Report No. 7697-IND Indonesia: Strategies for Sustained Development of Tree Crops (In Two Volumes) Volume l: The Main Report December 7, 1989 Agriculture Operations Division Country Department V Asia Regional Office FOR OFFICIAL USE ONLY Document of the World Bank This document has a restti. ted distribution and may he used by recipit nts only in the pertormance of their offk ial cluties. Its ((.)ntents may not oth -rwise be disclosed witho, it Wodld Bank authori,atiorn. CURRENCY EQUIVALENTS Before November 15, 1978 US$1.00 = Rp 415 Annual Average 1983-88 1983 US$1.00 = Rp 909 1.984 US$1.00 = Rp 1,026 /a 1985 US$1.00 = Rp 1,111 1986 US$1.00 = Rp 1,283 /b 1987 US$1.00 = Rp 1,644 1988 US$1.00 = Rp 1,681 September 29, 1989 US$1.00 = Rp 1,7S3 FISCAL YEAR Government - April 1 to March 31 Bank Indonesia - April 1 to March 31 State Banks - January 1 to December 31 /a On March 30, 1983 the Rupiah was devalued from US$1.00 = Rp 703 to US$1.0. = R- 970. /b Or. September 12, 1986 the Rupiah was devalued from US$1.00 = Rp 1,134 to *S$'.?^ RI1,64 .R FOR OMCIAL USE ONLY ABBREVIATIONS, ACRONYMS AND INDONESIAN TERMS AAR." - Agency for Agricultural Research and Development ADB - Asian Development Bank BAPENGKO - Badan Pengelola Kopra (Copra Marketing Board) BPKP - State Auditing Agency BPPM - Center for Oil Palm Research BPS - Biro Pusat Statistik (Central Statistical Bureau) BTU-BUMN - Biro Tata Usaha - Badan Usaha Milik Negara (Bureau for State-owned Enterprise within a Government Department) CCO - Crude Coconut Oil CPO - Crude Palm Oil DGE - Directorate General of Estate DISBUN - Dinas Perkubanan Daerah (Regional Estate Crops Service) DRK - Dana Rehabilitasi Kopra (Cess on interisland and export trade in copra) DSP - Priority List for Investments ffb - fresh fruit bunches (oil palm) HGU - Hal: Guna Usaha (Land Utilization Certiricate) INPRES - Instruksi Presiden (grant by presidential instruction) JMO - Joint Marketing Office LNG - Liquefied Ndtural Gas MOA - Ministry of Agriculture MOF - Ministry of Fcrestry NES - Nucleus EState and Smallholders Project (in this report refers to foreign-assisted projects) PBSN - Private National Estates Persero - Directorate of State Enterprises (within Department of Finance) PIR - Perkebunan Tnti Rakyat (Nucleus Estate and Smallholders Project)--in this report refers to wholly Government- financed projects. PIR-TRANS - A Scheme for Private Nucleus Estate and Smallholder Development for Transmigrants PKO - Palm Kernel Oil PMA - Joint Venture Companies PMU - Project Management Unit PNP - Perusahaan Negara Perkebunan (Departmental Trading Enterprises) PRPTE - Projek Rehabilitasi den Peremajaan Tanaman Ekspor (Export Estate Crops Rehabilitation and Extension Project) PTP - Perseroan Terbatas Perkebunan (State-owned Limited Liability Estate Company or Public Estate Company) REC - Rural Extension Center Repelita - Five-Year Development Plan SCDP - Smallholder Coconut Development Project SRDP - Smallholder Rubber Development Project TGHK - Tata Guna Hutan Kesepakatan (Forest Land Use Agreements) TKPIR - Tim Khusus - Special Team in DG-E for estate projects TP3 - Tim Pengendali (under the Minister of Agriculture) VAT - Value Added Tax This document has a restricted distr:bution and may be used by recipients only in the performance of their official duti-s. Its contents may not otherwise be disclosed without World Bank authorization. - i - 1WDONESIA STRATEGIES FOR SUSTAINED DEVELOPMENT OF TREE CROPS (Rubber, Coconut and Oil Palm) Table of Contents Page No. PREFACE .................................................... i EXECUTIVE SUMMARY ........................................... ii I. KEY FINDINGS AND CONCLUSIONS ................................ 1 A. Tree Crops in the Economy ............................... 1 B. Potential for Development ............................... 4 C. Past Performance and Emerging Constraints ............... 6 D. Towards a Strategy for Development ...................... 17 II. TREE CROPS IN THE E'CONOMY ................................... 28 III. MEDIUM- TO LONG-TERM PRODUCTION AND MARKET POTENTIAL ........ 39 - Edible Oils ............................................. 39 - Natural Rubber .......................................... 45 IV. POLICY ENVIRONMENT .......................................... 54 - Edible Oils Trade Policy ................................ 56 - Rubber Marketing and Trade Policy ....................... 67 V. STIMULATING PRIVATE INVESTMENT .. 74 - PIR-Trans: Issues and Options .......................... 76 - Private Estate: PBSN Scheme ............................ 80 - Regulatory Barriers to Entry ............................ 81 - Special Foreign Investment Restrictions .84 - Enterprise Licensing ......................... 86 - Need for Greater Competition Within Private Sector .87 VI. STREAMLINING PUBLIC ESTATES (PTPs) . .88 - Role in Smallholder Development .89 - PTP Estates and Processing Facilities .91 - Financial Performance .92 - Management/Organizational Structure ..................... 96 - Future Options .......................................... 97 VII. REACHING THE SMALLHOLDERS .................... 100 - Social Factors .......................................... 100 - Economic Analyses and Options ........................... 104 - Future Approaches ....................................... 109 VIII. FINANCING OPTIONS ..ie...................... 1 - Export Cesses ........................................... 118 - Credit As A Cost-Recovery Mechanism . l19 - Smallholder Financing Requirements .129 - Alternative Options of Indirect Financing and Cost Recovery .132 - Specific Options for Cost Recovery . 134 Page No. IX. DEVELOPING TECHNOLOGY......................144 - Future Oil Palm Research .................145 - Future Coconut Research..................148 - Future Rubber Research ..................152 X. SUSTAINABLE LAND USE AND ENVIRONMENT...... ........157 - Improved Land Use Planning ................157 - Land Stabilization and Rehabilitation...........160 - Control of Pollution from Processing Plants........162 xi. THE UNFINISHED AGVENDA AND PRIORITIES FOR EXTERNAL ASSISTANCE ... ....................167 - Remaining Agen'da .....................167 - External Assistance....................170 - iii - Text Tables Page No. 2.1 Total Area ........................-.. 29 2.2 Total Production ....................... 30 2.3 Export Volumes .............................................. 31 2.4 Export Earnings ............................................. 32 2.5 Smallholder Households .34 2.6 Employment .35 2.7 Regional Incidence of Poverty-.--------------------------- 36 2.8 Annual Household Incomes: Transmigration in Rural Areas.... of Receiving Provinces .37 3.1 Projected Production ar.d DeLiand. 43 3.2 Total Area Planted, Area Under Rubber and Potential Output, 1987-2010 .--------------------------- 48 3.3 Smallholders: Area Planted Annually Under Alternative Planting Strategies . 49 3.4 Estimated Rubber Consumption, 1970-2000-.................... 51 3.5 Indonesian Rubber Consumption by Industry, 1988-90 .51 4.1 Copra Traded to Java ........................................ 61 4.2 Capacity Utilization in Palm (CPO), Coconut (CCO), and Cooking Oil Manufacture ................................. -. 62 4.3 Planned and Realized Allocations of Palm Oil ................ 65 4.4 Olein and Stearin Exports ................................. 66 4.5 Price Comparisons of Malaysian SMR-20 and Indonesian SIR-20 ................... 70 4.6 Prices Received by SRDP, PRPTE and Partially Assisted Rubber Smallholders, 1985-87 ........... 71 5.1 Total Planted Area by Public and Private Estates ............ 75 5.2 Repelita V Planting Targets for Oil Palm: PIR-TRANS and Private Estate Development ................................ 76 7.1 Comparison of Performance Criteria for Ongoing Government- Assisted Projects and for Future Options/Approaches ....... 108 7.2 Summary Characteristics of One Scenario of Smallholder Planting Program ....................1-----.... 112 8.1 Planned and Realized Credit Expenditures for Tree Crops Projects ....................-.-------------.120 8.2 Plantings and Conversions of Lands by NES/PIR Project Type ...........12.. ......... 121 8.3 Quality Classifications of NES/PIR-Type Projects .123 8.4 Quality Classifications of PMU-Type PRojects .124 8.5 Annual Investment Requirements: S.nallholder Development ...............................................-131 8.6 Tax Obligations of the Estate Crop PTPS .134 8.7 1987 PBB Land Tax Collections by Selected Tree Crop Producing Regions .......................------------------ 136 - iv - Page No. 9.1 1985/86 Budget for Oil Palm Research Institute .............. 147 9.2 1985/86 Budgets for Rubber Research (Sungei Putih and Sembawa) Intitutes. .55 10.1 Area Officially Allocated to Tree Crops in Sumatra .15. 10.2 Area Recommended for Large Block Tree Crop Development in Sumatra .150 10.3 Critical Land in Sumatra by Province ........................1.60 INDONESIA STRATEGIES FOR SUSTAINED DEVELOPMENT OF TREE CROPS Preface This sector review is based upon the findings of a mission 1/ that visited Indonesia during September 19-October 14, 1988, to examine and propose a medium- to long-term strategy for the development of rubber, oil palm and coconut tree crops. To limit the scope of the review, beverage crops were excluded. The review draws extensively upon! (a) data compiled by the Directorate-General of Estates; (b) discussions with Government officials apd private investors; and (c) discussions with the staff and consultants of the Center of Policy Implementation Studies (Harvard Group) in Jakarta. The report briefly assesses the role and past performance of rubber, oil palini aind coconuts, and evaluates the production and market potential of these comrno- dities. The other sections of the report focus on the emerging constraints and the concomitant development strategies needed to facilitate: (a) a wider participation of the private sector; (b) a more efficient and streamlined public sector; and (c) a broad-based replicable growth in smallholder develop- ment. The requirements for a conducive policy environment, relevant research, stable financing, and sustainable land use and environment are discussed in the remaining sections. Given that different agencies within the Government would like to focus on different sections of the report, each section is self- contained. For the reader wishing to get an overview of the report, a detailed summary of key findings and recommendations is contained in Section I. The report updates and conmplements an earlier Bank report on the tree crop subsector,2/ some of whose recommendations have already beer, implemented. This report reaffirms the conclusion of the earlier report that tree crop investments continue to be financially and economically sound. However, it devotes greater attention to a number of topics, including the policy environ- ment and private sector, land use and environment, the measures needed to reach a larger proportion of smallholders, and the need to devote increasing resources to a replanting program. 1/ The mission consisted of Mss. S. Ganguly (task manager), J. Aden, S. Tan (Bank staff), M. Hawkins, G. Vayre (consultants) and Messrs. J. Greenwood, D. Larson, D. Whittle (Bank staff), A. Green, A. Juanengo, Marasigan, and S. Tabor (consultants). The extensive assistance provided by various Government departments is gratefully acknowledged. A draft of the report was discussed with the Government in September 1989. 2,' Indonesia: The Major Tree Crops: A Sector Review (Report No 5318-IND, dated April 15, 1985). - ii - INDONESIA STRATEGIES FOR SUSTAINED DEVELOPMEN; OF TREE CROPS Executive Summary The Case for and Role of Tree Crops 1. Rubber, coconuts and oil palm already play an important role in the Indonesian economy. They generate foreign exchange earnings, create productive employment opportunities and alleviate poverty for smallholders, stimulate agro-industrial development, and foster regional development. 2. The three crops occupy about 6.6 million ha, or over 702 uf the total area planted to estate crops in Indonesia. Over 80? of area planted in these crops is located on the Outer Islands. Total production in 1986 was 1.1 million tons of rubber (dry rubber), just under 2 million tons of coconut (copra equivalent) and 1.4 million tons of oil palm (CPO). Since 19/8, rubber and coconut production has grown by about 2.5Z p-a. and oil palm production by about 11.5Z p.a. Indonesia continues to account for nearly one-fourth of world supply of rubber and coconuts and one-fifth of world supply of palm oil. 3. Rubbet, oil palm, and coconut-derived products currently account for 602 of estate crop eaxports, 482 of total agricultural exports, and 152 of non- oil/liquefied natural gas exports. After peaking at US$1.4 billion (1983 constant prices) in 1980, total export earnings from the three crops declined until 1988. This decline was caused by volume and price fluctlations; it reversed when commodity prices rose substantially and export eorninigs returned to US$1.2 billion. Given that there Is an anti-export bias in agriculture and that tree crop commodities receive low or negative effective protection, Lhere could be real resource gains to the economy from expanding production and exports of tree crop products. 4. Future tree crop investments will remain a priority, given the need for rapid growth in non-oil exports, and a faster growth in the labor force in the Outer Islands. Tree crops can also contribute to sound environmental management by increasing the productivity of marginal lands, avoiding exploitation of flora and fauna in forests, and stabilizing soil erosion and loss. There are some environmental risks associated with tree croo development. The adverse environmental impacts can be mitigated by improving siting, avoiding wildlands, managing use of pesticides and controlling factory effluents. The scope for further development is considerable. Much of Indonesia is well-suited to the production of tree crops on a sustainable basis, and tree crop investments continue to be financially and economically sound. The economic rates of return range between 182 and 282, wrich are roughly comparable with the returns for small-scale manufacturing. The tree crop investments remain robust at current and projected prices and prevailing exchange rates, even when tested against the effects of a substantial decline in output prices, or delays in implementation. _- iii - Past Performance 5. Past achievements have been impressive. An enormous planting program has been undertaken, including block-planting schemes for smallholders and new settlements in the under-populated islands. Mainly as a result of this expansion in area, tree crop production has grown at an average rate of about 4.51 p.a., over the past decade. Yet Indonesia still accounts for only 32 of world trade in edible oils, and the report estimates that past increases in production have had an insignificant impact on world prices. Between 1980 and 1985, total employment in these crops grew at about 3.8? p.a., compared with the 2.52 growth of the entire labor force, and the 3.4Z growth of labor force in the Outer Islands. In 1985, the crops provided about 10 of agricultural employment and 5? of total employment in Indonesia; in the Outer Islands, the relative shares were 20Z and 121, respectively. Cultivation of tree crops is also associated with lower incidence of poverty, particularly in areas where soils are not suitable for.foud crops. 6. Yet the achievements to date have, in some respects, fallen short of Government's expectations. While the supply of edible oils has met growing consumer demand, consumer cooking oil prices have been above world market levels, producer prices have been well below world market prices, fractionation/refining capacities have been underutilized, and super-normal profits/rents have accrued to a small group of firms. In rubber, past policies have not succeeded in upgrading quality, and as a result there have been losses to the economy and uncertainty about Indonesia's abil4.ty to mset the future import demand of industrial countries. 7. The participation of the private sector has been inadequate and not sufficient'ly broad-based. The public estate companies (PTPs) succeeded in planting large areas for smallholders, but now face major debt service obligations and operational inefficiencies. However, the most serious problem is that the Government assistance has reached only a small fraction of the smallholders who constitute the largest part of the sector, and for whom tree crops are an important source of income and employment. Yields among unassisted smallholders have remained static and even some of the schemes that have reached smallholders may not be sustainable. 8. The four major reasons for disappointing performance are: (a) deficiencies in the marketing and trade policy regime affecting edible oils, and the complex regulations affecting the entry of new firms; (b) shortcomings in the direct support for the private sector, such as the requirement to develop smallholder plantings and assist with the settlement of transmigrants, and the allocation of subsidized credit to a few investors; (c) policies that hinder PTPs in operating as commercial enterprises; and (d) lack of a comprehensive strategy to reach the mass of smallholders. To date, emphasis has been on new plantings in new areas and not on urgently- needed replanting. Moreover, there is neither the institutional framework nor a reliable source of financing to meet the needs of this large group of unassisted smallholders. 9. To meet future challenges, tree crop investment and policy strategies need to adapt to changing sectoral development constraints and requirements. Since Government resources are much more limited, a greater share of - iv - investment must come from the private sector. For this to happen, a new incentive environment will be needed. The PTPs will need to return to their role as commercial enterprises and their expansion, particularly in the downstream activities, should be confined to joint ventur,s with private investors. Scarce Government resources should be focussed primarily on completing and consolidating past investments in tree crop development and transmigration and providing infrastructure and support services, particularly to reach a larger number of smallholders. Toward a Strategy for Development 10. Changing the Policy Environment. The report contends that it is now necessary to revise the edible oils trade regime by abolishing marketing and export restrictions, licensing restrictions on investment in crude palm oil (CPO) milling, and the inter-island copra tax, and by gradually reducing import tariffs. To improve rubber quality, supply-side interventions, such as incentives at the processing end, are required in lieu of the present expolt ban on low quality rubber. 11. Stimulating Private investment. The main priority is to streamline procedures for land alienation and forest conversion. The Government could provide a service to potential investors by identifying land for plantation development, and renting it to private investors at competitive market rates. An open licensing system that imposed no restrictions on capac..ty or production systems would be the best way to encourage efficiency in processing. In the short term, Government might establish special export zones that would be exempt from restrictive requirements, and lift licensing restrictions on CPO. While the private sector is induced to establish estates and processing facilities, it should not be required to develop plantings and undertake other ancillary services for smallholders unless the contractual arrangements between the Government, private investors and the smallholders are clearly established and proven to the functional and effective. These arrangements shou.ld be closely monitored to ensure that these are mutually beneficial to both the private investors and the smallholders. The expansion should not be on a scale that can lead to adverse environmental impacts. Since the constraint to private investment is primarily regulatory, rather financial, the interest rates under Government programs should be progressively raised to approach the opportunity cost of caoital. 12. Streamlining Public Estates. While PTPs can continue to plant for smallholders on a contract basis, they should concentrate on their primary role as commerc;.al enterprises. Some improvement in the financial health of PTPs can be achieved through greater efficiency. However, to support efficiency improvements, Government might consider assigning a single agency to set standards, monitor their performance and provide guidance in corporate planning. Other options could be: creating a holding company with the individual PTPs as subsidiaries, and introducing contract plans to monitor performance. To initiate partial privatization and facilitate technology transfer, the PTPs should enter into joint ventures with private sector, particularly in the downstream activities. Over the longer term, the very rationale for direct public investment in areas where the private sector is willing to go in and compete effectively may need a review. - v - 13. Reaching the Smallholders. A major development priority will be to reach larger number of smallholders. Several approaches are discussed, including low-cost (larger private equity) packages for smallholders on the perimeter of existing Project Management Unit (PHU) scheme3, and a wide network oE nurseries supplying good quality planting material and extension advice. A large majority of rubber and coconut smallholders will need to replant their existing genetically inferior and/or aged trees with improved varieties, so that the potential to increase their yields and incomes can be realized. Institutional and financing mechanisms will be needed to sustain a major replanting program. Smallholders will need extension advice, and an adequate availability of inputs which the private sector could provide. Settlements in new areas could be done through comnercial contractoLs, who could be PTP., private eLtates, or firms specializing in land clearing and tree crop planting. 14. The magnitude of the task facing the Government in trying to reach the mass of smallholder producers is enormous and the Directorate General of Estates (DGE) is already overburdened. To gear up for the job, the Government may wish to creato a unit to oversee the task, either by strengthening the DGE or by setting up a separate authority. This unit could formulate and oversee the implementation of a comprehensive strategy for reaching a larger number ot smallholders, and could also be used to channel revenues for smallholder development programs. Careful considerat'on would have to be given to the division of responsiuility between the new unit and the existing institutions, particularly the unified extension service. 15. Smallholder development needs a stable eource of finance. In the immediate future, there is a need to break the present impasse over loan recovery. Until a wide network of viable rural financial institutions is developed, the Government may wish to consider other financing and indirect cost recovery options. This report suggests revenue enhancement measures such as a modest export tax/development cess on rubber, which is botn an optimal tax leading to welfare gain, and a source of revenue to finance smallholder development. 16. The proposed strategy entails some significant adjustments to past development strategy- progressively deregulating marketing and trade in edible oils; * removing barriers to private sector development; * using public estate companies to establish smallholder plantings on a commercial contract basis, and absolving them from other smallholder development responsibilities; * extending successful PMU-based schemes to provide low-cost packages for smallholders on their perimeters; * providing a network of nurseries and extension to reach the majority of smallholders who have not been assisted in the past; * giving an increased emphasis to replanting. - vi - 17. The proposed strategy would call for a progressive redefinition of the role of the Government in the sector, with less regulatory intervention in the market and direct public investment in production and more emphasis on ensuring a favorable environment for private investment and more effective programs to support smallholder development. 18. The strategy would effectively contribute to all the major objectives set by the Government for the Repelita V period (1989/90 to 1994/95): accelerated growth in agriculture, a greater focus on efficiency, increased productive employment opportunities in rural areas, an accelerated attack on poverty, and a more balanced regional distribution of growth (through the promotion of tree crops in the Outer Islands). 19. The proposed strategy could have a significant impact on the Indonesian economy. Some of the benefits that could be obtained include: * palm oil production could increase by one-half million tons by the year 2000, the potential fall in rubber output could be reversed, and Indonesia could become a consistent exporter of coconut oil; * exports could increase by US$37 million a year by improving rubber quality and by another US$40 million just by improving PTP yields; * fir.ncial returns to rubber smallholders could be boosted by over 50.- through the use of improved planting material, some fertilizer an: limited extension advice; * smallholder incomes from oil palm production could increase by more than Rp 200,000 per ha and returns to investment could increase by nearly 3 percentage points, as a result of trade liberalization; * the economy could gain US$860 million in value-added (present value terms) just by expediting approvals of private investments on about 400,000 ha of oil palm; * proaucers, consumers and the economy could benefit by perhaps US$185 million a year by eliminating the excessive profits earned by special interest groups; * the fiscal burden on the Government could be reduced; * the equivalent of 164,000 man-years of annual employment could be created at a low cost (US$550 per job compared with US$3,500 per job in small-scale manufacturing). I. KEY FINDINGS AND CONCLUSIONS A. Tree Crops in the Economy--Rubber, Coconut and Oil Palm Contribution to the Economy 1.1 Rubber, coconut and oil palm tree crops play an important role in the Indonesian economy. They generate foreign exchange earnings, create produc- tive employment opportunities and alleviate poverty for smallholders, stimu- late agro-industrial development, foster regional development, and in the case of edible oils, provide a staple foodstuff at an affordable price. Although they contribute only about 5Z of overall agricultural GDP, these crops have considerable scope for potential development. 1.2 Area and Production. In 1986 there were estimated to be over 3 mil- lion ha under coconut, nearly 3 million ha of rubber and about 600,000 ha of oil palm. In all, the three crops occupied about 6.6 million ha, or over 70? of the total area planted to estate crops. Over 80? of total area planted in the three crops was located on the Outer Islands, with about 1OZ of rubber and oil palm area and about 30Z of coconut area located on Java and Bali. 1.3 Total production .n 1986 was 1.1 million tons of rubber (dry rubber), just under 2 million tons of coconut (copra equivalent) and 1.4 million tons of oil palm (CPO). Since 1978, rubber and coconut production has grown by about 2.52 p.a. and oil palm production by about 11.5? p.a. 1.4 Foreign Exchange Earnings. Rubber, oil palm, and coconut-derived products currently account for 60? of estate crop (para. 2.2) exports, 48? of total agricultural exports, and 15? of non-oil/liquefied natural gas (LNG) exports. Due to fluctuations in both volumes and prices, total export earn- ings frcm the three crops, after peaking at US$1.4 billion (1983 constant prices) in 1980, have declined thereafter to levels well below that until 1988, when commodity prices rose substantially and export earnings climbed to US$1.2 billion. Rubber vies with textiles as the single largest contributor of non-oil/LNG foreign exchange earnings and, with a fall in coffee prices over the last few years, has been by far the largest contributor of agricul- tural export earnings. 1.5 These commodities also have an important domestic market. Given the rapid increase in domestic demand (average annual growth of 17? during 1970-86), the import substitution effect of oil palm production has been particularly large, and over the past decade, imports of the three commodities have averaged only 3? of export earnings. Foreign exchange savings from dom- estic supplies of coconut are also high because domestic consumption is largely of high-value fresh coconut and oil, while exports have consisted primarily of low-value meal. 1.6 Employment. These crops provided (for smallholders and estate workers together) an equivalent of 2.5 million full-time jobs in 1978, growing to about 3.2 million in 1986. Rubber alone accounts for about two-thirds of the employment in these crop:, and women constitute about one-third of the labor force. Between 1980 and 1985, total employment in these crops grew at about 3.8? p.a., compared with the 2.5Z growth of the entire labor force, and the 3.41 growth of labor force in the Outer Islands. In 1985, the crops pro- vided about 3CZ of agricultural employment and 52 of total employment in Indo- nesia; in the Outer Islands, the relative shares were 20? and 12?, respec- tively. 1.7 Poverty Alleviation. Cultivation of tree crops is associated with a lower incidence of roverty, particularly in areas where soils are not suitable for annual crops. In 198., the households that had rubber as their main source of income had an average annual income of about Rp 970,000 and total expenditures of about Rp 840,000, well in excess of the estimated poverty line of about Rp 600,000 and about equal to the average household expenditure for rural Indonesia. On average, these households derived about 40? of their income from rubber, while other farm-related work and off-farm sources each generated about another 301. A detailea income survey for 1984 suggests that perhaps 15-20? of these households fell below the poverty line. 1.8 Households having coconuts as a major source of income had average incomes of Rp 920,000 and total expenditures of about Rp 800.000, again well above the poverty line. On average, cocorut cultivation provided a much smal- lr proportion of income, with only about 20? of the total. The data on income and land distribution for coconut farmers suggest that there are pockets of poverty among smallholders in certain provinces, such as East Timor, East Nusa Tenggara and Southeast Sulawesi. 1.9 With an improved package of inputs, rubber households can expect to earn net annual incomes ranging from Rp 1,000,000 to Rp 1,500,000/ha for approximately 195 days of labor. For coconut (90 days) and oil palm (85 days), the range is Rp 700,000 to 800,000. Structure of Production 1.10 Tree crops are produced by three distinct groups: smallholders, public estates and private estates. The structure of production differs mark- edly between crops: (a) coconut is almost wholly produced by smallholders (with 98? of the area); (b) rubber is largely a smallholder crop (832), but with significant participation of public (9?) and private (82) estates; and (c) oil palm is predominantly grown on estates (80: of the area), but with a rapid increase in smallholder production since 1978. These differences between the crops affect both their performance and the future prospects for their development. 1.11 Smallholders. There are about seven to eight million smallholders engaged in the production of rubber, coconut and oil palm, of which about two and one-half million depend upon one or more of these crops as their primary -3- source of income. Smallholders can be divided into two broad groups: the small but conspicuous group of about 220,000 households who have been assisted by one of the Government-sponsored schemes referred to in para. 1.62, and those who have received little or no help from the Government. Most of the schemes have supported new plantings in new areas to benefit both transmi- grants and local farmers. 1.12 The transm"igrants are generally from diverse occupational backgrounds--agricultural laborers, transport workers, sharecroppers and the unemployed. It can be assumed that they have little or no previous knowledge of tree crop farming. Each participating household is allocated 2 ha of iand for tree crop production and between 0.5 and 1 ha of food crop/houselot land. With few exceptions, they make little use of their food crop land, and little, if any, project extension work is directed towards food crops. In some part, the smallholders' apparent lack of interest in food crop: is because most schemes are located in relatively isolated areas, far from major markets. At the same time, the local markets for food crops ire small, because most people have sufficient food crops for their own consumption. Moreover, poor soils are often not suited to large-scale food cropping. Perhaps 90Z of household income is derived from tree crops and wage work on the nucleus estate. 1.13 Local farmers participating under Government schemes are generally "progressivem farmers, i.e., smallholders who already have a good general knowledge of tree crop cultivation, willingness to try new techniques, and the ability to self-finance some of the required inputs. 1.14 The vast majority of smallholders in Indonesia fall into the unas- sisted (or "swadaya") category, who cultivate their crops with little or no help from the Government. Economic activities among this group of small- holders are highly diversified, and tree crops are but one of their several sources of income. Mixed forming and diversificatior. into nonagricultural activities is clearly the smallholder's prime mechanism to manage risk and safeguard household incomes. 1.15 Public Estates. Government participation in estate plantations has been extensive since 1958 when foreign estate enterprises were nationalized. Their contribution to tree crop production expanded rapidly after 1977, with the introduction of the nucleus estate (NES) concept, under which Public Estate Companies (PTPs) provided support to smallholders surrounding a nucleus estate. Since the inception of the NES schemes, PTPs have planted some 230,000 ha for smallholders and over 100,000 ha in nucleus estates. With the inclusion of estate plantings not associated with NES-type schemes, total PTP plantings have amounted to some 450,000 ha. 1.16 Private Estates. Government interest in promotion of tree crop dev- elopment has focused on the rehabilitation and expansion of public estates and on the smallholder sector. Historically, the private estates received little attention, although a program for development of private tree crop estates was begun in 1977 when the Directorate General of Estates (DGE) launched the Pri- vate National Estates (PBSN) credit scheme (para. 1.55). More recently, the Government also started a scheme for private nucleuu estates and smallholder development for transmigrants (PIR-TRANS) (para. 1.57), which allows private estates to develop tree crops, on the condition that they plant adjacent land for smallholders. - 4 - 1.17 Domestic private estates account for 12? of oil palm and 52 of rubber area. There are reported to be about 1,200 plantation units, but this number is probably understated since many small plantations growing rubber or coconut are unlicensed. There are 15 foreign estate companies on 70 plantation units, accounting for 92 of oil palm and 3Z of rubber area. Five large plantation holdings (London Sumatra, Socfindo, Uniroyal, Tolson Tiga and Goodyear), with a combined planted area of 138,600 ha, account for 902 of the area under for- eign estate companies. B. Potential for Development Economics of Tree Crop Investments 1.18 Investments in rubber, coconut and oil palm are economically sound, with economic rates of return (ERRs) ranging between 182 and 28Z. These are comparable with ERRs for small-scale manufacturing. The ERRs for tree crop investments remain robust ranging between 142 and 252, even if a 25Z decline in output price is assumed in view of the likely deviation of the actual world prices from the Bank projected prices (beyond a five-year period). The investments are relatively insensitive to cost overruns or decreased benefits stemming from lower yields and lower output prices. A sensitivity analysis undertaken in this report indicates that for various types of schemes, the ERR would decline to 102 i.e., the opportunity cost of capital only if: (a) berefits decline by 40Z-632; (b) investment costs increase by 1232-3172; or (c) operating costs increase by 1482-381Z. (For details, see paras. 7.25-7.28, Table 7.1 and Annex Table 2.15.) The cost of developing a new productive employment opportunity will be about US$550 in tree crops compared with US$3,500 in small-scale manufacturing. Furthermore, recent studies have shown that: (a) manufactured goods are protected more than agricultural goods; (b) import-substituting agricultural goods receive higher effective prctection than export-oriented agricultural goods; and (c) tree crops receive relatively low or negative protection. Consequently, there is an implicit anti-export bias in agriculture, and there could be real resource gains to the economy from expanding production and exports of tree crop products. A strong emphas.s on public investment has in the past compensated partly for indirect discrimination against the tree crop subsector. Land and the Environment 1.'9 Much of Indonesia is well-suited to the production of tree crops. They -ntribute to sound environmental management by increasing the product- ivity ,f marginal lands, providing economic activities to smallholders dwel- ling within forest boundaries, and providing a buffer to forests to prevent forest exploitation by underemployed transmigrants or spontaneous migrants. Where opening of sloped land to cultivation without adequate soil conservation mea,- es has resulted in accelerated erosion and soil loss, an appropriately sit'; tree crop development can stabilize the slopes by introducing proper te: ;cing techniques. Tree crops also provide a vegetative cover which is co.T,. tible with envirormental sustainability. There are some environmental ri.9', associated with tree crop development. Most adverse environmental impants could be mitigated by improving siting, avoiding wildlands, managing use Df pesticides, and controlling factory effluents. -5- Edible Oils 1.20 Production Potential. Although prices are projected to remain low by historic standards, the scale of past plantings, especially of oil palm, are expected to guarantee large production increases through the mid-1990s. Pro- duction forecasts until the year 2000 are based on the assumption that new oil palm area will continue to expand at about 40,000 ha annually. Production of palm oil (CPO) can be expected to grow from 1.5 million tons in 1987 to over 3 million tons by 1995. The rate of expansion will then slow as replantings will be required, resulting in lower average yields; yet overall production is projected to continue to grow, reaching 3.4 million tons of CPO by the year 2000. Coconut (CCO) production is expected to grow from 0.8 million tons in 1987 to 0.98 million tons by 1995, and to 1.1 million tons by the year 2000. However, if the policy and regulatory environment for the private sector is not conducive (paras. 1.45-1.54), the investments in oil palm could slow down, leading to a reduction in CPO production to 3.0 million tons in the year 2000. Similarly. if the requisite replantings and subsequent yield increases in smallholder coconut production do not take place, CCO production could stab- ilize at around 950,000 tons in the year 2000. 1.21 Domestic Demand Potential. Spurred on by growing incomes, an expand- ing population, and real prices which are quite low by historical standards, the demand for vegetable oils should expand rapidly throughout the projection period. The demand for coconut oil is projected to expand slowly, rising from 762,000 tons in 1987 to 92E,000 tons in 1995 and to 960,000 tons in the year 20C0. On the other hand, palm oil consumption is projected to grow more rapidly, as Indonesia continues to switch to the less expensive of the two vegetable oils. Domestic demand for palm oil is projected to grow from 757,000 tons in 1985 to more than twice that level in 1995. By the year 2000, domestic consumption of palm oil is expected to reach 2.4 million tons. 1.22 Export Market Potential. Despite the fact that Indonesia is the world's second largest producer of palm oil (20Z of world production) and second largest producer of coconut oil (25Z of world production), Indonesia produces only about 3Z of world trade ir. fats and oils. The production changes in Indonesia, therefore, have a limited impact on world prices. At the projected prices of edible oils, Indonesia, being a low-cost producer, should remain competitive in the world market, at least until the close of the century. 1.23 Indonesia, which has been a sporadic importer/exporter of coconut oil in the past, can become a consistent exporter of coconut oil in the future, as domestic demand switches to palm oil. Exports of coconut oil can increase to 43,000 tons by 1995, and to 173,000 tons by the year 2000. As domestic pro- duction of palm oil accelerates, expoLts are expected to increase rapidly, reaching about 1.6 million tons by the mid-1990s. Then, as domestic demand continues to grow rapidly while production grows more slowly due to age struc- ture of plantings, exports will begin to fall, dipping slightly below 1 mil- lion tons in the year 2000. Rubber 1.24 Production Potential. Estimates of potential output are based on the assumption that the rate of future planting will at least replace the outgoing - 6 - tree stock (i.e., aged and low yielding trees) in each year. While this replacement will contribute to an increase in potential output from mature rubber areas from 1.20 million tons (24Z of world production) in 1937 to 1.76 million tons 26Z) in the year 2000, there will be a subsequent decline to 1.49 million tons in 2010. If "sleeping rubber' areas (i.e., mature rubber trees which are not being tapped in any given time period) are included, then potential output would be higher by about 0.10-0.15 million tons. The aged structure of the existing tree stock which leads to an output decline can be reversed by a faster rate of planting than a mere replacement of outgoing tree stock. This will require a larger increase in area to be planted and/or a major replanting program which can improve the genetic variety of planting materials and thereby substantially improve yields. 1.25 Domestic Demand Potential. Domestic consumption of rubber is pro- jected to be between 160,000 tons and 250,000 tons in the year 2000. The highei estimate assumes that domestic consumptio-i will increase faster in the future, n line with faster growth in the manufacturing of non-transport rub- ber goods, such as rubber shoes and latex-based rubber products/gloves and medical insulation goods. However, the uncertainty about domestic consumption trends is not too important, since less than 152 of potential output is likely to be consumed locally. 1.26 Export Market Potential. It is estimated that abovt 1.5 million tons can be exported at world prices in the year 2000 (compared to about 1.0 mil- lion tons in 1987). However, the rubber quality in Indonesia will need to be improved (para. 1.47) for it to continue meeting the import demand of indus- trial countries. These countries will increasingly demand the higher quality natural rubber needed for high-performance radial tires and high-value rubber goods. C. Past Performance and Emerging Constraints Overall Objectives and Achievements 1.27 The Government has intervenled in the development of tree crops by: (a) large-scale public investment programs in tree crop development and trans- migration, including public ownership and management of a substantial share of large-scale estates; and (b) a range of interventions, including control over licensing and operation of private estates and processors, restrictions on the domestic pricing and international trade of edible oils, provision of special credit facilities for production and export, provision of subsidized ferti- lizers, and provision of publicly financed research and extension services. 1.28 Investment. After 1977 public investment grew rapidly as part of an effort to channel petroleum earnings into export-oriented sectors. The level of investment, however, flactuated greatly from year to year in response to budget constraints. Investment for smallholder projects, for example, increased from Rp 40 billion in 1979 (at constant 1985 prices) to a peak of Rp 284 billion in 1982, but had fallen back to Rp 124 billion by 1987. Public investment in smallholder projects was equivalent to about 40% of the small- holder rubber and coconut GDP in 1982 and declined to an average of 1C:, thereafter. Public estate investment doubled, from Rp 216 billion in 1982 to Rp 433 billion in 1987. 1.29 Interventions. Government intervention in the edible oils trade dates back to the late 19th century. The objectives of Government policy include! providing cooking oil at a low, stable price to consumers; support- ing producer incomes; ensuding adequate returns to processing investment; and stimulating exports. The policies used to achieve these objectives have var- ied over time, but the most important at present are: (a) restricted licensing of exports of CPO, copra and CCO. These are 'supervised export products' which can only be exported with the approval of the Minister of Trade; tb) a two-tier export tax for CPO, comprised of a fixed tax and a variable tax which rises or falls in line with the world price; (c) assignment to the Joint Marketing Office (JMO) of all marketing rights for public sector (PTP) CPO and for domestic sales of a portion of private sector CPO; (d) a quota system which directs PTPs to sell a fixed quantity at a fixed price for allocation to domestic processors and for market operations ostensibly to stabilize retail prices; (e) a fixed "ceilingw price for domestically produced refined oil; (f) high import tariffs on refined edible oil; (g) licensing restrictions on CPO processing factories; and (h) a cess on inter-island trade of copra. 1.30 The Indonesian rubber trade comes the closest, in practice, to a free market cf any of the major export commodities. The Government has consciously avoided intervening in marketing and trade, to enhance competitiveness and encourage a stable supply of rubber exports. 1.31 These past Government efforts have resulted in some notable achieve- ments. These include: a planting program which has been enormous by any scale, block-planting schemes for smallho.Lders that have the potential to reach maximum yields, new settlements established in the underpopulated parts of the archipelago, and an adequate supply of edible oils to meet growing domestic consumer demand in the 1980s. 1.32 Yet the achievements have fallen short of expectations in some impor- tant areas: (a) Between 1978 and 1987, value added :rom rubber, coconut and oil palm production grew at an average rate of 3.4? p.a., compared with much higher rates of over 6? for other estate crops, 4.52 for the agricul- tural sector as a whole, and 5.2Z for the total non-oil/LNG sector. (b) Some of the major goals of Government policy have not been met. For example: (i) Market operations have not succeeded in keeping consumer cooking oil prices at or below world market levels. On the contrary, over the last few years, the domestic price of cooking oil in Indonesia has ueen generally higher than in Europe, and in 1988, the average price of cooking oil in Jakarta was 23% above an equivalent Rotterdam price, adjusted to the Jakarta wholesale level. Furthermore, the current policy regime has not significantly irnproved consumer price stability. (ii) The policy has not been successful in protecting producer returns: on average, between 1980 and 1988, world market parity - 8 - prices (adjusted to the farm-gate level) of copra have been 5.22 above domestic farm-gate prices. Similarly, in the case of CPO, the official procurement price, in border parity terms, has usually been well below world market prices adjusted to the primary producer level. (iii) Despite the goal of matching raw material supply and processing capacity, cooking oil manufacturers operate at only 282 of installed capacity; CPO fractionation and refining mills at 542 of capacity and CCO factories at 44Z of capacity. Government licensing restrictions have provided firms with incentives to overinvest, partly to lower licensing costs and partly as an attempt to capture market share. Until recently, the effective ban on copra exports, together with tight licensing controls on CCO exports, has contributed to the development of a high-cost domestic copra milling sector. Profit margins on copra crushing are twice as high in Indonesia as in Europe, and value-added in copra crushing, evaluated at world market prices, has been negative for 10 of the 12 years between 1975 and 1987. (iv) Finally, the policy framework has not been particularly success- ful in stimulating export growth. CPO exports, in volume terms, are at about the same level as in the early 1970s. Net export earnings, in dollar terms are below levels reached in the early 1980s. 1.33 Performance of Private Estates. The Government's primary objective has been to expand public estate areas as a means to develop new areas for smallholders. The private estate development has been constrained by Govern- ment policies. Between 1970 and 1987, rubber area planted by private estates declined by 0.92 p.a., although the oil palm area increased by 6.92 p.a. (com- pared to an 8.5Z increase in the oil palm area under public estates). 1.34 The private sector credit schemes (para. 1.55) have not been effec- tive in expanding the area under private estates largely because they empha- sized the rehabilitation. A total area of 168,000 ha has been planted, rehab- ilitated or intensified. 1.35 A major deficiency of the program has been that it allows a few sel- ected private investors to obtain low-cost capital and to dominate the sector. A large conglomerate group now has a total share of 65? of the cooking oil market, as well as 45? of national licensed capacity for CPO fractiona- tion/refining. Its ot.her processing investments include practically all pro- ducts based on CPO ani coconut oil, such as shortenings, margarine and soap. The group started in oil plantations in 1983 and currently manages about 20 plantation units totaling almost 100,000 ha. 1.36 Performance of Public Estate Companies (PT?s). The PTPs, while being successful in planting large areas for smallholders, are now experiencing e::cessive debt service obligations, and major operational inefficiencies. The financial performance of PTPs as a group in terms of profitability has been satisfactory over the last five years. Turnover reached Rp 1,075 billion (US$632 million) at the end of 1987, having grown at an average rate of 182 .. 9 _ p.a. over the previous five years. The large increase in sales is the result of heavy investments in Repelita III, particularly in oil palm, and improved commodity prices generally. Aggregate data show net profit margins of 15? or higher during 1983-1987 period, compared with the low in 1982 of 3.71. The return on equity of llZ in the two years, 1986 and 1987, i,, satisfactory. 1.37 The PTPs represent an enormous industry with fixed assets valued at Rp 2.4 trillion (US$1.4 billion) and total assets of Rp 3.4 trillion (US$2 billion). Asset growth in the last five years has increased at 27? p.a. On average, the debt-equ'ty ratios of the 17 tree crop PTPs in 1987 was 42:58, bu_. only seven of the 17 PTPs can be said to have healthy capital structures. The level of debt of the PTPs is a serious threat to their financial health. Present findings are that PTPs with total debt to equity ratios of 50:50 may already have debt rervice ratios (para. 6.18) of 401 or higher and are already unable to service their debts. 1.38 The combined average yield of the PTP rubber producers is 1,240 kgl ha, whereas average yields of 1,500 kg/ha are easily obtainable in the estate sector. An increase in yields could increase exports of rubber by about 43,400 tons and revenues by about US$40 million at present prices. The qual- ity of rubber has deteriorated in a number of PTPs. 1.39 While oil palm yields are generally satisfactory, only four of the PTP mills achi ve average extraction rates of 21? or higher, and only one PTP had a kernel extraction rate of 5.5Z in 1987. .'et there is no reason why extraction rates of 211 on palm oil and 5.52 on kernels cannot be achieved in all CPO mills. 1.40 PTP productior, costs are estimated to be about 15Z higher on average (resulting from higher harvesting, transport and processing costs) than the private sector, Most of the PTPs require rationalization of estate rubber production with factory location and factory expansion programs to realize transport cost savings and product quality improvements. 1.41 During the past ten years, expansion programs of some of the PTPs have made their operations far too dispersed spatially. The span of control of such operations has become unmanageable and the required supervision from headquarters-bAsed managers cannot be adequately achieved. 1 42 Performance of Smallholders. Increase in smallholder production has been primarily due to increase in area, as opposed to yield. Smallholder yields for coconuts and rubber have been essentially static: between 1970 and 1985, the coconut (copra equivalent) production per mature hectare declined by 0.2Z and rubber (DRC) production per mature hectare increased by only 0.32. This is partly because many of the planted areas remain immature; it is prim- arily because most smallholdings, planted with unselected material over a period of many years, continue to operate at a low level of efficiency. 1.43 Government assistance has reached less than 102 cf those smallholders for whom tree crops provide the main source of income, and an even smaller proportion of all tree crop producers. The low coverage rate from public investment is due to the priority accorded to new area settlement, the high administrative cost of reaching dispersed smallholders and the limits in the - 10 - financing and management of smallholder projects. However, the potential for development (and poverty alleviation) lies with the majority of smallholders who have yet to be reached. 1.44 Given the importance of tree crop development for Indonesia, it is necessary to understand the reasons for the disappointing perfcvmance of the subsector in the past and formulate a strategy for faster and sustainable growth. The report analyzes three factors that have impeded development: (a) deficiencies in the policy environment; (b) shortcomings in direct support for the private sector, especially the smallholders; and (c) problems emerging for the PTPs. These factors are discussed in detail below. Domestic Policy Environment 1.45 The implementation of the CPO procurement and trade policy has con- tributed to a trading system in which supernormal profits are reaped on inter- nal and international trade. Such profits are confined to a small group of businesses, which are interlocked with the largest cooking oil processors in Indonesia. CPO traded through the administered pricing system sells at one price and that which trades freely sells at another. The difference in these prices provides an incentive to seek economic rent. Domestic market alloca- tions and market operations are conducted by two private firms on behalf of the Ministry of Trade. Exports of CPO are licensed to four firms. It is estimated that between 1984 and 1987 these firms could have earned total cumu- lative supernormal profits of around Rp 950 billion. Tbe firms that manage this distribution system are also the largest private producers of CPO in the country and, tbrough sistet companies, control about 65Z of the total cooking oil market. A lack of competition in the market may also explain why the average 1988 Jakarta cooking oil price has been 23Z above an equivalent export-parity price. 1.46 The domestic price system, which is currently anchored in the pro- curement of C,PO at low, administered prices from PTPs, may no longer be sus- tainable, as an increasing share of the fresh fruit bunches are produced by smallholders. Lower PTP prices will be reflected in lower procurement prices for bunches which, in turn, will adversely affect smallholder incomes. The adverse impact on farmer incomes, particularly in laads to be opened up in new transm-gration siLes, will be difficult to reconcile with the objective of increasing farmer incentives and reducing rural poverty. 1.47 Rubber from Indonesia suffers from three quality defects: (a) a high content of impurities; (b) unsatisfactory physical properties of the various types and grades of rubber; and (c) lack of consistency. As a result, Indonesia SIR-20 traded at a pri.e discount of US$22 a ton over the past six years, compared to Malaysian SMR-20. Over the whole crop, the discount suf- fered by Indonesia would amount to some US$37 million a year. While some of this loss is due to high transport costs, most must be due to inferior and inconsistent quality. The response of the Government to the rubber "quality problem" has been primarily through demand-side, regulatory intervention, including a mandatory export standards system and export bans on low-quality rubber. However, relatively little can be done on the demand side, without endangering disruption of the export trade and requiring more rapid adjust- ments than either processors or small farmers can afford. - 11 - 1.48 The PTPs are required to export their rubber through the Joint Mar- keting Office (JMO) in order to reduce competition among the PTPs and to pro- vide a degree of market power in price setting. The JMO is, however, a higher-cost rubber distributor than most market brokers, and is unable to pass on proper marketing sig'ials to the PTPs to ensure proper quality control of their products or invest in processing into the types of rubber most suited by importers. 1.49 Regulatory Barriers to Entry. One of the most important determinants of private investment is the licensing policies governing access and use of public lands. According to the regulations, a total of 28 official letters of approval are required to obtain the right to develop public land, and a total of 14 letters of approval are required to obtain the right to convert forestry land to estate crop production. All these regulatory requirements are sup- posed to be accomplished within a period of 6 months to 1 year; in fact, far more time (3-4 years) is normally recuired. 1.50 Taken individually, each regulation can possibly be justified. How- ever, it is not each regulation taken individually, but the sum total of all regulations, that the investor faces. High initial investment costs, combined with a large degree of uncertainty in regard to processing time, probability of surc.ess and additional administrative costs, constitute a formidable bar- rier to entry into the sector. Employment generation is reduced in two wavs by cumbersome regulations: investments foregone, due to perceived high regu- latory costs, directly reduce employment generation; indirectly, employment generation is reduced by biasing project scale to large-scale, capital-inten- sive investments. 1.51 Even a delay in investment--let alone a loss of investment--repre- sents a significant loss to the economy. It is estimated th.at for each pro- ject of 8,000 ha delayed by four years, the social loss is equivalent to Rp 19 billion, in present value terms, over the course of the investment. If, for example, the plantings targeted under the PIR-TRANS program (para. 1.57), equal to about 400,000 ha, were all delayed by four yesrs because of diffi- culties in securing land usage permits, the direct social loss would be equal to Rp 950 billion, or nearly US$500 million. The loss in tax revenues alone- -from delayed collection of the value-added tax (VAT)--wculd more than offset the cost of a smallholder development program. 1.52 Foreign Investment Restrictions. There are additional investment restrictions, specific to foreign investment, which reduce the rate of private investment, and reduce the rate of technology transfer to the sector. The Government restricts foreign investment through the opening or closing of various sectors on the Priority List for Investment (DSP). While this list has recently been changed to a negative list, CPO milling, for example, continues to be closed to new foreign investment. 1.53 The Basic Agrarian Law of 1960 prohibits foreigners from owning or renting land, although rights of use and exploitation may be granted for 25-30 years, with a possible extension to 50 years. Inability to own land is a severe restriction for foreign firms wishing to develop any form of vertically integrated, agro-industrial enterprise. Investment requirements also require - 12 - foreign investors to form joint ventures, with initial foreign ownership lim- ited to 802 or 95Z for large export-oriented projects or those located in rural areas. For large projects, foreign ownership is to be reduced to less than 80? in 10 years and 50Z in 15 years. For investments with a long gestation period, there is little incentive to transfer technology that will achieve peak profitability only after divestiture. 1.54 Enterprise Licensing. Through the use of licensing restrictions, the Government attempts to match supply of raw materials to domestic processing capacity. A serious negative effect of these restrictions is to reduce com- petition in downstream processing. This serves to protect firms that are high-cost processors, but have obtained approved licensing capacity. This encourages firms to establish processing capacities in excess of normal oper- ating requirements in order to reduce the licensing burden. At a more local level, limits to licenses for processing serve to protect market segments for established industries and, by stifling competition, reduce the performance of regional markets. Use of industrial licensing to guide capacity development in tree crop processing shifts the burden from the private to the public sec- tor to coordinate provision of raw material supplies to downstream processors. Direct Support to the Private Sector 1.55 PBSN Credit Scheme. The PBSN credit scheme was designed to provide low-cost venture capital for private estates. A weakness of the PBSJ program is that it does not adequately address the small to medium estates, n-:luding those that require rehabilitation. Under the scheme, the Government, )y implicitly granting or denying access to low-cost credit, attempts to direct the allocation of estate crop investment funds to particular commodities, activities (upgrading vs. new investment) and regions. But such criteria are not made transparent to all investors, and the time required to process the loan application depends upon the perceived suitability of the project. These factors introduce an added element of uncertainty to investment credit allocation, although most investors do not consider credit as the binding constraint. 1.56 Another weakness of this program is that it has not been sufficiently broad-based and has allowed a selected few private investors to obtain low- cost capital. High profits are enjoyed by indLviduals able to obtain access to low-cost credit. 1.57 PIR-TRANS Program. There is growing recognition within the Govern- ment that greater private investment will be required to sustain future growth and development. Under Repelita V, the importance attached to private sector participation in the PIR-TRANS program illustrates the extent to which the Government wishes to shift the investment burden from the public to the pri- vate sector. Under the program, a private investor develops an estate and settles transmigrants and local households on these lands. The program, how- ever, focuses only on large estate operations and is predominantly in oil palm. The private estates could have even less interest in smallholder welfare than did the PTPs. Since this program at present dwarfs all other -13 - smallholder tree crop programs. it needs to be closely monitored before it can be established that this strategy can succeed in promoting tree crops for smallholders. 1.58 It is too early to draw definite conclusions about this program since little has been planted, none of the crops have come into production and a small amount of financing has been approved. However, from the design alone, it is apparent that the burden on the private sector will be higher than under a privately managed estate operation, because of the need to settle transmigrants and to provide training and extension services to small farmers. Moreover, without control over sufficient land, the investor cannot ensure an adequate supply of raw materials to maintain satisfactory factory utilization. Given the long gestation period and risk of crop failure and international price fluctuations, estate crop investmentc are already at a "natural' risk disadvantage to investments in domestic consumer goods, light manufacturing, trade and services. There is, therefore, a risk that investors will turn to other sectors if they are obliged to absorb the additional costs of smallholder development, particularly in new development areas, where there is relatively little public infrastructure to begin with. The program is expansive in ter.ns of subsidized liquidity credits, and could suffer from smallholder credit repayment problems. 1.59 Another practical problem with this program is that it involves the Government setting unit-cost standards and output pricing formulae for private enterprises. The use of standard cost estimates for project financing does not reflect actual financing requirements, which differ by firm and location. The use of a standard pricing formula imposes an additional measure of uncer- tainty on the investor, since variable costs at maturity will be, to a large part, administratively determined. 1.60 It also appears that the program, as presently designed, does not include sufficient incentives for the private investor to convert land from a project to a smallholder status. In fact, there are provisions for nucleus company management of the entire estate, if there is a lack of transmigrants or local settlers or if conversion is delayed, written into the PIR-TRANS guidelines. 1.61 Moreover, the continued Government support for both PBSN and PIR- TRANS might not anyway be sustainable due to Government's stated intention to phase out Bank Indonesia liquidity credits, in the medium term. As indicated above, there are also a number of other reasons why these schemes should be modified and closely monitored. 162 Smallholders. Two types of Government-sponsored schemes for small- holder tree crop development have been implemented. The first has been the formation of geographically concentrated Project Management Units (PMUs), under DGE. which assist smallholders to plant, replant, and rehabilitate their holdings bv providing extension advice, planting material and fertilizers, and incentive payments for labor. Bank-assisted Smallholder Rubber Development Projects (SRDP I and II) and Smallholder Ccconut Development Project (SCDP) and Government-funded Export Crops Rehabilitation and Extension Project (PRPTE) are examples of this approach. The early PMU projects begun in 1973 were considered too demandirg on scarce management resources and too slow in - 14 - meeting the objective to plant large areas for smallholders on a national scale. The PMU approach has therefore been complemented by a second approach since 1977: the establishment by Government-owned estate companies (PTPs) of block-planted tree crops for smallholders, often in newly established settle- ment areas. The PTPs transfer the land to smallholders after the trees are established, and smallholders are then responsible for maintenance and har- vesting. PTPs also operate the processing facilities and the nucleus estates adjoining smallholder area. Bank-assisted and Government-financed Nucleus Estate and Smallholder projects (NES/PIR projects) are examples of this approach. 1.63 Major concerns about NES/PIR projects include: poor quality planting and poor technical standards of the PTPs; high cost of development of small- holder tree crops; inadequate implementation, particularly in the planned settlement of smallholders and development of supporting infrastructure for the projects; limited capacity for ensuring adequate welfare for smallholders and organization of smallholder groups; poor ability to meet the objectives for training and extension of smallholders and organization of smallholder groups. It is not reasonable to expect PTPs to undertake such ancillary development for smallholders. 1.64 Block-planting schemes designed to achieve maximum yields through the application of a full package of inputs have worked well when they have been under good management and supervised by well-functioning PMUs. However, these very conditions raise concerns about the sustainability of the investment, after project assistance is removed. Another factor that could limit the sustainability of existing smallholder investments is the relative lack of economic diversification of these smallholder tree crop projects vis-a-vis the nonassisted farm enterprises. Relatively limited attention has been devoted to intercropping or development of alternative income sources for the small- holder, particularly in the NES type of block-planting schemes. In some cases, projects are so remote that there may be no market for other crops. 1.65 Given the aging structure of existing plantings, there is clearly a need for major replanting programs, particularly for rubber and coconuts. Neither the NES nor the PMU strategy is tailored to the critical need for replanting. The unselected, low-yielding stock of trees needs to be replaced with improved material. Financial incentives need to be provided so that smallholders find it feasible to replant. Smallholders are also constrained by information and technology gaps. Extension services will need to be strengthened so that smallholders can be given technical advice concerning whether, when, and how they should replant. 1.66 The lack of a reliable source of development financing could continue to plague implementation of smallholder development programs. Budgetary project allocations have been less than expected and have been released late into the budget year. The primary source of financing is credit provided through the State Commercial Banks. This applies to the PMU and PIR projects, including the new PIK-TRANS schemes. In contrast, credit for most externally- assisted NES projects has been through the Investment Funds Account. The credit system was intended primarily as a cost-recovery mechanism to collect loan repayments from project participants, but also as a means of introducing farmers to the banking system. However, recovery of existing loans (Rp 1 - 15 - trillion) is not proceeding as planned because of administrative difficulties, problems with the incentive structure for the banks, and because some small- holders have insufficient income due to substandard planting quality. Com- mercial banks are now reluctant to make new loans, as they consider such loans too risky for a variety if reasons. Furthermore, the greater the debt over- hang in a particula. tegion, the lower is the incentive to establish bank branches and encourage formal sector financial deepening. This implies that, unless major remedial measures are taken, the smallholder tree crop program could actually inhibit financial deepening. Recently, however, the Government has revised some of the guidelines for loan conversion and recovery, and has decided not to make fundamental changes to the financingicost recovery mechanism until the impact of these revisions can be evaluated. In the meantime, the Government has indicated that it wishes to carry out a study to examine other financing/cost recovery options for the medium- to long-term. The Role of Public Estate Companies (PTPs) 1.67 The advantage of using PTPs in smallholder development is their experience in planting large areas. To this end, the PTPs have been success- ful. Total plantings of tree crops by PTPs in Government-sponsored projects amounted to 155,664 ha in Repelita IV in the three major crops, compared with plantings under the PMU schemes of 51,335 ha. 1.68 The PTPs have been forced to begin work contracts arranged with DGE prior to provincial and local Government approvals of the legal status of the land. Disputes with Agrarian Affairs and Forestry departments in the Provin- cial Government have resulted in delays in project implementatio... Further- more, the delays in approval and release of budget funds for smailholder development have slowed implementation. In many cases, the PTPs have been unable to prefinance land clearing contracts, procure agrochemicals and fer- tilizers--all of which must be done in a timely and phased manner--and this has contributed to plantings being substandard. 1.69 The NES approach has been a useful interim expedient which has bene- fited from the ability of the PTPs to plant large areas of tree crops. Unfor- tunately, the PTPs have been blamed (perhaps unfairly) for such serious prob- lems as misallocation of reserve lands, delays in transfer of ownership to smallholders, inadequate attention to settler welfare, neglect of smallholder food cropping, and difficulties with credit and cost recovery. 1.70 The Department of Finance, as the sole shareholder of the PTPs, moni- tors the affairs of the PTP through the Directorate of State Enterprises (Persero). However, almost all responsibility for the PTPs and their guidance now rests within the Ministry of Agriculture, and the role of Persero has become ambiguous. At present, its responsibility as a shareholder tends to be exercised through control over budget and expenditure rather than performance. More recently, the management of one of the PTPs has been taken over by a company overseen by the Department of Finance. The impact of this change would need to be evaluated. 1.71 Management of the NES/PIR program is vested in TP3 (Tim Pengendali) directly under the Minister of Agriculture. The TKPIR (within DGE) was also created to supervise and monitor the quality of work of the PTPs ir. these - 16 - projects. This has resulted in dual and overlapping management responsi- bilities, and in practice the PTPs frequently bypass the DGE's TKPIR and report directly to the Minister. Performance criteria, as set by DGE, are difficult to ensure in such an organizational setting. 1.72 The operations of the PTPs are supervised by a Board of Commissioners composed of two to five members appointed by the Minister of Finance. Few of the appointees have the technical credentials to oversee plantation enter- prises. 1.73 The Commercial Departments of the PTPs, prior to large-scale expan- sion, were organized with emphasis on marketing, sales, procurement and con- cracts. The role of finance in the management structure of the PTPs needs greater emphasis. Other problems include the dual responsibility of the Pro- duzction Director for estate and producti3n management as well as precessing. Management of processing, process engineering and civil engineering is at times confused between the Production and Development Directors. 1.74 One problem in all of the PTPs seems to be that the headquarter grants too little authority to site management. Moreover, since site develop- ment is carried out on a budget plus margin basis, and payment of the overhead and management fee is automatic as part of the budget procedures, there is no incentive for cost savings in field or related expenditures. There are no incentives to high quality work and no penalties for substandard performance. Bonuses are paid on PTP profitability without relation to staff performance. Response to Changing Constraints and Requirements 1.75 Tree crop investment strategies and policies now need to adapt to changing sectoral constraints and requirements. Future tree crop sector investments will remain a priority, given that the continuing pressure on balance of payments will necessitate rapid growth in non-oil exports, and a faster growth in labor force in Outer Islands will require the sector to con- tinue to provide employment opportunities to nearly one seventh of the labor force, and to arrest a decline in the real wages of unskilled labor. However, domestic resource constraints will limit the volume of direct public invest- ment, and a greater share of investments must therefore come from the private sector. The incentives environment for private investments and trade will become increasingly important, as the private sector is called upon to serve as the main engine of sustainable growth. A different incentives environment will be needed from the Government. The public sector enterprises should return to their role as commercial enterprises, which, inter alia, requires consolidation of their existing investments instead of major expansions, and increase their efficiency. Scarce budgetary resources should be used for improving infrastructure and support services, and completing past invest- ments, to ensure efficient utilization of the existing capital stock. More broad-based growth, encompassing a larger number of smallholders, supported by stable financing mechanisms, will be required to provide a more sustainable and replicable basis for generating productive employment opportunities and increasing smallholder incomes. These emerging priorities underlie the fol- lowing proposed strategy. - 17 - D. Towards a Strategy for Development Stimulating Private Sector Accivity 1.76 A primary challenge will be to widen the participation of the private sector, which is seen as the only way to achieve a more rapid, sustained growth in the years ahead. This will require changes in the general policy environment, for all segments of the sector, and more effective ways of encouraging private investment. t.77 Conducive Policv Environment. The report sees the need for a major change in the pclicy enivironment to incresse producer incentives, lower con- sumer prices, improve efficiency, induce greater competition in processinig, arid increase export revenue. I1.78 Socioeconomic conditions have changed since the basic elements of present policy for cooking oils were forged in the early 1970s in the shadow of a domestic shortfall in supply. The specter of an edible oils deficit has passed. Infrastructure and communications facilities have developed, enabling a vastly improved flow of goods and price signals between Java and the Outer Islands, and CPO-based cooking oils have become widely accepted throughout all segments of society. 1.79 The report contends that it is now opportune to revise the edible oils trade regime given that inter alia: (a) the import restrictions have resulted in domc-stic consumer prices of cooking oil being 23I above the equivalent Rotterdam prices adjusted to the Jakarta wholesale level; and (b) the investment and domestic allocation restrictions have resulted in under-utilization of processing capacities, a few firms earning between 1984 and 1987 :umulative supernormal profits of around Rp 950 billion, and profit margins on copra crushing twice as high as in Europe. Six separate policy reforms needed, in order of priority, are: (a) abolition of export restrictions on CPO, copra and CCO (removal of these products from the 'Supervised Export Products' list); (b) abolition of market allocations and market operations for CPO at a controlled price; (c) abolition of the mandatory requirements for PTPs to market their CPO through the JMO, if the PTPs continue to receive either lower prices for their output and/or inadequate marketing signals from JMO; (d) removal of licensing restrictions on CPO processing; (e) abolition of the interisland copra tax; and (f) a gradual reduction in import tariffs on CCO, CPO, copra, olein and stearin. 1.80 In rubber, the report contends that supply-side intervention would be more efficient as a means of promoting quality than is the banning of parti- cular products for export. Incentives are required at the processing end, e.g., factories could be provided tax breaks, based on the amount of field- latex, or clean thin slabs, they procure directly from smallholders. Alter- natively, tax credits (on the corporate tax) could be provided for firms which retire vintage hammer mills and invest in processing equipment which utilizes field-dried sleet or latex. 1.81 The provision of smallholder rubber drying s'%eds and mangling centers has proven successful in upgrading farm level quality in certain regions. Such centers have encouraged group marketing and sales of clean thin slab. In - 18 - the future, such centers could be developed in areas where physical infra- structure is relatively good, alternative demands for labor are limited, local rubber production is ad .ate to support such a unit, prospects for sound farmer group management are promising, and financing is available. 1.82 The PTPs should increasingly market their rubber directly because of the need to ensure proper quality control, the tendency of major importers to demand long-term purchase contracts with particular estates, and the need to guide PTP processing investment into the types of rubber most suited by importers. 1.83 IM&ct. An econometric quantitative analysis of the results of a policy change is hampered by the difficulty in modeling the switch from a noncompetitive to a competitive trade regime. In qualitative terms, the direction of likely impacts can be identifieC. Liberalization of edible oils trade and investment policy will have important dynamic effects. Increased competition and efficiency could be promoted by abolishing the set of incen- tives that have encouraged the private sector to seek rents (in the order of Rp 950 billion between 1984 and 1987), develop high cost processing behind protected trade barriers, and take advantage of regulations to increase their market shares. The expected dynamic effects would be a faster rate of techno- logical transformation in production and processing, a more competitive loca- tion of factories, development of long-term contracts for export of edible oils, increased foreign investment interest in downstream and upstream edible oil processing, higher producer prices and lower consumer prices. A clear trade-off would be between the efficiency gains from a package of edible oil reforms that would be shared by producers, consumers and the economy and the loss incurred by the special interest groups who now benefit from regulatory- induced inefficiency. A deregulation of edible oils would lead to a 52 increase in farm-gate copra price and a 152 increase in oil palm price. Consequently, smallholder income from oil palm production could increase on average by more than Rp 200,000 per hectare (constant 1988 prices), and the financial and economic returns to investment could increase by nearly three percentage points. A deregulation would also lead to about a 202 decline in the consumer cooking oil prices. 1.84 Encouraging Private Investment. The main priority in reviewing the regulatory system is to streamline and redesign procedures for land alienation and forest conversion. The most desirable move would be for the Government to provide an integrated package of services to potential investors. This would include: identifying land for plantation development, obtaining land utiliza- tion certificates, satisfying forestry replacement requirements and then rent- ing public lands to private investors at competitive market rates. The land utilization period should also be extended for a far longer period, to reduce investor uncertainty and encourage a more rational phasing of private invest- ments. Government scrutiny of investments should be shifted from evaluating the technical merits of the investment to examining the financial solvency of the investor. 1.85 Although a wholesale reform of foreign investment regulations is needed, a more modest means of reducing the regulatory burden would be to establish export zones for foreign export-oriented investment. Investors - 19 - based in these zones would, under present legislation, be exempt from divesti- ture and high local equity participation requirements. By linking such zones to leased production areas, downstream processors would have assured access to primary raw materials. 1.86 An open-licensing system, with no restrictions on capacity or diver- sification options, would provide the most favorable atmosphere for techno- logical innovation and sustainable industrialization. In the near term, licensing restrictions for investment in CPO milling should be lifted and none applied for downstream processing for either rubber or coconuts. 1.87 The most urgent need for Lhe success of the PIR-TRANS program is to lessen the burden now placed on the investors in serving as development agents for smal"holders. One option might be to allow private investors to progres- sivaly divest a portion of their holdings to estate crop laborers, through distributicn of company shares, after an initial period in which investment costs are recouped. From the perspective of the private investors, employee shareholding schemes could serve to induce greater efficiency in enterprise operation and would impose a lower burden than outright transfer of productive assets. There would also be a need to clarify and streamline regulations for transfer of shares or land ownership to smallholders, and ensure proper remuneration and flow of funds to private estates for infrastructure and related activities. 1.88 PBSN Credit Subsidies. To have more impact, the PBSN schemes should be made more broad-based and not limited to just a few investor3. PBSN investment priorities should be made fully transparent and a negative list of projects that will not be financed, rather than a positive list, should be used to guide investment. The constraint to private investment is primarily regulatory rather than financial. Interest rates under the PBSN scheme should, therefore, be progressively raised to approach the opportunity cost of capital, and interest should be fully capitalized during the initial grace period. PBSN credit should be channeled through both State Commercial Banks and the private banks, and strict time requirements set for processing credit applications. PBSN credits should be secured either on the creditworthiness of the company or on the perceived profitability of the investment. 1.89 Impact. Stimulating private sector could contribute to a more rapid, sustained growth: for example, CPO production in the year 2000 could reach 3.4 million tons compared with the 3.0 million tons projected to occur under a less favorable investment climate. Just by expediting the approvals of pri- vate investment, say, 400,000 ha of oil palm, the economy could gain about Rp 950 billion, or US$860 million. Streamlining Public Estates 1.90 Guidelines detailing the responsibilities of the PTPs vis-a-vis other Government institutions and village cooperatives were issued in late 1985. The PTPs are responsible for providing technical guidance to smallholders, using farmer groups, and are to be supported by extension agencies. In addi- tion, guidelines have been issued for the chain of activities from harvesting to marketing, again specifying relationships of PTPs to farmer groups. The intent is to pass these responsibilities on to the village cooperative units. - 20 - However, the reliance on PTPs for these activities, for the development of food crops and for extension and training, is unlikely to best serve small- holder interests. The report suggests that these activities should not be the responsibility of PTPs, but should be undertaken by existing agencies in extension and food crops, or by a specialized smallholder development auth- ority. 1.91 While they can undoubtedly be used to undertake further block plant- ing for smallholders on a contract basis, particularly for oil palm, the PTPs should be encouraged to concentrate on their primary role as commercial enter- prises. This will not only help improve their financial performance but also a:iow PTPs to upgrade substandard areas, complete their existing investments and reduce large new investments. 2.92 Significant impiovemencs ir: the finazncial healtn of PTPs can be made via increased yields, improved product quality, greater factory efficiency, decreased production costs, improved internal management, and rationalization of their operations. However, the Government should consider how to increase their economic efficiency on a sustained basis. To maximize profits in a competitive market, PTPs need to operate under able managers with the autonomy and motivation to respond to competition. To improve efficiency, the Government should consider assigning functions of guidance, monitoring and some degree of regulation to one of the agencies involved with the PTPs. Such regulatory functions can provide performance standards and guidance to PTPs in corporate planning. Another option might be to create a holding company, with the individual PTPs as subsidiaries. Once such a coordinating body were in place, it would be desirable to introduce contract plans on a pilot basis for the enterprises which have been recently rehabilitated/restructured. These plans are essentially performance agreements negotiated between the Government, acting as owner of a public enterprise, and the managers or directors of the enterprise itself. Contract plans would define the enterprise's objectives, and state what resources and latitude would be provided by the Government to enterprise management so that it may accomplish the specified goals. Such plans would also set out the physical and financial indicators to measure enterprise performance. 1.93 The PTPs might also enter into joint ventures with the private sec- tor, particularly in downstream activities. This would initiate partial pri- vatization and facilitate technology transfer. In case of some PTPs, divesti- ture of their nonviable assets and/or operations may be required to enable them to stand on a sound footing. Over the longer term, the very rationale for direct public investment in areas where private sector is willing to go in and compete effectively may need review. In terms of sequencing of the future options for PTPs, contracting out, leasing, management contracts, joint ven- tures, and efforts to increase competition may be prerequisites to privatiza- tion. It is important that divestiture programs ate tailored to the potential for competition. Divestiture can take several forms, including: (a) liquida- tion, both formal and an informal method for mothballing, whereby operations are suspended, but the enterprise retains a legal and economic life; (b) pri- vatization of ownership through the sale of the firm as a going concern or of all or part of the assets; and (c) privatization of management through leases and management contracts. Divestiture programs must also deal with social implications of laycffs and plant closures, as well as develop a realistic approach to financing these costs. - 21 - 1.94 Different options will be needed for different PTPs, depending on the viability of their assets portfolio, management capacities, financial situa- tion and the competitive environment prevailing for a particular tree crop investment both with and within the private sector. 1.95 Impact. The operation of PTPs on a commercial basis will lead to greater economic efficiency by improved resource allocation and utilization. Significant improvements in the financial health of PTPs will also lead to greater tax revenues and dividends for the Government. Reaching the Smallholders 1.96 Ts -.ain challenge for the Governmnent in the future will be to develop smallholder investment programs which are suetainable, replicable and have a broad-based or widely-linked stream of social benefits. One way of improving the spread effect of public investment in tree crops is to direct more resources towards the large group of, heretofore, unassisted small- holders. The Government is clearly conscious of the need to provide better service to this group. Improvement in the services provided to wself-financ- ing' or "swadaya" farmers is highlighted in the DGE's proposed five-year plan. This will involve improvement in the availability of planting material, exten- sion services, and other agro-inputs. 1.97 The mass of smallholder can only be effectively reached through a combination of approa^hes: concentrating resources on more successful PMU- based schemes; extending such schemes to oil palm; extending low-cost, partial PMU outreach packages for smallholders on the perimeter of existing PMU schemes; providing a widespread network of nurseries supplying good quality planting material and extension advice; and providing simple technologies for on-farm processing of copra and slab rubber. In the case of rubber and coconuts, where the tree stock is aging, increased emphasis to replanting would be appropriate. Organizational (para. 1.105) and financing (para. 1.112) mechanismE dill be needed to sustain a major replanting program. Smallholders will need technical advice which the extension services must provide, and an adequate availability of inputs which the private sector can provide; a case in point is the network of private nurseries. The Government should make the inputs available only if the private sector cannot. Settle- ments in new areas could be done through contractors, who could be PTPs, pri- vate estates, or firms specializing in land clearing and tree crop planting, engaged on purely commercial terms. 1.98 The above approach wouid require annual public investment costs of about Rp 60 billion, and create a total of 164,000 man-years of employment. From the suggested investment package, a total of Rp 700 billion of value added would be generated. In the aggregate, the ratio of benefits to costs from these investments would be about 1.8:1. 1.99 While such new investments would be most desirable, the Goverrment cannot afford to neglect those that have been ;rIdertaken during the past decade. Selective upgrading, on an area-by-area basis, remains an important means of maximizing the returns from past investments. The investment con- solidation should include: construction of trunk and feeder roads in existing project areas, together with formulation and implementation of a plan for O&M - 22 - of existing road systems in smallholder areas; provision of land titles as rapidly as possible to as many smallholders as can be reached; provision of general credits to the private sector to establish processing facilities, where these are required to complete investments; and development of small- scale processing centers for copra crushing and rubber coagulating, to raise quality and increase value-added at the farm-gate level. In the case of ear- lier transmigration projects, second-stage development entailing tree crop solutions would be needed to ensure that the potential benefits of these projects are realized. 1.100 Research and Extension. Attempts need to be made to quantify the returns to investmer.t in particular research programs, set iriorities and to ensure an efficient use of resources. More research needs to be applied and adaptive, i.e., probiem-oriented rather than compartmentali=dd by disciplines And the personal inclinetions of scientists involved. More research is needed on the profitability of the whole farm enterprise and not merely on productivity. There are, for example, opportunities to increase farm incomes through improved husbandry, provision of higher yielding varieties of suitable intercrops, or changing crop or crop/livestock mix where market considerations make this desirable. While small farmers aversion to excessive risk is well- reccgnized and rational, too little is known about the sort of returns they require in order to invest in purchased agro-inputs or how the farm family allocates its time. A better understanding of the farming behavior gained from well-focused socioeconomic studies is essential to design appropriate field trials which take into account the actual conditions faced by smallholders. Efforts to adapt and transfer already available technology should take pzecadence over research per se, particularly, in the case of coconuts and rubber. However, given Indonesia's significant role in world production and markets for these commodities, continued long-term research will be vital to remain internationally competitive. 1.101 There is a real need to provide as many smallholders as possible with technical advice. However, given the likely budget constraints, the intensity of advisory input will have to vary according to the nature of the program and the most critical needs of the target beneficiaries. 1.102 At present, the nucleus estates in NES/PIR schemes are responsible for teaching husbandry and harvesting methods to participants, although in practice little attempt has been made to explain the husbandry procedures which settlers have carried out as paid laborers. Advice on food crops is the responsibility of staff from the Directorate General-Food Crops and a number of food crops extension workers have been assigned to NES/PIR projects to assist PTP staff. The allocation of staff has, however, often been delayed and nowhere has it been possible to post an adequate number of personnel. In all PHU schemes, participants have received technical advice from the PMU field staff and, in the fully structured SRDP and SCDP projects, particular effcrts have been made to train staff in both technical and extension methods, and also to provide training courses for project participants. For all other smallholders with tree crops, advice is provided by the provincial estate crop advisory service (DISBUN) which is guided in technical matters by the DGE but is administered as a part of the national integrated agricultural extension service. - 23 - 1.103 In view of the fact that the unassisted sma1lholders operate in a mixed farming system, the most cost-effective way of reaching these small- holders should be through a general extension service with a broad national coverage, which is already being put in place. The national program also has a large cadre of food crop staff at the field level who are better trained than DISBUN colleagues, and who could also be trained in the key estate crops in their own particular area. The major challenge for DGE in the case of the 'partially assisted" and the "dispersed nursery* programs will be how to train these field staff more effectively. The shortage of subject-matter special- ists could be overcome by making use of the expertise resident in PHUs, where they are adjacert to the rural extension centers, and not by using cther DISBUJN staff, as now happens. 1.104 The present scope cf DCE responsibilities for private and public sector plantations and all smallholder develooment projects as well as the policy and regulatory functions, are too extensive. There is no question about the magnitude of the task facing the Government in trying to reach the mass of smallholder producers. To gear up for the job, the Government may wish to create a specialized unit to oversee the task either by strengthening DGE or consider an option of setting up a separate authority. Such a specialized function will become increasingly important as the volume and dispersal of smallholder tree crop activities increase. Whatever organizational form is adopted, it would be appropriate to give the unit full responsibility for formulating and overseeing the implementation of a comprehensive strategy for reaching the unassisted smallholders. This would need to cover the full range of existing supporting services as well as new approaches to emerging problems, such as the need for extensive replanting and improved processing and marketing. 1.105 The report examines the option, which the Government may wish to consider, of establishing a specialized agency, which once established, could also be used to channel specific tax/development cess or other revenues earmarked for smallholder development programs. However, several issues would need to be resolved in determining the appropriate nature and functions of such an agency: (a) It would have to be decided whether the unit or agency would handle all estate crops or only some. (b) The locus and level of responsibility of the agency would need to be determined. It could essentially be an implementation agency and not a policy-making body. Effectively, it would mean separating out a part of DGE--either as a subdivision of DGE or as a separate auth- ority--because of the importance which the Government gives to small- holder tree crop development and the size of the program that is needed. The authority could have separate implementation units required for replanting, new settlement, second-stage transmigration, etc. (c) Careful consideration would have to be given to the division of responsibilities between the specialized unit/agency and existing institutions, particularly the general extension service. It would be possible for the agency to continue the technical advisory service - 24 - now provided through PMUs, but perhaps also provide technical backstopping and training for estate crops through the network of dispersed nursery units located near the rural extension centers. 1.106 Impact. Increased support to a larger number of smallholders who presently have low yields and holdings with unselected planting materials would simultaneously help meet the objectives of growth, poverty alleviation and increased employment opportunities. The net present value of financial returns to rubber smallholders could increase from Rp 1,541,000 per hectare to Rp 2,383,000 per hecta-e, and the net present value of economic returns could i.ncrease from Rp 2,216,000 per hectare to Rp 3,126,000 per hectare, (in constant 1988 prices), by use o' improved planting material, some fertilizer and limited extension advice. Improved coconut. yields for smallholders can ensure that CCO production will increase from 0.8 million tons in 1987 to 1.1 million tons by the year 2000, instead of stagnating. Indonesia can also become a more consistent exporter of coconut oil instead of a sporadic importer/exporter as in the past. 1.107 Replacing the aging stock of rubber at a rate of about 40,000 ha p.a. can increase potential output from 1.20 million tons in 1987 to 1.76 million tons in the year 2000. The potential output decline r r 2000 can be reversed by increasing the area to be planted and/or using improved planting material that will give higher yields. The economy can gain about US$37 million p.a., a 3Z increase in the current export revenue, just by improving rubber quality. Thus, a more sustainable, replicable and efficient growth in the sector is feasible if a large number of smallholders are reached through Government programs. 1.108 Need for Stable Financing. A steady and stable source of development financing is needed for smallholder development programs. In the immediate future, there is a need to ensure that the flow of financing for existing smallholders is maintained, and to break the present impasse over loan recovery. The longer-term need will be to provide a wide network of rural financial institutions, in line with the October 1988 financial sector reforms. The goals would be to mobilize rural savings, to provide a broad range of financial services, including credit for on-farm investments possibly including tree crops, and ultimately to increase rural incomes to the point where smallholders have sufficient equity to borrow commercially for tree crop investments. 1.109 However, such a process will take a long time. In the meantime, until the formal financial sector in the countryside is developed, the Govern- ment may wish to consider indirect cost recovery/financing options, which can reduce collection costs and facilitate a stable source of revenue for a broad package of smallholder development schemes. 1.110 The report considers several alternatives. One option would be to treat smallholder development programs as a public good and finance them from general Government revenues or FTP taxes. However, this would not provide a stable source of financing, particularly in times of more general budgetary austerity. There might also be objections from an ecuity viewpoint to financ- ing relatively capital-intensive investments, with a high private-benefit content, from general revenues. - 25 - 1.111 A less distortionary form of indirect taxation would be a land tax or an income tax surcharge on ussisted farmers but these are not currently fea- sible because of the small tax base, unequal coverage and incomplete valuation systems. A surcharge on the VAT would discriminate against the edible oils, and domestic rubber manufacturers, since rubber for export is exempt from VAT. Furthermore, it would require about a doubling of edible oil VAT rates to meet required budgetary obligations for smallholder tree crop development schemes. This would violate VAT tax equalization objectives and would heavily penalize domestic consumers. 1.112 The report concludes that a revenue enhartcement measure such as a modest export tax/development cess o;; rubber could be the best choice for indirect cost recovery. A tax tate of 4-702 would be an optimal export tax, in the sense that the sum of producer, consumer surplus and tax revesues would be greater with than without the tax. The heaviest tax incidence would be on domestic producers, of which smallholders comprise the Largest group. The administration und collection cost would be very low. Application of the tax would partially redress distortions to downstream processors for the domestic market, who face a higher tax burden due to nonexemption from VAT. Finally, at a modest tax rate, adequate revenues could be generated to fully recover the costs of a smallholder development program. 1.113 A simulation of the dynamic effects of an export tax shows that a 5Z tax on rubber would generate between Rp 63 to 65 billion worth of tax revenues in 1995, while smallholders would lose Rp 49 billion (1988 terms) and estate producers Rp 1' billion of gross revenues. Domestic consumers, on the other hand, would gain approximately Rp 3 billion in consumer welfare from lower domestic prices, even after accounting for the higher world market prices. Col.ection costs would be trivial for a tax in this range. 1.114 An export tax should not be applied across-the-board on all tree crop commodity exports. As a world market price-taker, with fairly elastic (for a food item) domestic demand and inelastic supply, an export tax on edible oils could be highly d:stortionary. Such a tax would have little effect on domestic supply but rapid domestic demand growth would reduce exportable surpluses and hence reduce tax revenues. This increase in domestic demand could be offset by imposition of a domestic consumption tax on edible oils, but this could cause the same problems raised earlier with VAT surcharges. 1.115 Revenue enhancement measures such as a rubber export tax deserv- consideration by the Government, since it is an optimal export tax, leading to a welfare gain. The sensitivity of supply response to Rupiah devaluation indicates that an export tax, if scheduled in relation to currency movements, can minimize the negative effects of taxation on supply response. It could also be phased in with the lifting of an export ban on low quality (SIR 50) rubber. A reliable channeling mechanism would be needed to ensure a clear audit trail from revenues to expenditures, and a lower risk of fund diversion to nonsmallholder-based activities. Priorities for a tax-based grant could be for provision of planting material and some fertilizer to smallholders, particularly those who wish to replant rubber and coconuts. In the case of oil palm, the channeling bank arrangement, which uses the Investment Funds Account to provide Goverrment loans to smallholders, could be continued. - 26 - Incentives Determining Tree Crop Practices and How Proposed Policies Will Induce a Change in Behavior 1.116 Despite the sound financial and economic returns to investment in tree crops, a large number of smallholders have not reaped the benefits because they have not been assisted by the Government-sponsored schemes. Yet these smallholders can increase the net present values of financial and eco- nomic returns to investment by Rp 842,000 per hectare and by Rp 910,000 per hectare, (in constant 1988 prices), respectively, by increasing their yields through improved planting material, some fertilizer and limited extension advice. These inputs, if available, would close the present technology and information gaps for these smallholders. A specialized unit or agency to oversee smallholder ievelopment is suggested so that this unit can further formulate and develop comprehensive strategies to assist smallholders, particularly with respect to replantiing programs. 1.117 Private sector participation in tree crop development has been hin- dered by regulatory barriers. Streamlining of procedures for land alienation and forest conversion could go a long way in stimulating private investment. The Govturrment, through improved land use planning and allocaticn, could iden- tify land for plantation development, rather than putting the onus on the private sector to ensure land suitability for tree crops, which in turn entails several approvals by different Government agencies. 1.118 While the immediate priority for PTPs is to streamlinie and improve their efficiency, allow them to operate as commercial enterprises and limit their expansion in downstream activities to joint ventures with the private sector, the Government will, over a longer term, need to review the very rationale of direct public investment in areas where the private sector is willing to go in and compete effectively. The Unfinished Agenda and Priorities for External Assistance 1.119 This report has identified some information/data gaps, and priority areas which require a more in-depth review than undertaken in this sector report. These are: (a) Complete and consistent data bases will be needed to underpin improved policy analyses and planning within the Government; (b) To ensure land-use and environmental sustainability, there is a need for land reclassification and improved siting of tree crop development. Detailed slope and soil studies will be needed to assess how much land is suitable for tree crops and consequently whether intensive or extensive approaches should be followed; (c) The priorities, organization and delivery of research and the dissem- ination of results needs to be reviewed. This will become increas- ingly important as the Government shifts its emphasis towards the unassisted smallholders and their replanting needs. Well-focused socioeconomic studies will be needed to better understand the small- holder investment behavior (including the incentives needed to induce smallholders to replant). A review of the extension services will - 27 - also be needed to assess how best to reach a larger number of small- holders; and (d) There is a need to review the constraints, potential and strategies required to develop the beverage and other estate crops not covered in this report. External donors could assist the Government with technical assistance in these areas. 1.120 There is scope for further financial assistance, either through sub- sector policy-based lending operations or discrete investment projects with major policy content. Three possible investment operations could provide support for: (a) smallholder development, focusing primarily on the need for replicability and risk diversification; (b) completion and consolidation of past and existing investments; and (c) restructuring of public enterprises, to enable PTPs to conform to their changing role of commercially viable, economi- cally efficient and competitive enterprires. - 28 - II. TREE CROPS IN THE ECONOMY 2.1 Tree crops, in the context of mixed-cropping and mixed-farming sys- tems within which smallholders operate, are well-poised in the economy to provide the same momentum of agricultural growth in the Outer Islands, as mono-cropped paddy has done on Java. Investments in rubber, coconut and oil palm are economically sound with economic rates of return (ERRs) ranging between 18Z and 28Z. These are roughly comparable with ERRs for small-scale manufacturing, and remain robust at current and projected prices and prevailing exchange rates, even when tested against the effects of a substantial decline in output prices or cost overruns (paras. 7.25-7.28). The tree crop subsector can not only continue to contribute to a decrease in the economy's dependence on oil as a source of foreign exchange, but also simultaneously meet the objectives of increasing employment opportunities and decreasing the incidence of poverty. When appropriatel3 sited and well managed, tree c-op production can utilize, and in fact, stabilize marginal land in critical areas for which few other sustainable land uses may be available. The primary challenges for the subsector will be to: (a) widen the participation of the private sector in conjunction with changing the role of public sector; (b) support a more broad-based, replicable growth, encompassing a larger group of smallholders, where the untapped potential lies; and (c) retool some of the policies and instruments to facilitate a more sustainable and efficient growth. These challenges can be easily met, given the Government's track record in s"ccessful management of macroeconomic policies and its ability to undertake a series of structural reforms, as demonstrated in the adjustment era commencing 1982. 2.2 Contribution to GDP. Over the past decade, all estate crops 1/ contributed about 172 of agricultural GDP; rubber, oil palm, and coconut alone have contributed about 52. However, while value added in these three crops rose steadily, its growth did not keep pace with the other estate crops, the overall agriculture sector, or the non-oil economy as a whole. As indicated in Annex Table 1.1, GDP attributable to these three crops grew at an average rate of 3.41 p.a. between 1978 and 1987, while that for other estate crops grew at over 6Z p.a., the agricultural sector GDP as a whole grew at 4.5? p.a., and total non-oil/LNG GDP grew at 5.2X p.a. over the same period. Consequently, the contribution of rubber, oil palm and coconut to total estate crops declined from 36Z in 1978 to 29? in 1987, and their contribution to agricultural GDP has in recent years stabilized at around 5?. 2.3 The aggregate figures mask important differences between the crops. Of the three crops, coconut remained the largest source of value added, but it expanded the most slowly, with 1.7Z p.a. growth. Oil palm GDP grew from a small base in 1978 at a rate of lOZ p.a., until by '.987 its GDr contribution nearly equaled that of rubber, which grew at only 2.42 p.a. over the period. 2.4 Area and Production. In 1986, rubber, oil palm, and coconut together occupied about 6.6 million ha, which represented over 70Z of all area planted in estate crops in Indonesia. Coconut alone occupied 3.1 million ha, with 1/ "Estate crops" refer to ruDber, oil palm, coconut, tea, coffee, cocoa, sugar, cotton, tobacco, cloves, pepper, etc., although a number of these crops are smallholder-dominated and not grown. on plantations or estates. - 29 - rubber a close second at nearly 2.9 million ha. Oil palm area was far less, at about 600,000 ha. Over 802 of total area planted in the three crops was located on the Outer Islands, with less than 107 of rubber and oil palm area and 30X of coconut area located on Java and Bali (Annex Table 1.4). 2.5 As Table 2.1 shows, the area under all three crops grew steadily between 1978 and 1986, but oil palm area (partly due to its small base) grew much faster in percentage terms--nearly 12! p.a. versus about 32 for both rubber and coconut. Smallholders predominate in rubber and coconut, with 822 and 982 of the area, respectively, in 1986. In contrast, only 201 of oil palm land is cultivated by smallholders, up from almost 01 in 1978. Table 2.1: TOTAL AREA ('000 ha) Average annual 1978 1982 1986 growth (1978-86) (Z) Rubber Smallholder 1,871 2,036 2,367 3.0 Estate 442 448 507 1.7 Total 2,313 2,484 2,874 2.8 Oil Palm Smallholder 0 9 130 - Estate 250 311 477 8.4 Total 250 320 6C)7 11.7 Coconut Smiallholder 2,454 2,809 3,057 2.8 Estate 52 43 56 0.9 Total 2,506 2,852 3,113 2.8 Total 3 Crops 5,069 5,656 6,594 3.3 Smallholder 4,325 4,854 5,554 3.2 Estate 744 802 1,040 4.3 Source: DGE. 2.6 Production has increased roughly at the same rate as area for all three crops since 1978, with rubber and coconut growing about 2.51 p.a. and oil palm about 11.5!. Rubber production in 1986 was 1.1 million tons (dry rubber), coco:nut was just under 2 million tons (copra equivalent), and oil palm 1.4 million tons (CPO). - 30 - Table 2.2: TOTAL PRODUCTION ('000 tons) Average annual 1978 1982 1986 growth (1978-86) (2) Rubber (DRC) Smallholder 612 586 763 2.5 Estate 272 314 350 2.8 Total 884 900 1,113 2.6 Oil Palm (CPO) Smallholder 0 3 53 - Estate 501 884 1,297 11.1 Total 501 887 1,350 11.6 Coconut (copra equiv.) Smallholder 1,553 1,587 1,950 2.6 Estate 26 18 25 0.4 Total 1,579 1,605 1,975 2.5 Total 3 Crops 2,964 3,392 4,438 4.6 Smallholder 2.165 2,176 2,766 2.8 Estate 799 1,216 1,672 8.6 Source: DGE. 2.7 Although production has increased significantly over the decade, the growth in the case of smallholder dominated crops (rubber and coconuts) has been primarily due to the increase in area, as opposed to yield. Smallholder yields for both crops have been essentially flat over the decade, and indeed the average yield for both crops has not increased since 1970. Between 1970 and 1986, the coconut (copra equivalent) production per mature hectare has declined by 0.2Z p.a., and rubber (DRC) production per mature hectare has increased only by 0.32 p.a. for the smallholder sector. This is partly because many of the planted areas remain immature; it is primarily because of the mass of unimproved smallholdings, which dominate the smallholder tree crop subsector are planted with unselected material. On the other hand, during the same period (1970-1986), coconut (copra equivalent) production per mature hectare increased by 4.42 p.a. in public estates (declined by 0.4Z on private estates), and rubber (DRC) production per mature hectare increased by 3.62 p.a. in public estates (increased by 2.42 in private estates). In the case of oil palm (CPO) production per mature hectare, the increase in public estates - 31 - was 1.6Z p.a., compared to 5.9Z increase in private estates. (See Annex Tables 1.5-1.11 for mature and immature area, production and yield for small- holders, public and private estates). 2.8 Export Earnings. Rubber continues to vie with textiles as the single largest contributor of non-oil/LNG foreign exchange earnings, and, with the fall in coffee prices over the last few years, rubber has been by far the largest contributor of agricultural export earnings. Rubber-, oil palm-, and coconut-based products currently account for 60? of estate crop exports, 482 of total agriculture exports, and 15? of total non-oil/LNG exports. However, export earnings from the three commodities have fluctuated widely, due to movements in both export volumes and world prices. 2.9 Over the past decade, exports of these commodities have increased less steadily in volume terms, in contrast to other estate crop commodities, for which volumes rose fairly steadily from 574,000 tons in 1978 to 1.2 mil- lion tons in 1986, as indicated in Table 2.3. Exports have varied between a low of 1.4 million tons in 1984 to a high of nearly 2.7 million tons in 1988. Rubber exports have been the most stable, varying only between 860,000 and 1.1 millior, tons. The largest fluctuations have been in the exports of oil palm- based products, which have been influenced by a complex set of Government regulations affecting trade, domestic allocations and fixed prices (Section IV). These export volumes have experienced an off-trend variation of 0.47, higher than that for coconut (0.35) and rubber (0.11). Table 2.3: EXPORT VOLUMES ('000 tons) Coefficient 1978 1980 1984 1986 1988 of variation Products derived from: Rubber 862 956 1,009 958 1,159 0.11 Oil palm 421 503 262 725 1,008 0.47 Coconut 335 163 181 388 531 0.35 Subtotal 1,618 1,622 1,452 2,071 2,698 0.23 Other estate crops 574 647 1,161 1,225 n.a./a Total Estate Crops 2,192 2,269 2,613 3,296 n.a. La Not available. Source: DGE. 2.10 Export unit values fell dramatically over the decade. From the peak period of 1979, to 1987, the unit value for rubber exports fell 46?, for 7almr - 32 - oil 682, and for coconut (primarily copra meal) 422. Prices for all three commodities have recovered in 1988, but to nowhere near the levels of the late 1970s and early 1980s (paras. 4.3 and 4.4). 2.11 Although there have been strong fluctuations, the net effect of the movements in volumes and prices has been a general downward trend, until 1987, in the total export earnings from these commodities. Total export earnings peaked at US$1.4 billion (1983 constant prices) in 1980, falling thereafter to levels well below that until 1988, when conmodity prices rose substantially and export earnings rose back to US$1.2 billion. Export earnings from other estate crop commodities and from the overall agricultural sector have been volatile as well, but the differences between peak and trough have been less. 2.12 In relative terms, the contribution of rubber, oil palm, and coconut products to total estate crop export earnings has varied between 612 (1980) and 412 (1986), with the share rebounding to 602 in 1938. As a proportion of agricultural export earnings, the three commodities, contribution has been decreasing, from a 47-597 range in 197S-82 to a 33-452 range in 1983-87. Due, in large part, to the tremendous growth in the exports of manufactured goods, the contribution of these three commodities to total non-oil/LNG exports fell steadily from 262 in 1978 to 152 in 1968 (Table 2.4). Table 2.4: EXPORT EARNINGS (US$ Million, 1983 Constant Prices) Coefficient 1978 1980 1984 1986 1988/b of variation Products based on: Rubber 859 1,105 965 617 926 0.19 Oil palm 257 21-5 125 -,-I 250 0.35 Coconut 41 51 53 31 102 0.57 Subtotal 1,157 1,402 1,143 776 1,278 0.19 Other Estate Crops 898 912 1,006 1,100 836 0.19 of which coffee 589 633 575 697 393 0.25 Total Estate Crops 2,055 2,314 2,149 1,876 2,114 0.16 Total Agriculture /a 2,480 2,388 2,541 2,350 2,653 0.14 Total Non-Oil/LNG 4,387 5,956 5,974 5,556 8,257 0.21 Rubber, Oil Palm and Coconut as: I of Estate Crops 562 612 532 412 602 2 of Agric. Exports 472 592 452 332 482 : of Non-Oil/LNG 26Z 242 19: 14Z 152 /a Excluding timber. /b Preliminary figures from Bank Indonesia. Source: Central Statistical Bureau (BPS). - 33 - 2.13 The above figures do not, of course, reveal the net impact of the commodities on Indonesia's trade balance. Domestic production of the commodi- ties substitutes directly for imports, with the result that the value of imports has averaged only 32 of export earnings over the decade. Although it is difficult to determine the exact value of foreign exchange savings from this import Rubstitution, one approximation is the relative weight of domestic consumption versus exports. Domestic consumption of rubber is about 102 of exports, indicating that foreign exchange savings are in the order of 102 of rubber export earnings. For palm oil, import substitution is much larger, particularly given the rapid increase in the domestic demand for palm oil (about 172 p.a. during 1970-86 period). The actual foreign exchange savings from coconut are higher than the relative volume of exports versus domestic consumption suggest because exports consist primarily of low-value meal, while domestic consumption is largely3 of high-value fresh coconut and oil. 2.14 Direction of Trade. In 1978, Singapore was the principal market for Indonesian rubber, with the United States second, but over the past decade the US has emerged as the major Indonesian export market. In 1987, the US market absorbed 462 (by value) of exported rubber, while Singapore absorbed 202. Since Singapore is a transshipment port, an undeterminable part of its share also goes to the US market, which means that the US probably now absorbs over half of Indonesian rubber exports. In 1987, no other market accounted for more than 5S of exports, and Europe as a whole accounted for only about 102. 2.15 The markets are different for palm oil and coconut products. In 1978, Iraq was the biggest market for Indonesian palm oil, with other large customers being Europe, India, Pakistan and Kenya. The US absorbed 81 of palm oil exports in 1978. By 1987, European markets dominated, with the Netherlands alone accounting for 302. The US market absorbed less than 12 of teCf1 p r TAn.vno44- nal1 nil eYports in 19R7. sinre -78. 65-952 of exports of copra meal have been to West Germeny, with the only other large customer being the Netherlands (5-25Z). Significant amounts of coconut oil exports have been allowed only recently, in 1985, 1987, and 1988, with markets being primarily thle onthlrea ends, tl, and S19.gap8mr.ma 2.16 Employment. The 1983 agricultural census classified 11.5 million households as tree crop households (i.e., includlng those for whom tree crops are important but not the main source of income). Between 7 and 8 million of these households are estimated to be engaged in production of rubber, coconut and oil palm. Of these 7-8 million smallholder households, there are about 700,000 rubber households, 42,000 oil palm households, and 1.8 million coconut households, for whom these crops are a main source of income. As the table below indicates, about 8Z, or 219,000 of these households have been assisted by Government-sponsored tree crop schemes, which focused primarily on new plantings in new settlement areas. - 34 - Table 2.5: SMALLHOLDER HOUSEHOLDS ('000) Assisted (2) Unassisted (2) Total Rubber 97 (14) 620 (86) 717 Oil palm 42 (100) - (-) 42 Coconut 80 (4) 1,749 (96) 1,829 Total 219 (8) 2,369 (92) 2,588 Source: DGE, BPS. 2.17 Although translating these figures into equivalent full-time employ- ment is difficult, it is clear from area expansion data (Table 2.1) that the crops have generated steady growth in employment over the past decade.. It is estimated that the crops provided (for smallholders and estate workers together) an equivalent of about 2.5 million full-time jobs in 1978, growing to about 3.2 million in 1986 (Table 2.6). The largest increase over the decade in absolute terms was provided by rubber (420,000 new jobs), but in percentage terms, oil palm employment grew by far the fastest, at nearly 16? p.a., providing 124,000 new jobs. Coconut cultivation, which is the least labor-intensive of the three crops, generated the equivalent about 181,000 new full-time jobs over the period. 2.18 Based on the available data, it appears that employment in the culti- vation of these crops has grown faster than both agricultural and total employment on both Java and the Outer Islands. As Table 2.6 indicates, between 1980 and 1985, total employment in these three crops grew at about 3.8? p.a., higher than the 2.52 growth rate of the entire labor force, and slightly above the 3.42 p.a. growth of labor force in the Outer Islands. In relative tem-. tho rrnps provided about 201 of Outer Islands agricultural employment and about 102 of countrywide agricultural empioyusent in 1Q85. In the same year, the crops generated about 122 of total Outer Islands employment and 51 of total employmeznt in Indonesia. Rubber alone accounts for about two- thirds of employment from these crops. It is estimated that women constitute about one-third of the labor force in these crops. - 35 - Table 2.6: EMPLOYMENT /a ('000 workers) Average annual growth (Z) 1978 1980 1985 1986 (1980-85) Rubber 1,735 1,788 2,081 2,156 3.1 Oil palm 88 100 209 212 15.9 Coconut 627 668 704 808 3.5 Subtotal 2,449 2.555 3,084 3,176 3.8 - of which on Outer Islands 2,138 2,228 2,696 2,778 3.9 Outer Islands 18,351 21,638 3.4 - of which agric. 11,717 13,656 3.1 Total labor force 51,191 57,805 2.5 of which agric. 28,040 30,777 1.9 Rubber, coconut, oil palm as: Z of Outer Islands (Total) 12.1Z 12 ,JZ I of Outer Islands (Agric) 19Z 19.7Z Z of Total Labor Force 5.0? 5.3Z Z of Total Agric. 9.1Z 10.0Z /a A full-time job is assumed to be equivalent to 250 man-days of employment a year. The employment generated by tree crops is assumed to be 0.75 man- years/ha/year for rubber, 0.35 for oil palm and 0.25 for coconut. Source: BPS (ad>usted), DGE, and World Bank Stiff estimates. 2.19 Poverty Alleviation. The incidence of poverLy In Indonesia (as defined by household expenditures too low to meet a set of "basic needs") declined on both Java and the Outer Islands from 1970 to 1980. Over this period, poverty among rural inhabitants of the Outer Islands fell from about 452 to 30Z. During the early 1980s, however, as poverty continued to decline in urban and rural Java and in the urban Outer Islands, the trend reversed for the rural inhabitants in the Outer Islands, in part because of the influx of transmigrants during that period. Per capita consumption in the rural Outer Islands fell 1.6Z p.s. between 1980 and 1984, with the result that in 1984 the incidence of poverty had risen to approximately 351, equal to about 17 million people (Table 2.7). - 36 - Table 2.7: REGIONAL INCIDENCE OF POVERTY (Z) 1970 1980 1984 Java Urban 56 21 14 Rural 57 53 45 Other Islands Urban 41 17 11 Rural 44 30 35 Indonesia Urban 51 20 13 Rural 59 45 41 Source: V.V. Bhanoji Rao, World Bank (1984 and 1986); Poverty defined as consumption/capita/month (1980 terms) of Ro 5,429 (Java-Rural), Rp 6,462 (Java-Urban), Rp 5,733 (Outer Islands-Rural), and Rp 6,471 (Outer Islands-Urban). 2.20 Cultivation of tree crops is associated with a low incidence of pov- erty, and tree crops are especially important for poverty nlleviation in areas where soils are not suitable for food crops. Although the following figures are cited for Indonesia as a whole, they are not substantially different for the Outer Islands. In 1984, the average smallhol.der rubber household had a total annual income of about Rp 970,000, and had tctal expenditures of about Rp 840,000, well in excess of the estimated poverty line of about Rp 600,000 2/ and about equal to the average household expenditure for rural Indonesia. A detailed income survey for that year suggests that perhaps 15-202 of rubber households fell below the poverty line. This survey also showed a strong correlation between land holdings and income (although the return per hectare drops substantially as the size of land holdings increases). Farmers owning less than one hectare (6Z of total households) had an average income of Rp F70,000 (implying expenditures close to the poverty line), while those with 1 to 3 ha (442 of total households) had average incomes of Rp 870,000, with expenditures probably well above the poverty line (Annex Table 1.2). 2.21 Of total income in smallholder rubber households, rubber cultivation alone generated about Rp 420,000, or 40?, while other farm-related work and off-farm sources each generated another 30Z. 2.22 In 1984, coconut smallholder hotuseholds in Indonesia had average incomes of Rp 920,000 and average total expenditures of about Rp 800,000, again well above the poverty line. Coconut cultivation provided a much 2/ Equal to 1980 Outer-Island rural poverty line cited in Table 2.7, inflated by essential commodity price index and multiplied by an average household size of 4.8 members. - 37 - smaller proportion of income, however, with only about Rp 180,000, or 20? of the total. Other farm-related work generated over 45? of total income, with off-farm sources contributing about 35Z. The data on income and land distri- bution for coconut farmers suggest that there are pockets of poverty among smallholders in certain provinces, such as East Timor, East Nusa Tenggara and Southeast Sulawesi. 2.23 The incomes of both rubber and coconut smallholder families can be compared with average incomes for all 'households and specifically for transmi- grant households in Outer Islands. Table 2.8 shows that in 1984 about one- fourth of nontransmigrants (i.e., locals already resident) in receiving areas in these provinces had incomes below Rp 600,000/year, while in 1985, over one- half of the transmigrant families (i.e., new arrivals to receiving areas--the majority of whom do not cultivate tree crops) fell below the poverty line. Table 2.8: ANNUAL HOUSEHOLD INCOMES: TRANSMIGRANTS AND NONTRANSMIGRANTS IN RURAL AREAS OF RECEIVING PROVINCES (Z households) Under Under Under Under Under Rp 240,000 Rp 360,000 Rp 600,000 Rp 900,000 Rp 1,200,000 Nontransmigrants (Locals) (1984) 1 4 24 48 27 Transmigrants (1985) 6 20 50 26 13 Source: 1985 Transmigration Survey, BPS; 1988 Transmigration Report, World Bank. 2.24 Schemes to promote wider and more intensive tree crop cultivation can be a vehicle both for lifting nontree crop households out of poverty and for keeping traditional tree crop farmers above the poverty line. Over 100,000 farmers (most of whom were not previously tree crop cult-vators) have been assisted to plant rubber, coconut and palm oil under Government-sponsored NES/PIR 3/ schemes in the Outer Islands. Another 100,000 or more farmers (most of whom were already cultivating tree crops) have been assisted under PMU-type 4/ schemes (Annex Table 1.3). Although the quality of implementation has varied substantially, the incomes of farmers benefiting from reasonably well managed projects can increase substantially. Based on models and given current price projections, at crop maturity, rubber cultivating households can expect to earn net annual incomes (1984 terms) from Rp 1,000,000 to 3/ Externally-assisted Nucleus Estate and Smallholder (NES) projects and Government-financed PIR projects, where the Government-owned estate companies (PTPs) establish block-planted tree crops for smallholders (para. 7.4). 4/ Geographically concentrated Project Management Units (PMUs) are established to assist smallholders. - 38 - 1,500,000/ha for approximately 195 days of labor, depending on the level of inputs and harvesting practices. For coconut (90 days) and oil palm (85 days) the range is Rp 700,000 to 800,000 for both crops. 2.25 The challenge for the future is to make the existing tree crop schemes more sustainable and complement these with more replicable approaches to smallholder development, so that these schemes can help lift and/or keep out of poverty a greater proportion of the millions of poor rural households in the Outer Islands. 2.26 Thus, the primary objectives of Government policy in the subsector are to: generate foreign exchange earnings; create productive employment ooportunities for small farmers; stimulate agro-industrial development; create a sound economic base for settlement in the comparatively underpopulated parts of the archipelago; and provide, in the case of edible oils, an ample supply of an essential staple food at an affordable price, 2.27 Growth in the tree crop subsector is managed by the Government through the following main instruments: (a) a large-scale public investment program in tree crops development and transmigration; (b) public ownership and management of a substantial share of large-scale estates; (c) control over licensing and operation ci private estates and processors; (d) restrictions on the domestic pricing and international trade of edible oils; (e) provision of special credit facilities for production and export; (f) provision of subsi- dized fertilizers; and (g) provision of publicly financed research and exten- sion services and supporting infrastructure, such as roads, ports and termi- nals. Over the past decade, Government subsectoral policy has been com- plemented by a fiscal and monetary policy regime supportive to tree crop investment. This has included relatively neutral exchange rate managemient under an open capital account, a reduction in trade protection for manufac- tured goods, fiscal expansion for rural and urban infrastructure development, and elimination of taxes which discriminate specifically against exports. 2.28 Future tree crop subsector investment will remain a priority. A continuing pressure on balance of payments will necessitate rapid growth in non-oil exports. A faster growth in the labor force in the Outer Islands will require the subsector to continue to provide employment opportunities to nearly one-seventh of the labor force, and to arrest a decline in the real wages of unskilled labor. To meet these challenges, tree crop investment strategies and policies now need to adapt to changing sectoral const:aints and requirements, as discussed in the rest of the report. Government resource constraints, however, will limit the volume of direct public investment. A greater share of investments must, therefore, come from the private sector, and the incentives environment for private investment and trade will become increasingly important as the private sector is called upon to serve as the main engine of growth in Repelita V. Public sector expenditures should focus primarily on completing and consolidating past investments, while improving infrastructure and support services, to ensure efficient utilization of the existing capital stock. More rapid, broad-based growth, encompassing a larger number of smallholders, supported by dependable and sustainable financing mechanisms, is required to provide a stable, replicable basis for generating productive employment opportunities. These emerging priorities underlie the strategy proposed in this report. - 39 - III. MEDIUM- TO LONG-TERM PRODUCTION AND MARKET POTENTIAL 3.1 An Overview. In the context of the projected world market and price scenario, Indonesia has ample production and market potential. However, it should be noted that the development strategies (particularly the adjustments in the policy/incentives regimes affecting edible oils, the adjustments in the regulatory framework affecting the private sector, and the improvements in rubber quality) outlined in the subsequent sections of the report, are critical if Indonesia is to fully tap this potential and ensure that the gains (in terms of production, domestic consumption and exports) from investment.s (existing and new) are not lost. The hypothesis underlying the producti(n and export projections of edible oils is that Tndonesia is a price taker in :he world vegetable oil market. The production changes in Indonesia, :hereiore, have a limited impact on world prices. An important finding related to rubber is that the aging rtructure of the tree stock will lead an output decline even if plantings to cormpensate for the outgoing (i.e., aged and low-yielding) trees axe ensured in the future period. The potential output decline after the year 2000 can be reversed by a faster rate of planting than a mere replacement of the outgoing tree stock. This will require an increase in area to be planted and/or a major replanting program to replace unselected planting material with improved varieties that can substantially increase yields. Edible Oils 3.2 World Market. The fats and oils market is a highly integrated market characterized by substantial substitution possibilities in demand and diverse supply sources. ProuucLion sources include oilseeds such as soybeans, rape- seed, and sunflower seed which are planted annually; perennial crops such as oil palm and coconut palm; and animal fats, including butter and tallow. Production decisions for annual crops are characterized by land allocation choices and expected prices for meal and oil prices, while tree crop produc- tion entails decisions alin to capitai investment. nima; fats are a su,all part of the complicated investment dccision involving the joint production of meat, dairy products, and fat by-products. Production location remains diverse, with various products produced and traded throughout the world. (Annex Table 2.2 indicates the wide distribution of fats and oils production throughout the world). Cooking oil that is indistinguishable in terms of taste characteristics can be blended from a variety of vegetable oils, includ- ing soybean oil, rapeseed oil, palm oil, coconut oil, cottonseed oil, and sunflower seed oil. Each of the vegetable oils has special uses to which it is best adapted--especially coconut oil which is used in shampoos and confec- tionery--but at the margin a great deal of substitutability exists. Despite completely different supply conditions, world prices remain highly correlated among the vegetable oils, indicating that substitutior.s in demand largely compensate for fluctuations in the supply of individual oils. For the period 1963-84, the simple correlations between palm oil and, in turn, soybean oil, sunflower oil, rapeseed oil, and coconut oil were 0.97, 0.94, 0.97, and 0.93, respectively. Correlations between coconut oil and soybean oil, palm oil, and palm kernel oil were 0.90, 0.93, and 0.99. Given a broadly defined market for all major fats and oils, including animal products such as tallow and butter, the world produced over 72 million tons of edible fats and oils in 1987. - 40 - 3.3 While vegetable oil production is growing rapidly in Indonesia, the country remains a relatively medium-size producer in the larger total market of fats and oils. Consequently, substantial changes in the Indonesian produc- tion and consumption of vegetable oils would not have much of an effect on the world market. (That is, Indonesia can be treated as a price-taker.) Indonesia is the world's second largest producer of palm oil (20Z of world production) and second largest producer of coconut oil (252 of world produc- tion), but of the total amount of fats and oils, Indonesia produced only about 3Z and exported about 3Z of world trade. 3.4 Indonesia produces its vegetable oils almost entirely from perennial tree crops in a world market dominated by annual crops. Except through short- term stock buildups, the only feasible production adjustments to changes in demand are through planting new trees, which only begin to produce after four years, or by slowly depreciating existing stands of trees. In contrast, adjustments in annual crop production can occur within a year which would more than overwhelm any adjustment Indonesia could make. For example, in 1988 a drought in the American midwest caused US soybean production to drop 22Z, or about 11 millior. tons. This is equivalent to a 2.26 million ton drop in world edible oil availability, which is more than one and a half times Indonesia's total palm oil production. 3.5 The World Bank's multicountry model of the vegetable oil sector was used to validate the notion of Indonesia as a price taker in the world vege- table oil market. As can be seen in Annex Table 2.1, the impact of extremely large changes in domestic production in Indonesia quickly becomes dispersed and muted in a global context. While the impact of production changes in Indonesia have a limited effect on world prices, the domestic market within Indonesia does react dynamically to world and domestic events and policies (for policies, see Section IV). 3.6 Indonesian Model Description. The model developed for Indonesia .uAm!u* of 24 equaLiUnS which simuitaneousiy aeteruuine paim oi_ and palm kernel oil production, the pruduction of coconuts, coconut crushing, fresh nut use, coconut oil production, total expenditures for vegetable oils, and the share of expenditures devoted to palm oil, palm kernel oil and coconut oil demand, as well as the export of palm oil, palm kernel oil and coconut oil. 3.7 The demand for vegetable oils is modeled using Deaton & Muellbauer's Almost Ideal Demand System, a two-stage budgeting model of consumer demand. Total expenditures per capita devoted to vegetable oils are determined in the first stage as a function of total income (private consumption levels) per capita, an aggregate index of vegetable oil prices, and the price of rice, the major food staple in Indonesia. All prices are deflated by the Indonesian Consumer Price Index. Expenditure share equations are specified as a function of relative prices of coconut oil and palm oil, and total vegetable oil expen- ditures, all deflated by an endogenously determined index of vegetable oil prices. The shares are then applied to the first-stage expenditure level, and multiplied by population to derive domestic demand for coconut oil and palm oil. - 41 - 3.8 The supply of palm oil is modeled using a vintage capital approach. As an oil palm tree matures, the oil yield of the tree rises from zero in the first three years to over 4.6 tons/ha by year eight. The yield remains fairly stable for about nine years and then slowly begins to decline. As the tree age rea^hes the mid-twenties, harvesting becomes more difficult as the tree grows taller. At some point, depending upon the coet of labor and the price of oil, it becomes economically advantageous to replant the tree--at which point the yield drops to zero once more. By tracking cohorts of newly planted trees through this life cycle, a variable representing potential production can be calculated. Using this variable in a behavioral equation along with output and input prices in real terms, provides a reasonably good forecast of actual production. 3.9 In the case of coconuts, a simple linear trend explains over 991 of the expansion in the area over the 1970-87 period.l/ However, coconut produc- tion from planted area does respond to real prices through harvesting intensi- fication. In the model, coconut production is a function of harvested area, lagged production, and real prices. 3.10 Once coconuts have been produced, they can be used as fresh nuts or can be further processed into dried copra. Copra can be exported, or further crushed into meal and coconut oil. The fresh nuts can be used directly as food, or locally processed into kelentic oil. The demand for fresh fruit nats 2/ is modeled as a function of the coconut oil price, real income, and the real price of rice, the main food staple of Indonesia. The amount of coconut production devoted to the formal copra sector then is calculated as a residual, i.e., the difference between coconut production (in copra equivalent) and fresh use (in copra equivalent). Since copra exports are limited by trade restrictions in Indonesia, most of the copra in the formal sector is converted into coconut oil, providing the model's supply of coconut oil. 3.11 Production and Market Potential. Table 3.1 contabIIS projec.te pro- duction, consumption, and trade for Indonesian palm oil, palm kernel oil and coconut oil. Despite price projections (Annex Tables 2.3 and 2.4) that remain low by historical standards, past investments in new tree plantings, primarily by the public sector for oil palm, and by smallholders for coconut palm, will guarantee large production increases through the mid-1990s. Assumptions 1/ While the coconut area has grown consistently, increasing from 1.2 million ha in 1970 to 3.2 million ha in 1987, yields have remained relatively stable, suggesting that the maturity and varietal composition of the tree stock has remained fairly constant over the last two decades. 2/ While the total supply of coconuts does not seem responsive to economic variables, the allocation of nuts to the copra industry does seem responsive to price and income movements. In 1970, 47! of the total coconut production was crushed as copra to produce meal and oil. As prices jumped in the mid-1970s, more than 63X of production moved into the formal copra milling sector. This share dropped as prices fell in 1985 and 1986, but in 1987, the share increased again to 602 of production. - 42 - concerning the success of PIR-TRANS (a program under which the Government intends to assign smallholder development responsibilities to the private sector investors--for details of this program, see Section V) in continuing what have been rapid investments in oil palm, are important to the latter part of the projection per.od. Investment in new planting during Repelita V will have negligible impact on production through the end of the plan in 1994, but, if sufficiently large, could be important for the last six years of the projection period. Adding in new areas from the expansion of existing and new private estates, to the Government's PIR-TRANS program would bring total new area investment to 75-80,000 ha p.a., a large area even by the standards of recent years. Considering that the opening-up of new areas will require substantial investment in infrastructure, posing a heavy burden on Government resources, it is expected that the anticipated expansion of the larger small- holder development aspects of the PIR-TRANS program will require more time than presently allocated by the Government. Taking this into account, it is assumed that total investment in new oil palm areas could continue to expand, averaging about 40,000 ha annually, largely in the public estates and private sector. The area under cil palm is projected to increase by 4.32 p.a. during 1987-2000 (compared to 10.32 p.a. growth during the 1970-87 period), and the area under coconuts is projected to increase by 2.6? p.a. (compared to 3.4? p.a. growth during 1970-87 period). 3.12 Production of palm oil (CPO) is expected to grow from 1.5 million tons in 1987 to over 3 million tons by 1995. The rate of expansion should slow as replantings will be required at that point, lowering overall yields, yet overall production is projected to continue to grow, reaching 3.4 million tons of CPO by the year 2000. Ccconut oil production is expected to grow, but at a more regular, less meteoric rate as the area will continue to expand. Coconut (CCO) production is expected to grow from 0.8 million tons in 1987 to 0.97 million tons by 1995, and to 1.1 million tons by the year 2000. Palm kernel oil (.'0) production will grow rapidly as well, but will remain a minor vegetable oil 4th production reaching about 350,000 tons in 1995 and 420,000 tons in the year "000. 3.13 The demand for vegetable oils in 'ndonesia is expected to grow rapidly as well. Despite impressive dietary gains over the past two decades, Indonesian per capita consumption of fats and oils remains at two-thirds of the world average, and less than one-quarter of the consumption level of developed nations (Annex Table 2.5). Spurred on by growing incomes, a rapidly expanding population, and real prices which are quite low by historical stan- dards, the demand for vegetable oils should expand rapidly and consistently throughout the projection period. This demand will .c%ntinue to change, not only in terms of total quantities of vegetable oil consumed, but also in composition. Continuing a trend that began in the 1970s, the share of edible oil expenditures devoted to palm oil will grow steadily, increasing from one- third in 1987 to two-thirds in the year 2000. The demand for coconut oil is projected to expand slowly, rising from 762,000 tons in 1987 to 926,000 tons in 1995 and to 960,000 tons in the year 2000. Palm oil consumption is projec- ted to grow more rapidly, however, as Indonesia continues to switch to the less expensive of the two vegetable oils. Domestic demand for palm oil (CPO) is projected to grow from 757,000 tons in 1987 to more than twice that level in 1995. By the year 2000, domestic consumption of palm oil is expected to reach 2.4 million tons. Domestic demand for palm kernel oil should reach 109,000 tons in 1995, and about 170,000 tons by the year 2000. - 43 - 3.14 The trends which dominate production and domestic demand are evident in the trade projections. Indonesia, which has been a sporadic importer/ exporter of coconut oil, slowly becomes a consistent exporter of coconut oil as domestic demand growth of vegetable oils is primarily in palm oil. Exports of coconut oil will increase to 43,000 tons by 1995, and to 173,000 tons by the year 2000 (Table 3.1). As domestic production of palm oil accelerates, exports of palm oil will increase rapidly, reaching about 1.6 million tons in 1991 through 1995. Then, as domestic demand continues to grow rapidly while production grows more slowly, exports begin to fall, dipping slightly below one million tons in the year 2000. Production gains in palm kernel oil are expected to outpace domestic demand, with palm kernel oil exports growing to 242,000 tons by 1995, and about 250,000 tons in the year 2000. Simulation with a 5? export tax ia included in Section VIII. The following table indicates the projected production and demand estimates. Table 8.1: PROJECTED PRODUCTION AND DEMAND ('000 at) Produc- Produc- Produc- Domestic Domestic Domestic Export Expoet Export tion tion tion deomnd d-m0nd demand quantity quantity quantity Year CCO /a CPO PKO CCO CPO PKO cco CPO PKO 1967 796 1,477 137 762 767 60 11 697 87 196 771 1,600 18 769 S0o 6e 9a 726 117 1969 797 2,237 211 742 80 as 66 1,431 146 1990 826 2,460 241 784 940 74 42 1,610 167 19,91 637 2,660 271 614 l,O. 80 28 1,606 191 1992 68a 2,791 294 849 1,163 67 84 1,6e8 207 1998 908 2,906 S18 662 1,276 94 22 1,680 219 1994 948 8,020 8as 908 1,892 101 39 1,626 232 190S 969 3,113 861 926 1,617 109 48 1,696 242 1996 1,006 8,191 a6e 939 1,671 119 67 1,620 247 1997 1,036 3,260 361 945 1,841 130 s8 1,419 260 1996 1,070 8,829 896 964 2,026 142 le 1,303 263 190n 1,100 8,387 406 967 2,227 16e 143 1,169 268 2000 1,188 3,487 420 s60 2,464 171 178 968 249 la Production in terms of copra equivalent is expected to increase from 2.0 million tons in 1987 to 2.7 mIllion tons in the year 2000. CCO a Crude Coconut Oil CPC = Crude Palm Oil. PKO a Pals Kernel Ol. Source: Milsion's estimates. 3. 15 However, if the policy and regulatory environment (Sections IV and V) is not conducive for the private sector, the investments in oil palm could slow down leading to a reduction in CPO production to 3.0 million tons in the yeer 2000 (instead of 3.4 million tons estimated in Table 3.1). Similarly, if the requisite replanting and subsequent yield increases in smallholder coconut production do not take place (Section VII), CCO production could stabilize at about 950,000 tons, instead of increasing to 1.1 million tons in the year 2000. - 44 - 3 16 Implications for Investment in Milling/Processing Facilities. As noted earlier, investment in vegetable oil crops has been rapid over the past two decades. New plantings in coconuts have been relatively low-cost and have been undertakern primarily by numerous smallholders. Investments in oil palm, however, have been on a large scale and primarily undertaken by the public estates. 3.17 Indonesia appears to have a comparative advantage in producing vege- table oils, especially palm oil. Cross-country cost of production comparisons are difficult for a number of reasons: oilseed production contains both a meal and oil component, as does copra; oil palm fruit contains both an oily mesocarp and a kernel; certain oilseeds, for example, soybeans, contain very little oil, but produce a valuable high-protein meal. The production of these products is joint, and cost comparisons among the various vegetable oil components necessarily contain assumptions concerning the allocation of costs between these joint products. In addition, the rental value of land, a major component of the cost of annual crops, is not independent of the prevailing price of crops which can be grown on that land. Finally, exchange rate poli- cies can quickly alter cross-country comparisons, even with constant producer costs. Despite the difficulties, a study commissioned by the World Bank in 1986 attempted to measure the cost of production among major producing coun- tries. 3.18 Under a variety of scenarios examined in the study, Indonesian palm oil would remain one of the lowest cost sources of vegetable oil. Estimating production costs of pal.m oil (CPO) in Indonesia at slightly over US$200/ton (constant 1985 US dollars), Indonesia should remain competitive in the world market through the close of the century. The world prices of palm oil are projected to be around US$300/ton (constant 1985 US dollars) until the year 2000. With per unit costs at around US$350/ton for crude coconut oil, and projected world prices at US$400-425/ton, Indonesian coconut oil production is less profitable than palm oil, but is certainly competitive with the Philippines, the world's largest producer of coconut oil. 3.19 Rapid processing of fresh fruit bunches is an integral part of pro- ducing crude palm oil, since delays in milling would reduce the oil content of the freshly cut fruit. In contrast, it is possible to process coconut long after it has been harvested and dried into copra with a certain moisture con- tent. Consequently, all CPO milling plants are necessarily located near production sites, but a disproportionately large percentage of copra milling capacity remains on Java, resulting in high transportation costs. 3.20 Total copra milling capacity has grown slowly in Indonesia over the past decade, although ownership of milling capacity has become more concentra- ted. In 1977, 415 firms held an existing capacity of 1.66 million tons (copra). In 1985, 333 firms owned 1.98 million tons of capacity. In 1975, firms averaged a 51Z capacity utilization rate. In 1985, the last year for which data are available, the industry averaged a 45Z utilization rate. Because of Government licensing procedures, firms have an incentive to both overinvest and to overstate their potential capacity (see Section IV). By overinvesting, existing firms prevent the establishment of new firms; by over- stating their capacity, the firms accomplish the same goal without costs. - 45 - 3.21 While the location of existing milling plants is not ideal, there appears to be little need for increasing capacity. Crushings are projected to remain under 1.9 million tons of copra. Current excess capacity for copra milling can easily absorb projected production gains. 3.22 In 1982, 25 plants milled oil palm with a collective capacity of 794 tons of fresh fruit bunches (ffb) per hour milled palm oil. By 1987, capacity had grown to 2,130 tons ffb/hour. Even assuming an optimistic extraction rate of 202 for oil, and plant operations of 450 hours/month, existing capacity translates into 1.9 million tons of palm oil, while production of CPO in Indonesia probably already exceeded 1.8 million tons in 1988. The need for rapid expansion of CPO milling plants is thus crucial, and the possibility of local shortages in milling capacity are real. At least one Government estate is currently shipping fresh fruit bunches over 60 km of bad roads because of lack of adequate milling. Ten more milling plants with a total capacity of 300 ffb tons/hour are scheduled for completion in 1988/89, five of which are supported by World Bank and Asian Development Bank (ADB) loans. During Repelita V. which ends in 1994, an additional 34 milling plants with 1,030 tons of capacity are scheduled for construction. This does not include new private milling capacity for either existing estates, or estates started under the PIR-TRANS scheme (para. 5.3). 3.23 The need for rapid expansion of milling capacity is well understood in Indonesia, and the schedule of new plant construction addresses the prob- lem. At the same time, however, new milling plants require one to two years to construct in Indonesia, and Government and public estate companies' finan- cial and management resources are currently quite stretched. Slippage in meeting construction schedules would result in local capacity shortages by the early 1990s. Should the investments fail completely to materialize, some future production gains from existing trees will be squandered. On the other hand, there is, at present, underutilization of the fractionation/refining capacities for CPO and CCO-based cooking oils. These capacities are discussed in para. 4.26. Such subopti-.al patterns of investment stem from interven- tionist public policy in edible oils. Restrictions on domestic allocations, pricing and export of edible oils will need to be eased, before the potential markets can be fully tapped and the gains from investments realized (see Section IV). Natural Rubber 3.24 World Market. World natural rubber consumption is projected to grow from 4.6 million tons in 1987 to 6.5 million tons in the year 2000. The United States will remain the single largest consumer, with consumption of 1.2 million tons by the year 2000. In contrast, a slowdown of Japanese consump- tion growth is expected in the next decade because of the increasing globali- zation of the auto industry and the 'transplanting' of tire manufacturing facilities out of Japan. The fastest growth in rubber consumption will be in the developing countries, especially in the newly-industrializing countries of Asia, as well as China and India. In the industrial countries, the effect of demand for high-performance radial tires and high-value rubber goods is increased demand for higher-quality natural rubber in the form of sheets, technically-specified or crumb rubber, and latex concentrate. In contrast, - 46 - lower-quality rubber will go to the developing countries where nascent demand exists for road transportation, and where poor road conditions will warrant the continued use of the traditional cross-ply tires.3/ In the centrally planned economies, natural rubber demand is projected to grow slowly. This is because the growth in elastomer demand will be mainly satisfied by the projec- ted increased production of general-purpose synthetic rubber in the countries arising from joint ventures with the western multinational corporations. 3.25 The increased production will come primarily from Indonesia, Malaysia and Thailand. Increased production in Malaysia is expected to result from increased replanting by the estate and smallholder sectors in tile coming years, in response to the recent price increases and to the new demand for rubber-based medical insulation products. The latter source of demand is expected to affect market perceptions sufficiently to slow the decline in natural rubber areas which has been occurring in Malaysia through diversifica- tion to alternative crops such as oil palm. 3.26 World rubber exports are projected to reach 5.0 million tons in the year 2000. Of this trade, 90Z will originate from the four major producing- cum-exporting countries (Malaysia, Indonesia, Thailand and Sri Lanka). The balance of exports will largely be from Cote d'Ivoire, Liberia and Nigeria. Intradeveloping-country trade is projected to absorb one-third of total trade. Projected rubber prices are included in Annex Table 2.14. 3.27 Indonesian Model Description. The method used to estimate potential production of rubber in Indonesia is based on the principles underlying the Vintage model.4/ 3.28 Two problems encountered when attempting to project Indonesia's rub- ber production are: (a) the age distribution of the existing tree stock; and (b) the extent of "sleeping rubber" areas (i.e., mature rubber trees which are not being tapped in any given time period), both of which pertain to the smallholder as well as the estate sectors. The method outlined below applies to both the sectors. 3.29 Mature and immature area data that are available from the DGE covers only the recent 1970-87 period. While the data differentiate the smallholder from the estate sectors, the data do not provide any indication of the age distribution of these areas. Since data on pre-1970 plantings are also not available, a plantings matrix was constructed to show the assumed age distribution of the area under rubber (i.e., by their vintages). This matrix is then multiplied by the yield profile vector to give the annual potential output from the mature area. Since the area derived from the vintage model (which assumes 40-year and 30-year life cycles for the smallholders and estate sectors, respectively) imposes consistency between the mature and immature 3/ Such tires are less stringent in their rubber quality requlrements and have a higher proportion of synthetic than natural rubber input. 4/ C. Suan Tan and Victor Gabor, 'Estimating Rubber Production in Indonesia--A Vintage Approach," International Commodity Markets Division, the World Bank (forthcoming). - 47 _ areas, it is inferred that the total area differential between the DGE data (which are consistently higher) and the Bank's model refers to "sleeping area" rubber having respective life cycles for smallholders and estates. 3.30 In discussing rubber production in Indonesia, it is essential to distinguish the smallholder and estate sectors because of their behavioral differences that range from the type of planting materials used to the mainte- nance of trees and the length of their productive lifespans. Because of the Government-supported planting programs that began in 1978, it is also neces- sary to distinguish assisted smallholders from the unassisted smallholders and estate planters. 3.31 Production Potential. The total smallholder rubber area and poten- tial output is the sum of the areas and potential outputs of the four different groups of smallholders.51 Annex Table 2.6 presents the aggregated smallholder plantings, area and potential output for the 1978-2010 period. Annex Table 2.7 presents production details for the aggregate estate sector as derived by the Vintage model and as reported by DGE. 3.32 Table 3.2 gives the production details for the aggregated smallholder and estate sectors. The mature area and potential output for the 1988-2010 period are based on the vintage approach using the assumption that all plant- ings in the future period under consideration will be at rates to replace the outgoing/aged tree stock in each future year. 3.33 Total mature area under rubber is projected to increase from 1.95 million hectares in 1988 to peak at 2.34 million hectares in the year 2000, then decline slightly to 2.30 million hectares in 2010. Potential output from this mature area will increase from 1.20 million tons in 1987 to 1.76 million tons in the year 2000 and then decline to 1 49 million tons in 2010. If 'sleeping rubter* is included, then potential output would be higher by about 0.1C-0.15 million tons. The share of smallholder potential production will, under the assumptions used, increase from 672 in 1985 to 702 in 2010. The following table presents the total potential rubber output timepath to the year 2010. 5/ Unassisted smallholders, smallholders in the Govrernment-sponsored PMU- type schemes, and the NES/PIR schemes, and the partially assisted smallholders (para. 7.45. - 48 - Table 3.2: TOTAL AREA PLANTED, AREA UNDER RUEIBER AND POTENTIAL OUTPUT, 1987-2010 (Base Case) Area Immature Mature Potential output Year planted area area from mature area -------------- ('000 ha) -------------- ('000 tons) 1987 107.0 697.3 1,865.1 1,204.3 1988 123.8 678.0 1,948.2 1,244.0 1989 116.6 704.9 1,978.0 1,281.4 1990 104.4 723.7 2,003.6 1,319.9 1991 50.7 696.5 2,030.8 1,349.8 1992 50.7 656.7 2,070.6 1,390.0 1993 50.7 578.8 2,148.5 1,446.3 1994 50.7 500.5 2,226.8 1,521.3 1995 50.7 440.4 2,286.9 1,587.4 1996 50.7 386.7 2,340.6 1,654.5 1997 50.7 386.7 2,340.6 1,693.3 1998 50.7 386.7 2,340.6 1,729.4 1999 50.7 386.7 2,340.6 1,747.1 2000 47.6 383.6 2,343.7 1,757.4 2001 65.3 398.2 2,329.0 1,747.5 2002 74.9 422.5 2,304.8 1,737.4 2003 55.7 427.5 2,299.8 1,725.9 2004 98.5 475.3 2,252.0 1,704.7 2005 46.1 470.8 2,256.5 1,683.4 2006 46.5 469.7 2,257.6 1,657.0 2007 56.7 461.1 2,266.2 1,619.4 2008 44.4 434.4 2,292.9 1,589.0 2009 51.5 433.9 2,293.4 1,543.7 2010 49.9 431.8 2,295.5 1,493.5 Source: Mission's estimates. 3.34 Simulations for the Smallholder Group. Given the importance of smallholders, a majority of whom have not to date been assisted by Government- sponsored schemes, separate simulations have been done for this group. 3.35 Three alternative scenarios are considered as summarized in Table 3.3, where the plantings with varying degrees of assistance (in terms of planting material, and other inputs including extension services) will trans- late into different yield profiles. The future annual plantings for Scenarios A and B are kept at the base case levels for purpose of comparing the returns to different combinations of planting materials. The future annual plantings are assumed to be lower in Scenario C to show the trade-off between output and land use. - 49 - Table 3.3: SMALLHOLDERS: AREA PLANTED ANNUALLY UNDER ALTERNATIVE PLANTING STRATEGIES Full Partial Unassisted with Scenarios assistance/a assistance/b dispersed nurseries/c Total ------------------ ha/year during 1988-2001 ----------------- A 41,000 - - 41,000 B - 15,000 26,000 41,000 C - 15,000 15,000 30,000 /a Assistance with full package of inputs as under ongoing Government-spon- sored block-planting schemes. /b Partial assistance for smallholders who are on the periphery of existing schemes. /c Assistance with planting material (made available from dispersed nur- series), some fertilizer and limited extension advice. (For details, see paras. 7.32-7.35). 3.36 In all three scenarios, the total unassisted smallholder rubber area is held constant at 1.8 million ha throughout the 1988-2000 period and, instead of area expansion, replanting with improved varieties is assumed. The differences in the mature area and potential output profiles are therefore direct consequences of differences in: (a) gestation period (5, 7 or 8 years); (b) productive lifespan (23 or 32 years); and (c) yield profiles, all of which affect tapping lifetime average yields (of 0.52-1.15 ton/ha). 3.37 The potential outputs projected under different planting strategies from 1988 onwards show that: (a) the aging structure of the existing tree stock will lead to a gradual output decline ever if plantings to compensate for the outgoing trees are ensured in the future period; (b) the potential output situation will change significantly only after 1994; (c) the high-yielding planting materials give higher potential output with less land use; (d) ceteris paribus, the aging tree stock in both the smallholder (predo- minant) and estate sectors would be reflected in the near-stagnant future production extrapolated from the historical trend. This is not the case presented here because of the extent of Government- funded plantings in both sectors since 1978. 3.38 Comparing the impact of the different planting strategies (for pres- ently unassisted smallholders) on total potential output, it is seen that projected potential output (Annex Table 2.8) under Scenario C (which utilizes - 5a - less land but provides some assistance to dispersed smallholders) is margin- ally higher than that in the base case (which utilizes more land but no assis- tance to dispersed smallholders) with total potential output of 1.789 million tons in the year 2000, compared with the base case total of 1.757 million tons. The next highest total potential output of 1.835 million tons in the year 2000 is obtained under Scenario A (which u.±lizes the same land as under base case, but provides high-input, high-cost assistance to smallholders). An interesting result of this investigation is that the potential output streams will all peak in the year 2000 except with Scenario A where potential output continues increasing until year 2005 before the onset of production declin, Thus, under all scenarios, a faster rate of planting than a mere replacement of outgoing tree stock is required if potential output in the smallholder sector is to increase continuously in the long term. This will require an increase in area to be planted and/or a major replanting program to replace unselected planting material with improved varieties that give higher yields. However, it should be noted that these scenarios for smallholders neither take into account the overall costs, financing and the management/institutional capacity constraints nor the impact on the number of beneficiaries. These elements are accommodated in the analysis included in Section VII. 3.39 Domestic Market Potential. Projecting Indonesia's consumption of rubber is hazardous because there are no data on domestic consumption and only estimated data on stocks. Past domestic consumption has therefore been estimated from the data on production, net exports, and the estimated stocks. According to these estimates, domestic consumption increased from 35,000-40,000 tons in 1970 to between 100,000 and 11v,000 tons in 1985 (see Table 3.4). 3.40 Historical Argregate Consumption Trends. Two series of projections of future domestic consumption are made. In the low case, it is assumed that domestic consumption will continue from the base of 35,000 tons in 1970 along the trend observed during 1970-87. In this case, domestic consumption is projected to rise to 160,000 tons in the year 2000. In the high case, con- sumption is projected from the base of 4C,000 tons in 1970 and is assumed to grow faster in response to increased demand for nontransport rubber goods manufacturing such as rubber shoes and latex-based rubber products (gloves and medical insulation goods). Under this scenario, domestic consumption is pro- jected to increase to 250,000 tons in the year 2000. - 51 - Table 3.4: ESTIMATED RUBBER CONSUMPTION, 1970-2000 ('000 tons) Year Low High 1970 35.0 40.0 1975 53.0 63.0 1980 78.0 85.0 1985 100.0 110.0 1990 118.0 130.0 1995 135.0 160.0 2000 160.0 250.0 Source: Mission's estimates. 3.41 Projected Consumption by End-Use. With the growing interest in down- strean processing within Indonesia, an attempt is made here to project demand by end-use industries. Annex Tables 2.9-2.11 present the rubber input requirements by the shoe industry, latex-based goods and tire manufacturing in Indonesia during the 1988-2000 period. Table 3.5 summarizes the domestic market demand for 1988 and 1990, where total rubber consumption is projected to grow from 70,000 tons in 1988 to about 114,000 tons in 1990, or close to the low estimate given in Table 3.4. In the 1990-2000 period, more rapid growth of domestic tire production would lift rubber consumption from the low- growth to the high-growth path, to reach 250,000 tons in the year 2000. Table 3.5: INDONESIAN RUBBER CONSUMPTION BY INDUSTRY, 1988-90 ('000 tons) Industry 1988 1990 Shoes manufacturing goods 25.85 63.15 Latex-based goods 0.01 0.12 Tires 44.16 50.47 All Industries 70.02 13.3.74 Source: Annex Tables 2.9-2.11. 3.42 Export Market (Various Simulations). To assess the role of Indonesia in the world rubber market, various scenarios concerning changes in Indonesia's production, exchange rate, and domestic consumption growth were analyzed for the 1988-2000 period. Based on these alternative assumptions, simulation results are compared with results of a base case scenario where (a) the exchange rate is held constant at the 1988 level; (b) there are no - 52 - Government interventions at the production and export levels; (c) domestic consumption of rubber will increase to 160,000 tons in the year 2000, leaving an exportable surplus of 1.6 million tons in the same year (of which 1.47 million tons will be exported at the projected world prices); and (d) poten- tial output from the smallholder sector will reach 1.2 million tons in the year 2000 (Annex Table 2.6). 3.43 In the base case scenario, the world price in nominal terms as given by the New York price for RSS1 will reach US$2,471/ton in the year 2000, with total world supply and demand reaching 6.53 and 6.40 million tons, respec- tively. I-donesia's potential output in the year 2000 will reach 1.76 million tons (or 272 of world supply) of which 1.47 million tons will be exported, yielding total export revenue of Rp 3,651 million 6/ (in constant 1990 terms). 3.44 Impact of Faster Supply Growth. In the base case scenario, small- holder plantings during the 1988-2000 period were assumed only to replace the outgoing tree stock. If the Scenario A program of assisted plantings (para. 3.35) is assumed, then smallholder potential output can grow faster to reach 1.45 million tons in the year 2000, instead of 1.2 million tons. 3.45 The impact of higher potential output in the year 2000 will be higher exports of 1.50 million tons (1.47 million tons in the base case), lower RSS world price of US$2,413/ton (US$2,471/ton in the base case), and higher world consumption of 6.44 million tons (6.40 million tons in the base case). The higher exports are partially offset by lower prices, so that total export earnings will increase by a negligible 0.2Z. 3.46 Impact of Currency Devaluation. Indonesia has had three major deval- uaticns since 1970, each devaluation exceeding 402 in magnitude (512 in 1978, 44Z in 1983 and 461 in 1986). Despite these devaluations, export taxes for rubber were reduced to 0Z in 1982. 3.47 A scenario of gradual devaluation of 12 a year between 1988-2000 was simulated to evaluate the impact of the exchange rate on the rubber economy. The exchange rates in the simulation were assumed to move from US$l:Rp 1,700 in 1988 to US$1:Rp 1,878 in the year 2000. 3.43 Under a scenario of gradual devaluation, the rubber price in domestic currency will increase, thereby increasing Indonesia's production and exports. This leads to lower world prices which will in turn encourage higher consump- tior.. In the longer run, lower --oduction elsewhere in response to the lower prices will partially offset the nigher output from Indonesia, so that world production will only be marginally higher at 6.59 million tons (6.53 million tons in the base case) in the year 2000. Indonesia's exports will increase by 2.7Z in the year 2000 to reach 1.51 (instead of 1.47) million tons, and the local currency price of RSS rubber will be about 12.52 higher than in the base case. 6/ This is obtained by multiplying the export volume of 1.47 million tons by the weighted average of wholesale prices for all RSS grades in the Jakarta market, i.e. Rp 2,484/ton (in constant 1990 terms). - 53 - 3.49 Impact of Faster Growth in Domestic Consumption. Given the growing interest by foreign investors in establishing rubber goods manufacturing oper- ations in Indonesia, the scenario of faster growth in domestic consumption to 252,000 tons (552 higher than in the base case) by the year 2000 is simulated. The increased domestic consumption will reduce the exportable surplus to 1.51 million tons (from 1.6 million tons in the base case) by the year 2000. The lower exports will initially cause higher world, and heiice domestic, prices. This will result in increased production, with slightly higher exports. How- ever, since consumption in Indonesia ranges only between 2.6Z and 4.1? of total world consumption, the impact of higher domestic consumption will be small. By the year 2000, world consumption will be 6.2 million tons instead of 6.3 million tons in the base case. 3.50 Implications for Investment in Processing Facilities. Given the difficulty in obtaining historical data on rubber process:.ng capacity, the fragmentary data available on active and nonactive processing capacities dur- ing the 1982-88 period has been used. Annex Table 2.12 indicates total avail- able rubber processing capacity, which shows a sharp expansion in capacity in 1983 and 1984. This suggests investment in processii.g capacity in response to the increase in world rubber prices in 1983, which was reinforced by the Rupiah devaluation in the same year. The total available capacity declined by 3.7? p.a. during 1984-88. By comparison with the 18.5X decline in the number * of processing units during the same period, it may be inferred that the processing units that went out of production were the smaller units. (The number of active processing units declined by 16.2? during 1982-88.) 3.51 Rates of processing capacity utilization are estimated using (a) active capacity as a share of actual output; (b) nonactive capacity as a share of total available capacity; and (c) total available capacity as a share of actual output during the 1982-88 period. These estimated capacity utiliza- tion rates show that desnite capacity expansions in 1983 and 1984, utilization of active capacity nevertheless reached 103Z in 1984. Depressed rubber prices in 1984-86 prompted further consolidation of the processing sector where one processing unit was removed and nine units were idled. Further consolidation occurred after 1986 with another 22 units removed, despite an increase in production, thereby reflecting the higher proportion of bigger processing units. Continued consolidation of the processing sector throughout 1984-88 is seen from the 18.5? fall in the number of processing units (from 124 to 101) against a 3.7? fall in available processing capacity (from 1.09 to 1.05 mil- lion tons). The increased profitability of thl.se larger units can be inferred from the gradual increase in ratio of active capacity to production (from 78? in 1986 to 86.4? in 1988). 3.52 Annex Table 2.13 shows that nonactive (idle) capacity ranged from 0? to 14.32 during the 1982-88 period, with a peak level in 1986 when the smaller processing units were removed. The table also provides estimates of the total available capacity relative to actual output, and shows processing capacity to have been kept in tight balance to actual output. This would seem to suggest that capacities have been activated/closed in accoLdance with raw material supply and output responses to price movements. The same trend of maintaining an appropriate balance between the processing capacity in the private sector and the rubber output can be expected to continue in future. Hcwever, the private sector will need incentives to enable an increased focus on improving rubber quality, which is critical to Indonesia maximizing the returns from these investments (see Section IV). - 54 - IV. POLICY ENVIRONMENT 4.1 An Overview. A conducive policy environment is needed to increase producer incentives, lower consumer prices, increase efficiency, induce greater competition in processing, and increase export revenues. The incen- tives environment for private investment and trade will become increasingly important as the private sector is called upon to serve as the main engine of growth. This section suggests a deregulation of marketing and trade policy regimes affecting edible oils, since the socioeconomic conditions prevailing when the policies were fashioned in the early 1970s have changed, and the existing policies have not been effective in achieving the Government's objec- tives. To improve rubber quality, incentives at the processing end are sug- gested in lieu of the present export bans on low-quality rubber. Improvements in rubber quality could become critical to Indonesia's ability to meet the futire import demand of industrial countries. 4.2 Protection of Tree Crop Commodities vis-a-vis Other Commodities. Recent studies have shown that: (a) manufactured goods are protected more than agricultural goods; (b) import-substituting agricultural goods receive higher effective protection than export-oriented agricultural gcods; and (c) tree crop commodities receive relatively low or negative protection. The effective rates of protection 1/ are estimated to be 6.2 for rubber, 2.9 for coconut, -0.8 for coconut oil and 6.2 for palm oil compared to 17.6 for paddy, 47.5 fo; soybeans and 45.4 for sugar. This implies that there is an implicit anti-export bias in agriculture, and there could be real resource gains to the economy from expanding production and exports of tree crop commodities. A strong emphasis on public investment has in the past compensated partly for indirect discrimination agaiast the tree crop subsector. 4.3 Trends in Incentives. Trends in real and nominal world market prices are presented in Annex Table 6.1. World rubber prices rose sharply between 1976 and 1980, rising in real 1985 terms by 4.3Z p.a. During this cyclical upturn, Indonesia began a series of major investments in rehabilitation and new rubber planting. Rubber prices peaked in both nominal and real terms in 1980. Between 1981 and 1985, rubber prices plunged, declining on average by 6.2Z p.a. in rsal terms. Since 1985, rubber prices have recovered, rising by about 15% p.a. in real terms between 1985 and 1988. World Bank forecasts call for prices to soften in the near term and then rebound between 1990 and 1995 to real price levels above the cyclical peaks prevailing in 1988. 4.4 World market prices for copra, crude coconut oil (CCO) and crude palm oil (CPO) have been highly erratic during the past two decades. In every 1/ The effective rates of protection (ERP) measure the degree to which protection causes actual value-added to diverge from the value-added that would have prevailed in the absence of protection. i positive ERP implies that production of a particular commodity is receiving positive net incentives, while a negative ERP indicates a net disincentive. The ERP estimates are obtained from "Agricultural Policies in Indonesi.a: Existing Policies and the Scope for Reform," George Fane and Greg Cutbush, ADB Consultancy Report, September 1988. - 55 - five-year period since 1970, copra prices have both exceeded US$500 per ton and been below US$300 por ton. CCO and CPO prices have been equally volatile. The average coefficient of variation from a 17-year trend in nominal copra and CCO prices is 401; for CPO, off-trend variation is 312. Future forecasts call for a steady increase in copra, CCO and CPO prices to the year 1995, with a pronounced fall-off thereafter, due primarily to expansion of palm oil, soy- bean and rapeseed acreage in major producing nations. 4.5 During the early 1970s, Rupiah overvaluation turned the terms of trade against estate crop exports, during a period of deteriorating real world market prices. This has been corrected by more flexible exchange rate manage- ment beginning in 1979 (Annex Table 6.2). The 1986 devaluation of the Rupiah effectively arrested the real decline in international prices in Rupiah terms. The 1979 and 1983 devaluations, by comparison, increased profitability at a time of rising real world market prices. 4.6 Movements in output prices and exchange rates have been far more volatile than shifts in wages. Official estate labor wage rates rose sharply in the early 1970s, peaking in real terms in 1977/78. Since that time, real wages have followed a steady decline (Annex Table 6.3), reflecting rapid growth in the labor force and a reduction in the real cost of essential staple goods. (Actual wages paid are often reported to be well below official levels). 4.7 Capital costs have also fluctuated far more than movements in wage rates. This high degree of volatility in interest rates mirrors patterns of the Government monetary management. Interest rates for short-term, money- market borrowing are relatively high (compared to other estate crop producers such as Malaysia), and reflect real capital costs, higher intermediation costs and expectations of currency devaluation. Money-market interest rates peaked at 18.6Z in 1984, declined thereafter, and by 1988 they were back at the high levels prevailir,g in 1984. 4.8 Incentives and Investment Patterns. The linkage between prices, costs and investments in the tree crop sector has been tenuous in the past, because of long lags between investments and production, irreversibilities in perennial crop investment, the dominance of public investment, and the impor- tant role of public policy shifts in stimulating domestic investment. Cycli- cal movements in incentives have not had a pronounced effect on public invest- ment, primarily because public investment has been determined to a greater extent by domestic resource availability and absorptive capacity. Volatility in public investment has been less a reflection of movements in expected prof- its or replacement requirements than a reflection of short-term budgetary constraints. Smallholder rubber production, however, has shown signs of responding positively to increase in real export prices. Smallholder rubber production rose sharply in 1979 and 1980, in response to cyclically high world market prices and then it fell sharply in 1982 in response to the depression in world market rubber prices. It picked up sharply again between 1984 and 1987 with the upturn in world market rubber prices. The fall-off in real rubber prices between 1980 and 1983 was not accompanied by a fall-off in smallholder plantings largely because of public investments in smallholder - 56 - rubber production. Likewise, between 1975 and LS85, Government estate plant- ings increased at an even faster rate than smallholder plantings, reflecting the Government's decision to utilize public estates as development agents for smallholder projects (paras. 6.3 and 6.4). 4.9 The doubling of immature areas under coconuts between 1970 and 1987 can in part be traced to Government rehabilitation programs in the 19709 rather than to short-term movements in world market or domestic market prices. 4.10 The rapid growth in oil palm area, particularly in the private sec- tor, reflects the comparatively greater profitability of CPO in domestic edi- ble oil production and the ability of CPO--in an insulated domestic edible oils market--to capture a progressively larger share of domestic market demand. 4.11 To a limited degree, public investment has operhted independently of signals driving private investment. For example, investment in rubber by private estates has stagnated at about replacement values, while public investment--both for public estate compani s (PTPs: Section VI) and smallhold- ers--has proceeded at a rapid pace. Private investment has shifted squarely into oil palm production, while public investment for smallholders has been geared more to coconut than to oil palm production. Edible Oils Trade Policy 4.12 The Government has actively intervened in the edible oils market. The primary objective of the Government's edible oils policy is to ensure an adequate and stable supply of cooking oil--one of Indonesia's nine essential commodities--at an affordable, stable price for consumers. Other objectives include income support for smallholder coconut producers; prctectior. of mills and refineries to ensure a satisfactory return on capital investments; export revenue generation; and development of new, low-cost sources of edible oil. On the industrial side, the primary objective of Government policy in edible oils is to align the supply of raw materials with the processing capacity. The policies used to achieve these objectives have varied over time, but the most important at present are: (a) restricted licensing of exports of CPO, copra and CCO. These are 'supervised export products,' which can only be exported with the approval of the Minister of Trade; (b) a two-tier export tax for CPO, comprised of a fixed and a variable tax, which rises or falls in line with world prices; (c) assignment to the Joint Marketing Office (JMO) of all marketing rights for public sector CPO and for domestic sales of a portion of private sector CPO; (d) a quota system which directs public estates to sell a fixed quantity of CPO and CCO at a fixed price for allocation to domestic processors and for market operations to stabilize retail prices; (e) a fixed wholesale "ceiling' price for domestically produced refined palm oil; (f) high import tariffs on refined edible oils; (g) licensing restrictions on CPO processing factories; and (h) cess on interisland trade of copra. However, the current policy regime was instituted in the early 1970s, and the environment prevailing during t'nat period has changed dramatically in the last decade and a half. Furthermore, the objectives of the Government's adible oils policy have proven to be mutually incornpatibl--e.g., high farm prices, high mill profits (and capacity utilization), low/stable consumer prices, and increased exports. - 57 - 4.13 The principal conditions prevailing when the edible oils policy regime was fashioned in the early 1970s were as follows: (a) interisland trade facilities were poorly developed; (b) a depression in coconut prices, combined with a failure by the Government to honor procurement obligations, had contributed to regional political unrest; (c) Indonesia had shifted from being the largest exporter of copra in the world at the turn of the century to a net importer of cooking oils in 1978; (d) the bulk of the population was poor, and edible oils constituted a large proportion of their expenditure on food; (e) coconut oil was the main source of edible oil for all segments of the population; and (f) a shortage of foreign exchange constrained public investment, and high rates of inflation prevailed. 4.14 Changing Environment. Socioeconomic conditions in Indonesia have changed since the early 1970s as a result of rapid economic growth and struc- tural transformation. The foreign exchange and inflationary crises of the late 1960s have eased, although debt service problems remain. Infrastructure and communications facilities have developed at a rapid pace,2/ and enable a vastly improved flow of goods and price signals between Java and the Outer Islands. The earlier rationale for Government intervention in interisland miarkets was to ensure a smooth flow of products between islands. This is no longer necessary today. An example of the benefits that can accrue from a reduction of Government intervention in interisland trade logistics is the reduction in copra margins, betw,een Sulawesi and Java, following the 1985 abolition of interisland copra licensing. In 1983 and 1984, the average nomi- nal margin between copra at the wholesale level in Sulawesi and copra at the wholesale level in Java was Rp 104.5/kg. In 1986, without a change in the rate of interisland trade taxes, but with an abolition of licensing require- ments, trade margins declined (in nominal terns) to Rp 63/kg: a savings of 40Z compared to 1983/84 margins. The copra case illustrates that lifting regulatory controls can vastly improve the ability of the domestic market to allocate supplies efficiently across islands. 4.15 The second important change between conditions in the late 1960s and those at present is the increasing spending power of the Indonesian popula- tion. Between 1970 and 1985, real per capita disposable private consumption expenditures increased at an annual rate of 4.9Z p.a. This amounted to a doubling of average real consumer purchasing power in a 15-year period.3/ Even among the poorest segment of the population, in both rural and urban areas, edible oils account for only about 32 of total expenditures (Annex Table 6.4). 4.16 The largest consumers of edible oils are not the low-income consum- ers. In both rural and urban Indonesia, the bottom quarter of the population consumed less than 10X of all edible oils and less than 15% of all coconuts 2/ Between 1969 and 1985, the total length of paved roads increased from 84,000 km to 204,000 km; the number of trucks from 94,000 to 845,000; the number of interisland freight vessels from 89 to 398; and the number of telephones from 184,000 to 829,000. (CBS, Statistical Yearbook, various issues). 3/ Private Consumption Expenditures are taken from the National Accounts, deflated by the 17-cities CPI. This is a better indicator of - 58 - consumed. The low budget share of poor households allocated to edible oils suggests that such households may be able to shift resources away from other goods to meet edible oil needs in a time of fluctuating or rising prices. For the poor, rice consumption is far more important, both budget-wise and nutri- tionally, than is edible oil consumption. Rice accounts for approximately 291 of the total expenditure budget and 652 of total calories of the poorest 202 of the urban and rural consumers.4/ Poor consumers have been able to offset the higher costs of edible oils by shifting expenditures between rice and edible oils.5/ A case in point is the sharp increase in real cooking oil prices (46Z) in 1984 which was more than offset, in household budget terms, by a slight decline in consumption of rice, leading to a 7? fall in real rice prices in the same year. 4.17 At the time the present edible oils policy was conceived, it was assumed that the vast bulk of the edible oils supply would originate from coconut oil, and that, compared to forecast demand patterns, domestic supplies would be unable to meet demand. Policies were designed primarily to contain copra imports. The experience of the past decade suggests that CPO-based cooking oils are widely accepted throughout all segments of society. In both urban and rural areas, the middle and upper classes consume more palm oil- based cooking oils than coconut-based cooking oil (Annex Table 6.4). Nation- ally, the share of CPO-based Looking oils to total cooking oil consumption reached 59? of a total consumption of 832,000 tons of cooking oil produced in 1985.6/ Future projections call for CPO-based cooking oils to fill nearly 702 of total domestic cooking oil needs by the year 2000 (para. 3.13). The switch-over from coconut oil-based to palm oil-based cooking oil sources means, for the time being, that the policy objective of providing an adequate supply of edible oils has been achieved. 4.18 At the time the present edible oils policy was conceived, Indonesia was also progressively plunging into an edible oils shortfall and a severe shortage of foreign exchange. Copra production had declined precipitously during World War II and was stagnant in the 1950s and early 1960s. The edible oils policy was fashioned largely as a strategy for import substitution and conserving foreign exchange. By the mid-1980s, this situation had reversed. The reported copra supply grew from 1.2 million tons in 1970 to 2.0 million tons in 1987, increasing at an average rate of 3.1 p.a. CPO production increased ever more rapidly, from 220,000 tons in 1970 to 1.4 million tons in 1988, and, as discussed above, has served to plug the domestic edible oils gap. It is forecast (para. 3.14) that Indonesia will have a surplus, over domestic consumption requirements, of about 1.5 million tons of CPO in 1990, disposable income, specific to food consumption, than is per capita GDP because of the low private savings ratio and the importance of public savings to GDP. 4/ These estimates are based on the 1984 SUSENAS survey. 5/ Cross-price elasticities of demand between edible oils and rice are not known with any certainty. Richard Monteverde ('Food Consumption in Indonesia,* unpublished PhD dissertation. Harvard University, 1987) estimates cross-price elasticities in the order of -0.1 to -0.2 for middle-income groups. 6/ Edible oil consumption estimates are from the Ministry of Industry, and Unilever (for 1985). - 59 - and about 1.0 million metric tons in the year 2000. Likewise, Indonesia is forecast to have a small surplus of CCO equal to 42,000 tons in 1990, and 173,000 tons in the year 2000. Therefore, import substitution is no longer an immediate concern. 4.19 In the 1950s, the fall in copra prices, combined with a Government failure to honor procurement obligations, contributed to the regional ten- sions. The Government reaction was to provide minimum copra floor price guar- antees, originally through direct procurement and stockpiling of copra and more recently through public CPO distribution and regulation of domestic CPO prices. The potential now, however, for low prices to spark off regional tensions is apparently quite less, as a result of a number of factors. First of all, in the traditional coconut-producing provinces, there )- been a not- able diversification of economic activities and hence income scurces. Even in traditional coconut-producing provinces such as North Sulawesi, smallholder coconut producers receive an average of about 302 of their income from nonco- conut sources.71 Second, the increase in the development of copra processing facilities in the main producing areas, particularly since 1986, has improved farmer prospects for credit assistance and relief during times of low copra prices, since these factories' prosperity depends on building sound links with local traders and farmers. Third, there has been no evidence of regional unrest in reaction to turbulent copra prices during the past decade. Actual domestic copra prices have vacillated quite sharply, even with Government controls. In real 1985 terms, farm-gate copra prices in South Sulawesi Cell from Rp 442/kg in 1984 to Rp 279/kg in 1985. Earlier still, copra prices fell from Rp 560/kg (in real 1985 terms) in 1973 to Rp 203/kg in 1975. Increasing diversification of income sources, development of a vertically integrated local processing sector, and the lack of apparent social turbulence in reac- tion to very low domestic copra prices imply that regulating edible oil prices to ensure regional security is of much less importance now than it was in 1968. 4.20 Effectiveness of Edible Oils Policy. The Government's edible oils policy has not been particularly successful from the vantage point of either effectiveness or efficiency. Despite the Government's objectives, consumer prices have been high and variable, farm-gate prices have been low, and pro- cessing costs have been excessive. 4.21 Consumer Prices of Cooking Oil. One of the primary objectives of the Governmenc's edible oils policy is to maintain low, stable cooking oil prices for consumers. However, there is no evidence that, as a result of market operations, the Government has kept consumer cooking oil prices below world market levels. In fact, just the opposite is the case. Only for 7 out of the past 55 months has the domestic price of CPO-based cooking oil been less than the price of CPO-based cooking oil in Europe. Only for 16 of the past 55 months has the domestic price of CCO-based cooking oil been less than the price of CCO-based cooking oil in Europe (Annex Table 6.5). As an exporter of CPO and CCO, Indonesian cooking oil prices should be far lower than those prevailing in Western Europe, both because of quality differences and because of the freight and incidental costs incurred in trade from Indonesia to 7/ These estimates are derived from the Central Bureau of Statistics, Agricultural Census 1983, Volume 4, 1986. - 60 - Europe. According to private trade sources, incidental costs (freight, insur- ance, loading) between Medan and Rotterdam averaged US$60/ton for the first seven months of 1988. If these costs are subtracted from Rotterdam CPO- sourced cooking oil, then the average 1988 Jakarta cooking oil price has been 23Z above an equivalent export-parity price. This implies that Indonesian edible oil policy--even with large amounts of CPO allocated for market opera- tions--has not been effective at providing low prices of cooking oils. 4.22 Jakarta cooking oil prices have been marginally more stable than CIF Rotterdam cooking oil prices, when the coefficient of variation in annuEl prices is used as an indicator of price stability (Annex Table 6.5). However, the greater variability in Rotterdam prices (in Rupiah equivalent) is partly a reflection of a high degree of variability in the Rupiah to the dollar exchange rate. In 1987 and 1988, prices of CPO-based cooking oils have been about equally variable in both Indonesia and Europe. Since Indonesian cooking oil prices have been held above world market prices, the variability measure is relative to a higher average price, and therefore absolute price changes are greater for a given percentage change in Indonesia's coefficient of varia- tion. This implies that, in fact, absolute price variations have been greater for CPO-based cooking oils in 1987 and 1988 in Jakarta than in the Rotterdam market. There is thus an evidence that the current policy regime has not significantly improved consumer price stability. 4.23 Producer Prices. A second important objective of Government policy has been to protect producer incomes through controls over copra and palm oil pricing, marketing and trade. Since 1979, high duties have been applied to imports to protect domestic copra producers. Annex Tables 6.6 and 6.7 compare world and domestic prices at the producer level, under export parity condi- tions, for copra and for CPO, for the years 1980 to 1988. In 1982 and 1986, the Government procurement price was above the border parity price for CPO. In all other years, the official procurement price has been well below world market prices, in border parity terms. Furthermore, if the prices reported by one of the PTPs are used as an indicatcr of the actual price received by the PTPs for their output, then the implementation of Government policy has reduced PTP producer incentives for CPO each year since 1980. The reduction in incentives at the PTP level will be passed back to the small farmers, since PTP oil palm production is partly derived from the nucleus estates. Govern- ment import and pricing controls have provided copra farmers with a measure of protection in some years and have implicitly taxed farmers in others. 4 24 As a result of the ban on copra exports, coconut small.iolders have received lower prices than would have prevailed in the years of negative pro- tection. On average, between 1980 and 1988, world market parity prices have been 5.2: above domestic farm-gate prices. 4.25 Interisland Supply Availability. Another important objective of the Government's edible oils policy has been to ensure an "equitable" distribution of raw materials supply between processors located in the main consuming region, Java, and those (usually more modern and efficient processors) located off-Java. Various mechanisms have been used to allocate copra, including direct public marketing (pre-1974) and licensing of copra processing and - 61 - interisland trade (until 1985). However, in the absence of licensing, more copra is flowing to Java than before. The amount of copra traded to Java, according to Ministry of Trade monitoring records is as detailed in Table 4.1 below. Table 4.1: COPRA TRADED TO JAVA ('000 tons/year) Copra traded to Java With Licensing 1981 194 1982 181 1983 177 1984 151 Average 175 Post-Licensing 1985 312 1986 208 1987 210 Average 243 Note: Tonnage traded to JLva includes all trade from Sulawesi, the Moluccas and Riau. Source: Department of Trade, Laporan Statistik Perdagangan Dalam Negeri, September 1988. 4.26 Matching Raw Material Availability and Processing Capacity. A fourth important objective of Government policy has been to match production capacity with domestic raw material availability. This has not occurred for either copra crushing or CPO fractionation. Government policy to coordinate process- ing capacity with raw materials supply, through industrial licensing restric- tions, has not been a success. By restricting market access, the Government has provided processors with incentives to overinvest, partly to lower licens- ing costs and partly as an attempt to capture market share. Cooking oil mard- facturers operate at 282 of installed capacity, CPO fractionation and refining mills at 542 of capacity, and CCO factories at 44? of capacity. The fact that such overcapacity exists reflects a Government pollcy in which: la) in the case of copra, vintage mills in consuming areas of Java were supplied raw materials at the expense of new mills in producing areas; (b) domestic alloca- tions of CPO were made to processors in accordance with their installed capa- city, inducing processors to overbuild in order to guarantee raw material supply; and (c) CPO mill licenses were granted to selected firms. In the case of copra, overcapacity part'y reflects replacement of older-vintage, smaller crushing plants by newer, lTrger mills. For CPO, this also reflects an - 62 - attempt by large conglomerates to restrict access to the CPO market by estab- lishing excess processing capacity during a period when the Ministry of Indus- try had a licensing ban on CPO factories. The high costs of low-capacity utilization are passed on, in part (as discussed in paras. 4.21-4.24) in terms of lower farm-gate prices and higher cooking oil prices. The following table indicates the extent of low capacity utilization. Table 4.2: CAPACITY UTILIZATION IN CPO, CCO AND COOKING OIL MANUFACTURE ('000 tons) Installed Actual 1 of capacity output installed capacity 1985 Cooking Oil Processing CPO-based cooking oils 1,796 457 26 CCO-based cooking oils 1,138 375 31 Total Cooking Oil 2,934 832 28 Margarine 437 39 9 oleochemicals 70 n.a. n.a. Soaps 181 150 57 1987 CPC Fractionation and Refining Capacity Licensed capacity 1,611 Installed capacity 2,715 1987 CPO output 1,476 Output/installed capacity (Z) 54 1985 Capacity and Utilization of Copra Mills Licensed capacity 1,983 Production 880 Capacity utilization (Z) 44 Note: 1985 cooking oil estimates are from Ministry of Industry and Unilever. 1987 CPO fractionation and refining capacity estimates are from Associasi Pemasaran Bersama Perkebunan, "Laporan Minyak Sawit," report number M.132.51.0.85, 1986. Copra mill capacity and utilization esti- mates are Ministry of Industry estimates cited elsewhere. 4.27 Stimulate Export Growth. Another important objective of the Govern- ment edible oils policy has been to increase exports; however, export volumes of CPO are at about the same level as in the early 1970s, and the net export earnings, in dollar terms, are below levels reached in the early 1980s. How- ever, it should be noted that rapid growth in CPO supply has primarily been absorbed in the domestic market. Exports of coconut Dil have been erratic; they have been totally banned in some years and liberalized in others (gener- ally high world price years). Between 1970 and 1984, exports averaged about US$6.0 million (current terms). Exports of coconut oil skyrocketed to almost - 63 - US$100 million in 1985, dropped to US$1.2 million in 1986 and again rose to about US$100 million in 198e. Throughout the 1970-87 period, exports of copra meal have earned generally between US$30 to US$40 million per year and palm kernel exports have accounted for less than an average of US$5 million per year. CCO and palm oil imports combined have been very small over the period, with the exception of 1978-81, when drought led to imports of US$18-58 mil- lion, and the period of 1986/87, when imports equaled US$8-42 million. Thus, although it is difficult to estimate the "without policy" case, there is little evidence to suggest that the edible oils policy has been particularly successful in stimulating exports over the past 10-15 years. 4.28 Copra Trade Ban and Inefficiency in Coconut Oil Milling. Government copra export prohibitions and restrictive CCO import and export licensing, combined with an historical policy of allocating Outer Island copra to vintage (and low-capacity utilization) Javanese mills has created regulatory barriers that fostered the development of a high-cost CCO milling/refining sector. According to some estimates for 1985, the profit margins on coconut oil refin- ing averaged 102 of the price of refined oil in Java, 171 of the refined oil price in Manado, and 472 of the refined oil price in Medan. Similar computa- tions for a UK-based coconut oil refining mill showed profit margins in the order of 6Z of the refined oil price. Other estimates indicate that, when evaluated at border parity prices, there has been negative value-added created in copra crushing for 10 out of 12 years between 1975 and 1987. Although EEC import policies complicate comparisons of crushing margins, there is strong evidence that trade protection, in copra and CCO, has allowed Indonesian CCO mills to maintain high profit margins, when at world market prices and givenr their cost structure, they would be incurring losses. 4.29 Cess on Interisland Trade in Copra (DRK). The DRK ("Dana Rehabilitasi Kopra') was established in 1979 by the Ministry of Trade (Decree No. 667/M/IX/69) as a special tax on copra. This tax was to replace all regional taxes on copra and CCO. r K revenues were to be reinvested in the coconut-producing sector. DRK rates have varied over time, but current rates are Rp 15/kg on interisland copra trade, Rp 8/kg on interisland CCO trade and Rp 1/kg on CCO exports.8/ BAPENGKO in the Ministry of Trade still collects a cess on interisland movement and international trade in copra and CCO, even though licensing for interisland copra and CCO trade was abolished under the INPRES-4 Decree of 1985. At Rp 15/kg, the DRK is equivalent to a 32 ad- valorem tax on copra exports. at mid-1988 prices. Two-thirds of DRK revenues are allocated to provincial governments for theiz development needs. One- third of DRK revenues are allocated to BAPENGKO in the Ministry of Trade. Few DRK revenues have been reinvested among coconut smaliholders. At the central government level, DRK revenues enter into a general revenue pool used by the Department of Trade. In 1987, DRK collections reached Rp 3.6 billion.9/ 8/ The legal basis for the present DRK is Ministry of Trade Decree No. 16/KM/V!87 dated May 7, 1987. Actual fees vary somewhat by islands with areas such as Gorontalo exempt from interregional taxes to Manado. Trade in CCO is also subject to a 10Z VAT withholding. Copra is not subject to VAT until it has been processed. This has increased incentives to ship ropra from Sulawesi to Java, rather than process copra into CCO in the Outer Islands. 9/ BAPENGKO Report, Ministry of Trade, 1988. - 64 - Furthermore, DRK taxation has not replaced the levying of local taxes on the copra trade, according to the results of various recent coconut marketing studies. With the abolition of licensing requirements, the DRK has become an outmoded nuisance tax, which has not been able to channel revenues back to producers or eliminate local trade fees charged by regional governments. The incidence of the DRK tax falls heavicst on the coconut smallholder, since coconut demand is more elastic than coconut supply. 4.30 Inefficient CPO Trade Practices. The implementation of the CPO pro- curement and trade policy has developed into a trading system in which super- normal profits are reaped on internal and international trade. Such profits are the confine of a small group of businesses, which are interlocked with the largest cooking oil processors in Indonesia. Under the current pricing struc- ture, there are at least eight different prices prevailing for CPO in the Indonesian market. These are: (a) the administered PTP/PMA procurement price received from the JMO; (b) the FOB export price; (c) the CIF import price; (d) the wholesale release price from appointed distributors to registered processing factories; (e) the wholesale release price for CPO sold under mar- ket operations to registered processing factories; (f) the wholesale price from private producers distributing outside the allocation system to fraction- ation plants and other end-users; (g) factory-gate prices for private produc- ers; and (h) the factory-gate CPO price for PTP CPO not sold under domestic allocations, market operations or assigned exports. The difference in these prices provides producers, processors and traders an incentive to seek rents by buying (selling) at one price and selling (buying) at another. Multiple prices also provide incentives to private producers to smuggle CPO out of the country when administrative procurement prices are bet below export parity prices, as was the case each year between 1980 and 1985.10/ By taking advantage of differences between tariff rates on exports and imports, firms have been able to "export" CPO from Belawan and simultaneously "import" CPO in Java. This explains the simultaneous exporting and importing of CPO in 1984, 1985 and 1987. 4.31 In years when domestic allocation prices have been set above prevail- ing "free market" prices, domestic processors have not accepted their full CPO allocetion, seeking instead to buy CPO from private distributors. In years when the allocation CPO price was below the 'free-market" price, processors have sought to collect more than their full allocation. The actual allocation of CPO under domestic allocations and under market operations, compared to the planned allocations, is listed in Table 4.3 below. Domestic market alloca- tions and market operations are conducted by only two private firms on behalf of the Ministry of Trade. Exports of CPO are licensed to only four firms. There is evidence that, by virtue of having the authority to procure CPO for market operations, to allocate it to domestic processors, and to export it, these firms are reaping supernormal profits. 10/ During some years, domestic CPO prices have been so low that producers have found it profitable to refine CPO into stearin and olein, which can then be legally exported to Singapore where it is reconstituted into CPO. - 65 - Table 4.3: PLANNED AND REALIZED ALLOCATIONS OF CPO ('000 mt) Planned Realized Realized 2 realized Total CPO domestic domestic market of total production a:locations allocations operations production 1978 501 88 88 - 18 1979 641 342 168 - 26 1980 721 518 304 - 42 1981 800 683 536 - 67 1982 887 705 532 - 60 1983 982 n.a. 618 - 63 1984 1,147 750 871 221 76 1985 1,242 870 558 140 45 1986 1,350 400 352 283 26 1987 1,476 410 230 71 16 1988 Planned 410 250 Source: Ministry of Trade. 4.32 Annex Table 6.8 presents a computation of the "profitsw earned in administrative trade of CPO. Total administrative trade is defined as that which is procured for domestic allocations, market operations dnd export. The latter is included because practically all CPO exports flow through the JMO and are then traded by a subset of the same firms which handle domestic market allocations. Exports are valued at export unit values and domestic sales are valued at 67Z of the wholesale price of CPO-based cooking oils in Jakarta.11/ If the actual administrative price had been paid, then in 1985, 1986 and 1987, the companies would have registered negative profits on CPO trade. This is unlikely since the Government does not subsidize the operations of these firms. However, if the firms paid the PTPs less than the official price--as is reported by at least one PTP in its financial accounts to the Ministry of Agriculture (BUMN Repelita IV Evaluation Report)--then the firms' profits would be very large indeed. The estimated profit, from administrative trade and exports, is in the order of Rp 219 billion in 1987. This is equal to a profit margin of 61Z on gross sales. Total cumulative profits, between 1984 and 1987, for these firms from administrative distribution services only--if the lower reported PTP prices are correct--was about Rp 951 billion. These are the rents which accrue from administered trade rights. The firms that manage this distribution system are also the largest private producers of CPO in the country and, through sister companies, control about 65? of the total cooking oil market. A lack of competition in the market may also explain why CPO-based cooking oil prices (Jakarta wholesale level) have been well above Rotterdam CPO-based cooking oil prices since 1985. Under these circumstances, replacing quantitative trade restrictions with tariff protection would not 11/ The latter ratio is a conservative estimate based on cost and processing margins presented in the 1986 University of Indonesia edible oils study. - 66 - alter patterns of price formation. Measures to improve competition in the market place--or conversely, to remove the opportunities for garnishing rents --need to be considered. 4.33 Liberalization of Olein and Stearin. The December 1987 trade package removed restrictions on the export of olein and stearin. Since these are intermediate products into the refining of cooking oils (see Annex Chart 2), trade liberalization theoretically signifies the abandonment of quantitative restrictions as a means of controlling consumer prices. However, the world market for olein and stearin is thin, and trade volumes will likely be limited to 40,000 to 50,000 tons of each annually. For the first eight months of 1988, after trade liberalization, olein and stearin exports were lower than they were in 1987, as indicated in Table 4.4. This has been a piecemeal reform, and needs to be accompanied by abolition of export restrictions on CPO, CCO a..d copra as well. The November 21, 1988 trade package has now allowed imports of CPO, CCO, olein and stearin to be shifted from an appointed trader basis to a general trader basis. This implies that any firm with a trading license revalidated in early 1989 will be able to import any of these goods. Table 4.4: OLEIN AND STEARIN EXPORTS ('000 tons) Olein Stearin 1984 0 0 1985 77 49 1986 59 43 1987 87 62 1988 (to August) 52 n.a. Source: Ministry of Trade. 4.34 Effect on Smallholders' Income. The domestic price syctem, which is currently anchcred in the procurement of CPO at low, administered prices from the PTPs, may no longer be sustainable, as an increasing share of the fresh- fruit bunches (ffb) are produced by smallholders. Lower PTP prices are reflected in lower procurement prices for ffb which, in turn, adversely affect smallholder incomes. To the extent that smallholders are able to sell outside of the PTPs, at competitive market prices, this will surely occur. However, the characteristics of ffb ave such that marketing outside a limited radius is not technically viable. The adverse impact on farmer incomes from low-price procurement, particularly in lands to be opened up in new transmigration sites, will be difficult to reconcile with the objective of increasing farmer incentives. A deregulation of edible oils would lead to a 5X increase in farm-gate copra price and a 15Z increase in oil palm (ffb) price. Conse- quently, smallholder income from oil palm production could increase on average by more than Rp 200,000 per hectare (constant 1988 prices), and the financial and economic returns to investment could increase by three percentage points. - 67 - 4.35 Requisite Adjustments. While the December 1987 and November 1988 trade packages have been steps in the right direction, there are still regula- tions binding both exports and domestic trade. The benefits from a comprehen- sive package of edible oil trade reforms would be increased producer incen- tives, lower processing costs, lower consumer prices, greater competition in processing, increased export revenues, and improved integration of regioiial with national markets. To achieve these goals, six further separate policy reforms are needed. These are, in order of priority: (a) abolition of all export restrictions on CPO, copra and CCO (i.e., removal of these products from the 'Supervised Export Products' list, which entails approval of the Minister of Trade); (b) abolition of market allocations and market operations for CPO at a controlled price; (c) abolition of the mandatory requirements for PTPs to market their CPO through the JMO if the PTPs continue to receive either lower prices for their output and/or inadequate marketing signals from JMO; (d) removal of licensing restrictions on investment in CPO milling; (e) abolition of the DRK tax on copra; and (f) a gradual reduction in import tariffs on CCO, CPO, copra, olein and stearin. 4.36 Both consumers and primary producers (smallholders and PTPs) should gain from such deregulation. The losers will be those benefiting from trade monopolies, from rents between market and administered prices, from regulatory-based opportunities for dominating domestic markets, and from pro- tected operation of high-cost processing. There is a clear trade-off between efficiency gains--to producers, consumers and the economy--from a package of edible oil reforms, and to special-interest groups who derive great benefit from regulatory-induced inefficiency. 4.37 An econometric quantitative analysis of the results of a policy change of this type is hampered by the difficulty in modeling the switch from a noncompetitive to a competitive trade regime. However, in qualitative terms, the direction of the likely impacts can be identified. The important changes expected from a liberalization of edible oils trade and investment policy are more dynamic than static in nature. The abolition of incentives to seek rents, to develop high-cost processing capacity behind protected trade barriers, and to utilize market regulations to capture large market shares will lead to incentives favoring competitiveness and efficiency. The expected dynamic effects of such a reform are: (a) a faster rate of technological transformation in production and processing; (b) more efficient siting of factories; (c) development of long-term contracts for export of edible oils; (d) increased foreign investment interest in both downstream and upstream edible oil processing; and (e) higher producer prices and lower consumer prices. Rubber Marketing and Trade Policy 4.38 The Indonesian rubber trade comes the closest, in practice, to a free market of any of the major export commodities. Government policy in mRrketing and trade (or rather the absence of an interventionist policy) has enhanced competitiveness and encouraged a stable supply of rubber exports. 4.39 Indonesia is a member of the International Natural Rubber Organiza- tion (INRO) that administers the International Natural Rubber Agreement (INRA) and, as such, provides financing for its share of the short-term world market - 68 - buffer stock. INRA, however, has not had a major impact on price formation in either the world or the domestic market.12/ About 902 of domestic natural rubber supply is exported, primarily in the form of SIR-20 and RSS1. The balance is consumed domestically, largely by the domestic tire industry, with a small share used for sport shoes and other specialty rubber products.l3/ Export taxes have been set, since 1980, at OZ, and exporters are exempt from VAT via the rebate mechanism. 4.40 Marketing and the Quality Problem. There have been repeated concerns voiced that the Indonesian rubber market produces an inferior-quality product and that this, combined with irregular exporting practices, reduces farmer incomes and value-added in the rubber sector as a whole.14/ Given the ongoing technical devalopments in the tire industry, it is necessary to trichotomize this quality issue into: (a) quality in terms of impurities content; (b) quality in terms of physical properties for each type and grade of rubber; and (c) quality in terms of material consistency across different shipments of rubber to the same consumer. Rubber from Indonesia suffers from all three quality defects. 4.41 The quality problem at the farm-gate is one of smallholder adultera- tion of natural rubber and the use of inferior cosgulants. Farmers typically produce thick slab or cup-lump, typically with a high moisture content, for domestic marketing. It is common for smallholders to mix dirt and other for- eign material with the slab to increase product weight. It is also common for 12/ Some analysts have argued that developing countries reap significant gains from the short-term, countercyclic operation of the INRA buffer stock (C. Suan Tan, World Rubber llarket Structure and Stabilization: An Econometric Study, World Bank Staff Working Paper No. 10, 1984). H.S. Dillon and S. Tabor ('The V'alue of the International Rubber Agreement to Producers and Consumers and the Benefits Likely to be Derived from INRA," International Rubber Study Group, Hamburg, 1987) have argued that the long-run costs of nonadjustment, due to a masking of price signals by INRA stock operations, may cost developing econo- mies more than their short-run gains. Furthermore, to the extent that industrial countries reduce their stocks as INRA builds its stock, the supply risk burden is partly shifted from consuming to producing nations. 13! The Ministry of Industry estimates that 1986 domestic rubber utilization is as follows ('000 tons): automobile tires--71.4, motorcycle tires--29.9, bike tires--26.8, other auto rubber goods-- 21.4, sports shoes--18.3, rubber compound--2.7, latex goods--5.4. This is reported in Ministry of Industry, "Pembinaan dan Pengembangan Industri Karet," (Guidance and Development of the Rubber Industry), Jakarta, 1987. L4/ Concerns over inferior quality were recently raised by GAPKINDO chief, Dr. S. Budiman, "Masallah Karet Indonesia: Tinjauan Dari Aspek Pengolahannya," Seminar on Strategic Factors Related to the Rubber Trade, Jakarta, July 1987. - 69 - farmers to use inferior coagulant, such as battery acid, which lowers product quality. In many instances, downgrading product quality is a rational farmer marketing strategy because of the prevailing trade practice of buying rubber by the truckload, with the individual farmer paid an average price by weight, rather than a price based on dry-rubber content.15/ Processing, at the mills, of batches of assorted slab rubber from the multitude of smallholders each of whom adulterate their rubber output differently, compounds this quality prob- lem. Poor transportation (both roads and rivers) system in most of the rubber growing regions reinforces the vulnerability of rubber to further adultera- tion, albeit involuntarily at this stage. 4.42 Consequently, the rubber slabs require extensive cleaning at the rubber mills, before they can be processed into blankets and then into crumb rubber. But extensive cleaning of the raw material affects the physical prop- erties of rubber output. Furthermore, since the efficiency of mill operations is influenced by the extent of standardization possible in the milling pro- cess, the millers tend to combine rubber slabs of assorted quality into batches, using cleaner rubber to the extent necessary to compensate for dirt- ier rubber. This adversely affects quality consistency which is important for tire manufacturers in their input mix of natutal and synthetic rubbers. Another consequence of imperfect removal of impurities from the rubber is that it can cause problems for the advanced tire-making technology which has very low or no tolerance for impurities. For these reasons, some tire manufactur- ers have found it optimal to revert to the use of the traditional unsmoked sheets where the physical properties are more acceptable and the impurities are minimized. 4.43 The uneven quality of rubber exports have often led to claims by importers. Furthermore, past experiences of delayed settlement, with frequent eventual nonsettlement of these claims, provided importers with a raison d'etre for a built-in price discount when purchasing rubber of Indonesian origin. The problem related to marketing practices by Indonesia exporters has been attributed, in part, to the lack of an organized, transparent export market for Indonesian rubber, and in part to the continued dependence of Indonesian traders for offshore (Singapore-based) rubber brokerage services.l6/ 4.44 Market analysts predict that quality discounts for inferior, incon- sistent and irregularly traded Indonesian rubber will increase with the increase in automation in consuming-nation tire factories. Unless Indonesia is able to shift trade more towards low-quality (e.g., nonautomated) tire- producing nations, rising demand for superior, consistent-quality rubber will widen the quality discount applied against Indonesia. 15/ See Indoconsult, Karet Alam di Indonesia, 1987 and the review of the rubber sector in Cole, W. S. and Schydlowsky, 'Downstream Manufacturing of Latex Concentrate' (mimeo draft), DSP Research Study 165, Jakarta, 1988. 16/ Harry Tanugraha, 'Tata Niaga Karet Alam,' (Natural Rubber Distribution), Seminar on Strategic Factors for Natural Rubber in Indonesia), July 29, 1987. - 70 - 4.45 Losses to the Economy from Trading Low-Quality Rubber. A conserva- tive estimate of the losses to the economy from trade in low-quplity rubber can be approximated by comparing Indonesian rubber prices to Malaysian rubber prices of technically specified SIR-20 and SMR-20 rubber. Table 4.5 below compares an average FOB price for SIR-20 rubber from Medan, Jambi and Pontianak with the price of SMR-20 rubber in Kuala Lumpur. Table 4.5: PRICE COMPARISONS OF MALAYSIAN SMR-20 AND INDONESIAN SIR-20 (US$/ton) Malaysian Indonesian SMR-20 SIR-20 Difference 1982 752 733 18 1983 942 873 68 1984 892 885 7 1985 699 693 5 1986 741 730 11 1987 890 870 20 Note: Malaysian SMR-20 price is FOB Kuala Lumpur. The Indonesian SMR-20 price is an average of the annual FOB price of SIR-20 in Medan, Palembang and Pontianak. 4.46 On average, Indonesian SIR-20 traded at a price discount of US$22/ton over the past six years, compared to Malaysian SMR-20. Mission estimates indicate that half of this cost can be attributed to higher port charges, and the balance to substandard quality and inconsistent export practices. The economic losses for inferior quality, in 1987, are estimated to equal (for all rubber traded) to about USS10 million. According to Data Consult (1987) esti- mates, the cost of transporting rubber from the farm-gate to the factory is about 4Z of the FOE price. The cost of cleaning pounded slabs, in the pro- cessing factories, is estimated at 2Z of the FOB price (in 1985/86). If it is assumed that 50Z of transport and cleaning costs can be reduced by marketing a cleaner and lower-weight product, then the economic gains from lower-cost transport and processing would be in the order of US$27 million a year. Hence, total annual gains--e.g., higher world market prices and lower domestic incidentals--resulting from improved product quality wculd be about UtS$37 million annually. 4.47 There is evidence that farmers producing better-quality rubber do realize a higher price for their product, although frequently the incentive is inadequate to induce farmers to upgrade product quality on a large scale. Table 4.6 below compares prices received by SRDP (Smallholder Rubber Develop- ment Project) farmers in the Palembang area with those of PRPTE (Export Crops Rehabilitation and Extension Project) and partially assisted farmers in sur- rounding areas. The SRDP-assisted Palembang farmers produce thin, air-dried - 71 - slab whereby the other farmers largely produce thick, dirty slab. In 1987, the additional cost of producing thin, air-dried sheet (including own-labor costs) was approximately Rp 135/kg. This would imply a margin, from producing a better-quality produce (in SRDP areas) of Rp 50/kg over neighboring PRPTE farmers. Possibilities for upgrading quality, at the farm level, differ mark- edly across regions. Where infrastructure is poor, such as in Jambi, there will be difficulties in maintaining the integrity of the thin, clean slabs in transport, if such were produced at the farm level. In other areas, such as West Kalimantan where smallholders traditionally produce sheet, efforts to upgrade product quality meet with less resistance. In the final analysis, market incentives will determine the speed with which farmers upgrade (or do not upgrade) product quality. TatLe 4.6: PRICES RECEIVED BY SRDP, PRPTE AND PAkTIALLY ASSISTED RUBBER SMALLHOLDERS, 1985-87 (Rp/kg-drc) Partially SRDP PRPTE assisted price price price Difference (1) (2) (3) (1)-(3) 1985 522 430 442 80 1986 692 659 561 131 1987 1,078 893 756 322 Source: Directorate General of Estate Crops. 4.48 Government Policies to Upgrade Quality. The response of the Govern- ment to the 'quality problem' has been primarily through demand-side, regula- tory intervention. Since 1970, the export of unprocessed rubber and by- products, such as slabs, lump, scrap, blanket sheet, cuttings, remilling scraps and bark crepe have been banned. A mandatory export standards system, which defined the different classes of Standard Indonesia Rubber (SIR), was introduced in 1969 and later revised in 1983. The latest in this series of regulatory measures is the Ministry of Trade Decree (No. 184/KP/VI/88), rede- fining S'R standards and banning exports of SIR-5LV, and SIR-50.17/ This ban 17/ As part of this regulatory reform, three new grades of SIR %Zere introduced, and the dirt content and plasticity retention index (PRI) requirements of Indonesian exports were tightened. PRI restrictions were designed to meet consumer requirements and also to reduce the possibility for quality upgrading at the final consumer end. Special regulations were also provided for plastic packing materials to improve market transparency (e.g., different colors for different SIR types) and to ensure the integrity of product packaging in shipment. - 72 - will have a limited effect on the export trade in that there was no apparent production of SIR-5LV, and SIR-50 accounted for less than 0.4Z of total rubber exports. 4.49 By providing minor obstacles to trade in low-quality rubber, the Government is signaling the private sector that external benefits will accrue from upgrading product quality. However, relatively little can be done on the demand side, without disrupting export trade and requiring more rapid adjust- ments than either processors or small farmers can afford. 4.50 Requisite Adjustments. It would be more cost-efficient for the Gov- ernment to target assistance directly, through supply-side interventions, to factories and farmers, in order to encourage quality upgrading, thlan to ban particular products or classes of products for the export trade. Factories could be provided tax breaks, based on the amount of field latex or clean thin slabs they procure directly from farmers. Alternatively, tax credits (on the corporate tax) could be provided for firms which retire vintage hammer mills and invest in processing equipment which utilizes field-dried sheet or latex. Such a system of tax credits has been used to encourage retooling in the tex- tile industry. 4.51 At the field level, the problems of low quality are closely inter- woven with infrastructural and institutional conditions. Under the Government-assisted SRDP project, rubber drying and processing (mangling) centers have been introduced as a means of encouraging group marketing and sales of clean, thin slab or rolled slab. This has helped overcome the prob- lems faced by individual farmers who are paid an average price by weight (rather than a price based on dry rubber content), which in turn has provided an incentive to farmers to mix dirt and foreign material to increase product weight. Group marketing and centers would induce a change in smallholder behavior. Such centers are relatively inexpensive--the average unit fixed cost is approximately Rp 1.5 million (center plus mangle) with estimated unit costs in t'ie order of RD 18/kg, without mangling, to Rp 73/kg with mangling, in Prabumulih. In SRDP areas of South Sumatra, farmers ate producing air- dried thin slab, and farm prices are estimated (1987) at Rp 181/kg-dry rubber content (drc) more than farmers producing thick slab.18/ Adoption of the mangling technology has been iess rapid in SRDP sites in Riau and West Kalimantan, although drying centers are used to near-capacity in both areas. In the future, such centers should be developed in areas where physical infra- structure is relatively good, where alternative demands for labor are rela- tively limited (and hence the cost of mangling kept low), where rubber produc- tion is adequate to support such a unit, and where prospects for sound farmer group management and shed/mangling unit financing appear promising. 4.52 Rubber Traded by the Joint Marketing Office. The PTPs produce about 202 of total rubber supply. Their rubber is marketed through a Joint Market- ing Office (JMO--"Kantor Pemasaran Bersama') which is under the coordination of a Joint Marketing Association. The JMO trades rubber through open-auction sales in Jakarta and Medan and through forward contracting with traditional 18/ These figures are based on SRDP project management reports. - 73 - buyers. Marketing through the J'1O is advocated by the Government in order to reduce competition among the estates and to provide a degree of market power in price setting. 4.53 The JMO appears to be a "high-cost" rubber distributor. One of the PTPs received on average about 72Z of the FOB price for SIR-20 during 1984-86. PTP accounts also indicate that total commissions paid to JMO and other sell- ing expense deductions have been as high as 4?. More frequently, JMO commis- sions on rubber sales are 1-1.5Z of FOB values, which is higher than the mar- gin of 0.5-12 of FOB values charged by most market brokers. The consequent losses to PTPs reduce their incentives to produce rubber and to invest in processing facilities that would maximize returns from the rubber trade. The PTPs should, to the extent possible, market their rubber directly because of: (a) the need to ensure proper quality control; (b) the tendency of major importers to demand long-term purchase contracts with particular estates; and (c) the need to facilitate PTP processing investment into the types of rubber most suited by the importers.19/ 4.54 Requisite Adjustments. In the future, if the PTPs continue to receive either lower prices for their output and/or inadequate marketing signals from JMO, it would be advisable to progressively divest the Joint Marketing Office of its responsibilities in the rubber trade. This would: (a) lower trade costs (and hence raise returns) for the PTPs; (b) induce greater reliance on long-term trading and investment planning in the PTPs; (c) raise buyer confidence regarding the consistency of PTP rubber exports; and (d) induce a greater operational awareness of market conditions within the PTPs. The prospects for an improvement in market conduct and performance are, in fact, better under direct than inuirect marketing arrangements because of the incentive offered to the PTPs, under direct marketing, to standardize contracts, improve contract enforcement and upgrade quality control. 19/ These views are discussed in E. Sitorus, 'Perkembangan di Pasaran Internasional dan Dampaknya Atas Kebijaka Komoditi Karet Nasional," P.T. Perkebuanan V-Sei Karang, presented at the Seminar on Strategic Factors Influencing Indonesian Rubber Development, July 29, 1987. - 74 - V. STIMULATING PRIVATE INVESTMENT 5.1 An Overview. Domestic resource constraints will limit the volume of direct public investment. A greater share of investments must, therefore, come from the private sector, which can contribute to a more rapid, sustained growth. Wider participation is needed to encourage competition within the private sector. Che Government operates a complex, multi-tiered system of regulations which affects entry, operation and exit of private firms into the production and processing of tree crop commodities. The Government's regula- tory apparatus has been streamlined under the deregulation packages of May 1986, December 1987 and November 1988. However, regulations (including licensing of private estates) still in force raise the cost of operating a business, and create barriers to entry. This section reviews the adjustments needed in the regulatory framework which can: reduce the burden on private investors to assist with smallholder development and settlement of transmigrants; facilitate the ongoing credit schemes to be more broad-based; simplify some of the requirements for land alienation and forestry replacement; stimulate private investments in upstream and downstream processing; and widen the participation of foreign private investors. 5.2 During the past decade, the Government's primary objective has been to expand the area cultivated by Government plantations. Expansion of public estate areas was conducted partly as a means to develop new areas for small- holders. During the past decade, the development of private estates has not been adequately stimulated. Rubber area cultivated by private estates declined, although oil palm oil area increased moderately. Of the total area planted to rubber in 1987 (3.0 million hectares), 83Z was owned by smallhold- ers, 92 by Government estates, and 82 by private estates (5Z domestic and 3Z foreign). The area under oil palm comprised 708,000 hectares, with 31? owned by smallholders, 487 by Gove.nment estates, and 211 by private estates (122 domestic and 92 foreign). There are reported to be about 1,200 plantations operated by domestic private companies. Annex Table 5.1 indicates the area of tree crops planted by foreign private estates. Of the 15 foreign estate com- panies (holding 154,000 ha), five are large plantation companies includ.ig London Sumatra, Socfindo, UniRoyal, Tolson Tiga and Goodyear, with a combined planted area of 138,600 ha (901 of the area under all fo.eign estate compa- nies). Table 5.1 below illustrates estate area growth over the past decade for rubber and oil palm, two crops in which large-scale private and public enterprises participated. - 75 - Table 5.1: TOTAL PLANTED AREA BY PUBLIC AND PRIVATE ESTATES ('000 ha) Government estates Private estates Year Rubber Oil palm Rubber Oil palm 1970 224 87 280 47 1971 221 91 306 48 1972 197 146 306 55 1973 216 98 134 63 1974 197 118 259 64 1975 201 121 254 68 1976 197 141 252 70 1977 189 149 236 72 1978 189 163 253 87 1979 187 176 271 81 1980 190 199 246 89 1981 232 213 243 100 1982 206 224 242 96 1983 224 261 236 107 1984 241 340 234 130 1985 261 335 231 143 1986 273 332 235 144 1987 284 342 240 146 2 growth 1.4 8.5 -0.9 6.9 Note: Area figures include mature and immature areas reported by the Direc- torate General of Estates. Growth rates are from a trend equation. 5.3 There is a growing recognition within the Government that greater private investment will be required to sustain future growth and development. Repelita V places heavy emphasis on the PIR-TRAN; program, a private sector estate crop investment scheme that carries an obiigation to develop smrall- holder plantings as well, for achieving area expansion targets, narticularly in the case of oil palm and cocoa. In addition to area under oil palm (Table 5.2), the Directorate General of Estates (DGE) plans for the private sector to plant an annual average of 9,000 ha of coconuts, 13,000 ha of cocoa and about 1,000 ha of tea. The DGE estimates that, under Repelita V. the total investment requirement for the private sector will average (in 1988 terms) Rp 156 billion per year. Annex Table 4.6 includes the estimated investment costs for the FIR-TRANS program under Repelita V. The bulk of financing for private investments is to be supplied through bank lending. Loan requirements for private investors, PTPs and small farmers during Repelita V are estimated at Rp 491 billion per year. The targets are set out in the table below; - 76 - Table 5.2: REPELITA V PLANTING TARGETS FOR OIL PALM: PIR-TRANS AND PRIVATE ESTATE DEVELOPMENT ('000 ha) PIR-TRANS Planting Targets Private Government Private estates Realization 1987 4 0 45 1988 12 9 38 Target 1990 44 10 34 1991 79 19 32 1992 86 15 21 1993 70 17 19 1994 58 13 32 337 74 138 Note: Data based on DGE Fifth Plan projections. Estimated share of nucleus ("inti") and smallholder ("plasma') in the PIR-TRANS projects for the next five-year plan is 40Z:602. Note 1987 figures for PIR-TRANS may be 1,000 ha instead of 4,000 ha according to other DGE sources. 1988 figures are preliminary forecasts. Source: DGE. 5.4 Other documents provided by DGE indicate even greater reliance on PIR-TRANS projects than shown in the above table. T;ese plans indicate that two PIR-TRANS projects were started in 1987 and five are being commenced this year for a total of seven projects actually onstream going into Repelita V. The plan then calls for a rapid acceleration of PIR-TRANS investments to a total of 36 projects, which together would establish an area of 386,000 ha (117,000 ha of private nucleus and 269,000 ha of smallholder area) planted to oil palm during Repelita V. 5.5 Although Government targets are set on the high side, the importance attached to private sector participation in the PIR-TRANS program illustrates the extent to which the Government intends to shift the investment burden from the public to the private sector. PIR-TRANS: Issues and Options 5.6 One of the main policy initiatives of the Government is to encourage private participation in estate crop development through the PIR-TRANS pro- gram. This program is an outgrowth of earlier private sector nucleus estate - 77 - schemes, and has been in operation since 1986.1/ tinder this program, a private investor develops an estate and settles transmigrants and local residents on these lands. The company is responsible for developing a factory and the estate lands, and the Department of Transmigration is responsible for financing housing, sanitation, roads and other essential infrastructure. On average, the nucleus: smallholder area ratio is expected to be 40:60, although it may vary from 20:80 to 70:30 depending on how much equity the estate is willing to invvst and other considerations. 5.7 Credit financing is available for the PIR-TRANS program for oil palm, rubber, tea and cocoa, although the vast bulk of investment applications have been for oil palm. Land development and operation costs, plus a 152 management fee, are gazetted as standard unit development costs 2/ which may be reimbursed to the private investor, and converted4 to smallholder credit. The costs are lower for Sumatra and Sulawesi and higher for Kalimantan and Irian Jaya. The nucleus firm is required to provide 352 own equity and is given a loan at a nominal interest rate of 162 for a total term of 13 years, with a four-year grace period (in the case of oil palm), to finance the project. The loan is comprised of 45Z of the banks' own funds and 55Z Bank Indonesia (BI) liquidity credits. For the smallholder land, the banks provide the estate with lOCZ credit, comprised of the same blend of funds as the loans to the estate for its own land. The terms are again 16Z interest rate, and in the absence of conversion, the total term is 13 years. However, it is envisioned that at year 4, the land will be converted to smallholders. The smallholders will be provided with 162 KIK loans t 'buy out' the compounded loan balance for their land from the estate. The estate will then use that money to repay the bank the loan that it got to develop the smallholder land. At that point, the Government will also pay the estate, a management and overhead fee of 15Z of the amount converted. 5.8 The primary advantage to the private investor of the PIR-TRANS pro- gram, in addition to concessionary financing (subsidized Liquidity credits), is the accelerated procedures for obtaining usage rights over agricultural, land. After initial acceptance in principle of an application to develop a PIR-TRANS project, the private irvestor is supposed to be able, within one year, to obtain the land usage rights, conduct feasibility studies and obtain permission to replace forestry lands, a process that usually requires from one to four years for private investors. An Interministerial Technical Committee, chaired by the Director General of Estates, with representatives from the Ministry of Agriculture, Finance, Transmigration, BAPPENAS, Forestry, Home I/ The legislation establishing the PIR-TRANS scheme is Presidential Instruction No. 1, 1986, dated March 3, 1986 More detailed guidelines are provided in Ministry of Agriculture instruction Letter 333/KB,510/1986, dated June 4. 1986. Guidelines on financirg requirements are set out in Ministry of Finance Instruction Letter No. 59la/,KM.K011/1986, dated July 8, 1986. Unit costs are established in a Ministry of Finance and BAPPENAS decree No. S-748a/MX.011/1986, dated July 17, 1986. Bank Indonesia application procedures are con- tained in Decree No. 19'4/iKE?/lTP., dated June 4, 1986. Tne organization asnd obligaticns ,f the tehnir c ,-an are contained i.r Ministry of Agrizulture :e-ree NG. 516iKP. 50/1986 dated August 18. 1986. 2/ These standard costs are estz'.ished in the Ministry of Finance Decree 2-420/MX.ll dated July 8. 1987. - 78 - Finance, Transmigration, BAPPENAS, Forestry, Home Affairs, Cooperatives and Bank Indonesia is responsible for reviewing program applications and acceler- ating project implementdtion. 5.9 On the basis of a Governor's approval to develop lands, a land survey from local government departments, a micro-study for forest exploitation, a consultant's presurvey and feasibility study, the Ministry of Finance issues a letter of agreement on the Financing Plan for the project and the Ministry of Agriculture issues a letteL of agreement on the technical feasibility of the project. As of July 1988, these approval letters had been issued for 405,000 ha of PIR-TRANS lands. Based on these letters, an investor may request credit from one of the banks to initiate financing. In 1987, a total of 12,000 ha were scheduled to be planted under the program, but realizations reached only 4,000 ha. As of January 1988, only one private firm had received approval for PIR-TRANS credit. Applications from six other private firms were pending.3/ 5.10 It is too early to draw definite conclusions about the PIR-TEANS scheme, since little has been planted, none of the crops have come into pro- duction and only a small amount of financing has been approved. However, from the design alone, it appears that a drawback to the PIR-TRANS scheme could be that the economic efficiency of the enterprise is reduced in order to satisfy income distribution objectives. The contractual arrangements would require monitoring to ensure that these are mutually beneficial to both the private investors and the smallholders. The private estates could have even less interest in smallholder welfare than did the PTPs. Since this program at present dwarfs all other smallholder tree crop programs, it ne ds to be closely monitored before it can be established that this strategy can succeed in promoting tree crops for smallholders. 5.11 Investment costs to the private sector, under the PIR-TRANS scheme, are higher than under a privately managed estate operation because of the burden associated with settlement of transmigrants, and of providing training and extension services to small farmers. There would be a need to clarify and streamline regulations for transfer of land ownership to smallholders, and ensure proper remuneration and flow of funds to private estates for infrastructure and related activities. In the absence of control over a sufficient amount of land, the estate cannot guarantee an adequate supply of raw materials to maintain satisfactory factory capacity utilization rates. Given the long gestation period and high risk of crop failure and international price fluctuations, estate crop investments are already at a "natural" risk disadvantage compared to investments in domestic consumer 3/ Data on investment applications and approvals are contained ir. the report of t.e PIR-TRANS Coordinating Team. 'Laporan Tengahi Tantinan Penyeienggaraan Proyek PIn-TRANS Tahun Anggarani 197/88," November 1987, with updated information provided by the Director of Planning, Director General of Estates. - 79 - goods, light manufacturing, trade and services. The imposition of a redistri- butive burden on private investment, particularly in new development areas where there is relatively little public infrastructure to begin with, could induce capital flight to other sectors. The prog.am is expensive in terms of subsidized liquidity credits, and could suffer from smallholder credit repayment problems. 5.12 One practical problem with the PIR-TRANS scheme is that it imposes complex interministerial financing responsibilities on tie Government. Under this program, the Ministry of Transmigration is required to finance construc- tion of basic social infrastructure, such as schools, houses and sanitation equipment. However, coordination between the Ministry of Agriculture and the Ministry of Transmigration on these schemes has been insufficient. According to Ministry of Transmigration officials, no funds have been programmed in 1987/88 for providing social infrastructure specifically for PIR-TRANS areas. This raises the question of the rights and obligations of the private investor with respect to recouping the costs of developing social infrastructure if the Government simply does not finance it. 5.13 Another practical problem with this program is that it involves the Government in setting unit-cost standards and output pricing formulae for private enterprises. The use of standard cost estimates for project rinancing does not reflect actual capital financing requirements, which differ by firm and location. The use of standard pricing formulae, regardless of how these are designed, imposes an additiornal measure of uncertainty on the investor, since variable costs at maturity will be, to a large part, administratively determined. 5.14 The contractual arrangements between the Government, private investors and the smallholders need to be clearly established and proven to be functional and effective if the Government's distributional objectives are to be achieved using the PIR-TRANS Scheme. Almost all of the PIR-TRANS companies have no expertise in plantation crops. There will be need for these firms to enter into technical assistance agreements or management contracts. Initial private sector reports suggesc a degree of diversion of subsidized PIR-TRANS credit to nontree crop activities. It also appears that the program, as presently designed, does not include sufficient incentives for the private investor to convert land from a project to a smallholder status. This will require streamlining since in the absence of land conversion, the private investor can enjoy the benefits of a private estate financed on lower tern.' than would be available otherwise, while the smallholders do not acquire any land ownership. In fact, there are pro-isions for nucleus company management of the entire estate, due to a lack of transmigrants or local settlers, written into the PIR-TRANS guidelines. 5.15 A Suggested Alternative. It is understandable that the Government wishes to promote land ownership among smallholders instead of having them merely work as laborers on plantaticns. Still, it would be efficient for the Government to provide investors incentives to efficiently develop productive - 80 - assets before control over uch assets is distributed to smallholders. One alternative is to require I ivate investors to progressively divest a portion of their holdings to estate crop laborers, through distritution of company shares, after an initial period in which investment costs are recouped. Share-based smallholder ownership schemes have been tested in Malaysia and appear to be technically feasible. From the perspective of the private inves- tor, employee shareholding schemes can serve to induce greater efficiency in enterprise operation and would impose a lower burden than outright transfer of productive assets. Private Estates: PBSN Scheme 5.16 An important policy for inducing private estate investment has been the provision of credit to Private National Estates (PBSN). PBSN credit is designed to provide low-cost venture capital for private estates, both for field development and for processing facilities. This credit program, prior to 1977, was essentially a regulatory scheme for licensing pLivate estates. The domestic private estates were not greatly expanded under the program. In part, the lack of expansion was due to Government commitment to rehabilitation of existing private estates under the program. The scheme is in its third phase, with the first phase limited to Rp 250 billion (1977-81) and the second to Rp 600 billion (1982-86). Under the first PBSN period, a total area of 33,000 ha was rehabilitated or intensified. Under the second period, a total of 135,000 ha of private lands were developed.4/ In the present PBSN scheme, a licensed private investor, after obtaining a land utilization certificate (HGU rr Hak Guna Usaha) for a Tree Crops Project and project approval from the Provincial Estate Crops Service, may apply to designated state commercial banks for project financing. The present scheme is for rehabi7.tation, replanting, new planting or the perimeter of existing estates, and planting of entirely new areas. Annex Table 4.7 includes the estimated investment costs for the PBSN scheme under Repelita V. 5.17 PBSN credit is provided for development, expansion or rehabilitation of estates under oil palm, coconut, rubber, tea, coffee and cocoa. A ceiling is placed on the amount of land eligible for concessionary financing. This limit differs by crop and whether it is an initial, rehabilitation or expan- sion investment. Financing is also provided for specific types of processing facilities to be developed along with the estates, such as CPO mills for an oil palm estate. For a new investment, the private company must make a 302 equity contribution. For a rehabilitation investment, the private company must contribute 10% from own equity. In addition, 302 of operating cost 4/ Credit utilization and area achievement estimates are provided in Directorate General of Estate Crops, Monitoring of Activities of Private Estates and Capital Information ("Pemantuan Pola Usaha Perkebuanan Besar Swasta dan Informasi Permodalan"), August 1987. Credit procedures are cont ;-..^ 4n Bank 'naorlesia -burat Edaran: kepada Semua Bank Umum Pemerintah dan Bank Pembangunan Indonesia: Kredit Untuk Perkebunan Swasta Nasional Dalam Rangka Program PBSN III," April 7, 1987. - 81 - requirements are to be financed from own equity. The interest rate on PBSN loans is set at 121 p.a., with an initial grace period (for new investments) of three years for oil palm, coconuts and coffee, and four years for rubber and tea. Bank Indonesia (BI) liquidity credits provide from 751 to 85? of capital requirements for the State Commercial Banks. The BI share is off-lent to the State Banks at an interest rate of 32 p.a. to be blended to a 122 lend- ing rate. 5.18 The PBSN scheme, providing as it does an ample supply of highly sub- sidized credit--subsidized at a higher rate even than smallholder credit schemes--is generally well received by private investors. However, the Gov- ernment has recently signaled its intention to substantially reduce the use of subsidized Bank Indonesia liquidity credits, and it remains to be seen how much new PBSN lending will be done at subsidized rates. Private investors do question the need to limit channeling of PBSN funds to state commercial banks. Greater competition among the banks for th3 use of these funds would reduce financial intermediation costs. 5.19 By implicitly granting, or denying, access to low-cost credit, the Government has attempted to direct the allocation of estate crop investment funds to particular commodities, activities (upgrading vs. new investment) and regions. Since such criteria are not transparent to all investors, and since the perceived suitability of the project is an important determinant of the time required to process the loan application, this introduces an added element of uncertainty to investment credit allocation. As in the case of land right allocations, high returtns are paid to individuals able to obtain access to low-cost credit, as opposed to those able to efficiently utilize scarce capital resources. 5.20 Reguisite Adjuscments. The constraint to private investment is pri- marily regulatory rather than financial. Interest rates under the PBSN scheme should, therefore, be progressively raised to approach the opportunity cost of capital. Interest should be fully capitalized during the initial grace period. PBSN credit should be channeled through both state commercial banks and the private banks. PBSN investment priorities should be made fully trans- parent and strict time requirements set for processing credit applications. PBSN credits should be secured either on the creditworthiness of the company or on the perceived creditworthiness of the investment. A negative list of projects that will not be financed, rather than a positive list, should be used to guide investment. In cases where adequate investment collateral is available to secure the loan, this should be accepted instead of a formal project evaluation. Regulatory Barriers to Entry: The HGU Issue 5.21 One of the most important determinants of estate crop investments are licensing policies governing access and use of public lands. There are % number of decrees, both national and regional, which stipulate regulatory requirements for alienation of public lands. - 82 - 5.22 According to the two key regulations,5/ a total of 28 official letters of approval are requi.ed to obtain the right to develop public lands, and a total of 14 letters of approval are required to obtain the rights to convert forestry land for an Estate Crops project. This includes, for all projects larger than 100 ha, direct approval by the Minister of Forestry, Minister of Agriculture and Minister of Home Affairs. Documentation requirements typically run well in excess of the 42 approval letters cited above because of the need tc resubmit incomplete or incorrect documentation. According to these Government regulations, all regulatory requirements should be accomplished within a period of six months to one year. In fact, far more time (3-4 years) is required to satisfy these regulatory procedures. One of the main problems for the private investor is that some permits expire before others are issued. Hence, the investor must backtrack to reobtain past permits before proceeding further. The procedures for obtaining access to land are described in Appendix 3. 5.23 Based on the issuance of the land utilization certificate (HGU), the investor is eligible for low-cost credit provided under the PBSN scheme. Before 1987, HGUs were valid for 20 years, with a ten-year renewal option thereafter. Since 1987, the valia4ty period has been extended to 30 years, and may be extended thereafter on a case-by-case basis. In theory, without the HGU, the investor may not clear the lands or construct a factory. In practice, however, investors typically begin processing credit applications (and eventually are given a limited amount of credit), open lands and con- struct the factory. After the credit is approved, the bank requests a feasi- bility study, with a detailed financing plan. The bank examines this, and visits the field site, and then sets the amourt of credit that can be obtained. After the HGU is issued, credit can be claimed according to a schedule approved by the bank. 5.24 Taken individually, eack regulation might possibly be justified and, in terms of preventing adverse external effects, could perhaps be considered socially efficient. It is not each regulation taken individually, however, but the sum total of all regulations that the investor faces. It is the risk- discounted probability that an investor will be able to satisfy all regulatory requirements within a given time period that determines the "expected costs' of the regulatory regime. High initial investment costs combined with a high degree of uncertainty regarding these costs--in terms of processing time, probability of successful processing, and excess administrative costs--consti- tute a barrier to entry into the sector. 5/ Key legislation affecting alienation of public lands is presented in Decree No. 3, of the Minister for Home Affairs, dated April 19, 1984 entitled, "Method for Obtaining Land P.ights and Construction Permits 'or Agricultural Lands' wnich provides instructions for land a'lienation procedures, and Decree No. 145/Kpts-II/1986, dated May 5, 1986 of the Minister of Forestry entitled 'Regulations Governing the Release of Forestry Lands for Agricultural Projects." - 83 - 5.25 Scale and capital intensity are positively related in estate crop development. Consequently, employment generation is reduced in two ways by an encumbering regulatory regime. Lower rates of private investment, due to perceived high regulatory costs, directly reduce employment generation. Indirectly, employment generation is reduced by biasing project scale to large-scale, capital-intensive investments. 5.26 Besides slowing the rate of private investment, the lengthy and cum- bersome regulatory procedures for land alienation and forest replacement dis- tort incentives for efficient land management. The more complex and expensive the regulatory apparatus, the higher will be market incentives to reward indi- viduals skilled in satisfying regulatory requirements as opposed to rewarding individuals with technical skills in operating plantations and factories. The lack of technically trained individuals in plantation management and small- holder development can, in part, be traced to a distorted incentives regime in the sector as a whole. 5.27 Requisite Adjustments. The main improvements required are a stream- lining and redesign of the regulatory structure for land alienation and fores- try replacement. As an interim step, restricting the processing time for processing HGU requests will reduce investment costs. Given that the aliena- tion of land is a complex matter, it would be preferable for the Government to establish a service to identify land for plantation development, obtain HGUs, satisfy forestry replacement requirements; and then after such procedures are completed, rent public lands to private investors at competitive mna.ket rates. Shifting the burden for provision of HGUs to the public sector would provide an institutional incentive to the Government to lowe.- the costs of alienating public lands. Regulatory requirements concerning coamodity choice bhould also be shifted from a positive- to a negative-list basis. Rather than only open investment to specific commodities, only those that are restricted due to trade quotas, such as coffee, should be prohibited. 5.28 Land alienation requirements which require submiscion and review of technical and economic feasibility studies should be eliminated. The techni- cal and economic viability of the project are risks that the investor must, in any event, assume. The emphasis, if at all, should be on examining the finan- cial solvency of the investor, rather than evaluating the technical merits of the investment. 5.29 In the near term, extending the land utilization period for a far longer period will reduce investor uncertainty and will encourage a more rational phasing of private investments. Limits to land leases are, in fact, unnecessary because of the constitutional authority vested in the Government to confiscate assets when such is deemed to be socially necessary. Provision of land-use leases, with purely symbolic expiration limits, subject to perfor- mance and environmental control, will provide for a more sustainable means of managing public assets than does the present, short-period, leasehold system. - 84 - 5.30 Social Costs of Investment Delay. The social costs of investment delay due to encumbering regulations are not immediately apparent, however, Annex Table 5.2 provides an indicative example of the costs of regulatory delay to investment in an 8,000 ha oil oalmA plantation and CPO factory. Under one investment scenario, one year is required to process the necessary docu- ments for land alienation and forestry replacement. Under another scenario, four years are required to process the necessary documentation. Although this suffers from the difficultie3 inherent in discounting consumption streams-- present wages should be more valuable than future wages--a comparison of net present values of value-added, under a delayed and a nondelayed regulatory regime, provides a benchmark estimate of the direct soc..al cost of excess regulation. 5.31 The loss to society, in terms of value-added foregone, can be calcu- lated as the difference between the net present value under the nondelayed and the delayed investment-approval regime. In terms of loss to the economy, for each 8,000-ha project delayed by four years, the social loss is equivalent to Rp 19 billion, in present value terms, over the course of the investment. If, for example, the plantings targeted under the PIR-TRANS program, equal to about 400,000 ha, are all delayed by four years because of difficulties in securing an HGU and forestry conversion permit, thenL the direct social loss is equal to Rp 950 bl'lion, or nearly US$560 million. Actual social losses would be greater because certain prospective investors would 'drop out," or 'select out' from the program because of uncertainty regarding license processing time. The Joqs in tax revenues alone--from delayed collections of the VAT-- would more than offset the cost of a smallholder developmen. program. Special Foreign Investment Restrictions 5.32 There are additional investment restrictions specific to foreign investment, which reduce the rate of private investment and reduce the rate of technology transfer to the sector. The Government restricts foreign invest- ment through the opening or closing of various sectors on the Priority List for Investment (DSP) according to biannual review and regulation by BKPM. While this list has recently been changed to a negative list, CPO milling, for example, continues to be closed to new foreign investment, 5.33 The Basic AgrF.rian Law of 1960 prohlbits foreigners from owning or leasing land. Rights of use and exploitation may be granted for a period of 25 to 30 years, with a possible extension to 50 years. Even a joint venture controlled by local investors cannot own or lease land; the Indonesian partner in the joint venture has lease rights which are conveyed to the joint venture. Inability to own land is a severe restriction for foreign firms wishing to develop any form of vertically integrated, ag-o-industrial enterprise. 5.34 Until recently, foreigr investors were required to have a local a8ent or distributor for marketing their produc- in the domestic market. For tree _rop products where demand is largely domestic, such as in edible oils, lack - 85 - of direct market access placed foreign firms at a distinct comparative disad- vantage compared to domestic private industries. Recently, however, under the November 21, 1988 trade package, foreign investors have been allcwed to estab- lish joint ventures with domestic firms to wholesale their products on the domestic market. This is a step in the right direction, wnich could lead to greater competition in marketing of cooking oils (para. 4.31). 5.35 BKPM investment requirements stipulate that all foreign investments can only take the form of incorporated joint ventures (PMA companies) with initial foreign ownership limited Lo 80Z. For large projects, which are export-oriented or located in rural areas, initial foreign ownership can be up to 95Z. For a regular PMA, foreign ownership is to be reduced to below 502 within 15 years. For large projects, foreign ownership is to be reduced to less than 80Z in ten years and 50Z in 15 years. For investments in proje ts with a long gestation period, as are most of the tree crop production proj- ects, there is little incentive to transfer technology that will yield peak returns following asset divestiture. 5.36 The present policy of Indonesianization limits the use of expatriate personnel to short-term technical assistance and special fields where Indonesian expertise is unavailable. For tree crop projects, where good qual- ity management expertise is in short supply, lack of access to trained manage- ment from other producing nations severely constrains domestic growth. 5.37 Requisite Adjustments. General foreign investment deregulatory mea- sures 6/ will improve prospects for investment in downstream processing of tree crop products, but the fact remains that without improvements in access to land., and a change in divestiture restrictions, the relative costs of down- stream investment in tree crops processirg in Indonesia will be at a regula- tory disadvantage compared to such investment in neighboring nations. A modest means of reducing the regulatory burden would be to establish export zones linked to rural concession areas for foreign, export-oriented invest- ment. Investors based in these zones would, under present legislation, be exempt from divestiture and high local equity participation requirements. By linking such zones to specific concession areas, downstream processors will have assured access to primary raw material supply. 6/ The May 6, 1986 and December 27, 1987 deregulation packages have improved the regulatory environment for foreign investment. The DSP list has been made more transparent, broad-banding of investment approval categories allows limited diversification, the number of BKPM investment application documents were sharply reduced, access to local equity markets was improved, local ownership requirements were eased, PMA firms with majority local ownership were given access to State Bank credit and swap facilities. A last important change is that PMA companies which export 10OZ of its products can be established in bonded zones, with only 5Z domestic participation and no requirement to increase domestic partnership. The November 22, 1988 deregulation package has now allowed the foreign firms to establish joint ventures with domestic firms to wholesale their products on the domestic market. - 86 - Enterprise Licensing 5.38 The Government uses a number of policies to direct the development of downstream manufacturing enterprises. This includes license requirements for factory construction and exparsion, taxation on corporate earnings, property value and value added in processing, licensing for access ta public utility ser'.rices, and restrictions on employment and discharge of hired labor. Through the use of licensing restrictions, the Government attempts to match supply of raw materials to domestic processing capacity. Since 1986, new investment in CPO milling for the domestic market has been prohibited. This prohibition was enacted because of concern over apparent excess processing capacity. To avoid these restrictions, industrialists have (a) obtained spe- cial exemptions; (b) developed subscale CPO plants, under provincial license with an investment plan valued below Rp 100 million; and (c) invested in manu- facture of a cocoa butter substitute which requires a CPO mill. Since new factory licensing prohibitions on copra milling were removed in 1986, there has been significant investment expansion in copra milling throughout Sulawesi. This has included development of two new factories in Central Sulawesi with expected installed capacity of up to 300,000 tons a year, and expansion of an existing Bimoli copra crushing/oil mill in North Sulawesi by 400,COO tons. 5.39 The primary negative effect of licensing restrictions is to reduce competition in downstream processing. This serves to protect firms that are high-cost proressors but which have obtained approved licensing capacity. This encourages firms to establish processing capacities in excess of normal operating requirements in order to reduce the licensing burden. Limits to processing licenses, at a more local level, serve to protect market segments for established industries and, by stifling competition, reduce the perfor- mance of rpoional markets. Use of industrial licensing to guide capacity development in tree crop processing shifts the burden from the private to the public sector to coordinate provision of raw material supplies to downstream processors. 5.40 Requisite Adjustments. For all of the tree crops under review (coco- nucs, oil palm and rubber), there is scope for improved and more diversified downstream processing. For rubber, there is considerable investor interest in increasing production of sport shoes and production of latex-based surgical go:ods (LEGs). For oil palm, there are plans to diversify into oleochemical production. For coconuts, there is interest in charcoal production, which remains untapped. A continuation of licensing policies would mean that increasingly Government would be called upon to arbitrate between the demands of downstream processors and those of raw material exporters. An open-licens- ing system, with no restrictions on capacity or diversification options, will provide a level playing field thwt will allow capital to be put to its most efficient use. It will also create an atmosphere most conducive to technolo- gical innovation and sustainable industrialization. In the near term, licens- ing restrictions for investment in CPO milling should be lifted and none - 87 - applied for downstream processing of either rubber or coconuts. Particularly in sectors such as oleochemicals, where initial capital investment is high, there will be demands to restrict efficient competition by limiting market access to a relatively small number of investors. Such restraints, while providing an initial impetus to new industry formation, quickly stifle compe- tition and reduce prospects for a wide-based diffusion of technological inno- vation. Need for Greater Competition Within Private Sector 5.41 Major investments in oil palm production are being made by a large conglomerate group, to achieve backward integration with its established pro- cessing facilities. This group has a total share of 65Z of the cooking oil market, with the total annual volume translating to about 750,000 tons of coconut and palm oils in finished product form. In 1983, the Government appointed this group to handle the distribution of 10,000 tons of cooking oil monthly for price stabilization purposes. 5.42 A company in the conglomerate group handles interisland shipping of edible oils with its fleet of 15 tankers. These tankers are also engaged in the export and import of edible oil with nearby countries. 5.43 The group has a licensed capacity for CPO fractionation!refining of 600,000 tons, which is 40? of total national licensed capacity. This gives the group the largest share of CPO allocated volume which is based on licensed capacity. Its installed capacity may be slightly bigger. The group also operates the largest slngle copra processing operation in Sulawesi. Its other processing investments include practically all products based on CPO and coco- nut oil, such as shorterings, margarine and soap. It is currently building a large ole fatty alcehol plant in Medan which will be one of the biggest in South East Asia, with a 30,000 ton capacity. There are already plans for a second plant, possibly in Riau. 5.44 The group started in oil palm plantation in 1983. It currently manages about 20 plantation units totaling almost 100,000 ha, mostly in Riau. The group has demonstrated its capability to open 25,000 ha in one year, and it is claimed that its immediate target is to expand to 250,000 ha, which would comfortably support the supply needs of its current facilities into the future. 5.45 A criticism of the PBSN program has been that it has not been suffi- ciently broad-based and has a'lowed a selected few private investors to obtain low-cost capital. Similarly, the PIR-TkANS program has included a heavy con- centration of approvals for two specific investor groups which have obtained usage rights of agricultural land on an accelerated basis for their related and subsidiary companies. The risk of a further increase in concentration exists. This might happen if the group attains an inordinately large propor- tion of oil palm investments in the implementation of the PBSN and PIR-TRANS programs, and if the regulatory barriers to entry by both domestic and foreign private firms are not eased. -88- VI. STREAMLINING( PUBLIC ESTATES (PTPs) 6.1 An Overview. The role of Government-owned enterprises (PTPs) in the context of smallholder development will need to be rationalized and the opera- tions of PTPs streamlined so that they can return to their role as commercial enterprises, leading to gr.=ater economic efficiency by improved resource allo- cation and utilization. The PTPs have been allowed to develop their own estates at phenomenal rates irrespective of their abilities to generate profits for their shareholders or improve their operations. This section indicates that most PTPs will need to postpone or shelve major components of their investment program in line with their debt servicing abilities and gene- ration of own funds. New development should be expected only from the most healthy of the PTPs where a contract is entered into specifically for oil palm development where the PTPs have a comparative advantage and where their work is limited to field development for smallholders. Improvements in the finan- cial health of individual PTPs can be made via increased yields, improved product quality, greater factory efficiency, decrease in production costs, improved internal management, and rationalization of their operations. How- ever, the Government should consider options for improving performance of the PTPs as a group (such as assigning functions of guidance, monitoring and some _egree of regulation to one of the agencies involved with the PTPs to provide performance standards and guidance in coLporate planning, or creating a holding company with the individual PTPs as subsidiaries, introducing contract plans/performance agreements, encouraging PTPs to enter into joint ventures with private sector, particularly in downstream high-value added activities, and divesting nonviable assets) which can increase efficiency and the finan- cial stability of PTPs on a sustained basis. Over the longer term, the very rationale for direct public investment in areas where the private sector is willing to go in and compete effectively may need a review. 6.2 Evolution of PTPs. Government participation in estate plantations has been extensive since 1958 when foreign estate enterprises were nationa- lized. In response to declining production on these estates, many of which were planted in the 1930s and 1940s, the Government reorganized them for reha- bilitation in 1968 into 28 separate departmental trading enterprises known as PNPs (Perusahaan Negara Perkebunan). Another two PNPs were established in 1972 while one was liquidated. These 29 PNPs were gradually converted to PTPs (Perseroan Terbatas Perkebunan) or limited liability companies operating under the ordinary rules of the commercial and civil codes with the Government as the sole shareholder. At present, the Government estates comprise 26 enter- prises, of which 17 are producers of tree crops. Fifteen of the 17 tree crop PTPs are rubber producers and rubber is the dominant crop of three of these PTPs. Twelve of the 17 PTPs now grow oil palm and it is the dominant crop of three of the PTPs. About nine of the PTPs are well diversified, mixed-crop PTPs growing three or more crops in large areas. PTPs produce 122 of total rubber production and about 701 of paim oil and kernels. The location and crops of the PTP estate companies at the end of 1987 is shown in Annex Table 4.1. The expansion of the PTPs began gradually following their reorga- nization in 1968 but rapidly picked up momentum as a result of the Government- sponsored Nucleus Estates and Smallholder Projects (NES/PIR), begun in 1977. - 89 - Role in Smallholder Development 6.3 In addition to relying on project management units (PHUs) of differ- ent types (begun in 1973), the Government has since 1977 employed another approach to promote smaliholder development, i.e., using Government esta.tes (the PTPs) to establish settlements and new plantings for transfer to Piall- holders in association with a new estate development. This approach began with Bank assistance under the NES I project. The Bank has, to date, financed seven Nucleus Estate and Smallholder (NES) projects in 17 different locations for smallholder tree crops with nucleus estates or expansion of the PTP tradi- tional estates. The Asian Development Bank has supported three separate NES projects, and finance was arranged for one NES scheme by the Saudi Fund. The projects established by the DGE from 1981 without foreign assistance became known as PIR proiects. There are now 73 NES/PIR schemes, which are enormous by any scale. Since inception of these schemes, PTPs have plantea 230,750 ha (512 of the program planting target for rubber, coconuts and oil palm) for smallholders, and about 101,000 ha (56Z of the target) for nucleus estates. With the inclusion of estate plantings not associated with NES/PIR schemes, total PTP plantings have amounted to some 450,000 ha. 6.4 The advantage of using the PTPs in smallholder development has focused on their experience in planting large areas. To this end, the PTPs have been successful. Total plantings of tree crops (rubber, oil palm and coconut) by PTPs in Government-sponsored projects amounted to 155,664 ha in Repelita IV, compared with plantings under the PMU schemes of 51,335 ha. 6.5 Many PTPs have, however, been forced to begin work contracts arranged with rGE prior to provincial and local Government approvals of the legal sta- tus of the land. Disputes with Agrarian Affairs and Forestry Departments in the Provincial Governments have resulted in delays in project implementation. Furthermore, the delays in approval and release of budget funds for small- holder development have slowed implementation. In many cases, the PTPs have been unable to prefinance land clearing contracts, procure agrochemicals and fertilizers--all of which must be done in a timely and phased manner--and this has contributed to plantings being substandard. Problems which have occurred in varying degrees at smallholder project sites have included: land clearing operations not done properly; quality of planting material available from project nurseries not to an acceptable standard; lining, holing and planting frequently poor; weed and lalang control delayed and costly; fertilizer inade- quate and delayed; and other aspects of poor field maintenance and upkeep. 6.6 Through the immature phase, tree crop development is carried out by the nucleus estates on the basis of prescribed budget unit costs, plus a lOx allowance for overheads and 52 for a management fee, calculated on field deve- lopment costs. The unit costs are, in general, standard amounts applying to a large region of the country, and for any particular project site, some may be unrealistically high or low. The system provides no incentive for cost savings in field or related expenditures and payment of the overhead and management fee is automatic as part of the budget procedures.l/ There are no incentives to high quality work and no penalties for substandard work. It 1/ The analysis of development costs of various PTPs in the NES/PIR projects (Annex Table 4.10) indicates that the everage cost overrun on 17 projects was 42?. Some projects have experienced cost overruns as high as 120-1302, due primarily to poor land suitability conditions. - 90 - seems that commercial contracts with payment made as work progressed but only for works conforming to specification would have been of advantage, in avoiding the substandard investmeuts. However, the internal system of PTP does not reward field staff and estate managers to carry out high-quality work. Bonuses are based on PTP profitability without relation to staff performance. 6.7 In the mature phase, the nucleus estate purchases the smallholders' crop for processing and commercial marketing. For oil palm bunches, which should be processed within a few hours of harvest and for which no established market exists outside the projects, a mechanism is necessary to ensure that prices paid for smallholders' fruit are equitable. This is particularly important in the monopsony situations where the estate is the sole available purchaser/processor. Pricing formulas have, therefore, been developed for oil palm and rubber, wnich aim to ensure that the smallholder receives fair prices, while at the same time allowing thp nucleus estate proper compensation for processing and marketing costs. Because the formulas work on regional averages of costs, including those for some high-cost factories, there is some shifting of the burden for processing inefficiency to the smallholders, and lessening of incentives to a factory to contain costs (paras. 8.14-8.16). A more serious concern is that the introduction of major new procedures such as these require close oversight by TKPIR (Tim Khusus within DGE) if the smallholders interests are to be adequately protected. In the case of rubber, where price competition from private sector dealers and processors exists, smallholders frequently sell at least a part of their rubber outside of the nucleus estate to gain higher prices on the private market and to pay off outstanding short-term debts to middlemen. 6.8 The NES/PIR approach has been a useful interim expedient which has been valuable for the ability of the PTPs to plant large areas of tree crops. Unfortunately, much of the strength and financial stability of PTPs as commer- cial enterprises has been sapped in the process and PTPs are blamed for such serious problems as misallocation of reserve lands, problems in trantfer of ownership and conversion of land, settler welfare, smailholder food cropping and problems with credit and cost recovery. Guidelines detailing the respon- sibilities of the PTPs vis-a-vis other Government institutions and village cooperatives were issued in late 1985. The PTPs are supported by extension agencies and are responsible for providing technical guidance to smallholders using farmer groups. In addition, guidelines have been issued for the chain of activities from harvesting to marketing, again specifying relationships of PTPs to farmer groups. The int-t is to pass these responsibilities on to the village cooperative units. The liance on PTPs for these activities as in the case of food crops, extension and training is unlikely to best serve smallholder interests. These activities should not be the responsibility of PTPs, but should be undertaken by existing agencies in extension and food crops. or by a specialized tnit or agency overseeing smallholder development (para. 7.44). All existing responsibilities of PTPs in the NES/PIR projects, other than planting and basic infrastructure development for a planta.ion, should be removed as they ~.e unreasonable and unmanszeable burdens. 6.9 While the PTPs can be utilized for further block planting for small- holders on a contract basis, particularly for oil palm, the PTPs should be allowed to return to their role as commercial enterprises. An option for future settlements of landless people in new development areas could be through project implementation units developing settlement areas through - 91 - contractors. These contractors could include PTPs, private estates, or firms specializing in land clearing and tree crop planting, and engaged on purely commercial terms (see Appendix 2 for detai:.s of this approach). PTP Estates and Processing Facilities 6.10 Plans for Expansion. DGE objectives for the planting of tree crops in Repelita V are summarized in Annex Table 4.4. A total of about 117,000 ha of oil palm has been proposed for PTP own plantings of oil palm in the next five years, about 30,600 ha of coconuts and no rubber development. These plans: (a) ignore the need for PTPs to replant rubber at a minimum of 32 of the total area anrually or about 6,600 ha; (b) include planting targets for oil palm which are unrelated to PTPs' own plans; and (c) indicate a continued domina.it role of PTPs in smallholder oil palm plantings and a relativtly less important role for private estates in smallnolder plantings (i.e., under the PIR-TRANS program). 6.11 PTP plans for oil palm represent 150,500 ha compared with DGE propos- als of about 117,000 ha. The PTPs also plan for rubber development on a total of 95,300 ha, about 62,300 ha more than replanting requirements. The 2TPs' target program is provided in Annex Table 4.3. The investment program for the PTPs, as they have prepared, is considered massive since, in addition to these npw plantings, past plantings and infrastructure need to be rehabilitated and maintained, and managerial, technical and financial skills within the PTPs need to be improved. 6.12 Details of the projected processing facilities are provided in Annex Table 4.2. This program includes: (a) expansion of PTP rubber processing facilities by 35 units and extension of others with a combined capacity of 619 tons per day, representing an increase of existing capacity of 50Z; and (b) construction of 43 new CPO mills plus extension of others, increasing total capacity by 2,111 tons ffb/hour. This represents doubling the number of existing mills and increasing capacity by 1202. 6.13 The investment programs of the PTPs have been estimated from the recent Financial Evaluations and projections made for PTPs. The program, if all PTPs were to implement their targets, would represent a total investment of Rp 5.0 trillion over the next five years. Processing and infrastructure development represents over 80Z of these costs. The sunmmary of these invest- ments is provided in Annex Table 4.5. These plans are not feasible. While total PTP investments have risen to over Rp 525 billion per year (1987) for tree crop-related investments, continuation of this level of investment is unlikely. (The PTPs with large borrowing capacities are only PTP VII, VIII, XVIII, XXIII and XXVI. Marginal increases in borrowing capacity are possible for PTP III, VI and XIII). As fresh equity for the PTPs is unlikely from the Ministry of Finance, the borrowing capacitv of the PTPs is likely to constrain future investment. 6.14 Based on past performance, a more feasible investment program for the PTPs in Repelita V is about Rp 2.9 trillion.2/ Assuming the financial 2/ This estimate has been made assuming that 75! of the field development would be undertaken, that 602 of mills and factories will be completed on schedule but only 50! of the large infrastructure and civil works programs will be completed. - 92 - requirements are reduced from Rp 5.0 trillion to Rp 2.9 trillion in line with implementation capacity of PTPs, the limitations on their new borrowing capacity and on their ability to generate own funds, will not allow even the scaled-dowTn program to be implemented. Investments by PTPs above Rp 1.5 trillion are highly unlikely during the Repelita V period. The investment program will, therefore, have to be met with private initiative in joint ventures. Financial Performance 6.15 Within the Public Sector. At the end of 1986, there were 222 public sector enterprises in Indonesia excluding local Government enterprises. About 124 of these corporations are limited liability companies (or Perseros). Twenty-six of these limited liability companies represent the public planta- tion companies. These PTPs have the same status as P.T. Pueri (Fertilizer), P.T. Krakatau Steel and P.T. Garuda (Airlines) in that they are all respon- sible to the Ministry of Finance as their major shareholder. Seventeen of the 124 comprise the tree crop plantation companies. Together, these 17 companies repr -nt the largest single component of the public sector corporations in terms of their turnover. The tree crop PTPs' combined revenue for 1986 was Rp 798 billion. The only public sector corporation with a comparable turnover was PLN, the powet authority, with revenues of Rp 595 billion. The telecommu- nication authority, Perumtel, had the third largest turnover of Rp 323 billion in the same year. With the exception of PLN, the 17 tree crop PTPs have a higher level of net fixed assets than other public corporations. 6.16 Profits before taxes of the 17 PTPs are higher than all other public corporations in absolute terms. These PTPs have net profit margins (after taxes) un par with most of the other companies. The PTPs' net profit margins in the aggregate have varied from 15-26Z over the last five years. Government ib taking steps to improve the operations of public sector corporations, and is considering disposing of those which are unprofitable. The tree crop PTPs represent an interesting opportunity and challenge. As a g:oup in 1986, they earned more profits (in absolute terms) than other public enterprises, and with improved efficiency they could be even more profitable. However, some are less profitable, and some currently suffer from worrying levels of debt relative to equity, high debt service ratios, and insufficient liquidity for comfortable operational needs. In contrast, the debt ratios of almost all other public non-financial corporations are higher. Perumtel (telecommunications) has a ratio of debt to equity of 67:33, P.T. Jasa Marga (transport) 89:11, and P.T. Pusri (fertilizer )66:34. These ratios need to be judged relative to the nature of the debt, and the vulnerability of the corporation to wide fluctuations in future earnings. Some views on the appropriate levels for the PTPs are stated in paras. 6.18 and 6.21. 6.17 Performance During 1983-87. Aggregate financial data of the 17 tree crop PTPs is provided in Annex Table 4.9. Financial performance in terms of profitability (which measures essentially the results of the operations of mature estates and processing, ignores the cash demands of new investments, and the interest cost on borrowings for new estates) has been generally satis- factory over the last five years. The turnover of these PTPs reached Rp 1,075 billion (US$632 million) at the end of 1987, having grown at an av?rage rate of 18% p.a. over the previous five years. The large increase in sales are the result of heavy investments in Repelita III, particularly in oil palm and improved commodity prices generally. Aggregate data show net profit margins - 93 - of 15Z or higher during the 1983-87 period, compared with the low in 1982 of 3.7?. The return on equity of 112 in the last two years, 1986 and 1987, is satisfactory. 6.18 The PTPs represent an enormous industry with fixed assets valued at Rp 2.4 trillion (US$1.4 billion) and total assets of Rp 3.4 trillion (US$2 billion). Asset growth in the last five years has increased at 271 p.a. The industry is subject to wide variability in earnings due to severe fluctuations in the markets and prices for tree crops, and at any given time the value of the rupiah can also have a marked effect upon profitability. In these circum- stances, it would be prudent to improve key capital and debt ratios. In the past, the Government (and the Bank) have agreed to debt/equity ratios of 60:40 and even 70:30, but a recent review of Bank group experience of investments in estate enterprises indicates that such high leverage is not prudent. On average, the debt/equity ratios of the 17 tree crop PTPs in 1987 was 42:58, but only 7 of the 17 can be said to have healthy capital structures. The debt/equity ratio, although easy to calculate, is not in fact as useful a guide to the health of the capital structure, as the debt service ratio. It would be preferable in fi:ture to use the debt service coverage ratio, which measures the ratio of the after tax cash flow from operations (excluding interest on debts over one year in duration) to the cash requirem3ntR for servicing principal repayments and interest on debts over one year ir dura- tion. Whereas the Bank has in earlier estate projects in other parts of the world looked to see debt service ratio of 67?, the experience would indicate that a cut-off point of 402 would be preferable; and even this should be subject to risk analysis especially with respect to future earnings. 6.19 Individual PTPs: Capital Structure. The level of borrowings to finance expansion of the traditiuu.al and nucleus estates has resulted in the deteriorating capital structure of almost all of the PTPs. Six of the PTPs are carrying excessive debt. (These are PTP I, IV, V, X, XI and XXVIII.) One of these PTPs, PTP XI is financially insolvent and another, PTP XXVIII, requires capitalizaticn by the Government to enable it to carry on operations. Three other PTPs have only marginal capital bases in view of rising levels of debt. (These are PTP II, III and VI.) 6.20 Debt Servicing. As many of the long-term debts of the PTPs have fallen due, the seriousness of the debt is becoming more apparent to opera- tions aLid liquidity of the PTPs. Present findings are that PTPs with total debt to equity ratios of 50:50 may already have debt service ratios of 4C0 or higher and are unable to service their debts. The debt servicing capacity is anticipated to worsen as many of the NES loans fall due between 1989-92. 6.21 Liquidity. Only two of the PTPs operate consistently with adequate liquidity. Only five of the PTPs ended 1987 with a current ratio of 1.5 or better, a broad measure of short-term solvency. Serious liquidity problems are represented in eight of the PTPs with current ratios of 1.2 or less in 1987. Most of the PTPs operate with acid-test ratios of less than 1, meaning their cash and readily convertible assets plus accounts receivable do not cover their current liabilities. In the past, a yardstick of acceptable J1l-lidity for the PTPs was a current ratio of 1.5 and an acid test ratio of 1.0. Based on experience with these agricultural corporations, these standards are too low to report a safety point or cut-off of acceptabilitv. The liquidity ratio standards should be set at 2.0 for current ratio and 1.5 for the acid test ratio. Even with improved commodity prices and - 94 - profitability in the recent years, the PTPs have not improved their liquidity. A review of PTP inventories for finished goods shows that °TPs are generally not carrying higher levels of inventories than in the past. Inventory turnover has improved in most of the PTPs. The deteriorating liquidity is rather a result of PTP continual outlays of own funds to meet investment requirements. The liquidity problem is exacerbated with the requirements of PTPs to prefinance smallholder development in the absence of Government funds dropped in DIP? expenditures. BTU data on tne PTPs confirms that 11 of the PTPs were prefinancing massive sums in 1987 of Rp 71.8 billion (US$42.2 million). PTP V was the largest prefinancing PTP (with outlays of Rp 26.4 billion (US$15.5 million). 6.22 Profitability. With the return of higher commodity prices in 1983/84, the PTP profit margins in almost all cases rose to 102 or higher, the exceptions being PTP I and PTP XI. As costs of production rose in 1985/86, these margins were reduced and only eight of the 17 PTPs recorded profit mar- gins in both of these years above 10Z. The devaluation of the Rupiah in late 1986 increased export revenues and improved PTP profitability. Only PTP VIII and PTP XI had profit margins below 102 in 1987. PTP profitability as evi- denced in the Financial Evaluations of these corporations indicates that the profitability will seriously deteriorate with any downturn in commodity prices, and this would impact markedly on liquidity, in view of the rising debt servicing requirements in the coming years. While one of the PTPs, PTP XXIII, has been highly profitable and nine others have been reasonhaWy profi- table, the financial status of many of the PTPs will deteriorate without stringent contro. of investmen;-s and operations. In addition to the two tree crop PTPs which are financially insolvent, PTP XI and PT? XXVIII, six PTPs are expected to be at financial risk without Government intervention in debt rescheduling, deferred repayments or further equity contribution. (These are PTP I, II, IV, V, VIII and X.) 6.23 Improving Financial Health. The ongoing Financial Evaluations of the PTPs have identified a number of common findings concerning improvement for the financial health of the PTPs. (a) Proluction/Sales. (i) Rubber: All of the PTP rubber producers can improve revenues with greater field and factory discipline. Average yields in rubber have deteriorated in many of the PTPs and only three of the nine PTPs studied had average yields of 1,300 kg/ha. The combined average yield of the PTP rubber producers is 1,240 kg/ha. With proper field discipline, tapping standards and adequate levels of annual replanting, average yields of 1,500 kg/ha are easily obtainable in the estate industry. An increase to 1,500 kg by all PTP producers would increase exports of rubber by 43,403 tons and revenues by US$39.9 million at present prices. Furthermore, the quality of PTP rubber sold has deteriorated in a number of the PTPs. All of the PTPs have the capacity to produce 80? in high grades of RSS 1 or SIR 20, or better. A few of the PTPs are now producing at less ti-an 70Z high giade. (ii) Palm Oil and Kernels: While yields are generally sat_sfactory, production improvements in many of the PTPs can be made with - 95 - greater factory efficiency in palm oil and kernel extraction. In the older oil palm-producing PTPs, there is no reason why extraction rates of 212 on palm oil and 5.52 on kernels cannot be achieved in the CPO mills. Only four of the PTP palm oil producers achieve average extraction of 212 or higher. PTP VII is the highest at 21.62. Only one PTP had a kernel extraction rate of 5.52 in 1987. The foregone revenues from such efficiency losses would be enormous. (b) Costs of Production. PTP production costs are estimated to be about 15Z higher on average than the private sector. Most of the PTPs require rationalization of estate rubber production with factory location and factory expansion programs to realize transpoLt cost savings and product quality improvements. Field transport costs in rubber should be Rp 10/kg at most, but PTP field transport costs in 1986 and 1987 varied from Rp 6/kg to Rp 28/kg. A number of the PTPs including PTP I and XI could reduce their processing costs by 302 with improved processing controls. Private producers have indicated their direct costs of produ tion between Rp 90-110/kg CPO and kernels, combined weight. The direct costs of production of four of tne palm oil PTPs has varied from Rp 100-128. The highest-cost producer of palm oil is PTP X. Economies in PTP oil palm production can be achieved in almost all categories of production including maintenance, harvesting, transport and processing. General estate expenses, the overheads of PTP estates, are in son.e cases 1002 higher than the private producers. (c) Liquidity. Improvements in liquidity of the PTPs are unlikely in terms of inventory or receivables turnover. Only a few of the PTPs have tinished good inventories in excess of two months' production and these inventories are routinely carried in such crops as coffee and cocoa. Most of the PTPs carry inventories of less than 82 of sales. The major improvement to liquidity will only result from better cash management via improved financial planning and control of the investment programs. (d) Investments and Loan Management. Improved cash management and ulti- mately profitability would result if PTPs would undertake only those investnients with adequate sources of own funds and arrangements for long-term finance, prudently leveraged. Almost all PTPs studied in the course of the ongoing Financial Evaluations, with the exception of PTP XIII and PTP XVIII, should be required to postpone major components of their investment program in line with their debt servicing abilities and generation of own funds. The major means of improving the financial health of the PTPs would be in investment cost reductior, in field development expenditure. The other common finding concerning PTP investment programs is that few of them adhere to construction of mills and factories in optimal timing with produc- tion, resulting in loss of revenue from unprocessed or poorly processed crop. Proper investment scheduling for mill construction in the case of PTP X would have avoided the serious financial diffi- culties the PTP is now experiencing. In the case of PTP XI, no solu- tion short of liquidating the PTP and distribution of its assets and liabilities to other PTPs in West Java, or sale to private interests, was found viable in the Financial Studies unless Government was - 96 - willing to convert Rp 63.6 billion (US$37.4 million) in debts to equity. The financial situation of PTP XI has further deteriorated since late 1987 without action on the part of the Ministry of Finance. Management/Organizational Structure 6.24 During the past ten years, expansion programs of some of the PTPs have made their operations too dispersed. Three PTPs with bases ot operations in North Sumatra, two PTPs with basos of operations in West Java and another two with bases in Central Java have expanded into areas as far away as Kalimantan and Irian Jaya. Another concentration of expansion is Sn Jambi and Riau provinces although no PT? is based in either province. The span of con- trol of such operations has become unmanageable, and the required supervision from headquarter-based managers cannot be adequately carried out. PTPs which could be reorganized as a matter of priority are PTP II, IV, VI and X. Other PTPs having areas which could be divested into separate corporate entities include PTP VII, XVIII and XXIII. If the unmanageable operations cannot be consolidated within the PTP management capacities, they are best offered for private placement and/or management/contract lease. 6.25 Role of Directorate of State Enterprises. The PTPs are wholly owned by the Government through the Department of Finance. The Department, as the sole shareholder, is to monitor the affairs of the PTP through the Directo.ate of State Enterprises (Persero). The Department of Agriculture, as the techni- cal ministry concerned, also monitors PTP performance through its Administrative Bureau for State Enterprises (BTU-BUMN), and indeed normally plays a more major role than Finance. The principles underlying the estab- lishment of the PTPs as state-owned limited liability companies is that they should be autonomous, and supervised by their boards of outside directors (Dewan Komisaris). This indeed is a worthwhile principle but the Government is currently at risk in applying it in the absence of suitable safeguards. The oversight by the Departments of Finance and Agriculture is not supposed to be of day-to-day affairs, but of general policies and budgets. However, the Directorate of State Enterprises (Persero) tends cnly to evaluate the finan- cial results of the PTPs on an ex-post basis. The control tends to be budget and expenditure rather than performance oriented. BTU-BUMN oversight also is supposed to be essentially administrative, to assist the Minister and Director General of Estates in their oversight (para. 6.23). Given that tla PTPs do not currently possess strong financial departments, this level of oversight is not providing an adequate protection for public investments in the substantial assets involved. 6.26 Role of the Directorate General of Estates (DGE). The institutional weakness of the control by Persero and BTU-BUMN had until recently been further aggravated by a lack of clear responsibility under the Minister of Agriculture for PTP activi-ties. While the Minister has recently issued decrees clearly delegating responsibility for oversight to the Director General of Estates, there may be some transitional problems with the PTPs, used to normally dealing directly with the Minister. 6.27 Management of the NES/PIR program is vested in TP3 (Tim Pengendali) directly under the Minister of Agriculture. The TKPIR (Tim Khusus) was also created to supervise and monitor the quality of work of the PTPs in foreign- assisted projects. This has resulted in dual and overlapping management - 97 _ responsibilities where the PTPs frequently bypass the DGE's TKPIR ard report to the Minister. Performance criteria, as set by the DGE are difficult to ensure in such an organizational setting. 6.28 Board of Commissioners. The operations of the PTPs are supervised by a Board of Commissioners (Dewan Komisaris) composed of not less than two nor more than five members appointed by the Minister of Finance. In practice, the Dewan Yomisaris is represented by the Departments of Finance, Agricultttre and Defense and Security. The Board members are given five-year renewable con- tracts. Many of these appointments reflect approval and rewztd by the Gover.ament of performance in another sector unrelated to plantation management or the running of a large corporatirn. Few of the appointees have the techni- cal credentials to oversee plantation enterprises. PTP performance and opera- tions would be better served with well-defined criteria for the background and experience that appointees should have to supervise the PTPs. 6.29 Management of the PTPs. The Boards of Commissioners of the PTPs delegate the management of the PTPs to full-time Directors of the corporation. These include a President Director, a Commercial Director, a Production Direc- tor and a Development Director. These appointments are made by the Minister of Finance on recommendations of the Minister of Agriculture. Apart from the recent expansion of the directorship team to include a Development Director, the present structure of Directors was developed 21 years ago at the time of reorganization of the PNPs. This structure was suited to the operation of traditional estates but is increasingly less suited to the PTPs operating in diverse regions with the large projects as they have evolved. 6.30 The Commercial Departments of the PTPs prior to large-scale expansion of the PTPs were organized with emphasis on marketing, sales, procurement and conttacts. The role of finance in the management structure of the PTPs in view of the size of these corporations must be elevated. Other problems include the dual responsibility of the Production Director for estate and production management as well as processing. Management of processing, pro- cess engineering and civil engineering has become confused between the Produc- tion and Development Directors. Overlapping responsibilities of the Directors within the PTP (such cases as PTP VI) seriously delayed large-scale project implementation. 6.31 Internal PTP Management. A major problem in all of the'PTPs is the little authority the headquarters grants to site management of the PTP projects. Improvements in the internal management structure, in view of the importance of project development within the PTPs, must focus on the authority and delegation of responsibility given to Site Managers and the underlying system of Senior Assistants and Assistants. The qualifications of PTP Managers, particularly at project sites, requires clear definition. Performance standards are required at all levels of PTP management and the system of promotion within the PTPs must be based on sLzh standards in lieu of the present seniority system. Future Options for PTPs 6.32 In 1983, the previous more intensive supervision of the PTPs by the Minister of Agriculture's expert staff (SBPN) was replaced by lighter over- sight by BTU-BUMN in the Secretary General's office of the MinJstry of Agriculture. Based on the activities to date, BTU's role in PTP financial and - 98 - physical planning has been limited to recording for comparison the historical PTP data in statistical form. The BTU also records PTP projections made for corporate plans when available, but does not guide forward planning or estab- lish guidelines. The deficiencies in PTP corporate plans have resulted in ambitious targets, overstatement of profitability, excessive investments based on assumed cash generation, and overestimation of the ability of the PTPs to repay their debts. While the PTPs, through their individual boards of manage- ment, should contin-.e to act with greater autonomy to manage their own internal organization, staffing and operations, they will require some coordi- nation and monitoring of activities. Guidance in planning and supervision of operations could be important to avoid duplication and provide for total resource use commensurate with the PTPs' individual capacities, location and experience in growing specific tree crops. Improvements in management of the PTPs must involve the elevation of corporate planning within the PTPb and the supervision and guidance for corporate planning by a central monitoring unit. There have been several interim measures discussed in the previous years to place coordinating responsibility under a suitable location but no action has been taken since. 6.33 The Government may wish to consider some of the following options which would increase the economic efficiency of PTPs on a sustained basis. To maximize profits in a competitive market, PTPs need to operate under managers with the autonomy, capacity and motivation tc respond to competition. Options include: (a) Government should assign functions of guidance, monitoring and some degree of regulation to one of the agencies involved with the PTPs, to support improved efficiency. Such regulatory functions can provide performance standards and guidance to PTPs in corporate planning. (b) Creation of a holding company over the independent individual PTPs' boards of directors. Such a company could possibly include represen- tatives from Departments of Finance, Agriculture, Trade, and Industry on its controlling board. An advantage would be that the holding company would control the PTPs as subsidiaries, and a rationalization of the capital structures and liquidity of the PTPs as a whole might be possible without recourse to additional Government funds or major concessions on loan repayments. Adjustments in investments, equity and operation of PTPs could be made in the financial policies of a holding company, seeking to maximize profitability in each PTP, but managing them as a group. (c) Once a coordinating body (as under option (a) or (b)l is in place, it would be desirable to introduce contract plans (CPs) on a pilot basis for the enterprises which have been recently rehabilitated/ restructured. These plans are essentially performance agreements negotiated between the Government, acting as owner of a public enterprise, and the managers or directors of the enterprise itself. Contract Plars define the enterprise's objectives, and state what resources and latitude will be provided by the Government to enterprise maragement so that it may accomplish the specified goals. Contract Plans also set out the physical and financial indicators which will measure enterprise performance. Many contract plans also establish the principle that the Government will compensate the - 99 - enterprise for costs incurred in fulfilling noncommercial objectives, and specify the way in which compensation will be made. This can be an integral part of contract plans until PTPs are fully divested of any except voluntary responsibility as agents of umallholder development. An option for monitoring such plans could be to set up physical audit capabilities within the State Auditing Agency (BPKP), as part of this agency's responsibility to audit the PTPs. The physical audit services could be provided with consultant support to BPKP. (d) The PTPs should enter into joint ventures with private sector, parti- cularly in the area of downstream activities. This would initiate partial privatization and facilitate technological transfer. Some PTPs may require divestiture of their non-viable assets and/or opera- tions to enable them to stand on a sounder footing. Over the longer term, the very rationale for direct public investment in areas where private sector is willing to go in and compete effectively may need a review. In terms of sequencing of the future options for PTPs, contracting out, leasing, management contracts, joint ventures, and efforts to increase competition (para. 5.45) may be prerequisites to privatization. It is important that divestiture programs are tailored to the potential for competition, as well as to the adminis- trative capacity of the Government. Divestiture can take several forms, irrluding: (i, liquidation, both formal and an informal method of mothballing, whereby operations are suspended, but the enterprise retains a legal and economic life; (ii) privatization of ownership through the sale of the firm as a going concern or of all or part of the assets; and (iii) privatization of management through leases and management contracts. Divestiture programs must also deal with social implications of layoffs and plant closures, including the development of a realistic approach to financing these costs (severance pay, redeployment programs, settlement of arrears, etc.). 6.34 Recently, the Government gave the PTP directors a clear mandate to consolidate the management of their assets. Now may be an opportune time for the Government to provide performance standards and guidance to PTPs in corpo- rate planning, introduce contract plans on a pilot basis, encourage PTPs to enter into joint ventures with private sector, and consider some divestiture programs. Different options will be needed for different PTPs, depending on the viability of their assets portfolio, management capacities, financial situation, and the competitive environment prevailing for a particular tree crop investment both with and within the private sector. The policy environment needed for the PTPs to operate on a commercially viable basis and compete with the private sector on the same footing is discussed in :ection IV. - 100 - VII. REAC!iING THE SMALLHOLDERS 7.1 An Overview. More broad-based approaches to smallholder development, encompassing a larger number of smallholders, where the untapped potential lies, will not only erhance growth, but more importantly, will provide employ- ment opportunities to the expanding labor force in the Outer Islands and arrest a decline in real wages of unskilled labor. In the context of the future development strategy, an understanding of the socioeconomic milieu within which smallholders operate is important. The following section high- lights the fact that the smallholders are heterogeneous, and their knowledge of tree crop farming varies substantially. Extension inputs and mechanisms of delivery of technical advice, therefore, need to be different for different smallholder groups. Similarly, a majority of smallholders operate in mixed farming/diversified systems, unlike those participating in block-planting schemes who derive nearly 902 of their income from one crop. The strategies to support tree crop development will need to accommodate the smallholders' risk management strategy of crop diversification. 9 7.2 The suggested options for assisting a larger number of smallholders are to complement the existing Project Management Unit (PMU) approaches to smallholder eevelopment with: (a) extension of low-input, partial PMU out- reach packages for smallholders on the perimeter of existing schemes; and (b) provision of a widespread network of nurseries supplying good-quality planting material and technical advice to existing, dispersed smallholders. A large majority of rubber and coconut smallholders will need to replant their existing genetically inferior and/or aging trees -with improved varieties. In this context, a review cf the organization and delivery of support services (including extension services) will be needed to assess how the majority of smallholders can be best reached and can be given technical advice (and incen- tives) for replanting. Organizational and financing mechanisms will be needed to su,tain a major replanting program. Some suggestions on institutional arrangements are made in this section and suggestions on financing mechanisms are made in Section VIII. Scarce public investment resources are best used for completing and consolidating past investments in tree crop development and transmigration and providing infrastructure and support services, particularly to reach a larger number of smallholders. Smallholders will need technical advice which the extension services must provide, and an adequate availability of inputs which the private sector can provide; a case in point is the network of private nurseries. The Government should make the inputs available only if the private sector cannot. For the landless people to be settled in new areas, an option could be to have implementation units develop each settlement area through contractors. These contractors could be public or private estates, or firms specializing in land clearing and crop planting, engaged on purely commercial terms. Social Factors 7.3 The term "smallholder' is useful only in so far as it groups together households that own and cultivate tree crops on no more than 25 hectares. This classification, however, does not indicate the way in which the small- holder households use their land, the cultivation techniques they employ, or - 101 - the proportion of total household income they derive from tree crops. These and other broad socioeconomic factors can be better understood, if the follow- ing categories relevant to tree crop producers 1/ are considered: (a) project-assisted smallholders (both transmigrants and local farmers) included under Government-sponsored tree crop schemes; (b) unassisted smallholders; and (c) sponsored transmigrants settled as food crop producers and spontaneous migrants. 7.4 Project-assisted smallholders are those who have been sponsored under: (a) the externally-assisted Nucleus Estate and Smallholder projects and Government-financed PIR projects, where the Government-owned estate companies (PTPs) establish block-planted tree crops for smallholders; and (b) the externally-assisted Smallholder Rubber and Coconut Development Proj- ects (SRDP and SCDP) and Government-funded PRPTE project and some other projects, where the geographically concentrated PMUs are established to assist smallholciers. 7.5 The NES/PIR transmigrants, accounting for about 8Z of all rubber- producing households, are located primarily in Sumatra and Kalimantan, and are generally from diverse occupational backgrounds--agricultural laborers, trans- port workers, share croppers, and unemployed. It can be assumed that their previous knowledge of tree crop farming is minimal, and perhaps nonexistent. Each participating household is allocated two hectares of rubber, and between a half and one hectare of food crop/house lot land. Land title is issued to the smallholders, to be held as collateral for loans granted.2/ Block plant- ings of rubber, tapping regimes, and field maintenance activities during the immature phase are organized by the nucleus estate. 7.6 With very few exceptions, these NES/PIR smallholders make little use of their food crop land, and little if any project extension work is directed towards food cropping. In some part, the smallholders' apparent lack of interest in food cropping is because production in excess of household con- sumption is uneconomical. Most NES/PIR projects are located in relatively isolated areas, far from food crop marketing centers, and the local market for food crops is small, because most local people produce their own food. More- over, poor soils are often not suited to large-scale food cropping. 7:7 The greater part of household labor is expended working for wages on the rucleus estate and working on their own rubber smallholdings. Some house- holds gain additional income from off-farm work--NES I rubber smallholders mentioned temporary employment with logging companies--but the major portion of household income--perhaps as high as 90Z--is derived from the sale of rubber and wage work on the nucleus estate. 1/ While the smallholder profiles considered in this section are based on smallholder rubber producing households, these are generally applicable to other tree crops as well. 2/ Government credit expenditures are converted into smallholder loans (in principlc, once the tree crop stands are three years old), upon surveying the land, granting land title, and evaluating the quality of planting and smallholder performance. - 102 - 7.8 Local PMU-assisted farmers account for about 6Z of all rubber produc- ing households and are generally the "progressive" farmers, i.e., smallholders who already have a good general knowledge of tree crop cultivation, a willing- ness to try new techniques, and the ability to finance at least some of the required inputs. 7.9 PMU projects provide inputs for between one and two hectares of rub- ber per participating household. Many of the project households, however, own or have laid claim to a larger area of rubber. In South Sumatra and West Kalimantan, two provinces where PMU projects have been implemented, the major- ity of smallholders have more than two hectares of rubber: 65Z of rubber smallholders in South Sumatra and 62Z of rubber smallholders in West Kalimantan own between 2 and 7.5 hectares (Annex Table 3.1). In these provinces, and in the Outer Islands in general, the planting of land to perennial crops is recognized as representing an inalienable claim to that land. It can, therefore, be inferred that at least some of the PMU partici- pants have chosen to use their PMU credit to clear and plant new land, thus increasing their overall land holdings. Indeed, PMU projects have been responsible for new plantings rather than replantings on existing smallhold- ings. 7.10 The emphasis in PMU extension, as in NES/PIR projects, is on techni- cally correct cultivation procedures designed to maximize tree crop yields per hectare. Nevertheless, PKU participants have been encouraged in some areas to intercrop newly planted rubber with rice, most of which is consumed bv the household. Because intercropping cannot continue past the third year after planting, most households retain access to ladang (dry fields), which they cultivate with rice and vegetable crops. Most household labor is expended on, and the majority of household income is derived from, rubber production. 7.11 Unassisted smallholders, who have not been covered under any spon- sored scheme, represent the majority--over 85Z--of smallholder rubber produc- ers. These smallholders have received no assistance, because the emphasis of the Government-sponsored schemes has been on new plantings in new settlement areas. Most of the unassisted smallholders own more than two hectares of rubber, but constraints on labor and finance largely determine their cultiva- tion techniques--little or no fertilizer, no herbicide, and minimum labor inputs. 7.12 Economic activities among this group of smallholders are highly diversified. Tree crops are but one source of income among several, and tree crop yields should be assessed in relation to the labor expended, rather than their biological potential. If an activity other than rubber farming provides more attractive short-term returns to labor, smallholders may choose to neglect their rubber. Of the 674,000 rubbei producing households surveyed by BPS in 1984, for example, 83,000 or 17Z reported that they had neither main- tained nor tapped their rubber during the previous twelve months. Diversifi- cation 3/ into other crops and into nonagricultural activities is clearly the 3/ More than three-quarters of all coconut smallholdings in Java are inter-cropped, and although intercrops are less pronounced outside of Java, small farmers (under 1.3 ha of coconuts) in North Sulawesi were found to intercrop 75Z of their land, compared to larger farmers (about 4 ha) who intercropped only 25Z of their land. Studies undertaken in North Sulawesi found that intercropping increased small farmer returns. - 103 - smallholders' prime mechanism for both managing risk and maximizing household income. 7.13 Sponsored transmigrants and spontaneous migrants are generally food crop producers. Each sponsored transmigrant household is given a first ha of house lot and cleared food crop land and a second uncleared hectare for later expansion. However, in the majority of transmigrant sites, the second hectare has not been used, either for food crops or tree crops. Transmigrants' know- ledge of the latter is, in any case, minimal. Relatively infertile land, restricted access to agricultural inputs and distance to markets are just some of the factors that have compelled transmigrants to seek off-farm work. According to the 1985 BPS Transmigration Survey of Repelita II and III trans- migration sites, between 5^) and 70% of household income is earned from off- farm work.4/ 7.14 Wage Labor and Land Tenancy. Rubber smallholders earn an average 6% of their total hous-hold income from wage labor on the smallholding of other rubber producers. Local farmers in the process of establishing their own smallholdings, and transmigrants with poor land and limited access to finance, are probably the most frequent wage labor seekers. For this group, wages provide a satisfactory return to labor, at least until their own farms are established. However, because time spent working another's land implies less time for their own, smallholders with limited household labor capacity may never get the opportunity to fully establish their own smallholdings. Addi- tionally, in Outer Island provinces like Lampung that will soon enter the land-scarce category, temporary abandonment of uncultivated land in order to take up wage work elsewhere may become permanent abandonment if that land is taken and cultivated by another. 7.15 In areas where population density is high--North Sumatra, Lampung, West Java, South Kalimantan and Aceh--the one to three hectare category accounts for more than half of all rubber smallholders. But where population density is lower, such as in Central and West Kalimantan, Jambi, and Riau, holdings are larger. A larger land holding, however, does not necessarily produce a greater household income (Annex Table 1,2). Most smallholders farm their land almost entirely with their own household labor and have preferred a land-use strategy that maximizes returns to labor rather than returns to land. 7.16 Not enough is known about unassisted smallholders' land tenancy arrangements, nor about their use of or participation in wage labor. Neither is there adequate inform.ation regarding the economic activities of sponsored transmigrants in the years after Government assistance ceases. It is not known, for instance, whether: (a) these transmigrants are taking up share- cropping of rubber and/or wage labor in rubber, and in the process gaining knowledge of tree crop farming; (b) by entering wage labor they are abandoning lahan usaha dua (second hectare) allotments, and "losing" these in the higher population density provinces to perhaps spontaneous migrants; (c) they are moving to other less populous provinces, where they are clearing new land and working for wages while establishing it; (d) migrants are given preference 4/ "Indonesia: The Transmigration Program in Perspective," A World Bank Country Study. - 104 - over local households, who lose access to land taken for NES/PIR projects, and that lack of land title and exclusion from project planning and implementation decisions render the project participants mere laborers. Any development strategy that targets unassisted tree crop smallholders must surely recognize that it is vital to provide answers to these questions. Appropriate and well- focused socioeconomic studies need to be undertaken to better understand the smallholder investment behavior (para. 9.46). 7.17 Farmer Groups (kelompok tani) will become increasingly important, particularly in the case of unassisted, dispersed smallholders. These groups are frequently assumed to be an indigenous organization, but this is largely a misrepresentation. At the very least, a distinction should be made between groups which work together, and groups joining only in marketing and distribu- tion. The notion of kelompok as a work group is drawn from a particular char- acterization of the relations of production among Javanese wetland paddy farm- ers. In this production system, land is a scarce resource, and many house- holds do not have access to land. Paddy is the major crop. The peak labor demands of paddy are met by forming a kelompok of landowners and landless, who plant, weed and harvest the paddy. The harvested crop is shared among the group, four-fifths being allocated to the landowner and one-fifth divided among the others in the group. 7.18 While this may be the custom of Javanese wetland paddy farmers, tree crop smallholders cannot be similarly characterized. Except perhaps for ini- tial land clearing, smallholders prefer to tree crop on a household-by-house- hold basis. Because there are no peaks for labor demand for perennial tree crops, and also labor can be temporarily withdrawn from rubber and coconuts without irreversible damage to the crop, smallholders cat fit tree crop culti- vation activities around their other economic activities. They have no desire to form a work group, or to adjust their individual schedules to satisfy the needs of a group. This 4s particularly true of lower income smallholders, who rely on a flexible allocation of household labor resources in order co maxi- mize their incomes. 7.19 Kelompok as tree crop smallholder marketing and distribution units are not, however, unknown. The successful Smallholder Rubber Development Project (SRDP) located at Prabumulih in South Sumatra incorporates such groups, and some groups have arisen even spontaneously. Kelompok are most likely to be formed by tree crop smallholders when bulk selling gives a price advantage, when collection of produce cannot be handled by the household elone, and when the procurement and distribution of inputs is most efficiently met through group effort. Any kelompok training program should concentrate on transmission of marketing skills as well as on methods of work planning and organization. Economic Analyses and Options 7.20 Direct public investment in tree crop projects has been the most important Government intervention for smallholders, and the resources invested in such projects has been relatively large. During the last five-year period, an estimated total expenditure of Rp 1.375 trillion was allocated to smallholder-based production projects. Although this is a large expenditure, by Ministry of Agriculture program standards, it is not particularly large - 105 - when compared to other Government agricultural expenditures. For example, this would equal about 90Z of total Government expenditures on fertilizer subsidies for twc years 1986/87 and 1987/88 (Rp 1.53 trillion). 7.21 On average, a total five-year expenditure of Rp 1.375 trillion is equivalent to an average expenditure of about Rp 175,000 for each smallholder household producing tree crops. However, with actual expenditures per small- holder totaling about Rp 6 million for a NES project and Rp 3 million for a PMU project, total coverage of Government public investments during the Fourth Plan has been limited to some 4% of the total smallholder population.5/ Naturally, not all of the smallholders would have required new planting or replacement planting during the course of the last five-year plan. According to the DGE estimates, during the first four years of the Fourth Plan, project- assisted smallho'der plantings reached a total of 229,000 ha, while unassisted (nonproject) smallholder plantings are estimated to have reached a total of 828,000 ha. (These unassisted plantings are generally of unselected, low- yielding variety.) Therefore, in area terms, about 22Z of smallholder plantings were covered by one Government project or another. However, since average project holdings under the major crop are larger than nonproject holdings, somewhere between 15 to 20Z of total smallholder plantings would have been financed through a Government project. Since 75% of public expendi- tures were in NES/PIR schemes, where mainly new (non-tree crop) farmers were provided tree crops, the proportion of existing (preproject) tree crop small- holders served by public investments would be less than 10% of those who elected to plant during the past five years.6/ The low coverage rate from public investment is due partly to the priority accorded to new area settle- ment, the high administration cost of reaching dispersed smallholders, and to limits in the management of smallholder projects.7/ 7.22 An important lesson from past tree crop investments is that the block-planting schemes designed to achieve maximum yields through the applica- tion of a full package of inputs have worked well when they have been under 5/ This is estimated as a total expenditure of Rp 1.375 trillion divided by an average cost per household of Rp 4.5 million (weighted average cost of NES/PIR and PMU planting schemes) and divided by 7.8 million smallholder households. The 1983 Agricultural Census classifies 11.5 million households as tree crop households (these also include the households for whom tree crops are important but not the main source of income). The mission's estimates are that about 1 milliGn are estate workers in oil palm, rubber, tea and coffee, 1.2 million are producing sugar, and another 1.5 million are producing cloves, spices and beverage crops. After these adjustments, an estimate of 7.8 million households is arrived at. 6/ Note that these figures can only be treated as best, order-of- magnitude, estimates. Budget expenditure and area achievement figures do not bear an exact relationship. The DGE progress report evaluating Repelita IV shows no area planted/rehabilitated under the PRPTE scheme for 1987/88, although budget expenditures for the scheme were estimated at Rp 16 billion. According to DGE officials, less than half of this was for maintenance of existing plantings. I t-,r rr,n nrni rtWC - e - 106 - good management and superviced by well-functioning project management units. However, these very conditions raise concerns about the sustainability of the investment (particularly, during the post-maturity phase) after project assis- tance is removed. Another factor that could limit the sustainability of existing smallholder investments is the relative lack of economic diversifica- tion of these smallholder tree crop projects vis-a-vis the nonassisted farm enterprises. Relatively limited attention has been devoted to intercropping or development of alternative cash income sources for smallholders, particularly in the NES/PIR type of block-planting schemes. In some cases, however, projects are so remote that there may be no market for other crops. 7.23 It is incorrect to attribute all project costs to the benefit stream from tree crops production, given the multiple development objectives of these projects, which include settlement of previously underpopulated regions. Even so, due to poor planting leading to low yields, some of the project components have been expensive relative to the present estimates of expected returns. As of July 1988, the Directorate General of Estate Crops classified 31X of the NES/PIR rubber lands, 42Z of PRPTE lands (msinly rubber), and 34? of the SCDP coconut lands as Class D or highly substandard plantings (paras. 8.15-8.17). However, only 4? of the NES/PIR oil palm plantings were classified as substan- dard. These classification systems have a high degree of variance attached to them--and to their correspondence with expected yields--but they do provide an order-of-magnitude estimate of the technical standards achieved by project plantings. Even if social infrastructure costs are not counted as economic costs of tree crop development, the Class D NES/PIR rubbeL lands generate a negative stream of benefits over costs. For example, in D-class NES rubber plantings, the net present value of returns less costs, with both valued at economic prices, is Rp -1.9 million per hectare (see Annex Table 3.2). 7.24 It is difficult to judge the full effects of smallholder tree crop public investment programs, since peak yields for most project-assisted farm- ers are still more than five years away. Still, many of the better projects have a high ex-post rate of return, and a relatively high ratio of project benefits to cos s. However, some of the project sites can be classified as relatively high-cost, low incremental-output schemes, primarily because of poor-quality plantings. On average, however, after taking into account the different shares of A, B. C and D lands (para. 8.16) under the projects, the technically assisted projects are still expected to generate a reasonably high rate of return, in terms of both past and future investments. 7.25 Table 7.1 presents a comparison of performance indicators (ex-post evaluations) for the selected ongoing Government-assisted projects, and for the future approaches to tree c,:op development (ex-ante evaluation). Annex Table 2.15 presents a sensitivi.y analysis. Ex-post evaluations of rubber projects show that PMU-based schemes generally had a higher rate of return and net present value (NPV) than NES schemes, reflecting the lower initial settle- ment cost component in the PMU schemes. The ongoing NES rubber schemes are estimated to have an ERR of 162, which is comparable with the ERR of 14Z-152 estimated for the recently completed NES III project (smallholder component). The ongoing NES oil palm schemes are estimated to have an ERR of 22Z, compared to the 19? estimated for the recently completed NES IV project (smallholder component). For future investments, returns to rubber appear quite bright, largely because of an expected buoyancy in future world market prices. Even if there were a 25? decline in rubber price because of the likely deviation of the actual world prices from the Bank projected prices (beyond a 5-year - 107 - period), the economic returns are robust, ranging between 182 and 212 for various ex-ante project evaluations. Highest returns--in terms of the net present value of the investment--obtain when a full-PMU package is planted, especially if such a package includes an intercrop, such as corn. However, the benefits of this approach are limited (due to a management and fin ncing constraint) to a small group of beneficiaries. What is encouraging is the high forecast rates of return for partially assisted smallholders, i.e., the smallholders on the periphery of existing PKU schemes (ERR-23Z, NPV-Rp 3.9 million/ha) and for farmers who are provided improved planting material and some technical advice (Nursery model, see paras. 7.32-7.35: ERR=21z, NPV-Rp 2.6 million/ha). The primary advantage of these schemes is that the investment cost--both financial and in terms of public management intensity-- is far lower per participant and hence a greater sweep of smallholders can benefit from public investment. The dispersed nursery schemes (para. 7.32) will need to be tested out on a pilot basis, before these can be replicated. In the case of five types of rubber schemes (ex-ante evaluations in Table 7.1), only: (a) a 52Z-63Z decline in benefits; (b) a 226Z-317Z increase in investment costs; or (c) a Z13Z-3812 increase in operating costs could reduce the NPV to zero. 7.26 It is interesting to note that returns to private rubber and oil palm estate investment will continue to outperform even the best smallholder investment in terms of farm returns per hectare (NPV=Rp 9.1 million/ha for rubber and Rp 7.5 million,ha for oil palm). This illustrates the equity/growth trade-off in the tree crop subsector. However, to the extent that regulatory reform can be used to provide better estate investment ince-- tives, while a more diverse portfolio of public investmEnts is undertaken for smallholders, Government can increase growth and improve equity simul- taneously. 7.27 Ex-post evaluation of hybrid coconut investment reveals the same degree of profitability as that of a PMU rubber scheme. On an ex-ante basis, intercropping of existing tall varieties with cocoa is an attractive invest- ment (ERR=25Z, NPV=Rp 4.6 million/ha). A 252 decline in copra price (from 1995 onwards) could reduce the ERRs from 18-25Z (in the base case in ex--ante project evaluations) to 14-21%. In the case of three types of coconut schemes (ex-ante evaluations in Table 7.1): (a) benefits would have to decline by 40Z-51Z; (b) investment costs increase by 1232-2922; or (c) operating costs increase by 1482-160Z before the NPV drops to zero. As expected, the schemes which entail intercropping are relatively more robust investments. 7.28 Future ex-ante calculations suggest that an oil palm PMU-type project would have high returns (ERR=262, NPV=Rp 5.5 million/ha). An important chal- lenge for the Government, over the next decade, will be to shift smallholder public investment towards those commodities, such as oil palm, with high returns to investment. A 252 decline in oil palm price (from 1995 onwards) could reduce the ERRs from 26Z-282 (in the base case in ex-ante project evaluations) to 222-25Z. In the case of a PMU-type scheme, only: (a) a 552 decline in benefits; (b) a 246% increase in investment costs; or (c) a 2477 increase in operating costs could reduce the NPV to zero or decrease the ERR to 102 i.e., the opportunity cost of capital. - 108 - Table 7.1: COMPARISON OF PERFORMANCE CRITERIA FOR ONGOING GOVERNMENT- ASSISTED PROJECTS AND FOR FUTURE OPTIONS/APPROACHES (Rp'000/ha) Rubber Ex-post project evaluations /a Ex-ante project evaluations Full Full Full Full PMU Partially Private flursery Criteria PMU NES PMU + corn assisted estate only NPV-Financial 3,035 833 4,636 7,068 3,083 6,826 2,383 NPV-Economic 3,597 2,444 5,333 5,664 3,891 9,064 3,126 FRR (Z) 19 12 23 33 21 20 21 ERR (Z) 19 16 24 26 23 25 23 Coconut Ex-post project Ex-ante project evaluations evaluations /a Full Full PMU Full PMU (Cocoa Criteria Full PMU PMU with corn with existing Talls) NPV-Financial 2,509 2,595 3,156 3,591 NPV-Economic 3,087 2,716 3,282 4,577 FRR (C) 20 19 24 23 ERR (2) 20 18 22 25 Oil Palm Ex-post project evaluations /a Ex-ante project evaluations Criteria NES smallholder Full PMU Private estate NPV-Financial 2,809 4,452 4,918 NPV-Economic 4,923 5, 80 7,471 FRR (2) 16 24 20 ERR (2) 22 26 28 /a For ongoing Government-assisted projects. Completed NES III rubber project (smallholder component) had ERR of 142-15Z and NES-oil palm project (smallholder component) had ERR of 192. Notes: Values are based on Farm Models for each crop or crop combination. NPV estimates are evaluated, exclusive of debt service, at a 102 discount rate and are in 1988 constant terms. Economic computations incorporate shadow-price estimates for land, labor, fertilizers and agrochemicais. Economic rates of return are estimated net of taxes aL&d other transfers. A phase out of fertilizer subsidy and a 52 increase in copra price (due to trade liberalization) are reflected in the farm models. Detailed farm models are available upon request from AS5AG. Results of sensitivity aralyses are included in Annex Table 2.15. - 109 - Future Approaches 7.29 The main challenge in the future will be to develop smallholder investment programs which are efficient, sustainable, replicable and have a broad-based or widely linked stream of social benefits. One way of improving the spread effect of public investment in tree crops is to direct more resources towards a larger group of presently unassisted smallholders. The Government is clearly conscious of the need to provide better service to this group. Improvement in the services provided to "self-reliant' or 'swadaya' farmers is highlighted in the DGE's proposed Five-Year Plan. This will involve improvement in the availability of planting material, extension services and other agro-inputs. The technical viability, the potential contribution of improved planting material alone to incremental yields, and the contribution of a low-input technology package in general, remains a subject of heated debate among tree crop specialists. There is clear agreement, however, on the need to improve the availability of improved planting material and extension advice for smallholders. A large majority of rubber and coconut smallholders need to replant their existing genetically inferior and/or aging trees with improved varieties. Organizational and financing mechanisms will be needed to sustain a major replanting program. 7.30 The replicability and sustainability of smallholder development schemes could be improved by placing more emphasis (e.g., investment) on smallholdings within mixed-cropping and mixed-farming systems as opposed to monocrop, block-planting arrangements. Diversification need not only be crop- based. Livestock and fishponds can also be integrated with tree crop produc- tic-. Where markets are within a reasonable distance, production of perish- ables for sale, and development of cottage industries to service urban demands for construction material, textiles and processed foodstuffs would be possible avenues for diversification. Diversity of farm systems, centered around tree crop-based enterprises, rather then a tree crops focus with diversification as an additional project component, could induce more sustainable patterns of smallholder development. 7.31 An important challenge for the Government is to consolidate and complete existing smallholder projects, assist a larger number of existing smallholders with replanting, and/or some new planting 8/ and integrate the best elements into a public investment program for future smallholder develop- ment. This will involve concentrating resources on the more successful PMU- based schemes; extending such schemes to oil palm; extending low-cost/greater private equity, partial PMU outreach packages for smallholders on the perimeter of existing PMU schemes; providing a widespread network of nurseries supplying good-quality planting material and extension advice, initially on a pilot basis; and providing simple technologies for on-farm processing of copra and slab rubber. Smallholders will need technical advice which the extension services must provide, and an adequate availability of inputs which the 8/ The details of a future model (for the landless people to be settled in new development areas) are suggested in Appendix 2. The approach is essentially of a PMU (or a Project Implementation Unit) developing each new settlement area through contractors. These contractors could be PTPs, private estates, or firms specializing in land clearing and tree crop planting, engaged on purely commercial terms. - 110 - private sector can provide. Government should make the inputs available only if the private sector cannot. 7.32 Dispersed Nurseries for Smallholder Plantings. This approach (see Appendix 6 for details) will be most appropriate for those smallholders who car muster some of their own resources for tree crop development and require primarily reliable planting material and technical guidance. The results achieved by planting materials from dispersed nurseries will vary according to the maintenance provided by individual smallholders through the immature phase. For evaluation purposes. it is assumed that any smallholder using materials from the nurseries will be distant from a full PKU development, that much of the planted rubber will have been neglected over many years (indicat- ing the smallholders' preoccupation with other income sources) and that a degree of neglect will continue in the new plantings. It is, therefore, envisaged that plantings assisted with improved materiass and technical advice will come into production in the eighth year after planting and over a (reduced) tapping life of 21 years, will achieve an average yield of 750 kg per ha per year (albeit, an improvement over the present average yield of 495 kg/ha) compared with about 870 kg achieved by smallholders in the neigh- boring areas of major PMU activity (i.e., partially assisted smallholders) and the 1,050 kg average yield achieved by fully assisted participants in PMU and block-planting schemes. It is estimated that the net present value of finan- cial returns to rubber smallholders could increase from Rp 1,541,000 per ha to Rp 2,383,000 per ha. and the net present value of economic returns could increase from Rp 2,216,000 per ha to Rp 3,126,000 per ha, (in constant 1988 prices), by use of improved planting material, some fertilizer and limited extension advice. 7.33 If nursery costs are to be minimized, considerable effort will be required to determine where nurseries can usefully be located. This could be undertaken by the existing extension service or by special teams set up by DGE for the purpose. In areas of dense rubber planting where it seems probable that replanting is needed, the mass media would first be necessary to explain the advantages of replanting and the importance of good-quality, high-yielding planting material. This would be followed by meetings in the area and, if there appeared to be interest in replanting, the existing rubber (in particu- lar, the bark reserves and the yield levels) would then be surveyed. These early contacts with smallholders may require up to 12 morths of planned opera- tions. This expenditure of time would be essential given that in most old rubber areas there has been negligible replanting and a significant change in smallholder attitudes is required. 7.34 Each nursery could serve an area large enough to provide a minimum of 300-400 ha of rubber planting or replanting, at an average rate of about 100 per year. However, the first year should preferably aim at planting no more than 50 ha while nursery procedures are refined and farmer contacts extended. The nursery numbers need not be restricted and could grow to whatever size is needed to meet demand in their vicinity. 7.35 Nurseries could be operated on force account, through contractors or by private investors (Appendix 6). Nursery contractors might in some instances be farmer groups or it is also possible that unpaid farmer groups could operate nurseries under the guidance of an extension officer to supply * 111 - themselves with material. It would seem desirable to encourage independent private nurseries wherever it is deemed that this can serve smallholder needs and elsewhere to operate Government nurseries through closely supervised contractors. Each nursery could be the responsibility of one or, maximum, two extension officers. Smallholders undertaking planting or replanting must have access to other inputs, i.e., fertilizers and sometimes herbicides. It would be an objective of the dispersed nursery schemes to ensure that all such inputs are available in a local town or even in villages, through private sector dealers. The schemes would be used to inform smallholders on what inputs should be used and where these can be obtained at reasonable prices. 7.36 Costs and Benefits of Different Approaches. The costs and benefits of different approaches to sma'lholder planting programs are provided in Table 7.2. These are based on aggregations of economic costs and returns from project-specific farm models, and are results of just one scenario. These are not meant to be an indicative package of future smallholder programs. Annual plantings are based on DGE estimates of Government capacity to efficiently manage various types of investments. Annual public investment costs are esti- mated to average about Rp 61 billion per year. This will be lower in the earlier years and higher thereafter as more area !s brought under culltivation. Average annual employment generated by such a package of it,vestment would total 164,000 man-years. This varies, however, by project type and commodity: the costs of employment creation under partial-package schemes are substan- tially lower than that under the full-package schemes. Annual private invest- ment (farmers' own equity) 9/ is about Rp 93 billion per year for such a about US$550 compared with US$3,500 in small-scale manufacturing (such as wood-based industries, metal products, textiles, and food processing).10/ 9/ For the full PHU approaches, farmers' equity in'ludes: (a) the value of their labor not compensated for by incentive payments (during the immature phase), and (b) all labor and operating costs after the crop matures. For the partial PMU and nursery approaches, all costs are assumed to be covered by farmers' equity. lO/ Other estimates indicate US$3-4,000 as cost per job created in tree crops and US$10-20,000 per job in industry. The estimate for tree crops probably includes costs of settlement and infrastructure and the estimate for industry is probably for large-scale manufacturing. - 112 - Table 7.2: SUMMARY CHARACTERISTICS OF ONE SCENARIO OF SMALLHOLDER PLANTING PROGRAM Annual public Full Partlol Full Full lnvoot..nt PrJ PMU Nurseries PW PMW costs rubber rubber rubber / coconut oil palm Total (Rp bin) -__------------ '000 He Planted ------------------ 1999 26 6 0 0 O 45 85 19n0 26 6 20 16 6 70 64 1991 25 C 40 16 5 90 67 1992 26 6 40 156 90 76 1993 25 C 40 16 5 90 87 1994 86 1996 28 1996 19 1997 10 Average onnual employment ('000 man-years) 72 14 63 1S 7 164 Avorago annual public invost- ment coats (Rp bin) 26 4 8 17 6 61 Avorago annual public invost- ment coats per ha (Rp mIn) 2.64 1.69 0.69 2.22 2.91 Average annual private invost- Mont coats (Rp bIn) 41 7 23 17 6 93 Average annual private invest- mnt coats per ha (Rp *In) 4.14 2.87 1.86 2.23 2.63 Avorage production ('000 tons/yoar) 93 14 44 133 218 NPV-Gross rovonue (Rp bin) 762 112 287 296 111 1,668 NPV-Public costs (Rp bIn) 172 28 26 102 31 369 NPV-Privot- costa (Rp bIn) 242 '3 11a 102 33 633 Bonefits/costo ratio 1.8 1.6 2.1 1.4 1.7 1.8 Number of *sall- holder households ('000) 66 26 140 36 10 276 / A more feosible sconario could be 10,000 ha in 1990, 16,000 ha in 1991, 20,000 ha in 1992 and 26,000 ha in 1993. However, to estimate the upper limits of invest- ment coats, highor areas are included in the abovo tobfo. Notes: All coats and returns volued at economic prices in constant 1988 terms. Revenue and costs defined at the form-gate. Employment refers to a 260-day work year. Private costs refer to the former's own equity (labor, and oporating coats in the post-maturation phase). Public costs are all other initial invostment cost. NPV calculetions aro at a 10% diaccunt rate. Annual average public investment costs are calculated ovor tho initial inveatment period only. Annual average privato coats, production and employ- ment aro calculated over the full 20-yoor life of the investment. The benefit to coat ratio is dofined as the ratio of the NPV of groso revenuo to the sum of the NPV of public and private costs. Source: Aggrogations based on Farm Models. - 113 - 7.37 As a result of this investment package, smallholders vill produce an annual average of 151,000 tons of rubber (dry rubber content equivalent), 133,000 tons of copra and 218,000 tons of CPO. Gross revenue from this investment package vill equal Rp 1.6 trillion, in present-value 1988 terms, at a discount rate of 1OZ. The present value of total costs, both private and public, is about Rp 900 billion, again in present value terms. The difference between the present value of output and that of investment and operating costs (at economic prices) is a measure of the value added from all expenditures. From this investment package, a total of Rp 700 billion of value added will be generated. On aggregate, the ratio of benefits to costs, from all of these investments, will be about 1.8. However, the low-cost/low-input (provision of planting material and limited extension advice) rubber model shows the highest benefit to cost ratios. The ratio of benefits to costs is 1.8 for the full PMU rubber investments, 1.6 for the partial-PMU rubber investments, 2.1 for the nursery rubber, 1.4 for the coconut PHU investments and 1.7 for the oil palm PMU investments. With greater focus on existing smallholders and on replanting. some 275,000 smallholder households can be reached over the next five years, compared to 220,000 households reached in more than a decade by Government schemes which focused on new plantings in new areas. 7.38 Consolidation of Existing Investments. While moving forward with new investments, the Government cannot afford to neglect those that have been undertaken during the past decade. It is estimated that, for some substandard areas, returns to upgrading through selective replanting and infilling are very high.ll/ A program of selective upgrading of existing assisted smallholder areas, such as that which is now in operation for externally assisted NES projects, should be extended into the PMU areas, where such investment would be economically viable. However, the economic viability of upgrading depends very much on the cause of the substandard planting. Where this was not the result of a natural disaster, the risks are that upgrading might fail if the deficiencies in project implementation which originally led to the substandard situation are left unchanged. Selective upgrading, on an area-by-area basis, remains an important means of ensuring benefits from past investments. It is important that field inspections be started soon after planting and continued on a regular basis so that deficiencies may be detected in time for them to be corrected at reasonable costs. The present situation in which field inspection is delayed until trees are mature, allows corrections only at high costs, sometimes through overall replanting. There may be areas where funds could be better utilized to encourage crop and livestock diversification, rather than upgrading poorly performing tree crops. Financing estimates for upgrading are provided in Section VIII. The investment consolidation should also include: (a) construction of trunk and feeder roads where these are not in place in existing project areas and, more importantly, the formulation and implementation of a plan for O&M of existing road systems in sma.lholder areas; (b) provision of land titles as rapidly as possible to bs many smallholders as can be reached; (c) provision of general credits to the private sector to establish processing facilities, where these are required to complete previous investments; and (d) development of small scale processing centers for copra drying and rubber coagulating, to raise quality and increase value-added at the farm level. In the case of earlier transnmigration projects, second stage development entailing tree crop solutions would be needed to ensure that the potential benefits of these projects are realized. 11/ World Bank, Upgrading of Substandard Smallholder Plantings on Indonesian Tree Crop Projects, 1987. - 114 - 7.39 Extension Inputs. Each type of smallholder development will require participants to be provided with technical advice, but because of the numbers involved and the particular objective of reaching as many smallholders as possible within constrained budgets, the intensity of advisory input would need to be adjusted according to the requirements of the target beneficiu.ries. The fully assisted participants would receive training in each cultural opera- tion as well as regular visits from staff combining supervisory and advisory functioi.s, while the users of planting material from dispersed nurseries would require no more than a minimum service. This minimal contact would, if possi- ble, be maintained throughout the life of the planting but comprise no more than four visits during each of the first two critical years, two visits annu- ally through the remaining years of immaturity (years 3-7), four visits during the year in which tapping starts and one visit each yeiar thereafter. If each visit occupies, on average, a quarter of a working day, little more than five extension days would be devoted to each participant purchasing rubber planting material, through the period from first inquiry to opening of trees for tap- ping. Participants in fully assisted schemes might expect close to this level of attention during a single year. 7.40 There are several organizations through which technical advice is being channeled to project participants. At present, the nucleus estates in NES/PIR schemes are responsible for teaching husbandry and harvesting methods to participants. Advice on food crops is the responsibility of staff from the Directorate General of Food Crops and a number of food crops extension workers have been assigned to NES/PIR projects to assist PTP staff. The allocation of staff has, however, often been delayed and nowhere has it been possible to post an adequate number of experienced personnel. For participants in the PMU schemes of all types, technical advice has been given by the PMU field staff and, in the fully structured SRDP and SCDP projects, particular efforts have been made to train staff in both technical and extension methods, and also to provide training courses for project participants. For all other smallholders with tree crops, advice is provided by the provincial estate crops advisory service (DISBUN), which is guided in technical matters by the Director General of Estates but is administered as a part of the national, integrated, agricul- tural extension service. 7.41 By 1986, in addition to the 22,000 food crop extension workers at the field level, there were 6,000 in tree crops (3,000 in PMUs and 3,000 in the unified extension service), 2,200 in livestock, and 1,700 in fisheries. They were trained by some 800 subject-matter specialists (PPS) in food crops, 150 in livestock, 190 in fisheries, and 29 in estate crops. The weak impact in estate crops has been partly due to the lack of PPSs. Therefore, under the restructured National Agricultural Extension III Project (NAEP III), over 600 PPSs will be recruited, of which at least 200 will be in tree crops. 7.42 In view of the fact that the majority of smallholders operate in a mixed farming system, the most cost-effective way of reaching these smallhold- ers will be through a unified, multicommodity extension service with a broad national coverage, which is already being put in place. The NAEP III project, which is continuing to develop the unified service, has the funds for recruiting more PPSs and field staff, and for their training, transport and equipment. The national program also has a large cadre of food crop staff at - 115 - the field level who are better trained than DISBUN colleagues, and who can also be trained in the key estate crops in their own particular area. The major challenge for DGE in the case of the "partially assisted" and the 'dispersed nursery' programs will be how to train these field staff more effectively. The shortage of PPSs should not just be overcome as at present by using other DISBUN staff, but also by making use of the expertise resident in PMUs, where they are adjacent to the rural extension centers (RECs). More senior PMU staff could act as PPSs for nearby RECs, and devote one day per fortnight or month to training these staff at the regular training sessions. While the special programs through the PMU will continue to reach those small- holders who get the majority of their income from tree crops, the PHU will also need to strengthen its support to mixed crop farmers in other areas through the national program. This will entail enlarging and better training the key cadre of PPSs, and supplementing them in some areas with PMU staff released from completed projects. 7.43 The small implementation units (typically of two people) implementing the dispersed nursery program would best operate as a part of the integrated extension service. The staff could be attached to the RECs for administration purposes and, when distances permit, work physically from a REC. They would, however, work specifically as rubber or coconut extension officers and only on the nursery program, for which financial ar,d technical parameters could be set by DGE or, in future, by an authority if it grows out of the current opera- tions of DGE. The operational links between the large PHUs and the integrated extension service could be feasible at the provincial level, initially through the DISBUN but perhaps ultimately through provincial representatives of an authority. 7.44 An Option of a Smallholder Tree Crops Development Authority. Given the magnitude of the task facing the Government in trying to reach the mass of smallholder producers, the Government may wish to create a specialized unit to oversee the task either by strengthening DGE or consider an option of setting up a separate authority. The present scope of DGE responsibilities for private and public sector plantations and all smallholder development projects, as well as the policy and regulatory functions, is too extensive. The existing development strategies are not sustainable because the institutions have not evolved to implement them. Perhaps a small DGE is required which deals with policy and regulation, and implementing units are required for replanting, new settlement, second-stage transmigration etc. Establishment of a Smallholder Tree Crops Development Authority could be considered in light of the logical continuation of the changes which have taken place over recent years, in respect of tree crop development. The one- time individual Project Coordinating Committees have been consolidated in the Provincial Coordinating Committees which, with their district-level counterparts, now act in respect of all provincial development projects. Also, the major project management units for SRDP and SCDP, which previously reported independently to the Director General of Estates are now the responsibility of the Director of Rehabilitation and Expansion, together with all other PMU activities. It may be appropriate that coordination should grow into specialization through the establishment of an authority specifically to plan and implement tree crop projects aimed at assisting smallholder development. A comprehensive strategy would be needed for reaching the unassisted smallholders. This could entail formulation and implementation of new approaches to emerging problems, such as the need for extensive replanting. A specialized unit or an authority could formulate and implement - 116 - such strategies. The authority might also consolidate the interrelationships built up by DGE with the several *qencies involved in the variety of smallholder projects (including t national extension service), through the representation of all these agencies in the authority. Further, the authority could become essential as the volume and dispersal of smallholder tree crop activities increases, and especially if the Government opts to use indirect financing mechanisms (Section VIII) to support smallholder development. The authority could then control a fund receiving such revenues for tree crop programs, and it would have responsibility for controlled channeling of these revenues to the designated beneficiaries. 7.45 An authority could provide a focus and stable career prospects for individuals trained in smallholder tree crop development. In the absence of stable career prospects for smallholder development staff, it will be diffi- cult to mount a competitive and sustainable smallholder support program. The heightened Government emphasis on supporting large-scale, private-sector proj- ects in Repelita V will tend to cause better workers to be bid away from Gov- ernment programs to these commercial projects, given the limited number of trained development and extension manpower in the sector. The better exten- sion and development staff will be lured from smallholder projects to PTP and private estate development schemes in the absence of an equally competitive smallholder de-relopment authority. Under civil service-wide salary and incen- tive limitations, it is unlikely that the Ministry of Agriculture can compete with either the PTPs or the private plantation firms for staff. In order to place smallholder development services on an equal footing, in terms of access to trained and capable staff, establishment of a specialized unit or an authority may be warranted. 7.46 The involved agencies, and particularly the Director General of Estates, are best placed to determine the most effective membership of the authority, and also its level of responsibility. The authority is, however, seen as strictly an implementation agency of the overall program (detailed implementation may be handled by sub-units or provincial agencies), not in any way a policy-making body. Responsibilities for policy generation, regulation and overall development coordination could remain with the Director General of Estates, and no change would be envisaged in the position of the Director General of Estates as regulating all activities in estate crop development, including operations mandated to the proposed authority: effectively a part of the Directorate General of Estates could be separated out because of the importance which Government gives to smallholder tree crop development and the size to which the total program is expected to grow. An organogram indicating a possible structure for an authority is included in Annex Chart 1. 7.47 The suggested authority would require time to develop, and a transi- tion period would be needed. A possible start might be the delegation to the authority of responsibility for replanting and future (but not ongoing) NES/PIR-type projects, which could be implemented through project implementa- tion units rather than nucleus estates (see Appendix 2). The authority could have separate implementation units required for replanting, new settlement, second-stage transmigration, etc. These might entail incorporation of some units of the Directorate General of Estates into the embryo Authority as the - 117 - central monitoring unit. Other responsibilities could be assigned as the body proves capable of absorbing them, rather in the way that small PKUs in the PRPTE programs have been absorbed into the more structured Smallholder Rubber Development Project. 7.48 However, several issues would need to be resolved in determining the appropriate nature and functions of such an authority. (a) It would have to be decided whether the unit or authority could handle all estate crops or only some; (b) the focus and level of responsibility of the authority would need to be determined. As suggested earlier, it could be an implementation unit and not a policy-making body. Effectively, it would mean separating out a part of DGE because of the importance which the Government gives to the smallholder tree crop development and the size of the program that is needed; and (c) careful consideration would have to be given to the division of responsi- bilities between this agency and existing institutions, particularly the unified extension service. It would be possible for the authority to continue the technical advisory service now provided through PKUs, but perhaps also provide technical backstopping and training for estate crops through the net- work of dispersed nursery units located near the rural extension centers. - 118 - VIII. FINANCING OPTIONS 8.1 An Overview. A stable and steady source of development financing is required for smallholder tree crop investments because of the multiyear nature of such investments, the long lags between initial investment and peak returns, and the need to harmonize construction of processing facilities with the investments in primary production. In the immediate future, there is a need to put in place arrangements that would ensure that the flow of investment financing for existing smallholders is maintained, and to break the present impasse over loan recovery. In March 1989, the Bank made a proposal to the rovernment for some changes to the pressnt credit system. The Government has responded that for the immediate future, it wishes to continue with the present system, for which a series of procedural changes had recently been implemented, and to consider nore fundamental changes later. Over a longer term, the need would be to lay the basis for a wide network of viable rural financial institutions, in line with the October 1988 financial sector reforms. The goals would be to mobilize rural savings and provide a broad range of financial services, including credit for on-farm investments including tree crops, and ultisately to increase rural incomes to the point where at least some smallholders have sufficient equity to borrow commercially for tree crop investments. However, such a process will take time. Meanwhile, the Government may wish to consider indirect cost recovery options (a cess or a specific commodity tax), which can reduce collection costs and facilitate a stable source of revenue for a broad package of smallholder development programs. This section, after reviewing the constraints of the existing financing mechanisms, and the various indirect cost recovery alternatives suggests a revenue enhancement measure such as a modest export tax/development cess on rubber, and an option of a smallholder development authority, which can serve as a channeling entity for commodity development funds. Export Cesses 8.2 Between 1969 and 1977, export cesses and taxes 1/ were used to finance tree crop development schemes. In practice, the cess scheme proved difficult to administer. The coverage rate was low, exemptions were frequently granted and effective tax rates varied considerably by region and enterprise. Furthermore, there was little recycling of export taxes to the 1/ In 1969, a rubber cess of Rp 3/kg for estates and Rp 1.6/kg for small- holders was declared. In 1971, the cess was removed. In 1973, the cess was reimposed at Rp l!kg until September 1973 and Rp 2/kg thereafter. In addition, between 1970 and 1976, a stamp duty of 0.5Z of the export value was levied on the rubber trade. Also, starting in 1970, an export tax was levied at 1OZ of foreign exchange earnings. This was reduced to CZ in 1973, before being increased to 5Z of the check price in March 1976. Cess and export revenues from primary product exports were channeled to regional development accounts (ADO or Allokasi Devisa Otonom) for use in planting tree crops and in providing essential infrastructure. - 119 - tree crops sector as the majority of financing was used for more general regional development purposes. 8.3 Between 1979 and 1984, export tax revenues were channeled directly into an Export Crops Fund (DTE) to finance tree crop investments. However, since 1980, export taxes for the major tree crop exports have been sharply reduced. The export tax rate for rubber, Indonesia's largest export crop, has been set to 02 since 1980. The reduction in export tax rates severely reduced the level of resources available in the Export Crops Fund to finance tree crop sector activities. Total export revenues and special additional export taxes, which were earmarked to finance a part of the tree crops subsector project costs, since 1979, have declined sharply, both in absolute terms, and relative to overall central Government revenues, since the late 1970s. Credit as a Cost-Recovery Mechanism 8.4 The primary source of financing for smallholder tree crop development schemes is credit provided through state commercial banks. This applies to the PMU and PIR projects, including the new PIR-TRANS schemes. In contrast, credit for most externally-assisted NES project has been through the Invest- ment Funds Acccunt. The credit system was intended primarily as a cost-recov- ery mechanism to collect loan repayments from project participants, after expenditures by PTPs and PHUs on estate crop development are converted to smallholder loans, but was also intended to introduce smallholders to the banking system. The banks have been used as both a channeling mechanism, where they are charged with on-lending and recovering Government funds, with no risk to the banks (as in the NES projects); and as an executing agency, where the financing package includes some of their own funds, and where they take some risk (as in the PMU and PIR schemes). The terms and conditions of smallholder tree crop loans vary by project type. In general, an interest- free grace period is provided during the initial field development and plant- ing period. Thereafter, a low interest rate is applied during the period in which the loans are convertf- from the projec: to a smallholder's debt. Repayment schedules vary but, in general, subsidized interest rates are charged and annual repayment is limited to 301 of the gross value of output. For executing-basis credit, interest subsidies, administrative charges and preconversion interest payments to the state commercial banks are provided by the Ministry of Finance. Smallholder default risks are covered through risk- sharing arrangements with Bank Indonesia, the Ministry of Finance, and, in selected cases, through reinsurance with the state reinsurance agency, ASKRINDO. Special liquidity credits from Bank Indonesia are used to provide the state commercial banks with financing for these development schemes.2/ 8.5 Smallholder credit expenditures have lagged far behind budgetary approvals, partly because of delays in approval of credit and noncredit finance, and partly because of more systemic difficulties in implementation. Table 8.1 below compares planned and realized credit expenditures for tree crop projects from 1983/84 to 1987/88. On average, between 1985 and 1988, 2/ Credit arrangements under the NES/PIR and the PMU approach are described in detail in: World Bank, Cost Recovery Issues Under Ongoing Estate Crop PrrJects, February 1988. - 120 - credit expenditures were only 492 of approvals. According to the representa- tives of the state commercial banks, one of the main reasons for the low credit realizations, post-1983, are the difficulties in collecting outstanding debts due them by smallholder tree crop producers. The state banks are reluc- tant to increase their exposure to a subsector where, in fact, the vast major- ity of loan recipients are technically in arrears. Table 8.1: PLANNED AND REALIZED CREDIT EXPENDITURES FOR TREE CROP PROJECTS (Rp billion) Planned Realized Z 1983/84 168 123 72 1984/85 231 67 29 1985/86 247 82 33 1986/87 262 166 63 1987/88 272 135 50 Note: Values do not include expenditures for the tree crop component of transmigration projects. Source: Ministry of Finance and Directorate General of Estate Crops. 8.6 In theory, there are many advantages to the use of a credit mechanism as a cost-recovery device. A credit system is a 'fair' means of cost recov- ery, in that direct project beneficiaries beaL the cost of their resource transfer. Furthermore, to the extent that the use of a credit system fosters financial deepening, the social benefits from increased lending and investment may outweigh the typically high costs associated with direct collections. In addition, the use of credit as a direct cost recovery device is relatively less distortionary than indirect cost recovery and other financing schemes, since incentives that influence resource allocation for nonproject partici- pants are not directly affected by project credits. 8.7 The problem with the use of the credit mechanism for recovery of the cost of tree crop development in Indonesia is inter alia one of the sequencing by which innovations are introduced. Financial deepening requires a reason- ably broad rural economic base to begin with. Imposing formal financing as a cost-recovery device, before an initial economic base is established, adds a great deal to the costs of the investment, and has proven to date to be not viable in Indonesia's case. 8.8 Credit as a Nonviable Smallholder Cost-Recovery Device. Based on the experience to date, the viability, replicability, sustainability and effi- ciency of credit as a means of cost recovery are in doubt. The factors which give rise to this prognosis are described below. 8.9 The Conversion Problem. The low rates of convErsion from Government credit expenditures into smallholder loans reduce the viability of credit as a - 121 - cost-recovery mechanism. For the NES/PIR type of projects, only 4Z of the total area planted has been converted into loan status (Table 8.2). Of the areas planted, only 9.5Z have managed to obtain land titles, a prerequisite to credit conversion. In addition, 572 of the NES/PIR lands have not had a qual- ity control audit, another precondition for loan conversion. Credit conver- sion rates have been generally better under PMU projects, although here too, the rates are very low. Under the Government-financed smallholder rehabilita- tion program (PRPTE), 30Z of the lands eligible (quality-wise) for credit conversion have been converted. However, this is only 4? of the lands actu- ally planted under the PRPTE projects (Annex Table 7.1). Table 8.2: PLANTINGS AND CONVERSIONS OF LANDS BY NES/PIR PROJECT TYPE (AS OF JLY 1988) Project Area planted Area titled Z Area converted I type (ha) (ha) (ha) NES 134,559 11,774 9 5,422 4 Local PIR 19,137 5,444 5 1,734 9 Special PIR 107,635 7,708 8 2,000 2 Source: Ministry of Finance, and Directorate General of Estate Crops. 8.10 Participant Selection Problem. Another problem which impedes the utilization (and raises the costs) of credit as a cost-recovery device, are difficulties in screening project beneficiaries to ensure that, in fact, the eventual loan recipients are creditworthy individuals.3/ According to Ministry of Finance project audits, in all of the NES/PIR projects, both foreign and domestically financed, there are participants who fall outside of the prescribed age bounds, who do not reside in the project areas, and who have arrears on loans, typically BIMAS rice loans, to the state commercial banks. Once selected, it is practically impossible to evict "ineligible" participants from project lands. The state commercial banks have the option of either accepting individuals who are a poor credit risk, or are holding previous arrears, or refusing to collect credit from the noneligible participants. If the latter course of action is chosen, this would provide a strong incentive to the "eligible' participants to avoid repayments. If the 3/ In addition to the provision of a land title to a state commercial bank as collateral for credit repayment, the other requirements for loan conversion are that: (a) the participant meets prescribed eligibility criteria, i.e., is between 18 to 45 years old, married, engaged in farming, domiciled in the project area, of good character, not participating in other tree crop projects and is not in arrears on other bank debt; (b) the plantings meet the required quality standards; (c) the State Auditing Agency (BPKP) has audited the accounts establishing each individual's loan account; and (d) a credit agreement is signed by the participant acknowledging his debt and the terms of repayment obligations. - 122 - lands from the ineligible participants are not converted to loans, but those from the eligible participants are, then the 'ineligible" participants will bear a markedly lower share of the cost-recovery burden compared to farmers meeting established eligibility criteria. 8.11 High Substandard Planting Rate. Another condition for credit conver- sion, and repayment, is that project-assisted plantings must meet accepted technical performance criteria. Since the quality of development has been highly uneven, there have been delays in credit conversion and complications in the process of assigning ccsts to the smallholders at conversion. 8.i2 The Government classifies plantings into four categories: A, B, C and D. Class A plantings correspond to those which are of a satisfactory standard with regards to tree density and growth, and which have been ade- quately maintained and are expected to produce yields according to a certain profile. Class B plantings do not quite meet class A physical standards, but they are expected to achieve, belatedly, the class A yield profile. At the other end of the spectrum are class C and D lands which are substandard and will yield substantially less than initial projections. Technical criteria for classifying lands in categories E., B, C and D differ by crop and project type, but generally, factors such as tree population, girth, r i conditions, disease conditions and appatent ground maintenance are taken into account when making these classifications. As of July 1988, of the total NES/PIR projects, 402 of the total rubber area, 9Z of the coconut area and 5X of the oil palm area were classified as C and D lands, as indicated in Table 8.3. For the PMU-type projects (Table 8.4), only 112 of the SRDP (rubber) lands are classified as C and D type, although more than half of all SCDP (coconut) and PRPTE (rubber and coconut) lands fall in these categories. Such classifica- tions are highly contentious. Figures provided by state commercial banks show a markedly higher share of class C and D lands than those provided by the Special Team (Tim Khusus) for the management of foreign- assisted projects. - 123 - Table 8.3: QUALITY CLASSIFICATIONS OF NES/PIR-TYPE PROJECTS (Ha). July 1988 Commodity/Project Area Percent Percent of Quality Classes Planted surveyed A B C D Rubbar NES - I 11,900 100 66 2 11 21 NES - II 18,994 62 64 14 12 10 NES - III 27,305 49 35 16 11 38 NES - V 4,476 5 66 14 4 16 NES - VI 4,445 17 38 18 10 34 NES - VII 7,861 17 41 33 7 19 Local PIR-I 9,286 37 67 9 10 14 Special PIR-I 46,811 14 36 17 8 38 Special PIR-II 28,240 4 40 11 7 42 Average 32 45 15 9 3J Coconut NES - V 7 842 27 71 17 11 1 NES - VI 3,312 27 94 6 0 0 Average 27 78 14 8 1 Oil palm NES - IV 7,200 55 95 3 1 1 NES - V 12,929 28 76 6 2 16 NES - VII 11,981 14 55 16 10 19 ADB NES 1,250 100 100 0 0 0 OPI NES 6,000 0 0 0 0 0 OPII NES 2,500 0 0 0 0 0 OPHIR NES 4,188 68 99 1 0 0 Local PIR-I 24,264 63 99 1 0 0 Local PIR-II 1,800 28 100 0 0 0 Special PIR-I 8,429 62 99 1 0 0 Special PIR-lI 33,679 34 98 1 1 0 Average 40 84 3 1 4 Source: Ministry of Finance, and Directorate General of Estate Crops. - 124 - Table 8.4: QUALITY CLASSIFICATIONS OF PMU-TYPE PROJECTS (Ha), July 1988 Total Class Class Class Project planted A&B C D SRDP 74,554 88 8 3 SCDP 49,871 51 15 34 PRPTE 321,02_ 39 19 42 Other 12,717 55 26 19 Source: Ministry of Finance and DGE. 8.13 In those cases where project implementation has been particularly poor, it is doubtful that the smallholders will have the capacity to repay, regardless of the credit terms. Initial analysis suggests that the class D NES rubber smallholders would be able to meet repayment requirem'ents only if the credit terms are extended from 13 to 22 years of repeyment. Similarly, class D NES coconut smallholders will be able to meet repayment requirements, under prespecified loan conditions, only if the credit repayment period is extended from 14 to 20 years.4/ In 1987, the Government undertook to upgrade substandard areas under NES projects on a 502 cost-sharing basis with partici- pating PTPs, although to date few hectares have actually been upgraded. Mea- sures have yet to be agreed for the upgrading of substandard PMU project areas. The fact that such a high share of the developments are technically substandard implies that the terms and conditions urder which credit was granted can no longer be applied uniformly across all participating farmers. In cases where class C and D lands comprise a relatively large share of the holdings, substantial adjustments of credit terms could induce large-scale confusion about repayment obligations. 8.14 Pricing Formulae. Another factor which complicates the use of credit as a cost-recovery mechanism is the need for equitable and transparent pricing formulae for compulsory purchase of smallholder produce by the nucleus estates. Based on a pricing formula issued by the Ministry of Agriculture, the agreed price is paid to the smallholder and a negotiated portion of the smallholder's earnings are paid directly into a bank account for loan repay- ment. The pricing regulations seek to ensure that for compulsory sales to the nucleus estates, the smallholders will receive a fair price in line with mar- ket conditions, that the estates will receive a reasonable return and adequate incentive to invest in processing facilities, and that there will be suffi- cient savings gene-ated to repay the smallholders' loans. For both oil palm 4/ World Bank, Cost Recovery Issues Under Ongoing Estate Crop Projects, 1988. - 125 - and rubber, the basic pricing mechanisms are the same. The price received by the smallholder is to be based on the market price for the processed produce, less allowan,.es made for: product quality, direct processing costs, transpor- tation, marketing and other incidentals and returns to capital. 8.15 The Minister of Agriculture's decree Number 15, of January 9, 1987, sets the broad framework for rubber pricing.5/ In practice, the formula is not yet fully transparent to the smallholders, in that processing costs, depreciation allowances and even dry rubber content involve complex calculations which cannot be easily verified. There have been numerous reports of farmers selling their rubber outside of the nucleus estate to gain higher prices or better services on the private market. The use of the JMO price as a reference standard is not particularly good, since these prices tend to be out of line with spot-prices provided by private traders. In practice, the dry rubber content has also proven difficult to establish accurately, but this problem is not peculiar to the use of the pricing formula, as it affects smallholder marketing through private traders as well. 5/ The decree first provides that smallholders must deliver all their produce to the nucleus estate. Second, it provides that the smallholder price shall be calculated using the following formula: H = K (HE - B) where H is the farmers' purchase price, B is the cost of production, processing and depreciation, K is the dry rubber content and HE is the reference export price. The reference export price is set biweekly based on Joint Marketing Office prices. Latex is priced at the equivalent price of SIR5, dried sheet at 802 of SIR5 and 20Z of SIRIO, cup lump at 80Z of SIR10 and 20X of SIRZO and other coagulum at 75% of SIR20. Third, the reference export price is to be announced two times a month. The time and procedure for payment is to be mutually agreed by the estate and the farmers, and the dry rubber content is to be technically measured. - 126 - 8.16 The CPO pricing formula,6/ as presently devised, is also not a fi.lly trarsparent tool for competttive pricing. The use of an average monthly reference price implicitly penalizes those estates which, under times of high world and low administered domestic prices, sell more domestically than inter- nationally. The K-factor, a regional discount factor designed to account for marketing costs, depreciation, and processing charges, is set as a proportion of the reference price, rather than proportional to the volume of CPO and PKO traded, although, in fact, incidental costs are proportional to trade volumes, not to prices. Furthermore, sufficiently detailed guidelines for the setting of the K-factor have not yet been issued. As in the case of rubber, the set- ting of dise-u.nt factors on the basis of regional overall costs of factories implicitly shifts the burden for processing inefficiency to the smallholders and reduces factory incentives to contain costs. Operationalizing the oil palm formula will require monthly revision of the reference price and quar- terly revision of the K-factors. The cost of collecting and processing the data required to accurately revise the K-factors, on a quarterly basis, is very high. 8.17 Subsidies Inherent in Past Credit Packages. One of the main problems with the use of the past credit system, as a means of cost-recovery, is that it has a very high in-built subsidy rate to begin with. NES/PIR projects include a five or six year grace period, with no interest capitalized during the grace period. Implicitly, the interest subsidy--even assuming 100Z loan recovery--would be worth nearly half of the present value of the expenditure. In the SRDP/SCDP/PRPTE type of PMU projects, Lhere is an initial five- to six- year grace period, with an interest rate of 6.5Z (SCDP) to 122 (SRDP) there- after. The long grace period, followed by the below-market intprpit rAte Pft1rctve1y redures the nresen" -luc ct the costs recovered by 30 to V),7 depending on the credit terms. 8.18 Annex Table 7.2 presents a set of expenditure and repayment estimates for different project models, assuminpR irn -.1 - 1A010 -f F-u ' repay (Option I) or that 70Z of the smallholders repay (Option II). These 6/ The Minister of Agriculture's Decree No. 43 of February 2, 1987, provides that smallholders must deliver all their fresh fruit bunches (ffb) to the nucleus estate; that the average prices of CPO and palm kernels received by the Joint Marketing Office (JMO) during the previous month, multiplied by the relevant extraction rates, and further multiplied by a K-factor, will be used to calculate smallholder ffb prices; that the Director General of Estates will stipulate the K- factor on a quarterly basis, and will also stipulate extraction rates, and provide guidance on procedural and technical matters; and that the initial K factors will be 802 for Aceh and North Sumatra, 75Z for Riau, 70Z for West Sumatra, Jambi and South Sumatra. The implementation guidelines, issued by the Director General of Estates, in Decree No. 31, dated June 27, 1987 provides detailed technical directives concerning ffb purchasing procedures and stipulates the extraction rates for crude palm oil (CPO) and kernels. The reference price for CPO and PKO is to be set monthly based on a weighted average of export and domestic sales by the JMO in the previous month. - 127 - cost and repayment streams are estimated in constant 1988 terms. Cost ele- ments are the direct costs, or private benefits, for which the smallholder is liable for repayment. Repayments are a measure of the amount estimated to be repaid by the smallholder, less the actual costs of collection to BRI. The ratio of the net present value of the revenue to the cost stream is a measure of the percentage subsidy embodied in the credit system. At a discount rate of 102, and a default rate of 302 (option II), the effective subsidy element in the SRDP-type project is 672, for the SCDP project it is 842, and for the NES-PIR project, 782. Under the PMU projects (Tree Crop Smallholder Develop- ment and Transmigration Second-Stage Development) now under consideration, with interest charged at 16I, and fully capitalized through the life of the loan, the effective subsidy rate would be 392. 8.19 In the case of credit attached to programs such as the PRPTE, where conversion is long overdue, the present value of the outstanding credit has eroded rapidly due to the high time-cost of funds. In the case of PRPTE proj- ects, where the 1.988 present value of private benefits conferred upon small- holders is about Rp 2 million per participant, the effective subsidy rate-- assuming improved, but delayed conversions and collections--would be in the order of 802. This underscores an important problem with using smallholder credit as a cost-recovery device: the longer the delay in conversion and c:llection, the greater the effective grant element to the program. 8.20 Negative Effects of Subsidized Credit on Financial Deepening. Besides such high costs (subsidies), another factor which indicates that the past credit system has not been a desirable or viable means of cost-recovery is the aDparent perverse effect of a credit-based cost recovery system on formal-sector financial deepening in existing smallholder project sites. One Df the strong arguments in favor of utilizing credit as a cost-recovery mecha- nism is that the external benefits to the surrounding community from financial deepening should offset the high costs associated with developing a bank- based, term-credit recovery mechanism. In practice, hc-ever, finUncial deep- ening appears to have been retarded rather than stimulated by the use of the banking system to recover smallholder tree crop project costs. For example, in PRPTE areas surveyed by researchers from Sembawa institute, smallholder rubber farmers tended to view credit as a grant rather than as a formal finan- cial obligation.7/ This can be expected to retard prospects for future credit discipline amongst these project participants. According to a 1987 evaluation of the NES/Ophir oil palm project, relatively prosperous smallholders were unable to accelerate repayment of their tree crop loans, or obtain access to short or medium-term Government loans, because of their unconverted, outstand- ing tree crop loans.8/ From the perspective of the state commercial banks, it is cost-inefficient to establish branches or expand lending operations in areas where the bulk of the target-lending clientele are holding delinquent 7/ C. Nancy et. al, "Penelaahan Terhadap Petani Peserta Proyek PRPTE di Kecamatan Banyuasin III (Research on PRPTE Farmers in Banyuasin, S. Sumatera)," Sembawa Research Institute, 1987. 8/ K. Altemeier et. al, "A Socio-Economic Evaluation of the NES/Ophir Project," (mimeo project document), 1987. - 128 - loans, or are ineligible for short-term loans or saving schemes because of outstanding arrears. The greater the debt overhang in a particular region--as in the PRPTE areas--the lower the incentive to establish bank branches and encourage formal-sector financial deepening. This implies that, unless major remedial measures are taken, the smallholder tree crop program could actually inhibit financial deepening. 8.21 Banks Assuming a Low Risk Profile. Another factor which suggests that the use of direct baa,k lending and credit repayment has not been a sus- tainable cost-recovery mechanism is the revealed unwillingness of state com- mercial banks to assume more than a minor share of nonrepayment risks. 8.22 Although the state commercial banks are holding a larger share of the repayment risk under the more recent NES and PMU projects, the banks, before conversion, assume no risk and are paid an interest spread to cover adminis- tration and eventual repayment costs. Even under the PI4U-based risk sharing agreement, tle greater the delay in conversion, the less of the actual risk that is borne by the state commercial bank. The spread provided to the banks is, in most cases, larger before conversion than after. For the World Bank- assisted NE3 projects, the collection fee after NES conversion is only 2.5Z of outstanding loan collections, which is below estimated costs of administering collections. In the case of the PRPTE projects, a delay in conversion of three years would, in effect, offset the effects of a 252 risk sharing agree- ment on the part of the state banks. In fact, the longer the delays in con- version, the lower the effective risk and the greater the net returns accruing to the state commercial banks from these investments. This pattern of limited risk lending. with banking incentives biased in favor of noncollection, does not provide a sustainable basis for an exparnded prugLam uf cust recovery through the banking system. 8.23 Lessons Learned from Continued Dependence on Credit for Cost Recov- erV. There are three important lessons to be learned from the failure to date of the credit system to serve as an efficient form of cost recovery in small- holder tree crop development programs. The first lesson is that there are preconditions to efficient cost-recovery for tree crop programs through a banking system, and these include: (a) bank branches in project areas; (b) bank staff trained in managing tree crop credit; (c) bank capacity and authority to alter repayment schedules according to commodity price fluctua- tions or variable project performance; (d) financial solvency of the banks to enable them to assume repayment risks for their loanF; (e) technical project implementation standards which are reasonably uniform; (f) proper cadastral. surveys and land titles issued before a project is initiated if land is to be insisted upon as a collateral; (8) well-tested processing factory pricing formulae in place; and (h) credit packages tailored to the requirements of the individual smallholder. Although the Government has made a marked effort to improve land titling procedures, improve smallholder pricing formulae and upgrade NES/PIR project lands, most of the essential preconditions for using banks as an efficient cost-recovery device are not yet developed. Bank branches still do not exist in the majority of tree crop Fites; the banks are still not in a position to plan and assume collection risks for smallholder tree crop projects; the banks do not have the capacity or authority to alter - 129 - repayment schedules so as to absorb downside risks from commodity price fluc- tuations; technical standards of project implementation continue to be highly heterogeneous; and reasonably transparent formulae for factory-channeled repayments are still not in place. 8.24 A second lesson from the use of a credit-based system for cost-recov- ery is that this imposes a complex set of interinstitutional coordination requirements on a project investment. This, in turn, raises the costs and management requirements for the investment. In order to use a credit system as a cost-recovery device, the creditworthiness of the participant must be established, the value of the asset must be independently assessed, and clear title to collateral must be provided. Although in thecry, this should provide a system of checks and balances to ensure efficient project implementation, in practice, the costs of satisfying bankable project requirements often prove to be very high. 8.25 The third lesson from the Indonesian experience in using the credit system as a means of supplementary financing and cost-recovery is that such a system, in times of general budgetary contraction, does not necessarily pro- vide a stable and assured flow of finance to the sector. Furthermore, as outstanding arrears from past investments rise, the willingness of the banking system to commit additional resources to smallholder development falls. This, in turn, threatens the sustainability and replicability of smallholder tree crop investments. 8.26 In view of the difficulties for tree crop funding and cost recovery, the Bank proposed to the Government. in March 1989, some changes to the credit system. These proposals are included in Appendix 7 The Government has indicated that it wishes to consider more fundamental changes later, and in the meantime, it wishes to carry out a study to examine other financing/cost recovery options. The remainder o. thi. section presents some of these options for more fundamental changes. Following the broad, indicative estimates of the financing requirements for smal.'ItIder development (under the proposed strategies), the various alternative financing options are discussed. Smallholder Financing Requirements 8.27 As a financing device, a specific tax or a cess-based revenue generating system is sufficient only to the extent that it generates an adequate and stable source of revenue, without inducing greater countervailing economic losses through price distortions. This leads to the question regarding the size of the tree crop sector public expenditure program, whose costs need to be recovered from indirectly collected revenues. 8.28 The specific tax/development cess can be used to finance the costs of private benefits conveyed through smallholder tree crop'. These are primarily what are termed 'field development" costs. Infrastructure costs associated with such schemes, such as construction of roads, provision of schools, health centers, running water and electricity can continue to be a general revenue obligation, as part of the social-overhead cost of new area development. Large-scale estate development costs, either in the public or private sector, should be financed to the maximum extent by equity, and supported by state commercial bank loans, since collection costs from these large-scale credits are relatively low. - 130 - 8.29 The main public investment item which would require specific- tax/development cess financing are the smallholder development schemes. An important constraint to the expansion of technically efficient smallholder PMU schemes are Government management limitations.9/ To ensure that future programs are implemented efficiently, public sector planting/replanting targets should be set low enough so as not to overshoot management capabilities within the DGE. Average annual plantings under PHM-style projects reached 13,200 ha in 1984/85, 8,600 ha in 1985/1986, and 17,600 ha in 1986/1987. In addition, partially assisted plantings, where farmers are provided planting material, were targeted to reach approximately 8,000 ha in 1988. If financing constraints were eliminated, as much as 30,000 ha per year of PMU land could be developed while maintaining existing project sites, over each of the next five years. If a full-scale PMU program were mounted, this would require a source of financing, and cost-recovery, for between 20,000 ha to 30,000 ha of fully assisted PMU plantings. AccordinLg to DGE records, there were between 148,000 ha (1986/1987) and 282,000 ha (1984/1985) planted by unassisted smallholders each year during Repelita IV. Additional costs will be incurred to establish nurseries, and provide improved planting material and extension advice for these smallhelders. This includes both those smallholders on the perimeter of existing PMU projects and the more dispersed smallholders. For the more advanced smallholders on the periphery of existing PMU schemes, a partially assisted PMU package should be provided. For the more dispersed smallholders, good quality planting material and extension advice should be made available. Additional expenditures are also required to upgrade substandard smallholder plots from existing projects, where such upgrading measures are economically viable. It is estimated that a total upgrading program of 150,000 ha is required, over a two to three year period. A large proportion of upgrading would be financed by the PTPs and the Government; however, a portion from the existing PMU-projects will have to be financed by smallholders. According to World Bank estimates, a total of 12,000 ha of SRDP rubber lands, 46,600 ha of PRPTE rubber lands, 20,800 ha of SCDP coconut lands and 4,000 ha of PRPTE hybrid coronut lands are technicallv Sh1p t'o be upgraded. Of this total of 83,400 hl, itb than half could be efficiently upgraded because of delays in initiating an upgrading program. In order to rewire the backlog of approximately 40,000 ha of PMU lands requiring upgrading, over a two to three year period, approximately 10,000 to 15,000 ha would require upgrading each year.l0/ In addition to the cost of developing new smallholder PMUs, providing partial PMU services to farmers on the periphery of existing PMUs, developing a network of low-cost nurseries and extension sites and upgrading substandard existing PMU holdings, public investment will be required to expand the network of small-scale copra kilns and rubber processing centers. Under planned and existing World Bank assisted projects, approximately 200 copra kilns and 200 rubber processing centers will be developed in new PMU areas over each of the next five years. These will be established largely in sites with good access to complementary infrastructure. 9/ World Bank, 'Implementation Issues and Problem's in the Tree Crops Practice,' 1986. 10/ Wnrld Bank, Upgrading of Substandard Smal'lholder Plantings on Indonesian Tree Crop Projects, 1987. - 131 - 8.30 The public costs of a proposed minimum and maximum annual smallholder development public investment package is provided in Table 8.5.111 Table 8.5: ANNUAL PUBLIC INVESTMENT REQUIREMENTS: SMALLHOLDER DEVELOPMENT (Billion 1988 Rupiah) Low High Item estimate estimate Full PHUs 28.00 42.0 Partially-assisted PMUs 1.80 3.5 Dispersed nurseries 1.40 2.8 Upgrading existing PMUs 6.00 9.0 Processing centers 0.15 0.3 Total 37.35 57.6 Note: PMU unit costs estimated at Rp 1.4 million/ha for between 20,000 to 30,000 ha of annual planting. Upgrading costs are estimated at Rp 600,000/ha, for between 10,000 to 15,000 ha per year. Processing center establishment costs are estimated at Rp 500,000 per unit for copra kilns, and Rp 1 million per unit for rubber processing centers. Low estimates are based on 100 of each unit and high estimates for 200 units. All O&M costs are to be assumed by local farmers. The cost of supplying planting material, including nursery development and exten- sion, is estimated to be Rp 136,000/ha. Nursery and planting material distribution costs are applied to a low estimate of 10,000 ha planted and a high estimate of 20,000 ha planted. Partially assisted PHUs are costed at P. 700,0°f ppr ha. A 1nw oRtimtp of 2,500 ha per annum planted and a high estimate of 5,000 ha per annum planted are used tor these calculations. 8.31 The total direct costs of operating a smallholder development program would be between Rp 37 to 57 billion per year. If, in addition to this, another 10% is estimated as the cost of administering such a set of programs, then the total annual budgetary requirements for a broad-based smallholder development program would be in the order of Rp 41 to 63 billion (1988 terms) per year. These estimates approximate the average annual public investment 1/ Inputs for the full and partial-cost PHUs are based on estimated unit field costs provided by the DGE and adjusted by the mission; costs of establishing nurseries are based on those reported in the SRDP 11 project document, other costs of partially assisting smallholder replanting are based on a modified version of the model presented in Barlow, Shearing and Darainda (1988); upgrading costs are based on World Bank estimates, and costs of establishing processing centers are based on estimates provided by Tim Khusus and DGE officials. - 132 - cost of Rp 61 billion estimated for one scenaric of smallholder planting pro- grams (Table 7.2). In addition to these public investment costs, annual pri- vate investment costs would be in the order of Rp 93 billion. Infrastructure costs would continue to be a general revenue obligation. Although the public investment estimate of about Rp 60 billion is very crude, this would be the range of funds required to operate a smallholder program. For the program to be self-financing, this would also be the amount that would need to be recovered from smallholders, each year. using a development cess-based cost- recovery mechanism. Alternative Options of Financing and Indirect Cost-Recovery 8.32 A major reform of existing smallholder tree crop financing policies may well be needed to overcome the existing debt overhang problem (recovery of smallholder creoit) and to improve the flow of funds from the Government to the sector. The prospects for a financial reform of such dimensions would be medium- to long-term. Moreover, the use of flexible repayment schedules, regular revision of factory-operated pricing formulae, establishment of inde- pendent inspection services, an increase in state commercial bank branches, and an increase in staff able to appraise, manage and collect tree crop loans would require a vast investment in skilled manpower, just for this particular subsector, within the state commercial banks. Even if this was technically feasible, this would raise collection costs even further. 8.33 Since there has b.2en only a trivial amount of smallholder tree crop credit repayment to date, unless the situation changes dramatically, the credit-based, cost-recovery system is in danger of becoming, in all practical terms, analogous to a grart. The net cttect of the current _redit-based cosL recovery system is that the participating farmer receives a lump sum transfer to induce a particular pattern of investment behavior. The only difference between this and a pure grant system is that the initial collection costs, in the form of bank handling fees and deferred interest payments, are deducted at the start ot the sinvsebLeL4L. HtL1e, LiLe LieL transier to the project benefi- ciary is less, ceteris paribus, under a nonperforming, credit-based cost- recovery system, than under an indirect cost recovery system. In the absence of a working cost recovery system, the economy as a whole bears the cost of the investment. This raises important questions regarding the 'fairness' of this form of public investment. 8.34 In the early stages of large-scale, smallholder tree crops develop- ment, Malaysia, Thailand and Sri Lanka have all relied heavily on cess- financed, grant-based tree crop programs. The main reasons for utilizing indirect cost-recovery, grant-based schemes in all three nations were: (a) low collection costs associated with cess; (b) the need to provide a mech- anism for ensuring stable financing to the sector; and (c) the relative under- development of the formal financial sector in the countryside, which negated the practical feasibility of using credit schemes. In all three countries, cess financing has provided a relatively stable--although not always suffi- cient--source of smallholder development financing. Perhaps, not coinciden- tally, smallholder planting and replanting programs in these countries have also proceeded at a faster pace, and with better technical performance, than in Indonesia. - 133 - 8.35 In the future, a more diverse, personalized approach to smallholder tree crops lending is preferred for large, prosperous smallholders, regardless of the choice of the cost-recovery system. The primary target group for these programs is the smallholder holding a sufficiently large amount of lands so as to be, in all practical terms, ineligible for grant-financed planting or replanting. Programs should still be designed for bank-based support to smallholder tree crop development programs. Smallholder development schemes should be designed to utilize routine Government term-credit financing pro- grams, such as the small investments credit of Bank Rakyat Indonesia (KIK) and the Cooperative Bank Investments Credit (BUKOPIN Investment Credit). These programs should be designed to reach the larger, more prosperous farmers who wish to expand or rehabilitate their holdings. 8.36 Indirect Cost Recovery and Distortions. The use of a cess or a commodity-specific tax as a cost-recovery system for grant-based development can, depending on the instrument chosen, lead to a wide range of distortions and efficiency losses, but measures can be taken to reduce these distortions and losses to reasonable levels. Assuming positive supply response, any spe- cific tax will reduce incentives to produce the taxed good or to apply varia- ble factors in the production of the taxed good. The direct effect of a spe- cific tax is to reduce supply. The use of a commodity-specific tax, by driving a wedge between domestic and world market prices, lowers domestic prices and leads to higher domestic demand. The net result, all other factors being unchanged, is a reduction in exports. Furthermore, the provision of a grant to induce planting or replanting can, in theory, reduce the perceived economic lifespan of the capital investment and induce myopic patterns of resource management. Grant-based planting/replanting schemes, on a large scale, can induce farmers to reduce the rate of privatel, financed planting or replanting. Such schemes, if tied to particular commoditJ programs, induce suboptimal patterns of commodity choice, since high initial capital formation costs are offset under the grant but are not offset if the farmer elects to prnd:clt- A n or,arPnt_-qunnoriteri crywi,r-,d I tv 8.37 The distortionary effects of a cess-financed, grant-based smallholder development scheme can be offset by: (a) providing such schemes for tree-crop commodities with low elasticities of supply and domestic demand; (b) selecting commod.ties which have a nonzero optimal tax to begin with; (c) maximizing recipient's own equity contribution (i.e. minimizing the size of the grant); (d) providing the grant for a narrow range of services; (e) providing a grant for a range of smallholder commodities; and (f) building in a phase-out of grant-based schemes. In the Indonesian context, the use of a cess-financed, grant-based system is a second-best cost-recovery alternative, but could be superior to the credit-based, cost recovery system. Distortions will be introduced as a result of a switch to a tax/grant system, but the costs of such distortions need to be compared to the very high costs, including value added foregone by erratic and suboptimal availability of financing associated with using a credit-based system as a financing and cost recovery mechanism. - 134 - Specific Options for Cost-Recovery 8.38 PTP Tax Earmarking. One option for recovering costs for smallholder projects is to target a portion of the taxes collected from PTPs to a special fund for financing smallholder schemes. This would, in essence, be an ear- marking of a portion of the revenues already collected in the sector, to spe- cial schemes for smallholder development. Total tax obligations from the PTPs include corporate earnings taxes (PPH), dividends to the Finance Ministry, property taxes (IPEDA/PBB), and local taxes for land use, factory establish- ment and use of local infrastructure. Total tax obligations from the Estate Crop PTPs, between 1982 and 1987, were as follows: Table 8.6: TAX OBLIGATICNS OF THE ESTATE CROP PTPS (Rp billion, current prices) Year Pretax profits Tax obligations Z tax 1982 21 32 1983 149 82 55 1984 352 133 38 1985 183 58 32 1986 194 49 25 1987 301 146 49 S^urcc: Department of Agriculture, Secretary of AgriLulture's Office, Report of the Results of the BUMN Firms, 1982-87, Jakarta, March 1988. Tax rpvenues from- the vulic estates. in 1987, were- -proximately three t_:es as great as the costs of operating smallholder development schemes, as pro- vided in Table 8.5. However, it is unlikely that earmarking PTP tax funds, or private estate taxes, to a smallholder development fund is a viable financing option. First, a large portion of these revenues accrue to regional govern- ments, through the property tax and through local taxes and licenses, for their routine development expenditures. Secondly, the PTPs are technically in arrears on a large portion of their property tax payments, according to records held at the Directorate General of Taxation. Third, the tax incidence does not fall primarily on the beneficiaries of the financing (i.e., small- holders). 8.39 Land Taxes. One of the least distortionary options for indirect cost-recovery is a special tax on smallholder tree crop lands. This is a nondistortionary tax if levied on the unimproved site value of the land. If levied on the improved value of the land, this is equivalent to a tax on potential agricultural output. To the extent that land ownership is correla- ted with wealth, such taxes would be equitable, and hence preferred on both a distributive and minimal-distortion basis. - 135 - 8.40 Indonesia switched in December 1985 from the previous land tax sys- tem, IPEDA, to a new property tax system, PBB. Under the new system, those cultivating the lands are levied a tax equivalent to 0.12 of the assessed market value of their property. Ten percent of the proceeds from the property tax accrue to the Central Government, 92 is assigned to cover valuation charges, 162 is allocated to Provincial Governments and 65Z to local govern- ments. 8.41 Since the PBB tax base is so uneven to begin with, it would be diffi- cult to design a supplementary tax that would be implementable on an equitable basis in the near future. As it is operated at present, effective PBB rates are extremely low and are highly variable across regions. In 1987, Estate Crop lands in Deli Serdang, Medan paid a property tax averaging Rp 19,400 per hectare compared to a rate of Rp 2,400 per hectare for Estate lands in Tapanuli Seletan, Medan. A farmer in North Maluku paid an average of Rp 230 per hectare for property tax in 1987 compared to Rp 5,129 in Minahasa, North Sulawesi. Both areas are major coconut producers. Table 8.7 reports average PBB rates by selected areas which are major tree crop producers. It is esti- mated that another decade will be required before rural property valuation is done in a consistent fashion, and compliance is reasonably universal. 8.42 A cost-recovery surcharge on the PBB would be a poor choice for reve- nue generation, both on equity and efficiency grounds, at least for the fore- seeable future. The PBB tax-base is very small to begiL. with. In 1985, total IPEDA revenues from estates were Rp 16.5 billion; total revenues from the rural sector, nationwide, were only Rp 40.6 billion. Actual estimates for PBB incidence for smallholder tree crops do not exist. However, in total, this could not be more than a fifth of total rural property taxes. This would imply a tax base in the order of Rp 7 to 10 billion. In order to generate Rp 60 billion per year (to recover smallholder development costs), tax rates would have to be increased sixfold. Arrears are already quite high and cover- Rae is uneven. despite the 1nt Pffepr4ivp TPFDA!PR -o rate- If nropertV taxes were to be used to finance smallholder development costs, special sur- charges in the order of 500 to 1,0001 would be required. Such increases would likely induce taxpayer noncompliance on an even larger scale and hence raise collection costs further. - 136 - Table 8.7: 1987 PBB LAND TAX COLLECTIONS BY SELECTED TREE CROP PRODUCING REGIONS (Rp million) PBB PBB Rural Effec- Estate Effec- (total tive (total tive collec- rate/ha collec- rate/ha Arrears Regions tions) (Rp) tions) (Rp) N. Sulawesi Mongondau 212 3,785 2.3 287 695 Minahasa 672 5,129 - - ?,585 Gorontalo 266 4,586 3.0 666 356 Medan Deli Serdang 294 2,055 2,978 19,464 4,177 Langkat 79 752 1,898 16,946 2,443 Tapanuli Selatan 20 41 99 2,357 443 Banjarmasin Baniar 23 1,277 101 11,882 n/a Tanah Laut 25 609 45 12,857 n/a Jambi Batang Hari 52 1,181 38 6,333 87 Bunjo Tebo 49 1,160 27 3,375 20 Kerinci 39 2,294 252 31,500 28 Lampung S. Lampung 565 3,121 385 14,807 561 C. Lampung 1,362 4,509 290 4,461 891 N. Lampung 468 2,659 113 3,228 480 Ambon N. Maluku 21 230 0 0 206 C. Maluku 6 240 0 0 153 Note: Rates are defined as total taxes collected divided by the taxable area, where the latter is based on assessed areas recorded by the Directorate General of Taxation. Arrears are cumulative arrears for IPEDA and PBB, registered with the Directorate General of Taxation. Source: Directorate General of Taxation, 'Himpunan Data dan Statistik Ke-Ipedaan, dan luran Pembangunan', Monthly administrative reports, 1987/1988. 8.43 An increase in broad-based taxes such as an income tax, or a tax on products consumed specifically by smallholders, which are the least distort- ing, are not administratively feasible. In 1986, there were only 614,000 personal income taxpayers in Indonesia, practically all of whom were urban - 137 - residents or civil servants.l2/ Further, there are no consumption items specifically purchased by tree crop smallholders. Nonsmallholders would bear the incidence of a tax surcharge levied on "smallholder" consumer durables. Since smallholders are not confined to narrow geographic regions, any such tax on smallholder consumptions items would induce formation of secondary market trading in nontaxed goods. 8.44 VAT Surcharge. Another possible indirect tax instrument for cost recovery is the value-added tax. However, the cax base of VAT from tree crop products is too small to levy a surcharge on. Furthermore, the incidence of such a surcharge would be borne more by edible oil consumers than by small- holders. Under the present system, a 1OZ value-added tax is taken from the final value of all processed goods. In the case of exportables such as rubber, the value-added tax is returned, or credited against the end-of-the- year corporate income tax of the exporter. Hence, the effective value-added tax, for rubber, would be near-zero. 8.45 Total alue added tax collections in 1987 totaled Rp 4,787 billion. A disaggregation of the value-added tax by industrial origin is nct available. However, from the 1984 Socioeconomic Household Survey, it is estimated that the share of total private consumption expenditures accounted for by coconuts, coconut oil and edible oil produced from palm oil is 0.8Z. If freshly con- sumed coconuts are excluded, then the share of edible oils in total consump- tion expenditures is 0.62. If the share of value-added taxes is assumed to be roughly proportionate to the share of edible oils in final consumption, and that tax compliance rates in edible oils are equal to those prevailing in the economy on average, then total edible oil VAT collections would be about Rp 28.7 billion. It would require more than a doublirg of VAT rates to ensurp collection of approximately Rp 60 billion. An increase in edible "il VAT rates of that magnitude would likely encourage greater taxpayer noncompliance and would severely discriminate against domestic consumption, in favor of exports. The Government's policy in application of the VAT is to equalize rates across sectors so as to minimize inLerindu.u-ia. doubur>,o.4,. A - ing of the VAT for raising smallholder development revenues would be inconsis- tent with the broader thrust of tax simplification and equalization. Further- more, the effect of a VAT surcharge on edible oils would be to drive a sharp wedge between domestic and international prices. Given that short-term edible oil demand is far more elastic than short-term supply, consumers as a whole would bear the bulk of the tax incidence rather than smallholder tree crop producers. An effective VAT tax rate of 20% on edible oils would be inconsis- tent with the Government policy of providing edible oils at an affordable price to the consuming population. Even under strict trade controls, a VAT- induced difference of 202 between domestic and international prices would be high enough to encourage smuggling. 8.46 An option of a Development Cess/Export Tax. Revenue enhancement measures such as a modest export tax/development cess on rubber would be the best choice of the possible available indirect cost-recovery mechanisms, This would be an optimal tax, in the sense that the sum of producer, consumer surplus and tax revenues would be greater with than without the tax. The sensitivity of supply response to Rupiah devaluation indicates that an export tax, if scheduled in relation to currency movements, can minimize the negative 12/ World Bank, Indonesia: Selected Issues of Public Resource Management, 1988. - 138 - negative effects of export taxation on supply response. It could also be phased in with the lifting of an export ban on low quality (SIR 50) rubber. The heaviest tax incidence would be on domestic producers, of which smallholders comprise the largest group. The administration and collection costs would be very low. Application of the tax would partially redress distortions to downstream processors for the domestic market, who face a higher tax burden due to nonexemption from VAT and higher costs of working capital. Finally, at a modest tax rate, adequate revenues will be generated to fully recover the costs of a smallholder development program. 8.47 An export tax should not be applied across-the-board on all tree crop exports. In the case of the edible oils, revenue gains from an export tax would be small, but losses to producers and gains to consumers quite large. Allocatively, export taxes on edible oils will involve large transfers of welfare from domestic producers--primarily estates, to domestic consumers-- primarily middle and upper-income consumers, with ample deadweight efficiency losses. 8.48 The main argument for taxing rubber is that worlu demand is inelastic so that reductions in Indonesi&n natural rubber exports, will tend to increase the world market price. The elasticity of demiand facing Indonesia will depend on the extent to which changes Li the world price are passed through to other producers, the speed with which the producer price in other countries is adjusted to the new expected long-run world equilibrium price, the speed with which substitution from natural to synthetic rubber will take place and the - 139 - speed with which this affects investment in new planting and supply.13/ The optimal long-run export tax will range between 2.8Z and 7.62, depending on the degree of substitution between natural and synthetic rubber in world demand.14/ 8.49 In the 'ndonesian case, long-run optimal taxes are of greater inter- est than short-run taxes because 'he intention is to use such a tax as a long- term cost-recovery device. To avoid relatively high collection costs and the low efficiency of a nuisance tax, the lowest export tax rate charged should be 52. An export tax rate of 52 would be in the range of an optimal export tax. Compared to past patterns of rubber export taxation (Annex Table 7.3), a tax of 52 would not be particularly large. 8.50 Since 1981, tl.e export tax rate for rubber has been set to zero, although the tax has not been formally abolished. Export and import tax rates for edible oils (Annex Table 7.3) have varied far more than those for rubber, reflecting the Government's desire to add a measure of insulation to the domestic market. Since 1986, export taxes have been set at 02 for CPO and 13/ In the short-run, it may be that other countries will not vary their supply, in which case the short _un excess world demand elasticity facing Indonesian natural rubber producers will be e/s, where e is the world demand elasticity facing Indonesia and s is Indonesia's share in total world trade. In the long-run, the rest of the world will lower supply in response to the lower long-run equilibrium price. The long- run net excess demand elasticity facing Indonesia is equal to the short-run elasticity plus n(l-s)/s, where n is the elasticity of supply of the rest of the world. If natural and synthetic rubber are treated as perfect substitutes, in both supply and de-rnnd, then the relevant share is the share or total I wrl_ rubber marker, rather tb l t- l'a f the natural rubber market alone. In 1986, Indor,esia's share of world natural rubber production was 232, but its share of the total world rubber market, natural and synthetic, was only 8.42. The shcrt-term .l' d._.a..d Casticty i t'084) at aDoroximately -0.3. Under the strong assumption teat natural and synthetic rubber are perfect substitutes, the short-run net world import demand elasticity facing Indonesia is 3.57 and the optimal short-run export tax is 1/3.57 or 282. What is of more interest is the optimum long-run tax, since other producing nations can be expected to react strongly to the short-term increase in world prices. Again, based on estimates from Tan (1984), the long-term rest-of-the-world supply elasticity for natural rubber is about 3.5, with a six-year period to full adjustment. If we assume tha; the rest-of-the-world supply elasticity for synthetics is slightly lower, then the aggregate long-term supply elasticity would be about 3. Again, assuming perfect long-run substitution between natural and synthetic rubber within the range traded on the world market, the long-term elasticity of world demand, facing Indonesia is: 3.57+3.0*(1-0.084)/0.084 - 36. Hence, the optimal long-run export tax, under perfect synthetic and natural rubber substitution, is only 2.82 (1/36). If we assume that there are no long-term substitution possibilities between natural and synthetic rubber, then the optimal long-run tax will be 7.62 (computed: 1/(0.3/0.23+3.5*(1-0.23)/0.23)). 14/ M. Imran and R. Duncan, Optimal Export Taxes for Exporters of Perennial Crops, Policy, Planning and Research Working Papers, World Bank, June 1988. - 140 - CCO, but, for these commodities, licensing restrictions are used to limit export volumes. Rubber, by comparison, is freely traded, except for that portion which is produced by the PTPs, which is exported collectively through their Joint Marketing Office. JMO rubber marketing is conducted by direct auction and through forward contracting with established buyers. 8.51 The dynamic effects of an export tax on Indonesian natural rubber would be relatively complex. The short-run effects of an export tax would be to depress domestic Indonesian prices relative to world market prices. This would lead to a contraction pr'-.arily in smallholder supply and a marginal increase in domestic demand. Indonesia's exports would decline, and facing inelastic world market demand, world prices would rise in the short term. Other rubber producers would try to expand production due to the higher world prices, while downstream manufacturers would begin to substitute synthetically produced goods for natural rubber based goods. In the long-term, world prices would equilibrate at a lower level in response to increased supplies from competing natural rubber producing nations and because of substitution to synthetics. A fully specified model of world rubber supply and demand is needed to analyze the dynamic effects of an Indonesian export tax, because of the vintage nature of rubber investment, the differences in adjustment pat- terns among competing natural rubber producers, and the dynamic patterns of demand for synthetic and natural rubber. 8.52 The main effects of the export tax in the simulation model 15/ are to reduce Indonesian supply, raise natural rubber supply in the rest of the world, increase world prices marginally through the year 2000, reduce the share of natural rubber in total world demand, and reduce gross incomes to Indonesian smallholders and estates. However, a 5Z tax would generate between Rp 63 and 65 billion worth of tax revenues, sufficient for the type of small- holder program under cons;.deration. In 1995, the smallholders would lose Rp 49 billion (1988 terms) 'f revenue from the tax, and the estate producers would lose Rp 15 billion. '1,al tax revenues would be Rp 64 billion, offset- ting the loss in producer returns. Domestic consumers, on the other hand, would gain approximately Rp 3 billioi. in consumer welfare from lower domestic prices, even after accounting for the higher world market prices. These results confirm that the upper limits to an optimal tax is in the neighborhood of approximately 5X p.a. In the year 2000, total tax revenues are forecast to equal Rp 65.6 billion and the loss in income to domestic producers (smalihold- ers and estate producers) at Rp 65.1 billion. Again, smallholders would bear 77Z of the reduction in income as a result of the tax. Indonesian domestic natural rubber consumers would gain about Rp 4 billion worth of consumer wel- fare from lower domestic prices. Collection costs will be trivial for a tax in this range. These results imply that the Indonesian ec,nomy would be better off by imposing a small export tax than under free trade. However, for domestic producers as a whole, an optimal export tax is only beneficial if the tax revenues are reinvested in the sector. This, in fact, is precisely what is proposed if such a tax is to be used as a cost-recovery mechanism. 15/ The world rubber supply and demand model prepared for the International Rubber Study Group by Smit and his colleagues at the Free University of Amsterdam, has been used to simulate the effect of a 5% tax on rubber exports (Appendix 5). - 141 - 8.53 The application of an export tax across the board for all tree crop commodities is not a good idea. For the edible oils, domestic consumption is estimated to be relatively price elastic (for a foodstuff), although supply is found to be highly price inelastic.16/ There is no apparent evidence of more than a very small short-term elasticity of domestic supply for both coconuts and oil palm. Long-term elasticities for these two commodities are likewise considered to be very small, because of the lack of substitution possibilities for coconut lands or of the family labor used in coconut production, and because of the evidence of excess demand for investment in oil palm produc- tion. However, Indonesian edible oils can be expected to face a near- perfectly elastic world market excess demand curve because Indonesia's exports comprise less than 3Z of total world edible oils trade. As a world market price-taker, with fairly elastic (for a food good) domestic demand, and ine- lastic supply, an export tax would be highly distortionary. The export tax will have little effect on domestic supply, but the shifts in domestic demand would reduce the exportable surplus and reduce total tax revenues. Deadweight losses will be large, and producer surplus will be shifted to consumer sur- plus. Some of the deadweight losses and incidence problems of an edible oils export tax could be offset by imposition of a domestic consumption tax on edible oils, but this could cause the same prob.ems raised earlier with VAT surcharges. 8.54 Annex Table 7.4 presents the results of a simulation of an export tax levied on the edible oils. World Bank edible oils commodity model projections were used to calculate supply, domestic demand, exports and producer revenue under a neutral trade regime. A 5% export tax is then imposed on both CPO and CCO simultaneously. This 5Z tax on exports leads to a greater than 5% decline in farm-gate prices (since the absolute tax is a larger percentage of the farmers' price, which is net of transportation costs). Demand and supplies shift relatively small amounts, but producer revenues and export revenues take a significant drop. Since the world market for vegetable oils is so competi- tive, the incidence of Pn export tax stays entire. within Indonesia, and is borne by producers. 8.55 As a result of applying a 5% tax on CPO and CCO exports, domestic CPO supply falls by about 0.04% p.a. during the 1989-2000 period while domestic demand rises by 17Z p.a. The lower supply and higher demand lead to a fall in exportable surplus of 1.92 p.a. Farm-gate prices decline by 71 p.a. In 1995, export revenues would fall by Rp 100 billion (US$59 million) as a result of the imposition of the tax. Tax revenues in the same year would be about Rp 77 billion (US$45 million). 16/ Richard Monteverde, Food Consumption in Indonesia, Unpublished Doctoral Dissertation, Harvard University, 1987 and World Bank, 'World Edible Oils Commodity Model", 1988. University of Indonesia, Edible Oils, 1987. Other supply and demand parameters are contained in World Bank, 'Coconut Harndbook", 1984 and "Fats and Oils Handbook", 1981, Commodity Studies and Projections Division. - 142 - 8.56 For CCO, a 5Z export tax causes domestic demand to fall by 0.09Z p.a. while suppl, falls by 0.92 p.a. Exportable surplus falls by 162 p.a. Farm- gate prices fall by 7Z p.a. In 1995, total tax revenues would be about Rp 2.2 billion (US$1.3 million), while export revenues foregone would be more than Rp 13 billion (US$7.7 million). 8.57 The Advisability of Earmarking. Although a development cess/tax on rubber may be an optimal tax, be relatively efficient and generate adequate revenues to meet smallholder development program costs, this is not in itself an adequate justification for earmarking proceeds from the tax for specific purposes. From a macroeconomic vantage point, earmarking is considered to be a poor budgeting procedure, since it introduces rigidities and does not allow optimal allocation of general Government revenues across competing uses. Earmarking of rubber taxes may also not be a particularly equitable means of raising revenue, in that the distributive impact of such a transfer will be minimal. Rubber smallholders will bear a higher tax incidence than will smallholder producers of other resource-competing tree crops. Large-scale rubber producers, the estates, will also bear a heavier burden than will estates producing other commodities. In this case, however, earmarking is appropriate purely as a second-best, cost-recovery device for private benefits provided to smallholders in general. Such an export tax will only approximately distribute costs in line with benefits received. Earmarking is important to the extent that such a specific tax can provide a steady and reasonably stable source of revenue for long-term program financing. Priorities for an export tax-based grant could be for provision of planting material and some fertilizer to smallholders, particularly those who wish to replant rubber and coconuts. In the case of oil palm, the present channeling bank arrangement, which uses the Investment Funds Account to provide Government loans to smallholders, can be continued. 8.58 A Phase-out of Indirect Financing. An export tax/development cess on rubber might be used as a form of "bridging finance" and a cost recovery device only until: (a) there is a reasonably large number of smallholders able to finance new planting/replanting through direct or group-based borrowing; and (b) tne rural financial institutions are more widely dispersed in smallholder areas and have experience with providing financial services in these areas. A minimum of about 10-15 years will be required before a phase- out of indirect financing car be initiated. 8.59 An Option of using a Smallholder Development Authority as a Channeling Body. In the past, one of the main difficulties with using specific cess and export tax revenues to finance tree crop orograms was the inability to channel more than a nontrivial portion of such funds to the sector. The problem of devising a reliable means to channel revenues for smallholder development has lessened due to the experience gained by the Directorate General of Estate Crops, and the PTPs, over the past decade in implementing domestically and externally-financed smallholder projects. The primary institutional challenge over the next decade is to consolidate and focus resources available for smallholder development within a more sustainable and efficient 'channeling" entity. This could be accomplished by considering an option of establishing a Smallholder Development Authority (paras. 7.44-7.48). - 143 - 8.60 An authority might initially be responsible for implementing small- holder grants. The authority could report to the Minister of Agriculture but could be authorized to recruit staff and subcontract to implement the various smallholder development schemes. Revenues, initially from an export taxldevelopment cess on rubber, could be used to finance the smallholder outlays. The authority could function as a nonprofit-making body and could be subject to Ministry of Finance audit. 8.61 There are examples of smallholder development authorities, such as FELDA and the Rubber Replanting Board in Malaysia, and ORRAP in Thailand, which have successfully served as channeling entities for indirectly-collected commodity development funds. For Indonesia, there could be important fiscal advantages to consolidating smallholder development services within a single authority, if an export tax/development cess is to be used to recover smallholder development costs. The primary fiscal advantages of consolidating smallholder development services within a single authority are: (a) the clear audit trail from revenues to expenditures; (b) greater economies of scale- -particularly in management--from consolidating smallholder support services; and (c) a lower risk of fund diversion to nonsmallholder-based activities. It could be difficult to estimate actual revenue requirements for financing unless smallholder development services were consolidated under a single authority. In the absence of a smallholder development authority, estimates would need to be made of the portion of general Ministry of Agriculture overhead costs rightly attributable to smallholder development schemes. This could be difficult given present budgeting procedures of the Ministry. Outside of purely fiscal advantages, there could be other advantages to consolidating smallholder development services within a single authority (paras. 7.44-7.48). _ 144 - IX. DEVELOPING TECHNOLOGY 9.1 An Overview. Improved technology is needed to support smallholder development and for Indonesia to maintain its international competitiveness. In the context of future research, particularly in rubber and coconuts, this section emphasizes the need to set research priorities, strengthen research/ extension linkages, and more specifically highlights the need for: more research to be applied and adaptive; increased emphasis on profitability of the farm enterprise and not merely on productivity; and socioeconomic studies to better understand smallholder investment behavior (including the kinds of incentives needed to encourage replanting). Continuity of funding for long- term research will be vital for Indonesia to remain internationally competitive in rubber, coconuts and oil palm. 9.2 The Impact of Research. It is extremely difficult to obtain any measure of the impact of research on development. Quite apart from the inade- quacies of the production data base for smallholders (paras. 11.5 and 11.6), there is also the problem of quantifying the results of research in any mean- ingful way. Research objectives have, in general, been expressed rather loosely; for example, the Master Plan for Estate Crops Research under Repelita V enunciates the following objectives: (a) increasing productivity and quality of estate crop products; (b) increasing the farmers', estate workers' and producers' income and standard of living; (c) promoting growth and employment opportunity; (d) increasing export earnings; (e) supporting regional development and transmigration; and (f) maintaining the potential of human and natural resources. 9.3 However, there is no way of making ar. ex ante assessment of the likely impact of a research program in quantitative terms. Even ex post there is little that can be done to assess the past contribution of estate crops research in Indonesia. Various methods have been used in other countries, for example: (a) assessment of the resources saved by the adoption of new techno- logies; (b) assessment of producer and consumer surplus; and (c) assessment of the impact of new technology on national income. 9.4 Basic to all approaches is the need to associate new technology with particular research programs. This is extremely difficult in the case of estate crops where much of the existing technology has developed as a result of transfer of knowledge between producing countries. For example, the intro- duction of the pollinating weevil (Elaeidobius kamerunicus) has had a signifi- cant impact on cil palm yields, but the research was done in West Africa and the weevil imported cn the basis of the knowledge acquired there. The tissue culture technique needed to produce clonal oil palms was acquired through agreements with overseas collaborators. Polybag nurseries have become stan- dard practice and have significantly shortened the immature period; again, however, the initial research was done elsewhere and the technology adapted locally. Dwarf x tall hybrids have greatly increased the production potential of the coconut, but most of the hybrids planted in Indonesia to date have been Malaysian Yellow Dwarf x West African Talls, first developed by the IRHO in Cote d'Ivoire. Research into the use of stimulants to increase yields and reduce production costs on rubber originated elsewhere. It would, therefore, be fair to conclude that in recent years, a large proportion of the estate crops research has been applied and adaptive, in order to make the best use of - 145 - imported technology under local conditions. This pragmatic approach has enabled Indonesia to remain competitive in world markets as a major producer of all three crops. Nevertheless, to maintain this position, research insti- tutes need to define their objectives more precisely and set up programs which can be monitored during implementation. Attempts must be made to quantify the returns to investment in particular research programs and to ensure an efficient use of resources. Future Oil Palm Research 9.5 Oil palm has, until recently, been essentially an estate crop in Indonesia and much of the research has been funded by the estate sector. This has given it both continuity and a relevance to the needs of the industry that has not generally been achieved for the predominantly smallholder crops. Appendix 4 provides details of all oil palm res-earch institutes and their work. 9.6 Socioeconomic studies feature prominently in the Repelita V program for the Center for Oil Palm Research (BPPM) at Medan and are aimed at improv- ing the efficiency of estate management, trade and marketing, as well as strengthening the transfer of technology to the rapidly expanding smallholder sector (already approaching 30Z of the total oil palm area in the country). 9.7 The post-harvest technology program includes work on effluent con- trol, byproduct utilization, end-us2Ž diversification and nutritional studies. 9.8 There is currently a great deal of adverse publicity directed against the tropical vegetable oils, particularly palm, palm kernel and coconut. Although much of the criticism is unsubstantiated and is generated by special interest groups (notably the soybean lobby) who are concerned to reduce compe- tition in the world vegetable oils market, there is a need for concerted action by the major producing countries to state the case for tropical oils, and to conduct appropriate research to substantiate their claims. As pointed out by Hornstra,l/ palm oil has never been properly tested for its supposed tendency to increase plasma cholesterol levels despite its alleged harmful effects. Indonesia being the world's second largest producer of palm oil, with a still expanding program, the nutritional studies in the Repelita V pr3gram should consciously address these issues. It would be unfortunate if developing countries, many of whom are chronically short of edible oils, should be deterred from using palm oil on account of alleged health hazards which have not been proven. Even if some ill effects are found, they might well be of significance only in some of the industrialized countries, where per capita consumption of oils and fats is excessive (in some cases about three times the quantity considered necessary for a properly balanced diet). 9.9 The agronomy program embraces all aspects of production technology- breeding, production of planting material, husbandry, pest and disease control, nutrition. harvesting standards, etc. In the past, breeders have been mainly concerned about maintaining a high degree of uniformity between 1/ "Dietary Lipids and Cardiovascular Disease: Effects of Palm Oil' by G. Hornstra, Limburg University; presented at the International Oil Palm Conference, Kuala Lumpur, Malaysia, 1987. - 146 - palms within the progeny. Now the breeding programs probably need to be re- oriented to some degree in order to produce maximum heterogeneity and create the outstanding individual palms that will be used as source material for the creation of clones. Emphasis will probably continue to be placed on increas- ing oil yield per hectare, and with the advent of clonal material there will be greater scope for doing this than in the past. For example, there are already clones under test which have relatively low vegetative production cour:ed with a high harvest index, and which may be expected to perform well at much higher planting densities than have traditionally been used. 9.10 Vegetative propagation (clones) also improves the ckances of effect- ing desirable changes in the composition of palm oil, especially, though not exclusively, in the hybrids between Elaeis quineensis and Elaeis oleifera. Arguably, palm oil breeding programs could be split--the mainstream approach being still to maximize the production of palm oil as presently constituted, with a secondary stream aimed at producing a new type of palm oil, with a different fatty acid composition, providing a more liquid oil that could capture a larger share of the cooking oil market.2/ On the other hand, it is also argued that breeding for changed oil composition is so long term that new technology in processing will enable manufacturers to create the characteris- tics they require by other means. The Indonesian industry should take a posi- tion on this and ensure that the breeding programs are directed to meeting the industry's needs. In this context, it would seem more efficient to establish a single national breeding program rather than having research institutes at Marihat and Medan continue their separate ways (Appendix 4). At least all the parental material should be freely exchangeable between the two institutes. 9.11 In view of the large quantities of fertilizer required to realize the yield potential of today's planting material, and the high proportion this represents of total production costs, the progress has been disappointing in establishing profitable fertilizer regimes adapted to different soil and climatic conditions. Although some estates do run their own field trials, backed by soil and foliar analysis, far too many producers are prepared to accept without question the very generalized fertilizer recommendations that the institutes have been able to make as a result of their past research. 9.12 There has been some improvement in the design of fertilizer experi- ments, but they rarely have the precision necessary to establish as statisti- cally significant the often small differences to be expected between the treatments under test. Selection of experimental sites receives insufficient care. Often nothing is known about the previous history of the experimental site, and pre-treatment data are rarely collected as a means of determining optimum plot size, and, generally, increasing experimental preci-on. More attention needs to be paid to the day-to-day running of the experiments, ensuring that the correct amount of the right treatment gets applied, that the individual palm yield recording is accurate, and that sufficient supporting data (foliar analysis, meteorological records, measurements of vegetative growth, bunch analysis, etc.) are collected to allow maximum information to be extracted from the trials. 2/ "Prospects for the Alteration of Fatty Acid Composition in the Oil Palm through Breeding'--N.T. Arasu, M.J. Lawrence and N. Rajanaidu; presented at the 1987 International Oil Palm Conference, Kuala Lumpur, Malaysia, 1987. - 147 - 9.13 As in the case of rubber (see discussion in para. 9.46), emphasis must be placed on profitability and not merely on productivity. Producers, whether they are large estate companies or smallholders with two hectares, are in the business to make money, not to produce maximum oil palm yields regard- less of cost. 9.14 Financing Oil Palm Research. The Agency for Agricultural Research and Development's (AARD) financial contribution to oil palm research is small. The allocated budget is routinely less than the amount requested by the oil palm research institutes and whatever funds are made available are usually released late. Table 9.1: 1985/86 BUDGET FOR OIL PALM RESEARCH INSTITUTE (Rp million) AARD Estates Other Rp X Rp 2 Rp 2 Total 149 4.4 2,154 64.1 1,057 31.5 3,360 9.15 Almost half of the budget (1986/87 proposals) was for salaries and wages, nearly a quarter for farm operations, and only 52 for research. 9.16 In view of the many other demands on AARD's resources and the profit- ability of the industry, there are good grounds for funding oil palm research through a cess. The research institutes should be allowed to concentrate on their research mandate and not divert such a large proportion of their resources into commercial, revenue generating activities. Consideration should be given, for example, to making commercial seed production a separate enterprise, a profit center in its own right, and something quite apart from the responsibilities of the oil palm breeders and geneticists. A foliar analysis laboratory should be considered as a service center, not a research activity. The laboratory should charge for its work, at cost if on behalf of the research units, or at profitable levels if for third party clients. 9.17 The magnitude of the cess would, obviously, be determined by the scope of the agreed research activities. Here the industry would have to make a commitment to support over a span of years a given level of research that would afford reasonable prospects of bringing the different projects to a successful conclusion. It would be the responsibility of a program committee to monitor the implementation of the program on a regular basis. 9.18 An annual production of around 1.4 million tons of palm oil and 0.3 million tons of palm kernel oil, at the world market (1988) prices is expected to value about US$725 million. A research cess of US$2 per ton of crude palm oil (less than 0.5Z of value) would provide US$2.8 million, rising to US$5 million by the year 2000. This should be more than sufficient to meet the presently identifiable needs of a national research program. - 148 - Future Coconut Research 9.19 A detailed evaluation of ongoing coconut research is included in Appendix 4. About 98? of coconut production comes from nallholdings, and yield per hectare has not measurably improved since formal coconut research commenced more than half a century ago. There are socioeconomic constraints which have so far precluded the vast majority of growers to accept husbandry practices which could more than double yield. While in the long term there is a clear need for more and better research, there can be no doubt that efforts to transfer already available technology should take precedence over research per se in the short- to medium-term planning. In particular, research/exten- sion linkages need to be strengthened and both training and financial support given to the Dinas Perkebunan if that organization is to continue to provide extension services to coconut growers. The capacity to produce improved planting material already substantially exceeds demand, and many of the existing hybrid seed gardens are operating far below capacity. 9.20 Although, for the purpose of the present review, it will be convenient to consider the various programs from different aspects, it cannot be too strongly stressed that every program will require, for effective imple- mentation, inputs from a number of scientists, each with expertise in a parti- cular discipline. Thus, the breeding program will require close collaboration between geneticists, plant breeders, cytologists, physiologists, agronomists, pathologists, entomologists, etc. If a number of such program implementing teams are to be assembled and effectively directed, some reorganization of the coconut research institute will be necessary. The present system of identi- fying, and often funding separately, research "activities' within departments runs counter to the whole concept of programmed researLh and has often left individual scientists 'doing their own thing' regardless of whether or not it is relevant to any of the perceived needs of the sector. Some of these studies have been very academic and while such work may have a place in the universities, it cannot be justified in an institute established to promote development and provide a service to industry. In 1985/86, there were 128 activities scheduled, ranging from 25 in agronomy/farming systems to 12 in agro-economics: only 11, less than 10%, were listed as involving cooperacive work. 9.21 Breeding. Although useful breeding material has been assembled, the program has so many identified weaknesses that it might, in the long term, be better to make a fresh start rather than continue to work in conditions that impose almost insuperable constraints to effective research. The number of nuts collected to represent a particular ecotype have generally been inade- quate, poor germination has further reduced the number of seedlings available for planting, and post-planting losses have taken a further toll. 9.22 Indonesia, located in what is believed to be the area of origin of the coconut palm, is unusually rich in coconut genetic resources; collections to date represent only a small fraction of what is available. Unless further collection is done quite soon, much of this diversity may be lost with local varieties facing extinction, or at least serious contamination, as development programs using hybrid varieties are initiated in the major growing areas. - 149 - 9.23 There are -JO distinct ecotypes available within Indonesia. In addi- tion, there are exotic varieties which should be introduced since they may produce high-yielding hybrids when crossed with the local material. To plant up such a collection, using statistically designed trials to permit valid comparisons between varieties, would require a site of at least 1,000 ha of reasonably uniform and flat land. Several years' work would be required to bring the material together but, once assembled, it would be the largest coco- nut gene pool in the world and a collection of great importance to the inter- national coconut community, transcending purely local interest. 9.24 A proposal was recently submitted to the Technical Advisory Committee (TAC) of the Consultative Group on International Agricultural Research (CGIAR) for establishing an international research initiative on coconut. The report suggested that the area with the highest potential pay-off from research lay in the field of coconut breeding and therefore concluded that the first priority should be the collection, evaluation and distribution of germplasm. The collection would be held under international auspices to ensure that all coconut-producing countries had right of access to the material. As many countries as possible would be invited to participate in the program, either by contributing germplasm or by housing subsidiary collections for evaluation under a wide rdnge of environmental conditions. The site chosen should be one free from frequent natural disasters such as hurricanes, and from major pests and diseases which would militate against ready transfer of material and near the center of origin of the crop. Indonesia suggests itself as the ideal choice and the mission believes that it would be in the national interest, if the nroject does go ahead, for Government to volunteer to host the collection. The station would be internationally funded, would keep Indonesia in the fore- front of progress, and would reduce the cost of the national collection since not all of the material would need to be duplicated at both sites. 9.25 It appears that operation and maintenance of seed gardens absorbs nearly 402 of the research operation's budget. This clearly is an unaccep- table situation. If seed production is to be undertaken, then the operation should be run as a commercial, profit-oriented activity under separate manage- ment. Research staff rarely have either the inclination or appropriate professional training to be effective in commercial operations, nor are commercial operations the most appropriate use of staff with research skills. 9.26 Although the germplasm collection constitutes the basis for the breeding program, it is probable that most commercial seed distributed in future will be of hybrid origin, from either dwarf x tall, or tall x tall varietal crosses. The main activity of the breeders should, therefore, be the improvement of existing hybrids by recurrent selection within the parent popu- lations and the production and testing of new hybrids. Once tissue culture as a means of vegetative propagation becomes feasible, as may be expected within the next decade, four-way crosses to produce elite individuals for cloning will also become a part of the breeding program. 9.27 Agronomy and Agro-Ecology. The boundaries between the two disci- plines are ill-defined. If the agro-ecologists are to obtain useful informa- tion on the comparative productivity of coconuts in different provinces around the country, they can only do so by means of a network of properly designed agronomic trials. There seems little point in setting up separate programs. - 1SO - Where the ecologists need to undertake studies peculiar to their own disci- pline, there is no reason why these should not be done on the sites of the agronomic experiments. Indeed, as stressed earlier, all the programmed research will require contributions from teams of scientists representing different disciplines. 9.28 The weaknesses in the current coconut agronomy program are similar to those identified for oil palm: unsatisfactory statistical designs, levels of precision insufficient to show significant differences to be expected between the treatments under test, and too little concern with the reliability of the data collected. Ther- are enormous difficulties inherent in carrying out experiments on farmers' fields; but, with 991 of its clientele in the small- holder sector, the research institute has a clear obligation to devote a lot more effort to findings ways of acquiring meaningful results applicable on traditional smallholdings. At the same time, some measure of formal collabo- ration between the coconut research institute and the PTP-iunded PKK would enable the industry as a whole to benefit from the results obtained from experiments carried out much more easily under estate conditions. Given a willingness on the part of the PTPs to make resources available on a contrac- tual basis, it would be quite possible to simulate smallholder conditions in formal experiments involving multicropping, low inputs, and reduced standards of maintenance. 9.29 Because farmers traditionally grow their coconuts in association with other crops, much emphasis has been given recently to the importance of "farming systems research' (FSR). However, the term is often used loosely with no very clear understanding of what is involved. What is required is farm research (albeit with a farming systems perspective) aimed at increasing the profitability of the enterprise by improved husbandry, by provision of higher-yielding varieties of suitable intercrops, or by changing the crop or crop/livestock mix where mrarket or other considerations make this desirable. This area calls for collaboration between the coconut research institute, the Food Research Institute, which already have expertise in farming systems research methodology, and the CAER. Some very complex multicrop systems have evolved over the centuries in Indonesia, best known internationally being the home garden (pekarangan) and the village-forest-garden (talun) of Java. Further study of these gardens can provide a great deal of information about the relationships between species in an indefinitely sustainable system. Those working with coconut-based farming systems could keep abreast of developments in agroforestry (e.g. through regular contacts with the International Council for Research in Agrof estry--ICRAF--.in Nairobi); the objectives are essentially the same, to study the interrelationships between tree/tree and tree/nontree mixtures. Much interesting work is also being done by the Institute of Terrestrial Ecology in Scotland. 9.30 Whether coconuts are cultivated intensively (higher yielding varie- ties on existing areas) or extensively (area expansion under coconuts) depends very much on the availability of land, and it is significant that intensive systems have usually developed only where population pressure is high. Where the farmer is able to adopt an extensive system, it has been shown that the ratio between cost of production and gross value of produce may actually be highest in coconut monoculture. 'Where the principal input is farm-family labor, it is a rational decision for the farmer to continue with hls extensive - 151 - system where he is able to do so. There will, therefore, be many cases where the farmer's perception of his own best interest is at variance both with the ideas of land-use planners (para. 10.5) and with national production targets. 9.31 Entomology and Pathology. It is likely that most work in these fields will be applied and adaptive. There will be a constant stream of routine screening and testing to be undertaken in support of the coconut breeding program. As new hybrids are produced, their resistance or suscepti- bility to both pests and diseases will have to be assessed in a wide range of environments. Where intervention becomes necessary to control a disease out- break, emphasis should continue to be (n the application of environmentally acceptable methods, using biological control in preference to long-persiŁtence agrochemicals. 9.32 Post-Harvest Technology. At the farm level, the primary neei is still for low-cost efficient copra dryers, and research should continue in order to improve on what is currently available. The present methods of copra production are essentially labor-intensive and, there will in the long term be a need to develop equipment such as mechanical dehuskers, and to mechanize at least the more arduous tasks involved in the operation of the traditional copra kiln. By-product utilization also merits further attention and one could envisage the development of an installation combining copra drying and shell. charcoal production. 9.33 The sale of coconut stems for timber can dramatically improve the economics of replanting. The necessary technology has already been developed, largely as a result of work done in the Philippines under the UNDP/FAO proiect with assistance from the New Zealand Government. The application of this technology in Indonesia calls more for a concerted extension than for additional research. 9.34 The concept of increasing on-farm value added by replacing copra production with the production of coconut oil fit for direct human consumption is an attractive one. However, the methods traditionally used for preparing oil for on-farm consumption are costly in terms of labor and highly ineffi- cient in terms of extraction rate. Technology has yet to be developed to replace the traditional process with an efficient village-scale industrial plant. 9.35 Coconut oil has been consumed, without apparent harmful effects, for thousands of years and is widely used in the food industry today but, like palm oil and palm kernel oil, it is currently under attack on health grounds. Indonesia should actively proniote the research necessary to clarify the true effects and to suggest new uses and/or processing methods that will ensure a healthy demand for the product. Although Indonesia does not have comparative advantage in researching new end-uses for coconut oil, it will be important to follow developments in biotechnology and oleochemistry that may open up new markets. 9.36 Financing Coconut Research. In 1984/85 industri&l crops received 6,1? of the AARD local budget of Rp 32 billion (US$18.8 million at the 1988 exchange rate), of which 2.3? (Rp 736 million, US$0.4 million) was allocated for coconut, 3.2? (Rp 1,024 million, US$0.6 million) for spices and mediciral - 152 - crops, and 0.61 (Rp 192 million, US$0.1 million) for tobacco. At 5Z of the AARD total development budget, the support to coconut was high in comparison with the 2.52 the crop contributed to agricultural GDP, a 2:1 ratio compared with 1:1 ratios for both the palawija and estate crops. However, the total AARD support to coconut still represented only 0.18? of the value of the 1982 crop estimated at Rp 400 billion or US$235 million. 9.37 The failure of more than half a century of research to achieve any measurable impact on smallholder production suggests either that the research has been irrelevant to the real needs of the sector or that the services available for the transfer of technology to the farmer are ineffectual. Although some of the research has indeed been academic, with no practical application in view, there can be little doubt that the major problem has been the lack of effective demonstration and extension services. Priority must be given to remedying this situation. There is no point in increasing the funds available for research unless there are efficient channels for comnunicating the results to growers. 9.38 Continuity of funding for long-term research is as vital for coconut as it is for rubber and oil palm but, because so much of the production is consumed domes.ically and does not pass through market channels which would facilitate the collection cf a research cess, some alternative means may have to be found. However, the most urgent need is to create an effective organi- zation for the management of both research and development. Coconut has very little in commoi. with the other "industrial" crops and coconut research seems to benefit very little from being incorporated in this grouping. A strong case could be made for taking it out of the industrial crops network and, if it is to be linked at all, associating it with oil palm. Since there are good grounds for increasing coconut oil e.ports and increasing the domestic consumption of palm oil, it might even be possible to justify financing research on both crops through a common research cess levied on vegetable oils. Future Rubber Research 9.39 In considering the research programs planned under Repelita V, it is necessary to attempt some assessment of the work already carried out. Appendix 4 provides details of all the rubber research institutes, and the work undertaken by these institutes. A judgment is made difficult by the relatively short time the institutes at Sungei Putih and Sembawa have been in operation. 9.40 Plant Breeding. The estate sector remairs heavily dependent on the long established primary clones and unassisted smallholders continue to plant unselected seedling material. Attempts to produce new clones by crossing some of the best of the existing clones have so far made little prog:ess; and the strategy to be employed for exploiting the potential of the Brazilian collec- tion has yet to be clearly defined. 9.41 The Repelita V program recognizes that maximum use should be made of the germplasm collection and proposes that a gene center be established in conserved forest in North Sumatra. It also calls for the development of improved clones appropriate for smallholders. The importance of the first two - 153 - objectives is not questioned, but there are grounds for considering very care- fully the concept of producing clones specially adapted for smallholder condi- tions. It has yet to be demonstrated that there are characteristics which render any of the existing clones significantly better adapted to smallholder than to estate conditions. Although it may be argued that clones which require the use of stimulants to realize their yield potential are not at present to be recommended for planting by smallholders, there can be little doubt that in time the use of stimulants will become standard practice throughout the industry. It is also true that some clones perform better than others under the intensive tapping regimes used by most smallholders. However, there seems little merit in breeding to enhance this chr7acteristic. This implies that no progress will be made in farmer education or in the development of new tapping systems that meet the smallholders requirements without drastically shortening the tapping life of the tree. Disease resis- tance, adaptability to specific environments, good bark renewal and resistance to wind damage are equally relevant under estate or smallholding conditions. In short, a special breeding program for smallholders would seem to be a need- less distraction from the primary objective of producing higher yielding clones with good secondary characteristics. 9.42 Too little is known at present about the adaptability of specific clones to particular environments. However, several PTPs do have information resulting from trial plantings on their own estates and the collation and interpretation of these results could provide information of great value to the industry as a whole. 9.43 The priorities should be to establish a strategy for the exploitation of the germplasm collection and to ensure the closest possible collaboration between centers in the development of a national breeding program. The principal objectives should be to select for: (a) precocity, in order to shorten the immature period; (b) a rapid build up in yield once the trees come into tapping; (c) good performance under low frequency tapping systems, impor- tant in order to remain competitive by keeping down exploitation costs as the standard of living rises and labor becomes more expensive; ar.d (d) general factors such as good bark regeneration, and resistance to root, leaf and panel diseases. 9.44 Agronomy and Physiology. The Estate Crops Master Research Plan lists no fewer than thirty objectives in the agronomy/physiolagy programs for Sungei Putih and Sembawa. With the resources available, there is no possibility of realizing all of them, and there is a clear need to establish priorities and concentrate on those most likely to have beneficial effects in the relativel'y short term. It has to be recognized that in the smallholder sector: (a) yield per hectare has not increased significantly since 1970; and (b) there is an ever-widening gap between yields that could be achieved by the adoption of well established agronomic techniques and the yields achieved in practice. 9.45 A very strong case can, therefore, be made for having Sembawa concen- trate on technology transfer to smallholders rather than on the development of new techniques per se. Sungei Putih would continue with some basic work but there, too, the pay-off comes only when the practices advocated are adopted by the industry. Although it is not possible to make any precise judgment as to - 154 - what proportion of expenditure should be on basic as opposed to applied and adaptive research. it would not be unreasonable to envisage a split of 202 basic and 80? applied and adaptive. Thus 802 of the program would be demand driven in response to the expressed needs of the producers and would be problem oriented rather than compartmentalized by discipline and the personal inclinations of the scientists involved. 9.46 Fertilizer costs account for a significant proportion of the budget for immature rubber; but, because there is too little information regarding the specific fertilizer requirements of particular soil types in different environnents, the tendency is to apply fairly generous doses of a compound fertilizer. There is a need for a comprehensive network of trials throughout the country designed to provide a reliable guide to profitable fertilizer use on rubber of all ages. In view of the difficulcy of carrying out sophisti- cated trials on farmers' fields it would be desirable to enlist the help of the PTPs in implementing this program. Results obtained on estates directly concerned with NES programs would be relevant to their associated small- holders. In order to take into account the limitations imposed by the lower standards of management on smallholdings, the trials should also include levels of management as a treatment comparison. The objective would be to maximize not yield but returns to investment. Therefore, in addition to the standard analysis showing yield responses to the various treatmelt combina- tions, it would be necessary to conduct further analyses taking into account the prices of rubber and fertilizer and the lag between application of ferti- lizer and yield response. While the small farmer's aversion to risk is well recognized, too little is known about the sort of return he requires in order to invest either in purchased agro-inputs or an incrpRepd allocation of his own time. In parallel with the field trials program th're would. therefore, have tc be appropriate socioeconomic studies in order to achieve a better understanding of smallholder behavior. 9. 47 Improved husbandry practices aimed at shortening the period of imma- turity. e.g., by the use of advanced planting materials, are relevant to the estate sector and to assisted smallholders who have the necessary extension support. Tapping systems which economize on labor and extend the economic life of the tree by reducing bark consumption are of immediate concern to estates but will not be readily adopted by smallholders. whcse present methods are perfectly rational taking into acccunt their available time and cash recources. 9.48 In the Master Plan for Estate Crops ReseLrch, tissue culture ib included as A means of producing more uniform piancing materials (clcnen on their own roots should he less variable than when grafti?d onto seedling root- stocks). The subject was also included in the recommendations of the team which undertook the AARD review of Estate Crc.ps Research. How ver, this topic does not app-ar in the Repelita V list of prioJri-ies issued in Sepcember 1988. Anticipated budgetary constraints may have been responsible for the om,.ssion, and deferment is unlikely to have drastic consequences .:`ace the necessary technology can probably be bought in frokn overseas when the cime comes to apply it. In the longer tern, there iF little doubt .hat tissue culture will have an important role to play in producing a more heniogenous starn of tree: and thus higher yield- per unit -rep. - 155 - 9.49 Further study of the major rubber diseases is included in the Repelita V program under the general theme of integrated control. More needs to be known about the economics of the various prophylactic treatment regimes that are being investigated. The cost of any such measure is likely to be high and it is not evident from currently available data that it would pay the small farmer to invest in the chemicals required. 9.50 The post-harvest technology program includes studies on ways of improving the quality of smallholder rubber. Here, too, perfectly adequate technology is already available for the production of thin slab or smoked sheet, but the incentives to the farmer are often insufficient to justify the additional time he is required to invest in making a superior product (paras. 4.50 and 4.51). The problems would seem to be financial and organizational rather than technical, and it is the former constraints that should be primarily addressed in the forthcoming research program. 9.51 End-use research is going on around the world and, although there may be work to be done in developing new products for the domestic market, research cn products aimed at the international market should only be under- taken where it can be shown that Indonesia has comparative advantage. 9.52 Financing Rubber Research. The PTPs, in addition to wholly funding two research institutes, namely, Tanjung Morawa and Getas, also make a major contribution to the costs of the other institutes. Funds are channeled through the Bureau of Administration of State Owned Enterprises within the Ministry of Agriculture and the Board of Estate Crops Research Management. Additional funds are derived from sales, contract research and laboratory services. In 1985/86 only about 127 of the Sembawa and Sungei Putih 'inancing came from the AARD. Table 9.2: 1985/86 BUDGETS FOR SUNGEI PUTIH AND SEMBAWA INSTITUTES (Rp million) Sou.rces of funds Institute AARD PTPs Other Total Sungei Putih 196 851 0 1,047 Sembawa 144 1,097 300 1,541 Note: Precise figures regarding the allocations betweeln research and other activities such as extension, contract services and production, are not available; a 502 split was assumed in the calculations of the 1986 review team. 9..., In 1985/86, the total rubber research budget was estimated at about Rp 3 billion (US$1.8 million), representing an investnent in research equiva- lent to Rp 1,773 (US$1.06) per hectare of mature rubber or Rp 2.78 (US$0.17) per kg of rubber produced. Since a significant proportion of the total budget was devoted to post harvest and end use research, the aniount allocated to - 156 - production research was substantially less than this. For comparison, it may be noted that the current research cess in Malaysia is US$0.81 per kg and in Thailand US$0.35 per kg, generating total research budgets of US$13.0 million and US$3.1 million, respectively. 9.54 The 1986 review team advocated raising US$10 per mature hectare to cover the cost of both research and extension. Although the present budgets are clearly insufficient, an increase of the magnitude proposed would provide funds of around US$18 million, far in excess of what the institutes could effectively spend, bearing in mind manpower and other constraints. 9.55 Perhaps more important than the absolute amount of funding available is the lack of assured continuity of support for long-term projects. With the present multiplicity of sources, it is difficult to establish any relationship between the amount of research realized and the funds actually spent to imple- ment it. One consequence of this is that a certain amount of the research is opportunistic rather than problem-oriented; that is to say projects are under- taken because funds become available for their execution. Again, the estates crops have to compete with many other institutes for limited AARD funds--a problem exacerbated by the late release of such funds as are allocated to them. In the Estate Crops Research Master Plan, it is proposed that Sungei Putih's funding from the AARD would increase from Rp 301 million in 1988/89 to Rp 953 million in 1993/94; for Sembawa the increase would be from Rp 164 mil- lion to Rp 450 million. The likelihood of realizing increases of this order is open to question, and in reality the need to generate alternative sources of funding is likely both to remain a major preoccupation and to distract staff from the research activities that should be their major concern. It would be far better for the industry to provide the funds necessary for the implementation of an adequate research program, and it is believed that a case can be made for a reversion to the cess funding of research that operated prior to 1976. The rate would depend on whether research and extension were to be funded out of a conmon cess or independently, and would rise as imple- mentation capacity increased. Initially US$0.23 per kg would probably suffice for the research component. 9.56 As a general comment, it may be noted that the proposed investment in scientific manpower development for the estate crop institutes has been criti- cized as excessive relative to the work requiring to be done. However, until research priorities have been further reviewed (this review is presently being undertaken in the context of the Agricultural Research Management Project), it will be impossible to assess either the physical requirements or the manpower development and training needs over the Repelita V period. If, for example, Sembawa institute is to give greater attention to technology transfer and relatively less to research, then the staffing requirements will also change and it will be difficult to justify the heavy program of training for higher degrees that is envisaged in the present plan, an increase from 3 to 17 in the number of staff holding PhD degrees. Similarly, the amount of sophisticated laboratory equipment to be acquired seems out of line with institute's mandate to assist smallholder producers, as does the five-fold increase in journal holdings, 1,214 titles by 1993/94, a collection which w,uld apparently be duplicated at the institute at Sungei Putih. - 157 - X. SUSTAINABLE LAND USE AND ENVIRONMENT 10.1 An Overview. Tree crop development can contribute to sustainable land use and sound envirormental management by increasing the productivity of marginal lands, providing economic activities to smallholders dwelling with.A.n forest boundaries, and providing a buffer to forests to prevent exploitation of flora and fauna in forest areas by underemployed transmigrants or spontane- ous migrants. Any adverse environmental impacts of tree crop development can be mitigated by improving siting, avoiding conversion of wildlands, managing use of pesticides, and controlling factory effluents. This section focuses on the need to: (a) improve land use planning and allocation for tree crop cul- tivation and other uses, which is critical to both improved siting of tree crop development and the future strategy related to tree crop land extensifi- cation versus intensification; and (b) control the pollution from processing plants. Some options for institutional arrangements needed to monitor envi- ronmental impacts of tree crop development are also suggested. Improved Land Use Planning 10.2 Land suitability for tree crop cultivation depends principally on fertility and slope. Outer Island soils are, with the exception of a few highland areas with volcanic soils, generally marginal to only moderately fertile. The Government's current food self-sufficiency policy requires that the most fertile flat or moderately sloped land in each province be allocated to food crop cultivation. Marginal soils and slopes of more than 200 should, in theory, be kept under forest cover. Tree crops are most appropriately grown on moderately fertile land--that is, neither on soils that can support food crop cultivation, r.or on soils too lacking in nutrients to support permanent cultivation. 10.3 Current procedures for designation of tree crop development areas are as follows. If the proposed site is believed to be within Forestry Department boundaries, the Agency for Forest Land Use Inventories (Badan Intag) within the Ministry of Forestry (MOF) stipulates whether the site is convertible to agricultural uses under the Tata Guna Hutan Kesepakatan (TGHK, Forest Land Use Agreements). The TGHK, which cover 22 Outer Island Provinces and were promul- gated in the early 1980s,l/ allocate land withir. forestry boundaries for protection, conservation, production and conversion functions.2/ Conversion forest may be allocated for agricultural, mining and other development pur- poses. If the proposed development site is within conversion forest bounda- ries and is approved by Badan Intag for release for development, the developer applies to the Governor to allocate the site for the proposed use. After a 1/ TGHK were revised in some provinces .n 1984185. 2/ 'Protection forest' is intended for watershed protectLon. 'Conservation forest" is set aside fcr conservation and national parks. 'Production forest' is designated for selective lcgging. 'Conversion forest' is available for conversion to agricultural and other land uses. - 158 - review by a committee consisting of Agraria,3/ BAPPEDA and DGE officials, the Governor decides whether or not to approve the allocation. 10.4 Recent land status and land usage maps prepared by Bakosurtanal under the RePPProT project 4/ indicate that provinces in Sumatra have allocated 3.18 million ha for tree crop development as of 1988. Allocated areas according to the RePPProT/Bakosurtanal maps for Sumatra are as shown in Table 10.1: Table 10.1: AREA OFFICIALLY ALLOCATED TO TREE CROPS IN SUMATRA (ha) Aceh 72,200 North Sumatra 791,140 West Sumatra 139,000 Riau 994,200 Jambi 409,400 Bengkulu 78,000 South Sumatra 514,100 Lampung 185,500 Total 3,183,800 10.5 The TGHK establish basic forest use categories and, at the time they were compiled, were a useful initial response to the Government's urgent need to preserve remaining forest area and manage forest land use in the face of strong pressures for regional development. As a framework for land allocation for tree crop and other agricultural development, however, the TGHK ha-re two shortcomings. First, the base maps on which they were originally drawn were inadequate and outdated. The RePPProT/BakoFurtanal maps show significant dis- crepancies between land status boundaries as defined on TGHK maps and actual land use. RePPProT/Bakosurtanal maps for Sumatra, for example show that 10.3 million ha (412) of area designated as conservation, protection and production forest in Sumatra are no longer under closed canopy forest. Of this, some 472,800 ha is tree crop land (13? of all land under tree crop cultivation in Sumatra) and should be reclassified. The second shortcoming of the TGHK maps is that conversion forest boundaries reflect proximity to existing infrastruc- ture and l.kelihood of future development and do not take account of soil or slope. Some 3.6 million ha (42Z) of the 8.7 million ha designated as conver- sion forest is currently under forest cover and shoald be considered for designation as production forest. 3/ Reconstituted as National Land Agency (Badan Pertanahan Nasional) in November 1988. 4/ Regional Physical Planning Program for Transmigration. - 159 - 10.6 The objectives of the RePPProT/Bakosurtanal project, which is produc- ing the first comprehensive set of land use and status maps (based on aerial photos at 1 to 250,000 scale) for the entire archipelago,5/ are to identify and recommend blocks of more than 10,000 ha for various agricultural uses, including tree crops. The identification of smaller blocks according to soil and slope criteria is left to more detailed hydrological and soil surveys. The RePPProt/Bakosurtanal maps and analyses are a potentially valuable tool for assessing whether conversion forest boundaries and land allocations for tree crop development are appropriate in light of improved actual land use data. Areas assumed by RePPProT analysis to be suitable for large block tree crop development in Sumatra are as shown below: Table 10.2: AREA RECOMMENDED FOR LARGE BLOCK TREE CROP DEVELOPMENT IN SUMATRA (h3) Aceh 66,700 North Sumatra 208,900 West Sumatra 40,800 Riau 137,100 Jambi 335,100 Bengkulu u South Sumatra 162,700 Lampung - Total 951,300 10.7 Given growing ?ressures on land and competition among forest and agricultural uses in the Outer Islands, it is essential that choice of land for new tree crop development be based on the best available data on soils, slope and actual land use. Land status, use and suitability maps prepared by RePPProT/Bakosurtanal for Sumatra have already been distributed to provincial planning agency (BAPPEDA), whose staff nave received training to use the maps in land use planning methods under an ADB-funded Land Resource Evaluation and Planning (LREP) Project. A proposed second LREP project will cover another 15 provinces. RePPProt/Bakosurtanal maps should also be distributed to DG-E's regional offices (Dinas Perkebunan), provincial representative offices of the Ministry of Forestry (Kanwil Kehutanan), and regional offices of newly estab- lished National Land Agency (formerly, DG Agraria). Ideally, forest use maps should be reviewed and conversion forest boundaries should be redrawn in light of the best available actual use data. 10.8 The absence of areas for tree crop development in Bengkulu and Lampung provinces suggests that remaining suitable land in those provinces is 5/ RePPProT/Bakosurtanal materials for Sumatra, Kalimantan and Irian are already available, and analyses of Sulawesi, Java and the Lesser Sundas (West and East Nusatenggara) will be completed within the next two years. - 160 - limited. In these and other Outer Island provinces in which hilly terrain, poor soils and/or population densities in excess of 100 persons/km2 limit extent of suitable land area, there are two options for tree crop development without forest conversion. The first is crop intensification. Smallholders could be assisted to upgrade the 2 to 3 million ha of low-productivity rubber in the Outer Islands. The second option is to use land which is currently degraded or underutilized. Land Stabilization and Rehabilitation 10.9 There is ample scope for further use of tree crops to increase the productivity of marginal land, to stabilize forest dwelling populations, and to channel migrants away from forests intended for timber production and watershed protection. According to the Directorate General of Reforestation and Land Rehabilitaticn within MOF, 'critical land'--that is, land that has been stripped of forests and rendered susceptible to erosion--totalled 10.4 million ha in Indonesia in 1986-87. The estimated area of critical land in priority watersheds in Sumatra in 1983 is shown below. Table 10.3: CRITICAL LAND IN SUMATRA BY PROVINCE (ha) Aceh 424,000 North Sumatra 955,200 West Sumatra 118,300 Riau 256,900 Jambi 51,800 Bengkulu 561,990 South Sumatra 594,000 Lampung 305,200 Total 3,267,500 10.10 The Government's major initiatives for the rehabilitation of critical lands have been the Regreening and Reafforestation Programs, which include planting trees such as pine, construction of check dams, and demonstration of soil conservation practices. Tree survival rates have been low, partly due to poor quality of seedlings and partly due to inattention to the needs of the local population for sustainable livelihood in regreening and reafforestation areas. Since tree crops offer higher returns 6/ per hectare on suitable Outer Island soils than timber plantations and, with proper terracing, can often be planted on the same slopes that are considered appropriate for timber planta- tions, Government should consider including tree crops in its critical land rehabilitation programs. 6/ 'Forest, Land and Water: Issues in Sustainable Development," World Bank report. - 161 - 10.11 In addition, tree crops could be used to stabilize shifting cultiva- tors. MOF is currently reviewing its policies regarding settlements within forest boundaries. A new approach is being considered which would allow half the approximately 500,000 households within forest boundaries to remain where they are and would channel them into timber plantations and other approved forest uses. Since soil and slope conditions in some critical areas within forest boundaries may be as suitable for tree crops as for forest trees, and tree crops are likely to provide higher incomes and hence have a higher chance of survival, MOF should consider including tree crops among the options to be made available to forest-dwelling households, where forest land being made available to these households is not protection or conservation forest. 10.12 BAPPEDAS should also consider tree crops as a potential instrument for prevention and control of environmental damage from unplanned, spontaneous transmigration into recently opened areas. Where penetration of logging roads into concession areas is drawing underemployed transmigrants or spontaneous migrants into forests, for example, a tree crop development sited near the logging road could divert these people from unsustainable forest exploitation into pe-.-manent cultivation. Where shifting cultivators are entering primary forest and engaging in short-fallow cultivation that can lead to fertility loss and ultimately invasion of grassland, a tree crop development sited out- side the primary forest could help buffer the forest and perhaps also rehabil- itate degraded land. Where opening of sloped land to cultivatior, without ade- quate soil conservation measures has resulted in accelerated erosion and soil loss, an appropriately sited tree crop development could stabilize the slopes by introducing proper terracing techniques. BAPPEDAS should identify such areas and recommend that they be given priority for tree crop development. 10.13 Control of Pesticides and Herbicides. Pesticide use is regulated by the Directorate of Plant Protection within DGE. A Pesticide Commission issues a list of weed and pest control substances app-oved for agricultural use. A Bank pesticide specialist has reviewed the lisL and suggested that the fol'ow- ing 6 (of 209) substances currently approved for use on rubber, coconut and oil palm be reconsidered. "Temik' (recommended for coconut) and 'monitor' (recommended for oil palm) are appropriate for use by trained specialists, but are too toxic for use by smallholders. "Bidrin' (recommended for coconuts) is very toxic to birds and is banned in Malaysia. "Difolatan" (recommended for rubber) is believed to be carcinogenic and is being phased out by OECD and the UK. 'Nuvacron"/"azodrin" (recommended for oil palm) and "actidione" are also highly toxic, and their use should be restricted. 10.14 Monitoring of field application of herbicides and pesticides by the Directorate of Plant Protection is as yet limited. A laboratory equipped to conduct pesticide quality control analysis for the tree crop sector is being built in Medan with ADB support. The Directorate of Plant Protection is building smaller field laboratories in provincial capitals which will be oper- ational by 1990 and will monitor quality of herbicide and pesticide stocks, test residue levels, and instruct smallholder intensification teams in proper application techniques. In order for the new laboratories' envirormental benefits to be fully realized, laboratorv staff should emphasize the follow- ing: (a) selection of the pesticide from the approved list that is least - 162 - toxic and least hazardous to plants and animals. Use of crop cover and small livestock to duvbtitute for chemical substances should be encouraged wherever possible; (b) selection of application equipment (individual sprayers vs. air- blowing fumigators) and techniques that minimize drift of herbicides and pes- ticides beyond target areas; and (c) an active training and outreach program to instruct extension workers and farmers' groups in safe application tech- niques. Control of Pollution from Processing Plants 10.15 Palm oil and rubber processing plants produce effluents containing high concentrations of organic matter and low pH. Palm oil factory effluents average 25,000 mg/i BOD (biological oxygen demand); rubber factory effluents average 5,000 mg/l BOD. When discharged into rivers without treatment, efflu- ents of these orders of magnitude can destroy aquatic life, reduce crop yields on land irrigated by contaminated water and render groundwater unfit for some uses. 10.16 Sumatra has over 802 of total national palm oil mill capacity and over 50% of rubber mill capacity. The 4 million m3 total effluent from palm oil mills in North Sumatra and Aceh in 1983 is estimated to have contained 100,000 tons BOD, which is equivalent to human waste generated by a population of 6.7 million. The 2 million m3 effluent from North Sumatra rubber mills in 1983 produced 10,000 tons BOD, equivalent to human waste generated by a popu- lation of 670,000.7/ 10.17 Both in-plant effluent treatment capacity and pollution control moni- toring and enforcement capacity at national and provincial levels need to be developed. As recently as 1982, there was no treatment of palm oil or rubber effluents by either the Government or private estates prior to discharge of effluents into waterways in North Sumatra, the province of highest concentration of mill capacity. Designs of recently built palm oil factories include decanters and anaerobic/facultative pond treatment systems. Reports of treatment systems being bypassed, resulting in direct release of untreated effluents to receiving waters, are frequent, however. Reports persist that pollution control system specifications are not enforced and systems are operated inefficiently. 10.18 The Government's general effluent standard for BOD is a very stringent 30 mg/l. Effluent standards for palm oil processing promulgated by North Sumatra and Lampung, in consultation with processing industry representatives, are considerably less stringent than international standards. Both require 2,500 mg/i BOD in the first stage, and 500 mg/l BOD in the second stage of implementation. Malaysia has tightened its standards in stages from 5,000 mg/l BOD in 1978 to 100 mg/l BOD as of 1984. 10.19 The palm oil processing subsector presents opportunities for develop- ing effective in-plant treatment and Government monitoring and enforcement capacities. Costs of anaerobic/facultative control systems for factories with 7/ D. Bangun, 'Mill Effluent Problems in Oil Palm and Rubber Plantations,' 1983. - 163 - capacities of 30 tons FFB/hour range from US$300,000 to US$500,000. In a fast-growing and profitable industry such as palm oil processing, costs in this range car be absorbed. A plant processing 30 tons of FFB/hour (about 6 tons of oil/hour) working 20 hour days, generates US$500,000 in gross receipts every two weeks or so. Furthermore, efficiently operated waste treatment sys- tems can provide organic fertilizers to reduce need for chemical fertilizers which a plantation would otherwise have to purchase, and can produce animal feeds, both of which can reduce costs. 10.20 A study of options for institutional arrangements for pollution con- trol at the provincial level will be carried out under the Bank-supported Tree Crop Processing Project (Loan 3000-IND). An important strategic factor in any initiative to improve tree crop processing pollution control capacity will be the necessity to develop both in-plant treatment capacity and Government moni- toring capacity at the same time. Appeals to factories' interest in incorpo- rating effluent self-monitoring and treatment measures are not likely to be effective unless backed by Government monitoring and persuasion. Similarly, improved monitoring capacity by itself does not reduce discharges, unless fac- tories' technical capacity to comply with effluent standards is improved as well. As technical capacity improves, the provinces should consider tighten- ing effluent standards in stages. 10.21 A second important consideration in improving pollution control mea- sures is that the monitoring data and enforcement capability which are neces- sary prerea 'isites for an effective regulatory approach involving "polluter psys' penalties are not yet in place in Indonesia. Because of the adverse impact of measures (such as plant closings) that threaten jobs, incentives that do not entail punitive measures are initially likely to be more effective than attempts at regulation. One form such incentives might take is a pollu- tion control reimbursement fund, possibly financed through bilateral funding and administered by pollution monitoring and control units within DGE, that would be disbursed only to factories able to show that appropriate pollution control equipment designed to comply with Indonesian standards has been installed and is operating. The fund would be available to both Government and private estates, and would pay for technical assistance to factories to improve their operations and maintenance, productivity and quality control. Once the cost-cutting benefits have been demonstrated by a few factories, others can be expected to adopt efficient effluent treatment, and the need to provide incentives to encourage factories to adopt such measures should grow less. 10.22 Regulatory measures such as "polluter pays fines' should be intro- duced later in the development of pollution control capacity, when the data base and continuous monitoring and reporting capacities are better established and potential for enhancing overall productivity and effluent controls paying for themselves has been well demonstrated. Only when there are baseline data, technical capacity and experience with solutions, can such punitive measures be expected to be effective. - ;64 - 10.23 Environmental Impact Assessment and Management. In 1986, the Government promulgated an Environmental Impact Assessment (EIA) regulation (Regulation 29/1986), which requires preparation of a Preliminary Environmental Information Review (PEIR) for all projects and a detailed EIA for projects expected to have significant adverse impacts. Review of PEIRs and EIAs is the responsibility of the concerned sectoral agency. A backlog of perhaps 350 to 400 ongoing agricultural projects, of which an estimated 120 are in the tree crop subsector, is currently awaiting retrospective review by the Ministry of Agriculture (MOA), and approximately 200 to 300 new projects, about 80 of which will be in the tree crop subsector, will come up for review each year. An Environmental Review Commission has been established in MOA, but pending promulgation of an MOA decree to guide its operations, the Commission is not yet operational. 10.24 In view of the large number of new projects requiring environmental review each year and the lack of previous experience with EIAs in Indonesia, the environmental assessment procedures adopted by MOA need to be streamlined and made as efficient as possible. Two means of ensuring efficient and effec- tive environmental review in the tree crop subsector are: (a) sorting proj- ects according to design type, and requiring different environmental assess- ment procedures for each category; and (b) designating projects involving large blocks of land or miajor environmental impact for national-level review, and smaller projects for provincial review (see Appendix 1 for details on these different approaches for EIAs, and management thereof). 10.25 Institutional Arrangements. The Environmental Impact Assessment Regulation of 1986 requires establishment of Environmental Impact Assessment (EIA) Review Commissions in the line ministries at the national level (Komisi Pusat) and at the provincial level (Komisi Daerah), but leaves technical sup- port for the Commissions' deliberations and division of labor between techni- cal support staff and the Commission to the discretion of the ministries con- cerned. MOA needs to (a) assess technica;. support requirements for national- level EIA review and determine allocation of responsibilities between techni- cal support staff and Komisi Pusat; and (b) agree with provincial governments on provincial-level environmental review and management procedures and techni- cal support for such procedures. 10.26 National-Level Review. Draft environmental review procedures which are currently under consideration by MOA 8/ propose the following arrangements for technical support at the national level. Twenty-nine environmental spe- cialist positions would be created in the Planning Bureau, the four director- ates general (DGs), AARD, and the Agricultural Extension, Education and Train- ing agency of MOA. The specialists in the Planning Bureau would coordinate the review activities of specialists in DGE and the other DGs and provide technical support to Komisi Pusat. Advantages of locating coordination of technical support for environmental review in the Planning Bureau would 8/ S. Berwick and S. Soewardi, 'Guidelines for Applying the Environmental Impact Assessment Process to Resource Development in Indonesia," 1987, and S. Berwick and B. Soewardi, 'AMDAL in Departamen Pertanian for kepelita V," 1988. - 165 - include the Planning Bureau's sectoral overview and a degree of autonomy from the DGs, which would facilitate critical review of projects and addressing of cross-subsectoral impacts. 10.27 Provincial-Level Review. If environmental review requirements for new projects are to be met, it is essential that responsibility for review of smaller projects involving less significant impacts be devolved to the prov- inces. Two institutional issues in environmental review of agricultural proj- ects at the provincial level require attention. First, the Komisi Daerah are not yet operational in most provinces. Second, in light of the Governor's prestige and overarching responsibility for provincial development and the current debate on decentralization, the role of the line ministries in policy formulation and implementation at the provincial level in general, and envi- ronmental review in particular, is unclear. This issue is particularly acute for the Komisi Daerah, which are mandated to review projects in all sectors. 10.28 A first priority in improving environmental review capabilities at the provincial level should be to make the Komisi Daerah operational. An assessment should be made as to whether BAPPENAS' allocation of Rp 35-50 mil- lion per year per province for Komisi Daerah operations is sufficient. A manageable goal might be to assign priority to making Komisi Daerah opera- tional in the ten 'category one" provinces 9/ in the next two years, and leave the other provinces for later. The Komisi Dae.ah would report directly to the Governor, or at least to a Vice-Governor. An alternative to providing techni- cal support to Komisi Daerah would be to establish environmental specialist positior,s in the Governor's office. Technical guidelines for environmental review would be provided by the Planning Bureau of MOA. Policy guidelines would be provided by annual provincial workshops convened by the Kanwil for the subsector, which would assess environmental issues and set guidelines for environmental review for the subsector (see Appendix 1). 10.29 National-level technical support staff would have the following responsibilities: (a) screening of proposed projects to (i) determine land requirements, significance of expected impacts and type of environmental assessment required, and (ii) channel large block planting projects for national-level review, and PML, partial assistance and dispersed nursery schemes for provincial review; (b) liaison with consultants during preparation of EIAs and environmental management and monitoring plans for projects involv- ing large blocks of land and significant environmental impacts; and (c) assis- tance in preparation of project components designed to protect and/or compen- sate for effects of tree crop development on forest, water and wildlife resources. 10.30 Provincial technical support staff would have the following responsi- bilities for review of tree crop projects: (a) review of suitability of land allocated for tree crop development based on analysis of the best available 9/ These are the provinces in which institutional development and capacity to implement decentralization measures are deemed most advanced. They are the five provinces of Java, North Sumatra, West Sumatra, South Sumatra, Bali and South Sulawesi. - 166 - land suitability data. Where indicated, technical staff would recommend against development of unsuitable land and support application to the Ministry of Forestry or National Land Agency for more suitable areas; (b) in provinces in which 'he remaining suitable land for tree crop extensification is limited, liaison x\.th BAPPEDAS to designate critical areas to be targeted for tree crop development; (c) liaison with consultants during preparation of environmental reports, management plans and monitoring plans for small projects; td) liaison with forest and wildlife protection agencies to implement measures to compen- sate for impacts of tree crop development on forests and wildlife; and (e) monitoring and mitigation of environmental impacts of tree crop develop- ment, including impacts of herbicide use and effluents from agroprocessing plants and effects on forests, water, soil and wildlife. - 167 - XI. THE UNFINISHED AGENDA AND PRIORITIES FOR EXTERNAL ASSISTANCE Remaining Agenda 11.1 This section identifies some of the major information/data gaps, and the priority areas which require a more in-depth review than undertaken in this report. 11.2 Heed to create complete and consistent data bases to underpin improved planning and policy analyses.l/ The clients for improved data would be the Bina Program, DG Estates; Bureau of Planning, Ministry of Agriculture; Directorates of Internal Trade, and External Trade, Department of Trade; BUMN division, Ministry of Agriculture; Agriculture Bureaus within BAPPENAS, and Ministry of Agriculture. 11.3 Despite the large amount oE data put together by DGE for this sector review, it was found that the data base for planning and policy analysis in the tree crops subsector is incomplete and often inconsistent. There is very little information available on sources of smallholder income, cultivation costs, marketing costs, and the agrarian structure of the smallholder segment of the sector. Whatever is available in special studies and feasibility reports tends to be area-specific and ad hoc in nature. 11.4 Data reported on the estate and industrial segment of the sector also tends to be impressionistic. For example, Ministry of Agriculture estimates CPO production in 1988 to be 1.7 million tons, while the Ministry of Trade estimates CPO production in 1988 at 2.2 million tons. The licensed capacity for fractionalization is, according to Ministry of Industry sources, about 1.9 million tons. Private industry sources place actual installed capacity in the range of 3.4 million tons. Similar inconsistencies occur for production and processing capacities of rubber and cocoruts. 11.5 The present data do not differentiate between new planting and replanting; nor do they provide an age profile of the national tree crop stand. The area classified as 'immature" rubber probably includes nonproduc- tive trees regardless of their actual age. 11.6 One of the main causes of inconsistent and incomplete data is the technical difficulty involved in actually measuring area and productivity of multicropped, or temporarily dormant, smallholder lands. Measuring productiv- ity per unit-area becomes a near impossible exercise, particularly where tree crops are integrated into home gardens, as in the case of coconuts in Java. '.ield per mature hectare, for the bulk of the smallholder sector, remains a matter of informed guessvork. 11.7 Another cause of data inconsistencies is the existence of trade and investment regulations and restrictions in the subsector. For example, in the 1/ This is extensively discussed here since it is not covered in the rest of the report. - 168 - case of CPO, the wide margins between administered and free-market prices create an incentive for underreporting of actual production and processing capacity, and also for the apparent simultaneous reporting of imports ane exports from the same port. Processing and distribution costs tend to be extremely high, ae reported, since these are inversely proportional to the corporate tax burden of the processor. 11.8 One of the consequences of the high margin of error in tree crops data is an equally wide margin of error in design and evaluation of tree crops public policy. Investment planning, market interventions, taxation policy and industrial licensing are based more on informed opinion than an accurate exam- ination of subsectoral conditions. Tracking the impact of public policy is equally difficult in the absence of an accurate and consistent data base. Too often, ex-ante expectations regarding investnient nerformance or policy impact are retained as measures of ex-post performance, in the absence of any other more reliable performance yardstick. 11.9 Since accurate data are not readily available for many key variables, the Government is unable to provide an adequate supply of market information to smallholders. Asymmetries in access to information, between processors and smallholders, limit the scope for smallhoider technological innovation and provide a fertile ground for development of local traae monopolies. 11.10 One of the priority areas for improved data collection is r better measure of area, yield and productivity by different vintage of tree crops. For rubber, better estimates of the "sleeping rubber' area would provide an important measure of in-ground stocks of rubber available for exploitation. Better estirates of rubber and coconut production, in particular from Govern- ment assisted projects, is required in order to plan future programs for reha- bilitation and investment consolidation. 11.11 Another high-priority area for data collection is a regular estimate of costs and returns of smallholder production, marketing and processing activities. This information is required in order to track the progress of existing and planned smallholder development programs. Regular collection of basic farm management and marketing data will also provide the Government with a mear- of identifying sources of inefficiency in the sector. 11.12 A regular series of in-depth, socioeconomic studies of smallholder econrmics is required to complement annual farm management and marketing cost data rollecticn. Such studies are needed to examine the effects of a changing agrarian structure on patterns of economic activity, to identify prospects and barriers to technological innovation and to signal the structural transforma- tion of smallholders out of tree crops. A regular series of in-depth studies of smallholder economics would also provide an adequate basis Sor monitoring implementation of both publicly and privately financed smallhoider development schemes. 11.13 The costs of improving data collection systems in the tree crops sector would be relatively higr, given the inherent technical difficulties in tracking key variabeis; a shortage of DGE staff to assIst with data collection - 169 - and analysis, and fairly strong market incentives to distort information. In order to reduce the incremental costs of additional information collection, the Government should consider consolidating and upgrading the quality of information already regularly collected. Improved area, production and cost information can be obtained with the assistance of the Central Bureau of Sta- tistics. Better socioeconomic information can be obtained through the use of research institutes and regional universities. The focus of expanded collec- tion efforts should not be on obtaining additional data at the lowest possible cost, but on improving the overall quality and consistency of the tree crop data base for planning and policy analysis purposes. 11.14 Need to Improve Land Use Planning and Allocation (Section X). While the slope and soils in the Outer Islands provide suttable land for tree crop cultivation and cDntribu - lo increase in productivity of marginal lands, there is need to improve s ...ing of tree crop development, i.e., improve land allocation for tree crop and other land uses. Some areas designated as con- servation, protection and production forest are no longer under closed canopy forest, and could instead be used for tree crop development. On the other hand, some areas designated as conversion forest are actually under forest cover and should be reclassified as production forest. In some areas, the detailed slope and soil studies could show that remaining suitable land for tree crops is limited. In such areas, there will be greater need for land intensification andior rehabilitation to restore degraded lands rather than land extensification. This will inxluence future strategy of tree crop devel- opment, i.e.. more emphasis on replanting on existing lands in lieu of new plantings in new areas. Where shifting cultivators are entering primary for- est and engaging in short-fallow cultivation that can lead to fertility loss and ultimately invasion of grassland, a tree crop development sited outside the primary forest could help buffer the forest and perhaps also rehabilitate degraded land. Where opening of sloped land to cultivation without adequate soil conversion measures has resulted in accelerated erosion and soil loss, an appropriately sited tree crop development could stabilize the slopes by intro- ducing proper terracing techniques. Such areas need to be identified and given priority for tree crop development. Thus, a detailed assessment of land use, i.e., allocation to forests, wild lands, tree crops, is warranted. 11.15 Need to Review the Priorities, Organization and Dissemination of Research. Another area requiring attention will be to review the priorities and organization of research and the dissemination of results. This will become increasingly important as the Government shifts its emphasis towards the unassisted smallholders and their replanting needs. Well-focused socio- economic studies will be needed to understand the smallholder investment behavior, including the incentives needed for replanting the existing low- yielding tree crop stands. A review of the organization and delivery of extension services will also be .aeeded to assess how best to reach a larger number of smallholders operating within mixed farming systems, and how the unified extension services can liaise with a specialized unit or an aut..ority, if it evolves, for sLmallholder development. 11.16 Need to Review the Constraints and Potential of Beverage and Other Estate Crops 'Whi le this sector review focused only cn rubber, coconuts, and - 170 - oil palm, there is a need to revieu the constraints, potential, and the strat- egies required to develop the beverage crops and other estate crops. In the context of strategies for crop diversification, e.g., intercropping of coco- nuts and cocoa, the constraints and potential of cocoa will become an integral part of the strategies for coconuts. Similarly, spices and other crops and livestock activities facilitate increased diversification, which has not been explored in this sector review. This will become increasingly important as the risk management strategies evolve for the smallholders. Coffee is another major non-oil/LNG export commodity, which needs an in-depth review. External Assistance 11.17 The major donor agencies assisting tree crop development in Indonesia, i.e. the World Bank, the Asian Development Bank (ADB), the Japanese Export-Import Bank (EXIM) and the Overseas Economic Cooperation Fund (OECF), will need to achieve a broad consensus among themselves and with the Govern- ment on the major thrusts of future development strategies for tree crops, Some of the strategies relating to policy reforms, consolidation of existing investments, smallholder development, unleashing the potential of private sector and the streamlining of public enterprises, cut across the traditional boundaries for lending by these agencies. The existinig crop-wise division of labor, with the World Bank lending for rubber, coconuts and oil palm, the ADB lending primarily for tea, cocoa, oil palm and spices, and the EXIM Bank financing large private sector projects, downstream processing investments, and providing counterpart funding to the Bank and the ADB projects, does not allow a synchronized approach to assist the Government with strategic planning in the sector. 11.18 In terms of technical assistance, external donors can assist the Government with: (a) creation of complete and consistent data bases to under- pin the improved policy and planning analyses within Government; (b) a review of land use planning and allocation, including training in land suitability assessment, and environment assessment and management; (c) a review of the priorities and organization of research and extension; and (d) a review of the constraints, potential and the strategies needed to develop beverage and other estate crops. 11.19 Financial Assistance. The following are the lending priorities iden- tified for the external donors. 11.20 Support f.or Policy Reforms. The donors need to gradually shift their emphasis from discrete investment projects to subsector policy-based lending operations. Alternatively, these operations could constitute support for investments as identified in paras. 11.21-11.23 below, but with greater empha- sis on support for policy reforms. Some of these reforms, including the requisite adjustments in the regulatory framework are discussed in Sections IV and V. 11.21 Support for Smallholder Development (Section VII). The primary focus of this lending oppration could be tc formulate and implement roplicable appruachEs to smaflho'dpr development. The needs ot smallFholders for greater - 171 - risk diversification and for replanting will have to be built into such an operation. Some of the elements could be the establishment of a Smallholder Development Authority (if the Government decides to institute a specialized function for assisting smallholders), provision and staffing of nurseries throughout the unassisted smallholder areas, development of nurseries on the periphery of existing PMU-based schemes, support for extension programs geared to the now-unassisted smallholders who operate within mixed cropping/mixed farming systems, and implementation of a replanting/ne'.? planting cess-based grant scheme on a pilot basis. In conjunction with this approach, the exter- nal donors could continue supportir.g the successful PMU-based schemes, and extending such schemes to oil palm. 11.22 Support for Consolidation of Existing Investments (Section VII). A careful rehabilitation strategy is called for, with an identification of those essential investments which will raise incomes and employment, at the lowest possible cost. Investment consolidation should not be designed merely to replant/infill what was not well planted in the first place. The major ele- ments of investment cinsolidation should include: (a) construction of trunk and feeder roads in existing project areas, together with the formulation and implementation of a plan for O&M of existing road systems iL smallholder areas; (b) provision of funds for replanting/upgrading, together with planting material and other agro-inputs to smallholders in poorly performing NES and selected transmigration sites. These funds snould be used also to encourage crop and livestock diversification, rather than only upgrading poorly perform- ing tree crops; (c) provision of land titles as rapidly as possible to as many assisted smallholders as can be reached; (d) provision of general credits to the private sector to establish processing facilities whe:e these are required to complete previous investments; (e) development of a network of small-scale processing centers for copra drying and rubber coagulating, to raise quality and value-added at the farm level; and (f) establishment of a market informa- tion service to provide information on prices and market prospects to the smallholder commuunity. 11.23 Support for Rationalizing and Streamlining the Public Estate Compa- nies (PTPs) (Section VI). The main elements of this operation could include support for: (a) setting up alternative organizational arrangements under NES/PIR projects, so that PTPs can progressively divest their responsibility of assisting smallholders to the existing agencies in extension and food crops or to a specialized smallholder development authority if and as it evolves; (b) streamlining the operations and the structure of PTPs; (c) changing the marketing/incentives environment for the PTPs; (d) assisting in setting up functions of guidance and monitoring of PTP performance and corporate planning or in creation of a holding company; (e) introducing contract plans on a pilot basis; and (f) supporting PTPs to enter into joint ventures with private investors and supporting other divestiture/privatization programs, if and where needed.