Chile - Lota Coal Mine Modernization Project

R E S T R I C T E D R e p o r t N o. P-135 FILE COPY This report was prepared for use within the Bank. In making it available to others, the Bank assumes no responsibility to them for the accuracy or completeness of the information contained herein. INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT REPORT AND RECOMMENDATIONS of the PRESIDENT to the EXECUTIVE DIRECTORS on a PROPOSED LOAN to CORPORACION DE FOMENTO DE LA PRODUCCION and COMPANIA CARBONIFERA E INDUSTRIAL DE LOTA in the REPUBLIC OF CHILE July 8, 1957  I;TEIFNATIOIAL BANE FOR RTECOWTSTRUCTION AND DEVFLOP1,57I' REPrOrT APO R-EcCOMEiDAT.OlWr tV P'E TETD'T TO THE -Y-ECUTIVE LDIRTTCORHS nPI A L.O7OSI . .OA11 TO, THE CORBPORCION DEHOPTITODMM D L, PRODJCCIO1 iA`D THE C?_M!IA CARBONTiF E IflTdTRI L 1fli LOTA IN THE F7TPUBLIC OF CHILEI 1. I submit herewith a report and recommendations on a proposed loan -n an amount equivalent to 59.6 million to the Corporacion de Fomento de la Produccion (Fomento) and the Comnania Carbonifera e Industrial de Lota (Lota) to finance the foreign exchange cost of a nroject for modernizing the Lota mines. PART I - HI.TOPJCAL 2. The Bank i7as first auproached in 19h9 to finance the Lota p)roject for the concentration, expansion and modernization of its coal mines. Lota had already carried out considerable work on this project, and it is now seeking a Bank loan to continue the work. 3. A preliminary re-port by a consuiltant engaged by the Bank was favorable but consideration of the 'project had to be delayed until Lota could comnletc arrangements with the Chilean Government to obtain a nart of the local cur- rency required for the project and assurance of a Government guarantee for a loan from the Bank. By the time these matters had been settled in 1953, the Bank could not take action on the project because of the deterioration in Chile's economic position. 4. It was not until June 1956 that the 3anc could inform the Chilean Government that it was prepared to resume lending onerations in Chile by proceeding with three loans including the Lota project (R-979). In the same month, the Bank engaged another consultant to reappraise the technical and financial 4spects of the nroject. After the submission of the consultant's rePort, the Bank in February 1957 invited the Lota Company to send repre- sentatives to '1ashington to start loan negotiations. The Lota reprssentatives arrived at the Bank on ADril 22, 1957, but the first three weeks were scent in obtaining more complete information on the comnany, the croject and the market for coal. Loan negotiations started in mid-May. 5. If the proposed loan is made, it would increase the total amount of Bank loans in Chile to $61.9 million. If the Proposed loan for the Schwager project is also made, it would increase the total amount of Bank loans in Chile to $74.1 million. The Bank has already made the following loans:  -2- Principal Out- Serial AmoUAnt standing as of Year No. Borrower Purpose (Millions) May 31, 1957 19l8 5 CH Fomento & Erndesa Power Development $13.5 $10,678,OCO 19l18 6 CH Fomento Agricultural Develon- 2.5 none ment 1951 49 CH Fomento Exploration for 1.3' 43L,456 undergrolmd water 1953 83 CH Fomento & Papel-es Paper and pulp mill 20.0 1299,681_/ y Cartones 9 1956 153 CHi Fomento & Endesa Powesr development 15.0 9O5,196V 1/ Of which $hb5,5Lh cancelled 2/ Amount disbursed to Hay 31, 1957 PART II - DESCRTrTION OF TTrF PROPOSED LOAN Borrowers 6. The loan would be made to the Corporacion de Fomento de la Produccion and to the Compa ma Carbonifera e Industrial de Lota, as co-borrowers. Fomento, a Chilean Government corporation established in 1939 to carry out the Goverrment's develonMent program, would be party to the loan primarily because of requirements of Chilean guarantee legislation. Lota is a joint- stock corporation whose ownership is widely distributed. The original company was founded in 1852. There have been several reorganizations since then. 'The present company dates from 1933. Guarantor 7. The Guarantor would be the ReDublic of Chile. Amount 8. The loan vpuld be in an amount in various currencies ecuivalent to US A9.6 million. Purnose 9. The proceeds of the loan would be used to finance foreign exchange costs (including interest during construction) of the equirment needed for the improvement and reconstruction of coal haulage installations for the construction of a new coal prenaration plant with storage and loading facilities for rockwork development. The total cost of the project in the period 19>7-1962 is estimated at about the equivalent of US$15,875,000  Amortization 10. The loan would be for a period of 15 years. It would be amortized by semi-annual payments beginning October 15, 1962, and ending April 15, 1972, as set forth in Schedule 1 of tlhe proposed Loan Agreement, Interest Commission and Commitment Charges 11. The loan would bear interest at the rate of 5 3/4 % per annumy including the statutory commission of 1%, The commitment charge would be 3/4 of 1% per annum and would accrue from e date of the Loan reement o- 60 days after the date of the Loa Legal Instruments and Legal Authority 12. Drafts of the following legal instruments relating to the proposed loan are attached. (i) A Loan Agreement between Fomento and Lota, as co-.borrowers, and the Bank (No. l)o (ii) A Guarantee Agreement between the Republic of Chile and the Bank (No. 2), (iii) The report of the committee provided for in Article V. Section (vii) of the Articles of Agreement of the Bank (No. 3). (iv) Letter regarding assets of the Company to be mortgaged to secure the B ankts loan (No. 4). Special Provisions of the Loan and Guarantee Agreements A. Loan Agreement 13.. The Loan Agreement is in substantially the same form as those usually entered into by the Bank and its borrowers. The following provisions are of special interest: (i) Because of special requirements of Chilean legislation the Bank will be entitled to receive notes rather than bonds to evidence the amount of the loan disbursed (Art. IV). The loan and the notes will be secured by a mortgage and industrial pledge to be executed under Chilean law, covering substantially all the mining properties of Lota (Sections 5.03, 5.04, 5.05, 5.o6, Schedule 4). A mortgage and industrial pledge covering property now owned by Lota will be executed before the effective date. Supplemental mortgages and pledges will be executed from time to time thereafter as required.  (ii) Because a trustee under a trust indenture of the tyDe usual in many jurisdictions is not contemplated under Chilean law,r provision will be made in the mortgage and industrial pledge for anpointment of a representativTe. Although the renresentative would not have exactly the rights and duties of a trustee, he would act as agent of the bank and of the holders of notes in matters relating to or arising out of the mortgage instriument or the enforcement of rights under it (Section 5,03). (iii) Lota agrees not to create or maintain any liens other than the lien of the mortgage and industrial oledge to the Bank on any of its property except for certain excepted types of liens (Section 5.07). It is con- templated, however, that indebtedness of Lota to Fomento pursuant to the agreement referred to in paragranh 24 below, vill be secured by a second lien on the properties securing the Bank's loan. (iv) Limitations are imoosed on the amount of interest- bearing debt which Lota may incur and upon cash dividends it may pay or other distributions it may make to its shareholders (Sectionsr5.08 and 5.09). 14. The draft Loan Agreement is substantially similar to the proposed Loan Agreement between Fomento, Compania Carbonifera y de Fundicion Schwager and the Bank. B. Guarantee Agreement 15. The draft Guarantee Agreement is substantially similar to previous guarantee agreements between the Republic of Chile and the Bank. As in the case of other loans to nrivate companies, the Government wiould guarantee only payment of principal, interest and other charges and not performance of' all obligations of the borroTwers (Section 2.01). 16. To orotect Lota against a default solely on the part of the guarantor (e.g., a violation of the negative pledge) the Bank has no right under the Loan Agreement to premature the loan for a default by the guarantor under the Guarantee Agreement. In case of such a default by the guarantor, how- ever, the Bank has the right to premature the loan against the guarantor. The guarantor then succeeds to the rights of the Bank under the mortgage, but not under the Loan Agreement and may exercise its rights under the mortgage only in case of default by Lota under the provisions of the mortgage. PART III - APPRAISAL OF THE PROPOSED LOAN 17. A detailed appraisal of the project, T.O. 1hL (nlo. 5), is attached.  j_,::sti r 'Cication of the Project 18. Since 1952, Lota has spent about $3.2 million from its own resources to install new equipment and sinc two new shafts. The proposed oroject, w1hich will continue and expand the work already begun, covers the period l957 to 1962. Production capacity ihich is now about 3,600 tons oer way would be increased to ,C000 tons by 196a. From 1960, production costs should be reduced and sales receints increased because of the better grade of coal which the imnroved plant would nrovide and also because of reduced breakage of coal in the new handling and haulage facilities. 1). Proved reserves are sufficient to last until 1970 on the assumption that an output of 4,000 tons per day starts in 1964. By that time some of the reserves now classified as indicated or inferred should have been proved, thereby extending the useful life of the mine beyond the period of the prposed loan. 20, Domestic coal production now accounts for about one fourth of Chile's total energy consumption. It is estimated that the demand for Chilean coal will continue to increase frcm an estimiated level of 2.05 million tons of coal in 1957 to 2.72 million tons in 1964. Although Lota7s present canacity is about 900,000 tons a year, sales i-n 1957 have been conservatively estimated at 750,000 tons, corresponding to about 37% of the total market. It is estimated that in 1964 Lota, after comnletion of the uroject, would produce and find a market for 1.1 million tons, about 10% of the estimated consump- tion in that year. The modernization program is essential for reducing the cost of production. 21. Although Chilean production cf fuel oil from domestic crude is ex- pected to increase rapidly, it is unlikely to be sufficient to meet domestic requirements, Coal is fully competitive with domestic oil and with imported oil wzithout tariff protection for some nurnose, e.g., coking coal. There are, how,sever, sectors where coal needs some tariff orotection. This degree of protection is more than ,juntified by the benefits to be derived from con- tinued coal production in Chile, the most important of which .*ou2d be a substantial saving of foreign exchange (estimated at US ,70 million ner annum, if both the Iota and Schwager projects are carried out, corpared to tot2l Chilean imports of $399 million in 1955). 22. Lota has a competent and progressive management. However, some strengthening of its technical staff and the establishment of a separate Planning Department are required. In letters to the Bank, Lota would express its willingness to take the necessary action. As a matter of fact, it has already started to implement these undertakinrgs. Method of Procurement 23. As in the case of items already ordered, practically all equipment and services to be financed by the proposed Bank loan would be orocured on the basis of international competition, excent in a very few cases where standardization of equinment is required.  - 6 - Arran-er-ents for Financing Local Currency C.osts 24. An agreement is being negotiated bet7,een Fomento and Lota which sets forth the conditions under wihich Foriento TwTould become a co-borrower and would lend Lota a portion of the local currencv required for the project. Fomento would lend Lota pesos over a long-run period from its own resources and from counterpart funds w1hich the Chilean Government will realize from the sale of U.S. surnlus commodities (P.L. 480 funds). Lota wouldc repay in nesos, but the value of the Fomento loans would be maintained by relating them to the selling nrice of coal at, the time of repa2mnent, in the case of Fomentots loans from its owTr. resources, and to the rate of exchange at which the Govern- ment must reoay the U.S., in the case of the loans from P.L. 480 funds. The proposed agreement nro-ides that: Fomento would have a non-voting renre- sentative on Lotals Board of Directors; Fomento would obtain 10% of that nart of Lota's annual profits which are in excess of 8% of Iota's equity, but the aggregate of these narticipations is not to exceed 40% of the total loans made by Fomento to Lota for the uroject. By way of security Lota would grant Fomento a second mortgage on the nroperties which are being mortgaged to the Bank. Economic Situation 25. The last economic renort on Chile (WH11-55a) was distributed to the Board on ;pril 2, 1957, and was also made available to the Chilean Government. At that time, attention was drawn to three issues that would need to be resolved in the current year in order to ensure continued progress in the stabilization procram: curtailment of bank credit, cutting back of imports and financing of the fiscal deficit. 26. Chile's ability to cone vith these nroblems has been l,eakened in recent months by elnments beyond Chile's control, such as a decline in copuer prices, a severe drought in agriculture and sharp increases in the world price of sugar, one of Chile's major imports. In the last si.x months, the progress of the stabilization program has been slowed. Bank credit in recent months h.as continued to expand, while imports have not yet been cut back to a level which could be financed by the lower exch2nge earnings which are now expected. The fiscal deficit has grown and the weaklening of political suDport for a second year of austerity -- with nationnal elections just Il months away -- may preclude amrr substantial tax legislation in time to reduce the 1957 deficit. By tho end of May, the cost cf living had risen about 10%, but when the inflationary imoact of the budget deficit is registered on the banking system, orices will probably rise still further. Chile also faces a temporary exchange nroblem which it is seeking to resolve by extending its lines of credit with Wlew York banks, borrowing from the U.S. Government and possibly drawsin- unon the Stabilization Frnd of $75 million which has not yet been used, although renewed by the DPTF, the U.S. and the commercial banks in Arril of this year. Up to now,however, the external debt situation remains substantially unchanged since the last report. 27. Althou gh the orogram has been slowed, the Government still maintains a firm policy of seeking stabilization and continues to move ahead with  - 7 - measures to free the economy of direct controls, eliminates subsidies and create incentives for production. In July, for examnle, it is expected that the last of the subsidies to consumer goods will be eliminated. In spite of the civil disturbances of last April, railroad rates were raised 25% on May 1 and further increases are being considered. 28. It has been hoped that this second year of the nrogram would be a period of consolidation of last yearts gains and of further orogress. But the factors enumerated above had created newr short-run problems which have increased the difficulty of achieving financial stability. Notti thstanding those immediate difficulties the long-run creditworthiness of Chile remains adequate to cover the loans of $22 million under consideration for Lota and Schwager. By 1963, the year in which these loans would begin to be amortized (Lota would make the first amortization payment in October 196?, Schwager in April 1963), Chile will have maid off $15 million in long-term debt since 1948 and will have assumed government-guaranteed new long-term debt of only $37 million ($15 million for the Endesa loan last November plus $22 million for the two coal loans) making a net reduction in long-term debt of over $100 million in fourteen years. Amnual service on long-term debt, including these loans, will be reduced to approximately 320 million equivalent, which is only 4% of the net exchange that Chile may expect to earn in 1963. Even if the present level of medium-term debt service were maintained, total debt service would then be no greater than 8-9% of net exchange receipts. Prospects of Fulfillment of Obligations 29. The total cost of the Lota project would be equivalent to US $15.9 mil- lion. The foreign exchange cost, amounting to the equivalent of approximately US $9.6 million, including interest during construction, would be financed by the proposed loan from the Bank. The local currency would be equivalent to about US $6.3 million, of which about $2.8 million would be loaned by Fomento from its own resources and from P.L. 480 funds. Lota should be able to finance the remaining $3.5 million equivalent in nesos from its own earnings during the construction period. If, however, a shortage of local funds should at any time threaten the project, the additional pesos required would be made available by Fomento. 30. Lota's profits in recent years have been substantial. Expected earnings after completion of the oroject should be sufficient to provide the pesos for servicing the proposed loans from Fomento and the Bank, for meeting Lota's other obligations and for the Dayment of reasonable dividends. Amortization payments on the proposed loan from the Bank are not scheduled to begin until October 1962. In addition to meeting its other obligations, Chile should be able to provide the amounts of foreign exchange required for the payment of the debt service on the pronosed loan.  - 8- PiART IV - CO:TLIINCE WITH ARTICLES OF AGREMENIT 31. I am satisfied that the proposed loans would comply with the requirements of the Articles of Agreement of the Bank. PART V - RECOIIENDATIONS 32. I recommend that the Bank at this time make a loan in various currencies equivalent to US $9e6 rillion to Corporacion de Fomento de la Froduccion and Compan-a Carbonifera e Industrial de Lota, S.A. with the guaxantee of the Republic of Chile, at the rate of 5 3/4 % and on such terms as are specified in the attached draft loan and guarantee agreements, and that the Executive Directors adopt a resolution to that effect in the form attached (wo. 6). Eugene R. Black Attachments Washington, D. C. July 8, 1957