China - Shanghai Machine Tool Project

Document of The World Bank FOR OFFICIAL USE ONLY 10 /. 10) 1> -K Report No. 5994-CHA STAFF APPRAISAL REPORT CHINA SHANGHAI MACHINE TOOL PROJECT January 28, 1987 Industry Department This docunent has a restricted distribution and may be used by recipients only in the performance of their official duties. lts rontents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS Currency Name - Renminbi Currency Unit - Yuan (Y) US$1.00 = Y 3.70 Y 1.00 = US$0.27 (as of October 1986) WEIGHTS AND MEASURES 1 meter (m) = 3.28 feet 1 square meter (nm2) = 10.76 square feet 1 cubic meter (m3) = 35.31 cubic feet 1 milligram (mg) = 0.001 gram or 0.015 grain 1 kilogram (kg) = 1,000 grams or 2.205 pounds 1 metric ton (ton, t) = 1,000 kilograms or 2,205 pounds 1 carat (ct) = 200 milligrams GLOSSARY OF ABBREVIATIONS cif - Cost, Insurance and Freight ct - Carat CNC - Computerized Numerically Controlled ERR - Economic Rate of Return GOC - Government of China ICB - International Competitive Bidding IRR - Internal Rate of Return kg - kilogram in - meter ...mg - milligram MMBI - Ministry of Machine Building Industry NC - Numerically Controlled PCS - Pieces PIU - Project Implementation Unit ppm - parts per million SBMEIA - Shanghai Bureau of Mechanical and Electrical Industries Administration SD - Synthetic Diamond SMG - Shanghai Municipal Government SMTC - Shanghai Machine Tool Corpration SMTW - Shanghai Machine Tool Works t - tons tpy - tons per year FISCAL YEAR January 1 - December 31  FOR OFMCL USE ONLY CHINA SHANGHAI MACHINE TOOL PROJECT TABLE OF CONTENTS Page No. LOAN AND PROJECT SUMMARY ......................................... iv - v Io INTRODUCTION ...... .....eooo ............................... I II. THE MACHINE TOOL SECTOR ............... ...................... 2 A. International Status of the Sector ....................... 2 B. Status of the Sector in China ............................ 2 C. The Government's Sector Objective and Strategy ........... 6 D. Project Justification and the Rationale for Bank Support . 6 III. THE PROJECT BENEFICIARIES ..... .............................. 7 A. Organizational Structure ... ... . ....................... 7 B. SMTTW ..................................................... 8 C* SMTC ......................................... ......... 9 IV. THE PROJECT **.......... ................................ 10 A. Project Objectives ..* ............................ 10 B. Project Descriptions ... - ............... .......... 10 1. Plant Rehabilitation and Modernization Component ...... 11 2. Technology Transfer Component ......................... 17 3. Management System Component ........................... 18 4. Training Component .... *.........* ................ 18 C. Materials, ':omponents and Energy Inputs O-*.............. 18 D. Demand and Market Aspects ..... ........... 20 E. Environmental Aspects ............. .............. . .. ..... 21 V. PROJECT IMPLEMENTATION ......... .............................. ........ 21 A. Project Management ....................................... 21 B. Engineering ............................................ .*....... 22 C. Technology Transfer, Management System and Training ...... 22 D. Implementation Schedule ...... ..... .... .... ... ..... ..... * ... 23 E. Status of Preparation ....... ............................. 24 VI. CAPITAL COSTS, FINANCING PLAN, PROCUREMENT AND DISBTRSEMENT . 25 A. Capital Costs .... ................... ....... de......*....... 25 B. Financing Plan ............ .............................. ...... 26 C. Channelling of the Proposed Loan ......................... 27 D. Procurement .............................................. 28 E. Allocation and Disbursement of Bank Loan ................. 29 This report has been prepared by M.R. Amin, A.J. Ewing, K.K. Zamani and S-W. Leong of the Industry Department. Mrs. V. Sellappan provided word processing assistance, and secretarial support was provided by Mmes. F. Tate and E. Tam. This document has a resticted distribution and may be used by rcipients only in the performance of their official duties. Its contents may not otherwise bc disclosed without World Bank authrization  - ii- Page No. VII. FINANCIAL ANALYSIS ...... ................ 31 A. Basis of Projections *................................... 31 B. Sales Volume and Revenues o.o......ee ........... 31 C. Production Costs ........ ............................... 32 D. Financial Projections ............* ........................ 32 E. Financial Rates of Return and Sensitivity Analysis ....... 34 F. Financial Covenants ...... .............* 37 G. Auditing and Reporting Requirements ...................... 38 VIII. ECONOMIC ANALYSIS ................ ...... ......... 38 A. Adjusted Costs and Benefits for Economic Analysis *s....s 38 B. Economic Rates of Return and Sensitivity Analysis ........ 39 C. Net Foreign Exchange Savings .* .......................... 40 D. Other Benefits ........ ...................... . ........ 41 E. Risks .. ......... ..... ... ......... ..... *........ 41 IX. AGREEMENTS AND UNDERSTANDINGS REACHED AND RECOMMENDATIONS ... 42 ANNEXES 2 World Machine Tool Production and Trade ..................... 44 3-1 SMTW's Organization Chart .... ........................ .............. 45 3-2 SMTC Headquarters' Organization Chart ....................... 46 4-1 List of SMTC Plants and Institute ........................... 47 4-2 Guidelines for the Control of the Foundry Environment ....... 48 5-1 Scope of Work for Engineering Consultancy Services .......... 52 5-2A SMTC Terms of Reference for Management Consultancy Services . 53 5-2B SMTW Terms of Reference for Management Consultancy Services . 59 5-3 SMTW Project Implementation Schedule sscsscescssescccccsecccs 64 5-4 SMTC Project Implementation Schedule ............ .........c.... 65 6-1 Plant Capital Cost Estimates .......................... 66 6-2 Projected Di-bursement Schedule for Proposed Bank Loan ...c... 67 7-1 Assumptions Used in Financial Analysis ....... ..........c...... 68 7-2 SMTW Production and Revenue Tables Table 1: Projected Production Volume .ceeeece.ceeeecsc..cc 71 Table 2: Projected Export and Domestic Sales Volume and Revenues ....... ...e cc........ c..s sc........o..... 72 7-3 SMTC Production and Revenue Tables Table 1: Foundries and Forge - Prices, Production and Sales Revenues ....c. ........ c..*.*.c.......... 73 Table 2: Accessory Works - Projected Production Volume .. ... 74 Table 3: Accessory Works - Projected Selling Prices ........ 75 Table 4: Accessory Works - Projected Sales Revenues ........ 76  - iii - Page No. Table 5: #2 and #3 Metal Cutting Nachine Works - Prices, Production and Sales Revenues ................... 77 Table 6: #4 and #8 Netal Cutting Machine Works - Prices, Production and Sales Revenues ................... 78 Table 7: Metal Forming Machine Works - Prices, Production and Sales Revenues ..... ......... ................ 79 Table 8: #2 Metal Forming Machine Works - Prices, Production Sales Revenues * ...................... 80 7-4 SMTW Projected Financial Performance Table 1: Historical and Projected Income Statements ........ 81 Table 2: Historical and Projected Fubnd Flow Statements .... 82 rable 3: Historical and Projected Balance Sheets ........s.. 83 7-5 SMTC Projected Financial Performance Table 1: Historical and Projected Income Statements ........ 84 Table 2: Historical and Projected Funds Flow Statements .... 85 Table 3: Historical and Projected Balance Sheets ........... 86 7-6 SMTW - Cost-Benefit Streams for Financial Rate of Return .... 87 7-7 SMTC - Cost-Benefit Streams for Financial Rate of Return *... 88 7-8 Financial Rates of Return for SHTC Project Plants ........... 89 8-1 Assumptions Used in Economic Analysis ....................... 90 8-2 SMTW - Cost Benefit Streams for Economic Rate of Return ..... 92 8-3 SMTC - Cost Benefit Streams for Economic Rate of Return *.... 93 8-4 Economic Rates of Return for SMTC Project Plants ............ 94 8-5 Analysis of Foreign Exchange Effects *----------------------- 95 9 Selected Documents and Data Available in the Project File .. 96 MAP IBRD 19458  - iv - CHINA SHANGHAI MACHINE TOOL PROJECT Loan and Project Summary Borrower: People's Republic of China Beneficiaries: Shanghai Machine Tool Works (SMTW) Shanghai Machine Tool Corporation (SMTC) Amount: US$100.0 million equivalent Terms: 20 years, including 5 years of grace, at standard variable interest rate. Onlending Terms: The Government will onlend, through Shanghai Municipal Government, US$36.0 million equivalent to SMIW and US$64.0 million equivalent to SMTC for a period of 15 years, including 5 years of grace, at a fixed annual interest rate of 8.5% and a commitment charge of 0.75%. SMTW and SMTC will bear the foreign exchange risk. Project Description: The .ajor objectives of the Project are: product rationalization; product upgrading and manufacture of precision machines; improvements in quality and quantity of inputs; increase in manufacturing efficiency; expansion of design and engineering capabilities; and improvements in management systems. The Project consists of: (a) rehabilitation and modernization of 18 plants and 2 research institutes, owned by the two beneficiaries; (b) import of appropriate technology; (c) establishment of a modern management structure and system; and (d) development and implementation of a comprehensive training program. Benefits: import of technology will enable the beneficiaries to manufacture quality products and precision machine tools efficiently. Rationalization measures during project preparation have already led to a restructuring of SMTC's organization and agreements to: reduce overlapping operations among the beneficiaries' plants; and close down two polluting foundries. Management support will add considerable flexibility to the operations, improve maintenance and inventory control, and facilitate the introduction of cost-accounting techniques. Support to the research institutes will streamline product development and help to ensure the compatibility of product design with market requirements. The training program will result in expansion of the beneficiaries' design and engineering capabilities and will improve the  - v - managerial abilities of shop, plant and corporate managers. The Project will have a demonstration effect on other provincial machive tool manufacturers as well as capital goods manufactJring industries. Risks: The Project's potential risks are: whether the technology can be transferred to the project entity; and whether the products which result from the introduction of the new technology can be marketed on the scale anticipated. These risks have been carefully addressed in project preparation and design to the extent that necessary safeguards and other measures to minimize their potential impact are in place. Local Foreign Total Estimated Cost: - (US$ millions) - SMTw: Plant Cost 15.0 28.2 43.2 Engineering, Management, Training & Technology Transfer 0.7 7.6 8.3 SMTC: Plant Cost 16.5 53.4 69.9 Engineering, Management, Training e Technology Transfer 1.4 10.9 12.3 Base Cost a/ 33.6 100.1 133.7 Physical Contingencies 3.4 10.0 13.4 Price Escalation F'0 9.8 15.8 Installed Cost 43.0 119.9 162.9 Incremental Working Capital 38.1 3.4 41.5 Interest During Construction 8.8 9.9 18.7 Total Financing Required 89.9 133.2 Z23.1 -~~~~~~ -i Local Foreign Total Financing Plan: - (US$ millions) - IBRD Loan - 100.0 100.0 Domestic Loans 51.8 29.8 81.6 Self-generated Funds 38.1 3.4 41.5 Total 89.9 133.2 223.1 Estimated Bank FY: 1987 1988 1989 1990 1991 1992 Disbursements: -- - (US$ millions) - Annual 0.9 22.9 33.2 25.0 15.4 2.6 Cumulative 0.9 23.8 57.0 82.0 97.4 100.0 Economic Rate SMTW - 31Z of Return: SMTC - 31Z a/ Estimated Project costs exclude taxes.  CHINA - SHANGHAI MACHINE TOOL PROJECT I. INTRODUCTION 1.01 The Government of the People's Republic of China (the Government, GOC) has requested a Bank loan of US$100 million equivalent to finance 75Z of the foreign exchange cost of rehabilitation and modernization of two major machine tool manufacturing corporations in Shanghai (the Project); the balance of financing to be provided by domestic banks. For the machine tool industry, the Project is expected to meet two of the Government's major objectives in the industrial sector: (a) modernization of existing enterprises, particularly through import of new technologies; and (b) generation of foreign exchange indirectly through import substitution and directly through increased exports. The Project also aims at rationalization of organizational and physical structures, improvement in management systems, improvements in quality and quantity of inputs, increase in manufacturing efficiency and expansion of design and engineering capabilities. 1.02 The Project consists of four components: (a) rehabilitation and modernization of 18 plants and 2 research institutes, all of which are owned by one or other of the two Shanghai machine tool manufacturing corporations; (b) import of appropriate technology; (c) establishment of a modern management structure and system; and (d) development and implementation of a comprehensive training program with emphasis on middle management training. The Project will require total financing, including physical and price contingencies and interest during construction of about US$223.1 million equivalent, of which US$133.2 million will be in foreign exchange. 1.03 The Project was proposed to the Bank's Industrial Reconnaissance Mission in May 1983. The Bank's first preparation mission (September 1983) prepared a comprehensive sector review of the machine tool industry in Shanghai,,/ which identified the sectoral issues and the core of the Project, and recommended three major feasibility studies to be carried out by foreign consultants. The studies were prepared by: Foundry Management and Design Co. Ltd. of the UK in association with Forging Development (International) Ltd. of the UK; Roland Berger and Partner of the FRG in association with Hayek International Ltd. of Switzerland; and Ingersol Engineers Inc. of the USA. These studies, which were financed by the Bank's Technical Cooperation Credit to China (CR-1412 CHA), together with the sector review formed the major steps in project preparation. The Project was appraised in October/November 1985 by Messrs. M.R. Amin, A.J. Ewing, K.K. Zamani and S-W. Leong (Industry Department), and Mr. H.G. Rohs (Consultant). Financial information and projections were updated in October 1986. 1/ Industry Department: China - Shanghai Machine Tool Project, Preparation Mission's Full Report, December 1983.  -2- II. THE MACHINE TOOL SECTOR A. International Status of the Sector 2.01 Metal-working machine tools, which form the core of the metal-working machinery industry, are divided into two distinct main categories, namely the metal-cutting and the metal-forming machines with the former accounting for the major share (65-71%) of the machine tool output in the industrialized countries. Technologically, all the basic types of machine tools in use today had been developed by the end of the 19th century. The next significant impetus to development of machine tools was the emergence of the automobile industry and the moving assembly line which created the demand for more productive and accurate machines. During the past two decades, the major area of development has been automation by incorporating the fruits of the electronic industry in machine tools as exemplified by the development of sophisticated numerically controlled (NC) and computerized numerically controlled (CNC) machines. While a relatively small portion of machine tools in use today is numerically controlled, the share of NC machines in the annual machine tools output of the world's advanced producers has been rising since the early 1970s. it reached a range of 26-39% in 1980 and is currently estimated at about 50Z for the USA and Japan. 2.02 Although it serves as the backbone for au engineering industries including several major industries such as capital goods, cransport machinery and aerospace equipment manufacturing, the machine tool industry's share of all manufactured goods in the industrialized countries is small (0.2% to 0.8% in 1980). In 1981, about 99% of the world production of machine tools (approximately US$26.8 billion) was accounted for by 35 industrialized and newly industrialized countries, with the first 10 leading countries' share amounting to about 84Z. The bulk of international trade (about US$10 billion in 1981) takes place among the leading industrialized countries. In 1981, USA, FRG, Japan, USSR, GDR, Canada, UK, France, Italy and Switzerland accounted for about 80% and 57% of the world's exports and imports, respectively. The world machine tool production and trade for 1981 and 1982 are given in Annex 2. Analysis of gross investments in machine tools in developing and developed countries indicates high correlation coefficients between per capita consumption of machine tools, and per capita gross national product and industrial investment. In 1981, among the 35 countries referred to above, Switzerland and India with a per capita machine tools consumptions of US$46.5 and US$0.35 ranked the highest and the lowest, respectively, while China with a per capita consumption of about US$1.05 ranked 34th. B. Status of the Sector in China 2.03 Structure and Production. During the last three decades China's machine tool production grew by almost 10 times from 13,700 sets in 1952 to about 100,000 metal-cutting and 30,000 metal-forming machine tools in 1982. The sector, which includes manufacture of metal-working machine tools, casting and wood-working machinery and machine tools accessories, comprised over 400 small, medium and large plants, employing about 600,000  -3- people (about 1X of industrial employment).2/ Among these plants, 121 are considered the main enterprises which, operating under the direction of Ministry of Machine Building Industry (MMBI), account for the bulk of machine tools and accessories production, i.e., 79 and 42 plants, respectively. Of the former group, 10 large plants (each with employment of over 5,000 people) provide 10% of the total machine tools production. In 1981, the value of the sector's output was about Y 3.2 billion, corresponding to approximately 1% of China's industrial output. With the share of machine tools (metal-cutting and metal-forming) in the total sector output amounting to about Y 1.6 billion, China ranked sixth among the world's machine tool manufacturing countries. In 1982, 1984 and 1985, the value of China's machine tool output reached Y 1.8, Y 2.5 and Y 2.7 billion (in 1981 prices), respectively. 2.04 Technology. A major issue facing the machine tool industry in China is its outmoded technology. In its early development (1950s), the industry was based on the USSR technology of the time, while during tihe 1960s and 1970s development depended on the indigenous technology which was based on the work of Chinese research/design institutes, internationally published literature and occasional imports of sample machine tools. 'The policy of development based exclusively on indigenous technology, which prevailed until the late 1970s, resulted in a very slow and probably costly technological development and in China's current technological backwardness. During recent years as a result of China's adjustment policy (para 2.13) and the increasing demand of the user industries for better quality and more efficient machine tools, some 20 collaboration agreements (mostly buy-back agreements) have been signed with advanced manufacturers in the industrialized countries. With the exception of a limited number of machine tools which are built through these recently acquired technologies, the currently employed technology in the vast majority of machine tool manufacturing plants is about 20 years old. Old designs combined with poor quality purchased components (e.g., castings, bearings, electric parts and hydraulic equipment), inadequate manufacturing facilities and insufficient experience in production management result in products which in addition to having a short life (5-7 years compared to 12-15 years in the industrialized countries), are unreliable and not suitable for precision work. 2.05 Trade. Although China started exporting machine tools in 1957, published literature (Chinese and international) presents very sketchy data on Chinese exports and imports prior to 1978. During 1978-82, China's exports and imports of machine tools averaged about US$40 million and US$100 million per annum, respectively - a low trade activity for the world's sixth-ranking producer and consumer of machine tools. The main reasons for the low trade level were that while poor quality and outmoded technology of domestically manufactured machine tools limited exports to low-priced conventional machines, restrictions by the Government resulted in imports of only badly needed sophisticated machines. The bulk of Chinese machine tools exports is still to traditional markets in Southeast 2/ In China, the industry includes manufacturing, mining and electric power generation.  - 4 - Asia, though exports to the other parts of the world - including the industrialized countries - has increased during recent years. 2.06 Supply/Demand. With exports and imports amounting to about 3% and 10% of the value of domestic production, the average annual apparent consumption of machine tools during 1980-82 has been estimated at about 107% of the domestic output. In 1982, China's installed machine tools were estimated at about 3 million units which, when compared with the machine tools in use in the USA and FRG during 1980 (2.63 and 1.25 million units, respectively), appears excessive. This is partly explained by the adherence of the Chinese industry to the principle of self-sufficiency and the fact that contrary to the practice in the industrialized countries where old and obsolete machines are replaced with modern machines, in China old machines are kept and new machines are simply added. To this end, based on visits to a number of industrial plants by various Bank missions, it is estimated that about one third of machine tools installed in China are idle. Another reason for the relatively high number of installed machine tools in China is the low productive level of Chinese machine tools due to their old designs, short life and unreliable performance. Considering these factors, a significant element of future demand will be replacement of a large portion of existing machine tools with machines of better quality and longer economic life. 2.07 National demand projections for machine tools are not available. International studies, however, using the world's and the Chinese historical consumption growth rates (3.3% and 6.4% per annum during 1965-80, respectively) project demand growth rates of 2.4% and 4.9% per annum for the world and China during 1980-95, respectively.3/ The projected growth rate for China is considered conservative when compared with the Bank's least growth case scenario for the Chinese economic growth during 1981-2000.4/ Under this scenario gross domestic product is projected to grow at 5.4% per annum and the machine building industry - the main market for machine tools - at 7.6%. Thus, with a consumption level of about Y 1.7 billion in 1981 and a projected growth rate of 5-7% per annum during the succeeding two decades, the main issue is not the demand but the supply, and in this respect, whether China will be able to modernize its machine tool industry fast enough to meet the domestic demand for reliable and efficient machines. 2.08 Distribution System. Until 1982, production and output of all the main enterprises (para 2.03) were subject to the Government's quota and allocation system. In this respect, annual production quotas were established by the Government for each enterprise and then the products were allocated to the domestic users under the centrally controlled unified distribution system. One of the major deficiencies of this system, among others, was that the manufacturer seldom knew the users of its products and the latter had no freedom in choosing the manufacturer. In line with the 3/ Source: Predicasts Incorporated, Cleveland, Ohio, USA; Industry Study No. 270 entitled 'World Machine Tools to 1995, May 1982. 4/ -China: Long-term Issues and Options,- Report No. 5206-CHA, May 22, 1985.  - 5 - Government's recent reforms, there has been a continued reduction of the Government's quotas since 1982. As an example, in 1985, about 50X of metal-cutting machines and 47Z of metal-forming machines, manufactured by the Shanghai machine tool industry, was under the Government's quota and allocation system. With the expected increase in the non-allocated share of output, the main enterprises' responsibilities for marketing their products, providing after-sales services, and responding to the market signals in production planning would also increase. Most of China's exports of machine tools are handled by the China National Machinery and Equipment Import and Export Corporation, a centrally controlled organization. There are, however, a number of enterprises, among them the project beneficiaries, which are allowed direct exports. 2.09 Input Prices. The principal inputs for machine tool manufacturing are iron and steel castings, steel products, bearings, and electrical and hydraulic components. The industry is not energy intensive and the share of energy cost in the total cost of production is relatively small (3% in Shanghai). The foundry industry, whose principal inputs are sand, scrap, pig iron and coke, is on the other hand, energy intensive - the share of energy amounting to about 14% of the direct production cost. The sector review (para 1.03), which included a detailed financial and economic analysis of the Shanghai machine tool industry in 1983, concluded that: all material input prices were reasonable when compared with international prices; electrical energy prices were compatible with economic prices; and coke prices were about 30% of economic/international prices. Discussions held in the context of the Bank's first coal project in China (the Changeun Coal Mining Project, Loan 2501-CHA) indicate that within a few years coal/coke prices will be progressively raised to be in line with long-run marginal costs, i.e., be set at economic levels. The appraisal mission confirmed that the sector review's findings regarding all input prices were valid in 1985 and found that coke prices had already been increased to about 64Z of international prices. 2.10 Output Prices. For the purpose of pricing, machine tools are divided into two broad categories: special purpose machines, i.e., machines which are built to the customers' orders; and general purpose machines, i.e., machines which are manufactured for sale in the market on a regular basis. There are no price restrictions on the first category and these machines are sold at negotiated prices. The second category is, however, subject to price control by the Government, but the system includes the following important adjustment rules: (a) price review and adjustment every 2-3 years on the basis of market conditions and changes in input prices; (b) 8-20% price increases allowed if a product is upgraded; (c) higher price increase allowed if a product is priced abnormally low; (d) negotiated prices permitted up to 20% higher than fixed prices if input materials are not provided under the unified distribution system; and (e) no price control for exports. The above price incentives, which were introduced in 1982, have been implemented as exemplified by the experience of the Shanghai machine tool industry during 1983-85. 2.11 The sector review of 1983 (para 1.03) provides detailed analysis of the then prevailing prices of domestically manufactured machine tools in  - 6 - Shanghai. The conclusion reached was that these prices, after adjustment for quality, life and reliability, were generally competitive when compared with the international prices. This conclusion was supported by the export prices which were either the same or slightly higher than the domestic prices. Thus, with the implementation of the price adjvscments (para 2.10), the current level of prices is considered reasonable. In the future, as a result of reduction in the share of 'overnment-allocated products (para 2.08), the manufacturers, in proposing adjustment in existing product prices or prices for new products, would have to consider not only their costs but also the prices of comparable machines. C. The Goverrment's Sector Objective and Strategy 2.12 Objective. China plans to quadruple its 1980 agricultural and industrial output by the end of the century, with per capita GNP increasing from US$300 to US$800 (in 1980 dollars). The focus of GOC is not only a major quantitative increase in the industrial output, but also a substantial improvement in product quality. To achieve the latter, better quality and more reliable machinery will be required - a requirement which cannot be met without upgrading the quality of the domestically manufactured machine tools. Given the above objective and requirement, modernization of the machine tool industry has been assigned high priority, with the Project being the first major effort in that respect. 2.13 Strategy. In industry, the Government's current policy of adjustment and reform is to correct several fundamental weaknesses, which became prominent by the end of the 1970s: inefficiency in the use of capital, labor, raw materials and energy; poor product quality; and an imbalance in capacity. The adopted adjustment policy includes: generation of foreign exchange indirectly through import substitution and directly through increased exports; stress on modernization of existing enterprises; and improvement of energy efficiency. In line with phe overall industrial adjustment policy, the Government's specific strategies for the machine tool industry are: to keep the current level of output in nuLibers but increase output value by changes in product-mix and improvemen: of product quality; to improve machine design and manufacturing techniques through import of appropriate technologies; to discontinue production of obsolete ui3chines and to manufacture precision machine tools; to satisfy, primarily, thle needs of the light user industries; and to improve management systems in machine tool manufacturing enterprises. D. Project Justification and the Rationale for Bank Support 2.14 In line with the above objective and strategy, GOC has selected the Project as its first major operation in the sector. The choice is appropriate because the Shanghai machine tool industry covers a wide spectrum of metal-cutting and metal-forming machines as well as accessory equipment and foundry products, and accounts for about 10% of the country's machine tools output and about 20% of its exports. The Project also meets most of the Bank's industrial objectives in China, namely: improving policies and institutions; technology upgrading; energy conservation; and export promotion.  2.15 One of the major shortcomings which contributed to the weaknesses of the Chinese industry (para 2.13) has been identified by the Government as lack of proper preparation and evaluation of investment projects. The Bank, through its sector review and the subsequent Bank-assisted feasibility studies, has already played an important role in the preparation of the Project. The sector review identified a number of major issues and made the following recommendations for their resolution: (a) organizational restructuring cf the beneficiaries; (b) physical restructuring of plants involving gradual phasing out of three cast iron foundries and mergers of some of the machine tool and accessory manufacturing plants; (c) rationalization of production and reduction of overlapping operations among the Shanghai plants; (d) measures to assure adequate supply of sanc, scrap, pig iron and coke for the foundries; and (e) conclusion of collaboration agreements between experienced foreign manufacturers and the relevant Shanghai enterprises, not included in the Project, for the manufacture of quality bearings, electric parts and hydraulic components. These recommendationE either have been implemented or agreement has been reached to implement them during the course of project execution. The feasibility studies, which started with comprehensive market studies, have identified the required products for the fiture and thus have suggested changes in layout and addition/deletion of manufacturing equipment for each plant involved in the Project to meet these requirements. Participation of the beneficiaries' personnel and a domestic consulting firm in the sector review and the feasibility studies, both of which involved financial and economic analysis, has resulted in the transfer of project preparation and evaluation techniques to the sector in Shanghai. The Bank's role in the future, inter alia, would include assisting the Chinese in import of technology, establishiment of management systpms at plant and corporate levels, ard training of personnel. III. THE PROJECT BENEFICIARIES A. Organizational Structure 3.01 The project beneficiaries are the Shanghai Machine Tool Works (SMTW) and the Shanghai Machine Tool Corporation (SMTC) whose combined output of mar*-ine tools amounted to over US$100 million equivalent in 1982, corresponding tc about 50% of India's production in that year. SMTW was registered as an independent industrial enterprise in 1981 and SMTC, which was an administrative agency of the Shanghai Municipal Government ZSMG) until August 1984, changed its status to an independent enterprise. Both corporations are owned by the Government and, for administrative purposes, report to the Shanghai Bureau of MechaniLal and Electrical Industries Administration (SBMEIA), an organ of the SMG. SBMEIA, which also reports to the MMBI, appoints the corporations' general managers, issues the central and municipal governments' guidelines and directives to the corporations, reviews price proposals by the corporations, and makes sure that the Government's allocated produ'cts are manufactured and delivered.  -8- 3.02 Articles of association (charters) for SHTW and SHTC, describing the scope of activities, responsibilities and authorities of their organizations, were prepared by the beneficiaries and reviewed by the Bank in 1985. According to these Charters, which were approved by SBMEIA and became effective as of January 1986, the beneficiaries have full responsibility for managing their affairs and are authorized to: change their organizational structures; determine their employment policies; 'uarket their non-allocated products; enter into contracts with domestic and foreign organizations; borrow from domestic and foreign sources; and allocate and use their retained earnings. 3.03 While SMTW operates an integrated plant, SMTC behaves more like a holding company with 44 plants and 1 research institute under its purview. Locations of SMTW and SMTC's plants and research institute are given in the attached Map (IBRD 19458). For SNTC's research institute and each of its 16 plants included in the Project, detailed descriptions covering organization chart, existing physical facilities, product types, output level, employment and financiel performance are given in the Project File. This file also includes brief descriptions of SNTC's 28 non-Project plants. The financial projections contained in Chapter VII detail the recent financial performance of SMTW and SMTC which is satisfactory. The management and staff at SMTW and SMTC are competent and, with the assistance of foreign advisors and consultants, will be able to implement the Project efficiently. However, for plant and corporate operation, the mangement systems at both corporations are inadequate and management skills from shop to corporate level need improvement. These shortcomings have been addressed under the Project (paras 4.13 and 4.14). The important features of the beneficiaries' structure and operations are described briefly in the succeeding paragraphs. B. SMTW 3.04 SMTW's integrated plant comprises three distinct sections: the captive foundry; the hydraulic compGaent manufacturing section; and the grinding machine manufacturing section which also includes manufacturing of roundness testers and coordinate measuring machines. The plant's principal products are cylindrical, surface, double disc, crankshaft, roll, thread and gear grinding machines. SHTW's existing organization chart is presented as Annex 3-1. Salient features of the operations are summarized below:  - 9 - SMTW - Salient Features Unit 1985 Employees person 6,366 Gross fixed assets million yuan 73.4 Machine tool output set 2,221 Domestic sales million yuan 71.1 Of which, machine tLols million yuan 60.2 Exports million US$ 1.1 Profit before tax million yuan 22.4 Source: SMTW. C. SMTC 3.05 As stated earlier SMTC currently has 44 plants and one research institute, spread throughout Shanghai, under its purview. Based on the Bank mission's recommendations, SMTC's corporate organization was changed drastically to reduce the number of people reporting directly to the corporate manager from 47 to 8 and decentralize the decision-making process. SMTC's new organization chart is given in Annex 3-2. The plants are grouped in four divisions comprising foundry and forging, accessories and tools, metal-forming machines and metal-cutting machines. SMTC issues guidelines to the plants, reviews and approves/disapproves plant investments, appoints plant managers, allocates the Government's product quotas to the plants and handles the exports. Other than the Government quotas, the plants are free to plan production and are responsible for the domestic sale of non-quota products. The plants are free to manage their affairs within SMTC's guidelines. Each plant produces its own independent annual financial statements and pays SMTC a fee for the provision of services. SMTC has not prepared consolidated financial statements in the past, but has agreed to do so on a regular basis beginning in FY87. Confirmation of this agreement was obtained during negotiations. 3.06 SMTC manufactures a broad range of products. The plants in the foundry and forging division manufacture steel castings, iron castings and forged products. While steel castings are sold to SMTC's machine tool plants as well as other manufacturers, iron castings and forged products are exclusively for sale to the SMTC plants. The accessory division's plants manufacture a wide variety of measuring equipment and machine tool accessories which are sold to STHC's plants and other machine tool manufacturers throughout the country. SMTC's principal metal-cutting machines output includes: lathes, milling machines, drilling machines, shaping machines, gear cutting and gear grinding machines, guideway grinding machines, electro-discharge machine and wire-cutting machines, special purpose machines and transfer lines. The metal-forming machines, manufactured by SMTC, are: mechanical presses, folding machines, guillotine shears, extrusion presses, die-casting machines and pipe-bending machines. The salient features of SMTC operations are summarized below:  - 10 - SMTC - Salient Features Unit 1985 Employees person 30,042 Gross fixed assets million yuan 316.8 M{achine tool output set 17,186 Domestic sales million yuan 364.9 Of which, machine tools million yuan 217.0 Exports million US$ 8.5 Profit before cax million yuan 102.8 Source: SMTC. IV. THE PROJECT A. Project nbjectives 4.01 The principal goals of the Project are: (a) rationalization of products through physical restructuring of plants; (b) upgrading of products and manufacture of precision machines through technology transfer; (c) improvements in quality and quantity of inputs through alleviation of existing constraints; (d) increase in manufacturing efficiency through renovation of buildings, removal of obsolete machinery, installation of suitable new equipment, training of middle management and establishment of appropriate production planning and control systems; (e) expansion of design and engineering capabilities through strengthening of the research institutes; and (f) improvements in the plant/corporate management systems through employment of modern management techniques. Successful implementation of the Project is expected to have a demonstration effect on other provincial machine tool industries as well as capital goods manufacturing industries. B. Project Description 4.02 The Project includes four components: (a) plant rehabilitation and modernization component covering four cast iron foundries, one forging plant, six accessory equipment manufacturing plants, five metal-cutting machine manufacturing plants, two metal-forming machine manufacturing plants and two research institutes; (b) technology transfer component; (c) management system component; and (d) training component. Of the plants under component (a) one cast iron foundry, one metal-cutting machine manufacturing plant and one research institute belong to SMTW while the rest of the plants/institutes are under the purview of SMTC. Annex 4-1 lists the titles of all SMTC's plants and institute, and designates those included in the Projact. Components (b), (c) and (d) cover SNTW and SMTC's central organizational units as well as all plants and institutes involved in the Project. Because of the heterogeneity of products and in order to avoid repetition, instead of presenting detailed project description for each corporation, homogeneous operations are grouped and the relevant details are described.  - 11 - 1. Plant Rehabilitation and Modernization Component 4.03 The principal criteria used for the rehabilitation and modernization program of each plant were rationalization of production and identification of marketable products. Under the first criterion, the extent of diversification will be reduced in favor of specialization to improve quality and efficiency. In other words, the principle of plant self-sufficiency, a common practice in China, will be replaced with the interdependency principle. The second criterion was used to choose the appropriate product-mix for each plant. In this respect, domestic market studies were carried out first and then existing products were divided into three categories: products to be phased out, products to be retained 'as is- and products to be upgraded. New products to be manufactured by each plant were also identified by the market studies and form the fourth product category. Alternative manufacturing technologies were studied and an appropriate technology was chosen for each plant (para 4.11). The chosen product categories and manufacturing technologies will necessitate changes in plants' layouts and removal/addition of machinery and equipment in each plant. The overall results of these changes will be that: the number of installed machinery will be reduced considerably; with the exception of two new buildings, the civil works will be limited to renovation and, in some cases, extension of existing buildings; and the additional land requirement of the Project will be about 12,000 m2. To this end, because of closure of two existing foundries (para 4.04), there will be a net gain of about 11,000 m2 in available land which will contribute to the alleviation of the land constraint in the Shanghai area. 4.04 (i) Foundry Subcomponent. Due to the poor quality of castings, the foundries will be modernized and their product mixes will be rationalized. The resulting adjusted capacities are expected to satisfy over 97% of the future needs of SMTW and SMTC for quality castings. At SMTW, the existing foundry will be expanded to meet all SMTW's future needs, except castings weighing more than 10 tons which will be procured from external domestic suppliers. At present, SMTC operates six cast iron foundries of which five are independent and the sixth is a part of one of SMTC's machine tool plants. The current practice is that each foundry serves a selected number of machine tool manufacturing plants, producing the whole range of their requirements, i.e., from the very small to the very large castings. As this practice is highly inefficient and as two of the independent foundries are very old and located in congested residential areas, the future foundry operations of SMTC will be limited to three plants which will be specialized in manufacture of small, medium and large castings, respectively. Consequently, the two foundries in the residential areas and the foundry in the machine tool manufacturing plant will be closed down, and the remaining foundries, after rehabilitation, will serve all SMTC plants according to the size requirements. The following table compares the current and projected output of the foundries.  - 12 - Shanghai Machine Tool Project - Annual Foundry Output (in tons) After Project Completion Foundry 1985 a/ Output Range A. SMTW 10,700 16,000 Up to 10 t castings B. SMTC: Foundry No. 1 7,600 22,000 Large Castings Foundry No. 2 3,900 - None Foundry No. 3 6,600 10,900 Small Castings Foundry No. 4 12,200 - None Foundry No. 5 9,500 7,500 Medium Castings Foundry in Machine Tool Plant. 2,700 - None Subtotal (B) 42,500 40,400 Total 53,200 56,400 a/ Preliminary. As the above table indicates, the capacity of the SMTW foundry will increase as a result of design changes and a slight increase in the number of machine tools produced. For SMTC, however, there wlll be a reduction in the combined foundry outpuxt as a result of rationalization and decrease in the number of machine tools produced (para 4.09). 4.05 (ii) Forging Subcomponents. The present forging operation at SMTC's forging plant is unsatisfactory due to poor material handling practices, inefficient furnace operation and use of outmoded equipment. The rehabilitation/expansion program will result in increasing the plant's output from 2,500 tons in 1985 to 10,000 tons in 1991. The annual output of 10,000 tons will satisfy SMTC's projected demand of 4,500 tpy and about 73Z of the demand of other consumers for shaft forgings, including SMTW, in the Shanghai area. The plant's future capacity was determined on the basis of the demand analysis and the smallest available economic-size forging machine. With completion of the rehabilitation program, major forging operations in all SMTC's other plants and SMTW will be discontinued. 4.06 (iii) Accessories Subcomponent. At present, SMTC has 14 independent accessory equipment manufacturing plants which provide SMTW and other consumers (domestic and international) with parts used in the manufacture of machine tools as well as abrasive materials/tools for grinding. Under the rationalization program: one of these plants, located in the Anhui Province, will be transferred to that province; another plant, engaged in manufacture of various types of gears, rotary tables and universal milling attachments, will discontinue manufacture of these products and the plant facilities will be used for assembly of numerical control devices (para 4.16); a third plant, currently engaged in the manufacture of lathes and name plates, will stop production of the former  - 13 - and concentrate on the manufacture of the latter. Six of the remaining plants, which should be rehabilitated on a priority basis, have been included in the Project. These comprise five parts-manufacturing plants and the plant which nanufactures grinding wheels and abrasive paper/cloth. 4.07 The purpose of plant modernization for the five parts-manufacturing plants is to upgrade their existing products, introduce new products required for manufacture of the more sophisticated machine tools of the future and adjustlexpand capacities. As all but synthetic diamond (SD) products manufactured by the Grinding Wheel plant, are acceptable in quality, modernization of this plant will be limited to the import of equipment and technology for manufacture of synthetic diamond tools. A significant feature of the rehabilitation program concerns the Gear Works, one of the five parts manufacturing plants. With modernization of this plant, gear manufacturing will be discontinued in all but three of SMTC's metal-cutting machine and accessory msnufacturing plants. Concentration of metal-cutting machines' gears manufacturing in one plant will result in proision of uniforu, standard and precise gears to manufacturers and consumers (as spare parts). The following table summarizes the rehabilitation program for and its effects on the selected six accessory manufacturing plants.  - 14 - SMIC - Rehabilitation of Accessory Parts Manufacturing Plants Annual Value of (i mwillion yuam at 1986 Prices) After Plant Existing Project Title Products Change New Products 1985 a/ Co2pl. NO. I Tooling systems Upgrade Drill Chucks None 5.6 9.7 No. 3 Sheet covers None Telescopic covers Channels Upgrade Guards Cabinets Upgrade Wipers Upgrade 2.2 4.4 No. 6 Lead Screw Upgrade Aluminium, Plastic Steel Op. Units None and Coated Operating Units 3.3 4.8 Gear Grade 7-8 Gears Upgrade Grade 5 Gears Works Grade 6 Gears Upgrade 3.3 12.0 Level Inductosyn Upgrade Linear Glass Scale Works Levels, Encoders None Digital Tool Presetters Optical Tool Pre- setters None Opt. Reading head None 2.4 20.6 Grinding Conventional None Synthetic Diamond (SD) Wheel Wheels Tools Works Abrasive Cloth/ None Paper SD Grains None 65.3 89.5 a/ Preliminary. 4.C8 (iv) Machine Tool Manufacturing Subcomponent. This subcomponent, which accounts for about 55% of the value of the Project's imported machinery, includes the entire parts and machine manufacturing of SMTW's integrated planws and six of SMTC's machine tool manufacturing plants (four metal-cutting and two metal-forming) which would have a significant impact on SMTC's operation. At present, SMTC has 14 plants in its metal-cutting division and 7 plants in its metal-forming division. As a part of rationalization program at SMTC: one metal-cutting machine manufacturing plant, located in Anhui Province, will be transferred to that province; because of oversupply of conventional lathes, output of lathes will be decreased and the lathe manufacturing plants wifl be reduced from six to five; manufacture of conventional grinding machines will be discontinued at SMTC plants and will be concentrated at SMTW; and  - 15 - metal-forming machine manufacturing plants will be reduced from four to three with the welding operations for all metal-forming machines to be concentrated in one of these plants. 4.09 Using the criteria discussed in para 4.03 and taking the Government's sector strategy (para 2.13) into consideration, the future product-mix of each of the seven plants in this subcomponent was determined. Based on the projected product-mix and the chosen manufacturing technology (para 4.11) existing machinery and equipment in each plant were assessed and the required new manufacturing machines were identified. The result of these analyses is that in the 7 selected plants, about 1,000 old, obsolete and uaproductive machines would have to be removed, and about 120 new maceaines, with high precision and productivity, would have to be added. The slgnificant reduction ln the number of installed machines will provide additional space which in turn would remove the current congestion constraint and allow better material flows. The changes in the product-mix as well as current and future volume and value of production for each plant are presented in the following table.  - 16 - Sm dbm Mahie Too! Project Machine Tool Manufacturing Plante' product iz nxd Annual Volum and Value of Production Umber of Ptoduct Tyne Phase Maim- Up- Volume Cets Product 1985 out tad grade Now Future a/ N985 Future *l SHiV Grinding Machines 22 7 11 4 10 25 2,212 2,320 Keasuring Equipment 4 - 4 - 3 7 9 130 Total 26 7 15 4 3 2.221 2,450 Value of Production (in milIlon ) c/ (64.4) (206.5) SMTC No.2 Metal-Cutting Works Conventional Lathes 9 S - 4 - 4 1,235 400 CNC Lathes 4 - 4 - 182 Total 9 5 - 4 T 8 1,235 582 Value of Production (in million Y) c/ (15.7) (54.9) SHTC No. 3 Metal-Cutt