Peru - CENTROMIN Expansion Project

FILE CoP Document of e World Bank FOR OFFICIAL USE ONLY Report No.P-1855-PE REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT ON A PROPOSED LOAN TO EMPRESA MINERA DEL CENTRO DEL PERU (CENTROMIN) WITH THE GUARANTEE OF THE REPUBLIC OF PERU FOR THE CENTROMIN EXPANSION PROJECT May 17, 1976 This document bas a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents my not otherwise be disclosed without World Bank authorimation.  RATE OF EXCHANGE Currency Unit Sol (S/.) us $1 S/. 45.o s/. 1 US$0.02 S/. 1,000 US$22.22 S/. 1,000,000 US$22,222.22 Peru Fiscal Period - January 1 to December 31 of the following year. CENTROMIN Fiscal Period - January 1 to December 31 of each year. ABBREVIATIONS AND ACRONYMS CIPEC Conseil Intergouvernmental des Pays Exportateurs du Cuivre, an association of major copper exporting countries COFIDE Corporacion Financiera de Desarrollo, a Government- owned development corporation EDC Export Development Corporation of Canada ELECTROPERU Government-owned electrical utility HIERROPERU Empresa Hierro del Peru, a Government-owned iron-mining company, formerly known as Marcona Mining Company IDB Inter-American Development Bank MINEROPERU Empresa Minera del Peru, a state-owned mining company MINPECO Mineroperu Commercial, a Government-owned minerals marketing agency MTPY Metric Tons Per Year SPCC Southern Peru Copper Corporation, a U.S. Controlled copper mining company STPY Short Tons Per Year  FM OfMIAL US ONLY INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT REPORT AND RECOMMENDATION OF THE PRESIDENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO EMPRESA MINERA DEL CENTRO DEL PERU (CENTROMIN) WITH THE GUARANTEE OF THE REPUBLIC OF PERU FOR THE CENTROMIN EXPANSION PROJECT 1. I submit the following report and recommendation on a proposed loan to Empresa Minera del Centro del Peru (CENTROMIN) with the guarantee of the Republic of Peru for the equivalent of US$40.0 million to help finance the CENTROMIN expansion project. The loan would have a term of 15 years, in- cluding 4-1/2 years of grace, with interest at 8-1/2 percent per annum. The Government of Peru would charge CENTROMIN a guarantee fee of 1-1/2 percent per annum on the outstanding amount of the Bank loan. PART I - THE ECONOMY 2. A report entitled "Economic Position and Prospects of Peru" (No. 655-PE) was distributed to the Executive Directors on March 3, 1975. Country data sheets are attached as Annex I. 3. Since 1968 the Government has followed a development strategy in which economic growth is linked to a transformation of the society to achieve broader popular participation in the country's economic, social and political life, thus addressing one of the most serious problems of Peru's economy and society -- the sharp differences in wealth and opportunities between income classes and geographical regions. As was recognized by the Consultative Group for Peru, which met in Paris in April 1975, progress has been made during recent years in implementing this strategy. The land reform in the coastal areas is advanced and, although greater difficulty has been found in improving the lot of the Sierra peasants, efforts to organize production cooperatives there are being accelerated. In the field of industry most enterprises have complied with the Industrial Community legislation -- which provides for a gradual participation of the workers in the ownership of enterprises -- and a new Social Property Law was approved aimed at promoting new industrial and entrepreneurial capacity within a system of self-management by the employees. 4. A new government headed by General Morales Bermudez took office in August 1975. It has been reassessing the progress made since 1968 and has publicly acknowledged that errors had been committed during the past eight years in the difficult task of reconciling growth, financial stability and better income distribution. The main problems that arose were a contraction in domestic savings, a fall in efficiency in the productive sectors and a retrenchment in the level of investment by the private sector. The President has publicly stated the need for important modifications in policies that This document has a restricted distribution and may be used by recipients only in the performance of their ofiicial duties. Its contents may not otherwise be disclosed without World Bank authorization.  - 2 - would leave the basic long term objectives unchanged, but would call for a more gradual approach to reforms of the economic and social system, and would emphasize measures that increase domestic savings, boost private sector investment and improve efficiency in production. 5. GDP grew at an annual rate above 5.5 percent during 1970-74. Gross domestic investment rose from less than 13 percent to almost 17 percent of GDP between 1970 and 1974, largely because of the increase of public and private investment In mining and petroleum. However, as consumption also grew faster than GDP and heavy losses were incurred by public enterprises marketing imported petroleum and foodstuffs, gross national savings fell from 15 to 11 percent o'f GOP between 1970 and 1974. The excessive growth of aggre- gate demand combined vith the sharp rise in Peru's import prices since 1973 resulted in an acceleration of the annual rate of domestic inflation -- from an average annual'rate of 7.2 percent during 1969-73 to over 18 percent in 1974 -- and an increase.in the deficit of the balance of payments on current account from 0.5 to 6p2 percent of GDP between 1972 and 1974. Net long-term capital inflows rose from $110 million in 1972 to $840 million in 1974 and allowed a $275 million increase in net international reserves in spite of the widened resource gap. 6. During 1975 the Government approved a series of tax and price measures directed at attacking some of the causes of Peru's financial diffi- culties, l.e. excessive growth of aggregate demand with a resulting fall in national savings, stagnation of food output and low of export growth. In January 1975 indirect taxes were increased and subsidies on food were reduced. On June 30 a second set of measures included: (a) increases in prices of basic foodstuffs, petroleum (ranging from 25 percent for diesel fuel to 100 percent for premium gasoline), and other basic goods such as steel and cement; (b) a 40 percent reduction in prices of fertilizers; (c) strict controls on salary adjustments in, the public and private sectors. Subsequently, in September the Sol was devalued by about 14 percent. 7. The measures taken did not suffice to stop a sharp deterioration of Peru's external and internal finances largely because of two factors. In the first place, export earnings fell because of the decline in world prices of Peru's exports, adverse weather conditions and labor strikes. The decline in export demand, together with work stoppages, resulted in a drop in mining output; ecological conditions limited the recovery of fishmeal production and reduced the catch of food fish; while bad weather conditions, inadequate supply and'high prices of fertilizers and other production inputs, and in- adequate price and marketing policies followed in previous years affected agricultural output. Secondly, while gross domestic investment rose to 19 percent of GDP, savings continued to drop and the resource gap widened to over 9 percent of GDP. The fall in savings was principally caused by the large losses of state enterprises marketing petroleum, foodstuffs and fertilizers. Import demand grew rapidly not only because of the expansionary  - 3 - financing of public sector deficits, but also because of the sharp increase In food and petroleum imports and because the new investments (mainly in petroleum and mining) had a high Import content. Net long-term capital in- flows totalled an estimated $1.1 billion in 1975, but were not sufficient to finance the current account deficit and net International reserves fell from $680 milliop in December 1974 to around $127 million in December 1975 equiva- lent to less than three weeks of merchandise imports. 8. This year will be a difficult one for Peru's finances. By March 15, 1976, although gross international reserves were still around $440 million, net international reserves had become negative by about $110 mlllion. A viablE financial position will require import cuts since: (a) terms of trade are not likely to improve In 1976, while the volume of exports will remain well below the 1972 level; and (b) Peru may have dlfficulties in obtaining substantial additional funds from commercial sources. Both the President and the Minister of Finance in recent public statements have underllned the seriousness of the economic and financial difficulties and have emphasized the need to increase both domestic savings and labor productivity. This has been reflected in a series of measures approved early this year. On January 10, 1976 a package of measures was approved aimed at reducing the public sector deficit, discouragin2 imports and stlmulating agricultural production. These measures Include: (a) further increases in prices of petroleum products and basic foodstuffs; (b) increase in taxes on income, property and consumption abroad; (c) inclusion of agricultural cooperatives and public enterprises in the income tax rolls; and (d) a 5 percent cut in Central Government budgeted current expenditures. Partly because of these measures, the public sector's overall deficit may fall from 10.9 percent of GDP in 1975 to 8.1 percent in 1976. However, a substantia unfinanced gap of approximately 1 percent of GDP remains, which the Government intends to eliminate with additional revenue measures and expenditure cuts. In April the mining and fisheries sectors were declared in a state of emergency among other things this effectively prohibits strikes. More recently, the President has also emphasized the importance of a dynamic private sector and the need for a more stable environment that would enhance the investment climate. 9. On March 3 the IMF approved SDR 97.3 million (approximately $112.5 million) of financial assistance (first credit tranche and oil facility) on the basis of a letter of intent which refers to additional measures to reduce the public sector deficit and increase interest rates and puts ceilings on credit to the private and public sectors. On April 16, an additional SDR 61.5 million of financial assistance was approved by the IMF under the compensatory financing scheme.  - 4 - 10. During 1968-70 commitments of medium- and long-term loans to the public sector averaged less than $200 million annually. Thereafter, they rose sharply to an annual average of almost $1.1 billion in 1973-74 and $0.9 billion In 1975. The rapid increase was mainly the result of the sharp increase in public Investment and during 1974-75 large requirements of com- mercial borrowlng for balance of payments support. 11. While total public sector external debt (outstanding and disbursed) more than tripled between 1970 and 1975 -- from $0.9 billion to $3.6 billion -- average terms deteriorated markedly. Average maturities fell from 17 years in 1970 to 14.3 years in 1974, since over 65 percent of net disbursements during 1970-74 came from commercial banks. During 1975, the situation worsened since not only commercial banks continued to account for about 70 percent of net disbursements but their terms hardened. The average terms in 1975 of commitments from commercial banks were: 5.8 years maturity (including 2.3 years of grace) and 9.5 percent interest rate. 12. The public debt service ratio rose from 22 percent in 1974 to an estimated 30 percent in 1975 reflecting both a sharp increase in interest payments and the decline In the value of merchandise exports. During 1976 the public debt service ratio is expected to fall to 26 percent because of the expected recovery in exports and a small decrease in debt service pay- nents. However, given the very serious foreign liquidity squeeze the country is now going through, this level of debt service will place a heavy burden Dn the balance of payments. The Government has committed itself to give Eirst prlority in foreign exchange allocation to debt service payments. During 1977-80 the public debt service ratio may rise further to 35 percent, 3ut would decline in the 1980s if the government is successful in increasing aational savings and stimulating nontraditional exports and if more suitable Lending terms are obtained In future years. 13. Peru is a country with some very serious constraints to its devel- Dpment efforts but also with a large untapped resource potential. The Govern- nent is trying to accelerate growth while broadening the participation of the population in the development process. It has been caught by a short- term financial squeeze at a time when some of the unavoidable negative effects )f the structural transformation were being felt. Consequently, the present situation is difficult. The Government is aware of these difficulties and is letermined to resolve them. The President has publicly called for a process )f consolidation and re-examination of social and economic policies. Improve- nents in the balance of payments position during 1977 and thereafter will lepend on: (a) continued efforts to increase savings, contain import growth and reduce dependence on foreign borrowing; (b) reducing dependence on imported petroleum with the completion of the oil pipeline and with additional petroleum axploration; and (c) increasing export volume with the timely completion of nining projects now underway and -- since it is now unlikely that Peru will become a substantial net exporter of petroleum in the foreseeble future -- the axpansion of nontraditional exports. On the basis that such improvements will take place, Peru will continue to be creditworthy for Bank lending. The Bank 3oth as a lender and as chairman of the Consultative Group will continue to nonitor developments closely.  - 5 - PART II - BANK GROUP OPERATIONS IN PERU 14. The Bank has made 29 loans in Peru for a total amount of $430.7 mil lion, net of cancellations. Of this amount 51 percent has been for trans- portation (mainly highways and ports), 24 percent for electric power, 19 per- cent for agriculture and about 6 percent for education. In addition a small loan was made for industry. 15. IFC commitments to date have been about $24.0 million ($15 million to Southern Peru Copper Corporation for the Cuajone Copper mining project and the rest all in industry) of which $15.3 million is held by the Corporation. Project execution has been generally satisfactory. Annex II contains a statement of Bank loans and IFC investments as of March 31, 1976, and notes on the execution of ongoing projects. 16. On July 25, 1975, the Government nationalized the assets of the Marcona Mining Company in Peru without making provision for the payment of compensation. Subsequent negotiations between the Company and the Governmelnt did not reach a conclusion and the matter was taken up for negotiations between the United States and the Peruvian Governments. Substantial progress is being made in these negotiations and an agreement is expected to be signed in the near future. I intend to review further progress made on this matter prior to presentation to the Board of other loans now at an advanced stage of consideration (see paragraph 18 below). 17. The Bank plans to assist the Government in achieving its economic and social development goals by aiding in: (a) the expansion of productive capacity in crucial sectors; (b) the creation of a physical and social in- frastructure capable of sustaining and fostering the positive evolution of the nation's productive capacity; and (c) the consolidation of structural and institutional reform which will help the socioeconomic transformation now underway. Also the Bank expects to continue to play a role in coordinating external assistance by being a catalyst for new sources of funds for major investment projects through the mechanism of the Consultative Group. 18. The Bank's program in agriculture has a two-fold objective: to raise the standard of living of the large rural population of the highlands and to increase food production. Following up on the agricultural sector mission which visited the country in 1974, Bank staff and the Bank/FAO Cooperative Program are assisting the Government in the preparation of projects for rural development in the Sierra and Irrigation rehabilitation in the coastal area; a first irrigation rehabilitation project is being appraised by the Bank. A sites and services project to help alleviate poverty among the urban poor is being negotiated. Also, a DFC project is currently being appraised. In addition, the Bank has identified other projects in the water supply and transport sectors.  19. At present, Bank loans to Peru constitute about 6.0 percent of total outstanding debt, including undisbursed, and absorbed 4.0 percent of the country's external debt service obligations in 1975. No significant changes in these ratios are expected for the next five years. PART III - THE MINING SECTOR A. Background 20. Peru is a mineral-rich country with large proven deposits of copper, zinc, silver, iron ore and lead. Exploitation of Peru's mineral resources goes back to the mining of gold, silver and copper by the Incas prior to the Spanish conquest in order to fashion them into adornments, weapons and utensils. The growth of the mining sector was particularly impressive during the 1950s, when the enactment of a simplified mining code with a clear and favorable tax regime greatly improved the investment climate and foreign capital flowed into the sector. Copper production increased from 30,000 MT to 180,000 MT during the decade, the output of lead, zinc and silver more than doubled, and exploit- ation of Peru's iron ore potential began. In total, the value of mineral production rose from US$41 million in 1950 to almost US$200 million by 1960. 21. In contrast to the previous decade the 1960's were years of relative stagnation in the sector, characterized by decreasing investor confidence and little investment. After the 1968 coup the Government began to assume a more active role within the sector. In 1970 a state-owned mining company, Empresa Minera del Peru (MINEROPERU), was established with the purpose of bringing ito operation a series of high-priority mining and metallurgical projects. The Cerro de Pasco Corporation, now CENTROMIN, was nationalized in early 1974 and the Marcona Mining Company, now HIERROPERU, in mid-1975. Compensation has been paid for Cerro de Pasco and a compensation package for Marcona is being negotiated. The Government has also taken over all overseas marketing of metals and centralized this function in a new state enterprise, MINEROPERU COMERCIAL (MINPECO). B. Current Institutional Situation 22. Four companies -- CENTROMIN, HIERROPERU, Southern Peru Copper Corporation (SPCC) and MINEROPERU -- now constitute the large-scale mining group, which accounts for 65% of the country's mining output and almost 45% of the sector's work force. CENTROMIN has the most diversified output, producing copper, silver, zinc, lead and other metals at seven mines in Peru's central Sierra and accounts for around one-third of the sector's output and employment. HIERROPERU operates Peru's major iron ore mining complex. SPCC, the only remaining private company in large-scale mining, is the country's single largest producer and exporter of copper. MINERO- PERU's only plant in operation thus far is a large copper refinery at Ilo.  23. Peru's medium-scale mining operations consist of a heterogeneous collection of some 60 companies producing partially-treated copper, lead, zinc and silver ores. These operations, which account for 30% of Peru's mining output and employ 40% of the scirtor's work force, are almost all privately owned. The small mining optLations comprise more than 1,000 privately-owned small mines, most of tehem poorly mechanized, labor-inten- sive operations. A large portion of the concentrates produced by the small and medium miners is sold to CENTROMIN for smelting and refining. Expansion of medium and small-sized mines is expected to be much slower than for the large companies during the seventies, and their present share of output will probably decline. 24. Peruvian experience in the planning of major mining development projects is limited both in the companies themselves and in the various Gov- ernment institutions, since this function has traditionally been performed in the headquarters of the foreign parent companies. All mining operations including sector planning now come under the jurisdiction of the Ministry of Energy and Mines, which is responsible also for the petroleum and power subsectors. The Ministry's Planning Department establishes investment priorities but leaves to Corporacion Financiera de Desarrollo (COFIDE) the primary responsibility for financing the investment projects of the state- owned enterprises. COFIDE is relatively inexperienced in the mining industry and has been slow to help the public sector companies with planning their investment programs, partly because of the uncertainty of government funding to COFIDE for such programs. The Planning Department of the Ministry of Energy and Mines has not proven to be effective enough in establishing real- istic priorities and programs for the industry's expansion. 25. The operational problems in the sector include labor unrest. Government policy has raised the wages of workers and miners, resulting in substantial increases in operating costs, but despite the improvement in worker benefits, labor unrest has continued. Besides disputes over wages and working conditions, there has been controversy and uncertainty over the management participation of the mining communities, i.e. the associations representing the mine workers. As has been the case in the private indus- trial sector since 1970, this participation in the private mining sector now takes the form of profit-sharing and a mechanism for increasing share ownership up to a maximum of 50%. The effects and future structure of this experiment in worker participation are still uncertain. In the case of CENTROMIN, the mining communities receive bonds rather than shares, and the Govenment has resisted any excessive influence over decision-making by the mining community or other agencies. Although CENTROMIN is nominally a subsidiary of MINEROPERU, it is effectively controlled by the Ministry of Energy and Mines. C. Mineral Exports, Prices and Strategy 26. The volume of Peru's mineral exports has increased in recent years only marginally and changes in their value have occurred mainly because of fluctuations in world prices. Exports rose from US$465 million in 1970 to  - 8 - US$875 million in 1974 but fell back to an estimated US$567 million in 1975. Peru accounts for 19% of world mine output of silver and about 12% of world exports of zinc and lead and 5% of world copper exports. Since copper constitutes roughly 40% of the value of Peru's mineral exports, variations of its price have a substantial impact on the country's exports. Despite large fluctuations, copper prices followed a long-term upward trend in real terms from 1929 through early 1974, reaching an all-time high of US$1.52/lb. on the London Metal Exchange in early 1974. Since then, copper prices fell sharply to below US$0.55/lb., mainly because of the slowdown in world economic growth, but have recently firmed up to about US$0.70/lb. In November 1974 the Conseil Intergouvernmental des Pays Exportateurs du Cuivre (CIPEC) -- a grouping of copper exporting nations of which Peru is an important member -- agreed to reduce exports temporarily by 10% in an attempt to halt the decline in copper prices. A further cutback of 5% was agreed to in April 1975. In November 1975 the cutbacks were extended through June 1976. Because of the reduced demand for copper some of the major U.S. and Canadian copper companies have also cut production. Peru's export earnings from metals are expected to increase substantially with the economic recovery now under way in major metal consuming countries. Metal prices have recently begun to recover from their depressed levels. An upward trend in real terms is expected over the next few years and the long-term upward trend in world metal demand will call for continuing expansion in the world capacity to produce various minerals. 27. Peru's development strategy, given the relative paucity of her agricultural resources (outside of fishing), and the still small industrial base, is to rely heavily on her richly endowed mining sector to provide the bulk of the foreign exchange earnings needed to maintain her economic growth. In line with this strategy, Peru's four large-scale mining companies have been projecting expansion which, in combination with the prospective invest- ments of other entities in the sector, would have called for total invest- ments in excess of US$3.5 billion during the 1975-80 period. Taking into account the limited project preparation and executing experience of the companies and probable financial constraints, investment in the sector is not likely to exceed US$2 billion during 1976-80, 60% of which would be public. Even this, however, depends on the country's ability to raise the necessary financing. Given this investment rate, the value of Peru's min- eral exports could reach some US$2.5 billion in current prices by 1980 or about 70% above the 1974 value, with about half of the increase resulting from increased production. The largest single project to date is SPCC's development of the Cuajone mine, which is scheduled for completion in early 1977. Cuajone will effectively double Peru's copper producing capacity. After 1980 sector growth is expected to be fuelled primarily by investment in copper and to a lesser extent in zinc, phosphates, lead, and silver.  - 9 - THE PROJECT A. Project Concept 28. Bank staff have worked closely with CENTROMIN on the formulation of a Stage I expansion program consisting of six projects designed to improve the Company's operating performance through replacement of obsolete facili- ties, to expand production and the degree of processing, and to reduce envi- ronmental pollution. The six projects include the expansion of the Cobriza and Casapalca mines, the modernizatiDn and expansion of the copper smelter/ refinery, the zinc refinery and the lead sinter plant at La Oroya, and the replacement of a copper cementation plant with a solvent extraction and electro-winning plant at Cerro de Pasco. The following two components of the Stage I expansion program comprise the proposed project and have been selected for Bank financing because of their high priority to the country, their advanced state of preparation, and their self-contained nature: (a) The Cobrlza Mine Expansion - This project would expand under- ground mine production from 0.7 million STPY of ore grading 2.2% copper to 3.5 million STPY grading 1.8% copper. This ore will be treated in a new concentrator, increasing concen- trate output from 50,000 STPY to 223,000 STPY containing 25% copper and 5.5 oz of silver/ton. Related adminstrative, in- dustrial, and social infrastructure are also included in the project. Project cost is estimated at US$134.1 million. (b) The Cerro de Pasco Mine Water Treatment Plant - This project would improve the economics of copper recovery by replacing an existing cementation plant with a more efficient solvent extraction and electro-winning plant producing refined copper In place of cement copper, and eliminating the existing plant's polluticn of the San Juan and Mantaro rivers. Project cost Is estimated at US$12.4 million. B. Costs and Financing 29. The total cost of the two projects (excluding interest during con- struction) is estimated at US$146.5 million equivalent with an estimated foreign exchange component of US$76.3. The estimated direct foreign exchange costs of the project (US$61.3 million), consisting of equipment, supplies, erection, englneering, project management and technical assitance services would be financed by the IBRD and the IDB on the 55:45 basis. The IBRD/IDB loans would also finance interest during the construction perlod. Total financing requirements are estimated to be US$176.2 million equivalent, of which the Bank would provide US$40 million and the IDB US$33.4 million. The IDB Loan has been negotiated and is expected to be submitted to the IDB Executive Directors during the month of June.  - 10 - 30. The remainder of the financing (US$102.8 million) would be covered almost entirely by US$99.8 million in loans from COFIDE having a term of about 10 years, including four years of grace and an interest rate of 8% per annum. The IBRD loan would have a term of 15 years, including 4-1/2 years of grace, at the prevailing interest rate of 8-1/2% per annum, in addition to which the Company would pay the Government a guarantee fee of 1-1/2% per year. The IDB loan would have to same term with an interest rate of 8% per annum. 31. The plan for virtually 100% debt financing of the two projects should cause no problems since at the present time the Company is in a sound financial position and has very little debt. Even after borrowing for these two projects CENTROMIN will have a low debt/equity ratio and thus should be able to borrow additional funds without impairing its financial position. Projected financing of the Company's other requirements during the execution of the Stage I Program is outlined in paragraphs 41-48. C. Market and Production Aspects 32. The value of the concentrate produced at Cobriza would increase from US$10 million in 1975 to about US$63 million in 1981 in constant 1975 dollars. About 62% of the concentrate produced at full production of the expanded plant would be smelted and refined at La Oroya, and that balance exported in concentrate form. Operating costs per tone of concentrate pro- duced would be reduced by about 40% in real terms as a result of the larger and more efficient plant. The value of the copper produced by the mine water treatment plant is expected to be about US$8.5 million in constant 1975 dollars by 1979 when full production is achieved. The annual copper output of the plant is expected to decline slowly from the 7,000 ST level projected for 1979, due mainly to the depletion of copper values in the mine dumps. The two projects would increase Peru's annual mineral exports by more than US$50 million, about 9% over the 1975 leve!l. 33. CENTROMIN markets all of its products through MINPECO, the autono- mous government-owned minerals marketing agency which handles all the overseas marketing of Peru's mineral output. On completion of CENTROMIN's Stage I program in 1981, some 35% of the Company's sales will be copper. Given the high quality, low impurity grade of the copper products, the additional out- put should be readily marketable. 34. No major problems are foreseen in obtaining the inputs needed for the planned expansion. Ore reserves in the Coris area which are presently being mined total about 50 million tons, sufficient for 14 years at the pro- posed rate of mining. In addition, CENTROMIN has investigated an extension of the deposit in the adjacent Pumagayac ridge. Additional reserves are indicated to be of the order of 60 million tons of comparable grade. There- fore, at least 20 years operations are reasonably assured. The mining method will be cut and fill, the method presently utilized. The concentrator flow- sheet is conventional, involving crushing, grinding and flotation. No  - 11 - technical difficulties are foreseen. Existing infrastructure is sufficient for the current operations of CENTROMIN and adequate plans to meet the in- creased needs resulting from Stage I expansion program have been made. The main infrastructure need for the two projects to be financed by the Bank is the construction of a power transmission line to the Cobriza mine. In addi- tion, capacity to transport concentrates will have to be expanded. Assur- ances regarding the timely availability of both items are included in the loan documents in Section 4.02 (c) of the draft Loan Agreement and Section 3.03 (i) and (iii) of the draft Guarantee Agreement. D. Implementation 35. CENTROMIN's organizational structure is sound and its operations are well-managed. There is a lack of experience in project and financial planning, however, because these activities had been done abroad by the former parent company and very little planning and investment activity has been done during the last 10 years. These shortcomings are recognized by the Company's present senior managers and various steps are being taken to overcome them, including the appoincment of engineering firms as project engineers and managers. CENTROMIN has already appointed a foreign engineer- ing firm for the Cerro de Pasco project and is presently selecting a firm for the Cobriza project to take responsibility for detailed engineering, procurement services, and overall project management until start-up of the plants. 36. In view of the heavy management load resulting from the simultaneous execution of six remote and widely separated Stage I projects, CENTROMIN is also planning to retain on a contract basis a number of senior staff experienced in the execution of mining projects. With government approval, salary levels will be sufficient to attract qualified staff from overseas. The additional senior staff will assist in project management and train company staff on the job in the techniques needed for project execution. The costs of this techni- cal assistance will be financed by the IBRD/IDB loans. Assurances have been obtained that the Company will fill key positions in the expansion management structure by July 31, 1976, before a substantial amount of expansion activity is under way, (Section 3.02 of the draft Loan Agreement). The Company will also give increased emphasis to training of Peruvian staff, including arrang- ing for them to gain additional experience abroad. E. Procurement and Disbursement 37. It is expected that the Company will start placing orders for internationally-bid equipment by the fourth quarter of 1976. All foreign equipment and supplies (US$51 million) will be procured under international competitive bidding guidelines of the IBRD and IDB. Equipment which is manufactured locally must be procured in Peru under the Peruvian law and would not be financed from the IBRD/IDB loans. This will apply to only a few minor items amounting to less than US$5 million. Disbursements will made on the following basis: a) 55% of the CIF cost of imported equipment and  - 12 - materials; and of the expenditures made in foreign exchange for consultant services; and b) 100% of interest and other charges on the loan due on or before April 30, 1980. Some retroactive financing for engineering services will be required, but will not exceed US$700,000 equivalent. F. Financial Analysis 1. Current Financial Position of CENTROMIN 38. Production and sales volumes have been fairly static over the 1970- 75 period but, with the exception of strike-caused drops in 1971 and 1975, generally improving metal prices resulted in steady growth in sales revenue and profits through 1974. Metal prices were particularly high in 1973 and 1974 and more than compensated for steady increases in operating costs. In contrast to the fluctuations in metal prices, labor and other costs have risen steadily in the past few years such that, given the recent depressed state of most metal prices, 1975 profits were dramatically lower than those of 1974. These cost increases reflect the recent rapid inflation in Peru. As mentioned previously, government policies have allowed substantial increases in workers' wages which, together with energy and other cost increases, have greatly in- creased CENTROMIN's operating costs. The devaluation of the Sol by 14% against the US dollar in September, 1975 helped to restore the deteriorating relationship between Company revenues and operating costs. 39. The Company's financial structure has remained sound, despite recent low metal prices, local inflation and the significant drain on CENTROMIN's resources resulting from the financing of its acquisition from the Cerro Cor- poration, for which payments of US$76 million were made in 1974. One of the Company's strengths is its wide range of mineral products; the recent deterio- ration in CENTROMIN's earnings power would have been much worse, but for the firmer silver, gold and zinc prices partially offsetting the low copper and lead prices. As mentioned previously, the Company's borrowing capacity is largely unused. 2. Financial Projections 40. Company financing during the execution of Stage I (1976-81) is projected to be as follows:  13 - (In US$ Million) Sources Applications Cash Generation 354.2 Cobriza 148.7 Long-Term Debt Cerro de Pasco 15.0 Foreign Loans Other Stage I Projects 233.4 IBRD 40.0 Subtotal Stage I (fixed IDB 33.4 assets including interest Other 132.3 during construction) 397.2 Other Replacements/ Local Loans Improvements 99.9 Housing and Related Infrastructure 164.9 Mining Community 20.2 Subtotal, Fixed Assets 662.0 Other (including COFIDE) 193.9 Amortization of Long-Term Subtotal 419.8 Debt 52.8 Increase in Other Assets 1.2 Share Capital 164.9 Increase in Working Capital 57.8 TOTAL 938.9 773.8 Cash Surplus 165.1 41. This projection of CENTROMIN's future financial performance, as well as other projections summarized below, assumes that metal prices in real terms will recover in the next few years from their recent depressed levels with economic recovery in major metal consuming countries and that prices will also reflect the effect of world inflation assumed at 7,-8% per annum to 1980 and 7% per annum thereafter. The financial projections also incorporate the forecast impact of all six projects which comprise CENTROMIN's Stage I Program. 42. The projected US$165 million cash surplus over the 1976-81 period provides some cushion in the event of depressed metal prices or overruns in the Stage I Program, as well as a basis for initiating a Stage II Program. Most of this surplus would occur during 1980 and 1981, when some of the Stage I facilities are scheduled to be on stream, and by which time invest- ment in Stage II should have commenced. 43. Assuming that execution of all Stage I projects is under way be- fore the end of 1976, their full operation is expected to be achieved by 1982, by which time net sales are projected to more than double from the 1974 level to US$707 million in current terms. Of the US$389 million  - 14 - increase, approximately US$81 million, or 21% is due to the two Bank-financed projects. While the Company's profitability is projected to improve from the 1975 level of 4.5% to 7.2% of sales, reflecting improvements in operating efficiency and metal prices, it would still fall short of the all-time peak in 1974, when metal prices hit unprecedented heights and depreciation and interest were relatively minor expense items. After completion of Stage I, the profit break-even point for the Company is projected to be about 79% of production capacity and for the expanded Cobriza and the Cerro de Pasco plants 69% and 43%, respectively. 44. The Cobriza and the Cerro de Pasco projects have incremental finan- cial rates of return in real terms of about 15% and 18%, respectively, and the incremental financial return of the full State I Program -- though less firmly based than that of the two Bank-assisted projects -- is expected to be at least 20%. Sensitivity analyses for the main parameters affecting the financial rate of return i.e., variations of 10% in capital and operating costs and revenues, indicate that even under adverse circumstances the Cerro de Pasco project shows good rates of return while those of the Cobriza project become somewhat marginal if copper prices over the life of the project were to be significantly lower than projected. However, such a situation is unlikely to arise and the project risk in this respect is acceptable. The Cerro de Pasco project is sensitive mainly to the operating cost savings that it will bring about as compared to similar cost increasing factors acting on Cerro de Pasco without the Project. 45. Projected sources and application of funds for 1976-84 indicate that CENTROMIN should have little difficulty servicing its debt. Sensitivity analysis shows that average long-term metal prices (1980-84) could drop by 25% below the base case projections before long-term debt service coverage would drop to 1.0. 3. Financial Covenants 46. While the metal price trends used in the projections are considered to be realistic, CENTROMIN's financial planning must allow for the possibility of revenue, cash flow and profit levels being below those projected during periods of depressed metal prices as has been the case since mid-1974. To safeguard CENTROMIN's financial soundness the agreed covenants would (a) limit the increase of additional debt in terms of long-term debt/equity ratio (maxi- mum 50:50) and projected debt service coverage (at least twice covered on the basis of projections satisfactory to the Bank) (Loan Agreement Section 5.04 (a) and (b)); (b) limit annual investment additional to the Stage I expansion program and the housing program to US$30 million (Loan Agreement, Section 5.06); and (c) require maintenance of a ratio of current assets to current liabilities of no less than 1.5 to 1 (Loan Agreement, Section 5.05). During negotiations assurances were obtained from the Government that it would make contributions to CENTROMIN's equity in amounts equivalent to CENTROMIN's investment in the housing program and its payment of dividends to the Govern- ment -- CENTROMIN is required by law to pay 50% of its net profits to the Treasury, and to commit share capital increases, if and as necessary, to maintain the long-term debt/equity 50:50 ratio-  - 15 - 47. Execution of all the projects in CENTROMIN's Stage I Program is important for the future financial soundness of the Company, even though the two Bank projects are technically and financially viable without the other four Stage I projects, which involve mainly modernization and expansion of the La Oroya smelting and refining facilities, most of which are old and require extensive maintenance. If major modernization of the facilities, especially the copper smelter, were not undertaken within the next five years, the Company would be faced with continuing increases in maintenance costs, the increasing risk of production losses through down-time, and the need for substantial investment just to maintain present production levels. It is difficult to quantify the likely effects of such a situation precisely, but it is quite probable that the Company could be placed in increasingly serious financial difficulties. To avoid the risk of such a possibility, the Company and the Government have agreed that the Stage I Expansion Program will be carried out in accordance with a time schedule satisfactory to the Bank (Loan Agreement, Section 4.03 and Guarantee Agreement, Section 3.03 (ii)). Financing offers have been received by the Company from the Export Development Corporation (EDC) of Canada and Canadian commercial banks for the zinc refinery and the copper smelter/refinery, and from the U.S. Export- Import Bank and a U.S. commercial bank for the lead sinter plant. These offers are sufficient to cover most of the foreign exchange costs of these projects. The Company plans to finance the Casapalca mine expansion from its own funds. G. Economic Analysis 48. The estimated economic rate of return for the Cobriza project, which represents about 91.5% of total project cost, is about 16% and for the Cerro de Pasco project is about 20%. The weighted average rate of return is estimate( at 16.3%. The economic importance of the projects somewhat exceeds their direct financial benefits to CENTROMIN due to the import duties and other taxes paid to the Government. CENTROMIN plays a major role in the Peruvian economy by accounting for about 5% of the Government's income tax revenues and about 20% of its foreign exchange receipts. The proposed projects and the Stage I Program will help accelerate the country's economic growth and maintain Peru's market position in a number of key minerals. 49. The net annual foreign exchange benefits generated by the Stage I Program are projected to reach about US$59 million equivalent in 1975 dollars by 1982 of which the two projects to be financed by the IBRD and IDB represent US$30 million. The Government will benefit greatly through the increased fiscal and profit sharing revenues, and the foreign exchange earned by the projects. 50. The workers too, will benefit, with expanded incomes under the existing profit sharing arrangements. An additional 700 jobs will also be created by the Stage I expansion. Furthermore, if the Company did not undertake this program of modernization and expansion, jobs would be jeo- pardized by the deteriorating production situation resulting from outdated facilities.  - 16 - H. Conclusions, Recommendations and Major Loan Conditions 51. Although the Peruvian mining sector has been going through a difficult period of change and uncertainty and suffers from a lack of investment and certain institutional deficiencies, it is vital to economic growth in Peru. 52. The most suitable vehicle for the Bank's involvement in the sector is CENTROMIN, which despite its increasing costs and old and obsolete plant, has considerable mining experience, basically sound technical and operating capabilities, a diverse range of products, and is in a good financial posi- tion. Furthermore, the Company has now put together a well conceived program of modernization and expansion, and the Bank's most effective role in the sector at this time would be to assist in financing the most advanced projects in this program, and to aid indirectly in attracting funds from other insti- tutions for the other projects. A positive contribution could thus be made through helping to move sectoral development from the planning to the execu- tion stage. Subsequent Bank involvement could then, on the basis of some successful demonstration of its participation, address itself more directly to some of the institutional deficiencies elsewhere in the sector. 53. The major risks inherent in the two projects proposed for Bank financing and for CENTROMIN's Stage I Program overall are: (a) a protracted period of low metal prices; (b) the problems of simultaneously managing a number of remote and widely separated projects given the limited experience of the Company's management in this regard; (c) the limited experience of the Company's management in overall corporate and financial planning; (d) the possibility of significant production losses due to protracted strike action; and (e) a continuing high rate of inflation in Peru, especially rela- tive to metal prices. However, to the extent that these risks can adequately be foreseen and are controllable by the Company and/or the Government, they have been taken into account in the actions taken or planned by the Company and Government, e.g. in strengthening project implementation management and improving workers' benefits, and in the covenants which have been agreed upon. In addition, realistic assumptions have been used for metal price trends and domestic inflation rates in the financial projections. 54. The most important of the agreed covenants, which have been summarized above, are concerned with (a) strengthening of the Company's financial and project management capabilities through the recruitment and appointment of suitably qualified staff; (b) ensuring Government and Company commitment to the completion of the full Stage I Program; (c) ensuring pro- vision of funds by Government, if needed, to carry out the project and the Stage I Program; (d) restricting the Company's borrowing so as to provide protection against swings in metal prices; and (e) restricting the Company's investments in addition to the Stage I Program so as not to overtax its management capabilities or overstrain its financial position.  - 17 - PART V - LEGAL INSTRUMENTS AND AUTHORITY 55. The draft Loan Agreement between the Bank and CENTROMIN, the draft Guarantee Agreement between the Republic of Peru and the Bank, the Report of the Committee provided for in Article III, Section 4 (iii) of the Articles of Agreement and the text of the draft resolution approving the proposed loan are being distributed to the Executive Directors separately. 56. Special conditions of the loan are listed in Section III of Annex IV. A special condition of effectiveness of the loan is that all conditions precedent to the initial disbursement under the IDB Loan Agreement with CENTROMIN have been fulfilled (Section 7.01 of the draft Loan Agreement). 57. I am satisfied that the proposed loan would comply with the Articles of Agreement of the Bank. PART VI - RECOMMENDATION 58. I recommend that the Executive Directors approve the proposed loan. Robert S. McNamara President Attachments Washington, D.C. May 17, 1976   ANNEX I fpeg 1 of 3 pmess 00U1T