China - Inner Mongolia Local Railway Project

Document of The World Bank FOR OFFICIAL USE ONLY 4-A/ Z3c'c$cz' Report No. 7459-CHA STAFF APPRAISAL REPORT CHINA INNER MONGOLIA LOCAL RAILWAY PROJECT APRIL 19, 1989 Transportation and Energy Operations Division Country Department III Asia Regional Office This document has a restricted distribution and may be used by recipients only in the performance of their offlicial duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS Currency : Renminbi Yuan (RMB1 ) 1 Yuan (RMBV) = 100 Fen = US$0.27 RMBY 3.712 = US$1.00 (as of April 1989) FISCAL YEAR (FY) January 1 to'Decernber 31 WEIGHTS AND MEASURES m = meter (= 3.281 feet) sq m = square meter (= 10.764 square feet) cu m = cubic meter (= 35.315 cubic feet) km = kilometer (= 0.621 mile) tkm ton-kilometer (= 0.621 ton-mile) pkm = passenger-kilometer (= 0.621 passenger-mile) mu = 0.1647 acre = 0.0667 hectare (ha) kwh = kilowatt hour (= 860.42 kcals) ctkm = converted tkm or traffic unit (1 pkm = 1 tkm) mt = million tons mtpy = million tons per year PRINCIPAL AB;AREVIATIONS AND ACRONYMS USED AAPRC = Industrial Transport Bureau of the Audit Administratior AHB = Animal Husbandry Bureau CIF = Cost, Insurance and Freight EARRP = Economic Analysis of Rural Road Projects EPPEC = Economic Prices for Project Evaluation in China ERR = Economic Rate of Return FOB = Free on Board FYP = Five-Year Plan GIM N Government of Inner Mongolia GNP = Gross National Product GVIAO = Gross Value of Industrial and Agricultural Output TCB = International Competitive Bidding IMLRC = Inner Mongolia Local Railway Corporation LCB = Local Competitive Bidding ME = Ministry of Energy MOF = Ministry of Finance MR = Ministry of Railways NPV = Net Present Value SOE = Statement of Expenditure SPC = State Planning Commission  FOR OMCAL USE ONLY CHINA INNER MONGOLIA LOCAL RAILWAY PROJECT Loan/Credit and Project Summary Borrower: People's Republic of China Beneficiary: Inner Mongolia Local Railway Corporation Amount: IBRD loan: US$70.0 million equivalent IDA credit: SDR 58.6 million (US$80 million equivalent) Terms: IBRD loan: 20 years including 5 years of grace, at standard variable interest rate IDA credit: standard, with 35 years maturity Project DescriDtion: In addition to helping alleviate critical energy constraints, this project represents an opportunity for the Bank Group to support for the first time the Government's pol; X of encouraging local railway development and to assist an economically disad- vantaged region seeking to remedy a serious transport problem. The project consists of the construction of a new 948 km, single- track line, running from Jining in central Inner Mongolia to Tongliao in the eastern part of the region. The line will connect at both ends with the national network. It will have an initial capacity of 7 million tons per year (per direction) and will be expanded as traffic builds up. Major components of the project are: (i) the construction of the railway line; (ii) the acquisi- tion and installation of operational equipment; and (iii) the recruitment and training of staff to operate the railway. Relat- ed components include land acquisition and resettlement, and the development of the second-most important coal deposit in China, so far largely untouched. The project will create low cost, reliable freight and passenger transportation, facilitating in particular the movement of coal and other products between Inner Mongolia and the northeast of China, thus alleviating energy shortages. It is also expected to stimulate other economic activities and trade. In addition, it supports formation of a sound provincial railway company, which will be responsible for the country's longest locally-managed line. This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World BAnk authorization.  - ii - Project costs: Local Foreign Total ---------- US$ million ---------- Land acquisition 2.1 2.1 Resettlement 3.3 - 3.3 Preparation 0.7 0.1 0.8 Infrastru-ture 45.7 9.6 55.3 Bridges & culverts 8.7 18.7 27.4 Tunnels 2.7 1.8 4.5 Track 21.4 3 .9 53.3 Rails - 49.2 49.2 Signalling & communic. 5.4 - 5.4 Power supply 0.3 1.4 1.7 Buildings 10.1 1.6 11.7 Oper. equip. & buildings 5.5 1.7 7.2 Weather contingencies 12.5 1.4 13.9 Temporary construction 13.8 3.3 17.1 Design & administration 21.3 1.4 22.7 Training 0.4 - 0.4 Taxes 6.3 - 6.3 Rolling stock 10.3 - 10.3 Base cost 170.5 122.1 292.6 Physical contingencies 14.8 6.1 20.9 Price contingencies 11.8 9.7 21.5 Total project cost /a 197.1 137.9 335.0 Interest during construction /b - 14.9 14.9 Total financing required 197.1 152.8 349.9 Financing plan: Gov. of Inner Mongolia 102.1 - 102.1 Central Government (MR) 82.9 14.9 97.8 IBRD - 70.0 70.0 IDA 12.1 67.9 80.0 Total financing: 197.1 152.8 349.9 Estimated Disbursements: Bank Group FY 1990 1991 1992 1993 1994 1995 1996 -------------------- US$ million -------------------- Annual 3.0 27.0 37.5 33.0 24.0 16.5 9.0 Cumulative 3.0 30.0 67.5 100.5 124.5 141.0 150.0 Economic rate of return: 18 % /a Import tax and duties are not included in project costs, as the Government will not charge such taxes and duties on imports for the project. b Includes commitment fee on IBRD loan and service charge on IDA credit.  - iii - CHINA INNER MONGOLIA LOCAL RAILWAY PROJECT Table of Contents Paire No. I. THE TRANSPORT SECTOR . ........... . . . .. . . . . . . . 1 II. THE RAILWAY SUBSECOR ..... ..................... 3 III. BACKGROUND ON INNER MONGOLIA ........ .................. 8 IV. THE PROJECT A. Project Origin ....... . . . ................. 9 B. Project Objectives and Relation to the Sector .... .. . 10 C. Alternative Routes Considered .......... .... .C....... 10 D. Project Description * . * ......................... 11 E. Financing Plan ....... . . . . . . . . . . . . . . . . ........ 14 F. Project Implementation ...................... 15 G. Procureme-,t . ...........................a. 17 H. Disburs( .,ents ..................................... 19 I' Environment ......*. . . . .. . . . .. . . . . . ....... 19 V. ECONOMIC EVALUATION A# Overview . . . . . . .. .. v 21 B. Traffic and Tariffs . . I . . . . . . . . . . . . . . . . ..... . 21 C. Capital Costs ..... * . . . . . . . . . ... .a. .a .. .. . 22 D. Sources of Benefits . ... . o oo......... ... .. . .. . . 22 E. Base Case Results .. ...... .*. .o .o.. . a... .o. .. . . . . 23 F. Distribution of Benefits ... oo....... ................a 23 G. Sensitivity Analysis and Risks ..o ............... 25 VI. FINANCIAL ANALYSIS . .....o. . ........ .. . .. . . . o . . . . . 26 VII. AGREEMENTS REACHED AND RECOMMENDATION . ....... o . 28 This report is based on the findings of an appraisal mission to China in July 1988. Mission members included E. Karman (mission leader), T. Watanatada, K. Stephenson, M. Ashraf, S. Chattopadhya, and S. Salman. G. Davis and J. Doolette assisted with environmental and social issues. H. Yen and L. Lin assisted with the economic analysis. C. Harral and R. Huenemann (consultant) assisted with the overall preparation of this report. The report was edited by M. Buchanan (consultant).  -iv- ANNEXES 1. Organization Chart of IMLRC ....... ............ 30 2. Coal Resources in Inner Mongolia and Northeast Demand . 31 3. Land Acquisition and Resettlement Program ......... 34 4. Coal Mine Development and Financing ............. 36 5. Environmental and Social Impact Monitoring Programs . . 40 6. Economic Evaluation Methodology .............. . . 43 7. Animal Husbandry Benefits ........ o............ 56 8. Financial Analysis ... ....................... 59 8. Documents Available in the Project File ............ 65 SUPPORTING TABLES 1.1 Freight Traffic Intensities in Selected Countries 1.2 Railway and Road Network Densities in Selected Countries 1.3 Transport Investment vs. Economic Output in China 1.4 Investments in the Transport Sector 2.1 Freight Traffic Performance 2.2 Originating Ereight Traffic 2.3 Freight Traffic Average Distance 2.4 Passenger Traffic 2.5 Selected Operational Statistics 2.6 Indicators of Railway Asset Utilization 4.1 Investments and Cost Estimates (RMBV) 4.2 Investments and Cost Estimates (US$) 4.3 Staffing and Training Program Lists of Goods to be Financed by the Proposed Loan 4.4 I.C.B. Construction Materials (RMBV) 4.5 I.C.B. Track Materials (RMBF) 4.6 I.C.B. Equipment (RMBV) 4.7 L.C.B. (RMBV) 4.8 Direct P.rchase (RMBV) 4.9 Total List of Goods (RMBV) 4.10 I.C.B. Construction Materials (US$) 4.11 I.C.B.Track Materials (US$) 4.12 I.C.B.Equipment (US$) 4.13 L.C.B. (US$) 4.14 Direct Purchase (US$) 4.15 Total List of Goods (US$) 4.16 Disbursement Schedule 4.17 Implementation Schedule 5.1 Jitong Line Traffic Forecasts 5.2 Economic Net Present Value and Rate of Return Calculations (Base Case)  6.1 Scenario I - Income Statements 6.2 Scenario I - Balance Sheets 6.3 Scenario I - Souices and Uses of Funds Statements 6.4 Scenario II - Income Statements 6.5 Scenario II - Balance Sheets 6.6 Scenario II - Sources and Uses f Funds Statements 6.7 Loan and Credit Disbursement and Repayment Schedule MAPS IBRD 21120 - China, Inner Mongolia Local Railway Project IBRD 21156 - China, Inner Mongolia Local Railway Project, Jining-Tongliao Line.  1. THE TRANSPORT SECTOR 1.1 The transport system in China is characterized by intensive freight traffic in relation to economic output, heavily suppressed demand, high utilization of assets, a heavy emphasis on railways, and distortions in tariffs and costs. Freight traffic intensity (tkm/US* of GNP) in China is exceeded only by that of the Soviet Union, and is much higher than in India, Brazil or the United States (Table 1.1). The major reasons behind China's high freight traffic intensity are a relatively large manufacturing sector, a large share of other low value-added products, and reliance on coal as a major source of energy. In addition, energy efficiency in China is relatively low, and there is still little pre-processing of raw materials before shipping. On the other hand, the density of China's tranBport network, measured both on the basis of geographic area and population, is among the lowest in the world (Table 1.2). 1.2 The economic reforms since 1979 have provided the impetus for a large upsurge in both freight and passenger traffic, severely taxing the transport system. Freight traffic has grown at about 8% p.a. and passenger traffic at about 13% p.a. Port traffic has grown at about 12% p.a., and intercity highway traffic has grown at about 15% p.a. These rates would have been even higher were it not for the capacity constraints which now are evident in all modes. Many power plants and factories have fallen short of their production quotas because the transport system has not been able to deliver the needed raw materials in time. Coal production in Shanxi province, the largest coal producer, continues to be hampered by inadequate rail capacity. Rural areas throughout the country are short of transport, both for crops and for local light industry. At the ports, lack of proper handling facilities is hampering trade in bulk commodities such as fertilizers, cement, and grain. Passenger travel per capita is about one-half the level prevailing in India. Civil aviation is still extremely limited, and most long-distance travel is by railway; 55% of railway passenger-kilometers (pkm) are generated by passengers on trips of 1,000 km or more. 1.3 The Government of China recognizes the transport bottleneck as one of the most severe constraints to economic growth and has increased investments in transport infrastructure. Nevertheless, transport investments are still insufficient and have not grown fast enough to keep Dace with the rapid growth of the economy. Investments in transport infrastructure represented about 1.4% of GNP during 1980-86, compared to 2-3% for countries such as Korea and Brazil. Trans- port investments as a percentage of the GNP have been declining from a high of 2.4% during the Fourth Five-Year Plan (4FYP), to 1.5% during the 6FYP. Despite an absolute increase in transport investments during the 6FYP, the relative investment level is expected to continue to fall during the 7FYP, perhaps to 1% (Tables 1.3 and 1.4). In the future, a substantial expansion of investments will be needed if the transport-related constraints to economic growth are to be overcome. 1.4 Larger investments alone will not be enough, however. There also is need for better coordination among transport agencies to achieve a more balanced development of transport modes, a more intensive effort to modernize transport technology, and further reforms in transport tariffs and in the structure of the transport service industry as a whole. The Government already has taken steps  - 2 - to respond to some of these challenges. It has allowed local authorities more power to plan, finance, and implement projects which wisl expand transport capacity. It has done this partly by encouraging provincial authorities to develop their local railway systems (paras. 2.17-2.24). 1.5 The Government also is introducing more modern technology into the transport system, for example by improving railway rolling stock technology and increasing the use of computers in transport operations. Finally, the Government has authorized private enterprises and individuals to provide trucking, busing and inland shipping services; this deregulation of entry has spurred the growth of highway and inland waterway traffic in recent years. Prices of transport services are still centrally controlled, except for certain elements of road and inland water freight servicee where controls have recently been relaxed. 1.6 The Bank Group has supported the initiatives of the Government in the transport sector through lending, sector studies, technical assistance, and training. As of mid-1988, the Bank Group had loaned about US31.7 billion equivalent to China for the transport sector. The Bank Group presently is implementing twelve trans- port projects and is processing several new projects as well. 1.7 The railway subsector has received about US$885 million in Bank Group funding under four projects (Loan 2394-CHA; Loan 2540-CHA; Loan 2678-CHA/Credit 1680-CHA; and Loan 2968-CHA). Some of these projects are described in Chapter II which discusses the railway subsector. 1.8 The highway subsector has received about US$459 million in Bank Group financing under five projects (Loan 2539-CHA/Credit 1594-CHA; Loan 2811-CHA/Cre- dit 1792-CHA; Loan 2951-CiA/Crodit 1917-CHA; Loan 2452-CHA; and Credit 1984- CHA). These projects provide for the construction of high-quality national roads, totalling about 890 km, and the expansion and improvement of some 2,800 km of rural roads. When completed, some of these roads will help to provide vital missing links in the national highway network; others will help to ease the severe conges- tion in the network or provide access to remote areas. The projects also are designed to support foreign technical assistance and training of Chinese personnel in areas such as supervision and quality control of road construction, design and planning. The projects also support studies on key issues of highway development such as road user charges and methods of financing the expansion, improvement, and rehabilitation of the road network. 1.9 The ports subsector has received about US$494 million of Bank Group iinancing under six projects (Loans 2207-CHA; 2689-CHA; 2907-CHA; 2877-CHA; 3006- CHA; and 3007-CHA). Most of the funds have been used for construction of port infrastructure in Shanghai, Tianjin, Dalian, and Huangpu. Included in this construction are the building of terminals, jetties and berths for handling bulk commodities, general cargo, and containers, as well as the dredging of navigation channels. Funds also have been used for training, technical asqistance, and various studies such as port planning, operations management, and containerization. 1.10 The dialogue between the Government and the Bank Group on transport sector operations and strategy has been strengthened both through the project- financed studies mentioned above and through independent studies carried out in collaboration with Chinese authorities. Being completed is a provincial transport study in Guangdong Province so support the design of a new multimodal transport plan in the province. The Bank Group also recently conducted a survey of the national water transport system, which has reaffirmed the need to further exploit  - 3 - the large potential of the Chinese waterways. Chinese authorities and the Bank group are initiating new transport studies which will focus on long-term strategies for China's transport system. These studies include a multi-ports optimization study which will evaluate medium- to long-term options for developing the deep- water seaport at Ningbo; a transport study which will examine strategic options in developing the transport system for the Yangtze Economic Zone; and a coal transport study which will evaluate strategies for handling coal transport demand through the year 2005. II. THE RAILWAY SUBSECTOR Background on Traffic Load 2.1 The Chinese rail system is the fifth largest in the world and carries the second highest combined freight and passenger traffic. In 1986, the railways in China provided for about 63% of the country's total freight traffic and 56% of passenger traffic. Freight traffic density in China averages about 17 million net tkm per route-km, making it second only to that of the Soviet Union and much higher than that of India and the United States. Three quarters of all freight traffic in China involves ten important basic commodities (including coal, iron and steel products, grain and construction materials -- Tables 2.1-2.3). During 1980- 1986, railway freight traffic in the country grew at about 7% p.a. Coal is by far the largest rail user and a critical source of energy for the economy. In fact, the spatial pattern of the railway network reflects the location of coal mines and industrial centers as it emanates from the north to the east, northeast and southeast. 2.2 The shortage of freight capacity has emerged as a key constraiy..: to economic growth. Because demand far exceeds supply, rail traffic is heavily rationed, a process which in itself is slow and cumbersome. Insufficient capacity has caused millions of tons of coal in coal producing regions to be stockpiled on the ground. Some users arrange to truck coal over a distance of several hundred kilometers in order to secure supplies, even though truck tariffs can be ten times as high as rail tariffs. 2.3 China's passenger traffic density is about 5 million pkm per route-km and is the highest in the world. The rate of growth in rail passenger traffic since 1979 has been particularly rapid--about 11% p.a. (Table 2.4). There is an acute shortage of passenger coaches, and on crowded lines passenger trains compete for space with freight trains. Due to the rationing of passenger traffic in the railway system and inwufficient development of alternative modes, the Chinese have one of the lowest mobility rates of any people in the world--about 500 km per capita per year. This compares to about 900 km per capita per year in India. Orgranization and Management at the National Level 2.4 The Ministry of Railways (MR) is the principal institution in the railway subsector. With a staff of some 3.2 million people, MR administers a nationwide, interconnected system consisting of 53,000 route-km. Several different ministries administer railways for uses associated with their own operations, and provincial governments administer railways for limited services within their own jurisdictions (paras. 2.17 - 2.24).  - 4 - 2.5 MR administers 24 bureaus and offices concerned with specific functions and 12 regional administrations which are responsible for operations. Overall management of the railways is highly centralized. Although the administrations have responsibility for day-to-day operations, strater:-- decisions are taken by the Ministry or by other agencies of the Central Government on representations by MR. 2.6 MR also controls a number of factories which produce the bulk of its requirements for locomotives, passenger coaches, and freight cars. Fourteen construction bureaus carry out most of the civil works. Design, engineering and architectural services are also carried out "in-house" by a number of special design institutes and bureaus, although some recently have been restructured as companies with limited financial independence. The latter serve both the national network and local railways. 2.7 Finally, MR also operates 11 universities and 20 staff colleges for in- service training; these institutions offer training ranging from technical subjects to support services for employees. More than 60 vocational schools train locomotive drivers and other operations staff of MR and the local railways. National Railway Network ard Operations 2.8 Under the administration of MR, China's railway network has more than doubled in size since 1949--from about 22,000 to 53,000 route-km. Much of the technology employed in the rail system dates back before the Second World War, however. At present, 61% of the locomotives are steam-powered, 33% are diesel- powered, and 6% are electric-powered. There are about 10,000 km of double- or multiple-track lines and 4,400 km of electrified lines. Further double-tracking and electrification programs are in progress. Like the Soviet railways, Chinese railways employ very few specially equipped cars for rapid loading and unloading of cargo. Manual rer-rting and record keeping systems are still used for dispatching and controlling movements of locomotives and rolling stock. 2.9 Despite these limitations, MR has been able to maintain a high level of operating efficiency, as exhibited by high utilization rates of both infrastructure and vehicle fleets (Table 2.5). Freight car and locomotive utilization in China exceeds that of the US and compares favorably with that of the Soviet Union, particularly considering that the fleet is less modern and less powerful (Table 2.6). Despite the high traffic densities, track and other fixed facilities are carefully maintained in China, and the average freight car turnaround time of 3.5 days may be the world's best. Still, the rigidity of the operating system has greatly compromised service quality for customers, and the lack of modiern computer technology has hindered further improvements in operating efficiency. Large productivity increases in the future are likely to be achieved only through rather sophisticated changes in the overall operating system and management of rolling stock. The strategic study for the Beijing-Shanghai corridor under the Fourth Railway Project is expected to help solve the very complex issues of system modernization. Tariffs 2.10 As in other sectors, tariffs in the railway subsector have changed very little since the early 1950s. Freight rates were increased in 1983, the first change since 1967 (at which time they were reduced); passenger rates remained at the 1967 level. The 1983 reform doubled the minimum chargeable distance to 100 km and increased rates by an average 23% on many bulk commodities such as coal, cement,  oil, and fertilizers. To discourage short-haul traffic, further increases in rates were made in 1985: (a) 37% for passenger trips of less than 100 km.; (b) 50% for monthly suburban season tickets; and (c) RMBV 4.00 per ton for freight transport up to 200 km. Although the effect of freight tariff increases on transport patterns has not been obvious, passenger tr,iffic has dropped slightly. Tariffs are still considered very low, averaging about 1.9 fen/tkm for freight and about 1.9 fen/pkm for passengers. These low *ates have not had a noticeable effect on MR's financial position so far. 2.11 MR runs a financially profitable operation, and its tariffs are well in excess of unit operating costs in the aggregate. However, financial operating costs appear to be lower than economic costs, because depreciation is under-reported and because artificially low prices are paid for coal and electricity. The recent acceleration of inflation has substantially increased railway operating and con- struction costs. This may adversely affect MR's financial health in the future unless tariffs are raised. Therefore, MR is beginning to look more closely at the profitability of individual routes and services; this practice is reflected in the coostirng system being developed under components of the First and Third Railway Projects. Major Issues 2.12 The most important issues confronting the railway sector at this time are: (a) shortages of route capacity and rolling stock which restrict both freight and passenger traffic; (b) outdated technology in most aspects of operations; and (c) overly centralized and cumbersome management procedures. To solve these problems the Government has attempted to expand the system's capacity by Increasing the productivity of existing facilities and by making new investments. MR is taking several steps in this direction: during the 7FYP, new line construc- tion and capacity increases will be initiated on the busiest lines under the umbrella of existing projects. MR is increasing line capacity through double-tracking, electrification and better signaling on about 7,000 km of main routes. It is. augmenting locomotive and rolling stock production capacity to increase the motive power fleet by over 50% by 1990. It is attempting to improve operational efficiency by modernizing the telecommunications network, the operating information system, and the locomotives, rolling stock, and other railway equipment. MIR also is streamlining its management information system and delegating more decision- making powers to the bureaus and regional administrations. As a result, MR's carrying capacity has increased year after year. Transport demand also continues to increase, however, so that more capacity expansion programs are needed in the coming years. Role of the Bank Group 2.13 The Bank Group has supported the Government's strategy for the railway subsector in four operations to date. These operations, totalling about US$885 mil- lion in Bank Group funding, make the railway subsector the largest recipient in the transport sector (48%). The four projects all involve expanding route capacity, including double-tracking and electrification; upgrading signalling systems and enlarging supporting infrastructure; and increasing domestic capacity to manufac- ture locomotives, rolling stock and signalling equipment. The total length of railway routes being expanded with Bank Group financial assistance is about 3,400 km, or 7% of the national network. Some of the Bank Group-financed railway lines are among the busiest in China, e.g., the line between Zhengzhou and Wulan  - 6 - on the Beijing-Guangzhou corridor and the coal supply line between Yueshan in Henan province and Xiangfan in Hubei province. 2.14 Under some of the technical assistance components in the four railway operations, the Bank Group is supporting several key efficiency-related studies for MR. A railway costing study is being carried out to set up a computer-based system to perform cost-accounting of railway operations and to compile railway operating statistics. Ultimately this system will enable the railways to control their operating costs better and to price their services more efficiently. Implementation of this study on a pilot basis is currently under way in one subadministration of MR. Another study is under way to improve MR's management information system by streamlining the flow of information between different levels of the ministry. The most ambitious effort so far under way is the strategic study for the Beijing- Shanghai corridor (para 2.9.); the study aims to develop plans to modernize and enlarge the telecommunications network and operating information system, and to find the most cost-effective way to expand line capacity. MR will be assisted in this study by foreign railways with extensive experience in this type of work. 2.15 Moreover, the Governmnent and the Bank Group are now developing a closer dialogue through independent sector work on planning in the railway sector. This work emphasizes traffic forecasting and analysis of investment priorities. For example, a coal transport study (para. 1.10) has been initiated this year, to be conducted jointly by Bank Group staff and a Chinese counterpart team under SPC. Also initiated this year is a railway investment study which will be used to develop a methodology for determining an economically optimal medium- and long-term investment plan. 2.16 The Fourth Railway Project was approved in May 1988 and has just been declared effective (March 1989). Implementation of the three previous projects, while satisfactory in other respects, generally has been slow due to protracted procurement activities and contract negotiations. As a result, some components are delayed by up to two months and disbursements are behind schedule. Although there have been improvements in the past few months, additional measures are still required to assure satisfactory project implementation in the long run. Also, training and technical assistance components have not progressed as quickly as desired, given their considerable importance. This is due in part to the reluctance of the Chinese authorities to spend the proceeds of loans and credits on expatriate technical assistance, which they perceive as extremely expensive. The Bank Group continues to encourage MR to move forward quickly on needed technical assistance and training. Development of Local Railways 2.17 In order to expand line capacity to meet local transport needs and foster regional development, the Government has been encouraging the development of "local railways." These are railways built and operated by local governments and enterprises, typically with financial and management assistance from the State. Local railways are not a recent phenomenon; in fact, their development began in 1958 as a means of enlarging the Chinese railway network. About 6,800 km of these lines have been built, often by using some second-hand materials and local labor. Operated by more than 400 local entities, they represent about 12% of the total route length of the national network. 2.18 The Government is now strongly encouraging local railway development in porder to accelerate the expansion of the national railway network. By 1990, local  - 7 - railways are expected to grow to a total route length of about 8,000 km. During 1991-2000, more than 10,000 km of new rail lines are expected to be built, and about half of them are expected to be local railways. 2.19 Local railways tend to have greater flexibility and operating responsibility than national railways and they benefit from recently-granted financial incentives (para. 2.20). Their construction tends to be less costly for a number of reasons. Land acquisition can normally be accomplished faster and at lower cost, and there is greater local support for the investment. Greater use is made of second-hand materials and equipment, and the work force is generally made up of local labor, making mobilization easier and faster. Design standards are generally lower, responding to the traffic level expected and local conditions; close coordination is maintained with MR, however, to assure efficient and safe train operations. Roughly two-thirds of these local railways are of standard gauge. With smaller staffs and simplified organizational structures, the local railwa3rs also tend to operate more flexibly than railways run by MR, which has a large organization and work force. 2.20 As an incentive to build local railways, the Government allows them greater financial autonomy. For example, since the economic reforms in the late seventies, local railways have been subject only to a 3% business tax on gross revenues and are allowed to retain their profits. Most importantly, local railways have been permitted to set their own tariffs (subject to approval of the local price control board), to levels much higher than MR tariffs. Freight tariffs range from 3 fen/tkm to as high as 12 fen/tkm, compared to MR's 1.4-2.5 fen/tkm. The large difference between local railway and MR tariffs appears to be the major reason why some recently-built local railways have been profitable, while a number of recently-built MR lines have been losing money in their early years of operations. 2.21 Local railways are generally considered to be an integral part of the national transport network, and their development is integratud with the State and local planning process. Large and medium-size local railway projects, such as the proposed Inner Mongolia Local Railway Project, require approval from both the central and local governments. Small projects may be locally approved. 2.22 MR is responsible for assisting the management of local railways-by providing guidelines for management, conducting data surveys for construction and transportation planning, specifying technical standards for construction and operations, integrating the operations of local railways with those of MR, and assisting in training technical and managerial personnel. 2.23 Guidelines on the financing of local railways also are set forth by MR, the State Planning Commission (SPC), and the Ministry of Finance (MOF). If investment in a local railway benefits only one province, it should be financed by the respon- sible provincial government. On the other hand, if the local railway is expected to benefit multiple parties, funds for the construction of the line should come from the various beneficiaries. The development of the Inner Mongolia Local Railway Project essentially has followed the latter policy. Because of its significance both at the national and regional levels--through opening up a major new coal route to the northeast and promoting regional development--the proposed project has received support from both the State (through MR and MOF) and the Government of Inner Mongolia (GIM). 2.24 The proposed railway project is the first local railway investment the Bank Group has been requested to finance. The project will be conducted under the auspices of GIM in association with MR. It represents a significant opportunity  for the Bank Group to work closely with highly motivated provincial authorities in an isolated, economically disadvantaged region seeking to eliminate a serious transport constraint. It also supports MR policy in encouraging the development of locally-managed railways. III. BACKGROUND ON INNER MONGOLIA 3.1 Inner Mongolia is one of five designated autonomous regions in China, because of its minority Mongol population. The total population is about 20 million, of whom 83% are Han Chinese and 13% are Mongols. This rather elongated region covers an area of 1.2 million sq km, is the third largest of the country's provinces or autonomous regions, and occupies about 12% of the total land area of China. Three mountain ranges cut across the region, both in the west and east. Much of the area, though, is dominated by a long plateau stretching diagonally from the southwest to the northeast; the terrain varies from forested steppes to semi-desert and desert steppes. Located there are the grasslands of Inner Mongolia; they are the largest in the country and cover about 880,000 sq km, or two-thirds of the region's land area. The grasslands are considered one of the most important natural resources of the region, providing a base for its significant animal husbandry activities. Finally, the climate of Inner Mongolia is characterized by uneven distribution of rainfall and extreme ranges in temperature. The winters are long and cold, and the summers short and cool. 3.2 Inner Mongolia is undeveloped economically, with an average GVIAO per capita of about RMBV 1,000. Its GVIAO in 1987 was RMB3 18.1 billion, putting the region in the lowest 25% of all provinces/autonomous regions in China in terms of GVIAO. Agricultural and animal husbandry activities represent about 42% of GVIAO. Light and heavy industry represent a larger share, about 58% of GVIAO; industrial activities include the production of iron and steel, coal, rare earths, machinery, building materials, woolen textiles and handicrafts. Major factors inhibiting economic development are the lack of infrastructure and the shortage of resources for investment in the region. 3.3 Bordering Inner Mongolia to the northeast are the heavily industrial provinces of Liaoning, Jilin, and Heilongjiang. To the southwest are the coal- producing provinces of Shanxi, Shaanxi and Ningxia. The western part of Inner Mongolia, with its substantial but largely undeveloped coal reserves, is considered part of China's prime coal-producing area. It ranks second only to Shanxi province in terms of coal resources: its reserves were estimated in 1985 at 217 billion tons. The coal is generally of high quality (para. 3.6). However, over the last 30 years, only about 2% of total proven reserves has been extracted, largely because of insufficient transport capacity to bring the coal to major consuming parts of the country. Much of the present coal production is used locally to support existing industrial production, based in the city of Baotou, where the region's iron and steel works are located. Western Inner Mongolia also produces much of the country's very high quality anthracite; its production is exported to Europe and Japan and thus is given priority on the busy Datong-Beijing-Qinhuangdao line (the main coal route from Shanxi province). Coal Demand in the Northeast 3.4 The idea of a rail line connecting Inner Mongolia directly with the north- east emerged many years ago. However, the project recently has been given  priority because of the rapid economic and industrial development of northeastern China. There is a net deficit of coal in the northeast, and this deficit is projected to grow, particularly in Jilin province. Coal mining prospects in the northeast do not look attractive, as existing mines require deeper and costlier extraction. Jilin is currently importing 10 million tons per year (mtpy) of coal, both from neighbor- ing Heilongjiang province and from Shanxi province. But its coal deficit is expected to grow to about 22 mtpy in 1995 and 27 mtpy in 2000. Driving that demand is electricity and industrial production, which are projected to grow by 7% and 9% respectively between 1990 and 2000 and may end up growing even faster. 3.5 Current supply routes from Shanxi are now close to capacity; moreover, critical sections of those lines would be very costly or impractical to expand. The abundant reserves of good quality coal in western Inner Mongolia, minable at low cost, are a logical source of supply for the northeast, and the quality of the coal is comparable to that of Shanxi. Development of the Donosheng Coal Field 3.6 Most of the coal traffic on the proposed Jitong line will come from the Dongsheng coal field in western Inner Mongolia. This field contains about 95.3 billion tons in situ of high quality thermal coal. This Jurassic coal deposit is excellent by world standards, with high volatile and high calorific value (about 6,700 kcal/kg), and low ash and sulfur content. The geological structure is simple, with man1y thick coal seams occurring close to the surface; mining conditions are considered easy. The field lies 170 km south of the industrial city of Baotou and just west of northern Shanxi province. It borders the Shenmu coal field of northern Shaanxi province. Existing production (about 1 mtpy) is limited to very informal local efforts of cooperatives, mining thoce areas easily exploitable with simple equipment. 3.7 The Inner Mongolian authorities now plan more extensive development to build up Dongsheng as a major source of coal supply. Development of the coal field is being planned in phases, with production to rise from about 6.7 mt in 1994 to 16.5 mt by 1998. A new 170-km rail line from Baotou to tl.e Dongsheng coal field was recently completed. From Baotou, the Dongsheng coal will be transported via the existing railway to the Jitong line. Details on the Dongsheng coal field and the coal supply-demand situation are given in paras. 4.27-4.29 and in Annex 2. IV. THE PROJECT A. Project Origin 4.1 In October 1986, SPC requested that the Bank Group include the Inner Mongolia Local Railway Project in its lending program, and submitted a feasibility study which indicated that the project would have a beneficial impact on the economy of both Inner Mongolia and Jilin province. The feasibility study and detailed designs were prepared by MR's Third Design Institute in Tianjin, which is well qualified in such works. The project was sponsored by GIM in partnership with MR. An identification mission sent in April 1987 recommended that early assurances be sought on two related questions: (a) the supply and demand for coal in the area of influence of the project; and (b) environmental and sociological issues in the region. The results of this preparatory work were positive, and the project was preappraised in October 1987 and appraised in July 1988.  - 10 - B. Project Objectives and Relation to the Sector 4.2 The main objective of the project is to provide low-cost, reliable freight and passenger transportation, facilitating in particular the movement of coa' and other products from western Inner Mongolia to northeasterrA China. The line will literally open up a market for Inner Mongolia's coal by giving it direct access to Jilin province, a domestic coal importer; about 80% of the eastbound traffic is expected to be dedicated to coal haulage. But the railway would also facilitate two- way trade in other products, such as cement and timber. 4.3 Another objective of the project is to promote regional development. The rail line will pass through 12 counties, but is expected to have a development impact on 21 counties, with a total area of influence of 300,000 sq km and a total population of over 4 million. Although this population accounts for 20% of the total population of Inner Mongolia, its economic production (mainly pastoral agriculture and some associated light industry) is only about 10% of Inner Mongolia's total output. In 1985, the average per capita income in these areas was only about US$100 p.a., about half the national average. Although the region has significant mineral deposits, they remain largely unexploited due to insufficient transport. 4.4 The project also has an institutional objective -- the formation of a local company to manage what will be the longest locally-administered railway in China. In line with recent policy to decentralize the operating management of local railways, this new company will have operating responsibility but will function in close coordination with MR operations. Indeed, top management and many of the staff will come directly from MR bureaus. Over 5,000 staff will undergo training in railway operations before the line is opened to traffic (Table 4.3). C. Alternative Routes Considered 4.5 Several feasibility studies of alternative alignments have been undertaken over the years. The most attractive route is the 948 km line proposed in this project--connecting at both ends with the existing MR network at Jining in central Inner Mongolia and Tongliao in the eastern part of the autonomous region and thus called the "Jitong Line" (Map IBRD 21156). Three other routes were evaluated: Jining-Zhenglan-Chifeng, Jining-Linxi-Chifeng, and Jining-Naiman. From either Chifeng or Naiman, traffic would then take the existing MR line to reach Tongliao. 4.6 All three routes would require a major upgrading or double-tracking (estimated at RMBV 200 million) of the. Naiman-Tongliao section, which is already almost saturated. The Jining-Chifeng routes (both alternatives) are shorter but very expensive, becutuse they cut through mountainous terrain. In such an area the new line would have only a marginal regional development impact; therefore these routes were eventually rejected. The Jining-Naiman route is longer than the Chifeng routes, but still 114 km shorter and, excluding the upgrading of the Naiman-Tongliao section, RMBV 75 million cheaper than the proposed Jitong line. However, it was rejected because its developmental impact would be very low, since it would cross the central part of the Keerqin desert and would be 200 km away from any major community. 4.7 The proposed Jitong alignment Is the least-cost solution at the national level if the cost of double-tracking the Naiman-Tongliao section of MR is included In the cost of the other alternatives, as it should be. It also has the maximum pot_ntial for regional development benefits because the area through which it passes has more settlements and economic activity. The line would pass through  - 11 - the rolling hills of the Inner Mongolia plateau and the alluvial plain of the Xiliao River. The area has a dry to semi-dry continental climate and is affected by Siberian currents in winter, with very cold conditions lingering for many months. D. Pro.iect Description 4.8 The main components of the project are: (a) the construction of the railway line; (b) the acquisition and installation of operational equipment; and (c) the recruitment and training of staff to operate the railway. Related components include land acquisition and resettlement, and. the development of the second-most important coal deposit in China, so far largely untouched. Line Construction and Desion Features 4.9 Because of limited financial resources, GIM is taking a conservative approach to the construction of the Jitong line. The new line will have an initial capacity of 7 mtpy in each direction, which is adequate for the first three or four years of operations. However, given the strong demand for coal in Jilin and the potential for trade between Inner Mongolia and the Northeast, traffic on the Jitong line is expected to develop quickly. As traffic demand grows, the Inner Mongolia Railway Corporation (IMLRC) intends to use retained earnings from early operations to: (a) purchaso more locomotives and freight cars; and (b) build more crossing loops and/or extend the length of existing crossing loops. Together, these additional investments would progressively bring annual capacity to an estimated 17 mtpy by the year 2000. This phasing of investments makes good economic sense: no investment will be made prematurely, and no investment made in the first phase will be wasted later. 4.10 The single track will be placed on 1,600 ties per km and a 25-30 cm crushed stone ballast. The gradients are less than 0.6% except between Haoluku and Linxi, where they reach 1.2% and where double-heading will be needed. Curves will have a radius of 800 m in general, falling to 350-400 m in some difficult areas. Bridges are designed on the basis of 100-year floods, and tunnels will be built to the national standard clearance. Crossing loops will be 700-750 m long, an adequate length for 2,800-ton trains to be hauled by steam locomotives. They will be expandable to accommodate later needs. Operational Equipment 4.11 Another component of the project is the acquisition of the operational equipment needed to run the future railway. Here again, a conservative approach is taken by IMLRC. Used steam locomotives in good working order are available from MR as a result of its dieselization and electrification programs, and can be obtained at favorable conditions. Signalling equipment of simple design, but adequate for the Jitong line traffic, is also being released by MR when more elaborate equipment is installed on higher density lines. IMLRC will obtain from MR the few used freight cars it needs for its own use and for local traffic within Inner Mongolia. Freight cars for inter-provincial traffic are centrally pooled in China, and IMLRC will pay MR a rental fee per day of usage, like all MR administrations and other local railways do. Staffing and Training 4.12 At present, IMLRC is organized as a development enterprise, comprising six divisions (Auditing, Construction Supervision, Personnel, Engineering, Planning  - 12 - and Finance, and Material Supply) under the General Manager and two Deputy General Managers (Annex 1). About 55 people are on IMLRC staff, 40 transferred from GIM and 15 from MR, and key management positions already have been filled. Bank Group staff has found IMLRC's key personnel to be highly motivated, capable of discharging their duties, especially in organization, planning and engineering. All of IMLRC's expenses for staff salaries, office space, vehicles, etc, are being covered by GIM. 4.13 The staff size will be enlarged as the opening date of the railway approaches. In the coming years, more quialified middle-management staff will be transferred from MR and other staff will be recruited, bringing the staff force to 440 by 1989, 2,700 by i990, 4,500 by 1991, and 7,600 by 1992 and thereafter. Most of the new staff will be attached to a new transport operations department. A comprehensive training program will be carried out, either in Inner Mongolia or in MR training centers for special skills such as locomotive drivers and signalling personnel. This program will provide vocational and on-the-job training to about 5,000 staff and is estimated to cost about US$0.4 million (Table 4.3). Agreement was reached during negotiations that IMLRC will carry out its staffing and training according to the agreed program, in order to assure staff readiness when opera- tions begin in 1993. Cost Estimates and Financing 4.14 Quantities were derived from final engineering, and unit prices are based on current world market prices for equipment and materials to be imported and on current domestic prices for equipment and materials to be procured locally. Including contingencies and US$14.9 million for interest during construction, the estimated project cost is US$349.9 million (RMBV 1.42 billion), of which US$152.8 mil- lion represents direct and indirect foreign exchange costs (January 1989 prices). Cost estimates are given in Tables 4.1 and 4.2. A summary breakdown of the project costs and of the proposed loan and credit is shown below. 4.15 Construction materials and equipment will be purchased by IMLRC and delivered to the contractors, but there is an issue concerning the cost of construc- tion contracts for civil works, representing 44% of estimated project costs, because of uncertainties regarding the number of man-days needed and the unit cost per man-day. The estimates given by IMLRC appeared low, but given the local manage- ment of civil works and the use of local labor, it was difficult to compare these costs with typical MR projects. Reliable cost estimates were needed to finalize the financing plan, particularly the amount committed by domastic sources. Therefore, the Bank Group stipulated that negotiations would not be considered formally completed until bids are received for two of the five civil work packages (para. 4.37) and, in the event of a funding shortfall, that GIM will be committed to providing the additional funds (para. 4.18). Bids were received on April 10, 1989, and were generally in line with IMLRC's cost estimates. 4.16 An average of 7.0% for physical contingencies is included in the estimated project costs. Annual price escalation rates are applied following the purchasing power parity method as follows: local costs: 7.0% in 1989, 6.5% in 1990, and 6.5% in 1991 and thereafter; foreign costs: and 3.0% in 1989, 3.0% in 1990, and and 4.0% in 1991 and thereafter. The April 1989 exchange rate of RMBY 3.712/US$ is used for the conversion of foreign exchange costs.  - 13 - Estimated Project Costs (January 1989 prices) ------------- Cost Estimates --------- Pro- For. For- For- posed % of Local eign Total Local eign Total Loan Total ---- RMBY mln. --------- US$ mln. ---- Land acquisition 7.8 - 7.8 2.1 - 2.1 - Resettlement 12.5 - 12.5 3.3 - 3.3 - - Preparation 2.5 0.4 2.9 0.7 0.1 0.8 - 14 Infrastructure 173.8 36.6 210.4 45.7 9.6 55.3 9.6 17 Bridges & culverts 33.3 70.9 104.2 8.7 18.7 27.4 25.0 68 Tunnels 10.5 6.7 17.2 2.7 1.8 4.5 1.8 39 Track 81.3 121.4 202.7 21.4 31.9 53.3 43.1 60 Rails - 187.1 187.1 - 49.2 49.2 49.2 100 Signalling & comm. 20.4 - 20.4 5.4 - 5.4 - - Power supply 1.0 5.6 6.6 0.3 1.4 1.7 1.4 85 Buildings 38.4 6.0 44.4 10.1 1.6 11.7 1.6 14 Oper. eq. & buildings 20.8 6.6 27. 4 5.5 1.7 7.2 1.7 24 Weather contingencies 47.7 5.0 52.7 12.5 1.4 13.9 - 10 Temporary construction 52.3 12.6 64.9 13.8 3.3 17.1 3.3 19 Design & administr. 80.9 5.1 86.0 21.3 1.4 22.7 - 6 Training 1.5 - 1.5 0.4 - 0.4 - - Taxes 23.7 - 23.7 6.3 - 6.3 - Rolling stock 39.1 - 39.1 10.3 - 10.3 - - Base Cost 647.5 464.0 1.111.5 170.5 122.1 292.6 136.7 43 Phys. Contingencies 56.1 23.4 79.5 14.8 6.1 20.9 3.8 29 Price Contingencies 95.5 77.6 173.1 11.8 9.7 21.5 9.5 45 Total Project Cost a/ 799.1 565.0 1,364.1 197.1 137.9 335.0 150.0 41 Inter. dur. constr. b/ - 55.3 55.3 - 14.9 14.9 - 100 Financing required 799.1 620.3 1,419.4 197.1 152.8 349.9 150.0 44 a/The project is exempt from import taxes and duties. b/Interest during construction includes commitment fee on the IBRD loan and service charge on the IDA credit.  - 14 - 4.17 Detailed lists of items to be financed by the proposed loan and credit are provided in Tables 4.4 to 4.15, and are summarized below. Component Cost (US$ million) Construction materials (ICB) 49,8 Track materials (ICB) 59.1 Equipment (ICB) 4.1 Local materials (LCB) 17.4 Direct purchase 6.3 Subtotal 136.7 Physical contingencies 3.8 Price contingencies 9.5 Total 150.0 E. Financing Plan 4.18 The Government has requested a loan and credit of US$150.0 million (RMBV 557 millon) which will finance 97% of the total foreign exchange needs, equivalent to 43% of the total project cost or 81% of the net project cost excluding reserved procurement items (para. 4.34). The balance of the project cost, including interest during construction, will be financed by IMLRC's two owners, as follows: Responsible PartyiComponent RMB V US$ million million Government of Inner Mongolia (GIM) 449.6 102.1 Central Government (MR) 363.0 97.8 IBRD 259.8 70.0 IDA 297.0 80.0 Total financing 1,419.4 349.9 of which: Project construction cost 1,364.1 335.0 Interest during construction La 55.3 14.9 1,419.4 349.9 La Includes commitment fee on the IBRD loan, and service charge on the IDA credit.  - 15 - MR has formally agreed to contribute RMBV 363.0 million to the construction cost; GIM will contribute the remainder, currently estimated at RMBV 449.6 million. MR and GIM contributions will represent their equity shares in the newly established railway company. Because of the uncertainty in the cost estimates (para. 4.15), GIM indicated its commitment to finance any cost overruns; this was confirmed during negotiations. 4.19 The proposed Bank loan will be made available to the People's Republic of China at the Bank's variable interest rate with 20 years maturity, including five years of grace. The IDA credit will be made available at a service fee of 0.75% p.a. on the disbursed and outstanding amounts. MOF will onlend the loan and credit to GIM (represented by its Bureau of Finance) at an interest rate of 5%; the repay- ment terms will be the same. This onlending rate is typical for revenue-earning, transport-infrastructure entities in China. GIM will pay the 0.75% commitment fee on the loan and will bear the foreign exchange risk. GIM has the ability to bear the foreign exchange risk because of its export earnings from anthracite and animal husbandry goods produced in the region. GIM's Bureau of Finance will relend the Bank Group loan and credit to IMLRC under the same terms and condi- tions with two exceptions: first, the foreign exchange risk will not be passed on to IMLRC; and, second, GIM will pay interest during construction and, if necessary, during the first year of operation (confirmed during negotiations). The interest during construction paid by GIM will be capitalized as an interest-free loan from GIM to IMLRC. Such capitalization is needed because IMLRC will start earning income only after the line is completed. IMLRC should be able to repay the loan by about 1998, once its cash flow is sufficient to do so (para. 6.6). F. Project Implementation 4.20 The Jitong line will be constructed and, after completion, operated by IMLRC. IMLRC is a separate legal and accounting entity and is jointly owned by GIM and MR. Its charter has been reviewed by the Bank Group and is considered satisfactory. The charter assures a strong link with MR while giving IMLRC significant management control, including the authority to propose tariff increases as needed. An initial tariff, which is higher than the average MR rates, has already been agreed for the Jitong line. 4.21 IMLRC's Board of Directors consists of 11 members, six from GIM and five from MR; the current chairman is from GIM, and is the first Vice-Governor of the autonomous region. The Board of Directors is responsible for setting up policies and making basic decisions. The General Manager of IMLRC will be responsible for supervision of construction of the line and, later on, for day-to-day operations. Since the project will be carried out by IMLPC, a Project Agreement will be signed between the Bank Group and IMLRC. This agreement will detail the responsibilities of IMLRC in carrying out the project (para. 7.5). 4.22 The implementation schedule is shown in Table 4.17. Supervision will be carried out according to criteria laid down by MR. IMLRC will set up a construc- tion supervision division composed of a number of supervising engineers, respon- sible for monitoring the quality of the project. There will be one division head, one deputy, one secretary, and several engineers. This division will manage the on-site supervision groups, one every 50 km. Each such group will be made up of four supervising engineers: the head of the group, an engineer for earthworks, one for bridges, culverts and tunnels, and one for water supply. The whole line will not be started at the same time, but there will be at least ten supervision groups from the start, i.e., 40 supervision engineers, with a vehicle for each group.  - 16 - 4.23 In addition, there will be 11 supervising engineers in charge of the second, higher level of supervision, one in charge of bridges and tunnels, the others in charge of water supply, telecommunications, signalling, power supply, rolling stock, etc. These supervisors will be well qualified, certified at a minimum as assistant engineers, with at least three years of specialized construction experience. Most of them will be recruited from within MR--staff on board or retirees--but some may come from construction companies in Inner Mongolia. 4.24 Standards will be set for the type of food and shelter to be provided to laborers during the construction period. These standards will be included in the contracts with the construction firms. Assurance was obtained from GIM during negotiations that provision of these services will be monitored by an office attached to GIM and separate from IMLRC. Because of severe climatic conditions, civil works will be carried out only during the warmer seven months of each year. 4.25 Land acquisition and resettlement. The acquisition of approximately 3,700 hectares of land for the construction of the Jitong line will be conducted in accordance with compensation practices determined by law, and is not expected to present any major obstacles. The costs of land acquisition and resettlement, totalling RMB' 20 million, will be funded out of the project account and are iden- tified in the cost tables. The implementation of land acquisition and resettlement will be overseen by the Land Acquisition, Demolition and Resettlement Office (LADR Office) of GIM, an agency independent of IMLRC. If needed, the LADR Office will arbitrate any dispute over monies to be paid to the local population, in compensa- tion for expenses caused by the construction of the Jitong line, such as demolition of houses or other real estate property, etc. 4.26 A plan for land compensation has been developed, was approved by the relevant authorities, and was submitted to the Bank Group at negotiations. It provides adequate rules for land acquisition and satisfactory arrangements for some 5,000 people who will be affected by the railway. The proposed railway enjoys strong support from local residents and no delays in land acquisition are expected. During negotiations, assurances were obtained from IMLRC that the residents displaced by the proposed railway will be resettled according to a plan acceptable to the Bank Group. More details are given in Annex 3. 4.27 DonishenX mine development. While this project was being prepared, the developmient plan for the Dongsheng coal field was discussed with Inner Mongolian authorities. The Bank Group has encouraged GIM to consider various alternatives to assure optimal development of the field. Given a tight budget, GIM has decided in favor of developing a number of small mines, which requires less capital than a full-scale, capital intensive approach. Moreover, the mines will be more labor- intensive, will go into regular production within 3-4 years, and will assure an early cash flow. 4.28 The mines are in various stages of planning (Annex 2). The first phase of construction of these mines and infrastructure for a production capacity of 6.7 mtpy is projected to be completed by 1994 at an investment cost estimated at RMBV 1.05 billion. Six mines will regularly supply the Jitong line. Five under- ground mines (capacity of 3.9 mtpy total) will be funded and operated by GIM and two local coal mine administrations. A medium-size open pit mine (capacity 1.8 mtpy) will be jointly financed by GIM and the Huaneng Fine Coal Development Corp., a company under the auspices of SPC which provides funding for national energy projects. These two entities also will jointly finance the development of several collective and village-level mines, out of which one mtpy will be committed  - 17 - to feed the Jitong line. The joint financing will cover development of the mines and mine site facilities. Other infrastructure costs for power supply, railway spurs, approach roads, housing etc. will be financed by the Huaneng Corp. An agreement to that effect exists between GIM and the Huaneng Corp. 4.29 Timely development of the Dongeheng field is important for assuring sufficient coal traffic on the Jitong line--as well as for realizing revenue from this important local resource and for meeting demand for coal in Jilin province. The preparatory work to develop these mines was satisfactory, and the Bank Group has received confirmation from the Government (Annex 4) on the development plans and availability of firm financing sources for the Dongsheng coal field development. 4.30 Commitments on connectinst lines. The traffic carrying capacity of the existing connecting lines operated by MR was investigated during preparation of the project. This review was done to ensure that the connecting lines into Jilin province could accommodate the additional traffic from the Jitong line. The carrying capacity of the lines west of Jining appears to be adequate through the year 2001. The two eastern sections into Jilin province were investigated: Siping- Changchun and Tongliao-Shuangliao-Siping. 4.31 The Siping-Changchun section will be electrified during the 1991-95 period; its freight traffic capacity is then expected to increase from about 35 mtpy to about 60 mtpy. Thus, the Siping-Changehun section should have ample spare capacity for traffic from the Jitong line through the year 2000. 4.32 The Tongliao-Shuangliao-Siping section is now sche'luled for upgrading during 1991-94. The upgrading will basically involve addint( more sidings, length- ening them, expanding marshalling yards, and changing traction from steam to diesel. The freight traffic capacity after upgrading will be about 12 and 15 mtpy on the respective two legs. Assuming no delays in the upgrading work, the two legs of the line would both have adequate capacity through 1995, based on the traffic forecast. Beyond that date, the spare capacity above the 1995 forecast level (of 1.6 and 2.0 mtpy on the respective legs) is likely to be used up quickly. 4.33 MR has formally confirmed to IMLRC that it accepts responsibility for assuring adequate capacity on the connecting lines. During negotiations, the Bank Group obtained assurance that the borrower (MOF on behalf of the Government) would require MR to assure such investments in a timely fashion in order to handle the expected level of freight traffic to and from the Jitong line by 1995 and in later years as the Jitong line is expanded. G. Procurement 4.34 In the estimated cost of the project, three items totalling US$165.2 million are considered reserved procurement, all three in local costs: the US$. 48.3 million construction contracts (para. 4.38), and the used rolling stock (US$10.7 million) and signalling equipment (US$6.2 million) (para. 4.11). These items will not be financed by the proposed Bank Group loan and credit. Under the circumstances, reserved procurement will not affect the satisfactory execution of the project in terms of costs, quality and completion time. 4.35 The lists of equipment and materials to be procured under the proposed loan and credit are shown in Tables 4.4 to 4.15 and are summarized below. The procurement of equipment and materials for an estimated value of US$123.4 million (82% of the loan and credit amount) will be subject to International Competitive  - 18 - Bidding (ICB) procedures, in accordance with Bank Group guidelines for procure- ment. Some of the locally available materials, (such as stone, gravel, construction aggregates, concrete poles and girders, etc.) for a total value of about US$19.5 mil- lion are unsuitable for ICB and will be procured under Local Competitive Bidding (LCB), under procedures consistent with the Bank Group Guidelines, and satisfac- tory to the Bank Group (the Chinese regulations governing procurement under LCB are available in the Project File). A number of small items worth less than US$150,000 per order and totaling about US$7.1 million (5% of the loan and credit amount) will be purchased directly from local sources of supply such as the villagers along the line, who would be legally ineligible to bid under LCB because they are not established suppliers of sand, gravel, bricks, etc. The transaction price will be determined in accordance with official price lists for such materials. Procurement ArranRgements Procurement Method Total Project Element ICB LCB Other Cost --------------- US$ million-------------- Land acquisition - - 2.4 2.4 Resettlement - - 3.8 3.8 Construction Materials 54.8 19.5 9.6 83.9 (54.8) (19.5) - (74.3) Track Materials 64.2 - 9.5 73.7 (64.2) - (7.1) (71.3) Construction Equipment 4.4 - 1.2 5.6 (4.4) - - (4.4) Construction Contracts - 148.3 - 148.3 Signalling Equipment - - 6.2 6.2 Rolling Stock - - 10.7 10.7 Training - - 0.4 0.4 Total 123.4 167.8 43.8 335.0 (123.4) (19.5) (7.1) (150.0) Note: All figures include physical and price contingen- cies. Figures in parentheses are the amounts to be financed by the Bank Group. 4.36 All bid packages valued at over US$500,000 will be subject to the Bank Group's prior review of procurement documentation. In bid evaluation, Chinese bidders will be allowed a preference of 15% of the CIF prices of competing imports, or the relevant prevailing levei of customs duties, whichever is lower.  - 19 - 4.37 For items not financed by the Bank Group, local procurement procedures will apply. Such items include various local materials, miscellaneous equipment, and the construction contractB for civil works. Civil works will be divided into five packages and up to five general contractors will be selected under LCB, according to procedures acceptable to the Bank Group (para. 4.35). Potential bidders are the construction bureaus of MR, MOC, and other ministries, which have been given legal and financial autonomy in the recent past, as well as other locRl construction entities. The delivery of major materials such as rails, other steal, timber and cement will be independently arranged by IMLRC and supplied to the contractors. Some of these materials are to be procur( i through ICB and LCB, and will be financed by the proposed Bank Group loan and credit. 4.38 Construction Contracts. The contractors will provide overall management and supervision of the works, and skilled labor not available locally. Unskilled labor will in turn be provided to the contractors by the local authorities of Inner Mongolia, according to procedures and compensation generally applied to similar projects in the area. Unit labor costs are expected to be somewhat lower than in other parts of China, reflecting the few employment opportunities in the area. H. Disbursements 4.39 Disbursement of the proposed loan and credit will be as follows: (a) 100% of the foreign expenditures for the CIF cost of imported equipment and materials; and (b) 100% of local expenditures for the ex-factory cost of locally procured equipment and materials. The estimated disbursement schedule (Table 4.16) follows the Bank profile for railway projects, with a proposed Closing Date of December 31, 1996. For this project, however, work should proceed faster than for a typical railway upgrading project carried out under traffic, for which the track is available only a limited number of hours each day. Disbursements may thus occur faster than shown in the Bank profile. 4.4G Domestic transport from port or factory will not be eligible for Bank Group financing. Any savings under the proposed loan and credit will be cancelled unless otherwise agreed with the Bank Group. Disbursements against contracts for equip- ment and materials valued at less than US$200,000 each will be made on the basis of Statements of Expenditure (SOEs). To facilitate disbursements, a Special Ac- count will be established with an initial deposit not exceeding US$5.0 million, representing about four months of expected expenditures. Replenishment of the Special Account will be made monthly or whenever the Special Account is drawn down by 50% of its initial deposit, whichever occurs first. Documentation support- ing the SOEs will not be submitted to the Bank Group but will be kept in the project office in Hohhot for review by the Bank Group's supervision missions. I. Environment 4.41 The Bank Group, including a special environment team, and the Government have reviewed the potential environmental and social impacts of the proposed railway. Their conclusions are summarized below and discussed in greater detail in Annex 5.  - 20 - Crassland Impact 4.42 In the past, overgrazing has put tremendous pressure on the grasslands. However, recently-enacted legislation and regulations have provided for measures which are beginning to rectify the situation. Procedures for land ownership and usage rights have been established. The laws permit grassland areas to be leased out under contract to collectives and individuals for livestock raising, for their own management and profit, thus preventing general public grazing. They also provide for local jurisdictions to develop and maintain grasslands, including supervisory programs to prevent misuse. Grassland development activities have been strength- ened, allowing many hectares of fenced and man-made grassland to be built up. 4.43 In addition, special measures are planned in conjunction with the construc- tion of the Jitong line. Cultivated land and grasslands are to be occupied as little as possible. Where vegetation must be destroyed, replanting measures are to be taken immediately. Sand and rock material required for railroad earthworks will be obtained from nearby quarries rather than excavated along the roadbed. GIM has submitted a plan to the Bank Group showing details of passages to be built for livestock movement and plantation alongside the embankment. These measures are satisfactory and environmentally sound. 4.44 The easy transport access provided by the railway is expected to help reduce the problem of overgrazing in nearby counties. Herding of livestock from grassland to slaughterhouse over distances of hundreds of kilometers--which can take 15 days or longer and cause the animals to consume considerable amounts of grass--will be mostly eliminated. Moreover, since the railway will make coal more accessible and at a relatively low price, many households will be able to switch from hay and animal dung to coal as a heating fuel, thereby releasing animal dung as fertilizer and additional hay for livestock raising. On the other hand, more access to markets could create conditions for more intensive herd-raising activities, putting pressure again on the grasslands. The Bank Group has requested GIM to develop a plan to monitor the impact of the railway on adjacent grasslands. The monitoring is to be conducted by the Environmental Protection Research Institute, which is under the leadership of the Environmental Protection Bureau of the Central Government. The plan was submitted at negotiations and found satisfac- tory. Social Impact 4.45 The Bank Group mission mentioned above also considered possible adverse social effects of the railwa7 investment on the 3 million people living within about 90,000 sq km of the areas along the proposed railway corridor. About 400,000 of them are Mongols. The mission concluded that the traditional cultures of these people should not change significantly, since the railway's alignment will follow that of existing roads, and the local people are already fully engaged in the state's economy, supplying goods and services in return for cash and commodities. The Bank Group proposed and GIM agreed that the impact of the railway on socio- economic development should be monitored over a period of years. A plan for the long-term monitoring of the social and economic impact of the project was submitted to the Bank Group during negotiations and found satisfactory. The monitoring will be conducted by social scientists at the University of Inner Mongolia.  - 21 - Air Pollution Impact in Jilin Province 4.46 Coal from western Inner Mongolia has a higher heating value and lower ash and sulfur content than coal from the Northeast. Therefore, an increase in use of western Inner Mongolian coal as a result of the railway construction would contribute to a reduction in air pollution in Jilin province. V. ECONOMIC EVALUATION A. Overview 5.1 The proposed project would directly contribute to China's objective of increasing railway transport capacity and enhancing access to new energy resources needed to sustain economic growth. The existing coal route from Shanxi to Jilin, via Datong and Beijing, is now saturated. Indeed, the Datong-Beijing line, already double-tracked and electrified, has reached its full freight traffic capacity of about 80 mtpy eastbound, one of the highest traffic densities in the world; further expansion of this line is impractical and a new line would have to be built. As mentioned (paras. 4.5 to 4.7), the Jitong line is the least-cost solution of the four possible new coal routes considered, and it also has the greatest potential for regional development. 5.2 The phasing of the railway construction--building up the traffic capacity first to 7 mtpy and later to 17 mtpy--is consistent with the pace of traffic develop- ment and the budget constraints facing GIM. The capacity of 17 mtpy resulting from the second-phase construction (during 1997-1999) is about the maximum that can pass on a single track line in China under normal circumstances. The east- bound traffic is expected to reach the 17 mtpy capacity level by the year 2003 or so, at which time double-tracking or other capacity-enhancing investments on the line may prove to be economically desirable. 5.3 The 12 counties traversed by the proposed railway are known to have significant deposits of coal, oil, copper, silver, aluminum, zinc, iron, sodium chloride, and other minerals. In conjunction with the railway construction, many of the deposits are included in official plans for development over the next few years. Also included in official plans are proposed new factories for producing construction materials such as steel and cement. However, it is difficult to obtain reliable data on the proven reserves, planned production capacities, and costs. The estimation of economic benefits related to local mining and other industries is based on a limited subset of projects proposed and is considered conservative. z3. Traffic and Tariffs 5.4 The traffic forecasts for the Jitong line are shown in Table 5.1. Coal represents about 80% of the eastbound traffic and timber about 65% of the west- bound traffic. An average freight tariff of 3 fen per tkm and an average pas- senger tariff of 2 fen per pkm have been approved. These figures are used for the purposes of distributing benefits among recipients in the economic analysis, with one exception. For westbound freight traffic, an average of 2 fen per tkm is adopted to make the Jitong rail transport service competitive with the existing MR route. The latter currently carries timber from the forests in northeast Inner Mongolia and Heilongjiang province to the markets in western Inner Mongolia. A detailed explanation is given in Annex 6, paras. 9 to 11.  - 22 - C. Capital Costs 5.5 The proposed project is treated as a joint investment which consists of the direct investment in railway construction and the complementary investments in the development of coal mines and local industries which increase their capacity to produce the commodities transported by the Jitong railway. As summarized in Table 5.2, these capital costs are expressed in mid-1988 prices and have been shadow- priced. The total cost of railway construction, RMBV 1.73 billion, includes both initial construction (through 1992) to 7 mtpy traffic capacity and subsequent expansion (1997-99) to 17 mtpy capacity, and covers physical contingencies. About 5% of this total is for locomotives and rolling stock. The total cost of coal mine development, RMBY 232 billion, is based on an economic unit development cost of RMBV 167 per ton of annual coal production capacity--a weighted average of development costs of central, provincial and other local mines. The total cost of local industry development, RMBV 285 million, is roughly one-half of the develop- ment cost of the 19 projects proposed under the official plans (since only half are assumed to be related to the railway development). The capital costs of expanding the connecting lines, i.e., MR's railway sections serving the new west-east coal route via the Jitong line, are not explicitly calculated as they have already been amortized in the capacity-constrained, long-run marginal transport costs on MR's lines for eastbound traffic. Further details are given in Annex 6, paras. 3 and 4. D. Sources of Benefits 5.6 The economic benefits of the proposed railway are estimated from the following sources: (a) Increase in coal production in western Inner Mongolia. The opening of the proposed railway would permit additional coal to be produced in western Inner Mongolia and transported to eastern Inner Mongolia and Jilin province. The existing coal routes are at present fully saturated and cannot be easily expanded. The increase in coal production would bring benefits to the coal producers, the transporters (including IMLRC), and the coal users. The benefits are measured on the basis of the export- equivalent price of coal in Jilin. This is considered a conservative estimate; given the severe shortages of coal in China, the economic value of coal to the country should be much higher than its international border prices indicate. (b) Increase in local industry production. The increase in the production of cement, marble, metallic and non-metallic ores, etc. in the counties traversed by the proposed railway would benefit the producers, transport- ers, and users. The benefits are measured on a value-added basis. (c) Savings in transport costs for other freight traffic. This would result from diverting various other freight traffic from truck to cheaper rail transport. (d) Increase in animal husbandry production. The volume of animal husbandry products in the counties along the proposed railway is expected to increase in various ways. The benefits are measured as an iricrease in the cash income of the herdsman. (e) Increase in people's mobility. Thie people who live along the railway would have convenient access to inexpensive and reliable transportation.  - 23 - Similarly, the people who live in the western and eastern parts of Inner Mongolia and in Jilin province would have better access to each other, thereby promoting services and trade. The benefits are measured in terms of passenger willingness-to-pay. The data, methodology and calculations, including shadow pricing, are described in detail in Annex 6, paras. 12 to 18. E. Base Case Results 5.7 The net present value (NPV) for the package of complementary invest- ments, discounted at 12%, is RMBY 1.30 billion, and the economic rate of return (ERR) is 18%. As summarized in Table 5.2, the economic evaluation is based on a 20-year period of benefits, 1993-2012. Some of these investments, including railway infrastructure, rails, locomotives and rolling stock, have a life expectancy of more than 20 years, but adding benefits to the calculations increases the NPV and ERR only marginally. By allocating the project capital costs between freight and passenger traffic on a freight-equivalent basis, the NPV can be broken down as follows: BREAKDOWN OF PROJECT NET PRESENT VALUE NPV @ 12% % (RMBB million) Freight traffic Coal traffic 420 32 Other traffic 530 41 Subtotal freight 950 73 Passenger traffic 50 4 Animal husbandry products 300 23 Total 1,300 100 Note that in the above table animal husbandry products represent a negligible volume of freight traffic but have a very high value of benefits per ton (Annex 7). F. Distribution of Benefits 5.8 As shown in the table above, about 73% of the NPV of the project is attributable to freight traffic, 32% of it to coal, and 41% to other traffic. Most of the 41% goes to the population in the counties traversed by the Jitong railway. About 4% of the NPV is attributable to passenger traffic, mostly generated by this same population. A sizeable share (23%) of the NPV would be enjoyed by the local herdsmen (mostly Mongols) through an increase in their cash income. All in all, the people who live in the Jitong influence area would be the recipients of a large portion of the net economic benefits.  - 24 - 5.9 Because of financial transfers and distortions between economic and financial prices, the actual financial benefits received by the various parties will differ from the net economic benefits shown above. Consequently, a further analysis has been done to identify the net gainers or losers in financial terms. No shadow pricing of the costs and benefits is &pplied as the beneficiaries are considered to gain or lose according to the financial costs and benefits they actually experience. 5.10 The major groups of beneficiaries in this analysis are Inner Mongolia, the Central Government, and Jilin province. The Inner lMongolia beneficiaries includ, GIM, IMLRC, railway passengers, local truck operators, freight shippers, coal consumers, indigenous investors of coal mines and local industries, and herdsmen. The beneficiaries in the Central Government category comprise the Ministries of Railways and Energy. The beneficiaries of Jilin province include coal users--power generating plants and a variety of industries and consumers--and people who would travel to western and central Inner Mongolia on the Jitong line for both business and pleasure. 5.11 The capital costs of the package of complementary investments are charged against these groups of beneficiaries according to their shares of the investments. The value-added benefits of coal and local industry production are distributed through the producer surplus, transporter surplus and consumer or user surplus associated with the production, transportation and consumption of these com- modities. The benefits due to road-to-rail and rail-to-rail traffic diversion are allocated according to the transporter and transport user or shipper surplus. The passenger traffic benefits are distributed through the transporter and passenger surpluses. A detailed analysis of these benefits is given in Annex 6, paras 12 to e,8. 5.12 The project benefits are roughly distributed among the three groups of beneficiaries--Inner Mongolia, the Central Government, and Jilin province--as follows: DISTRIBUTION OF PROJECT BENEFITS NPV i 12% X (RNBE million) Inner Mongolia 900 57 Central Government -170 -11 Jilin Province 860 54 Total 1,590 100 5.13 The above distribution of benefits reflects the existing structure of coal prices and transport tariffs. For simplicity, it assumes that inflation would occur  - 25 - at equal rates for all costs and prices during the 25-year analysis period. As mentioned, no shadow pricing has been applied to costs and benefits associated with the beneficiaries, in order to illuminate the full distribution of benefits among various parties. Some of these benefits occur precisely because financial prices differ from economic prices. Because financial costs are generally smaller than their corresponding shadow-priced economic costs, the sum of the NPVs for the three beneficiary groups, RMB'# 1.59 billion, is greater than the total economic NPV for the project, RMBI 1.30 billion. The difference of RMBY 290 million represents an indirect transfer of resources from the Chinese economy as a whole, on a dis- counted cash flow basis, to the main project beneficiaries, Inner Mongolia and Jilin province. 5.14 The magnitude of the benefits for these two groups, RMBY 900 and 860 million, is very similar. The main reason is that, while the coal users in Jilin province reap sizeable gains from the C Apply of coal from Inner Mongolia, they do not have to pay for the capital development costs. The negative NPV of RMBV 170 million for the Central Government means that there is another transfer of re- sources from the Chinese economy to the main project beneficiaries. The transfer implies an insufficient recovery of investment costs in railway and coal development through coal prices, railway tariffs and taxes. The total amount of resources transferred equals RMBY 290 + 170 = RMBV 460 million. G. Sensitivity Analysis and Risks 5.15 The ERR of the project is evaluated below for a variety of scenarios: Case Description ERR (X) I Base case 18 2 Railway construction, 20% cost overruns 17 3 Coal development costs, 20% higher 17 4 Local industry development costs, 20% higher 17 5 Coal prices, 20% less than projected 14 6 Benefits delayed by two years 14 7 Only coal traffic materializes 12 5.16 In relation to the base case, the downside risks are rather modest with respect to increases in capital costs (Cases 2 - 4), decreases in coal prices (Case 5) and delays in the construction of the railway and implementation of the comple- mentary projects (Case 6): none of the ERRs falls below 14%. The most severe downside risk is that only coal traffic will use the railway and coal value added is the only benefit (Case 7). This is the only scenario in which the ERR drops to 12%. However, the latter scenario is unlikely and is intended to reaffirm the point that other benefits, in particular, regional development benefits, are also important.  - 26 - VI. FINANCIAL ANALYSIS 6.1 Introduction. The financial analysis of IMLRC focuses on the elements which are likely to assure a sound financial position for this new company once it begins operations in 1993. IMLRC has the opportunity to use its relative autonomy and favorable demand prospects to build a financially strong and efficiently managed company. 6.2 Canitalization. IMLRC will be capitalized with equity initially at about RMBV 810 million, of which GIM will contribute about RMBV 450 million and MR RMBV 360 million, depending on final project costs. This healthy equity contribu- tion provides strong capital for the company. Moreover, no dividend distributions are planned since retained earnings will be used to expand the line's capacity as traffic demand grows. The financial backing by GIM and MR indicates the priority placed on this project because of the anticipated economic benefits from coal transport and the development of regional economic activities and trade. 6.3 Tariffs. IMLRC already has received approval for a freight tariff of 3 fen per tkm. This freight rate represents an average of different rates which will eventually be established for different classes of traffic and lengths of haul. The rate is higher than the MR average of 1.9 fen/tkm, but not as high as some established for other local railways (para. 2.20). IMLRC is presently authorized to charge a passenger rate of 2 fen/pkm, which approximates MR's current average of 1.9 fen/pkm. 6.4 The presently authorized level of tariffs will be reviewed at the start of railway operations, taking into consideration projected operating costs and cash flow and also the level of MR and local tariffs at that time. If, in view of these considerations, the authorized target tariff appears too low, IMLRC has the authority to propose a tariff increase for the Jitong line. 6.5 Taxes. IMLRC will pay a 3% business tax on its gross sales revenue to GIM. Local railway companies are exempt from income and other taxes on profit. 6.6 Debt Service. Interest during construction on the RMBV 557 million onlent from the Central Government to GIM will be paid by GIM and will be considered a non-interest bearing loan to IMLRC, repayable from IMLRC's future cash flow. At negotiations, it was confirmed that GIM will also pay interest charges during the first year of operation, if necessary, to assure sufficient working capital for the company. This is reflected in the forecast. A schedule for repayment of the advance from GIM has not been fixed. However, the financial projections indicate that a repayment period of four years beginning in 1995 is r-easonable. _ 6.7 The principal debt obligation will be the Bank Group loan and credit which IMLRC will begin to service in 1994. As mentioned above (para. 4.19), IMLRC will pay an onlending interest rate of 5% and will not bear the foreign exchange risk. Financial Forecast and Sensitivity Analysis 6.8 Tariff levels, traffic volume, and the level of operating costs are the three factors critically affecting the financial position of IMLRC. These factors are explored in the financial analysis. Projected income, balance sheet and flow of funds statements over a 10-year horizon beginning in 1993 are presented in Tables 6.1 to 6.6, and a supporting debt service schedule for the Lank Group loan and  - 27 - credit and advances from GIM as presented in Table 6.7. Two scenarios are given, assuming different tariff levels for eastbound freight traffic (3 fen/tkm and 4 fen/tkm). Although the difference seems small, the extra margin makes a large difference in the financial picture, particularly if traffic buildup is slower or operating costs are higher. Under both scenarios, a tariff of 2 fen/tkm is applied to westbound freight traffic and to passenger traffic. 6.9 Scenario I: 3 fen/tkm for eastbound freight. Under this scenario, three cases are presented -- a base dase, which uses the same traffic levels as in the economic analysis, and two variations to explore the sensitivity of IMLRC's financial projections to the downside risk of: (i) Slower buildup of eastbound and westbound traffic. The absolute levels of traffic are lower also: eastbound traffic reaches a level which is 85% of the base case; westbound traffic reaches 70% of the base case. This sensitivity case represents conservative assumptions, especially the assumption on the absolute level of traffic being lower than the traffic- carrying capacity. (ii) 25% increase in operating costs, including major repairs. Again, this sensitivity case represents a conservative assumption since anticipated inflation is already reflected in the operating costs in the base case. Detailed financial projections are shown in Tables 6.1 to 6.3. Annex 8 provides a detailed discussion of the results. Under the base case, the company reaches profitability within two years, and debt service is satisfactory (1.5 or above after the second year). The cash flow generated would enable the company to finance 54% of the costs of the expansion investment beginning in 1997. 6.10 The two sensitivity cases demonstrate, however, that the company is more vulnerable financially to lower traffic buildup or higher costs, or both. Most important, in both sensitivity runs the company would fail to generate enough cash flow to finance the expansion costs; moreover by 1997 the company would need to borrow money to meet the then-existing debt obligations and all major repair expenses. 6.11 Scenario II: 4 fen/tkm for eastbound freight. Under this scenario, all other aesumptions remain the same in order to svaluate the sensitivity of IMLRC's finances to tariff increases (detailed financial projections are shown in Tables 6.4 to 6.6). The detailed analysis in Annex 8 indicates the much higher profitability and liquidity achieved, demonstrating the strong sensitivity of the financial results to this 33% tariff increase. In the base case, the company would generate sufficient cash flow to fund the entire expansion investment. The higher tariff also reduces the impact of lower traffic or higher operating costs, if either were to materialize, at least initially. In these sensitivity cases, the company would be able to finance 65-75% of the expansion investments out of internally generated cash. Both scenarios indicate the importance of assessing IMLRC's future operating conditions before operations begin in 1993, in order to determine proper tariff levels. 6.12 Financial Covenants. As a new company, IMLRC should start off onI a sound financial footing and monitor closely its current and projected financial perform- ance. Therefore, a financial covenant was agreed during negotiations, stating that IMLRC will take all measures necessary, including proposing tariff increases, to cover all operating costs from revenue and to achieve a debt service coverage ratio of 1.5 within the first three years of operations.  - 28 - 6.13 During negotiations, it was also agreed that, in the year before the line is opened to traffic, IMLRC will prepare eight-year financial projections and compute the following ratios: return on assets, operating ratio, current ratio, debt-to- capital ratio, debt service coverage ratio, and self-financing ratio. The self- financing ratio is defined as the percentage of the 1997-1999 expansion investments funded by IMLRC's internally generated cash. These projections will be reviewed with the Bank Group during supervision, and target ratios will be established for monitoring operational performance once the line starts operations. This will be the first time that financial covenants have been introduced in a Bank Group-financed railway project. The start-up nature of the company and the fact that it is locally managed create the circumstances which make this appropriate. 6.14 Auditing and Reporting. It was agreed during negotiations that project accounts and IMLRC's financial statements will be audited in accordance with sound accounting practices by independent auditors acceptable to the Bank Group. The audit reports will be sent to the Bank Group for review not later than six months after the end of each fiscal year. It was also agreed during negotiations that IMLRC will (a) prepare and submit to the Bank Group semi-annual progress reports on the execution of the project; and (b) prepare a Project Completion Report to be submitted to the Bank Group. not later than six months after the loan and credit Closing Date. VII. AGREEMENTS REACHED AND RECOMMENDATION 7.1 As a condition of negotiations, the Bank Group had requested a letter of representation from SPC or MOF, confirming the development plans and the availability of firm financing sources for the development of the Dongsheng coal field (para. 4.29). 7.2 During negotiations, the Bank Group received the following documents, which were found satisfactory: (a) a plan for land compensation, approved by the relevant authorities and providing adequate rules for land acquisition and satisfactory arrange- ments for the people who will be affected by the railway (para. 4.26); (b) a plan to monitor the impact of the railway on adjacent grasslands, to be conducted by the Environmental Protection Research Institute under the leadership of the Environmental Protection Bureau of the Central Govern- ment (para. 4.44); and (c) a plan for the long-term monitoring of the social and economic impact of the project, to be conducted by social scientists at the University of Inner Mongolia (para. 4.45). 7.3 During negotiations, it was agreed that GIM will: (a) meet cost overruns if they occur (para 4.18); (b) pay interest during construction (including commitment fees) and, if necessary, also during the first year of operations (paras. 4.19 and 6.6): and  - 29 - (c) assure that the provision of adequate food and shelter for laborers during railway construction will be monitored by a GIM office independent of IMLRC, to avoid possible conflicts of interest (para. 4.24). 7.4 During negotiations, a covenant in the Loan and Credit Agreements was obtained from the Government, stating that the Borrower (MOF on behalf of the Government) will require MR to provide investments in a timely fashion in order to assure adequate capacity on the connecting lines for handling the expected traffic to and from the Jitong line by 1995, and in later years as the line is expanded (para. 4.33). 7.5 During negotiations, agreement was obtained from IMLRC on the following matters: (a) a covenant in the Project Agreement, stating that IMLRC will carry out its staffing and training according to the plan shown in Table 4.3, in order to have qualified staff in adequate numbers when operations begin in 1993 (para. 4.13); (b) a covenant, stating that IMLRC will ensure that the people displaced by the proposed railway will be resettled according to a plan acceptable to the Bank Group (para. 4.26); (c) a financial covenant, stating that IMLRC will take all measures necessary, including proposing tariff increases, to ensure a debt service coverage ratio of 1.5 within the first three years of operations (para. 6.12); (d) a commitment that, in the year before operations begin, IMLRC will prepare eight-year financial projections and compute the following ratios: return on assets, operating ratio, current ratio, debt-to-capital ratio, debt service coverage ratio, and self-financing ratio, to be reviewed with the Bank Group during supervision, in order to establish indicators for monitoring operational performance when the railway begins its operations (para. 6.13); (e) the auditing of project accounts and IMLRC's financial statements by independent auditors acceptable to the Bank Group, according to sound accounting practices; the audit reports should be sent to the Bank Group for review not later than six months after the end of each fiscal year (para. 6.14); and (f) the preparation by IMLRC, and submission to the Bank Group, of semi- annual progress reports on the implementation of the project (para. 6.14); (g) the preparation by IMLRC of a Project Completion Report, to be submitted to the Bank Group no later than six months after the loan Closing Date (para. 6.14). 7.6 Given the above assurances, the proposed project would be suitable for a Bank loan of US$70.0 million equivalent and an IDA credit of SDR 58.6 million (equivalent to US$80.0 million) to the Peoples' Republic of China. The loan would be for a term of 20 years including a five-year grace period, at the standard variable rate, and the IDA credit would be on standard IDA terms, with 35 years maturity.  CEN InNE MONGOLIA LOCAL RAILWAY PROJECT ORGANIZATION CHART OF INNE DONGOLIA LOCAL RAILWAY CORPORATION Board of Directors _ _ II_ General Managers (2 Deputies) Auditing Construction Personnel Secretariat Engineering Planning Materials Division Supervision Division Division Division Supply Division Division - Locomotives Planning - Rolling Stock Statistics - Signalling Accounting and Tele- comnmunications Operations  - 31 - ANNEX 2 Page 1 CHINA INNER MONGOLIA LOCAL RAILWAY PROJECT Coal Resources in Inner Mongolia and Northeast Demand 1. Inner Mongolia has 217 billion tons of coal resources and ranks second to Shanxi Province in the country for coal resources. Of the total, 43.6 billion tons, mainly lignite, are located in the eastern region and 173 billion, consisting of bitu- minous steam and coking c, 'l, are located in the western region. In 1987, the western region produced about 18 million tons of raw coal. The various coal mines are operated by the Ministry of Enr gy (ME), the local government, and townships. In 1987, 9.0 million tons came from M2 mines, 3.8 mt from GIM and local government- run .iines, and 5.2 mt from township/individual mines. The total coal mined over the past 30 years accounts for only about 2% of the total proven reserves. The main reason for the low level of exploitation so far has been insufficient transpor- tation capacity. By the year 2000, western Inner Mongolia plans to have in produc- tion three coking coal areas, two steam coal mining areas, and its anthracite mining area; planned total production capacity is to exceed 70 mtpy, an ambitious target. A significant share of this increased production is earmarked for domestic export to the northeast. 2. IMLRC anticipates that coal carried by the Jitong railway will come from both the Wuhai and Dongsheng areas. With some of the best quality steam coal reserves, the Dongsheng coal field looks the most promising for domestic export to Jilin. Because of the timing of its development, however, during the early period of operation of the Jitong line, coal production from many underutilized mines in the Wuhai area, 350 km southwest of Baotou, may have to provide supplies for Jitong. Wuhai coal has a higher sulphur content and is located further away from the starting point of the Jitong line; it is considered only a temporary alternativ,. Dongsheng coal is preferable in terms of quality, market suitability, and access to Jitong. 3. The Dongsheng coal field contains about 95.3 billion tons in situ of high quality thermal coal. The reserves are excellent by world standards, with low ash, high volatile and high calorific value, and low sulphur and phosphorous content. The geology is simple, and mining conditions are easy. The coal field lies 170 km south of the industrial city of Baotou and just west of northern Shanxi province and borders the Shenmu coal field of northern Shaanxi province. The coal bearing area covers 12,860 sq km. A spur railway from Baotou to the coal field was completed recently. From Baotou, Dongsheng coal will be transported via the existing railway (360 km) to the proposed Jitong line. Existing production is limited to very informal, local efforts of cooperatives, mining those areas which can be easily exploited with simple equipment. The Inner Mongolian authorities now plan more extensive development to build up Dongsheng as a major source of coal supply. 4. Simultaneous development of the Dongsheng coal field will occur through state-run and local government operations. Three phases of development are planned. Phase I is expected to reach a design capacity of 6.7 mtpy by 1994 and 16.5 mtpy by 1998. The first phase of construction, including infrastructure to reach design capacity in 1994, is estimated to cost around US$280 million. Phase II construction will begin in 1992, reaching a design capacity of 25 mtpy in 2001.  - 32 - ANNEX 2 Page 2 Phase III, to begin in 2001 and end in 2010, will bring total capacity to 50 mtpy. Throughout the period, there will continue to be some township- and individually- owned mine production, although it is expected to decline over time. 5. The southeast portion of the coal field is planned for initial development because of its better quality coal, good mining potential, and thick seams. The area has been arbitrarily divided into seven mining blocks. A Bank team reviewed and discussed initial plans for five of the mines which will be developed by Inner Mongolia and the Huaneng Fine Coal Development Corporation. In the section of the coal field reviewed by the Bank team a design capacity of 4.8 million tons is planned for the first phase. Three underground mines will have capacities of 900,000 tpy, 600,000 tpy, and 600,000 tpy, one open-pit mine will have a capacity of 1.8 mtpy. 6. The rest of the production is expected to come from cooperatives or village-level mines. Since the Dongsheng coal field is still basically a virgin field, the team emphasized that GIM has the opportunity to develop it in an optimal way. The team therefore suggested that the authorities commission a master plan study to suggest proper phasing of exploitation of the entire coal field as well as individual mine design studies. Too fragmented an approach could lead to sub- optimal, though still economic, production. Finally, because of concern over timing of coal field and infrastructure development, the Bank has obtained letters from MOF and GIM confirming the development plans and availability of firm financing sources for exploitation of the Dongsheng coal field (Annex 4). Coal Import Needs of Jilin Province 7. Steam coal deposits in western Inner Mongolia, particularly the Dongsheng field, would have a strong market in Jilin province and could be delivered via the Jitong railway at a competitive cost. Although it produces coal, Jilin is still a net importer of coal (presently about 10 mtpy). The remaining coal mines in Jilin are small, and the geology is such that the reserves will not be easy to exploit. Moreover, much of the coal is deep seated and of inferior quality, bituminous coal and lignite suited primarily to electric power goneration. Import needs of the province are expected to grow, as industrial growth continues. The Inner Mongolia and Northeast United Coal Corporation, covering the economic zone of the Northeast plus the eastern part of Inner Mongolia, provide the following projections of Jilin's net import needs to the year 2000:  - 33 - ANNEX 2 Page 3 199C 1995 2000 ------- million tons ------- Jilin demand 42.4 50.4 59.2 Jilin production 23.1 26.2 29.3 Stock drawdown 1.6 2.2 3.2 Net import needs To be supplied by: Northeast/North Korea 7.7 6.7 6.7 Shanxi and western Inner Mongolia 10.0 15.0 20.0 8. Jilin's coal demEad is driven by the demand for coal in electricity and industrial production, which is expected to grow by 7% and 9% p.a. respectively between 1990 and 2000. Available statistics (1986) indicate Jilin's aggregate industrial and agricultural output value has been growing at about 7% p.a., with industrial output growing at 8%. These rates could end up being even higher. 9. Current supply routes from Shanxi are now close to capacity; moreover, critical sections of those lines would be very costly or impractical to expand because of the rough terrain from Beijing to Tongliao. The abundant reserves of good quality coal in western Inner Mongolia, minable at low cost, are thus a logical new source of supply for the Northeast, and the coal is comparable to that of Shanxi.  - 34 - ANNEX 3 Page 1 CHINA INNER MONGOLIA LOCAL RAILWAY PROJECT Land Acquisition and Resettlement Program 1. Land acquisition and resettlement are conducted under the "Land Manage- ment" and "Prairie" laws of the State as well as the "Forestry Management" law of Inner Mongolia. A land compensation plan has been developed and its implementa- tion will be overseen by the Office of Land Acquisition, Demolition and Resettlement for the Jitong railway (LADR office) of the Governor's office of Inner Mongolia. An approved version was reviewed during negotiations and considered satisfactory. 2. The Government of Inner Mongolia (GIM) has made an effort to direct the railway through less densely populated areas to avoid unnecessary compensation and has located railway stations about one km outside the 48 villages through which the Jitong line will pass. A lot of preparation has already taken place, and surveys have been made of the area and population affected. The impact of land acquisition and resettlement, for Chifeng city and each of the three leagues affected, is described below: Land Acquisition Impact Affected Chifeng Wu League Xi League Zhe League Total item City Farmland (mu) 13,179 8,401 3,519 3,921 29,020 Grassland (mu) 19,374 1,673 4,714 1,168 26,929 House area (sq m) 29,233 4,834 372 1,269 35,708 No. of houses 1,624 269 21 71 1,985 No. of households 812 135 11 36 994 Population 4,060 673 52 187 4,972 3. Approval of both GIM and the State is required for acquiring land, buildings, and resettle people displaced by the railway construction. The plan spells out the procedures for land acquisition and resettlement and specifies compensation formulas for the taking of land, houses and other structures, as summarized below:  - 35 - ANNEX 3 Page 2 (a) Cultivated land. The formula comprises a compensation fee for lost production and a subsidy for resettlement. The compensation fee equals four times the average annual production value per mu three years prior to the land acquisition. The resettlement subsidy is determined according to the density of the agricultural population to be resettled; the latter, in turn, is calculated according to the area of cultivated land to be acquired, divided by the average per capita area of cultivated land of the county concerned. The amount of subsidy per capita of the agricultural popula- tion to be resettled equals three times the average production value per mu three years prior to land acquisition. (b) Natural and man-made grasslands. The compensation fee and resettlement subsidy equal ten times the average value of fodder production per mu three years prior to land acquisition. (c) Irrigated, vegetable-growing and forest lands. The compensation fee is determined through consultation between the LADR office and the counties concerned. 5. Compensation for houses will be in the range of RMBY 40-90 per square meter according to their structures and condition; the plan contains detailed standards in respect of housing structure for determining compensation. There are also specified ranges of compensation for removal of enclosures, wells and graves. Finally, there is a strong penalty clause to help prevent deviations from the plan or fraud from occurring during implementation. 6. The county authorities will be responsible for land acquisition and resettlement of local residents and herdsmen one year prior to the railway con- struction. They will allocate land to the resettling residents in return for the acquired land. If some residents prefer to choose their own location, government approval will be needed prior to building. IMLRC will pay all compensation, which will be distributed through local governments. Arbitration, if necessary, will be the responsibility of GIM. The proposed railway enjoys strong support from the local people and no delays in land acquisition or resettlement are expected.  - 36 - ANNEX 4 Page 1 CHINA INNER MONGOLIA LOCAL RAILWAY PROJECT Coal Mine Development and Financinx (translation) November 10, 1988 Mr. Attila Karaosmanoglu Vice President, Asia Region The World Bank Dear Mr. Karaosmanoglu: I am pleased to learn that the World Bank has agreed to finance the Inner Mongolia Local Railway Project. Our understanding is that the feasibility of this project is largely based on the development of the coal reserves in the Inner Mongolia region. I agree to the commitment made by the Inner Mongolia People's Government to mobilizing adequate f'Ands for the coal development and the infra- structure of the coal mines. I wish success to the Jitong railway project. Sincerely yours, (signed) Chi Haibin Vice Minister of Finance People's FRepublic of China  - 37 - ANNEX 4 Pace 2 October 4. 1988 (translation) Mr. Attila Karaosmanoalu Vice President. Asia Region The World Bank Dear Mr. Karaosmanoelu: I am pleased to inform vou that the Donsrshena Coal Field Development and Funding Program proposed by the Planning Bureau of the Inner Mongolia Autono- mous Region was approved by the People's Government of the Autonomous Region durina the meeting of its standine committee on Au