World Bank Document...CREDIT AND MARKETING REFORM PROJECT (LOAN 2727-BR) PREFACE This is the...

Document of

The World Bank

FOR OFFICIAL USE ONLY

Report No. 13080

PERFORMANCE AUDIT REPORT

BRAZIL

CREDIT AND MARKETING REFORM PROJECT(LOAN 2727-BR)

MAY 23, 1994

Operations Evaluation Department

This document has a restricted distribution and may be used by recipients only in the performance oftheir official duties. Its contents may not otherwise be disclosed without World Bank authorization.

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CURRENCY EQUIVALENTS

Currency Unit : Cruzeiro

Cr$1.00 = NCz$1.00US$1.00 = Cr$ 35.500

(As of May 1993)

FISCAL YEAR

January 1 - December 31

GLOSSARY OF ABBREVIATIONS

BANESPA = Banco de Sio Paulo(State Bank of Sio Paulo)

BMF Sio Paulo Bolsa de Mercadorias e Futuros(Commodities and Futures Exchange of Slo Paulo)

CACEX Carteira do Com6rcio Exterior(Foreign Trade Portfolio - Bank of Brazil)

CETIP = Central de Custodia e de Liquidagio Financeira de Titulos(Center for the Safekeeping and Financial Settlement of Titles)

CM-G = Certificado de Mercadoria com Emissao Garantida(Commodity Certificate with Guaranteed Delivery)

CONAB Companhia Nacional de Abastecimento(National Food Supply Company)

FAO = Food and Agricultural Organization of the United NationsICMS = Imposto sobre a Circulacio de Mercadorias e Serviqos

(Sales Tax)IMF International Monetary FundIPEA = Instituto de Planejamento Econ6mico e Social

(Institute for Economic and Social Planning)PAR = Performance Audit ReportPLE = Prego de Liberaqao des Estoques

(Stock Release Price)PROINVEST = Programa de Investimentos Agricolas

(Rural Investment Program; a line of credit)PROSTOCK = (Name of a credit line; not an acronym)SAL Structural Adjustment LoanSECAL = Sectoral Adjustment LoanUN = United NationsUNDP = United Nations Development Programme

WORLD BANK UNITS

ASTEN = Asia, Technical Department, Environment & Natural Resources Dev. DivisionECA = Europe and Central Asia Regional OfficeEMTAG = ECA/MENA Regions, Technical Department, Environmentally Sustainable

Development: Agriculture TeamLA1EA = LAC, Country Department I, Environment and Agriculture DivisionLATAD = LAC, Technical Department, Advisory GroupMENA = Middle East and North Africa Regional Office

FOR OFFICIAL USE ONLYTHE WORLD BANK

Washington, D.C. 20433U.SA

Office of Director-GeneralOperations Evaluation

May 23, 1994

MEMORANDUM TO THE EXECUTIVE DIRECTORS AND THE PRESIDENT

SUBJECT: Performance Audit Report on BrazilCredit and Marketing Reform Project (Loan 2727-BR)

Attached is the Performance Audit Report on the above project prepared by the OperationsEvaluation Department.

The audit confirms the conclusion of the Project Completion Report that the outcome of theproject is satisfactory, and its achievements sustainable. In fact, outcome and sustainability emergedas more favorable in light of audit findings. In terms of institutional development, the achievementsare rated as modest, with success in disengaging the Government for agricultural marketing andfinancing tempered by the failure of market-based risk management mechanisms to take hold.

The adjustment operation was consistent with both Government policies and Bank supportstrategy. The grain marketing and trade liberalization component, the core of the reform program,was successfully implemented, generated welfare gains for both producers and consumers, reduceddemands on the budget, and contributed to a significant supply response.

The project design was innovative. It introduced market methods of handling riskmanagement and financing agricultural marketing to a country with a huge Government interventionin grain handling and disposal. The component designed in this respect failed, even after having beensubstantially revised during supervision, but led eventually to significant developments in these areasafter project completion. The concept was also innovative for the Bank which had traditionallyaddressed such issues through marketing parastatals and state agricultural banks. The audit raises theissue of whether the Bank had at the time the required expertise in market-based financial andhedging instruments and mechanisms.

The audit compares the success of the Brazil project with the failure of three concurrentagricultural adjustment operations in three other South American countries, and identifies the mainfactors behind such success.

Robert Picciotto

by Hans-Eberhard K6pp

Attachment

This document has a restricted distribution and may be used by recipients only In the performance oftheir official duties. Its contents may not otherwise be disclosed without World Bank authorization.

FOR OFFICIAL USE ONLY


BRAZIL


TABLE OF CONTENTS

PaMe No.

Preface ............................................................... iBasic D ata Sheet ....................................................... iiiEvaluation Summary ..................................................... v

1. Loan Origin and Objectives ............................................ 1

2. Implementation and Outcome .......................................... 2

The Credit Component ............................................ 2

The Trade Liberalization and Price Reform Component ..................... 2

a) Liberalization of Domestic Trade ................................. 2b) Liberalization of External Trade ................................. 4c) Trade Liberalization: the Case of Wheat ............................ 4

The Technical Assistance Component .................................. 5

The Risk Management and Marketing Finance Component ................... 5

3. Transferring Risk Management and StorageFinancing Functions to the Market .................................... 6

The Original Design ................................................ 6The Revised Design ................................................. 7The Reasons for Failure ............................................. 8Deeper-Seated Problems with the Original and Revised Designs .............. 10Developments after Loan Closing: How the Idea Eventually Took Root ........ 11

This report was prepared by Jos6 Olivares (Task Manager), who audited the project in May1993. Pilar Barquero provided administrative support.

This document has a restricted distribution and may be used by recipients only in the performance of their

official duties. Its contents may not otherwise be disclosed without World Bank authorization.

a) Cash and Forward Markets ..................................... 12b) Futures M arkets ............................................. 12c) Commodity Funds ........................................... 14d) New Negotiable Instruments ................................... 14

4. Overall Assessment ................................................ 15

5. Issues and Lessons ................................................. 16

Lack of Other Adjustment Operations in Brazil ........................... 16

Issues in Loan Processing .......................................... 16

a) Identification and Preparation .................................. 16b) Appraisal and Approval ...................................... 17c) Release of the Second Tranche ................................. 18

Reasons for Success .............................................. 18

a) Good Preparation ............................................ 20b) Good Timing ................................................ 20c) Strong Commitment ........................................... 20d) Non-threatening Nature of the Reforms ........................... 21e) Location of Loan Management ................................. 21f) Macro-Economic Framework ................................... 21g) Serendipity ............................................... 22

Sustainability ................................................... 22

Bank Relations with the Borrower and the IMF .......................... 22

ATTACHMENTS

1. Evaluation Summary PCR (Loan 2727-BR) ................................ 23

2. Effects of Bank Loans on Agricultural Credit Policy in Brazil ................... 29

3. Summary of Operating Procedures for Commodity Funds ...................... 31

4. Summary of the Operating Procedures for the Certificados de Mercadorias comEmmisio Garantida (CM-G) ....................................... 33

5. Comments Received from the Borrower .................................. 37

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BRAZIL


PREFACE

This is the Performance Audit Report (PAR) on the (Agricultural) Credit and MarketingReform Project. Loan 2727-BR, for USD 500 million equivalent, was approved on June 26, 1986,signed on July 15, 1986, and declared effective on September 8, 1986. The first tranche of USD 300million was released on effectiveness; the second tranche of USD 175 million was released inNovember 1988, two years after originally anticipated. The Closing Date was extended four timesto June 30, 1993 in order to complete Part C, Technical Assistance and Studies. An amount of USD1&2 million equivalent was canceled.

The PAR is based on the Project Completion Report prepared by the Latin America and theCaribbean Regional Office;y the President's Report;y the Loan and Project Agreements; supervisionreports; correspondence between the Bank and the Borrower; consultant reports; Bank studies;economic and sector work; memoranda and other material in the Bank files; Borrower studiesproduced under the Loan; and interviews with Government officials, Bank staff, universityresearchers, and relevant officers at national, state and private banks, commodities and futuresexchanges, and private sector companies and trade organizations.

An OED mission visited Brazil in May 1993. The mission discussed project genesis,implementation and results, as well as developments after project closing, with current and formerofficials in the Ministries of Planning, Finance, Agriculture, and Industry and Commerce; the CentralBank, Bank of Brazil, BANESPA, and the Brazilian Federation of Banks; the Institute for Economicand Social Planning (IPEA); University of Slo Paulo's Faculty of Economics; Cereal Exchange,Central of Registry, and Futures Exchange in Sio Paulo; a large economic group, and the nationalorganization of soybean producers. Their kind cooperation and valuable assistance is gratefullyacknowledged.

The Project Completion Report is comprehensive, candid and informative. It analyzes anddiscusses the background, justification and effects of the Loan, and criticizes the design of the riskmanagement component. Therefore, the PAR does not repeat materials already in the PCR, whoseEvaluation Summary is attached for easy reference (Attachment 1). The audit text summarilypresents the main features of the project and developments throughout its processing only as requiredto introduce the discussion and make the text self-standing.

I/ Project Completion Report: BraMl CreM and Marbeing Reform Prqject (La. 2727-BR), Report No 10456, March 27, 1992.

;y President's Report: Bnrg Credit and Marketing Reform Project, Report No P4345-BR, June 5,1986.

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The PAR builds on the PCR account and discusses some further issues. In particular, itanalyzes two of them. First, after completion, the loan looks even more successful and sustainablethan at the time of the PCR; the audit describes such increasing success and explores the factorslikely to have contributed to it. And second, the risk management and marketing finance component,which failed during implementation, took a life on its own after completion and contributed to severalimportant developments. Since improved financial intermediation and the development of futuresand other derivative markets is an area attracting increasing attention in Bank business, lending andresearch, the audit devotes a special chapter to discuss the original and revised designs, the reasonsfor their failure, and their linkage with the current developments.

In terms of impact, the audit confirms the PCR assessment of the Loan outcome asSatisfactory and likely to remain Sustainable.

Following OED procedures, copies of the draft PAR were sent to the Government forcomments in October 28, 1993. Comments received were taken into consideration in finalizing thePAR; they are included as Attachment 5.

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BRAZILCREDIT AND MARKETING REFORM PROJECT

(LOAN 2727-BR)

BASIC DATA SHEET

KEY PROJECT DATA

Date Planned Date Revised Date Actual

Identification - - 08/83Preparation --- 12/83Appraisal -- 04/84Re-Appraisal - 09/85Lan Negotiation 03/85 05/86Board Approval - - 06/86Loan Signature 07/86Lan Effectiveness - - 09/86Loan Closing 06/89 093 0693Project Completion 12/88 12/92 12192

CUMUATIVL ESTIMATED AND ACTUAL DISBURSEMENT

(US$ MILLION)

FY87 FY88 FY89 FY90 FY91

Appraisal Estimate 450 490 500 500 495bl

Actual 300 320 495 495 482Y

Actual as % of Estimate 66.7% 653% 99.0% 99.0% 97.0%11 - 1 - I - =I

1V At the Borrower's request, the loan closing date was catended four times to provide time to complete the technicalassistance component of the project.

& Excludes US$ 5.0 million which were cancelled.

g/ An amount of US$15.0 million was returned from the Special Account to the Loan Account. This amount continued to be

available for disbunement against eligible cpenditures for the technical assistane component of the project.

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STAFF INPUTS(Staff weeks)

FY 84 85 86 87 88 89 90 91 92 93 Total

Pre-appraisal 303 303Appraisal 13.4 33.2 23.1 69.7Negotiation 2.3 7.1 9.4Supervision .1 21.7 48.6 15.4 9.6 27.0 12.9 2.6 137.9Other 6.8 12.8 133 32.9

Total 50.5 483 43.6 21.7 48.6 15.4 9.6 27.0 12.9 2.6 280.2

MISSION DATA BY STAGES OF PROJECT

Through Appraisal Month/Year No. of Days in Specialization Performance Type OfPersons oeld Rating Status Problems

Identification 08/83 1 5 b10/83 1 5 b

Preparation 12/83 1 5 bPre-appraisal 01/84 1 15 bAppraisal 04/84 5 29 a,b,cdPost-appraisal 06/84 3 10 b,d,e

08/84 3 14 a,b,d04/85 2 20 b,e08"5 1 10 b

Re-appraisal 09/85 3 27 a,b,cFollow-up 01/85 3 15 b,c,d

Supervision 07/86 3 15 b,c,d03/87 1 5 c07/87 3 5 b,e09/87 6 12 b,c,f,g12/87 5 12 b,c,h,i01/88 1 10 b 3 (1)03/88 + 1 5 f *04/88 ++ 2 4 j06/88 1 18 b 109/88 ++ 1 2 j10/88 1 2 b 112/88 ++ 4 16 bhj 106/89 + 1 5 b 112/89 + 2 10 b 2 (2)07/90 + 2 3 b 2 (2)03/91 1 5 b 2 (2)

Specialization: a - Financial Analyst; b - Economist; c - Marketing Specialist; d = Loan Officer; e - DivisionChit, f - Resource Planner; g - Computer Specialist; b - Legal Specialist; I - Futures MarketSpecialist; j = Financial Specialist.

Performance Ratings: 1 = Improving; 2 - Stationary; 3 - Deteriorating; * No rating (no formal supervision reportissued).

Types of Problems. (1) slow progress on trade liberalization; reintroduction of wheat subsidy, due to the June-Sept. 1987price freeze; limited administrative capacity of the implementing agency; and delays in establishingPROSTUCIL (2) delays in implementation of technical assistance component (Part C).

+ - Technical Assistance (Part C) component only+ + - PROSTOCK (Part B) component only.

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BRAZELCREDIT AND MARKETING REFORM PROJECT

(LOAN 2727-BR)

EVALUATION SUMMARY

1. The Bank approved Loan 2727 (Agri- trade procedures and removed unnecessarycultural) Credit and Marketing Reform, for restrictions. And it abolished the wheat mo-USD 500 million equivalent, in June 1986. It nopoly.released the first tranche of USD 300 millionon effectiveness and the second tranche of 5. On studies, the component led to goodUSD 175 million in November 1988, two years quality output. Three problems are raised byafter originally envisaged. The Closing Date the audit: (i) money allocation was excessive;was extended four times to complete the Loan (H) implementation was delayed by the officialstudies. The policy components, however, had procurement and payment systems; the Bankbeen implemented fully by the original Closing failed to incorporate alternative arrangementsDate of June 1989. during both preparation and supervision; and

(iii) intended end-users found the studies too2. The Loan supported three major policy technical and academic.changes: (i) to consolidate positive interestrates for agricultural credit; (ii) to liberalize 6. On risk management and marketinggrain marketing and simplify export proce- finance, the Loan proposals failed duringdures; and (iii) to introduce new instruments implementation, but took a life of their ownto transfer to the private sector stock financing after Loan closing. The audit discusses experi-and risk management. In addition, Loan 2727 ence during and after the Loan.financed equipment, technical assistance, andstudies. Risk Management and Storage Financing

Implementation and Outcome 7. Transferring responsibility for acquiringand storing agricultural commodities to the

3. On agricultural credit, Loan 2727 was private sector required developing financingone of five operations approved over six years and hedging mechanisms. The Loan aimed toto support the successful transition from develop domestic futures markets, allow themsubsidized credit to real positive rates. The to operate in offshore markets, and establish aseries was reviewed in a recent OED study on credit line (PROSTDCK) to finance agricul-agricultural credit and rural finance. tural storage. This innovative concept intro-

duced the market way of doing things to a4. On liberalization, all the envisaged Bank used to dealing with marketing parast-policy changes were implemented. The Gov- atals and state agricultural banks. The auditemnment adopted a new policy for market in- raises the issue of whether the Bank had attervention, retaining a modified system of sup- the time staff with the required expertise.port prices while adopting explicit and trans-parent stock release price and rules. It elimi- 8 But the original Loan concept did notnated quantitative restrictions on external tra- work; PROSTOCK regulations were issued butde in the agreed commodities. It simplified there were no takers.

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9. The Bank landed a specialized supervi- instruments to address risk management, andsion mission, which concluded the original must be used in conjunction with others todesign was based on an incomplete diagnosis, complement their respective shortcomings.and redesigned it. The revised design moved Second, their successful operation requiresaway from the line of credit concept into a well-developed cash markets with standardizedrediscount window to support a secondary grades, unhindered merchandise movement, nomarket in bankers' acceptances. But the Government intervention, and capacity torevised design did not work either. deliver on the contracts; this condition was

absent in Brazil. Therefore, the Loan had a10. The reasons for failure. The main sequencing problem; it should have not pur-ones were the weak paper base underlying the sued futures markets without having firstsystem, and the lack of attractiveness of the developed the spot ones. These would not,PROSTOCK facility. On the paper base, the and did not, develop automatically as a resultproblem lies with the lack of credibility of of liberalization. In this regard, the Loanwarehousing in Brazil. Commodity standard- design lacked parallelism: careful preparationization and grading for domestic market were of the institutional, legal, financial and coi-deficient, and the warrants issued were not mercial aspects of the futures markets on thedeemed of negotiable quality. On its attrac- one hand, and neglect of similar elements oftiveness, there were problems of cost (for the cash markets on the other. And third, theborrowers) and of potential risks and low Loan's design was intrinsically inconsistentprofitability of PROSTOCK papers (for inves- because it promoted the development oftors), while commercial banks had already had futures markets while retaining a Governmenta bad experience with another line of credit capacity for price stabilization, thus removingsupported under a previous Bank operation. the incentives for the private sector to operateTwo additional problems were that PROSTO- in the futures markets.CK was designed from the top down, and itsintroduction required concurrent liberalization 13. Developments after Loan Closing.in four other areas: storage, grading and Major advances towards market-based riskclassification, insurance, and banking and management instruments occurred after Loanfinance, which was well beyond the scope of a closing; the audit concludes that the Loan wassectoral adjustment operation. a major factor behind the intellectual and

commercial stirring which eventually led to11. The PCR raises an alternative issue, them.whether "the project ... focused too narrowly onspecific foms of commercial stock finance." 14. The Sio Paulo Grain Exchange, theThe audit concluded otherwise. Experience in largest grain cash market in Brazil, is nowthe use of modern market-based financial and marketing its services among potential users,hedging instruments for crop financing in has added forward contracts to the spot ones,Brazil was very limited. The discipline of and is trying to set up a network linking all 22going through the detailed definition and State commodity exchanges, including a jointlyimplementation of one particular instrument owned clearing house just established.proved very useful.

15. Agricultural contracts represent only12. Deeper-seated problems. But both one percent of trading in the Sio Paulo Com-designs had more basic problems which, even modities and Futures Exchange (BMF). BMFif well implemented, would have prevented now allows State exchanges to operate inthem from generating the intended benefits. futures contracts, to be cleared at BMF com-First, futures markets are one among several puters. It is working with Government to

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make existing procedures for linking with It took two full years to develop the CM-Goffshore markets more flexible, and to allow paper, and the reasons behind such an extend-foreign brokers and traders to operate on the ed period are illustrative of the institutional,BMF floor. And BMF is trying to interest the technical and legal problems involved in a real-federal food agency to conduct operations life liberalization program.through the BMF. This would not seem to bea good idea. Parastatals are too large for such Overal Assessmentmarkets, and lack the flexibility and speed indecision-making to operate in futures con- 19. The Loan outcome is rated Satisfactorytracts. in terms of both substantive policy change and

policy stability at a time of general policy16. Two tax issues that prevent a wider turmoil. The Loan provided policies, instru-expansion of both cash and futures markets ments and support to dismantle the Goverrm-are being addressed: (i) States insisted on ent's grip on agricultural marketing, and stabil-applying sales tax each time a contract is sold ity and consistency in agricultural pricing andrather than on final delivery, and (ii) profits on marketing policy. Sustainability of the policyindividual operations are taxed but deduction changes was assured in 1990, when the Collorfor losses on related operations is not allowed. Government accelerated the pace of reformFour States have already decided to defer sale and extended economy wise the Loan-sup-taxes till final delivery. ported reforms. No backsliding or reversals

have occurred.17. Commodity Investment Funds wereauthorized in July 1992. These raise resources 20. As a result, agricultural producers werein the market and must invest them in a range not seriously affected by macroeconomicof financial products; between 25 and 80 instability. The policy changes significantlypercent of them must be on papers backed by contributed to the recent expansion in agricul-agricultural commodities. The Funds operate tural production and exports. Even thoughon both cash and futures markets. In their agricultural growth decelerated during thefirst year of operation, Commodity Funds 1980s it did so at a rate lower than the rest ofraised some USD 5 billion. They may become the economy. Sector growth in the 1990S isthe main vehicle for raising financial resources some 3 percent per annum.for funding agricultural production and mar-keting. They have ran into the same warrants Issues and Lessonscredibility problem as PROSTOCK, however.

21. Adjustment Sequencing. It is surprising18. Actions started before Loan closing are that adjustment in Brazil were to start with anow leading to new negotiable instruments. sectoral Loan, and that the Bank never madeTo improve the credibility of warrants, Bank of a structural adjustment loan or any otherBrazil and two State banks now guarantee sectoral adjustment loan thereafter. The mainwarrants issued by registered warehouses. A reason for this was the lack of a credible andnew instrument, the Commodity Certificates lasting macroeconomic stabilization program.with Guaranteed Delivery, is being developed.CM-Gs are sale contracts on commodities, 22. Macro Economic Framework. The lackissued by the owner, registered at the exchang- of a macro-economic stabilization programes' clearing houses, and guaranteed by a com- made implementation of Loan 2727 difficult,mercial bank. They will be traded in the cash but did not otherwise derail it. Two possiblemarkets and are expected to be the main reasons for this is the pervasive indexation ofpaper to be bought by the Commodity Funds.

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the Brazilian economy, and the micro-economies, which were to lead to action plans, whichic nature of many of the reforms. were to lead to agreement on the detailed

conditions for tranche release. The good23. Issues in Loan Processing. Prepara- Bank-Government relations and the existencetion. Studies funded under the previous loan of a mutually-agreed policy change programdefined the policy base for Loan 2727, created facilitated agreeing on the required actionsa consensus among different government units, plans and eventually releasing the tranche.the private sector and the Bank on the intend- Today, adjustment operations must have clear-ed reforms, and generated ownership. This cut, event-like, easily monitorable conditionsresulted from the high caliber of the leaders for tranche release.and members of the working groups, and thefact that these included representatives of all 27. Reasons for Success. Four agriculturalinterested sectors. Bank missions maintained adjustment operations in South Americanclose dialogue with them. countries were approved within a short period.

The audit discusses the factors which made24. Eight missions were required to ap- Brazil a satisfactory experience while thepraise the project. The early missions found others proved unsatisfactory.the Government was not ready to go ahead.Only the September 1985 mission was able to 0 The preparation effort was wholly basedactually appraise the project - and still re- in the country.quired a follow-up mission. Even then, theproject was not fully prepared; more time and 0 The preparation team was close to thework would have been needed to deepen the Minister of Planning and included mem-diagnosis and fine tune the proposals on risk bers of all interested parties in the publicmanagement and marketing finance. and private sectors; the solutions pro-

duced enjoyed wide consensus.25. Post-Appraisal. But this was not goingto be the project to reach the Board. The The Loan was timely in addressing urgentproject as appraised was meant to support needs (agricultural financing and subsi-trade and price liberalization, heavily front- dies were a large burden on the budget)loaded. But the Government launched a and providing foreign exchange resources.macroeconomic stabilization plan which frozeall prices. The Bank could not then supportprice liberalization. To reach the Board by the The policy reforms were non-threatening,end of the fiscal year, policy conditionality on and improved the situation or welfare ofliberalization was couched in weak language almost everyone, from the budget toand transferred to second tranche release. producers to traders to consumers.The setting of interest rates for agriculturalloans at ten percent in nominal terms (an issue a The Loan was handled directly from thenot analyzed at appraisal) was made the only Ministry of Finance, which had full con-condition of appraisal. The Loan was ap- trol on policy and budgetary matters.proved within the scheduled fiscal year.

a Investments made earlier under "wrong"26. The weak language included in the policy conditions were put to good useLoan Agreement delayed by almost two years when the policy framework was righted,the release of the second tranche. Conditions thus leading to a immediate supply re-for the release had not been negotiated in sponse, which in turn reinforced Govern-detail. The Loan Agreement called for stud- ment commitment to sustain the reform.


BRAZIL


1. LOAN ORIGIN AND OBJECTIVES

1.1 "As a sector loan, the project was deficient in not providing a perspective on sector policies.... The lesson being that the potential gains from policy improvement... and the likely benefits whichwould have followed from adopting a wider sector adjustment loan format for the operation ... areenormous"Y This was OED's judgment on the project which preceded Loan 2727Y TheAgricultural Credit and Export Development Project (Ln. 2348-BR) had been the first policy-based loan to Brazil, but the Bank still couched it in the investment lending format. Therefore,it missed the opportunity to effect badly needed policy reforms, and OED rated Loan 2348unsatisfactory.

1.2 The studies financed under Loan 2348, however, provided an effective channel for policydialogue and contributed to a significant extent to defining the policy base for Loan 2727, theonly adjustment operation ever financed in Brazil.

1.3 Processing of Loan 2727 could not have been more timely. In the last years of militaryrule (1983-1984) and first two years of the Sarney Administration (1985-1986), Governmentintervention in crop financing and marketing had expanded substantially - and becomeunaffordable. The Bank approved Loan 2727, for USD 500 million equivalent, on June 26, 1986,and declared it effective on September 8, 1986. It released the first tranche of USD 300 millionon effectiveness, and the second tranche of USD 175 million, originally scheduled for December1986, in November 1988. The Bank extended the Closing Date four times to June 1993 tocomplete Part C, Technical Assistance and Studies. The Loan's policy components, however, hadbeen implemented fully by the original closing date.

1.4 The Loan supported three major policy changes. First, to consolidate and furtheradvance achievements under previous projects towards positive interest rates for agriculturalcredit Second, to liberalize grain marketing and simplify export procedures. And third, tointroduce new instruments to transfer to the private sector stock financing and price riskmanagement as a necessary complement for liberalization to take hold and develop. In addition,Loan 2727 financed equipment, technical assistance, and studies.

I/ PAR on Brazil Agricultural Credit and Eport Developmenst Prqjct (La. 2348-BR), Report N* 7922, June 28, 1989paras iR, 78, and Preface, third paragraph, respectively.

3 The operation is widely known in Brazil as "the 2727"; therefore, the term Lan 2727 is used through this report to refer toit. I.an 2727 still carries the name tag "project" (maybe as a relict of Loan 2348), but it is definitely an adjustmentoperation and not an investment project.

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2. IMPLEMENTATION AND OUTCOME

THE CREDff COMPONENT

2.1 Loan 2727 was the third in a series of five operations approved over six years whichsupported the successful transition from heavily subsidized credit in the 1970s to positive realrates today. There was no significant controversy on the objectives or implementation of thiscomponent. Since the case is discussed in detail in a recent OED Study,3 the PAR does notaddress it; the relevant paragraphs of the Study are attached for easy reference (Attachment 3).

THE TRADE LIBERALIZATION AND PRICE REFORM COMPONENT

2.2 Trade liberalization and price reform constituted the core of Loan 2727's policy program:to reduce uncertainty in marketing; to reduce the role of Government in domestic marketing; tosimplify external trade and make it more transparent; and to eliminate subsidies on wheatmarketing.

2.3 The envisaged policy changes were successfully implemented. The Government adopteda new policy for market intervention, retaining a modified system of price support while adoptinga transparent stock release price (PLE) and rules. It eliminated quantitative restrictions onexternal trade in the commodities covered by the loan (rice, maize, beans, cotton, and soybeans).It simplified trade procedures, and removed unnecessary restrictions on agricultural trade. Andit abolished the wheat monopoly.

2.4 Subsequent Government decisions, not related to the Loan, increased the likelihood ofsuch reforms being sustainable. The policy changes, enhanced by the policy continuity inducedby the Loan (para 4.1), can be credited as one of the factors behind the substantial expansion ofboth agricultural production and exports (para 4.3). The policy changes and their effects onproduction and trade are described in detail in the PCR and the last sector report.-* Thefollowing paragraphs discuss issues in their design and implementation.

a) Liberalization of Domestic Trade

2.5 Before Loan 2727, Government had a major role in agricultural marketing. TheGovernment acquired a large proportion of each year's harvests, through purchases fromproducers and cooperatives, and affected imports. The commodities so acquired were releasedon the basis of ad hoc demand/supply studies, and opinions of technicians and political figures.

N OED, A Review of Bank Lending for Agricultural Credit and Raral Finance (1948-1992), Report N- 12143, June 19,1993. The most relevant paragraphs on Brazil are 6.16 to 6.18, reproduced in Attachment 2.

Y PCR, op.cit., paras 35 to 39, and 42 to 44; and LA1EA, Bra3Al, The Management of Agriculture, Rural Development andNatural Resureas, Green Cover Report N0 11783, May 27, 1993, Volume II, pages 34 to 36; and 42 to 49; respectively.

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Often, commodities were released at prices and moments - even in the middle of the marketingseason - which caused havoc among what remained of private trade.

2.6 As agreed under the Loan, in 1988 the Government drastically reduced its marketinterventions and let the private sector carry out most marketing functions, retaining only someprice stabilization and food security functions. To perform these without disturbing the privatetrade, Government adopted explicit, transparent rules to regulate its own interventions.

2.7 On the supply side, Government adopted the stock release price mechanism (PLE). ThePLE is a pre-announced trigger price for the sale of stocked commodities. They apply to maize,rice and beans (three of the commodities targeted for reform), wheat and beet They aredetermined on the basis of a monthly moving average of prices over a period ranging from 48 to60 months according to the commodity, expressed in real terms plus a mark-up of up to 15 percent. Public stocks can only be released when market prices surpass the PLE. The automaticnature of the PLE lets everyone know if and when the Government is likely to sell stocks. Thus,it is now up to the price system and not to the Government to signal when there is scarcity.

2.8 On the demand side, the Government continued using minimum prices. The relevantworking group (para 5.4) had wanted to have a symmetrical system, in which minimum priceswould be set automatically as the PLE, at say 20 percent below an average of past market prices.This proposal faced insurmountable resistance. The minimum prices are thus still setadministratively, on the basis of pre-2727 criteria such as cost of production, international prices,and whether the Government wants to support the expansion of certain crops. The ensuingasymmetry in the price band structure is inherently instable, and may lead to conflicts.

2.9 Another remaining problem is posed by Brazil's inflation (which at the time of the auditmission had reached about 30 percent per month). Since each PLE remains valid up to 45 daysfrom the date of announcement (say, the PLE price announced on April 15 becomes effectiveon May 1st and remains valid up to May 31), inflation rates in the current range reduce by one-third each month's PLE within its period of validity.y

2.10 Today, domestic markets operate freely. The rules were codified in the Agricultural Actof 1990; the numbers are published monthly, and the Government has abided by them. Inaddition, Government market interventions have been constrained by stringent budgetaryconditions. In its heyday, the Government purchased 12-13 million tons of agriculturalcommodities per year; today, it purchases less than one million tons a year.

Let's assume the PLE for a commodity was set on April 15 at CRS 100/kg. With an inflation rate of 30% per month, asduring the audit mission's visit (May 1993), the PLE on May Ist, first day of validity, would be worth in real terms (usingApril 15 as the base) CRS 87.70kg; on May 30th, its last day of validity, it would be worth CRS 67.SQ/kg. At the currentinflation rate of 36% a month (August 1993), PLEs real worth on the first day of its validity month would be CRS 85.75/k;and on the Lat day of the month, CR$ 63.05/kg.

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b) Liberalization of External Trade

2.11 Trade liberalization moved quickly in 1987 and 1988. Quantitative exports restrictions onfour crops (rice maize, cotton, and soybeans) were eliminated first, followed by export taxes.Many rules and procedures were dropped. Then, imports started being liberalized. Tariffreduction began in 1988; quantitative restrictions were removed in 1990 and substituted by tariffs.Then the Collor Government expanded such reforms through the economy, including a tariffreduction program and eliminating the list of prohibited imports.

2.12 The reforms had unanticipated institutional consequences. Under the Loan, linkages wereestablished between the three major Government agencies involved in foreign trade: the CentralBank, the tax revenue system, and the statistical system. Such linkages, plus the liberalizationdiscussed above, made CACEX (the Foreign Trade Agency of the Bank of Brazil), in charge offoreign exchange allocation, redundant; the Government eliminated it in March 1990.

2.13 Finally, there is an issue of attribution. While it is clear that Loan 2727 was instrumentalin freeing domestic trade of agricultural commodities, the causal relationship in the case ofexternal trade is less explicit. There is no doubt that policy change was designed by the workinggroup, supported by the Loan, and implemented by GovernmenL It can be argued, however, thatthe general political mood was moving towards liberalization, and that most of the changessupported under Loan 2727 would have been introduced anyway. This may be so, but Loan 2727created a consensus and a coherency which made change more systematic, consistent and fasterthan would have been the case otherwise.

c) Trade Liberalization: the Case of Wheat

2.14 For 25 years, the Government monopolized wheat acquisition and imports, transportation,and delivery - in quotas - to the mills, a case of vertically integrated interference. Privatetransaction in wheat was illegal. This wheat scheme led to the emergence of a large constituencyof favored interests, which included the Government organs which handled the official part of thewheat deal, the mills, and the wheat producers. A large subsidy benefitted directly wheat flourconsumers, basically middle and upper income families in the South and Southeast regions. Allof them had vested interests in continuing the wheat monopoly and resisted change.

2.15 Funding for the wheat scheme was included in the monetary budget, one of the threeconcurrent budgets that Brazil used to have. When the three budgets were unified in 1987, itbecame apparent that the wheat scheme was no longer affordable.

2.16 Loan 2727 had envisaged only a partial policy change: to eliminate the subsidy. But withbudget resources ebbing and the progressive momentum towards liberalization, the wheat schemebecame unsustainable. The subsidy was ended in 1990. Uberalization then proceeded by steps,progressively transferring responsibilities to the private sector. In 1991, the Government stopped

& The other two were the federal budget, and the parsatal' budget. The monetary budget raised money by selling Treasurypapers and was the main source of funds for official agriculture credit.

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wheat purchases; it still made a last import, presumably to have stocks handy in case liberalizationwere to fail. In 1992, intervention in the wheat markets ended; wheat became just one othercommodity, subject to price bands as described above.

2.17 Therefore, the whole conversion from a totally controlled system to a free market wascompleted within two years. It speaks highly of the political consistency, commitment andtechnical capacity of the Brazilian Government that it effected the whole process in such a shortperiod without major upsetting of prices or supplies, and during a period of turmoil in most othermarkets.

THE TECHNIcAL ASSISTANCE COMPONENT

2.18 Like the predecessor Loan 2348, Loan 2727 funded technical assistance to support thepolicy reform program. This component proved important in providing a continued focus andframework for policy dialogue (para 5.5). The Institute for Economic and Social Planning (IPEA)became the executing agency for the studies sub-component. Studies done would seem to havebeen of good quality and acceptance; some have been published.

2.19 Three problems must be debited against the technical success of the component. First,the amount of money earmarked for studies was excessive. USD 25 million were allocated fortechnical assistance and studies, a ten-fold increase over Loan 2348. USD 5 million werecanceled. Of the remainder, only USD 6.6 million were spent by the extended Closing date.Second, time required to implement the component was excessive. Much of the delay can beattributed to the efforts of the inter-agency Steering Committee and its Technical Secretariat todevelop a strategy and research priorities consistent with the policy objectives supported by Loan2727 ("a well designed program of technical studies directed specifically towards the preparation ofbasic policy reform"Y and set up a data bank on researchers on agricultural economics.Implementation was further delayed by the cumbersome official procurement and paymentprocedures (compounded by high inflation, which drastically reduced the real worth of finalpayments). It was only after the original Closing date that the Bank recommended the possibility,a common practice elsewhere, of using the UNDP (or any other UN agency, like FAO) asexecuting agency for the studies. The Government promptly adopted this recommendation andcommitments and disbursements accelerated. The failure to recommend the use of the UNexecuting agency system was a major shortcoming in Loan design and supervision. And third,officers in the Ministry of Agriculture, the Central Bank and the commodity exchangescomplained that the studies had been too technical and academic; their staffs did not have theskills to read them and would need a "translation" into operational language.

THE RISK MANAGEMENT AND MARKErlNG FINANCE COMPONENT

2.20 The Loan's risk management and marketing finance component failed to achieve its goalsduring Loan implementation, but it took a life of its own after Loan closing and contributed to

7J President's Report, Credit and Marketing Reform Project. Report No P-4345-BR, June 5, 1986, pars 67.

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several important recent developments. Since the development of futures and other derivativemarkets is an area attracting increasing interest in Bank business today,5' the next chapter isdevoted to discuss experience under and after the Loan.

3. TRANSFERRING RISK MANAGEMENT AND STORAGEFINANCING FUNCTIONS TO THE MARKET

THE ORIGINAL DESIGN

3.1 As discussed above, trade liberalization was the policy core of Loan 2727 (paras 2.3 to2.10). But liberalization cannot be decreed by flat; many changes are required in the structureand functioning of commodity and financial markets for liberalization to take hold. A major oneis to transfer responsibility for acquiring and storing agricultural commodities to the private sector.And for this, it is necessary to develop mechanisms to finance grain acquisitions and storage, andto hedge the price risks associated with holding commodities, which up to then had been carriedout and funded (and subsidized) by the Government. Hence the inclusion in the original Loandesign of a component to this effect.

3.2 The original Loan concept was to develop domestic futures markets, and to establish anew credit line (PROSTOCK) to finance the storage of agricultural commodities. For hedgingand financing purposes, market operators were to be allowed to operate in offshore commoditymarkets as well. PROSTOCK was envisaged as a dollar-denominated credit line at the CentralBank to finance the storage of hedged and fully-insured commodities. Financing terms were tobe similar to those available to holders of export contracts. PROSTOCK was expected to supportcommercial stock financing through the issuance of warrants by storehouses and, later on, throughthe issuance of bankers' acceptances against such warrants or other negotiable documents. Inaddition, Loan 2727 supported training in the use of the new financial instruments; changes intax regulations which discriminated against domestic futures trading; and other measures todevelop futures markets and to improve access to offshore commodity markets.

3.3 This was an innovative concept, which the Bank had never attempted before. Thetraditional Bank solution to storage problems had been a string of "grain storage" projects, whichsupported parastatal development and marketing centralism from Argentina to Yemen - includingBrazil. The other standard Bank solution, the agricultural credit project, was already showing itslimitations, and Brazil already had received two of them. The Loan's market-based solution tostorage and risk management was also an alternative to the food security proposals then beingdeveloped and tested, most of which, again, placed physical stocks and importing responsibilitiesin the hands of parastatals.

&/ For emple, cf. EMTAG, Risk Management in Liberaliing Economies Issues of Access to Food and AgrkulturalFutures and Options Markets, Regional Sector Study, Yellow Cover Report NO 12220 ECA, August 17, 1993; and the on-going research piece on Price Risk Management: Assessment of the Relative Merits of Various Initiatives, being carriedout by LATAD.

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3.4 The Loan introduced the market way of doing things to a Bank used to dealing withmarketing parastatals and state agricultural banks. Staff involved in appraisal interviewed duringthe audit stated they had found few in the Bank's clearance process wf o understood theconcept.2 This raises the issue of whether the Bank had at the time stal with the requiredexpertise in market-based private sector financing of agricultural commodities or, as those staffstated during the audit interviews, lagged behind technologically in this area.

3.5 For Brazil, the Loan was similarly innovative, and came at the time of the most extensiveState intervention in agricultural marketing and financing. It stirred up a lot of questioning andintellectual search. It is not that warrants were a new thing for Brazil. The Storage Act of 1903had regulated their issuance and use, and they had been successfully used for many years tofinance coffee stocks. But they had never been used for grains, or for soybeans, the mostdynamic export performer in the 1980s. Brazilian officials involved in debt renegotiation saw oneadditional advantage in the proposed scheme is that papers sold in international commoditymarkets would provide fresh financing and yet not be counted as incremental foreign debt.

3.6 It took a long time and a lot of effort and policy dialogue to prepare this component.The main challenge was to develop a system which, based on the experience of the Chicagocommodity boards and the New York and London re-financing markets, could be adapted to theBrazilian conditions and experience. This required simultaneous revision of regulations in fourfields: storage, grading and classification, insurance, and banking and finance. Commercial bankswere expected to play a major role in the new financial order. They would handle PROSTOCKcontracts and provide the links with the international markets. They would provide the credibilityfor the warrants issued by local warehouses. They would issue the bankers' acceptance to betraded in the futures markets. Contacts with the international commodity and financial marketsalso meant a larger role for the Central Bank.

3.7 But the original loan concept did not work. The Central Bank issued the PROSTOCKregulations in September 22, 1987 (Resolution No 1398), but no operation was ever transacted,or a bankers' acceptance issued. The Central Bank closed PROSTOCK and repealed the decreewhich had established it (Resolution No. 1502 of July 28, 1988).L'

THE REvIsED DESIGN

3.8 To its credit, the Bank fielded a highly specialized supervision mission, including the taskmanager, a Bank expert, a banker from the USA Federal Reserve, New York, and the generalcounsel, Federal Reserve, Cleveland. The mission concluded the original design was based onan incomplete diagnosis of the specific institutional, policy, legal, and regulatory constraints. Therelations between the tax regime and the way contracts are drawn in Brazil had not beensufficiently investigated, and the system design relied too much on the US and UK experience.

2/ The fact that the project got cleared at all was a vote of confidence in the team which led preparation and appraised theproject.

10/ The USD 75 million originally allocated to finance PROSTOCK were reallocated on December 13, 1988 to the generalimports category.

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And the mission thought the USD 75 million allocated for PROSTOCK was too small for acountry where annual crop financing runs in the order of about USD 6 to 8 billion.

3.9 The supervision mission re-designed the component. The two major changes were: (i) tomove away from the line-of-credit concept into a rediscount window to support a secondarymarket in bankers' acceptances in order to leverage the scarce Loan resources, and (ii) to priceaccess to such window at a market level, to avoid "creating a market" on the basis of a transientdemand just attracted by its lower access cost. The Central Bank opened an account and theGovernment committed itself to deposit in Cruzados the equivalent of USD 75 million. But therevised design did not work either.

THE REASONS FOR FAILuRE

3.10 There were several reasons for the repeated failure. The main ones were the weakpaper base underlying the system, and the lack of attractiveness of the PROSTOCK window. Inaddition, procedures required technical skills most commercial banks did not have.

3.11 On the former, the main problem lies with the lack of credibility of warehousing in Brazil.The warrants issued by warehouses are not trusted as really representing a physical stock actuallystored. Commodity standardization and grading for the domestic market were deficient, andcredible only in a handful of States. Existing grades were used in Government purchases but notin private trading. Storage conditions were deficient. The 1903 Storage Act was widely seen asdeficient. Therefore, the warrants issued by official and private warehouses were not deemed ofnegotiable quality.

3.12 On the attractiveness of PROSTOCK to potential users, there were problems of cost (forthose coming for financing); and of risks and profitability of PROSTOCK papers (for thosecoming as investors). Among the former, PROSTOCK aroused little interest because the ratesit charged (12-13.5 percent, versus 10 percent in nominal terms for regular agricultural credit)were among the highest in the market. This became even worse when the Plan Cruzadocollapsed, inflation accelerated, and agricultural credit became substantially subsidized in realterms. L'

3.13 For those coming as investors, there was no promotion campaign to explain theadvantages of availing themselves of the facility. Being PROSTOCK a new financial product,potential users needed to have a much clearer idea of the risks involved. They needed some sortof guarantee that they would not incur undue losses, and that the rediscount facility wouldoperate regularly and funds would be available as needed. In this respect, banks had already had

LI A concurrent problem was the availability of alternative sources of financing. At the time, large corporations in theagricultural commodity markets (multinational and domestic) were able to borrow in the international markets at rateslower than those prevailing in the domestic markets. They provided producers with good terms for production contracts,which were then refinanced under the pre-export financing facility. According to researchers in the University of SAoPaulo, the volume of such flows is widely under-reported in official sources of data, and they guess they may be as large as25% of the total official credit for agriculture (say, some USD 2 billion). Such funding went primarily to exportable crops(but financial resources are fungible), and to the most export-oriented regions.

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a bad experience with the PROINVEST line of credit the Bank had supported under thepredecessor Loan 2348. In January 1984, the Central Bank had interrupted refinancing loansmade under PROINVEST to meet monetary targets agreed with the IMF. Many participatingbanks were caught with loans disbursed but not yet refinanced. Such lending commitments -which were not indexed - had to be funded from the banks' own funds or from market funds athigher rates - i.e., at a loss.y

3.14 Further, PROSTOCK papers were not as profitable as other financial instruments (e.g.,pre-export financing funds). PROSTOCK did not provide a tax break, historically one of themain incentives to sell a new financial instrument. PROSTOCK acceptances would be exemptfrom reserve requirements, but the Central Bank subsequently eliminated reserve requirementson time deposits and thus eliminated this as a possible incentive. Then, the Government wasfinancing its deficit with short-term securities, at rates significantly higher than those proposedfor PROSTOCK The maturity period of PROSTOCK acceptances (a minimum of 30 to 60 days,and a maximum of 365 days) was too short at a time of accelerating inflation, when potentialinvestors held very short-term investment portfolios on the order of one to two weeks. Finally,disparities in the treatment of capital gains of agricultural as compared to other commercial andfinancial transactions encouraged non-agricultural business to transfer funds to the agriculturalsector, increasing the availability of alternative sources of funding to the detriment ofPROSTOCK instruments.

3.15 At a deeper level, two more basic problems were at the root of PROSTOCK failure.First, PROSTOCK design was done from the top down. No demand analysis was carried out tounderstand what the potential users needed, wanted, and needed to know. And second,PROSTOCK introduction required the concurrent liberalization of several interrelated markets.Domestic futures markets were to be linked to international commodity markets. The financialsector had to change many of its ways of doing business. Insurance companies had to chargelower premia for loans which, backed by hedged physical stocks, involved lower risks. But theliberalization of those other markets involved issues larger than those which could be addressedunder a SECAL, and had not been addressed under Loan 2727.

3.16 The PCR raises an alternative issue. In the PCR's view, "the project appears to havefocused too narrowly on specific fonns of commercial stock finance. A broader, perhaps moreproductive approach would have been to develop the appropriate conditions for the expansion ofcommercialfinance..., leaving it to financial institutions to design the specific financial instrumentsor innovations".1y In comments provided on the draft audit report, the Region expanded thiscomment as follows: "Provided that the incentives are right, experience shows that Brazil'sbankers can be relied upon to develop new financial products. Hence the statement in the PCRthat the focus of Bank support for commercial stock financing should have been on theconstraints that inhibited the development of such financing rather than on the design of aspecific financing instrument".LA After discussions with the Bank task managers and the

2J. PAR, 2si*., para 45; attached PCR, para 4.06.

J PCR, op.ct., para 57.

J/ Electronic memo of October 21, 1993.

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relevant public and private sector officials in Brazil, however, the audit concluded otherwise.Experience in the use of modern, market-based financial and hedging instruments for cropfinancing in Brazil was very limited. Loan 2727 prompted a discussion on the hedging andfinancing possibilities created by cash and futures markets. It forced the different actors in bothprivate and public sectors and in academia to meet and to develop a common language andframework for discussion, and to explore the pros and cons of different instruments andprocedures. In the view of those involved in generating PROSTOCK, the Loan's well defined,specific idea was not the result of a narrow Bank focus but rather of many months of discussionsand the emerging consensus within the working group (which did include Brazilian bankers) andwith the Bank. The discipline of going through the detailed definition and implementation of oneparticular instrument was useful to all to understand the potential offered by such instrumentsand their technical, legal, tributary and procedural constraints.

DEEPER-SEATED PROBLEMS WITH THE ORIGINAL AND REVISED DESIGNS&

3.17 The sub-section above explored the factors which hampered implementation of theoriginal and revised Loan proposals. But both designs had problems which would have preventedthem, even if implemented, from generating the intended benefits. First, the Loan's strategy forprice stabilization and risk management was not systematic and exhaustive. It tried to correct oneapproach deemed as myopic (the grain storage projects, para 3.3) with another, similarly myopicapproach (futures markets as a panacea). Futures markets are good at handling short-termfluctuations for commodities with spot price variability and without governmental intervention toreduce it, and where there is some correlation between spot and future prices which is relatedto discount rates and risk. But they cannot handle longer-term volatibility; the time seriesproperties of commodity prices make the success of futures markets in handling longer-term pricerisk very doubtful. Therefore, futures markets are only one among several instruments to addressrisk management, and must be used in conjunction with others to overcome their shortcomings.The Loan made no provision for this.

3.18 Second, futures markets require well-developed, functioning spot markets (also called cashor physical markets) with standardized grades, unhindered merchandise movement, noGovernment intervention, and capacity to deliver on the contracts. This basic condition wasabsent in the case of Brazil. Operations in cash markets for agricultural commodities are notsignificant in quantitative terms. Most of the 22 State exchanges operate locally; some of themare significantly dependent on Government operations. Therefore, the Loan design had asequencing problem; it should have not pursued futures markets without having first developedthe spot ones. Somehow those preparing the Loan, both in Brazil and the Bank, came to believethat spot markets would develop automatically as a result of liberalization. They do not, and didnot. Eight years later, they are still struggling to develop, in a rather haphazardous way andwithout the benefit of a well-thought-of scheme, as it was the case with risk management (paras3.22-3.23). A more proper sequencing would have begun by reinforcing the relevant spotmarkets; developing then forward markets (not even mentioned in the project design); and onlythem, and only if necessary, establish a domestic futures market.

J/ This sub-section and the next one benefitted from comments received from IECIT.

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3.19 In this regard, the Loan design displays a surprising lack of parallelism. Bank andGovernment designers explicitly acknowledged the need for careful preparation of theinstitutional, legal, financial, and commercial aspects of the new market featres and functions,like hedging and future trading. And they did so through the respective working group andintensive Bank support. Whichever its shortcomings, there was a detailed plan to guideimplementation (paras 3.1, 6, 8-9, and 16; see also 3.35). But Bank and Government designersfailed to carry out a similar effort to develop the spot markets.

3.20 And third, the Loan design was intrinsically inconsistent because it promoted thedevelopment of futures markets while retaining (and streamlining) a Governmental capacity forprice stabilization (paras 2.6-2.10). Such market interventions remove the incentives for privateproducers, processors and market operators to hedge their commodities.

DEVELoPMENTS AFTE LOAN CLOSING: HOW THE IDEA EVENTUALLY TOOK ROOT

3.21 Loan 2727 has been closed on policy terms for some three years. There is now, however,a major move towards market-based risk management instruments similar to those the Loansupported, involving cash and futures markets for agricultural commodities. Some of thesedevelopments might have occurred spontaneously in Brazil without Loan 2727. The auditconcludes, however, that such developments would have been less systematic, less successful, andslower than what has actually happened. Most interviewees in both Brazil and the Bank creditedLoan 2727 as the original source of the intellectual and commercial stirring, and of the detailedanalyses of possibilities and constraints, which eventually led to the current developments.'These are briefly summarized in this sub-section.

3.22 Some current actions are direct though belated results of the Loan. For example, at thetime of the audit mission a project to amend the 1903 Storage Act - a major legal constraintidentified during the design and implementation of PROSTOCK (para 3.11) - was ready to besent to Congress. The new legislation, once enacted, would allow warehouse owners andmanagers to trade on their own account, and would remove limits on the financial activities whichcan be performed with commodity stocks. Others are the result of activities started under theLoan; of continuing meetings of the working group or of some of their members; of reactions tothe attempts to establish PROSTOCK and analyses of the reasons for its failure; or of ideaswhich originated under Loan-related meetings or policy dialogue.

16/ A secondary issue raised by some is the source of the idea, namely. was this some kind of World Bank imposition or was itgenerated internally in Brazil. The answer is both. There was significant experience in Brazil in using such instnuments incoffee exports, but they had never been looked into for crop marketing, dominated by State intervention. The Banksuggested trying to explore warrants, bankers' acceptances, and futures markets as tools for transferring to the private sectorthe responsibilities for risk management and crop financing, and brought new ideas and technology to carry out suchfunctions. The Brazilians elaborated on the technical, institutional, tax and legal framework for actual operations. It isinteresting to note that each side credits the other as the most important actor in defining such Loan proposals.

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a) Cash and Forward Markets

3.23 The S5o Paulo Grain Exchange (Bolsa de Cereais) is the largest and most sophisticatedgrain cash market in Brazil. It is trying to expand its business and, in the process, to expand thatof other exchanges as well. For the first time, it is marketing its services among potential users.It has added forward contracts to the spot ones, a direction which the Loan should have takenin the first place. It carried out a training program for exchange operators throughout Brazil, anessential element for the introduction of sophisticated hedging instruments. The Exchange's long-term objective is to set up a network linking all 22 State commodity exchanges. For this purpose,it led in the establishment of a jointly owned clearing house for their operations (Central deRegistro),2' already officially licensed but not fully operational as of the time of the auditmission. A second long-term objective is to raise funds from investors to finance (eventually) allagricultural credit needs, for both production and marketing.

b) Futures Markets

3.24 The S5o Paulo Commodities and Futures Exchange (Bolsa de Mercadorias e Futuros,BMF) reported trading some 250,000 contracts per day, worth USD 1.5 billion, which they reckonmake them the sixth largest futures market in the world. Ninety nine percent of their trading isin financial items: interest rate options, gold (options and cash), US dollar options, and stockmarket index futures. Agricultural contracts (almost exclusively on coffee) represent only onepercent of their trading (some 130,000 contracts per day). Agricultural contracts are bound toincrease on account of the new instruments being developed, particularly the Commodity Funds(section c). L2

3.25 BMF is also trying to interest CONAB, the federal agency in charge of national foodsupplies and price support, and equivalent State agencies, to conduct some of its operationsthrough the Exchange. In other countries, state corporations have used future exchanges, buttheir experience suggests that CONAB's participation in the Exchange may not seem a good idea.First, operations in futures market result sometimes in profits, sometimes in losses ("futurestrading is not for the faint-hearted", as stated on an ASTEN memo on futures markets inMENA/ECA countries).A Most parastatals cannot sustain losses resulting from administrativedecisions; most are not even legally authorized to run operational losses - even if by the year'send they achieve a consolidated profit.N Second, operating in futures markets needs fast (andaggressive) decision-making to take opportunities - and avoid pitfalls - literally on the spot; again,

L7/ Its original ownership shares are 40% for the cash exchanges (all 22 of them); 40% for the state and private banks, and 20%to be sold to the public (brokers, warehouses, traders, etc.).

18/ After returning to headquarters, the audit mission was informed that trading on soybean contracts had started. As it is onlybeginning, it is not yet very active or liquid.

19/ E. Chobanian, ASTEN, August 26, 1993.

2Q/ Heavy losses were the result of inexperience in trading on the Chicago Board of Trade by officials and professionals of theIndian Government (in the late seventies and the eighties) in wheat trading, and of the Thai Government in the cornmarket. E. Chobanian, loc. cit. At the time of finalizing this report, an investigation on losses sustained by CODELCO(Chilean Copper Corporation) is under way. Mistakes in futures market deals led to losses currently estimated to be largerthan USD 200 million.

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most parastatals do not have a decision-making process fast enough, nor can they commit fundingon real time. Such decision making also requires top-class real-time information, somethingdifficult to come by in the public sector. Third, parastatal operations are normally too largeto accommodate in a market which functions better under atomistic supply and demandconditions. In Brazil, the volumes CONAB might wish to buy or sell at a given time are severaltimes larger than those tendered/demanded by private sector operators and, thus, are likely todominate the market and make the private sector shy away from using it.

3.26 Like the Grain Exchange, BMF is trying to develop a network throughout the country.It has agreements with several cash exchanges to enable each to trade on each other's floors; allsuch transactions get cleared in BMF computers. This has meant an increase in BMF agriculturaloperations by five percent already. BMF carried out a training program on futures marketsoperations. BMF is also offering the cash exchanges the possibility of moving into futuresoperations.

3.27 Procedures for linking with offshore markets do exist, but they are too complicated tooperate. For example, the Central Bank, concerned about possible illegal capital exports, checksevery transaction to ensure that actual exports and imports match the amounts hedged. Somemarket participants, like agricultural producers and cooperatives, are allowed to sell in offshoremarkets, but not to buy, so they cannot hedge. BMF is currently working with the Governmentto make current procedures more flexible, and to allow foreign brokers and traders to operateon the Sdo Paulo Exchange floor.

3.28 Two tax issues hampered a wider expansion of cash and futures markets. One, Statesinsisted on applying sales taxes (Imposto sobre a Circulagdo de Mercadorias e Serviqos, ICMS)each time a warrant or other stock-backed negotiable paper is sold, and not only on the final,physical transaction. The Ministry of Finance and the Central Bank are working with the States lon this issue; at the time of the mission, four states (Stio Paulo, Parand, Espirito Santo, andMinas Gerais) had already agreed to defer tax collection till the physical transfer of thecommodity takes place. And two, there is a tax asymmetry which makes hedging undulyexpensive, namely, profits in hedging operations are taxable but related losses cannot bededucted. Therefore, if someone earns money on cash (or futures) contracts but losses it onfutures (or cash) contracts, taxes must be paid on the earnings but co-related losses cannot bededucted (this rule does not apply to financial futures).

2IJ In certain cases, and in order to overcome problems involving quick decision-making and flexibility, state companies havecreated a semi-autonomous trading arm to handle such transactions.

2 Through the National Council of Financial Policy, COMFAZ, which groups the secretaries of finance of all States.

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c) Commodity Funds

3.29 On the basis of studies conducted under Loan 2727, the establishment of CommodityInvestment Funds, a new type of publicly-traded investment fund, was authorized in July 1992.Commodity Funds must invest the resources raised in the market in a range of financial products,of which eventually a minimum of 25 percent and a maximum of 80 percent should be investedin papers backed by agricultural commodities, including warrants, CM-Gs (section d), and futurescontracts. Any commercial bank can set a Commodity Fund. The Federal and State governmentscan buy and sell positions in the Funds. A summary of the operating procedures for CommodityFunds prepared by the Central Bank is attached (Attachment 4).

3.30 In their first year of operations, Commodity Funds raised substantial amounts of funds;their capitalization at the time of the mission's visit was equivalent to USD 4.8 billion.2 Sincesuch resources are meant to be used for financing agricultural storage and production, the Fundsare on the way to becoming the main vehicle for gathering financial resources in the market forfunding agricultural production and marketing.ly But this is not yet the case; the Funds haverun into the same problem already identified above for PROSTOCK, namely, the lack ofcredibility of the warrants (para 3.11).

3.31 To be attractive to investors, publicly-traded investment funds must be competitive withalternative investment opportunities. PROSTOCK was not (para 3.14). Commodity Funds, incontrast, have a more favorable tax regime than most other investment funds.!Y l

d) New Negotiable Instruments

3.32 To improve the credibility of warrants, Bank of Brazil, the largest commercial bank in thecountry, is now guaranteeing warrants ("gold warrants") issued by warehouses registered with it("gold warehouses"). Two State banks, BANESPA - the State Bank of S5o Paulo - and theBanco do Espirito Santo have started similar programs, guaranteeing warrants issued by Statewarehouses. As banks expand this line of activity, it should create a larger volume of negotiableinstruments which, through the Commodity Funds, could lead to new sources of financing for thesector.

_/ This is an encouraging sign, for it means there are enough financial resources in the market which could be channeled intoagricultural marketing financing; what is still missing are agricultural-backed papers of negotiable quality. For newdevelopments in this field, see Section d, below.

L/ This is a welcomed improvement over PROSTOCK, which was not designed as a tool to raise capital in the markets tosubstitute for official credit.

SThere are four other types of investment funds in the market: Financial Funds (Fundos de ApiUcajdo Financiera); same,but in shares, to allow smaller investors to buy positions in them (Fundos de Invesimeus an Quotas); fixed rent funds(Fundos Musuar de Renda Fra); and equity funds (Fundos de Acioes).

2/ As a floating rent fund, investors pay only on revenues that eceed inflation, while fixed rent funds pay taxes on totalrevenue, as do all financial transactions.

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3.33 A new instrument being developed, the CM-G (Commodity Certificate with GuaranteedDelivery - Certificado de Mercadoria com Emissdo Garantida) may offer a better promise. CM-Gs are sale contracts on commodities. They will come in two versions: (i) Guaranteed ImmediateDelivery, which refer to stocks already existing; and (ii) Guaranteed Future Delivery, which referto commodities not yet harvested - or even to crops not yet established. They are intended tomobilize resources from the market to finance commodity storage and production costs,respectively. They would be issued by the owner of the commodity, registered in the exchanges'clearinghouses, and guaranteed by a commercial bank. The CM-G contracts will be traded in thespot markets, and are expected to be the main stock-backed paper to be purchased by theCommodity Funds instead of warrants. A summary of the CM-G operating procedures, preparedand distributed by the Central de Registros, is attached (Attachment 5).

3.34 It took two full years to develop the CM-G, and the reasons behind such an extendedperiod illustrate the institutional, technical and legal problems involved in a real-life liberalizationprogram. The Sdo Paulo Grain Exchange led the effort, with participation of all public andprivate entities to be involved in approving regulations for the new paper and in using it. First,it was realized that people at spot and futures exchanges speak two different jargons; as did publicagencies like ministries, Central Bank, and tax administrators. Second, spot exchanges operatein a less formalized way, while futures exchanges are heavily regulated, with norms andprocedures supervised by the Central Bank. Third, physical and financial exchanges havedifferent clearing houses.El And then, banks which had established Commodity Funds initiallyopposed the new paper because they had thought the CM-G's would reduce the market for theFunds.

4. OVERALL ASSESSMENT

4.1 Both the PCR and the audit rate the Loan as satisfactory. But the Loan looks even moresuccessful in the field than what the PCR portrays. Government officials highlighted the Loan'sachievements in terms of both substantive policy change and policy stability and advance at a timeof general policy turmoil.2 The Loan provided the policies, instruments and support todismantle the Government's grip on marketing. At the same time, it provided a beacon (an"anchor" in their words) which oriented the top level technical echelons in Government inkeeping agricultural pricing and marketing policy consistent and stable.

4.2 Sustainability of the Loan-supported policy changes was assured when the CollorGovernment, which took office in March 1990, accelerated the pace and extended the reforms

27/ Negotiations between the two clearing houses alone took six months. The main issue seem to have been that the financialexchange clearing house (CETIP) did not fully trust the cash exchange's house (Cenral de Regisro). The eventual solutionwas that CM-Gs will be cleared twice, once at each clearing house.

_ During project implementation, there were five macroeconomic stabilization plans (plus some actions adopted in July-August 1988 under the Transitory Dispositions of the Constitution) (see para 5.2), ten Ministers of Finance, and some eightMinisters of Agriculture.

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beyond their original frame. The Franco Government, in power since October 1992, generallycontinued the main policy orientation. No backsliding or reversals have occurred.

4.3 As a result, agricultural producers were not as affected by the macroeconomic and policyinstability as it might have been the case. Agricultural sector growth decelerated during the 1980sbut not as severely as the rest of the economy. Sector growth resumed in the 1990s; it wouldseem to be in the order of 3 percent per annum in spite of declining international prices, somepoor harvests, reduced access to credit, and much higher interest rates.&

5. ISSUES AND LESSONS

LACK OF OTHER AnJuSTrmr OPERATIONS IN BRAzE

5.1 It is surprising that the Bank started to support adjustment in a country encumbered withmajor macroeconomic problems with a sectoral Loan.N It is even more surprising that the Banknever made a structural adjustment loan or any other sectoral adjustment loan thereafter. Themain reason for this was the lack of a credible and lasting macroeconomic stabilization program.The Bank started processing two other adjustment operations: a trade adjustment loan and afinancial sector reform loan. Both collapsed when macroeconomic conditions in Brazil collapsed.

5.2 As a consequence of the lack of a credible stabilization program, the Loan's policy reformwas implemented under an adverse macroeconomic environment. The Plan Cruzado deliveredstability for a few months and then collapsed, leading to four additional Plans (and no stability)over the following five years.' This led to budget constraints and exorbitant inflation rates,which affected the technical assistance component because the Government had to generate localresources before getting reimbursed from the Bank, and those hired for the studies saw theirpayments shrink in real terms.

ISSUES IN LOAN PROCESSING

a) Identification and Preparation

5.3 The studies funded under the preceding Loan 2348 proved most useful for theidentification and preparation time of Loan 2727. They were instrumental in defining its policybase; in creating a consensus among government units, the private sector and the Bank on thenecessary reforms; and in generating ownership for reform in Brazil.

VI LA1EA, 2p.ct, volume II, pages 10-12.

N/ The issue of sequencing in adjustment is discussed in further detail in the audit on the Argentina Agricultural Sector Loan,op. c . paras. 5.6 to 5.11.

2J Plan Bresser, 1987; Plan Verfo (Summer Plan), 1989; Collor Plan, 1990; and Collor II, 1991.

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5.4 The main reason for such success was the high caliber of the leaders and members of theworking groups, and the way in which these were organized and managed. Little progress hadbeen made under the military Government. When the Sarney Government took office in March1985, the new Minister of Planning brought to Brasilia members of his University of Sfio Pauloteam and charged one of them with coordinating the Studies. Five working groups wereestablished to cover price liberalization and stabilization, futures markets and price riskmanagement, storage financing and standardization, external trade simplification, and agriculturalmarket information systems.1y Bank missions supervising Loan 2348 and preparing Loan 2727maintained close dialogue with the working groups and were granted plenty of opportunity toparticipate in discussions and comment on drafts.

5.5 Another factor contributing to a successful Loan preparation was the fact that theworking groups included representatives of all interested parties, including members fromdifferent Ministries and Government organizations, academia, and the private sector. These werevery different people, who had different objectives and ideas, and spoke different jargons. Mostof them had never met before. It took a long time just to develop a common language andreference framework. Eventually persistence paid off, and agreements on diagnosis andprescriptions emerged; group members internalized the process and committed themselves to theintellectual merits of the proposals being discussed.m The groups opened a dialogue betweenthe Government and the private sector, and became the Government's principal fora fordiscussing with this sector. As a result, the emerging policy package represented the views of awide constituency. When they became the policy basis for Loan 2727, this one was assured ofownership and commitment.

b) Appraisal and Approval

5.6 Eight missions were required to appraise the Loan, with an input of 2 staff-years in thefield alone (PCR, table 5).2y The PCR is silent on this unusual feature. The main problem waslack of interest, and consequent lack of preparation, on the part of the military Government. Thepre-appraisal mission found no project. The appraisal mission found the Government was notready to go ahead with the project. The four "post-appraisal missions" were really additionalpreparation missions. Only the September 1985 mission was able to actually appraise the Loan -and still required a follow-up mission.

5.7 Yet this was not going to be the Loan to reach the Board. The Loan appraised inSeptember 1985 was meant to support trade and price liberalization, heavily front-loaded. But

3; These were the working groups of relevance to Loan 2727. In total, Loan 2348 provided USD 2.24 million to fund some 58studies (plus other minor studies and other technical assistance activities). See PAR op. paras 46-47 and 67 to 71, andPCR, Annex 10, attached to the PAR.

L/ An example of the time required to forge such a consensus is provided below in regard to developments on derivativemarkets after Loan 2727 (para 3.34).

34 Pre-appraisal, 01/84 (1 person * 15 days in the field); Appraisal, 04/84 (5*29); Post-Appraisal I, 06/84 (3*10); II, 0884(3014); Ill, 04/85 (2*20); IV, 08/85 (1*10); Re-Appraisal, 09/85 (3*27); and Follow-up appraisal, 01/86 (3015), for a total of408 staff-days in the field (just shy of 2 staff-years).

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in February 1986, the Government launched a macroeconomic stabilization plan, the PlanCruzado, with Bank and IMF support. The Plan Cnzado declared inflation dead and froze allprices. The Bank, having applauded the Plan and its consequent price freezing, could not thensupport price liberalization. All policy conditionality on trade and price liberalization was thustransferred to second tranche release with vague language. Since the Plan Cruzado seemed toprovide an IMF-sanctioned macroeconomic stabilization program, there was no need to specifyany other macroeconomic conditionality. But some conditionality had to be included for firsttranche release. Even though agricultural credit had not been appraised, the setting of interestrates for agricultural loans at 10 percent in nominal terms M was made the only condition ofBoard presentation. The Loan was approved within the scheduled fiscal year.

5.8 But even then, the Loan was not fully prepared. On the one hand, more time and workwould have been needed to deepen the diagnostics and fine tune the proposals on the riskmanagement component (paras 1.4, 3.6 and 3.8), even though no amount of additionalpreparation could have pre-defined everything. On the other hand, the vague language includedin the Loan Agreement (the relevant paragraphs are in Box 1) delayed by almost two years therelease of the second tranche.

c) Release of the Second Tranche

5.9 Actually, the conditions on policy reform and subsidy reduction had not been negotiatedin detail; the Loan Agreement just called for studies on the basis of which action plans were tobe developed on the basis of which detailed tranche release conditions were to be defined. Thehistory is told in the PCR and is not repeated here.2y It took two additional years for studiesto be finalized and action plans agreed upon. Thanks to the good Bank-Government relationsand the existence of a solid, mutually-agreed policy reform program, there were no further delaysin agreeing on the required actions plans and eventually releasing the tranche. The main lessonhas already been learnt and operationalized by the Bank; today adjustment operations must haveclear-cut, event-like, easily monitorable conditions for tranche release.

REASONS FOR SuccESS

5.10 The success of the Brazil loan stands in stark contrast with the failure of concurrentagricultural adjustment operations elsewhere in South America (Uruguay, Argentina and

g/ Since inflation had been declared to be zero, that Board condition theoretically meant 10% positive interest rate in realterms, a noteworthy achievement on top of Loan 2348, under which interest rates had moved close to becoming positive inreal terms.

36/ PCR, op.ct, paras 21, 26 and 27. The audit, however, disagrees with the PCR's interpretation on one point. According tothe PCR, "at the time of loan negotiations, it was not possible to define in detail the action program(s)" (para 21). Theaudit found that the main reason for the vague language was the need to change the project's description after theGovernment launched the Plan Cruzado (see pars 5.7).

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BOX1

CONDITIONS FOR SECOND TRANCHE RELEASE

Schedule 1. Pars. 2

Notwithstanding the provisions of paragraph 1 above, no withdrawals shall be made

(b) under Category 1 [General Imports]:

(B) after the aggregate of the proceeds of the Loan withdrawn from the Loan Accountand the total amount of such commitments under such Category (1) shall have reached theequivalent of $300,000,000 unless:

(1) the Borrower and the Bank shall have agreed upon the program referred to InSection 3.02 of this Agreement [reproduced below] and the Bank shall besatisfied, after an exchange of views with the Borrower, that progress has beenmade in the Implementation of such program In respect of each of the policyareas mentioned in Section 3.02 of this Agreement;

(11) the Borrower and the Bank shall have agreed upon the programs referred toin Section 3.03 of this Agreement [reproduced below]; and

(iI) the Central Bank shall have enacted PROSTOCK Regulations satisfactory tothe Borrower and the Bank.

Section 3.02

The Borrower shall: (a) prepare, under the terms of reference specifled in the letterreferred to in the Preamble of this Agreement, and furnish to the Bank, a program for tradeand pricing policy reform for agricultural commodities which shall specify the short-term andlong-term actions to be carried out in, Inter alia. the following areas: commodity pricestabilization, management of price risks, storage finance, trade regulation and marketInformation; and (b) thereafter carry out such program, taking all the administrative actionsthat may be required for that purpose.

Section 3.03

The Borrower shall: (a) furnish to the Bank a program to gradually reduce Its budgetallocations for subsidies for wheat production and consumption: and (b) thereafter carry outsuch program taking all the administrative actions that may be required for that purpose.

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Ecuador).Z' All four operations were processed by the same Regional Office, within a relativelyshort time span, while all four countries were getting their first democratic governments afteryears of military rule, and suffering from macroeconomic and policy instability. (The Loans forArgentina, Ecuador and Brazil were approved within a nine-month period; the one for Uruguayhad been approved the year before.) This Section discusses the factors which made the Brazilexperience successful while the others proved unsatisfactory.

a) Good Preparation

5.11 A strong preparation effort, wholly based in the country, started early (actually, duringthe implementation and with funding of the predecessor Loan 2348). A large Brazilian teamworked in five working groups, bringing together persons from different public and privateagencies and academia, while maintaining a strong dialogue with Bank staff (paras 5.4 and 5.5).In Argentina, preparation was also done in the country, but it was limited to a small circle withinthe Ministry of Agriculture, without participation of either the Ministry of Finance or the groupslikely to bear the brunt of the policy change. Both cases contrast with Ecuador, where the loanwas prepared by Bank staff and discussed with the Government; and with Uruguay, where solidpreparation work by Bank staff did not find a match in the country, and the fiscal effects ofadopting the proposed policy changes were not quantified. As a result, the Brazil loan enjoyedwide support among technical staff and the private sector, which the others did not.

b) Good Timing

5.12 The Brazil Loan was prepared at a time when agricultural financing and subsidies wereamong the largest burden on public finances. It was most timely in addressing urgent needs,clearly perceived as such by the Government, and in providing badly needed foreign exchangeresources. In Argentina, Ecuador, and Uruguay, in contrast, there was no clearly perceivedurgency to address major issues.

c) Strong Commitment

5.13 The team which prepared the Loan was close to the Minister of Planning, and includedmembers of all interested parties. The solutions they produced enjoyed wide consensus. TheGovernment threw its full support behind them. Middle management and technical level officialsremained basically in place (while ministers and economic plans moved in and out), retaining theagreed policy changes as their beacon. In Argentina, in contrast, commitment was strong withinthe Secretariat of Agriculture, but weak at Finance and Planning, and untested at the President'slevel. In Ecuador, only a handful of top Government executives was privy to the discussions;there was no commitment at the middle management and technical levels. When a new

27J PARs on Uruguay Agricultural Sector Loan (La. 2468-UR), Report N* 8806, June 29, 1990, Argentina AgriculturalSector Loan (Loan 2675-AR), Report No 11925, May 28, 1993; and Ecuador Agricultural Sector Loan (Ln. 2626-EC),Report No. 12633, December 30, 1993. All three Loans were rated as Unsatisfactory.

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Government was voted into office, nobody remained in the governmental structure committedto, or even with knowledge o, the agreed policy changes. In Uruguay, there was substantialdisagreement within Government, and between the Government and the Bank, on the nature ofthe operation (the Minister of Economics and Finance wanting a SAL rather than an agriculturalSECAL) and its policy package, and a lack of definite commitmentff

d) Non-threatening Nature of the Reforms

5.14 As in the case of Tanzania,& the fact that the reforms being supported in Brazilimproved the situation or welfare of almost everyone, from the budget to the producers to thetraders to the consumers, was a major factor behind the success of Loan 2727. Only the publicagencies and parastatals which used to have monopolistic control over marketing, and theirnational and local staff and authorities, were to lose their power and privileges (which wasrecognized as a benefit by and to everybody else). In contrast, landowners, a powerful class inArgentina, saw reforms as a major financial and political threat, while the Treasury, which wouldhave had to give up an easily administered export tax to maybe get revenue later from a new,untested land tax, saw them as a risk. In Uruguay, the reduction in export taxes increasedproducer prices but reduced consumer surplus and Government revenues. The Government sawthe Loan supported tax reduction as a threat to its fiscal deficit reduction program, and later on,as in conflict with its commitments with the IMF; ultimately, the Bank had to waive most of theconditions to release the second tranche.

e) Location of Loan Management

5.15 A major factor behind the failure of the Argentina and Ecuador loans was placingresponsibility for implementation of the reform program in the Secretariat or Ministry ofAgriculture, respectively. These had little control over the policy and resources affecting thesector, which were controlled by the Ministry of Economy in Argentina, and by Finance, Industry,Planning and the Central Bank, in Ecuador. In contrast, the successful Brazilian loan washandled directly by the Ministry of Finance.

f) Macro-Economic Framework

5.16 Normally, it is considered necessary to have a macro-economic stabilization program inplace for a sector adjustment program to succeed. The Argentina audit report explicitly discussedthis as an issue.9 In the case of Loan 2727, the lack of such framework made implementationmore difficult (para 5.2), and contributed to the failure of the PROSTOCK scheme (paras 3.13-

-V 1his conclusion is similar to that in countries in other Regions, such as Tunil Agrikultl A4ntment Sedr [ana, Loan

2754, apprwved by the Board three months after the Brazil operation (PAR, Report NO 9308, January 23, 1991).

2I Tamanis Agrulural A41astment Credit, Cr. 2116-TA, PCR under preparation.

M PAR on Argentina, o L, pars 5.6 to 5.11, particularly 5.8 and 5.9.

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16). But the rest of the reforms were all implemented. The reasons for this unusual feature arefar from obvious, but two facts can be mentioned. One is the pervasive indexation of theBrazilian economy, which reduces inflation effects on the structure of relative prices; the otheris the micro-economic nature of many of the reforms, which did not require a macro frameworkfor implementation.

g) Serendipity

5.17 An unanticipated development concurrent with loan implementation was the substantialand sustained increase in productivity throughout the country, and particularly in the cerradoareas.1 Farmers, who had gone through a large capacity expansion in the 1970s usingsubsidized credit resources, put such resources to work in the 1980s under high relative prices.sThis is a notable case of serendipity. Investments made under "wrong" policy conditions(subsidized credit) were put to good use when the policy framework was righted, thus leading toan immediate supply response (para 4.3), which in turn reinforced Government commitment tosustain the reform.

SUSTAINABILTY

5.18 The policy package introduced under Loan 2727 is deemed to be sustainable. Thereasons are both intrinsic and extrinsic to the Loan. On the one hand, the policy changesintroduced under the loan benefitted almost everyone with an interest in agricultural productionand marketing, and in commodity consumption and exporting. On the other hand, the CollorGovernment, voted into office in 1990, deepened those changes and expanded them to the restof the economy on the grounds of its own political plank, buttressing the Loan's sustainability.

BANK RELATIONS wrrH THE BORROWER AND THE IMF

5.19 Bank relations with the Borrower were excellent at all times. Both sides perceive theirdialogue as excellent as well, and the Government credits the Bank with solid technical supportthroughout the preparation and implementation periods. Those interviewed during the auditmission spoke highly of discussions of a related Bank document (green cover version of the 1990Agricultural Sector Report) which was extensively discussed in Brazil and, in their view, set thebasis for the current policy dialogue with the Bank.

5.20 In contrast to the implicit or explicit confrontations observed in the case of the Uruguayand Argentina loans,9 and the embarrassing PROINVEST affair under the preceding Loan2348 (para 3.14), relations with the IMF were good throughout the preparation and implementa-tion of Loan 2727.

41/ Cerrado is an open savanna woodland of Central Brazil.

2 LA1 EA, 2.cit., pages 6-9.

43/ PARs on both loans, 2ocit.

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ATTACHMENT 1

Page 1 of 5

BRAZIL


PROJECT COMPLETION REPORT

EVALUATION SUMMARY

1. Objectives. The main objectives of the project were to (a) support the process ofmaking the rural credit system more market oriented and of reducing rural credit subsidies, and (b)bring about a reform in trade and pricing policy for key agricultural commodities (rice, maize, beans,cotton and soy products). The first objective was to be achieved, initially, by raising interest rates onofficial rural credit to levels which, though below market interest rates, would substantially coverfunding costs, and subsequently, by adjusting official interest rates in line with changes in marketinterest rates. The second objective was to be met by reducing Government intervention in theexternal trade in agricultural commodities; providing consumers and producers with effectivesafeguards against extreme price fluctuations; increasing market-based opportunities for riskmanagement through the development of domestic futures markets and expanded access to domesticand foreign futures markets; expanding commercial financing of agricultural stocks through a dollar-denominated line of credit for holders of hedged commodities (PROSTOCK) and a system of storagewarrants and associated bankers' acceptances; simplifying trade regulations; improving marketinformation systems; and reducing the wheat subsidy.

2. Originally, the Bank loan in support of the project was to be disbursed in two tranchesof US$300 million and US$200 million. The entire first tranche and US$100 million of the secondtranche were to be disbursed against general imports (Part A of the project). US$75 million of thesecond tranche was to be used to set up PROSTOCK (Part B). The balance of US$25 million wasto be used to finance consultants, training and equipment (Part C).

3. Project Implementation. The loan was released in two tranches, the first (US$300million) in September 1986, and the second (US$175 million) in November 1988. The allocation ofUS$25 million for the technical assistance component (Part C), originally part of the second tranche,was made available for disbursement earlier than the second tranche release through an amendmentof the Loan Agreement in November 1987. Also, the Loan Agreement was amended in December1988 to change PROSTOCK from a credit line into a discount facility to provide liquidity for asecondary market in bankers' acceptances. The amount earmarked for PROSTOCK under the loan(US$75 million) was re-allocated to finance general imports, and released as part of the secondtranche. An equivalent amount in local currency was contributed by the Government to set upPROSTOCK.

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ATTACHMENT 1Page 2 of 5

4. The delay between releases of the first and second tranches is partly attributable to thedesign of the project. The specific policy conditions for second tranche release were fully definedonly in April 1987 after the Government working groups organized under the project had finalizedtheir recommendations and discussed them with the Bank. Most of the delay in second trancherelease, however, reflected the difficulties of carrying out an adjustment program in a highly unstablemacroeconomic environment. Between loan approval in June 1986 and second tranche release, Brazilwent through two unsuccessful stabilization programs involving price freezes and trade controls whichdelayed compliance with the trade liberalization conditions of the second tranche. The lack ofcontinuity in the Government coordinating team responsible for managing the adjustment programalso contributed significantly to the delay in compliance with second tranche conditions. Throughoutthis difficult period, the Government maintained a strong commitment to the objectives of theproject. The Bank also monitored closely the reform process and maintained an intensive policydialogue with the Government through frequent supervisions. By November 1988, all second trancheconditions were satisfactorily met.

5. Because of delays in establishing the required administrative arrangements and inincluding the budget for the technical assistance component in the overall Government budget, loanfunds for Part C were made available for expenditure only two months prior to the original loanclosing date (June 30, 1989). To provide additional time for the implementation of Part C, the loanclosing date was originally extended by one year to June 30, 1990. However, because ofadministrative and budgetary problems associated with the change in Government, implementationpractically ground to a halt during the first half of 1990. A second extension to June 30, 1991, wasagreed with the new Government, and a third extension to June 30, 1992, has been requested.

6. Results. Important policy and institutional improvements were achieved in most policyareas of the project. However, little or no progress was achieved in expanding commercial stockfinancing and the use of market-based price risk management techniques. Although considerablydelayed, implementation of Part C resulted in a number of highly relevant and useful studies. Whileit is not possible at this stage to assess fully the economic impact of the improvements introducedunder the project, the effects on trade flows appear to have been positive.

7. Areas of progress included: (a) rural credit - after a resurgence of negative interest ratesand credit subsidies because of the suspension of monetary correction during the Cruzado Plan in1986/87, full indexation of official rural credit balances was restored at the end of February 1987.Since then, although below market rates, interest rates on most official rural credit have beenadjusted to substantially positive levels in real terms, with the average cost of federal securities servingas the floor. Currently, interest rates on most official rural credit are 9% per year plus full monetarycorrection based on a market-determined reference rate. With the support of two Bank loansapproved in 1988 (Loans 2960-BR and 2971-BR, the Fourth Agro-Industries Credit Project and theAgricultural Credit Project, respectively), the Government has also been reducing the volume ofofficial rural credit and encouraging the expansion of private commercial finance; (b) tradeliberalization - external trade in the commodities covered by the loan is now free of quantitative andqualitative restrictions, except for a very limited amount of products entering under the drawbacksystem or under international agreements. While licensing of exports and imports has beenmaintained, steps have been taken to make it more automatic. For imports of maize and rice, asystem of variable tariffs was adopted in 1988 to equalize the landed cost of lower-price imports with

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the domestic intervention prices for the sale of Government stocks. However, this system has notbeen used since the international prices for these products have not been lower than the interventionprices; (c) price stabilization - a system of market safeguards (price bands) has been established formaize, rice and beans, with clear rules for Government intervention in domestic markets and salesof public stocks. However, there are no prescribed rules for setting producer minimum prices (thelower limits of the price bands). These continue to be set based on a number of factors, includingproduction costs, international prices as well as Government policy to promote or discourage aparticular crop; (d) trade simplification - steps have been taken to reduce or eliminate unnecessaryagricultural inspections, cut down on customs red tape and establish better information systems tomonitor trade transactions. Decisions on trade licenses have been decentralized to field offices ofCACEX (now the Foreign Trade Department of the Ministry of Economy). A system of automaticexport registration is now being applied to soy, maize, rice and cotton exports; (e) market informationsntems - a crop forecasting project of the Brazilian Institute of Geography and Statistics (IBGE),financed under the technical assistance component of the project, is already beginning to improve thequality of the Government's agricultural production forecasts for the southern region of Brazil;(f) wheat subsidy - adjustments in consumer and producer prices have reduced Governmentexpenditures on the wheat program from US$ 1.8 billion equivalent in 1986 to US$0.6 billion in 1990.

8. The areas where little or no progress was achieved under the project were: (a)commercial stock financing - various institutional, policy, legal and regulatory constraints haveinhibited the issuance by banks of bankers' acceptances secured by storage warrants. As a result, thePROSTOCK facility is not operating; (b) price risk management - although tax discrimination againstdomestic relative to offshore futures market transactions has been ended, the use of futures marketsfor hedging price risks has not increased mainly because of Government interventions in thesemarkets and the unstable macroeconomic environment. Furthermore, access to offshore commodityexchanges has remained limited because of the Government's concern over the risk of capital flight.

9. In addition to the IBGE crop forecasting project, the studies and training activities whichhave received financing under Part C are highly relevant and supportive of the policy reformsinitiated under the project. Under the current Government, the criteria for selecting technicalassistance activities have been strengthened to emphasize support for economic deregulation andprivatization.

10. The economic impact of the trade and pricing policy reforms supported under theproject is difficult to evaluate given the unsettled economic conditions in recent years and therelatively short period during which the reforms have been in effect. For example, while theliberalization of agricultural trade should have led to an increase in domestic producer prices toborder price equivalents (thus reducing the negative protection or implicit taxation of agriculturalproducts), the results during 1988-90 were mixed. Abstracting from the effects of currencyovervaluation and taxes, the neutral or near neutral protection of rice and maize during 1985-87 wasbasically maintained during 1988-90. When currency overvaluation and taxes are taken into account,corn was somewhat negatively protected or implicitly taxed during 1985-87, and its implicit taxationincreased significantly during 1988-90; the implicit taxation of rice increased in 1989 but became zeroor neutral in 1990. Depressed domestic demand and sharp reductions in official marketing credit(EGF) for soybeans and cotton appeared to have swamped the positive impact on domestic producerincentives during 1988-90. Domestic producer prices for these commodities decreased relative to

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border prices, and their implicit taxation increased rather than decreased, both with and without theeffects of currency overvaluation and taxes.

11. Reflecting the trade liberalization supported by the loan, exports of soy products andlow grade cotton expanded substantially in 1989-90. Following the disappointing 1989/90 harvest,substantial imports of rice and maize, principally for areas which could be not be suppliedcompetitively from the Government's stocks which overall were adequate, were also made in 1990.However, unlike in 1986-87, the last time when large amounts of rice and maize were also imported,the imports in 1990 were made by private traders and were absorbed in domestic markets with littleor no disruption.

12. Sustainability. The prospects for maintaining and deepening the reforms supported bythe project are good in light of the commitment of the current Government to reduce furthergovernment intervention in the economy and liberalize markets. In the case of the trade and pricingpolicy reforms, important steps have been taken to deepen the reforms (e.g., minimum price policy)or to extend them to other agricultural commodities (e.g., wheat and sugar) or other sectors. Despitethese advances, there is the risk of backsliding if macroeconomic instability continues.

13. Findings and Lessons. The loan was part of a broad Bank assistance program in supportof the Government's stabilization program (the so-called Cruzado Plan) and other policy adjustmentsinitiated in 1986. Based on the plan's initial positive results, the Bank's expectation was that theeconomy would stabilize and inflation would be kept under control. Based on this expectation, theBank decided not only to proceed with the loan at an early stage of the plan, when progress towardmacroeconomic stability was still fragile, but also to postpone for the second tranche most of thepolicy reforms supported by the loan. The first tranche release was based solely on a rural creditreform which involved the introduction of a system of variable nominal interest rates, a system whichwas viable only under stable macroeconomic conditions.

14. In the event, the Bank's expectations regarding the effectiveness of the Cruzado Planwere overly optimistic. Starting with the breakdown of the Cruzado Plan in the last months of 1986,Brazil entered a prolonged period of macroeconomic instability which made it impossible to continuewith the rural credit reform supported by the first tranche and extremely difficult to comply with thesecond tranche conditions. While satisfactory actions to meet the objectives of the first and secondtranches were eventually taken (involving, in the case of rural credit, a return to full indexation), thiswas at the cost of a long delay. At least two lessons can be drawn from this experience: first, a sectoradjustment loan should be made only after a trend toward macroeconomic stability has been firmlyestablished, and second, a sector adjustment loan should, as much as possible. be made in support ofactual rather than prospective reforms.

15. Beyond the operational issues of timing and strategy, the lack of a supportivemacroeconomic environment during project implementation also meant the persistence of anovervalued currency, which was a major tax on agriculture. This factor, coupled with the continuedprotection and high costs of manufactured agricultural inputs, sharply limited the positive impact onagricultural incentives of the sector-specific trade reforms supported by the loan. Withoutcomplementary improvements in non-agricultural policies which accounted for a large share of theimplicit taxation of agriculture, it is unclear whether the positive impact on agricultural incentives of

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the sector-specific trade reforms more than compensated for the negative impact of the reduction incredit subsidies (which were presumably designed to help offset the high costs of agricultural inputs).

16. The preceding observations have several implications for the content and sequencing ofreforms in agriculture. In the usual case where the sector is initially subject to high rates of implicittaxation, improving economic efficiency would require that the rate of effective protection toagriculture be increased until the implicit taxation is eliminated. In those cases where the implicittaxation is due significantly to non-agricultural policies, as was true of Brazil, reforms in these policiesshould precede or accompany the elimination of sector-specific distortions which have artificiallyincreased the profitability of agriculture (e.g., credit and input subsidies). Without these reforms,either as complementary adjustment operations or as part of the sector adjustment loan itself, the neteffect of the sector adjustment loan may be to worsen rather than improve the initial implicit taxationof agriculture. If there is no guarantee of reform in non-agricultural policies, elimination of sector-specific distortions which are initially decreasing the profitability of agriculture (e.g., agriculturalexport controls and taxes) should be given equal if not higher priority over reforms in policies thatattempt to help offset the anti-agricultural biases of other policies (e.g., credit and input subsidies).

17. The change in PROSTOCK, from a credit line for storage financing into a discountfacility to support a secondary market in bankers' acceptances, was not sufficient in itself to inducebanks to provide storage financing through bankers' acceptances. The institutional, policy, legal andregulatory constraints to this use of this financial instrument should have been fully identified andanalyzed first before changing PROSTOCK. Had this been done, the change would have beenpostponed until after the various constraints had been eliminated. More fundamentally, the projectappears to have focused too narrowly on specific forms of commercial stock finance. A broader,perhaps more productive approach would have been to develop the appropriate conditions for theexpansion of commercial finance (without creating distortions elsewhere), leaving it to financialinstitutions to design the specific financial instruments or innovations.

18. The large technical assistance component of the loan (US$25 million) was not asthoroughly prepared as it would have been if it were a freestanding operation. In addition, thedifficulties of managing the technical assistance activities also appear to have been underestimated.In particular, while management by the Ministry of the Economy, Finance and Planning (MINEC)was effective in ensuring the policy relevance of the studies, the bureaucratic processes involved inthe contracting and administration of the studies slowed considerably the pace of implementation,especially during 1989. The negative effects of the delays on contractor morale were exacerbated bythe high inflation rate which wrought havoc on contract values.

19. In future, where technical assistance activities in support of adjustment operations arelarge and complex, it is better to structure them as a separate, freestanding operation with a realisticimplementation period (i.e., considerably longer than the quick disbursing companion project). Themanagement and administrative arrangements for these activities also need careful preparation andplanning to reduce the risk of delay during implementation.

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EFFECTS OF BANK LOANS ON AGRICULTURAL CREDIT POLICY IN BRAZIL Y

1. The Brazil case is different The huge Bank loans to agricultural credit started in theearly 1980s, with Agro-Industries Credit IH (1983 for USD400 million) and Agricultural Creditand Export Development (1984 for USD303 million). They were followed by three more: Creditand Marketing Reform (1986 for USD500 million - actually an adjustment-type loan withconditionality on agricultural credit and pricing policies), Agro-Industries Credit IV (1988 forUSD300 million) and Agricultural Credit (1988 for USD300 million). All five ostensibly sharedthe objective of supporting the Brazilian government make its slow and belated transition fromthe heavily subsidized credit regime of the 1970s toward market rates. Those expanding subsidieshad reached 2 percent of GDP (para 6.22), and government had come to realize by the early1980s that its budget could no longer support them. Hence there was no significant controversyover the ultimate goal, and the Bank's agreements then line up closely now with the objectivesof the present RFM reform in the Bank. The transformation of official credit policy in Brazil isnow nearly complete, from negative rates to real positive rates at levels (14-15 percent) exceedingthose in almost all of the other major Bank borrowers. The Bank can take some satisfaction heretoo from its close association with this policy evolution.

2. But the picture in Brazil is not as sharp as in the other two countries. For one thingthere was no significant, sustainable institutional infrastructure being created, as with NABARDand FIRA. In fact the unit in the Central Bank responsible for implementing the rediscountprograms lost that function in 1989, when the latter was transferred (with some staff) to theTreasury. More important, there are signs in the Brazil case of the Bank shifting directions,abandoning policy initiatives, and accepting revised conditionality weaker than the original setThis was especially true of the adjustment project titled Credit and Marketing Reform approvedin 1986. It is not part of the study's short list of 41 projects, but it is included in the completelisting of 683 projects. It was redesigned at the last moment to support government's 1986austerity program (the Cruzado Plan), the interest rate conditionality was added because the Planeliminated the justification for the price and trade conditionality which had theretofore beenemphasized, and the interest rate agreement on first tranche release was considered by some staffat that time as too soft. Nevertheless, the Bank was willing to accept ostensibly optimisticprojections of decreased inflation to demonstrate its support for the Plan. For the secondtranche, the Bank's attitude was to stiffen. The word "irresponsible" does not fit here either.And the project must be seen as one of a series of five approved over six years, the total effectof which was to help government make what was indeed a painful transition from its previoussubsidy orientation.

3. One way lending pressure would appear in the Brazilian scenario would be if the loanamounts were inflated above the levels dictated by on-lending requirements. That is not the case,at least for the last two USD300 million loans. They were defined by credit gap analysis, and, as

1 This Attachment reproduces the most relevant paragraphs an Brazi from OED, A Review of Bank Lmag for Agricultural Craftand Rural Finance (1948-1992), Report IW 12143, June 29, 1993, par 6.16-6.1&

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it turned out, were popular beyond expectations and could have been much higher. The previousCredit and Marketing Reform Project, revised and approved at USD500 million, was an upperlimit on what the Bank thought acceptable for a single adjustment operation, and apparently wasaimed not at a credit gap but at the balance of payments. But the size of the earlier two loansstarting in 1983 was also related more to credit needs than to macro considerations, and in thissense the Bank's support over the whole period has the shape of responsible programming. Thefact that the Bank has now terminated all discussion with the Brazilian government about futureagricultural credit projects, pending improvements in overall economy policy, is additionalevidence that this sector portfolio has not been driven since the early 1980s primarily by lendingpressure.

ATTACMElT 3

SLIARY OF OPERATIN PROCEDURES FOR COMMIDITY FUllS

RESOURCES SOURCES AGENTS COMPOSITION OF PORTFOLIO

Comodity Mobilizing resources in the market for - All-purpose bank I, 21% at a minimum in:Investment application in the portfolio of - Commercial bank a) Export notes for agricultural, livestockFunds financial assets Linked to - Investment bank and agri-industriaL products, to a maximum of

agricultural, livestock and agri- - Economic Fund 10%;Circular industrial products and other - Lending, financing and2,205/92 financial assets, and to operations in investment company b) Certificates of deposit associated with2,265/93 organized futures markets involving - Brokerage company dealing sates of agricultural products and/or2,299/93 contracts for these products. in stocks and bonds and financing of agricultural machinery and

other securities equipment, to a maxibun of 15%;- Company distributing stocksand bonds and other c) "Warrants" representing deposits ofsecurities agricultural, Livestock or agri-industrial

pro-tcts, provided that they are guaranteed bya financiaL institution;

d) Merchandise certificates and othersecurities and contracts representing orpledging agricultural, livestock and agri-industrial products, provided that they are

guaranteed by a financial institution orbrokerage copany and subject, in the lattercase, to coopliance with the regulationsissued by the Serintendency of PrivateInsurance - SUSEP;

s . 60% at a maximum in National freasury or CentralBank bonds; state and muicipal public debtbonds; certificates of deposit, bills ofexchange, mortgage notes and debentures, sharesin Financial Application Funds; and promissorynotes issued by stock coanies for public offer;

1b. 20 at a maximum in the stock of open companiestrading on the stock market or in over thecoiuter sales if regulated and authorized by theSecurities Committee;

IV. 10% at a maximum in gold bars acquired incommodity and futures markets.

Source: BACEN/DEN/CORAG, RURAL CREDIT -- RESOURCES, updated through May , the

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SUMMARY OF THE OPERATING PROCEDURES FOR THE CERTIFICADOSDE MERCADORIAS COM EMMISAO GARANTIDA (CM-G)

(Prepared and distributed by Central de Registros)

Principal Information on Operating Procedures

1. In brief, the CM-Gs are contracts (commercial rather than financial) for the purchaseand sale of merchandise, incorporating stipulations accepted by the parties involved;these may be supplemented by side documents which can become an integral part ofthe CM-G.

2. The transaction occurs at two moments:

2.1 When the merchandise is offered for sale;

2.2 The negotiation and closing of the deal.

3. The sale may involve two kinds of CM-G-

3.1 Merchandise Certificate: Immediate Delivery Guaranteed;

3.2 Merchandise Certificate: Future Delivery Guaranteed.

4. The CM-G: Future Delivery Guaranteed is intended to mobilize resources to enablethe producer to cover the costs of his operations by delivering the product sold after ithas been harvested.

5. The CM-G- Immediate Delivery Guaranteed will be negotiated with the classified andstored merchandise as counterpart.

6. The CM-G will be issued by the producer, its existence being registered by theclearinghouse; it will be stamped and guaranteed by a bond and must be offered freelyfor sale and resale on the commodity markets.

7. Only CM-Gs properly registered in the clearinghouse guaranteeing the system will beable to be offered freely for sale and resale on the commodity markets.

8. The CM-G: Immediate Delivery Guaranteed can be issued by any individual orcorporation owning title to the merchandise.

9. The mandatory stamp of the financial institution acting as guarantor of the issuer onthe CM-G does not imply any obligation to grant a loan to the issuer.

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10. Only storage agents who are properly registered by the commodity markets andincluded in the list of certified depositaries of the clearinghouse will be accepted.

11. Only those merchandise classification certificates that have been issued by agenciesproperly accredited by the commodity markets and registered with the clearinghousewill be accepted.

12. Annexed to the CM-G will be a 'Terms of Negotiation" providing space fortransaction stipulations and conditions that must be agreed during the process ofselling the certificate.

13. The merchandise must be insured, otherwise it will not be accepted for registrationand sale.

14. The CM-G's official existence begins after its registration with the clearinghouse; atthis point, all the relevant guarantees become effective.

15. The CM-G itself does not circulate in the market but is kept by the issuing bank,which delivers the authorization for its sale directly to the clearinghouse.

16. The following are full parties to the transaction of the CM-G:

16.1 The producer and/or holder of the merchandise, as the seller;

16.2 The storage agent, as depositary;

16.3 The financial institution, as financing agent, custodian and guarantor;

16.4 The insurance agent;

16.5 The clearinghouse for the system and its registered members;

16.6 The commodity market and its official brokers;

16.7 The buyer.

17. Regulations governing the records, documents, operating modalities, purchase and saleorders, classification of merchandise, client agreements, forms of guarantee, amongother things, are the responsibility of the commodity market and clearinghouse.

The Flow of Funds Mobilized by the CM-G

Example 1: The producer goes to the bank who lends him Cr$100,000. Having signed thecontract and provided the guarantees, the producer, at the bank's suggestionand with the offer of its services, issues the CM-G (CMFG) and places it forsale on the commodity markets; once the CM-G is sold, the producer receives

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the money and pays off his bank loan; the bank, having received its moneyback, can lend it over again to the producer, which restarts the process. It isclear that the system allows for the multiple rolling-over of credit, while thecurrent, static system can only do this once.

Example 2: The purchaser buys a raw material (soybeans) on the commodity market usingthe CM-G (CMFG) since there is a bank guarantee of physical delivery, thesame buyer can therefore offer his manufactured products (bran and oil) forsale through CM-Gs (CMFG), on the basis of the real guarantee of thephysical delivery of the raw material purchased; he can thus plan hisproduction process. In turn, the product produced by this buyer (bran) can bethe raw material for another buyer (animal feed), which in turn can be the rawmaterial for a third buyer (chickens or hogs). This flow of production fromindustry to industry benefits commerce and especially exports, where theguarantee of physical delivery is the basic element in commercial relations.The increased credibility of the seller leads to a significant reduction in thecost of mobilizing financial resources.

- 37 - ATTACHMENT 5Page 1 of 4

Presidency of the Republic (PR)Secretariat of Planning, Budgeting and Coordination (SEPIAN)Secretariat of International Affairs (SEAIN)

Fax No. 357 Brasilia, 02/17/94

To:Mr. Graham DonaldsonChief, Agriculture and Human Development DivisionOEDWorld Bank

From:Alencar Soares de FreitasCoordinator, Office of Evaluation and Performance Coordination (CAD)SEAIN/SEPLAN-PR

Subject: Performance Audit Report - Brazil - Credit and Marketing Reform Project - LoanNo. 2727

Dear Sir:

With reference to the draft PAR transmitted to my office on October 28, 1993 and to yourfax of January 6, 1994, oxtending the date for submission of our comments, I am pleased to send youherewith a copy of Brazil's position on this matter.

Very truly yours,

/s/ Alencar Soares de FreitasEvaluation and Performance Coordinator

SEAIN/SEPIAN-PR


Mr. Graham Donaldson Brasfilia, February 11, 1994Chief, Agriculture and Human Development DivisionOEDWorld Bank

Subject: Brazil - Credit and Marketing Reform Project - Loan No. 2727 - Performance AuditReport - PAR

Dear Sir:

On October 28, 1993 we received from OED a copy of the draft PAR on the above-referenced project, sent to us for review, analysis and comments. In response to the fax sent to youby this office on November 22, 1993 (ratified by fax of January 5, 1994), OED agreed (fax of January6, 1994) to extend the December 3, 1993 deadline for receipt of our comments to February 15, 1994.

We are now pleased to send you a series of comments compiled by this office, reflectingBrazil's position on this matter. This document was generated through contacts with the FederalGovernment agencies involved in this project, which had access to the World Bank's PAR and wereable to give their opinions in this regard.

The process of adjustment of the Brazilian economy to a new context both at home andabroad, initiated following the public debt crisis and economic recession of the early eighties, washandled well by the private sector, while the public sector, as demonstrated by recent events, failedto make any substantial adjustment to the needs of the time.

Consequently, Loan No. 2727, negotiated between the Brazilian Government and the WorldBank in 1986, had two main objectives:

1. help set up a market-oriented system of rural credit;

2. reform the agricultural marketing system, focusing on primary commodities such as

rice, maize, beans, cotton and soybeans.

To achieve these objectives, three basic targets were established:

1. consolidate and further advance the objectives of previous projects to establishpositive interest rates for rural credit;

2. liberalize the procedures involved in the domestic marketing and export of agriculturalproducts;

3. establish new market instruments to transfer stock financing and price riskmanagement to the private sector.


The purpose of the reforms was to organize the agricultural markets and liberalize prices witha view to opening up external trade. A further aim was to stimulate the creation or strengtheningof certain marketing-related services (storage, insurance, commodity exchanges, futures markets, etc.).

The new orientation given to agricultural policy in 1985 was designed to phase outgovernment intervention and give free play to the market forces, principally through the followingmeasures:

1. In the area of credit, the new policy resulted in: (a) elimination of negative interestrates for rural credit; (b) elimination of inflation-generating sources, with the abolitionof the conta movimento and the creation of an official credit budget; and(c) introduction of noninflationary sources of credit such as rural savings andcommodity funds.

2. Implementation of the policy for the marketing of government stocks and theminimum price policy resulted in: (a) adoption of the stock release price mechanism,representing the trigger price for the sale of government stocks, and which, by givingtransparency to the timing of the Government's market interventions, enables theprivate sector to act with less risk; (b) creation of a special Federal Marketing Credit(EGF), allowing private storage of the harvest to continue beyond the time-limit setfor the normal EGF; (c) establishment of a liquidation bonus to enable the marketto absorb the production of regions located far from the consumption centers and theports; (d) creation, for products whose only price support comes from the EGFswithout sale option, of the loan price; (e) revival of the regionalized Minimum PricePolicy (PGPM), establishing minimum prices by region that reflect transport costdifferentials between production and consumption zones; and (f) abolition of thegovernment wheat marketing monopoly.

With respect to component C, financing of studies, research and training, an agreement wassigned at the end of 1991 between the Union and the Institute for Economic and Social Planning(IPEA), entrusting the latter with responsibility for execution of this component of the loan. Underthe new research financing plan, the UNDP was appointed to receive and manage the funds.Following on from the studies of the five areas initially designated as basic to the project, IPEA hasso far contracted a total of 40 research projects and conducted an international seminar on certainagricultural-policy-focused topics. The results of the research were published in the Estudos dePolftica Agricola (Agricultural Policy Studies) series, in three forms: executive summaries (inPortuguese and English), research reports, and working documents.

Two years later, IPEA is regarded as having the necessary attributes and knowledge to identifythe topics of studies needed to support the preparation of agricultural policies appropriate to adevelopment model in which there is less government intervention and increased participation in theinternational market.


In addition, the experience gained by IPEA in the administrative and technical process ofdeveloping the research side of the project have endowed it with the necessary institutional capacitiesto perform policy-focused studies and research projects.

[It should be noted that paragraph 4.21 of the PAR contains an error. The letters sent tosome 1,000 agricultural economics researchers were needed for the establishment of a consultant databank containing the names of the researchers, the institutions for which they work, and theirmain areas of research. At no time did IPEA ask those researchers what they thought should bestudied or researched. The seven main areas of research topics were defined on the basis of theareas of study of the working groups, at meetings between the Loan 2727 Technical Committee,the Project Management (IPEA), World Bank missions, and a few experts, who were specially invitedto give their opinion on this matter.

Thus there is no justification for footnote #18, which reads: "The way in which studies wereidentified for the [last] phase of the studies component is alarmingly typical of the lack of a long-termvision." On the contrary, during the last phase of the studies, when IPEA was executing agency, theobjective was to build on and update the agricultural policy guidelines [? adopted] by the project inthe early days (1986/87). At no time did the studies fail to address either the primary objectives ofthe loan or the need to support the decision-making process (as a policy instrument) to promote theachievement of those objectives.] '

It may be said that the liberalization of external trade represents the area of structural reformin which the greatest progress was made following elimination of most of the nontariff barriers, givingthe agricultural sector greater freedom to export, while the domestic market still needed to developefficient private-sector marketing systems, such as futures markets, warrants, grading, private storage,and commodity markets.

It should be emphasized that the country's low level of economic development, reflected inthe persistent macroeconomic imbalance, high inflation rates, and public-sector deficit, is having aserious impact on the agricultural sector. However, given the widespread indexation of the economyand the microeconomic nature of the reforms proposed in Loan No. 2727, the project may beregarded as having succeeded, even though some of its objectives have not been met.

Lastly, we would draw your attention to the fact, on which both the Brazilian agencies andOED itself have often commented, that it is highly inadvisable to carry out sectoral projects such asthat financed by Loan 2727 without taking account of the macroeconomic framework within whichthey are to be implemented.

1. OED Note: The references to paragraph 4.21 and footnote 18 refer to the draft PAR sent to the Government for comments. Inview of the comments provided in the two paragraphs above, the draft PAR paragraph 4.21 and footnote 18 were eliminated.Hence, the comments for the Government have been printed between brackets.

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