Mexico - Industrial Technology Development Project

Document of The World Bank FOR OFFICIAL USE ONLY Report No. 13271 PROJECT COMPLETION REPORT MEXICO INDUSTRIAL TECHNOLOGY DEVELOPMENT PROJECT (LOAN 2747-ME) JUNE 30, 1994 Country Operations Division I Country Department II Latin America and the Caribbean Regional Office 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 Equivalents Currency Unit = One Mexican Peso (Mex$) = 100 cents Average Exchange Rates 1978 US$1= 22.8 1979 US$1= 22.8 1980 US$1= 23.0 1981 US$1= 24.5 1982 US$1= 57.4 1983 US$1= 120.2 1984 US$1= 167.8 1985 US$1= 257.0 1986 US$1= 611.8 1987 US$1= 1,378.2 1988 US$1= 2,273.1 1989 US$1= 2,261.7 1990 US$1= 2,821.0 1991 US$1= 3,020.5 1992 US$1= 3,070.5 1993 (March) US$1= 3.1 (New Peso) FISCAL YEAR January 1 - December 31  FOR OFFICIAL USE ONLY ABBREVIATIONS AND ACRONYMS USED ACF Index of Average Cost of Funds BdM Banco de Mexico (Central Bank) CENAM Centro Nacional de Metrologia (National Center for Metrology) CONACYT Consejo Nacional de Ciencia y Tecnologia (National Council of Science and Technology) DGCP Direccion General de Capacitacion y Productividad (Department of Training and Productivity) DGPI Direccion General de Politica Industrial (General Directorate of Industrial Policy) FIDETEC Fondo de Investigacion y Desarrollo Tecnologico (Technology Research and Development Fund) FOMIN Fondo Nacional de Fomento Industrial (National Fund for Industrial Development) FONEI Fondo de Equipamiento Industrial (Industrial Equipment Fund) FONEP Fondo Nacional de Estudios y Proyectos (National Fund for Studies and Projects) GIRA General Interest Rate Agreement IDB Inter-American Development Bank IMF International Monetary Fund INFOTEC Instituto de Informacion Tecnologica (Institute for Information and Technological Development) ITD Industrial Technology Development NAFIN Nacional Financiera S.A. (Govemment's National Industrial Development Bank) PCR Project Completion Report R&D Research and development SAR Staff Appraisal Report SECOFI Secretaria de Comercio y Fomento Industrial (Ministry of Trade and Industrial Development) SINCA Sociedad de Inversiones en Capitales (Capital Investment Company) SOE Statements of Expenses TA Technical Assistance 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.l   FOR OFFICLALUSE ONLY THE WORLD BANK Wahbin0o, D.C. 20433 U.S.A. Of0ic of DiricGoOm Op.rtioa EvaBAtioc June 30, 1994 MIEMORANDUM TO THE EXECUTIVE DIRECTORS AND THE PRESIDENT SUBJECT: Project Completion Report on Mexico - Industrial Technology Develoment Proiect (Loan 2747-ME) Attached is the Project Completion Report on Mexico - Industrial Technology Development Project (Loan 2747-ME) prepared by Latin America and Caribbean Regional Office. Part II was prepared by the Borrowers. The project aimed at: (i) improving industrial technology development (ITD) policy instruments through policy analysis; (ii) selective strengthening of technology infrastructure; and (iii) expansion and strengthening of specialized technology financing. A combination of factors: (a) uncertain investment climate, particularly in the early stages of implementation; (b) high real interest rates; (c) absence of an explicit technology policy; (d) limited commercial bank participation in rislier financial operation such as equity, conditional loans or venture capital; (e) tendency to finance commercialization rather than activities more upstream of the innovation cycle; and (f) disruption in Industrial Equipment Fund's (FONEI) activities as a result of its merger with Nacional Financiera (NAFIN) in 1989, helped slow down the disbursement of the line of credit and seriously undermine the realization of the project objectives. The selective strengthening of technology infrastructure also met with little success as the restructuring/privafization of the R & D institutes received little support from the private sector and was eventually abandoned. The ITD policy analysis component was instrumental in providing a framework for the discussion between the Bank and the Government of Mexico, leading eventually to the adoption of technology policies which were supported under the Bank's Industrial Sector Policy Loan 3087-ME. Despite the relative success of this policy analysis component, the other components of this project were poorly designed and did not achieve their objectives. The project outcome is, therefore, rated as marginally unsatisfactory. The sustainabiity of the project is rated as uncertain and its institutional development as modest. The PCR is of satisfactory quality. It provides a good and candid assessment of the implementation experience. No audit is planned. Robert Picciotto by H. Eberhard Kopp Attachment This document bas a restricted distibution and may be used by recipients only in the performance of their official duties. Bs contents nay not otherwis be disclosd without World Bank authorization.   PROJECT COMPLETION REPORT MEXICO INDUSTRIAL TECHNOLOGY DEVELOPMENT PROJECT (Loan 2747-ME) Preface ............................................i Evaluation Summary ........................................ ii PART I: PROJECT REVIEW FROM BANK'S PERSPECTIVE I. Project Identity ........................................ H. Background ........................... 1 m. Project Objectives and Description ............................ 3 IV. Project Design and Organization ........................... 5 V. Project Implementation ........................... 10 VI. Project Results .................................... 15 VII. Project Sustainability and Future Directions ...................... 22 VII. Bank Performance .................................... 24 IX. Borrower Performance .................................. 24 X. Project Relationships .................................... 25 XI. Consulting Services .................................... 25 XII. Project Documentation and Data ............................. 26 XIII. Lessons Learned .................................... 26 Part II: PROJECT REVIEW FROMM BORROWER'S PERSPECTIVE I. Background ................................... 30 H. Project Objectives and Description ............................ 30 III. Project Organization and Design ............................. 31 IV. Project Implementation ................................... 31 V. Project Results ................................... 33 VI. Lessons Learned ................................... 35 Part III: STATISTICAL INFORMATION Table 1. Project Timetable and Use of Bank Resources and Disbursements Table 2. Status of Covenants Table 3. Project Costs and Financing Table 4. Subproject Data and Performance Table 5. Characteristics of Enterprises Financed Table 6. Subprojects with NAFIN Guarantees Table 7. Technical Assistance Subprojects   MEXICO INDUSTRIAL TECHNOLOGY DEVELOPMENT PROJECT (Loan 2747-ME) PROJECT COMPLETION REPORT PREFACE This is the Project Completion Report (PCR) for the Industrial Technology Development Project in Mexico, for which Loan 2747-ME in the amount of US$48.0 million was approved by the Bank on July 29, 1986. The closing date has been extended to December 31, 1993 to allow the Borrower to complete disbursement. The Project Completion Report (PCR) was prepared by the Country Operations Division I of the Latin American and the Caribbean Regional Office (Preface, Evaluation Summary, Parts I and III), and the borrower (Part II). Preparation of this PCR was started in November, 1992, and it is based inter alia, on data obtained during a ten-day mission to Mexico in November, 1992, and on the Staff Appraisal Report, the Loan and Guarantee Agreements, Project Supervision Reports, correspondence between the Bank and the Borrower, interviews of Bank staff involved in the implementation of the project, and internal Bank memoranda.  I  MEXICO INDUSTRIAL TECHNOLOGY DEVELOPMENT PROJECT (Loan 2747-ME) PROJECT COMPLETION REPORT EVALUATION SUMMARY Objectives I. The Industrial Development Technology (ITD) Project was designed to help improve the capability of industry to undertake technological innovation needed to face increasing competition in the context of the Government's economic liberalization program. The project had three objectives: (a) improving ITD policy instruments through policy analysis; (b) selective strengthening of technology infrastructure; and (c) expansion and strengthening of specialized technology financing. Of these objectives, perhaps the most crucial was to help focus the Government's attention on policies and related instruments designed to encourage lrT industry-wide. This was expected to become an integral part of the ongoing industrial policy dialogue between the Government and the Bank, and to help improve explicit policy instruments. Infrastructure strengthening was sought through the restructuring of a number of public R&D centers and improvement in the metrology services. Finally, the project provided funds through a line of credit channelled through the Industrial Equipment Fund (FONEI) located in the Banco de Mexico (BdM), to support FONEI's on-going lTD financing program. Economic and Fmnancial Sector Environnent II. Following the sharp drop in industrial production in 1982-83, major improvements in macroeconomic policies in 1984 led to a modest recovery in industrial output. However, this recovery was short-lived due to a reflation of the economy in early 1985 which, while providing a short-term stimulus, soon led to balance of payment difficulties. Industrial output fell by 5% during 1986, aggravated by the collapse of oil export earnings. Problems caused by the severe recession in the domestic market were compounded by the deterioration in the financial structure of many industrial enterprises. The crisis was felt more by among medium and large-scale enterprises which had to reduce output considerably. The larger enterprises with higher overhead had the most difficulties in adjusting to the reduced demand situation. III. Until 1988 the Government intervened heavily in the financial sector to fund Government deficits and to favor certain economic activities. Commercial banks were forced to lend the bulk of their funds to the Government, public enterprises and other favored sectors at below market interest rates. Efforts to limit Govemment transfers and interest rate subsidies to development banks and trust funds led to the General Interest Rate Agreement (GIRA) between the Government  - iii - and the Bank in 1984 under which interest rates to final borrowers were made variable and were to be raised over time. Starting in 1988 the Government implemented a series of measures to liberalize the financial sector, supported by the Bank under the Financial Sector Adjustment Loan - FSAL (Ln. 3085-ME). Most directed lending and all interest rate controls on deposits were removed. Far-reaching legislative and constitutional reforms supported the financial sector liberalization process. By 1989, several laws governing various types of financial institutions were amended with a view to increasing competition and reducing market segmentation. The supervision and regulations of banks and nonbank financial institutions were strengthened and restrictions on participation of foreign investors in the capital of nonbank financial institutions were relaxed. Finally, the constitution was amended in 1990 to allow full private ownership of commercial banks. The effects of the changes were dramatic in terms of growth rates and profitability in the commercial banking system. These increasingly profitable and stable operations set the stage for a re-privatization of the commercial banks and a retrenchment of the development banks and trust funds. III. As part of restructuring the financial sector, starting in 1988 the Government refocused the lending of its development-related institutions to viable projects and stopped using them to distribute transfers. Subsidies were generally reduced. The largest development bank, Nacional Financiera S.A. (NAFIN), was transformed into a second-tier lender, while four industry related trust funds, including Fondo Nacional de Equipamiento, the Industrial Equipment Fund (FONEI)), which was originally in charge of implementing the project, were merged into it. The reforms diminished considerably the role of directed credit. While in 1987 directed credit represented over 60% of total credit flows, this was reduced to 12% by 1990. Implementation Experience IV. The project was identified in September, 1984, appraised in August, 1985, negotiated in April, 1986, and approved by the Board in July, 1986. It became effective in October, 1986. Loans funds were planned to be fully committed by June, 1989 and disbursed by June, 1992. The loan of US$48.0 million was made available to NAFIN with the guarantee of the Government for 15 years, including 3 years' grace. The closing date has been extended twice to December 31, 1993. The project will thus close one and the half year behind schedule. The slower than expected disbursements were caused by: (a) clouded investment climate, particularly in the early stages of implementation, exacerbated by extremely high nominal and real interest rates resulting from a deceleration of inflation and the downward stickiness of interest rates; (b) absence of an explicit technology policy and strategy, during the early years, that would foster technological investments; (c) under-performance in equity, risk capital, financing; (d) limited commercial bank participation in riskier financial operations particularly upstream of the innovation cycle; and (e) disruption in FONEI's activities as a result of its merger with NAFIN in 1989. V. In retrospect, the following aspects of project design contributed to the mixed success of the project. On the positive side, the IDT policy analysis component was instrumental in bringing about improvements in the policy and institutional framework for technology innovation in Mexico (paras. 6.4-6.5). On the negative side, the R&D centers and the ITD financing components were  - iv - badly conceived. In the mid-1980s while Mexico was going through the worst economic crisis, very few Mexican companies were willing or able to invest in R&D facilities. Those which could build their own centers rather than buy public R&Ds with all their inherent problems. Besides, the component did not have strong support within Consejo Nacional de Ciencia y Tecnologia, National Council of Science and Technology (CONACYT), except for the then Deputy Director who, however, left the institution early during project implementation (para. 5.7). The underlying conception and assumptions of the credit line were incorrect. Risky operations such as technology development should not be financed with loans. Although conditional loans were offered, they were not used by generally traditional commercial banks and were discontinued when FONEI was merged with NAFIN in 1989. The end result was that the majority of subloans either financed the commercial stages of of the technology process, or the pre-commercial stages, but with guarantee from NAFIN up to 90% of the subloan amount, de fac making NAFIN (and not the commercial banks) the lender. Finally, the first-tier banks were reluctant to take equity in ITD companies and the little use of the equity investment component (36% of the original $5 million amount) was by NAFIN, with the remainder 64% transferred to the credit component. The merger of FONEI into NAFIN did not facilitate the implementation of the equity component either as resposiblitity for it was transferred to NAFIN's Equity Investment Department, which has neither the expertise nor a special interest in financing small, complicated, and risky ITD projects (paras. 5.5 and 5.6). Project Sustainability and Future Directions VI. The project might have been premature, coming as it did in the early stages of a profound transformation of Mexico's economy, when conditions were not yet ripe for the private sector R&D and, therefore, in this light the R&D and equity components of the project were not well thought. On the other hand, the project can be credited for having been a catalyst in the policy dialogue on ITD and a factor in the ensuing changes in institutions and operational environment that are now providing a much more fertile ground for technological innovation in Mexico. Studies financed under the project enabled the Government to improve its ITD policy and infrastructure. The metrology studies produced a number of significant findings which cumulated with the creation of the metrology center, the Mexican Industrial Property Institute, a new copyright protection law, and new legislation on the promotion and protection of industrial property. These efforts were subsequently supported by the Bank under the Science and Technology Infrastructure Project (Ln. 3475-ME). The new project benefitted greatly from the groundwork carried out under this loan. VII. With regard to 1TD financing, there seems to be a consensus that the two-tier lending approach is less than optimal and that a different mechanism more adapted to the high risks/high returns nature of ITD operations must be developed. Over the last few years, Mexico has seen the emergence of a number of new initiatives in the financial sector which could be adapted to support technology innovation. One of the most important of these is the Sociedades de Inversion de Capitales-Capital Investment Company (SINCAS), which are a hybrid between a growth fund and a venture capital company. Typically, SINCAS seek out existing companies with growth potential. Often these are old, established, enterprises whose owners have difficulty adapting to  the more competitive economic environment or are badly managed. SINCAS enter these companies with equity capital and managerial assistance, often insisting on a management shake- up. The main aim is to increase the market value of the firms they have invested in and sell their share at a profit. In May 1991, the Bank proposed to use US$5-10 million under the Industrial Restructuring Loan (Ln. 3047-ME) to test the SINCA scheme by establishing a venture capital fund with interested private investors to take equity participants in lTD projects but, the Borrower did not follow up on this offer. The possibility of adapting the SINCA scheme and use it as a conduct for ITD financing merits to be studied further. Lessons Learned VIII. Inportance of Macro Variables. The project was prepared and appraised in the midst of Mexico's worst economic crisis, with no hope of fast recovery in sight. The President's Report stated that "most program targets were missed in 1985. The fiscal deficit rose to 9.8% (of GPD), inflation increased to 63.8%, non-oil exports declined by over 10% from their 1984 levels, and most components of the balance of payments deteriorated. Foreign resewrves declined by nearly US$3.5 billion". Yet, the difficult economic situation was not given the weight it deserved in the design of the project. The SAR did not fully analyze the impact of the economic crisis on the demand for investment in technology development. It only mentioned as a possible risk the impact of the 1985 earthquake and the 1986 oil price decline "on relevant Government economic measures" and the uncertainty as to "how quickly Mexico will return to sustained economic growth and what impact any delay in economic recovery would have on the demand for ITD finance". As it turned out, while the need for technology modernization exists, the effective demand was much smaller. This is evidenced by the slow pace of commitmnent and disbursement. The project will be closing a year behind schedule. In future ITD lending, the macro conditions should be thoroughly analysed and taken into account in the design of the project (para 13.0). IX. Project Design. The problems which arose in connection with the R&D centers component were already evident as early as appraisal. It was clear that very few companies could afford to invest in R&D facilities in the mid-1980s and those who could preferred to build their own instead of buying public R&Ds. There was also strong resistance within CONACYT with the restructuring and privatization of R&D centers. The component was premature and should not have been included in the project (para 13.1). X. A major objective of the project was to expand ITD financing in Mexico. To this end, the project proposed to (i) strengthen FONEI through provision of technical assistance and financial resources Oine of credit); and (ii) introduce a new financing instrument (conditional loans) and a pilot equity component for which intermediaries will bear the investment risk. While strengthening of FONEI, the second-tier institution in the project was clearly needed, the Bank should also have better assessed the capabilility and willingness of the first-tier banks to invest in ILTD projects. As it tumed out, the first-tier banks were unwilling to do so and the conditional loan instrument was discontinued, while the equity component was only used by FONEI and then NAFIN, two public development institutions. This experience also confirmed that conventional  - vi - loans are not the appropriate lending instrument to finance ITD. This conclusion is supported by a study made by NAFIN on the subject. Indeed, as discussed in the PCR, 42% of the subloans made under the project were guaranteed by NAFIN up to 90%, de facto making NAFIN, and not the first-tier banks, the lender (para 13.2). XI. Local Ownership. Local ownership is a sine qua none condition for success and no component should be included in a project unless it has the full backing of the executing agencies. This lesson is again proven true in this project with the R&D component which faltered bacause it had no local support once the CONACYT's Deputy Director who was in favor of restructuring and privatizing public R&D centers left the institution. Lack of local support was also a major cause for the problems encountered by the equity component. However, the merger of FONEI into NAFIN and the transfer of responsibility for the equity component to NAFIN's Equity Investment Department could not be foreseen as it occured three years after project appraisal (para 13.3). XII. Importance of Policy Analysis. A lasting contribution of this project is to have helped focus the Government's attention on policies to encourage IDT industry-wide. Thus, despite the problems with the R&D centers and the equity/credit components, this project could be considered a relative success because of its impact on the policy and institutional framework for ITD in Mexico. This shows the importance in project design of focusing on policy analysis and improvements (para 13.4). XIII. Project Data and Reporting. The Project Agreement correctly focused on the need to maintain integral records of the operations, both in terms of accounting information and of the components financed. Although every audit report pointed out that this covenant was not being complied with, nothing was done to correct the situation. In this particular case, part of the problem stemmed from the lack of staff continuity due to the restructuring reorganization taking place in both institutions during project implementation. However, keeping good records of project activities is essential, particularly to carry out an ex-post review of the operation. Necessary corrective measures should have been taken during project implementation (para 13.5). XIV. The Borrower's lessons learned record a series of interesting experiences at the technology project and institutional support levels (part II, pages 6-11).   MEXICO INDUSTRIAL TECHNOLOGY DEVELOPMENT PROJECT (Loan 2747-ME) PROJECT COMPLETION REPORT PART I: PROJECT REVIEW FROM THE BANK'S PERSPECTIVE I. Project Identity Name: Industrial Technology Development Project Borrower: Nacional Financiera S.A. Guarantor: United Mexican States Loan No.: 2747-ME RVP Unit: Latin America and the Caribbean Region Country: Mexico Sector: Industry II. Background 2.0 At the time of loan approval in July 1986, Mexico's manufacturing industry had developed into one of the leading sectors of the economy, with a share of GDP of nearly 25%, and generating one out of eight jobs in the country. For many years, Mexico's industrial strategy had emphasized import-substitution behind high protective barriers and generous tax breaks and subsidies. As a result, Mexican industry had remained largely uncompetitive, with a limited export base. In the wake of the 1982 economic and financial crisis, the domestic market collapsed and industrial growth came to an abrupt halt. After a drop in industrial production during 1981- 1983, the industrial sector began to recover as output grew 4.8% in 1984. This upswing mainly stemmed from rising exports encouraged by sharp devaluations of the peso. Given the Government's commitment to a gradual opening of the economy initiated in 1985, prospects for further growth were good, but it had to come from exports and efficient import-substitution. The need for the diversification in exports become more urgent after the collapse of oil prices in 1986. And to accomplish the necessary restructuring of the industrial sector to enable it to compete with foreign products, improvements in technology were required.  -2- Government Policy 2.1 In the past, the Government had sought to strengthen Mexico's Industrial Technology Development (ITD) through building up public R&D agencies. Other measures had included fiscal incentives, public purchase programs, regulation of technology imports, and specialized ITD financing. While at the time of project approval the proportion of Mexican GDP spent on industrial R&D was comparable to Brazil and Argentina, this was in fact on the low end of the spectrum compared to newly industrialized countries and developed countries'. Moreover, the R&D expenditures were concentrated in the public sector, accounting for about 85 % of total industrial R&D expenditures (compared to 60% in Brazil, 30% in Korea, and less than 20% in the USA) and were 95 % financed by the Government. This public concentration of R&D resulted in in-house technology being confined to large parastatal enterprises, firms associated with multinational corporations, and a small number of mostly large private enterprises. Smaller firms often lacked the management, technical expertise, manpower and financial means to undertake technological innovation. Often they also have difficulties in formulating their R&D needs in an operational and bankable form. Since little effort had been made to develop in-house R&D capabilities even relatively large firms were forced to import technology. The shortage of in- house R&D capability were compounded by insufficient orientation of the available public sector R&D infrastructure towards private sector's needs and by a lack of an effective system of industrial standards, metrology and quality assurance.2 Industrial public sector R&D centers were run with little industry participation, often undertaking projects for which industrial demand was unclear, and they were insufficiently equipped and staffed. In addition to these constraints, there were a number of regulatory obstacles: excessive Government control over direct foreign investment and technology transfers which kept out, or made it difficult to acquire, the necessary foreign technology and attract technology intensive foreign investors. There was also a need to strengthen protection and enforce property rights, to ensure both local and foreign investors, and technology suppliers that their intellectual property rights were protected. Satisfactory resolution of these issues has been a critical factor to promote technology intensive direct foreign investment and the transfer of technology to Mexican enterprises. ITD Fnancing 2.2 Several specialized financing for ITD schemes was available at the time of project appraisal from a number of sources. The main financing source was FONEI, which was a trust fund established in 1971 and administered by the Banco de Mexico to provide long-term financing for industrial projects by rediscounting commercial loans. In 1978 FONEI had added a line of I Total science and technology expenditures rose from 0.13% of GDP in 1982 to an estimated average of 0.5% per year during 1984-1988, a level which was comparable to Brazil (0.45% in 1982), but well below Korea (2%) and the highly industrialized countries (Japan 3.4%, USA 3.1 %). 2 'Metrology' refers to making measurements at selected levels of accuracy. It requires measurement equipment, reference materials, etc., in the industrial firms and in specialized laboratories, whose quality and accuracy must be traceable to internationally accepted references.  - 3 - ITD loan rediscounting and guarantees,3 supported by Bank loan 1560-ME. Other sources of ITD financing included Fondo Nacional de Fomento Industrial (FOMIN), a trust fund established in 1972 and administered by NAFIN to make equity investments in small and medium-sized firms, including some technology innovative ventures. FONEP (Fondo Nacional de Estudio y Proyectos), another NAFIN trust fund financed engineering and other studies for industrial development, including some R&D studies. Besides these trust funds, the National Science and Technology Council's (CONACYT) "shared risk program" provided grants and "conditional" loans to industrial firms for ITD projects in line with the Government's subsectoral and regional priorities, mainly utilizing the services of public sector R&D services and local engineering firms. A component of a 1992 Inter-American Development Bank financed Science and Technology loan supported this program. 2.3 Despite these efforts, ITD financing in Mexico was small compared to the potential demand. Total commitment of funds to industrial firms for ITD by specialized agencies in 1984 was only about US$13 million (about 20% of total private industry R&D expenditures) and FONEI provided about 80% of this financing. In general, the financing available did not adequately meet industry's requirements, and was fragmented among several agencies. In addition, there were no institutional sources of private venture capital, and existing regulations did not encourage private financing of the more risky LTD investments. 2.4 The project was initiated on the expectation that the structural changes occurring in the Mexican economy since 1982 and especially since 1985 would also give impetus to a growing demand for R&D and its financing. It was a view shared by the Government, whose emerging policy at the time emphasized the need to strengthen relationships between public R&D centers and industry. Accelerated depreciation and fiscal incentives to industrial firms were to support ITD in priority areas and subsectors. Government funding of R&D through CONACYT was to be revised to address industrial needs better. A national science and technology program consistent with this changed emphasis was drawn up and provided a policy and strategic foundation for the project. Im. Project Objectives and Description General 3.0 The ITD project and loan to Mexico were designed to help improve the capability of industry (especially private firms) to undertake technological innovation needed to face increasing competition in the context of the Government's economic liberalization program. The project had three objectives: (a) improving ITD policy instruments through policy analysis; (b) 3 FONEI, together with FOMIN and FONEP was merged with NAFIN in 1989 when the latter begun its transformation into a second-tier lender.  - 4 - selective strengthening of technology infrastructure; and (c) expansion and strengthening of specialized technology financing. Policy Analysis 3.1 A major objective of the project was to help focus the Government's attention on policies and related instruments designed to encourage ITD industry-wide. This strategy was expected to become an integral part of the ongoing industrial policy dialogue between the Government and the Bank, and to help improve explicit policy instruments. Towards this objective, Secretaria de Comercio y Fomento Industrial-Ministry of Trade and Industrial Development (SECOFI), through its General Directorate for Industrial Policy (DGPI), was to carry out studies on the factors that influence technological innovation in industrial enterprises, including fiscal incentives, specialized financing and technology assimilation strategies. The studies were to assess the impact of explicit technology policies on industry, examine interdependencies among them and with broader policy areas (e.g., general industrial policy, taxation), compare relevant experience in other countries, examine the effects of alternative mid-term macroeconomic scenarios on ITD strategy and on the demand for specialized ITD finai1cing, and draw lessons and make specific recommendations for improving Government measures supporting, technology development at the enterprise level. The studies, expected to cost about US$0.8 million, were to be financed entirely by SECOFI. Selective Strengthening of Infrastructure 3.2 The Project sought to increase the responsiveness of public sector's technology infrastructure to private industry's through: (a) restructuring of R&D centers and (b) improvement of metrology services. Restructuring of R&D Centers 3.3 CONACYT selected four from among eight public sector R&D centers in the pharmaceutical, agroindustry and biotechnology, metalmechanics, and chemical sectors and commissioned feasibility studies for the corporate reorganization and financial restructuring of each center with private sector participation. The restructuring of the centers and their reorientation to better serve the needs of their clients was expected to be especially valuable to medium-sized enterprises which did not have in-house R&D capability and, indirectly, to large firms whose quality control and technology problem-solving capability would benefit from the project. 3.4 Under the project, subloans were to be provided to private industrial enterprises for their equity participation in the selected centers. Such R&D investment subloans were to be made by FONEI to finance up to 100% of an enterprise's holding in any center. The amount of equity was to be determined on the basis of the investment plans, which would specify the restructuring of the center's ownership, the equipment, works and services needed to start up the canters' new activities, and the institutional arrangements, ensuring major participation of the private investors  as well as of Govemment, CONACYT, and other entities as appropriate. The cost of the four centers was estimated at about US$16.8 million, of which the Bank was to finance US$8.2 million, including up to US$0.2 million of retroactive financing to September 1, 1985 for the cost of consultants used to prepare studies and promote the proposed restructuring operations. Improvement of Metrology Services 3.5 SECOFI's General Directorate of Standards (DGN) was to assess the adequacy of existing industrial metrology infrastructure and the quality of available services, with the assistance of a metrology institution and consultants. This study, to be partly financed with loan funds (up to US$0.4 million), was to recommend cost effective solutions to problems arising from inadequate service and incomplete infrastructure. Specific metrology programs and institutions requiring strengthening were also to be identified. Subloan funds were also made available (up to US$1.6 million) for the execution of such programs. Technology Development Financing 3.6 One of the primary objectives of the project was to strengthen FONEl's financing of lTD projects by private industry and to develop R&D capability in industry, research centers and engineering firms. A line of credit of US$37.1 million was provided to FONEI to help expand its ITD program. With this support, and related improvements in FONEI's policies and procedures, it was estimated that FONEI ITD commitments would grow an average 46% per annum in dollar terms between 1986 and 1988. Retroactive financing of US$4.6 million was provided for feasibility studies of the R&D centers and for ITD financing. 3.7 FONEI's ITD programs were to be further strengthened through technical assistance which included: (a) local and overseas training for FONEI staff and first-tier commercial banks; and (b) support to FONEI's promotional efforts and technical assistance in project evaluation. US$0.7 million was allocated to this component. A breakdown of total estimated project costs and financing by component at the time of appraisal compared to actuals are shown on Table 3 of PART III. IV. Project Design and Organization General 4.0 The project was identified in September, 1984, and Bank appraisal took place in August, 1985. Because of the innovative nature of the project, considerable time was required in its preparation and appraisal (108.9 staff-weeks4, see Table I, PART III). However, the About the same as for adjustment lending operations in the LAC Region.  - 6 - remainder of loan processing, through effectiveness, went fairly rapidly. The project was negotiatiated in April, 1986, approved by the Board in July, 1986 and signed in September, 1986. It became effective shortly thereafter in October, 1986. Loan funds were planned to be fully committed by June 30, 1989 and disbursed by June 30, 1992. 4.1 The project had five components: (i) industrial technology development analysis ($0.8 million); (ii) strengthening of technology infrastructure through feasibility studies and private sector investments in restructured R&D centers ($13.9 million); (iii) strengthening of metrology services by assessing the needs of the industrial sector and programs for initial improvement of metrology services ($2.9 million); (iv) specialized finance for technology development investments of industrial enterprises ($75 million); and (v) institutional strengthening of FONEI ($0.6 million). The Bank loan of US$48.0 million financed: (a) R&D studies and investments ($8.2 million); (b) strengthening of metrology services ($2.0 million); (c) technology development investments of industrial enterprises ($37.1 million); and (d) strengthening of FONEI ($0.7 million). The loan was made available to NAFIN with the guarantee of the United Mexican States for 15 years, including 3 year's grace, at the Bank's standard variable interest rate. In order to help capitalize FONEI, the Government was to repay the full principal of the loan, pay interest and other charges, and bear the foreign exchange risk associated with the loan. Execution of contractual arrangements between the UMS and NAFIN and FONEI on terms satisfactory to the Bank, was a condition of effectiveness. The project's major features are described in more details below. Policy Analysis and Infrastructure Strengthening 4.2 SECOFI was to carry out the work with its own staff, assisted by consultants, and guided by an advisory committee to be appointed by Direccion General de Capacitacion y Productividad-Department of Training and Productivity (DGPI), with representation of industry, academia and other Government agencies. During negotiations, agreement was reached that SECOFI would complete the studies no later than September 30, 1987, furnish them to the Bank, and exchange views with it on the studies' conclusions and recommendations. To facilitate restructuring of the R&D centers, feasibility studies were completed and investment plans prepared by CONACYT and the centers with consultants, under terms of reference and timetable agreed with the Bank. The loan was to finance, through FONEI, 100% of eligible expenditures in public sector R&D centers. Metrology investments to be financed under the loan, were to depend on the results of studies to be completed by SECOFI. Final retention by SECOFI of a foreign metrology institution to help carry out these studies with qualifications and under terms of reference to be agreed with the Bank was a condition of disbursement for the metrology studies, as well as for any subsequent investments. Technology Financing 4.3 During loan processing, several aspects of FONEI's policies and procedures were identified as areas needing improvement: (i) expansion of financial instruments; (ii) improvements  - 7 - in project evaluation and supervision procedures; and (iii) articulation of a clear policy and strategy for the technology program. They were all addressed in the project. 4.4 Also to better support firms undertaking high risk technology projects, FONEI added a conditional loan instrument. However, following the introduction of the GIRA and the transfer of FONEI to NAFIN in 1989, conditional loans were eliminated because of a lack of demand. This was to be used primarily for financing investments required for full scale production using locally-developed technology, which had higher market risk than similar projects financed under the traditional equipment lending program. With conditional loans, FONEL and the investors shared the investment risk. Loan repayment schedules were to be based on the expected revenues to be generated by the project. If revenues were less than expected, FONEl could reduce amortization of principal to a percentage of net revenues generated by the project and reschedule or remit any outstanding balance at loan maturity. To compensate for the higher risk, a premium was to be added to the established interest rate. Additionally, FONEL was to initiate a program to provide loans for ITD equity investments. These were to be loans to commercial banks for them to take equity positions in firms investing in ITD. Operating guidelines for ITD equity loans were similar to equity loans for other FONEI lending with the financial intermediary bearing the investment risk. To encourage intermediary participation in this new quasi-venture capital financing, FONEI discounted 100% of the commercial banks' participation. Project appraisal was to be in accordance with FONEI's ITD operations manual. Some deficiencies were identified in project evaluation and supervision procedures during project appraisal and were corrected in FONEI's revised operating manual. FONEI's staffing of its Technology Development Unit (TDU) was also found deficient; however, by loan negotiations a total of 17 new staff positions had been approved by FONEl and the Banco de Mexico. 4.5 To provide focus and direction for the ITD program, FONEI prepared a policy and strategy statement identifying the program's objective, FONEI's grant and interest rate policy, lending and staffing targets, promotional strategy and other features discussed during loan processing. A key element in the statement was FONEI's commitment to adjust interest rates over the project execution period towards market rates as the program became more established and to offer by January 1, 1987, potential clients of conventional ITD loans the option of a non-subsidized loan with a larger direct grant to offset the interest rate differential. Terms and Conditions of R&D Investment Loans 4.6 To attract firms to this new concept, FONEI was initially to lend up to 100% of the funds needed by eligible industrial enterprises to invest in restructured R&D centers, at an interest rate of not less than ACF 5. After about one year, FONEI's maximum participation was to be reviewed in order to bring it in line with the terms of FONEI's specialized ITD financing. Maturities of R&D investment loans were up to 13 years, including up to five years' grace. ' The ACF (Average Cost of Funds) index is calculated monthly as a weighted average of interest rates paid on all funds and deposits by the Mexican banking system.  - 8 - Terms and Conditions of FONEI's Specialized ITD Financing 4.7 Under its ITD program, FONEI lent primarily to private sector industrial firms, research centers and engineering firms to finance all elements necessary to support ITD projects, including purchase of basic information, process engineering, raw materials and supplies, operational and training expenses for staff involved in the project, R&D equipment and operating expenses, and pilot scale production using locally developed technology. Its project review and approval process included review by a technical committee with representation of industry, academia and other outside agencies. All ITD lending was to be channeled through commercial banks who were to assist with promotion of FONEI loans. 4.8 FONEI provided a mix of loan and grant funds. FONEI discounted eligible subloans made by commercial banks, and provided grants to the enterprises. FONEI financed up to 80% of total subproject costs and the firm the remaining 20%. FONEI's grant component was up to 30% (average 10%), depending on project characteristics, such as its innovative merit and the level of risk. The maximum outstanding technology subloans to any one borrower from the proceeds of the Bank loan was US$4 million equivalent. Conventional and conditional ITD loans were to have maturities of up to 13 years including a maximum grace period of 3 years. Equity subloans were to have maturities of up to 10 years, including a maximum grace period of 5 years. 4.9 FONEI was to charge the commercial banks interest rates equivalent to 88% of the ACF 6 on conventional technology loans, ACF plus one percentage point on equity loans, and, on conditional loans 104% of the ACF, plus a risk premium which would vary among loans. The commercial banks were to retain a spread of 6% of ACF which was expected to be sufficient to attract commercial banks to technology financing, as FONEI, in addition, was to discount 100% of technology subloans and guarantee up to 90% of conventional and conditional ITD subloans. Under the project, financial intermediaries were to charge ultimate beneficiaries variable interest rates equivalent to 94% of the ACF for conventional technology and 110% of ACF for conditional subloans plus a risk premium. At the time, GIRA' set only the interest rate on conventional subsidized subloans at a minimum level equivalent to the ACF less three percentage points. It 6 Given the then high nominal values of the ACF, NAFIN requested during negotiations, and the Bank eventually agreed, to a change in the interest base. Under the new proposal, interest rates were to be expressed as a percentage of ACF, as opposed to the earlier mechanism of setting the rates in terms of the ACF plus or minus a constant. Following the dramatic reduction in the ACF in 1988, the earlier mechanism was reinstated. ' GIRA - The General Interest Rate Agreement - was introduced in 1984. While short of ensuring fully market-determined rates, GIRA eliminated direct Government subsidies for most onlending through financial intermediaries. The agreement covered Bank financial intermediary operations totalling US$2.3 billion. The agreement is legally binding as long as there are loans outstanding under GIRA. New loans made after the signing of the agreement were incorporated in GIRA.  was agreed during negotiations that GIRA would be amended to reflect the above new nominal interest rates for technology financing; this amendment was a condition of loan effectiveness. 4.10 Conventional ITD subloans and equity loans in excess US$0.5 million and conditional loans in excess of US$0.8 million required Bank review and approval prior to Full documentation for all loans including those below the set limits was to be available for Bank review during supervision and for audit. The first five technology and equity subloans were to be submitted for Bank prior approval regardless of size. 4.11 To improve FONEI's financial soundness, the Government decided to further capitalize FONEL by repaying on its behalf both principal and interest for this and the Industrial Recovery (Ln. 2746-ME) as well as absorbing the foreign exchange risk. This was to ensure that FONEI could adequately provide the subsides required to support expansion of the ITD program from its net income over the project period. Provisions for losses in FONEI's financial projections of 2.5 % of new ITD disbursements were considered adequate to protect FONEI's net income in the event it had to honor its guarantees to financial intermediaries. The return on the conditional portfolio was expected on average to be equivalent to that on conventional loans, with high retums on most projects compensating for lower returns on less successful loans; an additional risk premium ranging from 2-10% was expected to compensate for an expected 30% failure rate on these loans. To ensure transparency, it was agreed that separate financial statements would be prepared for the ITD program, which would reflect the extent of grant and interest rate subsidy. The Bank agreed with these arrangements which were, however, rendered null and void when the Govemment introduced a new budgeting system for development banks and trust funds in 1989. Key Features of Project's Success/Failure 4.12 In retrospect, the following aspects of project design contributed to the mixed success of the project: on the positive side, the ITD policy analysis component was instrumental in bringing about improvements in the policy and institutional framework for technology innovation in Mexico. On the negative side, the R&D centers and ITD financing components were badly conceived. In the mid-1980s, very few Mexican companies were willing or able to invest in their own R&D facilities, least take over a public R&D with all its inherent problems. Besides, the component did not have strong support within CONACYT, except for the Deputy Director who, however, left the institution early during project implementation. The underlying conception and assumptions of the credit line were incorrect. High risk operations such as technology development should normally not be financed with loans. Although conditional loans were offered in the project, they were not used and were discontinued following NAFIN's reorganization in 1989, with the result that the majority of the subloans financed the commercial stages of the technology development process. R&D or subprojects at pre-commercial stages are generally covered by guarantee from NAFIN. Finally, the first-tier commercial banks were reluctant to take equity participation in ITD companies and the equity component was only used by NAFIN for 36 % of its original amount of US$5 million. The remainder 64% was reallocated to the credit component.  - 10- Procurement and Disbursement 4.13 Procurement procedures for goods and services financed with loan funds was to comply with those customary for industrial development finance operations. Under the project's infrastructure and metrology component limited international bidding procedures was to be applied on goods costing in excess of US$500,000, while below that level, and for civil works, local or international shopping procedures with a minimum of three quotations was required. The Bank was to have prior review of contracts for goods and services estimated to cost in excess of US$150,000 equivalent under the agreed investment plan of any research and development center or metrology program. To facilitate disbursements, a special account of up to US$4.0 million was set up and administered by NAFIN. The loan was expected to be fully disbursed by June 30, 1992. Accounts and Audit 4.14 The accounts of NAFIN and FONEI, the Special Account, and Statements of Expenditure were to be audited annually by independent auditors acceptable to the Bank and submitted to the Bank not later than six months after the end of NAFIN and FONEI's fiscal year. In addition FONEI was to prepare annually separate accounts for its technology development in a manner satisfactory to the Bank. Payments for SECOFI's and CONACYT's project components, were to be made directly by NAFIN, and the relevant accounts and SOEs were to be audited by NAFIN's independent auditors. V. Project Implementation Economic and Financial Sector Environment 5.0 Following the sharp drop in industrial production in 1982-83, significant improvements in macroeconomic policies in 1984 led to a modest recovery in industrial output. However, this recovery was short-lived due to a reflation of the economy in early 1985, which provided a short-term stimulus, but soon led to balance of payment difficulties. Industrial output fell by 5% during 1986, aggravated by the collapse of oil export earnings. Problems caused by the severe recession in the domestic market were compounded by the deterioration in the financial structure of many industrial enterprises. The crisis was felt more among medium to large-scale enterprises which had to reduce output considerably. The larger enterprises with their larger overhead in general had the most difficulties in adjusting to the reduced demand situation. 5.1 On the banking side, the outward looking, private sector led development strategy of the early 1980's was not immediately adopted for the financial sector. Following the  - 11 - nationalization of the banking sector in 1982, the number of banks was reduced from about 60 to 20 banks, including eight development banks, through a combination of closing and mergers. This state owned banking sector was then used increasingly as an instrument to channel credit to favored sectors at below market rates. Private sector initiative in the capital market was increasingly found in brokerage firms which became important intermediaries and were not subject to state control over day-to-day operations. 5.2 Until 1988, the Government intervened heavily in the financial sector to fund public deficits and to favor certain economic activities. Commercial banks were forced to lend the bulk of their funds to the Government, public enterprises and other favored sectors at below market interest rates. To circumvent these restrictions, the commercial banks gradually moved several types of transactions off their balance sheets which were estimated to represent 48% of the banking assets in 1987. Lending to the Government increased steadily, while lending to the private sector declined. Efforts to limit Government transfers and interest rate subsidies through lending by development banks and trust funds led to the General Interest Rate Agreement (GIRA) between the Govemment and the Bank in 1984 under which interest rates to final borrowers were made variable and were to be raised over time to at least ACF by 1987, except for loans to small farmers and for housing. By late 1988 the Government began to implement a series of measures, supported by the Financial Sector Adjustment Loan (Loan 3085-ME) approved in June, 1989. to liberalize the financial sector. Most forced lending requirements and all interest rate controls on deposits were removed. Far-reaching legislative and constitutional reforms supported the financial sector liberalization process. By 1989, several laws governing various types of financial institutions were amended with a view to increasing competition and reducing market segmentation. The supervision and regulations of banks and nonbank financial institutions were strengthened and the restriction on participation of foreign investors in the capital of nonbank financial institutions were relaxed. The constitution was amended in 1990 to allow full private ownership of commercial banks and the re-privatization of the nationalized banks. The effects of the changes were dramatic. Commercial bank assets increased at an average annual rate of 24% in real terms between 1989 and 1991; lending to the private sector climbed from 25% of total commercial bank assets in 1986 to almost 60% in 1991. These increasingly profitable and stable operations set the stage for a re-privatization of the commercial banks and a retrenchment of the development banks and trust funds. 5.3 As part of restructuring the financial sector, after 1988, the Government refocused the lending of its development finance institutions to viable projects and stopped using them to transfers resources except for agriculture. Interest rate subsidies were generally reduced. The largest bank, NAFIN, was transformed into a second-tier lender, while four industry related trust funds (including FONEI) were merged into it. Total assets of the combined development-related establishments were reduced by 46% in real terms, dropping from 50% of all assets in the financial system in 1987 to 27% in 1990. Also by 1990, total staff was cut by 20%. The reforms diminished considerably the role of directed credit. While in 1987 this form of lending represented over 60% of total credit flows, this was reduced to 12% by 1990.  - 12 - Critical Variances in Project Implementation 5.4 Loan closing is expected to take place on June 30, 1993, compared to June 30, 1992, estimated at appraisal. Disbursements would thus be completed in seven years, somewhat slower than the standard disbursement profile for apex type lending. Several key factors have been responsible for the slower than expected pace of disbursements (Figure 1) and for the variances in project implementation from appraisal: (a) uncertain investment climate, particularly in the early stages of implementation, exacerbated by extremely high nominal and real interest rates resulting from a deceleration of inflation and the downward stickiness of interest rates; (b) absence of an explicit technology policy and strategy, during the early years, that would foster technological investments; (c) under-performance in equity and risk capital financing with only US$1.79 million of the original US$5.0 million allocated to this component disbursed (paras. 5.5 and 5.6); (d) inability to formulate and implement restructuring plans for public R&D centers under the supervision of CONACYT. Only one center (new) was financed (para. 5.7); (e) limited commercial bank participation in riskier financial operations upstream in the innovation cycle and (f) disruption in FONEI's activities as a result of its merger with NAFIN in 1989. While in retrospect, given the innovative nature of the operation, the estimated project implementation period was perhaps too optimistic, the slow start of operations and the failure of the R&D and equity components had more fundamental structural and institutional causes. Equity Component ACCWllATED 8UMSEIUN EST ATED VS. ACUX 5.5 Only a total of six equity 50 investment subprojects were approved for o 4~ 40 financing for a total disbursed amount of 2 US$1.79 million (Table 3), compared to 3/ US$5.0 million allocated for this D v component at appraisal. The reasons for 25 the low level of utilization for this 20 component are both structural and 1s institutional. On the structural side is the z lo traditional nature of Mexican banking