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 IIIndustry, Trade, Finance Sector Operations DivisionLatin America and the Caribbean Regional Office

This document has a resticted disibution and may be used by reciplents only in the performance oftheir official duties. Its contents may not otherwise be disclosed without World Bank aothorization.

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CURRENCY EQUIVALENTS - Peso (Mex$)

An exchange rate representing the mid-June 1987 freemarket 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 FurnaceCANACERO - Camara Nacional de la Industria del Hierrc, y del AceroCMC 1/ - Carbon y Minerales Coahuila S.A.DRC - Domestic Resource CostEAF - Electric Arc FurnaceFISA - Fundidora Monterrey S.A.HYLSA - IiYLSA S.A.mtpy - million tonnes per yearNAFIN - National Financiera S.N.C.NKK - Nippon Kokan of JapanOHF - Open Hearth FurnaceRMD - Raw Materials Division of SIDERMEXSECOFI - Secretaria de Comercio y de Fomento IndustrialSEMIP - Secretaria de Energia, Minas y Industria ParaestatalSICARTSA - Siderurgica Lazaro Cardenas Las Truchas S.A.SPP - Secretaria de Programacion y PresupuestoTAMSA - lubos de Acero de Mexico S.A.tpy - tonnes per yearUEC - United Engineers and Consultants (Div. of US Steel)

1/ CMC is the legal entity being set up as a holding company tooversee the mining operations of the Raw Materials Division ofSIDERMEX.

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 *............... , 3C. Structure and Main Institutions 4 6D. The Policy Framework ... .................................. 6

III. STRATEGIC ISSUES AND BASIS FOR SECTOR REFORM ................ 8

A. Strengths and Weaknesses ........................ . , 8B. The Strategic ;ssues ..................................... 9C. Agenda for Policy Reform ................................. 10

IV. THE RESTRUCTURING PROGRAM ................................... 11

A. Objectives *..........o......o......* 000e00oooo00ooo 000o 11B. Global Policy Actions ..............0........ , 0e..000 e. 12Co SIDERMEX .eo........o...00000oo 0o 00o0oo 0oooo0oo0o00o00oooo 14D. Private Sector .............. 17

V. THE PROJECT o...................................O,.. ....... 18

A* Objectives ....oo.ooo..o..o.oo......oo. e oe*o 18B. Project Description *o.ooe...oo.o........ e...............o 19C. Project Management, Organization and Implementation ...... 21D. Role of NAPIN *.....0.......... ...............e......o 23g. Training and Manpower Development soeoo0ooo00)00o000000000@ 23Fo Environmental Issues ..................................... 24

VI. CAPITAL COST, PINANCING PLAN, PROCUREMENT AND DISBURSEMENT oo. 25

A. Capital Cost ooooo........................................ 25B. Financing Plan oo.....................................o ... 26C. Onlending Arrangements .0..........................o..o.... 28D. Procurement o..ooo...o.oo.o.o..ooooo.o.oo.oo...o....o* 29E. Allocation of the Loan and Disbursements ................. 30F. Auditing .*000000000000,00 000000000000000000w 900.0@000.00 32

This report was prepared on the basis of appraisal missions in March andMay 1987 by Messrs. R. Venkateswaran, E. Mangan, I. Rivera and G. Konomos(Consultant) with assistance from Mr. X. Simon, and in the raw materialssegments by Messrs. F. Remy, S. von Klaudy and L. Moran (Consultant) allformerly of the Industry Department. Mr. J. Malatinsxky of the LatinAmerica and Caribbean Region also assisted in the preparation.

Thidocumenthmansetitedditbudtnand maybeoud by re -in oly in d peformneoof 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 .*.. . 33B. Financial Projections ..................... 36C. Financial Covenants ..... e.............. *.*.... 40D. Financial Rate of Return ................................ 40

VIII. ECONOMIC EVALUATION AND RISKS ............................... 42

A. Assumptlons .................................... 42S. Economic and Rate of Return Analysis .................... 42C. Domestic Resource Costs and CompetitLve Positlon ......... 44D. Benefits and Risks * ..................................... 45

IX. AGREEMENTS REACHED AND RECOMMENDATION ....................... 46

ANNEXES

2-1 The Steel Sector in Mexico ................................ 492-2 Raw Haterial Supply Position .............................. 552-3 The Policy Framework and Proposed Policy Changes .......... 63

3-1 Operations Technology and Strategic Position 713-2 Competitive Position of Raw Materials 773-3 The Steel Market in Mexico ..... *.*.*................ 81

4-1 Matrix of Issues, Measures and Actions 874-2 Steel Sector Policy Letter 89

5-1 Imports Eligible for Financing ..... 935-2 The AHKSA Component ..................................... 94

Appendix 1 - Environmental Control 995-3 The CMC Componentt 1025-4 SIDERMEX - Strategic Planning Studies 1055-5 The HYLSA Component 107

6-1 Summary Project Cost - AHMSA Project Component - Part Bo1 . 1106-2 Summary Project Cost - CMC Project Component - Part B.2 1116-3 Summary Project Cost - HYLSA Project Component - Part C 1126-4 Sumary Total Project Cost - Parts B and C ................ 1136-5 Estimated Disbursement Schedule of Bank Loan .............. 114

MAPS

IBRD 20418 - Steel Mills and Major MarketsIBRD 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 (ReportNo. 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 SIDERMEXRestructuring Progzam

B5.1 AHMSA: Industrial Reconversion Project, Phase I - Technical andFinancial Feasibility Study

B5.2 AHNSA: Report of UEC Consultants (incorporated i BSi.1 above)

B5.3 Raw Materials Division: Report of UEC Consultants (METCHEMDivision). 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 RavMaterials Division Components including Feasibility Studies preparedby the Companies

B8.1 Working Paper on Economic Analysis of Products and Project ComponentsPrepared 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 standardvariable interest rate.

Loan andProdeetDescription: The proposed Bank loan would help finance the foreign

exchange cost of a major restructuring and policy reformprogram for the Mexican steel industry. The public sectorportion of the program aimed at rationalizing SIDERMEX hasalready resulted in the shutdown of one major steel plant,ENSA, and includes an additional reduction in steelmakingcapacity and shift in product mix at its largest remainingplant, AHMSA. Investments are aimed at rehabilitation,cost reduction and quality improvement of the flat productlines at AHMSA and supporting raw material supply. Asimilar program is included for the privately owned HYLSAMonterrey flat product facilities in order to maintain itsdomestic competitive market position. Investments areonly included in facilities for which the long-termdomestic market needs have been identified.

Part A-(US$100 million) is tied to implementation of pricedecontrol, trade reform, including elimination of OfficialReference Prices for steel products and reduction andequalization of steel tariffs, and presentation of aGlobal Steel Sector Policy Statement to expose theindustry to international competition. It would fiaan&eeligible raw material and steel product imports during theadjustment period.

Part B (Us$225 million) provides financing for theSIDERMEX restructuring program comprising the physicalrehabilitation of the AMHSA steel works (UJ$170 million)and rehabilitation and restructuring of SIDERMEX Miningoperations (US$50 million). It also provides assistancein corporate-wide organizational and financialrestructuring and for development of SIDERMEX's long-termstrategy (US$5 million).

Part C (US$75 million) supports the restructuring effortof HYLSA in the modernization of its flat productsfacility, in parallel with the financial restructuringpackage under negotiation with creditor banks.

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Onlending Termsand Conditions: Part A, the Inpat Materials and Steel Product Imports

Component of the Project, to Government, at 0.25% abovethe Bank's standard variable interest rate and with thesame terms as the Bank loan. Parts B and C, in support ofthe SIDERMEX Restructuring Program and HYLSARestructuring, respectively, to SIDERMEX, AHMSA, SIDERMEXMines (Carbon y Minerales de Coahuila, SA, CMC) and HYLSA,at a rate equal to 110% of the Bank's standard variableinterest rate and with the same terms as the Bank loan.

Benefits andRisks: The decontrol of domestic steel prices, coupled with the

trade liberalization measures already implemented and theoverall restructuring of the steel subsector, will lead toefficient import competition, forcing domestic steel pro-ducers to improve quality and product mix in order toserve better downstream steel consuming industries. Bud-getary transfers to the public steel sector, and indirectsubsidies to the industry as a whole, would be eliminatedand the necessary internal funding would be provided forthe proposed restructuring and rehabilitation of thephysical plant of the entire subsector. The physicalrehabilitation of the AHMSA, and HYLSA plants will sub-stantially improve the international competitiveness offlat products both in terms of better quality and loweroverall cost. Rationalization of existing capacity willalso allow the two plants to improve utilization. Down-stream users of flat products will be able to obtain awider range of quality flat products at lower cost. Therehabilitation of the SIDERMEX mines will allow lower costexploitation of available resources and maintain Mexico'scomparative advantages in steel production. Technicalassistance (financed from other sources) will enable thesteel producers to map out viable long-term strategies andthe means to implement them.

The main potential risk is that the Government will delayactions on complete price decontrcl which could aggravatethe financial position of steel producers and induce areturn to higher protection. The steel price increasesaccorded in December 1987 and January 1988, and the agree-ment on monthly adjustments of steel prices in real termsbased 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 areversal of agreed policy actions and a sharp real appre-ciation of the exchange rate which could affect projectviability. The agreements concerning the definition offuture investment strategy, the Government's commitment tothe liberalization program, the substantial physicalrestructuring and rehabilitation of the public sector com-panies, and agreement on Action Plan for monitoring opera-tions and performance of the target companies all combineto mitigate the potential adverse impact of the aboverisks.

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EstimatedDisbursements: Part A of the Loan would be disbursed in two equal

tranches linked to trade liberalization., price decontroland elaboration of a Global Steel Sector PolicyStatement. Retroactive financing up to a maximum ofUS$20 million for eligible import expenditure afterNovember 1, 1987, would be allowed. The first tranchewould be available for disbursement at loan effectiveness.The second tranche would be released upon completeelimination of any remaining price controls on domesticsteel products, continued maintenance of the tradeliberalization measures, and presentation of the GlobalSteel Sector Policy Statement along substantially agreedlines. The second tranche release is expected in January1989.

Parts B and C of the Loan would be disbursed againsteligible goods and services procured under World Bankguidelines, including retroactive financing up to amaximum of US30 million equivalent for expendituresincurred after February 1, 1987.

EstimatedProject Cost: The estimated project cost and financing requirements (not

including normal capital replacements) for the period1987-1991, are summarized in the following table:

Local Foreign Total(USJi0llion equivalent)

Part A - 100 100Parts B and CEquipment and Spares 88 328 416Civil Works/Erection 91 10 101Engineering Project Management 17 17 34TA/Training 8 18 26

Base Cost 204 373 577

khysical Contingencies 25 36 61Price Escalttion 38 30 68

Installed Cost 267 439 706

Taxes and Duties 104 - 104Total Installed Cost 371 439 iiRS

Incremental Working Capital 80 20 100Total Project Cost 451 195 !i

Interest during Construction 4 36 40

Total Financing Required 455 495 950

GRAND TOTAL 455 595 1,050

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FinancingPlant The proposed financing plan for the Project is summarized

in the following table:

Local Foreign Total(in US$ M equivalent)

IBRD - 400.0 400.0Local Baars 64.0 - 64.0AMSA 185.0 92.0 277.0CMC 78.0 56.0 134.0SIDERMEX 3.0 - 3.0RYLSA 125.0 47.0 172.0

455.0 595.0 1,tO0.0

EstimatedSchedule ofDisbursements: IBRD FY: 1988 1989 1990 1991 1992 1993

Annual 58.1 108.8 110.4 86.8 26.4 9.5Cumulative 58.1 166.9 277.3 364.1 390.5 400.0

Economic Rateof Return: In excess of 18?

Staff AppraisalReport: No. 6892-ME dated February 8, 1988

&-mv8 IBRD - 20418 - Steel Wines and Major MarketsIBRD - 20419 - Iron Cra Mines, Coal Mines and Natural GasFields

MEXICO - STEEL SECTOR RESTRUCTURING PROJECT

I. INTRODbCTION

1.01 The Government of Mexico (GOM) has requested a Bank loan to helpfinance the restructuring of the Mexican steel industry, and support policyreforms that will substantially alter the manner in which steel producersconduct and develop their business in the coming years. The proposed leanof US$400 million equivalent comprises three major elements: Part A(US$100 million) is tied to implementation of wide-ranging policy measureswith specific emphasis on exposing the industry to internatio2kalcompetition, and would finance steel-related imports during the adjustmentperiod. Part B (US$225 million) provides financing for the restructuringneeds of the public sector steel company, SIDERMEX, including the physicalrestructuring of its integrated steel plant and the country's major flatproduct facility, AHMSA, and its coal and iron ore mining operations, aswell as corporate-wide organizational and financial restructuring andlong-term strategy formulation. Part C (US$75 million) supports therestructuring efforts of the major private sector steel producer, HYLSA, inthe modernization of its flat products facility at Monterrey, in parallelwith a financial restructuring package that has been negotiated withcreditor banks.

1.02 Project financing requirements, including contingencies, priceescalation, interest during construction and incremental working capitalare estimated at US$946 million equivalent net of US$104 million equivalentof taxes and duties, with about US$595 million equivalent in direct andindirect foreign exchange costs. The proposed Bank loan of US$400 millionwould thus cover about 67% of the estimated direct and indirect foreignexchange costs, or about 421 of the total financing requirements net oftaxes. The balar.ce of the financing needs are to be met from internal cashgeneration and from short-turm borrowing for working capital. Supplierscredits and/or cofinancing represent other possible funding sources.

1.03 Bank involvement in the project arose from initial discussionswith Mexican authorities in 1985, as part of the review of the country'ssectoral investment plans. A Bank mission in May 1986 carried out a SteelSector Strategy Review (Report No. 6429-ME). Bank missions in Septemberand November 1986, reviewed this report and its recommended changes insteel sector pricing policy and the product mix and investment strategy ofSIDERMEX, with Government authorities, SIDERMEX management, and privatesector representatives. Following these reviews, project identificationwas completed and SIDERMEX and HYLSA began to assemble the technicaldetails with the help of outside consultants. A Bank mining review missionfirst visited Mexico in January 1987. The project was preappraised inFebruary 1987. Appraisal was initiated in March and completed in May 1987when the final technical reviews by consultants became available.

1.04 Previous Bank involvement in the steel sector began in 1972 whenMexico embarked on a rehabilitation and expansion program designed toincrease raw steel capacity to about 9.2 million tons per year by 1980 and11.0 million tons by 1985 in order to satisfy growing domesti.- demand andto improve productivity of their existing facilities. As part of thisprogram, in 1973 the Bank extended a loan (President's Report No. P-1307-ME

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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 atLazaro Cardenas on the Pacific Coast. The plant has a capacity of1.1 muilion tons per year of non-flat products (rebars, merchant bars, wirerods). The project also included the development and exploitation of acaptive iron ore mine and a port to handle imported raw materials (mainlycoking coal) and export of excess finished products. The project wasimplemented and commissioned in collaboration with British SteelCorporation under a general know-how and technical assistance agreement.The project was completed successfully, a few months behind schedule andwith some cost overruns due to the particularities of the project(greenfield plant in an underdeveloped region, new staff, period of highinflation throughout the world, etc.). The plant is now operating close torated capacity producing high-quality non-flat products at internationallycompetitive costs.

,05 In 1976, the Bank approved a loan of US$95.0 million for thesecond stage of the SICARTSA program (Appraisal Report No. 1060-ME ofJune 15, 1976) designed to produce 1.7 million tpy of flat steel products(hot and cold rolled coils and sheets). The Government of Mexico, whichchanged shortly after the approval of the loan, decided to reconsider theproject and consequently cancelled the Bank loan. A new project, based ondirect reduced iron ore, producing different flat products (heavy plate),was presented to the Bank in 1979/80. The Bank decided not to participatebecause the market demand analysis for the new product was consideredinsufficient. The project, SICARTSA II, is still under construction withfinancial 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 fromthe 1940s through the 1960s, the Mexican economy started to slow down inthe early 1970s. The Government attempted to foster growth throughexpansion of the public sector. The oil boom of the mid-1970s inducedfurther inflationary expansion that led to a basic disequilibrium, whichaccelerated external borrowing. This brought about a generalized financialcrisis in 1982. Since its onset in August 1982, there has been a growingrecognition that a return to sustainable growth would require not onlystabilization policies, but also far reaching structural reforms on thesupply side of the economic structure. This perception gained ground afterthe 1982 stabilization program faltered in late 1985 (partly due toinsufficient focus on structural change) and became a central issuefollowing the collapse of international oil prices in early 1986. TheGovernment responded to the 1985/86 crisis by intensifying stabilizationmeasures and introducing significant structural changes focusing on tradeliberalization, encouraging private sector activity and reducing the roleof the public sector while increasing its efficiency. Implementation oftrade liberalization measures was accelerated in 1987.

2.02 The most fundamental policy reform in this economic program isthe shift from inward-oriented protected growth towards an

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outward-oriented, open market development strategy, based on graduallydeclining protection and eliminating price controls to improve theefficiency and export competitiveness of the economy. Such a shift isparticularly significant to the steel sector in terms of the implicatinasof trade liberalization, the elimination of domestic price controls onsteel products and the role of external competition in bringing efficiencyand market response to the sector. The steel sector is part of theinfrastructure for downstream engineering industries with considerableexport potential, and as such its competitiveness in price, quality andservice will play a strategic role in the success of the newoutward-oriented development model.

2.03 A second fundamental structural change is the decision to clarifythe role of the public sector in the production side of the economy byimproving the performance and reducing the influence cf state-ownedenterprises and actively stimulating the private sector. Along tb'selines, the Government has intensified its efforts in divestiture, selling,merging, closing and/or transferring of several public sector firms, and inindustrial restructuring. In particular, in the steel sector there hasbeen substantial progress along these lines in 1986. SIDERMEX has shutdown one of its largest integrated plants. The company itself has beenreorganized with large numbers of its subsidiary companies 5ol4, liquidatedor transferred and further measures, of which this project i, an importantstep, are being planned. The end result of this process will be a smallerbut more efficient public sector, coupled with a growing private sectorplaced in a framework of healthy intervational competition.

B. The Steel Sector

2.04 The Mexican steel industry is of substantial size with atheoretical installed capacity in 1987 of just over 9.0 mtpy of crudesteel. After relatively modest growt!s in the 1940s and 1950s, highlyprotectionist policies, heavy government investment and large budgetarytransfers and input subsidies allowed the industry to grow rapidly in the1960s and 19709, at 10.2X and 7.5% p.a., respectively, with productionbasically in balance with consumption. During the oil boom of 1976-81,demand for steel products grew substantially faster (14.9Z p.a.) thanproduction (9% p.a.) and imports increased from 0.3 to 2.5 mtpy in thatperiod. The economic crisis of 1982 severely hit the steel industry;domestic steel demand contracted by about 45X, imports by 86Z, and domesticproduction by 13X. The debt burden of the companies grew out of allproportion, and cash flow problems led to inadequate maintenance and abacklog 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 nearly65,000 and the annual production was 7.2 million tonnes of ' ude steel and5.6 million tonnes of finished products. The production and consumption ofsteel products in the country was basically in balance. The overallproduction and consumption balance has changed from net imports ofUS$1,750 million in 1981 to an import/export balance at aboutUS$260 million of finished products in 1986 (Annex 2-1).

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C. Structure and Main Institutions

2.06 In its present structure, the industry comprises five integratedprodacers and 23. non-integrated mini-mills, and a number of Independentrerollers scattered throughout the country. There are effectively twomajor operating entities in the sector, SIDERMEX and HYLSA, which accountfor over 80% of the production, value added and employment. More detailsare in Annex 2-1. Map IBRD 20418 shows the main steel plant locations. Atpresent the Mexican steel industry receives practically all its rawmaterial supplies (iron ore, coking coal and flux) from internal sourceswith the exception of (i) steel scrap, a large part of which is imported,and (ii) occasional small quantities of coking coal or pellets forSICARTSAe Mexico's reserves of iron ore are low grade and relatively smallwhile proven coking coal reserves in the north are larger and richer (seeAnnex 2-2). Map IBRD 20419 shows the location of the main iron and coalmines in the country.

2.07 Several government agencies are involved in policy formulation,control and promotion of the steel industry in Mexico. The most importantis the Secretariat of Energy, Mines and Parastatal Industry (Secretaria deEnergia, Minas e Industria Paraestatal - SEMIP) which directly supervisesSIDERMEX in terms of both current operations and investment policies andprograms. SEMIP's influence extends beyond its public sector role.Although formal authority over industrial policies in general and steelsector policy in particular rests with the Secretariat of Commerce andIndustrial 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 policyformulation for the steel sector, including such matters as price controls,quotas and trade restrictions, tariff levels, subsidies and investmentplans and programs. Besides SEMIP and SECOFI, a third major player in theGovernment's policy-making role is the Secretariat of Planning andBudgeting (Secretaria de Programacion y Presupuesto - SPP); it coordinatesthe preparation of medium-term plans, approves the capital and annualoperating budgets of the parastatal steel companies, and monitors theirimplementation.

2.08 SIDERMEX was established in 1979, to manage the activity of thethree public steel companies: AHMSA, FMSA, SICARTSA and their 87subsidiaries in mining, downstream manufacturing, marketing anddistribution, and real estate. Although, SIDERMEX was initially successfulin coordinating the strategic activities of the public steel sector, it didso at the expense of excessive centralization of commercial, financial andoperational activities in the hands of a corporate management, leading toinefficient plant operation. The centralization of a large part of thedecision making authority also resulted in an isolation of the SIDERMEXplants from the needs of the ,arkets, The organizational and legalstructure were complicated. The large number o' subsidiaries with verywide ranging missions diluted the management effort.

2.09 The operating performance of the SIDERMEX steel companies variedsubstantial'y, reflecting the technology in place, the state of repair ofthe facilities and the stability and the competence of the plant management

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concerned. The unfavorable economic environment in which these companiesoperated (low controlled output prices, depressed market, etc.) led to highoperational losses compounded by very high debt service obligations. By1986, SIDERMEX debt exceeded US$1.75 billion equivalent, of which roughlyUS$0.9 billion equivalent was foreign debt. A substantial portion of thisdebt represented the financing of non-performing assets, including over 50%in the SICARTSA II facility still under construction and awaiting furtherdecision on its target completion. The earning power of the remainingassets was considerably lower than their book values and considerablydiminished by the state of disrepair, the technical and organizationalinefficiencies, and the lack of coherent government policies towards thesector. By the end of 1985 it had become obvious that no seriousimprovement could be made in the performance of the public sector companieswithout deep changes in the organizational and financial structure ofSIDERMEX and in the economic environment surrounding the steel sector.Consequently, early in 1986, the GOM appointed a new management team andgave it the mandate to implement the major steps of a restructuring programaimed at restoring SIDERMEX efficiency and competitiveness and torestructure its organization, financial position, management andoperations. The restructuring program is discussed in Chapter IV.

2.10 HYLSA vas founded in 1942 as a tin reroller. In the 1950s HYLSAdeveloped the first industrial process for production of direct reduced(DR) sponge iron with operation starting in 1957. The company grewsteadily, through the 1950s and 1960s establishing a non-flat productfacility in 1969 and integrating it backwards through an improved DRprocess. Over the years, HYLSA remained the major cash earner for the AlfaIndustrial Conglomerate (Grupo Industrial Alfa - Alfa). In the 1970s, Alfaundertook a substantial diversification program financed in part throughthe HYLSA cash engine. The economic crises of the early 1980. left HYLSAand the parent Alfa saddled with an extraordinary debt burden. Thefinancial restructuring of the Alfa debt was completed in 1986 and a numberof activities are being spun off. HYLSA's debt burden reachedUS$1.15 billion equivalent at the end of 1986, about 25% of whichrepresented mounting payments arrears. The bulk of the debt is owed toforeign (mainly US) commercial banks. A financial restructuring packagehas been negotiated that allows for conversion of up to US$375 million ofHYLSA's debt into equity and provides for flexibility in repayment of theremaining debt through separation into mandatory and optional tranches,each bearing different rates of interest. The agreement also provides forHYLSA's implementing its capital expenditure program aimed at rest.Jring itscompetitiveness. Provision is also made for infusion of new debt insupport of the capital program. The restructuring package and relatedterms have been drawn up but remain to be cleared by all the institutionsinvolved. A final signed package is expected to be completed in mid-1988.The restructuring package provides an acceptable and reasonable basis forHYLSA to resolve its financial crisis and allow it to remain as a majorproducer in the Mexican steel sector.

2.11 The other entities in the sector, TAMSA and the semi-integratedproducers 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

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main product - seamless pipes - being for use mainly in oil exploration.TAMSA's financial position has deteriorated in the past three years. Thecompany is burdened with over US$600 million equivalent in term debt, over60X of which is owed to foreign commercial banks. A substantial part ofthis debt was incurred in financing a major plant expansion in the early1980s based on optimistic views of the oil industry and consequent demandprojections for oil field products. Although TAMSA is seeking arestructuring agreement with its creditor banks its very specializedproduction profile serving a specific market (mainly PEMEX) would onlyconstitute a small part of the whole steel sector restructuring. Severalsmaller producers including those involved in stainless and specialtysteels are also facing financial structure problems. As a condition of theproposed project, NAPIN will make available funds from other sources,including existing Bank credit lines to all of these producers includingTAMSA for assistance in preparation of physical, organizational orfinancial 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, asa forum for exchange of basic market and technical information, and as alobby for favorable steel policies. CANACERO's influence on policy hasbeen minimal, however, reflecting the past divergence of opinions onfundamental policy issues such as price controls, tariff and quotaprotection, etc. between the private sector producers and the SIDERMEXgroup. Moreover, the protective environment of the 19609 and 19709 and thesubstantial market control and price levels of that era provided littleincentive to the steel industrv to develop an effective association. Therecent structural changes in the Mexican economy and the consequent adverseimpact on the steel sector have brought about a change in attitudes as welland CANACERO is now beginning to take a more active role in lobbying onbehalf 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 manufacturingsector and has significant impact on the availability, cost and quality ofmaterial inputs for downstream manufacturing, particularly, the engineeringand capital goods industries. Over the past two decades, the Governmenthas created and applied a policy framework intended to be favorable to thisindustry. This framework was successful in creating a steel industry ableto meet the steel demand of the country in quantitative terms, but one thatis now unable to satisfy the expectations of supplying low-cost andhigh-quality steel products to the market place. The highly protectionisttrade policies before 1985 (Annex 2-3) included:

(a) quantitative restrictions, that covered 100% of imports in 1982and 1983;

(b) high tariffs (up to 401 for steel products);

(c) unrealistically high official reference prices, that served asthe basis for calculating the amount of custom duties, resultingin a substantial increase of duties to be paid;

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(d) domestic content requirements for capital goods and automotiveindustries; and

(e) public sector procurement practices which gave preference todomestic products over imports.

This trade regime had created an inward oriented industry that faced verylimited 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 neededspecifications, lot sizes and delivery schedules.

2.14 The key policy issue addressed in the restructuring project andthe proposed loan is the decontrol of steel prices which have been set inthe last two years below both the total cost of the efficient Mexicanproducers and below the actual landed cost of imports (not includingtariffs). As discussed in Annex 2-3, the price control deprives theproducers of the financial benefit of protection and does not provide anyincentive for improvement of product quality and service to customers. Inaddition, the low level of profitability and return on investmentdiscourages entry of new private investment capital into the sector. Inother words, the price control offsets the resource generating benefit ofthe protection while all the negative impact of the protection remains infull effect both for the steel industry and for the downstream users.

2.15 An important element of the Government's policy towards the steelindustry is its direct participation in the production activities.The public steel sector was created as a result oi the takeover of the thentwo largest private sector steel producers, AHMSA and PMSA, in order tosave 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 topromote the development of the remote region of Lazaro Cardenas.Government policy regarding its direct investment in steel has changedsubstantially in the last two years. Action has been taken to streamlinethe public sector steel companies, to stop uneconomic activities and spinoff non-essential plants. After years of futile efforts to convert FMSAinto a healthy, profit-making company, the Government closed it in April1986. Further public investment plans have been reduced drastically and alarge 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 investmentstrategy, 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 expectedneeds of the market. The present situation discourages major investmentsin the private sector and makes it very difficult to develop optimalinvestment programs in both the public and private sectors. The SteelSector Restructuring Project and proposed Bank loan will, among others,address this situation through the elabcration by GOM of a Global SteelSector Policy Statement based on the Policy Letter (Annex 4-2) that waspresented by GOM at negotiations.

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III. THE STRATEGIC ISSUES AND BASES FOR SECTOR REFORM

A. Strengths and Weaknesses

3.01 A detailed analysis of the Mexican steel industry's currentoperating performance, cost and quality competitiveness, and its strengthsand weaknesses was carried out under the sector strategy study completed in1986. The main findings and conclusions of that analysis are presented inAnnex 3-1. The technical comparisons of the major steel plant operationsin the country lead to the following main conclusions:

(a) non-flat products are by and large produced in modern facilitiesin both the private and public sector and are quality and costcompetitive with international norms; the sole exception isAHNSA's outdated facility; the strategic implications arediscussed in para 3.07 and 3.08 below;

(b) the industry's main weakness lies in the quality and cost of itsflat product lines at both AHMSA and HYLSA; modernization ofthese facilities would enable both producers to substantiallyimprove 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 competitivefrom economic and financial points of view, and can be expectedto maintain this position if no major shifts in relative costs(labor, energy, transport) occur;

(b) coking coal production shows substantial potential for furthercost and quality improvements as older mines are closed and newmines are opened with concomitant changes in mining techniquesand higher productivity;

(c) iron ore is generally of lower grade but even with higherprocessing costs is competitive as inputs to the steel industryon both an economic and financial basis; and

(d) there is small room for improvement in two of the iron minesbecause they are nearing depletion; the remaining three ironmines and the coal mines could show improved cost performancethrough increased capacity utilization rates.*

3.03 The marketing and distribution practices and infrastructure havebeen deficient, particularly those of SIDERMEX. Past protectionistpolicies held back the development of an efficient and competitivedistribution network. This deficiency has particularly affected thesmaller companies in the engineering industries and capital goods, whichhave suffered from inadequate and unpredictable supply of steel products.

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B. The Strategic Issues

3.04 An analysis of the present and potential steel market demand andsupply in Mexico is presented as Annex 3-3. Domestic producers arepresently unable to supply high-quality steels to the domestic market,particularly for the rapidly growing capital goods and manufactured metalproducts subsectors. Mexican producers in these subsectors have potentialcomparative advantages in three significant areas, viz., labor cost,proximity to substantial riarkets, and indigenous resources. Recentgovernment policy changes have added an additional factor that has spurredrapid growth and an export-oriented internationally competitive approach.As a result, this segment of t.he steel market is the most demanding interms of the quality dimension and cost competitiveness. The ability ofthe steel industry, and particularly the flat product producers, to adaptto the changing needs of this segment of the steel market is a key factorin Its future growth.

3.05 The bases for projecting steel demand are an assumption of amodest rate of growth of 3-4% p.a. of GDP in the next five years and afurther opening of the Mexican economy which is expected to lead to afaster-than-average growth of the manufacturing industry. This is expectedto 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 aremajor opportunities for the Mexican steel industry in diversification ofthe product mix and improvement of product quality to capture a greatershare of the specialized market segments that show higher than averagegrowth potential. The strategic analysis described in Annex 3-1 indicatesthat from a wide range of flat and non-flat products, Mexican producershave considerable potential for improvement of their competitiveness tocover not only their short-run marginal cost, but their long-run economiccosts as well (see paras 8.08-8.10). The restructuring Fcogram in theshort run and the proposed project are designed to tap thts potential whichwould benefit both the steel industry and its downstream tiers particularlyin the capital goods and manufactured metal products subsectors.

3.07 The main conclusions from an assessment of the industry'sstrategic position in relation to the potential market demand and takinginto account the industry's cost and quality factors are that the steelindustry is well placed in the non-flat product area. The opportunity thatneeds to be tapped is the demand for high-quality bar products that couldbe produced in SICARTSA's modern facilities and the shift of thesefacilities from export to domestic production. However, the AHMSA non-flatproduct lines are clearly in a weak strategic position with respect to costand quality. Abandonment of these lines could provide the private sectorproducers with the opportunity to expand production, provided the pricingincentives are in place. Structural profiles are an exception to thisgeneral thrust. Further analysis shows that AHMSA should continue toproduce structural steel profiles (wide flanges, beams, etc.) as well asmodify its structurals mill to produce rails for the domestic market (seealso para 8.09).

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3.08 The strategic thrust that can be derived from the analysis isthat, in the short and medium term, Mexico should (i) concentrate onimproving the quality and cost factors in the flat product lines; and(ii) focus its most modern non-flat facilities on the internal markets toservice a demand for higher-quality products. With regard to raw materialresources, a crucial issue is whether available iron ore reserves and thecapacity of existing mines and new projects will be able to satisfy futuredemand of the steel industry. As a general conclusion, local supplysources, based on current reserve estimates would be sufficient to meetiron ore demand fully in the short and medium term, and coking coal demandin the longer term, well into the next century. Periodic reassessments ofthese global forecasts will obviously have to be made in the light of newexploration results.

C. Agenda for Policy Reform

3.09 The strategic development issues facing the Mexican steelindustry also have a major impact on future trade liberalization. Thepolicy reform proposals which underlie the comprehensive program ofrestructuring are aimed at creating the framework under which the steelindustry can achieve greater competitiveness in the coming years andthereby open the way for liberalization measures affecting downstreamindustries. Annex 2-3 presents an analysis of the main policy reformproposals.

3.10 Given that the program of trade liberalization and tariffreduction has already been agreed, the most critical element in theshort-term agenda for policy reform is the elimination of domestic pricecontrols. As discussed in greater detail in Annex 2-3, this will permitthe rise of domestic steel prices to their opportunity cost levels andeventually, as quality improves with the project, to the level of CIF plustariff. This measure would also allow the steel producers to obtain thefinancial benefits of the announced tariff policy and, thereby, generatethe funds necessary for adequate maintenance of facilities, upgrading oftechnology and servicing of the debt. It would also allow the Governmentto eliminate budgetary transfers averaging about US$75-100 million a yearto cover both operational losses and to support capital expenditures in thepublic sector and indirect subsidies to the industry as a whole. It wouldattract needed new investment capital to the steel sector, and will lead toefficient import competition forcing domestic producers to improve qualityand product mix and to serve better their customers. This willsubstantially improve the supply of steel products in the domestic marketas producers become more specialized and more competitive. These measureswould further facilitate movement towards liberalizing domestic contentrequirements in downstream manufacturing industries, such as auto parts,for which a broader approach is foreseen. The proposed policy reforms inthe steel sector are vital in ensuring greater competitiveness in both costand quality terms.

3.11 The steel sector report prepared by the Bank recommended that aglobal steel sector policy be elaborated by Government with activeparticipation of the private sector. This policy should include a clearstatement of Government's intent in order to encourage private sectorinvestments and permit it to seek its market niches and exploit its

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comparative advantages in an effective manner. The first practical step inthis direction has been the completion of a comprehensive, in-depth marketstudy which serves as a basis for the medium and long-term strategy. Themain objective of the study was to review the structural changes occurringin the demand for steel products, identify the market niches that presentthe greatest opportunities for domestic steel producers, and assess thebasis for longer-term market growth, so that appropriate supply strategiescan be defined and implemented. Consultants were appointed under the aegisof CANACERO and the study was completed in October 1987. This studyprovides the input for the strategic planning study that has beenundertaken by SIDERMEX and for other less formal studies by the privatesector producers. The Government has agreed to elaborate the Global SteelSector Policy Statement by July 31, 1988, i.e., after the presentation ofthe SIDERMEX Long-range Strategic Plan (para 4.10). The Government'sPolicy 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 policyreform program concerning budgetary transfers and subsidies, theGovernment's clear intentions, as articulated in the SIDERMEX convenio andconfirmed in the Policy Letter (para 4.02), are to reduce and eliminatedirect and indirect subsidies and transfers to the public sectorcompanies. With the expected implementation of the recommended policychanges, the steel industry will be able to operate, modernize and evenmodestly expand on the basis of its sales revenues. The total eliminationof direct subsidies and government transfers to the steel industry is alsoexpected to occur in a relatively short time.

IV. THE RESTRUCTURING PROGRAM

A. Objectives

4.01 The Steel Sector Restructuring Program involving public andprivate sector producers is an important element in Mexico's generaladjustment process. Reflecting the strategic thrust described inpara 3.08, major objectives of the program are to maintain, enhance andrestore 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 makinguniform tariffs on steel products and eliminating officialreference prices in line with the agreed calendar of tradepolicy reforms, so as to assure competitiveness in themarketplace; and

(ii) reducing and eventually eliminating government subsidies toproducers.

(b) On the technical side by:

(i) closing down uneconomic operations, reducing or eliminatingproduction inefficiencies, and optimizinag existing and

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planned new facilities in terms of the product mix andmarkets served;

(ii) carrying out economically justified immediate and urgentinvestments in catch-up maintenance, debottlenecking ofexisting productive facilities, quality control andproductivity improvements; and

(iii) undertaking the market and technical studies needed to planfor the longer-term investment needs of the sector.

(c) On the organizational side by: improving the management andorganization of SIDERMEX by decentralizing the decision-makingprocess and devolving operating responsibilities to the steel,mining and other operating units, placing particular emphasis ontheir market responsiveness.

(d) On the financial side by: improving the financial condition ofSIDERMEX, the major private sector producers, HYLSA and TAMSA,and other semi-interrelated producers by undertaking neededfinancial restructuring and financial engineering of theirbalance sheets.

B. Global Policy Actions

4.02 Following discussions on the underlying trade and price controlpolicy framework, a number of actions have been taken as part of theGovernment's trade liberalization program, supported by the Bank's First(TPL I, Loan No. 2745-ME) and Second (TPL II, Loan No. 2882-ME) TradePolicy Loans. Import tariffs for finished non-flat steel products werereduced in 1986 from 40% to 37%, and on most flat products were reducedfrom 25% to 20%. Recently, tariffs on all steel products were reduced to0% to 15%. All quantitative restrictions for import of steel products wereeliminated. The Government's policy actions are included in the PolicyMatrix (Annex 4-1) and in the Policy Letter providing an outline ofGovernment intentions with respect to the steel sector (Annex 4-2). Theseaction measures and policy intentions constitute the Steel Sector ReformProgram, summarized as follows:

(a) The Government plans to open the steel market in Mexico tointernational competition so that the manufacturing sector willbenefit from high-quality, low-cost input materials. Changesinclude the elimination of quantitative restrictions and officialreference prices for imported steel products. In December 1987tariffs were reduced to 0% to 15%.

(b) Steel price controls will be totally eliminated not later thanDecember 31, 1988. Prior to this event, the Government willcontinue to adjust the domestic prices of all steel productsmonthly based on the anticipated changes in the Consumer PriceIndex in order to dampen any possible sharp increases andfluctuations that might occur after complete price decontrol.The price increases accorded in December 1987 and January 1988have already brought all domestic product prices to or aboveequivalent international landed price levels and continuedadjustments will maintain the domestic price levels in realterms.

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(c) Through these policy changes the Government seeks to provide astable long-run framework of trade and domestic industrialpolicies that in the new open market environment will provide thenecessary incentives for efficient production of quality productsand the conditions necessary for proper long-term planning. Itis the Government's intention to maintain these policies in orderto ensure the development of an internationally competitive steelindustry able to operate without further protection.

(d) The Government has taken significant restructuring steps with itsparastatal steel company, SIDERMEX, including (i) thhe closing ofthe inefficient steel plant, Fundidora de Monterrey ;.A.;(ii) the financial and organizational restructuring cf SIDERMEX;and (iii) the closure, spin-off, reduction and consolidation ofits subsidiary companies. The Government plans to continue thetransformation of SIDERMEX into an effective holding company thatperforms strategic management and general supervisory functionsover the entire parastatal steel sector.

(e) By March 31, 1988, SIDERMEX will publish a Long-term StrategicPlan which will include details of the remaining restructuringwork and the investment program supported by the proposed Bankloan. This plan will elaborate further on the issues regardingmanagement and organization as well as details pertaining tofacilities to be operated and products to be produced in the nextfive years. Government investment will be limited to furtherbalancing and technical upgrading of existing facilities and tocompletion of existing projects that are shown to be economicallyand financially viable.

(f) In the long term the Government plans to eliminate all budgetarytransfers to SIDERMEX. After the publication of the SIDERMEXStrategic Plan, Government will further elaborate and publish aGlobal Steel Sector Policy Statement, not later than July 31,1988, substantially along the lines indicated in the PolicyLetter. tn particular, the Global Policy will be consistent withboth the guiding principles of the SIDERMEX Strategic Plan andwith the Plan itself. These actions will clearly define thescope and extent of the public sector's investment and operatingstrategies and investment plans, and will, thereby, allow theprivate sector to plan its own operations and investments. TheGovernment's goal is to continue the transformation of the sectorinto a group of solvent and viable companies with well-maintainedfacilities, producing internationally competitive products tobetter serve the country's downstream users including the growingexport-oriented manufacturing industries.

As they are vital to the short- and long-term success of therestructuring effort, and to the viability of the physicalinvestments to be implemented under this project, the continuedmaintenance of the price decontrol and trade liberalizationmeasures is a covenant of the entire proposed loan.

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C. SIDERMEX

Overall Restructuring Thrust

4.03 Significant progress has been made by the Government with regardto the restructuring of SIDERMEX operations and following actions have beentaken:

(a) The country's least viable and most loss-ridden steel plant, FMSAat Monterrey was closed in May 1986;

(b) The Government and SIDERMEX worked out a comprehensiverestructuring program of the public steel sector and inSeptember 1986, signed an agreement (Convenio), which providedfor major financial restructuring of SIDERMEX companies (AHMSAand SICARTSA), defined the overall program of physical plantrestructuring and organizational changes to be carried out withGovernment assistance, and specified SIDERMEX obligations interms of performance improvements, productivity targets andprofitability goals.

(c) The corporate structure of SIDERMEX was rationalized, withdevolution of responsibility for all operating, marketing andfinancial activities from corporate level to the plant operatinglevels. The number of corporate employees was reduced from 1,070to approximately 800 with further reductions contemplated.

(d) A large part of SEMIP's decision making authority was delegatedto SIDERMEX corporate management; and

(e) The process of rationalization of the size and profile ofSIDERMEX has been initiated. Ten of the former SIDERMEXsubsidiaries have been transferred under direct control ofSEMIP. A process of sale of 22, liquidation of 20, andconsolidation of the remaining companies into 24 units has seenstarted, and substantially completed (see para 4.06).

4.04 The SIDERMEX Restructuring Program incorporated in the Convenioaddresses the most urgent aspects of operational changes needed to restoreSIDERMEX's competitive position, including the rehabilitation of existingfacilities and undertaking the organizational and financial changes toaccomplish the basic objectives. The Convenio provided that SIDERMEX wouldlaunch these actions as a medium-term program, while studying a longer-termstrategic plan to be decided upon and implemented as soon as the requisitefinancing plan and detailed investigations were ready. The proposedproject addresses the implementation of the medium-term restructuring.

Organizational Changes

4.05 At the beginning of 1986, SIDERMEX consisted of 3 integratedsteel plants and 87 subsidiaries. Most of the subsidiaries were engaged inactivities not closely related to the steelmaking and marketing process.The decision of the Government was to keep in the SIDERMEX group the largeintegrated steel producers, the coal and ore mines, some of the marketing

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network, ferro alloy producers, and the production of refractorymaterials. The rest will be divested from the SIDERMEX portfolio. At theend of the reorganization process, SIDERMEX will have 2 integrated steelplants, a raw materials operating group and 24 related subsidiaries mainlyin mining of iron ore and coal, and production of refractories.

4.06 A major change that is an integral part of the current phase ofSIDERMEX restructuring is the shut down of its most problematic plant, FMSAat Monterrey. This was a painful decision, since it liquidated nearly9,000 direct jobs and many thousa;ds of indirect jobs. Associated mineshave since then also been shut down affecting some 2,000 workers in smallcommunit.es. SIDS-RMEX and the Government have examined the socialimplications of these changes and after discussions with the trade unions,have agreed on compensation measures. After the signing of the Convenio in1986, the restructuring process continued with ten of the former SIDERMEXsubsidiaries transferred under direct control of SEMIP and 42 companiesbeing sold to the private sector or liquidated. The remaining 35subsidiaries are being consolidated into 24 units. Furthermore, the miningsubsidiaries are being grouped into a single holding company, CMC, with itsfinancial structure being rationalized through a recapitalization programaimed at eliminating inter-company debts, and allowing for transparency inthe 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 thatperforms strategic management and general supervisory functions over theparastatal steel sector. The responsibility and autonomy of the plantmanagement will be substantially increased. The marketing and productionplanning activity has already been transferred from the SIDERMEX corporatemanagement to the plants. The new organization, which is already in placeadministratively, will -Je legally formalized in 1988 not later than 90 daysafter loan signature (para 5.14). It will group all operations under fiveindependent operational entities: AEMSA, SICARTSA, the raw materialsdivision under the corporate name Carbon y Minerales Coahuila S.A. (CMC),Refractories and related operations, and international marketing and othernon-technical units. This reorganization will considerably improve themanagement of both the steel producing and non-steel related companies.

Financial Restructuring

4.08 In the framework of the Convenio, the Government assumed andconverted to equity about US$883 million equivalent or 50% of theUS$1.75 billion equivalent total debt of the SIDERMEX companies. AnotherUS$250 million of FMSA debt will be dealt with in the bankruptcy process ofthat enterprise. The conversion of debt includes essentially all capitalrepayment falling due in 1986, 1987 and M9A8 and the interest payable fromFebruary to September 1986. This operation makes the debt more realisticand manageable, but does not offer a final solution of the problem,especially if account is taken of the growth of debt expected in relationwith the possible continuation of the SICARTSA II investment.Decontrolling prices would permit the companies to generate a large portionof the funds needed to service the debt, but probably further financialrestructuring measures will be needed in the future, including a possiblewrite-down of some remaining SIDEIMEX assets which consultants will reviewunder the project (para 4.12).

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Technical Restructuring

4.09 Key weaknesses in the mines and steel plants are due toinsufficient funds in recent years allocated for maintenance and facilityupgrading that have resulted in higher operating costs and lower productquality. In addition, technical improvements, particularly in automationand systems development, have not been carried out even in the more modernfacilities. The sector strategy review and the competitiveness analysescarried out earlier have identified that the product mix of the plants donot fully correspond to (i) the requirements of the market, (ii) thetechnical conditions of the plants, and (iii) the possibilities ofspecialization between the large public and private producers. There isgeneral technical agreement between SIDERMEX and the Bank that certainspecialization should be developed among the public and private sectorplants, e.g., flat products at AHMSA and HYLSA and non-flat products atSICARTSA I and in the private sector. Taking into account this strategicthrust and existing technical weaknesses, SIDERMEX has developed theshort-term investment program with the assistance of US Steel EngineeringConsultants (para 5.11) that is the basis for the project componentsdescribed in Chapter V.

Long7term Action

4.10 By the end of the proposed project, SIDERMEX is expected to be agroup of solvent and viable companies with well maintained facilities,producing internationally competitive quality products at lower cost thannow and with an adequate product mix to better serve the downstreamsteel-consuming industries. However, this immediate phase of therestructuring process does not include all the potentially neededmodernization, balancing or the completion of the investments in progress.SIDERMEX is therefore carrying out a long-term strategy study to define thebasis for its development through the 1990s. The Strategic Plan will beconsistent with the guiding principles spelt out in the Policy Letter(para 4.02(e) and (f)). Terms of reference for this work were reviewed andagreed by the Bank. British Steel Corporation Overseas Services (BSCOS)was selected and has carried out the task. SIDERMEX will present itslong-term strategy proposal for Bank review by March 31, 1988. The marketstudy (para 3.11) has also provided a major planning input to th2e strategystudy. The strategy developed for SIDERMEX will provide the basis for theGovernment's Global Steel Policy statement which will define the role ofthe public sector and along with the results of the market study theopportunities available for the private sector.

4.11 The integration of the proposed SICARTSA II investment programinto the SIDERMEX complex is a critical element in the long-term strategy.The completion of this investment parallel with further facilitiesrestructuring in the AHMSA plant may lead to excess capacities,particularly in plate production. Therefore, disetssion with SIDERMEX andthe Government has led to an understanding that alternatives to completionof SICARTSA II would be evaluated on their technical, economic andfinancial merits once the medium-term product and market studies arecompleted. Such an evaluation would be completed as part of thepresentation of the SIDERMEX Long-term Strategic Plan and will include:

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(a) review and discussion with the Bank of the conclusions andrecommendations of its long-term strategy study in particular, those withrespect to major investments in facilities not included in the now agreedRestructuring Program and use of facilities not now in operation;(b) implementation of the agreed elements of the long-term strategy inaccordance with investment criteria, financing plans and implementationschedules that are acceptable to the Bank; and (c) annual review of theplani and progress achieved.

4.12 In reviewing the SIDERMEX financial restructuring alreadyeffected by the Government, and in particular, the financial pi. pects forits steel companies, it has became apparent that there is a need forfurther balance sheet restructuring, including revaluation of the fixedasset base in relation to the earnings potential and a correspondingwritedown of the equity base, so that future SIDERMEX financial performanceis measured against achievable financial return criteria and reflects theoverall cost of equity and loan capital. It has been agreed that withinsix months after the signing of the loan documents SIDERMEX will carry out,based on agreed Terms of Reference: (i) a complete analysis andrevaluation of its fixed assets, including fixed assets of all of itssubsidiaries, and (ii) an adjustment and updating of the relevant balancesheets based on these results.

D. Private Sector

4.13 The most important elements of the restructuring needs of theprivate sactor pertain to the current financial situation at HYLSA andTAMSA, the two integrated producers. Other private sector producers, ingeneral, appear to be in relatively satisfactory financial condition,although profit margins have eroded in recent years and iivestment risksincreased. The policy reform package described in para 4.02, by and large,would be sufficient of itself to strengthen the financial position of thesmaller, non-integrated steel producers and to provide the right signals tothem to reinvest in the potentially profitable market niches, and toattract new entrants to the industry. The case of HYLSA and TAMSA is,however, more problematic. Financial restructuring is a necessarycondition for their survival as viable and dynamic entities.

4.14 As described in para 2.10, HYLSA owes about US$1.2 billion and inthe present economic environment is not capable of generating sufficientfunds on the existing facilities to fully service this debt. The companyhas recently completed negotiations on the restructuring of its debt withthe advisory committee of the creditor banks. Since HYLSA, like theSIDERMEX companies, did not have sufficient funds in recent years for /maintenance and upgrading of its facilities, it badly needs to carry out amajor rehabilitation and modernization program. The program has beendefined by HYLSA with consultant assistance (see para 5.12) and forms thebasis for the proposed project component. The implementation of thisprogram is essential for HYLSA to maintain its competitive edge and retainits market share in a period when its main coLpetitor, SIDERMEX, iscarrying out a significant improvement program. As discussed in para 2.10,the restructuring agreement with the banks would allow it to retainsufficient financial capacity for the implementation of the minimuminvest:ment program. The financial assessment of the HYLSA rehabilitation

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component of the project reflects the preliminary agreements reachedbetween HYLSA and the creditor banks (para 7.08). Signature of the finalagreements with terms acceptable to the Bank is an agreed disbursementcondition for the HYLSA component of the proposed loan (para 6.06).

4.15 Based on the analysis, it appears that, taking into account theterms of the financing restructuring plan, the major capital investmentneeds, and HYLSA's working capital requirements for ongoing operations,HYLSA would not appear capable of carrying out a successful rehabilitationand modernization program without financial assistance under the proposedproject. Moreover, the financial restructuring package would permit HYLSAto obtain additional substantial write-down of the debt burden if part ofthe annual free-cash flow in the early years were to be used to retiredebt. To the extent that HYLSA is able to finance at least a part of itsinvestment needs from new external sources, the restructuring of HYLSA'sbalance sheet could be accelerated, resulting in a sounder capitalstructure. This would also allow HYLSA to remain a stronger competitor tothe public sector in the domestic market.

4.16 Coupled with the financial restructuring needs (para 2.11), sometechnical restructuring involving new technology and upgrading of existingfacilities of smaller producers in the private sector, particularly thespecialty-steels producers, have been identified by the Government.Although these requirements are not specifically funded under the presentproject, NAFIN has agreed that technical assistance for these purposes willbe provided from other funding sources, including existing Bank creditlines, already available to it. Funding for subsequent investment andworking capital needs would also be channeled through existing creditlines, including existing Bank loans, with additional funds possiblyincluded in a proposed Industrial Restru^turing loan.

V. THE PROJECT

A. Objectives

5.01 The project is based on the strategic analysis discussed inChapter III and supports the policy reform measures discussed inChapter IV. Its first objective is to assist the Mexican Government inimplementing a comprehensive and far-reaching reform of the steel sectorand in carrying out the needed restructuring actions. Its second objectiveis to assist the major players to rehabilitate potentially efficient plantand equipment with demonstrable viability, enhance product quality andreduce product costs, eliminate bottlenecks to achieve better utilizationof existing capacity, improve technical, financial and managerial controlsand information systems, train operations and maintenance staff and developthe human resources to achieve the overall objectives of greatercompetitiveness and responsiveness to market needs. Its final objective isto assist the Government and the industry in elaborating their long-termstrategies and policies to achieve a healthier development of the steelsector in line with the country's development objectives. The projectspecifically avoids investments in product lines and facilities whoseviability is dependent on the outcome of the ongoing market study and theSIDERMEX long-term strategy study.

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B. Project Description

5.02 The proposed project consists of three parts: Part A is an InputMaterials and Steel Products Import component tied to implementation ofagreed policy reforms; Part B addresses the restructuring needs of SIDERMEXand its operating entities; and Part C supports the rehabilitation andmodernization of the HYLSA flat product facilities as part of itsrestructuring program.

Part A: Input Materials and Steel Products Import Component

5.03 This component is intended to support the Steel Sector ReformProgram of the Government described in paras 2.13-2.16 and 4.02. Thisprogram is in the process of execution having been launched by theGovernment in early 1986 with important components already implemented.Finalization and implementation of major components, including theelimination of domestic price controls, are under way. The policy reformwill substantially alter the manner in which the steel industry conductsits business and develops in the coming years. It is expected that thefurther deepening of the reform process will result in increased steelimports during the adjustment period when the industry will be carrying outits restructuring and rehabilitation. Accordingly, this component willsupport both the consolidation of the already adopted measures and theintroduction of new ones, and would finance a part of the increased importsduring the adjustment period.

5.04 The Government has already carried out twio of the triggeringevents, i.e., elimination of ORPs for all steel products, one of the eventsfor release of Tranche I, and reduction and equalization of tariffs onsteel products to no more than 25%, one of the events for release ofTranche II. In addition, the price adjustment in mid January 1988 and thepresentation of the Policy Letter at negotiations complete all actionsrequired for release of the first tranche at loan effectiventss. Thesecond tranche release will be triggered by final decontrol of all steelproduct prices, and the final elaboration of a Global Steel PolicyStatement 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 inAnnex 5-1.

Part B: SIDERMEX Restructuring Program

5.05 The SIDERMEX program includes: investments in the major flatproduct facility, AHMSA, aimed at improving the quality and competitivenessof its hot and cold rolling lines and improving the utilization of itsheavy section mill through the addition of equipment for the production ofrail; investments in the raw materials division, CMC, to ensure adequatecoal and iron ore supplies for the steel plants; and assistance to SIDERMEXin strategic planning and other studies.

5.06 The AHMSA component is detailed in Annex 5-2 and concentrates onshifting the product mix to flat products, heavy structurals and rails withan overall reduction in steelmaking capacity and improvements in qualityand lowering of costs of production, primarily in hot and cold rolled sheetand tin plate. The major technical thrust is to (i) rationalize thesteelmaking and continuous casting facilities; (ii) rehabilitate and

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improve the quality and productivity of the hot strip mill; (iii) balancethe cold rolling mills and improve the quality of cold rolled products;(iv) provide catch-up maintenance throughout plant operations and in theplant-wide utilities and services; (v) expand the product line by using theunderutilized heavy structural mill for the production of rail; and(vi) provide for enhancement of systems and training. The investmentsinclude, equipment for improvement of the steel-making facilities, the hotand cold rolling mills, rail section mill and plant-wide maintenancesincluding utilities and services, as well as services of consultants forenhancement of management information systems, engineering and projectmanage.ent and development of training programs and expenditures foroverseas training of operating personnel. About 900 man-months ofconsultant services are included.

5.07 The CMC component is detailed in Annex 5-3 and is concentrated onraising productivity in the coal mining operations and strengthening theHercules iron ore operation, bringing it to its intended level ofoperation, through a mixture of maintenance and equipment renewal,debottlenecking investments, systems and controls and technical assistancefor project management, operational improvements and upgrading of technicalskills. The proposed investments include replacement of mining, transportand conveyor equipment, purchase of new coal crushers, installation of aniron ore concentrator facility and consultant services (250 man-months) forimplementation of accounting and management information systems, ana forproject management and training.

5.08 Strategic planning studies for SIDERMEX are detailed inAnnex 5-4. The main objectives of these studies are to assist SIDERMEXmanagement in: (i) carrying out a long-term strategic study including thenecessary supporting technical studies; (ii) undertaking the corporate-wideasset revaluation exercise and translating the results into a suitablefinancial structure; (iii) implementing the organizational and financingrestructuring measures that emerge after the completio: of the long-termstrategic studies; (iv) assisting in the detailed planning of the long-termstrategic investments; and (v) providing assistance fo: implementation ofcorporate level management information systems. To these ends, thiscomponent 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 onimproving the competitive advantage of the Flat Products Division throughinvestments in cost reduction, productivity and quality improvement. Mostimportantly, this component is intended to be executed in a timely fashionto maintain a competitive balance between HYLSA in the private sector andAHMSA in the public sector, both of whom are pro-siding similar products tothe Mexican steel markets. This component includes: (i) establishing theproduction of high-quality slabs from the steelmaking shop; (ii) revampingand improving the quality and productivity of the hot strip mill; and(iii) debottlenecking the cold rolling mills and improving the quality andproductivity of these facilities. The physical investments includeequipment for steelmaking and hot and cold rolling mills. In addition,project management consultant services of about 250 man-months are included

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to assist HYLSA in carrying out detailed engineering and projectsupervision.

Sector-wide Technical Assistance

5.10 As stated in para 4.16, it was agreed that the identifiedrequirements for sector-wide technical assistance will be funded separatelyby NAFIN from other credit sources including existing Bank credit lines.Under this concept, NAFIN would finance:

(a) Diagnostic studies for individual private sector companies aimedat improving operating efficiency and identifying potential forfinancial restructuring, rehabilitation and/or expansion.

(b) Feasibility and engineering studies to assist individual privatesector companies to take advantage of new markec opportunitiesand arrest existing and potential new threats to theircompetitiveness or to assist in preparing proposals for fundingfrom existing and/or potential Bank-supported investment creditlines, recommended restructuring, rehabilitation, and operationalimprovements including technical assistance for managementdevelopment and staff training.

To this end, up to 400 man-month consultant services may be financed byNAFIN. Satisfactory and timely execution of these activities by NAFIN isan agreed covenant in the proposed loan operation.

C. Project Management, Organization and Implementation

5.11 The SIDERMEX project beneficiaries - AHHSA, and CMC - have bothhad 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 ofbid specifications pending selection of a consultant to assist with projectmanagement. Terms of reference have been discussed and selection is underway following Bank guidelines. As CMC's current project managementorganization is only now being set up, it has been agreed that CMC willemploy a suitably qualified consultant to assist in project management onterms of reference satisfactory to the Bank. CMC has also agreed tomaintain a suitably staffed project management team (see para 5.14) for theduration of the project.

5.12 HYLSA was assisted by Nippon Kokan of Japan (NKK) in projectpreparation and has agreed to follow Bank guidelines in selecting a newconsultant to assist in project management, which will include procurementassistance, assistance in overall project planning and cost control as wellas basic engineering, construction management and assistance duringcommissioning. Terms of reference similar to those at AHMSA have beenprepared. Both AHMSA and HYLSA have agreed, until project completion, toappoint a Project Manager and retain suitably qualified project managementconsultants on terms of reference and conditions satisfactory to the Bank.

5.13 The project includes retroactive funding (para 6.13), includingconsultant preparation work. Terms of reference were agreed for workalready under way and have been reviewed and agreed for the project

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managument functions. SIDERMEX Corporate management will also utilizeconst1:tant assistance in strategy studies and development. Terms ofreference 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 andthe SIDERMEX holding company have appointed a senior technical manager asinternal Project Manager with responsibility for seeing to efficientproject implementation. The Project Manager is supported with functionaland line staff as needed in carrying out the project. This is particularlyimportant as the physical plant rehabilitation is a complex task andinterference with day-to-day operations needs to be minimized, with projectimplementation carefully phased into existing production and maintenanceschedules. The companies have agreed to assign staff from the existingorganizational structures as required for the duration of the project.Since CMC is a new organizaSion a more formal project management team willbe organized. In all cases, however, a senior technical manager will beappointed as Project Manager and will be supported by (i) technical staffmade up of both operating and engineering parsonnel; (ii) constructionsupervisors; (iii) planning and scheduling personnel; (iv) financial, costaccounting and cost control personnel; and (v) other specialized support asneeded (e.g., procurement, systems and training, etc.) to carry out theproject. This staff will interface with the consultant teams who willfunction in an advisory role. Responsibility for project implementation ateach of the operating companies will be in the hands of the ProjectManager. As discussed in para 4.06, the organization of CMC is beingsubstantially changed through creation of a holding company for all miningoperations. It was agreed that the completion of the conversion of CMC toa legal holding company for all of the SIDERMEX raw materials holdings musttake place before the distbursement of any project funds to CMC.

5.15 The SIDERMEX holding company has also assigned senior staff toassist with project implementation. This includes accounting, financialand legal staff to monitor overall progress and help coordinate projectimple:aentation by the operating units and a second group to handlestrategic planning and the implementation of consultant studies relating tostrategy development, organizational structure, reporting and managementinformati-A and control systems, financial studies (includes assetrevaluations) and other restructuring tasks.

5.16 Individual detailed implementation schedules are shown inAnnexes 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 88Closing August 88 August 88 April 89Contract Award April 89 July 89 October 89Installation of Equipment October 90 July 90 November 90Commissioning January 91 September 90 February 91

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The most critical element in the installation schedule is the delivery timefor major equipment. For the major components up to 18 months is allowedand although a judicious mix of local and domestic supply may allow forsome shortening of the schedule it will require careful planning andfollow-up. The HYLSA component starts prequalification at a later datewhilst awaiting the conclusion of its debt restructuring arrangements(para 2.10). The work in the HYLSA plant, however, is expected to proceedat a faster rate than the others since much of the new equipment is alreadyon hand. Overall, the work is taking place at existing plant sites withstaff and infrastructure in place. The implementation schedule takes intoaccount numerous short outages in existing facilities for equipmentinstallation. With technical staff in place experienced in operations,engineering and construction it is expected that all work includingstart-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 theGovernment as the Borrower in this operation. NAFIN is a Government owneddevelopment finance institution, that has ample experience inadministering and onlending Bank loans in Mexico. In this operation itwill (i) borrow from the Bank and onlend to the ultimate beneficiaries(Government, SIDERMEX companies, HYLSA) the respective components of theloan (para 6.07); (ii) organize and coordinate the collection andpresentation to the Bank of the documentation concerning imports financedfrom the proceeds of the quick disbursing component of the loan(para 6.12); (iii) assist the ultimate beneficiaries in the loanadministration and accounting and facilitate the financial part of thesupervision of the project (para 6.12); and (iv) serve as a liaison in allfinancial matters between the Bank and the ultimate beneficiaries.

5.18 In addition to its direct involvement in the administration ofthe Loan, NAPIN will have a further role in assisting the small privatesteel producers. In order to avoid unnecessary duplication andproliferation of new credit lines with all their bureaucratic implications,funding for initial studies and for later investment and working capitalneeds for the small private producers would be channeled through existingand/or potential new credit lines (para 5.10). Since NAFIN is the Borrowerfor some of the existing loans and designated as the Borrower for futurecredit lines to the industrial sector, it will serve as a key link betweenthe Steel Restructuring Project and other operations.

Z. Training and Manpower Development

5.19 Each of the project components includes planned funding fortechnical assistance. The most extensive program is planned for the AHMSAoperation which is an older plant where extensive new technology is beingintroduced and where the opportunity exists for widespread retraining andreallocation of human resources. Current plans include a decrease in thepresent work force from over 21,000 to approximately 18,000 totalpersonnel. A human resource development group has been established in theplant organization to see to planning and implementation of trainingprograms including general operation and maintenance in addition to the

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training that will accompany the purchase, installation and start-up of newequipment. These programs, which include training abroad, are expected tobridge the full duration of the project. The new CMC is in the most urgentneed of technical assistance ranging from geological exploration totraining in mining operations and maintenance of all major equipment. Thiscomponent includes extensive on-site training and development.

5.20 The HYLSA operation has demonstrated excellent ongoing in-housetraining programs for both operations and maintenance. These programs willcontinue without the need for additional outside technical assistance.Specific training on new equipment is included in the estimate which mightalso include trairing by suppliers abroad, but beyond assistance in projectmanagement no general technical assistance is included.

5.21 The technical assistance components for AHMSA, CMC and HYLSAcoupled with equipment investments are expected to result in higherproductivity, yield and quality of finished products as well as lowerenergy consumption and other significant cost reductions. The integrationof these programs in operating steel plants and at operating mines requiresconstant diligence by facility management and their consultants in order toobtain the operational improvements predicted. Therefore it was agreedthat Action Plans covering these improvements will be developed by AHMSA,CMC and HYLSA, that include monitorable steps and a timetable of expectedresults. The presentation of these Action Plans is a condition ofdisbursement of the respective components under Parts B and C of theproject. The Action Plans will also include details on training programsto be undertaken and results expected therefrom. The development andsatisfactory implementation of these plans will be monitored by the Bank toensure satisfactory progress of the AHMSA, CMC and HYLSA components.

F. Environmental Issues

5.22 Restructuring at AHKSA includes rehabilitation of existing airand water pollution control systems throughout the plant. Annex 5-2,Appendix 1, provides data on the environmental situation before and afterthe project. Measured dust emissions are presently 2,517 kg/hr. With theshutdown of various facilities and rehabilitation of others, dust emissionsafter the project are expected to amount to 996 kg/hr, a reduc51on of over60% in absolute terms. The major air pollution problem stem3 I q' theobsolete Siemens Martin open hearth steelmaking shop which contributesapproximately 80% of the dust emissions. The project includes the shutdownof a major section of this operation. Final elimination of the remainingopen hearths is envisioned in a later phase for AHMSA but would not takeplace until the early 1990s. The plant will not meet Mexican andinternationally accepted norms for air pollution until that time. Waterpollution control studies and expenditure are currently budgeted and underway to bring waste water into compliance by the completion of the projectin 1991. The AHMSA Action Plan includes consultant assistance to furtherevaluate and seek specific recommendations to improve the plant's abilityto monitor environmental quality, to ensure pollution control equipment isinstalled and maintained properly, and to undertake training in pollutionabatement.

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5.23 The CMC and HYLSA operations are already in conformance withMexican air and water pollution standards and no change is foreseen as aresult of this project. Mine safety improvements including training andequipment expenses are included in the CMC portion of the project to bringabout a level of safety standards higher than currently required underMexican 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 shownin Table 6.1 below, and amounts to US$810 million equivalent. Incrementalworking capital needs are estimated at US$100 million equivalent through1991, 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 financingrequirements amount to US$1,050 million equivalent, of which US$596 millionequivalent is in direct and indirect foreign exchange costs.

Table 6.1

wIury Total Estimted Fincidng ieFWe ot

$ billion US$ million Z Base Zlioal 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 79Civil W,*k/Erection 112 12 125 91 10 101 17 10Fangiiuering/Project NMIbzgmnt 20 22 42 17 17 34 6 53TA & 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 59Price 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 0Total 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 90Total 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 _ _ _ _ _

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6.02 The base capital cost estimates for Parts B and C of the projectwere 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 shownas Annexes 6-1 through 6-4, and details are included in the project files.The base cost estimates have been checked against recent internationalexperience in steel plant rehabilitation and are based on extensiveresearch by the engineering consultants. Despite a high degree ofconfidence in the base cost estimates, a physical contingency factor ofapproximately 11X of the base cost is included as the nature of therestructuring process in an operating plant imposes constraints on detailengineering design until appropriate plant shut-down procedures are set upand erection and installation schedules are drawn up. The estimatesinclude provision for price escalation (1.01 in 1988, 1989 and 1990 and3.5% in 1991 and thereafter on the foreign cost components; the domesticinflation rates in equivalent US$ terms are taken at 2.5% in 1988, 1989 and1990 and 3.5% in 1991 and thereafter, based on a moderate inflationscenario and an expected correction for the continuing exchange rateundervaluation) in accordance with IBRD guidelines modified to take intoaccount the l'kely behavior of the Mexican peso exchange rate movementsduring the project implementation period. The price escalation andphysical contingencies amount to 23X of the base cost. No contingencieswere applied to Part A of the project, as this would finance actual cost ofimports of raw materials, steel products and other consumables up to thetotal amount of the loan allocated to that component (i.e., US$100 millionequivalent).

6.03 The cost for consultant services (including consultants' fees,travel and subsistence expenses) is estimated on the basis of the long-termnature of the major consultant service assignments. Consultantrequirements 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 thedetailed assumption discussed in Chapter VII and in the Project File. Theworking capital needs relate mainly to financing of the production build-up(finished goods and work-in-process inventories, receivibles, pre-paidexpenses) and to the reduction of short-term liabilities from the base ofend December 1986. About 40X of the incremental needs are expected to befinanced from extension of existing commercial bank credit lines. Iuterestduring construction will not be capitalized by the companies.

B. Financing Plan

6.05 The proposed financing plan for the proposed project is shown inTable 6.2 below.

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Table 6.2

Summary Financing Plan(in US$ million)

For- X of Total XLocal eign Total Required Foreign

Proposed Bank LoanPart A of Project 0.0 100.0 100.0 9.5 100.0Part B of Project 0.0 225.0 225.0 21.4 100.0Part 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 GenerationPart B of Project 266.0 148.0 414.0 39.5 35.8Part 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 loanare shown in Table 6.3 below.

Table 6.3

Financing Plan by Company

Total SIDER- Total Total GrandPart 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 75.0 400.0Local Banks (Short Term Debt) - 32.0 - - 32.0 32.0 64.0Internal 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 26.5 100.0Z 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 theSIDERNEX restructuring program; 25X would be allocated to the raw materialand steel products import component, and 19X to the HYLSA modernizationprogram. The financing plans for each of the main beneficiaries, AHMSA,CHC and HYLSA, are based on a conservative mixture of debt and internalcash generation, with continued access to existing short-ter. credit lines

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for incremental working capital. The reliance on internal cash generationhas been verified by the projected financial position which is based onvery conservative assumptions about steel prices, demand growth, marketshare, production build-up after project completion, and expected build-upof cost and quality improvements (as detailed in Chapter VII). Atwo-phased price decontrol program in line with the policy changes targetedand described in para 4.02 is expected to take place, but the effectiveimpact, particularly on non-flat products, is projected in a gradualmanner. This is due to continued excess market supply in relation to aslow projected growth in demand, and an expected reluctance by theproducers to effect substantial price increases on commonly used non-flatproducts to avoid any loss of existing market shares. Under theseassumptions, the proposed financing plan involving about 62% contributionfrom internal cash generation for the SIDERMEX group, including anestimated US$50 million budgetary transfer in 1987, and nearly the samecontribution from HYLSA cash generation, is considered feasible. In thecase of HYLSA, the financing plan is very conservative since the financialrestructuring proposals include the premise of 100% internal cash financingfor the agreed modernization program.

6.06 In view of the above and with consideration to the conservativenature of the financial forecasts, it has been agreed that:

(a) Part B of the project will be supported by the Government throughthe SIDERMEX financing plan, including adequate annual budgetaryauthorizations and when required, additional equitycontributions, in the event that internal cash generation doesnot reach the conservatively estimated levels shown, or shouldcapital cost overruns exceed SIDERMEX ability to cover anyadditional requirements through internal cash generation; and

(b) Part C of the project will be supported through the finalrestructuring agreement between HYLSA and the creditor banksreflecting the project financing plan and allowing for excesscash generation over and above that required for successfulproject completion to be used to retire existing debt to theextent that doing so would not Jeopardize HYLSA ability to covereventual project cost overruns.

C. Onlending Arrangements

6.07 The Bank loan will be made to NAFIN as borrower under guaranteeof the United Mexican States, on standard World Bank terms. NAFIN willonlend funds in the following manner:

(a) Part A: Funds will be onlent to the United Mexican States at theBank'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; onlendingterms will be 15 years including 3 years grace.

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(c) Part C: Funds will be onlent to HYLSA on the same terms as forPart B above.

The foreign exchange risk will be borne by the beneficiaries: Government,SIDERMEX, AHMSA, CMC and HYLSA. The coverage of risks relating to foreigncurrency pooling as well as reimbursement for commitment fees will berecovered by NAFIN through the 10% premium applied to the lending rate fromthe Bank.

6.08 The Project Agreements with each of SIDERMEX, CMC, AHMSA andHYLSA have been agreed along with the proposed content of the SubsidiaryLoan Agreements between these firms and NAFIN. The signing of theseagreements are conditions of disbursement of Parts B and C of the loan.

D. Procurement

6.09 The main project beneficiaries are now completing the packagingof their proposed investment programs so that the packages are technicallycoherent and permit the main equipment suppliers to provide the necessaryperformance guarantees. The major packages would include supervision oferection/installation by the supplier in order to ensure satisfactoryperformance, and may include in some cases, "limited turnkey" bids coveringengineering and erection/installation. By grouping packages into the majorplant areas (hot strip mill, cold rolling mills, steelmaking shop, etc.),the steel plants would be able to minimize erection scheduling conflictsand downtime of existing production runs.

6.10 International competitive bidding (ICB) procedures under Bankguidelines will be used for procurement of all goods and equipment expectedto exceed US$0.5 million in value to be financed under Parts B and C of theproject except as noted below. All ICB investment packages valued aboveUS$2.0 million will be subje^t to prior Bank review and approval. Forcontracts valued below US$0.5 million, procurement will be carried outthrough International Shopping (IS) with price quotations from at leastthree foreign suppliers from at least two foreign countries. The aggregatevalue of these contracts should not exceed US$10.0 million. Directpurchasing or quotation from two or more identified suppliers will bepermitted for spare parts or where proprietary technology is involved foran aggregate amount not to exceed US$23.0 million. Finally, LimitedInternational Bidding (LIB) will be permitted when the equipment or goodsto 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/orinstallation contracts. The standard preference margins of the lower ofthe tariff level or 15X for goods of domestic origin will be allowed underICB procurement. Consultant services will be procured using Bankguidelines. Terms of reference have been agreed in advance for theproposed project management consultancies and for the strategic studies andshortlists have been approved by the Bank. Procurement of goods andsupplies under Part A of the project will follow existing Bank practicefor policy-based lending. Contracts expected to exceed US$5.0 million invalue will follow ICB procedures. Other contracts will follow the normalprocurement procedures of the purchaser, which are satisfactory. Theprocurement arrangements are summarized in Table 6.4 below.

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Table 6.4

Procurement Arrangements(US$ million)

ICB LIB/IS LCB Other TotalParts B and C a/Equ.pment & Spares 316 41 95 56 508

(Bank Financed) (210) (30) (23) (263)Civil Works/Erection - - 124 - 124Engineering/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 capitaland taxes and duties.

ICB procurement under Bank guidelines for Parts B and C of the projectamount to a total of US$316 million or 45% of total expenditures andEquipment and Spares contracts financed from the US$263 million Bankportion amounts to US$210 million or 80Z of these contracts. LimitedInternational Bidding and International Shopping amount to 6% of totalexpenditures, with local competitive bidding, direct purchase andconsultancy 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 isshown in Table 6.5 below:

Table 6.5

torn ianirn

Part Pabt Part X of Z of ReudituresA B C Total Total To Be PFluOSd

I. Raw ?tedals & OtherEUiLble 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 cenditwesand 100% of locaaqp ditures (ex-faty)

IIL Cauultant Servics - 21.0 3.5 24.5 6.0 100iv. 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 andpreparation and submission of withdrawal applications under Part A.

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Disbursement of Part A of the project would be against 100% of foreignexpenditures of eligible imports defined in Annex 5-1 and would be based ona Statement of Expenditure from the Banco de Mexico detailing individualtransactions in each relevant period in respect of eligible imports,together with a Certification from the Banco de Mexico of payment of theamounts involved and of their eligibility under the loans Applications forwithdrawal will be consolidated and submitted in amounts of not less thanUS$1 million. Retroactive financing for expenditures incurred afterNovember 1, 1987, up to a maximum of US$20 million has been agreed. As allprior conditions for release of tranche 1 (US$50 million) have beenfulfilled (i.e. elimination of ORPs and adjustment of prices in realterms), tranche 1 will be available for disbursement at loan effectiveness.

6.13 For disbursements under Parts B and C of the project, a specialaccount will be opened in a bank acceptable to the World Bank, with aninitial deposit of US$20 million, representing an estimated four months ofBank-financed expenditures on Parts B and C of the project. As SIDERMEX,AHMSA and CMC have already begun project implementation and as eligibleexpenditures for urgently needed maintenance spare parts have beenauthorized 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 accountwill be audited annually in accordance with Bank guidelines. Disbursementswill be fully documented, except for contracts valued at US$2.0 million orless, for which Statements of Expenditure will be accepted. Thedocumentation for such expenditure will be retained by the SIDERMEXbeneficiaries and by HYLSA and will be made available for periodicinspection 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): completeelimination of price controls on all remaining steelproducts and elaboration of a Global Steel Sector PolicyStatement; an additional condition, reduction andequalization of steel tariffs at 25% or less, has alreadybeen fulfilled.

(b) Part B of the Project

(i) signature of the subsidiary loan agreements, acceptable tothe Bank, between NAPIN and each of SIDERMEX, AHMSA and CMC;

(ii) completion of the CMC reorganization and restructuring andestablishment and staffing of the CMC Project ManagementTeam; and

(iii) the development of an agreed Action Plan for AHMSA and CMCbased on specific monitorable levels of operationalimprovement and their timing throughout the project.

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(c) Part C of the Project

(i) signature of the subsidiary loan agreement, acceptable tothe Bank, between NAFIN and HYLSA;

(ii) satisfactory formalization of the HYLSA RestructuringAgreement with creditor banks incorporating the projectfinancing plan; and

(iii) the development of an agreed Action Plan for HYLSA based onspecific monitorable levels of operational improvement andtheir timing throughout the project. -

It was agreed that the Government must continue vo make piogress in theoverall Steel Sector Reform Program (para 4.02) that is satisfactory to theBank. To this end it was specifically agreed and the draft legal documentsreflect as covenants maintenance of the price liberalization and tradepolicy programs along with annual review and agreement by the Bank with theSIDERMEX investment program.

6.15 The estimated schedule of disbursements of the proposed Bank loanof US$400 million, taking into account a realistic schedule for procurementof all the proposed equipment packages, and the disbursement profile ofrecent IBRD projects in the Latin America and Caribbean region is shown inAnnex 6-4 and summarized in Table 6.6 below. The loan is expected to beeffective 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 14.51989 108.8 27.2 166.9 41.71990 110.4 27.6 277.3 69.31991 86.8 21.8 364.1 91.11992 26.4 6.6 390.5 97.71993 9.5 2.3 400.0 100.0

The loan is expected to be fully disbursed at the end of FY93 (i.e., byJune 30, 1993.

F. Auditing

6.16 Annual financial audit reports by independent auditors acceptableto the Bank would be submitted by the project beneficiaries not later thansix months after the close of the financial year including annual audits ofStatement of Expenditures.

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VII. FINANCIAL EVALUATION

A. Assumptions Used and Forecast of Production Costs

7.01 The proposed policy changes in the restructuring program aredesigned to benefit the entire Mexican steel sector. The assumptionregarding steel prices is that domestic prices gradually reach CIF pricelevels of equivalent imported products by 1990. This scenario isconsistent with the major policy reforms regarding elimination of internalprice controls and substantially more conservative because it does notinclude any benefit from tariff protection. The pricing policy changeresults in an average increase of selling prices (in constant terms) ofabout 8% on flat products and about 25% on non-flat products. Sincenon-flat products are substantially below CIF levels at the present time(i.e., prior to completion of the agreed price decontrol actions), themajor benefl.ciaries of the policy change are the non-flat producers, whoare mainly in the private sector. The non-flat producers include theprivate sector companies - HYLSA (Puebla and Apodaca), the mini-mills andrerollers - as well as the SIDERMEX companies, SICARTSA I and, with reducedparticipation in non-flat products, AHMSA. The financial benefits of thepricing change on the flat product cperations of AHMSA and HYLSA aremarginal (para 7.17) when compared with the significant financial benefitsthat result from the proposed investment program - higher output yields,improvements in product mix, and lower production costs. The combined flatand non-flat price changes allow an average increase of about 11.0% inAHMSA's selling prices, as the product mix is predominantly in flatproducts (84% of total product volume). Since HYLSA's non-flat productswill account for about 40% of total (flat and non-flat) product volume, theimpact of pricing policy changes will be slightly more favorable for thecompany; the pricing policy change results in an average increase of about15%.

7.02 The main beneficiaries of the investment portion of therestructuring are the flat producers - AHMSA and HYLSA. The major goal ofthe investment program is to strengthen and improve AHMSA's and HYLSA'scompetitive position in flat products, and allow them to produceinternationally competitive flat products with substantially lowerproduction costs. The investments will also result in debottlenecking ofthe production process which will bring about higher sales volume with noexpansion of production capacity. Lastly, the capital program will allow ashift in product mix to higher-quality and hence higher-value products.The above improvements in operating performance (together with the policychanges) will favorably impact the key variables that determine AHMSA's andHYLSA's profitability - output prices, sales volume and production costs.

7.03 An extensive analysis of the expected financial benefits of theproposed investment programs, and of the expected changes in financialposition and performance of the two major steel operating companies hasbeen carried out along with a separate analysis of the financialperformance of CMC. The projections are carried out in current US$equivalent terms through 1992, when the project is completed and fullyoperational, and in constant terms thereafter.

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7.04 Table 7.1 shows the unit production costs before and after theimplementation of the investment program. Reductions in variable cost as aresult of the program are due to improvements in yield, reductions inrejects, lowering of energy costs, improvements in maintenance and overalllabor reductions. A shift in product mix along with better capacityutilization after the debottlenecking efforts also contributes to alowering of fixed costs.

Table 7.1

AHMSA - Impact of Total Investment on Cost Structure a/(in constant 1987 US$/tonne)

Before AfterProduction Costs Investment Investment

(1987) (1993)Total Materials 54.86 53.92Total Energy 51.19 49.07Other Variable 67.91 62.83Variable Labor 14.90 14.10

Total Variable 188.86 179.92Total 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 rolledand tin sheet products.

In addition to the reduction in the level of production costs, two factorsaccount for the favorable impact on AHNSA's sales profitebility broughtabout by the investment program. The first is the shift So a higher valueadded product mix and the second is the improvement in product quality thatallows for the recoupment of certain profits that had previously been lostin the sale of lower-priced second grade material. The cumulative impactof the implementation of the investment program and pricing policy changescan be measured by analyzing the Increase in gross profit (sales less costof sales except depreciation charges) between the years 1987 and 1993. Asshown in Table 7.2 the AHMSA investment program accounts for nearly 69X ofthe increase in gross profit between 1987 and 1993.

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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 345Sales 696.4 951.7 255.3Cost of Sales 463.4 480.8 17.4Gross Profit 231.2 470.9 237.9

Increase in Gross Profit due to:1. Increase in volume of products sold 35.42. Reduction in costs 57.43. Change in product mix 50.54. Improvement in quality 20.1

Total attributable to investment program 163.45. Increase in average selling price 74.5

Total increase 237.9

7.05 HYLSA's financial performance in recent years has been adverselyaffected by the company's heavy debt burden (para 2.10) which precluded anymajor capital investment program. Since the flat products division whichaccounts for 62% of HYLSA's installed capacity and 100% of flat productproduction is 45 years old and has no continuous casting, there has been anerosion of market share and a contraction of profit margins in recent yearsdue to inadequate quality and rising costs. A second problem for HYLSA isthat its major source of iron ore, the El Encino mine, is facing depletionof its reserves. The financial restructuring plan between HYLSA and itscreditor banks and financial institutions (para 2.10) enables the companyto proceed with the major strategic investment program described inpara 5.09. The major financial benefits of the two stage investmentprogram are as follows:

(a) a change in product mix through the installation of a newpickling 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 arisingfrom rehabilitation of the hot strip mill; and

(e) lower production costs due to the installation of the continuouscaster and the consequent improvement in slab yields.

HYLSA is also developing a new iron mine (Cerro Nahauti) that will have alimited life of 12 years and will supplement production from the older El

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Encino mine. This mining investment is viewed as an intermediate step thatwill allow HYLSA time to develop a more comprehensive plan for theacquisition of future raw materials. The financial impact of thisinvestment is taken into account in the cash flow analyses. The totalimpact of HYLSA's investment programs on production costs is set forth inTable 7.3. The higher materials cost result from higher levels of scrapsteel 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 AfterProduction Costs Investment Investment

(1987) (1995)

Total Materials 63.85 65.32Total Energy 52.53 51.11Other Variable 47.09 45.94

Total Variable 163.47 162.37Total 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 rolland tin sheet products.

B. Financial Projections

AHMSA

7.06 The income statement set forth in the Project File and summarizedin Table 7.4 below presents AMHSA's operating results for the projectionperiod. Sales are estimated to increase from US$696.4 million in 1987 toUS$951.7 million in 1993, equivalent to an average annual growth rate of5.3%. This increase reflects the combination of product mix changes,increases in selling volumes due to rise in demand and the projectedaverage 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 insales during the 1987 to 1990 period. The decline in profit margins after1990 reflects the conservative pricing assumptions underpinning theprojections (sales do not reflect any adjustment for inflation while costsare escalated at the domestic inflation rate) rather than any deteriorationin profitability. The cumulative effects of the improving price-coststructure are reflected in the net income ratio that shows the relationshipbetween after-tax profits and sales. This key index of profitabilitysteadily improves during the projection period, from 2.5% in 1987 to 8.5%in 1993.

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Table 7.4

AHHSA - Financial Projections(in current USM million)

18 1988 1989 1990 1991 1992 1993

Sales (Constant 1987 US$) 696.4 687.4 793.8 881.3 930.0 940.7 951.7Profit after Tax 17.4 25.2 56.9 65.8 70.0 56.4 80.5Internal Cash (Before Interest) 166.0 162.7 192.1 218.4 220.5 206.5 228.8Debt Service 115.1 95.1 81.4 59.2 46.0 48.8 46.9EBIT/Sales (X) 15.8 15.8 19.9 18.6 17.7 14.5 14.8PRT/Sales (%) 2.5 3.7 7.1 7.4 7.5 6.0 8.5Current Ratio 2.3 2.1 1.8 2.2 2.7 3.0 3.2Debt/Equity Ratio 17:83 17:83 18:82 18:82 18:82 17:83 16:84Debt 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 theprojection period is forecasting internally generated funds totallingU$499.1 m.lion. For the four years, capital expenditures aggregateUS$434.5 million and working capital requirements US$190.9 million. Inaddition, existing debt repayments for 1987 to 1990 come toUS$110.7 million. The funding requirement or the difference betweeninternally generated funds and uses totals US$237.0 million for thefour-year period. The proposed Bank project loan of US$170.0 million willcover approximately 70% of this funding need. The remaining 30% isexpected to be met through a reduction in cash balance in 1987 andshort-term borrowing from domestic commercial banks. Because of AHMSA'scurrent strong financial position (due to the 1986 financial restructuring)and post-1989 cash generation capability, the company should be able tosupport these additions to short-term debt without any adverse financialeffects. This assumption is supported by an examination of the projectedcurrent and debt service ratios (see Table 7.4). In 1990 AHMSA will beginto generate surplus funds and be able to reduce short-term debt incurredduring the previous three years. In 1992, the cash surplus is sufficientto completely repay short-term borrowings and to begin dividend payments.

CMC

7.08 In order to assure an adequate supply of raw materials forSIDERMEX's future operations, an investment program has been formulatedthat is designed to bring production from existing iron mines in the northup to their capacity, and to increase, modernize and decrease costs in thecoal mines.

7.09 The projection of CHC financial performance is included in theProject File. As CMC's output will be almost entirely transferred to thetwo SIDERMEX steel plants, the financial analysis is confined to anexamination of the operating cash flow in order to evaluate the impact ofthe produced investment program on CMC's financing needs. CHC is currentlynegotiating the ore and coa'l supply contract terms with AHMSA and SICARTSAwith a view to rendering the transfer price more fully reflective of theongoing investment and capital maintenance needs of the mines and allowing

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for efficiency incentives to ensure that the nearly sole source/sole clientrelationship that prevails does not imply cost penalties for either party.The financial restructuring that is now being undertaken will ensure thatCMC can start on its new supplier/client relationship with a satisfactorycapitalization including needed working capital. The presentation of afinancial restructuring plan for CMC, acceptable to the Bank, is acondition of disbursement of the CMC component (para 6.14). Under theproposed contractual arrangements, CMC sales revenue will be determe'-ed onthe basis of standard cost plus a margin so that any gain due to costimprovements will be reflected in the income statements of the SIDERMEXsteel companies. CMC financial forecasts, therefore, consist of cash flowprojections which show the capabilities of the mines for internal cashgeneration derived from the given gross profit margin and depreciationprovisions, and the derived external financing requirements. Internal cashgeneration results from a proposed margin of 3X to be paid by the SIDERMEXsteel companies on total production costs (including depreciation andfinancial charges) of the CHC products. The project investments totalUS$181.0 million (including incremental working capital) over four years1987 to 1990. Over the same period, an additional US$51.0 million isscheduled for replacement investments. Out of the total four year capitalspending program of US$232.0 million, US$50.0 million would be financedfrom the proposed Bank loan and US$25.4 million out of budgeted Governmentfunds in 1987 and 1988. The remainder would be financed through internalcash generation and addition to short-term debt (para 6.05).

HYLSA

7.10 Table 7.5 below summarizes the projected operating results forHYLSA 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 sellingvolumes and substantial change in product mix attributable to theinvestment program at the flat products division, and the increa.e inaverage selling prices arising from the impact of pricing policy changes(para 7.01). The favorable impact of the investment program is seen by theincrease in earnings before taxes and interest margin (EBIT) which expandssharply in 1989 and in 1992 because of lower operating costs. The sharpdrop in profit after taxes in 1993 reflects the end of carried-forwardlosses resulting in start of income tax payments in that year. Thecombined beneficial impact from the modernization program (higher salesrevenue and lower production costs) and the financial restructuring plan(lower financial charges) as well as a lower level of SGA expense inrelation to sales are reflected in the final profit ratio, net income tosales, which increases between 1987 and 1993 from 3.2% to 10.71.

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Table 7.5

HYLSA - Financial Projection(in current US$ million)

1987 1988 1989 1990 1991 1992 1993

Sales (in Constant 1987 US$) 408.0 449.2 547.0 578.9 572.7 696.4 751.6Profit after Tax 13.0 23.5 64.1 65.3 55.8 123.2 80.4Internal Cash (Before Investment) 108.6 106.7 161.6 178.6 164.2 234.8 184.2Debt Service 96.4a/ 56.1 63.7 66.0 92.0 198.2 151.8EBIT/ales (X) 19.7 16.8 22.1 21.0 19.7 25.9 26.9PAT/Sales (X) 3.2 5.2 11.7 11.3 9.7 17.7 10.7Current Ratio 4.5 2.7 3.4 1.9 2.0 2.2 2.4Debt/Equity Ratio 69:31 65:35 59:41 55:45 52:48 42:58 36:64Debt 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 theproject period a total funds requirement of US$690.5 million. The bulk ofthis is for capital expenditures which aggregate US$454.6 million.Approximately US$278 million of investment spending is for the proposedproject investments in flat products modernization and US$30.0 million forthe new Cerro Nahauti mine. There are also additional working capitalrequirements of US$46.6 million and debt repayments of US$189.3 million forthe period. Internally generated funds aggregate US$406.4 million for theperiod 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 milliondebt-equity swap associated with the restructuring plan, reduce the cashrequirement to approximately US$132 million. The proposed Bank projectloan of US$75 million will cover approximately 60S of this funding need.The remaining 401 is expected to be met through reduction in cash balancesand modest short-term borrowings.

7.12 An examination of HYLSA's projected capital structure as well askey financial ratios indicates that the company should be able to handleits future debt service. This includes not only its existing debt that hasrecently been rescheduled but also the Bank project loan and the additionalshort-term debt used to fund operating deficits. The current ratio neverfalls below 1.9 during the projection period (1987-93), an indication thatthere Is sufficient current asset coverage to warrant the use of short-termdebt to fund operating cash deficits. The debt-equity ratio (seeTable 7.5) which is 69:31 in 1987 (year end) improves steadily throughoutthe 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 HYLSAshould generate adequate financial resources to meet its future debtservice requirements. As shown in Table 7.5, beginning in 1988, MYLSA'sdebt 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.

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However, since the repayment schedule used in the projection reflectsmanagement's strategy to reduce HYLSA's indebtedness as rapidly aspossible, considerable financial flexibility exists because the mandatorydebt amortizations are significantly lower.

C. Financial Covenants

AHMSA

7.13 To ensure the maintenance of a sound financial position forAHMSA, the subsidiary loan agreements between NAFIN and AHMSA will providefor the following: (i) the company will maintain a current ratio of notless than 1.2 and a debt/equity ratio not greater than 67:33; and (ii) thatthe company will not incur additional debt if to do so would cause thecompany debt/equity ratio to exceed 67:33 or its projected debt servicecoverage to fall below 1.5 times.

CHC

7.14 Since CMC is dependent on the SIDERMEX steel companies for itssales, the project description includes the establishment of a standardcost system on which pricing will be based. The project agreement with CMCprovides for an annual rev:.ew by the Bank of the sales agreements betweenCMC and the SIDERMEX steel companies. The purpose of this review would beto adjust the margin on total costs (paid by the steel companies) so as toinsure that CMC has sufficient funds to meet its financial requirements,including capital expenditures and debt service, which has been included asspecific covenants in the subsidiary loan agreements.

HYLSA

7.15 The subsidiary loan agreements between NAFIN and HYLSA willprcvide for financial covenants including maintenance of working capitaland debt-equity levels, limitations on dividends and restrictions on theuse of surplus funds. These financial covenants will be related to andconsistent with the financial covenants contained in the debt restructuringagreement between HYLSA and its creditors (para 2.10). Satisfactoryformalization of the Agreed Term Sheet and Financial Restructuring Plan forHYLSA to incorporate the agreed financing plan for Part C of t projectand due execution of the Agreements with HYLSA's creditors are conditionsprerequisite 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 cashflow basis for the AHMSA and HYLSA investment programs are 32.7% in thecase of AHMSA and 17.5% for HYLSA. The substantial difference in thefinancial rates of return reflects primarily the present difference inoperating performance of the two companies. In general, HYLSA has beenachieving better capacity utilization, higher yields, better laborproductivity and lower production costs. As a result, the margin for

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improvement is considerably smaller for HYLSA than it is for AH4SA.However, without the proposed. investment program, HYLSA's performance wouldshow a significant deterioration over the next five years as its ability tomeet the quality demands of the flat products market will be significantlyworsened. At the same time, its relative competitiveness to AHMSA wouldalso suffer greatly. In order to test the key assumptions a sensitivityanalysis was performed with respect to output prices, exchange rates andsales volume, one at a time (Table 7.6).

(a) Sensitivity to Price Changes. The base case financial rates ofreturn assume that domestic steel prices reach CIF levels by1990, but never rise above CIF levels. The CIF level and priceequivalents are based on a weighted average of FOB prices inearly 1987 for steel exports from Japan, EEC, Brazil and SouthKorea. Two assumptions were tested with respect to pricing. Inthe first case domestic prices rise due to improved quality andreach a level of CIF plue 5.0% by 1990 and continue at this levelthrough the projection period. In the second case prices areheld at the present level in order to isolate the returnsattributable to the investment program.

(b) Sensitivity to Exchange Rate. The base case exchange ratescenario is for a continuation of the present undervaluation ordiscount from purchasing power parity of the peso in relation tothe US dollar. In early 1987 this was approximately 37% and thebase case assumes that future peso-dollar exchange rate movementswill follow the Mexican inflation rate, thereby preserving thepeso undervaluation. Sensitivity was tested on a reduction inundervaluation of the peso of 10% and 20% against the US dollar.The recent sharp devaluation of the peso at end-1987 wouldimprove the financial and economic returns on the project, andenhance the financial results, since product costs are lowercompared to equivalent landed prices, thereby providing higheroperating margins. This, in turn, would reduce the downside riskin event of a future revaluation.

(c) Sensitivity of Sales Volume. Incremental sales volumes (in termsof 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 19.3Prices stay at current levels 27.7 14.8

B. Revaluation of Peso by 10% 29.1 15.6Revaluation of Peso by 20% 24.7 13.2

C. Decrease in incremental production volume of 10% - 15.6Decrease in incremental production volume of 20% 25.9 -

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CMC

7.17 The calculation of the financial rates of return for CMCinvestments have not taken into account incremental benefits but only costdifferentials between two cases - one with the investments being made andone without the investments. The rate of return for the coal mines is46.0%, for the iron ore mines 52.0%, and for the total project 50%. Thenet present values at 15% discount rate is US$87.3 million for the coalmines, US$130.0 million for the iron ore mines and US$231.8 million for thetotal project.

VIII. ECONOMIC EVALUATION AND RISKS

A. Assumptions

8.01 CI landed prices of steel products based on a weighted averageof FOB prices of the main exporters to Mexico, have been used in theeconomic cost benefit and Domestic Resource Cost calculations.

8.02 Full cost domestic prices have been used for domestic iron oreand coal delivered to AHMSA and HYLSA. Landed CIF prices plus internaltransport costs of imported steel scrap have been used to value steelscrap. Subsidy-free prices have been used for power and oil consumed inthe steel process. Conversion factors have been used for the rest of theinputs inclduing a shadow price factor of 0.77 for labor. Capital rentalcosts have been estimated for AHMSA's integrated plant at US$1,000/tonne ofinstalled capacity, and for HYLSA direct reduction based plant atUS$875/tonne of installed capacity for flat products; in addition, aneconomic life of 20 years and an opportunity cost of capital of 12% havebeen assumed.

8.03 The new policy framework of liberalized trade, moderate tariffsand liberalized internal prices, implies that Mexico will be a price-takerin the world market for steel products and that internal production will besupply determined. In the above context, movements in product prices areindependent of movements in domestic demand and supply. Therefore, aseparate 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 forthe investment project in AHMSA. ERR sensitivity was performed withrespect to output prices, increments in production capacity, capitalproject costs and Mexican peso revaluation, one at a time. The modal valuefor 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 incrementalcapacity or 20% increases in capital project costs both in a context of a10% reduction in output prices. Switching values for the above variablesare also shown. ERR results are most sensitive to reductions in economicproduct prices, which are exogenous variables determined in the worldmarkets. They are sensitive to peso revaluation which is a policyvariable, and they are also sensitive to incremental capacity reductions,which is variable that can be controlled within the project framework.

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Table 8.1

AHMSA: Sensitivity Analysis of Total InvestmentEconomic Internal Rate of Return (ERR)

Economic Product Prices-10 Base Case +5X

Base Case 25.3 32.3 35.6Incremental Capacity: -20% 19.9 25.8 28.7Capital Project Costs: +20X 19.9 26.1 29.1Mexican 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 modalERR 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 incapital project costs coupled with a 101 reduction in output prices.Switching values for the above variables are shown in the lower part ofTable 8.2. In the HYLSA case ERR results are again most sensitive toreductions in economic product prices. They are then sensitive to capitalproject cost variations and to fall in incremental capacity utilization.

Table 8.2

HYLSA: Sensitivity Analysis of Total InvestmentEconomic Internal Rate of Return (ERR)

Economic Product Prices-101 Base Case +5%

Base Case 10.7 14.8 16.7Incremental Capacity: -10% 9.2 13.0 14.8Capital Project Costs: +10% 9.0 13.0 14.8Mexican 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 pricevariations because in a supply determined production market revenues alwaysmove in the same direction of price changes. HYLSA results are moresensitive to reductions in incremental capacity than AHMSA's because the

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HYLSA project benefits come mainly from reduction in fixed cost byincreased use of production capacity after debottlenecking investments,whereas AHMSA's benefits come as much from reductions in average variablecosts as they come from generating economies of scale. HYLSA results aremore sensitive to increments in capital project costs than AHMSA's becausethe incremental capital cost directly affect the main source of benefits ofHYLSA, i.e., the reduction in average fixed costs. The higher AHMSA'sexpected profitability is associated with its larger scope for variable aswell as fixed cost reductions than in the HYLSA case; and with the changein the product mix from non-flat relatively low priced and inefficientlyproduced products, to flat and non-flat which both have higher prices andare more efficiently produced. Although the HYLSA ERR is highly sensitiveto downside price swings, the likelihood of such change is nowsubstantially diminished in the current steel market price scenarios. Inthe latter part of 1987 there have been substantial international priceincreases on the order of 10% to 15% particularly in the flat productcategories. This is due to reduced supply in most developed countries andalso due to the substantial devaluation of the US dollar vis-a-vis the maintrading currencies, i.e., Japanese yen and German mark.

8.07 In the AHMSA case the marginal ERR is larger than the average ERRfor the plant as a whole and therefore contributes to increase its averageprofitability. AHMSA's average ERR rises from 11% without the project to16% with the project.

C. Domestic Resource Costs and Competitive Position

8.08 The main objective of the economic analysis of the project is toascertain if AHMSA and HYLSA can be internationally competitive after theoptimization and maintenance investments are completed. This is importantboth for efficient allocation of investment and to find out if the steelindustry can have a positive supply response in the context of the tradeliberalization program that the Mexican Government is now implementing. Itis also worth noting from the beginning that the significant recent realdevaluation of the Mexican peso has improved the competitive position ofthe Mexican steel industry. We assume in what follows that the rea±exchange rate will stay at Its present level.

8.09 Table 8.3 shows that the project substantially improves AHMSA'sflat products competitive position particularly in hot coil and sheet andcold rolled products. In both cases the cost reductions come fromimprovement in production costs and reductions in fixed costs due to theproject investments. AHMSA's non-flat products competitive position isweaker. Heavy sections become marginally competitive with the project as aresult of adding rail product to that mill. The results clearly supportthe AHMSA strategy of concentration in flat products, heavy structurals andrail, abandoning progressively all other non-flat lines.

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Table 8.3

AHMSA: Domestic Resource Cost and Competitive PositionWithout and With the Project

DRC Variable Cost/Tonne Total Cost/TonneWithout With Without With Without With CIF Price

Plate 0.98 0.59 164.5 157.7 289.3 257.8 343Hot Coil & Sheet 1.03 0.64 149.8 146.3 275.5 247.9 318Cold Rolled 1.55 0.85 198.4 186.2 390.0 341.2 384Tin Sheet 0.79 0.47 314.4 303.2 535.7 480.6 722Heavy Sections 1.52 1.01 179.1 176.8 349.9 337.2 350Bar & Sections 2*70 1.52 188.1 185.9 336.3 324.5 289Wire 6.74 2.37 258.9 257.1 411,7 400.3 323

Source: Project File.

8.10 'Table 8.4 shows that the project substantially improves thecompetitive position of HYLSA. Cold rolled coil, the only non-competitiveproduct without the project, will become competitive with the project. Themajor gain in competitiveness is in the hot roll pickling line that isprecisely where the most important debottlenecking occurs. Table 8.4 alsoshows that HYLSA's improved competitive position comes mainly fromeconomies of scale generated by a more efficient and intensive use ofexisting facilities.

Table 8.4

HYLSA: Domestic Resource Costs and Competitive PositionWithout and With the Project

DRC Variable Cost/Tonne Total Cost/TonneWithout With Without With Without With CIF Price

Unpickled Hot Coil 0.8 0.75 172.8 176.3 289.4 282.8 318Pickled Hot Coil 0.83 0.71 182.8 183.8 316.5 297.4 343Cold Rolled Coil 1.05 0.94 207.8 206.8 392.4 373.5 384Tin 0.48 0.42 265.8 264.0 484.7 455.7 722

Source: Project File.

8.11 The comparison of results of Tables 8.1-8.4 indicate that AHMSA'seconomic position is relatively more improved than HYLSA's as a result ofthe project. This is due to the fact that there is more room forimprovement in AHMSA and because AHKSA is adjusting its product mix tocapture new profitable market niches, such as rail.

D. Benefits and Risks

8.12 The major benefit of the project will be to permit a deepening oftrade liberalization in the steel industry and in the downstream industriesand, thereby enable these industries to play their strategic role in the

- 46 -

development of an export oriented competitive economy. World class carbonsteel sold at competitive international prices is a key factor for abroadly based export oriented development of the capital goods andengineering industries. The decontrol of domestic steel prices, theannoun.ed trade liberalization measures and the overall restructuring ofthe steel subsector, including, in particular, the closure of uneconomicplants, will lead to efficient import competition forcing domestic steelproducers to improve quality and product mix in order to serve betterdownstream steel consuming industries. The policy changes would eliminatebudgetary transfers to the public steel sector, and indirect subsidies tothe industry as a whole, as well as provide the necessary internal fundingfor the proposed restructuring and rehabilitation of the physical plant ofthe entire subsector. The physical rehabilitation of the AHMSA, and HYLSAplants will substantially improve the competitiveness of flat products bothin terms of better quality and lower overall cost. Rationalization ofsteelmaking capacity will also result in improved plant utilization.Downstream users of flat products will be able to obtain a wider range ofacceptable quality flat products at lower cost. The rehabilitation of theSIDERMEX mines will allow lower cost exploitation of available resourcesand maintain Mexico's comparative advantages in steel production. Thetechnical assistance efforts will enable the steel producers and governmentto map out viable long-term strategies and the means to implement them.

8.13 The major risk is any delay in decontrolling steel prices whichcould seriously aggravate the financial position of the major steelproducers and induce them to ask for additional protection. Priceincreases accorded in December 1987 and January 1988 and the agreement onmonthly adjustments based on changes in the Consumer Price Index in orderto maintain steel prices in real terms until complete elimination of pricecontrols not later than December 31, 1988, substantially eliminate thispotential risk. A secondlrisk could be a reversal in the tradeliberalization program. This would retard competition from abroad, wouldpermit domestic oligopolistic pricing behavior and would not be anappropriate framework to improve product quality. The Government's ongoingcommitments under the Trade Policy Reform substantially reduce this riskunder the project. A third risk is exchange rate swings which could affectproject cost and viability. Finally, if the steel companies fail toachieve their target performance, there could also be a risk of renewedimposition of price controls and pressure from the producers for increasedtariff protection, resulting in deterioration of qiility steel supply tothe market. Government commitment to the liberaliation program,substantial physical restructuring and rehabilitation of the majorproducers along with clearer definition of future investment strategy aswell as agreements related to action plans for operating performance of thetarget companies combine to mitigate the potential adverse impact of theabove risks. The sensitivity analysis demonstrates that such swings wouldhave to be substantial before they would adversely affect the viability ofthe project enterprises.

IX. AGREEMENTS REACHED AND RECOMMENDATION

9.01 The following major agreements were reached with NAFIN, theGovernment, SIDERMEX, AHNSA, CMC and HYLSA.

- 47 -

1. NAFIN will:

(a) onlend the proceeds of the loan in the following manner on termsand conditions agreeable to the Bank (para 6.07):

(i) to Government - US$100 million for Part A of the project;(ii) to AHMSA (US$170 million), CMC (US$50 million) and to

SIDERMEX (US$5 million), for Part B of the project;(iii) to HYLSA (US$75 million) for Part C of the project;

(b) make available credits to other private sector producers as wellas administer, channel and coordinate the provision of technicalassistance services (para 5.17).

2. The Government will:

(a) support the SIDERMEX financing plan through adequate annualbudgetary authorizations, including provision of any additionalfunds that may be needed to ensure satisfactory projectcompletion (para 6.06);

(b) continue with the actions, policies and objectives summarized inthe Steel Sector Policy Letter provided to the Bank (para 4.02);

(c) maintain in effect the Steel Trade Policy Program measures,including elimination of ORPs for all steel products, andreduction and rationalization of tariffs on all steel productimports at less than 25% (para 4.02);

(d) complete and maintain in effect the Steel Price LiberalizationPolicy including monthly adjustments of domestic steel prices inreal terms leading to removal of all price controls on steelproducts by December 31, 1988 (para 4.02); and

(e) complete the elaboration of a global Steel Sector PolicyStatement by July 31, 1988 (para 4.02).

3. SIDERMEX will:

(a) see to the signature of Subsidiary Loan Agreements between NAFIN,SIDERMEX, AHMSA, and CMC for Part B (paras 6.08, 7.15 and 7.16)incorporating, in particular, the agreed financial covenants withrespect to working capital, debt service and capital structure;

(b) see to the effective reorganization of CMC and approval of itsfinancial restructuring plan (para 5.14), and the staffing of itsProject Management unit including employment of consultants forproject management assistance (para 5.11);

(c) see that AHMSA retains consultants for project management onterms and conditions acceptable to the Bank (para 5.12);

(d) see to the development of an agreed Action Plan for AHMSA and CMCbased on specific monitorable levels of operational improvement

- 48 -

and their timing throughout the duration of the project(para 5.21);

(e) not later than March 31, 1988, discuss with the Bank theconclusions and recommendations of its long-term strategy studyand thereafter implement the agreed elements in accordance withinvestment criteria, financing plans and implementation schedulesacceptable to the Bank; and review progress on implementation atleast once a year with the Bank (para 4.11); and

(f) see that an asset revaluation exercise is carried out within sixmonths after the signing of the loan documents at all SIDERMEXoperating entities on terms of reference acceptable to the Bank(para 4.12).

4. HYLSA will:

(a) complete a comprehensive financial restructuring agreementbetween HYLSA and its creditors including the agreed projectfinancing plan (para 6.06);

(b) sign the Subsidiary Loan Agreement between NAFIN and HYLSA forPart C (paras 6.08 and 7.17) incorporating, in particular, theagreed financial covenants with respect to working capital, debtservice and capital structure as reflected in the HYLSA financialrestructuring plan;

(c) name a Project Manager and retain consultants for projectmanagement on terms and conditions acceptable to the Bank(para 5.12); and

(d) develop and implement an agreed Action Plan for HYLSA based onspecific monitorable levels of operational improvement and theirtiming throughout the duration of the project (para 5.21).

9.02 The Bank will disburse funds for Part A of the project in twotranches based on the following bases:

(a) for the first tranche, at loan effectiveness (para 6.12); and

(b) for the second tranche, the complete elimination of pricecontrols on all remaining steel products and presentation of aGlobal Steel Sector Policy Statement, an additional condition,the reduction and equalization of steel tariffs at a maximum of25% has already been fulfilled (para 6.14).

9.03 Subject to the foregoing agreements, the project is suitable for aBank loan of US$400 million for 15 years including 3 years grace at theBank's standard variable interest rate.

Country Department II - Industry, Trade, Finance Sector Operations DivisionLatin America and the Caribbean Regional OfficeFebruary 1988

ANNEX 2-1- 49 - Page 1

MEXICO - STEEL SECTOR RESTRUCTURING PROJECT

The Steel Sector in Mexico

A. Introduction

1. The Mexican steel industry is of substantial size with atheoretical installed capacity at the beginning of 1986 of over 10.5 mtpaof crude steel. The SIDERMEX facility Fundidora de Monterrey SA was closedin May 1986 lowering the current capacity to just over 9.0 mtpa. Some ofthe remaining capacity, particularly at AHMSA, is in technically obsoleteand under-maintained facilities which are addressed in the restructuringproject.

2. Historically, modern steel production in Mexico began in the1940s and grew slowly through the 1950s. Aided by import substitution andprotectionist policies the annual growth of production averaged 10.2% inthe 1960s and 7.5% in the 1970s, reaching a production peak in 1981.Between 1981 and 1983 there was an 8.6% decline due to the economic crisisin the country, then a partial recovery in the last two years. Theproduction of finished steel products has remained below the 1981 leveluntil today. In 1985, Mexico occupied 20th place in the world and secondplace in Latin America for production of steel. In 1984, the steelindustry employed 88,000 people (64,000 of them workers), and it produced1.3% of the GDP and 4.2% of the manufactured export.

3. In 1986, the industry produced 7.1 million tonnes of crude steeland 5.7 million tonnes of finished steel products. In quantitative termsthe country is self-sufficient with the production and consumption of steelproducts roughly in balance during the last three years. The industry,however, cannot meet all the quality requirements of the downstream users.For example, in 1985, Mexico exported 0*4 million tonnes of mainlycommercial products, while importing 0.5 million tonnes of higher qualityproducts.

B. Steel Producers and Capacities

4. Steel mills fall into two main groups, integrated andnon-integrated producers. The traditional integrated producers produceliquid iron from coal and iron ore through coke ovens and blast furnaces,and refine the iron into the final steel composition desired in steelmakingfacilities such as open hearths or basic oxygen processes. Thenon-integrated producers base their operations on electric arc furnaceremelting and refining of steel scrap. In Mexico, the integrated categoryalso includes two steel producers (HYLSA and TAMSA) which combine the twotraditional categories in an integrated fashion, utilizing iron ore andnatural gas in the HYL direct reduction process to produce sponge ironwhich is used with steel scrap in electric arc furnaces to produce steel.

5. The industry then is comprised of five integrated steelproducers, a non-integrated private sector including 23 mini-mills ofvarious sizes, and a number of independent rerollers scattered throughout

ANNEX 2-1- 50 - Page 2

the country. Three of the five integrated plants are state owned and workunder the management and central control of SIDERMEX. They are: AltosHornos de Mexico S.A., AHMSA; Fundidora de Monterrey S.A., FMSA; andSiderurgica Lazaro Cardenas de Las Truchas S.A., SICARTSA. Totalemployment in these plants amounted to over 53,000 in 1985. The twoprivate sector integrated producers are HYLSA and Tubos de Acero de MexicoS.A., TAMSA. Total private sector employment was approximately 35,000 in1985.

6. Theoretical crude steel capacity from 1975 to present is shown inTable 1 below:

Table 1

Theoretical Crude Steel Capacity('000 tonnes)

1975 1977 1979 1981 1983 1986SIDERMEXAHMSA 2,580 3,330 3,330 3,330 3,950 3,950FMSA 980 1,500 1,500 1,500 1,500 -SICARTSA - 1 300 1 300 1 300 1,300 1,300

Subtotal 3,560 6,130 6,130 6,130 6,750 5,250

Private SectorHYLSA 1,545 1,545 1,635 1,700 1,700 1,700TAMSA 360 420 450 465 465 465Mini Mills 917 1 035 1 440 1,633 1 633 1,633

Subtotal 2,822 3,000 3,533 3,798 3,798 3,798

Total 6,383 9,130 9,663 9,928 10,548 9,048% Public 55.8 67.1 63.4 61.7 64.0 58.0

Source: SEMIP.

Theoretical capacity reached a level of over 10 million tonnes in 1982 withthe partial completion of an expansion at AHMSA. In this period SIDERMEXexpanded its rated capacity by 901 (although the expansion of FMSA tookplace while it was still in the private sector), and the private sector by35%. Overall public sector capacity grew from 55.8% to 64.0X of the totalcapacity in the country. In 1986 the FMSA facility was shut down reducingpublic sector capacity to 58.0%.

7. Production and capacity utilization for the period 1981 through1986 is shown in Table 2 below.

ANNEX 2-1- 51 - Page 3

Table 2

Production of Crude Steel and Capacity Utilization('000 tonnes)

1981 1982 1983 1984 1985 1986SIDERMEXAH1MSA 2,424 2,279 2,227 2,468 2,603 2,869FMSA 961 837 537 822 943 254a/SICARTSA 804 869 1 013 1 028 613 1,192

Subtotal 4,289 3,985 3,777 4,318 4,159 4,315CapacityUtilization X 70.0 65.0 56.0 64.0 61.6 76.7

Private SectorHYLSA 1,771 1,576 1,641 1,634 1,631 1,582TAMSA 395 383 386 343 279 232Mini Mills 1,099 1,057 1,097 1,111 1,314 1,046

Subtotal 3,265 3,016 3,124 3,088 3,224 2,860CapacityUtilization Z 86.0 79.4 82.3 81.3 84.9 75.3

Total 7,554 7,001 6,901 7,406 7,383 7,175I Public 56.8 56.9 54.7 58.3 56.3 76.1

a/ Production through March 1986. FMSA shut down operations in May 1986.

Source: SEMIP.

During this period, 1981 saw the highest production within the industry butcapacity utilization in SIDERMEX reached only 70% while the private sectormaintained higher figures over the full period. In 1986 AHMSA reached itshighest production level but only 72.6% capacity utilization. With thePhase I restructuring of AHMSA and the removal of a portion of the obsoleteOpen Hearth Steelmaking dop the theoretical capacity will be reduced toapproximately 3,500,000 tonnes. FMSA was closed by SIDERMEX in early 1986taking its 1,500,000 tonnes of capacity out of service completely.

8. HYLSA has operated at levels very close to its theoreticalcapacity for some time (over 90% since 1979). The restructuring effort atHYLSA is not expected to significantly affect its capacity since thePhase I project is aimed primarily at improving quality.

C. Production and Consumption Balance

9. As a result of the oil boom and the related high investmentactivities of both the public and private sectors, between 1976 and 1981both the demand and the production of steel grew vapidly as shown inTable 3. During these five years the apparent consumption of steel grew by85%, and the crude consumption of steel products by 100%. In 1981 Mexicoproduced 42.5% more steel and 54X more steel products than in 1976.

ANNEX 2-1- 52 - Page 4

Table 3

Production, Consumption and Balance of Steel in 1976-81(in thousands of tonnes)

1976 1977 1978 1979 1980 1981ProductionCrude Steel 5,298 5,601 6,814 7,012 7,024 7,554Finished Products- 4,038 4,225 5,157 5,784 5,930 6,209

Apparent ConsumptionCrude Steel 5,746 5,949 7,317 7,957 9,551 10,652Finished Products 4,379 4,488 5,538 6,563 8,063 8,757

BalanceCrude Steel -448 -348 -503 -945 -2,527 -3,098Finished Products -342 -262 -381 -779 -2,133 -2,547

Value ofExport (US$ million) 40 69 100 92 40 34Import (US$ million) 261 235 728 861 1,446 1,782

Source: SEMIP.

10. With the build-up in productive capability and the economiccrisis of 1982, the country became a net exporter for the first time in1983. Since then, the shifts in balance have been only ± a few percentwith the industry remaining roughly in balance as shown in Table 4.

Table 4

Production, Consumption and Balance of Steel in 1981-85(in thousands of tonnes)

1981 1982 1983 1984 1985 1986ProductionCrude Steel 7,554 7,001 6,902 7,405 7,382 7,176Finished Products 6,209 5,515 5,418 5,873 5,907 5,575

Apparent ConsumptionCrude Steel 10,652 7,998 6,182 7,098 7,552 7,068Finished Products 8,757 6,301 4,853 5,629 6,043 5,300

BalanceCrude Steel -3,098 -998 +719 +307 -170 +108Finished Products -2,547 -786 +565 +244 -136 +275

Value ofExport (US$ million) 34 73 235 281 145 271Import (US$ million) 1,782 846 301 474 309 260

Source: SEMIP.

D. Steel Products

11. The overall production, consumption and balance for the last sixyears by product group are shown in Table 5. Within product groups

ANNEX 2-1- 53 - Page 5

high-quality flat products are being imported while commercial gradenon-flat products are being exported. SICARTSA I, the main exporter,produces non-flat quality that is acceptable worldwide.

Table 5

Apparent Consumption of Steel Products('000 tonnes)

1981 1982 1983 1984 1985 1986Flat ProductsProduction 2,955 2,490 2,293 2,500 2,639 2,259Apparent Consumption 4,164 3,102 2,242 2,582 2,788 2,384- Balance -1,209 -612 +51 -82 -149 -125

Non Flat ProductsProduction 3,003 2,760 2,891 3,047 2,975 3,108Apparent Consumption 3,845 2,779 2,404 2,776 3,017 2,733

Balance -842 -190 +487 +271 -42 +375

Seamless TubeProduction 251 265 234 326 293 208Apparent Consumption 748 420 207 271 238 183

Balance -497 -155 +27 +55 +55 25

Source: SEMIP.

TAMSA, the sole producer of seamless tubing, is closely tied to theoperations of PEMEX, the Mexican petroleum producer, hence the sharpdecline in consumption. TAMSA is left with little option but to attempt toexport in a very difficult world market.

12. Flat products were produced by AHNSA, FMSA and HYLSA MonterreyDivision. These include plate, hot and cold rolled sheet and coil and tinplate. The total flat products production for the last six years is shownin Table 6.

Table 6

Flat Products Production('000 tonnes of Finished Products)

1981 1982 1983 1984 1985 1986

AHMSA 1,329 1,040 961 1,247 1,332 1,320FMSA 736 651 540 442 466 219HYLSA 890 799 792 811 841 720

Total Flat 2,955 2,490 2,293 2,500 2,639 2,259

Source: SEMIP.

ANNEX 2-1- 54 - Page 6

AHMSA has the only wide plate mill in the country. Plate produced at. FMSAand HYLSA is actually narrow heavy sheet produced on the same mills thatproduce hot rolled coil and sheet. All producers are able to produce hotand cold rolled sheet products. Tin plate is mainly produced by AHHSA withonly a small facility at HYLSA. HYLSA's production peaked in 1981 at890,000 tonnes while AHMSA attained its highest production in 1985. As isevident from the table, FMSA, mainly a flat products producer, steadilydeclined prior to its shutdown in 1986. With the shutdown of FMSA, therewill be greater opportunity for the other facilities in the country.

13. Non-flat products are produced by AHMSA, SICARTSA, FMSA, theHYLSA Puebla and Apodaca Division, and the private sector mini-mills andrerollers. Non-flat production is shown in Table 7.

Table 7

Non Flat Products Production('000 tonnes of Finished Products)

1981 1982 1983 1984 1985 1986

AHMSA 482 426 440 504 531 450FMSA 27 25 35 42 43 15SICARTSA 677 617 710 764 529 893HYLSA 614 540 520 544 547 559TAMSA 28 15 38 56 74 77Mini Mills & Rerollers 1,175 1,139 1,148 1,137 1,252 1,114Total Non Flat 3,003 2,760 2,891 3,047 2,975 3,108

Source: SEMIP.

Non-flat products include reinforcing bar, wire rod, merchant bar, andcommercial and structural profiles. SICARTSA I, which has a rollingcapacity of over 900,000 tonnes, is the largest single producer in thecountry. HYLSA is the second largest producer followed closely by AHMSAwhich also has a rerolling mill near Mexico City. FMSA and TAMSA produceonly a small quantity of non-flats with the balance in the hands of theprivate sector mini-mills and rerollers.

Country Department IIIndustry, Trade, Finance Sector Operations DivisionLatin America and the Caribbean Regional OfficeJanuary 1988

ANNEX 2-2- 55 - Page 1

MEXICO - STEEL SECTOR RESTRUCTURING PROJECT

Raw Material Supply Position

A. Background

1. At present the Mexican steel industry receives practically allits raw material supplies (iron ore, coking coal and flux) from internalsources with the exception of (i) steel scrap, most of which is imported,and (ii) occasional small quantities of coking coal or pellets forSICARTSA. Mexico's reserves of iron ore are low grade and relatively smallwhile proven coking coal reserves are larger and richer. Based on currentprojections, local supply sources would be sufficient to meet iron oredemand fully in the short and medium term and coking coal demand in thelonger term, well into the next century.

2. Production of ferrous inputs to the steel industry in 1987 isestimated at 7.7 million tonnes in the form of sinter and pellet feed,which is sufficient for the present level of consumption of the steelindustry. The open pit iron ore mines of the North currently produce2.3 million tpy, only 45% of their designed capacity, which means that theremaining supply for the northern steel mills, an additional2.4 million tpy, has to be transported by rail over distances of about1,500 km from the open pit southern mines where reserves are larger.SIDERMEX owns and operates the two northern mines and one of the mines inthe South, totaling 3.9 million tonnes, or 51% of the 1987 expectedproduction of ferrous inputs. SIDERMEX, in association with privatecompanies, also participates with 55% of the capital of another southernmine, expected to produce 2.7 million tonnes in 1987. The remaining1.3 million tonnes will come from a mine owned by a private company.

3. About 70% of the coking coal requirements of the steel industryin Mexico are met by the production of SIDERMEX coal mines near thenorthern steel mills. All the coal mines of SIDERMEX are undergroundoperations that use the long wall mining method of extraction. The productis of good quality and mining conditions are relatively easy, whichcombined with low labor and energy costs makes coking coal productionhighly competitive, although productivity levels have room forimprovement. As the reserve situation is satisfactory, with more than100 years of production at present levels, the possibility of replacing theexternal coal supplies becomes attractive.

4. While two of the southern iron ore mines remain integrated in theoperations of specific steel companies, and one is an independent outfitsupplying ore to all integrated steel mills, the northern iron oreoperations have been grouped with the coal mines of SIDERMEX into onesingle subsidiary, Carbon y Minerales Coahuila S.A. (CMC). SIDERNEX's topmanagement has manifested its intention to organize this subsidiary as anindependent, financially responsible agency, in order for it to assume theresponsibilities of operating the iron and the coal mines, as well as theflux materials.

ANNEX 2-2- 56 - Page 2

B. Iron Ore Production Centers

5. Mexico's iron ore is produced in five open pit mines: two ofthem are located in the Northeast of the country, La Perla (state ofChihuahua) and Hercules (state of Coahuila); and three in the South, closeto the Pacific coast, Las Truchas (state of Michoacan), Pena Colorada(state of Colima) and El Encino (state of Jalisco). SIDERMEX owns, throughits subsidiaries, three of these mines: La Perla, Hercules and LasTruchas It also owns 55% of Pena Colorada, whereas the remaining 45% isowned by private companies (28.5% HYLSA and 16.5% TAMSA); El Encino belongsto HYLSA. At present the total output from these mines, estimated for 1987at 7.7 million tonnes of ferrous inputs in the form of sinter and pelletfeed, suffices for the expected demand of the Mexican steel mills, however,the mines of the north currently produce only 2.1 million tpy of theestimated 4.7 million tpy demanded by the northern steel mills; theremaining 2.6 million tpy for the northern mills (AHMSA's Monclova plusHYLSA's plant in Monterrey), is transported by rail, over distances ofabout 1,500 km,from the mines in the South.

6. Despite the fact that it is a deposit nearing depletion, La Perlais currently the only mine producing high quality ore, suitable to beshipped, without a concentration process, as sinter feed for AHMSA'sMonclova steel mill (at a rate of 300,000 tpy). This ore is transported bytrain. La Perla also produces pellet feed by concentrating lower-qualitymaterial through magnetic separation and flotation processes. The pelletfeed concentrates (786,000 tonnes in 1986) are pumped as slurries toMonclova through a pipeline of 381 km. The other northern mine, Hercules,exploits tabular bodies of hematite-magnetite, which produced in 1986 only752,000 tonnes of pellet feed, or 25% of its installed capacity, and isestimated to improve its production by 30% in 1987.

7. The southern mines exploit deposits containing magnetic ores.The Las Truchas mine is integrated in the SICARTSA complex and producespellets only for the consumption of SICJARTSA. The design capacity of theconcen:rator and the pellet plant is 1.78 million tpy, approximately thesame as the volume of ferrous input required by the SICARTSA I steel mill;both plants are running close to the aforementioned design capacity. PenaColorada is a mixed enterprise involving SIDERMEX and the two rivategroups that operate integrated steel mills in Mexico. Althougrt ?enaColorado has a board in which all stockholders are represented, itsmanagement reports directly to SEMIP (Secretaria de Energia Minas eIndustria Paraestatal), and is run as an independent parastatal enterprise,except for the fact that it only sells pellets to its owners and in avolume proportional to their equity participation. The installed capacityof the pellet plant and of the concentrator is 3.0 million tpy, but until1986 it has only produced at the rate of 2.0 million tpy,because of lowdemand from its owners; in 1987 production is projected to go up to2.7 million tpy. The El Encino mine belongs to Las Encinas S.A., asubsidiary of HYLSA; because the deposit is nearing depletion (reservesshould last for four to five more years), HYLSA would like to givepreference in the supply of the ferrous inputs for its Monterrey and Pueblamills, to the pellets coming from Pena Colo ada, and use El Encino toproduce the balance to supply the demand (presently, HYLSA demands

ANNEX 2-2- 57 - Page 3

approximately 2.0-1.8 million tpy and Pena Colorada's 28.5% is570,000 tpy). The concentrator and the pellet plant located in Alzada,50 km away from the mine have a design capacity of 1.6 million tpy and areexpected to run at about 1.3 million tpy. The following table summarizesthe present supply situation of iron ore in Mexico.

Mexico Iron Ore Supply Situation, 1987Production and Capacities by Mine of Ferrous Imports to Steel Mills, 1987

('000 tonnes per year)

Installed 1987 ProjectedMine Plant Product Capacity Production

La Perla Sinter Feed 600a/ 300Pellet Feed 1500 1000

Hercules Pellet Feed 3000 2000Monclova(pellet plant) Pellets 3000 2000

Las Truchas/ Pellet Feed 1470 1500SICARTSA(pellet plant) Pellets 1785 1500

Pena Colorada Pellet Feed 3600 2600Pena Colorada(pellet plant) Pellets 3000 2600

Fe Encino/Alsada Pellets 1660 1400

a! Installed capacity of washing plant is much larger, however,constraints in the availability of reserves would make it difficult toproduce at a yearly rate higher than 600,000 tpy.

Co Iron Ore Resources and Reserves

8. Mexico's iron ore reserves are small in volume and low (34-59%Fe) in grades. At current consumption iron ore supplies would besufficient for about 15 years, although mention must be made of theexistence of prospects, which are likely to increase reserves ifexploration efforts are stepped up. Production of ferrous inputs in 1987is estimated at 7.7 million tonnes in the form of sinter and pellet feed,which is sufficient to satisfy the Mexican steel industry.

9. The La Perla deposit occurs in a flat lying tabular body ofhematite-magnatite. As of end of January 1987, geological reserves wereestimated at 16.12 million tonnes of which 9.64 million tonnes areconsidered exploitable. Additionally, there are numerous stockpiles ofmaterial, most of which date back to when the concentrating facilities werenot built yet and only lump ore or sinterfeed was produced. Total reservesat La Perla (mine plus stockpiles) are reported as 17.96 million toxnnesaveraging 57.5% Fe, 0.38% P and 0.07% sulphur.

ANNEX 2-2- 58 - Page 4

10. The ore at Hercules occurs as tabular bodies ofhematite-magnetite with minor limonite and jarosite; proven reserves areestimated at 40.6 million tonnes averaging 54.9% Fe and 0.66% P, inaddition to which there are 64 million tonnes of probable and possiblereserves, with grades averaging approximately 55% Fe; the proven reservesare found in five ore bodies located at a distance of less than 3 km to thecrusher, out of the fourteen ore bodies identified in the area; the twomain ore bodies, which are now under exploitation, have been drilledadequately (17,000 m. of core drilling); exploratory work remains to bedone in the twelve other identified ore bodies in the area.

11. The deposits in the South consist mostly of magnetic material;the Las Truchas mine, where the exploitation rate is 2.6 million tpy ofore, has 97.8 million tonnes of proven ore containing 51.4% Fe, including75.4 millioi tonnes of magnetic ore with 39.5% magnetic iron; probable oretotals 45.6 million tonnes, including 37.2 million tonnes of magneticmineral. Because the SICARTSA II expansion includes plans for agravimetric and flotation concentration plant (in addition to a magneticplant), the oxidized material is included in the reserves estimate as ore;however, further work has yet to be done in the SICARTSA II project inorder to define if facilities to treat oxidi_ed ore are justified. TheExploration and Geology Department of SICARTSA is also planning to do someexploratory work outside the area of the Las Truchas district; six areaslocated within a 200 km radius of Lazaro Cardenas have been selected forthis work, based on anomalies found on previous aeromagnetic work. PenaColorada shows mineable reserves of 149.1 million tonnes with a grade of34.2% magnetic iron, extraction is projected at 6.3 million tpy for thenext five years; in addition to the area under exploration, whereexploration continues, two areas outside the Pena Colorada district, but inthe same region, have been identified and selected for further exploratorywork.

12. El Encino has proven reserver of 12 million tonnes of magneticore averaging 51% Fe of which 90% are mineable, and the extraction rate is1.6 million tpy. The deposit has been thoroughly studied and the chancesof incorporating additional ore are remote. The stripping ratio iscurrently 9 to one in an operation in which the walls of the pit are verysteep (56), thus the economic life of the mine is estimated at 4.5 to 5more years. Hence, the short life of EL Encino and the need to find analternative source of supply of iron ore or ferrous inputs, is a centralissue for the management of HYLSA. The Cerro Nahuatl deposit is now beingopened as a new source of iron ore in order to replace El Encino; CerroNahuatl is located some 30 km away from Alzada (where the existingconcentrator is located), and is a low grade deposit with 31.8 milliontonnes of proven reserves averaging 31.8%.

D. Coking Coal Production Centers

13. Of tlhe eight known coal bearing geologic provinces in Mexico, twoappear to have potential for economic exploitation of coking c al, onelocated in the state of Coahuila and one in Tezoatlan-Mixtepec, Oaxaca. Atpresent, mining operations exist only in the former.

ANNEX 2-2- 59 - Page 5

14. SIDERMEX, the main producer of coking coal, operates nine minesand is developing two new mines in the Sabinas and the Saltillito districtsin Coahuila; all of these properties were initially owned and operated byAHMSA and FMSA and were integrated in their steel operations. Theseparation of the mines from the management of the steel mills ia recentand dates back, in the case of the mines owned by FMSA to creation of RawMaterials Division of SIDERMEX in 1984, and in the case of the mines ownedby AHMSA, to 1986. The production of the nine coal mines of SIDERMEX in1986 totalled 2.4 million tpy of washed coal, and contributed to supply theMexican demand for coking coal, as follows:

Supply of Coking Coal to the Mexican Steel Industry

Year 1986tonnes x 106 Washed Coal

Production from SIDERMEX Mines 2.4Comision de Fomento hinero (CFM) 0.5Imported 0.4

Total Demand for Coking Coal 3.3

In order to produce 2.4 million tpy of washed coal, the mines extracted atotal of 5.7 million tpy run of mine (ROM) of coal with ash content varyingfrom 40% to 55%, which were fed to four washing plants that operated with ayield of 44% to produce 2.4 million tonnes with 15% ash content.

15. The supply coming from the Comision de Fomento Minero (CFM) canbe broken down in 450,000 tonnes of its own mines, which are close todepletion and working with very high stripping ratios, rendering thissource as expensive and unreliable, and 50,000 tpy produced by small minersand marketed through the CFM. The imported coal was brought In by theLazaro Cardenas port and was consumed at SICARTSA.

B. Coal Resources and Reserves

16. Because the supply coming from ChM is considered unreliable andexpensive and because the imported coal is more expensive than the Mexicancoal, an adequate supply of coking coal to the steel mills will requirethat the volume of washed coal produced by SIDERMEX increase from thepresent level of 2.3 million tpy to approximately 3.0 to 3.3 milliontpy. As can be seen, the projected total figure is very similar to thepresent consumption of washed coking coal; this is explained by the factthat most of the growth in the production of steel in Mexico will beabsorbed by the SICARTSA II mill which uses gas instead of coke because itsprocess is one of the direct reduction and not blast furnace. Theadditional volume can come from either improved productivity of theexisting mines or from the expansion of the coal operations in Coahuila.

17. The coal region of Coahuila covers an area of approximetely13,000 km2 and includes several districts, which can be grouped accordingto the type of coal that each one is known to have, in two well definedsubregions, the southern subregion has a subbituminous coal of medium to

ANNEX 2-2- 60 - Page 6

low volatility (19-22%) which, except for its high ash content (40-55%) andsulfur content (0.9-1.0%), has very favorable characteristics for theproduction of coke; the northern subregion, known as Rio Escondido, has asubbituminous coal of high volatility and large flame with very poorcharacteristic for the production of coke. The former coal is used tosupply the Mexican steel industry and the latter for the generation ofelectricity. Proven geologic reserves of coking coal in the Coahuilaprovince total 861 million tonnes, out of which 562 million tonnes, or 65%of the total proven reserves, have been assigned to SIDERMEX. Thefollowing table summarizes the equivalences of the SIDERMEX reserves:

Equivalents of SIDERMEX Coal Reserves

Item Factor (%) Tonnes ('000)

Geologic Reserves 561,546Recoverable Reserves 54.8 307,725Washed Coal 41.4 127,398Coke 74.0 97,274

The above mentioned reserves have been proven through diamond drilling doneon a grid with 500-1,000 m centers; the areas close to faults or thosewhere important developments were going to be made had additional drillingdone. The recovered cores were used to identify the exploitable width ofthe seam at the different locations, by determining in the laboratory theash content, the coal content and the washing characteristics o' the coal.The information thus obtained has been closely consistent with the19.2 million tonnes of washed coal extracted during the last seven years.Hence the stated reserves are considered to be reliable.

18. The Tezoatlan Mixtepec province in the state of Oaxaca has beensubject only to preliminary geophysical and geological work. Furtherexploration work has been programmed by SIDERMEX. The interest of thesedeposits lies in their location, approximately 300 to 400 km away fromSICARTSA and 150-200 km from the sea. Given the fact that the Coahuilaregion is 1,600-1,700 km away from SICARTSA an interesting reduction in thefreight costs, in the supply of SICARTSA, appears as an attraction for thenew area.

F. Organization and Management of CMC

19. Areas of Responsibility. CMC has been made responsible for theoperation of the two iron mines in the North and of all the coal mines ofSIDERMEX. The iron mines of the South, in which SIDERMEX hasparticipation, will continue to operate as previously, Las Truchas as apart of the SICARTSA complex and Pena Colorada as an independent company.According to a scheme which has been agreed in principle but which has yetto be defined in detail, the role of CMC in Las Truchas would be tbat ofthe owner, and SICARTSA's that of the operator; a contract would be signedspecifying that CMC would do sll the planning, define the technicalparameters, and later would control the operation. SICARTSA would executethe plan as defined by CMC. The different treatment of the northern minesvis-a-vis the southern mines is explained by the geographical distances and

ANNEX 2-2-61 - Page 7

by the different results obtained in the past; whereas the Herculesoperation was allowed to be run down, the continuity in the supply ofsinter feed has been endangered and the maintenance of equipment has beenallowed to slip, Las Truchas supplied its mill satisfactorily.

20. The situation of Pena Colorada is more complicated. It is anenterprise with a 45% share of private capital and 55% state participationbelonging to SIDERMEX. However, the Secretaria de Energia Minas eIndustria Paraestatal (SEMIP) has decided that Pena Colorada will operateas a separate parastatal company, reporting directly to SEMIP. This hasrendered the Board of Pena Colorada useless, since management can and doesbypass it, coordinating directly with SEMIP. The production of this unitis sold to the owners in proportion to their participation in the capitalof Pena Colorada, based on the reserves of the deposit (SIDERMEX 55%, HYLSA28.5%, TAMSA 16.5%). Because the owners of Pena Colorada include all theintegrated mills in Mexico (the rest are mini-mil'ls using scrap as rawmaterial), there is no additional market in Mexico for the pellets itproduces; no effort has been made to export, not even in an incrementalbasis, because it is felt that the benefits would be minimal, if at all,and it would deplete a scarce resource for Mexico. The owners are chargeda full cost price with the result being an over equipped operation, withlittle incentive to reduce operating costs and investments. Equipment hasbeen installed that enables Pena Colorada to increment its production,although operation has been running at only 70% of the original designcapacity of the concentrator and of the pellet plant. The installation ofa preconcentrator designed to raise the grade of ore fed to theconcentrator by four to eight points, places the concentrator in a positionto produce above 3.5 million tpy, while the capacity of the pellet plant is3.0 million tpy and production has been at a level around 2.0 million tpy,the mine does have the equipment to supply the additional ore.

21. A situation of excess production of concentrates at Pena Coloradawould clearly interest HYLSA, because it has a pellet plant at a shortdistance and a mine that is getting depleted; TAMSA does not have pelletplant and SIDERMEX could prioritize the increased production of pellets atMonclova in order to reduce its freight costs from the transportation ofpellets from Pena Colorada to Monclova.

22. Once the decision to take away the Northern mining operationsfrom AHMSA and FMSA and to make CMC responsible for them was made, theissue of where to separate the operations between AHMSA and CMC wasraised. The resulting definition has been essentially geographic; alloperations located in Monclova (the pellet plant and the steel mill) arerun by AHMSA, while those away from Monclova (the mines, the concentratorsand the slurry pipeline) are run by CMC. Whereas in the cases of coal andsinter feed this decision raises no problems, because both of thesematerials can be stored inexpensively either at the washing plant patio, asa finished product, or at the steel mill, as a raw material; the pellet

ANNEX 2-2- 62 - Page 8

feed concentrates pumped through a slurry pipeline is different. Thedecision Itken to have the Monclova pellet plant under AHMSA's management,implies a separation of responsibilities of two operations, theconcentrators and the pellet plant, which are linked, not separated, by theslurry pipeline. Nevertheless, starting from the assumption that La Perlaand Hercules are an integral part of the Monclova operation, and that thepossibilities of these northern iron mines of finding additional marketsfor their products are remote, the defined separation of responsibilitiescan work, but will demand close coordination between AHMSA and CMC.

23. Organization and Management. The Raw Materials Division datesback to 1984, and it has assumed its responsibilities gradually; in theinitial stage (1984-86) its role was mostly one of establishing policies,which were considered necessary in order to rationalize the operation ofthe mines; at that stage it did not have an operational nor a financialrole. As the operations of AHNSA were transferred in 1986, the scope ofCMC changed notably, and it is only now that it is becoming an independent,financially responsible entity. The process of implementation, however, isstill under way.

24. CMC has implemented a centralized structure with the groupmanagement based in Monterrey, hence maintaining geographical distancebetween decision makers and operations. The stated intention of the CMCmanagement is to later decentralize the structure once methods and systemsare in place. This process should be accelerated and the decentralizationshould not be made contingent on any event. The great majority of the CMCexecutives were recruited in 1986, and came from enterprises in the steelbusiness with iron and/or coal operations, hence the main sources wereHYLSA, FMSA and AHMSA.

Country Department IIIndustry, Trade, Finance Sector Operations DivisionLatin America and the Caribbean Region4l OfficeJanuary 1988

ANNEX 2-3- 63 - Page 1

MEXICO - STEEL SECTOR RESTRUCTURING PROJECT

The Policy Framework and the Proposed Policy Change

1. The steel sector plays a strategic role in the deepening of tradeliberalization. A successful restructuring of the steel sector accompaniedby domestic price liberalization, elimination of Official Reference Prices,lowering and equalization of tariffs for steel products will open up theroad to liberalizing the downstream industries and will contribute toreorienting the whole industrial structure toward the export market. Thisannex analyzes the present status of steel sector policies in Mexico andthe effects of the proposed policy change.

2. The Government considers the steel industry a priority area, thedevelopment of which is vitally important for Mexico. It has been makingserious efforts to promote the growth of this subsector for severaldecades. It created and applied policy sets intended to be favorable forthis industry, helped to generate the necessary internal resources and toshift external resources from other sectors of the economy into the steelindustry, both directly through budgetary outlays in the form of publicinvestments and direct subsidies, and indirectly through a system ofprotection from outside competition, industrial regulation, fiscalincentives, etc. This good-intentioned policy-set of the Government hasnot led fully to the desired results.

A. Role of Government and Other Agencies

3. There are several government agencies involved in policyformulation, control and promotion of the steel industry in Mexico. Themost relevant one is the Secretariat of Energy, Mines and ParastatalIndustry (Secretaria de Energia, Minas e Industria Paraestatal - SEMIP)which is the direct supervisor of the state owned steel corporation,SIDERMEX. SEMIP appoints the top executives of SIDERMEX and its majoroperating companies, and oversees the current operations and investmentactivities of these companies. It provides the link between them and othergovernment agencies.

4. Officially, SEMIP has no authority at all over the private steelproducers, but in practice, its activity goes far beyond the limits of thepublic sector in many ways. First, it collects, processes and analysesdata and prepares projections referring to the whole steel industry;second, it prepares recommendations for the Government, sometimes regardingthe whole sector (e.g., setting domestic controlled prices, quotas, foreigntrade regulations). The formal authority over industrial policies ingeneral and the steel sector policies in particular, rests with theSecretariat of Commerce and Industrial Development (Secretaria de Comercioy Fomento Industrial - SECOFI), but since SIDERMEX has a predominant rolein the steel sector, SECOFI does not feel responsible for the overallpolicy formulation in the steel industry. Nevertheless, SECOFI hasimportant tasks in many areas like foreign trade regulation and domesticprice setting for the whole steel industry.

ANNEX 2-3- 64- Page 2

5. The Secretariat of Planning and Budgeting (Secretaria deProgramacion y Presupuesto - SPP) coordinates the preparation of the mediumterm plans of the steel industry, approves the investaent plans and annualbudgets of the state-owned steel companies, and monitors the implementationof these budgets.

6. The Chamber of the Steel Industry (Camara Nacional de laIndustria del Hierro y del Acero - CANACERO) is a joint organization forboth the private and public enterprises. In addition t) representing theindustry as a whole it provides technical, data gathering and analysisservices. Since the public sector has its strong representation inSIDERMEX and SEMIP, CANACERO focusses priority on the representation of theprivate steel companies.

B. Direct Participation of the Government

7. The most important element of the Government's policy towards thesteel industry is its direct participation in the production activities.Presently the public sector represents more than half of the capacity,production, and employment. Public sector participation in the Mexicansteel industry has evolved not as a result of a deliberate effort to assurethe dominance of the state in this subsector, but rather as an end-productof a set of actions aimed at reducing unemployment, promoting regionaldevelopment and providing reliable domestic steel supply for the industry.

8. The direct involvement of the Government started in the fortieswith the takeover of AHMSA. In the early 1970s, the Government started(with Bank assistance) the establishment of SICARTSA I, a new, largeintegrated steel mill, partly to meet the fast growing domestic demand,partly to promote the development of the region of Lazaro Cardenas. In1979 the Government took over the FMSA in order to save it from bankruptcyand to avoid the layoff of more than ten thousand people. After havingfinished the first phase of SICARTSA, in the midst of the oil boom, thepublic sector embarked on an even larger project, the SICARTSA II, with 2million tonne liquid steel and 1.5 million tonne flat product capacity.This investment, however, has not been finished, because in the wake of the1982 crisis, both the demand for extra capacities and the resources tofinance the investment have been reduced drastically.

9. The policy of the Government regarding its direct involvement insteel production has changed substantially in the last two years. TheGovernment is trying to streamline the public steel industry, to stopuneconomic activities and spin off non-essential plants. After seven yearsof futile efforts to convert FMSA into a healthy, profit-making company,the Government closed it in May 1986. Further public investment plans werereduced drastically and it was decided that a large number of SIDERMEXsubsidiaries will be transferred, sold or liquidated in the near future.

10. But still there is a link missing. A more moderate directactivity of the Government should be accompanied by a far broaderinvolvement of domestic and foreign private capital. Government policywith regard to the cooperation and division of labor between the privateand public steel producers is not clearly enunciated, thereby making it

ANNEX 2-3- 65 - Page 3

difficult for the private sector to plan its development in an orderlymanner. The Government has placed a great deal of attention on arestructuring program for the public sector, but the policies in place areinsufficient to induce the private sector to embark on a similar program.

C. Tax and Fiscal Incentive System

11. Mexico has a modern tax system. The income tax, the value addedtax and the excise taxes are the principal taxes which joint1v represented86% of the tax collection or 9.3% of the GDP in 1985. The steel sector,like the great majority of industries, pays 42% corporate income tax, 15%value added tax and does not pay excise taxes. Since there are sectorswhich do not pay corporate income tax (e.g., agriculture, transportation)or pay 0-6% value added tax (agriculture, food industry and transportation)the steel industry is to some extent at a disadvantage in comparison withthe above-mentioned activities. However, this is not serious since theindustry is the single largest beneficiary of different fiscal incentivesbased on investment, employment generation, regional development, exportpromotion, etc.

D. Transfers and Subsidies

12. The Government supports the steel industry with direct budgetarytransfers and indirect subsidies. Naturally the transfers are applicableonly to the state-owned enterprises. These transfers cover deficits oncurrent operations, and they contribute to physical investments and debtservice. The Government makes constant efforts to reduce the transfers,forcing its companies to cut current expenditures and save on investments.

13. The indirect subsidies have been channelled in the form of lowinput prices from upstream state-owned companies. Since these prices arebasically equal for every customer, both public and private companies arebeneficiaries of these kinds of subsidies. The steel industry has beenreceiving natural gas, electric energy, railway transport and some otherinputs at subsidized price (tariff) for a long time (see Annex 8-1).Recently there were substantial increases in these prices and tariffs tothe extent that some of them are now at or near the international pricesconverted at the controlled exchange rate. (For example, natural gas wassold in 1982 at 9% of the international price, while in December 1986, itsdomestic price was in line with the international price.)

14. The subsidized inputs were not unambiguously beneficial for thedevelopment of the steel industry. It is true that on the one hand theyhelped to transfer resources from other sectors of the economy, but on theother hand they contributed to the creation of a greenhouse environment forthe steel industry and induced bad or not fully justified investmentdecisions. (For example, they distorted the calculations of theSICARTSA II, based on the use of natural gas for the direct reductionprocess).

E. Trade and Pricing Policies

15. Over the last 20 years, Mexico has followed an inward-lookingimport substitution protectionist trade policy in which quantitative

ANNEX 2-3- 66 - Page 4

restrictions (QRs) played a major role and tariffs a secondary one. Duringthe 1960s and most of the 1970s, QRs covered about 60-65% of the totalimports. With the crisis of 1982, the QRs had been extended to cover 100%of total imports. Average tariffs were at around 15% in the mid-1970s,then rose to around 27% in 1982. Effective rates of protection exhibited a"cascading" pattern with very high levels on final goods and low ornegative levels on primary commodities.

16. There are two other tools of protection: the Official ReferencePrices (ORP), which were phased out in December 1987, and the domesticcontent requirements. Official reference prices serve as the basis tocalculate the amount of customs duties, and while they were originallyintroduced to counteract dumping, they are now used for protectionistpurposes. Since ORPs are sometimes twice as high as the effective importprice, the customs duty to be paid will be about twice as much as it wouldhave been without ORPs. The domestic content requirement and someprocurement rules of public entities make imports impossible even if itwould be substantially cheaper or of better quality than the competingdomestic product.

17. This trade regime created an inward-oriented non-specializedindustrial growth. In the case of the steel industry, it led to very slowgrowth of productivity, limited specialization, low competitiveness, ofteninefficient physical investments, and a detrimental effect on downstreamindustries forced to use low quality and expensive domestic steel products.

18. The Government, in an attempt to eliminate these negativeeffecrs, launched a trade liberalization program on July 25, 1985. The QRswere reduced to 39% of imports, while the average overall tariff levelincreased marginally from 23.4X to 25.4% and the coverage of ORPs wasexpanded from 4.4% to 7.6% of imports. On June 19, 1986, the Governmentissued a Statement of Foreign Trade Policy which announced its furtherplans to reduce, by October 31, 1988 the maximum rate of tariffs to 30%,the tariff average to 17.3% and its weighted average to 10%. This wasreplaced in December 1987 with a new policy lowering all steel tariffs to amaximum of 20% with commensurate averages.

19. On the basis of the above protection mechanisms the Mexican steelindustry would appear to be protected from outside competition to theextent that it could easily generate funds needed for debt service,modernization and modest growth. This is not so, because the internalprices are controlled and set at a level lower than the international FOBprice. These prices do not allow the steel sector to generate an adequatelevel of income.

20. Table 1 shows the evolution of protection for the steel industryas a whole. There are no disaggregate studies of effective protection forthe steel industry so this data should be taken as an average of theprotection covering the sector as a whole. The general path that Table 4shows is that effective protection is very sensitive to the acceleration ofdevaluation, this could be principally due to a temporary lag in adjustingcontrolled prices of steel products to changes in the exchange rate.Negative nominal protection indicates also that domestie# controlled prices

ANNEX 2-3- 67 - Page 5

have been below international prices since 1983, with the exception of thefirst quarters of 1985. This situation does not appear to have changedduring 1986.

Table 1

Evolution of Protection for the Steel Sector(X)

Implicit Nominal EffectiveProtection Protection

1979 1 121980 5 381981 9 37March 1983 -14 -2June 1983 -18 -13September 1983 -26 -28January-March 1985 5 9July 1985 -5 -8December 1985 -15 -21

Source: IMCE: "La Proteccion Efectiva en Mexico, 1985";preliminary calculation for the year 1985.

21. Thus, the trade and price control system excluded outsidecompetition in almost all products produced in Mexico, did not force thedomestic producers to improve the quality and the product mix, or to betterserve their customers, and at the same time, did not allow them to enjoythe financial benefit of the protection. In other words, the pricecontrols offset the resource generating benefit of the protection while allthe negative impact of the protection remains in full effect both for thesteel industry and for the downstream industries.

P. Technical Analysis of Proposed Policy Changes: Price Liberalizationcum Tariff Reduction for Steel Producte

22. This section analyzes the effects of the restructuring cum priceand trade liberalization package, on steel production and prices, and onthe overall liberalization program of the Mexican economy. It shows thatthis package will permit an increase in production, quality and prices inthe steel sector. It also shows that the increased competitiveness of thesteel sector will permit a further reduction in steel tariffs by the early1990s. This, in turn, will allow the deepening of the trade liberalizationprogram in the downstream industries.

23. The steel sector is subject to the overall program o tar±lgfreductions and ORP elimination, but, at the same time is subject tointernal price controls which keep domestic price below the CIF prices ofequivalent imported products. Table 2 shows the status of prices, averagecosts and trade policies for the steel industry at the time of Appraisal.The steel industry was heavily protected from external competition bytariffs that ranged from 37% for non-flat products to 22.5% for flat

ANNEX 2-3- 68 - Page 6

products, and by Official Reference Prices (ORPs) that raised the tariffsto a range of 32% for flat products to 51% for non-flat products. Table 2also shows that domestic producers do not profit from protection becausedomestically controlled pcices of most steel products are belowthe CIF prices of equivalent imported products (see column C/A).Controlled prices are also below average cost of all steel productscontributing to the long-run capital erosion of the steel producers (seecolumn B/A).

Table 2

Status of Prices, Costs and Trade Barriers in the Steel Industry

A B C D E F GlDmestic

Con- Average Officialtrolled Full C&F ef- Adjusted ImportPrice Cost Price erence Tfriff Price

a/ b/ c/ Price Zriff d/ B/A C/A

eabars 209 287 272 300 37 0.51 389 1.37 1.30Wire Rod 238 - 294 300 37 0.46 406 - 1.24Co. Prof ile/

Mrch. Pars 213 513 285 310 37 0.49 400 2.40 1.34Structural

Profiles 298 565 350 310 37 0.43 411 1.90 1.17Plate 315 319 343 400 22.5 0.32 406 1.01 1.08Hot RolledCoil 290 308 318 400 22.5 0.35 390 1.06 1.10

Cold RolledSheet 407 510 384 500 22.5 0.36 469 1.25 0.94

a/ December 1986 domwstic cmtrolWl prices, extras added. Emcipge rate - US$1 - NM925.3.b/ Avge full cost of the uwrgensl producer for 1986.c i ed average of Jap= (40a), EEC (20%), Brazil (20%) and Korea (l0X) PFM pdres plus

US$40 for freight and insrance plus 5% for port charges.d/ Official reference price tariff/FOB price.

24. Under the overall liberalization program, tariffs were supposedto be reduced to 20% for flat products and to 25% for non-flats by October1988. Mexican authorities, however, originally prposed to raise flatproduct tariffs to 25% and to end up by October 1988 with a 25% uniformtariff for steel products. The 25% tariff level was thought to be theminimum politically attainable level for the restructuring period andcovered appropriately the anticipated lag in the devaluation of the Mexicanpeso that could occur during that period. Recent events have resulted in afurther devaluation of the peso, however, and the Government has reducedtariffs on all steel products to a maximum of 20%.

25. Internal price liberalization is the crucial element of policythat is lacking to attain an efficient transition toward a more competitivesteel sector. Price liberalization with technical restructuring will bringcost reductions, increases in quality, increases in production and the

ANNEX 2-3- 69 - Page 7

necessary financial health that will allow the steel sector to compete inan open market framework with external suppliers during projectimplementation.

26. Table 3 shows a summary of the effects of price liberalization,ORP elimination and tariff equalization at the 25% level on domestic steelprices. The upper limits of internal price increases range from 61% forcommercial profiles and merchant bars to 14% for cold rolled sheet. Thelast column of Table 4 shows that this maximum domestic price will be only20% above the opportunity cost of importing steel (i.e., above the CIFprice of imported prodvts). This is because in Mexico the tariffs areapplied on FOB prices (i.e., a 25% tariff on FOB prices becomes a 20%tariff on CIF prices). Given the preference for imported products and thedifferences in quality between imported and domestic products the mostprobable outcome is that domestic prices will stay around the CIF price atleast until quality comparable to imported steel can be attained.

Table 3

Effect of Price Liberalization, ORP Elimination andTariff Equalization on Internal Steel Prices

A B C D EDomesticCon-

trolledPrice FOB C&F Tariff Importa! Price Price (%) Price b/ E/A E/C)

Rebars 209 219 272 25 327 1.56 1.20Wire Rod 238 240 294 25 354 1.49 1.20Comm. Profiles/Merch. Bars 213 232 285 25 343 1.61 1.20

StructuralProfiles 298 293 350 25 423 1.41 1.20

Plate 315 286 343 25 414 1.31 1.20Hot Rolled Coil 298 262 318 25 383 1.28 1.20Cold Rolled Sheet 407 325 384 25 464 1.14 1.20

a/ Assumes AHESA exits production of commercial profiles and bars by 1991.b/ Import price - 1.05 (FOB price + 40) + 0.25 FOB price.

27. The firmer policy package will permit financially, technicallyand economically successful restructuring. Table 4 shows that by 1991 allsteel products, but wire drawing and marginally cold rolled sheet andrebars, will be competitive with the interuational ones. Then, with anappropriate change in the product mix the tariffs on steel products can beset at a minimum as soon as restructuring is completed. This, in turn,will permit deepening trade liberalization in the downstream industries.

ANNEX 2-3- 70 - Page 8

Table 4

Effects of the Restructuring and the Policy Change on theCompetitive Position of the Steel Industry

A B CAverage

Costs after C&FRestructuring Prices DRC A/B

Rebars 275 272 1.03 1.01Wire Drawing 400 323 2.37 1.24Comm. Profiles/Bar 275 285 0.93 0.97Structural Profiles 337 350 1.01 0.96Rail 317 456 0.51 0.70Plate 258 343 0.59 0.75Hot Rolled Coil 282 318 0.75 0.88Cold Rolled Sheet 374 384 0.94 0.97

28. It should also be noted that the dollar-denominated exchange rateto the currency of other steel-exporting countries along with a realincrease in steel prices brought about by reduction in supply in thedeveloping countries has resulted in higher real prices for steel in theinternational market. These factors improve Mexico's competitive positiondrastically.

Country Department IIIndustry, Trade, Finance Sector Operations DivisionLatin America and the Caribbean Regional OfficeJanuary 1988

AMNEX 3-1- 71 - Page 1

MEXICO - STEEL SECTOR RESTRUCTURING PROJECT

Operations, Technology and Strategic Position

A. Introduction

1. The Mexican steel industry is divided on the basis of ownershipbetween the public sector producer SIDERMEX and the private sectorproducerG HYLSA, TAMSA, the mini-mills and rerollers. From a technologystandpoint the public sector SIDERMEX operates conventionally integratedfacilities using coke ovens, blast furnace and BOP and OH steelmaking.HYLSA and TAMSA are also considered integrated producers utilizing thedirect reduction, EAF steelmaking process. The mini-mills are conventionalnon-integrated producers using purchased scrap or other ferrous inputs tothe EAF steelmaking process.

B. Industry Operating Performance Comparison

2. By comparing general and specific operating statistics, it ispossible to comment on operating performance and possible strengths andweaknesses of the sector. The following tables are based on 1985 Mexicodata collected by the mission. Table I indicates crude steel capacity,actual production in 1985 and resulting capacity utilization.

Table 1

Steel Industry ComparisonKey Performance Factors - Capacity Utilization

('000 tonnes per annum)

Crude Steel Crude Steel CapacityCapacit Production Utilization

-t'1000 tonnes) ------ (%)--

AHMSA 3,950 2,603 65.9FMSA 1,500 943 62.9SICARTSA 1,300 613 47.2HYLSA 1,700 1,631 95.9Mini-mills 1,633 1,314 80.5

10,083 7,090 70.3

Source: SEMIP.

3. Capacity utilization is a measure of how well the industryutilizes its facilities resources and contributes to lowering unit fixedcosts. SICARTSA, the newest operating plant carrying a very largefinancial burden, had a poor production year in 1985 after reaching 79%capacity utilization in 1984. This was caused by a blast furnace relinewhich shut down all iron- and steel-making at the plant and the earthquakewhich hit Mexico in the fall. In total, approximately one third of theproduction capacity was out of service. A reline is not due again untilafter 1990. FMSA and AHMSA both operated well below total capacity.

ANNEX 3-1- 72 - Page 2

HYLSA, on the other hand, is an example of remarkable performance as is theprivate sector in general.

4. A relative measure of how well the industry utilized its materialresources is given in Table 2.

Table 2

Steel Industry ComparisonKey Performance Factors - Material

FinishedCrude Steel SteelProduction Shipments Gross Yield

- ('000 tonnes) ----- ---

AHMSA 2,600 1,860 71.5PMSA 1,940 500 53.2SICARTSA 610 530 86.9HYLSA 1,630 1,390 85.3Mexico 5,780 4,280 74.0

Brazil 4,000 3,200 80.0USA 57,800 45,300 78.4Korea 9,200 8,200 89.1Japan 76,800 72,700 94.7

Sources: Based on P. Marcus, World Steel Dynamics;Karlis M. Kirsis, Financial Dynamics of 60International Steelmakers, March 1986; and SEMIP.

The gross yield for the integrated Mexico producers, as a whole, is thepoorest in the comparison; however, the very low yields at FMSA distort thefigures and that plant has since been closed. Without FMSA the Mexicofigure would rise to 78.1%, close to the USA and the sample from theBrazilian integrated steel sector. The yield figure clearly points out theworld class capability of SICARTSA, even though underutilized in 1985, andthe example of HYLSA operating a great deal of equipment in t1 flatproducts line of a very similar vintage to that at AHNSA but with verydifferent result. Some of this difference may be due to the lack ofinvestment at AUMSA in maintenance and systematic upgrading. But the poorperformance may also be influenced by centralized control. Yieldimprovement typically comes from close production control, by matchingproduction and inventory levels with market needs and in general themanagement's overall operating philosophy of the plant. A related issue isproduct quality and rejects. During 1985 a significant tonnage ofoff-specification material was inventoried and sold as seconds at depressedprices. Improvement in yield and quality will result in lower operatingcosts as well as higher realized prices. HYLSA also appears to have donean excellent job in controlling inventories and maximizing shipments. Thisfurther demonstrates the market and profit orientations of the company.

ANNEX 3-1- 73 - Page 3

5. The coke rate, given in Table 3, is expressed in kg of cokerequired to produce a tonne of liquid iron. In an integrated steel plantcoking coal is the largest single energy input to the plant, therefore, thecoke rate is an important measure of how well a plant utilizes its energyresourcesj lThe three SIDERMEX plants are the only integrated producersutilizing the conventional coke oven/blast furnace route. HYLSA's primaryfacilities are based on the direct reduction process whloh does not permitdirect comparison,

Table 3

Steel Industry ComparisonKey Performance Factors - Energy

(kg)

Coke Rate

FMSA 657AHMSA, Plant #1 626AIHMSA, Plant #2 560SICARTSA 525Brazil 550USA 500Korea 480Japan 450

Sources: Based on P. Marcus, World Steel Dynamics;Karlis M. Kirsis, Financial Dynamics of 60international Steelmakers, March 1986; SEMIP forMexican data; and mission visits.

The older blast furnaces of AHMSA's plant #1 show their disadvantage.However, the newer AHMSA furnace and especially the computer-controlledfurnace at SICARTSA demonstrate world class performance. The high cokerate of the FMSA furnace, which is the same age as the AHMSA plant #2 unit,shows the difference in operating practices. Efforts to further improvethe older furnaces at AHMSA are thought to require some investment, but,compared to other blast furnace operations in developing countries recentlystudied (e.g., India, SAIL 843, TISCO 745; and Zimbabwe 775), the Mexicanperformance demonstrates excellent capability and no comparativedisadvantage in terms of energy consumption.

6. Labor productivity and the utilization of the industry's laborresources shown in Table 4 is an additional set of statistics that providerelative comparisons and in some cases insight in the typical problem ofovermanning in developing countries.

ANNEX 3-1- 74 - Page 4

Table 4

Steel Industry ComparisonKey Performance Factors - Labor

Shipments Labor Cost AnnualNumber of per per Tonne Cost perEmployees Employee Shipped Employee('000) (tonnes) ("IS$) (US$)

AHMSA 32,638a/ 96.1 79.7 4,54Zb/FMSA 12,755a/ 39.9 120.3 4,800b/SICARTSA 7,522a/ 70.3 61.8 4,345b/HYLSA 7,195a/ 193.2 61.5 11,877b/

Brazil 31,300 102.2 65.6 6,700USA 214,200 211.0 186.8 39,400Korea 13,800 594.0 15.0 8,900Japan 167,400 434.0 57.8 25,100

a/ Number of employees includes works plus administration.b/ Total wage bill divided by total number of employees.

Sources: Based on P. Marcus, World Steel Dynamics; Karlis N. Kirsis,Financial Dynamics of 60 International Steelmakers, March 1986;and SEMIP and mission estimates for Mexican data.

HYLSA demonstrates the major comparative advantage of the country with thehighest productivity and lowest labor cost per tonne shipped even with anannual cost per employee more than double the public sector companies.Since the number of employees at SICARTSA is expected to remain at thecurrent level and production and shipment increases are expected in 1986,the probability is that shipments per employee in SICARTSA will reach 120with cost per tonne shipped dropping to US$36.2 which would rival some ofthe lowest labor cost facilities in the world. AHMSA clearly shows theeffects of overmanning due mainly to much of the vintage technology stillin use (e.g., open hearth furnaces) and the large maintenance forces neededto keep them in operation. Finally the FMSA operation clearly was thecountry's worst in terms of labor inefficiency and cost. Overall thisindicates that the country's labor force provides a cost advar.:!ge and canperform under the proper management and with modern equipment to worldclass standards. Public and private subsector comparisons show glaringdifferences especially when comparing FMSA and HYLSA which are both inMonterrey with FMSA actually having more modern equipment.

7. There are 23 semi-integrated steel producers in Mexico operatingon a much smaller and less capital-intensive scale than the integratedproducers. The plants vary in size from 10,000 to 300,000 tpy and as agroup are considered mini-mills since they produce carbon steel productsusing scrap-based electric furnaces. Five of the producers concentrate onspecialty and tool steel products utilizing essentially the same productionequipment.

ANNEX 3-1- 75 - Page 5

8. The total rated mini-mill capacity is approximately 1.6 mtpy andas shown in Table 1 operated in 1985 at just over 80% capacityutill- ,.on. The mills produced approximately 1.3 mtpy of crude steel butshipped only 984,000 tonnes of non-flat products. A portion of thedifference went to rerollers in the form of semi-finished billets. All ofthe semi-integrated producers are in the private sector although ownershipin some cases may be by state-owned banks.

9. Karkets served by this segment tend to be local with millsdispersed throughout the country. The product ranges are narrow withconcentration on items such as wire rods, concrete reinforcing bar andcommercial profiles. In total this segment accounts for almost 20% of thetotal crude steel production and 33% of the non-flat products produced in1985. Raw material for the electric furnaces is primarily scrap, bothdomestic and imported mostly from the USA. Sponge iron is not regularlytraded within the country; however, with the SICARTSA II direct reductionfacility coming on line in late 1986 or early 1987 there may be anopportunity, depending on price, to displace imported scrap with domesticsponge iron depending on cost.

10. Total employment is 16,462 in the semi-integrated plants. Forthe steel producers this represents approximately 60 tonnes shipped peremployee. This is quite low when compared to an efficient US mini-millwhich would have labor productivity typically in the range of 500 tonnesshipped per employee. No data was available on labor cost in this segment,however, as in the integrated sector, it is believed to be low enough tobring labor cost per tonne shipped into line with other countries'efficient producers. It is also difficult I make direct productivitycomparisons since some of the mini-mill operations include furthertransformation of the rolled bar and wire into manufactured products likefencing, fasteners, chain and cable, etc. The manpower utilized in theseoperations is not distinguished in the data provided to the Bank. AcerosNacionales S.A., a major mini-mill operation, employs approximately 400people in steel production with a total employment of approximately 2,200.Labor productivity is over 400 tonnes/employee if the downstreammanufacturing operations are taken separately.

11. The rerollers typically use billets provided by both theintegrated and semi-integrated producers as feedstock for small non-flatproduct rolling mills. In 1985 they produced 261,000 tonnes of suchproducts in 52 separate companies. Total employment was just above 4,000,indicating the small business nature of this segment of the industry.

C. Strategic Position Analysis

Methodology

12. In order to appreciate the strategic market position of theMexican steel sector an analysis of the cost and quality dimensions inrelation to the markets for various products by each major producer wasundertaken. Details are included in the Steel Sector Strategy Review datedOctober 23, 1986 (Report No. 6429-ME), and in the Project File. Theanalysis included a detailed breakdown of production cost weighted by

ANNEX 3-1- 76 - Page 6

quality factors in order to compare real domestic cost to the equivalentlanded price of higher-quality products from efficient world scaleproducers and the higher-quality current and future needs of the downstreamusers.

Interpretation of Results

13. For non-flat products the strategic position of the two majorproducers, SICARTSA and HYLSA, is equal to or better than the comparativeinternational norms. These product lines also have potential market growthwhich combined with the competitive position supports modest expansion toserve the domestic market. Data from other private sector producers alsoindicate their competitiveness so that overall it is judged that theindustry is in an excellent position in this product area. The singleexception is a substantial cost and quality gap in bar and rod productsfrom AHMSA. Hence the recommendation to exit these lines allowing otherprivate sector producers an opportunity to expand their output. Theproducts of the heavy structural mills at AHMSA are marginal in thisanalysis but with the addition of rail products to these mills, which arethe only facilities in the country capable of producing this range ofproducts, continued operation is justified. Further economic analysis hasalso been carried out to confirm these results.

14. For flat products which are penalized by lower quality but are ina growing market the analysis confirmed that with rehabilitation AHMSA andHYLSA could become internationally competitive particularly in hot and coldrolled sheet. These results were also confirmed by the economic analysis.

15. Overall the strategic analysis confirmed the product mix shiftsrecommended in the Steel Sector Strategy Review and later reinforced by theindependent Market Study.

Country Department IIIndustry, Trade, Finance Sector Operations DivisionLatin America and the Caribbean Regional OfficeJanuary 1988

ANNEX 3-2- 77 - Page 1

MEXICO - STEEL SECTOR RESTRUCTURING PROJECT

Competitive Position of Raw Material Supply

A. Coal

1. Production costs at SIDERMEX' coal mining operations are lowoverall and competitive with imported coal, not only in the north (assupplies to AHMSA) but also in the south where SICARTSA is using cokingcoal and competitiveness is more critical given transport costs from thenorth as well as SICARTSA's location very close to the Lazaro Cardenasport. Over the past five years, coal production costs have fluctuatedconsiderably. Their development has been influenced by exchange ratemoJvements, local inflation, variations in quantities produced, andproductivity differentials in different mines and coal washeries. The costrange of washed coal produced by SIDERMEX is quite substantial, varyingfrom about US$16.7/tonne to US$33.8/tonne. These differences are dueprincipally to productivity differences related to the age and layout ofthe mine, technical conditions of coal extraction and equipment used. Onthe average, the more recent coal mines have higher productivity and lowercosts and, as older mines are phased out and new mines opened, overallproductivity should be further improved.

2. The competitive position of these mines (Table 1) is very strongin the north where the distance to AHMSA's installations is less than100 km of direct rail link. By comparison, the distance to SICARTSA'ssteel mill is about 1,400 km and adds about US$15 to the ex-washing plantcost. However, even at that distance and level of transport cost the mostexpensive coal (produced by Hullera Mexicana) costs about US$48-49/tonnedelivered which is still lower than the cost of imported coking coal wouldbe (US$51-56 tonne). There is however, a quality difference to SIDERMEXcoal which contains about 13% ash against 8% in imported coking coal.Taking into account this difference, costs of coal from Hullera Mexicana,delivered to SICARTSA would be about equal to the deliverid price ofimported coal. Coal from the other mines and washing plants would,however, still be substantially less expensive.

3. The assessment of detailed production costs from the differentSIDERMEX mines (Table 2) reveals a number of interesting results. Thefirst one is that in practically all operations, except for Cia. Minera deGuadalupe, costs in real pesos as well as in US dollars have droppedsubstantially over the past five years. The most dramatic case is the DonEvaristo mine of Carbon y Cok which, albeit with wide fluctuations, showeda decline of 55%. Although some investments were carried out during thatperiod and various operational improvements were made, the main reason forthis development of overall costs has been the general decrease in wages,salaries and prices in real terms in Mexico after the start of the economicdecline in 1982, and the fact that local costs represent a major portion oftotal costs in coal mining. Although information on prices of inputs overthe period is not available, the more than 60% decrease of wages of mine

ANNEX 3-2- 78 - Page 2

workers may be a representative indicator of the dramatic drop in factorcosts (but also of the loss in purchasing power).

Wage of Qualified Coal Mine Worker a/

1982 1983 1984 1985 1986

Current M$ 540 680 940 1,412 1,9691982 M$ 540 337 281 268 208US$ 9.41 4.52 5.08 4.55 3.23

a/ Base wage per day in SIDERMEX coal operations.

4. A further conclusion is that substantial cost differences existbetween the various mines and washing plants of SIDERMEX. In 1982, washedcoal was priAuced between US$30 and 52 per tonne while unit cost in 1986ranged bet-;-an US$17 and 34 per tonne. These differences are due tovarious factors including mining conditions, depth of mine, mine design,equipment used, age of mine and management, as well as financial resourcesto invest, all of them factors which are reflected in productivity andcosts. While a number of changes in the relative positions of thedifferent operations have occured, the two principal producers (Cia. Minerala Florida de Muzquiz and Minerales Monclova) have shown a consistentlysatisfactory performance and are crucial for the overall competitiveness ofSIDERMEX' coal operations because of their low costs, high volumes andpotential. An exact breakdown in mining and washing costs is difficult tocalculate since SIDERMEX washing plants have in the past not only processedcoal from SIDERMEX mines but also from other suppliers (Comision de FonentoMinero) and not all elements are known to separately determine the unitcosts of coal from different sources. The figures provided are generallybased on a mixture of SIDERMEX and other coal whereby SIDERMEX mining costshave been lower than purchase prices for coal from other sources. AsSIDERMEX increases its own production in the future to replace these othersources, additional cost reductions because of the cost differential can beexpected.

5. From an analysis of cost breakdowns in percentages (Table 3)several general conclusions can be drawn reflecting the development oflocal and foreign cost as well as of efficiency changes: (i) thepercentage of personnel costs has remained constant or has slightlydecreased in most operations. This is due to the fact that wages andsalaries as well as total costs have decreased. But since wage declineshave been greater, some other parameters such as fringe benefits may havecompensated for this difference; (ii) the percentages of depreciation andmaintenance costs in mines have increased which is mostly due to the effectof relative increases of prices of imported materials for maintenance andconsistent revaluation of assets in the accounts of Mexican companies; someinvestments and operational measures may also have contributed to thisdevelopment; (iii) fixed costs have decreased in nearly all operationsshowing a conscious reduction of nonproduction related expenses.

ANNEX 3-2- 79 - Page 3

6. Although the figures discussed should provide a sound basis forthe assessment of overall coal production costs, the details may not beeasily comparable. This is due to the fact that the SIDERMEX coaloperations had two different owners in the past and used differentaccounting and costing systems. Differences can also arise because ofdifferent accounting for the various elements in the coal washing processincluding the mixture of SIDERMEX coal and coal from other sources.SIDERMEX raw materials division is currently unifying the costing andaccounting systems for all mines which will facilitate comparisons betweencoal operations as well as and decision making.

B. Iron Ore

7. Mexican iron ore production is competitive overall albeit not asmuch as coking coal production and with less potential for furtherimprovement. Although the mining conditions are in general not verydifficult, ore grades are relatively low compared to internationalstandards and result in higher production costs for equivalent products.Comparative costs of iron ore production and imports are summarized inTable 4. The northern iron ore mines (Hercules and La Perla) benefit froma natural protection since they are located close and linked to the steelmill of AHMSA to which they supply pellet feed. The approximate cost ofsupply of pellet feed to AHMSA's pellet plant amounts to about US$20/tonnewhile imported pellet feed would range around US$35/tonne. Pellet supplyto AHMSA and to HYLSA's northern plant is assured from mines in the south(Encinas and Pena Colorada) and ranges between US$33 and 36/tonne comparedto costs of imported pellets (from Brazil or Chile) amounting toUS$42.5-44/tonne. A similar difference would hold for pellet supplies toHYLSA's Puebla plant near Mexico City. The eituation for the south isdifferent because of he closeness of SICARTSA to the Lazaro Cardenas port.No detailed information has been received from SICARTSA on the cost of itsown ore supply from the Las Truchas mine although the company hasapparently been able to keep production costs of its own pellets belowpurchase prices of imported pellets in the past. Pellets from PenaColorada delivered to SICARTSA would currently run around US$33/tonnecompared to costs of imported pellets of US$29.5-31/tonne and studies arebeing undertaken whether the relatively long and expensive land transportcannot be replaced by cheaper barge transport along the coast when SICARTSAstarts up its second phase production facility.

8. Cost comparisons in iron ore mines are made difficult by the factthat the coiting and accounting systems are different, financial costs andassets and therefore depreciation may not be accurately reflected in thecase of La Perla and Hercules, and that La Perla changed its productcomposition substantially in recent years and started using mine dumpswhich are difficult to evaluate. Cost data available for iron ore mines donot permit an evaluation of trends of past years but it can be assumed thatinflation, exchange rate movements and the development of factor costs hasresulted in a similar cost decreasing impact as for the coal mines. While,however, the coal mines have a good potential to decrease costs furtherthrough development of more wodern mines and implementation of additional

ANNEX 3-2- 80 - Page 4

long walls in existing mines, the iron ore operations have only a limitedpotential for improvement. Pena Colorada does not operate at full capacityand could produce at lower costs if its capacity were used fully. Herculeshas a good potential for lowering its production costs since it operatesonly at very low capacity. Even so, it is not clear yet whether it will bea low cost operation if the full impact of financial costs and of pastinvestments is taken into account. La Perla is rapidly approaching the endof its life, as is the HYLSA mine Las Encinas, which therefore do not havemuch potential for cost reductions. The effect of the planned expansion ofthe SICARTSA mine Las Truchas on its costs *nave not yet been determined,and the potential project of HYLSA (Cerro Nahuatl) is low grade and highcost. In summary, Nexican iron ore production is competitive but itscompetitive position could change easily if macroeconomic developmentswould modify the cost of important production factors in relation to c,therproducers.

Country Department IIIndustry, Tr*de, Finance Sector Operations DivisionLatin America and the Caribbean Regional OfficeJanuary 1988

ANNEX 3-3- 81 - Page 1

MEXICO - STEEL SECTOR RESTRUCTURING PROJECT

The Steel Market in Mexico

A. Introduction

1. Domestic supply to the Mexican steel market has traditionallybeen in the form of low-quality commercial grade mild steels mainly forconstruction and other infrastructure uses. Engineering-quality steels ofhigher grade are in short supply domestically, are variable in quality andadversely affect the quality and cost of many final products. Thereforethe majority of the higher-grade steels, particularly in flat products, arepresently imported. A brief analysis of the current domestic product mixalong with some detail of the manufacturing sector are included in thisAnnex along with projections for supply and demand through 1991.

B. Market Segments

2. Details of current steel shipments to the domestic market bybroad industry sector were not readily available at the time of thisreport. However, 1984 data from Canacero for domestic production has beenanalyzed to demonstrate the approximate current allocation of productionfor flat and non-flat products. This is given in Table 1:

Table 1

Domestic Shipments in 1984 - Market DistributionXe

All Flat Non-flatProducts Products Products

Construction 44 12 73Autmotive 12 18 6Industrial Goods 10 11 10Packaging 10 22 -Domestic Appliance Production 9 16 2Agriculture 4 2 6Railways & Shipbuilding 3 5 1All Others 8 14 2

100 100 100

Source: CANACERO.

3. Construction is the largest user of steel, taking 44% of overallproduction and 731 of non-flats. Reinforcing bar and wire products, mainlyfor reinforcing mesh, are the most important items used. Structuralsections are only used in small quantities, since Mexican construction isgeared very much towards concrete rather than steel buildings. Most flatproducts for this sector are for the production of steel pipe.

ANNEX 3-3- 82 - Page 2

4. The automotive industry is the next highest user sector, but onlyaccounts for 12% of production. This industry is also a large importerespecially of flat products. Domestic producers have generally not beenable to satisfy the price and quality requirements of the companiesexporting steel-based products.

5. Packaging is currently the most important user of flat products.This is attributable to the large use of tinplate for canned goods, andother metal packaging requirements. This demand is likely to continue forsome time, but increasing use of plastics and aluminium for packaging woulderode this market in the longer term.

6. The industrial goods sector, plant machinery and equipment, withsome 10% of both flats and non-flats, is surprisingly low, and reflects twoimportant factors: firstly, the low current level of activity in oil andpetrochemical development compared with the early 1980s; and secondly, thelow general levels of development and activity in the capital goodsindustry.

C. Supply and Demand Projections

7. In order to plan for the longer term and as a basis for furtherrestructuring of the sector, an in-depth, industry-wide market and productmix study has been undertaken. This study includes: (i) a review of thesteel-consuming market segments along with growth patterns in the uses ofvarious steels and competing products; (ii) a review of steel productioncapabilities detailing ranges of products, capacities and interlinkagesbetween products; and (iii) overall supply/demand projections andidentified gaps in current capabilities that would offer opportunity forinvestment. The results of this study are still being evaluated by thesteel producers and will be integrated in their strategic plans. The datapresented in the following paragraphs is based on earlier work done bySEMIP and projections made by Bank staff at the time of appraisal. Theseresults have been compared with the results of the market study andalthough there are some small differences between products the overallestimates of demand growth through 1991 are very similar. The Bank'sestimates of market growth are lower and therefore the Appraisal Reportrepresents a more conservative view of the future.

8. The projections prepared by Bank staff take into considerationprojections prepared by SEMIP in April 1987, which included a base case andan alternative scenario which included a severe decline in 1989 dueapparently to changes in Government. The average annual growth rates inthese projections range from 9.0% for all steel products in the base casedown to 3.1% in the alternative scenario. The base SEMIP projections seemvery optimistic and result in consumption levels by 1991 surpassing the1981 peak year. The alternative scenario conversely seems overlypessimistic especially for industrial planning purposes. In contrast theBank staff estimates included in the October 1986 Steel Sector StrategyReport represent a conservative and less dramatic view of the future. Thesimple underlying assumptions in these projections are a 3-4% p.a. growthof GDP and a gradual opening of the Mexican economy which is expected tolead to a faster-than-average growth of the manufacturing industry. This

ANNEX 3-3- 83 - Page 3

results in a growth in demand from the 1986 level of about 4.4% for flatproducts, 3.3% for non-flats, 3.5% for seamless tubes and 3.8% for totalproducts. The actual results of these projections including a breakdown ofproduct categories are given in Table 2.

Table 2

Projection of Apparent Consumption of Steel Products(thousands of tonnes)

1986 1987 1988 1989 1990 1991Flat ProductsPlate 580 605 632 660 689 719Hot Rolled Sheet 584 610 637 665 694 730Cold Rolled Sheet 1,016 1,060 1,107 1,156 1,237 1,260Tin Plate 204 220 230 240 252 262

Total Flat 2,384 2,495 2,606 2,721 2,872 2,972

Non-flat ProductsReinforcing Bar 925 956 987 1,020 1,054 1,088Wire Rod 754 779 805 831 859 887Profile & Bar 774 /99 825 853 881 910Structural & Rail 280 289 299 309 319 329

Total Non-flat 2,733 2,823 2,916 3,013 3,113 3,214

Seamless Tube 183 189 196 203 210 217

Total Products 5,300 5,507 5,718 5,937 6,195 6,403

Source: Bank staff.

These projections lead to a total growth in five years of 20.8% in allproducts, 24.7% in flat products, 17.6% in non-flat products and 18.6% inseamless tubing. The consultant study results in a total growth in fiveyears to a level of 6,618,000 tons of total product, only 3.3% larger thanthe Bank staff estimate. This figure includes soze shifts in productsresulting in a flat product level of 3,038,000 tons, non-flat of3,335,000 tons and seamless tube of 245,000 tons. The consultantprojection bayond 1991 is for overall growth at approximately 5.1% peryear.

9. Projections of production for the next five years for the sameproduct categories are given in Table 3. These figures include theproduction of FMSA for 1986.

ANNEX 3-3- 84 - Page 4

Table 3

Projection of Production of Steel Products(thousands of tonnes)

1986 1987 1988 1989 1990 1991Flat ProductsPlate 497 513 559 605 643 665Hot Rolled Sheet 697 587 551 698 722 801Cold Rolled Sheet 897 978 1,021 1,103 1,139 1,148Tin Plate 195 214 229 250 261 262

Total Flat 2,259 2,292 2,360 2,656 2,765 2,876

Non-flat ProductsReinforcing Bar 1,382 1,150 1,151 1,168 1,152 1,127Wire Rod 790 800 820 850 875 900Profile & Bar 755 770 800 825 850 875Structural & Rail 181 200 250 300 325 350

Total Non-flat 3,108 2,920 3,021 3,143 3,202 3,252

Seamless Tube 208 2i0 217 225 233 240

Total Products 5,575 5,422 5,598 6,024 6,200 6,368

Source: Bank staff.

10. Projections of production for flat products is based onproduction plans of the two producers as laid out in the respectiverestructuring projects. It is assumed that each can penetrate thehigher-quality market now going to imports as their technical and marketingcapability improves.

11. The non-flat products categories, reinforcing bar, profile andmerchant bar can be produced by practically all the producers. Wire rod islimited to fewer facilities. Therefore, non-flat projections by producersare more arbitrary. SICARTSA I projections were used as a stating pointassuming that plant reaches and sustains high product levels by the 1990/91period. HYLSA which is the second major producer is rot involved in anysignificuat technical improvement program and is assumed to maintain itscurrent high capacity utilization. AHMSA has reduced production based onproduct mix changes to better serve the flat products market and the-balance is assumed to be taken by the remaining producers in a mannerconsistent with their performance in the last several years.

12. Estimated production by producer is shown in Table 4 with thefurther assumption that TAMSA will continue to actively pursue the exportmarket for seamless tube and will maintain a production level *ve thedomestic market consistent with the last several years.

ANNEX 3-3- 85 - Page 5

Table 4

Projection of Production by Producer(thousands of tonnes)

1986 1987 1988 1989 1990 1991Flat ProductsAHMSA 1,320 1,582 1,597 1,832 1,963 2,026HYLSA 720 710 763 824 802 860Other 219 - - - - -

Total 2,259 2,2^2 2,360 2,656 2,765 2,886

Non-flat ProductsAHMSA 451 270 321 398 402 402HYLSA 559 550 550 550 550 550SICARTSA 892 900 950 1,000 1,050 1,100TAMSA 77 50 50 50 50 50Others 1,129 1,150 1,150 1419 1,150 1,150

Total 3,108 2,920 3,021 3,43 3,202 3,252

Seamless TubinRTAMSA 208 210 217 225 233 240

Total ProductsAHMSA 1,771 1,852 1,918 2,230 2,365 2,428HYLSA 1,279 1,260 1,313 1,374 1,352 1,410S1CARTSA 892 900 950 1,000 1,050 1,100TAMSA 285 260 267 275 288 290Others 1,348 1 150 1,150 1,150 1 150 1 150

Total 5,575 5,422 5,598 6,029 6,205 6,378

Source: Bank staff.

13. In overall balance production of flat products remains below thevery conservative demand projection. Due to interlinkages between theproducti.in facilities for some plate products and hot and cold rolled sheetand coil shifts are possible depending on actual demand. As qualityimproves the balance decreases inlicating successful implementation of theoverall restructuring plan. In the non-flat product categories, commercialprofiles and bars and structural and rail where imports have existed in thepast, the projections remain below the demand estimate assuming someproducts will still not be available in Mexico. This could change asSICARTSA I improves its product mix and uses its excellent facilities tosatisfy more of the domestic demand. In the traditionally exportedproducts reinforcing bar and wire rod, exports are assumed to continue butat a declining rate. Table 5 provides a projection of balance for eachproduct category.

ANNEX 3-3- 86 - Page 6

Table 5

'.roduction Consumption and Balance of Steel Products(thousands of tonnes)

1986 1987 1988 1989 1990 1991Flat ProductsProduction 2,259 2,292 2,360 2,656 2,765 2,876Consumption 2,384 2,495 2,606 2,721 2,872 2,972Balance -125 -203 -246 -65 -107 -96

Non-flat ProductsProduction 3,108 2,920 3,021 3,143 3,202 3,252Consumption 2,733 2,823 2,916 3,013 3,113 3,214Balance +375 +97 +105 +130 +89 +38

Seamless TubesProduction 208 210 217 225 233 240Consumption 183 189 196 203 210 217Balance +25 +21 72-1 +22 +23 +23

TotalProduction 5,575 5,422 5,598 6,024 6,200 6,368Consumption 5,300 5,507 5,718 5,937 6,195 6,403Balance +275 -85 -120 +87 +5 -35

Country Department IIIndustry, Trade, Finance Sector Operations DivisionLatin America and the Caribbean Regional OfficeJanuary 1988

M - s 9Rw m pEwr

Hoaix of ism, 1me and Atios

tr Prohias Actions Taken Actions To Be Takem toiitoriZg Ations aol T6in

L. Structural lear

1. k Polic

Controlled It-c pric bes tMtnchly adjustment btsed o A ati Elionatimn of price contrls. Cntinued ete ulctn of priceInternational oppwrttxty cost; Inflatin iMac Pric Increasm In adjuarts of prics In real base an controls by arer 31, 1988adjute for inflation n a d hoc 1987 amA Jurazy 1988 to teach or anticipeted dwes In the Oxwar Pric Isd (lmu,e 2 release). r alybasi. emceed equiwlat led prim larels. until empletim of pric liberaliition. adjus- of pris in real tens

aatil dit Gae.

2. Po

Htgh taiffs mA high offical eliaiiwted in Decmaber 1987. Tarffs Ph further actioes are s ded or p d at Cbutinued dntem2 of sdcedreferens prics (P) do atwt all reduced on 1l1 steel products to 0-15Z i prIset taiff lewles wiut further amexteLal 1 Ttitiome 1987. restrictions wA/or reintroduction

of Beferen Prices.3. aobe' St mu fl

Ia£i of defintio of pblc sector Beluatim of the production mrAstiat Qintiuee evalation Of I tera production Prepration of SIIE lmescop ad role. strate of SIESL Preliminary and in t stratye of SIIEL Strategc Plan by &Arch 1908.

amoltduw led to aortiore t r SMERBeetnntwng belw.

lad of lo-term, polic, framk. Outline of Mnbal Steel Sector Pblicy Dateniz tie long-term taiff, pricing, arA Preparstion of Mobal Steel Sectorpreaented in Jamiary 1988 as the Steel tax/iometive policy fOr tie ector sucb Oht Policy a by July 31, 1988,Sector Policy letter. Maret and Product aD revemr occar on the agreel policy balW subetantia y the PolicyMix Sttdy coaleted In Sepember 1987. padmg. letter (liance 2 Re's).

4. Qmtitative lmuort Pestriction

lhestic cotat rquirmenes on steel Rthr evaluation urler my as part of Oadual elimlnatim of sae restrictions. tkder the ponposed dialuer. subect stuies for ropsl Indutrial Restructitrivg Iosm

lbstrtcturing tana.IL. s 0x Restrcurin

lnefficient, centralzed magmet. Reorganization _talo five profit ceters xuplete foimtim of fiwe irdepeit Duriig 1988.Ide SImEX SIlDt departments ad coapes under SUM=E acting as a holding

fuaaction edud to only tdoe ze uy by cny. Foralize holing apya bolding oQany and saff reduced by 700. relatiomuhips.

Ibyslop _ t t xtrol and operatig an 198B as part of the project.systems anid procedures for bolding ac pey wAprofit cers.ntr

_ubeecor-wide 9 Problm Actions Taken Actims To Be Tal MMitoring Actik and Timug

Ctra.iUod Darketing with service Sal responsibility devolved to plaits and Detarmite fmetion of srvice oente.-s, fn-ing 1988 as part of the project.cnters lad to a breakduA of service service oenters canerted frae cost to incorporate, and decide mther to privatize.to clients. profit acnters.

ITmfficient facilities. Smtdma of RM san associated dme , and FPrther rationalization of the ARA product Daing 1988 as purt of the project.tentative deciim to discoinimm sme-late lm, iztialig possible lay-off of 4,000at AlA; 12,000 wirkers laid off. additional workers.

2. Fi:nncial Structure

Inefficient organizatim brou&t lowr Signature of Qxmenio with Gveent wde S m1 to tale steps to fulfill the tarets ang 1988 as part of tde projectproductivity, amirntAnce. uttketing which asbot tE83 million equivalent, or specified by the Cawvilo. IMI-ttiouiard product udx probles tdat ended up 502 of the total debt on SMIE s booksin f-isil zestricticus that me it wil be axwerted to equity. SIE(i _icasil for tih grsw to reawr agrees to follw a tedctdcal restrutuinfiaial bealth idtbout debt plaa with specific targets to recive thisLesucturing. debt ref durig 1986, 1987 and 198

3. cal s

iinteAmic 1b-dlOg, iffiCimit Studies and formulatim of a tedmicel Cletim of o i staies. pematati 1988 to 1990. as part of tleproduct-ixt, l1ow quality in edatin pI gra for reblUitatiee of SUiE* of first ise nbhilitation investmats. roject.production a city. operating plants md utiliatim of RFI

facilities.

Capacity emo on in llgt of Ptelimumry evaluatin of SMB> II Gapletion taciml md eonomic evalattosu SflG Strateic Pan to beoptimizatim (balancig) of atin femibility. Qultmt study of SIIM of alternatiw routes for SI1M1 lo1g-ten coMleted by lr 1988.asd proposed m facilities IncU long-term strateg completad in October developit, aincldng a fitl decisim m timamoletion of the S W II 1987. scpe of the SMAWS fI plJat.inm_.

IL Private Sector

1. HY1U can owtribute to debt servic Peaenatio of a ompreasive debt FOrmUztion of ibatructrig Agreasets in Qdtiton of dLsburait of ISAbat ct be finanialy viable restruing plan bed on stu by i Ib 1988I. co_smntwithout a debt restructurig. Dli to determum ipe t capacity.

amplettn of egotiatiai cn a debtrestcetri cage with anmrcial asis.

2. Wrni-mlIs h1m restricted product fc to a9pete SBI> II invtmEnt biAew S1CWAS II decii. md ax.,,lete plat Stuiaes a-lete during 1987;qusality beo timy ae scap bed. thnrouh sp ira n plant stage to provide throgh spo imr stage. spoW iron plait will be ocsia-Qomd potential clients for spW irn. srce of priary iroQ to feed dmwstic ioad in late 1988, following

dewam!d. reviewtof SU = long-termStratgc Pla in MWrh 1988.

3. Credit Avalablity

Difficulties of private mini-mills to (alet4tg procures of interudiarias of Adjust t of existing idustrial credit lianes IE W " Cred "n- and theget credit 14r for wrking andl edsti ls ing reviewd. and prepration of props Industrial poposed IrAustrald Kestructriginventusunt capital. R.uStructuarig Loan.

Onsitry Deparbout 11Listry, e, tmnnce &ctor Oegtional Dicvisimlatin As rica Tr d the aribbean bgealtI Officeio

Pebary 1988 X

- 89 - AM 4-2

Page 1

MEXICO - STEEL SECTOR RESTRUCTURING PROJECI.

Steel Sector Pollcy Letter1

Restructuring of the Parastatal Steel Industry

Restructuring the parastatal steel sector is internded to enable itto expand the already major role it has taken in the process ofindustrialization and national development.

The Mexican Government has promoted restructuring of this sectorso as to make the domestic supply pattern compatible with internationalsupply, correct the low utilization of sector Installed capacity, andhasten the c.evelopment of steel substitutes. In the course of a November1986 address to the Chamber of Deputies, the Secretary of Energy, Miningand Parastatal Industry enumerated the following as the goals of theindustrial reorganizatioa proposed for the parastatal steel sector:

(a) to moderni?e the industry by ctmpleting projects in progress,launching facilities improvement prograws, and closing downstructurally inefficient operations;

(b) to raise industry opetating efficiency by eradicating the problemsassociated with obsolescence of equipment and poor integration ofchains of production;

(c) to raise the operating efficiency of mines and processing plantsto as to counter the inadequacy of coal and iron reserves;

(d) to link the sector efficiently to the external market; and

(e) to put the financial structure of the sector on a sounder footingand generate resources for its expansion programs.

Policy Outline for the Parastatal SteAl Industry

Signature of the Financial Rehabilitation Agreement with theSIDERMEX Group in September 1986 marked the beginning of the restructuringprocess. Commitments by both the Federal Government and the Group werespelled out and a timetable set for the goals to be achieved by theenterprises over the period 1986-90. In 1986 and the first months of 1987,the following steps toward restructuring of the industry were accordinglytaken:

(a) Internal Reorganization of SIDERMEX. SIDERMEX as a holdingcompany was organized on a more rational basis, retaining onlythose functions properly belonging to a supervisory entity. Theenterprise themselves were vested with the functions that would

This is a Bank translation of a signed letter from the Government(SEMIP and SECOFI) dated January 15, 1988, titled *Lineamientos dePolitica para la Industria Siderurgica Paraestatal."

- 90 -

Page 2

allow them autonomy of management, particularly in marketing andfinances.

(b) Reorganization of the Marketing System. Previously, there was nolink between production and the demands of the market, since thesteel producers themselves were not responsible for marketingoperations, which were concentrated in the hands of the holdingcompany and marketing entities that functioned independently ofthem. Currently, only planning and coordination are theresponsibility of the ho]iing company, while domestic marketing isleft to the enterprises themselve.s and export activity to SIDERMEXInternational, Inc.

(c) Deregulation of External Trade. Mexico's accession to the GeneralAgreement on Tariffs and Trade on August 24, 1986, constituted afurther step toward rationalizing protection, assuring theenterprise of high-quality, low-cost inputs against a backgroundof international competition. In this regard, the FederalGovernment abolished the mechanism of official benchmark prices asof January 1, 1988. In addition, although the original proposalhad been to set a maximum duty of 25% on steel products beginningin October 1988, a new tariff ranging from 0 to 20% was broughtin on December 15, 1987, within the context of the EconomicSolidarity Pact, with steel products subject to a duty range of 0tto 15%, a move which will further the goal of creating a morerational structure for production in this branch of industry.

(d) Institution of a New Pricing Policy. While liberalizing externaltrade for the steel sector, the Mexican authorities alsoinstituted a timetable for the deregulation of domestic steelprices, a process scheduled for completion in mid-1988. Theprogram, as approved by the Secretariat of Trade and IndustrialDevelopment on October 1, 1987, is set up as follows:

(i) Phase I. January 1988: Elimination of controls on domesticprices for seamed pipes, wire products, forged-quality wire,low-carbon wire, and wire rod.

(ii) Phase II. March 1988: Elimination of controls on domesticprices for heavy shapes (structural), merchant rods andshapes, ingots, billets, and coated sheet.

(iii) Phase III. June 1988: Elimination of controls on domesticprices for hot-rolled sheet, cold-rolled sheet, tin plate,corrugated rods, and plates.

This scheme is designed to link the parastatal steel industryefficiently with both the domestic and international economies,ensuring that it gives preference to manufacture of products thatallow it to capitalize on the country's structural advantages.

(e) Reduction in Size of SIDERMEX Group. Besides its full members,the SIDERMEX Group also had 87 associate members. With the ideaof forming a cluster of enterprises engaged exclusively in

- 91 -

Page 3

producing steel and priwary commodities, it was decided the Groupshould divest itself of all enterprise not meeting this criterion.Recently, in the Economic Solidarity Pact, the Mexican Governmentreiterated its intention of continuing and even accelerating thisprocess of divestiture of non-strategic and non-priorityenterprise.

(f) SIDERMEX Strategic Plan. At the end of March 1988, the SIDERMEXGroup will issue its Strategic Plan, which will incorporate thecapital spending program that includes the investments earmarkedfor the first phase of industry restructuring. The Plan will setout the actions through which the rationalization of bothoperations and organization will be continued, a process thatbegan with the Financial Rehabilitation Agreement between theGroup and the Federal Government. Given the results of both thelong-term strategy and market studies conducted recently byinternational corsultants and SIDERMEX's own analyses andevaluations, the Plan does not envisage promoting new projects tocreate additional installed capacity. It will instead concentrateon achieving more intensive use of existing facilities, efficientbalancing of lines of production, higher yields and greaterproductivity, and on ensuring that projects already underconstruction justify themselves technically and economically.

(g) Capitalization of GrouD Enterprises. The SIDERMEX FinancialRehabilitation Agreement lays the foundations on which the steelproducers in the Group can achieve financial self-sufficiency.They have been reorganized financially by means of increases intheir capital stock that will enable them to reduce theirliabilities and financial charges and generate enough cash flow tofund their restructuring programs. Consequently, the MexicanGovernment's intention for the long term is not to intervenefinancially in the parastatal steel sector any further than isprovided for in the Financial Rehabilitation Agreement, under theterms of which the enterprises commit themselves to, among otherthings, restricting annual borrowing to real payment capacity,tailoring investment plans to income growth, and rationalizingrecurrent expenditure generally. Within 90 days of publication ofthe SIDERMEX Strategic Plan, the Government will announce a globalpolicy for the steel sector that marks out the fields of activityof its parastatal and private branches and defines theGovernment's specific policies, criteria and intentions for theindustry as a whole.

In addition, the Government is continuing its efforts torestructure public finances and place them on a sounder footing, a processwhich involves ensuring that the parastatal enterprises become financiallyself-sufficient, are run by professionally competent managers, and conducttheir operations in an atmosphere of administrative and financialtransparency. The divestiture of public enterprises in non-strategicsectors is also going ahead, and it is hoped to accelerate the processduring what remains of the present Administration's term of office; as faras SIDERMEX itself is concerned, 50 of its 87 associate member enterprisesare currently in the process of sale, winding up or merger.

- 92 -

ANNEX 4-2Page 4

In general terms, the Government is intent on transforming thesteel sector into a productive, competitive industry organized on modernlines and equipped with up-to-date plant and facilities, the ultimate goalbeing to support the development of the manufacturing industries that aredependent on steel.

By letter of February 7, 1988, and in view of the provisions ofthe Economic Solidarity Pact, the Government clarified the actions underpara (d) as follows:

a) the Guvernment remains committed to complete elimination ofprice controls;

b) during the period leading to complete elimination of pricecontrols, the Government will adjust monthly the domesticsteel prices in real terms. The March 31, 1988 prices willform the base prices for such adjustments.

c) All price controls will be eliminated by December 31, 1988.

Country Department IIIndustry, Trade, Finance Sector Operations DivisionLatin America and the Caribbean Regional Office

- 93 - ANNEX 5-1

MEXICO - STEEL SECTOR RESTRUCTURING PROJECT

Imports Eligible for Financing

1. Expenditures for the following imported products will be eligiblefor financing under the Part A component of the loan:

Divi- Sub-Description of Item sic Group group

Sands, natural of all kinds - - 273.3

Clays & other refractory minerals - - 278.2

Iron ore & concentrates - 281 All

Ferrous waste & scrap - 282 All

Bituminous coal, not agglomerated - - 321.21

Coke & semi-coke of coal - 325 All

Fuel oils - - 334.4

Iron oxides & hydroxides - - 522.54

Refractory bricks & other refractory materials - - 662.3

Refractory ceramic goods - - 663.7

Iron & steel 67 All All

Structures & parts of structures of iron or steel - - 691.1

2. No withdrawals will be made to finance import of any goods:

- Supplied under a contract which any official national orinternational financial institution or agency shall finance througha loan or any financial instrument with maturity longer than oneyear.

- Intended for a military or paramilitary purpose or for luxuryconsumption.

Country Department IIIndustry, Trade, Finance Sector Operations DivisionLatin America and the Caribbean Regional OfficeJanuary 1988

ANNEX 5-2- 94 - Page 1

MEXICO - STEEL SECTOR RESTRUCTURING PROJECT

The AHMSA Component

A. Introduction

1. Altos Hornos de Mexico S.A., AHMSA, is the largest steel plant inMexico with a rated crude steel capacity of 3.9 million tonnes per year.In 1986 crude steel production exceeded 2.8 million tonnes and finishedproducts aproached 2.0 million tonnes, the highest level in the plant'shistory. The plant produces both flat and non-flat products primarily forthe domestic market. Based on the Steel Secto- Strategy Review completedin October 1986, the Bank recommended that AHMSA reduce or exit some of thenon-flat. products for which there are other more efficient domesticproducers and concentrate on producing higher-quality flat products nowbeing demanded by the country's engineering industries. Thisrecommendation has been accepted in part by SIDERMEX and AHMSA managementwith an agreement to review the production costs and product offerings inlight of predicted domestic demand and alternate sources of supply. Amarket study is currently under way and a detailed strategy study plannedfor all of SIDERMEX which will provide a basis for long-term facility andproduct planning.

B. Objoctives of the Project

2. The restructuring project developed by AHMSA concentrates onimproving the competItive advantage of ite flat products, primarily hot andcold rolled sheet, through investments in catch-up maintenance,debottlenecking and quality improvement in the facilities related to theproduction of these products. Other facility maintaining investments areincluded to keep the balance of the plant in operating order until otherstrategy studies are complete and the overall strategy elaborated.

3. The new investments are primarily aimed at reducing operatingcosts and improving product quality by increasing production in the plant'smost modern steelmaking and continuous casting facilities and balancingthese with improvements in the hot strip mill and cold rolling mills.Secondary investments are included in catch up maintenance of operatingequipment from the coke ovens to the rolling mills and plant services inorder to improve availability and reduce unplanned shutdowns and thesubsequent negative impacts on productivity. Other maintaining investmentsthat will be made by AHMSA and investments related to introducing theproduction of rail on the heavy atructural mill are also considered in theproject description and analysis. However, the major criterion for all ofthe project components is that they are in product lines that are expectedto remain viable after the market and strategy studies are completed, andthat they will result in internationally competitive products with coststhat are both financially viable to AHMSA and economically viable to thecountry.

ANNEX 5-2- 95 - Page 2

C. Produetion Program

4. The rehabilitation project is set against the projection ofapparent consumption of flat products detailed in Annex 3-1. Theprojection of production of flat products for AHMSA is shown in Table 1based or the criterion that AHMSA is the marginal producer. Theseprojections take into consideration the production program of HYLSA and theeffect of its restructuring effort thereby reducing the portion of themarket available to AHMSA. This remaining portion is allocated to AHMSA tothe extent of its capacity for each product. These projections do notinclude products that are not now currently produced in the country (e.g.,some silicon steels, chrozized sheet, etc.). The growth assumptions areconser'.ative in that they accept the decline in apparent consumption of1986 as a starting point and project an increase from this base of 4.4X peryear thereafter. Plate production beyond 1991 may be affected by decisionsregarding SICARTSA II which will be reviewed in the strategy study.

Table 1

Projections of Production Flat Products - AHMSA(in thousands of tonnes)

1986 1987 1988 1989 1990 1991Product CategoryPlate 346 421 460 500 540 540Hot Rolled Sheet 322 385 304 440 469 500Cold Rolled Sheet 483 570 617 666 717 738Tin Plate 169 206 216 226 237 248

Total 1,320 1,582 1,597 1,832 1,962 2,024

The reduction in hot rolled coil production anticipated in 1988 ceflectsthe time the hot strip mill will be out of service for rehabilitation.Other mill outages have also been taken into considerat'on in theproduction planning exercise.

5. The projectIon of consumption and national production capabilityfor non-flat products is shown in Annex 3-1. The production for AHNSA isshown in Table 2 and is in products where there is no other supplier in thecountry or as in the case of wire rod where AHMSA appears to have acompetitive advantage based on wire drawing facilities of theirwholly-owned subsidiary Southern Division near Mexico City. The productionscenario has been developed in order to properly allocate all the primaryfacilities for iron and steelmaking as well as developing the finishedproduct figures for the plant.

ANNEX 5-2- 96 - Page 3

Table 2

Projections of AHMSA's Production for Non-flat Products(in thousands of tonnes)

1986 1987 1988 1989 1990 1991

Reinforcing Bar 76 0 0 0 0 0Wire Rod 155 103 139 141 145 145Profiles & Bar 80 84 84 84 84 84Structural & Rail 75 80 95 170 170 170Billet 328 0 0 0 0 0

6. In the development of these projections, AHMSA is assumed to exitthe reinforcing bar product line, exit the production of billets for saleand for rerolling at other divisions which are to be closed down, and exitthe structural profiles market. Pending further studies wire rod isproduced only for transfer to the Division Sur for drawing into wire andsubsequent domestic sale. Similarly merchant bar production is limited toproduction of spring material both round and flat for Rasini Rheem, aproducer of finished automotive spring assemblies for domestic and exportmarkets. AHMSA has the only production facilities at the present time inMexico for these products. Finally, production of heavy structuralsections is assumed to rise from approximately 70,000 tonnes in 1986, toapproximately 100,000 tonnes in 1989 and be augmented in that year by anadditional 70,000 tonnes of rail pr:oduction. The figures for non-flatproducts are included in order to develop an overall production plan withthe agreement that all will be reviewed further after the strategy study iscomplete. It should be clear, however, that no investments are planned atthis stage for facilities whose products might be in question until thelong-term strategy is developed and agreed.

D. Description of the Project

7. As described earlier, the primary facilities of the plant, fromraw materials to crude sreel production are a mixture of technologies andmethods. The facilities of plant #2 are modern and up to date and havebeen reasonably maintaired. They provide a sound technical basis forexpanded operations. The major technical thrust is to (i) debottleneck thesteelmaking and continuous casting facilities in plant #2;(ii) rehabilitate and iLaprove the quality and productivity of the hot stripmill in plant #1; (iii) debottleneck the cold rolling mills in plant #1 andimprove the quality of cold rolled products processed in plant #2;(iv) provide catch-up maintenance throughout plant operations and in theplantwide utilities and services; (v) expand the prcduct line by using theheavy structural mill for the production of rail; and (vi) provide forenhancement of systems and training. The proposed investments include:

(a) Improvements in steelmakingn through the addition of doubleblowing in both BOF1 and BOF 2 and ladle metallurgy in BOF2; andautomatic level control and electromagnetic stirring in thecontinuous slab casting machines.

AMNkX 5-2- 97 - Page 4

(b) Hot rolling mill renovations through the construction of new slabyard facilities and reheating furnaces; the revamping of the hotstrip mill including extensive mechanical and electricalupgrading along with the introduction of extensive computercontrol; and new coiler equipment and coil transport and storagesystems.

(c) Cold rolling mill balancing through the addition of new equipmentat the entry and the exit of No. 3 pickling line; the combinationof two existing cold rolling rills into one unit; and additionalchanges in processing lines to process a heavier weight coil fromthe revamped hot strip mill.

(d) Maintenance in the production plants aimed at lowering downtimeand in general to bringiag the operating facilities up to a baseperformance level and in maintaining other facilities at AHMSAand its subsidiary plants until the final product strategies aredeveloped. Rehabilitation of plant-wide utilities and servicesincluding a new electric substation and rearrangement of electricdistribution system, rehabilitation of the industrial watersupply and rehabilitation of existing pollution control equipmentat BOFI and BOF2.

(e) Production of rail which is a standalone project aimed atutilizing the modern heavy structural mill which currently hassignificant excess capacity for the production of rail productswhich are not domestically produced.

(f) Technical assistance for development of technically up-to-datemanagement information systems to provide information for(i) management decisionmaking and statistical quality control;(ii) sales order entry and customer service performance;(-ii) production planning and control; and (iv) accounting andfinancial reporting including product cost accounting. Funds arealso included for training throughout the plant with particularemphasis on worker and supervisor skills improvement. Technicalassistance in project management to assist in implementing theproject is also included (900 man-months).

8. The overall project has been developed and prepared with theassistance of an outside engineering and consulting firm. Of the totalprogram ICB packages for possible Bank financing have been developed forHot Strip Mill revamping, Cold Rolling Mill and Process line equipment andRail production. Additional Bank funding is also proposed for Maintenanceand Technical Assistance. Other agreed areas of investment are beingundertaken directly by AHKSA.

G. Project Management

19. Funding is included to assist in the management of the overallproject. Engineering assistance has already been provided to AHMSA by USSteel engineers in the preparation of the project involving development ofthe technical components, scheduling and estimating costs. The cost of

ANNEX 5-298 - Page 5

this assistance is included for retroactive financing. Based on this work,terms of reference have beeu prepared for a project management consultantto assist in implementing the project from procurement to start-upincluding assistance in finalizing basic engineering, preparing technicalspecifications and final u&ldding documents, bid evaluation and preparationof contracts. It is planned to maximize the utilization of AHMSA and localengineering staff in this effort.

20. Implementation schedules have been developed by AHMSA for each ofthe major subprojects with the overall program expected to take three yearsto complete. Table 3 provides an overall guide by activity assuming astart date of July 1987.

Table 3

AHMSA - Imglementation Schedule

1988 1989 1990 1991Project/Activity _ _ _-

ProectActvit II2 3 4 1 2 13 4 11 21 3 4 1 2 3 4V + 0

Steelmaking V _ _- - _ _ .. OV 4. 0

Hot Strip Mill V _ - -_ _ - ..

Cold Rolled Mills e _ _ _ _ _ _ _ _ .0

Maintenance and Service __ -_ _ + _ _ _ OV + 0

Rail Production - - - - -. V +

System and Training __ __ _ _ . ..V + ____

Project Management I I I I

Legend:

V Invitation to Bids+ Contract0 Operation

- - - Engineering and ProcurementManufacture/Construction/Shipping

..... .Installation/Commissioning

Country Department IIIndustry, Trade, Finance Sector Operations DivisionLatin America and the Caribbean Regional OfficeJanuary 1988

ANNEX 5-2Appendix 1

- 99 - Page 1

MEXlCO - STEEL SECTOR RESTRUCTURING PROJECT

Environmental Control

1. The nature of operations carried out in an integrated steel plantleads to the generation of air and water polluting components, most of themimpacting mainly on the local environment. The AHMSA plant which beganoperations before the detrimental effects of some pollutants was known hasa mixture of operations and technologies some of which include effectivecontrols and others with none whatsoever. The piant rehabilitation programtakes into consideration the shut down of some of the technically obsoleteand highly polluting equipment which will greatly reduce existing levels ofair and water emissions. In addition, the program includes rebuild andexpansion of air and in particular water pollution controls to bring themajority of the operating equipment within existing levels allowed byMexican regulations. The Phase II rehabilitation program will aim toremove the last of the obsolete facilities and very high pollution sources(e.g., Siemens Martin open aearths).

Air Pollution

2. Table 1 indicates the particular emissions by department comparedwith the current Mexican regulations and notations regarding this source.

Table 1

AHiMSA - Air Pollution by Department(kg/hr)

Department Measured Allowed Remarks

Pelletizing Plant 46 42.3 Pellet transfer operationsSinter Plant #1 423 102.1 Transfer of materialsSinter Plant #2 291 161.9 Transfer of materialsCoke Plants a/ - - Coke pushing and screeningBlast Furnaces a/ - - Cast floor emissionsBOF #1 and 2 ar - - Secondary emissionsOpen hearths 1,757 256.8

Total b/ 2,517 563.1

a/ These facilities include modern air pollution control equipment which,when operating, eliminate all primary emissions. Maintenanceinvestments are included to improve performance.

b/ Total is calculated on the basis of full operation.

With all facilities operating the total accumulated emissions are2,517 kg/hr corresponding to a maximum permitted of only 563.1 kg/hr. Aspart of this project, it is planned to shut down the sinter plant #1 andfour of the Siemens Martin open hearth furnaces. These changes are

ANNEX 5-2Appendix 1

- 100 - Page 2

expected to drastically reduce the current levels of emission. In addition,it is planned to expand the duet collection equipment at the pellet plantand rework a portion of the equipment at sinter plant t2. In total, theseefforts are expected to:

(a) bring the pellet plant into compliance;

(b) reduce sinter plant .1 to 237 kg/hr;

(c) reduce the open hearths to 659 kg/hr; and

(d) bring the total to 996 kg/hr compared to an allowable emissionlevel of 300.6 kg/hr.

3. Therefore, instead of exceeding the current allowance by347%, the plant will be exceeding the allowance by approximately231%. Further improvement can only come after elimination of the openhearth furnees and determination of the production levels of the otherfacilities which will be addressed after the strategy studies leading tophase II are completed.

Water Pollution

4. At normal operating levels plants #1 and #2 operate eightresidual water discharge liner with a total volume of 226 liters persecond. Table 2 lists the principal parameters for measurement of waterquality regarding pollution of soil, subsoil, and water in the area. Theeight discharge lines are associated with the following equipment:

(a) discharge #1 into Ri, Monclova from the water treatment plant,steel plant and blast furnaces in plant #1;

(b) discharge #4 into Arroyo Frontera from the water treatment plant,power plant and oxygen plant in plant #2 and steel plant #1;

(c) discharge #5 into a waste well from the pickle lines,electrolytic cleaning, tin plating, and rolling mills in plant#1;

(d) discharge #6 into Arroyo Frontera from the blast furnace, cokeovens, and steel plant #2;

(e) discharge #4 into Arroyo Frontera from the water treatment plant,blast furnace and mineral stores and eteel plant #2; and

(f) discharge #8 into Arroyo Prontera from the BOP, continuouscaster, cold rolling mills and steel plant #2.

Discharge lines #2 and #3 associated with plant #1 were rerouted throughthe new water treatment plant in plant #2 when the facility wasconstructed.

ANNEX 5-2Appendix 1

- 101 - Page 3

Table 2

AHMSA - Water Pollution by Discharges

Volume Temp. Solids OilDischarge I (1/sec) pH (eC) (Ng/1) (Mg/l)

Maximum Allowed - 4.5-10.0 35.0 1.0 70#1 25.0 7.9 40.0 0.1 Trace#4 20.0 7.4 30.0 0.8 Trace#5 110.7 2.5 38.0 - Trace#6 36.0 9.4 27.5 9.0 2.3#7 30.9 8.4 23.0 0.5 0.3#8 3.6 8.4 20.5 0.5 9.0

5. Discharge #1 temperature of 40°C exceeds the water temperaturemaximum of 35'C Discharge #5 pH of 2.5 is more acidic than the 4.5allowed. Discharge #6 exceeds the solids allowed. Studies are under wayand funds are included in the Phase I project to bring the acid content of#5 and the solids content of #6 under control. The tempersture of waterfrom #1 will drop with the phasing out of the Siemens Martin ->pen hearthfurnaces.

Country Department IIIndustry, Trade, Finance Sector Operations DivisionLatin America and the Caribbean Regional OfficeAugust 1987

ANNEX 5-3- 102 - Page 1

MEXICO - STEEL SECTOR RESTRUCTURING PROJECT

The CMC Component

As The Project

1. Several structural issues are linked to the future development ofMexican iron ore production. First, the supply of pellet feed and pelletsin Mexico is split geographically between North and South and although anoverall national balance provides a positive picture in terms of productionand capacities, in 1987 the northern mills will have to transport by railsover distances of about 1,500 Km from the southern mines, 55% of their4.7 tpy total demand of ferrous inputs while the southern mills willconsume ore produced in the region and save considerably in freight.Second, the two northern mines, in particular Hercules suffer frommanagement and technical problems and have in the past suffered frominsufficient coordination with the steel planls; consequently therehabilitation of Hercules is a top priority because of (i) its largereserves; (ii) its installed capacity, unused due to the poor condition ofits mine equipment (production of pellet feed in 1986 was 0.75 milliontonnes, or 25X of the capacity of the concentrator); and (iii) its northernlocation, and consequently, the potential for savings in freight. Third,La Perla is currently the only mine producing high quality ore suitable assinter feed for AHMSA. However, its reserves are small, and it istherefore necessary to improve the knowledge of reserves at La Perla and toidentify other reliable sources of sinter feed. Finally, Pena Colorada isan operation with a large resource base, whose owners include all theintegrated steel mills in Mexico. The recent decision by HYLSA to developthe Cerro Nahuatl mine to replace El Encino, as the latter approachesdepletion, will leave Pena Colorada with excess capacity once Hercules andLas Truchas are rehabilitated/expanded.

2. In addition to the above, the supply of ferrous inputs to theMexican steel mills faces several temporary urgencies, which because oftheir potential economic impact, have become major issues requiring promptattention: (i) the Hercules mine is considerably behind in its strippingand in danger of not being able to feed the concentrator with ore;furthermore the yields obtained by the Hercules concentrator in processingsome of the ores of the mine, have been less than satisfactory, as theplant design appears not to suit some of the more frequently occuring oresof the deposit; and (ii) the investments for the mine and concentrator arelagging behind the SICARTSA II project; SICARTSA II is therefore likely tostart its operations using imported iron ore and pellets.

3. About 70% of coking coal requirements of the Mexican steelindustry (the only two steel plants that requiri; coking coal are AHMSA andSICARTSA I) are met by the production of Sidermex coal mines in the state

ANNEX 5-3-103 - Page 2

of Coahuila, near the northern steel mills; half of the remaining 30% issupplied by the Comision de Fomento Minero (CFM), a source considered to beexpensive and unreliable, and the other half is imported. Sidermex'sproven reserves suffice for 35 years of production at current levels; theproduct is of good quality and mining conditions are relatively easy;however, productivity levels do not compare favorably with internationalstandards. The coal content of some of the materials now being rejected astailings by the coal washers is considered to be high enough to merit theanalysis of possible further processing.

4. Based on the above considerations, the proposed project willconsist of:

(a) The execution of an emergency plan to initiate the process ofbringing up to date the stripping of the Hercules mine; the planincludes:

- contracting the removal of a minimum of 4 million tonnes,adjustable to 7 million tonnes of overburden;

- contracting with the original manufacturers, or theirrepresentatives, the repair and maintenance of the existingmine and major plant equipment in Hercules;

- Insuring an adequate level of inventories for the normaloperation of the referred unit.

(b) Debottlenecking of the existing operations. In Hercules,providing the mine with the equipment to finalize the updating ofthe mine stripping and then to sustain the required level ofproduction, and habilitating the concentrator to process lowergrade ores. This will include the purchase and/or installationof mining equipment such as three 15 m3 shovels, two rotary blasthole drills, eight 120 tonne trucks, two front end loaders, twodozers, electrical loops; the analysis and modification of theconcentrator, through the addition of magnetic separators;support facilities such as completion of truck maintenance shop,new truck warehouse and steam cleaning, expansion of concentratorshop and mobile service equipment; urban facilities such asadditional 30 houses, termination of 78 houses and townsitesupport infrastructure. In the slurry pipeline, new agitatingtanks. In the coal mines the replacement of the armoured faceconveyor of three mines.

(c) Safety in the coal mines - rock dusters, upgrading mineventilation and communication systems, face lighting and powercenters, conveyor belt slippage switch and emergency stopsystems, fire protection systems.

(d) Increased coal production to replace the coal purchased fromthird parties - general upgrading of the mine equipment of three

ANNEX 5-3- 104 - Page 3

mines; new wash plant in Palau; finalize the opening of theMimosa IV mine and install a new longwall system complete;additional railroad track and mobile equipment related to the newwash plant and Mimosa IV mine.

(e) Other investments - include the purchase of hardware for dataprocessing at the mines, Monclova end Monterrey.

(f) Technical Ass.stance - a progr.m including four components isproposed; an exploration component that will review the entireexploration strategy of all of Sidermex enterprises; anoperational component stressing Hercules and the coal minesseeking to bring their production to designed levels and henceimproving productivities; a project execution component to assistin the preparation of technical specifications, bid requests andanalysis as well as in the engineering, p:.ocurement andconstruction management of the project; and assistance for thedevelopment of adequate management information systems.

Country Department IIIndustry, Trade, Finance Sector Operations DivisionLatin America and the Caribbean Regional OfficeJanuary 1988

ANNEX 5-4- 105- Page 1

MEXICO - STEEL SECTOR RESTRUCTURING PROJECT

SIDERMEX - Strategic Planning Studies

1. The SIDERMEX long-term goal is to maintain the installedproduction capacity, technologically updated and competitively positionedin terms of quality, cost and products in order to respond aggressively tothe needs of the domestic market. In support of this goal it is recognizedthat steps must be taken to assure the development of a professionalcompetent work force as well as being able to obtain an adequate return oninvested capital consistent with the norms set by the financial markets andensuring a continued flow of capital funds at market rate for investmentand asset renewals in the future.

2. The objective of the proposed strategic studies is to develop thetechnical, economic and financial plans and programs that would permitSIDERMEX to attain the above goals. The first step is to develop the broadoutline of the long-term strategy and determine the particular studiesnecessary to successfully implement the desired programs and plans.

3. Evaluation of the following major elements are part of the firststep to develop the long-term strategy:

(a) the alternatives from a technical, financial and economicstandpoint for the upgrading and modernization of the AHMSAfacilities beyond the steps being taken under the Phase IRestructuring Program;

(b) the balancing of the existing facilities and product liesconsistent with market needs and with the need to maintaintechnological competitiveness, including the possible technicaland economic use of the shut-down FUNDIDORA facilities;

(c) the alternatives arising from the technical, economic andfinancial capabilities of the SICARTSA I and SICARTSA IIfacilities, including the plate mill investment, in the contextof market needs and a corporate wide product mix and plantspecialization approach;

(d) the availability and cost of the ore and energy reserves in thecountry to allow the above development to be carried out in aneconomic and financially feasible manner, and the alternatives tofurther development of the raw material resources in the SIDERMEXcomplex;

(e) the human resource development needed to carry out the long-termprograms and to maintain technological competence;

ANNEX 5-4- 106 - Page 2

(f) the organizational and systems needs that will be best suited tothe long-term strategy;

(g) the financial programs and further restructuring steps that arerequired to meet the stated objectives of long-term return oninvested capital; and

(h) the social and regional economic impact of the proposed facilityhanges needed to meet the long-term strategic objectives.

4. The first step work program is being carried out in parallel withthe Market Study that started in early June. It will draw from existingplant-level technical studies and use other available data and economic andfinancial studies that have been carried out as part of the SIDERMEXStage 1 Restructuring Program. The SIDERMEX strategic response to themarket needs will be framed in the light of the underlying competitivenessof the existing facilities and product lines and the potential intechnical, economic and financial terms to restructure and change, modifyand enhance that competitiveness. It will take into account theconstraints and limits imposed by the existing facilities, commitments andpolicies and should attempt to develop and strategy including possibleresponses to the constraints and limitations. Finally, it will also takeinto account the known and possible investment plans of private sectorsteal producers.

S. The following was the proposed time schedule of activities forthe first step program and items (a) through (f) have already beencompleted:

(a) Finalization of the Terms of Reference - March 30, 1987(b) Letter of Invitation to Consultants - March 30, 1987(c) Formation of the SIDERMEX Study Team - April 1, 1987(d) Proposals Received from Consultants - April 30, 1987(e) Evaluation of Proposals - May 28, 1987(f) Finalization of Consultant Contract - June 5, 1987(g) Start of Study - June 30, 1987(h) First Progress Report - August 15, 1987(i) Completion of Draft Phase I Report - September 9, 1987(j) Review and Finalization of Strategy Report - September 17, 1987(k) Presentation to SIDERMEX - October 1, 1987

6. British Steel Overseas Services Corp. was selected to carry outthis first step study and has completed the study as scheduled. SIDERMEXis presently reviewing the strategy options and will have prepared theirLong-term Strategic Plan by March 31, 1988.

Country Department IIIndustry, Trade, Finance Sector Operations DivisionLatin America and the Caribbean Regional OfficeJanuary 1988

ANNEX 5-5- 107 - Page 1

MEXICO - STEEL SECTOR RESTRUCTURING PROJECT

The HYLSA Component

A. Introduction

1. HYLSA S.A. is the largest private sector producer with two majoroperating steel plants. Both are integrate4 facilities based on thein-house developed HYL direct reduction process for conversion of iron oreto sponge iron and conventional electric arc furnace for the production ofliquid steel. The Monterrey nolat Products division has a theoretical crudesteel capacity of approximately 1.1 million tonnes per annum and the Barand Rod Division located at Puebla has a theoretical crude steel capacityof 0.6 million tonnes per annum. The Puebla operation also includes asubsidiary rerolling plant at Apodaca. These non-flat producing facilitiesare not included in the present restructuring project which focuses solelyon the Flat Products division.

2. The HYLSA Corporation is a wholly owned subsidiary of the privatesector conglomerate Grupo IndustriAl Alfa and was for some time the cashengine for the group's expansion. At the present time both HYLSA isnegotiating financial restructuring with both domestic and foreign banks(Alfa recently reached a comprehensive agreement with its creditors). Aprerequisite for including a component for the Flat Products Division isthe signing of a term sheet covering the HYLSA financial restructuring.

B. Objective of the Project

2. The restructuring project developed by HYLSA and NXK concentrateson improving the competitive advantage of the Flat Products divisionthrough investments in cost reduction, yield, productivity and qualityimprovement. The resulting products are intended to better satisfy theflat products market in Mexico which is demanding higher qtality, bettercustomer service and a broader range of specifications. 1 addition theproject is intended to be executed in a timely fashion to 4atintain acompetitive balance between HYLSA in the private sector and AHNSA in thepublic sector which is also undergoing extensive modernization.

3. The new investments are primarily aimed at reducing operatingcosts and improving product quality by utilizing the plant's excellentsteelmaking operation in conjunction with new continuous casting facilitiesand balancing these with improvements in both the hot and cold rollingmills. With the exception of the casting machines most of the equipmentincluded in this project was purchased in the early 1980s for an expansionproject which would have increased capacity to 1.6 mtpa but due tofinancial difficulties was never completed. The major criteria as in thecase of the AHMSA investment in similar product lines is that the resultantproducts will be internationally competitive with costs that arefinancially viable for HYLSA and economically viable for the country.

C. Production Program

4. The projection of apparent consumption of flat products isdetailed in Annex 3-1. The production plan for RYLSA is shown in Table 1

ANNEX 5-5- 108 - Page 2

and is based on high utilization of existing capacity, as has beendemonstrated over the last ten years, and increases in production asrevamped and new facilities come on line. The remaining apparentconsumption is assumed to be filled by AHKSA or imports.

Table 1

Projection of Production of Flat Products - HYLSA(thousands of tonnes)

Praduct Category 1986 1987 1988 1989 1990 1991

Plate 93 92 99 105 103 125Hot Rolled Sheet 204 202 247 258 253 301Cold Rolled Sheet 418 408 404 437 422 410Tin Plate 5 8 24 24 24 24

Total 720 710 824 824 802 860

HYLSA competes directly with AHMSA and imports mainly in the hot rolled andcold rolled product groups. It is HYLSA's plan to shift production in thecoming years to the higher value added cold rolled products. Significantflexibility is also built itito the program to allow reaction to marketshifts between products and between the categories within the major groups.

D. Description of the Project

5. The project was originally defined in three stages, however, thetotal quality improvement does not take effect until after the addition ofcontinuous casting which is in stage two and high production levels of coldrolled products does not occur until stage three. These stages wereoriginally based on HYLSA's ability to self-finance the total project overa four year period and not on a technical basis. The project is presentedhere in a three year time frame without the artificial constraint ofstaging the elements. The investments are well balanced and are intendedto (i) establish the production of high quality slabs from the steelmakingshop; (ii) rehabilitate and improve the quality and productivity of the hotstrip mill; and (iii) debottleneck the cold rolling mills and improve thequality and productivity of these facilities. The physical investmentsinclude:

(a) Improvements in steelmaking through the addition of ladlemetallurgy; a new continuous casting machine; and a slab cooling,reconditioning and stocking yard.

(b) Hot rolling mill renovation through the additional of new slabstorage and handling facilities and two new reheat furnaces;revamping the existing hot strip mill including changes in theroughing stands, finishing mill and strip cool:ng system; and theaddition of a new coiler, skin pass mill and roll shop.

(c) Cold rolling mill expansion through the addition of a new pickleline, improvements to existing mills, new automation and controls

ANNEX 5-5- 109 - Page 3

and coil handling improvements throughout the operation; andinstallation of a new tandem mill and a new temper mill.

In addition, project management consultant services of about 250 man-monthsare included to assist HYLSA in carrying out detailed engineering andproject supervision.

E. Project Management

6. Funding is included to assist in the management of the overallproject. Engineering assistance has already been provided by Nippon Kokan(NKK) in the preparation of the project including development of technicalcomponents, scheduling and estimated costs. Terms of reference have beenprepared for a project management consultant to assist in implementing theproject from preparation of detailed specifications and bid documents tostart-up of equipment. The implementation program for the overall projectis shown in Table 2 below. HYLSA has given internal responsibility for theproject to the technical director of the Flat Products Division.

Table 2

HYLSA - Implementation Schedule

1988 1989 1990 1991Project/Activity.__________Project/Activt 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4

Steelmaking _+V + 0

Hot Strip Mill __ __ V _ _ __ _... .OV 4. 0

Cold Rolled Mills __ _.

Pro4ect Management

Legend:

V Invitation to Bids+ Contract0 Operation--- Engineering and Procurement

Manufacture/Construction/Shipping... Installation/Commissioning

Country Department IIIndustry, Trade, Finance Sector Operations DivisionLatin America and the Caribbean Regional OfficeJanuary 1986

- 110- ANNE 6-1

MEI - sL uR W

Siuary Pmoject Cost - AHMSA Project Chimernt - Part B.l

z %Ib Mlitm Us$ muLWm Foreign Base

Iccal Fore:gp Total loca Forel otal Content Cost

Equipment & *Mres 54.5 212.4 266.9 44.1 172.0 216.1 79.6 75.5Civil Works/Erectimx 38.0 11.5 49.5 30.8 9.3 40.1 23.2 14.0Fog/Project Iaegennt 6.0 11.2 17.2 4.9 9.1 14.0 65.2 4.9TA/trainIng _6.9 12.8 19.7 5.5 10.4 15.9 65.2 5.6PrM Cost (Mxdi. Ixs

& Dities) 105*4 247.9 353.3 85.3 200.8 286.1 70.2 100.0

Physical 11.9 17.5 29.4 9.6 14.2 23.8 59.5 8.3Price CkntinsFrcies 19*7 17.3 37.0 16.0 14.0 30.0 46.7 10.5Installed Q6t (excl.

Taes & Duties) 137.0 282.7 419e7 110.9 229.0 339.9 67.4 118.8

Taixes & Duties 61.9 0.0 61.9 50.1 0.0 50.1 0.0 17.5

Installed Cost 198.9 282.7 481.6 161.0 229.0 390.0 58.7 136.3

Working Capital 66.9 16.7 83.6 54.2 13.5 67.7 19.9 23.7

Project Cost 265.8 299.4 565.2 215.2 242.5 457.7 53.0 160.0

bnterest Ibring Coktnsrctio 2.7 24.5 27.2 2.2 19.8 22.0 90.0 7.7

Total FinancingNeeds 268.5 323.9 592.4 217.4 262.3 479.7 54.9 167.7

F 4nncn PlaProposed Benk loan 0.0 209.9 209.9 0.0 170.0 170.0 100.0 59.4Short-tenn Debt 39.5 0.0 39.5 32.0 0.0 32.0 0.0 11.2Internal Cash Generation 229.0 141.5 370.5 185.4 92.3 277.7 33.2 97.1

Country Diertment IIIndustry, Trade, Finane Seor qCei Division

Latin America and the Caribbean Regional OEficJanay 1988

- 111 - A 6-2

If ) - b8E WT 1Jmp

S r Poect COt - OC Project 22MqR!LX - Part B.2

2 XbtUim US$ t L UOn F1vep us

local F TeW Total local e Total cont cost

Bqul4ant & *ares 9.2 100.1 109.3 7.5 81.0 88.5 91.A 74.5Civil WoIk/Erectlon 31.9 0.0 31.9 25.8 0.0 25.8 0.0 21.8fo/Project hnage et 0.0 2.0 2.0 0.0 1.6 1.6 100.0 1.3TA/TrainIng 0.4 3.0 3.4 0.4 2.4 2M. 87.5 2.3Base Cost (ext . Tas

& Duties) 41.5 105.1 146.6 33.7 85.0 1187 71.7 100.0

l2 ysical O,ntIigerci 7.7 10.0 17.7 6.2 8.1 14.3 56.5 121Price Ctlzingesces 8.5 7.3 15.8 6.9 5.9 12.8 46.1 10.8Installed Cost (eMdl.

Taxes & Duties) 57.7 122.4 180.1 46.8 99.0 145.8 67.9 122.8

Taxes & Duties 36.0 0.0 36.0 29.2 0.0 29.2 0.0 24.6

InstaUled Cost 93.7 122.4 216.1 76.0 99.0 175.0 56.6 147.4

working Capital 1.7 1.6 3.3 1.4 1.3 2.7 48.1 2.3

Project Cost 95.4 124.0 219.4 77.4 100.3 177.7 56.4 149.7

Interest DUwig Co tructiom 0.8 7.4 8.2 0.7 6.0 6.7 9D.0 5.6

Total FinancingNeeds 96.2 131.4 227.6 78.1 106.3 184.4 57.6 155.3

Proposed lank Loan 0.0 61.8 61.8 0.0 50.0 50.0 100.0 42.1Sx .- term Debt 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0Internal Cash Ganeratimn 96.2 69.6 165.8 78.1 56.3 134.4 41.9 112.9

Country Dqlrtnwit I1Industry, Trade, Fimaic. Sector Operamtim DivisionLatin Anwica and the Ckribbea Regional OffieJaway 1988

- 112 - ANNEK 6-3

MMOD - STEL S=C1U ICSIURU PRIECT

amar Project Cost - M Project CoMment - Part C

%XM$ billion US$ million Forelgn Base

local !2reig Total Local ForeLgn Total Cbntant Cost

Equlpment & Spares 44.4 93.3 137.7 36.0 75.5 111.5 67.7 67.8Civil Works/Erection 42.9 0.3 43.2 34.8 0.3 35.1 0.8 21.3&bgfProject Imbnagaunt 13.8 8.4 22.2 11.2 6.8 18.0 37.8 10.9TA/Train1mg 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0Base Cost (excl. bxs

& Duties) 101.1 102.0 203.1 82.0 82.6 164.6 50.2 100.0

RPbyscal CbrtilQFIlie 11.5 16.3 27.8 9.3 13.2 22.5 58.7 13.7PricOe rt 19.0 12.5 31.5 15.4 10.1 25.5 39.6 15.5Tlstalled Cbst (endl.

Taxes & DtAles) 131.8 130.8 262.6 106.7 105.9 212.6 49.8 129.2

Taxes & Duties 30.6 0.0 30.6 24.8 0.0 24.8 0.0 15.0

Installed Cost 162.4 130.8 293.2 131.5 105.9 237.4 44.6 144.2

Wbrking Capital 29.8 7.4 37.2 24.1 6.0 30.1 19.9 18.3

Project Cost 192.2 138.2 330.4 155.6 111.9 267.5 41.8 162.5

Interest During Construction 1.4 12.1 13.5 1.1 9.8 10.9 89.9 6.6

Total FinancingNeeds 193.5 150.3 343.8 156.7 121.7 278.4 43.7 169.1

nn!gf PlaProposed Bank loan 0.0 92.6 92.6 0.0 75.0 75.0 100.0 45.6Short-temn Debt 42.0 0.0 42.0 32.0 0.0 32.0 0.0 19.4Ioternal Cash CGeKration 153.9 77.7 231.6 124.7 46.7 171.4 27.2 104.1

Cosntry Dapartamt IIInlustry, Mrade, Fnace Sector Oeations DivisioLatin Amirlca and the Caribbean Pegional OfficeJ 198B

- 113 - AMR 6-4

MCCO - SML MMse MUM PWU1

ummay Total Project Cost - Parts B and C

X%Mbilion US$ milln o :rep -i

local Fre Tbtal local FL Total Cbrtent Cost

Equipimn. & Spares 108.2 405.7 513.9 87.6 328.5 416. b 79 73Civil Works/Erection 112.9 11.9 124.7 91.4 9.6 101.0 10 18Eng/Project bnagement 19.9 21.6 41.5 16.1 i7.5 33.6 52 6TVtragN 7.3 15.8 23.1 5.9 12.8 18.7 68 3Ba4e Cost (emr. Taxes

& Thties) 248.2 455.0 703.2 201.C 368.4 569.4 65 100

Ptysical Ctendes 31.0 43.8 74.8 25.1 35.5 60.6 59 1147.3 37.1 84.4 38.3 30.0 68.3 44 12

Installed Cost (exdc.Txes & Duties) 326.5 535.9 862.4 264.4 433.9 698.3 62 123

Taxs & Dities 128.6 0.0 128.6 104.1 0.0 104.1 0 18

Installed Cost 455.1 535.9 991.0 368.5 433.9 802.4 54 141

Woking Capital 98.4 25.7 124.1 79.7 20.8 100.5 21 18

Project Cost 553.5 561.6 1,115.1 448.2 454.7 902.9 50 159

Interest wt>ing Constructio 4.9 44.0 48.9 4.0 35.6 39.6 90 7

Tobtal Pinancing Xeeds 558.5 605.5 1,164.0 452.2 490.3 942.5 52 166

SI1M1 Studies Part B.3Tehbntcal Assistance 3.1 6.2 9.3 2.5 5.0 7.5 67 1

Total Parts B & C 561.6 611.7 1,173.3 454.7 495.3 950.0 52 167_ _ m m _ _m

Proposed Bank Loan 0.0 370.5 370.5 0.0 300.0 300.0 100 53Short-tena Debt 79.0 0.0 79.0 64.0 0.0 64.0 0 11Ioternal Cash Generation 482.5 241.2 723.8 390.7 195.3 586.0 33 103

Coxmtry Departmt nIIindtatryt bae, Finane Sectorpeatis Divisionlatin Amrica and the Cwribbean Regional OfficeJanay 1988

- 114 - ANNEX 6-5

MEXICO - STEEL SECTOR RtESTRUCTURING PROJECT

lstimated Disbursement Schedule of Bank Loan

IBRD FY & U$ million Percenttu^arter Endig In Quarter Cumulative In Quarter Cumulative

March 31, 1988 26.3 26.3 6.6 6.6June 30, 1988 31.8 58.1 8.0 14.5

Sept. 30, 1988 19.1 77.2 4.8 19.3Dec. 31, 1988 21.3 98.5 5.3 24.6March 31, 1989 30.1 128.6 7.5 32.2June 30, 1989 38.3 166.9 9.6 41.7

Sept. 30, 1989 36.0 202.9 9.0 50.7Dec. 31, 1989 21.9 224.8 5.5 56.2March 31, 1990 24.6 249.4 6.2 62.4June 30, i990 27.9 277.3 7.0 69.3

Sept. 30, 1990 21.1 298*4 5*3 74.6Dec. 31, 1990 21.6 320.0 5.4 80.0March 31, 1991 21.0 341.0 5.2 85.3June 30, 1991 23.1 364.1 5.8 91.1

Sept. 30, 1991 11.4 375.5 2.9 93.9Dec. 31, 1991 7.0 382.5 1.7 95.7March 31, 1992 3.7 386.2 0.9 96.6June 30, 1992 4.3 390.5 1.1 97.7

Sept. 30, 1992 2.9 393.4 0.7 98.4Dec. 31, 1992 2.5 395.9 0.6 99.0March 31, 1993 2.0 397.9 0.5 99.5June 30, 1993 2.1 400.0 0.5 100.0

Country Department IIIndustry, Trade, Finance Sector Operations DivisionLatin America and the Caribbean Regional OfficeJanuary 1988

WarS

NOTES

MAP SECTION

IBRD 20418

K UNITED STATES OF AMERICA M E X I C O

STEEL MILLS AND MAJOR MARKETS

8AJA .,.I

AiLFORNLA NglX RA/A, * I <e ~Ij N.

r~~~~ ~~~ |Vl , f1I 1''

.0.N A R I

. ).A .l ;if> :S H t f Asl

rI STEEL MILLSo STEEL MARKETS

; NATIONAL CAPITAL

AAb 0'' STATR CAPITALS

IPQLN/A *%'4. .j vI-t,, ; ,. ,

CAL -. 0 PRINIPA !.CI AND . TOWNS~~~SUR ~~~~~~~~~~' \). ~~~~~~~~~~~~~ Parrot ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ - DIVIDED HIGHWAYS-SEL.ECTED MAIN ROAD$

A - ~~~~~~~~~~~~~~~~~~~~ROALROADS

- 4 PRINCIPAL ARPORTS

* - STATE BOUNDARIES

INTERNATIONAL BOUNDARIES

2lOEtR P0. V1.0 10,0 D4, 0f~\T __~

"I )~ ~~~~~~~Ic

- \ GUATEMAL~~~~~~UATA +f_A _0_dr_*tfzabX/ -51CARTSA ASA-CO I 1

OCOOW - ~~~~~~~~~~. ~~BELIZE

RILOHETER 0 MC 2CR ICR 400 no

MILES 0 too 100 30R 4P.t... GUATEMALA

Tapochil ~~HONDURASilo, iqw ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~JUNE 1987

IBRD 20419

UNITED STATES OF AMERICA M E X I C O

'½ 09< ->tb .IRON ORE MINES, COAL MINES AND NATURAL GAS FIELDS

"AJA C lr ,

\CAIIPORNIANgt4 Ju

N.AtzOewa ~4- 3 5.W > tx, . S 5 Z

c AI U A H h A

Old IA | % l ,t , x IRON ORE MINES

91 PELLETIZING PLANTS NOT AT STM MLLSL. /. Q C \ i COAL AINES

PEAL ~~~~~~~~~~~~~~~~~~~~~~~~~A NATURAL GAS FIELDS

BAJA '; A c i COAN.'XLA COAL REGION

CAII I UL 0 NATEO CAPITAIL$

R MGANOPAL CMES OR TOWNSDIVDED HIGHWAYS

SELECTED MAIN ROADS

To P~~~~~~~~~~~~~~~~~~~~~~~~~~~~~AILROAGS

M RNCIPAL AIRPORT

D U R A N ------ ~~~~~~~~~~~~~~~~~~~~~~~~~~STATS BOUNDARIES

- \ DII I.'A INTERNATIONAL BOUNDAriES

Pat !. E Do.,r .JUNEIACs CAS /

S. t-Mttli. *.* ' SAN ulOTS'

Mw- ~ ~ ~ ~ ~ ~ ~ ~

PE~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~~~~~~~~~~~~~~~~~~ APCI

EILGUEIRBS RI IRS 2U 3W *o@ soc ~ ~ ~ ~ ~ ~ ~~~~USTRU

RI ISO GUA~~~~~~~~~~~~~~~~EMALA~~~~GE

Taiii ~~~HONDURAS1W ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~JUNE 1987