Peru - Railway Rehabilitation Project (Vol. 1 of 2) : Report and recommendation of the President

R E S T R I C T E D Report No. P-153 FILE COPY This report was prepared for use within the Bank. In making it available to others, the Bank assumes no responsibility to them for the accuracy or completeness of the information contained herein. INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT REPORT AND RECOMMENDATIONS of the. PRESIDENT to the EXECUTIVE DIRECTORS on a PROPOSED LOAN to the PERUVIAN CORPORATION for the RE-HABILITATION OF THE CENTRAL AND SOUTHERN RAILWAYS in PERU March 21, 1958  REPORT A!TD RECOMMIDAaTONS OF THE IRESIDENT TO THE EXECUTITVE DIRECTORS ON A R OPOSED LOAN TO THE FERUVIAN CORPORATION FOR THE REHABIIITATION OF THE CENTRAL AND SOUTHERN RAILWAYS IN PERU 1. I submit herewith the following report and recommendations on a proposed loan in an amount in various currencies equivalent to $15,000,000 to the Peruvian Corporation Limited (the Corporation) to finance the importation of diesel electric locomotives, freight cars, rails and other railway accessories for the rehabilitation of the Central and Southern Railways in Peru. PART I - HISTORICAL 2. The Corporation was incorporated in England in 1890 and since that date has operated, inter alia, the Central Railway of Peru Limited and the Southern Railway of Peru Limited, In 1928, the Republic of Peru granted the Corporation the perpetual ownership of these two railways, For the greater part of its existence, the Corporation has been in financial difficulties and substantial amounts had accrued in arrears of interest due to the Debenture Holders. 3. In February 1956, a canital reconstruction scheme was put into effect whereby t>e Corporat:on became the wholly owned subsidiary of the Peruvian Transport Corporation Limited, a new company incorporated in Canada. In May 1956, the Peruvian Corp:oration and its subsidiaries moved their residence from England tc Canada, with a consequent saving of taxes. The reorganiza- tion by simp]ifying the Corporation's capital structure enabled it to raise additional capital. 4. A leading part in the capital reconstruction of the company was played by the firm of S. G. Warburg and Company Limited of London, England. In February 1956, a member of the firm visited the Bank to discuss informally the possibility of the Bank financing a rehabilitation program for the Central and Southern Railways. 5. In April 1956, the Corporation engaged engineering consultants to study and report on the requirements and prospects of the Southern and Central Railways. In August 1956, before the consultants' report could be completed, traffic conditions became very congested on the Southern Railway due to large grain shipments sent by the United States Government to reliove the famine caused by severe droughts in the Puno and Cuzco areas in Peru. After consulting with the Bank, the Corporation applied for and received from the Export Import Bank, a loan of $1,550,000 to cover the cost of three twin-unit diesel electric locomotives to combat these emergency conditions.  I  - 2 - 6. The report of the engineering consultants was presented to the Bank in December 1956, and after suggestions from the Bank, a revised report was completed in March 1957. Thereafter a Bank Mission visited Peru in March and April. Technical discussions with the Manager of the Southern Railway and the Manager of the Central Railway, together with representatives of S. G. Warburg and the Chairman of the Corporation, were held in Washington in August and September. 7. Negotiations took place in September and October with Mr. Korner, a Director of S. G. WTarburg, Mr. Grierson and Mr. 1W-illiam Wdhite representing the Corporation. A Bank Mission visited Peru in November to negotiate the Guarantee Agreement and other financial arrangements with the Peruvian Government. Legislation enabling the Peruvian Government to sign the Guarantee Agreement was promulgated in March 1958. 8. If the proposed loan is made it would increase the total amount of Bank loans in Peru to $55.9 million equivalent net of cancellations. 9. The Bank has already made the following loans in Peru:- Year Loan No. Borrower Purpose Amount Princial (in millions Disbursed as of o) f Dec.-VT 29)57 1952 57PE Government Development of Port of Callao 2.4 S 2,410,528 1952 67P1E Government Operation of Agricultural 1.3 1.300,000 Machinery Pools by SCIPA 1954 98PE Government Operation of Agricultural 1.7 1,700,000 Machinery Pools by SCIPA 1954 105PE Banco Agricultural Agropecuario Credit 5.0 4,999,771 1955 114PE Government Irrigation - Quiroz-Piura 18.0 13,959,098 Project 1955 116PE Pacasmayo Manufacture Cement Co. of Cement 2.5 2,457,827 1955 127PE Government Highway Maintenance 5.0 3,1407,509 1957 162PE Banco Agricultural Agropecuario Credit 5.0 1,338,235 TOTAL 40.9 $ 31,572,968 Principal repaid as of 31 Dec. 1957 amounted to A,2,25h,528  I~~~~~~ 4~~~~~~~~~~~~~~~~~  - 3 - PART _I - DESCRIPTION OF THE PROPOSED LOAN 10. The proposed Loan would finance a substantial part of the foreign exchange cost of a rehabilitation program for the Southern and Central Railways of Peru. Purchases under the proposed loan would include diesel locomotives, shunters and spare parts, freight cars, rails and accessories, station handling equipment and equipment to deal with derailments and wrecks. 11. The Loan would have the following characteristics: Borrower The Peruvian Corporation Limited Guarantor The Republic of Peru Amount The equivalent, in various currencies, of $15,000,000. Term The Loan would be for a period of 15 years, amortized by semi-annual instalmients from February 15% 1961 to February 15, 1973. Interest Rate per cent per annum, including 1 per cent commission. Commitment 3/4 of 1 per cent per annum. Char,! e Legal Instruments and Security 12. Attached are drafts of the following legal instruments which would give effect to the proposed loan: (a) Loan Agreement between the Bank and Peruvian Corporation Limited (No.1). (b) Guarantee Agreement between Republic of Peru (the Guarantor) and the Bank (No.2). 13. The draft Loan Agreement conforms generally to the normal pattern of the Bank's Loan Agreements. Attention is specifically drawn to the following provisions: (a) The Bank is to receive, as security for the loan, a first mortgage upon the immovable and movable properties comprised in the Central and Southern Railways. The Borrower is to be at liberty, however, to create similar and pari passu mortgages in favor of the Export-Import Bank to secure the Borrower's  rp I  indebtedness to the latter. Also, the Borrower may create similar but junior mortgages in favor of the Banco Industrial del Peru as representing the Guarantor, by way of indemnity to the latter against liabilities under its guarantee (Section 5.Ol). (b) The Borrower and its subsidiaries are precluded from disposing of any property having a value in excess of $100,000, or the equivalent, in any period of twelve months, unless the Bank shall otherwise agree (Section 5.10). (c) Unless the Bank shall otherwise agree, the future borrow.ings of the Borrower and its subsidiaries must be in the ordinary course of business and may not exceed $500,000, or the equ-ivalent (exclusive of inter-group borrowings) (Section 5.11). (d) Payments by the Borrower to its parent company, the Peruvian Transport Corporation Limited, may be made only under certain specified conditions which are designed to enstre that the Borrower retains adequate surplus and working cajoital Never- theless, the Borrower may pay its parent company during the period ending June 30, 1960 sums aggregating A1,323,000 to enable it to service the parent Company's own debentures (Sections 5.12 and 5.13). (e) Additional conditions of effectiveness include the completion of the security arrangements, the completion of the Mortgage, the completion of arrangements between the Borrower and its p,rent company regarding their financial arrangements and the completion of an agreement between the Guarantor and the Borrower regarding railway tariffs. (Section 7.01). 14. The Guarantee Agreement is similar, in substance, to previous Guarantee Agreements given by the Republic of Peru. Since the Borrower is a private corporation, the guarantee would extend only to the payment of principal, interest and other charges. In addition, the Agreement contains a covenant regarding the timely adjustment of railway tariffs (Section 3.06). PART III - APPRAISAL OF' THE PROPOSED LOAN 15. A detailed appraisal of the project, T.0.154(a)(No.3) is attached. 16. The Central and Southern Railways are two distinct and separate systems. Together they represent more than two-thirds of Peru's present railway transportation system and their efficient operation is necessary to the economic development of the important regions which they serve. 17. The Central Railway links the capital, Lima, and the nearby Port of  bk A  Callao (Peru's chief port) with the Sierra (highlands). Its most important function is the carrying of refined metals, ores and concentrates from the Sierra to the Port of Callao for export, and bringing back supplies for the mining companies, such as fuel and cement. Forty per cent of Peru's foreign exchange earnings are derived from the export of minerals. The major part of such exports are carried by this railway. The remainder of the Central's traffic consists of agricultural produce brought from the Sierra to Lima, and petroleum products, manufactured goods and foodstuffs destined for the Sierra. Since agricultural production on the coast is limited by the small amount of water available, the Lima area will have to look more and more to the Sierra for the foodstuffs needed to supply its growing industrial population. 18. The Southern Railway links the populated southern highlands of Peru, including Peru's second largest city, Arequipa, with the Port of Mollendo and by a separate spur line with the Port of Matarani. A link with landlocked Bolivia is also provided by means of steamer service across Lake Titicaca and rail service from Guaqui (in Bolivia) to La Paz, the capital, both services being operated by the Corporation. 19. Traffic carried by the Southern Railway is much m*.ie diversified in character than that carried by the Central Railway, the greater part consisting of general merchandi'se moving both ways for destinaticns in Peru. A considez'able part of the traffic carried is general merchandise to Bolivia, and minerals from Bolivia for export through Peruvian ports. There are alternative routes for the Bolivian traffic through the Chilean ports of Arica and Antofagasta, but it is expected that the Southern Railway will increase its share of Bolivian traffic. For traffic destined for points in Peru, there is no substitute form of surface transportation, as roads have not yet been constructed which will permit the operation of trucking services. Due to the necessity of constructing newq roads in many parts of Peru where there are at present no means of mechanical transportation, it is unlikely that, for many years to come, roads will be constructed which would permit substantial truck competition with the Southern Railway. 20. The prosnects of the Central Railway are more uncertain than those of the Southern Railway. The Central is more dependent upon mineral traffic, for which freight rates are tied to the selling price of the minerals, a large part of which is generated by a single company (Cerro de Pasco). Since there is a road from Lima to the Sierra, which the Government is in the process of improving, the Central is also more likely to encounter serious competition from road transportation. This further limits its ability to combat falling revenues or increasing costs by increasing tariff rates. However, since the costs of road transportation are more likely to increase than to decline, it seems unlikely that road transportation can displace rail transportation for such commodities as refined metals, concentrates, ores and bulk merchandise, provided the railway can furnish an efficient, reliable, and reasonably-priced A service. The rehabilitation of the Central railway should enable it to offer such a service.  rI  -6- 21. The earnin-s of the railways in recent years have not been impressive. They increased in 1956, the year the new Board of Directors took office, but declined in 1957 due to a decline in Cerro de Pascots operations (due to labor disputes and to a shortage of power caused by a drought). Failure of the Government to adjust tariffs promptly also contributed to a fall in the net revenues of both railways. However, the Government has very recently granted the Southern Railway the full amount of the tariff increases requested by the Corporation under the formula set out in Section 3.06 of the Guarantee Agreement. If railway tariffs continue to be adjusted by the Government promptly to meet changing conditions, future earnings should be more satisfactory. In this connection, it should be noted that the Technical Operations Department Report (No. 3) has allowed for a decline in the projected operating revenues for 1957/58, as a consequence of the current slump in non-ferrous metals prices, and only a slow rate of growth thereafter. 22. Over a period of years, the economies realized from the rehabilitation program should reduce real costscZ both the Central and Southern Railways, with a substantial savirgs in the cost of maintenance of rolling stock. On balance, there is a reasonable probability that modest increases in wages and in the pric- of materials and supplies can be absorbed by increases in traffic volume and in efficiency and by adjustments in rates without seriously affect-ing the competitive position of either of these two railways. Procurement 23. The Borrower has secured and will secure equipment and supplies on the basis of international competitive bidding. Economic Situation 2L. The economic situation against which the proposed loan can be considered is set out in the report on the current economic position and prospects of Peru, W.H. 70 which was distributed to the Executive Directors on f4arch 3 1958. The basic economic prospects of Peru remain favorable. The country has developed rapidly since 1949 and the basic conditions for continuing advance remain. The country's exports are well diversified and should continue to increase. Industry for home consumption is developing and the country continues to be regarded as providing a favorable climate for private foreign investment. 25. While the basic economic prospects of Peru remained favorable, there was a serious deterioration in the financial situation in the last 18 months. As inflationary pressures grew, exchange reserves were reduced and the need for immediate action in the monetary and fiscal field became evident. While remedial actions were not taken as firmly or as quickly as might have been hoped, the situation is now being brought under better control. By permitting the exchange rate to find its own level, the Peruvian authorities  -w  -7- have again demonstrated their firm intention to have the Peruvian economy live within its means. While complete financial stability is not assured, there are good grounds for expecting that financial instability will not reach the point where it counteracts the favorable long term trends operating in the Peruvian economy. 26. Service payments on Peru's external debt are high but are scheduled to fall rapidly and, in view of the countryts economic prospects, leave a sizeable margin for long term borrowing provided short-term credits are undertaken in moderation. Expenditures Necessary to Complete the Project 27. The total cost of the project is estimated to be .120.4 million. The balance of the funds necessary to complete the project will be supplied by the Corporation from its own resources. Pro cts of Fulfilment of Obligations 28. The General Managers of each of the railways and their respective staffs are ccmpetent and these two railways have been well. operated in past years. The new Board of Directors of the Corporation have decided to give the local management board a full measure of local autonomy and have agreed to strengthen the local Board, particularly its ability to handle relations with the Peruvian Government. The Corporation has agreed to establish a contingency fund independently invested to take care of tax and other contingent liabilities (No. 4). 29. In the Guarantee Agreement and in a separate agreement between the Government and the Corporation, the Government, the rate making authority, would undertake to adjust railway tariffs to such levels as will be calculated to cover the Corporation's operating costs, interest upon all outstandin7 debt, and a fair return upon the ewity. So that the Government may be in a position to implement its undertaking as promptly as possible, the Government has agreed to the establishment of an independent railway tariff commission to inform appropriate Government departments of the financial condition of all railwqays in Peru and to make recommendations to the Minister of Development and Public Works who has the power to fix railway tariffs. A formal undertaking in this respect (No. 5) will be signed at the same time as the Loan Documents. 30. Given these arrangements on tariffs, and the provisions detailed in sub-paragraphs (b), (c) and (d) of paragraph 13 above, the Corporation should be able to operate on a sound financial basis and to meet the service requirements on the Bank loan. The transfer of the loan service into foreign exchange should not impose an undue burden on the Peruvian economy. PART IV - COMPLIANCE ITITH ARTICLES OF AGREEMENT 31. The Report of the Committee provided for in Article III, Section 4(iii) of the Articles of Agreement of the Bank is attached (No. 6).  _8_ 320 I am satisfied that the proposed loan will comply with the Artitles of Agreement of the Bank. PART V - RECOMMENDATIONS 33. I recommend that the Btnk make a loan in an amount in various currencies equivalent to U.S. $15 million to the Peruvian Corporation Lindted for a term of 15 years with interest (including commission) at 5j % and on such other terms as are specified in the form of the Loan and Guarantee Agreements and that the Executive Directors adopt a Resolution to that effeet in the form attached (No.7). Washington, D.C. Eugene R. Black March 21, 1958 President