Mexico - Integrated Rural Development Project

CIRCULATING COPY F uSE copy TO BE RETURNED TO REPORTS DESK DOCUMENT OF INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT Not For Public Use Report No. P-1515-ME 'REPORT AND RECOMMENDATION OF THE PRESIDENT TO THE EXECUTIVE DIRECTORS, ON A PROPOSED LOAN TO NACIONAL FINANCIERA, S.A. WITH THE GUARANTEE OF UNITED MEXICAN STATES - FOR AN INTEGRATED RURAL DEVELOPMENT PROJECT I (PAPALOAPAN BASIN) OctQber 16, 19 74 Latin America and the Caribbean Regional Office This report was prepared for official use only by the Bank Group. it may not be published, quoted or cited without Bank Group authorization. The Bank Group does not accept responsibility for the accuracy or completeness of the report.  Currency Unit - Peso (Mex$) US$1.00 Mex$12.50 Mex$1.0 = US$0008 Mex$1 million US$80,000 Fiscal Year - January 1 to December 31  INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT REPORT AND RECOMMENDATION OF THE PRESIDENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO NACIONAL FINANCIERA, S.A. WITH THE GUARANTEE OF THE UNITED MEXICAN STATES FOR AN INTEGRATED RURAL DEVELOPMET PROJECT I (PAPAIDAPAN BASIN) 1 I submit the following report and recommendation on a proposed loan to Nacional Financiera, S. A., with the guarantee of the United Mexican States, for the equivalent of US$50 million to help finance a project for integrated rural development. The loan would have a term of 25 years, including five years of grace, with interest at 8 percent per annum. PART I - THE ECONOMY 2. "The Economy of Mexico: A Basic Report?t (192-ME) was distributed to the Executive Directors on June 26, 1973. It was designed to provide both a long-term perspective on the Mexican economy and a framework for the assessment of short run trends. An economic mission visited Mexico in March 1974 and its report,dated September 27, I974,has been distributed to the Executive Directors. The mission's conclusions are reflected in the discussion which follows. Annex I contains country data sheets. 3. For the three most recent of the six decades since the Revolution of 1910, the success of the Mexican economic system, measured in terms of GDP growth, has been outstanding. Since 1940, the annual average growth rate has exceeded 6 percent. And from the mid-1950s to 1972 Mexico was among the few countries in the developing world to combine a sustained high rate of growth with monetary and balance of payments stability. The average annual rate of inflation was less than 5 percent and the dollar value of the peso was maintained at the level fixed in 1954. Rapid and sustained growth was the product of successful policies affecting the mobilization and use of both private and public sector resources. The role of Government in promoting economic growth was concerned on one hand with the development of strategic infrastructure and major utility industries and on the other with policies which featured, in the agricultural sector, the development of price support, import control and agrarian reform measures, and in the industrial sector external protection and the provision of fiscal incentives. 5. The sectoral allocation of public and private investment was reflected in a changing structure of output and employment. This featured the growth of manufacturing industry and the relative decline of agriculture; the latter, however, continued to be the chief source of employment and accounted in 1970 for 39 percent of the economically active population.  - 2 - 6. However, given rapid population growth at an annual rate of 3.4 percent over the last decade, economic expansion has not generated sufficient employment opportunities to absorb the labor force which has recently been growing at about 3.0 percent per year. In 1973 it was estimated that about 40 percent of the labor force was engaged in either marginal occupations - relatively unproductive and hence poorly paid - or was totally unemployed. Partly as a consequence of rapid population growth but also as a result of the pattern of distribution of incomes and assets in the Mexican economy, the strategy which succeeded in promoting rapid growth was not camparably successful in spreading its benefits. The incidence of poverty has been reduced. But the differentials between rich and poor, both between people and places, have probably increased over time. 7. There was, until recently, little evidence (apart from the continuation of the land reform program begun in earnest during the Cardenas regime in the 1930s) that Government policies were much concerned with such programs. By 1970, however, it was apparent that a revised economic strategy - one which would focus on the improvement of the living conditions of the poor - was required. It seemed to be understood that this goal should not be pursued at the expense of rapid growth or of the mone-tary and balance of payments stability which appeared to be sine qua non of sustained economic expansion. The last three years have demonstrated the Government's determination to develop such a strategy. The events and trends of this period have also revealed some of the constraints to doing so. S0 Among the progressive measures introduced since 1970 are a revision of the Agrarian Reform Law and a new Federal Water Law, both of 1971, and increases in the allocation of bank credit to the rural sector (see paragraph 30)- These measures are all responsive to the needs of the rural sector and demonstrate the Government's concern to confront them. Another initiative in a similar category was the introduction in 1972 of a 5 percent payroll tax to finance a new housing program for workers in the lower-middle income groups, It is clear, however, in the light of the experience of the last three years, that neither the needs of the poor nor those of the public sector enterprises (on which the growth of the economy as a whole partly depends) can be met without the mobilization of additional public sector resources. 9. In 1971, after the economy had begun to show signs of stress in 1970, the Government took restraining action in order to preserve monetary and balance of payments stability, and the GDP growth rate fell from the 1960-70 decade average of 7.1 percent to only 3.7 percent while prices increased by 4.8 percent. In 1972 renewed economic expansion was stimulated by public sector expenditures and the GDP growth rate rose to 7.5 percent while prices increased (in terms of the GDP deflator) by slightly more than 5 percent. In 1973 a further substantial increase in public expenditures  - 3 - was largely financed by recourse to increased internal and external borrowing. Private savings mobilized through the financial intermediaries, which in the past provided non-inflationary internal financing for budget deficits, fell below the levels of previous years. Consequently, in 1973 the Government's internal borrowing had a significant effect upon money supply, which increased by 24 percent during the year. This expansion coincided with and was partly responsible for an acceleration in the rate of domestic price increases. These, however, also reflected changes in internat.ional prices, the impact of which was especially serious because of a poor harvest in 1972 and the resulting need to import basic foodstuffs. Consumer orices increased by 22 percent and wholesale prices by 25 percent during 1973, while the deficit on the.current account of the balance of payments increased by 63 percent over 1972. 10, In the light of these trends the Government and the monetary authorities began to take action to stabilize the economy in the middle of last year. First, monetary policy was tightened from June 1973 onwards. Second, in an effort to mobilize additional domestic resources, electricity rates were increased by an average of almost 30 percent in October 1973 and hydrocarbons prices were increased by an average of almost 100 percent in December 1973. In aggregate, these measures were expected to yield the equivalent of almost 2 percent of 1974 GDP for public sector revenueso Thirdj the planned increase in real expenditures in the 1974 budget (approved in December) was very modest, while the planned use of resources emphasized the more intensive use of existing fixed investment on one hand and new investment in productive sectors on the other. Consistent with a restrictive monetary program and with restraint in foreign borrowing, the planned fiscal deficit for 1974 was lower in nominal terms than the final deficit for 19730 1% In the light of the performance of the economy during the first half of the year it is evident that the program has been successful in certain respects but less so in others. While the rate of inflation is now expected to be in the range of 15 - 18 percent in 197h, this is a suibstantial improvement over 1973 and should not be markedly out of line with that in Mexico's major trading partners. Some of the inflationary pressure this year has been derived from a general increase in wages negotiated at the end of 1973 and the actual rate in 1974 will also be influenced by the impact of further wage increases negotiated in September this year, .1.2. In certain other respects however -the stabilization program appears to have been ILess successful. First, the fiscal deficit will be considerably higher than was planned and wi.ll probably be in the same nominal order of magnitude as in 1973 although it will be lower in terms of a ratio of GDP. Second, the current account deficit in the balance of pay- ments will also be higher than was expected, partly as a consequence of  - 4- thoi need to import petroleum and petroleum products at high international nrices and partly because the rate of real growth in the econormy will exceed the level of 4.5 percent which was originally anticipated; the current, estimate for GDP growth is in the order of 6.0 percent. 13. This impact notwithstanding, Mexico has been relatively less affected bhv the world energy crisis than many other developing countries. Some 95 percent of the countrvys energy requirements are satisfied by hldrocarbons, -t.he balance being supplied from hydro resources; about 10 nercent cf total hydrocarbons requirements have been imported in recent - s. "he hyc-dtrocarbons import bill for 1973 was U $283 million; in 1974 . r- le -aue of hvcirocarbons imports is estimated at US$450 million. `ai; ,'i -ure woll2d have been much higher but for the development of new .'Jee.s in Chianas andl Tabasco which were formerly expected to come on- stream in 1Y75 but have done so this year. The impact of the energy crisis on the balance of payments will thus be attenuated by the discovery of t,hese unusually productive fields. -i!h. In the light of the above it appears that the task of stabi] Iszation has proven to be extremely difficult. The government and the monetary authorities have nevertheless stressed their determination no restore price and balance of payments stability and are considering the introduction of' substantial fiscal reforms before the end of 1974. The uackage of measures under contemplation is expected to generate the eauival ent of around 2.0X of 1975 GDP. The government hes also announced a r?og?' 9 price controls. This program does not aim at rigid controls, but -athher at limiting price increases to what can be justified by increases in the cost. of nroduction. In the case of some staple foods, where the retail prices nave b ezn held down by government subsidy, the control levels are sufficiently --I, rh 00. exnenditures for subsidies are likely to be reduced rather than -nc eaisej. 1V. As of December 31, 1973 Mexico's outstanding disbursed public debt was 113`.3 billion of which the IBIM share was US$808 million. For 1974 net public medium and long-term external borrowing is estimated at US$1.3 biillion, an increase from US$1.1 billion in 1973 and uS$0.5 billion in 197'2. '!The high ievels of borrowing in 1973 and 1974 reflect large public sector (leficits brought on by the failure to increase public revenues sufficiently and, in 1973, the need to inicreaise international reserves despit,e a turn around in short term capital. movements. Borrowing in 1974 hals alLso been severely affected by the need to import, food and fuel at uecord prices. In 1975 there should be some relief as newly discovered oil. fie:Lds and normal demand/supply relationships for food reduce imports of these items. Lcb. Annex I, Page 4 shows that 41.3 percent of public external capital contlacted, in the period 1968-72 was obtained from private banks. This was the largest single source. International organizations accounted for the  - 5 - next largest share (22.2 percent) and the World Bank for 14.7 percent of total commitments. Annex I, Page 4 also shows the sectoral allocation of public external capital and reveals that power, transport and manufacturing were the dominant sectors. In view of Mexico's good reputation as a creditworthy borrower, it continues to receive public external capital on reasonable terus. 17. The level of net public external borrowing of US$1,300 million for 1974 is consistent with Mexico's debt service capacity. As a result particularly of longer maturities on borrowing from financial institutions, Mexico's external public debt service ratio has declined over the last ieveral years and was 17.3 percent in 1973. If the average terms in the future were to be about the sane as those which have been recently obtained, the debt service ratio would remain well below 25 percent during the remainder of the 1970s. Given the uncertainties in the world capital markets, however, future borrowing terms might deteriorate. This possibility underlines the importance of the fiscal measures now being considered by the Government. The Bank's share in public debt outstanding and disbursed at the end of 1973 was in the order of 14 percent while its share in the corresponding debt service was about 10 percent. These ratios are not expected to change significantly during the remainder of the 1970s. 18. Mexico thus remains creditworthy for borrowing on conventional terms provided that the Government continues to follow prudent monetary and fiscal policies. Its recent actions in the field of public sector prices and the prospective fiscal measures for 1975 suggest that it intends to do so. 19. In order to adequately meet its financing needs to assure continued growth with equity in the future, Mexico will have to both strengthen its fiscal effort and supplement that effort with substantial external borrowing. Given that the country's diversified industrial structure is capable of supplying a good part of its capital goods requirements, some local cost financing by external agencies is necessary. Bank loans in sectors like power, highways and irrigation are traditionally tied to the foreign exchange cost of projects. I consider some local currency financing in other sectors to be justified, especially for high priority and institutionally complex projects like those for integrated rural development which offer substantial economic and social benefits in hitherto deprived areas and which call for strong institutional support from the Bank. PART II - BANK GROUP OPERATIONS IN MEXICO 20. With the US$25 million loan for airports development signed on June 28, 1974, the Bank has made 37 loans to Mexico for a total of US$1,838 million, net of cancellations. At the end of August 1974, the Bank held US$1.5 billion including US$0.7 billion not yet disbursed. Most of these loans have been made for power, roads and agriculture. Execution of Bank- financed projects has, on the whole, been satisfactory. However, the  -6- National Railways have not succeeded in achieving the operating ratio targets establiihed under the Second Railway Project (Io 824-ME of May 1972), partly because the required tariff increases have not been introduced, and partly because of unexpected labor and fuel Cost increases. Schedales for a new tariff structare, including substantial tariff increases,, have been however completed anid actions on this matter are being considered by the Government. 21. IPC has made eleven investment commitments in Mexico amounting to US$54.3 million, of which as of itugust 31, 1974, US$35o5 million had been sold, terminated or cancelled0 The US$18.8 million held by the Corporation consist of US$16.7 million in loans and US$201 million in equity. Annex II contains a summary statment of Bank loans and IFC commitments as of August 31, 1974 and notes on the execution of ongoing projects0 22. During the recent past, Bank lending in Mexico has become increasingly diversified as activities have been expanded and more closely related to emerging bottlenecks in Mexico's development. While the fiscal year 1974 lending of US$309 million still centered on the traditional sectors of industry, water supply, transportation and agriculture, a number of these projects were given a new emphasis0 Thas the Las Truchas steel mill is expected not only to further Nexico s industrial growth in an efficient manner, but also to support the Govermentgs program of regional industrial decentral- ization. The Fourth Agriculture and Livestock Credit Project is designed not only to help expand Mexico's agricultural production by increasing the flow of institutional credit along with technical services, but also to make some of the hitherto neglected small farmers benefit from modern production technkblogy. A sizeable component of the loan is therefore specifically earmarked for low- income farmers0 Another example is the Mexico City Water Supply Project which helped create a specialized institution (Valley of Mexico-Water Commission) for efficient management of scarce water resources, cutting across existing functional and administrative boundaries, and dhich supports a policy of relating water charges broadly to the consumers' ability to pay while recovering the full cost of investment. The Rio Sinaloa and Panuco projects of last year were the first in a new series of irrigation projects which, in addition to their productiontobjective, will also attempt to broaden the distribution of the project bmnefits to as large a eegment of mnaU farmers as possible. 23. Traditional projects will continue to form part of Bank lending to Mexico, although in a declining proportion in comparison with the past. These projects will have the triple objective of closing the foreign resource gap to help sustain Mexico's high rate of economic growth, assisting the Government to meet the increasing demands for no-cial expenditures without cutting back on essential productive investment, and of supporting the Government in its efforts to create efficient institutions capable of increasing public savings. We are attempting however to turn our attention increasingly to projects with direct social implications. In addition to integrated rural development, we are exploring the possibilities of assisting the Governmentgs efforts to expand agricultural and technical education, and to foster regional develop- ment and urban decentralization, As has to be expected, such projects require a sabstantial lead time and intensive preparation because of  - 7 - their large technical assistance and institution-building components; but the initiative has been taken and it is most encouraging to note the high priority the Government has assigned to these fields. 24. The integrated rural development project for the Papaloapan Basin is indicative of the new social and economic orientation of the Mexican Government and the Bank's readiness to support this policy, Originally, this project was perceived as a limited test case for strategies to bring Mexico's rural poor, many of whom live in similar conditions to those in the Papaloapan Basin, closer to the mainstream of Mexico's rapid economic development. Energetic action taken by the Government and the existence of a capable Papaloapan Basin Commission has however permitted the project scope to be enlarged. At the same time, in a wider context, a separate, ably-led organizational structure has been set up under the Ministry of the Presidency which will implement a nation-wide integrated rural development program (paragraph 31). The Baik has given intensive technical support to the preparation of this program too and cooperated with the Government in setting the stage for a series of rural development projects. Following the present Papaloapan Project, we hope to have another integrated rural development project ready for your consideration in the first quarter of 1975. PART III - THE RURAL SECTOR 25. Mexico's rural sector, defined statistically as the population living in villages with less than 2,500 inhabitants, has undergone little socio-economic change since the Revolution of 1910. Agriculture is still the main income source of about 40 percent of the population and the rural society is still polarized into a small, highly efficient class of agricultural entrepreneurs and a large class of traditional peasants. These peasants have been bypassed by the rapid economic growth of the post- revolution period, live in primitive social conditions, barely participate in the market economy and subsist on a modicum of food production from their small farms. 26. In spite of the far reaching Agrarian Reform which led to the redistribution of nearly half of Mexico's land, one percent of the farmers still controlled more than 30 percent of total cropland in 1960 and 5 percent of the farmers in public irrigation districts more than 40 percent of the area in 19653 The rapidly growing rural population has, on the other hand, led to excessive farm fragmentation in many parts of the country and a landless agricultural labor force of close to 2 million. The skewed land distribution is reflected in the distribution of rural production and, consequently, income. It is estimated that h percent of all farms produced over 50 percent of agricultural output and commanded nearly 65 percent of market sales while, conversely, 85 percent of the farmers contributed only