Mexico - Industrial policy and regulation

Report No. 8165-ME Mexico Industrial Policy and Regulation August 15, 1990 Country Operations Division I Department II Latin America and the Caribbean FOR OFFICIAL USE ONLY U Document of the World Bank 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.  S CURRENCY EQUIVALENTS Currency Unit - Mexican Peso (HexP) On November 28. 1989 the exchange rate in the controlled market was lU$l MexP2517.00; the free market exchange rare stood at US$1 - NexP2637.00. LIST OF ABBRtVIATIO.:S AZUCAR, S.A National Sugar Company BANCOMEXT Banco Nacional d. Cosortio Ext.;ior (National Bank for Foreign Trade) CEPROFI Certificado dec Promocion Fiscal. Fiscal Promotion Certificate) CETE Certificado dt. Tesorerla (Treasury bill) CIT Corporate ncomc tax CFE Consejo Federal de Electricidad COMASUPO Compania Nacional de Subsistencia Popular (National Company for Pop ar Subsistence) CR4 4 Firm Concentration Rati DCRs Domestic Content Requirements DDF Departamento Distrito Federal (Federal Districr) DFI Direct Foreign. Investment DCNCC Direccion General de Noruatividad v Control d. las Comunicaciones (Director Seneral of Norms and Control of Telecomounications) OCT Director Ceneral de Telecomunicaciones (Director General of Telecomounications) DINA Diesel Nacional E. A Economic Comission of LAtin America ERe Effective rate of protection ESP Economic Solidarity Pact FEDEIN Industrial Park Trust Fund FERTIKEX Fertilizantes Mexicanos (Mexican Fertilizer Company) FOB Free on board FOGAIN Small- and Medium-Scale Industry Development Fund (Fondo de Garantia de Induatria Mediana y Pequefial FLL Federal Labor Law FOxEX Fondo de Fomento de las Exportaciones Mexicanas (Fund for the Development of Exports) FONEI Fondo de Equipamiento Industrial (Fund for Industrial Equipment) FONEP Fondo de Evaluacion de Proyectos (Fund for Project Evaluation) FM Ponds de Hinereles No Metalicos (Fund for Nonmetallic Minerals) GDP Cross Domestic Product GIRA General Interest Rate Agreement ILET Instituto Latino A&ericano de Estudios Transnacionale itSS Instituto Kexicano de Seguridad Social (Mexican Institute for Social Securicy) INEGI Institute Nacional de Estadistica Industrial y Ceografia (National Institute of Industrial and Geographic Statistics) I1NtECAFE Instituto Mexicano d. Cafe (Mexican Coffee Institute) INFONAVIT Instituto National Para la Violcnda de los Trabajadores (Housing Fund for Workers) ISPL Industrial Sector Policy Loan ITAH Instituto Tecnologico Autonomo de Mexico (Autonomous Technological Institute of Mexico) LIFO Last in first out (inventory accounting system) METR Marginal effective tax rates NAFIN Nacional Financiera NTBs Nontariff Barriers PECE Economic Stabilization and Crowth Pact PEr.EX Petroleos Kexicanos (National Petroleum Company) i;qL Public Enterprise Reform Loan PIT Personal income tax PRONAFIDE Plan National d Financiamiento de Desarrollo (National Plan for Financing Development) PRONAFICE Programa Nacional de Fomento Industrial y Comercio Exterior (National Program for Industrial Development and Trade) PRONASOL Prograsa Naciona Solidaridad (National Program to Combat Poverty) PVD Present Value of Depreciation QR Quantitative restriction SARH Secretaria de Agricultura y Recursos Hidraulicos (Ministry of Agriculture and Hydraulic Resources) SCDT Subsecretaria de Comunicaciones y Desarrollo Techn.logico (Ministcy of Comeunications and Technological Development) sCT Secretaria de Comunicacione. y Transportes (Ministry of Communications and Transportation) SECOFI Secretaria de Comercio y Fomento Industrial (Ministry of Trade and Industrial Development) SEHIP Secretaria de Energia. Mineras e Industria Paraestatal (Ministry of Energy. Minerals and Parastatal Industry SENEAM Servicios a la Navegacion en el Espacio Aeres Hexicano (Service to the Navigation of Mexican Aerospace) SERTEL Servicios de Tolereservaciones (Telereservation Service) SEDUE Secretaria de Desarrollo Urbano y Ecologia (Ministry of Urban Development and Environment) SHCP Secretaria de Hacienda y Credito Publico (Ministry of Finance and Public Credit) SIDERUEX Siderurgia Mexicana (Mexican Steel Company) SPP Secretaria de Planeacion y Presupuesto (Ministry of Planning and Budgeting) SRE Secretaria de Relaclones Exteriores (Ministry of External Relations) SS Secretaria de Salud (Ministry of Health) TELMEX Telefonos de Mexico, S.A.C.V. (Narional Telephone Company) VAT Value-added Tax VCm Vinyl Chloride UPS Workers' Payment System  FOR OFFICIAL USE ONLY MEXICO INDUSTRIAL POUCY AND REGULATION Table of Contents Page No. Executive Summary .... , ................. vi-xi Chapterl - Introduction. 1 A. The Changing Policy Framework, 1950-88 . . . . . 2 B. Toward Structural Reform, 1986-89 . . . . . . . . 3 ,' C. The Challenges Ahead . . . . . . . . . . . . . . 5 D. Organization of the Report . . . . . . . . . . . 6 Chapter 11 - Industrial Policies .10 A. The Evolution of Trade Policy . . . . . . . . . 11 B. Programs to Develop Priority Industries . . . . . 12 C. Direct Government Participation in Priority Industries . . . . . . . . . . . . . 16 D. Price Controls and Their Impact . . . . . . . . . 20 E. Bureaucratic Procedures . . . . . . . . . . . . . 23 F. Policy Recommendations and the Government's Program for 1989-93 . . . . . . . . . . . . . 25 Chapter III - Industrial Credit Policies ............................. 29 A. Rationale for Preferential Industrial Credit . 29 B. Key Mechanisms and Institutions for Industrial Credit .30 C. The Subsidy in Preferential Credit Policies . . . 33 D. Distribution of Credit to Industry . . . . . . . 36 E. Conclusions .40 Chapter IV - Tax Policies and Investment Incentives .42 A. Tax Policies .42 B. Effects of the New Tax System on the Marginal Effective Tax Rates (METRs) . . . . . . . . . 48 C. The Effects of Investment Incentives on the METRs 51 D. Competitiveness of the Mexican Tax System . . . . 54 E. Conclusions .56 Chapter V - Labor Market Regulation .57 A. Trends in the Labor Market . . . . . . . . . . . 57 B. The Role of the Unions . . . . . . . . . . . . . 60 C. Job Security Legislation . . . . . . . . . . . . 66 D. Conclusions and Policy Options . . . . . . . . . 67 This document has a restricted distribution and mnay be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  - ii - Chapter VI - Regulation of Trucking Services: ...... .................. 70 A. Responses from Industrial Users . . . . . . . . . 70 B. The Regulatory Setting Before 1989 and the Main Issues . . . . . . . . . . . . . 72 C. Assessment of the Impact of the Regulations . . . 77 D. Conclusions and the Trucking Deregulation in July 1989 .... . . . . . . . . . . . . . 80 Chapter Vll- Regulation of The Telecommunications Industry .... ......... 83 A. Sector Organization . . . . . . . . . . . . . . . 83 B. Sector Development . . . . . . . . . . . . . . . 83 C. Pricing and Tax Policy . . . . . . . . . . . . . 85 D. Telephone Tax System and Reinvestments by the Government . . . . . . . . . . . . . . 89 E. The Regulatory Structure . . . . . . . . . . . . 91 F. Competition Policy . . . . . . . . . . . . . . 93 G. Toward a New Regulatory Framework in Telecommunications Policy . . . . . . . . . . 95 H. The Government's Telecommunications Program, 1989-94 .... . . ...... . . . . . . 100 Chapter VIII - Industrial Market Structure . . . 101 A. Market Structure of Manufacturing Industries . 102 B. Concentration and Entry Barriers . . . . . . . 108 ANNEX I - Industrial Programs ANNEX 2 - Calculations of Marginal Effective Tax Rates ANNEX 3 - Tax Credits on Investment and Development ANNEX 4 - Cross-Subsidies in Mexico's Telephone Tariff Structure ANNEX 5 - Regulatory Issues in the Implementation of Price Reform ANNEX 6 - Statistical Tables This report was prepared by Marilou Uy (team leader, LA2TF), Marko Voljc (IA2ME), Ivan Rivera (LATTF), Luis Riveros (CECMG), Mohua Mukherjee (LA2TF), Bjorn Wellenius (AFTIE), Ulrich Zachau (Young Professional), Enrique Mendez (LATTF) and Robert Bruce (Consultant) basei on the findings of missions conducted in July and August 1988. This report benefited from suggestions from Claudio Frischtak (IENIN), Neil Roger (LACVP), A. Musalem (LA2TF), P. Knotter (LA2TF), S. Ramachandran (LATTF), A. Schwartzman, G. Martinez, E. Rodriguez, A. Fernandez and P. Noyola (SECOFI), F. Clavijo, R. Samaniego, and representatives from SCT, SHCP and Ministry of Labor. Mrs. Sandra B. Vivas and Ms. Vicky Sugui provided secretarial assistance.  - iii - Ust of Tables and Flaures Page No. Tables 2.1 Industrial Programs . . . . . . . . . . . . . . . . . . . . . . 13 2.2 Industrial Promotion Polic.es by Industry, 1987-88 . . . . . . 15 2.3 Industrial Parastatals by Product Category . . . . . . . . . . 17 2.4 Composition of Products with Price Controls, November 1988 . 22 2.5 Selected Regulatory Requirements and Time Required to Obtain Them ....... ........... . 26 3.1 Estimated Subsidies in Preferential Credit Operations of Development Banks and Trust Funds . . . . . . . 35 3.2 Credit Allocation to the Manufacturing Sector -- Some Indicators. ............ 36 3.3 Development Bank Credit to Selected Manufacturing Subsectors 37 3.4 Ten Largest Manufacturing Borrowers in 1987 and 1989 . . . . . 39 4.1 Tax System Related to Investment Income . . . . . . . . . . . . 43 4.2 Comparison of the In-ariance Properties of the METR under Full Dividend Distribution in the 1987 and 1989 Tax Systems . 50 4.3 Effect of the Investment Tax Credits (CEPROFI) on the METR under the Full Cash Dividend Distribution System in the 1989 Tax System .52 4.4 Effect of Expensing the Present Value of Depreciation on the METR under the Full Cash Dividend Distribution in the 1989 Tax System .53 4.5 Tax Rate Comparison, Mexico, Canada, and the US, 1989 . . . . . 55 5.1 Labor Market Indicators .58 5.2 Mexico Economic Indicators for Manufacturing . . . . . . . . . 59 5.3 Production and Employment Indexes by Manufacturing Brarch . . . 59 5.4 Labor Costs in Manufacturing . . . . . . . . . . . . . . . . . 60 5.5 Degree of Unionization in Manufacturing . . . . . . . . . . . . 62 5.6 Employment (L), Real Wages (W) and Average Labor Product (Q) Across Manufacturing Branches . . . . . . . . . . 64 5.7 Some Indicators of Wage Reviews and Strikes . . . . . . . . . . 66 6.1 Survey of Users to Determine Applicability of Official the Rate 72 6.2 Comparison of Trucking and Delivery Costs in Two Areas in Mexico ..75 6.3 Main Users of Public Trucking for Movements to and From Ports ..77 6.4 Results of Interviews with Providers of Public Trucking Services 1988 ..78 7.1 Comparison of Domestic Telephone Charges Between Mexican and Other Countries, January 1988 . . . . . . . . . . . . . . 86 7.2 Mexico -- Teleohone Real Rates . . . . . . . . . . . . . . . . 88 7.3 Mexico -- Rates of Taxes on Telephone Services, 1988/89 . . . . 90  - iv - Lst of Tables of Figures (cont'd) Page No. 7.4 7.4 Transfers of Funds Between TELMEX and the Mexican Government, 1987 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91 7.5 TEIMEX'S Operating Revenues and Government Reimbursement, 1976-87 ..... . 92 8.1 Distribution of Firms by Employment Size, 1970-85 . . . . . . . 102 8.2 Changes in Technical Concentration, 1970-1985 . . . . . . . . . 104 8.3 Market Concentration in Selected Countries . . . . . . . . . . 106 8.4 International Comparison of Four-Firm Concentration Ratios . . 107 8.5 Shares of Largest 50 and 100 Firms in Manufacturing . . . . . . 107 Flgures 1.1 Growth of Manufacturing GDP and Exports . . . . . . . . . . . . . 4 1.2 Total Gross Fixed Investment, 1980-87 . . . . . . . . . . . . . . 4 1.3 Real Exchange Rates, 1970-89 . . . . . . . . . . . . . . . . . . 4 1.4 Total Factor Productivity Growth, 1964-85 . . . . . . . . . . . . 7 1.5 Structure of Manufacturing Sector, 1980-87 . . . . . . . . . . . 7 2.1 Export Price Premium in US (Petrochemicals) . . . . . . . . . . 20 2.2 Mexico - Procedures to Initiate a Business . . . . . . . . . . 24 3.1 Financial System . . . . . . . . . . . . . . . . . . . . . . . 34 Statistical Annex Tables A2.1 Structtre of Manufacturing GDP, 1980-87 A2.2 Total Factor Productivity in the Manufacturing Industries, 1964-85 A2.3 Breakdown by Industry of Remaining QRs, 1988 A2.4 Structure of Production of Public Enterprises A2.5 Public Sector Investment by Destination A2.6 Share of Production by Parastatals in Selected Industries A3.1 Credit to the Manufacturing Sector, 1985-87 A5.1 Employment (L), Real Wages (W) and Output (Q) Indexes Per Branch A5.2 Estimated Labor Demand Functions for Manufacturing A5.3 Estimated Legal Cost of Dismissing 10% of Manufacturing Workers A6.1 Relative Share of Trucking in Selected Countries A6.2 Weighted Average Index of Transport Costs Across Countries A6.3 Survey of Users co Determine Choice of Trucking Firms A6.4 Official Rate ftracture for Public Trucking, 1987 A6.5 Age Provile of the Public Trucking A7.1 Summary of TELMEX Tariffs as of August 1988 A7.2 Comparison of Selected TELMEX Telephone Tariffs A7.3 Cross Country Comparisons of Telephone Installation Fee, 1982 A7.4 Cross Country Comparisons of Telephone Annual Subscription Rate, 1988 A7.5 Cross Country Comparisons of Tariffs on Local Calls, 1988 A7.6 Cross Country Comparisons of Tariffs on Domestic Calls, 1988 A7.7 Cross Country Comparisons A7.8 Comparison Based on Purchasing Power Sum of Telephone Charges  A7.9 Working Hours Required for the Sum of Telephone Charges A7.10 TELMEX's Revenue Over Cost Ratios by Type of Service, 1986 and 1988 A7.11 Cross Country Comparison of Taxes on Telephone Charges, 1988 A7.12 Operating Revenues and Costs of TELNEX in Real Terms 1976-1987 A7.13 Mexico Operating Revenues, Reinvestment Payments, and Investments in Real Terms, 1976-87 A7.14 Mexico: Basic Statistics of the Telecommunications Sector, 1974-87 Figure A7.1 Ministry of Communications and Transport (SCT): An Organizational Chart Figure A7.2 Director General of Telecommunications: An Organizational Chart A8.1 Technica' Concentration, 1970-1985 A8.2 Differences in Technical and Economic Concentration, 1980 A8.3 International Comparison of Eco.iomic Concentration by Type of Goods  - vi - MEXICO: INDUSTRIAL POLICY AND REGULATION EXECUTIVE SUMMARY 1. Mexico is currently undergoing a rapid structural transformation. Since 1983, the Government introduced macroeconomic stabilitization measures, with impressive results, progressed substantially in trade liberalization, and has been undertaking major efforts in domestic deregulation. Deregulation is aimed at reducing distortions that constrain the functioning of markets and, therefore, improve the potential gains from trade liberalization. 2. This report examines selected regulatory policies and its impact on industrial performance. Completed in mid-1989, the report assisted the Government in formulating a program for industrial regulatory reform and served as a basis for policv dialogue between the World Bank and the Government.' he Government has since removed some of the regulations covered in this report and made others more flexible. This report is updated to reflect the changes made until ea,.y 1990. The rapid ptogress towaLd deregulation can serve as an interesting example for other countries embarking on and undergoing a process of rapid structural change. 3. This report is organized as follows. Chapter I provides a brief description of the macroeconomic policies of the past few years and lays out the orgar.ization of the report. Chapter II discusses industrial policies, focusing on the incentives and regulations affecting the manufacturing goods market. Chapters III to V discuss the regulatory policies affecting factor markets -- industrial credit, taxation and labor -- and how they have affected industrial incentives and firms' capacity to adjust. Chapters VI and VII deal with the regulation of trans-ortation and telecommunications, which provide important services to the industrial sector. Chapter VIII presents a preliminary analysis of how Mexico's market structure has evolved over time and how it may have been influenced by the regulatory system. 4. Over the past two decades, economic and adminlstrative regulations as well as direct government participation have been pervasive in key sectors of the Mexican economy, favoring the development of a select group of industries and redistributing income to certain groups. While achieving some of their objectives, the regulations have also had negative consequences, such as diminishing competitive pressure, reducing flexibility and discouraging efficient change among producers. These occurred most frequently through a ' This report was an important input into the preparation of the Industrial Sector Policy Loan (June,1989) and the Road Transport and Telecommunications Sector Adjustment Loan (P!ay, 1990).  - vii - combination of entry restriction and the discreticnary application of the rules. 5. Firm concentration also increased in the early eighties Many medium sized firms contracted or exited while the number of small establishments rose dramatically. The largest increases in concentration were observed in industries that were highly protected and dominated by parastatals. Future research needs to focus on how trade liberalization may have affected t..e pattern and levels of firm concentration. 6. Trade liberalization brought concerns about excessive or inconsistent regulations to the forefront. For example, it became apparent that better services in trucking and telecommunications were necessary if firms were to compete effectively in international markets. Other forces also favored regulatory .eform. Rapid technological change requires higher factor mobility and easier entry and exit, and has exertedl pressure to reduce the administrative regulations on firms. Domestic fiscal retrenchment also favored regulatory reform since it called for a smaller role for the state. So the Government reduced tax credits, increased prices on energy, and reduced many of the subsidies to state enterprises, and is embarking on a major privatization effort of banks anl of the manufacturing sector. 7. While trade liberaliza.ion and the reduction of various subsidies to industry has moved Mexico away from a selective approach to industrial policy, a few industrial programs stil) provide high protection and regulation in the automobile, microcomp-uters, and pharmaceutical industries. The report recommends phasing out the quantitative restrictions on imports of these items, together with the removal of regulations on domestic content, firm operations, entry and, in the case of pharmaceuticals, the reduction of price controls and the formulation of appropriate health standaids. Recently, Government has announced a program that would increase gradually import competition in these items over the next five years. 8. Another vestige of the selective import subsitution strategy is the presence of industrial parastatals. The Government has been an important producer of steel, fertilizer, and basic petrochemicals since the early seventies. In industries where parastatals dominate, the regulation of entry and price setting contributed to poor performance of parastatals and instability in their output. For example, private secondary petrochemicals producers face uncertain supplies of basic petrochemicals, which only PEMEX, the state owned oil company, produces. Importing basic petrochemicals is expensive because these private companies are regarded as transitory customers in the world market. Tax credits (prior to their elimination), preferential credit and informal business ties between public enterprises also create huge cost advantages for public companies. Reforms should focus on phasing c. entry and price controls and the eventual privatization of industrial parastatals, in line with the Government actions and announced plans over the past two years. 9. Turning to regulations affecting factor markets, preferential (and directed) credit schemes complemented the selective industrial policy. Based  - viii - on data about the distribution of industrial credit between 1985 and 1987, both commercial and development banks channeled a major part of this financing to a few priority industries and a few firms. In particular, the development banks channeled 48X of their industrial credit to three parastatals and nearly 70X to eight parastatals. The commercial banks distributed their len&ding to industry more broadly, still parastatals and private firms within the same priority industries have been their major clients. After the elimination of preferential credit in 1989, the firm concentration of lending by both commercial and development banks remained focussed on parastatals, albeit to a lesser extent. 10. The recently-announced reprivatization of commercial banks will strengthen more market-oriented criteria .n the allocation of credit. Additional efforts are still needed, however, to streamline the role of development banks, create alternative financing instruments for industrial development (e.g., through capital markets), and strengthen prudential regulation of commercial banks. 11. The government has also made major advances in income taxation and fiscal incentives since December 1986, indexing interest payments, depreciation and inventories, making the system less biased toward debt financing in a high inflation environment. 14arginal effective tax rates (METRs) are currently lower for projects financed primarily by equity. The Government also loweree corporate income tax that brings effective tax rates closer to levels in the 'JS and Canada. The tax rates applied to foreign investment have also been brouC'it closer to the levels in the US and Canada. Further improvements could make the Mexican tax system more attractive to foreign investors, such as slightly lowering the effective tax rates on the profits of foreign corporations. Investment incentives, whose major impact was to reduce marginal effective tax rates drastically in a few activities, were practically eliminated. All told, these reforms, while increasing the cost of investments, have made the structure of effective tax rates more neutral across industries. 12. The labor market shows high wage flexibility and some rigid institutions, which have contributed to fairly stable employment. Labor legislation can impose large adjustment costs, especially for firms that need to undergo sizable reallocation of labor. High severance payments and union participaticn in hiring and firing decisions are features of labor legislation that raise exit costs. When unions dispute the layoff(s), firms have to go through a legal process that is often lengthy to negotiate the severance pay or reinstatement. Firms seek to circumvent these requirements through temporary employment contracts, promoting 'collaborative" unions, and delayi.dg severance payments. Moreover, unions are influential mainly in industries where collective agreements cover two-thirds of the firms, such as in garments and some parastatals. Future research should focus on the impact of these agreements on productivity and labor mobility. 13. Reform of labor legislation has been slow. Severance pay requirements and job security legislation need revision to make them less onerous for employers. In particular, union participation in hiring and  - ix - firing decisions should be defined more narrowly, and legal procedures for dismissing workers need to be simplified. Greater retraining of displaced workers and workers with outmoded skills is also desirable to ease industrial adjustment. The aforementioned recommendations have been crafted to serve the needs of inidustrial adjustment but do not take into account social or political objectives which may lie behind certain existing labor institutions and regulations. Future work needs to address the other facets of labor regulation and relations. 14. Regulatory policies in service industries may also affect the competitiveness of the i.adustrial sector. For example, inadequate transport services became a major concern once firms felt the pressure of competition from advancing trade liberalization. Prior to 1989 trucking regulations repressed prices and restricted entry scverely, hindering the development of trucking services. Entry restrictions consisted of a system of route concessions and permits to haul specific products, a state-sanctioned container transport monopoly, and mandatory use of cargo centers. Route comnittees, consisting of existing concession holders, decided on who obtained additional concessions. Fifteen families controlled the main corridors and the transport of major products. The black market that developed for rights of affiliation with an established concessionaire provided evidence of monopoly felnts. Thle regulaZions reduced competitive pressure, res'i1ting in poor service quality, low productivity, a deteriorating trucking fleet, and evasion through illegal operations. 15. ln 1990, the Government implemented rapid deregulation of the trucking industry. It removed routle restrictions, implemented clear and minimal repq1iremnents for receiving concessions and permits, allowed private sector entry intG container serv-ces, abolished mandatory use of cargo centers and eliminated price restrictions. Rapid deregulation was made possible by trade liberalization, which altered cargo transport demand patterns. Since onlv a few concession holders were able to capture the enhanced profits from the new demand patterns, most turned in favor of deregulation. The preliminary results of the deregulation have been impressive: large numbers of new entrants have registered, service quality has improved signicantly, and prices have dropped by about 20% on average. One outstanding issue for policy reform is the development of appropriate safety ard environmental standards. 16. Industrial users have also expressed concern over the role inappropriate regulations have played in the deteriorating telecommunications services. Major regulatory issues include expanding role of the private sector in an area traditionally dominated by the Government, introducing market-sensitive pricing, enhancing competition, and developing an appropriate regulatory institution. These have all been addressed in the six-year telecommunications program published in 1989. The Government's position, shared by this report, is to reeuce the role of the state througb privatization of TELMEX, and, eventually, many of the business operacions of 2 The deregulation measures for trucking and telecommunications services were announced after completion of a first draft of this report in mid-1989.  - x . the SCT or the Ministry of Transport and Telecommunications. The Government has also reduced some pricing distortions, raising rates for local calls, reducing those for international calls, and lowering installation charges, in line with the proposals in this report. Telephone user taxes were also replaced by a tax on revenues. The tariff and tax reforms, combined with a reduced transfer to the Government from TELMEX's profits should enable the privatized entity to generate resources needed to finance its investment needs. Still not clear is how tariff policy will be managed in the future to ensure efficient resource allocation and by whom.  CHAPTER I INTRODUCTION 1.01 Mexico is currently undergoing a rapid and profound structural transformation. The Government's goal is to carry out economic adjustment leading to growth and more efficient use of resources. In mid-1985 it began a program of reforms whose immediate objectives were to introduce macroeconomic stability and initiate structural change. It has made substantial progress, but achieving this goal will depend on sustaining that macroeconomic stability and deepening the changes in the incentive regime. The next few years will be a period of rapid change for Mexico, during which the nature of public policies toward key sectors will be undergoing significant transformation. 1.02 In the case of the industrial sector specifically, an important concern at this point is the implementation of a set of policies and policy changes that promote sustainable and efficient growth. As long as growth was rapid, as was the case in Mexico until 1982, many of the rigidities in the goods and factor markets were not perceived as hindrances to adjustment. However, as industry declined and import competition rose, many of these rigidities became binding obstacles. Since 1982, several factors -- especially the fiscal problems and the contraction of the domestic market -- have created a difficult climate for industrial adjustment while simultaneously showing how urgently changes are needed. Policymakers (and enterprises) are particularly concerned with '-ays to provide the right incentives for firms to adjust and to strengthen their capacity to do so. They recognize that, in addition to macroeconomic policy, microeconomic policies will also be important in adjustment, notably those that directly affect the operations of industry. 1.03 The objective of this study is to analyze the nature of the regulation of industry in Mexico and the potential for change. Besides trade and some policies directly affecting industrial goods, very little is known about the nature of microeconomic policies in other areas also important to the performance of industry. Because the coverage of these policies is so wide, this study focuses only on selected policy areas that affect the operation of not only the goods markets, but also of the factor and service markets. It does not look at industrial policy alone, which would include only measures expressly designed to promote industrial goods held desirable by the Government. This approach would place too much emphasis on only a few measures and disregard others outside the narrow plan for industry that have a large impact. Thus, this report also covers regulation of the labor market and of the transport and telecommunications industries. 1.04 To introduce the major themes and set out tne structure of the report, this chapter begins by surveying the broad direction of Mexico's changing policy framework and economic performance in recent years and the challenges that lie ahead, particularly in terms of the implications for industry. It then lays out the organization of the report and the issue. addressed in each chapter.  A. The Changing Policy Framework. 195G-88 1.05 After almost 30 years of sustained economic growth since the fifties, Mexico, including the industrial sector, has experienced no real growth since 1982. This stagnation has motivated the series of policy reforms that have emerged since mid-1985, whose objectives include the restoration of growth and increased efficiency in the use of productive resources. The key elements of the changes include macroeconomic stability, a more open trade regime and other structural changes that would increase the role of private sector investment and its efficiency. This strategy contrasts markedly with the public sector-led growth and import-substitution policies, and the series of short-term macroeconomic adjustment policies, that characterized Mexico's policies in the past three decades. 1.06 Public Sector-Led Growth. 1970-82. The period 1970-82 was characterized by rapid economic growth -- GDP rose at an annual average rate of 6% and manufacturing a little above 7%. The reason was the rapidly expanding Government involvement in the economy: between 1970 and 1976, the share of public seztor expenditure in GDP rose from 20% to 28%. Parastatal enterprises doubled in number and expanded faster than the economy during the same period. The rise in expenditures was not, however, matched by rising public revenues or private savings. As a result, the inflation tax and external debt became increasingly important sources of finance. Inflation accelerated, the real exchange rates appreciated and external debt rose beyond the rate of GDP beginning in 1974. 1.07 In the mid-seventies, major oil discoveries and the subsequent sharp increase in oil prices provided relief from the fiscal and external problems. Government revenues expanded, as did public sector borrowing. The Government also increased its role rapidly in the economy -- its share of value added rose by about a third, while its share in total investment went from 33.5% over the period 1970-75 to substantially more than 40% in later years. The real exchange rate appreciated by more than 25% between 1976 and 1982. External debt fueled much of the expansion, increasing from $16 billion to $86 billion between 1975 and 1982. 1.08 The inflationary policies, an overvalued exchange rate and negative real interest rates exacerbated the weakness of the basic incentive regime. The subsidies given through the incentive system rose, reaching 8.5% of GDP by 1980. Fiscal incentives and input subsidies were commonly used to protect domestic enterprises, especially in industry. By 1981, total gross fixed investment (both public and private) declined and reached its lowest level historically in 1983. 1.09 Attempt at Macroeconomic Adjustment. 1983-85. By 1982, external factors, including rising world interest rates and falling oil prices, and the subsequent cut-off from external capital markets, put an end to the expansionary policies and paved the way for fiscal reform. By late 1982, Mexico had begun a drastic contraction of domestic demand through fiscal and monetary policy. It also tightened import controls.  - 3 - 1.10 There was some initial success: the fiscal deficit was halved, international reserves recovered, and inflation came down. Then, in 1984 and 1985, there was some fiscal expansion and monetary relaxation. Economic growth and manufacturing output dropped (Figure 1.1). The largest decline in manufacturing output occurred in the capital goods industries, whose products were sold mainly to the major parastatals. While exports of manufactures grew at an impressive rate of about 50% between 1982 and 1983, they consisted mostly of residual output that could not be sold domestically (Figure 1.2). Domestic investment, particularly private investment, recovered slightly from the 1983 level until 1985, when it declined again. B. Toward Structural Reform. 1986-89 1.11 Since mid-1985, the stabilization efforts have been accompanied by policy changes designed to reduce the structural rigidities. The most important area of change has been trade policy. A key measure was removal of the quantitative restrictions (QRs) on imports from about half of production. The real depreciation of the peso also spurred manufactured export-, whose growth more than compensated for the fall in oil revenues resultinL from the oil price decreases (Figure 1.3). 1.12 In December 1987, the Government initiated a stabilization program (Economic Solidarity Pact or ESP) that consisted of a further tightening of the fiscal and monetary policies as well as structural reforms. Trade liberalization was accelerated. By the end of 1988, only 23% of domestic production remained under QRs. Tariffs were reduced, with the highest tariff rate falling from 100% to 20%. Other measures included the privatization of sele:ted state enterprises and the reduction of credit subsidies. Other accompanying measures were the pegging of the exchange rate against the dollar and a freeze on public sector prices. 1.13 The performance under the ESP was exemplary in almost all areas. Between the end of 1987 and early 1989, inflation and the public sector deficit fell dramatically, despite further drops in oil prices, increasingly high real interest rates on debt and the high level of domestic real interest rates, which reached almost 40% by the end of 1988. However, and not surprisingly given the restrictive demand management and lower public investment, real growth did not resume. 1.14 The changing set of incentives brought about by the trade liberalization was beneficial in some ways, particularly for export and productivity growth. Manufacturing exports became relatively more important, partly compensating for the fall in oil export revenues. Based on some preliminary estimates, total productivity seems to have grown, too. Between 1970 and 1983, it had on average been negative, an indication that much of the growth was based on factor accumulation rather than more efficient factor use (Figure 1.4). Labor productivity growth was positive but capital productivity declined, a further indication that capital accumulation may have fueled the growth. Between 1983 and 1985, total factor productivity growth was positive  Figure 1.2 Total Gross Fixed Investment Mexico, 1980-87 t liont oN 1960 Peeo") t200 Figure 1.1 Manufacturing GDP and Exports Average Annual Growth Rate 600 Mexico 1981-1988 200 60 19U0 161 1902 1983 a9"4 1988 s 1987 60 0Total nv Total PrIvtnb Im a Totbl Pub ic n 40- 20-41 10. / = Figure 1.3 Real Effective Exchange Rate 0 Mexico 1979-1988 ldax 1960.19 -10 160 1981 1982 1983 t984 1985 1986 1987 1988 0 Mfg. GDP - Total G3DP Mfg. Exports 120 100 Source: Sanco de Mexico, 1980 prices. 8o B0 40 20 Satun IM,F and osouIuons  in many industries, and preliminary evidence for 1986 to 1988 shows positive and improving factor productivity growth.I On average, however, it is still low relative to many countries that are industrializing fast. 1.15 On the other hand, the change in the incentive regime did not affect the structure of production. The composition of GDP has shown very little change except for the fall in the share of crude oil. The manufacturing sector shows that chemical and food products have increased their relative shares slightly (see Figure 1.5 and Annex Table A2.1). The share of metal products declined, but some of its industries, particularly automobiles, have grown in importance since 1980. C. The Challenges Ahead 1.16 The most important objectives for the Mexican Government are the resumption of growth and more efficient use of Mexico's productive resources. It is also clear that the public sector and fiscal efforts under the short- term stabilization efforts can play only a supportive role in achieving higher growth. Private investment will have to take the lead. In 1989, however, private investment was only 11% of GDP, compared with 19.2X in 1980. To stimulate its growth, much will have to be done to achieve a stable macroecon.'mic environment and to implement an external debt management that is consistent with it. In addition, regulatory reforms will foster factor mobility and competition, which will also encourage an investment response. 1.17 Increased economic efficiency can be attained only if factors are valued at their oppcrtunity costs. The changes in trade policy have been important steps toward that direct!on. So have been the ongoing internal price and regulatory reforms that match the new outward orientation, in line with the structural reforms during the past few years that have been geared toward reducing the role of the public sector in the economy. In some areas, the changes in the incentive regime complement macroeconomic concerns. For example, the reduction of state involvement in production and subsidies is clearly compatible with the fiscal retrenchment. 1.18 The change in the domestic regulatory framework involves deregulation of policies affecting practically every sector of the economy -- agriculture, the markets for industrial products, services and utilities. The process is complex -- reducing and rationalizing the Government's role as regulator and producer, easing many of the mechanisms (pricing and incentives) that have been used to guide resource flows, and streamlin