Mexico - Steel Sector Restructuring Project

Document of The World Bank FOR OFFICIAL USE ONLY A-V a'I(m- ~~-F Report No. 6892-ME STAFF APPRAISAL REPORT MEXICO STEEL SECTOR RESTRUCTURING PROJECT February 8, 1988 Country Department II Industry, Trade, Finance Sector Operations Division Latin America and the Caribbean Regional Office This document has a resticted disibution and may be used by reciplents only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank aothorization.  CURRENCY EQUIVALENTS - Peso (Mex$) An exchange rate representing the mid-June 1987 free market rate has been used in the project analysJs: 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. BOF - Basic Oxygen Furnace CANACERO - Camara Nacional de la Industria del Hierrc, y del Acero CMC 1/ - Carbon y Minerales Coahuila S.A. DRC - Domestic Resource Cost EAF - Electric Arc Furnace FISA - Fundidora Monterrey S.A. HYLSA - IiYLSA S.A. mtpy - million tonnes per year NAFIN - National Financiera S.N.C. NKK - Nippon Kokan of Japan OHF - Open Hearth Furnace RMD - Raw Materials Division of SIDERMEX SECOFI - Secretaria de Comercio y de Fomento Industrial SEMIP - Secretaria de Energia, Minas y Industria Paraestatal SICARTSA - Siderurgica Lazaro Cardenas Las Truchas S.A. SPP - Secretaria de Programacion y Presupuesto TAMSA - lubos de Acero de Mexico S.A. tpy - tonnes per year UEC - United Engineers and Consultants (Div. of US Steel) 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.  ION OFFkAL US ONLY MEXICO - STEEL SECTOR RESTRUCTURING PROJECT TABLE OF CONTENTS Page No. LOAN AND PROJECT SUMMARY i - iv I. INTRODUCTION ................... . O 0 1 II. BACKGROUND e 2 A. The Economy - Recent Structural Changes 2.................. B. The Steel Sector *............... , 3 C. Structure and Main Institutions 4 6 D. The Policy Framework ... .................................. 6 III. STRATEGIC ISSUES AND BASIS FOR SECTOR REFORM ................ 8 A. Strengths and Weaknesses ........................ . , 8 B. The Strategic ;ssues ..................................... 9 C. Agenda for Policy Reform ................................. 10 IV. THE RESTRUCTURING PROGRAM ................................... 11 A. Objectives *..........o......o......* 000e00oooo00ooo 000o 11 B. Global Policy Actions ..............0........ , 0e..000 e. 12 Co SIDERMEX .eo........o...00000oo 0o 00o0oo 0oooo0oo0o00o00oooo 14 D. Private Sector .............. 17 V. THE PROJECT o...................................O,.. ....... 18 A* Objectives ....oo.ooo..o..o.oo......oo. e oe*o 18 B. Project Description *o.ooe...oo.o........ e...............o 19 C. Project Management, Organization and Implementation ...... 21 D. Role of NAPIN *.....0.......... ...............e......o 23 g. Training and Manpower Development soeoo0ooo00)00o000000000@ 23 Fo Environmental Issues ..................................... 24 VI. CAPITAL COST, PINANCING PLAN, PROCUREMENT AND DISBURSEMENT oo. 25 A. Capital Cost ooooo........................................ 25 B. Financing Plan oo.....................................o ... 26 C. Onlending Arrangements .0..........................o..o.... 28 D. Procurement o..ooo...o.oo.o.o..ooooo.o.oo.oo...o....o* 29 E. Allocation of the Loan and Disbursements ................. 30 F. Auditing .*000000000000,00 000000000000000000w 900.0@000.00 32 This report was prepared on the basis of appraisal missions in March and May 1987 by Messrs. R. Venkateswaran, E. Mangan, I. Rivera and G. Konomos (Consultant) with assistance from Mr. X. Simon, and in the raw materials segments by Messrs. F. Remy, S. von Klaudy and L. Moran (Consultant) all formerly of the Industry Department. Mr. J. Malatinsxky of the Latin America and Caribbean Region also assisted in the preparation. Thidocumenthmansetitedditbudtnand maybeoud by re -in oly in d peformneo of thek officW dutis Its contents maY no othwise be dicosed wihout Wod bnkauthoizbon.  TABLE OF CONTENTS (contd.) Page J4o. VII. FINANCIAL EVALUkTION .......................... 33 A. Assumptlons Used and Forecast of Production Costs .*.. . 33 B. Financial Projections ..................... 36 C. Financial Covenants ..... e.............. *.*.... 40 D. Financial Rate of Return ................................ 40 VIII. ECONOMIC EVALUATION AND RISKS ............................... 42 A. Assumptlons .................................... 42 S. Economic and Rate of Return Analysis .................... 42 C. Domestic Resource Costs and CompetitLve Positlon ......... 44 D. Benefits and Risks * ..................................... 45 IX. AGREEMENTS REACHED AND RECOMMENDATION ....................... 46 ANNEXES 2-1 The Steel Sector in Mexico ................................ 49 2-2 Raw Haterial Supply Position .............................. 55 2-3 The Policy Framework and Proposed Policy Changes .......... 63 3-1 Operations Technology and Strategic Position 71 3-2 Competitive Position of Raw Materials 77 3-3 The Steel Market in Mexico .....*.*.*................ 81 4-1 Matrix of Issues, Measures and Actions 87 4-2 Steel Sector Policy Letter 89 5-1 Imports Eligible for Financing .....93 5-2 The AHKSA Component ..................................... 94 Appendix 1 - Environmental Control 99 5-3 The CMC Componentt 102 5-4 SIDERMEX - Strategic Planning Studies 105 5-5 The HYLSA Component 107 6-1 Summary Project Cost - AHMSA Project Component - Part Bo1 . 110 6-2 Summary Project Cost - CMC Project Component - Part B.2 111 6-3 Summary Project Cost - HYLSA Project Component - Part C 112 6-4 Sumary Total Project Cost - Parts B and C ................ 113 6-5 Estimated Disbursement Schedule of Bank Loan .............. 114 MAPS IBRD 20418 - Steel Mills and Major Markets IBRD 20419 - Iron Ore Mines, Coal Mlnes and Natural Gas Pields  TABLE OF CONTENTS (contd.) SELECTED DOCUMENTS AND DATA AVAILABLE IN THE PROJECT FILE A. Reports and Studies on Steel Subsector Al IBRD: Mexico Steel Sector Strategy Study, October 1936 (Report No. 6429-ME) A2 Miscellaneous Market and Sector Data (see also Al above) B. Reports and Documents on Companies and Individual Project Components 34.1 SIDERMEX: Convenio and Supporting Studies and Annexes on SIDERMEX Restructuring Progzam B5.1 AHMSA: Industrial Reconversion Project, Phase I - Technical and Financial Feasibility Study B5.2 AHNSA: Report of UEC Consultants (incorporated i BSi.1 above) B5.3 Raw Materials Division: Report of UEC Consultants (METCHEM Division). Fe&sibility Study and Technical Proposal B5.4 HYLSA: Report of Nippon Kokan Consultants (February 1987) B35.5 HYLSA: Technical and Financial Feasibility Studies B6.1 AHMSA: Detailed Cost Estimates 36.2 Raw Materials Division: Detailed Cost Estimates B6.3 HYLSA: Detailed Cost Estimates B7.1 Working Papers on Financial Analyses of AHMSA, HYLSA and Rav Materials Division Components including Feasibility Studies prepared by the Companies B8.1 Working Paper on Economic Analysis of Products and Project Components Prepared by Bank staff  MEXICO - STEEL SECTOR RESTRUCTURING PROJECT Loan and Project Summary Borrower: Nacional Financiera, S.N.C. Guarantor: United Mexican States Beneficiaries: Government, SIDERMEX, AHMSA, CMC and HYLSA. Amount: US$400 million equivalent Term:s 15 years, including 3 years grace, at the standard variable interest rate. Loan and Prodeet Description: The proposed Bank loan would help finance the foreign exchange cost of a major restructuring and policy reform program for the Mexican steel industry. The public sector portion of the program aimed at rationalizing SIDERMEX has already resulted in the shutdown of one major steel plant, ENSA, and includes an additional reduction in steelmaking capacity and shift in product mix at its largest remaining plant, AHMSA. Investments are aimed at rehabilitation, cost reduction and quality improvement of the flat product lines at AHMSA and supporting raw material supply. A similar program is included for the privately owned HYLSA Monterrey flat product facilities in order to maintain its domestic competitive market position. Investments are only included in facilities for which the long-term domestic market needs have been identified. Part A-(US$100 million) is tied to implementation of price decontrol, trade reform, including elimination of Official Reference Prices for steel products and reduction and equalization of steel tariffs, and presentation of a Global Steel Sector Policy Statement to expose the industry to international competition. It would fiaan&e eligible raw material and steel product imports during the adjustment period. Part B (Us$225 million) provides financing for the SIDERMEX restructuring program comprising the physical rehabilitation of the AMHSA steel works (UJ$170 million) and rehabilitation and restructuring of SIDERMEX Mining operations (US$50 million). It also provides assistance in corporate-wide organizational and financial restructuring and for development of SIDERMEX's long-term strategy (US$5 million). Part C (US$75 million) supports the restructuring effort of HYLSA in the modernization of its flat products facility, in parallel with the financial restructuring package under negotiation with creditor banks.  - ii - Onlending Terms and Conditions: Part A, the Inpat Materials and Steel Product Imports Component of the Project, to Government, at 0.25% above the Bank's standard variable interest rate and with the same terms as the Bank loan. Parts B and C, in support of the SIDERMEX Restructuring Program and HYLSA Restructuring, respectively, to SIDERMEX, AHMSA, SIDERMEX Mines (Carbon y Minerales de Coahuila, SA, CMC) and HYLSA, at a rate equal to 110% of the Bank's standard variable interest rate and with the same terms as the Bank loan. Benefits and Risks: The decontrol of domestic steel prices, coupled with the trade liberalization measures already implemented and the overall restructuring of the steel subsector, will lead to efficient import competition, forcing domestic steel pro- ducers to improve quality and product mix in order to serve better downstream steel consuming industries. Bud- getary transfers to the public steel sector, and indirect subsidies to the industry as a whole, would be eliminated and the necessary internal funding would be provided for the proposed restructuring and rehabilitation of the physical plant of the entire subsector. The physical rehabilitation of the AHMSA, and HYLSA plants will sub- stantially improve the international competitiveness of flat products both in terms of better quality and lower overall cost. Rationalization of existing capacity will also allow the two plants to improve utilization. Down- stream users of flat products will be able to obtain a wider range of quality flat products at lower cost. The rehabilitation of the SIDERMEX mines will allow lower cost exploitation of available resources and maintain Mexico's comparative advantages in steel production. Technical assistance (financed from other sources) will enable the steel producers to map out viable long-term strategies and the means to implement them. The main potential risk is that the Government will delay actions on complete price decontrcl which could aggravate the financial position of steel producers and induce a return to higher protection. The steel price increases accorded in December 1987 and January 1988, and the agree- ment on monthly adjustments of steel prices in real terms based on changes in the Consumer Price Index until elimi- nation of price controls by not later than December 31, 1988 minimize this risk. Additional risks include a reversal of agreed policy actions and a sharp real appre- ciation of the exchange rate which could affect project viability. The agreements concerning the definition of future investment strategy, the Government's commitment to the liberalization program, the substantial physical restructuring and rehabilitation of the public sector com- panies, and agreement on Action Plan for monitoring opera- tions and performance of the target companies all combine to mitigate the potential adverse impact of the above risks.  - iii - Estimated Disbursements: Part A of the Loan would be disbursed in two equal tranches linked to trade liberalization., price decontrol and elaboration of a Global Steel Sector Policy Statement. Retroactive financing up to a maximum of US$20 million for eligible import expenditure after November 1, 1987, would be allowed. The first tranche would be available for disbursement at loan effectiveness. The second tranche would be released upon complete elimination of any remaining price controls on domestic steel products, continued maintenance of the trade liberalization measures, and presentation of the Global Steel Sector Policy Statement along substantially agreed lines. The second tranche release is expected in January 1989. Parts B and C of the Loan would be disbursed against eligible goods and services procured under World Bank guidelines, including retroactive financing up to a maximum of US30 million equivalent for expenditures incurred after February 1, 1987. Estimated Project Cost: The estimated project cost and financing requirements (not including normal capital replacements) for the period 1987-1991, are summarized in the following table: Local Foreign Total (USJi0llion equivalent) Part A - 100 100 Parts B and C Equipment and Spares 88 328 416 Civil Works/Erection 91 10 101 Engineering Project Management 17 17 34 TA/Training 8 18 26 Base Cost 204 373 577 khysical Contingencies 25 36 61 Price Escalttion 38 30 68 Installed Cost 267 439 706 Taxes and Duties 104 - 104 Total Installed Cost 371 439 iiRS Incremental Working Capital 80 20 100 Total Project Cost 451 195 !i Interest during Construction 4 36 40 Total Financing Required 455 495 950 GRAND TOTAL 455 595 1,050  - iv - Financing Plant The proposed financing plan for the Project is summarized in the following table: Local Foreign Total (in US$ M equivalent) IBRD - 400.0 400.0 Local Baars 64.0 - 64.0 AMSA 185.0 92.0 277.0 CMC 78.0 56.0 134.0 SIDERMEX 3.0 - 3.0 RYLSA 125.0 47.0 172.0 455.0 595.0 1,tO0.0 Estimated Schedule of Disbursements: IBRD FY: 1988 1989 1990 1991 1992 1993 Annual 58.1 108.8 110.4 86.8 26.4 9.5 Cumulative 58.1 166.9 277.3 364.1 390.5 400.0 Economic Rate of Return: In excess of 18? Staff Appraisal Report: No. 6892-ME dated February 8, 1988 &-mv8 IBRD - 20418 - Steel Wines and Major Markets IBRD - 20419 - Iron Cra Mines, Coal Mines and Natural Gas Fields  MEXICO - STEEL SECTOR RESTRUCTURING PROJECT I. INTRODbCTION 1.01 The Government of Mexico (GOM) has requested a Bank loan to help finance the restructuring of the Mexican steel industry, and support policy reforms that will substantially alter the manner in which steel producers conduct and develop their business in the coming years. The proposed lean of US$400 million equivalent comprises three major elements: Part A (US$100 million) is tied to implementation of wide-ranging policy measures with specific emphasis on exposing the industry to internatio2kal competition, and would finance steel-related imports during the adjustment period. Part B (US$225 million) provides financing for the restructuring needs of the public sector steel company, SIDERMEX, including the physical restructuring of its integrated steel plant and the country's major flat product facility, AHMSA, and its coal and iron ore mining operations, as well as corporate-wide organizational and financial restructuring and long-term strategy formulation. Part C (US$75 million) supports the restructuring efforts of the major private sector steel producer, HYLSA, in the modernization of its flat products facility at Monterrey, in parallel with a financial restructuring package that has been negotiated with creditor banks. 1.02 Project financing requirements, including contingencies, price escalation, interest during construction and incremental working capital are estimated at US$946 million equivalent net of US$104 million equivalent of taxes and duties, with about US$595 million equivalent in direct and indirect foreign exchange costs. The proposed Bank loan of US$400 million would thus cover about 67% of the estimated direct and indirect foreign exchange costs, or about 421 of the total financing requirements net of taxes. The balar.ce of the financing needs are to be met from internal cash generation and from short-turm borrowing for working capital. Suppliers credits and/or cofinancing represent other possible funding sources. 1.03 Bank involvement in the project arose from initial discussions with Mexican authorities in 1985, as part of the review of the country's sectoral investment plans. A Bank mission in May 1986 carried out a Steel Sector Strategy Review (Report No. 6429-ME). Bank missions in September and November 1986, reviewed this report and its recommended changes in steel sector pricing policy and the product mix and investment strategy of SIDERMEX, with Government authorities, SIDERMEX management, and private sector representatives. Following these reviews, project identification was completed and SIDERMEX and HYLSA began to assemble the technical details with the help of outside consultants. A Bank mining review mission first visited Mexico in January 1987. The project was preappraised in February 1987. Appraisal was initiated in March and completed in May 1987 when the final technical reviews by consultants became available. 1.04 Previous Bank involvement in the steel sector began in 1972 when Mexico embarked on a rehabilitation and expansion program designed to increase raw steel capacity to about 9.2 million tons per year by 1980 and 11.0 million tons by 1985 in order to satisfy growing domesti.- demand and to improve productivity of their existing facilities. As part of this program, in 1973 the Bank extended a loan (President's Report No. P-1307-ME  - 2 - of August 21, 1973 and Appraisal Report No, 220-ME dated August 10, 1973) of US$70.0 million to SICARTSA to finance a new integrated steel plant at Lazaro Cardenas on the Pacific Coast. The plant has a capacity of 1.1 muilion tons per year of non-flat products (rebars, merchant bars, wire rods). The project also included the development and exploitation of a captive iron ore mine and a port to handle imported raw materials (mainly coking coal) and export of excess finished products. The project was implemented and commissioned in collaboration with British Steel Corporation under a general know-how and technical assistance agreement. The project was completed successfully, a few months behind schedule and with some cost overruns due to the particularities of the project (greenfield plant in an underdeveloped region, new staff, period of high inflation throughout the world, etc.). The plant is now operating close to rated capacity producing high-quality non-flat products at internationally competitive costs. ,05 In 1976, the Bank approved a loan of US$95.0 million for the second stage of the SICARTSA program (Appraisal Report No. 1060-ME of June 15, 1976) designed to produce 1.7 million tpy of flat steel products (hot and cold rolled coils and sheets). The Government of Mexico, which changed shortly after the approval of the loan, decided to reconsider the project and consequently cancelled the Bank loan. A new project, based on direct reduced iron ore, producing different flat products (heavy plate), was presented to the Bank in 1979/80. The Bank decided not to participate because the market demand analysis for the new product was considered insufficient. The project, SICARTSA II, is still under construction with financial and technical assistance from Japan and che United Kingdom. II. BACKGROUND A. The Economy - Recent Structural Changes 2.01 Following three decades of high and stable economic growth from the 1940s through the 1960s, the Mexican economy started to slow down in the early 1970s. The Government attempted to foster growth through expansion of the public sector. The oil boom of the mid-1970s induced further inflationary expansion that led to a basic disequilibrium, which accelerated external borrowing. This brought about a generalized financial crisis in 1982. Since its onset in August 1982, there has been a growing recognition that a return to sustainable growth would require not only stabilization policies, but also far reaching structural reforms on the supply side of the economic structure. This perception gained ground after the 1982 stabilization program faltered in late 1985 (partly due to insufficient focus on structural change) and became a central issue following the collapse of international oil prices in early 1986. The Government responded to the 1985/86 crisis by intensifying stabilization measures and introducing significant structural changes focusing on trade liberalization, encouraging private sector activity and reducing the role of the public sector while increasing its efficiency. Implementation of trade liberalization measures was accelerated in 1987. 2.02 The most fundamental policy reform in this economic program is the shift from inward-oriented protected growth towards an  -3- outward-oriented, open market development strategy, based on gradually declining protection and eliminating price controls to improve the efficiency and export competitiveness of the economy. Such a shift is particularly significant to the steel sector in terms of the implicatinas of trade liberalization, the elimination of domestic price controls on steel products and the role of external competition in bringing efficiency and market response to the sector. The steel sector is part of the infrastructure for downstream engineering industries with considerable export potential, and as such its competitiveness in price, quality and service will play a strategic role in the success of the new outward-oriented development model. 2.03 A second fundamental structural change is the decision to clarify the role of the public sector in the production side of the economy by improving the performance and reducing the influence cf state-owned enterprises and actively stimulating the private sector. Along tb'se lines, the Government has intensified its efforts in divestiture, selling, merging, closing and/or transferring of several public sector firms, and in industrial restructuring. In particular, in the steel sector there has been substantial progress along these lines in 1986. SIDERMEX has shut down one of its largest integrated plants. The company itself has been reorganized with large numbers of its subsidiary companies 5ol4, liquidated or transferred and further measures, of which this project i, an important step, are being planned. The end result of this process will be a smaller but more efficient public sector, coupled with a growing private sector placed in a framework of healthy intervational competition. B. The Steel Sector 2.04 The Mexican steel industry is of substantial size with a theoretical installed capacity in 1987 of just over 9.0 mtpy of crude steel. After relatively modest growt!s in the 1940s and 1950s, highly protectionist policies, heavy government investment and large budgetary transfers and input subsidies allowed the industry to grow rapidly in the 1960s and 19709, at 10.2X and 7.5% p.a., respectively, with production basically in balance with consumption. During the oil boom of 1976-81, demand for steel products grew substantially faster (14.9Z p.a.) than production (9% p.a.) and imports increased from 0.3 to 2.5 mtpy in that period. The economic crisis of 1982 severely hit the steel industry; domestic steel demand contracted by about 45X, imports by 86Z, and domestic production by 13X. The debt burden of the companies grew out of all proportion, and cash flow problems led to inadequate maintenance and a backlog in technological development. After 1983, there was some recovery, but neither consumption nor production reached the 1981 level (Annex 2-1). 2.05 At the end of 1986, the steel industry employment was nearly 65,000 and the annual production was 7.2 million tonnes of ' ude steel and 5.6 million tonnes of finished products. The production and consumption of steel products in the country was basically in balance. The overall production and consumption balance has changed from net imports of US$1,750 million in 1981 to an import/export balance at about US$260 million of finished products in 1986 (Annex 2-1).  - 4- C. Structure and Main Institutions 2.06 In its present structure, the industry comprises five integrated prodacers and 23. non-integrated mini-mills, and a number of Independent rerollers scattered throughout the country. There are effectively two major operating entities in the sector, SIDERMEX and HYLSA, which account for over 80% of the production, value added and employment. More details are in Annex 2-1. Map IBRD 20418 shows the main steel plant locations. At present the Mexican steel industry receives practically all its raw material supplies (iron ore, coking coal and flux) from internal sources with the exception of (i) steel scrap, a large part of which is imported, and (ii) occasional small quantities of coking coal or pellets for SICARTSAe Mexico's reserves of iron ore are low grade and relatively small while proven coking coal reserves in the north are larger and richer (see Annex 2-2). Map IBRD 20419 shows the location of the main iron and coal mines in the country. 2.07 Several government agencies are involved in policy formulation, control and promotion of the steel industry in Mexico. The most important is the Secretariat of Energy, Mines and Parastatal Industry (Secretaria de Energia, Minas e Industria Paraestatal - SEMIP) which directly supervises SIDERMEX in terms of both current operations and investment policies and programs. SEMIP's influence extends beyond its public sector role. Although formal authority over industrial policies in general and steel sector policy in particular rests with the Secretariat of Commerce and Industrial Development (Secretaria de Comercio y Fomento Industrial - SECOFI), the predominant position of SIDERMEX insures that, in practice, SIDERMEX and SEMIP exercise substantial influence on government policy formulation for the steel sector, including such matters as price controls, quotas and trade restrictions, tariff levels, subsidies and investment plans and programs. Besides SEMIP and SECOFI, a third major player in the Government's policy-making role is the Secretariat of Planning and Budgeting (Secretaria de Programacion y Presupuesto - SPP); it coordinates the preparation of medium-term plans, approves the capital and annual operating budgets of the parastatal steel companies, and monitors their implementation. 2.08 SIDERMEX was established in 1979, to manage the activity of the three public steel companies: AHMSA, FMSA, SICARTSA and their 87 subsidiaries in mining, downstream manufacturing, marketing and distribution, and real estate. Although, SIDERMEX was initially successful in coordinating the strategic activities of the public steel sector, it did so at the expense of excessive centralization of commercial, financial and operational activities in the hands of a corporate management, leading to inefficient plant operation. The centralization of a large part of the decision making authority also resulted in an isolation of the SIDERMEX plants from the needs of the ,arkets, The organizational and legal structure were complicated. The large number o' subsidiaries with very wide ranging missions diluted the management effort. 2.09 The operating performance of the SIDERMEX steel companies varied substantial'y, reflecting the technology in place, the state of repair of the facilities and the stability and the competence of the plant management  - 5 - concerned. The unfavorable economic environment in which these companies operated (low controlled output prices, depressed market, etc.) led to high operational losses compounded by very high debt service obligations. By 1986, SIDERMEX debt exceeded US$1.75 billion equivalent, of which roughly US$0.9 billion equivalent was foreign debt. A substantial portion of this debt represented the financing of non-performing assets, including over 50% in the SICARTSA II facility still under construction and awaiting further decision on its target completion. The earning power of the remaining assets was considerably lower than their book values and considerably diminished by the state of disrepair, the technical and organizational inefficiencies, and the lack of coherent government policies towards the sector. By the end of 1985 it had become obvious that no serious improvement could be made in the performance of the public sector companies without deep changes in the organizational and financial structure of SIDERMEX and in the economic environment surrounding the steel sector. Consequently, early in 1986, the GOM appointed a new management team and gave it the mandate to implement the major steps of a restructuring program aimed at restoring SIDERMEX efficiency and competitiveness and to restructure its organization, financial position, management and operations. The restructuring program is discussed in Chapter IV. 2.10 HYLSA vas founded in 1942 as a tin reroller. In the 1950s HYLSA developed the first industrial process for production of direct reduced (DR) sponge iron with operation starting in 1957. The company grew steadily, through the 1950s and 1960s establishing a non-flat product facility in 1969 and integrating it backwards through an improved DR process. Over the years, HYLSA remained the major cash earner for the Alfa Industrial Conglomerate (Grupo Industrial Alfa - Alfa). In the 1970s, Alfa undertook a substantial diversification program financed in part through the HYLSA cash engine. The economic crises of the early 1980. left HYLSA and the parent Alfa saddled with an extraordinary debt burden. The financial restructuring of the Alfa debt was completed in 1986 and a number of activities are being spun off. HYLSA's debt burden reached US$1.15 billion equivalent at the end of 1986, about 25% of which represented mounting payments arrears. The bulk of the debt is owed to foreign (mainly US) commercial banks. A financial restructuring package has been negotiated that allows for conversion of up to US$375 million of HYLSA's debt into equity and provides for flexibility in repayment of the remaining debt through separation into mandatory and optional tranches, each bearing different rates of interest. The agreement also provides for HYLSA's implementing its capital expenditure program aimed at rest.Jring its competitiveness. Provision is also made for infusion of new debt in support of the capital program. The restructuring package and related terms have been drawn up but remain to be cleared by all the institutions involved. A final signed package is expected to be completed in mid-1988. The restructuring package provides an acceptable and reasonable basis for HYLSA to resolve its financial crisis and allow it to remain as a major producer in the Mexican steel sector. 2.11 The other entities in the sector, TAMSA and the semi-integrated producers and rerollers, have been founded mainly in the past 20 years, with TAMSA being the oldest at over 35 years. Its activities, however, fall outside the direct ambit of the traditional steel product markets, its  - 6 - main product - seamless pipes - being for use mainly in oil exploration. TAMSA's financial position has deteriorated in the past three years. The company is burdened with over US$600 million equivalent in term debt, over 60X of which is owed to foreign commercial banks. A substantial part of this debt was incurred in financing a major plant expansion in the early 1980s based on optimistic views of the oil industry and consequent demand projections for oil field products. Although TAMSA is seeking a restructuring agreement with its creditor banks its very specialized production profile serving a specific market (mainly PEMEX) would only constitute a small part of the whole steel sector restructuring. Several smaller producers including those involved in stainless and specialty steels are also facing financial structure problems. As a condition of the proposed project, NAPIN will make available funds from other sources, including existing Bank credit lines to all of these producers including TAMSA for assistance in preparation of physical, organizational or financial restructuring studies. 2.12 All steel companies are grouped under a steel producers' association, the Camara Nacional de la Industria del Hierro y del Acero (CANACERO), which has mainly functioned as a spokesman for the industry, as a forum for exchange of basic market and technical information, and as a lobby for favorable steel policies. CANACERO's influence on policy has been minimal, however, reflecting the past divergence of opinions on fundamental policy issues such as price controls, tariff and quota protection, etc. between the private sector producers and the SIDERMEX group. Moreover, the protective environment of the 19609 and 19709 and the substantial market control and price levels of that era provided little incentive to the steel industrv to develop an effective association. The recent structural changes in the Mexican economy and the consequent adverse impact on the steel sector have brought about a change in attitudes as well and CANACERO is now beginning to take a more active role in lobbying on behalf of the industry's interests in a more unified manner. D. The Policy Framework 2.13 The steel industry is an important part of Mexico's manufacturing sector and has significant impact on the availability, cost and quality of material inputs for downstream manufacturing, particularly, the engineering and capital goods industries. Over the past two decades, the Government has created and applied a policy framework intended to be favorable to this industry. This framework was successful in creating a steel industry able to meet the steel demand of the country in quantitative terms, but one that is now unable to satisfy the expectations of supplying low-cost and high-quality steel products to the market place. The highly protectionist trade policies before 1985 (Annex 2-3) included: (a) quantitative restrictions, that covered 100% of imports in 1982 and 1983; (b) high tariffs (up to 401 for steel products); (c) unrealistically high official reference prices, that served as the basis for calculating the amount of custom duties, resulting in a substantial increase of duties to be paid;  - 7 - (d) domestic content requirements for capital goods and automotive industries; and (e) public sector procurement practices which gave preference to domestic products over imports. This trade regime had created an inward oriented industry that faced very limited import competition making it difficult for the downstream users (especially for the export-oriented manufacturers of engineering products) to obtain high-quality, competitively priced steel products in needed specifications, lot sizes and delivery schedules. 2.14 The key policy issue addressed in the restructuring project and the proposed loan is the decontrol of steel prices which have been set in the last two years below both the total cost of the efficient Mexican producers and below the actual landed cost of imports (not including tariffs). As discussed in Annex 2-3, the price control deprives the producers of the financial benefit of protection and does not provide any incentive for improvement of product quality and service to customers. In addition, the low level of profitability and return on investment discourages entry of new private investment capital into the sector. In other words, the price control offsets the resource generating benefit of the protection while all the negative impact of the protection remains in full effect both for the steel industry and for the downstream users. 2.15 An important element of the Government's policy towards the steel industry is its direct participation in the production activities. The public steel sector was created as a result oi the takeover of the then two largest private sector steel producers, AHMSA and PMSA, in order to save them from bankruptcy and to avoid the layoff of thousands of workers. In the 1970s, the Government establinhed a new integrated steel works, SICART8A, partly to meet the fast growing domestic demand, partly to promote the development of the remote region of Lazaro Cardenas. Government policy regarding its direct investment in steel has changed substantially in the last two years. Action has been taken to streamline the public sector steel companies, to stop uneconomic activities and spin off non-essential plants. After years of futile efforts to convert FMSA into a healthy, profit-making company, the Government closed it in April 1986. Further public investment plans have been reduced drastically and a large number of SIDERMEX subsidiaries have been or will be transferred, sold or liquidated (Chapter IV). 2.16 Despite the increasing clarity on the public sector's investment strategy, Mexico lacks a global steel policy and long-term strategy, clearly defining the respective roles of the public and private sectors, and assuring the conformity between the development plans and the expected needs of the market. The present situation discourages major investments in the private sector and makes it very difficult to develop optimal investment programs in both the public and private sectors. The Steel Sector Restructuring Project and proposed Bank loan will, among others, address this situation through the elabcration by GOM of a Global Steel Sector Policy Statement based on the Policy Letter (Annex 4-2) that was presented by GOM at negotiations.  -8- III. THE STRATEGIC ISSUES AND BASES FOR SECTOR REFORM A. Strengths and Weaknesses 3.01 A detailed analysis of the Mexican steel industry's current operating performance, cost and quality competitiveness, and its strengths and weaknesses was carried out under the sector strategy study completed in 1986. The main findings and conclusions of that analysis are presented in Annex 3-1. The technical comparisons of the major steel plant operations in the country lead to the following main conclusions: (a) non-flat products are by and large produced in modern facilities in both the private and public sector and are quality and cost competitive with international norms; the sole exception is AHNSA's outdated facility; the strategic implications are discussed in para 3.07 and 3.08 below; (b) the industry's main weakness lies in the quality and cost of its flat product lines at both AHMSA and HYLSA; modernization of these facilities would enable both producers to substantially improve their competitiveness and strategic position. 3.02 The mining operations are analyzed in Annex 2-2 and Annex 3-2. The main conclusion from this analysis are: (a) coking coal and iron ore production in Mexico appear competitive from economic and financial points of view, and can be expected to maintain this position if no major shifts in relative costs (labor, energy, transport) occur; (b) coking coal production shows substantial potential for further cost and quality improvements as older mines are closed and new mines are opened with concomitant changes in mining techniques and higher productivity; (c) iron ore is generally of lower grade but even with higher processing costs is competitive as inputs to the steel industry on both an economic and financial basis; and (d) there is small room for improvement in two of the iron mines because they are nearing depletion; the remaining three iron mines and the coal mines could show improved cost performance through increased capacity utilization rates.* 3.03 The marketing and distribution practices and infrastructure have been deficient, particularly those of SIDERMEX. Past protectionist policies held back the development of an efficient and competitive distribution network. This deficiency has particularly affected the smaller companies in the engineering industries and capital goods, which have suffered from inadequate and unpredictable supply of steel products.  -9- B. The Strategic Issues 3.04 An analysis of the present and potential steel market demand and supply in Mexico is presented as Annex 3-3. Domestic producers are presently unable to supply high-quality steels to the domestic market, particularly for the rapidly growing capital goods and manufactured metal products subsectors. Mexican producers in these subsectors have potential comparative advantages in three significant areas, viz., labor cost, proximity to substantial riarkets, and indigenous resources. Recent government policy changes have added an additional factor that has spurred rapid growth and an export-oriented internationally competitive approach. As a result, this segment of t.he steel market is the most demanding in terms of the quality dimension and cost competitiveness. The ability of the steel industry, and particularly the flat product producers, to adapt to the changing needs of this segment of the steel market is a key factor in Its future growth. 3.05 The bases for projecting steel demand are an assumption of a modest rate of growth of 3-4% p.a. of GDP in the next five years and a further opening of the Mexican economy which is expected to lead to a faster-than-average growth of the manufacturing industry. This is expected to result in an average growth in demand through 1991 of about 4.4% p.a. from the 1986 level for flat products, 3.2% p.a. for non-flats and 3.5% p.a. for seamless tubes, or 3.8% p.a. for all products. 3.06 Although overall demand growth is projected to be slow, there are major opportunities for the Mexican steel industry in diversification of the product mix and improvement of product quality to capture a greater share of the specialized market segments that show higher than average growth potential. The strategic analysis described in Annex 3-1 indicates that from a wide range of flat and non-flat products, Mexican producers have considerable potential for improvement of their competitiveness to cover not only their short-run marginal cost, but their long-run economic costs as well (see paras 8.08-8.10). The restructuring Fcogram in the short run and the proposed project are designed to tap thts potential which would benefit both the steel industry and its downstream tiers particularly in the capital goods and manufactured metal products subsectors. 3.07 The main conclusions from an assessment of the industry's strategic position in relation to the potential market demand and taking into account the industry's cost and quality factors are that the steel industry is well placed in the non-flat product area. The opportunity that needs to be tapped is the demand for high-quality bar products that could be produced in SICARTSA's modern facilities and the shift of these facilities from export to domestic production. However, the AHMSA non-flat product lines are clearly in a weak strategic position with respect to cost and quality. Abandonment of these lines could provide the private sector producers with the opportunity to expand production, provided the pricing incentives are in place. Structural profiles are an exception to this general thrust. Further analysis shows that AHMSA should continue to produce structural steel profiles (wide flanges, beams, etc.) as well as modify its structurals mill to produce rails for the domestic market (see also para 8.09).  - 10 - 3.08 The strategic thrust that can be derived from the analysis is that, in the short and medium term, Mexico should (i) concentrate on improving the quality and cost factors in the flat product lines; and (ii) focus its most modern non-flat facilities on the internal markets to service a demand for higher-quality products. With regard to raw material resources, a crucial issue is whether available iron ore reserves and the capacity of existing mines and new projects will be able to satisfy future demand of the steel industry. As a general conclusion, local supply sources, based on current reserve estimates would be sufficient to meet iron ore demand fully in the short and medium term, and coking coal demand in the longer term, well into the next century. Periodic reassessments of these global forecasts will obviously have to be made in the light of new exploration results. C. Agenda for Policy Reform 3.09 The strategic development issues facing the Mexican steel industry also have a major impact on future trade liberalization. The policy reform proposals which underlie the comprehensive program of restructuring are aimed at creating the framework under which the steel industry can achieve greater competitiveness in the coming years and thereby open the way for liberalization measures affecting downstream industries. Annex 2-3 presents an analysis of the main policy reform proposals. 3.10 Given that the program of trade liberalization and tariff reduction has already been agreed, the most critical element in the short-term agenda for policy reform is the elimination of domestic price controls. As discussed in greater detail in Annex 2-3, this will permit the rise of domestic steel prices to their opportunity cost levels and eventually, as quality improves with the project, to the level of CIF plus tariff. This measure would also allow the steel producers to obtain the financial benefits of the announced tariff policy and, thereby, generate the funds necessary for adequate maintenance of facilities, upgrading of technology and servicing of the debt. It would also allow the Government to eliminate budgetary transfers averaging about US$75-100 million a year to cover both operational losses and to support capital expenditures in the public sector and indirect subsidies to the industry as a whole. It would attract needed new investment capital to the steel sector, and will lead to efficient import competition forcing domestic producers to improve quality and product mix and to serve better their customers. This will substantially improve the supply of steel products in the domestic market as producers become more specialized and more competitive. These measures would further facilitate movement towards liberalizing domestic content requirements in downstream manufacturing industries, such as auto parts, for which a broader approach is foreseen. The proposed policy reforms in the steel sector are vital in ensuring greater competitiveness in both cost and quality terms. 3.11 The steel sector report prepared by the Bank recommended that a global steel sector policy be elaborated by Government with active participation of the private sector. This policy should include a clear statement of Government's intent in order to encourage private sector investments and permit it to seek its market niches and exploit its  - 11 - comparative advantages in an effective manner. The first practical step in this direction has been the completion of a comprehensive, in-depth market study which serves as a basis for the medium and long-term strategy. The main objective of the study was to review the structural changes occurring in the demand for steel products, identify the market niches that present the greatest opportunities for domestic steel producers, and assess the basis for longer-term market growth, so that appropriate supply strategies can be defined and implemented. Consultants were appointed under the aegis of CANACERO and the study was completed in October 1987. This study provides the input for the strategic planning study that has been undertaken by SIDERMEX and for other less formal studies by the private sector producers. The Government has agreed to elaborate the Global Steel Sector Policy Statement by July 31, 1988, i.e., after the presentation of the SIDERMEX Long-range Strategic Plan (para 4.10). The Government's Policy Letter, providing the outline for the Steel Sector Reform Program, is discussed in para 4.02. 3.12 While no specific annual targets are included in the policy reform program concerning budgetary transfers and subsidies, the Government's clear intentions, as articulated in the SIDERMEX convenio and confirmed in the Policy Letter (para 4.02), are to reduce and eliminate direct and indirect subsidies and transfers to the public sector companies. With the expected implementation of the recommended policy changes, the steel industry will be able to operate, modernize and even modestly expand on the basis of its sales revenues. The total elimination of direct subsidies and government transfers to the steel industry is also expected to occur in a relatively short time. IV. THE RESTRUCTURING PROGRAM A. Objectives 4.01 The Steel Sector Restructuring Program involving public and private sector producers is an important element in Mexico's general adjustment process. Reflecting the strategic thrust described in para 3.08, major objectives of the program are to maintain, enhance and restore the sector's competitiveness and restructure its technical, financial and organizational characteristics: (a) On the policy side by: (i) eliminating domestic price controls, reducing and making uniform tariffs on steel products and eliminating official reference prices in line with the agreed calendar of trade policy reforms, so as to assure competitiveness in the marketplace; and (ii) reducing and eventually eliminating government subsidies to producers. (b) On the technical side by: (i) closing down uneconomic operations, reducing or eliminating production inefficiencies, and optimizinag existing and  - 12 - planned new facilities in terms of the product mix and markets served; (ii) carrying out economically justified immediate and urgent investments in catch-up maintenance, debottlenecking of existing productive facilities, quality control and productivity improvements; and (iii) undertaking the market and technical studies needed to plan for the longer-term investment needs of the sector. (c) On the organizational side by: improving the management and organization of SIDERMEX by decentralizing the decision-making process and devolving operating responsibilities to the steel, mining and other operating units, placing particular emphasis on their market responsiveness. (d) On the financial side by: improving the financial condition of SIDERMEX, the major private sector producers, HYLSA and TAMSA, and other semi-interrelated producers by undertaking needed financial restructuring and financial engineering of their balance sheets. B. Global Policy Actions 4.02 Following discussions on the underlying trade and price control policy framework, a number of actions have been taken as part of the Government's trade liberalization program, supported by the Bank's First (TPL I, Loan No. 2745-ME) and Second (TPL II, Loan No. 2882-ME) Trade Policy Loans. Import tariffs for finished non-flat steel products were reduced in 1986 from 40% to 37%, and on most flat products were reduced from 25% to 20%. Recently, tariffs on all steel products were reduced to 0% to 15%. All quantitative restrictions for import of steel products were eliminated. The Government's policy actions are included in the Policy Matrix (Annex 4-1) and in the Policy Letter providing an outline of Government intentions with respect to the steel sector (Annex 4-2). These action measures and policy intentions constitute the Steel Sector Reform Program, summarized as follows: (a) The Government plans to open the steel market in Mexico to international competition so that the manufacturing sector will benefit from high-quality, low-cost input materials. Changes include the elimination of quantitative restrictions and official reference prices for imported steel products. In December 1987 tariffs were reduced to 0% to 15%. (b) Steel price controls will be totally eliminated not later than December 31, 1988. Prior to this event, the Government will continue to adjust the domestic prices of all steel products monthly based on the anticipated changes in the Consumer Price Index in order to dampen any possible sharp increases and fluctuations that might occur after complete price decontrol. The price increases accorded in December 1987 and January 1988 have already brought all domestic product prices to or above equivalent international landed price levels and continued adjustments will maintain the domestic price levels in real terms.  - 13 - (c) Through these policy changes the Government seeks to provide a stable long-run framework of trade and domestic industrial policies that in the new open market environment will provide the necessary incentives for efficient production of quality products and the conditions necessary for proper long-term planning. It is the Government's intention to maintain these policies in order to ensure the development of an internationally competitive steel industry able to operate without further protection. (d) The Government has taken significant restructuring steps with its parastatal steel company, SIDERMEX, including (i) thhe closing of the inefficient steel plant, Fundidora de Monterrey ;.A.; (ii) the financial and organizational restructuring cf SIDERMEX; and (iii) the closure, spin-off, reduction and consolidation of its subsidiary companies. The Government plans to continue the transformation of SIDERMEX into an effective holding company that performs strategic management and general supervisory functions over the entire parastatal steel sector. (e) By March 31, 1988, SIDERMEX will publish a Long-term Strategic Plan which will include details of the remaining restructuring work and the investment program supported by the proposed Bank loan. This plan will elaborate further on the issues regarding management and organization as well as details pertaining to facilities to be operated and products to be produced in the next five years. Government investment will be limited to further balancing and technical upgrading of existing facilities and to completion of existing projects that are shown to be economically and financially viable. (f) In the long term the Government plans to eliminate all budgetary transfers to SIDERMEX. After the publication of the SIDERMEX Strategic Plan, Government will further elaborate and publish a Global Steel Sector Policy Statement, not later than July 31, 1988, substantially along the lines indicated in the Policy Letter. tn particular, the Global Policy will be consistent with both the guiding principles of the SIDERMEX Strategic Plan and with the Plan itself. These actions will clearly define the scope and extent of the public sector's investment and operating strategies and investment plans, and will, thereby, allow the private sector to plan its own operations and investments. The Government's goal is to continue the transformation of the sector into a group of solvent and viable companies with well-maintained facilities, producing internationally competitive products to better serve the country's downstream users including the growing export-oriented manufacturing industries. As they are vital to the short- and long-term success of the restructuring effort, and to the viability of the physical investments to be implemented under this project, the continued maintenance of the price decontrol and trade liberalization measures is a covenant of the entire proposed loan.  - 14 - C. SIDERMEX Overall Restructuring Thrust 4.03 Significant progress has been made by the Government with regard to the restructuring of SIDERMEX operations and following actions have been taken: (a) The country's least viable and most loss-ridden steel plant, FMSA at Monterrey was closed in May 1986; (b) The Government and SIDERMEX worked out a comprehensive restructuring program of the public steel sector and in September 1986, signed an agreement (Convenio), which provided for major financial restructuring of SIDERMEX companies (AHMSA and SICARTSA), defined the overall program of physical plant restructuring and organizational changes to be carried out with Government assistance, and specified SIDERMEX obligations in terms of performance improvements, productivity targets and profitability goals. (c) The corporate structure of SIDERMEX was rationalized, with devolution of responsibility for all operating, marketing and financial activities from corporate level to the plant operating levels. The number of corporate employees was reduced from 1,070 to approximately 800 with further reductions contemplated. (d) A large part of SEMIP's decision making authority was delegated to SIDERMEX corporate management; and (e) The process of rationalization of the size and profile of SIDERMEX has been initiated. Ten of the former SIDERMEX subsidiaries have been transferred under direct control of SEMIP. A process of sale of 22, liquidation of 20, and consolidation of the remaining companies into 24 units has seen started, and substantially completed (see para 4.06). 4.04 The SIDERMEX Restructuring Program incorporated in the Convenio addresses the most urgent aspects of operational changes needed to restore SIDERMEX's competitive position, including the rehabilitation of existing facilities and undertaking the organizational and financial changes to accomplish the basic objectives. The Convenio provided that SIDERMEX would launch these actions as a medium-term program, while studying a longer-term strategic plan to be decided upon and implemented as soon as the requisite financing plan and detailed investigations were ready. The proposed project addresses the implementation of the medium-term restructuring. Organizational Changes 4.05 At the beginning of 1986, SIDERMEX consisted of 3 integrated steel plants and 87 subsidiaries. Most of the subsidiaries were engaged in activities not closely related to the steelmaking and marketing process. The decision of the Government was to keep in the SIDERMEX group the large integrated steel producers, the coal and ore mines, some of the marketing  - 15 - network, ferro alloy producers, and the production of refractory materials. The rest will be divested from the SIDERMEX portfolio. At the end of the reorganization process, SIDERMEX will have 2 integrated steel plants, a raw materials operating group and 24 related subsidiaries mainly in mining of iron ore and coal, and production of refractories. 4.06 A major change that is an integral part of the current phase of SIDERMEX restructuring is the shut down of its most problematic plant, FMSA at Monterrey. This was a painful decision, since it liquidated nearly 9,000 direct jobs and many thousa;ds of indirect jobs. Associated mines have since then also been shut down affecting some 2,000 workers in small communit.es. SIDS-RMEX and the Government have examined the social implications of these changes and after discussions with the trade unions, have agreed on compensation measures. After the signing of the Convenio in 1986, the restructuring process continued with ten of the former SIDERMEX subsidiaries transferred under direct control of SEMIP and 42 companies being sold to the private sector or liquidated. The remaining 35 subsidiaries are being consolidated into 24 units. Furthermore, the mining subsidiaries are being grouped into a single holding company, CMC, with its financial structure being rationalized through a recapitalization program aimed at eliminating inter-company debts, and allowing for transparency in the transfer pricing sales between the mining group and the steel plants (see para 7.07). 4.07 The Convenio will transform SIDERMEX into a holding company that performs strategic management and general supervisory functions over the parastatal steel sector. The responsibility and autonomy of the plant management will be substantially increased. The marketing and production planning activity has already been transferred from the SIDERMEX corporate management to the plants. The new organization, which is already in place administratively, will -Je legally formalized in 1988 not later than 90 days after loan signature (para 5.14). It will group all operations under five independent operational entities: AEMSA, SICARTSA, the raw materials division under the corporate name Carbon y Minerales Coahuila S.A. (CMC), Refractories and related operations, and international marketing and other non-technical units. This reorganization will considerably improve the management of both the steel producing and non-steel related companies. Financial Restructuring 4.08 In the framework of the Convenio, the Government assumed and converted to equity about US$883 million equivalent or 50% of the US$1.75 billion equivalent total debt of the SIDERMEX companies. Another US$250 million of FMSA debt will be dealt with in the bankruptcy process of that enterprise. The conversion of debt includes essentially all capital repayment falling due in 1986, 1987 and M9A8 and the interest payable from February to September 1986. This operation makes the debt more realistic and manageable, but does not offer a final solution of the problem, especially if account is taken of the growth of debt expected in relation with the possible continuation of the SICARTSA II investment. Decontrolling prices would permit the companies to generate a large portion of the funds needed to service the debt, but probably further financial restructuring measures will be needed in the future, including a possible write-down of some remaining SIDEIMEX assets which consultants will review under the project (para 4.12).  - 16 - Technical Restructuring 4.09 Key weaknesses in the mines and steel plants are due to insufficient funds in recent years allocated for maintenance and facility upgrading that have resulted in higher operating costs and lower product quality. In addition, technical improvements, particularly in automation and systems development, have not been carried out even in the more modern facilities. The sector strategy review and the competitiveness analyses carried out earlier have identified that the product mix of the plants do not fully correspond to (i) the requirements of the market, (ii) the technical conditions of the plants, and (iii) the possibilities of specialization between the large public and private producers. There is general technical agreement between SIDERMEX and the Bank that certain specialization should be developed among the public and private sector plants, e.g., flat products at AHMSA and HYLSA and non-flat products at SICARTSA I and in the private sector. Taking into account this strategic thrust and existing technical weaknesses, SIDERMEX has developed the short-term investment program with the assistance of US Steel Engineering Consultants (para 5.11) that is the basis for the project components described in Chapter V. Long7term Action 4.10 By the end of the proposed project, SIDERMEX is expected to be a group of solvent and viable companies with well maintained facilities, producing internationally competitive quality products at lower cost than now and with an adequate product mix to better serve the downstream steel-consuming industries. However, this immediate phase of the restructuring process does not include all the potentially needed modernization, balancing or the completion of the investments in progress. SIDERMEX is therefore carrying out a long-term strategy study to define the basis for its development through the 1990s. The Strategic Plan will be consistent with the guiding principles spelt out in the Policy Letter (para 4.02(e) and (f)). Terms of reference for this work were reviewed and agreed by the Bank. British Steel Corporation Overseas Services (BSCOS) was selected and has carried out the task. SIDERMEX will present its long-term strategy proposal for Bank review by March 31, 1988. The market study (para 3.11) has also provided a major planning input to th2e strategy study. The strategy developed for SIDERMEX will provide the basis for the Government's Global Steel Policy statement which will define the role of the public sector and along with the results of the market study the opportunities available for the private sector. 4.11 The integration of the proposed SICARTSA II investment program into the SIDERMEX complex is a critical element in the long-term strategy. The completion of this investment parallel with further facilities restructuring in the AHMSA plant may lead to excess capacities, particularly in plate production. Therefore, disetssion with SIDERMEX and the Government has led to an understanding that alternatives to completion of SICARTSA II would be evaluated on their technical, economic and financial merits once the medium-term product and market studies are completed. Such an evaluation would be completed as part of the presentation of the SIDERMEX Long-term Strategic Plan and will include:  - 17 - (a) review and discussion with the Bank of the conclusions and recommendations of its long-term strategy study in particular, those with respect to major investments in facilities not included in the now agreed Restructuring Program and use of facilities not now in operation; (b) implementation of the agreed elements of the long-term strategy in accordance with investment criteria, financing plans and implementation schedules that are acceptable to the Bank; and (c) annual review of the plani and progress achieved. 4.12 In reviewing the SIDERMEX financial restructuring already effected by the Government, and in particular, the financial pi. pects for its steel companies, it has became apparent that there is a need for further balance sheet restructuring, including revaluation of the fixed asset base in relation to the earnings potential and a corresponding writedown of the equity base, so that future SIDERMEX financial performance is measured against achievable financial return criteria and reflects the overall cost of equity and loan capital. It has been agreed that within six months after the signing of the loan documents SIDERMEX will carry out, based on agreed Terms of Reference: (i) a complete analysis and revaluation of its fixed assets, including fixed assets of all of its subsidiaries, and (ii) an adjustment and updating of the relevant balance sheets based on these results. D. Private Sector 4.13 The most important elements of the restructuring needs of the private sactor pertain to the current financial situation at HYLSA and TAMSA, the two integrated producers. Other private sector producers, in general, appear to be in relatively satisfactory financial condition, although profit margins have eroded in recent years and iivestment risks increased. The policy reform package described in para 4.02, by and large, would be sufficient of itself to strengthen the financial position of the smaller, non-integrated steel producers and to provide the right signals to them to reinvest in the potentially profitable market niches, and to attract new entrants to the industry. The case of HYLSA and TAMSA is, however, more problematic. Financial restructuring is a necessary condition for their survival as viable and dynamic entities. 4.14 As described in para 2.10, HYLSA owes about US$1.2 billion and in the present economic environment is not capable of generating sufficient funds on the existing facilities to fully service this debt. The company has recently completed negotiations on the restructuring of its debt with the advisory committee of the creditor banks. Since HYLSA, like the SIDERMEX companies, did not have sufficient funds in recent years for / maintenance and upgrading of its facilities, it badly needs to carry out a major rehabilitation and modernization program. The program has been defined by HYLSA with consultant assistance (see para 5.12) and forms the basis for the proposed project component. The implementation of this program is essential for HYLSA to maintain its competitive edge and retain its market share in a period when its main coLpetitor, SIDERMEX, is carrying out a significant improvement program. As discussed in para 2.10, the restructuring agreement with the banks would allow it to retain sufficient financial capacity for the implementation of the minimum invest:ment program. The financial assessment of the HYLSA rehabilitation  - 18 - component of the project reflects the preliminary agreements reached between HYLSA and the creditor banks (para 7.08). Signature of the final agreements with terms acceptable to the Bank is an agreed disbursement condition for the HYLSA component of the proposed loan (para 6.06). 4.15 Based on the analysis, it appears that, taking into account the terms of the financing restructuring plan, the major capital investment needs, and HYLSA's working capital requirements for ongoing operations, HYLSA would not appear capable of carrying out a successful rehabilitation and modernization program without financial assistance under the proposed project. Moreover, the financial restructuring package would permit HYLSA to obtain additional substantial write-down of the debt burden if part of the annual free-cash flow in the early years were to be used to retire debt. To the extent that HYLSA is able to finance at least a part of its investment needs from new external sources, the restructuring of HYLSA's balance sheet could be accelerated, resulting in a sounder capital structure. This would also allow HYLSA to remain a stronger competitor to the public sector in the domestic market. 4.16 Coupled with the financial restructuring needs (para 2.11), some technical restructuring involving new technology and upgrading of existing facilities of smaller producers in the private sector, particularly the specialty-steels producers, have been identified by the Government. Although these requirements are not specifically funded under the present project, NAFIN has agreed that technical assistance for these purposes will be provided from other funding sources, including existing Bank credit lines, already available to it. Funding for subsequent investment and working capital needs would also be channeled through existing credit lines, including existing Bank loans, with additional funds possibly included in a proposed Industrial Restru^turing loan. V. THE PROJECT A. Objectives 5.01 The project is based on the strategic analysis discussed in Chapter III and supports the policy reform measures discussed in Chapter IV. Its first objective is to assist the Mexican Government in implementing a comprehensive and far-reaching reform of the steel sector and in carrying out the needed restructuring actions. Its second objective is to assist the major players to rehabilitate potentially efficient plant and equipment with demonstrable viability, enhance product quality and reduce product costs, eliminate bottlenecks to achieve better utilization of existing capacity, improve technical, financial and managerial controls and information systems, train operations and maintenance staff and develop the human resources to achieve the overall objectives of greater competitiveness and responsiveness to market needs. Its final objective is to assist the Government and the industry in elaborating their long-term strategies and policies to achieve a healthier development of the steel sector in line with the country's development objectives. The project specifically avoids investments in product lines and facilities whose viability is dependent on the outcome of the ongoing market study and the SIDERMEX long-term strategy study.  - 19 - B. Project Description 5.02 The proposed project consists of three parts: Part A is an Input Materials and Steel Products Import component tied to implementation of agreed policy reforms; Part B addresses the restructuring needs of SIDERMEX and its operating entities; and Part C supports the rehabilitation and modernization of the HYLSA flat product facilities as part of its restructuring program. Part A: Input Materials and Steel Products Import Component 5.03 This component is intended to support the Steel Sector Reform Program of the Government described in paras 2.13-2.16 and 4.02. This program is in the process of execution having been launched by the Government in early 1986 with important components already implemented. Finalization and implementation of major components, including the elimination of domestic price controls, are under way. The policy reform will substantially alter the manner in which the steel industry conducts its business and develops in the coming years. It is expected that the further deepening of the reform process will result in increased steel imports during the adjustment period when the industry will be carrying out its restructuring and rehabilitation. Accordingly, this component will support both the consolidation of the already adopted measures and the introduction of new ones, and would finance a part of the increased imports during the adjustment period. 5.04 The Government has already carried out twio of the triggering events, i.e., elimination of ORPs for all steel products, one of the events for release of Tranche I, and reduction and equalization of tariffs on steel products to no more than 25%, one of the events for release of Tranche II. In addition, the price adjustment in mid January 1988 and the presentation of the Policy Letter at negotiations complete all actions required for release of the first tranche at loan effectiventss. The second tranche release will be triggered by final decontrol of all steel product prices, and the final elaboration of a Global Steel Policy Statement by the Government. The two tranches will be in equal amounts (see para 6.12) and will be used to finance eligible imports as set out in Annex 5-1. Part B: SIDERMEX Restructuring Program 5.05 The SIDERMEX program includes: investments in the major flat product facility, AHMSA, aimed at improving the quality and competitiveness of its hot and cold rolling lines and improving the utilization of its heavy section mill through the addition of equipment for the production of rail; investments in the raw materials division, CMC, to ensure adequate coal and iron ore supplies for the steel plants; and assistance to SIDERMEX in strategic planning and other studies. 5.06 The AHMSA component is detailed in Annex 5-2 and concentrates on shifting the product mix to flat products, heavy structurals and rails with an overall reduction in steelmaking capacity and improvements in quality and lowering of costs of production, primarily in hot and cold rolled sheet and tin plate. The major technical thrust is to (i) rationalize the steelmaking and continuous casting facilities; (ii) rehabilitate and  - 20 - improve the quality and productivity of the hot strip mill; (iii) balance the cold rolling mills and improve the quality of cold rolled products; (iv) provide catch-up maintenance throughout plant operations and in the plant-wide utilities and services; (v) expand the product line by using the underutilized heavy structural mill for the production of rail; and (vi) provide for enhancement of systems and training. The investments include, equipment for improvement of the steel-making facilities, the hot and cold rolling mills, rail section mill and plant-wide maintenances including utilities and services, as well as services of consultants for enhancement of management information systems, engineering and project manage.ent and development of training programs and expenditures for overseas training of operating personnel. About 900 man-months of consultant services are included. 5.07 The CMC component is detailed in Annex 5-3 and is concentrated on raising productivity in the coal mining operations and strengthening the Hercules iron ore operation, bringing it to its intended level of operation, through a mixture of maintenance and equipment renewal, debottlenecking investments, systems and controls and technical assistance for project management, operational improvements and upgrading of technical skills. The proposed investments include replacement of mining, transport and conveyor equipment, purchase of new coal crushers, installation of an iron ore concentrator facility and consultant services (250 man-months) for implementation of accounting and management information systems, ana for project management and training. 5.08 Strategic planning studies for SIDERMEX are detailed in Annex 5-4. The main objectives of these studies are to assist SIDERMEX management in: (i) carrying out a long-term strategic study including the necessary supporting technical studies; (ii) undertaking the corporate-wide asset revaluation exercise and translating the results into a suitable financial structure; (iii) implementing the organizational and financing restructuring measures that emerge after the completio: of the long-term strategic studies; (iv) assisting in the detailed planning of the long-term strategic investments; and (v) providing assistance fo: implementation of corporate level management information systems. To these ends, this component would include consultant services of about 445 man-months. Part C: HYLSA Restructuring Program 5.09 The HYLSA program which is detailed in Annex 5-5 concentrates on improving the competitive advantage of the Flat Products Division through investments in cost reduction, productivity and quality improvement. Most importantly, this component is intended to be executed in a timely fashion to maintain a competitive balance between HYLSA in the private sector and AHMSA in the public sector, both of whom are pro-siding similar products to the Mexican steel markets. This component includes: (i) establishing the production of high-quality slabs from the steelmaking shop; (ii) revamping and improving the quality and productivity of the hot strip mill; and (iii) debottlenecking the cold rolling mills and improving the quality and productivity of these facilities. The physical investments include equipment for steelmaking and hot and cold rolling mills. In addition, project management consultant services of about 250 man-months are included  - 21 - to assist HYLSA in carrying out detailed engineering and project supervision. Sector-wide Technical Assistance 5.10 As stated in para 4.16, it was agreed that the identified requirements for sector-wide technical assistance will be funded separately by NAFIN from other credit sources including existing Bank credit lines. Under this concept, NAFIN would finance: (a) Diagnostic studies for individual private sector companies aimed at improving operating efficiency and identifying potential for financial restructuring, rehabilitation and/or expansion. (b) Feasibility and engineering studies to assist individual private sector companies to take advantage of new markec opportunities and arrest existing and potential new threats to their competitiveness or to assist in preparing proposals for funding from existing and/or potential Bank-supported investment credit lines, recommended restructuring, rehabilitation, and operational improvements including technical assistance for management development and staff training. To this end, up to 400 man-month consultant services may be financed by NAFIN. Satisfactory and timely execution of these activities by NAFIN is an agreed covenant in the proposed loan operation. C. Project Management, Organization and Implementation 5.11 The SIDERMEX project beneficiaries - AHHSA, and CMC - have both had the benefit of qualified international consultant assistance (UEC - consulting arm of US Steel) in the preparation of the project components. They are continuing their existing consultant contracts for preparation of bid specifications pending selection of a consultant to assist with project management. Terms of reference have been discussed and selection is under way following Bank guidelines. As CMC's current project management organization is only now being set up, it has been agreed that CMC will employ a suitably qualified consultant to assist in project management on terms of reference satisfactory to the Bank. CMC has also agreed to maintain a suitably staffed project management team (see para 5.14) for the duration of the project. 5.12 HYLSA was assisted by Nippon Kokan of Japan (NKK) in project preparation and has agreed to follow Bank guidelines in selecting a new consultant to assist in project management, which will include procurement assistance, assistance in overall project planning and cost control as well as basic engineering, construction management and assistance during commissioning. Terms of reference similar to those at AHMSA have been prepared. Both AHMSA and HYLSA have agreed, until project completion, to appoint a Project Manager and retain suitably qualified project management consultants on terms of reference and conditions satisfactory to the Bank. 5.13 The project includes retroactive funding (para 6.13), including consultant preparation work. Terms of reference were agreed for work already under way and have been reviewed and agreed for the project  - 22 - managument functions. SIDERMEX Corporate management will also utilize const1:tant assistance in strategy studies and development. Terms of reference were agreed and a.consultant, British Steel Overseas Services (BSCOS), selected for the first phase of the work. 5.14 In addition to consultant assistance, each operating company and the SIDERMEX holding company have appointed a senior technical manager as internal Project Manager with responsibility for seeing to efficient project implementation. The Project Manager is supported with functional and line staff as needed in carrying out the project. This is particularly important as the physical plant rehabilitation is a complex task and interference with day-to-day operations needs to be minimized, with project implementation carefully phased into existing production and maintenance schedules. The companies have agreed to assign staff from the existing organizational structures as required for the duration of the project. Since CMC is a new organizaSion a more formal project management team will be organized. In all cases, however, a senior technical manager will be appointed as Project Manager and will be supported by (i) technical staff made up of both operating and engineering parsonnel; (ii) construction supervisors; (iii) planning and scheduling personnel; (iv) financial, cost accounting and cost control personnel; and (v) other specialized support as needed (e.g., procurement, systems and training, etc.) to carry out the project. This staff will interface with the consultant teams who will function in an advisory role. Responsibility for project implementation at each of the operating companies will be in the hands of the Project Manager. As discussed in para 4.06, the organization of CMC is being substantially changed through creation of a holding company for all mining operations. It was agreed that the completion of the conversion of CMC to a legal holding company for all of the SIDERMEX raw materials holdings must take place before the distbursement of any project funds to CMC. 5.15 The SIDERMEX holding company has also assigned senior staff to assist with project implementation. This includes accounting, financial and legal staff to monitor overall progress and help coordinate project imple:aentation by the operating units and a second group to handle strategic planning and the implementation of consultant studies relating to strategy development, organizational structure, reporting and management informati-A and control systems, financial studies (includes asset revaluations) and other restructuring tasks. 5.16 Individual detailed implementation schedules are shown in Annexes 5-2, 5-3, 5-4 and 5-6 along with detailed project descriptions. These schedules are summarized in Table 5.1. Table 5.1 Implementation Schedule AHMSA CMC HYLSA Bid Documentation Available January 88 January 88 October 88 Closing August 88 August 88 April 89 Contract Award April 89 July 89 October 89 Installation of Equipment October 90 July 90 November 90 Commissioning January 91 September 90 February 91  - 23 - The most critical element in the installation schedule is the delivery time for major equipment. For the major components up to 18 months is allowed and although a judicious mix of local and domestic supply may allow for some shortening of the schedule it will require careful planning and follow-up. The HYLSA component starts prequalification at a later date whilst awaiting the conclusion of its debt restructuring arrangements (para 2.10). The work in the HYLSA plant, however, is expected to proceed at a faster rate than the others since much of the new equipment is already on hand. Overall, the work is taking place at existing plant sites with staff and infrastructure in place. The implementation schedule takes into account numerous short outages in existing facilities for equipment installation. With technical staff in place experienced in operations, engineering and construction it is expected that all work including start-up will be completed as scheduled after the bid documentation dates. D. Role of NAFIN 5.17 Nacional Financiera, S.N.C. (NAFIN) has been designated by the Government as the Borrower in this operation. NAFIN is a Government owned development finance institution, that has ample experience in administering and onlending Bank loans in Mexico. In this operation it will (i) borrow from the Bank and onlend to the ultimate beneficiaries (Government, SIDERMEX companies, HYLSA) the respective components of the loan (para 6.07); (ii) organize and coordinate the collection and presentation to the Bank of the documentation concerning imports financed from the proceeds of the quick disbursing component of the loan (para 6.12); (iii) assist the ultimate beneficiaries in the loan administration and accounting and facilitate the financial part of the supervision of the project (para 6.12); and (iv) serve as a liaison in all financial matters between the Bank and the ultimate beneficiaries. 5.18 In addition to its direct involvement in the administration of the Loan, NAPIN will have a further role in assisting the small private steel producers. In order to avoid unnecessary duplication and proliferation of new credit lines with all their bureaucratic implications, funding for initial studies and for later investment and working capital needs for the small private producers would be channeled through existing and/or potential new credit lines (para 5.10). Since NAFIN is the Borrower for some of the existing loans and designated as the Borrower for future credit lines to the industrial sector, it will serve as a key link between the Steel Restructuring Project and other operations. Z. Training and Manpower Development 5.19 Each of the project components includes planned funding for technical assistance. The most extensive program is planned for the AHMSA operation which is an older plant where extensive new technology is being introduced and where the opportunity exists for widespread retraining and reallocation of human resources. Current plans include a decrease in the present work force from over 21,000 to approximately 18,000 total personnel. A human resource development group has been established in the plant organization to see to planning and implementation of training programs including general operation and maintenance in addition to the  - 24 - training that will accompany the purchase, installation and start-up of new equipment. These programs, which include training abroad, are expected to bridge the full duration of the project. The new CMC is in the most urgent need of technical assistance ranging from geological exploration to training in mining operations and maintenance of all major equipment. This component includes extensive on-site training and development. 5.20 The HYLSA operation has demonstrated excellent ongoing in-house training programs for both operations and maintenance. These programs will continue without the need for additional outside technical assistance. Specific training on new equipment is included in the estimate which might also include trairing by suppliers abroad, but beyond assistance in project management no general technical assistance is included. 5.21 The technical assistance components for AHMSA, CMC and HYLSA coupled with equipment investments are expected to result in higher productivity, yield and quality of finished products as well as lower energy consumption and other significant cost reductions. The integration of these programs in operating steel plants and at operating mines requires constant diligence by facility management and their consultants in order to obtain the operational improvements predicted. Therefore it was agreed that Action Plans covering these improvements will be developed by AHMSA, CMC and HYLSA, that include monitorable steps and a timetable of expected results. The presentation of these Action Plans is a condition of disbursement of the respective components under Parts B and C of the project. The Action Plans will also include details on training programs to be undertaken and results expected therefrom. The development and satisfactory implementation of these plans will be monitored by the Bank to ensure satisfactory progress of the AHMSA, CMC and HYLSA components. F. Environmental Issues 5.22 Restructuring at AHKSA includes rehabilitation of existing air and water pollution control systems throughout the plant. Annex 5-2, Appendix 1, provides data on the environmental situation before and after the project. Measured dust emissions are presently 2,517 kg/hr. With the shutdown of various facilities and rehabilitation of others, dust emissions after the project are expected to amount to 996 kg/hr, a reduc51on of over 60% in absolute terms. The major air pollution problem stem3 I q' the obsolete Siemens Martin open hearth steelmaking shop which contributes approximately 80% of the dust emissions. The project includes the shutdown of a major section of this operation. Final elimination of the remaining open hearths is envisioned in a later phase for AHMSA but would not take place until the early 1990s. The plant will not meet Mexican and internationally accepted norms for air pollution until that time. Water pollution control studies and expenditure are currently budgeted and under way to bring waste water into compliance by the completion of the project in 1991. The AHMSA Action Plan includes consultant assistance to further evaluate and seek specific recommendations to improve the plant's ability to monitor environmental quality, to ensure pollution control equipment is installed and maintained properly, and to undertake training in pollution abatement.  - 25 - 5.23 The CMC and HYLSA operations are already in conformance with Mexican air and water pollution standards and no change is foreseen as a result of this project. Mine safety improvements including training and equipment expenses are included in the CMC portion of the project to bring about a level of safety standards higher than currently required under Mexican law but more in line with international standards. VI . CAPITAL COST, FINANCING PLAN, PROCURMENT AND DISBURSEMENT A. Capital Cost 6.01 The estimated total capital cost of the proposed project is shown in Table 6.1 below, and amounts to US$810 million equivalent. Incremental working capital needs are estimated at US$100 million equivalent through 1991, when all elements of the project would be fully operational. Interest during construction amounts to US$40 million equivalent. Together with the policy based component of US$100 million, total financing requirements amount to US$1,050 million equivalent, of which US$596 million equivalent is in direct and indirect foreign exchange costs. Table 6.1 wIury Total Estimted Fincidng ieFWe ot $ billion US$ million Z Base Z lioal Foi Total local Fonei Total Cost Lorein Part A of the Project - 123 123 - 100 100 17 100 Parts B & C of the Project qtp.Mxnt & Spsres 109 406 514 88 328 416 72 79 Civil W,*k/Erection 112 12 125 91 10 101 17 10 Fangiiuering/Project NMIbzgmnt 20 22 42 17 17 34 6 53 TA & Itainig 10 22 32 8 18 26 5 69 BsSe Cost (Jum 1987) 251 WU 713 2 373 377 100 65 Pdial Cotizncies 31 44 75 25 36 61 11 59 Price scalation 47 37 84 38 30 68 12 44 Installd Cost 329 543 872 267 439 706 123 62 TUxe & uties 129 - 12 104 - 104 18 0 Total Installed Cost 458 543 1,001 371 439 810 141 54 Increimtal Wording Capital 98 26 124 so 20 100 17 20 $btal Project Cost 556 569 1,125 451 459 910 158 51 Iterest Dring Gxstrction 5 44 49 4 36 40 7 90 Total Fninuucing Reqd. Parts B & C 561 613 1,174 455 495 950 165 52 GRAND OMAL 561 613 1,297 455 595 1,050 182 57 _ m _ _ _ _ _  - 26 - 6.02 The base capital cost estimates for Parts B and C of the project were prepared by the SIDERMEX operating companies and HYLSA, respectively, with the assistance of reputed international engineering consultants (para 5.11-5.12). Summaries of capital cost estimates by plant are shown as Annexes 6-1 through 6-4, and details are included in the project files. The base cost estimates have been checked against recent international experience in steel plant rehabilitation and are based on extensive research by the engineering consultants. Despite a high degree of confidence in the base cost estimates, a physical contingency factor of approximately 11X of the base cost is included as the nature of the restructuring process in an operating plant imposes constraints on detail engineering design until appropriate plant shut-down procedures are set up and erection and installation schedules are drawn up. The estimates include provision for price escalation (1.01 in 1988, 1989 and 1990 and 3.5% in 1991 and thereafter on the foreign cost components; the domestic inflation rates in equivalent US$ terms are taken at 2.5% in 1988, 1989 and 1990 and 3.5% in 1991 and thereafter, based on a moderate inflation scenario and an expected correction for the continuing exchange rate undervaluation) in accordance with IBRD guidelines modified to take into account the l'kely behavior of the Mexican peso exchange rate movements during the project implementation period. The price escalation and physical contingencies amount to 23X of the base cost. No contingencies were applied to Part A of the project, as this would finance actual cost of imports of raw materials, steel products and other consumables up to the total amount of the loan allocated to that component (i.e., US$100 million equivalent). 6.03 The cost for consultant services (including consultants' fees, travel and subsistence expenses) is estimated on the basis of the long-term nature of the major consultant service assignments. Consultant requirements for the various project components are estimated as follows: AHMSA - 900 man-months; CMC - 250 man-months; SIDERMEX Corporate - 445 man-months; and HYLSA - 250 man-months. 6.04 The incremental working capital needs are calculated from the detailed assumption discussed in Chapter VII and in the Project File. The working capital needs relate mainly to financing of the production build-up (finished goods and work-in-process inventories, receivibles, pre-paid expenses) and to the reduction of short-term liabilities from the base of end December 1986. About 40X of the incremental needs are expected to be financed from extension of existing commercial bank credit lines. Iuterest during construction will not be capitalized by the companies. B. Financing Plan 6.05 The proposed financing plan for the proposed project is shown in Table 6.2 below.  - 27 - Table 6.2 Summary Financing Plan (in US$ million) For- X of Total X Local eign Total Required Foreign Proposed Bank Loan Part A of Project 0.0 100.0 100.0 9.5 100.0 Part B of Project 0.0 225.0 225.0 21.4 100.0 Part C of Project 0.0 75.0 75.0 7.2 100.0 Total Bank Loan 0.0 400.0 400.0 38.2 100.0 Incremental Short-term Debt (Local Banks) Part C of Project 32.0 0.0 32.0 3.0 0.0 Total Short-term Debt 64.0 0.0 64.0 6.K0 0.0 Internal Cash Generation Part B of Project 266.0 148.0 414.0 39.5 35.8 Part C of Project 125.0 47.0 172.0 16.3 27.2 Total Internal Cash 391.0 195.0 586.0 VE-8 33.3 Total Financing 455.0 595.0 1,050.0 100.0 56.7 -_ m _ The financing requirements by company and the allocation of the Bank loan are shown in Table 6.3 below. Table 6.3 Financing Plan by Company Total SIDER- Total Total Grand Part A AHMSA C( MEX Part B Part C Total Total Requirements 100.0 479.7 184.4 7.5 671.6 278.4 1,050.0 Proposed Bank Loan 100.0 170.0 50.0 5.0 225.0 75.0 400.0 Local Banks (Short Term Debt) - 32.0 - - 32.0 32.0 64.0 Internal Cash Generation a/ - 277.7 134.4 2.5 414.6 171.4 586.0 % of Total Requirements 9.5 45.7 17.6 0.7 64.0 26.5 100.0 Z of Total Bank Loan 25.0 42.5 12.5 1.3 56.3 18.8 100.0 a/ Including approved 1987 Government budgetary transfers. Approximately 561 of the proposed Bank loan would be allocated to the SIDERNEX restructuring program; 25X would be allocated to the raw material and steel products import component, and 19X to the HYLSA modernization program. The financing plans for each of the main beneficiaries, AHMSA, CHC and HYLSA, are based on a conservative mixture of debt and internal cash generation, with continued access to existing short-ter. credit lines  - 28 - for incremental working capital. The reliance on internal cash generation has been verified by the projected financial position which is based on very conservative assumptions about steel prices, demand growth, market share, production build-up after project completion, and expected build-up of cost and quality improvements (as detailed in Chapter VII). A two-phased price decontrol program in line with the policy changes targeted and described in para 4.02 is expected to take place, but the effective impact, particularly on non-flat products, is projected in a gradual manner. This is due to continued excess market supply in relation to a slow projected growth in demand, and an expected reluctance by the producers to effect substantial price increases on commonly used non-flat products to avoid any loss of existing market shares. Under these assumptions, the proposed financing plan involving about 62% contribution from internal cash generation for the SIDERMEX group, including an estimated US$50 million budgetary transfer in 1987, and nearly the same contribution from HYLSA cash generation, is considered feasible. In the case of HYLSA, the financing plan is very conservative since the financial restructuring proposals include the premise of 100% internal cash financing for the agreed modernization program. 6.06 In view of the above and with consideration to the conservative nature of the financial forecasts, it has been agreed that: (a) Part B of the project will be supported by the Government through the SIDERMEX financing plan, including adequate annual budgetary authorizations and when required, additional equity contributions, in the event that internal cash generation does not reach the conservatively estimated levels shown, or should capital cost overruns exceed SIDERMEX ability to cover any additional requirements through internal cash generation; and (b) Part C of the project will be supported through the final restructuring agreement between HYLSA and the creditor banks reflecting the project financing plan and allowing for excess cash generation over and above that required for successful project completion to be used to retire existing debt to the extent that doing so would not Jeopardize HYLSA ability to cover eventual project cost overruns. C. Onlending Arrangements 6.07 The Bank loan will be made to NAFIN as borrower under guarantee of the United Mexican States, on standard World Bank terms. NAFIN will onlend funds in the following manner: (a) Part A: Funds will be onlent to the United Mexican States at the Bank's standard variable rate plus a spread of 0.25% to NAFIN; onlending terms will be the standard for Bank terms. (b) Part B: Funds would be onlent to SIDERMEX, AHKSA and CMC at 110% of the Bank's standard variable interest rate to NAFIN; onlending terms will be 15 years including 3 years grace.  - 29 - (c) Part C: Funds will be onlent to HYLSA on the same terms as for Part B above. The foreign exchange risk will be borne by the beneficiaries: Government, SIDERMEX, AHMSA, CMC and HYLSA. The coverage of risks relating to foreign currency pooling as well as reimbursement for commitment fees will be recovered by NAFIN through the 10% premium applied to the lending rate from the Bank. 6.08 The Project Agreements with each of SIDERMEX, CMC, AHMSA and HYLSA have been agreed along with the proposed content of the Subsidiary Loan Agreements between these firms and NAFIN. The signing of these agreements are conditions of disbursement of Parts B and C of the loan. D. Procurement 6.09 The main project beneficiaries are now completing the packaging of their proposed investment programs so that the packages are technically coherent and permit the main equipment suppliers to provide the necessary performance guarantees. The major packages would include supervision of erection/installation by the supplier in order to ensure satisfactory performance, and may include in some cases, "limited turnkey" bids covering engineering and erection/installation. By grouping packages into the major plant areas (hot strip mill, cold rolling mills, steelmaking shop, etc.), the steel plants would be able to minimize erection scheduling conflicts and downtime of existing production runs. 6.10 International competitive bidding (ICB) procedures under Bank guidelines will be used for procurement of all goods and equipment expected to exceed US$0.5 million in value to be financed under Parts B and C of the project except as noted below. All ICB investment packages valued above US$2.0 million will be subje^t to prior Bank review and approval. For contracts valued below US$0.5 million, procurement will be carried out through International Shopping (IS) with price quotations from at least three foreign suppliers from at least two foreign countries. The aggregate value of these contracts should not exceed US$10.0 million. Direct purchasing or quotation from two or more identified suppliers will be permitted for spare parts or where proprietary technology is involved for an aggregate amount not to exceed US$23.0 million. Finally, Limited International Bidding (LIB) will be permitted when the equipment or goods to be procured can only be supplied by a limited number of manufacturers. The aggregate value of these contracts should not exceed US$20.0 million. The proposed loan will not finance civil works and local erection and/or installation contracts. The standard preference margins of the lower of the tariff level or 15X for goods of domestic origin will be allowed under ICB procurement. Consultant services will be procured using Bank guidelines. Terms of reference have been agreed in advance for the proposed project management consultancies and for the strategic studies and shortlists have been approved by the Bank. Procurement of goods and supplies under Part A of the project will follow existing Bank practice for policy-based lending. Contracts expected to exceed US$5.0 million in value will follow ICB procedures. Other contracts will follow the normal procurement procedures of the purchaser, which are satisfactory. The procurement arrangements are summarized in Table 6.4 below.  - 30 - Table 6.4 Procurement Arrangements (US$ million) ICB LIB/IS LCB Other Total Parts B and C a/ Equ.pment & Spares 316 41 95 56 508 (Bank Financed) (210) (30) (23) (263) Civil Works/Erection - - 124 - 124 Engineering/Project Management - - 35 35 (Dank Financed) (15) (15) Technical Assistance & Training - - - 39 39 (Bank Financed) (22) (22) Total 316 7T Y1T 130 706 (Bank Financed) (210) (30) - (60) (300) _ _ _ _ _ _ _ _ _ _ ~~_ _ m - -_ a/ Not including interest during construction, incremental working capital and taxes and duties. ICB procurement under Bank guidelines for Parts B and C of the project amount to a total of US$316 million or 45% of total expenditures and Equipment and Spares contracts financed from the US$263 million Bank portion amounts to US$210 million or 80Z of these contracts. Limited International Bidding and International Shopping amount to 6% of total expenditures, with local competitive bidding, direct purchase and consultancy contracts procured under Bank guidelines making up the balance. E. Allocation of the Loan and Disbursements 6.11 The allocation of the proposed Bank loan of US$400.0 million is shown in Table 6.5 below: Table 6.5 torn ianirn Part Pabt Part X of Z of Reuditures A B C Total Total To Be PFluOSd I. Raw ?tedals & Other EUiLble Iaots 100.0 - - 100.0 25.0 100% of fcorin expenditurs IL WPuipmt & Spare Pts - 163.0 57.5 220.5 55.0 100% of forign cenditwes and 100% of loca aqp ditures (ex-faty) IIL Cauultant Servics - 21.0 3.5 24.5 6.0 100 iv. UbaUocatd - 41.0 14.0 55.0 14.0 - Total 100.0 225.0 75.0 400.0 100.0 6.12 NAFIN will be responsible for maintaining loan accounts and preparation and submission of withdrawal applications under Part A.  - 31 - Disbursement of Part A of the project would be against 100% of foreign expenditures of eligible imports defined in Annex 5-1 and would be based on a Statement of Expenditure from the Banco de Mexico detailing individual transactions in each relevant period in respect of eligible imports, together with a Certification from the Banco de Mexico of payment of the amounts involved and of their eligibility under the loans Applications for withdrawal will be consolidated and submitted in amounts of not less than US$1 million. Retroactive financing for expenditures incurred after November 1, 1987, up to a maximum of US$20 million has been agreed. As all prior conditions for release of tranche 1 (US$50 million) have been fulfilled (i.e. elimination of ORPs and adjustment of prices in real terms), tranche 1 will be available for disbursement at loan effectiveness. 6.13 For disbursements under Parts B and C of the project, a special account will be opened in a bank acceptable to the World Bank, with an initial deposit of US$20 million, representing an estimated four months of Bank-financed expenditures on Parts B and C of the project. As SIDERMEX, AHMSA and CMC have already begun project implementation and as eligible expenditures for urgently needed maintenance spare parts have been authorized by the Bank after completion of the technical reviews, retroactive financing of all expenditures incurred after February 1, 1987, up to a maximum of US$30 million would be a&lowed. The special account will be audited annually in accordance with Bank guidelines. Disbursements will be fully documented, except for contracts valued at US$2.0 million or less, for which Statements of Expenditure will be accepted. The documentation for such expenditure will be retained by the SIDERMEX beneficiaries and by HYLSA and will be made available for periodic inspection by Bank staff. 6.14 The conditions for the disbursement of funds are as follows: (a) Part A of the Project i) for the second tranche (US$50 million): complete elimination of price controls on all remaining steel products and elaboration of a Global Steel Sector Policy Statement; an additional condition, reduction and equalization of steel tariffs at 25% or less, has already been fulfilled. (b) Part B of the Project (i) signature of the subsidiary loan agreements, acceptable to the Bank, between NAPIN and each of SIDERMEX, AHMSA and CMC; (ii) completion of the CMC reorganization and restructuring and establishment and staffing of the CMC Project Management Team; and (iii) the development of an agreed Action Plan for AHMSA and CMC based on specific monitorable levels of operational improvement and their timing throughout the project.  - 32 - (c) Part C of the Project (i) signature of the subsidiary loan agreement, acceptable to the Bank, between NAFIN and HYLSA; (ii) satisfactory formalization of the HYLSA Restructuring Agreement with creditor banks incorporating the project financing plan; and (iii) the development of an agreed Action Plan for HYLSA based on specific monitorable levels of operational improvement and their timing throughout the project. - It was agreed that the Government must continue vo make piogress in the overall Steel Sector Reform Program (para 4.02) that is satisfactory to the Bank. To this end it was specifically agreed and the draft legal documents reflect as covenants maintenance of the price liberalization and trade policy programs along with annual review and agreement by the Bank with the SIDERMEX investment program. 6.15 The estimated schedule of disbursements of the proposed Bank loan of US$400 million, taking into account a realistic schedule for procurement of all the proposed equipment packages, and the disbursement profile of recent IBRD projects in the Latin America and Caribbean region is shown in Annex 6-4 and summarized in Table 6.6 below. The loan is expected to be effective in the second half of FY88* Table 6.6 Summary Estimated Disbursement Schedule IBRD Disbursement % FY in FY % Cumulative Cumulative 1988 58*1 14.5 58.1 14.5 1989 108.8 27.2 166.9 41.7 1990 110.4 27.6 277.3 69.3 1991 86.8 21.8 364.1 91.1 1992 26.4 6.6 390.5 97.7 1993 9.5 2.3 400.0 100.0 The loan is expected to be fully disbursed at the end of FY93 (i.e., by June 30, 1993. F. Auditing 6.16 Annual financial audit reports by independent auditors acceptable to the Bank would be submitted by the project beneficiaries not later than six months after the close of the financial year including annual audits of Statement of Expenditures.  - 33 - VII. FINANCIAL EVALUATION A. Assumptions Used and Forecast of Production Costs 7.01 The proposed policy changes in the restructuring program are designed to benefit the entire Mexican steel sector. The assumption regarding steel prices is that domestic prices gradually reach CIF price levels of equivalent imported products by 1990. This scenario is consistent with the major policy reforms regarding elimination of internal price controls and substantially more conservative because it does not include any benefit from tariff protection. The pricing policy change results in an average increase of selling prices (in constant terms) of about 8% on flat products and about 25% on non-flat products. Since non-flat products are substantially below CIF levels at the present time (i.e., prior to completion of the agreed price decontrol actions), the major benefl.ciaries of the policy change are the non-flat producers, who are mainly in the private sector. The non-flat producers include the private sector companies - HYLSA (Puebla and Apodaca), the mini-mills and rerollers - as well as the SIDERMEX companies, SICARTSA I and, with reduced participation in non-flat products, AHMSA. The financial benefits of the pricing change on the flat product cperations of AHMSA and HYLSA are marginal (para 7.17) when compared with the significant financial benefits that result from the proposed investment program - higher output yields, improvements in product mix, and lower production costs. The combined flat and non-flat price changes allow an average increase of about 11.0% in AHMSA's selling prices, as the product mix is predominantly in flat products (84% of total product volume). Since HYLSA's non-flat products will account for about 40% of total (flat and non-flat) product volume, the impact of pricing policy changes will be slightly more favorable for the company; the pricing policy change results in an average increase of about 15%. 7.02 The main beneficiaries of the investment portion of the restructuring are the flat producers - AHMSA and HYLSA. The major goal of the investment program is to strengthen and improve AHMSA's and HYLSA's competitive position in flat products, and allow them to produce internationally competitive flat products with substantially lower production costs. The investments will also result in debottlenecking of the production process which will bring about higher sales volume with no expansion of production capacity. Lastly, the capital program will allow a shift in product mix to higher-quality and hence higher-value products. The above improvements in operating performance (together with the policy changes) will favorably impact the key variables that determine AHMSA's and HYLSA's profitability - output prices, sales volume and production costs. 7.03 An extensive analysis of the expected financial benefits of the proposed investment programs, and of the expected changes in financial position and performance of the two major steel operating companies has been carried out along with a separate analysis of the financial performance of CMC. The projections are carried out in current US$ equivalent terms through 1992, when the project is completed and fully operational, and in constant terms thereafter.  - 34 - 7.04 Table 7.1 shows the unit production costs before and after the implementation of the investment program. Reductions in variable cost as a result of the program are due to improvements in yield, reductions in rejects, lowering of energy costs, improvements in maintenance and overall labor reductions. A shift in product mix along with better capacity utilization after the debottlenecking efforts also contributes to a lowering of fixed costs. Table 7.1 AHMSA - Impact of Total Investment on Cost Structure a/ (in constant 1987 US$/tonne) Before After Production Costs Investment Investment (1987) (1993) Total Materials 54.86 53.92 Total Energy 51.19 49.07 Other Variable 67.91 62.83 Variable Labor 14.90 14.10 Total Variable 188.86 179.92 Total Fixed 35.87 28.40 Total Costs Before Depreciation & Financial Charges 224.73 208.32 _ _ _ __._ m -_.. a/ Based on a weighted average of plate, hot coil and sheet, cold rolled and tin sheet products. In addition to the reduction in the level of production costs, two factors account for the favorable impact on AHNSA's sales profitebility brought about by the investment program. The first is the shift So a higher value added product mix and the second is the improvement in product quality that allows for the recoupment of certain profits that had previously been lost in the sale of lower-priced second grade material. The cumulative impact of the implementation of the investment program and pricing policy changes can be measured by analyzing the Increase in gross profit (sales less cost of sales except depreciation charges) between the years 1987 and 1993. As shown in Table 7.2 the AHMSA investment program accounts for nearly 69X of the increase in gross profit between 1987 and 1993.  - 35 - Table 7.2 AHMSA: Analysis of Increase in Gross Profit (in constant 1987 US$ millions) 1987 1993 Increase Tonnage Sold ('000 mt) 2,138 2,483 345 Sales 696.4 951.7 255.3 Cost of Sales 463.4 480.8 17.4 Gross Profit 231.2 470.9 237.9 Increase in Gross Profit due to: 1. Increase in volume of products sold 35.4 2. Reduction in costs 57.4 3. Change in product mix 50.5 4. Improvement in quality 20.1 Total attributable to investment program 163.4 5. Increase in average selling price 74.5 Total increase 237.9 7.05 HYLSA's financial performance in recent years has been adversely affected by the company's heavy debt burden (para 2.10) which precluded any major capital investment program. Since the flat products division which accounts for 62% of HYLSA's installed capacity and 100% of flat product production is 45 years old and has no continuous casting, there has been an erosion of market share and a contraction of profit margins in recent years due to inadequate quality and rising costs. A second problem for HYLSA is that its major source of iron ore, the El Encino mine, is facing depletion of its reserves. The financial restructuring plan between HYLSA and its creditor banks and financial institutions (para 2.10) enables the company to proceed with the major strategic investment program described in para 5.09. The major financial benefits of the two stage investment program are as follows: (a) a change in product mix through the installation of a new pickling line. The output price for pickled coil is about 6.0% higher than the unpickled hot coil; (b) reduced operating costs resulting from savings in electricity, raw materials and acid usage; (c) a reduction of about 4.0X in the level of second quality product; (d) a 20% increase in volume and a 9.0% improvement in yields arising from rehabilitation of the hot strip mill; and (e) lower production costs due to the installation of the continuous caster and the consequent improvement in slab yields. HYLSA is also developing a new iron mine (Cerro Nahauti) that will have a limited life of 12 years and will supplement production from the older El  - 36 - Encino mine. This mining investment is viewed as an intermediate step that will allow HYLSA time to develop a more comprehensive plan for the acquisition of future raw materials. The financial impact of this investment is taken into account in the cash flow analyses. The total impact of HYLSA's investment programs on production costs is set forth in Table 7.3. The higher materials cost result from higher levels of scrap steel that have to be imported. Table 7.3 HYLSA - Impact of Total Investment on Cost Structure a/ Flat Products Division (in constant 1987 US$/tonne) Before After Production Costs Investment Investment (1987) (1995) Total Materials 63.85 65.32 Total Energy 52.53 51.11 Other Variable 47.09 45.94 Total Variable 163.47 162.37 Total Fixed Costs 69.07 51.14 Total Costs Before Depreciation & Financial Charges 232.54 213.51 a! Based on a composite of pickled hot coil, unpickled hot coil, cold roll and tin sheet products. B. Financial Projections AHMSA 7.06 The income statement set forth in the Project File and summarized in Table 7.4 below presents AMHSA's operating results for the projection period. Sales are estimated to increase from US$696.4 million in 1987 to US$951.7 million in 1993, equivalent to an average annual growth rate of 5.3%. This increase reflects the combination of product mix changes, increases in selling volumes due to rise in demand and the projected average increase in selling prices of around 11% in constant 1987 terms. RAflecting the positive financial effects of the investment program, profitability is expected to grow at a more rapid rate than the change in sales during the 1987 to 1990 period. The decline in profit margins after 1990 reflects the conservative pricing assumptions underpinning the projections (sales do not reflect any adjustment for inflation while costs are escalated at the domestic inflation rate) rather than any deterioration in profitability. The cumulative effects of the improving price-cost structure are reflected in the net income ratio that shows the relationship between after-tax profits and sales. This key index of profitability steadily improves during the projection period, from 2.5% in 1987 to 8.5% in 1993.  - 37 - Table 7.4 AHHSA - Financial Projections (in current USM million) 18 1988 1989 1990 1991 1992 1993 Sales (Constant 1987 US$) 696.4 687.4 793.8 881.3 930.0 940.7 951.7 Profit after Tax 17.4 25.2 56.9 65.8 70.0 56.4 80.5 Internal Cash (Before Interest) 166.0 162.7 192.1 218.4 220.5 206.5 228.8 Debt Service 115.1 95.1 81.4 59.2 46.0 48.8 46.9 EBIT/Sales (X) 15.8 15.8 19.9 18.6 17.7 14.5 14.8 PRT/Sales (%) 2.5 3.7 7.1 7.4 7.5 6.0 8.5 Current Ratio 2.3 2.1 1.8 2.2 2.7 3.0 3.2 Debt/Equity Ratio 17:83 17:83 18:82 18:82 18:82 17:83 16:84 Debt Service Coverage Ratio 1.4 1.7 2.4 3.7 4.8 4.2 4.9 7.07 AHMSA's financial projection during the first four years of the projection period is forecasting internally generated funds totalling U$499.1 m.lion. For the four years, capital expenditures aggregate US$434.5 million and working capital requirements US$190.9 million. In addition, existing debt repayments for 1987 to 1990 come to US$110.7 million. The funding requirement or the difference between internally generated funds and uses totals US$237.0 million for the four-year period. The proposed Bank project loan of US$170.0 million will cover approximately 70% of this funding need. The remaining 30% is expected to be met through a reduction in cash balance in 1987 and short-term borrowing from domestic commercial banks. Because of AHMSA's current strong financial position (due to the 1986 financial restructuring) and post-1989 cash generation capability, the company should be able to support these additions to short-term debt without any adverse financial effects. This assumption is supported by an examination of the projected current and debt service ratios (see Table 7.4). In 1990 AHMSA will begin to generate surplus funds and be able to reduce short-term debt incurred during the previous three years. In 1992, the cash surplus is sufficient to completely repay short-term borrowings and to begin dividend payments. CMC 7.08 In order to assure an adequate supply of raw materials for SIDERMEX's future operations, an investment program has been formulated that is designed to bring production from existing iron mines in the north up to their capacity, and to increase, modernize and decrease costs in the coal mines. 7.09 The projection of CHC financial performance is included in the Project File. As CMC's output will be almost entirely transferred to the two SIDERMEX steel plants, the financial analysis is confined to an examination of the operating cash flow in order to evaluate the impact of the produced investment program on CMC's financing needs. CHC is currently negotiating the ore and coa'l supply contract terms with AHMSA and SICARTSA with a view to rendering the transfer price more fully reflective of the ongoing investment and capital maintenance needs of the mines and allowing  - 38 - for efficiency incentives to ensure that the nearly sole source/sole client relationship that prevails does not imply cost penalties for either party. The financial restructuring that is now being undertaken will ensure that CMC can start on its new supplier/client relationship with a satisfactory capitalization including needed working capital. The presentation of a financial restructuring plan for CMC, acceptable to the Bank, is a condition of disbursement of the CMC component (para 6.14). Under the proposed contractual arrangements, CMC sales revenue will be determe'-ed on the basis of standard cost plus a margin so that any gain due to cost improvements will be reflected in the income statements of the SIDERMEX steel companies. CMC financial forecasts, therefore, consist of cash flow projections which show the capabilities of the mines for internal cash generation derived from the given gross profit margin and depreciation provisions, and the derived external financing requirements. Internal cash generation results from a proposed margin of 3X to be paid by the SIDERMEX steel companies on total production costs (including depreciation and financial charges) of the CHC products. The project investments total US$181.0 million (including incremental working capital) over four years 1987 to 1990. Over the same period, an additional US$51.0 million is scheduled for replacement investments. Out of the total four year capital spending program of US$232.0 million, US$50.0 million would be financed from the proposed Bank loan and US$25.4 million out of budgeted Government funds in 1987 and 1988. The remainder would be financed through internal cash generation and addition to short-term debt (para 6.05). HYLSA 7.10 Table 7.5 below summarizes the projected operating results for HYLSA from 1987 to 1993. The company's sales are expected to grow 10.7% p.a. This growth occurs through a combination of increases in selling volumes and substantial change in product mix attributable to the investment program at the flat products division, and the increa.e in average selling prices arising from the impact of pricing policy changes (para 7.01). The favorable impact of the investment program is seen by the increase in earnings before taxes and interest margin (EBIT) which expands sharply in 1989 and in 1992 because of lower operating costs. The sharp drop in profit after taxes in 1993 reflects the end of carried-forward losses resulting in start of income tax payments in that year. The combined beneficial impact from the modernization program (higher sales revenue and lower production costs) and the financial restructuring plan (lower financial charges) as well as a lower level of SGA expense in relation to sales are reflected in the final profit ratio, net income to sales, which increases between 1987 and 1993 from 3.2% to 10.71.  - 39 - Table 7.5 HYLSA - Financial Projection (in current US$ million) 1987 1988 1989 1990 1991 1992 1993 Sales (in Constant 1987 US$) 408.0 449.2 547.0 578.9 572.7 696.4 751.6 Profit after Tax 13.0 23.5 64.1 65.3 55.8 123.2 80.4 Internal Cash (Before Investment) 108.6 106.7 161.6 178.6 164.2 234.8 184.2 Debt Service 96.4a/ 56.1 63.7 66.0 92.0 198.2 151.8 EBIT/ales (X) 19.7 16.8 22.1 21.0 19.7 25.9 26.9 PAT/Sales (X) 3.2 5.2 11.7 11.3 9.7 17.7 10.7 Current Ratio 4.5 2.7 3.4 1.9 2.0 2.2 2.4 Debt/Equity Ratio 69:31 65:35 59:41 55:45 52:48 42:58 36:64 Debt Service Coverage Ratio 1.1 1.9 2.5 2.7 1.8 1.2 1.2 a/ Net of 112.7 million exchanged for equity. 7.11 Based on the financial projections, HYLSA has forecast over the project period a total funds requirement of US$690.5 million. The bulk of this is for capital expenditures which aggregate US$454.6 million. Approximately US$278 million of investment spending is for the proposed project investments in flat products modernization and US$30.0 million for the new Cerro Nahauti mine. There are also additional working capital requirements of US$46.6 million and debt repayments of US$189.3 million for the period. Internally generated funds aggregate US$406.4 million for the period equivalent to around 60% of total uses. Cert-ir -on-cash items, deferred interest of US$25.0 million (over five years) &. a US$113 million debt-equity swap associated with the restructuring plan, reduce the cash requirement to approximately US$132 million. The proposed Bank project loan of US$75 million will cover approximately 60S of this funding need. The remaining 401 is expected to be met through reduction in cash balances and modest short-term borrowings. 7.12 An examination of HYLSA's projected capital structure as well as key financial ratios indicates that the company should be able to handle its future debt service. This includes not only its existing debt that has recently been rescheduled but also the Bank project loan and the additional short-term debt used to fund operating deficits. The current ratio never falls below 1.9 during the projection period (1987-93), an indication that there Is sufficient current asset coverage to warrant the use of short-term debt to fund operating cash deficits. The debt-equity ratio (see Table 7.5) which is 69:31 in 1987 (year end) improves steadily throughout the period; it reaches 55:45 in 1990 and by 1993 is projected to be 36:64. Moreover, the debt service ratios set forth in Table 7.5 show that HYLSA should generate adequate financial resources to meet its future debt service requirements. As shown in Table 7.5, beginning in 1988, MYLSA's debt service ratio is over 1.21 for each year. In the years 1992 and 1993 (when the ratio declines) HYLSA begins to repay both its Tranche A debt (under terms of its restructuring agreements) and the Bank project loan.  - 40 - However, since the repayment schedule used in the projection reflects management's strategy to reduce HYLSA's indebtedness as rapidly as possible, considerable financial flexibility exists because the mandatory debt amortizations are significantly lower. C. Financial Covenants AHMSA 7.13 To ensure the maintenance of a sound financial position for AHMSA, the subsidiary loan agreements between NAFIN and AHMSA will provide for the following: (i) the company will maintain a current ratio of not less than 1.2 and a debt/equity ratio not greater than 67:33; and (ii) that the company will not incur additional debt if to do so would cause the company debt/equity ratio to exceed 67:33 or its projected debt service coverage to fall below 1.5 times. CHC 7.14 Since CMC is dependent on the SIDERMEX steel companies for its sales, the project description includes the establishment of a standard cost system on which pricing will be based. The project agreement with CMC provides for an annual rev:.ew by the Bank of the sales agreements between CMC and the SIDERMEX steel companies. The purpose of this review would be to adjust the margin on total costs (paid by the steel companies) so as to insure that CMC has sufficient funds to meet its financial requirements, including capital expenditures and debt service, which has been included as specific covenants in the subsidiary loan agreements. HYLSA 7.15 The subsidiary loan agreements between NAFIN and HYLSA will prcvide for financial covenants including maintenance of working capital and debt-equity levels, limitations on dividends and restrictions on the use of surplus funds. These financial covenants will be related to and consistent with the financial covenants contained in the debt restructuring agreement between HYLSA and its creditors (para 2.10). Satisfactory formalization of the Agreed Term Sheet and Financial Restructuring Plan for HYLSA to incorporate the agreed financing plan for Part C of t project and due execution of the Agreements with HYLSA's creditors are conditions prerequisite to the disbursement of Bank funds for Part C of the project (para 6.14). D. Financial Rate of Return AHMSA and HYLSA 7.16 The incremental financial rates of return on a discounted cash flow basis for the AHMSA and HYLSA investment programs are 32.7% in the case of AHMSA and 17.5% for HYLSA. The substantial difference in the financial rates of return reflects primarily the present difference in operating performance of the two companies. In general, HYLSA has been achieving better capacity utilization, higher yields, better labor productivity and lower production costs. As a result, the margin for  - 41 - improvement is considerably smaller for HYLSA than it is for AH4SA. However, without the proposed. investment program, HYLSA's performance would show a significant deterioration over the next five years as its ability to meet the quality demands of the flat products market will be significantly worsened. At the same time, its relative competitiveness to AHMSA would also suffer greatly. In order to test the key assumptions a sensitivity analysis was performed with respect to output prices, exchange rates and sales volume, one at a time (Table 7.6). (a) Sensitivity to Price Changes. The base case financial rates of return assume that domestic steel prices reach CIF levels by 1990, but never rise above CIF levels. The CIF level and price equivalents are based on a weighted average of FOB prices in early 1987 for steel exports from Japan, EEC, Brazil and South Korea. Two assumptions were tested with respect to pricing. In the first case domestic prices rise due to improved quality and reach a level of CIF plue 5.0% by 1990 and continue at this level through the projection period. In the second case prices are held at the present level in order to isolate the returns attributable to the investment program. (b) Sensitivity to Exchange Rate. The base case exchange rate scenario is for a continuation of the present undervaluation or discount from purchasing power parity of the peso in relation to the US dollar. In early 1987 this was approximately 37% and the base case assumes that future peso-dollar exchange rate movements will follow the Mexican inflation rate, thereby preserving the peso undervaluation. Sensitivity was tested on a reduction in undervaluation of the peso of 10% and 20% against the US dollar. The recent sharp devaluation of the peso at end-1987 would improve the financial and economic returns on the project, and enhance the financial results, since product costs are lower compared to equivalent landed prices, thereby providing higher operating margins. This, in turn, would reduce the downside risk in event of a future revaluation. (c) Sensitivity of Sales Volume. Incremental sales volumes (in terms of tonnage) were varied using a 20% decrease for AHMSA and a 10% decr-aase for HYLSA. Table 7.6 Financial Rate of Return Analysis (X) AHMSA HYLSA Base Case 32.7 17.5 A. Prices exceed Base Case levels by 5% 35,9 19.3 Prices stay at current levels 27.7 14.8 B. Revaluation of Peso by 10% 29.1 15.6 Revaluation of Peso by 20% 24.7 13.2 C. Decrease in incremental production volume of 10% - 15.6 Decrease in incremental production volume of 20% 25.9 -  - 42 - CMC 7.17 The calculation of the financial rates of return for CMC investments have not taken into account incremental benefits but only cost differentials between two cases - one with the investments being made and one without the investments. The rate of return for the coal mines is 46.0%, for the iron ore mines 52.0%, and for the total project 50%. The net present values at 15% discount rate is US$87.3 million for the coal mines, US$130.0 million for the iron ore mines and US$231.8 million for the total project. VIII. ECONOMIC EVALUATION AND RISKS A. Assumptions 8.01 CI landed prices of steel products based on a weighted average of FOB prices of the main exporters to Mexico, have been used in the economic cost benefit and Domestic Resource Cost calculations. 8.02 Full cost domestic prices have been used for domestic iron ore and coal delivered to AHMSA and HYLSA. Landed CIF prices plus internal transport costs of imported steel scrap have been used to value steel scrap. Subsidy-free prices have been used for power and oil consumed in the steel process. Conversion factors have been used for the rest of the inputs inclduing a shadow price factor of 0.77 for labor. Capital rental costs have been estimated for AHMSA's integrated plant at US$1,000/tonne of installed capacity, and for HYLSA direct reduction based plant at US$875/tonne of installed capacity for flat products; in addition, an economic life of 20 years and an opportunity cost of capital of 12% have been assumed. 8.03 The new policy framework of liberalized trade, moderate tariffs and liberalized internal prices, implies that Mexico will be a price-taker in the world market for steel products and that internal production will be supply determined. In the above context, movements in product prices are independent of movements in domestic demand and supply. Therefore, a separate sensitivity analysis was performed for each of this variables. B. Economic Rate of Return Analysis 8.04 Table 8.1 below shows the range of more probable ERR outcomes for the investment project in AHMSA. ERR sensitivity was performed with respect to output prices, increments in production capacity, capital project costs and Mexican peso revaluation, one at a time. The modal value for the ERR is 32.3% and the range of variation goes from 35.6% for a 5% increase in output prices, to 19.9% for 20% reductions in incremental capacity or 20% increases in capital project costs both in a context of a 10% reduction in output prices. Switching values for the above variables are also shown. ERR results are most sensitive to reductions in economic product prices, which are exogenous variables determined in the world markets. They are sensitive to peso revaluation which is a policy variable, and they are also sensitive to incremental capacity reductions, which is variable that can be controlled within the project framework.  - 43 - Table 8.1 AHMSA: Sensitivity Analysis of Total Investment Economic Internal Rate of Return (ERR) Economic Product Prices -10 Base Case +5X Base Case 25.3 32.3 35.6 Incremental Capacity: -20% 19.9 25.8 28.7 Capital Project Costs: +20X 19.9 26.1 29.1 Mexican Peso Revaluation: +10% 21.4 28.2 31.5 Switching Values Economic Product Prices -27X Capital Project Costs +90% Incremental Capacity -55% Mexican Peso Revaluation +50% Source: Project File. 8.05 Table 8.2 shows equivalent ERR results for HYLSA. Here the modal ERR value is 14.81 and the range of variation of results goes from 16.7% for a 5% increase in economic output prices, to 9.0% for a 10% rise in capital project costs coupled with a 101 reduction in output prices. Switching values for the above variables are shown in the lower part of Table 8.2. In the HYLSA case ERR results are again most sensitive to reductions in economic product prices. They are then sensitive to capital project cost variations and to fall in incremental capacity utilization. Table 8.2 HYLSA: Sensitivity Analysis of Total Investment Economic Internal Rate of Return (ERR) Economic Product Prices -101 Base Case +5% Base Case 10.7 14.8 16.7 Incremental Capacity: -10% 9.2 13.0 14.8 Capital Project Costs: +10% 9.0 13.0 14.8 Mexican Peso Revaluation: +10% 9.8 13.7 15.3 Switching Values Economic Product Prices -7% Capital Project Costs +15% Incremental Capacity -15% Mexican Peso Revaluation +30% Source: Project File. 8.06 AHMSA and HYLSA results are most sensitive to output price variations because in a supply determined production market revenues always move in the same direction of price changes. HYLSA results are more sensitive to reductions in incremental capacity than AHMSA's because the  - 44 - HYLSA project benefits come mainly from reduction in fixed cost by increased use of production capacity after debottlenecking investments, whereas AHMSA's benefits come as much from reductions in average variable costs as they come from generating economies of scale. HYLSA results are more sensitive to increments in capital project costs than AHMSA's because the incremental capital cost directly affect the main source of benefits of HYLSA, i.e., the reduction in average fixed costs. The higher AHMSA's expected profitability is associated with its larger scope for variable as well as fixed cost reductions than in the HYLSA case; and with the change in the product mix from non-flat relatively low priced and inefficiently produced products, to flat and non-flat which both have higher prices and are more efficiently produced. Although the HYLSA ERR is highly sensitive to downside price swings, the likelihood of such change is now substantially diminished in the current steel market price scenarios. In the latter part of 1987 there have been substantial international price increases on the order of 10% to 15% particularly in the flat product categories. This is due to reduced supply in most developed countries and also due to the substantial devaluation of the US dollar vis-a-vis the main trading currencies, i.e., Japanese yen and German mark. 8.07 In the AHMSA case the marginal ERR is larger than the average ERR for the plant as a whole and therefore contributes to increase its average profitability. AHMSA's average ERR rises from 11% without the project to 16% with the project. C. Domestic Resource Costs and Competitive Position 8.08 The main objective of the economic analysis of the project is to ascertain if AHMSA and HYLSA can be internationally competitive after the optimization and maintenance investments are completed. This is important both for efficient allocation of investment and to find out if the steel industry can have a positive supply response in the context of the trade liberalization program that the Mexican Government is now implementing. It is also worth noting from the beginning that the significant recent real devaluation of the Mexican peso has improved the competitive position of the Mexican steel industry. We assume in what follows that the rea