Report No. 11823-ME Mexico Country Economic Memorandum Fostering Private Sector Development in the 1 990s (In Two Volumes) Volume I Main Report May 16, 1994 Country Operations Division I Country Department II Latin America and the Carribean Region FOR OFFICIAL USE ONLY MICROGRAPHICS Report No: 11823 MX Type: ECO Document of the Worl 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 Currency Equivalent Currency Unit = New Pesos Average exhange rate per US $1.00 1986 = 0.6118 1987 = 1.3782 1988 = 2.2731 1989 = 2.4615 990 = 2.8126 991 = 3.0184 199 = 3.0949 993 = 3.1156 FOR OFFICIAL USE ONLY ACRONYMS ACF Averg Cost of Funds ADR Amercan Depository Receipt ASM Agriculunl Sector Memordum BANOBRAS Banco Nacional de Obms y Servicios Publicos ELT Bid, lease, trnsfer BOO Build, own, operate BOT Build, opeate, transfer CAPNFE Camios y Puente Federides CEMEX Cementos Mexicanos CET Mexic80 Treasy Bills CFE Comsion Fededa de Electrcidd CIMO Multiple Support Service Pogram to MSMEs CNA Comision Nacional de Agus CNB Comision Nacional BancRia CNV Comison Nacional do Valo CONASUPO Nadina CODy for Popu: CPP Costo Prmedio Poreental (swe ACF) DCR Domestic content requirements DF Distrito Federal DFI Direct Forei Investment FOMEX Fund for the Development of Eports FNM Ferrocarriles Nacionales de Mexico (AAP Generally Agreed Accounting Priciples (OM Govemment of Mexico ICD Inland Cleanmce Depots IFC International Finance Corporation imSS Instituto Mexicano de Seguts Sociale DIME lstituto Nacional de Ecolo8ia IRR lnternationl rat of return IVA Value added tax LCL Less than container load MCMA Mexico City Metropolitan Area MPTO Mexico Patent and Trademark Office MSME Micro, small and moeium sizd entpises MTO Multi-modal Transport Organization NAFIN Nacional Financiera NAFTA North American Free Trade Agreement OECD UIN Orgaization for Economic Cooperation and Development PM Puertos Mexicanos PROBECAT Progma de Becas de Capacitacion par Trabajadomes PSA Private Sector Assessment PSD Private Sector Development R&D Research and Development SAR Sistema de Ahorros parn e Retiro SARH Secretaria de Agricultura y Recursos Hiaulicos SCT Secretaria de Coam a y Transporte SEC Securites Exchange Commisson SECOFI S _cretuia de Comerro v Fomento Indua SEDESOL Seretaria de Desarrollo Social SEMIP Secrtria de Energia, Minas, e Industria Pareestatia SHCP Secretar de Hacienda y Credito Publico SOE State owned enterprises TELEMEX Telefonos Mexicanos TFP Total Factor Productivity TRIMS Trade-related investmernt measures This document has a restricted distriuWon and may be used by recipien only in the pefmam otbr official duties. Its conets may not otherwise be disclosed wifout World Bank autlozaton. CONTES INTRODUCTION AND EXECU SUD4ARY .................. i L THEECONOMMC ANDPOLICYFRAMEWORK .. I A. COUNIRY BACKGROUND 1.... I B. THE REFORM PROGRAM. 4 i. Stabilizatin 4 ii. Trade Liberaition . 9 iii. Direct Foreign Invesnet .. .12 iv. FinancialSectorLiberalization . .16 V. Taxation . .27 vi. Manufacturing Industry Deregulaion . .31 vii. Privatzation .... . . . . ............... 33 viii, Technology Trnsfer and Intellectual Property Protection . .38 ix. Agriculture .. ...... .40 C. PROGRAM RESULTS AND CURRENT PROBLEMS .43 UL PROFDLE OF THE PRIVATE SECTOR ...52 i. Size and Composition of the Private Sector .52 ii. The Role of Industrial Groups .58 iii. Regional Distribution and Ownership Pattemrs .60 iv. The Maquiladora.. 63 v. Foreign Investment .64 mI. CONSTRAINTS ........... 65 A. IITIASTRUCTURE .... . .. 66 i. Inadequate Infraucture as a Constraint to Private Sector Development .. . .... 66 ii.. Private Sector Participation in Infastructure Services. 68 iii. Developmentsby Sub-sector ...... 69 B. TH"E ENION0N ................................. 89 i. TheProblem .. ......................... 89 U. RegulationPolicies and Enforcement ......... 91 im. Issues ..................... . . 95 C. FINANCIAL SECT'OR ........................ 98 i. The Cost ofFiace .............. . . . .... 98 ii. Opertion oftheBanidng Sygm ............. 99 iii. Non-Bank Financial Services ........ ....... 101 iv. Securities Markets . 102 D. THE LEGAL SYSTEM . ....................... 105 i. TheConstitutionalFramework .......... 10% ii. General .......................... 105 in. The Commercial Law FrAmework ............ 106 iv. Dispute Resolution ..................... 112 B. HUTMAN RESOURCES ........................ 116 i. EducationandTTaining .................. 116 ii. The Labor Market and the Regulatory FrAneork .......................... 124 IVt STRATEGY .. ............ . 129 A. ELEMENTSOFA DEVELOPMENTSTRATEGY .... ... 129 B. THE BANK GROUP ROLE ...................... 132 ANNEX: The Madxco Pivate Sector Assessment Survey .... ......... 135 Mh rMeort was prepared by Robet Kanchger (team lader, LC); Frak Lysy, Danil Oh, Nei Roger, Violeta Rosenthal, Ann Revenga, Tom G1aess, Daniel COisu , Tony Oliwro and Lydia Lee (LA2CI); Eric Haythome (LEGEC); LuiL Guasch (LATAD); and Joost Draa_a (RESMEX. Eric Rice and Fnrnk Lysy (LA2C1) prepaed the final revisions. lhe report benefited f*m wodc done and sugtons by Araceli de Leon-erlihy (CPLDl) and Andrew Stone (PSD). Th report is based ijsc jug on the findings of a mission which took place iunJanuay 1993. ITe entis survey conducted for ho study vas caried out by Macro Asesora, S.C Ihe firm Coufil Abogadod pri constant servces for the secto on the Legal System INTRODUCTION AND EXECUTIVE SUMMARY Inrdctioo Mexico has been a pioneer in the stategy of private sector led development. a stategy now being replicated by many other of the Banlks borrowing members. Until the mid-1980s, the Mexican economy was highly proteed and regulated, inward oriented, and dolLnated by state run industries. As a result of the poicy changes and reforms that have taken place since then, Mexico has made great progress in stabiliing, libeliing, and privatizing its economy. The govemment strategy has been to utiliz the private sector to drive economic growth, with the govemment focussing on the policy framework and on macro-stabilization. With much of the economic reform program in place and the ratification last year of the North American Free Trade Agreement (NAFTA) with Canada and the United States, Mexico now enters a period in which the private sctor wi be exposed to new opporunities and challenges. The reform program removed many of the constramnts to private sector development and NAFTA wil furither open new markets to Mexican enterpnses. Many firms are now having to fae increased intenational competition, and their survival and growth will depend on their ability to modernize and compete in the world economy. This, therefore, is an opportune moment to assess what has taken place, exmine what remains to be done, and identify the major issues for govnment action and World Bank Group assistance. Struture of the Study Part I looks at the economic and policy framework that Mexico has put in place. It begins with a review of the historical role of the private and public sectors in the economy and the antecedents of the economic crsis of the early 1980s. It then revws the economic reform program undertakn by the government to deal with the crisis and examines what must be done to consoliate the program's achievements and fill in the remaining gaps. The story is told to better understand the current position of the private sector in Mexico, and for the lessons it may contain for other countries. The results of the reform program are assessed and curent economic issues affecting private sector development are reviewed. Part II presents a profile of the private sector. It sets forth basic information on the size and composition of the sector and considers some of its special characterstics. It looks at the powerful industrial groups and examines their role and influence in the economy. Regional distribution and ownership pattems are examined, as is foreign participation in the sector, and the important role that maquIladoras (in- bond assembly manufcting idusties which produce for export) have had. Although other subsectors are considered, the report's major focus is on man. Agriculture, finance, and mining have special chaeacteristics, and have been the subject of other Bank studies. Pa III is concerned with the microeconomic environment for susainable ptivate sector development. With most of the major reforms and adjustments in the macroeconomic and policy framework now in place, the attention of the authorities can now be focussed on microwxonomic issues. Slow economic growth and disappointing increases in productivity have lent an urgency to identifying constraints on private sector development. Five priority areas have been selected for review: infrastructure, the environment, die financial sector, the legal system, and human resources. Part IV discusses the principal issues affecting private sector development that merit attention in the World Bank Group/country diogue and the support that the Bank Group may be able to provide to Mexico. It identifies the principal strucl reforms requred to complete the reform program and recommends acton to rmove some of the obstacles to private sector growth. The findings, information, and recommendations made in the study draw on the Bank Group's expenence in Mexico over the years, and in particlr on the work that was done by Bank Group staff in support of the government's economic adjustment and reform program beginning in the mid-1980s. Additional information was obtained during a mission in January 1993, through the engagement of Mexican consultants who did a firm level survey of about one hundred firms, and through the report of a Mexican legal firm that prepared a study of some of the principal legal constraints encountered byv the private sector. 1. THE ECONOMIC AND POLICY FRAMEWORK i. Background. During the 1950-81 period, GDP grew at an average annual 6.5 percent rate. The policy environment during this period included a progressive expansion in (i) tariff protection and quantitative restrictions on imports; (Hi) fiscal incentives and subsidized credit for sectors deemed to be a high priority; (iii) restrictive regulations on business entry and operations; (iv) restrictions on foreign investment; (v) rising public exenditures, not matched by increases in revenues; and (vi) a rapid expansion of parattal enterprises especially during the 1970s. But the rapid economic growth in this period was associated with increasng mefficiencies and stagnating productivity, and proved not to be sustainable. By 1981, the governmentfs primary fiscal deficit had reached 8 percent of GDP, inflation was at an annual rate of 30 pent, the exchange rate had become significantly overvalued, and foreign debt had increased ten-fold over the decade to US $78 billion. In this highly vulnerable state, msing world interest rates and falling oil pnces in 1982 led to an economic collapse. Mexico's reserves were soon exhau'ted and foreig debt service had to be suspended. ii. Stabiition. Beginning with the election of a new President in 1982, Mexico undertook an unprecedented reform program that combined macroeconomic stabilization and structural reform. The cornerstone of the stabilization effort was a fiscal adjustment program based on drastic cuts in public sector expenditures and increased revenue generation though tax reform and adjustments in the prices of goods and services produced by public enterprises. The stabilization program, once complemented with fundamental structural reform measures, was eventually a great success. Mation fell from an annual rate of 159 percent in 1987 to an average annual 20 percent in 1989-1992. Inflation in 1993 fell to 8 per cent. And in 1989, Mexico successfillly renegotiated its extemnal debt under the Brady plan, reducing debt service and the macroeconomic uncertainties that the massive debt had caused. iii. Trade Liberalization. Since 1985 Mexico has moved rapidly from being a closed to an open economy. The aim of Mexico's trade liberalization has been to improve the productivity of the tradeables sector, and open the economy to internationat competition to encourage efficiency in both export and import substitution activities. Mexico is now one of the more open economies in Latin America. The government has embarked on a complementary extensive reform program to modenize the customs process and improve efficiency and collection. NAFrA will advance this process furither by providing for the phased elimination of tariff and most non-tariff bariers within ten years for Mexico's principal trading partner, although some sensitive products will have a fifteen year transition penod. The remaining trade liberalization agenda is to reduce tariffs to non-NAFTA countries (which account for only about 30 percent of Mexico's trade), and to reduce further administrative burdens such as customs procedures. iv iv. Foreign Investment. A series of guidelines and regulations have been issued since 1984 which have liberalized the climate for direct foreign investment (DFI). Majonty foreign ownership is now generally allowed and the application process for foreign investment has been expedited. I)FI flows have reacted to the liberalization and economic recovery, as evidenced by the increase in the stock of DFI by about 50 percent between 1989 and 1992. The recently enacted law on foreign investment writes into law the regulatory changes that have taken place since 1984 and assures investors that the new regime is here to stay. In addition, NAFTA contains a model chapter on DFI that goes beyond the current liberalized regime. The agenda for future libealization would be to extend the NAFTA treatment to investors from other countries. v. The Financial Sector. During the 1988-92 period, Mexico moved from a system where financial resources were largely centrally directed by government authorities, to one that relies on the market. All non-prudential controls on commercial banks were lifted and the privatization of commercial banks was completed. At the same time, the supervisory and regulatory framework for commercial banks and securities brokers was modemized. The development banks and trust funds were reduced in number and size, and the government introduced measures to limit subsidies and transfers to agricultural financial institutions. Securities market reforms included lal, regulatory, and tax measures, improvements in market supervision, and the development of the institutional structure required to support greater participation by finns of all sizes in Mexico's securities markets. vi. Taxation. The principal tax reform measures that have been undertaken have been aimed at broadening the tax base, reducing excessive marginal rates in non- favored sectors, and making the system more inflation neutal. These measures have succeeded in increasing tax revenues, simplifying and increasing the efficiency of tax administration, and creating a more rational and equitable tax structure. However, the reform process has also been accompanied by frequent changes which have imposed burdensome compliance costs on the private sector. Remaining reforms include restrcting the tax loophole which exempts fringe benefits from taxable income and fiurther improving tax administration. vii. Manufacturing Industry Deregulation. Mexico's industrial strategy during the 1980s included the promotion of five sectors deemed to be priorities: automotive, pharmaceuticals, microcomputers, capital goods, and petrochemicals. The program used both protection and regulatory measures in promoting its goal of developing strong national industries that would dominate the local market. The government began to phase out the programs in 1985, and under NAFTA they will eventualy be eliminated. viii. Privatization. A program of privatizaton and liquidations has reduced the number of public enterprises from 1,155 in 1983 to about 200 at present. The sale of V companies has generated about US$22 billion, the bulk coinig from sales that took place between 1990 and mid-1992. The privatizations generated revenues that enabled the government to reduce its debt and the fiscal burden of transfers to many of the public enterprises. Most importantly, the privatizations led to the more efficient provision of the services to the economy. These public enterprises had previously held many of these services in a monopoly. All of the major commercial banks, the steel companies, the telephone company, the two major airlines, and the principal mining companies have been privatized. Most of the reveniue has come from the sale of the commercial banks (US$13 billion) and the sale of the telephone company (US$6.2 bilion). The government has also given priority to obtaining additional private sector participation in infrastructure developnment. With respect to pet.oleum, the Mexican Constitution reserves petroleum exploration and extraction for the State. On this basis, Petroleos de Mexico will retain its legl monopoly on the petroleum sector, with the exception of recent pnivatization of some service stations and plans to privatize or liquidate parts of the secondary petrochemicals sub-sector. ix. Technology Trausrer and Intellectual Property Protection. Private sector development in Mexico depends on the transfer of foreign technology and the development of domestic technology. The reform program enacted several laws between 1987 and 1991 aimed at creating a satisfactory legal and regulatory environment to protect inteRlectual property rights and assure foreign and domestic enterpnses and individuals that their rights would be protected. As with other reforms, NAFTA will consolidate this progress and provide credibility that the reforms will be sustained. The remaining agenda is to enforce the new laws and bring the practice of intellectual property protection up to industrial country standards. X. Agriculture. Agricultural reform3 begun in 1985 have eliminated many parasiatals, slashed subsidies on agricultural inputs, removed official targets for crop production, and reduced protection to such major commodities as wheat, barley, and oilseed. In 1991, the Constitution was amended to allow (but not require) communal ejido farmers to switch to a system where their land is owned individually, with all the rights this entails. This amendment will allow a land market to develop as a means to improve productivity and encourage private agricultural investmentL Under NAFrA, the system of subsidies to grain producers will be reformed, which will align economic incentives with Mexico's comparative advantage in agnculture. There is still a need to reform the system of agncultural credit subsidies. Institutional changes, beginning with an effective land titling program, must also take place if the private ownership of communally held lands is to become a reality. NAFTA will have far-reaching effects on Mexican agrculture, and the transition from the current highly protected agricultural system to an open one would cause important disruptions if no remedial measures for the transition are adopted. Responding to this, the government has recently announced its intention to adopt a program of direct income transfers to Mexican farmers (a program labeled PROCAMPO), which has been carefully designed to cushion the impact of the changes while not distorting the new system of incentives. vi xi. Program Results. After the stagnation of the 1982-88 period, growth resumed during 1989-92 to an average of 3.6 percent annually, or 1.6 percent in per capita terms. A renewal in confidence has resulted from the large drop in inflation, the decline in interest rates, the renegotiation of the ecternal debt, and, most importandy, the ongoing structural reforms. This has led to a surge in annual long-term capital inflows to over US$20 billion a year since -1991, after having been negative over the 1981-1985 period. However, economic growth has slowed since the second half of 1991, from a 4.4 percent peak in 1990 to an estimated 0.4 percent in 1993. The slowdown has been more pronounced in the manufacturing sector, where growth declined from 8.4 percent of GDP in 1990 to a decline of 1.5 percent in 1993. The slow-down in economic growth that started in 1991 was also accompanied by a large deterioration in the current account deficit, which peaked at 6.9 percent of GDP in 1992 and was still an estimated 5 1/2 to 6 per cent in the recession year of 1993. xii. As can be expected during a period of deep reforms and adjustment, economic growth has been uneven, not just over time, but also across sectors. During the 1988-91 period, the manufacturing sector, one of the most affected by reforms, grew about 50 percent faster than agricuiture or mining, where reforms have been late in coming. Studies have indicated that manufacturing has become more efficient as a result of trade liberalization, with gross labor productivity in the sector increasing at a 3.5 percent cumulative annual rate during the 1986-91 period. xii. Current Lssues. Current concerns center around stalled GDP growth, modest productivity growth for the economy as a whole, and the very high current account deficit. Over the last five years there has been a substantial appreciation of the real exchange rate, which has led to a very large increase in the price of non-tradeable goods relative to tradeables, which in turn has impacted the production of these broad sectors. So far, Mexico has been able to finance the current account deficit through lage capital inflows, but only along with the inducement of high domestic interest rates. Also of concern is the low and f611ing level of private savings, which has increased the dependency on foreign financing :,;r investment. 2. PROFILE OF THE PRIVATE SECTOR xiv. Size and Composition. The private sector has been the key player in the economy and its role has been growing. In 1990, the private sector accounted for 86.5 percent of total employment, 77.5 percent of value added, 90 percent of total consumption, and 73 percent of total fixed investment. The private sector is characterized by sharp and growing distinctions between its large traditional sector and a growing modem sector. The former, comprised primarily of small and medium-size enterprises, employs a large share of the labor force, but accounts for a much smaller portion of output and exports. Productivity growth in this taditional sector has been slow and output growth sluggish. In contrast, the modern sector, consisting principally vii of large firms, has experienced faster productivity growth and stronger output and export performance. This sector appears to account for a large and increasing share of output and exports. xv. IndustWial Groups. Estimates are that the twelve largest industrial groups in Mexico may control as much as one-third of manufacturing GDP and the bulk of production in eleven key industrial sectors, including copper, aluminum, cement, glass product, paper products, and chloric acid production. The possible anti-competitive effects of concentration in the tradeables sector are frequently offset by competition from international producers, thus minimizing efficiency losses. However, the potential anti- competition effects of increased concentration are more of a concern for non-tradeables, where international competition does not serve as a disciplining device. xvi. Regional Distribution. Mexican manufacturing industry is heavily concentrated in the Mexico City/State cf Mexico neighboring areas and in the border states adjoining the United States. Sampling data indicates that about 40 percent of manufacturing output and 43 percent of manufacturing employment are located in the former area, while firms in the border states account for another 21 percent of both manufacturing employment and output. xvii. ITe Maquiador. The maquiladora has become one of the most dynamic sectors of the Mexican economy. Components and raw materials for maquiladora operation are imported duty-free. The finished product is then exported to the United States, with the manufacturer paying tariffs only on the value added in Mexico. Value added by the maquiladoras has grown by about 20 percent a year since 1987 and the maquliadoras now employ about 9 percent of the manufacturing workforce. It is important to note that the phased elimination of tariffs and most non-tariff barriers contemplated under NAFTA would eliminate the distinction between the maquiladora and other domestic manufactiurng industries. xviii. Foreign Investment. Direct foreign investment has grown spectacularly in recent years in response to liberalization and economic recovery. From 1989 to 1992, the stock of foreign investment increased from about US$26 billion to about US$40 billion, with a little over half of that investment in manufacturing and most of the balance in services. The US accounted for 62 percent of direct foreign investment, with no other country accounting for more than 7 percent. Sampling data indicates the importance of foreign ownership, showing that about 24 percent of large manufactuning firms (over 500 employees) have substantial foreign ownership (over 25 percent). This foreign share represents about 43 percent of manufacturing output, 33 percent of manufacturing employment, and nearly 56 percent of manufacturing exports. viii 3. CONSTRAINTS AND ISSUES InfraStUcture xix. Constraints. During the 1980s public investment was cut by more than half, and by the end of the decade non-oil public investment was at its lowest level since World War I. Although a substantial share of the previous high level of public investment was for questionable projects, and thus could be cut, the cuts were then so large that there was a marked detenoration in the infrastructure capital stock. Poor infrastructure and services in the transportation sector have been identified by the private sector as a leading constraint to its development, but other infrastructure sectors present problems that could become significantly more critical if new investnent is not initiated in the near future, given the long lead time necessary for capital projects to become operational. With a proper policy frAmework, the private sector could provide for these infrastructure needs more efficiently than the public sector has. In addition, the inancing needs for such investments are great, and public expenditure has been limited by the overriding priority that the government has given to maintaining fiscal discipline. XX. Private Sector Partidpation. The government has adopted the stategy of giving the private sector an increasingly important role in the building, ownership, and operation (BOO) of infrastructure. Although the program to privatize public enterprises began in 1982, the sale of infrastructure assets did not begin until 1988 with the sale of one of the state-owned airlines. The government subsequently sold another airline and the telephone company (the latter comprising the largest sale of infrastructure assets). Concessions and other financing arrangements have extended private sector participation to toll roads (which in terms of investment levels has been the government's largest concession program), intermodal transport terminals, railway maintenance, water treatment plants, and electricity generation. xxi. A motivation for some for involving the private sector in providing infrastructure service has been the tight public sector budget. However, the fundamental aim of private sector participation is, and should be, efficiency: the government has now recognized that many services traditionally provided by the public sector can be provided more efficiently by the private sector. However, it has often failed to establish the correct incentives and regulations to secure efficient provision at competitive prices for consumers (e.g., toll roads). An appropriate framework for private sector participation should ensure: (i) competition both in bidding to provide the services and, to the extent possible, in their operation; (ii) incentives exist to encourage the efficient provision of services; (ii) regulatory controls will prevent abuses of monopoly power where natural monopolies exist. This study applies these criteria in reviewing the status of private sector participation. Our recommendations include improving the bidding and concession contracts (e.g., toll roads), further deregulation and devolution of ix responsibilities (e.g., in railways), and the creation of able and independent regulatory agencies (e.g., for electricity and telecommunications). The Environment xxii. While industry is only one source of Mexico's very serious environmental problems, it is an important one and the single largest source of solid and toxic wastes. Mexico's alleged lax enforcement of its environmental laws and regulations was a major issue in the NAFTA ratification process. Industrial pollution has been the result of rapid growth, high pollution intensity of output, and concentration in certain geograsphic areas. To reverse this, industries must adopt production processes that reduce Allution and minimize waste and maximize the efficiency of material use. Failure to do so will constrain industrial development and growth. xxiii. Regulation. Major efforts have been made to establish a regulatory and institutional framework modeled after the systems in developed countries, particularly the United States. While gaps remain, the framework is near completion. The system, however, relies almost exclusively on quantitative limits on the emissions of pollutants, requires a very strong institutional set-up for its effective implementation, and is excessively costly because it fails to consider differences in abatement costs among polluters. And at the same time that the system has been set-up in a manner which makes enforcement not easy to do, there is institutional weakmesses resulting from insufflcient budgetary resources, and a lack of monitoring networks and expertise. Only a small fraction of all polluting industries are being monitored, and the results of inspections indicate that a large fraction are not in compliance with the current, extremely complex, system of regulations (85 percent of all plants inspected between August and December 1992 were in violation of at least one aspect of the code). The government is aware of these problems and is strengthening its enforcement capacity while it explores the possibilities of employing alternative instruments that wiU be more effective in achieving a better environment, will produce a system which is more 'enforceable' and will ease the burden on regulators, and will achieve environmental improvements in a cost-effective manner. The environmental side agreement negotiated for NAFTA will result in more intemational attention being placed on Mexico's enforcement of its environmental regulations. xxiv. PoUqc alternatives. Measures to promote industral compliance with environmental regulations while reducing the administrative burden are already being considered, but must be firther exploited. The enactment of water pollution charges, the implementation of industrial audits, and the introduction of tradeable permits for the elimination of ozone depleting substances, are all recently adopted measures that offer great potential for efficient environmental improvements. However, there are stiU many more opportunities to introduce instruments that are self-enforcing, self-monitoring, and which transfer the burden of proof of compliance to the polluting sources. Among these, pricing and taxing policies figure prominently, in particular, social maginal cost A pticing of natural resources, and taxation of energy and polluting inputs and outputs. Other instruments, such as deposit-refund schemes, pollution charges, and tradeable permits for pollutants discharged into the air, water and soil, also deserve serious consideration. inancial Sector XXv. The Cost of Finance and the Banking System. The high cost of finance is the major concern of many producers. Recent interest rates for commercial bank loans have been between 20 and 40 percent, depending on the size of the borrower and the oollateral offered, malkng them prohibitive for many compames, given the current 8 percent inflation rate. Although larger companies, partcularly those engaged in exports or that have a foreign partner, have access to credit from abroad, such borowing exposes the borrowers to foreign exchange risks. This high cost of finance is due in part to macroeconomic policies, but the largest part can be explained by inefficiencies in the banking and finance system. xxvi. Some of the inefficiencies in the newly privatized commercial banks are a legacy of their former public sector ownership. Progress in raising efficiency would be aclerated with increased competition from new entries, which is now iimited. NAFTA will increase pressure to improve efficiency in the sector by allowing the phased entry over sven years of foreign financial entities into Mexico, as well as the entry of Meaican financial entities into Canada and the United Stae xxvii. Non-Bank Financial Services. Thtre has been an important expansion in the provision of non-banking financial services -- including leasing, factoring, bonding, warehousing, insurance, and pension system services - since the legal and regulatory reforms of the 1987-1990 period. Nevertheless, these services remain small and will have to grow significantly to meet the needs of a modern economy. Further development of these services is dependent on additional institutional development and various improvements in the legal framework. xxviii. Securities Markets. Despite the reforms that have been adopted, and the progress so far, the securities market (other than for government scuridtes) remains relatively sinall while the remaining agenda to develop Mexico's securities markets remains substantial. In particular, efforts are needed to broaden the class of institutional investors, develop the legal and regulatory framework for asset-backed securities, and improve the functioning of the new second-tier market for the securities of small and medium enterprises. The Legal System xxix. General. The rights to own and dispose of property, of equal legal treatnent teen interests in public and private property, to work and engage in xi business or trade and form business vehicles, are well established in Mexico and guaranteed under the Constitution. Nevertheless, weaknesses in the commercial law framework and dce mechanism for the resolution of disputes constitute important constraints to private sector development. In general, larger domestically-owned firms are relatively much less constrained by difficulties in the legal system than are smaller firms. xxx. The Commercial Law Framework. The antiquated laws governing commercial transactions are frequently not adequate to meet the complex business and financing needs of a rapidly opening economy, and are in need of revision and epansion. Although significant progress has been made in deregulating and simplifying existing regulations, particularly at the Federal level, more progress is required. A greater ability to use collateral would be one means of reducing the cost of credit to smaller borrowers. Institutional improvements in the notary system and property registration would help in this. More adequately trained legal practitioners would also contribute to the efficiency of the system. xxxi. Dispute Resolution. The judicial system suffers a widespread lack of confidence, particularly at the State level. Extensive reforms are required to have better trained and paid judicial personnel. Given the weakness of the judicial system, arbitration is receiving increasing attention as an alternative dispute resolution mechanism. Further institutional development and training in both the judicial and arbitration systems would make both mechanisms more effective. Human Resources xxxii. Education. The relatively low level of education, and of basic education in particular, has contributed to an insufficiently skilled labor force. The average number of years completed in school is six and there are high repeater and drop-out ratios. Government efforts should be directed primarily at improving basic education. Given an improved basic education base, efforts to promote private sector training and other productivity enhancement activities in the labor market could be more effective. xxxiii. On-the-Job-Trahining. Pnvately provided on-the-job training is the most effecdve, as well as the cheapest, way to upgrade workers' skills, and provide workers a means to adapt to changing technology and demand. However, Mexican workers appear to receive far less such training than their counterparts in Organization for Economic Cooperation and Development (OECD) countries. A program to promote on- the-job-training should include: (i) dissemination of information of the benefits of such taining; (ii) training of trainers for the development of enterprise training programs; and (iii) the creation of incentives for employers to provide tra:ning and for the workers to participate in such training. xii xxxiv. Labor Regulations There is a necd to increase labor mobility and flexibility within firms. The first priority is to reduce reiance on traditional seniority based promotion and compensation schemes in favor of performance based mechanisms. A second priority is to eliminate regulations which act as constraints on labor mobility and which constrain the ability to define the job function flexibly. 4. STRATEGY xxxv. There are five principal elements to a private sector development strategy for Mexico. The first, and perhaps the most important, is the maintenance of a sound macroeconomic and policy framework. Although Mexico has performed well in this respect, upholding such policies is a continual process, adjustments always need to be made, and policies fine tuned. Second, adjustments will need to be made by both the private sector and the government to help take advantage of the opportunities opened by NAFTA, as well as to ease the transition for those sectors that will face the most difficulties. Third, obstacles to growth need to be removed, including alleviating mfrastructure constraints (through more efficient private sector participation in and financing for infrastructure development), raising the skill level and effectivss of the workforce, modernizing the legal system, and broadening access to and decreasing the cost of financing. Fourth, Mexico must step up efforts to protect the environment from further degradation. Fifth, smaller businesses face some particularly difficult challenges and (non-distortionary) programs should be designed to assist them. xxxvi. World Bank and International Finance Corporation (IFC) lending and investment operations in Mexico grew rapidly after the structural reform program began in earnest in 1986. Bank lending supported the adjustments that were made and the development of the economic and policy framework promoting private sector led development (PSD). IFC investment operations were more directly in support of the private sector, featuring operations for industrial restructuring, medium-size enterprises, and encouraging the reintroduction of foreign investors to Mexico. xxxvii. Future Bank operations in Mexico will continue to provide major support to the government's strategy for private sector led development, with a focus in particular on the major priorities outlined above. It is anticipated that roughly one-third of Bank lending will provide support in infrastructure development and agriculture (necessary for there to be a revival in the rate of sustainable growth), one-third will focus on environmental issues, and one-third will focus on poverty and human resources development. In this way, a solid basis can be laid for Mexico to achieve again the high rates of growth it once enjoyed, but this time maldng growth sustainable. I. THE ECONOMIC AND POLICY FRAMEWORK A. COUNTRY BACKGROUND 1.1 The period in Mexico from the time of the Revolution of 1910 to the 1970s may be characterized as economically isolationist in objective. Successive governments relied on an economic growth model that featured discretionary controls to encourage the development of a private sector onented to producing substitutes for imports. The pre- revolutionary policies of support of the private sector and foreign investment to industrialize Mexico were abandoned. Over the years, there were growing restrictions on direct foreign investment and expropriations, most notably of large agricultural investments, the railways and oil industry in the 1930s. 1.2 During the 1950-81 period, GDP grew at an average annual 6.5 percent rate, which until the collapse of this approach in 1982, was termed the Mexican "miracle". Underlying the "miracle" was a policy environment which included a progressive expansion in (i) tariff protection and quantitative restrictions; (ii) fiscal incentives and subsidized credit to sectors deemed to be a priority; (iii) restrictive regulations on business entry and operations; and (iv) restrictions on foreign investment. These policies of highly discretionary economic decisions allowed high profit margins for those sectors deemed a prionty, protection of selected private interests, and the development of powerful industrial monopolies. But the rapid economic growth achieved during this period was characterized by increasing inefficiencies and stagnating productivity, and proved not to be sustainable in the long run. 1.3 The import substitution model was initally sustained by foreign exchange earnings from agricultural exports. This model worked into the mid-1960s, when firming exports deteriorated due to increased domestic demand, the scarcity of suitable new land for the expansion of agricultural production, and decreased productivity. The average annual rate of agricultural growth from 1940 to 1965 was 5.7 percent, but it slowed to 2.6 percent per annum between 1967 and 1980 when the opportunities for extensive growth had been exhausted. The slack in foreign exchange earnings in agriculture was picked up by the petroleum sector in the 1970s after the petroleum discoveries and price increases in this period. Euphoric expectations for growing oil income led to the abandonment of government policies to maintain fiscal equilibrium. The early 1970s also began a period of increased state ownership in the productive sectors. This reflected a marked change in government's attitude, from reliance on policies to guide indirectly private sector-led economic growth, to direct public investment and, coupled with expansionary fiscal policies, public sector-led growth. 1.4 The parastatal sector then grew rapidly. In 1970 there were 391 public enterprises and by 1982 there were 1,155. Approximately half of the enterprises were created as public enterprises in accordance with Constitutional provisions providing for a state monopoly of strategic enterprises, and the remaining half were bankrupt fimns taken over by the State to maintain employment and ensure the domestic supply of basic products. Between 1975 and 1983, the government's share of value added in industry -2- jumped from 15.6 percent to 33.0 percent, although much of this must be attributed to the expansion of the oil and oil-related businesses. In the financial sector, its share climbed from 4.0 percent of value added in 1975 to 16.7 percent by 1983. Public enterprises, excluding PEMEX, accounted for only 4 percent of total manufacturing output in 1970. By 1980 this share had risen to 7.1 percent, and by 1983 it stood at 8,8 percent. In 1985, at the peak of the parastatal era, public enterprises accounted for 24 percent of GDP, of which 7 percent was contributed by PEMEX. 1.5 The role of foreign investment was closely tied to the Constitution of 1917, which restricted rights to own land and to work and engage in business. Foreign control of natural resources and other parts of the national patrimony were forbidden under Article 27. In 1973, all of the administrative decrees aimed at extending control over foreign investment were codified in a highly restrictive 'Law to Promote Mexican Investment and Regulate Foreign Investment". Foreign investors were excluded from some sectors entirely, and were resticted to a maximum 49 percent ownership in enterprises in other sectors. They were also subject to arbitrary and tme-consuming application and registration procedures. Also in the 1970s, the Technology Transfer Law and the Law on Inventions and Trademarks went into effect. These laws and regulations created burdensome administrative and bureaucratic requirements that put foreign-owned businesses at a disadvantage and discouraged the transfer of technology from abroad. As a result, foreign investment was low, and by 1985, direct foreign investment represented less than 10 percent of gross total fixed investment and accounted for only about 2 percent of GDP. 1.6 The "maqidla" program (duty-free offshore assembly operations) represented the exception to the restrictive policies of government on direct foreign investment. Following termination of the U.S. Laborer ("Bracero") Program in 1965, the maquila program was established to offer altemative employment to Mexicans who could no longer legally perform seasonal farm work in the United States. Incentives were provided to attract foreign-owned manufacturing to locate at first along the U.S. border, and eventually throughout all of Mexico. While 100 percent foreign ownership was permitted, there were limitations on the nature of activities and numerous administative requirements. Despite these restrictions, the maquilas have grown into an important segment of the Mexican economy, whose exports in 1991 were equal to almost 26 percent of the value of all Mexican manufiatured exports in that year. 1.7 The aggressive policies of public sector-led growth resulted in severe problems. Public funds were no longer focussed on traditional infrastucture investnents in support of the private sector, as large investments were also made by the government for the production of goods and services by public enterprises. Due to poor planning, ill- equipped management, overemployment, and the widespread disregard for efficiency in production, subsidies to public enterprises increased. Private sector development became increasingly constrained by lirmts on private sector participation in areas deemed to be of national strategic importance and a crowding out of the private sector in 3 - financial markets due to the large financing requirements of the government and public enerprises. 1.8 By 1981, the government's primary deficit (i.e. debt excluding interest payments) reached 8 percent of GDP, compared to 0.4 percent a decade earlier, and inflation reached almost 30 percent. The exchange rate became overvalued, imports increased fburfold from 1975 to 1981 and capital flight ensued. Foreign debt increased dramaically from US$7 billion in 1972 to US$78 billion in 1981. In 1982, rising world interest rates and falling oiI prices sparked a collapse of these unsustainable policies. By August 1982, foreign reserves were exhausted, forcing a float of the peso and Lthe temporary suspension of foreign debt service. The low level of private sector confidence was further reduced with the nationaliztion of the commercial bank in September 1982. The period of what had, on the surface, appeared to be one of economic stability and growth had been brought to its inevitable end by the inefficiencies and rigidities induced by an increasingly closed and regulated economy. -4- B. THE REFIORM PROGRAM i. Stabilization 1.9 Macroeconomic instability: 198241987. The onset of the financial and economic crisis of 1982, prompted by expansionary fiscal policies in the 1970s and early-1980s, brought explosive inflationary and balance of payments difficulties in its wake. As foreign interest rates shot up and intemational oil prices declined, Mexico's expansionary fiscal policies were no longer sustainable. Capital flight, which had begun well before the outset of the debt crisis, eventually prompted a run on the peso, compounding the growing reluctance of creditors to refinance short-term loans. In August 1982, Mexico suspended debt service and Mexico was cut off from foreign capital markets. A sharp, real peso depreciation was initially followed by strong fiscal and menetary adjustment efforts. However, these efforts focussed on stabilization only, and were not complemented by more fundamental structural reforms until much later. Inflation therefore remained at very high levels (and reached 159 percent in 1987). Mexico's policy makers began to recognize that in the absence of more profound structural reforms, it would be impossible to bring about macroeconomic stability. Structural reforms began in a cautious way with some limited privatizations of state enterprises, and a start at trade liberalization in mid-1985. After external shocks in late 1985 (the Mexico City earthquake) and in 1986 (the collapse of international oil prices), the government recognized that a comprehensive program of structural adjustment would be necessary for the economy to be stabilized and placed on a path of sustainable growth. This more comprehensive structural reform program got seriously underway in 1987-88, as described in the subsequent sections of this chapter. 1.10 Coping with the foreign debt problem. Domestic stabilization efforts came along with three major commercial debt reschedulings, respectively in 1982-83, 1984-85 and 1986-87. However, despite a substantial drop in the average interest rate on foreign debt (due, in part, to lower spreads but, mainly, to lower international interest rats), the average annual net transfer to creditors over 1983-86 averaged about 4 percent of GDP.' In order to service the debt, the US$6 billion trade deficit in 1981 was turned into an average US$10 billion trade surplus in 1983-87; the domestic counterpart of that, though, was virtual stagnation. It became apparent that new financial resources were needed to bndge the gap between the short-term costs and long-term benefits of adjustment, more so, in view of the sharp decline in international oil prices in 1986. In late 1986, market-based debt reduction schemes began to complement the traditional debt rescheduling and new money approaches. About US$3.6 billion of foreign public debt was canceled through a debt-equity swap program between June 1986 and April 1988. However, the program was discontinued in April 1987 to avoid the adverse fiscal and inflationary impact of debt-equity swaps. Following a Morgan Bank proposal, a US$3.7 billion collateralized debt exchange was implemented in 1988, resulting in net ITh dobt'service GDP ratio remained high, in part, due to the real peso devaluation. -5- interest savings of US$1.5 billion spread over 20 years. However, this clearly was not enough to eliminate the macroeconomic uncetainties resulting from the continued high levels of foreign debt service following from the debt. 1.11 Fiscal adjustment. During most of the 1982-88 administration of President de la Madrid, Mexico embarked on an unprecedented fiscal austerity progrmn. However, macroeconomic instability continued, in part as a consequence of Mexico's virtual inability to borrow from abroad. The reforms in the 1983-8; period, though, were crucial for the success of the stabilization policy announced in December 1987. A primary deficit (non-interest public expenditure minus public revenues) of 8 percent in 1981 was tumed into a surplus of on average 4.5 percent of GDP in 1983-87 (Vol.11, Table A5.2); notwithstanding the 50 percent drop in oil prices in 1986, the primary surplus was 5.6 percent of GDP in 1987. The fiscal turnaround was largely due to a reduction in non-interest public expenditure and, in particular, public investment (Figure 1). Public investment declined from 12.9 percent of GDP in 1981 to 5.6 percent of GDP in 1987. Fiscal adjustment also included revenue generating policies. Net sales of public firms were the main source of fiscal revenue over the period. In 1983-84, such revenues were about three times larger in size than tax revenue. The sharp drop in oil revenue following the 1986 oil crisis was offset by higher domestic oil prices and higher non-oil tax revenue derived, in turn, from important tax reforms, including inflation indexation of the income tax, and tax administration reforms leading to greater Primary Balance Components (as % of GOP) 30- 25. 20 815 - -a 5- 80 8i 82 82 84 85 86 8i 88 89 90 SI Ye - Ta R.mas - Nan-taX Kv - PtM kwwlm - Ofth I-4. Flgure 1 Soucu: Secratia de Hacinh y Credito Pubrico -6- compliance. lTx revenue responded positively to these measures, increasing from around 8 percent of GDP in the mid-1980s to around 10 percent of GDP in 1988. Stabiiation and recovery: 1988-92 1.12 The "Pacto". Economic growth ground to a halt over 1982-87, resulting in a sharp deterioration of living standards, a deteriorating infrastructure, high inflation, and a loss of investor confidence. Policy makers responded to the inflation explosion of 1987 (of 159 percent) with an ambitious stabilization progm, klown as the 'Econoniic Solidarity Pact' or 'Pacto". The Pacto, announced in December 1987, was an agreement between business, labor, and govemment which called for accelerated structural reform, further tightening of fiscal and monetary policy, controls on wages and of basic public and private sttor prices, and, the cornerstone of the Pacto, a freeze of the nominal exchange rate against the U.S. dollar. The Pacto was renewed, with important modifications, by the new Mexican Administration under the name of 'PECE' (Pact for Stabilization and Growth). Under the PECE and its successive retiewals (the latest one in October 1993) public tariffs, minimum wages and private sector prices were revised, with a de facto removal of most price controls, and a daily adjustment of the peso exchange rate against the U.S. dollar was introduced (one peso a day in 1989 which gradually was reduced to 20 centavos a day in 1992, before increasing back to 40 centavos a day in October 1992). An exchange rate band, with floor fxed at the November 1991 exchange rate level, and whose ceiling grows with the preannounced daily rate of devaluation, was introduced in early 1992; the band had widened to about 9 percent by the end of 1993. Contractual wages in the private sector were liberalized in 1989.2 1.13 Succesful stabilization. On almost every target that is under direct or indirect governmental control, performance under thte "PECE" has been exemplary, in some instances going far beyond what was originally planned. The combination of fiscal adjustment, a stepping up of the process of structual reform (e.g., including the financial sector, deregulation and privatization), and the heterodox components of the Pacto (wage and pnce policy, including the quasi-fixing of the exchange rate) finally succeeded in bringing inflation down. Infation dropped from 159 percent in 1987 to an average of 20 percent in 1989-92 (Figure 2). The period was been marked by relatively low monthly rates of inflation for most of the year, but with peaks late in each year and in the early months of the following year, as a consequence of the adjustments in public sector tariffs (e.g. for gasoline and electricity), wages, and the unfreezing of the prices of certain private products, associated with the renewals of the Pactos each year at that time. At the same time, the economy has showed encouraging signs of economic recovery, led by a strong resurgence of private investment and private consumption. After being stagnant over 1982-88, output growth averaged 3.5 percent 2 In October 1992, though, a 9.9 percent coiling for contnactal wage evisions was included in the Pacto/PECE as a guideline'. -7. in 1989-92. However, after peaking in 1990 c Pri WU (Figure 3), output growth has slowed. GDP growth averaged only 2.7 per cent at an annual rate between ft. mid-1991 and the end of 1992, and fell to S just 0.4 per cent in 1993. Reflecting improved confidence 2' L I in the economy, ___ nominal interest rates ... .. ...i have declined to record low levels (fr the period of the last Figure 2 15 years), and Mexico has received massive private capital inflows, at an annual average of US$9 billion in 1989-90, and over US$20 billion per year in 1991-93. 1.14 The roles of exchange rate and MP OGrow iscal policy. Pior to 1988, only the 6, 'orthodox' policies of fscal discipline and \ tught money were 4 followed, and these failed to bring down / infation and induce a sustained economic -. recovery. It was only . with the combination of "orthodox' macro ss low s sea sb44 isi Isu ib she .i .b .b subi policies, structural r reforms, and the income policies under Figure 3 the Pacto (including the temporary, initial price freeze), that the economy stabilized and started to grow. fation came down sharply. The initial freezing of the exchange rate (and, later, the nominal depreciation at less than the rate of inflation) proved to be an effective nominal anchor for price inflation, even if, in the process, a substantial real peso appreciation started. However, in view of the "wait and see' attitude on the overall success of the - 8 - program, (ex-post) real interest rates3 on public debt increased sharply, to about 20-30 percent in 1988-89. This, in turn, required considerable furither fiscal tightening to prevent domestic public debt from growing explosively. With domestic public debt in excess of 20 percent of GDP and real interest rates in the 20-30 percent range, the real interest service on domestic debt alone absorbed almost the entire primary fiscal surplus of 1987. In 1988-89 the real domestic interest service was twice as burdensome as the ngminal foreign interest service (even though foreign public debt was more than twice the size of domestic debt), and it absorbed three quarters of total tax revenue (compared to 30 percent in 1985-87). Despite the initially tight fiscal situation, the credibility problems mentioned, which were reflected in high real interest rates, required extra fiscal control to service tlil domestic public debt. The primary fiscal balance increased from 5.6 percent of GDP in 1987 to an average of 8 percent of GDP in 1988-90. 1.15 Brady Plan: Sequel of structural adjustment. Despite fiscal efforts, the consolidation of public finances required a comprehensive solution to the external debt problem. This was an explicit objective of President Salinas from the beginning of his administration. The Brady plan, signed in July 1989 (and implemented in February 1990), marked a turning point for Mexico's debt problem. The debt relief was sizable: annual interest relief resulting from the Brady plan was estimated at US$1.3 billion. But reducing macroeconomic uncertainty was far more important than debt relief. The reduction in macroeconomic uncertainty stemmed from the favorable impact of smaller and smoother (and, hence, more predictable) transfers to foreign commercial creditors. Previously, peaks in debt repayment were associated with frequent external debt renegotations and related macroeconomic policy changes. The plan was widely regarded as a permanent rather than temporary solution to the debt problem. Mexico's excellent track record on policy reform and on achieving macwroeconomic policy targets led to the recognition that Mexico was strongly committed to adjustment and reform, and thus that, with debt reduction, there was a good chance that stability and growth could be restored. The important lesson is that it was the combination of deep reforms (both macro and structural) and debt reduction that was necessary. The return of business confidence in Mexico was also validated soon after the implementation of the Brady plan with the announcement of negotiations for the NAFTA, and the re- privatization of the commercial banks. 3 Obtained subtracting actual inflation over the period from the average nominal interest rate. -9- 11. Trade Liberalization Background 1.17 Beginning in the 1950s, industrialization through import substitution was the dominant development stategy in Latin America, including Mexico. Trade restrictions, particularly tariffs and quantitative controls on competing imports, were used to promow production for the domestic market, particularly manufacturing, at the expense of export activities. The in-bond export manufacturing industry known as maquiladoras was an important exception.4 Trade restrictions were also used to support extensive controls on the pricing and marketing of agricultural goods. Trade policy was also directed at achieving macroeconomic goals: periodic balance of payments crises led to the tightening of import restrictions, and periodic attempts to reduce inflationary pressures led to reductions in restrictions, particularly tariffs. Trade Liberalization Since 1985 1.18 In response to the debt payment crisis in 1982, practically all merchandise imports were put under quantitative controls. After some initial modest liberalization efforts in 1983 and 1984, since July 1985 Mexico has undertaken a fast and far-reaching liberalization of the merchandise trading regime as part of the stabilUzation and adjustment program. The aim has been to expand the tradeables sector, and open the economy up to international competition to encourage efficiency in both exporting and import-substitution activities. Through the reforms, Mexico has been transformed from a largely closed economy to one of the more open economies in Latin America. Mexico joined GATT in 1986, adding to the credibility of its reform program. Some summary quantitative indicators of liberalization are shown in Table 1. 1.19 Progress in merchandise trade liberalization has been very impressive. The coverage of import licensing in terms of competing domestic production is 17.4 percent, nearly one-fifth of what it was in June 1985. The remaining controls affect agricultural and agro-industrial products, oil and derivatives, and certain industrial products (mainly cars and trucks). The coverage of export controls was also substantially reduced, and now covers 17 percent of domestic production, and mainly affects products subject to domestic price controls. Offlcial reference prices have been completely abolished on imports and almost so on exports. The maximum tariff is 20 percent with the average tariff at 12.4 percent, respectively about one-fifth and one-half of what they were in 4 Prior to the import liberalization, various programs were introduced to promote exports. The most substantial of these was the maquiladora system (discussed in Section HJ.iv). In 1991, the maquilas accounted for nearly 16 percent of manufacturing employment and generated net exports of over US$4 billion. - 10- June '985. Almost all tariffs are now in the range of 10 to 20 percet. Mexico also introduced a modem and GAIT consistent anti-dumping system. TA= : TRADM LIBUALZTION, 1965-M Jun8S Dec85 Jun86 Dec84 Jun8T 0ec87 Jun88 Dec89 ec90 DOec91 lrport Licensing a 92.2 47.1 46.9 39.8 35.8 25.4 23.2 20.3 17.4 17.4 Reference Prices a 18.7 25.4 19.6 18.7 13.4 0.6 0.0 0.0 0.0 0.0 Tariffs-Kaxlt.m 100.0 100.0 45.0 45.0 40.0 20.0 20.0 20.0 20.0 20.0 -Average W 23.5 28.5 24.0 24.5 22.7 11.8 11.0 12.8 12.4 12.4 Export Controts g/ n.a. n.s. n.s. n.s. n.a. 24.8 23.4 17.9 17.6 17.4 Real Effective 100.0 121.8 134.7 145.2 136.0 128.5 112.6 11S.0 110.6 99.7 Exchange Rate g/ Percentage coverage of produiction of tradeabtes- 1986 weights Veighted by production of tradeables; 1986 wef Ats;: excludes five peent surcharge. y Increas in the index represents a depreciation of the peso in real terms. Custom Reform 1.20 Beginning in mid-1989, the government embarked on complementary reform to modernize the customs process and improve efficiency and collections. Customs procedures had become highly cenlzed and antiquated, involving numerous, complex, time- nsuming and non-transparent steps. Traders fced long delays and undocumented costs. The system had become bogged down in a mire of bureaucracy, ad hocery and corruption. Basc lepl and institutional changes to the customs process went into effect on January 1, 1990, with changes in procedures having been formalized through implementing reguations. Customs has now been intgted with general tax collection. The rights and obligations of traders and customs have been widely published to enhance transparency. 1.21 The Mexican tax administration operates on the basis of voluntary declaration of tax liability by the taxpayer, with selective checks on complance. Payment of tariffs is made in advance to commercial banks before proceeding to clear merchandise. A computer genlerated random selection process determines which trade transactions are inspected. Stiff penaties are handed down for infractions. Theprocess has been simplified and standadized, reducing the number of steps from roughly twelve (of which nine involved some paperwork) to four. Entry into the formerly tightly controlled customs brokers' profession has been liberalized and the regulated fee structure phased out. Operations have been decentralized and linked by an electronic data communication network. In a recent development, the entire Customs Police were replaced to reduce corruption. While considerable progress has been made, there are still many complaints about the efficiency of the customs process. NAFTA brings a new imperative for continued modernization of customs. North American Free Trade Agreement 1.22 After three years of negotiations, the historic North American Free Trade Agreement (NAFTA) and Side Agreements (on Labor, the Environment, and Protection Against Import Surges) went mito effect on January 1, 1994. NAFTA represents the most comprehensive free trade pact (short of a common market) ever negotiated between regional trading partners and is the first reciprocal free trade pact between a developing and an industrialized country. 1.23 NAFTA is essentially an expanded version of the Canada-US Free Trade Agreement (PTA) of 1988, with Mexico committing to implement the degree of trade and investment liberalization to which its northemn neighbors had previously agreed. NAFTA provides for a phased elimination of tariff and most non-tariff barriers on regional trade within ten years, although some sensitive products will have a 15-year transition period. US-Canada bilatera tariffs will continue to be phased out according to the US-Canada FrA schedule by the end Of 1998. In addition, NAFTA and the Side Accords extend the innovative dispute settlement procedures to Mexico, move into the new areas of services and investment, and begin to address cross-border environmental issues. 1.24 NAFTA contains three notable liberalizations of trade and invesament. First, it eliminats all tariffs and quotas on regional trade in textiles and apparel. This is the first time that imports from an important non-OECD supplier in this heavily protected sector have been significantly liberalized by the US and Canada. Second, the accord immediately onverts key agricultural restrctions into tariff-rate quotas, and sets a maximum 15-year period for the phase-out of the tariff surcharges. Tird, the pact substantally opens Mexico's financial services market to US and Canadian participants by the year 2000, and removes significant obstacles to land transportation and telecommunications services. 1.25 NAFrA widens the scope of the market and enlarges the range of available labor skilis, enabling North American firms and workers to compete more effectively against foreign producers both at home and in world markets. For Mexico, NAFrA consolidates the market-oriented policy reforms implemented since 1985 and extends the reform process to sectors such as autos, textiles and apparel, finance, telecommunications, and land transportation. Mexican exporters also stand to benefit as the existing, relatively unrestricted access to the US market will be sustained, and most remaining US trade barriers will be liberalized. It should also be noted that some areas will enjoy little or no liblizon. For example, basic energy remains immune to free trade, and restrictive rules of origin apply to the key sectors of textiles and apparel, and autos. 1.26 In the context of a broader process of regional economic integration in Latn America, Mexico is also involved in several regional trade initiatives. Chile and Mexico signed a free trade agreement 1991 which has resulted in a doubling of trade (albeit from a low initial level). Also in 1991, the governments of Mexico, Costa Rica, El Salvador, Guatemala, Honduras, and Nicaragua signed an agreement for the gradual establishment of a free trade area between the six countries by end-1996. Since then, there have been bilateral negotiations between Mexico with each of the Central American countries on establishing a free trade regime. The first of these agreements was reached, in March 1994, with Costa Rica. Finally, Mexico, Colombia, and Venezuela are working toward establishing a free trade zone. Conch lsons 1.27 Mexico has rapidly transformed from a closed economy to an open one, and NAFTA and the successful completion of the Uruguay round of the GAIT will together help - 12 - reinforce this process. The immediate priority in trade is for both the private sector to improve its competitive position internationally and the public sector to ensure a supportive environment for exports. Consideration should be given to taldng advantage of the flexibility allowed under NAFrA to further advance liberaization where the negotiation process made less progress. Mexico is also seeldng to make advances in its trade regime with non- NAFrA countries; a priority would be to enhance the competitiveness of Mexican producers and avoid wasteful trade diversion by reducing Mexican twade bariers against non-NAFTA countries to levels that would be compettive with its NAFrA partners. 1.28 The ongoing improvement and steamlining of administrative processes affecting trde, such as customs, should be continued to ensure that the new regimes are effectively implemented. Finally, the implementation of measures such as anti-dumping, and standards and norms should avoid inadvertent imposition of inappropriate barrers to open trade. iii. Direct Foreign Investment Background 1.29 From the time of the 1910 Revolution until the reforms of the 1980s, Mexico's policy towards direct foreign investment (DFI) was generally restrictive. The Constitution specifically forbade foreign ownership of natural resources and other parts of the "national patrimony," and there were several large-scale expropriations. Nevertheless, Mexico was able to attract some foreign investment, mostly from the US. Substantial DFI entered the country during the 1960s and 1970s, in large part, due to the establishment of the in-bond export manufacturing industry known as maquiladora in 1965. 1.30 Restrictions on foreign investment reached their peak with the passage of the 1973 Law "To Promote Mexican Investment and Regulate Foreign Investment". This law, interpreting the Constitution's restrictions on foreign investment and codifying existing laws and regulations, specifically reserved certain economic activities for the State and nationals. The law defined areas where DFI would be permitted but generally limited foreign equity to a minority of 49 percent. Exceptions were permitted, but the fundamental perception was tat, apart from the maquiladora sector, only minority ownership was welcome. The 1973 Law remains the fundamental legal framework for DFI today. In the three years prior to the debt crisis (1979-1981), authorized new DFI averaged only US$1.4 billion per year, with the accumulated investment on a historical cost basis at end-1981 at only US$10 billion. DPI accounted for less than 10 percent of total gross fixed investment. After the crisis started in 1982, DPI was even less. The nationaiztion of the commercial banks in 1982 also sent a discouraging signal to potential investors. Recent Reforms 1.31 Since 1984 Mexico has progressively reduced impediments to foreign investment as part of a strategy of integrating Mexico into the world economy, with DFI seen as: providing financing, and improving the structure of foreign liabiLdtes by letting foreigners share risks; - 13 - * bringing a package of technology, management innovations, and marketing links; and * strengthening the competitiveness of the domestic market. A series of Guidelines and General Resolutions over the period 1984-88 significantly lbemlized the climate for DFI. In a fundamental change, they specifically allowed majority feign ownership in selected activities, and cut the red tape for freign investors. 1.32 In May 1989, the government made sweeping changes to DPI rules by issuing new Regulafions for the 1973 Law. The 1989 Regulations supplanted existing provwions governing DFI, liberized the interpretation of the 1973 Law, and simplfied and carified investment procedures. The government aimed to attact US$25 billion of DPI during the Salinas administration (more than double that in the previous administration), and US$5 billion a year by 1994. These targets have been well exceeded. 1.33 The 1989 Regulations incorporated a table of classified activities still subject to specific restrictions (based on the Mexican Catalog of Economic and Productive Activities which includes 754 activities in all), with: - 12 reseved for the state, including energy, basic petrochemicals, electicity and railroads; - 34 reserved for Mexicans, including radio and television, foretry, gas distribution, road, domestic air and maritime transport; e 37 reserved to minority participation by foreigners, including mining (maximum foreign ownership of 30 per cent), car parts and se ry petrochemicals (40 percent), financial services, insurance and telecommunications (49 percent); and i 58 where majority foreign ownership is allowed with prior authorizon, including agriculture, printing, and construction. 1.34 Foreign Investors are now allowed to establish new enterprises in Mexico and may have a 100 percent ownership in unrestricted sectors. These represent about two-thirds of GDP and include food, beverages and tobacco, textiles, clothing, leather, pulp and paper products, restaurants, hotels and commerce. Projects in most unrestricted sectors do not require approval by the National Foreign Investment Commission (CNI). Automatic approval is ganted upon registration with the National Registry of Foreign Investment (NIE) for projects that meet six criteria: * pre-operative fixed investment of less than US$100 million; * the investment is funded with resources from abroad; * industial projects located outside Mexico City, Guadalajara and Montrrey; * foreign exchange flows which are balanced over te first 3 years; * the inestments create permanent jobs, incorporate worker taining and development; and * the investments satisfy environmental requirements. - 14 - Other projects are required to obtain prior authorization from CNIE, but approval is automatic if a response is not received within 45 working days. 1.35 Temporary indirect foreign majority investment is allowed in some classified activities including domestic air and maritime transport, gas distribution, mining, secondary petochemicals and car parts through a trust mechanism. 1.36 Separately, financial legislation has been amended to allow foreigners to own up to 30 percent of banks and brokerage houses. The 1991 amendment to the Constitution regarding communal farmers allows foreigners to acquire land and establish joint ventures (up to 49 percent foreign owned) with Mexican farmers (See Section LB.ix). 1.37 Foreign investment flows have reacted strongly to the liberalizaton and economic recovery, as shown in Table 2. Since 1985, when the value of new, authorized foreign investment was US$15 billion, foreign investment has almost tripled, reaching almost US$40 billion in 1992. The composition of foreign investment in mid-1992 was 56 percent in manufacturing, 35 percent in services, 8 percent in commerce, 1 percent in mining, and less an one half of a percent in agriculture. DPI in services is growing quickly, accounting for 60 percent of DFI in 1991. The major supplier country was the US with 62 percent, followed by the UK with 7 percent, Germany with 6 percent, and Japan, Switzerland and France with about 4 percent each. About two-thirds of the foreign investnent is concentrated in the Mexico City area. Among Latin American countries only Brazl has more DFI. TABLE 2: DIRECr FOREIGN INVESTMrENT (BiLtiors of dollars) IZED ACTtML VIM amE DFI JIUATIVE MEU DFI 1979 0.81 6.84 1980 1.62 8.46 1981 1.70 10.16 1982 0.63 10.79 1.66 1983 0.68 11.47 0.46 1984 1.44 12.90 0.39 1985 1.87 14.63 0.49 1986 2.42 17.05 1.52 198? 3.88 20.93 3.25 1988 3.16 24.09 2.60 1989 2.50 26.59 3.04 1990 3.72 30.31 2.63 1991 3.57 33.87 4.76 1992 5.70 39.57 4.80 Y Actual foreign imwestment flows may differ from new foreign investment registered or authorized due to lags between authorizations and investment. Cuulative stock is valued on a historical basis. W Excluding portfolio investment. Preliminary. Source: SECOFI and Bank of Mexico - 15 - 1.38 Over the last three years, foreign investors have made extensive use of the automatic approval system. Of 7,203 investment projects received in the 1989-1991 period, only 751 (10.4 per cent) were submitted for formal approval by the CNIE. Moreover, in that same period foreign investors established 2,028 new business enterprises in Mexico, of which only 141 (7 per cent) were required to obtain prior authorization from the CNIE, while 1,887 (93 per cent) were established by making use of the automatic approval procedures. The NAFTA Investment Chapter 1.39 NAFTA contains a model chapter on investment, which extnds the Canada-US PTA provisions and is superior to the Uruguay Round proposals on trade-related investment measures (rRIMS). NAFTA commits the countries to the better of national treatment or most favored nation treatment for investors and their investments from NAFTA partners. No pefmance requirements are allowed. Export performance, domestic content, domestic sourcing, trade balancing, product mandating, and technology tnsfer practices are specifically forbidden. The existing requirements are to be phased out over up to ten years. Some non trade-related requirements are allowed, such as worker training, and local research and development (R&D). 1.40 NAFTA forbids restrictions on capital movements, including profits, except for prudential or balance of payments reasons. It prohibits nationaliztion except for a public purpose, on a nondiscriminatory basis, after due process, and upon payment of fair compensation. NAFTA forbids partners from dictating the nationality of senior managers, although they may require a majority of their board members to be nationals or residents. It also contains extensive provisions for dispute resolution through binding arbitration or domestic courts. 1.41 NAFTA will provide substantial sectoral liberalization of investment, although each country is alowed certain exceptions to the rules. Petrochemicals, electricity and mining are three notable areas where foreign investment has been liberalized in Mexico. Yet Mexico has continued to exempt the primary energy sector. Mexico also has the right to screen DPI above an initial threshold of US$25 million, rising to US$150 million over ten years. Conclusions 1.42 A new law on DFI went into effect in early 1994, which wrote into law the reforms discussed above, which had been previously through decrees and regulations only. The new law also implemented changes agreed to under NAFTA. The government has also stated it intends to negotiate bilateral investment treaties with non-NAFTA nations. Together with the new law, this could effectively provide NAFTA conditions for them also, and provide Mexican investors with reciprocity. These changes would consolidate the remarkable change in attitude toward DFI and assure investors that the new regime is here to stay. - 16 - iv. mnancial Sector Liberalization a Banking Background 1.43 In September 1982, the government nationalized the entire bankdng system in the aftermath of the extemal debt crisis. This action, coupled with administrdve acins of the public development banks and the trust funds administered by Banco de Mexico, led to a fall in commercial bank credit extended to the pnvate sector from 40 percent of total bank credit in 1980-81 to only about 25 percent in 1986 (see Figure 4). During the 1985-87 period, the govenment absorbed most bank lending as commercial banks were used to finance the public sector deficit. This amounted to forced lending in the form of very high reserve requirements on client deposits. These requirements applied to more than 70 percent of bank deposits in 1985. Between 1982 and 1987, this government borrowing was often at negative real lending rates, as deposit and lending rates were fixed by the Ministry of Finance. The 1982-87 period was characterized by both high Panel A Chwigs In AUocflon of Stock of Credit to 1w Phbk & lrivato Sector by Comrocl B8kc (1986 - 1992) *. d so** 40 iti- 10 'ISS7 '. .uu ' ' sui 'n Yew md Ahb Meto " rate 5oto Hgure 4 So.: Ba C - 17- and variable rates of inflation, and volality in both nominal and real interest rates (see Figure 5). The economy also suffered further disintermediation as well as reductions in pivawe investment. Measures of finacil depth highlight the effects of these factrs: by 1988 the ratio of M4 to GDP had fallen to about 35 percent of GDP versus nearly 45 percent just prior to the onset of the debt crisis. Commercial Bank Deregulation and Privatization cms L",=z zWt4gf,$d - 1.44 Wide-ranging financial reforms a'L ~ I were undertaken from 1988 to 1992, culminating in the re-privatzaion of
World Bank Group · Pre-2003 Economic or Sector Report
Mexico - Country economic memorandum : fostering private sector development in the 1990s (Vol. 1 of 2) : Main report
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World Bank Group
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Pre-2003 Economic or Sector Report
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Mexico
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