Mexico - Pacific Railroad Rehabilitation Project

LN 103 1 FLE COPY P-71 RESTRICTED This report is restricted to use within the Bank. INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT REPORT AND RECOMMENDATIONS OF THE PRESIDENT TO THE EXECUTIVE DIRECTORS ON THE PROPOSED LOAN TO PACIFIC RAILROAD OF MEXICO FOR ITS REHABILITATION PROGRAM August 17, 1954  IMERTNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMEN REPORT A.D REC]MMENDATIONS OF THE PRESIDENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO THE PACIFIC RAIIROAD CF MIEXICO FOR ITS REHABILITATION FROGRAM 1. I submit the foflowing report and recommendations on a proposed loan of $61,000,000 to tlhe Pacific Railroad of Mexico (Ferrocarril del Pac4fico, S.A. de C.V.) to finance a rehabilitation program. PART I - HISTCRICAL 2. In 1951 the Mexican Government purchased the Ferrocarril del Sud- pacifico from the Southern Pacific Railway Company of the U. S5, which had operated it since 1909, and renamed it Ferrocarril del Pacifico. The railroad, some 1,200 miles long, extends from Nogales on the Nexict.. Arizona border to Guadalajara, Mexico's second city, and serves the fer- tile coastal area of the States of Sonora, Sinaloa and Nayarit as well as the ports of Guaymas and IJazatlan. 3. Early in 1954 the Mexican Government decided to proceed with the rehabilitation of the railroad in accordance with a program drams up during 1953 by a firm of New York consultants (Coverdale and Colpitts), and to seek external linancial assistance for this purpose. 4. At first the Mexican Government approached the Exportt-Import Bank for this purpose. However, after examination of the project it appeared that the uncommitted balance ($23 raillion) of Mexico's existing line of credit with that Bank was insufficient to meet the need and the U. S. Government was not prepared to increase that linie of credit. After consultation among the interested parties, it was decided that a loan application for the entire amount required should be presented to the IBRD. 5. In May 1954, a Banlc mission visited M'exico in order to: (a) discuss with the Government certain major policy questions concerning the Pacific Railroad which the Bank considered should be settled before it could make a detailed appraisal of the project. (b) if these questions ijere satisfactorily settled, malce this detailed appraisal. (c) reassess Mviexicots economic position and prospects.  - 2 - 6. As a result of the discussions referred to under (a) above, the Mexican Government and the Pacific Railroad took a number of important steps, of which the most significant were the following: (a) lMoving the headquarters of the railroad from Mlexico City to Guadalajara. (b) Reorganizing the Board of Directors so as to diminish the Government's representation and to increase great- ly that of the private interests in the area served by the railroad. (c) Reorganizing the top management and appointing a Direc- tor of Rehabilitation. (d) Concluding an agreement with the labor syndicate where- by a number of important posts were withdrawn from the syndicate's control. (e) Retaining the services of the consultants for the duration of the rehabilitation program. (f) Agreeing that a 10% tax levied on freight charges and passenger fares would be retained by the railroad as a regular source of income. 7. In view of the satisfactory nature of these steps, the mission proceeded vnth the detailed appraisal of the project. In making this appraisal, the mission hlad the assistance of the consultants, who also revised their 1953 report to take account of the devaluation of the peso in April 1951. At the same time, the mission made a reassessment of Mexicots economic position. 8. Formal negotiations for a loan opened in VTashington on,July 23, 1954. The Mexican Government was represented by Mgr. Raul Martinez Ostos, Sub-Director General of Nacional Financiera, and the Pacific Railroad by Mr. Benjamin Mendez, General Manager. PART II - DESCRIPTION CF THE PROPOSED LOAN Borrower 9.. The ,Borrover vwould be Ferrocarril del Pac.fico, S.A. de C.V., a Sociedad Anonima de Capital Variable organized under the laws of Mexico. Apart from some small participation by the States of Sonora and Sinaloa and private investors, the slhares of the Borroner are held entirely by tlhe Mexican Government. 10. The Guarantor would be United-IvIexican States, a member of the Bank.  - 3 - Amount 11. The loan would be in the amount of $61,000,000, or its equivalent in other currencies. Purpose 12. The proceeds of the loan would be used to finance the foreign exchange costs of a four-year program for the rehabilitation of the track, rolling stock and other facilities of the Pacific Railroad. Interest, Commission and Commitment Charges 13. The loan would bear interest at the rate of 4-5/8% per annum, including the statutory commission of 1%. The commitment charge would be 3/4-of .1% per-annum, and would accrue from the effective date of the Loan Agreement or a date 60 days after signature, whichever is the earlier. Amortization 14. The loan vould be for a period of 15 years (with a four-year period of grace corresponding to the expected period of construction). It would be amortized by semi-annual payments beginning June 1, 1959 and ending December 1, 1969, as set out in Schedule 1 of the proposed Loan Agreeraent. Legal Instruments and Legal Authority 15. Drafts of Loan and Guarantee Agreements are attached as Appendix 1 and Appendix 2 respectively. These agreements are substantially in the forms currently used by the Bank. The provisions of special interest are as follows: (a) Loan Agreement Section 2.02 makes the riglht to withdraw loan proceeds conditional upon the Mexican Government's making appropriate revision in the railroad's present sched- ule of rates. Sections 5.03 and 5.05 restrict the Borrower's povwer to incur additional debt and to pay dividends. Section 5.06 requires the Borrower ifhenever necessary to take prompt steps to obtain appropriate rates.. Section 5.07 requires the Borrower to retain the ser- vices of consultants. (b) Guarantee Agreement Section 3.03. The C-uarantor undertakes that the Borrower will from time to time be awvarded appro- priate rates.  Section 3.04. The Guarantor agrees to continue to permit the Borrower to retain as normal income the proceeds of a 10% tax on freight charges and pass- enger fares. 16. Before the Loan could become effective, a law would have to be passed by the Mexican Congress renewing WIacional Financiera's authority to guarantee loans from the International Bank on behalf of the Mexican Government. Previous legislation conferring such authority expired on October 31, 1952. The Uovernment is drafting an appropriate bill for submission to Congress when it convenes in September 1954. 17. The Loan Agreement will be ratified by the Board of Directors and by a general meeting of shareholders of the Borrower. 18. The report of the Committee provided for in Article III, Section 4 (iii) of the Articles of Agreement of the Bank is attached as Appendix 3. PART III - APPRAISAL CF THE PROPOSED LOAN 19. A detailed appraisal of the project (T.O. 58-a) and a report entitled "Current Economic Position and Prospects of Mlexico"' (W.H. 29-a) were distributed to the Executive Directors on August 10, 1954 (R-819). Justification of the Project 20. The Pacific Railroad serves an area which, largely as a result of extensive irrigation, has in recent years undergone rapid agricultural development. Irrigation projects now under construction or planned should ensure the continuation of this development for many years to come. The rise of cotton in recent years to the foremost place among Mexico's ex- ports, and the approaching elimination of wheat imports, wlich have in the past cost from 420-030 million a year, are largely due to the in- crease of production in this area. 21. For the long distance haulage of such bulky products, the Pacific Railroad is essential. Its deficiencies in recent years, both in physical equipment and in management and administration, have been a serious handi- cap to the producers of the area, and a disastrous breakdown threatens if thorough rehabilitation is not promptly carried out. Conversely, the program now proposed should soon yield striking results from the point of view both of the general prosperity of the area and of the railroad's earning capacity. 22. I attach great importance to the fact that, in planning the reha- bilitation program, as much stress has been laid on improving the admin- istrative and operating efficiency of the railroad as on rehabilitating its physical assets. T have been impressed by the Mlexican Government's determination, already clearly shoam by the important decisions referred to in paragraph 4 of this report, to mwake this project a model for im- provements in other parts of Mexico's railway system, The project may  - 5 - thus have an importance far exceeding its immediate economic effects, significant though these should be, and I therefore believe that it is of very high priority for Mexico's development. Methods of Procurement 23. Commitments to the extent of approximately $10 million have already been entered into by the Pacific Railroad, and the foreign ex- change expenditures made to date against these comitments have been financed by interim advances from Nacional Financiera, by short-term borrowings from the Bank of America, and by suppliers? credits. These commitments were made almost entirely in the U.S.A., because of the Mexican Government's original intention to finance this program through the Export-Import Bank. The proposed Bank loan would cover these commit- ments. The Bank's engineers are satisfied that they are on reasonable terms and that the purchases are suitable for the efficient execution of the project. Commitments entered into after the presentation of the project to the Bank have been and will be on the basis of international competitive bidding. 24. It has hitherto been virtually impossible to acquire railroad ties in Mexico, although the country produces muclh timber from which they could be cut. Provision has therefore been made in the loan for the purchase outside Mexico of all the ties needed. The Mexican Govern- ment has informed the Bank, hovever, that it intends to make the most vigorous efforts to develop tie production in Mexico. To the extent that these efforts are successful, ties would be financed from the rail- road's peso funds and not from the loan. Economic Situation 25. The report on the "Current Economic Position and Prospects of Mlexico" concludes that the outlook for Mlexico's economic growth and balance of payments is favorable. For the next year or two, crops are likely to be good and the devaluation will stimulate output and reduce imports. In the longer run there are good opportunities for growth of output, while the balance of payments position is basically strong because of diversification of exports, high earnings from tourism, and the coun- try's near self-sufficiency in food and raw materials. The report con- cludes, however, that it is essential to raise the level of public revenue and to improve the selection and coordination of public investment in order to naintain progress and at the same time to avoid periodic dis- turbances in internal monetary stability and in the balance of payments; 26. After the Economic Report vwas comipleted, cordial discussions were held between the Mexican Government and rmembers of the Bank's staff re- garding the Government's economic policies, especially on public finance and public investment. The Government's views on desirable policies are substantially in harmony wiith those of the Bank's staff, and it is appar- ent that the Government is aiking strong efforts to implement those views. 27. The Government considers that it is ifiapnropriate to increase taxes or to impose nei7 ones so soon after the devaluation. It will,  -6 therefore, for the next year or so, concentrate on increasing Government revenue by improving the collection of existing taxes. Encowuaging results are already being obtained. 28. The Government is determined to keep public expenditures-, within the limits of public revenue and non-inflationary borrowving. Food sub- sidies have been reduced by raising the price of imported corn. It has not been finally decided whether to subsidize the new food crop of this fall or instead to raise retail prices, but the Ministry of Finance strongly opposes subsidies. The Government and the Bank of Mexico have agreed that the Government agricultural banks will not receive any new loans from the Bank of Mexico, and thus no further inflation should arise from their operations. 29. The Government aims at making autonomous government agencies and enterprises financially self-supporting in order to avoid one source of past inflation. Pemex, the nationalized petroleum corporation, plans to undertake important new investments, but will draw new financial strength from increases which are now being made in its domestic selling prices and from contracts now being negotiated for the export of natural gas to the United States. An increase in power rates in September will largely offset the effects of the devaluation on the Federal Electricity Commission as well as on Mexlight. A further adjustment will be made next year. 30. The Government is determined to make the Investment Committee an efficient instrument for the control of public investment and for its improved selection and coordination. The Committee is now working directly under the President, while a new director has been appointed, and the staff strengthened. No new public investments may be initiated without its approval. 31. Through the Investment Committee and the Nacional Financiera, the Government intends to control all external borrowing of autonomous govern- ment agencies and enterprises, thus ensuring that such obligations will be incurred only for well justified purposes. 32. There is thus good reason to believe that Mexico will use the breathing space afforded by the devaluation to strengthen the economy. If this is done, I believe that the Bank could extend its investment in Mexican development considerably further than the loan now under considera- tion. Prospects of Fulfillment of Obligations 33. On the physical side the project, although large, is of a straight- forward nature and its execution should present few difficult problems. On the administrative side, the important changes already made, the retention of the services of the consultants) and the appointment of a competent engineer as Assistant General Manager in charge of rehabilitation give good reason to believe that the Project will be well directed and that the new equipment will be efficiently operated. On this basis, the finan- cial forecasts made in the technical report should prove well justified.  -7- These show that after the first two years of the program, during which some assistance from the Mexican Government in the form of further equity investment vill be necessary, the operation of the railroad should gener- ate sufficient funds not only to meet the peso costs of the project and to service its obligations, including the proposed Bank loan, but also to yield an increasing cash surplus. 3k. In the Guarantee Agreement (Section 2,.02) the Guarantor undertales to remedy any shortage of funds to complete the project which the Borrower may encounter. The obligation of the Mexican Government to maintain the rates of the railroad at an adequate level (Guarantee Agreement, Section 3.03) is of fundamental importance in assuring the financial success of the project. 35. It will be noted that amortization payments are not scheduled to begin until the four-year rehabilitation period is completed. Amortization in the years 1960-1962 has been kept at a somewhat lower level than would normally be the case in order to allow for the heavy purchases of freight cars which are scheduled for those years. The Borrower has given the Bank an undertaking thats if and to the extent that these freight car purchases prove unnecessary, it would devote the cash thus set free to prepayment of the loan. 36. The Bank's interests as a creditor are further safeguarded by Sections 5.03 and 5.05 of the Loan Agreement, which require the Borrower to obtain the Bank's consent to proposals to incur additional debts or to pay dividends on its capital stock other than any Class A shares now out- standing. 37. I am therefore satisfied that, taking into account the obliga- tions which the Guarantor is assuming with reference to rates and the provision of local currency, there are good prospects that the Borrowerts income over the life of the loan should be adequate to meet its obliga- tions and to provide the local currency needed to purchase the foreign exchange to service the loan. I am further satisfied that the economic condition of the Guarantor, together with the fact that the loan how recommended should promote increased production and improvement in the balance of payments, is such that Mexico should be able to maintain the service of this loan in addition to the service of its existing debt. PART IV - C0Il[PLPAE l7,ITH ARTICLES CF AGEEMEONT 38. I am satisfied that the proposed loan would comply with the requirements of the Articles of Agreement of the Bank. PART V - REC0EINflATIONS 39. I recommend that the Bank at this time make to Ferrocarril del Pacifico, S.A. de C.V., with the guarantee of United Mexican States, a loan of $61,000,000 or the equivalent thereof in other currencies, for a term of 15 years, with interest (including commission) at the rate of  - 8 - 4-5/8% per annum, and on such other terms as are specified in the draft Loan and Guarantee Agreements attached herewith as Appendix 1 and Appendix 2. Eugene R. Black August 17, 1954