Technical Assistance Consultant’s Report

Project Number: 38301 September 2007

Proposed Loan and Technical Assistance Grant People’s Republic of China: Dryland Sustainable Agriculture Development Project

Prepared by: Roger A. Collier

For Ministry of Agriculture

This consultant’s report does not necessarily reflect the views of ADB or the Government concerned, and ADB and the Government cannot be held liable for its contents. (For project preparatory technical assistance: All the views expressed herein may not be incorporated into the proposed project’s design.)

CONTENTS Page

LOAN AND PROJECT SUMMARY # MAP # I. THE PROPOSAL 1 II. RATIONALE: SECTOR PERFORMANCE, PROBLEMS, AND OPPORTUNITIES 1 A. Performance Indicators and Analysis 1 B. Analysis of Key Problems and Opportunities 2 III. THE PROPOSED PROJECT # A. Impact and Outcome # B. Outputs # C. Special Features # D. Project Investment Plan # E. Financing Plan # F. Implementation Arrangements # IV. TECHNICAL ASSISTANCE V. PROJECT BENEFITS, IMPACTS, ASSUMPTIONS, AND RISKS A. Benefits and Impacts # B. Social Dimensions # C. Environmental Impact # D. Risks # VI. ASSURANCES # A. {Specific Assurances} # B. {Conditions for Loan Effectiveness} # C. {Conditions for Disbursement} # VII. RECOMMENDATION #

APPENDIXES # 1. Design and Monitoring Framework # 2. Sector Analysis # 3. Selected Enterprise Performance # 4. Promotion of Sustainable Agriculture # 5. Cost Estimates and Financial Plan # 6. Implementation Schedule 7. Organization Chart and Flow of Funds 8. Socio-economic Analysis 9. Summary Poverty Reduction and Social Strategy 10. Gender Action Plan 11. Environmental Assessment and Management Framework (to be undertaken) 12. Economic Analysis 13. Project Performance and Monitoring System 14. Technical Assistance

SUPPLEMENTARY APPENDIXES #

A. Detailed Sector Analysis # B. Enterprise Investments # C. Detailed Cost Estimates # D. Socio-economic Survey # E. Detailed Economic Analysis # F. Detailed Financial Management Assessment G. Detailed SIEE (to be undertaken)

Project Area Map to be inserted by ADB map makers as discussed with RR in August 2007

Dryland Sustainable Agriculture Project Provinces

LOAN AND PROJECT SUMMARY

Borrower The People’s Republic of China

Classification Targeting classification: General intervention Sector: Agriculture and natural resources Subsectors: Agriculture production, agroprocessing Themes: Sustainable economic growth Subthemes: Public-private partnerships, private sector development, and capacity development

Environment Category B Assessment

Project Description The Project area includes 26 poor rural counties of three provinces, Henan, Shandong and Gansu with a population of 8.2 million, 27% of whom are in poverty, relying on very small farms (0.28ha or 4.2mu), for most of their income.

The Project is structured provincially to match the three Provincial IAs and sub-borrowers. In each Province there will be two sub- components. First, sustainable agricultural partnerships will promote financially and environmentally sustainable agriculture in dryland areas. These relationships give farmers access to: (i) a contract minimizing price risk; (ii) reduced transfer costs; (iii) clear quality specifications and market signals; (iv) advice, training and specialized technology so farmers’ produce will meet the firm’s quality requirements through sustainable farming; (v) may also include mechanization and logistic services; and (iii) credit facility for farm inputs to be recovered from harvested farm produce.

Rather than focusing on a narrow product range the Project responds to local conditions of diversified processing and production of cereals, fruits, vegetables, herbs and livestock. The Project will develop 50 partnerships, which provinces estimate will directly benefit 0.84 million farm households and 4.45 million mu (300,000ha). The agro-enterprises will produce an incremental 722,000 mt of products annually and create some 18,000 new off- farm employment opportunities.

Secondly, agricultural support services will be developed primarily in the form of services and input capacity for sustainable agricultural production, including soil testing labs, agricultural extension and technology transfer centers, mechanization services centers, organic fertilizer production, and high quality seed production. Additionally, market access support will be provided through centers for marketing, product quality analysis and quality management systems training. Generally, these services will be integral units of the agricultural partnerships, making them commercially sustainable after project completion without reliance on government funding. Six investments will be ii

independent commercial ventures in specialized machinery manufacture, seed production, organic fertilizers, and wholesale markets. These 6 will provide benefits of improved services and supplies to an additional 0.25 million households.

Rationale The pressures of intensified land use and rapid economic growth in recent decades have adversely impacted the people and land. Land degradation is severe and rural poverty is high. The strong correlation between poverty and land degradation is evident from three features: (i) average farm household income of CNY 2,247 is only two-thirds of the national average farm household income (CNY 3,587); (ii) 60% of household income is from farming; and (iii) 40% of the 811,000ha arable land is classed as degraded. Off- farm income is increasingly important, with average urban income three times average rural income. Some 24% of rural labor is underemployed.

Poverty is seen as a cause of land degradation, and improved access to finance and income opportunities will enable farmers to adopt appropriate and sustainable farming practices. In order to enable the farmer to improve incomes and agricultural practices, the Project will address market failures in the provision of technology and finance to farmers and also give them more assured access to markets to give security to their expectations of increased cash incomes.

To address these failures and produce the desired outputs, the Project will build on vertically-integrated agro-enterprises engaged in mutually beneficial contract partnerships with farmers and farmer groups. The vertical integration concept has been successfully promoted in PRC to develop agriculture industries since the mid-1990s, and provincial governments strengthen the partnerships by coordinating with agro-enterprises in provision of support services to farm households.

Growth in food manufacturing and food distribution services has led to increasing vertical integration in the sector as agro- enterprises seek to improve supply security and control quality of raw materials. This vertically integrated model can improve rural incomes through supply chain efficiencies, access to higher value markets, and employment opportunities. Relationships between farmers and enterprises may be based on formal contracts with individual farmers or associations (especially with new crops and industries) or informal, but generally long-term, relations established and maintained by agents or purchasing officers of an agro-enterprise (generally with mature industries like livestock).

The Project adopts a proven model and supports its extension, in partnership with existing agro-enterprises, to poor rural areas in which large agro-enterprises do not usually operate.

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Impact and Outcome The Project impact be to contribute to the Government’s priority requirement to reduce the increasing rural-urban income gap by reducing rural poverty in project counties through increased incomes and livelihood opportunities from sustainable use of agricultural resources. The impacts will benefit 0.84 million households by including then within contract farming systems and an additional 0.25 households through provision of independently provided services and goods supporting sustainable agriculture.

The outcome will be increased farm incomes and employment and adoption of sustainable agriculture activities in the Project area, supported by higher value on-farm and post-harvest commercial activities. Through partnership between enterprises, farmers and government, the Project will facilitate farmer access to finance, technology, and markets so that higher value crops can be produced using sustainable agricultural practices.

Project Investment Plan The project investment cost of the project is estimated at $244.4 million, including financial charges during implementation estimated at $15.96 million and taxes and duties of $27.5 million.

Financing Plan Source Total $m Percent A. Asian Development Bank 96.88 39.60 B. National Government .30 .10 C. Provincial and County Governments 9.83 4.00 D. Enterprises 64.99 26.60 E. Farmers 72.45 29.60 Total 244.45 Source: Consultant estimates.

Loan Amount and Terms A loan of $96.88 million from the ordinary capital resources of the Asian Development Bank (ADB) will be provided under ADB’s London interbank offered rate (LIBOR)-based lending facility. The loan will have a 25-year term including a grace period of 5 years, an interest rate determined in accordance with ADB’s LIBOR- based lending facility, and a commitment charge of 0.35% per annum.

Allocation and Relending The borrower will be the PRC, which will on-lend the proceeds of Terms the ADB loan to the Provinces under the same terms and conditions as those of the original loan. The Provinces in turn will on-lend to the County Governments. The interest rate will be at the same LIBOR-based rate paid by the PRC and will be subject to the same terms and conditions as the PRC loan. The Counties will then on-lend to enterprises and, through the enterprises, to farmers and farmer groups on terms which are of shorter duration compatible with achieving required financial ratios relating to debt and liquidity but at the same fees and rates. The proposed term for enterprise finance is 15 years including a grace period on principal of 5 years. Debt service by enterprises paid in advance of debt service by provinces will create a circulating fund to be invested in similar agro-enterprise development and on similar iv

terms as the original loans varied only in so far as to accommodate the Province’s debt service obligations to PRC.

Period of Utilization Until 30 June 2013

Estimated Project 31 March 2013 Completion Date

Executing Agency Ministry of Agriculture

Implementation The MoA will be the EA. It will coordinate and supervise all Arrangements implementation activities through an existing leading group. Provincial and county leading groups will also be constituted in Henan and Shandong and municipal (Tianshui) and county leading groups in Gansu. Provincial and county governments will be the IA for all project components. The EA will be in charge of overall coordination and monitoring. The Provincial PPMO to supervise implementation activities will be established in the Department of Agriculture offices in Henan and Shandong and the Financial Bureau in Gansu. PPMO’s major tasks include (i) overseeing the implementation of all sub-component activities; (ii) drawing up the annual work program and budget in consultation with the EA; (iii) supervising compliance of procurement with ADB guidelines; (iv) maintaining consolidated accounts, including developing an FMIS to track all financial transactions with sub- borrowers; (v) preparing and submitting to the EA for processing and forwarding to ADB withdrawal applications; (vi) monitoring physical and financial progress, including benefit flow to intended beneficiaries, and submitting reports to EA and ADB; (vii) supporting county PMOs to implement the Project and ensure counterpart financing. The PPMO will also help counties implement the Project, and ensure counterpart financing. The municipality and county PMOs will assist the PPMO. These PMOs will be the implementing agencies working directly with farmers and with the agro-enterprises, which will be the construction unit responsible for day-to-day implementation. Agro-enterprises will implement the activities working in commercial contractual relationships with farmers and farmer groups.

Procurement All procurement will be done in accordance with ADB’s Guidelines for Procurement following the procedures for “Procurement in Loans to Financial Intermediaries” set out in paragraph 3.12 for loans “to be re-lent to beneficiaries such as individuals, private sector enterprises, small and medium enterprises, or autonomous commercial enterprises in the public sector for the partial financing of subprojects, the procurement is usually undertaken by the respective beneficiaries in accordance with established private sector or commercial practices, which are acceptable to ADB.”

Consulting Services An integral part of the project concept is that the enterprises have demonstrated an established track record of technical, financial, v

management and marketing skills and no consulting services will be required.

Project Benefits and The major benefits will be reduced rate of land degradation and Beneficiaries reduced rural poverty from: (i) improved rural income opportunities; (ii) increased adoption of sustainable agricultural practices; (iii) improved farm productivity; (iv) increased contract farming, resulting in improved income security to farmers, and improved quality and security of supply to enterprises involved in a range of agro-products involving grains, meat, dairy, juice, fodder, vegetables, fruit, and other farm products; (v) improved agricultural support services, including soil analysis, seed testing, farm machinery, standards-based quality management services, and market information; and (vi) reduced uncertainty and efficiency gains from supply chain organization. Additional benefits will accrue as lessons learned are applied outside the project area.

The Project’s investment in subprojects in the three provinces will benefit the rural population, of whom some 29% are poor, and significantly contribute to decreasing degradation of the 810,000ha arable land in the project area. The 50 agro- enterprises and 6 independent agricultural support activities will provide contracts and other alliances with an incremental 1.08 million households, and create about 18,000 full-time direct off- farm jobs, as well as additional employment created in services including farm machinery contracting, harvest, transport and distribution, and pre-processing and post-processing value-adding operations. The agro-enterprises will produce an incremental 722,000 mt of products annually. By increasing rural income opportunities, the project will reduce the number of people who remain farming by default, having no better income option, thus assisting people to exit farming, or reduce dependence on it, and reducing pressure on the land.

The Project will provide employment and on-farm income opportunities for women, and through mechanization reduce their labor burden in agriculture. Through improved skills and increased share of household cash income, women will be better able to participate in community and household decision-making processes.

Risks and Assumptions Inflexibility of Project Implementation: Flexibility to respond to changes in financial and market conditions is considered essential in most PCR and PER of such projects and this experience with SME agro-enterprise projects in China is the same as in other countries: flexibility in design and implementation is essential to success. Despite this clear evidence, from experience, that flexibility is essential to successful implementation and despite the evidence to date that the Project, like all others, needs such flexibility, it will denied that flexibility. In principle, the substantial vi

risks arising from inflexibility will be un-mitigated due to the decision of NDRC to seek a project loan and consequent inflexible project design rather than a sector or sector-like loan. Sponsors will drop out, markets will change and there will be a need to re- allocate resources if they are to be used optimally. Inflexibility risks: (i) slow implementation due to inability of some sponsors to provide equity in a timely manner, if at all; (ii) substantial commitment fees on un-disbursed balances as a result of slow implementation and drop outs; (iii) sub-optimal use of resources in supply-driven implementation instead of a market driven response to emerging opportunities; (iv) probable substantial cancellation of loan balances; and (v) failure to achieve project objectives. The only mitigation possible for the inflexibility in a project loan is in the planned review in the third year of implementation and ad hoc, but cumbersome, procedures for re-allocation of loan proceeds.

Capacity of Implementing Agencies: Even with these rigidities, enterprise loan repayments will create a revolving fund to be re- lent to similar, as yet unidentified, agro-enterprises. This will require credit skills to assess the proposed investments and determine creditworthiness of the borrowers. In addition, rigorous supervision and monitoring of subloans are necessary to ensure efficient debt recovery and achieve development objectives. A project approach does not avoid the need for financial and credit skills during implementation. A financial management assessment has been made of IAs and agro-enterprise borrowers and they are considered to have the necessary accounting skills. However, experience in financial analysis of proposals in project preparation suggests that the IAs do not have financial analysis skills. In other countries implementation of SME credit projects has produced significant capacity building benefits, but not in China.

Established financial institutions have no interest in providing rural SME credit and government’s recent initiatives to develop rural financial services could not currently cope with the burden of a directed special credit program. This situation is substantially unchanged since the Bank funded projects over ten years ago in Hainan and Fujian. In Fujian, use of the financial bureau was considered successful, providing credit in one province for 9 agro- enterprises. It is a significant assumption that the same stop gap arrangement will succeed as a credit conduit in 3 provinces and 26 counties to finance and service 56 projects. Mitigation could be made through TA for project management as most counties only have 1 or 2 loans. This is unlikely to prove efficient. Thus, there will be no development of rural financial institutions under the project and the risks from a lack of rigorous appraisal, supervision and monitoring will be un-mitigated.

Commercial Risks: Investments will face normal commercial risks of changing markets and technology but such risks are mitigated by restricting project support to established enterprises vii

able to demonstrate track record in successfully managing such risks.

Technical Assistance An advisory TA grant of $350,000 will be provided by the Government of Spain and administered by ADB. The objective of the advisory TA is to improve sustainable farming practices to reduce land degradation and improve water conservation

I. THE PROPOSAL

1. I submit for your approval the following report and recommendation on a proposed loan to the People’s Republic of China (PRC) for the Dryland Sustainable Agricultural Development Project.

II. RATIONALE: SECTOR PERFORMANCE, PROBLEMS, AND OPPORTUNITIES

2. In August 2005, the Asian Development Bank (ADB) approved project preparatory technical assistance (TA) to formulate the Dryland Farming in Northern Regions Project for the People’s Republic of China (PRC). This report is based on the findings of the TA, Government feasibility studies, findings of ADB missions, and discussions with officials and stakeholders. The project design and monitoring framework (PDMF) is in Appendix 1.

A. Performance Indicators and Analysis

3. The Project area includes 26 poor rural counties of three provinces, Henan, Shandong and Gansu. These dryland areas represent a transition from western plateau to eastern plains, linked by the Yellow River. The Project area has a population of 8.2 million, 27% of whom are in poverty, relying on very small farms (0.28ha or 4.2mu), for most of their income. The pressures of intensified land use and rapid economic growth in recent decades have adversely impacted the people and lands of the north-western and north central PRC. Land degradation is severe and rural poverty is high. The strong correlation between poverty and land degradation is evident from three features: (i) the average farm household income of CNY 2,247 is only two- thirds of the national average farm household income (CNY 3,587); (ii) 60% of household income is from farming; and (iii) 40% of the 811,000ha arable land is classed as degraded, causing declining productivity, increasing farm input costs, and decreasing farm incomes. Off- farm income is increasingly important, with average urban income three times average rural income, but opportunities are limited and some 24% of rural labor is underemployed.

4. These households are highly vulnerable to the impact of land degradation and natural or economic shocks. They have limited access to markets and technology to diversify into higher valued crops, but current farming practices do not sustain land and other natural resources. Individually, they have little or no ability to cope with the costs and risks of changing to more sustainable farming practices, or to reduce reliance on farming. There is a need to strengthen sustainable farming practices and also to support higher value on-farm and off-farm activities.

5. Growth in food manufacturing and food distribution services has led to increasing vertical integration in the sector as agro-enterprises seek to improve supply security and control quality of raw materials. This vertically integrated model can improve rural incomes through supply chain efficiencies, access to higher value markets, and employment opportunities. In addition, the model provides a commercial incentive for agro-enterprises to support farmers to adopt sustainable farming practices and technologies.

6. For example, the wheat processing investment sponsored by the Huanxiang Food Company in Ruzhou County, Henan, would result in an estimated 150 to 200 new jobs. The rural production base that the enterprise works with contains over 80,000 farmers, and many of these will be given training in sustainable farming practices, technological support services, and farm credit to ensure they supply the enterprise with the high quality raw materials it needs to meet its market demands.

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B. Analysis of Key Problems and Opportunities

7. Although improvements have resulted from the PRC Government’s programs for agriculture, rural development and combating land degradation, the Government remains concerned about the need to improve rural livelihoods and agricultural sustainability. It is challenged by the high cost of public-sector approaches, which include subsidies, state-financed agricultural support services, and the lack of a coordinated approach within the institutional system to tackle cross-sector issues. Government recognizes the private sector can play a major role.

8. The increased population pressure and land degradation have resulted in very small and fragmented land holdings. In the past, industrial technologies, such as chemical fertilizer, have partially compensated small farm size and declining land productivity, but there is no scope to continue such compensation. All provinces report sharp increases in total farm input costs, without commensurate increases in farm commodity price or yields. To reduce poverty and land degradation, the sector must gradually restructure and adopt more sustainable farming practices. Several aspects of land degradation are well recognized, such as deeply gullied slopes, dust storms and desertification, but there is lack of awareness of the less visible loss of soil fertility and the cots required to address it: access to improved agriculture machinery, access to soil analysis services that give more precise fertilizer recommendations, and manufacturers of organic or appropriately balanced fertilizers with trace elements. Introducing alternative crops into the predominant wheat–corn cropping pattern, and adoption of technologies such as integrated pest management (IPM) and conservation agriculture, will reduce farm inputs and “pull” people into more sustainable farming.

9. Lack of alternatives ties people to farm incomes by default. There is a strong response to off-farm work where it is available, due to the ratio of 1:3 in farming incomes compared to non-farming incomes. Reducing pressure on farm-derived incomes – getting people off the land – is linked to reducing land degradation. Rural enterprises supplying food and industrial products provide markets for alternative farm products and provide employment in processing and services so rural people can exit farming. Enterprises need medium and long-term finance both for enterprise development and to strengthen their production base to secure supply in terms of raw material volume and quality. Due diligence of project area agro-enterprises has identified enterprises with: consistent profitability, debt service capacity; experience in financing contracted farmers: and sound business plans. However, they and their farmer groups have limited access to medium-term finance and their growth is limited to their own resources for equity finance.

10. Lending in rural areas is a low priority for banks as they reform themselves and serve the more readily accessible urban markets. Financial Bureau have been used for ad hoc credit lines but this is a stop-gap which neither addresses the fundamental market failure nor builds sustainable credit capacity and, indeed, hinders development by sending the wrong signals both to borrowers and potential lenders. Government is promoting more innovative solutions for rural finance, addressing governance issues in rural credit cooperatives (RCC). The China Banking and Regulatory Commission has introduced new regulations to promote Township and Village Banks (TVB) and Community Credit Cooperatives (CCC) and, in December 2006, the Postal Savings Bank, with its extensive network, was empowered to develop lending activities. These initiatives are at an early stage at which imposition of a special Project credit line is more likely to hinder than help their development.

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11. The vertically-integrated contract farming model provides a strong commercial rationale for agro-enterprises to strengthen their links with farmers and thus minimize transaction costs, uncertainty, asset specificity and avoid market failures in changing agri-food systems. Farmers have demonstrated willingness to adopt more sustainable practices associated with financial return, but investment in machinery and other aspects of farm restructuring requires access to finance, markets and technical support. Farmers’ small operations provide little or no collateral and are not able to access finance individually. Alliance with agro-enterprises facilitates exchange of information, improves logistic planning for mechanized farm and post-harvest operations, and provides more financial security. Evidence from the Project area and elsewhere in PRC shows this agro-enterprise model also provides a strong development rationale though increased rural employment, access to higher-priced markets for farm products, and security of farm income through contracts and other forms of vertical integration.

12. Since the 1990s, the Government has developed a variant of the vertically integrated contract farming model in which the largest and strongest agribusiness enterprises are designated “dragon heads” 1. This status entitles the firm to reduced tax and other benefits, including support from all levels of government and, since 2002, financing from the Agricultural Development Bank of China – thus they do not need externally financed project support. Criteria for the award include economic strength, operational scale, level of technology and management, and potential to improve farm incomes2. The criteria restrict the status to large enterprises which are predominantly agri-businesses, excluding small and medium agro- enterprises as well as large, diversified enterprises in which agri-business is less than 70% of the whole enterprise. At State level criteria are set for each region, with lower size requirements for those in the Western Region, including Gansu. At Province level, with provincial but not state benefits, the criteria can be varied: Shandong makes no significant variation, Henan reduces the required size by 30% to 40% and Gansu by up to 80%. Even with the much lower requirement at province level, 77% of the sponsors for investments under this Project appear not qualify for the designation3.

13. Smaller enterprises sponsoring investments in this project meet all of the “enterprise quality” criteria for financial management and soundness, agri-business focus, contribution to the local economy and even the number of households benefiting. However, their size excludes them for dragon head status and the access to the Agricultural Development Bank of China which that brings. Dragon heads thus tend to serve areas which are already more prosperous and able to support larger local enterprises. Despite their lack of “dragon head” status, the Project’s agro-enterprise sponsors already provide contract support and market access to 514,653 farm households4 and over 2 million family members. “Dragon heads” have proved a highly effective variant of the model, but poverty reduction benefits are determined by the quality of the vertically integrated enterprises and not by their individual “dragon head” designation. There is, therefore, a clear opportunity to intervene and secure poverty reduction benefits by supporting enterprises with proven track record which fall outside the dragon head supports.

1 The “dragon head” has been repeatedly supported by the Bank in a series of projects since 1995: the concept was significantly developed during implementation of ithe “Fujian Soil Conservation and Rural Development Project” (Loan 1386-PRC) 28 September 1995, replicated in the “Fujian Soil Conservation and Rural Development II Project” (RRP:PRC 33439 March 2004, and again in the “Henan Sustainable Agriculture and Productivity Improvement Project” being processed in 2007. 2 Detailed criteria are given in Appendix 2. 3 The designation is used by lower levels of government but with little relevance as they have few benefits which can be added to the fundamental benefits of the vertically integrated model, it is also understood that many sponsors do not qualify for this “form of words” designation. 4 This excludes markets, fertilizer and machinery manufactures customers. 4

14. Since reforms of collective farming, there has been a strong growth of farm supply merchants, service providers, contractors and commodity buyers, which generally provide a comprehensive commercial support service to farmers. Demonstrations of conservation tillage, supported by Ministry of Agriculture and Provinces, continue to increase adoption of sustainable agricultural technologies. However, county agricultural support services typically have limited operating budget (e.g., eight government extension workers trying to service 50,000 farmers in one township of Tan Cheng County, Shandong Province). More effective support services are financed and managed by agro-enterprises in contract with farmers or farmer groups. Enterprises gain efficiencies by providing farmer support services to assist them in control of raw material quality, environmental management, operational and material logistics, and financial flows. Farmers organizations and support services of enterprises keen to retain or expand their production base have a mutual commercial interest in higher-value farm products and adoption of more sustainable farming technologies. Support services need to provide: (i) laboratory analysis of soils and agricultural products (including composition, pesticide residues, and heavy metals); (ii) fertilizer recommendations and analysis; (iii) seed certification (germination percentage); and (iv) technical and farm management advice. Some enterprises already have these capacities in-house or via specialist seed and fertilizer agribusiness, university or agricultural institutions.

15. Compliance to domestic and international quality standards, such as China Green Food certification and Food Safety (ISO 22000), are increasingly required by enterprises in order to access higher-value domestic and export markets. Full certification of these management systems requires training and monitoring evidence that best practices (sustainable and with low food hazard, such as minimal use of pesticides) are complied with at all levels in the supply chain, including by farmers. An innovative feature in the project design is support to agro- enterprises for activities which improve capacity for implementing quality and environmental management systems, such as farmer training and in-house laboratories for pesticide residue analysis and soil analysis so that farmers get precise recommendations for farm inputs (rather than “best guess”) and their practices are monitored. This initiative therefore has potential to strengthen enterprise and farmers' environmental performance as well as demand for their products, achieving both environmental and poverty impacts.

16. The Project has strong commitment from stakeholders to apply a farm-to-market value chain approach, that will support expansion of vertically-integrated agribusinesses so that they can increase the number of farmer contracts and improve delivery of agriculture support services for sustainable farming. The approach also has a wider demonstration and replication impact within and to other provinces to address rural development issues, including the sharing of different experiences and improving the adoption from the lessons learned. This approach is fully consistent with PRC’s New Socialist Countryside Policy which recognizes the role of agro- enterprise to increase rural incomes by improving farming opportunities and increasing off-farm employment. The 11th national Five Year Plan (FYP) also supports adoption of standards-based quality management systems, and continues to emphasize means of combating land degradation such as agricultural technology transfer, re-forestation and alternative household energy. The Government also prioritizes development in the west, including Gansu.

C. Lessons Learned

17. The Bank has undertaken and post-evaluated similar SME financing projects in many countries with varying degrees of success but consistency in the lessons learnt. For rural, agro- enterprise SME finance a recent Bank PER “identified the following key success factors: (i) professional management; (ii) vertical integration and coordination with farms, offering constant 5 and sufficient supply of raw materials; and (iii) financial strength of sponsors.”5 It also identified one of the principal factors associated with failed subprojects as inadequate working capital. Although there are as yet no post-evaluations of similar projects in China the preliminary findings presented in PCR6 indicate that successful application of the vertically integrated model in China, and other countries, has similar requirements and risks. Building on this experience, all of the agricultural partnership sponsors selected have established track record in applying the vertically integrated contract farming model in the project areas in which they will invest. So far as resources have allowed, review of sponsor enterprises has also addressed the issues of professional management and financial strength by applying strict financial criteria (Appendix 3). This specifically avoids the general weakness of Bank SME projects in China of relying on new, untested enterprises7.

18. The PCR for the Fujian project (footnote 6) draws particular attention to weaknesses in the financing arrangements for agro-enterprises: “Key reasons for delayed repayment or nonpayment were that (i) agroprocessing enterprises had to start repaying local loans immediately even if they were not yet operating fully; (ii) for some subprojects the first due date was ahead of the physical completion (the grace period was too short); and (iii) some profit- earning entities were investing in market expansion and increased production capacity and thus suffered a shortage of working capital.” The tendency to use long term credit provided by the Bank for short term financing of the private sector is not confined to China 8 . Measures incorporated into project design to address these issues include: (i) on-lending terms to agro- enterprises are set to a standard loan period of 15 years with a grace period on repayments for 5 years to ensure time for full development of production base and processing activities with adequate liquidity and debt service coverage; (ii) designing enterprise financial plans on the basis of the financing needs of a sound balance sheet, including fixed assets and working capital, instead of a “procurement package” of goods; and (iii) projecting the quantity and timing of investments in debt, equity, and necessary retained earnings/internally generated funds to minimize risks of debt service funds being required to finance working capital, which is 54% of the total investment9.

III. THE PROPOSED PROJECT

A. Impact and Outcome

19. The Project will address the Government’s priority requirement to reduce the increasing rural-urban income gap by reducing rural poverty in project counties through increased incomes and livelihood opportunities from sustainable use of agricultural resources. This impact will be measured through increases in per capita net farm incomes and reduced numbers of poor people in the project areas. An essential aspect of the sustainability of the project impacts will

5 ADB 2006 Performance Evaluation Report on the Uzbekistan Rural Enterprise Development Project OED, Manila 6 ADB. 2003. Project Completion Report on the Fujian Soil Conservation and Rural development Project (Loan 1386- PRC) in the People's Republic of China. Manila ADB. 2004. Project Completion Report on the Hainan Agriculture and Natural Resources Development Project (Loan 1372-PRC) in the People's Republic of China. Manila World Bank. 2004. Implementation Completion Report on a Loan in the Amount of US$ 120 million to the People's Republic of China for a Heilongjiang Agricultural Development Project. Washington DC. ADB. 2004. Project Completion Report on the Yunnan-Simao Forestation and Sustainable Wood Utilization Project (Loan 1304-PRC) in the People's Republic of China. Manila. 7 ADB. 2007. People's Republic of China: Success Drives Demand for More Innovative and Responsive Services. Manila. 8 See, for example, ADB 2005 PER on the Viet Nam Rural Credit Project (Loan 1457-VIE(SF)) 9 See Appendix 5 and Supplementary Appendixes B and C, 6 be adoption of sustainable farming technologies and practices which will, over the long term reduce the rate of farmland degradation. The impacts will benefit 0.84 million households by including then within contract farming systems and an additional 0.25 households through provision of independently provided services and goods supporting sustainable agriculture. The total incremental beneficiary households will be 1.08 million in 26 counties in 3 provinces, targeted as poor counties suffering from degradation of agricultural land resources.

20. The outcome of the Project will be increased farm incomes and employment and adoption of sustainable agriculture activities in the Project area, supported by higher value on- farm and post-harvest commercial activities. Through partnership between enterprises, farmers and government, the Project will facilitate farmer access to finance, technology, and markets so that higher value crops can be produced using sustainable agricultural practices - including but not limited to conservation agriculture (CA) - which will improve farm incomes whilst reducing the rate of land degradation. The expansion of agro-processing enterprises will increase rural value added and off-farm employment opportunities.

B. Outputs

The Project is structured provincially to match the three Provinces implementing the project and activities in each Province will be divided into the following two sub-components:

1. Sustainable Agricultural Partnerships

21. The principal output of the Project is the promotion of financially and environmentally sustainable agriculture in dryland areas. Poverty is seen as a cause of land degradation, and improved access to finance and income opportunities will enable farmers to adopt appropriate and sustainable farming practices. In order to enable the farmer to improve incomes and agricultural practices, the Project will address market failures in the provision of technology and finance to farmers and also give them more assured access to markets to give security to their expectations of increased cash incomes.

22. To address these failures and produce the desired outputs, the Project will build on vertically-integrated agro-enterprises which are interested in expanding mutually beneficial partnerships with farmers and farmer groups. The vertical integration concept has been successfully promoted in PRC to develop agriculture industries since the mid-1990s, and provincial governments strengthen the partnerships by coordinating with agro-enterprises in provision of support services to farm households. Relationships between farmers and enterprises may be based on formal contracts with individual farmers or associations (especially with new crops and industries), or informal but generally long-term relations established and maintained by agents or purchasing officers of an agro-enterprise (generally with mature industries like livestock). These relationships provide benefits farmers may otherwise not have access to: (i) a contract minimizing price risk; (ii) reduced transfer costs; (iii) clear quality specifications and market signals; (iv) advice, training and specialized technology so farmers’ produce will meet the firm’s quality requirements through sustainable farming; (v) may also include mechanization and logistic services; and (iii) credit facility for farm inputs to be recovered from harvested farm produce.

23. The output is expected to be sustainable production and processing partnerships in which the enterprise and farmers combine to develop a production base, and the farm products are then processed and marketed by the enterprise. Rather than narrowly focusing on a narrow product range, such as apple juice, the Project follows the diversified processing and production 7 patterns of the project area to include: wheat, dates, fruit, vegetables, peanuts, soybeans, sweet potatoes, maize, mushrooms, cotton seed, herbs, bees, poultry (broilers and layers), pigs, sheep, cattle, and dairy. The Project will develop 50 such partnerships, which provinces estimate will directly benefit 0.84 million farm households and 4.45 million mu (300,000ha).

2. Agricultural Support Activities

24. This output consists of two sub-outputs. The first is services and inputs capacity for sustainable agricultural production. Outputs include: facilities for soil testing and providing holistic fertilizer recommendations, agricultural extension and technology transfer centers, mechanization services centers, facilities for organic and trace-element balanced fertilizer production, and high quality seed production. The second is support for market access for farmers through marketing centers and centers for product quality analysis and quality management systems training.

25. These outputs will generally not be produced independently but be integral units of the enterprises or production bases, owned and operated by an enterprise or the farming community. As an essential element of a commercially based relationship, these service facilities will be sustainable after project completion without reliance on any government funding. They will be financed by the producer/processor partnerships and on a revenue generating cost recovery basis. In six cases they will be independent of agro-processing enterprises providing inputs and services to the project area in the form of specialized machinery manufacture, seed production, organic fertilizers, and wholesale markets.

C. Special Features

26. The Project design recognizes the need to address rural poverty and agricultural land degradation in an integrated and financial sustainable manner in which, the farmer receives benefits from measures to reduce land degradation rather than the farmer incurring the cost of conservation measures. As such, it follows the principle successfully applied in PRC by the International Crops Research Institute for the Semi-Arid Tropics in promoting congruence between poverty reduction and environmental improvement.

27. The Project design develops an existing and replicable model of partnership between agro-enterprises, which incorporates long-term sustainability of both poverty reduction and environmental project benefits without reliance on grants or subsidies. The vertically integrated contract farming model provides a channel through which an integrated package of financial, technical, and market support can be provided to farmers at negligible cost to the Government during implementation10 and with no on-going demand on public funds. Once established with project facilitation, the benefits are supported by the commercial cash flows of the partnerships.

28. In project preparation, the Project provinces have sought to go beyond simple repetition of the “dragon head” support for large enterprises, which are few in poor areas, and promote small and medium agro-enterprises which, without the designation of dragon heads, have successfully applied the vertically integrated contract farming model in poor areas and which can, with project support, expand their activities and increase poverty impacts. Rather than replicating the “dragon head” model they have sought to develop an extension of contract farming which addresses the weaknesses of “dragon heads”:

10 Government funding of project costs is restricted to the costs of the project management offices alone, with no financing of other costs. 8

• extending support to smaller enterprises which serve and are typical of poorer rural communities and less developed parts of PRC; and • extending support to diversified enterprises which do not presently have a high enough proportion of agribusiness to be designated as “dragon head” but which can increase agribusiness investment in poor rural communities.

29. This places considerable reliance on the enterprise as a partner in implementation and rather than a beneficiary of the Project. For this partnership to be effective and to establish and sustain project benefits, it is critical that enterprise and subproject selection criteria, in Appendix 3, be applied rigorously to ensure that only established, strong enterprises are included as partners in implementation.

Table 1: Project Investment Plan ($ ‘000) Item Amountsa b A. Cost 1. Henan Sustainable Agriculture 99,020 Sustainable Agricultural Partnerships 89,512 Agricultural Support Activities 5,488 Provincial Project Management 4,020 2. Shandong Sustainable Agriculture 56,303 Sustainable Agricultural Partnerships 51,816 Agricultural Support Activities 1,798 Provincial Project Management 2,689 3. Gansu Sustainable Agriculture 71,895 Sustainable Agricultural Partnerships 65,371 Agricultural Support Activities 4,370 Provincial Project Management 2,154 4. National Project Coordination 274 Subtotal (A) 227,492 B. Contingenciesc 997 C. Financing Charges During Implementationd 15,960 Total (A+B+C) 244,449 a Includes taxes and duties of $27.5m. b Costs other than project management are financial provisions based on enterprise financial projections and financial plans at current prices, project management costs are based on mid-2007 prices projected to 2008. c Contingencies are financed by Government. Physical contingencies are 5% of base cost. Price contingencies were computed using foreign cost escalation factors of 0.8% for years 2008 to 2012; and local currency escalation factors of 2.2% for 2008, and 3.0% for 2009 to 2012. d Includes interest during construction computed at the five-year forward London interbank offered rate (LIBOR), with a spread of 0.6%, and a commitment charge at 0.35%. Source:Consultant estimates

D. Project Investment Plan

30. The project investment cost is estimated at CNY 1,843 million ($244.5 million equivalent). Financial charges during implementation (comprising interest during 9 implementation) are estimated at $15.9 million.11 Cost estimates by project component are summarized in the table below, and the summary financing plan is presented in the following section. Detailed cost estimates and assumptions are provided in Appendix 7.

E. Financing Plan

31. The Government has requested a loan of $96.88 million from ADB’s ordinary capital resources to help finance the Project. The loan will have a term of 25 years, including a grace period of 5 years, an interest rate determined in accordance with ADB’s London interbank offered rate (LIBOR) based lending facility, a commitment fee of 0.35% per annum, and such other terms and conditions as set forth in the loan agreement. The Government has provided ADB with (i) reasons for its decision to borrow under ADB’s LIBOR based lending facility on these terms and conditions, and (ii) an undertaking that these choices were its own independent decision and not made in reliance on any advice or communication from ADB.

Table 2: Financing Plan ($ million) Source Total % A. Asian Development Bank 96.9 39.60 B. National Government 0.3 .10 C. Provincial and County Governments 9.8 4.00 D. Enterprises 65.0 26.60 E. Farmers 72.4 29.60 Total 244.4 100.00 Note: Figures may not add up due to rounding. Source: Consultant estimates.

F. Implementation Arrangements

1. Project Management

32. The MoA will be the project executing agency (EA). It will coordinate and supervise all implementation activities through an existing leading group. Provincial and county leading groups will also be constituted in Henan and Shandong and municipal (Tianshui) and county leading groups in Gansu. Provincial and county governments will be the implementing agencies for all project components.

33. The EA will be in charge of overall coordination and monitoring. The Provincial PPMO to supervise implementation activities will be established in the Department of Agriculture offices in Henan and Shandong and the Financial Bureau in Gansu. PPMO’s major tasks include (i) overseeing the implementation of all sub-component activities; (ii) drawing up the annual work program and budget in consultation with the EA; (iii) supervising compliance of procurement with ADB guidelines; (iv) maintaining consolidated accounts, including developing an FMIS to track all financial transactions with sub-borrowers; (v) preparing and submitting to the EA for processing and forwarding to ADB withdrawal applications; (vi) monitoring physical and financial progress, including benefit flow to intended beneficiaries, and submitting reports to EA and ADB; (vii) supporting county PMOs to implement the Project and ensure counterpart financing.

11 The final amounts will be subject to ADB loan appraisal in 2007. 10

The PPMO will also help counties implement the Project, and ensure counterpart financing. The municipality and county PMOs will assist the PPMO. These PMOs will be the implementing agencies working directly with farmers and with the agro-enterprises, which will be the construction unit responsible for day-to-day implementation.

34. Agro-enterprises will implement the activities working in commercial contractual relationships with farmers and farmer groups. The organization chart is included in Appendix 7

2. Implementation Period

35. The Project will be implemented over 5 years starting in 2008. In 2010, ADB and the Government will jointly evaluate implementation progress and take measures, including modifying the scope, implementation arrangements, and allocation of loan funds, necessary to achieve the project objectives. The implementation schedule is presented in Appendix 6.

3. Flow of Funds and On-lending Arrangements

36. The borrower will be the PRC, which will on-lend the proceeds of the ADB loan to the Provinces under the same terms and conditions as those of the original loan. The Provinces in turn will on-lend to the County Governments. The interest rate will be at the same LIBOR-based rate paid by the PRC and will be subject to the same terms and conditions as the PRC loan. The Counties will then on-lend to enterprises and, through the enterprises, to farmers and farmer groups on terms which are of shorter duration compatible with achieving required financial ratios relating to debt and liquidity but at the same fees and rates. The proposed term for enterprise finance is 15 years including a grace period on principal of 5 years.

37. Debt service by enterprises paid in advance of debt service by provinces will create circulating fund to be invested in similar agro-enterprise development and on similar terms as the original loans varied only in so far as to accommodate the Province’s debt service obligations to PRC. The flow of funds is presented in Appendix 7.

4. Procurement of Goods and Services

38. All procurement will be done in accordance with ADB’s Guidelines for Procurement following the procedures for “Procurement in Loans to Financial Intermediaries” set out in paragraph 3.12 for loans “to be re-lent to beneficiaries such as individuals, private sector enterprises, small and medium enterprises, or autonomous commercial enterprises in the public sector for the partial financing of subprojects, the procurement is usually undertaken by the respective beneficiaries in accordance with established private sector or commercial practices, which are acceptable to ADB.”

5. Consulting Services

39. An integral part of the project concept is that the enterprises have demonstrated an established track record of technical, financial, management and marketing skills and no consulting services will be required.

6. Accounting, Auditing, and Reporting

40. County PMOs will maintain records of all project expenditures and forward them regularly to the PPMO, which will prepare consolidated project accounts, including its own 11 record of expenditures. Each PPMO will then forward the consolidated accounts to the EA, which will ensure that independent auditors acceptable to ADB will audit the consolidated project accounts annually. The audited accounts will be submitted to ADB no later than 9 months after the end of the fiscal year.

41. Each PPMO will submit summary reports every quarter and a consolidated progress report every 6 months to the EA for consolidation and submission to ADB and relevant government agencies, containing information on (i) physical and financial achievements; (ii) problems and issues identified and actions taken; and (iii) work plans for the next quarter or 6 months, as the case may be. Semiannual progress reports will follow ADB’s project performance report format. Provincial, municipal, and county finance bureaus will establish an FIMS, consistent with the PPMO system, to track loan disbursement and recovery and facilitate audit. Within 3 months of project completion, each PPMO will prepare and submit to the EA for combination and submission to ADB, a PCR including loan utilization, attainment of objectives, evaluation, and performance rating.

42. Although China’s accounting regulations no longer require an external audit of all enterprise accounts it will be a requirement of each sub-loan agreement that such external audit shall be undertaken annual and that the audited accounts, including notes on those accounts, will be supplied to the County PMO and by reported to indicate compliance with financial ratios set as criteria for the investments.

7. Performance and Benefit Monitoring and Evaluation

43. Within 1 year of loan effectiveness, the EA and the PPMOs will develop a performance and benefit monitoring and evaluation (PBME) system to establish the benchmark indicators to assess project performance and impact. The PBME will include, but not be limited to, indicators as proposed in the Design and Monitoring Framework in Appendix 1. With benchmark indicators determined, two surveys will be conducted during implementation - one in the third year before the midterm review and the other in the fifth year as input to PCR - with data made available to evaluate benefits and impacts after project completion.

8. Project Reviews

44. When project implementation starts, an inception mission will finalize a project administration memorandum, which will define implementation details, including the poverty- targeting mechanisms and poverty-monitoring indicators. In the third year of implementation, a midterm review will be undertaken to make implementation more efficient, and to determine if project design and scope, and poverty-targeting mechanisms are appropriate. Regular review missions will assess the Project’s progress at least once a year.

9. Anticorruption Policy

45. ADB’s Anticorruption Policy (1998, as amended to date) was explained to and discussed with the Borrower and Executing Agency. Consistent with its commitment to good governance, accountability and transparency, ADB reserves the right to investigate, directly or through its agents, any alleged corrupt, fraudulent, collusive, or coercive practices relating to the Project. To support these efforts, relevant provisions of ADB’s Anticorruption Policy are included in the loan regulations and the bidding documents for the Project. In particular, all contracts financed by ADB in connection with the Project shall include provisions specifying the right of ADB to 12 audit and examine the records and accounts of the Executing Agency and all contractors, suppliers, consultants, and other service providers as they relate to the Project.

10. Disbursement Arrangements

46. Disbursements will be made in accordance with ADB’s “Loan Disbursement Handbook” (Jan 2007) as proposed for funding DFI in paragraphs 11.1 to 11.5. As a Project loan, all subloans are approved with the loan and no further approval will be required before disbursement. Disbursement of subloans will be made through an imprest account to be established by MOF once the loan is effective. The advance funding in these cases should not exceed 6 months’ estimated expenditures for cash flow required for payments to be made to sub-borrowers. The imprest account will be established, managed, replenished, and liquidated in accordance with ADB’s Loan Disbursement Handbook.

IV. TECHNICAL ASSISTANCE

46. An Advisory Technical Assistance (TA) based on farmer’s priorities for sustainable farming will be implemented in association with the Loan Project. The TA will improve sustainable farming practices to reduce land degradation and improve water conservation. The TA will be implemented in parallel with the loan project activities of agro-enterprises in Gansu, Shandong and Henan to strengthen opportunities for contracted farmers to adopt new sustainable farming practices and technology. Implementation methods will draw on proven participatory and holistic approaches such as participatory watershed management, farmer field schools, and build on the interests of agro-processors through their contract farming and other vertical relationships. The TA would provide specialist expertise for training, and limited training and demonstration equipment and supplies. In line with PRC policy to develop the western region, Gansu will be given priority in implementation.

47. Total cost of the TA is estimated at US$500,000 equivalent. A grant from the Government of Spain will provide US$ 350,000 covering full foreign costs and part of the domestic costs. This will cover (i) preparation and delivery of training to farmers in the project area on participatory soil and water management and sustainable agriculture (either international or domestic institution or firm); (ii) local institutions or NGO in Gansu, Henan and Shandong, to facilitate adoption of sustainable agriculture in collaboration with the training course delivery, and (iii) training materials. The EA Provincial Governments will contribute US$150,000 equivalent covering office and training facilities, domestic travel, counterpart agency support service staff as appropriate, materials and equipment to demonstrate sustainable agricultural technology. The Provincial Governments, agro-enterprises and farmer communities will cover the costs of implementing the sustainable agriculture activities they prioritize as a result of the TA.

V. PROJECT BENEFITS, IMPACTS, ASSUMPTIONS, AND RISKS

A. Benefits and Impacts

1. Major Impacts

48. The major impacts will be reduced rate of land degradation and reduced rural poverty from: (i) improved rural income opportunities; (ii) increased adoption of sustainable agricultural practices; (iii) improved farm productivity; (iv) increased contract farming, resulting in improved income security to farmers, and improved quality and security of supply to enterprises involved 13 in a range of agro-products involving grains, meat, dairy, juice, fodder, vegetables, fruit, and other farm products; (v) improved agricultural support services, including soil analysis, seed testing, farm machinery, standards-based quality management services, and market information; and (vi) reduced uncertainty and efficiency gains from supply chain organization. Additional benefits will accrue as lessons learned are applied outside the project area.

49. The Project’s investment in subprojects in the three provinces will benefit the 8.2 million rural population including some 2.4 million poor, and significantly contribute to decreasing degradation of the 810,000ha arable land in the project area. The 50 agro-enterprises and 6 independent agricultural support activities will provide contracts and other alliances with an incremental 1.08 million households, and create about 18,000 full-time direct employment jobs, as well as additional employment created in services including farm machinery contracting, harvest, transport and distribution, and pre-processing and post-processing value-adding operations. The agro-enterprises will produce an incremental 722,000 mt of products annually. By increasing rural income opportunities, the project will reduce the number of people who remain farming by default, having no better income option, thus assisting people to exit farming, or reduce dependence on it, and reducing pressure on the land.

50. The Project will provide employment and on-farm income opportunities for women, and through mechanization reduce their labor burden in agriculture. Through improved skills and increased share of household cash income, women will be better able to participate in community and household decision-making processes.

2. Financial and Economic Analysis

a. Due Diligence

51. Financial analyses and due diligence were carried out for 56 proposed investments. Results of assessments of the audited accounts of sponsor enterprises (Appendix 3 and Supplementary Appendix B) suggests that these enterprises have the financial and management capacity to effectively participate in the project, with demonstrated skills in finance, marketing, and production, and ability to deliver benefits to target rural communities. The Financial Management Assessment of both enterprises and implementing agencies is presented in Supplementary Appendix F.

b. Internal Rates of Return and Net Present Value

52. Financial and economic cash flows have been calculated for each approved investment proposal, combining the incremental flows of agro-processing enterprise and production base as necessary to reflect the overall performance of the integrated activity. These have been summed to province level through inclusion of PPMO costs calculated in COSTAB for economic and financial values. The full set of cash flow calculations are presented in Supplementary Appendix E and the financial and economic analyses are summarized in Appendix 12.

53. The overall project FIRR is 20.4% with provinces ranging from 19.1% in Shandong to 21.9% in Gansu. Individual activities show a greater variation than the summary combinations, varying from 13.4% to 36.3%. Returns are often high because the investments are expansions of existing activities and benefit from increased utilization of existing assets.

54. The overall project EIRR is substantially higher, at 39.9% for the whole project and ranging from 33% in Shandong to 63.4% in Henan. This large difference between the FIRR and 14

EIRR is the result of the FIRR assessing financial costs and the EIRR resource costs only. As shown in Appendix 5, some 54% of the investment costs are for working capital needs in terms of inventory, accounts receivable and the like. The increased working capital is especially large at the beginning of the new and expanded operations in year 2 of each investment and even at that stage is typically a larger financial investment than the fixed assets and is, thus, a major determinant of the FIRR. Economics does not consider investment in working capital as a resource cost and, thus, ignores it.

55. Appendix 12 illustrates the impact of ignoring working capital by estimating an “EIRR including Working Capital” by reducing changes in working capital to constant prices and applying the SCF to them. This would give an “EIRR” 15% lower, at 25%, and account for 75% of the difference between FIRR and EIRR. In the case of Henan, with the highest EIRR, the treatment of working capital accounts for 85% of the difference. The balance of the difference is due to economics’ treatment of transfer payments, discounting tax on inputs as a cost and including tax on outputs as a benefit. The apparently high EIRR is inevitable in this context, reflecting the high economic impact of private sector productive investments.

56. Both financial and economic NPVs, discounted at 12%, are strongly positive at CNY 1,927 million and CNY 2,574 million respectively.

c. Sensitivity

57. The financial model has allowed assessment of sensitivity of each individual investment to changes in development cost, prices, output volumes, variable costs and fixed costs. Development costs, which are less than half the total investment on average, have no significant impact on viability, nor do fixed costs. Changes in output volumes have a typically marginal impact as they influence both revenues and variable costs in an offsetting manner.

58. Viability is sensitive to variable costs and, especially, to output prices as they determine the gross margin of each enterprise and its capacity to cover fixed costs and financial charges. The gross margins are typically less than 20% of sales and often 10% or less. This sensitivity is unavoidable in competitive commercial markets and skilled management is necessary to offset this risk, hence the importance of due diligence to assess the track record of sponsor enterprises.

3. Sustainability

59. The Project’s overall sustainability will be assured by the fact that individual agro- enterprise investments will generate large revenue streams to support on-going operations. On- going fiscal implications for the government will be limited. Sub-component investments will be managed by experienced commercial enterprises that have demonstrated sustainable commercial operation and growth, and full responsibility for the financial operation of their existing investment. All subproject activities will be financed through commercial organizations. There is no reliance on public funded support services (which typically are under-resourced) to achieve subproject requirements.

60. The project focus on adoption of sustainable agricultural technologies and approaches in itself will strengthen farm-level sustainability. However, the extent of current land degradation and the rate of population growth continue to threaten the rural economy in project areas. The project is one contribution to mitigating poverty and land degradation, but the problem is complex, and the scope larger than this project alone. 15

B. Social Dimensions

1. Social Benefits and Poverty

61. The Project targets rural poor counties comprising 8.2 million potentially vulnerable rural population over 3 provinces. Ethnic minorities are well integrated and dispersed through the area rather than in concentration, and represent less than 1% of the population. Poverty analysis concluded that rural poverty was worst in areas with hilly land, marginal soils, and difficult access to markets and support services. Poverty is linked closely to limited land per capita, declining productivity, low education levels, increased migration for work and female headed households, increased dependence on straw and crop residues for heating, and limited off-farm work. Average rural incomes are 30% of urban incomes creating incentives for urbanization for those who are able to move. Most poor farmers have limited land, technology, working capital, and have no other choice of income.

62. The Project strategy will facilitate rural labor to move into off-farm employment, obtain higher income opportunities, and build capacity to exit poverty. A key design feature builds on the findings of a recent ADB evaluation of poverty exit achievements12, which highlighted the success from linking the rural poor to commercial value-adding enterprises and the associated off-farm employment opportunities. Rural livelihoods improvement will significantly impact the incomes of participating households. New off-farm employment for about 18,000 people will give them incomes of about CNY5,500 (US$1,000) compared with the average project area rural income of CNY2,247 ($300).

63. The Project design uses contract farming, processing, and alternative livelihoods through links with enterprises, which will provide credit, farming support services, and technical training. The interventions will result in productivity improvements and greater market certainty leading to increased incomes. Conservation agriculture technologies, crops and land use matched to soils and land capability, efficiency gains in water and nutrient use, strengthened farmer associations, access to rural finance, contract farming agreements linked to processing and market chains, and capacity development will all contribute to improved sustainable livelihoods and improved resilience for poor rural households.

64. The participation of stakeholders including beneficiaries will continue to be built through participatory planning and implementation processes. For example, vertical integration with enterprises will strengthen farmer organizations and farmers’ experience with contractual negotiations and supporting arrangements with organizations, farmer agents, and individuals.

65. Women now contribute up to 70% of the rural workforce. Female participation standards for training, employment, and contract farming opportunities have been proposed to ensure the provision of opportunities in an equitable manner.

2. Land Acquisition and Resettlement

66. No involuntary land acquisition or resettlement is planned in project activities.

12 ADB. 2006. Special Evaluation Study on Pathways Out of Rural Poverty and the Effectiveness of Poverty Targeting. Manila 16

C. Environmental Impact

67. The project investments are expected to have a range of generally positive impacts but individual agro-enterprise activities create wastes and possible pollutants which require assessment prior to implementation. Environmental impact assessment is in process.

D. Risks

1. Inflexibility of Project Implementation

68. In the five months from May to September 2007 exogenous changes in the project have included: (i) Shanxi Province dropped out; (ii) Henan Province reduced the number of counties and enterprises from 14 to 12; (iii) Shandong Province has reduced the number of counties by 1 but number of enterprises by 4; (iv) Gansu Province has increased its share of the loan from $20 million to $25 million; and (v) the financial plans of almost all investment activities have been changed. Such changes are normal in commercially oriented projects and will not stop before or after loan agreement: in Fujian13, 4 of the 9 core subprojects were not financed; in Shanxi 14 , 3 of the initial projects were dropped before any investment was made; in Uzbekistan15, 11 out of the first 16 subprojects could not be financed due to lack of sponsors’ equity funds.

69. Flexibility to respond to changes in financial and market conditions is considered essential in most PCR and PER of such projects: (i) Fujian13 “Selection and approval of agroprocessing subprojects should take into account the capacity and flexibility that allow quick response to changes in market trends.”; (ii) Shanxi14 “Flexibility in addressing emerging market opportunities is a key success factor.”; (iii) Hainan16 “fixed targets set at appraisal precluded a flexible approach to achieve the overall goal, making the project supply-driven instead of market-driven. The PCR recommended that the design of future ADB projects should adopt a flexible approach to targeted outputs, and should be sensitive to changes in market demand and product prices”; (iv) Yunnan17 “commercial projects require greater flexibility in design, and more proactive and timely responses by ADB to key emerging issues during implementation”. (v) Heilongjiang 18 “considerable flexibility was applied based on the changing market, as at the design stage many of the emerging market opportunities could not be anticipated. Over the … implementation period … significant market challenges and opportunities emerged. … took advantage of such changes, designed some new and important project activities … and dropped activities that were no longer demanded by the market.” This experience with SME agro-enterprise projects in China is the same as in other countries: flexibility in design and implementation is essential to success.

70. Despite the clear evidence, from experience, that flexibility is essential to successful implementation and despite the evidence from project preparation that the Project, like all others, needs flexibility in design and implementation in order to succeed it will denied that flexibility. In principle, the substantial risks arising from inflexibility will be un-mitigated due to the decision of NDRC to seek a project loan and consequent inflexible project design rather than a sector or sector-like loan. As in other projects, sponsors will drop out, markets will change and

13 ADB. 2003. PCR the Fujian Soil Conservation and Rural development Project (Loan 1386-PRC). Manila. 14 World Bank 2004 ICR on the Shanxi Poverty Alleviation Project (IDA-28340 TF-29222), Washington DC 15 ADB 2006 Performance Evaluation Report on the Uzbekistan Rural Enterprise Development Project OED, Manila 16 ADB. 2004. PCR on the Hainan Agriculture and Natural Resources Development Project (Loan 1372-PRC) Manila. 17 ADB. 2004. PCR on the Yunnan-Simao Forestation and Sustainable Wood Utilization Project (Loan 1304-PRC). 18 World Bank. 2004. ICR on the Heilongjiang Agricultural Development Project. Washington DC. 17 there will be a need to re-allocate resources if they are to be used optimally. Inflexibility risks: (i) slow implementation due to inability of some sponsors to provide equity in a timely manner, if at all; (ii) substantial commitment fees on un-disbursed balances as a result of slow implementation and drop outs; (iii) sub-optimal use of resources in supply-driven implementation instead of a market driven response to emerging opportunities; (iv) probable substantial cancellation of loan balances; and (v) failure to achieve project objectives.

71. The only mitigation possible for the inflexibility in a project loan is in the planned review in the third year of implementation and ad hoc, but cumbersome, procedures for re-allocation of loan proceeds.

2. Capacity of Implementing Agencies

72. Even with the rigidities of the project approach, the shorter enterprise loan period will create a revolving fund to be re-lent to similar, as yet unidentified, agro-enterprises. This will require credit skills to assess the proposed investments compared to the selection criteria and determine creditworthiness of the borrowers. In addition, even for the initial projects “rigorous appraisal, supervision and monitoring of subloan proposals … are necessary to ensure efficient subloan recovery and to achieve development objectives.”19 “The success of project credit components is highly correlated with the intensity and quality of project supervision and management …. particularly their ability to assess market prospects for commodities to be produced using the subloan and to develop repayment schedules consistent with agribusiness income streams.”20 A project approach does not avoid the need for financial and credit skills during implementation. A sector approach would require the same, but no more, financial skills and provide the time to develop those skills as well as flexibility in implementation.

73. A financial management assessment has been undertaken21 of IAs and agro-enterprise borrowers and they are considered to have the necessary accounting skills to record the disbursement and recovery of loans. However, experience in financial analysis of proposals in project preparation suggests that the IAs do not have such skills, including the PPMO based in the Municipal Financial Bureau in Gansu.22 In other countries23 implementation of SME credit projects has produced significant capacity building benefits, but not in China.

74. Established financial institutions have no interest in providing rural SME credit and government’s recent initiatives to develop rural financial services could not currently cope with the burden of a directed special credit program (see Appendix 2). This situation is substantially unchanged since the Bank funded projects in: (i) Hainan24 “financial bureaus may not be the appropriate channel to onlend ADB funds to private companies, because they may not have the required technical expertise, particularly in risk assessment. A major improvement in the financial sector is needed, so that this task could be assigned to commercial financial institutions—the appropriate conduit for onlending of development funds from multilateral institutions”; and (ii) Fujian: “the use of financial bureaus at provincial and county levels was

19 ADB 2003 PCR on the Rural Enterprise Development Project in Uzbekistan. Manila 20 World Bank 2005, ICR on the Agricultural Development Project in Georgia, Washington DC. 21 Supplementary Appendix F 22 Financial analyses have been undertaken principally by consultants using data provided by PPMOs, as all 56 proposals were analysed over less than 60 days the analyses can be consider broad but not deep and further review prior to commitment would be prudent. 23 E.g. ADB 2006 PER on the Uzbekistan Rural Enterprise Development Project; ADB 2005 PER on the Viet Nam Rural Credit Project (Loan 1457-VIE(SF)); and ADB 2003 PCR Sri Lanka Second Small and Medium Industries Project (Loan 1084-SRI[SF]) 24 ADB. 2004. PCR on the Hainan Agriculture and Natural Resources Development Project (Loan 1372-PRC). 18 necessary to overcome the unwillingness of financial institutions”25 In Fujian the use of the financial bureau was considered successful, providing credit within one province and only to 9 agro-enterprises. Because of the lack of development of rural financial institutions in the more than 10 years since Hainan and Fujian, the project is left with no choice other than to use the financial bureau as a credit conduit in 3 provinces and 26 counties to finance and service 56 projects.

75. Mitigation could be made through technical assistance but this would have no sustainable institutional benefits since neither PPMOs nor financial bureau have any role in rural credit beyond the immediate impact. The TA would then be for project management over a number of years in 26 counties, of which most counties will implement only 1 or 2 loans. This is unlikely to prove efficient. Thus, as with earlier projects, there will be no development of rural financial institutions under the project and the risks from a lack of rigorous appraisal, supervision and monitoring will be un-mitigated.

3. Commercial Risks

76. In addition to the above project specific risks the investments will face normal commercial risks of changing market conditions in terms of prices, competitors and consumer preferences. Technically they will also need to establish appropriate sustainable practices on production bases and in processing facilities and be technically and financially able to respond to future developments. Such risks are mitigated by selection criteria which restrict project support to established enterprises able to demonstrate track record in successfully managing such risks.

VI. ASSURANCES

77. To be drafted as necessary during fact finding.

VII. RECOMMENDATION

78. I am satisfied that the proposed loan would comply with the Articles of Agreement of the Asian Development Bank (ADB) and recommend that the Board approve the loan of $96.9 million to the People’s Republic of China for the Dryland Sustainable Agriculture Project from ADB’s ordinary capital resources, with interest to be determined in accordance with ADB’s London interbank offered rate (LIBOR)-based lending facility; a term of 25 years, including a grace period of 5 years; and such other terms and conditions as are substantially in accordance with those set forth in the draft Loan and Project Agreements presented to the Board.

Haruhiko Kuroda President {Date26}

25 ADB. 2003. PCR on the Fujian Soil Conservation and Rural development Project (Loan 1386-PRC) 26 {Use date of the President's approval of the RRP for submission to the Board.}