Philippines - Telephone System Expansion Project

I-~~ /\ d. ) if/ Document of The World Bank FOR OFFICIAL USE ONLY M9 T CPORJ ,t VH UL>'.' ,ep r t N!.: U'?.14 rH Tvi4): (SNP) 1 t] r NtrLVFiH1j1N4r FT ypeF F ( S RFN4 Report No. 9444-PH AlP,tl hc r !. f\:]1 7f f , i H. E,: t . e, 1E9 1, [-. c-,r,. : F - '9~7 5 ) C t 0. :{' T 1 STAFF APPRAISAL REPORT PHILIPPINES TELEPHONE SYSTEM EXPANSION PROJECT AUGUST 14, 1992 Industry and Energy Operations Division East Asia Country Department I This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS (As of December 1990) Currency Unit 8 Philippine Pesos (P) US$1.00 P 28.0 P 1,000 U.$35.7 P 1 = 100 Centavos (ctvs.) FISCAL YEAR January 1 - December 31 WEIGHTS AND MEASURES M4Hz = Megahertz (1,000,000 hertz) GHz Gigahertz (1,000 megahertz) km = Kilometer (0.6214 mile) ABBREVIATIONS AND ACRONYMS ASEAN - Association of South East Asian Nations DBP - Development Bank of the Philippines DOTC - Department of Transportation and Communications IBRD - International Bank for Reconstruction and Development ICB - International Competitive Bidding IFC - International Finance Corporation LCB - Local Competitive Bidding NTDP - National Telecommunications Development Plan NTP - National Telephone Program NTC - National Telecommunications Commission OBU - Offshore Banking Units PCO - Public Call Office PLDT - Philippine Long Distance Telephone Company TELOF - The Government's Telecommunications Off'.ce  FOR OMCLAL USE ONLY PHILIPPINES TELEPHONE SYSTEM EXPANSION PROJECT Loan and Proiect Summary Aorrower: Development Bank of the Philippines (DBP) Guarantor: Republic of the Philippines Isnaeficiar: Philippine Long Distance Telephone Company (PLDT) Amount: US$134 million equivalent Lending Torm: Repayable over 20 years, including five years of grace, at the standard variable interest rate. Relending Terms: DBP would relend the funds to a banking syndicate that in turn would relend the entire proceeds to PLDT through separate facilities: (a) the first, of which DBP would subscribe the entire $35 million, would include a term of twelve years and a grace period of four years; and (b) the second, of which each partitipating Bank would assume the intermediation risk for its subscribed portion of the remaining $99 million, would include a ten year term and a grace period of four years. The interest rate applicable to both facilities would be 3A%X above the Bank's rate. PLDT would assume the exchange rate risk between the Philippine peso and the US dollar. From the spread, the Government would receive a fee of 1X for guaranteeing the Bank loan, and a second fee of 1X for assuming the cross currency risk between the US dollar and the other currencies involved in the Bank loan. Secondarv Lending: The float resulting from the differences in maturities between the Bank loan and the two relending operations would be made available to the Government according to terms that mirror those of the Bank loan, and consequently hold DBP free of benefit or loss. Pxojeeq; Objectives: The objectives of the proposed project are to (a) increase telephone penetration and leased line facilities in PLDT's service areas, with an emphasis on provincial development; (b) improve PLDT's quality of service; and (c) address deficiencies in sector This document ha a uctod diurlbution and may be used by recipients only in the performance of theit ofciaW dutie& Its covtets may not othawie be dibclsed without World Bank authoXztbn.  - li - management and regulation. Most of the proposed project has been designed to provide improved telephone facilities in areas that the Government has identified as having major economic importance. DeiU2ELgtigC: Under the proposed project PLrT will undertake the following activities: (a) provision of new, and expansion of existing telephone services, mostly in provincial municipalities but also in Metro Manila; (b) extension of its toll network to interconnect the remaining isolated exchanges managed by other operators; (c) provision of networks, throughout the Philippines, for leasing to businesses and other operators; (d) provision of equipment to improve its operations and maintenance capabilities and training facilities; and (f) strengthening of its project management capabilities. In association w'th the project, the Government proposes to strengthen its management and regulation of the sector. Benefits: The benefits of the project would accrue to all sectors of the economy through increased access to communications facilities. Businesses and the public in the 239 provincial municipalities involved in the project would benefit most through new and expanded telephone services which will markedly improve existing communication services. Risks: No significant risks are foreseen.  * iii - Estimated Costa: i Local Foreig Total --- -US$ Million-------- Telecommunications facilities 65.5 110.0 175.5 Operations and Training Facilities 3.5 9.5 13.0 Power Equipment, Towers 6.0 6.0 12.0 Vehicles & Miscellaneous Civil Work for Buildings, Sites 27.5 6.5 34.0 Outside Plant Consultancy 2.. Base Cost 102.5 134.0 236.5 Physical Contingency 8.5 8.5 17.0 Price Contingency 11.0 5.5 16.5 Total Project Cost 122.0 148.0 270.0 Interest During Construction 5.0 13.0 18.0 Total Financing Requirements 127.0 161.0 288.0 PinanciUg PlAn: PLDT 127.0 27.0 154.0 IBRD 0.0 134.0 134.0 Total 127.0 1fi1L0 2s88.0 Estimated IBRD Disbursements: IBRD Fiscal Year 199 194 1995 122k 1222 1298 122i Annual 8.0 22.0 32.0 32.0 26.0 12.0 12.0 Cumulative 8.0 30.0 62.0 94.0 120.0 132.0 134.0 Zn Inclusive of duties and taxes estimated at US$40 million equivalent. Totals have been rounded to nearest $0.5 million.  PHILIPPINES Telephone System Expandon Projed Staff Appraisal Rtport TAe of Cone LAo andPtojectSummnary ... . ................... -........ . . ..... TIlTHE TELECOMMUNICATIONS SECrOR ........................... . -1 A. Background ....... ................................. . -1- B. SetorStutur e ................. .......... .......... . I-1 C. DemandandExpansion ........ ..............3.... -3- D. Govenmen Strategy fbr the Sector ........... .............. . -6- E. Rationale for Bank Involvement .......... ..... ................. .8- 2. TH*' PROJECT ................................. . 9- A. Gener ......................................... .-9- B. P Is invemtent Progs= ....... ... ........................ . 9. -9- C. ProjectObjves .......................... ........... .9- D. Projea D ctf l on .......................... .......... . -10- E. Projed os ..................... . .... 4.. .. O.. -12- P. ProJect Financng ................. .. ... ........ . -13- 0. Procurme ..... ... .. ..................... -14- H. Disbursemet .... .............................. .-16- I. Projet Ile me on and Schedule .. ......................... . -17 - J. Montong and Repordng ................................... . 18 - IL SupervisionPln .. .. .............. ...... . 18- L. Enviromnet ................................... .-18 -  -vi- 3. THE BORROWER AND THE BENEFICIARY ...... ....... ....... - 19- A. Introduction .. .................................. -19 - B. The Development Bank of the Phflippines .......................... . -19 - C. lhe Philippine Long Distance Telephone Company ....... ............ - 22 - 4. FINANCLAL ANALYSIS .................................... - 28 - A. Backgrond . .................................... -28- B. Past and Present Financial Performance . . . . .-...... 28- C. Financing Plan .................................... - 31- D. Future Finance .................................... - 33- S. ECONOIIC ANALYSIS .................................... . 36- A. Benefits .................................... ...... . 36- B. Tarif .s . .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. ..... - 36 - C. Return on lIvestment .................................... . 37- D. Least Cost Solution .................................... .- 38 - E. Project Risks ..................................... 38- 6. AGREE.ENTS AND RECOMMENDATION ......................... . 39 - A. Agreements Reached .................................... - 39 - B. Recommendaion .................................... -40-  - vii - 1.1 Philippines - Growth in Telephone Services 1.2 DOTC Circular 90-252 - Telecommuni -tions Policy 1.3 DOTC Departmental Order 90-483 - Formation of Telecommunications Policy Directorate 1.4 DOTC Letter of Intent on Telecommunications Policy Matters 2.1 Details of X-5, X-SC and "Other Worksl Projects 2.2 Description of Project Services 2.3 Estimated Project Costs 2.4 Proposed Secondary Lending Arrangements Related to Government us of the Float 2.5 Proposed Procurement Arrangements for World Bank Financed Itms 2.6 Project Disbursement Schedule 2.7 Schedule of Construction 2.8 Draft Terms of Reference for Project Management Consultants 3.1 PLDT Organizational Chart 3.2 PLDT Staffing Distribution (Pie Chart) 3.3 PLDT Staffing Patterns 3.4 PLDT Operational Performance Targets 4.1 PLDT Annual Financial Statements and Projections 1987-97 5.1 PLDT Tariffs 5.2 PLDT Return on Investment 5.3 List of Documents in Project File IBRD 22934 - PLDT's Telephone System Expansion Project  1. THE TELECOMMUNICATIONS SECTOR A. Background 1.1 For much of the last half of the '980s, the Philippines was striving to sustain its recovery from the economic turmoil of the first half of the 1980s. In 1985, the GDP growth rate in real terms was -3.81, foreign debt bordered on $30 billion, and about 701 of Filipino households lived below the poverty line. In contrast, by 1988, GDP growth in real terms increased to more than 6X, the inflation rate fell to slightly below 91, and other economic indicators registered positive improvement. However, starting in December 1989, the economy sustained one shock after another as a result of political unrest, natural disasters, and the Persian Gulf crisis. The growth rate for GDP slowed to less than 3X in 1990, and turned negative in 1991. 1.2 Telecommunications is one of the least developed infrastructure sectors in the Philippines. Service is generally unavailable; and, where it is available, the quality of service is considered patchy. The Government be- lieves that inadequate communications were a constraint to economic devel- opment during the recent recovery, and a deterrent to the foreign investment needed to offset the negative economic impact of the recent shocks. 1.3 The telephone sub-sector is the segment of the telecommunications sector that most urgently needs expanding and upgrading. Service coverage is sparse, with most telephone installations being concentrated in Metro Manila and only to a lesser degree in other principal cities; some cities, small towns and rural areas, and even relatively populous outskirts of principal cities have little or no access to telephone service. As of 1986, the nation- wide telephone density of 1.0 lines per 100 population was among the lowest among the ASEAN countries; by contrast, telephone density was about 32.5 per 100 population in Singapore, 6.5 in Nalaysia, 1.7 in Thailand, and 0.4 in Indonesia. The telephone density in Manila of about 9.6 per 100 population is very low for a Southeast Asian capital city, and waiting lists for service average three to five years. Elsewhere in the country, telephone density is a virtually non-existent 0.3 per 100 people. B. Sector Structure 1.4 The Government has regarded the provision of telecommunications services to be mainly the responsibility of the private sector. An array of privately owned carriers provide a reasonable range of services for both in- ternational and local communications. Generally, the Goverwaent intends that these services be offered by franchised carriers on a "reguiated competition" basis; however, the Government recognizes that certain faci'Lties, such as local telephone service, are most efficiently provided on a single carrier per franchise area basis. The Government's Telecommunications Office (TELOF), re- sponsible to the Department of Transportation and Communications (DOTC), also provides telegraph services, and some telephone services to remote areas.  - 2- 1.5 Historically, one group of companies has been licensed to provide record services (telegraph, telex, data and facsimile) and another licensed to provide telephone services. National record services are provided by six privately owned carriers and TELOF, while four privately owned carriers pro- vide the international segment of these services. Two international record carriers, Eastern Telecommunications Philippines, Inc. (ETPI) and Philippine Global Communications (PHILCOM), have telephone correspondence agreements with several countries in the region, and are also licensed as carriers of record and telephone services. Two of the privately owned dow3stic record carriers, the Philippine Telegraph and Telephone Corporation (PT&T) and Radio Commu- nications of the Philippines, Inc (RCPI), maintain small nationwide record transmission facilities in parallel with those of the dominant telephone carrier, the Philippine Long Distance Telephone Company (PLDT), and have used them to provide unlicensed voice toll services. In some cases, these three companies cooperate by leasing circuits from and providing restoral facilities to each other. Moreover, PLDT often leases the local loop cable connections to the record carriers. Two other companies, both carrier's carriers, are li- censed to operate satellite communications facilities. The Philippine Commu- nications Satellite Corp. (PHILCOMSAT) leases international circuits to tele- phone and record carriers; the Domestic Satellite Philippines Corp (DONSAT) is supposed to provide'similar services domestically; but it currently provides only television relay services. An affiliate of PLDT, PILTEL, is the major provider of mobile telephone services. A second company, Extelcom, was licensed in 1989 to provide mobile telephones in competition to PLDT/PILTEL. 1.6 As of early 1990, PLDT was providing telephone service to about 902 of the country's 625,000 working lines and about 941 of the nation's 1.05 mil- lion installed telephones (many subscribers share party lines). Its local service areas consist of most major cities and larger towns, so that the Com- pany serves many of the nation's lucrative markets. PLDT is one of the na- tion's largest companies; at the end of 1991, its net worth exceeded P 18 bil- lion and its annual revenues were about P 16.6 billion. About 50 other inves- tor and local government owned operators provide 81 of te1ephone connections. Generally, they are small, financially weak, and thinly cspitalized; and they provide poor quality of service. TELOF provides the remaining 22 of connec- tions. TELOF's efforts to provide telephone service have proven ineffectual; an affiliate of PLDT currently operates TELOF's networks in Regions I and II (northern Luzon). DOTC is planning to divest itself of TELOF's activities. 1.7 PLDT also owns most of the long distance networks that interconnect with local exchanges. It carries virtually all domestic long distance and international traffic. Until recently, PLDT was the only carrier to provide international telephone service; however, in 1989, NTC opened this service to competition by awarding licenses to operate gateways to ETPI and PHILCOM. Small operators that are not interconnected to PLDT's long distance networks are limited to providing local service in marginal markets and thus have a weak revenue base. Operators that are interconnected share only modestly in revenues from long distance and international service. The Government needs to provide leadership so that operators will become more accountable to their consumers and to the national interest; this is particularly true of PLDT,  -3- whose policies and actions set the standards for investment and operating per- formance for the sector. 1.8 DOTC is the core Government agency responsible for the sector. Its 'le is Inter alia to formulate (i) policies for directing the sector- (ii) a framework for the future expansion of service; and (iii) objectives against which the operational performance and investments of sector partici- pants could be measured. An attached agency, the National Telecommunications Commission (NTC), is responsible for regulating the activities of the opera- tors by (a) awarding and renewing , rating licenses to franchised companies; (b) approving the expansion plans and tariffs of carriers; (c) monitoring the performance of network operators; and (d) managing the frequency spectrum. 1.9 These arrangements could work satisfactorily; however, because of the low priority accorded to telecommunications until recently by the Govern- ment, neither DOTC nor NTC has adequately fulfilled its responsibilities. DOTC has lacked both a clear strategy for development of the sector and a clear policy regarding sector structure, service priorities and operational performance. The uncertainty created by this lack of a policy framework has left NTC without a clear direction for its regulatory activities, which has been ranifest by inconsistency in rulings regarding the sector's structure and delays in approving expansion plans. The resultant lack of timely and effec- tive regulation has led to operators pursuing parochial interests without any official authority interceding to ensure that national developmental pri- orities would be served, and that consumers would receive satisfactory quality service. Most importantly, in the absence of effective competition and an effective medium for accountability, PLDT understandably furthered its cor- porate interests by (i) structuring rates and revenue sharing arrangements to its own advantage, often to the detriment of the small operators; (ii) denying interconnection to some operators, and disconnecting others in instances of non-payment; and (iii) providing patchy quality of service to its subscribers. C. Demand and Expansion 1.10 Because of the low priority accorded to the telephone sub-sector by the Government, expansion of service has been too slow to keep pace with the development of other sectors of the economy. During the 1980s, PLDT's number of working lines grew by only about 6% per year; this corresponds to a growth rate of about 5.9% for Metro Manila and about 7.0% for the provinces (Annex 1.1). These rates are below the 8% average for developing countries and much less than the 12-15% rates recorded in the more dynamic econc ,es. 1.11 PLDT has historically taken a conservative approach to meeting de- mand growth in the large cities; and given the existence of other local opera- tors including TELOF, and the lack of guidance from the Government, it has never actively sought to extend its service beyond narrowly defined, hig.hly profitable areas. Moreover, the Government has prevented PLDT from growing as fast as the Company itself had proposed. In the early 1980s, after consider- able delays, NTC required that PLDT substantially reduce its planned X-5 ex- pansion program. Then, the Government constrained the Company's access to  -4- foreign exchange, thereby making loan syndication for the reduced X-5 more difficult and delaying its start. Implementation of that program has only begun within the past year. In turn, the smaller operators hid behind the modesty of their profits and the high cost of capital to curtail their own in- veatment programs. With such sparse penetration of telephores and the rela- tively slow growth in service during the 1980s, PLDT not surprisingly has a backlog of about 400,000 applications for telephone service. For the same period, the other operators realized a growth rate of 3.6% for working lines. They too have significant backlogs in applications for service. In contrast, TELOF's complement of working lines fell by about 5.6% during the 1980s. 1.12 In the early 1980s, the Government decided that TELOF should imple- ment its own nationwide program to expand service. Under the first phase, 18,000 lines were installed in Regions I and II (northern Luzon). The demand on which the project was based never materialized, and TELOF was unable to operate and maintain the networks. After several years of contracting with a PLDT subsidiary for their operation, the Government has decided either to privatize or lease these networks (para. 1.15). 1.13 Future expansion of telephone service is expected to flow from three initiatives: (a) PLDT's Long Term Exoansion Erogrm. During the 1990s, PLDT plans a major expansion program to install about 658,000 new lines, for an annual growth rate of about 10%3/. The first phase (the X-5) is now under construction; the needed financing for the second phase, the X-5C, is currently being finalized; and plans for the third phase, the X-6, are nearing completion. The proposed project, which would provide 149,000 of the new lines under this long term expansion program, was formulated by ?LDT specially to meet the Government's appropriate and feasible sector development priorities by bringing forward ccaponents of the X-6 and subsequent expansion plans; moreover, it contains only components that NTC indicated it could approve, pending financing. This combined program is expect- ed to stretch the institutional and financial limits of PLDT's capability to expand, and therefore represents appropriate medium term growth for the company. (b) The Natlonal Telephone Program (MTP). This initiative aims to in- stall some 87,000 new lines by 1994 in localities unserved by PLDT in Regions III-XII. This would double the service currently being provided by TELOF and the other operators. The Government has se- cured bilateral financing for different segments of the NTP from Japan, France and Italy. Some additional finance may be needed; and the Bank indicated it could consider financing part of the bal- 3/ After appraisal, PLDT substantially increased the size of its expan- sion plans; the changes are reflected in Annex 3.4. During project supervision the Bank would appraise the scope and size of those new plans and PLDT's capacity to implement them.  -5- ance if the Government (i) engages capable operators for the planned networks, and (ii) revises designs and procurement arrange- ments to ensure that those networks are least cost. The Government will address the operator issue using technical assistance financed by a Bank-managed Japanese Grant. (c) The Municlial Telephone Act. This Act, passed in 1989, mandates that the Government implement a program to provide basic telecom- munication service to the 1,200 or so unserved municipalities by 1993. It directs DOTC to administer the program and authorizes the Government to use its own funds as well as official loans to fi- nance private sector efforts to implement this program. Currently, the Government is receiving bilateral offers of support for this program. Few detail'.s were available about the expansion plans of the other 60 or so operators or of independent companies that have expressed interest in entering the telephone industry. However, these efforts are expected to be modest and in keeping with their low development profiles of recent years. Pgst Bank Involvement in the Sector 1.14 The Bank has been actively involved for several years in helping the Government address some of the basic policy issues constraining the growth of the sector. In 1985, under the Technical Assistance Project (Loan 2495- PH), the Bank made a $4 million loan aimed at strengthening NTC and updating the NTP. Despite a number of implementation problems, that project met most of its objectives. During supervision of that project, the Government fol- lowed the Bank's advice to constitute a National Telecommunications Develop- ment Committee (NTDC) as a forum for discussing policy issues facing the sec- tor; based on those deliberations, DOTC would formulate the urgently needed policy framework. The NTDC has reached the end of its term and was dissolved, but many of its recommendations have been used as inputs to legislation and to the formulation of sector policy. Recently, the Government and the Bank agreed to (i) continue NTC's institutional development efforts; and (ii) en- sure adequate operating arrangements for the NTP. In conjunction with the proposed project, a Japanese Grant will finance consultancy services to assist the Government's efforts at addressing these issues. Separately, IFC has maintained long-standing financing relationship with PLDT. Since 1969, IFC has made five investments (fcr a total of $128.5 million) with the Company which included, at one point, the owning of some 376,000 shares of PLDT's stock. Recently, IFC served as PLDT's financial advisor. In that role, IFC led the syndication of $155 million in loans for the X-5 -oject. That syndi- cation included a direct IFC loan of $30 million and a B-Loan of another $40 million, both of which were approved by .., Board in June 1989. IFC is expected to assist PLDT complete its financing arrangements for the X-5C project. The main lesson to be drawn from IFC's experience is that PLDT has generally met its implemenuation targets apart from delays in completing the assembly of project financing plans, regulatory clearances, or equipment deliveries. Consequently, IFC has rated PLDT's project implementation capa- bility as very good. Past implementation problems are being addressed under  -6- the proposed project: (i) the proposed Bank loan will provide all the neces- sary external financing; (ii) the regulator has already given approval-in- principle for PLDT to implement the project components (formal clearance can only follow confirmation of the financing arrangements), and efforts to obtain final regulatory clearance are well advanced; and (iii) under the Bank's procurement procedures, bids from potential suppliers will not be accepted unless accompanied by commitments to meet PLDT's delivery timetable. D. Government Strategy for the Sector 1.15 For many years, the Government has been unclear about its object- ives for the telephone sub-sector as well as about its own role. As a result, the privately owned carriers have generally felt free to maximize their short term profitability and foreswear investments that failed to promise immediate strong returns, without regard for national priorities. In 1988, DOTC begar. the process of filling the policy vacuum by establishing the National Telecom- munications Development Committee (NTDC) to serve as a forum within which all interested Government agencies and private carrisrs could air their views regarding proposed policies. More recently, DOTC has made substantial prog- ress in the following areas: (a) DOTC's Role. On August 10. 1990, DOTC issued Department Circular 90-252 (Annex 1.2) stipulating that the Government would (i) vest responsibility for operation and maintenance of telecommunications networks and investment in the future development of facilities in the private sector; (ii) serve as a facilitator for and regulator of sector participants, while occasionally serving ag developer of last resort; (iii) privatize its telecommunications networks; (iv) address the sector's business environment to enable private compa- nies to operate more profitably, and thereby undertake responsibil- ity for investment in their service areas; and (v) strengthen the sector's regulatory framework. On November 21, 1990, DOTC issued Department Order 90-483 (Annex 1.3) establishing a Policy Director- ate inter alLa to implement Department Circular 90-252. (b) Development Plan for the Sector. In October 1990, DOTC adopted the National Telephone Development Plan (NTDP), which provides a rea- sonable policy framework for future expansion and operation of the sector. The NTDP, which was formulated with the active collabora- tion of the private sector, addresses (i) investment priorities for the medium and long term, and (ii) network performance standards. These objectives could be used by NTC as the basis for assessing the operators' (a) investment plans, and (b) applications to renew their operating licenses. This is a dynamic plan that needs to be reviewed regularly and adapted to changing conditions in the coun- try and in the sector. (c) FlnancIng of Investment. Despite the inrerent profitability of telecommunications operations, the country's large outstanding for- eign debt and current uncertain economic climate constrains even  -7- the strongest of the privately owned operators from raising needed investment capital solely from commercial sources. Having recog- nized this problem, the Government decided in 1990 to make avail- able to private operators borrowings from official sources; in the past, this form of funding had been reserved to finance only tele- communications investments being pursued by Government entities. As a first step, the Municipal Telephone Act includes a pr,vision for making available the proceeds of official loans up to the equivalent of P 300 million and up to P 200 million of budget funds to support private sector investments in public call offices in currently unserved localities. The proposed loan in support of PLDT is in keeping . x this revised Government policy. In gener- al, the Government t. r,visages its role as a facilitator of private investment-i zler than as an implementor and/or owner of telecommunicatior..- tems. (d) Interconnection and Revenue Sharlng. NTC has recently promulgated acceptable guidelines governing (i) access of all local service operators nationwide to ocher local networks, domestic long dis- tance, and international service, and (ii) revenue sharing arrange- ments between local and long distance operators (domestic and in- ternational). PLDT has developed plans for complying with the in- terconnection guidelines, and the proposed loan will finance a sub- stantial part of the necessary investment. It has also adjusted its rate sharing formula to provide local operators with a greater share of domestic long distance and international revenues. In coming years, the Government and PLDT will need to review the stru- cture of rates to ensure that implied levels of cross subsidization are appropriate. (e) Strengthenlng of Government Institutions. DOTC has received ap- proval of a V 278 million grant from a Bank managed Japanese Gov- ernment facility to finance technical assistance to (i) develop sound operating arrangements for the NTP; (ii) continue NTC's institutional development efforts; and (iii) provide services and facilities to improve the telecommunications sector's training pro- grams. DOTC and NTC have retained some consultants and are in the process of retaining others for these activities. 1.16 The Bank has assisted DOTC in the formulation and development of these initiatives. Through a continuation of the dialogue, the Bank can help ensure the coherence of these efforts and that necessary follow-up activities are adequately supported. During negotiations, the Government agreed that it would (i) furnish to the Bank a summary of the results of its annual review of the implementation of its telecommunications policies; and (ii) seek the Bank's comments if major change in any such policy is expected. In addition, the Government sent a letter (Annex 1.4) to the Bank confirming that it would conduct an annual review of progress with regard to implementing its policies and plans, including the provisions of Departmental Circular 90-252; (b) by January 1, 1994, review its policy framework including the structure of telephone tariffs; and (c) share with the Bank the results of those reviews  -8- and adopt, if feasible, the recommendations reached. Moreover, the letter affirmed that the Government would share with the Bank the result of thest. and other reviews that might result in major changes in sector development policy, and solicit the Bank's views prior to deciding any such changes. E. Rationale for Bank Involvement 1.17 The inadequacy of infrastructure generally, and of telecommunica- tions services specifically, is a major constraint to investment and economic growth in the Philippines. For telecommunications services to improve to levels comparable to nearby countries, the sector needs (i) considerable in- vestments to upgrade existing facilities and expand networks at a time when country conditions inhibit even the strongest companies from raising invest- ment capital from commercial sources; and (ii) greater institutional cohesion, wherein the Government and the major providers of service improve their effec- tiveness in their allotted roles. In addition, the Government needs to imple- ment the policies enunciated in the NTDP and develop an institutional frame- work within which the sector can grow; and, it needs to provide the leadership needed for PLDT to evince greater concern for national developmental priori- ties and increased responsiveness to the service requirements of its consum- ers. Because of the depth of its existing dialogue with both the Government and PLDT, the Bank is uniquely positioned to use its involvement in the pro- ject to address all of these issues. In particular: (a) By financing a project that focuses on developing service in areas of high priority to the Government, the Bank would lead PLDT to take a more balanced approach toward future network development. (b) By financing the proposed project, the Bank would assume the role of a cornerstone financier for PLDT, thereby enhancing the Com- pany's financial credibility as well as its efforts to obtain the balance of its investment requirements from commercial sources. (c) By emphasizing cost optimization and quality of service as well as a more expansive approach to investment, the Bank would induce PLDT to become more responsive to its consumers. (d) By channeling a substantial official loan to a private company, the Bank is encouraging the private sector to assume responsibility for a major development investment. (e) By supervising the consultancies financed by the Japanese Grant, the Bank would continue pursuing sector policy and regulatory issues, including (i) the institutional strengthening needed to enable DOTC to become more effective at managing and NTC at regu- lating the sector; and (ii) the constructive dialogue between the Government and PLDT needed to enable PLDT to play a leading role within a clearly defined policy framework.  2. THE PROJECT A. General 2.1 The proposed project is a stand-alone part of PLDT's planned in- vestment program for the period 1991-94. B. PLDT's Investment Program 2.2 PLDT's investment program for 1991-96 is divided into four princi- pal ccmponents: (i) the X-5 project, which is currently under implementation; (ii) the X-5C project, part of which is under implementation; (iii) the pro- posed project; (iv) the X-6 project which is planned to start in 1994; and (v) other works. The Bank's appraisal mission examined PLDT's investment program, except for the X-6 project for which plans were still being formulated, and found it fully consistent with the sector objectives outlined in para. 1.15. 2.3 The X-5 and X-5C parts of PLDT's expansion program provide for ex- pansion of existing networks and customer facilities. Contracts for the X-5 project have been awarded and works are expected to be completed in 1992. Contracts for the turnkey construction of 120,000 lines of the X-5C project have been awarded and bids for the drawing, supply and construction of the remaining 265,000 lines have been called. The other works included in the investment program are expected to expand PLDT's international and local transmission networks and include a variety of sub-projects for expanding and improving service, including works to rehabilitate PLDT's cable networks. Contracts related to the "other works" component of the investment program are being let on a case-by-case basis; progress is to a large extent dictated by the availability of acceptable financing. Further details about these proj- ects are provided in Annex 2.1. C. Project Objectives 2.4 The proposed project aims to (i) increase telephone penetration and leased line facilities in PLDT's service areas, with an emphasis on provincial development; and (ii) improve PLDT's quality of service and efficiency. In general, the proposed project will enable PLDT to advance its plans for imple- menting a variety of customer and operating facilities needed urgently to meet demand in areas that the Government has identified as having major economic importance (para. 1.13(a)) and to improve PLDT's operational performance. 2.5 In conjunction with, yet separate from the proposed project, the Government has agreed to take action to strengthen sector management and regu- lation (para. 1.15). The Bank will support DOTC's efforts to improve its ca- pacity to manage the sector, and NTC's efforts to improve its ability to regu- late sector activities, through (i) continuing dialogue with DOTC and NTC dur- ing project supervision; and (ii) technical assistance which is being provided from the Bank-managed Japanese Grant Facility (para. 1.15(e)). That technical  -10- assistance Grant for 1 278 million has been approved and is effective, and the Grant amount is therefore not included in the project costs. The amount of technical assistance is adequate given the absorptive capacity of DOTC and NTC to effectively use consultant support. D. Project Description 2.6 The main components of the project are (Annex 2.2): (a) Expansion and rehabilitation of telephone services in provincial areas through the provision of 133,000 lines of exchange equipment; (b) Provision of about 97 public calling offices (PCOs) in currently unserved municipalities in 10 provinces; (c) Interconnection of six isolated exchanges, managed by independent operators, with PLDT's toll network thereby providing them with ac- cess to national and international services; (d) Provision of outside plant to connect about 41,000 new customers thereby utilizing more completely the local exchange capacity be- coming available in the Metro Manila area; (e) Provision of special circuits,, in the Metro Manila area and 20 Pro- vincial cities, to be used as leased voice and data lines; (f) Provision of a transmission maintenance system to improve PLDT's inter-exchange circuit operations and maintenance performance; (g) Provision of training equipment for PLDT; and (h) Consultants to strengthen PLDT's program management capabilities. 2.7 Provincial Telephone Expansion. This component involves the in- stallation of about 133,000 lines of exchange and related telecommunications equipment for providing (i) new telephone services in 53 unserved municipalit- ies in 9 provinces; (ii) expanding existing telecommunications facilities; and (iii) replacing obsolete equipment. The areas were selected on the basis of government priority (para. 1.13(a)). A total of 32 new exchanges (34,000 lines) are to be installed in provincial towns, and 23 existing exchanges are to be expanded by about 51,000 lines to accommodate pending requests for ser- vice. In many cases lines will be extended from new and expanded exchanges to serve adjoining municipalities. In addition, about 20,000 lines of obsolete electromechanical equipment at 23 exchanges will be replaced with about 49,000 lines of new digital exchange equipment. Six of the above new exchanges will provide modern telecommunication facilities for eight industrial parks; two exchanges will each serve two parks. The parks are under development in Re- gions III and IV, and the availability of acceptable telecommunications facil- ities is a prerequisite to attracting investors. In total, after allowing for replacement of old exchanges and an exchange fill ratio of 95X, this component will provide a net increase of about 108,000 new telephone lines.  - 11 - 2.8 Public Call Offices. Through this component, PCOs will be in- stalled in 97 currently unserved municipalities in 10 provinces. The PCOs will be connected to exchanges through a variety of techniques, including: (i) fixed base stations to access PLDT's existing cellular mobile radio facil- ities, and (ii) multi-access radio systems being provided under the project. The use of cellular techniques will make these services robust and more immune to outages during natural disasters. This component will enable PLDT to ful- fill its obligations under the Municipal Telephone Act (para. 1.13(c)). 2.9 Interconnection of non PLDT exchan,es. Through this component, one Government and five independently operated telephone exchanges would be inter- connected to PLDT's toll network. These are 6 of the 25 licensed Government and independently owned telephone exchanges in the Philippines that are still not connected to toll networks that would give them access t .omestic long distance and international services. Services in these isolated exchanges are therefore confined to local calls. Interconnection has been mandated by a recent NTC guideline, and PLDT plans to install most of the facilities needed to comply with that guideline through the X-5 and X-5C projects. PLDT plans to interconnect, under this project, the six remaining isolated telephone ex- changes that are in proximity to its toll networks!/. 2.10 Manila Outside Plant and Services. Under the X-5C project, PLDT will implement a significant upgrading and expansion of telephone exchanges in the Metro Manila area. The resultant rationalization of customer connections will release some spare exchange capacity throughout the network. This compo- nent will utilize that spare capacity by providing outside plant and equipment for customer premises for about 41,000 new connections. 2.11 Leased Line Facilities. This component would accommodate growing demand from businesses for leased voice and data lines by providing a dedicat- ed transmission network in the Metro Manila area and selected provincial cit- ies. The network would consi.t of a distributed optical fiber cable system with a capacity of about 2,000 voice and data circuits interconnecting major exchanges and buildings through 21 nodes in the Metro Manila area. Extensions to the system will be provided to 20 nodes in provincial cities through the use of PLDT's existing and planned network transmission facilities. 2.12 Transmission Maintenance System. This component will provide a special digital maintenance system with facilities to improve PLDT's ability to centrally monitor and test inter-exchange and private circuits in the Metro Manila network. This component is designed to reduce circuit outage times and thereby improve service quality. 2.13 Tralning Facillties. Additional simulatior and miscellaneous training equipment will be provided in order to maintain PLDT's training fa- cilities at an acceptable level of performance. !/ The Government plans to interconnect the other isolated exchanges to the long distance networks being developed under the NTP.  -12- 2.14 Strenthenlng of PLDT's Protect Managemt CapablUtles. Consul- tants will be engaged to review and help PLDT strengthen their project manage- ment operations (para. 2.30). E. Project Cost 2.15 The total project cost is estimated at US$270 million (excluding interest during construction), of which US$148 million is projected to be the foreign cost (direct and indirect). Detailed cost estimates for the project are presented in Annex 2.3 and summarized in Table 2.1: Table 2.1: PROJECT COST ESTIMATE Foreign Cost Pesos Million US$ Million as % of Local Foreign Total Local Foreign Total Total Ecuinment & Servioes Telephone Exchanges 563.5 1.414.0 1.977.6 20.0 50.5 70.5 72 Transmission Equipment 334.0 733.5 1,067.5 12.0 26.0 38.0 se Outside Plant 882.5 831.5 1,714.0 31.5 29.5 61.0 48 Customer Premises 59.5 114.5 174.0 2.0 4.0 6.0 67 Equipment Operations and Training 102.0 271.0 373.0 3.5 9.5 13.0 73 Facilities Power Equipment, Towers, 175.0 174.0 349.0 6.0 6.0 12.0 50 Vehicles & Miscellaneous Civil Works Outside Plant 238.5 65.0 303.5 8.5 2.5 11.0 23 Suldingp and sites 526.0 105.0 631.0 19.0 4.0 23.0 17 Consultansv 0.0 56.0 56.0 0.0 2.0 2.0 100 TotlE BeCo tm 2,881.0 3,764.5 6,645.5 102.5 134.0 236.5 57 Physioal Contingenoy 232.5 235.5 468.0 8.5 8.5 17.0 - Ptice Contingency 311.5 156.0 467.5 11.0 5.5 16.5 - Tot Protect Cost is 3,425.0 4,156.0 7,581.0 122.0 148.0 270.0 53 INT. DURING CONSTRUCTION 138.0 369.0 506.0 5.0 13.0 18.0 - TOTAL F^IANCING REUIRED 3,561.0 4,525.0 8,087.0 127.0 161.0 288.0 se NgW: Cost estimates have been rounded to the nearest 0.5 million. l The project cost includes an estmated US$40 million equivalent in duties and taxes 2.16 All costs are in April 1992 prices and based on recent price quota- tions from equipment suppliers. Physical contingencies related to (a) foreign  -13- costs are 5X for switching equipment and 10 for other items, and (b) local costs are 5 for goods and 10 for labor and overheads. The price escalation of foreign costs is calculated according to anticipated international price movement of 3.9X per annum during the implementation period of the project (1992-96). The price escalation for local costs is calculated according to the projected local inflation rate of 10 per annum. Interest during con- struction is calculated by applying the Bank's current interest rate of 7.73X plus a spread of about 3.25X applicable to the onlending to PLDT, to the aver- age amount expected to be drawn down during each year of construction and by adding the commitwent fee on the average undrawn amount of the loan. The proportion of interest during construction attributable to the proposed Bank loan itself, is allocated to foreign cost; the proportion attributable to the spread is allocated to local cost. F. Project Flnancing 2.17 The financing plan for the project is presented in Table 2.2 below: Table 2.2: PROJECT FINANCING PLAN (US$ million equivalent) Local Foreign Total 1 of Total IBRD 0.0 134.0 134.0 46.5 PLDT 127.0 27.0 154.0 53.5 Total 127.0 161.0 288.0 100.0 2.18 The proposed Bank loan of US$134 million would be lent to the De- velopment Bank of the Philippines (DBP) for 20 years, including five years of grace on repayment of principal, at the standard variable interest rate. The Government would guarantee the entire amount of the Bank loan to DBP, and would charge a guarantee fee equal to 11 per annum on the outstanding loan amount. While DBP would assume (and transfer to PLDT) the exchange rate risk between the Peso and the US dollar, the Government has agreed to assume the cross currency risk between the US dollar and the Bank's currency pool, for a second fee of 11 per annum on the outstanding loan amount. 2.19 In turn, DBP would relend the proceeds of the Bank loan to a bank- ing syndicate, which would include DBP as well as four other participating banks. The Banking Syndicate would in turn relend the entire proceed to PLDT through two separate facilities: (i) the first, of which DBP would subscribe the entire $35 million, would include a term of twelve years with a grace period of four years on repayment of principal; and (ii) the second, of which each participating bank would take the primary responsibility and assume the intermediation risk for its subscribed portion of the remaining US$99 million,  *14- would include a ten year term with a grace period of four years on repayment of pxincipal. In addition to serving as a member of the syndicate, DBP would serve as originator of the syndicate and would act as agent for the syndicate members throughout the life of the loan to PLDt. 2.20 In addition to bearing responsibility for the Bank's interest rate, the aggregate of 2X in fees being charged by the Government will be borne by the banking syndicate and flow through to PLDT. DBP would earn 1XX on the entire amount for its role as originator and administrator of the relending arrangements, and each of the syndicate members (including DBP) would share an additional spread of 1% to compensate for the intermediation risk. Thus, the rate to PLDT will be 31.% above the Bank's rate, which over time is expected to be a reasonable proxy for market rate for a loan of similar size and maturity. 2.21 Each participating bank is in good standing with the Central Bank of the Philippines and in compliance with posted prudential regulations. Moreover, all participating banks have been accredited under the Bank financed Industrial Restructuring Project (Loan 3287-PH). 2.22 Because the maturities applicable to the two relending operations are considerably shorter than the term of the Bank loan, PLDT shall amortize its loans ahead of DBP's amortization of the IBRD loan. Consequently, DBP will need to manage a float resulting from the excess of the principal repay- ments made by PLDT over the amounts that would be due to the IBRD. The Gov- ernment wishes to use this float for application to general macroeconomic purposes, according to an arrangement for secondary lending that would func- tion as though the Government were the Borrower of the IBRD loan; thus the arrangements for secondary lending will need to be tailored so as to hold DBP free of benefit or cost (Annex 2.4). 2.23 The documentation for the arrangements described above are unusual and complicated. For that reason, negotiations were held open until the drafts were reviewed satisfactorily by the Bank. A condition of effectiveness of the proposed loan will be the execution of satisfactory documents for: (a) onlending to the syndicate and syndicate operations (between DBP and the other participating banks); (b) onlending to PLDT (between the syndicate members and PLDT); (c) guarantee of the Bank loan, coverage of the cross currency risk, and secondary lending (between the Government and DBP). G. Procurement 2.24 Procurement arrangements for the proposed project are summarized in Table 2.3. Details are provided in Annex 2.5. Contracts for about US$114 million (including contingencies) for goods and services would be awarded according to International Competitive Bidding (ICB) procedures using the Bank's standard procurement guidelines. The Bank has cleared PLDT's proposed wording for its model document, "Invitation to Bid and Conditions of Con- tract", which would be applied to all ICB procurement financed by the Bank. Items to be procured according to ICB include (a) new telephone exchange equi-  - is - pment; (b) transmission equipment; (c) outside plant items such as optic fiber cable, copper cable, and miscellaneous jointing materials; and other items Table-2.3: SUMMARY OF PROCUREKENT ARRANGEMENTS (US$ million) Procurement Method ICB LCB OthertLa NBF& Total Eguipment and Services: Telephone Exchanges 38.5 16.6 22.5 77.5 (38.5) (16.5) (55.0) Transmission Equipment 28.0 0.5 13.5 42.0 (28.0) (0.5) (28.5) Outside Plant 34.5 38.0 72.5 (34.5) (34.5) Customer Premises Equipment 7.0 7.0 Operations and Training Equipment 10.0 1.0 4.0 15.0 (10.0) (1.0) (11.0) Power Equipment, Towers, 3.0 11.0 14.0 Vehicles & Misc. (3.0) (3.0) Civil Works: Outside Piant works 13.0 13.0 Buildings and sites 27.0 27.0 C.onsultancy: 2.0 2.0 (2.0) (2.0) Total 1HA Z Z& 12 (114.0) (20.0) (134.0) NOTE: Figures in parentheses indicate financing from the Bank loan. Costs have been rounded to nearest $0.5 million. fa Direct purchase, international and local shopping, and Bank procedures for selection of consultants. & NBF refers to nonBank-funded items and includes equipment, works and services and expenditures on engineering and administrative overheads and also duties and taxes, all of which are funded by PLDT. The cost of duties and taxes is estimated at US$40 million. including powerplant equipment, network transmission monitoring equipment and training aids. The equipment suppliers will be required to install outside plant equipment and provide services for supervision of the installation of most equipment items. Equipment needed to extend PLDT's most up-to-date, ex- isting, digital telephone exchanges ($16.5 million, representing about 6X of the total project cost) and expand existing multiplex radio systems ($0.5 mil- lion) is of a proprietary nature and would therefore be procured directly from the suppliers. Use of other equipment for these applications would not be I Pj,j-  .16- economic. In order to ensure that negotiated prices for telephone exchange equipment are reasonable, PLDT has agreed to engage an independent inspecting firm (acceptable to the Bank) to confirm that the prices are comparable with, or less than, international prices for similar equipment recently provided by the supplier. Most contracts for goods procured under ICB are expected to be awarded to foreign suppliers. PLDT proposes to procure telephone instruments and small-size copper cables from local suppliers using its own funds. Con- tracts for specialized training equipment costing less than $50,000 each with a total value not exceeding $0.8 million may be procured through international shopping; and smaller training support items such as personal computers cost- ing less than $50,000 each with a total value not exceeding $0.2 million may be procured using local shopping procedures. Bank financed project management consultants (about $2 million) would be selected according to Bank guidelines. 2.25 All ICB contracts for goods estimated to cost more than $1.J mil- lion individually, and all contracts for consultants services, will be subject to prior review by the Bank. This would involve about 85% of the total value of contracts to be financed by the Bank. The remaining Bank-financed contracts would be subject to post-award review. H. Disbursement 2.26 The proposed Bank loan would be disbursed over a 6-year period. Disbursements would be made as follows: (a) 100l foreign expenditures for equipment and material imported directly; 10OZ ex-factory costs of local ex- penditures for equipment and materials manufactured locally and 85X of expen- ditures for other items procured locally; (b) 100l of total expenditures for consultant services. Disbursements for equipment contracts with a value of less than $1 million equivalent may be made against Statements of Expenditures (SOEs). The supporting documents will-be retained by PLDT and will be avail- able for review by supervision missions upon request. All other requests for disbursement would be fully documented. To the extent possible, DBP and PLDT would consolidate withdrawal applications for direct payment and reimbursement procedures into amounts of not less than US$1.00 million equivalent prior to presentation to the Bank. During appraisal, DBP and PLDT were assessed as having the capacity to manage the above arrangements properly. 2.27 To facilitate project disbursement, a Special Account in a fully convertible currency would be established by DBP. The authorized allocation to the Special Account would be US$3 million, representing an estimated aver- age of four months' disbursements. Replenishment of the Special Account would be made quarterly or whenever the available balance in the account dropped below 501 of the initial deposit. The Special Account would be established with terms and conditions acceptable to IBRD including that: (a) the deposi- tory bank for Special Account funds would be a commercial bank, and (b) DBP should have direct and ready access to funds deposited. During negotiations, (i) DBP agreed to have its records in relation to the Special Account audited for each fiscal year and the results of the audit furnished to the Bank by June 30 of the end of such year; and (ii) PLDT a3reed to have its records in relation to Statement of Expenditures, being maintained for disbursement pur-  .17 - poses, audited for each fiscal yenr and the results of the audit furnished to the Bank by June 30 of the end of such year. 2.28 The project completion date for the proposed loan will be June 30, 1998, and the closing date of the loan will be December 31, 1998. For IFC projects, PLDT has generally met its implementation targets apart from delays in completing the assembly of project financing plans, regulatory clearance, or equipment deliveries. Consequently, IFC has rated PLDT's project implemen- tation capability as very good. These past problems have been addressed under this project (para. 1.14). Furthermore, consultants are to be engaged under the project to review, and if necessary, strengthen PLDT's project management capabilities so as to avoid any delays that could occur as a result of the proposed project stretching PLDT's project management capacity (para. 2.30). The estimated disbursement schedule, given in Annex 2.6, is based upon the profile for all Bank telecommunications projects during FYs 1978-90. I. Project Implementation and Schedule 2.29 Responsibility for project implementation will be shared between PLDT and the various suppliers and contractors. Path design, specification and installation of most transmission systems are well within PLDT's capabili- ties and will be undertaken by the Company. Switching systems and those transmission and other systems relying on technology unfamiliar to PLDT will be installed by PLDT's technical staff; suppliers will be contracted to pro- vide adequate training to PLDT's staff and to supervise the installation. In a manner similar to other PLDT projects, outside plant networks will be de- signed by PLDT with contractors' assistance as required, and constructed and tested by contractors under PLDT supervision; a combination of separate local contractors and PLDT staff will wire customer premises and install new custom- er telephone facilities. PLDT has invited bidders to pre-qualify for the out- side plant supply and erect contracts, has prepared the bid documents for switching equipment and generator sets, and is finalizing bid documents for transmission equipment. A schedule of construction activities is given in Annex 2.7. 2.30 PLDT will retain responsibility for managing its investment pro- gram. Project management is the responsibility of a single division in PLDT which already has two project management groups in operation. One of the groups is responsible for managing the proposed project together with ongoing works; the other group is responsible for managing the large X-5 and X-5C pro- jects. Consultants are to be engaged under the proposed project to strengthen PLDT's project management capabilities. The consultants are to review PLDT's project management structure, work practices, training, and support systems and recommend appropriate improvements; and assist with project management where necessary. In their review, the consultants would be required to pay particular attention to the adequacy of PLDT's preparations for managing the proposed project and a key responsibility will be to ensure proper coordina- tion between the two different project management groups. Draft terms of reference for the consultants are given in Annex 2.8. During negotiations of the proposed loan, PLDT agreed to appoint the management consultants, a:cord-  - 18- ing to terms of reference and a selection procedure acceptable to the Bank, not later than June 30, 1993. J. Monitoring and Reporting 2.31 Satisfactory procedures for monitoring (i) the physical execution of the project; (ii) project expenditures; and (iii) PLDT's technical, commer- cial, and financial performance were developed at appraisal. PLDT will fur- nish progress reports to the Bank every six months. K. Supervision Plan 2.32 Supervision of this project will focus upon the following key im- plementation aspects: (i) fast and effective procurement of goods and services in the early stages of the project. (ii) implementation progress and coordina- tion of the various project elements of civil works, switching, transmission, outside plant and connection of customers; (iii) proper coordination of the project with related elements of PLDT's other expansion program components; (iv) compliance with financial covenants to assure the financial health of PLDT while undertaking its large investment program; and (v) assurance that adequate steps are taken to protect the environment. A substantial component of supervision time would be spent reviewing and assisting the Government's efforts toward strengthening sector management, mainly through the use of con- sultants to be engaged under the Japanese Grant Facility (para. 1.15(e)). Three missions annually for a period of five years are foreseen for adequate supervision of this project. The total estimated staff inputs are: (a) a telecommunications engineer and financial analyst, with assistance from an economist being drawn as required -- 47 staff-weeks; and (b) a specialist on telecommunications regulation and policy -- 15 staff-weeks. L. Environment 2.33 The proposed project is not expected to cause any environmental problems. Construction would involve some minor site clearing, and access roads may be needed to reach transmission tower sites. Where optic fiber is used, some plowing of cable trenches may be needed. However, these disrup- tions normally follow existing power, road and rail alignments. The disrup- tion of virgin land is expected to be minimal. 2.34 Because the project's impact on the environment is expected to be minor, no special environmental assessment is needed. However, as designs and contracting for the proposed project become more advanced, the measures that PLDT proposes for protecting the environment would be assessed during project supervision to ensure their conformity with both local guidelines and stan- dards acceptable to the Bank.  3. THE BORROWER AND THE BENEFICIARY A. Introduction 3.1 The Borrower of the proposed loan will be the Development Bank of the Philippines (DBP). The Beneficiary will be the Philippine Long Distance Telephone Company (PLDT), which will receive the proceeds of the proposed loan flom DBP according to acceptable onlending arrangements (para. 2.19), and will use the funds to execute the project. B. The Development Bank of the Philippines Background 3.2 DBP was established in 1958 as a Government-owned development bank. Until 1986, DBP's financing operations reached into almost all segments of the economy, including large and small-scale enterprises. In addition to its industrial, agricultural, real estate and transportation lending, DBP made substantial loans to social sectors such as education and health care. Start- ing in the 1970s, under the guise of its development mission, DBP financed high risk and low return Government development programs ("directed" or "be- hest" lending), as well as takeovers of financially distressed firms when so directed by the Government. This lack of financial discipline in its lending, compounded by serious weaknesses in its internal organization and procedures (notably credit appraisal and supervision), led to massive defaults in its portfolio and, in turn, serious financial prcblems. 3.3 With its resource mobilization c..apacity thus undermined, DBP had to rely mainly on Government deposits for funding its activities. Still, its financial difficulties were so severe that 8) several capital increases be- tween 1972-80, (ii) substantial government deposits to shore up its liquidity position, and (iii) various measures to strer *hen its organization and proce- dures, all failed to prevent DBP's further firin'cial deterioration in the early 1980s. Serious portfolio arrears and poo- collection rates persisted; all the same, the Government continued pressing IBP to make high-risk and low- interest behest loans. Despite corrective action.; agreed with the Bank in the context of various Bank operations (the last on; being the Industrial Finance Project, Loan 1984-PH; 1981), DBP's financial and operationa'l performance continued to deteriorate, culminating in a suspension of Bank lending to DBP. DBP's Rehabilitation (1986-1989) 3.4 Following the change of Government in 1986, the severity of DBP's problems and its technical bankruptcy were addressed by a comprehensive reha- bilitation program that included a financial restructuring and reorganization developed in conjunction with the Bank financed Economic Recovery Loan (ERL). Those two provisions of the rehabilitation program, were implemented during 1987-89 and are now completed. DBP's Policy Statement, which was issued in  - 20 - 1989, provides for it to have: (a) a private sector orientation combined with decision-making autonomy; (b) an interest rate and fees policy that (i) is consistent with prevalent market rates and (ii) ensures full coverage of all its direct and indirect costs, including provisions as required, plus an ade- quate profit margin; (c) a prudent matching of interest rates and maturities between its assets and liabilities; and (d) a debt-equity ratio not exceeding 5:1. 3.5 DBP now has a good management team. Its financial indicators (cap- ital adequacy, liquidity, return on equity, return on assets) are healthy and in line with the leading private financial institutions in the Philippines (Table 3.1). In 1989, the Bank agreed to finance the Industrial Investment Credit (IIC) Project (Loan 3123-PH), with DBP acting as the apex organization channelling investment funds to private industry through accredited partici- pating financial institutions (PFI). Implementation of that project has so far been satisfactory. Under IIC, DBP agreed to implement an Institutional Development Plan (IDP) that defines and makes operational DBP's wholesale banking strategy. In connection with this proposed project, DBP will continue to implement the IDP, including (i) the market-oriented policies that form the basis of its operations and (ii) the privatization of its retail operations. In January 1991, DBP reaffirmed these principles in connection with a new Bank loan for US$175 million (Loan 3287-PH) to finance the Industrial Restructuring Project (IRP). Table 3.1: SUMMARY OF DBP'S FINANCIAL PERFORMANCE, 1989-1991 (Peso billion) Year 1989 1990 1991 Total Loans Outstanding 5.7 9.2 15.3 Total Debt 5.3 10.0 20.2 Total Equity 6.3 6.9 7.3 Net Income 1.1 1.1 1.2 Ratios: Debt/Equity 0.9 1.4 2.8 Net Worth/Risk Assets (X) 100.5 71.6 42.9 Liquid Assets/Deposits (X) 165.3 113.6 103.5 Provisions for Doubtful Accounts/ 24.0 11.9 8.4 Total Loans (X) Net Interest Margin/Total Assets (X) 8.4 8.4 8.5 Return on Average Net Worth (X) 17.5 17.5 16.8 Administrative Expenses/ 4.5 4.5 4.3 Average Total Assets (X) Personnel Costs/Total Assets 2.6 2.6 1.7  - 21 - DBP's New Role and Strategic Orientation 3.6 DBP's financial restrv.cturing and the major elements of its insti- tutional strengthening were completed in 1989. and left DBP solvent. As a condition of the Financial Sector Adjustment Loan of 1989, its role was rede- fined so that DBP is now becoming a wholesale bank, which would mobilize and channel term funds to the private sector through retail financial institu- tions. Given the availability of domestic long-term funds from the Social Security System, insurance companies and pension funds, DBP is expected to play a major role in domestic resource mobilization and in developing domestic capital markets. At the same time, DBP will be divesting itself of its retail operations. A partial divestiture is expected in 1992. By separating DBP from some of its more risk activities, this divestiture is likely to improve DBP's financial prospects. Under the IIC and IRP, the Bank is monitoring closely DBP's financial and operating performance, as well as its compliance with the targets set out in its Policy Statement. Through conditionality related to those two prcjects, the Bank will address on an ongoing basis any activities or difficulties that would reduce DBP's ability to fulfill its responsibilities under the proposed project, 3.7 In moving toward wholesale banking, DBP can only gradually increase its reliance on domestic resource mobilization; in the short term, the lack of a developed internal capital market and the Government's continuing needs to tap domestic savings through high-yield Treasury bills would impede DBP's ef- forts to raise significant long term local currency funds. Given these con- straints, DBP will have to fund a significant proportion of its wholesale banking activities from foreign sources in coming years. In this context, DBP has been designated to serve as a conduit for official foreign borrowings, channeling the proceeds through retail financial institutions for use in fi- nancing private enterprises. 3.8 The onlending arrangements under the proposed loan are consistent with DBP's reorientation into wholesale banking. DBP has performed due dili- gence in satisfying itself with regard to PLDT's credit. Having decided that the proposed transaction was attractive financially while also being consis- tent with the Government's development objectives, DBP has structured the arrangements in keeping with financial prudence principles. Not only is it thus providing PLDT with much needed investment finance, but it is also en- abling the participating banks to improve the return on their existing assets. 3.9 Under the Financial Sector Adjustment Loan (1989) DBP's Board adopted a policy statement spelling our operational and financial practices and targets that it intends to meet in the future years. Moreover, it agreed nether to amend nor abridge that policy statement without the bank's prior consent. That policy statement continues to be relevant and appropriate. In addition, during negotiations of the proposed loan, DBP agree to furnish to the Bank by June 30 of each year, its annual financial statements for the previous year certified by an auditor acceptable to the Bank.  - 22 - C. The Philippine Long Distance Telephone Company Background 3.10 Telephone service was introduced to the Philippines in 1905 with the founding of the Philippine Islands Telephone and Telegraph Company. PLDT, itself, was founded on November 28, 1928 with the Philippine Legislature's passage of Act No. 3436, which incorporated the Company and vested it with a 50 year franchise to provide telephone service nationwide; that franchise was extended by another 50 years in the late 1970s. Subsequently, PLDT acquired the assets, franchises and businesses of the then existing telephone systems. The Company's ownership passed to Filipino hands in 1967. While PLDT has sub- stantially expanded its capital structure since ther, the interests that ac- quired it in 1967 have continued to retain operating control over the Company. Ownership 3.11 PLDT has nearly 500,000 holders of its common and preferred shares. About 14% of its paid-in capital was raised from common stock, about 36% from issues of cumulative non-convertible preferred stock, and the remaining 50% from the Company's Subscriber Tnvestment Plant/. While the preferred shareholders have the right to vote on capital increases, only common share- holders may vote for directors, annual business, and auditors; as a result, the common shareholders control the company. These arrangements vest inordi- nately broad corporate powers in a narrow group of shareholders; still, this is not expected to have any noticeable impact on the proposed project. 3.12 PLDT's common stock is traded not only on the Manila and Makati Stock Exchanges, but also on the American Stock Exchange. About 39% of the common stock is closely held by interests that have owned large blocks of shares for many years. Another 30% is owned beneficially by U.S. based stock brokerage firms on behalf of their investors; those holdings are generally large blocks. Another 17% of the common stock is owned by foreign investors and held abroad. The remaining 14% is held by investors in the Philippines. While this includes some large blocks, it also includes many small holders. Virtually all the common stock that is traded in the Philippines comes from that last group of 14%. !/ Under that plan, when subscribers receive their connections, they are required to purchase 180 shares of preferred stock bearing a P 10 par value and a coupon rate of 10%. Those shares are tradeable on the Ma- nila and Makati Stock Exchanges. After one year, those preferred shares are convertible to common stock at a 10% discount from the average mar- ket price of the common stock on those Stock Exchanges. In practice, few of those preferred shares get converted to common stock. Their own market value has tended to fluctuate with that of PLDT's common stock, and the 10% dividend rate provides a higher pay out. Moreover, many subscribers are not financially sophisticated and therefore unaware of whatever may be the comparative advantages of converting these holdings to common stock.  - 23 - Organization, Management and Staff 3.13 PLDT's corporate powers are exercised by its eleven-member Board of Directors. Each Board member is elected by the common shareholders to serve until the next Annual Meeting and may be reelected without limitation. The present Board consists primarily of senior executives drawn from the business community and high level public servants. The Board meets once a month; the Executive Committee may act as the Board between meetings. In addition, the Board has a finance committee to consider financial matters; an Audit Commit- tee to consider issues of internal audit; an Executive Compensation Committee to set the pay of the Company's senior officers; and an Advisory Committee of non-Board members to provide specialized advice to the Board members them- selves. 3.14 PLDT's management is vested in its President, who is himself a Di- rector and serves as the Company's Chief Executive Officer. He is appointed each year at the first meeting of the reconstituted Board of Directors follow- ing the Annual Meeting. The Board has also designated the Senior Executive Vice President to serve as Chief Operating Officer. 3.15 PLDT's organization chart is presented in Annex 3.1. The structure presented therein is appropriate. The three line functions - operations, finance and administration, and development and expansion - each report to an Executive or Senior Vice President. Some of the staff functions - including strategic planning, public affairs, internal audit, electronic data process- ing, and management information systems - report directly to the President; others - including corporate affairs, legal services, collections, and opera- tions support - report to the Chief Operating Officer. All PLDT functions are centralized except for operations, which is decentralized on a geographic basis. PLDT's distribution of its manpower of 17,501 as of December 31, 1991, is given in Annex 3.2; its staffing patterns are summarized in Annex 3.3. Operation and Maintenance 3.16 PLDT is the country's largest telephone operator. As of December 1990, its operations included ibout 600,000 working telephone lines (over 90X of the cotntry total), of which 82% are located in the Metro Manila area. The remainder are spread throughout all Regions of the country, but centered most- ly in the major cities and towns. PLDT also (i) operates a nationwide trans- mission backbone network, through which it provides toll services for its own consumers as well as for most of the small telephone operato: Itara. 1.7); (ii) switches almost all of the international telephone traffi. o and from the country through its four international gateways (para. 1.7); (iii) oper- ates a mobile telephone service in Metro Manila and major towns throughout Luzon; and (iv) provides leased line services to businesses (for data and voice communications) and to record carriers for local loop connections for record services. 3.17 Operations in Metro Manila are combined under one major grouping, while operations in all other parts of the country are organized into a second grouping. The Metro Manila grouping is organized into four divisions, with  - 24 - each one having an exchange operations unit and a service center. Each ex- change operating unit is responsible for the needs of all subscribers served by the particular exchange, while the technical activity related to the provi- sion of service is the responsibility of the centers. Similarly, the Metro Manila divisions do not handle billings or collections. Outside Metro Manila, operations are organized into one division for Luzon and a second for the Visayas and Mindanao. Within those divisions, each exchange is responsible for operations as well as the provision of service. While billing is still centralized, the exchanges handle their own collections. The exchanges and service centers are adequately staffed and equipped to handle operations and maintenance requirements effectively. 3.18 PLDT's operational efficiency and service quality has been weak compared with most other telephone operators in the ASEAN region. This weak- ness is generally related to pcor outside plant, obsolete exchanges, and the overloading of existing services resulting from high unmet demand. In addi- tion, line and service staff are subject to heavy pressures from inadequately served subscribers or unserved applicants. However, its expansion program is Inter alla designed to bring about significant operational improvements. Apart from providing high quality extensions to its networks, the expansion program should significantly improve the technical performance of existing netwoiks through specific upgrading measures and relief of congestion; this, in turn, would enable improvements in staff related performance. 3.19 PLDT contemplates a number of initiatives to address operational weaknesses. PLDT's ratio of staff per 1000 lines is 31; this is relatively high compared with Korea (6), Malaysia (27), and Thailand (20), but better than Indonesia (50). PLDT plans to reduce this ratio to 22 by 1996 largely as a result of operational economies of scale, which it believes can be realized through expansion. PLDT plans also to reduce average faults per 100 lines per month from 14 to 9 by 1996, largely through improved outside plant, rehabili- tation and rearrangements of aging equipment, and replacement of obsolete exchange equipment. Such a major improvement would bring PLDT's average fault performance to a level comparable with Indonesiat/ and would build a sound base for yet further improvements. PLDT has also begun a program to increase the speed of service restoration; by 1996, the Company hopes to increase the proportion of faulty services restored within 48 hours from the current 90X level to 95X. This would be achieved largely through system improvements and technical training. 3.20 One of the Government's important objectives is to improve the op- erational performance of participants in the sector. To that extent, during supervision of the proposed project, the Bank will want to monitor the effec- tiveness of PLDT's performance improvement measures. During negotiations of the proposed loan, PLDT agreed that, for the next five years, it will prepare annually for joint review with the Bank, a comparative analysis of its actual performance against a set of operational performance targets (Annex 3.4), and to implement mutually acceptable recommendations to remedy any shortfall in performance. t/ This is still well below the Part 1 country standard; as an example, the U.K.'s fault per 100 lines per month ratio is 2.0.  - 25 - Development and Expansion 3.21 PLDT has a strong development planning group that has shown excel- lent capabilities for formulating and implementing projects. The group has demonstrated a facility for handling the full range of telephone technology. The modesty of the Company's expansion in recent years (para. 1.10) has re- sulted from political constraints and financial conservatism, and not from inadequate facilities or staff. Training 3.22 PLDT has a substantial and effective in-house training program. The program focuses on (a) orientation of new staff; (b) skills development for working level and clerical staff; (cj technical development, particularly adapting to changing technology, for engineers and technicians; (d) issues related to quality of service for all professional staff; (e) managerial skills development for (i) existing managers, and (ii) staff identified as having potential for promotion to management; and (f) communications courses and training the trainer programs for staff of specially targeted units. In addition, PLDT arranges for on-the-job or external training for deserving staff to cover topics that are not available from the in-house program. These arrangements are appropriate. PLDT is seeking to modernize its training equipment to enable its staff to keep abreast of modern techniques and tech- nology. The proposed project will provide this new equipment. Accounting Systan 3.23 PLDT uses an accrual accounting system. The system, which is based on the practices followed by U.S. telephone companies, observes generally accepted international accounting principles. PLDT presents two separate sets of annual financial statements: (i) the first, which presents the Company's financial condition to its shareholders, is based on valuing fixed assets at historical cost, and (ii) the second, which is used for reporting to NTC, is based on valuing assets at replacement cost. PLDT's accounting system, and the practices it implies, are appropriate. Jtnandail Planning and Budgeting 3.24 PLDT has well staffed units for financial planning and budgeting. The financial planning unit has developed extensive integrated computerized financial planning models, which are used primarily to test the impact of investments and financial decisions, and to provide information to external financiers. PLDT prepares budgets annually. The budget is revised periodi- cally during the year, and comparisons of actual performance against budget is a regular managerial exercise.  - 26 - Commerial Systems 3.25 Most PLDT exchanges are equipped to generate a centralized automat- ic metering accounting tape for recording toll calls; those few that are not use digital systems to record toll calls, and billing records of those calls are therefore generated manually. The records of toll calls are sent daily to the electronic data processing department at headquarters, where the charges are entered into the consumers' accounts. Bills are sent out monthly; to regularize its cash flow, PLDT distributes its consumer accounts among six different monthly billing cycles, each at five day intervals. Customers who generate tolls exceeding P 2,000 within the first fifteen days of their cycle receive an interim bill. Bills are delivered by hand by messenger service. In the case of Government Offices and large industrial consumers, the messen- ger service delivering the bill is responsible for returning as needed to collect the payment. Other consumers may remit payment by cash or check at any of PLDT's business offices, which are located near exchanges or spread throughout its larger areas of operations. All consumers must pay by the last day of the billing cycle, or the amount is shown on the next bill to be over- due. About ten days after delivery of the next bill, PLDT sends a disconnect notice to those accounts that are still outstanding. These notices are deliv- ered by hand and include a delivery receipt. A consumer may be disconnected after ten days following receipt of the notice. The Company is deliberate about disconnecting consumers, so that this policy is effective. Audit 3.26 PLDT has its annual financial statements audited for inclusion in its Annual Report and presentation to its Annual Meeting. The accounting firm of Sycip, Gorres, Velayo and Company (SGV), which enjoys a strong professional reputation region-wide, has been reelected to serve as PLDT's external auditor since the 1960s; SGV coordinates with Arthur Andersen and Co. for reporting to the U.S. Securities and Exchange Commission. At negotiations, PLDT agreed that, by June 30 of each year, it will furnish to the Bank audited financial statements for the previous year, together with the certification and related report prepared by an acceptable auditor. 3.27 PLDT has an extensive internal audit department. This unit has broad responsibilities, including: (i) safeguarding of assets; (ii) optimizing the usage of assets; (iii) reviewing internal controls and ensuring that they are followed; (iv) ensuring that Company policies are followed; (v) reviewing systems and procedures for consistency with Company policy; (vi) ensuring the consistency of all contracts and negotiated arrangements are consistent with Company policy; and (vii) ensuring that all revenues are accounted for and collected. Internal Audit verifies inputs to the Company's computerized ac- counting system; this activity is then reviewed by the external auditor. Taxes 3.28 PLDT is liable for income tax, assessed at 35X of income after in- terest. The pre-tax income figure has been adjusted to recognize certain  * 27 - expenditures related to foreign exchange losses and interest during construc- tion that had been capitalized for reporting purposes as expenses during the current year. The Company must also pay a franchise tax, assessed at 3X of gross operating revenues, and real estate taxes. PLDT is liable for customs duties in the range of 15-30% on all imports. Insurance 3.29 PLDT insures its assets through a combination of self insurance and commercially purchased policies. Risk management analyses are performed regu- larly by the Company's security division. At appraisal, these practices were reviewed and found satisfactory. Dividends 3.30 PLDT has paid dividends on its common stock continuously since 1954. Since 1988, the amount paid has been P 3.20 per share, representing a rate of about 4.5X on paid-in capital, and a yield of 3-5X on the recent mar- ket price. In addition, PLDT has been paying dividends regularly on its vari- ous series of cumulative preferred stock. Dividends on all common stock and the 15X preferreds are declared quarterly; dividends on all other preferred shares are declared semi-annually. These dividend levels are not excessive. Moreover, as PLDT's shares are publicly listed in both the Philippines and the U.S., its declarations of dividends are given widespread coverage. In the current political and economic climate, PLDT wants to avoid appearances of paying out large dividends at the expanse of service quality or expansion; therefore, the publicity attendant to its declarations of dividends effective- ly acts as a deterrent against possible excessive increases.  4. FINANCIAL ANALYSIS A. Background 4.1 PLDT maintains its own accounts and manages its own financial af- fairs. As such, it has authority to set prices, formulate its own investment program, enter into contract with suppliers of goods and services, and borrow from foreign, as well as domestic, lenders. However, its financial autonomy is limited. As a carrier of a regulated service, its prices as well as its planned investments are subject to NTC's approval. Despite its financial strength (para. 4.2), PLDT's ability to raise needed capital from foreign commercial sources is limited by lender concerns about country risk; thus, in recent years, the Company has sought Government guarantees for official foreign loans to supplement finance it is raising from commercial sources. B. Past and Present Financial Performance 4.2 PLDT's financial performance for 1988-91 is presented in Annex 4.1 and summarized in Tables 4.1 and 4.2: Table 4.1: PLDT's Key Financial Indicators - 1988-91 (Pesos Billion) FINANCIAL YEAR ENDED DECEMBER 31 1988 189 1990 1991 Actuals OPERATING REVENUES 7.7 9.5 12.8 16.6 OPERATING EXPENSES 4.4 5.6 7.4 9.0 OPERATING INCOME 3.3 3.8 5.4 7.6 NET INCOME 2.2 2.1 3.2 4.7 CAPITAL EXPENDITURES 1.9 3.3 5.5 7.7 REVALUED RATE BASE 24.0 24.2 35.8 42.3 TOTAL ASSETS 22.9 26.6 36.2 44.0 RETAINED EARNINGS 3.9 5.6 8.5 12.7 4.3 PLDT experienced severe cash flow constraints in the mid 1980s. However, during the last four years, the Company has recovered strongly and is currently one of the healthiest in the Philippines. During this period, reve- nues, expenditures and profitability all grew by about 29X per year. Much of this growth resulted from the expanded use of existing facilities. The Com- pany's rate base, after holding relatively static during 1987-89, grew by about 0 17.6 billion (about 48X) in 1990 and P 6.5 billion (about 181) in 1991; of that amount, about P 11 billion represented new plant or work in progress, while financial transactions related to the valuation of assets ac- counted for the remainder. While these  * 29 - Table 4.2: PLDT's Key Financial Ratios - 1988-91 FINANCIAL YEAR ENDED DECEMBER 31 1988 1989 1990 1991 Actuals CURRENT RATIO 1.5 1.7 1.6 1.4 QUICK RATIO 1.3 1.4 1.3 1.2 OPERATING RATIO 57% 59% 58% 54% NET PROFIT MARGIN 29% 22% 25% 28% INTEREST COVERAGE 2.7 2.9 3.7 4.9 DEBT SERVICE COVERAGE RATIO 1.9 1.8 2.3 2.4 DEBT/TOTAL EQUITY - WITH REVAL. SURPLUS 36:64 34:66 35:65 36:64 - W/OUT REVAL. SURPLUS 57:43 55:45 56:44 52:48 RETURN ON RATE BASE - HISTORICAL (X) 23% 20% 23% 22% - REVALUED (%) 11% 10% 9% 11% SELF-FINANCING RATIO (%) 74% 33% 78% 13% ACCOUNTS RECEIVABLE - MONTHS 4.0 3.1 3.0 2.5 ACCOUNTS PAYABLE - MONTHS 2.3 3.3 3.2 4.2 results have been recorded in pesos, that currency held relatively stable at P 22-US$1 from early 1987 through mid 1990; it then devalued to about P 28 - US$1 by late 1990 and held steady at that level during 1991. Thus, about 38% of the rate base increase in 1990 and about 20% of the increase in 1991 refl- ect the changes in the value of the peso and not additions to plant in serv- ice. 4.4 PLDT's key financial ratios for the 1988-91 period all portray a picture of financial strength. The current, quick, interest coverage, debt service coverage and self financing ratios are all comfortably high and point to outstanding liquidity for a Company that provides a capital intensive ser- vice. The drop in rate of return in 1990 and 1991 reflects the increase in PLDT's rate base and not a diminution in the Company's performance. The one area that may reveal some weakness is the debt/equity ratio, which at an aver- age of 55:45 (net of revaluation reserve) is slightly higher than normal for a telephone utility in this region. When considering that about half of PLDT's paid in capital was raised through preferred shares that the subscribers must purchase as a condition of obtaining their connections (para. 3.11), this ratio indicates that capital solicited from bona fide investors is very thin. Finally, the wide spread between the interest coverage and debt service cover- age ratios reflects the lack of available long-term debt instruments in the Philippine markets. Because the longest available instruments have a term of three years, and because that maturity is frequently unavailable in periods of exchange rate instability, PLDt must finance the local component of its in- vestments with short-term loans; and its financing strategy presumes that it will roll these loans over as they mature. This strategy is appropriate in the context of the Philippines. Regulatory LUmits on Revenues 4.5 PLDT must seek NTC's approval for revisions to its tariff. NTC's guidelines impose two important restrictions on the level of PLDT's revenues:  - 30 - (i) after covering operating costs, revenues may yield no more than 12% on PLDT's revalued rate base; and (ii) PLDT must remit a stipulated share of rev- enues for toll calls to the local operators handling those calls. During the last four years, PLDT has been sensitive to the political implications of ex- cess profitability, and has adopted a tariff designed to yield 7-10% on its revalued rate base. While revenues have thus been lower than the maximum al- lowable, they have been sufficient to maintain the Company's financial health. PLDT expects to continue observing a policy of pricing restraint during the next few years. While the revenue sharing guidelines are expected to improve the financial prospects of the smaller independent local carriers, the impact on PLDT is not expected to be great. PLDT currently handles more than 90% of local service and is expected to continue doing so for the foreseeable future. Tadffs 4.6 PLDT's tariff includes provisions whereby its charges for local service and international calls, which are denominated in Pesos, can be linked to and therefore maintain parity with the US dollar; in contrast, rates for internal long distance calls are denominated in Pesos and include no mechanism to adjust for exchange rate fluctuations (a detailed discussion of PLDT's tariff is given in Section B of Chapter 5). These arrangements do provide the Company with substantial protection against variations in the peso-US dollar exchange rate; however, they do not protect PLDT against variations between the US dollar (or the peso) and other hard currencies. 4.7 Since the mid 1980s, PLDT has not sought changes to the U.S. dollar equivalence of its local service charges or to the peso-denominated level of domestic long distance tolls. However, in 1990 PLDT lowered its international rates by 20%. This action represents the first appreciable change in the U.S. dollar denominated value of thosef rates in more than five years. PLDT shares revenue on outgoing international calls with destination countries and re- ceives a share of revenues generated abroad for incoming international calls. The Company estimates that incoming international calls outnumber outgoing calls by about 9:1. When combining international net revenues (incoming and outgoing) with local service revenues, about 90% of PLDT's revenues are effec- tively indexed to the U.S. dollar. In recent years, these dollar-based reve- nues have substantially exceeded PLDT's annual foreign exchange outflows. Foreign Exchange Exposure 4.8 PLDT's ample dollar-based revenues enabled the Company to raise considerable foreign debt. The Company has followed very prudent policies with regard to its foreign exchange exposure. Because its revenues are U.S. dollar related, the Company has limited itself, as far as practicable, to raising U.S. dollar denominated loans. As the peso-U.S. dollar exchange rate varies, the Company's dollar-based revenues adjusts in direct relationship with the requirements for servicing this debt. This policy has enabled PLDT to maintain control over its debt service obligations as a percentage of reve- nues. As of December 31, 1990, PLDT had outstanding P 17 billion (about US$607 million equivalent) in total lor.g-term debt. Some P 15 billion (about  - 31 - US$536 million) of these estimated borrowings were expected to be denominated in U.S. dollars, with the remainder being split between other foreign loans and local currency debt. As such, PLDT's exposure to cross currency risk is limited and well within its capacity to carry prudently; moreover, because it has managed its foreign exchange exposure so prudently, the Company will con- tinue to have ample capacity to borrow for the foreseeable future. 4.9 During the last four years, the Company has raised more than P 10 billion in fresh loans to finance the X-5 Program and other ongoing in- vestment activities. While PLDT's balance sheet is strong enough to accommo- date the additional long term borrowings needed to finance the X-5C and other planned investments, its capacity to borrow from commercial sources has been tainted by issues related to counti.y risk. In particular, by participating in the Government's debt rescheduling program in 1986, PLDT compromised somewhat its credit with existing lenders. Although the Company has been remitting its payments in pesos to the Central Bank on schedule, the lenders will receive the corresponding payments from the Central Bank much later than was agreed under the original loan agreements. When so requested by specific lenders, PLDT has followed accepted practice by purchasing some of its obligations at a discount; while this practice has provided financial advantages to both the Company and the particular lenders, it has resulted in a linkage between PLDT's credit and the commercial banking community's perception of country risk. Accounts Receivable 4.10 Despite effective billing and collection systems, PLDT's accounts receivable still equal nearly three months' sales. This largely reflects the time involved in settling accounts with other international carriers. Based on the Company's experience with these transactions, PLDT would have difficul- ty reducing accounts receivable below current levels. Asset Valuation 4.11 Asset revaluation is only conducted every several years at irregu- lar intervals, in connection with rate submissions to NTC. The revaluation usually follows an engineering appraisal of PLDT's plant and equipment by an independent firm. The last appraisal was conducted by the Asian Appraisal Company, a Philippine firm enjoying a good reputation within the region. The methodology followed is acccptable. Plant in service is revalued, but work- in-progress is not. PLDT takes the results of asset revaluation into the ac- counts it maintains for regulatory purposes; however, assets are valued at historical cost in the accounts maintained for reporting to shareholders. This practice is appropriate. C. Financing Plan 4.12 PLDT's financing plan for 1992-96, the period of the proposed pro- ject, is summarized in Table 4.3. The proposed project represents only 13X of  - 32 - PLDT's investment program for tht 1992-96 period. The proposed Bank loan represents only 7X of PLDT's external financing for the same period. 4.13 On an historical cost basis, the investments that PLDT will be im- plementing during that period will more than double PLDT's rate base. PLDT aims to realize a healthy growth rate of about 10 (para. 1.13(a)), at least through 1998. Whether the Company can indeed realize this growth will depend on its ability to raise the needed finance during a period when commercial sources of credit are wary of increasing their exposure to Philippine risks. Clearly, PLDT's investment program needs to be consistent with the Company's financial and implementation capabilities. At negotiations of the proposed loan, PLDT agreed to (i) conduct jointly with the Bank an annual review of its investment program for the next five years and its investment accomplishments for the previous two years, and (ii) adopt any mucually acceptable adjustmen- ts. Table 4.3: PLDT's Financing Plan - 1992-96 Pesos Million Percent i. Internal Cash Generation net of Working Capital Needs 30.803 55X 11. (Less): Debt Service A. Long-Term Loans Foreign Borrowings (16,187) -27X Local Currency Loans (6.182) -10% Subtotal (22,369) -37% B. Redemption of Preferred Shares (517) -1% Total '22.8861 ; III. Funds Available for Cash Dividends 7.917 IV. Cash Dividends (2.247) J1 V. Balance Available for Investment 5.670 au VI. Construction Proposed Project 8,087 131 Other Capital Expenditures 52,217 871 Total 60.304 VII. Balance Required to be Financed 54.634 VIII. Sources of Finance Subscriber Investment Plan 852 1I Subscriber Deposits 200 11 Proposed Bank Loan 4,240 7% Conercial or Other Borrowings 49,342 82% Total 54.634 9 4.14 PLDT plans to raise about 82% of its overall financing requirements through commercial and other borrowings. International commercial banks are  - 33 - expected to provide a portion of these needs, and international agencies that serve the private sector, such as IFC and the Asian Development Finance Corpo- ration (ADFC) are expected to provide still an additional portion of these funds. However, the major portion is expected to be raised from supplier credits in connection with the X-5 and X-5C programs. The financing plan for the X-5 is fully confirmed and assembling the financing package for the X-5C is virtually completed; the Bank's participation in PLDT's overall financing plan appears to be having a catalytic effect on the process. D. Future Finance 4.15 Financial projections for 1992-98 are presented in Annex 4.1. A summary of projected key financial indicators is given in Table 4.4, and a projection of key financial ratios is provided in Table 4.5. These projec- tions are based on the following: (a) PLDT's local service charges and its international toll revenues are expected to continued being related directly to the U.S. dol- lar. Similarly, its domestic long distance revenues are expected to continue being denominated in pesos. (b) The peso-U.S. dollar exchange rata is expected to decline each year during the projection period in relation to the difference between the assumed local inflation rate (10%) and the assumed inter- national inflation rate (3.9%). (c) The scope of PLDT's service is expected to grow substantially dur- ing the projection period. Average annual growth in (i) the number of working stations is projected to be about 15%, and (ii) the vol- ume of overseas toll calls is projected to be about 12%. The bulk of this growth is expected to be realized during 1992-96, as PLDT completes various components of the X-5, X-5C, the proposed proj- ect, and other investments cu:rently under implementation. (d) Through 1996, PLDT's investment program is dominated by prejects tv-it are well defined (the X-5, X-5C, and the proposed project), so that the annual cash flow for investment may be projected within reasonable levels of tolerance. Beginning in mid-1994, the invest- ment program is projected to be dominated by the X-6. While the framework for that project has been developed, some details have yet to be defined in detail. Therefore, the projections assume investment streams for the X-6 and notional investments for other projects yet to be identified starting at about P 3 billion in 1994, moving to about P 14 billion in 1995, and stabilizing there- after at about P 10 billion. (e) The Company has agreed, under existing loans, to meet financial performance targets different from those that will be sought under the proposed loan. These targets include interest coverage and a variety of operating and liquidity ratios. The projections were  Table 4.4: 1991-98 KEY FINANCIAL INDICATORS (Pesos Billion) Operat Revenues 16.6 17.9 20.8 24.4 29.1 34.7 41.4 49.4 Operating Expenses 9.0 10.6 12.7 15.0 17.5 19.8 22.9 25.9 Operating Income 7.6 7.3 8.1 9.4 11.6 14.9 18.6 23.5 Net Income 4.7 4.8 4.8 5.1 5.4 5.9 7.4 10.2 Capit Expenditure 7.7 8.8 12.7 14.0 15.3 9.4 9.5 10.0 Rate Base 42.3 58.5 75.1 96.7 121.6 147.6 170.8 196.5 Total Assets 44.0 52.9 66.3 81.9 98.7 109.3 118.4 127.3 Retaned Earnigs 1 2.7 17.1 21.5 26.1 31.0 36.4 43.3 53.1 Table 4.5: 1991-98 KEY FINANCIAL RATIOS Current Ratio 1.4 1.4 1.1 1.4 1.1 1.3 1.1 1.3 Quick Ratio 1.2 1.1 0.9 1.1 0.9 1.0 0.9 1.0 Operating Ratio - 54% 59% 61% 61% 60% 57% 55% 529 Net Profit Margin-(%) 28 27 23% 21 189 174 181 21 Interest Coverage 4.9 4.7 2.7 2.3 2.0 2.0 2.3 2.8 Debt Service Coverage 2.4 1.9 1.5 1.3 1.4 1.3 1.5 1.5 DebtaTotl Equity - with Reval. Surplus 36:64 39:61 42:58 48:52 50:50 50:50 46:54 42:58 - WlOut Reval. Surplus 52:48 52:48 54:46 57:43 57:43 56:44 51:49 46:54 Retum on Rate Base - Historical() 22 17 16% 15% 15% 15 17% 198 - Revalued(9) 11. 89 8% 89 8% 8% 8 9% Self Flnancng Ratio - (%) 13% 256 236 59 16 8 51% 421 Accowunts Receivable - Monfts 2.5 2.5 2.9 2.9 2.9 2.9 2.9 2.9 Acoounts Payable - Months 4.2 3.1 3.0 2.9 2.8 2.8 2.8 2.8  - 35 - formulated to ensure that PLDT complies with all its agreed targets, not only the covenants that will be sought in conjunction with the proposed loan. 4.16 PLDT believes that its projected growth rates, combined with its current rate levels, should enable it to realize an 8% rate of return on its revalued average net fixed assets in operation during 1992-98. Its financial performance based on this assumption would be consistently satisfactory thr- oughout the period. At negotiations PLDT formalized this expectation by ag- reeing to take steps, including inter alia proposing increases to its tariff as needed, to cover all expenses including depreciation and taxes, and yield at least an 8% return on its revalued net fixe.d assets in operation. To en- courage effective debt management, PLDT also agreed to incur additional debt only if a reasonable forecast of its net revenues after expenditures for each year during the term of the debt to be incurred would be at least 1.1 times its projected debt service requirement. This latter target is somewhat lower than what PLDT is projecting; however, it reflects the uncertainty shared by PLDT and the Bank about whether PLDT's local debt can consistently be rolled over for three years at a time. If the maturities of local borrowers would be for two years instead of three, the debt service coverage ratio would drop to 1.1. This would affect PLDT's cash flow, but not its accrual performance. 4.17 The projections indicate that while PLDT is expected to remain fi- nancially strong, it is facing a period of high growth. Revenues and profit- ability are projected to grow by about 17X and 12% per year, respectively. In the same period, PLDT's rate base is expected to increase by nearly 370%, or 24% per year; at the same time, total assets are expected to increase by about 190%, or about 16% a year. The Company is projecting some cash flow stringen- cy throughout the period, but especially during the years of heaviest invest- ment expenditure, 1994-96. For the whole period PLDT is projecting an average self-financing ratio (SFR) of about 20%, and a debt service coverage ratio of about 2.1. However, for 1994-96, this ratio is expected to average about 10% for the whole 1992-98 period; the debt service coverage ratio is expected to average about 1.6; however, this ratio will average about 1.3 for 1994-96. This is acceptable.  5. ECONOMIC ANALYSIS A. Beneflts 5.1 The benefits of the project would accrue to all sectors of the com- munity through improved access to telephone facilities and improved network quality. Because the project aims to partly correct the imbalance in services between major cities and provincial areas, the greatest benefits are likely to accrue to businesses and the public in the 128 provincial municipalities where new and expanded facilities will markedly improve existing communication ser- vices. Mostly these are areas recognized by the Government as offering high economic returns from investment in infrastructure. Here, access to modern telecommunications services will help stimulate growth and investments and increase the efficiency of market systems between (i) adjacent provincial com- munities, and (ii) provincial areas and the major cities. In addition, spec- ial emphasis on providing new facilities for seven industrial estates will help attract the development of secondary industries which are crucial to Philippine economic growth. Existing telephone services will benefit from the increase in access to about 149,000 new working telephone lines; the intercon- nection if 6 isolated exchanges to the national telephone network; and the ex- pected improvements in network and operator performance quality resulting from PLDT's overall development program of which the proposed project is a part. 5.2 In addition, the installation of rural PCOs in 97 municipalities without telephone service will provide these communities with basil' access to telecommunication services and thereby improve their participation in the Philippines economy. Benefits to these communities will include more effic- ient use of high cost transportation services, improved access to market in- formation, and extension of Government services. Apart from direct benefits to businesses, the provision of modern telephone facilities will add to the quality of life by providing voice communication opportunities between sepa- rated family members and improving the performance of public oriented servic- es; especially medical and emergency relief. 5.3 The Government will also benefit, first as a user of telecommunica- tions services and second through increased transfers from the sector as a re- sult of increased revenue generation and more efficient use of sector resourc- es. During 1991-1997 PLDT is expected to provide an additional US$75 million to the Government in the form of duties and taxes as a result of the project. B. Tariffs 5.4 PLDT's telephone tariffs (summarized in Annex 5.1) consist of an installation charge, fixed monthly network access charges (monthly rental) and call charges for domestic long distance and international (toll) calls. The monthly network access charges also entitle the customer to unlimited local calling as the tariff does not include separate charges for local calls. In  - 37 - addition, a compulsory subscriber investment plan that requires subscribers to buy PLDT shares when ordering new installations, generates equity for PLDT and has a dampening effect on demand. 5.5 The key factors on which tariffs are determined are: (a) overall tariff revenues to PLDT may not yield more than a 12% return on a rate base of revalued assets plus an allowance for operating expenses; (b) monthly rental charges are linked to the US$ exchange rate; and (c) charges for international calls are set in US$ and converted to pesos at the prevailing exchange rate. PLDT regularly seeks NTC review of rental charges pegged to foreign exchange. Appropriate adjustments are normally granted automatically. 5.6 The overall level of the tariff and the resulting revenues are ade- quate to support and justify the proposed network expansion under this project as indicated by the financial rate of returr. (para. 5.9). Furthermore, the tariffs recover the long run incremental costs of the local network and long distance project components respectively. Thus, revenues from local network access resulting from PLDT's expansion program are estimated at P53,000 per subscriber vs. long run incremental costs of P52,000 per subscriber. Domestic long distance plus international revenues resulting from the program are esti- mated at P137,000 per suvuu.Uber vs. long run incremental traffic sensitive costs of P74000 per subscriber. 5.7 Nevertheless, PLDT is aware that its tariffs are not optimized in the following respects: (a) monthly rental charges barely cover their long- run incremental costs and should be reviewed; (b) local call charges (pres- ently free) should be introduced, at least during periods when local network congestion occurs; (c) national long-distance charges are believed to be below cost and should be increased; (d) PLDT is too dependent on excessively high international charges; and (e) PLDT's tariff structure is much too complex with 15 local service location classes, each with their own tariff, and 59 domestic toll distance bands; simplification is warranted. 5.8 In the difficult area of obtaining government authorization for private monopoly or utility price changes, both PLDT and NTC deserve some credit for instituting a system which involves a considerable amount of auto- maticity in tariff adjustments and which is related to costs on a company-wide basis. Nevertheless, over the medium term, the tariff structure should be reviewed and important improvements introduced. Accordingly, during negotia- tions, the Government provided the Bank with a letter through which it indi- cated its intention to develop a policy framework within which the structure of telephone tariffs could be reviewed jointly by NTC and the Bank (para. 1.16). C. Return on Investment 5.9 The internal rate of return of the project based on financial flows (FRR) is 15X which justifies the investment as it is considered to be well above the cost of capital for this type of project. A summary of the calcula- tion results is given in Annex 5.2. The economic rate of return (ERR) is cal- culated at 211. The ERR is greater than the FRR due to the elimination of tax  - 38 - and duties, and the adjustment of unskilled labor rates using a conversion factor of 0.8. The resultant ERR is considered conservative and does not take into account consumer surplus and the benefits that accrue to the economy as a whole as a result of improved telecommunications services. Because these factors are difficult to quantify they are not included. In testing the sen- sitivity of the ERR, the most likely worst case scenarios and their effect on the ERR would be: (a) a delay of 18 months in connection of new customers re- sulting in a delayed revenue stream (ERR - 14%); (b) an increase of 10% in operating costs (ERR - 20%); (c) a reduction in tariffs resulting in a fall in operating revenue by 10% (ERR - 15%); and (d) a small increase of 5% in in- vestment costs, over and above the project contingency allowances (ERR - 19%). Combining the above would result in a fall in the estimated ERR to 11%. While such a combination of events is unlikely, after taking into account the un- quantifiable benefits resulting from the project, under this worst case sce- nario the project would still be acceptable. D. Least Cost Solution 5.10 The proposed project represents the least cost solution for expand- ing and modernizing PLDT's existing network. Standard telecommunications planning principles have been used in determining the most appropriate type of equipment and locations for telephone and transmission systems. Detailed design of outside plant networks will be undertaken by consultants, who will be required to tailor the local networks to serve demand locations using stan- dard minimum net present value dimensioning methods. The modernization pro- gram includes the replacement of obsolete exchanges that cannot be expanded further and those for which the high cost of operations and spare parts is too great to justify the exchange's retention. L. Project Risks 5.11 There are no significant risks associated with the project. Howev- er, although PLDT's project management capabilities are assessed by IFC as being very good (para. 1.14), taking into account that the proposed project needs to be managed in conjunction with the ongoing X-5 and X-5C projects and would extend PLDT's project management capacity beyond previous experience, project management consultants are to be engaged under the project. These consultants would assess and, if necessary, strengther. PLDT's project manage- ment capabilities (para. 2.30).  6. AGREEMENTS AND RECOMMENDATIONS A. Agreements Reached 6.1 The following agreements were reached during negotiations: The Government agreed to: (a) (i) furnish to the Bank a summary of the results of its annual re- view of the implementation of its telecommunications policies; and (ii) seek the Bank's comments if major changes in any of these pol- icy are expected (para. 1.16) DBP agr6eed to: (a) furnish to the Bank by June 30 of each year, a copy of its annual financial statements certified by an acceptable auditor (para. 3.9) (b) have its records in relation to the Special Account audited for each fiscal year, and the results of the audit furnished to the Bank by June 30 of such year (para. 2.27) PLDT agreed to: (a) appoint management consultants, according to terms of reference and a selection procedure acceptable to the Bank, by not later than June 30, 1993. (para. 2.30) (b) have its records in relation to Statement of Expenditures, being maintained for disbursement purposes, audited for each fiscal year and the results of the audit furnished to the Bank by June 30 of the end of such year (para. 2.27) (c) furnish to the Bank by June 30 of each year audited financial statements for the previous year, together with the certification and related report prepared by an acceptable auditor (para. 3.26) (d) (i) for the next five years, prepare annually for joint review with the Bank, a comparative analysis of its actual performance against targets for its construction program and its operations; and (ii) implement mutually acceptable recommendations to remedy any short- falls in performance (para. 3.20) (e) (i) conduct jointly with the Bank an annual review of its invest- ment program for the next five years and its investment accom- plishments for the previous two years, and (ii) adopt any mutually acceptable adjustments (para. 4.13)  - 40 ^ (f) take all necessary steps, including Inter alla proposing increases to its tariff as needed, to cover all expenses including deprecia- tion and taxes, and yield at least an 8% return on its revalued net fixed assets in operation (para. 4.16) (g) incur additional debt only if a reasonable forecast of its net rev- enues after expenditures for each year during the term of the debt to be incurred would be at least 1.1 times its projected debt ser- vice requirement (para. 4.16) 6.2 Following negotiations the Government sent a letter (Annex 1.4) to the Bank confirming that it would: (a) conduct an annual review of progress with regard to implementing its policies and plans, including the provisions of Departmental Circular 90-252; (b) by January 1, 1994, review its policy framework including the structure of telephone tariffs; and (c) share with the Bank the results of those reviews and, if feasible, implement the recommendations reached. Moreover, the letter affirmed that the Government would share with the Bank the results of these and other reviews that might result in major changes in sector development policy, and solicit the Bank's views prior to deciding any such changes. 6.3 The conditions of effectiveness of the proposed loan (para. 2.23) would be the execution of satisfactory documents for: (a) onlending to the syndicate and syndicate operations (between DBP and the other participating Banks); (b) onlending to PLDT (between the syndicate members and PLDT); and (c) guarantee of the Bank loan, coverage of the cross currency risk, and secondary lending (between the Government and DBP). B. Recommendation 6.4 Under the agreements reached on the above items. the project con- stitutes a suitable basis for a Bank loan of US$134 million equivalent to be lent to DBP. This loan would have a term of 20 years, including five years of grace on repayment of principal, and carry the standard variable interest rate. o0o.  ANNEXES  n m Iw r>c4O > jI iI~~IiI IIiI III I Ii ul1 1S - - - - - - - - - - - - - - - i [bIll~~ -------- ---- *