Mexico - Railway Sector Project

Document of The World Bank FOR OMCuL USE ONLY Rqprt NPI P-4088-E REPORT AND RECOMaENDATION OF PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN IN AN AMOUNT EQUIVALENT TO US$300.0 MILLION TO BANCO NACIONAL DE OBRAS Y SERVICIOS PUBLICOS, S.A. WITH THE GUARANTEE OF UNITED MEXICAN STATES FOR A RAILWAY SECTOR PROJECT May 20, 1985 Thi acemmeu ha a gesbie irbb&m mmd may be aed bY reciPlens 0Yiuyfn Mhe PerOmne Of I her.Uil uih.lb ciemt .m ma ehew1w be diadmed withot W.rd Imk smthodz  Currency Unit - Peso (Mex$) On March 31, 1985, the exchange rate in the controlled market was US$1 Mex$208.79; the freemarket exchange rate stood at US$1 = Mex$226.85. Both exchange rates are currently sliding at a rate of Mex$0.21 per day against the US dollar. Fiscal Year January 1 - December 31 Weights and Measures Metric: British/US Equivalent 1 meter (m) = 3.28 feet (ft) 1 kilometer (km) = 0.62 mile (mi) 1 kilogram (kg) - 2.20 pounds (lbs) 1 metric ton (MT) = 2,205 pounds 1 liter (1) = 0.26 gallons (gal) Abbreviations BANOBRAS Banco Nacional de Obras y Servicios Publicos, S.A. (National Bank for Public Works and Services) CIF Cost, Insurance, Freight CN Constructora Nacional de Carros de Ferrocarril, S.A. (National Railway Cars Construction) DGVF Direccion General de Vias Ferreas (Directorate General for Railway Lines) ERR Economic Rate of Return FUS Ferrocarriles Unidos del Sureste (United Southeastern Railways) GIRA General Interest Rate Agreement ICB International Competitive Bidding NAFINSA Nacional Financiera, S.A. N de M Ferrocarriles Nacionales de Mexico (Mexican National Railways) SCT Secretaria de Comuaicaciones y Transportes (Secretariat of Communications and Transport) SRCP Secretaria de Hacienda y Credito Publico (Secretariat of Finance and Public Credit)  FOR OMCIL USE ONLY RAILWAY SECTOR LOAN Loan and Project Summary Borrower: Banco Nacional de Obras y Servicios Publicos, S.A. CBANOBRAS) Guarantor: United Mexican States Project Executing Secretaria de Comumicaciones y Transportes (SCT) Agencies: Ferrocarriles Nacionales de Mexico (N de M) Auount: US$300.0 million equivalent Terms: 15 years, including three years of grace, at the standard variable interest rate. Project The proposed project would provide for investment, operational, Description: and financial improvements to the Mexican railways system during the period 1985-1988. Investment items supported by the loan would cover both the SCT and N de M investment programs for the period, and include: (i) acquisition of rails, track machinery, workshop equipment, locomotive spare parts, and freight wagon and passenger coach components; (ii) major construction and realignment of rail lines; (iii) consultant services; and (iv) training equipment and scholarships. The project would help accomplish the following objectives: (i) improve railway capacity; (ii) continue improvements in railway operating effi- ciency; (iii) promote financial self-sufficiency; (iv) strength- en commercial practices; and (v) upgrade rail infrastructure planning methods. BANOBRAS would relend the proceeds of the loan to N de M and the Terms: Government (in the case of SCT) in US dollars on the same terms and conditions as the Bank loan. N de M and the Government would assume the foreign exchange risk for their respective shares of the proposed loan. Project The railways are the principal transport mode for the movement Beneficiary: of important bulk items which are crucial to the Mexican econo- my, such as grain, fertilizer, coal, iron ore and cement. The incidence of transport costs in the final costs of these prod- ucts is significant, and, thus, an efficient rail operation should benefit the economy as a whole and help support the eco- nomic recovery. Lastly, the economy as a whole should benefit from the reduced railway burden on the public sector deficit, if operational and financial targets are met. This document has a restricted distribution and may be used by recipients only in the perfomance of their official duties. Its contents may not otherwise be disclosed without World Bank authorizationL  - il - Prolect The project faces three risks: (i) rail traffic projections are Risks: subject to substantial uncertainty, as experienced in railway projects all over the world-appropriate measures calling for an annual updating of traffic forecasts and investment requirements have been incorporated, and financial projections have been based on more conservative estimates of traffic to ensure an improved financial performance for N de M despite a possible traffic shortfall; (ii) Government counterpart funds may be fur- ther restricted during project implementation, but the proposed sector loan format-allowing for flexibility in investment prio- rities-and the agreed minimum outlays for maintenance-related activities would minimize the impact of budget cuts; and (iii) it may become more difficult for the Government to continue act- ing on its policy of reducing subsidies and raising prices to reflect the cost of services in the face of potential political resistance. The Government up to now has shown a serious comr mitment to its stated pricing poli-ies, particularly in the transport sector. Estimated Cost: The total cost of the SCT and N de M rail investment program for 1985-1988 is estimated at US$2.35 billion equivalent, with a foreign exchange component of US$849 million equivalent. The Bank loan represents 13% of the total program and 35% of the foreign exchange requirements. Railway Investment Program, 1985-1988: cUS$ Millions Equivalent) Local Foreign Total By N de H: Civil Works 197.1 - 197.1 Rails - 71.5 71.5 Equipment/Machinery 77.5 155.8 233.3 Locomotives/Wagons 372.9 173.2 546.1 Passenger Coaches 94.4 14.0 108.4 Administration/Technical Support 37.1 2.0 39.1 Subtotal 779.0 416.5 1,195.5 By scr: Civil Works 490.8 260.7 751.5 Rails - 79.9 79.9 Equipment - 9.8 9.8 Administration/Technical Support 73.8 1.4 75.2 Subtotal 564.6 351.8 916.4 TOTAL BASELINE COSTS 1,343.6 768.3 2,111.9 Price Contingencies 161.6 80.9 242.5 TOTAL COSTS 1,505.2 849.2 2,354.4  - iii - Financing Sources IBRD (1929-NE) - 44.5 44.5 IBRD (Sector Project) - 300.0 300.0 Supplier C-rdits and Commercial Banks - 273.9 273.9 Government 1,505.2 230.8 1,736.0 TOTAL FINANCING 1,505.2 849.2 2,354.4 Estimated (Bank FYIUS$ Millions) Disbursements: 86 87 88 89 90 91 92 Annual 20.0 49.0 81.0 66.0 42.0 24.0 18.0 Cumulative 20.0 69.0 150.0 216.0 258.0 282.0 300.0 Rate of Items to be financed under the proposed loan would be appraised Return: according to agreed technical and economic criteria, and would have a minimum estimated rate of return of 12%. A detailed evaluation of the major investment commitments in 1985 found that the SCT works have estimated rates of return ranging from 16% to 56%, and the N de M works and goods have estimated rates of return of from 18% to 74%. Staff Appraisal Report. No. 5464b-ME, May 14, 1985.  INTERNATIONAL BANE FOR RECONSTRUCTION AND DEVELOPMENT REPORT AND RECOHIKKNATION OF THE PRESIDENT OF TUE IBRD TO TUE MEECUTIVE DIRECTORS ON A PROPOSED LOAN TO BANCO NACIONAL DE OBRAS Y SERVICIOS PUBLICOS, S.A. VITM THE GUARSNTEE OF UNITED MEXICAN STAES FOR A RAIWAY SECTOR PROJECT 1. I submit the following report and recommendation on a proposed loan to the Banco Nacional de Obras y Servicios Publicos, S.A. (BANOBRAS) with the Guarantee of United Mexican States, for the equivalent of US$300.0 million, to help finance a Railway Sector Loan. The loan would be repaid over 15 years, including 3 years of grace, at the standard variable interest rate. The proceeds of the loan would be relent to N de M and the Government (in the case of SCT) in US dollars on the same terms and conditions as the Bank loan. N de M and the Government would bear the foreign exchange risk over their respective shares of the loan. PART I - TRE ECONOMY I/ 2. An economic report on Mexico (Mexico: Recent Economic Developments and Prospects, No. 4996-ME) was distributed to the Executive Directors on May 14, 1984. The report's main conclusions and recent economic developments are summarized below. 3. Following an import-substitution growth strategy, Mexico experienced some two decades of high and stable growth after the early 1950s. By the late 1960s, however, Mexico had largely exhausted the -easy- and efficient possibil- ities for import substitution, and faced a choice between outward-oriented growth or continued inward-directed growth led by expansion of public sector expenditures and rising subsidies and protection of inefficient domestic production. By 1972, the choice was made to pursue the latter course. Public sector expenditures as a percent of GDP more than doubled between 1970 and 1982, from 18.8% to 42.5% (Report No. 4996-ME, p. 114). By 1976, Mexico expe- rienced a serious financial and economic crisis, followed by an even more serious one six years later. The discovery of large oil reserves in the mid- 1970s led Mexico to a quick economic recovery, but it also removed the urgency of policy reforms. Primary among these was the need to reduce protection and the anti-export bias of the trade regime to thereby move over time toward greater efficiency and international competitiveness. Oil revenues also tempo- rarily helped finance the public sector deficit and reduced the need for greater fiscal restraint. 1/ Parts I and II of this Report are substantially unchanged from the corresponding sections in the President's Report for the Second Small- and Medium-Scale Mining Development Loan (Report No. P-4048-ME of April 30, 1985).  - 2- Developuents during 1977-1982 4. The stabilization measures initiated in 1977 and the discovery and exploitation of large oil resources in the mid-1970s allowed the Lopez Portillo Administration (January 1977-December 1982) to overcome the serious financial crisis of 1976 and to start working on structural, social, and economic prob- lems, including poverty, income and wealth inequality, unemployment, regional imbalances, and relatively slow agricultural growth. In the early years of that Administration (1978-80), GDP growth was high (8.5% a year), 2.5 million jobs were created, domestic consumption recovered, and the share of investment and savings in GDP surpassed historical levels; but the economy became increasingly overheated. 5. Rapidly rising public expenditures unmatched by revenues led to increas- ing public deficits. While inflation rose, no significant pressure was felt to adjust the exchange rate, thanks to the oil earnings and the relative ease of obtaining foreign finance. By mid-1981, the economic situation began to mirror the scene prevailing before the 1976 financial crisis. The current account deficit of the balance of payments reached 5.2% of GDP, while the deteriorating international oil market conditions caused large revenue shortfalls with re- spect to budget expectations. The public sector deficit rose to just under 15% of GDP. Non-oil exports dropped, and the trade deficit reached record levels. External borrowing was used to finance part of the domestic fiscal deficit and to defend the exchange rate. Mexico's foreign debt increased rapidly, at a time of high and rising international interest rates. A stabilization program initiated by the Government in mid-1981 was not sufficient to redress the grow- ing fiscal imbalance, the high cost of foreign loans, and the increasing pri- vate capital flight fueled by the public's anxiety over Mexico's financial troubles. 6. The crisis came to a head in 1982. In February, as capital flight intensified, the Bank of Mexico had to stop supporting the peso, which then experienced a 40% devaluation in US dollar terms. A large wage adjustment granted in March 1982, which tended to undo the effects of the devaluation, and continuing slack in the oil market kept the balance of payments under strain. Under the circumstances, the international banking community became reluctant to commit new funds to Mexico in the amounts required. These factors led to a second devaluation of 35% in August 1982, while the acute shortage of foreign exchange forced the Government to suspend the amortization payments of most of Mexico's external public debt, pending a broader agreement on its refinancing. Capital flight continued as private sector confidence was shaken by the nation- alization of the banks in September 1982, and the mandatory conversion of US dollar deposits into pesos. Also put into effect were a generalized system of exchange controls and quantitative trade restrictions covering an unprecedented 100% of imports. Recent Developnents 7. The Administration of President de la Madrid, that began its term in December 1982, lost no time in taking steps t. recover domestic and external confidence, and stabilize the public sector and external finances. The Govern- ment's stabilization program, supported by an EFF agreement approved by the IMF in December 1982, laid the basis for restoring economic stability and for the  -3- renegotiation of that part of Mexico's public external debt on which amortiza- tion p.4-Jments had been discontinued in August 1982. Commercial banks agreed to restructure some US$19 billion of public sector debt and provide US$5 billion in net new loans for 1983. All obligations falling due between August 23, 1982 and December 31, 1984 were restructured over an eight-year period starting from January 1983, with a grace period of four years and at an interest rate of 1-718 percentage points over LIBOR (or 1-3/4 over the New York prime rate). The US$5 billion syndication had a 6-year maturity, with a 3-year grace period, at a spread of 2-1/4 over LIBOR (2-1/8 over prime). The restructuring exercise included an understanding that the international banks would maintain their exposure to the Mexican banks that had been nationalized. At the same time, it provided a mechanism that would eliminate 1982 private sector interest arrears and facilitate payment of the rescheduled principal on such debt. 8. A new two-tier exchange rate system was introduced, with a controlled market for imports, most proceeds from merchandise exports (except those of in-bond industries) and debt related transactions, and a free market for all other transactions including those relating to tourism. The controlled rate was originally set at MexS95 = US$1, a depreciation of some 35% in relation to the previously prevailing ordinary rate of Mex$70 per US dollar. The free market rate had remained at about Mex$150 per dollar until September 1983, when the authorities decided to let it slide as much as the controlled rate. The differential between the two rates, which in December 1982 stood close to 60Z, is now down to less than 10%. Over the past two years, the peso has gradually appreciated in real terms as inflation in Mexico remained high. The Government increased the rate of slide of the peso from 13 centavos a day to 17 centavos in December 1984, and to 21 centavos early March 1985, in order to bring it closer to the expected inflation differential between Mexico and its tradin1 partners. Domestic deposit interest rates were also raised in early March 1985 from an average of about 45% to nearly 50%. 9. Under the DMF Agreement, the Administration committed itself to a dras- tic reduction of the public sector deficit, from 18.0X of GDP in 1982 to 8.5% in 1983, 5.5% in 1984, and 3.5% in 1985. Substantial progress has been made during the past two years in meeting the Drogram objectives, although the tar- gets for 1984 were not fully met. The public finances were strengthened con- siderably and the public sector deficit was reduced to 8.7% of GDP in 1983 and an estimated 7.4% in 1984. The main reason for the higher budget deficit than the 1984 target was the much higher than expected interest payments on the domestic debt. Curbs on expenditures were wide ranging. However, recent esti- mates suggest that real public investment-encompassing states and local governments--may have been well in excess of the targets for 1984. The author- ities nave given priority to completing projects that were already far advanced and to those that were important for employment, equity, or foreign exchange earnings. Nonetheless, public investment expenditures are estimated to have declined to about 7% of GDP in 1983-84, well below the 1982 level of 11.7%. The fiscal performance was also aided by significant price increases for nearly all public goods and services, including petroleum products, electricity rates, food, etc. The Government has committed itself to a substantial reduction and eventual elimination of most subsidies, including those provided in the form of low interest rates. 10. The balance of payments experienced a major turnaround in 1983 with the current account moving from a deficit of almost US$5 billion in 1982 to a  -4- surplus of US$5.5 billion. The strength of the current account and the avail- ability of external finance permitted Mexico to replenish its international reserves while paying a large part of the arrears that had accumulated in 1982. The net use of foreign financing by the public sector was US$4.2 billion for the year-below the ceiling of US$5 billion under the stabilization pro- gram. The errors and omissions account of the balance of payments dropped from US$8 billion in 1982 to an estimated US$1.4 billion in 1983, largely reflecting the decline in unrecorded capital outflows. The swing in the current account was mainly the result of a very sharp contraction of merchandise imports, to USS7.7 billion, representing a decline of about US$7 billion from their 1982 level. The recession, the large devaluation of the peso, and the quantitative restrictions, all contributed to this. The balance of payments remained strong in 1984, with a current account surplus of US$3.7 billion; and a further US$2.5 billion were added to the nation's foreign exchange reserves, which at the year's end are estimated at about 7-1/2 months of imports. Although imports recovered considerably, a rapid rise in non-oil exports, particularly in the first quarter of 1984, ensured that the trade surplus remained at the same level as in 19B3, i.e., about US$13 billion. Growth in tourism and in-bond industry was also strong, and helped in alleviating unemployment. These favor- able external trends during late 1983 and early 1984 weakened in mid-1984, owing to an appreciating real exchange rate. 11. Fighting inflation remains the pivot of the C-overnment's stabilization program. Although the Government's own inflationary targets have been missed by wide margins, the rate--of inflation continued to decline through mid-1984. It declined from a rate of about 100% in 1982, to 80X and 59% in 1983 and 1984, respectively. The main factors in this were restrained fiscal and mone- tary policies and moderate wage adjustments. The flow of savings into the banking system continued to rise, reflecting the beneficial influence of the exchange rate and interest rate policies. The impact of the severe and sudden cuts in public expenditure and imports on economic growth in 1983 was serious when GDP declined by over 5%. However, the economic recovery in 1984 was stronger than the Government's expectations: GDP is estimated to have risen by about 3.5%, compared to the earlier estimate of only 1%. Since the latter half of 1984, fiscal, monetary, and external trends have signaled a possible resurgence of inflationary pressures. 12. The Government also took steps to regain the confidence of both domestic and foreign private investors. These included efforts to deal with the prob- lems of private external debt, procedures to compensate owners of nationalized banks, and a more flexible application of the foreign investment law. Nego- tiations with commercial banks and other private creditors have been completed for the refinanciog of nearly half of the total of US$11.6 billioa of private sector obligations, at stretched out maturities varying between 6 and 12 years, with 3- to 4-year grace periods. Moreover, the Government undertook the re- structuring of Mexican private sector obligations guaranteed by official credit agencies abroad. The Government has also transferred back to private ownership most of the 400 private firms that were controlled by the commercial banks prior to their nationalization. These measures and announcements have been beneficial, but more remains to be done to restore the confidence of Mexican entrepreneurs and foreign investors. The Government realizes that this is an issue of the greatest importance, as economic recovery beyond the current stabilization period will depend critically on the resumption of vigorous private investment.  - 5 - 13. The general improvement in the Mexican economy has been widely noted, particularly by the international banking community. Mainly for this reason, the Government's 1984 borrowing of US$3.8 billion from commercial banks carried much more favorable terms than the borrowing in 1983 (10 year maturity, 5-3/4 year grace period, and a spread of 1-1/2% over LIBOR or 1-1/8Z ver prime). The negotiations between the Government and foreign commercial banks on the rescheduling of foreign debt have been virtually completed. The draft agree- ment, covering close to US$50 billion, has been submitted by the Banks' Advi- sory Group (consisting of the 13 largest lenders) to some 500 smaller regional banks for their acceptance. Under the proposed terms, the previously unre- scheduled debt (amounting to about US$20 billion), which is due for repayment in 1985-90, will have its maturitieg stretched over 14 years. The maturities of the previously rescheduled debt coming due in 1987-90 will be stretched over 11 years. The 1983 syndicate loan of US$5 billion will be restructured, after prepayment of US$1 billion, to carry terms identical to the 1984 syndicate loan. In summary, the pending rescheduling agreement will stretch maturities of US$50 billion public debt in such a way that the debt service remains vir- tually constant between 1985-1998, in contrast to the present situation, where 75% of the debt service is due in 1986-89. The banks will have the choice of LIBOR, a domestic reference rate, or a fixed rate. These terms are based on the understanding that the Government will continue to adhere to prudent eco- nomic policies. The rescheduling agreement covering US$29 billion of Govern- ment debt was signed on March 29, 1985. Another US$19 billion in loans to Mexican Government agencies will be refinanced between now and June. This followed the approval on March 25 by the IMF of a third-year Extended Fund Facility. Mediu-rTerm Prospects 14. The Government's strategy, as outlined in the National Development Plan (NDP) for 19C3-88, combines special efforts to recover from the present crisis with a longer-term perspective on regaining balanced and stable growth to over- come structural problems. The main problems facing Mexico in the years ahead include the still very high rate of population growth (2.6% estimated for 1983) together with an even higher rate of labor force growth (a little under 4%), slow growth in agriculture, poverty, a highly skewed interpersonal ane _nter- regional income distribution, and an overly oil-dependent economy with a strong anti-export bias. 15. The medium-term strategy presented in the NDP focuses on the need for structural changes in the economy, including a greater export orientation through revision of external trade policies, poverty alleviation through basic needs policies and improvement in labor absorption, and decentralization of economic activity. The basic elements of policies to address structural prob- lems are mentioned in the NDP, and further details on specific programs and schedules for policy adjustments are provided in the sectoral plans which were prepared subsequently. 16. Mexico's medium-term prospects for recovery and stable economic growth are reasonably good, provided economic management continues to be prudent, pri- vate sector confidence is restored, and the international environment remains favorable. Adequate domestic policies include inter alia continued efforts to reduce the fiscal deficit, liberalize trade, minimize price distortions, and maintain a competitive exchange rate. With regard to the latter, there is some  concern that the continuing hi'her than projected domestic inflation rate will lead to an undesirable appreciation of the real effective exchange rate. Restoration of private sector confidence is crucial, since only a strong and dynamic private sector will be able to raise investment from the p:esent de- pressed levels and to supply the increasing non-oll export surplus required for the resumption of growth. As regards the external environment, the coimercial banks are expected to maintain their exposure in Mexico in real terms, and for- eign markets, to be open to Mexico's non-oil exports. Mexico will benefit directly from a continuing fall in interest rates in the world financial mar- kets (a one percentage point drop means a savings of about US$800 million in overall interest payments, which compares to a loss of US$550 million in gross export revenues that would result from a one dollar drop in the export price of oil). 17. Under reasonably favorable external and domestic conditions, Mexico's economic growth could reach a sustainable 6% a year-the post-WWII average for Mexico--towards the late 1980s. This growth would materialize through a sus- tained redirection of the economy toward a more outward-oriented growth pat- tern. Fiscal discipline, in the absence of improved domestic efficiency and export development, would likely entail a prolonged period of slow growth, characterized by insufficient labor absorption in internationally competitive activities, domestic price distortions, and a continued need for subsidies. External Debt and Creditworthiness 18. Mexico's external public debt increased by about US$4 billion during 1983, and by about a similar amount in 1984. With an expected net new borrow- ing of some US$3 to US$4 billion a year, the ratio of external debt to GDP would decline steadily from 41% in 1984, to 33% by 1990. The debt service ratio, after the proposed rescheduling, is projected to peak at 472 in 1988; thereafter, it gradually declines to about 25% in 1995. 19. At the end of 1983, the last year for which a comprehensive external debt report is available at this time, the Bank's share in Mexico's debt was 4.3% (excluding undisbursed). The Bank share in Mexico's total public external debt service payments during that year was 4%. In view of the good medium- and long-term potential of its economy and the prospect of continued pursuit of sound economic policies by the present Administration, Mexico is considered creditworthy for IBRD borrowing. PART II - BANK GROUP OPERAIIONS IN NEXICO Bank Operations 20. As of March 31, 1985, Mexico had received 85 loans from the Bank, amounting to US$6,831.3 million, net of cancellations and terminations; of these, 58 loans totalling US$3,495.2 million were fully disbursed. The Bank held US$5,465.6 million, of which US$1,948.9 million had not yet been dis- bursed. Some 42% of Bank lending has been for agriculture and rural devel- opment, 23% fGr industry, 11% for pewer, and 13% for transportation; the remaining 11X has been for water supply, tourism, urban development, vocational training and pollution control projects. Annex II contains a summary statement of Bank loans as of March 31, 1985.  -7- 21. Of the US$6.83 billion total lending, about US$3.5 billion was for establishing or strengthening institutions for channelling credit to areas where credit supply was deficient or non-existent, and setting up in the cor- mercial banking system the ability to carry out project-related appraisal of investments '- agriculture, industry and tourism. These credit programs have facilitated lending to low-income farmers and small- and medium-scale indus- trial and tourism enterprises based on productive investment plans, rather than credit granted on the basis of collateral. 22. The Government arranged adequate budget financing in the years 1978 to 1981, which significantly improved project implementation. Government and Bank officials met periodically to review project implementation, and greater atten- tion was focused in Mexico on project monitoring. As a result of these mea- sures, most of the Bank-assisted projects were being implemented satisfactorily until mid-1982, and disbursements rose from US$91 million in FY78, to US$448 million in FY82. However, the present financial crisis is again causing delays in the provision of counterpart funds; consequently, disbursements in FY83 declined to US$389 million. A Special Action Program (SAP) was established in early 1983 to help the Government by alleviating the counterpart funding con- straints on development projects, and 18 Bank-financed projects are receiving support under the Program. Partly as a result of the SAP, disbursements during 1984 improved significantly at US$528.87 million or 35% over disbursements in 1983. IFC Operations 23. As of March 31, 1985, IFC had made investment commitments in 27 compa- nies in Mexico, for a total of USS753.9 million, of which US$562.5 million had been sold, repaid or cancelled. A summary statement of IFC investments is pre- sented in Annex II. IFC has been working together with the Bank in preparing proposals to establish a facility for provision of foreign exchange financing to private sector companies, for the importation of machinery, equipment and spare parts required for production of exportable products, for efficient import substitution, and for improvements in the utilization of their existing productive capacity. IFC approved a US$100 million facility (including funds mobilized from foreign commercial banks) in 1983, which is providing finance for fixed investments of a larger size than those assisted under the Bank loan for an Export Development Project. Bank Strategy 24. The main objectives of Bank lending in Mexico in the past eight years have been to: (a) support policies and programs leading to a wider distribu- tion of the benefits of economic growth; (b) help finance projects that, di- rectly or indirectly, contribute significantly to output and employment; (c) help reduce Mecico's urban/regional imbalances; and (d) help free bottle- necks which prevent rapid growth. More recently, however, in response to Mexico's requirements following the 1982 economic crisis, the Bank, in close cooperation with the IMF, also supported the Government's stabilization program through assistance for export promotion and intensified and broadened economic and sector work. As for medium-term prospects, the volume and composition of Bank lending to Mexico would be related to progress in the implementation of policy reforms needed for structural economic adjustments, through broad policy  - 8 - conditionality affecting the entire lending program or important parts of it. Specific policy reforms that are being pursued through a dialogue with the Government, conducted in parallel with the processing of lending operations, cover priority macroeconomic and cross-sectoral issues, such as interest rate policy, energy pricing, subsidy reduction, and export development. 25. Because of the difficult structural problems of agriculture and the sec- tor's crucial importance for the one-third of the nation's Ttopulation living in the rural areas, the Bank has made agriculture the leading sector for its lend- ing. The Bank's agricultural lending program in Mexico has four goals: first, to help increase productivity of presently cultivated lands in general; second, to give emphasis to improving the productivity of small farmers; third, to complement infrastructure investments with support services, such as extension, marketing programs and credit; and fourth, to promote employment-generating investments in rural areas. The Bank has made 14 loans in FYs78-83 totalling US$1,829.4 million for irrigation, rural development and agricultural, agro- industrial and livestock credit programs. A US$175 million loan for a rural development project and a US$180 million loan for an irrigation rehabilitation project were approved by the Executive Directors in FY82, and a US$138.4 mil- lion loan for San Fernando rainfed agricultural development was approved in early FY83. A US$115 million loan for marketing perishables was approved by the Executive Directors in April 1983, and a $300 million Eighth Agricultural Credit Project in June 1984. A US$90 million loan for a Chiapas Agricultural Development Project, together with a Chiapas Rural Roads Project, was approved by the Executive Directors on-April 30, 1985. Projects for tropical agricul- ture, irrigation rehabilitation, extension and research, seed multiplication, and agricultural credit are in various stages of preparation. 26. Bank lending for industry has aimed at: (a) reduction of the balance of payments deficit; (b) decentralizing industrial activities away from the major, increasingly congested, urban areas; and (c) promoting greater employment. A steel project, which the Bank helped structure and finance, is now operating in a previously underdeveloped area on the West coast of Mexico, and the city in which it is located, Lazaro Cardenas, is developing into a new growth pole. Four loans for industrial projects-to promote the development of small- and mediumrscale industrial enterprises, to finance expansion of small- and medium- scale mining, and to support an industrial equipment fund (FONEI)-iwere ap- proved by the Executive Directors in FYs78-80. A US$90.0 million loan for a vocational training project, which is assisting a program to increase the sup- ply of skilled workers and technicians, a US$152.3 million loan for the devel- opment of a capital goods industries project, and a US$60 million loan for pollution control were approved by the Executive Directors in FY82. A modifi- cation in the capital goods project was approved by the Executive Directors in early 1983, to set up a pilot export development fund to help satisfy the for- eign exchange needs of Mexican exporters. A US$350 million loan for an Export Development Project and a US$175 million loan for a Third Small- and Mediumr Scale Industry Development Project were approved by the Executive Directors in FY83. A US$105 million second small- and mediumr-scale mining development proj- ect is expected to be presented to the Executive Directors on May 21, 1985, and a second technical training project, on May 28, 1985. 27. Bank lending for physical infrastructure has been focused on regional development and strengthening of institutions and sector policies. Two highway  -9 - sector projects (FY79 and FY84), the fourth railway project (FY81), and an industrial ports project (FY84) support these goals. The first and second mediumr-size cities water supply and sewerage projects (FY76 and 81) reinforce the planning, management and finance of specialized water supply and sewerage institutions at the federal and municipal levels, and contribu--: to the estab- lishment of tariffs more closely related to costs; a third project was approved by the Executive Directors on May 17, 1983. 28. The Government has adopted a National Urban Development Plan that spells out its regional development priorities in operational terms. A project to assist in the development of the Lazaro Cardenas urban area was approved by the Executive Directors in FY78, and a second urban project for oil-producing southeastern Mexico was approved by the Executive Directors in FY81. A loan for the preparation of a deconcentration program for the Mexico City Region was approved by the Executive Directors in August 1982. 29. The Economic Development Institute (EDI) is assisting CECADE ("Centro de Capacitacion de Desarrollo Economico' under the Secretariat of Programming and Budgeting) in training Government staff in project preparation, monitoring, and evaluation. EDI assistance is directed at courses on urban and regional devel- opment, agriculture, rural development and agro-industries. The Bank has also assisted the Mexican authorities in training personnel for managing water supply and industrial credit projects. 30. The Inter-Americ'an Development Bank (IDB) is the second larkest source of multilateral aid to Mexico. The IDB has made loans to Mexico totalling US$3.4 billion as of March 31, 1985. Over 50X of the total has gone to agri- cultural and rural development projects, and the balance to transportation, industry, water supply and sewerage, tourism infrastructure, education, munici- pal development, and pre-investment. The IDB and the Bank have coordinated their assistance on several projects. Each has made loans for the national integrated rural development program (PIDER), agricultural and livestock credit, small- and medium-scale industries development, and hotel development projects. The International Fund for Agricultural Development (IFAD) has approved a loan of US$22 million for a rural development project in the state of Oaxaca, which was appraised by the Bank's staff and for which the Bank is acting as cooperating institution for administering the loan. 31. Bank-supported power, steel, fertilizer, and tourism projects in Mexico have been cofinanced by several bilateral export credit agencies and commercial banks. In January 1982, Mexico borrowed US$500 million from commercial banks to provide complementary financing for Bank-assisted projects where project specific cofinancing would have been difficult. PART III - THE TRANSPORT SECTOR General Background 32. Transport investments in Mexico have fluctuated over the past two de- cades, declining as a percentage of public sector investment from 21% in 1972, to around 9% in 1979. In response to the emerging bottlenecks, which were  - 10 - aggravated by the oil boom and high grain imports, investment outlays were raised after 1979, until budgetary restrictions in 1982 again cut back on sec- tor Investments. Transport investnents in 1984-net of allocations for urban transport--amounted to about US$1.2 billion, representing some 10.7% of total public investment. Maintenance, reconstruction and rehabilitation of existing infrastructure, and completion of ongoing works, have been given high priority, while major new investments have been deferred. Given the lull in transport demand since tne 1982 economic recession, this strategy has, up to now, been satisfactory, as several industries that experienced transport bottlenecks in the recent past do not now anticipate difficulties in the near future. 33. The 1985 investment program reflects continued severe budgetary restric- tions, with the sector's share in total public sector outlays remaining the same as in 1984. Recent Bank reviews of transport sector investments found that budgetted funds have been appropriately allocated among the various sub- sectors, taking into consideration the current economic constraints and that overall subsector investment programs are sound. During the remainder of the current six-year presidential term, however, the Government expects that, as the economy and demand for transport services recover, major new investments would have to be undertaken in the highways, railways, airports and ports sectors. Priority investments will include toll road widenings, new rail lines to and along the Gulf Coast, new railway yards, expanded capacity for the Mexico City airport, commercial port improvements, and the completion of an industrial port at Altamira. Their timing will depend on the speed of the economic recovery. Major Sector Issues 34. Mexico's transport sector faces two major issues: fuel prices and road user charges. Following a stated policy of gradually phasing out the price subsidies involved, the Government has, since 1981, raised gasoline prices by 247% in real terms, and diesel prices by 367%. The price of diesel currently stands at 77% of the relevant--Caribbean-based-international price, while the price of gasoline is slightly above the international comparator. In January 1985 the Government raised diesel prices by 20% and established an automatic monthly increase of 2.5% thereafter, which-together with additional periodic increases--should bring prices closer to international levels. With the pre- sent price levels, no major distortions are evident in the transport sector. The issue of whether road-related taxes cover sufficiently the cost of provid- ing road infrastructure and whether heavy vehicles are paying their costs, is currently under review in a study included in the Second Highway Sector Loan (Ln. 2428-ME). Institutional Framework and Planning 35. The current Administration introduced a far-reaching institutional re- form in December 1982, incorporating all transport agencies under the Secreta- riat of Communications and Transport (SCT). Earlier dispersed institutional arrangements hampered coordination of planning and investment, and limited the scope of the Bank's dialogue on sectoral issues. A new Subsecretariat for Infrastructure in SCT now handles infrastructure development for almost all modes of transport, and a Subsecretariat for Operations has responsibility for operational, regulatory and tariff matters, including those of the railways subsector.  - 11 - 36. The construction of rail infrastructure and yards is handled by the Directorate General for Railway Infrastructure (DGVF) of SCT, and the completed works are turned over to the Government-owned railways, including Nacionales de Mexico (N de M), which operates some 15,324 kms of the country's total network of 19,000 km'; the rest is operated by the Pacific Railway, the Chihuahua Rail- way, and the Sonora-Baja California Railway. The Government is cautiously considering the complete merger of all Government-owned railways under N de M. This is not expected to affect adversely N de M's operations or sector perfor- mance, as the screening criteria for investments (para. 58) would apply to any affiliate that is merged with N de M during implementation of the proposed project. Ferrocarriles Nacionales de Mexico (N de M) 37. N de M is a well-developed railway company, operating 802 of the coun- try's railway network and transporting 82% of total ton/kms and 70% of all passengers moving by rail. It employs some 64,000 people. The railways' man- agement achieved considerable improvements in operations and finance in the 1970-1984 period: it increased labor productivity, from 366,000 units of traf- fic per employee to 641,000; locomotive utilization rose from 75,600 kms per year to 93,500 kms per year for freight, and from 130,700 kms to 245,000 kms for passenger trains; the average carload increased from 39 to 55 tons per car; and passenger occupancy went up from 31 to 60 per coach. While some 27,000 foreign cars saturated yard and line capacity in 1980, their number has been reduced. to 2,500. Through the increased use of unit and direct trains, N de M also reduced car turnaround times from a high of 23 days to 17 days in the last four years. 38. Through these improvements, N de M has been able to serve a volume of traffic that grew-like GDP-at 5% per year in 1970-1984. In contrast to a worldwide trend, Mexico's railway traffic has steadily increased, and N de M kept its share in the transport of its principal commodities, such as grains, iron ore, coke, coal, sugar, fertilizer, cement, and many steel products. 39. Despite the growth in traffic, the gap betwen N de M's revenues and costs widened considerably, mainly because of inadequate tariff increases and sharply rising operating costs due to inflation. Operating losses were fi- nanced with Government subsidies and long-term borrowing. In order to ratio- nalize N de M's financial structure, freight tariffs were raised in real terms by 40% from 1980 to 1984. The combined effect of growth in traffic and real term tariff increases was a 28% real increase in N de M's revenues in 1983, over the 1982 level. Its working and operating ratios also improved from 1.49 and 1.72, respectively, in 1980, to 0.91 and 1.16 in 1983. Areas of Concern in the Railway Subsector 40. Through two previous railway operations (Lns. 1232-ME and 1929-ME), the Bank followed closely the difficulties facing Mexico's railways subsector, as well as the more recent initiatives by the Government to rationalize railway operations and finance. While N de M has achieved significant improvements (paras. 37 and 38), more remains to be done. The main problem areas of the railways are discussed below, as are the proposed remedial measures, which would be reflected in an agreed Plan of Action in connection with the proposed project's implementation (para. 67).  - 12 - Traffic Forecasts and Commercial Practices 41. Traffic forecasts prepared by N de M for previous Bank projects have proven to be overly optimistic, mainly because of a drop in demand for servi- ces caused by the severe recessions of 1976 and 1982, and because of ups-and- downs in grain imports due to unexpected poor or good harvests. To plan its investments-particularly in locomotives and rolling stock-traffic was fore- cast over 1985-1988 using N de M's product-by-product methodology, which pre- dicts an annual growth of 5Z in total ton-kms hauled. For its financial projections, however, N de M prepared a low forecast based on data from the past 14 years, which showed an annual growth rate of about 3% in total ton- kms. To help respond to expected traffic demand effectively, N de M would: (a) by March 1986, review its costing for a number of important product move- ments and for backhaul services; Cb) by September 1986, study the organization and staffing of its commercial department and propose a restructuring; and, (c) by December 1986, prepare a marketing strategy whi-ch would be applied no later than April 1987. Financial Status 42. Although N de M's working and operating ratios already improved signifi- cantly (para. 39) and freight tariff adjustments kept ahead of inflation since 1982, a number of important commodities, e.g., iron ore, coal, coke and cement, are still being carried at tariffs that do not cover long-run variable costs, i.e., operating costs, plus an adequate capital recovery factor. At negotia- tions it was agreed that, as a special condition of the proposed loan's effec- tiveness, the Government and N de M would take appropriate action to reclassify some of these commodities. It was also agreed that N de H would gradually increase revenues from its transport operations so as to cover, by no later than January 1, 1988, the long-term variable cost for the transport of each commodity (Section 4.02 of the Project Agreement). 43. Another obstacle to N de M's financial viability is its debt burden. By 1983, interest payments amounted to 46% of gross revenues. Since a major part of this long-term debt related to borrowing to cover operating cash short- falls that resulted from the Government's refusal to authorize tariff adjust- ments in line with inflation, N de M and the Government have decided to transfer a portion of the debt to the Government. An agreement has now been finalized according to which the Government would, through the Secretariat of Finance and Public Credit (SHCP), assume 40% of N de M's existing long-term debt by converting it into Government equity beginning in 1985. By 1988, the railways would be in a position to service its remaining debt, assuming that its financial situation is improved under the project as currently projected. During negotiations, an assurance was obtained that N de M would: (a) achieve for each fiscal year in 1985-1988 and maintain thereafter, ratios of its total working expenses to total operating revenues of, respectively, 78%, 77%, 75%, and 73%, and ratios of total operating expenses, including depreciation costs, to total operating revenues of, respectively, 105%, 103%, 100%, and 97% (Sec- tion 4.03 of the Project Agreement); and (b) achieve a debt service coverage of 94% by 1988 (Section 4.04 of the Project Agreement). Locomotive and Wagon Utilization 44. N de M's locomotive fleet comprises 1,608 standard gauge units, with an average age of over 10 years. Steadily increasing traffic in recent years led  - 13 - to neglected maintenance and a declining availability of diesel engines, which dropped to an all time low of 65.5% in 1983. A recovery in performance began in 1984, when locomotive availability climbed back to 68% under an integrated locomotive recovery plan. To help carry out the plan, N de M would allocate sufficient funds for locomotive spare parts, and carry out, not later than December 31, 1988, a scrapping program of about 218 locomotives (Section 3.02 (b), of the Project Agreement). In addition, N de M would rehabilitate loco- motives, review workshop practices, and provide the required training. To support its maintenance effort, N de M has already renegotiated with the unions the workshop labor practices dealing with staff reorganization, training, job upgrading and related pay incentives. As a result of these undertakings, loco- motive availability is expected to reach 802 by 1988, and the fleet size would be reduced to about 1,457 units. Wagon turnaround time also needs to be improved to achieve greater operational efficiency. Therefore, N de M would, by June 1986, complete installation of the operational control system and, by December 1986, report to the Bank on its experience with the new system and discuss its future application. Track Condition and Maintenance 45. N de M's track infrastructure faces two major problems: high operating costs and limited capacity due to excessive gradients and too many sharp curves on its main lines; and frequent accidents because of deficient track condi- tions. Labor-intensive maintenance techniques have become ineffective to meet the requirements of lines with heavy traffic densities. N de M has launched a program of mechanized track maintenance, with substantial equipment purchases and a redeployment of labor beginning in 1985. To support this program, an agreement was reached during negotiations that N de M would allocate sufficient funds for the maintenance of rail track and the equipment required (Section 3.02 (b) (i) of the Project Agreement). N de M would monitor the productivity of the mechanized maintenance units and-accomplish the agreed rehabilitation and maintenance targets set for 1985-1988. Yard Capacity 46. Freight wagons generally spend a major part of their available time in yards; hence, a principal factor in achieving reduced turnaround times is yard capacity. Existing yards in Mexico City, Monterrey, Guadalajara and Coatzacoalcos-have limited capacity, and-as they are located in dense urban areas-the possibilities for physical expansion are virtually nil. Therefore, N de M would, by September 30, 1986, carry out and furnish to the Bank a master plan study of its future yard needs to appropriately locate, design, and stage the construction of new yard facilities. The study also would-as a stopgap measure-review existing yard operations and determine what, if any, improve- ments can be achieved by reorganizing and rationalizing operations and manage- ment in the short-term, before the required new yard investments can be programmed. Passenger Services 47. N de M offers a variety of inter-urban passenger services, including sleeping car service, first class special, first class and second class servic- es, as well as a mixed freight and passenger train service on remote low densi- ty lines. Its revenues from these services account for about 3-4% of its total  - 14 - operational income. N de M's passenger operations continue to generate defi- cits, and service levels are deteriorating. About 43Z of all passenger servic- es were eliminated in the mid-1970s, after being declared uneconomic. However, traffic on the remaining services has grown in recent years. 48. Railway passenger fares cover only about three-fifths of short-run vari- able costs, and are at a level well below bus fares. Yet, the Government has been reluctant to raise railway fares substantially, because the service is inferior and nearly nine-tenths of all passengers are low-income earners, using second class service. In spite of this fare policy, declining unit costs, higher passenger occupancy, and reduced uneconomic services, have helped reduce N de M's deficit from its passenger operations by 37% in real terms between 1980 and 1984. But current Government subsidies still amount to some US$26 million each year, and the Government and N de M need to act to curb these losses. 49. As part of its modernization plan, N de M has proposed a comprehensive strategy for passenger services, including a new fare policy to reduce subsi- dies, the improvement of services along high density lines, an evaluation of the potential for new first class service on main lines, and the gradual elimi- nation of services on low density lines which have no social or economic justi- fication. Through this strategy, N de M expects its passenger kms to grow at a rate of 3.8% per year in 1985-1988. 50. To implement the above strategy, N de M would carry out, by November 1986, a detailed costing of passenger services by line. In addition, an agree- ment was reached during negotiations that N de M would gradually increase reve- nues from its transport operations, and would, not later than January 1, 1988, cover the long-term variable cost for the transport of passengers (Section 4.02 of the Project Agreement), provided, however, that, in the case of second-class passenger services, whenever the Government-based on economic and social con- siderations-establishes passenger fares lower than those required above, the Government would exchange views with the Bank on the relevant economic and social considerations (Section 4.02 of the Guarantee Agreement). As a princi- pal element of its strategy, N de M would replace existing, and purchase new, passenger coaches with appropriate design characteristics (paras. 59 and 66). Furthermore, to assure a sound financial basis for the above strategy, it was agreed that the Government would, in a timely manner, compensate FNM for the losses incurred by FNM in its passenger service operations (Section 4.03 of the Guarantee Agreement). Management and Training 51. To cope with growing traffic and the increasing complexity of its opera- tions, N de M needs to continue to improve its institutional capabilities through the adoption of modern management techniques and the provision of re- lated training. In addition to the actions referred to in paras. 41, 44 and 46, N de M would, by December 1987, modernize its accounting system to enable costing, budgetting, and other management information to be processed by comr puters, and, by September 1987, establish an accounting mechanism to monitor the cost of its workshops. While N de M has enjoyed a measure of stability in its management, it neglected to groom a cadre of young middle-management per- sonnel that would be needed as staff retires and as N de M adopts modern man- agement techniques. In the past, adequate training has been provided for oper- ational personnel, but not tor management. To shore up its management, N de M  - 15 - would upgrade and promote qualified personnel from its ranks and recruit young university graduates. Training would be provided under the project for these young professionals, and the loan would finance the estimated foreign exchange costs of the program (para. 61). Past Bank ParLicipation 52. The Bank has been involved extensively in Mexico's transport sector. It made nine highway loans, totalling US$587 million, helping develop the trunk road network and primary roads, and improving rural roads maintenance. The Bank also financed three port operations, including an engineering loan (Ln. 1964-ME) for project preparation, and the recently approved Lazaro Cardenas Industrial Port project (Ln. 2450-ME). An airport loan (Ln. 1022-ME) was made in 1974, assisting with the commercial accounting systems of the airport authority. 53. In the railways subsector, the Bank has made four loans totalling US$386 million, to help finance rehabilitation and modernization works, and the pur- chase of locomotives, rolling stock, rails and other equipment. The first loan (Ln. 103-ME) was made to Ferrocarriles del Pacifico, and the project was suc- cessfully completed in the late 1950s. The second loan (Ln. 825-ME)-as all other follow-up operations--was made to N de M. Repeater loans (Lns. 1232-ME and 1929-ME) to N de M were made in 1976 and 1980. The second N de M loan was completed in 1982, and the third one is nearing completion at this time. More than two-thirds of Ln. 1929-ME has been disbursed, and tenders-committing the full loan amount--ard-expected to be approved by the Bank by June 1985. Achievements in the railway subsector (paras. 37 and 38) have been supported by these loans. Yet, the economic policies that led to Mexico's 1982 economic crisis created considerable problems for N de M's management, operations, and financial performance. Project Completion Reports for the Seventh Highway Project (Ln. 968-ME), dated June 22, 1982, and for the Third Railvay Project CLn. 1232-ME), dated October 7, 1983, both recommended the sector lending format in order to broaden the Bank's participation in the subsectors and to provide for flexibility in dealing with changing investment priorities and budgetary allocations, caused by varying economic conditions. Bank Strategy 54. The current Government Administr4tion, that came into office in late 1982, has taken a series of important measures, which have been of long-stand- ing concern to the Bank in the past, particularly with regard to sector pricing and institutional arrangements. In response to these Mexican initiatives, the Bank's lending strategy for the sector, in accordance with its overall objec- tives for lending to Mexico, is to help improve infrastructure, strengthen operations and maintenance, assist in reassessing medium- and long-term invest- ment needs, provide support for a rational pricing policy, and develop quick- disbursing loans to transfer foreign exchange resources to the country. Stepped-up lending for the sector has provided a framework for constructive dialogue on the above objectives. The Second Highway Sector project (Ln. 2428-ME) and the Industrial Port project (Ln. 2450-ME) established the Bank's presence in the highway and port subsectors. The proposed Railways Sector project would round out the Bank's involvement in Mexico's transport sector.  - 16 - PART IV - TEE PROCT 55. The Government requested the Bank to consider a follow-up railways loan in February 1983. Following identification in September 1983, the project was prepared jointly by N de M and SCT. A Bank appraisal mission visited Mexico in October 1984. A far-reaching program to modernize the railways served as a basis for the appraisal and a February 1985 post-appraisal. Negotiations took place in the Bank in April-May 1985, and the Mexican delegation was headed by Mr. German Sandoval Faz, Manager, Special Operations and Financial Analysis, of BANOBRAS, and included Messrs. Francisco Gorostiza Perez and Salvador Manrique Morales, representing N de M; Oscar De Buen Richkarday and Eduardo J. Barousse Moreno, SCT; and Hector Flores Santana, SHCP. The Staff Appraisal Reporti (No. 5464b-ME of May 14, 1985) is being circulated separately. Annex III provides supplementary data on the project. Project Objectives 56. The proposed sector loan would help finance the 1985-1988 time-slice of the N de M and SCT investment programs, and accomplish the following objec- tives: (a) Improve railway capacity through a balanced investment program; (b) Continue improvements in railway opearting efficiency, through higher productivity of equipment and human resources; (c) Promote financial self-sufficiency for railway services, with tariffs appropriately related to railway costs and a rationalized debt structure; Cd) Strengthen the commercial practices for railway services; and Ce) Upgrade planning methods for assessing railway infrastructure requirements. 1985-1988 Railway Investment Program 57. Rail investments in Mexico have nearly doubled in real terms since 1977, reaching US$525 million equivalent annually in the 1980-1982 period. Track rehabilitation and new construction, including the electrification and double tracking of some main lines, have a major share in increased investments. Out- lays for signaling, telecommunications, workshop and track machinery, and pas- senger coaches have declined in relative terms. The Bank reviewed these past investments, and, in general, found them economically sound. 58. The Bank already evaluated the investment proposals for 1985, and con- ducted a general overview of the 1986-1988 investmbnts: N de M's program is about US$300 million equivalent each year, while SCT intends to invest US$230 million yearly. The programs give preference to track maintenance anc rehab'l- itation, signaling, telecommunications, and workshop and track equipment. Both the level and composition of railway investments are adjusted from year to year, in line with traffic expectations and macroeconomic developments. During negotiations, it was agreed that, no later than November 30, 1985, and every  - 17 - year thereafter until the coupletion of the project, N de M and sCT would fur- nish the railway investment program for the following four-year period, all in a manner acceptable to the Bank (Sections 2.05 and 3.05 of the Project and Guarantee Agreements, respectively). To help maintain the quality Of railway investments, an assurance was also obtained that any investment subproject included in SCT's and N de M's 1985-1988 investment program would: (a) have an economic rate of return of at least 12%, calculated in accordance with a method satisfactory to the Bank; and (b) conform to designs and specifications acceptable to the Bank (Sections 3.06 and 2.06 of the Guarantee and Project Agreements, respectively). 59. N de M would: (a) rehabilitate some 362 km of line with new rail, and another '23 km per year with recovered rail in 1985-1988; (b) acquire track machinery and introduce mechanized track maintenance; (c) comPlete central traffic control over 595 km of line, study further traffic control require- ments, and install additional traffic control equipment as justified by the study; (d) install combined telecommunications and operational control systems based on ongoing studies, extending them gradually to the network of its three affiliates, the Pacific, Chihuahua, and Sonora-Baja California Railways, and provide some 700 locomotives and track and train crews with VHF radios; Ce) purchase about 40 new locomotives through 1986, and rehabilitate 20 existing engines a year in 1985-1988; and {f) improve its rolling stock by purchasing 460 wagons in 1985 and an additional 1,500 each year in 1986-1988, and rehabilitating approximately 700 wagons per year in 1985-1988. In addition, some 330 passenger coaches would be purchased in 1985-1988,-beginning with 30-50 special first class coaches in 1985. 60. SCT-allocating some 67% of its 1985-1988 line and electrification investments to the completion of ongoing works--would: (a) complete the double tracking and electrification of the Mexico City-Queretaro-Irapuato line; Cb) regrade and realign other major lines; (c) complete a new line between Guadalajara and Monterrey, including bypasses around Guadalaiara, Monterrey and Saltillo; and (d) conclude realignment of the Mexico City-Lazaro Cardenas line. Towards the end of its four-year program, substantial allocations would also be made for major yard investments. Technical Support 61. To assist N de H and SCT in carrying out their 1985-1988 investment pro- gram, the Bank project would provide technical assistance for improving the railways' commercial practices and management accounting system, for a yard master plai study, and for the feasibility studies and engineering design of interim yard investments, as well as for a middle management training program by N de M. Costs, Financing, Bank Participation 62. The 1985-1988 railway investment programs of N de M and SCT are estimat- ed to cost US$2.35 billion, including about US$850 willion in foreign ex- change. A Bank loan of US$300 million would finance approximately 13% of total program costs and 35% of the foreign exchange requirements. The loan would be split into two equal parts between N de M and SCT, as follows:  - 18 - Total Cost Foreign Bank Components 1985-1988 Exchange Loan N de M ---In US$ Millions -- Rail 78.7 78.7 61.3 Track Machinery 76.5 67.4 33.1 Locomotive Spare Parts 151.6 106.1 22.5 Wagon and Coach Components 531.1 51.7 32.1 Technical Assistance 0.9 0.6 0.6 Training and Equipment 0.4 0.4 0.4 Subtotal 839.2 304.9 150.0 SCT Rail 86.5 86.5 86.5 Civil Works 847.4 293.4 52.1 Track Machinery 11.2 11.2 9.9 Technical Assistance 2.0 1.5 1.5 Subtotal 947.1 392.6 150.0 Bank-Financed Components 1,786.3 697.5 300.0 Other Components (Not 568.1 151.7 - - Financed By the.Bank) Total - Railway Investment 2,354.4 849.2 300.0 63. BANOBRAS would be the Bank's Borrower, who would, under the same terms and conditions as the Bank loan, transfer the proceeds of the loan to SCT and N de M (Section 3.01 of the Loan Agreement). These contractual arrangements would be satisfactory to the Bank, and their execution would be a special condition of the proposed loan's effectiveness (Section 6.02 (b) of the Loan Agreement). The Government also made a commitment during negotiations to provide counterpart funds for carrying out the project (Section 2.02 of the Guarantee Agreement). 64. N de M's investment program includes US$457 million in direct foreign exchange outlays for imported goods and services. It would be financed from the proceeds of two BLnk loans (1929-HE and the proposed loan), suppliers' credit, and U.S. Export-Import Bank loans/guarantees, including, possibly in the outer years of the 1985-1988 investment program, commercial bank cofinancing. Project Implemntation 65. The proposed railway sector loan is the Bank's first to finance a sub- stantial civil works component in Mexico. It also covers a broad range of sec- toral problem areas. Therefore, to strengthen the Bank's supervision effort during project implementation, it was agreed during negotiations that SCT and N de M would, at least twice a year, review the achievement of project objec- tives, including the actual and planned levels of expenditures and works, and the preparation of future works (Sections 2.04 and 3.08 (a) of the Project and  - 19 - Guarantee Agreements, respectively). To ensure an efficient review process by the Bank, an agreement was also reached that SCT and N de M would present investments for Bank approval, furnishing the appraisal of the subproject, a description of proposed expenditures, and the proposed designs and specifica- tions; in addition, SCT made a commitment to complete all subprojects included in its project component in a timely manner, and provide the funds and other resources required for the purpose (Sections 3.07 (b) and 2.07 of the Guarantee and Project Agreements, respectively). 66. The Bank reviewed the technical design of both freight cars and passen- ger coaches. The design of freight cars is satisfactory, but that of the passenger coaches is relatively outdated, not reflecting more modern tubular, all-welded, and anti-telescopic design features, which produce lighter and also relatively safer cars. N de M would, together with Constructora Nacional de Carros de Ferrocarril (CN)-the local manufacturer of wagons and passenger cirs, explore the possibility of modernizing the design of its coaches, and, by Pecember 31, 1985, furnish to the Bank and discuss its assessment of the advis- ibility of using improved designs, and establish a s,stem for monitoring the costs of passenger coaches. Plan of Action 67. The success of N de M's and SCT's 1985-1988 investment programs would lepend on timely and adequate action in key problem areas discussed in paras. A1 through 51, and 66. To assist N de M in implementing the proposed project, i- was agreed during negotiations'that N de M would take action, in a manner satisfactory to the Rank, to meet the operational and investment targets of a Plai of Action for 1985-1988 (Section 2.01 (b) and the Schedule of the Project Agreement). Together with the project's financial targets, it reflects the essence of N de M's modernization program, as follows: Caqxnpent 1985 1986 1987 1988 Opemtional Tarets Loaxmative KWhteight LooMDtive/Year 96,000 97,000 98,000 100,000 Lommotive Availability (%) 71 \ 74 77 80 Net TonHSii2gpn/vy 1,750 1,800 1,850 1,900 Averagn Wagn Turnarntd (Days) 17 16 15.5 15 W$ag Availabiity (%) 95 95 95 95 Foreign Cars n Line 3,500 3,500 3,500 3,500 Average loadA*n (Tons) 55 55 55 55 Prodictivity (Traffic Units/Eployee) 675,000 700,000 730,000 750,000 Investmnut Targets Km of Rehalitatio with New Rail 340 350 370 385 Km of Rehijitaticn with Recovered Rail 260 215 210 200 Km of HMaitenance 1,500 2,800 2,900 3,000 F-ancial Tarbts Woi