Mexico - Second Fertilizer (Lazaro Cardenas) Project

Eco Document of The World Bank FOR OFFICIAL USE ONLY Report No. P-2497-ME REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO NACIONAL FINANCIERA, S.A., AND FERTILIZANTES MEXICANOS, S.A. WITH THE GUARANTEE OF UNITED MEXICAN STATES FOR A SECOND FERTILIZAER PROJECT March 27, 1979 This document has a restricted distribution and may be usd by recipients only In the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  Currency Unit - Peso (Mex$) The fixed exchange rate of US$1 = Mex$ 12.50 which had prevailed since 1954 was abandoned on September 1, 1976 and the Mexican peso has been floating since then. Since mid-1977, the rate of exchange has fluctuated around Mex$ 22.60 to the US Dollar. On March 1, 1979, the peso traded at 22.75 per US dollar. Fiscal Year January 1 to December 31 Abbreviations BANRURAL = Banco Nacional de Credito Rural (the National Agricultural Credit Bank) CONASUPO = Comision Nacional de Subsistencias Populares (the National Marketing Board for Basic Products) DAP = Diammonium Phosphate FERTIMEX = Fertilizantes Mexicanos S.A. (Mexican Fertilizer Corporation) FFM = Fertilizantes Fostatados Mexicanos S.A. GUANOMEX - Guanos y Fertilizantes Mexicanos S.A., FERTIMEX's name up to December 31, 1977. NAFINSA - Nacional Financiera S.A. (financial agent for the Government) NPK The symbol used to indicate compound fertilizers and standing for the three main nutrients: nitrogen (N), phosphate (P205) and potash (K20). TSP - Triple Super Phosphate tpy - tons per year PEMEX = Petroleos Mexicanos S.A. (the National Petroleum Company).  FOR OFFICIAL USE ONLY MEXICO - SECOND FERTILIZER PROJECT (Lazaro Cardenas) LOAN AND PROJECT SUMMARY Borrowers: Nacional Financiera, S.A. (NAFINSA) and Fertilizantes Mexicanos, S.A. (FERTIMEX) Guarantor: United Mexican States Beneficiary: FERTIMEX Amount: US$80 million equivalent Terms: Repayment over 15 years including 4 years of grace. Interest to NAFINSA at 7 percent per annum. FERTIMEX would carry the foreign exchange risk and pay NAFINSA a fee of 3 percent per annum. Project Description: Construction of a complex to produce and sell the fol- lowing: 275,000 tons per year of diammonium phosphate, 250,000 tons per year of compound fertilizers, 190,000 tons per year of solid ammonium nitrate and 10,000 tons per year of phosphoric acid (expressed as P 0 5). The complex will include facilities to produce the following intermediate and end products: 1. sulfuric acid 660,000 tpy 2. phosphoric acid 198,000 tpy (as P 0 ) 3. nitric acid 215,000 tpy (as 160i) ammonium nitrate 270,000 tpy 4. diammonium phosphate (DAP) 275,000 tpy compound fertilizers (NPK) 250,000 tpy In view of the steps being taken to promote the use of high analysis fertilizers, and of their inherent advant- ages, the market risk is acceptable. The Company is taking steps to reduce the management risk by improving methods in some fields. Overall, the project presents a moderate level of risk. This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  - ii - Estimated Cost: (in US$ million equivalent) % of Local Foreign Total Base Cost Land and infrastructure 14.6 2.0 16.6 8.1 Civil works 29.7 4.3 34.0 16.7 Processing equipment, spares 15.8 32.6 48.4 23.8 Aux. equipment & materials 19.0 26.1 45.1 22.2 Plant erection 32.5 5.6 38.1 18.7 Licenses and engineering 3.3 8.1 11.4 5.5 Procurement services 1.2 1.9 3.1 1.5 Preoperating expenses 5.8 1.4 7.2 3.5 Base costs 121.9 82.0 203.9 100.0 Physical contingencies 14.0 7.2 21.2 Price contingencies 18.4 8.0 26.4 Subtotal 154.3 97.2 251.5 Interest during construction 3.5 20.4 23.9 Working capital 19.0 6.9 25.9 Total Financing Requirements 176.8 124.5 301.3 Financial Plan: (in US$ million equivalent) Local Foreign Total x Equity Government contribution 95.4 - 95.4 31.6 FERTIMEX cash generation 19.0 6.9 25.9 8.6 Subtotal 114.4 6.9 121.3 40.2 Loans IBRD - 80.0 80.0 26.6 Bilateral credits - 4.6 4.6 1.6 Borrowings from banks 62.4 33.0 95.4 31.6 Subtotal 62.4 117.6 180.0 59.8 Total Financing 176.8 124.5 301.3 100.0 Estimated Disbursements: Fiscal Years----- 1979 1980 1981 Annual 24.0 44.0 12.0 Cumulative 24.0 68.0 80.0 Rates of Return: Financial: 8.3 percent (before taxes) Economic: 12.3 percent Staff Appraisal Report: 2273-ME of March 30, 1979.  INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT REPORT AND RECOMMENDATION OF THE PRESIDENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO NACIONAL FINANCIERA, S.A. AND FERTILIZANTES MEXICANOS, S.A. WITH THE GUARANTEE OF UNITED MEXICAN STATES I,.t A SECOND FERTILIZER PROJECT (LAZARO CARDENAS) 1. I submit the following report and recommendation on a proposed loan to Nacional Financiera, S.A. (NAFINSA) and Fertilizantes Mexicanos S.A. (FERTIMEX) with the guarantee of United Mexican States for the equivalent of US$80 million to help finance a phosphate based fertilizer project at Lazaro Cardenas on the west coast of Mexico. The loan would be repaid over 15 years, including 4 years of grace, with interest at 7 percent per annum. PART I: THE ECONOMY 1/ 2. Some of the major features of the Mexican economy were analyzed in "An Updating Report on the Economy of Mexico" (1110-ME), distributed to the Executive Directors on March 23, 1976. A special economic mission visited Mexico in April-May 1977 and its report has been discussed with the Mexican authorities and is about to be circulated to the Executive Directors. The discussion which follows reflects the principal and updated findings of the mission. Past Performance 3. For most of the three decades preceding the mid-seventies, Mexico was outstandingly successful in achieving rapid economic growth while main- taining stability in prices and the balance of payments. From 1940 to 1970, average GDP growth exceeded 6 percent per year in real terms, inflation averaged less than 5 percent per year from the mid-1960s to 1972, and the dollar value of the peso, fixed in 1954, was maintained until the September 1976 devaluation. The Government's role in this achievement was to carry out direct investments in infrastructure and in key industries such as power, steel and petroleum, while creating a stable regulatory and institutional framework, as well as good profit prospects, to induce private sector growth. 4. This strategy produced rapid growth, but led to a sharpening of contrasts within the Mexican economy. While land redistribution under the reform of 1915 was continued, most of the peasants who received land could not improve their economic status in the absence of basic infrastructure, credit and technical assistance. Rapid population growth made social equity even more difficult to achieve. Population growth in Mexico accelerated steadily, primarily as a result of reduced death rates, and reached 3.5 percent per year by 1970. Despite economic growth, the high demographic growth rate made 1/ Part I is substantially unchanged from the President's Report for a Highway Sector Project (R79-43) of March 8, 1979.  - 2 - adequate absorption of the labor force in productive employment difficult. Some 40 percent of the labor force is either relatively unproductive and poorly paid, or openly unemployed. 5. During the 1970s, Mexico experienced increasing public sector deficits, inflation, large balance of payments deficits, capital flight and a marked slowdown in the real rate of growth of GDP, which dropped to 2 percent in 1976--the lowest annual growth rate experienced by Mexico since the mid-thirties. On September 1, 1976 the authorities abandoned the fixed exchange rate of 12.50 pesos per dollar that had remained unchanged since 1954 and let the peso float; in recent months it has remained rather stable at rates fluctuating around 22.60 pesos per dollar. Following the devaluation, Mexico obtained major support from the IMF. In the last quarter of 1976, Mexico was able to draw on the Fund for US$480 million. For 1977-79, an Extended Fund Facility accompanied by a comprehensive three-year stabiliza- tion program was negotiated. The new Government ratified the agreement with the IMF shortly after taking office on December 1, 1976, and to date has complied with the program agreed upon with the IMF. Current Economic Policy 6. The present Government inherited a difficult situation upon taking office on December 1, 1976. High inflation, large public sector deficits, in- creasing foreign indebtedness and lack of confidence in economic management indicated a need for economic stabilization. However, the situation also called for more expansionary policies; economic activity had slowed down, net private investment was virtually nil, and the gap between new job creation and growth of the labor force was increasing. High world prices for petroleum offered profitable investment opportunities in the petroleum sector; indeed, increased production for export of these products seemed by far the best way to meet a large part of Mexico's high debt service requirements in the coming years. 7. Faced with these conflicting needs and opportunities, the Mexican authorities adopted a mixed strategy aimed at reducing lower-priority public expenditures and increasing public revenues, while proceeding with petroleum and other high-priority investments. The objectives of the Government's program include control of inflation together with a return to high rates of economic growth. Better management of public sector expenditures, more rational pricing and cost control in public sector enterprises, promotion of private savings, limiting wage increases to justifiable levels, and more effective cooperation with the private sector are important parts of the Government's economic strategy. 8. The measures instituted by the new Administration have already produced good results. Inflation was brought back to less than 20 percent in 1978, down from an annual rate of more than 60 percent in the last quarter of 1976, immediately after the devaluation. The deficit in the current account of the balance of payments peaked at $4.2 billion in 1975 and declined to $2.0 billion in 1977. The favorable oil prospects allowed it to  - 3 - increase again and it is estimated to have been around $3.0 billion in 1978. Public sector financial requirements also peaked at 8.7 percent of GDY in 1975 and declined to 5 percent of GDY in 1978. Mobilization of savings by the banking system has also been recovering at a strong pace. The GDP rate of growth is estimated at about 6 percent in 1978 as compared to less than 3 percent in 1977. The outlook for 1979 is favorable; the rate o^ growth of the economy will increase while all efforts are going to be undertaken to make the rate of inflation decrease; the deficit in the current account of the balance of payments and the public sector's financial requirements are likely to remain at the 1978 levels. Economic Issues and Prospects 9. The Mexican authorities have adopted a comprehensive social program aimed at strengthening the political system, improving income dis- tribution and the living conditions of the poor, increasing public sector efficiency and accelerating growth. The program takes into account two overriding economic priorities--energy development and adequate supplies of foodstuffs--and takes the form of a three stage economic strategy. The first stage--the stabilization period--is almost over and has been devoted to overcome the serious economic problems the new Government inherited. The second stage would be devoted to establishing the basis for attaining a high, equitable and stable rate of growth. During this stage--1979-80-- efforts will be made to overcome supply bottlenecks, increase agricultural production, improve the marketing system, increase the efficiency and competi- tiveness of the country's industrial sector and create the conditions necessary for a more just distribution of the benefits of growth. Accelerated and equit- able growth would be the characteristics of the third stage. 10. Mexico has the human, institutional and natural resources necessary to attain these ambitious goals. The short-run disequilibria that have affected the country during the mid-70s have been brought under control; the new petroleum riches and the country's ability to exploit them have greatly relaxed the financial constraints on growth. In his last State of the Union speech President Lopez Portillo announced that Mexico's present oil and gas reserves amounted to 20 billion barrels on July 31, 1978 and that probable and potential reserves amounted to 37 billion and 120 billion barrels, respec- tively. These figures were revised upward in January 1979 and proven oil and gas reserves put at about 40 billion barrels. Exploitation of these reserves would allow Mexico to increase production of crude oil, natural gas and petrochemicals from the equivalent of about 1.2 million bbl/day in 1976 to about 3.3 million bbl/day in 1982 and to export the equivalent of about 1.4 million bbl/day of crude oil in 1982 (for approximately US$8.5 billion on the basis of conservative price assumptions), not counting gas exports. 11. The challenge ahead is how to use these vast riches to help resolve Mexico's long-term development problems which include the following: (i) Population and Poverty. Many Mexican families have not partici- pated in the sustained economic growth of the last several decades. As of 1975, about 4 million Mexican families--45 percent of the total--receive incomes equal to less than  - 4 - one-half the national average. The members of most of these families work--more than half of them in agriculture--but they produce little and receive little. Mexico's labor force is now growing at about 3.1 percent per year, which implies an average annual increase by some 550,000 workers during 1975-80; during the 1960s the growth rate was 2.7 percent per year. The challenge of providing productive jobs for both new entrants and existing underproductive workers is awesome; (ii) Stagnation in Agriculture. Crop and livestock production in Mexico, which had grown by 6 percent per year during 1945-55 and 4.2 percent per year during 1955-65, grew at only 2.1 percent per year during 1965-75, resulting in increased imports of corn and wheat; (iii) Regional Imbalances. The heavy concentration of people, production, and public services in the Mexico City area-- which has currently a population of about 12 million and is growing at over 5 percent each year--and the scarcity of productive employment and services for rural Mexicans are challenges to urban management, economic development, and social justice. They imply diversion of some of Mexico City's future growth to other regions, as well as the gradual concentration of scattered rural populations into small towns so that basic public services could be provided more economically and productive activities would have a better chance of developing. 12. In the medium term the prospects for resumption of economic growth with relative price stability are good. Poverty will remain a problem but the Government is taking steps to address it. The alleviation of the external constraint on growth brought about by the expected petroleum earnings (para. 15), together with the Government's efforts to increase public sector savings and to stimulate private investment, could produce economic growth of 7 to 8 percent per year in the remaining four years of the present administration. Resumption of economic growth combined with the intensification of the Govern- ment's family planning program (on October 28, 1977, President Lopez Portillo announced the ambitious goal of reducing the population growth to 2.5 percent per year by 1982, then progressively to 1.8 percent by 1988, 1.3 percent by 1994, and 1 percent by the year 2000), the new emphasis on rainfed agriculture, and the implementation of specific programs aimed at increasing productive employment, should help to address the structural problems mentioned above. 13. In agriculture, the current administration has undertaken a far- reaching administrative reform that will allow broader and more effective Government action in the sector. Emphasis is laid on productivity gains and yield increases in both irrigated and rainfed areas. The previous goal of self-sufficiency in agricultural goods is being rephrased in terms of the sector's overall capacity to pay for its own imports. Irrigation is fostered through a nationwide program for small irrigation and drainage works and rehabilitation of existing irrigation districts to increase efficiency  -5- of water use. The new emphasis on rainfed agriculture, relatively neglected in the past, should lead to an increase in the productive potential of vast areas currently under-exploited and to a reversal of past trends towards larger income disparities between the modern and traditional agricultural subsectors. These initiatives, together with the realistic exchange rate, promise a resumption of growth in production for both domestic and export markets and an improvement in the living conditions of the rural poor. 14. Industry has potential for considerable growth in many sectors, including import substitution in chemicals, petrochemicals and capital goods as well as exports of many different manufactured products. PEMEX has already started an ambitious investment program to produce a variety of primary petro- chemicals on a large scale for both domestic consumption and export, and it is expected that the private sector will complement this by investing in the production of secondary petrochemicals. Tourism export earnings are also expected to increase. 15. Paramount among the benefits of recent public sector investments are the new possibilities opened to the Mexican economy through the dis- coveries of rich petroleum fields. The Government has decided to use these large hydrocarbon resources to help manage Mexico's heavy debt service burden and to enhance the country's development prospects. The additional domestic demand likely to occur due to the large planned increase in Govern- ment expenditures associated with increased public investment and programs aimed at increasing employment and the productivity of the poor will have to be satisfied partially through increased imports. Net interest payments are likely to increase in the future given the rapid increase in foreign debt which occurred during the last sexenio and the borrowing expected to take place in the years to come. However, rapidly increasing petroleum exports and favorable tourism earnings prospects, the recovery of agricultural exports and resumption of growth of manufactured exports have strengthened the balance of payments outlook and will keep the current account deficit at reasonable levels. 16. Mexico's debt service ratio has been increasing over the recent past and reached 48 percent in 1977. This comparatively high debt service ratio is more a reflection of the low level of exports relative to GNP and the high proportion of Mexican borrowing from commercial banks than it is an indication of a high level of external debt relative to the size of the economy. When middle income developing countries are ranked by the ratio of external public debt to GNP, Mexico ranks as average. The debt service ratio is estimated to have peaked at slightly over 50 percent: in 1978 and, mainly as a result of the rapid expansion of petroleum export:s, is expected to decline sharply to levels of around 30 percent in the early 1980's. Debt service on bank loans amounts to about 3 percent of public debt service; this ratio is projected to decrease over the next two years and to increase to some 4.5 percent in 1982. The Bank currently holds about 8 percent of Mexico's total medium- and long- term public debt, and this ratio is not likely to change in any significant way over the next few years. Mexico remains creditworthy for borrowing on conventional terms considering the country's excellent medium- and long-term potential and the well conceived economic strategy which the Government has adopted to realize it.  - 6 - PART 11 - BANK GROUP OPERATIONS IN MEXICO 1/ Bank Operations 17. As of January 31, 1979, Mexico had received 57 loans from the Bank amounting to US$3,128.9 million net of cancellations and terminations; of these, 33 loans totalling US$1,486.4 million were fully disbursed. The Bank held US$2,604.4 million of which US$1,116.3 million had not yet been disbursed. Some 40 percent of Bank lending has been for agriculture and rural development (19 loans for US$1,264.4 million), 23 percent for power (12 loans for US$704.8 million) and 17 percent for transportation projects (12 loans for US$546.7 million); the remaining 20 percent has been for industry (US$352.5 million), water supply (US$130 million), tourism (US$114 million), and urban development (US$16.5 million) projects. Mexico is carrying out a stabilization program (para. 9), and because of scarcity of counterpart funds some projects fell behind schedule in 1976 and 1977. Adequate budget support for Bank projects has now been secured. Annex II contains a summary statement of Bank loans as of January 31, 1979 and notes on the execution of ongoing projects. IFC Operations 18. As of January 31, 1979, IFC has made investment commitments in 17 companies in Mexico, for a total of US$202.4 million, of which US$129.4 million had been sold, repaid or cancelled. The balance held by the Corporation, US$73.0 million, consists of US$63.2 million in loans and US$9.8 million in equity. A summary statement of IFC investments as of January 31, 1979 is presented in Annex 1I. Bank Strategy 19. The main objectives of Bank lending in Mexico have been to: (i) support policies and programs leading to a wider distribution of the benefits of economic growth; (ii) help finance projects that make dLrectly or indirectly, significant contributions to output, exports, and employment; and (iii) help resolve critical adjustment problems that Mexico is currently facing. The Bank is preferentially supporting projects of high social priority that help the rural or urban poor, projects that promote higher levels of employment and production and those that help to decentralize economic activity. 20. Because of the difficult structural problems of Mexico's agricul- ture and the sector's crucial importance to the country's further development, the Bank has made agriculture the leading sector for its lending. rhe Bank agricultural lending program for Mexicc has four goals: first, to Lncrease productivity of presently cultivated l;nds through selected program, of irri- gation rehabilitation and on-farm imprcvements; second, to improve che pro- ductivity of small farmers who receive the benefit of most Bank leniing through programs for (a) rural development, (b) rainfed agricultural develop?ment, 1/ Part II is substantially unchanged from the President's Report for a Highway Sector Project (R79-43) of March 8, 1979.  - 7 - (c) bringing new areas under cultivation, and (d) establishing irrigation and drainage units; third, to complement infrastructure investments with general support services including agricultural extension and marketing programs and provision of medium-term credit; and fourth, to promote off-farm employment opportunities in rural areas through programs of agro- and rural-industries. The Bank has made seven loans in FY's 72 through 77, totalling US`579 million, for irrigation, rural development and agriculture and livestock credit programs. A US$56 million loan for an agricultural development project designed to inten- sify agricultural production in Mexico's humid tropics and a US$200 million loan for an agricultural credit project were approved by the Executive Directors in FY78. A US$25 million supplemental loan for the Rio Panuco Irrigation Project was recently approved. Besides a small-scale agricultural infrastruc- ture project approved by the Executive Directors in December, 1978, future Bank lending for agriculture includes projects for rehabilitation of irrigation districts, water control, rural development and support services. 21. Bank lending for industry has been aimed at assisting the Government's efforts to reduce the balance of payments deficit and decentralize industrial activities away from the major (and increasingly congested) urban areas. Thus, a major steel project is now operating in a previously underdeveloped area on the west coast of Mexico, and a fertilizer project promotes new poles of development in the resource-rich southeast region and the north central area. A project to promote the development of small- and medium-scale enterprises and a third industrial equipment fund project were approved by the Executive Directors in FY78. The proposed project would reinforce the Government's efforts to create a new industrial center on the Pacific coast of Mexico, help strengthen one of the larger public sector enterprises in the country and support programs to improve efficiency in the agricultural sector. Further Bank support to the manufacturing industry by means of a credit project is being evaluated, and a capital goods industry project is under study. 22. As regards infrastructure, the Bank's operations have been focused on investments in key areas of the country as well as on institutional reforms and sector policies aiming, inter alia- at suitable pricing mechanisms to help generate additional resources for investment financing. The airports development project (FY74) was designed to support the Government's policy of regional integration; the third railway project (FY76) supported improve- ments of institutional aspects and financial management of the sector. The Mexico City (FY73) and medium cities (FY76) water supply projects have been instrumental in the establishment of a specialized institution for efficient provision of drinking water and in the pricing of water at levels more closely related to costs. A Highway Sector Project Loan was approved by the Executive Directors on March 20, 1979 and a second airports project to modernize and expand high priority regional airports is being processed for submission to the Executive Directors in the coming months. 23. The Government and the Bank have long recognized the regional economic disparities prevailing in Mexico (para. 11). In June 1976 the Government adopted the Law of Human Settlements to provide a new institutional framework to deal with the pressing problems of over-concentration of economic activities in the larger metropolitan areas. The Government has recently adopted a National Urban  Development Plan that spells out its regional development priorities in oper- ational terms, and several projects are now being prepared to meet the needs for basic urban services for poor families and provide key regional infrastruc- ture in selected priority cities. One such project, to assist in the develop- ment of the Lazaro Cardenas conurbation area on the West Coast, was recently approved by the Executive Directors, and another project for the southeast part of the country will be appraised in the coming months. PART III - THE FERTILIZER SECTOR Agricultural Background 24. More than 22 million of Mexico's 62 million population live in rural areas. About 40 percent of the national labor force is engaged in agriculture, forestry or fishing; the sector accounts for over one-third of commodity exports. Although agriculture provides important inputs for industry, its share in gross domestic production declined from 19 percent in the 1930s to below 10 percent in the late 1970s. Since the mid-1960s the growth in production of crops in general, and of cereals in particular, fell below the growth in domestic demand, while livestock production, accounting for about one-third of the sector's out- put, has been growing consistently at around 5 percent per annum. 25. The Mexican agricultural sector is marked by wide disparities in resource endowment, technology, productivity, and income. While between 1915 and 1965 over half of Mexico's arable and pasture lands were distri- buted to landless families under a pioneering agrarian reform program, the land varies considerably in quality and productive potential from the arid north to the tropical isthmus. Mexico has been a leader in applied agricul- tural research, but the link with the farmer has been weak; as a result, most small farmers have not yet fully benefitted from modern technology. Access to public services, credit and infrastructure has been uneven. Together, these factors have resulted in a sharp duality in Mexican agri- culture: one third of Mexico's cultivated area produces two-thirds of Mexico's agricultural goods. Farmers in the irrigated zones and a selected number of rainfed agricultural zones have developed into productive rural entrepreneurs, but most of Mexico's small farmers work by traditional methods, subsist on a modicum of production from their farms, and barely participate in the market economy. In an effort to correct this imbalance, the Government is intensifying technical, promotional, and organizational assistance to farmers and is concentrating public investment in agriculture on programs to benefit the small farmers and eiidatarios. 1/ The Government's Agricultural Development Policies 26. The Government has in recent years focused on increasing production of basic food crops (maize, wheat and rice) so as to attain self-sufficiency, and on raising the productivity, incomes and living standards for the poorer sections of the rural population. 1/ Eiidatarios are members of an eiido, a form of group land tenure based on usufruct.  - 9 - 27. The Government's strategy for increasing agricultural production includes measures to increase the cropped area and to increase the productivity of lands currently being cropped. The Government is bringing new lands into production and stimulating changes in cropping patterns to increase the area devoted to basic food crops. Development of new rainfed lands is getting underway mainl in the humid tropical zone, where a largely underutilized area of about 8 mili .on ha is estimated to have medium to high agricultural poten- tial. To induce changes in cropping pattern that would help offset the decreased area devoted to wheat and maize during recent years, the Government has recently increased the guarantee prices of these two crops relative to sorghum and soybeans. 28. The present administration is placing significant emphasis on developing programs to increase farm productivity. A program to rehabilitate those irrigation districts where infrastructure is inadequate or where lands are in poor condition has been expanded. Increasing attention is being given to development of the potential of rainfed agriculture. The 110 recently established rainfed agricultural districts would promote the adoption of modern technology and would be the basis for strengthening the delivery of technical assistance and marketing services to farmers. Such programs are complemented by other public investments to improve the incomes and employ- ment levels of the rural poor. The most important of these is the national Investment Program for Rural Development (PIDER) which provides a balanced package of directly productive support and social infrastructure to residents of Mexico's poorest rural zones and for which a Second Bank loan was approved by the Executive Director in FY1977. 29. Thus the Government's agricultural development strategy provides access to modern farming techniques for a higher proportion of its rural population. The strategy calls for investments by the Government in applied research and extension as well as in physical infrastructure. At the same time, the Government is stimulating private investment through credit institutions. The Bank is supporting the Government's strategy in both these areas. The tropical agricultural development project, approved by the Executive Directors in FY78, finances part of the Government's program to open the humid tropical areas to intensive use. In addition, projects for irrigation, drainage and improvement of the agricultural extension and marketing systems are under study. The sixth agricultural credit project, approved by the Executive Directors in FY78, supports private investment in agriculture and agroindustries. The proposed project would support a significant increase in Mexico's capacity to produce fertilizer. 30. Of Mexico's 15.5 million ha. of land under cultivation in 1977, 4.5 million ha. or about 30 percent, were irrigated. Overall, fertilizer was being applied to about half the land under cultivation, but a much higher proportion of irrigated land (88 percent) was being fertilized than of non-irrigated land (32 percent). This uneveness of fertilizer application is a reflection of the current duality in farming techniques and efficiency. However, in spite of this, improved cultivation practices, including the use of better seeds and greater amounts of fertilizer, have raised average cultivation yields over the past years; for instance, average corn yields -- a crop that accounts for about 46 percent of land under cultivation -- increased 21 percent between 1962 and 1976. Nevertheless, these improvements have not been sufficient to permit agricultural output to keep pace with population growth.  - 10 - The Fertilizer Market 31. Fertilizer consumption in Mexico has been increasing steadily. From 1960 to 1978, nitrogen consumption increased at an average annual rate of 14 percent while phosphate consumption increased at 15 percent and potash at 13 percent yearly. Despite these growth rates, fertilizer usage remains low in Mexico as compared to other countries. While Mexico uses about 34 kgs. per hectare of arable land per year, Brazil employs 49 kgs., Portugal 67 kgs. and the United States 92 kgs. of fertilizer. Considering that currently only about half of Mexico's cultivated land receives fertilizer, the opportunities for increasing fertilizer consumption are good. The major potential lies in areas where rainfall is more predictable and the soil better able to store moisture; such areas might account for as much as 20 percent of all land under cultivation. Efforts to increase the use of fertilizers would need to concen- trate on small farmers who at present use limited amounts. The Government has already redirected its agricultural development efforts to assist small farmers improve production, and is carrying out a number of different programs to this end. During negotiations, assurances were obtained that the Government would promote NPK and DAP fertilizers, particularly in rainfed areas (Section 3.05 of the draft Guarantee Agreement). 32. In the past, the proportion of nitrogen nutrient to phosphate nutrient used in fertilizing has fluctuated considerably, mainly due to supply deficiencies but, on the whole, the proportion is improving as phosphate fertilizers gain wider acceptance. 33. Consumption of nitrogen fertilizers has been projected to grow at a rate of 7.8 percent annually between 1978 and 1985, while phosphate fertil- izers consumption is expected to increase at 13.3 percent per year. These projections are considered realistic in view of past consumption growth trends, of the large potential for increasing fertilizer consumption in Mexico, and of the measures being taken by the Government's agencies to improve agricultural productivity. Domestic demand and production forecasts for the three specific products to be produced under the project are discussed in paragraph 52. The Fertilizer Industry 34. Mexico began to build up its fertilizer production capacity in the l950's. A major expansion of finished fertilizer production took place in the early 1960's when several manufacturers developed domestic demand for their fertilizers, but their production was largely dependent on imported intermediates. Capacity to produce intermediary products was built up in the second half of the 1960's, when phosphoric acid facilities were installed on the Gulf coast, and in the mid 1970's, when ammonia plants were constructed by PEMEX. In order to rationalize and consolidate the manufacture and distribu- tion of a key input to agricultural production, the Government decided in 1965 that sole responsibility for the import and distribution of fertilizers in Mexico would be given to FERTIMEX, S.A. 1/, a Government-owned corporation 1/ Then called Guanos y Fertilizantes de Mexico S.A. (GUANOMEX); the name was officially changed on January 1, 1978.  - 13 - yearly of marketable, 54 percent, phosphoric acid (expressed or P 0 5). To produce these fertilizers, the manufacturing complex will include facilities in four areas with capacities as follows: 1. Sulfuric acid 660,000 tpy 2. Phosphoric acid (54%) 198,000 tpy (as P205) 3. Nitric acid (55%) 215,000 tpy (as 100%) Ammonium nitrate 270,000 tpy 4. Diammonium phosphate (DAP) 275,000 tpy Compound fertilizers (NPK) 250,000 tpy The project would also include facilities for generating steam and critical power requirements, and for water supply and storage of all raw material and intermediates (except ammonia which will be stored by PEMEX) as well as finished products. The plant will be located on a 120 hectare grass roots site at Lazaro Cardenas on the west coast of Mexico, a site with good infrastruc- ture facilities and close to the main markets. 42. Raw materials will be supplied from both domestic and foreign sources. Sulfur, ammonia and diatomaceous earth will be available from domestic suppliers, whereas phosphoric rock will initially be imported, but may eventually be supplied from the deposits recently identified in Baja California. Potassium chloride will be imported. Facilities to handle and store these raw materials will be constructed on the project site. FERTIMEX will construct its own berth in the port of Lazaro Cardenas; dredging work to connect the existing channel to FERTIMEX's berth is also included in the project. 43. To facilitate engineering and management, FERTIMEX has divided the project into the four areas indicated above and a fifth, which covers all services and utilities, solid handling and conveying facilities as well as port and ship loading installations. Foreign engineering firms have already been appointed to be responsible for providing licenses, basic engineering design, foreign procurement services, technical coordination and supervision of local engineering firms. The latter will provide detailed engineering and local procurement services. For the fifth project area, FERTIMEX has decided to award one contract for all solids handling and conveying plants, and another for all utilities and service plants including coordination of the overall project. Storage facilities and buildings will be handled by FERTIMEX's own staff. In all cases FERTIMEX has selected proven processes and has awarded contracts to experienced firms which are acceptable to the Bank. Responsibility for overall management of the project and supervision of the prime contractors will rest with FERTIMEX's construction department, which has appointed a full- time project manager to lead the project management team. 44. Project implementation is expected to take 36 months from award of engineering contracts in October 1978; commercial production of all end-products is expected to start in October 1981. Basic engineering design has begun, and site preparation has already started.  - 14 - The Company 45. The project was prepared, and will be carried out and operated, by FERTIMEX, one of the largest industrial and trading enterprises in Mexico. FERTLMEX is the country's main producer and sole distributor of fertilizers and one of the Government's instruments to develop the agriculturil sector. The Company's shares are owned by NAFINSA. FERTIMEX's Managing oirector is appointed by the Executive Branch of the Government. The Secretary of National Patrimony and Industrial Promotion is Chairman of FERTIMEX's Board of Directors, on which the Secretariats of Agriculture and Hydraulic Resources, Trade and Finance are represented, as well as other government organizations with interest in agricultural development. FERTIMEX's Management is fully respon- sible for day-to-day operations, but major policy decisions, especially concerning fertilizer prices, capital investments and long-term borrowings, are made by the Board in coordination with the various Government agencies concerned with financial and/or agricultural promotion policies. 46. FERTIMEX's Management is satisfactory. The Company's Operations Department has a creditable record of running manufacturing facilities efficiently and at high rates of utilization. The Planning and Development Department was recently strengthened and has used help from consultants to broaden its construction management capabilities. The Financial Department has been reorganized recently and new control systems have been introduced. Substantial progress has been made in improving financial reporting and the Company intends to further develop financial planning and control systems so that they are more in accord with the size and complexity of its operations. 47. FERTIMEX currently owns fertilizer production facilities at ten locations in Mexico (See map 13550). In 1977, they had capacity to produce about 2.1 million tons a year of finished fertilizer products, equivalent to 430,000 tons per year of nitrogen nutrient and 260,000 tons per year of phosphatic nutrient. Capacity utilization has been very good; during 1977 many plants operated at above their nominal capacity. FERTIMEX's current expansion program includes, but is not limited to, the proposed project, and is expected to increase ammonium sulphate capacity by 30 percent, ammonium nitrate by 100 percent, urea by 300 percent, diammonium phosphate by 200 percent, simple superphosphate by 100 percent and compound fertilizers by 200 percent. In terms of nutrient content, FERTIMEX will have nearly trebled its nitrogen capacity and about doubled its phosphate production capacity after completion of its expansion program in 1982. FERTIMEX's Management is capable of carrying out this large construction program satisfactorily with no adverse effect on the implementation and financing of the proposed project. Employment and Training 48. The project will provide permanent employment to about 630 people, most of whom will be recruited in the Lazaro Cardenas area. Construction of the project is expected to provide a significant boost to employment at Lazaro Cardenas, which is experiencing significant unemployment. No major difficulty is expected in recruiting the less skilled labor though FERTIMEX  - 15 - will develop a plan for the recruitment and training of new staff. During negotiations, assurances were obtained that FERTIMEX would revise its opera- tions staff training program by December 31, 1979 and promptly thereafter carry it out (Section 4.06 of the draft Loan Agreement). Financial Situation 49. FERTIMEX's financial situation has been adversely affected by the Government's fertilizer pricing policies and by the substantial devaluations of the peso at the end of 1976. Reduced cash generation resulting from a policy of low prices for fertilizers would have caused the Company substan- tial losses but for compensatory payments made by the Government. In spite of these, FERTIMEX's liquidity has been reduced and its financial ratios have deteriorated. For example, the long-term debt equity ratio increased from 29/71 in 1974/75 to 65/35 at the end of 1977, largely as a result of operating losses and the intervening peso devaluations. The bulk of FERTIMEX's loans are denominated in foreign currencies. 50. FERTIMEX's practice of maintaining high levels of inventories and accounts receivable results in high levels of working capital which are financed through short-term loans. To improve its liquidity, FERTIMEX plans to reduce the level of its working capital and agreed during negotiations to maintain a current ratio of at least 1.3:1.0 after December 31, 1979 (Section 5.06(c) of the draft Loan Agreement). 51. The Government's main concern in setting fertilizer prices has been to stimulate increased agricultural output by supplying fertilizers at low prices. Since the 1976 financial crisis, it has also avoided action which might have an inflationary impact, particularly in the agricultural sector which has an important impact on inflation through food prices. Though the Government compensates FERTIMEX for losses incurred in marketing foreign fertilizers, for foreign exchange losses, and for discounts which the Government has requested it grant farmers, these compensations have not been enough to permit the Company to improve its financial situation. For instance, in 1978 FERTIMEX (excluding FFM) received compensatory payments equal to 20 percent of its total revenues, but despite these its net income was less than 0.1 percent on total assets. To improve FERTIMEX's financial prospects, assurances were obtained from the Government during negotiations that it would take all action to enable FERTIMEX, operating efficiently, to attain financial returns on average revalued assets in operation, plus working capital required for normal operation, of at least 3.5 percent in 1980-82, and 8.0 percent in 1983 and thereafter (Section 3.03 of the draft Guarantee Agreement). If retail fertilizer prices are insufficient to enable FERTIMEX to achieve these rates of return, the Government would make payments to FERTIMEX to partly compensate subsidies to farmers implicit in the retail price of fertilizers. FERTIMEX on its part has agreed to carry out studies of the costs and benefits to farmers of the use of fertilizers (Section 4.07 of the draft Loan Agreement) which could serve as a rational basis for fertilizer pricing.  - 16 - Market 52. The forecasts of domestic demand for the three products to be manufactured under the project are based on the assumption that consumption of ammonium nitrate will increase at an average of 4 percent a year up to 1985, diammonium phosphate at 7 percent, and compound fertilizers at 9 percent per year in the same period. The production of ammonium nitrate and compound fertilizers approximately matches proposed demand, but there would be a temporary surplus of diammonium phosphate equivalent to about 22 percent of total capacity immediately after project start-up. However, demand projections are conservative since they are based on past rates of consumption, which were depressed by insufficient supply of these products. Also, statistics on past consumption probably understate actual amounts used and, moreover, recent promotional efforts have shown that farmers accept higher analysis fertilizers of this kind readily. Given the conservative nature of the demand projections, and taking into account the likely effects of the proposed promotional program, domestic demand for the fertilizers to be produced under the project is expected to be sufficient to absorb the project's entire output. Marketing 53. The project's output will be marketed mainly in North, Central and South West Mexico, which includes important agricultural areas. FERTIMEX's marketing strategy is to avoid dependence on one mode of distribution. In 1977, it sold about 42 percent of its fertilizers directly to large farmers, industrial users or through commission agents, and the reminder through a two-step distribution system. Organizations such as the Banco Nacional de Gredito Rural (BANRURAL), sugar corporations, agricultural cooperatives and related organizations, and CONASUPO, the national marketing board for basic products, channel FERTIMEX's fertilizers to their respective farming partici- pants and clients. Although these distribution systems have been adequate in the past, they are not reaching a sufficient number of small farmers with low levels of productivity and income. Expansion of fertilizer production and marketing is expected to result in a sharp increase in rail traffic by 1982 when substantial amounts of primary, intermediate and finished products will have to be moved in a system which is already reaching full capacity in some areas. In order to identify areas of improvement in its marketing methods and product transportation systems, FERTIMEX has agreed to carry out studies which are to be completed by August 31, 1980 (Section 4.05 of the draft Loan Agreement). Project Costs and Financial Plan 54. Total financial requirements for the project, including working capital and interest during construction, are estimated at US$301.3 million equivalent, of which US$124.5 million equivalent is in foreign exchange. A breakdown of project costs may be found in the Loan and Project Summary. Physical contingencies were calculated at 10.4 percent of base costs. Price contingencies were based on annual escalation rates of 7.5 percent for 1979 and 7 percent thereafter for all equipment, and 10 percent for civil  - 17 - works and erection during the entire period. The same price escalation rates were used for both local and foreign expenditures on the assumption that the difference between domestic and international rates of inflation would be compensated by changes in the peso exchange rate. Permanent working capital requirements for the project are estimated at US$25.9 million equivalent on the assumption that FERTI14EX will reduce the level of its working capital needs substantially, as expected. 55. The project would be financed with equity contributions equivalent to 40 percent of total costs, and loans equivalent to 60 percent. Debt financing of US$180 million equivalent would be obtained from: the U.S. EXIMBANK, which is expected to provide about US$4.6 million to cover part of the licensing and foreign service costs; about US$95 million equivalent from international commercial banks, and the proposed loan of US$80 million from the Bank. Loans from international banks would finance indirect foreign exchange costs, local expenditures and interest during construction on other than the Bank loan. They would be arranged by NAFINSA which is a well estab- lished borrower in international markets, and the long term resources would be made available to FERTIMEX on terms satisfactory to the Bank and according to an agreed schedule (Section 5.09 of the draft Loan Agreement). Inter- national banks and insurance companies have already expressed interest in participating with the Bank in the financing of the project. 56. The proposed Bank loan would finance about US$7.7 million of engineer- ing, licensing, supervision and start-up assistance expenses, about US$33.5 million of equipment and materials awarded under international competitive bidding, about US$26 million of imported proprietary and critical equipment and small items, and about US$12.8 million of interest during construction and other costs. The Bank loan would be repayable over 15 years, including four years of grace, and interest charges to FERTIMEX would be 10 percent annually with the difference between this and the Bank lending rate payable to NAFINSA on behalf of the Government. FERTIMEX and NAFINSA would be joint borrowers and FERTIMEX would carry the foreign exchange risk. Procurement 57. All equipment items financed under the Bank loan would be procured by international competitive bidding according to procedures acceptable to the Bank, after prequalification of suppliers, except for imported small items totalling less than US$100,000 each (up to a maximum of US$16 million) and proprietary and critical items requiring a long lead time for delivery not exceeding US$10 million, which would be procured after prudent international shopping. Local suppliers would be entitled to a 15 percent margin of prefer- ence or the applicable import duties and taxes, whichever is lower. Procure- ment of all local equipment and materials not being financed by the Bank under its international bidding rules, and award of civil works contracts, would be according to FERTIMEX's own procedures involving competitive bidding among local suppliers. Advance contracting of items eligible for Bank financing are expected to amount to approximately US$45 million, including US$7.7 million of engineering contracts.  - 18 - Disbursements 58. The proposed Bank loan would be disbursed on the basis of 100 per- cent of expenditures for: foreign engineering, licenses, supervision and start-up assistance; foreign equipment and materials awarded under inter- national competitive bidding; foreign proprietary and critical equipment and small items; consulting services, and for interest during construction up to April 1, 1982. Retroactive financing of up to US$8.6 million (or 10.8 percent of the proposed loan) is recommended to cover expenditures incurred after October 1, 1978. Projected Financial Returns and Performance 59. The financial forecasts for FERTIMEX and the project are based on the program to improve the Company's financial situation which the Government has agreed to follow (see para. 51). The impact on the Company's performance should be apparent quickly and, by 1980, when the financial ratios agreed upon for the first project become operative, the Company is expected to meet all of them. On this basis, the financial rate of return for the project alone is calculated at 8.3 percent before taxes. 60. During negotiations assurances were obtained that the following financial ratios would be observed: (i) a debt/equity ratio of 60/40 or better will be maintained at all times; (ii) no additional debt over US$10 million equivalent will be incurred after December 31, 1980 if the projected debt service ratio would fall below 1.4; and (iii) the Company will pay no dividends or prepay debt if the current ratio drops below 1.5 (Section 5.06 of the draft Loan Agreement). The Company would submit audited financial statements annually within six months of the close of the fiscal year. Environmental Aspects 61. All potential emissions would be controlled to safe and environ- mentally acceptable levels by adequate plant design and appropriate clean-up facilities. Plants would be designed and constructed to ensure that the entire complex meets the contamination limits required by Mexican law, and in cases where such laws do not yet cover certain contaminants, the project would conform to the standards set by the US Environmental Protec- tion Agency. The plant site would include a 60 ha site for the adequate disposal of gypsum produced by the phosphoric acid plant. However, con- sidering the potential environmental and pollution problems associated with projects of this nature, confirmation was obtained during negotiations that FERTIMEX will ensure that the project will be designed, constructed and operated to meet generally accepted ecological and safety standards (Sections 3.05 and 4.04 of the draft Loan Agreement). Economic Benefits 62. The project has a satisfactory economic rate of return of 12.3 percent. This results from the extensive use of domestic raw materials, with associated savings in transporting these and finished products to the  - 19 - market, and also because the project would realize economies of scale in production. The project would also provide a substantial stimulus to the development of Lazaro Cardenas, a new development pole expected to attract investment away from the increasingly congested urban areas in central Mexico. Lastly, the project would enable Mexico to have an assured supply of an impor- tant range of finished, high analysis fertilizers, and would enable it to pursue its agricultural development policies without concern for possib