Mexico - Public Enterprise Reform Loan

Document of The World Bank FOR OFFMCIAL USE ONLY LAI 30f6- MtF Report No. P-4954-ME REPORT AND RECOMNENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED PUBLIC ENTERPRISE REFORM LOAN IN AN AMOUNT EQUIVALENT TO US$500 MILLION TO NACIONAL FINANCIERA, S.N.C. WITH THE GUARANTEE OF THE UNITED MEXICAN STATES MAY 22, 1989 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY UNIT - PESO (MEX$) On April 10, 1989, the exchange rate in the controlled market was US$1 = Mex$2,355.00; the free market exchange rate stood at US$1 Mex$2,370.00. FISCAL YEAR January 1 - December 31 PRINCIPAL ABBREVIATIONS AND ACRONYMS USED AHMSA - Altos Hornos de Mexico, S.A. BOD - Board of Directors CEPROFIS - Certificado de Promocion Fiscal CEO - Chief Executive Officer CFE - Comision Federal de Electricidad CGF - Comision Intersecretarial Gasto-Financiamiento CMC - Carbon y Minerales de Cohahila, S.A. CONASUPO - Compania Nacional de Subsistencia Populares FERRONALES - Ferrocarriles Nacionales FERTIMEX - Fertilizantes Mexicanos, S.A. FSL - Financial Sector Adjustment Loan ISPL - Industrial Sector Policy Loan NAFIN - Nacional Financiera, S.N.C. OECP - Organismos y Empresas Controlados Presupuestalmente PA - Performance Agreement Pacto - Pacto de Solidaridad Economica PE - Public Enterprise PECE - Pacto de Estabilisacion y Crecimiento Economico PEMEX - Petroleos Mexicanos PERL - Public Enterprise Reform Loan QR - Quantitative Restriction SARH - Ministry of Agriculture and Water Resources SCT - Ministry of Telecommunications and Transportation SECOFI - Ministry of Trade and Industry SECOGEF - Controller General's Office SEMIP - Ministry of Energy, Mines and Public Industry SHCP - Ministry of Finance and Public Credit SIDERMEX - Siderurgica Mexicana SPP - Ministry for Programming and Budgeting TELMEX - Telefonos de Mexico S.A. de C.V. UCD - Unidad de Convenios de Desempeno  FOR OMCIUL USE ONLY MEXICO PUBLIC ENTERPRISE REFORM TABLE OF CONITENTS Page No. LOAN AND PROGRAM SULMMARY ........................................ i-ii PART I - THE ECONOMY . ............................................... 1 A. Background ......................................... 1 B. Macroeconomic Development in 1988 ................. . 4 C. Macroeconomic Policies in 1989 .................. 5 D. Towards Renewed Growth ....................................... 6 E. External Debt and Creditworthiness .............. . 7 PART II - THE PUBLIC ENTERPRISE SECTOR ........... .................. 7 A. Evolution of the Sector ...................................... 7 B. Supervisory Institutions for Public Enterprises ............ 8 C. Past Performance of Public Enterprises ...................... . 9 D. Core Sector Issues .................... ....................... 10 E. Actions Taken to Date .................. ...................... 11 F. Past Bank Involvement .................. ...................... 12 PART III - THE PROPOSED PUBLIC ENTERPRISE ADJUSTMENT PROGRAM .... ... 13 A. Objectives of the Program .................................... 13 B. The Disengagement Program .................................... 14 C. Measures to Improve Efficiency of Retained Enterprises ... 18 (i) Measures to Improve the Competitive Environment of PEs.. 19 (ii) Measures to Foster Managerial Autonomy and Accountability ......................................... 21 (iii) Measures to Foster Financial Autonomy and Accountability ......................................... 26 D. Implementation of the Reform on Selected Enterprises ......... 28 E. Technical Assistance Program ............. .. .................. 28 PART IV - THE PROPOSED BANK LOAN ................................... 29 A. The Proposed Loan .................... ........................ 29 B. The Borrower and the Guarantor ............ .. ................. 29 C. Project Implementation .................. ..................... 29 D. Disbursement, Procurement, Administration and Auditing ....... 30 E. Debt Reduction Support ..................... 31 F. Loan Effectiveness and Tranche Release Conditions ... ........ 31 G. Other Loan Conditions under a Plan of Action ....... .......... 33 H. Monitoring and Reporting ................. .................... 34 I. Project Benefits and Risks, and Social Impact ...... .......... 34 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  PART V - BANK GROUP OPERATIONS IN MEXICO AND GOVERNMENT DEVELOPMENT OBJECTIVES .......................... 37 A. Bank Operations ............................... 37 B. Government Development Objectives ............................ 37 C. Bank Strategy .....................................,.r.39 D. Agriculture .................................... 40 E. Trade ..................................... 40 F. Industry ..................................... 41 G. Infrastructure .................................... 41 H. Housing ..................................... 41 I. Social Sectors and Environment ............................... 41 J. IFC Operations .................................... 42 PART VI - COLLABORATION WITH THE IMF ................................ 42 PART VII - RECOMMENDATION ..................................... 43 ANNEXES I. Mexico - Economic Indicators 1I. Mexico - Status of Bank Operations III. Mexico - Supplementary Loan Data Sheet IV. Letter of Development Policy V. Policy Matrix VI. Institutional Responsibilities for Program Implementation VII. Inventory Summary of Parastatals VIII. Table VIII.1: Mexico - PE Investments in 1981-87 Table VIII.2: Cash Flow for all PEs Included in the Federal Budget, Excluding PEMEX Table VIII.3: CFE, CONASUPO, FERTIMEX, FERRONALES and SICARTSA's Consolidated Cash Flow IX. Alternative Disengagement Procedures X. Technical Assistance  MEXICO PUBLI3 ENTERPRISE REFORM Loan and Program Summary Borrowers Nacional Financiera, S.N.C. (NAFIN) Guarantor: United Mexican States Beneficiary: United Mexican States Amounts US$500 million equivalent Terms: Repayable in 17 years, including 5 years of grace, at the standard variable rate. Obiectives: The proposed loan, which is part of a program of Bank support to the Mexican Government's objectives of stabilizing its economy and resuming growth, will assist in the improvement of the efficiency of public enterprises (PEs). It aims to reduce the heavy burden they impose on the economy and, particularly, on the national budget. Description: The program includes: (i) a "disengagement* component to continue with the sale, liquidation and merger of PEs; and (ii) a program of reforms in the policy and institutional environment for PEs to improve the efficiency of the enterprises to be retained by the Government. Benefits and Risk: The above measures will improve the competitive environment and will provide greater managerial and financial autonomy and accountability to PEs. They will increase market forces, decentralize decision making, redefine the role of Government agencies, strengthen managerial capabilities and incentives and improve the allocation of resources. The main risks of the proposed program relate to the possibility of further deterioration in Mexico's public finances and macro- economic environment--particularly inflation--which could lead to the re-emergence of increasing operational deficits and arrears of PEs, thus causing difficulties in balancing the duration and rigor of the reforms. There is also the risk that expected foreign finarcing would not materialize, t-lis undermining the macroeconomic objectives of stabilization and growth.  - ii - Estimated Disbursement: The loan would be disbursed against eligible imports in tranches of US$250.0 million and US$249.0 million, respectively. A US$1.0 million component would finance technical assistance and studies to carry through the initial effects of the reform. The first tranche would be available for disbursement at the time of loan effectiveness, upon fulfillment of specified conditions, including substantial progress in obtaining adequate financing for Mexico's requirement for 1989 and 1990, and also the drafting of regulations to the PE Law, defining the PE supervisory role of Government agencies, and the role and composition of PEs' Boards of Directors, in a manner consistent with providing parastaL"is with managerial and financial autonomy under clear accountability rules based on ex-post evaluation of performance. The second tranche would be released after November 30, 1989, upon fulfillment of specified conditions, including continued consistency of the macroeconomic policy framework with the public enterprise reform program; progress in obtaining adequate financing for Mexico's aggregate FY89190 and for its medium-term requirements; progress in reducing Government transfers to parastatals; progress in implementing the liquidation, merger and sales program for 199 PEs; implementation of Performance Agreement Plans; development of an action plan to simplify, deregulate and make more flexible the annual budgeting system for PEs; and issuance of regulations to the 1986 PE Law. Disbursement of the entire loan is expected to be completed by June 30, 1991. Retroactive Financing: US$100 million would be made available for retroactive financing of expenditures incurred after February 15, 1989, a date four months prior to expected loan signing. US$ million Schedule of Bank Fiscal Years PY90 FY91 Disbursements: Annual 499 1 Cumulative 499 500 Rate of Return: Not applicable. Appraisal Report: This is a combined President's and Staff Appraisal Report.  REPORT AND RECOHMENDATION OF THE PRESIDENT OF THE INTERNATIONAL4 BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN IN AN AMOUNT EQUIVALENT TO US$500 dILLION TO NACIONAL FIRANCIERA, S.N.C. FOR PUBLIC ENTERPRISE REFORM 1. I submit the following report and recommendation on a proposed loan to Nacional Financiera, S.N.C. (NAFIN) with the guarantee of the United Mexican States for the equivalent of US$500 million equivalent to support a program of reform of public enterprises. The loan would have a term of 17 years, including 5 -pears of grace, at the standard variable interest rate. PART I - THE ECONOMY A. Background 2. Between 1950 and 1974, Mexico enjoyed a remarkable period of high growth, low inflation and moderate external debt accumulation. Real growth averaged 6.4Z, and inflation was in single digits throughout the period. This era of fiscal conservatism came to an abrupt end in the early seventies. Rapidly expanding government involvement in the economy pushed up the rate of economic growth. However, increasing government expenaiture was not matched by rising public sector revenues. At the same time a decline in private savings incentives (real interest rates turned sharply downwards) prevented a matching increase in private savings. As a result, inflation tax and external debt became increasingly important sources of finance. The period of single digit inflation ended in 1973, the real exchange rate started to appreciatel and the accumulation of external debt accelerated above the GNP growth rate beyond 1973. 3. In 1976, Mexico experienced a serious, but comparatively brief financial and economic crisis, triggering a major devaluation of the Mexican peso and financial austerity measures. However, after major oil discoveries were announced the following year, the stabilization program was quickly terminated. In fact, the subsequent period was characterized by both rapidly expanding government revenues and vastly increased borrowing of the public sector. The Government's share in total value added increased by almost one third, and in total investment from 33.51 in 1970-75 to substantially over 401 in later years. Not surprisingly, the real exchange rate once again started to appreciate, eroding the gains of the 1976 devaluation. This expansion was largely fueled from abroad: Mexico's external debt increased from US$16 billion to US$86 billion between 1975 and 1982. 4. The situation changed dramatically in 1982 when rising world interest rates and falling oil prices put an end to Mexico's increasingly expansionary policies. The refusal of external creditors to roll over 11 The real exchange rate is defined as the price of foreign goods relative to domestic goods. Appreciation means a decline in this relative price.  Mexico's short term debt left no option but fiscal retrenchment. Mexico, which had run non-interest current account deficits Ut each of the preceding thirty years, suddenly needed to run surpluses on that account in every following year. The ratio of external debt to GDP increased substantiallr under the influence of rising interest rates and falling growth rates. The gap between the real interest rates on external debt and real GDP growth went from -6.32 in 1980-1981 to a full +10.52 in 1983. Such a high difference meant that. even without a non-interest current account deficit, the debt burden would increase rapidly, simply through the compounding effect of interest on debt inherited from the past. In addition, there were substantial capital losses on external debt due to the necessary real exchange rate depreciation. Given the major decline in oil revenues and rise in real interest obligations, the real depreciation of the exchange rate was unavoidable, but it led to an increase in external debt to GDP ratio of almost 25 percentage points during the period 1982-1987. 5. The counterpart to the non-interest current account improvement was a sustained fiscal adjustment effort that is probably unmatched in any country. A primary fiscal deficit of 7.6Z of GDP before the 1982 crisis was turned into a surplus of 4.92 in 1987 and an estimated 5.82 in 1988 (Annex I, Table 1). And this was achieved while revenues from oil exports declined by more than 72 of GDP between 1983 and 1988, and GDP growth declined dramatically. Non-interest Government expenditure was reduced from the equivalent of 35.4Z of GDP in 1982 to about 22.6? in 1988. The public enterprise divestiture program was successful in closing or selling roughly 700 small and medium entities, out of a total of about 1200 in 1982. In addition, in the same period, Mexico has undertaken far reaching structural reforms at an accelerating pace. 6. An IMF supported stabilization program was launched in 1983, during which the fiscal deficit was halved, international reserves recovered, and inflation began to decline. However, in 1984 and 1985 there was some fiscal expansion and monetary relaxation. Moreover, the earthquake in late 1985 and a major terms of trade deterioration in 1986 due to falling oil prices worsened Mexico's prospects. In response, the authorities adopted a deeper and growth-oriented stabilization program in July 1986. In return for renewed monetary and fiscal austerity, this program also called for a concerted financing effort on the part of Mexico's creditors. 7. The 1986 package included new elements of policy designed to eliminate structural rigidities in the economy. The most significant change was a major reorientation towards fuller integration with the world economy. Exports of manufactures, spurred by a 422 real exchange rate depreciation over thei July 1985-December 1987 period, have overtaken oil exports and more than compensated for the US$7 billion oil revenue loss experienced over the same time span. Since mid-1985, Mexico has undertaken a fast and far-reaching liberalization of the trade regime, aimed at expanding the tradeables sector, opening it to international competition and encouraging efficiency in both exporting, and import-substitu*ion activities. In 1986 Mexico acceded to the GATT. The trade liberalization  - 3 - process was supported by Bank operations (Trade Policy I and II, and Agricultural Sector I). While it will take some time before the full impact develops, the initial results are promising, incentives have been redirected and restructuring toward more efficient activity has begun. For example, in agriculture, the policy reforms initiated since 1985, and especially since October 1987, have substantially reduced direct and indirect price discrimination against producers. Exchange rate policy has become more favorable to all tradeable sectors. Import barriers have been sharply reduced for major agricultural inputs such as machines, pesticides, and other high technology inputs. Export restrictions on fruits and vegetables, which represent 25Z of crop output, have been substantially reduced, and most producer prices have been moved into a band of between 902 and 125Z of international prices. 8. The key reforms in the trade regime included reductions in the coverage of NTBs and tariffs. The progress has been impressive. Import licensing coverage is now less than one-quarter of what it was in June 1985, official reference prices have been completely abolished, the maximum tariff is now one-fifth and the average tariff about one-half of what they were in June 1985. Progress has gone beyond the Government's original schedule, GATT commitments, and the targets in the Trade Policy Loans I and II and the Agricultural Sector Loan I. 9. The ensuing fiscal retrenchment was unavoidable given Mexico's sudden difficulty in accessing the international capital markets and the adverse terms of trade shocks it experienced. As a byproduct, the severe fiscal cutbacks have greatly increased the efficiency of many of the remaining government operations. There is, for example, little doubt that few, if any, of the many dubious large projects of the late seventies remain in the public sector investment program. But, cutting back public investments from almost 102 of GDP in 1982 to around 4.42 in 1988, clearly has had its costs. Government investment has a role to play in areas that heavily complement private investment and in the social sectors. Also private investment has not made up for the decrease. 10. With lower investment on the one hand, and restrictive demand management on the other, real growth again stopped. There has been no real growth between 1982 and 1987, and hence a severe decline in per capita income (Annex I, Table 1). Also, inflation, rather than slowing down, in fact accelerated towards the end of the period, partially in response to a sharp nominal devaluation. This devaluation, however, had become necessary because of the abrupt oil price decline in 1986. The subsequent de-facto targeting of the real exchange rate, together with an increase in the frequency of wage and cost adjustments, introduced an element of inherent instability into the system. This latter became fully apparent towards the end of 1987. The stock market plunge and less than perfect management of private debt buy backs evolving from the 1987 debt rescheduling triggered a run on the peso in October 1987. This resulted in reserve losses and eventually a 372 devaluation, fueling inflation and expectations of further exchange rate depreciations. The Government responded with the 'Economic Solidarity Pact' (Pacto), a concerted effort to bring down inflation that was running well into triple digits by end-1987.  - 4- B. Macroeconomic Development in 1988 11. The "Economic Solidarity Pact" (Pacto) was negotiated in December 1987 between Govprnment, labor, farming, and business representatives. The program consisted of further tightening of fiscal and monetary policy, and renewed structural reform efforts. Trade liberalization was accelerated, credit subsidies substantially reduced, and the program of public enterprise divestiture reinforced. These measures were supplemented by a freeze of minimum wages, public sector prices and tariffs, and. what was a corner stone of the "Pacto", freezing the nominal exchange rate against the U.S. dollar. This partial freeze was originally intended for a couple of months only, but it was extended at three month intervals through the end of 1988. 12. On almost every target that is under direct or indirect control of the government, performance under the 'Pacto' has been exemplary and often went beyond what was initially planned. Trade reform was accelerated, partly because of the potential efficiency gains, partly because of its restraining effect on price increases. The fiscal deficit was brought closely in line with the low inflation targets embedded in the 'Pacto". This effort was all the more noteworthy, given the negative budgetary impact of further drop', in oil prices and increasingly high real interest rates on foreign debt towards the end of the year. 13. Moreover, this has been achieved in spite of high domestic real interest rates. These have been at around 302 in real terms during most of 1988, and have crept up to a compounded real rate in excess of 402 towards the end of the year. And, it must be stressed that real interest rates on Government debt swung from a negative 32 in 1987. With the domestic debt in 1988 equivalent to around 20X of GDP, such a turn around caused a massive increase in real interest payments to service the domestic debt. 14. The fiscal measures, backed up by the exchange rate freeze and an array of formal and informal price controls, have had a dramatic success in reducing the rate of inflation. Inflation figures for October 1988 indicate a monthly rate of 0.82 for the CPI and 1.4X for the WPI. In November 1988, the WPI actually declined and the CPI inflation rate slowed down further to 1.3Z. In December 1988, CPI inflation was 2.12, substantial food price ii._reases notwithstanding but the WPI went up by only 0.8Z. This is a tenfold reduction compared with the beginning of the year; if the October-December 1988 rates could be sustained, Mexico's inflation rate would be at an annualized rate of approximately 15Z. This would clearly be a dramatic change with respect to the 1592 inflation rate in 1987. 15. The policy of a fixed Peso-Dollar rate came under increasing pressure in 1988 as the year went by. The real exchange rate against the US Dollar appreciated by 9.22 since January, and by 5.52 since March, the first month with low inflation. The appreciation of the dollar between March and September 1988 added to the pressure: on a trade weighted basis  the real exchange rate appreciated by almost 7.42 between March and August. This should be set against a sharp real depreciation of 42Z on trade- weighted basis between July 1985 and December 1987. July 1985 was the month preceding a nominal devaluation of 17? itnd the beginning of a much more aggressive exchange rate policy. However, falling oil prices and rising international interest rates in the second half of 1988 added to pressure on the real exchange rate. 16. Doubts about the sustainability of the exchange rate may have been behind the second striking feature of 1988, an extraordinary surge in imports which increased by 48? in 1988. It seems that a substantial part of the import boom was related to speculation against the exchange rate, and, possibly, a gamble on future trade reform rollback. 17. At the same time, non-oil exports increased by 162 in dollar terms in 1988, (the 1987 over 1986 increase was 23.7Z). But because of the falling revenues from oil, total exports grew by only 5? in nominal terms in 1988 over 1987. In addition there was a strong increase in exports from the "Maquiladoras," the import/export industries along the US border. While separate export and import data for the 'maquila' sector are not yet available for 1988, preliminary data indicates that value added increased by 402 over 1987, adding a US$2.3 billion to the trade surplus in 1987 (as opposed to US$1.6 billion last year). The increase in exports was due to improved competitiveness since mid-85; as mentioned before, although the exchange rate depreciated iAs real terms by 42? between July 1985 and December 1987, some of the gains have been eroded since the beginning of 1988. Also, since 1985, Mexico's competitors have improved their competitiveness by almost 10?. 18. The net result was a deterioration in the current account of US$6.8 billion dollars from 1987 to 1988 (a swing to a deficit of Us$2.9 billion in 1988 from a surplus of about US$3.9 billion in 1987). C. Macroeconomic Policies in 1989 19. In December 1988 the Mexican Government and the various sectors of society agreed on a renewal of the 'Pacto" as the initial phase of economic policies for 1989. This renewed Pacto now called Stabilization and Growth Pact--PECE aims to consolidate price stability and contains specific guidelines through the end of July 1989. Within this framework, public sector prices and tariffs were adjusted, minimum wages were increased by 8?, and the peso is being depreciated daily according to a pre-announced schedule of one peso a day. Under the PECE it is expected that inflation will decline from 52? during 1988 to 202 during 1989. The fiscal measures approved by Congress in the 1989 budget will contribute to a reduction of the operational deficit. The fiscal stance, in conjunction with appropriate monetary and exchange rate policies, should help bring about the gradual recovery of investment and output, as well as lower inflation and the strengthening of international reserves. 20. The first quarter of 1989 indicates that the PECE is performing very much like the Pacto, with the same successes and weaknesses.  -6- Inflation, after accelerating to 2.1 and 2.42 -espectively in Decenber and January, came down to 1.42 in February and 1.1 in March. Current rates, if continued, are compatible with the Government's stated 202 year-end to year-end target (one percent a month until December implies 172 December to December inflation), an impressive reduction from the 1592 and 522 inflation rates in 1987 and 1988, respectively. Also, the nominal daily devaluation of the Peso has led to a small real depreciation of the exchange rate against Mexico's main trading partner, the USA. Current exchange rate policy and inflation targets are broadly consistent with a stable real e"change rate (a small real depreciation from December 1988 to December 1989). Exchange rate policy will be monitored in the context of the proposed IMF's EFF. D. Towards Renewed Growth 21. The predominant long term problem in Mexico is the continued low growth rate of the economy. This is not only an issue of great social concern, but also presents a major inefficiency and a threat to the success of the short term stabilization program as well. An efficiency issue, because it suggests that the rationalized incentive structure that is beginning to emerge as a result of the ongoing reform program is not sufficiently exploited; and threat to the stabilization effort because any fiscal deficit is much harder to finance at low than at high growth rates. Thus low growth rates increase the probability that recourse to reliance on the inflation tax is imminent. For all these reasons restoration of growth to the levels prevailing before the expansionary mid seventies is imperative. 22. It is clear, however, that because of the short-term problems, fiscal efforts cannot be the main engine of growth. In the short run, balance of payments considerations leave no option but exTort led growth. Then however, supply bottlenecks will develop in time, with the consequent need for additional investment. At present, investment is equivalent to 20.32 of GDP, public investment being at its lowest historical level. With fiscal retrenchment necessary in the face of low inflation targets and the likely negative impact of external shocks on public finance, private investment will have to lead the way. This is also more in line with the structural reforms currently underway in Mexico; these reforms seek to reduce rather than increase the role of the public sector. This then sets the stage for the three proposed adjustment operations: Financial Sector Adjustment Loan (FSL); Industrial Sector Policy Loan (ISPL) and Public Enterprise Reform Loan (PERL); iow to restore private sector based growth within the constraints set by external creditworthiness. A starting point would, therefore, have to be the design of a policy-financing package that will provide the framework for the increase in private investment necessary for resumed growth. The proposed operations are clearly an important component of such a package. 23. The need for a solution to Mexico's external debt problems is not only essential for the recovery of growth, but would also contribute significantly to the chances of success of the stabilization effort. Clearly, cutting back Mexico's access to foreign capital markets would in  7- fact reduce Mexico's creditworthiness because it would slow down GDP growth. Sustained access to external capital markets is necessary to provide room for the additional investment needed for renewed growth. But fears of the consequences of a lack of access to capital markets, with its implications for fiscal and exchange rate policy, are clearly among the factors holding this investment back. In turn, the resulting sluggish growth performance and public finance problems are among the factors causing the lack of access to external capital markets to begin with, thus closing the vicious circle. 24. It is exactly in such a vicious circle situation that the Bank has a major role to play. On the one hand, it can provide external funds as, for instance, through the three proposed adjustment operations and help secure other sources of financing, thus relaxing the external constraint that is stifling growth. But, at the same time the Bank would, through the policy package it supports, give a signal that the increased external funds will indeed, trigger the increased investment necessary for growth. Thus, Bank lending would play a major catalytic role in the process of breaking out of the macroeconomic bind in which Mexico finds itself. This is the main rationale for the three proposed adjustment operations: to act as a catalyzing agent for a process of renewed growth, where Merico and all its external creditors play an active participatory role. S. External Debt anc Creditworthiness 25. Mexico's gross external public and private debt increased by nearly US$11 billion during 1983-88, and net debt by about US$9 billion. The debt service ratio increased from 47.1S of exports of goods and non- factor services in 1982 to 60.52 in 1988, mainly due to large repayments of around US$3.5 billion of private sector debt and a decline in oil prices. At the end of 1988, the Bank's share of Mexico's long-term debt was 8.2X, and its share of Mexico's long-term debt service was 7.6Z. Mexico's share in the Bank's total exposure was 8.7Z in 1988. This latter ratio is expected to rise somewhat by the end of this decade because of Bank expanded assistance program, but will remain below 10% of the Bank's total portfolio. Provided that sound domestic economic policies continue to be pursued, and that the external environment remains favorable for the execution of these policies, Mexico is considered creditworthy for planned Bank lending. PART II - THE PUBLIC ENTERPRISE SECTOR A. Evolution of the Sector 26. One of the causes of Mexico's economic and financial crisis since the 1970s has been the large and weakly managed public sector, particularly the public enterprises (PEs). At present, these enterprises contribute about 12S of GDP, employ about one million people, and control the most important branches of basic industry and infrastructure. However, as noted below, PEs have persistently received substantial subsidies from the Government, aggravating fiscal deficits.  8- 27. The establishment of most public enterprises in Mexico occurred on an ad hoc basis. During the 1970s, the sector grew rapidly without a clear definition of the roles of the Government and the private sector: there were 12 PEs in 1930, 491 in 1970, 845 in 1976, peaking at 1,155 in 1982. A major source of growth was the acquisition by the Government of bankrupt private firms to avoid their closure and maintain employment. Efficient administration of PEs was hampered by the fact that prevalent PE legislation at the time focused on processes and controls that relied heavily on the administrative capacity of the Government. This legislation had originally been developed to deal with Central Governraent operations, investment and procurement (Education, Health, Housing, etc.) and was not suited for industrial and commercial enterprises. Partly as a result of ineffective management, and also because PE prices and tariffs were generally below their economic opportunity costs, the deficit of the largest PEs, as a percentage of the total Federal Government deficit, grew to 38Z in 1976. Direct budgetary transfers to the largest PEs were above 5Z of GDP in 1982. 28. Since 1982 the Government has implemented a major "disengagement* program for most of the small and medium PEs and some of the larger ones (in mining, air transportation and capital goods). Of the 706 companies disengaged under the program, 32Z were sold, 112 merged, 53Z liquidated, and 4Z transferred to local governments. By February 1989, this process has left only 449 entities in the public sector, of which 94 are in the industrial, energy and mining sectors. Excluding the oil and electricity companies, which must remain with the Government as dictated by the Mexican Constitution, the enterprises disengaged since 1982 in the industrial, energy and mining sectors represent 77Z of the number of enterprises, 66Z of labor, 41Z of sales, and 23Z of the asset value of the initial universe of PEs in these sectors in 1982 (para 50). B. Supervisory Institutions for Public Enterprises 29. Since 1976, public enterprises have been under the control of Sector Ministries, acting as sector coordinators. The Ministries of Energy, Mines and Public Industry (SEMIP), Telecommunications and Transportation (SCT) and Agriculture and Water Resources (SARH) control the largest number of PEs. In addition to the Sector Ministries, the Ministry for Programming and Budgeting (SPP) exercises authority and control over the operating and investment budgets of the PEs. Further authority on operational, credit, and financial matters is exercised by the Ministry of Finance and Public Credit (SHCP) and the Controller General's Office (SECOGEF). Lastly, the Interministerial Committee for Expenses/Financing 'Comision Intersecretarial Gasto-Financiamiento' (CGF), created in 1985 to resolve issues of public expenditures and funding, coordinates actions of SPP, SHCP and SECOGEF on public enterprise matters of relevance to both the budget and the macroeconomic stabilization program. CGF also approves particularly complex PE sales. There is significant duplication of efforts among these agencies, and some of them have gone far beyond their originally stipulated functions becoming deeply involved in the day-to-day management of public companies. This has caused disruptions which impede a more effective management of PEs.  -9- C. Past Performance of Publd Enterprises 30. The economic and financial performance of PEs during the last decade has not been satisfactory. Since 1982, the disengagement program has helped, but other efforts have focused on immediate cost-containment measures rather than on long-lasting efficiency improvement measures. Though PEs' payroll and investment costs have dropped dramatically in real terms since 1981, many enterprises are still facing low capacity utilization, high operating costs, and financial losses. They continue to receive large subsidies from the Government: total transfer of Government funds to PEs amounted to approximately 2.8X and 2.1Z of GDP in 1987 and 1988, respectively. About 672 of these transfers have been to service PE debt, 82 for new investments, and 252 to cover operating costs. Of the latter, the largest component represents indirect subsidies to consumers, because these transfers support PEs affected by Government controlled prices generally set below opportunity cost (e.g., fertilizers, food produe:ts and electricity). In addition to these direct transfers, the Government has also assumed debt of PEs; its service is estimated at about 1.8t of GDP in 1987 and 1.3Z of GDP in 1988. 31. The financial performance of PEs during the 19808 can be depicted as follows. The large majority of small- and medium-sized PEs, which are commercial in nature and operate in non-monopolistic markets, have remained profitable throughout most of the decade; they have been prime candidates for the PE-sales program. On the other hand, a handful of companies, noticeably the larger ones with a mix of social and commercial objectives, account for most of the parastatal sector crisis in Mexico. In fact, the consolidated financial statements for these large enterprises--CFE (power), CONASUPO (food and grain marketing), FERRONALES (railway), FERTIMEX (fertilizer), and SICARTSA (steel)--show that during the first half of the 1980s, their cumulative value added (i.e., net sales revenues minus cash production cost other than labor) was negative. Consequently, the Government has financed labor costs, investment costs and debt service of these five large PEs through both budgetary transfers and, since 1985, the assumption of debt. During 1980 to 1985, budget transfers averaged 1.2 times the sales revenues generated by these PEs and were equivalent to 2.82 of GDP p.a. In addition, the PE-debt assumed by the Government reduced real interest payments of these PEs by nearly two thirds between 1984 and 1987. 32. Government's austerity and cost-containment efforts undertaken between 1982 and 1987 gradually resulted in drastic cuts in labor and investment costs of the above five large PEs. During this period, labor costs dropped by 36X and investment costs by 402, in real terms. In spite of the3e efforts, federal transfers to these five PEs in 1987 still accounted for 902 of total direct budgetary transfers to PEs. This is partly because product prices were kept artificially at low levels. Furthermore, austerity measures failed to reduce direct non-labor operating costs of these FEs. Consequently, their consolidated gross margin remained negative. The evolution of Government transfers, labor costs, other operating costs, and investments of these large PEs, and of the rest of the parastatals under direct Government budgetary control, is detailed in Table 2, Annex VIII, and summarized in the following graphs (in constant 1978 billion pesos):  - 10 - 0gavha of Selected PI C9sh Fovw -ZonA T_MNMf PtD La Code ~~~~~~~~~~~tto~~m wu0 ao to pm LSb02 Ot"S a*e 10 ' S0a 60~~~~~~~~~~~~~~8 40 40~~~~~~~~~~~~~~2 w~~~~~~~~~~~~~~~~~~17 1970 100 198 18e2 108s 1ossa ttt 984 a10 tits82 gg8* 1086 198teg 20 d 8e 303 Se are low cr iu us MA th mefosa? of the public enterprise sector Priin poiiesfori a few la"rge my hv beeiadeuae.N arenPsLabor Opnlicin social andctommrca 40 197 it 1080 100 10 82 K)8 1984 108 1088 108