Mexico - Export Development Project

Document of The World Bank FOR OFMCL USE ONLY . Z5l-ME Report No. P-3601-ME REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INT 3=4XlIOAL BANK FOR RtECONSTRUCTIONI AND DEVELOPSMET TO TEE EXECUTIVE DIRECTORS ON A PROPOSED LOAN IN AN AMOUNT EQUIVALENT TO US$350 MILLION TO BANCO NACIONAL DE COMERCIO EXRIO WITH THE GUARANTEE OF UNITED MEXICAN STATES FOR AN EXPORT DEVELOPMENT PROJECT May 31, 1983 This documnt h; a restrcted distribution and mmy be wed by weciints eoily in the performac of their official duties Its contents may not dberwise be dislosed withot World Baink anhrzatica.  CURRENCY UNIT - PESO (MEX$) Since December 20, 1982, Mexico has the following exchange rates. (i) a sliding controlled rate for priority imports, most exports and service payments on foreign debt; this was set at 95 pesos per dollar on December 20 and was about 115 on May 20, 1983; and (ii) a free exchange rate for all other transactions; in recent days the free peso has been trading around 148 pesos per dollar_ FISCAL YEAR January 1 to Decembar 31 ACRONYMS ACF Index of Average Cost of Funds to Multipurpose Banks (Costo Porcentual Promedio de Captacion) BNCE National. Foreign Trade Bank (Banco Nacional de Comercio Exterior - also referred to as BANCOMEXT in government Zocuments annexed) COMPEX Mixed Advisory Commission on Foreign Trade Policy (Comision Mixta Asesora de Politica de Comercio Exterior) EDF Export Development Fund FOMEX Trust Fund for Promotion of Exports of Manufactured Products (Fondo de Fomento a las Exportaciones de Productos Manufacturados) FONATUR Trust Fund for Tourism Development (Fondo Nacional de Fomento al Turismo) FONEI Trust Fund for Industrial Equipment (Fondo de Equipamiento Industrial) IMCE Mexican Foreign Trade Institute (Instituto Mexicano de Comercio Exterior) NAFINSA National Development Bank (Nacional Financiera, S.A.) SARH Ministry of Agriculture and Hydraulic Resources (Secretaria de Agricultura y Recursos Hidraulicos) SECOFIN Ministry of Commerce and Industrial Development (Secretaria de Comercio y Fomento Industrial also referred to as SECOFI in government documents annexed) SHCP Ministry of Finance and Public Credit (Secretaria de Hacienda y Credito Publico) SPP Ministry of Programming and Budgeting (Secretaria de Programacion y Presupuesto)  FOR OMCIAL USE ONLY CONTNTS Loan and Project Summary i - ii PART I - THE ECONOMY 1 PART II - BANK GROUP OPERATIONS IN MEXICO 9 PART III - THE EXPORT SECTOR: EVOLUTION, STRUCTURE & INSTITUJTIONS 12 Performance through 1982 12 Policies Affecting Export Performance 16 Export Prospects for 1983-85 16 Institutional Framework for Financing Export Operations 17 Financing of Tourism Investments 23 Non.-Financial Assistance and Services to Exporters 24 PART IV - THE EXPORT DEVELOPMENT PROGRAM 25 Export Development Strategy - Policy Framework 25 - Administrative Procedures 26 - Non-Financial Assistance and Export Promotion 26 - Export Finance and Insurance 27 - Top Level Govern ment Support 27 Progress in Implementation 28 Periodic Reviews 30 PART V - THE PROJECT AND THE PROPOSED LOAN Introduction and Objectives 30 Loan Components 31 Borrower and Implementing Agencies 33 The Export Development Fund (EDF) 33 The Investment Fir.ancing Component 35 Technical Assistance Component 37 Procurement 38 Disbursements 39 Approval Limits 40 Auditing and Reporting Requirements 40 Project Benefits 40 Project Risks 41 This document has a restricted distribution and may be used by recipieats only in the performance of their offwial duties. Its contents may not otherwise be disclosed without World Bank authorization.  - 2 - PART VI - LEGAL INSTRUPMENTS AND AUTHORITY 41 PART VII - RECOMMENDATION 42 ANNEXES Annex I: Social and Economic Data Sheets 43 Annex II: The Status of Bank Group Operations in Mexico 48 Annex III: Supplementary Project Data Sheet 56 Annex IV: Summary of the Stabilization Program 58 Annex V: Project Related Tables 59 Annex VI: Government's Export Policy Letter 65 Annex VII: Integral Export Promotion Program (1983-1988) 69 Annex VIII: Timetable of Key Actions 91 Annex IX: Principal Policy Measures Affecting Trade 95 Annex X: Estimated Disbursement Schedule 98 IBRD Map 15553  MEXICO EXPORT DEVELOPMENT PROJECT Loan and Project Summary Borrower: Banco Nacional de Comercio Exterior Guarantor: United Mexican States Beneficiaries: Trust Fund for the Promotion of Export of Manufactured Products (FOMEX), the Borrower itself, the Trust Fund for Industrial Equipment (FONEI), the Trust Fund for Tourism Development (FONATUR), and certain government entities providing technical assistance to exporters. Amount: US$350 million equivalent, including capitalized front-end fee. Terms: Fifteen years, including 3 years of grace, at the standard variable interest rate. Relending Terms: (i) BNCE would make available to FOHEX, in US dollars, 79 percent of the loan's proceeds to establish a revolving fund to make working capital subloans to exporters. Final beneficiaries of these US dollar denominated subloans would receive financing at an interest rate of three percentage points above the published New York Bankers' Acceptance Rate, including a spread of two percentage points for participating intermediaries and one-half of one percentage point for FOMEX. (ii) About 20 percent of the loan amount, which is allocated for fixed investment sub-loans, would be on-lent directly by ENCE or through other participating institutions (FONEI and FONATUR): either (a) in pesos at a floating interest rate equal to the average cost of deposit funds (ACF index) plus two percentage points, including a spread of between two and two and three-quarters percentage points for the participating intermediaries; or (b) in UIS dollars at an interest rate equal to two and one half percentage points above the Bank's lending rate to BNCE applicable in the semester when the sub-loan is made, including a spread of up to two percentage points for participating intermediaries. (iii) The Borrower would bear the foreign exchange risk and any interest rate risk related to (i) above. Project Description: The proposed project would support Mexico's strategy to expand non-petroleum exports. The project would have four components: (i) expansion of the US$100 million Export Development Fund established recently under the amended Capital Goods Industries Development Project (R83-71 dated March 28, 1983); this fund would provide urgently needed  - ii - foreign exchange not presently available to Mexican exporters from commercial sources for importing inputs required by exporters; (ii) credit for fixed investments required by exporters; (iii) technical assistance and training to exporters for improved production and more effective marketing; and (iv) technical assistance to project implementing agencies for studies to improve the Government's export development strategy and for institutional strengthening. An estimated 400-600 exporters are likely to benefit from working capital finance and 120-150 firms from credits for fixed investm.!nts under the project. The annual export plans of these firms are expected to account for between one-quarter and one-third of Mexico's annual non-oil export earnings. Project Risks: The project faces a risk that adoption of administrative procedures and/or policy measures envisaged in the export development strategy may lag behind schedule. The Govern- ment has adopted a comprehensive export strategy and taken action in several key areas such as exchange rate, institutional and administrative arrangements for promoting exports (Annexes VI to VIII). These have been reviewed and found to be satisfactory. The Mexican authorities and the Bank would closely review these procedures and monitor developments every six months to modify them as needed. With these commitments, the above risk is ac_eptable. The success of the project could also be reduced if protectionist measures are taken that limit Mexico's access to foreign markets. Financial Plan: Local Foreign Total =-- USS Million - Government/Banking System 75.0 75.0 Beneficiaries 27.0 - 27.0 Bank - 350.0 350.0 Total 102.0 350.0 452.0 ------ US$ Million -- Estimated Disbursements:l/ Bank FY 1984 1985 1986 Annual 180 140 30 Cummulative 180 320 350 Rate of Return: Not applicable Staff Appraisal Report: This is a combined Staff Appraisal and President's Report. 1/ Since a majority of loan funds would be disbursed for working capital financing of exporters under the EDF, standard IDF disbursement profile does not apply.  INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT REPORT AND RECOMMENDATION OF THE PRESIDENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO BANCO NACIONAL DE COMERCIO EXTERIOR WITH THE GUARANTEE OF UNITED MEXICAN STATES FOR AN EXPORT DEVELOPMENT PROJECT 1. I submit the following report and recommendation on a proposed loan to Banco Nacional de Comercio Exterior with the Guarantee of United Mexican States for the equivalent of US$350 million to help finarce an Export Development Project. The loan, which includes a capitalized front-end fee of 0.25 percent on the Bank loan, would be repaid over 15 years, including 3 years of grace, at the standard variable interest rate. Final beneficiaries of short-term export sub-loans denominated in US dollars would pay interest rates equal to the New York Bankers' Acceptance Rate plus three percentage points. Peso-denominated sub-loans for fixed investments would carry floating interest rates, adjusted every six months, equal to the current ACF (Average Cost of Funds to Multipurpose Banks) plus two percentage points; fixed investment silbloans denominated in US dollars would carry interest rates to the final beneficiaries of at least two and one half percentage points above the Bank's lending rate applicable in the respective semester. The margin for implementing agencies would be between one half of one and two and three-quarters percentage points. The Borrower would assume the foreign exchange risk. PART I: THE ECONOMY 1_ 2. The Bank's last economic report on Mexico, Mexico: Development Strategy - Prospects and Problems- (3605-ME), was distributed to the Execu- tive Directors on August 31, 1981. Since then the Mexican economy has faced sevzre economic and financial strains. An economic mission to undertake an in-depth analysis of the maero-economic developments and prospects for the Mexican economy visited Mexico in February 1983. The mission's preliminary findings have been incorporated in the discussion below and its full report is expected later in 1983. Country data sheets are attached as Annex I. Background 3. Mexico's GDP grew at an average rate of 6 percent a year in real terms between 1950 and 1980, yielding an increase of 3 percent a year in output per capita. This rate of expansion was somewhat better than the exp?ri'nce of other middle income LDCs. Agriculture grew at 3.5 percent a year and industry grew at an average rate of 7.5 percent. The sustained and rapid industrialization resulted in the rise of the share of the industrial sector. A similar change took place in the structure of foreign trade, with manufactured products accounting for an increasing share of total exports until 1975. The last thirty years also witnessed the passage of Mexico from a rural to a largely urban society: in 1980, the fraction of total population living in urban areas was estimated at two-thirds, while it had been less than 30 percent in 1950. 1/ This section is identical to Part I of the President's Report for the Third Small and Medium Scale Industry Development Project.  - 2 - 4. A dynamic private sector was the main engine of growth in the Mexican economy even though the public sector continued to account for vell over one-third of domestic capital formation until the mid-1970s. The public sector's role in Mexico was seen both to set the pace and pattern of economic grovth an. to help correct the effects of an uneven distribution of resources on the relative position of the poorer segments of the population and of the less favored regions of the country. The Government's success in this regard, however, vas only partial. While the living standards of many Mexicans improved considerably, the income of the poor farmers and marginal urban dwellers lagged behind. Consequently, contrasts within the Mexican economy remain conspicuous. 5. In the early seventies, the Government sought to build up infra- structure, expand basic Industries, stimulate agricultural output and imple- ment massive social programs. The difficulties it encountered in mobilizing resources simultaneously to attain all these aims led to excessive public sector deficits, while domestic supply rigidities caused a large part of ti-e aggregate demand to spill over into imports. Efforts to redress financial imbalances by strengthening public revenues fell short of their goal and, in September 1976, the Government abandoned the fixed parity of the peso and imposed a strict stabilization program on the economy in the context of the Extended Facility arrangements with the IMF. The program yielded positive results within a relatively short time, as described below. Economic Performance, 1976-1982 6. The last Administration, which took office in December 1976, saw the control of inflation and the improvement of the current account balance as its most urgent tasks. It succeeded in reducing the rate of increase of domestic prices by half between 1977 and 1978 while, at the same time, the current account deficit decreased by over 40 percent. After two years of limited growth, in 1978, the economy resumed its rapid growth. One of the major constraints on economic growth--the availability of foreign exchange -- had been greatly relaxed by the successful exploitation of Mexico's oil reserves; at the end of 1981 proven reserves were estimated at 72 billion barrels. Oil not only contributed directly to foreign exchange earnings and government revenue, but it also enabled the country to carry a much larger external debt. The additional resources enabled the purchase of raw materials and capital goods needed to sustain a high GDP growth, and allowed the Government to embark on an ambitious expenditure program. 7. Public expenditure grrow 20 percent per year in real terms between 1979 and 1981. Revenues grew mere slowly, thus causing the public sector deficit to rise rapidly: as a proportion of GDP, the deficit jumped to about 15 percent in 1981, compared to a ratio of around 7 percent In the preceding several years. Despite a high rate of mobilization of private savings into the financial system, the Government had to resort increasingly to foreign borrowing. Although public sector foreign indebtedness, as a percentage of GDP, had fallen from 31 percent in 1977 to 20 percent in 1980, it rebounded again to more than 30 percent in 1981. By 1980, the rapid rise in aggregate demand was again beginning to exert pressure on prices, and domestic infla- tion reached 26 percent. Since the nominal exchange rate had remained prac- tically stable since 1977, the higher Mexican inflation resulted in an appre- ciation of the peso in real terms. By 1980 the competitive edge gained after the 1976 devaluation had been lost. This made non-oil exports progressivel, less attractive, while imports rose at over 30 percent per year in real terms.  - 3 - 8. On the positive side, Lhe economic growth rate accelerated to over 8 percent during 1978-R1, and resulLed in an improvement of the labor market. Conditions were creaLed not only to absorb the new entrants into the labor force, but also to lower open unemploymenL, which is estimated to have fallen to 4-5 percent of the labor force in the modern sector. The Administration also sLrengthened its support to agriculture through subsidies, reversing the trend towards a worsening trade balance on basic foods, containing rural migration to some extent, and providing small farmers with access Lo more efficient producLion methods. Finally, a combination of fiscal incentives and administrative regulations had a positive effect on spatial decentralization, one of the major policy objectives of the Administration. 9. The Mexican economy witnessed a progressive deterioration In the course of 1981, and the Government's actions could be seen as responses to, instead of guiding, events. By 1981, the need to bring domestic inflation under controL and Lo help restore the competitiveness of non-oil exports had become apparent. The Administration chose to follow a policy of gradual adjustment, and expecLed that the deceleration in the growth of demand, to be brought about through slowing the rise in public expenditures, would reduce inflation. With a continued favorable outlook for oil exports, no major problems were expected in the external sector, and a path of gradual adjustment to a raLe of growth of 6-7 percent appeared sustainable in the long run and was considered to be less costly in terms of inflation and unemployment than more drastic stabilization measures. Thus, the Administratio;a decreed a 4 percent cut in lts expenditures, broadened coverage of import licenses to about 80 percent of imports, tightened publIc procurement procedures, and allowed a more rapid depreciation of the peso. 10. Unfavorable external circumstances as well as the ineffectiveness of the policies adopted were at the root of the deteriorating economic conditions in 1981-82. Prospects for the world oil market worsened in the second half of 1981, and Mexico's actual oil revenues, at US$14 billion, turned out to be 25 percent below the budget estimate. Moreover, imports continued to increase. There was also a tightening of the international financial market, with a steep rise in interest rates, which greatly increased Lhe debt servicing burden since the bulk of Mexico's external borrowing had been conLracLed aL variable interesL rates. By the end of 1981, the current accounL deficit reached $11.3 billion, or about 6 percent of GDP. Half of the public sector's financing gap in 1981 was meL through external funds, with net borrowing amounting to USS18 billAon, half of which consisted of short Lerm debt. The foreign exchange proceeds were requlred to susLain Lhe reserve position of the Bank of Mexico as concern over economic managemenL and the continued rpal appreciation of the peso in the course of the year led to substantial private capital ouLflows. 1I. Altho'igh the budget approved for 1982 was moderate, showing virtually no real increase in expendiLures, the beli'ef that the oil market would remain weak and continuing doubts ahout financial discipline in the public secLor fueled the expectation that the Government would not succeed in reducing Lhe deficit and bringing down Lhe rate of inflation. In fact, the general expectation was thaL inflation would worsen. Raising the minimum wage rate hv 34 percent on January 1, 1982 and the award of a 24 percent wage increase to public employees in March (retroactive to February 18) did little  - 4 - to improve confidence in the management of the economy. In addition, foreign commercial lenders became progressively wary of extending new loans or rolling over the past ones as the country's financial and economic condition worsened. By early 1982 private capital outflows had reached such proportions that on February 18, 1982, the Bank of Mexico withdrew from the exchange market, allowing the peso to depreciate from Mex$27 to Mex$45 to the US dollar. 12. The Administration also announced an adjustment program following the devaluation. On April 19, 1982, a 17-point stabilization program was decreed, with further cuts in public expenditures, increases in prices of public goods and services, and a ceiling on domestic deficit financing. Nevertheless, public expenditures continued to rise faster than revenues; in fact, the public sector deficit for 1982 reached the unprecedented level of 18.5 percent of GDP. As confidence in the ability of the Administration to implement these measures continued to erode and further difficulties were experienced in obtaining external funds, there was a renewed outflow of capital. On August 5, the shortage of foreign exchange forced the Bank of Mexico to withdraw once again from the exchange market. Following this, major policy and institutional changes were introduced, the most salient being rigorous control of foreign exchange transactions, a dual exchange rate system (of Mex$50 and Mex$70 to the US dollar), nationalization of the domestic commercial banks, and the mandatory conversion into pesos of the US dollar accounts held in Mexico (the so-called Mex dollar accounts) as they matured. The Government also requested the foreign commercial banks to roll over principal repayments on public debt falling due during the 90 days from August 23, 1982. 13. Thus, 1982 witnessed an abrupt halt to economic growth and a sharp rise in prices. Preliminary estimates show a slight decline, of 0.2 percent, in GDP and a 98.8 percent increase in consumer prices. Gross fixed capital formation, which had been growing in real terms at 25 to 30 percent during 1978-80 and some 15 perce;it in 1981, fell sharply, by almost 17 percent. At the same time, the fall in imports (by more than 40 percent), reflecting both the imposition of controls and the decline in demand, led to a substantial trade surplus of the order of US$6.5 billion, reducing the current account deficit to US$2.4 billion or about 1.3 percent of GDP. 14. On December 1, 1982, Lic. Miguel de la Madrid took office as the new President. On December 23, the IMF Board approved an Extended Fund Facility that would provide SDR 3.6 billion over three years to the Government of Mexico in support of a medium-term stabilization program. The main features of the IMF agreement are summarized in Annex IV. In accordance with the program, the Administration of President Miguel de la Madrid has begun to carry out important changes in domestic and external policies. These are briefly described below. Recent Stabilization Measures 15. A key ob4ective of the IMF-supported stabilization program is to hring about a substantial improvement in fiscal performance in order to create the conditions for the resumption of sustained economic growth. The program calls for a reduction of the public sector defic-it, from the equivalent of about 18.5 pcrcent of GDP in 1982 to 8.5 percent in 1983, with  further reductions in 1984 and 1985. Achievement of the above objective will require a major effort to reduce public sector expenditure and to increase revenues. The authorities propose to hold down current expenditures by eliminating or reducing subsidies to both the private and public sectors, and by controlling the increase in the wage bill through a freeze on hiring and pursuit of a restrained wage policy. 16. Furthermore, the authorities have undertaken a review of public investment projects with a view to reducing expenditures in sectors which have in the recent past registered very large increases in capital formation, in particular the petroleum, electricity and industrial sectors. No new projects are to be started in these sectors, and priority will be given to completing existing projects that are already quite advanced and which have high rates of return. In line with this policy, the investment budget of PEMEX for 1983 has been drastically scaled down in real terms, but exploration and development expenditures are not expected to suffer. The size and distribution of PE14EX's investment program remain an important issue, due both to its claim on present scarce resources and to oil being a critical determinant of future resource availability. Investment in power is also being pared down through delaying construction of new generating plants. Overall, public investment expenditures are projected to decline in 1983, bv nearly 3 percentage points, to about 8 percent of GDP. Recent organizational and procedural changes in programming and budgeting should help tighten control over public expenditures and align them closer to the Government's objectives. A major institutional change introduced by the present Administration is the upgrading of the Office of the Comptroller General to a Federal Secretariat. 17. With regard to public sector revenues, the authorities are carrying out major adjustments in general taxation and public enterprise pricing policies. The authorities are widening the tax base through the elimination of special exemptions, and are adjusting taxation rates. The general rate of the value added tax has been raised from 10 percent to 15, and new rates of 6 and 20 percent have been introduced for certain previously exempted goods and luxury goods, respectively. There will be a 10 percent surtax during 1983 on personal income above five times the minimum wage and shareholders will now have to declare their holdings and include dividends received as part of their taxable income. 18. In regard to public enterprise pricing, the authorities have implemented major adjustments, with the objective of bringing them into line with domestic costs. Prices of petroleum products were increased by 20 to 70 percent in August 1982, followed by increases of 100 to 200 percent in December 1982, and further increases of 20 to 25 percent in March 1983. Electricity prices were increased by 50 percent in December 1982 and monthly adjustments are scheduled throughout 1983. The price of sugar more than doubled in November 1982, with further adjustments In December. Other public enterprise prices are scheduled to be adjusted in accordance with the policy objective stated above. 19. In the area of monetary and credit policy, the operations of the Bank of Mexico will be subject to limits consistent with the anti-inflation and balance of payments aims of the program. The domestic credit policy of the Bank of Mexico will reflect the aim of ensuring that the private sector receives an appropriate share of domestic financial savings. The funds  - 6 - available to the private sector will nonetheless be restricted by the limits on domestic credit growth and the projected 10 percent shrinkage in the real money base. Meanwhile, private sector demand for credit is expected to be strong despite a decline in output, since this will be more than offset by the need to .inance debt service. Interest rates on deposits are being adjusted upwdrd to help promote savings and discourage further capital outflows. The authorities have stated their intention to increase nominal deposit rates so as to make them positive in real terms. By the end of March 1983, che interest paid on 90 day certificates of deposit and treasury bills had risen to over 80 percent (effective .ompounded yield) from about 40 percent in the first quarter of 1982. Controls over interest rates charged for loans are being relaxed. Credit subsidies will be reduced by relating the interest charges on preferential credits granted by the Government development banks to the average cost to the banks of loanable funds. 20. Exchange Rate Policy: On December 10, 1982 the Mexican author- ities revoked the generalized exchange control system that had prevailed since September and established a new exchange system that included a controlled exchange rate and a generalized free market. The new system became operative on December 20, with the exchange rate in the controlled market initially set at Mex$95 = US$1, a depreciation of some 35 percent in relation to the previously prevailing ordinary rate of Mex$70 per US dollar. Authorized imports and exports of most goods and debt related transactions are expected to take place through this market. The free market opened at a rate of Mex$150 = US$1 and has stayed close to that level for some time. The authorities have emphasized the temporary nature of this arrangement and expect both rates to converge, as the controlled rate is adjusted daily. So far the adjustment of the controlled rate has been at an annual rate of about 50 percent and will be modified as required in the light of changes in the differential between the rates of inflation expected in Mexico and its main trading partners. The controlled rate represents a substantial real devaluation of the peso (relative to 1978 when exports were rising), thus compensating in part for the anti-export bias implicit in the protection system. In addition to these two exchange markets, the Bank of Mexico will provide forward coverage in foreign exchange for the repayment of private sector foreign debt obligations. 21. Trade Policies: The Administration recognizes that the generation of a substantial trade surplus will be essential in managing the country's external payments position. This will require policies to stimulate non-petroleum exports combined with temporary measures to contain imports. These actions should be consistent with longer-run objectives of reducing excessive dependence on petroleum exports and raising domestic productivity and efficiency. The principal components of this comprehensive trade strategy include: pursuit of a flexible exchange rate that will help ensure the profitability of export and import-competing sectors; a reorganization of the protective system; progress in negotiations on bilateral and multilateral trade arrangements; judicious use of export incentives and promotional mechanisms; and setting up and/or strengthening of institutions that will implement and monitor particular policies. A detailed discussion of trade policies appears in Part IV.  - 7 - 22. External Debt Management: A central objective of the adjustment effort is to lower Mexico's reliance on external financing over the next few years, and ttereby contribute to an easing of the debt servicing problems that Mexico has experienced in the recent past. Thus, the authorities are in the process of completing the formalities for restructuring Mexican debt. The restructuring exercise applies to nearly $20 billion in public debt, consolidating short-term public debt into medium and long-term facilities, and rescheduling pr'ncipal payments on medium and long-term public debt due to the commercial banks during the period August 23, 1982 - December 31, 1984. The restructuring exercise includes an understanding that the interna- tional banks will maintatn their exposure to the Mexican banks that are now nationalized. At the satre time, it provides a mechanism that will eliminate 1982 private sector in.zerest arrears and, in due course,facilitate payment of principal on such debt. Based on the terms negotiated with the co ercial banks and on the projected net inflows, the actual ratio of debt service to exports of goods and services is expected to decrease sharply in 1983 and 1984. Thereafter, it would increase to over 60 percent, as repayments on the pre-1982 debt commence, and would stay around 60-65 percent through 1989 (as compared to the peak of 66.2 percent reached in 1979); amortization payments on new borrowing and on the rescheduled debt are due to begin in 1986 and 1987, respectively. External debt as a proportion of GDP is expected to fall from 34 percent in 1982 to about 30 percent in 1985, and 25 percent in 1987. 23. Balance of Pavments Outlook and Financing Requirements for 1983: The economic program requires a continued surplus in the trade balance in order to provide for the US$12 billion in contractual interest payments, while maintaining a relatively small current account deficit (around US$2.0 billion in 1983 as against US$11.4 billion in 1981 and US$2.4 billion in 1982). Exports are projected to be around US$23 billion in 1983, from US$21 billion in 1982. Revenues from petroleum exports are projected to stay at the previous year's level despite the expected increase in volume from an average of about 1.4 million barrels per day in 1982 to 1.5 million in 1983 with the average price of the export mix between light and heavy crude oil dropping to an estimated US$26 per barrel. Other exports are expected to increase by JS51.9 billion in 1983 to a total of US$7.6 billion as a result of the more favorable exchange rate and the expected recovery in the US (Mexico's primary trade partner)- Imports are expected to remain around the low levels of 1982 (USSl4.9 billion) reflecting the stagnation of domestic output and investment. 24. To ensure adequate financing of the adjustment program, it was generally agreed that Mexico needed USS8.3 billion through 1983 with the IMF providing US$1.3 billion. Of the rest, US$2 billion would be forthcoming from other official sources, complementing the US$5 billion committed by the banking community early in March 1983. Whether Mexico will require further external financing during the year will depend on how well the safety cushions (through anticipation of lower oil prices, building up of Central Bank reserves, interest rate and import projections) built into the IMF program will stand the recent drop in international oil prices. Prospects 25. It is particularly difficult at this stage to predict the course the Mexican ecofiomy wil follow in the next few years. Even with the good start made by the Government in 1983 in taking the required stabilization  measures, it is clear that the years ahead will be a period of austerity and sacrifices on the part of the Mexican population. The Government faces the challenge of maintaining the required policies over a difficult period. The factor which helped to postpone difficult policy decisioas in the past - abundant foreign exchange - cannot be expected to provide a cr- hion in the future. Although the Mexican economy can count on substantial natural resources, an educated and skilled labor force, and well-developed institutions, the prospects of growth in the short and medium-term will depend basically on: (i) the deflationary effects of the proposed sharp reduction in the budget deficit; (ii) the constraint on resource availability imposed by the need to service the large external debt; and (iii) the specific measures the Government adopts to stimulate production of agricultural and manufacturing products. Under generally favorable conditions, a reduction of the budget deficit to 8.5 percent of GDP - the target under the lIl agreement - will imply a decline of about 2-3 percent in national output in 1983. This should, however, considerably lessen the inflationary pressures in the economy. Once a reasonable budget balance has been establlshed -and it may take some time- the economic health of the economy should be restored, creating conditions favorable to steady growth. 26. To avoid another financial crisis in a few years, there is need to ensure that the country's debt servicing capacity improves quickly. A critical element in this is the growth of the non-oil economy, specifically agriculture and industry. Although a reduction in the budget deficit is likely to impose limits on the overall growth of the economy, appropriate incentive policies are needed to stimulate the growth of agriculture and manufacturing, which are largely private sector activities. 27. Restoration of a high and sustained rate of growth vill provide the strongest weapon to tackle the long-term problems mentioned above. At present, Mexico is going through a period of adjustment, which dictates lower real growth and employment generation in the next few years. However, this will afford an opportunity to reappraise many of the past years' goals and policy instruments, and provide a sounder basis for Mexico's development. The new Administration has already shown its ability to take difficult and politically unpopular decisions. 28. The external debt problems have been described in para. 22. Debt service on Bank loans amounted to about 3 percent of public debt service in 1981; this ratio is projected to remain about the same during the mid-1980s. The Bank currently holds about 6 percent of Mexico's total medium and long-term public debt, and this ratio is not likely to change significantly over the next few years. In view of the medium and long-term potential of the economy and provided that the new Administration continues to address forcefully the challenges outlined above, Mexico is considered creditworthy for IBRD borrowing. In view of the country's estimated foreign exchange needs over thte next few years, financing of ongoing and new projects should include some local costs.  - 9 - PART II - BANK GROUP OPERATIONS IN MEXICO 2/ Bank Operations 29. As of March 31, 1983, Mexico had received 78 loans from the Bank amounting to US$5,749 million, net of cancellations and terminations; of these, 50 lcans totalling US$2,724.6 million were fully disbursed. The Bank held US$4,795.8 million, of which US$2,035.0 million had not yet been disbursed. Some 46 percent ox Bank lending has been for agriculture and rural development, 17 percent for industry, 12 percent for power, and 14 percent for transportation; the remaining 11 percent has been for water supply, tourism, urban development, vocational training and pollution control projects. Annex II contains a stmmary statement of Bank loans as of March 31, 1983, and notes on the execution of ongoing projects. 30. Of the US$5.7 billion total lending, about US$2.6 billion was for establishing or strengthening institutions for channelling credit to areas where credit supply was deficient or non-existent, and setting up in the commercial banking system the ability to carry out project-related appraisal of investments in agriculture, industry and tourism. These credit programs have facilitated lending to low-income farmers and small- and medium-scale industrial and tourism enterprises based on productive investmeat plans, rather than credit granted on the basis of collateral. 31. The Government arranged adequate budget financing in the years 1978 to 1981, which significantly improved project implementation. Government and Bank officials met periodically to review project implementation, and greater attention was focused in Mexico on project monitoring. As a result of these measures, most of the Bank-assisted projects were being implemented satisfactorily until mid-1982 and disbursements rose from US$91 million in FY78 to US$448 million in FY82. However, the present financial crisis is again causing delays in the provision of counterpart funds, and proposals for special actions are under preparation to help the Government ease the counterpart funding constraints on the implementation of projects. IFC Operations 32. As of March 31, 1983, IFC had made investment commitments in 23 companies in Mexico, for a total of US$551.2 million, of which US$411.6 million had been sold, repaid or cancelled. A summary statement of IFC investments is presented in Annex II. IFC has been working together with the Bank in preparing proposals to establish a facility which would complement the proposed Bank loan for the Export Development Project. The IFC loan facility would provide foreign exchange financing to private sector companies for the importation of machinery, equipment and spare parts required for production of exportable products, for efficient import substitution and for improrements in the utilization of their existing productive capacity. IFC is aiming at a US$75-100 million facility (including funds mobilized from foreign commercial banks) which would provide financing for fixed investments of a larger size than those assisted under the proposed Bank loan. 2/ This section is substantially unchanged from the President's Report for the Third Medium Size Cities and Sinaloa State Water Project (Report No. P-3532-ME of April 21, 1983), and identical to Part II of the President's Report for the proposed Third Small and Medium Scale Industry Development Project (except for para. 35).  - 10 - Bank Strategy 33. The main objectives of Bank lending in Mexico in the past six years have been to: (a) support policies and programs leading to a wider distribu- tion of the b-nefits of economic growth; (b) help finance projects that, directly or i-.irectly, contribute significantly to output and eomployment; (c) help reduce Mexico's urban-regional imbalances; and (d) help free bottle- aecks which prevent rapid growth. Under the present circumstances, the Bank also intends to support the Government's stabilization program, in close cooperation with the IMF, through quick-disbursing operations and assistance to increase non-oil export earnings, and to participate in an intensive macroeconomic and sector policy dialogue to support design and implementation of appropriate development policies. 34. Because of the difficult structural problems of agriculture and the sector's crucial importance for the one-third of the nation's population living in the rural areas, the Bank has made agriculture the leading sector for its lending. The Bank's agricultural lending program in Mexico has four goals: first, to increase productivity of presently cultivated lands; second, to improve the productivity of small farmers; third, to complement infrastructure investments with support services, such as extension, market- ing programs and credit; and fourth, to promote employment-generating invest- ments in rural areas. The Bank has made 13 loans in FYs77-82 totalling US$1,834.4 million for irrigation, rural development and agricultural, agro- industrial and livestock credit programs. A US$175 million loan for a rural development project and a US$180 million loan for an irrigation rehabili- tation project were approved by the Executive Directors in FY82, and a US$138.4 million loan for San Fernando rainfed agricultural development was approved in early FY83. A US$115 million loan for marketing perishables was approved by the Executive Directors in April 1983. Projects for rainfed agriculture, regional development and rural credit are in preparation. 35. Bank lending for industry has aimed at: (a) reduction of the balance of payments deficit; (b) decentralizing industrial activities away from the major, increasingly congested, urban areas; and (c) promoting greater employment. A steel project which the Bank helped structure and finance is now operating in a previously underdeveloped area on the west coast of Mexico, and the city in which it is located, Lazaro Cardenas, is developing into a new growth pole. Four loans for industrial projects to promote the development of small- and medium-scale industrial enterprises, to finance expansion of small- and medium-scale mining, and to support an industrial equipment lund (FONEI) were approved by the Executive Directors in FYs78-80. A loan for a vocational training project was approved by the Executive Directors in July 1981; it is assisting a program to increase the supply of skilled workers and technicians. A US$152.3 million loan for development of a i.'pital goods industries project and a US$60 million loan for pollution control were approved by the Executive Directors in FY82. A modification in the capital goods project has now been approved by the Executive Directors to set up a pilot export development fund to help alleviate the current foreign exchange shortage confronting Mexican exporters. In addition to the proposed loan, a US$175 million loan for a proposed small and medium-scale industry project is being presented to the Executive Directors along with this project.  - 11 - 36. Bank lending for physical infrastructure has been focused on regional development and strengthening of institutions and sector policies. A highway sector project (FY79) and the fourth railway project (FY81) support these goals. The first and second mediumr-size cities water supply and sewerage projects (FY76 and 81) reinforce the planning, management and finance of specialized water supply and sewerage institutions at the federal and municipal levels, and contribute to the establishment of tariffs more closely related to costs; a loan to finance a thirc project was approved by the Executive Directors on May 17, 1983. 37. The Government has adopted a National Urban Development Plan that spells out its regional development priorities in operational terms. A project to assist in the development of the Lazaro Carderas conurbation area was approved by the Executive Directors in FY78, and a second urban project for oil-producing southeastern Mexico was approved by the Executive Directors in FY81. A loan for the preparation of a deconcentration program for the Mexico City Region was approved by the Executive Directors in August 1982. 38. The Economic Development Institute (EDI) is assisting CECADE (a similar institute under the Ministry of Programming and Budget) in training Government staff in project preparation, monitoring and evaluation. EDI assistance is directed at courses on urban and regional development, agricul- ture, rural development and agro-industries. The Bank has also assisted the Mexican authorities in training personnel for managing water supply and industrial credit projects. 39. The Inter-Arierican Development Bank (IDB) is the second largest source of multilaLero.l aid to Mexico. The IDB has made loans to Mexico totalling US$2,974.3 million as of March 31, 1983. Over 50 percent of the total has gone to agricultural and rural development projects, and the balance to transportation, industry, water supply and sewerage, tourism infrastructure, education, municipal development, and pre-investment. The IDB and the Bank have coordinated their assistance on several projects. Each has made loans for the national integrated rural development program (PIDER), agricultural and livestock credit, small- and mediu-m-scale industries devel- opment, and hotel development projects. The International Fund for Agricul- tural Development (IFAD) has approved a loan of US$22 million for a rural development project in the state of Oaxaca which was appraised by the Bank's staff and for which the Bank is acting as cooperating institution for admin- istering the loan. 40. Bank-supported power, steel, fertilizer and tourism projects in Mexico have been co-financed by several bilateral export credit agencies and commercial banks. In January 1982, Mexico borrowed US$500 million from commercial banks to provide complementary financing for Bank-assisted projects where project specific co-financing would have been difficult.  - 12 - PART III - THE EXPORT SECTOR: EVOLUTION, STRUCTURE AND INSTITUTIONS Performance Through 1982 41. Mexico's exports of goods and services have accounted for less than 10 percent of total output in most of the post World War II period, one of the smaller ratios among the newly industrializing countries. This situation reflects, in part, the broad natural resource base of the country and its large domestic market (Mexico was the eleventh most populous nation in the world in 1979). Moreover, Mexican administrations have generally followed a development strategy that has been oriented towards import substitution behind protective barriers. This has led to a substantial anti-export bias affecting the productive sectors. 42. From the early post World War II years through the end of the 1960s Mexican exports were primarily crude or simply processed agricultural or natural raw materials. The need to diversify and expand exports, particularly of manufactured products began to be recognized in the mid-1960s as the limits of the import substitution approach to industrial and economic development became apparent. Facilitated by fiscal incentives and other measures taken by the Government to promote exports, several industries with favorable characteristics were able to achieve internationally competitive levels of output aud began to seek foreign markets. By the end of that decade, exports of manufactures accounted for one-quarter of total exports (compared to less than 10 percent at the beginning of the period), although they still represented only 4 percent of the gross value of manufactured output. During the 1970s, the structure of Mexico's exports underwent considerable transformation- Responding in part to increased Government incentives as well as institutional support, the share of manufactured exports in total exports grew through the mid-1970s to about one-half-3/ Beginning in 1975, however, the exploitation of the newly discovered hydrocarbon resources radically changed the pattern of the external sector as well as of the economy itself. Exports of crude petroleum rose from ll percent of total exports (about US$400 million) in 1975 to 70 percent (US$14 billion) in 1981, resulting from a ten-fold increase in volume and doubling of international oil prices. Despite a favorable impact of the 1976 devaluation on manufactured exports which persisted until 1978, the share of manufactures in total exports was reduced by 1981 to less than 20 percent; primary products, mainly agricultural items such as coffee, cotton and fresh fruits and vegetables and service exports, accounted for the remaining 10 percent of exports. Manufactured exports as a percentage of domestic manufacturing output peaked at 5.5 percent in 1978, and since then have been declining (to less than 4 percent in 1982). The volume of manufactured exports actually declined during 1980 and 1981, although the dollar value 3/ Total manufacturing output grew in real terms at about 7 percent per annun between 1970 to 1981, slightly above the 6.6 percent growth rate recorded for GDP. By 1981 manufacturing accounted for about 23 percent of the GDP while manufacturing exports accounted for less than 4 percent of the gross output of the economy.  - 13 - showed slight increases. The poor performance of non-petroleumA exports reflected the pull of the rapidly expanding domestic market, deteriorating market conditions abroad and the impact of a continually appreciating exchange rate as Mexico's domestic inflation considerably exceeded that of the main importing countries. Total exports of Mexico (including petroleum) grew, however, from about 8 percent of GDP in 1970 to 13 percent in 1981. 43. In 1982, the value of exports of crtide petroleum continued to rise in spite of the decline in petroleum prices from those of the previous year. Substantial increases in export volume which were achieved in the latter part of the year more than offset the 15 percent decline in average prices. However, despite the devaluations during the year, which allowed some increase in the volume of manufactured exports, the value of primary as well as manufactured exports fell in dollar terms during 1982 as a result of world recessionary conditions and increasing shortages of imported inputs due to the foreign exchange restrictions imposed. Net revenues fr3m tourism transactions, which are permitted at the free market exchange rate, started increasing sharply towards the eud of 1982 and in early 1983, marking a reversal of a downward trend in net tourism revenues caused by the real appreciation of the peso in recent years; net tourism revenues estimated at US$618 million for 1982, are projected to grow to US$1 billion in 1983. 44. The structure of exports is influenced by natural resource endowment, available human resources as well as location in relation to potential markets. Mexican exports have included not only items in which obvious advantages are offered by Mexico's natural resources or labor intensity (e.g., processed foods, chemicals and petrochemicals and furniture) but also those where skilled labor, quality or technology play an important role (e.g., fashion clothing, steel rolling-mill equipment, small electric motors and foundry casting). Proximity to the United States, particularly to the Western and Southwestern regions, often offers substantial advantages to Mexican industries, in some cases even vis-a-vis competing U.S. industries. Thus more than 70 percent of Mexico's manufactured exports are to the U.S.; the remaining are distributed mainly among Western Europe, Central and South America and Japan. Collaborative agreements with foreign (particularly U.S.) industries facilitated technology transfer in the case of many product lines. Overall, Mexico's exports are well diversified among different product groups, reflecting the broad base of Mexican industry as well as an increasing capability to achieve internationally competitive levels of production. Annex V, Tables 1 and 2 provide a summary of the structure and evolution of Mexico's principal merchandise and service exports and a more detailed breakdown of manufactured exports. A fuller discussion of the structure of Mexican industry and exports and related issues is included in the report entitled Mexico: Future Directions of Industrial Strategy", which is being distributed to the Executive Directors. 45. Three subsectors, processed foods, chemicals and petrochemicals (including petroleum derivatives), and metal products, machinery and equip- ment, currently comprise more than two-thirds of manufactured exports accord- ing to the trade classification. These are followed by light industries (textiles, clothing and leather goods) which have consistently accounted for 5-10 percent of total manufactured exports over the last six years.  - 14 - 46. The food exports involve relatively little processing and essentially reflecL natural resoturce endowment and locational advantages (e.g., the processing of fruits and vegetables for the U.S. market). Although the relative share of this group declined in recent years rainly due to the virtual disappearance of exports of sugar and related by-products since the mid-0970s, several product groups such as Drocessed fruits, vegetables and seafood exhibited significant export growth. Exports from the chemical and petrochemical industries are also essentially resource based. Over the last decade they have included a wide range of both inorganic and petrochemical products. Exports of petroleum derivatives rose sharply in 1980 and 1981 reflecting the emergence of exports of heavy fuel oil, butane and propane gases and refinery by-products reflecting a growth of external demand. 47. The sub-group which has shown the most dynamism during this period is engineering industries, comprising metal products, machinery and equipment, whose share in manufactured exports had risen from roughly 11 percent in 1970 to 28 percent in 1982. Exports of these products, which are not generally resource-based, reflect growing Lechnological capabilities combined with the availability of relatively inexpensive skilled labor in Mexico. The bulk of this category is accounted for by automobiles and automobile parts (e.g., transmissions, brake parts and assemblies, motor blocks etc.); specialized machinery and equipment for oil exploration and exLraction, petrochemical production, electric generation and distribution, and bottlemaking; and electrical and electronic parts (e.g., electric cables, television parts). In recent years a small but rapidly growing export of technological services in the field of engineering and design, covering a wide range of construction and manufacturing activities (e.g., assistance in production processes such as bottlemaking, direct reduction of iron ore, non-woven cloth and cables for petroleum extraction), has also emerged, illustrating the growing sophistication of Mexican industry. 48. In addition to the exports from domestically based industry, which has been covered in the above discussion, Mexico also continues to maintain maquila (in-bond) industries, (mostly labor intensivE: assembly operations) located primarily in the U.S. - Mexico border region. The "maquila- industries transform production inputs imported from the U.S. into final products which are then shipped back to the U.S., thus providing a *transformation service utilizing inexpensive Mexican labor. It was estimated that in 1980, the maquila activities earned net foreign exchange income of about US$800 million and provided employment to about 125,000 workers (7 percent of the total labor force in manufacturing). Another institutional development oriented towards promoting exports has been the establishment of export consortia (based on a special fiscal incentive which was earlier available to them) which help exporters reduce marketing and overhead expenses by grouping together several small or medium sized export operations. Policies Affecting Export Performance 49. The above export performance is explained not only by changes in domestic demand and internatIonal economic conditions (e.g., the general world trade expansion in the early and late 1970s, and the worldwide recession in 1974 and 1975) butL also to a substantial degree by the  - 15 - prevailing policy environment. Most important among the policy variations vere those involving the commercial and exchange rate policies and export incentives. 50. Mexican comercial pclicy has been characterized by a significant amount of protection for domestic productive activities during most of the past two decades. While import tariff levels have generally been moderate relative to other Latin American countries, the protective system included a rather comprehensive system of import licensing, which led to an anti-export bias affect!ng most productive sectors. During the l960s, licenses vere required for approximately 60 percent of the miaoer of items in the tariff nomenclature vhich accounted for slightly more than that share of the value of total imports. In the early 1970s, as a result of the increasing real appreciation of the peso (see below), pressL-P for additional protection increased and the number of items subjected Lo licenses rose to about 80 percent, covering about 75 percent of the total value of Imports. Pollowing the major devaluations which occurred in the last half of 1976, the authorities initiated a process of reducing the average tariff level and reliance on the import licensing system. The process of import liberalization continued through the end of 1979, by vhich time only one-fourth of the tariff items was subject to licensing; although they still accounted for some 60 percent of the total value of imports, import licenses were granted on a relatively liberal basis for many product groups (e.g., capital goods). Reflecting this, nominal protection in 1979 for 24 out of 27 key subsectors Vas lower than in 1970. Average nominal protection for manufacturing (excluding petroleum refining which had negative protection of 59 percent) was estimated at 3 percent based on direct price comparisons; for all productive sectors the level of nominal protection was zero. However, some subsectors such as household appliances, autos, plastics and electronic equipment continued to have bigh levels of nominal and effective protection (exceeding 100 percent in the case of effective procection). Imports accounted for 12.8 percent of all manufactures consumed in Mexico in 1980, as compared to 9.7 percent a decade earlier. 51. Further liberalization measures which had been planned for 1980 and 1981 vere not undertaken as the increasing real appreciation of the peso once more gave rise to protectionist pressures. During 1981, some items which had been previously decontrolled were put back on the licensing list while tariffs on a number of other products were also increased. Following the February 1982 devaluation, there was a reduction in some tariff levels. But, with the imposition of full exchange controls in September 1982, and the continuing severe foreign exchange shortage, the Government imposed prior import license requirements for virtually all imports, which implies potentially unlimited protection in the short run. The Government intends, however, to reinitiate import liberalization, starting first with liberalization of imports for export industries (paras. 81, 87 and 88). 52. Exchange rate policy in the early 1970s was characterized by a marked real appreciation of the peso. From 1972 through August 1976, Mexican prices rose 20-30 percent more than those of its principal trading partner, while the exchange rate remained at 12.5 pesos to the U.S. dollar, the same rate which had been maintained since 1954. To reverse capital flight and help stimulate exports, the Government abandoned the fixed exchange rate in September 1976 and permitted the peso to float. The peso subsequently stabilized and fluctuated around 22.6 pesos to a U.S. dollar during most of the period from 1977 through the end of 1980. The new rate which in 1977  - 16 - represented a 25 percent dep.eciation of the peso in real t'rms vis-a-vis 1970, was instrumental in enabling the large expansion of manufactured exports registered during 1977-1980. However, the relative attractiveness of exports declined during that period as the Mexican inflation consistently exceeded world inflation levels. Although the exchange rate waE allowed to -crawl" during 1981 and early 1982 in response to pressures building in the financial markets (to about 27 pesos to the U.S. dollar by early February 1982), the rate of devaluation was not sufficient to compensate for the differential between price increases in Mexico and abroad, leading to further real appreciation of the peso. By the end of 1981 the peso was estimated to have appreciated more than 35 percent in real terms in comparison with its 1977 level. Together with a rapidly expanding aggregate domestic demand, this contrituted to a dwindling of interest in export-oriented activities among industries, despite the moderate export incentives offered through the CEDIs scheme (para. 53). The attractiveness of exports was restored only after the major devaluations, which the Government had to undertake in February and August 1982 in the face of a severe foreign exchange crisis, and the introduction of a more flexible exchange rate system towards the end of 1982 (see para. 20). 53. Export incentives offered included pre- and post-shipment financing at preferential rates for manufactured exports and fiscal incentives in the form of rebate of indirect taxes paid by exporters mainly through the CEDIs (Indirect Tax Rebate Certificates) system, which was in effect from 1971 until August 1982 (except for a brief period after the 1976 devaluation). At the beginning of 1980, a number of the taxes reimbursed under the system were removed and replaced by the value added tax (VAT) which was not applied to exports. However, the CEDI rates which stood at about 11 percent of the value of eligible exports on average (but varied across products depending on domestic content, value added and exports growth), were not adjusted to take account of the introduction of VAT. In August 1982, the CEDI system was suspended (although exports remain exempt from the value added tax); moreover, FOMEX's interest rates on pre- and post-shipment credits are being reviewed with a view to revise them upwards (para. 60). These actions reflect the Government's concern to avoid frictions with its major trading partners, as well as a belief that the new attractive exchange rate would be sufficient to promote exports. In a related measure, Mexico is actively pursuing a bilateral trade agreement with the U.S. in order to arrive at trade understandings and establish mutually agreed criteria for trade relations, including an agreement on subsidies and export incentives substantially equivalent to that under the GATT Subsidies Code, applicability of the 'injury test" to U.S. industries competing with imports from Mexico and the use of the U.S. Generalized System of Preferences. Export Prospects for 1983-85 54. With expectations of lower petroleum prices, foreign exchange earnings from these exports in 1983 are expected to at best equal those of 1982. Expansion of non-petroleum exports has become a matter of considerable urgency to help meet the country's financial liabilities and essential imports for the economy. Total debt service (including amortization payments on public debt and interest payments on total debt) is estimated to reach a staggering level of about US$23 billion in 1985. This implies that in order  - 17 - to limit Mexico's debt service ratio to about 60 percent, the total dollar value of exports of goods and non-factor services should grow at least at 10 percent per year in constant dollars during 1983-85. Using available projections of petroleum and service export earnings, the implied minimum growth rate of non-petroleum merchandise exports required would be 20-25 percent per annum in real terms from about US$4.9 billion (excluding exports from *maquila" operations) in 1982 to about US$9 billion per year by 1985/86. 55. Given the broad and diversified base of the manufacturing sector, the considerable spare capacity which currently exists as a result of the recession, and the technological base which Mexico has developed, Mexican industry is well positioned to expand exports under the proposed macro-economic framework, particularly with an exchange rate regime that encourages exports. Under these expected favorable circumstances, annual growth rates of 20 percent or more should be possible for manufactured exports, and are consistent with the IMF projections. Mexican industry appears to be in an especially good position to take advantage of a recovery of the U.S. economy. Export growth rates of the orders ot magnitude indicated above could help sustain industrial output and employment under the current situation of depressed domestic demand. A critical element in enabling the projected export growth would be availability of sufficient foreign exchange to meet the import needs of exporters. Institutional Framework for Financing Export Operations 56. Traditionally, Mexican exporters, particularly larger firms, have had adequate access to both domestic and foreign banks to finance production and sales of their exports; working capital financing was available in peso and foreign currencies as were the foreign suppliers' credit lines for raw materials and equipment. In addition, Banco de Mexico has been providing pre- and post-shipment financing for exporting industries through its special rediscounting funds (F0MEX and FONEI-- see paras. 58 to 68). Export financing has also been facilitated through the selective credit schemes of Banco de Mexico which require Mexican banks to channel at least 1.6 percent of their total deposits for financing of exports of primary products (except petroleum and coffee) and, until recently (para. 57), also 3.5 percent of their dollar deposits for financing the production, inventories and sales of manufactured exports. 57. The foreign exchange crisis currently faced by Mexico has added to the financing problems of exporters in several important ways. Since mid-1982 direct access of private industries to new foreign commercial credit has virtually disappeared because the banks were unwilling to increase or even maintain their exposure to Mexico. Moreover, the sudden disruption of foreign exchange markets and the inability of Banco de Mexico to honor requests for foreign exchange prevented many export firms from servicing their foreign credits, leading to high arrears of both principal and interest payments on their obligations. The problem is particularly severe with supplier credits which involve a large number of foreign suppliers and, for the most part, are of short-term maturities. Arrears in servicing these supplier credits have led to disruption of relationships with suppliers and, in some cases, to cutting off critical supplies of imported inputs. In  - 18 - addition, the mascive devaluations of the peso combined with the stagnation of the Mexican economy during 1982 have led to liquidity and decapitalization problems for many Mexican industries, particularly those with large foreign debt, which in turn increases the difficulties in obtaining accesb to commercial cr%Jit. These problems were compounded by the elimination of dollar deposits in the Mexican financial system since the inception of exchange control, which effectively removed selective credit programs as a source of financing for manufactured exports. Given the stringent actions contemplated by the Mexican Government under the stabilization program agreed with the IMF, and pending discharge of the debt service obligations, prospects are for an Increasingly tight credit situation through 1983 and 1984. 58. Four Mexican institutions have been involved in providing export credit and/or export credit insurance and guarantees. The most important of these has been Fondo de Fomento a las Exportaciones de Productos Manufacturados (FOMEX), which was established in 1962 as a trust fund of Banco de Mexico with the principal objective of promoting exports in order to strengthen the country's balance of payments and assist economic growth. While production and sales financing for exports represent by far its most important activities, FOMEX also offers programs for export credit guarantees for locally produced capital goods and financing of sale/purchase of locally produced consumer goods in the border zones. The financing of FOMEX is provided by rediscounting up to 100 percent of loans made by Mexican banks covering both domestic and foreign cost components; the rediscounting percentage varies depending on the type of operation, type of enterprise and domestic content. FOMEX's guarantees can be provided either to the bank making a loan to the exporter or directly to the exporter. Although FOMEX's credit guarantee programs cover a broad range of risks, their main focus is coverage of political and "country- risks. In addition, FOMEX can finance a number of supporting activities related to exports (e.g., product adaptation and market studies), but it has not pursued these operations actively in the past. FOMEX's highest decision-making body is its Technical Committee which is chaired by the Minister of Finance and composed of high ranking representatives of SECOFIN, Banco de Mexico, NAFINSA, IMCE, BNCE, and the chambers of private industries. FOMEX's total staff of approximately 150 people is well qualified and is organized in three principal departments (technical, operational and administrative) which are assisted in their operations by seven regional offices located in main industrial and commercial centers. 59. During the 20 years of its operation, FOMEX's lending has grown rapidly. Some 3,500 different enterprises have benefitted from FOMEX financing since its inception. More than 80 percent of FOMEX's financing was related to pre-export (production) and export sales financing (see Annex V, Table 3). The share of FOMEX's export sFles financing in the total value of Mexico's manufactured exports grew from a modest 4 percent in 1965 to about 28 percent in 1970 and 43 percent in 1982. Operations in 1982 were financed using resources from recovery of its past loans (71 percent), a 2 percent special levy which is included in the structure of import taxes and earmarked by the Government for FOMEX (3 percent), retained earnings and other domestic sources (6 percent), and external borrowings (20 percent).  - 19 - 60. Until recenLly, loans under FOMEX's pre-export financing programs have been given in local currency and with maLurities covertng the period from the moment of purchase of inputs until the date of export at interest rates of 8 percent per annum for Lhe final borrower including a 3 percentage point spread for the intermediary. FOMEX's sales financing provided dollar loans wiLh maturities of up to 10 years and interest rates varying between 6 percent and 8.75 percent per annum depending on Lhe country of destination of e'xports and maturity of the loan with a spread for intermediaries of up to 3 percentage points. Interest rates on both pre-export and export sales financing are, however, currently under review (para. 53) and are expected to be revised upwards substantially, to be comparable to the cost of credit for international trade. 61. Over the years, FOMEX has acquired considerable experience and expertise in its traditional pre-export, sales, and import substitution financing programs which have accounted for the bulk of its operations. It has succeeded in establishing effective working relationship with most of the parLicipating banks which have assumed full responsibility for appraisal of firms and operations to be financed through FOMEX. FOMEX's financial condition is sound and its portfolio of good quality. Given the commercial naLure of most of its operations, FOMEX has been able to process financing applicaLions rapidly. However, an expansion of pre-export-cum-sales financing as envisaged under the project (para. 95) will require more detailed evaluation of the export plans of beneficiary firms; given the analytical skills ane capabilities of FOMEX's technical department, this should not pose any major difficulties. FOMF.X's guarantee program and financing of activities complementing and supporting production and sale of export goods (e.g., financing of market studies, technical training, technology development, support to trading companies, transport equipment and warehousing of export products) have, however, had limited success; most of these programs were introduced during the past 2-3 years and are not sufficiently known to potential beneficiaries. The export development program supported by the proposed loan is expected Lo help expand these programs Lhrough increased resources and publicity and strengthening of FOMEX's capabilities in these regards (paras. 103 and 104). A condition of effectiveness of the proposed loan would be that the impending transfer of the trusteeship of FOMEX from Banco de Mexico to BNCF (paras. 84 and 88) be formalized. 62. Banco Nacional de Comercio Exterior (BNCE) was created in 1937 as a state development bank with the principal objective to act as financial agent of the Federal Government and oLher public sector entities for foreign trade and other financial transactions with Lhe rest of the world. Through subsequent modifications of its legal status and main objectives, BNCE became a multipurpose bank dedicated to the promotion and development of foreign trade activities of both public and private sectors. Apart from its traditional role as financial agent, BNCE's current activities include imporL-export financing operations and related services (e.g., provision of letters of credit and acceptances) as well as financing of import substitution activities. BNCE has considerable experience in contracting and administering foreign lines of credit from export-import banks and other official sources. BNCE also has a subsidiary, IMPEXNAL, which functions as an export consortium to finance and provide services to participating firms, particularly in the agro-industries sub-sector.  - 20 - 63. BNCE's Board of Directors is chaired by the Minister of Finance and includes eleven additional members selected from high level officials of government entities dealing with external trade and finance. Tt has a competent staff of about 630 (including staff at five regional offices) organized under Lhree main departments (credit, finance and international transactions and administration) reporting to the DirecLor General (its chief execujtive). Annex V, Table 4 presents 3 summary of the lending operations of BNCE over Lhe past Lwo years. RNCE's financial position is sound. 64. With its network of correspondent banks worldwide (of which it has accouints with some 350), BNCE has accumulated considerable experience in entering into intern.iAonal transactions, contracting and managing external loans and issuing and accepting letters of credit. Due to its specialtzation in foreign trade transactLions, close ties with the Government and its established links with foreign banks, BNCE has adjusted relatively quickly Lo Lhe changed circumstances thaL followed the 1982 foreign exchange crisis. Yet, BNCE is sLill predominantly a financial agent for the public sector and an important financier of Mexico's imports and import substituLing activities, wiLh pre-exporL and exporL financing operations representing only a small portion of its total lending. In order to Lransform BNCE into Mexico's principal export-import bank, a stated Government objective, BNCE will have to focus its operations more on e-;port and pre-export financing and plans to consolidate its operations with those of FOMEX (para. 84). Also, to faciLitate a more active role for BNCE in financing export oriented investment projects, BNCE's project preparation, appraisal and supervision capabilities, currently of satisfactory quality but limited in size, will have Lo be expanded. Any assistance to BNCE required for this would be eligible for financing under the technical assistance component of the proposed loan (para. 104). 65. Fondo de Equipamiento Industrial (FONrI) was established in 1971, following extensive discussions between the Mexican authorities and the Bank to help improve industrial efficiency, the structure of industrial financing, and the country's balance of payments position. As a second tier trust fund of Banco de Mexico, FONEI has been providing term financing through rediscounting of investment loans made by Mexican banks for industrial projects with an expected positive impact on the balance of payments through higher exports or efficient import substitution. As FONEI became a more mature institution, additional objectives were emphasized including a more efficient reallocation of resources through Lhe financial system by inducing banks Lo make their lending decisions increasingly on Lhe basis of comprehensive project appraisal and lending for new high priority activities such as technology development. To help achieve these objectives, the Bank has made four loans totalling US$360 million for FONEI's general industrial lending for investment projects. FONEI is also one of the lending agencies in the Bank's Pollution Control and Capital Goods Industries Development Projects. A full institutional appraisal of FONEI is available in the Staff Appraisal Reports circulated to the Executive Directors in connection with Lhc Fourth FONEI project (Report No. 2478-ME of May 1979) and the Capital Goods Industries Development Project (Report No. 3756-ME of April 1982).  - 21 - 66. FONEI's Operating Regulations, which are already being used under the ongoing Bank loans being channeled through FONEI, specifv that in selecting projects for financing, FONEI should consider, inter-alia , the f-'lowing economic criteria: {i) the project's foreign exchange generation or savings; (ii) its economic rate of return; (iii) its utilization of labor and its value added; and (iv) indistrial decentralization aspects. The maximum amount of financing FONEI can normally provide to a single investment project is Mex$300 million. However, to facilitate significant participation in relatively large projects considered of high priority by the Government (e.g., capital goods and petrochemicals), FONEI can approve financing in excess of the above amount provided prior authorization of the SHCP is obtained. FONEI's subloans are denominated in pesos and have maximum maturities of 13 years, including up to 3 years of grace. Onlending interest rates on FONEI's loans for investment projects are set on a floating rate basis (adjustable every six months) at two percentage points above the current level of the index of the average cost of term deposit funds to Mexican multipurpose banks (the ACF index--the base rate generally used for peso-denominated loans made through the Mexican banking system), including a spread of two percentage peints for the intermediary bank, which assumes the full credit risk. 67. FONEI has a competent professional staff of about 50, organized under the technical (credit), promotion and administration departments which report to its Director. FONEI's project appraisal and supervision capabilities have developed well over the years. It has been reasonably successful in its efforts to encourage the irtermediary banks to take over the responsibility for carryirng out full project appraisals before submitting tha finaacing requests Lo FONE! and to undertake regular and systematic supervision of the projects. This was partly achieved by offering additional spreads of 0.25-0.5 percent to intermediary banks willing to assume project appraisal responsibility, and a further 0.25 percent if the bank also agrees to undertake full project supervision following FONEI's guidelines. FONEI's lending operations and loan portfolio have grown rap dly over the past five years (with an almost 10-fold increase in pcrtfolio between 1976 and 1981), as a result of vigorous domestic demand as well as the promotional efforts and expanding contacts of FONEI with private sector industries and banks. New loan approvals in 1982 were about US$210 million equivalent, for about 140 projects (see Annex V, Table 5). Total loan portfolio of FONEI at year-end 1982 stood at about US$325 million equivalent. It is expected that after a decline in FONEI's equipment financing in 1983, its operations will resume their dynamic growth from 1984. FONEI's financial condition is sound; although it is exposed to some foreign exchange interest payment obligations under prior Bank loans and foreign exchange risk on a limited amount of commercial borrowing, this is expected to be largely covered by the increase in the applicable (floating) interest rates on its peso-denominated lending. 68. In the past, FONEI has focussed primarily on -integrated" projects involving creation of new production capacity or major capacity expansions. Accordingly, its operating regulations set a minimum limit of MexS10 million (about USS100,000 equivalent at the controlled exchange rate) on the size of its subloans. Also, under the Government's decentralization policv, FONEI is currently not allowed to rediscount loans for plants located in Mexico City and its environs, where a majority of the older industrial plants with the most critical replacement needs are located. In the light of the current  - 22 - low demand for new industrial investments and in order to meet changing needs of its clients more adequately, FONEI's operating regulations have recently been amended to allow it to finance smaller investments involving removal of existing bottlenecks or filling critical equipment replacement needs. These mod'ificationF, which were discussed at loan negotiations, facilitate adequate FONEI participation under the proposed loan (para. 93). 69. Compania Mexicana de Seguros de Credito (COMESEC) was created in 1970 with authorization of SHCP and Comision Nacional Bancaria and with an initial equity capital of Mex$20 million, 60 percent of which was underwritten and paid-in by 41 Mexican insurance companies. COMESEC's principal objective is to offer coverage of commercial risks to Mexican exporters originating from financial insolvency of foreign buyers. In 1976, an internal credit insurance program was added. 70. COMESEC's Board of Directors has 12 members, including representatives of Banco de Mexico, commercial banks and insurance companies. COMESEC has currently some 140 staff, located at Mexico City headquarters and five regional offices. Through its global and special insurance policies COMESEC offers credit insurance for a period from 30 days to five years with premia varying from about 0.25 percent to 5 percent depending on the duration of insurance, experience of the exporter, prior credit record and financial position of the foreign buyer, and the country of destination. COMESEC only covers commercial risks from the moment of shipment of goods; political risks are covered by FOMEX (para. 58). In estimating the risks of its operations, COMESEC relies on 400 different sources of information worldwide. Generally, COMESEC covers 85 percent of the insured amount of short-term credits and 75 percent of long term credits. 95 percent of COMESEC's export credit insurance is done through its global policy,- designed for short-term credit involving continuing trade transactions throughout the year. Its -special policy- is normally used for medium to long-term loans financing individual exports of capital goods. In 1982, some 800 export credits to Mexican exporters were insured by COMESEC through 2,500 policies, covering about 35 percent of Mexican manufactured exports. Of the total amount of credit insured by COMESEC, over 60 percent was for export credits. COMESEC reinsures 90 percent of the amount of insured credit. 71. COMESEC works closely with FOMEX; in particular COMESEC insurance is a precondition for exporters to participate in FOMEX's post-shipment guarantee program which is oriented mainly to cover political risks. Both COMESEC's c^-edit insurance and FOMEX's guarantee mechanisms have played an important role in reducing risks faced by Mexican exporters and the banks that help finance their trade. Traditionally, export credits insured and premia charged by COMESEC were in US dollars. With the 1982 exchange controls, COMESEC has been unable to offer full insurance coverage in dollars. In the future, COMESEC may have to provide new or modified type of insurance to cater to the new circumstances and markets, e.g., to ensure that exporters would continue to be considered by Mexican banks as acceptable credit risks in the face of the foreign exchange control.  - 23 - Financing of Tourism Investments 72. The main government entity providing finance for tourism investments is Fondo Nacional de Fomento al Turismo (FONATUR). FONATUR was established in 1974, as a trust fund of the federal government under the administrative supervision of NAFINSA through the merger of two prior trust funds devoted to financing of tourism investments. FONATUR's operating regulations empower it to engage in tourism infrastructure operations, participate in equity investments and rediscount loans for tourism investments acting as a second-tier financing institution. FONATUR has successfully implemented three Bank loans, two for tourism infrastructure (Loans 793-ME of January 1972 and 1420-ME of July 1977) and one for its lending operations (Loan 1524-ME of February 1978), totalling US$114 million. A full institutional appraisal of FONATUR is available in the Staff Appraisal Report circulated to the Executive Directors in connection with the last loan (Report No. 1760-ME of February 1978). 73. FONATUR's Board is chaired by the Minister of Tourism and includes representatives of SHCP, SECOFIN and NAFINSA. In deciding on lending operations, the Board is assisted by a Credit Committee consisting of the representatives of the above agencies plus FONATUR's Director General. FONATUR currently has a staff of some 800, organized under five main departments (credit, equity investments, tourism infrastructure, marketing, and finance and administration). 74. FONATUR's lending operations, which are channeled through the entire network of Mexican banks, grew rapidly from 1977 onwards, reaching some Us$450 million equivalent in 1981. Due to shortage of resources and the financial crisis, FONATUR's lending in 1982 was sharply cut back, amounting to only about one-third of the previous year's amount (see Annex V, Table 4). Because of the attractive exchange rate, prospects for tourism related investments appear good: FONATUR expects that its credit operations will resume their dynamic growth and that total credit will grow almost three times between 1982 and 1984. The emphasis would be on upgrading of existing hotel capacity and construction of high category hotels which are expected to attract foreign tourists and generate foreign exchange. In order to best meet the growing demand for hotel investments, FONATUR is currently modifying the operating regulations that would: (i) allow it to authorize a maximum loan of MexS1,000 million for fixed asset investments and Mex$100 million for working capital financing (replacing the current maximum limits of MexS200 million and MexS30 million respectively); (ii) increase the beneficiary firm's minimum participation in the investment from 35 percent to 50 percent; and (iii) require a minimum commercial bank participation of 20 percent of the credit amount. FONATUR's loans have a maximum maturity of 15 years with up to three years of grace at an interest rate to the final beneficiary varying from 80 to 100 percent of the ACF index, depending on the size of the loan. 75. FONATUR's credit appraisal skills have developed considerably over the years, and are supported by a competent professional staff of about twenty. A comprehensive computerized project evaluation program has been designed recently, including a sophisticated sensitivity analysis for hotel investments. With a few exceptions (e.g., BANAMEX, BANCOMER), commercial banks have not developed speciatized units for FONATUR financed operations;  - 24 - most of the project analysis is undertaken by consultants, with FONATUR staff preparing the final appraisal report. Subproject supervision has until recently been left predominantly to the participating banks and requires some strengthening. With the current financial crisis and growing arrears problems of Mexican companies, efforts are being made to strengphen FONATUR's control and supervision of ongoing credits. These efforts would be closely followed and supported under the proposed loan. Non-financial Assistance and Services to Exporters 76. The principal government agency providing export promotion services and non-financial assistance to exporters is the Instituto Mexicano de Comercio Exterior (Mexican Foreign Trade Institute - IMCE). Since its creation in 1970/71, IMCE has been organizing industrial fairs and special exhibitions of Mexican exports, and providing market information gathered through its foreign offices (currently 25, located mostly in North and South America and Europe) to Mexican exporters. It also has 8 regional offices (delegations) within Mexico to provide liaison with the Mexican exporters. IMCE has also been preparing comparative advantage analyses and subsectoral studies to identify product groups with good export potential and examine the production and market aspects of particular groups -e.g., textiles, shoes, petrochemicals and flovers. In some cases this has led to the establishment of COMIEXPOS, which are export promotion committees set up with the participation of private sector firms to review the problems of a particular subsector or product group and promote the required improvement. In addition, IMCE has also created the Comision Asesora Mixta de Politica de Comercio Exterior (COMPEX), with the participation of SECOFIN, SHCP, SARH (Ministry of Agriculture and Hydraulic Resources), SPP (Ministry of Programming and Budgeting), FOMEX, national chambers of industries and associations of exporters, to facilitate a concerted effort of the public and private sectors to stimulate exports. IMCE acts as the coordinator of COMPEX at its monthly meetings. 77. At present, an excessively large proportion of IMCE's staff (of about 900) is stationed at its Mexico City Office with less than adequate numbers at the regional offices. Despite a large organizational effort and its success in establishing a good network of foreign offices and a data base which can be used to provide market information to potential exporters, in the past IMCE's work has suffered from a less than adequate focus on service and technical assistance to individual exporters. The Government is reorganizing IMCE's structure and redefining its work program as part of the Export Development Program supported by the proposed project (para. 83). 78. Mexican industries have been handicapped in recent years by slow and cumbersome administrative procedures affecting their import-export operations (e.g., granting of import licenses and duty drawbacks, and more recently foreign exchange authorization), which add considerably to the effective cost of imports and exports. As a result of declining interest in export activity (paras. 50 to 52), neither the industries nor the Government gave sufficient attention in the recent past to improving the procedures, although some studies were initiated in this respect. While the new Customs Law passed in 1982 contemplates several simplifications in customs procedures, action to implement them has been suspended following the new measures to control imports and foreign exchange. Mexico has no experience  - 25 - with foreign exchange controls and administrative allocation of foreign exchange and related import permits. It is therefore of critical importance to ensure simple and efficient procedures. Actions by SECOFIN and related agencies towards substantial simplification and streamlining of administrative procedures, particularly as they affect exports, but also covering import operations in general, are planned as part of the export development program supported by the prowosed loan. Under its reoriented structure, IMCE is expected to take a leading role in this respect, by providing a *single-window service to exporters (para. 82). PART IV - THE EXPORT DEVELOPMENT PROGRAM Export Development Strategy 79. The Mexican authorities recognize that a rapid expansion of non-petroletu exports will have to be an essential part of their medium-term strategy in order to manage effectively the country's balance of payments position. A four-fold increase in such exports has been established as the target for this Presidential term, 1983-88. An increase of this magnitude will require a major shift of emphasis in the industrial sector, where exports have been treated as a marginal activity in the past. The large devaluation of the peso that has taken place has made exporting a much more profitable activity. The authorities have begun to define and put in place a comprehensive export development strategy to encourage and assist existing as well as potential exporters to undertake an aggressive and sustained export drive. These measures complement other adjustment policies being undertaken, e.g., those concerning aggregate demand management, external debt management, and public sector pricing and investment as described in Part I. 80. The Government's strategy is oriented towards maintaining and expanding exports in the near term and diversifying both exported products and markets in the medium-term. A greater competitfveness of exports would be achieved through improved policies and procedures, more focussed financial and non-financial assistance to exporters, improved product quality and adaptation to markets, satisfactory linkages between export activity and the rest of the domestic industrial activity, and adequate and sustained top level support. The appraisal mission has worked closely with the Government in defining the main elements of its immediate and medium-term export strategy. In connection with the proposed project, the Government has provided the Bank a policy letter, together with supporting documents describing the Government's export strategy and incorporating timetables for major actions. This set of policy documents (referred to as the export strategy paper-) would be put into effect by the Government as part of its export development program (Section 3.03 of the Guarantee Agreement). The export strategy paper, the main parts of which are attached in Annexes VI to VIII, covers the following points. 81. (a) Policy Framework. The Government intends to rely mainly on an attractive exchange rate to provide incentives for exports and import substitution. Any remaining anti-export bias will be eliminated by progressive liberalization of quantitative restrictions and reduction of the average tariff levels, together with reasonable levels of export incentives (e.g., through indirect tax rebates). A review of the structure of the  - 26 - tariff system will be carried out on the basis of the effective protection studies now in progress; the first stage of a new tariff structure that would reduce both the average level and the dispersion of tariffs is expected to be introduced by the end of 1983. A de facto free-trade regime will be put into effect for preda.ction of all manufactured exports by facilitating temporary import- (inciuuing in-bond) treatment and automatic duty-drawbacks for them. Facilities for the maquila- (in-bond) industries and infrastructural support for exports will be re-inforced. An important objective in designing the above measures would be to ensure that export activities are at least as profitable as producing for the domestic market. Foreign direct investment will be encouraged in new export industries, and negotiations to help promote Mexican exports will be pursued with major trading partners in connection with bilateral and multi-lateral trade agreements. Through these policy actions, the Government aims to achieve domestic prices of Mexican products which are not out of line with the ir.ternational market prices. Additional studies to help refine future export-related policies (e.g., on productivity, technical efficiency and international competitiveness of industries) will be undertaken.4/ 82. (b) AdministraEive Procedures. The import licensing, duty drawback and customs procedures in respect of industrial raw materials and intermediates will be streamlined and simplified, particularly as these procedures affect exporters (para. 78). Procedures intended to give exporters priority access to foreign exchange, as well as foreign exchange surrender provisions applicable to exporters, will be improved to make them more effective. Export permit and certification procedures, which in many cases have been cumbersome and time-consuming, will be substantially simpli'ied. As far as possible, the authority to issue temporary import permits and export permits will be delegated to the regional offices of SECOFIN to help cut processing times. A -single-window service will be offered to exporters through IMCE, in order to help cut down drastically the number of agencies which exporters have to deal with to fulfill administrative requirements. The provisions of the 1982 customs law affecting exporters (e.g., the industrial deposit and inventory replenishement schemes) will be put into effect in the very near future. Flexible import procedures for duty-free zones, which were discontinued following the 1982 foreign exchange control regulations, will be reinstated. Studies will be undertaken on ways to improve design and flow of export-related paperwork and to extend the de facto free-trade regime to indirect exporters (domestic suppliers of final exporters). 83. (c) Non-Financial Assistance and Export Promotion. IMCE is being restructured as a public agency whose primary function is to stimulate exports, monitor export performance and ensure adequate coordination among agencies supporting export activities. IMCE's organization and work program will be reoriented to expand its direct contact with firms and improve the overall quality of its services (para. 77). IMCE will involve itself more actively in helping exporters draw up realistic export development programs. Its economic and sectoral work will focus increasingly on analyses which translate into practical product and market-specific recommendations. The 4/ These and other studies (para. 82) envisaged under the export development program, as well as related technical assistance would be eligible for financing under the proposed loan (para. 104).  - 27 - regional office staff of IMCE will act increasingly as extension agents, identifying the needs of individual exporters, providing buyer and market information and other services (e.g., buyer lists, supplier lists, latest legislation, assistance in paper work, import-export documentation, transport arrangements, etc.), and directing them to more specialized assistance when required. Together with an effective use of the foreign offices, this is expected to result in significantly improved buyer and market information and publicity for Mexican products in other countries. IMCE w4ll also take an active role in organizing export consortia and trading companies which could help groups of firms achieve scale economies, e.g., through consolidation of production to meet large batch orders (in the case of firms producing similar products) and, sharing of overhead expenses. To enable the above reorienta- tion, IMCE is expected to undertake a major shift of resources in favor of departments which are directly involved in providing services to exporters and its regional offices which serve exporters throughout Mexico; the changes will also involve creation of some new departments and bolstering several of IMCE's specific services (e.g., assistance in product adaptation and packaging). 84. (d) Export Finance and Insurance. Financing mechanisms will be created and strengthened to ensure adequate and timely access to credit and foreign exchange to exporters. Suitable mechanisms are being established and refined to resolve outstanding loan .5%rearage problems vis-a-vis foreign creditors, including those associated with suppliers credits (e.g., by increasing the percentage of export earnings which can be retained by exporters in foreign exchange to pay suppliers or through special arrange- ments with foreign export-import banks). Export credit guarantee and insurance schemes will be strengthened and modified to suit thb: new circum- stances of foreign exchange scarcity. Exporters affected by Teso liquidity and decapitalization problems stemming from foreign liabilitis will receive help through suitable peso financing arrangements, including equity and quasi-equity financing from public development banks and trust funds. Steps will be taken towards the establishment of a consolidated 'export-import bank" of Mexico under the umbrella of BNCE which would coordinate all export financing and related services to Mexican industries; as a step towards this, the trusteeship of FOMEX will be transferred to BNCE in the very near future. 85. (e) Top Level Government Support. SECOFIN would have principal responsibility for the implementation of Mexico's export development strategy along the above lines. In addition to its direct responsibilities which cover trade and protection policies, industrial development policies and related administrative actions, SECOFIN participates together with SHCP and Banco de Mexico on matters related to exchange rate policies and would also keep close contact with other agencies on trade matters relevant to their responsiblities (e.g., with SARH on controls over agricultural exports and SHCP on customs regulations). SECOFIN would review on a continuing basis all policy aspects relating to external trade, take measures to ensure a sustained high priority for export development, and promote public confidence and attitudes favorable to export-oriented activities. SECOFIN also provides support to the work of the ministerial level Foreign Trade Cabinet which advises the President on top level policy matters related to external trade. For the purposes of reporting to the Bank on progress in the implementation of the various policy, administrative and other measures proposed under the  - 28 - export development program, BNCE will assume responsibility for preparing semi-anntial reports in consultation with SECOFIN and other concerned agencies; these reports would provide the required background information for the periodic reviews of the program (para. 89). Progress in Implementation 86. The strategy which is contemplated by the Government thus takes an integrated approach to export development. It covers many complex areas and its implementation requires collaboration of several agencies. Given the prevailing macro-economic and external sector uncertainties and the limited prior experience in Mexico with operating under a foreign exchange control regime, the design of the measures as well as the implementation timetables may have to be refined and adjusted as experience is gained with the program. Annex VIII provides an indicative timetable for key actions under the Government's export strategy, as reflected in the export strategy paper. It is expected that the main elements of the strategy and action plan would be incorporated In the National Development Plan and the Industrial Develop- ment and Foreign Trade Program due to be published in September/October 1983. 87. The Government has already taken several important steps towards implementing the above strategy: (i) Most importantly, the Government has been adjusting daily the controlled exchange rate, which is the rate applicable for most exports, to take account of expected differences between Mexican and international inflation rates. By May 20, 1983 this crawling rate reached 115 pesos to a U.S. dollar, representing nearly a 40 percent real depreciation of the peso relative to its level during 1977 after the previous devaluation. A free exchange rate (cur- rently fluctuating at about 148 pesos to a U.S. dollar) is appli- cable to other transactions. Domestic interest rates levels are being set with a view to discourage capital flight and provide some stimulus to the repatriation of capital (paras. 19 and 81). (ii) In late 1982, the Government made available emergency financing of Mex$50 billion through its major industrial financing trust funds to help alleviate the peso liquidity and decapitalization problems of industries. Towards the end of February 1983, the Government also announced its intention to provide additional special financing for firms suffering from decapitalization problems; new ways of reducing the amortization burden of term loans through automatic capitalization of part of the interest payments (to achieve approximately equal debt service payments in real terms) will also be promoted (para. 84). (iii) In February 1983, as an initial step towards import liberalization, the authorities removed prior license requirements for imports of spare parts valued at US$1,500 or less, provided that the importer is willing to obtain the required foreign exchange in the free market. The authorities have also initiated preliminary work towards a review of the tariff levels to provide a basis for reductions in average level and dispersion of tariffs. The basic  - 29 - criterion in the review of tariffs (together with the exchange rate and export incentives) would be that production for exports should be at least as profitable as meeting domestic demand (para. 81). (iv) In late February, regulations were issued allowing enterprises to establish deposits denominated in US dollars acquired at official exchange rate for servicing of suppliers' debt incurred prior to December 20, 1982 and falling due prior to June 30, 1983 (para. 84). (v) A decree was issued on March 4 to improve substantially the treatment of exporters by: providing exporters the right to retain part of their export proceeds or to obtain access to previously surrendered foreign exchange at the controlled exchange rate, in order to pay for costs of imported goods required in their productive process and expenses associated with the imports or exports;5! allowing exporters to transfer part of their rights for foreign exchange at the controlled rate to other enterprises, subject to SECOFIN authorization, inter-alia as a means to facilitate access to foreign exchange for -indirect exporters" and trading companies and to liberalize foreign exchange surrender policy affecting exporters; allowing exporters to engage in "barter transactions authorized by SECOFIN; and providing exporters the option to obtain a -single-window" service, including foreign exchange authorization, financing as well as open import licenses for periods of up to one year, on the basis of satisfactory annual export plans authorized by IMCE (para. 82). (vi) In early April, the Government formally announced a new scheme to facilitate the rescheduling of foreign debt of private firms (including suppliers' credit); the scheme provides for sale of foreign exchange futures by the Banco de Mexico to private firms to help them hedge the exchange risk associated with the rescheduling, coupled with financing on reasonable terms and conditions to enable the firms to purchase such futures contracts. The scheme would be applicable to loan reschedulings of private foreign debt incurred before December 29, 1982 provided that the rescheduling is for minimum terms of 6-8 years including grace periods of 3-4 years (para. 84). These actions clearly evidence the Government's commitment to follow the export strategy which has been elaborated, and represent an excellent first step in implementing the strategy. To have an overview of all Government actions taken in this area since February 1982, a list including dates of Government actions related to trade and exchange rate policies is included in Annex IX. 5/ Servicing of supplier credits in arrears contracted prior to December 20, 1982 (up to a maximum of 20% of the export earnings) had already been allowed since December.  - 30 - 88. Additional actions expected to be taken by about the end of the current calendar year include: (i) issuance of formal regulations and administrative instructions to implement liberalization of temporary import procedures (including automatic reimbursement of import tariffs); (ii) update of the effect're protection study to cover data for 1981/82; (iii) prepara- tion of speci^