Mexico - Fourth Railway Project

Document of The World Bank p Eff FOR OFFICIAL USE ONLY Report No. 3078b-ME STAFF APPRAISAL REPORT FOURTH RAILWAY PROJECT MEXICO November 20, 1980 Projects Department Latin America and the Caribbean Regional Office 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 Currency Unit = Peso (Mex$) US$ 1 = Mex$ 23.0 Mex$l = US$0.043 Mex$ 1 million = US$43,000 Fiscal Year January 1 to December 1 System of Weight and Measures: British/US 1 meter (m) = 3.28 feet (ft) 1 kilometer (km) = 0.62 mile (mi) 1 kilogram (kg) = 2.2 pounds (lb) 1 metric ton (m ton) = 2,205 pounds Abbreviations ALALC Latin American Free Trade Association BANOBRAS National Bank for Public Works and Service CN Constructora Nacional de Mexico CNCP Commission for Port Coordination CTC Centralized Traffic Control DGA General Directorate of Airports, SCT DGP General Directorate of Planning, SCT Hacienda Secretariat of Finance IMSS Mexican Institute of Social Security N de M Ferrocarriles Nacionales de Mexico NAFINSA National Financing Association NAP National Airport Plan PEMEX Petroleos Mexicanos SAHOP Secretariat of Human Settlements and Public Works SCT Secretariat of Communications and Transport SPP Secretariat of Programing and Budgeting  FOR OFFICIAL USE ONLY STAFF APPRAISAL REPORT FOURTH RAILWAY PROJECT MEXICO TABLE OF CONTENTS Page No. I. THE TRANSPORT SECTOR ..... ................................ I1 A. General ............. 0 .......... .......................... 1 B. The Transport System ................ ....................... 2 C. Planning and Coordination ... .......... ........... ......... 6 II. THE RAILWAY SUBSECTOR ........,,,,............. .8 A. Background ............... .- ..... 8 B. Organization ....... 0 ...........................-@6@*s--s-dee 10 C. N de M Mfanagement, Staff and Tfaining ....... ............... 10 D. Railway Facilities.......... .........* ..* .....*....... 11 E. Traffic ........................ . . . . . . . . 0 . .. .. 13 F. Operations ...................................... . 15 G. Tariffs and Costs ......................................... 16 H. Budget, Accounting and Audit ......................, 19 III. THE INVESTMENT PLAN AND THE PROJECT ...... ...................... 20 A. N de M's Investment Plan ........................ ...... 20 B. The Project and the Proposed Loat .......................... 21 C. Main Project Items ............................ *... 22 D. Cost Estimates .................. .................. 23 E. Financing Plan ..................................... 23 F. Project Implementation . . . . ........................ 24 G. Plan of Action . . ............ 24 H. Procurement . . . ................ 26 I. Disbursement .............................. ..... 27 IV. ECONOMIC EVALUATION ............... .. ....... ...... 28 A. General .................................................... 28 B. Benefits and Economic Returns ........................... - 28 C. Overall Economic Evaluation ................................e, 30 D. Sensitivity and Risks .................................... 30 This report is based on the findings of an appraisal mission w*hich visited Mexico in May 1980. The mission comprised Messrs. }I. Lal (railway engineer), N. Rasheed (financial analyst), (Ms) K. Sierra (project economist), J. Veniard (sector economist) and J. Kesson (consultant). The report has been edited by Miss V. Foster. This ocurocnt has a restricted distribution and may be used by recipients only in the performance of their officiai duties. its contenst may not otherwise be disclosed without World Bank authorization.  TABLE OF CONTENTS (Continued) Page No. V. FINANCIAL EVALUATION ..*......... ......*.* * * * * .. .' . . 31 A. Past Financial Performance .* .................... s ...# ..... *O.. 31 B. Forecast Financial Performance............................. 34 C. Sensitivity Analysis .... * .................... . .........O-* 38 VI. AGREEMENTS REACHED AND RECOMMENDATION ...... .. .... 40 TABLES 1.1 Distribution of Public Investment ...................... 42 1.2 Summary of Domestic Freight and Passenger Traffic by Mode ...... 43 2.1 Staff Data - N de M (2 pages) .................... I ...... 44-45 2.2 Current Rolling Stock Data .. ..... .. ........................... .46 2.3 N de M - Freight Traffic 1970-1979 .................... ......... 47 2.4 N de M - Freight Traffic Forecasts 1980-1985 .................. 48 2.5 N de M - Passenger Traffic ....... .............................o. 49 2.6 N de M - Operating Statistics .50 3.1 N de M - Investment Program ...... 51 3.2 SCT Infrastructure Works 1981-1985 (2 pages) ..... ...... .. 52-53 3.3 N de M Project and Bank Loan ................................... 54 3.4 List of Goods to be Financed from Bank Loan .55 3.5 N de M - Track Renovation Program (2 pages) .56-57 3.6 N de M - Locomotive Requirements 1981-1985 ..................... 58 3.7 N de M - Freight Car Requirements 1981-1985 (2 pages) 59-60 3.8 Estimated Schedule of Disbursements ......................... 61 4.1 Economic Rates of Return ........ ............ 62 5.1 Nde M - Income Statements 1975-1979 .................... . 63 5.2 N de M - Summary Cash Flow Statements 1976-1979 ................ 64 5.3 N de M - Summary Balance Sheets 1976-1979. 65 5.4 Nde M - Income Statements 1980-1985 ..* ........................ 66 5.5 N de M - Cash Flow Statements 1980-1985 ........... ..*67 5.6 Nde M - Balance Sheets 1980-1985 ................... 68 ANNEXES 1. N de M Track and Equipment Development o .................. 69-71 2. N de M Operations Review . ............................ ....... 72-73 3. Technical Assistance Program - Guidelines ............ ............ 74-75 4. Details of Financing Plan ..................................... . 76-77 5. Freight Traffic Forecasts: Rationale .......................... 78-84 6. Economic Evaluation of the N de M Investment Plan ............ 85-93 7. Economic Evaluation of the SCT Infrastructure Program ..o J- 94-102 8. Methodology and Principal Assumptions for the Financial Forecast (1980-1985) ......................................... 103-105 9. Transfer of Medical and Social Insurance and Pension to Mexico's Social Security System ................. ........, 106-108 10. Selected Documents and Data Available in the Project File 109  TABLE OF CONTENTS (Continued) CHART Chart 1 - Organization Diagram - N de M - World Bank 21793 MAPS IBRD 3655R1 - Mexico: Railways IBRD 11844R - N de M Traffic Density   I. THE TRANSPORT SECTOR A. General 1.01 Transport has played an important role in the economic development of Mexico, and, by the mid-1970s, the transport system was generally adequate. This system was supported over the years by sufficient public investments (of about 20% of the total budget) for transport infrastructure in all modes and a strong, mostly privately financed bus, truck and aviation industry providing an adequate fleet of vehicles and levels of service. This combination produced a system with a good modal balance and a capacity to serve the demand. 1.02 The general adequacy of the transport system up to the mid-1970s called for a policy of selective expansion and modernization as required to meet the needs of a growing economy and to support Mexi 's strategy of spatial decentralization of population and economic activit,. However, relative reductions in transport sector investments since 1973, coupled with a surge in economic growth and rapidly increasing demand for transport services, have led to a situation in which the system faces serious bottlenecks. This situation is already affecting the railway system and backlashing to some of the ports and the highway system. 1.03 Public investment support to the transport sector decreased after 1973 because of a shift of Government priorities to other sectors under macro- economic measures for controlling inflation. The share of transport sector in total public investment dropped to 16.6% in 1974 and to 9.1% by 1979 (a low of about 1% of GNP). In the 1980 budget, it stabilized at about 9.3%. The years 1977 and 1978 represented a period of real annual reductions in transport investments, and 1979 and 1980 showed a real growth of 6.4% p.a., modest in relation to the growth of total public investment (nearly 14%). The distribution of investment among the modes has shown a relative shift in the last few years, with highways diminishing its share from some 65% in the early 1970s to the present 43%. Ports remained relatively constant at some 9% during the same period, while aviation fluctuated between a low of 4% and its present high of 13%. Railways' share increased from its level of some 22% in the early part of the decade to its present level of 35% (Table 1.1). 1.04 Mexico relies upon extensive road and rail networks for its general transportation needs. Pipelines and coastal shipping are important, but specialized, while aviation, the most dynamic mode in terms of growth, is relatively small and highly specialized. In 1978, road transport carried about 41% of all ton-km generated in the country and about 93% of all pass-km, while the railways carried about 21% of the ton-km and 3% of the pass-km. The remaining traffic, consisting for the most part of petroleum products, was moved by pipelines and coastal shipping, 23% and 15% respectively of all ton-km generated in the country. Finally, aviation's share of intercity passenger traffic was about 3% (Table 1.2),  1.05 Traffic grew at about 10% p.a. between 1970 and 1978. Traffic increases were experienced by all modes, reflecting the growth of the economy as indicated by a GDP growth of 5% p.a. in real terms in the same period. This growth imiplies increasing transport intensity in Mexico, as measured in ton-km per unit GDP. Transport intensity increased from 2.4 ton-km per unit GDP in the beginning of the seventies to 3.5 ton-km per unit GDP by 1977. The Mexican economy has recovered from the 1976-1977 recession, growing at nearly 7% in 1979, and is expected to achieve a rapid and sustained real growth rate of 8% in the future. Transport is expected to continue growing at the same pace or faster than GDP in the eighties, and, in the long run, with the emergence of integrated regional economies consistent with the Government's goal of spatial decentralization, to start leveling off. For the coming years, the implications for the transport sector of Mexico's economic growth prospects would be rapid increases in demand for land transport and selected ports. This demand would affect, in particular, the railways, which, in order to be able to meet it through the 1980s, should invest judiciously to expand their carrying capacity. The financing of such an investment program is the main objective of the project. B. The Transport System (i) Railways 1.06 The railway subsector is reviewed in detail in Chapter II. (ii) Highways and Road Transport 1.07 The road network expanded very rapidly in the last 30 years. In 1950, there were only 22,500 km of roads in Mexico. By 1978, the network had grown to 200,000 km, of which 62,000 km or 30% were paved. Between 1950 and 1978, the length of paved roads grew at an annual rate of 6%. The highway network covers most populated areas of the country adequately. The main traffic corridors are served by paved roads and, on some of the most heavily traveled routes, by multi-lane facilities. The development of the main highway network could be considered to be nearing maturity. In recent years, increased emphasis has been given to low standard roads in lightly populated areas. This emphasis led to the construction of an extensive system of rural roads, which, coupled with the relative decline of budgetary allocations for highways and the steady increase in the number of vehicles and resulting traffic volumes, led to the present inadequacy of the main highway network. Road maintenance has been given low budgetary priority, as reflected in the old age of the equipment, and there are mounting requirements for rehabilita- tion and strengthening of existing roads. In addition, high rates of growth of road transport require the localized expansion of highway capacity to relieve emerging bottlenecks. 1.08 The availability of an extensive highway network and the rapid economic expansion in the last decade have strongly stimulated the development of the vehicle fleet, which grew at 12.5% p.a. over the period 1968-1978. Automobile ownership has been traditionally high in Mexico in comparison with  - 3 - other Latin American countries and even with some European countries. 1/ Overall, the level of motorization is about one vehicle per 16 inhabitants. The geographical distribution of the vehicle fleet reflects the concentration of economic activity and population in Mexico City, where 35% of the fleet is registered. 1.09 Trucking services are supplied by a fleet of 1.1 million vehicles. The fleet has been growing at about 10% p.a. in recent years. Its carrying capacity has increased even faster because of the shift to larger size trucks and the incorporation of modern units produced by the rapidly developing local automobile industry. Bus services are supplied by a much smaller fleet of some 60,000 vehicles. The road transport industry (trucks and buses) has expanded and operates in an environment free of economic control (tariffs) even though other Government regulations on road transport are complicated. Regulations were enacted as early as 1932, and, from the beginning, they were directed to control long-distance trucking (federal). It is estimated that approximately 8% of the total fleet falls into this category and is referred to as the public freight vehicle fleet. The current trend in Government, supported by the established transport companies, is to gradually tighten the enforcement of regulations in other segments of the industry with the objec- tives of providing improved reliability and geographical distribution of road transport services and improving the drivers' working conditions. The supply of trucking services and its tariffs have, in the past, proved to be adequate and the services satisfactory; in the recent surge of traffic demand, the trucking industry has generally been able to cope. However, there are growing indications that, given sustained growth of imports such as grains and oil industry supplies, it would not be able to manage the overspill if railway bottlenecks are not removed. An important constraint is the lack of sufficient trucks. Although the national industry provides some 100,000 new trucks per year, there is a gap in current needs which might be supplied by direct imports of fully assembled units. (iii) Ports 1.10 Port traffic, if petroleum is excluded, is surprisingly small in spite of Mexico's economic size (GDP of US$94 billion in 1978), perhaps because of the country's long-standing policies of self-sufficiency and relative isolation, resulting in comparatively light foreign trade. Furthermore, much of the foreign trade has been with the US, for which overland routes (railways and roads) have been used. Shipping transport in Mexico is largely concentrated on domestic coastal movements, mainly of petroleum. International shipping deals mostly with the exports of mineral products and petroleum and the imports of capital goods and grain and food supplies. There are some 30 ports on the long Mexican coastlines, of which 12 are international ports. Combined, they handle some 40 million tons of international traffic (1978), of which about 55% consists of petroleum products. 1.11 VTeracruz and Tampico, Mexico's largest ports, moved 1.1 million tons of general cargo each in 1978, accounting together for some 58% of the total imported/exported through the 12 principal ports of the country. Most 1/ 1978 passenger cars/1,000 population - Mexico, 40; Brazil, 38; Colombia, 32; Greece, 60; and Turkey, 15.  - 4 - of this traffic moves through these two gulf ports plus Coatzacoalcos. Main commodities handled at the ports include, besides petroleum, agricultural dry- bulk--mostly grain imports--(3.7 million tons in 1979); sulphur (1.8 million tons); mineral products (1.5 million tons); coal (700,000 tons); tubes and petroleum equipment (600,000 tons); chemicals, cement and iron (about 500,000 tons each); syrup and molasses (500,000 tons); paper and salt (200,000 tons each); and bauxite, cotton and sugar (100,000 tons each). 1.12 Port operations and administration were transferred, in 1977, from the Secretary of the Navy to the Secretary of Transport and Communications (SCT). A newly established Under Secretary of Ports at SCT is now responsible for port administration, while port planning is handled by the National Commission for Port Coordination (CNCP), under the SCT Minister. This transfer of responsibilities is expected to help streamline and modernize the operations at some of the ports in order to deal with the surge in economic growth, increased international trade and large grain imports. Port infrastructure capacity is generally adequate. However, congestion has recently been expe- rienced at some of the ports handling grain imports, although the responsibility seems to lie with insufficient carrying capacity on the part of the land transport systems servicing those ports more than with the ports themselves. 1.13 Coordination among shippers, consignees and the ports was not adequate, at the time of high volumes of grain imports, to prevent the bunch- ing of ship arrivals. This shortcoming, together with an already saturated system in critical parts of the railways (para 2.12) and a shortage of trucks (which were called to supply peak capacity for a traffic which was normally carried by rail), combined to produce the congestion. CNCP has worked actively on short-term remedial measures. A coordinating committee of ports, railways and large shippers, fostering advanced planning on shipping, handling and inland transport of imported commodities, has been successful in relieving the situation. 1.14 In the long run, the railway investment plans for infrastructure (para 3.02) and for equipment and facilities financed under this project (para. 3.01) are designed to remove the capacity constraints. On the port side, in order to cope with grain imports and the general traffic increases, a study of port capacity and a resulting program for the years 1981-1982 are being prepared by CNCP in coordination with SCT's General Directorate of Planning (DGP). The 1979-1980 domestic grain production 1/ has been excep- tionally low because of extensive droughts resulting in high import levels (expected at 10.5 million tons in 1980), and, in future years, it is expected that grain imports would be at levels more similar to those in 1979 (4.5 mil- lion tons), easing port congestion and leaving sufficient time for port invest- ments and capacity expansions, wvhich may be indicated by this study, to develop. 1.15 The Government is also paying attention to the port system in connection with a regional development plan which calls for the shift of population and economic activity away from the central plateau to the coastal areas. The development of industrial port growth poles is part of this strategy. Highest priority is given to accelerating growth in the zones comprising four industrial ports - Tampico-Altamira, Coatzacoalcos, Lazaro Cardenas and Salina Cruz - where port facilities are being planned for construction beginning in 1980. 1/ Normally of about 18 million tons/year.  -5- (iv) Air Transport 1.16 Mexico's extensive area, rugged topography and the considerable distances separating a number of its population and commercial centers have made air transport an important element in the country's transport system; it also connects the country interregionally and internationally. Domestic passenger traffic has been growing at a high rate: 17.4% p.a. for the period 1970-1978 (Table 1.2), reaching a level of over 14 million passengers (domestic and international) in that year. On the other hand, the relative participation of freight cargo in domestic traffic is minimal, reflecting the high freight rates of air transport in comparison with competing modes as well as the aircraft carrying capacity limitations due to high altitude at several key airports. Airport infrastructure is, in general, well developed, with some 50 airports capable of handling medium or larger size aircraft. The Mexico City airport accounts for about 40% of the total commercial passenger traffic and 55% of the air cargo. 1.17 Increases in traffic and the incorporation of larger aircraft on domestic routes have recently resulted in existing facilities in several airports becoming inadequate. Runway extensions, new or larger terminal buildings, navigational and communications equipment and improved utilities are needed. Some of the airports are located in heavily populated areas unsuitable for expansion and have to be relocated. Even plans for relocating the lIexico City airport are under active consideration. 1.18 A National Airport Plan (NAP), developed in 1964 by a Government-wide committee, has provided, with modifications, the framework for airport develop- ment until the present. On this basis, a five-year (1980-1985) airport invest- ment plan was formulated by the General Directorate of Airports (DGA) of the Secretary of Human Settlements and Public Works (SAHOP). Some of the relative priorities in this plan were questioned by SCT and its General Directorate of Civil Aviation as not responding to the most pressing operational needs. A document defining the policies and priorities for airport programs was then prepared by SCT, and a Committee of the Secretaries of SCT, SAHOP and Budgeting and Programing (SPP) reformulated SAHOP's program for 1980, calling for invest- ments to satisfy the demand up to 1985 at ten airports, in particular those of Mexico, Guadalajara, Monterrey and Cancun. Except for works already approved in 1979, it seems that the SAHOP plan has been shelved and that the control for the planning and formulation of future investment plans would rest in the hands of the Secretaries' Committee with strong participation of SCT, which has already advanced in the preparation of an investment program for 1981-1982. (v) Pi2elines 1.19 Pipelines account for a large share of petroleum and refined products transport in the country. 1/ There are about 5,300 km of crude oil pipelines in operation or under construction, 6,300 km of refined products pipelines and about 9,300 km of gas pipelines in the trunk system. All are owned and operated by PEMEX, the state oil enterprise. The oil pipelines connect the oil fields and refineries to the export ports and the central plateau area. 1/ In 1978, pipelines moved 56% of the total petroleum and products ton-km; zoastal shipping, 33%; trucks, 8%; and railways, 3%.  -6- They are largely concentrated in the Gulf Coast area of Tuxpan and Tampico, the state of Tabasco, where they connect with the large export terminal at Pajaritos, near Coatzacoalcos, and across the Tehuantepec Isthmus. Domestic consumption of products is served by coastal ships originating at Salina Cruz on the Pacific and Pajaritos, Veracruz, Tuxpan and Tampico on the Gulf. The vast network of products and gas pipelines is designed to serve the consumption of main urban centers (such as Mexico City and Guadalajara) and, through ongoing expansions, the Yucatan Peninsula and the Pacific coast. There are plans to expand the network of pipelines, with some 6,700 km currently under study (of which 4,300 km are gas pipelines). C. Planning and Coordination 1.20 Investment decisions for most public transport expenditures are made within the overall Government planning and budgeting sys4m framework. SPP has been responsible, since its establishment in 1977, for this activity. SPP is basically responsible for three areas: (a) yearly Government budget preparation; (b) Government-wide planning and programing; and (c) evaluation and control. Early this year, SPP produced its first economic plan (Plan Global de Desarrollo, 1980-1982), several years after the last major effort in this area. The Plan Global was adopted by decree on April 15, 1980; it is to be followed by a detailed Programa de Accion del Sector Publico (PASP) to be published in October 1980. The Plan reflects the strengthened National Planning System with SPP, in coordination with the Secretary of Finance and Credit (Hacienda), assuming the global planning role, and the other, specialized, Government Secretaries, with the various state agencies and para-state entities in their area, assuming the sectoral planning respon- sibilities. This arrangement is being complemented by the regional planning effort of the state governments. 1.21 In the transport sector, the leadership of SCT in planning matters is being established gradually in accordance with the objectives of the admin- istrative reforms of 1976 and the sectoralization of the public administration. SAIIOP is responsible for the planning of highways and related investments. For others, such as Aeromexico, the Government-owined carrier, the investment plans are normally approved by SCT. Overall, however, all transport invest- ments are still scrutinized together in SPP. The role of SCT has been to prepare multi-year perspective plans for investments, aside from its responsi- bility for the annual budget request. The last plan of this type is the "Lineamientos de Politica, Metas y Estrategia, 1978-1982," published by SCT at the end of 1978. It contains a comprehensive definition of sectoral and sub- sectoral policies and objectives and tentative investment plans. This document has served as a basis for the formulation of the Plan Global 1980-1982; it is supported by other subsectoral documents on policy and objectives and modal development programs prepared by SCT, such as the Program for Road Transport, March 1980; Problems and Perspectives of Railway Transport, May 1979; Policies and Program for the Merchant Marine, June 1979; and Airport Infrastructure Program, February 1980. 1.22 The Plan Global contains recommendations for transport policies and development strategies which are reflected in the formulation of the budget (Presupuesto de Egresos de la Federacion - PEF) for 1980. Overall, transport sector investments would grow 11.5% p.a. in real terms (1980-1982), reflect- ing its designation as a priority sector, together with agriculture and welfare.  - 7 - Within the transport sector, investments are planned in the railways, with a program for new construction and realignment of existing lines and yards (para 3.02) as well as track rehabilitation and equipment acquisition (para 3.01), to be supported by this project. For roads, the emphasis is on the moderniza- tion and reconstruction of high priority sections (supported by the Bank's Highway Sector Project) as well as bridges. For ports, the modernization of some ports by construction of container terminals (at Veracruz, Coatzacoalcos and Salina Cruz) and grain storage and handling facilities, together with the construction of four industrial ports, is planned (para 1.13). In air transport, the modernization and reconstruction of ten airports (para 1.16) and the acqui- sition of aircraft for Aeromexico are anticipated. 1.23 In the areas of transport policy and coordination, particularly on matters such as tariffs, road user charges, regulation and intermodal transport, SCT has traditionally dedicated great effort. These areas cover several impor- tant issues which have, Ln the past, been mentioned in connection with Bank lending in the sector. These issues gain special importance in the light of the strong economic growth and larger sectoral investments which are planned for the next several years. In particular, the pricing issue reflects an acute problem in both the railways, as it burdens a well run and relatively efficient system with heavy subsidies (US$160 million in 1979), and in road transport, as it provides road vehicles with underpriced fuel 1/ and low or almost no charges made for using the road system, while some reconstruction and modernization efforts face being postponed because of fund shortages. A clear tendency of these subsidies is to encourage more transport demand, both road and rail, than would otherwise be the case. In regard to the regulation of the trucking industry, much remains to be done toward understand- ing the impact of such regulations. The Government's desire to improve the efficiency and distribution of trucking services is a supportable objective (para 1.09). 1.24 The pricing and regulatory issues, fully understood by the Government, are inherited from the past and are difficult to tackle because of the size and complexity of the country and the economy together with a political system 1/ The retail prices of diesel fuel and gasoline (regular) are Mex$ 1.00/liter and Mex$ 2.80/liter respectively. "Super" gasoline, which accounts for only 6% of all gasoline sales, retails at Mex$ 7.00/liter. Wh1ile there is no direct diesel fuel tax, the retail price of regular gasoline includes a tax of Mex$ 0.70/liter. The equivalent export prices (1980) for these fuels are estimated at Mex$ 5.20/liter for diesel fuel and Mex$ 5.80/liter for regular gasoline. Consumption by the transport sector is estimated at 15.4 billion liters of regular gasoline and 7.9 billion liters of diesel in 1980. These levels of consumption imply potential revenue foregone by the Mexican Government of about Mex$ 79 billion in 1980 (US$3.5 billion). Potential revenue foregone is measured as the export price less the domestic retail price, multiplied by consumption.  - 8 - that seeks consensus among interested parties. The Bank-financed Highway Sector Project (Loan 1671-ME, August 1979) would promote rational policies that affect the highway subsector, in particular concerning road transport regulations and road user charges. The loan provides for periodic joint reviews among the Bank, SCT and SPP on these matters. A major policy statement has been included in the recent Plan Global, indicating that the prices and tariffs of the goods and services produced by the public sector would be revised and updated and the subsidies reoriented toward those social and economic sectors for which they are most needed. These actions would be in accordance with the following criteria: (a) prices should cover the direct production costs; (b) prices should, additionally, permit the accumula- tion of savings for the purpose of investment; and (c) prices should be adequate to support the development of the economy and social welfare. In particular, with reference to the transport sector, the stated policy is to modify "gradually" the road user charges in order to be able to recover, in the medium-term, infrastructure investments as well as road maintenance expenditures, while seeking to promote the efficient use of the facilities. As for the railways, the stated policy is to raise tariffs to nearly the full cost of the services provided in order to bring about the elimination of subsidies. II. THE RAILWAY SUBSECTOR A. Background 2.01 Nacionales de Mexico (N de M) is the largest of the five separate Government-owned railways; their extent is indicated below and shown on Map IBRD 3655R1: Standard Narrow Gauge Gauge (1,435 m) (0.914 m) Total % Nacionales de Mexico 14,121 90 14,211 71 Del Pacifico 2,310 - 2,310 11 Chihuahua al Pacifico 1,509 - 1,509 8 Sonora Baja California 610 - 610 3 Unidos del Sureste 927 424 1,351 7 Total 19,477 514 19,991 100 2.02 A major portion of the traffic (80%) is carried by N de M, whereas del Pacifico, the second largest, carries about 14%. The other three railways are, to a large extent, long branch lines feeding into the main Nacionales and Pacifico systems (see map). Rolling stock and motive power are interchanged through five main junctions. 2.03 In January 1977, a Government decree authorized the integration of the five railway enterprises into a single operating unit, and this process is being accomplished gradually. The first phase of the unification has so far been carried out; management has been entrusted to a single board under the control of a single General Manager. The President of N de M has taken over as the General Manager of all the railways, and the new management board consists of the Secretary for Communications and Transport as chairman and the Secretaries for Agriculture, Commerce and Industry, Finance and Programs  - 9 - and Budget, as well as representatives of the labor unions, as members. Since working rules and labor regulations differ on the five railway systems, it is necessary, before the complete integration of the railways into N de M can be carried out, to have (a) an agreement with each of the labor unions concerned and (b) a legal decree setting out in detail the basis on which the integration will take place. These processes have been nearly completed for Unidos del Sureste, which will be the first railway to join N de M. The next two railways to follow will be the Sonora Baja California and the Chihuahua al Pacifico, and finally the Del Pacifico, which is the largest of the other systems outside N de M. Accounting systems differ from one railway to the other. Some of them are fully computerized and are more advanced than that of N de M. The impact of the amalgamation on N de M's finances will be very small. The operating ratios are different for each railway, e.g., for Unidos del Sureste, it was 140 for 1979 against N de M's L34 and against all railways' 139. The advantages from the amalgamation will 3e the optimum use of equipment, lower operating costs and administrative expenses and lower number of employees. Existing different systems of operations, salaries and wages, accounting and reporting will continue until final amalgamation. The entire process, including unification of operating practices, administration, accounts, etc., is expected to be completed within the next five years. 2.04 Three Bank-financed projects, one for Ferrocarril del Pacifico and two for N de M, have helped to finance important rehabilitation and modernization works such as track renovation, strengthening of bridges and purchase of motive power and rolling stock. The first loan (103-ME) of US$61 million for the rehabilitation and modernization of Ferrocarril del Pacifico was made in 1954, and the works were completed successfully in the late fifties. The second loan (825-ME) of US$75 million for the rehabilitation of N de M was made in 1972 and completed in 1977. The Project Completion Report for this project concluded that its main objectives, i.e., the rehab- ilitation of N de M's operations and the improvement of its organization and management, were largely achieved, although financial performance was below appraisal targets, mainly because of inadequate tariff increases. The overall economic rate of return at 20% was better than the appraisal estimate of 18%. The third railway loan was made in 1976, and the works are being executed now in accordance with an investment plan which was revised in 1979 in consultation with the Bank. The project is expected to be completed in 1981 and has included important modernization works such as the installation of a telecom- munications network on N de M, modern yard and tra'in control systems and the introduction of unit train operations. As in the Second Railway Project, performance with respect to implementation of important covenants has been good except for tariff increases. However, the Mexican Government has, in recent years, shown a greater awareness of the need for cost-based tariff increases, and there has been a substantial improvement in this field (para 5.06). Improvements in technical and operational areas continue, and the Government of Mexico has now requested that a fourth railway loan be considered to augment the carrying capacity of the railway to meet increasing traffic demands (paras 2.17 to 2.21 following) and to continue the development of N de M toward becoming a more efficient and financially viable railway system.  - 10 - B. Organization 2.05 N de M is a state enterprise under the supervision of SCT. It is responsible for the operation of the railway and has the authority to approve its internal organization and regulate its affairs. As prescribed by its charter, N de M has considerable autonomy in its management. However, the Government exercises a substantial degree of control over N de M in the review of its investment plans, tariff levels, and annual operating and capital budgets. Government policy toward N de M has been a key factor in determining tariff levels, staff numbers and salaries and the level and quality of investments. 2.06 SCT is responsible for large scale construction works such as new lines, marshaling yards and major realignment works, which are then passed on to the users (the railways) for operation. Thus, SCT not only reviews the programs and plans of the operating enterprises but also prepares its own budget for railway infrastructure works. In preparing and implementing its programs for railway infrastructure investment, SCT consults regularly with N de M, both to ensure proper coordination and to take advantage of technical expertise within N de M. The overall plans are, thereafter, analyzed and approved by SPP. Since 1979, a Tripartite Commission headed by the Controller General for Accounts in SCT and consisting of the External Auditors and the Finance Director of N de M has been entrusted with the responsibility of over- seeing the financial performance of N de M. This commission has done good work in its initial year; its achievements include, in general, the promotion of greater cost consciousness in the management of N de M and, in particular, the revaluation of N de M's assets for the first time in its history. C. N de M Management, Staff and Training 2.07 The present management organization of N de M is shown in Chart 1. The day-to-day operations are the responsibility of the Departmental Managers whose work is coordinated by a Deputy General Manager working directly under the control of the General Manager. As integration of the smaller railways into N de M progresses, these systems will be taken over as divisions of N de M. 2.08 A study of its manpower requirements was made by N de M as part of the ongoing third railway project; after review by the Bank, and subsequent changes, the manpower projections (up to 1982) were considered to be generally satisfactory to the Bank. Staff data for N de M are given in Table 2.1. It is seen that, between 1970 and 1979, the traffic carried by N de M increased by 55%, whereas the staff increased by 6%. The productivity per worker increased from 366,000 units 1/ in 1970 to 532,000 units in 1979. These figures compare favorably with those for other railway systems, including the leading European railways. During the third railway project, particularly during the years 1976-1978, considerable tightening up of staff needs was achieved. This accomplishment and other improvements such as unit trains and 1/ Freight net ton-km plus pass-km (Table 2.1, page 1).  - 11 - the introduction of the telecommunications network are now beginning to show positive results. Productivity per worker is expected to go up to 603,000 units in the year 1980, to 617,000 in 1981 and to 649,000 in 1982. A small increase in staff is envisaged, mainly because of additional lines and yards under construction, but, on the other hand, the N de M medical staff will be transferred to the social security system (para 2.09 following). As part of the Plan of Action for the fourth railway project, N de M agreed during negotiations to update the Manpower Plan to the year 1985 (para 3.10). 2.09 One of the major staff problems confronting N de M has been the large number of pensionable staff. Since 1976, N de M has been negotiating with the Government Department for Social Security (IMSS) on the subject of transfer of N de M's pension and medical scheme to the social security system. These negotiations have now reached the final stage, and it is expected that the terms and conditions for the transfer will be finalized before the next revision of the contract with the labor unions. N de M foresees that, with the proposed transfer, the hitherto intractable problem of the superannuated staff will be resolved. In addition, the transfer of the medical services to IMSS will involve the movement of 2,720 medical staff to IMSS, the reduction of the projected staff strength of N de M from 63,579 to 60,859 in 1982, and the consequent improvement in the productivity per worker from 649,000 to 678,000 traffic units. 2.10 N de M has a large and well managed training establishment which has organized programs for training at principal railway centers and through schools and correspondence courses for (a) maintenance of way and structures; (b) operation of stations, yards, trains and locomotives; (c) maintenance of locomotives and rolling stock; and (d) general administration, including training courses for railway officials at the middle-management level. The training institute also responded to the training needs for new technologies such as telecommunications and developed excellent courses in the operation and maintenance of telecommunications equipment. During the past few years, the N de M training institute has also organized special training courses to cater to the specific training needs of other Latin American railweys which have been using N de M's facilities to an increasing extent. D. Railway Facilities (i) Track 2.11 N de M operates approximately 14,211 route-km of railway, of wt. h the principal traffic routes, which carry 90% of total traffic, total about 7,600 km (Map IBRD 3655R1). On these routes, N de M has been carrying out a program of selective track renewal, using heavy rail with welded rail joints and elastic type fastenings, supported on concrete sleepers and new stone ballast; the objective is to provide an improved standard of track for sections where important increases of traffic are taking place and also where heavier locomotives and freight cars are now in use. Secondary lines are being renovated with rails released from the main routes. In addition, the mainte- nance of the track, especially on the renovated and improved sections, is being steadily improved by a mechanization program, started under previous projects, which calls for increasing use of track machinery and a regrouping  - 12 - of the labor forces. Further data about N de M track and equipment are given in Annex 1. N de M has demonstrated its ability to carry out the track program in a timely and efficient manner. 2.12 The principal lines between the seaports and the central plateau were built in the 19th century with steep gradients and sharp curves which now present operating and maintenance problems under the progressively increasing tonnages of traffic. On these and some other heavily used routes, capacity constraints have arisen, and a major program of grade and curvature realign- ments is under way to remove bottlenecks, to improve speeds and generally to increase line capacity. This infrastructure program, which has been developed jointly by N de M and SCT, will be executed by SCT during the years 1981-1985. (ii) Motive Power and Rolling Stock 2.13 The N de M system is wholly diesel-operated and has approximately 1,160 locomotives in its fleet. Apart from the provision of additional locomotives to cater to the increasing traffic, N de 2I has also been replacing its old and smaller horsepower locomotives with heavier units in keeping with its policy of increasing train loads. The 1981-1985 investment plan envisages the purchase of about 72 main line locomotives in 1981 and another 60 per year in 1982-1985 to cater to additional traffic and to replace older units no longer economical to maintain. With the progressive increase in traffic and longer trains, it has also become necessary to acquire heavier shunting locomotives for the marshaling yards, and 50 shunters of 2,000 horse- power each are being acquired to improve yard performance. 2.14 The N de M freight car fleet totaled about 32,100 units at the end of 1979; in addition, considerable use is being made of hired foreign cars, which enter the country carrying imports from the US, and tank cars for oil traffic are mostly owned or leased by the state oil enterprise PEMEX. The N de M fleet is relatively modern and of good design. The 1981-1985 program, for additional cars to accommodate increasing traffic, envisages the purchase of about 3,100 freight cars per year over the period. The passenger car stock totals 1,300, of which some 50% are 30-40 years old; however, apart from the 200 new cars purchased under the Third Railway Project, N de M has not made any further provision for replacement of passenger cars in the 1981-1985 investment plan, nainly because priority is being given to augmentation of capacity for carrying freight. Details of the present N de M locomotives and rolling stock fleet are given in Table 2.2. (iii) Workshops 2.15 N de M's major workshops are at Aguas Calientes (for freight cars and passenger coaches) and at San Luis Potosi (for diesel locomotives). Smaller workshops at Guadalajara, Monterrey, Ciudad Frontera, Matiss Romero, Jalapa Apizaco and Torreon take care of the intermediate and minor repairs. During the last few years, N de M has been providing the workshops with modern equipment, partly financed from the ongoing Bank loan (1232-ME). The workshops are generally well organized, but, whereas rolling stock availability has been maintained at satisfactory levels, there was a marked deterioration in locono- tive availability during the past two years, leading to a progressively declin- ing rate of utilization of locomotives. The situation is being tackled by  - 13 - (a) tightening up the maintenance organization; (b) scrapping over-aged locomo- tives; and (c) purchasing new locomotives, including shunters. On the suggestion of the Bank, N de M has also engaged the services of a consultant (TOPS-ON-LINE (USA)) for an investigation into the maintenance and workshop practices. This study is financed from the ongoing Bank loan (1232-ME) and is expected to provide useful analysis and guidance to N de M since TOPS-ON-LINE has been associated with N de M for several years and is familiar with the strengths and weaknesses of the system. (iv) Signaling and Telecommunications 2.16 The highlight of the Third Railway Project was the installation of a modern telecommunications system comprising a VHF/UHF network spanning the entire railway network; the installation is expected to be completed by the end of 1981. In addition, computerized yard and train control systems have been introduced on N de M with the aid of consultants TOPS- '-LINE and Missouri Pacific (USA). Centralized traffic control (CTC) has so fai been provided on 950 route-km, and future plans cover extension of this system to lines carrying the highest traffic densities. With the completion of a modern communications system, priority will be given, in future years, to the development of an integrated Management Information System (para 3.06). E. Traffic (i) Freight Traffic 2.17 N de M's freight traffic grew from 38.3 million tons and 18.1 billion ton-km in 1970 to 54.8 million tons and 30.1 billion ton-km in 1979 (Table 2.3). Average growth rates over this period were 4.0% p.a. and 5.8% p.a. respectively, with ton-km growing faster than tons as average hauls increased from 472 km in 1970 to 549 km in 1979. Between 1970 and 1975, traffic grew at an accelerated rate of 6.4% p.a. and 8.4% p.a. in terms of tons and ton-km respectively. Traffic declined in 1976 with the general recession in the Mexican economy, recovering in 1977-1978. By 1979, after the Government's stabilization program and major oil discoveries, Mexico had recovered from its economic downturn, and the demand for transport surged. However, inadequate railway investment over the 1970s, particularly investment cuts in 1977 and 1978, coupled with the increased demand for rail transport, led to a crisis in 1979, with N de M unable to meet demand. The short-run bottlenecks experienced in 1979 and 1980 are being tackled vigorously (para 2.23), and N de M is prepared for an important recovery in 1981. Strong traffic growth is antici- pated over the coming years as the stage is being set for rapid and sustained real growth rates in the Mexican economy of around 8% from 1980 on. 2.18 The most important group of commodities, in terms of ton-km, carried by N de M consists of intermediate industrial products (cement, fertilizers, sugar, petrochemicalo, and steel) which represented 38.5% of total ton-km in 1979 as compared to 31.J% in 1970. Mineral products represented 26.9%, agricultural products, 18.4% and inorganic products, 8.7% of ton-km in 1979. Petroleum products, increasingly carried by pipelines, have declined in terms of the total share of railway traffic (11.4% in 1970 to 6.0% in 1979) as well as in absolute terms. The main commodities carried in 1979, in order of importance in terms of ton-km, were iron ore (17.6%), fertilizers (6.0%), sozghum (5.3%), cement (3.7%), wheat (3.3%), crude oil (3.3%) and corn (3.0%).  - 14 - 2.19 Traffic is concentrated on three major lines, two running south from the US border to Mexico City and the third from Mexico City to Manzanillo. A fourth corridor, Veracruz and Coatzacoalcos to Mexico City, is of increasing importance. In 1977, the Mexico City-Nuevo Laredo line handled the most ton-km in the system, carrying 7.0 billion ton-km, or 24% of the total traffic. Second in importance is the Mexico City-Ciudad Juarez line, with 4.6 billion ton-km (16%), and third is Irapuato-Manzanillo, with 3.3 billion ton-km (12%). Together, these three lines carry 52% of the total traffic, while representing 27% of the network. Traffic is dense on the lines radiating from Mexico City, with a high of 12 million net tons per year between Mexico City and Lecheria, dropping to about 8 million tons on the sections from Lecheria north to Saltillo. The Celaya-Queretaro-Irapuato sections have the second highest traffic densities, ranging between 8 and 10 million net tons in 1979 (Map IBRD-1 1844R). 2.20 It is expected that traffic growth will be rapid and sustained over the coming years as the economy as a whole is stimulated by oil production and exports. In particular, expected economic growth over the 1980-1985 period of around 8% in real terms will mean greater traffic growth than that experienced in the seventies when Mexico's growth rate fell from about 6% p.a. in real terms in the early part of the decade to less than 2% during the recession years of 1976-1977. The implications of this growth on rail traffic are discussed in Annex 5. Over the forecast period (1979-1985), freight tonnage is expected to increase by 6.6% p.a. to about 80 million tons, and ton-km by 7.3% p.a. to 46 billion ton-km (Table 2.4). After 1985, traffic is expected to grow at about 4.6% in terms of tons and 5% in ton-km, which is closer to the historical long-term growth trend. The average length of haul is expected to increase, reaching 571 km by 1985. The most important feature of the expected traffic is the sharp increase in grain traffic (with unusually high traffic in 1980) due to a heavy program of grain imports from the United States. Agricultural traffic is expected to increase by 6.9% p.a. in terms of ton-km between 1979 and 1985. Mineral traffic is also expected to be dynamic, growing 9.1% in tons and 12.2% in ton-km. Industrial products are forecast to grow at 6.2% p.a., with fertilizers showing the strongest increases. These traffic fore- casts were prepared by N de M and revised by the mission during appraisal; they were based on market studies for 36 commodity groups which comprise 88% of the railway traffic. Total national traffic was estimated on the basis of the traffic derived from national production and imports. These estimates were then related to projected railway traffic shares for each commodity. 1/ For the remaining commodities, traffic was projected using regression analysis 1/ For many commodities, rail's share of the total traffic is expected to decline relative to that of road. The most significant departures from current trends are expected in foodgrains, iron ore and limestone. The railway is expected to increase its share, relative to road, of total foodgrain movement as imports, which are handled almost exclusively by rail, become more important as a source of national supply. The railway will maintain its dominance in land transport of iron ore, but will lose ground in total transport of this commodity since imports through ports will play an increasing role in steel production. Limestone transport will not grow at the same pace as cement as plants increasingly locate near sources of primary materials.  - 15 - in which railway traffic was related to appropriate macroeconomic indicators, such as GDP. Traffic demand in ton-km was then forecast by commodity by applying estimates of average lengths of haul which, for some commodities, are expected to be different from present averages. To obtain line densities, the tonnages were distributed by commodity along the lines in the same proportions as exist at present with the exception of iron ore, coal, coke and fertilizer traffic, for which commodity origin and destination matrices were projected individually. 2.21 The issue of N de M's competitive position with respect to freight traffic is often raised since (a) both Mexico's road and rail networks are well developed and (b) presently both rail and long haul trucking are subsidized. While this latter fact may result in the purchase of more transport services than would be the case if transport were charged its resource cost, there is no evidence that there are serious intermodal distortions within Mexico. In assessing the impact of Liiese facts, it is necessary to consider that the existing highway network is parallel to all the major rail links. Thus, shippers have been offered alternative road and rail services for some time and have, for the most part, adjusted their operations to a modal choice based on a combination of service characteristics and tariffs. An added dimension is the fact that the Government, through ownership of the foodgrain distributor (CONASUPO), the fertilizer industry (FERTIMEX), part of the iron and steel industry (AHMSA and SICARTSA) and the petroleum industry (PEMEX), has a great deal of control over the modal choice for the inputs and outputs of these industries. With the notable exception of PEMEX, the great bulk of the traffic associated with these industries moves by rail. Long haul bulk traffic - especially foodgrains, coal, coke, iron ore, fuel oil, fertilizer and cement - form the rail freight traffic base. Of these products, only cement is in the private sector, and it moves by rail as a matter of choice. These bulk commodities move long distances in large quantities, and their movement by rail is appropriate. (ii) Passenger 2.22 In the last decade, passenger traffic has declined by 6% p.a. from 33.2 million passengers in 1970 to 18.7 million by 1979. Because average distances traveled increased from 103 km in 1970 to 176 km in 1979, the decline in terms of passenger-km has been considerably less marked, averaging 0.5% during this period (Table 2.5). The decline in passenger traffic can be attributed in part to the expansion of public road transport and private automobile ownership. A more important factor, however, was the reduction by 43% of all passenger services between 1974 and 1978. N de M is currently carrying out a study of passenger train services which will form the basis for policy recommendations on the subject to the Government (para 5.03). Pending the results of this study, N de M has tentatively forecast that passenger traffic will remain constant over the plan period. This forecast is considered reasonable. F. Operations 2.23 A summary of N de M's principal operating statistics for the years 1970-1979 is given in Table 2.6. A review of operating performance of N de H1 in recent years is given in Annex 2. Overall, the operational targets set in  - 16 - the Plan of Action under Loan 1232-ME were mostly achieved by 1976-1977. Following these years, even though N de M continued to have progressively higher levels of traffic, operating performance declined because of the slowdown in the Government investment program during 1977-1978 and an unpre- cedented upsurge in freight traffic in late 1978 and in 1979 due to renewed economic activity. These occurrences, in turn, led to the excessive utiliza- tion of locomotives at the expense of the scheduled program maintenance, resulting in deterioration of locomotive availability, an increase in freight car turnaround time and general congestion on the system. A renewed drive to tighten up maintenance practices with the assistance of consultants (para 2.15) and an integrated program for the scrapping of old locomotives, coupled with the purchase of new locomotives, are already improving locomotive availability and are expected to improve it steadily in the coming years (para 3.10). Capacity constraints not directly related to the short-run problem of locomo- tive availability are emerging, at the same time, as a serious problem. An analysis of the operations of the railway over the last few years indicated that, as traffic levels increased, capacity constraints developed in the traffic yards and in certain mainline sections over the system. Congestion levels in the major yards at Valle de Mexico, Monterrey and Guadalajara have been increasing, and, although the installation of computerized yard control systems improved the performance and fluidity of the yards substantially, the need for creation of new traffic yards to cater to the increasing volumes of traffic in recent years has become manifest. On the main lines, the sharp curves and steep gradients of a railway system built largely in the latter part of the 19th century emerged as a major constraint to the higher speeds and loads made possible by modern diesel locomotives and freight cars. Thus, an SCT infrastructure construction program for the realignment of lines and the construction of new mechanized yards, which had been in gestation over the past several years, became urgent and has been included in the SCT construction program for the years 1981-1985. This program (para 3.02 and Annex 7) is aimed at removing the capacity constraints in a timely manner and at providing additional capacity to move the greater volumes of traffic projected for the future. G. Tariffs and Costs 2.24 The rail tariffs are regulated by the Director General of Tariffs in SCT. Proposals for increases in tariffs are originated by N de M and are considered and recommended by the Special Committee of Prices and Tariffs and SCT's Consultative Committee on Tariffs. 1/ The Director General of Tariffs makes the final decision, which is published in The Official Journal. For 1/ The Special Committee is made up of representatives of the Secretariates of Industry and Commerce (Head of the Committee), Finance, Labor and Patrimonio Nacional. The function of the Committee is to control prices and tariffs. The Consultative Committee is part of SCT and is appointed by the Secretary of SCT. The head of this Committee is the Director General of Tariffs in SCT. This Committee, which includes representa- tives of the Government and private industry, presents its recommenda- tions to SCT on railway tariffs.  - 17 - 15 years (1960 to 1974), the Mexican Government practically froze railway tariffs. Since 1975, SCT's tariff strategy has been cost-oriented. In addition to substantial tariffs increases, the Government, in 1975, restruc- tured tariffs to cover variable costs and a contribution of fixed costs and introduced uniform tariffs across the country. Between 1975 and 1979, tariffs have been increased as follows: Tariff Increases Consumer N de M's Salary Year Month Freight Passenger Price Index Increases (%) (M) (% increase p.a.) (M) 1975 (Feb.) 44 22 15.2 16 1976 (Sept./Dec.) 38 20 15.8 27 1977 0 0 28.9 10 1978 (Jan.) 15 19 (2nd class) 17.5 12 23 (lst class) 1979 (Feb.) 15.5 15.5 18.0 15 1980 (March) 29.03 20 24.0 25 (est) Cumulative (Freight and Passenger) 245.0 295.0 260.0 These tariff increases are substantial and represent a significant improvement in the Government's policy in recent years. However, the revenues were not sufficient to absorb cost increases because of insufficient and delayed actions on tariff increases between 1975 and 1980. Furthermore, the tariffs on some important commodities, whose traffic growth has been relatively higher, have been reclassified downward,resulting in lower revenues. 2.25 Costs increased in 1976 in real terms as a result of the peso devaluation in that year, but have decreased by 28% since then as a result of traffic increases, more efficient operating performance and technical improvements. The table below summarizes the relative levels of average revenues and costs between 1975 and 1979 and shows that, after a marked deterioration in 1976, the situation has improved considerably. 1975 1976 1977 1978 1979 ----------(1974 constant Mex$)---------- Revenue/ton-km 0.125 0.100 0.100 0.100 0.094 Cost: Variable 0.120 0.130 0.110 0.100 0.090 Fixed 0.050 0.050 0.050 0.050 0.040 Total 0.170 0.180 0.160 0.150 0.130 2.26 N de M's Costing Section carried out a revenue/cost analysis of freight traffic, comparing variable cost/ton-km with the revenue/ton-km for each commodity. This analysis indicated that 19 commodities comprising 40% of the annual rail tonnage did not even cover the variable cost of providing service. The major beneficiaries of relatively low tariffs were iron ore, cement, coal, coke, fluoride, sugarcane, cotton, salt and baryte. Iron ore, which is nearly 20% of N de II's total annual tonnage, showed an average  - 18 - revenue of Mex$ 88/ton for an average haul of over 725 km, against the variable cost of Mex$ 112/ton. Cement, which is 10% of the total annual tonnage, showed an average revenue of Mex$ 43/ton, against the variable costs of Mex$ 54/ton. The current structure of rail freight tariffs, therefore, bears little relation to costs. The desirability of increasing railway revenues by charging justifiably higher tariffs to some industrial users of the railway is, therefore, clearly demonstrated. There is still a wide margin between the truck rates and rail rates of major commodities. 1/ The railway can, therefore, afford to increase the rates without any danger of losing the traffic to the highways because this is low value, bulk traffic over long hauls. During discussions, the Mexican Government (SCT) agreed that tariffs for each commodity and service should cover variable costs and make a contribution to fixed costs. The recently published Plan Global (para 1.24) also confirms that the Mexican Government's current tariff policy is basically cost-oriented. The issue would also be addressed in the tariff structure studies and their implementation (para 5.09). 2.27 N de M's passenger fares are also very low. A comparison of current passenger train fares and bus fares is given below: % of Bus Fare Train Fare Bus Fare to Train Fare (per pass-km in Mex$) First Class Sleeper/Luxury 0.23 0.36 159% First Class Coach 0.18 0.33 178% Second Class 0.11 0.32 291% As part of the ongoing Third Railway Project, N de M discontinued a large number of passenger trains and reduced the passenger train deficits substan- tially. However, the need for periodic increases of passenger fares, in keeping with cost increases, persists as in the case of freight tariffs, even though the Government pays specific subsidies to N de M for the remaining passenger services (para 5.03). 2.28 Less than carload traffic (LCL) was about 0.1% of the total ton-km in 1979. LCL tariffs are about 300% higher than the average regular freight carload tariff. Under the ongoing project, N de M carried out a study of LCL traffic and, since 1975, has reduced about 30% of the LCL traffic. N de M is gradually transferring LCL traffic to Express Service so that the loss on LCL can be eliminated and an improvement in the financial situation of the Express can be made. N de M is studying the possibility of transferring LCL and Express traffic to the carload service in unit trains. Although various actions are being taken by N de M to improve the LCL service, progress has been slow. Agreement was reached, during negotiations, that N de M would furnish to the Bank, not later than June 30, 1981, a plan to accelerate action in reducing losses on LCL traffic on the basis of the study already carried out under the previous Plan of Action. 1/ For example, the margin was 350% for iron ore, 240% for cement, and 215% for fertilizer.  - 19 - H. Budget, Accounting and Audit (i) Budget 2.29 N de M prepares annual operating and investment budgets and submits them to SCT by September of each year for approval. SCT apprcvras and then sends them to SPP with or without modifications. The overall budget includes the annual operating deficit, debt service charges for foreign loans, the investment program, the maintenance program for the track, specific compen- sations for passenger train service losses and other items as required. The Government, after approving the budget regularly needed, pays subsidies to N de M on a monthly basis. The Government has recently improved the budgeting system and has instructed Government agencies such as N de M to follow it. The new system represents a change from traditional budgeting to programed budgeting, which allows the management to evaluate and control the performance of each segment of activities, thus enabling it to improve the future planning of the work program coinciding with the country's overall development plan. Other advantages of program budgeting include the fact that it will avoid duplication of activities and make the executers of the programs responsible for their performance, thus reducing costs. (ii) Accounting 2.30 N de M uses the same accounting methods as the US railways. The balance sheet shows that the equity has improved since 1979 as the results of the revalued fixed assets and the corresponding accumulated depreciation have been incorporated into it. N de M does not create depreciation reserve for track (e.g., rails, ties and ballast); instead, it charges the maintenance of track to the working cost, whereby the track is always kept in good operating condition and does not depreciate. In the past, however, regular track main- tenance works did not always keep pace with the targets, largely due to budget restrictions, which created the need for deferred maintenance. Since the revaluation of track represents the present replacement cost of good track and not the track at the present condition, N de M analyzed and, with the permission of the Tripartite Commission (para 2.06), reduced the revalua- tion figures by one-third, from Mex$ 46,500 million to Mex$ 30,200 million. The adjustment was made only in equity and not in working cost in order not to distort the working ratio. The Tripartite Commission is presently study- ing a changeover to a depreciation system. A decision will be made after the study is completed in late 1980. Whatever accounting method is chosen, as long as it is used properly and consistently, it will be satisfactory. 2.31 N de M needs to introduce into its accounting system a good financial reporting program to the management. This reporting system would be an input to the overall management information system. Such a system would help the railway executives to receive valuable information on time and to make correct decisions promptly. N de M agreed to the establishment of such a system and will carry out studies to determine specific needs (Annex 3).  - 20 - (iii) Audit 2.32 The auditing of N de M's accounts is carried out regularly by private external auditors. The audit reports have been sent to the Bank with one to three months' delay. The Tripartite Commission decided that N de M should submit the financial statements and related information to the auditors early enough and that the auditors should complete their reports within five months of the closing of the year so that a copy could be sent to the Bank on time. III. THE INVESTMENT PLAN AND THE PROJECT A. N de M's Investment Plan 3.01 Based on the forecast of traffic and on the anticipated operational and capacity improvements of the system, N de M has prepared an Investment Plan for 1981-1985 which is set out in Table 3.1. This plan continues and supplements the ongoing plan for 1976-1980, which is being financed under the Third Railway Project. As in the 1976-1980 plan, investments will be made principally in track rehabilitation, motive power, rolling stock, and technical assistance. Total investment in 1981-1985 is estimated at Mex$ 67.1 billion (US$2.9 billion equivalent) with a foreign exchange component of Mex$ 20.6 billion (US$897 million). 3.02 N de M's Investment Plan for track rehabilitation and equipment is complemented by SCT's infrastructure program for 1981-1985, which aims at the realignment of existing lines and the construction of new lines and yards. This approach is in keeping with the traditional policy of the Mexican Government, whereby the Government (SCT) constructs major infrastructure works which, on completion, are handed over as equity to the user (in this case N de M). The doubling of the Mexico-Queretaro Section and the construc- tion of the Coronondiro-Las Truchas line (connecting N de M to the Las Truchas Steel Plant) are among the important infrastructure works executed by SCT in recent years. The SCT Investment Plan for 1981-1985, detailed in Table 3.2, covers infrastructure works including realignments of main line sections and construction of new lines and yards. The program envisages the expenditure of about Mex$ 43.3 billion (US$1.8 billion equivalent) during the years 1981-1985 with a foreign exchange component of Mex$ 12.4 billion (US$537.7 million). 3.03 The Bank has been asked by the Mexican Government to participate in the financing of N de M's Investment Plan for rehabilitation and equipment, whereas SCT's infrastructure program is to be financed entirely by the Government. Since, however, the two plans are closely interlinked, regular consultation between SCT and the Bank would be desirable. Therefore, it was agreed with the Government, during negotiations, that the Bank would have the opportunity to review and to comment upon the scope and the timing of the main works in the SCT program. As a matter of fact, this process has, to a con- siderable extent, already been carried out in that about 80% of the subprojects  - 21 - in the SCT program have already been examined by the Bank and are considered to be technically and economically justified. The consultation with the Bank also resulted in the expansion of what was earlier a three-year investment program into a five-year program covering the years 1981-1985. The Bank has, however, not yet received the feasibility studies for some of the subprojects (principally new lines, electrification and other works scheduled for later years of the investment program) since these are not yet available. During negotiations, it was agreed by the Government that it would, with respect to its railway infrastructure program for 1981-1985, furnish to the Bank, as and when available, the feasibility studies for the subprojects and the proposed annual investment program for the railway infrastructure and would afford the Bank an opportunity to comment on the feasibility studies for the subprojects. B. The Project and Proposed Loan 3.04 The project combines the 1981-1983 portion of ` de M's 1981-1985 Investment Plan with a Plan of Action aimed at improving the operating perfor- mance of the railway. The proposed Bank loan of US$150 million would finance about 28% of the foreign exchange cost of the project. The cost estimates are detailed in Table 3.3 and are summarized below: Project Proposed Loan Local Foreign Total Amount % of Loan -------------(In US$ million)---------------- Track and Structures 121.5 57.5 179.0 38.8 25.8% Signaling and Telecommunications 23.1 22.1 45.2 - - Locomotives and Rolling Stock 442.9 350.9 793.8 88.2 58.8% Engineering and Supervision 31.7 0.7 32.4 - - Consulting Services 2.0 2.0 4.0 2.0 1.3% Subtotal 621.2 433.2 1,054.4 129.0 85.9% Contingencies - Physical 9.5 4.9 14.4 2.3 1.6% - Price 360.2 97.7 457.9 18.7 12.5% Total 990.9 535.8 1,526.7 150.0 100.0% 3.05 The objectives of the project, together with those of the Plan of Action, are. (a) to augment the carrying capacity of N de M by the continued rehabilitation of the track, improvements in signaling, and the acquisition of additional motive power and rolling stock; (b) to continue the improvement of N de M's operating efficiency in accordance with the targets set forth in the Plan of Action; (c) to reduce N de M's operating deficits and improve the financial position of N de M with the objective of reaching eventual financial viability; and (d) to provide improved information systems for the management of N de M. The Plan of Action, which covers the period 1981-1985, is detailed in paragraph 3.10. The list of goods and services to be financed by the Bank is given in Table 3.4.  - 22 - C. Main Project Items 3.06 The main items included in the project are as follows: (i) Track and Structures: N de M will continue, in 1981-1983, various track and structure improvement programs, of which previous phases have been executed under the Second and Third Railway Projects: (a) track rehabilitation, using new heavier rails, sleepers and ballast on about 780 km of principal traffic routes and second-hand recovered rail, with new sleepers and ballast, on about 560 km of secondary lines. The sections to be dealt with are listed in Table 3.5; (b) provision of track maintenance machinery and equipment, together with the regrouping of labor forces, to improve the standards of maintenance, to cater to increased average speeds and traffic requirements, and to maximize sectional capacity on the rehabilitated sections; (c) strengthening and, where necessary, replacing about 510 older bridges to carry the heavier locomotive and car axle loads now in use on the system; and (d) lengthening of existing sidings and construction of new sidings to enable longer freight trains and more frequent services. (ii) Signaling and Communications. N de M proposes to extend the system of CTC to three heavily used single line routes, to improve train control and to increase traffic capacities. The routes are Irapuato- Guadalajara, San Luis Potosi-Benjamin Mendez (near Saltillo) and (tentatively) Teotihuacan-Veracruz via Los Reyes, a total of 960 km, which will double the route lengths equipped with this type of train control. (iii) Locomotives: To cater to the increasing traffic, and in keeping with a program for scrapping older locomotives no longer economical to repair, N de M has arranged contracts for the provision of additional main line locomotives; the contracts provide for the delivery of 72 units in 1981, 60 units in 1982 and 60 units in 1983. Additionally, N de M is considering ordering 50 large horse- power shunting locomotives, partly to replace old units and partly to enable handling larger and heavier trains in the principal traffic yards. N de M has completed a review of its locomotive needs in the light of recent increases in traffic and has furnished to the Bank an integrated program for locomotive scrapping and purchases on the basis of this review. Agreement was reached on the locomotive scrapping and purchase program for the project period. The locomotive position by year, arising from the N de M program of main line unit purchases and its scrapping program, is set out in Table 3.6.  - 23 - (iv) Freight Cars: To meet the demands of the increasing traffic and to keep the utilization of foreign cars to a reasonable level, N de M proposes to purchase about 2,885 cars in 1981, 2,985 in 1982 and 3,480 in 1983. These numbers are based on assessments as set out in Table 3.7. (v) Workshop Machinery: For the workshops and service depots, N de M proposes to continue (from the Third Railway Project) the provision of replacement and of additional machinery and equipment to improve efficiency, and to provide for the gradually increasing number of locomotives and rolling stock in the railway system. (vi) Consulting Services/Technical Assistance: Three areas have been identified for the possible use of consulting services: (a) Development of a comprehensive Management Information System for N de M; (b) Development and adoption of computer models for rail line and yard capacity planning; and (c) Improvement of train and yard operations and locomotive and freight car utilization. Draft terms of reference have been developed for the consultants on the basis of discussions held with N de M during appraisal and negotiations as outlined in Annex 3. D. Cost Estimates 3.07 The cost estimates for N de M's Investment Plan, including the project period, are based on prices at the end of 1980. Local costs of material and labor and contract data for similar work carried out on N de M have been used. Physical contingencies have been added at 5% on work items. Price contingencies have been taken on local costs at 23% for 1980, 20% for 1981, 17% for 1982, 15% for 1983 and 13% per year for 1984-1985; for foreign costs, the price contingencies have been taken at 10.5% for 1980, 9% for 1981, 8% for 1982 and 7% per year for 1983-1985. The cost of consultants for 1981-1983 is US$2 million for 222 man-months at about US$9,000/man-month. E. Financing Plan 3.08 The cash flow forecast was prepared for N de M for the years 1980- 1985 and is shown in Chapter V. Details of assumptions used in preparing the financing plan are given in Annex 4. A summary of the financing plan for the proposed project and for the ongoing program is given in the following:  - 24 - Financing Plan (Mex$ million) 1980 1981 1982 1983 Total Application of Funds Ongoing Program 8,060 170 8,230 Proposed Project Local - 6,078 7,192 9,519 22,789 Foreign - 4,560 3,802 3,793 12,155 8,060 10,808 10,994 13,312 43,174 Sources of Funds IBRD Loan: Proposed Project - 1,003 1,313 1,134 3,450 Ongoing Project 871 170 - - 1,041 NAFINSA 4,741 7,454 7,250 8,817 28,262 BANOBRAS 1,396 1,906 2,143 2,485 7,930 Other 206 - - 506 712 Government Contribution 846 275 288 370 1,779 8,060 10,808 10,994 13,312 43,174 The above figures include physical and price contingencies. The financing has been fully arranged for the ongoing program in 1980. For the proposed project, BANOBRAS has been appointed as N de M's financing agent. Even though the Government's contribution is very small, it will assume the debt service charges on behalf of N de M. It is expected that there will be parallel financing by Eximbank USA (about US$94 million) and international banks (about US$127 million) through NAFINSA to finance the purchase of locomotives and to complete the financial package for N de M. Such financing would reduce N de M's need to rely on BANOBRAS and NAFINSA. A complete financing plan was agreed with the Mexicans during negotiations. F. Project Implementation 3.09 N de M would be responsible for the implementation of the project. The project implementation schedule for track renovation works would be in accordance with the program detailed in Table 3.5, whereas other works and the procurement of motive power, rolling stock and equipment would conform to the year-by-year program detailed in Tables 3.1, 3.3 and 3.4. G. Plan of Action 3.10 In order to achieve the project's objectives, N de M agreed during negotiations to implement a Plan of Action on the lines set out on the following page.  - 25 - (i) N de M shall prepare and introduce a corporate plan designed to achieve the following targets: 1981 1982 1983 1984 1985 (a) (i) Working ratio 129 121 109 100 94 (ii) Operating ratio 144 131 126 114 107 (b) Locomotive-km per freight locomotive in service in a given year 85,000 90,000 95,000 100,000 105,000 (c) Average of locomotives out of order expressed as a percentage of total fleet 23 22 21 20 19 (d) Ton-km per freight car per day 2,100 2,200 2,300 2,400 2,500 (e) Average turnaround time of freight cars expressed in days 12.4 12.1 11.9 11.7 11.5 (f) Average of freight cars out of order expressed as a percentage of total fleet 5 5 5 5 5 (g) Average net train load expressed in tons 1,280 1,330 1,380 1,430 1,480 (h) Number of foreign cars on line per day 10,000 9,000 8,000 7,000 7,000 (ii) In order to attain the targets set forth in paragraph (i) preceding, N de M shall: (a) reduce the operating costs of the railways as necessary to operate them in the most efficient manner; (b) furnish to the Bank, not later than December 31, 1981, a manpower plan updating the manpower plan prepared in connection with the Third Railway Project to the year 1985, including, inter alia, the departmental distribution of manpower year by year to the year 1985 in accordance with the improvements in the operation of the railways as set forth in the investment plan and plan of action for such Project;  - 26 - (c) (1) periodically carry out a cost analysis o- branch lines and, on the basis of such analysis, relacU progressively any losses of N de M from their operation; and (2) each year, request from the Guarantor: (A) permission to abandon low-density branch lines or (B) compensatiorn for the losses estimated to be incurred during such year by operating low-density branch lines, and, whenever the Bank shall reasonably request, identify the losses with respect to each one of such lines; and (d) furnish to the Bank, not later than June 30, 1981, a plan to accelerate action to reduce losses on less-than-carload traffic on the basis of the study carried out unda ; Railway Project. (iii) The Plan of Action shall further include: (a) periodic reviews by N de M of the operational and financial condition of the passenger train services and progressive reductions, on the basis of such review, of the losses of N de M from the operation of such passenger services; (b) in order to reduce losses carried by N de M, annual requests by N de M to the Guarantor for compensation for the losses estimated to be incurred during such year by operating uneconomic passenger services, and identification in the request of the losses with respect to each one of such services; (c) presentation by N de M to the Guarantor of claims for the total cost of mail service provided by N de M; and (d) earning by N de M of such revenues as will cover, by December 31, 1988, all its operating costs and interest on debt and, to attain such purpose, review of the financial projections and related actions of N de M with the Bank periodically in accordance with the progress made from year to year and the necessary adjustment of such projections. P. Procurement 3.11 All items to be procured with the proceeds of the proposed loan would be subject to international competitive bidding (ICB), in accordance with Bank guidelines. In bid evaluation, Mexican manufacturers would be allowed a preferential margin of 15% of the CIF cost of competing imports, or the relevant prevailing level of custom duties, whichever is lower. 3.12 The principal items to be purchased under ICB would be rails, compo- nents for freight cars and special types of freight cars that would be purchased complete. The components would be used in the manufacture of cars by Constructora Nacional (CN), a state-owned enterprise which operates efficiently on a commer- cial basis and produces good quality cars. Under the Second and Third Railway  - 27 - Projects, this enterprise secured the contracts not only for the cars reserved for manufacture within the country, but also for some of the cars tendered through international bidding. CN's factories have the capability to produce 3,000 to 3,500 cars per year; therefore, the Mexican Government and N de M have requested, in keeping with the Government's policy of utilizing the optimum installed capacity, that 8,800 cars be purchased from Constructora during the three-year period 1981-1983. For these cars, the prices of which are subject to adequate Government control and are consistent with prevailing market prices, the imported components would be financed by the Bank, as in the ongoing railway project. The components to be obtained on ICB are estimated to cost about 18% of the total price of the cars to be manufac- tured by CN and would mainly comprise some steel sections, door fittings, brake equipment, roller bearings, wheels and axles. 3.13 The diesel locomotives included in the project would be obtained by N de M, as in the past, for reasons of standardization, from General Motors and General Electric in the USA. I. Disbursement 3.14 For imported goods, disbursements would be made on the basis of CIF costs, and, with respect to bids won by local manufacturers under ICB, disburse- ments would be made on the basis of 100% of the ex-factory costs. The Bank would also finance 100% of the foreign exchange costs of consulting services. The estimated quarterly disbursement for the proposed loan, based on the assumption that the loan would become effective by 1981, is shown in Table 3.8. Agreement was reached during negotiations that there would be retroactive financing of about US$15 million for track and freight car component purchases made after November 1, 1980. The closing date would be June 30, 1984. IV. ECONOMIC EVALUATION A. General 4.01 Mexico's railways continue to play an important role in the develop- ment of the country's economy. Despite the fact that road transport's share of total freight transported relative to rail has increased, with railways transporting 23% of freight in 1977 compared with 26% in 1970, the railways maintain their dominance in the transport of bulk commodities, such as food grains, minerals and fertilizers, over long distances. The traffic forecasts given in Chapter II and Annex 5 reflect this situation, and both N de M's and SCT's investment programs were formulated to ensure that N de M's capacity would be sufficient to handle forecast demand. The SCT program of infrastruc- ture investments and about 80% of N de M's Investment Plan are primarily geared toward increasing railway capacity. These two investment programs, and the subprojects which define them, are complementary. As such, the realization of the benefits from the N de M Investment Plan is dependent in part upon the timely implementation of the complementary SCT works. 4.02 The SCT Program and its economic justification are discussed in Annex 7. This Program includes line rehabilitation and reconstruction as well as the construction of new marshaling yards and new lines, and is well  - 28 - justified. About 80% of the subprojects included in the program have been subject to economic evaluation by SCT, yielding rates of return varying from 16% to 33%, with an overall economic rate of return (ERR) of 22%. The remaining subprojects would be evaluated prior to their implementation (para 3.03). B. Benefits and Economic Returns 4.03 The economic evaluation concentrates on the three years of N de M's Investment Plan which make up the project period, 1981-1983. The economic viability of investments in rolling stock and motive power, track renewal and associated track machinery, bridge rehabilitation and CTC is assessed. These subprojects constitute about 85% of the total cost of the Plan. Items not evaluated include miscellaneous station and building works, minor investments in telecommunications, electricity and lighting, workshop machinery of a replacement nature, service cars and technical assistance. The economic costs include physical contingencies and exclude taxes. Annex 6 gives details. 4.04 The N de M Investment Plan is an integrated package with a number of interrelated components. For example, the realization of benefits from capacity-increasing investments, such as investments in rolling stock and motive power, is dependent upon the availability of adequately maintained infrastructure which would allow commercial speeds, and locomotive and car utilization envisaged under the Plan of Action. In turn, the benefits from works such as track renewal, which prevent line deterioration, thereby avoiding capacity restrictions, are dependent in part upon the availability of adequate motive power and rolling stock to carry forecast traffic. In the evaluation of the N de M Investment Plan, each of the subprojects is first evaluated separately to determine its economic viability. Because of the interrelation- ship between the subprojects, however, some degree of overlap is unavoidable in evaluating each separately. Thus, for example, it is assumed, when evaluating infrastructure investments (track renewal and CTC), that expansions of fleet and motive power would take place to sustain the increasing traffic. Their depre- ciation is included in the operating costs for these lines, and it is assumed that the operatiorial improvements under the Action Plan would be realized. In evaluating the investment program as a whole, therefore, care was taken to avoid double counting in arriving at the economic return of the Investment Plan, as described in Annex 6. (i) Acquisition of Motive Power and Rolling Stock 4.05 The program of acquisition of motive power and rolling stock, which represents 70% of the three-year Investment Plan, was analyzed on a network-wide basis. The determination of needs took into account forecast traffic as well as targets for improved operating performance, particularly increases in locomo- tive and car utilization, locomotive availability and average train loads. The benefit from these investments is measured in terms of transport cost savings for the overall economy, calculated as the difference between the economic costs of rail and road transport, taking into consideration the traffic which would be diverted from rail to road if the investments are not carried out. Details are given in Annex 6, Table 1. These benefits yield an ERR of 18%.  - 29 - (ii) Track Renewal and Bridge Rehabilitation 4.06 The Investment Plan calls for the purchase and installation of new rail of 115 lb/yard on some 790 km of main line. In addition, second-hand rail, released from the main line, would be used to rehabilitate about 700 km of lower density lines. These investments provide for track-laying equipment needed to carry out the program. In both cases, the improvements include the replacement of rails, sleepers and ballast. In addition, the program calls for the reconstruction of a number of bridges and culverts. The benefits from main line track renewal are: (a) reduction in track maintenance costs, includ- ing avoidance of investment in deferred maintenance to bring the lines to a minimum standard of safety; and (b) avoidance of continued track deterioration, which, without the project, would result in extensive speed restrictions, ultimately limiting line capacity and causing diversion of traffic from rail to road. As noted in paragraph 4.04, the long run rail variable costs include depreciation of fleet and motive power. This serves to is 'icitly evaluate these investments on the corridors considered. Benefits fiom reduced wear and, therefore, maintenance of locomotives and rolling stock, and increased safety were not quantified. ERRs, calculated for each line, ranged from 15% to 18% and yielded an overall ERR of 17% (Annex 6, paras 7-9). Benefits from track renewal with recovered rail include: (a) reduced track maintenance costs; and (b) benefits from improved equipment utilization due to increased speeds on lines, which, without the project, would be subject to speed restric- tions, yielding an overall ERR of 21% (Annex 6, para 10). Quantified benefits from bridge improvements are savings from improved equipment utilization by avoiding abnormally low speeds on bridges. The ERR of this component of the program is 26% (Annex 6, para 11). (iii) CTC Signaling 4.07 The 1981-1983 Investment Plan provides for the acquisition and installation of a CTC system on three high density lines: Irapuato-Guadalajara, San Luis Potosi-Benjamin Mendez and (tentatively) Teotihuacan-Los Reyes. Project benefits consist principally of savings derived from avoidance of delays on the line and savings due to increased capacity. Benefits from avoidance of delays were calculated by estimating locomotive, wagon, fuel, and repair costs per hour and applying them to the difference in train running time, with and without the project, in a base year and projected as a function of expected traffic. In calculating benefits from increased line capacity, it was assumed that, without the proposed investment, the line would become saturated as traffic grew, resulting in the diversion of traffic to roads at a higher economic cost. Details are given in Annex 6, paragraph 12. The rate of return for works on the San Luis Potosi-Benjamin Mendez line is 40%, on the Irapuato-Guadalajara line 33%. The Teotihuacan-Los Reyes line was analyzed as part of the SCT Investment Program for that section, which includes limited regrading as well as CTC, yielding an economic return of 32% (Annex 7). C. Overall Economic Evaluation 4.08 The N de M Investment Plan is well justified, with an overall economic return of 22% (Table 4.1).  - 30 - D. Sensitivity and Risks 4.09 A shortfall in the realization of forecast traffic is usually the main risk in transport projects. To test the project's sensitivity to traffic shortfalls, it was assumed that the rate of growth of freight traffic would be 25% lower than forecast. This assumption implies an overall growth rate of 5% between 1979 and 1985 and a long term rate of 3.5%. Under this assumption, the economic rate of return on investment in motive power and wagons would be reduced from 18% to 15%. If the traffic growth rate were reduced by 50% (e.g., 3.3%), the return on this component would still be acceptable at 12%. While the risk of a shortfall in traffic growth, given Mexico's rapidly growing economy, is not considered great, in order to minimize this risk, it was agreed during negotiations that the analysis of freight car requirements would be reviewed annually to relate year to year procurement to any changes in the types and volumes of traffic transported by N de M. A sloiel a.L o,f traffic growth affects, to a lesser extent, the returns on the track renewal program, but does not alter the basic conclusions concerning its economic viability. All of the subprojects evaluated remain viable, with a 10% increase in project costs. The overall economic return, considering a 25% reduction in the traffic growth rate, is 17%, and, considering a 10% increase in project costs, 19%. If both these factors are taken together, the overall ERR would be 16%. Thus, the economic viability of the Investment Plan is not very sensitive to the types of changes most likely to occur. The results of the sensitivity tests are given in Table 4.1. V. FINANCIAL EVALUATION A. Past Financial Performance 5.01 N de M's financial performance in the past five years, since the appraisal of the Third Railway Project (Loan 1232-ME), was a combination of major achievements in some areas and poor performance in others. Major achievements were the revaluation of fixed assets; the curtailment of over 40% of the passenger train services; the rationalization of uneconomic lines; the Government's payment of specific subsidies to N de M on the remaining passenger train operating losses identified with each service; the cancellation of taxes on gross revenues; and the reimbursement of total cost of operating the mail service to N de M. 5.02 Concerning the revaluation of fixed assets, the General Manager of N de M agreed with the Bank, through a supplementary letter, to carry out the revaluation and to use the results for the adjustment of tariffs, but without changing the official balance sheet, since the Government did not allow it to do so. This revaluation was carried out, but without taking any action on tariff adjustment. In the meantime, a Tripartite Commission (para 2.06), formed in 1978 to study and resolve the railway's financial problems, issued a decree allowing N de M not only to carry out the revaluation of fixed assets, but also to incorporate the results into the official balance sheet. N de M then carried out the second revaluation in 1979, and the results were incor- porated into the balance sheet. N de M plans to revalue the fixed assets once every three years.  - 31 - 5.03 Concerning the passenger train services, the General Manager of N de M agreed with the Bank that N de M would progressively reduce the uneconomic services and the related losses. During the period 1974 to 1978, N de M reduced the number of passenger trains by 43%, from 56 to 32 trains, for which it has been claiming specific losses from the Government. Conforming to Section 3.03 of the Guarantee Agreement for Loan 1232-ME, the Government agreed that the above-mentioned 32 trains be continued in service for social reasons and, through a letter of February 9, 1976, authorized the railway to identify the specific losses by each passenger train. N de M is, however, presently carrying out a study on the entire passenger train service in order to recommend to the Government a suitable policy to be adopted which may involve (a) reduction or discontinuance of further services and improvements in others, particularly on principal routes, to attract, if economical, passenger traffic now moving by buses or private cars; and (b) an increase in tariffs to reduce losses. The Bank would be given the opportunity to review the study and comment thereon. It was agreed during negotiations that N de M would (a) periodically review the financial and operational condition of the existing passenger train services and take action to progressively reduce the losses on them; and (b) continue to request from the Government compensation for losses on uneconomic passenger services and to identify such losses with each of the services. It was also agreed that the Government would compensate for such losses. 5.04 Regarding the 34 low density branch lines, 1/ the railway was, under Section 5.06(ii) of the Loan Agreement, obliged to request each year from the Guarantor specific compensation for the losses from those lines. Although N de M has been receiving such compensation for its total deficits, a specific request similar to that for the passenger trains was never submitted to the Government. On October 18, 1979, N de M requested the Bank to waive the requirement under Section 5.06(ii) because the specific calculations would need additional staff. Furthermore, after studying 39 low density branch lines (five more than the Bank asked for), N de M to date has abandoned four lines, found 17 lines to be economic, included one line as part of the main line because of gauge widening, found five lines needed to be restudied, and found 12 to be uneconomic. The deficit on these 12 branch lines represents under 2% of the total operating deficit. Therefore, the Bank, through a letter of February 5, 1980, concurred with N de M's request and waived the requirement under Section 5.06(ii). It was, however, agreed during negotia- tions that N de M would continue periodically to carry out a cost analysis on low density branch lines, identify the losses for each one of such lines whenever the Bank shall reasonably request, and request the Government either to compensate for losses or to permit abandonment. The Government also agreed to pay compensation for losses on uneconomic lines. 5.05 Regarding mail service, the Tripartite Commission (para 2.06) canceled, in 1979, the franchise that the Government agencies previously had for very low cost mail service and instructed them to pay, in the future, the full cost of mail services to N de M through the Mexican postal agency 1/ Under the Second Loan (825-ME) in 1972, N de M agreed to study 34 low density branch lines for the purpose of reducing deficits.  - 32 - (Departamento de Correo). To conform to this instruction, an agreement was reached with N de M and the Government, during negotiations, that N de M would claim the total cost of mail service and the Government would provide it. 5.06 The Government (SCT) showed substantial improvement in the railway tariff policy in the past six years (1975-1980) as compared with 15 years prior to that period (1960-1974). During 1960-1974, no freight tariffs were increased, but, since 1974, the tariffs have been increased practically once a year (para 2.24). In spite of these favorable actions, however, the finan- cial situation did not improve especially from 1976 on. The real problems have been: (1) the massive devaluation of the Mexican peso in August 1976 and (2) inadequate tariff increases to recover the 1976 major setback. The Mexican peso was devalued from Mex$ 12.5 per US dollar to Mex$ 23.0 per US dollar. Staff costs increased in that year by 27% and the material costs made a big leap of over 85% and continued to increase thereafter. 5.07 Income statements for the years 1975 through 1979 are given in Table 5.1 and are summarized in the following: 1975 1976 1977 1978 1979