China - Third Railway Project

Dan of The World Bank FOR OMCIuL USE ONLY C& /- :PC C,- C1t- Report No. P-S_-CHA REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT AND THE INTERNATIONAL DEVELOP?JENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN IN AN AMOUNT EQUIVALENT TO $160.0 MILLION AND A PROPOSED CREDIT OF SDR 63.0 MILLION TO THE PEOPLE'S REPUBLIC OF CHINA FOR A THIRD RAILWAY PROJECT March 17, 1986 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS Currency unit - Yuan (Y) Y 1.0 = Fen 100 Calendar 1985 January 1986 $1 = Y 2.96 Y 3.20 Y 1.0 = $0.34 $0.31 FISCAL YEAR January 1 to December 31 WEIGHTS AND MEASURES X = meter (= 3.281 feet) sq m = square meter ( 10.764 square feet) cu m = cubic meter { 35.315 cubic feet) kcm = kilometer C= 0.621 mile) tkm = ton kilometer (= 0.621 ton-mile) pkml = passenger-kilometer ( 0.621 passenger-mile) am = 0.1647 acre = 0.0667 hectare (ha) mu = kilo-Newton (-=9.81 ton-force) kWh = kilowatt hour (= 860.42 kcals) CTK = Converted ton-km or traffic unit >CTK = million tons mtpy = million tons per year PRINCIPAL ABBREVIATIONS AND ACRONYMS USED CIF - Cost, insurance and freight CRSCC - China Railway Signal & Communications Company CTC - Centralized Traffic Control EAAMS - Economic Analysis of Aluminum Milling in Shanghai ERR - Economic Rate of Return FAS - Free Alongside Ship FOB - Free on Board FYP - Five-Year Plan GRS - General Railway Signal ICB - International Competitive Bidding MR - Ministry of Railways SAA - State Audit Agency SOE - Statement of Expenditure SPC - State Planning Commission TSP - Triple Superphosphate XRSF - Xi'an Railway Signalling Factory  FOR OFFICIAL USE ONLY CHrNA THIRD RAILWAY PROJECT Loan/Credit and Project Summary Borrower: People's Republic of China. Beneficiary: Ministry of Railways (MR). Amount: IBRD Loan: $160.0 million. IDA Credit: SDR 63.0 ($70 million equivalent). Terms: IBRD Loan: 20 years including 5 years of grace; standard variable iaterest race. IDA Credit: standard. Project Description: This will be the Bank Group's third invoLvement in the railway subsector. The proposed project will support the Government's objectives of increasing railway capacity and improving its operations and efficiency. It will also further develop MR's technical and managerial capabilities and contribute to the-overall economic growth of the country. The project will consist of five components: (a) upgrading and electrification of the 456 km single track Line between Chongqing in Sichuan province and Guiyang in Guizhou province; (b) upgrading and electrification of the 704 km single track line between Yingtan in Jiangxi province and 2iamen in Fujian province; (c) increasing the capacity of the Xi'an Railway Signalling Factory, which is a part of the China Railway SignaL and Communications Company, and improving the quality of its production; (d) introducing mechanized track maintenance on a pilot project basis by providing equipment, technical assistance and training; and (e) supporting continuation of the Traffic Costing Study, initiated under the First Railway Project (Loan 2394-CHA). The electrification works involve proven technology that is already in wide use in China and elsewhere in the world; technological risks are therefore small. Similarly, the modernization of the Xi' an factory carries little risk, since it will include the participation of an established foreign manufacturer. The Ministry of Railways has successfully completed similar projects for a number of years; risks from inadequate project implementation and operation are tberefore negligible. Accordingly, the risk that the benefits of the project will fall substantially short of projections is low. This docunment has a reucted distribution and may be used by recipients only in the pcrfornnanc of their ofcil dutics. Its contents may not otherwise be disclosed without World Bank authorization.  - ii - Project Cost: Local Foreign Total ($ min) -- Chongqing-Cuiyang Line 104.7 95.7 200.4 Yingtan-Xiamen Line 113.8 119.2 233.0 Xi'an Railway Signalling Factory 0.9 12.0 12.9 Permanent Way Maintenance - 17.2 17.2 Traffic Costing Study - 0.3 0.3 Base Cost 219.4 244.4 463.8 Physical contingencies 22.0 12.2 34.2 Price contingencies 39.1 40.4 79.5 Total Project Cost /a 280.5 297.0 577.5 Financing Plan:- IBRD - 160.0 160.0 IDA - 70.0 70.0 Government 280.5 67.0 347.5 Total Financing 280.5 297.0 577.5 Estimated Disbursements: Bank Group FY 1987 1988 1989 1990 1991 1992 1993 Annual 2.3 16.1 57.5 57.5 50.6 41.4 4.6 Cumalative 2.3 18.4 75.9 133.4 184.0 225.4 230.0 Rate of Return: 30% Staff Appraisal Report: No. 6002-CHA, dated March 7, 1986. /a The project is exempt from import taxes and duties.  REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT AND THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN AND CREDIT TO THE PEOPLE'S REPUBLIC OF CHINA FOR A THIRD RAILWAY PROJECT 1. I submit the following report and recommendation on a proposed loan and credit to the People's Republic of China to help finance a third railway project. The loan for $160 million would have a term of 20 years, including 5 years of grace, with standard variable interest rate. The credit, for SDR 63.0 ($70 million equivalent), would be on standard IDA terms. PART I - THE ECONOMY 2. A country economic report entitled, "China: Long-Teim Issues and Options" (No. 5206-CHA) was distributei to the Executive Directors on : May 22, 1985. Basic data on the economy are given in Annex I. Background 3. Since 1978, China has initiated economic reforms in both rural and urban areas and in the external sector. Reforms have been greatest in rural areas. Following some experiments with the abolition of collective farming in impoverished areas, the Government implemented a comprehensive restructuring of rural institutions based on various forms of the "production responsibility system". By 1983 the farm household had become the fundamental unit of management and production in agriculture, within a framework of collective or state ownership of land and major fixed assets. Reforms have not yet proceed- ed as far in the urban economy, but there have been significant changes in enterprise management and finance. The scope for collective and individual economic activities has been enlarged and state enterprises have been allowed greater freedom in production, pricing and marketing above their mandatory plan targets. State enterprises have also been allowed to retain some profits and investment projects have increasingly been financed on a loan rather than a grant basis. 4. In international trade and investment, China has promoted opening up to the rest of the world in recent years. Between 1978 and 1984, the share of exports to GDP nearly doubled to about 10Z, a ratio similar to other large economies such as the U.S. and Brazil. Foreign investment has been encour- aged, first through establishment of four Special Economic Zones and signing of joint venture contracts for offshore oil exploration, and more recently through opening of several coastal cities to foreign investment.  -2- Growth and Stabilization 5. Reform have helped stimulate rapid development of the whole economy. Real GDP growth averaged 5Z p.a. between 1978 and 1981 and 1OZ p.a. between 1981 and 1984. During these six years, per capita incomes in real terms more than doubled in rural areas and increased by more thAn 50% in urban areas. Agriculture has continued its remarkably strong performance, with gross agricultural output value (excluding rural industry and comerce) rising at nearly ;1Z p.a. between 1981 and 1984 and grain output at 8Z p.a. (reaching over 400 million tons in 1984). Cash crops and animal husbandry, stimulated by rising demand and attractive prices, have also grown rapidly. Gross indus- trial output value grew at over 1OZ p.a. over the same period, with heavy industry growing somewhat faster than light industry (12Z p.a. vs. 9Z p.a.). If rural industrial output is included, total industrial output value grew at close to 12Z p.a. in real terms between 1981 and 1984. The energy constraint on industrial growth was eased by rising coal output (8Z p.a. between 1981 and 1984), renewed increases in crude oil production (4Z p.a. between 1981 and 1984) and improvements in the efficiency of energy utilization (primary comiercial energy consumption grew only 60Z as fast as GDP between 1981 and 1984). Manufactured exports growth at 8Z p.a. between 1981 and 1984 was slower than during the 1978-81 period but it started from a much higher base and in the face of worsening world market conditions. 6. The Government continues to face difficulties in combining system reform and rapid overall growth with maintenance of economic stability. During 1979 and 1980, China experienced large budget and current account deficits combined with excessive investment and inflationary pressures. In response, a strict stabilization program was introduced in 1981 relying mainly on administrative controls on investment spending. The program slowed growth but also helped lower the budget deficit from about 5Z of GDP in 1979 to less than 1Z in 1981, reduce inflation to around 2% p.a., and change China's external position to one of current account surpluses averaging nearly $4 billion during 1982-84. As a result, foreign debt and debt service ratios remained at low levels ($6.4 billion and 5.5% respectively in 1983) and China's foreign currency reserves (excluding gold) rose to $17 billion (over 7 months' imports) by mid-1984. 7. This comfortable balance of payments position, achieved at the cost of drastic reductions in investment spending and some recentralization of investment decisionmaking, disappeared rapidly during the course of 1984 and early 1985. Partly as a result of decentralization of decisionmaking and the lack of effective indirect levers, there was a rapid acceleration of invest- ment and consumption during 1984 and the first half of 1985 causing the economy to overheat. Real GDP grew by 14Z during 1984, while average wages in state-owned enterprises rose by 20% and domestic credit grew by 36%. The retail price index rose by only 3Z in 1984, but inflation is expected to be higher in 1985. Imports of capital goods increased from $4 billion in 1983 to over $7 billion in 1984, with most of the increase occurring in the second half of the year. There was also a rapid expansion in consumer goods imports. These trends continued during early 1985. As a result, foreign exchange reserves (excluding gold) had fallen to about $10 billion by July 1985 (equivalent to 3.1 months of exports), and the current account  -3- deficit for the year is likely to be in the range of $10 billion. The Govern- ment has responded quickly by launching a strict stabilization program that includes further increases in interest rates as well as a series of adminis- trative directives governing bank credit and project approval. As a result, aggregate credit and demand as well as new import orders have begun to slow, though total imports will continue to rise as past orders are filled. Recent Reforms 8. The Central Committee of the Chinese Communist Party issued a major document on "reform of the economic structure" in October 1984. Recent reform developments have been fully in accordance wiLh the directions indicated in the October decision: (a) state enterprises should be made fully independent units which pursue profits and are responsible for losses; (b) the scope of mandatory planning should be reduced and replaced by indicative planning while the focus of planning should shift from annual to medium- and long-term guidance planning; (c) a more rational price system should be introduced by reducing the role of state-controlled prices and increasing the role of "floating" and free market prices; and (d) the tax system should be improved, finance and banking should be reformed and a larger role should be given to indirect macroeconomic regulation through instruments such as tax, credit and pricing policy. 9. Rural reforms have continued to progress more rapidly than reforms elsewhere in the economy. There has been a remarkable spread of nonagri- cultural activities like processing, transport, and commerce. "Specialized households"' (which concentrate on cash crops, animal husbandry, or nonagri- cultural activities) and pooling of capital by small groups of households in various types of ventures are becoming increasingly common forms of economic organization in China's rural areas. Wholesale markets for some agricultural products have emerged. To encourage investment in land improvement and devel- opment, farming contracts between collective and peasant households for the use of land (which typically had been fixed for no more than 3-5 years) can now be extended to as long as 15-20 years. In early 1985, the system of agricultural procurement was changed. Previously the Government purchased quota output of grain and other crops at relatively low prices and stood ready to purchase all above-quota output at a higher p-ice. Under the new system, procurement up to a certain amount (below former quota procurement) is based on contracts concluded voluntariLy between peasants and procurement agencies. Prices for these purchases are based on the reLatively high average price of past years. Output above the contracted amount must be sold by peasants directly on the free market, but the Government will ir' ene to purchase grain if the price falls to the original low quota procurement price. Thus a considerably larger portion of basic crop production will be produced for and traded on markets with flexible prices. 10. The momentum of urban reforms has revived, with significant progress on several fronts. In enterprise management, the focus has been on broadening and delineating the decisionmaking authority of urban enterprises. Profit retention now extends to virtually all state-owned industrial enterprises and to nonindustrial sectors like transport, commerce, construction, and other services. Urban collectives and individual enterprises, as well as a variety  of joint ventures between them and state enterprises, have grown rapidly (the number employed in urban individual enterprises rose from 150,000 in 1978 to 2.31 million in 1983). 11. In financial reforms, the most important new development has been the implementation of a profit tax system to replace profit remittances by state enterprises to the government budget. Though most enterprises have switched to this system, the benefits have been limited because of the application of a different effective tax rate for each enterprise, to offset the impact of distorted relative prices and other factors. Similar problems have resulted in the abandonment of an attempt to impose a fee or charge on the fixed capital provided to state enterprises by the Government, and they have hindered the shift from grant to loan financing of new fixed investment. Financial discipline at the enterprise level remains weak, in spite of efforts to strengthen accounting and auditing systems and more strictLy enforce existing financial regulations. 12. Some progress has been made with price reform. The majority of r agriculture commodity prices were decontrolled even before the recent change in pricing and procurement of grain. Prices of many minor consumer goods are also set by negotiations between producers and commercial units. "Floating prices" (up to 20Z above or below official prices) are now allowed for many industrial producer goods (either for all output or for output above the mandatory plan target). Price adjustments for key energy products and raw materials (which in many cases are severely underpriced) and for subsidized basic consumer goods like grain and edible oil have proven more difficult to implement, hindered by the potential impact of price changes on urban living standards and on the finances of energy-using enterprises. Nevertheless, some price rises have occurred (e.g., for coal and petroleum), and moreover the share of free market transactions, at largely uncontrolled prices, has increased in recent years. Gradually over time, and only partly as a result of conscious policy, a two-tier system is emerging; a large but shrinking share of the total supply of most important goods is subject to mandatory plan allocation and administratively set prices, while at the margin a substantial and growing share is allocated by the market mechanism, largely at flexible prices. This pattern may permit China to "grow out of the plan" in a rela- tively smooth transition, though there are obvious threats to this strategy arising from the strong incentive for arbitrage between planned and unplanned realms. 13. The Government recognizes the need to develop new tools of indirect macroeconomic management and has taken some steps to do so. The People's Bank of China was established as a separate central bank at the beginning of 1984, with its commercial banking functions taken on by the newly created Industrial and Commercial Bank of China. In 1985, new methods of credit planning and control were introduced and lower-level and specialized banks were given significant redeposit requirements. Interest rates (including deposit rates) were also raised in 1985, with some move toward unification of rates and development of a term structure resembling that in other countries. Technical transformation loans with a maturity less than one year and loans for working capital now carry the same 7.9% interest rate while loans of longer maturity carry higher rates, up to 10.8% for 10-year loans. However, interest rates on  -5- budgetary capital construction loans (formerly grants) remain low and there are a variety of directed credit schemes. On the external side greater use is now being made of the exchange rate. The old internal settlement rate was abolished at the beginning of 1985 and between January and end-October 1985 the rate against the U.S. dollar declined by over 13%. Despite these changes progress in developing new indirect levers of control has been slow. Recent difficulties in securing macroeconomic balance highlight the need to strengthen institutions and macroeconomic management tools (including monetary, fiscal, and exchange race instruments) for a decentralized and more market-oriented economy. Long-Term Issues and Prospects 14. In September 1985 a national party conference adopted a proposal which will be the basis for drafting a new Seventh Five-Year Plan covering the period 1986-90. The proposal reaffirms a political commitment to economic reform and provides guidelines for future reform and development. One of the main objectives of the plan will be to create a favorable environment for reform which, in turn, will set the stage for future development. Target growth rates (7% p.a. for industry, 6Z for agriculture, a little over 7% for GlNP) are b'low rates of growth achieved with the Sixth Five-Year Plan, invest- ment is to be restrained in the next few years, and emphasis is to be placed upon quality rather than quantity of output. It is felt that slower growth will facilitate reform. 15. The plan proposal identifies three main areas of reform. First, enterprise management and incentives are to be improved by: giving enterprises greater autonomy in production, pricing, and employment decisions; lowering and equalizing taxes; increasing competition, increasing accountability for performance; and reforming personnel procedures. In addition, some small state enterprises will be turned over to collective or individual management through contract or lease. Second, the role of the market is to be extended and market networks strengthened. The scope of mandatory planning will be further reduced and markets for capital, technology, and labor will gradually be developed. Third, the emphasis of planning will shift from detailed admin- istrative control to indirect macroeconomic control through economic policy. To this end a series of mutually reinforcing reforms in the planning, pricing, fiscal, banking, and labor and wage systems will be introduced during the plan period. 16. Implementation of the plan proposal will help foster an environment in which fundamental reforms can be gradually implemented in a coordinated way. But specific policy measures will take time to design and then to imple- ment. Many of the reforms required will be difficult, particularly since reforms in different areas are closely interrelated, and thus appropriate sequencing and coordination are essential. For example, price reform in the absence of improvements in enterprise financial discipline will have limited benefits, yet the more profit-oriented behavior that would result from tighter financial discipline would exacerbate the adverse impact of distorted prices. Similarly, reform of the labor allocation system will be incomplete without eliminating many of the "social responsibilities" of enterprises (which now provide housing, medical care, and pensions for their workers and  -6- in many cases education and jobs for workers' children) and replacing them wich Covernment-supported social service programs. The plan proposal suggests moving in this direction by comercializing housing. 17. China's objective of quadrupling the gross output value of industry and agriculture between 1980 and 2000 (which means CDP growth of well over 6X p.a.) will require significant improvements in efficiency as well as continued high saving and investment rates, The plan proposal recognizes there must be major structural changes in the economy over the next two decades, including a reduction in the share of agriculture, a rise in the share of industry and services (which at present is unusually low), and substantial urbanization. There will also be a shift within agriculture, away from grain and basic crops and into cash crops and animal husbandry. The new plan will emphasize development of the service sector, mainly through removing restrictions on collective and individual activity. Urban development will focus on small and medium sized cities and towns while restrictions on growth of large urban areas will continue. 18. Certain physical/technical constraints will hinder the attempt to achieve China's targets for the year 2000 and its longer-term goal of catching up with developed countries. Despite rapid growth and substantial improve- ments in efficiency in recent years, agriculture may again become a constraint on overall growth, since land in China is severely limited. In energy, short- ages of fuel (primarily coal) and electricity may continue to constrain growth in transport and commercial infrastructure. Without large new investments and improved efficiency, economic growth will lag. In mobilizing resources in all these areas, China could profitably make use of foreign borrowing. Finally, the rising share of the elderly in' China's population (related to the slowdown in population growth) means that more resources will have to be devoted to maintaining their consumption levels, especially in the decades after 2000. 19. Poor motivation and inefficient utilization of labor in the state sector of the economy are major problems which can be solved only by coor- dinated reforms in labor allocation, the wage system, enterprise management, and social services, among other things. Reforms in the system of education and training to develop China's "human capital" potential also are crucial. Backward technology and inefficient use of existing technology must be addressed by a combination of reforms, appropriately directed investment, and transfer of advanced foreign technology. Irrational location of factories, suboptimal scale of many plarts, and poor utilization of physical capital in general are related problems. 20. If reforms successfully transform the economic system, with a bene- ficial impact on growth and efficiency, a new set of issues will come to the fore, as the plan proposal recognizes. Management of a reformed economy with indirect fiscal, monetary, and other instruments is a major issue (see para. 13 above). In this context, maintaining an adequate saving rate (if the Government no longer accounts for the bulk of aggregate saving) and avoiding inflation (as well as deep cyclical downturns) will be major goals. Assuring an adequate minimum standard of living for the population and an appropriate level of social services will become a major challenge as enterprise and rural communal responsibilities in these areas are reduced. The problem of poor,  -7- backward rural areas in various parts of the country will continue to require attention. Redistributing financial resources to these areas through the fiscal system, easing restrictions on migration out of the poorest areas, and lowering nonagricultural wages to make investment in them more attractive are some options for alleviating poverty. 21. In order to mobilize the external resources needed for rapid, sustained growth the plan proposal calls for export growth of 40-50% over the next five years, greater efforts to attract foreign investment, and increased commercial borrowing. If exports grow at 8% p.a. between 1984 and 1990 and imports grow at 9% p.a., China would have a relatively modest current account deficit of around $4-5 billion p.a. (except in 1985) during the remainder of this decade, equivalent to about 1% of GNP. This implies that the present debt service ratio would increase only moderately by 1990. If China's exports grow more slowly imports will probably have to be cut back because a higher borrowing target, though feasible in terms of debt service indicators, would probably run into supply constraints as China would become one of the largest developing country borrowers. This highlights the need for continued export growth in order to meet other plan objectives and service greater commercial borrowing. The plan proposal recognizes that greater use of exchange rate and pricing policies will be needed to encourage export growth. 22. Even with continued good export performance, China will have substantial external capital requirements during the remainder of the decade. Under the trade growth assumptions outlined above (exports growing at 8% p.a. and imports at 9% p.a. during 1984-90), the current account deficit would be over $5 billion in 1990 and the gross borrowing requirement would be about $6.5 billion. If export growth fell to 6% p.a. during this period and imports continued to grow at 9% p.a., the current account deficit would reach $14 billion by 1990. Although the plan proposal calls for increased borrowing at commercial rates, access to concessionary capital will play an important role in sustaining China's growth. China also has a claim to concessionary lending because it is still one of the poorer countries of-the world. But China's access to concessionary capital to finance development and moderniza- tion is limited; apart from Bank Group funds, a significant amount of conces- sionary capital is likely to come only from Japan and a few other bilateral donors and will probably average no more than $500-600 million p.a. during the rest of the 1980s. PART II - BANK GROUP OPERATIONS 23. To achieve the target growth rates envisioned in proposals for the Seventh Five-Year Plan, to increase efficiency and innovation, and to maintain equity in distribution, China will need continuing and fundamental reforms. Large investment will be required and China will need to import more technol- ogy and increase trade. In the next few years, therefore, the Bank can best assist China by increasing its access to foreign technology and practices and supporting the development and implementation of reforms that will help to increase the efficiency of resource use and reduce poverty.  -8- 24. To address China's objective to update technology, the Bank will play the role of intermediary. In transportation, energy, industry, agriculture and the social sectors, the Bank will contribute to technology transfer by bringing the Bank's experience to bear on project design and by helping China to seek appropriate technical solutions through international competitive bidding, training, and foreign technical assistance. 25. Bank assistance will be closely linked with the Government's reform efforts. There are five major elements common to both rural and urban reform in China that will be the focus of the Bank's involvement. First, institu- tional clhange, involving both the separation of economic and administrative functions and further decentralization of decisionmaking, will extend to every sector in which the Bank is involved as well as the overall process of plan- ning and management. Second, financial sector reform, primarily development of financial institutions that can serve as intermediaries between the suppliers and users of resources, has become a focus of reform and is an area where Bank assistance can play a useful role. Third, improving planning and project analysis will be critical to reform in sectors such as agriculture and industry, where decisions are now being made by households and independent enterprises, as well as in infrastructure where direct government involvement will be required. The Bank will therefore continue its emphasis on introduc- ing appraisal methods and will include sector investment and financial planning as well as analysis of intersectoral issues. Fourth, the Bank will be involved in the Government's major program of price reform and development of indirect levers such as control via money, credit and fiscal policies. And finally, the Government will make institutional and policy changes to further improve the quality of social programs. The Bank will thus support reforms in health, education and other social services and measures in particular, to address the problems of poor regions. Economic and Sector Work 26. Our economic and sector work in China aims to develop the Bank's understanding of the structure and direction of the Chinese economy and to introduce to the Government new perspectives on economic management. This work builds a foundation for lending and for the dialogue with Government on issues of reform and development options and policies in the various sectors. Past work has included two major economic reports, studies on sectoral investment analysis and planning, and collaborative research with Chinese institutions. We have also organized seminars on macroeconomic and sector issues. 27. Over the next two years, the Bank will carry out a large program of studies to-follow up on issues identified in che most recent economic report and analyze policy options. In this program, we will examine alternatives for developing the financial system and foreign trade and investment. We will also analyze issues of intersectoral and interregional planning and develop- ment of resource-poor regions. One such study is already underway in Gansu province to review and formulate programs to increase interregional resource flows, improve the spatial efficiency of development and reduce poverty. Research on urban development and transport planning and finance at the provincial level wilL also be initiated, and we will undertake studies of  -9 regional industrial subsectors to form the basis for project preparation. Collaborative studies with Chinese research institutions will continue. An ongoing study of management and guidance of state-owned industrial enterprises will be followed by a study of collective enterprises, which are expected to become increasingly important industrial organizations in the reformed system. Lending Operations 28. Since China's change of representation in the Bank Croup in May of 1980, 33 projects involving lending of $3,159.L million to China have been approved. Of the projects, eleven have been in the agriculture sector, seven in energy! four in transport, four in industry, three in eduration, two in technical cooperation and one each in health and water supply. In FY85, IFC made its first investment in China of $17.02 million in automobile manufactur- ing. Annex II contains a summary statement of these loans, credits and IFC investment as of September 30, 1985. 29. In addition to the proposed third railway project and the recently approved Second Rural Credit, Third Industrial Credit, and Second Technical Cooperation projects, we expect to present projects to the Board this year for aquaculture, provincial higher education, port, power, gas development, and health. For FY87 and beyond, we expect the China lending program to continue to grow from current levels. Infrastructure projects in energy and transport will remain priorities. Technical renovation of enterprises, particularly in industry, will be given greater attention and support as will the regional approach to project development, now being used to assess the needs of Gansu province. 30. In the energy sector, future Bank lending will be aimed at reducing energy consumption and expanding energy production. For example, in the coal subsector, we will assist in upgrading the facilities and operations of exist- ing mines and in transferring improved technology for mines under construction or in operation. in power, we will assist China in technology transfer, staff training and institution building. Through a power tariff study, we will seek to introduce a tariff system based on marginal cost and emphasize the need for a nationwide power system development program. In the gas subsector, the rationale for Bank involvement will lie in the identification, packaging and transfer of specialized technologies as well as in the strengthening of investment planning and management capabilities. 31. Future transport projects will both upgrade technology and strengthen institutions. In roads, major changes in organization and financing will be required as a result of administrative decentralization and introduction of the production responsibility system in rural areas. In railways, we will focus on technologies to improve domestic production of railway equipment and materials in addition to our work on line construction and electrification. We also intend to broaden our involvement in ports to include coastal shipping and inland water transport. For all transport subsectors, we will support efforts to improve financial analysis and investment planning. 32. Agriculture lending will focus on developing institutions to provide services to individual farmers and to monitor and stimulate change in the pace  - 10 - and pattern of agricultural development. The shift from grant to loan finance and the increased autonomy of the rural banking system will be major aspects of change that will be supported through rural credit projects. We will continue to assist with the training, research, extension, and other service activities of the ministries concerned with agriculture. In addition, we ezpect to finance programs for specialized agricultural development such as livestock and fisheries, and for irrigation and area development. 33. Bank lending in industry, as in agriculture, will focus on strength- ening of financial intermediaries which provide credit to state and collective enterprises. In addition, we expect that there will be large regional projects in fertilizer, cement and machine tools and other subsector projects concerned with upgrading technology and improving organization and management. 34. Bank lending in education will gradually be broadened beyond the present concentration on higher education. For example, we will finance vocational and technical education which is now being given great emphasis in China. In view of the Government's recent decision to universalize access to primary and lower secondary education, another major aim of education lending will be to assist with basic education, particularly in poor rural areas. In this context, support for teacher education will be given priority. 35. Project preparation in the urban sector is currently concent-ated in Shanghai on efforts to improve services, especially in environmantal upgrading and housing, and development of municipal institutions. Future lending is expected to include support for development of medium-size and small urban areas in specific provinces. In addition, we expect to continue lending for rural water supply. Bank lending in health will provide access to new medical technologies for more efficient health care in both the lingering problems of communicable disease, primarily in poor rural areas, and the emerging problems of chronic disease. This will involve further support for medical training and planning and management of service delivery systems. Projects will also support the reform of systems for supplying and financing health services. 36. Cofinancing with multilateral and bilateral agencies has been arranged for projects in coal, power and rural water supply and will remain a feature of our assistance program. We will ezplore options for cofinancing with export credit agencies. Commercial bank cofinancing and the use of B-loans also appear viable, particularly as China increases the overall volume of its foreign borrowing. In technical assistance, we will continue to incor- porate into projects components for training, overseas study, and access to foreign expertise. In addition, we will be the executing agency for a second UNDP umbrella project in China. EDI activities remain an important element of the Bank's program and in coming years will provide an extensive program of policy seminars for senior Chinese officials, and economic tnd financial management courses and sector-specific training for officials from core and line agencies.  - 11 - Implementation 37. Project implementation is generally proceeding well. Most project agencies, as well as the Ministry of Finance and the State Planning Commission, have established and staffed offices to handle Bank projects. Disbursement performance has also been satisfactory. Special accounts have been established for 22 of the 33 approved projects and have helped to speed up disbursements. In October 1985, the Bank opened a resident office in Beijing to support further expansion of the lending program, accelerate project preparation, improve project implementation and further economic and sector work. PART III - THE TRANSPORT SECTOR 38. The structure of China's economy, which for three decades emphasized heavy industry at the expense of light industry and the service sector, is still inherently "transport intensive," despite recent reforms of the sectoral priorities. Chinese policy statements repeatedly identify transportation and energy shortages as the two most critical bottlenecks in the economy. Coal is at the heart of both problems, because coal is simultaneously the most impor- tant source of energy and the largest user of transport capacity. This dual problem with coal is exacerbated by China's high level of energy consumption per unit of GDP (about two and a half times that of other LDCs). However, the need to ship large volumes of coal is not the sole cause of the transportation bottleneck. 39. The rapid growth of China's economy in recent years has naturally entailed a growing demand for the shipment of commodities of all sorts, and for passenger travel as well. Efforts to reduce waste within the transport system (for example by eliminating cross hauling of the same commodity, increasing the processing of raw materials before shipment, and increasing the intensity of road and waterway utilization) are certainly desirable. More fundamentally, however, the Government's strategy for solving transportation shortages will have to rely on an expansion of the system's capacity, primarily by increasing the productivity of existing facilities whenever possible, and secondarily by building new facilities where needed. 40. Freight Traffic. Domestic freight transported in 1984 reached 1,131 billion ton-km (tkm), more than a 15-fold increase since 1952, or an average annual growth rate of almost 9X, systematically higher than the growth of domestic product. By the year 2000, domestic freight traffic could be in the range of 3,000 billion tkm, or nearly three times the 1984 level. The modal split has moved toward a more balanced use of modes, but the railways still handle 64Z of the traffic versus 82Z in 1952; this predominance is expected to continue for quite some time. 41. Passenger traffic reached 362 billion passenger-km (pkm) in 1984, a 14.6-fold increase since 1952 and an average annual growth rate of almost 9Z. Since 1978, growth has averaged 13% p.a. This illustrates the potential demand for travel as income grows. It is likely that this growth would have  - 12 - been even more rapid if it had not been constrained by the limited capacity, particularly of the railways, to offer more passenger services. The modal split has shifted more rapidly than for freight, and the railways now hAndle 56% of the traffic versus over 80X in 1952. Despite the rapid growth of passenger traffic in recent years, the mobility of people in China is still much lower than in countries of comparable income levels. By the turn of the century, passenger traffic may well reach about 1,500 billion pkm per year or about four times current levels. 42. Investments. Over the period 1953-84, some Y 136 billion, or 14X of all new investments under central government control went to transport. In comparison with other countries, annual levels of transport investment appear somewhat on the low side, a factor contributing to make transport a bottleneck to economic development. For example, by 1983, 30 million tons of coal had accumulated in Shanxi for lack of transport, and some of this stockpiled coal was destroyed by spontaneous combustion. Despite a recent policy of curtailing production to match available transport, the volume of coal stockpiled in Shanxi increased during 1984. Rural areas are short of transport, both for agriculture and for local enterprises. In the ports, lack of proper handling facilities is hampering trade of bulk commodities such as fertilizers, cement and grain. In the forthcoming decades, a much larger investment effort will be needed in transport if these bottlenecks are to be overcome. 43. Port traffic has grown rapidly since 1976, reflecting the economic opening of China to foreign trade. Annual growth has averaged 11.3Z. Domes- tic coastal shipping and inland water transport also increased substantially. As a result, ports became congested despite commendable efforts to achieve high productivity. A major effort to modernize ports started in the early 1970s and continues with particular emphasis on container and bulk terminals, the latter mainly for coal. The Bank's first transport operation in China was the Three Ports Project (Loan 2207-CHA, December 1982), which includes container terminals at Huangpu, Shanghai, and Tianjin, and a coal berth at Huangpu. A second port project, which will provide eleven additional berths at Tianjin, is now being considered for Bank financing. 44. The highway network comprised about 915,000 km in 1983, of which about 180,000 km were asphalt paved, about 510,000 km were gravel or sand paved, and the remainder were earth roads. Despite impressive expansion of the road network since 1949, when only some 80,000 km of roads suitable for motor vehicles existed, the roads in China today are inadequate because: (a) pavement strength and quality are poor; (b) there are many thousand kilo- meters of extremely rough macadam surfaced roads with traffic in excess of 300 average daily traffic; (c) congestion is severe near cities, due to mixed slow and fast moving traffic; and (d) there are gaps of about 4,000 km on major national roads linking large cities and provincial capitals. The road network and road transport in China today can therefore be characterized as under- developed. Road maintenance, however, is well organized and currently absorbs much of the attention and resources of the provincial and other local authorities.  - 13 - 45. Except for western China, the highway network is still very much a system of feeder roads to the railways. Nevertheless, motor traffic on the national highways has grown at a very high overall annual average of 15Z since 1978. The Bank's First Highway Project (Loan 2539-CHA/Credit 1594-CHA, September 1985) involves the construction or improvement of about 290 km of national roads and about 1,400 km of rural roads. 46. Transport Issues and Objectives in the 1980s. The transport system has been severely taxed by the recent economic development, and capacity con- straints are evident in all modes. At present, railway transport is a greater constraint on energy supplies than coal mine development. Recently initiated projects of line electrification and new line construction are addressing the problem although it will take several years to alleviate bottlenecks between major mining areas and coastal cities. Improved freight car technology and other operational improvements could also contribute to capacity increases. China will also need to expand substantially its port and waterway facilities for domestic and foreign trade. But the most serious transport need is for dramatically expanded road transport, especially in rural areas where increased specialization has created an urgent demand for better farm-to- market transport services. It is widely recognized in China that road trans- port should and will play a larger role in the future. Yet there seems to be no strategic plan to bring this about. There is a need for more efficient trucks of both larger and smaller size, as well as for more and better roads to handle the traffic. Potential sources of financing for road development, such as road user charges, need to be investigated as they could generate sufficient funds for an accelerated construction and betterment program as well as contributing to an economically appropriate division of traffic between modes. Considerable efficiency gains could be made in the entire transport system through better intermodal coordination, which has thus far been impeded by the vertical and self-contained organization of transport and other sectoral agencies. Through container transport from origin to destina- tion is still the exception. Changes in policy, pricing and management of the system are needed to maximize the benefits of intermodal transport. To support all the development referred to above, staff development and training will also be an important objective in the sector. The Railway Subsector 47. Organization. The principal agency in the subsector is the Ministry of Railways (MR), with a staff of some 3.1 million, which administers a nationwide, interconnected system of 52,000 route-km. Other railroads are administered by the Ministries of Coal Industry, Forestry, and Communications for uses associated with their own operations, and by provincial governments for limited services within their own jurisdictions. The Chinese system is the fifth largest and carries the second highest freight and passenger traffic in the world. 48. Four Vice-Ministers and a Chief Engineer support the Minister of Railways in administering 19 bureaus concerned with specific functional aspects of MR's work, and 13 regional administrations which are responsible for operations. The regional administrations are organized in the form of State-owned enterprises, which are self-accounting, have authority over their  - 14 - own retained earnings, and have contractual capacity and the right to hire and fire staff. Each administration is headed by a general manager, and is typically divided into a number of sub-administrations, each of which controls the basic units (stations, workshops, etc.) that are responsible for day-to- day operations within its territory. 49. MR also controls a number of factories, which together provide the greater part of MR's requirements of locomotives, passenger and freight cars, ties, fishplates, etc., and nine construction companies which carry out most of the civil works. Design, engineering and architectural services are also carried out "in house" by a number of specialist bureaus. Signalling and communication facilities are the responsibility of the China Railway Signal and Communications Company (CRSCC), a State-owned enterprise under the direction of MR. CRSCC will be a beneficiary of part of the proposed project. 50. Education and Research. In coordination with the State Education Commission, MR operates 11 universities, 20 staff colleges for in-service training, and more than 2,000 schools with 100,000 teachers and staff. Eight of the universities provide technical courses, two provide medical courses, and one is a teacher training college. Most of them now offer graduate programs. For high school graduates unable to enter university, MR operates more than 60 vocational schools which train locomotive drivers and other operations staff; MR's other schools provide primary and secondary education for an enrollment now exceeding one million. Graduates of MR's schools proceed exclusively to employment in MR, but graduates of MR's universities may be employed elsewhere. 51. MR also operates the ten research institutes which comprise the China Academy of Railway Sciences. Mostly, the institutes are concerned with applied research and acceptance tests on new products procured locally and abroad, but also provide instruction at Masters and Doctorate levels. 52. Planning and Investment. On the basis of national production plans and origin/destination tables for key products and of its own observation of passenger movement patterns, HR develops five-year traffic forecasts by prin- cipal routes throughout its network. At the regional administration level, these forecasts are translated into traffic density patterns and compared wita existing Line capacities. From these comparisons are derived the railways' requirements in motive power and rolling stock and in route capacity enhance- ment. Production schedules and work programs are developed for MR's own fac- tories and construction companies, and the total investment plan is submitted to the State Planning Commission (SPC) for approval; SPC may indicate the need for some adjustment, and further iterations of some or all of the process may be required, but finally a total plan is evolved which is consistent (and integral) with the national five-year plan. From this plan, various subsi- diary plans are derived, including a manpower development plan and a schedule of material requirements (in particular, rails and other steel products) from external suppliers. At present, however, a financial plan does not form part of the package. 53. In the 1981-85 Sixth Five-Year Plan (FYP), after falling to Y 1.4 billion in 1981 during a period of budgetary stringency, railway investments  - 15 - were increased to Y 2.6 billion in 1982, Y 4.2 billion in 1983, and Y 6.4 billion in 1984. The 1983 amount represented over half the total investment in transport of Y 7.2 billion, but was still far short of the level which would be needed to alleviate bottlenecks. The Seventh FYP (1986-1990), now in preparation, will focus on upgrading existing facilities; the anticipated traffic growth will be carried primarily by the existing system. Neverthe- less, expenditure levels are expected to be at least equal to those of the Sixth FYP. 54. Budgets, Accounts and Audit. The expense of MR's bureaus fo.rms part of the central Government budget, and is not recovered from railway revenues. Operating costs of the regional administrations are controlled by annual bud- gets compiled at sub-administration level. Accounting is likewise focused at the sub-administration level, although some basic procedures such as cash collection and disbursement are decentralized to the operating units. Consolidation of budgets and financial statements is routinely carried out only up to the administration level; consolidation at the overall system level (all administrations combined) is generally confined to income statement items. The accounting system is double entry, on the accrual basis, and accounting rules and procedures are uniform between administrations. 55. In common with all ministries whose responsibility includes the su- pervision of enterprises, MR contains an Audit Bureau, whose principal func- tions are to monitor compliance with accounting rules and to evaluate the efficiency of operations. MR's Audit Bureau was established in 1985, and its procedures are being developed with a pilot administration. The Industrial Transport .Bureau of the State Audit Agency (SAA) also carries out test audits of parts of MR's operations selected randomly. In particular, SAA will audit the accounts of sub-administrations which are beneficiaries of Bank loans and IDA credits. 56. Railway Facilities and Rolling Stock. China's railway network more than doubled in size between 1949 and 1984, from 21,800 to 51,700 route-km. The network now includes 9,700 route-km of double track and 3,100 route-km of electrified track. Further double tracking and electrification works are in progress as present line capacity is insufficient to meet traffic demands. The rail network is served by a fleet of 11,100 locomotives, 291,000 freight cars and 19,600 passenger coaches. At present, 68% of tractive power is still steam, 28% is diesel and 4% is electric. Rolling stock includes large numbers of older wagons and coaches, many in poor condition and with high operational and maintenance costs. Traffic growth has outstripped production of new units and the fleet is far from adequate. 57. Operations. Despite the limitations of network and rolling stock, rail operations utilize track and equipment intensively and efficiently. Freight traffic density averages 15.0 million net tkm per route-km which is the highest freight density in the world after the Soviet Union, and 50% higher than freight density in the United States. China's passenger traffic density of 4.2 million passenger-km per route-km is also the second highest in the world, this time after India. Passenger traffic density in the Soviet Union is roughly the same as in China. Despite this heavy traffic density, track and other fixed instalLations are carefully maintained, aLthough the  - 16 - labor-intensive methods now used are rapidly becoming inadequate for the maintenance of trunk lines and will soon become inadequate elsewhere under the traffic planned for the future. 58. Scope for utilizing track and equipment even more efficiently is mostly limited to lengthening trains (freight car turnaround time is already extremely quick and it would be difficult to improve upon the present average of 3.4 days). The average train now has 35 cars as 75X of passing loops are only 650 meters Long. Most of the remaining 25% of loops are 850 meters long, which allow 50-car trains to run in some regions. A program is under way to extend passing loops in more regions. 59. Traffic. Freight traffic on the railways has grown from about 100 million tons in 1950 to 1.2 billion tons in 1984. Because of an increase in the average length of haul, traffic volume in tkm has grown even faster, from 39.4 billion in 1950 to 533.2 billion in 1978, averaging 1OZ p.a. Since 1978, growth has slowed to around 4.5% p.a., but was again 9% in 1984. Three quarters of all freight traffic involves ten important basic commodities (including coal, iron and steel products, grain and construction materials), and the shortage of freight capacity has emerged as one of the key constraints on economic growth. The Seventh FYP envisions an annual growth rate of 6%, leading to a freight traffic of 1.7 billion tons by 1990. 60. In 1950, the railways carried about 150 million passengers; in 1984, they carried 1,123 million. The growth of passenger traffic has been partic- ularly rapid since 1978 -- that is, since the introduction of major economic reforms. In just the six years from 1978 to 1984, passenger traffic increased from 109.1 to 204.3 billion pkm, an average of 112 p.a. This rapid growth shows the high priority afforded to personal travel out of the extra income generated by the economic reforms. Yet the mobility of people in China is still low. Average per capita travel in India is about 800 pkm p.a., much more than China's average of about 300 pkm p.a. This low mobility is partly due to a shortage of transport infrastructure; there is an acute shortage of passenger coaches, and on crowded lines passenger trains compete for space with freight trains. The Seventh FYP envisions an annual growth rate of 6%, leading to a ridership of 1.6 billion passengers by 1990. 61. Tariffs. In common with other sectors, the railways have changed their tariffs very little since the early 1950s. Freight rates were increased in late 1983 for the first time since 1967, at which time they had been reduced. Passenger rates, however, remained at the 1967 level. The 1983 freight rate reform doubled the minimum chargeable distance to 100 km, and increased rates for 75% of the commodities (including coal, cement, oil and fertilizers) by 23% on average. As of end May 1985, the average freight haul of about 572 km yields an average gross revenue of Fen 1.68 per tkm, 57% above average operating costs. The average passenger journey was 169 km, and this yielded a gross revenue of Fen 1.78 per pkm, 65Z above operating costs. To further discourage short haul traffic, the Government introduced the following rate increases effective June 1, 1985: (a) 36.8% for less than 100 km passenger trips; (b) 50% for monthly suburban season tickets; and (c) Y 4.00 per ton for freight transport up to 200 km. It is too early to assess the effect of these rate changes on MR's financial results.  - 17 - 62. Government Objectives and the Role of the Bank Group. The Sixth Five-Year Plan (1981-1985) allocated Y 27.5 billion, 16.2Z of total investments, to the transport sector. Of this, Y 17.3 billion was for investment in railway. These resources have facilitated considerable development of the railway network, but not enough to keep pace with China's rapid economic growth. If China is to achieve its goaL of quadrupling the gross value of industrial and agricultural output by the year 2000, the railway's expansion and modernization must be accelerated. The Bank Group's strategy for the subsector is to support this acceleration of railway expansion and the improvement of operational efficiency. It will, in addi- tion, assist HR in modernizing its technical and management capabilities. The first part of the strategy is thus to be responsive to the immediate materiaL needs of China's railway system as they arise; the second part is to help better equip the subsector with the expertise it needs to manage the future development of the railway system. 63. The first project (Loan 2394-CHA, April 1984, presently being implemented on schedule) contained components to alleviate bottlenecks on two key routes, and to increase locomotive production; the second (Loan 2540-CHA, August 1985, just entering implementation) focused on further route capacity improvements and the expansion of passenger coach manufacture. The proposed project will continue the provision of enhanced route capacity -- in this case aimed at improving the flow of mining and agricultural products and will provide both hardware and software to increase and modernize the manufacture of signalling and switching equipment. Updated technology in track maintenance will also be introduced. 64. On the software side, the first project initiated the design of a traffic costing system, and a study team from MR has now examined railway costing systems in Europe and in the USA and has reported on its main conclusions and recommendations. The second stage (supported partly from the first loan and partly from the proposed one, para. 77) will complete system specification and implement it on a pilot basis. The second railway project provided for the startup of a major management information system study, which is just getting under way in selected areas of MR. In the context of ongoing project work, the Bank Group has also begun a dialogue with MR on aspects of total system planning and control, and will shortly present a seminar (with the assistance of senior railway executives from UK) to demonstrate approaches to system management better tailored to MR's needs in the new era of economic reforms (para. 92). By such means, the Bank Group hopes, through the instru- mentality of future projects, to be of assistance to China's railway subsector in its organizational development as well as in its system expansion. PART IV - THE PROJECT 65. In January 1985, the Government requested Bank Group assistance in financing urgently needed investments to increase transport capacity on the Chongqing-Guiyang and Yingtan-Xiamen lines, to modernize and increase the production capacity of the Xi'an Railway Signalling Factory, to improve the maintenance of permanent way on heavy-traffic lines and to support the  - 18 - continuation of the Traffic Costing study initiated under the First Railway Project. The proposed project was prepared by the Government and was appraised in June/July 1985. A Staff Appraisal Report (No. 6002-CRA, dated Karch 7, 1986) is being distributed separately. Supplementary project data are given in Annez III of this report. Negotiations were held in Washington, February 24-27, 1986 with a Government delegation headed by Mr. Luo Qing, Deputy Director of the Ministry of Finance. 66. Project Objectives. The project will make a direct contribution to the Government objective of increasing railway capacity to support economic growth. In particular, the project will significantly improve transport capa- city in the southwestern provinces of Sichuan and Guizhou and the southeastern provinces of Fujian and Jiangxi, all four of which rank below the median in terms of provincial per capita incomes. The modernization of production of switch machines and relays at the Xi'an Railways Signalling Factory and a pilot project in track maintenance will introduce significant technological changes enabling capacity increases throughout the system without large new infrastructure investments. 67. Project Description. The proposed project consists of the following five components designed to: (a) provide much-needed additional capacity on the 456 km Chongqing- Guiyang line, which supports vital mining and agricultural activities in southwest China; (b) provide urgently-needed additional capacity on the 704 km Yingtan- Xiamen line, which is the major link between the Special Economic Zone at Xiamen and the interior of China and carries important coal and timber traffic; (c) improve technology and increase production at the Xi'an Signalling Factory, thereby providing essential equipment for the upgrading of traffic control and safety throughout China; (d) provide better maintenance for permanent way on lines with heavy traffic density, where traditional labor-intensive methods prove inadequate; and (e) proceed with the traffic costing study started under the First Railway Project (Loan 2394-CHA, April 1984). The five subsections which follow give a brief summary of each of the project components. 68. Chongqing-Guiyang Line Upgrading and Electrification. The Ministry of Railways proposes to upgrade and electrify the 456 km single-track line from Chongqing in Sichuan province to Guiyang in Guizhou province, most of which runs through difficult mountainous terrain. On the most difficult section, the 1984 traffic of 5.14 million tons in the heavy (northbound) direction, plus six daily pairs of passenger trains, was already in excess of normal operating capacity and was achieved only by extraordinary efforts.  - 19 - Traffic on the remaining sections is also approaching capacity. Because of the difficult terrain, double tracking or realignment would be far more expensive than electrification. Electricity will be provided primariLy by the 630 MW hydro project at Wujiang, and secondarily by two thermal generating stations at Chongqing and Guiyang. 69. Three alternatives were considered for increasing the capacity on this line: a major realignment to reduce ruling gradients; the use of foreign diesel locomotives instead of the present mix of steam and domestic diesels; and electrification. Electrification was found to be the least-cost solution and also offers operational advantages because adjoining routes are already electrified. Adequate electric locomotives to serve the line will be produced by the Zhuzhou factory, supported in part by the Bank's First Railway Project. 70. Yingtan-Xiamen Line Upgrading and Electrification. The 704 km single-track line from Yingtan in Jiangxi province to Xiamen on the coast in Fujian province was built to low gradient and curve standards in the 1950s. The line's limited capacity has three causes: steep gradients, lengthy sections without passing loops, and heavy curvature. The ruling gradient for most of the line is 1.2Z. More serious is the problem of long sections that have no passing loops, which occurs because the line snakes its way through a series of narrow river -alleys, with a steep slope on one side and water on the other. Finally, there is the problem of severe curvature: of the 704 km, curves occupy a total of 372 km (54%), and curves with a radius of 300 m or less occupy 193 km (28%). 71. Six alternatives were considered for increasing the capacity on this line: two realignments; an entirely new line in a parallel river valley; the use of domestic diesel locomotives instead of the present steam locomotives; the use of imported diesels; and electrification. Electrification was found to be the least-cost solution. In the beginning electricity for this project will come from the existing grid, but in the future primarily from two new hydro stations, both under construction: 300 MW at Shaxikou and 1,400 MW at Shuikou. 72. Xi'an Railway Signalling Factory (XRSF). The Xi'an factory is part of the China Railway Signal and Comunications Company (CRSCC), a State-owned enterprise under the supervision of MR. XRSF has about 3,200 employees, including 335 technical personnel. Among its products are relays, switch machines, other signal parts, control panels for diesel locomotives, and locomotive radiators. System-wide, MR uses about 2,000,000 relays of the AX type manufactured at XRSF. The AX relay has several shortcomings, which affect its reliability in the field; its current life expectancy is one million cycles or about 15 years. XRSF produced about 110,000 relays in 1984, near its capacity limits, but is being asked to produce 220,000 in 1988, and 300,000 in 1990, of which only about 30,000 are for replacement and the rest are for new installations. Yet, with the current life expectancy, replace- ments alone should require about 133,000 relays per year. The proposed modernization of the factory would increase output to 300,000 relays p.a.  - 20 - 73. The model ZD6 switch machine, of which XRSF can produce about 6,000 per year, was designed for use with 43 kg rail and is too weak for handling 50 kg rail, especially in cold weather. The ZD6 sometimes fails in service, creating the risk of derailment. Since MR plans to upgrade its high density routes to 60 kg (and eventually 70 kg) rail, a stronger, safer model is needed. The Seventh Five Year Plan calls for XSRF to produce 12,000 switch machines per year in 1990, either the ZD6 or preferably an improved model, and this target is far beyond the factory's current capabilities. 74. In late 1985, CRSCC entered into a technical assistance contract (not financed by the Bank Group) with an American supplier, General Railway Signal (GRS) of Rochester, N.Y. The contract includes technology transfer to XRSF, technical assistance by CRS experts seconded to XRSF, and training of factory staff. Specifically, GRS will assist CRSCC to modernize XRSF, increase its capacity, and improve both the design and quality of the relays and switch machines produced. The Bank Group contribution will be to finance machine tools, handling equipment, and other production and management aids. 75. Maintenance of Permanent Way. Track maintenance has traditionally been carried out manually in China, although a few primitive mechanical devices are used for some operations. Traffic is increasing on many lines and the track deteriorates faster while time for track maintenance becomes shorter; manual maintenance is a slow process, no longer adequate for providing the track quality and safety needed for present and future traffic levels. To prevent accidents, slow orders are increasingly imposed, reducing line capacity at a time when more capacity is badly needed. Better track maintenance methods are clearly required and MR has now decided to mechanize some operations such as tamping, levelling, lining, ballast cleaning and ballast regulating. 76. The proposed project will assist MR in determining the types and numbers of mechanical equipment best suited to the Chinese conditions of heavy traffic, short intervals between trains, and low wage levels. Equally impor- tant are the design of a track maintenance program, the organization of track maintenance teams, the adjustments needed in train operations to allow the use of heavy on-track machinery, and the training of staff in operating and main- taining the new equipment. The proposed project will therefore, in addition to providing financing for hardware, focus heavily on the important matter of staff training. 77. Traffic Costing Study. This study was initiated under the First Railway Project (Loan 2394-CHA, April 1984). The study is progressing well and on schedule. Since it will not be completed by December 31, 1987, the loan closing date, the proposed project will include funds (about $300,000) to finance the foreign costs of the study after that date. During negotiations, it was agreed that the Borrower shall continue to carry out the study accord- ing to the terms of reference and timetable agreed with the Bank under the First Railway Project, and according to arrangements acceptable to the Bank Group. 78. Technical Assistance and Training. Training of staff in new technology and management is included in the components above. The  - 21 - corresponding technical assistance and training program totals 333 man-months, of which 261 man-months are for training Chinese staff abroad and 72 man- months are for technical assistance by foreign experts in China. During negotiations, it was agreed that the training program will be carried out in accordance with the outline and timetable agreed with the Bank Group. 79. Cost Estimates and Financing. Detailed designs are completed for all project works. Quantities were derived from final engineering, and unit prices are based on current world market prices for equipment to be imported. The cost of equipment and materials to be procured locally and not to be financed by the Bank Group was estimated on the basis of current domestic prices. The estimated project cost, expressed in January 1986 prices and including training and contingencies, is about $577.5 million, of which $297.0 million represents direct and indirect foreign exchange costs. The Government has requested a loan and a credit totalling $230 million which woultd cover about 77Z of the estimated foreign exchange cost. The Government will finance other materials, equipment and construction costs from its own resources. 80. An average of 7.4Z physical contingencies was included in estimated project costs. AnnuaL price escalation rates were applied to local and foreign costs in accordance with Bank Group guidelines, as follows: 7.0% in 1986 and 1987, 7.5X in 1988, 7.7% in 1989, 7.6% in 1990, and 4.5% in 1991. The January 1986 exchange rate of Y 3.20 to the US dollar was used for the calculation of the foreign exchange costs. The total cost of consultants to assist MR in track electrification works and track maintenance mechanization is estimated at about $400.000. In addition, $1.2 million will be earmarked for training MR personnel abroad in track electrification works, signalling equipment technology and manufacture, and mechanized track maintenance. $300,000 will be allocated to the continuation of the costing study. 81. The proposed Bank loan and IDA credit would provide financing for the following: (a) the Chongqing-Guiyang and Yingtan-Xiamen lines upgrading and elec- trification: rails, other steel products, timber and cement, trans- formers, copper wire, insulators, power and signalling cables, design and construction equipment, technical assistance and training; (b) the Xi'an Railway Signalling Factory: machine tools and other equipment needed to increase production to the required levels, technical assistance and training; (c) the maintenance of permanent way: the foreign exchange cost of imported equipment, technical assistance, and training; and (d) the Traffic Costing Study: the foreign exchange component of the continuation of the study beyond December 31, 1987. 82. Project Implementation. Upgrading and electrification of the Chongqing-Guiyang and Yingtan-Xiamen lines will be carried out by the rail-  - 22 - ways' own forces. This is common practice for work on lines with heavy traffic. The Ministry of Railways is well equipped and has experience in this type of work. In this case, the Second and Fourth Design and Construction Bureaus will be responsible for track, station and yard upgrading and the Electrification and Automation Bureau for installing electrification equip- ment. Implementation of the other components of the project will be carried out by MR with the help of competent consultants (para. 74). The project is expected to be completed by December 1992, and the Closing Date of the proposed loan and credit would be June 30, 1993. 83. Procurement. Procurement of materials and equipment for electrifi- cation works and of equipment for the XRSF will be subject to international competitive bidding (ICB) in accordance with Bank Group guidelines for pro- curement, except for a number of small items worth less than $150,000 per order and totalling less than $4.0 million, which would be purchased on the basis of quotations received from at least three potential suppliers. All bid packages valued at more than $500,000 will be subject to the Bank Group's prior review of procurement documentation. In bid evaluation, Chinese manu- facturers will be allowed a preferential margin of 15% of the CIF cost of competing imports, or the relevant prevailing level of customs duties, whichever is lower. 84. For items not financed by the Bank Group, Government procurement procedures will apply. Such items comprise civil works, various local materials, and miscellaneous equipment. The civil works involved in this project are not suitable for ICB. They include a large number of small concrete foundations for the catenary masts all along the lines to be elec- trified, and clearance adjustments on a few bridges; these works have to be carried out under heavy traffic. Other civil works include lengthening crossing loops by 200 m each and minor modifications to existing workshops at the XRSF. Delivery of major materials such as rails, other steel and cement is independently arranged by the owner and supplied to the construction bureaus. In this case, such materials are to be procured through ICB and financed by the Bank loan and IDA credit.  - 23 - ($ million) Project Element Procurement Method Total ICB Other Cost Civil Works 0.0 189.6 189.6 (0.0) (0.0) (0.0) Materials 57.4 137.0 194.4 (57.4) (0.0) (57.4) Equipment 175.6 16.2 191.8 (166.6) (4.0) (170.6) Services 0.0 2.0 2.0 (0.0) (2.0) (2.0) Total 233.0 344.8 577.8 (224.0) (6.0) (230.0) Note: Figures in parentheses are the respective amounts to be financed by the Bank Group. 85. Disbursement. Disbursement of the proposed loan and credit would be as follows: (a) 100% foreign expenditures of the CIF cost of imported equipment and materials; (b) 100% local expenditures of the ex-Eactory cost of locally manufac- tured equipment and materials; and (c) 100% of the cost of technical assistance and training. 86. Domestic transport from port or factory would not be eligible for Bank Group financing. Any savings under the loan and credit would be cancelled unless otherwise agreed with the Bank Group. Disbursements against training and contracts for goods and services valued at less than $200,000 each would be made on the basis of Statements of Expenditure (SOEs). To facilitate disbursements for these items, a special account will be estab- lished with an initial deposit of US dollars equivalent to SDR 900,000 repre- senting about four months of expected expenditures. Documentation supporting the SOEs will not be submitted to the Bank Group but will be kept in the project office in Beijing and made available for review by the Bank Group's supervision missions. 87. Disbursements are expected to be very similar to the standard profile. The disbursement schedule is based on the assumption that the proposed loan and credit would become effective by September 30, 1986.  - 24 - 88. Environment. No negative impact on the environment is anticipated from the project. The electrification of the 1,160 km of lines between Chong- qing and Guiyang (currently steam and diesel operated), and between Yingtan and Xiamen (currently steam operated), will significantly reduce pollution in the area. 89. Recent Financial Performance. The MR's recent results indicate a satisfactory growth of profits. While profit growth was driven chiefly by the volume of traffic, careful control of operating costs also contributed; unit costs per traffic unit remained virtually constant throughout the period. Freight revenues also benefitted from tariff increases effected in late 1983. 90. Future Financial Performance. At the present time, so many elements of MR's financial affairs are in the process of change that it would not be sensible to attempt to quantify future results. In the context of national reconsideration of the role of prices in the economy, a number of MR's costs -- especially fuel and energy -- are liable to change; tax policies are in a process of evolution; and financing mechanisms are being radically altered. In such changing circumstances, MR could derive considerable benefit from enhanced procedures for planning and control. Well developed techniques of project financial evaluation and investment planning are already in place and budgetary control is used effectively to manage costs of operations. MR has recently sought Bank Group assistance in improving its management information and costing systems, and measures to address these needs are already in the process of implementation under the First and Second Railway Projects. But the management process lacks the framework of an overall corporate plan -- and especially a financial plan --- to coordinate the individual short and medium term planning mechanisms and focus on the systems of control. 91. Until very recently, State systems of control made it unnecessary for MR to think of itself in corporate terms -- as witness the lack of consolidated financial statements. But new responsibilities increasingly require the operational administrations of MR to be in a position collectively to relate operational results to their new debt service obligations; evaluate the longer term effect of the intended policy of lOOZ debt financing for capital expenditure; assume control of increasing amounts of retained earnings (even though their use is not yet fully discretionary); and formulate and recommend tariff policies for services in a period when costs may become more volatile than hitherto. 92. Such concepts have already been addressed in the context of the broadening dialogue between the Bank Group and MR on financiai and management matters, and will shortly form the subject of a presentation to MR managers by Bank Group staff and consultants (para. 64). The adoption by MR of suitable financial planning procedures is a condition precedent to the formulation of appropriate financial objectives and performance criteria, and none such are therefore proposed for the present project. These are, in any event, sensitive areas in which progress can be expected only gradually. 93. Financial Impact of the Chongqing-Guiyang Line Upgrading and Elec- trification. Because of the line's difficult terrain and the use of expensive diesel traction, often in multiple units, operating costs were about 60% above  - 25 - the network average in 1984 and will remain well above this average even after electrification. Unit saLes revenues reflect the network average, not the cost characteristics of individual routes. Thus, the line income statement currently shows a small operating loss (Y 8.4 million) which is, however, negligible when compared with overall network operating profits (Y 5,400 mil- lion). In 1991, "with project" unit costs are expected to be about 8Z below "without project" costs, even though only 40% of the electrified line's capacity will be used in that year. Unit costs will decrease further with increased capacity utilization. The project is expected to generate a 7Z discounted cash flow rate of return over 25 years, based on present traffic, cost and tariff projections. 94. Financial Impact of the Yingtan-Xiamen Line Upgrading and Electrifi- cation. The 1984 line operating cost of Fen 1.01 per traffic unit was very close to the network average, despite the line's relatively difficult terrain, due to the exclusive use of cheap steam traction, and to the spread of the line's fixed operating costs and overheads. Due to the same factors, "with project" unit costs, although declining with increased utilization of the electrified line, are expected to remain higher than "without project" costs. The profitability of the additional traffic made possible by the project is partly offset by this increase in unit costs. As a result, the discounted cash flow rate of return the project is expected to generate over 25 years is 3%. 95. Such financial returns do not prejudice the railways' overall profitability, since they are insignificant in relation to total earnings. Neither is the project justification called into question, since the economic return is very high. The significance of the results is that they suggest the desirability of considering regional tariff supplements where local unit costs differ significantly from the system average. This would represent a radical departure from previous principles of rate fixing and may not be acceptable at this stage. The ongoing traffic costing study will provide MR with the first opportunity to review the adequacy of its rate structure. 96. Financial Impact of the Xi'an Railway Signalling Factory Moderniza- tion and Expansion. The project will finance the purchase of modern machine tools and equipment to replace existing obsolete ones which have been producing poor quality products. SpecificalLy, the quality of reLays and switch machines will be improved and annual production increased from 110,000 to 300,000 for relays and from 6,000 to 12,000 for switch machines in 1990, the year when the project takes full effect. Furthermore, unit costs of these two products will decrease as a result of better production equipment and economies of scale. In financial terms, the return on investment in new plant and machinery -- represented by the gross profit on the incremental sales and the incremental profit on existing sales -- is 12X. The effect on the factory's results (assuming the mix of products remains unchanged) will be to reach a satisfactory pre-tax rate of return of 28% in 1990. 97. Audits. It was agreed during negotiations that the project accounts and the financial statements of the Chongqing, Guiyang and Fuzbou railway subadministrations, and the Xi'an Railway Signalling Factory will be audited by independent auditors acceptable to the Bank Group, and that audit reports  - 26 - will be sent to the Bank Group for review not later than six months after the end of each fiscal year. 98. Main Benefits. This project will make a direct contribution to the Goverment's overall plan for providing the increased rail transport capacity that is essential for sustained growth of the economy. Under electrification, the Chongqing-Guiyang and Yingtan-Xiamen lines will carry increased tonnages of coal, minerals, timber, iron and steel, grain, and other key commodities, without having to curtail their essential passenger traffic. By increasing both the quality and quantity of production at the Xi'an Railway Signalling Factory, the project will supply components that are essential to the growth of traffic capacity on the railway system, at a substantial cost saving compared to imported components. The proposed project will also improve the quality of track maintenance on high-traffic routes, thereby avoiding the loss of traffic capacity that occurs when slow orders must be imposed. Project benefits will thus be well spread throughout the economy. 99. Overall Evaluation and Risks. Overall economic evaluation shows that implementation of all project components is well justified and should proceed without delay. The overall economic rate of return (ERR) is estimated at 30%. Sensitivity analysis for the various project components indicates that in no case does the ERR for any component fall below 17%. The eLectrifi- cation works involve proven technology that is already in wide use in China and elsewhere in the world; technological risks are therefore small. Similarly, the modernization of XRSF carries little risk, since it will include the participation of an established foreign manufacturer. MR has successfully completed similar projects for a number of years; risks from inadequate project implementation and operation are therefore negligible. The constraints placed on China's development by transportation bottlenecks insure that this subsector will continue to receive Government attention and priority. The evident success of the recent economic reforms, and the rapid growth of transportation demand that has accompanied the reforms, suggest that rail traffic is likely to grow as projected, or even faster, so the risk that the benefits of the project would fall substantially short of projections is low. PART V - RECOMMENDATION 100. I am satisfied that the proposed loan and credit would comply with the Articles of Agreement of the Bank and the Association, and recommend that the Executive Directors approve the proposed loan and credit. A. W. Clausen President March 17, 1986 Washington, D.C.  -27 - Annex I T A I LE LA Page 1 of 7 CHINA. PtOtr ociaL INDICA0OR DATA SMUT aINI. PEOPLrS U1. or u r cin (EIGI AVUSE) /a MOST CmOS RECENT EsTIMATE) lb 17LlS Rt= Lo umt la"11c a (mourn. sq. no ZSrtl-A ASIA & PACIFIC ASIA a PACIrlC TOTAL 9561.0 9561.0 9561.0 wIOI.ITURAL 3z37.6 3 32.0 2665.9 m F CwTA (3519 .. .. 300.0 275.) 1011.1 (KILOGams OP aIT EQuZYALET 202.0 259.0 441.9 ins.? 3n.. P6lA0 II VXTL S _AM PoPUIAnoNmD-n (THOUSANDS) 651000.0 s15110.0 1019.102.0 AM IILAO CZ OF TOTAL) 16.4 s. .. Z1.0 22.3 25.9 POPULATION liRCtzCIIOS oouriaT ZN TsEA 2000 (HILL) 1242.3 STATIOAEY POPULATION CHILL) 1571.0 PowLAzION aamTU 1.6 POPLATON OBESITY PER Sq. Ra. 68.1 11.3 106.2 173.5 366.9 PER Sq. M. Aitt. LAND 199. z10.0 260.6 353.3 1591.2 PMOULATUO "M STRUCUB CX) 0-14 13S 38.9 37.6 32.0 36.3 38.2 15-6 IRS 56.2 57.2 63.1 59.4 57.7 65 ASD AMOVE .7 5.0 5.0 4.3 3.5 POPULTIN GRcwm RATE CZ) TOWL t.1 2.2 1.7 2.0 2.3 URfl .. .. .. 4.1 4.1 -DIEMH RAU (PI TDIOUS) 39.2 /d 35.7 18.6 27.5 30.1 CROn nunA RA (PR TROUS) 23.5 7 6.84 7.1 Lo.2 9.4 GROSS SEnODUCTON RATE 1z.8 Id 2.3 1.0 1.7 1.9 FAMILY PLAIWaI ACCePTRS. AUAL (TOOS) .. USES CZ or MAUE HH .. .. 7t.0 49.4 56. isHUI or FOOD PROD. PER CAPITA C1969-71-100) .. 100.0 123.0 116.6 124.4 PER CAPITA SUPPLY OF CALRIES CZ OF EUQUIrZTS) 94.6 fd 101.6 119.8 106.3 115.7 PWrIL'4S (CRAMS PER D1T) 53.0 77 56.2 69.7 60.1 6O.3 OF 11IC AUMAL AND PULSE 12.5 7d 13.3 15.9 14.4 14.1 ChILD (CAES 1-4) DEA RATM 13.5 8.5 2.0 7.3 7.2 HELTH LIFE XPECr. AT SEIN (TEAS) 41.0 la 60.9 67.1 60.5 60.6 INFANT MM. RATE (PER THOUS) 161.0 7 69.0 38.0 69.2 64.9 ACCESS TO SAFE WATER (CiOP) TOTAL .. .. SO.0 .4.2 &0.0 -MAN .. .. 85.0 7".2 57.6 RURAL .. .. 40.0 34.b 37.1 ACCESS TO EXCRETA DtSPOSAL C ' OF POPULATION) TOrAL .. .. .. 7.8 50.1 US .. .. .. 26.8 52.9 RUML .. .. .. 5.1 64.7 POPMATtiON PER PHYSICIa 7940.0 If 3190.0 /t 17A0.0 If 3318.0 7751.7 POP. PEt SURSING PERM50 3630.0 2760.0 1710.0 4690.7 U464.8 POP. PEM 1SPITAL bED TOTAL 1040.0 760.0 640.0 1039.2 1112.1 UERI 210.0 .. 160.0 299.1 651.4 RURAL 10140.0 .. 1020.0 6028.2 2596.9 ADMISSONS PER ROSPnTAz LED .. .. .. 52.3 41.1 AVERAGE SIZl OF HOUSEHOLD TOTAL .. .. 5.1 . CREAMA. 4.1 RURAL .. .. 5.4 AVERAGE HO. OF PESOMiROOCN TOTAL .. .. URSAN RURAL .. .. PERCEm1TAOE oD ULcINS WM UEECT. TOTAL .. .. UR .. .. RURAL .. ..  -28- Annex I TL^ ^ L..LL , Page 2 of 7 iRh.-Lg@ tk