municipalities. The Project activities include planting of walnut, red jujube, apples, crispy pear, prickly ash, Chinese traditional herbs, asparagus, and fast-growing poplars. Total area to be covered is estimated to be 7,500 ha, benefitting about 110,000 households, which include an estimated 27,000 poverty households and 17,000 low income households. 68. Walnut production includes establishment of new walnut orchards over an area of about 5,600 ha. For planting of Red jujube (Chinese dates) two models will be employed: dense planting (1,650 seedlings/ha) and low-density planting (825 seedlings/ha). Production will start in the third year. The total area is estimated at 1,100 hectares. Apple orchards will be established in arable land with well irrigation, over an area of 1,500 ha for Red Fuji variety and about 700 ha for granny smith variety. Wheat will be intercropped during the first three years in both cases. Local varieties of high-quality biennial crisp pear will be planted over an area of 415 ha. Prickly ash will be planted @ 600,000 plants per ha over an area of 2,260 ha for production of sprouts. Asparagus will be planted over an area of 1, 240 ha. The rotations period will be 15 years and then replanted with asparagus after a gap for five years, during which maize will be planted to rejuvenate the soil. 69. Fast-growing poplar plantations will be established over an area of 900 ha. During the first rotation of five years, poplars will be interplanted with winter wheat for the first two years. For the subsequent rotations, intercropping will be practiced only during the first year. 70. Six perennial species of Chinese traditional medicinal herbs will be planted over an area of 500 ha. These include: (i) Rehmannia glutinosa (without irrigation); (ii) Rehmannia glutinosa (with irrigation); (iii) Salvia miltiorrhizae (with irrigation); (iv) Bupleurum falcatum (without

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irrigation); (v) Bupleurum falcatum (with irrigation); and (vi) Scutellaria baicalensis G. (without irrigation). In addition, the Chinese annual medicinal herbs Isatis tinctoria (Dyer’s Woad) will be planted over an area of 40 ha.

b. Higher Value Annual Crop Production 71. This subcomponent will focus on annual crops such as high value vegetables, and Chinese herbs (referred to above). The main investment focus under this subcomponent would be in supporting infrastructure such as greenhouses, improved water use efficiency and terracing. The Vegetables will be produced in two types of greenhouses, whereas yellow millet will be field grown. 72. Vegetables including cucumber, vegetable marrow and tomatoes will be undertaken in greenhouses. On flat land, 1,260 Sunshine greenhouses and 4,700 Archcanopy greenhouses will be built. Similarly, 1,520 Sunshine greenhouses will be built on hilly land. Each greenhouse occupies an area of 667 m2 and will be established by a single household. Production of “Qinzhou Yellow” millet will be undertaken in the dryland areas of Qin County, the place of origin of the nationally famous yellow millet brand, over an area of 587 ha.

c. On-farm Processing 73. On-farm processing investments include the drying of Chinese dates and temperature-controlled household-level storage warehouses. To prevent splitting of red jujube soon after harvest time, they are dried just before full ripening. Drying ensures quality and longevity of the fruit with associated benefits to farmers. To facilitate the drying process of an estimated additional production of about 4,000 tons annually from about 400 ha, construction of 100 drying rooms, each with a capacity of 24 tons, will be constructed. Each drying room will be managed by one household and cater to a group of ten households. 74. Four 150 ton capacity controlled atmosphere storage warehouses will be built. Establishment of controlled atmosphere storage will address farmers’ storage problems during the harvesting period and prolong the life of fruits and ensure better prices during off-season sales. Each household-level storage warehouse will benefit a group of ten households, and will be managed by one household.

d. Improved Livestock Production

75. This subcomponent will promote high value small-scale livestock production. In line with the Project’s poverty focus, limits would be placed on the size of livestock ventures to ensure the benefits of the Project go to poor farmers and also to ensure as wide as possible distribution of the benefits. 76. The subcomponent covers farmer households in 20 counties in five municipalities. It includes pig breeding and fattening, beef cattle breeding and fattening, sheep breeding for meat and goats for Cashmere, and broiler and layer chicken production. In cooperation and collaboration, agro-enterprises’ livestock production bases will expand to over 9,000 households, over 5,000 of which are poverty households.

e. Farmer Training 77. Successful adoption of improved crop cultivation and livestock husbandry practices, and

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diversification from resource-hungry annual crops to perennial crops, will require an intensive farmer training program. Initially, staff of relevant local government technical agencies and "farmer technicians"22 will be trained as trainers in new crop and livestock technologies and the need to ensure environmentally sustainable systems of production. These trainers will then be responsible for delivery of training to farmers at the township and village level. Training will be provided in improved crop and livestock production technologies and practices, in environmental awareness in relation to cultivation techniques, input usage, and waste disposal, and in the marketing of agricultural products. Training of advanced farmers and farmer groups in water level and pollutant level in groundwater will also be undertaken. Training will be spread over the life of the Project in accordance with the phasing of investment activities. Given that training will be held at the village and community level, it will not be limited to farmers participating in the Project, but will be provided to all interested local farmers to increase awareness of new technologies and issues relating to sustainability. Farmers will be able to attend refresher courses in the years following their initial training. It is expected that training will be provided for 280,000 trainees in the Project area over the five year Project life. On the assumption that each farm household participating in the Project (63,000) attends two rounds of training, 154,000 non-participating farm households will also benefit from the Project's farmer training program.

2. Developing Farmer-Market Linkages a. Study of Farmer-Market Linkages

78. The wide range of marketing channels available to farmers in Shanxi, the fact that not all provide for appropriate returns to farmers from their participation in the value chain, and the need to establish effective marketing channels for participating farmers diversifying into new, largely perennial, crops indicates a need for an in-depth study of existing and potential marketing alternatives. This study, to be undertaken in the first year of the Project, will review existing linkages within Shanxi and neighboring provinces in the crop and livestock activities that will be supported under the Project, and identify a number of best practices in production and marketing (contract farming, farmer organizations, brokers, etc) appropriate to the market, logistical and financial conditions facing Project area farmers. These practices will be promoted over the remaining years of the Project amongst Project area market actors (farmers, brokers, markets, agro-enterprises, etc) through a series of workshops, demonstrations and study tours with the intention of facilitating the establishment of effective, competitive market linkages.

b. Expanding Agro-processing Opportunities

79. There are 121 agro-enterprises in the Project area engaged in the processing of fruit, vegetable, nut, Chinese herb, timber and other perennial crop products, annual crops, and livestock products. These are linked to farmers through a variety of formal and informal arrangements and provide an important market outlet for many farmers..23 However, for many, their ability to expand these market opportunities is constrained by a lack of storage and processing facilities, which is in turn constrained by limited access to investment financing. The Project will support five agro-enterprises to expand cold storage capacity in fruit (2 agro-enterprises), millet and meat, and in vegetable pickling capacity. This will facilitate an expansion in (i) production by existing farmers with whom the agro-enterprises have supply arrangements,

22 Farmer technicians are lead or key farmers within their local community who will be responsible in part for training

delivery and to promote sustainability in agriculture within their local farming community. 23 Formal arrangements include contract farming through the household-production base-enterprise system that is

common in many areas in PRC agriculture.

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and (ii) the overall number of farmers supplying the agro-enterprises. The five agro-enterprises have been identified according to eligibility criteria (Appendix 8) established during Project preparation and agreed with provincial government, and have investment proposals that are financial viable (Appendix 15). These agro-enterprises will receive investment financing under the Project to implement their proposals subject to their continued eligibility and to a review of the viability of their investment proposals at the time of the appraisal of their loan applications. In addition to the implementation of their individual proposals, the agro-enterprises will participate in Project activities aimed at demonstrating effective farmer-market linkages and how such linkages can improve farm-level value-added by improving product quality to satisfy the demands of international and, especially, increasingly discerning national consumer markets. Based on these criteria, five AEs were identified for participation under the Project and include (1) Shanxi Zeyu Livestock Development Co. Ltd., (2) Longlang Fruit Storage and Transportation Co. Ltd., (3) Shanxi Xintai Food Co. Ltd., (4) Shanxi Qinzhou Yellow Millet Co. Ltd., and (5) Huarong Fruit Co. Ltd.

c. Capacity Building of Agricultural Associations 80. According to the PMO’s December 2007 survey, there are a total of 1,899 farmers’ intermediary agencies (such as farmers’ associations, industry associations), which are officially registered. In the Project area, there are 1,220 agricultural associations. Despite the proliferation of agricultural associations, most of these associations are weak, sometimes too small to be effective, even though vital for the sustainable development of the sector. 81. To demonstrate the role that agricultural associations play in the marketing of agricultural produce and the dissemination of farm technologies and practices, the Project will support five associations in key crop and livestock product activities. These have been identified during Project preparation by the provincial government as offering the potential for a significant demonstration effect within the Project area as a whole. Five associations have been identified for support under the Project to demonstrate the role that associations can play in agricultural production. Associations identified for support include (i) Xinnong Science and Technology Association in Qin County; (ii) Prickly Ash Association and Walnut Association in Pingshun County; and (iii) Vegetable Association, and Livestock Association in Liulin County. Among other things, the support will include training to enhance their organizational skills, study tours to understand performance of similar associations within and outside the province, and equipment and furniture. Farmer associations will also be provided training in farmer mobilization and group management to make them more effective as a conduit for information transfer.

3. Building Capacity of Technical Support Services

82. Under the Project, support will be provided to technical line agencies to enhance their capacity in providing necessary technical support to farmer households. This will include support to provincial, municipal and county level agencies in facilitating (i) preparation and printing farm manuals; (ii) demonstration of pollution-free farming practices, farming practices in greenhouses for quality safety and high value of vegetables, efficient micro-irrigation systems in orchards in hilly areas, and high value farming practices including stall-feeding livestock; and (iii) monitoring of environmental parameters, including water quality, and soil conditions.

4. Project Management 83. The existing PMO of PADO will be strengthened through staff training, workshops and study tours, and the provision of vehicles and equipment. Relevant staff from the PMO’s

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implementing agencies as well as from the provincial, municipal, and county finance bureaus will receive training at the start of the Project in financial management and reporting, and ADB disbursement and procurement procedures. The provincial PMO will establish and maintain a PMS to monitor Project implementation and performance in meeting Project targets. C. Special Features

1. Environmental Improvement 84. The Project interventions that include promotion of modern environmentally sound technologies in crops and livestock production will lead to significant improvement in environmental parameters with net benefits to society. This will be achieved through efficient water use, reduced use of agrochemicals and increased use of organic manure and compost, production of pollution free agricultural crops, as well as safe disposal of livestock waste. 85. While groundwater has been used for irrigation in Shanxi province for several decades, much of the technology used is several decades old, entailing, primarily flood irrigation combined with a lack of real knowledge of crop water requirements and soil/water requirements. Investments under the Project would allow farmers to upgrade their irrigation facilities to include more efficient equipment and also provide concomitant training to ensure that water and equipment was being used effectively and understanding of soil/water characteristics is increased. This would be particularly important in areas where there has been a discernable drop in water tables in the past few years and access to the resource is in jeopardy. These interventions will result in significant savings in water with both environmental benefits and financial dividends. 86. Training in efficient use of water resources, fertilizers and pesticides will be provided to the farmers. Participating farmers will be used as an entry point to provide this information to the farming community as a whole. The focus of training activities will also be farmer associations through which a large number of farmers growing particular types of crops with similar technologies can be reached. Farmer associations will also be provided training in farmer mobilization and group management to make them more effective as a conduit for information transfer. Monitoring activities will focus on upgrading and training staff in mandated agencies to monitor ground water levels as well as residual pesticide and fertilizer levels in the groundwater. Advanced farmers and farmer groups will also be provided training in monitoring of groundwater levels and pollutant load to enhance their skills in monitoring environmental implications of inappropriate use of agrochemicals. Awareness raising on the dangers and marketing implications of residual pesticide and fertilizer levels in produce will also be provided to farmers and farmer associations’ representatives, where relevant and feasible.

2. Farmer-Market Linkages and Enhanced Food Quality/Safety 87. The Project will review existing farmer market-linkages and establish a series of best practices appropriate for farmers, given their location, agricultural and financial status, etc and within their specific product supply chain. The Project will promote such best practices amongst farmers as they begin to participate in the Project. This will include promoting awareness amongst project farmers of the need to adopt agricultural practices that ensure both the safety and quality of food products, and the need for environmental sustainability. This reflects concerns for such issues in both international and, increasingly, national markets. Improving

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farmer-market linkages will: (i) enhance farmer's awareness of these issues, (ii) improve farmers' access to stable market outlets, (ii) enhance product quality to attract premium prices, (iv) reduce price volatility, and (v) increase farm incomes. It will also provide a stable supply of consistent quality raw material to agro-enterprises, either directly through contract farming arrangements or indirectly through brokers who consolidate product for sale to agro-enterprises. Both farmers and agro-enterprises will benefit from reduced transaction costs.

3. Gender and Development 88. Women in the Project areas play very important productive, child bearing and social roles at home and in the communities. Their credentials such as careful planning of domestic economy, trustworthiness, hardworking ethics, etc. could make them contribute to the success and sustainable development of the Project. Therefore, a Gender Action Plan (Appendix 9) was developed to protect women’s rights, interests and participation while maximizing their contribution to the Project. 89. To promote the effectiveness and sustainability of the Project, and to ensure that its benefits accrue equitably to women and men, this Gender Action Plan has the following objectives:

(i) ensure an equitable access to loan funds for Project activities; (ii) ensure equitable access to technical advice and training, information, markets, and

employment; (iii) ensure women’s representation in Project management; and (iv) strengthen the functions of ACWF at villages in mobilization of women’s participation

in, and protect their benefit from, the Project. 90. For overall promotion of gender awareness, training on gender for PMOs, financial and technical service providers, leaders of township governments and village committees will be provided to increase gender awareness among stakeholders, and to provide women with information on opportunities for access to project fund, technical advice and training, information, and employment opportunities. 91. For enhancing employment opportunities and access to loan funds, women who actually or potentially use and manage the fund for the income generation activities within the families will be able to sign the loan agreement. An estimated 65% of the employment opportunities generated by the Project will be provided to women since poverty and lack of income earning opportunities has led to outmigration of men to urban areas or work in coal mines where employment opportunities are available. To achieve the target, the activities suitable for women will be emphasized for women to participate. Employment opportunities will be made accessible equally to both women and men, as one of the conditions for the agro-enterprises to get the Project loans. Increased employment opportunities for men at home will reduce their outmigration, thereby alleviating women’s workload and keeping the family together with significant social benefits. D. Project Investment Plan 92. The Project investment cost is estimated at $222.8 million, including taxes and duties of $17.4 million, contingencies of $19.3 million, and financial charges during implementation of $18.4 million. A summary of cost estimates is shown in Table 1, details are provided in Appendix 10.

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Table 1: Project Investment Plan

($ million) Item Amounts a

A. Base Cost b 1. Increasing Agricultural Value Added a. Perennial crops 78.0 b. Annual crops 23.1 c. On-farm processing 1.0 d. Livestock 71.6 e. Farmer training 1.2 2. Developing Farmer-Market Linkages a. Promoting farmer-market linkages 0.2 b. Expanding agro-processing opportunities 4.6 c. Capacity Building in Agricultural Associations 0.3 3. Building Capacity of Technical Support Services 1.7 4. Project Management 3.5 Subtotal (A) 185.2

B. Contingencies c 19.3C. Financing Charges During Implementation d 18.3

Total (A+B+C) 222.8a Includes taxes and duties of $17.4.b In end 2007 prices. c Physical contingencies computed at 5% on all Project costs. Price contingencies

computed at 0.8% on foreign exchange costs, and 2.2% on local currency costs in 2008, and at 3.0% thereafter; include provision for potential exchange rate fluctuation under the assumption of a purchasing power parity exchange rate.

d Includes interest and commitment charge. Interest during implementation has been computed at the five-year forward London interbank offered rate plus a spread giving a rate of 6.12%. The commitment charge is computed at 0.1% on undisbursed funds.

Source: Asian Development Bank estimates. E. Financing Plan 93. The Government has requested a loan of $100.0 million from ADB’s ordinary capital resources to help finance the Project. The loan will have a 26-year term, including a grace period of six years, an interest rate determined in accordance with ADB’s London interbank offered rate (LIBOR)-based lending facility, a commitment charge of 0.1% on undisbursed funds, and such other terms and conditions set forth in the loan agreements. The Government has provided ADB with (i) the reasons for its decision to borrow under ADB’s LIBOR-based lending facility on the basis of these terms and conditions, and (ii) an undertaking that these choices were its own independent decision and not made in reliance on any communication or advice from ADB. The financing plan is in Table 2.

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Table 2: Financing Plan ($ million)

Source Total % Asian Development Bank 100.0 44.9 Local Government Finance Bureaus 47.7 21.4 Crop/Livestock Associations 0.2 0.1 Farmers 72.3 32.5 Agro-enterprises 2.5 1.1

Total 222.8 100.0 Figures may not sum due to rounding Source: Asian Development Bank estimates.

94. The ADB loan will finance 44.9% of the total Project costs. The remaining cost will be financed as follows: (i) local government, through finance bureaus, $47.7 million; (ii) crop and livestock associations $0.2 million, (iii) participating farmers, $72.3 million; and (iii) participating agro-enterprises $2.5 million. The Shanxi Provincial Government (SPG) has agreed to finance interest during implementation and commitment charges. They have nor been included in the ADB loan amount. SPG has also agreed to finance all contingencies relating to expenditures to be financed by the ADB loan. F. Loan Funds Flow 95. The ADB loan to PRC will be channeled through the Ministry of Finance (MOF) to the Shanxi Provincial Government (SPG). The Shanxi Finance Department (SFD) will on-lend loan funds to each of the five municipal finance bureaus (MFBs) in the participating municipalities. The MFBs will on-lend to the respective county finance bureaus (CFBs). The CFBs in participating counties will on-lend funds to final borrowers subject to loan approval by appropriate authorities. The flow of funds is presented in Appendix 11 The on-lending of funds between finance bureaus and between finance bureaus and final borrowers will be subject to separate loan agreements. On-lending from MOF to SFD, MFBs and CFBs will be subject to the same terms and conditions as the ADB loan to PRC. On-lending to final borrowers (farmers and agro-enterprises) will be subject to the condition that the rate of interest charged will be no lower than the prevailing commercial rate of interest for equivalent types of loan. MFBs and CFBs will bear the foreign exchange and interest rate risk relating to loan proceeds provided to them, except for loans made to agro-enterprises in which the agro-enterprises will bear these risks. The margin between the cost of funds from ADB and the final borrower will be retained by the finance bureau responsible for the loan to the final borrower to cover administration costs and credit risk. The sum of all loans to agro-enterprises will not exceed 10% of the ADB loan amount. 96. Loan approval authority will be delegated by MFBs to CFBs according to loan size. CFBs will have authority to approve all loan applications up to a maximum of CNY50,000 (US$6,900).24 Loans in excess of CNY50,000 will be forward to the relevant MFB for approval. All loans to agro-enterprises, which range from CNY1 million to CNY4 million (US$140,000 to US$560,000), will be subject to approval by the relevant MFB. Individual farmers will submit loan applications to their local township finance station which will undertake an initial

24 This covers all loans to farmers with the exception of on-farm storage and three livestock investments.

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assessment of the applicant's eligibility (in accordance with criteria specified in Appendix 7). Eligible applications will be forwarded to the relevant CFB for review and, where appropriate, approval. Loans in excess of the lending authority of the CFB will be reviewed and, where appropriate, forwarded to the relevant MFB with a recommendation for approval. Once loan is approved, the CFB will enter into a loan agreement with the applicant. For farmers, loan funds will be channeled from the CFB to the borrower through the borrower's township finance station. The township finance station will be responsible for disbursing funds to the borrower, monitoring implementation of the borrower's investment, recovering the loan in accordance with the loan agreement, and initiating any remedial action necessary to ensure proper implementation of the investment and utilization and recovery of loan funds. As appropriate, County and Municipal PMOs will support finance bureaus and township finance stations in monitoring investment implementation to ensure the eligibility of activities financed. For AEs, the concerned CFB’s will enter into a loan agreement with an AE and will be responsible for disbursement and recovery of loan funds and monitoring investment implementation. To ensure proper investment implementation and utilization of loan funds, all loans will be disbursed according to a schedule specified in the loan agreement between the finance bureau and the borrower that reflects the phasing of the development of an investment and its cash flow. Where previous disbursements are not utilized in accordance with the loan agreement, borrowers will be required to take remedial action before further disbursements are made. SFD will reimburse MFBs (and MFBs reimburse CFBs) in accordance with disbursements made by CFBs to final borrowers. 97. Loan terms will reflect the projected cash flow of the investment for which the loan is provided, subject to a maximum of ten years. Where a grace period is agreed within a loan, this will not exceed the grace period on the loan between ADB and MOF. Borrowers will pay interest during the grace period. All loans to final borrowers will be secured by appropriate collateral, which in the case of loans to agro-enterprises will be an agro-enterprise's fixed assets. Where physical assets are used to secure a loan, their value will be 125% times the loan amount. G. Implementation Arrangements

1. Project Management 98. The Poverty Alleviation Department Office of SPG will be the executing agency (EA) for the Project. The EA will coordinate and supervise all implementation activities through a Leading Group chaired by the Vice Governor of Shanxi Province, with the deputy director of the Provincial Development and Reform Commission, deputy director of the Shanxi Finance Department (SFD), and director of PADO as Vice Chairpersons. The deputy director, Provincial Department of Water Resources, deputy director, provincial Department of Agriculture, deputy director, provincial Department of Land and Resources, deputy director, provincial Department of Forests, deputy director, provincial Department of Audit, and deputy director, provincial Environmental Protection Bureau (EPB) will be the members. Municipal and County leading groups will also be constituted. 99. The SPG will set up the Project Management Office (PMO), based in Taiyuan. The PMO, together with the Fund Administration Unit (Division of International Capital Management) of SFD will coordinate and oversee implementation of all activities on a day-to-day basis. The PMO’s major tasks include (i) organizing, coordinating and guiding the related departments in Project municipalities and counties for implementation of the Project; (ii) drawing up the annual work program and budget; (iii) organizing procurement; (iv) maintaining consolidated accounts, including developing PMS to track all financial transactions with sub-borrowers; (v) preparing and submitting to ADB Withdrawal Applications and Statements of Expenditure (SOEs) through

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SFD; (vi) monitoring physical and financial progress, including benefit flow to intended beneficiaries, and submitting reports to the provincial government and ADB; and (vii) liaising with the SPG through SFD for reporting to Ministry of Finance, and ADB. The municipality and county PMOs, one in each of the five municipalities and 26 counties, will assist the PMO. These PMOs will be the implementing agencies (IAs) for all Project components and responsible for day-to-day implementation under the overall guidance of PMO. The provincial EPB will be responsible for monitoring compliance with national environmental standards, rules, and regulations. 100. The IAs for financing, supervision, and monitoring of agro-enterprise activities in their respective areas will be concerned County Governments for the five agro-enterprises in Wanrong County, Taigu County, Yuci District, Pingyao County and Qin County. Participating farmer households will be responsible for implementing activities in crop, livestock, and on-farm processing. 101. Capacity building for governments technical support agencies will be coordinated the PMO. These agencies will then be responsible for implementing technical support and training to farmers and AEs. These include the agriculture and livestock bureaus at various levels of government. Implementation of environmental monitoring of water resources quality and usage will be implemented by EPB and Water Resources Bureau at the relevant level of government.

2. Implementation Period 102. The Project will be implemented over six years from 2008 to 2014. An implementation schedule is presented in Appendix 12.

3. Procurement 103. Contracts for goods estimated to exceed $1.0 million and contracts for works estimated to exceed $10.0 million shall be procured using international competitive bidding (ICB) procedures. Contracts for goods and works estimated to cost equal or less than the above ICB values but more than $100,000 shall be procured through national competitive bidding procedures in accordance with the PRC Tendering and Bidding Law (1999), subject to modifications agreed with ADB. Contracts for goods and works estimated to cost $100,000 or less shall be procured using shopping procedures. For farm inputs, procurement will be undertaken through shopping by the respective borrowers in accordance with the established private sector or commercial practices which, based on an assessment carried out during special review mission immediate after loan negotiation, are acceptable to ADB. More details are provided in Appendix 13, Procurement Plan. The relevant sections of ADB’s Anticorruption Policy (1998, as amended to date) will be included in all procurement documents and contracts.

4. Consulting Services 104. The Project will provide 54.8 person-months of national consulting services. National consultant person months will be contracted to: (i) study project area farmer-market linkages and to establish and promote best practices in marketing for agricultural products to be supported under the Project (5.9 person months); (ii) provide capacity building in crop and livestock associations (9.0 person months), (iii) provide training to provincial level technical service bureaus (agriculture, livestock, environment protection, water resources, etc) in

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participatory approaches, gender analysis, training of trainers in crop technologies, and training in trainers in livestock technologies (a total of 0.9 person months), (iv) deliver provincial level workshops in monitoring agricultural product quality and safety, monitoring soil quality, monitoring water resources and water quality, monitoring treatment of animal waste, and environmental impact assessment (for a total of 0.9 person months), (v) provide support to provincial project management in implementation preparation, project monitoring and supervision, preparation and management of bidding and procurement, mid-term review, and project completion and evaluation (for a total of 36.3 person months), (vi) provide support to municipal project management in preparation and management of bidding and procurement, and mid-term review (for a total of 1.2 person months), and (vii) provide monitoring and evaluation training to project management (0.6 person months). Contracts for consulting services estimated at $200,000 and above will be awarded using consulting firms, biodata proposals, and quality-and cost-based selection procedures (80:20), in accordance with ADB’s Guidelines on the Use of Consultants (as amended from time to time). A Summary of Consulting Service inputs is given in Appendix 14.

5. Advance Procurement and Retroactive Financing 105. SPG has requested retroactive financing for the procurement of materials and equipment including irrigation and farm equipment, site preparation including land leveling, irrigation system establishment, and procurement of saplings and seeds for perennial crops planting. The details of activities to be financed will be set out in a written request to ADB. ADB has advised that retroactive financing could only apply to up to 20% of the ADB loan with respect to expenditures incurred not earlier than 12 months before the signing of the loan agreement. All contracts proposed for advance action and retroactive financing will be undertaken in accordance with ADB’s Procurement Guidelines and ADB’s Guidelines on the Use of Consultants. The Government and SPG have been advised that approval of the advance action and retroactive financing does not commit ADB to financing the Project.

6. Anticorruption Policy

106. ADB’s Anticorruption Policy (1998, as amended to date) was explained to and discussed with the Government of the People’s Republic of China, the SPG, the EA and the PMO. Consistent with its commitment to good governance, accountability and transparency, ADB reserves the right to investigate, directly or through its agents, any alleged corrupt, fraudulent, collusive, or coercive practices relating to the Project. To support these efforts, relevant provisions of ADB’s Anticorruption Policy are included in the loan regulations and the bidding documents for the Project. In particular, all contracts financed by ADB in connection with the Project shall include provisions specifying the right of ADB to audit and examine the records and accounts of the EA and all contractors, suppliers, consultants, and other service providers as they relate to the Project.

7. Disbursement Arrangements 107. The proceeds of the loan will be disbursed in accordance with ADB’s Loan Disbursement Handbook (2007, as amended from time to time). Because some of the payments will be made for large contracts, funds will be withdrawn from the loan account using direct payment, reimbursement, and commitment procedures. To expedite the flow of funds and simplify document processing, the statement of expenditure procedure may be used to reimburse eligible expenditures for any individual payment not exceeding $100,000. Payments

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exceeding this ceiling will be reimbursed based on the full documentation process. SFB will on-lend loan funds to the municipalities and will enter into an on-lending agreement with them. The municipalities will then on-lend to the counties and enter into an on-lending agreement with them for their respective share of the loan funds. The counties will, upon loan approval disburse loan funds to the farmers and AEs. Farmers and AEs will be responsible for repayments to the counties, and will provide collateral to secure loans. The counties will be responsible for repayment to municipality, and municipality will be responsible for repayment to the SFD. A institutional and financial management assessment of the municipalities and counties is presented in Supplementary Appendix E. The assessment concludes that SFD and a sample of the five municipalities, 26 counties and their township finance stations satisfy ADB’s financial management requirements for municipalities and counties. They are all government offices in the hierarchy under the Ministry of Finance and have satisfactory financial management capability. 108. An imprest account will be set up for the Project by the SFD in a commercial bank acceptable to ADB. Disbursements from the imprest account will be supported by an appropriate withdrawal application and related documentation. The initial amounts to be deposited in the imprest account shall not exceed the estimated expenditures for the following six months or 10% of the loan amount, whichever is lower.

8. Accounting, Auditing, and Reporting 109. All participating agro-enterprises and other government agencies involved in Project implementation will maintain separate accounts for the Project. These accounts and related financial statements shall be audited annually by an independent auditor in accordance with auditing standards acceptable to ADB. PMO will verify the subproject accounts and prepare the accounts for the entire Project by consolidating the sub-accounts of subprojects. Within six months after the end of each fiscal year, PMO will submit to ADB certified copies (in English) of such audited project accounts and financial statements and auditor's reports. The participating AEs will also submit annual audited financial statements for their operations, including income statements, balance sheets, and cash-flow statements to ADB through PMO within six months after the end of each fiscal year. The audit of such financial statements will also include: (i) an assessment of the adequacy of accounting and internal control systems with respect to Project expenditures and other financial transactions, (ii) an assessment of compliance with loan covenants and ADB's requirements on Project management, (iii) an opinion on the operation of the imprest account and on the use of the statement of expenditure procedure, and (iv) review of the execution of commitments between the participating agro-enterprises and their farmer level production bases. The PMO will prepare consolidated quarterly reports indicating progress made, problems encountered during the period, steps taken or proposed to remedy the problems, and a proposed program of activities with progress expected for the next quarter. Within three months of physical completion of the Project, the PMO will submit to ADB a completion report that describes the achievements in relation to the Project’s expected impact, outcome, and outputs. The participating agro-enterprises will have their accounts audited and their financial statements prepared in accordance with international financial reporting standards by auditors acceptable to ADB. The participating agro-enterprises will make their financial statements available to the PMO within six months of the end of each financial year.

9. Project Performance Monitoring and Evaluation 110. To monitor the progress of the Project in achieving the planned outcome and outputs, the PMO will establish and maintain a performance management system (PMS), which will be

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designed to permit adequate flexibility to adopt remedial action regarding Project design, schedules, activities, and development impacts. The PMS will adopt the following agreed indicators as a minimum: (i) physical progress of farmer and AE subproject implementation (production base, processing capacity expansion, and livestock); (ii) changes in perennial crop varieties and yields compared with present levels; (iii) changes in the application methods and volume of water used in various activities using efficient irrigation systems as compared with pre-Project levels; (iv) the types and application rates of fertilizers and agrochemicals in crop production compared with present levels; (v) progress in the implementation of the environmental management activities such as waste disposal; (vi) progress of capacity building in extension and training delivery and outreach; (vii) strengthening of farmers' organizations and their role in agricultural products supply chains; (viii) increases in farm incomes; (ix) reduction in poverty incidence, and gender and social development; and (x) reduction in agrochemical usage, and improvement in soil nutrient content and water quality. The PMO, with the support of consultants and in consultation with each IA, participating agriculture bureau, and agro-enterprise, will develop comprehensive PPMS procedures to systematically generate data on inputs and outputs of Project activities, and the physical, socioeconomic, and environmental indicators to measure Project impacts. Within the PPMS framework, the PMO will confirm achievable targets, refine monitoring and recording arrangements, and establish systems and procedures no later than six months after the start of the Project. Baseline and progress data will be reported to the PMO at the requisite time intervals by the IAs, participating agriculture, livestock, environment, and water resources bureaus, and AEs, and will include annual reporting on the environmental management plan prepared for the Project. The PMO will be responsible for analyzing and consolidating the reported data through its management information system, and for reporting the outcome to ADB through quarterly progress reports.

10. Project Review 111. In addition to regular monitoring, Project performance will be jointly reviewed at least once a year by ADB and the Government. The review will assess implementation performance and achievement of progress towards Project outcomes and outputs, financial progress, and issues and constraints affecting implementation. It will also include development of a time-bound action plan for resolution of issues and constraints. ADB and the Government will undertake a midterm review to assess implementation status and take appropriate measures—including modification of scope and implementation arrangements, and reallocation of loan proceeds, as appropriate—to achieve the Project’s outcomes and impact.

IV. PROJECT BENEFITS, IMPACTS, ASSUMPTIONS, AND RISKS A. Farm Investment and Incomes

112. The Project will support a large range of investments in the establishment of perennial crop, greenhouses, millet production, on-farm processing, and livestock. The level of investment ranges from CNY5,300 for improved millet production, to CNY528,000 for establishing household-level, on-farm cold storage. The level of loan financing available for each investment varies from 30% in the case of Chinese herbs (though most perennial crops would attract 45% loan financing) to 60% for greenhouses and livestock. The resulting farmer household contributions range from CNY1,270 for millet to CNY50,110 for chicken broilers. A number of the larger investments could, however, be established by a group of households collaborating, thereby reducing the actual level of investment per household. Financial analysis indicates that financial internal rates of return (FIRRs) for perennial crops range from 16.4% for pear orchard establishment to 47.6% for asparagus. The latter reflects the current significant demand and

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high prices paid for asparagus, which are expected to continue as the demand for processed asparagus increases in national and international markets. The FIRRs for greenhouse investments range from 17.9% to 28.0%, the FIRR for millet improvement is 29.0%, and FIRRs for on-farm processing are 20.4% for the household cold storage, and 21.7% for Chinese date drying. Incremental FIRRs for all perennial crops, greenhouses, millet, and on-farm processing are all well above the individual estimated weighted average costs of capital (WACCs) for each investment, which are around 5.1%. Exceptions include Chinese date production under rainfed conditions and under irrigation for which the incremental FIRRs are 10.4% and 6.4% respectively. Sensitivity analysis indicates that all investments, with the exception of Chinese date drying, are robust with respect to adverse changes in revenue and costs. Switching values for revenues and costs are generally above 20% and 40% respectively. The Chinese date drying investment is shown to be relatively sensitive to negative changes in revenue (with a switching value of 8.4%) and operating costs (switching value 9.7%). This indicates the need for detailed review of the investment and input and output market prospects when farmers make applications for this investment. The total number of proposed date drying investments is 100 and their combined contribution to the net incremental benefit of the Project amounts to only 0.4%. A lower number of investments in date drying will not, therefore, adversely impact overall Project benefits.

113. Investments in livestock activities are generally of a larger scale, with investment costs ranging from CNY30,210 for a four-head cattle breeding unit to CNY156,590 for a 3,000 bird broiler chicken unit. Larger units may be established by a number of households in collaboration, to reduce the level of investment required per household. All livestock units are expected to attract loan financing of up to 60%, leaving farmer household contributions ranging from CNY9,670 for cattle breeding to CNY50,110 for broiler chicken. FIRRs for livestock activities range from 14.6% for the cashmere goat unit, to 22.6% for pig fattening. Sensitivity analysis suggests that a number of the livestock investments are sensitive to changes in revenue and operating costs. Both pig investments, cattle fattening, and both chicken investments show switching values for revenue and operating costs below 10%. Careful appraisal of these investments will need to be undertaken at the time of loan application to review and update investment assumptions.

114. The returns to farmer households vary according to the number of days of incremental labor required for each activity. Net incremental return per day, however, understates the actual level of return to households since the cost of labor has been included in the estimation of operating costs for each activity. Not all the labor included in operating costs will necessarily be provided from farm households. The actual level will depend upon the availability of household labor, and the level of skill available within the household for the individual tasks required in each crop and livestock activity. Quantification of household incomes for each investment is limited, therefore, to that of net incremental returns per incremental day of labor. This is a conservative estimate of the actual level of income that households will earn from their investment. Within perennial crops investments, net incremental returns per day range from CNY15 (for apple and pear orchards) to CNY174 (for poplar plantations). These reflect the relative labor inputs which are around 170 days for apple and pear orchards and only 40 for poplar plantations. Corresponding total net incremental income per year at full development ranges from CNY2,480 for prickly ash production to CNY18,270 for fast-growing poplar. Although total net incremental income from greenhouse investments range from CNY1,510 to CNY6,and 300, net incremental returns per day are comparable with those of perennial crops because greenhouse investments require a high level of labor input of 180 days. As a result, the net incremental return per day from the tunnel greenhouse investment is only CNY 8. For livestock investments, total net incremental income ranges from CNY1,490 for pig fattening to

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CNY16,810 for broiler chicken. Both pig investments require around 130 days of labor per year which results in a net incremental return per day of CNY11 for pig fattening. Both chicken activities also have a large labor demand (270 days) but the significantly higher net income provides for a much higher net incremental return per day, which in the case of broiler chickens is CNY62. A detailed analysis of proposed farm investments is presented in Appendix 15, and Supplementary Appendix F.

B. Financial Analysis of Agro-enterprises

115. The Project will support investments in expanding cold storage capacity in four agro-enterprises (two engaged in the fruit subsector, one in millet products, and one in pork products), and in the establishment of a vegetable pickling line and associated storage in a fifth. The five agro-enterprises have been assessed for eligibility for participation in the Project according to socio-economic, environmental, and financial criteria (see Appendix 8). They have all been in operation for at least four years and, based on an assessment of their last three years' financial statements, are financially sound, privately owned, with professional management and qualified, experienced staff. They have well established markets, which for some include export markets in Europe and South-East Asia. The agro-enterprise engaged in millet products supplies 40% of the PRC market. Investments will be financed by a mix of debt (from Project loan funds) and equity. Loan financing will not exceed 50% of the total cost of each investment. Each agro-enterprise has confirmed the availability of its own resources to complement loan financing.

116. The Huarong Fruit Production Company proposes to expand capacity by 2,000 tons from its existing level of 2,000 tons, at a cost of CNY6.6 million, of which CNY3.0 million would be from Project loan funds. The FIRR of the proposed investment is 37.5%. The Longlang Fruit Company proposes to expand its fruit storage capacity from 1,750 tons to 2,350 tons, at a cost of CNY2.4 million with loan financing of CNY1.0 million. The FIRR of the investment is 25.0%. The Qinzhou Yellow Millet Company proposes to establish a 2,000 ton storage facility for millet at a cost of CNY7.6 million, of which CNY3.5 million will be from Project loan funds. The FIRR of the investment is estimated to be 44.1%. The Xintai Food Company proposes to establish a 2,000 ton capacity vegetable pickling line plus associated storage at a cost of CNY8.5 million, including a loan from Project funds of CNY4.0 million. The investment's FIRR is estimated at 30.0%. The Zeyu Livestock Development Company proposes to expand refrigerated storage for meat products by 500 tons to double its existing capacity. The cost of the investment is CNY8.1 million, of which CNY3.5 million will be financed from Project loan funds. The FIRR of the proposed investment is 26%.

117. While all of the proposed investments are shown to be financially viable, sensitivity analysis indicates that they are all relatively sensitive to potential falls in revenue or increases in operating costs. Switching values for revenue are in the range of 5% to 9%, and for operating costs in the range 6% to 11%. These levels of sensitivity are not uncommon for investments in storage, where value added is relatively low. They highlight the need for detailed re-appraisal of the proposed investments at the time of loan application to ensure input and output market conditions remain favorable, including an assessment of the degree to which increases in operating costs (especially raw material supplies) may be passed on in the form of higher product prices. A detailed analysis of proposed agro-enterprise investments is presented in Appendix 9.

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C. Economic Benefits

118. Based on the estimation of economic net incremental benefits over a 20-year period derived from the number, phasing, and net incremental benefit of individual productive activities, and Project non-productive, establishment costs, the economic internal rate of return is estimated to be 20.7%. Sensitivity analysis indicates that the Project is extremely robust with respect to declines in the net incremental benefits from individual activities. The main activities contributing to net incremental benefits are the production of pork products (15.6%), walnut production in hilly areas (8.5%), cattle fattening (7.6%), and table apple (5.8%). No other individual activity contributes more than 5%. In terms of groups of activities, perennial crops contribute 32.9% of total net incremental benefit, livestock 30.1%, and agro-processing 25.1%, together accounting for 88.1%. The spread of benefits across multiple activities indicates that the Project is not sensitive to potential negative changes in respect of the individual activities. If there were to be no benefit realized from pork products, the EIRR would only fall to 20.5%. If the entire net incremental benefit from perennial crops were not to be realized, the EIRR would fall to 15.4%. Such a failure to achieve any benefit from these activities is highly implausible. Sensitivity to negative changes in the incremental returns from all other individual activities is negligible.

119. Delays in implementation have the potential to adversely impact the Project. However, assuming that all Project capacity building and management activities proceeded as planned but that there was a delay of one year in the take-up of all productive activities would only reduce the EIRR to 20.3%. It is extremely unlikely that all productive activities would be delayed.

120. In all respects, the Project can be considered to economically viable and robust to potential negative changes in key Project parameters. Details of the economic analysis are presented in Appendix 9 and Supplementary Appendix F.

D. Environmental Benefits and Impacts

121. The persistence of traditional, extensive farming systems, combined with large population, presents a major threat to the Project area's natural resource base, especially soil and water. Degradation of forests continues in spite of government efforts to restrict agricultural encroachment through programs such as the Land Conversion Project, which provides incentives for rural communities to conserve natural resources. The Project will address this by supporting conversion of grain producing sloping land to perennial fruit and tree production, which will conserve water and soil resources, increase forest cover, increase agricultural value added, and provide income and employment opportunities in local communities that will act as an incentive to more sustainable, environmentally-sound agricultural practices. At the same time, the output of animal wastes from Project livestock units, if properly handled and applied, offers an effective, low-cost alternative to chemical fertilizers that should see their levels of use decline in the long-term. See Appendix 16 for summary initial environmental examination (SIEE). A qualitative assessment of the potential indirect, environmental benefits that may be expected to derive from the Project is presented in Supplementary Appendix F. See Supplementary Appendix G for IEE.

122. The savings from improved water usage and more effective application of fertilizers and agrochemicals are significant though the savings are not universal across all Project area counties. Depending upon the nature and number of activities to be established, there may be a net increase in water, fertilizer and agrochemical usage. Over the whole Project area, it is estimated that annual savings of water will be approximately 3.8 million m3, with a value of CNY7.6 million. The reduction in fertilizer usage is expected to be 2,300 tons, with an

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approximate economic value of CNY7.8 million. However, there is expected to be a net increase in the use of agrochemicals of 5.4 tons with an estimated incremental cost of CNY0.6 million. The expected increase in the use of agrochemicals derives from the increased use of pesticides on perennial crops compared with that currently used on annual crops. The net savings from reduced water, fertilizer and agrochemical uses are expected to be around CNY15 million annually.

E. Employment and Training

123. The Project will generate incremental employment through all of the productive activities proposed. Within farm-based activities (crops, on-farm processing and livestock), based on the incremental labor requirement expected for each activity and assuming 300 days per year, a total of approximately 10,900 person years of employment will be generated annually at full development. Of these, 7,600 are expected to be in perennial crop cultivation, 630 in greenhouse vegetables and annual crops, 40 in on-farm processing, and 2,700 in livestock activities. In addition to this permanent employment creation, there will be approximately 23,000 person years of temporary employment required to establish investment activities. Of this, 20,000 will be required for establishing perennial crops since these investments will require labor inputs over a number of years.

124. Much of the labor generated will be provided from within farm households making the investments in the various activities. Some, however, in particular unskilled agricultural work will be available to non-household labor. Given the tendency for migration by household heads in search of urban labor, a significant but not quantified proportion of total employment will be available for women.

125. It is expected that training will be provided for 280,000 trainees in the Project area over the five year life of the Project. On the assumption that each farm household participating in the Project (63,000) attends two rounds of training, 154,000 non-participating farm households will also benefit from the Project's farmer training program

F. Poverty Impact

126. The implementation of the Project will accelerate the adoption of modern crop production and livestock production technologies, forestry, and on-farm products processing and as a result increase farmers’ income. It is estimated that the Project will benefit about 70,000 households or about 300,000 farmers, and increase incomes by CNY 6,032 per household. 127. With enhancement of farmers’ capability (training and technical instruction) the Project will directly improve about 40,000 poverty households and about 25,000 low-income households, and the average income of almost 170,000 poor people will rise to CNY 2,000, and the average income of about 110,000 low-income people will rise to CNY 2,200. A summary poverty reduction and social strategy is presented in Appendix 17. G. Gender and Development

128. Consequent, to promotion of gender awareness and training on gender sensitivity for provincial staff at various levels of responsibility, the status of women will improve and the women will have equal opportunities for participation in various Project activities Village committees will also be provided training to increase gender awareness among stakeholders, and to provide women with information on opportunities for access to Project funds, technical advice and training, information, and employment opportunities.

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129. The technical and financial management training programs will have gender-sensitive curriculum. The Project, with emphasis on women’s participation in economic development activities, will provide the same opportunities and resources for women as for men. It is estimated that Project will provide about 18,000 job opportunities, which include about 12,000 women. About 300,000 man days of training will be provided to enhance farmers’ technical knowledge, which will include about 200,000 women. On-the-spot advices will be given to women who are actually involved in the annual and perennial crops and livestock production activities. Qualified women will be encouraged to lead farmer trainers, training and demonstration activities. 130. To ensure that adequate and proportional representation is provided to women in Project implementation, women will elect their own representatives for village councils to facilitate consultation and participation of women. The village level chapter of the All China Women’s Federation (ACWF) will be entrusted to help promote self-help and mutual learning programs to benefit women. ACWF could also participate in the monitoring of Project management in the village to protect the participation and benefit for the women, especially the poor and female-headed households. The level of women’s participation will be monitored by the PMOs. H. Risks and Mitigation Measures

131. The principal risks associated with the Project relate to the maintenance of a stable macroeconomic environment and the effective implementation of the provincial government's declared policy on the maintenance of private sector agriculture production, addressing sustainability in agriculture, and the reduction of poverty in rural areas. The constraint related to current failure of the financial sector to provide access to investment capital for production and agro-processing activities which would be a potential risk is being addressed in the short term through the Project. In the longer-term, further improvements in agricultural productivity and sustainability will be constrained unless a supportive financial sector environment develops. Policies relating to the financial sector must facilitate the expansion of lending into agriculture and rural areas. This will require that rural financial markets remain competitive and free from non-market interference and that an enabling legal and regulatory environment is maintained. Protection of financial institutions’ interests in respect of loan default and foreclosure on collateral must be protected and enforceable by law. Without this, the risk that financial institutions continue to limit their lending to agriculture and that the sector continues to be starved of investment capital will be considerable. On a broader level, both international and trade policy must remain favorable and not create distortions that undermine the operation of market forces in the sector. The development and maintenance of public infrastructure (water resources, transport, communications, markets, etc) is necessary to support continued development in the sector.

132. At the Project level, the ability and willingness of Project participants to respond to market signals and the opportunities presented by the Project will be critical to its success. The risk will be addressed through extensive promotion and training among participant groups, particularly in respect of developing effective farmer-market linkages. Responding to opportunities will only be possible if the improved technologies proposed under the Project are made available. This will require the provision of equipment and inputs of the required quality by suppliers who are able and willing to invest in realizing the opportunities that an expanded agriculture sector will provide. In addition to demonstration and training that will be provided through the Project, other agencies serving the sector (extension, veterinary services, contractors, etc) must continue to provide complementary support to Project participants. A

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further risk is that the current level of demand, and the preference for domestically-grown produce of increasingly higher quality and safety will not be maintained, thereby undermining the potential for increased productivity. Risks relating to the marketing of fresh and processed products are limited, given the strong domestic and global demand and prices for PRC's agricultural produce. There is only limited technical risk in production activities, as both Project area farmers and agro-enterprises have experience of fruit cultivation and processing and livestock production and processing, suggesting that they will be able to adopt the proposed new technologies and crop and farm management practices. This will be reinforced during Project implementation through advisory service capacity building and farmer training.

133. Finally, the success of the Project will also, to a large degree, depend upon effective implementation by the Project management offices at provincial, municipal and county levels of government, and monitoring by ADB to identify potential problems and initiate remedial measures at an early stage. This risk is mitigated to the extent that Project management offices are already established at each level government, and have experience of other integrated agricultural development projects.