Turkey - Erdemir Steel Project - Stage Two

Document of The World Bank FOR OFFICIAL USE ONLY Report No. 7905 PROJECT COMPLETION REPORT TURKEY ERDEMIR STAGE II STEEL PROJECT (LOAN 1606-TU) JUNE 27, 1989 Country Department I Europe, Middle East and North Africa Regional Office This document has a restricted distribution and mas be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCi EQUIVALENTS Currency Unit = Turkeish Lira (TL) Year V. lue of US$ 1976 * TL 16.05 1977 TL 18.00 1978 TL 2'4.28 1979 TL 3,08 1980 January TL 70.00 1981 " TL 91.00 1982 " TL 139.60 1983 TL 191.15 1984 " TL 309.20 1985 " TL 451.40 1986 TL 586.40 1987 " TL 752.83 1988 February TL 1160.00 * Annual averages through 1979 ABBREVIATIONS AND ACRONYMS BOF - Basic Oxygen Furnace CIF - Cost, Insurance, Freight CIM - Capacity Improvement & Modernization Project Erdemir - Eregli Demir ve Celik Fabrikalari, T.A.S. ERR - Economic Rate of Recurn IDC - Interest During Construction IRR - Internal Rate of Return NPBT - Net Profit Before Taxes NKK - Nippon Kokan Kaisha PIP - Productivity Improvement Project SEE - State Economic Enterprise UEC - U.S. Steel Engineering Consultants  FMR ONFICIA U OLY THf WORLD BANK Washenon. D.C 20433 U.S.A Olke id O.w4c-GumeM June 27, 1969 MEMORANDUM TO THE EXECUTIVE DIRECTORS AND THE PRESIDENT SUBJECT: Project Completion Report on Turkey Erdemir Stage II Steel Project (Loan 1606-TU) Attached, for information, is a copy of a report entitled *Project Completion Report on Turkey - Erdemir Stage II Steel Project (Loan 1606-TU)' prepared by the Europe, Middle East and North Africa Regional Office. No audit of this project has been made by the Operations Evaluation Department at this time. Attachment IThis document has a restricted distribution and may be used by recipients only in the perfor nanee of their official duties. Its co.ltents may not otherwise be disclosed without World Bank authorintion.  FOR OFFICIAL USE ONLY PROJECt COMPLETION REPORT TURKEY ERDEMIR STAGE II STEEL PROJECT (LOAN 1606-TU) TABLE OF CONTENTS Page No. Preface . ......................................................i Basic Data Sheet ............................................... i Evaluation Summary ............................................ v PROJECT COMPLETION iEPORT I. INTRODUCTION ............................................ 1 II. CLARIFICATIONS AND COMMENTS ON BORROWERS REPORT ......... 3 Ongoing Bank Invoivement with Erdemir ................... 4 Erdemir and Turkish Future Membership in EEC .... ........ 5 Management--Training, Staffing, and Development Programs. 5 III. THE ROLE OF THE BANK--PROJECT FORMULATION, APPRAISAL AND SUPERVISION ........................................... 5 A. Project Covenants ................................... 5 1. Restrictions on Commitments for Capital Expendi- tures, or Routine Capital Investments--Project Agreement Section 4.04 ........................ 5 2. Restrictions on Total Employment Levels (Manpower Level) ........................................ 6 3. Restrictions on Payment of Dividends--Project Agreement Section 4.05 ........................ 6 4. Restrictions on Financial Ratios--Project Agree- ment Section 4.03 5. Covenants to Permit Coal Imports (Government) Loan Agreement Section 4.04 ................... 6 6. Covenant to Permit iron Ore Imports--Loan Agree- ment Section 4.04 ............................. 7 B. Appraisal: Project Scope and Analysis of Alternatives 7 C. Project Supervision ................................. 7 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  TAbLI OF CONTINTS (Cont'd) Page No. IV. TU ROLES OF TEN IORROWUV, TEC CONSULTANT. AND TEE GOVERISUNT 8. ***..* ........ A. Irdasir ................. ............. .... ........ 8 S. Nippon Kokan Kaisha (NKm) .... C. The Government of Turkey .8 V. LESSONS LEARNED ..8 A. Private Legal Status of Erdemir .8 D. Management .8 C. Feasibility Studies and Changes in Project Scope 9 D. Selling Price Covenant. 9 E. Project Supervision. 9 F. Procurement - Local Preference for Turkish Goods 9 G. Cofitiancing. 9 H. Institution Building .10 BORROWER'S PROJECT COMPLETION REPORT ..11 I. INTRODUCTION .13 A. Economic and Political Environment .14 B. The Turkish Steel Sector .15 C. ERDEMIR - The Company .16 1. Origin .16 2. S.age I Expansion Project .16 3. Stage II Expansion Project .17 4. Ownership and Control .17 5. Organization and Management .18 II. Proiact Background .19 A. Origin, Preparation and Justification . 19 B. Project Description and Objectives .20 a. Original Concept .20 D. Changes in Project Scope .21 C. Environmental and Community Linkages-Present and Future .23  TAJLZ OF CONThNTS (Cont 'd) Page No. III. PROJICT IKPLUNTATION AND MANAGfIENT .................. 25 A. Achievnoat of Project Objective . 25 B. Project Scope .........25 C. Project Haagsemnt ..................... ..... . ... . 26 D. Use and Performance of Consultants 26 L. Implem_ntation Schedule . ................ 27 F. Procurement Performance of Suppliers/Contractors, Allocation and Disbursement of Bank Loan. 28 G. Project Capital Cost ........................30 B. Project Financing ......... 34 IV. PROJECT OPERATION .36 A. Production and Sales .36 B. Manpower Development .39 1. Work Force .39 2. Training .39 3. Social Aspects (and Labor Relations) .40 C. Prices and Production Cost .41 1. Prices .41 2. Production Costs .43 D. Market Development and Performance . .45 V. Financial Performance ....... ........................... 47 A. Financial Results ........ ........................... 47 B. Financial Covenants and Targets ..... ................ 47 C. Financial Rate of Return ...... ...................... 49 'vI. Economic Rate of Return .50  List of Annexes 1-1 Erdemir Shareholders . ................................. . 55 K 1-2 Changes in Erdedir Presidents and Terms of Office ....... 56 2-1 Detailed List of Project Facilities - At Tim of Appraisal ........................................................ 57 2-2 Project Background, Description, Objectives and Changes in Scope .............. ...................... 59 2-3 Detailed List of Project racilities - As Actually Installed . .............................. 67 3-1 Implementation Schedule, Aar Charts .................... 70 3-2 List of Exchange Rates, 1980-1987 ...................... 74 3-3 Main Causes of Local Cost Over-Underrun ................ 75 3-4 Appraisal Plan and Actual Financing Sources .... ........ 76 4-1 Erdemir-Past and Projected Total Production wit the Project .............................................. 77 4-2 Base Price of Erdemir's Main Product Groups (In Current TL. and USS .......................................... 78 4-3 Actual Base Price of Erdemir's Main Product Groups (In Constant Mid-1987 TL) ............................ 79 4-4 Actual Inflation Indices ............................... 80 4-5 Manpower - Actual, 1978-1987 ........................... 81 5-1 Erdemir Historical Income Statement ..... ............... 82 5-2 Erdemir Historical Balance Sheet ....................... 83 5-3 Erdemir Projected Income Statement with the Stage II Project .............................................. 84 5-4 Erdemir Projected Cash Flow Statement - With the Stage II Project ........................................... 85 5-5 Erdemir Projected Balance Sheet - With the Stdge II Project .............................................. 86 5-6 Erdemir Stage II Project Capital Cost Stream -or Rate of Return Calculations .................................. 87 5-7 Stage II Incremental Costs and Benefits Streams 8..... a 5-8 1987 Erdemir Production Cost Structure With the PL _ct at Full Production ........ ....................... .. 89 6-1 Economic Price of Main Flat Steel Products .... ...... .. 90 6-2 Stage II Incremental Economic Costs and Benefit Streav 91 Chart - Erdemir General Lay-Out .92  PROJECT COMPLETION REPOI" TURKEY KRDDHIR STAGZ It STEEL PROJECT (LOAN- 1606-TU) MPRFAC 1. This Project Completion Report (PCR) reviews the performance of the loan extended to Zregli Demir ve Celik Fabrikalari, T.A.S. (Erdemir) in July 1979. The loan under review involved an amount of US$95 million. The report covers the period 1979 to 1987, during which disbursements under this loan were made. The loan became effective in July 1979 and disbursements (in the amount of US$95 million) effected by Hay 1987, the closing date being extended from June 30, 1983 up to Hay 31, 1987. 2. The PCR has been prepared by Erdemir and supplemented by Bank staff, and is based, inter alia, on the Staff Appraisal Report; the Loan, Guarantee, and Project Agreements; supervision reports; correspondence between the Bank and the Borrower, and internal Bank memoranda. 3 The PCR was read by the Operations Evaluation Department. The draft PCR was sent to the Borrower on May 10, 1989, for comments by June 9, 1989, but none were received.  - ii - PROJECT COMPLETION REPORT TURKEY ERDEMIR STAGE II STEEL PROJECT (LOAN 1606-TU) BASIC DATA SKEET (Amounts in USSm) LOAN POSITION Original Disbursed Cancelled Repaid Outstanding Loan No. 1606-TU 95 95 0.0 47.52 47.49 CUMULATIVE LOAN DISBURSEMENT FY79 FY80 FY81 FY82 FY83 FY84 FY85 FY86 FY87 (i) Planned 4.52 40.1 87.5 99.6 100* 100 100 100 100 (ii) Actual 2.9 30.2 51.1 59.7 55.5 74.6 92.1 100 (iii) (ii) as Z of (i) 7.2 34.5 51.3 59.7 55.5 74.6 92.1 100 F First Quarter STAFF INPUT (unweks) 1i77 1978 1979 1980 1961 19N2 1988 1984 198S 1966 1987 1986 TOTAL Pr ppraisal 9.8 4.7 - - - - - - - - - - 14.5 Appraisal - 62.8 - - - - - - - - - - 62.8 Negotiation - 27.0 - - - - - - - - - - 27.0 Supervision - - 14.9 15.0 18.8 26.1 25.6 17.8 13.2 4.5 11.7 11.6 153.0 TOTAL 9.6 94.0 14.9 15.0 18.6 25.1 26.6 17.6 18.2 4.5 11.7 11.6 268.8  - iv _ MISSION DATA No. of No. of Date of Month/Year Weeks Persons Manweeks Report Appraisal 02/78 3.6 2 7.2 05/78 Supervision x 09/78 3.6 2 7.2 10/78 Supervision II 05/79 2 2 4 08/79 Supervision III 10/79 2.8 2 5.6 12/79 Sapervision IV 04/80 3.2 2 6.4 05/80 Supervision V 03/81 2.8 2 5.6 - Supervision VI 06/81 2.8 2 5.6 07/81 Supervision VII 06/82 8 4 32 07/82 Supervision VITI 01/83 3.2 2 6.4 02/83 Supervision IX 11/83 2.8 2 5.6 01/84 Supervision X 07/84 2.8 2 5.6 08/84 Supervision XI 02/85 2.4 2 4.8 03/85 Supervision XII 01/87 5.2 2 10.4 02/87 PCR Mission 04/88 4.2 2 8.4 06/88 Total Staff Input 114.8 OTHER PROJECT DATA Original Loan Actual or Date Reestimated Board Approval -- 06/29/78 Loan Agreement -- 06/30/78 Effectiveness -- 07/31179 Loan Closing 06/30/83 05/31/87 Borrower Rep. of Turkey Executing Agency Erdemir Fiscal Year of Borrower Jan. 1 - Dec. 31  v PROJECT COMPLET1ON REPORT TURKEY ERDESMR STAGZ 1I STEEL PROJECT (LOAN 1606-TU) EVALUATION SUMMWAY 1. The Erdemir Stage II Steel Project, (Loar 1606-TU, US$95.0 million) is the Bank's second lending operation with Erdemir (following Loan 817-TU, US$76 million). The project vas appraised in October 1977 and the loan became effective on July 31, 1979. The loan could become effective only after Erdemir was able to obtain additional financing of US$20 million, which it did in July 1979 from the Bank of Tokyo. Although the project went through several changes in design and physical scope (Sect. II. B. b.), its original components were completed in 1983 about 16 months later than appraisal estimates (Annex 3-1), with a su:ltantial underrun in project capital cost. 2. Since many praject components were relatively independent of one another, achievement of most expected benefits did not have to await for completion of the full project. That factor, together with a strengthening of the world steel industry and Erdemir product price levels in 1987 (Sect. IV. C. 1.), high production volume, facilitated in part by importing slabs, and other favorable factors (see Section II) contributed to an estimated ERR of 252, higher than appraisal estimates of 182. at least if based on final performance using 1987 data (Sect. VI). Estimated IRR is 202 vs. 18Z expected at appraisal (Sect. V. C.). Most key objectives of the project, i.e.: production volume of total finished product for sale (Sect. IV. A.); cost reduction, (including energy savings) (Sect. IV. C. 2.); profitability (Annex 5-1); product quality improvements; financial status of the company (Sect. V); financial structure; management development (Sect. IV. B.); technology transfer; ecological protection (Sect. III. C.); and regional development (Sect. IV. B., III. C.), have all been achieved to a very reasonable degree. Other goals have not been fully achieved: (i) the production level of liquid steel is 1.9 million tpy, has not yet been achieved. The shortfall is 172 (Sect. IV. A.); and (ii) product mix improvement, i.e. increased tonnage of higher valued cold rolled product in final product mix is 40Z below targetted levels (Sect. IV. A.). 3. Business risks for the project are also moderately higher than originally expected, mainly because of increased reliance on use of imported slabs. Those risks could be considered to be acceptable business risks in the steel industry conditions prevailing over the last decade or more. However, recent developments in the steel industry point to more volatility in supply conditions for slabs and the profitability of importing slabs should be monitored closely by Erdemir in future years.  _ vl - 4. Based on the facts as known today, the project can be judged to be essentalaly successful, if not fully. Further improvement can be expected in the future. grdemir's management is aware of its :ptions and risks and is taking effectlve measures to maintain its very r-spectable profitability and competitiveness. Furthermore, Irdemir's managemnt has shown substantial growth and development since tle project was appraised in 1978, and has dmonstrated high levels of business aeumn, flexibility and initiative in formulating effective responses to changing technical parameters and business conditions. In the rourse of project implementation, the company has achieved a sound financial structure and made a substantial positive contribution to the Turkish economy. All things considered, the final results of the Stage II Project are comendable.  PROJECT COMPLETION REPORT TURMY ERDEMIR STAGE II STEEL PROJECT (LOAN 1606-TU) I. INTRODUCTION 1.01 The Erdemir Stage II Steel Project, (Loan 1606-TU, USS95.0 million) is the Bank's second lending operatior. with Erdemir (following Loan 817-TU, US$76 million). The project was appraised in October 1977 and the loan became effective on July 31, 1979. The loan could become effective only after Erdemir was able to obtain additional financing of US$20 million, which it did in July 1979 from the Bank of Tokyo. Although the project went through several changes in design and physical scope (Sect. II. B. b.), its original components were completed in 1983 about 16 months later tha. appraisal estimates (Annex 3-1), with a substantial underrun in project capital cost. 1.02 Total production of finished flat products for sale exceeded appraisal estimates in 1984, about one year ahead of appraisal estimates (Sect. IV. A.).l/ However, early recognition of certain technical shortcomings of the project including deficiencies in liquid steel production and product mix, coupled with technological improvements then being achieved in the world steel industry (higher product quality, cost reduction, energy savings) -- all led to a further study of project design and investment alternatives. In 1983, the availability of TJS$27.0 million still unutilized from the Bank loan led to a request by ERDEMIR to add some 10-12 items to project scope, then designated the "Productivity Improvement Project" (PIP). Objectives of that component of the project were to (Sect. II. B. a2, Annex 2-2, p. 5): (i) increase productivity of bottleneck production facilities; (ii) decrease unit costs of production, and (iii) substantially improve quality of finished products; and (iv) improve product mix (higher value products). After separate and detailed technical/economic justification of project components by qualified consultants U.S. Steel Engineering Consultants (UEC), Bank approval of financing for 9 of the highest priority components was given, and suitable extensions of loan closir,g dates were granted to Erdemir by the Bank (Annex 2-3, p. 3). Thus, the "Stage Ii Steel Project' is made up of its original (appraised) components and the P.I.P. components.2/ 1/ That was due in part to utilization of imported slabs rather than production from liquid steel. 2/ This sequence of events caused late completion of the project and a lag of final loan disbursements of 4 years behind appraisal estimates.  -2- 1.03 The PIP Project was completed with about 6 months delay by early 1987 (Annex 3-2), with a final underrun in total capital cost of 26Z (Sect. III. H.). Erdemir's production of finished products climbed to 1.8 million tpy, or 23Z over appraisal estimates, by 1987 (Sect. IV. A.). Financial performance improved quickly, achieving a very favorable profitability and cash position in 1987, especially in comparisor to recent norms for the steel industry (Sect. V. A., Annex 5-1, 5-2). Erdemir's financial outlook appears to be very favorable for 1988 and beyond. 1.04 Since many project components were relatively independent of one another, achievement of most expected benefits did not have to await for completion of the full project, That factor, together with a strengthening of the world steel industry and Erdemir product price levels in 1987 (Sect. IV. C. 1.), high production volume, facilitated in part by imporr ng slabs, and other favorable factors (see Section II) contributed to 6 estimated ERR of 25Z, higher than appraisal estimates of 18X, at least if based on final performance using 1987 data (Sect. VI). Estimated IRR is 201 vs. 18X expected at appraisal (Sect. V. C.). Most key objectives of the project, i.e.: 1) Production volume of total finished product for sale (Sect. IV. A.) 2) Cost reduction, (including energy savings) (Sect. IV. C. 2.) 3) Profitability (Annex 5-1) 4) Product quality improvements 5) Financial status of the company (Sect. V) 6) Financial structure 7) Management development (Sect. IV, 3.) 8) Technology transfer 9) Ecological protection (Sect. III. C.) 10) Regional development (Sect. IV. B., III. C.) have all been achieved to a very reasonable degree. Other goals have not been fully achieved: 1. The production level of liquid steel is 1.9 million tpy, has not yet been achieved. The shortfall is 17? (Sect. IV. A.). 2. Product mix improvement, i.e. increased tonnage of higher valued cold rolled product in final product mix is 40? below targetted levels (Sect. IV. A.). 1.05 Business risks for the project are also moderately higher than originally expected, mainly because of increased reliance on use of imported slabs. Those risks could be considered to be acceptable business risks in the steel industry conditions prevailing over the last decade or more. However, recent developments in the steel industry point to more volatility in supply conditions for slabs and the profitability of importing slabs should be mon,tored closely by Erdemir in future years.  1.06 Based on the facts as known today, the project can be judged to be essentially successful, if not fully. Further improvement can be expo. -d in the future. Erdemir's management is aware of its options and risks and is taking effective measures to maintain its very respectable profitability and competitiveness. Furthermore, Erdemir's management has shown substan- tial growth and development since the project was appraised in 1978, and has demonstrated high levels of business acumen, flexibility and initiative in formulating effective responses to changing technical parameters and business conditions. In the course of project implementation, the company has achieved a sound financial structure and made a substantial positive contribution to the Turkish economy. All things considered, the final rtsults of the Stage II Project are commendable. II. CLARIFICATIONS AND COMMENTS ON BORPOWERS REPORT 2.01 Actual Achievement of Benefits and Impact on FRR/ERR Calculation. Section II B of Erdemir's Project Completion Report clearly describes the physical nature of the project. From an engineering/operational viewpoint, it can be seen that most project components, especially those in the PIP, completed in 1986-1987 have only limited linkages to one another. Ths expected benefits for these components can be derived before completion of other components. Thus, the apparent delay in completion of the full project and the very late disbursement of the full Bank Loan, had limited impact on the overall rate of return for the project. This explains, at least in part, the very respectable FRR and ERR in spite of delays in completion. 2.02 The benefits achieved (ANNEX 6-2, PCR) zlearly show that almost immediately after Pr;'Ject Completion, calendar year 1987, Erdemir experienced a very good year in terms of total production of finished product, sales and financial performance. Metallic yield, labor productivity and coke rate improvements exceeded expectations at appraisal. Product quality improvement was also tangible but is difficult to quantify. When compared to 1982-1983 as a BASE period3/ the over 'l benefits are substantial but it should be noted that some of the benefits may have accrued from the STAGE I PROJECT, with delayed effect from the normal learning curve, and from other factors not related directly to the STAGE II PROJECT. Some of the most important of these are: 1. Use of Imported Slabs 2. Increased Product Volume and Unit Valuation Due to Market Conditions 3. Exchange rate movements 4. Time Period of Measurement (Costs and Benefits). 3/ Very roughly approximating 1.1 million tpy production level achieved under the Stage I Project.  - 4- 2.03 The use of substantial tonnages of imp.orted slabs (635,000 tpy in 1987) does expose Erdemir's operations to somev.hat more risk than production from iron ore and coal (some of which is also imported) since the long-term availability, price, and supply conditions of slabe can be expected to be more variable than supply conditions for primary raw materials. Ihe addi'ional risk of higher dependence on slab imports is judged to be acceptable for now and is a prudent business decision in the conditions prevailing in 1980's (over capacity and imbalance in world steel industry). Recognizing the business risks associated with a higher dependence on imports of slabs, Erdemir should monitor closely world "arket conditions which may affect future supply conditions of slabs to determine if their current strategy continues to be profitable. Also, recent indications (1st quarter 1988) are that Erdemir can produce more liquid steel and cold rolled product with existing facilities, as operating practices continously improve. Performance in future years may be a better indicator of "full achievement" of benefits from the project, since such large industrial projects normally take several years after physical completion to achieve their full long-term benefits.2' There may be certain advantages to delaying preparation of Bank "Project Completion Reports" by one year or so to reflect accurately full benefits for large, complex industrial projects. 2.04 The estimated benefits of the project are favorably influenced by a strengthening of world steel markets in 1987, resulting in increases in nominal selling pri es for ERDEMIR products by some 10-20% over depressed 1985/86 prices. That, with appreciably higher sales, had a favorable effect on the ERR calculation. 2.05 The effect on performance of short term relat-ve price movements,-- etc. can not be easily evaluated at this time. Analysis of ERDEMIR's performance in future years would allow smoothing of these short-term factors to assess long term project benefits. 2.06 The comparison of estimated and actual costs2- tends to exagerrate the differences between "actual" expenditures and appraisal estimates in the category: "Equipment, materials and spares" because of the way in which price and physical contingencies have been allocated between equipment, materials and spares and other categories such as civil works and installation. Overall project cost comparisons are not distorted by this treatment, so detailed adjustments have not been made. ONGOING BANK INVOLVEMENT WITH ERDEMIR 2.07 Besides the Stage I (1972), and Stage II (1978) loans, Erdemir has been allocated US$ 4.75 million from the "Turkish Electric Power Survey and Development Administration" from a World Bank loan for a Turkish energy conservation project. Erdemir plans to use this allocation in 1988/1989. For example, a time lag between increases in product selling prices and actual changes in production costs (or vice versa) has a major impact on financial results. PCR, p. 19  2.08 Erdemir and the Government also plan to pursue further their previous requests for World Bank or IFC participation in its Capacity Improvement and Modernization (CIM) Project even if Bank/IFO involvement were limited to assistance in obtaining other financing or technical assistance for its future projects.- ERDEMIR AND TURKISH FUTURE MEMBERSHIP IN EEC 2.09 Erdemir sees potential benefits for its business due to possible Turkish participation in the EEC (1990-1992) even if terms of membership are limited. Improvement in quality of finished products attributable to the Stage II Project coupled with Erdemir's competitive cost structure, could make future exports to EEC countries potentially profitable, especially as oversupply in the steel industry declines in the early 1990's. MANAGEMENT--TRAINING, STAFFING, AND DEVELOPMENT PROGRAMS 2.10 In a project with a relatively mature borrower firm (Erdemir has been operating its plant since 1965) more attention should be given to longer range plans for management staffing/replacement as older highly-experienced management staff leave the company for retirement or other purposes. Progress on Lite next major expansion for Erdemir will require more attention to longer range management selection, training and development programs. III. THE ROLE OF THE BANK--PROJECT FORMULATION, APPRAISAL AND SUPERVISION A. PROJECT COVENANTS 3.01 Several of the legal provisions (Loan Covenants) specified in the Bank Loan/Project agreements with Erdemir and the government of Turkey proved to be of major importance for successful project implementation and continuing operation of the Company. For example: 1) RESTRICTIONS ON COMMITMENTS FOR CAPITAL EXPENDITURES, OR ROUTINE CAPITAL INVESTMENTS--PROJECT AGREEMENT SECTION 4.04 This covenant proved to be important in assisting Erdemir's management to conserve limited capital for the requirements of the Stage II Project. During the period 1979-87 there were several proposals for "outside investments" that could have potentially diverted funds away from the project. The covenant ensured that there was very close scrutiny of any proposed investments outside of the project, and resulted in outright decline of such requests when clear justification was lacking. Other potential requests were thought to have been deferred due at least in part, to the covenant. '/ IBRD financed the feasibility studies for the CIM and made an initial evaluation of the project in 1987.  - 6 - 2) RESTRICTIONS ON TOTAL EMPLOYMENT LEVELS (MANPOWER LEVEL) Project Agreement Section--Side Letter No. 7 This covenant restricts the amount of irdemir's total work force to levels justified on technical grounds by Erdemir's quaified engineering consultants (mainly UEC). It is judged by the Company to have been helpful in maintaining a very gradual increase (122) in permanent work force, especially during project implementation (1979-87) when plant prcduction levels increased by over 120X. Without the covenant, Erdemir's work force could have increased at a faster rate, due to strong pressures to create more jobs as plant volume increased. The covenant, together with a firm management may have made a positive contribution to Erdemir's long-term competitiveness. 3) RESTRICTIONS ON PAYMENT OF DIVIDENDS--PROJECT AGREEMENT SECTION 4.05 This provision proved to be valuable in two ways: 1. It limited dividend payout to Non-Founder Share Holders to maintain an adequate capital structure and keep Erdemir shares competitive in the securit.es market. 2. It severely limited dividend payout to Founder (government) share holders until project completion. In effect this limitation meant no payout at all of dividends to Founders Shares until project completion in 1987. The provision was very helpful in enabling Erdemir to retain funds from earnings as required to finance the Stage II expansion Project. 4) RESTRICTIONS ON FINANCIAL RATIOS--PROJECT AGREEMENT, SECTION 4.03 This provision proved to be helpful to Erdemir in maintaining a sound financial structure. For example, in 1984, prior to startin3 the PIP Project, Erdemir was able to achieve a total capital increase (with Government cooperation) of TL 5.6 billion, by conversion of tax arrears (4.9 billion TL) and infusion of added tax funds (0.7 billion TL) as equity. That action kept tthe company's financial ratios within the limits set by the Project Agreement, and facilitated Bank approval of financing for the PIP Project and related extensions of Loan closing dates by three years. 5) COVENANTS TO PERMIT COAL IMPORTS (GOVERINMENT) LOAN AGREEMENT SECTION 4.04 In the world steel industry, one of the most important factors affecting productivity, product cost and quality, and general competitiveness is the quality and cost of basic raw materials used in the steel plant. In many cases non-economic (mainly low quality) raw materials are used solely because they are available locally, for local currency. In the case of Erdemir, the company and the Government made the complex analysis required, and then recognized in the early 1980's that the use of much more high quality imported coal for steel production was the economic choice, rather than major expansion of both production and use of local coal. The project was modified (coal blending facility) to reflect this basic policy decision. It is likely that the existence of L.A. Sect. 4.04, and follow up by the Bank, including insistence that the Government make foreign exchange for coal imports  available to Erdemir in times of shortage, contributed to establishing and implementing the long-term policy on the raw material base of Erdemir and other Turkish steel plants such as Iskenderun, and helped to increase its continuing competitiveness in product quality and cost. 6) COVENANT TO PERMIT IRON ORE IMPORTS--LOAN AGREEMENT SECTION 4.04 This provision was already contained in the agreement for the Stage I Project; and was re-stated for the Stage II Project. It has similar objectives as for coal imports described above, and facilitated expanded use of high quality imported iron ore when that was the economic choice. B. APPRAISAL: PROJECT SCOPE AND ANALYSIS OF ALTERNATIVES 3.02 During project formulation and appraisal, the Bank worked closely with Erdemir, and facilitated (through financing of qualified engineering consultants) the technical/economic analysis required for establishing priorities and choosing individual project facilities. One facility which was removed at the Bank's suggestion, from project scope at appraisal was the electrolytic tinning line and related equipment (with estimated capital cost of US$ 110 million), since it was eventually shown to have a FRR of about 3X. That decision is now considered to have been a sound decision. It was fortunate, since it increased Erdemir's capacity to sell niore high value cold rolled products and actual demand for tin plate has been much lower than expected. Bank promotion of such technical/economic analysis of investment proposals was felt to be very constructive. The large number of changes in project scope reflected both the long time period (1978-87) involved in implementation and Erdemir's efforts to recognize changing conditions of technology, market requirements, cost factors, etc. 3.03 As with the Stage I Project, the Bank played a key role in promoting inclusion of pDllution control equipment in the project. Bank involvement also promoted attention to design, installation and monitoring of that equipment. Later, supervision by Bank pollution control specialists helped Erdemir focus on measurement and monitoring techniques for improved long-term performance of the pollution control equipment. C. PROJECT SUPERVISION 3.04 Given Erdemir's long association with the World Bank, and the continuity of contacts established with its management, consultants, and financing agencies, etc., very effective communications were established, leading to good understanding of IBRD requirements and practices. In procurement this led to effective compliance with Bank procurement requirements. Following Bank procurement guidelines helped to encourage a high degree of effective competition between suppliers of project components and hence, efficient utilization of the funds used for the project. Favorable exchange rates and equipment supply conditions also contributed to that result. The most important contribution of the Bank in the supervision stage, however, was to persuade the Government, from time to time, to ensure the maintenance of the various covenants as outlined in Section III.A above.  -8- IV. THE ROLES OF THE BORROWER, THE CONSULTANT, AND THE GOVERNMENT A. ERDEMIR 4.01 Erdemir has come quite close to being an ideal borrower. Its management had gained considerable experience during the Stage I expansion. This was reflected, particularly as the project progressed, both in technical as well as in administrative matters. The management was very careful in re-evaluating and detailing their needs to the foreign suppliers when the strength of the dollar made the purchase of equipment from their "wish-list" possible. The professionalism of its finance and accounting departments has also similarly been very reassuring. Uptil now, fortunately, Erdemir has been able to retain most of their staff who had gained experience from the expansion projects. B. NIPPON KOKAN KAISHA (NKK) 4.02 NKK as a consultant to the project has performed the task successfully. Even though they had come on-board after the project scope had been decided, they carefully reevaluated the needs and improved upon the original suggestions. It was one of their very first major foreign experience but by the end of the implementation period they had been successful in transferring the responsibilities of operation to the Turkish personnel. C. THE GOVERNMENT OF TURKEY 4.03 The Government hxas allowed and continues to allow Erdemir to operate as a private company in Lhis crucial sector, although it is the major shareholder of the company. This allows Erdemir Fn have, among other things, different procurement, personnel, and price setting policies from those of state enterprises. The project has particularly gained due to the special policy of the Government towards coal and iron ore imports by Erdemir as explained in Sections III.A.6 and III.A.7 above. V. LESSONS LEARNED A. PRIVATE LEGAL STATUS OF ERDEMIR 5.01 Of all the legal covenarns governing the project, that ensuring that the private nature of Erdemir witn its clear exemption from laws that apply to state economic enterprises (concerning employment, salaries, purchasing, auditing, financing, etc.) would be maintained (Section 4.03 Loan Agreement) is surely one of the most important. Effective monitoring by the Bank of any changes that could affect Erdemir's status, such as increases in authorized or actual share capital, have also helped to assure the continued independent private sector status of Erdemir. B. MANAGEMENT 5.02 The quality and competence of management is central to the success or failure of project implementation and later, operations. In the case of this project, Erdemir's management demonstrated much more aptitude and willingness to undertake project management responsibilities than in the earlier project, and the positive effects on project implementation were tangible.  -9- C. FEASIBILITY STUDIES AND CHANGES IN PROJECT SCOPE 5.03 This project experienced a higher than normal degree of changes in technical scope of the project, due in part to changes in engineers consulting from (UEC) to Nippon Kokan Kaisha (NKK). The long period between initial feasibility and final engineering studies (5-6 years) and the changes in state of the art technology during that time, contributed to additional changes in scope. For future projects in fields where technical change is rapid the feasibility btudies should be carried out not more than one to two years before project implementation. D. SELLING PRICE COVENANT 5.04 The covenant on product selling prices proved difficult to administer in a inflationary economy; a simplified (more automatic) formula based on agreed criteria proved necessary and was subsequently developed. E. PROJECT SUPERVISION 5.05 Although project supervision by the Bank can be judged as very effective, it required more time than anticipated at appraisal. More use of Borrower personnel to assist in Bank supervision work could be considered for future projects. F. PROCUREMENT - LOCAL PREFERENCE FOR TURKISH GOODS 5.06 The application of a continuously variable preference system for bid comparison of locally produced of goods with foreign goods proved to be a practical system which benefited the project. This system used a sliding scale of local preference from 0-15% based on the local value added; 15% was only provided when local content was 100%. Wider use of that system for the procurement of goods in other Bank industrial projects could be considered. (Also see Section F., page 16, PCR). G. CO-FINANCING 5.07 Erdemir feels that Section 6.01 c of the Loan Agreement, requiring that agreements for suppliers credits be concluded as a condition of effectiveness proved ultimately to (1) increase financing costs of the project, and (2) cause a delay of about 1 year in the effectiveness of tb- Bank loan. It is felt that this provision weakened Erdemir's negotiating position with potential lenders, causing a long delay in reaching acceptable borrowing terms. Ultimately, Erdemir settled for what it considered only marginally acceptable terms (8 1/2% interest rate, payable in Japanese Yen, 8 year repayment). It is possible that additional help from the World Bank in making arrangements for suppliers credits could have alleviated the problem.  - 10 - INSTITUTION BUILDING 5.08 Erdemir's senior management thinks that the most important "Lesson" learned from the project is the high level of discipline requiied of the Borrower to participate in a World Bank financed project. That discipline affected 1. Feasibility studies, project justification 2. Procurement procedures 3. Organization of implementation, cost controls 4. Financial controls and structure 5. Management information systems (and decision making) That discipline continues with Erdemir's ongoing operations and expansion projects. Bank inputs were costly in terms of staff time, but brought substantial benefits. Direct project lending of this type makes it possible for the Bank to "transfer" techniques of managerial discipline such as these.  - 11 - PROJECT COMPLETION REPORT TURKEY ERDEMIR STAGE II STEEL PROJECT (LOAN 1606-TU) April 1988 Eregli Demir ve Celik Fabrikalari, T.A.S. (ERDEMIR)  - 13 - 1- INTAOUTIDN The Government of Turkey and Ere4li Demir ve Celik Fabrikalarl, T.A.5. (Erdemir) have requested the Bank's participation in the financing of Stiaq II Expansion of Erdemir steel plant to increase the annual iiquid steel production capacity from 1.5 to 2.0 million metric tons per year (tpy), equivalent of 1.1 to 1.5 million tpy of finished products, respectively. ERDEMIR which was officially established as a company on.0ay 1960, started operations in 1965. It is Turkey's only integrated steel plant for production of flat product, and its production is expected to continue falling short of domestic market demand. Total financial requirements for the project, including interest during the construction, were estimated, at appraisal to be US$ 341.8 million with US$ 173.1 million in foreign exchange. The Bank loan (US$ 95 million) would therefore provide 28 ? of the total and 55 " of the foreign exchange needs of the project. Bilateral financing sources, primarily European banks, internally generated funds, and in case these are insufficent, newly paid tu equity would provide the remainder of the funds required. The Stage II Expansion Project which, originally, was a single project was completed by the end of 1987. It was comprised of two projects namely; Stage II Expansion Project and PrAictivity InproiffEnt Project. The prodictiac level hps readie to 1.5 mil'icin tomes flat products in 1984 ard 1.65 millicn taTes in 198;. kid the actual cost realized for the whole project was US% 251.8 million of which US$ 139 million was foreign exchange. Withdrawals from the Bank loan of US$ 95 million had been completed in May 1987. In 1972 the Bank granted its first loan (Loan 817 TU of US$ 76 million) for Erdemir's Stage I Expension Project and it has been paid back totally in 1987. The Stage II Project was presented to the Bank in December 1976 and appraised in October 1977 by a mission consisting of Messrs. O'Neil (Chief) and Roet of the Industrial Projects Department aid Mr. Maffei of the Legal Departm,nt.  - 14 - A- ECONOMIC AND POLITICAL ENVIRONMENT During the second half of the 1970's Turkey experienced a severe and prolonged foreign exchange crisis as well as a serious deterioration of the domestic Cconomy with a combination of low economic growth, high inflation rates and labor strikes. In response to the financial crisis of late 1970's the Turkish Government started a reform program, so called January'24 decisions, with the objective of growing through free-enterprise system. So that a number of sub-programs were put into operation for establishing financial stabilization, switching the orientation of economy outward, changing the role of the public sector, supporting the private sector for leading economic growth. With the rescheduling of foreign debts and international financial asistance the reforms were verysurtessful in improving the financial position of the Country and in promoting structural adjustment. Sir e then macroeconomic performance has improved and creditworthiness in the international financial markets has been re-established. The growth rate in GNP had been negative in 1979 and 1980, - % 0.4 and - ' 1.1 respectively, as a result of deteriorating domestic economy and baiance of payment crisis in late 1970's. But the results of January 1980 decisions were seen since 1981 and real growth rate in GNP has been % 4.1, 4.6, 3.2 in the years 1981, 1982, 1983 respectively. After the Civilian Government had taken the office in 1983, the real growth rate in GNP has increased and been % 5.9, 5.1, 8 and 6.8 for the years 1984, 1985, 1986 and 1987. The most remarkable performance has been in the field of exports since the reform programs wre put into action. Despite the adverse effect by the considerable slowdown in international trade growth exports have increased three times from 1980 to 1985 and it became 8 billion US dollars in 1985. It was slowed to 7.5 billion dollars in 1986 but it has picked up since and the latest estimate for 1987 was 10 billion dollars (It is a provisional figure). Ott the other hand imports has been increasing since 1980. Although this kept foreign trade deficit without mich iipnoemnt in dollar figires, the ratio of imports covered by exports went up to % 72 in 1987 from % 37 in 1980.  - 15 - The rate of domestic inflation, though decelarating since 1980, remains in high levels and is a major source of concern at the present. In fact it had decreased until 1989 and it was 29 Xo in 1986 (State Institute of Statistics' wholesale price index). But it paced up in 1987 due to referandum made and general elections took place on Nov. 29, 1987. The wholesale price index of State Institute of Statistics is 49.9 Z for the year 1987. The political environment has been very stable since the Military took over on Sept. 12, 1980. The Military left its place to Civilian Government in 1983 with general elections. The positive effects of stability in the political environment has seen in the economy as well as the top management of State Economic Enterprises and Erdemir. In the case of Erdemir, this stability has payed its tolls and caused no major delays and other project difficulties. B- THE TURKISH STEEL SECTOR 1/ The berinning of a modern steel industry in Turkey goes back to 1930's with the construction of the Karabuk integrated steel plant in northern Turkey, folloved by Erdemir, the second integrated steel producer which began operating in 1965. A thirj plant, Isden,hir at Iskenderun in South Turkey, constructed with Russian assistance, started production at the end of 1976. Today, there also exist in Turkey, in addition to the three integrated plants in Eregli, Karabuk and tskenderun, which produce steel by processing hot metal from iron ore installation with are-type furnaces which produce steel by processing scrap. The total crude steel output of Turkey was increased from 2.5 million tonnes in 1980, to over 7 million tonnes in 1987. In this era when there are plans in many countries to close down existing plants and to attain a capacity utilization rate of over Z 70, Turkey has used its crude steel capacity (about 8.9 million tonnes) very well and has attained a crpacity utilization of 79 %. 52 Z of this capacity is that of the integrated plants while the remaining 48 % is that of the electric furnaces ( 27 Z in the early 1980's). I /See bank comments for additional information  - 16 - In the periods ahead, though, it is aimed to attain the production level of 7.5 million tonnes at the end of the 5 th five-year Development Period (in 1989) and 10 to 11 million tonnes at the end of the 6 th five-year Development period (in 1994). At this level of production, tre demand for flat products is UqNcted to b 4.5 nillian ta*.The demand for flat products is expected to be 8 to 9 million tonnes in the early 2000 a. It is therefore necessary to adopt soonest the measures for production of flat products in particular. C- ERDEMIR - THE COMPANY 1. Origin Erdemir which was established in 1960 occupies approximately 4 million square meters of land near the comunity of Ere