Mexico - Steel Sector Restructuring Project

Document of The World Bank FOR OFFICIAL USE ONLY Report No. P-4618-ME MEMORANDUM AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BAN1 FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN IN AN AMOUNT EQUIVALENT TO USW400 MILLION TO THE NACIONAL FINANCIERA, SNC WITH THE GUARANTEE OF THE UNITED MEXICAN STATES FOR A STEEL SECTOR RESTRUCTURING PROJECT. February 8, 1988 This document has a resticted disibution and may be u"s by redpiens only In the performance of their officd dutis Its contens may not otheise be dbslosed wihout Wodd Bank authorization.  CURRENCY EQUIVALENTS Peso (Mex$) An exchange rate representing the mid-June 1987 free market rate has been used in the project analysis: US$1 - Mex$1,235 The most recent exchange rate as at January 26, 1988, was: US$1 = Mex$2,206 in the free market FISCAL YEAR January 1 - December 31 ABBREVIATIONS AND ACRONYMS AHMSA - Altos Hornos de Mexico S.A. CMC 1/ - Carbon y Minerales Coahuila S.A. FMSA - Fundidora Monterrey S.A. HYLSA - HYLSA S.A. NAFIN - National Financiera S.N.C. SICARTSA - Siderurgica Lazaro Cardenas Las Truchas S.A. SIDERMEX - Public Sector Steel Holding Company 1/ CMC is the legal entity being set up as a holding company to oversee the mining operations of the Raw Materials Division of SIDERMEX.  FOR OMCILu USE ONLY MEXICO - STEEL SECTOR RESTRUCTURING PROJECT Loan snd Proiect Sumnary Borrower: Nacional Financiera, S.N.C. Guarantor: United Mexican States Beneficiaries: Government, SIDERMEX, AHMSA, CMC and HYLSA. Amount: US$400 million equivalent. Terms: 15 years, including 3 years grace, at the standard variable interest rate. Onlending Terms: Part A, the Input Materials and Steel Product Imports Component of the Project, to Government, at 0.25% abovc the Bank's standard variable interest rate and with the same terms as the Bank loan. Parts B and C, the Support for the SIDERMEX Restructuring Program and HYLSA Restructuring, respectively, to SIDERMEX, AHMSA, CMC and HYLSA, at a rate not less than 110% of the Bank's standard variable interest rate and with the same terms as the Bank loan. Exclhange risk will be borne by the subborroaers. Financing Local Foreign Total Plan: ---- (US$ Million) IBRD - 400.0 400.0 Local Banks 64.0 - 64.0 AHMSA 185.0 92.0 277.0 CMC 78.0 56.0 134.0 SIDERMEX 3.0 - 3.0 HYLSA 125.0 47.0 172.0 Total 455 595 1.050. Economic Rate of Return: In excess of 18%. Staff ARgraisal ReRort: No. 6892-ME, dated February 8, 1988. Map_s: IBRD 20418, IBRD 20419 This document has a restricted distribution and may be used by recipients only in the performanc i of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  MEMORANDUM AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO NACIONAL FINANCIERA, SNC WITH THE GUARANTEE OF THE UNITED MEXICAN STATES FOR A STEEL SECTOR RESTRUCTURING PROJECT-_ 1. I submit for approval the following report on a proposed loan of US$400 million to Nacional Financiera, S.N.C. (NAFIN), with the guarantee of the United Mexican States, and a maturity of 15 years, including 3 years grace, at the standard variable interest rate. NAFIN will onlend the proceeds of the loan as follows: (a) US$100 million to the Government of Mexico (GOM) in support of a steel sector policy reform program; (b) US$170 million to Altos Hornos de Mexico, S.A. (AHMSA), US$50 million to Carbon y Minerales Coahuila, S.A. (CMC) and US$5 million to SIDERMEX, S.A. in support of a Restructuring Program; and (c) US$75 million to HYLSA in support of a rehabilitation and modernization program of its flat products facility at Monterrey. Background 2. The steel industry is an important part of Mexico's manufacturing sector, contributing 4.2% of industrial output and 1.3% of GDP, in 1986; it has a crucial impact on the availability, quality and cost of material inputs for downstream manufacturing activities, particularly the engineering and capital goods industries. With an installed capacity of 9 million tons of crude steel equivalent, the sector comprises two public (58% of capacity) and two private sector (24% of capacity) integrated producers, and several independent, non-integrated mini-mills (18% of capacity) and rerollers. Mexico has relatively favorable conditions for its steel industry, including competitive supplies of iron ore, coking coal and natural gas, a well-trained and motivated labor force, well-qualified technical and managerial cadre and a growing domestic market especially for higher quality steel products. 3. Following years of rapid growth from the mid-1940s, steel demand and output fell sharply with Mexico's economic crisis in 1982, and, despite a recovery since 1983, remain below the pre-crisis peak levels; medium-term growth is projected at about 3-4% a year. Mexican production and consumption of steel products are about in balance. Non-flat producers, dominated by the private sector, but including the modern SICARTSA I public sector plant, are substantially competitive by international standards. The two flat producers, AHMSA in the public sector and HYLSA in the private, are not currently competitive internationally, particularly as regards quality. Highly protectionist trade policies prior to 1985 and controlled domestic prices below the full cost of efficient domestic producers and landed cost of imports had resulted in an inward-oriented industry, without much incentive to improve product quality and service to customers. This was particularly detrimental in flat products vital to developing competitive engineering and capital goods industries. By early 1986, the public and private sector entities were reeling under the combined effects of low demand, falling domestic prices in real terms, heavy debt service burdens contracted during the years of high growth, and internal cash generation inadequate to maintain existing plant and equipment and reinvest in new technology to meet changing market needs for quality and product range.  - 2 - 4. In early 1986, the Government, recognizing the industry's financial and technological plight, began a long-term effort to restructure the steel sector within its overall economic reform agenda. AS a critical element of that process, the Government developed a restructuring plan for SIDERMEX, the public sector steel holding corporation, and carried out the first steps, including financial restructuring of the viable entities, closure of the uneconomic integrated plant of the publicly owned Fundidora de Monterrey, S.A. (FMSA), organizational changes to ensure effective management, retrenchment and layoffs of operating personnel, and divestiture of virtually all non-steel related businesses. The organizational restructuring of SIDERMEX and the rehabilitation of physical plant is now under way. The Government is also assisting HYLSA, the major private sector producer, to restructure its massive US$l billion-plus external debt. 5. On the policy front, the Government (i) has eliminated Official Reference Prices and reduced tariffs on all steel products to a range of 0% to 15%; (ii) has brought controlled domestic product prices up to international levels; (iii) has committed itself to a program which includes month'ly adjustments to maintain domestic steel prices in real terms until complete elimination of price controls not later than December 31, 1988; and (iv) has substantially eliminated input subsidies. On balance, these actions will provide the incentives and signals for market-driven performance and strategic planning in the Mexican steel sector. The remaining other major elements in the short-term restructuring agenda are urgently needed improvements in facilities and technology by the two flat producers, together with minor balancing, debottlenecking and modernization investments by the other sector producers. No expansion of steelmaking capacity is foreseen or plan-ed. The Government has also presented the Bank with a Steel Sector Policy Letter which confirms the scope and direction of the steel sector policy reforms that have been undertaken and that will be carried out in the future. The outline presented in the Policy Letter will be further elaborated into a Global Steel Sector Policy Statement, to be completed before end-July 1988, based on the recently completed Market Study and the SIDERMEX Long-term Strategic Plan, wh,ch will be prepared by end-March 1988. The Annex shows a matrix of actual and planned GOM policy actions in support of the restructuring process. Rationale for Bank Involvement 6. The proposed Bank involvement in the steel subsector is part of and consistent with ongoing and planned assistance programs to GOM in a wide range of restructuring and adjustment actions such as trade liberalization, price decontrol and private sector promotion in the agricultural, industrial and parastatal (steel and fertilizer) sectors. These actions aim at improving competitiveness and efficiency of the Mexican economy. Previous Bank support to steel (Ln. 934-ME of 1973) contributed to making SICARTSA I the premier non-flat producer in Mexico and presently a highly internationally competitive entity in the SIDERMEX complex. By its recent actions and declared policies, GOM has demonstrated its determination to address major sector issues, expose the Mexican steel industry to international competition, fundamentally restructure the subsector and promote more efficient and rational resource allocation and utilization. It is in this context that the Mexican authorities are  -3- desirous of continued Bank investment in this subsector to help maintain the momentum of policy reform and to enable the private and public sector steel producers to arrest further deterioration and improve their competitive efficiency. Project Objectives 7. The ov*rall objective of the project is to assist GOM in implementing comprehensive and far-reaching policy reforms for both the public and private steel sectors and in carrying out the needed restructuring actions. The project would finance input materials and steel product imports during the adjus-.ment period; and would assist (i) CMC in the supply of raw materials; (ii) AHMSA and HYLSA to improve their competitive position in flat products; and (iii) GOM in designing and implementing a sound steel sector policy and sectoral public investment program within the framework of a liberalized market environment and in financially restructuring the industry. Overall the restructuring process would result in a reduction of steel-making capacity of approximately 20% (including closure of uneconomic plants), almost exclusively, all in the public sector, while allowing the industry to raise utilization of existing capacity and concentrate its product lines in competitive market segments. Proiect Description 8. The proposed project, with an estimated total cost of US$1,050 million (including taxes and duties of US$104 million equivalent) and a for .gn exchange component of US$595 million, supports a steel restructuring program and consists of three parts: (a) Part A fUS.100 million), an input materials and steel products import component tied to (i) implementation of agreed policy reforms involving elimination of domestic price controls and completion of trade liberalization measures, viz., reduction and rationalization of tariffs on steel products and elimination of Official Reference Prices (ORPs); and (ii) presentation of a Global Steel Sector Policy Statement; (b) Part B (total cost. u$ .72 million), involves physical investments in plant and equipment for rehabilitation, debottlenecking and modernization and technical assistance in support of the SIDERMEX restructuring effort to: (i) improve quality and competitiveness and increase capacity utilization for the AHMSA flat product facility (US$480 million), (ii) raise productivity in CMC iron ore and coal mining operations (US$184 million); and (iii) enhance SIDERMEX strategic planning capacity and imprc-ve corporate-wide management information and control systems (US$8 million); and (c) Part C (total cost. US$278 pillion), involves physical investments and technical assistance to support rehabilitation and modernization of the HYLSA flat products facilitv. The project would be implemented over a four-year period. The main project beneficiaries would each be responsible for the implementation of ;:heir respective components, with the assistance of qualified engineering and project management 'consultants. AHMSA, CMC and HYLSA have also set up internal Project Management teams whose staffing, functions and duties will ensure smooth project implementation. A breakdown of costs and financing plan are shown in Schedule A. Amounts and methods of procurement and the disbursement schedule are shown in Schedule B. A timetable of ke, project process events and the status of Bank Group operations in Mexico are given in Schedules C and D. Two maps showing the location of steel plants and iron ore and coal mines are attached. The Staff Appraisal  -4- Report (Report No. 6892-ME) dated January 29, 1988, is being circulated separately. Agreed Actions 9. The actions already taken (para 5), including a January 1988 adjustment of steel prices in real terms, and the presentation of the Policy Letter satisfy all conditions of Oisbursement of the first tranche of Part A, at loan effectiveness. Complete price decontrol on all steel products will take place no later than December 31, 1988, and is a conditton of disbursement of the second tranche of Part A. A further c.ndition of second tranche release is the elaboration by GOH, not later than July 31, 1988, of the Global Steel Sector Policy Statement, satisfactory to the Bank and based substantially on the Policy Letter provided at negotiations, in order for the private sector to react and complete its strategic planning. This statement will specify among others the respective roles of the public and private sectors and the Government's parastatal steel sector investment and operating policies, and elaborate on the Government's intended sector-wide policies and actions in line with the guidelines for the SIDERMEX Long-term Strategic Plan as provided in the Policy Letter. In addition, assurances were obtained that the overall Steel Sector Reform Program including the agreed elements of trade and price liberalization and global policy will be implemented and maintained in a manner satisfactory to the Bank, and that during the remainder of 1988 and until complete elimination of price controls, the Government will adjust domestic prices monthly based on the changes in the Consumer Price Index in order to maintain them in real terms. Finally it was also agreed that SIDERMEX would present its Long-term Strategic Plan for March 1988 Bank review, and thereatter implement the plan's agreed elements in accordance with investment criteria, financing plans and implementation schedules satisfactory to the Bank; it would also carry out annual reviews with the Bank on the progress of implementation as well as agree on the investment plan for the coming year. Benefits 10. The proposed project would permit local steel users to improve their efficiency due to a&'ailability of high-quality steel products at internationally competitive prices and, thereby, enhance their strategic role in the development of an export-oriented competitive economy. AHNSA and HYISA will attain international competitiveness since their restructuring will involve closure of uneconomic capacity and eliminate production bottlenecks resulting in (i) some increase in production despite a lower production capacity and (ii) a shift in the respective product mixes to higher- quality, higher-value products. The incremental financial rates of return on a discounted cash flow basis are 33% for the AHNSA and 17% for the HYLSA investment programs, differing due to the current performance of the two companies. Project Risks 11. A delay in decontrolling steel prices could aggravate the financial position of the major steel producers and induce calls for higher protection. This potential major risk is minimized by actions to date to adjust steel prices and the agreed calendar for monthly adjustments in real  - 5 - terms until complete decontrol by end-1988. Additional risks include a reversal in the agreed policy actions and a sharp real appre^iation of the exchange rate which could affect project viability. The potential adverse impact of the above risks is mitigated by Government commitment to the policy actions as demonstrated to date and as incorporated in the agreements. Recommendations 12. I am satisfied that the proposed loan would comply with the Articles of Agreement of the Bank and recommend that the Executive Directors approve the proposed loan. Barber Conable President Attachments Washington, DC February 8, 1988  -6- Schedule A MEXICO - STEEL SECTOR RESTRUCTURING PROJECT Estimated Project Cost: Local Foreign Total (US$ million) - Part A - 100 100 Parts B and C Equipment and Spares 88 328 416 Civil Works/Erection 91 10 101 Engineering/Project Management 17 17 34 TA/Training 8 18 26 Base Cost 204 373 377 Physical Contingencies 25 36 61 Price Escalation 38 30 68 Installed Cost 267 439 706 Taxes and Duties 104 0 104 Total Installed Cost 371 439 810 Incremental Working Capital 80 &0 100 Total Project Cost 451 459 910 Interest during Construction 4 36 40 Total Parts B and C 455 495 950 GRAND TOTAL Parts A, B and C 455 595 1,050 -~ ~~~ = Financing Plan: IBRD - 400.0 400.0 Local Banks 64.0 - 64.0 AMKSA 185.0 92.0 277.0 CMC 78.0 56.0 134.0 SIDERMEX 3.0 - 3.0 HYLSA 125.0 47.0 172.0 455.0 595.0 1,050.0 S==NM  - 7 - Schedule B MEXICO - STEEL SECTOR RESTRUCTURING PROJECT Procurement Arrangements (US$ million) ICB LIB/IS b/ LCB Other Cost Part A 100c/ - - - 100 (lOOT (100) Parts B and C a/ Equipment & Spares 316 41 95 56 508 (210) (30) (23) (263) Civil Works/Erection - - 124 - 124 Engineering/Project Management - - 35 35- (15) (15) Technical Assistance & Training - - - 39 39 (22) (22) Total Parts B & C 316 41 219 130 706 (210) (30) - (60) (300) a/ Not including interest during construction, incremental working capital and taxes and duties. b/ Limited International Bidding/International Shopping. c/ For contracts expected to exceed US$5.0 million. Other contracts would follow normal procurement procedures of purchasers. Note: Figures in parenthesis indicate amounts fir.anced from proposed Bank loan. Ioan Allocation Part Part Part % of Z of Expenditures A B C Total Total To Be Financed I. Raw Materials & Other 100.0 - - 100.0 25.0 100% of foreig expenditures Eligible IMPorts IL Fqupoent & Spare Parts - 163.0 57.5 220.5 55.0 100% of foreign expenditures and 100% of local expenditues (e-factory) III. Consultant Services - 21.0 3.5 24.5 6.0 100% IV. Unallocated - 41.0 14.0 55.0 14.0 - Total 100.0 225.0 75.0 400.0 100.0 Summary Estimated Disbursement Schedule IBRD FY: 1988 4989 1990 1991 1992 1993 Annual 58.1 108.8 110.4 86.8 26.4 9.5 Cumulative 58.1 166.9 277.3 36&.1 390.5 400.0  - 8 - Schedule C MEXICO - STEEL SECTOR RESTRUCTURING PROJECT Timetable of Key Project Processing Events (a) Time Taken to Prepare : Six months (b) Prepared by : S!DERMEX and HYLSA with consultant and Bank assistance (c) First Bank Mission : May 1986 (d) Appraisal Mission Departure : Match 1987 (e) Negotiations : January 1988 (f) Planned Date of Effectiveness : March 1988 (g) List of Relevant PCR and PPARs : PCR on SICARTSA I Investment Project, dated June 14, 1979  - 9 - Schedule D Page 1 STATUS OF BANS GROUP OPERATIONS IN MEXICO 1/ A. 9tot.oont ot lank Looen IA. of Soptember 80, 1807) (USS sattitan FPt a& Amount Lose Undi1- Loan No. veer alrrover Purpose Csanetletiena burnod 70 teene fully d1vbureod 4*700.8 t708-5 t979 NAFINSA Irrigation 92.00 80.12 18085e 1800 NAFINSA Irrigetion 70.00 S0.89 101S 18t1 SANOORAS Water Suppty 115.00 44.48 1990 18S1 SANOBRAS Urban Deletopeant l 1t64.00 5p.04 2048 1962 NAFINSA Intsegrted Rutat Oov. 175.00 20.8S P142 1992 NAFINSA Capitat Goods Industry 152.30 70.70 2154 1082 NAFtNSA Pottution Controt 25.00 11.91 2194 1983 BANOORAS Urben Engineering 9.20 5.07 9612 108s NAFINSA Agriculturel Marketing 115.00 48.45 9181 19Ss UANOORAS Third Water Suppty 100.80 50.93 PS26 1903 NAFINSA Third Bs/Med Industry 175*00 6.03 2881 1089 BANCONEXT Export Devetopment 850.00 56.25 24PS 1094 SAMOORAS HighWays 200.00 100.91 P450 1904 SAXPESCA Ports 76.30 89.t7 2525 1985 NAFINSA Chiapas Rurat Roads 12.00 19.95 2520 1905 NAFIbSA Chiapee Agric Dev. 90.00 77.34 2540 1995 NAFINSA 0o/Nad Secale ining II 105.00 91.00 P559 1905 NAFINSA Vocationtl Education 91.00 56.88 2575 198S BANODRAS RoaLseps V 800.00 218.09 2610 3980 MAFINSA Agriculturat Credit 180.00 5.65 2612 1986 SAMNORAS Lou-Income Housing I 150.00 109.05 1s5s 108 lAFIN Proderith II 109.00 90 47 2005 1906 SAMOSRAS Earthquake Rehab. 400.00 11 2 2668 1986 BANOSRAS Nunicipet Strengthening 40.00 37.80 2600 1986 BANOSRAS Solid Veste Pitot 25.00 P2.90 2745 1907 BANCONEXT Trade Poticy Loan I 500.00 10.99 2740 1907 NAFIN Industriet Recovery 150.00 117.79 1747 1907 NAFIN Technology DoevaloPent 40.00 30.87 2777 1987 8NCE Export Dsv.top.ont 11 2S0.00 159.15 1624 1997 SANOSRAS Urban Transport 125.00 125.00 2837 1Se0 NAFIN Agriculturat Credit 400.00 859.98 2895 8/ 1997 NAFIN So/Med Induatri.e IV 105.00 185.00 1050 1987 NAFIP Agricutturat Extension 20.00 17.41 TOTAL 9.709.91 Of which bas been repaid to the Bank 1,421.25 Total nso outstanding 7,280.86 Amount *etd 92.34 Of *hich as been repaid 92.34 0.00 Totat now bald by Bank 2/ 7t98.086 Totat undisbursed 2 47P .72 Muana==0ss. 1/ Tho status of the projects tisted in Pert A Is In a separated report on att Bank/IDA financad projects in exscutian, which la updated twica yearty and circutated to the Executive Directors on Aprit 80 and Oetober 31. / Prier to oxchengs .djusttente. 8/ Mot yet effective. LoenStatus#8N:1NXCsAI ...J75 ESArevatoaLA2CO October 22, 1987  - 10 - Schedule D Page 2 D. *sot*sUos of Svc Ivesselsest As of Septleber *e. 1095 ltiO ilitisa) Pimeel Origiset Appros--