China - Second Railway Project

Document of The World Bank FOR OFFICIAL USE ONLY og }M. -6vo - C* 9 Report No. P-4037-CRA REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN IN AN AMOUbNT EQUIVALENT TO USS 235.0 MILLION TO THE PEOPLE'S REPUBLIC OF CHINA FOR THE SECCND RAILWAY PROJECT April 23, 1985 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 Calendar 1984 April 1985 Currencv Unit = Renminbi (RMB) (RMB) US$1.0 Y (Yuan) 2.32 Y 2.84 Y 1.0 = US$0.43 USSO.35 FISCAL YEAR January 1 to December 31 WEIGHTS AND MEASURES m = meter (3.281 feec) km = kilometer (0.621 mile) tkm = ton-kilometer (0.621 ron-mile) pkm = passenger-kilomecer (0.621 passenger-mile) kwh = kiiowatt hour (960.42 kcals) CTK = Converted ton-km, -raffic unit (1 pass-km - I ton-km) Mt = milLion tons mtpy = million tons per year ACRON'YMS CIF - Cost, insurance and freight CTC - Centralized Traffic Control FCL - Full car load FOB - Free on board GFA - Gross fixed assets GVIAO - Gross value of industrial and agricultural output ICB - International Competitive Bidding LCL - Less than car load MOC - Ministry of Communications MOE - Ministry of Education MR - Ministry of Railways NFA - Net fixed assets PBC - People's Bank of China PCBC - People's Construction Bank of China RRAs - Regional Administrations SAA - State Audit Agency SFYP - Sixth Five-Year Plan TU - Traffic Unit  FOR OFFICIAL USE ONLY CHINA SECOND RAILWAY PROJECT Loan and Project Summary Borrower: People's Republic of China. Beneficiary: Ministry of Railways. Amount: US$235.0 million equivalent. Terms: 20 years including 5 years of grace; standard variable interest rate. Project Description: This will be the second Bank Group's involvement in the railway subsector. The proposed project would make a direct contribution to the Government's objectives of increasing railway capacity to support economic growth and of modernizing the railways management. The project consists of the following components: (a) upgrading and electrification of the line between Zhengzhou and Wuhan, a 547 km central section of the Beijing-Guangzhou main line, and a 72 km feeder line to the large coal mines at Pingdingshan; (b) the first stage of a modernization program of the pa3senger coach factory at Changchun, which would provide technical assistance necessary to increase the quantity and improve the quality of current production and determine the investment needed for production of a new coach design of 1,500 per year; (c) assistance for new laboratories and staff training at the Vhina Academy of Railway Sciences; (d) a Management Information System study to lay the basis for improving the railway's managerial and operational efficiency; and (e) assistance to railway universities in updating their curricula. The project has no particular risk as the Ministry of Railways has successfully completed similar projects in the past and the demand for both freight and passenger transport is increasing rapidly as a result of economic reforms being implemented by the Government. This document has a restricted distribution and may be used by recipients only in the performance of their officiail dutim Its contents may not otherwise be disclosed without World Bank authoriwiion.  - ii - Profect Costs: Local Foreign Total (US$ million) Zhengzhou-Wuhan line Track upgrading 132.9 63.2 194.2 Electrification 93.2 108.4 201.6 Construction Equipment - 7.9 7.9 Techn. assist. & training - 0.5 0.5 Changchun coach factory 1.3 7.2 8.5 Academy of Railway Sciences Laboratories 4.3 10.3 14.6 Technical assistance & training - 1.3 1.3 Management Information System Study - 0.5 0.5 Base Cost 229.8 199.2 429.0 Physical Contingencies 19.8 4.8 24.6 Price Contingencies 71.4 43.9 115.4 Total Project Cost /a 321.1 248.0 569.1 Financing Plan: IBRD - 235.0 235.0 Government 321.1 13.0 334.1 Total Financing 321.1 248.0 569.1 Estimated Disbursement: Bank Group FY 1986 1987 1988 1989 1990 1991 Annual 3.8 41.6 67.5 50.5 50.6 21.0 Cumulative 3.8 45.4 112.9 163.4 214.0 235.0 Rate of Return: 25x. /a Import tax and duties are not included in project costs and the Government will not charge such taxes and duties on imports for the project.  REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO THE PEOPLE'S REPUBLIC OF CHINA FOR THE SECOND RAILWAY PROJECT 1. I submit the folLowing report and recommendation on a proposed loan to the People's Republic of China to help finance the Second Railway Project. The loan for US$235.0 million equivalent would have a term of 20 years, including 5 years of grace, at standard variable interest rate. The beneficiary of the loan would be the Ministry of Railways. PART I - THE ECONOMY 2. A country economic memorandum, entitled "China: Recent Economic Trends and Policy Developments" (No. 4072-CHA), was distributed to the Executive Directors on March 31, 1983. An economic mission that visited China early in 1984 is preparing a report on long-term development issues and options, which is expected to be submitted to the Executive Directors by May 1985. Basic data on the eronomy are given in Annex I. Background 3. To address problems of economic inefficiency and structural imbal- ances, the Government initiated a program of reform and adjustment in 1979. Reform implementation proceeded most rapidly in agriculture and culminated with the introduction of the "production responsibility system" (in various forms), which gave households and small groups autonomy in production and investment decisions and allowed them to keep most income earned after con- tracted payments to the state and collective. By the early 1980s, the vast majority of production teams in China had implemented such a system. Reform of the urban economy started out much more slowly, but nevertheless sigai- ficant systemic changes occurred, including bonuses for individual workers; profit retention by state-owned industrial enterprises (at first on an experi- mental basis); fiscal decentralization measures, which allowed provinces to share in the benefits of increased revenues and gave them more freedom in budgeting; and some decentralization of foreign trade authority. Adjustment policies resulted in an increase in the share of consumption in GDP; a rise in the share of light industry in total industrial output, substantial improve- ments in living standards, rapid growth of foreign trade (particularly manu- factured exports), and relatively modest (in relation to past trends) GDP growth. 4. A number of problems emerged in the process of reform and adjust- ment, including large budget deficits in 1979 and 1980, deterioration of the  external position and a significant current account deficit in 1980, infla- tionary pressures and some overt price increases, and excessive investment demand resulting from decentralization of investment decision making and financing. In response to these difficulties the Government imposed a stabil- ization program in early 1981, which reLied mainly on administrative con- trols. It resulted in a slowdown in growth, a reduction in price inflation (to around 2% p.a.), a sharp cutback in buaget-financed investment, a lower budget deficit (1Z of GDP in 1981); and a current account surplus of $1.5 bil- lion in 1981 and $5.6 billion in 1982. Economic Performance, 1981-84 5. Economic growth picked up in 1982 with the resumption of rapid growth of heavy industry and the rebound in investment. Overall performance has remained strong, with real GDP growth averaging over 8% p.a. from 1981 to 1984. Shortages of energy, many producer goods, and construction materials were exacerbated by the rapid growth of demand, yet price inLreases were limited by further strengthening of administrative price controls (particu- larly in 1983). Government budget revenue grew very slowly in 1982 (1.3%) but much more rapidly in 1983 (7.9%) and 1984 (as much as 10%), due to a new tax on enterprise retained funds and extra budgetary incomes of Government organizations. This permitted an increase in budget expenditures on invest- ment of 17% in 1983 and a further rise in 1984, while maintaining a relatively small budget deficit (less than 2% of GDP in 1983). Growth of subsidies was largely stemmed by stopping increases in most of the agricultural procurement prices. 6. Gross industrial output value grew at over 10% p.a. between 1981 and 1984, with heavy industry growing somewhat faster than light industry (12% vs. 9%), a reversal of the 1978-81 pattern. The energy constraint on industrial growth was eased by rising coal output (8Z p.a. in 1981-84), consistent annual crude oil output at over 100 million tons, and improvements in the efficiency of energy utilization (primary commtercial energy consumption grew only 60% as fast as GDP in 1981-83). Agriculture has continued its very strong perfor- mance, with gross agricultural output value rising at 9% p.a. in 1981-84 and grain output at 7% p.a. (reaching over 400 million tons in 1984). Cash crops and animal husbandry, stimulated by rising demand and attractive prices, have also grown very rapidly. 7. There have been impressive increases in personal incomes throughout the period 1978-83. Average per-capita income in rural areas rose by about 12% p.a. in real terms and urban incomes by about 5% p.a. Rural income growth was mainly due to production increases, efficiency improvements, and growth of employment in non-agricultural activities, as well as substantial agricultural procurement price increases (through 1981). Urban income growth, on the other hand, can be attributed primarily to wage and benefit increases, which have exceeded growth of laber productivity. 8. Control of the aggregate level of investment and its composition has continued to be a serious problem. Enterprise and local government investment continued to increase sharply in 1982, far exceeding plan guidelines. In 1983, more stringent measures brought this part of investment under control  -3- (though it still exceeded plan targets). But investment outside the rural sector remains rather inefficient, and improvements in efficiency have been hindered by administrative controls. Construction costs have risen continu- ously (10% p.a. in 1978-83). 9. China has maintained a strong external position. The dollar value of both exports and imports stagnated in 1981-83, but this masked considerable increases in the volume of foreign trade. Since 1983, imports have grown more rapidly than exports, and in 1984, exports rose by an estimated 10% while imports increased by 25%. Manufactured export growth was slower in 1981-B4 than in 1978-81, but it started from a much higher base and occurred in the face of worsening world market conditions. Foreign debt and debt service ratios remained at very low levels ($6.4 billion and 5.5% respectively in 1983); China's foreign currency reserves (excluding gold) rose to $17 billion (over 7 months' imports) by mid 1984 and have stabilized at that level since then. The value of the Chinese renminbi declined by about 36% against the SDR between the end of 1981 and late 1984 (60Z against the US dollar). Recent Reforms 10. Rural reforms have continued to progress more rapidly than reforms elsewhere in the economy. There has been a remarkable spread of non- agricultural activities such as processing, transport, and commerce. "Specialized households" (which concentrate on one undertaking - often cash crops, animal husbandry, or non-agricultural activities) and pooLing of capital by small groups of households in various types of ventures are becoming more common forms of economic organization in China's rural areas. Wholesale markets for some agricultural products have emerged. To encourage investment in land improvement and development, farming contracts between collectives and peasant households (which typically had been fixed for no more than 3-5 years) can now be extended to as long as 15-20 years. In early 1985, it was announced that planned procurement quotas for agricultural commodities will be aboLished; more methods of financing investment in rural non-agricultural activities will be permitted (including tax exemptions, local government bonds, higher interest rates to attract more saving, etc.); and the growth of the agricultural processing industry in coastal areas will be promoted. 11. The momentum of urban reforms has revived, with significant progress on several fronts. Since early 1984, the focus has been on broadening and delineating the decision-making authority of urban enterprises. Profit retention now extends to virtually all state-owned industrial enterprises and to non-industrial sectors like transport, commerce, construction, and other services. Urban collectives and individual enterprises, as well as a variety of joint ventures between them and state enterprises, have grown rapidly (the number employed in urban individual enterprises rose from 150,000 in 1978 to 2.31 million in 1983). 12. In financial reforms, the most important new development was the implementation of a profit tax system to repLace profit remittances by state enterprises to the Covernment budget. Though most enterprises have switched to this system, the benefits have been limited because of the application of a different effective tax rate for each enterprise, to offset the impact of  - 4 - distorted relative prices and other factors. Similar probLems have resuLted in the abandonment of an attempt to impose a fee or charge on the fixed capital provided to state enterprises by the Government, and they have hindered the shift from grant to loan financing of new fixed investment, despite strong Government support. Financial discipline at the enterprise level remains weak, in spite of efforts to strengthen accounting and auditing systems and more strictly enforce existing financial regulations. 13. In the crucial area of price reform, a major price adjustment for textiles and textile raw materials occurred in early 1983; it helped balance suppLy and demand, to a large extent equalized profit rates for synthetic and cotton textiles (which are close substitutes in production and consumption), and drastically reduced subsidies for cotton procurement, with only a small net effect on the Government budget. Prices of many "minor" consumer goods (which individually do not have a significant impact on living standards) and the majority of agricultural commodity prices have been decontrolled and are now set by negotiations between producers and commercial units. "Floating prices" (up to 20Z above or below official prices) are now allowed for many industrial producer goods (either for all output or for output above the mandatory plan target). Price adjustments for key energy products and raw materials (which in many cases are severely underpriced) and for subsidized basic consumer goods like grain and edible oil have proven more difficult to implement, hindered by the potential impact of price changes on urban living standards and on the finances of energy-using enterprises. Nevertheless, some price rises have occurred (e.g. for coal and petroleum), and moreover the share of free market transactions (at largely uncontrolLed prices) has increased in recent years. 14. Reforms in the employment and wage system have made limited progress. The bulk of urban labor is still allocated administratively, and transfers of workers or professionals among enterprises are heavily impeded. Numerous attempts are being made to link individual performance more closely with rewards, including piece-rates, "floating wages," and various types of contractual "responsibility systems." These have achieved some success, but problems of egalitarian distribution of bonuses remain, and many enterprises give out bonuses in kind or disguise them as allowances in order to evade reguLations. 15. China's foreign exchange rate system has been unified with the abolition of the "internal settlement rate" (Y 2.8 to $1) at the beginning of 1985. Direct foreign investment (which was first allowed in the late 1970s but developed slowly due to the lack of a legal framework) is being actively encouraged and joint venture agreements have increased sharply. In addition to four "special economic zones" open to foreign investment and subject to more flexible policies, 14 coastal cities were recently opened up in the same way. 16. Significant steps have been taken to develop new tools of indirect macroeconomic management. The central banking functions of the People's Bank of China were separated from its commercial banking functions (which were given to the newly established Industrial and Commercial Bank of China) at the beginning of 1984. The central bank relies on redeposit requirements and a  - 5 - discount window to influence the operations of specialized banks, and even- tually may use discount rates and interest rates in general as a flexible tool of macroeconomic management. Adjustments in indirect taxes Irmay be used to affect profitability and supply, in the absence of or as a supplement to price reform. Scope for horizontal flows of investment funds is also widening, as enterprises invest in each other and in joint ventures and as some individuals purchase stocks. Though restrictions on secondary trading remain, Government bonds purchased by individuals can now be sold to banks or used as collateral for loans. Long-term Issues and Prospects 17. The Central Committee of the Chinese Communist Party issued a major document on urban reforms in October 1984, which reaffirms and consolidates recent reforms and provides some general guidelines for the direction of future reform. rt emphasizes the need for breakthroughs in: (a) enlivening and better motivating urban enterprises; (b) clearLy separating Government and enterprise functions (and limiting direct intervention by Government organizations in enterprises' day-to-day operations); Cc) reforming the price system; (d) improving incentives in the wage and bonus system; (e) establish- ing a planning system that is in harmony with greater reliance on the market mechanism and developing indirect macroeconomic management; (f) upgrading managerial personnel to meet the new demands on them in a reformed economy; (g) removing obstacles to a unified national market and promoting cooperation and technology transfer among regions; and (h) expanding utilization of foreign capital and advanced technology. Among the main themes of the document are the role of competition in promoting a more dynamic, flexible economic system; the recognition that a certain degree of income inequality is necessary to provide better incentives for economic development; the need for clear responsibilities and appropriate incentives at all levels in the economy; and the recognition that thoroughgoing price reform must involve liberalizing the mode of price determination, not just adjusting administra- tively set prices. Managers of large state-owned enterprises, however, wiLl still be appointed by the Government; a few key products will still be subject to mandatory planning and distribution by the Government; state ownership and control over certain institutions like banks and railways will not be relinquished; and establishment, relocation, changing product lines, mergers, and shutdown of enterprises will still be subject to Government approval. 18. The Central Committee declaration represents a political commitment to economic reform, which will help foster an environment in which fundamental reforms can be gradually implemented in a coordinated way. But specific policy measures will take a considerable length of time to design and then to implement. Many of the reforms required will be very difficult, particularly since reforms in different areas are closely interrelated, and thus appro- priate sequencing and coordination are essential. For example, price reform in the absence of improvements in enterprise financial discipline will have limited benefits, yet the more profit-oriented behavior that would result from tighter financial discipline would exacerbate the adverse impact of distorted prices. Similarly, reform of the labor allocation system will be incomplete without eliminating many of the "social responsibilities" of enterprises (which now provide housing, medical care, and pensions for their workers and  - 6 - in many cases education and jobs for workers' children) and replacing them with Government-supported social service programs. 19. China's objective of quadrupLing the gross output value of industry and agriculture between 1980 and 2000 (which means CDP growth o' well over 6X p.a.) will require significant improvements in efficiency as well as continued high saving and investment rates. There will be major structural changes in the economy over the next two decades, including a reduction in the share of agriculture, a rise in the share of industry and possibly in that of services (which at present is unusually low), and substantial urbanization (in smaller towns if not in large cities). There wiLl also be a shift within agriculture, away from grain and basic crops and into cash crops and animal husbandry. 20. Certain physical/technical constraints will hinder the attempt to achieve China's targets for the year 2000 and its longer-term goal of catching up with developed countries. Despite rapid growth and substantial improve- ments in efficiency in recent years, agriculture may again become a constraint on overaLl growth, since Land in China is severeLy limited. In energy, shortages of fuel (primarily coal) and electricity may continue to constrain growth in transport and commercial infrastructure. Without Large new investments and improved efficiency, economic growth will lag. En mobilizing resources in all these areas, China could profitably make use of foreign borrowing. Finally, the rising share of the elderly in China's population (related to the slowdown in population growth) means that more resources will have to be devoted to maintaining their consumption levels, especially in the decades after O000. 21. Poor motivation and inefficient utilization of labor in the state sector of the economy are major problems which can be solved only by coor- dinated reforms in labor allocation, the wage system, enterprise management, and social services, among other things. Reforms in the system of education and training to develop China's "human capital" potential also are crucial. Backward technology and inefficient use of existing technology must be addressed by a combination of reforms, appropriately directed investment, and transfer of advanced foreign technology. Irrational location of factories, sub-optimal scale of many plants, and poor utilization of physical capital in general are related problems. 22. If reforms successfully transform the economic system, with a beneficial impact on growth and efficiency, a new set of issues will come to the fore. Management of a reformed economy with indirect fiscal, monetary, and other instruments is a major issue. In this context, maintaining an adequate saving rate (if the Government no longer accounts for the bulk of aggregate saving) and avoiding inflation (as well as deep cyclical downturns) will be major goals. Assuring an adequate minimum standard of living for the population and an appropriate level of social services will become a major challenge as enterprise and rural communal responsibilities in these areas are reduced. The problem of poor, backward rural areas in various parts of the country will continue to require attention. Redistributing financial resources through the fiscal system, easing restrictions on migration out of the poorest areas, and lowering non-agricultural wages to make investment in them more attractive are some options for alleviating poverty in these areas.  23. The Government is in the process of finalizing its Seventh Five Year Plan (covering the period 1986-90). The combination of potentially fundamental reforms and the urgent need for large investments in many parts of the economy to build the foundation for further growth makes this task difficult. In order to mobilize the investment resources needed for rapid, sustained economic growth and development, China will need to rely in part on foreign borrowing. Recognizing this need, the Government plans to gradually draw down its substantial foreign exchange reserves and hopes to attract foreign capital through a variety of channels. China also has a claim to concessionary lending because it is still one of the poorer countries of the world. But China's access co concessionary capital to finance development and modernization is limited; apart from Bank Group funds, a significant amount of concessionary capital is likeLy to come only from Japan and a few other bilateral donors and will probably average no more than $500-600 million p.a. during the rest of the 1980s. PART II: BANK GROUP OPERATIONS 24. For China to sustain rapid growth over the coming decades, with increases in efficiency and innovation while maintaining equity in distribu- tion, China will require continuing and fundamental reforms. These challenges are compounded by China's large investment requirements and difficulty in efforts to open up to the rest of the world. In light of this, there are several broad objectives for the Bank to pursue in its relationship with China. First, the Bank can offer China development experience and institu- tional knowledge as well as opportunities for interaction with the Bank's other member countries. Second, the Bank can assist China in removing major constraints on development and in improving investment planning and policy coordination in the priority sectors - namely energy, transport, other infrastructure, human development and industry. Third, the Bank can assist the Government in efforts to remove the remaining pockets of poverty. 25. The Bank Group's strategy to meet these objectives is formulated in line with China's broad development priorities and related issues outlined in Part I of this report. However, Bank Group lending can provide only a small portion of overall resource needs. As a key element of the stravegy, there- fore, the Bank's lending operations will aim to create a substar.tial demon- stration effect applicable to China's overall development efforts. For example, projects involving new techniques for land deveLopment or for provi- sion of social services have been designed so they can be repeated by local authorities with their existing resources. Some of the agriculture projects and rural health projects are examples of this approach. The introduction of international competitive bidding through Bank projects (first to finance goods, and later civil works) is being adopted by the Government for most local purchases and many domestic construction projects.  - 8 - 26. Bank assistance can help improve the efficiency of investment, through introduction and dissemination of improved analytical techniques for investment and project pLanning and through institution building. Preparation of the project appraisal manuals for the China Investment Bank and the Agricultural Bank of China, consultant assistance and the EDI-sponsored pro- grams, as welL as specific sector work in transport, industry, health, educa- tion and other sectors have improved the quality and content of project pro- posals. Assistance to Chinese enterprises and agencies through staff train- ing, consultant assistance, creation or reorganization of institutions, and improvement of costing and financial management has been included in a number of projects ranging from the ports and railway projects to the several educa- tion and petroleum projects. Sector work in enterprise management, urban deveLopment, health and industry has also provided assistance for improvement of investment efficiency. 27. Human resource constraints are a particularly serious problem for China's development. There are severe scarcities of higher level trained manpower. Substantial economic and sector work and technical assistance and training components in most of the Bank projects are providing support. In terms of poverty alleviation, the rural health project, proposed urban and water suppLy projects and sector work on labor mobility and regional develop- ment options address poverty, heaLth and equity issues. 28. Transfer of technology in the broad sense is of fundamental impor- tance in China's efforts to improve efficiency of the economy. Outmoded, inefficient and costly industrial technologies are serious impediments to development and are wasting valuable energy resources. Here, the Bank can play the roLe of an intermediary. In transportation, energy, industry, agri- culture and even education, the Bank can finance transfer of technology through equipment imports, provision of foreign consulting assistance, arrangement of training and promotion of licensing and other agreements such as are now being discussed in the railways and other projects. Long-term investment for new technology will require increased foreign borrowing in the future and the Bank can assist China through cofinancing. Progress is being made in introducing co-financing under the first and second power projects, coal, urban, water, and some agriculture projects, and the Bank will continue these efforts. 29. For most of these elements of country strategy, however, progress will be gradual and will require sustained Bank involvement over a series of projects in various sectors. Economic and Sector Work 30. Economic and sector work in China was initially designed in part as a learning experience to provide the Bank with a basis of knowledge on the development and functioning of the Chinese economy. It also introduced the Government to alternative ways of economic analysis and views about its achievements. 31. In the last four years, the above approach has been well received and has fostered economic and sector work that is responsive to the problems  - 9 - of adjustment and reform. Follow-up to the first economic report emphasized technical assistance and sector work for investment analysis and selection techniques and enhanced sector planning. The content of the lending program has been direccly influenced as a result. The rural credit project, the China Investment Bank projects, and future regional industry projects are examples of the links between economic and sector work and the Lending program. 32. More fundamental research by the Bank in collaboration with Chinese economic research institutions into the problems of enterprise management is nearing completion. The research has yielded insights into the attitudes of enterprise managers toward system reform and has led to better understanding of how policy changes can improve planning, performance and management of enterprises. In addition, the:e is a variety of pro5ect-related sector work underway through studies included in the projects. These are expected to produce the basis for detailed discussion of development options and poLicies in the various sectors. 33. Current economic work focuses on future options and issues to the year 2000. A comprehensive report will be ready later this fiscal year. In light of the experience of other countries in making the transition from low to middle income levels, the report will pay special attention to inter- sectoral Linkages and cross-sectoral and economy-wide issues. 34. Future economic and sector work will be based on the conclusions of the economic report and will look in more detail at some of the issues raised. It will continue to improve our knowledge of the economy - its struc- ture, the issues and constraints in key sectors, and the functioning of the economic management system. Collaboration with Chinese research institutions on issues of institutional and policy change will continue. Review of the investment program in key sectors when the Seventh Five Year Plan (1986-90) is finalized will help develop the next generation of projects for the lending program. Lending Operations 35. Since China's change of representation in the Bank Group in May of 1980, 24 projects involving lending of $2,391 billion to China have been ap- proved. Annex II contains a summary statement on these loans and credits as of March 31, 1985. For this fiscal year we expect to present a total of twelve projects to the Board. These include: the already approved projects for Second Agricultural Research, Second Power, Second University Development, Changchun (Luan) Coal Mining, Seeds Development, and Rural Water Supply; the proposed Second Railways Project; and other projects in roads, fertilizer production, forestry, Pishihang-Chaohu area development and gas engineering. 36. For FY86 and beyond, the China lending program should continue to grow from current leveis. Areas of emphasis would include development of energy resources, transport infrastructure, skilled manpower and improved technology. We will also investigate the feasibility of a regional approach in a number of sectors to take better accourt of inter-sectoral linkages. 37. In the transport sector, railway, port and road capacity must be substantially increased. So far, one project each in ports and railways has  - 10 - concentrated on increasing capacity, upgrading technology for lower cost operations, and establishing better costing systems. This would continue to be the focus of effort in the Second Railways Project. Expanding domestic capacity to manufacture improved transport equipment wiLl continue to be a theme in the sector and this should provide scope for substantini foreign private sector involvement. Improved management and information systems and analytical techniques for better cost controL will be encouraged under the proposed and subsequent projects, which, once proven, will be suitable for wider use throughout transport enterprises. Intermodal coordination and planning and assessment of alternative investment choices will have increasing prominence in both lending and sector work. 38. In the energy sector, lending has included six projects, which have emphasized increased energy output and technology transfer through financing of equipment, technical studies, training and consultant assistance. The Lubuge Hydropower Project has resuLted in the Government's extensive use of competitive bidding for power projects. Fuel alternatives for electric power, generating plant location and interconnection of power grids will be the subject of future work. For development of China's petroleum and coal resources, Bank Group assistance is emphasizing acquisition of appropriate technologies, Least cost planning of investment and related transport investment programs. 39. In agriculture, six projects have emphasized support services through improved research and education, production increases through new land development, reclamation, use of improved technologies and management, strengthening of the agriculture credit system and seeds development. Projects in forestry and agriculture credit will continue to strengthen sup- port services and rural institutions. Land and area development projects will endeavor to provide models of integrated regional development. Specialized activity projects such as fisheries, livestock and agro-processing may also be developed to support ongoing structural transformation in agriculture. 40. In the industrial sector, two projects have focused on establishing and strengthening the China Investment Bank. Improved investment selection criteria, incentives for more efficient management, technology transfer, and energy conservation are priorities for future projects. Lending will have a two-pronged approach - further s-rengthening of the China Investment Bank (and perhaps other financial intermediaries) and financing large regional produc- tion-oriented projects such as for fertilizer, machine tools, and cement, to expand output and demonstrate the merits of improved subsector ana'ysis and planning. 41. Further expansion of higher education and improvement of teaching, curricula and graduate quality will be needed to the end of the century. The human resource constraints have already been addressed by five education projects and a component of the Rural Health/Medical Education Project. The value of international competitive bidding for equipment purchases and of international advisory panels for educational policy and curriculum reform has been demonstrated in the first projects. Improved university management is being encouraged through establishment of quantitative targets for growth, student-teacher ratios, classroom utilization, laboratory experiments  - 11 - performed, and other reforms (including development of evaluation and monitoring procedures and greater decentralization). Projects in health, urban deveLopment and water supply will assist the Government in addressing difficult poverty-linked questions of affordability, cost recovery, and minimum standards with focus on particularly impoverished regions. 42. Implementation. Project implementation is generally proceeding well. There have been some initial delays in procurement because of the Covernment's unfamiliarity with the concept of bidding, but these are now being addressed through a central procurement agency. Most project agencies, as well as the Ministry of Finance and the State Planning Commission, have established and staffed offices to handle Bank Group projects. To support further expansion of the lending program, accelerate project preparation, improve project implementation, and facilitate further economic and sector work, the Bank Group is planning to open a resident office in China early in FY86. PART III - THE TRANSPORT SECTOR 43. Like other centrally planned economies, China's transport system exhibits a high freight intensity, measured in ton-km dollar of output, and a low personal mobility in its population. This high freight intensity is explained partly by: (a) China's economic structure, with the service sector accounting for a very low share of GUP; (b) the historical emphasis on heavy industry, requiring the movement of ores, steel, and other bulk products; and (c) the high level of energy consumption per unit of output in China's industry; energy use per unit of GDP is two and a half times that of other low-income developing countries. 44. Traffic Trends. Domestic freight traffic in 1983 reached 1,006 billion ton-km, almost a fourteen-fold increase since 1952, or an average annual growth rate of almost 9%, systematically higher than the growth of domestic product. The modal split has moved toward a more balanced use of modes, but the railways still handle 66% of the traffic, versus 82% in 1952; this predominance is expected to continue for quite some time. By the year 2000, domestic freight traffic could be in the range of 3,000 billion ton-km or about three times the 1983 level. 45. Passenger traffic reached 310 billion passenger-km in 1983, a 12.5-fold increase since 1952 and an average annual growth rate above 8%. Since 1978, growth has averaged 12! p.a., well above twice the overall rate of economic growth. It is likely that this growth would have been more rapid if it had not been constrained by the limited capacity, particularly of the railways to offer more passenger services. Despite the rapid growth of passenger traffic in recent years, the mobility of people in China is still much lower than in countries of comparable income levels. By the turn of the century, passenger traffic in China may well reach about 1,500 billion passenger-km. per year or about five times current levels.  - 12 - 46. Invescmencs. Over the period 1953-80, some Y 110 billion, or 15X of all new investment under cencral government control went to transport. Compared to other countries, the annual investment in China's transport sector has been somewhat low, and this has made transport a bottleneck to economic development. For example, in 1983, 10 miLlion tons of coal had to be stored in Shanxi for Lack of transport, and some of the stock-piled coal was destroyed by spontaneous combustion. These coal inventories have now been reduced somewhat, but only by curtailing production to match available transport. Rural areas are short of transport both for agriculture and for commune and brigade enterprises. In the ports, lack of proper handling facilities is preventing the import of buLk fertilizer, while for grain the ship waiting time has exceeded 15 day. at some ports, resuLting in large demurrage charges. In che forthcoming decades, a much larger effort will be needed in transport if bottlenecks to economic development are to be avoided. 47. Port traffic has grown rapidly since 1976, reflecting the economic opening of China to foreign trade. Annual growth has averaged over 11%. Domestic coastal shipping and inland water transport also increased substan- tially. As a rebult, ports became congested despited commendable efforts to achieve high productivity. A major effort to modernize ports started in the early 1970s and continues with particular emphasis on container and bulk terminals, the latter mainly for coal. The Bank's first transport operation in China was the Three Ports Project (Loan 2207-CHA, November 1982), which includes container terminals at Huangpu, Shanghai and Tianjin, and a coal berth at Huangpu. A second port project, which will provide ten additional berths at Tianjin, is now being considered for Bank financing: 48. The highway network comprised 915,00 km in 1983, of which about 173,000 km are asphalt paved, about 510,000 km are gravel/sand paved, and the remainder are earth roads. Despite impressive expansion of the network since 1949, the roads in China today are inadequate because: (a) pavement strength and quaLity are poor; (b) there are many thousands of kilometers of extremely rough macadam-surfaced roads with average daily traffic in excess of 300 vehicles; (c) congestion is severe near cities due to mixed slow and fast moving traffic; and (d) there are gaps totalling about 4,000 km on major national roads linking large cities and provincial capitals. The road network and road transport in China today can therefore be characterized as underdeveloped. Road maintenance, however, is well organized and currently absorbs much of the attention and resources of the provincial and other road authorities. Except for western China, the highway network is still very much a system of feeder roads to the railways. The Bank's first highway project in China, which will involve the construction or improvement of about 230 km of national roads and about 1,400 km of rural roads, was negotiated in April 1985. 49. Transport Issues and Objectives in the 1980s. The Sixth Five-Year Plan, 1981-85 (SFYP) approved in December 1982 ,includes Y 27.5 billion (16.2% of the total) earmarked for transport sector investments. The railways are scheduled to receive 63% of this amount. The plan document does not directly mention issues in the transport sector, but a number of other recent publications give a fairly consistent picture of some key problems. The most important sectoral issues at this time are: (a) the capacity constraints for  - 13 - both freight and passenger traffic; (b) the appropriate economic role of the various modes and in particular the modal allocation of short-distance traffic; (c) the management of the transport system, including policy, planning, coordination, and pricing; (d) the modernization of technology for both infrastructure and vehicles; (e) the conservation of energy; and (f) the training and development of staff in all the above matters. The RaiLway Sector 50. RaiLway Facilities and Rolling Stock. China's railway network more than doubled in size between 1949 and 1983, from 21,800 route-km to 51,600 route-km. The netwnrk now incLudes 9,200 route-km of double track and 2,650 route-km of eLectrified track. Further double tracking and eLectrification works are in progress as present line capacicy is insufficient to meet traffic demands. The rail network is served by a fleet of '0,000 locomotives, 260,000 freight cars and 15,000 passenger coaches. At present, 75% of attractive power is still steam, 22% is dieseL and 3% is electric. Rolling stock includes large numbers of older wagons and coaches. many in poor condition and with high maintenance costs. Traffic growth has outstripped production of new units and the fleet is far from adequate. 51. Operations. Despite the limitations of network and rolling stock, rail operations in China utilize track and equipment intensiveLy and efficiently. Freight traffic density averages 13.8 million net ton-km per route-km which is the second highest freight density in the world after the Soviet Union, and 50% higher than freight density in the United States. China's passenger traffic density of 3.7 million passenger-km per route-km is also the second highest in the world, this time after India. Passenger traffic density in the Soviet Union is roughly the same as in China, but in the United States it is only 0.1 million passenger-km per route-km. Despite this heavy traffic density, track and other fixed installations are carefully maintained although the labor-intensive methods now used will become inadequate to handle the heavier traffic planned for the future. 52. Scope for utilizing track and equipment even more efficiently is mostly limited to lengthening trains (freight car turn-around is already very quick and it would be difficult to improve upon the present average of 3.3 days.) The average train now has 35 cars as 75% of passing loops are only 650 meters long. Most of the remaining 25% of loops are 850 meters long, which allows 50-car trains to run in some regions. A program is underway to extend passing loops in more regions. 53. Traffic. Rail remains the major carrier in China's transport sector. In 1983, rail freight accounted for 665 billion ton-km of total domestic freight of 1006 billion ton-km and between 1950 and 1983 rail freight increased more than 17 times: freight tonnage increased 12-fold to 1,188 million tons and the average haul distance increased over 40% to 560 km. China's freight traffic is now the third largest in the world after the Soviet Union and the United States. 54. The growth in rail freight traffic between 1950 and 1983 averaged 9Z p.a. Since 1978, traffic growth has slowed to around 4.5% p.a. as traffic  - 14 - has saturated existing line and rolling stock capacity. However, 1983 traffic already reached the SFYP forecast for 1985. Three quarters of all freight traffic involves the movement of ten important basic or intermediate commodities (including coal, iron and steel products, grain and construction materials) and the shortage of freight capacity has emerged as one of the key constraints to economic growth: shortages of electricity suppLy capacity are estimated to be loosing China up to 20Z of potential industrial output and freight capacity to serve the power sector is an important part of this constraint. 55. The Covernment is aware of these impediments to growth and is placing special emphasis on developing the energy and transport sectors. As part of the Government's program to expand capacity, the first railways project in China financed by the Bank (Loan 2394-CHA, March 1984) is helping to provide important new rail lines, to double track and electrify sections of existing lines, and to double domestic production of electric locomotives to 120 per year. The Ministry of Railways is also taking steps to increase freight car production. 56. Passenger traffic grew from 24 billion passenger-km in 1950 to 310 billion passenger-km in 1983 and rail is again the most important carrier. In 1983, rail accounted for 57% of total passenger travel and the railways trans- ported 1060 million passengers, eight times more than in 1950. Most of the increase in rail passenger traffic occurred with the opening of the economy and the start of system reforms between 1978 and 1983. In just these five years traffic increased to 177.3 billion passenger-km at an average 10% p.a.. The growth in total passenger traffic was more than double GNP growth and shows the high priority afforded to personal travel out of the extra income generated by the economic reforms of the late 1970s. 57. Although this growth in passenger traffic is formidable, the mobil- ity of people in China is still low. Annual per capita mobility in India averages about 800 passenger-km, much more than China's average of about 300 passenger-km, despite India's lower per capita income. Partly this low mobil- ity is because of a shortage of transport infrastructure; on the railways there is an acute shortage of passenger coaches. Even though trains are very crowded, many would-be passengers are now turned away for lack of space. Demand probably will continue to exceed capacity for the foreseeable future: even if the 1978-1983 income elasticity of rail travel of 1.3 subsides to unity as income increases, China's coach production of 1,200 per year will satisfy only half the demand increase that would be generated by planned economic growth of 7% p.a. and it is unlikely that coach production can be increased quickly enough to make good all the shortfall. 58. Tariffs and Costs. In common with other sectors, railway charges changed little since the early 1950s. Freight rates were increased in late 1983 for the first time since 1967 at which time they had been reduced. Passenger rates, though, remain at the 1967 level. The 1983 freight rate increase doubled the minimum chargeable distance to 100 km, and increased rates for 75%. of freight (including coal, oil, cement and fertilizer) by 23%. The present average freight haul of 572 km yields average revenue net of sales tax of Fen 1.68 per ton-km, 75% above average operating costs. The  - 15 - average passenger journey is 169 km and this yields net revenue of Fen 1.78 per passenger-km, 65Z above average operating costs. As part of the First Railway Project, MR is now carrying out a comprehensive costing study. 59. Although operating margins are high, the railways are an integral part of Government and have until recently remitted all earnings to the State. In 1983, a package of broad financial reforms was put into effect for all state agencies and enterprises, to encourage and incroduce better manage- ment and new concepts and incentives. The railways, even though not an enter- prise, are now liable for a sales tax set at 15Z of gross operating revenues and income tax at 55Z of net profits. A certain share of after-tax profits has to be remitted to the State as well. Overall, the effect of the reforms has been to substitute tax revenues for direct profit remittances to the State. In 1983 the railways contributed Y 4.8 billion (US$1.7 billion) to State revenues. 60. Organization. The railways employs 2.7 million people; 1.6 million in railway operations and 1.1 million in industry (MR operates 68 factories producing locomotives, rolling stock, etc.) in capital construction (new railway track, bridges, electrification, workshops, housing, etc.) and in various support services (education for example). Central control of the railways is vested in the Ministry of Railways, though operations are managed by 13 regional administrations, seven fewer than in 1983. Each regional administration is headed by a General Manager and consists of eight depart- ments and at least three sub-administrations concerned with operations. Management is generally effective though management techniques are somewhat out of date. 61. The Ministry of Railways has six design bureaus and seven construc- tion bureaus. All of these are adequately staffed with skilled workers and management (unskilled labor is recruited locally for each project). All pro- ject designs are tailored to the labor intensive construction methods appro- priate in China, and construction work is done to a good standard. Projects have mostly been completed on or ahead of schedule without cost overruns. Two of the design bureaus are specialized. One deals with track electrification and has prepared all China's electrification projects to date (about 2,650 km) using technology wideLy used in developed countries, i.e. 25kV-50Hz. Another bureau specializes in major bridge design. The remaining four bureaus deal with general design. Of the seven construction bureaus, five deal with general construction projects and two are specialized: one in tunnel con- struction and one in factory construction. 62. Education and Research. Under the coordination of the Ministry of Education, the Ministry of Railways operates 10 universities, 20 colleges for in-service training and more than 2,000 schools with 100,000 teachers and staff. Seven of the universities provide technical courses, two provide medical courses and one is a teacher training college. Most of the ten now offer graduate programs. For high school graduates unable to enter univer- sity, MR operates more than 60 intermediate technical schools which train locomotive drivers and other operations staff. MR's other schools provide primary and middle education for an enrollment now exceeding one million.  - 16 - 63. The Ministry aLso operates the ten research institutes which comprise the China Academy of Railway Sciences. Mostly, the institutes are concerned with applied research and acceptance tests on new products procured locally and from abroad, but the institutes also provide instruction to Masters and Doctorate Levels. The institutes are seriousLy cuncerned about a number of raiLway operating probLems which they are iLl-equipped to research, but which need prompt attention because of the traffic disruption the problems are causing. Excessive rail wear, the cracking of concrete sleepers and design shortcomings in some types of rolling stock are the most serious of these probLems. 64. Budgets, Accounts and Audits. The railways annual capital budget is prepared by MR within the sectoral allocation of resources decided by the State Planning Commission. Some of MR's tax remittances to the State are used to finance railway investments directly and to service debt contracted for railway investments. But in common with other sectors, MR's budget allocation is no longer limited by the amount of uncommitted state resources. Following its recent economic reforms, the State will, when necessary, now provide foreign loan financing to sectors to sustain its desired level of investment. 65. An annual recurrent budget for the railways is prepared first at the sub-administration level, then at the regional administration level and is then finalized by the Ministry. Regional capital budgets are coordinated centrally by the Ministry's Planning and Statistics Bureau, which is responsible for all investment planning. 66. Accounting procedures are based on a double-entry accrual system. Their most unusual feature is a dual system of depreciation: a basic provision of 3% of the cumulative historic gross value of assets, and an additional provision for major repairs of 3.5%. Some part of the extra provision would normally be charged to working expenses and the current practice probably understates MR's net asset base and overstates its earnings position. A review of the dual system of depreciation is part of the overall review of MR's accounting plan being conducted under the First Railways Project. 67. The Ministry of Railways has a "Financial Checking Division" that performs internal auditing and checks the correlation of revenue and expend- iture with planned allocations. The People's Bank of China is MR's paying and collecting agent. It keeps a close record of budgetary allocations including their subsequent adjustments; its inspectors regularly check the use of funds by MR. The People's Construction Bank of China fulfills a similar role for investment funds. External auditing will in the future be undertaken by the newly-established State Audit Agency (SAA) which has the status of a Ministry and reports directly to the State Council. The SAA is progressively taking over responsibility for auditing all Government departments and state-owned enterprises. 68. Investments and Planning. China's railways investments fluctuated considerably throughout the 1950s, 1960s and 1970s because MR's budget alloca- tions were tied closely to total State revenues, which in turn varied with China's rate of economic development. More recently, recognition of the  - 17 - important role of the railways in the development process has fostered a long- term view of the need to develop railways capacity and budget allocations are now less arbitrary. The Sixth Five Year Plan (1981-1985) aims to increase coal carrying capacity from western provinces to China's east coast, to relieve constraints on lines on the eastern seaboard and to develop passenger traneport in the most populous provinces. Accordingly, after falling to Y 1.5 billion in 1981 during the period of budgetary stringency, rail investments were increased to Y 3.7 billion in 1982 and in 1983 to Y 4.2 billion, over half the total investment in transport of Y 7.2 billion, but still far short of the level which would be needed to alleviate bottlenecks. 69. Within the Ministry of Railways, investment planning is the responsibility of the Planning and Statistics Bureau. Proposals for expansion, new production capacity and new technology are developed by the Ministry. Total investmenc amounts and priorities are determined by the State Planning Commission. New technologies, system expansion, imports versus increased production and total investment levels and financial options are all key issues to the sound future development of China's railways. 70. Government Objectives and Bank Goals. The Sixth Five-Year Plan C1981-1985) allocated Y 72.5 billion to the transport sector, 16.2Z of total investments. Of this, Y 17.3 billion was for investment in railways. These resources have facilitated considerable development of the rail network, but not enough to keep pace with China's rapid economic growth. The present saturation of the rail network and the constraints this imposes on further economic growth have brought into sharp focus the important role transport plays in the development of all main sectors. If China is to achieve its goal of quadrupling the gross value of industrial and agricultural output (GVIAO) by the year 2000, the railways expansion and modernization must be accelerated so that limited capacity does not hold back economic growth. The resources needed for an adequate level of investment are now much larger than could be provided from China's previous practice of funding all investments from within the sector. Some further expansion of investment financing through loans, both domestic and foreign, is desirable for the higher economic growth if would facilitate. 71. The Bank Group's strategy for the subsector is to support the Government in increasing the capacity and improving operations and efficiency of its railways and in further developing MR's technical and management capabilities. The first part of the strategy is to be responsible to the materiaL needs of China's railway system as they arise; the second part is to help better equip the subsector with the expertise it needs to meet the increasing and more complex demands being placed upon it. Thus, the strategy is a balance between helping to provide sufficient transport capacity to match economic growth and to improve MR's ability to manage future developments of the railway system. 72. Through this and subsequent projects, the Bank hopes to work with MR in almost every aspect of railways planning and operations. The Bank will concentrate its efforts in the following five areas where it can have most effect:  - L8 - (a) capacity and suitability of infrastructure and equipment; (b) manufacture and maintenance of infrastructure and equipment; (c) financial management; (d) management structure; and (e) technology transfer and education. PART IV - The Project 73. In December 1983, the Government requested Bank assistance in financing urgentlv needed rail investments to increase railway capacity. The proposed project was prepared by the Government and Bank staff; it was appraised in October/November 1984. A Staff Appraisal Report (No. 5512-CHA, dated April 22, 1985) is being distributed separately. Supplementary project data are given in Annex III of this report. Negotiations were held in Washington on April 8-12, 1985 with a Government delegation led by Mr. Wang Lian Sheng of the Ministry of Finance. Project Objectives 74. The project would make a direct contribution to the Government's objective of increasing railway capacity to support economic growth. The project would increase railway line capacity in Central China on the important route between Zhengzhou and Wuhan and increase the production of passenger coaches. In addition, the project would strengthen applied research, continue the modernization of MR's management techniques, and advise on improvements in university curricula. Project Description 75. The project comprises the following five components: (a) additional line capacity on the 547 km Zhengzhou-Wuhan section of the Beijing-Cuangzhou line, one of the most important transport arteries in China; (b) improvements in production technology and increases in coach production at the Chungchun Passenger Coach Factory; (c) assistance in development of the China Academy of Railway Sciences with new laboratories for materials and equipment testing; (d) a Management Information System Study in a selected area of MR; and (e) technical assistance to MR's universities to strengthen curricula and meet MR's changing technology and management needs.  - 19 - The five subsections which follow give a brief summary of each of the project components. 76. Zhengzhou-Wuhan Upgrading and Electrification. This section is in the central part of the Beijing-Guangzhou main railway artery, which has the second highest traffic density in China. The section has already reached ics maximum practical capacity (about 37 million tons p.a. in the north-south direction) and is now a severe bottleneck for transporting both freight and passengers. Three alternatives were considered for increasing the capacity of this section: to build a new line in the mountainous region between Xinyang and Cuangshui; to use foreign diesel locomotives, instead of the present 50/50 mix of steam and domestic diesel locomotives; or to electrify the line. 77. Electrification was found to be the Least cost solution and accords with MR's long-term development plan to electrify all lines carrying very heavy traffic. Adequate electric locomotives co serve the line would be produced by the Zhuzhou factory, supported in part by the Bank's First Railway Project. This component of the Second Project would include: (a) track lengthening (from 850 m to 1,050 m) at 59 stations and increase of the loading gauge at 18 bridges on the Zhengzhou-Wuhan section; (b) electrification of the 547 km double track section and of the 72 km single track feeder line from Pingdingshan (the site of a major coal mine now being expanded) to Mengmiao, on the Zhengzhou-Wuhan section; (c) expansion of three marshalling yards along the Zhengzhou-Wuhan section; Cd) provision of construction and maintenance equipment for the overhead catenary system; and Ce) technical assistance and training in design and construction of electrified railway lines. 78. Changchun Passenger Coach Factory (CPCF). The Ministry of Railways has four coach faictories, which together produce about 1,200 coaches p.a. The largest is the CPCF. It was established in 1950 to produce 1,000 passenger coaches p.a., but has never been able to produce more than 700 p.a. because of a combination of various technical and managerial shortcomings. Bank assistance was requested by MR for developing a program to correct these deficiencies and eventually to increase production capacity to 1,500 coaches per year. The Ministry of Railways also would like the program to improve the quality of the coaches produced to make them more durable, so that major overhauls could be spaced at 12 to 15 years intervals instead of the six years interval for the current model. The Changchun factory produces the most common passenger coach used in China. It is a basic design with a compact hard seat arrangement and is equivalent to a third class coach in other- countries.  - 20 - 79. The activities supported by the project cover the first stage of a two-stage program to modernize CPCF. The objectives of this first stage are: (a) technical assistance to CPCF, to increase current production and improve coach quality; (b) training of CPCF personnel in modern technical and management practices; (c) preparation of a feasibility study on the expansion of production; (d) development of a new coach design adapted to Chinese conditions; and (e) provision of welding and surface treatment equipment and production machinery. The factory would be expanded under the second stage of the program, possibly supported by a subsequent project. 80. The Ministry of Railways has selected a suitable partner (British Rail Engineering Ltd., U.K.) who would help in the design of a new generation coach, plan the work needed to expand production facilities, determine which equipment to purchase, and assist CPCF from production start-up to achievement of full output. The selection of this technical assistance was carried out in accordance with Bank guidelines under terms of reference agreed with the Bank. 81. China Academy of Railway Sciences. The Academy is the main railway research center in China and the prime quality control body within HR, for both domestic and imported equipment and materials. It is fairly well- equipped for meeting basic research needs and employs 3,665 people, 2,046 of whom are technicians covering a wide range of specialties. In 1978, the Academy started a university level education program with eight specialities leading to the Bachelor's degree level and two to the Ph.D. level. To date, 58 students have obtained Bachelor's degrees and 102 postgraduates are currently enrolled. 82. Two new laboratories are needed to test rolling stock and track components. The Association of American Railroads assisted MR to select the = basic concept of the laboratories, but the Academy needs further assistance to finalize the design, prepare tender documents for ICB, carry out procurement and set up the facilities. Selection of a suitable consultant is under way, in accordance with Bank guidelines, and with terms of reference agreed with the Bank. This component will include: (a) consultant services as defined above; (b) provision of equipment and instruments to equip the laboratories; and (c) training of Academy staff in fields related to the laboratories.  - 21 - 83. Management rnEormacion System Study. To act efficiently, managers at all levels must be provided with adequate and timely information. At present, not all MR managers have access to the information they need; others are presented with too much which obscures what they need to know. To better tailor information flows to the needs of managers throughout the railways and the related factories, a Management Information System Study is proposed which would do four things: (a) record present information flows to each level of management; Cb) determine for each level of management what is the minimum of essential information; tc) recommend both improvements to present information flows and ways of speeding up the flows; and (d) assist MR and the factories to implement the improvements, including the provision of computer hardware and software. 84. In addition to streamlining and accelerating flows of information, the study wilL provide an opportunity to review MR's managerial functions and to amend them where appropriate. The ultimate objective of the study is to heLp improve the overall management and operations efficiency of the railways and related factories. 85. The study's ambitious objectives will take several years to research and implement and therefore probably will be spread over several Bank proj- ects. The study team wiLl be formed by the end of 1985 and the study is expected to start in earLy 1986. The study will be carried out in accordance with terms of reference agreed with the Bank and upon completion of each phase MR will furnish to the Bank a copy of the report for review and comment (Section 3.03 of the draft Loan Agreement.) 86. Education. China's rapid economic growth has led to a shortage on high level manpower throughout the economy. In the railway subsector the shortage of manpower is particularly acute. High traffic growth has been accompanied by further improvements in technology as more lines are converted to electric traction. China urgently needs the new capacity that will be provided through electrification and MR needs to have the managerial and technical capabilities to accelerate capacity expansion if the railways are not to impede economic growth. This will mean maintaining peak management efficiency whilst strengthening MR's ability to take full advantage of the contribution which new technology can make in MR's growing investment program. 87. While MR's skilled manpower will increasingly be provided from China's wider university system, MR's own universities will continue for many years to supply the majority of MR's new high level staff. There is therefore a need to improve and strengthen curricula at MR's universities in areas where new technology, through complementing traditional work practices, could facilitate investment planning and help further improve the efficiency of railway operations. This is a particularly opportune moment to explore the universities' needs, since there are potential overlaps and complementarities  - 22 - between their work and that of the Academy. For this purpose, the project would include an international panel of six specialists to assist KR in reviewing and strengthening curricula of MR's universities. The panel would have three tasks: (a) to compare the numbers of graduates and their mix of skills with the subsector's likely future needs; (b) to determine areas of MR's planning and operations where new technology are most relevant and, in light of these; (c) to review and recommend university curricuLa improvements to provide MR with better qualified high level manpower in areas of new technology and economics/finance, management and planning. 88. Training and Technical Assistance. In conjunction with each of the five project components, an extensive training program has been set up under which Chinese railway staff will study and gain practical experience abroad (about 810 man-months) and foreign trainers would spend about 117 man-months in China, mostly giving instruction in new technologies and modern management practices. In addition, technical assistance will be provided to the Changchun Passenger Coach Factory and to the Academy of Railway Sciences. The total cost of the combined program is about US$7.0 million or 3% of the proposed loan. Technical assistance will be contracted according to Bank Guidelines. During negotiations, assurances were obtained that the training will be carried out in accordance with the agreed program (Section 3.04 of the draft Loan Agreement). 89. Cost Estimates and Financing. Detailed designs are completed for all project works. Quantities were derived from final engineering, and unit prices are based on current world market prices for equipment to be imported. The cost of equipment and materials to be procured locally and not to be financed by the Bank was estimated on the basis of current domestic prices, but shadow pricing was used for the economic analysis. The estimated project cost, expressed in April 1985 prices and including training and contingencies is about US$569.1 million, of which US$248.0 million represents direct and indirect foreign exchange costs. The Government has requested a loan of US$235.0 million which would cover about 95% of the estimated foreign exchange cost. It will finance other materials, equipment and construction costs from its own resources. 90. An average of 6% physical contingencies is included for all project costs. For the calculation of price contingencies, it is assumed that eschange rate adjustments will, on average, be made to maintain "purchasing power parity" during the project implementation period. On this basis, price escalation for both foreign and local costs: (a) when expressed in US dollars, is based on expected international inflation rates of 5% in 1985, 7.5% in 1986, 8Z in 1987 to 1990, and 5% in 1991; (b) when expressed in Yuan, is based on expected domestic inflatioa of 3% p.a. in 1985-1991. Price con- tingencies thus represent 25.4Z of base cost estimates plus physical contin- gencies expressed in US dollars, and 10% of the same total expressed in Yuan.  - 23 - 91. The proposed Bank loan wouLd finance: (a) for the Zhengzhou-Wuhan line electrification: rails, other steel products, timber and cement, transformers, copper wire, insulators, power and signalLing cables; design and construction equipment; and technical assistance and training; (b) for the Changchun Passenger Coach Factory: on-site technical assistance and training by the foreign partner and training of factory production and management staff abroad; the foreign cost involved in the development of a new coach design and its engineer- ing; the production of three prototypes and the transfer of know-how for the new coach; the preparation of a feasibility study on the expansion of production facilities to 1,500 coaches per year; some basic items such as welding and surface treatment equipment; and a limited number of machines tools, urgently needed by the factory independently of the new design chosen; (c) for the China Academy of Railway Sciences: the foreign exchange cost of the technical assistance program; equipment and instruments to equip the new laboratories; and the training of Academy staff in fields related to the work to be performed in the new laboratories; and (d) for the Management Information System Study: the foreign exchange cost of study tours; technical assistance; and computer hardware and software to implement the new MIS. 92. Project Implementation. Upgrading and electrification of the Zhengzhou-Wuhan line will be carried out by the railways' own forces. This is common practice with uark on .iaes with heavy traffic. The Ministry ,f Railways is well equipped and has experience in this type of work. In this case, the Fourth Design and Construction Bureau will be responsible for track, station and yard upgrading and the Electrification and Automation Bureau for installing electrification equipment. Implementation of the other components of the project will be carried out by MR with the help of competent consul- tants (para. 88). The project is expected to be completed by December 31, 1991, and the Closing Date of the proposed loan is June 30, 1992. 93. Procurement. Procurement of materials and equipment for electri- fication works and of equipment for the Changchun Passenger Coach Factory and the China Academy of Railway Sciences will be subject to international competitive bidding (ICB) in accordance with Bank guidelines for procurement, except for a number of small items worth less than US$100,000 per order and LGtalling less than US$2.0 million, which would be purchased on the basis of quotations received from three potential suppliers. All packages for equipment subject to ICB (about 95% of the total amount) will be subject to the Bank's prior review of procurement documentation. In bid evaluation, Chinese manufacturers will be allowed a preferential margin of 15X of the CIF cost of competing imports, or the relevant prevailing level of customs duties, whichever is lower.  - 24 - 94. For items not financed by the Bank, Government procurement proce- dures will apply. Such items comprise civil works, various locaL materials, and miscellaneous equipment. The civil works involved in this project are not suitable for ICB. They include a large number of small concrete foundations for the catenary masts all along the line to be electrified, and clearance adjustments on 18 bridges; these works have to be carried out under heavy traffic. Other civil works include Lengthening 59 crossing loops by 200 m each, and adding more tracI' in three marshalling yards. Delivery of major materials such as rails, other steel and cement is independently arranged by the owner and supplied to the construction bureaus. In this case, such materials are to be procured through ICB and financed by the Bank loan. (US$ million) Procurement Method Project Element ICB Other Total cost Civil works 0.0 291.2 291.2 (0.0) (.J) (0.0) Materials 97.1 33.5 130.6 (97.1) (0.0) (97.1) Equipment 128.9 11.3 140.2 (128.9) (2.0) (130.9) Services 0.0 7.1 7.1 (0.0) (7.0) (7.0) Total 226.0 343.1 569.1 (226.0) (9.0) (235.0) 95. Disbursement. Disbursement of the proposed loan would be as follows: (a) 100% foreign expenditures of the CIF cost of imported equipment ar4 materials; (b) 100X local expenditures of the ex-factory cost of locally manufactured equipment and materials; and (c) 100Z of the cost of technical assistance and overseas training. 96. Domestic transport from port or factory would not be eligible for Bank financing. Any savings under the loan would be cancelled unless otherwise agreed with the Bank. Disbursements against training and contracts for goods and services valued at less than US$50,000 each would be made on the basis of Statements of Expenditures (SOEs). To facilitate disbursements for these items, a revolving fund will be established with an initial deposit of US$500,000. Documentation supporting the SOEs will not be submitted to the Bank but will be kept in the project office in Beijing and made available for review by the Bank's supervision missions.  - 25 - 97. Disbursements are expected to start slightly slower but proceed slightly faster than the standard profile. Disbursement experience with the First Railway Project has been good thus far. 98. Environment. No negative impact on the environment is anticipated from the project. The electrification of the 619 km section between Zhengzhu, Wuhan and Pingdingshan (presently steam and diesel operated) will signifi- cantly reduce pollution in the area. 99. Recent Financial Performance. The operations of the Ministry of Railways (MR) have been highly profitable. The following table shows the system's actual 1982 and 1983 and estimated 1984 financial results. 1982 1983 1984 Actual Actual Estimate Cash working ratio (Z) /a 36 35 37 Total working ratio (Z) 54 52 52 Operating ratio (Z) 70 67 66 Rate of return on average net fixed assets in use (Z) 6.5 7.6 8.3 COC gross budgetary revenues from the railway (Y bln) 4.2 4.8 5.4 GOC budget expenditures for railway investments (Y bin) 3.7 4.6 4.5 GOC net budget revenues from railways (Y bln) 0.5 0.2 0.9 /a Ratio of cash working expenses, excluding major repairs, to sales revenues, net of sales tax. 100. Until recently, most of the net earnings of MR were remitted to the State and formed part of general State revenues. Retentions were permitted for only a small number nf clearly defined purposes. Capital investment and working capital were financed exclusively from the State budget. Investment levels were not related to net revenues earned by MR. Investment priorities were determined nationally by the State Planning Commission, and were made with reference to national and plan needs, not with reference to MR's greater financial capabilities. Possible Future Performance (1985-1995) 101. Recently, China has introduced budget loans for capital investment projects, and pronouncements by Chinese leaders suggest that this will play an increasingly important role in the funding of national investment programs, including that of MR. At the same time, more autonomy is gradually being delegated from the State Planning Commission to ministries and enterprises for the development of their own investment plans and priorities and the manage- ment of their own finances. For the railway, it is possible - though by no  - 26 - means certain - that in the pursuit of such reforms, the Government will consider adopting a different form of organization for the operational part of MR which would emphasize its self-accounting character and would convey a somewhat greater degree of autonomy to its management. 102. Even if this does not happen in the near future, it is appropriate that MR should increasingly focus on questions such as the scale and pace of its expansion program, the appropriate mix of local and foreign loans and budget contributions to finance this expansion, and the relationship between its tariffs and the growth of traffic, investment, tax and other dues to the State, and debt service. Until these basic policy questions have been resolved, it is not meaningful to attempt to quantify MR's future financial performance. However, the prudence with which its affairs have been conducted in the past encourages confidence that its future policies will be soundly based. 103. Under the First Railway Project (Loan 2394-CHA, March 1984), a dialogue on railway finances was initiated between MR and the Bank. Up to the present, this has productively emphasized current financial performance, new financial concepts, and links to planning of each year's operations and improved management systems. These are areas where the Bank's substantial international experience and methodologies of planning and analysis can be particularly useful to the Ministry, but they are also sensitive areas in which the Bank should not expect to move quickly. The focus of our dialogue should gradually be broadened to include development of an investment program, its financing, and the implications for the railway's financial situation; but progress can be expected only gradually and only to the extent that the Bank can be seen to be offering useful and practical advice in the Chinese context. Therefore, no specific financial performance requirements or investment plan reviews have been included in this project. 104. Financial Benefits of Zhengzhou-Wuhan Electrification. The financial implications of this component of the project have been assessed by comparing the line's operating costs and revenues with and without the project through 1995. Without the project, line traffic would be restricted to 33.8 billion net CTK, whereas traffic projections indicate that with the project the line would carry 46.4 billion net CTK in 1991 and 56.3 billion net CTK in 1995. With the project, revenues in 1991 wouLd be Y 669.7 million and net revenues would be Y 207.5 million; more than four times the net revenue of Y 46.5 million which would be earned without the project. By 1995, net revenues with the project would be Y 317 million; over six times what they would be without the project. Electrification would also improve the rate of profit on the line: without the project the line's operating ratio in 1991 is expected to 90%; with the project it would be 69%. By 1995 the operating ratio with the project would improve further to 65%. 105. Financial Benefits of Changchun Passenger Coach Factory Development. In 1986, CPCF will discontinue production of its present coach model in favor of an interim model, which would be produced through 1989. After 1989, production of the new design coach will start and gradually build up to 1,500 per year. It is estimated that the interim coach will cost Y 156,000 to build and will sell for Y 187,000 and that the new design coach  - 27 - will cost Y 162,000 and sell for Y 200,000. On the basis of these figures, CPCF estimates that through 1991 it would earn a 42% rate of return on average net fixed assets in use. Details of this projection are in the Project File. 106. Audits. Assurances were obtained during negotiations rhat project accounts and the financial statements of (a) the Zhengzhou and Wuhan railway = subadministrations; and Cb) the Changchun Passenger Coach Factory, will be audited in accordance with sound accounting practices by independent auditors acceptable to the Bank, and that audit reports would be sent to the Bank for review not later than six months after the end of each fiscal year (Section 4.01 of the draft Loan Agreement). The Bank currently accepts SAA (para. 67) audits for this purpose. 107. Benefits. The project would make a direct contribution to the GovernmentT plan for providing the increased rail transport capacity that is essential for sustained economic development. By electrifying the Zhengzhou- Wuhan section of the Beijing-Cuangzhou line, the project would provide more capacity to move coal frDm the rich fields of Shanxi and Henan provinces to the major consuming points that lie to the south, thereby easing the serious energy shortages in that region. Regional trade in grain and other essential commodities and passenger travel would be facilitated as well. By helping to increase production at the Changchun Passsenger Coach Factory and improve coach quality, the project will help satisfy some of the rapidly growing demand for passenger travel. Further production increases and quality improvements wilL be facilitated by engineering studies of an improved coach design and by a feasibility study of expanding the Changchun factory which are also included in this part of the project; this further production expansion could be the subject of a subsequent Bank loan. The proposed project would also provide new research and quality testing facilities for the China Academy of Railway Sciences which would be used to investigate a number of serious operating problems on the railways (excessive rail wear and sleeper cracking, for example). Finding a solution to any of these problems would further increase the efficiency of railway operations. In addition, the project would help further develop the subsector's technical and management expertise through the Management Information System study and through updating university curricula on the advice of a panel of specialists to include more new technology. Project benefits would thus be well spread throughout the economy. 108. Overall Evaluation and Risks. Overall economic evaluation shows that implementation of all project components is well justified and should proceed without delay. The overall ERR including the costs of the research and the training components and the costs of complementary investments in coal mines and other equipment is estimated at 25Z. The electrification works involve proven technology that is already in wide use in China and elsewhere in the world: technological risks are therefore small. Similarly, the project at Chungchun carries little risks, since the foreign partner is an established coach builder. In addition, MR has successfully completed similar projects for a number of years; risks from inadequate project implementation and operation are therefore negligible. The constraint placed on China's development by tight energy supplies insures that the Government will continue to focus on coal transport, just as the recent reforms in agriculture suggest  - 28 - that transport of agricultural products will continue to be vital to the economy. Passenger travel also has an important and constructive role to play as the economy grows. Thus the risk is very low that the benefits of the project would fall substantially short of projections. PART V - LEGAL INSTRUMENTS AND AUTHORITY 109. The draft Loan Agreement between the People's Republic of China and the Bank, and the Report of the Committee provided for in Article III, Section 4(iii) of the Articles of Agreement are being distributed to the Executive Directors separately. llO. Special conditions of the project are listed in Section III of Annex III. A special condition of loan effectiveness is that China's State Council shall have approved the Loan Agreement. 111. I am satisfied that the proposed loan would comply with the Articles of Agreement of the Bank. PART VI - RECOMMENDATION 112. I recommend that the Executive Directors approve the proposed loan. A. W. Clausen President Attachments April 23, 1985 Washington, D.C.  -29- ANNEX I Page 1 of 6 CYlll. o O.5 U7Ot - w .IUICA DATA *ST CElllA rIOPLZS U. OP UFImN COUPS (IIQ103un AVIUAsIS) /a HOST (mOT 3ICUIT ESThIAU) b- 33CKIW ~LOW ERCdmS Him" 111- z9utkb 197aotk ZSTDIULb ASIA 8 PACIFIC AsIA 6 PAciFIC TOTAL 3381.0 ,s6i.0 9381.0 AURICLTO3AL 3257.8 3642.0 385.9 cw In carf (to") 40.0 IC 80.0 310.0 278.0 1091.2 vm= inornuu a cairn (czwauAS or OIL F4OIVALET) 191.0 250.0 412.0 272.0 567.3 orPuLATION.MIDT4AR (THOUSANDS) 6700. 0 843700.0 1008175.0 Ulm POPUlATION Z1 0f TOTAL) 18.4 /d 20.8 21.7 IL POPMUTlOJ cnxrls POPMLATION I 1TM 2000 (DULL) 1118.3 STATIOUAET POPUlATION (MILL) 161.0 POPMLATION Ngamma 1.7 PoratAnou DCSITT taR So. m. 71.9 U .5 103.8 16b.8 281.9 P SO. mX. ACI. LAND 211.1 217.9 256.8 345.5 1735.1 POrAlAXSTI!ON E S1330M (2) 0-16 us 3J.9 37.7 30.9 35.8 39.0 15-,s 3s 58.3 57.2 83.3 59.8 37.8 65AN ASCY 4.8 5.1 5.5 6.3 3.3 POPULATflON GRWTH KMT (Z) roTaL 1.j 2.1 1.5 1.9 2.3 a - .. .. 4.1 6.3 CD SIar UTE (PER 2T1o) 39.2 /a 34.0 18.5 27.7 30.1 CRUDEt STE MATE (DEL Tom) 23.5 1- 10.1 6.6 10.1 9.5 Gamss mbODfCSTON 16T1 2.8 7a 2.3 1.2 1.8 2.0 FAULT PLANIlNG aCWTOSS. ANNUAL (TIOUS) .. OS1U CZ OF URILD WI01) *- *- 89.6 7f *- 52.7 FOO Am nwines 1150 OF POOD PRlOD. Pn CAPITA (L98f-71-100) .. 100.0 124.0 112.8 123.0 aC CAPITA SauPLr OT cFatus (S OP EQUIRBKNTS) 93.0 88.0 107.0 97.7 116.6 METINS (GRS PR DAT) 56.0 53.0 8.0 56.8 57.0 or NICI U AUL ND PULSE 16.0 16.0 17.0fjA 14.9 16.1 CUfID (ACES 1-A) D=E lATEZ 26.0 14.0 7.0 9.8 7.2 LIFE MuE. AT 311m (TEAMS) 61.0 l 52.3 86.5 60.0 60.4 SACT mor. NAE (FP 21) * 165.0 1 109.0 67.0 83.8 ".3 ACSS TO Sn WATE (13OF) TOTAL .. 41-0 32.9 37.0 1111 .. .. 70.9 54.8 5L .. .. 3,0 22.1 26.4 ACGESS TO ECflEA DISPOSAL (I OF POPULATION) TOTAL I.. .1. 61.3 Mn , .. .. 72.3 67.4 30. . . *6 .33.3 POPUATON PER PITCIAN 8390.0 /1 3830.0 11 1810.0 Il 3464.2 7769.4 POP. TM UUSLIG 350 '050.0 2870.0 1790.0 4793.1 240.4 POP. Pl OSPITAL ED TOTAL 1060.0 760.0 690.0 1066.5 1004.2 3A 210.0 . 160.0 296.0 651.2 iEL 10160.0 .. 1020.0 5993.6 2594.6 M555095 In UOfTAL RED . . .. 27.0 -SD