China - Fertilizer Rehabilitation and Energy Saving Project

Document of The World Bank FOR OMCIAL USE ONLY Report No. P-4036-CH REPORT AND RECOMMENDATION OF THE PRESIDEENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO TIE EXECUTIVE DIRECTORS ON A PROPOSED LOAN IN AN AMOUNT EQUIVALENT TO US$97.0 MILLION TO THE PEOPLE'S REPUBLIC OF CHINA FOR A FERTILIZER REHABILITATION AND ENERGY SAVING PROJECT April 22, 1985 This docunmet bu a resicted distributin d may be used by recipets only in the perfn of ther offica dusb hg contents may no othewi be dsclosed withu World BDk authorlatio  CURRENCY EQUIVALENTS Calendar 1984 April 1985 Currency Unit = Renmimbi (RMB) US$1.00 = Y 2.32 Y 2.84 Y 1.00 = $0.43 $0.35 (Project cost estimates are based on the January 1985 exchange rate of Y 2.8 per US$1.00.) FISCAL YEAR January 1 to December 31 WJEIGHTS AND MEASURES 1 hectare (ha) = 2.47 acres i metric ton (ton, t) = 1,000 kilograms or 2,205 pounds ACRONYMS AN - ammonium nitrate CCFC - Cangzhou Chemical Fertilizer Company CFDC - China Fertilizer Development Center C'NCCC - China National Chemical Construction Compzny CIF - cost, insurance and freight FOB - free on board ICB - international competitive bidding LCFC - Liaohe Chemical Fertilizer Company LNCCC - Luzhou Natural Gas Chemical Company MCI - Ministry of Chemical Industry MOF - Ministry of Finance NCIC - Nanjing Chemical Industry Company p.a. - per annum SPC - State Planning Commission tpd - tons per day tpy - tons per year tpyn - tons per year of nutrients YNGCC - Yunnan Natural Gas Chemical Company  FOR OFFICIAL USE ONLY CHINA FERTILIZER REHABILITATION AND ENERGY SAVING PROJECT Loan and Project Suumary Borrower: People's Republic of China Beneficiaries: Luzhou Natural Gas Chemical Company (LNGCC) Yunnan Natural Gas Chemical Company (YNGCC) Cangzhou Chemical Fertilizer Company (CCFC) Liaohe Chemical Fertilizer Company (LCFC) Nanjing ChemicaL Industry Company (NCIC) China Fertilizer Development Center (CFDC) Amount: US$97.0 million equivalent Terms: 20 years, including 5 years of grace, at standard variable interest rate Relending The Government will onlend: (a) US$87.0 million equivalent Terms: to the five companies as follows: LNGCC (US$40.3 million), YNGCC (US$10.1 million), CCFC (US$11.1 million), LCFC (US$8.7 million) and NCIC (US$16.8 million) for 10 years including 3 years of grace at an interest rate of 8% per annum and a commitment charge of 0.75%; and (b) make available under its current procedures US$10.0 million equivalent to CFDC through the Ministry of Chemical Industry (MCI) at an interest rate of 3.5% p.a. and a commitment charge of 0.75Z for repayment over 20 years including 5 years of grace. The companies and CFDC will bear the foreign exchange risk. Project The major objectives of the project are to: rehabilitate, Description: modernize and save energy in selected fertilizer facilities; improve research planning in the fertilizer industry; foster the beneficiary companies' capabilities to implement projects, and manage operations and finances; and develop strategies for modernizing medium-size fertilizer plants. The project consists of (a) rehabilitation, modernization and energy- saving modifications in the fertilizer plants of the five companies and training of their staff; (b) equipment, data processing facilities and training to strengthen the research and design capability of CFDC and its member institutes; (c) a study, to be conducted by MCI, of nitrogenous fertilizer production costs; and (d) technical assistance in international procurement. The project wiLl lead to significant savings in specific energy consumption, increase production of urea by 129,000 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed withouL World Bank authorization.  tpy, ammonium nitrate by 24,000 tpy, methanol by 29,000 tpy, surplus ammonia for sale by 14.000 tpy, and replace production of about 180.000 tpy of sulfuric acid. Over its econmic life, the project will generate a net foreign exchange saving of US$694 million in January 1985 US dollars. Technical ris?.s are moderate as project investments will be in existing plants using commercially proven technologies. The main risks of the project are possible delays in procurement and implementa- tion. These should, however, be minimized by the provision of consultazy services for procurement and of experienced engineering firms for project implementation. The companies are financiaLly sound and adequate measures are provided for in the project to maintain such soundness. Estimated Cost: Local /a Foreign Tota. - US$ million equivalent -- Rehabilitation, Energy Saving and Training /b LNGCC - Luzhou 11.9 32.5 44.4 YNGCC - Yunnan 4.4 10.1 14.5 CCFC - Cangzhou 4.2 8.9 13.1 LCFC - Liaohe 4.4 8.3 12.7 NCIC - Nanjing 24.7 20.7 45.4 Subtotal 49.6 80.5 130.1 Fertilizer R&D (CFDC) 0.7 8.9 9.6 Base Cost 50.3 89.4 139.7 Physical Contingency /c 5.0 7.2 12.2 Price Contingency 7.9 13.7 21.6 Incremental Working Capital 0.3 - 0.3 Total Project Cost 63.5 110.3 173.8 Interest During Construction 0.6 12.4 13.0 Total Financing Required 64.1 122.7 186.8 /a Including taxes of US$2.0 million on equipment and material procured locally. /b Including US$0.5 million base cost of technical asssistance in international procurement which is distributed proportionally among the five companies. /c Physical contingencies for the fertilizer R&D (CFDC) component are included in base cost.  - iii - Financing Plan: Local Foreign Total -- US$ million -- IBRD - 97.0 97.0 Domestic Bank Loans 21.2 1.6 22.8 Beneficiary Companies 42.1 24.1 66.2 CFDC 0.8 - 0.8 Total 64.1 122.7 186.8 Estimated Disbursements: Bank FY 1986 1987 1988 1989 ------ US$ million Annual 13.0 39.0 40.0 5.0 Cumulative 13.0 52.0 92.0 97.0 Economic Rate of Return: 31% Staff Appraisal Report: No. 5367-CHA, dated April 22, 1985.  REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO THE PEOPLE'S REPUBLIC OF CHINA FOR A FERTILIZER REHABILITATION AND ENERGY SAVING PROJECT 1. I submit the following report and recommendation on a proposed loan to the People's Republic of China for the equivalent of US$97.0 million to help finance a fertilizer rehabilitation and energy saving project. The loan would have a term of 20 years, including 5 years of grace, at the standard variable interest rate. The Covernment would onlend (a) the equivalent of US$40.3 million to the Luzhou Natural Gas Chemical Company {LNGCC), US$10.1 million to the Yunnan Natural Gas Chemical Company (YNGCC), US$11.1 million to the Cangzhou Chemical Fertilizer Company (CCFC), US$8.7 million to the Liaohe Chemical Fertilizer Company (LCFC) and US$16.8 million to the Nanjing Chemical Industry Company (NCIC) for 10 years, including 3 years of grace, at an interest rate of 8% per annum (p.a.) and a commitment fee of 0.75%; and (b) make avaiLable under its current procedures US$10.0 million equivalent to the China Fertilizer Development Center (CFDC) through the Ministry of Chemical Industry (MCI) at an interest rate of 3.5Z p.a. and a commitment fee of 0.75% for 20 years, including 5 years of grace. The companies and CFDC would bear the foreign exchange risk. PART I - THE ECONOMY 2. A country economic memorandum, entitled "China: Recent Economic Trends and Policy Developments" (No. 4072-CHA), was distributed to the Executive Directors on March 31, 1983. An economic mission that visited China early in 1984 is preparing a report on long-term development issues and options, which is expected to be submitted to the Executive Directors by May 1985. Basic data on the economy are given in Annex I. Background 3. To address economic inefficiency and structural imbalances, the Government initiated a program of reform and adjustment in 1979. Reform implementation proceeded most rapidly in agriculture and culminated with the introduction of the "production responsibility system" (in various forms), which gave households and small groups autonomy in production and investment decisions and allowed them to keep most income earned after contracted payments to the state and collective. By the early 1980s, the vast majority of production teams in China had implemented such a system. Reform of the urban economy began much more slowly, but nevertheless significant systemic changes occurred, including bonuses for individual workers; profit retention by state-owned industrial enterprises (at first on an experimental basis); fiscal decentralization measures, which allowed provinces to share in the benefits of increased revenues and gave them more freedom in budgeting; and some decentralization of foreign trade authority. Adjustment policies  -2- resulted in an increase in the share of consumption in GDP; a rise in the share of light industry in total industrial output, substantial improvements in living standards, rapid growth of foreign trade (particularly manufactured exports), and relatively modest (in relation to past trends) GDP growth. 4. A number of problems emerged in the process of reform and adjust- ment, including large budget deficits in 1979 and 1980, deterioration of the external position and a significant current account deficit in 1980, infla- tionary pressures and some overt price increases, and excessive investment demand resulting from decentralization of investment decision making and financing. In response to these difficulties the Government imposed a stabil- ization program in early 1981, which relied mainly on administrative con- trols. It resulted in a slowdown in growth, a reduction in price inflation (to around 2% p.a.), a sharp cutback in budget-financed investment, a lower budget deficit (1% of GDP in 1981); and a current account surplus of $1.5 bil- lion in 1981 and $5.6 billion in 1982. Economic Performance, 1981-84 5. Economic growth picked up in 1982 with the resumption of rapid growth of heavy industry and the rebound in investment. Overall performance has remained strong, with real GDP growth averaging over 8% p.a. from 1981 to 1984. Shortages of energy, many producer goods, and construction materials were exacerbated by the rapid growth of demand, yet price increases were limited by further strengthening of administrative price controls (particularly in 1983). Government budget revenue grew very slowly in 1982 (1.3%) but much more rapidly in 1983 (7.9Z) and 1984 (as much as 10%), due to a new tax on enterprise retained funds and extrabudgetary incomes of Govern- ment organizations. This permitted an increase in budget expenditures on investment of 17% in 1983 and a further rise in 1984, while maintaining a relatively small budget deficit (less than 2% of GDP in 1983). Growth of subsidies was largely stemmed by stopping increases in most of the agricul- tural procurement prices. 6. Gross industrial output value grew at over 10Z p.a. between 1981 and 1984, with heavy industry growing somewhat faster than Light industry (12% vs. 9%), a reversal of the 1978-81 pattern. The energy constraint on industrial growth was eased by rising coal output (81 p.a. in 1981-84), consistent annual crude oil output at over 100 million tons, and improvements in the efficiency of energy utilization (primary commercial energy consumption grew only 60% as fast as GDP in 1981-83). Agriculture has continued its very strong perfor- mance, with gross agricultural output value rising at 9% p.a. in 1981-84 and grain output at 7% p.a. (reaching over 400 million tons in 1984). Cash crops and animal husbandry, stimulated by rising demand and attractive prices, have also grown very rapidly. 7. There have been impressive increases in personal incomes throughout the period 1978-83. Average per-capita income in rural areas rose by about 12% p.a. in real terms and urban incomes by about 5% p.a. Rural income growth was mainly due to production increases, efficiency improvements, and growth of employment in nonagricultural activities, as well as substantial agricultural procurement price increases (through 1981). Urban income growth, on the other  - 3 - hand, can be attributed primarily to wage and benefit increases, which have exceeded growth of Labor productivity. 8. Control of the aggregate level of investment and its composition has continued to be a serious problem. Enterprise and local government investment continued to increase sharply in 1982, far exceeding plan guidelines. In 1983, more stringent measures brought this part of investment under control (though it still exceeded plan targets). But investment outside the rural sector remains rather inefficient, and improvements in efficiency have been hindered by administrative controls. Construction costs have risen continuously (10% p.a. in 1978-83). 9. China has maintained a strong external position. The dollar value of both exports and imports stagnated in 1981-83, but this masked considerable increases in the volume of foreign trade. Since 1983, imports have grown more rapidly than exports, and in 1984, exports rose by an estimated 10 while imports increased by 25Z. Manufactured export growth was slower in 1981-84 than in 1978-81, but it started from a much higher base and occurred in the face of worsening world market conditions. Foreign debt and debt service ratios remained at very low levels ($6.4 billion and 5.5% respectively in 1983); China's foreign currency reserves (excluding gold) rose to $17 billion (over 7 months' imports) by mid 1984 and have stabilized at that level since then. The value of the Chinese renminbi declined by about 36Z against the SDR between the end of 1981 and late 1984 (60Z against the US dollar). Recent Reforms 10. Rural reforms have continued to progress more rapidly than reforms elsewhere in the economy. There has been a remarkable spread of nonagri- cultural activities such as processing, transport, and commerce. "Specialized households" (which concentrate on one undertaking - often cash crops, animal husbandry, or nonagricultural activities) and pooling of capital by small groups of households in various types of ventures are becoming more common forms of economic organization in China's rural areas. Wholesale markets for some agricultural products have emerged. To encourage investment in land improvement and development, farming contracts between collectives and peasant households (which typically had been fixed for no more than 3-5 years) can now be extended to as long as 15-20 years. In early 1985, it was announced that planned procurement quotas for agricultural commodities will be abolished; more methods of financing investment in rural nonagricultural activities will be permitted (including tax exemptions, local government bonds, higher interest rates to attract more saving, etc.); and the growth of the agricultural processing industry in coastal areas will be promoted. 11. The momentum of urban reforms has revived, with significant progress on several fronts. Since early 1984, the focus has been on broadening and delineating the decision-making authority of urban enterprises. Profit retention now extends to virtually all state-owned industrial enterprises and to nonindustrial sectors like transport, commerce, construction, and other services. Urban collectives and individual enterprises, as well as a variety of joint ventures between them and state enterprises, have grown rapidly (the number employed in urban individual enterprises rose from 150,000 in 1978 to 2.31 million in 1983).  -4- 12. In financial reforms, the most important new development was the implementation of a profit tax system to replace profit remittances by state enterprises to the Government budget. Though most enterprises have switched to this system, the benefits have been Limited because of the application of a different effective tax rate for each enterprise, to offset the impact of distorted relative prices and other factors. Similar problems have resulted in the abandonment of an attempt to impose a fee or charge on the fixed capital provided to state enterprises by the Government, and they have hindered the shift from grant to loan financing of new fixed investment, despite strong Government support. Financial discipline at the enterprise level remains weak, in spite of efforts to strengthen accounting and auditing systems and more strictly enforce existing financial regulations. 13. In the crucial area of price reform, a major price adjustment for textiles and textile raw materials occurred in early 1983; it helped balance supply and demand, to a large extent equalized profit rates for synthetic and cotton textiles (which are close substitutes in production and consumption), and drastically reduced subsidies for cotton procurement, with only a small net effect on the Government budget. Prices of many "minor" consumer goods (which individually do not have a significant impact on living standards) and the majority of agricultural commodity prices have been decontrolled and are now set by negotiations between producers and commercial units. "Floating prices" (up to 202 above or below official prices) are now allowed for many industrial producer goods (either for all output or for output above the mandatory plan target). Price adjustments for key energy products and raw materials (which in many cases are severely underpriced) and for subsidized basic consumer goods like grain and edible oil have proven more difficult to implement, hindered by the potential impact of price changes on urban living standards and on the finances of energy-using enterprises. Nevertheless, some price rises have occurred (e.g. for coal and petroleum), and moreover the share of free market transactions (at largely uncontrolled prices) has increased in recent years. 14. Reforms in the employment and wage system have made limited progress. The bulk of urban labor is still allocated administratively, and transfers of workers or professionals among enterprises are heavily impeded. Numerous attempts are being made to link individual performance more closely with rewards, including piece-rates, "floating wages," and various types of contractual "responsibility systems." These have achieved some success, but problems of egalitarian distribution of bonuses remain, and many enterprises give out bonuses in kind or disguise them as allowances in order to evade regulations. 15. China's foreign exchange rate system has been unified with the abolition of the "internal settlement rate" (Y 2.8 to $1) at the beginning of 1985. Direct foreign investment (which was first allowed in the late 1970s but developed slowly due to the lack of a legal framework) is being actively encouraged and joint venture agreements have increased sharply. In addition to four "special economic zones" open to foreign investment and subject to more flexible policies, 14 coastal cities were recently opened up in the same way.  16. Significant steps have been taken to develop new tools of indirect macroeconomic management. The central banking functions of the People's Bank of China were separated from its commercial banking functions (which were given to the newly established Industrial and CommerciaL Bank of China) at the beginning of 1984. The central bank relies on redeposit requirements and a discount window to influence the operations of specialized banks, and even- tually may use discount rates and interest rates in general as a flexible tool of macroeconomic management. Adjustments in indirect taxes may be used to affect profitability and supply, in the absence of or as a supplement to price reform. Scope for horizontal flows of investment funds is aLso widening, as enterprises invest in each other and in joint ventures and as some individuaLs purchase stocks. Though restrictions on secondary trading remain, Government bonds purchased by individuals can now be sold to banks or used as collateral for Loans. Long-term Issues and Prospects 17. The Central Committee of the Chinese Communist Party issued a major document on urban reforms in October 1984, which reaffirms and consolidates recent reforms and provides some general guidelines for the direction of future reform. It emphasizes the need for breakthroughs in: (a) enlivening and better motivating urban enterprises; (b) clearly separating Government and enterprise functions (and limiting direct intervention by Government organizations in enterprises' day-to-day operations); (c) reforming the price system; (d) improving incentives in the wage and bonus system; (e) establish- ing a planning system that is in harmony with greater reliance on the market mechanism and developing indirect macroeconomic management; tf) upgrading managerial personnel to meet the new demands on them in a reformed economy; (g) removing obstacles to a unified national market and promoting cooperation and technology transfer among regions; and (h) expanding utilization of foreign capital and advanced technology. Among the main themes of the document are the role of competition in promoting a more dynamic, flexible economic system; the recognition that a certain degree of income inequality is necessary to provide better incentives for economic development; the need for clear responsibilities and appropriate incentives at all levels in the economy; and the recognition that thoroughgoing price reform must involve liberalizing the mode of price determination, not just adjusting administra- tively set prices. Managers of large state-owned enterprises, however, will still be appointed by the Government; a few key products will stiLl be subject to mandatory planning and distribution by the Government; state ownership and control over certain institutions like banks and railways will not be relinquished; and establishment, relocation, changing product lines, mergers, and shutdown of enterprises will still be subject to Government approval. 18. The Central Committee declaration represents a political commitment to economic reform, which will help foster an environment in which fundamental reforms can be gradually implemented in a coordinated way. But specific policy measures will take a considerable length of time to design and then to implement. Many of the reforms required will be very difficult, particularly since reforms in different areas are closely interrelated, and thus appro- priate sequencing and coordination are essential. For example, price reform in the absence of improvements in enterprise financial discipline will have  limited benefits, yet the more profit-oriented behavior that would result from tighter financial discipline would exacerbate the adverse impact of distorted prices. Similarly, reform of the labor allocation system will be incomplete without eliminating many of the "social responsibilities" of enterprises (which now provide housing, medical care, and pensions for their workers and in many cases education and jobs for workers' children) and replacing them with Government-supported social service programs. 19. China's objective of quadrupling the gross output value of industry and agriculture between 1980 and 2000 (which means GDP growth of well over 6X p.a.) will require significant improvements in efficiency as well as continued high saving and investment rates. There will be major structural changes in the economy over the next two decades, including a reduction in the share of agriculture, a rise in the share of industry and possibly in that of services (which at present is unusually Low), and substantial urbanization (in smaller towns if not in large cities). There will also be a shift within agricuLture, away from grain and basic crops and into cash crops and animal husbandry. 20. Certain physical/technical constraints will hinder the attempt to achieve China's targets for the year 2000 and its longer-term goal of catching up with developed countries. Despite rapid growth and substantial improve- ments in efficiency in recent years, agriculture may again become a constraint on overall growth, since land in China is severely limited. In energy, shortages of fuel (primarily coal) and electricity may continue to constrain growth in transport and commercial infrastructure. Without large new investments and improved efficiency, economic growth will lag. In mobilizing resources in all these areas, China could profitably make use of foreign borrowing. Finally, the rising share of the elderly in China's population (related to the slowdown in population growth) means that more resources will have to be devoted to maintaining their consumption levels, especially in the decades after 2000. 21. Poor motivation and inefficient utilization of labor in the state sector of the economy are major problems which can be solved only by coor- dinated reforms in labor allocation, the wage system, enterprise management, and social services, among cther things. Reforms in the system of education and training to develop China's "human capital" potential also are crucial. Backward technology and inefficient use of existing technology must be addressed by a combination of reforms, appropriately directed investment, and transfer of advanced foreign technology. Irrational location of factories, suboptimal scale of many plants, and poor utilization of physical capital in general are related problems. 22. If reforms successfully transform the economic system, with a beneficial impact on growth and efficiency, a new set of issues will come to the fore. Management of a reformed economy with indirect fiscal, monetary, and other instruments is a major issue. In this context, maintaining an adequate saving rate (if the Government no longer accounts for the bulk of aggregate saving) and avoiding inflation (as well as deep cyclical downturns) will be major goals. Assuring an adequate minimum standard of living for the population and an appropriate level of social services will become a major challenge as enterprise and rural communal responsibilities in these areas are  reduced. The problem of poor, backward ruraL areas in various parts of the country will continue to require attention. Redistributing financial resources through the fiscal system, easing restrictions on migration out of the poorest areas, and lowezing nonagricultural wages to make investment in them more attractive are some options for alleviating poverty in these areas. 23. The Government is in the process of finalizing its Seventh Five Year Plan (covering the period 1986-90). The combination of potentialLy fundamental reforms and the urgent need for large investments in many parts of the economy to build the foundation for further growth makes this task difficult. In order to mobilize the investment resources needed for rapid, sustained economic growth and deveLopment, China will need to rely in part on foreign borrowing. Recognizing this need, the Government plans to gradually draw down its substantial foreign exchange reserves and hopes to attract foreign capital through a variety of channels. China also has a claim to concessionary lending because it is still one of the poorer countries of the world. But China's access to concessionary capital to finance development and modernization is limited; apart from Bank Group funds, a significant amount of concessionary capital is likely to come only from Japan and a few other bilateral donors and will probably average no more than $500-600 million p.a. during the rest of the 1980s. PART II: BANK GROUP OPERATIONS 24. To sustain rapid growth over the coming decades, to increase efficiency and innovation, and to maintain equity in distribution, China will need continuing and fundamental reforms. These challenges are compounded by China's large investment requirements and difficulty in efforts to open up to the rest of the world. In light of this, there are several broad objectives for the Bank to pursue in its relationship with China. First, the Bank can offer China development experience and institutional knowledge as well as opportunities for interaction with the Bank's other member countries. Second, the Bank can assist China in removing major constraints on development and in improving investment planning and policy coordination in the priority sectors - namely energy, transport, other infrastructure, human development and industry. Third, the Bank can assist the Government in efforts to remove the remaining pockets of poverty. 25. The Bank Group's strategy to meet these objectives is formulated in line with China's broad development priorities and related issues outlined in Part I of this report. However, Bank Group lending can provide only a small portion of overall resource needs. As a key element of the strategy, there- fore, the Bank's lending operations will aim to create a substantial demon- stration effect applicable to China's overall development efforts. For example, projects involving new techniques for land development or for provi- sion of social services have been designed so they can be repeated by local authorities with their existing resources. Some of the agriculture projects and rural health projects are examples of this approach. The introduction of international competitive bidding through Bank projects (first to finance goods, and later civil works) is being adopted by the Government for most local purchases and many domestic construction projects.  26. Bank assistance can help improve the efficiency of investment, through introduction and dissemination of improved analytical techniques for investment and project planning and through institution building. Preparation of the project appraisal manuals for the China Investment Bank and the Agricultural Bank of China, consultant assistance and the EDI-sponsored pro- grams, as well as specific sector work in transport, industry, health, educa- tion and other sectors have improved the quality and content of project pro- posals. Assistance to Chinese enterprises and agencies through staff train- ing, consultant assistance, creation or reorganization of institutions, and improvement of costing and financial management has bien included in a number of projects ranging from the ports and railway projects to the several educa- tion and petroleum projects. Sector work in enterprise management, urban development, health and industry has also provided assistance for improvement of investment efficiency. 27. Human resource constraints are a particularly serious problem for China's development. There are severe scarcities of higher level trained manpower. Substantial economic and sector work and technical assistance and training components in most of the Bank projects are providing support. In terms of poverty alleviation, the rural health project, proposed urban and water supply projects and sector work on labor mobility and regional develop- ment options address poverty, health and equity issues. 28. Transfer of technology in the broad sense is of fundamental impor- tance in China's efforts to improve efficiency of the economy. Outmoded, inefficient and costly industrial technologies are serious impediments to development and are wasting valuable energy resources. Here, the Bank can play the role of an intermediary. In transportation, energy, industry, agri- culture and even education, the Bank can finance transfer of technology through equipment imports, provision of foreign consulting assistance, arrangement of training and promotion of licensing and other agreements such as are now being discussed in the railways and other projects. Long-term investment for new technology will require increased foreign borrowing in the future and the Bank can assist China through cofinancing. Progress is being made in introducing co-financing under the first and second power projects, coal, urban, water, and some agriculture projects, and the Bank will continue these efforts. 29. For most of these elements of country strategy, however, progress will be gradual and will require sustained Bank involvement over a series of projects in various sectors. Economic and Sec.tor Work 30. Economic and sector work in China was initially designed in part as a learning experience to provide the Bank with a basis of knowledge on the development and functioning of the Chinese economy. It also introduced the Covernment to alternative ways of economic analysis and views about its achievements. 31. In the last four years, the above approach has been well received and has fostered economic and sector work that is responsive to the problems  - 9 - of adjustment and reform. Follow-up to the first economic report emphasized technical assistance and sector work for investment analysis and selection techniques and enhanced sector planning. The content of the lending program has been directLy infLuenced as a result. The rural credit project, the China Investment Bank projects, and future regionaL industry projects are examples of the links between economic and sector work and the lending program. 32. More fundamental research by the Bank in collaboration with Chinese economic research institutions into the problems of enterprise management is nearing completion. The research has yielded insights into the attitudes of enterprise managers toward system reform and has Led to better understanding of how policy changes can improve planning, performance and management of enterprises. In addition, there is a variety of project-related sector work underway through studies included in the projects. These are expected to produce the basis for detailed discussion of development options and poLicies in the various sectors. 33. Current economic work focuses on future options and issues to the year 2000. A comprehensive report will be ready later this fiscal year. In light of the experience of other countries in making the transition from low to middle income levels, the report will pay special attention to inter- sectoral Linkages and cross-sectoral and economy-wide issues. 34. Future economic and sector work will be based on the conclusions of dhe economic report and will look in more detail at some of the issues raised. It will continue to improve our knowledge of the economy - its struc- ture, the issues and constraints in key sectors, and the functioning of the economic management system. Collaboration with Chinese research institutions on issues of institutional and policy change will continue. Review of the investment program in key sectors when the Seventh Five Year Plan (1986-90) is finalized will help develop the next generation of projects for the lending program. Lending Operations 35. Since China's change of representation in the Bank Group in May of 1980, 24 projects involving lending of $2,391 million to China have been ap- proved. Annex II contains a summary statement on these loans and credits as of March 31, 1985. For this fiscal year we expect to present a total of twelve projects to the Board. These include che already approved projects for Second Agricultural Research, Second Power, Second University Development, Changcun (Luan) Coal Mining, Seeds Development, Rural Water Supply, and the proposed Fertilizer Rehabilitation and Energy Saving Project as well as projects in roads, railways, Pishihang-Chaohu area development, forestry and gas engineering. 36. For FY86 and beyond, the China lending program should continue to grow from current levels. Areas of emphasis would include development of energy resources, transport infrastructure, skilled manpower and improved technology. We will also investigate the feasibility of a regional approach in a number of sectors to take better account of intersectoral linkages.  - 10 - 37. rn the energy sector, lending has included six projects, which have emphasized increased energy output and technology transfer through financing of equipment, techiiical studies, training and consultant assistance. The Lubuge Hydropower Project has resulted in the Government's extensive use of competitive bidding for power projects. The Second Power Project places particular emphasis on becter system planning. Fuel alternatives for electric power, generating plant Location and interconnection of power grids will be the subject of future work. For development of China's petroleum and coal resources, Bank Group assistance will emphasize acquisition of appropriate technologies, least cosc planning of investment and related transport investment programs. 38. In the transport sector, railway, port and road capacity must be substantially increased. So far, one project each in ports and railways has concentrated on increasing capacity, upgrading technology for lower cost operations, and establishing better costing systems. Expanding domestic capacity to manufacture improved transport equipment will continue to be a theme in the sector and this should provide scope for substantial foreign private sector involvement. Improved management and information systems and analytical techniques for better cost control will be encouraged under the projects, which, once proven, will be suitable for wider use throughout transport enterprises. Intermodal coordination and planning and assessment of alternative invest.mnent choices will have increasing prominence in both lending and sector work. 39. In agriculture, six projects have emphasized support services through improved research and education, production increases through new land development, reclamation, use of improved technologies and management, strengthening of the agriculture credit system and seeds development. Projects in forestry and agriculture credit will continue to strengthen sup- port services and rural institutions. Land and area development projects will endeavor to provide models of integrated regional development. Specialized activity projects such as fisheries, livestock and agro-processing may also be developed to support ongoing structural transformation in agriculture. 40. In the industrial sector, two projects have focused on establishing and strengthening the China Investment Bank. Improved investment selection criteria, incentives for more efficient management, technology transfer, and energy ccnserv&tion are priorities for future projects. Lending will have a two-pronged approach - further strengthening of the China Investment Bank (and perhaps other financial intermediaries) and financing large regional produc- tion-oriented projects such as the proposed project for fertilizer as well as other projects for machine tools and cement, to expana output and demonstrate the merits of improved subsector analysis and planning. 41. Further expansion of higher education and improvement of teaching, curricula and graduate quality will be needed to the end of the century. The human resource constraints have already been addressed by five education projects and a component of the Rural Health/Medical Education Project. The value of international competitive bidding for equipment purchases and of international advisory panels for educational policy and curriculum reform has been demonstrated in the first projects. Improved university management is  - 11 - being encouraged throug> establishment of quantitative targets for growth, student-teacher ratios, classroom utiLization, Laboratory experiments per- formed, and other reforms (including development of evaluation and monitoring procedures and greater decentralization). Projects in heaLth, urban development and water supply will assist the Government in addressing diffi- cult poverty-linked questions of affordability, cost recovery, and minimum standards with focus on particularly impoverished regions. 42. Implementation. Project implementation is generally proceeding well. There have been some delays in procurement because of the Government's unfamiliarity with the concept of bidding, but these are now being addressed through a central procurement agency. Most project agencies, as well as the Ministry of Finance and the State Planning Commission, have established and staffed offices to handle Bank Group projects. To support further expansion of the lending program, acceLerate project preparation, improve project implementation, and facilitate further economic and sector work, the Bank Group is planning to open a resident office in China early in FY86. PART III - THE FEiRTILIZER SECTOR AND THE BENEFICIARIES 43. China is the world's third largest producer of chemical fertilizers after the USSR and USA, with a total production in 1983 of 13.8 million tons per year of nutrients (tpyn). Nevertheless, in recent years, China had to import an average of about 2.5 million tpyn at a value of over US$1 billion p.a., making China one of the world's largest importers of fertilizer. Fertilizer plays an important role in China's agriculture. Although China accounts for less than 8Z of the world's arable land it supports about 22% of the world's population. Increased fertilizer use is thus central to China's efforts to increase agricultural output. 44. Consumption of fertilizers in China increased at an average annual rate of about 13% during the last decade. Consumption in 1983 amounted to 16.3 million tpyn, of which 73% was nitrogen, 23% phosphate and 4% potash. Current application rates of chemical fertilizer at about 115 kg of nutrients per sown ha are more than three times those in India, about equal to levels in the US and a third of those in Japan or South Korea. The fertilizer alloca- tion process has so far favored food crops in the high, stable yield and irrigated areas and state farms. There are also disparities in fertilizer use among provinces with a range of 50 kg to 170 kg of nutrients per sown ha. The marginal yield responses in some high yield areas reportedly have declined from 15-25 kg of grain per kg of nitrogen in the 1960s to about 5-10 kg of grain today. To correct this problem, the Government plans to allocate a larger proportion of the incremental fertilizer production to zones outside the high, stable yield areas, where marginal yield responses to fertilizer application are expected to be higher. 45. China's application of phosphate and potash fertilizers is low. The nutrients ratio of nitrogen: phosphate: potash of 100:32:5 in 1983 compares unfavorably with the world average of about 100:51:37. This serious nutrient imbalance reduces synergism and the benefits from the relatively high levels  - 12 - of nitrogen use. Therefore, projections of nitrogen demand up to 1990 are based on a much slower growth rate of about 1.2% p.a., whereas consumption of phosphate and potash are projected to increase at average annual growth rates of 7% and 22%, respectively, by 1990. 46. Chemical fertilizer production in China has increased from 3.7 mil- lion tpyn in 1972 to 13.8 million tpyn in 1983, from some 2000 plants with a wide range of production technologies and sizes. Most of the plants are very small and use outdated technologies. Among the 1,270 nitrogen plants, only 14 are in line with international standards and out of some 700 phosphate fertilizer plants, only 8 have capacity exceeding 200,000 tpy of low grade phosphate fertilizers. This evolution reflects the technologies available at the time of plant construction and China's decision in the early phase of fertilizer industry development to rely on indigenous technology to the extent possibLe. It was only in the early 1970s that large-scale nitrogen fertilizer plants were built and equipped with imported technology and equipment. The average capacity utilization for the 13 large nitrogen plants in 1983 was 81%, with five plants operating below 80% capacity due to constraints in feedstock supplies (natural gas and naphtha). The operation of the only large nitrogen plant using indigenous technology has so far suffered due to technical problems. Domestic fertilizer production in China is characterized by a small number of product types and low average nutrient content. 47. The Government's target for total nutrient production by 1990 is about 17.1 million tons, with only a modest growth of 2.3% p.a. for nitrogen. The target growth rate for phosphate fertilizer is about 6Z p.a., which may be difficult to achieve. The Government's current plans for increasing the production of phosphate fertilizers are to construct six medium- and large-size plants. Potash output is projected to more than triple by 1990 but will remain very small in relation to demand. 48. Despite the impressive buildup in production capacity during the last decade, China is still not self-sufficient in fertilizer requirements. While domestic nitrogirn production and consumption are expected to be nearly balanced by 1990, deficits of phosphate and potash fertilizer will substan- tially increase. The gap between domestic production and consumption, to be met by imports, is expected to increase from 2.5 million tpyn in 1983 to about 4.3 million tpyn in 1990, or from 15% to 20Z of requirements plus provision to cover fertilizer in transit, stocks and distribution losses. 49. Energy Consumption. Generally, energy consumption in China's nitrogenous fertilizer plants is higher than current levels for modern plants. The large plants, built in the 1970s, do not incorporate the technol- ogical improvements now a-vailable to minimize energy consumption. Substantial possibilities also exist for energy saving in the 55 medium-size plants, which require major process modifications in view of their age and obsolete technology. The small-size nitrogen plants (about 1,200) consume about 46% more energy compared with the more efficient anthracite/coke-based medium-size plants now being designed. Given the age, obsolete technology and broad range of process configuration of the amall plants, the most appropriate energy efficiency measures will likely be better management and maintenance.  - 13 - 50. The problem of high energy consumption in the fertilizer industry can be solved only gradually as it requires substantial capital investment in technical renovation and some restructuring of the industry. The Government has assigned high priority to efficient energy use and has adopted a number of policy measures to achieve them. These include: cutbacks in planned alloca- tions of energy to major industrial users; a gradual reduction in energy consumption norms and their more strict application; bonuses for below quota use; penalties in the form of higher prices for additional energy consumption; closing down of very inefficient plants; and escablishment of some 55 energy conservation centers to assist enterprises in improving energy efficiency. The Government has also recently raised prices of natural gas and coal and increased taxes on petroleum fuels to ancourage both conservation and fuel substitution. The current energy prices are, however, noc fully conducive to energy conservation. Appropriate reform of the price system especially of energy prices (para. 53), complemented by more effective implementation of the administrative measures, should provide additional incentives to further save energy. 51. Fertilizer Pricing. Both ex-factory and farmgate prices of ferti- lizers, like those for other essential commodities in China, are administered by the Government. After having remained unchanged since the mid-1970s, the ex-factory prices of urea and ammonium nitrate (AN) were increased in February 1984 by 14% and 22%, respectively, to cover increases in raw material prices and reflect consumer preferences. These prices are at present 77% for bagged urea and 59% for fertilizer grade AN of FOB international prices, and 61% and 48Z, respectively, of landed price at Shanghai. Domestic prices are thus lower than international prices, principally because energy input prices in China are also lower than international prices. Domestic relative prices of fertilizers and energy inputs are, however, in line with international relative prices. The Government's policy on ex-factory fertilizer pricing is to cover on average the full production costs and provide a profit margin of about 17% after product tax on sales. In the past, these prices have provided satisfactory financial returns on investments. 52. While prices currently play only a limited role in resource alloca- tion and consumer decisions, the Government has become increasingly aware that without overall price reforms and an increased role for market forces, efforts to revitalize enterprise planning and management through financial reforms cannot succeed. The two main elements of the Government's October 1984 deci- sion to reform the economic structure thus relate to overall price reforms and a decrease in the Government's direct control of the economy. However, due to its importance in the national economy, fertilizer production will continue to be planned by the Government and its prices will remain administered. 53. The Government is aware of the need to rationalize energy prices, and consequently in 1984 it increased gas prices for fertilizer production by 43Z for the Luzhou and Yunnan plants and by 74Z for the Cangzhou plant, and in early 1985 by 64% for the Liaohe plant. Coal prices for the Nanjing plant were also increased by about 18% in 1984. Nevertheless, current natural gas prices paid by these plants are on average about 60% of the economic value of fuel oil equivalent in calorific terms. Similarly, the price of anthracite for the Nanjing plant is about 60Z of its economic value. Because energy is a  - 14 - major input in fertilizer production, future increases in the price of feedstock, fuel and electricity, if large, would directly affect the financial viability of nitrogen-producing companies. The Government's plans are to make compensating adjustments in the ex-factory price of fertilizers. These adjustments, however, are not expected to fully cover the increases in energy prices; plants would need to make up the difference by increasing efficiency and reducing energy consumption. The Government considers the proposed proj- ect a model for other industriaL enterprises which could also improve energy efficiency and minimize production costs to respond to the new incentive regime of the price strucFure. 54. Farmgate prices of fertilizers also have not changed during the last decade, except in February 1984 when the prices of urea and AN were increased by about 13% and 16Z, respectively, following an increase in their ex-factory prices. Current prices are 78% and 64% of the present import CIF prices, respectively. Farmgate nitrogen fertilizer price relative to the price of wheat is in line with international levelf. The present farmgate fertilizer prices are higher than ex-factory prices and margins are adequate on the average to cover marketing and distribution costs. It is expected that as ex- factory prices are adjusted to reflect economic energy input prices, farmgate fertilizer prices will also be adjusted accordingly. The Beneficiaries 55. The beneficiaries of the proposed loan are five chemical fertilizer companies, the Luzhou Natural Gas Chemical Company (LNGCC), the Yunnan Chemical Fertilizer Company (YNCCC), the Cangzhou Chemical Fertilizer Company (CCFC), the Liaohe Chemical Fertilizer Company (LCFC) and the Nanjing Chemical Industry Company (NCIC), and the China Fertilizer DeveLopment Center (CFDC). The companies are all state-owned industrial enterprises operating under the supervision of the Ministry of Chemical Industry (MCI) and their respective provincial governments. They are distinct legal and independent accounting entities. The four fertilizer complexes owned by LNGCC, YNGCC, CCFC and LCFC are among the 13 large ammonia/urea complexes built in the 1970s with foreign know-how and substantially imported equipment. CFDC and its eight fertilizer research and design institutes are also state-owned and operate under the jurisdiction of MCI. 56. As is the case for alL state-owned industrial enterprises in China, the five fertilizer companies have hitherto enjoyed limited managerial and financial autonomy. Direction received from the center has included: (a) annual production targets based on State Planning Commission (SPC) projec- tions; (b) allocation of major inputs from designated sources at pre- determined prices; (c) directed marketing of output at administered prices; and (d) specified investment plans and budgets. As part of the ongoing economic reforms, the Government has recently begun to revise planning and financial regulations to provide more autonomy to industrial enterprises and thereby encourage greater operational and financial efficiency. The fertilizer sector, due to its importance in the national economy, will continue to be planned by the Government. Nonetheless, ongoing reforms in financial regulations (tax system, remittances to the Government, profit retention, etc.) will provide increased freedom to management of the five companies and incentives to improve operational efficiency.  - 15 - 57. Research, development, design and engineering in the fertilizer sector are shared by several chemical research and design institutes specializing in specific areas. Eight such major regional institutes report to MCI. In order to coordinate their activities, MCI established CFDC in January 1984. The proposed project will support CFDC's tesearch and develop- ment activities through assistance in acquiring up-to-date research equipment and improving data-processing capabilities, and in providing training and technical assistance to upgrade knowledge and strengthen design capabilities. In order to ensure a well-focussed research program, assurances were obtained from the Government that it will cause CFDC to furnish to the Bank for review and commencs (a) by October 31, 1985 its four-year research and development plan (1986-1990) including coordinated allocation of work among its eight member institutes; and (b) by October 31 of each year starting 1986 and up to 1990, its annual research and development plan for the following year including an assessment of achievements of the previous year (Loan Agreement, Section 3.06). Government Stracegy in the Fertilizer Sector 58. The major focus of the Government's priorities in the fertilizer sector are to rehabilitate and save energy in nitrogen plants; to rapidly expand capacity of phosphate production based on local raw materials; and to identify and develop domestic resources for potash production. Conservation is an important element of the Government's efforts to ease energy shortages which pose a severe constraint to China's future economic growth. The Government plans to use the rehabilitation and energy-saving measures under the project as a model in developing and implementing similar investments in other large and mediumrsize nitrogen fertilizer plants. The Government recognizes that small nitrogen plants, although important, are less economic, and therefore no new ones will be built. Some have been closed in recent years and more are scheduled to be closed in the future. Simultaneously, efficiency is being improved through retrofitting and some increase in capacity where economically feasible. While no significant new nitrogen capacity has yet been planned, large nitrogen fertilizer plants based on recent natural gas finds can be built for both domestic consumption and exports. 59. China's Low application levels of phosphate and potash fertilizers will have to be substantially increased to improve crop response and increase agriculture production. The Government's strategy is to rapidly expand phosphate fertilizer production capacity using phosphate reserves which have not yet been tapped due to difficulties in both mining and processing and the lack of adequate infrastructure. The Bank is financing technical assistance under the IDA-financed Technical Cooperation Credit (1412-CHA) for testing of phosphate rock and necessary feasibility studies for preparation of a phos- phate mine project. There is also a need to optimize investments in the subsector through integrating approaches to mining, transportation and phosphate fertilizer manufacturing. The Bank has proposed to the Government an outline of a phosphate subsector investment planning study and has offered to finance assistance for it also from the TechnicaL Cooperation Credit.  - 16 - Bank Role in the Sector and Project Justification 60. The Bank's major objectives in the fertilizer sector are to support the Government's efforts in (a) introducing technical renovation and energy- saving measures in nitrogen fertilizer plants; (b) improving nutrient balance through capacity expansion in the phosphate fertilizer subsector; and (c) institution building and training. The proposed project wouLd be a first step in furthering these objectives. The technical rehabilitation and energy- saving component has been designed to provide experience which will enable China to formulate and implement similar programs for other ammonia pLants. The Bank has played a major role in project design through economic analysis in optimizing the rehabilitation component, and in institution building, by ensuring the close involvement of MCI, the project entities and the design institutes in project preparation and appraisal. The Bank has also helped define the scope of CFDC's activities. Bank participation will contribute to improved financial management of the companies through their use of appropriate financial performance criteria and strengthen their capabilities in project implementation and plant operations. The outcome of the fertilizer production cost study will help provide a basis for formulating strategies to modernize medium-size fertilizer plants. Continued Bank assistance for fertilizer development will be necessary and is justified considering the critical link between the fertilizer and agriculture sectors, and the large needs of China's fertilizer industry for technical renovation, energy-saving investments and development of the phosphate fertilizer subsector. PART IV - THE PROJECT 61. The project was identified in September 1983, and appraised in July/August 1984 and in January 1985. Negotiations were held in Washington in April 1985 with a delegation led by Mr. Wang Liansheng, Deputy Director, External Finance Department, Ministry of Finance and included representatives of the beneficiaries. A Staff Appraisal Report (No. 5367-CHA, dated April 22, 1985) is being distributed separately to the Executive Directors. Special features of the project are given in the Loan and Project Summary and in Annex III. A map (IBRD 18561) of the country showing the project locations is attached. Project Objectives and Description 62. The main objectives of the project are to assist China to (a) imple- ment rehabilitation and energy-saving measures to improve efficiency and minimize production costs in the nitrogenous fertilizer plants of the five companies; (b) strengthen these companies' capabilities in project implementation, operations and financial management; (c) strengthen the newly established CFDC and its eight fertilizer research and design institutes to improve research and engineering capabilities in the fertilizer industry; and (d) develop strategies for modernizing medium-size fertilizer plants.  - 17 - 63. The project consists of four main components: (a) Rehabilitation and energy conservation in the large- and medium-size fertilizer pLants of the five companies which would incLude: (i) energy-saving modifications in four large ammonia plants; (ii) installation of hydrolysis units in four large urea plants to reduce pollution and recover urea from liquid effluents; (iii) reha- bilitation and capacity expansion of two medium-size ammonia plants; (iv) rehabilitation and capacity expansion of a medium-size urea plant; (v) improvements in the fertilizer grade AN plant, addition of a porous granular AN unit to produce industrial grade AN, and installation of a 200,000 tpy sulphuric acid plant at Nanjing to replace two obsolete lines, one of which was shut down in 1983 and the other to be shut down in 1988; (vi) training aids and training of the staff of the project companies in pLant operations and maintenance; and (vii) overseas visits by local staff for engineering and procurement. (b) Fertilizer research and deveLopment which would include: (i) research equipment and scientific instruments for CFDC's eight member institutes; (ii) computer hardware and software to increase data-processing capability; (iii) training aids; (iv) training abroad and in China; and (v) overseas visits by local staff for procurement. (c) Nitrogenous fertilizer production cost study which would be conducted by MCI to develop a basis for (i) evaluating operational and energy efficiency of fertilizer production and (ii) developing strategies for modernizing medium-size nitrogen fertilizer plants. (d) Technical assistance comprising up to 30 man-months of consultant services to assist the project implementation coordination unit of MCI with international procurement (para. 67). Project Cost and Financing 64. Total financing required for the project including taxes, physical and price contingencies, and interest during construction is estimated at US$186.8 million equivalent including foreign exchange requirements of US$122.7 million equivalent or 65.7% of the total. Physical contingencies are calculated at 10 of the base cost. For calculation of price contingencies, it is assumed that exchange rate adjustments will be made to maintain "purchasing power parity". Price contingencies for both foreign and local costs (a) when expressed in US dollars, are based on expected international annual inflation rates of.5Z in 1985, 7.5Z in 1986 and 8Z in 1987-88; and (b) when expressed in yuan, are based on expected domestic inflation of 3% p.a. in 1985-88. There is no additional cost associated with the fertilizer produc- tion cost study, which will be carried out by MCI's own staff. The above estimates include foreign consultant services for technical assistance in project management (360 man-months) and training (8 man-months for process control and maintenance for LNGCC and 12 man-months for visits by foreign experts to CFDC) for a total base cost (excluding contingencies) of about US$5.1 million.  - 18 - 65. The proposed Bank loan of US$97.0 million would cover about 79% of the total foreign exchange requirement. The balance of the foreign exchange would be met by domestic bank loans for LNGCC and LCFC (US$1.6 million), from the companies' own resources (US$22.5 million), and from the Panjing Oil Company (US$1.6 million) for the installation of a purge gas recovery unit at the Liaohe plant from which it will buy recovered hydrogen. The local cost (US$64.1 million) would be met by domestic bank loans for LNGCC and LCFC (US$21.2 miLlion), and from the beneficiaries' own resources (US$42.9 mil- lion). The five companies are capable of meeting their financing requirements and their cash flow situation is expected to remain sound. On-Lending Arrangements 66. About US$87 million equivalent of the proposed loan would be onlent by the Government to LNCCC (US$40.3 million), YNCCC (US$10.1 miLlion), CCFC (US$11.1 million), LCFC (US$8.7 million) and NCIC (US$16.8 million) at an interest rate of 8% p.a., with a commitment charge of 0.75% to be repaid over 10 years, including 3 years of grace (Loan Agreement, Section 3.02). The balance of US$10 million will be made available under the Government's current procedures to CFDC through MCI at an annual interest rate of 3.5Z with a commitment charge of 0.75% to be repaid over 20 years including 5 years of grace. The companies and CFDC will bear the foreign exchange risk. The execution of subsidiary loan agreements between the Government and the five companies for the onlending arrangements and approval of the Loan Agreement by China's State Council, will be additional conditions of loan effectiveness (Loan Agreement, Section 6.01). The domestic bank loans will be for 10 years including 3 years of grace at an interest rate of 3.6% p.a. Project Implementation 67. MCI will supervise the implementation of the overall project. Because project implementation will involve coordinating several plants and institutions, MCI has established a project implementation unit within the Ministry. The unit will monitor progress including procurement and take timely action to facilitate smooth project implementation. The Government has agreed to maintain this unit with staff and responsibilities acceptable to the Bank and to employ by November 30, 1985, a procurement advisor to assist the unit in international procurement of equipment and material (Loan Agreement, Section 3.03 and Schedule 4, Section II). The companies will be responsible for implementing their respective plant rehabilitation and energy-saving modifications, and CFDC for the fertilizer research and development component. The management and staff of MCI's project unit, the companies and CFDC are competent and capable of implementing the project efficiently. How- ever, for basic engineering, supervision of detailed engineering, and for assistance in procurement, construction, erection and start-up the companies will require consultant services for which provisions have been made in the project. The project is expected to be completed by June 30, 1988. 68. The companies' technical plant management skills are good but need to be upgraded through exposure to experience outside China and to specialized technology and equipment. The project will provide training for this purpose and the companies have agreed to develop appropriate programs by September 30,  - 19 - 1985 for review with the Bank and subsequent implementation (Project Agreement, Section 2.06). Training for CFDC and its eight member institutes will include training abroad to build and upgrade knowledge of recent advances in technology and visits to China by foreign experts and researchers to promote exchange of research experience. The Government has agreed to cause CFDC to develop its training programs by September 30, 1985 for review with the Bank and subsequent implementation (Loan Agreement, Section 3.07). Reporting and Auditing 69. The companies' annual financial statements and both the companies' and CFDC's project accounts, including withdrawals from the special account, will be audited by independent auditors acceptable to the Bank. Audit reports wilL be furnished to the Bank within six months after the close of each fiscal year. The companies and CFDC will furnish quarterly project progress and procurement status reports. Financial Performance 70. The present financial performance and position of the companies are sound with return on net assets in service in 1984 ranging from 16% to 30%. The current ratio of four of the companies was over 10.8, and for NCIC, it was 4.6. Long-term debt is almost nonexistent. It is possible, however, that as part of the ongoing economic reform in China, there could be changes in the existing price structure. Energy prices, should they increase rapidly, could have an adverse financial impact on the project companies. Consequently, the Government has agreed to continue to take, or cause to be taken, all measures which, under conditions of efficient plant operation, would enable each of the companies to at least meet all operating expenses from revenues from all sources and service its debt from internal cash retention (Loan Agreement, Section 4.03 and Project Agreement, Section 4.02). Accordingly, if energy input prices for fertilizer production were to increase, it would imply adjustments in the ex-factory fertilizer prices. 71. The financial situation of the five companies is expected to remain satisfactory throughout the project life. The companies are expected to generate cash sufficient to more than meet their debt service requirements. Nonetheless, assurances were obtained that the companies will (a) take all measures which, under conditions of efficient plant operation, would enable them to at least meet all operating expenses from revenues and service their debt from internal cash retention; (b) maintain a debt service coverage ratio of not less than 1.2; and (c) prepare and furnish to the Bank by October 31 of each year, starting in 1985 and up to 1990, for exchange of views with the Bank their production, investment and financial plans in the form of projected financial statements, for the next five years (Project Agreement, Sections 4.02, 4.03 and 4.04). Understandings were also obtained that the companies will maintain a current ratio of at least 1.4 and a long- term debt to equity ratio of 60:40 or better.  - 20 - Procurement and Disbursement 72. Procurement arrangements are summarized in the table below: Bank Financing Chinese Total Int'l Direct Financing project ICB LIB Shopping contracting Other Other cost ----------