Tanzania - Mufindi Pulp and Paper Mill - Technical Assistance and Energy Conversion Project

Document of The World Bank Report No. P-3546-TA REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A PROPOSED DEVELOPMENT CREDIT OF SDR 16.7 MILLION (AN AMOUNT EQUIVALENT TO U$$18 MILLION) TO THE UNITED REPUBLIC OF TANZANIA FOR THE MUFINDI PULP AND PAPER MILL - TECHNICAL ASSISTANCE AND ENERGY CONVERSION PROJECT May 2, 1983 This report may not be published nor may it be quoted as representing the views of the World Bank. The World Bank does not accept responsibility for the accuracy or completeness of the report.-  CURRENCY EQUIVALENTS Currency Unit = Tanzania Shilling (TSh) TSh 1.00 = US$0.107 US$1.00 = TSh 9.43 US$1.00 = SDR 0.927 (As the Tanzania Shilling is officially valued in relation to a basket of the currencies of Tanzania's trading partners, the USDollar/Tanzania Shilling exchange rate is subject to change. Conversions in this report were made at US$1.00 to TSh 9.43 which was the level set in the most recent exchange rate adjustment in March 1982. The USDollar/SDR exchange rate used in this report is that of March 31, 1983.) WEIGHTS AND MEASURES 1 metric ton (t) = 1,000 kilograms (or 2,204 pounds) i meter (m) = 39.37 inches 1 cubic meter (3) = 35.31 cubic feet 1 kilometer (km) = 0.621 mile 1 hectare (ha) = 2.47 acres ABBREVIATIONS AND ACRONYMS CDC - Commonwealth Development Corporation KfW - Kreditanstalt fur Wiederaufbau NDC - National Development Corporation NIB - Nordic Investment Bank OMC - Operating Management Contract (Contractor) SIDA - Siwedish International Development Authority SPB - Seshasayee Paper and Boards Limited, India SPM - Southern Paper Mills Company Limited Stothert - Stothert International Corporation, Canada TAC - Tanzania Audit Corporation TANESCO - Tanzania Electric Supply Company TANZAM - Tanzania-Zambia Highway TAZARA - Tanzania-Zambia Railway Authority TWICO - Tanzania Wood Industry Corporation ]FISCAL YEAR Government - July 1 to June 30 NDC and subsidiar:Les: January to December 31  FOR OFFICIAL USE ONLY TANZANIA MUFINDI PULP AND PAPER MILL - TECHNICAL ASSISTANCE AND ENERGY CONVERSION PROJECT Credit and Project Summary Borrower: United Republic of Tanzania Beneficiaries: National Development Corporation (NDC) and Southern Paper Mills Company Limited (SPM). The Government would make the proceeds of the credit available through NDC to SPM as shareholder equity. Amount: SDR 16.7 million (US$18 million equivalent). Terms: Standard. Project Description: The project would assist SPM to manage and operate the Mufindi Pulp and Paper Mill, which is currently under construction, and to market its output. The project would (i) provide SPM with expatriate management services for six years, including about one year prior to the start-up of the first paper machine in July 1984, (ii) convert the existing power boiler from dependence on oil/coal to one that can also use fuelwood from the nearby Sao Hill forestry plantations, and provide SPM with related wood harvesting and transport equipment and (iii) supply imported fuel and pulp to the mill for the first six months of operation, and other materials and supplies (chemicals, spares, consumables, etc.) for about the first three years of operations. Benefits: The project would allow Tanzania to operate its largest industrial facility based on local resources and to achieve significant foreign exchange benefits through import substitution and export earnings. On a sunk cost basis, the project would have an economic rate of return of 20%. The project would also facilitate steady progress towards output levels, export sales and training targets necessary for ensuring financial self-sufficiency for the Mufindi pulp and paper mill and eventual replacement of expatriate staff with Tanzanian personnel. Risks: The project would face significant risks, including the mill's possible inability to reach assumed levels of capacity utilization for exogenous reasons, such as the lack of imported supplies and I This document has a restricted distribution and may be used by recipients only in the performance ofJ their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  - ii - transportation bottlenecks. Domestic demand for pulp and paper products may rise more slowly than expected as a result of slow overall growth in the economy, and the mill may not be able to penetrate new export markets sufficiently to sell all of its output and generate adequate foreign ex-hange to meet its long term import requirements. Some of these risks would be addressed directly through financing of the mill's initial import nteeds and ensuring it ready access to foreign exclhange resources through a specia L external acc-ount. The operating management firm would receive significant bonuses for good sales perf ormance and has considerable knowledge of a key export mnarket (India). There is also a risk that Tanzania personnel may not be able to replace all internationally recruited staff over a six-year period. The operating management firm would have specific training incentives in its contract, which should reduce this risk. Extensive trai-ning of Tanzanian personnel has also been undertaken under the existing project. Estimated Local Foreign Totatl Project Costs:1 -US$ million--------- Operating Management Servicas 3.5 18.9 22.4 Energy Conversion Boiler 0.3 2.5 2.8 Fuelwood Harvesting 0.3 4.0 4.3 Import Requirements - 10.0 10.0 Sub-total 4.1 35.4 39.5 Contingencies: Physical 0.4 1.2 1.6 Price 0.5 3.4 3.9 Total 5.0 40.0 45.0 Financing Plan: Local Foreign Total ---------US$ -million--- IDA - 18.0 18.0 SIDA - 13.5 13.5 Federal Republic of Germany (KfWt) - 8.5 8.5 Government 5.0 - 5.0 Estimated Disbursements: IDA Fiscal Year 1984 1985 1986 1987 1988 1989 1990 -US--------------us$ million------------------ Annual 3.4 3.8 5.1 2.6 1.6 1.1 0.4 Cumulative 3.4 7.2 12.3 14.9 16.5 17.6 18.0 'The project would be exempted from identifiable taxes and duties.  - iii - Rate of Return: 5% (on basis of full project cost); 20% (on basis of treating all previous expenditures as sunk costs). Staff Appraisal Report: No separate Staff Appraisal Report has been prepared. Map: IBRD Map No. 13486.   INTERNATIONAL DEVELOPMENT ASSOCIATION REPORT AND RECOMMENDATION OF THE PRESIDENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED CREDIT TO THE UNITED REPUBLIC OF TANZANIA FOR THE MUFINDI PULP AND PAPER MILL - TECHNICAL ASSISTANCE AND ENERGY CONVERSION PROJECT 1. I submit the following report and recommendation on a proposed credit to the United Republic of Tanzania of SDR 16.7 million (US$18.0 million) equivalent on standard terms to help finance the Mufindi Pulp and Paper-Technical Assistance and Energy Conversion Project. The proceeds of the credit would be passed on to the National Development Corporation and Southern Paper Mills Company as equity. PART I - THE ECONOMY 2. The last economic memorandum on Tanzania (Report No. 3086-TA) was distributed to the Executive Directors on January 23, 1981. A revised memorandum, based on the work of two economic missions which visited Tanzania in July and September 1982, will be issued in late 1983. Background 3. At Independence in 1961, Tanzania (then Tanganyika) was one of the poorest countries in the world. Almost solely dependent on subsistence agriculture and a few estate crops, the country had a very modest indus- trial base (less than 5% of GDP), and a very small number of educated and trained personnel. For the first six years after Independence, the Govern- ment's development objectives resembled those of many other less developed countries, stressing growth in per capita income and national self-suffi- ciency in skilled manpower, based on market forces and capital intensive agricultural projects. This approach had a number of drawbacks, such as high investment costs in the agricultural sector, and led in the Govern- ment's view to unacceptable economic and social conditions, such as widen- ing income differentials and unequal opportunities for advancement in the rural areas. In response to this situation, the national development strategy was reassessed in 1967. The new priorities, enunciated in the Arusha Declaration and related policy statements, were directed towards establishing a socialist society, with greater emphasis on broad-based rural development, self-reliance in development efforts, and the intro- duction of mass education. To accomplish these ends, the State, with guidance from the Party, was expected to play the leading role, especially in the reform and creation of appropriate institutions. This led in the late 1960s to the nationalization of large-scale industry, commerce and finance, the creation of numerous parastatal bodies, the formation of ujamaa (cooperative) villages, the decentralization of Government (1972), and the mass campaign of villagization (1974-76).  4. Despite some disruption arising from these major institutional changes during the period, Tanzania managed to show improvements both in social welfare and in macroeconomic performance. Primary School enroll- ments increased by more than 50%, life expectancy rose by almost 5 years, and access to safe water increased in both the rural and urban areas. GDP grew by 4.4% per annum from 1966 to 1973, investment averaged 24% of GDP from 1970 to 1973, and domestic resource mobilization :improved with recur- rent revenues rising from 15% of GDP in 1967/68 to 19% in lthe mid 1970s. However, the productive sectors grew slowly and the rate oiF return on new investments (which was centered on the industry and transport sectors) was poor. Perhaps the principal disappointment was in agriculture, the domi- nant sector in the economy, which grew by only 2.3% per anium from 1966 to 1973. This growth was also uneven among regions and precluded any narrow- ing of rural-urban income differentials. Tanzania made rapid progress towards localizing key posts in the economy, but large gaps in manpower requirements remained. DependerLce on foreign aid to finance both domestic investment and the widening balance of payments gap also increased. By 1973, the issues which were to be so important for Tanzania throughout the 1970s and early 1980s were becoming clear: How quickly could a country with limited trained personnel develop a strong and efficient centrally administered economy? The Government's emphasis on equity was often at the expense of efficiency and incentives; how long could the country afford these costs? What could be done to improve theX growth rate of the monetized, productive sectors? 5. The oil price increases and world recession of 1973-74 coincided with two years of below average rainfall in Tanzania. Agricultural produc- tion also was affected by disruptive changes in the rural areas at this time (decentralization and villagization), and there was a serious short- fall in foodgrain production. The Government was forced into the world market, making large purchases of foodgrains for cash. Export crop production also fell during this period and the barter terms of trade dropped by about one-third during these two years. As a result, the current account deficit rose from US$118 million in 1973 to around US$340 million in both 1974 and 1975. Domestically, the recurrent budget fell into deficit and Government bank borrowing rose from TSh.416 million in 1973/74 to TSh.1061 million in 1]975/76. 6. The Government prepared a program to deal with at least the short-term effects of the crisis and was able to receive some assistance from the IMF and a program l-oan from the Bank. Under this program, import levels were tightly restricted, wages were frozen, government development expenditures were redirected towards the productive sectors, and the Tanzanian shilling was devalued by 10% against the SDR. Producer prices for food crops were substant:ial:Ly increased and at the same time, the National Milling Corporation (NMC) was instructed to purchase a number of drought-resistant crops such as cassava, sorghum, and pigeon peas in addi- tion to the usual foodgrains like maize. While these steps were taken to increase food production, they also discouraged the production of export crops, weakened the financial position of NMC and required the banking system to extend large amounts of credit to NMC. Aside from the devalua- tion, little scope was given to market forces and Tanzania made no basic changes in its system of administered prices and government controls. The basic weaknesses of the economy persisted: declining export volumes,  - 3 - limited trained manpower, disappointing growth in the monetized and productive sectors, and poor maintenance of existing capital stock and infrastructure, especially in agriculture and transport. 7. Nonetheless, the Government program, boosted greatly by the coffee boom of 1977, additional foreign assistance and reasonable weather for agriculture, was able to keep the economy in balance until 1978. During 1978, the overly stringent import controls were relaxed at the same time as the terms of trade began to deteriorate again. The balance of payments went into deficit and foreign reserves were drawn down. Then, in October 1978, the country was invaded by forces from Uganda. The resulting war, the oil price increases of 1979 and flooding and drought in different parts of Tanzania led to a worsening balance of payments deficit and the Government built up major arrears on its import payments for the first time since Independence. The domestic budget fell heavily into deficit as expenditures (led by defense) rose by 50% from 1977/78 to 1978/79 and revenues improved by only 10%. As a result, Government borrowing from the banking system increased from TSh. 600 million in 1977/78 to more than TSh. 3,000 million in 1978/79. Such borrowing was the major factor in money supply growth, which exceeded 53% in this period. 8. According to the official National Accounts statistics, GDP in constant prices has risen by 4.7% per annum since 1966, and by a slightly higher rate of 5.1% per annum over the past six years. However, this latter trend assumes an 8.6% per annum increase in subsistence agriculture, which seems somewhat overstated in the light of Bank Group project experience and the known marketed surpluses of food. Assuming a more realistic growth rate of 4.0% per annum for subsistence agriculture, overall GDP growth since 1973 would also be reduced to 4.0% per annum. With population growing by around 3.3% per annum, this implies an increase in per capita GDP of only 0.7% per annum. There also has been a change in the structure of the economy over the past seven years, away from the productive monetary sector and towards subsistence and service activities. Excluding public administration, commercial services and trade, the monetary sector has grown by only 2.3% per annum over the past seven years, well below the population growth rate. This change in the structure of the economy has been a major factor hampering the Government's efforts to mobilize domestic resources. 9. Although Tanzania has sustained a high investment ratio, this has not been matched by a similar success in the mobilization of domestic savings or in the return on investments. Up to the mid-1970s, foreign savings had financed 20%-40% of domestic investment. However, the depend- ence on foreign savings- rose sharply to more than 60% of domestic invest- ment during the crisis years of 1974-75 and again from 1978. The major shortfalls in domestic savings have occurred in the Government sector, where they have actually been negative in some years since 1975. The low return on investments is reflected in the incremental capital-output ratio for the monetary sector, which was around 4.5 at the start of the decade and rose to between 6 and 7 by 1980. 10. Agriculture remains the most important sector in Tanzania, accounting for 90% of total employment, 50% of GDP and 80% of exports. The long-term trend growth rate of agricultural production has hardly kept pace  with population growth and apparently has fallen in more recent years as the initial expansion of export crop production (through the mid-1960s) has been reversed. This poor performance cannot be adequately explained by the limitations of the natural environment. Although the importance of rural development has continuously been highlighted in Government statements, including the Arusha Declaration and successive plans, this has not always been reflected in the allocation of resources to the agricultural sector or in policy formulation and implementation. The general direction of the Government's post-Arusha agriculture strategy has also tended to emphasize the transformation of the institutional structure of rural development (through the formation of villages and increasing public involvement in the sector) over measures designed to improve agricultural production direct- ly. Many of these institutional changes were introduced too rapidly, with- out careful planning or sufficient recognition that by themselves they could not compensate for inadequate incentives and shortages of skilled manpower and managers. More recently there has been a greater awareness of the role of incentives, and recent price adjustments attest, to the Govern- ment's willingness to use them to influence the pattern of agricultural production. Available manpower, however, is still stretche!d rather thinly throughout the sector, mainly because of the predominant role assigned to the public sector. This has resulted in weakened capacity for policy planning and implementation, especially in the areas of research and extension, and deficient distribution of fertilizers and other on-farm supplies and equipment. Another factor underlying the poor performance of agriculture has been the deterioration of transport services. Road, rail and water services have declined. owing to a lack of spare parts, poor maintenance and inadequate planning and management. The Current Balance of Payments Crisis and Medium Term Prospects 11. The slow growth in. agricultural production, transport bottlenecks and external shocks described above have all contributed to the severe deterioration in the balance of payments over the past three years. Export volumes have fallen to a level one-third below the peaks of the mid-1960s and early 1970s. Furthermore, the terms of trade have decLined by 27% since the coffee boom of 1977, due to a sharp increase in import costs, especially for petroleum, at. a time when the overall level of export prices has been rising very slowly. Oring to these adverse developments, the purchasing power of Tanzanias's exports in 1980 was one-third lower than in 1977 and only one-half of tbhe 19166 level. Part: of this shortfall has been offset by additional external resources, including a sharp increase in commodity and program aid to more than US$200 million in 1980, as well as by drawings under the IMF st:andby program concluded in September 1980. But Tanzania has also had to utilize large amounts of excepticonal financing, including suppliers' credits and an increase in import payment arrears. Despite this, the volume of imports has had to be severely curtailed, and in 1982, was still no higher than in the mid-1970s. 12. Given the deterioration in international commodity prices, as well as the limited SCOpE! for further exceptional financing, there is little immediate prospect for an improvement in the balance of payments. This continuing balance of payments constraint is inevitably having a debilitating effect on the economy, with lower imports reducing production. and maintenance of existing assets, resulting in further falls in exports  - 5 - and available foreign exchange. This vicious circle will be difficult to break, unless there is a substantial injection of foreign exchange and major improvements in producer incentives, parastatal operations, import allocations, the promotion of non-traditional exports, and overall government planning and budgeting. In March/April 1981, the Government introduced a number of significant measures--such as higher producer prices for coffee, sisal and tobacco and the establishment of a Special Agricultural Account at the Bank of Tanzania to ensure that a substantial proportion of foreign exchange earnings are returned to the agricultural sector. This Export Rehabilitation Program was supported by a US$50 million credit from IDA (Cr. No. 1133-TA). 13. During negotiations of the Export Rehabilitation Credit in March 1981, agreement was also reached on a Memorandum of Understanding on Follow-Up Measures. These included more restraint and selectiveness in the public investment program, more emphasis in the recurrent budget on the operations and maintenance needs of the economy, improved foreign exchange budgeting, a re-examination of the roles (particularly purchasing mandates) of the State-owned crop authorities, the introduction of more payment-by- results schemes in industry and a review of subsidy and cost recovery arrangements in the public sector. The Government also agreed that an independent Advisory Group would be established to assist the Government in preparing a comprehensive program of economic rehabilitation and recovery. 14. The Advisory Group began work in November 1981 and completed its Report in April 1982. The Government adopted a large number of its recommendations and incorporated these in a Structural Adjustment Program which was issued in July 1982. This Program includes a series of important initiatives and proposals. The development budget for 1982/83 has been substantially cut back for the second year in a row to release resources for the operations and maintenance needs of the economy. Difficult decisions have been taken in the light of limitations on available foreign exchange and physical resources. The price control system has been reviewed and food marketing arrangements are to be reorganized. The Government has begun to allocate a larger, though still inadequate, share of foreign exchange resources to agriculture through the Special Agricultural Account established under the Export Rehabilitation Program. Agricultural producer prices have been adjusted to maintain them broadly constant in real terms, and the Government has announced its intentions to relax restrictions on interregional trade. It has also opened up the marketing of some funds (mainly minor grains such as millet) to anyone interested in conducting such trade. Special steps are being taken to control Government recurrent spending and to reduce parastatal losses. The functions of key agricultural agencies are being reduced and will be taken over by other bodies, such as cooperatives. All of these measures will serve to trim overall burdens on the public sector and give further encouragement to smallholder production. 15. However, while most of the key issues of economic recovery have been raised in the Government's Structural Adjustment Program, important decisions remain to be taken on matters such as the exchange rate and real adjustments to agricultural prices. Furthermore, the Government has yet to complete the preparation of specific action programs in key sectors (e.g. transport) which would have a measurable impact on production. In  - 6 - the most important economic sector - agriculture - a Presidential Commission has recently prepared a detailed set of recommendations, and a Government policy paper on agriculture has been issued. Measures proposed include the elimination of most consumer food price subsidies, reduction in the field marketing responsibilities of the export crop parastatals, relaxation of import procedures for agricultural inputs and equipment and the strengthening of researc]n and extension services. However, follow-up work is still needed to permit implementation of some of these measures and to define appropriate policiess in other key areas, especially the decentralization of input distribution and the diversification of crop marketing channels. Further work is also necessary in estimating the resource requirements of a medium term adjustment program and indicating precisely how domestic and foreign exchange budgets will be administered to support the program. 16. A Bank economic mission reviewed the Government's program in September/October 1982. The recommendations of the Government's Agricultural Commission, and an agricultural sector report prepared by Banlk staff were also discussed with senior Government officials in Dar es Salaam in March 1983. Bank staff will assist the Government during the next few months in further strengthening its proposed agricultural rehabilitation program. 17. Discussions with the IMF on a possible Standby Arrangement are continuing. Tanzania has ha,l no access to Fund facilities since December 1980, when the Government failed to meet performance targets under a previous Standby. Following three rounds of discussions in May, June and August 1982, the Government invited a Fund mission to visit Dar es Salaam for three weeks in October 1982. No agreement was reached during this mission, particularly on the appropriate magnitude of an exchange rate adjustment, and discussions were resumed briefly in Washing/ton in March 1983. An IMF mission visited Tanzania again for Article IV consultations in April 1983. 18. Even with a much improved export performance, Tanzania will continue to face a very difficult balance of payments situation, especially over the next three to five years. To sustain an increase in per capita GDP will require increasing amounts of aid in real terms and a careful review of import requirements, especially those for low-priority projects with long gestation periods and high foreign exchange costs. Otherwise the prospects would be for generally stagnant economic activity over the 1980s as a whole, with a substantial decline in per capita incomes. To avoid this, there will need to be continued emphasis on export performance and a concerted effort to improve the level of capacity utilization and effi- ciency in the economy. Furthermore, this must be done without jeopardizing vital food production. 19. Although it may be possible to finance a small portion of the current account gap through commercial borrowings, the scope for this is clearly limited; in addition to the difficulties of raising commercial credit during a period of balance of payments problems, Tarnzania simply cannot afford the heavy burd,en of debt service payments. Therefore, the bulk of the financing requirements will have to be met by additional foreign assistance. Possible sources for this include further drawings  from the IMF (which could add US$100 million per annum), deferred payment arrangements and other concessional financing from oil-supplying countries, additional new commitments from traditional bilateral and multilateral sources, and a continued movement towards non-project assistance. External Debt 20. Owing to the very concessional terms on which past aid has been given to Tanzania and the Government's previous reluctance to use higher cost commercial loans and suppliers' credits, the country's overall debt service ratio has historically been less than 10%. However, the debt service burden is expected to increase as past loans fall due for repayment and new borrowings, including some on commercial terms, are required to meet the widening balance of payments gap. Such borrowings, together with very poor export prospects, could raise the debt service ratio to 15%-20% during the 1980s. In 1981, it is estimated that the Bank held 14% of Tanzania's external debt outstanding and disbursed (for the Bank Group, it was 33%) and the Bank Group received 21% of Tanzania's debt service. Including Tanzania's share of obligations under East Africa Community loans, the Bank's exposure was 17% (and the Bank Group share, 36%). This level of Bank exposure reflects in part the impact of recent debt write-offs, totalling US$277 million in 1978 and 1979. We are projecting the Bank Group's share in debt service to fall over the coming decade owing to the reduced IBRD component in the lending program and the continued need for Tanzania to borrow funds on less concessional terms from other sources. PART II - BANK GROUP OPERATIONS IN TANZANIA 21. Tanzania joined the Bank, IDA and IFC in 1962. Beginning with an IDA credit for education in 1963, 54 IDA credits and 19 Bank loans, two of these on Third Window terms, amounting to US$1046.8 million have so far been approved for Tanzania. In addition, Tanzania has been a beneficiary of 10 loans totalling US$244.8 million which were extended for the development of the common services and development bank operated regionally by Tanzania, Kenya and Uganda through their association in the East African Community. IFC investments in Tanzania, totalling US$4.7 million, were made to the Kilombero Sugar Company in 1960 and 1964. This Company encountered financial difficulties and in 1969, IFC and other investors sold their interest in the Company to the Government. A new IFC investment of US$1.7 million in soap manufacturing in Mbeya was approved by the Executive Directors on June 8, 1978 and an investment of US$1.5 million in metal product manufacturing was approved in May, 1979. Annex II contains summary statements of Bank loans, IDA credits and IFC investments to Tanzania and the East African Community organizations and notes on the execution of ongoing projects. 22. Bank Group lending in Tanzania has been centered on: (i) agriculture; (ii) transport and communications; (iii) industry; and (iv) education and manpower development. Since FY81, new Bank Group lending has been focussed primarily on rehabilitation and use of existing productive facilities and the introduction of infrastructure and services (such as power generation and education facilities) of long term use to the economy. Projects have been designed to minimize new demands on the Government's recurrent, development and foreign exchange budgets; have been  - 8 - centered on already experienced or financially healthy institutions; have been logistically insulated, as far as possible, from general supply difficulties in the economy; and have included considerable technical assistance and training for better maintenance and use of existing capital facilities and more effective resource allocati on in the economy. Recent lending along these lines has included a seconcd petroleum exploration project, a third technical assistance credit (focussed on key manpower gaps in the agricultural sector), and a rehabilitati-on project i-or the Dar es Salaam sewerage system. 23. A small number of other projects may be proposed in the agriculture, energy and transport sectors during the next three years. A fourth power project, a rehabilitation program for the port of Dar es Salaam and an eighth education project have been appraised. A sixth highways project, involving mainly the reconstruction of sections of the Tanzania-Zambia highway, and a sugar and cotton rehabilitation project are also under preparation. However, the design of viable pro jects in the productive sectors of the economy, especially aLgriculture and industry, will remain problematical iDn the absence of a wide ranging economic adjustment program. 24. In addition to financing specific prcjects, the Bank Group has provided non-project assistance on three occasions in support of Government efforts to deal with its balance of payments dif-ficulties. The first such Credit was made in 1974, the second in 1977, ancd the most recent, an Export Rehabilitation Program Credit (No. 11.33-TA), in April 1981. 25. Project implementation in Tanzania has been adversely affected during the last four years by the disruptions of the Uganda. War and the country's extreme foreign exchange difficulties, which haves resulted in shortages of fuel and building materials, even when budgetary allocations for, purchasing them have been adequate. External financing agencies have been increasing the share of direct and indirect foreign exchange costs covered by project budgets; however, it is impossible to cuishion projects completely, particularly in remote areas, from the ramifications of the economic crisis. Despite implem[entation difficulties, disbursements have remained remarkably steady; Bank Group disbursements grew from US$58 million in FY78 to US$81 million in FY81 and reached US$114 million in FY82. A comparison with other portfolios in the Eastern Africa Region indicates that Tanzanian disbursements have been slightly below average for the Region, ranging as a proportion of outstanding commiitments at the start of the financial year, from 18.9% in 1976 to 15.7% in 1980 (compared with 20.6% and 16.5% in the same years for the Region as a whole). 26. Supervision missions have been concerned with adapting project implementation to difficult factors facing the country or individual sectors, which were not anticzipated or have proved worse than expected at appraisal. A major Country Implementation Review was held in Dar es Salaam in October 1982 during which Government officials and Bank staff agreed to recommend the restructuring or discontinuation of several projects which have faced persistent implementation problems. At the same time it was agreed that the Project Implementation Monitoring Unit at the Ministry of Planning and Economic Affairs would be strengthened as a focal point for further consolidation and imi?rovements in the Bank Group program.  - 9 - Intensive supervision, and in the case of the Mufindi Pulp and Paper Project, timely assistance from co-financiers have already had some remedial results. Even in the agricultural sector, where constraints on implementation have been most severe, there have been important improvements in some projects, e.g. Dairy Development. However, considerable work remains to be done in improving project implementation and disbursements. The next Country Implementation Review will be held in October 1983. East African Community (EAC) 27. Developments affecting the East African Community (EAC) were outlined to the Executive Directors in a memorandum, dated December 29, 1977, (R77-312) and in a statement made on May 6, 1980 (Sec M80-364). One of the positive results of the ongoing mediation effort has been the Partner States' decision, taken upon the mediator's recommendation, that the East Africa Development Bank (EADB) -- one of the former Community's institutions -- should continue, and a revised charter to this effect has been enacted. The three Governments commented on the mediator's proposals for the three Partner States during their meeting in Nairobi in July 1981, and decided to commence negotiations based on the mediator's proposals. The negotiations started in December 1981 in Arusha and continued in April 1982 in Jinja, September 1982 in Nairobi and December 1982 in Kampala. The discussions have passed the fact finding stage and are now focussing on details of a division formula for assets and debts. While it is generally accepted that both location of assets and the principle of equal rights of all former EAC partners should be taken into account, the weight to be given to these principles from case to case remains the major issue in the continuing negotiations. PART III - THE INDUSTRIAL SECTOR 28. At Independence in 1961, Tanzania had only a rudimentary industrial structure, with cotton ginning being the single largest manufacturing sub-sector. Total manufacturing employment was only about 20,000 out of a total labor force of around 5 million and manufacturing and handicrafts together contributed less than 5% of GDP. 29. With the new orientation of economic policies after the Arusha Declaration of 1967, industrial development became a major concern of the Government, the primary focus being on import substitution in essential consumer goods and meeting the basic needs of the population. The Basic Industrial Strategy, which was adopted by the Government in 1974, provided the guidelines for restricting the range of products by placing emphasis on the use of domestic resources in the production of import substitutes. Major manufacturing plants were brought under the newly established Government parastatals (companies), and these parastatals became the leading investors in medium and larger scale industrial units. However, even with the increase in parastatal activity, the private sector still accounted for more than two thirds of manufacturing value added.  - 10 - 30. The expansion of public ownership of manufacturing enterprises has been accompanied by increasing reliance on direct controls in allocation decisions. Components of the control system include centralized decision making on investments, detailed allocations of foreign exchange through import licensing, credit allocations according to the annual Finance and Credit Plan, wage setting, and price controls. 31. The growth of industry until the early 1970s was significant. During 1966 to 1973, the manufacturing sector grew by 7.82 per annum and its share in total GDP incr,sased from 8% to 11%. The major contributions to this growth came from the newly developed large-scale industries. However, even before the impact of the adverse events of the mid-1970s, the growth rate was beginning tD slow. Furthermore, despite the emphasis on the development of industries producing capital and intermediate goods, the dominant activity remained the production of consumer goods: by the mid-1970s, basic consumer goods--viz. food processing, beverages, tobacco, cotton, textiles and shoes--still accounted for more than one-half of value added and two-thirds of empLoyment in manufacturing. 32. After 1973, the performance of the industrial sector deteriorated in the wake of steep increases in the prices of imported commodities and the acute balance of paymenls problem. From 1973 to 1979, manufacturing value added grew by only 1.7% per annum in real terms, with an actual decline of 5.2% in 1979; as a result, in 1980 value added was no higher than in 1973. 33. The principal problems facing the industrial sector at present are the critical shortage ol- foreign exchange and low capacity utilization. In 1981, due 1:o tihe lack of foreign exchange, manufacturing enterprises received only 14% of their requested imports of raw materials compared to 50% in 1978, andl this was further reduced in 1982. At the same time, despite the stagnation in output, investment in new capacity increased sharply after 1975 and more than tripled over the next four years. With rising import prices, the foreign exchange allocated to industry simply has been too small to allow firms to operate efficiently. As a result, with the exception of firms producing beer and cigarettes where capacity utilization iis high, average capacity utilization has now dropped to 30% compared to 70% in 1978. Other factors such as interruptions in power and water supplies, inadlequate and costly transport, machinery breakdowns, lack of skilled labor andi experienced management, and irregular supplies of domestic inputs have also constrained industrial output. Employment, however, continued to grow by more than 8 percent per year between 1973 and 1979, despite the dismal trend in output. The decline in productivity which this implied was particularly noticeable among the parastatals. 34. Manufacturing exports accounted for only 6% of total exports in 1978. Since 1978, the Government has given prjiority to industrial export promotion and has achieved some success. The value of manuafactured goods exports increased from about: US',30 million in ]978 to US$815 million in 1980 and were an estimated US$62.5 mi'llion in 1981. Most of this increase has been through the expansion of trade with neighboring countries under bilateral trade agreements. The difficulty with this pattern of trade is that most of these countries are experiencing severe balance of payments  - 11 - difficulties and payments to Tanzania in hard currencies are problematical. Tanzania has also begun discussions and concluded bilateral trade agreements with various Eastern European countries. 35. Faced with a deepening economic crisis, the Government is showing flexibility in the implementation of some of its policies. The Government's Structural Adjustment Program of 1982 recognizes the shortcomings of past policies and the need to rationalize and streamline the country's industrial structure, including the possibilities of postponing, redesigning and cancelling some existing projects and closing down inefficient firms. At the same time, the Program gives priority to increasing the capacity utilization of the efficient firms producing essential goods for the domestic market and completing projects based on local resources with significant export potential (e.g. Mufindi). The coverage of price controls has been substantially reduced from over 2,000 to around 500 items. Furthermore, enterprises have been encouraged to introduce payment-by-results schemes and to boost labor productivity. Under the IDA financed Export Rehabilitation Program (Cr. No. 1133-TA) approved in 1981, the Government introduced a number of specific measures to encourage nontraditional exports, including a cash export bonus scheme. National Development Corporation and the Southern Paper Mills Company 36. The National Development Corporation (NDC) and its subsidiary, the Southern Paper Mills Company (SPM), are the co-sponsors of the proposed project. NDC was the sponsor of the Mufindi Pulp and Paper Project (Mufindi Project) financed by the Bank and IDA (Loan No. 1650-TA/Credit No. 875-TA) in 1979. SPM, which is responsible for the implementation and operation of the Mufindi project, would be the ultimate beneficiary of the proposed credit. 37. NDC was established in 1964 with its headquarters in Dar es Salaam. It is Tanzania's largest parastatal holding company, in terms of total investment, with its plants effectively operating as separate legal and financial entities, and the country's principal instrument for industrial investment until the Government reorganization of the industrial sector which took place during 1979/80. 38. In 1979/1980 new corporate groups were established to be independent of NDC. All leather tanning and processing companies formed the "Tanzania Leather Associated Industries" (TLAI); paper converting, printing and publishing companies were grouped together as the "Tanzania Karatasi Associated Industries" (TKAI); the Tanzania Cigarette Company and Tanzania Breweries became autonomous organizations reporting directly to the Ministry of Industry; Tanganyika Instant Coffee was transferred from NDC to the Tanzania Coffee Authority (TCA); chemicals and allied products companies formed "The National Chemical Industries" (NCI); and, all motor vehicle activities were transferred from NDC to the State Motor Corporation. 39. NDC's ten-man Board of Directors functions as a policy making and controlling body as well as a liaison and coordinating group between NDC and the Government. The influence of the Government on financial and investment planning is strong, although there is little direct involve-  - 12 - ment in day-to-day operational matters. NDC is: well managed and has demonstrated great competence in. the implementation of the Mufindi Project. NDC has 227 staff (excluding the employees in subsidiary companies) of whom 98 are professionals (including two expatriates) serving in five operating departments: -- (i) Planning aLnd Finance; (ii) Accounting; (iii) Manpower Development; (iv) Administration; and (v) Inuustrial Development. The Industrial Development Department, which prepares and implements projects for NDC as well as monitors existing operations, is organized into five Divisions, each responsible for a specific group of sectors of NDC's activities. This Department, together with SPM, is responsible for the implementation of the Mufindi Project. 40. NDC holds shares in 13 operating companies of which 12 are classified as subsidiaries (over 50% NDC shareholding). Its total portfolio is currently Tshs 488.5 million (US$52 million). The 13 companies operate in the fields of metal working, mechanical and electrical engineering employing a total of 4,200 people. The consolidated operations of the NDC Group companies have been profitable every year since 1975. The overall capitalization of NDC had a debt/equity ratio cf 7/93 as of December 31, 1981. 41. SPM was formed as a limited liability company under Tanzanian industrial and commercial laws. Its initial authorized share capital of TSh 10 million has been increased to TSh 1,500 million to provide for additional equity subscriptions as execution of the project proceeds. While NDC will own all the company's shares, the management of SPM will be autonomous; NDC would invest the proceeds of the proposed credit to increase its shareholding in SPM. The total staff of SPM, after the start of operations, is planned to reach about 1,500 people. Forest Resources and Industries 42. Almost half of Tanzania's land area is classified as forest land, although most of this is dominated by slow growing scattered trees which yield little commercial timber. There are however, about 900,000 hectares of commercial forests, of which about one quarter is being exploited. Most of the balance is eithe r in-accessible or poorly stocked. The indigenous forests supply most of the fuelwood and timber for the population. 43. The most valuable forest resources of the country consist of about 60,000 hectares of sofitwood plantations. A,bout half of this is scattered throughout the country and the other half is at Sao Hill, where pine plantations have been developed with Bank Group financing. The Sao Hill plantation presently supplies wood to the Tanzania Wood Industries Corporation (TWICO) sawmill at Sao Hill, and wi:Ll be the source of the main raw material for the Mufindi Pulp and Paper Pro,ect. 44. Forest-based industries are not highly developed in Tanzania. There are about 150 small andL ill-equipped sawmills producing about 150,000 cubic meters per year. The TWICO mill, the only sawmill of reasonably efficient design and size, produces about 12,000 cubic meters per year. It has an annual design capacity of 45,000 cubic meters per year but is restricted in its output by a shortage of foreign currency which  - 13 - results in poor maintenance, breakdowns of logging trucks, and a resulting shortage of sawlogs. 45. Tanzania's paper industry is very small and most of the country's paper is imported. Kibo Paper Industries Limited, an NDC subsidiary, began operating near Dar es Salaam in June 1978, producing 10 tons per day of low grade papers and board from waste paper and imported pulp. In the fall of 1982, Kibo Match Company started up another small board plant with a capacity of 36 tons per day at Moshi, producing a reasonable quality of board from waste paper and groundwood prepared on-site from pine and imported pulp. The Dar es Salaam plant is being expanded as a sub-project under the Bank Group's fourth line of credit to the Tanzania Investment Bank (Ln. 1750-TA), to produce 30 tons of paper per day. The grades produced at Kibo Paper and at Kibo Match all contain waste paper and are threfore of a lower quality and are aimed -at a different end use than the grades to be produced at Mufindi (see paragraphs 59-60 below). Bank Group Experience in Industry and Forestry 46. The Bank Group has approved projects totalling US$215 million in Tanzania's industry and forestry sectors. These include four lines of credit to the Tanzania Investment Bank (TIB) (US$61 million); one line of credit to the Tanganyika Development Finance Limited (TDFL) (US$11 million); two textile projects at Mwanza and Morogoro (US$60 million); an industrial estate project at Morogoro (US$23 million); and an integrated pulp and paper project at Mufindi (US$60 million). The two forestry projects (Sao Hill Phases I and II), involved Bank Group assistance of US$19 million. 47. The Bank Group has been involved with TIB and TDFL since they were established to provide medium and long-term finance for investments in the productive sectors. These development finance companies have become relatively mature organizations with substantially increased operations. However, in view of the severe foreign exchange crisis since 1979, TIB has reoriented its operational strategy in the near term towards assisting its borrowers to rehabilitate or modernize their plants, improve capacity utilization, and promote exports. 48. The two textile investments were made in subsidiaries of the National Textile Corporation. The first loan of US$15 million (Ln. 1128-TA) financed the expansion of the Mwanza Textile Corporation mill by 20 million square meters per annum. The project was completed on schedule, well within budget, and operated extremely well for 18 months, until it experienced serious difficulties due to power failures and the lack of foreign exchange for import of supplies and spare parts. The second project, the Morogoro Textile Project (Ln. 833-TA of US$20 million and Ln. 1607-TA of US$25 million) involved the construction of an integrated polyester textile mill with an annual capacity of 21.5 million meters of blended fabrics and 650 tons of yarns. Implementation of this project has been delayed by about three years, largely due to delays in awarding the main civil works contract and the lack of funds previously committed to the project. Furthermore, in view of Tanzania's foreign exchange difficulties, the project has been modified to produce 100% cotton fabrics instead of polyester blends. The modified project is now expected to be completed by the end of 1984 with a cost overrun of about 25%.  - 14 - 49. The Morogoro Industrial Complex Project (Loans 1385-TA and 1386-TA of US$11.5 million each) is essentially, complete. However, the operation of one of its components - a shoe factory - has ifaced serious difficulties and operated at only a fraction of capacity, owing to poor management and a severe shortage! of foreign exchange for spare parts and some imported materials. The Gcovernment, with the assiLstance of UNIDO consultants, is studying various options to restructure and strengthen the leather and shoe industry. Progress of implementation of the Mufindi Pulp and Paper Project (Loan No. 1650-TA and Credit 875-TA of US$30 million) is dealt with in paragraphs 51-66 below. 50. A Bank loan of US$7.0 million (No. 1307-TA) was approved in 1976 for the First Sao Hill Forestry Project. This project was completed in late 1981. About 18,000 ha of plantations have been estab:Lished, exceeding the original target by about 10%. The Second Sao Hill Project, financed under Credit No. 1229-TA of US$12 million, of April 1982, will finance the further development of about 18,000 ha of existing plantat:ions and the establishment and development of about 10,000 ha of new plantations. Implementation of this project has just begun. The above projects, particularly those that have started operationE;, have demonstrated the paramount importance of good marnagement and training and adequate foreign exchange funds for recurrent operating needs to ensure efficient and high utilization of plant capacity. These lessons are the principal foundation of the proposed project. The Mufindi Pulp and Paper Project 51. Introduction. The proposed project would be a follow-up to the Mufindi Pulp and Paper Project (Mufindi Project) which was financed in 1979 by the Bank Group, the Swedish International Development Authority (SIDA), the Federal Republic of Germiany (KfW), the Commonwealth Development Corporation (CDC), the Kuwait Fund, the OPEC Special Fund, and the Nordic Investment Bank (NIB), and i.s now reaching the final stages of implementation. The financing required for the follow--up project is estimated at US$45 million equivalent, including US$40 mil:Lion in foreign exchange, for three components: operating management assistance and training; energy conversion; ancl imported operating supplies for about three years of operations. 52. Operating management assistance and training, which would be the major part of the proposed project, were foreseen as necessary at the time of the original Mufindi Project appraisal in view of the country's lack of skilled personnel to operate such a pulp and paper mill. The energy conversion component, which includes the modification of the power boiler and provision of necessary equipment to harvest, prepare and deliver fuelwood to the mill, is made necessary because of the high cost of both imported coal and oil and the delays Tanzania has experieneed in developing its indigenous coal resource.s, which at the time of thes MuEindi Project appraisal, were expected to be the primary fue:L for the mill. The deterioration of the Tanzanian economy in the intervening years and the present severe lack of foreign exchange has resulted in thie need to provide the Mufindi mill with foreign funds to finance imported operating materials for the first few years unti.l the mill can support itself through export earnings. The implementation of the proposed project is tied directly to  - 15 - the completion schedule of the Mufindi mill and its associated infrastructure. 53. Description. The Mufindi Project is under construction in Iringa District, some 800 km southwest of Dar es Salaam. The mill is designed to utilize the forest resources of the nearby Sao Hill plantations, and will have a production capacity of 60,000 tons per annum (tpa) of various categories of pulp, paper and paperboard. It will produce printing and writing papers, newsprint, kraft sack paper, and linerboard and will supply all of the country's requirements except for certain grades such as tissues, cigarette paper, bank note, and similar low volume specialized grades. A small amount of semi-bleached kraft pulp will also be produced for sale to other mills in Tanzania. A significant portion of the mill's output will be exported. 54. Modern but appropriate technology has been applied in the design of the mill which will use a standard bleached kraft pulping process with chemical recovery and a conventional stone groundwood mill, to supply pulp to two paper machines. The mill also includes an electro-chemical plant for the manufacture of the chlorine and caustic soda required in the pulp bleaching process, as well as primary and secondary effluent treatment facilities. 55. Status of Implementation. Physical implementation of the Mufindi Project is proceeding well although anticipated completion is about 18 months behind the appraisal estimate. This delay is due mainly to delays in making all of the project financing effective. The civil works are now complete. All of the major process equipment packages have been purchased and are on site. Erection of the equipment has been started. The two paper machines are currently scheduled for start-up in July 1984 and January 1985. The present implementation schedule is given in Annex IV. 56. Several key items of infrastructure essential to the Mufindi Project, including the power line, railway sidings, escarpment road and township for mill personnel are being implemented by the Government and financed outside the Project. These infrastructure items have been delayed to varying degrees but are now under control. The power line and railway siding are essentially complete . Construction of the escarpment road for delivery of wood to the mill is underway, after some delays due to procedural problems in making the foreign loan (EEC) effective and in appointing the consultants and contractor for the work. Since the completion of the road is not expected until August 1984 - following the start-up of the first paper machine (July 1984) - alternative temporary arrangements will be made to transport the wood to the mill site via the railway. The township is now under construction using supplementary financing of US$25 million from the Kuwait Fund, and will be completed in February 1985. However, with the purchase of the contractors' houses, there will be sufficient housing to accommodate the operating personnel (mostly bachelors) for the start-up of the mill. In summary, implemen- tation of the Mufindi project has proceeded remarkably well despite Tanzania's difficult economic circumstances. 57. Project Cost and Financing Plan. The following table summarizes the current (February 1983) and appraisal estimates of the project cost. Further details are presented in Annex V.  - 16 - Mufindi Project - Summary Cost Estimate (US$ million) Appraisal Current Local Foreign Total L.ocal Foreign Total Plant Cost 21.8 130.3 152.1 39.2 171.2 210.4 Other a/ 7.7 11.8 19.5 7.8 16.5 24.3 Base Cost Estimate 29.5 142.1 171.6 47.0 187.7 234.7 Contingencies & Escalation 9.5 36.6 46.1 3.0 5.3 8.3 Installed Cost 39.0 178.7 217.7 50.0 193.0 243.0 Working Capital 4.0 2.7 6.7 4.8 5.2 10.0 Interest During Construction 15.1 12.2 _27.3 17.8 5.6 23.4 Total Financing Required 58.1 193.6 251.7 72.6 203.8 276.4 a/ Includes logging capital and pre-operating cost. The total financing required for the Mufindi Project is currently estimated at US$276.4 million equivalent, about a 10% increase over the appraisal estimate of US$251.7 million. The revised total foreign exchange requirement of US$203.8 million represents an increase of about 5% compared to the appraisal estimate of US$193.6 million. These cost increases are due primarily to the delay in project implementation. The present cost estimates of the project, shown above, are based largely on. fixed price contracts already awarded and are therefore considered reasonably firm. 58. As seen from the above table, the project which was fully financed at the time of appraisal now has higher financing requirements, amounting to US$14.5 million equivalent in local currency and US$10.2 million in foreign exchange. The Mufindi Project has been assigned high priority by the Government and has received all the local currency needed throughout project implementation. In FY83 the Government has provided TSh 233 million (US$24 million) and will allocate TSh 200 million (US$21.3 million) in the budget for FY84. The additional foreign exchange requirements have been met through a supplier's credit (Yugoslavia) in connection with the mechanical erection contract. The costs of the infrastructure still under construction, namely the township and escarpment road, have been fully financed by the Government, the EEC, and the Kuwait Fund. 59. Mufindi Market Prospects. The Mufindi Project was originally intended to supply primarily the domestic market and, at the time of appraisal, it was estimated that, on average, less than 6,000 tons per year would be available for export during the first eight years of operation. By 1990, it was expected that the domestic market would consume all of the mill's output. However, the domestic market has stagnated, due to both a  - 17 - shortage of foreign exchange for imports and a general decline in economic activity in the country. Actual consumption over the past several years was as follows: Paper Consumption in Tanzania Year (tons) 1977 37,500 1978 30,500 1979 24,800 1980 24,500 1981 26,500 Sources: Government Statistics 60. A large part of the country's paper imports in recent years has been made through commodity aid programs from Sweden and Canada. An analysis of the grades of paper and paper board consumed in 1981 indicates that, of a total of 26,500 tons, approximately 21,900 tons were of the grades that can be produced by the Mufindi mill; the balance of 4,600 tons consisted of board paper and other grades which were either produced locally (paragraph 45) or imported. Current estimates are that the shortage of foreign exchange will limit paper imports and hence constrain domestic consumption at existing levels until mill start-up, but it is expected that consumption will increase by 20% to about 32,000 tons in 1985 to fill latent demand.This represents only 85% of the level of consumption reached in 1977. Thereafter, the market is projected to grow at 5.6% annually to satisfy incremental demand and reach about 43,000 tons by 1990. This will leave a significant exportable surplus that will amount to about 36% of the total output of the mill in its first five years, assuming it operates at near to full capacity. Should the market stagnate at the 1986 level, the mill would have to export 42% of its total production during this five year period. Mufindi Mill - Production and Exportable Surplus (Thousand tons) Exportable Year Mufindi Production Domestic Demand a/ Surplus 1984 7.5 26.3 1985 33.0 27.8 5.2 1986 44.0 29.4 14.6 1987 51.4 31.0 20.4 1988 56.9 32.6 24.3 1989 60.0 34.5 25.5 1990 60.0 36.4 b/ 23.6 a/ Only the grades to be produced by Mufindi. b/ The balance of the domestic demand of 6,600 tons would be met from the production of the other two mills (Kibo Paper Industries and Kibo Match Company) as well as imports (about 2,000 tons).  - 18 - 61. The grades considered most suitable for export are those which are widely traded throughout the world, namely newsprint and sack kraft (cement bag paper), and to a lesser extent, printing and writing papers. The major potential marketing areas are the Middle East and the Indian sub-continent. Neighboring Eastern African countries will offer additional marketing opportunities although these will be limited by the lack of foreign exchange in these countries. 62. Newsprint is the major item of potential sale tc) India, which in 1981 imported over 300,000 tons of this grade. The total quantity of newsprint to be exported from Mufindi (i.e. about 15,000 tons) would be less than 5% of India's imports. All of the Middle East countries are net importers of paper. In 1980, their combined imports were about 830,000 tons. Mufindi's total exports would be about 2% of this figure, and half of that would probably be sold to India as newsprint. With the marketing know-how to be provided under the project's operating management assistance and the intimate knowledge that one of the parties in this assistance, the Seshasayee Paper and Board Company of Madras (paragraph 70) has of the Indian market, it is expected that Mufindi's exportable surplus will be successfully marketed.Furthermore, the operating management contract (OMC) contains strong export incentives as the management firm would receive a significant bonus based on sales. Because of its modern equipment, high quality wood supply and the technical skill of the management team, Mufindi will also produce paper of internationally acceptable quality. Nevertheless, it is expected that in the initial years of operation, Mufindi will have to offer )rice discounts to penetrate the market. Under the operating contract discussed in paragraphs 69-71 below, the expatriate management of the Mufindi mill would be required to prepare annual marketing plans, the first of which would be ready by March 31, 1984, i.e., three months before the start of the first paper machine (Section 3.05 of the draft Joint Financing Agreement). 63. Prices of pulp and paper products have been rising sharply since 1979, due to higher costs of wood and energy, which together account for about 60% of production cost. In the past year, however, because of oversupply, prf.ces have dec:lined by about 15%, and in the first quarter of 1983 have returned to the levels of mid-1980. These trends are graphically illustrated in Annex VI. It is anticipated that in about two years, the supply demand situation wil:L be in balance and prices will return to their previous trend. In the case of newsprint, for example, it is anticipated that by 1985, when Mufindi wouldl be starting production, the international price f.o.b. Canada, the world's major newsprint exporter, will reach US$550/ton in current terms, which was the price prevailing in 1982/83. Equivalent prices for other grades to be produced by Mufindi are US$600/ton for sackkraft and US$925/ton for printing and writing paper. The corresponding c.i.f. prices at Dar es Salaam, landed prices (after addition of the prevailing 15% imporl: duty) and the ex-mill prices used in the projections for both domestic sales and export are summarized below from Annex VI. As shown in Annex VI, the assumed c.i.f. prices for paper at DaLr es Salaam are slightly lower than the corresponding c.i.f. prices in IndiaL which imports large quantities of paper and pays freight charges very close to those paid by Tanzania for its paper imports. The ex-mill price is calculated by deducting from the landed price of paper the transport cost  - 19 - of paper from Mufindi to Dar es Salaam (US$30-40/ton equivalent), the largest consuming center of paper in Tanzania. Import and Mufindi Mill Net Prices C.I.F. Landed in Mill Net Price Dar es Salaam Dar es Salaam Domestic Export --------------------1985 US$/ton--------------------- Newsprint 675 775 745 525 Sackkraft 725 835 804 575 Printing and Writing 1,075 1,240 1,200 - 64. At present the Government sets the prices of paper at the c.i.f. import price, plus 15% import duty. The Government has reconfirmed its previous commitment to establish prices at levels which will permit SPM, operating efficiently, to obtain revenues sufficient to cover all of its costs, to service all of its debts and to earn a reasonable return on its invested capital (Section 5.07 of the draft Joint Financing Agreement). This will require that the existing modest import duty be maintained to enable the project to cover its initial start-up cost as well as high infrastructure cost that any new mill has to carry. As regards exports, it is assumed that the Mufindi mill may have to provide a US$50 discount per ton on its exports which would seem sufficient to penetrate the market. Although export prices would be lower than corresponding domestic prices, they would still be higher than the production cost (US$400/ton for newsprint and $510/ton for sackkraft in 1985 prices) and would allow the company to generate the foreign exchange required to operate the mill. 65. Raw Materials and Fuel Supplies. The primary raw material for the Mufindi mill is the pine resource from the Bank-financed Sao Hill plantations. When the Mufindi mill is at full production in 1990, availability of pine from Sao Hill will be 350,000 cubic meters per year on a sustained yield basis, which will easily meet the pine demand of about 250,000 cubic meters per year for Mufindi and 50,000 cubic meters per year for the Sao Hill Sawmill. The pulpmill's requirement of short-fibered wood will be met from eucalyptus also planted under the Sao Hill Project. The annual allowable cut of eucalyptus is over 50,000 cubic meters per year compared with the pulpmill's requirement of about 11,000 cubic meters per year at full production rate. The total volume and the ratio between pine and eucalyptus required by Mufindi mill will depend on the grade mix of papers produced. The majority of chemicals for the Mufindi mill will need to be imported. The two exceptions are limestone which is available from domestic quarries, and salt, obtained by solar evaporation of seawater. 66. At the time of appraisal, it was expected that the Songwe-Kiwira coal deposit would be developed and provide the main source of fuel for the power boiler of the Mufindi mill. This development has not taken place and it is for this reason, plus the difficult logistics and high cost of imported coal or oil that the proposed new project would contain a major component to convert the boiler to burn fuelwood. The source of this wood, and the proposed scheme of harvesting and delivering it are discussed in  - 20 - detail in paragraphs 72-74 below. In order to simplify operations at start-up, it is envisaged that during the initial months of operation, the boiler will burn fuel oil obtained from a domestic refinery operating on imported crude or coal imported from a neighboring country. The power supply for the mill will be obtained from the existing interconnected grid system, which was recently expanded to serve the Mufindi area. PART IV - THE PROJECT Project Background, Objectives and Description 67. The eventual financing of technical assistance for the Mufindi mill has been a recurrent topic of project supervision missions and periodic consultations with the co-financiers. The proposed OMC contract was prepared by NDC, with the assistance of its legal advisers and Bank staff, and negotiated during the period August-November 1982. The proposed project was appraised in February 1983. Negotiations were held in Washington D.C. on April 22, 1983. The Tanzanian delegation was led by Mr. Francis Byabato, Assistant Commissioner, Ministry of Finance, and included Mr. Arnold Kilewo, Chairman and Managing Director, NDC. A Credit and Project Summary is given at the beginning of this report. A Supplementary Project Data Slheet is attached as Annex III. 68. With the Mufindi Project expected to be completed in mid-1984, a major effort will be require,d to manage and operate the mill and market its output. This is the main objective of the proposed project which would: (i) provide Southern Paper Mills Company (SPM) with expatriate operating management and training services for six years, including about one year prior to the start-uip of the first paper machine in July 1984; (ii) convert the existing power boiler from dependence on oil and coal to one that can also use wood fuel readily available from the nearby Sao Hill plantations; and (iii) provide SPM wiLth imported inputs such as fuel and pulp for the first six months of operation, i.e., until the wood fuel is available, and other materials and supp:Lies (chemicals, spares, consumables, etc.) for about the first three years of operations. Detailed Features 69. Operating Management Contract. As envisaged in the Staff Appraisal Report of the Mufindi Project dated December 14, 1978 (Report No. 1929-TA, paragraphs 5.27--5.33) the Mufindi mill cannot be operated without the assistance of expatriate management, due to the unavailability of local skilled personnel w:ith pulp and paper nill operating experience. NDC/SPM have negotiated an operating management contract (OMC) with Stothert International Corporation (Stothert), to manage SP]M and operate the Mufindi mill for a period of approximately six years, including about one year prior to start-up. Stothert is a Canadian consulting firm located in Vancouver that specializes in pulp and paper and other forest-based  - 21 - industries. It was founded in 1966 and is associated with C. D. Schultz and Co., also of Vancouver, which is the oldest established forestry consulting firm in Canada. Stothert have undertaken major operating management assignments in Canada and in Nigeria. The personnel to be assigned to Mufindi have acquired extensive management and operating experience in pulp and paper industries located in developing countries. The General Manager to be assigned by Stothert has more than 20 years experience in operating mills in Colombia, Peru, Thailand, Guatemala, and Nigeria. Stothert's forestry associates have worked for more than 35 years in assignments throughout the world, including a National Forest Inventory in Tanzania in 1970. 70. Under the OMC, Stothert, together with its subcontractor, Seshasayee Paper and Board (SPB) of India, would manage the entire company, including personnel relations, financial activities, mill operation, forestry operations, domestic and export marketing, and matters related to the township. The General Manager would be responsible to the Board of Directors of SPM. A Tanzanian General Manager Designate would work in parallel with the Contractor's General Manager. An organization chart for SPM is presented in Annex VII. Stothert personnel would fill the top 15 management and supervisory positions in SPM, and through the sub-contract provide 131 operating and maintenance personnel from SPB. In total, the contract provides for 4,857 man-months of services, of which 552 man-months would be from Stothert directly, and 4,305 man-months from SPB. The distribution of man-months by category and year is given in Annex VIII and is considered satisfactory to allow sufficient time to train Tanzanians and give them the necessary operating experience before assuming key positions. 71. In addition to managing the company, Stothert would train and develop Tanzanians systematically to take over all positions in the company. This training, which supplements manpower development already carried out during implementation of the Mufindi project (for about 170 people), would take place before and after mill start-up, commencing with ovetseas courses for about 100 Tanzanians who would eventually occupy key operating and supervisory positions in SPM. Under this contract, the OMC would prepare annual training programs, the first of which would be completed by December 31, 1983 and actual training progress will be reviewed quarterly by the Board of Directors of SPM. A bonus of US$0.6 million would be paid to the OMC based on achieving specific training results. A detailed training program would be submitted to the Association for its review by December 31, 1983 (Section 3.06 of the draft Joint Financing Agreement). Furthermore, SPM would submit to the Association by June 30, 1984, a compensation and incentive system for its personnel to attract and retain qualified Tanzanians (Section 4.02 of the draft Joint Financing Agreement). 72. Energy Conversion Component. The lack of sufficient domestic coal and the high cost and difficult logistics of importing coal or oil has led to the decision to convert the power boiler to burn fuelwood as well as these other two fuels. The proposed project would provide funds to undertake the boiler conversion work and to harvest, prepare, and deliver fuelwood to the mill. While considerable work is planned to develop Tanzania's domestic coal deposits (including exploration activity under a proposed coal engineering credit from IDA), there is uncertainty about the cost at which this coal will be available. At recent production rates,  - 22 - the only existing mine at Ilima will be exhausted by the end of 1983 and production to replace it will not begin until late 1986 at the earliest. The proposed energy conversion component would allow the Mufindi mill considerable versatility and permit it to start production, using local fuel resources, at a capital cost which would be recovered in three to four years. It is also possible that it will remain more economic for the mill to use fuelwood for its boiler, even once domestic coal becomes available, in view of comparative transport costs. The alternative of importing coal for a limited period, until domestic supplies are better assessed, has been examined and found to be less attractive in view of the eventual disruption to output which would be caused by converting the boiler at a later date,once it was installed and operating. 73. The present boiler is designed to produce 50 tons of steam per hour by burning low quality domestic coal plus bark frcom pulplogs. A study of the boiler design underta'ken by EKONO (Finland) has revealed that with relatively minor changes to the boiler and its ancillary equipment, it can produce the same amount of steam, necessary for running the mill at full capacity, while burning only green fuelwood (50% moisture). This capability has been confirmed by the boiler manufacturer, Mitsubishi Heavy Industries (Japan) who have also provided a fixed price! for the boiler alterations to reach its guarantee production level. This work can be undertaken during the erection of the boiler which has already commenced. 74. In order to generate the average steam load, EKONO estimates that about 38,300 tons per annum, of green fuelwood (50% moisture content) will be required. Tests undertaken by Mufindi's forestry consultants, Swedeforest (Sweden), in the Sac Hill plantations have showm that more than twice this amount of bio-mass will be left behind as logging residue after pulpwood harvesting. At present, this residue must be piled and burned in the forest in order to, clear the land for replanting. This material instead can be gathered., chipped and delivered to the mill to be used as fuelwood. All of the equipment to recover this bio-mass and feed it into portable diesel powered chippers is available as standard equipment from several manufacturers, and would be financed under the project. It is well proven in many installations around the world. The resulting chipped fuelwood will be discharged to side-dumping box trailers and pulled to the mill by truck, an average haul of 55 km. 75. Import Requirements. Given the difficult econom:ic environment and the experience of other industrial enterprises in Tanzania, it is unlikely that the mill could. operate unless imported raw materials were made available. Therefore, the project would provide funds for this purpose for the first three years of operation until SPM had built up a steady flow of foreign exchange revenues' from exports. The Government has also agreed in principle that SPM would retain part of its export earnings in a foreign exchange account. This account would be opened by December 31, 1983 and adequate portions of SPM's e!xport revenues would be retained in this account to meet its operating requirements (Section 4.04 of the draft JoirLt Financing Agreement). It is estimated that ret:ention of 30-40% of such earnings would be necessary, depending on the :Level of export sales. Furthermore, since SPM will need ready access to foreign funds for payments to suppliers of materials and consumables long before it can be expected to generate export revenues (irn late 1985), it would be necessary to establish  - 23 - a revolving fund of about US$1.0 million for use by SPM to meet its requirements of about three months. Appropriate arrangements to this effect between the Government, SIDA and KfW were discussed during negotiations. Project Cost and Financing 76. The total project cost is estimated at about US$45.0 million equivalent, of which US$40.0 million would be in foreign exchange. Detailed estimates are shown in the Credit and Project Summary and in Annex IX of this Report. The OMC and overseas training is expected to cost US$24.5 million of which US$20.5 million would be in foreign exchange. The average cost per month for Stothert personnel is US$13,000 and for SPB, US$2,500, including all reimbursable foreign and local expenses. These man-month rates are considered reasonable. The training incentive bonus (US$0.6 million) is payable only after achieving specific results. Advisory, legal and technical services (US$0.5 million) would also be provided to allow SPM to monitor the performance of the OMC. The estimated sales incentive bonus (US$1.4 million) is calculated from the contract formula which is summarized in Annex VIII. The sales and training bonuses would represent about one third of the contractor's estimated profit. The amount shown for escalation (US$3.4 million) includes price contingencies on the man-month rates which are zero for the first two years and 5% per annum fixed thereafter, as provided in the contract with Stothert. Provision has also been made for possible escalation of 7% per annum on the import requirement and energy conversion components. The project would be exempted from identifiable taxes and duties. 77. The proposed credit of SDR 16.7 million (US$18.0 million equivalent) would cover 40% of total project costs. Complementary financing on grant terms from SIDA (US$13.5 million equivalent) and the Federal Republic of Germany (KfW) (US$8.5 million equivalent) would cover 30% and 19% of total costs respectively. External funds would meet 100% of the foreign exchange costs, while the Government would finance the balance of US$5 million in local costs (16% of total costs). The credit would be made to Government on standard IDA terms. The proceeds of the credit would be passed on to NDC and SPM as equity, in view of the need to maintain a sound financial structure and debt service coverage for SPM (paragraph 82). The following table is a summary of the project cost and financing plan. Summary Project Cost and Financing Plan (current US$ million) Project Cost Financing Plan Component Local Foreign Total Govt IDA SIDA KfW Total Operating Management 4.0 20.5 24.5 4.0 15.0 5.5 - 24.5 Energy Conversion -Boiler 0.5 3.0 3.5 0.5 3.0 - - 3.5 -Fuelwood 0.5 5.0 5.5 0.5 - 5.0 - 5.5 Import Requirements - 11.5 11.5 - - 3.0 8.5 11.5 Total 5.0 40.0 45.0 5.0 18.0 13.5 8.5 45.0  - 24 - Procurement and Disbursement 78. The selection of the Operating Management firm was determined in accordance with Bank Group guide:Lines for the selection of consultants. Throughout the bidding and evaluation process, the cofinanciers were consulted and kept fully informed. The agreed draft contrazc has been carefully reviewed and approved lby the Association and the cofinanciers. 79. Equipment for the alteration of the boiler would be procured through a new contract with t:he boiler manufacturer, Mitsubishi (Japan) who have already given a firm pr:Lce bid valid until June 1983. Erection would be undertaken as an extra task by the existing erection contractor, INGRA (Yugoslavia), who is already on site. Equipment external to the boiler, which is primarily off-the-shelf conveyor systems and equipment for fuelwood harvesting, preparation, and delivery would be tendered from bidders who have already quoted prices on the main forestry equipment in accordance with internationa:L competitive bidding procedures. Bidding on the portable chippers, estimated to cost approx:imately US$1.0 million, would be limited to the few firms that specialize in this equipment. Imported operating materials and supplies would be procured in accordance with SIDA and KfW procedures. 80. The credit would be disbursed against 100% of foreign expenditures on consultants' services, training and support equipment (mainly vehicles and teaching aids) and 100% of foreign expenditures on the boiler conversion component. The Association and SIDA would jointly finance the OMC contract, in the ratio of 2.7:1, while SIDA and Germany (KfW) would cofinance other expenditures on a parallel basis. The IDA credit would be fully disbursed by December 31, 1989 (see Annex X). Financial Position and Prospects 81. SPM is not expected to start up its operations and generate revenues until July 1984, because of the 18-month delay in project implementation. As a result, SPM will not be in a position to service the first loan repayments due in 1983-84. The Government, therefore, has agreed in principle to extend the grace period of all the subsidiary loans to SPM related to the Mufindi Project by about two years, and to amend the existing subsidiary loan agreements with NDC/SPM accordingly by December 31, 1983. 82. Under existing loan agreements, one-third of the IDA credit and SIDA grant are to be passed on to SPM as loan funds and the remaining two-thirds as a Government equity contribution iin order for SPM to maintain a reasonable debt-equity rati o of 50/50. Since this equity contribution has been reduced as a result of the depreciation of the Swedish Kroner vis-a-vis the US$ (from SKr 4.2/US$1.0 at the time of the loan agreement to Skr 7.2/US$1.0 ) and to safeguard SPM's financial position from further realignment of the Tanzanian shi:Lling, the Government has agreed that the previously on-lent portions of the IDA credit and SIDA granit will be converted to equity (Section 3.04 of the draft Joint Financing Agreement). These arrangements will be reviewed by the Government at regular intervals (every 2-3 years) beginning on July 1, 1986 in the light of SPM's actual cash position and earning prospects at the time,, with a view to converting the equity contribution to loan terms, if possible, at prevailing parastatal borrowing rates.  - 25 - 83. The financial prospects of SPM for 1984 to 1990, which are summarized in Annex XI, have been projected on the basis of the following principal assumptions: SPM's two paper machines will commence production in July 1984 and January 1985 respectively; Mufindi will gradually build up its production to capacity level by 1989 (see table below); and domestic and import prices will be at levels discussed in paragraphs 63-64 above. The mill is shown to operate eventually at 100% of capacity, which may appear optimistic in Tanzanian conditions. However, it should be noted that the 100% level represents 60,000 tons per year which is the guaranteed design level rather than the ultimate mill capacity. In fact, the paper machines and all other major process departments could accomodate 75,000 tons of production per year; thus, 60,000 tons per yearrepresents 80% of the design capacity. SPM Summary of Projected Financial Data 1984-90 a/ (in current US$ million unless otherwise stated) Year Ending December 31 1984 1985 1986 1987 1988 1989 1990 (1/2 yr) Capacity Utilization % 12.5 55.0 73.0 86.0 95.0 100 100 Income Cash Flow Statements Sales Revenue 6.8 31.2 41.2 49.6 57.5 60.8 61.7 Manufacturing Costs 10.9 21.7 26.5 28.9 31.4 31.7 30.2 Depreciation and 4.2 17.0 17.7 18.0 18.3 18.5 18.7 Amortization Interest - 9.5 8.9 8.2 7.5 6.8 6.2 Net Income (Loss) After (8.3) (17.0) (11.9) (5.5) 0.4 3.8 6.6 Taxes Cash Generation Before Interest Payment (4.1) 9.5 14.7 20.7 26.2 29.1 31.5 Debt Service 1.6 11.1 13.3 15.5 14.8 14.1 11.9 Balance Sheet Current Assets 3.9 9.2 16.5 21.6 31.8 44.0 59.6 Current Liabilities 2.9 7.6 11.4 12.3 13.1 11.7 11.7 Long-Term Debt 97.3 92.9 85.6 78.3 71.0 65.3 59.6 Equity 179.9 173.9 173.0 170.5 172.9 177.7 184.3 Ratios Current Ratio 1.3 1.2 1.4 1.8 2.4 3.8 5.1 Debt/Equity Ratio 35/65 35/65 33/67 31/69 29/71 26/74 24/76 Debt Service Coverage - .9 1.1 1.3 1.8 2.1 2.6 (times) a/ After taking into account the extension of grace period of the subsidiary loans and the conversion to equity the portions of IDA and SIDA funds that were to be passed on as loans.  - 26 - 84. The above table indicates that SPM is expected to incur net losses every year during the first four years of operation, reaching a maximum of US$17.0 million e(quivialent in 1985 when SPM would just begin its production buildup. Howewer, SPM is expected to earn net income after taxes of US$0.4 million equivalent in 1988, increasing to US$6.6 million in 1990. SPM's cash generation would be tight during the initial years. Debt: service coverage would be very marginal during 1985-86, but would reach a level of 1.3 in 1987 and improve to a comfortable level thereafter. The debt-equity ratios ranging from 24/76 to 35/65 during 1984-90, and other financial ratios appear stronger than they really are considering that practically all of the long-term loans are in foreign exchange for which SPM assumes the foreign exchange risk. 85. The above projections are based on the domestic and export market sales levels discussed earlier (paragraph 60). Should the domestic market continue to stagnate and remain at the 1986 level, thereby requiring more exports, the mill would be exporting about 42% of its output and its sales revenue would be reduced by about 3%. The effect of such sales on SPM's cash position and debt service would be as follows: 1984 1985 1986 1987 1988 1989 1990 Sales Revenue 6.8 31.2 41.2 48.7 55.6 57.7 57.7 Cash Generation (4.1) 9.5 14.7 19.8 24.2 26.0 27.5 Debt Service 1.6 11.1 13.3 15.5 14.8 14.1 11.9 Debt Service Coverage - 0.9 1.1 1.3 1.6 1.8 2.3 (times) 86. To ensure prudent financial management, the following financial covenants, which are included in. the existing Joint Financing Agreement dated April 6, 1979 for the Mufindi Project, would be repeated with some modification under the proposed project: SPM should not incur any debt (beyond that already contracted) which would raLise its debt-equity ratio above 50:50 and reduce its debt service coverage below 1.5.; it should maintain a current ratio of not less than 1.2 and not make dividend payments if by doing so the current ratio fell below 1.5 (Sections 5.03-5.06 of the draft Joint: Financing Agreement). 87. As a capital intensive project, the Mufindi mill requires a high. rate of capacity utilization before it reaches the project break-even point. For the first year of full operation in 1989, the profit break-even point is expected to be about 82% of capacity. The initial tight financial position of SPM and the high break-even point indicate that it is imperative for the mill to reach full production as quickly as possible and to preserve a sound financial structure and liquidity position particularly in the initial years of opeIations.  - 27 - Auditing and Reporting 88. As for all parastatal entities, SPM accounts are audited by the Tanzania Audit Corporation (TAC), which is a satisfactory arrangement. SPM's audited annual accounts, together with the auditor's report would be submitted to the Association within four months of the end of the financial year (Section 5.02(b) of the draft Joint Financing Agreement). In addition, SPM would submit quarterly financial statements and project progress reports including training and marketing plans within 45 calendar days after each quarter. At the end of the project, SPM would submit a Project Completion Report to the Association within three months of the Closing Date of the credit (Sections 3.03(b) and (c) of the draft Joint Financing Agreement). Project Justification and Benefits 89. As mentioned earlier, the implementation of the Mufindi project has proceeded satisfactorily in view of its size and complexity as well as current difficult conditions in Tanzania. However, starting up the mill and keeping it operating will require the assistance of expatriate operating management as well as foreign exchange funds to import chemicals, spare parts and other consumables. The OMC and import financing components of the proposed project would address these needs directly. 90. The energy conversion component of the project would be justified because it would be more economical for the Mufindi mill to burn wood than imported fuel oil or coal. The internal rate of return on this component would be 46% compared with the fuel oil alternative and 18% compared with imported coal. The ready availability of fuel wood in sufficient quantities from the existing plantations close to the mill site will also ensure the continuous firing of the power boiler of the mill. 91. The Mufindi Pulp and Paper Project is the most important industrial project underway in Tanzania. It accounted for 10% of all development expenditures during the Third Five Year Plan period (1976-81) and about 50% of all industrial investment during the last five years. While the original rate of return for the project (11%) was low for a large investment, and has been further reduced by lower than expected domestic demand for paper products and an overall increase in project costs, the investment of additional resources is essential for generating some return on a very sizeable sunk investment. The Government has shown strong commitment to the project, especially by meeting the full local cost requirements of the project in a timely manner, despite growing pressures on the development budget and the decision to consolidate public investments in less critical areas. Most importantly, with the financing provided for the proposed project, the Mufindi mill could significantly improve the net foreign exchange flow to the country, which is expected to accumulate to about US$77 million by the end of 1990, when the project would attain full capacity operations.  - 28 - Mufindi Project - Summary of Foreign Exchange Effect of Proposed Project (US$ Million) 1984 1985 1986 1987 1988 1989 1990 Foreign Exchange Revenues Import Substitution 5.7 24.1 27.5 31.1 35.0 36.8 38.7 Export - 3.0 8.8 13.0 16.4 17.3 16.0 Total 5.7 27.1 36.3 44.1 51.4 54.1 54.7 Foreign Exchange Operating Costs Direct 3.2 4.3 5.3 6.1 7.1 7.4 7.5 Indirect 0.9 3.9 5.3 6.7 8.0 8.4 8.5 OMC 3.8 4.6 5.1 3.1 2.1 1.3 - Total 7.9 12.8 15.7 15.9 17.2 17.1 16.0 Debt Service (Foreign Exchange) Interest and Principal 10.7 14.8 14.4 13.9 13.5 13.5 13.2 Foreign Exchange Surplus (Deficit) (12.9) (0.5) 6.2 14.3 20.7 23.5 25.5 Cumulative Surplus (12.9) (13.4) (7.2) 7.1 27.8 51.3 76.8 (Deficit) Should the domestic market stagnate at the 1986 level, the cumulative foreign exchange savings resulting from the Muf:indi operation would be reduced to US$70 million by the end of 1990. 92. The economic rate of return on the Mufindi Project, taking into account the revised project cost including the cost of energy conversion and operating management, and production build-up, is about 5%, compared to the appraisal estimate of 11%,. 'If all project expenditures as of March 1983 are taken as sunk costs, the economic rate of return would be about 20%. The following major assumptions have been used in the economic analysis: (i) border prices have been used for all tradeab:Le goods; (ii) infrastructure costs not recovered through direct charges have been added to the project capital costs; and (iii) a shadow rate of exchange of TSh 18.6 to the US dollar has been used for all local inlputs. Details are shown in Annex XII. 93. The reduction in economic rate of return compared with the appraisal estimate results primarily from lower projected revenues and the initial delays in implementing the project. The lower revenlues are caused by slower than anticipated growth of the domestic market, and the consequent need to export more of' the mill's production. The higher freight cost on exports results in a lower mill net revenue on exports. Furthermore, to penetrate export markets a discount of US$50/ton has been  - 29 - placed on international prices. Higher costs for the township and escarpment road also contribute to the lower rate of return. 94. Sensitivity tests have been made on the above economic rate of return vis-a-vis sales revenues, manufacturing costs and capacity utilization. The rate of return is most sensitive to sales revenues; a 10% reduction in revenues would lower the return to about 4% on a full cost basis and to about 17% on a sunk cost basis. Risks 95., Industrial enterprises in Tanzania face several common difficulties. Among these are: the lack of trained people with industrial management and operating experience; lack .of spare parts, fuel and other imported materials due to shortage of foreign exchange; and failure of the infrastructural systems such as railways and electrical power. In addition to these difficulties, Mufindi is faced with a potential export marketing problem. The proposed project is designed to insulate the mill as far as possible from these problems. 96. The Operating Management Contractor would be the key to Mufindi's success. The selected contractor is competent and experienced and the contract provides him with the authority, means, and financial incentives (bonus) to manage the company effectively and train Tanzanians. However, there is always a risk that trained Tanzanians will seek employment elsewhere. Although the possibility of losing trained people will be reduced by providing the employee with a suitable compensation and incentive system (paragraph 71), SPM will nevertheless have to train more people than actually will be required. The proposed project includes provision for financing of such additional people. 97. The provision of foreign exchange for imported materials and spare parts for the first three years of Mufindi's operation, would ease one of the major problems facing most Tanzanian industry. After a secured start-up and three years of operation, the mill could be expected to export and become self-sufficient in foreign exchange, and would operate its own foreign exchange account in order to have an assured supply of critical materials and spares. The energy conversion component of the project would assure the mill of a reliable supply of cheap fuel which is also indigenous, renewable and physically close to the mill. A storage tank for fuel oil would also be installed as a back-up for the main wood fuel. 98. The mill is linked with the interconnected power grid and to the TAZARA railway through a new spur. The power supply to the mill is reliable, as the grid system is based almost entirely on hydroelectric generation and does not depend on imported fuel. 99. Penetration of export markets is a challenging problem for any new mill. Mufindi will have the advantage of an OMC collaborator with an intimate knowledge of the major importing countries, particularly India, and the incentive to export in order to maximize his production bonus which is calculated on tons sold. In the event that the domestic market continued to stagnate, even more paper would have to be exported. While no major difficulties are foreseen in disposing of additional tonnage in  - 30 - export markets, the lower mill net prices will have an effect on the cash position of SPM. If the domestic market remained at the 1986 level, sales revenue would decline by about US$10 million in total during, the four-year period up to 1990, and it would not be until 1989 that the Company could post a positive net profit (US$0.7 million). However, the Company would still maintain acceptable debt service coverage and cash flow. 100. In the event that the project faced a persistent combination of adverse circumstances, namely a 10% reduction in sales volumes, plus a 10% reduction in sales prices, plus aL 10% increase in production costs, a cash deficit, after debt service, would continue until 1989 by which time it would have accumulated to approximately US$22 million, and the accumulation would not become positive until 1993. However, since the Company will have a competent Operating Management Contractor, the foreign exchange for initial years of import requirements, a reliable fuel supply, and a built-in surplus capacity, the above combination. of circumstances is considered unlikely to occur. PART V - LEGAL INSTRUMENT AND AUTHORITY 101. The draft Development Credit Agreement between the United Republic of Tanzania and the Association, the draft Joint Financing Agreement among the United Republic of Tanzania, the Kingdom of Sweden, the Association, Southern Paper Mills Company Limited and the National Development Corporation and the Recommendation of the Committee provided for in Article V, Section l(d) of the Articles of Agreement of the Association are being distributed to the Executive Directors separately. Special conditions of the credit are listed in Section III of Annex III. 102. It would be conditions of effectiveness of the proposed credit (a) that the Subsidiary Financing Agreement had been executed on behalf of the Government, SPM and NDC, (b) that all conditions precedent to the effectiveness of the Swedish grant agreement had been fulfilled, (c) that satisfactory evidence had been obtained that the German contribution to the project would be available, and (d) that the management consultants to operate the Mufindi mill had been employed (Section 4.01 of the draft Development Credit Agreement.) 103. I am satisfied that the proposed Credit would comply with the Articles of Agreement of the Association. PART VII - RECOMMENDATION 104. I recommend that the Executive Directors approve the proposed Credit. A.W. Clausen President Attachment May 2, 1983 Washington, D.C.  ANNEX I - 31 - Page 1 of 6 TABLE 3A TANZANIA - SOCIAI. INDICATORS DATA SHIEFT TANZANIA REFERENCE GROUPS (WEICHTED AVERACES AREA (TIIOUSAND SQ. FM.) - MOST RECENT ESTTMATE4