Mexico - Industrial Recovery Project

The World Bank FOR OMCIL USE ONLY Report No. 5904-HE STAFF APPRAISAL REPORT HEXICO INDUSTRIAL RECOVERY PROJECT July 10, 1986 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be discksed without World Bank authorizaion.  Carrerc Unit - Peso Oftx$) On June 6, 1986, the exchange rate in the controlled market was US$1 - Mex$627.00; the freemarket exchange rate stood at US$1 - Mex$588.00 lincal Year January 1 - December 31 Wihts and Ne1aures 1 hectare (ha) - 10,000 square meters (m2) - 2.47 acres (8) 1 kilometer (km) - 0.62 mile (mi) 1 square kilometer (km2) 0.39 square miles - 100 ha 1 kilogram (kg) 2,205 pounds (lbs) 1,000 kilograms - 1 metric ton (t) - 0.98 long ton 1 liter (1) 0.26 gallons (gal) Abbreviations ACF Average Cost of Funds (see CPP for Spanish) BANCOMER Banco Comercial, S.A. BANCOMEXI Banco Nacional de Comercio Exterior, S.N.C. BANPAIS Banco Nacional del Pais BdM Banco de Mexico [Central Bank] CEPROFI Certificado de Promocion Fiscal CETES Certificado de Tesoreria CPP Costo Promedio Porcentual (see ACF for English) EFF Extended Fund Facility ERR Economic Rate of Return FICORCA Fideicomiso para la Cobertura de Riesgos Cambiarios FIRA Fideicomisos Instituidos en Relacion con la Agricultura FOGAIN Fondo de Garantia y Fomento a la Industria Mediana y Pequena FOEI Fondo de Equipamiento Industrial FRR Financial Rate of Return GDP Gross Domestic Product GIRA General Interest Rate Agreement ICB International Competitive Bidding IMF International Monetary Fund NAFINSA Nacional Financiera, S.N.C. PEMEX Petroleos Mexicanos PRONAFICE Progruna Nacional de Fomento Industrial y Comercio Exterior PVP Sistema de Pagos al Valor Presente QRs Quantitative Restrictions  FOR OFF0AL USE ONLY STAFF APPRAISAL REPORT MEXICO INDUSTRIAL RECOVERY FROJECT TABLE OF CONTENTS Page No. I. PROJECT SUMMARY ........................................ iv II. THE INDUSTRIAL AND FINANCIAL SECTORS ................... 1 The Industrial Sector ............ ..1............... Background ............................... 1 Development Constraints ............... 2 Government Policies ..... ..................... 2 The Financial Sector ...... ........................ 3 Background ............................... 3 Development Constraints ..... ................. 3 Government Policies ................. 5 Bank Assistance ................................... 6 III. THE PROJECT ............................................ 7 Project Objectives ................... 7 Project Description and Design ............... 7 Executing Agency and Experience with Past Lending.. 8 Loan Amount and Terms ............................. 9 Financing Plan ........ ............................ 9 Relending Terms and Conditions ........ ............ 10 Project Implementation .......... ................ 11 Procurement and Disbursement .......... ............ 12 Accounting and Auditing ........................... 12 Benefits and Risks ............................... 13 IV. RECOMMENDATIONS ........................................ 13 This report was prepared by Messrs. Eberhard von Loehneysen, Ovaise Saadat, Ms. Aida Velarde and Ms. Judith Press, LCPI2, and Mr. Jonathan Parker, LCPII, following two idssions to Mexico in April and June 1985. This document has a restricted distribution and may be used by recipients only in the performace of their official duties. Its contents may not otherwise be disclosed without World Dank authoriutionz  -ii- LIST OF ANNEXES ANNEX 1. Summary of the Sistems de Pagos al Valor Presente (PVP) ANNEX 2. Nominal and Real Interest Rates ANNEX 3. Outline for a Technical Assistance Program ANNEX 4. Operations of the Fondo Nacional de Equipamiento Industrial (FONEI) ANNEX 5. Experience with Past Lending ANNEX 6. Guidelines for the Financing of Equity and Quasi-Equity Investments by Co mercial Banks ANNEX 7. Key Indicators for Project Implementation ANNEX 8. Estimated Schedule of Bank Loan Disbursements ANNEX 9. Supporting Tables Industrial Sector T-1 Gross Domestic Product by Sector of Origin 1975-84 T-2 Quarterly Index of Industrial Production 1979-84 T-3 Quarterly Index of Manufacturing Production 1979-84 T-4 Structure of Value Added in the Manufacturing Sector 1970-84 T-5 Manufactured Exports by Product Group 1970, 1975, 1980-84 T-6 Import of Manufacturing Industry by Product Group 1975) 1980-84 T-7 Selected National Wage indices 1977-85 Financial Sector T-8 Monetary Aggregates 1970-84 T-9 Total Financing of the Banking System 1982-84 T-10 Financing of the Banking System in National Currency 1982-84 T-11 Financing of the Banking System in Foreign Currency 1982-84 T-12 Credit to Public and Private Sector by Principal Economic Activity 1979-84 T-13 Total Liabilities of the Banking System 1982-84 T-14 Consolidated Financial Operations of the Public Sector 1978-84 T-15 Financial Sources of the Federal Government Internal Debt 1977-84 T-16 Traded Volume at the Stock Exchange 1978-84 T-17 Public Offers through the Stock Exchange 1978-84 T-18 Money Market Operations of Casas de Bolsa 1984 T-19 Bond Market Operations of Casas de Bolca 1984 T-20 Operations of the Corporate Stock Market 1978-84 T-21 Capital Increases of Companies registered in the Stock Exchange by Sector 1979-84  -iii- FONEI: Actual and Projected Financial Performance T-22 Income Statement T-23 Balance Sheet T-24 Sources and Uses of Funds T-25 Assumptions for Financial Projections FONEI: Portfolio Comsiwition T-26 Total ConmmL.uents by Program Type 1979-84 T-27 Commitments under the Equipment Program by Loan Size 1981-84 T-28 Commitments under the Equipment Program by Economic Sector 1981-84 T-29 Total Commitments by Region 1980-84 T-30 Total Disbursements by Financial Intermediary 1979-84 FONEI: Subproject Performance T-31 Summary of Projected and Actual Subproject Performance 1981-84 T-32 Financial Composition of Subprojects under the Equipment Program 1979-84 T-33 Projected and Actual Rates of Return oi a Sample of Subprojects T-34 Projected and Actual Performance of Borrowing Companies 1981-84 T-35 Commitments under the Equipment Program by Product Destination 1979-84 T-36 Projected and Actual Export Performance of Borrowing Companies T-37 Summary of Commitments and Disbursements under Previous FONEI Loans 1973-84 ANNEX 10. Selected Data and Documents Available in the Project File ANNEX 11. Status Summary on Current Industrial Loans to Mexico  -iv- HmCO INDUSTRIAL RECOVERY PROJECT Loan and Project Summary Borrower: Nacional Financiera, S.N.C. (NAFINSA) Guarantor: United Mexican States BenefiLciay :Fondo de Equipamiento Industrial (FONEI) Amount: US$150.0 million equivalent Terms: 15 years, including three years of grace, at the standard variable interest rate Relending Ter m: NAFINSA would pass on loan funds to FONEI on the same terms as the Bank loan. The Government would repay the principal of the Bank loan, pay interest, and bear the foreign exchange risk. FONEI would relend funds to intermediaries at rates not less than the average cost of funds to the banking system (CPP) plus one percentage point. The spread intermediaries would charge on fixed investment subloans would vary between a minimum of one and a maximum of four percentage points; there would be no upper limit on the spreads for working capital subloans. Maturities would vary between 3 and 13 ye_rs for equipment loans, 3 and 7 years for working capital subloans, and 3 and 10 years for the rediscounting of equity investments. The grace period would not exceed 3 years for equipment and working capital subloans, and 5 years for the financing of equity investments. FONEI would offer, as an option, the Sistema de Pagos Variables al Valor Presente (PVP)," in order to ease the cash flow of borrowers. Project Description: The proposed project would improve the quality and broaden the scope of financial services to medium-sized and large private industrial companies. More specifically, it would: (i) intro- duce a repayment mechanism for long-term credit, which better matches debt service with cash generation; (ii) promote development of the capital market by introducing, on a pilot basis, the financing of equity and quasi-equity investments by commercial banks; and (iii) develop corporate finance capabilities within FONEI to offer comprehensive financial packages and related technical assistance. The project would provide: (i) finance for fixed investment and working capital, and as a pilot program for the restructuring of over-leveraged companies, equity and quasi-equity investments, and (ii) technical assistance to FONEI.  -v- Project Risks: The loan is expected to disburse quickly, given FONEI's current project pipeline and expected industrial financing needs. However, commitments could slow down because of slow economic recovery or reluctance by financial intermediaries in accepting new financial instruments that will be introduced under the proposed project. To minimize these uncertainties, the loan amount is based on conservative demand estimates, and the amount allocated to equity finance is relatively small (US$20 million). Estimtaed Cost: Local Foreign Total US$ Millions Equipment Subloans 70.6 86.4 157.0 Working Capital Subloans 80.0 20.0 100.0 Equity Investments 22.1 17.9 40.0 Technical Assistance 2.0 1.0 3.0 TOTAL 174.7 125.3 300.0 Financing PlAn: World Bank 24.7 125.3 150.0 FONEI/Government 104.3 0.0 104.3 Intermediaries/Beneficiaries 45.7 0.0 45.7 TOTAL 174.7 125.3 300.0 EstLuated (Bank FY/US$ Millions) 87 88 88 90 91 92 93 Annual 7.0 28.0 39.5 39.0 20.5 13.0 3.0 Cumulative 7.0 35.0 74.5 113.5 134.0 147.0 150.0 Rate of Return: Subprojects would have to have FRRs and ERRs of at least 1OZ in real terms.  II. TUE INDUSTRIAL AND FINANCIAL SECTORS The Industrial Sector 2.01 Over the past three decades, manufacturing developed into one of the leading sectors of the Mexican economy: its share in GDP rose from 17% in 1950 to 24% in the early 1980s; manufactured exports grew even faster, now contrib- uting about 29% to total exports; and the manufacturing sector creates about 13% of all jobs in the country. These growth trends look even more impressive when taking into account the discovery of huge petroleum reserves, which became the dominant source of economic growth since the mid-1970s. The composition of manufacturing had shifted gradually over the years. During the 1960s and early 1970s, manufacturing concentrated on light industrial goods (textiles, apparel, and wood products), which represented more than two-thirds of manufacturing value added in 1960. Twenty years later, this share had fallen below 40X, while the share of heavier industrial products (metal works, machinery, and equipment) rose from 23% in 1960 to 30% in 1980. 2.02 As a result of the economic and financial crisis, however, industrial growth came to an abrupt halt in 1982. Production dropped 11% from its 1981 level, and gross domestic investment as a proportion of GDP fell from a peak of 29% in 1981 to 16.5% in 1983. Many Mexican companies came close to bank- ruptcy. To avoid massive defaults, the banks had to reschedule the large-scale debt of their corporate customers. To alleviate their foreign exchange risk, the Government set up FICORCA ("Fideicomiso para la Cobertura de Riesgos de Cambios-) in 1983, with a long-term currency and interest swap mechanism that enabled private companies to pay their foreign debt in pesos at domestic inter- est rates and, at the same time, to capitalize a portion of the interest pay- ments. Government agencies such as FONEI ("Fondo de Equipamiento Industrial") provided emergency liquidity to affected companies through special assistance programs. Also, the Government introduced an accelerated depreciation scheme allowing a 75% write-off against new investments in 1984 and a 50% write-off in 1985, which continued in 1986. 2.03 The industrial sector began to recover in 1984, especially during the second half of the year. Industrial production grew by 4.8%, as opposed to a decline of 9% in 1983; manufacturing output rose by 4.7%; and construction activities also rose by 3.8%. Electricity and cement production were up by 5.9% and 8%, respectively. The recovery was led by a revival of capital goods and consumer durables, which had suffered particularly severe contractions in the preceding two years. Also, a 50% rise of the share of manufactured exports in total exports in 1984 contributed to growing output. The increases in production and exports reduced widespread overcapacity observed over the last two years, and gave rise to an expansion in fixed capital investments. The recovery continued into the first half of 1985, during which the industrial sector grew at an annualized rate of 9%. In the second half of 1985, however, economic growth, and with it, industrial expansion, slowed down as a result of the Government's efforts to limit inflationary pressures and restrict public spending. The industrial growth rate for the year as a whole was 5%.  -2- Development Constraints 2.04 Despite the 1984/85 recovery, however, serious problems remain. The sudden growth in manufactured exports in 1983-84 was the result of a suppressed domestic market and a drastic currency devaluation, and not of increased international competitiveness or export orientation. Mexican companies have, in general, not introduced lasting improvements in their competitiveness. In addition, the financial situation of many companies remained precarious: high financial costs limit profitability, and improvements in liquidity after 1983 have been only temporary. afforded by postponed interest payments under the FICORCA mechanism. 2.05 Insufficient Export Orientation. Through decades, the Mexican Govern- ment has followed an import-substitution strategy in industrial policies. High protective barriers, combined with tax breaks and subsidies, have nurtured domestic industries, many of which are simply not competitive in the world markets. As a result, the export base in manufacturing has remained limited. The number of important exporters is small, and most companies view export ventures only as a residual effort to complement slackening domestic sales. Manufactured exports have been concentrated in chemicals and petrochemicals, as well as transport equipment and automotive parts. Diversification is only beginning now. As 70% of manufactured exports go to the U.S. market, there is a potential for growth in export possibilities to other markets. 2.06 Weak Finanmial Condition of Firms. The structural weakness of Mexico's industrial sector is compounded by the difficult financial condition of many enterprises. The massive devaluations sharply increased the debt burden of companies that had accumulated a high foreign debt exposure. In 1983, for instance, some 30% of all industrial companies had a debt/equity ratio of more than 2:1; 10% of the companies had a ratio exceeding 5:1. Although the financial structure of the industrial sector improved during 1984, many companies remain financially weak. Recent increases in domestic interest rates further elevated financial costs. Within the next two years, company liquidity will deteriorate further, because the grace period under the Government's FICORCA scheme, which had assumed that industrial growth would recover by 1986, is now coming to an end. Government Policies 2.07 Recognizing the limits of an import-substitution strategy and Mexico's limited foreign exchange availability, PRONAFICE, the Government's industrial development plan announced in 1984, emphasizes the need for structural changes in industry. A first step in this direction was a trade liberalization package in July 1985, consisting of a reduction in quantitative import restrictions and a devaluation. Despite this change in the import protection system, the actual level of effective protection has not been lowered. In some cases, tariffs have been temporarily increased and official reference prices introduced in order to compensate for the loss of quantitative restrictions. But the Govern- ment has recently announced multi-year calendars for a tariff program significantly reducing tariffs by 1988 to 0-30Z, for phasing out official reference prices by end-1987, and for additional quantified reductions in non-tariff barriers, such as quantitative restrictions. Breaking with its economic policy of the past two decades, Mexico has also applied for membership  in the GATT. At the same time, the Government has already provided further incentives to exporters, including an expansion of the temporary import scheme, the simplification of rebate procedures for the value added tax on imported inputs, the partial elimination of export permits, the reduction of export taxes, and the maintenance of a realistic exchange rate. 2.08 The Government is aware, however, that these recent measures will have to be complemented with improvements in financial services to industry and the financial structure of companies. To be able to compete internationally, industry will have to invest more in plant, equipment, and working capital. But many companies with an overleveraged financial structure cannot afford to borrow because of the high financial costs and negative cash flow created by high nominal interest rates. Thus, in addition to a general need for term credit, many companies require equity, especially enterprises with healthy operations and good business prospects. But equity finance is not available in sufficient amounts. The Fiasncial Sector Backg,round 2.09 Mexico's nationalized banking system comprises the Banco de Mexico (BdM, the Central Bank), 19 multibanks (general purpose commercial banks), and a num- ber of development banks, of which two (Nacional Financiera, S.N.C., NAFINSA, and the Banco Nacional de Comercio Exterior, BANCOMEXT) provide financing to the industrial sector. The commercial banks are sophisticated and efficient institutions in traditional banking services, but they are highly concentrated: the two largest multibanks account for almost 50% of total banking assets. Two banks are still privately held and are operating under "grandfather" clauses. A number of Government trust funds (fideicomisos-) provide credit, often through the banking system, to priority activities. Non-banking financial services are being offered through the stock exchange with 30 brokerage houses and 4 independent brokers. 2.10 The current institutional setup is the result of drastic changes in structure and ownership of Mexico's financial system over the last decade. Private and mixed-ownership banks numbered 132 in 1978, declining to 76 in 1980, and to 59 in 1981. In September 1982, the commercial banks were nation- alized, and by year-end, they numbered only 51. The remaining specialized banks were merged into multibanks in 1983, and currently 19 multibanks are in operation. At the same time, the number of branches of the nationalized bank- ing system slowly increased from 3,719 in December 1980 to 4,429 in early 1986. Development Constraints 2.11 Drastic changes in economic environment over the last years also affect- ed financial sector development. The 1982 debt crisis had a profound impact on the balance of supply and demand of domestic and foreign financial resources. In addition, the increases in domestic inflation, from the 15-25% range in the late 1970s to above 70X currently, contributed to a drastic decline in the availability of adequate long-term finance. New lending and deposit  - 4 - instruments that are suitable for a high-inflation environment have not been introduced, and the long-term bond and equity markets have remained too small to serve as an effective complement to commercial bank credit. 2.12 Declining Supply of FinaciLal Resources. Traditionally, only a limited portion of the resources mobilized through the banking system has been allocated to industry without restrictions. Until 1984, some 48% of total banking deposits was subject to reserve requirements of the Banco de Mexico and used to finance the public sector deficit. Another 27% was directed to official credit programs, leaving the balance -- only 25% - for free lending to interested customers. Policy reforms, initiated at the beginning of 1985 to limit Government access to Central Bank resources and increase the private sector share in commercial bank credit, have effectively been reversed in the second half of 1985 to meet the funding requirements of a sharply rising domestic debt. This has led to further crowding out of the private sector (para. 2.17). Moreover, the deposit base itself has eroded as a result of a persistent disintermediation process in recent years. The ratio of MI/GDP has steadily declined since 1979 (9Z) to 1985 (5.5%), and banking system assets declined from 80% of GDP in 1982 to 65% in 1984 and recovered to only 70% in 1985. In addition, access to incremental foreign borrowing has all but collapsed since 1982. 2.13 Lack of Adequate Long-Tern Financing. As in many high inflation econo- mies, the availability of long-term finance has declined dramatically in Mexico. Although the maturity structure of the commercial banks' assets is not known, a relative decline in long-term deposits shows the increasing difficul- ties of banks in funding maturity-matched long-term loans. The shortage of long-term financing is compounded by the negative cash flow effects of high nominal interest rates. While many Latin American countries have introduced indexing to adjust the outstanding principal for inflation, Mexico has opted, until now, to compensate for inflation through high nominal interest rates. High nominal interest rates, however, effectively shorten the maturity of a long-term loan, because the effects of the declining real value of principal repayments are more than offset by high interest payments. The resulting repayment stream, if calculated in real terms, implies that most of the loan is being repaid within two to three years-imposing a debt service burden which exceeds the cash flow generated by most fixed asset investments. To help over- come these difficulties FONEI proposed, and the Government agreed, to introduce a new repayment mechanism for borrowing from commercial banks--Sistema de Pagos Variables al Valor Presente- (PVP), the use of which the proposed loan would encourage (para. 3.14). 2.14 Changing Structure of Real Interest Rates. Real interest rates have shown wide fluctuations over the last several years. During 1979 and 1980, the effective cost of the average term deposit to the commercial banking system, even if compounded monthly, was negative in real terms: after dropping to about -5% in 1980, it recovered to 1% in 1981, before pluumeting again to a low of -22% in 1982. Since 1983, however, the average cost of funds (compounded monthly) to the banking system (ACF) has become positive and reached an annual average of 52 in 1984 and 6% in 1985. Consequently, interest rates which are set at or above the ACF have also become positive, averaging about 14% per year in 1984 and increasing further in 1985. This encouraged financial rather than productive investments, which will be necessary as industries try to adapt to a  -5- more open trade regime. To maintain a reasonable level of resource mobilization through the banking system, Mexico is expected to continue to allow term deposit rates to be positive in real terms. This should ensure that lending rates for large- and medium-sized industries are high enough to promote sound investment decisions. Continued movement towards a more realistic exchange rate and action to curb the fiscal deficit is central to achieving a sustainable, but not excessive, level of interest rates. 2.15 Small Size of the Bond and Equity Markets. Neither the money nor the long-term bond markets have yet developed into effective complements to commer- cial banking credit. Over 90% of the money market is accounted for by CETES ('Certificados de Tesoreria'), which were introduced in 1978. Commercial paper and bankers' acceptances accounted for the remaining 10% of the money market. Gross emissions in the bond market totalled a mere Mex$35 billion in 1984 (about US$210 million), with PEMEX's -Petrobonos- accounting for almost 60! of the total. 2.16 Mexico's equity market is still in the early stages of development. It is limited to only a few enterprises, and has remained small. Only about 160 companies are currently listed on the stock exchange, representing a decline from previous years; many registered companies were not actively traded. The commercial banks, originally holders of sizable equity portfolios, had to sell off their investments after the 1982 nationalization. The market for private placements is limited to a few well-known names, but inaccessible to most of the medium-sized companies. And, venture capital funds that could fill the institutional gap do not yet exist. The aversion of many Mexican industrialists to -go public' appears to be one of the main reasons for the infancy of the equity market, because it involves the partial surrender of company control, public scrutiny of financial and operational performance, and increased exposure to tax auditing. Also, potential investors are reluctant to associate themselves with companies that are not registered at the stock exchange. To initiate action for building up the equity market in Mexico, the proposed project has been designed to include a pilot equity component that would provide finance to over-leveraged companies, and studies of the long-term financing needs of industrial enterprises and the factors affecting the supply of equity (paras. 3.05-3.06). Government Policies 2.17 In a legislative reform of the financial sector in 1985, the Government took initial steps to fill some of the institutional gaps and clarify the role of existing financial institutions. In particular, the reform restricted Banco de Mexico to monetary regulation; it limited Government access to credit thus forcing the Government increasingly to borrow in the financial market through CETES; it aimed at funding the development banks through bonds and long-term borrowing from the commercial banks; and it confirmed the role of commercial banks as competitive, profit-oriented institutions. However, the Government's stabilization efforts during the second half of 1985 effectively overrode some of these reform objectives. To limit credit expansion and force repatriation of Mexican capital abroad, the Government froze private sector credit at its nominal July 1985 level, thus diminishing private sector credit in real terms and raising marginal reserve requirements to 100X. Changes in the auctioning process of CETES, and discretionary ceilings set on their yield, have reduced  their market acceptance and further increased direct Banco de Mexico credit to the Government. The Government is aware that these measures are not sustainable in the long run and is expected to address these issues in the context of its 1986-87 stabilization and external finance plan. 2.18 One of the key objectives of Mexico's financial sector development is the strengthening of its risk capital markets, thereby improving the financial structure and growth potential of the industrial sector. The Government has expressed its commitment to this objective in the National Program for Development Financing (PRONAFIDE), launched in 1984. PRONAFIDE, among others, emphasizes the need to form risk capital funds and to foster the participation of institutional investors in the primary and secondary equity markets, assigning a leading role to the private sector. To provide special incentives for the development of the securities markets, capital gains on securities traded on these markets are tax exempt. While the nationalized commercial banks are now excluded from the stock brokerage and insurance business, they would have, through temporary and limited equity investments in industry, an important promotional and catalytical function in this process, drawing on their long experience with equity investments as well as their long-standing connections with private industry. Long-term financing, provided on favorable terms under the proposed project, would encourage the commercial banks to build up their equity portfolio within the limits established by the new legislation (para. 3.15). The new financial legislation has also established a legal framework for the operation of venture capital companies, but some of its provisions are considered as overly restrictive and the development of this type of institutional investor is likely to remain limited. Notwithstanding the new incentives, which are expected to have a significant favorable impact on the supply of equity financing, the equity market may fail to attract substantial financial resources as long as it has to compete with a large supply of Government securities, generally perceived as lower-risk investments and currently yielding high real interest rates. A planned gradual reduction in the fiscal deficit would, therefore, make a very important contribution to equity market development. Bank Assistance 2.19 The Bank has assisted Mexico's industrial sector with a number of opera- tions. Four of these (Lns. 824-, 1205-, 1560-, and 1712-ME) provided term financing through FONEI. The first three loans are fully disbursed, and the fourth is expected to be disbursed shortly (para. 3.08). Subsequently, the Bank expanded the range of its industrial credit operations with projects addressing the problems of specific industrial target groups, such as the small- and medium-sized industry (Lns. 1552-, 1881-, and 2325-ME), capital goods producers (Ln. 2142-ME), and efforts to reduce environmenta'l contamination (Ln. 2154-ME). This strategy recognizes that sectoral policy issues and institutional problems are best addressed through subsectoral assistance programs. While the first three loans are meeting their objectives, demand for capital goods has suffered because of the economic crisis, and inadequate enforcement of regulations has resulted in low utilization of credit for pollution control investments. 2.20 Given tne current needs of the industrial sector, export development has become a top priority in the Bank's lending program since 1983. A first Export  Development Project (Ln. 2331-ME) assisted the Government in improving export incentives, reducing the anti-export bias of policies, and introducing a tempo- rary import scheme. The loan is now almost fully committed and expected to be disbursed by end-1986. 2.21 These operations have focussed on delivery of credit and industrial sec- tor issues. The Bank's assistance to the financial sector has largely been concentrated on improvements of individual financial institutions. A broader approach was initiated through a dialogue with the Government on interest rate policies, which led to a General Interest Rate Agreement (GIRA), which commits the Government to phasing out gradually interest subsidies. Since 1984, all Bank lending to Mexico involving financial intermediation has been subject to GIRA's requirements. The proposed project would put additional emphasis on financial sector development, help reestablish an adequate supply of long-term funds, and upgrade the corporate banking capabilities of participating finan- cial institutions. Thus, the project is also expected to set the stage for a future financial restructuring operation. III. THE PROJECT 3.01 In December 1984, the Government, together with FONEI, showed interest in Bank support to the industrial recovery process. A credit project was iden- tified jointly with FONEI in early 1985. A Bank pre-appraisal mission visited Mexico in April 1985, followed by an appraisal mission in June 1985. Negotia- tions were held in January 1986; the Mexican delegation was headed by Lie. Luis Nava Hernandez, NAFINSA Representative in Washington, D.C., and included Lic. Hector Flores Santana, Manager of IBRD Banking Operations in NAFINSA, Lic. Jesus Villasenor Gonzalez, Director General of FONEI, and Lic. Antonio Cervera Sandoval of the Secretariat of Finance and Public Credit (SHCP). Project Objectives 3.02 The proposed project is aimed at improving the quality and broadening the scope of financial services to medium and large industrial companies, which represent the bulk of FONEI's clientele. Given the over leveraged financial structure of many companies, the availability of comprehensive financial packages for their long-term needs and of financing instruments that ease their cash flow in high inflation will be as critical as -ontinued access to traditional project/equipment financing. In some measure, Mexico's industrial recovery and return to sustainable growth also depend on such new financing arrangements. Therefore, the project's objectives would be to: - Adapt lending terms to a high-inflation environment through the introduction of a new repayment mechanism; - Promote development of the capital market by introducing, on a pilot basis, the use of additional financial instruments, such as equity and quasi-equity, by the commercial banking system; and - Develop corporate finance capabilities within FONEI to offer comprehensive financial packages and provide financial restructuring assistance to over leveraged companies.  -8- Project Description and Design 3.03 To achieve the above objectives, the project would include financial as well as technical assistance components. It would provide credit for equipment and working capital requirements, finance for equity and quasi-equity invest- ments of industrial enterprises, and a technical assistance program. 3.04 Credit for Equipmut and Working Capital. This would be the project's largest component, accounting for about 86% of the loan. It would provide long-term financing to industrial enterprises, covering plant improvements or construction and acquisition of equipment-for which FONEI's clientele has had the greatest demand in the past, and providing for the long-term working capi- tal requirements of eligible companies. The inclusion of working capital financing not associated with plant and equipment investments would, under currently prevailing circumstances, stimulate output by improved capacity utilization in industry. 3.05 Equity and Quasi-Equity Investments. A pilot component representing some 13X of the loan amount would provide finance for the purchase of equity and quasi-equity instruments by intermediating commercial banks. Such instru- ments would include, inter alia, common or preferred stock, convertible securi- ties, or subordinated debt, which could be used either alone or packaged in combination with debt. Through this pilot component, FONEI would be able to offer, for the first time, comprehensive financial packages designed to meet the long-term needs of companies that are operationally healthy but suffer from a weak financial structure and prevailing high financial costs. This project component, together with the technical assistance program outlined below, would enable FONEI and the commercial banks to build up institutional capabilities in comprehensive corporate analysis and financial restructuring. Favorable repay- ment conditions of equity loans to be financed from the loan would encourage temporary equity investments and promote a se-ndary equity market through incentives of the law regulating the sale of stocks and securities. Given the recently introduced tax break on capital gains from trading on the equity market, commercial banks are expected to encourage enterprises in which they invest to get listed on the local stock exchange. 3.06 Technical Assistance. The project's technical assistance component would be its smallest, accounting for 1% of the loan. It would complement the provision of finance through: {i) improvements in FONEI's technical capabili- ties by designing and implementing a promotion campaign and a staff training and development program, and by upgrading FONEI's internal information and con- trol systems; (ii) financial market studies, assessing the financial situation and long-term financing needs of industrial enterprises, the supply of equity and quasi-equity to the industrial sector, and the use of direct borrowing instruments (such as bonds) by industrial companies; and (iii) specific assist- ance in the design of restructuring packages for final borrowers. Consultant services and computer equipment, including the development of software, would be financed by the proposed loan. Executing Agency and Erperlence With Past Lending 3.07 FONEI would be the project executing agency. Founded in 1971 as a trust fund of the Banco de Mexico, FONEI has become an important source of industrial term lending in Mexico, highly regarded by both commercial banks and the pri-  - 9 - vate sector. Today, FONEI is administering a wide variety of industrial financing programs, and it has become an important source of technical assis- tance, offering training programs for project analysis and supervision. FONEI has developed guidelines for the design, evaluation, and supervision of proj- ects for its own use, as well as for the participating financial intermediaries and borrower companies. Over the years, FONEI has maintained a sound financial structure and satisfactory operating results: it showed a 28% return on equity in real terms in 1984, despite an increase of equity's share in its total assets from 4% in 1979 to 45% in 1984; its total assets grew at 6% per annum through 1983, but then began to decline in real terms due to high domestic inflation; FONEI's operation is adequately supervised by a qualified and expe- rienced staff, as shown, for instance, by a low arrearage affecting only 2.7% of its current portfolio--a commendable achievement under current financial and economic conditions in Mexico. 3.08 The Bank has made four loans to FONEI. In addition, FONEI is partici- pating as one of the executing agencies in Bank-supported projects for capital goods development, export promotion, and pollution control. The first two FONEI loans (US$35 million, 1972; US$50 million, 1976) helped to consolidate its institution and establish basic project evaluation capabilities. Building up project appraisal capabilities in the financial intermediaries, however, turned out to be more difficult than expected, and two subsequent operations (US$100 million, 1978; US$175 million, 1979) continued to assist industrial enterprises and commercial banks in these areas. Loan funds financed sound 1 subprojects, according to a project performance audit report (PPAR), and had a substantial foreign exchange and employment impact. Loan Amount and Terms 3.09 A US$150 million loan is proposed, with a maturity of 15 years, includ- ing 3 years of grace, at the Bank's standard variable interest rate. As in previous operations with FONEI, NAFINSA would be the Borrower, as an agent of the Mexican Government; the Government would guarantee the Bank loan. Under contractual arrangements satisfactory to the Bank, NAFINSA would pass on the proceeds of the loan to FONEI, and formal execution of such arrangements would be a special condition of the proposed loan's effectiveness. The Government would repay the principal of the Bank loan and pay interest charges, as a means of building up FONEI's equity, and would also be responsible for the associated foreign exchange risk. The recoveries of the loan and the Government's counterpart resources would be accumulated in FONEI to strengthen its financial base, and FONEI would use these resources for purposes similar to those of the proposed project. Financing Plan 3.10 The project's cost is estimated at a total of US$300 million equiva- lent. The proposed US$150 million loan would finance 50% of the costs of eli- gible equipment and working capital subprojects, which would be committed over 1/ See Report No. 2594 of June 29, 1979.  - 10 - 1986-1990. As the foreign exchange component is estimated at US$125.3 million, representing 42% of total costs, the proposed US$150 million loan would also finance US$24.7 million in local costs. Financing of local costs is justified in view of Mexico's continued difficulty in stabilizing the public sector's fiscal performance. Given the Government's commitment to deep cuts in the 1986 budget, the Bank's increased cost sharing would help keep priority investments on schedule, which is a precondition for sustained growth. The remaining half of project costs would be covered by FONEI, which would, depending on the individual subproject, finance up to 90 of subloans made by financial interme- diaries, as well as from funds provided by the financial intermediaries and subborrowers. Relending Terms and Conditions 3.11 The project would finance technically, financially, and economically sound investment subprojects of industrial enterprises. Subprojects would have to yield financial and economic rates of return of not less than 10% in real terms. Interest rates charged to final beneficiaries would conform to the requirements of GIRA. Equity investments would be expected to yield an after tax return on equity of at least 12% in real terms. FONEI's financing of sub- projects or equity investments by commercial banks would not exceed US$10 mil- lion equivalent, when added to any other subloan or equity investment to the same enterprise. 3.12 On-lending Rate of FONEI to Intermediaries. FONEI would on-lend project funds to financial intermediaries at an interest rate of not less than the average cost of funds to the banking system (ACF), plus one percentage point. This would assure FONEI that it can cover its own financial costs, including interests on its borrowing from the Banco de Mexico, as well as its administra- tive costs in support of the proposed project. Assuming a rational foreign exchange policy over the medium term, this on-lending rate also includes an adequate allowance for the foreign exchange risk to be assumed by the Government. Given the relative openness of Mexico's financial markets and a generally positive ACF since 1983, an interest rate based on this index should, in the long run, be equivalent in real terms to rates prevailing in international financial markets. The proposed on-lending rate is also in line with the marginal financial costs of commercial banks, which are estimated to be above the ACF. 3.13 On-lending Rate of Intermediaries to Subborrovers. The financial inter- mediaries would add to FONEI's on-lending rate an additional spread of at least one percentage point so that the minimum rate to the final subborrower would be not less than the ACF plus 2 percentage points, as provided for in GIRA. The maximum spread that intermediaries could charge on equipment subloans would be 4 percentage points. No maximum would be established for working capital sub- loans. Variable spreads would be introduced by FONEI for the first time, allowing the financial intermediaries flexibility in assessing risks and dif- ferences in creditworthiness, or covering administrative costs associated with individual clients. More importantly, this mechanism is expected to increase competition among the intermediaries who would bear the full credit risk of each subloan made. Linking rates to the ACF is expected to ensure that they continue to be positive in real terms and that they be broadly in line with those charged on other commercial bank lending.  - 11 - 3.14 Repay-ent Mechanism, Haturitles, and Grace Periods. To diminish the cash flow implications of high nominal interest rates, subborrowers, with the agreement of their commercial banks, would have the option of choosing the *traditional- repayment schedule or one based on the PVP scheme. By capital- izing interest payments, this scheme greatly reduces the cash drain on borrow- ers during the early part of the maturities. Consequently, it is likely to induce borrowers to undertake investment projects in the prevailing unfavorable climate of high nominal interest rates. The maturity of investment and working capital subloans would vary from 3 to 13 years and 3 to 7 years, respectively. Equity and quasi-equity investments would have maturities ranging between 5 and 10 years. The maximum grace period would be 3 years for equipment and working capital subloans and 5 years for equity and quasi-equity investments. No grace period wouid be granted under PVP subloans, since the initial payments under a PVP subloan would still be lower than the interest payments during the grace period of a 'traditional' subloan. 3.15 Special Conditions for the Equity Component. To be eligible for financ- ing, equity and quasi-equity investments would have to be used for purposes similar to term credit, including plant improvement or construction, acquisi- tion of equipment, and permanent working capital requirements. Project funds, however, could not be used for the refinancing of existing debt. Equity in- vestments by commercial banks to be financed with loan funds would be restrict- ed to a maximum of 25X of the share capital of any company, and investments exceeding 10% of a company's capital would not be held for more than five years, after which the investing commercial bank would have to reduce its equi- ty holding to below 10Z of the company's total equity. This scheduled reduc- tion would be reflected in the respective subproject proposals and subloan/ investment agreements. The above restrictions not only are in line with cur- rent legislation and would help keep the risks within reasonable limits, but they would also promote a secondary equity market. The risk of equity invest- ments would be borne by the financial intermediary, as FONEI would merely finance the equity holdings according to agreed guidelines, which are reflected in FONEI's revised Operating Regulations. Project Implementation 3.16 FONEI, as the executing agency, would on-lend project funds to partici- pating commercial banks to finance their clients' long-term plant, equipment, and working capital needs, or make equity or quasi-equity investments. Commer- cial banks would be responsible for subproject appraisal and supervision. FONEI would review the documentation submitted by the commercial bank for sub- project approval. It would take some five-and-one-half years to implement the project, and the commitment period for subprojects would end on December 31, 1990. 3.17 Except for subloans made to commercial banks under the equity component, the Bank would not carry out a prior review of subprojects, but would review samples of subprojects costing in excess of US$2 million. Based on these reviews, Bank supervision missions would discuss with FONEI changes in the evaluation procedures, if so required. In case a subloan would not have met agreed eligibility criteria, the Bank would not finance the subproject, and FONEI, if it had withdrawn funds from the project's Special Accournt for the purpose, would be obliged to reimburse the Special Account in tne same amount.  - 12 - The proposed procedure is justified because FONEI has now become sufficiently experienced in subproject evaluation and supervision (para. 3.07) and has a good track record under previous Bank loans. Under the previous FONEI loan (Ln. 1712-ME), the Bank approved every single subproject proposal, which confirms PONEI's appraisal capabilities. However, since FONEI's equity financing program is new, the Bank would have prior review of the first three equity investments, as well as all other equity investments which would exceed 10Z of the company's total capital or US$2 million, whichever is lower. :-ONEI's Operating Regulations, originally developed with Bank assistance, have now been amended to help carry out the proposed project and are satisfactory to the Bank. Procurement and Disbarsement 3.18 Procurement procedures for goods and services financed with loan funds would comply with those customary for industrial development finance opera- tions. FONEI has had extensive experience with these Bank requirements, and it would, during project implementation, ensure the competitiveness of items procured in terms of price, quality, and their suitability for the purposes intended. Consultants financed from the loan would have qualifications and terms and conditions of employment satisfactory to the Bank, and related equipment would be purchased through local procurement procedures which have been reviewed and found satisfactory. 3.19 To simplify management of the loan account, the Bank would disburse against 100% of FONEI's loans to financial intermediaries up to 50% of total investment costs of borrowers. The Bank would disburse to cover 50% of the cost of consultant services, staff training, and related computer equipment. A Special Account with an initial deposit of US$15 million would be established at NAFINSA to finance the Bank's share of FONEI's operations, thus helping prompt project execution. Withdrawals from the loan account would be made on the basis of statements of expenditures, and NAFINSA would maintain all sup- porting documentation and make it available for review upon the Bank's request. NAFINSA would submit to the Bank a monthly statement of the transac- tions of the Special Account. Upon FONEI's request, retroactive financing for up to US$15 million, accounting for 10% of the loan amount, is recommended for expenditures incurred after September 30, 1985. Thin will help bridge FONEI's financing gap between the date when funds under the previous Bank loan (1712-ME) were fully committed and when the proposed loan is expected to be signed. The Government is unable to cover this gap fully because of its fiscal constraints. Accounting and Auditing 3.20 The accounts of NAFINSA and FONEI, including those kept for the purpose of the project, the Special Account, and statements of expenditures, would be audited annually by independent auditors acceptable to the Bank. The audit reports, including an opinion regarding the supporting documentation for dis- bursements based on statements of expenditure, would be submitted within six months after the end of NAFINSA's and FONEI's fiscal year.  - 13 - Benefits and RisLk 3.21 The proposed project is expected to improve the quality and breadth of financial services available to medium and large industrial companies. Aside from providing scarce term financing, the project would benefit Mexico's finan- cial system by introducing a subloan repayment mechanism that is suitable in a high inflation environment. The pilot equity component would enable FONEI to offer comprehensive financial packages, covering the long-term financing needs of its industrial clients. Together with the project's technical assistance program, they would enable FONEI to establish the financial and institutional mechanisms required for in-depth corporate financial restructuring that will have to be addressed through a broader program in the future. By encouraging the financing of equity by commercial banks, this component will make a modest, but significant, contribution to the solution of overindebtedness in industry. Because of their size and intimate knowledge of their clients' business, com- mercial banks are the only viable source of increased equity investment in the immediate future. A lasting solution to the financial problems of enterprises will require the mobilization of savings from other institutions and individuals, and the means for achieving this would be studied under the project's technical assistance component. 3.22 FONEI has developed into a reasonably efficient and mature financial institution. Therefore, the project presents no special risk concerning the soundness of the subprojects financed. However, it may take longer than ex- pected to implement the project if economic recovery is slower than expected or if the Government would slow down its trade liberalization process, tbereby taking off pressure from the enterprises to modernize. In addition, the extent to which commercial banks and their clients will use the new financial instru- ments proposed is uncertain. Although FONEI intends to strongly promote the new PVP repayment scheme, which-at times of high nominal interest rates-is more favorable to clients than the traditional repayment methods, they may be reluctant to respond. The local market for equity is small and relatively undeveloped in Mexico. That is not expected to change fundamentally during project implementation, in part because owners of privately held companies may remain reluctant to allow the recently nationalized commercial banks to hold shares in their companies, if only for a limited period of time. To deal with these uncertainties, the loan size has been set for conservative demand projections, and the US$20 million allocated for equity and quasi-equity instruments is relatively small. If this allocation proves too optimistic, the funds would be reallocated for traditional credit operations. IV. 4.01 During negotiations, agreement has been reached with the Mexican Government, Banco de Mexico, NAFINSA and FONEI on: (a) the project's objectives and the contents of its components (paras. 3.02-3.06); (b) the loan amount, as well as arrangements for channeling the resources to FONEI, repayment of the Bank loan, accumulation of project funds in FONEI (para. 3.09);  - 14 - (_) the financing plan, including the size of the Bank loan and the financing percentage required by FONEI and the financial intermediaries (para. 3.10); (d) onlending interest rates, spreads, maturities, grace periods and maximum amounts for subloans (paras. 3.11-3.15); (e) institutional arrangements for project implementation, including subproject appraisal, supervision and disbursement procedures (paras. 3.16 and 3.17); (f) procurement and disbursement arrangements (paras. 3.18 and 3.19); and (g) accounting and auditing arrangements (para. 3.20) 4.02 It would be a condition of effectiveness of the loan that NAFINSA (in its function as the borrower) and the Government enter into contractual arrangements, satisfactory to the Bank, to transfer the proceeds of the loan to FONEI as the executing agency of the project. 4.03 The proposed project would constitute a suitable basis for a Bank loan of US$150 million with a term of 15 years, including three years of grace.  - 15 - Annex 1 Page 1 of 2 MEXICO INDUSTRIAL RECOVERY PROJECT Summary of the Sistema de Pagos al Valor Presente (PVP) In an inflationary environmant such as that in Mexico, in which high nominal interest rates prevail, long-term lo-_ns, if available at all, have - in real terms - only short maturities. The attached table shows an example which explains this phenomenon as well as two different ways to deal with it - an indexing mechanism and the PVP scheme. - In a regular loan (section 1 of the table), the outstanding balance (column 2) declines with the principal payments (column 3); the interest payments (column 4) are being based on the outstanding principal. Deflating the total annual payments in nominal terms (column 5) with the accumulated inflation rate results in the total payments in constant prices of year zero (column 6). This column does not represent a net present value; rather, it contains an undiscounted cash flow in real termo. In the example, the borrower would, in real terms, have to repay some SOZ of the 10-year loan after three years. Even the introduction of a grace period would not solve the problem; the real maturity of the loan remains short. -An indweng mechanim (section 2 of the table) solves this problem through the adjustment of the principal with an inflation index. Thus the outstanding balance of the loan and, with it, the principal repayments grow with inflation while the interest payments are being based on the real (deflated) interest rate. The distribution of the annual total payments in constant prices is, therefore, as it would be without inflation. - The PEP scheme represents a different solution to the cash flow problem (section 3 of the table). Instead of adjusting the outstanding balance with the inflation rate, it capitalizes interest payments. A loan is being split into its individual maturities; for each of these maturities, interest is being accumulated over time and paid only once the respective maturity becomes due. Thus interest is not being paid on the average outstanding balance in a given period, but is accrued and paid for each maturity individually. As a result, payments in real terms increase slowly and would therefore correspond better to the cash flow of an investment project. To avoid a period without payments for the borrower, a PVP loan does not carry any grace period.  - 16 - MEXICO Annex 1 Page 2 of 2 INDUSTRIAL RECOVERY PROJECT Comparlson of Regular, Indaxed and PVP Loans ASSUMPTIONS Grace Period (Reg. Loan) O Inflation Rate s5z Grace Period (PUP Loan) O Nominal Interest Rate 60S Maturity (Years) 1 Real Interest Rate 7S Year Outstand. Principal Interest Total Real Payment Balance Payment Payment Payment Payment Difference (1) (2) (3) (4) CS) (6) (7) 6 100 S a S 0 0 RE6ULAR LOAN 1 l00 16 60 70 47 0 2 96 10 54 64 28 0 3 86 is 48 58 17 0 4 70 Is 42 52 Is 0 5 66 10 36 46 6 0 6 s6 10 30 40 4 O 7 40 Is 24 34 2 0 8 36 10 18 28 1 0 9 20 Is 12 22 1 0 is 10 10 5 16 a 0 INDEXED LOAN 1 SO 1S is 25 17 30 2 203 23 13 36 16 12 3 270 34 18 52 15 2 4 354 51 24 74 15 -4 S 456 76 30 106 14 -8 6 570 114 38 152 13 -10 7 683 171 46 216 13 -11 8 769 256 51 308 12 -11 9 769 384 S1 436 11 -11 16 577 577 38 615 11 -10 PUP LOAN 1 100 16 6 16 11 36 2 96 10 16 26 11 17 3 80 16 31 41 12 5 4 70 16 56 66 13 -3 5 60 16 95 105 14 -8 6 SO 10 158 168 15 -11 7 40 10 258 268 16 -14 8 30 16 419 429 17 -16 9 20 16 677 687 18 -17 16 10 10 1690 1166 19 -19  - 17 - Annex 2 Page 1 of 2 mEIco INDUSTRIAL RECOVERY PROJECT Nominal and Real Interest Rates 1. The real interest rates in the financial sector section of the SAR compare the movements of the compounded CPP with the inflation rate of the corresponding periods. The calculation is based on the following: - The CPP is the average of the various deposit rates determined by BdM. It does not include demand deposits and savings deposits. The CPP is calculated and published monthly by BdK. - The interest rate and the inflation rate have to cover the same period. For example, to calculate real returns ex post, an Investor would compare the interest income accruing over the life of his investment and compare it to the price increases over the same period. The real interest rate referred to in the financial sector section is the 90-day deposit rate, since 90-day deposits constitute the bulk of all banking deposits. The real interest rate level of, say, July 1984, is then determined by 'discounting' the nominal 90-day deposit rate of that month with price increases from July to September 1984. - Since Mexico uses the simple (European) method to calculate sub-annual interest rates, published deposit rates have to be 'reco pounded to arrive at a meaningful comparator with the respective inflation rate. 2. The table attached to this annex contains, for purposes of comparison, additional calculations of real interest rates to reflect some of the interest payment and charging practices used in commercial banks. - In view of the high inflation rates prevailing in Mezico, many banks pay and charge interest on a monthly basis. Accordingly, the nominal interest rate of a 90-day deposit would then increase in comparison to quarterly interest payments because the depositor can reinvest the monthly interest payment umtil the principal of his deposit becomes due. - For most of the commercial loans, customers have to pay interest on a monthly basis in advance. This payment method is advantageous for the lender, because the advance interest payments can be reinvested over the life of the loan.  - 18 - Annex 2 Page 2 of 2 MEXICO INDUSTRIAL RECOVERY PROJECT Nominal and Real CPP* Rates, 1978-84(Z) 1978 1979 1980 1981 1992 1983 1984 1985 NOMINAL CPP RATES (Annual Averages) Published Rate 15.4 16.4 20.7 28.6 40.4 56.7 51.2 56.1 Quarterly Coup. Rate 15.9 17.1 21.2 30.1 44.0 67.3 64.0 65.1 Monthly Coup. Rate 16.1 17.3 21.6 45.7 45.7 71.1 67.4 68.7 Monthly Prepaid Rate 16.6 17.8 22.3 32.4 49.0 78.8 74.4 75.9 Inflation 15.2 19.2 29.2 28.7 89.5 91.7 61.3 61.4 REAL CPP RATES (Annual Averages) Published Rate 0.1 -2.3 -6.2 0.2 -24.6 -14.7 -5.4 -2.2 Quarterly Comp. Rate 0.7 -1.7 -5.8 1.4 -22.7 -8.5 2.5 3.4 Monthly Camp. Rate -0.7 -1.5 -5.5 1.4 -21.8 -6.3 4.6 5.6 Monthly Prepaid Rate 1.2 -1.1 -4.9 3.2 -20.1 -2.0 8.9 10.2 MONTHLY COMPOUNDED REAL CPP RATES (Annualized) January n.a. -5.4 -13.2 -7.3 -6.1 -43.4 -8.3 -10.7 February n.a. -6.8 -16.5 -8.4 -13.2 -43.8 -6.6 -13.8 March n.a. -8.5 -16.9 -5.5 -15.9 -27.3 -7.0 -12.9 April -13.3 0.9 -5.7 -1.2 -16.5 -10.7 -0.3 2.8 May 2.1 1.5 -2.3 3.1 -21.5 -5.4 5.4 12.3 June 0.8 2.7 -1.5 6.3 -24.4 -0.5 6.0 21.4 July -1.2 1.5 -5.0 8.7 -22.2 5.8 10.4 21.7 August -0.9 1.0 -6.8 6.8 -34.6 8.2 11.6 13.9 September -0.3 0.2 -3.3 5.7 -33.6 11.2 14.8 9.7 October 2.0 -1.5 2.1 5.0 -31.6 17.9 14.1 10.5 November 1.8 -0-6 4.2 6.7 -12.8 8.8 11.2 1l.5 December 3.2 -2.7 -0.9 3.9 -29.8 3.3 4.6 1.4 ____________________________ Calculated for an average maturity of 90 days  - 19 - Annex 3 Page 1 of 4 MEXICO INDUSTRIAL RECOVERY PROJECT Outline for a Technical Assistance Program Institutional Development of FONEI 1. The institutional development program of the industrial recovery project would comprise efforts to increase the effectiveness of FONEI's promotion, training to develop financial engineering and restructuring skills, and improvements in the management information systems. 2. Promotion. In the future, FONEI would concentrate on medium to large, privately owned companies that are internationally competitive, have promising growth prospects and aim at increased exports. To improve the effectiveness of its promotion efforts in this target group, FONEI would implement a promotion program consisting of the following steps: - Build-up pro otion data base. Since the number of target ccmpanies is sufficiently small, FONEI would, with assistance of company data collected by BdM, establish a promotion data base, containing for each of the target companies (i) operational data such as sector and export performance; (ii) financial performance data such as balance sheet and income statement (available from BdM); (iii) customer relationship data such as past FONEI loans and number of promotional visits by FONEI and/or the responsible 'asesor industrial" in the respective commercial bank; (iv) promotional data such as names, addresses and telephone numbers of important executives, and the main commercial banking serving this company. - Design relatiousbip _mnagement program wLth rcial banks. To concentrate its scarce icanpower resources, FONEI would assign, using the information contained in the data base, promotion priorities for each of the target companies, applying criteria such as the company's growth prospects, its investment plans, its export possibilities, and its technology development plans and prospects. Based on these priorities, FONEI would, together with the respective commercial banks, design and implement a relationship management program for its target clients, consisting of (i) promotion responsibilities assigned on a company by company basis; (ii) a more detailed analysis of the company's financial needs; and (iii) a field visit program. - Monitor prootion effectiveness. The success of the promotion program will, to a large extent, depend on the monitoring of the promotion effectiveness and the taking of corrective measures. A monitoring program would (i) keep track of promotion efforts (such as visits) by FONEI and commercial bank staff; (ii) check to what extent promotion efforts result in the generation of projects and loans; and (iii) decide periodically on the continuation, strengthening or termination of the promotion efforts in an individual company.  - 20 - Annex 3 Page 2 of 4 3. The preceding program would be complemented through training of, and fellowships for, FONEI's promotion staff. Therefore, the project's technical assistance component would include funds for consultant services and the costs of fellowship programs. 4. Fin ncial Engineering and Res tucturing. To develop institutional skills in financial engineering and restructuring, FONEI would design and implement a training program for its promotion, credit analysis and supervision staff. The program would focus on company diagnosis in fields such as strategy, finance, operations, and organization, and it would include techniques in the use of a broad variety of financial instruments such as commercial credit, bonds, equity and quasi-equity. The program would finance internal and external training programs and fellowships in other financial institutions. 5. System Development. To improve available management information, especially in financial planning and control, the project would help finance consultant services and the purchase of computing equipment for the design and implementation of a comprehensive management information system. Analysis of Financial Markets 6. The analysis of financial markets would consist of a study on the long-term financing needs of industrial companies, and of studies analyzing the development of the equity, quasi-equity, and long-term bond markets. 7. Long-term Financing Needs of Industrial Interprime.. As a result of the recent economic crisis, the financial situation of many industrial companies has drastically deteriorated. Of particular concern is the high debt leverage, the unfavorable debt maturity structure, and the high financial costs that many enterprises face. The objective of this study would be to determine the extent and the structure of this problem and to identify future finaucing needs of the industrial sector. The study could make use of BdM's data base containing financial information of industrial companies. In particular, the study should answer the following questions: - What is the extent of the financial problems in the industrial sector, and which companies are mainly affected by these problems? - To what extent do balance sheet figures differ from the actual financial structure of a given company as a result of asset revaluation problems? - Are the financial problems of the industrial sector minly a result of -external' factors (e.g., peso devaluation), or were they caused by imprudent financial management of the affected companies? - What is the extent of equity and long-term debt needs of the industrial sector? 8. Equity amd and Quasl-Equity Nerket. The institutionalized supply of equity and quasi-equity has generally remained limited and has largely been  - 21 - Annex 3 Page 3 of 4 restricted to -blue chip' companies. The objective of the equity market study would be to analyze the current size and structure of the market and identify future development issues. In particular, the study should address the following questions: - What is the structure and the size of the institutionalized equity and quasi-equity market, who are the main users, suppliers and intermediaries, and which are the main equity and quasi-equity instruments being used (e.g. common and preferred stock, subordinated and conditional loans, convertible bonds)? Which legal restrictions have to be taken into account when using the various equity and quasi-equity instruments? - What are the constraints to a wider use of institutionalized equity markets (e.g. stock exchange, mutual funds, venture capital funds, private placements to institutional and individual investors)? - What are the roles of the private and the public sectors in the mobilization of additional equity after the recent enactment of new financial sector legislation? - Is the placement power of casas de bolsa and commercial banks sufficient to handle an increased market volume of the stock exchange or private placements? - To what extent does the existing legal framework (in particular, the taxation differential between dividend and interest income) promote the mobilization of additional equity; to what extent does it provide a disincentive? 9. Bond Narket. Until now, the bond market has remained small and has not developed into an effective complement of commercial credit supply. The objective of the bond market study would be to analyze size and participants of the market and to identify the issues that are restricting a wider use of bonds by industrial companies. In particular, the study would focus on the following questions: - What is the current size of the bond market, who are the main users, investors and intermediaries, what are the main characteristics (amounts, maturities, interest rates, fees for management, underwriting and selling) of recent bond issues? - Does the use of bonds offer cost advantages (e.g., administrative costs, opportunity costs of equity, risk premium) or financial advantages (e.g., maturity structure) over the use of long-term commercial credit to the issuing company? - Is the placement power of casas de bolsa and commercial banks sufficient to handle an increased market volume?  - 22 - Annex 3 Page 4 of 4 - To what extent are bonds being viewed by institutional and personal investors as 'acceptable' investment instruments? - To what extent does the current legal and regulatory framework promote the use of bonds for industrial financing, to what extent does it provide a disincentive? Implementation of the Technical Assistance Program 10. As executing agency of the project, FONEI would be responsible for the implementation of the technical assistance program. FONEI would prepare detailed terms of reference for the training programs of its staff and the studies covering financial market issues, and it would submit the terms of reference to the Bank for approval prior to hiring consultants. Once the terms of reference are approved, FONEI would hire the consultants and supervise study implementation. Upon completion, FONEI would submit a final report of the studies carried out under the technical assistance program to the Bank. The timetable for the implementation of the technical assistance program is as follows: - To ensure speedy implementation of the project's credit component, the promotion program would receive top priority in the timing of the technical assistance program. By the end of September 1986, FONEI would prepare a detailed timetable for the execution of the promotion program along the lines spelled out in paras. 1 to 3, including terms of reference for consulting services and promotion staff training. At the same time, FONEI would start building up the promotion data base, which should be completed not later than December 1986, and it would also hire consultants and organize the fellowship programs so that the implementation of the promotion program can start in January 1987. - The program for staff training in financial engineering and restructuring would be prepared during the third quarter of 1986 by FONEI's training department; the implementation of the program would take place in 1987/88. - FONEI has already started preparation of its system development program; it has carried out a feasibility study for improvements in the computer support of its information systems and it has begun a discussion of the results of the study with its technical committee. By September 1986, FONEI would prepare detailed terms of reference for a comprehensive information system development plan, which should indicate the various modules of the future information system as well as the hardware and software requirements for its implementation. Consultants for the implementation of this plan would be hired during the last quarter of 1986, so that the system could be designed and developed during 1987. - The terms ot reference for the financial market studies would be prepared until September 30, 1986. Until December 30, 1986, FOhEI would hire consultants; the studies would be carried out starting January 1, 1987.  - 23 - Annex 4 Page 1 of 8 MEXICO INDUSTRIAL RECOVERY PROJECT Operations of the Fondo Nacional de Equipamiento Industrial (FONEI) 1. Founded in 1971 as a semi-autonomous department of the Banco de Mexico, FONEI has become an important source of industrial term lending in Mexico, highly regarded by the commercial banks and the private sector. Today, FONEI is administering a wide variety of industrial financing programs, and it has become an important source of technical assistance through external training programs covering project analysis and supervision. In addition, FONEI has developed detailed guidelines for project design, evaluation and supervision for its own use as well as that of participating financial intermediaries and benefiting companies, thus ensuring adequate preparation, selection and implementation of financed subprojects. Financial Performance 2. Profitability. Until now, FONEI has demonstrated a good financial performance and maintained a sound financial structure. Even after allowing for inflation, operating profits increased steadily over the last six years. In real terms, FONEI's return on equity increased from 41% in 1979 to 138Z in 1981; then, however, it fell to only 8Z in 1983 as a result of the high inflation rates during this period, and recovered to 28% in 1984. The main reason for the good performance is the favorable interest rate structure of FONEI s balance sheet. While succeeding in replacing low-yielding fixed rate assets through variable rate assets whose interest rate is tied to the CPP, FONEI'S liabilities have been, until now, dominated by low-cost, fixed rate refinancing instruments such as the Banco de Mexico bonds and previous Bank loans. 3. In the future, however, the mismatching profits of previous years will decline. The net interest income will decrease because favorable fixed rate liabilities, maturing over the next year, will have to be replaced by more expensive variable rate refinancing instruments. In addition, the devaluations of 1982/83 have also increased the costs of external borrowing and will continue to have a negative profitability effect in the future. To maintain its favorable financial performance, FONEI intends to increase its lending rate to the commercial banks to at least CPPI1 to cover its own opportunity costs of funding and its administrative expenses. In addition, the Government has agreed to finance subsidies of the technology development program through direct budget appropriations. 4. Arrears. The participating commercial banks are responsible for making principal and interest payments to FONEI on time, whether or not they receive payment from their industrial clients. FONEI, therefore, does not show any subloans in arrears and makes no provision for possible losses in its lending operations. However, as part of its supervision requirements, FONEI asks the financial intermediaries to submit periodic reports on the status of subloan payments in arrears. These reports show that subloans in arrears as a percentage of FONEI's total loan portfolio have been maintained at a rather reasonable level, notwithstanding the increase from 0.7% in 1982 to 1.8% in 1983 and 2.7% in 1984.  - 24 - Annex 4 Page 2 of 8 5. Asset and Liability Structure. The structure of assets and liabilities changed substantially over the 1979-1984 period. On the asset side, investments in Government bonds, reaching a peak of 11% in 1980, are down to a mere 1% of total assets; all available resources are now invested in the loan portfolio. On the liability side, domestic funding, originally representing soae 50% of total assets, declined to only about 10Z in 1984. Funding through Bank projects also declined from 431 in 1979 to 34% in 1984. The share of equity, on the other hand, increased from 4% in 1979 to 45% in 1984. The main reasons for this increase were the Government's policy to capitalize the repayment obligations of the Bank loans and the complete retention of FONEI's current profits. 6. Portfolio Growth aud Composition. The economic and financial crisis also impacted the level of FONEI's operations. After strong growth in the late 1970s and early 1980s, FONEI's expansion came to a halt; in real terms, the balance sheet size even decreased in the last two years. While total assets grew by 34% in real terms from 1979 to 1980, real growth was limited to merely 6% in the following two years. In 1983 and 1984, total assets declined by about 25% per year in real terms, while the level of new commitments, measured in constant prices, declined in 1984 to only 25% of the peak in 1981. For the future, however, FONEI is expecting an increase of its commitments in line with the ongoing industrial recovery. Lending Strategy 7. Traditionally, FONEI has focused on the supply of long-term financing to medium to large companies, leaving the financing of smaller companies to other Fideicomisos such as FOGAIN. In addition, FONEI views itself as a private sector-oriented institution that finances primarily companies that are privately owned or have a majority private ownership. In all of its operations, FONEI acts as a second-tier institution, rediscounting loans of comercial banks, to take advantage of the banks' existing customer portfolio and lending experience while avoiding unnecessary duplication of efforts. While FONEI has achieved a high degree of operating efficiency, it remains a passive rediscounting window for long-term project financing. To play a more active role in industrial sector development, FONEI intends to broaden the scope of its financial assistance and the variety of the financial instruments it offers. In addition, it inter.ds to amend its current price policy, terms and limits of financing as well as its current risk policy. 8. Product Line. In the past, FONEI has concentrated on equipment- financing through long-term loans, which, together with lending for capacity optimization, accounted for more than 75% of commitments. Other assistance programs such as technology development and working capital financing have begun only recently and represent only a tsmall, yet growing proportion of FONEI's overall operations. In the future, FONEI would like, with the support of the proposed industrial recovery loan, to place more emphasis on the design of integrated financial packages for a company as a whole rather than o01 the financing of discrete equipment investments. Consequently, FONEI intends to broaden its product line with respect to both the expenditures eligible for financing and the financial instruments used.  - 25 - Annex 4 Page 3 of 8 9. As a new program, FONEI would introduce the financing of working capital investments, and it would substantially upgrade, with the support of the Bank, its efforts in the financing of technology development. In addition, FONEI would offer long-term loans to financial intermediaries which, in turn, would use the funds for equity or quasi-equity investments. To help companies with promising investment projects, but without sufficient collateral, FONEI intends to offer, on a trial basis, a limited number of loan guarantees. To counter the adverse cash flow effects of high nominal interest rates, FONEI would introduce PVP as an option to industrial borrowers. 10. Price Policy. After charging fixed interest rates on its portfolio in the initial years of operation, FONEI moved to a system of variable interest rates based on the CPP under the second Bank-supported FONEI loan. Today, the bulk of PONEI's portfolio carries CPP-related interest rates; only a few old loans are still based on a fixed interest rate. Initially, FONEI's equipment loans were made at CPP+2, based on the General Interest Rate Agreement (GIRA) with the Bank. In 1984, however, FONEI increased its equipment lending rate to CPP+5 because of increases in market interest rates. This rate is currently competitive with co mmercial lending rates. For other programs, the intermediaries charge subsidized rates: CPP-3 for technology development; CPP for pollution control; and CPP-3 for pre-investment studies. 11. Terms and Lidits of Financing. Under its current operation regulations, FONEI can lend up to 3% of its assets for any single project and up to 5% to any single company. For projects of high priority, FONEI's technical conuittee (its highest decision-saking body) can authorize higher amounts, subject, however, to the approval of the Ministry of Finance. Loan maturities and grace periods are being determined based on the characteristics of the project to be financed. The maxinm maturity for any loan is 13 years. In their previous form, the operating regulations limited FONEI's financial participation to some 70Z of the costs of a subproject, while the remainder was to be contributed by the financial intermediary and the final borrower. This regulation, however, has recently been changed to allow for cases in which a company is underleveraged". As a result, FONEI's financial participation now depends on the situation of the particular company and the project to be financed, and it can be as high as 90% of total project costs. 12. Risk Policy. In its traditional lending areas (e.g., equipment) FONEI has limited itself to the funding of investment projects without assuming the default risk, which rests entirely with the respective commercial bank. In only a few exceptional cases has FONEI assumed the default risk to ensure implementation of priority projects which did not have collateral sufficient for traditional commercial bank credit. FONEI offers credit guarantees of up to 90% of a loan otly under its technology development program, aiming primarily at smaller firrs that do not have sufficient collateral. In the future, FONEI intends to maintain this risk policy for its equipment lending. However, it intends to broaden its risk lending in technology development under the Bank-supported technology development project (appraised in August 1NS), and it also intends, on a test basis, to offer credit guarantees for investment projects that do not meet the collateral requirements of comercial banks.  - 26 - Annex 4 Page 4 of 8 Business System 13. Over the years, FONEI has developed a business system that is largely meeting current requirements of FONEI's strategy. The main elements of the business system - promotion, subproject appraisal and supervision, and external training programs - have, in the past, been sufficient to support FONEI's role as a largely passive rediscounting mechanism of long-term financing. However, given FONEI's strategic shift from passive rediscounting to more active financial engineering while delegating typical banking activities to financial intermediaries, the business system will have to be adjusted, especially in the areas of promotion and subproject processing. 14. Promotion and Acquisition. FONEI's management recognizes that adequate promotion is one of the critical prerequisites for the successful supply of financial services. In the early stages of FONEI's institutional development, all promotion activities were concentrated in a separate organizational unit; today, promotion is the responsibility of one of FONEI's departments (subdireccion de promocion). The department is staffed with five professionals. In its promotion activities, FONEI focuses mainly on Hexico's industrial centers around the capital and the cities of Monterrey and Guadalajara, where it has established regional promotion offices. The existing external training programs that FONEI offers to banks and companies complement the direct promotional activities. In these programs, staff of potential clients and financial intermediaries not only familiarize themEelves with the techniques of project appraisal and supervision, but also get a. comprehensive picture of what FONEI does and what it can offer. In addition, FONEI keeps a record of all ex-participants of its courses and circulates a monthly sumnry of its activities to this group. Ex-participants who have been promoted within their organization are being put into a special register for reference and special promotion activities. 15. About 50% of the professional staff time available for promotion is being used for -field activities' such as company visits and promotional seminars. In these field activities, FONEI has tried to leverage its limited promotion capacity to the extent possible, restricting the tire used for direct company visiti (5% of available staff time) while focusing primarily on visits to commercial banks (25%) and industrial associations (20%). In addition, the promotion staff provides initial guidance in the preparation of the required documents to companies applying for a loan. However, whether the strong tilt toward -wholesale promotion" has paid of-" remains questionable. While FONEI has developed excellent relationships with many of the commercial banks and private sector organizations, only some 20% of all projects are being identified through these channels; the remaining 80% of the projects result from direct company applications. 16. To improve the effectiveness of its promotion efforts in its target group of medium to large private industrial companies, FONEI has recently introduced a program of "industrial advisers" in commercial banks. Under this program, FONEI pays part of the salary of the adviser and receives, in return, staff time of the adviser for project promotion and preparation. Under the project, FONEI would implement additional measures in promotion and staff development, including the establishment of a promotion data base containing  - 27 - Annex 4 Page 5 of 8 important company data of target clients, design of a relationship management program together with the commercial banks, and monitoring of promotion effectiveness (Annex 6). 17. Subproject Preparatilon and Appraisal. By now, FONEI has become an experienced institution in project finance and is training financial intermediaries as well as companies in preparing, evaluating and supervising investment projects. As a result, its process of preparing and appraising subprojects is well developed and meets Bank standards for subproject evaluation. The criteria being applied for the evaluation of subproject applications include all standard Bank requirements and are considered sound. Over the years, FONEI has, in its daily practice with the Bank, also developed adequate reporting formats to be submitted to the Bank for subproject evaluation. 18. Originally, FONEI was almost exclusively responsible for evaluating subproject applications, receiving little help from the respective financial intermediary. In recent years, however, the distribution of responsibilities between FONEI and the banks has changed. At FONEI's insistence, the banks are now assuming an increasing role in the preparation and appraisal of subprojects. To stimulate their participation, FONEI iP offering the intermediaries an additional spread of 0.25% for a project appraisal. 19. The typical preparation and approval process of a subloan application takes about four months. FONEI requires about one week for the initial review of an application, mainly to determine the eligibility of a subproject for FONEI financing. After the initial review, in which the outline of a feasibility study and the information requirements for the approval process are also being discussed with the enterprise and the financial intermediary, the company typically needs about two months to prepare the required feasibility study - either alone or with the help of a consultant. FONEI then needs about another 1.5 months to process the application. The length of the process as a whole is comparable to commercial banking practices and has not emerged as an issue with FONEI's customers. 20. However, to speed up the subproject appraisal process and take advantage of the increased appraisal and supervision capabilities of many of the commercial banks, FONEI would simplify its appraisal and supervision process and delegate more responsibilities to participating intermediaries. In particular, FONEI would take the following measures: - If the subproject appraisal has been carried out by a project evaluator who has participated successfully in FONEI's training programs, FONEI would receive only a summary evaluation from the intermediary. Full docume-itation (appraisal report, feasibility study) would be required in other cases. - Subloans of less than about US$1 million would be approved within FONEI by an internal loan committee; only larger subprojects would be submitted to FONEI's technical committee for approval.  - 28 - Annex 4 Page 6 of 8 - Under the project, PONEI would calculate an economic rate of return for all subloans in excess of US$1 million. A financial rate of return would be calculated for all subloans, except for working capital subloans below US$1 million. 21. Subproject S.pervisiom. As in project appraisal, FONEI's supervision process also meetq Bank requirements for DFCs. Currently, FONEI's supervision portfolio comprises some 400 projects. Not ail of these projects, however, are being actively supervised; rather, FONEI is concentrating on projects with implementation probleus, leaving the supervision of problem-free projects to the respective financial Intermediary. The iatermediary, ln turn, is to submit to FONEI a supervision report of all subprojects every six months. The supervision process would also be simplified in the future. The main improvements would include reduced general reporting requirements for smaller subprojects and reduced supervision of problem-free subprojects after an initial period. 22. External Tralning Progra . In addition to its financial assistance, FONEI has become, over the last years, an important source of training for financial intermediaries, industrial companies and consultants In the preparation, appraisal and supervision of Industrial investment projects. The training courses - initialny two weeks, with subsequent refresher courses of three days each four times a year - are aimed at qualified professional staff of banks, companies and consulting firms. The largest group of participants comes from the banks: over the five years of training activities of FONEI, some 1,100 banking employees, about 300 company employees, and about 120 consultants have participated in the courses. Institutional Profile 23. The future strategy would also require changes in FONEI's institutional setup. The organizational structure would have to be amended to allow for the increasing importance and particular characteristics of technology financing. The managewent information systems would have to be upgraded to the future requirements of financial management and promotion, and the personnel policy would have to secure high-quality personnel within the salary restrictions of BdM. 24. Organizational Structure. FONEI's highest ranking decision-making body is its technical committee,composed of high level Government officials from the Ministry of Finance, BdM, the Ministry of Planning, NAFINSA, the Ministry of Commerce and Industrial Development, and industrial chambers. The technical committee meets once a month; its responsibilities include the approval of its operating rules and regulations, the appointment of FONEI's general director, and the approval of individual loans. For technology subprojects, the technical committee has delegated most of its authority to a special subcommittee, that includes officials from a number of research institutes, private sector representatives and Governument ministries. FONEI is managed by a director; it is organized into four departments, covering promotion, project evaluation and supervision, external training, and administration.  - 29 - Annex 4 Page 7 of 8 25. Management Infoxmation System FONEI's current information and accounting system is still in its early stages of development. While basic data are now available on computers, evaluation and processing tools are still rudimentary and do not allow a comprehensive and decision-oriented evaluation. Much of the preparation process in financial planning and control is still being done manually, and some important planning data (e.g., financial projections, interest structure of assets and liabilities) are not readily available. BdM's Univac mainframe offers only Fortran and Cobol; advanced languages or more sophisticated application modules are not available. In addition, FONEI enjoys only low priority on the mainframe and can therefore often not access the existing information. As a result, the application of EDP for information retrieval and processing has been limited. 26. FONEI recognizes that improvements in this area will be necessary; to overcome these problems, FONEI intends to expand its EDP hardware and software capabilities substantially in the immediate future. The centerpiece of its future EDP equipment would a be minicomputer, which would give FONEI adequate mainframe support for the bulk of its operations. In addition, FONEI plans to strengthen its project evaluation capabilities through additional microcomputers with ready made software. 27. Personnel Planning and Development. Traditionally, FONEI has attempted to build up a highly qualified and experienced staff of senior professionals for a}l of its operations. It has emphasized the necessity of offering competitive salaries and providing adequate career prospects to its professional staff. In its recruitment efforts, FONEI has not only focused on current employees of BdM and university graduates, but it has also attempted to recruit an increasing number of qualified professionals from outside. However, given salary restrictions within BdM and limited internal career prospects, FONEI has had difficulties competing with the private sector and the commercial banks in personnel recruitment and retention. 28. In recognition of these constraints, FONEI is currently reviewing its recruitment and personnel management strategy. While it will be impossible in the future to compete effectively with commercial banks and the private sector, FONEI can position itself as an att.tactive first employer for outstanding university graduates who are interested in a long-term career in projezt financing. In this role, FONEI can offer excellent on-the-job training and good connections to prospective future employers within the private sector. An average employment period of about five years would be commensurate with this approach, ensuring not only that sufficient experience is being built up but also that FONEI can -- at least for a period of two to three years - take advantage of its original training input. Future Operations and Funding Requirements 29. Projected Cbmmtments. Since the industrial sector, as well as the economy as a whole, is only slowly recuperating from the 1982/83 crisis, it is unlikely that industrial investment and, thus, long-term financing needs will, in the near future, reach the levels of the early 1980s. Nevertheless, a recovery process is in place and has led to increasing commitments under FONEI's  - 30 - Annex 4 Page 8 of 8 lending programs as well as to a strong pipeline of projects under consideration by FONEI and the commercial banks. In addition, the possibility of working capital financing is expected to result in additional demand for FONEI's resources, especially considering the declining liquidity levels in uany companies over 1985. 30. FONEI estimates that its total annual commitments will grow from Mex$ 26 billion in 1985 to Mex$ 51 billion in 1990 (constant terms), equivalent to an annual growth rate of 15% in real terms. While the equipment lending program is expected to show moderate growth after an initial recuperation period, the working capital program is likely to show the highest growth rates in the initial years, given current financial needs of the industrial sector. In addition, the technology development program, including the commercialization of technologies, is expected to grow rapidly over the next few years, especially after the process of import-liberalization has begun. 31. Funding Requirements. Assuming a Bank participation of 50Z in FONEI's future commitments under the proposed industrial recovery project, FONEI would require, in addition to its internal resource generation, about US$70 million to carry out the lending program envisaged in its financial projections. This program assumes that the use of PVP loans would increase from 50% of total commitments in 1985 to 80% of commitmento in 1987, and that all loans under the pilot equity component, as well as all loans under FONEI's technology development lending program, would be based on the PVP repayment mechanism. In addition, the program assumes that, as agreed to between the Bank and the Government during appraisal of the proposed technology project, subsidies planned under the technology development program would be transferred directly to FONEI and would not have to be financed out of FONEI's internal resource generation. 32. Projected Financial Results. Under the above assumptions, FONEI's assets are expected to grow from Mex$ 36 billion at the end of 1984 to Mex$ 116 billion (constant terms) at the end of 1989, implying an annual compound growth rate of 20% in real terms, which does not appear excessive given the reduction of the balance sheet in previous years and the expansionary balance sheet impact of the PVP-Loans. Net profits are expected to grow from from Mex$ 4 billion in 1985 to Mex$ 18 billion in 1989. With these profits, FONEI would achieve a return on assets of about 122 and a return on equity of about 14% in real terms. Thus, FONEI's financial structure is expected to remain sound over the forecast period. Auditing 33. In line with Bank requirements, FONEI has submitted to the Bank its audited financial statements within the six months time limit (except for a three months delay in 1983). The audits, carried out by the accounting firm Alfonso Ochoa Ravize, did not contain any qualifications.  - 31 - Annex 5 Page 1 of 4 MEXICO INDUSTRIAL RECOVERY PROJECT Experience with Past Lending 1. The Bank has made four loans to FONEI. In addition, FONEI is participating as executing agency in Bank-supported projects for capital goods development, export promotion and pollution control. The first two FONEI loans (US$35 million, 1972; US$50 million, 1976) helped to set up FONEI and establish basic project evaluation capabilities within the institution. Bank funds available under these loans were allocated to sound subprojects (according to the project performance audit report) and had a substantial foreign exchange and employment impact - albeit lower than originally forecast. Improving the project appraisal capabilities of participating financial intermediaries, however, turned out tc be more difficult than expected. As a result, the following two operations (US$100 million, 1978; US$175 million, 1979), in addition to providing scarce long-term resources for industrial investment, focused on improving the project preparation and appraisal capabilities of industrial companies and commercial banks. The experience under these loans, as it relates to subproject characteristics and performance, is discussed in the following paragraphs. Portfolio Distribution 2. FONEI offers nedium- to long-term financing through a wide variety of programs. An Industrial Equipment Program (65Z of 1984 commitments) offers financing for the establishment of new, or the expansion, modernization, or relocation of existing, enterprises. Through a component included in the Bank supported Capital Goods Development Project, FONEI has also begun to offer working capital financing (7%) for capital goods industries. A Technology Development Program (13Z), established under the FONEI IV project, offers financial assistance for technical research and adaptation of new processes and products. Other resources are available for capacity optimization (IIZ), and preinvestment studies (1%). The Bank-supported Pollution Control Program (1%) is aimed at companies located in zones of dense industrial concentration. A Special Program (3X), providing emergency liquidity assistance, was initiated in response to the economic and financial crisis in 1982/83 and is now terminating. 3. Customer Foeos. In line with FONEI's focus on medium to large enterprises, the largest portion of FONEI's financial resources is being committed to a smaln number of sizable enterprises. For example, 70Z of the 1984 commitments of FONEB'a industrial equipment program went into only 15 loans, each of a size larger than Nex$175 million, representing about one-third of all loans m*de during this perio-1. The remaining 30% of the commitments were more equally distributed in smaller operations. The average subloan size, however, decreased in real terms throughout the 1979-84 period, and represented, In 1984, only 25Z of the 1979 figure. About one-third of FONEI': clients are new enterprises, while the remaining two-thirds are existing companies requiring financing for the expansion of their production. State-owned companies play  - 32 - Annex 5 Page 2 of 4 only a minor role in FONEI's activities; only 6X of the number of subloans, representing 8% of the total subloan amounts, were made to publicly owned companies in the period of 1980-1984. 4. Sectoral Distribution. Traditionally, the metal products and machinery sector and the secondary petrochemicals sector have been the largest recipients of FONEI lending, accounting for more than 50% of the commitments for most of the years. In 1984, for example, commitments to the metal products and machinery sector reached 27% of total comitments; commitments to the secondary petrochemical sector were 25Z of the total. Other important sectors include non-metallic minerals (13%), basic metals industries (12%), and textiles (10%). Producers of intermediate goods represented the largest share of FONEI's customers, accounting for 72% of 1984 commitments, while capital goods producers accounted for only some 12% of 1984 commitments, down from 49% a year earlier. 5. Regional Focus. The regional compoeition of FONEI's portfolio closely follows the pattern of industrial concentration in Mexico. The largest proportion of its lending program (20% of 1984 commitments) is being channeled to the province of Nuevo Leon, which contains the industrial center of Monterrey. The second most important area is Mexico City and its surroundings (17%), followed by Jalisco (8Z), Tlaxcala (7%), and San Luis Potosi (7%). Together, these regions account for almost two thirds of FONEI's lending program. 6. Financil Intermediaries. Although all of Mexico's commercial banks are eligible to participate as intermediaries, FONEI's lending activities are concentrated within a small group of banks. Five banks (Banco Internacional, BANFAIS, BANCOMER, NAFINSA, and BANCOMEXT) accounted for more than 50X; 11 banks, for more than 90% of total commitments in 1984. Banco Internacional, a medium-sized bank by Mexican standards, was, with a share of almost 15%, the most active financial intermediary in 1984. The remaining 10% of total commitments were distributed among smaller regional banks. 7. Loan Naturity. Most of the new loans have a maturity between four and seven years; 82% of the 1984 commitments fall into this category. Only 4% of the 1984 commitments had a maturity of less than four years; 14% of the new loans had a maturity of seven to ten years. 8. Financial Composition. Although FONEI could finance up to 75% of an investment according to the past operating regulations, its financing share in the subprojects in which it participated has been about 30% over the last few years. The borrowing company has, on average, contributed 25-30%, and financial intermediaries have contributed another 20-25% of total project costs, including associated working capital requirements. The remaining funds were contributed by other sources such as suppliers' credits or intercompany borrowings. While domestic intercompany lending is likely to continue playing a role in project financing, the availability of foreign suppliers' credits has declined sharply. As a result, FONEI expects to finance an increasing share of the investment costs in the future.  - 33 - Annex 5 Page 3 of 4 Subproject Performance 9. FONEI financed subprojects - as the industrial sector in general - were affected by the economic crisis. Because of sharply increasing inflation and the slump in domestic demand, a substantial number of investment projects suffered from cost overruns and unsatisfactory sales, leading to diminished financial and economic rates of return. The contribution to the balance of payments and employment creation, on the other hand, has been satisfactory. 10. Rturn 05 Ian *atint mmd Company Profitability. According to the financial and economic rates of return that were calculated during subproject appraisal, FONEI is financing economically and financially sound investments. For example, the average financial rate of .eturn (FRR) of the subprojects authorized in 1984 was 36Z; the average economic rate of return (ERR) was 60X. FONEI has also calculated ex-post financial rates of return of a sample of 20 subprojects approved in previous years to assess the actual performance of company investments. According to this sample, two-thirds of the companies reported FRRs below the originAl projected rate; one-third, above original projections. The average actual FRR was 17Z, 3Z below the average rate of 20% that was originally projected. The actual ERR is likely to exceed the actual FRR, given the above difference between the projected rates. 11. The economic and financial problems facing the industrial sector as a whole have affected both the actual investment costs of the subprojects (through increasing inflation) and the sales performance (through declining domestic and international demand). Cost overruns were common throughout the 1981-1984 period but did not exceed domestic inflation: they were moderate for projects supervised in 1981 (13% over original cost estimate), and they increased to a level of 62Z over the original cost estimate in 1984. The sales performance followed the development of the general economic situation: in 1982, actual sales remained 21% below projected sales (constant prices), and in 1983, this difference increased to 44%. In 1984, however, the situatirri improved; actual sales were only 26% below their projected level. The impact of the general economic conditions becomes especially apparent when analyzing the current profitability situation of FONEI's clients with ongoing projects: in 1981, only 15% of the borrowing companies experienced losses; by 1983, this figure had risen to 44%; and, in 1984, it declined only marginally to +2%. In contrast, in 1981, 39% of the borrowing companies reported profits as projected or above; in 1984, only 19% of the companies were performing as well as projected or better. 12. Bal mce-of-Payments Impact. "I^ number of export oriented projects, and with it the amount of funds committed for this purpose, has increased substantially in the last two years, in line with the general upsurge of Mexico's industrial exports. In 1984, 57% of commitments under the equipment financing program were for export-oriented projects, up from 34% in 1984 and only 14Z in 1982. However, the actual export performance of the subprojects financed has lagged substantially behind expectations at the time of subproject appraisal. According to a sample of 40 companies, only 10 companies met or exceeded the projected export targets; on average, only 60X of the expected exports materialized.  - 34 - Annex 5 Page 4 of 4 13. Eiployinnt Creation. FONEI-financed subprojects had a substantial employment impact. In 1984, for example, FONEI-financed subprojects helped create a total of 27,000 jobs. In 1981/82, the number of jobs created initially exceeded projections during subproject appraisal, but then fell below expectations, mainly because of the impact of the economic crisis. 14. As a result of these problems, FONEI's subproject evaluation process w.ll have to focus more on the viability and the competitiveness of the company as a whole, going beyond the limited subproject focus. The proposed project will therefore emphasize the development of adequate know-how and expertise in corporate strategy, marketing and market assessment as well as finance to improve FONEI's appraisal capacity. Disbursement Speed 15. While the previous FONEI loans have achieved many of their institution- building objectives, the disbursement speed has only partially met original expectations. The first of the FONEI loans experienced a startup delay of more than one year because of managerial problems, lack of promotion, and high liquidity in the banking system. As a result, commitments were spread over a five-year period; disbursements required six years, and the closing date had to be postponed four times. FONEI II and III were committed and disbursed more quickly, largely in line with appraisal estimates. FONEI IV, however, required six years for commitments and has been fully disbursed only recently. One of the reasons for the slow implementation speed has been the impact of the economic crisis, resulting in a sharp decline of industrial investment and demand for investment financing. In addition, FONEI's limited scope of financial instruments and insufficient promotion efforts have contributed to these problems. 16. To ensure a better disbursement performance of the proposed new operation, special emphasis would be placed on the comprehensiveness of FONEI's financial assistance program and on adequate promotion activities. The inclusion of freestanding working capital financing into the proposed project is in line with the current financial needs of many industrial companies, as was demonstrated by the recent commitment performance of the Bank supported Capital Goods Project, which included such financing. Moreover, the introduction of the new PVP repayment mechanibm, which alleviates the negative cash-flow impact of high nomina'l interest rates, is expected to stimulate demand for project funds. Also, the lack of previously available external financial resources is expected to increase demand for funds under the loan. Particular emphasis would be placed on program promotion, to which a portion cf the technical assistance component would be devoted.  - 35 - Annex 6 Page 1 of 2 MEXICO INDUSTRIAL RECOVERY PROJECT Guidelines for the Financing of Equity and Quasi-Equity Investments by Comme rcial Banks Equity Investments 1. To increase the institutionalized supply of equity and improve the financial structure of individual companies, FONEI would finance equity investments of financial intermediaries in eligible enterprises. For these investments, comprising common stock and preferred stock, the following rules would apply: - Incorporation and ouership. The company to be invested in would be a duly incorporated entity, in accordance with Mexican laws, and its activities would be concentrated in the industrial sector. The controlling interest in the company (i.e., voting rights exceeding 50Z of the company's stock) would be clearly defined. The direct or indirect state participation in the company's equity, including the participation of other state-owned commercial banks, would be less than 50%. - Required cmmpan performance. To be eligible, companies would have to have an operating return (net operating income over operating assets) of at least 10% in real terms. Companies with a lower operating performance would be eligible only if the investment project that is being financed with an equity participation of a financial intermediary would result, over the implementation period, in an operating return of at least 10 in real terms. The propc.-d eoaity investment would have to yield an after-tax return on equity of at least 12% in real terms. - Extent and duration of Investment. The size and the duration of the intermediary's investment would be based on the financial needs of project and company. The maxiumm participation of any one financial intermediary would be 25% of the company's equity. In case the intermediary's participation exceeds 0I of the company's equity, the participation would be limited to a maximum term of five years, after which the participation would have to be reduced to not more than 10%. In this case, the subloan application to FONEI and the documentation submitted to the Bank would have to include a schedule indicating the timing and the method of the reduction of the finAncial intermediary's participation. - Wale of znvsmtennt. The conditions of the sale of the investment after expiration of the applicable investment period are subject to the agreement between the commercial bank and the respective company. Possible forms of sale would include (i) the resale of the stock to the current owners of the company, based on a stock price that has been repurchase the stock according to an amortization plan ('acciones de  - 36 - Annex 6 Page 2 of 2 amortizacion') or receive a loan for the repurchase (which, however, could not be financed through Bank funds (ii) private placement of the stock through, for example, existing stock brokers; or (iii) public placement of the stock if the respective company has been registered at the stock exchange. - Matwlty and repayment of aubloas. The subloan maturity would depend on the duration of the investment; it would not be less than five and not more than 10 years. All repayment schedules of investment subloans would be based on the PVP. The grace period of a subloan would depend on the payout agreement between the financial intermediary and the company; it could extend up to five years in case of full profit retention during this period. In case the intermediary divest before the final maturity of the subloan used to finance the investment, the respective subloan would have to ?-e repaid to FONEI. - Eligible expendItures. Subloans for equity investments would be used to finance the same expenditures (plant, equipment, permanent working capital) as regular equipment and working capital loans. As a consequence, the investment of a financial intermediary would have to result in an equity increase of the respective company. A transfer of shares from current owners to financial intermediaries, or the repayment of existing debt, would not be eligible for financing. - Project amalysis and documentation. Equity investment projects would be subject to the same project analysis and documentation requirements as projects using loans for financing. However, particular emphasis would be placed on the analysis of the company as a whole, including its strategy and future market prospects, its financial structure and future debt service obligations, its cash flow and the prospects for recovering the investment within a specified time frame. Quasi Equity Investments 2. In addition to equity, quasi-equity instruments such as convertible bonds and subordinated debt would be eligible for project funds under the following conditions: - Convertible bonds. The purchase of convertible bonds would be eligible for project funds provided it finance. investments in plant, equipment and working capital. Bond purchases in the secondary market would not be eligible for financing. The yield of a convertible bond would have to meet the interest rate minima of regular subloaDs. The conversion rate would be negotiated between issuer and manager; upon conversion, the rules governing equity investments would apply. The maturity of PONEI's subloan could be extended to cover the equity investment, subject, however, to the maturity limits for equity investment (10 years). - Snbord