Document of

The World Bank

FOR OFFICIAL USE ONLY

LAl 2'3a-,tJ

Report No. 7091-HU

STAFF APPRAISAL REPORT

THE HUNGARIAN PEOPLE'S REPUBLIC

AGROPROCESSING MODERNIZATION PROJECT

April 11, 1988

Europe, Middle East and North Africa Region

Country Department IVAgriculture Operations

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

US$1 = Forint 46Ft 1 US$0.02

WEIGHTS AND MEASURES

1 liter 0.908 quart1 hectoliter = 100 liters1 hectoliter _ 3.53 cubic feet1 metric ton = 1,102 short tons1 kilogram = 2.2 pounds

ABBREVIATIONS AND ACRONYMS

AGROBER - Agricultural Construction and Engineering FirmAKI - Research Institute of Agricultural Econom-,csBCB - Budapest Credit BankCCB - Commercial and Credit BankEEC - European Economic CommunityHCB - Hungarian Credit BankHUNGEXPO - Agency for Trade Fairs & Export PromotionKOMPLEX - Agroindustrial Equipment Foreign Trading CompanyKOPINT - Institute for Market ResearchMEM - Ministry of AgricultureMT - Ministry of TradeNBH - National Bank of HungaryNPO - National Planning OfficeUHFI - University of Horticultural and Foud Industries

FISCAL YEAR

January 1 - December 31

FOR OFFICIAL USE ONILY

HUNGARY

AGROPROCESSING MODERNIZATION PROJECT

Table of Contents

Chapter Page No.

LOAN AND PROJECT SUM MARY. .. . .i-iv

I. INTRODUCTION . . . . . . . . . . . . . . . . . . . . 1

II. BACKGROUND ON AGROPROCESSING . . . . . . . . . . . .2

A. Sector Overview. . . . . . . . . . . . .* . .2

B. Export Performance . . . . . . . . . . . . . . .3

C. OrganiLation and Firm Size . . . . . . . . . . .5

D. International Competitiveness . . . . . . . . .6

E. Linkage with Government's Reform Program . . . . 6

III. POLICY AND INSTITUTIONAL ISSUES . . . . . . . . . .8

A. Sector and Subsector Development Strategies . .8

B. Trade-Related Issues . . . . . . . . . . .... 11

C. Financial Issues .... . . . . . . .. . .13

D. Institutional Issues . . . . . . . . . . . . . .17

E. Impact of Bank Lending in Agriculture . . . . .19

IV. THE PROJECT . . . . . . . . . . . . . . . . . . .. 20

A. Concept, Design and Objectives . . . . . . . . .20

B. Project Description . . 0 . . .. . .. .. .21

C. Cost and Financing . . . . . . . . . . . . . . .22

D. Procurement . . . . . . . . . . . . .24

E. Bank Loan Allocation and Disbursement . . . . .26

F. Envirormental Impact . . .t . . . . . . . .27

V. PROJECT IMPLEMENTATION . . . . . . .. ..28

A. Organization of Implementation . . . . . . . . .28

B. Intermediary Banks . . . . . . . . . . . . . . . 30

C. Subloan Criteria and Onlending Terms . . . . . .31

D. Technical Assistance and Training . . . . . . .32

E. Reporting and Auditing . . . . . . . . . . . . .35

This report was prepared by Wayne Ringlien (mission leader), Franco Lucca,

Vance Pulley (Bank) and James Tustin (Consultant).

This document ha a restricted diribution and may be used by recipients only In the peorfoman

of their official duties. Its contents may not otherwise be dbclosed wkhout Wordd BDnk authodrtion.

Chapter Page No.

VI. FINANCIAL RESULTS, PRODUCTION AND MARKETS . . . . . . . 36

A. Financial Results.. . . . . . .... . 36

B. Production . . . . . . . . . . . . . . . . . . . . 39C. Marketing and Markets . . . . . . . . .. a .. 40

VII. JUSTIFICATION AND BENEFITS . . . . . . . . . . . . . . . 44

A. Results of Economic Analysis . . . . . . . . . . . 44

B. Major Risks . . . . . . . . . . . . . . . . . . . . 47

VIII. AGREEMENTS AND RECOMMENDATIONS . . . . . . . . . . . . . 47

ANNEXES

1. Export Market Performance for Selected Products

2. Barriers to Entry into EEC Market3. System of Prices, Taxes and Subsidies4. Financial Ratios for Selected US and Hungarian

Agroprocessing and Wood Processing Subsectors for 1986

5. Financial Projections for Poultry, Processed Fruits

and Vegetables, Wine, and Wood Products to 1995

6. Subsector Grading and Quality Control7. Food Industries Research and Development Facility8. Management and Marketing Training9. Issues concerning Feeder Industries10. Detailed Cost Table11. Estimated Disbursement Schedule for Bank Loan

12. Business Plan at EnterpriLe Level13. Swmnary of Projected Financial Statements

- Commercial and Credit Bank- Budapest Credit and Development Bank- Hungarian Credit Bank

14. Active Market_ng Component15. Specific Product-Market Export Prospects16. Selected Documents Available in the Project File

MAPS

IBRD 19989 - Location of Potential Project Enterprises

IBRD 19990 - Location of Raw Material Supply

- I -

HUNGARY

AGROPROCEING MODERMZATION PROJECT

LU and Proi ummt

Barrower. National Bank of Hungary (NBH)

Guarantor Hungarian People's Republic

About 70 agroprocessing and wood processing enterprises

Aimount: US$70 million equivalent

Terum Fifteen years, including three years grace at thestandard variable interest rate.

OkffleadiM Tern= US$64.5 million of the proposed loan would be onlentthrough intermediary banks to state enterprises andcooperatives for a maximum period of 10 years,including a maximum of 3 years grace. NBH will onleudthe loan proceeds to intermediary banks at theprevailing Bank rate plus a 20X mark-up which includesa fee for the foreign exchange risk to be borne by NBH,or at its rediscount rate, whichever is higher. Atpresent, NBI would make the funds available to thebanks at its rediscount rate, which is currently 10.5land therefore higher than the Bank's current interestrate plus a 20S mark-up. US$5.5 million equivalentwill be lent to Government and its agencies forfinancing marketing, training, research anddevelopment, packaging and quality standards andgrading of raw materials and processed products on thesam term as the Bank loan.

Proeot The objective of the project is to increase exportearnings of processed agricultural products,particularly, to the convertible currency market, byimproving their quality and to improve the efficiencyof operations of enterprises in the agroprocessingsector by reducing their unit costs of operations andimproving their productivity. The project would alsosupport training and technical services in order toprepare managers of the enterprises to become directlyinvolved with the marketing and sale of products totheir customers. Based on completed export marketstudies and the results from a workshop on marketingand technology held in Budapest in June 1987,enterprises would develop product and market strategieswhich would indicate the type of investment required bythem over the medium-term for improving product quality

-ii-

and increase market penetration. Equipment tomodernize processing lines, packag4;g, canning,bottling, chilling, freezing and cold storage would bethe major areas for plant improvement under theproject. The improvement of feeder industries whichsupply goods to agroprcoessing plants would also beencouraged under the project. Project componentsinclude institutional strengthening of existing effortsin research and development, grading and settingproduct standards and of new efforts in packagingtechnology and testing of final product quality. TheMi"istry of Trade would establish in Hungexpo anagro-marketing office for export trade promotion andmarketing to provide export and marketing services toenterprises.

Proiect BeneritsarA Risks: The economic benefit would be a restructuring of the

most important agroprocessing enterprises in thecountry toward those products in which Hungary has thebest export market possibilities. The project wouldimprove the marketing and technology of processed foods

and wood which would improve their quality and reducecosLs of production. Agroprocessing enterprises wouldfight to retain their existing markets of productsalready under production, while at the same timedevelop new products and the skills to package andmarket them so that additional agroprocessing productswill be sold on the export market, and thus, increasethe foreign exchange earnings to the country. Theproject faces three sets of risks: (a) at the macrolevel, policy and institutional reforms may lack theintensity and sequencing required for movements towardsa market-oriented system. The risk is being minimizedby the current Government commitment and the ongoing,continuous dialogue between the Bank and Hungarianofficials on policy and institutional reforms; (b) atthe micro level, traditional practices may delay theresponse by managers and employees of productiveenterprises to the freeing of prices and reduction incorporate taxation and subsidies. Supporting servicessuch as export trade promotion, raw material and finalproduct grading system, research and development, andtraining will help to accelerate changes in thebehavior of managers; and (c) at the internationallevel, unfavorable terms of trade and tariff andnon-tariff barriers may limit Hungarian exporters'ability to increase sales abroad. Apart from theimport tariffs and the specific regulation regime underits Common Agricultural Policy, export opportunities tothe Comminity are also limited by the general status ofproduction and imports in the EEC, and in someproducts, the market shares of Hungary are already so

-iii-

high, or the porportion of extra-EEC imports in total

trade is so low, that large incremental exports are

likely to be difficult. But, in spite of these

constraints to trade, Hungary's overall performance in

the EEC market showed improvement between 1980 and

1987. Hungarians can cope with thesu exogenous factors

by imk,roving the quality and servicing of their

products; the signing of a trade agreement, which

is

under active consideration with the EEC, is also

expected to improve access to EEC markets. Finally,

environmental risks of water and air polluW.ion are

reduced as enterprises are finding it more economical

to install pollution control devices rather than pay

the charges, assessed by Government for pollution.

Estimated Costs:Local /a Foreign

Total

----------(US$ Million)-

Wine & Fruit Juice 17.8 16.9

34.7

Processed Vegetables & Fruits 11.6 12.2

23.8

Poultry 28.1 28.5

56.6

Wood Processing 11.9 17.0

28.9

Technical Assistance 3.2 5.5

8.7

Marketing 1.3 6.2

7.5

TOTAL 73.9 86.3

160.2

/a Including an estimated US$32.8 million of taxes

and duties.

Financing Plan:

Local ForeiRn Total

----------(US$ Million)-

IBRD - 70.0

70.0

Government 3.2 -

3.2

Commercial Banks 36.8 16.3

53.1

Project Beneficiaries 33.9 -

33.9

TOTAL 73.9 86.3

160.2

- iv -

Estimated Disbwments:

IIRD FY1989 1990 1991 1992 1993 1994

-----------(s(S$ Million)

Anual 8.0 12.0 15.5 15.5 11.0 8.0Cumulative 8.0 20.0 35.5 51.0 62.0 70.0

MAPS: IBRD# 19989IBRD # 19990

Economic Rateof Return Average of 33S per investmaent with ranges between 16S

and 57%

HUNGARY

AGROPROCESSING MODERNIZATION PROJECT

STAFF APPRAISAL REPORT

L INTRODUCTION

1.01 The three agricultural projects in Hungary financed by the World

Bank to date have concentrated mainly on grain production and storage,

livestock production and export marketing, and farm mechanization, with major

emphasis on upgrading deteriorated and obsolete equipment at the farm as well

as the agroprocessirg levels. As part of the macroeconomic dialogue on

economic reform, the Bank is becoming more strategically involved with policy

analysis in the agricultural sector, which is being implemented by the

Ministry of Agriculture (MEM) and its related agencies. The proposed project

grew out of the dialogue to respond to the urgent need for Hungary to expand

its earnings from convertible currency exports of agricultural and

agroprocessed products on an increasingly competitive world market. The

objectives of the project comrlement the restructuring of the industrial

sector which is underway with the assistance of a series of Bank-financed

industrial sector loans, two of which are under implementation.

1.02 The proposed Agroprocessing Modernization Project seeks to increase

the country's foreign exchange earnings by reorientating the operations of

agroprocessing firms, especially the large ones, toward those products which

present the best opportunities on the export market (paras 6.09-6.25), while

at the same time seeking concrete ways in which enterprises can reduce their

costs of production and increase the productivity of capital and labor. In

order for those desirable changes to occur, Government will need to intensify

the implementation of key economic reforms in the critical areas of reduction

of subsidies to loss-making enterprises, trade, investment, wages and credit

as well as permit enterpri¶.e managers increased financiai autonomy and

responsibility for operational matters. At the agroprocessing enterprise

level, it is necessary to introduce modern business planning regarding

product/market strategies, technology, management tools of analysis and

effective organization. Under the project, enterprises are expected to be

responsible for their own profits or losses but will be supported by expanded

and improved services of export trade promotion, training in management and

marketing, grading and quality control of raw materials as well as final

products and research and development.

1.03 The project was appraised in October/November 1987 after two

detailed preparation vmissions (November 1986 and February 1987) which included

the completion of international market studies by country and by product, a

workshop on marketing and technology (June 1987) of international caliber and

the preparation of five subsector strategy reviews in poultry, processed

fruits and vegetables, wine, fruit juices, and wood processing, which were

carried out by a joint expatriate-local venture cf A.L. Little (US) and

Szenxor (Hungary), consulting companies under contract with MEM.

- 2 -

II. BACKGROUND ON AGROPROCESSING

A. Sectoral Overview

2.01 Over the past two decades the Hungarian agroprocessing sector hasplayed an important role in the country's development. The agricultural,

including agroprocessing, and forestry sectors accounted for 20Z of GDP, 22Z

of employment and 30% of convertible currency exports; it is a "hard" currency

sector since it earrs about 30% of all convertible-denominated trade to the

country; and only 18% of all ruble-denominated trade as opposed to

manufacturing which earns the same share of convertible currency, but accounts

for over 75% of ruble-denominated trade. Agriculture, in the mid-to-late

1970s, received a substantial chunk of investment which was associated with

some technical and organizational changes at the enterprise level; it

sustained agricultural growth at 3.7% p.a. from 1970 to 1982. Since 1982,

however, average annual growth in agricultural GDP has slowed considerably.

While a large part of the recent stagnation in agriculture is weather and

external-market determined, the simultaneous occurrence and persistence of

sevreral factors has served to highlight certain critical issues which have to

be faced. They broadly cover three areas of activity:

a) renewal of capital stock for productive subsectors which havesupported significant depletion because of the tight demandmanagement policies adopted since 1979;

b) complicated pricing, taxation and subsidy measures and thecomplex financial influence exercised by government over state

farms and enterprises and, to a lesser extent, over thecooperatives; and

c) need for restructuring of farms and enterprises in order toimprove their efficiency and performance, particularly, withreference to exports.

These broad themes which cover the agricultural sectGr as well as the

agroprocessing sector are being pursued by the Bank as the key discussion

points with Government.

2.02 During the 1970s, the agroprocessing sector continued to produce

traditional goods under the assumption that increasing volumes could

compensate for declining world prices grew at an average rate of 4.5% p.a.

which lagged behind overall industrial growth. This growth rate was partly

attributable to the decision by Government to expand the agroprocessing sector

under the Fifth Five-year Plan (1976-81) in order to increase the country's

capacity to further process primary agricultural production, which had

expanded rapidly during the early 1970s. In 1981-87, however, growth slowed

down in the manufacturing sector (1.6Z p.a.) as well as in the agroprocessing

sector (1.4% p.a.). Severe winters, droughts and the price collapse of some

of Hungary's majoz export products (meat, wheat and vegetable oil) in

international markets contributed to this decline. Wood-processing industries

showed a similar pattern in that this rates of growth was relatively high

- 3 -

(6.21 p.a.) in the 1970s, but fell in the 1980s (-1.0% p.a.) mainly due to a

15% p.a. decline in the prices of sawn wood and plywood, reflecting a major

decline in construction on the domestic as well as their export markets. The

subsectors which stand out as the best performers during the 1980s in the

agroprocessing sector, in terms of annual growth rates greater than the 4%

p.a. were distilling and starch, beer, vegetable oil, and poultry. Declines

were experienced in the five subsectors of: meat, wheat milling, sugar,

confectionaries and wineries.

B. Export Performance

2.03 Hungarian exports of agroprocessed products amounted to about

US$1,200 million both in 1986 and 1987, which was about two-thirds of

agricultural exports; the agricultural sector as a whole accounted for 201 of

total exports from the country. The most important markets for Hungarian

agricultural and agroindustrial products are socialist countries, primarily

the CMEA. These markets account for over 532 of sales revenue in the sector

compared to 40% from sales to developed capitalist countries and 6% from those

to developing countries. Sales revenue from exports of agricultural products

nevertheless represents an important source of convert ble foreign exchange --

251 of the total for the economy. During the 1980s, an average two-thirds of

the foreign exchange earnings generated in the sector were denominated in

convertible currency and about one-third was denominated in roubles.

2.04 The apparent contradiction between the large market share held by

the CMEA and high proportion of convertible currency-denominated trade in

agriculture is explained by the fact that a portion of Hungary's exports to

the CMEA are denominated in dollars rather than transferable rubles. Although

the proportion of total Hungarian exports to the CMEA that are denominated and

cleared in convertible currency was only 20% in 1985, the corresponding

proportion for agriculture was 462. In 1986, data shows substantial

deterioration for Hungary with only 331 of agricultural trade with socialist

countries denominated in convertible currency. One notable contributor to the

trend was the poultry subsector which received much less favorable treatment

on exports to other CMEA countries in 1986.

2.05 Although agroprocessed exports stagnated from 1983-85, they have

expanded at an impressive average annual rate of 4.81 during the period

1979-1986. This exceeded the rate of growth in total exports, which was only

2.61 p.a. Agricultural exports enjoy large subsidies from the Government --

as much as 341 in 1987 for sales to non-CMEA markets and perhaps even higher

on sales to the CMEA, depending on the domestic price which Hungarian export

enterprises could receive for their products.

2.06 The most important agroprocessing export commodities are processed

meat products including poultry, which accounted for about one half of sales

of agroprocessed exports in 1986. Sizeable, but considerably lower

contributions to exports were made by beverages, tobacco and other products

(201), canned fruit3, vegetables and spices (191) and vegetable oil (91).

Baking, milling, sugar, confectionaries and sweets represented only negligible

components of agroprocessing exports. As for the products covered by the

proposed project, Table 1 below shows that these groups accounted for US$ 693

million equivalent in 1986.

Table 1: EXPORT VALUE OF SELECTED PRODUCT GROUPSIN AGkOPROCESSING AND WOOD-PROCESSN!¢G

Total S growth/decline

Product Group 1984 1985 1986 between 1084-86

---- (in US$ '000)----

Poultry and Products 203.3 201.8 243.4 19.7

Wine 187.2 193.7 149.4 -20.1

Processed Fruits 68.1 79.5 93.9 37.9

Processed Vegetables 93.0 119.1 139.9 50.4

Pulp Wood 31.4 35.2 39.1 24.5

Parquet Flooring 7.2 7.4 9.9 37.5

Sawn Wood 7.6 7.1 8.4 10.5

Plywood, Veneers, Logs 5.3 6.1 8.9 67.8

for ProcessingTOTAL 603.0 649.5 692.9 14.9

Source: Hungarian Trade Yearbook, Budapest 1984-86.

2.07 All of these product groups showed impressive increases in foreign

exchange earnings between 1984 and 1987 except wine, which declined by 20X

between 1984 and 1986 due to poor harvests in 1985-86 and a sobriety campaign

initiated in the Soviet Union, Hungary's largest market for wine exports.

2.08 On the non-CMEA markets, forty-two percent of the value of the listed

products represented exports to the EEC, 24S to other industrial markets aad

34S elsewhere, mainly the Middle East and North Africa. Given the small size

of Hungary's economy, it has basically no influence on the pricing structure

abroad and has to content itself with the role of a price taker.

Nevertheless, Hungary's overall performance in the EEC market showed

improvement between 1980 and 1987, and Government is actively negotiating a

trade agreement with the EEC Commission (para. 3.12). This includes Hungary's

principal export items of fresh, chilled and frozen meats and meat products.

Other products such as canned meat, aad vegetable oil did less well but were

able to maintain their market share. Despite this performance, Hungarian

foreign trading organizations have not been innovative or risk-taking in the

export of agroprocessed products as they tend to sell products through

exclusive rights to a foreign agent under long-term contracts, and in this

sense, become order takers rather than aggressive marketers. Although the

proposed project encompasses all enterprises in agroindustry which satisfy the

onlending criteria, 5 subsectors have been targeted on the basis of their

share of exports, recent performance in this area, or their potential for

significantly increasing sales to convertible currency markets. The export

performance of these subsectors viz., poultry, processed fruits & vegetables,

-5-

wine, fruit juices, and wood processed products is reviewed individually in

Annex 1.

C. Orianization and Firm Size

QCganization

2.09 The government began decentralizing the food industry in the early

1980s by breaking up 10 subsectoral trusts which had maintained wiie-ranging

authority over member firms' decisions in such strategic areas as production,

export and investment, and by introducing enterprise management reforms in

1985. The primary goal of these reforms was to improve firms' efficiency and

profitability by increasing their financial responsibility and managerial

independence. Only the grain and dairy subsectors continue to retain the

trust form of organization. There are 1,375 individual enterprises involved

in food processing, including a large number of state farms and cooperatives

which carry out some processing of primary production, a few small private

firms, and 199 large, state-owned agroprocessing firms, which represent about

80% of production. The structure of the wood processing industry is rather

distinct from agroprocessing firms with more enterprises (68%) organized as

cooperatives and most falling under the regulatory framework of the Ministry

of Industry rather than MEM.

Firm Size

2.10 High concentration of production exists in both agroprocessing and

Hungarian industry as a whole, with large agricultural enterprises employing

more than 300 workers representing more than 95% of the gross value of

production in 1984. Although the number of large enterprises within the

industrial sector has remained basically constant (56%), the number of firms

employing more than 300 workers within the agroprocessing sector increased

dramatically from 36% in 1965 to 85% in 1984.

2.11 Moderate to significant economies of scale exist in canning and

poultry, the two project subsectors where size significantly exceeds industry

norms on a per plant basis. Wood processing firms, which are predominantly

cooperatives, on average tend to be significantly smaller and fall below the

norm for Hungarian industry. The possible inefficiencies associated with a

high degree of concentration in Hungarian agroindustry result from their link

to non-competitive behavior and high cost production structures. The lack of

competition in the past is likely to have contributed to the sector's low

productivity performance and reduced growth below its potential. The success

of the tax reform and other measures in decentralizing the economy and

strengthening profit orientation will be determined to a large extent by the

government's willingness to reduce the degree of industrial concentration and

thereby increase competition among firms. The dismantling of the trusts will

reduce barriers to entry and exit in agroprocessing. Tne promulgation in

January 1988 of the new law allowing the establishment of limited liability

corporations should also ease the entry of small and medium sized enterprises,

including agroprocessing, into industrial and agricultural activities. A Law

of Association has also been promulgated which permits the establishment of

joint ventures between cooperatives and/or private individuals, foreign

companies and state enterprises.

- 6 -

D. International Competitiveness

2.12 As about half of Hungary's GNP is derived from foreign trade, all

sectors must attempt to contribute to the overall trade balance by exploiting

international comparative advantages which are inherent in Hungary's current

level of technology in transforming products and in factor endowments. In

addition, the Hungarians need to compensate for shortcomings by selling in

competitive areas through aggressive and penetrating marketing methods and

techniques. Based on average domestic resource costs (DRCs) estimated for

1981, 1983 and 1986, those project product groups, currently being produced

and exported, which are most competitive on the international market are fruit

juices, wood products, cherries and apricots. The least competitive project

product groups are vegetables and broilers. Increased export earnings from

poultry sales will depend on the development of new products derived from

chicken such as fresh and chilled poultry including ducks and turkey, and

poultry parts. Vegetable exports will largely depend on ef' ttve demand from

convertible currency markets and on the response of agroprotl -ing enterprise

managers to produce higher quality products, which are packaged to take

advantage of market niches.

E. Linkage with Goverment's Reform o

2.13 In support if a comprehensive five-year industry policy reform

program in an environment of increased fiscal austerity, a series of

industrial restructuring projects financed by the Bank have been initiated in

Hungary to improve industrial efficiency through increased competition,

enhanced reliance on market forces and increased enterprise autonomy. Because

of the importance of industry in the Hungarian economy and the "systemic"

nature of the policy changes, the reforms being implemented have also

important implications for the agricultural and, especially, the

agroprocessing sectors. Of the eleven policy areas being discussed with

Government under the ongoing industrial restructuring loans 1/ from the Bank,

and in the current dialogue between the Bank and Government, five are

particularly relevant for the agricultural and agroprocessing sectors.

(a) Entry and liquidation of enterprises--to encourage competition

and encourage the mobility of productive resources. Action on

these lines, which has already occurred in 1986 in the case of

meat, with the breakup of marketing and trade monopolies, is the

fundamental policy reform required for the creation of a

business environment and the provision of incentives to managers

of enterprises, to maintain their market shares, to expand new

product lines and to improve enterprise profitability in the

medium-term.

(b) Improved pricing, incentive and taxation policies to (i) promote

market-based allocation of resources through price deregulation,

and (ii) rationalize the taxes and subsidies system to improve

1/ See the SAR for the Hungary Second Industrial Restructuring Project,

Report No. 6643-HU, Table 3.1, May 15, 1987.

-7-

cost efficiency and remove in:entive distortions. Since January

1988, the proportion of on-farm producers prices that are in the

fixed category of the Materials and Pricing Board was reduced

from 50% to about 10% and consumer food prices from 55% to 252;

all subsidies for agricultural inputs except fertilizer have

been eliminated. Furthermore, comprehensive economy-wide tax

reforms are being introduced. The impending standardization of

income taxation and the introduction of the value-added tax

would directly have positive effects on the profitability of

efficiently managed agricultural enterprises, but have negative

effects on loss-making enterprises. The elimination of all

subsidies on commercial inputs, except fertilizer, may also

increase the cost pressure on agricultural enterprises but the

government hopes that the reduction (and, in several cases, the

elimination) of consumer subsidies would compensate for these

disincentive effects. In any case, further decontrol of prices

(away from cost plus pricing) is likely to improve the business

climate for enterprise performance. The impact of these changes

is analyzed in paras. 3.17 - 3.20.

(c) Liberalization of foreign trade in 1988, now permits interested

enterprises to acquire direct foreign trading rights either on

an individual basis or through joint trading houses formed by

two or more enterprises. Enterprises are rewarded with positive

incentives for exports to the convertible currency market such

as export subsidies, tax rebates, and duty drawbacks. But there

are virtually no commensurate penalties for enterprise managers

to pay, such as bankruptcy or loss of management positions

within enterprises if the enterprise stays with the CMEA markets

even when threatened with future losses. This inertia of

enterprise managers has left convertible currency trade

promotion in the hands of foreign trading companies which do not

control product supply and act only as marketing agents of

enterprises. While these problems are particularly pronounced

in the agroprocessing sector, they are present in other

sectors. The Bank is addressing these issues under a

macro-economic dialogue with the Hungarians which includes:

(a) e medium-term program to phase out all forms of support to

ineftAcient or loss-making enterprises; and (b) an export

promotion program which would provide additional incentives to

exporters such as devaluation of the forint against convertible

currencies, access to direct foreign trading rights, and import

competition.

(d) Wage regulations continue to be tightly controlled by

Government, based on the view that strict demand management is

one of the key actions required by economic managers for growth

and stability. Currently, wage regulation in the agricultural

and agroprocessing sectors differs from the other sectors and

the rest of the economy which is set at an overall rate of 32 in

wage increases for 1988; these sectors will tie wage increases

to improvement in productivity and any increases in excess of

such improvement will meet with prohibitive taxes.

(e) Increasing financial autonomy of enterprises and the

corresponding decline of the traditional practice of assigning

production quotas without regard to cost constitutes two of the

most critical areas for renewed growth and development of those

enterprises which are, particularly, inte nationallycompetitive. Financial discipline of enterprise is to be

strengthen by the threat of bankruptcy and management's greater

accountability for its profits and losses. While the

establishment of a commercial banking system in 1987 is evidence

of movement toward improving the financial institutionalenvironment, Government continues to exercise a strict control

over credit policy and foreign exchange through the NBH. Under

its macro-economic dialogue with the Bank, the Hungariara are

making progress on permitting enterprises to have greater access

to foreign exchange than previously was the case and are

committed to introducing reforms in the banking system which

would gradually shift greater responsibility to the commercial

banks for the management of their operations without the current

influence exercised by the NBH. These issues are being

discussed under the proposed Industrial Sector Adjustment Loan.

Efforts under the project will, essentially, help deepen these economic

restructuring efforts in the agroprocessing sector.

M. POLICY AND ThTSTITUTIONAL REFORMS

A. Sector and Selected Subsector Development Strategies

Sector

3.01 The strategy for developing the agricultural and agroprocessing

sectors falls within the objectives of the Seventh Five-year Development Plan

and the efforts under the industrial restructuring program with consideration

given to the special characteristics, roles and problems facing agriculture.

In addition to contributing to economic growth and export earnings,

agriculture has played a critical role in income dittribution and reducing the

population and employment pressure on the large cities. Development strategy

in agriculture and agroprocessing is based on four fundamental sets of

policies and actions:

(a) liberalization and support of trade with the convertible

currency markets;

(b) improvement of the incentive system facing enterprise managers

in terms of prices, taxes and subsidies;

(c) identification and implementation of those actions in the areas

of the production, processing, marketing chain which reduce

costs, promote efficiency and emphasize products which have the

best export market prospects at internationally competitive

prices; and

(d) introduction of management-labor systems in agriculture and

agroprocessing enterprises which provide more effective use of

land, particularly of the cooperatives, and use of capital for

meeting specific production targets based on market forces.

- 9 -

These four policy areas are the focus of the Bank's discussions with

Government on agricultural and agroprocessing policy, and are being followed

up with Government.

Selected Subsectors

3.02 Poultry. The poultry br, .ch of agroindustry is not internationally

competitive at present. Subsidies of about US$108 million equivalent, 30X of

gross production value, were provided in 1986 to enable processors to maintain

exports and domestic sales at current depressed price levels in the face of

negative value added which totalled US$34 million. International

broilerprices have fallen substantially since 1983. Nevertheless, major

indicators of efficiency of the poultry show Hungary lagging behind its major

competitors in world markets.

3.03 Improving feed formulation is a prerequisite to achieving

competitiveness for poultry. Average feed conversion ratios are below and

mortality rates, and days to slaughter recorded in Hungary are substantially

above those recorded for the United States. The two most critical factors

contributing to this poor performance are inadequate supply of high protein

soymeal required for feeds and government maintenance of high prices on

imported protein in order to conserve foreign exchange and promote domestic

production. The artificially high price of soymeal results in inefficient

substitution of grain for soymeal in feeds which lowers protein content. The

government maintains a defacto quota on imports through import licensing and

control over foreign exchange. The total soymeal deficit for the country in

1987 is estimated at 100,000 tons, appoximately 20% of imports. Increasing

soymeal imports and the supply available to poultry producers at lower prices

are essential at least in the short- to medium-term if Hungary is to improve

production efficiency and profitability and reduce the budgetary drain caused

by the subsidies. Otherwise, current levels of poultry production should be

reduced in line with appropriate feed supplies. In the longer term, the new

IFC-financed, lysine facility scheduled for full development by 1992 and

increasing domestic production would help reduce import requirements, but the

economic viability of domestic soybean production is yet to be proven. Local

costs of soymeal prnduction are currently 15-20% higher than importing. High

mortality rates in Hungary can also be improved through better veterinary

practices and better care during transport to the processor.

3.04 Processed Fruits and Vegetables. As in the case of poultr

- 10 -

3.05 The most important cause of the first two constraints is the weakness

of domestic feeder industries which provide glass, jars* cans, packaging,

additives and other ingredients for processed products. This issue is not

exclusive to this branch, but affects wine and many other agroprocessed

exports. Two problems with packaging are evident throughout the food

processing industry; poor quality and unreliable supply. The latter causes

enterprises to hold large inventories in order to guarantee that production

schedules and supply contracts can be met, but this imposes high financial

costs and efficiency losses. The poor quality of packaging also affects the

pos.tioning of Hungarian products in international markets and results in a

lower price, irrespective of the quality of the contents of the product. This

leads many importers of Hungarian products in convertible markets to provide

their own labels and packaging and implement expensive quality control

measures at the Hungarian factory, thus raising their transaction costs.

Although the import of labels and other packaging material does not result in

an outflow of foreign exchange, it reduces the domestic value added and

incremental foreign exchange earned by the branch due to lower net prices paid

by importers. It also contributes to the very high import content for these

products.

3.06 Two steps are necessary to improve this situation; first, greater

competition among enterprises in feeder industries is needed so as to improve

the quality and supply of products and services they provide to agroindustry;

second, modernization of these industries is required to upgrade industrial

design, graphics, and domestic content of convertible currency exports. These

steps are particularly pertinent to this project in respect of the feeder

industries involved in the production of glass bottle, jars, metal cans and

lids, cardboard and other laminated and coated paper containers and printed

labels and aluminum foils. The four largest processed fruits and vegetables

plants operate their own can manufacturing departments to overcome the

problems of reliability of supply and they supply cans to the smaller

processing plants, but suffer from underinvestment, fully depreciated

equipment, and inefficient management.

3.07 Over staffing in his branch has resulted from industry attempts to

satisfy peak labor demands with full time employees and growth in

administrative staff has not been commensurate with increased quality or

volume of output. The modernization of plant and equipment and reorganization

of production expected to take place through this project will, if successful,

likely exacerbate the problems of redundant labor. Enterprises will,

therefore, need to carry out a manpower assessment and make a medium-term

training and employment plan as part of the business plan attached to their

subloan application.

3.08 Wine. Unlike canning and preserving, 95% of packaging materials in

this branch are procured domestically. This situation is facilitated by the

fact that 85% value of wine is shipped to convertible markets in bulk, and

packaging requirements for such products are less rigorous than for bottled

wine. The steps outlined earlier for improving the quality and services of

feeder industries including glass bottles, labels, boxes, and corks are also

essential if this branch is to launch a successful effort to market higher

value bottled wines and champagnes in convertible currency markets.

3.09 As in the case of processed fruits and vegetables, improving feeder

industry is a necessary, though insufficient, condition for achieving

competitiveness in these product lines. In addition, new investment will be

- 11 -

needed to modernize physical and chemical wine treatment methods including

heat and filtration. An estimated 50% of equipment in the industry is

fully

depreciated. Investment is also needed to expand storage capacity

and upgrade

its standards. Current capacity is insufficient and almost two-thirds

fails

to meet western hygienic standards. Improvements in quality control and

laboratory testing facilities are also needed. Enterprises will be

required

to submit a qualification statement from MONIMPEX, the relevant FTO,

to the

lending commercial bank confirming that the enterprise has equipment

in place,

or that it will be procured under the subloan, in order to carry out

necessary

quality control tests on both raw materials used in processing and

the

finished product itself.

3.10 The final area in which greater attention and financing is

needed is

marketing. Again, while this concern applies to all branches included

under

the project, the issue is highlighted in this branch since bottled wines

are

not currently marketed in convertible markets to any great extent.

Enterprises and the responsible foreign trading organizations must therefore

make a strong commitment in terms of human and financial resources to

undertake an aggressive product promotion campaign to launch Hungarian bottled

wine in the convertible currency markets (paras. 6.15-6.16).

3.11 Wood Processing. The problems facing wood products are somewhat

different from the agroprocessed products. Principally, there is a

strong

demand on the international market for wood products, particularly for

the

hard woods which are indigenous to Hungary, despite the heavy felling

program

for the last ten years. The most important issue is to maximize the

return

from production and exports by better processing and marketing and by ensuring

that each product is sold in the best market. The main export items are

sawn

timber for packaging and for furniture structures, fiber board supply and

both

traditional and panel parquet. There are some fifty companies with direct

export licenses; virtually all of them are in need of replacement equipment

with modern technology which would ensure less waste and greater efficiency

in

the manufacturing process.

B. Trade-Related Issues

EEC Barriers to Entry

3.12 The barriers to entry faced by Hungary in its export markets

(especially the EEC) are comprised of tariffs and quantitative restrictions,

as well as of non-tariff barriers (e.g., legal, hygienic requirements).

In

general, the EEC, which receives about 402 of agroprocessed exports, imposes

an average 107 tariff on raw materials and 257 on processed goods. Hungary

must compete with other more favored exporting countries (ACP members,

countries of the Mediterranean rim), but in the type of temperate climate

exports Hungary produces, it does not face more restriction than any of its

competitors. But since 1980, world growing supplies of agroprocessed products

and tightening demand have created a buyer's market. Hungarians can cope

with

those exogenous factors through the improvement in the quality and servicing

of their products on export markets and signing of a trade agreement with

the

EEC, which is under active discussions between the Hungarians and the

representatives of the EEC and is expected to improve the Hungarian position

on the EEC market. The trade agreement is expected to halt discrimination

against Hungarian exports by EEC countries and develop understandings between

Hungary and EEC on a series of important products, which include agroprocessed

goods. EEC trade restrictions will continue to constrain Hungarian exports

to

the Community, but exporters are finding ways to find the niches for

- 12 -

agroprocessed products by evidence of export improvement in the EEC between

1980 and 1987. See Annex 2 for greater detail on barriers to entry into the

EEC for Hungarian agroprocessed goods.

Lack of Trade Promotion Services

3.13 Government-controlled Foreign Trading Organizations (FTO) manage all

product flows to the CMEA market and, until recently, controlled virtually all

export sales of agroprocessed goods to convertible currency markets. They

work through well-established agents and basically take orders which are

conveyed back to the processing plants. HUNGEXPO is an autonomous agency of

the Ministry of Trade MT and is responsible for trade fairs and the "Gutes aus

Ungarn" program, which is an advertising program under which high quality

goods are labelled and sold in the West German market. The Chamber of

Commerce invites and entertains foreign businessmen to Hungary and attempts to

develop general trade contacts abroad through a series of programs. KOPINT is

a market research institute which undertakes market studies on a contract

basis for paying clients. The commercial and agricultural attaches located at

Hungarian Embassies throughout the world attempt to carry out irregular

promotional efforts on behalf of Hungarian producers.

3.14 To initiate a breakthrough for Hungarian products, enterprises must

start the process of developing a marketing capability within those individual

enterprises that have achieved sufficient economies of scale in their

operations to justify direct marketing overseas, and to support those efforts

through an enhanced and more focussed infrastructure of public services

offering current market related information and analysis, as well as trade

related activities. 1/

Accomplshments in Trade Activities

3.15 While the country is facing important challenges in export

competition and requires strategic planning and action at the government level

as well as the enterprise level, it has undertaken over the last three years

several measures which indicate an acknowledgement of trade, constraints and

an apparent willingness to take the following actions:

(a) eliminate the trusts which handled resource allocation marketing

and sales of poultry, wine, and fruits and vegetables in the

early 1980s and abolished restrictions affecting exports;

1/ Hungary's lack of market intelligence, its primarily consignment-orientedtrading and the lack in flexibility of response to chenging world market

conditions represent another set of difficult constraints to overcome. They

arose out of: (i) traditional trading approach which seeks, mostly on an

ad-hoc 'Masis to provide the products they have been used to providing through

traditional channels; (ii) use of importing agents, foreign trading companies

ar.d trusts (the last ones being trading and market monopolies) which acted

more as "common agents" or passive sellers with little incentive to actively

search for new market prospects or niches; (iii) relative isolation of

producing agents from export markets; and (iv) pricing, subsidy and taxation

signals set by the state which often do not reflect world market signals and,

jointly with an inadequate accounting system, distorted the "true"profitability of firms thus providing opportunities for uneconomic investments.

- 13 -

(b) completed market studies of project product groups by

internationally known firms and through the Hungarian Chamber of

Commerce and organized a workshop with Bank assistance on

marketing and technology of project products in June 1987 in

Budapest;

(c) granted subsidies on export-oriented investments and direct

subsidies for selected agroprocessing and wood processing

exports to convertible currency markets together with an

improved automatic duty drawback system in order for Hungarian

goods to compete on world markets, particularly the EEC market;

and

(d) reduced import tariffs and eliminated many quantitative

restrictions on project products coming into Hungary in line

with GATT regulations.

C. Finaniagd Issues

3.16 In line with the economic reform program, Hungarian authorities

launched a program in January 1988 of changes in the way enterprises calculate

their prices to wholesalers and retailers and the way Government grants

subsidies. In general, prices to producers and consumers were liberalized and

a new set of taxes - value added, personal income and linear profit tax

replaced several other taxes. Current subsidies being transferred to the

agricultural and agroprocessing sectors are scheduled to be significantly

reduced over the medium-term. Despite these important changes in the current

system, the degree of change in prices and subsidies will depend directly on

the new tax system at the enterprise level. The details of those policy

changes can be found in Annex 3.

Impact of Reforms on Project Subsectors

3.17 Although the overall impact of the various price, tax and subsidy

changes is expected to be revenue neutral for much of agriculture, the impact

on project subsectors such as wine, soft drinks, and to a lesser extent,

poultry is expected by the government to be positive. For six enterprises

examined in the wine subsector, total sales revenue is expected to rise by 52

over 1986 baseline measures after 10-152 domestic price increases are offset

somewhat by reductions in consumer demand. The recent (November 1987)

devaluation against the dollar (42) and rising sales revenue should permit a

immediate reduction in subsidies. The most significant benefit for wine

enterprises stemming from the reform program is the reduction in the corporate

tax rate from 47% to 40%. This change, along with the other measures

affecting pricing, would result Ln an estimated 53% increase in net after tax

profits of the subsector.

3.18 In the fruit juice subsector, aggregate sales revenue for 5

enterprises studied is expected to increase by about 52 as a result of the

reforms, but domestic demand is expected to contract sharply with the

application of the VAT tax on these products. The reduction in corporate

taxation from 561 to 502 is, again, expected to be the most significant factor

affecting profitability for these products. Application of this lower rate

along with the assumptions on sales revenue are expected to result in a net

increase in after-tax profits by about US$ 0.8 million.

- 14 -

3.19 The benefits for the poultry subsector would increase net, after-tax

profits by 40X. This is primarily the result ot increasing sales revenue

due

to price liberalization and the devaluation against convert'tble currencies.

These results will depend on the ability of the industry to avoid an

overall

increase in production cost due to the planned increase in the price

of corn

and the expected increase in wages. Total subsidies to the industry can

be

reduced by about 2.52 as a result, in part, of the devaluation.

3.20 The reforms are expected to have a neutral impact on the processed

fruits and vegetables subsector, which would increase after-tax subsector

profit by about 42. Total sales revenue will increase slightly due to the

combined effects of higher domestic revenues and devaluation against

convertible currencies and revaluation against the rouble. Higher prices

that

will be demanded by small producers of fruits and vegetables whose marketed

sales make them liable to taxes and will likely be passed on to processors

who

will face higher costs of production. If they are not compensated, small

producers can be expected to reduce output or resort to other non-taxable

forms of exchange.

Financi Performnance of Agrorocessng Enterprises

3.21 Improvement in the management of corporate assets and in the capital

structure of enterprises is essential to increase efficiency and profitability

in agroprocessing in Hungary; progress in this area is expected to yield

substantial financial and economic benefits. At present, financial

management

of corporate assets is hampered by frequent underutilization of production

capacity, excessive build up of inventories of raw materials and finished

products, and excessive delays in collecting accounts receivables and

in

paying suppliers. Further, inadequate use of financial leverage for

investment financing limits the availability of financial resources to

agroprocessing enterprises and results in an excessive recourse to government

financing in the fcrm of subsidies.

3.22 A comparative analysis recently carried out with the assistance of

NBH and MEM on financial performance of enterprises operating in the same

subsectors in Hungary and in the U.S. clearly indicates these deficiencies

in

Hungarian agroindustries. The exercise is based on the comparison of 14 key

business ratios as derived from subsectoral aggregate financial statements

provided by the Hungarian authorities and on a set of Dun and Bradstreet

median financial indicators, which represent standard industry norms.

3.23 The fourteen business ratios are categorized into three major groups

as follows:

(a) Solvency or Liquidity Ratios which provide a significant measure

for evaluating a company's ability to meet short-term and

long-term obligations;

(b) Efficiency Ratios which indicate how effectively a company uses

and controls its assets; and

(c) Profitability ratios showing how successfully a business is

earning a return on its assets and to its owners.

- 15 -

3.24 As indicated by Table 2, the comparative analysis of the six

most

significant ratios provide a valuable insight into the Hungarian

agroprocessing and wood processing subsector. Detailed financial ratios,

can

be seen in Annex 4.

Table 2: HUNGARIAN AGROINDUSTRY BUSINESS RATIOS

Solvency Ratias Efficiency Ratios Profitability

Ratio

Current Total Liabilities/ Collection Sales/Inventory Assets/ Return

on

Ratio Networth X Period (Days) Turnover Sales X

Assets S

X (Days) X

POUJLTRYNorm 1.8 129.9

18.6 21.6 21.9 7.7

Hungarian 1.8 95.1 45.2 6.2 63.7

3.7

FRUITS AND VECETARLESNorm 1.6 147.4

23.3 4.9 50.3 5.1

Hungarian 1.8 97.6 58.9 2.2 107.6

3.8

Norm 1.8 93.9 51.4 1.6 133.3

1.0

Hungarian 1.8 88.8 51.1 2.0 113.7

2.3

WOOD PROCE5SINCNorm 0.8 67.1

92.3 7.2 161.0 0.3

Hungarian 3.3 20.7 40.3 4.2 106.1

5.7

Source: Dun and Bradstreet, IndustrX Norms and Key Business Ratios. 1986

and Mission Estimates.

3.25 The solvency ratio analysis indicates that the financial performance

of Hungarian agroindustrial enterprises compares well with the subsector

norms; but a large number of Hungarian firms in poultry, fruits and

vegetables, and wood processing are underleveraged with regard to

their

long-term borrowings position as indicated by the comparison of the

total

liabilities to net worth ratios. These show that on average in the

po-altry

and processed fruits and vegetables subsectors, Hungarian enterprises

use

about 40t less long-term borrowings than similar American enterprises

and in

the wood processing sector about 302 less. It is important that

financing of

investment of Hungarian agroprocessing enterprises should be done increasingly

through long-term borrowings instead of subsidies or equity capital.

This

would decrease the burden on Government funds and probably result in more

funds made available to enterprises for restructuring their assets.

It would

also improve capacity utilization and financial responsibility of

agroprocessing enterprises.

3.26 The comparison also shows that poultry and wood processing

enterprises make use of short-term borrowings less than their peer

enterprises

in the US as excessive financing of inventories often occurs through

a

Government-financed, quasi-equity facility. This transfer of long-term

funds

for current expenditures results in an unnecessary financial burden

for the

Government and excessive build-up of working capital. The latter

is normally

financed through short-term borrowings, which also oblige enterprises to

be

more financially responsible for their operations.

3.27 The efficiency ratios show significant deviations of financial

performance of Hungarian enterprises from the industry's norms. First,

slow

- 16 -

collection of receivables which is a problem especially in the poultry and

canning subsectors where the collection period is about 2.5 times longer than

the norm. This excessive delay results in significant financial cost on

account of lost interest to the companies and in liquidity shortages. The

excessive delays in collecting accounts receivables by enterprises and delays

in timely paying of accounts payables is, in fact, due to the current system

of cross-subsidizatien among enterprises. Primary producers are not timely

paid by agroprocessors who in turn are not paid in time by wholesalers and

retailers. This practice makes it difficult if not impossible, to charge

financial costs to those enterprises that actually incur them. Efforts should

be made throughout the industry to reduce the payments collection periods.This would permit better identification of corporate profitability and result

in decreased Government subsidies.

3.28 Second, the sales to inventory ratio, which is a useful inventory

control measurement tool to prevent excessive build up or ' sufficientinventory stocks, indicates an extremely low inventory tu. "er in the entire

agroprocessing sector in Hungary with the exception of the wine processing.

The situation is particularly anomalous in the poultry subsector where the

inventory turnover is about 4 times below the norm. It is also problematic in

fruits and vegetables, and wood processing with a turnover about half of the

norm. Extremely high inventories are usually the result of conservative or

inadequate sales management. A more aggressive sales and marketing policy and

a more conservative policy of inventory accumulations is required in order toreduce financial costs to the sector.

3.29 Third, the analysis of total assets-to-sales ratio indicates that

processed fruits and vegetables and poultry enterprises are undertrading or

not generating sufficient sales to warrant the assets invested. A more

aggressive sales policy and reorientation of investment is needed in order to

achieve a more efficient utilization of capacity. The sales-to-net working

capital ratio indicates that a company is overtrading or conversely carrying

more liquid assets than needed for its volume. In the case of Hungarian

agroprocessing enterprises, this ratio indicates excessive use of working

capital per unit of sales and that, therefore, a drastic reduction in the net

working capital position is required, especially in the case of the processed

fruits and vegetables and poultry subsectors. The accounts payable-to-sales

ratio indicates a problem only in the case of the Poultry subsector showing

that firms throughout the subsector may be using suppliers to help finance

operations.

3.30 Finally, profitability ratios indicate that the return on assets and

on net worth of the processed fruits and vegetables and poultry subsectors are

much below average performance. This is attributed to excessivecapitalization, and hence, the value of fixed assets is out of proport£on to

the processing activities undertaken. In general, Agroprocessing enterprises

in Hungery have a tendency to employ substantially more asset and inventoryvalue per unit of production and to use less borrowed capital than do similar

firms operating efficiently in a market-oriented economy.

3.31 Under the revised income regulation system, most enterprises willhave to increase their self financing capacity by a more efficient management

of their assets, especially current assets. This could be done through the

- 17 -

use of computerized corporate medium- and long-term planning to foresee

financial, technical, managerial and marketing improvements needed to improve

overall profitability. Commercial banks making subloans, for investment and

working capital, to agroindustrial enterprises need to see that medium- and

long-term restructuring planning is prepared at the company level as a

condition of subloan eligibility. Banks would have the obligation to ensure

that, in all cases, corporate plans of agroprocessing enterprises indicate

measures to improve their management of current assets. To achieve an

improved financial position, sub-borrowers would also need to improve their

capital structure by bringing about a more balanced total liabilities to net

worth position.

3.32 As a general rule, commercial banks would have to be assured prior

to subloan approval that improvement in the following ratios over the

medium-term be achieved up to the norm levels as a measure of acceptable

financial performance; current ratio, current liabilities to networth,

collection period, sales to inventory, assets to sales, and return on assets.

In addition, a computerized c)rporate plan would be submitted when applying

for a subloan, the plan would be periodically reviewed for performance by the

commercial banks. In addition, Annex 5 provictes a subsectoral example of

projections of financial statements of agroprocessing and wood processing

categories. Commercial banks would have to see that a similar methodology is

applied in the preparation of corporate medium-term planning of

sub-borrowers.

D. Istitutional Issues

3.33 Apart from the upgrading of vital supports of export trade promotion

and marketing which government and specialized agencies would render to

enterprises exporting to the convertible currency, enterprises are also in

critical need of the following institutional assistance: (a) grading and

quality control of raw material and final products; (b) training in management

and marketing of agrprocessed products; and (c) research and development of

new products, food technology and use of food processing machinery.

Grading and .ualitY Control

3.34 A major factor relevant for increasing earnings on western markets

is not the volume of raw material but its quality which requires the setting

and enforcement of industry standards at the raw material and final product

level. The introduction of an enforceable grading system based on uniform

standards on which processing firms can justify differential payment to

producers as a function of the quality of raw materials would increase the

supply of higher quality raw material, reduce losses at the processing -nt,

and improve the quality of the processed product. Likewise, agroprocessing

firms have not been sufficiently concerned with the quality of product

presentation, particularly regarding container labeling and packaging. Until

recently, Hungarian agroprocessing firms could sell low quality products

presented poorly on the domestic and the CMEA markets, but with their sights

now set on the sophisticated western markets and the Soviet market demanding

better quality products, firms are beginning to pay greater attention to the

overall presentation of their products in line with the competition.

- 18 -

3.35 The Hungarian food law is currently under review and revision by

Government; it is vague in its application and confusing to administer since

several government agencies -- Ministries of Agriculture, Trade and Health as

well as the Bureau of Standards and the University of Horticultural and Food

Industries -- are assigned tasks without sufficient clarity regarding

authority or enforcement of the law at the industry and enterprise levels.

Moreover, with prices officially prescribed by Government in the past, the

rewarding of volume production and the regulatory environment under which the

economy generated, there was little incentives f.,r managers to excel in

quality of product. It is still a widespread practice, particularly in the

processed fruits and vegetable industry, to ignore established quality

standards and accept all raw materials that are offered, which result in an

overall low average product quality. Revised grading system and quality

control standards are needed and should be based on existing western European

and U.S. practices both at the raw material and final product levels

(Annex 6).

Research and Development

3.36 The University of Horticulture and Food Industries (UHFI) is charged

with the responsibility of undertaking R&D for the food industry in general

and for specific enterprises on a contract basis. It seeks to achieve the

development of new products for export, improvements in production efficiency,

quality assurance and better utilization of by-products. The University has

proposed a series of programs for the project products, but requires a broader

view of its role in that research findings and quality control practices

actually reach the factory-floor. It needs to initiate a comprehensive

program on quality improvement in product packaging wh

4ch would integrate

handling, transport and processing line technologies in the development of

improved product presentation to final buyers. Unfcrtunately, as in the case

of agricultural research, other than the transfer of technology spread by the

technical production units, final users of the research have initially no

input into the setting of priorities and design of the work. Therefore,

priority setting of UHFI should be a result of structured meetings with MEM,

MT and various industry groups (Annex 7). R&D is also required in packaging

standards, technology and design if Hungarian products are to increase their

international competitiveness.

Traing in Management and Marketing

3.37 The University of Horticulture and Food Industries (UHFI) has

proposed a training program for management and marketing specific to the

project that would aim at training personnel from foreign trading

organizations, commercial and agricultural attaches, commercial banks, and

ministries of agriculture, trade and industry. They would organize special

training programs for the different levels of enterprise managers on a case

study method. Marketing candidates would be placed in a foreign branch of a

trading office or supermarket chain store which carries on business in

Hungary. In order to improve its own capacity for training, UHFI would send

its staff abroad for study and research and bring expatriates regularly to

Budapest as guest lecturers. A key to the success of the program will be the

development of the international cooperation with management training

institutes in other countries and the exchange of staff that this will allow

(Annex 8).

- 19 -

Feeder Industries

3.38 The lack of quality and timely availability of jars, bottles,

lids,

cans, boxes, labels, printing and other goods and services needed

by the food

industry is one of the fundamental constraints to growth of food exports

and

profitability of enterprises. The food industry should set its own

standards

for the packaging the) procure from the feeder industries, and set up

a

program, with their suppliers on a one-to-one basis for quality improvement.

Government would be expected to assist these feeder industries which

have

particular problems in meeting the quality, variety and timeliness

requirements of agroprocessing enterprise as they target specific customers

in

convertible currency markets. One of the major constraints for expanding

exports of processed fruit and vegetables and wine is the lack of appropriate

glass containers delivered in a timely manner by the current monopoly

enterprise which controls the four glass contair%.L plants in the country.

Another constraint is the lack of specialized ma, :aufacturing companies

which use modern technology to produce modern style tans for exports (Annex

9>

E. Impact of Bank Lendin in Agriculture

3.39 The Grain Storage and Farm Mechanization Project (1983, Ln.

2316) was

the first Bank operation in Hungary and has been followed in the agricultural

sector by two other projects, the Integrated Livestock Industry Project

(1985,

Ln. 2510) and the Crop Production Improvement Project (1986, Ln. 2738).

The

Grain Storage Project was successfully closed on December 31, 1986 and

contributed to the replacement of obsolete, deteriorated grain storage

facilities and on-farm equipment such as combine harvesters, tractors,

etc.

with modern equipment, embodying new technology. It also introduced

the

Hungarians to cost effective storage facilities in terms of both construction

and operating costs and helped trained operators of storage facilities

in

efficient storage and handling practices. Under the first Bank project, the

project preparation system used by Bank staff was initially transferred

to

Hungarian counterparts in the agricultural sector and the door was slightly

opened for exchange of views on agricultural policies, particularly

in the

area of prices, taxes and subsidies. Under the initiative and guidance

of

Bank staff, the Hungarians began a series of economic, technical

and financial

studies which formed the basis of an increasingly relevant dialogue

regarding

current government strategies in agriculture. The Livestock project

is

assisting the Hungarians to modernize the production and marketing system

for

beef, sheep, pork, milk and products and lamb/mutton, and includes

improvements in institutions and practices in input supply, on-farm

development, slaughterhouse rehabilitation and export marketing. Within an

overall Government program to gradually liberalize the economy, discussions

between the bank and authorities under the project resulted in a

complete

review of their price policy and led to increases in milk prices

to consumera

and the eventual breakup of the Meat Trust in January 1987; both actions

proved to be important and were subsequently followed by further

price

liberalization (para 6.05) and export trade liberalization (para 3.15).

The

project was innovative as it focussed on improvements in export marketing

with

particular reference to changing the traditional ways of thinking

about how

livestock products are sold on foreign markets. In response to this project,

MEM reorgan! -A itself to place production and marketing activities under one

deputy minister whereas these two functions had been managed earlier

under

different deputy ministers. More recently, the Crop Production project

is

funding high-efficiency farm machinery and construction equipment for land

improvement. In line with the need for high levels of fertilizer, liquid

- 20 -

fertilizer plants are expected to be constructed or rehabilitated. However,

demand appears slow for these funds and a reduced construction plan is

envisaged compared to appraisal estimates. The project has also introduced a

computerized management information system at the Papa State farm level as a

pilot exercise and is expanding the traIning of agricultural extension agents

in farm management techniques and practices. Since the commencement of Bank

involvement in the sector, the Hungarians have made significant reforms in

agricultural policy particularly in prices and tax liberalization. They have

reduced the amount to be sold in the category of fixed prices to farmers from

50% to 10% and the amount to be sold to consumer food goods in the category of

fixed prices from 55Z to 25X. Enterprises management is now largely

responsible to the workers and not to MEM and agroprocessing enterprises have

directly exported about 15% of food products to convertible currency markets

without going through the traditional FTOs.

IV. THE PROJECT

A. Concept. Desiga and Objectives

4.01 In parallel with the ongoing restructuring of the industrial sector,

the concept underlying the proposed project is to realign, over time, the

production mix of the agroprocessing sector in line with expected effective

market demand, particularly, on the convertible currency market. The Project

seeks to achieve a breakthrough in motivating agroprocessing managers towards

efficiency, exports and profitability by internalizing the commitment of

managers of enterprises to produce improved product quality and to engage in

direct marketing to the large supermarket chains and other large buyers in

Western Europe and other selected parts of the world. Individual anterprises

are expected: (a) to develop clear product and market strategies, (h) to

reduce costs of production, (c) to improve product quality through better and

more efficient technologies in product processing, and (d) to impose methods

of enterprise management which fulfill modern standards such as those

practiced in comparable model countries like Denmark and Holland. These

developments are expected to be accompanied by greater financial autonomy and

by greater independence from the Ministry of Agriculture in terms of capacity

and freedom to take and to carry out major decisions on investment, product

selection, pricing and medium-term, business planning.

4.02 The Project was originally designed by MEM to include a number of

pre-selected firms in the subsectors of poultry, processed fruits and

vegetables, wine and fruti juices, and wood products. In the judgement of MEM

and NBH, these firms were in need of rehabilitation of their capital stock and

reorganization of their product lines in order to take advantage of presumed

current and potential export opportunities in the convertible currency

markets. It became apparent during project preparation that, due to the

difficulty of market access and the weak overall financial structure of some

of these enterprises, all firms should be required to meet a series of lending

criteria which would include, in addition to the financial analysis of the

project investment, assessment and improvement of the financial structure of

the enterprise, its organization and management, its technology, and its

country specific marketing strategy. In addition, in January 1987 a new

commercial banking system was established, which provides for competition

among the banks and requires them to take responsibility for subloan

decisions. The project was redesigned from financing a possible list of

enterprises selected by MEM to a credit line, open to all agroprocessing

- 21 -

enterprises which qualify under the criteria set by the commercial banks.

This expansion of the project scope challenges the preselected firms to

improve their plans for the future in line with market signals and permits

only the best firms with a viable investment package to support such

development to be included in the Project.

4.03 The Project seeks to enhance international competitiveness of

Hungarian agroprocessed exports and increase the efficiency of production and

effectiveness of marketing of agroprocessed products. The specific objectives

of the Project are to:

(a) increase earnings of processed agricultural and forestry

exports, particularly to the convertible currency market, by

improving the quality and marketing of exports;

(b) improve the efficiency of operations of enterprises in the

agroprocessing sector by reducing their unit costs of operations

and improving their productivity; and

(c) create a more effective business climate in the agroprocessing

subsector in line with macro economic price and tax reforms.

These objectives directly support the macro-economic goals of the Government,

which are to achieve a balance in its foreign payments account by increasing

exports and greater efficiency in the production of agricultural and

agroprocessed goods.

B. Project Description

4.04 The Project would provide funds through the intermediary banks to

about 70 agroprocessing enterprises to modernize their facilities and to

incorporate improved management. marketing and technology into the

operations. Each enterprise requesting subloans would prepare, with the help

of qualified consultants, a medium-term business plan which would include

country-specific product and market strategies, the appropriate equipment

technology, modern management practices and a responsive organizational

structure; an environmental impact assessment would also be included with each

subloan application. Modern, up-to-date equipment for packaging, canning,

bottling, chilling, freezing and cold storage of food and wood products would

be the major areas for plant improvement. Computer software and consultant

services would also be financed for those firms which want to install

inventory control systems, cost accounting, including management information

systems and other operations requiring automation.

4.05 The project selected subsectors are poultry, processed fruits and

vegetables, wine and fruit juices and wood processing. Apart from meat

products which are covered under an ongoing bank-financed project, those

subsectors offer the greatest possibilities for increasing earnings from

exports. Improving competitiveness of poultry production through targeted

financing under the Agroindustry Modernization project is critical given the

importance of these products among agroindustrial exports (approximately, 20%

of total) and the fiscal drain caused by subsidies. There is an identified

need to modernize plant and equipment of processing operations and improve

- aZ -

their capacity to produce higher value products such as cut chicken,

turkey,

and other products suitable for export to convertible currency markets.

Major

constraints on achieving competitiveness relate to shortcomings at the breeder

and grow-out stage. Feed formulation, poultry management, the quality

of

day-old chicks, lack of modern equipment and competition at the hatchery

stage, as well as the genetic qualities of breeding stock are issues that

must

be addressed in the context of financing for the subsector. The project

would

provide funds ror investment in the poultry breeder industry currently

held by

two enterprises and for rehabilitation of grow-out farms. Processed fruits

and vegetables receive large subsidies from Government due to high costs

of

production and low prices received from the USSR. Major restructuring

of the

existing enterprises as well as the feeder industries supplying

glass

containers and cans is urgently needed in order to become more -ompetitive

on

Western markets.

4.06 Hungary's production of wine is divided into three broad

groups; bulk

wine, bottled wine, and sparkling wine. Only bulk wine can be characterized

as marginally competitive in convertible currency markets at present. Value

added in this branch was slightly positive in 1986 (US$4 million equivalent).

Several constraints facing the wine industry relate to packaging, processing,

storage, quality control and marketing must be addressed if Hungary is

to

increase its convertible currency earnings in this branch and increase

value

added in production. Unlike the other subsectors, wood products

enjoy a

strong demand, particularly the hard wood, which is indigenous to

Hungary.

Enterprises are in need of rehabilitated factories along the lines of those

high value added products indicated by market studies carried out during

project preparation (para. 6.22).

4.07 The Project would upgrade support services to enterprises,

in terms

of: (a) export trade promotion and marketing; (b) training in management

and

marketing; (c) grading and quality control of raw materials and final

products; and (d) research and development. It would also seek to create

restructuring of the glass container industry and can manufacturing so

as to

assist agroprocessing enterprise to improve its competitive position

on export

markets with more attractive and appropriate jars, bottles and cans.

C. Cost and Financing

4.08 The total financing required for the Project is estimated at

US$160

million, of which US$86 million (54X) would be in foreign exchange, as

shown

in Table 3:

- 23 -

Table 3: PROJECT COST ESTIMATE

HUNGARYAGROPROCESSING MODERNIZATION PROJECT

PROjECT COST SUMIARY

(FT '0001 (USS '000\ S Total

------------------------ ^----------- --------------------------- I Foreign Base

Local Forsign Total Local Foreign Total Exchange Costs

_=c=======z= ===:-===== =:::=:===:=z =======: ==

=::==:::=::= =:::

A. MINE AND JUICE 660,854.9 712.012.3 1.372,867.2 14,045.3 15,132.6 29.177.8

52 22

8. PROCESSED VEGETABLES AND FRUITS 281.091.7 513,761.7 794,853.4 5,974.1 10,919. 1 16,893.2

65 12

C. POULTRY 1,046,008.5 1,240, 191.3 2,286. 199.9 22,231.0 26. 358. 1

48 589. 1 54 36

0. FORESTRY 446,366.9 707.515.3 1.153,882.3 9.486.7 15,037.0 24.523.7

61 18

E. TECHNICAL ASSISTANCE 259. 592.4 188, 084.4 457. 676.8 5, 729.7 3,997.4

9, 727. 1 41 7

F. NARKETING 49,392.0 260.610.0 310,002.0 1,049. 7 5,538.8 6,588.5

84 5

Total BASELINE COSTS 2. 753.306.4 3.622, 175. 1 6.375.4U1.5 58,516.6 76,982.9 135,499.5

57 100

Physical Contirgencies 269.619.7 328,529.0 598, 148.7 5,730.3 6,982.3 12,712.6

55 9

Price Contingencies 453,930.7 111.645. 1 565. 575.8 9.647.5 2,372.8 12,020.3

20 9

Total PROJECT COSTS 3.476,856.9 4.062. 349. 1 7,539. 206.0 73. 894. 4 86. 338.0

160,232.4 54 118

January 19. 1988 21:42

4.09 The base costs were derived from feasibility studies and adjusted

by

the appraisal mission to prices of March 1988 at the exchange rate of US$1 =

FT 46. The cost estimates