Mauritania - Societe Nationale Industrielle Et Miniere (SNIM) Rehabilitation Project

Doment of The World Bank FOR OMCAuL USE ONLY Repqt Nwo. P-4139-MAU REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN IN AN AMOUNT EQUIVALENT TO US$20.0 MILLION TO THE SOCIETE NATIONALE INDUSTRIELLE ET MINIERE (SNIM) WITH THE GUARANTEE OF THE ISLAMIC REPUBLIC OF MAURITANIA FOR A REHABILITATION PROJECT November 12, 1985 IT ** k docUeo bs a resice bgd _d my bxe usebyecte only in t performace of thIr fi dud lbr ow ad dkwie be dUS_n w_Cm Wad Bu nobrai  CURRENCY EQUIVALENTS Currency Unit Ouguiya (UM) UK 67 = US$1.00 UK 1,000 = US$14.93 UK 1 million = US$14,930 WEIGHTS AND MEASURES I meter (m) = 3.281 feet (ft) I cubic meter (m3) = 33.315 cubic feet (ft3) 1 kilometer (km) = 0.62 miles 1 kilogram (kg) = 2.205 po':nds (lb) I metric ton (tonne, t) = 1,000 kg or 2,205 lb ABBREVIATIONS AND ACRONYMS AFESD - Arab Fund for Economic and Social Development BRCK - Bureau de Recherches Gfologiques et Minieres BRPM - Bureau de Recherches et de Participations Mini5res CCCE - Caisse Centrale de Cooperation Economique EIB - European Investment Bank KFECIC - Kuwait Foreign Trading, Contracting and Investment Company MIFERMA - Mines de Fer de Mauritanie OECF - Overseas Economic Cooperation Fund of Japan SAFA - Societe Arabe du Fer et de l'Acier SNIM - Societe Nationale Industrielle et Minigre SOCOMINE - Societ,e de Cooperation Miniare et Industrielle SOFRESID - Societe Frangaise d'Etudes de la Siderurgie MAURITANIAN FISCAL YEAR January 1 - Decembe. 31  FOR OMCIAL USE ONLY MAURITANIA SKIM REHABILITATION PROJECT LOAN AND PROJECT SUHMARY Borrower: Societe Nationale Industrielle et Miniare (SNLM). Amount: US$20.0 million. Terms: Repayable in 15 years, including 3 years of grace, at the Bank standard variable interest rate plus a guarantee fee to the Government of 10 percent of the variable interest rate. Project Objectives SKIM's increasing production costs and debt service, and Description: both due to the now completed Guelbs Project, require tight financial management in the coming years. The Project's main objective is to secure the medium-term financial and economic viability of SKIM, one of the most valuable assets to the Mauritanian economy. The Project would consoLidate and further advance the ongoing action program for managerial and technical improvements and would in particular: (i) help SNIM continue to improve its management and reduce its production costs; and (ii) assist with the necessary financial restructuring of SNIM by transforming part of its short-term debt/overdraft into long-term debt. The Project consists of: (i) measures by SKIH aimed at improvements and cost reductions in management, operations, procurement and investments, persconnel, overhead costs and cash management; and (ii) purchase of equipment and supplies, and provision of training and technical assistance necessary for the implementation of these measures. Project Risks: The Project faces major financial, but also managerial, coumercial and technical risks. Sound project preparation, conservative assumptions for the financial projections and the fact that SNIM has already successfully started its rehabilitation program, limit the risks to an acceptable level. IThis documcnt has a rsicied distfibution and m;2y be used by reapients only in the peqorT&v!ce of |their officia duties. Its contents may not otherwise be disdosed without World Bankt autborizaXon  -ii- Estimated Cost (net of taxes): Local Foreign Total (US$ million) Replacement of Equipment 2.5 25.7 28.2 Major Overhaul and Improvement of Equipment 13.3 30.9 44.2 Tools and Control Equipment - 4.6 4.6 Training and Technical Assistance - 8.5 8.5 Base Cost (Mid-1985 Prices) 15.8 69.7 85.5 Physical Contingencies 0.2 1.3 1.5 Price Contingencies 0.8 4.4 5.2 Total Project Cost 16.8 75.4 92.2 Financing Plan: Local Foreign Total C(US$ miliion) External IBRD - 20.0 20.0 Kuwait/Arab Funds - 18.2 18.2 Abu Dhabi Fund _ 5.8 5.8 Saudi Fund - 5.7 5.7 OECF - 3.1 3.1 CCCE - 3.0 3.0 Internal SNIM 16.8 19.6 36.4 Total 16.8 75.4 92.2 Estimated Disbursements of IBID Loan: Bank FY 1986 1987 1988 -((US$ m1lion) Annual 3.0 7.0 10.0 Cumulative 3.0 10.0 20.0 Economic Rate of Return: 25 percent Staff Appraisal Report: Report No. 5819-MAU, dated November 12, 1985 IBRD No. 19048 IBRD No. 19049  REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO SOCIETE NATIONALE INDUSTRELLE ET MINIERE (SNLM) FOR A REHABILITATION PROJECT 1. I submit the following report and recommendation on a proposed loan to Societe Nationale Industrielle et Miniere (SNIM) for US$20.0 million to help finance a Rehabilitation Project for the Company. The loan will be made available to SNIK at the Bank standard variable interest rate, plus a guarantee fee of 10 percent thereof payable to the Government, and is repayable in 15 years, including 3 years of grace. Additional financing has been made available by Kuwait/Arab Funds (US$18.2 million), Abu Dhabi Fund (US$5.8 million), Saudi Fund (US$5.7 million), Overseas Economic Cooperation Fund of Japan (OECF) (US$3.1 million) and Caisse Centrale de Cooperation Economique (CCCE) (US$3.0 million). PART I - THE ECONOMY 2. A report entitled Islamic Republic of Mauritania - Country Economic Memorandum (5537-MAD), dated July 10, 1985, has been distributed to the Executive Directors. Updated country data are given in Annex I. The Land and its People 3. Mauritania bears many of the characteristics of the 'Least Developed Countries' in terms of its physical and human resources, despite a level of per capita income (US$450 in 1984) somewhat higher than the ceiling for lowest income countries. Three-quarters of the country is desert or semi-desert, the principal economic activity being livestock herding. Crop farming is generally limited to the sub-Saharan zone in the south, where rainfall is nonetheless sparse and irregular. Pockets of modern economic activity are found in the mining complex of Zouerate, the fishing center of Nouadhibou and the administrative capital of Nouakchott. These centers are geographically separated from the agricultural zones, and there is little economic interaction between them and the rural sector. 4. The tbree centers of modern economic activity account for a major share of the country's overall output, while livestock and crop farming, which support about two-thirds of the population, account on average for about 20 percent of total output. The mass of the population (total 1.7 million) suffers from an extremely low standard of living, as reflected in key social indicators: life expectancy at birth is estimated at 46 years, infant mortality is 136 per 1,000, only one in every three children of school-age attends primary school, and about 18 percent of the population is literate in either of the two official languages, Arabic and French.  -2- Past Economic Performance 5. Led by increases in iron ore production, Mauritania's GDP sustained an average annual growth rate of 8 percent during the 1960s. The economy experienced a sharp deceleration in growth in the mid-1970s, however, and a period of marked financial instability in the latter part of the decade. Principal factors were reduced world demand for iron ore, on which the country had been dependent for 70-80 percent of its export earnings, and the effects of severe and repeated drought on output in the rural sector. These factors were compounded by prolonged military conflict in the Western Sahara and a poorly conceived investment policy. The investment program was stepped up in the mid-1970s to rates approaching 40 percent of GDP with the support of heavy inflows of foreign assistance, particularly from OPEC sources and commercial lenders. These resources were used principally to finance the nationalization of the mining sector, ambitious projects in transport infrastructure and a few large industrial ventures which were to prove unviable. 6. In 1978 the Government undertook a stabilization program which called for the rescheduling of more than US$200 million In debt service obligations, tight controls over the Government expenditures and a reinforced tax effort. Increased iron ore and fish exports and higher crop and livestock production enabled the economy to pull out of the stagnation which had characterized it since 1977; real GDP growth over the 1979-1981 period averaged 4.1 percent per annum. 7. The iWroved performance of the economy could not be sustained, however,- in the face of a depressed world market for iron ore and the recurrence of severe drought. Iron ore production fell by more than 20 percent in 1982/83 to a level only 65 percent of that registered 10 years earlier. With rainfall only about 30 percent of normal levels in the 1983/84 and 1984/85 seasons, the livestock herd suffered major losses, and cereals production met less than 10 percent of total demand; aggregate output of the economy increased by only 1.4 percent p.a. from 1982 to 1984. In the absence of sustained growth, per capita average income in 1985 is essentially unchanged in real terms from that of a decade ago. 8. The public finance situation deteriorated substantially during the 1982-84 period. The Government's consolidated fiscal deficit rose from UK 1.7 billion (4.6 percent of GDP) in 1981 to a peak of UM 4.8 billion (11.2 percent of GDP) in 1983, before falling to UK 3.6 billion (7.8 percent of GDP) In 1984. A 9 percent increase in the size of the civil service in 1982/83 and high debt service payments contributed to the deficits. The deficits were financed out of Central Bank advances to the Treasury and through an accumulation of external and domestic payment arrears, estimated at about UM 5.5 billion by the end of 1984. 9. In the external sector, the growth of exports has been modest while imports have been high, mainly because of capital imports associated with major public investments. In 1983-84 the current account deficit  -3- was close to US$230 million on average, or more than 30 percent of GDP, as the investment ratio averaged 35 percent of GDP. Financing came mainly from external loans from Governments and multilateral institutions on concessional terms. 10. Despite the high degree of concessionality, annual debt service obligations are well beyond Mauritania's payment capacity. Arrears on debt service have increased from US$23 million at the end of 1981 to an estimated US$103 million as of end 1984. Total scheduled payments on existing debt imply a debt service averaging US$180 million over the 1986-1988 period without taking into account new borrowing after December 31, 1984. The Recovery Program and the Current Outlook 11. Mauritania's balance of payments and budgetary situation thus remains extremely weak, requiring continuing adjustment measures over the medium term and heavy support from abroad in the form of financial and technical assistance and food aid. The gradual depreciation of the ouguiya during 1984 was one of a series of recovery measures required to reduce external and domestic imbalances to sustainable levels and maximize the modest prospects for the economy in the medium-term. Further reform measures in the areas of exchange rate and price policy, fiscal administration, the public enterprise sector, the banking system and the public investment program are being pursued in the context of an Economic and Financial Recovery Program, that the Hauritanian authorities approved in early September 1985, and will present at a Consultative Group meeting chaired by the Bank on November 26 and 27, 1985. Already in March 1985, the Government reached agreement with the IMF on a proposed Stand-By arrangement for SDR 12 million. In accordance with that agreement, it undertook in February 1985 a further 19 percent effective devaluation of the ouguiya in domestic currency terms, as well as increases in cereals prices at both producer and consumer levels ranging from 12-50 percent. The Government also raised all interest rates by 2 percent to levels which are positive in real terms and took measures to restrict credit expansion. The IMF Stand-By arrangement is noaw being implemented, while negotiations with Arab and Western bilateral :reditors to fill the projected 1985 financing gap of about US$200 million (including arrears) are progressing satisfactorily. 12. Successful implementation of the Government's Economic and Financial Recovery Program, which includes priority macroeconomic and sectoral policy measures and a sound public investment program, should be supported by the international community because of its critical importance to the medium-term outlook for the economy. With disciplined economic management and well-conceived measures to exploit Mauritania's limited resources, modest but sustained growth in output is possible. Although international iron ore markets are not expected to recover significantly through the 1980s, it is possible for SNIM to continue to improve the cost effectiveness of its operations. SNIM's rehabilitation is an essential part of the Government's Recovery Program. Rural sector production should recover moderately from the drought-iuduced lows of 1984. In the livestock sector, some time will be needed to reconstruct the herd following the  -4- heavy mortality and accelerated offtake over the past two years. In the medium-term, irrigation development will increasingly contribute to food supplies, even though cereals production will remain highly vulnerable to the effects of drought. In the fisheries sector, now a major source of foreign exchange and budgetary revenue, growth could remain strong for another 3-4 years, but should then level off if resources are not to be over-exploited. Under favorable assumptions, overall growth of the economy through the remainder of the 1980s could average 3 percent annually, about the projected rate of population growth. PART II - BANK GROUP OPERATIONS IN MAURITANIA 13. To date, che Bank Group has had 22 operations in N4auritania for a total of US$242.5 million. Of these, two are Bank loans for mining operations (US$66 million to MIFERMA in 1960, and US$60 million to SNIM in 1979 for the Guelbs Iron Ore Project). The other 20 are IDA credits totalling US$116.5 million. Of the IDA operations, five have been in the transport sector, seven in the rural sector, two for education, two for technical assistance to economic planning and one for technical assistance to the Rural Sector, and there have been separate projects for urban and rural development, Public Enterprise Rehabilitation, Artisan and Industrial Development and petroleum exploration. In 1985, the IFC has financed a food oil refinery. The Bank Group's presence in Mauritania was fairly substantial in the early 1970s, and in 1970-72 it was the third largest donor providing about 18 percent of Mauritania's external capital assistance. Since then, external financial assistance to Mauritania from other sources has increased rapidly and at present, the Bank Group's share in Mauritania's external capital assistance amounts to about 8.0 percent. i4. Until the mid-1970s, Bank Group strategy for Mauritania focussed on financing traditional projects mainly in agriculture, transport and education. This assistance has since been broadened to address the institutional weaknesses in country economic management, investment planning and project implementation. In 1978, the Association assisted the Government in designing a financial and economic rehabilitation program for which the first Technical Assistance Project (FY77) provided the expertise. Assistance for the formulation of macroeconomic policy, a medium- and long-term development strategy, and investment programs is being continued under a Second Technical Assistance Project (FY82), which is also helping to develop a pipeline of feasible investment projects. The objective of this assistance is to institute a much more thorough analysis of investments than in the past, especially to avoid large, capital intensive projects with low productivity and unsatisfactory rates of return. Priority will now be given to projects involving the rehabilitation and maintenance of existing infrastructure, and only to those new investments that promise a high rate of return. 15. After a comprehensive review of public sector enterprises financed under the first Technical Assistance project, assistance was also provided to the Interministerial Committee for the Rehabilitation of Public  -5- Enterprises in the course of preparing a medium-term rehabilitation program for the public enterprise sector. This program includes measures to increase the efficiency of existing enterprises through selective rehabilitation, privatization and liquidation, and outlines rehabilitation programs for several of these enterprises, including pricing policies, personnel adjustments, streamlining of management and appropriate maintenance of equipment. In support of this program, a Public Enterprise Technical Assistance and Rehabilitation Project was approved by the Board of Executive Directors in FY85. 16. In order to address Mauritania's severe balance of payments problems, tight fiscal situation and inability to service its public debt, the Association, in close cooperation with the IMF, helped the Government finalize a Recovery Program (1985-86) to be presented to a Consultative Group meeting scheduled on November 26 and 27, 1985. To back-up these efforts, our country and economic sector work, concerning particularly the banking, fisheries, education, energy and urban development sectors, has been intensified. To support the program more directly, a policy based operation is envisaged for FY87 which will aim at improving economic mnagement and the utilization of domestic resource potential. 17. Professional training and technical assistance will remain an essential ingredient of IDA assistance to overcome the acute shortages of trained local staff at all levels, a major difficulty in project implementation. Through project aid and technical assistance, efforts have been made to strengthen farmers' training and vocational training for the modern industrial sector, as well as to broaden access to primary education. Nonetheless, pupils completing secondary and vocational schools with satisfactory results remain scarce; this partially explains the low productivity of employees in the modern sector. 18. Assistance to the education sector is being provided under the Second Education Project (FY82) which aims at expanding access to primary education, improving vocational training in the modern industrial and commercial sectors, and training of lower secondary school teachers to replace a substantial number of foreign technical assistants. The C-overnment recently requested that the Association assist its Education Reform Committee in reviewing key sectoral issues, defining long-term objectives, formulating policies, preparing an investment program to increase the efficiency of education and training, and reducing recurrent costs because of the already large share of education (30%) in the national budget. 19. Assistance to agriculture will continue since this sector is still considered Mauritania's principal source of long-term growth, despite its weak base and extreme vulnerability to drought, and the high cost of investment which is due to difficult physical conditions, limited transport infrastructure, and the high level of technical assistance needed. Through the Second Technical Assistance to the Rural Sector Project (FY83), rural institutions are being strengthened and incentives for efficiency developed  -6- by addressing such fundamental issues as input and product pricing, subsidies and land tenure. A Small Scale Irrigation project (FY85) continues IDA's assistance to the irrigation program by financing the establishment of 75 command areas of 20-25 ha each. The participation of beneficiaries in construction, maintenance and operation is being emphasized to minimize investment costs. A Second Livestock project, scheduled to be presented to the Board of Executive Directors during FY86, would improve livestock production, strengthen services and-based on experience in Niger and Mali-establish pastoral cooperatives on a trial basis and allocate grazing rights to identifiable land areas. 20. In the energy sector, our assistance consists of supporting the Government's search for oil through the Petroleum Exploration Project (FY82), and carrying out an energy assessment in order to recommend strategies and policies for improving energy demand management, developing indigenous energy resources, strengthening institutions, and identifying areas for follow-up technical assistance that could form the basis for a future operation. 21. The Association is also helping Mauritania to develop an overall strategy for the urban sector. Urbanization has accelerated dramatically in recent years, but appropriate measures to ad5 ust to this development have not been taken. Sector work is being carried out to gather detailed knowledge of urban requirements, and to examine wider urban policy issues in the overall context of Mauritania's development prospects. This sector work may lead to the design of an urban project at a later stage. 22. To assist in Mauritania's efforts to diversify employment and sources of in-come, financing was provided through the Mauritaaian Development Bank (Credit 888-MAU) to encourage private enterprise and to promote artisanal carpet-weaving activities. A Second Industrial Development project (Credit 1572-MAU) approved by the Board in FY85 is continuing support for these objectives by financing studies to develop appropriate policies for improving subsector performance and to assess the possibilities for further expansion of the manufacturing sector. 23. The Recovery Program for 1985-86 has identifted fisheries and banking as two priority sectors where well-defined actions are urgently required to help the economy recover from its past record of low growth. To assist the government in defining meaningful strategies in these two key sectors, the Bank has financed two studies which will provide the government and the donor community with a sound basis for defining basic studies and other policy actions. A first set of actions should be carried out in 1986. As the best source of growth in the short-term, the strategy objective in the fisheries sector will be to capture a larger share of the benefits currently reaped by foreign trawlers or contractors operating in Mauritanidn waters. Once this sector strategy is in place, a fisheries project would be considered.  -7- 24. The banking sector is composed of six banks, four of which are fully controlled by the Central Bank. The sector has been suffering from a steady decline in its profitability (despite a continuous expansion of lending), obvious illiquidity, a tight cash position and risks that are out of proportion to the banks' potential, The capital and net worth of the banks have been progressively eroded )because of accumulated deficits and bad debts, which are reaching the point where the future of the banks is jeopardized. The study, cofinanced with the Arab Monetary Fund, will provide an objective analysis of the means and actions required to restore the banks' financial viability, improve their management and change their system of credit control. The implementation of the rehabilitation program for the banking sector is obviously crucial for the promotion of all productive sectors. The Bank will consider providing some assistance for this rehabilitation program as part of the policy-based operation envisaged for FY87. PART III - THE MINING SECTOR Role of Mining Sector in the Economy 25. Despite the recent development of the fisheries sector, mining continues to be the most important sector of the Mauritanian economy. The mining sector consists almost exclusively of the exploitation of iron ore, which dates back to 1963 when Mines de Fer de Nauritanie (MIFERNA), the predecessor of SNIM, commenced operations. Production capacity is about 11.5 million tonnes per year. The most recent investment was the Guelbs Project that started production in March 1985. The operations are located inland at Zouerate, about 650 km east northeast of Nouadhibou, the port of shipment, which is connected with Zouerate by a company-owned railway. 26. Iron ore mining by SNIM has been a mainstay of the Mauritanian economy, and its development has been the chief determinant of the country's economic growth. While still a very important sector in the Mauritanian economy, the mining sector's direct contribution to GDP has fallen from 13.9 percent in 1975 to 9.2 percent in 1983, partly due to declining iron ore output and partly to growth in other sectors, in particular the fisheries sector which increased its contribution to GDP at market prices from 3.6 percent in 1975 to 7.7 percent in 1983. Also, Government Services and Transport and Communications have grown relative to other sectors in the same period. However, in addition to its direct contribution to GDP, iron ore mining has some indirect impact on GDP - through value-added in the industrial, construction and services sectors. 27. Iron ore is still a very important source of foreign exchange, although its share in Mauritania's total merchandise exports fell from 86 percent in 1975 to 42 percent in 1983, basically due to the emergence of earnings from the export of fish and fish products. SNIM contributes to public revenues directly through the payment of a 10 percent tax on all  -8- iron ore sales and indirectly through the tax payments of its approximately 6,100 employees. The sales tax alone amounted in 1984 to an estimated 8 percent of total public revenues. Resource Base 28. Iron Ore. Iron ore is being mined from several small mines in the Kedia mountains near Zouerate, where high grade ore (iron content 62-64 percent Fe) occurs which can be exploited and exported without prior beneficiation. In view of declining ore reserves at KCedia, the Guelbs Project has been prepared as a high priority since the mid-1970s. The project provides in its first phase for a partial replacement (6 million tonnes per year) of Kedia ore through the mining and beneficiation of low grade ore (38 percent Fe). The new mine, the beneficiation plant (which upgrades the ore to a marketable product of 64 percent Fe content) and some additional infrastructure were commissioned in 1984 and are now in the initial start-up phase. Presently, the remaining high grade ore reserves of Kedia are estimated to be in the order of 30 million tonnes. With an estimated average future extraction of three million tonnes per year, this would allow the parallel operation of Kedia and Guelbs until the mid-1990s. The reserves of low grade Guelbs ore (about 2.3 tonnes are needed to yield 1 tonne of product) were originally estimated at about 450 million tonnes. 1/ However, at present iron ore prices, only about 50-60 percent would be economically recoverable. This would allow operation of the existing Guelbs facilities for about 20 years, but would be an insufficient base for the previously planned phase 2 expansion of Guelbs. 29. Other Minerals. Other than iron ore, only copper and gypsum have been mined in Mauritania. The Akjoujt copper deposit, located about 200 km northeast of Nouakchott, was mined by Societe des Mines de Mauritanie (SOMIMA) from 1971 to 1978 21, which became a subsidiary of SNIM during the last three years of this period. Due to continuous high losses, the operations were shut down in 1978. The market and prices further deteriorated, and the outlook for a successful reopening is bleak. A high arsenic content of the ore would add to the marketing difficulties. Gypsum from an area north of Nouakchott has been mined since 1973 by SNIN. In 1983, this operation was separated from SNIM. The output is small (17,000 tonnes per year) and entirely sold to the Rufisque cement plAnt in Senegal in return for a rebate on cement sold to Mauritania. Other minerals, which are not mined but have been reported existing in Mauritania include phosphate, rare earth and gold. About 90 million tonnes of raw phosphate rock have been explored near the Senegal river, some 300 km from the sea. The market situation, relatively low reserves and the lack of transport infrastructure preclude an economical exploitation at present. Similarly, market considerations, remote desert locations and poor geological indications presently do not suggest any possibility of economical exploitation of rare earth or gold. 1J Including 100 million tonnes from the nearby Guelb Oum Arwagen. 2/ IFC partic'.pated in the establishment with share and loan capital in an amount of approximately US$20.0 milion, but has since sold all shares.  -9- The Borrower: Societe Nationale IndustrieLle et Miniere (SN3DM) 30. Ownership, Organization and Management. Since the nationalization of MIFERMA in 1974, the mines have been operated by SOIM, established as a State company in 1972. In 1978, SKIM was made a state-controlled, limited liability corporation (Societe d'Economie Mixte a Najorite d'Etat), permitting private and foreign ownership. SIND's share capital is currently held by the Mauritanian government (70.9 percent), the Kuwait Foreign Trading Contracting and Investment Company (9.6 percent), the Arab Mining Company (7.6 percent), the Iraq Fund for External Development (6.2 percent), le Bureau de Recherches et de Participations Kiniares du Maroc (3.1 percent), la Banque Islamique de DWveloppement (2.4 percent) and Mauritanian individuals (0.2 percent). 31. Apart from the iron ore mining operation (SNIM Fer), SNIM includes a few minor ventures: (i) SNIM Explosifs, a small explosives factory, now being made redundant by the introduction of modern explosive mixing trucks in the mines; (ii) SNIM Acier, a small steel plant producing steel bars used in construction mainly for the local market; and (iii) SNIM Paris, the marketing branch located in Paris. The operation of SINK Acier has so far made cash losses. SNIM has sold off two-thirds of its shares in this company and the steel mill is nor legally, financially and administratively separated from SNIM. 32. Starting in late 1984, SNIN's management structure was modified from a flat structure (22 departmental managers reporting directly to the general manager) to a pyramid shaped structure (10 managers reporting to the general msanager, each with three to seven divisional managers reporting to them). In early 1985, the previous technical manager was promoted to the position of general manager. His background and experience are valuable for implementing management, production and cost improvements. A review of the management and organizational structure by consultants CCEGOS/METCHEK), whose terms of reference were reviewed by the Bank, was completed in September 1985 and confirmed the appzopriateness of SHIM's new overall organizational structure. 33. From 1979 to 1984, SINM's work-force has increased by about 17 percent, from 5,165 to 6,059. This high growth in the work-force is a major reason for the company's present financial difficulties and will be addressed in the proposed Rehabilitation Project (para. 54). On the other hand, SINM has reduced the number of expatriates from about 400 to approximately 100. 34. Operations. SINM's headquarters are located at Nouadhibou, the port of ore shipments. The mines are managed from Zouerate and the port and railway are managed from Nouadhibou. For its operations, SHNM also maintains a small office in Nouakchott for liaison with the Government and a small purchase office in Las Palmas. Although the labor force is large compared to efficient iron ore operations elsewhere, SHNM's operations are reasonably efficient, and equipment maintenance is, in general, appropriate.  -10- 35. The Kedia mining operations are spread over six small pits, equipped with older 4m3-electric rope shovels and trucks, mainly in the 60 tonnes-class. There are two crushing and train loading stations, one at Rouessa and one at Tazadit, each having a capacity of about 5 million tonnes per year. The mobile mining equipment, as well as the fixed installations, need continuous planned maintenance and overhaul for efficient operation. Central workshops along with other services such as power/water supply and warehousing, are located in Zouerate. The town now has about 50,000 inhabitants of which about 2,500 are employed by SNIM. Although major services for the town, such as schools, hospitals, food distribution and airport operation have, to a large extent, been transferred to Government agencies or private enterprises, SNOM is still responsible for power and water supply, as well as for major road maintenance. By the end of 1986, SNIM will decide on further cost saving measures in this area. 36. The railway connects Zonerate, over a distance of about 650 km, with the port at Nouadhibou. Although SNIM has regularly maintained the railway track, some of its sections are now so heavily worn, that replacement has become critical to sustain present production rates. Some of the locomotives are worn out and need either new engines or complete replacements. The port equipment consisting of ore tipping, crushing, screening, stockpiling and shiploading facilities is basically in good operating condition; only the shiploader requires overhaul in the near future to secure high availability. 37. The Guelbs Project. This project was implemented to replace the production of iron ore from the depleting reserves of the Kedia mine. It consists of a new mine at Guelb (mountain) El Rhein, about 30 km north of Zouerate, a beneficiation plant of 6 million tonnes per year capacity and some extension of the existing railway and port. Financing from 12 lenders, including the Bank, was secured in 1978 and first contracts were issued in 1979. After initial delays caused by late effectiveness of the loans and procurement inefficiencies, construction was completed by end 1984 at a cost of US$350.0 million, about 20 percent lower than estimated at appraisal, mainly due to the lower than expected inflation and the highly competitive bid prices obtained. The first beneficiated ore was shipped in March 1985. Apart from the initial delays and the still remaining task of bringing the output of the beneficiation plant to full capacity, the project was implemented satisfactorily from a technical, financial and managerial point of view. 38. The mine is equipped with modern, large equipment. The beneficiation plant is the key component of the project. Due to lack of water, a completely dry semi-autogenous grinding process followed by dry magnetic separation was selected. Provisions have been made for a possible later addition of production lines. A new 60 KW diesel power station has also been added.  -ll- 39. The output for 1985 is estimated at about 1.0-1.5 million tonnes. SNIM plans to increase the production over the next two years to 4.5 million tonnes per year (75 percent of capacity) and accordingly decrease the production from Kedia. Although all major operating parameters have been verified to range within design limits, SNIM experienced some technical problems, in particular with the control of dust from the totally dry process. The plant designer (SOCOMINE), the French steel company (SOLMER), the French steel industry's consulting branch (SOFRESID) and equipment suppliers all provided technical assistance for the start-up. Based on the experience gained during the first six months of operation, SNIM has prepared a detailed plan for improvements and has created a task force to solve technical problems. These measures are considered appropriate. 40. Past Production and Sales Performance and Recent Financial Position. In 1984, SNDM produced and sold 9.5 million tonnes, which enabled it to reverse a trend of declining production and sales from 11.7 million tonnes in 1974 to 7.4 million tonnes in 1983. The recent increase was primarily due to increased sales to Italy, Belgium and the UK, where SNIM's share of imports increased from 1982 to 1984 by 5 percent, 4 percent, and 2 percent, respectively (para. 47). 41. Over the last five years SNIM has been able to keep its production cost constant at a level of about US$15/tonne. A reduction of about 20 percent was achieved in 1984, mainly due to the higher production rate and the ougulya devaluation. While production costs have been sufficiently low to prevent major cash deficits in the past, SNIM has, however, not been in a position to accumulate the funds needed for self-financing of the originally planned second phase of the Guelbs Project. 42. Despite the balanced cash flow in the past and the production cost improvements of 1984, SNID is in a difficult financial situation. Internal cash generation of US$35.0 million plus external financing in the amount of US$47.5 million (total US$82.5 millioln) was insufficient to cover payment of royalties (US$13.8 million), debt service (US$6.5 million) and capital expenditure (US$71.9 million, including change in working cLpital). Consequently, SWIM's bank overdrafts increased to US$15.1 million. The curreat ratio 3/, still above 1.0 in 1982 and 1983, dropped to 0.9 in 1984. 43. Repayment of the Guelbs debt has started in 1984 and debt principal payments have increased from US$6.5 million in 1984 to US$19.1 million in 1985. This, together with the outlook for production cost at the Guelbs plant (para. 44) and SNIM's 1984 financial results, clearly indicates that costs must be cut to increase internal cash generation if the increasing cash requirements are to be met. SNIM, together with Bank missions, has identified areas where sufficient cost reductions in the short- and medium-tenm can be achieved. 3/ Current assets/current liabilities.  -12- 44. SNIM's Medium- and Long-Term Outlook. Starting in 1985, SNIM will over the medium-term operate its traditional Kedia operations and the new Guelbs plant in parallel. Ore sales are expected to amount to 9 to 10 million tonnes per year, of which the Guelbs plant, after the initial start-up period, would produce up to 6 million tonnes per year; the remainder of 3 to 4 million tonnes per year being produced as high grade and siliceous ore by the Kedia,mines. Due to the low ore grade and the resulting high mining volume aita beneficiation costs, ore produced from the Guelbs would cost about US$4.2/tonne more than from Kedia. This means an increase of SNIM's overall cash production cost by about 20 percent once the Guelbs plant is in full operation. In addition, SNIM will, during this period, have to service the Guelbs debt. 45. After depletion of the Kedia mines, estimated to occur around 1995, SNIM's production and sales volume would decrease. Depending on the amount of siliceous ore SNIM could produce and sell at that time from Guelbs, the drop in production may be in the order of 20 percent, so that the long-term production rate may be about 7-8 million tonnes per year. Operation of the existing Guelbs facilities may be financially possible at that rate, since SNIM then would have paid back most of the Guelbs debt. However, the operation at the reduced production level would require further drastic adjustment of overhead cost beyond the cost cutting measures of the proposed Project. The Iron Ore Market 46. The international iron ore market is the major determinant of SNIN's financial viability and of the value of SNIM to the Mauritanian economy. The uncertainty of this market is consequently the major source of financial risk for SNIM and for the proposed Project. An estimated 98 percent of iron ore goes to steel industry blast furnaces to produce pig iron for steel making. Consequently, the iron ore market is intimately linked to the steel market. The steel market has contracted substantially during the last 15 years, and steel consumption and production is expected to grow by a modest 15 percent over the next 10 years, almost exclusively in developing countries. It follows that growth in iron ore requirements will come from steel mills in developing countries, whereas demand projections for the seaborne iron ore of industrialized countries (the market SNIM is catering to) indicate poor market prospects. Given the presently substantial excess in world iron ore production capacity and the fact that the two major producers, Brazil and Australia, are profitable at current prices, iron ore prices in real terms are likely not to increase over the medium- to long-term. A slow and gradual decline of prices from 1984 to 1995 amounting to a total of 7 percent in real terms is projected. 47. SNIM's major markets in 1984 were Italy (accounting for 31 percent of sales), France (23 percent), Belgium (23 percent), the United Kingdom (11 percent) and Germany (6 percent). SNIM's recent export performance has been acceptable. Even at a time when European iron ore markets were particularly depressed, SNIM has consistently captured about 7  -13-. percent of the European seaborne iron ore market. However, SNIM exports are concentrated in three countries (France, UK and Italy) where its market share reaches 15 percent. SNIM has traditionaliy little market penetration in Germany which is the major European market for imported iron ore. This leaves SNIM in a somewhat unfavorable market positiou as its sales are concentrated in the European markets with low expectations for future growth. On the other hand, SNIM's share of the total European market is relatively small at 7 percent, and its Guelbs sales are to replace existing Kedia sales. Also, European steel mills may wish to retain supply capabilities in West Africa to avoid concentrating their supply sources in Brazil and Australia. To the extent reserves are being depleted in Liberia and prospects are not favorable for new iron ore projects In Africa to add substantial new capacity, SNIM should be able to maintain its sales level in the European iron ore market. SNOM sales to developing countries are mainly to countries around the Mediterranean (Tunisia, Turkey and Yugoslavia). These sales have been and are expected to stay small. For the faster growing Asian developing countries, SNIM's geographical position is unfavorable. PART IV - THE PROJECT Background and the Bank's Role 48. The proposed Proiect was identified in connection with supervision of the Guelbs Project. Since 1981, Bank staff have projected a serious future cash deficit, if SNIM would not take remedial actions. In 1984, SNIM took the first steps to improve its financial situation, declared its intention to complete a full rehabilitation program, and requested the Bank's and other donors' assistance in the financing of such a program. The Guelbs colenders agreed to it. Whereas most lenders could make available unused portions of their Guelbs loans (due to lower than estimated project cost) or reschedule their loan repayments, the Bank considered a new loan, provided agreement could be reached on details of the future rehabilitation program. 49. The Rehabilitation Project is in line with the Bank's lending strategy for Mauritania and the West African region, aiming at creating economies which do not depend on continued external financial assistance. SNIM is a major asset of the Mauritanian economy which has a considerable positive macroeconomic impact, and its technical and financial viability is crucial. The scope for improvements exists and SNIM and the Government have started taking actions. The Bank's support helps focus on priority actions and implementing them in a timely manner; moreover, it is also welcomed by the colenders, who recognize the benefit of the Bank's leadership in this connection. 50. The Project was appraised in April 1985. Negotiations took place in Washington from October 16 to 18, 1985. The Mauritanian delegation was headed by Mr. Mohamed Lemine Ould Deidah. The main features of the Project  -14- are outlined in the Loan and Project Summary at the beginning of this report. A Supplementary Project Data Sheet (Annex III) and Maps Nos. IBRD 19048 and 19049 are attached. A Staff Appraisal Report (No. 5819-HAU, dated November 12, 1985) is being distributed separately to the Executive Directors. Project Objectives and Description 51. Generally adverse market conditions and SNIM's market position underscore the importance of SNIM's strong and sustained efforts to remain a source of economic benefits to the Mauritanian economy, in addition to staying a financially viable operation. As part of the supervision of the Guelbs Project, the Bank assisted SNIM in preparing a rehabilitation program which it began implementing in 1984. The Project consists of the actions in support of this rehabilitation program, which covers the period 1984-1988. About US$36.7 million will have been expended by end 1985, of which US$27.9 million are being financed by SNIM and US$8.8 million by the Guelbs colenders. The proposed Loan of US$20.0 million, together with additional funds from SNTM's internal cash generation (US$7.7 million) and the colenders (US$27.8 million) will finance the project components to be implemented from January 1986 to mid-1988. 52. The Bank's financial involvement will consolidate and further advance the ongoing action program for managerial and technical improvements and will in particular: (i) help SNIM continue to improve its management and reduce its production costs; and (ii) assist with the necessary financial restructuring of SNIM by transforming part of its short-term debt/overdrafts into long-term debt. 53. The rehabilitation program, as prepared by SNIM, consists of a series of measures by SNIN aimed at improvements and cost reductions in the areas of management, operations, procurement and investments, personnel, overhead cost and cash management. The Project includes the purchase of critical equipment, as well as training and technical assistance necessary for the implementation of the rehabilitation program. 54. The Rehabilitation Program. The program consists of the following actions: - Management and Organization. SNIM has taken actions to simplify and improve the company's structure (para. 32). A few minor additional improvements were suggested by consultants (CEGOS/METCHEK) and will be implemented by SNIM as part of the rehabilitation program. As from 1986, a detailed five-year production and investment plan will be prepared and updated annually. New systems for cost accounting, reporting and budget  ; -15- control will also be introduced in 1986. The Bank reviewed SNIM's new operational efficiency and budget review procedures and found them satisfactory. Furthermore, in order to monitor and ensure the appropriate implementation of measures concerning financial management and capital structure, assurances were obtained that the five-year production/investment plan be reviewed annually and a copy submitted to the Bank for approval. Operations. The operations and maintenance improvements extend to mining activities, port and railway, and to the control of spare parts. Planned overhauls of fixed installations and equipment, close control of the utilization of critical equipment and the elimination of old and redundant equipment will be particularly emphasized during the years 1986 and 1987. SNIM has presented a satisfactory program for equipment overhauls in those two years. SNIM also made satisfactory arrangements for controlling the start-up of the Guelbs plant during the remainder of 1985 and during 1986 (para. 39). Definition of targets for 1987/88 is a condition of continued disbursement (para. 63). Technical assistance for railway maintenance has started. About 20 man-months of foreign technical assistance for spare parts management, financed by the Bank, will be obtained in 1986. Procurement and Investments. The procurement process will be made more efficient by consolidation of procurement and purchasing departments, the increase of technical staff and by greater recourse to international competition. These improvements started in 1984 and will be mostly completed in 1986. Investments will be closely controlled and restricted to the absolute minimum. Agreement has been reached that SWDM will not invest more than US$5.5 million per year without approval of the Bank. Agreement was also reached that SNIM will maintain a curreat ratio of no less than 1.1 until one year after project completion and of no less than 1.3 thereafter. Personnel. SNDM has provided the Bank with an acceptable plan for reduction of personnel and overtime. Achievement of these targets is a condition for continued disbursement (para. 63). SNIM will also prepare a five-year policy for salaries, which will help to achieve cost reductions, along with targets for 1987/88, and agree with the Bank on this policy before June 30, 1987. Overhead Cost. SNIM has started to reduce costs in areas such as its offices abroad and in Nouadhibou, non-iron ore and research activities, transport and general training. A study will be carried out in 1986 for further reductions, and SNIM's definition of 1987/88 targets, acceptable to the Bank, is a condition for continued disbursement (para. 63).  -16- - Cash Management. The day to day management of cash will be improved so as to reduce the short-term debt. At the end of 1984, SNIM had almost fully utilized its available bank overdrafts (about US$15.0 million). Presently, SNIM is slowly reducing the overdrafts. Further reductions by at least US$5.0 million from the December 31, 1985 level (expected to be about US$10 million) are a condition of continued disbursement (para. 63). 55. Project Components to be Financed. SNIM's internal cash generation, funds from colenders and the proposed Bank loan will finance the purchase of necessary equipment for the following purposes: - Replacement of Equipment. Some heavily worn railway track sections, locomotives and locomotive engines will be replaced to ensure adequate transport capacity, in accordance with the previous recommendations of a consultant. Worn and obsolete mining equipment will also be replaced. The capacity of the electric line between the Guelbs site and the mining town of Zonerate will be increased, so that the town can benefit from cheaper electricity. - Major Overhauls and Improvement of Equiyment Major fixed installations at Zouerate and Nouadhibou will be overhauled to eliminate production bottlenecks. All needed mobile mining equipment will be brought into good mechanical condition for high performance. Special emphasis will be on the availability of critical supplies needed for efficient operation, such as tires for mining trucks, conveyor belts and wearing parts. - Tools and Control Equipment. Sufficient and Improved tools and instrumentation will be provided for wXorkshops and for major field equipment to Improve efficiency and control. Also, for better control and planning, more use of computers wlll be made. - Training and Technical Assistance. SNIK will continue to employ about 24 key expatriates, who are training Mauritanians in the areas of operations, maintenance and supervision. Courses to develop supervisory skills will be offered by a consultant. Consultants services will also be obtained for the implementation, of a new management information system, mine planning ard mine operations, railway maintenance, spare parts management and start-up of the Guelbs plant. An estimated total of 1,735 mn-months are involved, of which 1,150 man-months (66 percent) are provided by expatriates presently employed by SNIM. About 730 man-months will have been provided by end 1985, of which 78 percent are being financed by SNIM and 22 percent by the colenders. The remaining services are already contracted with the exception of 40 man-months for: (i) assistance in spare parts management to provide SNIM with key expert advice on how to  -17- maintain and further improve good standards for this important function; and (ii) courses for managers and supervisors, to improve their managerial skills. The assistance in both these areas will be financed by the Bank under the proposed Project. Implementation Arrangements and Schedule 56. All activities will be nonitored by the company's controller, an experienced engineer directly reporting to the General Manager, who during the last two years has been increasingly involved in the design and implementation of SNIM's cost saving measures. Orders for the execution of the diffarent project components will be given by the General Manager through the line management to the executing units. Procurement will be bandled by SNIM's procurement/purchasing department which has sufficient experience to carry out efficiently the procurement tasks required under the Project. 57. Implementation of the rehabilitation program, of which the Project forms a part, started in 1984. Completion of the program is expected by mid-1988. Actions concerning Guelbs start-up, as well as reduction of personnel and overtime will be handled in two distinct phases. An evaluation of the results of the first phase and definition of plans and targets for the second phase, expected before July 1, 1987, will precede the implementation of the second phase. Project Cost and Financing Plan 58. The estimated total project cost in mid-1985 prices (net of taxes but including contingencies) is estimated at US$92.2 million, of which US$75.4 million is in foreign exchange. Total base costs net of contingencies amount to US$85.5 million. Costs were estimated based on SMI1's experience in procuring similar goods and services over the past few years. Actual expenditures were taken for components already started in 1984 and 1985. Physical contlngencies of 3 percent were added for expenditures in 1986 and 1987. Price contingencies were based on an assumed inflation of 7.0 percent in 1986 and 1987, and 7.5 percent in 1988. 59. All local project costs (US$16.8 million) plus US$19.6 million foreign costs are financed by SNIt from its own internal cash generation. The remaining US$55.8 million foreign exchange costs will be financed by SNIM's previous lenders for the Guelbs Project, including the Bank. Whereas the Kuwait/Arab/Saudi/Abu Dhabi Funds and OECF have made available unused portions of their Guelbs loans under the same favorable terms, the CCCE has made a new loan of US$3.0 million equivalent with an interest rate of 5 percent and repayable over 15 years, after a 5 year grace period. The Bank proposes also to provide a new loan in the amount of US$20.0 million to be made to SWIM at the standard IBRD variable interest rate plus a 10 percent guarantee fee to the Government for a 15-year term, including a 3-year grace period, and a commitment fee of 0.75 percent.  -18- 60. All loans will be included in the existing trust and set-aside agreements for the Guelbs project, whereby all proceeds from the sale of iron ore are allocated as a matter of priority to debt service payments and set aside tbrough monthly transfers to a London trust account from which lenders are paid. The agreements also provide for setting aside on a monthly basis the foreign exchange SNIM needs for its day-to-day operations. The remainder, consisting basically of SNIM's labor cost and royalties to the Government, is transferred to the Central Bank of Mauritania for the credit of SNIM. Procurement and Disbursement 61. All goods and services will be procured in accordance with Bank guidelines, except for specific items financed by colenders which would be procured under their own procedures. 62. Out of the US?18.0 million allocated under the proposed Bank loan for the purchase of goods and equipment, about US$10.4 million will be used for the direct purchase of spare parts and sub-assemblies from the manufacturers of equipment and some specialized operating supplies. Given the proprietary nature of most of this equipment, the small size of the contracts (none is expected to exceed US$300,000 equivalent) and the need to utilize genuine spare parts, this method is considered the most efficient and appropriate. However, the aggregate amount of sole source procurement shall not exceed an aggregate of US$10.5 million. The balance of the Bank loan will be used to purchase tools, instrumentation, tires for mining trucks, conveyor belts and wearing parts for mining and beneficiation equipment. Such goods are either purchased in small lots, are only available from a limited number of suppliers (e.g. tools and instrumentation), or require long testing periods before an adequate technical evaluation can he completed in order to select the most economical product for a specific application (tires, wearing parts). SNIM has purchased such goods from well-known international manufacturing firms. Therefore, the most appropriate procurement procedure is limited international bidding (LIB) fo all packages not exceeding US$300,000 or equivalent, on the basis of at least four bids being invited from at least three countries. Although not foreseen at this time, should larger packages be tendered during project implementation, they would be procured by international competitive bidding (ICB) under Bank guidelines. For all contracts not exceeding US$50,000 or equivalent, international shopping will be applied by inviting price quotations from at least 3 suppliers. Due to the large number of equipment items from various suppliers and SNIM's prudent policy to avoid stocking large quantities of spare parts and materials, the number of packages to be procured will be large (presently estimated at about 150). SNIM handles such procurement efficiently as part of its daily operations. Purchase orders for sole source equipment will be issued without delay as required by the materials management system. Also, the bidding procedure for LIB-procured packages, such as for tires, conveyor belts and wearing parts, will be initiated in a timely manner through the materials management system. Bank staff has reviewed with SNIK  'V -19- procedures and documents for sole source and LIB-procurement and found SNIM's procedures appropriate. There will be a prior review of all procurement documents (bidding documents, bid evaluations and contracts) for the first ten procurement packages (excluding international shopping) and all packages exceeding US$500,000. Procurement Arrangements (US$ million) Project Element Procurement Method Sole Total LIB Source Other Cost Replacement of Equip-nat 24.6 3.3 - 27.9 Sub-Assemblies, Spare Parts and Operating Supplies 10.1 23.3 - 33.4 (6.3) (10.4) (-) (16.7) Tools and Instrumentation 5.1 - _ 5.1 (1.3) (-) (-) (1.3) Training and Technical Assistance - - 9.0 9.0 C-) (-) (2.0) (2.0) SNIN Labor 1- 6.8 16.8 Total 39.8 26.6 25.8 92.2 (7.6) (10.4) (2.0) (20.0) Note: Figures in parentheses are the amounts to be financed by the Bank. 63. Disbursements of the Bank loan will be made on the basis of 100 percent of foreign expenditures for goods and 100 percent of total expenditures for technical assistance and training. A special account will be established at a foreign bank out of which SNK wll pay most purchases of goods and services. The total loan will be disbursed over a period of 2.5 years. The schedule differs from the normal country and industry profiles by the even distribution of disbursements. This is explained by the on-going status of the project and the recurrent nature of investments  -20- and expenditures. Due to SNIM's familiarity with similar procurement and its desire to reduce bank overdrafts, no delays in disbursements are expected. Disbursement against all categories will be divided into two equal tranches of US$10.0 million each. The first tranche covers disbursements until about June 30, 1987. The second tranche will be released only after certain actions have taken place, namely: SNDE shall have: (i) submitted to the Bank: (a) audited financial statements for 1986, which will help assess the progress made under the first tranche and define furthar steps; and (b) the Company's long- term policy for salary levels and structure; (ii) achieved: (a) a production from the Guelbs plant of not less than 1.0 million tonnes over three consecutive months; (b) the 1986 targets on the reduction of personnel and overtime; and (c) lowered its bank overdrafts from the December 31, 1985 level by at least US$ 5.0 million (para. 54); and (iii) prepared plans and targets, acceptable to the Bank, to be Implemented and achieved over the 12 mDnths following release of tranche 2, for: (a) production rate and technical assistance for the Guelbs plant; and (b) further cost reductions. the Government shall have: (i) completed a study of the public finance aspects of the royalties on SNIM's ore sales; and (ii) agreea with the Bank on the implementation of the recommendations of this study. Financial Analysis of SNIM 64. Financial projections for SNDM prepared in current US dollars are based on (i) a production/sales volume of 9.5 million tonnes per year; (ii) operating costs taking into account the cost reduction achieved in 1984 and projected additional cost reductions; (iii) an expected reduction of the iron ore price by 1990 by 7 percent in real terms from its 1984 level; and (iv) variations In the UM/US dollar exchange rate that compensates for the differential between Mauritanian price developments and world price developments as measured by the Manufacturing Unit Value index. Operating costs were developed on the basis of SNrM's present cost structure and corrected to allow for expected personnel and material cost reductions as a result of the proposed Rehabilitation Project measures. 65. The Rehabilitation Project is expected to bring about a reduction of: (i) non-labor operating costs, mainly consisting of materials, of 3.8  -21- percent in real terms for each of the years 1986 and 1987 with no further decreases thereafter; and (ii) labor costs by about 3.5 percent per year in real terms (total labor cost in current terms is projected to increase by only half the rate of inflation). In the period 1985-1990, the projected savings in labor costs amounts to US$23.0 million and in other operating costs to US$26.2 million. With these savings, SNIM's cumulative operating income in the period 1985-1990 is projected at US$138.0 million. SNIM pays a royalty to the Mauritanian Government amounting to 10 percent of iron ore sales. The royalty payments correspond to about 40 percent of the internal cash generation. The level of royalty is high compared to that paId by SNIM's competitors. Assurances were obtained that the Government undertake a study of the public finance aspects of the royalties. Terms of reference for the study together with a proposed implementation schedule has been submitted to the Bank. Agreement on implementation of the study's recommendations is a condition of release of the second tranche of the loan. 66. SNIM's financial performance is highly sensitive to variations in iron ore prices, sales volume, and cost savings. With total sales in the period 1985-90 forecast at about US$1.2 billion, a US$0.1/t reduction in the assumed price of iron ore throughout that period would increase the net financing need by about US$5 million for that period. Without the Rehabilitation Project, production and sales volume would likely be lower by at least 10 percent, given the technical and managerial efforts envisaged under the Project, and the result would be a net financing need for the 1985-90 period of US$100 million (or 75 percent of projected royalty payments during that period). 67. The sensitivity analysis shows that any adverse deviation from the base case can seriously curtail SNIM's availability of funds. Since the trust and set-aside agreements ensure that foreign debtors and suppliers are paid their dues (para. 60), any cash shortfall will reduce the funds available for the payment of local inputs, i.e. labor, and for the royalty to the Government. The labor force is large by international standards and wages and salaries are high by Mauritanian standards; similarly, the level of royalty is high compared to that paid by SNIM's competitors. Consequently, a cash shortfall can potentially be cushioned by reductions in royalty payments and further cuts in labor cost. Project Benefits and Risks 68. Benefits. SNIM is a valuable asset to Mauritania in its capacity as an essential source of foreign exchange earnings for the Mauritanian economy. Strengthening of SNIM's ability to generate foreign exchange is essential to assist the Government's investment effort in non-mining activities, and to support its strategy of diversification of its economic structure. Through efforts to enhance SNIM's international competitive- ness, the Project's principal benefit is to preserve SNIM as a financially viable enterprise contributing positively to the Mauritanian economy. The economic rate of return of the Project is 25 percent, and the financial rate of return is 21 percent. The economic rate of return is most  -22- sensitive to the basic assumption made concerning the cost saving effects of the Project. The economic rate of return is reduced to 15 percent (i) if cost savings are 57 percent below the appraisal value, (li) if project cost is 40 percent higher than appraisal value, or (iii) if iron ore prices are 26 percent below the appraisal base case. The economic rate of return of the Guelbs Project, given actual project cost, current forecasts of iron ore prices and updated estimates of production costs, is 2 percent; the economic rate of return of the Guelbs Project, combined with the Rehabilitation Project, is 5 percent. Net Incremental foreign exchange benefits of the Project average US$8 million per year in constant 1985 terms over the next ten years; SNIM's overall net foreign exchange earnings average US$57 million in constant 1985 terms over the same period. 69. Risks. The major sources of the substantial financial risk facing the Project are: (i) adverse changes in iron ore prices; and (ii) possible failure to Implement appropriately and in a timely fashion the cost savings and financial measures of the Project. A conservative iron ore price forecast based on a thorough market analysis was used, reducing the risk of lower than estimated iron ore prices. As to the achievement oi the expected effects of the Project, the training and technical assistance components, as well as the close monitoring of the implementation of the Rehabilitation Program including frequent progress reporting, reduce the risk of delayed and deficient implementation. It is the exact purpose of the Project to limit SNIM's financial risk. In view of the importance of SNIM to the economy, the Government will have to take all necessary steps to ensure the viability of the Company. As a last resort, therefore, any cash shortfalls can potentially be cushioned by further cuts in labor costs or royalty payments (para. 67). 70. To a lesser degree, the Project also faces managerial, commercial and technical risks, which have been minimized through extensive project preparation and the fact that SNIM has already successfully started its rehabilitation program. PART V - RECONMENDATION 71. I am satisfied that the proposed Loan would comply with the Articles of Agreement of the Bank and recomnd that the Executive Directors approve the proposed loan. A.W. Clausen President Attachments November 12, 1985 Washington, D.C.  -23- ANNEX 1 r A * L C 34 Page 1 of 6 NJrIMIA -SAL IUICAT D 0 U4TA - aaXex~~~~~~~~~~~~mTMa. _|cgrm ca GN Nwg ] /a mmS (MM 330511? 52DT ) lb 19mtIb 19d