CIRCULATING COPY Report No. P-1081 To BE REURNED TO REPORTS DESK

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1 Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized RESTRICTED CIRCULATING COPY Report No. P-1081 To BE REURNED TO REPORTS DESK This report is for official use only by the Bank Group and specifically authorized organizations or persons. It may not be published, quoted or cited without Bank Group authorization. The Bank Group does not accept responsibility for the accuracy or completeness of the report. INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT REPORT AND RECOMMENDATION OF THE PRESIDENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO ELEKTROPRENOS-ELEKTROPRIVREDNO PREDUZECE ZA PRENOS ELEKTRICNE ENERGIJE-SARAJEVO and HIDROELEKTRANE NA TREBISNJICI-PREDUZECE ZA PROIZVODNJU I PRENOS ELEKTRICNE ENERGIJE-TREBINJE and "ELEKTROPRIVREDA" - ZDRUZENO PODUZECE ELEKTROPRIVREDNIH ORGANIZACIJA RIJEKA and "ELEKTROPRENOS"-SPLIT-ORGANIZACIJA ZA PRENOS ELEKTRICNE ENERGIJE U SASTAVU ZDRUZENOG PODUZECA "ELEKTROPRIVREDA DALMACIJE`-SPLIT and "ELEKTROPRIVREDA"-ZAGREB-PODUZECE ZA PROIZVODNJU, PRIJENOS I KUPOPRODAJU ELEKTRICNE I TOPLINSKE ENERGIJE-ZAGREB and "ELEKTROSTOPANSTVO"-PRETPRIJATLJE ZA PROIZVODSTVO I PRENESUVANJE NA ELEKTRICNA ENERGIJA-SKOPJE and "ELEKTROCRNAGORA"-PREDUZECE ZA PRENOS ELEKTRICNE ENERGIJE I IZGRADNJU ELEKTROPRIVREDNIH OBJEKATA-TITOGRAD and "ELEKTROISTOK"-ORGANIZACIJA ZA PRENOS ELEKTRICNE ENERGIJE U SASTAVU ZDRUZENOG ELEKTROPRIVREDNOG PREDUZECA SRBIJE-BEOGRAD and SAVSKE ELEKTRARNE LJUBLJANA-ORGANIZACIJA V SESTAVU ZDRUZENEGA ELEKTROGOSPODARSKEGA PODJETJA SLOVENIJE-MARIBOR and DRAVSKE ELEKTRARNE MARIBOR-ORGANIZACIJA V SESTAVU ZDRUZENEGA ELEKTROGOSPODARSKEGA PODJETJA SLOVENIJE-MARIBOR and SOSKE ELEKTRARNE NOVA GORICA-ORGANIZACIJA V SESTAVU ZDRUZENEGA ELEKTROGOSPODARSKEGA PODJETJA SLOVENUE-MARIBOR WITH THE GUARANTEE OF THE SOCIALIST FEDERAL REPUBLIC OF YUGOSLAVIA FOR A POWER TRANSMISSION PROJECT June 1, 1972

2 CW.RXNCY EQUIVALENT I US dollar = 17.0 dinars 1 Dinar 5.88 US cents

3 REPORT AND RECOMMENDATION OF THE PRESIDENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO ELEVEN YUGOSIAV ELECTRIC POWER ENTERPRISES WITH THE GUARANTEE CF THE SOCIALIST FEDERAL REPUBLIC OF YUGOSLAVIA FOR A Pa4ER TRANSMISSION PROJECT 1. I submit the following report and recommendation on a proposed loan to the electric power enterprises in Sarajevo, Trebinje, Rijeka, Split, Zagreb, Skopje, Titograd, Belgrade, Ljubljana, Maribor and Nova Gorica (the Borrowers), with the guarantee of the Socialist Federal Republic of Yugoslavia, for the equivalent of US $75 million to help finance a project for power transmission. The loan would have a term of 20 years, including five years of grace, with interest at 7¼ percent per annum. In addition to the Bank and the eleven power enterprises, the loan agreement would be signed by the Union of Yugoslav Electric Power Industry (JUGEL) as the project coordinator and as the channel for disbursement and repayment of the loan. PART I - THE ECONONY 2. An economic mission visited Yugoslavia in October/November 1971, and its report on the "Current Economic Position and Prospects of Yugoslavia" (EMA-48a) dated May 26, 1972, has been distributed to the Executive Directors. Basic data on the economy of Yugoslavia are given in Annex II. 3. Yugoslavia has had rapid growth and rising living standards during the lastdecade, with total GDP at constant prices having increased at about 5½ percent per year and per capita.gdp at over 4 percent per year. Economic growth has proceeded in an environment of major institutional and organizational changes, characterized by the decentralizing of eoonomic management, the creation of a market economy, and the opening up of the economy to international trade, with the object of increasing economic efficiency and improving the allocation of resources. 4. The population growth rate has averaged 1.0 percent per year during the last decade, with the growth rate in the less-developed republics being 1.6 percent and in the developed republics 0.7 percent. There is little open unemployment. There is, however, some evidence of growing regional and occupational imbalances of labor demand and supply. This results from the low mobility between labor surplus less-developed regions and labor-scarce developed regions, and a discrepancy between the skills needed in a fastchanging eccnomy and those supplied by the current education system. 5. Economic development in the less-developed regions has increased at about the same rate as that of the more developed regions, but their per capita income has increased more slowly because of higher population.growth. Consequently, regional inequalities have widened. Yugoslavia has had an active regional development policy for more than two decades. The policy

4 aims at reducing regional inequality by achieving a growth rate above the national average in the less-developed regions, financed by a transfer of resources mainly through the Fund for the Accelerated Development of Underdeveloped Regions. In addition, Federal budgetary grants are provided to the less-developed republics for current expenditure for social purposes such as health and education. Recent Developments 6. Economic development since 1968 has been characterized by a relatively rapid increase in exports and production (averaging 12 and 8 percent per year, respectively, during ), the emergence ox serious inflationary pressures and substantial balance of payments deficits. The trade deficit increased from $660 million in 1969 to $1.2 billion in 1970 and about $1.4 billion in This was mitigated by the sharp rise in workers' remittances ($630 million in 1971) and growing surpluses in the balance of services. The current account balance of payments deficit was $108 million in 1969, $ million in 1970 and about $320 million in The deficits reflect the simultaneous existence of rapid growth, domestic inflationary pressure and import liberalization. 7. To counter the rising inflationary pressures and improve the external payments position, the Government since 1970 has adopted measures aimed at restricting monetary expansion, limiting public expenditures, strengthening price controls and developing an incomes policy. In addition, the Government has resorted to a more flexible exchange rate policy in order to neutralize the effect of inflationary pressure on the balance of payments. After a long period of unchanged rates, following a major devaluation in 1965, the dinar was devalued by 16.6 percent in January In the course of the international currency realignment in December 1971, Yugoslavia devalued again by 18.8 percent against gold and by 11.8 percent against the dollar. 8. The effects of the policy measures undertaken became evident in the second half of 1971, when import growth declined, export growth picked up and the investment boom began to slow down. These trends were even more pronounced on the first quarter of 1972 when exports rose significantly above, and imports fell below, the levels of the first quarter of Foreign exchange reserves, which were equivalent to about one month's imports in 1970 and 1971, have increased, and at the end of April were equivalent to nearly two months' imports. Prospects 9. Real GDP is expected to grow by about 5 percent in 1972 (compared with 8 percent in 1971) reflecting Government policies to slow down the expansion of investment and consumption. The reduction of excess aggregate demand, together with the recent devaluation and the imposition of restrictions on the import of luxury consumer goods, is expected to lead to export growth of about 12 percent and import growth of about 6 percent in Consequently, the balance of payments deficit is likely to be significantly lower than in 1970 and Inflationary pressures are expected to be reduced by a continuation of price controls and restrictive demand management.

5 The Social Plan, which has yet to be approved by the Republics and the Federation, aims at an overall growth rate of 7.5 percent per year wlth gross investments growing at the sane rate as production, and private consumption and government expenditure somewhat slower - 7 percent and 6.5 percent per year, respectively. Exports are projected to grow at about percent per year and imports at some 9-11 percent. The Plan stresses the importance of achieving domestic stabilization, improving resource allocation and increasing productive efficiency in attaining these targets. It also stresses that an increase in the production of power and the expansion of the transmission network system are preconditions for attaining the plan targets. Domestic savings rates are expected to be maintained at present levels - around percent of GDP, and would finance about 80 percent of gross investment. The bulk of the projected external resource gap would be met by rising factor income receipts (workers' remittances). 11. The prospects for continued economic growth in the medium term are good. The endowment of natural and human resources, together with the pragmatic and dynamic approach to the solution of economic difficulties, the readiness to consider and undertake necessary institutional changes, and the strong commitment to an open market-oriented enonomy give ground for a favorable assessment of future prospects. External Assistance 12. Gross capital inflows have almost doubled in the last five years reaching US $636 million in 1970, and an estimated US $715 million in Most of these funds were medium-term commercial credits, reflecting the limited assistance coming from governments, and the liberalization of foreign trade and borrowing regulations following the 1965 Economic Reform. The inflow of suppliers' and financial credits has come largely from the United States, Germany, Switzerland, Italy and the United Kingdom. IBRD loans have been the main source of long-term capital since Yugoslavia has, so far, not been able to issue bonds in the world's capital markets. However, a private placement (medium-term) of US $100 million has been made in 1972 and other possibilities for raising long-term funds are being explored. 13. The Government has tried to encourage private foreign investment through special legislation in Response of foreign investors has so far been relatively disappointing: by November 1971, 38 joint venture agreements had been signed between local and foreign enterprises, involving an investment of about US $90 million. The conditions for foreign partners in joint ventures with Yugoslav enterprises have recently been further improved in an effort to encourage foreign investment. External Debt Management 14. The pattern of capital inflow since the mid-1960's led to a deterioration in the maturity structure of external debt. The Government, aware of the dangers in the unregulated growth of external debt, has embarked on an active debt management policy. Since mid-1971 all foreign credits have to be

6 registered with the National Bank to ensure that contracted credits remain within the ceilings determined by the Federal Government and the National Bank, and that the terms of borrowing are appropriate to the transaction and to the general economic situation. Following the Standby Agreement with the IMF in July 1971, the Government decided to limit outstanding short-term credits to 1970 levels, and medium- and long-term loans incurred or guaranteed by the banks to US $900 million, and has kept borrowing within these limits. In April 1972, a new system for regulating external borrowing was adopted which operates by influencing the cost of external borrowing through varying dinar deposit requirements. The Government has also approached a number of countries to, reschedule or refinance existing debts and to extend longer term credits. The United States has agreed to reschedule US $58.5 million of debt payments falling due in 1971 and 1972, and Italy, Germany and France have agreed to extend financial credits of US $75 million, US $93 million and US $18 million, respectively. Active bilateral negotiations for similar credits are proceeding with other countries. 15. External public and publicly-guaranteed debt outstanding and disbursed on December 31, 1970, was US $1,208 million. In addition, there was US $863 million non-publicly guaranteed external debt outstanding on that date. Total debt service payments in 1971 are estimated to be about US $575 million, mostly in convertible currencies. The service of external debt in 1971 represented 18 percent of foreign earnings. Excluding debts and earnings in non-convertible currencies, the ratio becomes 25 percent. Debt service is expected to remain at about present levels durlng the next five years. Taking into account Yugoslavia's debt service record and the new measures for improved external debt management, Yugoslavia is judged creditworthy for continued Bank lending. Local Currency Financing 16. High priority projects in Yugoslavia, especially those designed to improve infrastructure and accelerate development in the less-developed regions, have relatively low foreign exchange components due to the relatively advanced stage of Yugoslav industry and the increasing competitiveness of Yugoslav contractors. Were the Bank to confine its lending to the foreign exchange costs of projects, an adequate contribution to Yugoslavia's external capital needs could be made only by spreading the lending over a large number of projects, including some of lesser priority. The latter alternative would make excessive demands on Bank manpower and restrict the Bank's ability to provide support for specific structural reforms. Local expenditure financing is therefore justified. PART II - BANK GROUP OPERATIONS IN YUGOSLAVIA 17. The Bank has made twenty loans to Yugoslavia totalling US $585.7 million. Two previous loans (277-YU in 1961 and 318-YU in 1962) were for power projects, three others for p4jects with a power component. The most recent of the latter was the Ibar Multipurpose Water Project (777-YU) in FY 71. Otherwise, Bank lending has been concentrated in transportation (five highway loans totalling

7 - 5 - US $150 million and three railway loans totalling US $115 million), telecommunications (us $40 million), industry (three loans totalling US $45:Million) and tourism (two loans totalling US $30 million). IFC has made four investments for total commitments of US $31.4 million in Yugoslavia. Its most recent investment (US $12.6 million) in the FAP-FAMOS Belgrade/Daimler Banz joint venture for the production of heavy commercial vehicles was approved by the Executive Directors in February Progress under most loans has been satisfactory, except for the Railway Modernization Program of FY65 (Loan 395-YU) and lengthy delays in making effective the four loans approved in June 1971 (751, 752, 777 and 782-YU). Annex I contains a summary statement of Bank loans and IFC investments as of April 30, 1972, and notes on the execution of on-going projects with particular reference to those which are encountering problems in execution and giving rise to delays in disbursement. 19. The major objectives of Bank lending to Yugoslavia are (a) to accelerate development in the less-developed regions of the country; (b) to promote structural reforms in major sectors of the economy through improved coordination the strengthening of institutions and technical assistance; and (c) to help provide Yugoslavia with external capital at long term and thus help redress the excessively short term character of Yugoslavia's external borrowings; (d) to help alleviate Yugoslavials shortage of foreign exchange by financing foreign exchange earning projects. These objectives are basically the same as those which guided lending in previous years. The recent constitutional changes, and the consequential changes in Yugoslavia's economic system, have confirmed their validity. However, efforts to give special support to the less-developed regions will be strengthened, and a continuing high level of technical assistance will be provided in appropriate cases. Given these objectives, the emphasis in future Bank lending will be on infrastructure projects which, due to the changes in the economic system, now seem to have less access to internal and external capital than other sectors of the economy. 20. In furtherance of these objectives, further support for railway modernization (see Annex I) and loans for the expansion of the port of Bar, highways, a water and sewerage (tourism infrastructure) project in Dubrovnik and a gas pipeline project are envisaged within the next two years. Lending in this period is also planned to include loans for an agro-industry project in Macedonia, a development finance company-type operation and one or two specific industrial projects of particular importanr.e for the country as a whole. A tourism project in Jaz (Montenegro) is also being prepared for Bank lending. All these projects would fit well into the Bank's lending objectives, and would, particularly, increase the share of lending going to the lessdeveloped regions. Several projects have been in preparation for some time and are expected to be appraised within the next few months, others are still in an early stage or preparation. IFC is currently investigating several new investment opportunities in various sectors, including vehicle tire production. 21. In addition to significant help with the preparation of projects for Bank financing, the Bankts recent technical assistance to Yugoslavia has included reviews of the power and transportation sectors. A tourism sector mission is

8 - 6 - now in the field. Other current activities include assistance in establishing a project appraisal training institution and the training of some of its teachers, a study of the Yugoslav capital market, and training of auditors in Yugoslavials Social Accounting Service which audits several Bank-financed projects. 22. Bank lending to Yugoslavia has averaged almost t1; $100 million annually in the past two years. Although this represents only a relatively small proportion of the country's needs for external finance, it is about two thirds of the long-term capital inflow. It is expected that Bank lending will continue at about the same level in the next few years. On this assumption, the outstanding debt to the Bank mould rise from 11 percent of Yugoslavia's total external debt in 1970 to 16 percent by Service on Bark loans as a proportion of total debt service would increase from 4 percent to 6 percent. PART III - THE ELECTRIC POWER SECTOR 23. The Yugoslav power systems have developed mainly on a regional basis as a result of political, geographical and technical considerations. Hydroelectric plants were slted in the valleys close to the nearest industrial centers. Thermal plants were located next to the lignite mines which predominate in the central part of the country, to supply nearby industrial centers. There are abundant resources of lignite and o-f 1JVdroelectricity which have not yet been exploited. 24. Demand for power is projected to increase from 25,370 GWh in 1970 to about 43,860 GWh in Domestic consumption has been increasing at the rate of 18 percent for some years and, by 1970, 83 percent of all cities, towns and villages had electricity. With the capacities and outputs of plant now in use or under construction the projected demand will not be met for some years; a deficit of about 1,500 GWh, 4 percent of energy demand, is likely by If all industrial plants now in the planning stage were to be completed by 1975, the deficit would be approximately three-and-a-half times this much, but it is unlikely that all will be completed by There are also substantial regional imbalances between demand and available capacity. The existing transmission network has insufficient capacity, particularly in the east-west direction, to transmit power from areas of surplus capacity to those with a shortage. Thus regional shortages exist from time to time even though there is an overall surplus of capacity. The fact that steam plants burning lignite, which must be operated at a fairly constant plant factor, constitute almost 50 percent of present thermal capacity increases the need for adequate transmission capacity between systems, since there are times when the output of these plants cannot be fully utilized in the particular system of which they form a part. M4oreover, about half the hydroelectricity capacity is in run-of-river plant. 26. Hitherto, the integration of power generating capacity has been carried out on a regional rather than a national basis. At present, therefore, the systems are characterized by a series of lines at 220 kv and lower voltages, primarily connecting generating and load centers within valley regions. Since

9 - 7 - Yugoslavia has several mountain ranges parallel with the Adriatic coast, the present 220 kv transmission system is predominantly north-south oriented and has experienced voltage drops of more than 20 percent below normal in Slovenia, in the Zagreb region of Croatia, and in Macedonia, resulting in substantial interference with industrial production. The links to adjacent countries are mainly limited to 110 kv lines. 27. The limited integration of the electric power system severely limits the transfer of power between regions and therefore imposes on the Yugoslav economy a heavy cost of inadequate supply while not fully utilizing existing generating capacity. Studies have shown that, with the expected growth of the market and the corresponding additions to generating capacity, still more lines at 220 kv would not be a satisfactory solution either physically or economically. This conclusion is reinforced by the approaching completion of the large Djerdap hydroelectric plant on the Danube river, the final capability (1,050 3W) of which cannot be fully utilized until a large part of the planned 380 kv transmission system is completed. The voltage of 380 kv was selected as the optimum following studies which included a 500 kv alternative. It is also the appropriate voltage for interconnection with neighboring countries. 28. A Bank review of the electric power sector in October 1970 confirmed that the development of the proposed 380 kv network was of the highest priority. In considering this project the Bank was concerned as much to support increased coordination in the construction and operation of the system as to help eliminate an important and damaging gap in Yugoslavia's infrastrcuture. Another important objective was to ensure that the electricity enterprises would be in a position to provide a reasonable proportion of investment financing from internally generated funds, which had become necessary because of the changes in the system of financing power projects in recent years (see paragraph 30). 29. There had been practically no coordinated planning of construction in the sector, apart from the proposed transmission project, since A national plan for power development, prepared by the Union of Yugoslav Electric Power Industry (JUGEL) in 1970, provided some preliminary information on the investment plans of the various power enterprises but without agreed priorities for their implementation. Based on this information it can be expected that capital expenditures for by the eleven enterprises, which would be responsible for the construction of the 380 kv transmission network, would be in the order of UJS $740 million. In view of the presently uncertain nature and cost of this investment program, it is difficult to Judge its technical, financial and economic feasibility. At the request of the Bank, JUGEL has accordingly initiated a study of the economic and geographic priorities for future investments in the power sector. Completion of the study and the investment plan is scheduled for mid-1972 and their submission to the Bank would be a condition of effectiveness of the proposed loan. The eleven Borrowers and JUGEL agreed to consult with the Bank from time to time on the implementation of the investment plan.

10 Until 1962 power projects were financed entirely by credits on soft terms from the general investment fund of the Yugoslav Investment Bank. Since then, the enterprises have had to finance a growing share of their investments, and since January 1, 1971, they have had to cover their operating costs and finance new investments without aasistance from the Federal Government. However, not all enterprises have been equally able to generate internal funds and raise local bank credits. Their major problem has been the need for substantial increases in bulk electricity tariffs to raise the level of self-financing from an average of 16 percent of the planned investments on the basis of existing tariffs to percent. This would enable the electricity enterprises to finance their development with the assistance of a reasonable amount of internal and external borrowing, so that the resulting debt service would not be such a burden as to inhibit financing of development in the even longer term. 31. In accordance with the Electricity Act of 1965, which ended a system of centralized Federal control, the pomer industry is now decentralized and broadly separated into a distribution sector and a generation and transmission sect6r. The 26 distribution enterprises, which are organized in an association, and the bulk consumers buy power from the generation and transmission enterprises. The tariffs charged by the distribution enterprises have so far been sufficient to cover all expenses and practically all funds needed for their expansion. The generation and transmission enterprises are members of JUGEL, which is responsible for overall coordination among its members in interconnected system planning and operations, preparation of tariff proposals, technical regulations, collection of statistics, and promotion of research. However, it has no executive authority over its members and no income of its own. PART IV - THE PROJECT 32. The proposed project was identified during a sector review mission in October A feasibility study prepared by JUGEL, in cooperation with Yugoslav consulting engineers and the eleven power transmission and generation enterprises responsible for power sector planning, was submitted to the Bank in March As a consequence of the complexity of the project and the continuing changes in institutional, financial and legal arrangements in the power sector and in the country as a whole, several missions to Yugoslavia were required for the appraisal of the project. An appraisal mission visited Yugoslavia in May and June This was followed by three further visits in the period July 1971 to January Because of the large number of institutions involved in the project on the Yugoslav side, negotiations were held in Yugoslavia in April The Yugoslav delegation included representatives of all the institutions mentioned above and was led by Mr. Gavra Popovic, Assistant Federal Secretary for Finance, and Mr. Lazar Ljubisa, General Manager of JUGEL. ProJect Description 33. The project is the first phase of the construction of a 380 kv power transmission network of mainly single circuit bundle conductor design. This network will serve all Republics and Provinces of Yugoslavia and involve the construction of about 3,000 km of single-circuit (except for about 50 km of

11 - 9 - double circuit) 380 kv transmission lines and 12 transformer substations with an aggregate capacity of 7,900 MVA, and the expansion of one 380 kv substation. Preliminary works only would be undertaken at five other substations with connecting lines operating initially at 220 kv. The individual lines and substations are shown in the attached map. Technical assistance and training has also been included in the project (see paragraph 36 below). A loan and project summary is attached as Annex III. The appraisal report, entitled "Appraisal of Power Transmission Project - Yugoslavia" (PU-87a), dated May 22, 1972, is being circulated separately to the Executive Directors. 34. The construction of the planned 380 kv project will be the responsibllity of the Borrowers, which are the eleven member enterprises of JUGEL concerned with power transmission, each within its service area and using Yugoslav contracting firms or force account, as appropriate. Corstruction would begin late in 1972 and proceed by stages towards completion by the end of Each Borrower is an enterprise, i.e. an independent legal and economic entity in accordance with the general Yugoslav concept of decentralized economic control and workers' self-management. The basic management structure is common to all the power enterprises. The Workers' Council, elected by and drawn from the personnel of the enterprise, acts as the top policy-making body in much the same way as the board of directors of a corporation in a non-socialist country. The Workers' Council approves major investment plans, decides on the disposition of income and appoints the General Manager, who is the chief executive officer of the enterprise. Coordination 35. The project thus involves the active participation of eleven independent power enterprises operating in all six Republics and the two Autonomous Provinces. It has, therefore, been a major objective of the Bank to ensure that the project should be planned, constructed, operated and expanded as one integrated 380 kv transmission network. To this end there is a single Loan Agreement with all eleven enterprises, which establishes JUGEL's role as coordinator for all aspects of the project, including procurement and disburseme; arrangements (see paragraphs 43 and 44 below). The Borrowers have also agreed on cooperation with each other and with JUGEL in planning, operating, maintaining and expanding the 380 kv transmission network. Moreover, coordination and cooperation will be strengthened as a consequence of the study on investment priorities (see paragraph 29 above), which is to lead to an agreed plan of investments in the power sector. 36. JUCELts and the Borrower's efforts towards greater coordination would be supported by the technical assistance included in the project, the foreign exchange cost of which would be financed under the proposed loan. Whereas the management and staff of the eleven Borrowers are competent to deal with normal business matters, and are operating thl.r enterprises efficiently, they have less experience with the technical and financial problems of a growing interconnected power system. The Borrowess and JUGEL will therefore review, with the aasistance of consultants, their existing management information systems and their interconnected system planning and operation practices and procedures.

12 They would submit to the Bank, no later than 12 months after the effective date of the loan, the report of the consultants and their plans to implement the consultantst recommendations. They would also submit a draft plan satisfactory to the Bank for the training of financial and technical officers in management methods for interconnected electricity systems: this would be a condition of effectiveness. ProJect Costs 37. The project is estimated to cost a total of US $225 million, excluding import duties. Except for the foreign currency items, the cost estimate was prepared by JUGEL, assisted by consultanta and the Borrowers, and is generally based on current construction costs and ex-factory prices of transmission line materials and substation equipment manufactured in Yugoslavia. The foreign exchange component is difficult to estimate, since there. is little experience in Yugoslavia with international competition in electrical equipment supplies. Yugoslav marmfacturers could supply all but about 25 percent of the materials and equipment needed; but since their capacity is limited, and the 15 percent preference for local manufacturers (see paragraph 42 below) would provide less protection than the import duties, which vary from 30 to 40 percent, it seems realistic to assume that about 50 percent of all equipment would be supplied from abroad. Including the foreign exchange costs of consultants and training, the foreign exchange component of the project would then be $65 million, and the local expenditure component $160 million, equivalent. The physical contingencies of 5 percent reflect recent experience in Yugoslavia on this type of work. The price contingencies of 15½ percent are based on expected price increases at an annual rate of 5 percent from mid ProJect Financing 38. The proposed Bank loan would be for US $75 million equivalent and would cover the foreign exchange component and about US $10 million of local costs (see paragraph 16). It would represent one-third of the cost of the transmission projrt and about 10 percent of the total investment program in power facilities contemplated during the period of project execution, The major part (US $65 million) of the loan would be distributed among the eleven Borrowers in proportion to the estimated cost of the part of the project within the operating area of each Borrower. The remainder (US $10 million) would, in addition, be distributed among the Borrowers operating in the less-developed regions to take into account the larger financing needs of these areas. 39. Yugoslav banks would participate with loans totalling $71.3 million, equivalent, or about one-third of total project cost. The Bank has received a letter of intent from all six local banks involved in the project (one in each Republic), according to which the banks will make lonns to the respective enterprises and also undertake to cover any cost overruns (except for the enterprises in Split and Belgrade, for which the Associations of Power Enterprises of Dalmatia and Serbia, respectively, would undertake the overrun commitment). The canclusion of the local loan agreements, providing

13 for an interest rate of not more than 8 percent and a repayment period of 16 years after the coming into operation of the individual parts of the project, would be & condition of effectiveness of the Bank loan. 40. The remainder of the transmission project cost would be financed from internal funds of the Borrowers. Their financial position has been generally satisfactory in the past but is not adequate to carry out their very large investment programs. Basic changes in the pattern of financing their investments are needed, particularly as Federal funds on soft terms are no longer available (see paragraph 30 above) and they cannot be fully replaced by loans from domestic banks. In order to provide a financially sound basis for the whole power sector and to reduce the future debt burden of the Borrowers, the Bark proposed, and the representatives of the Governments and the Borrowers agreed, that the Borrowers should be enabled to finance from internal revenues a reasonable portion not only of the proposed transmission project but of all future investments in power. The loan agreement therefore provides that the Borrowers will establish and maintain rates for the sale of power or take similar measures as described below, sufficient to cover from revenues all operating expenses, debt service and the financing of an average of not less than 35 percent of the power investment cost during any Yugoslav plan period. The Bank has received a letter from all Borrowers outlining the initial measures they will take to comply with this obligation. These measures in general include a 15 percent rate increase which was authorized in May 1972, and will come into force when approved by the Governments of the Republics and Provinces. In the case of the Borrowers in Rijeka and Zagreb, part of the funds would be provided from specific charges on consumers; in the case of the Borrowers in Split, Belgrade and Slovenia from the internal funds of the Associations of Electric Power Enterprises of which they are members. Satisfactory evidence that these measures have been taken would be a condition of effectiveness of the loan. The responsibility for establishing upper limits to increases in power rates has now been transferred from the Federation to the Republics and Provinces, and the Guarantor, the Socialist Federal Republic of Yugoslavia, would also undertake to conclude agreements with the Republics and Provinces by which they would agree to enable the Borrowers to comply with their obligation concerning power rates. The conclusion of these agreements would also be a condition of effectiveness of the loan. The aggregate OD the financing plans of the eleven Borrowers is shown in Annex III. 41. The financial position which is expected to be aciieved by the Borrowers by 1977, on the basis of the financing plan outlined in Annex III and of a growth of sales in the order of 8 percent annually, can be illustrated by the following ratios: Debt/Equity Ratio Debt Service Coverage Enterprises Sarajevo 60/40 58/ Trebire 75/25 69/ Rijeka 75/25 63/ Split 56/ / Zagreb 74/26 54/

14 Debt/Equity Ratio Debt Service Coverage Enterprises Skopje 77/23 74/ Titograd 67/33 57/ Belgrade 78/22 68/ Ljubljana 28/72 38/ Maribor 58/42 51/ Nova Gorica 26/74 34/ These figures show that the planned expansion program, if financed as proposed, would not impair the financial viability of the Borrowers and would in most cases improve their financial positions. Improvements in the debt/equity ratio would be a result of the increase in self-generated funds available for reinvestment in the enterprises, while the debt service coverage remains at acceptable levels. The detailed forecasts show that the Borrowerg would be able to finance at least 35 percent of their presently planned investment for from internal funds and special levies. The only probable exception -is Skopje, which may require a further tariff adjustment in 1976.,Until the share of the expansion program to be borne by each of the eleven enterprises is defined, following completion of the study of priorities mentioned in paragraph 29 above, these forecasts must remain tentative. Procurement 42. The Bank loan would be applied to the purchase of materials and equipment for the transmission lines and substations required for the project, and contracts for these items would be awarded on the basis of international competitive bidding in accordance with the Bank's guidelines for procurement. Domestic manufacturers of materials and equipment would be accorded a margin of preference, for purposes of bid comparison, which would be the existing rate of custom duty applicable to competing imports or 15 percent of c.i.f. costs, whichever is lower. 43. During negotiations, the Borrowers and JUGEL agreed to establish a Coordinating Committee for the procurement of material and equipment and the coordination of construction. The Committee would be composed of the General Managers of the eleven enterprises and the General Manager of JUGEL, serving as its chairman. It would be assisted by a new department at JtJELts headquarters with full-time staff provided by JUGEL and headed by a manager experienced in transmission line construction and procurement. The manager would be responsible for the organization of the department and its day-to-day operations. The Coordinating Committee would be responsible inter alia for preparing and approving the plans, detailed designs and technical specifications of the project; for preparing bid documents, asking for bids and evaluating them; and for reviewing the Borrowers' proposals for awarding contracts and forwarding these proposals to the Bank. Identical materials and equipment would, to the extent possible, be included in one single bid requiring a coordinated delivery schedule, but each Borrower would sign a separate contract for the delivery of material and equipment required for its part of the project.

15 Disbursements 44. The amount of the loan allocated to material and equipment would be disbursed for 100 percent of contracts for such items until the amounts allocated to each enterprise were fully disbursed. It would be possible to reallocate the loan between the categories for equipment and for consultant services for each individual Borrower, but not between the Borrowers. Disbursements for local expenditures would be made only if and when all expected foreign expenditures were covered. This procedure is possible because all major contracts are expected to be awarded relatively early in the construction period. The amount of the loan allocated to consultants' services and training would be disbursed for 100 percent of foreign expenditurea. The Borrowers have agreed that JUGEL should act as the channel for disbursements, and also for repayment of the loan and payment of interest and other charges. The Borrowers would designate JUGEL as their representative for the purpose of taking any action in this respect and JUGEL would assign qualified and experienced staff for this task, for the cost of which JUaEL would be reimbursed by the Borrowers. Justification 45. Major existing and future generation and load centers are to be supplied from the new 380 kv network. Although the layout of this network has been made without a firm program of additional generating plants, it was tested using two alternative programs, representing in many ways somewhat opposite extremes, and found to serve both equally well. The testing took into account different generating capacities and loads for 1975, 1980, 1985, mxwdmum and minimum load conditions and hydraulic conditions, and transmission line failures characteristic of this type of line. The testing showed that the layout had been optimized as far as is practical with respect to trade-offs between lengths of line, costs of substations, etc., and that the scale of the transmission ring could not be reduced and still provide an adequate standard of reliability. 46. It has not proved feasible to q.antify the benefits attributable to the 380 kv transmission ring and, therefore, to calculate its economic return. This is due partly to the fact that the long-term system plans in Yugoslavia have not been defined in detail and partly to the complexity of carrying out the return calculation on a "with and without the trannidssion line" basis. The Justification of the project rests basically on the unquantifiable benefits brought about by an interconnecting transmission ring, e.g. the pooling of generating plants of different operating characteristics, the reduction in the total reserve plant capacity required for a good standard of service, the ability to locate power stations at optimum sites and of optimum characteristics to take advantage of econonies of scale, and the flexibility to allow the best positioning of tapping of loading points. 47. Studies which have been done in other countries for smilar 380 kv systems and the limited studies which have been -ade in Yugoslavia all indicate strongly that all other types of solution would have a greater net cost.

16 Moreover, in the case of Yugoslavia, any delay in installing the 380 kv transmission ring would be the direct cause of future power shortages in some of the Republics, and there is every indication from the present supply position that the corresponding loss of economic and social benefits would greatly outweigh the savings in cost due to the delay. PART V - LEGAL INSTRUMENTS AND AUTHORITY 4 8. The draft Loan Agreement between the Bank, Elektroprenos-elektroprivredno preduzece za prenos elektricne energije, Sarajevo, Hidroelektrane na Trebisnjicipreduzece za proizvodnju i prenos elektricne energije, Trebinje, "Elektroprivreda" zdruzeno poduzece elektroprivrednih organizacija, Rijeka, "Elektroprenos" - Split Organizacija za prenos elektricne energije u sastavu zdruzenog poduzeca "Elektroprivreda Dalmacije", Split, 'lelektroprivreda"l - Zagreb - poduzece za proizvodnju, prijenos i elektricne kupoprodaju i toplinske energije, Zagreb, "Elektrospopanstvoll - pretprijatije za proizvodstvo i prenesuvanje na elektricna energija, Skopje, "Elektrocrnagorall - preduzece za prenos elektricne energije i izgradnju elektroprivrednih objekata, Titograd, "Elektroistok" - organizacija za prenos elektricne energije u sastavu zdruzenog elektroprivrednog preduzeca Srbije, Beograd, Savske Elektrarne Ljubljana - organizacija v sestavu zdruzenega elektrogospodarskega podœetja Slovenije, Maribor, Dravske Elektrarne Maribor - organizacija v sestavu zdruzenega elektrogospodarskega podjetja Slovenije, Maribor, and Soske Elektrarne Nova Gorica - organizacije v sestavu zdruzenega elektrogospodarskega podjetja Slovenije, Maribor (the eleven Borrowers), and Zajednica jugoslovenske :elektroprivede - Beograd (JUGEL), the draft Guarantee Agreement between the Socialist Federal Republic of Yugoslavia and the Bank, the Report of the Committee provided for in Article III, Section 4(iii) of the Articles of Agreement and the text of a resolution approving the proposed loan are being distributed to the Executive Directors separately. 49. Each of the Borrowers would only be liable for the repayment of a share of each maturity of the loan proportionate to the part of the loan allocated to it and for payment of interest and commitment charges accruing on such part. JUGEL would sign the loan agreement not as a borrower but because of its various responsibilities as a project coordinator and as a channel for disbursement and repayment of the loan described above. Given the number of Borrowers, it would seem impractical to provide for bonds, and any reference to bonds in the General Conditions and in the loan agreement would therefore be dileted. Several other changes would be made in the General Conditions in order to reflect the fact that the loan agreement would be signed by a multiplicity of Borrowers and by JUJGEL. 5C I am satisfied that the proposed loan would comply with the Articles of Agreement of the Bank. PART VI - RECaMENDATION 51. I recommend that the Executive Directors approve the proposed loan. Attachments J 7,Te Robert S. McNamara President

17 ANNEX I Page 1 THE STATUS OF BANK GROUP OPERATICNS IN YUGOSLAVIA A. STATEMENT OF BANK LOANS (as at April 30, 1972) US$ million Loan Amount (less cancellations) Number Year Borrower Purpose Bank Undisbursed Eight loans fully disbursed _ Yugodav Investment Bank Railways Yugoslav Investment Bank Industry Yugoslav Investment Bank Railways 50.o Yugoslav Investment Bank Industry Socialist Federal Republic Highways of Yugoslavia Yugoslav Investment Bark Industry Yugoslav Investment Bank Telecommu nications Socialist Federal Republic Highways of Yugoslavia 751* 1971 Socialist Federal Republic Highways of Yugoslavia 752* 1971 Hotel "Bernardin", Piran Tourism * 1971 Socialist Federal Republic Multipur of Yugoslavia pose Water 782* 1971 "Babin Kuk" Hotelsko Turisticki Centar, Tourism Dubrovnik Total of which has been repaid 67._4 Total now outstanding Amount sold 6.2 of which has been repaid 5 Q 1.2 Total now held by Bank Total undisbursed * Not yet effective

18 ANNEX I Page 2 B. STATEMENT OF IFC INVE$TNENTS (as at April 30, 1972) Arwunt in US$ million Year Obligor Type of Business Loan Ecquity Total 1970 International Investment Investment Corporation for Yugoslavia Corporation 1970 Zavodi Crvena Zastava Automotive - 8.o 8.0 Fiat S.P.A. Industry 1971 Tovarna Avtomobilov in Automotive Motorjev Maribor (TAM)/ Industry Kl8ekner-Humboldt Deutz A.G. (KHD) 1972 FAP-FAMOS Belgrade/Daimler Automotive l Benz A.G. Industry _ - Total gross commitments less cancellations, terminations, repayments and sales Total commitments now held by IFC Total undisbursed C. PROJECTS IN EXECUTION 1. The execution of most projects has been satisfactory, except for the Railway Modernization Program of FY 65 (395-YU) and delays in making effective the four loans approved in FY 71 (751, 752, 777 and 782-YU). The railway project has been delayed by financial, planning, and technical difficulties. After 1966 the Yugoslav Railways suffered a continuous deterioration of their financial position and liquidity for a number of related reasons. Project cost estimates increased nearly threefold between 1963 and 1971 because of inflation, devaluation of the dinar and revaluations of some European currencies. Payments for railway freight services were held back by the lack of liquidity in the whole economy. The five Railway Transport Enterprises which, under the Yugoslav system are expected to operate on a commercial basis, were restricted by Government regulations in their ability to respond to changed market conditions. Furthermore, the obligation of the Federal Government to meet railway deficits has been transferred to the Republic Governments, which have not yet been able to meet this responsibility in full.

19 ANNEX I Page 3 2. In order to be able to make proposals for dealing not only with the difficulties with the Bank project, but also with the basic problems of the Yugoslav railways as a whole, it was agreed with the Government that the Bank undertake a thorough review of the railways' problems. Following this review, which was carried out with the assistance of a consultant team, the Bank is now having discussions with the Federal and Republic Governments and the railways on a program designed to put Yugoslav railways back on a sound basis. This will require a clarification of governmental responsibility for the railways and an overall plan of action both for the Yugoslav railways as a whole and for each Railway Enterprise, which include inter alia clear marketing and related operational and financial objectives, a revised tariff policy, investment and disinvestment proposals and proposals for dealing with labor redundancy problems and for improvement in management. Any further delay in carrying out a minimal modernization program could further jeopardize the competitive position of the railways in relation to road traffic and would extend the period in which the economy would not benefit fully from the large investments made with Bank assistance since 1964 in the Modernization Program. In view of the importance to the Yugoslav economy of a solution to the railway problems and subject to satisfactory completion of the discussions mentioned above, the Bank is prepared to consider another railway loan in FY73 or The four Bank loans approved in mid-1971 were affected by difficulties in the governmental process arising from the constitutional amendments introduced at that time and which delayed their effectiveness. In some respects, the amendments were broadly stated and left important specific problems to be resolved in subsequent legislation. It took some time for the Federal and Republic Governments to adjust to the new procedures provided by the constitutional amendments. These difficulties of adjustment were aggravated by some internal political and economic problems and initially caused considerable delays in decision making. Meanwhile, however, the Federal Government has developed a system of Inter-Republican committees, chaired by members of the Federal Government and with representatives for each of the Republics, which should lead to more efficient decision-making. 4. Further delays were encountered because, under the new constitutional amendments, ratification of the two loan agreements and two guarantee agreements by the Federal Assembly (which took place on February 29, 1972) had to be preceded by approval of the agreements by the Assemblies of all Republics and Provinces. The two tourism loans (752 and 782-YU) have also been held up by delays in land acquisition and in the decisions by the Republic Assemblies concerned with the approval of legislation for the payment of interest subsidies for tourism projects; responsibility for these subsidies was transferred from the Federation to the Republics under the constitutional amendments. The formal procedures of approval of the loan agreement for the Ibar Multipurpose Water Project (777-YU) had been linked with the request by the Province of Kosovo that the more developed Republics provide funds for the development of this Province in addition

20 ANNEX I Page 4 to their coxtributions to the Fund for the Accelerated Development of Underdeveloped Regions. A compromise to meet this request has been agreed upon by all Republics and Provinces. Substantial progress towards making these loans effective has been made recently; all the problems of substance now appear to have been resolved, and the only conditions still to be fulfilled concern the legal opinions and the submission of supporting documentation.