Peru - Railway Rehabilitation Project

ILE CO P Y RESTRICTED Report No. P-312 This report was prepared for use within the Bank and its affiliated organizations. They do not accept responsibility for its accuracy or completeness. The report may not be published nor may it be quoted as representing their views. INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT REPORT AND RECOMMENDATIONS OF THE PRESIDENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO THE PERUVIAN CORPORATION LTD. FOR THE MODERNIZATION AND REHABILITATION OF THE CENTRAL AND SOUTHERN RAILWAYS IN PERU March 4, 1963  REPORT AND PECOMMENDATIONS OF THE PRESIDEIN TO THE EXECUTIVE DIHLCTORS ON A PROPOSED LOAN TO THE PERUVIAN CORPORATION LINITED (PERU) 1. I submit herewith the following report and recommendations on a proposed loan in various currencies equivalent to US$13.25 million to the Peruvian Corporation Limited (the Corporation) to finance a part of the foreign exchange cost of modernization and rehabilitation of its railway system serving Central and Southern Peru. PART I - HISTORICAL 2. In April 1958, the Bank made a loan of $15.0 million to the Corporation to finance a rehabilitation project similar to the present one. The loan was predicated on a number of conditions being complied with before it could become effective, the most important being a fur- ther increase in tariffs. However, shortly after the loan was signed, Peru's economic situation began to worsen, and with it the financial situation of the Corporation. The following devaluation of the sol caused a sharp increase in the Corporation's operating cost, requiring in turn a larger tariff increase than originally anticipaten. This increase the Corporation was not able to obtain by the time the loan was to be made effective. Furthermore, the Tariff Commission which had been established by the Executive Power was abolished. There was then no prospect of the Corporation being able to fulfill the conditions of effectiveness in the foreseeable future, and in August 1959 the Bank terminated the loan agreement. However, it agreed at that time that the Bank would consider a new loan request, provided that the Corporation's financial prospects improved and that a satisfactory basis could be worked out for a new project. 3. By 1961, conditions had in fact improved to the point where the Bank could again consider financing the modernization and rehab- ilitation of the railroads. A Commission for Economic Regulation of Transport had been established by Act of Congress which gave reason- able assurance of the Corporation obtaining tariff adjustments in the future; the Corporation engaged the firm of Coverdale and Colpitts to study its operations and its prospects for growth of traffic and to prepare a new project of further modernization and rehabilitation; and finally, the Corporation established a Board of Directors in Lima. These improvements and the consultants' report were the basis for the Corporation's request for a new loan. In June 1961, a Bank mission visited Peru to appraise the project.  - 2 - 4. Formal negotiationr began in Washington on May 24, 1962. M4r. 1J.H. WAhite, Chairman and Mr. Michael R. Lubbock, Deputy Chairman, represented the Borrower, assisted on different occasions by iMr. Richard Gardiner, who at that time was Managing Director of the Corpo- ration. The Government of Peru was represented by Mr. Carlos Gibson, Commercial Minister at the Peruvian Embassy in Washington. Presenta- tion to the Board, however, had to be delayed until the Military Junta, which took over after the inconclusive general elections of June 10, 1962, confirmed the previous Government's intention to guarantee the proposed loan. A further delay was caused by the Cerro de Pasco Cor- poration, the principal user of the Central Railway, threatening to move all its freight by road. This threat has now been removed, as explained in more detail in this report and its attachments. Negotiations were, therefore, resumed in January 1963. 5. The proposed loan would increase the Bank's lending to Peru, net of cancellations and refundings, as of January 31, 1963, from $92 million to f"105 million. The Bank has made the following loans to Peru: Amount Year Borrower Purpose (in $ milion equivalents) 1952 Republic of Peru Port development (Callao) $ 2L,410,528 1952 Republic of Peru Agricultural development 1,300,000 1954 Republic of Peru Agricultural development 1,700,000 1954 Banco de Fomento Agricultural development 4,999,771 Agropecuario 1955 Republic of Peru Irrigation project 17,999,464 1955 Cemento Pacasmayo Construction of cement plant 2,497,082 1955 Republic of Peru Highway maintenance 4,994,887 1957 Banco de Fomento Agricultural development 5,000,000 Agropecuario 1958 Autoridad Portuaria Port development 6,575,ooo 1960 del Callao 1960 Banco de Fomento Agricultural development 5,000,000 Agropecuario 1960 Lima Light and Power Power development 24,000,000 Company 1960 Republic of Peru Highway project 5,500,000 (Aguaytia-Pucallpa) 1961 Republic of Peru Highway maintenance and 10,000,000 improvement Total (net of cancellations and refundings) $91,976,732 of which has been repaid 17,779,381 Total now outstanding 7)4,197,351 c Amount sold $8,311,482 of which has been repaid 5,240,482 3,071,000 Net amount now held by Bank $71,126,351 e Includes $25,947,053 undisbursed balance as of 1-31-63.  - 3 - PART II - DISCRIPTION OF THE PROPOSED LOAN 6. Purpose: To finance a part of the foreign ex- change cost of modernizing the Central and Southern Railways, the two princi- pal railways of Peru oimed by the Corporation. Borrower: The Peruvian Corporation Limited. Guarantor: Republic of Peru. Amount: The equivalent in various currencies of $13.25 million. Amortization: 24 semi-annual instalments from Decemberl, 1967 to June 1, 1979. Interest rate: 5-1/2% per annum. Commitment charge: 3/4 of 1% per annum, Payment dates: June 1 and December 1. PART III - LEGAL INSTRUTENTS SECURITY AND LEGAL AUTHORITY 7. Drafts of a Loan Agreement (No. 1) and Guarantee Agreement (No.2) are attached. The following provisions are of special interest. (a) Loan Agreement (i) The Bank is to receive, as security for the loan, a first irortgage upon the imraiovable and movable prop- erties of the Central and Southern Railways. The Corporation is permitted, however, to give pari pa_su security f'-r the Export-Import Bank's lines of credits (7ection 5.04); (ii) The Corporation would be allowed to make payments to its parent company, the Peruvian Investment and Finance Limited, pursuant to the Inter-Company Debenture, only after June 30, 1967 and only from net earnings provided certain financial requirements are met, except for $2,205,000 payable during the five-year period ending June 30, 1967 that the parent company needs to service debentures issued by it to the public (Section 5.12);  (iii) Conditions of effectiveness include: granting of a mortgage to the Bank; a revision of the Inter- Company Debenture to restrict payments by the Corporation to its parent company; and the con- clusion of a loan agreement for about :,D5,000,000 with the Expert-Import Bank (Section 7.01). (b) Guarantee Agreement (i) The Guarantor undertakes to make, or allows to be made, timely adjustments in railway rates (5ection 3.06). (c) Collateral Documents (i) The Corporation would use its own resources to finance the purchase of goods and costs for the program whenever, and to the extent that, its net quick assets, as defined, exceed the equivalent of $.vi5 million, and it would reimburse the Loan Account periodically from June 30, 1965 to July 1, 1967 in the amount that net quick assets exceed $1.5 million (No. 3); (ii) The Guarantor recognizes the importance of the regu- lation of inland transportation and confirms that its undertaking with respect to rates is consistent with the relevant legislation ant acknowledges the importance of permitting the Corporation to main- tain its financial position in conformity with sound financial practices (No. 4). 8. The Government of Peru is authorized by Law 12960 of 1958 to guarantee payment of principal, interest and other charges. 9. The Report of the Committee provided for in Article III, Sec- tion (iii) of the Articles of Agreement of the Bank is attached (No.5). PART IV - APPRAISAL OF THE PROPOSED LOAN 10. A detailed appraisal of the project (Report TO-313d) is attached (No. 6).  -5- The Project 11. The Project is the four-year program of the Borrower for the modernization and rehabilitation of its Central and Southern Railways. The program calls for the purchase of 47 new diesel locomotives and related spare parts; 171 freight cars of various types, structural steel and equipment for certain workshops; about 29,000 tons of 80- pound rails with fittings for relaying a part of the tracks of the Southern and Central Railways; and miscellaneous railway equipment. The Borrower 12. The Corporation, incorporated in the United Kingdom in 1890, and at present domiciled in the U.S., is a wholly-owned subsidiary of the Peruvian Investment and Finance Limited. The parent Companyts only other assets are two small real estate holdings. The Corporationts affairs are directed by a ten-member Board which meets regularly in Lima. The Chairman, Deputy Chairman and the former Managing Director are members of the Board and reside in London, and the other seven are prominent Peruvian businessmen. The Central and Southern Railways are each managed by a Manager who reports to the General Manager in Lima. Execution of the Project 13. The project would be carried out entirely by the Corporation, which is well organized and managed, and is able to discharge its responsibilities efficiently. The consulting firm of Livesey and Henderson, of London, has been engaged by the Corporation to prepare the tender invitations for international competitive bidding, to analyze bids and make recommendations for awards. The Corporation plans to engage other consultants to study and mate recommendations for increasing the efficiency of its operations. Financing of the Project 14. The total cost of the four-year program is estimated to cost about US$21.3 million. The foreign exchange cost equivalent to about US$19.5 million would be financed as follows: Proposed IBRD loan US$ 13.25 million Proposed new Eximbank loan 4.75 Funds from existing Eximbank loan (disbursed in 1962) 1.50 " US$ 19.50 million  - 6 - The proposed Bank loan includes a reserve which is not expected to be fully drawn down. According to present estimates, the Corporation would generate by June 30, 1967, the Closing Date of the proposed loan, up to p5 million in excess of what it requires for working capital. Any such excesses would, as agreed in the loan documents, be used to finance a part of the foreign exchange cost of the project otherwise covered by the proposed loan. Actual disbursements from the proposed loan are therefore, likely to fall anywhere between US$8 million and US$13.25 million. 15. The proposed Eximbank loan of US$4.75 million to finance 19 locomotives for the Central, has been approved by the Eximbank's Board of Directors and a firm commitment is expected to be made shortly. The loan is expected to carry an interest rate of 5-3/4% with a repayment period of 7 years, starting in October l964. 16. The local currency cost of the project, equivalent to about US$1.8 million, would be financed by the Corporation from funds gene- rated by its own operations. Method of Procurement 17. Contracts for all imported goods to be financed out of the pro- posed loan would be awarded on the basis of international competition, except for 5 diesel locomotives (,p1,170,000) that had to be purchased from a previous supplier to achieve standardization of motive power on the Southern Railway, and for 1500 tons of rails and fittings (W215,000) that have already :een ordered from the Corporation's regu- lar supplier, on suitable terms, to meet an immediate need. The award for 19 locomotives for the Central Railway was also made on the basis of international competition in which a U.S. supplier was the lowest qualified bidder; the Corporation then sought and obtained Eximbank financing. Justification of the Project 18. The project is needed to enable the Central and Southern Railway systems to provide reliable and efficient transportation service. The new investment will bring about large operational econo- mies and represents the most economic means of providing needed trans- portation service to the areas served by the two railway systems. 19. The Central Railway links the capital, Lima, and the nearby Port of Callao, Peru's chief port, with the Sierra (the plateau of the Andes). Its most important function is carrying refined metals, ores and concen- trates, from the Sierra to the Port of Callao for export, and bringing back supplies for the mining companies, such as fuel and cement. About half of Peru's foreign exchange earnings are derived from the export of minerals. The mp.jor part of such exports are carried by this railway. The remainder of the Central's traffic consists of  - 7 - agricultural produce brought from the Sierra to Lima, and petroleum products, imanufactured goods and foodstuffs destined for the Sierra. The estimated annual increase in mineral exports for the next few years is only 2% and, therefore, the growth in the Central's traffic demand would be rather slow. Furthermore, road competition is a threat to the railway. Recently the Cerro de Pasco Corporation, the most im- portant mining operation in the area and the Central's main shipper, threatened to shift its freight to the road. Subsequently, the Cerro de Pasco Corporation reached an agreement with the Corporation to ship all its freight over the Central Railway as long as the present tariffs remain in effect, and thereafter, as long as the Central remains com- petitive. Because costs of road translportation are likely to increase at least at the rate of those of the railway, it seems unlikely that road transport:tion can diso'Lace railtransportation for such commodities as refined morals, concentrates, ores and bulk merchandise, as long as the railway can furnish an efficient, reliable and reasonably priced service; and with the improvements in service and the reduction in operating costs to be achieved by the proposed modernization and rehab- ilitation program, the Central lailway should be in a position to do so. 20 The Southern Railway links Boliria and the populated Southern hi,ghlands of Peru, including Peru's second largest city, Arequipa, wit'h the Port of MolLlendo, and b, a separate line, with the Port of i1at.arani. A link with land-locked Bolivia is provided by means of s6-airer service across Lake Titcaca and railservice from Guaqui (in Bolivia) to La Paz, the capital. The Southern Railway traffic con- sists largely of general merchandise moving in both directions for destinations in Peru. An important part of the traffic on the Southern Railway is the general merchandise carried to Bolivia, and minerals carried from Bolivia to Peruvian ports for export. Total railway freight traffic is expected to increase slowly but steadily. Road com- petition does not pose a serious threat to the Southern. 21. Both the Central and Southern Railways are, and will for some time be, important elements of Peru's transportation system and their effi- cient operation is essential to Peru's economic development. The Cor- poration is one of the few railways in Latin America that are still privately owned and managed and its operation is, on the whole, effi- cient. Its past financial performance has been unsatisfactory in large part because of its inability to re-equip and modernize itself. With the proposed loan, the Corporation has a reasonable chance to absorb further increases in wages and in the price of materials and supplies by increases in traffic volume, increases in efficiency, and adjust- ments in rates and, upon completion of the program to produce a steadily increasing net income. Nevertheless, it must be recognized that in this case there is considerable risk that the Corporation may have difficulty in meeting all of its financial obligations because it will always be in the squeeze between increasing operating costs on the one hand, and road competition on the other hand, both of which are in part beyond the con- trol of the Corporation and the Government. The special conditions in- cluded in the loan documents and mentioned in paragraph 7 of this report are designed to minimize this risk.  -8- Economic Situation 22. A report on the "Current Economic Postion and Prospects of Peru" (V-1h -121) d .ted S-p tember 28, 196)2 w3s distriutec-. to t'le Boaird or October 2 1962. 23. The economic position of Peru at the end of 1962 was better than in preceding years. The rate of growth of the Gross National Product was estimated at 6.5%, or about the same as that achieved in 1960 and 1961, following a recession in 1959. The main impetus came, as in previous years, from exports and from domestic manufacturing industry. An important contribution was made by agri