Document of

The World Bank

FOR OFFICIAL USE ONLY

Report No. 16656-ME

IMPLEMENTATION COMPLETION REPORT

MEXICO

STEEL RESTRUCTURING PROJECT(LOAN 2916-ME)

May 29, 1997

Mexico Country DepartmentLatin America and the Caribbean Region

This document has a restricted distribution and may be used by recipients only in theperformance of their official duties. Its contents may not otherwise be disclosed withoutWorld Bank authorization.

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CURRENCY EQUIVALENTSCurrency Unit: Peso (Mex$)

US$ 1.00 = Mex$ 7.85

FISCAL YEARJanuary 1 - December 31

WEIGHTS AND MEASURES1 cubic meter (m) = 1.308 cubic yards

1 metric ton (t) = 1,000 kilograms or 2,204.6 pounds1 kilometer (kin) = 0.62 miles

ABBREVIATIONS AND ACRONYMSAHMSA - Altos Hornos de Mexico S.A.(state owned)CANACERO - Camara National de la Industria del Hierro y del Acero (Iron and Steel

Chamber of Commerce)CMC - Carbon y Minerales Coahuila S.A.(raw materials division of SIDERMEX)EBIT - Earnings Before Interest Expense and TaxesFMSA - Fundidora Monterrey S.A.(state owned)GAN - Grupo Acecero del NorteGOM - Government of MexicoHYLSA - Private sector steel companyICB - International Competitive BiddingICR - Implementation Completion Reportmt - million tonsmtpy - million tons per yearNAFIN - Nacional Financiera S.N.C.PAT - Profit After TaxSAR - Staff Appraisal ReportSECOFI - Secretaria de Comercio y Fomento Industrial (Commerce Ministry)SEDUE - Secretaria de Desarrollo Urbano y Ecologia (Ministry of Environment

and Urban Development)SEMIP - Secretaria de Energia, Minas e Industria Paraestatal (Ministry of Energy,

Mines and Parastatal Industry)SHCP - Secretaria de Hacienda y Cr6dito Pfiblico (Finance Ministry)SICARTSA - Sider6rgica Lizaro Cdrdenas Las Truchas S.A.(state owned)SIDERMEX - State owned steel industry holding companySOE - State Owned EnterpriseSPP - Secretaria de Programaci6n y Presupuesto (Ministry of Budget and

Programming)tpy - tons per year

Vice President S. Javed BurkiDirector Olivier LafourcadeDivision Chief/Manager Carl DahlmanStaff Member Daniel Crisafulli

FOR OFFICIAL USE ONLY

CONTENTS

P R E F A C E .................................................................................................................................. ivEVALUATION SU1MARY..vPART 1: PROJECT IMPLEMENTATION ASSESSMENT

A. PROJECT OBJECTIVES AND DESCRIPTIONSCRB. ACHIEVEmENT OF PROJECT OBJECTIVES.. 2C. IMPLEMENTATION RECORD AND MAJOR FACTORS AFFECTING THE PROJECT ................ 7D. PROJECT SUSTAINABLITY............................................. 8E . B ANK PERFORM ANCE ................................................................................................. 8F. BORROWER PERFoRmANcEAE9G. ASSESSMENT OF OUTCOME .. 91 . FUTURE O PERATIoN ................................................................................................... 9I. KEY LESSONS LEARNED.9

PART II: STATISTICAL TABLES ......................................................................................... 12TABLE 1: SUMMARY OF ASsEssmENTs .TABLE 2: RELATED BANK LOANS ................................................................................... 12TABLE 3: PROJECT TI M ETABLE ...................................................................................... 12TABLE 4: LOAN DISBURSEMENTS: CUMULATIVE ESTIMATED AND ACTUAL ................... 13TABLE 5: KEY INDICATORS FOR PROJECT IMPLEMENTATION .......................................... 13TABLE 6: KEY INDICATORS FOR PROJECT OPELTION.................................................... 13TABLE 7: STUDIES INCLUDED IN PROJECT ...................................................................... 13TABLE 8A : PROJECT COSTS............................................................................................14TABLE 8B: PROJECT FINANCING.....................................................................................14TABLE 9: FINANCIAL AND ECONOMIC COSTS AND BENEFITS.......................................... 15TABLE 9A: FINANCIAL COSTS AND BENEFITS- UNDERLYING AssumpTIONs .................... 16TABLE 9B: EcoNOMIC COSTS AND BENEFITS- UNDERLYING ASSUMTIONS....................16

TABLE 10: STATUS OF LEGAL Cov NANTs.....................................................................18TABLE 11: COMPLIANCE WITH OPERATIONAL MANUAL STATEMENTS.............................20TABLE 12: BANK RESOURCES: STAFF INPUTS.................................................................20TABLE 13: BANK RESOURCES: M ISSIONS......................................................................21

Annex 1: ICR Mission Aide Memoire ................................................................................... 21Annex 2: Operation Plan for the AH.MSA Steel Plant..........................................................24Annex 3: Borrower's Contribution to the ICR.....................................................................26

This document has a restricted distribution and may be used by recipients only in the

performance of their official duties. Its contents may not otherwise be disclosed without

World Bank authorization.

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IMPLEMENTATION COMPLETION REPORT

MEXICO

STEEL RESTRUCTURING PROJECT

(LOAN 2916-ME)

PREFACE

This is the Implementation Completion Report (ICR) for the Mexico SteelRestructuring Project, for which Loan 2916-ME in the amount of $400 million wasapproved on March 15, 1988, and made effective on March 16, 1988.

The loan was closed on December 31, 1996, following three one-year extensionsto the original loan closing date of December 31, 1993. Final disbursement took place inDecember 1996.

The ICR was prepared by Edmund L. Mangan, Technical Advisor, and DanielCrisafulli, Task Manager, Sector Leadership Group, Latin America and the CaribbeanRegion, and reviewed by Carl Dahlman, Sector Leader of Finance and Private SectorDevelopment, Mexico Country Department, Latin America and the Caribbean Region.The Borrower provided inputs to the ICR that are included as Annexes.

A Case Study on this Project was prepared for EDI in conjunction with the Banksupervision mission undertaken in June 1995. Preparation of this report was begun duringthe Bank's ICR mission in December 1996 and includes information collected for the CaseStudy and material in the project file. The Government, Borrower and Beneficiariescontributed to the preparation of the ICR by exchanging views on all parts and phases ofthe Project including policy aspects, preparation, procurement, implementation experienceand related issues and by preparing its own contribution to this ICR.

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MEXICO

STEEL RESTRUCTURING PROJECT

(LOAN 2916-ME)

Evaluation Summary

Introduction

1. The Mexican steel industry, second largest in Latin America and nineteenth in theworld, has undergone a profound transformation since 1985 when interventionist policieswere identified as a main cause of the industry's low productivity, poor quality and limitedcontribution to the economy. In response to a GOM request for financial and technicalassistance from the Bank, a sector study was carried out in 1986, which, in cooperationwith the enterprises in the steel sector, recommended a series of economic policy reforms,coupled with a substantial restructuring program for the sector. The resulting Steel SectorRestructuring Project was a hybrid adjustment and investment loan developed jointly by theBank, the Government and the major public and private sector firms in the subsectordesigned to implement the strategy proposed in the sector study.

Project Objectives

2. The objectives of the project were to: (a) enhance competitiveness in the steel sectorthrough decontrol of domestic steel prices and continued implementation of tradeliberalization measures; (b) restructure the state owned steel holding company SIDERMEXoperations financially, organizationally, and administratively; (c) rehabilitate the AHMSAsteel production facilities and the CMC mining operations; and (d) modernize the privatesector steel producer HYLSA.

3. The loan consisted of three main parts: (1) a US$100 million quick disbursingcomponent tied to implementation of agreed policy reforms, which financed the additionalsteel imports that were expected during the adjustment period following the implementationof reforms; (2) US$220 million support for restructuring two SIDERMEX companies,AFIMSA and its mining affiliate CMC, with US$5 million for SIDERMEX HoldingCompany technical assistance and strategic planning studies; and (3) US$75 million supportfor rehabilitation and modernization of the private firm HYLSA.

4. The loan provided for significant technical assistance to Government policymakersin developing overall sectoral strategy and to the firms directly participating under theproject to assist in the design and implementation of individual firm strategies and projects.Project management assistance was provided to assist with the investment portions of theloan. An important goal of the technical assistance was to improve environmentalperformance throughout the sector.

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Implementation Experience and Results

5. The project as implemented met or exceeded all of its primary developmentobjectives. The steel industry now appears to be thriving, converted from a set ofinefficient, loss-making producers selling low-quality steel in a captive domestic market to aprofitable and growing industry that uses modem technology to compete internationally. Inaddition, the industry's competitiveness strongly supports the success of export-orienteddownstream industries, serving as an indicator of project sustainability.

6. During implementation, the delays occured due to lags in policy reform andbudgetary allocations. However, the reform program was carried out fully in the spirit ofthe objectives of the project, and the second tranche of Part A of the Loan, which had beendelayed from June 1988, was released in January 1990. In the same year, the Governmentaccepted the Bank's recommendations to privatize steel sector operations, which was notincluded in the original scope of the project, and began discussions with the Bank on theproposed the privatization of the state owned steel enterprises. The November 1991SIDERMEX privatization represented the first major industrial sector and "strategicindustry" to be privatized in Mexico and the first major Latin American steel industry to beprivatized.

7. All of the physical objectives of the project have been surpassed, although costswere higher as a result, primarily, of project delays totaling about three years. Part B wascompleted a cost of US$825 million, compared with US$644 million originally estimated(Part II, Table 8A). Financing arrangements were essentially as planned (Part II, Table 8B),with own cash generation of the firms covering the major part of the financing not coveredby the Bank loan. The project was completed in January 1995 which compares with aplanned completion date of January 1992. The major delays occurred early in the projectand were related to: incompatibility of Bank procurement arrangements for complexrehabilitation projects; bureaucratic difficulties faced by the Government in implementingagreed actions in restructuring the SOEs, particularly in the allocation and release of funds;and the actual process of privatization which in itself delayed the project for eighteenmonths.

8. The technical assistance provided in all phases of the project was highly successful.Strategy and market studies provided the basis for sectoral development and for eventualprivatization. At the firm level, strategic studies were undertaken for each of theSIDERMEX subsidiaries. Project management assistance was provided to AHMSA andCMC, including individual training at the plant and overseas, forming part of the hands-onimplementation assistance provided throughout the life of the project. Grant funds wereobtained from the United States Government to conduct a thorough environmentalassessment of the AHMSA steel plant. The study identified pollution problems and theirproposed solutions prior to privatization, allowing GOM and the new owners to quicklyagree and implement an environmental action plan. AHMSA reports that it is now incompliance with Mexican environmental regulations.

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9. The HYLSA component, (Part C) US$75 million, was canceled in 1990, at therequest of the firm, when they decided to bid for major SIDERMEX facilities rather thancontinue with the original project. Although unsuccessful in their bid attempt, HYLSAmodernized and expanded the existing facilities, building on and surpassing the originalobjectives of the Bank project. Although HYLSA did not use Bank funds, they benefitedfrom sectoral reforms and competition that had developed in the marketplace. Their projectwas completed successfully in 1995, making HYLSA a world class producer of flatproducts.

Summary of Findings, Future Operations, and Key Lessons Learned

10. All the objectives have been met or exceeded and the steel industry in Mexico issatisfying domestic and export market requirements with high quality steel products atcompetitive costs. The steel sector is totally privatized and the firms are operatingprofitably. The policy and institutional objectives have been met or exceeded, and thefinancial and economic benefits are positive and acceptable. The project outcome is ratedas highly satisfactory.

11. This project is an example of restructuring prior to privatization, and the stronglypositive results that can be attained when the Bank commits to a flexible long-termpartnership with government and the private sector to carry out a complex andcomprehensive restructuring program. The project began with sector work, undertaken byBank staff, which allowed all of the major steel producing and consuming enterprises tocontribute to a strategic and policy framework for the sector as a whole. The loan, basedon this framework, was the vehicle for the Bank to provide political and financial support,as well as technical and economic advice, from knowledgeable Bank staff andinternationally-recognized advisors. Because of this total commitment, the Bank had aninfluence at all three levels of the partnership (Government, sector, and firm). To beeffective, Bank staff had to be flexible and respected, seen as neutral, competent, third partyadvisors whose only objective was to see that the sector and its enterprises weresuccessfully transformed.

12. The success of the sectoral restructuring process facilitated the privatization of theSIDERMEX Companies at a date much earlier than originally envisioned. The steel sectorwas chosen for privatization prior to any other industrial subsector, in part, because therestructuring of SIDERMEX and the rehabilitation of AHMSA and CMC had proceededwith a high degree of success. From the beginning, the Bank presence served to facilitate arestructuring process with the eventual goal of privatization - the promise of possiblefinancial support allowed the Bank to use conditionality to incentivize sectoral reform andsupport the agreed restructuring process. The hybrid form of the loan, supported by wellwritten legal covenants, allowed disbursement of investment funds to be linked to policydialogue and policy based funds to be linked to agreements on enterprise strategy. Theselinkages allowed the Bank to apply pressure to keep the process moving and provided agreat deal of flexibility in dealing with change.

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13. These successes came as a result of significant institutional commitment in terms ofskills, budgetary resources and financial and political capital. Critically, extensive and costlysector work was undertaken prior to project preparation. Several lessons from this projectcould be applied to ongoing work in other countries. In particular, the Bank may wish toreexamine the use of hybrid loans to facilitate the implementation of difficult policydecisions that could be linked to restructuring and privatization. In the Mexico case, thehybrid loan structure developed on the basis of sector work and partnership provided theleverage at all three levels (Government, sector, and firm) that gave the Bank a strong rolein promoting economic change.

14. The Mexican steel sector, downstream steel consumers, and the economy overallhave benefited from privatization. However, this step was not on the explicit agenda whenthe project and loan were developed. The restructuring program supported by the Bankloan prepared both the government and the enterprises for that step when the opportunitypresented itself The Government decision to privatize was supported and influenced by theBank presence and facilitated by the advances brought about by the project. Bank presenceand support provided the catalyst to accelerate the transition of the Mexican steel sectorand could potentially play an analogous role today in economies heavily dependent onindustrial sector performance.

15. The successful restructuring and privatization of the Mexico steel sector wasaccomplished on a centralized, rather than decentralized (firm-by-firm) basis. In manyeconomies, the centralized approach may still have merit, along with the inclusion of bothpublic and private sector firms in Bank investment loans. Government implemented orcentralized actions as part of an overall restructuring program may be the only means tocarry out policy initiatives to improve the viability of enterprises and help prepare forprivatization. Support for centralized actions coupled with impartialfinancial supportprovided the necessary encouragement for the country to undertake this exceptionallythorough reform program.

16. In the privatization process, GOM sold the SIDERMEX companies to "strategicinvestors" rather than dispersing ownership more widely to managers, workers, and thepopulation in general. In this case, the investors were primarily Mexican groups that couldafford to raise the necessary funds to participate in the bid process. Possible oligopolisticpractices have been avoided through the simultaneous trade liberalization measuresundertaken. The results appear financially and economically successful, but the project didnot have specific poverty reduction and social objectives. This lack of coverage, in spite ofthe labor reductions envisioned in the restructuring program, may have been an oversight atthe time of project preparation. Further study would be warranted to assess the impact ofthe labor reductions (and the accompanying lump sum separation pay) on poverty reductionand other social objectives, particularly in the isolated areas of Monclova and LazaroCardenas, Mexico.

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IMPLEMENTATION COMPLETION REPORT

MEXICO

STEEL RESTRUCTURING PROJECT

(LOAN 2916-ME)

Part I: Project Implementation Assessment

1. The Mexican steel industry, second largest in Latin America and nineteenth in theworld, has undergone a profound transformation since 1985, when a Bank Public SectorInvestment Review identified government policies as a main cause of the industry's lowproductivity, poor quality, and limited contribution to the economy. In response to a GOMrequest for financial and technical assistance from the Bank, a series of economic policyreforms, as well as a very substantial restructuring program supported by a Bank loan, werejointly developed and implemented. Today, the steel industry appears to be thriving, convertedfrom a set of inefficient, loss-making producers selling low-quality steel in a captive domesticmarket to a profitable and growing industry that uses modem technology to competeinternationally. The industry's competitiveness strongly supports the success of export-oriented downstream industries.

A. Project Objectives and Description

2. During the interval 1985-1995, the World Bank played a critical role in encouragingand facilitating the transformation of the steel industry in Mexico. After the initial 1985 Bankinvestment review, GOM requested assistance in the development of a strategic framework forthe sector. As an indication of Government seriousness in dealing with the main problems, inMay 1996, GOM closed the second largest state owned steel plant (FMSA) putting 12,000employees out of work. The Bank, in response, began the requested strategic analysis in June1996. The Steel Sector Strategy Review, financed by the Bank, was carried out in cooperationwith all of the major steel producers and consumers and resulted in detailed recommendationsto restructure the steel sector and accelerate economic policy reforms. In March 1988, thedialogue between GOM and the Bank culminated in the approval of a US$1,050 million SteelSector Restructuring Project, financed in part by a US$400 million World Bank loan. This wasa "hybrid" loan, that provided both adjustment assistance to the Government and projectfinancing to individual steel firms in both the private and public sectors. To facilitatemovement of the sector toward greater competitiveness and responsiveness to market needs,the loan had the following of key objectives:

(1) assist GOM to enhance competitiveness in the sector by implementing a majorpolicy reform package including; continued liberalization of trade; complete elimination ofprice controls; and elaboration of a national steel sector policy;

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(2) assist GOM and the state owned steel holding company SIDERMEX inrestructuring its operations financially, organizationally, and administratively and assistSIDERMEX and the industry in developing and implementing its long term strategies;

(3) rehabilitate SIDERMEX's AHMSA flat product steel production facilities andCMC mining operations to enhance product quality and reduce costs; eliminate bottlenecks toachieve better utilization of existing capacity; improve environmental, technical, financial andmanagerial controls and information systems; train operations and maintenance staff; anddevelop human resources;

(4) modernize the private sector HYLSA flat product production facilities toimprove quality and cost and maintain competitiveness in the sector.

3. The loan consisted of three main parts: (1) US$100 million, quick disbursingcomponent tied to implementation of agreed policy reforms, estimated to cover the foreignexchange costs of additional steel imports expected during the adjustment period; (2) US$220million support for restructuring two SIDERMEX companies, AHMSA and its mining affiliateCMC, and US$5 million for the SIDERMEX Holding Company for technical assistance andstrategic planning studies; and (3) US$75 million support for modernization of the private firmHYLSA, in order to maintain its competitive position with the public sector firm AHMSA.The loan provided technical assistance to the sector as a whole, and to the firms included in theloan, to assist in detailing the overall strategy for the sector and the implementation ofindividual firm strategies and projects. This included a major goal to improve environmentalperformance throughout the sector.

B. Achievement of Project Objectives

4. Sector Policy Improvements. During implementation, the sectoral reforms that hadbeen agreed at loan negotiations were at times consistent with GOM policy, and thereforeimplemented quickly, and at other times troublesome to the government, with resulting delays.However all of the agreed policy changes were made in the first two years of the loan. In late1990, in consultation with the Bank, GOM proposed to go further than originally envisionedand privatize the state owned SIDERMEX companies. At GOM request, Bank staff advisedSHCP and assisted its advisors during the privatization process, and the Bank agreed to extendthe existing investment part of the loan to the private sector after privatization. Details onspecific policy reforms follow.

5. Trade Liberalization. The process of opening the Mexican economy to internationalcompetition started in 1986, when Mexico joined the GATT. During project preparation andas a condition for Board Presentation of this loan, the Bank insisted on further tradeliberalization and specific reductions in steel import tariffs. Between 1986, when the sectorstrategy was developed, and the end of 1987, steel import tariffs fell from about 40% to a rangefrom 0% to 15%, and Quantitative Restrictions and official reference prices were completelyphased out. There has been no subsequent tightening of trade restrictions and today tariffs onmost steel products range from 0% to about 8%.

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6. Price Liberalization. The process of freeing steel prices proved to be longer and morecomplicated than that of trade liberalization. The major concern was the possibility ofinflationary effects and conflicts with the Economic Solidarity Pact (ESP) of December 1987.In the context of economic uncertainty, accelerating inflation, and budget deficits, ESPcontained tight fiscal and monetary policies; price, wage and exchange rate controls acrossmany sectors of the economy; and rapid trade liberalization. The intent of ESP was to reduceinflation and restore confidence in macroeconomic policy, while avoiding a recession. Thesefactors delayed complete price decontrol until September, 1990.

7. Legal Reform. In May 1989, GOM modified the Foreign Investment Law to enlargethe number of sectors open to foreign ownership and relaxed regulations on foreign directinvestment. In the privatization of the SIDERMEX companies, 100% foreign ownership wasallowed.

8. Restructuring of SIDERMEX. The hybrid nature of the loan allowed the Bank todeal at the government, sectoral and firm levels. The Bank was able to provide support and toapply pressure to ensure that the difficult reform and restructuring measures were carried out.One example was Bank support of the SIDERMEX agreement with GOM, based on the 1986Strategy Study, which laid out the detailed restructuring program for the steel SOEs. Underthis agreement, the role of SIDERMEX Holding Company was narrowed to include onlystrategic management and general supervisory functions. Holding Company employment wasreduced and affiliated companies were reorganized under five independent entities: AHMSA;SICARTSA; a raw materials division, Carbon y Minerales Coahuila SA (CMC); othertechnical operations; and international marketing and non-technical units. Non-core andunrelated companies were merged, sold, or liquidated, reducing the number of companiesfrom 90 to 20.

9. The strategic business units in the core steel and mining activities became independentprofit centers and the remaining productive facilities were rationalized into a more logicaltechnological and product base. Each strategic business unit was headed by a professionalmanager, located on-site rather than in Mexico City, with full operating autonomy. Balancesheets were restructured, with SIDERMEX absorbing the pre-existing debt, to free the newmanagers from the burden of previous bad decisions and enable them to focus on the future.

10. After the closure of FMSA in 1985, SIDERMEX continuously reduced employmentlevels, from about 36,000 in 1986 to about 18,000 in 1991, a reduction of 50% prior toprivatization. Staffing cuts slowed following privatization, with total employment at about15,000 in 1995. The financial cost of labor reduction, estimated at US$10,000 equivalent peremployee terminated, was borne by SIDERMEX and later by the private sector. Bank fundswere not allocated to support labor reductions or the establishment of social safety netprovisions. During restructuring, the Government also supported the negotiation of new laborcontracts allowing management increased flexibility via new work rules, expandedoutsourcing, and greater management independence in operational decisions. Labor reductionand renegotiation of contracts were critical prerequisites for successful privatization andsuccessful operation of the enterprises.

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11. Steel Sector Reform. Bank dialogue with the Government regarding Steel SectorReform, which was continual and effective throughout the restructuring period, was deepenedfollowing the entry of the Salinas administration in late 1988. At this time, the dialogueexpanded to include the potential privatization of AHMSA and CMC. After discussions withthe Bank, the Government announced, in March 1990, the decision to privatize all ofSIDERMEX. The privatization was executed in a highly professional manner under directcontrol of the Finance Ministry (SHCP). Largely independent from the sectoral ministry(SEMIP), SIDERMEX, and the steel SOEs, SHCP formed a team which sought technical andfinancial advice from international sources including key officials involved in the British Steelprivatization. Throughout the process, Bank staff were part of the team, acting as advisor andproviding assistance to SHCP and the companies undergoing privatization.

12. To make the companies attractive to potential bidders, GOM directly assumedUS$1,700 million of SICARTSA I1 and US$600 million of AHMSA foreign debt. With thehelp of advisors, SHCP clarified property rights, renegotiated labor contracts, environmentalregulations, and energy supply contracts as a prerequisite to attracting bidders. Major newinvestments were prohibited, and operational capital expenditures were subject to approval. InNovember 1991, three firms, (AHMSA/CMC, SICARTSA I, and SICARTSA II together withtheir subsidiaries) were sold through a bid process. The total deal amounted to US$1,470million, comprising US$340 million in cash, US$195 million in short- and medium-term debt,US$350 million in long term obligations and future investment pledges by the three successfulbidders of US$585 million. The Government required the bidders to escrow the funds forinvestment pledges and loan commitments prior to actual transfer of ownership.

13. AHMSA and CMC, beneficiaries of the investment part of the project, were acquiredby a Mexican group for a total bid of US$1,030 million, which included US$145 million cash,US$350 million assumed debt and US$535 million committed investments. At that time, 52%of the Bank loan had been disbursed and about 70% of the total actual project cost had beencommitted. The privatization of AHMSA was not an explicit goal of this project and thereforea detailed cost-benefit analysis of investment in restructuring prior to privatization is notattempted in this report. However, note that sector reform and restructuring enabled AHMSAto return to profitability prior to sale.

14. The cost to the Government of AHMSA and CMC restructuring estimated at the timeof sale was US$1,200 million (US$300 million in investment, US$600 million in debtreduction and US$300 million in labor reduction). At GOM and private sector owner request,the Bank worked with NAFIN and others involved, to obtain the necessary agreements tocontinue project financing, with the same objectives and under the same conditions as theoriginal loan. This enabled the new owners to assume responsibility for the AHMSA/CMCparts of the loan totaling US$220 million. As a result, GOM total cost to restructure thesecompanies was approximately US$980 million.

15. Physical Objectives. All of the physical objectives of the project have been surpassed.The steelmaking facilities and flat products rolling mills of AHMSA and raw material supply ofCMC, (Part B) were modernized and rehabilitated under the project, as defined by the Bankand the firms in 1987, and updated by the new private sector owners and their technicalconsultants, during the privatization process in 1991. The investment program after

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privatization was accelerated and expanded, with the portion of the program related to theoriginal objectives and the Bank loan completed in 1996.

16. AHMSA and CMC surpassed the physical aspects of the project. For example,finished steel production of flat products reached 2.2 mtpy in 1996, compared to 1.6 mtpy in1987, prior to project commencement, and 2.0 mtpy projected for the project in the SAR.Capacity utilization in 1987 was 65.9% and today is about 98%. As part of the work in thesteelmaking facilities, obsolete and heavily-polluting steelmaking furnaces were shut down andphysically removed. Investments in new continuous casting and other facilities improvedsteelmaking capability and quality. Yield, a measure of material input utilization efficiency, hasincreased from 71.5% in 1987 to 83.5% in 1996. Labor productivity has improved from about16 man hours per ton in 1987 to about 10.8 man hours per ton in 1991, and is about 7.5 manhours today. Further improvements are presented in the Operations Plan attached to the ICRmission Aide Memoire and the Borrower's Contribution to the ICR (annexed to this report).CMC, the raw materials supplier, was integrated into AHMSA by the new owners afterprivatization. As an indication of project results, the amount of iron ore concentrate supplied toAHMSA in 1991 was 2.15 mtpy and in 1996 was 3.63 mtpy.

17. However, project implementation was not without problems. Overall, the project wasdelayed by about three years for various reasons, including; (i) delays by GOM in decontrollingprices; (ii) delays by SIDERMEX in developing an agreed sector strategy; (iii) budgetconstraints imposed by GOM on the SOEs; (iv) Bank slowness in reacting to procurementproblems; and (v) delays of about eighteen months resulting from the privatization process.

18. The component for the private sector firm, HYLSA (Part C), was canceled in 1990 atthe request of the firm's management. Implementation of Part C had been deferred at therequest of HYLSA due to the eighteen month delay in elaboration of the GOM Steel Sectorpolicy based on the SIDERMEX strategic plan. Shortly after the plan was agreed, the decisionwas made to privatize the SIDERMEX Companies. In response to the plan, HYLSAmanagement decided to bid for major SIDERMEX facilities rather than modernize existingfacilities. Since there was no intention to carry out the objectives of the investment project atthat time, the firm requested cancellation of this part of the loan. HYLSA's failure to acquireany of the SIDERMEX Companies again forced a change in strategy and a return to themodernization concept and the firm then implemented a major expansion p.ogram, based onthe original objectives of the Bank project. Although the Bank funds had already beencanceled, the firm benefited from the sectoral reforms and open competition which the projectsupported. The HYLSA project has been completed successfully; the firm has beentransformed into a world-class producer of flat products.

19. Technical Assistance Objectives. The technical assistance component was highlysuccessful, particularly in contributing to sectoral development and privatization. Building onthe strategic sectoral studies completed prior to appraisal (supported directly from the Bank'sbudget), the project supported detailed market studies for each SIDERMEX subsidiary.Extensive project management assistance was provided to AHMSA and CMC, includingtraining of personnel at home and overseas, and intensive hands-on assistance was providedthroughout the life of the project. Grant funds were obtained from the United StatesGovernment to conduct a thorough environmental assessment of the AHMSA steel plant that

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identified pollution problems and their proposed solutions prior to privatization. This allowedGOM and the new owners to quickly agree on actions and to have them carried out. AHMSAreports that emissions have significantly decreased and that the firm is now fully in compliancewith all Mexican environmental regulations.

20. Financial and Economic Objectives. Significant financial and economic benefitswere estimated at project appraisal. At loan closing these benefits are somewhat lower thanoriginally forecast, but are still positive (Part HI, Table 9) and are satisfactory. The ex-postfinancial rate of return of the AHMSA component is 16.1 percent versus the appraisal estimateof 32.7 percent. The difference is mainly due to the three year delay in project execution whichescalated costs and delayed benefits. The economic rate of return, estimated at appraisal to be32.3%, is calculated at 17.0%, slightly higher than the financial return due to effect of duties onimported equipment. There are currently no economic cost or price adjustments impacting thesteel producers. These calculations include the benefits to AHIVISA from the supply of rawmaterials from local sources which were improved in the CMC part of the project. Since 1991the iron ore concentrate output has increased by about 1.5 million tons. This raw material isdelivered to AHMSA at a cost of about US$28 per ton. Equivalent material from othersources is delivered to AIIMSA at about US$61 per ton. The opportunity savings to AHMSAfrom this part of the project amount to about US$175 million in the period 1992 to 1997.

21. Private Sector Development. While the project did not originally envisionprivatization of the SIDERMEX companies, it attempted to institute private sectormanagement practices within the Government while creating a sectoral environment in whichthe SOEs operated under competitive market conditions on a par with private sector firms.Prepared at a time when privatization was not yet accepted by the Government, the focus of theproject was the liberalization of the steel market in order to eliminate costly fiscal subsidies andto better serve the needs of downstream steel users. Even prior to the privatization, the projectwas well on the way toward meeting these goals. Due to the restructuring of SIDERMEX,which was successfully underway in 1990, the Salinas administration was able to use thehighly visible and strategic steel sector to demonstrate a strong commitment to reform. Thestrengthened condition of the steel sector, coupled with a promise of continued partnership bythe Bank, made it easier to select it as one of the early targets for privatization. By 1990, theperformance of state-owned steel companies had already improved substantially. SICARTSAwas the first Mexican steel company to win the coveted ISO 9002 quality certification, whichoccurred while still under public ownership. Despite AHMSA and SICARTSA's sizableforeign debt (US$2,300 million), the two firms' financial results were improving and AHMSAreported profits of US$12 million in 1989 with gross revenues 108% higher than in 1988. Theowner of AHMSA and CMC, Grupo Acerero del Norte, is a Mexican Group established solelyfor this bid, with no direct steel industry experience, but has continued to receive extensivetechnical assistance from a leading international steel producer. SICARTSA I was purchasedby another Mexican group that had been a consumer of steel and SICARTSA II was purchasedby an international steel producer based in Asia. After losing out in its bid for parts ofSIDERMEX, HYLSA raised funds to modernize its facilities and has now installed the mostadvanced steel industry technology available, becoming one of North America's mostcompetitive producers.

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22. The steel sector restructuring, combined with privatization, has produced a world-classindustry with vigorous competition between domestic and international suppliers, integratedproducers and mini-mills. Technology upgrading and capacity expansion have far outpacedexpectations at appraisal. Efficiency has improved substantially. In addition, joint ventureswith international producers have resulted in further improvements in customer service.Investments focused on expanding capacity, upgrading technology, and changing product mixto take advantage of increased demand for higher value added products. Between 1991 and1996, overall investment in the industry was estimated at over US$4,000 million, far exceedingthe commitments made by the bidders at the time of the auction. As a result, during the 8-yearperiod 1987-1995, aggregate production of the four largest Mexican steel companies rose52%, from 5.2 million tons in 1987 to 7.9 million in 1995. Sales increased from US$1,200million to US$2,500 million, a rise of 104%, and available data indicate that profits haveincreased as well.

23. Environmental performance in the sector improved continuously. Obsolete pollutingprocesses were shut down. New high-efficiency equipment, installed as part of the projects ineach plant, use the latest technology to reduce emissions at their source. Extensive recyclingwas begun during restructuring, and new waste water systems were installed. Sinceprivatization, the firms have responded to tighter environmental agreements negotiated in theprivatization process and in some cases have moved faster and gone beyond the initialagreements.

C. Implementation Record and Major Factors Affecting the Project

24. The project as implemented met or exceeded all of its primary development objectives,which were to restructure the basic steel industry in order that it could satisfy the needs ofdownstream steel consumers by providing steel products in sufficient quantity and quality, atworld competitive costs. It has provided a positive return to the economy, the sector and thesteel firms attaining the institutional, financial and economic goals that were set. The factorsthat delayed project implementation were related to the manner in which the Bank dealt withthe project; bureaucratic difficulties faced by the Government in implementing agreed actionsin restructuring the SOEs, particularly in the allocation and release of funds; and managing theprocess of privatization which required adequate time to accomplish its goals.

25. Factors not Subject to the Borrower's Control. The Bank imposed strictsupervision and procurement reviews on this project since the loan was consideredcontroversial and politically sensitive by Bank management. Bank staff rigorously analyzedand rejected several early versions of the SIDERMEX strategic plan, due to the inclusion ofadditional investments, which were contrary to the agreed restructuring program, and could notbe economically or financially justified. The agreement on the strategic plan was expected totake 3 months, but actually took 22 months, delaying the release of the second tranche of PartA of the loan. Bank procurement guidelines were a second source of delay. The guidelineswere initially followed strictly, but it was realized that they were better suited to greenfield siteprojects than to major rehabilitation of existing facilities. Completing the bid equalizationprocess for the single largest procurement package took significant time and effort that couldhave been avoided if Bank staff had realized that a two stage bid process would have better fit

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the circumstances. It is a credit to the teamwork in this project that these problems wereidentified and resolved jointly by Government, Bank, and AHMSA staff.

26. Factors Subject to the Borrower's Control. The borrower eventually carried out allof the agreed actions in the program and went further than envisioned at project appraisal.However, several significant delays caused by the borrower resulted in escalated costs andreduced benefits. These delays were related to the implementation of policy agreements;provision of counterpart funds to implement the investment parts of the project; late release ofbudgetary funds; and failure to allow the firms to continue with contracts already committedduring the privatization process. The annual budgeting process presented a significant barrierto effectively implementing the project. Funds for any multi-year project had to be requestedon an annual basis rather than making a full funding commitment at the start of the project.

27. Factors Subject to the Implementing Agency's Control. The implementing agencyNAFIN, and the firms AHMSA and CMC, the beneficiaries of the loan, performed their dutiesextremely well, especially considering the multiple and sometimes conflicting demands of theGovernment and the Bank. The firms worked closely with the Bank and technical assistanceproviders and attempted to get the most from it. The firms, together with NAFIN, handledBank procurement guidelines professionally and worked diligently with Bank staff to resolveprocurement problems and move the project ahead satisfactorily. After privatization the Bankallowed the use of "private sector type" procurement and turnkey bids which greatlyaccelerated the progress of the project.

D. Project Sustainability

28. The project has met and exceeded all of its objectives. The firms are continuing toinvest in further improvements to maintain and improve their competitive advantage. Thesector is now totally private and competing successfully in both domestic and foreign markets.Steel customers are able to utilize lower priced domestically produced steels in high qualityexport auto and appliance products. The project is considered fully sustainable.

E. Bank Performance

29. The project was conceived as a complex hybrid that attempted to deal with all of themajor issues relating to the sector. Unfortunately, before Board presentation, it was attackedby a major Bank Board government due to the project's perceived threat to that country'sdomestic steel industry. Project identification and appraisal were well-prepared and thorough,enabling a close collaboration with the Government on complex and politically difficult policyissues; however, after Board approval the project was not well supported in the Bank. Thislack of support, coupled with the timing of multiple Bank reorganizations, limited theavailability of resources to assist the borrower in the early critical stages of the project. In anattempt to partly alleviate this situation, Bank staff urged the Project Management Consultantto employ people experienced in World Bank investment operations in order to allow morescarce Bank resources to be spent on key issues related to the policy portions of the loan. Inspite of these efforts, the lack of supervision resources contributed to delays, particularly inrecognizing the problems relating to procurement procedures. On the positive side, the sameBank Industry Specialist, worked on this project from inception in 1985 to the present day.

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This continuity contributed to the outcome, and is considered especially beneficial in such acomplex project.

F. Borrower Performance

30. Overall, GOM's performance was satisfactory in that all of the project objectives wereeventually met or exceeded. The major problems in the early stages of the project arose fromthe delays that have already been detailed. The Government decision to fully privatize the steelsector resulted in levels of sustainable benefits far in excess of expectations at appraisal. Theperformance of the borrower, NAFIN, was fully acceptable, with capable and timelyadministration of the loan. NAFIN was also responsible for negotiating the agreement with thenew private owners of AHMSA/CMC to continue the Bank loan after privatization. Theperformance of AHMSA, CMC and SIDERMEX management in the public sector and of thenew post-privatization management of AHMSA and CMC was exceptional throughout the lifeof the project. The firm managers have been the primary contributors to success of theinvestment part of the project.

G. Assessment of Outcome

31. All the objectives have been met or exceeded, and the steel industry in Mexico issatisfying domestic and export market requirements in provision of high quality steel productsat competitive costs. The steel sector is fully privatized and the firms are operating profitably.The policy and institutional objectives have been met or exceeded, and the financial andeconomic benefits are positive and acceptable. The project outcome is rated as highlysatisfactory.

H. Future Operation

32. The project modernized the AHMSA steel plant and its raw material supply. Theproject supported extremely overdue investments to bring the facilities up to current standards- the firms' on-going program of maintenance, technical upgrading and investment that willensure the enterprises' long term viability. Near term operating and investment plans arespelled out in Annex 2: "Operation Plan for the AHMSA Steel Plant." It states that;"AHMSA's strategy for its steel segment is to consolidate its leading market-share position inthe Mexican flat products market, maintain an important presence in export markets, improvecapacity utilization with respect to its existing products, develop higher value-added steelproducts and increase its customer base. Operationally, AHMSA is focused on reducingproduction costs and improving product and process quality."

I. Key Lessons Learned

33. This project is an example of restructuring prior to privatization, and the stronglypositive results that can be attained when the Bank commits to a flexible long-term partnershipwith government and the private sector to carry out a complex and comprehensive restructuringprogram. The project began with sector work undertaken by Bank staff, which allowed all ofthe major steel producing and consuming enterprises to contribute to a strategic and policyframework for the sector as a whole. The loan, based on this framework, was the vehicle for

- 10 -

the Bank to provide political and financial support, as well as technical and economic advice,from knowledgeable Bank staff and internationally-recognized advisors. Because of this totalcommitment, the Bank had an influence at all three levels of the partnership (Government,sector, and firm). To be effective, Bank staff had to be flexible and respected, seen as neutral,competent, third party advisors whose only objective was to see that the sector and itsenterprises were successfully transformed.

34. The success of the sectoral restructuring process facilitated the privatization of theSIDERMEX Companies at a date much earlier than originally envisioned. The steel sector waschosen for privatization prior to any other industrial subsector, in part, because therestructuring of SIDERMEX and the rehabilitation of AHMSA and CMC had proceeded witha high degree of success. From the beginning, the Bank presence served to facilitate arestructuring process with the eventual goal of privatization - the promise of possible financialsupport allowed the Bank to use conditionality to incentivize sectoral reform and support theagreed restructuring process. The hybrid form of the loan, supported by well written legalcovenants, allowed disbursement of investment funds to be linked to policy dialogue and policybased funds to be linked to agreements on enterprise strategy. These linkages allowed theBank to apply pressure to keep the process moving and provided a great deal of flexibility indealing with change.

35. These successes came as a result of significant institutional commitment in terms ofskills, budgetary resources and financial and political capital. Critically, extensive and costlysector work was undertaken prior to project preparation. Several lessons from this projectcould be applied to ongoing work in other countries. In particular, the Bank may wish toreexamine the use of hybrid loans to facilitate the implementation of difficult policy decisionsthat could be linked to restructuring and privatization. In the Mexico case, the hybrid loanstructure developed on the basis of sector work and partnership provided the leverage at allthree levels (Government, sector, and firm) that gave the Bank a strong role in promotingeconomic change.

36. The Mexican steel sector, downstream steel consumers, and the economy overall haveall benefited from privatization. However, this step was not on the explicit agenda when theproject and loan were developed. The restructuring program supported by the Bank loanprepared both the government and the enterprises for that step when the opportunity presenteditself The Government decision to privatize was supported and influenced by the Bankpresence and facilitated by the advances brought about by the project. Bank presence andsupport provided the catalyst to accelerate the transition of the Mexican steel sector and couldpotentially play an analogous role today in economies heavily dependent on industrial sectorperformance.

37. The successful restructuring and privatization of the Mexico steel sector wasaccomplished on a centralized, rather than decentralized (firm-by-firm) basis. In manyeconomies, the centralized approach may still have merit, along with the inclusion of bothpublic and private sector firms in Bank investment loans. Government implemented orcentralized actions as part of an overall restructuring program may be the only means to carryout policy initiatives to improve the viability of enterprises and help prepare for privatization.Support for centralized actions coupled with impartial financial support provided the

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necessary encouragement for the country to undertake this exceptionally thorough reformprogram.

38. In the privatization process, GOM sold the SIDERMEX companies to "strategicinvestors" rather than dispersing ownership more widely to managers, workers, and thepopulation in general. In this case, the investors were primarily Mexican groups that couldafford to raise the necessary funds to participate in the bid process. Possible oligopolisticpractices have been avoided through the simultaneous trade liberalization measuresundertaken. The results appear financially and economically successful, but the project did nothave specific poverty reduction and social objectives. This lack of coverage, in spite of thelabor reductions envisioned in the restructuring program, may have been an oversight at thetime of project preparation. Further study would be warranted to assess the impact of the laborreductions (and the accompanying lump sum separation pay) on poverty reduction and othersocial objectives, particularly in the isolated areas of Monclova and Lazaro Cardenas, Mexico.

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PART H: STATISTICAL TABLES

TABLE 1: SUMMARY OF ASSESSMENTS

Achievement of ObjectivesNot

Substantial Partial Negligible Applicable

Macroeconomic policies xSector policies xFinancial objectives xInstitutional development xPhysical objectives xPoverty reduction xGender concerns x

Other social objectives xEnvironmental objectives xPublic sector management xPrivate sector development x

Project SustainabilityLikely Unlikely Uncertain

x

Bank PerformanceHighly Satisfactory Satisfactory Deficient

Identification xPreparation xAppraisal xSupervision x

Borrower PerformanceHighly Satisfactory Satisfactory Deficient

Preparation xImplementation xCovenant compliance x

Assessment of Outcome

Highly Satisfactory Satisfactory Unsatisfactory Highly Unsatisfactory

x

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Table 2: Related Bank loans

Year ofLoan Title Purpose Approval Status

Preceding Operations

Loan 2745-ME Liberalization of trade policy to enable 1986 CompletedFirst Trade Policy Loan entry to GATT and provide balance of

payments support

Loan 2882-ME Further liberalization of trade policy and 1988 CompletedSecond Trade Policy provision of balance of payments supportLoan

Following Operations

Loan 2919-ME Hybrid loan to support sectoral policy 1988 CompletedFertilizer Sector reforms and investment in restructuring ofAdjustment Loan fertilizer sector

Loan 3085-ME Reduction of public sector role in industry 1989 CompletedPublic Enterprise Reform through privatization and rationalizationLoan

Loan 3087-ME Create policy environment for increased 1989 CompletedIndustrial Sector Policy private sector investmentLoan

TABLE 3: PROJECT TIMETABLE

Steps in project cycle Date planned Date actual

Identification 10/86 10/86Project Brief 12/86 12/86Preappraisal 02/87 02/87Appraisal 03/87 03/87Negotiations 06/87 01/88*Board presentation 08/87 03/88*Signing 03/88 03/88Effectiveness 03/88 03/88Project Completion 01/92 01/95Loan closing 12/93 12/96

* Delays due to Bank reorganization, subsequent planned dates rescheduled at signing.

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TABLE 4: LoAN/CREDIT DISBURSEMENTS: C`UMuLATIvE ESTIMATED AND ACTUAL

($ million)

1988 1989 1990 1991 1992 1993 1994 1995 1996

Part A. Disbursement 50.0 0.0 50.0 0.0 0.0 0.0 0.0 0.0 0.0Part B. Disbursement 0.0 21.1 17.4 27.3 62.1 6.2 29.8 38.3 18.8Total Disbursement 50.0 21.1 67.4 27.3 62.1 6.2 29.8 38.3 18.8Appraisal estimate* 98.5 224.8 320.0 321.0 321.0 321.0 321.0 321.0 321.0Actual accumulated 50.0 71.1 138.5 165.8 227.9 234.1 263.9 302.2 321.0Actual% of estimate 50.8 31.6 43.3 51.7 71.0 72.9 82.2 94.1 100.0Final disbursement December 96Part C. Canceled

*Reflects revision due to cancellation of US$79 million in 1991.

TABLE 5: KEY INDICATORS FOR PROJECT IMPLEMENTATION

Key implementation indicators in SAR /a Estimated Actual

Hot Strip Mill Invitation to Bid 03/88 03/88Hot Strip Mill Contract 03/89 12/89Hot Strip Mill Installation 08/90 07/93Hot Strip Mill Operation of Step One 01/91 05/94Hot Strip Mill Operation of Step Two 01/92 01/95Commencement of project management technical assistance 04/88 05/88

/a Specific project implementation indicators were developed in the SAR for each major part of the project. HotStrip Mill represents the majority of the investment and its operation controls practically all the returns.

TABLE 6: KEY INDICATORS FOR PROJECT OPERATION

There were no specific indicators set apart from financial covenants.

TABLE 7: STUDIES INCLUDED IN PROJECT

.tul Pupose Status .Impac.tu ..............Part B.1 AHMSAProject Management Management Information System, Completed Effective Managementand Technical Engineering, Project Management and and InstitutionalAssistance Training DevelopmentPart B.2 CMCProject Management Management Information System, Completed Effective Managementand Technical Engineering, Project Management and and Technical AssistanceAssistance TrainingPart B.3 SIDERMEXStrategic Planning Planning and Implementation of Sector Completed Privatization of Public

Restructuring and Development Steel Sector

- 15 -

TABLE 8A: PROJECT COSTS

($ million)

Appraisal estimate Actual/latestItem Local Foreign Total Local Foreign Total

Equipment, materials and spares 51.6 253.0 304.6 150.0 359.6 509.6Civil works and erection 56.6 9.3 65.9 220.0 0.0 220.0EngineeringlProject Management 4.9 10.7 15.6 7.5 0.4 7.9Training and technical assistance 5.9 12.8 18.7 3.3 39.7 43.0

Base Cost 119.0 285.8 404.8 380.8 399.7 780.5

Physical contingencies 15.8 22.3 38.1 - - -Price contingencies 22.9 19.9 42.8 - - -

Installed Cost 157.7 328.0 485.7 380.8 399.7 780.5

Taxes & Duties 79.3 0.0 79.3 45.3 0.0 45.3Incremental working capital 55.6 14.8 70.4 0.0 0.0 0.0Interest during construction 2.9 25.8 28.7 0.0 0.0 0.0

Total Financing Required 295.5 368.6 664.1 426.1 399.7 825.8

Note: Actual civil works and erection cost, include equipment and materials estimated at about US$80million equivalent that were part of three major turnkey projects implemented after privatization.

TABLE 8B: PROJECT FINANCING

($ million)

Appraisal estimate Actual/latestItem Local Foreign Total Local Foreign Total

IBRD loan 0.0 220.0 220.0 3.1 216.9 220.0US EXIM Bank - - - 0.0 82.9 82.9KFW Germany - - - 0.0 15.0 15.0Other Short Term Loans 32.0 0.0 32.0 - - -Other Long Term Loans - - - 10.1 31.0 41.1Internal Cash Generation 263.5 148.6 412.1 412.9 88.9 501.8

Total 295.5 368.6 664.1 426.1 399.7 825.8

- 16 -

TABLE 9: FINANCIAL AND ECONOMIC COSTS AND BENEFITS

Benefits of the Project in Current US$ Million

1988 1989 1990 1991 1992 1993 1994 1995 1996 1997

Production - - - - (3.65) 7.06 (0.66) 21.00 42.33 42.33Increase

Cost - - - - 66.89 80.32 126.48 115.11 89.30 89.30Decrease

Incremental - - - - 63.24 87.37 125.82 136.11 131.62 131.62Cash Flow

Investments 43.94 69.56 54.18 66.19 88.10 103.76 201.71 120.85 77.65 -

Free Cash (43.94) (69.56) (54.18) (66.19) (24.85) (16.39) (75.89) 15.26 53.97 131.62Flow

Net Present 194.25Value

Internal Rate 16.1%of Return

Notes:

(1) The financial rate of return, calculated to be 16.1% is based on the results of Part B. 1,the AHMSA portion, which was estimated at appraisal at 32.7 %.

(2) The economic rate of return, calculated to be 17.3%, is based on the results of Part B. 1,the AHMSA portion, which was estimated at appraisal to be 32.3%.

(3) These calculations do not separately identify the benefits to AHMSA from the supply ofits own raw materials from local sources, which were further developed as Part B.2, the CMC portion.However, since 1991, when the benefits of the project were beginning to be obtained, there has been anadditional output of iron ore concentrate, delivered to AHMSA from the captive mines, totaling about 5.3million tons. This raw material is delivered at a cost of about US$28 per ton. Equivalent material fromother sources is delivered at about US$61 per ton. Considering the savings of about US$33 per ton, hadthis part of the project not been successful, the cash flow of AHMSA, could have been reduced by aboutUS$175million.

- 17 -

TABLE 9A: FINANCIAL COSTS AND BENEFITS--UNDERLYING AssumPTIONs

1. , The project was made up of a series of modifications and replacements to part ofan existing operating steel plant. To develop benefits related to the project, incrementalcash flows were developed based on comparison of actual performance of the company(AHMSA); during the years 1992, when the first new facilities that are part of the projectcame on line, through 1997, which is the first full year of production of all of the newfacilities; to the cost and production performance of the company before the project.

2. The benefits relating to production increase are based on the volume increasecredited to the new facility, or decrease if a facility was shut down due to modification,during the year. Cost decrease is developed across all tonnage produced by the modifiedfacilities by comparing cost of production before and after modification or replacement offacilities.

3. Investments are based on project expenditures in the year in which the cash waspaid out.

4. Returns assume that the 1997 cash flow remains constant for the next ten years.

TABLE 9B: EcoNoIc COSTS AND BENEFITS-UNDERLYING ASSIIPTIONS

1. The economic rate of return is calculated on the same basis as the financial returns.It is assumed that distortions in pricing of inputs and outputs to the sector in general andAHMSA in particular have been eliminated during the life of the project.

2. The same benefit cash streams for production increase and cost decrease are used.The investment stream is reduced by the duties paid on imported equipment of US$45.3million equivalent.

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TABLE 10: STATUS OF LEGAL COVENANTS

In Section Status Origi Revis Description of covenant CommentsStatus nal ed

Date DateLoan 4.01 OK NAFIN to furnish audited financial All pending audit reports have

statements for project account for been receivedexpenditures under Part A.

4.02 OK NAFIN to furnish audited financialstatements for Special Account.

Schd.6.1 OK AHMSAto maintain ratio of current Bank waived covenant in 1995(3) assets/current liabilities of at least 1.2 and and agreed phased return to

D/E ratio less than 67.33. original ratio.

Schd. OK AHMSA not to incur additional debt which Bank waived covenant in 19956.1(4) would cause D/E ratio to exceed 67.33 and and agreed schedule for phased

projected debt service coverage ratio to fall return to original ratio.below 1.5.

Schd.6.0 NA HYLSAto observe financial covenants Part C canceled at HYLSA'sV(3) similar to those included in Debt request. Debt restructuring with

Restructuring agreements with it private private creditors was concludedcreditors. in October 1989.

Guaran 2.03 NA Government to provide adequate Funding for investments in Parttee counterpart funding. B to come from new private

sector owners. In compliance.

3.03 OK 06/30/ Government to issue satisfactory global Satisfactory policy statement88 steel sector policy statement. received in January 1990.

3.04 OK 06/30/ Government to implement and maintain Prices officially liberalized in88 liberalized steel prices. September 1989; removed from

PACTO agreements inSeptember 1990.

3.05 OK 06/30/ Government to implement Steel Trade Tariffs on imported steel88 Policy Program and maintain it in effect in products reduced in 1987 and

manner consistent with Steel Sector Reform maintained at 0 to about 10%.Program. Performance satisfactory.

3.06 NA Government to prepare report on progress Not requested.of Steel Sector Reform Program uponrequest.

SIDER 2.01(b) NA SIDERMEX to designate and maintain SIDERMEX closed as part ofMEX satisfactory Project Manager within 90 days privatization. Part B.3 canceled

after first disbursement for Part B. at Government request.

2.06(a) OK 03/31/ 01/23 SIDERMEX to prepare satisfactory Satisfactory plan received in88 /90 Strategic Plan. January 1990.

2.06(b) NA 11/01/ SIDERMEX to review Strategic Plan Not applicable (see above).88 annually with the Bank.

2.07 OK 06/15/ SIDERMEX to carry out restructuring Privatization goes beyond the88 program in accordance with "convenio." program in the convenia.

4.01(b), OK SIDERMEX to furnish audited financial Satisfactory performance.

(c) statements to Bank, including audit of andseparate opinion on accounts identifyingexpenditure under Part B.3.

4.02 OK 09/15/ SIDERMEX and subsidiaries to revalue Revaluation of assets completed88 fixed assets and adjust balance sheets in June 1990 as part of the

accordingly. privatization process.

CMC 2.01(b) OK CMC to establish and maintain Project Satisfactory performance.

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Project Management unit to carry out project.

2.06 OK CMC to prepare and implement Action Satisfactory performance.Plan and review progress with Bankannually, beginning 6 months after firstdisbursement under Part B(2).

3.04 OK CMC to carry out satisfactory program for Satisfactory plan received Mayrestructuring and reorganize itself as 1989.holding company for mining operations.

4.01 OK CMC to furnish audited financial Satisfactory performance.statements to Bank, including audit ofexpenditures under part B(2) of project.

HYLS 2.01(b) NA HYLSAto designate and maintain Part C of the loan canceled atA satisfactory Project Manager within 90 days HYLSA's request.

after first disbursement for Part C.

2.06 NA HYLSAto prepare and implement Action Not applicable (see above)Plan and review progress with Bankannually, beginning 6 months after firstdisbursement under Part C.

4.01(b) NA HYLSA to finish audited financial Not applicable (see above).statements to Bank, including audit of andopinion on expenditure under Part C.

4.02 OK HYLSAto formulate program with its "Second-round" debtcreditors to restructure its debt and restructuring agreement withformalize satisfactory agreements to carry private creditors concluded inout debt restructuring plan consistent with October 1989.financial requirements of Part C.

AHMS 2.01(b) OK AHMSA to designate and maintain Satisfactory performance.A satisfactory Project Manager within 90 days

after first disbursement for Part B. 1

2.06 OK AHMSAto prepare and implement Action Satisfactory performance.Plan and review progress with Bankannually, beginning 6 months after firstdisbursement under Part B. 1

2.07 OK AHMSAto take all reasonable measures to Satisfactory steps were taken byensure that the execution of Part B. 1 of the AHMSA to correct damage toproject is carried out with due regard to environment. Continuedecological and environmental factors. monitoring required.

4.01(b) OK AHMSA to furnish audited financial 1993 audit received.statements to Bank, including audit of andseparate opinion on expenditures under PartB.1

Covenant types: Present status:1 = Accounts/audits 8 = Indigenous people C = covenant complied with2 = Financial performance/revenue 9 = Monitoring, review, and reporting CD = complied with after delay

generation from beneficiaries 10 = Project implementation not CP = complied with partially3 = Flow and utilization of project funds covered by categories 1-9 NC = not complied with4 = Counterpart funding 11 = Sectoral or cross-sectoral budgetary5 = Management aspects of the or other resources allocation

project or executing agency 12 = Sectoral or cross-sectoral policy/6 = Environmental covenants regulatory/institutional action7 = Involuntary resettlement 13 = Other

- 20 -

TABLE 11: COMPLIANCE WITH OPERATIONAL MANUAL STATEMENTS

There was no significant lack of compliance with an applicable Bank Operational ManualStatement (OD or OP/BP)

TABLE 12: BANK RESOURCES: STAFF INPUTS

Stage of project cycle Weeks US$

Through appraisal 189 331,890

Appraisal-Board 21 42,570

Board-effectiveness - -

Supervision 160 465,141

Completion 6.3 20,411

Total 376.3 860,012

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TABLE 13: BANK RESOURCES: MISSIONS

Mont No. of Days Specialized Implement- Develop- Type ofh/year persons in skills /a ation status ment problems/

field objectives b

Through appraisal 12/86 4 11 IS,F n/s n/s n/s2/87 2 10 IS,F n/s n/s n/s

Appraisal through 3/87 6 12 IS,E,F n/s n/s n/sBoard approval

4/87 1 14 IS n/s n/s n/s5/87 2 3 IS,E n/s n/s n/s8/87 1 14 IS n/s n/s n/s9/87 1 7 IS n/s n/s n/s2/88 1 7 IS n/s n/s n/s

Board approvalthrough effectivenessSupervision 4/88 4 15 IS,E,IE 2 1 LC

technical assist 8/88 1 7 IS 3 1 POtechnical assist 9/88 1 7 IS n/s n/s n/stechnical assist 9/88 1 7 IS n/s n/s n/s

10/88 3 14 IS,IE 2 3 PO,LCoperational assist 1/89 1 7 IE n/s n/s PO, LC,

11/89 2 21 IS,IE 2 2 PO,PR3/90 1 12 IS 2 2 PO6/90 2 14 IS,E 2 2 PO11/90 1 12 IS 2 1 PO,PI5/91 1 12 is 2 1 PO,PI,CF

technical assist 12/91 1 7 IS n/s n/s PI12/91 1 8 IS n/s n/s PI3/92 1 5 IS 2 1 PI7/92 2 2 IS,ES 2 2 n/s1/93 4 4 IS,ES 2 1 n/s6/93 2 3 IS,IE 2 1 MA,CF6/94 3 8 IS,E,ES S S MA11/94 2 7 IS,IE S S MA6/95 4 12 IS,IE,ES S S LC

Completion 1/97 2 10 ISJE S S n/s

/a F - Financial Analyst, IS - Industrial Specialist, E - Engineer, M - Mining Engineer, IE - Industrial Economist, ES - EnvironmentalSpecialist/ PO - policy, LC - loan conditions, CF - Counterpart funding, PR - procurement, CI - construction and installation progress, PM -project management/training, MA - market development, PI - Privatization.

-22- ANNEX I

ANNEX 1: ICR MISSION AIDE MEMOIRE

A World Bank Mission visited Mexico City and Monclova from January 7 to 18, 1997to discuss in detail the Implementation of the Steel Sector Restructuring Program (the Project)and details of the supporting Bank loan to NAFIN which closed December 31, 1996. Themission comprised Daniel Crisafulli (task manager) and Edmund Mangan (technical advisor).The Mission met with representatives of SHCP, the government, NAFIN, the borrower, andAHMSA and CMC, the beneficiaries, and with Grupo Acerero del Norte (GAN), the private,sector owner of the companies covered by the loan.

Key IssuesLegal Covenants and Loan Closing. Since the last supervision mission in June 1995,

a waiver was granted to AHMSA for two of the legal covenants (current and debt coverageratios) and the loan closing date extended to December 1996. There are presently nooutstanding issues.

Implementation Completion Report. NAFIN and the beneficiaries have each beeninformed of their obligation to prepare a report covering their part of the ICR. A draft outlinewas prepared and discussed, along with information on the Restructuring Project prepared bythe Bank for a Case Study and a preliminary ICR after the last supervision mission in June1995.

Overall StatusIn summary, the Project is complete and successful. The major goals, to improve

quality and service to the steel-consuming industries in order to improve their competitiveperformance are being accomplished. The steel industry is able to meet the demands of thedownstream steel consumers in terms of quality, quantity and price. In addition the industry iscompeting successfully in the world steel market. The companies supported by the loan areexpected to finish 1996 profitably, with increased production and sales resulting fromimplementation of the project. The loan closed in December 1996 after three extensions. PartsB. 1 and B.2 of the loan, the investment projects for AHMSA and CMC, were completed in1996 with all funds disbursed.

Part A US$100 Million Equivalent. The Steel Sector Reform Program was carried outfully in the spirit of the agreements with the Bank and fully satisfied with the privatization of allof the public sector steel companies in November 1991. The steel market in Mexico continuesto grow, with market based competition between imports and the products of the domesticfirms who have reduced costs and improved quality and customer service

Part B. 1 US$170 Million Equivalent. The Project at AHMSA is complete. All fundshave been disbursed and the benefits of the project are being realized. The mission discussed indetail the requirements of the Implementation Completion Report and assisted in drafting anoutline for preparation of the borrowers portion. The data for the Bank portion of the reportwas prepared during the mission.

-23- ANNEX 1

Part B.2 US$50 Million Equivalent. The CMC business plans for the coal and ironmining areas were reviewed along with details of that portion of the Project, which is alsocomplete. Both AHMSA and CMC have been closely integrated into the new GANorganization. The borrowers Implementation Completion Report will integrate the twoportions of the loan.

The modernization project supported by Part B of the loan was redefined afterprivatization and new portions will continue beyond the Project completion date. The detailsof this project and the operating plan are attached. This information was taken from thePROSPECTUS prepared by AHMSA for a successful offering, of US$85,000,000, 5% SeniorDiscount Convertible Notes due 2001, on the New York Stock Exchange in 1996.

Expected Development ImpactIn its early stages, the loan supported a broad-based reform of the Mexican steel sector,

that led to privatization of the state owned steel companies in 1991. The remaining componentsof the Project concern the financing of investments to transform the steel producing firm,AHMSA and its raw material supply CMC, from an insular firm with outmoded processes intoan internationally-competitive, integrated steel production operation. This has been critical tothe overall objective of the Project to provide the market with high quality steel at competitiveprices.

Environmental Protection. The mission reviewed environmental aspects of theAHMSA plant. A new HCL regeneration plant for the pickling line has been put intooperation eliminating environmentally damaging waste flow, which has been one of the mainenvironmental problems of the plant. Other environment related activities have concentratedmainly on improving the efficiency of water use, thereby reducing substantially the amount ofwater required and the flow of waste water. A final waste water treatment plant along withother environmental improvements are included in the ongoing project plans.

Procurement and DisbursementsAll funds have been disbursed and the loan closed on December 31, 1996.

Legal CovenantsAs of Project completion and the loan closing date, the borrower was in compliance

with all legal covenants.

Washington, DC January 17,1997

-24- ANNEX2

ANNEX 2: OPERATION PLAN FOR THE AHMSA STEEL PLANT

Strategy for Operations and InvestmentsAHMSA's strategy for its steel segment is to consolidate its leading market-share

position in the Mexican flat products market, maintain an important presence in exportmarkets, improve capacity utilization with respect to its existing products, develop highervalue-added steel products and increase its customer base. Operationally, AHMSA isfocused on reducing production costs and improving product and process quality.

Since 1992, AHMSA has implemented a modernization program for its steelbusiness, based on the World Bank Steel Sector Restructuring Project and furtherdeveloped by Grupo Acerero del Norte, S.A. de C.V. ("GAN"), AHMSA's controllingshareholder, and its technical advisor, Hoogovens Technical Services, B.V.("Hoogovens") at the time of privatization in 1991. The full plan is expected to becompleted by the third quarter of 1998. Specifically, at its Monclova steel facilities,AHMSA intends to: (i) boost liquid steel production to 3.50 million tons in 1997; (ii)increase the production of finished steel products to 2.98 million tons in 1998; (iii) raisethe production capacity for continuous casting of flat products to 100% in 1998(following certain other related improvements); (iv) increase the yield of finished steelproducts to liquid steel consumed to 84.3% in 1998; (v) improve productivity (measuredas steel plant employee hours per ton of liquid steel) to 7.13 employee hours per ton in1998; (vi) improve product quality to meet the specifications of the high-end segment ofthe domestic market; (vii) increase production of higher value-added products such asgalvanized, coated and tin-free steel; and (viii) modify and improve equipment andprocesses to meet existing Mexican environmental regulations.

A capital improvements program at AHMSA's coal and iron ore miningsubsidiaries (the former CMC) is currently expected to be completed by year-end 1998.This plan is designed to (i) modernize the coal and iron ore mines, expanding capacity tomeet AHMSA's requirements as its steel production increases and (ii) increase productionlevels of steam coal in order to meet anticipated increases in demand at CFE's powerplants. Between 1992 and September 30, 1996, the Company invested approximatelyPs.1,584.8 million ($209.8 million) in capital expenditures under the Mining CapitalImprovements Plan. To date, the Company has achieved the following goals under theMining Capital Improvements Plan: (i) increased the Company's production of iron orefrom 2.64 million tons in 1992 to 4.24 million tons in 1995 and 4.43 million tons (at anannualized rate) in the first nine months of 1996, (ii) increased steam coal production atMICARE from 5.10 million tons in 1992 to 6.32 million tons in 1995 and 7.27 milliontons (at an annualized rate) in the first nine months of 1996, and (iii) increasedmetallurgical coal production from 1.48 million tons in 1992 to 1.71 million tons in 1995.Metallurgical coal production decreased to 1.69 million tons (at an annualized rate) in thefirst nine months of 1996. An additional Ps.1,814.9 million ($240.2 million) is budgetedunder the Mining Capital Improvements Plan for the fourth quarter of 1996 through 1998.Management believes that the Company's metallurgical coal mining activities serve toenhance its steam coal operations.

-25- ANNEX 2

These plans are intended to enhance the Company's competitive advantages as alow-cost steel producer with access to domestic and international steel markets as follows:

Focus on the Mexican Market. Mexico is a developing country with substantialinfrastructure needs. Prior to the 1995 Mexican economic crisis, Mexico showed a robustdemand for steel products. In 1994, apparent domestic consumption of steel products was9.89 million tons, an increase of 49.3% from 1990. In 1995, apparent domesticconsumption of steel products declined to 6.15 million tons, of which 5.32 million tonswere supplied by domestic producers and 0.83 million tons were supplied by imports. Asthe domestic economy improves, the Company believes that domestic demand for steelproducts will increase.

Access to Ample Mineral Reserves and Economies of Scale. AHMSA has long-termconcessions to mine iron ore and metallurgical coal mines with proven and probablereserves sufficient to provide AHMSA's steel operations with an ample and secure supplyof primary raw materials. In addition, AHMSA mines steam coal reserves for sale to theCFE. The operation of five mining units (consisting of 14 operating mines) for both steelproduction and outside sales allows AHMSA to realize economies of scale in its miningoperations, which based on outside industry studies, are sufficient to achieve one of thelowest raw material input costs in the world.

Competitive Labor Costs. The Company's labor agreements, in combination withretirements and attrition, and productivity achievements have contributed to significantproductivity gains. AHMSA's average wage and benefit cost for its steel and miningoperations was approximately $3.39 per hour during 1995 (excluding ANSA) and the firstnine months of 1996 (including ANSA), which it estimates, based on outside industrystudies, to be significantly below that of most of its foreign competitors. As a result of thislow wage and benefit cost, AHMSA's cost of raw materials and production of steelproducts is substantially lower than that of most of its foreign competitors. In the first ninemonths of 1996, the Company signed agreements governing its unionized workers, whichprovided for nominal wage and benefit increases for 1996 ranging from 16% to 22% on anannual basis. Inflation in Mexico was 52.0% for 1995 and 20.4% for the first nine monthsof 1996. The next scheduled renegotiations of wages for AHMSA's workers will occurduring the first and second quarters of 1997.

Quality Products and Access to Foreign Markets. Since the privatization, AHMSA hasemphasized improvements to product quality. In 1995 and 1996, the Company obtainedan ISO 9002 certification from the International Standards Organization covering its blastfurnaces, its steelmaking, hot rolling and cold rolling facilities and its coke plants, pelletplant and sinter plant. Improved product quality and the increased competitiveness of theCompany's steel products in foreign markets following the peso devaluation allowed theCompany to increase its export sales of steel products from 102 thousand tons in 1994 to1,022 thousand tons in 1995 and 677 thousand tons in the first nine months of 1996.

-26- ANNEX2

Export sales volume accounted for 43% and 32% of total sales volume of steel productsin 1995 and the first nine months of 1996, respectively, compared to 5% in 1994.

Strategic Location. AHMSA's Monclova steelworks are located within 300 kilometers ofAHMSA's most important raw materials subsidiaries, thereby substantially reducingtransportation costs. In 1995 and in the first nine months of 1996, AHMSA's average costof delivery per ton of raw materials was approximately $1.15 and $1.10, respectively, perton of iron ore and approximately $3.07 and $3.20, respectively, per ton of coal. Similarly,AHMSA's location near its primary domestic markets and its relative proximity to pointsof export reduce finished product delivery costs.

Environmental MattersAHMSA's operations are subject to Mexican federal and state laws and

regulations relating to the protection of the environment, including regulations concerningwater pollution, air pollution, noise pollution and hazardous substance discharge. InNovember 1994, GAN entered into an environmental agreement with the governmentunder which it agreed to enter into self-audit programs. AHMSA had completed a self-audit with respect to its steel operations, and in November 1994 AHMSA entered into anenvironmental agreement with the government covering AHMSA's Monclova steelmakingfacilities. It is in substantial compliance with the Environmental Agreement.

As part of the modernization and improvements, between 1992 and September 30,1996, AHMSA invested Ps.341.7 million in environmental projects, including Ps.317.7 torenovate two pickling lines in the cold rolling mill to eliminate the discharge of sulfuricacid, iron and heavy metals. As part of AHMSA's capital expenditure program, AHMSAhas budgeted an aggregate of Ps.239.5 million from October 1, 1996 through December31, 1998 for environmental projects, including projects required to comply with theEnvironmental Agreement and existing Mexican environmental laws. In addition to theseexpenditures budgeted for environmental projects, other operational investments areexpected to provide environmental benefits. For example, the renovations to one ofAHMSA's coke plants, which were principally designed to improve efficiency, areexpected to reduce emissions and discharges from the plant.

Mexico, January 14, 1997

-27- ANNEX3

ANNEX 3: BORROWER'S CONTRIBUTION TO THE ICR

Background.1. Project description. Part A (US$100 million) was tied to the implementation of pricedecontrol, trade reform, elimination of Official Reference Prices for steel products andreduction and equalization of steel tariffs, and presentation of a global steel sector policystatement to expose the industry to international competition. Part B (US$225 million)provided financing for the SIDERMEX restructuring program comprising the physicalrehabilitation of the AHMSA steelworks (US$170.0 million) and rehabilitation andrestructuring of the SIDERMEX mining operations (US$50.0 million). It also providedassistance in corporate wide organizational and financial restructuring and fordevelopment of SIDERMEX's long term strategy (US$5 million). Part C (US$75 million)supports the restructuring effort of HYLSA in the modernization of its flat productsfacility, in parallel with the financial restructuring package under negotiation with creditorbank.

2. Objectives. The objectives of the Project were: (i) to assist the Mexican Governmentin implementing a comprehensive and far-reaching reform of the steel sector and incarrying out the needed restructuring actions; (ii) to assist the major players to rehabilitatepotentially efficient plants and equipment with demonstrable viability, enhance productquality and reduce product costs, eliminate bottlenecks to achieve better utilization ofexisting capacity, improve technical, financial and managerial controls and informationsystems, train operation and maintenance staff, and develop the human resources toachieve the overall objectives of greater competitiveness and responsiveness to marketneeds, and; (iii) to assist the Government and the industry in elaborating their long termstrategies and policies to achieve a healthier development of the steel sector in line withthe country's development objectives.

PART A. POLICY BASED COMPONENT

3. The steel sector reform project was very successful. Overall, policy objectives weremet and steel consumers have access to steel products of internationally competitivequality at free market prices. This enhanced the capability of the Mexican manufacturingsector to compete better in the world market. The US$100 million policy component wasdisbursed in two tranches. US$50 million at the time of loan effectiveness in March 1988and US$50 million at the time of agreement on sector strategy in January 1990. TheGovernment involvement in the sector, as regulator and producer, has been eliminated.Privatization has created a dynamic, export-oriented, low-cost, modern steel sector.

4. The opening of the sector presented conflicts between the firm interest(faster increasein prices but slower reduction in protection) and the global interest (slower reduction inprices but faster reduction in tariff to fight inflationary pressures). The liberalization oftariffs, initially, was not a problem, partially because lower local prices from pricecontrols, and import content requirements, made tariff ineffective.

-28- ANNEX3

5. The liberalization of price controls, on the other hand, was difficult and delayed, butnevertheless completed by September 1990. Other policy components were implemented,tariff were reduced and equalized between flat and not flat products, local contentrequirement was eliminated, subsidized input prices have been eliminated, inefficientinstallations were closed, divestitures of non-steel enterprises was done, strategic anddiagnostic studies were carried out and furthermore the sector was privatized.

6. The process of opening the Mexican economy to international competition started in1985, with a reduction of Quantitative Restrictions from 100% to 39%. Mexico joined theGATT in 1986, after which trade liberalization accelerated. Steel import tariffs fell in1986 from 40% to 37% on finished non-flat steel products, and 25% to 20% on most flatproducts. By the end of 1987, tariffs on steel products ranged from 0% to 15%, andofficial reference prices had been phased out. In the following years, no further tighteningof trade restrictions was imposed and Mexico is now a party of NAFTA agreements.

7. Privatization was the end result of a complex process, with a series of decision thatcreated the political and economic preconditions that ultimately led to privatization. Thepolicy and political changes started in the early eighties and culminated in 1991.

8. During the process of restructuring, AHMSA laid off employees, this provoked unionunrest and one strike. The firm took a strong stand that resulted in changing the laborcontracts and a reduction in union power. A second element was the conflict between theGovernment's financial constrained and the financial resource needs of the steel industry.The unwillingness of the Government to authorize funds for AHMSA's restructuring, ahigh return project, illustrate the conflict.

9. The process of freeing steel prices proved to be longer and more complicated than thatof trade liberalization, due to concerns about its inflationary effects and conflicts with theEconomic Solidarity Pact (ESP) of December 1987 and the ones that followed. The intentof these agreements was to reduce inflation and restore confidence in macroeconomicpolicy, while avoiding a recession. These factors delayed complete price decontrol untilSeptember, 1990. In May 1989, the Government modified the Foreign Investment Law toenlarge the number of sectors in which foreign ownership was permitted. Otherprotectionist measures which were phased out were domestic content requirements andsubsidized input prices.

10. SIDERMEX assets were separated into three groups and their liabilities sortedaccordingly. Also, in March, 1990, to make the companies more attractive to potentialbidders, the Government assumed US$2.3 billion of SIDERMEX foreign debt (of whichSICARTSA II comprised approximately 67%).

11. In March, 1990, the Government announced its decision to privatize SIDERMEX.The SHCP, the ministry responsible for implementation of the privatization program,formed its own independent teams and sought technical and financial advice frominternational sources, particularly officials who had been involved in the British Steel

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privatization. The presence of international experts is believed to have enhanced thecredibility of the process and helped diffuse resistance.

12. SHCP restrained steel companies from undertaking major new investments during theprivatization process, and made operational capital expenditures subject to prior approval.The Government wanted to ensure that buyers would have a sufficient stake in thecompanies and possess the necessary resources and expertise to implement requiredmodernization. Therefore, at SHCP's suggestion, the Government decided to sell eachcompany as a whole or in a package of a steel mill and mines, through open internationalbidding process. Also decided that an important selection criterion would be the amountof committed investment for restructuring and improving the competitiveness of the threesteel companies. Consequently, as a precondition of sale, bidders were required todevelop a complete business plan and commit legally to investing in modernization.

Government and NAFIN's Role in Project Implementation.13. Government through SHCP, SECOFI and SEMIP carried out the policy component,saw to the provision of counterpart funds and implemented the agreed strategic plan.NAFIN's role in the execution of the project was to coordinate and consolidate the workof all concerned enterprises and provide assistance in resolving project implementationissues to ensure smooth progress of the project.

Cooperation with the World Bank.14. During the whole course of the Project Implementation, even though there weredelays and differences of opinion, the cooperation between Government, NAFIN and theBank has been satisfactory. Whenever difficulties or problems arose, they were dealtthrough bilateral friendly discussions and consultations. The guidelines and proceduresadopted by the Bank in appraising and implementing the project were concise, technicallycorrect and efficient, and generally Bank requirements and suggestions to the executingagency were rational. Bank officials in charge of appraisal and supervision as well astechnical experts were skillful, competent and responsible. Their hard work contributed agreat deal to the successful implementation of the project.

Lessons Learned and Prospects15. The transformation from a non-market, closed, Government dominated sector, to anopen, private, market environment involved changes in behavior at government, sector andenterprise levels. From the Mexican steel sector experience, it appears that the sectorrestructuring program did help. A sector program, can be a positive contribution tomodernization, as long as, Government disengagement, opening of the sector andprivatization are enacted.

PART B. PUBLIC SECTOR INVESTMENT COMPONENT

Background.16. During Project preparation, The World Bank carried out a Steel Sector StrategyStudy to help the Government and the enterprises to identify appropriate strategies for the

-30- ANNEX3

development of an efficient domestic steel industry. This was followed by separate studiescarried out with consultants to prepare an optimal investment program for AHMSA andCMC to meet the requirements of the steel market in Mexico. As part of the Study, theBank designed a computer-based mathematical programming model to facilitate review ofthe options, using data provided by SIDERMEX. The model covers optimization ofinvestment at the national level as well as at each plant in terms of location, scale ofoperations and levels of production in the context of the constraints associated with thetransport of raw materials, intermediates and final products. Selection of optimalstrategies was based on a comparison of different options and scenarios.

Technical assistance in AHMSA and CMC.17. World class industry consulting firms ("Consultant") expert in project management,raw material and steel production were hired. Technical and commercial specifications forAHMSA's modernization projects, were originally prepared with the assistance of theConsultant. After the award of a technical assistance contract, the specifications werereviewed and some adequacies were included to provide a more complete scope of thetotal work to be performed. In CMC, the Consultant services focused more on operations,exploration to estimate the potential iron ore and coal reserves, and managementinformation systems. Directly related activity to the project was mainly the preparation ofsome technical specifications and some assistance for the development of a projectcomputerized cost control system.

18. Both AHMSA and CMC are pleased with the performance of their consultants whohelped in improving the projects management activities and also solving severalcontractual misinterpretations. After the privatization, AHMSA's new technical partnerwas also involved in the modernization project. A Task Force consultant group wascreated that combined key consulting staff with the new technical partner in order tocontinue with the modernization program. The Task group was very successful.

19. Once the decision to privatize the steel companies was made, the part of the loancorresponding to SIDERMEX was canceled. From the objectives of this part, only thatrelated to the assessment of the strategic study was carried out by a world classconsultant. With the privatization of the sector SIDERMEX was dissolved.

Project Objectives.20. AHMSA concentrated on shifting the product mix to flat products, heavy structuralsand rails with an overall reduction in steelmaking capacity and improvements in qualityand lowering the costs of production, primarily in hot and cold rolled sheet and tin plate.The major technical thrust was to: (i) rationalize the steelmaking and continuous castingfacilities; (ii) rehabilitate and improve the quality and productivity of the hot strip mill; (iii)balance the cold rolling mills and improve the quality of the cold rolled products; (iv)provide catch up maintenance throughout plant operations and in plantwide utilities andservices; (v) expand the product line by using the underutilized heavy structural mill forthe production of rail; and, (vi) provide for enhancement of systems and training. The mainchanges in objectives and scope were : cancellation of the rail project by budget

-31- ANNEX3

constraints (1989); closedown of the Siemens Martin steelshop by enforcement of theenvironmental regulations (1991); new management's business plan that changed scope ofinvestments in the cold mills and continuos casting areas; and, reorientation of the trainingcomponent with the assistance of the AHMSA's new technical partner.

21. CMC concentrated on raising the productivity in the coal mining operations andstrengthening the Hercules iron ore operation, bringing it to its intended level of operation,through a mixture of maintenance and equipment renewal, debottlenecking investments,systems and control and technical assistance for project management, operationalimprovements and upgrading of technical skills. After privatization, main focus was placedin the improvement of the iron ore mines mainly with the installation of the magneticseparation equipment; refurbishing of the iron ore slurry pipeline, magnetic concentration,and increasing capacity of the pellet plant

22. SIDERMEX was to carry out the long term strategic studies including the necessarysupporting technical studies to: undertake the corporatewide asset revaluation exerciseand translate the results into a suitable financial structure; implement the organizationaland financial restructuring measures that emerge after the completion of the long termstrategic study; assist in the detailed planning of the long term strategic investments; and,provide assistance for the implementation of corporate level management informationsystems. This part of the project was canceled following the dissolution of SIDERMEX asa result of the privatization of the steel companies.

Project Content23. AHMSA. In the Modernization Project of AHMSA, the hot strip mill project wassignificant in terms of the capital expenditures involved and its complexity. Investments inpredecessor's areas were necessary to achieve AHMSA's goals. Therefore, a descriptionof the hot strip mill project outlines most of the modernization plan of AHMSA. Theproject was divided in three main areas: a) New slab yard, b) New reheating furnaces, c)Hot Strip Mill modernization and Coil Handling and ancillary equipment.

24. The new slab yard comprises a new high speed transfer car, two new short transfercars and one large transfer car associated walking beam type handling equipment,scarifying systems, inspection areas, slab cooling areas, and new and modified cranes. Thenew slab yard was built on the area which previously housed the old Open Hearthsteelshop which has now been dismantled and removed.

25. Two new re-heating furnaces, walking beam type with a capacity of 250 tons/hr eachcapable of handling 20 tons slabs, were installed. Furnace No. 3 was started up in June1992 and Furnace No. 4 was commissioned in January 1995.

26. In the hot strip mill, an intermediate stand at the entry of the finishing mill wasinstalled. This was required for production of processing coils with weight up to 20 tons.Other improvements were made such as: installation of entry and exit edging mills into theroughing mill, automation of the roughing mill, modifications to the shear with new drum

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type cassette for quick change of blades, new descaling unit, replacement of the existing5,000 HP motors of the Fl, F2 and F3 finishing stands with new 7,000 HP motors,automation of the finishing mill with a new electrically driven inter-stand tension controlsystem and looper-less tension control between the M and F1 stands as well as a newautomatic gauge control system for all seven stands, quick roll change in the M stand andthe finishing mill, roll bending and roll shifting in F4, F5 and F6, new inter-stand coolingsystem, new laminar flow strip cooling system, and new down-coilers for 20 ton coils.

27. CMC. Similar to AHMSA component, the project executed in the iron ore minereflects the modernization project of CMC. These consisted of the: Renovation of thepellet plant to increase production capacity to 3.55 million tons per year. The mainrefurbishment made was from April 1995 to October 1996 and consisted of the installationof an additional balling disc, replacement of the green pellet double deck roller screen by amore efficient one; belt conveyors upgrade; installation of new pellet product classificationsystem; optimization of coke grinding system; and the complete replacement ofinstrumentation and control systems. A magnetic separation system was installed torecuperate iron units from an old tailing bond located at the Hercules mine providing themine with higher reserves. The main process consists of hydraulic mining of tails, a screensystem, low and high intensity magnetic separators and a thickener set from which therecuperated iron ore is derived to the concentration process in the main facility. Thisproject was completed in October 1995. A major repair of 39 Km. out of the 295 Kmlength of the iron ore slurry pipeline connecting Hercules facilities with AHMSA Pelletplant was completed in November 1995. This repair consisted in the replacement ofdamaged pipes avoiding the risk of leaks and possible AHMSA operations disrupts.

Project Implementation28. Implementation schedules were developed for each component of the loan withcompletion expected in 3 years. However, several factors had a negative impact on thepace of implementation. Most important was budgetary policy (prior to privatization)ofthe Government. As a result, the project suffered a lack of continuity leading to majordelays, scope changes and cost overruns. An example of this is the following comparisonbetween the budget requested by AHMSA and the approval given by the SPP.

Budget Figures in USS millionYear Requested by AHMSA Approved by SPP1988 136.2 8.91989 71.8 35.91990 145.1 93.41991 80.3 61.7

29. Procurement activities were delayed by scope changes, complexity of the technical bidevaluation, in particular the Hot Strip Mill (HSM) revamping, and construction contractordeficiencies. The procurement bidding process was too long and required an extensivetechnical equalization. One stage bidding process was selected. The two stage processshould have been used from the beginning for complicated bid packages like the Hot Strip

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Mill. Bank staff should more carefully consider the complexity of the project in order tospecify the proper bid process.

30. Efficiency levels foreseen in the Modernization Program started to be obtained by1995 once the HSM project was completed. For 1997 it has been scheduled the capacitygoal for the HSM contemplated in the Project (2.25 million tones).

Project Progress Timetable.31. The key indicators of the hot strip mill project are:

Indicator Estimated ActualInvitation to Bid March 1988 March 1988Contract March 1989 Dec 1989Installation August 1990 July 1993OperationStep 1 Jan 1991 May 1994Step 2 Jan 1992 Jan 1995

Commencement of ProjectTechnical Assistance April 1988 May 1988

The Achievement of Project Objectives and Results32. The Hot Strip modernization project was completed in the following steps as shownin the following table:

Execution StartingShutdown time Date Main activities executed# (days)1 27 December 1991 Elimination of site interference.2 10 July 1993 Main Civil works3 61 May 1994 Installation and commissioning of main electro-

mechanical equipment for Roughing Mill.4 20 February 1995 Installation and commissioning of main

automation equipment Finishing Mill area. CoilHandling System was completed in May 1995.

Management Objectives.33. The modernization project and the additional investments made after privatization,allowed the company to obtain significant operational improvements by raising productionvolume, reducing operational cost, and technological upgrading. Technical assistance inoperational and technical areas provided by the Consultants and the technical partner ledthe company to higher quality and productivity of the staff AHMSA has now a leadingposition in the Mexican market and it has taken advantage of its competitive position toopen markets for its products worldwide. In 1995, AHMSA and its mines (CMC) wereconsolidated in order to become a fully integrated steelworks. In 1993, AHMSA returnedto be listed in the Mexican Exchange Stock Market. In 1996, AHMSA issued a $85

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million convertible note and listed in the New York Stock Exchange. Further investmentshave also been budgeted to keep pace with market needs and operational improvements inboth the steel operations and mining areas.

Financial Objectives.34. AHMSA Financial information. Non consolidated

(US$ Millions, current)

Concept 1987 1991 1996 ESales 788 946 1,122Net income/loss 5 (203) 481Internal cash 193 61 195Debt service 208 49 158EBIT/Sales 16% N/A 10%PAT/Sales N/A N/A 43%Current ratio 3.45 1.88 0.75LT Debt/Equity ratio 15:85 25:75 36:64

Notes: 1996 data estimate of year end based on 9 months actual .

35. The financial rate of return was originally estimated at 32.7% under the assumption ofproject completion in 3 years. Due to the delays already mentioned in project completion,the estimated actual financial rate of return is 16.1%. Incremental operating cash flow in1996 accounts for $131.6 million of which it is estimated that $42.3 million are due to anincrease in production volume and $89.3 million are due to reduction in production costs.

36. The increase in sales for 1996 mainly reflected a higher volume of the tonnageshipped. Although net sales increased, EBIT margin was affected due to the decline inAHMSA's average selling price per ton. This decline is explained mainly by lower sellingprices for steel products in US dollar terms. (In Mexico, the steel prices are generally setby reference to US dollar denominated internal prices).

Performance of Bank37. Bank assistance in project preparation, appraisal and implementation was significantand efficiently supervised. After project approval Bank Supervision Missions visited theproject site every six months until project completion. Progress reports for each missionwere prepared by AHMSA and the project management consultant and discussedextensively with the Bank. After privatization, the Bank agreed to adapt the procurementprocedures to include items originally not contemplated but requested by AHMSA inorder to facilitate project execution. The changes requested were: incorporation of thelocal competitive bidding for contracts with domestic and foreign content but onlydomestic contractors bid; financing of construction costs in turnkey contracts. Thisaccelerated the project implementation and eventually the completion. Also, assistancewas provided for the retroactive financing of maintenance investments made in AHMSAand CMC after project approval.

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Project Management Performance38. The technical assistance before and after the privatization process was successfullyadequate, helping the company in solving several differences with the main suppliers, bothin technical and commercial aspects. The assistance as a Task Force group from theconsultant and the technical partner after the privatization helped in the successfullycompletion of the projects and the achievement of the performance guarantees.

Operation Status39. AHMSA. From the inception of the Modernization Plan through 1996, the Companyhas invested $618.4 million and has achieved the following goals under the ModernizationPlan at its Monclova steelmaking facilities:

Efficiency indicator Unit 1993 1995 1996 ELiquid steel production (Ls) Million tons/year 2.58 3.1 3.40Finished steel production (Fs) Million tons/year 2.0 2.41 2.73Continuous casting slab ratio % 76.5 83.3 89.3Yield (Fs tons/Ls tons) % 75.4 77.6 80.6Productivity Man-hour/ton of Ls 9.59* 7.88 7.40Coke rate Kgs. coke/ton of iron 533* 496 472Energy consumption Gigacalories/ton of Ls 7.0 7.0 6.5First quality products _% 91.7 93.6 94.8

Notes: * data from 1991. 1996E data estimated for full year based on 9 months actual performance.Energy and First Quality products data includes subsidiary companies.

40. Improvements in product quality led to an ISO 9002 certification from InternationalStandards Organization for the Company's blast furnaces, steelmaking, hot rolling andcold rolling facilities and coke plants, pellet plant and sinter plant. In connection with thecompletion of the Modernization Plan, the Company has budgeted an additional amountfor 1997 and 1998 for projects that principally involve the production of higher value-added products. Specifically, remaining outlays are for (i) ongoing renovations to one ofthe coke plants, (ii) improving blast furnace operations, (iii) upgrading the cold mill plantsand (iv) installing a painting plant. Additional capital investments have been envisioned toproduce more value added steel products, and further reduce operational cost.

41. Petween 1992 and 1996 AHMSA has made investments in environmental projects,including the renovation of two pickling lines in its steel mills to eliminate the discharge ofsulfuric acid. AHMSA has budgeted investments from 1997 to 1998 for environmentalprojects, including projects required to comply with the Environmental Agreement andexisting Mexican environmental laws and otherwise to address environmental concerns.

42. CMC. From the inception of the Modernization Plan through 1996, CMC has invested$207.6 million and has achieved the following goals under the Modernization Plan in theiron ore mines.

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Iron Ore Concentrate Productio(millions of tons) 1991 1992 1993 1994 1995 1996 E

MINOSA. Hercules Unit 2.15 2.61 3.02 3.29 3.52 3.63La Perla 0.79 - - - - -

Total 2.94 2.61 3.02 3.29 13.52 3.63Note: Annualized based on first nine months actual.

Project Sustainability43. The project supported AHMSA's post-privatization strategy which is to secure andexpand its leadership position in Mexico flat product market and increase its margins byinvesting in its facilities and employees, upgrading its product quality and product mix andenlarging its customer base and further reducing the Company's labor and raw materialcosts per ton of finished steel. Given the operational success of AHMSA prospects forproject sustainability are very strong.

Project Expenditure44. Total investment in AHMSA and CMC amounted to $825.0 million as compared with$664.1 million originally estimated. AHMSA and CMC components of investment are$618.4 million and $207.6 million, respectively. SIDERMEX investment in the long termstrategy was US$1.0 million.

45. Investments made in AHMSA in relation to the original scope of the modernizationplan amounted to $360.8 million. After privatization, AHNSA made additionalinvestments that were not part of the previous modernization plan. It consisted mainly of:$113.7 million in steelmaking and continuous casting, $17.7 million for a new tin free steelline; $32.8 million for the rehabilitation of coke plant # 1; $40.7 million for the revampingof blast furnace # 5; $30.1 million for the installation of a new hydrochloric (HCL) acidpickling line and the reconversion of the previous sulfuric acid pickling line to HCL acidpickling line with a HCL regeneration plant (it eliminated an old environmental problem);and, $22.6 million in other minor modernization investments.

46. Main investments made in CMC were: (i)$95.8 million in the iron ore mines, and (ii)$50 million in the coal mines. In the iron ore area the main investments consisted of: $13.3million for the renovation of a pellet plant, $13.7 million for the installation of a newmagnetic separation unit in the Hercules mine, $4.3 million for the replacement of 39 ofthe 295 kilometers slurry pipe from Hercules mine to AHMSA steelworks, $7.8 million forthe capacity increase of existing concentration facilities in the Hercules mine, $28.7.0million for the replacement of mining mobile equipment, and $28.0 million in various othermodernization items. In the coal mines, investments made consisted mainly in: $36.5million for the replacement of underground mining equipment, and $13.5 million therefurbishment of the coal washery plant at Palau.

Conclusion47. The steel sector reform and the rehabilitation program of the steel companies weresuccessful. The Mexican economy is now open. The steel and raw materials companies

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have been modernized. AHMSA and CMC are operating successfully in a competitivedomestic and export market environment. Steel consuming industries are able to purchasehigh quality steel products at low cost. In fact, AHMSA, which has received awards forquality, has also been ranked as one of the world lowest cost steel producer.

PART C. PRIVATE SECTOR INVESTMENT COMPONENT

48. The part of the Project was canceled at the request of HYLSA due to its participationin the privatization process. After losing in its bid for the three privatization packages,HYLSA responded by shifting its competitive strategy and investing vigorously tostreamline its operations. They invested $400 million in a new state-of-the-art thin slabcasting facility to make high quality sheet and also invested to improve the efficiency ofthe old flat products plant.

49. HYLSA has completed its modernization program without the financial assistance ofthe World Bank, but benefited from the overall work by the World Bank in the reform ofthe steel sector.

50. HYLSA is also competing successfully in the domestic and export steel market.

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IMAGING

Report No.: 16856Type: ICR