Costa Rica - Fourth Power and Third Telecommunications Projects

RELEASED FGOP THr E'(CLUSIVE RESTRICTED USE OF THE Report No. P-1022 INTERNATIONIAL ,4 ON LTA:7Y ', NID sa IL E Coms This report is for official use only by thc Bank Group and specitically authorized organizations or persons. It may not be published, quoted or cited without Bank Group authorization. The Bank Group does not accept responsibility for the accuracy or complctcness of thc rcport. INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT REPORT AND RECOMMENDATION OF THE PRESIDENT TO THE EXECUTIVE DIRECTORS ON TWO PROPOSED LOANS TO THE INSTITUTO COSTARRICENSE DE ELECTRICIDAD FOR A FOURTH POWER AND A THIRD TELECOMMUNICATIONS PROJECT WITH THE GUARANTEE OF COSTA RICA February 3, 1972  CURRENCY EQUIVALENrS US$1.00 = 06.62 (colones)  INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT REPORT AND RECOMMENDATION OF THE PRESIDENT TO THE EXECUTIVE DIRECTORS ON TWO PROPOSED LOANS TO THE INSTITUTO COSTARRICENSE DE ELECTRICIDAD FOR A FOURTH POWER AND A THIRD TELECOMMUNICATIONS PROJECT WITH THE GUARANTEE OF COSTA RICA 1. I submit the following report and recommendations on two proposed loans to Instituto Costarricense de Electricidad (ICE) with the guarantee of the Republic of Costa Rica for the equivalent of $6.5 million for a power project and $17.5 million for a telecommunications project, to help finance the foreign exchange cost of the next stage of ICE's development program. The two loans would each have a term of 20 years, including grace periods of 4-1/2 years for power and 5-1/2 years for telecommunications, with inter- est at 7-1/4 percent per annum. PART I - INTRODUCTION 2. Costa Rica has to date received eleven Bank loans and one IDA credit totalling $89.5 million. Four loans, amounting to $49.3 million, have been made for power and telecommunications, two loans and one credit, amounting to $25.8 million, for transportation and five loans, totalling $14.4 million, for agricultural and industrial development. The last loan, for roads, was signed in April 1970. In addition to the proposed loans, the lending program for FY1972 includes a loan of about $9 million for agriculture. 3. As of December 31, 1971, a total of $22.5 million remained to be disbursed on four ongoing projects (in agriculture, power, telecommunications and roads). The agricultural project (Loan 538-CR) had a very slow start mainly because funds for agricultural credit were available from other ex- ternal sources and the organization of the project unit was weak. This sit- uation changed in late 1970, and the loan was fully committed by August 31, 1971. The undisbursed balance, which on December 31, 1971, was $1.2 million, is expected to be fully disbursed by June 1972, about twelve months later than initially estimated. The third power project (Loan 631-CR) is about 24 months behind schedule, and cost estimates have been increased by about 40 percent due to severe tunnelling problems and late delivery of equipment. Consultants are now advising on the tunnelling difficulties and the project is under close supervision. In the case of the highway project (Loan 664-CR), the Government has requested supplementary financing to cover a large cost increase in the construction of the highway, which was initiated about six months ago. A mission will leave shortly to review this request. A summary statement of Bank loans/ IDA credits is in Annex 1.  -2- 47 IFC has made one investment in Costa Rica, in a company manufactur- ing concrete products (Productos de Concreto S/A). This has been repaid. PART II - THE ECONOMY 5. During the past decade Costa Rica's development has been impres- sive. An annual average increase of real GDP of 6 percent, coupled with a reduction in the annual rate of population growth from almost 4 percent to around 3 percent, resulted in a notable increase of per capita GDP (at 1969 prices) from $390 in 1960 to over $520 in 1970. Costa Rica has reached a rarely found level of social cohesion and democratic political institutions. The absence of a standing army resulted in minimal defense expenditures and permitted the public sector to devote increasing amounts of the country's resources to development purposes. The Government has tried to achieve a fair distribution of the benefits of development through education, health and other social programs. Today almost nine-tenths of the population over ten years of age are literate, and the mortality rate is one of the lowest in the Hemisphere. 6. This commendable long-term development performance, however, has been accompanied by recurrent financial difficulties. Central Government expenditures have risen rapidly to provide a high level of social services to a rapidly growing population. At the same time the fiscal revenue base, strongly dependent on foreign trade taxes, was weakened during the 1960s by the elimination of duties within the Central American Common Market (CACM). Furthermore, overly generous fiscal incentives were granted to stimulate industrial development within the market, and offsetting changes in the fis- cal revenue structure proved to be difficult to introduce. Thus, additional taxation of domestic transactions has persistently lagged behind needs. The result has been a chronic fiscal deficit, financed first by short-term bor- rowing abroad and later by large domestic credit expansion. Demand pressures resulting from rapid growth and Central Bank financing of fiscal deficits have inflated import expenditures, and it has only been during periods of exceptional export growth that rapid development and balance of payments equilibrium have been simultaneously achieved. By the end of 1966 the de- terioration of the fiscal and balance of payments accounts reached a criti- cal level. Net international reserves became negative by some $14 million and debt service absorbed over 18 percent of export earnings, due to heavy medium-term borrowing for fiscal purposes. This resulted in a marked slow- down of new commitments by the Bank and other external lending agencies, pending an improvement in the Government's economic policies. 7. During 1967-1969 a marked financial improvement took place, mainly as a result of buoyant exports, but reflecting also the more adequate govern- ment policies. Restrained credit expansion and the introduction of a dual exchange system combined with rapidly growing banana and industrial exports  -3- to achieve a considerable improvement in the fiscal and balance of payments situation. Fiscal deficits were drastically reduced, and public savings in- creased from 0.7 to 3.5 percent of GDP between 1968 and 1970. Although net foreign financing became negative, goverrment investment increased by over 10 percent per year, financed largely domestically through placement of bonds with the private sector. Net international reserves recovered and by the end of 1969 reached a level of $38 million, equivalent to almost six weeks of imports. 8. Nevertheless, during the second half of 1970 and in 1971, following the quadrennial change of government, serious financial problems once again aggravated Costa Rica's internal and external situation. During 1970, al- though exports grew healthily by 20 percent, imports rose by over 30 percent. This high import growth was due to the return to the old exchange parity at the end of 1969 - resulting in an effective revaluation -,to speculative buying in anticipation of the expected imposition of a 30 percent import surcharge, and to a drastic relaxation of credit policies. As a result, net international reserves fell $12 million to $26 million, equivalent to four weeks of imports. During 1971 the balance of payments situation deteriorated further as prices and value of coffee exports fell heavily. An accumulating fiscal deficit and a large expansion in banking system credit to the private sector, financed mainly by Central Bank rediscounting, fueled a level of aggregate demand inconsistent with the import and production possibilities of the economy. By the end of May 1971 net international reserves had de- creased to $23.3 million, instead of recording the normal seasonal increase, and on June 18 the Central Bank reintroduced the dual exchange system and imposed surcharges on non-essential imports. However, continued credit ex- pansion and inadequate management of foreign exchange transactions allowed imports to keep growing at over 10 percent on an annual basis, while exports stagnated. Although by the end of 1971, net international reserves had in- creased to approximately $37.6 million, $16 million had to be borrowed abroad, and a large amount of import payment arrears had also accumulated. Furthermore, recent movement of prices also show the relative short term inelasticity of domestic production to an excessive increase in aggregate demand. The wholesale price index, which rose annually by around 3.9 per- cent in the 1966-69 period, increased 6.5 percent in 1970 and 5.5 percent in the first seven months of 1971. 9. The rate of real GDP growth slowed down to around 5.4 percent in 1970, and probably about 3-4 percent in 1971. Although industry and commerce continued to expand briskly in 1970, a bad farm year, mainly due to adverse weather conditions, contributed to the slower rise in output. No national accounts data are yet available for 1971, but some indicators in the indus- trial and commercial sector, together with the stagnation of exports, point to a slowdown in economic growth. Agriculture, however, has recovered slightly and public investment and construction have been dynamic factors.  - 4 - 10. The Bank, in consultation with the International Monetary Fund, has kept a close watch on economic developments in Costa Rica during the past eighteen months, and a series of discussions has taken place with the Costa Rican authorities on measures needed to re-establish internal and ex- ternal financial stability. 11. The Costa Rican authorities have prepared an emergency stabiliza- tion program for 1972. The program is directed to curtail aggregate demand and hence imports, mainly through a more realistic monetary program and through additional taxes. Its main features are as follows: (i) A monetary and credit program for 1972, approved by the Central Bank's Board of Directors in late December 1971, which is designed to reduce liquidity and curtail aggre- gate demand. Accordingly, credit ceilings have been im- posed on individual banks, and total expansion of banking system assets for 1972 will be limited to less than 7 per- cent, down from around 28 percent in 1971. Excess liquid- ity in the economy will be absorbed through open market operations and a reduction of import payment arrears. (ii) A fiscal package, which is based on increasing taxes and containing expenditure growth. It includes a tax reform aimed at raising fiscal revenues and controlling import growth mainly through increased consumption and income taxes, and taxation of remittances abroad. The reform is expected to yield around 0100-120 million, equivalent to almost 2 percent of GDP. On January 14 the Congressional Fiscal Commission approved the tax measures, which are now being discussed by the Assembly. In addition, expenditure increases over and above the approved ordinary budget will be held back in order to ensure a manageable deficit in 1972. (iii) Modification of the foreign exchange regulations, simpli- fying the multiple exchange rate system. Import sur- charges will be eliminated and additional import trans- actions are to be transferred from the official rate (06.65) to the more depreciated free rate. The objective is to be able to cope with foreign exchange demand with- out further accumulating arrears. (iv) On the basis of the above fiscal and monetary guidelines, the Costa Rican authorities have started negotiations for a stabilization credit from the Central American Stabiliza- tion Fund recently established by the five members of the CACM, and have indicated their intention to seek a stand- by arrangement with the IMF. The higher liquidity of re- serves resulting from drawings on the proposed credits would allow the authorities to reduce and eventually eli- minate the existing payment arrears.  - 5 - 12. Medium and long term development prospects are good for Costa Rica, although the rate of economic growth in 1972 is likely to be reduced to 3 or 4 percent in real terms because of the problems which the country's tradi- tional exports are facing, together with the continued interruptions of trade within the Common Market. In general, future policies will have to concen- trate on expanding exports and diversifying the economy to reduce the recur- rence of short-term fluctuations, with an increase in private and public sav- ings to support investment and growth. Later in the decade, various new exportable agricultural foodstuffs, forest products and bauxite have good prospects for development. Also, if the Central American countries are suc- cessful in re-structuring the CACM and inducing the growth of less protected and more efficient local industries, Cost Rica's industry should be able to compete successfully in broader markets. An educated labor force and a long record of political stability are very positive factors from this point of view. 13. An inadequate transport system is still one of the major bottlenecks to the expansion of the economy. Substantial investments are also needed in power and telecommunications facilities if these are to keep pace with pro- jected demand increases. Availability of power at low cost will be a major element in the diversification of the economy and further development of in- dustry. Demand for adequate communication facilities in the larger cities continues to grow rapidly, while interconnection between rural towns and villages is still minimal and represents a serious handicap in rural devel- opment. Flood control and irrigation are also basic elements for the suc- cess of an agricultural diversification policy. The Bank's last economic report estimated that, if the same overall growth rates as in the 1960's were to be achieved in this decade, gross public external capital inflows of $320 million would be required during 1971-76. These should be attaina- ble without any major increase in the level of external public debt service which at present absorbs around 13-14 percent of export earnings, so long as Costa Rica can continue to rely on official aid for the bulk of the long-term capital required. The country's economic record justifies continued external support of its development efforts provided that inflation is prevented from getting out of hand. 14. Apart from the World Bank, external financing is principally pro- vided by USAID, the Interamerican Development Bank (IDB) and the Central American Bank for Economic Integration (CABEI). AID has been active in agricultural development, construction and maintenance of roads and health. IDB is financing mainly agricultural and industrial credit, water supply, housing, feeder roads, rural electrification and vocational education. CABEI is financing projects with a regional impact, principally in trans- port, industry and telecommunications. AID loans are for a term of 40 years with interest of 2-3 percent and most IDB loans are extended from the Fund for Special Operations, carrying 3-4 percent interest rates and terms rang- ing from 15 to 30 years. The terms of CABEI loans -- which often provide  -6- 100 percent financing of local expenditures -- vary in accordance with the ultimate source of financing, but generally contain a substantial conces- sionary element. The past lending of the main official lending agencies is summarized below. (US$ millions) IBRD IDA AID IDB- CABEL- Lending 1950-1965 47.7 4.6 33.8 35.9 4.5 Lending 1966-1971 37.2 - 40.8 30.8 50.4 Transport 15.7 - 7.1 7.5 29.0 Power and Telecommunications 18.5 - - 3.8 4.8 Education - - - 4.8 - Health - - 1.6 6.3 - Housing - - - - 5.2 Agriculture 3.0 - 21.4 2.9 - Industry - - 5.0 5.5 11.4 Others - - 5.7 - - Total 84.9 4.6 74.6 66.7 54.9 1/ Includes some local currency loans. 15. The World Bank's lending in Costa Rica over the past four years has been directed in the main towards the strengthening of economic infra- structure and the diversification of agriculture. In addition to the two loans now proposed for power and telecommunications, a further loan of $9 million for a second agricultural credit is included in the program for the current fiscal year. Operations under consideration for subsequent years include further lending for power and highways and possibly an edu- cation project. The Bank has agreed to act as an executing agency for an UNDP-financed transport study of the metropolitan area of San Jose. PART III - THE PROJECT Sector Background 16. Costa Rica's power and telecommunications systems are the most developed in Central America. Per capita power consumption (506 KWh) and installed capacity are the highest, and power rates the lowest, in the re- gion. Telephone density has doubled over the last five years and is now 3.3 telephones per hundred of population, which is higher than the average of the other Central American countries, though still well below the aver- age in Western Europe. As in the past five years, the power and telecommuni- cations sectors are expected to absorb about 17 percent and 9 percent res- pectively of public sector investment during 1972-76.  17. Sales of power in the interconnected system are expected to in- crease at an average annual rate of 9.3 percent up to 1985. As a proportion of total sales, sales for industry and commerce have increased rapidly from 36 percent in 1965 to 41 percent in 1971 and are expected to reach 53 percent in 1985. The standby generating capacity and other facilities required to support the expansion program would be provided under the proposed power project. 18. Out of the existing 39,000 connected telephone lines, a large proportion is concentrated around the capital of San Jose, with little or no service for rural areas. The proposed telecommunications project would not only expand and improve telephone service in the capital and the provin- cial cities, but also extend service to the outlying centers, providing basic telephone and telegraph services to some 600 smaller towns and villages, where public call offices would be established. Besides the social benefits of reducing the isolation of these rural centers, there will also be impor- tant non-quantifiable economic benefits from promoting the orderly marketing of agricultural products, reducing travel time and fostering trade among the rural centers themselves. Project Entity 19. ICE was established in 1949 as an autonomous agency of the Govern- ment, to plan and carry out a coordinated program of electrification of the country. In 1958 it was given by decree the additional responsibility of providing telecommunications services in Costa Rica, but it was only in 1962 that ICE was given a permanent concession and actually began carrying out its new responsibilities. In 1968 ICE acquired 92 percent of the shares of Com- pania Nacional de Fuerza y Luz (CNFL), a private company which operated the principal power distribution system in the country. ICE has a seven-member Board of Directors, one of whom is a government member. The six non-govern- ment members are appointed by the Government for eight-year staggered terms. The general manager, appointed by the Board, is responsible for all manage- rial and administrative functions. 20. Both power and telecommunications operations are well run, although their growth has brought about certain problems which need to be studied. The proposed power loan would finance a management and organization study of ICE by consultants, which would concentrate on three problem areas. First, ICE is highly centralized and the study would explore the possibility of greater delegation of authority and a clear distinction between management and policy making functions. Second, ICE uses its own staff to construct power projects and this has contributed to the difficulties under the third power project (Loan 631-CR), indicated in paragraph 3. The consultants would review ICE's policy with regard to construction. Third, the coupling of power and tele- communications has been an effective method of establishing these new ser- vices, but with continued expansion an orderly demarcation is becoming ne- cessary. The technologies of power and telecommunications, as well as account- ing requirements, are different, and supporting functions such as training and marketing have also little in common. The consultants would make recommenda- tions on how to achieve operational independence necessary for efficient fu- ture development of power and telecommunications.  2-. A review is also needed of the overall organization and regulation of the power sector. At prt-sent there are 57 public utilities and 120 auto- prodi,cers of energy most of wihich are small, poorly regulated and inefficient. No national power sector prcgram exists, and this has led to some duplicatiwt of facilities, lack of standardization and uneconomic tariffs. Although owned by ICE, the principal power distribution company (CNFL) is operated as a se- parate entity; a complete merger could perhaps result in a more efficient -e n" -aragerial. and financia' resources. T:ie functions of the regulatory agercy (Sar%;lcio Nacional de E