Document of r '" -I>tThe World Bank FILE Cue

FOR OFFICIAL USE ONLY

Report No.2780-IND

INDONESIA

APPRAISAL OF THE

NUCLEUS ESTATE AND SMALLHOLDERS IV PROJECT

March 31, 1980

Projects DepartmentEast Asia and Pacific Regional Office

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

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CURRENCY EQUIVALENTS

Currency Unit - Rupiah (Rp)

US$1 = Rp 625Rp 100 = US$0.16Rp 1,000,000 = US$1,600

WEIGHTS AND MEASURES

1 kilogram (kg) = 1,000 grams (g) = 2.205 pounds1 metric ton = 1,000 kg = 2,205 pounds = 0.98 long ton1 hectare (ha) = 10,000 square meters (sq m) = 2.47 acres

ABBREVIATIONS

APBD - Anggaran Pendapatan dan Belanja Daerah - Regional Budgetfor Revenues and Expenditures

APBN - Anggaran Pendapatan dan Belanja Negara - State Budget forRevenue and Exenditures

BAL - Basic Agrarian LawBAPPEDA - Provincial Development Planning AgencyBAPPENAS - Badan Perancana Pembungunan National - National Development

Planning AgencyBIMAS - Bimingan Massal Swa Sembada Bahen Mekarar, "Mass Guidance

Program for Self-Sufficiency in Foodstuffs"' - A farminput credit package program

BRI - Bank Rakyat Indonesia - People's Bank of IndonesiaBULOG - Badan mousan Logistik (rice procurement agency)CP - Cooperative ProgramCRIA - Central Research Institute for AgricultureDGA - Directorate General of Agrarian AffairsDGE - Directorate General of EstatesDGFC - Directorate General for Food CropsDIP - Daftar Isian Projek - Project Budget DocumentDPD - Dinas Perkebunan Daerah - Provincial Estate Crops ServicesDPUP - Provincial Public Works ServicesFAO - Food and Agriculture OrganizationFFB - Fresh Fruit BunchGOI - Government of IndonesiaINPRES - Instruksi Presiden - "Presidential Instruction" a special

programIPEDA - Iuran Pembanguanan Daerah - Land TaxJMO - Joint Marketing Officemd - man-daysMOA - Ministry of AgricultureMOASS - Ministry of Agriculture Support ServicesMOTC - Ministry of Trade and CooperativesMil. - Million

FOR OFFICIAL USE ONLY

REPELITA I - First Five-Year Development Plan (1969/70-1973/74)REPELITA II - Second Five-Year Development Plan (1974/75-1979/80)REPELITA III - Third Five-year Development Plan (1979/80-1984/85)PMU - Project Management UnitPNP - Perusahaan Negara Perkebunan, State-owned Estate EnterprisePPL - Field extension workerPT - Perseroan Terbatas - State-owned Corporation Operating

under the Commercial Code with Limited LiabilityPTP - Perseroan Terbatas Perkebunan, State-owned Enterprise with

Limited Liability

GLOSSARY OF INDONESIAN TERMS

Adat - Body of traditional lawBupati - Kabupaten ChiefDepartment Kesehatan - Department of HealthDesa - VillageDukuh - Hamlet of 25-30 housesGotong-royong - Community self-help projectHak Pakai - Individual's right of use or exploitation of assigned

landHak Milik - Right to full ownership of landKabupaten - DistrictKecamatan - SubdistrictLalang - A coarse grass, establihsing itself after the slash

and burn cycleMarga - Community grouping under Adat LawMushalla - Small prayer housePuskesmas - Community Health Center, subdistrict level

GOVERNMENT OF INDONESIAFISCAL YEAR

April 1-March 31

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

INDONESIA

NUCLEUS ESTATE AND SMALLHOLDERS IV PROJECT

TABLE OF CONTENTS

Page NB9.

1. BACKGeROUND . . . . . . . . . . . . . . . . . . . . . . . . . . I

General ................. . .1..... The Agricultural and Rural Sector . . . . . . . . . . . . . . 1The Palm Oil Subsector ... . . . . . . . . . . . . . . . . . 5

2. PROJECT AREA .... . . . . . . ..... . . . . . . . . . . . 9

Project Area Description . . . . . . . . . . . . . . . . . 9Existing Works and Infrastructure . . . .. . . . . . . . . . 10

3. THE PROJECT .. ......... . 11

Project Formulation . . . . . . . . . . . . . . . . . . . . . 11Project Summary.. ... 12

Detailed Features ... 12Project Costs and Financing Arrangements . . . . . . . . . . . 16Budgeting . . . . . . .. . . . . . . . . . . 19Procurement.. . . 20Disbursements . . . . . * . . . .. . . . . . . . . 21Quality and Cost Controls .. .22Accounts and Audit.... . 22

4. ORGANIZATION AND MANAGEMENT . . . . . . . . . . . . . . . . . . 22

5. DEMAND AND MARKETS.. . . . . . . . . 25

Palm Oil ... . . . 25

Food Crops . . . . . . . . . . . . . . 28

6. AGRICULTURAL PRODUCTION, FARM INCOMIES AND COST RECOVERY. . . . . 28

Crop Recommendations . . . . o . . . . . 28Yields, Production and Farm Incomes . . . . . . . . . . . . . 28Cost Recovery .. 30

7. BENEFITS, JUSTIFICATION AND RISKS . . . . . . . . . . . . . . . 31

Benefits.. . . . . . * 31Costs ... . . . . 31Financial Results.. . ... . . 31Economic Results.. . . . . . . . . . . . . 32Project Risks.. . 33Environmental Effects ....... . . . . . . ...... . 34

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Page No.

8. AGREEMENTS REACHED AND RECOMMENDATIONS . . . . . . . . . . . . 34

LIST OF TABLES IN MAIN REPORT

1.1 Indonesian Oil Palm Production Data3.1 Annual Inflation Indices3.2 Project Cost Summary3.3 Sources of Project Finance5.1 Projection of Coconut Oil Deficit and Utilization of Palm Oil6.1 Farm Family Income7.1 Sensitivity Analysis

ANNEXES

ANNEX 1 - OIL PALM - TECHNICAL ASPECTS OF ESTABLISHMENT AND PRODUCTION

Table 1: Mean Rainfall Data for Project AreaTable 2: Phasing of Planting ProgramTable 3: Summary of Oil Palm Establishment Cost/haTable 4: Yield Assumptions and Extraction RatesTable 5: Summary of Palm Oil and Kernel Production

ANNEX 2 - VILLAGE DEVELOPMENT

Table 1: Cost Structure of Smallholder HousingTable 2: Summary of Village Infrastructure - Unit Cost DataTable 3: Village Infrastructure - Physical Planning

ANNEX 3 - PROJECT PHASING. PROJECT COSTS AND EXPENDITURES. DISBURSEMENTS,AND RENT AND COST RECOVERY

Table 1 : Project PhasingTable 2 : Total Project CostsTable 3 : Betung Smallholders - Project CostsTable 4 PNP X - Project CostsTable 5 : Program Support - DGETable 6 : Estimated Schedule of Project ExpendituresTable 7 Sources of Finance - Project CostsTable 8 : List of Agricultural Machinery, Vehicles and EquipmentTable 9 : Estimated Schedule of DisbursementsTable 10: Proposed Allocation of Loan Proceeds

ANNEX 4 - CROP AND FARM BUDGETS, DEVELOPMENT COSTS PER FAMILY, INCOME ANDCASH FLOW, PNP X

Table 1 : Production from Garden LotTable 2 : Production from Field Crop AreaTable 3 : Farm Family Labor Availability and Labor Requirements

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Table 4: Estate Labor and Smallholder Labor RequirementTable 5 : New Settler Farm Income Statement (Constant 1979)Table 6: Rent and Cost RecoveryTable 7: Development Costs per FamilyTable 8: Projected Profit and Loss Statement, PNP XTable 9: Projected Cash Flow Statement, PNP X

ANNEX 5 - COST BENEFIT ANALYSES

Table 1: Calculation of Economic and Financial Price for Oil Palm (FFB)

Table 2: Calculation of Economic Farm-Gate Price of Paddy

Table 3: Calculation of Economic Price for Urea and TSPTable 4: Economic Costs and Benefits, Betung Smallholder Oil Palm Farm Model

Table 5: Economic Costs and Benefits - PNP XTable 6: Economic Costs and Benefits - Total Project

ANNEX 6 - PROGRAM SUPPORT TO THE DGE FOR NES V

Table 1: Investment Costs for NES V Project Startup

ANNEX 7 - STATEMENTS OF EXPENDITURE

ANNEX 8 - GUIDELINES FOR INDEPENDENT AUDITORS

ANNEX 9 - DATA AVAILABLE IN THE STAFF WORKING PAPERS

CHARTS

1. Organization Chart of Directorate General of Estates2. Organization Chart of Government-Owned Estate Group3. Project Implementation Schedule

4. Organization Chart of the Flow of Funds for Smallholder Development5. Project Organization Chart

FIGURES

1. Proposed Schematic Layout of Settlement Unit

2. Proposed Village Layout for Betung Area3. Basic House Design for New Settlers4. Indicative Road Cross Sections for Project Area

MAPS

Numbers 14505, 14503 and 14504

This report is based on the findings of an appraisal mission composed of

Messrs. P.R. Melkye, C. Carlier, G. Fox (Bank), G. Percival, T. Daley, R. Ury,

and V. Raswant (Consultants) which visited Indonesia in July/August 1979.Mrs. P. Urbano and Mr. D. Elz also contributed to the preparation of thereport.

INDONESIA

APPRAISAL OF THE

NUCLEUS ESTATE AlD SMALLHOLDERS IV PROJECT

I. Background

A. General

1.01 The Government of Indonesia (GOI) has requested Bank assistance todevelop 12,000 ha of oil palm and food crop land to settle 4,000 landlessfamilies in South Sumatra Province, using the public sector estate of PNP X asthe development agent under the nucleus estate development scheme. Assistanceis also sought to develop palm oil and rubber factories in PNP X to provideprocessing services for oil palm smallholders in the proposed project and forrubber smallholders included under the Nucleus Estates and Smallholders IProject (NES I) (Loan 1499-IND).

1.02 The project was identified by the GOI with Bank assistance, and itreflects the national needs and priorities outlined in GOI's Third Five-YearPlan (Repelita III), April 1979-March 1984. The project was prepared by theGOI and the Bank using reports by the consultant firms CommonwealthDevelopment Corporation and Hunting Technical Services.

B. The Agricultural and Rural Sector

Objectives

1.03 The Government's major objectives for the agricultural and ruralsector are to: (a) create productive employment to raise the incomes of therural poor; (b) increase domestic food supply to keep pace with rising demand;(c) expand agricultural exports, particularly of smallholder tree crops; and(d) ensure productive, sustainable use of Indonesia's land, water and othernatural resources.

Role and Performance

1.04 Despite a 4% average annual growth of production, agriculture'sshare of GDP has declined from 40% to 31% since 1968, while its share ofexports dropped from 45% to 37% due mainly to the markedly increased value ofoil exports. Nevertheless, the agricultural and rural sector remains of over-whelming importance to the great majority of Indonesians; nearly 80% of thepopulation lives in rural areas, and agriculture is the major source of incomefor about two-thirds of rural households and one-tenth of urban households.Some 15.6 million smallholder families produce subsistence and cash crops on15.8 million ha, while 1,800 estates occupying 2.2 million ha produce mainlyrubber, sugar, tea, palm oil, and tobacco.

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1.05 Employment. Agriculture's share of total employment decreasedfrom 69% in 1961 to 64% in September 1971, while in 1976 it ranged between66% in March and 60% in October./l Nevertheless, agriculture remained byfar the largest single source (with 46%) of new employment during 1971-76.Outside Java, employment prospects in agriculture appear quite promising,given the sustained increases in the smallholder area, due to land andirrigation development, including that under publicly sponsored andspontaneous transmigration. In Java, rehabilitation of irrigation systems,which generated significant employment in the last decade, should continueto provide additional construction and farm work.

Food Crops

1.06 Production Growth. Given its limited manpower and financialresources, GOI has concentrated on increasing the production of rice, thepreferred staple food of the great majority of Indonesians. Rice productionincreased rapidly (4.5% p.a.) between 1968 and 1974, chiefly due to irri-gation rehabilitation and the provision to irrigated rice growers of fer-tilizer and high-yielding variety seed, financed largely through the BIMAScredit program. The growth rate slowed markedly to 1.7% p.a. over 1974-77,in the wake of severe declines in fertilizer usage (due to restrictions onprivate sector fertilizer trade), successive seasons of untimely rainfall,and unprecedented attacks by pests and diseases, principally the brown planthopper and associated viruses. In 1978, a record rice harvest was achieved,with better weather, improved and liberalized fertilizer distribution, andnationwide Government distribution of recently-introduced pest resistantvarieties. Over the past decade, output of secondary food crops (maize,cassava, soybeans, peanuts, and sweet potatoes) grew more slowly, at anaverage of only 1.6% p.a., composed of a 1.1% p.a. average decline in area(much of this land shifting to irrigated rice) and a 2.7% p.a. increase inyield.

1.07 Demand-Supply Balance. These gains in food output did not keeppace with the 3.5-4.0% p.a. increase in demand due to rising population andincomes. Indonesia became the world's largest rice importer, with a recordimport of 2.3 million tons in 1977, and about 1.3 million tons in 1978.Simultaneously, wheat imports rose to 1.4 million tons in 1978, cassavaexports nearly disappeared, and soybean, maize, and coconut oil importsbegan to grow. The "Indonesia Supply Prospects for Major Food Crops"(Report No. 2374-IND of March 3, 1979) concluded that even with expandedirrigation, and improved technology, extension, credit and marketing, foodproduction growth would not exceed 3.5% p.a., leaving a basic food deficitup to at least 1990, with a rice deficit alone of 2-3 million tons.

/1 In 1976, shares were 63% in M4arch and 57% in October in Java, and 72%and 66%, respectively, elsewhere. The total drop in agriculturalemployment from March to October was 6.7 million. Precise estimation isdifficult due to the surveys' shifting definitions and seasonal timing.

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1.08 Future Strategy. To keep rice imports at some reasonable fraction

of the world rice trade, and to prevent a widening food production-consumption

gap, productivity and area of both rice and secondary food crops must be

increased. In Java, rice-cropping intensity could be raised through water

storage projects and by exploiting groundwater. Rice yields and cropping

intensity can also be increased by constructing tertiary irrigation and

drainage systems, and improving support services. In the Other Islands

there is potential for new irrigation systems, including tidal and swamp

land development. Despite the scarcity of high-yielding tropical varieties

of secondary food crops, yields of existing varieties could be increased

substantially by improved husbandry, including use of fertilizer and

insecticides. GOI is just beginning to give serious attention to marketing,

credit, seeds and research aimed at varietal improvement for secondary

crops. Bank assistance in these efforts is planned.

Tree Crops

1.09 Tree crops occupy about a third of total cropped land (coconuts

and rubber account for 80% of this), and generate almost half of total

non-oil export revenue. Smallholders cultivate 80% of the rubber area and

virtually all coconuts, coffee, cloves and pepper, whereas tea and oil palm

are grown primarily on estates. Despite recent higher world prices for

Indonesia's major tree crop products, only oil palm has shown sustained

large increases in production, due to investment programs by Government and

private estates. With the long immaturity of tree crops, static production

levels are a symptom of past low prices and neglect, especially inadequate

research and extension, and failure to replant with higher-yielding

varieties.

1.10 Smallholder Development. Efforts to revitalize the smallholder tree

crop sector are commencing on several fronts. One new approach, which is

being supported by three Bank-financed Nucleus Estates and Smallholders (NES)

projects, is for Government estates to plant and maintain rubber and oil palm

on previously undeveloped land for three years, using farmers selected to be

settlers (including local landless families and transmigrants) as employees,

and thereafter to supply the settlers with inputs, extension, and processing

facilities. Other new plantings of tree crops are being included in

transmigration projects. While the NES approach has been mainly for new

settlers, GOI has also initiated national programs to assist geographically

concentrated groups of existing smallholders to plant rubber or coconuts

themselves, with fairly intensive support from Project Management Units

(PMUs). This is the approach of the proposed project. Efforts to design a

lower cost strategy for tree crop planting with minimal demands on management

are also starting. Given the vast area of overaged and low yieldingsmallholder rubber and coconuts (smallholder rubber yields are half those in

Malaysia), the good market prospects for these crops, and the Other Islands'

land availability and natural comparative advantage in them, rapid expansion

of smallholder tree crops, using all suitable approaches, is a high priority.

As these programs will place a heavy demand on technical and managerial

personnel, major staff recruitment and training efforts will be required.

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Area Development and Transmigration

1.11 Java. In 1978, about 85 million people lived in Java, at a densityapproaching 650/sq km. The island, with 7% of Indonesia's land area, has45% of the cropped area and 63% of the population. Java generally hashigher fertility and better infrastructure than the Other Islands; however,its cultivable land is almost fully utilized, and in some higher watershedscultivation already exceeds ecologically safe limits, contributing toincreasing erosion, downstream flooding, and siltation of ports, dams, andirrigation canals. GOI is preparing watershed development and integrateddevelopment projects to address this problem.

1.12 Other Islands. The primary program for new area development in theOther Islands, as well as for creating employment and settlement nuclei forJavanese migrants, is transmigration. An organized transmigration programis important for regional and natural resource development in the OtherIslands, production of food and export crops, and creation of employment anddecent living conditions for landless Javanese. Unfortunately, this programhas long been hampered by unrealistic expectations of its potential forresolving Java's population problems and for stimulating large-scale regionaldevelopment, by overly ambitious targets, and by weak, uncoordinatedimplementation. Confronted by management problems, GOI reorganized theprogram in preparation for Repelita III, by transferring implementationresponsibility from the Directorate General of Transmigration to the lineagencies normally responsible for each sector. This measure needs to becomplemented by continued attention to technical and policy issues including(a) the suitability of the land for food crops, (b) the role of tree crops andlivestock, (c) appropriate target incomes and farm sizes, (d) the extent ofGovernment financial, marketing and other services to settlers, and (e) therole of spontaneous migration. The Second Transmigration Project (Loan1707-IND and Credit 919-IND) addresses these issues.

Role of Government

1.13 While the private sector should be encouraged to expand its rolein agricultural input supply, marketing, and processing, Governmentbears the major responsibility for infrastructure, resource conservation,and other services. Despite marked improvements over the past decade, overlycentralized procedures, weak regional planning, and technical and managerialmanpower constraints have impeded agricultural and rural developmentplanning and implementation. GOI's concern for area development has alsoincreased the need to strengthen provincial and local planning capabilities.Future programs responsive to GOI's stated objectives will necessarily be

complex, requiring closely coordinated programs of agricultural research,extension, input supply, credit, land development, transport, pricingpolicies and marketing. GOI must therefore continue to strengthen its keyrural development institutions, particularly through the education,recruitment, training and retention of technical manpower.

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Bank Lending Strategy

1.14 GOI and the Bank generally agree on overall objectives and strate-gies for the rural sector. While views sometimes differ on the relativeemphasis to be given to different investments, and on the technical design ofsome projects, such differences are not impeding Bank Group operationsgenerally and are usually resolved by further analysis and dialogue.

1.15 Projects. Since the first of 13 irrigation projects was approvedin 1968, the Bank Group's agricultural lending has rapidly expanded to includeestate and smallholder tree crops, fertilizer production and distribution,sugar, livestock, fisheries, research, extension, training, seeds, transmi-gration, and resource survey and mapping. The Operations EvaluationDepartment's Sector Operations Review of Bank Group agricultural lending inIndonesia (Report No. 2166, dated August 9, 1978) concluded that despitedeficiencies in some projects, the Bank's portfolio in Indonesian agriculturewas "of overall good quality and likely to contribute substantially toincreased production." Within the context of GOI's agricultural strategy,future Bank lending is expected to focus on:

(a) production of secondary crops (corn, peanuts, soybeans, etc.)especially through second phase projects for agriculturalresearch, extension and seeds;

(b) a diversified irrigation program to intensify rice cropping onJava and to extend water management to the Other Islands;

(c) smallholder tree crop planting programs; and

(d) area development projects aimed at (i) watershed management toconserve soil and ensure long-term productivity in the denselypopulated areas of Java, (ii) integrated rural development of poorareas on Java, and (iii) transmigration.

1.16 Sector Work. These projects have been and will continue to becomplemented by extensive sector work. Analyses of employment and incomedistribution, irrigation, agricultural support services, and food cropproduction have improved the Bank's understanding of the sector's needs andof GOI's policies. Review of the rubber subsector, the transmigrationprogram, secondary food crops, the land tenure system, and the supply andmanagerial manpower for agriculture are now under way.

C. The Palm Oil Subsector

Crop Production

1.17 Indonesia is the world's second largest palm oil producer, produc-ing 568,000 tons of palm oil and 115,600 tons of palm kernels in 1979.Indonesian palm oil represents 16% of the world's total production of

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3.5 million tons. Palm oil is the fourth largest agricultural export com-modity of Indonesia after timber, rubber and coffee, and comprises 2% of totalagricultural GDP and 7% of Indonesia's nonoil export earnings.

1.18 Commercial production of oil palm in Indonesia commenced in 1926 butdid not accelerate sharply until 1969. Favorable price increases in the worldmarket coincided with a significant shift in world consumption of fats andoils away from animal fats to vegetable oils. The total area of oil palm inIndonesia increased over the period 1969-79 from 119,000 ha to 232,000 ha, oran average annual rate of increase of 7%. With the exception of coffeeproduction, growth in palm oil production at 12% p.a. since 1969 has exceededgrowth in all other Indonesian agricultural commodities.

Table 1.1: INDONESIA OIL PALM PRODUCTION DATA

1969 1973 1975 1977 1979

Mature Area in Production ('000) ha

Public sector estates 60 76 88 109 139Private estates 26 39 52 56 57

Total 86 115 140 165 196

Average yield (tons ffb/ha) 12.0 13.6 14.2 15.5 15.5

Production ('000 tons)

Palm OilPublic sector estates 128 207 263 332 398Private estates 60 82 132 148 170

Total 188 289 395 480 568

Palm KernelPublic sector estates 29 46 56 63 83Private estates 13 18 24 26 33

Total 42 64 80 89 116

1.19 Estates and Smallholders. Produced largely as an estate crop, about95% of the total area of oil palm is located in North Sumatra. Public sectorestates dominate about 68% of the total area and production while privateestates account for remainder (Table 1.1). About 1,000 ha or less than 1% ofmature oil palm is owned by smallholders. The dominance of the estates inpalm oil production has arisen since smallholders are not able to process

palm oil themselves and have had no access to planting material or thetechnical expertise required for fruit collection or processing.

1.20 Future Prospects. Faced with growing domestic demand for fats andoils and a decline in domestic coconut oil production, GOI is committed to apolicy of rapid expansion in palm oil production to reverse the increasingheavy burden of imported coconut oil on the economy, and to maintain growth inthe export of palm oil. In 1978, about 100,000 tons of palm oil, 20% ofnational production, was diverted from the export market for fractionationinto edible oil for domestic consumption. All the palm kernel oil productionwas marketed locally. In 1979 GOI directed that 300,000 tons of palm oil bediverted from export for domestic consumption. Consequently, the proportionof total palm oil production exported fell from 85% in 1977 to 40% in 1979.With the new plantings of oil palm planned for South Sumatra, Kalimantan andWest Java it is expected that palm oil and palm kernel oil production willreach 1.8 million tons by 1990. This is equivalent to an annual growth rateof 9% from 1979 to 1990. During the same period, on average, about 50% ofthis production will be consumed domestically.

Institutions Involved in the Subsector

1.21 The Ministry of Agriculture (MOA) is made up of five DirectoratesGeneral (DG) - Estates, Fisheries, Food Crops, Forestry and Livestock - andthe MOA Support Staff. The DG of Estates (DGE) regulates all private estatesand smallholdings involving tree crops and industrial crops such as rubber,coconuts, oil palm, tea, coffee, sugar, tobacco, and spices. Within the DGEare five directorates: Planning, Production and Means of Production,Rehabilitation, and Development and Plant Protection (Chart 1). The increas-ing number of externally-financed DGE projects has placed considerable strainon these directorates, with resultant long delays in budgeting, procurementand staff recruitment. To streamline its procedures, DGE recently establisheda Special Team for Externally Assisted Projects (the Team), which hasassumed the responsibilities of these directorates for implementation ofsmallholder development projects. These responsibilities include projectfinancial administration, procurement and contract approval, and projectmonitoring and evaluation. The Team has 15 staff and utilizes the servicesof three consultants for finance, production management, and rubber andcoconut agronomy who are presently employed by the DGE.

1.22 The Indonesian Estates Industry includes 28 public sectorestates (PNP/PTPs) of which five are palm oil producers. All of thePNP/PTPs are responsible to MOA Support Staff which reports to the Ministerof Agriculture for policy formulation, coordination of estate cropactivities, estate financial administration and control and monitoring ofthe operations of the estates. The DGE has no direct authority for thesepublic estates, but is responsible for their supervision when the estatesare used as nucleus estate agents for smallholder development.

1.23 Development activities at provincial and district levels are handledby the Provincial Estate Crop Services (Dinas Perkebunan Daerahs = DPDs). The

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DPDs are responsible to the DGE through the administration of the provincialgovernments. Extension services to tree crop smallholders are limited by theinadequate quantity and sometimes quality of DPD personnel. The DPDs havevirtually no experience with oil palm development or cultivation.

1.24 Three other ministries involved in the oil palm industry are:(a) Trade and Cooperatives, which determines policy on product specificationand quality control; (b) Industry, which licenses processors; and (c) Finance,which, with the approval of the National Development Planning Agency(BAPPENAS), provides funds for development.

1.25 Bank Rakyat Indonesia (BRI), the Government commercial bank for theagricultural and rural sector, operates with 330 branches and 3,270 villageunits throughout Indonesia. BRI's main function is to assist the GOI withpolicies and programs to provide short-term credit to agricultural coopera-tives, farmers, fishermen and agricultural enterprises. Short-term creditsaccount for about 95% of BRI's total disbursements. BRI has gained consider-able experience in long-term credit operations under the Smallholder andPrivate Estates Tea Project (Credit 400-IND) and the Fisheries Credit Project(Credit 480-IND) and serves as channelling agency for smallholder rubber andoil palm finance under the North Sumatra Smallholder Development Project(Credit 358-IND) and the NES I, II and III Projects (Loans 1499, 1604 and1751-IND respectively). BRI has been hard-pressed, however, by the rapidexpansion of its branch and village unit network from the early 1970s whenthe BIMAS program expanded nationwide. Given its limited experience inlong-term credit operations, and the pressure to rapidly expand its creditoperations to new development areas in the Other Islands, the GOI has assistedBRI by bearing the credit risk on about 60% of its total loan portfolio. The

BRI is now being assisted in term lending and credit management procedures bya team of five consultants financed under the Rural Credit Project (Credit827-IND).

Bank Lending for Oil Palm

1.26 Government and Bank assistance for smallholder oil palm developmentis limited to one project, the North Sumatra Smallholder Development Project)for US$5 million. Although primarily for new rubber establishment, 1,000 haof oil palm was developed for about 500 families. Now nearing completion,implementation of the oil palm component has been impressive. There have beenseveral Bank loans and credits in support of planting and rehabilitation ofoil palm on estates. These include the First, Second, and Fourth AgriculturalEstates Projects, (Credits 155, 194, 319-IND respectively) and the NES I andIII loans. The recent project performance audits for Credits 155 and 194-INDrated both projects physically and financially successful.

The NES Projects

1.27 In recognition of the scarce technical and managerial expertiseavailable within GOI to implement rural development projects, GOI increasinglyseeks to utilize the untapped manpower and financial resources of the public

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sector estates to promote and guide smallholder development. To this end, GOIinitiated, in 1976, a large tree crop development program which, with theassistance of the public sector estates, will develop unutilized land for newsettlement and substantially increase rubber, coconut and palm oil productionfor export and import substitution. In support of this Government initiative,the Bank has financed three nucleus estates and smallholder tree crop projectssince November 1977.

1.28 The first two NES projects, the first of which became effective inJanuary 1978 and the second in September 1978, are sufficiently advanced toassess their effectiveness in smallholder tree crop development. Initialdelays in implementation of these projects were the result of delays in budgetpreparation and receipt of funds by the nucleus estates. These problems havebeen resolved by the Government in more simplified financial procedures withautomatic quarterly releases of funds to the nucleus estates. Smallholder andestate plantings are now on schedule. A total of 15,000 ha have been plantedto rubber, coconuts and oil palm. The standard of field development isexcellent. Less satisfactory, however, has been the rate of progress ofinfrastructure development: road building, water supply and the constructionof village facilities and settler housing. These works involve careful plan-ning and coordination of inputs from the central and provincial governmentsand the nucleus estates. In the third NES project which became effective inNovember 1979, project organization was modified to help overcome theseconstraints through delegation of greater autonomy in project implementationto the nucleus estates, and the establishment in MOA of the Team to implementNES and similar projects (para. 1.21).

2. THE PROJECT AREA

A. Project Area Description

Location and Land Use

2.01 Betung, South Sumatra (Map 14505). The project area, about16,000 ha, is located 75 km west of Palembang in Kabupaten Musi Banyuasin.The site is to the west of the PNP X estates of Tebenen and Betung and the NESI project area. The villages of Supat to the north and Teluk Kijing to thesouth border the project area. The vegetation in the project area is about65% coarse lalang grass, 30% bush and secondary jungle and about 5% old rubbertrees. The project area is virtually uninhabited, as it was reduced toexclude land holdings south of Supat as well as land holdings on either sideof the Betung-Sekayu road, and thereby avoid possible land disputes withexisting margas (community held land).

Climate

2.02 Climate. The climate is wet tropical with a mean annual rainfall ofbetween 2,500 to 3,000 mm. The normal dry period is from June to Septemberbut monthly averages are generally not below 60 mm during the driest month.Droughts have occurred about once every five years, but the mean annual

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maximum drought is 26 days. The amount and annual distribution of rainfallis therefore suitable for oil palm. Rainfall data are provided in Annex 1.The mean temperature in the project area varies from 26 to 31 degreesCentigrade and wind velocities are low, presenting no risk to tree crops.

Soils and Topography

2.03 Soils in the project area are red-yellow podzolics. It is welldrained and friable. It is a brown silty clay loam of good physical structurefrom 10 through 60 cm, below which the subsoil becomes mottled. It is acidicwith a pH of 4.7 to 5.2 and has a low availability of nutrients. It isparticularly deficient in nitrogen and phosphorus. Although heavyapplications of fertilizer will be necessary to maintain crop yields, thesoils are physically suited to oil palm development. The project area isgently undulating and dissected by many small streams running north toBanyuasin and south to the Musi River. Slopes on the valley sides are 4 to 5degrees but the broad area of the project has slopes of less than 3 degrees.As much of the flat land area as practicable will be utilized for food crops,the remainder for tree crops.

Population and Incomes

2.04 About 12,000 families or 60,000 people live within 10 to 15 km ofthe project boundary. Most farm marga land, some in units as small as40 families near Supat, to the largest with 300 families near Teluk Kijing.The amount of land available for closer settlement and intensification ofproduction is considerable. Scattered smallholders live along the road fromLais to Betung, and have an average farm size of 3 ha. These farmers grow onaverage about 50% of their family's rice requirements in addition to cassava,vegetables and fruit, but are largely dependent on tapping wild, worn-outrubber for cash income. Off-farm jobs in the area have recently beenavailable from land clearing associated with a nearby Government sponsoredtransmigration project and the NES I Project. Average annual incomes in thearea from on-farm and off-farm sources is about Rp 220,000 (US$350) per familyor Rp 44,000 per capita. At this level of income (below the absolute povertytarget level estimated at Rp 81,000 per capita) there has been littleopportunity for smallholders in the area to invest and bear the risk ofintensified food crop production or enable them to plant tree crops.

B. Existing Works and Infrastructure

Roads

2.05 A provincial highway serves the 75 km link between Palembang and theproject area. Only about 35 km of this road has an asphalt macadem surface.Road conditions for present traffic requirements are poor since drainage isinadequate and the road is badly potholed. Expected production from PNP X'srubber and palm oil factories under construction in the NES I Project and fromthe palm oil factory proposed for this project will double traffic volumes by1983. Funds have been budgeted by the provincial government to upgrade this

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road to main access road standards by 1981. The existing internal roadnetwork in the project area is poor with large sections impassible in therainy season. With the exception of 10 km of road from Lais to Teluk Kijing,upgraded in 1978 under the provincial government's INPRES program, the roads

are inadequate for the planned new settlement and transport of oil palm. Aninventory and description of existing roads in the project area is availablein Staff Working Paper No. 1.

Water Transport and Port Facilities

2.06 The Musi River borders the southern end of the project area and

PNP X's Tebenen rubber estate. River transport with barges to the Port ofPalembang for transporting palm oil and rubber is possible year round, butPNP X is likely to continue to use road transport to Palembang harbor for someyears to come. The palm oil bulking facility for PNP X is currently underconstruction at the Palembang Port. These facilities will require expansionby 1984 with additional palm oil production from smallholders in the proposedproject.

3. THE PROJECT

A. Project Formulation

3.01 The use of public sector estates is an effective means for Govern-ment to facilitate the transfer of resources and technology to smallholdersfor oil palm development. The techniques for oil palm establishment, upkeepand harvest are at present unknown to smallholders in Indonesia. In its for-mulation of the project, GOI has selected PNP X to be the nucleus estatedevelopment agent. This is appropriate since PNP X is successfully imple-menting part of the NES I Project and has an existing oil palm estate located

near the project area. Since PNP X is the only oil palm estate group operat-ing outside the traditional oil palm producing area of North Sumatra, it alsoaffords Government the opportunity to diversify, geographically, oil palmproduction and stimulate regional develpment, in particular those agro-industries reliant upon palm oil.

3.02 To alleviate problems of project implementation arising fromunsatisfactory coordination between the central and provincial governmentsand the nucleus estates as experienced in NES I and II, the proposed projectis formulated to provide greater autonomy of the nucleus estate in projectimplementation. Unlike the first three NES projects, responsibility forconstruction of village infrastructure, village roads, and water supply willbe assigned to the nucleus estate. The provincial government would continueto be responsible for the construction of specific infrastructure such asschools and health facilities as provided under provincial INPRES programs.Consistent with the need to concentrate responsibilities for project imple-mentation, the Project Manager will be the First Director of the PNP X estate.

3.03 The increasing need for settlement of formidably large numbers oflandless rural poor necessitates that the project be designed to minimize the

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cost of settlement per family and yet provide sufficient on-farm investmentto assure their successful livelihood. Farm plans for new settlement ofsmallholders provide for the establishment of 2 ha of oil palm, 0.1 ha of anintensively cultivated house garden lot, and 0.9 ha for field food cropdevelopment. To guarantee farm families an adequate income during oil palmimmaturity and provide practical training of smallholders in oil palm hus-bandry, the project is formulated to provide full-time employment of newsettlers as estate laborers for about three years after settlement. Settlerswill be paid the estate labor wage (presently Rp 725/day) during this period.After three years settlers will be given land title to operate their ownindividual oil palm and food crop land holdings.

B. Project Summary

Objective

3.04 The project's main objectives will be to: (a) provide new settle-ment for 4,000 poor, landless families on unutilized land in South SumatraProvince; (b) raise rural incomes of these families in the poverty targetgroup; (c) increase the production of oil palm to supply the rapidly expandingdomestic demand for edible oils; and (d) to reverse the declining exports andforeign exchange earnings from this shift to domestic consumption.

General Description

3.05 The main project components include block planting of 8,000 ha ofoil palm and 4,000 ha of food crop establishment for 4,000 families. Theproject includes development of 21 villages, erection of 4,000 houses, con-struction and upgrading of 92 km of village roads and the establishment of one30 ton FFB/hr palm oil mill for processing smallholder production. A blockcrumb rubber factory with a capacity of 40 tons per day will also be con-structed for 2,250 families settled under the NES I Project. The project willprovide basic health services for about 20,000 people through the Government'sprovincial health program. Primary and secondary education facilities will beprovided for about 8,000 children. Technical assistance has been included inthe project to strengthen PNP X's capacity in estate engineering and financialmanagement, and to assist the DGE with program support (short-term consultantspecialists) and start-up funds for a future NES project.

C. Detailed Features /1

Field Development

3.06 Oil Palm Establishment. Each smallholder family will receive 2 haof block planted oil palm. Land clearing of bush and secondary jungle willbe based on a combination of mechanical (crawler tractor) and manual land

/1 Cost estimates listed in the section are quoted in constant early 1980prices.

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clearing. All lalang areas will be cleared mechanically by two rounds ofplowing and harrowing at three week intervals. Together, these areas ofsecondary jungle and lalang constitute almost all the existing vegetation(para. 3.01). Land clearing costs (US$165/ha) are based on actual expendi-tures on PNP X e-c-ates and adjusted to project area conditions. PNP X willsupply high yielding germinated Dura x Pisifera oil palm planting material andwill employ smallholders as trainees to plant and maintain oil palms throughthe immature period. In Year 4 when oil palm comes into production, settlerswill be responsible for the operation of their individual holdings but willreceive guidance and training in harvesting, collection and maintenance by thenucleus estate. PNP X will also provide on-farm inputs, process smallholderoil palm and provide marketing services for smallholders.

3.07 Food Cropping and Subsistence Package. Each family will receive3 ha, a third of which will be used for subsistence food crop production.As part of a subsistence package to be supplied to new settlers, PNP X willclear 0.9 ha for field crop establishment in addition to a 0.1 ha house andgarden lot. Each family will receive an initial cash payment estimated atRp 40,000 (US$64) for food and transportation needs prior to arrival on theproject site. PNP X will procure and provide inputs for food crops includingseed and fertilizers at US$87 equivalent per family for the first year's foodcrop establishment.

3.08 Housing and Village Infrastructure. The basic design for smallhol-der housing is the Indonesian standard for transmigration houses with a totalfloor area of 36 sq m, constructed of timber with galvanized iron roofing(Figure 1). The first 570 houses will be constructed by contract and willcost about Rp 525,000 each (US$840). Thereafter, settlers will build thehouses themselves in work units under the supervision of the nucleus estate.Construction costs for the remaining 3,430 houses will be about Rp 422,000(US$675). Separate latrines will be constructed with each of these houses.In addition to the new settler housing, the project includes construction of181 houses (19 staff houses and 162 single units) for nucleus estateemployees, a new workshop, a central warehouse and five divisional offices.Civil works for processing facilities and estate housing will be built bylocal contractors employed by PNP X, while some of the minor civil works suchas garages and offices will be built by PNP X itself.

3.09 Village design and settlement planning have been based on socialfactors related to traditional community living patterns and those physicalfactors involving topography, water supply and access requirements. Theproject includes the construction of 21 villages to accommodate 190 familieseach. Settlement units will be radial in design with a central villagesurrounded by a food crop area, which in turn will be surrounded by the blockplanted oil palm area (Figure 2). House and garden lots will occupy thecircumference of the village while community facilities including healthcenter, office, market, hall, mosque and a school will be located at thecenter of the village (Figure 3). Dimensions of each of the village units andallowances for village infrastructure are explained in Annex 2 and StaffWorking Paper No. 2. The nucleus estate will have full responsibility to

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construct, or contract for construction, village offices, market buildings,mosques and recreation halls. Schools and health facilities will be builtunder the INPRES program. A preliminary master plan for settlement of theproject area is provided in Map 14503.

3.10 Roads. To ensure an adequate road network, transport requirementshave been examined in terms of initial requirements for moving heavy equip-ment, projected traffic volumes and the special road requirements for trans-porting palm oil to the proposed mill and processed palm oil from the mill tothe port. Upgrading of existing roads will provide an adequate foundationfor the network of village roads in the project. The proposed road networkto serve new villages and oil palm holdings will comprise:

(a) construction of 46 km of primary village roads of which 31 km willbe upgraded existing roads. These roads will each serve from twoto eight villages and provide direct all-weather access to the oilmill and to secondary village roads. Design standards provide fora maximum gradient of 6%, a pavement width of 6 m, with a 15 cmlaterite gravel surface, and a right-of-way of 15 m. New primaryvillage roads have been costed at US$8,500/km while upgradingto primary village standard of existing roads is estimated atUS$7,800/km;

(b) construction of 48 km of secondary village roads, each of whichwill serve from one to two villages and would be constructedto provide the shortest distance to primary village roads. Themaximum gradient will be 7%, with a pavement width of 4 m with a10 cm thick gravel surface and a 12 m right-of-way. These roadshave been costed at US$4,500/km; and

(c) construction of 105 km of farm access tracks to provide access fromfood crop areas to the village center. The dirt tracks will be3 m wide with an embankment height of 20 cm. The same standardwill be used for oil palm collection tracks included in the costsof oil palm development. The cost of these tracks has been esti-mated at US$700/km.

All road construction and upgrading will be carried out by PNP X. The roadscomponent of the project includes funds for routine annual maintenance byPNP X. Proposed alignments for the road network are indicated on Map 14504.Road cross-sections are shown in Figure 4 and the complete details of designstandards are available in Staff Working Paper No. 1.

3.11 Water Supply. Water in the project area is available from shallowwells from 2 m to 10 m deep which should be sufficient to provide a satisfac-tory water supply through most of the year. As a safeguard, a water supplysystem will be constructed with small earth dams surrounded by a number ofshallow wells. Such a system is being used satisfactorily in Baturaja, inthe Transmigration I Project (Loan 1318-IND) in South Sumatra. Water supplyfor each village in the project has been designed and costed with four earth

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dams (US$1,300 per dam) and ten shallow wells (US$160 per well) for each dam.

These civil works will be constructed by local firms contracting to the

nucleus estate.

3.12 Health. Five clinics and 16 first-aid posts will be constructed inthe project area as part of provincial government's low-cost health program

and will be operated under INPRES Puskesmas on standards for Repelita III.

This program will provide for basic health services, malaria control and

family planning.

3.13 Processing Facilities, Machinery and Equipment. Expected production

of oil palm will require the eventual completion of a 60 ton FFB/hr palm oil

mill for the project's smallholders. The first 30-ton line for this mill

which will be required by 1984 is provided for under the project. The second

stage mill will not be required until 1989 and would be eligible for financing

under a subsequent loan. A water pipeline extension of 4.7 km from PNP X's

Betung mill (NES I) will be required to provide water to the proposed mill.

The new mill will also require PNP X to expand the bulking facility at the

Port of Palembang from 3,000 tons to 5,000 tons under the proposed project.

Details of mill construction, phasing, engineering requirements, and all costs

are contained in Staff Working Paper No. 3. The project includes theconstruction of a 40 ton/day block crumb rubber factory for PNP X to process

smallholder rubber from NES I. The first 20 ton/day stage will be operational

in 1981. A water extension pipeline of 4.5 km will be required for this

proposed factory.

Technical Assistance and Program Support

3.14 PNP X. Provision is made to assist PNP X with technical assistance

for palm oil engineering and financial management (108 man-months). Given

that engineering assistance is required for the design work for factories in

the proposed project, employment of processing engineers wasa condition of

negotiations. Short-term consultant specialists and inspection services for

60 man-months will also be available to PNP X.

3.15 The DGE. About 200 man-months of consultant time will be provided

to the DGE and will include assistance for field inspection services, village

planning, land surveying, special project studies and project identification

and preparation of future NES projects. Program support for the DGE will

provide start-up capital for a future NES project in West Java (Annex 6) for

funds required by PTP XI and PTP XIII until October 1981 for nursery develop-

ment for oil palm and coconuts, initial staff housing and project buildings

and for road development to improve access to the project area. This assis-

tance to the DGE for a future NES scheme would speed later field developments

and settlement of smallholders.

Prolect Phasing

3.16 A summary schedule of project implementation is shown in Chart 3.

The physical components of project phasing are shown in Annex 3, Table 1,

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while details of phasing for mill construction, road works and villagedevelopment are available in Staff Working Papers 1-3. Project phasing hasallowed for oil palm nursery start-up and the construction of smallholderhousing, buildings and the block crumb rubber factory in late 1980 to early1981, one year prior to the first planting of smallholder oil palm. To facil-itate project start-up with early construction of initial housing and othercivil works, PNP X will utilize the NES IV preproject assistance fund (US$1.0million) allocated for the DGE in the NES III Project. In order to completethe 8,000 ha planting program with the final year's plantings of 1,540 ha in1985/86, a six-year disbursement period is proposed for the project.

D. Project Costs and Financing Arrangements

Project Costs

3.17 The project will be fully implemented over a ten-year period. The

Bank loan will assist with the financing over a six-year period. Table 3.2summarizes the costs of the project over the first six years of implementation(US$64.5 million). The foreign exchange component is estimated at US$42 mil-lion (65% of total cost). Total cost at full implementation of the projectover the ten-year period is estimated to be US$84.5 million. Government willmake available the funds required from Year 7 to project completion (US$20million). Details of the project costs are presented in Annex 3, Tables 2-5and in the staff working papers.

3.18 Base cost estimates in early 1980 prices were derived from detailedcost analyses of several public sector estates including the proposed nucleusestate PNP X. A physical contingency of 10% is allowed on all investmentitems and on the number of man-days of management consultants and isconsidered sufficient given the detail of design standards and inputrequirements as measured in other tree crop projects. The provisions forexpected price increases have been computed and are given in Table 3.1.

Table 3.1: ANNUAL INFLATION INDICES

Annual inflation rate (%)Calendar years 1980 1981 1982 1983-86

Domestic costs 15 15 10 10Foreign exchange component 9 8 7 7

An estimated schedule of project expenditures is shown in Annex 3, Table 6.Because of the tax exempt status of the implementing agencies, the projectcosts do not include provision for local, provincial or national taxes.

Table 3.2: PROJECT COST SUMMARY

% foreign % totalexchange project

Category Local Foreign Total Local Foreign Total cost cost

---- (Rp million) --- --- (US$ million --- )

I. Smallholder DevelopmentOn-farm development 4,273 3,276 7,549 6.8 5.3 12.1 44

34

Infrastructure, health, roads

others 1,116 2,327 3,443 1.8 3.7 5.5 67 15

Overheads and management 576 288 864 0.9 0.5 1.4 36 4

Subtotal 5,965 5,891 11,856 9.5 9.5 19.0 50 53

II. Nucleus Estate Processing

FacilitiesOil palm and rubber processing 430 5,518 5,948 0.7 8.8 9.5 93

26

Estate civil works/others 394 1,253 1,647 0.6 2.0 2.6 77 7

Subtotal 824 6,771 7,595 1.3 10.8 12.1 89 33

III. Program Support - DGE 1,089 2,050 3,139 1.8 3.2 5.0 65 14

Total base costs 7,878 14,712 22,590 12.6 23.5 36.1 65 100

IV. ContingenciesPhysical 788 1,471 2,259 1.3 2.4 3.7 65

-

Expected price increases 5,396 10,068 15,464 8.6 16.1 24.7 65 -

Subtotal 6,184 11,539 17,723 9.9 18.5 28.4 65 -

Total expected projectcosts 14,062 26,251 40,313 22.5 42.0 64.5 65 -

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Project Financing Arrangements /1

3.19 The proposed Bank loan of US$42 million will finance the projectestimated foreign exchange component (65%) for the first six years of projectimplementation. GOI will finance US$22.5 million of the proposed project (35%of total costs), and will bear the foreign exchange risk in the proposedproject. GOI will also provide the US$20 million required to carry out theproject in Years 7-10. Sources for all project finance are detailed in Annex3, Table 7 and are summarized in Table 3.3 below:

Table 3.3: SOURCES OF PROJECT FINANCE(US$ million)

Government of Indonesia TotalMinistry of DGE and Total estimated

Project component Finance INPRES PNP X GOI IBRD (%) cost

Smallholder development 17.0 1.0 - 18.0 17.0 48 35.0Nucleus estate processing

facilities - - 4.0 4.0 18.0 82 22.0Program support - DGE - 0.5 - 0.5 7.0 93 7.5

Total 17.0 1.5 4.0 22.5 42.0 65 64.5

3.20 Smallholder Development. All works to be carried out by the nucleusestate PNP X, including the credit items i.e. repayable by smallholders, ofon-farm development and settler housing and the noncredit items, i.e. non-repayable, of water supply, village infrastructure and project management willbe financed by the Ministry of Finance (US$17.0 million) and by the Bank(US$17.0 million). Noncredit expenditures for schools and health facilitiesas provided by provincial government agencies will be entirely financed byINPRES programs (US$1.0 million). The flow of funds for smallholderdevelopment is shown in Chart 4.

3.21 Funds for smallholder development from the Ministry of Financebudget sources will be channelled directly to the nucleus estate PNP X andmade in automatic quarterly disbursements in accordance with an approvedannual budget and in advance of the expenditures as required by the nucleusestate. Should project implementation proceed more rapidly than planned, theMinistry of Finance would, at the request of PNP X, increase disbursementsabove scheduled quarterly allocations. Bank funds will be used to reimburseexpenditures by PNP X based on the disbursement percentages for the worksas carried out (para. 3.30). The costs of development will be translated into

/1 Project costs listed in this section are quoted in current prices andinclude price and physical contingencies.

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standardized credit amounts for individual settlers in credit agreements atthe end of Year 3 when each area of oil palm has come into maturity. BRI willbe the designated handling bank for recovery of smallholder debt obligations.Loans to smallholders will be for 17 years, and will include a two-year graceperiod, with repayment starting in the sixth year after planting. Interestwill be at 10.5% p.a. and will be waived during the grace period. The GOIwill bear the credit risk on all funds onlent by the Ministry of Finance forsmallholder development.

3.22 Processing Facilities. The proposed palm oil and rubber factoriesas well as technical assistance for PNP X in estate engineering and financialmanagement will be financed from the proceeds of the Bank loan (US$18 million)and from PNP X's own funds (US$4 million). Bank loan funds will be onlent toPNP X by Bank Indonesia under the terms of a subsidiary loan agreement. Theloan will be made for 13 years, including 7 years of grace and repayable in 12equal semiannual annuities starting January 1, 1987. Interest will be 13.5%and payable from the date of signing the subsidiary loan agreement. Thesigning of this loan agreement between Bank Indonesia and PNP X will be acondition of disbursement for this project component.

3.23 Interest Rates for Onlending. Government policy is to onlend tosmallholders at 10.5% and to public sector estates at 13.5%. These rates arefixed for all such loans by Bank Indonesia. Inflation, which in 1980 is pro-jected at 15%, is expected to fall to an annual rate of 10% thereafter and itis therefore anticipated that the interest rate charged will not be signifi-cantly negative in real terms. Government policy in lending to smallholderson concessionary terms is justified since smallholder beneficiaries in theproposed project are below the absolute poverty target level and at this rate,GOI facilitates its objectives for the rural target population. Additionally,GOI assists, through interest subsidy, the expansion of key public sectorenterprises which return to GOI substantial dividends and corpQrate taxes.

3.24 Bank Loan. The Bank loan of US$42 million will be lent to Govern-ment for 20 years, including 5 years of grace at the prevailing interest rateon the date of circulation of the President's Report to the ExecutiveDirectors.

E. Budgeting

3.25 The Project Manager will prepare an annual work program and budgetincluding quarterly cost estimates for all works to be carried out by thenucleus estate for smallholder development. The Team will review and approveall annual budget appropriations on behalf of the DGE before submitting thebudget to the Ministry of Finance. The Project Manager will also beresponsible for annual budget requests for the noncredit expenditures ofschools and health facilities from the provincial government INPRES programs.The DGE will be responsible for making its own budget allocation for technicalassistance in the project. Assurances were obtained that the nucleus ProjectManager assisted by the Team will prepare an annual work program and budget byOctober 31 each year to be provided to the DGE.

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F. Procurement /1

3.26 All agricultural machinery and equipment (US$2.4 million) for oilpalm development and road construction and all processing plant machinery andequipment (US$14.7 million) will be procured through international competitivebidding (ICB) in accordance with Bank Guidelines. A preference limited to 15%of the c.i.f. price of the imported goods or the customs duty (which wouldhave been payable except for the tax exempt status of the project entity),whichever is lower, will be extended to qualified local manufacturers in theevaluation of bids. Equipment items costing less than US$30,000 could belocally procured through prudent shopping involving the solicitation of atleast three quotations. The total procured in this manner will be limited tothe aggregate amount of US$1.5 million for the project. A list of allagricultural machinery and other equipment is provided in Annex 3, Table 8.ICB in accordance with Bank Guidelines, will be used for fertilizers(excluding urea) and agrochemicals (US$4.8 million). Up to US$200,000 foragrochemicals could be procured annually following prudent shopping procedureswith at least three quotations. Since P.T. Pusri is the sole producer,supplier, and distributor for urea in Indonesia, and since world market pricesare about 50% higher than the price from Pusri, urea (US$0.5 million) will beprocured directly from Pusri or its authorized distributors and will notrequire competitive bidding.

3.27 All civil works contracts for housing, project and processing plantbuildings, and settlement infrastructure (US$9.4 million) will be awardedafter local competitive bidding (LCB). These civil works are not likely toattract foreign firms and would not be suitable for ICB since they would becarried out over a five-year period and would involve relatively small amountsof finance for individual contracts. These civil works would include thefirst 570 settler houses. Materials for subsequent houses to be built bysmallholders (3,430 units) will be procured by PNP X under LCB.

3.28 The detailed physical description of the work to be carried out toblock plant 8,000 ha of smallholder oil palm with maintenance up to threeyears (US$17.0 million excluding agrochemicals and machinery and equipment)will be governed by a Smallholder Development Agreement between the DGE andthe nucleus estate. Oil palm development involves the execution of aspecialized, integrated service of labor and machinery which cannot beprocured through a competitive bidding process. Land clearing, as part of oilpalm development, has been carried out by private contractors after LCB in theNES I Project. This was required because of delays in arrival of machinery.The proposed project will utilize the services of PNP X for land clearing tobetter coordinate all aspects of oil palm development and will not involve acompetitive bidding process. PNP X has demonstrated its ability in the NES Iand Credit 319-IND Projects to implement this type of force account work in acost effective manner. Unit cost information for oil palm development is well

/1 As quoted in current prices including price and physical contingencies.

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established and will be used to monitor financial requirements and guaranteequality control. Other works that must be integrated with oil palmdevelopment by the nucleus estate and phased over an extended period of time,will not involve a competitive bidding process. These include the initial landclearing by PNP X of a one ha food crop and house and garden area for eachfamily (US$1.0 million) and the construction and upgrading of primary andsecondary village roads and farm tracks (US$1.3 million). PNP X engineerswill carry out site surveys, plan alignments and other engineeringrequirements for these works.

3.29 Consultant specialists to be employed for PNP X (US$2.0 million)as well as all consultants for short-term contracts to the DGE, and a firmappointed by the DGE for field inspection services, (US$2.5 million) will beengaged in accordance with the Bank's Guidelines on terms and conditionsapproved by the Bank. Internationally recruited consultants are costed atUS$7,000 per man-month (including international travel, housing allowances andlocal transportation) on the basis of past experience in Indonesia. Allitems of expenditure included in start-up activities for NES V (Annex 6) asincluded in program support to the DGE (US$5.0 million) will follow the sameprocurement guidelines as outlined in paras. 3.26-3.28. The proposed alloca-tion of loan proceeds is shown in Annex 3, Table 10.

G. Disbursements

3.30 Disbursements will be made at the following rates: (a) 60% of oilpalm development expenditures including all land clearing and overheads, butexcluding agrochemicals, vehicles and equipment, as certified in quarterlyreports provided by the nucleus estate to DGE; (b) 100% of the foreign expend-itures for agrochemicals and 100% of the total cost of urea (ex-factory); (c)100% of foreign exchange cost of agricultural and processing plant machineryand equipment, 95% of the ex-factory cost of equipment manufactured locally,and 60% of imported farm equipment purchased locally; (d) 50% of the civilworks including estate housing and buildings, garages, workshops anddivisional offices; (e) 100% of the cost of all consultant specialists,inspection and technical services, and for project start-up expenditures for afuture nucleus estate project. The Bank will not disburse for settlerhousing, the provision of water supply, or for the construction and upgradingof village roads or farm tracks. An estimated schedule of disbursements isshown in Annex 3, Table 9. Documentation supporting claims for oil palmdevelopment expenditures including overheads not submitted for reimbursementwill be retained in Indonesia and made available for inspection and review byBank supervision missions (Annex 7).

H. Quality and Cost Controls

3.31 Oil palm development and all civil works in the project will bechecked for quality and cost control by the Team and its consultants. Inaddition, the DGE will appoint an independent firt for inspection services

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"para. 4.02) to certify satisfactory completion by the nucleus estate of eachyear's objectives for oil palm development and related annual expenditures.To ensure quality and cost control in development performance, the payment ofmanagement fees to the nucleus estate will be subject to a satisfactoryinspection report as provided annually by a firm appointed for inspectionservices. The fee will be payable at the rate of 5% of the direct expendi-tures of oil palm development excluding machinery and equipment. Constructionof the new palm oil and block crumb rubber factories would also be subject toinspection for quality by an independent firm appointed by the DGE.

I. Accounts and Audit

3.32 PNP X maintains NES I project cost accounts for smallholderdevelopment expenditures as well as its own corporate accounts. Project costaccounts are well kept and no change in the format for these accounts would berequired for the proposed project. PNP X will maintain separate accounts forexpenditures channelled to the nucleus estate by the Ministry of Finance forNES IV smallholder development and will furnish this account as part of aseparate quarterly report to the DGE and the Bank within 30 days of the closeof each quarter. Cost accounts for smallholder develpment in NES I were tohave been audited by state auditors but PNP X presently has these accountsaudited annually by a firm of private commercial auditors in conjunction withthe audit of its own accounts. These audits have been satisfactory to boththe GOI and the Bank. Auditing has been facilitated since the accounts of thePNP/PTPs are now standardized and prepared with uniform guidelines, thedevelopment of the system having been financed under the NES I Project.Assurances were obtained that both the accounts for smallholder developmentand accounts of PNP X would be audited by independent auditors acceptable tothe Bank and the audit reports would be submitted to the Bank within fourmonths of the close of each fiscal year.

4. ORGANIZATION AND MANAGEMENT

4.01 The Borrower will be the Government of Indonesia. The DGE will haveoverall responsibility for execution of the project. Smallholder developmentwill be implemented by the nucleus estate PNP X and the First Director ofPNP X acting as Project Manager, with assistance of central governmentagencies and the provincial government of South Sumatra. Development ofprocessing facilities and estate civil works will also be the responsibilityof the First Director of PNP X who will receive guidance and supervision fromthe Support Staff Unit in the MOA for these estate activities. Coordinationof these activities with smallholder development would be the responsibilityof the DGE and its Special Team for Externally-Assisted Projects. Projectorganization is shown in Chart 5.

4.02 Special Team for Externally Assisted Projects. This Team willoversee project implementation on behalf of the DGE (para. 1.21). The specificfunctions of the Team will include assistance to the nucleus estate and

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Project Manager in preparation of annual work programs and budgets, assistancewith financial administration and guidance in technical and engineeringrequirements for the project, and for project procurement. In practice, theTeam will assist the Project Manager with the administrative aspects ofprojects required at the central government level. The Team will also haveresponsibility for project monitoring and evaluation, including the annualinspection services for field development. To ensure effective monitoring, anassurance was obtained that the DGE will employ consultants to provideinspection services and regular progress reports on implementation of allproject components.

4.03 Nucleus Estate PNP X. Full authority will be given the nucleusestate PNP X to establish settler smallholdings, village infrastructure, roadsand processing facilities. As a condition of disbursement, a SmallholderDevelopment Agreement will be made between the DGE and the nucleus estatefor oil palm development, extension, processing and marketing services. Underthe terms and conditions of this agreement, the nucleus estate will beresponsible for the following services:

(a) For the Immature Period (three years). Land clearing (3 ha); plant-ing and maintenance of 2 ha of oil palm; procurement and applicationof inputs for oil palm development; siting of housing and villagesand procurement and supply of materials for settlers' houses;development of village infrastructure excluding education and healthfacilities; water supply; construction and maintenance of primaryand secondary village roads and oil palm and farm access tracks; theprovision of food crop seed and fertilizer in the first year ofsettler entry, and initial cash payments to settlers. PNP X willalso be responsible for employment of one member per family of allsettlers and for all smallholder training; and

(b) During the Productive Period. Smallholder training in oil palmharvesting and extension services, collection of FFB for processingand loan repayments, and the provision of marketing services.

PNP X has been selected to carry out these responsibilities since it hasdemonstrated its ability in smallholder development in the NES I Project andis one of the most capable of the Indonesian rehabilitated estates, havingreceived IDA assistance in the Fourth Agricultural Estates Project(Credit 319-IND of June 1972). GOI now wishes to grant greater autonomy toPNP X in estate management, development planning and financial administration.By converting PNP X to PTP X, operating as a state-owned enterprise withlimited liability, PNP X would be placed on a more competitive commercialbasis with revised taxation and dividend policies. The conversion of PNP Xto PTP X will be a condition of disbursement against the estate developmentcomponent of the project.

4.04 Prolect Manager. Project management proposed for NES IV representsa departure from previous NES projects. In order to concentrate fullauthority in the nucleus estate for project implementation, consistent with

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the need to grant greater autonomy to PNP X, the First Director of PNP X willbe made the Project Manager and will supervise and coordinate all projectactivities. To assist the Project Manager, the nucleus estate will appointone of its estate managers as site manager for the new project area. The sitemanager will ensure that the inputs required from the estate for smallholdersettlement, processing and marketing, do not inhibit the progress of projectimplementation.

4.05 The Provincial Government. The provision of health, education andsocial services will be the responsibility of the provincial government. TheChairman of Bappeda assisted by the Project Manager will be responsible forcoordinating local government INPRES programs for the construction of healthand educational facilities with the arrival of settlers. The ProvincialMedical Officer for the settlement area will ensure malaria control by theKabupaten health administration including supplies of DDT, chloroquine, andhouse spraying before settler arrival. Mother and child health care,including nutrition and family planning will be provided under existing GOIprograms.

4.06 Provincial Coordinating Committee (PCC). A PCC was formed in SouthSumatra province to implement the NES I Project. With the exception of thenew Project Manager the PCC for NES I will also serve this project. The PCChas for its membership, the Bupati, the head of the Dinas Perkebunan Daerah(Deputy Chairman), the Project Manager, the Nucleus Estates Site Manager, thehead of the provincial BRI and representatives of provincial governmentagencies.

4.07 The functions of the PCC will be to:

(a) secure and provide INPRES projects (schools and health facilities)for settlers within the project area;

(b) arrange for recruitment of prospective settlers for the projectto be approved by the Project Manager as suitable estate laborers;

(c) expedite the granting of land title to settlers.

4.08 Bank Rakyat Indonesia. A description of BRI is provided inpara. 1.25. BRI has been selected as the handling bank for recovery of small-holder debt obligations. BRI would enter into smallholder credit agreements,on behalf of the Borrower, with project settlers three years after settlementand will receive repayments on these credits from the nucleus estateprocessing smallholder oil palm. BRI will receive a handling fee for settlerloan administration of 1% or less on the outstanding loans.

4.09 Directorate General of Agrarian Affaris (DGA), Ministry of HomeAffairs. Land certification will be made by the DGA. The issue of grantingcertificate of land title (Hak Milik) requires a detailed plot survey whichwill be the responsibility of the provincial and district offices of Agraria.Hak Milik will be conveyed to those settlers whose performance has been judged

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satisfactory after working for three years as laborer/trainees in the oil palmarea developed by the nucleus estate. In agreement with the Project Manager,each smallholder family, upon arrival, will obtain the right to use 1 ha forfood crops (house, garden and food crop area). Land titles conveyed at theend of Year 3 will be retained by BRI as security for settlers' debts.

4.10 Settler Selection. In the initial years of the project, settlerswill be selected from landless families living close to the project area.TWhen these families have been accommodated, selection will be extended tolandless families in the greater Palembang area, and finally to transmigrants.Families with male heads of households between 20-40 years of age with familyincomes below Rp 250,000 (US$400) will receive first priority. Recruitmentand registration of potential settlers will be the responsibility of the PCCbut final selection will be the responsibility of the Project Manager todetermine the suitability of potential settlers for estate labor.

5. DEMAND AND MARKETS

A. Palm Oil

Demand and Consumption

5.01 Over the last decade there has been a significant shift in consump-tion of fats and oils away from animal fats in favor of vegetable oils.Between 1960 and 1978, world consumption of fats and oils expanded steadily atan average annual rate of increase of 3.6%, while the world's rate of increasein consumption of palm oil has grown at over 6.0% p.a. Although the overalldemand for fats and oils is inelastic, demand for palm oil is highly elasticdue to its substitution for other edible oils. During the decade ahead (1980-90) supplies of fats and oils are projected to grow at a slightly faster ratethan demand. An increasing share of the fats and oils supplies will come fromsoybeans and palm oil. The low price of palm oil strengthens its competitiveposition relative to many other oils. World palm oil production is expectedto increase from the present level of 4 million tons to 7.9 million tons by1990. Indonesia, which currently accounts for 16% of the world's productionof palm oil is expected to produce 23% of the world's palm oil in 1990.

5.02 Palm oil has been an Indonesian export crop, accounting for 85% ofproduction on average over the last five years. In addition to exports ofcrude palm oil, Indonesia has exported on average about 50% of its palmkernel production and 70% of all palm kernel oil processed locally. Thelargest export market of Indonesian palm oil, kernels and kernel oil has beento European countries, accounting for about 40% of Indonesia's exports. Thesmall proportion of palm oil sold locally has been fractionated and sold forcooking oil. Indonesia has been able to export the majority of its palmoil and obtain higher prices on the world market since it has traditionallyused its domestic production of coconut oil for domestic requirements foredible oils. Supply of coconut oil, however, has not kept pace with demand;coconut oil production in 1978 was 580,000 tons, the demand for edible oils,

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798,000 tons. Indonesia has had to import coconut oil to meet its demand foredible oils. Coconut oil imports are extremely costly since world marketprices are about 50% higher than the regulated domestic price. To meetpresent and expected deficits in edible oil requirements, GOI through theMinistry of Trade and Cooperatives has taken action to regulate and divertpalm oil and palm kernel oil to the domestic market. The GOI program tosubstitute coconut oil with palm oil to meet the deficit is summarized inTable 5.1.

Table 5.1: PROJECTION OF COCONUT OIL DEFICIT ANDUTILIZATION OF PALM OIL

('000 tons)

1979 1983 1985 1990

Coconut Oil Deficit 280 394 438 550

Palm Oil (crude oil equivalent)Production 568 808 991 1,558Domestic requirement /a 300 492 522 683Available for export 268 316 469 875

/a For fractionation to palm olein, palm stearin, together withpalm kernel oil to supply coconut oil deficit.

This substitution reduced exports of palm oil from the 1978 level of398,000 tons to 268,000 tons in 1979. All palm kernel oil is now locallyconsumed. The long-term forecast is that about 50% of palm oil productionwould be diverted to the domestic market.

Price Outlook

5.03 World Prices. A slight decline in real prices of fats and oils isprojected during 1980-90 as a result of increasing world supplies of fats andoils moving slightly faster than the rate of demand and an expected decline inthe market potential in developed countries. The level of palm oil pricesrelative to other fats and oils depends on the share of palm oil in total fatsand oils exports. The effect of increased supply of fats and oils on palm oilprices is aggravated by the fact that the market for soft oils (soybean oil,cottonseed oil, corn oil) expands faster than the market for hard oils(coconut oil, palm kernel oil, palm oil). Although it is physically possibleto substitute hard oils for soft oils, the rapidly growing output of hard oilscan be marketed only at lower prices than those of soft oils. A price dif-ferential, therefore, of about 20% between palm oil and its main competitor,soybean oil, has been assumed in Bank commodity forecasts by 1985. Inter-national palm oil prices (c.i.f. Europe) are expected to increase from the

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present price of US$611 per ton (constant 1980) to 1982 and then decline toUS$615 per ton by 1985. In 1990, the price for palm oil is projected atUS$594 per ton, about 97% of the present level.

5.04 Domestic Prices. Palm oil is now sold in Indonesia at a price about50% below this world market price; the current domestic price is US$316/ton.This price is fixed by the Ministry of Trade and Cooperatives and is based onaverage production costs in Indonesia and maximum producer profits on palm oilof 33%. Similarly, the GOI has controlled profits on exports by imposinghigher palm oil export taxes. In addition to the 5% export tax, Governmentrecently imposed a new variable tax (the PET tax) based on the margin ofprofitability in oil palm production. Total taxes on palm oil are nowequivalent to about 26% of the c.i.f. price. With rising costs of productionand declining world palm oil prices, it is expected that the GOI will nolonger impose the additional tax on palm oil producers by 1984.

5.05 Smallholder Palm Oil Prices. Smallholder production of oil palmresulting from the project will be processed for crude palm oil by PNP X andshipped to Jakarta for fractionation to supply palm oil products to thedomestic market. The present domestic price of palm oil at US$316/ton is tobe increased to US$385 in the near future. Based on the GOI price fixingformula for domestic sales of palm oil and expected oil palm production costsin the next few years, the domestic price is estimated to be US$405/ton in1985 (constant 1980) when smallholder oil palm would come into production.The maximum price payable to smallholders for their production after proces-sing, transport, port charges, depreciation and overhead costs would beequivalent to about 50% of the f.o.b. value of palm oil or Rp 38/kg FFB(constant 1980)(Annex 5, Table 1). Since Government seeks to ensure maximumbenefits for smallholders in the project, an assurance was obtained that thenucleus estate will pay project farmers for their FFB, a price equivalent to50% of the prevailing f.o.b. price for palm oil subject however to adjustmentfrom time to time for cases where there is a large variation in oil content offresh fruit, or significant changes in the collection processing or marketingcosts of the nucleus estate processor.

B. Food Crops

5.06 The farm plan proposed for new settlers is based on oil palm. Foodcrops produced by oil palm smallholders in the project would be largely forfamily consumption of such staples as upland rice, groundnuts, cassava, andbeans, and some vegetables and fruits produced from garden lots. In theevent small family surpluses of food crops develop in later years of theproject, no problems in marketing of these crops is envisioned. Food cropsfrom the Betung area are marketed in towns and villages on route to Palem-bang; there is a ready market for cloves and coffee in Palembang.

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6. AGRICULTURAL PRODUCTION, FARM INCOMES AND COST RECOVERY

A. Crop Recommendations

6.01 Oil Palm. Planting material will be high-yielding germinated Durax Pisifera, produced by the PNP/PTP-owned Marihat Research Station in NorthSumatra. Pre and main nurseries will be established using polybags at thePNP X nursery site on the Musi River. A leguminous cover crop will bebroadcast prior to planting oil palm. The density of planting will be 143plants per ha in a spacing 9 m x 9 m (triangular system). Planting materialwill be between 10 to 12 months old.

6.02 Production and Harvesting. It is anticipated that assisted polli-nation will be necessary during the first 4 to 5 years of production. Thenucleus estate will train smallholders in this operation and in weedingpractices and lalang control. Training for harvesting will be organized ineach village unit and harvesting will be done weekly. Each village unit with190 smallholders will be divided into six groups of 32 smallholders each.Groups of smallholders will have fixed days for harvesting their 2 ha fieldareas to ensure regular harvesting and efficiency in transport. Fulldetails are given in Staff Working Paper No. 3.

6.03 Food Crops. The first year package of food crop inputs for eachnew settler family in Betung will be supplied by the nucleus estate.Planting material and food crop inputs will be supplied on a cash basis bythe nucleus estate in subsequent years. No difficulty is perceived insmallholders purchasing planting material and other inputs since incomesfrom estate employment will be sufficient to meet these requirements.

B. Yields, Production, and Farm Incomes

6.04 Oil Palm. Although production of smallholder oil palm has beenassumed in the fourth year after an immature period of 36 months, it isexpected that harvesting of minor amounts would start 30 months afterplanting. Peak yields at maturity (Year 9) are estimated at 17 tons FFB/ha(Annex 1, Table 5). Comparable estate yields will be 21 tons FFB/ha. At thepeak month of production, the maximum total bunch weight to be harvested bysmallholders will be about 1,300 kg/day. High quality oil will be produced byensuring correct timing of harvest, careful handling, and rapid transport offresh fruit bunches to the mill.

6.05 Food Crops. The house garden lot will comprise fruit trees,vegetables and small amounts of cash crops. On the subsistence food croparea (0.9 ha), yields are expected to reach 1.6 tons/ha for padi; 12 tons/hafor wet cassava, and 8 tons/ha for sweet potatoes. Inorganic fertilizersand compost will be used to obtain projected yields. Prices for food cropproduction used in estimating smallholder incomes are included in Annex 4,Tables I and 2. The farm family labor availability and labor requirementsfor food crop production are given in Annex 4, Table 3.

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6.06 Farm Incomes. Farm incomes for settlers are summarized below.Family incomes are shown in constant 1980 prices, deflated from currentvalues where appropriate to reflect the projected payments for debt serviceand the relative price changes between palm oil and the cost of production.

Table 6.1: FARM INCOME - BETUNG OIL PALM SMALLHOLDERS

Year3 10 15 20 25…------ (Constant 1980 US$) --------

Gross value of production of:Food production (1 ha) 408 563 638 638 638Oil palm (2 ha) - 1,904 1,824 1,702 1,337

Total costs of production /a 195 443 450 444 426Net on-farm income 213 2,024 2,012 1,896 1,549Nucleus estate employment 331 - - - -Total income 544 2,024 2,012 1,896 1,549Debt repayments - 266 250 - -Net income 544 1,720 1,753 1,887 1,540Income without project 350 350 350 350 350Incremental net income 194 1,370 1,403 1,537 1,190

/a Includes Ipeda tax.