Mexico - Small- and Medium-scale Mining Development Project

Document of FILE COPY The World Bank FOR OFFICIAL USE ONLY Report No. 276Ub-ME STAFF APPRAISAL REPORT MEXICO SMALL AND MEDIUM SCALE MINING DEVELOPMENT PRO; February 25, 1980 Projects Department Latin America and the Caribbean Regional Office This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS Currency Unit = Peso (Mex$) US$1 = Mex$22.6 1/ Mex$1 = US$0.44 GLOSSARY OF ABBREVIATIONS ACF - Index of Average Cost of Funds to Financieras CFM - Comision de Fomento Minero CRM - Consejo de Recursos Minerales EDI - Economic Development Institute ERR - Economic Rate of Return FIRA - Fondo Instituido en Relacion con la Agricultura FMNM - Fideicomiso Minerales no Metalicos Mexicanos FOGAIN - Fondo de Garantia y Fomento a la Industria Mediana y Pequena IDD - Index of Dollar Deposit Interest Rates IFC - International Finance Corporation IFRR - Internal Financial Rate of Return NAFINSA - Nacional Financiera, S.A. PECAM - Programa Especial Complementario de Apoyo a la Pequena y Mediana Mineria (Special Complementary Program for Small and Medium-Scale Mining) PEMEX - Petroleos Mexicanos, S.A. PIDER - Programa de Inversiones Publicas para el Desarrollo Rural SEPAFIN - Secretaria de Patrimonio Nacional y Fomento Industrial SMM - Small and Medium Scale Mining SPP - Secretaria de Programacion y Presupuesto 'Program' or 'Special Program' refers to the Special Complementary Program for Small and Medium Scale Mining Development (PECAM) FISCAL YEAR January 1 - December 31 1/ The Mexican peso has been floating since September 1, 1976. The exchange rate for US$1 over the past two years has been fluctuating between Mex$22.50 and Mex$22.80. The peso was traded at about Mex$22.60 to US$1 in February 1980.  FOR OFFICIAL USE ONLY MEXICO SMALL AND MEDIUM SCALE MINING DEVELOPMENT PROJECT STAFF APPRAISAL REPORT TABLE OF CONTENTS Page No. I. THE MINING SECTOR AND SMALL AND MEDIUM SCALE MINING .... ..... 1 Sectoral Setting ............................................ 1 Sectoral Structure and the Special Mining Census .... ........ 2 Small and Medium Size Mining ................................ 3 Mining Sector Policies and Legislation ...................... 4 Mining Concessions .......................................... 5 Overall Potential and Development Constraints .... ........... 6 Environmental Considerations ................................ 7 Mine Safety and Labor Legislation ........................... 8 Financial and Technical Assistance for SMM .... .............. 8 Interest Rate Systems ....................................... 9 tl. INSTITUTIONS SUPPORTING THE SMALL AND MEDIUM SCALE MINING SECTOR .... 10 A. Comision de Fomento Minero (CFM) . .10 Background and Objectives . .10 Organization, Management and Staffing . .11 Operations ..12 Project Evaluation, Approval and Supervision . .18 Credit and Promotion Policies and Strategy . .19 Portfolio Quality ..20 Statement of Operating Policies and Strategy . .21 Accounting, Control and Auditing . .21 Financial Position, Resources and Projections . .21 Procurement and Disbursement . .22 B. Fideicomiso Minerales No Metalicos Mexicanos (FMNM) 22 Background and Objectives . .22 Organization, Management and Staffing . .23 Operations ..24 Overall Portfolio Quality . .26 Project Evaluation, Approval and Supervision . .27 Financial Position and Resources . .27 Accounting and. Auditing ..28 Procurement and Disbursement . .28 Operating Policies and Strategy . .28 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  - ii - TABLE OF CONTENTS (Continued) Page No. C. Consejo de Recursos Minerals (CRM) .... ............... 29 Background and Objectives ............................ 29 Organization and Staffing ............................ 30 Operations .......... ................................. 30 Project Evaluation ................................... 32 Future Operating Strategy ............................ 32 Financial Position and Resources ..... ................ 33 Procurement and Auditing ............................. 33 III. THE PROJECT AND THE PROPOSED BANK LOAN .33 Background and Objectives of the Project .33 Project Description .34 Eligible Enterprises .35 Maximum Size and Terms of Financing .36 Onlending Interest Rates and Leasing Terms .37 Institutional Arrangements and Program Coordination .37 Projected Overall Needs and Financing .38 The Proposed Bank Loan .38 Disbursement .39 Retroactive Financing .40 Channeling of the Resource, and Repayment and Capitalization Arrangements .40 Procurement and Auditing .40 Approval Limits .41 Project Benefits and Risks .42 IV. RECOMMENDATIONS .43 This report is based on the findings of an appraisal mission which visited Mexico in September 1979. The mission comprised Messrs. K. Challa, C. Joseph, N. Santiago, (LCPI2); W. Hill and B. Zinman (Consultants).  - iii - TABLE OF CONTENTS (Continued) ANNEXES Annex 1 Estimated Quarterly Schedule of Bank Loan Disbursements Annex 2 Chronology of Mexican Mining History Annex 3 Operating Guidelines of the Comision de Fomento Minero in Relation to the Special Program (Draft) Annex 4 Operating Guidelines of the Fideicomiso Minerales No Metalicos Mexicanos in Relation to the Special Program (Draft) Annex 5 Operating Regulations of the Coordinating Committee of the Special Program Annex 6 Variable Interest Rates and the ACF Index Annex 7 Index of Dollar Deposit Interest Rates Annex 8 System for Periodic Adjustment of Maximum Size Limit for Eligible SMM Enterprises Annex 9 International reference prices for Mexico's main minerals Annex 10 Organization Chart of the Comision de Fomento Minero Annex 11 Organization Chart of the Fideicomiso Minerales No Metalicos Mexicanos Annex 12 Organization Chart of the Consejo de Recursos Minerales Annex 13 Organization Chart of the Subsecretariat of Mines and Energy Annex 14 Supplementary Tables and Charts T-1: Evolution of Production from the Mining Sector, 1965-78 T-2: Production, Exports and Imports of Metallic Minerals (1978) T-3: Production, Exports and Imports of Non-Metallic Minerals (1978) T-4: Distribution of Mining Production by Enterprise Size (1978) T-5: Share of Small and Medium Scale Mining (SMM) in the Production of Various Minerals (1978) T-6: CFM - Summary of Past and Projected Approvals of Financing to Small and Medium Scale Mining, 1975-82 T-7: CFM - Summary of Existing and Projected Regional Beneficiation Plants T-8: CFM - Equity Participation in Subsidiaries and Affiliates (1978-79) T-9: CFM - Technical Assistance Provided to Mines and Concentration Plants, 1977-79 T-10: CFM - Analysis of Financial Assistance Operations Outstanding for Small and Medium Scale Mining Enterprises T-ll: CFM - Size Structure of Fixed Asset Credits and Long-term Equipment Leasing Operations (as of December 31, 1978) T-12: CFM - Analysis of Arrears and Reschedulings in Loan Portfolio as of June 30, 1979 T-13: CFM - Past and Projected Balance Sheets, 1978-82 T-14: CFM - Audited Income Statements, 1977-78 T-15: FMNM - Summary of Past and Project Financing to SMM, 1976-82 T-16: FMNM - Summary of Existing and Projected Regional Beneficiation Plants  - iv - TABLE OF CONTENTS (Continued) ANNEXES T-17: FMNM - Equity Participation in Subsidiaries (as of June 30, 1979) T-18: FMNM - Analysis of Approvals of Fixed Assets and Working Capital Credit, 1976-79 T-19: FMNM - Analysis of Arrears and Reschedulings in Credit Portfolio as of June 30, 1979 T-20: FMNM - Analysis of Arrears and Reschedulings in Consolidated Credit Portfolio as of June 30, 1979 T-21: FMNM - Audited and Projected Balance Sheets, 1977-82 T-22: FMNM - Audited and Projected Income Statements, 1977-82 T-23: Estimated Distribution of Commitments of Resources by Program Component and by Year C-1: Map of Mexico showing Existing and Proposed Locations of CFM's and FNNI's Regional Beneficiation Plants and Offices Annex 15 Selected Documents and Data Available in the Project File  I. THE MINING SECTOR AND SMALL AND MEDIUM SCALE MINING Sectoral Setting 1.01 Mining has traditionally exerted a dominant influence on the Mexican economy. Until the late 1920s, Mexico's mining sector had been one of the more dynamic sectors of the economy and a major contributor to the country's exports. Since then, the sector has gradually lost its dynamism, mainly because of the widely fluctuating international prices of minerals and inadequate domestic policies to spur sector development in general and Mexican participation in particular. This scenario was reflected in a slow growth of the mining output, causing the share of mining in total GDP to decrease from about 4% in the 1930s to only 1.4% in the 1970s (Annex 14, T-1). 1/ 1.02 Mexico's liberal policies prior to the 1960's permitted foreign corporations to participate actively in the mining sector, where they assumed a leading role. Starting in 1961 the government embarked on a program of "Mexicanization" of mines, which created an uncertain climate in the mining sector and led to the withdrawal of a substantial number of foreign mining interests. On the other hand, the positive effects of Mexicanization antici- pated by the government in mining exploration and investment were very slow to develop because the new owners had only limited experience in managing the mines and because of inadequate domestic policies and incentives. Moreover, past mining legislation and incentives, which were designed at a time of majority foreign ownership, were also inadequate to stimulate investments and it was not until 1975, through a new mining law, that the stage was set for a healthy growth in the mining sector. 2/ 1.03 At present, there are about 15,000 mining operations in Mexico, distributed widely among nearly all of Mexico's 32 states and providing direct employment for about 150,000 people. The total value of Mexico's mineral production was about Mex$24,200 million (about US$1.1 billion equivalent) in 1978, distributed among nearly 50 minerals. In recent years, metallic minerals accounted for about 77% of the total production of the mining sector. Mexico currently occupies the first position in world production for silver, fluorspar (fluorite) and graphite; it is among the world's top five producers of lead, zinc, mercury, sulfur, barite, bismuth, arsenic and antimony. The equivalent of 48% of Mexico's mineral production in 1978 was exported, accounting for a net positive impact of about US$510 milllion in the balance of payments. 3/ Exports in order of importance were: silver, zinc, sulfur, lead, fluorspar, salt, manganese, iron, chalk, copper and cobalt, which together accounted for more than 95% of total mineral exports. Annex 14, T-2 and T-3 present a more detailed view of Mexico's production, imports and exports of metallic and non-metallic minerals. 1/ All statistics and analyses of the mining sector presented in the report exclude figures for petroleum and related hydrocarbons. 2/ Annex 2 includes a brief chronology of Mexican mining history. 3/ The export figures should be viewed only as indicative because the export and import statistics of minerals also record processed minerals, which may be imported in one form and exported in another.  - 2 - 1.04 The long period of foreign predominance in the mining sector and the subsequent "Mexicanization" program left Mexico with only limited engineering and scientific capabilities in the sector. In particular, as a result of the rapid and substantial outflow of expatriate mining personnel, Mexico fell acutely short of qualified personnel experienced in exploration, operation and management of mines. In recent years, the number of universities offering courses in mining and geology has increased significantly and the requirements for younger technical personnel can be expected to be filled satisfactorily in the near future. However, sufficient numbers of experienced upper and middle level staff would be needed to provide the required guidance to the younger personnel; these requirements would have to be partially met, in the short term, from external sources. Sectoral Structure and the Special Mining Census 1.05 Only limited information is available on the total number and size distribution of operating mines for each mineral, and their operating and economic characteristics for different size categories. Reliable data is especially scarce on the small and medium size enterprises. Based on the 1975 industrial census and the operating statistics of the larger individual mining enterprises, the following important conclusions can be drawn. 1.06 Except for two large copper mines and mining for coal and iron ore, Mexico is essentially a country of small and medium-sized mines. In this connection the distinction between the size of the mining company and of the operating unit is important. Thus, while there are 15 "large" companies in Mexico (Annex 14, T-4), there are few large mines. Much of the output of even the large mining companies comes from a number of medium- and small-sized mines, and almost all the large companies started as small mining operations. This situation appears to reflect particular geological as well as economic factors, since the relative abundance of low cost labor and the high grades of ores enables smaller mines to compete effectively with the more capital-inten- sive larger mining operations. This is illustrated by the production figures of individual "large" and medium-size mining enterprises presented in Annex 14, T-4. 1.07 The larger mining enterprises or groups generally operate a group of individual mines to feed their concentrators, which can thus be operated economically. Partly reflecting the impact of the above, ownership of produc- tive mines is highly concentrated in Mexico. In the case of most minerals, the five companies producing the largest quantities of the specific minerals account for more than 50% of total production of those minerals. 1/ 1.08 In order to correct the existing dearth of adequate information on the physical, economic and other characteristics of Mexican mines and related enterprises, the Subsecretariat of Mines and Energy of the Ministry of National Patrimony and Industrial Development (SEPAFIN), 2/ in collaboration 1/ There are at present 30-40 mining companies which are fully or partly state owned, mostly through Comision de Fomento Minero, which acts as the state holding company (para. 2.07). These companies together account for about 35% of the total mineral production, and mostly include large- or medium-size enterprises. 2/ An indicative organization chart of the Subsecretariat of Mines and Energy is included in Annex 13.  with the Ministry of Programming and Budgeting (SPP), is carrying out a spe- cial mining census of all operating mines, beneficiation plants and smelters/ refineries in Mexico. The census, entitled "Censo Extraordinario de Mineria - 1979," was started in late September 1979. It is being carried out through the 31 regional offices of the Directorate of Mines of SEPAFIN, and should provide useful data on the economic and operating characteristics of the mining operations. Some preliminary results are expected by early 1980 and the full census and its analysis by mid-1980. Small and Medium Size Mining 1.09 There is no single definition for "small" or "medium" scale mining enterprises that is uniformly used in Mexico. Considering the natural divisions apparent in the size structure of the Mexican mining sector and the relevance of physical as well as the financial characteristics of mining enterprises in determining the target group of enterprises and the nature of assistance needed by them, the following definition based on the annual value and physical capacity of the production is proposed for operational and monitoring purposes: - Small mining enterprises would be those whose annual production value does not exceed Mex$20 million, 1/ provided that the physical capacity of their beneficiation facilities does not exceed 100 tons of crude mineral per day in the case of metallic minerals and 150 tons per day in the case of non-metallic minerals. 2/ - Medium scale mining enterprises would be those whose annual production value does not exceed Mex$150 million, provided that the physical capacity of the beneficiation plants does not exceed 500 tons per day of crude mineral in the case of metallic minerals and 800 tons per day in the case of non-metallic minerals. 3/ The above annual values of production use 1979 mineral prices as a basis, and would be adjusted periodically to take account of variations in the international price of a selected basket of minerals (para. 3.06 and Annex 8 contain details of the adjustment scheme). 1.10 Based on information available on the structure of the mining sector in Mexico and a mission survey of a representative sample of mining enterprises in Mexico, small- and medium-sized mining enterprises defined as above account for nearly one quarter of the value of Mexico's total mining 1/ This is also the limit prescribed on the value of annual production for defining small mining enterprises under the Mexican mining tax law. 2/ A higher limit on the physical capacity is used for non-metallic minerals as they generally tend to be high volume, low value minerals. 3/ For the purpose of the proposed Bank project these definitions would be employed for individual enterprises as well as for groups of related enterprises (para. 3.07).  -4- production and more than 95% of the total number of operating mines. SMM enterprises are also relatively labor intensive; average capital investment cost of most small mining enterprises under the proposed definition is likely to be in the range US$2,000-8,000 equivalent (in 1979 US dollars) per full- time job, and that for medium mining enterprises in the range of $8,000-20,000 equivalent. 1/ Mining Sector Policies and Legislation 1.11 Under previous mining legislation, which created uncertainties about the duration of concessions and provided inadequate incentives, mining exploration and investment lagged. Moreover, as a result of the uncertainties, and the prospect of increasing public sector participation, mineral deposits found by the larger private operators were often not fully disclosed. The vast number of small mine operators had neither the means nor the know-how to establish systematically the proven reserves of the deposits they exploit. In recognition of these shortcomings, a new Mining Law was enacted in 1975 and the tax policies for the mining sector were reformed subsequently. 1.12 The Mining Law of 1975 and the corresponding implementing regu- lations 2/ created a new legal framework and provided for important reforms of the mining sector. This law clearly defines the responsibilities of the various agencies involved in the mining sector. It also specifies regula- tions governing exploration, processing and trading in all solid minerals of commercial value or application, except salt and surface minerals such as sand- stone and gravel obtained by quarrying operations (and used in the constructing industry), which under the Law are not considered mines. It entrusts the application of the Law and supervision of compliance to the Directorate General of Mining in SEPAFIN which, through its branches, maintains the Public Mining Registry, 2/ grants and withdraws concessions and inspects mines and processing plants. 1.13 The Law establishes Mexican majority ownership of all mining, mineral processing and trading, and provides for close monitoring of explora- tion and investment programs submitted as a basis for granting concessions. The latter provision is intended as a safeguard against past undesirable experience, by which small concession holders could block the consolidation of mining in a continuous formation and where speculators could obtain con- cessions and hold them without any investment for future sale. In addition, there are discretionary powers for the government, such as declaring certain 1/ In comparison, the median investment cost per job of large-scale mining operation is of the order of US$100,000 equivalent per job. 2/ The Registry records mining and processing concessions, assignments, national and industrial mining reserves, expropriations, temporary occupations and easements applicable to Mexican firms and individuals.  -5- zones to be state mining reserves, 1/ as well as applying and interpreting provisions for the granting and revocation of concessions. 1.14 A new mining tax law was promulgated in late 1977. It simplifies and streamlines the tax structure, which had been unduly complex, consisting of up to five different types of taxes. Under the new law, the production tax is specified to be a flat rate, based on ex-smelter market value, of 9% for gold, silver and sulphur, 4% for coal, iron and manganese, and 7% for all other minerals. The law also allows enterprises with annual sales of up to Mex$20 million a reduction of 1% in their production tax rate as a special incentive for small- and medium-scale mining development. Other provisions of the tax law include an additional tax credit of up to 2% in the production tax rate based on the market value for re-investment in exploration or develop- ment, and exemptions from import taxes on equipment for mining operations. Mining enterprises are subject to the same income taxes as any other business activity. 1.15 These legislative measures represent a considerable improvement over the previous legislation, by increasing financial incentives for mineral exploration and exploitation, and reducing significantly the cumbersome bureau- cratic procedures and uncertainties which were associated with the 1961 Mexicanization Law. Most mining sector representatives believe that these measures are likely to have a significant positive effect on the sector's growth over the next several years. Mining Concessions 1.16 Concessions for underground deposits can be claimed anywhere in Mexico but require the specific authorization of SEPAFIN, whereas surface deposits (most of which are non-metallic) belong to the owner of the land. Although minerals in the ground belong to the state, the concession rights are transferable either by sale or by royalty of 2-1/2 to 3% on the production value for between 5 and 10 years. In the case of ejidos, ownership of the mining concession is not transferable and the rights can be transferred only through royalty payments. In addition, ejidos are to be paid fees equivalent to 10% of the production tax in exchange for the rights to use surface land in the case of open pit operations. The concessions are of two types: for exploration or for exploitation. Exploration concessions are granted for six months at a time but are renewable, up to a total of 3 years. 2/ In order to obtain a concession for exploitation, the miner must have formerly held an exploration concession. If the exploration work program, which must have the prior authorization of (and is monitored by) SEPAFIN, yields 1/ Large deposits of iron ore, coal, sulphur, phosphate, flourspar and potash are automatically classified as National Mining Reserves. Iron ore and coal are to be exploited only by the state or at least with state participa- tion. Exploration and exploitation of radioactive substances are governed by the Organic Law of the National Institute of Nuclear Energy. 2/ An individual exploration concession can be granted for areas of up to 50,000 ha and can cover up to eight minerals.  - 6 - favorable results within the 3-year period, the miner has the option of requesting conversion of the claim into an exploitation concession. If not, it may be reduced in size and renewed as a new exploration concession. Mining exploitation concessions are granted for a duration of 25 years (renewable for another 25) and have to follow the authorized work program. 1.17 The law makes special provision to exempt mining enterprises whose exploration concession does not exceed 20 hectares from the requirement to present an exploration work program, and to allow such enterprises to start exploiting part of their reserves as the exploration program proceeds. This is important since it allows the small mining operations to self-finance exploration work. 1.18 In the case of metallic minerals, prices are linked to the interna- tional markets. These minerals are sold in concentrated form to one of the privately or government-controlled smelters. Government policy since 1978 has been to use prices quoted in one of the world-wide metals exchanges (such as the London Metals Exchange) or a standard international source such as Metals Week, for the purpose of calculating ex-smelter prices (that is, net of smelter tolling fees) to enterprises providing the mineral concentrates. 1/ 1.19 In the case of non-metallic minerals, prices are fixed based on the regional demand-supply relationship and transportation costs. The government publishes official prices for most important non-metallic minerals (to avoid excessive price variations) that are not always directly comparable to international prices due to differences in quality and transportation costs. Wherever comparable international prices are readily available (e.g., barite and fluorspar), however, domestic prices have tended to be somewhat below international prices due to the fact that Mexico is a leading producer of these minerals. Overall Potential and Development Constraints 1.20 Mexico is endowed with substantial mineral resources; about 1.8 million sq. km., or 90% of Mexico's territory, show geological anomalies indi- cating mineral potential. On the other hand, during the entire history of mining in Mexico since pre-Columbian times, no more than 12,000 sq. km. have been used or designated as mining areas. Even if one assumes that the latter areas contain most of the easily accessible minerals, the mineral resource endowment of Mexico, particularly in its traditional metallic ores of gold, silver, lead, zinc and copper--appears to be very large. The resources are distributed among a wide range of minerals and geographical areas. Moreover, the likelihood of finding and blocking out new deposits greatly improved over the last few years as a result of legislative and tax reforms. 1.21 Mexico's long history of mining left the country with numerous old mines abandoned for a variety of reasons, including insufficiently sophis- ticated mining technology to make the best use of resources, unavailability of 1/ Annex 9 lists reference prices applicable in Mexico for the most important metals.  -7- beneficiation and concentration technology to handle poorer ores of less than adequate shipping grade, past declines in world market prices making mining unprofitable, and disruptions in the mining sector following the 1910 revolu- tion. With the recent favorable price trends for some significant minerals produced by Mexico, improvements in mining and concentration technology, reduc- tions in mining tax rates and the impetus of the government's program to support SMM development, increasing numbers of small and medium-size enterprises have re-entered the field or have taken measures to expand operations and explore for new deposits. 1.22 There is ample evidence that with the required financial and com- plementary technical support, large number of SMM enterprises would be able to operate efficiently and develop on an economically viable basis an im- portant part of Mexico's mining resources, whose exploration and development has received inadequate attention in the past. Since small and medium-sized mines are distributed over a wide geographical area, the development would also have a favorable impact on Mexico's regional development. The basic institutional structure required to develop the potential of SMM enterprises already exists in Mexico, although some strengthening of individual institu- tions is needed. Recognizing these elements, the government has placed high priority on development of the SMM sector. 1.23 The main constraints currently limiting the development of SMM enterprises are: (i) inadequate basic geological work and exploration because small mining enterprises generally have little capability to undertake system- atic exploratory activity on their own; (ii) deficiencies in technical and administrative capabilities of SMM enterprises, including inadequate experi- ence in planning mining activities, (iii) difficulties in obtaining financing because the smaller enterprises have neither a well-established credit records, adequate physical loan collateral, nor sufficient experience in presenting "bankable" projects; (iv) lack of mineral concentration facilities, requiring many small mining enterprises to transport crude minerals at substantial costs and over long distances to the plants of larger mining enterprises; and (v) limitations in the project preparation and evaluation capabilities of supporting institutions resulting from scarcity of professionals trained in promoting, preparing and evaluating bankable project proposals. Environmental Considerations 1.24 While the mining enterprises are obliged to operate subject to federal environmental standards, SMM enterprises generally have little problem in complying with the law. Chemical effluents or toxic vapors are almost non-existent in SMM operations. In processing ores, the beneficiation plants mainly use neutral materials (such as sand) with little harmful content, with the exception of sodium cyanide in gold-silver beneficiation plants. 1/ Tech- niques for containment of reject sand from beneficiation plants is well advanced in Mexico. 1/ Even this substance is rendered relatively harmless since it decomposes and oxidizes rapidly in sunlight prior to being discharged.  - 8- Miae Safety and Labor Legislation 1.25 Mine safety regulations are included in Article 89 of the Mexican Constitution and enforced by the Director General of Mines. In general, safety in the SMM enterprises which usually work narrow veins is not as dif- ficult a problem as in larger mines which have sizeable ore bodies and have problems related to explosive gases, ground support, and highly mechanized systems. Small mines, which are normally vertical in structure, are usually adequately ventilated by convection. Mine safety is also provided for in the contracts between the Syndicate of Mine Workers and incorporated mining enter- prises. A union representative, who is frequently a member of the board of companies, usually cooperates with the company to ensure careful monitoring of safety standards. Labor legislation is applicable to all industries, including mining operations. Mine owners are required to comply with inspec- tions by the Labor Department which are carried out routinely. Financial and Technical Assistance for SMM 1.26 Mexico has a well-developed banking system, comprising more than 200 public, private and mixed-ownership institutions. Most large mining enterprises in Mexico are able to cover their working capital as well as term financing needs through credits from the domestic and foreign banks and intern- ally generated funds. SMM enterprises, however, have far less access to the formal banking system, particularly for term credit. The large growth of the Mexican industrial and commercial sectors in recent years has provided the banks with substantial growth opportunities for their lending operations, without having to undertake the difficult tasks of technical assessment of ore reserves involved in lending to small mines. In cases in which sufficient mineral reserves have been proven and reasonable physical collaterals are available, some medium-sized mining enterprises have been able to obtain short- term financing for working capital needs. However, given the generally limited familiarity with the mining sector among the banks, the frequent lack of bankable physical collateral and of sophistication of small miners, banking credit to medium and particularly small mining enterprises has been extremely limited. 1.27 The lack of access of SMM enterprises to financing from the banking system is alleviated by three state-owned financing and technical assistance institutions serving the mining sector, namely, the Consejo de Recursos Minerales (CGRM), the Comision de Fomento Minero (CFM), and the Fideicomiso Minerales No Metalicos Mexicanos (FMNM). The three institutions operate with a high degree of autonomy but are formally responsible to SEPAFIN, with the heads of the three institutions reporting directly to the Subsecretary of Mines and Energy (Annex 13). CRM concentrates on carrying out and coordinating geological investigations, advising the government on policy matters concerning geology, exploration and exploitation of mineral resources, and assistihg mining enterprises in the exploration and evaluation of specific mineral prospects. For the latter purpose, CRM contributes by financing SMM enterprises or individual mine operators through a special type of financing involving risk-sharing. It also provides technical assistance and consulting serN-ices, i aueAng laborato-r-y analy-jsis to ev7aluate minerals and advice on exploration methods. CFM serves as a holding company for state participations  - 9 - in mining or mineral-related companies and as an executing agency for develop- ment of large-scale mining projects in the public sector. CFM also provides financial and technical assistance in support of exploitation of known metal deposits by SMM enterprises. It has also been operating on a "maquila" (tolling) basis, several regional beneficiation plants (plants for concentra- tion and other processing of minerals), in order to enable small mining enter- prises that cannot afford their own mineral concentration units to process and market their minerals on a financially viable basis. FMNM was established to stimulate exploration, exploitation and marketing of non-metallic minerals, in view of their distinctive characteristics compared to the metallic materials (para. 2.43). Since non-metallic minerals are often found in surface and sub-surface deposits in "ejido" land, FMNM's operations also facilitate the flow of economic benefits and generation of employment among the "ejidatarios" 1/ by opening the ejido land for exploration and exploitation of non-metallic minerals. Like CFM, FMNM provides financial and technical assistance to SMM enterprises and also holds substantial equity participation in several (cur- rently five) subsidiaries that were created at FMNM's initiative as part of its non-metallic minerals development program. 1.28 The financial assistance offered by CFM and FMNM to SMM enter- prises takes several forms, including: fixed asset loans ("refaccionarios") to finance on medium term the cost of mining equipment or mineral beneficiation facilities; short-term loans for working capital; long-term leasing, with the option for the client company to purchase mining or concentration equipment and machinery; and small amounts of other forms of short-term or risk capital financing. 1.29 While CFM, FMNM and CRM are playing a valuable role in providing assistance to a limited number of SMM enterprises, the assistance being pro- vided by these institutions to SMM has been falling considerably short of the needs, as a result of budget constraints, the lack of adequate focus towards SMM in their efforts and the limited experience of these institutions in providing an integrated support to SMM. This is particularly true in view of the substantially increased potential for the growth of economically viable SMM operations made possible, in part, by the favorable mining and fiscal legislation recently promulgated. Any effective and broad-based effort aimed at the development of SMM in Mexico would require a strengthening of the capabilities of CFM, FMNM and CRM to provide financial and technical assistance to SMM enterprises as well as additional resources. The government is under- taking such an effort thorugh the Special Program for SMM Development and has approached the Bank to help finance the project. Interest Rate Systems 1.30 Since 1974, financial institutions in Mexico have been adopting increasingly a variable interest rate system for term lending operations. The monetary authorities encouraged the development of this system in response to 1/ Ejidatarios are the members of land-owning cooperatives called "ejidos," which were created under the Mexican agrarian reform law to help the landless peasants. Each ejido owns and manages on a group basis a tract of land (which may or may not be immediately cultivable) assigned to the communi ty by the gorvernment.  - 10 - the uncertainties created by the high and fluctuating rates of inflation. By 1977, practically all term loans in Mexico (including Bank industrial credit operations through FONEI) were made at variable interest rates, using as an index the average cost of funds (ACF) to investment banking departments of intermediaries (Annex 6). 1/ The ACF is a weighted average of interest rates paid on bonds, notes and certificates of deposit and excludes checking and savings deposits. ACF was adopted readily by banks as it permits to reflect frequent changes in the cost of funds and avoids borrowers from being locked into high interest rates in nominal terms. 1.31 The ACF index increased from about 14.3% at year-end 1977 to 17.5% by the end of 1979 and about 18.4% in February 1980 in response to higher rates in world money markets and the Government's policy of allowing domestic interest rates to rise sufficiently to retain resources in the financial system. Banks are currently charging clients a spread of about two to five points over the ACF index, i.e., interest rates of about 20.0% to 23.0% at present, compared to average annual inflation rates in Mexico of about 18% over the last two years. The effective interest rates charged on loans pro- vided by CFM and FMNM have been about 17% (fixed rates) over the past year. 2/ In connection with the proposed Bank loan, CFM and FMNM, which would be the principal lending agencies under the project, would also move to a system of flexible rates based on the ACF index (para. 3.09). II. INSTITUTIONS SUPPORTING THE SMALL AND MEDIUM SCALE MINING SECTOR 2.01 As noted above, the three state-owned agencies CFM, CRM and FMNM, support SMM through various types of credits, risk capital for ore reserve development, technical assistance or a combination of these facilities. Each of these institutions has a different set of functions or cover a different set of minerals, although there is some overlap. A. COMISION DE FOMENTO MINERO Backgound and Objectives 2.02 Of the three agencies supporting SMM, CFM is the oldest and largest. It was established by the government under a law of December 31, 1938, as a decentralized public agency, to help the development and exploitation of mineral deposits throughout Mexico. Its objectives, which were redefined in the 1975 Mining law, may be grouped under four main headings: (a) serving as a holding company for state participations in mining or mineral-related companies and as an executing agency of the government for the development of large-scale mining projects in the public sector; (b) providing financial ) J SWSequentlYy subl oans mnaae by ageacies tlnat deal ith smal andl iadutm scale industry (including, mainly FOGAIN), which are participating in another Bank supported project, have also been converted to a ACF-based system. 2/ Except for the "ejido" communities, for which FMNM has been charging a concessional fixed rate of 14%.  - 11 - assistance to small and medium-sized mining companies; (c) owning and operat- ing mines and beneficiation plants; and (d) providing technical assistance to the mining enterprises, mostly of medium and small size. In addition to financial assistance through credits and equipment leasing to SMM enterprises, CFM has been assisting small mining enterprises through the operation of seven regional 'betneficiation plants' which enable small enterprises that cannot afford their own mineral concentration units to process their ore without incurring excessively high transportaion and processing costs. Acting as the government's holding company, CFM also fully or partly owns equity in 32 companies which are involved in the production of minerals or provision of services related to a variety of minerals (para. 2.07). In addition, CFM has the country's most important metallurgical laboratory serving the Mexican mining industry. Organization, Management and Staffing 2.03 CFM's overall policy-making body is its board of directors ('consejo directivo') headed by the Minister for National Patrimony and Industrial Development. The board is comprised of two other representatives from SEPAFIN, 1/ and the heads (or their representatives) of the Ministry of Finance and Public Credit, Ministry of Industry and Commerce, Nacional Financiera, S.A. (NAFINSA), CRM, Camara Minera de Mexico, 2/ Federacion Nacional de Asociaciones de Mineros Pequenos, A.C., 3/ and the National Syndicate of Mine Workers. CFM's day-to-day operations are directed by its Director General, who is assisted by a General Manager and several heads of departments/divisions responsible, respectively, for operations of affiliated companies, promotion and credit operations of affiliated companies, promotion and credit operations, technical evaluation, regional beneficiation plants, economic studies, administration, laboratory, and legal matters (see Annex 10 for Organization Chart). To help carry out its promotion and technical assistance activities throughout Mexico, CFM maintains 12 regional offices and 8 'promotion offices,' (for their locations see Annex 7 and map in Annex 14, C-1). CFM's management and professional staff is adequately qualified, dedicated and responsive to the leadership provided by the Director General. Mr. Aparicio Varela, who has been CFM's Director General for two years, is well qualified to provide the required leadership and has had valuable prior experience as the Director General of Mines in SEPAFIN and as a senior official of FIRA. 4/ 2.04 With the government's increased emphasis on SMM development, CFM has recently modified and streamlined its internal organizational structure to strengthen its capabilities to support SMM. The main changes involve the 1/ The Director General of Mines and Subsecretary for Mines and Energy. 2/ Chamber of Commerce representing medium and large sized mining enterprises. 3/ National Federation of small miners' associations. 4/ FIRA is a government trust fund which provides financing for agriculture and agroindustry and is a principal implementing agency for ongoing Bank loans to support the PIDER rural development program.  - 12 - consolidation of the promotion, regional plants, credit and laboratories departments under the newly created Technical Department, which would have the overall responsibility for all financial and technical assistance programs oriented towards SMM development, and a strengthening of the project evaluation and supervision units. Competitive salary levels in recent years enabled CFM to attract a number of experienced professionals from both the public and private sectors to fill key positions with responsibility for SMM development activities, including that of the Manager of the Technical Department. 2.05 Countrywide, CFM has a total staff of 1,432 including 234 profes- sionals. A total of 236 (including 118 professionals) are stationed at head- quarters in Mexico City, and 1,196 (including 116 professionals) at its regional and promotion offices. A large proportion (103, including 32 professionals) of the headquarters staff are attached to CFM's laboratory, which has good testing and quality control facilities and is highly regarded for its professionalism. Operations 2.06 Until recently CFM placed its operational emphasis and financial resources mainly on its equity holdings in mining and other mineral-related enterprises, and its activities as the government's executing agency in developing large scale mining projects. CFM's financial assistance to non- affiliated SMM enterprises has been small and fragmented in comparison, although its assistance to small mining enterprises through the operation of seven regional beneficiation plants and its technical assistance services for SMM has been significant. During 1975-77, for example, CFM's total annual approvals of financing (including various types of loans and leasing opera- tions) to SMM enterprises averaged only about Mex$140 million (US$6.4 million equivalent). However, reflecting the current dynamism of the SMM sector and the government's new impetus to SMM development (which falls almost entirely within the private sector), CFM's annual authorizations of financing for SMM during 1978-79 were more than twice as high and, by CFM's estimates, could increase by 30% or more annually (in nominal terms) during 1980-82 (Annex 14, T-6). The projected rapid growth appears feasible in view of the relatively low base of CFM's current SMM operations and the generally favorable climate in the sector resulting from the recent government reforms. The following is a more detailed description of CFM's activities. 2.07 Subsidiaries and affiliates. 1/ In its capacity as a holding company CFM owned outstanding shares, as of June 30, 1979, in 27 mining and mineral processing companies, and five other companies involved in transporta- tion, trading and provision of consulting services related to minerals. Total equity portfolio amounted to about US$85 million. It held virtually 100% of the shares in five companies, a majority shareholding in 9 additional companies, and a minority position in the remaining. (Annex 14, T-8 lists CFM's holdings.) Of these companies, several are involved in the mining and processing of 1/ Companies in which CFM holds a majority equity particpation are commonly referred to as its 'subsidiaries' and those with a minority participation as 'affiliates.'  - 13 - strategic minerals, and are required by law to have a majori:y 'participation of the state or CFM (para. 1.14). Excluding these and other companies which are primarily involved in providing services for the mining sector or only indirectly related to mining activities (for example, smelting companies and manufacturers of mining equipment and trading companies), CFM's remaining equity portfolio is primarily composed of participations in several large mining enterprises or groups with 'mixed' (public and privat,) ownership. Only three mining companies in CFM's present equity portfolio would fall within the definition of SMM suggested for the Special Program (para. 1.09). 1/ 2.08 CFM's holdings in affiliate companies and subsidiaries have grown from a total of about Mex$279 million at the end of 1971 to over Mex$2.2 billion in June 31, 1979, mainly as a result of the development of several new mines by the government. After tax return on its equity portfolio has varied over the last few years in the range of 15% to 22% (excluding companies in pre-operative stage). A substantial portion of this investment income resulted from the operations of four companies (Azufrera Panamericana S.A., Cia. Explotadora del Istmo S.A., Exportadora de Sal S.A., and Cia. de Real del Monte y Pachuca, S.A.). The first two companies are producers of sulfur and the other two of salt and silver, respectively. These subsidiaries are majority owned by CFM and account for about 75% of CFM's income on equity holdings. 2.09 Pursuant to the government's policy of maintaining some state participation in industry and mining, CFM plans to continue to hold equity participations in its subsidiaries and affiliates. However, CFM confirmed in connection with the proposed loan that, as a matter of policy, it would encourage the formation and expansion of SMM enterprises as far as possible on the companies' own initiative and capital. CFM would participate in the equity of such companies only in cases in which sufficient private initiative and financing is not forthcoming, or if the mineral produced or the region where it is located is of strategic importance. This strategy with respect to CFM's participation in subsidiaries and affiliates is reflected in CFM's Operating Guidelines (see para. 2.32 and Annex 3). 2.10 Financial assistance to SMM. CFM has been providing assistance to SMM enterprises through a variety of credit and equipment leasing opera- tions, including: (a) fixed asset loans ('refaccionarios') to finance mining, transportation and beneficiation/concentration plant equipment, construction and other costs of mine develop- ment, for terms usually not exceeding 5 years; 2/ 1/ CFM informed the appraisal mission that it is highly unlikely that these firms would in fact seek funds under the proposed Bank project for SMM, since they normally have access to other sources of financing. 2/ In the past, 'refaccionarios' included small amounts of financing (usually not exceeding Mex$1 million) for permanent (structural) work- ing capital. In the future, CFM would separate these two categories following the new guidelines under the Special Program for SMM develop- ment.  - 14 - (b) advances for ore delivered to the mineral concentration plant ('anticipos') or for ore mined and awaiting transpor- tation at mine site or in transit to a concentration plant ('pignoraciones'), with maximum limits of up to 80% of the value of the mineral in the case of 'anticipos' and up to 70% of the value in the cases of 'pignoraciones,' with terms not exceeding one year for both types; (c) medium-term (1-4 years) leasing of mining and other equipment such as compressors, drills and trucks, with option for the client company to purchase; (d) short-term leasing of mining equipment for periods of up to 3 months, with monthly rents equal to 5-10% of the value of the equipment, depending on its estimated total life; (e) 'risk capital' loans of up to Mex$150,000 to finance evaluative exploration (for the development of ore reserves), under which the client company has no obligation to repay the loan if the exploration is unsuccessful; and (f) emergency loans ('mutuos') of up to Mex$150,000 with terms of up to one year, for which no specific collateral is required. 1/ 2.11 CFM has in the past used only ad hoc procedures to determine the maximum amount and terms of financing and the lending conditions associated with each of the above categories of financing. Also, CFM has had no written policies on the interest rates to be charged under each of the above types of operations. As a matter of convention, however, CFM has been using resources borrowed from NAFINSA to finance part of the fixed assets loans CFM has been charging the client companies the same rate as that charged by NAFINSA to CFM (currently 17% per year) on all its loans (including ore advances) to client enterprises. The equipment leasing contracts have been carrying somewhat lower effective annual rates of interest, in the range of 12-15% depending on the type of contract and the leasing term. 2.12 CFM is taking immediate steps to streamline the procedure to formulate clearly defined and consistent lending and leasing limits, terms and conditions. The new procedures would be designed to ensure complete consistency with the financing limits, terms, interest rates and other conditions as proposed under the Special Program for SMM development (paras. 3.07 to 3.11) for all fixed asset loans, equipment leasing operations with option to purchase, and loans for permanent working capital and ore reserve development (evaluative exploration). CFM's short-term financing in the form of 'anticipos' and 'pignoraciones,' which are not covered under the Special Program, would continue, following the current guidelines (para. 2.10), but would carry interest rates identical to those under CFM's other lending operations. CFM 1/ Another type of emergency loans called 'autocompras,' which are essen- tially 'buy and lease-back' operations, has also been used by CFM in a few isolated cases in the past. However, CFM confirmed that it intends to discontinue such operations.  - 15 - would also continue to make emergency loans ('mutuos' which are also excluded from the Special Program) not exceeding Mex$150,000 but only at a penalty interest rate (4-5% higher than on its normal loans in effective terms) and for terms not exceeding 3 months, in order to discourage the use of such operations except in cases of exceptional need and urgency; in the future, such loans vould be made only when there is ample justification to believe that the operations of the client enterprise would be viable if the emergency is overcome. The above policies and procedures relating to CFM's credit operations for SMM are reflected in its Operating Guidelines (para. 2.32). 2.13 Annex 14, T-10 analyzes the number and amount of financing opera- tions outstanding in CFM's loan and equipment leasing according to size of credit, size of mining enterprise supported, geographical location, and type of financing. All client enterprises that received financing from CFM would fall under the definition of SMM enterprises proposed for the purpose of the Special Program (para. 2.09) and 70-80% of the number as well as the amount of financing outstanding was for "small" mining enterprises under the proposed definition. The number of financing operations are almost equally divided between new and expansion projects, although more than 70% of the amount of financing was for expansion of existing mines. Furthermore, over 95% of the total of financing outstanding (by number as well as by amount) was for enterprises located in Zones I and II as defined in the 1979 decen- tralization law, that is, in high priority areas outside Mexico City. More than 40% of the number of loans and nearly 30% of the amount of financing were for enterprises located in Zone I, which is comprised of areas designated by the government as of the highest priority. Annex 14, T-11 contains a more detailed analysis of the size structure of CFM's fixed asset loans and long- term equipment leasing operations. 1/ It shows that the median size of a fixed asset loan made by CFM has been of the order of Mex$1 million (about US$45,000 equivalent) and of the median equipment leasing operation is of the order of Mex$200,000 (about US$19,000 equivalent); these figures indicate that the average amounts of financing provided by CFM under these categories have tended to be relatively small, falling well within the maximum size limits being proposed under the Special Program. 2.14 In its efforts to accelerate the development of SMM enterprises under the Special Program, CFM plans to increase lending significantly in future years for ore reserve development, in order to complement the efforts of CRM in this area and help solve the "bottle neck" which CRM is experiencing in its SMM project evaluation program (para. 2.73); and to foster the development of private exploration consultant groups which could significantly help SMM development in the medium to long run. To carry out this work, CFM proposes to engage private contractors and consultants with specialized capabilities and knowledge of the geological and ore reserve development work, mine evaluations and feasibility studies. 2.15 Regional beneficiation plants. CFM is currently operating several regional beneficiation plants to serve groups of small mining enterprises (generally 10 to 30) located in the surrounding areas (map in Annex 14, 1/ The two basic categories of financing that are likely to account for the bulk of the Bank financing provided under the proposed project.  - 16 - C-1). The beneficiation plants offer their respective client SMM enterprises facilities to concentrate their minerals on a 'maquila' (tolling) basis, that is, for a processing fee and, in some cases, help them sell the mineral concentrates. CFM is, however, considering moving on an experimental basis from these 'maquila' operations at its regional plants to arrangements under which the regional plant would purchase the output from each mine and pay the individual client companies on the basis of the respective ore contents, and later sell the concentrates on its own account. The potential for higher volume 'runs' of the concentration plants under such a system could help achieve economies of scale 1/ whose benefits could be passed on to the client SMM enterprises in the form of higher purchase prices of the minerals, and would avoid "high-grading" of minerals towards which the small enterprises would be forced in the absence of economic ore processing facilities. If the initial experience with the new system is encouraging, CFM would consider converting all its regional plants from 'maquila' type to 'buy and sell' type operations. In principle this new strategy appears sound and well justified, although suitable steps would have to be taken to prevent unduly high risks from price fluctua- tions of inventory awaiting processing at the regional plants. Preliminary indications are that such risks would be minimal, because of the relatively short time required for processing and transporting the minerals to the smelters and the generally wide mix of minerals which diversifies and reduces risks from price fluctuations. 2.16 Annex 14, T-7 summarizes the salient characteristics of CFM's seven regional plants which are currently operating, six additional plants under construction and five future plants programmed for construction over the next 2 1/2 years. As is seen from this table, the physical capacity of most of the plants is in the range of 100 to 200 tons/day. The individual regional plants generally have 40-100 direct employees and involve total investment costs of US$1-2 million equivalent (for a new plant in 1979), implying investment costs of the order of US$2,000-4,000 equivalent per fulltime job created. 2/ 2.17 The regional beneficiation plants generally operate at a loss during the first few years, but begin to make nominal operating profits thereafter once the total volume of mineral permits operation at an economic scale. 3/ To date, CFM has sought to keep beneficiation tolls to 1/ The locations of the regional plants are chosen on the basis of a com- parison of the geological potential of the different mining regions and the demand from the surrounding small mines. However, some deficiencies are evident in the locational analysis, which has often been done in an ad hoc rather than in a systematic basis; some improvements are thus called for in relation to the procedures for selecting and evaluating the locations of CFM's future regional plant projects (para. 2.22). 2/' The indirect employment created at the small mines supplying to the regional mines is, of course, much greater, as is seen from Annex 12, T-7. 3! At present, of the seven regional beneficiation Plants, five are operating at close to capacity levels and two at 65-70% of production capacity.  - 17 - small miners low by not covering full financial costs in setting 'maquila' (tolling) charges. There is ample justification for the operation of regional beneficiation plants to provide small scale mining enterprises with facilities not otherwise available to them and to enable them to operate at total costs comparable to those of medium-sized enterprises that can afford their own concentration plants. However, there would be a need to increase 'maquila' charges to cover full costs of regional plants to make them financially self-sufficient. Regional beneficiation plants to be built under the proposed project would charge 'maquila' tariffs or margins sufficient to cover their full operating and capital costs of the life of the plants (para. 3.12). 2.18 Technical assistance activities. Through its laboratory facilities and its regional and promotion offices, CFM appears to be effective in provid- ing a wide range of technical assistance services--mainly to SMM--related to production of minerals. These activities include advice to clients (through consultation and site visits), on identification and evaluation of mineral reserves, mining techniques, beneficiation, costing, marketing, and a wide variety of technical problems faced by SMM. A summary of CFM's technical assistance visits and consultancies in 1978 and the types of technical prob- lems addressed by CFM is shown in Annex 14, T-9. 2.19 At present, CFM's central laboratory in the Mexico City area combines facilities for physical, chemical and metallurgical testing of ores and assaying the metal content of concentrates, and includes a bench scale/pilot plant for testing metallurgical processes. Until recently this laboratory has served the needs of clients country-wide. However, with the sharp increase in activities, especially in the last two years, significant delays appear to have developed in meeting the demand for information, which is basic to the evaluation of proposed mineral ventures (e.g., grades, and ore response to milling). 2.20 Based on a recognition of the above and an overall review of the need for laboratory services of the mining community, CFM has determined the need for five regional laboratories: one in Hermosillo to be completed in 1979/80; another for Sonora planned for 1980; one each for Zacatecas and Coahuila projected for 1981; and one in Jalisco for 1982. These regional laboratories would comprise basic analytical facilities for determining grades of metal in rocks and bench scale metallurgical testing equipment for evaluating the metal recovery response of the various commodities. The laboratories would serve as effective support services for the exploration and mine development of the regions in which they are located. This proposed plan for the development of a system of regional laboratories appears to be well justified, provided that the equipment for such laboratories is carefully selected to match the needs of SMM enterprises in the regions. Based on the success of these regional laboratories, CFM would review the need for any additional laboratories in the region. 2.21 Finally, the training program (para. 2.26), and new initiatives promotion (para. 2.28) now being prepared by CFM are also aimed, in part, at improving CFM's ability to provide technical assistance to its SMM clients.  - 18 - Project Evaluation, Approval, and Supervision 2.22 CFM's regional offices perform the initial phase of evaluation of applications by SMM for credits and equipment leasing. These offices are authorized to approve operations of up to Mex$150,000 for short-term equipment leasing, ore advances ('anticipos' and 'pignoraciones') and emergency loans ('mutuos'). CFM's Internal Credit Committee--which is headed by the Director General of CFM and consists of the General Manager, the Technical Director, and the Director of Affiliates and Subsidiaries--is authorized to approve all credit operations (including fixed asset loans and long-term equipment leases) of up to Mex$5 million. Operations in excess of Mex$5 million require the authorization of a committee composed of some members of CFM's board of directors, representing the board as a whole. 2.23 While both CFM's headquarters and regional staff are generally competent in the evaluation of geological and technical aspects of mining projects, the quality of this work has not been consistent. Standard guide- lines have been lacking on the approach and procedures used for the technical analysis and estimation of the mineral value. Futhermore, and perhaps more importantly, CFM's procedures for financial and economic evaluation of SMM projects have been generally weak, with the overall quality of such evaluation showing considerable variance. CFM's credit and leasing operations have been only a small and relatively new part of its total activities and its evaluation staff are not yet adequately oriented toward these development banking activities. 2.24 Over the past months, however, CFM has taken measures to ensure the systematic evaluation of the administrative, financial, marketing, technical and economic aspects of its projects in future project evaluations. As a first step, it has appointed an experienced analyst to head its reorganized Credit Department and is taking action to increase its evaluation staff from 4 to 8-10 professionals within the coming year. Also, CFM as well as CRM and FMNM would implement a satisfactory set of guidelines for systematic appraisal of administrative, financial, marketing, technical and economic aspects of their projects. As part of the appraisal process, they will pay particular attention to the evaluation of the mineral reserves (by experienced geologists), classifying them into proven, probable and possible categories. The degree of confidence in ore reserve estimation required for project financing will depend to a large extent on the characteristics of each proposed project. For projects involving the development of individual mines, a high level of estima- tion, confidence of proven and probable reserves is usually required in order to ensure adequate payback capacity from the mineral deposit. On the other hand where financing of a regional beneficiation plant for several small mines is contemplated, strict minimum requirements for the proven and probable reserves migbht not be appropriate or realistic, for each of these small mines and the use of the possible category for a least a part of the total mineral reserves in the area should be acceptable for financing, provided that a qualified and experienced geologist agrees with the assessment. 1/ CFM has already issued 1/ The reserves criteria would have to be considered in conjunction with the engineering implications which may vary from one mineral deposit to another. The considered judgement of a qualified engineer/geologist is therefore of the utmost importance.  - 19 - an indicative check list for its regional offices, suggesting the relevant points that would have to be covered in future appraisals of credits and leasing projects for SMM. For appraisals of proposed new regional bene- ficiation plants, CFM will take into consideration, in addition to the above: (a) a comparative evaluation (which would be updated periodically) of the geological and other potential of alternative regions as locations for future regional plants, (b) availability and cost of the required infrastruc- ture facilities, and (c) criteria for choosing a specific location, taking into account the convenience to the different miners to be served by the regional plant. 2.25 With respect to project supervision, CFM depends essentially upon site visits and spot reports on problems detected by its regional offices. While some project problems are identified and corrected under present super- vision practices, the system would have to strengthened considerably in light of the rapidly increasing credit program for SMM. In this connection, CFM management would introduce improved project supervision procedures involving: (a) more systematic supervision of its credits, investments, regional beneficia- tion plants and equipment leasing, (b) special attention (including site visits) to projects in arrears or experiencing major problems, (c) periodic reports from each field office on supervision and promotion activities, status of loans, including project pipelines, and early warning on potential "problem" projects, and (d) consolidated quarterly portfolio reviews including suggestions for corrective measures and management action in the case of problem projects. 2.26 During appraisal the Bank mission worked closely with SEPAFIN, CFM and FMNM on proposals for a training program in project evaluation and supervision and portfolio control for CFM's and FMNM's technical staff, in connection with the expansion of these institutions' SMM development activities contemplated under the Special Program. SEPAFIN, in conjunction with CFM and FMNM has prepared preliminary proposals for such a training program, which would include at least one training course each for CFM's and FMNM's technical staff in each of the years 1980 and 1981. The Bank's Economic Development Institute (EDI) has discussed the preliminary training proposals with SEPAFIN and would provide assistance in organizing the course material and other advice as needed. As part of project supervision, the Bank would closely follow the progress of the training efforts and the development of the required technical capacity in CFM and FMNM. Credit and Promotion Policies and Strategy 2.27 In addition to the streamlining of credit policies and the reforms described earlier (para. 2.12) which would be implemented to facilitate the proposed expansion of CFM's financial assistance programs for SMM, CFM intends to further strengthen its credit policies by adding some new features in the draft statement of Policy and Strategy. First, in evaluating its credit applications, CFM would focus its attention primarily on a full evaluation of the project (para. 2.24) including its expected cash flows. Since the mining concession represents the basis for the expected project cash flows, CFM would, in the future require, whenever possible, the mining concession as part of the loan security. Second, CFM would also make changes in its risk-sharing contracts for evaluative exploration to harmonize its terms and conditions with those of CRM. 1/ Thus, under ore reserve development loans (for which 1/ In the past, there were inconsistencies between the conditions offered by CFM and CRM for such contracts. For example, unlike CRM, CFM was not requiring its clients to pay royalties in case the exploration were successful.  - 20 - the borrower puts up no repayment guarantee), CFM would absorb 90% of the cost in the event of unfavorable results (para 2.76). If successful, the borrower would pay back full principal and interest (at rates identical to those under CFM"s fixed asset loans) plus royalties of 1-3% of the value of production from any deposits discovered and developed. 1/ 2.23 CFM intends to intensify its SMM promotional activities making use of direct visits to mine operators and prospective entrepeneurs, as well as through regional seminars. It is also planning to publish a brochure to familiarize SMM enterprises with the various sources, types and character- istics of the financial and technical assistance (including laboratory facil- ities) available, and the channels for obtaining them. In addition, CFM would arrange for systematic briefings/seminars for its regional staff to update their information on SMM development activities. In carrying out the above promotion activities, CFM would collaborate closely with FMNM and CRM and plan locations of its future 'sucursales', promotion offices and regional labora- tories in consultation with them. It would also attempt to foster interest in the private banking sector in financing SMM. 2.29 As a basis for its future promotion and planning activities, CFM has recently begun a detailed evaluation of the different mining districts in Mexico from the viewpoint of the basic geological potential, types of deposits, number and types of SMM operations and their perceived needs. This exercise is quite ambitious and has to be undertaken in stages, mainly using the staff of its regional offices. CFM expects to complete the first phase of such an evaluation within the next six months. Portfolio Quality 2.30 An analysis of CFM's loans outstanding as of mid-1979, presented in Annex 14, T-12, shows that Mex$36 million, or 8% of the total principal out- staLnding (Mex$445 million) was in arrears for more than 3 months, and the total amount of loans affected by such arrears accounted for 25% of CFM's total loan portfolio. A substantial amount of these credits in arrears are expected to be recovered over the medium term. Only three minor cases of loan reschedulings were reported in the first six months of 1979; in general, loan reschedulings are authorized by CFM only in very exceptional cases and have to be justified on the basis of future cash flow prospects. Of its outstanding loan portfolio at the end of 1978 only 1.03% was considered uncollectable. 2.31 A good part of the arrears problems can be attributed to inadequate portfolio control and management information systems rather than poor loan quaility. As mentioned earlier, CFM has recently strengthened its credit department and plans to introduce more effecitve methods of portfolio control, including more systematic loan supervision and better use of its regional offices to follow up with delinquent borrowers (para. 2.25). In addition, CFM would enforce the penalty interest rate required on the amounts not paid on time in the case of credits and leasing contracts in arrears. 1/ The apparent overlap in exploration of functions by CFM and CRM has been a subject of discussion between the Bank appraisal mission and CFM. In this connection, CFM indicated that it would finance contracts for ore reserve development or evaluative explorations only if CRM cannot under- take a contract because of lack of personnel or inability to fulfiil timing requirements.  - 21 - Statement of Operating Policies and Strategy 2.32 CFM has taken the opportunity of the expanded SMM development activities contemplated under the Special Program to review its basic operat- ing policies and strategy, and accordingly, has prepared draft Operating Guidelines for implementation of the Special Program (Annex 3). This statement covers, among other things, promotion strategy for SMM, credit and financial policies, strategy for regional beneficiation plants and CFM subsidiaries and affiliates, personnel, recruitment and training, project and credit evaluation policies, project supervision and portfolio control, and coordination of laboratory programs under the proposed project. Most of these topics have been covered in the description and analysis of CFM contained in this report. A satisfactory draft of the Operating Guidelines has been agreed upon at loan negotiations. Formal approval of the Guidelines by CFM's board would be a special condition of effectiveness of the proposed loan. Any subsequent substantial change in the Guidelines would have to be acceptable to the Bank. Accounting, Control and Auditing 2.33 CFM has an adequate accounting system for its credit operations as well as for payments to and collection from clients, subsidiaries and affi- liates, conforming to the official regulations and guidelines. The accounts of its regional offices and beneficiation plants are included in the consolidated financial statements of CFM but are shown separately, and they are subject to periodic internal auditing procedures. As mentioned above, CFM is fully aware of the need to develop practical control systems that would include project and portfolio control and also management methods designed to ensure prompt follow-up and corrective action by its staff, when required. 2.34 CFM's financial statements have been audited for the past several years by Despacho Jorge Reza Inclan, an independent public auditing firm selected and assigned by the Ministry of Planning and Budgeting (SPP). The audit reports for the past three years have been unqualified. Financial Position, Resource and Projections 2.35 Annex 14, T-13 and T-14 present summarized audited balance sheets of CFM as of December 31, 1977 and 1978, as well as projections through 1982. More than 60% of CFM's total assets of about Mex$3.2 billion (about US$141 million equivalent) at the end of 1978 were accounted for by its equity port- folio. Fixed asset loans and equipment leases with option to purchase, on the other hand made up a relatively small fraction of CFM's total assets in the past years. 2.36 Reflecting the expansion of CFM's credit program in support of SMM, projected balance sheet figures for 1979 through 1982 estimate growth of more than 30% annually in CFM's outstanding loan portfolio (from Mex$286 million at the end of 1979 to Mex$678 million at December 31, 1979). The projected balance sheets also show a substantial rise in fixed assets for the 1979-82 period, corresponding mainly to the expansion of CFM's regional bene- ficiation plants program. Similarly, the projections show continued growth-- about 27% per year in nominal terms--in CFM's investment in subsidiary or affiliate companies.  - 22 - 2.37 In the past, nearly 90% of CFM's resources for its operational costs and capital expenditure have been obtained in the form of direct contributions from the government, with the balance coming from surpluses generated from operations. CFM has been using small amounts of financing under different lines of short- and long-term credit lines granted by NAFINSA (currently about US$0.9 imillion equivalent), mainly for CFM's fixed asset loans. In support of the expanded SMM program, the government will contribute substantial amounts to cover the local currency component of CFM's SSM development activities, averaging about Mex$320 million (about US$14 million equivalent) per year for the period 1980-82 (para. 3.15). 2.38 CFM has had no experience in negotiating or obtaining credits from foreign or domestic banks, although it is legally authorized to borrow from other sources if needed. While such borrowing is not likely to occur soon, Mexican private banks indicated to the Bank mission that financing could be attracted--directly by mining companies or through CFM--if the government's SMM program results in improved project preparation, backed by good ore reserves and financial information for potential SMM clients. Procurement and Disbursement 2.39 Under its current procurement practices, CFM ensures that at least three price quotations from suppliers are obtained for all its purchases in excess of Mex$2,000. CFM's draft Operating Guidelines (para. 2.32) specify that it would continue to follow this procedure and would ensure price and quality competitiveness for all items financed under CFM's subloans to SMM enterprises as well as for items directly procured by CFM for its regional beneficiation plants and equipment leasing (para 3.23). CFM will also collaborate with CRM and FMNM to achieve consistency among the three agencies on procurement procedures, and study ways to ensure the most favorable prices possible for recipients of credits, including the possible application to SMM borrowers of the favorable prices offered (and registered) by manufacturers for procurement by government agencies. 2.40 Disbursement of the credit proceeds are governed by CFM's credit regulations and by provisions contained in each credit agreement between CFM and its client. Payments to borrowers are adequately controlled and certified by CFM against invoices and shipping documents submitted through CFM regional offices. B. FIDEICOMISO MINERALES NO METALICOS MEXICANOS Background and Objectives 2.41 FMNM was established by presidential decree on October 30, 1974, as a government trust ("Fideicomiso") administered by NAFINSA to stimulate exploration, exploitation and marketing of non-metallic minerals in Mexico. The Mexican authorities recognized that although substantial reserves existed in Mexico, the exploration and development of most non-metallic minerals had been traditionally neglected except for coal, sulfur, phosphate rock, salt and  - 23 - flourspar, and that many of the non-metallic minerals existing in Mexico were being imported (see Annex 14, T-3). A second objective of FMNM is to facilitate the flow of economic benefits and the creation of employment among the "ejidatarios", by opening ejido land for exploration and development of non- metallic minerals. The two objectives are consistent because non-metallic minerals c-en occur in shallow deposits close to the land surface, and are spread over large secluded areas which characterize many of the ejidos, making them suitable for organizing community-based small- and medium- size mining operations. A third objective is to support the development of the non-metallic SMM sector by providing adequate infrastructure and technology for its growth. 2.42 FMNM's plan is to fulfill these objectives, through technical and financial assistance for the exploration, development and exploitation of non-metallic mineral deposits. FMNM also plans to develop a construction program of regional beneficiation units to process non-metallic minerals and market the end-products, much along the same lines as CFM's regional benefi- ciation plants (para. 2.15), to help SMM enterprises which do not have adequate structure for processing/beneficiating their crude minerals. In addition, FMNM holds equity participations in five enterprises engaged in the mining and/or processing of non-metallic minerals, all of which have been formed as a result of exploration or other initiatives on the part of FMNM. Organization, Management and Staffing 2.43 The governing body of FMNM is its Technical and Funds Disbursement Committee ("Comite Tecnico y de Distribucion de Fondos"), formed by represen- tatives from the Ministry of Finance, SEPAFIN, Ministry of Industry and Commerce, Ministry of Programming and Budgeting, Department of Land Affairs and Rural Settlement, CFM, NAFINSA, and the National Fund for Ejido Development. The Minister for SEPAFIN is the chairman of the Committee. The Committee takes an active interest in directing FMNM activities, meeting periodically to make decisions on policies, procedures, financial plans and budgets; it also approves financing and equipment leasing operations larger than Mex$3 million, based on recommendations from FMNM's staff. 2.44 Authority is delegated to the Director General of FMNM for selection of key management staff and establishment of project evaluation criteria and credit. FMNM's current Director General, Mr. Moises Kolteniuk Toyber, has the necessary qualifications, support, and leadership qualities to develop FMNM into a competent institution, having earlier been the sub-director of projects and special studies in SEPAFIN. Mr. Kolteniuk is assisted by two able sub-directors - Mr. Ubaldo Alarcon Santana, for the Technical Department, and Mr. Jorge Medellin Ortega, for the Finance and Credit Department. 2.45 FMNM's staff are relatively young and inexperienced, but they possess the basic knowledge and skills necessary to carry out their tasks. They are generally well motivated and possess adequate potential to ensure the success of FMNM's development program. Several staff members have re- cently been hired, including some from private banking institutions, to fill key positions in the Finance and Credit Department. FMNM's salaries are sufficiently competitive to attract and retain high quality professionals.  - 24 - FMNM is planning to introduce specific training programs for its professional staff to further upgrade their skills in project evaluation and control, financial analysis and management (para. 2.58). In hiring new personnel for the expansion of its activities, FMNM will add headquarters as well as field staff as required by the potential for expansion in the various regions. FMNM's staff currently totals about 90 (including 52 professionals) and is expected to double during the development of the Special Program. Some 12 employees are currently stationed in 5 regional offices (see Annex 7 and map in Anne!x 14, C-l). An indicative organization chart of FMNM is presented in Annex 11. Operations 2.46 FMNM started operations only in 1976. FMNM is authorized under its operat:ing regulations to carry out a wide range of operations, including exploration (on its own initiative or at the request of a client enterprise or an ejido community), development, extraction, marketing, and distribution through credits, equity investments, equipment leasing, technical assistance activities and basic research. 1/ In effect, in the case of the non-metallic minerals, FMNM is authorized to fulfill the entire range of responsibilities that are covered for metallic minerals by CRM and CFM. FMNM's operations involve all non-metallic minerals except coal, sulfur, fluorspar, salt and phosphate rock, which are reserved for exploitation and extraction through enterprises fully or partly owned by the state or its agent, CFM. For explora- tion, FMNM has adopted a policy of carrying out geological investigations in project development activities in most cases through CRM. 2.47 Equity investments in subsidiaries. FMNM has made equity invest- ments totalling Mex$262 million (about US$11.4 million equivalent) in the following five subsidiaries: Sonocal (a limestone producer in Sonora); Grafitos de Mexico (crystalline and amorphous graphite); Minerales no Metalicos de Guerrero (pottery clay); Marmoles del Valle Mezquital (finished marble); and Barita de Sonora (barite). All of these subsidiaries are inte- grated producers covering mineral extraction and beneficiation as well as marketing. 2/ With the exception of Minerales No Metalicos de Guerrero and Grafito de Mexico, in which FMNM has a participation of about 80%, FMNM holds 100% of the shares of the remaining operations. Three of the subsi- diaries (Sonocal, Marmoles del Valle Mezquital and Minerales no Metalicos de Guerrero) are presently operating profitably (Annex 14, T-17); the remaining two are still in the construction stage. 2.48 Credits and other financial assistance to SMM. FMNM's focus has historically been on establishing and operating mining companies rather than on promoting and assisting small mines. Thus lending to small miners totaled Mex$25 million in 1976, practically none in 1977 (para 2.56), and Mex$20 million in 1978. In 1978, FMNM expects, in keeping with the recent government emphasis, to increase its lending to SMM to Mex$55 million, or about US$2.5 million equivalent. 1! FMNM is not directly involved in the marketing and distribution of minerals, although many of its subsidiaries provide such services. 2/ Four of the five subsidiaries are located in ejido land, and some offer mineral beneficiation facilities to the surrounding small mines.  - 25 - 2.49 FMNM has been making two types of credit operations: (a) fixed asset loans ("refaccionarios") of up to Mex$4.5 million to finance equipment costs and civil construction for terms usually not exceeding 5 years and grace periods of up to one year; and (b) permanent working capital loans ("habilitacion o avio") of up to Mex$3.5 million for terms not exceeding 3 years and grace periods of up to one year. In the case of fixed asset loans, FMNM has generally provided about one-half of the total costs of the projects supported, with the remainder being con- tributed by the project sponsor--a public or a private enterprise or an ejido community. 2.50 FMNM's onlending interest rates to its final borrowers follow the Ministry of Finance guidelines and have in the past usually been set equal to its borrowing rate from NAFINSA (currently 17.5% p.a.), except for ejidos which have been receiving loans at 14% p.a. (para. 1.31). FMNM's financial operations have thus far been made mainly using government budgetary resources. 2.51 As of June 30, 1979, FMNM had approved fixed asset and working capital credits totalling the equivalent of US$2.24 million, distributed as shown below (Annex 14, T-18): Total Credit Average Loan (US$'000 equivalent) Amount No. of Loans Recipients Amount % (US$'000) 13 Ejidos 280 13 21.5 5 Subsidiaries 1,620 72 324.0 7 Private Enterprises 340 15 48.6 25 Total 2,240 100 89.6 2.52 FINM is planning to increase significantly the level of its fixed asset and working capital credits over the next three years (Annex 14, T-15), in line with the objectives of the Special Program for SMM Development. FMNM plans to initiate within the next six months a program of long-term equipment leases with option for the clients to purchase, using terms, conditions and procedures similar to those being used by CFM (para. 2.10). This would fill an important need of small mining enterprises producing non-metallic minerals which are unable to finance their own mining equipment. The projected levels of the equipment leasing operations are indicated in Annex 14, T-15. Further- more, FMNM is also considering diversifying its credit operations in the future to include industrial mortgage-type loans and ore advances (similar to "anticipos" and "pignoraciones" being offered by CFM in the case of metallic minerals--see para. 2.10).  - 26 - 2.53 FMNM would change the limits of its credit and equipment leasing operations in order to meet the expanded needs of SMM and achieve full conformity with the size limits, terms, interest rates and loan conditions proposed for the Special Program for SMM Development, which are to be agreed upon during loan negotiations (paras. 3.05 to 3.11). 2.54 Regional beneficiation plants. Recognizing the critical need for regional beneficiation plants to provide beneficiation facilities for small mining enterprises, FMNM is planning to embark on a program for construction of regional plants for processing non-metallic minerals, following procedures, criteria for selection and location and other norms similar to those under CFM's regional plant program (paras. 2.15 to 2.17). FMNM projected that five beneficiation plants would be constructed over the 1980-82 period, which would have the potential to support 25-30 new small mining operations and generate 400-500 additional jobs in the mining areas (Annex 14, T-16 and map in Annex 14, C-1). However, this schedule may be optimistic in view of FMNM's lack of prior experience in this field and the relatively slow development that can be expected for a program of this kind. A more realistic program may be for three new regional beneficiation plants during 1980-1982. The capacity of these plants will vary substantially according to the type of mineral and the final stage of processing. Overall Portfolio Quality 2.55 An analysis of FMNM's outstanding portfolio shows that, as of June 30, 1979, FMNM's total reported arrears over three months amounted to 7.8% of outstanding portfolio, and the loans outstanding to such clients in arrears represented 10% of FMNM's total loan portfolio (Annex 14, T-19 and T-20). The rate of arrears is significantly higher if subsidiaries are excluded from the portfolio. Most of the arrears problems can be traced to a large number of loans made by FMNM to ejidos and one private borrower in 1976 (FMNM's first year of full operation), when its project evaluation experience was still limited. Moreover, the strong support of the Mexican Government prior to 1976 to financing of ejido lands may have superseded the rigor of project evaluation. Two of the credits made to a group of marble-producing ejidos were partly written off after the principal was recovered through a transfer of equipment and marble produced by these ejidos to a subsidiary of FMNM (Marmoles del Valle del Mezquital). FMNM and this subsidiary are giving intensive technical assistance to these marble-producing ejidos to raise their productivity and are purchasing raw marble for finishing and marketing. 2.56 FMNM is strongly committed to solving the arrears problems through more adequate project and credit evaluation policies. Since 1977, it has tightened its credit policies by requiring all projects, including ejido projects, to satisfy rigorous viability criteria. The immediate consequence has bleen that the volume of loans to ejidos (and hence the total volume) dropped drastically in 1977. Since late 1978, three credits for private SMM enterprises have been authorized after thorough evaluation, and these appear to be satisfactory. FMNM has taken legal action against the three private enterprises currently in arrears and expects to recover virtually all of the principal and interest outstanding. Through its regional offices and subsi- diaries, FMNM has also been making a concerted effort for training and pro- viding technical assistance to the ejidos, which appears to be achieving satisfactory results.  - 27 - Project Evaluation, Approval and Supervision 2.57 As indicated above, FMNM has strengthened its project evaluation procedures over the past year by considering more thoroughly the technical, administrative, marketing, financial, economic and credit aspects of proposed projects. The quality of FMNM's appraisal work, while acceptable, still leaves room for improvement. Evaluation of ore reserves of mining projects is generally performed by competent professionals with the assistance of CRM geologists. However, a lack of consistency and quality of reporting is noticeable in the evaluation of reserves. FMNM is making efforts now to analyze more thoroughly the creditworthiness of its clients and the adequacy of ore reserves and loan security, along the lines discussed in the case of CFM (para 2.24). 2.58 FMNM's project appraisals are developed under the supervision of a well-qualified and motivated financial and credit manager and three pro- fessionals. This team is expected to be expanded to seven within the next year. Since the past year, FMNM has been using uniform credit and project evaluation criteria for all borrowers regardless of their ownership structure. FMNM's draft Operating Guidelines (see para. 2.65 and Annex 4) reflect these policies regarding project evaluation. FMNM has also confirmed during loan negotiations that it would update its credit manual and prepare a detailed checklist and a satisfactory format for project evaluation which it intends to start implementing before mid-1980. In an effort to improve project evaluation capabilities, SEPAFIN intends to organize special training courses in which FMNM project analysts will participate jointly with their CFM counterparts (para. 2.26). 2.59 While project supervision would be the principal responsibility of FMNM's regional offices, it would be monitored on a continuous basis from the head office to cope with the expected rapid expansion in volume of FMNM's credit and leasing operations, regional beneficiation plant construction and equity investments. FMNM intends to adopt supervision procedures similar to those discussed in the case of CFM (para. 2.25). FMNM's Operating Guidelines (para. 2.65) specify that FMNM would pay special attention to supervision of subprojects involving financing to ejidos, with a view to providing them with intensive technical assistance to improve their operations. Financial Position and Resources 2.60 Annex 14, T-21 and T-22 present summarized year-end audited balance sheets and income statements of FMNM for the past two years and projections for 1980-82. FMNM's equity portfolio is expected to reach Mex$322.4 (about US$14 million equivalent), or about 62% of total assets by the end of 1979. Credit operations reflected in the outstanding loan portfolio for 1977/78 represent a small portion of FMNM's total assets. This portfolio, however, is projected to grow substantially from 1979 through 1982, from Mex$67.1 million to Mex$405.3 million, reflecting the expected expansion of this program (Annex 14, T-15) in support of the SMM. Fixed assets will also rise substantially in the period as a result of implementation of projected regional beneficiation plants and the proposed equipment leasing program.  - 28 - 2.61 While under its statutes FNNM, like CFM, can borrow from any source, including private commercial banks, its resource requirements in the past have been met from the government's budgetary resources and small amounts of borrowings from NAFINSA. On behalf of one of its subsidiaries (Grafitos de Mexico), FMNM has negotiated financing from private banks. Accounting and Auditing 2.62 FMNM maintains an adequate accounting system covering separately its own operations and those of its subsidiaries. As in the case of CFM, accounts of FMNM are audited annually by Despacho Jorge Reza Inclan. All of FMNM's audi.t reports have been unqualified. Subsidiaries of FMNM are also audited by public accountants assigned by the Ministry of Programming and Budgeting, and have received satisfactory reports in the last two years. 2.63 FMNM intends to maintain separate accounts for each of the regional beneficiation plants for the purpose of calculating adequate 'maquila' charges at each plant. These separate accounts will be consolidated into FMNM's financial statements. Procurement and Disbursement 2.64 FMNM's procurement procedures are generally adequate. FMNM normally requires quotations from at least three suppliers. This procedure has also been adopted in the case of client projects. Also, the Technical Department of FMNM verifies that goods and services purchased are suitable for the project and are reasonably priced. FMNM's disbursement procedures are satisfactory to ensure that funds are used for their intended purposes. Operating Policies and Strategy 2.65 In order to guide its expanded SMM development activities under the project, FMNM prepared draft Operating Guidelines for implementing the Special Program (Annex 4), similar to those prepared by CFM (para. 2.32). The Guide- lines aim among others for the closest possible cooperation among CFM, FMNM and CRM in order to derive synergy in areas such as promotion, training and planning of laboratory facilites and regional offices. A satisfactory draft of the Operating Guidelines has been finalized following discussions at loan negotiations. Formal approval of the Guidelines by FMNM's Technical Committee would be a condition of Board presentation of the proposed loan. Any substan- tial change in the Guidelines or FMNM's operating regulations (para. 2.46) during the project's implementation would have to be acceptable to the Bank. The following highlights important elements of FMNM's policies not covered thus far. 2.66 FMNM's credit policies would in general be analogous to those of CFM. EMNNM will require detailed supporting information on project proposals from the SMM enterprises which must include an adequate evaluation of its ore reserves and an adequate analysis of the technical, administrative, financial, economic, and market aspects of the project. To secure its credits the SMM enterprises would include the mining concession, whenever possible, along with other collaterals and guarantees as may be required.  - 29 - 2.67 FMNM intends to promote operations with private SMM enterprises primarily in three ways. First, through increases in credits to existing SMM. Second, by developing regional beneficiation plants to offer upgrading facili- ties to the SMM's minerals on a 'maquila' basis, i.e., for a processing fee or in some cases to market end-products for them. The 'maquila' charges at each plant will be set at levels that will cover full capital and operating costs at full capacity. Third, FMNM intends to complement CFM's laboratory facilities, as needed, by providing specialized equipment for analysis, determination and testing of non-metallic minerals. 2.68 FMNM will continue to participate in the equity of enterprises engaged in the mining or processing of non-metallic minerals, whenever private initiative and financing is insufficient for the formation or expansion of an SMM enterprise, or if the mineral produced or the region in which it is located is of strategic importance. In line with its original objectives, FMNM will continue assisting ejido communities. Whenever feasible, FMNM would encourage and help the ejido communities to set up mining operations, through provision of credit and technical assistance. However, such loans and assist- ance be considered only on the basis of adequate project and credit evaluations. C. Consejo de Recursos Minerales Background and Objectives 2.69 CRM was created by a decree in December 1957, as the decentral- ized government agency in charge of geological studies and mining exploration. The objectives of CRM as spelled out in the Mining Law 1/ include: (a) carry- ing out geological surveys, mining exploration and valuation of the mineral resources at the regional level as well as of specific mineral prospects; (b) advising the government on the mineral areas which should constitute "National Mining Reserves," granting of concessions on such areas, technical or legal matters related to the exploration, exploitation and preservation of mineral resources and to the setting of national mining policy; and (c) coordinating its own work with that of other public entities engaged in geological and related scientific studies and research, and preparing geological and mining summaries. 2.70 By mid-1978, the CRM received instructions from SEPAFIN to concentrate its efforts and resources increasingly toward evaluative (or project oriented) geology with special emphasis on the small and medium mining sector rather than regional geological projects. A substantial share of CRM's staff and financial resources is currently devoted to technical and financial assistance to SMM enterprises through geological studies and mining exploration. 1/ "Ley Reglamentaria" of Article No. 27.  - 30 - Organization and Staffing 2.71 CRM's executive head is its Director General, who is responsible to the board of directors comprised of SEPAFIN (3 representatives), Ministry of Commerce, Ministry of Finance and Ministry of Programming and Budgeting, and the Directors General of Petroleos Mexicanos (PEMEX), NAFINSA, and CFM. The Minister of National Patrimony and Industrial Development acts as the chairman and assigns a secretary to assist the board of directors. Annex 12 includes an indicative organization chart of CRM. CRM's operations are directed from its head office in Mexico but three-quarters of its personnel work out of 27 regional offices distributed throughout the country. 2.72 CRM's present Director General, Mr. Guillermo P. Salas, is a very experienced and highly regarded geologist. Its present staff of 870 include: 336 geologists, 94 other professionals, 195 technicians, and 245 administra- tive and support staff. The majority of CRM's professional staff are young (averaging about 30 years) with only a small core of older experienced geologists, reflecting the situation existing throughout the mining sector in Mexico. CRM's salary levels are controlled by the government (unlike CFM's and FMNM's), which tends to contribute to a relatively high turnover of promising professionals who join private and public sector enterprises, particularly PEMEX. This situation may be improved in future as salary levels are now under review. However, the general shortage of qualified geologists will likely continue to affect the capability of CRM in assessing large scale and complex technical problems, as it can only partly be alleviated through the use of expatriate and local consultants as well as through cooperation with international agencies or through bilateral agreements. 2.73 Nevertheless, the lack of adequate numbers of experienced profes- sionals does not appear to have hampered significantly CRM's capacity to technically appraise and assist SMM projects. In fact, these areas of work involve the tasks best performed by their younger geologists, namely, field work (drifting, trenching and drilling), data analysis, junior geologist evaluation and technical assistance to small miners. With the increased accent on SMM operations, CRM anticipates an expansion in the number of proje!Cts to assist SMM enterprises and recognizes the need for training its junior geological staff. In this connection, CRM foresees that the avail- ability of adequate numbers of senior geological staff to train the younger geologists may pose a constraint to its expansion plans. During negotiations satisfactory arrangements for a suitable training program for CRM's geological staff, including at least one training course for CRM's geological staff during each of the years 1980 and 1981, have been confirmed. Operttions 2.74 Regional exploration and general geological services. An important part of CRM's responsibilities is its role as Mexico's national geological service, under which it carries out regional (non-project oriented) geological work and special services to the government. Included in these are regional or aereal geological surveys oriented to mapping and determining the general geological qualities of large areas, often without specific targets. As part  - 31 - of its regional exploration objectives, CRM also launches special programs, from time to time, for search for specific minerals considered to be of strategic importance (e.g., iron, coal and sulfur) or for import substitu- tion of minerals in short supply in Mexico, such as nickel, chrome, asbestos, tin, bauxite and potash. CRM considers that exploration for tin, asbestos and bauxite is currently of high priority. CRM also undertakes some special projects for the state for exploration of promising areas. If such efforts are successful, the mines are turned over to CFM (as the government's agent) for development and operation. 2.75 Evaluative exploration. CRM offers, mostly to small and medium sized mining enterprises, financing for their exploratory work, with or without a risk-sharing feature, and in many such cases it also undertakes the explora- tion and geological work for them. When a request for financial assistance for exploratory activities is received by CRM from a client enterprise, CRM offers the client financing either of a risk-sharing type or in the form of secured loans. 2.76 The risk-sharing type contracts are applicable in cases where the client enterprise is unable to assume the full financial risk of exploration or does not have adequate loan securities. Under this type of contract, the client pays in advance 10% of the initially estimated cost of exploration and CRM agrees to cover the remainder (up to 90%) of the costs. In case no economically exploitable deposits are found, CRM absorbs the share of the costs financed by it and writes off the loan. On the other hand, if the exploration is successful the client is required to pay back the amount financed by CRM and an additional 20% premium, plus interest at an annual rate of 15%; 1/ in addition, clients with succesful prospects would be required over a period of up to 10 years to pay royalties ranging from 1-3% of the net value of the production from the deposits discovered, as the revenues start flowing in. Thus, in effect, CRM operates a type of "exploration fund" through which the risk of exploration can be shared among a large group of client companies. 2.77 In practice, CRM has been able to keep losses on its "'risk-sharing" contracts to a minimum, as only promising projects are accepted and CRM re- serves the right to discontinue the work under the contract if the initial results are not encouraging. In 1978, CRM signed 25 risk-sharing contracts for evaluative exploration, for a total financing of Mex$28 million. In comparison, during the first 9 months of 1979, CRM had signed 43 such contracts for a total amount of Mex$77 million, i.e., a substantial increase over the previous year. 2.78 The exploration contracts with secured loans are applicable in cases where the client enterprises have adequate guarantees to offer as loan secu- rity and are willing to bear the full exploration risk. The principal and 1/ The effective interest rates to the client enterprises on such financing is estimated to be in the range of 20-30% (without counting royalty payments) depending on the maturity of the exploration contracts which normally ranges between 6 months and 2 years.  - 32 - interest payment arrangements in these cases are identical to those under the risk-sharing type contracts, but in these cases the client enterprises are required to pay back the principal (plus "bonus") and interest whether or not the exploration contract results in a success. Also, no royalties are charged since there is no risk-sharing feature. 2.79 Advisory services and technical assistance. CRM acts as an adviser and consultant to the Mexican Government on matters relating to mineral resources, national reserves, and in formulating the national mining and minerals policy. Its 27 regional offices offer free geological advice to the SlMM in their districts. Finally, CRM offers to SMM enterprises valuable laboratory services for assaying and for mineralogical study but these appear to be overloaded with CRM's own work and require expansion. As a promotional measure, CRM's charges to the SMM client enterprises for the laboratory services are set to cover on the average only the variable operating costs of the laboratory. Project Evaluation 2.80 Technical or commercial feasibility studies are relegated to the mine owner or CFM and FMNM, who help set the targets prior to the exploration program. When unsuccessful projects are generally stopped prior to completion of the whole program; therefore, CRM evaluations need not be as precise as those for mine operations. The final evaluation after exploration, namely, evaLuation of ore reserves, seems to be well within the capabilities of CRM, whose staff is adequately prepared, especially for the exploration activities of S'MM. Future Operating Strategy 2.81 During loan negotiations, CRM confirmed that it intends to continue its present operating pattern but with increasing emphasis on to assistance to S'MM. This is reflected in the expected increase in SMM's share of CRM's total annual budget from 19.5% in 1979 to 30% in 1982. 1/ CRM also expects increases in its other activities, including regional exploration, although at a slower rate than the SMM assistance operations. CRM intends to continue to expand its operations of executing and financing contracts for the evaluative expLoration of specific mineral prospects (para. 2.77). CRM also expects to colLaborate closely with CFM and FMNM in providing support services and assistance in promotional activities, and part of the expected increase in CRM's operations is likely to result from such cooperation. To cover its additional workload, CRM expects to increase as necessary the number of geologists and technicians as well as the support services such as laboratory and exploration equipment. 1/ CRM expects its total annual budget to grow at an average annual rate of 10-20% in real terms.  - 33 - Financial Position and Resources 2.82 CRM finances its operations mainly using budgetary resources, and to a lesser extent through income derived from interest on loans and royalty payments. For 1979 it is estimated that CRM's income would account for about 16% of its annual budget. The budget for 1980 is expected to increase by about 50% over 1979, from Mex$611 million (about US$27 million equivalent) to Mex$922 milion (about US$40 million) with the estimated breakdown for 1979 and 1980 is as follows: Amount ( Mex$ '000) 1979 1980 Regional exploration 1/ 362,360 409,400 SMM assistance activities 157,350 300,000 Other activities 92,000 213,000 Total 611,700 922,400 A substantial portion of the 1980 budget will be spent on SMM projects under the investment account which itself has been growing at approximately 20% per year in constant terms. Procurement and Auditing 2.83 As in the case of CFM and FMNM (paras. 2.39 and 2.64), procurement policies are set by law. Purchases have to meet government standard prices and quotations must be requested from at least three suppliers. CRM's accounts are audited annually by external auditors satisfactory to SPP. Recent audit reports of CRM, while finding the overall accounts satisfactory, made several operational suggestions for improvements in the accounting and control systems. Some suggestions have been adopted while others should be implemented during 1980. III. THE PROJECT AND THE PROPOSED BANK LOAN Background and Objectives of the Project 3.01 Recognizing the potential of the SMM sector for employment generation and export expansion--and the sector's lack of access to adequate financial and technical assistance--the Mexican Government has expressed interest in mounting a broadly based and integrated program for SMM development, called the 'Special Complementary Program for SMM Development' (Special Program or PECAM). The Special Program aims at (i) exploiting the full potential of Mexico's mining resources and reversing the sector's low growth trend of the 1/ Including exploration for specific metallic and non-metallic minerals such as iron, coal, phosphate, bauxite and asbestos.  - 34 - 1970s (para. 1.01), (ii) generating employment, especially among the relatively low income groups, and (iii) activating some of the least developed regions of Mexico. Since most of the larger mines in Mexico were discovered as a result of the exploratory activities of smaller units, the development of SMM is expected to trigger the growth of the mining sector as a whole in the long run. In view of the potential of SMM in Mexico and the recent favorable legislative and fiscal reforms, the Mexican authorities give high priority to the Special Program. 3.02 Following the initial expression of interest in the first half of 1978 by the government and CFM in possible Bank support for SMM development, various Bank missions worked closely with the concerned Mexican agencies in developing a specific project which was identified in October/November 1978. A Bank mining sector mission in February 1979 reviewed, among other things, the basic potential of SMM and the quality of available institutional support. In June 1979, a Bank mission visited Mexico to continue preparation work and the project was appraised in September 1979. Negotiations for the proposed Bank loan took place in Washington during February 1980. ProLect Description 3.03 The proposed project would form the initial phase of the Special Program extending through its the first 2-1/2 to 3 years. The project would provide financial, technical and other assistance to SMM enterprises to help expand their mine development and exploration activities, and would strengthen the institutional capabilities and technical facilities of the local enti- ties supporting SMM. It would include the following components: A. Credit and Equipment Leasing Subprogram comprising: (a) financing through CFM and FMNM of a program of fixed asset loans, and purchase of machinery and equipment to be offered for long-term leasing (with option to purchase) to SMM enterprises for mine preparation, extraction, and concentration/beneficiation of minerals; (b) financing through CFM and FMNM of permanent working capital loans to complement fixed asset loans and long-term equipment leasing; (c) financing through CFM and FMNM of credits for evaluative exploration (ore reserve development loans) of both the risk-sharing (para. 2.76) and secured (para. 2.78) types; B. Regional Beneficiation Plants Subprogram comprising: (a) the construction by CFM and FMNM of regional beneficia- tion plants to provide access to economical mineral concentration/benefication facilities for small mining enterprises;  - 35 - C. Technical Assistance Subprogram comprising: (a) expansion of the capacity of CRM to provide assistance to SMM enterprises through (i) acquisition of additional exploration equipment by CRM as required to assist SMM enterprises in exploration and development of their mines; (ii) expansion of CRM's mineral laboratory to facilitate its chemical, metallurgical and other analyses; and (iii) provision of expert assistance, as needed, and organization of suitable training programs for the technical personnel of CRM on field procedures and effective use of the various geological, geophysical and geochemical techniques; (b) technical assistance to CFM and FMNM through: (i) training of their professional staff in the technical, financial, administrative and marketing evaluation of mining feasibility studies and project proposals, supervision of SMM projects, and portfolio control (para. 2.26); and (ii) expansion of the laboratory facilities of CFM and FMNM, including estab- lishment of about four regional 'bench scale' laboratories to serve better the needs of the client SMM enterprises outside Mexico City (para. 2.20); (c) technical advice and laboratory assistance to be provided to client enterprises by CFM, CRM and FMNM in conjunction with their financial assistance. 1/ 3.04 The project would involve a substantial institution bulding effort. In addition to the more direct technical assistance to the institutions, it would help CRM, CFM and FMNM establish more clearly the focus of their activi- ties to support SMM, improve their planning capabilities, streamline operating policies and strengthen the procedures for project selection, evaluation and follow-up. It would also ensure consistency of policies and procedures among three institutions and help coordinate their SMM development efforts. Eligible Enterprises 3.05 New or existing "small" and "medium" sized mining (and related) enterprises using definition presented in para. 1.09 would be eligible for support under the project. For the purposes of this definition, all enter- prises majority-owned and/or controlled by a single private or government industrial or financial group would be considered to be related enterprises and this limit would ensure that financing would be extended only to enter- prises that are not likely to have adequate access to alternative sources of financing; it would also imply that enterprises which are majority-owned by CFM or FMNM, with the exception of beneficiation plants for SMM enterprises, would not be eligible for financing under the project, as these enterprises are not likely to experience significant problems in obtaining the required financing. CFM and FMNM intend to apply uniform criteria for selecting and evaluating the financial and economic viability of subprojects, regardless of the ownership structure of the client enterprises. The physical capacity of regional beneficiation plants financed under the Special Program would not exceed 250 tons/day of crude minerals processed. 1/ It was confirmed during loan negotiations that a report would be prepared and provided to the Bank about once in every six months summarizing and justifying the expansion plans for the physical facilities under the technical assistance component (laboratory facilities and exploration equipment) and the nature and type of equipment proposed, in the light of the demand and needs of SMM enterprises.  - 36 - 3.06 In order to avoid unduly large variations in the set of eligible enterprises in terms of their technology, sophistication and physical capacity steTmning from fluctuations in mineral prices, the upper limit on production value for medium scale mining (currently about US$6.6 million equivalent) would be reviewed annually and revised, if necessary, to reflect changes in international prices of a pre-selected basket of minerals. For this purpose, an acceptable basket comprising the most important metallic and non-metallic minerals has already been defined. The detailed composition of the basket, the reference prices and the adjustment mechanism to be used for the periodic updating are included in Annex 8. These criteria have been confirmed at negotiatons and would be included in the Operating Guidelines of CFM and FMNM for implementing the Special Program (Annexes 3 and 4). Maximum Size and Terms of Financing 3.07 The maximum amount of financing (including Bank and Mexican counter- parit resources) to any individual subproject would be (i) Mex$15 million for fixesd asset loans to develop new or existing mines; (ii) Mex$30 million for fixed asset loans for construction by SMM enterprises of new or expansion of existing beneficiation plants; (iii) Mex$5 million for the value of equipment provided under the long-term equipment leasing with option to buy; (iv) Mex$10 million for ore reserve development loans; (v) Mex$4 million for loans for permanent (structural) working capital; and (vi) Mex$40 million for construc- tion of CFM's and FMNM's regional beneficiation plants. In addition, total financial assistance to a single enterprise, or a group of related enterprises, would be limited to Mex$50 million (Annexes 3 to 5). 3.08 The maximum amortization period would normally be 8 years (including up to 2 years of grace) for fixed asset loans, and 3 years for permanent working capital loans. Maximum terms of equipment lease contracts would be 5 years and may include grace periods of up to six months. Lending terms to CMF and FMNM for construction of their regional beneficiation plants would be up to 12 years including 3 years of grace. These limits, which would be incorporated in the Operating Guidelines of CFM and FMNM for implementing the Special Program, have been set on the basis of a review of CFM's and FMNM's past experience, and the expected future financing needs of the target enterprises. Given the experimental nature of the Special Program, flexibility would be retained to adjust the maximum amounts and terms of financing in exceptional cases justified by adequate project cost and cash flow analysis. The recipients of CFM's and FMNM's fixed asset loans would be required to finance at least 15% of the total project cost with their own resources, except that in special cases, this requirement may be waived or relaxed by CFM or FMNM on a case-by-case basis to take account of the special charact- eristics of a project and/or client enterprise, provided, however, that the project's cash flow is still acceptable (Annexes 3 and 4). 1/ 1/ This exceptional partial waiver of the 15% rule is likely to be particu- larly applicable in the case of ejidos financed by FMNM, which may have no financial resources of their own before starting the mining operations. This partial waiver is to be applied only in cases where proven mineral reserves have substantial value to cover for reduction in equity partici- pation.  - 37 - Onlending Interest Rates and Leasing Terms 3.09 Client enterprises receiving subloans from CFM or FMNM would have the option of choosing between peso-denominated and foreign currency denominated subloans. All peso-denominated subloans made by CFM and FMNM under the project would bear a floating interest rate (to the final benefi- ciaries) of between 1.5 and 2.0 percentage points above the index of the average cost of funds, excluding savings and checking accounts, to Mexican private and mixed mixed banks (ACF index). 1/ The interest rates would be reviewed by SEPAFIN and adjusted as necessary, at least semi-annually, to reflect any movements in the ACF index to the nearest one-quarter of a percentage point. 3.10 Subloans denominated in foreign currencies are expected to be requested only by the relatively large enterprises within the eligibility limits. It was confirmed through a letter from the Borrower that onlending interest rates on dollar denominated subloans, which are expected to account for the overwhelming majority of subloans made in currencies other than Mexican pesos, would also be floating and would be at least one percentage point above the six-month LIBOR rates. Onlending interest rates on subloans denominated in other foreign currencies would be set with similar margins above a comparable international market indicator of interest rates for loans in the respective currencies. The Government and the Bank would review the interest rates for foreign currency subloans from time to time and this minimum rate would be adjusted in the light of market conditions. 3.11 The long-term leasing contracts with option to purchase signed by CFM and FMNM would be denominated in either Mexican pesos or US dollars. The monthly lease payments and prices for the purchase option would be set to ensure effective yields consistent with the corresponding interest rates on subloans. 3.12 CFM's and FMNM's regional beneficiation plants to be built under the proposed project would be expected to charge 'maquila' fees or margins between mineral purchase and sales prices sufficient to earn, over their full life, an internal financial rate of return at least equal to the interest rate payable by client enterprises on subloans, after allowing for operation and maintenance expenses of such plants. The charges would be reviewed periodi- cally and adjusted, if necessary, in order to satisfy this criterion. Institutional Arrangements and Program Coordination 3.13 In order to coordinate all the activities contemplated under the proposed SMM development program and to ensure that subprojects meet with the objectives of the program, a Coordinating Committee has been established within SEPAFIN, comprised of the Subsecretary of Mines and Energy (to act as the chairman) and five other members representing the Ministry of Finance and Public Credit, SEPAFIN, CFM, FMNM, CRM and NAFINSA. The Coordinating Committee has adopted a set of operating regulations governing its activities in connec- tion with the implementation of the Special Program, specifying the Committee's coordinating functions, and subproject review and other administrative proce- dures, in the light of the overall objectives of the Special Program (Annex 5). 1/ See Annex 6, for details of this index.  - 38 - These operating regulations have been discussed and agreed upon during loan negotiations. SEPAFIN confirmed through a letter that the Bank would be promptly notified of any significant changes contemplated in the operating regulations of the Coordinating Committee and would be given an opportunity to comiment on such changes. 3.14 According to its operating regulations, the Coordinating Committee would review in detail all financing requests in excess of Mex$ 10 million, all subprojects for regional beneficiation plants and all credits to subsi- diaries and affiliates of CFM or FMNM. It may also review, on a sampling basis, other projects submitted for financing under the Special Program in order to monitor and ensure adequate project evaluation by the implementing agencies. In its review process, the committee would be assisted by a small secretariat of 3-4 experienced professionals, to be created within SEPAFIN, reporting directly to the Director General for Analysis of Projects within that ministry. The secretariat is expected to include a geologist, a mining engineer, an economist/financial analyst, and possibly an expert on benefi- ciation plants and equipment. Additional outside specialists would be contracted whenever necessary--for example, to review subprojects for which the secretariat might not have the appropriate specialists. Members of the secretariat would also be available for technical or administrative advice, if necessary, to CFM, FMNM and CRM concerning the overall program or indivi- dual subprojects. Projected Overall Needs and Financing 3.15 Based on demand projections and cost estimates from the three implementing agencies, during the initial 2-1/2 - 3 years phase of the Special Program, total financial resources of about Mex$2.46 billion (about US$107 million equivalent) would be required. The expected distribution of the program resources among the different categories of assistance ('subprograms') and among the three implementing agencies is summarized in Tables 3.1 and 3.2 below. The estimates of program resources allocated to the various components are based on (i) projections of demand for the various kinds of assistance, including technical assistance components, and cost and time schedules for the construction of regional beneficiation plants; 1/ (ii) the implementing agencies' plans to increase their staff to process a higher volume of opera- tions; and (iii) a balance between the amounts of resources allocated to the different program components. Taking into account contributions of the sponsors to the individual subprojects, which are expected to cover about 20% of the total subprojects costs (including fixed assets and working capital), the total investments supported under this first phase of the Special Program would amount to about Mex$2.81 billion (about US$122 million equivalent). The Proposed Bank Loan 3.16 To help finance the proposed Special Program for SMM development as outlined above, the Mexican authorities requested a Bank loan of US$40 million, which would be committed in 2 1/2 - 3 years and disbursed in 3 1/2 - 4 years. 1/ Six or seven plants by CFM and three by FMNM based on the expected demand/need for such services.  - 39 - The loan would be made to Nacional Financiera, S.A. (NAFINSA) (the government development bank), acting as the agent of the government. The tentative allocation of Bank funds among the various components of the project as shown in Tables 3.1 and 3.2, is based on the disbursement percentages proposed in para. 3.18, which reflect the approximate foreign exchange content of the various expenditure categories. 1/ Counterpart local resources required to complement the proposed Bank loan would be made available from the budgetary resources of the federal government, at the estimated proportions shown in Table 3.1. Annex 14, T-23 provides a detailed breakdown, by year and project component, of the Bank and local resources to be provided under the project. 3.17 The proposed loan of US$40 million would be used to finance: (i) 130-140 subloans through CFM and FMNM for financing machinery, equipment and civil works; (ii) 150-200 long-term equipment leases with option to purchase; 2/ (iii) the construction of about 10 regional beneficiation plants; and (iv) expansion of the capacity of the project's executing agencies to provide technical assistance to SMM, through the purchase of required laboratory equipment by CFM, FMNM and CRM, and the purchase of exploration equipment by CRM to expand its exploration assistance to SMM enterprises. The loan would finance about 37% of the total resources to be made available for the Special Program for SMM development over the commit- ment period of the loan, and an estimated 30% of the total cost of the investments supported through the Program. The terminal date for submission of requests for financing would be June 30, 1983 and the closing date would be June 30, 1984 (Annex 1). Disbursement 3.18 Disbursement of the proposed Bank loan would be made to cover up to 45% of the cost of machinery, equipment and the related spare parts, and 25% of the cost of construction and civil works, including for mine development. These percentages represent the estimated average foreign exchange content of the respective expenditure categories. 3/ Only expenditures made no more than 180 days prior to the date of receipt by the Bank of the corresponding finan- cing requests would be eligible for reimbursement under the proposed loan. 1/ As indicated in the tables, no Bank financing would be provided for working capital credits and ore reserve development (evaluative explora- tion) credits, since the proportion of the foreign exchange costs involved in these categories is very low and could be financed from local resources. 2/ Purchase of equipment for leasing purposes will follow the same rigorous procedures applied in the purchase of fixed assets by CFM and FMNM. 3/ The disbursement percentage for machinery and equipment is based on he estimated distribution of the particular categories of machinery and equipment to be financed among directly imported (5%), off-the-shelf (10%) and domestically manufactured (85%) goods, and the corresponding esti- mated foreign exchange contents.  Table 3.1: ALLOCATION OF PROGRAM RESOURCES AMONG SUBPROGRAMS (All amounts in millions of Iex$, unless otherwise specifieu) Total % 2 Program Total World Distribution Financing Program Bank of Bank funds Government Subprogram 1. Credits Fixed Assets 1,030 412 618 Working capital 103 _ 103 Ore reserve development 80 - 80 Subtotal Credits 1,213 49 412 45 -ll 2. Equipment Leasing 658 27 296 32 362 3. Regional Beneficiation Plants 354 14 113 12 241 4. Technical Assistance Laboratory Equipment 131 59 72 Exploration Equipment 89 40 49 Training, Consultants, etc. 15 - 15 Subtotal Technical Assistance 235 10 _9j9 11 13k TOTAL Mesx 2,460 100 920 100 1 540 TOTAL US$ equivalnt(illion) 107.0 40.0 (at 1 us$ - 23.0 Mex$) PROPORTION OF TOTAL 100% 37.4% 62.6% Table 3.2: ALLOCATION OF PROGRAM RESOURCES AMONG EXECUTING AGENCIES (All amounts in Millions of Mex5) Bank Bank Total Financing X CFM (1) Credits Fixed assets 785 314 40.0 Working capital 79 - 0 Ore reserve development 70 - n Subtotal 934 314 3336 (2) Equipment Leasing 520 234 45.0 (3) Regional Beneficiation Plants 238 76 32.0 (4) Technical Assistance Laboratory equipment 69 31 45,0 Training, etc. 5 - 0 Subtotal 74 31 41.9 TOTAL 1,766 655 37.1 FMNM (1) Credits Fixed assets 245 98 40.0 Working capital 24 - 0 Ore reserve development 10 - 0 Subtotal 279 98 35.1 (2) Equipment Leasing 138 62 45.0 (3) Regional Beneficiation Plants 116 37 32.0 (4) Technical Assistance Laboratory Equiplment & trataing 9 4 45.0 TOTAL 542 201 37.1 Technical Assistance Laboratory Equipment 53 24 45.0 Exploration Equipment 89 40 45.0 Technical Specialists, training, etc. 10 0 TOTAL 152 64 42.1 OVERALL TOTAL 2,460 920 37.4 US5 equivalent (million) 107.0 40.0 37.4  - 40 - The proposed extension of the Bank's normal 90-day limit under DFC projects would be justified in view of the complex institutional arrangements involving three implementing agencies and a two-stage review of subprojects by the indi- vidual agencies and by the Coordinating Committee of the Special Program. Retroactive Financing 3.19 Expenditures of up to US$1.5 million made between February 1, 1980 and the date of loan signing would be eligible for financing as part of the proposed loan, subject to all other conditions as described above. The expected expenditures prior to the date of loan signing have been reviewed during loan negotiations and would form an integral part of the efforts being undertaken under the Special Program. Channeling of the Resources, and Repayment and Capitalization Arrangements 3.20 Bank resources would be transferred by NAFINSA to the three executing agencies (CFM, FMNM and CRM) as required and would remain in the respective institutions permanently. The government would repay the Bank loan and would also service the interest charges on the loan through NAFINSA (and bear the associated foreign exchange risk), thus capitalizing CFM, FMNM and CRM as the Bank loan is disbursed. The resources thus accumulating in the implementing agencies would be used for purposes similar to those under the SMM develop- ment project. During the negotiations, it was also confirmed that all the counterpart resources provided to the three executing agencies for the various parts of the project would also be retained permanently in the respective agencies in the form of capital. 3.21 In view of the above arrangements, and given the fact that the government, rather than the individual executing agencies, would assume the responsiblity for repayment of the Bank loan, the loan would be repaid accord- ing to a fixed 17-year amortization schedule including 4 years of grace. Procurement and Auditing 3.22 A wide variety of domestically produced mining equipment is avail- able to the Mexican mining sector, much of it at reasonable prices (and quality) compared with international procurement. Small compressors, for example, which represent a high proportion of components required by small mining enterprises, are produced and sold in Mexico and sell for prices that are only about 5-10% above those for foreign-made compressors of similar quality. With the exception of drills, most of the main items used by medium-sized mining firms--such as larger compressors, flotation equipment, ball mills, pumps, and crushers--are produced and available in Mexico at prices which are about 10-15% higher than those for similar items produced abroad. Even the domestically produced drills, which are on the average 25-30% higher in price than imported drills, are expected to become more competitive as some of the newly established, less competitive, industries increase their scale of operations and efficiency. 1/ 1/ Percentage price differences refer to comparisons with FOB plant prices of international suppliers.  - 41 - 3.23 Procurement procedures for goods and services financed under the proposed loan would follow the procedures customary to Bank IDF-type projects, with the three implementing agencies (CFM, FMNM and CRM) having the responsi- bility for ensuring the competitiveness, in price and quality, of items procured and their suitablility for the purpose intended. Subloan contracts signed by CFM and FMNM with the client enterprises would contain provisions to ensure satisfactory procurement procedures along these lines. In the case of goods purchased by the executing agencies for their own account (i.e., for leasing operations, regional beneficiation plants and laboratory and explora- tion equipment) in packages of goods and civil works of US$1 million or more, international competitive bidding according to Bank guidelines would be required. Individual packages of goods or civil works of US$500,000 or more would also be subject to international competitive bidding. Local suppliers woul(d be entitled to a 15 percent margin of preference or the applicable import duties and taxes, whichever is lower. Packages estimated to be less than these limits would be procured on the basis of the Government's procure- ment procedures, which have been reviewed by the Bank and include comparative price and quality evaluation of at least three bids. Given the relatively smalL size of the individual items as well as of the total procurement involved under these components, 1/ the relatively efficient domestic manufacturing sector of mining equipment, stringent government procedures which ensure that no public agency shall purchase equipment at prices higher than those posted by the manufacturers with the government, and the active participation of tlhe client SMM enterprises in the selection of most pieces of equipment for leasing, the above procurement procedures are considered adequate to ensure satisfactory price and quality competitiveness. 3.24 Satisfactory arrangements would be made for full annual audits of CFM, FMNM and CRM by reputable auditors following accounting principles acceptable to the Bank. It was confirmed during loan negotiations that the audits of CFM and FMNM would show separately the financial accounts of the individual regional beneficiation plants. Approval Limits 3.25 Prior Bank approval would be required for (i) the first three subloan proposals for mine development projects and the first three other subloan proposals processed each calendar year by CFM and by FMNM (that is, a total of twelve subloans per year); (ii) all subloan proposals involving US$400,000 or more of Bank resources; (iii) all subloans to enterprises in which CFM and FMNM have a controlling interest; (iv) the first five equipment leasing proposals in each calendar year from CFM and from FMNM (that is, a total of 10 per year) requiring US$50,000 or more in Bank resources; and (v) all financing requests for regional beneficiation plants. Under these procedures, it is expected that between one- quarter and one-third of the number of subprojects financed under the proposed loan, involving 45-50% of the total Bank financing, would be subject to prior Bank approval. 1/ In comparison with the average sizes of procurement contracts under Mexican projects and the total procurement of CFM and FMNM.  - 42 - Project Benefits and Risks 3.26 The project is expected to help significant numbers of SMM enter- prises to operate efficiently, and develop on an economically viable basis an important part ^f Mexico's mining resources, whose exploration and development have received inadequate attention in the past. As many as 300-400 SMM enter- prises can be expected to benefit directly or indirectly from the proposed project. Incremental mining output of about US$250-280 million equivalent per year may be expected to be generated through investments supported under the program. SMM development is expected to have a large favorable impact on the development of the potential of the mining sector as a whole, particularly since SMM enterprises have traditionally been responsible for the discovery of most of the large mining deposits in Mexico and have provided the base for the development of large mining companies. 3.27 As many as 14,000-16,000 incremental jobs are expected to be gener- ated as a result of investments supported through the proposed project, many of which for members of the low income groups. The median investment cost per new job created is expected to be of the order of US$7,000 equivalent for small mining enterprises and US$12,000 equivalent for medium-sized mining enterprises. Because small and medium sized mines are distributed over a wide geographical area, the project would also help the development of some of the least developed regions of Mexico. SMM development would also generate significant amounts of exports, which in recent years amounted to 40-50% of the value of mineral production. 3.28 Finally, the project would support CFM, FMNM and CRM in focusing their activities to promote and support SMM, streamline their operating policies, improve planning, and strengthen their procedures for project selection, evaluation and follow-up. Through these it would further the integrated development of the SMM sector in Mexico. 3.29 The project involves two kinds of risks. Firstly, given that it represents a major new effort in the Mexican mining sector, the implementing agencies may not be able to increase their financial assistance to small and medium-scale mining enterprises as quickly as forecast because of insufficient manpower (arising from difficulties in recruiting and training adequate numbers of professional staff) or other institutional constraints. However, in view of the steps being taken by the government to prepare the agencies concerned, the support expected to be provided by the Coordinating Committee to the implementing agencies and the specific commitments of the agencies in connection with the project, this risk is considered relatively low. The second is a market risk: if international prices for minerals should drop sharply, demand for investment financing under the project might be reduced. In view of the broad range of minerals mined by the Mexican SMM sector, and of the generally favorable outlook for most minerals, this risk seems acceptable; a majority of the SMM projects reviewed in Mexico are likely to be financially viable even if the world mineral prices were to fall by as much as 30-50% on the average, from their current level.  - 43 - IV. RECOMMENDATIONS 4.01 During loan negotiations, agreements were obtained, or understand- inlgs reached: (i) with the Mexican Government and NAFINSA on: (a) the loan amount and the provision of the required counterpart resources (para. 3.16); and (b) arrangements for channeling the proceeds of the Bank loan and the counterpart resources, repayment of the Bank loan, capitalization of the executing agencies, and retroactive financing (paras. 3.19 to 3.21). (ii) with the Mexican Government, NAFINSA (in its own capacity and as the trustee for FMNM), CFM and CRM on: (a) eligible enterprises (para. 3.05), and expenditures eligible for financing under the Special Program and under the Bank loan (paras. 3.03, 3.16 and 3.18); (b) institutional arrangements for implementing the project (paras. 3.13 and 3.14); (c) draft operating regulations of the Coordinating Committee of the Special Program (para. 3.13 and Annex 5); (d) onlending interest rates, effective yields of rental contracts, and terms for the various categories of subprojects, and criteria for fixing the tariffs/margins on the regional plants; (para. 3.09 to 3.12); (e) satisfactory auditing arrangements for CFM, FMNM, and CR1I (para. 3.24); and (f) procedures for disbursements of the Bank loan (para. 3.18). (iii) with CFM, NAFINSA acting as the trustee for FMNM, and CRM on: (a) the allocation of the Bank loan and the counterpart resources among the different institutions and project components (paras. 3.15 and 3.16); (b) draft Operating Guidelines of CFM (para. 2.32) and FMNM (para. 2.65) for implementing the Special Program; (c) maximum limits on the amounts and terms of financing provided for the various subproject categories (paras. 3.07 and 3.08);  - 44 - (d) subprojects requiring prior Bank approval (para. 3.25); (e) satisfactory training arrangements for the project evaluation staff of CFM, FMNM and CRM (paras. 2.26, 2.58 and 2.73); and (f) satisfactory arrangements for procurement (para. 3.23). 4.02 Formal approval of the Operating Guidelines of CFM and FMNM for implementing the Special Program, by CFM's board and FMNM's technical committee, would be special conditions of effectiveness of the proposed loan. 4.03 The proposed project would constitute a suitable basis for a Bank loan of US$40.0 million with a term of 17 years including 4 years of grace on conditions as outlined in Chapter III.   -45 - ANNEX1 MEXICO: SMALL AND MEDIUM SCALE MINING DEVELOPMENT-PROJECT Estimated Quarterly Schedule of Bank Loan Disbursements (US$ million) IBRD Fiscal Year Disbursements in Cumulative and Quarter (Ending Date) Quarter Disbursements 1980/81 March 31, 1981 1.0 1.0 June 30, 1981 1.5 2.5 1981/82 September 30, 1981 2.5 5.0 December 31, 1981 2.5 7.5 March 31, 1982 3.5 11.0 June 30, 1982 3.5 14.5 1982/83 September 30, 1982 4.5 19.0 December 31, 1982 4.5 23.5 March 31, 1983 4.5 28.0 June 30, 1983 a/ 4.5 32.5 1983/84 September 30, 1983 4.0 36.5 December 31, 1983 2.0 38.5 March 31, 1984 1.0 39.5 June 30, 1984 b/ 0.5 40.0 a/ Terminal date for submission of subprojects. b/ Closing date. LCPI2 February 1980  - 46 - M,INEX 2 MEXICO: SMALL AND MEDIUM SCALE MINING DEVELOPMENT PROJECT Chronology of.Mexican Mining History Legal and Institutional Development of Education and Development Use of Technology 1532 First mine in Taxco, Guerrero 1535/37 Mint in Mexico 1718 Prohibition to produce mercury to protect Spanish mines. 1759 Mint in Guanajuato 1777 Foundation of the "Real Tribunal del Importante Cuerpo de la Miner- ia" and of the first "Camara Minera" in Mexico 1783 The King of Spain issues the first 1784 Foundation of the "Real Mexican Mining Law, the "Reales Or- Seminario de Mineria" denanzas para la Direccion, Regi- men y Gobierno de Importante Cu- 1790 Start of operations of the erpo de la Mineria" Royal Seminary of Mining First use of mules in the beneficiation of ores, re- placing men. 1792 Reorganization of the Royal Seminary into the "Colegio de Mineria en Mexico" 1805 The Mining Tribunal orders the first steel producing furnaces to be built 1808 Mints in Durango and in Zacatecas 1813 The mining building, latcr the national school of * ,in- eering, is inaugurated in Ncxic 1822 First importation of 3team engines from England for mining 1823 The First Congress of the Republic allows foreigners to acquire mining property 1824 Joint mining ventures with German and English companies  - 47 - A.TXFX 2 Picwo 2 1853 Foundation of the "Practical Mining School" (Escuela Prac- tica de Minas) in Fresnillo, Zacatecas 1865/67 Activities of the Scientific Commission under Maximilian of Austria 1877 First use of compressed air for perforation 1884 The Mining Code (Codigo de Mineria) was issued, a li- beral law, that resulted in a number of new min