Mexico - Industrial Sector Policy Loan

Document of The World Bank FOR OFFICIAL USE ONLY AM -7 Report No. P-4950-ME REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED INDUSTRIAL SECTOR POLICY LOAN IN AN AMOUNT EQUIVALENT TO US$500.0 MILLION TO NACIONAL FINANCIERA, S.N.C. WITH THE GUARANTEE OF THE UNITED MEXICAN STATES MAY 22, 1989 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY UNIT - PESO (MEX$) On April 10, 1989, the exchange rate in the controlled market was US$1 - Mex$2,355.00; and the free market exchange rate stood at US$1 - Mex$2,370.00. FISCAL YEAR January 1 - December 31 WEIGHTS AND MEASURES 1 hectare (ha) = 10.000 square meters (m2) - 2.47 acres (a) 1 kilometer (km) - 0.62 mile (mi) 1 square kilometer (kmZ) = 0.39 square milea - 100 ha 1 kilogram (kg) 8 2,205 pounds (lbs) 1.000 kilograms = 1 metric ton (t) - 0.98 long ton 1 liter (1) = 2.26 gallons (gal) PRINCIPAL ABBREVIATIONS AND ACRONYMS USED ACF Average Cost of Funds AGSAL Agricultural Sector Adjustment Loans CEPROFI Certificado de Promoci6n Fiscal (Certificate of Fiscal Promotion) CONACYT Consejo Nacional de Ciencia y Tecnologia (National Council for Science and Technology) DCR Domestic Content Requirement DFI Direct Foreign Investment DRC Domestic Resource Cost EDP I/II First and Second Export Development Project EFF Extended Fund Facility EQ Export Quotas FSL Financial Sector Adjustment Loan GATT General Agreement on Tariffs and Trade GIRA General Interest Rate Agreement IFAD International Fund for Agricultural Development INFOTEC Servicio de Informacion Tecnologica (Technology Information Service) ISPL Industrial Sector Policy Loan NAFIN Nacional Financiera, S.N.C. NICA Non-interest Current Account NCFI National Commission for Foreign Investment NOE Non Oil Expurts NTB Nor. Tariff Barriers NRFI National Register of Foreign Investment ORP Official Reference Price Pacto Economic Solidarity Pact PECE Stabilization and Growth Pact PE Public Enterprise PEMEX Petroleos Mexicanos PERL Public Enterprise Reform Loan PITEX Temporary Import Schemes RNIE National Register of Foreign Investment R&D Rese-arch and Development SAP Special Action Program QR Quantitative Restriction SCT Ministry of Communication and Transport SECOFI Ministry of Trade and Industry SHCP Ministry of Finance and Public Credit STPS Ministry of Labor and Social Security SMI Small and Medium Industry TFP Total Factor Productivity TPL IIII First and Second Trade Policy Loans  FOR OMCUAL USE ONLY MEXICO INDUSTRIAL SECTOR POLICY LOAN TABLE OF CONTENTS Page No. Loan and Program Summary ....................... i - ii I. THE ECONOMY ..1 A. Background . . 1 B. Macroeconomic Developments in 1988. . 3 C. Macroeconomic Policies in 1989 . . 5 D. Towards Renewed Growth . . 6 E. External Debt and Creditworthiness. . 7 II. SECTORAL CONTEXT .7 A. Overview ............................................. 7 B. Background ......................... 8 C. Import Substitution, Public Expenditures, Oil and Foreign Borrowing-Led Growth: 1978-1982 .10 D. Macroeconomic Adjustment and Awareness of the Need for Structural Reform: 1983-85 .10 E. The Beginning of Structural Reform: 1986-88 .11 F. Outlook for the Industrial Sector .11 III. THE INDUSTRIAL SECTOR REFORM PROGRAM .12 A. Program Scope and Actions Taken . .12 B. Sector Programs .. . 14 Automotive Industry . .16 Pharmaceutical Industry . . 18 Petrochemical Industry . .19 Micro-computer Induatry . .20 C. Competitive Goods Markets . . 20 Trade Policy Reform . .21 Price Controls . .24 Entry Barriers . .25 Cost of Doing Business (Bureaucratic Procedures) ....26 D. Competitive Factors Markets . .27 Fiscal and Credit Incentives . .28 Direct Foreign Investment . .29 Industrial Technology . .31 Labor Mobility . .33 E. The Trucking Sector . .34 Road Transport Regulations . .34 F. External Finance . ..35 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.  - 2 - IV. THE PROPOSED LOAN ............... ........36 A. Loan History. . . ................. .36 B. Loan Objectives .*.......... C. The Borrower, The Guarantor and Project Implementation. ....... . 38 D. Disbursement, Procurement, Administration and Auditing. .... 38 E. Medium Term Financing and Debt Reduction Support ......39 F. Loan Trenching ....39 G. Monitoring and Reporting .. ...40 H. Poverty Impact ...40 I. Benefits and Risks ...........41 V. BANK GROUP OPERATIONS IN MEXICO AND GOVERNMENT DEVELOPMENT OBJECTIVES. ... 42 A. Bank Operations.... 42 B. Government Development Objectives ... .43 C. Bank Strategy ............................ ....... 44 D. Agriculture. . . .......... 45 E. Trade .....46 F. Industry ........46 G. Infrastructure ......46 H. Housing .....46 I. Social Sectors and Environment... 47 J. IFC Operations ....... . t47 VI. COLLABORATION WITH THE IMF ........................ . . . 48 VII. RECOMMENDATION ............. 48 ANNEES Annex I - Mexico: Economic Indicators Annex I$ - Status of Bank Group Operations in Mexico Annex III - Supplementary Loan Data Sheet Annex IV - Letter of Industrial Sector Policy Annex V - Policy Matrix Annex VI - Industrial Sector Programs Annex VII - Trade Policy Reform Annex VIII - Entry Barriers Annex IX - Road Transportation Annex X - Statistical Annex Figure 1 - Manufacturing Industry Figure 2 - Manufacturing Industry GDP Figure 3 - Manufactured Exports Figure 4 - Exports and Imports 1987 Figure 5 - Total Factor Productivity  - i - MEXICO INDUSTRIAL SECTOR POLICY LOAN Loan and Program Summary Borrower: Nacional Financiera S.N.C. (NAFIN) Guarantor: United Mexican States Beneficiary: United Mexican States Amount: US$500 million Terms: Repayable in 17 years, including 5 years of grace, at the standard variable interest rate. Objectives: 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 modernizing the country's industrial sector. It aims at removing distortions in goods, factor and service markets, and at providing an appropriate institutional and regulatory environment to enable industrial enterprises to meet the challenge of a more competitive world economy and, thereby, stimulate investment and growth. Description: The proposed loan includes deregulation of the industrial sector programs in the automotive, pharmaceutical, petrochemicals, and microcomputer subsectors, the easing of bureaucratic procedures and barriers to entry, increasing of factor mobility (e.g. direct foreign investment, technology transfer and research and development, and labor), and the improvement of trucking services. The proposed loan will help implement initial, but in many cases fundamental changes. It also includes studies to identify further policy or legislative changes needed to improve the regulatory framework. Deregulation measures supported by the proposed loan follow up on other measures already taken by the authorities. Benefits and Risks: The program supported by this loan will help accelerate adjustment in the structure of production toward increasing competitiveness, and a more attractive environment for investment and technological development and transfer. It will help foster market flexibility, promote non-distorted markets, improve factor mobility, reduce the costs of doing business and improve trucking services. The main risk is possible political resistance to carrying out the reforms at the speed envisaged. There is also a risk that the macroeconomic objectives of stabilization and growth may be undermined if expected foreign financing does not  - ii - materialize. The Government's program and the design of the proposed loan together with the other two adjustment operations being processed simultaneously (the Financial Sector Adjustment Loan and the Public Enterprise Reform Loan) contain elements that should significantly reduce these risks. Estimated Disbursements: The proposed loan will be disbursed against eligible imports in two tranches of US$250.0 million and US$247.0 million, respectively. A US$3.0 million component will finance technical assistance and studies to carry tisrough the initial effects of the reform. The first tranche will 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 requirements for 1989 ar-A 1990. The second tranche would be released after November 30, 1989, upon fulfillment of specified conditions in all key policy areas supported under the loan, including continued consistency of the macroeconomic policy framework with the industrial deregulation program; progress in obtaining adequate financing for Mexico's aggregate 1989-1990 requirements; and satisfactory progress in implementing action programs concerning technology, direct foreign investment, trade, industrial sector programs and administrative simplification. Since it may be difficult for the Government to put in place an effective debt reduction scheme without direct Bank assistance, up to US$125 million equivalent would be used under the second tranche for a debt reduction plan meeting the requirements for Bank support. Disbursement of the entire loan is expected to be completed by June 30, 1990. Retroactive Financi-Eg: US$100 million will be made available for retroactive financing of expenditures incurred from February 15, 1989. Rate of Return: Not applicable. Appraisal Report: This is a combined President's and Staff Appraisal Report. Schedule of Disbursements: Amounts in US$ Millions Bank FY90 500.0  INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT REPORT AND RECOMMENDATION OF THE PRESIDENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED INDUSTRIAL SECTOR POLICY LOAN TO NACIONAL FINANCIERA, S.N.C. 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 in support of a program of industrial deregulation and policy reform. The loan will have a term of 17 years, including 5 years 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 expenditure 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 e&valuation 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 33.5Z in 1970-75 to substantially over 401 in later yeirs. 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 Mexico's short term debt left no option but fiscal retrenchment. Mexico, 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.  -2- which had run non-interest current account deficits in 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 substantially und.er the influence of rising interest rates and falling growth rates. The gap between the real interest rates on external debt and real GDP growtn went from -6.3Z 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 depreciaticn. 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 about 25 percentage points during the period 1982-1987. S. 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 (Financial Sector Adjustment Loan, FSL, 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 35.42 of GDP in 1982 to about 22.62 in 1988. The public enterprise divestiture program was successful in closing or selling roughly 700 smaller 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 IMP 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 the July 1985-December '.987 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-substitution activities. In 1986 Mexico acceded to the GATT. The trade liberalization process was supported by Bank operations (Trade Policy I and II, TPL I and II, and Agricultural Sector Adjustment Loan, AGSAL). 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 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, whiich represent 252 of crop output, have been substantially reduced, and most producer prices have been moved into a band of between 9O0 and 125? 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 TPL I and II and the AGSAL. 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 lOS of GDP in 1982 to around 4.4Z 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 (FSL, 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 37? 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. B. Macroeconomic Development in 1988 11. The Pacto was negotiated in December 1987 between Government, 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 a_d 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 UPacto". This effort was all the more noteworthy, given the negative budgetary impact of further drops in oil ;,rices 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 40% 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 0.8z for the CPI and 1.42 for the WPI. In November 1988, the WPI actually declined and the CPI inflation rate slowed down further to 1.3%. In December 1988, CPI inflation was 2.1Z, substantial food price increases 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 152. 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 5.5% 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 7.4Z 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% and 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 198W over 1986 increase was 23.72). But because of falling revenues from oil; total exports grew by only 52 in nominal terms in 1988 over 1987. In addition there was a strong increase in exports from the 'Maquiladoras," the importlexport industries alonig the US border. While separate export and import data for the smaquila' sector are not yet available for 1988, preliminary data indicates that value added increased by 401 over 1987, adding a US$2.3 billion to the trade surplus in 1987 (as opposed to US$1.S: billion last year). The increase in exports was due to improved competitiveness since mid-85; as mentioned before, although the exchange rate dipreciated in real terms by 422 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 102. 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 rhase of economic policies for 1989. This renewed Pacto now called Stabilization and Growth Pact (PECE) aims to consolidaLe 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 82, 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 522 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. Inflation, after accelerating to 2.1 and 2.42 respectively in December and January, came down to 1.42 in February and 1.1Z 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 exchange rate (a small real depreciation from December 1988 to December 1989). Exchange rate policy will be monitored in the context of the proposed IMP's EFF.  - 6- 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 vell. 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 export 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: Industrial Sector Policy Loan (ISPL), FSL, and Public Enterprise Reform Loan (PERL); how to restore private sector based growth within the constraints se,. 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 contrtbute significantly to the chances of success of the stabilization effort. Clearly, cutting back Mexico's access to foreign capital markets would in fact reduce Mexico's creditworthiress because it would slow down GDP growth. Sustained access to exteLnal 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 sucb 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  - 7 - 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 Mexico and all its external creditors play an active participatory role. E. External Debt and 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 47.12 of exports of goods and non- factor services in 1982 to 60.5Z 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 8.22. and its share of Mexico's long-term debt service was 7.62. 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 102 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 - SECTORAL CONTEXT A. Overview 26. Mexico's industrial sector had been sheltered from the rigors of foreign competition until the mid-1980s by three decades of policies relying heavily on import substitution and extensive government intervention in the sector. Intervention took place both directly, through the expansion of public enterprise scope and capacity, and indirectly through the incentive system and a complex industrial regulatory framework which applies both to private and public firms. The nation's industrial sector development depended heavily on public enterprises (PEs) and a restrictive regulatory framework has closely linked private sector production to PE activities in both the goods and factor markets. Private sector development was heavily regulated. 27. The cost of these policies may be observed in: ti) the industrial sector's general lack of competitiveness, (ii) the great dependence of the private sector on public sector activity, and (iii) low intersectoral resource mobility. Weak macroeconomic management in the past, volatility in the terms of trade and in international interest rates, and the high level of the country's foreign debt have increased risk and uncertainty for the private sector; this has undoubtedly affected the structure and volume of resources allocated to industrial activity. Therefore, continuity, consistency and credibility will be essential for the continued success of the Government's ongoing structural reform program, which was initiated in mid-1985 to open up the economy to foreign competition and remove distortions that have reduced competitiveness in the industrial sector. The trade reform is quite advanced and macroeconomic policies have been greatly improved; the implementation of complementary domestic policies and dismantling of industrial regulations is, however, lagging behind. The sectoral approach to industrial policy ("picking winners"), entry barriers,  - 8 - protective trade policy, price controls, selective credit and tax incentives, foreign investment rules, disincentives in research and development (R & D) and foreign technology transfer, labor market restrictions, inefficiency in trucking, are main areas where regulations affect goods and factor markets, hinder private sector adjustment to changes in the incentive system and contribute to increasing industrial and geographic concentration. B. Background 28. Mexico has a record of sustained industrial growth which has mainly resulted from increases in capacity expansion rather than productivity increases. Gross manufactured output in constant prices rose at average rates of 6.32, 8.3Z and 7? p.a. for each of the decades 1950-60, 1960-70 and 1970-80, respectively, and during each decade real industrial growth exceeded overall GDP growth. Since the 1950s through 1982 rapid expansion of domestic demand was the major source of industrial expansion. Growth of exports accounted for only 2-5X of industrial growth during the thirty year period. The share of manufacturing industry in GDP has been increasing since the mid-1970s, but more so in 1986-1987 when it reached about 25? (Table 1). The manufacturing sector accounted for about 11? of total wage employment in 1986. Three subsectors represent about 75Z of manufacturing GDP: (i) food, beverage and tobacco; (ii) textile, clothing and leather goods- and (iii) chemical, and metal products and machinery industries (Annex X, Figure 1). Direct PE involvement in manufacturing industry is significant (around 25?), and PEs are involved in the production of important industrial inputs (basic petrochemicals, steel, fertilizers) and nontradables (electricity, telecommunications, banking). Four of the ten largest firms are PEs, and the state-owned petroleum company Petroleos Mexicanos (PEMEX) is the largest enterprise in the country. The share of non-petroleum PEs increased between 1982 and 1983, largely due to the nationalization of the banking system. In the area of transport, storage and communications, PEs account for about 25? of all activities. 29. Import substitution and a public expenditure-led growth strategy was the hallmark of the industrial sector in the 1970s until around 1976 when the consolidated public sector deficit reached unsustainable levels. The Government undertook a combined program of stabilization and limited trade liberalization with renewed efforts to reform taxes, reduce protection and stimulate non-oil exports. However, major new oil discoveries in 1977 and 1978 were seen as the means to finance a quick return to high growth without politically costly structural reforms. The decision to join the GATT was postponed, and modest progress in trade liberalization was reversed after 1980. Beginning in 1978 and continuing through 1982, the economy experienced a period of unprecedented growth,  -9- Table 1: Mexico - Key Indicators of the Manufacturing Sector 1975-1987 1/ (in percent) 1975-1982 1983-1985 1986-1987 Manf. GDPIGDP 21.6 22.6' 24.9 Manf. Price Deflator/ Ir' GDP Deflator 100.1 107.2 118.1 Manf. Sector Imports/ Total Imports 89.5 92.3 93.2 Non-oil Exports/ 40.5 30.4 59.3 Total Exports Manf Exports/ Total Exports 24.0 22.2 46.4 Manf. Exports/ Non-oil Exports 59.1 72.9 78.3 Annual Rate of Growth of 9.1 4.7 23.7 Non-oil Exports (US$) Annual Rate of Growth of Manf. Exports (US$) 10.7 4.2 39.2 Hanf. Exports/ Manf GDP 8.1 13.0 26.1 Manf. Export Price/ Manf GDP Deflator 114.0 112.0 139.0 1/ Source: Staff estimates from LA2CO Mexico Data Base. fueled primarily by the rapid expansion of oil exports and substantial increases in public investment. Since 1982, the industrial sector has adjusted to the economic crisis primarily through reduction in industrial output and by increasing the share of exports. At the same time, the dependence of manufacturing production on imports has been traditionally high, as shown by the sector's relatively unchanged share of imports (Table 1). 30. Industrial sector strategies were implemented in three distinct phases since the late-1970s. The period from 1978-1982 was mainly characterized by a closed economy, enjoying a boom from oil revenues and abundant international credit. By 1982, growth based on import substitution and excessive reliance on public sector investment was virtually exhausted, and in the period from 1983-1985, Mexico undertook an adjustment program based on drastic contraction of domestic demand through  - 10 - fiscal and monetary policies. During this period the Government became increasingly aware of the need for fundamental structural reforms, which were finally introduced in mid-1985. The period 1986-1988 was characterized by the start of a new approach to industrial sector development. C. Import Substitution, Public Expenditures, Oil and Foreign Borrowing-Led Growth: 1978-1982 31. Large scale public and complementary private investments were encouraged by a combination of trade and fiscal incentives while export capability was severely repressed. The excessive focus on import substitution not only prevented industry from gaining the productivity and efficiency required to compete abroad, but also penalized the primary sectors (especially agriculture and mining) that had previously been export-oriented, by skewing incentives and drawing private sector resources away from them. Some sectors became heavily dependent on fiscal incentives, subsidized input prices, preferential credit and the "buy Mexican' procurement policies of the public sector. The overall effects of the industrial sector policy based on an import substitution strategy, direct industrial controls and public sector ownership are reflected in the poor productivity and international competitiveness of Mexican industry. Total factor productivity (TFP)2 declined throughout the period, and was especially low in subsectors enjoying protection through QRs. Low productivity growth was also reflected in insufficient international competitiveness of the industrial sector, as measured by the Domestic Resource Cost (DRC) ratio.3 While half of all industrial sector activities had DRC ratios below 0.9 (competitive), 27Z fell in the range between 0.9 and 1.1 (uncertain competitiveness), leaving at least a quarter of industrial activities in the uncompetitive range. Meanwhile, the agricultural and primary sectors experienced negative effective rates of protection. D. Macroeconomic Adjustment and Awareness of the Need for Structural Reform 1983-1985 32. The macroeconomic environment and its impact on the public sector greatly affected industrial performance during this period. Private investment in Mexico, at that time, directly depended, aw ng other things, on public investment in infrastructure and, due to regulations and trade barriers, on expansions in PEs' capacity to produce inputs as well. Accordingly, the latter was a precondition for complementary downstream private investments. Moreover, increased public sector investment fostered new private sector investments undertaken in part to satisfy the additional public sector demand. Aggregate public sector expenditures in relation to GDP fell sharply in 1983. Links in the prevailing market structure necessarily implied that the cutbacks in infrastructure and PE investments induced a contraction in private investment. The result was a magnified cost of adjustment, which was reflected in a sharp reduction in industrial output and employment in sectors where linkages were high (e.g., capital 21 TFP provides a measure of output growth, net of the growth attributable to increased factor inputs. 3/ DRC compares output at international prices with inputs at shadow prices.  - 11 - goods). As a result of the stabilization effort, imports fell and the external balance showed large surpluses. Unfortunately, the implementation of trade liberalization measures was very slow during 1983-1984. The creation in 1983 of a 'free trade status" for exporters through the Temporary Import and Duty Drawback schemes diminished the anti-export bias. However, the import regime continued to be restrictive as QRs rather than tariffs provided the effective constraints on most imports, and domestic sales remained highly protected. Only limited trade liberalization was achieved in the first half of 1985, against strong opposition in many parts of the private and public sectors. However, the ensuing fiscal crisis proved that the public sector-led import substitution growth model was unsustainable, and the need for structural reform became apparent. As a result a major reduction of QRs took place in mid-1985. E. The Beginning of Structural Reform: 1986-1988 33. Trade policy was the first area in which major structural reforms were undertaken. The net effect was intended to permit Mexico to exploit its comparative advantage in manufacturing, mining and agriculture, to generate rapid growth of non-oil exports and to increase efficiency in the import-substituting sector. The liberalization process was accelerated in late 1987 as part of the measures taken under the Pacto. The commitment to liberalize trade was reinforced by Mexico's formal accession to GATT in August 1986. As the trade liberalization began to take effect, the need to change domestic industrial policies vhich were preventing an adequate response to external competition, became pressing. 34. Trends in the development of the manufacturing sector suggest that there has been a supply response in the manufacturing sector, as can be seen from the positive relationship between the behavior of relative prices for the manufacturing sector and the share of the manufacturing sector in GDP (Table 1). All of the indicators show consistency regarding the direction of structural change towards increasing export orientation, especially since 1985. There has also been an increase in manufactured exports relative to both non-oil exports (NOE) and to manufacturing GDP. These results may be partly related to trade liberalization and partly to counter-cyclical behavior of these shares during recessions. The increase in the price of manufacturing exports relative to the implicit price deflator for manufacturing GDP experienced after 1985 reflects mainly the depreciation of the Mexican peso. 35. The opening of the economy since 1985 allowed the increase in productivity mainly in the sectors where the Mexican industry has a comparative advantage. The gains were more pronounced, since 1986, in the dynamic industries exhibiting solid export performance and trade balance surplus, namely food, textiles and metal products. Moreover, except in the iron and steel industry, in most other industries there was an increase in factor productivity since 1986 (Annex X, Figure 5). In addition, the paper, chemical, metal products and machinery industries ran trade deficits in 1987; while the food, textiles, non-metallic minerals and basic metals industries ran a trade surplus in 1987 (Annex X, Figures 3 and 4). F. Outlook for the Industrial Sector 36. In response to the crisis, labor markets have shown unexpected  - 12 _ flexibility mainly through a sharp reduction in real wages. The virtual elimination of fiscal and credit incentives and changes in the corporate tax system reducing the bias in favor of debt financing and against equity financing are encouraging companies to take a hard look at the economic returns of alternative production choices, and to seek sounlder sources of financing that permit the assumption of greater risk. The Government is also seeking greater mobilization of venture capital financing for the industrial sector and it has embarked on a far-reaching program for restructuring or divesting parastatal industries. 37. Mexican authorities have recognized that the resumption of growth will require, among other things, increased private investment and participation in industrial activity. Reforming the regulatory framework in order to foster a more competitive domestic market structure will be one of the means to attain this objective. 38. The policy agenda is now focussed ont (i) consolidating the stabilization achieved under the Pacto; (ii) completing and consolidating the trade reform including the dismantling of non-tariff barriers, and (iii) proceeding with the liberalization of domestic policies which effectively inhibit competition. Leaving such policies in place may prevent trade liberalization gains from being fully realized because they affect price signals and factor mobility and therefore inhibit the supply response. If the required structural changes can be carried out consistently and at a suitable pace, including the freeing-up of many domestic controls, prospects for the sector are good. 39. Improved macroeconomic management, the advanced stage of the trade reform, the continuing privatization of PEs and the initial steps taken with regard to deregulation, are important elements in setting the stage for robust and sustainable industrial growth. Part III of this report outlines a series of measures to support the Government's industrial sector program, aimed at reducing inefficiencies in the goods and factor markets and in the provision of trucking services. PART III - THE INDUSTRIAL SECTOR REFORM PROGRAM A. Program Scope and Actions Taken 40. Following its initiatives in trade liberalization, the Mexican Government has started modernizing its industrial policies, and has been devising strategies for more comprehensive deregulation of the cector. Its long term objective is to achieve an internationally competitive industrial structure that is responsive to technological change. The process of deregulation is complex, however, as shown by the experiences of countries like Japan, U.S.A., Great Britain, and, recently, New Zealand. Regulatory instruments are diverse, trade policy being just one of them, and they cut across sectors. This diversity raises questions of optimal sequencing and timing of policy changes. Furthermore, attempts at deregulation can be expected to encounter strong opposition by interest groups who benefit from the present policy environment. The Government's direct involvement in manufacturing and some services also complicates the deregulation process. 41. The proposed ISPL will support a program geared toward  - 13 - deregulating the Mexican industrial sector. It will support policy changes to be initiated in 1989 that will encourage more efficient allocation of resources in the industrial sector and stimulate sustainable industrial growth, based on market forces rather than on the use of discretionary policy instruments. The program will emphasize: (i) deregulation of the industrial sector programs; (ii) further improvement in the trade regime; (iii) establishing more open direct foreign investment and technology transfer regimes and improving the environment for R & D; (iv) relaxing barriers to entry and reducing the cost of doing business; and (v) implementing regulatory changes to improve the provision of trucking services. An attempt will also be made to review and implement initial measures aimed at increasing labor mobility. The details of the proposed program are discussed below and summarized in the policy matrix (Annex V). 42. The Government has already taken a number of important steps designed to initiate the process of reform of the industrial sector. A new procurement law has been introduced, and the provisions of the foreign investment law have been simplified and made more flexible to stimulate direct foreign investment (DFI). To that end, the Government just published a Reglamento to the DFI Law (interpretative regulations to implement the Law). The new Reglamento gives transparency and automaticity to the system and eliminates the requirement of case by case approval in the vast majority of cases. For specific subsectors, increased patent protection is being extended for new technology in the chemical- pharmaceutical sectors, domestic content requirements (DCRs) have been lowered for automotive exports, QRs on microcomputer components have been eliminated, private petrochemical firms have been given greater freedom to import inputs and produce a greater variety of final products, while a 302 subsidy on basic chemical inputs has been eliminated and QRs on secondary chemicals have been replaced by tariffs. To promote a more competitive environment, simplified procedures have been adopted for registration and administration of microenterprises, and the certificate of fiscal promotion (CEPROFI) incentive for investment has been eliminated for practically all industrial activities. In addition, interest rate subsidies to industry have been virtually eliminated by adopting market-oriented lending rates. In the area of services, international trucking movements are now permitted across the U.S. border and limitations on the shipment of goods by container have been removed. 43. While the measures to be supported by the proposed ISPL are diverse, they address only a subset, albeit a crucial one, of the existing regulations. For example, while recognizing how important regulatory issues are to labor mobility, in the context of the proposed ISPL, major changes in this area 'ill be left for the future, because they require thorough analysis and difficult and likely time-consuming legislative actions. The same approach applies to major entry barriers in industries where regulations governing property rights are not well defined. There exists great uncertainty regarding the optimal timing and sequencing for implementing an effective process of deregulation causing the least possible disruption. Accordingly, to maximize the impact, the proposed loan will support studies in the areas of DFI, technology transfer and R & D, labor mobility, the pharmaceuticals, automotive, and computer industries, the system of export quotas, unfair trade practices regulations, and regulations on trucking to review key issues as a basis for agreeing on plans of action for further changes.  - 14 - B. Sector Programs 44. Much of Mexico's recent industrial strategy has been carried out through programas de rama (Sector Programs). These Sector Programs were developed by the Ministry of Industry and Trade (SECOFI) in consultation with industry representatives during the early 1980s. The objective of the Sector Programs was to alleviate balance of payments difficulties and to target industries designated as high priority. The most important Sector Programs are for the automotive, pharmaceutical, petrochemical and computer industries. The first three of these Sector Programs were established by decree, the one for computers is an informal program. Annex VI provides details on the Sector Programs. 45. The Sector Programs combine protective instruments, like import restrictions, tax incentives and domestic entry restrictions, with regulatory measures like DCRs, mandatory export quotas and the requirement to maintain a foreign exchange balance position between exports and imports, and, in some cases, price controls. The Sector Programs also regulate DFI in their respective subsectors, and have extended the set of industries reserved for Mexican nationals in the foreign investment law, although some exemptions to foreign firms were granted. 46. As of March 1989, 22.32 of domestic production of tradeables were protected by QRs on competing imports, of which 3? corresponds to the industrial sector,4 including about 2.7S representing the Sector Programs. However, these figures underestimate the incidence of non-tariff barriers since they do not account for domestic restrictions embedded in Sector Programs, in particular DCRs. 47. Industrial subsectors subject to Sector Programs represent 4.32 of GDP, as compared with their 25 share of manufacturing GDP. Two of these subsectors, basic chemicals and pharmaceuticals, worsened their growth performance in 1987 with respect to the period 1981-1986. Basic petrochemicals continued to grow at a fast pace, the automobile sector accelerated its rate of growth impressively, and auto-parts production improved its growth performance significantly in 1987. Industries subject to Sector Programs exported about 36Z of manufacturing exports during 1987 (Table 2). 48. Overall the Sector Programs are quite specific in the goals they seek, primarily in terms of increased exports and import substitution, and seem to have generally met some of their targets such as investment and export growth, job creation, and sectoral trade balances. However, because of trade liberalization measures taken after the introduction of the Sector Programs and significant changes in the macroeconomic environment, these improvements can only be attributed in part to the Sector Programs. Moreover, the entry restrictions and the remaining disproportionate protection provided to these sectors have contributed to large efficiency 41 Including agricultural inputs (e.g., pesticides, irrigation equipment, agricultural machines), but excluding those on oil and derivatives, and agroindustrial products.  - 15 - Table 2: Mexico Sectoral Proqram Indicators GDP and Exports GOP Rstes Sector COP Sector Export. of Growth /GDP /Manuf .Exports* (U) 1981-se 1987b 198sb 1987b GDP 0.0 1.4 100.0 - Manufacturing GDP 0.0 .0 24.7 - Selected Sectors: Textile and Clothing (24.25,26,27) -2.0 -1.9 2.0 3.2 Basic Petrochemical (34) 13.0 16.8 0.8 1.1 Basic Chem. (86) 4.0 2.6 0.8 8.2 Pharmac. (88) 2.0 -1.4 0.4 0.8 Automobile (6B) -8.0 18.1 0.8 0.8 Auto-parts (67) -2.0 2.1 0.5 16.7 Trot-sport Equipment (58) -4.0 -8.7 0.2 0.8 Total 4.8 25.7 Source: WS calculations based on INEGI (Sector classification number) a. Includes oil derivates and petrochemical exports. b. Based on preliminary data. Nominal and Effective Protection Rates and Quantitative Restrictlons (as of March 1989) Effectivo Tariff Ratesa Protection Rates QRsb (X) Average Total (Sectors 1-69)c/ 12.6 15.6 22.8 Selected Sectors: Texti le Soft Fiber Prodcuts (24) 14.2 18 0.0 Hard Fiber Product. (25) 11.8 14 0.0 Other Textiles (26) 17.7 27 0.1 Clothing (27) 20.0 88 0.0 Basic Petrochemical (84) 6.8 11 0.0 Basic Chemical (36) 10.2 13 0.0 Pharmaceuticals (88) 16.7 82 0.1 Automobile (65) 19.0 s0 2.4 Auto-parts (57) 18.2 8 0.1 Transport Equlpment (58) 12.8 16 0.0 TOTAL: 2.7 Source: Bank estimates; SECOFI date. a/ Weighted by 1986 production (matching of weights for the Tariff Harmonized System 's approximate). b/ 1988 production coverae . c/ Includes all tradeables setors (agrieulture, agroindustry, mining and manufacturing).  - 16 - losses and a less competitive industrial sector environment. Finally, the DRC of the net foreign exchange earned through exports from iniustries subject to Sector Programs tends to be among the highest of Mexico's industry. 49. While initially, the Sector Programs served a useful purpose, stimulating investment and export growth in certain subsectors, but generally at a high economic cost, these programs have outlived their usefulness, particularly in an economy that is opening up as rapidly as Mexico's. Consequently, since the protection presently being granted to these sectors is no longer justified, the Government has agreed to reduce them to levels comparable to those in other sectors and make them more transparent. This strategy has been defined in consultation with industry representatives, taking into consideration existing contractual arrangements, as necessary. The action plans to deregulate individual Sector Programs include the reduction of QRs and DCRr, the flexibilization of foreign exchange balance requirement, and the rationalization of price controls and compulsory R&D spending together with other measures restricting market forces. Specific actions for each program are presented below. Automotive Industra 50. In 1981 the automotive sector accounted for about 60? of Mexico's trade deficit. To promote the national autoparts industry. improve the integration of the various stages of production and to increase exports, the automotive industry sectoral program was established in 1984. 51. The automotive industry consist.s of auto and truck vehicle and parts producers. All must comply with DCRs, which vary depending upon whether production is for the domestic or export market. Foreign ownership of Mexican autoparts firms is limited to 40?. The number of lines and models which auto producers may manufacture are limited. Production of gasoline trucks are restricted. Maquiladoras which produce autoparts are exempted from the regulations. 52. Recently the Government has made significant progress in deregulating the industry by changing some important regulations. DCRs on exports of both automobiles and auto parts were redvced from 602 to 302, restrictions on the imports of steel (which is important for the automative sector), were eliminated, and tariffs on imported "kits" were abolished. In addition, auto producers were allowed to produce a wider variety of models for exports. These changes are supported under the Industrial Restructuring Project approved by the Board of Directors on April 25, 1989. 53. The volume of automobile exports has increased significantly and, after several years of stagnation, the export value of autoparts has almost quadrupled since 1984. While both product categories accounted for over 272 of manufacturing exports in 1987, the automobile sector presently accounts for about 1.32 of GDP. Because of subsequent economy-wide trade liberalization which occurred after the establishment of the Sector Programs, the protection provided to the sectors covered by the Sector Programs has increased relative to other sectors. Currently, effective protection for automobile production is about 502 compared to the 15? average for the manufacturing industry as a whole. On the other hand, the  -17 - estimated effective protection for autoparts of about 82 is below the manufacturing sector average (Table 2). These estimates do not take into account either the protection granted to autoparts and the implicit taxation on autos stemming from DCRs to car producers or the effects of the remainir.g features of the program. However, the significant decline in real wages has contributed to improving the sector's competitiveness. 54. To further increase the competitiveness of the Mexican automotive industry and to improve industry wide resource allocation, the Government has agreed to implement a plan of action to deregulate the automotive sector (including trucks, buses and parts) comprising the following measures: ti) imports of automobiles, light, medium and heavy trucks, tractor-trailer trucks and buses will be opened gradually, beginning with the 1991 model year. The liberalization of new cars, similar to the ones domestically produced, and all trucks will proceed in the following stages: - initially vehicle producers and, subsequently, other importers will be allowed to import; - initially imports of economy cars will be permitted, bhile other types of cars to complement domestically produced lines will be imported later, and - QRs will be maintained for luxury cars not similar to the domestically produced ones. QRs on cars, trucks and buses, similar to those domestically produced, will be gradually reduced to increase international competitiveness of domestic car producers; (ii) DCRs for the production of automobiles, light, medium and heavy trucks, tractor-trailer trucks and buses will be reduced gradually. In the first step concerning the 1991 models, DCRs for automobiles produced for the local market will be lowered from 602 to 502 and by 10 percentage points for each category of trucks and buses (DCRs for light trucks is 702, for medium and heavy trucks is 802, and for tractor- trailer trucks and buses is 90?). DCRs will be further reduced for subsequent model years; (iii) DCRs for autoparts will be reduced gradually, beginning with a reduction from 60t to 502 in the 1991 year model. Also. the remaining QRs on autoparts imports will be removed gradually; (iv) depending on the results of the program for DCR and QR reduction, the foreign exchange balance requirements between exports and imports will be made more flexible; (v) regulations restricting efficient organization of production of vehicle and autoparts producers (e.g., restrictions concerning the number of car models and lines) will be eliminated; and (vi) an official announcement will be made that the above program of import liberalization and industrial deregulation for the automotive sector will begin with model year 1991.  - 18 - a 55. The Government agreed to carry out a study to elaborate the new strategy for the automotive sector, analyze the sector's competitiveness and strengthen the regulatory framework for environmental and safety standards. The release of the second tranche of the loan will be contingent upon: (i) satisfactory progress in implementing the above- described plan of action for the automotive sector and (ii) agreement on a plan for future action that takes into account the recommendations of the aforementioned study. Pharmaceutical Industry 56. Pharmaceutical production represents 0.42 of GDP. A shortage of pharmaceuticals in 1983 led to the creation of the Pharmaceutical Sector Program in 1984. Reflecting the Bank's dialogue with the Government, the Government let this Sector Program expire at the end of 1988 while honoring existing commitments which will expire gradually over the next five years. The Sector Program aimed at developing a national pharmochemical industry through import substitution and restrictions on DFI. The Sector Program sought to obtain maximum self-sufficiency with the ultimate target that 982 of all pharmaceutical requirements and 60X of all active ingredients (pharmochemicals) would be produced in Mexico. Imports of pharmochemicals are constrained by QRs and DCRs, and health requirements restrict pharmaceutical imports. A further objective is to provide medicines at accessibleO prices. The Sector Program also stater that exports should represent a minimum of 142 of pharmaceutical sales and 30? of pharmochemical sales. Entry of new firms is Alowed only if inc-umbents cannot meet domestic demand. In addition, public sector procurement, which represents 202 of the domestic consumption of pharmaceuticals, favors Mexican firms. Other regulations include price controls and quality norms. Restrictions on imports and firm entry have reduced competition in the pharmaceutical industry. Public bidding for pharmaceutical products which is restricted to domestic producers is usually ineffective because of a monopolistic domestic market structure. Price controls deter entry and growth in many basic pharmaceutical products. Furthermore, there is a potential for conflict of regulatory responsibilities and objectives between SECOFI, which administers the program, and the Health MInistry, which implements health regulations. 57. The pharmaceutical Sector Program has not achieved its most important goals. This subsector had the worst growth performance amorg the sectors subject to Sector Programs. From a positive average growth rate of 2? p.a. during 1981-1986, output declined by 1.4? in 1987 (Table 2). Exports have remained about the same as before the program was initiated and the industry continues importing almost half of its raw materials. To increase efficiency and promote further growth in the industry, the Government bas reformulated its strategy for the pharmaceutical sector and, as stated above, it has not renewed the current program. The rules on pricing and DFI have recently been relaxed and the National Commission for Foreign Investment (NCFI) now automatically approves applications for DFI in the sector. However, the existence of price controls on basic pharmaceuticals continues to be an important disincentive to investment in this industry. Moreover, the effective protection of 32? for this sector continues to be more than double the manufacturing sector's average effective protection rate of 15.5? (Table 2).  :z 19 - 58. To address the above issues the Government has agreed: (i) not to renew this Sector Program; and (ii) to implement a gradual and concerted elimination of QRs and to reduce DCRs for pharmochemicals, both in parallel with the expiration of existing contractual arrangements. Initially, QRs on 15 harmonized tariff items will be eliminated, and further reductions will take place subsequently. In this context the Government has also agreed to carry out a study as a basis to establish a clear classification of products, appropriate health standards and procedures for the pharmaceutical industry, and implement an efficient price policy, including international bidding for public health procurement. Satisfactory progress in implementing the plan of action for the pharmaceutical industry and agreement on a plan to implement the recommendations derived from the study are conditions for second tranche release. Petrochemical Industry 59. The petrochemical industry accounts for about 0.3Z of GDP. The Petrochemical Sector Program was established in 1986, with the objective of increasing private sector participation in the production of petrochemicals. The Sector Program: (i) lim-4ts the state-owned Petroleos Mexicanos' (PEMEX) role to being the sole domestic producer of 34 products classified as basic petrochemicals, leaving the production of downstream products to the private sector, (ii) requires PEMEX's basic petrochemical pricing policy to be flexible (in practice, prices have been set at 80Z of their international levels since 1983), (iii) permits direct imports of basic petrochemicals by the private sector, and (iv) promotes the selective use of fiscal instruments to foster petrochemical investments. 'While secondary petrochemicals are produced by the private sector, entry into the sector requires authorization by an official commission. DFI is also restricted to secondary industries and with a 402 maximum participation; 100? DFI is permitted in the tertiary sector. Although the assezsment of the opportunity cost and availability of natural gas in Mexico is eritical to the design of a sector strategy, the program does not take it in%o account. 60. Under the Pacto, a 30? subsidy on energy inputs was eliminated and the PEMEX prices for basic petrochemicals have been frozen. This price freeze, at a time when international prices are going up, has resulted in domestic feedstock prices that are below international levels. By mid-1988 almost all basic petrochemical products were liberalized from import licensing and tariffs ranged from 0 to 15?. 61. The key problems of the industry are the lack of a reliable supply of basic products from PEMEX and of a clearly articulated strategy by the Government to deal with PEMEX's dominant position in the industry. For these reasons, private secondary petrochemical companies in Mexico are at a disadvantage compared with their international competitors. First, they cannot vertically integrate. Second, the unreliable supply from PEMEX forces them to source part of their basic inputs in the international spot market. Third, vertically integrated international competitors can impute transfer prices for their inputs well below prices charged on sales to Mexico. Fourth, since foreign suppliers view the Mexican market as short- lived due to PEMEX's ongoing expansion plans, they supply basic petrochemical inputs to Mexican secondary producers at less favorable rates  - 20 _ than those offered to other large non-integrated companies on long term contracts. 62. The Government has agreed to implement a plan of action for this sector which includes the following key measurest (i) limiting the exclusive right of PEMEX to producing a maximum number of 25 basic petrochemical products and defining an initial list of secondary petrochemicals that are open to private sector participation; and (ii) encouraging cooperative arrangements between the private sector and PEMEX. Satisfactory progress in implementing this plan of action is a condition for second tranche release. Micro-computer Industry 63. The major elements of the micro-computer program are QRs, DCRs, and duty-free imports of inputs. DFI is normally limited to minority ventures approved by the NCFT. Since 1986, the program has been changed significantly, by eliminating QRs on components, spare parts and peripherals, and by reducing DCRs. In practice, DCRs have been largely circumvented and producers have tried to increase their effective rates of protection by producing items with less value added, usually micro- computers assembled from fully imported parts. As a consequence, domestic prices of micro-computers have been brought down from 2502 to 1252 of the U.S. list price. Although this sector accounts only for a very small share of GDP, its present level of high protection is unwarranted and unnecessary given the degree of international competitiveness already attained. The Government agreed to implement the following plan of action, including the phasing out of this program by the end of 1992: (i) gradual import liberalization of new computers starting by allowing imports of specialized hardware (e.g., Laptop computers, Laser printers) until complete elimination of QRs is achieved in 1992. Gradual reduction of DCRs for computer production beginning with one-third of current levels of DCRs until complete elimination in 1992; (ii) foreign exchange balance requirements will be made more flexible depending on the results of the programs; and (iii) the Sector Program will be phased out by the end of 1992. The Government has also agreed to carry out a study of Mexico's international competitiveness in micro-computers. Satisfactory progress in implementing the program and agreement on implementing a strategy based on the recommendations of the study are conditions of second tranche release. C. Competitive Goods Markets 64. In addition to protecting specific industries through the sectoral programs, the Government has protected domestic industry in general through trade policy instruments, price controls, and various forms of entry barriers. Entry by private firms and foreign investment have been restricted in some "strategic' industries. Moreover, the sectoral approach is further reinforced through Government intervention in factor markets as discussed in Section D of this Chapter. In addition, bureaucratic requirements have not only made entry difficult, but also imposed a substantial cost on doing business in Mexico. In this section, some of the major policy issues impairing competition in the goods markets and measures to cope with them are discussed in the areas of: (i) trade policy, (ii) price controls, (iii) entry barriers, and (iv) bureaucratic procedures  - 21 - (cost of doing business). Price controls will only be discussed briefly since they are being dealt with in detail in the President's Report for the proposed FSL. Trade Policy Reform 65. The onset of the debt service payments crisis in 1982 saw quantitative controls on all imports, and thus protection of all domestic production of import substitutes. As mentioned earlier, since mid-1985, Mexico has undertaken a fast and far-reaching liberalization of the trade regime, aimed at expanding the tradeables sector, opening up to international competition and encouraging efficiency in both exporting, and import-substitution activities. In 1986 Mexico acceded to the GATT. The pace of liberalization was quickened in 1987, and early 1988 as part of the Pacto. The trade liberalization process was supported by the following Bank operations: TPL I (Loan 2745-ME), TPL II (Loan 2882-ME), First and Second Export Development Loans (EDP I, Loan 2331-ME and EDP II Loan 2777-ME) and the AGSAL (Loan 2918-ME). As explained in para. 7 above, it will take some time before the full impact of the trade policy reform measures will be felt. However, the initial results are promising as incentives have been redirected and the restructuring toward more efficient activity has begun. 66. The key reforms have included reductions in the coverage of NTBs and tariffs as reflected in the following table: Trade Liberalization 198S-1989 June 85 DOc 86 June 86 Dec 86 June 87 Dec 87 may 88 Mlar 899/ Import Liconsing !/ 92.2 47.1 46.9 39.8 85.8 26.4 28.2 22.8 Reference Prices a/ 18.7 25.4 19.0 18.7 13.4 0.6 0.0 0.0 Tariff - Rango 0-100 0-100 0-45 0-46 0-40 0-20 0-20 0-20 -Average g/ 238. 289. 24.0 24.S 22.7 11.8 11.0 12.6 Real Exchange Rate */100 127.1 148.5 157.4 164.8 147.2 124.8 122.4d/ a Percentage coverag, of production of tradeables; 1986 weights. J Weighted by production of traduables In 1986; excludes SX surcharge. ;I Preliminary Bank estimates. J Latest exchange rate index Is for December 1988 / Trae weighted foreign prices relative to the domestic price level. 67. The progress in trade liberalization has been impressive. Import licensing coverage is now 22.3? of domestic production which is less than one-quarter of what it was in June 1985, official reference prices (ORPs) have been completely abolished, the maximum tariff is now 20? and the average tariff is about 13?, i.e., about one-fifth and one-half respectively of what they were in June 1985. As pointed out in para. 8, progress as of early 1989 had gone beyond the Government's original schedule, GATT commitments, and the targets in the TPL II and the AGSAL.  - 22 - 68. This substantial opening up of the economy was achieved quickly during a period of considerable macroeconomic instability and uncertainty. The priority now is for a period of consolidation of the impressive improvements in the neutrality, transparency and simplicity of the trading regime, and deepening of reforms in areas where there has been lesser progress so far. The Government has recently published a Trade Policy Statement with a clear indication of its commitment to maintaining existing achievements and making further advances over time to enhance the neutrality, transparency and simplicity of the trade regime. The current trade regime and proposed reforms are discussed below, and set out in more detail in Annex VII. 69. Quantitative Restrictions have been an important element in the Mexican trade regime and have been used to achieve both protective and macroeconomic objectives. After the balance of payments crisis of 1982, 100? of imports were controlled by QRs. They were not much reduced in the 1982-84 period, but from July to December 1985 coverage of domestic production of competing tradeables was dramatically reduced to 46?, and from 1986 further reductions took place, leaving only 22.3! of domestic production and about 18X of imports currently subject to controls. Most of the import restrictions remain in the agricultural and agroindustry sectors (6.2? and 6.12 of production, respectively), followed by petroleum and derivatives (5.5?) and the industrial sector programs (2.7?). 70. This position represents an improvement of about 10 percentage points in production coverage of QRs beyond the targets in TPL II and the AGSAL. The following table shows the March 1989 and TPL I and II target positions on the basis of both 1983 and 1986 weights. The reweighting is approximate (and the figures in the table have been rounded to reflect that). Quantitative Restrictions al Situation TPL II targets TPL I targets March 1989 b/ end-1987 end-1987 1986 1983 1986 1983 1983 weights weights weights weights weights All tradeables 22.3 34 33 43.1 49.8c/ Oil & Der. 5.5 20.5 5.5 20.5 20.5 Other 16.8 13 27 22.6 29.3 a/ Coverage of domestic production of competing tradeables: 1983 or 1986 weights. b, Preliminary estimates. cl Plus 13.3? of coverage of ORPs giving total (net) NTB coverage of 63.12 of tradeables. 71. The protective incidence of the remaining QRs is likely to be quite variable. Mexico is an exporter of oil and derivatives and the QRs are likely to have little protective effect. In industry, the QRs support the  - 23 - Sector Programs for autos and auto-parts, microcomputers and pharmaceuticals. Mexico has significant exports of auto-parts and autos. In agriculture and agro-industry the QRs support price controls, guaranteed prices and international marketing agreements. Again many of the products are exportables. The ISPL will support a program of further reductions in the coverage of QRs. The Government agreed to implement the following measures: (i) by November 1989, reduce QRs coverage by about 0.5 percentage points plus any progress derived from the deregulation of the Sector Programs; and (ii) further reduce QRs coverage depending on the evolution of the Sector Programs and measures to be taken in the context of a possible future Second AGSAL. Satisfactory progress in the implementation of this action plan is a condition for second tranche release. 72. Tariffs have been dramatically reduced over the last few years. As of June 1985, tariffs ranged from 0 to 100Y, with a production-weighted average of 23.5Z. By end-1987 the maximum tariff had been reduced to 202 (lower than the target of 30? set in the TPL II and lower than Mexico's GATT bindings). As of July 1988 Mexico introduced the Harmonized System of tariff classification. Mexico has signed the GATT Customs Valuation Code, and as noted above has eliminated all ORPs for imports. 73. Since December 1988 and within the 1989 Mexican Budget objectives, the tariff structure has been consolidated to raise revenues and reduce the variability of protection across importable activities. The new tariff structure raises tariffs for many items previously subject to the 0 and 5? rates to 10?. Only about 310 tariff items out of a total of about 12,000 items now are subject to 0 and 5? rates, but these items account for about 23? of imports (July to December 1988). This structure leads to production- weighted average of 12.6Z and an import-weighted average of 9.9?. 74. By the standards of most developing countries, both nominal and effective rates of protection stemming from tariffs are no longer high or markedly dispersed in Mexico. Further progress can be made on reducing tariffs and thus reducing the variability of protection, but this is not an urgent task. More important is the consolidation of existing progress and reduction of the uncertainty about the continuation of the trade reform. As stated in its Letter of Industrial Sector Policy (Annex IV), the Government intends to avoid any significant reversal of past reforms. 75. Export regulations have also been significantly liberalized, although traditionally they have been less binding than import controls (and information is scarcer). By mid-1988, export taxes prevailed for 2.4? of exports or only 0.6? of production, and the coverage of export licences was 13.1? of exports or 24.82 of production of tradeable goods, as compared with 48.9? in 1982. The controls can be differentiated between those exercised by SECOFI and those due to quotas, export monopolies or preservation of rare flora and fauna. SECOFI's export controls concern industry (4.1?) and agroindustry (2.5?). The Government agreed to carry out a study in support of a strategy to eliminate "voluntary* export controls and to introduce an auction system for allocation of "involuntary' export quotas (due to international agreements). Completion of the study and agreement on an action plan for implementing the recommendations of the study are conditions for second tranche release.  - 24 - 76. An Anti-Dumping law and regulations were introduced in 1985-86. In 1988 Mexico signed the GATT Anti-Dumping and Countervailing Code. While the experience with the new system is limited and conclusions are tentative, there was some appearance of protectionist tendencies in 1987 and 1988, inconsistent with the opening-up of the economy: (i) the number of cases has increased rapidly; (ii) the 'injury test" is not playing a strong role in evaluation of dumping; (iii) high anti-dumping duties have been imposed; (iv) in 1988 the first "ex-officio' case was initiated covering 12 countries and a wide range of products. 77. The Government has confirmed its desire to ensure that the Mexican anti-dumping practice is consistent with trade liberalization and will review the experience of the anti-dumping system, particularly with regard to consistency with the trade liberalization process. The Government has agreed to implement an action plan for further improvement in the anti- dumping system, through improved training programs and information systems. The Government has also agreed to carry out a study to review unfair trade practice regulations. Satisfactory progress in implementing this action plan, completion of the study and agreement on a plan for implementing its recommendations are conditions for second tranche release. 78. Mexico uses several temporary import and duty drawback schemes to allow exporters access to duty fres imported inputs including: (i) the maquila enclave industry; (ii) temporary imports based on three year export agreements providing duty free access to imported inputs and machinery, and reimburses indirect taxes; and (iii) duty drawback which reimburses duties paid. The schemes have been improved since 1985 with Bank assistance under EDP II to expand coverage and improve benefits. The schemes have expanded rapidly in recent years along with a strong growth in exports. 79. Some 600 firms accounting for roughly one third of manufactured exports use the temporary imports and duty drawback system. Many other exporting firms which had imported inputs at zero or low duties will likely avail themselves of the schemes with the consolidation of tariffs at the 10 percent rate. The schemes reportedly work reasonably well, although they suffer the typical difficulties of all such schemes -- very hard to cover indirect, distant and small exporters; high administrative costs; and leakage to the domestic market. Price Controls 80. Prices on goods produced by the private sector are controlled by SECOFI; and those produced by the public sector are controlled by SHCP (Ministry of Finance and Public Credit). Changes in policies between 1985 and 1987 have reduced the number of products subject to controls to basic commodities and made the criteria for setting prices more flexible. Many of the price controls were eliminated in conjunction with the removal of import and export restrictions during this period. 81. While in 1982, strict price controls covered about 22Z of total production, at present only about 92 of total production is covered by controls. In October 1985, the Government introduced another category of price controls, caLied "registered controls,' where price changes are partially indexed to inflation. At present, products under registered price  - 25 - controls account for about 62 of production. A third category of price controls applies to about 5Z of production, and requires only that any price increase be registered with SECOFI. 82. Since 1982, substantial adjustments have also been made in the prices of the goods and services produced by the public sector, based on international price comparisons as well as costs of production. For example, the domestic price of gasoline was adjusted from 462 of its border price in 1982, to 742 in 1985 and to almost 1002 in 1987. 83. In a few commodities, price controls have led to market shortages (e.g., in milk, eggs, meat). In pharmaceuticals, the controls have caused disruption and uncertainty as firms have tried to evade controls through stopping operations temporarily and reopening with higher prices. Before the introduction of the Pacto, the industry and Government agreed on a pricing approach according to three categories: (i) generics (basic list); (ii) over the counter products (subject to quarterly, inflation-adjusted price increases); and (iii) prescription drugs. As part of the Pacto, in December 1987 a price freeze on publicly produced goods and services was introduced and in March 1988, virtually the same products under SECOFI price controls were made subject to the Pacto rules. Since appraisal of the three adjustment operaticns in October 1988, the Government has taken policy actions towards a more flexible system. The current phase of the Pacto includes adjustments in public sector prices, a daily depreciation of the exchange rate, and selective adjustments in controlled prices in response to shortages of particular products (para. 19). This is a clear move in the right direction and further progress towards a more flexible system should be an important component of the economic policies to be implemented after the PECE expires on July 31, 1989. The proposed ISPL will support this strategy in the context of the deregulation of industrial sector programs, particularly pharmaceuticals. Entry Barriers 84. There is a range of entry barriers in the Mexican industrial sector (Annex VIII). Several "strategic' industries e.g., petroleum and hydrocarbons, basic petrochemicals, and certain mining activities, are reserved for the Mexican Government and other industries are reserved for Mexican nationals (para. 97). However, the recent publication of the Reglamento to the DFI Law has reduced entry barriers in these sectors. Entry barriers are also evident in industries that use forest, mineral, aquatic and other resources where laws governing property rights are not well defined. Entry is also regulated through licensing in industries promoted through SECOFI's Sector Programs (Annex VI). To some extent, bureaucratic licensing procedures also serve as an entry barrier. Under the proposed ISPL, entry to the petrochemical sector will be facilitated because the Government will define a narrower range of basic petrochemicals and will support cooperative arrangement between PEMEX and the private sector (para. 62), and will encourage entry through the deregulation of the others Sector Programs. Other regulatory issues are expected to be addressed in connection with possible Bank operations providing support to the mining and forestry sectors. In addition, the regulatory changes supported by the proposed PERL will also facilitate entry.  - 26 - Cost of Doing Business (Bureaucratic Procedures) 85. Extensive bureaucratic requirements significantly raise the cost of doing business in Mexico. Lengthy procedures are needed to register and start up a business, change its name, and comply with many regulations related to its operation. Additional regulatory procedures must be followed by firms making DFI, or bringing in new technology. These procedures cause particular problems for small and medium sized firms since larger firms and conglomerates normally have specialized legal departments to handle bureaucratic requirements. The evidence on the costs to firms of these procedures is not conclusive, because transaction and opportunity costs are difficult to measure. However, preliminary estimates suggest that regulations affecting operations could in some cases account for 32 to 5? of a firm's operating costs and opening a business may take up to 420 days. 86. The bureaucratic procedures confronting firms may be divided into two general categories, registration/establishmentlexit and operations of enterprises. To register and establish a firm involves 17 separate procedures and 5 ministries. Many of the steps seem unnecessary (e.g. authorization from the Ministry of External Relations and Justice) or redundant (separate steps involving different sections of one ministry). The bureaucratic requiremcrts for operating a firm are even more extensive, Involving 13 different Government entities. Many of the operational requirements are linked to various industrial regulatory policies. Among these are taxation, health regulations, SECOFI-managed permits covering transfer of technology, price controls, and norms and patents. Operational procedures are also lengthy and individual steps could take as long as 180 days. 87. A number of important measures to simplify bureaucratic procedures have been taken in the past few years and Government entities report a significant number of measures toward simplification. Among the changes affecting business specifically, registration and installation procedures for microenterprises have been substantially reduced with a one stop window established to handle them. The time for issuing licenses for new construction has also been reduced to about one day and family home construction has been exempted from licensing requirements. 88. The recent simplification of the Fiscal Code has had a substantial impact on the time spent in filing tax forms and returns. The introduction of the Forum for National Consultation for Fiscal Simplification in 1987 specified 84 simplification measures. The process of simplifying the norms and procedures and information flows between the federal fiscal authorities and the lower-level fiscal entities has started and SHCP is committed to further simplification. Finally, the position of ombudsman in SHCP has been established whose task is to study ways to simplify procedures for taxpayers and to follow-up specific complaints. To study the regulatory distortions in goods, factors and service markets a program for economic deregulation was also established by Presidential Decree. 89. While the scope for further administrative simplification is still substantial, issues are complex and often not well understood. In order to achieve more meaningful results, the Government, by Presidential decree, has established a task force for administrative simplifications, that will study the factors causing the high costs of bureaucratic procedures, explore ways of simplifying them and reducing their costs, develop specific proposals for  - 27 - doing so, and oversee their implementation. The Government has recently published a strategic plan for administrative simplifications and agreed to implement the following actions in the context of the ISPL: (i) Ministry of Foreign Relations: decentralization of authorization to constitute a corporation to the offices in the cities of Toluca, Monterrey, Hermosillo, Guadalajara and La Paz; (ii) SHCP: decentralization of decision-making capacity to the different custom offices, automation of customs services, simplification of formats, speeding up customs procedures, and for ALTEX firms (highly export intensive firms), elimination of the required fiscal guarantees and increase the time period to re-export merchandise in the temporary imports regime, and reduction in the time spent in procedures by ALTEX firms; and (iii) SECOFI: modernization to simplify and speed-up licensing of imports and exports, simplification of procedures for: registration, ALTEX firms, PITEX program (temporary admission), exports of technology, engineering services and construction, tax rebates and textile and steel quotas, simplification of the registration in the National Registry for the Pharmaceutical Industry (NRPI). Improvement in inspection visits to check the requirements for registration in the NRPI, permanent registry of products and services subject to obligatory norms, permanent authorization of the model for metrology instruments, and establish a computerized system to register prices. Satisfactory progress in implementing the above action plan is a condition for second tranche release. D. Competitive Factors Markets 90. As pointed out earlier, Mexico followed a consistent strategy of industrial protection in the past. Policy interventions in factor markets have reinforced the distortions in goods markets and they have reduced the mobility of capital and labor. Protection was granted in the form of different types of entry barriers in the goods markets (increasing the return to capital) which are used more intensively in the production of import substitutes. Also, interest rate subsidies, tax incentives for investment, and restrictions on DFI and technology transfer have protected the return on installed capital and have granted protection to the production of capital intensive import substitutes. Moreover, the selective use of these instruments has increased the distortions. 91. When the Government adopted its new strategy of industrialization in 1985, which takes into consideration the country's comparative advantages, it first embarked on a program of trade reform. However, the supply response of the economy to the changes in the incentive system depends on the ability of production factors to adjust. A restrictive regulatory framework causes rigidities in the factor markets. If these rigidities continue, the program of trade reform may worsen economic conditions rather than improving them. The Government recognizes that, to ensure the feasibility of the new policy and to speed up adjustment, the new industrial policy framework needs to be complemented by orderly deregulation and the removal of distortions in factors markets. 92. This section discusses the major issues affecting competitive factor markets and strategies to cope with each of them. The major areas of concern aret (i) fiscal and credit incentives; (ii) regulation and tax treatment of DFI; (iii) regulations and incentives on R & D and technology transfer; and (iv) labor mobility.  - 28 - Fiscal and Credit Incentives 93. Mexico's industrial strategy relied heavily on the selective use of tax and credit incentives to direct investment to industrial subsectors which the Government considered a priority. These incentive programs reduced the cost of capital relative to the cost of labor and distorted the cost of capital between sectors and between industrial subsectors. They also induced misallocation of resources since they tended to favor sectors with negative social rates of return and to promote rent-seeking behavior in those subsectors receiving the highest incentives. Moreover, the fiscal incentives reduced Government revenues and the credit incentives increased budget outlays and distorted financial markets. 94. Fiscal Incentives. Selective tax incentives to industry have been used extensively to promote investment and employment in the manufacturing sector, decentralization and export development. The most important fiscal instrument has been the CEPROFI with the amount of the tax credit based on the size and location of the investment undertaken and the number of jobs created. Beneficiaries of the program (other than small and medium sized firms) are required to have an approved development program (programa de fomento) with SECOFI. The manufacturing sector received 592 of the value of CEPROFI's issued in 1985 of which some 8OZ went to priority sectors (agro-industry, iron and steel and capital goods). The balance supported the purchase of domestic machinery (16.52), SMI (1.7X) and employment (1.62). Most of the benefits went to large firms, and only 32 were granted through the special program for small enterprises, most likely due to the program's costly and non-transparent procedures. The CEPROFI program has already been eliminated for the majority of industrial activities, except for micro and small enterprises, and for agriculture and construction of low income rental housing. In the future, as stated in its Letter of Industrial Sector Policy (Annex IV), the Government intends to limit the use of CEPROFIs in the industrial sector to micro and small scale enterprises and used only on an exceptional basis. 95. Credit Incentives. The granting of subsidized credit and the use of directed lending have led to a significant misallocation of resources. The development banks and FIDECOHISOS (trust funds) have mobilized resources primarily from multilateral and bilateral sources and have been used as instruments to channel fiscal transfers to priority sectors and parastatals. Interest rate subsidies were reduced gradually between 1984 and 1987 as lending rates were adjusted upward towards the average cost of funds rate of the commercial banking system (ACF), in accordance with the General Interest Rate Agreement (GIRA) between the Government and the Bank. Isterest rate subsidies to industry have been significantly reduced under the Pacto as all lending rates, except for industrial pollution control and microenterprises, were set above the ACF. A reduction in the public sector borrowing requirement and increased resource mobilization resulting from a successful implementation of the Pacto, have lead to increased availability of financial resources for the private sector including industry. The Government has already begun to make the allocation of credit resources to Fideicomisos and public development banks more transparent, and on the basis of non subsidized loans rather than on equity contributions. The Government has virtually eliminated credit subsidies to industry by allowing banks to charge market based lending interest rates on all  - 29 - industrial sector lending regardless of source. Because of the substantial liberalization recently achieved within the commercial banking system through the introduction of market determined interest bearing deposit instruments, the ACF now reflects more appropriately the marginal cost of funds for financial intermediaries and the subsidy element in new industrial lending has virtually disappeared. As stated in its Letter of Industrial Sector Policy (Annex IV), the Government is cormitted to continue with the current interest rate policy and to increase credit allocation to the industrial sector. Direct Foreign Investment 96. Increased DFI is essential to the modernization of Mexico's industrial sector. DFI typically includes the transfer of capital, technology, management and marketing, all essential for the modernization of the industrial sector, and to make it more competitive. Moreover, attracting the maximum possible flows of DFI is essential for maintaining a sustainable external position and to supplement domestic savings to finance a needed recovery of investment in Mexico. DFI averaged between 0.92 and 1.12 of GDP in the past, rising to 2.5Z of GDP in 1987, due primarily to the large debt-equity swap program which has been suspended except for pending applications. The suspension was based on concerns about possible negative macroeconomic effects of swaps involving public debt in eschange for private investment. Maintaining the past levels of DFI flows will not be sufficient if DFI is expected to make a significant contribution to Mexico's economic development. Consequently, a series of actions by the Government is essential for achieving the levels of DFI required to meet the objectives mentioned above. In this context, several key factors need to be addressed that have a negative effect on DPI flows: (i) an unstable macroeconomic environment; (ii) a restrictive regulatory framework; (iii) discretionary DFI approval procedures; and (iv) tax disadvantages. 97. The Foreign Investment Law incorporates the following restrictions on DFI: (i) product groups reserved exclusively for the Mexican public sector include petroleum and other hydrocarbons, basic petroleum products, radioactive and strategic minerals, nuclear energy, electricity, railroads, telegraphic and radio communications, banking and other activities as may be specified; (ii) product groups reserved exclusively for Mexican public or private sectors include radio and television, agricultural activities, road, air and maritime transportation, forestry, gas distribution and financial intermediation; and (iii) product groups which must have majority local control without exception include mining and basic industrial subsectors such as steel, cement, glass, secondary petrochemicals, and aluminum. Main criteria used by the NCFI are that DFI must: (i) complement and not displace national companies; (ii) have positive balance of payments and employment effects; (iii) utilize some local inputs in production; (iv) contribute to technological modernization; (v) improve product prices and quality; and (v) preserve Mexican social and cultural values. 98. The Law also establishes a 49? limit on foreign equity participation as a general principle, and allows exceptions subject to a case by case review. Thus, although all DPI must be registered with the National Registrar of Poreign Investments (NRFI), new projects with up to 49? foreign capital do not require prior approval. However, new acquisitions which bring foreign ownership above 25? have to be approved.  - 30 - The policy from 1973 to 1983 was to strictly enforce the 49Z limitation, and therefore, it is often mistakenly assumed that majority Mexican ownership policy is in fact require under the lav. Foreign ownership of 100? has been allowed for approved in-bond assembly operations (maquila), and on an exceptional basis for specific projects primarily under sectoral programs (e.g., automobile production, tertiary petrochemicals, pharmaceuticals, computers). 99. In addition to the above restrictions, inadequate patent and trademark protection, and lack of product patent protection for chemicals and pharmaceuticals, discouraged technology intensive DFI. Another factor which discouraged DFI was the 50? withholding tax on dividend remittances to foreign companies. This was significantly higher than the total of federal and state taxes against which the taxes withheld by Mexico could be credited in the U.S. (from which 65? of DFI flows originate). Moreover, the lack of a bilateral taxation agreement with the U.S. and other countries from which DFI may originate also tends to discourage DFI. Beginning in 1989, the Government harmonized the tax systems by eliminating the deductability of dividends as well as the withholding tax on remittances to foreign companies while aligning the corporate income tax rate. 100. In February 1984, the NCFI announced that Mexico's policy would favor DFI. Since 1986, foreign companies with less than $8 million in sales and less than 500 employees have been exempted from the approval process if they exported at least 35Z of their production, maintained a neutral balance of payments position and did not operate in the commerce or service sectors. In November 1987, a new resolution simplifying the general resolutions for implementing the Foreign Investment Law was issued. This helped resolve some inconsistencies and simplified administrative procedures. For firms already established in Mexico, the new rules permitted up to the approved maximum ownership and provided some liberalization for capacity expansion and relocation. In 1988, the NCFI published clearer criteria for approving majority foreign owned projects and established a reference system that specifies the criteria applied in more than 1,500 previous decisions to serve as a body of precedents in order to provide more consistency in the approval process. The NCFI also compiled a compendium of regulations with a view to streamlining them. 101. Significant progress has recently been achieved with the publication of the Reglamento of the DFI Law on May 16, 1989 involving: (i) the regulations of the Law, which were never issued before; (ii) a single general resolution issued in 1987, that consolidated all general resolutions issued from 1973 to 1986; and (iii) a simplified version of the Reglamento to register DFI. To further simplify procedures, the Law and this Reglamento consolidate the regulatory framework on DFI, therefore, derogating all existing regulations referring to topics covered in the Reglamento. 102. The Reglamento of the DFI Law contains measures: (i) allowing automatic 100? DFI participation in activities comprising about 60? of GDP, requiring only the registration of the investment with the NCFI. This procedure applies if minimum requirements concerning exports, regional development, technology and investment size are met; (ii) allowing increased participation of the private sector (domestic and foreign) in  - 31 - areas subject to specific regimes; (iii) increasing transparency and speed of NCFI decision making; and (iv) simplifying and deregulating registration procedures in the NRFI. While the Law defines the activities reserved to the Government and to Mexican investors and maximum DPI participation in petrochemicals, autoparts and mining, the Reglamento clearly defines concepts that were rather obscure in the Law, in order to reduce discretionality and define precisely the scope of DFI. this goes a long way towards eliminating the case by case approach to DFI approval and registration in a significant number of activities. 103. Another objective of the Reglamento is to simplify procedures for those cases for which authorization is still required. It aims at reducing the time elapsed between application, approval and registration from about 1 1/2 years, at present, to 2 months. Therefore, for the first time clear, transparent and automatic rules have been established. 104. Although significant liberalization of DFI has already been attaii. d with the above measures, promotional efforts are just beginning and further liberalization is still needed. The Government has agreed to implement an action plan to promote DFI comprising: (i) implementing a comprehensive DFI promotion program, to position Mexico as a country with important comparative advantages, and willing to compete in the international market for capital; (ii) elaborating periodically and making widely available up-to-date information on the national economy; and (iii) establishing a data bank on investment opportunities and on specific projects with co-investment possibilities for SECOFI's Subsecretaria de Industria e Inversion Extranjera (Vice-Ministry for Industry and Foreign Investment) to function as a catalyst for co-investment. The Government has also agreed to carry out a study to further promote and liberalize DFI. Satisfactory progress in implementing the action plan on promotion, and completion of the study and agreement on a plan of action for the implementation of its recommendations are conditions for second tranche release. Industrial Technology 105. In the context of increasing internationalization of the world economy, increased competition, and more rapid technology change, technology is becoming ever more significant as an element of industrial policy. This is particularly important for Mexico in light of the ongoing process of opening up its trade regime. 106. Technology policies have actively encouraged the strengthening of Mexican industrial development through building up public sector research agencies and through technology transfer from abroad. Seven regional centers coordinated by the National Council for Science and Technology (CONACYT) provide applied research and technical assistance to industry. The Technology Information Service (INPOTEC), a trust fund, was established to serve as an industrial technology information service. Several major universities are also active in research. However, on balance, the R & D infrastructure has largely been unresponsive to the needs of private industry. SECOPI has also begun to undertake programs to strengthen the links between Mexican souL-ces of R & D and private firms. The authorities revised the 1973 Invention and Trademark Law in 1987 to increase patent protection from 10 to 14 years, strengthened penalties for infringement and  - 32 - extended protection to several unprotected chemical and pharmaceutical processes. However, product protection in these sectors is only to be implemented in 1997. In addition, actions to streamline the administrative process for granting such incentives were undertaken. 107. More recent technology measures include the reduction in the withholding tax on royalties payments from 21Z to 15X, granting of fiscal incentives, promotion of DFI and specialized financing, the latter supported by the Industrial Technology Development Loan (2747-ME) approved by the Board of Directors in July 1986. Total science and technology expenditures rose from 0.13? of GDP in 1982, to an estimated avera-e of 0.5? per year during 1984-1988, a level which is comparable to Brazil (0.45% in 1982), but still well below Korea (2Z) and the highly industrialized countries (Japan 3.4?, USA 3.12). Unfortunately, these efforts have largely failed to reach private firms, especially small and medium industrial enterprises. Expenditures on science and technology by public sector agencies account for about 85? of total expenditures (compared with about 60? in Brazil, 30? in Korea, and less than 202 in the USA) and 95X is financed by Government (Brazil 66?, USA about 60X). In- house industrial technological capability is mostly confined to large parastatals, firms associated with multinationals, and a small number of mostly large private firms. As a result, the current level of technology in Mexican industry is very disparate. There are a very few state-of-the art firms, a small number of reasonably modern and efficient firms, and a large number of firms which are not competitive by world standards, including many large and small traditional firms with little technological capability. 108. In order to increase the technological level of Mexican industry, a series of regulatory, institutional, and even awareness obstacles must be addressed. On the regulatory side, the key problems are that, in spite of some recent moves in the direction of liberalization, there is still too much control over DFI and technology transfers which keeps out, or makes it more difficult to acquire, some of the foreign technology that is necessary to improve the technological level of industry. In addition, there is a need to strengthen protection and enforce property rights, to assure both local and foreign investors, and technology suppliers that their intellectual property rights will be protected. This is an important factor to encourage local R & D, and to promote technology intensive DPI and the transfer of technology to Mexican enterprises. 109. On the institutional side, the key problems are: (i) insufficient technical information and technical assistance services that can help promote the diffusion and assimilation of technology, particularly among small and medium size firms; (ii) weak and insufficiently developed norms and standards that can help promote specialization and improvements in quality; (iii) insufficient and cumbersome procedures for industrial technology financing; (iv) a public research infrastructure that has not been attuned to the technological needs of the productive sectors; and (v) insufficient quantity and quality of technically oriented training in the formal and informal educational systems. The incraasing exposure to a more open economy has raised awareness of the importance of technology, especially among the more modern firms. However, there is still not much understanding of technology issues among the more traditional firms. Regarding financial incentives, credit programs have been established to  - 33 - provide loano at below market lending rates to higher risk industrial technology development projects. Until the introduction of the Pacto, fiscal incentives were granted to industrial firms for developing technology. 110. To raise the level of industrial technology in the industrial sector, the Government agreed to implement a plan of action for technology development, comprising: (i) facilitation of the access of firms to new technology by eliminating excessive regulations from the Registry of Technology Transfer; (ii) orientation of the activities of SECOFI's Direccion General de Desarrollo Tecnologico (General Directorate for Technology Development) towards a more active promotion of technological modernization of firms; and (iii) coordination of efforts of different entities and organizations in the public and private sectors, which are involved with technological modernization of industries. The Government has also agreed to carry out a study on major problems and constraints to technology development including: (i) improving the protection of industrial property to motivate technological innovation within industry and strengthen property rights; and (ii) determining the merits of continuing compulsory expenditures on R&D and of advancing patent protection for chemicals and pharmochemicals to promote technology. Satisfactory progress in implementation of the plan of action, completion of the study and agreement on a plan for its implementation are conditions for second tranche release. Labor Mobility 111. Labor mobility is crucial for a successful industrial restructuring effort. The ease of transfer of labor across industries requires wage flexibility as well as provision of training to facilitate industrial labor mobility. In Mexico, real manufacturing wages declined by about 40S between 1982 and 1987, reflecting a substantial degree of wage flexibility. In this period the cost of labor in manufacturing has been reduced to about one-half in dollar terms, i.e. to levels similar to those in Korea and Brazil. This reduction in labor costs is, obviously, associated with depressed macroeconomic conditions, but it is also a result of concerted action between the Government and the labor unions to minimize unemployment. Between 1982 and 1986, the decline in employment in the manufacturing sector was mainly associated with economic recession and the consequent decline in domestic demand. After 1986, when production started to rise and the first stage of industrial sector restructuring was taking place, employment did not increase significantly. The small increase in employment in the export sector and the small decline in the import substituting industries suggest that there may be problems in intersectoral labor mobility, that expectations that the trade liberalization measures would be reversed may have delayed adjustment, or that outputs were simply shifted to exports. 112. Existing labor legislation has introduced rigidity into the labor market, by making the dismissal of workers very difficult and costly, which has greatly impacted on small and medium-size firms. Moreover, the manufacturing labor market has been segmented by the important role played by unions. In fact, unionized sectors show a very different labor demand behavior than less unionized sectors, which are more wage-elastic and adjust more rapidly. Consequently, and as a result of the economic  - 34 - recession, a relatively small reduction occurred in employment in highly unionized industries, but at the cost of declining productivity and Labor mobility. To support the necessary structural adjustment and growth in the industrial sector, labor legislation may ultimately need to be modified to improve labor mobility. 113. In order to increase industrial labor mobility, the Government has established, under the Bank's Manpower Training Project (Loan 2876-ME) approved in October 1987, a pilot program for labor retraining, and has established a Government employment service at the state level. A preliminary diagnosis of the factors impairing labor mobility and a catalogue of occupations and training needs have been prepared. Recently, the Ministry of Labor and Social Security (STPS) has taken measures to improve its mediation capabilities in industrial disputes. While these are important steps in increasing labor mobility, clearly, more needs to be done. Analysis of the factors impairing labor mobility would be continued through a study supported undvr the proposed loan to ti) identify short-run actions which can be carried out under existing labor laws, (ii) make proposals for amending labor legislation to increase labor mobility, (iii) identify skills mismatches across industries, and (iv) allow predominantly export firms to enter into more flexible labor contracts. The Government has agreed to carry out a study of these issues. Completion of the study and agreement on a plan to implement the recommendations of the study are conditions for second tranche release. E. The Trucking Sector 114. Improving the regulatory environment for the Mexican industrial sector is essential in order to establish competitive markets within which manufacturing firms can modernize, become more efficient and competitive. However, substantial improvement in services to industry, both in terms of quality and in quantity, is of crucial importance to realize more fully the effects of industry modernization and increase in industrial efficiency. A key service which greatly affects the efficiency of industrial firms is trucking. Any distortions or inefficiencies in the provision of this service, such as delays, excessive freight rates and significant losses of cargo in route, reduce any efficiency gains achieved in manufacturing, such as through improved inventory management methods or more advanced production techniques. Close to seventy percent of all cargo is moved by road transport in Mexico, which is heavily regulated and has therefore been included in the industrial sector policy program. Road Transport Regulations 115. Concessions for federal routes must be approved by the Government. They are granted on a route by route basis and there are serious restrictions to the operation of carriers across routes. Companies granted a concession on a particular route must become members of the company established for that route. Such companies enjoy a monopoly in their particular route. Existing concessionaires have an important role in approving increases in capacity on their route and are given preferential trestment when new concessions are granted. Freight service centers play a powerful role in allocating cargo among truckers. In many cases they assign vehicles and thereby exert significant control over trucking  - 35 - operations. A single freight forwarding company has a virtual monopoly on the assignment of container movements, (although recently a second company was allowed to operate as container agent) and only international cargo can be shipped in containers. However, the Ministry of Communication and Transport (SCT) has requested a change in legislation to allow containerization of national cargo and thereby increase the capacity of utilization of containers. Consolidation of containers is now taking place in inland depots. Trucking rates are fixed by the Government for all trucking services using formulas which are applied nationwide, but unofficial payments appear to increase trucking costs significantly. Finally, existing legislation limits compensation for lost or damaged cargo to Mex$800 (about US$0.35 equivalent) per ton (Annex IX). 116. Not all cargo movements are restricted to the concessionaires. The Federal Government has the authority to designate some cargo as *specializeds cargo and allow any properly registered vehicle with a permit to operate to transport it without being subjected to the route restrictions. Agricultural products, construction material, liquid chemicals, mineral ores and some other bulk commodities can be transported by any carrier. In addition, firms can move their own business cargo in their own trucks without restriction, but can not move the cargo of other enterprises. 117. The existing system is costly and generates large distortions. A survey of manufacturing firms indicated the extent of current unreliability and low quality of trucking services. Delayed shipments, damaged and lost merchandise are widespread occurrences. Because of the freight center allocation system, a user must use the trucking company to which his goods are assigned regardless of his prior experience with the trucking firm. Whereas large firms can negotiate more easily with concessionaires or move cargo in their own vehicles, smaller firms are affected the most by the existing system. The totally inadequate compensation limit for lost and damaged cargo, creates little incentive to avoid such losses or to develop insurance programs to cover them. The limitations on container movements prevent the benefits from this mode of transport (including lower damage and cargo losses) from being realized. In addition, existing restrictions tend to reinforce the heavy geographical concentration of industry in Mexico City since most authorized routes radiate from there and the cost of serving the national market is, therefore greater from any other part of the country. 118. Changes in the present regulatory system are essential to provide users with world class trucking services. A phased deregulation program is necessary to avoid possible problems of overcapacity during the implementation period. Accordingly, the Government has agreed to carry out a comprehensive study on the regulatory environment for trucking services with the purpose of producing a comprehensive, consistent and enforceable program for the removal of impediments to competition and efficiency. Completion of the study and agreement upon a plan of action for its implementation are conditions for second tranche release. F. External Finance 119. Given the sensitivity of Mexico's macroeconomic growth prospects to the availability of external finance, adequate resource mobilization for  - 36 - Mexico in 1989-94 will be of crucial economic and political importance. The success of the adjustment program to be supported under the proposed ISPL then hinges on Mexico's access to external finance. The Government has already initiated discussions with principal external creditors, including creditor nation governments, key bilateral donors and commercial banks to design a financing package consisting of a blend of debt reduction, restructuring and new money in adequate amounts to alleviate net transfers abroad and meet the projected financing gap over the medium term. It may be difficult to obtain commitment for financing for a long period, which would be needed to restore confidence and revive investments, thus helping recover economic growth. However, the expected presence of the IMF with a three-year program and the policy content of the three proposed adjustment operations should offer a measure of comfort to Mexico's creditors as they consider providing a new financial package in 1989, including some form of debt relief that can reduce net transfers to external creditors from the current high level. Therefore, a condition for loan effectiveness will be substantial progress in obtaining adequate financing for Mexico's requirements for 1989-1990. Continued substantial progress in obtaining financing for 1989-90 and for the medium term will be a condition for second tranche release. PART IV - THE PROPOSED LOAN A. Loan HSstory 120. Direct Bank support for the Government's program of opening the Mexican economy began with EDP I in 1983, through which the Bank provided financing and technical assistance for export promotion, in the context of a liberalized import regime for exporters. In July 1986, TPL I was approved to support the initial phase of trade liberalization measures in Mexico. TPL II, approved in November 1987, was designed to provide support for the phase of the trade reform implemented in 1987. The trade reform measures actually implemented in 1987 and early 1988 went beyond those required under TPL II, and remaining trade liberalization measures will be carried out under the proposed ISPL. Also in 1987, EDP II was approved, extending the assistance for export promotion achieved under EDP I. Finally, in order to facilitate adjustment induced by the trade liberalization process the Industrial Restructuring Project was approved in April 1989. It supports restructuring of specific sectors and enterprises exposed to foreign competition. The proposed ISPL compliments the efforts began in 1985 to liberalize trade, as it will support measures to deregulate the economy in order to achieve an industrial structure based on competitive markets that is responsive to technological change. The loan was appraised in October-November, 1988. Negotiations were held on March 7-15 and April 24-29, 1989. The Mexican delegation was led by Mr. Enrique Vilatela. Supplementary loan data are provided in Annex III. B. Loan Objectives 121. The proposed loan is part of a program of Bank support to the Mexican Government's objectives of stabilizing the economy and resuming growth. The loan supports a program of reforms to modernize the Mexican industrial sector by removing distortions in goods, factor and service markets, and at providing an appropriate institutional and regulatory environment to enable industrial enterprises to meet the challenge of a  - 37 - more competitive world economy and thereby stimulate investment and growth. 122. The program of actions and the studies to be supported under the ISPL embodies a wide-ranging deregulation effort which focuses on the deregulation of the sector approach to industrial development, the easing of bureaucratic procedures and barriers to entry, increasing factor mobility (especially direct foreign investment, technology transfer, and labor), and improving trucking services. Such a comprehensive set of policy changes could not be expected to be carried out in full during the time frame encompassed by the proposed loan. Consequently, the proposed ISPL will seek to ensure that satisfactory progress is made initially under all components of the program, and that subsequent steps are carefully planned and programmed as conditions to use of Bank's funds. The reform program, which is described in detail in Part III and is summarized in the Government's Letter of Industrial Sector Policy (Annex IV) and the Policy Matrix (Annex V), will have the following main objectives: (i) Direct Foreign Investment. Liberalize foreign investment regulations and procedures, introduce greater transparency and automaticity into the system, harmonize tax treatment, and strengthen promotional efforts to attract foreign investors. (ii) Industrial Technology. Imprcve access to foreign technology and promote domestic research and development activities. (iii) Sector Programs. Gradually deregulate Sector Programs in the automotive, petrochemicals, pharmaceuticals and microcomputer subsectors as instruments of industrial promotion, in order to improve the efficiency of resource allocation. (iv) Goods Markets. Remove entry barriers and simplify administrative procedures affecting enterprise competitiveness, efficiency and costs. (v) Trucking Services. Carry out a comprehensive study to identify and remove impediments to competition and efficiency in the trucking sector, and develop a plan to implement that study's recommendations. (vi) Trade Liberalization. Achieve further reductions in QRs in line with import liberalization achieved under the Sector Programs, carry out studies of rationalization of the allocation of involuntary export quotas, elimination of voluntary export quotas, and the adequacy of unfair trade practices regulations. 123. Much needs to be done to restructure the regulatory framework and the institutions which administer it. The proposed loan supports initial, although in many cases, fundamental changes, as well as studies to identify further policy changes or amendments to existing legislation needed to improve the regulatory framework. Many of the measures supported by the proposed loan will complement and supplement actions already taken by the Government.  - 38 - C. The Borrower, the Guarantor and Proiect Implementation 124. The Government has designated NAFIN as the borrower of the Bank loan, in line with its function as Mexico's official industrial development bank and financial agent of the Government. The loan would be guaranteed by the Mexican Government. SHCP will be responsible for project implementation. Specific borrowing and project implementation arrangements were agreed upon during negotiations of the proposed loan. D. Disbursement, Procurement, Administration and Auditing 125. The proposed loan will be released in two tranches, of US$250 million and US$247 million, respectively. US$3 million will be allocated for technical assistance and to finance studies necessary to identify further areas of liberalization and deregulation. The first tranche will become available upon loan effectiveness, and the second tranche after November 30, 1989 and upon the fulfillment of specific conditions for tranche release. The Government has informed the Bank that the scope and timing of implementation of the agreed upon actions concerning technology, sector programs and trade liberalization may be affected according to progress in internatiovil negotiations. At the same time, the Government stated its intention to intensify the process of negotiations and to establish a mechanism for consultation with the Bank to evaluate the progress of negotiations based on market access. Without limiting the provisions of the Loan Agreement, the Bank will take into account the state of international negotiations in determining whether progress under the program has been satisfactory to justify second-tranche release. The closing date of the proposed ISPL will be June 30, 1990. 126. The loan proceeds will be re-lent on terms and conditions satisfactory to the Bank, and will be used to reimburse 100? of the foreign cost of eligible imports (any import except those contained in a negative list). Loan proceeds will be available for retroactive financing of import expenditures incurred from February 15, 1989 up to a ceiling of US$100 million. The Government will compile import bills and payment documents for immediate use of the loan funds upon the loan becoming effective. 127. The Borrower will be responsible for maintaining loan accounts and for the preparation and submission of withdrawal applications. Disbursements from the proposed loan will be made on the basis of statements of expenditure from Banco de Mexico detailing individual import transactions in each relevant period, and their eligibility under the proposed loan. Applications for withdrawal will be consolidated and submitted in amounts of not less than US$5 million. 128. Both private and public sector imports will be eligible for financing. Individual contracts under US$ S million each will be awarded on the basis of the normal procurement practices of the purchaser. Individual contracts above US$ 5 million, will be procured on the basis of international competitive bidding following Bank Guidelines. Consultants financed out of loan proceeds will have qualifications and terms and conditions of employment satisfactory to the Bank and will be selected according to the Bank's guidelines for the employment of consultants. 129. Audits of the supporting documentation for statements of  - 39 - expenditure used for disbursements will be carried out annually by independent auditors acceptable to the Bank. The audit reports vill be submitted to the Bank within six months of the end of the fiscal year. E. Medium Term FinanciAi and Debt Reduction Support 130. As explained in the President's Report of the proposed FSL Loan, it may be difficult to mobilize new money in an amount sufficient to cover Mexico's financial gap over the medium term. However, any financing short of a multi-year commitment would compound macroeconomic problems and would lead to continued uncertainty about Mexico's public finances and tax and exchange rate policies. Therefore, the Government intends to include some form of debt reduction in its next financing package, which would be expected to restore confidence and thus spur investment and help recover growth. 131. Since without specific Bank assistance it may be difficult for the Government to put in place effective debt reduction scheme, the Bank has agreed that, subject to its agreement, up to US$125 million equivalent under the second tranche of the proposed loan could be used for the implementation of a debt plan which, in the Bank's judgment, shall meet the requirements of the Bank's support of debt reduction programs. F. Loan Tranching 132. Since appraisal, the Government has followed a policy consistent with the objectives of trade liberalization and deregulation, and has taken the following actions: 1. publication of the Reglamento of the DFI Law (para. 101), harmonization of the tax systems concerning profit remittance (para. 99), reduction in the withholding tax on royalties payments (para. 107), deregulation of interest rates to industry (para. 95), announcement of policy statement on trade, interest rates and fiscal incentives to industry (para. 68, 94 and 95), and preparation of action plans satisfactory to the Bank to: (i) promote direct foreign investment (para. 104); (ii) promote technology development (para. 110); (iii) deregulate Sector Programs in the automotive (para. 54), petrochemicals (para. 62), pharmaceuticals (para. 58), and microcomputer (para. 63) sectors; (iv) achieve further improvement in trade regime (para. 71 and 77); and (v) achieve administrative simplification of bureaucratic procedures (para. 89) 2. reached agreement on terms of reference for studies of: (i) major constraints to DFI (para. 104); (ii) major constraints to technology development (para. 110); (iii) factors impairing labor mobility (para. 113); (iv) major constraints to the competitiveness of the pharmaceutical industry and on establishing adequate health standards and procedures and an efficient pricing policy (para. 58); (v) major constraints on the international competitiveness of the automotive and microcomputer industries and on the safety and environmental standard regulations for the automotive industry (para. 55  - 40 - and 63); (vi) adequacy of the unfair trade practice regulations (para. 77), (vii) the introduction of an auction system for allocating involuntary export quotas and the elimination of voluntary export quotas (para. 75); and make a comprehensive assessment of the regulatory environment for trucking services (para. 118). 133. Conditions for Loan effectiveness are (i) substantial progress in obtaining adequate financing to meet Mexico's 1989-90 requirements (para. 119), and (ii) that NAFIN shall have entered into contractual arrangements with the Government that are satisfactory to the Bank, for re-lending the proceeds of the loan. The second tranche would be released after November 30, 1989, after an exchange of views with the Government and confirmation that the conditions for second tranche release have been met. To this end, the Bank would need to be satisfied that (A) continued substantial progress has been made in obtaining adequate financing for 1989-90 and over the medium term, in the context of the adjustment program and growth targets set forth in Mexico's economic strategy issued by SHCP, and (B) that: 1. satisfactory progress had been made in implementing each of the plans of action under the reform program referred to in para. 132; 2. Studies of DFI, technology development, labor mobility, unfair trade practices, auctioning of involuntary export quotas, elimination of voluntary export quotas, the automotive, the microcomputer, and the pharmaceutical industries studies, and on the appropriate regulatory framework for the trucking sector, had been completed and agreement reached on action plans for implementing the studies recommendations (para. 132); and 3. The Government's macroeconomic framework (FSL, Annex VIII) is consistent with the program. G. Monitoring and Reporting 134. Assessing the effectiveness of industrial deregulation and of other actions to be taken under the proposed loan, will require monitoring of the adequacy and consistency of the macroeconomic framework and of the implementation of specific actions under the program detailed in the Government's Letter of Industrial Sector Policy. SHCP, which would be responsible for coordination of project implementation, would maintain regular contacts with Bank staff. NAFIN, as the Borrower, would prepare quarterly reports on the implementation of the program. The Bank will also monitor these matters through regular supervision and exchanges of views with the Government. H. Poverty Impact 135. The alleviation of poverty in the short term could be best tackled directly through well-targeted programs to provide social services and job training, rather than indirectly through interventions in the factor and goods markets. Nevertheless, changes in levels of employment are one way of looking at the effect of industrial reform on the poverty of the  - 41 - affected population. Although there is very little evidence in other countries that opening of the economy adversely affects employment, the transition to a more market-oriented economy may be aggravating the situation of some of the poor in the shorter term, particularly in connection with Mexico's recent macroeconomic adjustment measures. However, the reduction in protection of capital-intensive activities is likely to stimulate the demand for labor. Furthermore, the relaxation of government intervention in factor and goods markets can be expected to stimulate economic activity in general. Hence, the longer-term effect on employment, and therefore on the poverty status of the population, is likely to be beneficial. I. Benefits and Risks 136. Benefits. Reforms to deregulate industrial activity are an essential complement to the ongoing trade reform and are expected to greatly facilitate the response of industrial firms to the new incentive structure introduced by the trade reform. The adjustment by firms is expected to increase their levels of efficiency and expand their share of domestic and external trade. This should make a significant contribution to the recovery of sustained growth and of Mexico's creditworthiness. The program would help to reorient production from less efficient import- substitution industry toward more competitive export markets and production for the domestic market based on competitive goods and factor markets, and a more attractive environment for invesiment and technology trancfer. The program would foster market flexibility, promote non-distorted markets, improve factor mobility, reduce the costs of doing business and improve key services to industry. Furthermore, the proposed ISPL, combined with the proposed two parallel operations (the FSL and PERL) constitute a comprehensive program of support for overall economic restructuring in Mexico. 137. Risks. The main risk is possible political resistance to carrying out the reforms at the speed envisaged. There is also a risk that the macroeconomic objectives of the stabilization and growth may be undermined if expected foreign financing does not materialize. The Government's program and the design of the proposed loan contain elements that should significantly reduce these risks. 138. A serious risk concerns the political feasibility of carrying out the reforms on a timely basis. For example, the deregulation of the Sector Programs, DFI and trucking could face stiff opposition from vested interests, and thit opposition could lead to deceleration of the reform program. The Government will need to make a concerted effort to obtain the support of the private and labor sectors and to demonstrate to those affected that the ultimate benefits of the proposed program clearly outweigh the costs and that benefits and costs are fairly distributed. These considerations were taken into account in the plans of action to implement the reform proposals. 139. A major risk of the program could also be that the macroeconomic policy framework might not continue to be consistent with the program of industrial sector policy restructuring. For example, a sharp appreciation of the real exchange rate could potentially derail the current strong export drive and cause balance of payments difficulties. A failure to  - 42 - reduce public sector borrowing requirements could adversely affect efforts to control domestic inflation and to reduce high real interest rates, which would reduce private investment and growth and undermine private sector confidence, crucial to successful adjustment. This could in turn undermine and even reverse trade liberalization and weaken support for the deregulation program. 140. A lesser risk is that, as the industrial adjustment process deepens, dislocations in inefficient import competing sectors will be inevitable, which could also undermine trade liberalization and the deregulation program. However, complementary actions under the FSL and PERL, as well as support to enterprises under the recently approved Industrial Restructuring Project, which would facilitate resource reallocation in the economy, should reduce this risk. Moreover, the encouraging performance of non-oil exports is reinforcing the Government's resolve to continue with the present reforms. 141. A possible risk could be adverse external developments which could include a decline in oil prices or higher international interest rates as well as increased protectionism in Mexico's export markets. However, Mexico's accession to GATT and recent bilateral trade agreements enable it to address possible protectionist tendencies in its foreign markets from a stronger negotiating position, and Mexico's adequate level of international reserves and expected continuing access to bilateral and international financing should provide sufficient financial support to insure continuity of the economic recovery program. Conversely, an increase in the oil price and an improved balance of payments perfo mance could also reduce the need for external financing and could make it more difficult to adhere to a consistent macro policy framework and s' uctural reforms. PART V - BANK GROUP OPERATIONS IN MEXICO AND GOVERNMENT DEVELOPMENT OBJECTIVES Bank Operations 142. As of March 31, 1989, Mexico had received 111 loans from the Bank, amounting to US$11.5 billion, net of cancellations and terminations; of these, 75 loans, totalling US$5.5 billion, were fully disbursed and US$2.4 billion remained undisbursed. The Bank's exposure was US$5.89 billion (on book value basis) (Annex II), while on a cash basis this is equivalent to US$7.4 billion. Some 292 of Bank lending has been for agriculture and rural development, 182 for industry, 14t for transportation, 62 for power, and 17Z for policy-based lending; the remaining 162 has been for water supply, tourism, urban development, and vocational training. Commitments for new loans reached US$1.7 billion in FY87 and US$2 billion in FY88. For FY89-90, the annual amount of Bank lending commitments, subject to the successful consolidation of agreed reforms, is expected to be about US$2.0 billion. 143. Currently, the Bank has 36 operations under supervision. Nine of these projects are in agriculture, 11 in trade, industry and finance, 12 in infrastructure (including transportation, urban, and water sectors and one earthquake emergency reconstruction operation), two in education. and two in low income housing. Project implementation, on the whole, has been  - 43 - satisfactory. Bank disbursements reached US$1.22 billion in FY87 and US$1.0 billion in FY88. Government Development Objectives 144. The Government's overriding objective for the current Sexenio is the restoration of growth after six years of fll1ing per capita income. But the experience of the past six years has made it clear that without macroeconomic stability and access to external financing, sustainable growth will remain out of reach; thus the Government considers the success of the stabilization effort and a resolution of the debt overhang problem as prerequisites for any success towards renewed growth. Moreover, increased growth will have to go together with increasing living standards for the poorer segments in society, both in its own right and to maintain the consensus underlying the Government's program. To this end the Government has embarked on a significant expansion in policies oriented towards poverty alleviation. 145. In addition, the Government strongly feels that growth should be rrivate sector based, with the Government providing a supporting role. Thus the Government intends to continue its reform program towards a modern, rationalized incentive structure for the private sector. This will reduce the need for government intervention, improve private sector resource allocation and provide full support for efficient private sector investment by foreigners and domestic entrepreneurs alike. To allow the public sector to play a supportive role towards private sector based growth, the Govornment intends to modernize the machinery of the state and focus its role on legitimate public sector functions. This involves continued privatization/modernization where called for, and improvement of the efficiency of the remaining parts of the public sector. 146. With these in mind, the Government has adopted a policy agenda, consisting of the implementation of macroeconomic policies that are consistent with the objectives of the recovery of growth, increased fiscal efforts, improved efficiency of the financial system, reduction of interest subsidies and strengthened prudential regulation. To improve the efficiency of public enterprises (PEs), and to reduce the heavy burden they impose on the economy, the Government is focusing on: (i) *disengagement" of enterprises, including privatization, liquidation, mergers, and transfer of PEs to local governments and (ii) a program of reforms in the policy and institutional environment to improve the efficiency of PEs which would be retained by the Government. These measures will improve the competitive environment and provide greater managerial and financial autonomy and accountability to PEs, increase market forces, decentralize decision making, strengthen managerial capabilities and incentives and improve the allocation of resources. To help complete the transformation of Mexico's industrial sector from its inward-oriented and highly protected structure to an open system where the factors of production and services compete freely, the Government is undertaking a broad deregulation effort. This is designed to provide, at the same time, for technological change and modernization, so as to ensure an adequate supply response to new policies. 147. Provided the Government is able to resolve these intertwined stabilization, debt, growth, and efficiency issues, maintains satisfactory progress in advancing the major structural adjustment policies already  - 44 - described, and benefits from a reasonably favorable international environment, the fundamentals for sustained rapid growth look promising. First, Mexico has a rich natural and human resource base and close proximity to the world's largest market. Secondly, the rationalization of the trade regime has created incentives strongly favoring international competitiveness and improved investment efficiency. Lastly, low Mexican unit labor costs make the country attractive as an industrial base. The Bank's base case macroeconomic scenario shows that with moderately favorable external conditions and consistent macro policies and deeper adjustment efforts, GDP growth would climb slowly from about 2? p.a. in 1989 to about 5Z p.a. by 1994. The realization of this scenario is contingent on foreign financing. If this financing were not available, or if Mexico's external conditions were to deteriorate, output growth would slow down and employment opportunities would not keep pace with population growth. Mounting social pressures, in that case, would make it very difficult for the Government to stay the course and the efficiency gains of structural reforms may be lost. An under-financed adjustment program would simply compromise Mexico's ability to service even its current debt. 148. Given the fiscal crunch under which Mexico's policy makers must operate, more effective programs are necessary in the social sectors, including health, education, and nutrition, which are designed to target resources and cushion the needy against the impact of adjustment, while permitting the benefits of structural reform to be reaped. Therefore, the new Administration has, in December 1988, unveiled the "National Solidarity Program' to address the worst manifestations of poverty in the ten poorest states of the Union and the urban poor in Mexico City and all state capitals. Of the total of approximately US$400 million set aside for 1989, 20Z will be allocated to agriculture, 30? to infrastructure, and 50? on social services. 149. Historically, ecological and natural resource management issues have ranked low on the list of Mexican policy priorities. However, over recent years extremely serious environmental problems have been affecting the health of most Mexicans and the country's economic growth potential. The worst problems have been encountered in air and water pollution, soil erosion and deforestation. These and other issues in Mexico's management of its ecology and natural resources have received increasing Governmental attention and the Government is now committed to put in place a strategy that can deal with these issues effectively over the medium and long term. Bank Strategy 150. The Bank's assistance strategy is designed to support Mexico's major reform initiatives through an expanded policy dialogue and substantial volumes of lending, thus contributing to the consolidation of an outward-oriented development model and serving as a catalyst for mobilizing external finance in the required amounts for the restoration of the growth of the economy. 151. The Bank has transferred increasing amounts of resources to Mexico through policy-based and sector adjustment loans in the context of an adjuistment-oriented framework that was supported by the 1986-87 commercial financing package; it has become Mexico's largest single source of new money. Six Bank loans in trade, exports, agriculture, and industry were  - 45 - linked to the multi-facility financing scheme, providing drawdown conditions for the parallel money and growth facilities which were mobilized fully in March 1988. The Bank also put up guarantees of US$750 million. In addition, the Bank facilitated Mexico's efforts to issue of securitized bonds for retiring old debt in January 1988. The Bank's strategy supported primarily policies designed to open the economy. 152. The-objectives of the Bank's strategy are to engage the Mexican Administration in a wide-ranging dialogue on macroeconomic measures required to complete stabilization and spur growth, and on efficiency issues across the board, including finance, industry and agriculture, and to help tackle problems of structural poverty and alleviate the social cost of the adjustment process. The Bank has taken a staged approach in its support of the initiatives of the Government. As a first step, the Bank conducted an overview of Mexico's adjustment priorities and, jointly with the Government, agreed on the conditionality of three adjustment operations (ISPL, FSL and PERL). The policy content of these three operations provides the central element in the Bank's support for Mexico in 1989. 153. To provide the intellectual underpinnings for a continued dialogue, the Bank is carrying out jointly with the Government an expanded program of economic and sector work, including (a) a review of the current regulatory and financing framework in industry and agriculture; (b) a study of future tax reform options; tc) an intensive analysis of urban air pollution in collaboration with the World Health Organization; (d) an assessment of infrastructure and energy sector issues; (e) the development of strategies for integrated health and nutrition initiatives; (f) an assessment of improved programs to ameliorate rural poverty; and (g) an analysis of environmental issues to come up with a set of recommendations. This collaborative effort is also expected to help keep in place a robust lending program in 1990 and beyond, designed to support priority reform measures and optimize resource flows. In this context, the semi-annual country strategic and implementation review between the Bank and the Government -- introduced in 1985 -- affords the Bank a timely opportunity to make adjustments in the existing portfolio to adapt to new conditions. Agriculture 154. Because of longstanding structural problems in agriculture and the sector's crucial imDortance for the one-third of the country's population living in rural areas, agriculture has been the leading sector for Bank lending. The Bank's lending program in agriculture is aimed at: (a) helping correct the incentives regime in agriculture through gradually reductions in input subsidies and export controls; (b) promoting more efficient and rationale use of natural resources supported by improved technologies and services; (c) generating employment-intensive investments in rural areas and effective assistance to small farmers; and (d) creating an integral framework for sound rural development. To support these goals, the Bank made a US$300 million Agriculture Sector Loan during FY88, and, starting in FY90, expects to support policy adjustment in agriculture, rehabilitation of the irrigation infrastructure, including improved cost recovery and maintenance operations, investments for agricultural marketing and storage facilities, food security, poverty alleviation, and forestry development.  - 46 - Trade 155. The Bank has made two trade policy loans of US$500 million each in FY87 and FY88 in support of the Government's sweeping trade reforms. The two operations supported the speedy reduction of non-tariff barriers (quotas and official reference prices) and rationalization of the tariff system (reduced levels and dispersion). The Bank supported the development of non-oil exports through two export development operations in FY83 and FY87. These export development loans were intended to strengthen the supply response by Mexican industry to the new trade policy signals. A third export development loan is under preparation, which would strengthen the temporary import regime, provide further support to indirect exporters, assure automatic access to finance by exporters under the various credit programs, streamline financial and administrative procedures, and seek further reductions in export controls. Industry 156. The Bank's lending strategy for industry, covering small and medium-scale industry, mining, the capital goods industry, industrial restructuring and technology development, is designed to support: (a) trade policy reform; (b) financial sector policies to reverse the prolonged contraction of savings mobilization through interest rate decontrol and the development of a wider menu of savings inst_wments, and tue rationalization of credit allocation in support of viable, competitive private companies; (c) industrial restructuring, regulatory reform, clarification of foreign investment rules, and export promotion to assure a vigorous supply response to trade liberalization and increased international competitiveness. Recent Bank operations provided support for restructuring of the fertilizer, steel, automotive parts, textile, and flower sectors, and other key private industrial subsectors demonstrating a capacity for undertaking integrated restructuring operations. Infrastructure 157. Lending for infrastructure is focussing on regional development, decentralization, more efficient public investment allocation, and improved cost recovery. Recent Bank loans supported the highway, railways and port sub-sectors. Emphasis was placed on obtaining more realistie user fees and deferring all but the highest-yielding investment projects so as to permit a minimum of budgetary outlays for maintenance expenditures and protect the existing capital stock. Proposed loans would support the Government's decentralization initiatives, cost-based pricing, and managerial improve- ments. Loans are being prepared to finance the upgrading, rehabilitation, and maintenance of roads at the state level, the construction of toll roads cofinanced with the Mexican private sector, the restructuring of several ports, w4ater supply and sewerage, urban transport, and power. Housing 158. Government housing programs designed to improve cost recovery, while providing transparent and controlled credit subsidies only to the truly needy, have also benefitted from Bank financing. A Second Housing Finance loan would support graduated loan cost recovery linked to the  - 47 - income of final borrowers, thus ensuring a reduced drain on the fisc and affordability for low-income beneficiaries. Social Sectors and Environment 159. The Bank is assisting the Government in redesigning public health, education, and human resource programs to make them more cost effective and targeted to meet the needs of the poor. A proposed health project would support decentralization measures, finance new primary health facilities, and strengthen professional services. Similar initiatives are being pursued in education and nutrition. A pilot project under preparation would improve the well-being of women in rural areas. It includes the provision of water wells, health and educational services, training for productive activities, and credit for launching new microenterprises. These focussed operations would be followed by broader programs, once the institutional conditions and capacity for project implementation can support a larger Bank presence. 160. The Bank is also undertaking jointly with the Government and the World Health Organization a major review of air pollution issues to determine how the Bank could best contribute to new Government programs for cleaning up polluted urban environments. With strong Government commitment, the Bank would focus on technical assistance operations, include strengthened environmental components in investment loans, and -- as soon as the policy framework and suitable institutional arrangements are there -- make loans for sector-wide environmental programs and in support of remaining environmental policy issues. IPC Operations 161. The IFC has worked with the Bank to: (i) identify private sector investment opportunities likely to thrive in the current climate of growth- oriented adjustment and greater integration with the world economy; and (ii) assist in strengthening the country's capital markets through economic sector work and venture capital operations. As of March 31, 1989, the IFC had invested US$990.7 million in 37 companies in Mexico, of which US$690.2 million had been sold, repaid, or cancelled. PART VI - COLLABORATION WITH THE IMF 162. Bank/IMF collaboration has been close over the years, especially since 1982, when the Fund began to assist the Government to help address the underlying causes of the economic crisis. Since that time the Government benefited from an EFF of SDRS 3.6 billion, a special emergency drawing of SDRs 291 million after the 1985 earthquake, and a stand-by of SDRs 1.4 billion. Currently, the Government is committed tn its commercial creditors under the terms of the 1986 multi-facility financing package to engage the Fund in an enhanced surveillance of the macroeconomic program. Since the ending of the stand-by program in 1988, the first such review has taken place in the beginning of 1989. 163. Extensive consultations have taken place between Fund and Bank staff concerning Mexico's current economic situation and prospects, covering fiscal, monetary, financial and exchange and interest rate  - 48 - policies, and there is an understanding about the measures that will be needed to wind down the stabilization program, strengthen the balance of payments and recover growth in 1989. Since the time of appraisal, discussions between the Government and the Fund have advanced considerably about a possible EFF. Currently, it is expected that a three-year facility would be in place possibly before the scheduled Board date of the proposed ISPL, but definitely before it would be declared effective. Further consultations would take place between the two institutions to monitor macroeconomic performance during the implementation period of the proposed ISPL. PART VII - RECOMMENDATION 164. I am satisfied that the proposed loan would comply with the Articles of Agreement of the Bank, and recommend that the Executive Directors approve the proposed loan. Barber B. Conable President Attacbments May 22, 1989 Washington, D.C.  - 49- ANNEX I "MC 4111c - mon BDCAT Page 1 of 3 Hid-uS PWIOs..ta(se. SW6 Per C.P;IS PW is VW am A. She's. of Gross Dummetic Product 8.0550biei Per P.M.) &1668 let9,7008 iwoam 16 190 *I 68-? 1978-0 tlS-Vr uS? lISA P/ rom Omtic product s 10.0 S. W.0 100 10.0 1S0. SAW.0 6.9 8.3 0.8 1.4 1.1 was ladirot Yese" 4.8 8.0 8.81 8.8 10.4 . . . Iadsetr 37.1 39.0 U.S U.S 88.8 0.8 7.0 40.8 8.0 1.0 W. ublAl lhuufetturiel) 19.7 02.1 0.1 34.0 34.I . 8.8 5.? 0 0 g.6 9.8 serwiam 89.1 89.s 89.0 86.8 S8.8 ...9 6.1 0.0 1.0 1.6 bess's. lb Ieonc -1.9 -1.9 .4.8 4.8 7.11 .38 . . b...,s of ines 7.7 6.9 10.7 16.9 19.3 18. 8.3 8.8 7.6 18.8 ?.8 Imts" of am 9.8 8. 18.0 128. 18.0 14.0 .0. 0.7 40.9 8.8 18 9 v.5.1 aeeediturs. 101.9 201. U10.8 9.7 98.6 07.7 6.9 8.8 -1.8 -0.8 1.i Total Cassuut.oe 60.* 9.9 71.1 7.8. 74.2 77.4 8.6 8.8 0.4 -1.8 4.2 Privets cv,sumption, 73.6 71.6 "-.1 67.7 81.6 69.0 8.8 8.5 -01I -1 e Osasrel Government 6.81 8.2 10.0 9.1 6.5 6.4 8.7 7.8 8.3 -1.0 Grace Ossg.t..c tRea.sont 80.8 80.0 87.8 18.8 to.61 80.8 6.4 7.60 -7.0 -4.8 4.8 Fixed IwesImit 17.6 19.2 84.8 17.6 28.9 I8.1a 9.8 7.2 .8.4 -0.8 0 7 Oweas.. insStack. 2.9 0.8 8.4 0.9 -0.8 1.6 . . are" COOMsCC kw.ag 18.8 16.1 24 9 03.2 983.6 0 6 .4 65. -4 5 7 6 4 4 Hint Fots~ IRCc. .3.6 -4.1 -3.9 43.9 4.0 -4.8 . . Hct C.rr..tat ..fera 0.0 0.1 0.1 0.4 0.5 0.8 11. Orem btisaael 8a,ia 18.7 14.31 2.1 17.7 81.8 284.11 18.2 7.7 4.0 8387 42 I In bu;lI ;o, of LCO ~ to"8 1978 s " 1960 16 971156P/ (et emmebtas 19600 Priam.) -- - - 41.oesfl.e.eti. Prodluct 166 SM9 4470 4738 49 A"6 8.9 6.2 0.8 1.4 1.1 Cs.stit. to jtwort 116 No0 479 448 48 81t 6.7 18.8 .-3.0 8.6 13 1 7.... of Trod. AUJ.atmwt .41 -98 0 4318 -89 496. . Orats, Doestic Intome 16o gm9 4470 440 489 4446 6.9 6.4 40.6 -0.2 1.1 41roes Sbtl.'aI Product 1891 M"6 484 4477 4709 4748 7.7 8.9 0.6 8.3 0.7 Gross, btim'al Incte. 188 1771 48141 4189 4814 4844 7.6 6.8 .0.6 8.7 a 7 (Iw a 1t)---- ---1sf lteft joestes11 P.* )- C. Price liLt.. iw1o 1904 SMo 1on 1167 It" of 19865-73 19781-0 190-67 1S67 190 P CssrPritee (M0 64) 100.0 879.0) 1071.3 19,94.9 4834.7 9906.1 4.81 80.8 711.0 181.6 114.2 Uwmlem* prig". (Ns5 68) 100.0 M6.0 106.4 1964.4 4M7.9 an. 4 .0 02.8 78.7 118.,6 106.8 lwiltit MP 2sf tar 10.0 6,14.8o 90 Is"87.81 411S1.8 6am64 8.9 31.8 86.9 148.0 104.0 Illslet