Statement by Jan Piercy at the meeting of June 8, 1999

International Bank for Reconstruction and Development International Development Association International Finance Corporation 87358 Multilateral Investment Guarantee Agency FOR OFFICIAL USE ONLY CONFIDENTIAL EDS99-192 June 7, 1999 06:48:20PM Statement by Jan Piercy Date of Meeting: June 8, 1999 Mexico - Country Assistance Strategy 1. We welcome this opportunity to discuss the Bank Group's proposed country assistance strategy for Mexico, the IBRD's largest borrower. We support the general thrust of this CAS and its priorities, but are sobered by its clear indication of serious issues still to be tackled (e.g., p. 5, the "[persistent] differences in income and wealth" and the need for "social inclusion"). Clearly, despite Mexico's progress in restoring macroeconomic and fmancial stability, enormous challenges remain. 2. As the CAS acknowledges, the link between political and economic cycles is problematic. The deterioration in Mexico's poverty indices since 1994, primarily due to the deep 1995 recession, exacerbated to some extent by adverse external developments over the past year, underscores the need for reinforced and accelerated policy reforms. We encourage the government of Mexico to undertake such reforms so as to reap full advantage of the opportunities provided by the CAS. We can assure Mexico of our full support if it does so. 3. This said, our support for the CAS has some important caveats: First, in its efforts to be flexible, the CAS becomes less strategic. It is stronger at identifying problems than in framing clear strategies to address them. No doubt this reflects in part the upcoming elections and resultant political uncertainties. We therefore request that Bank staff and management revisit the CAS with the government and civil society after the elections and return to the Board with an update that not only confirms or clarifies the priorities, but also identifies strategies. 4. Second, our general concurrence with the types of lending operations listed in Table 2 and Annex B3 should be viewed as preliminary and subject to further review given the political uncertainties as well as the lack of any information in the CAS about the scale of proposed operations. i1llis document has a restricted distribution and may be used by recipients only in the 1 rerfonnance of their official duties. Its contents may not otherv.·ise be disclosed without i \\'·,Jrld Bank authorization. 5. Third, the proposed lending level should not be regarded as an entitlement. Lending operations should be undertaken only where there is both broad consensus between government and civil society on the objectives to be accomplished and a demonstrable government capacity to deliver the required policy and legislative reforms. 6. Finally, we ask that staff and management view selectivity in the Bank's activities and coordination with other donors as on-going processes requiring continuing reflection and hard choices. The current list of proposed loans and non-financial services suggests a substantial risk of over-programming. 7. As a final general remark, we wish to commend the government and the Bank for having developed the CAS in consultation with NGOs, the business community,.religious groups, and other elements of civil society. Such consultation is crucial to building the consensus that underpins successful development. 8. Specific comments on the four issues that have been suggested for Board discussion follow, along with points on three topics which we believe warrant explicit reference in all CASs: selectivity, exploitation of synergies within the Bank Group, and donor coordination. Objectives and Priorities 9. We agree with the CAS's three overall objectives: social improvement; removing obstacles to sustainable growth and maintaining macroeconomic stability in the context of globalization; and enhancing public governance. Within this very general framework, which is probably suitable for virtually all Bank borrowers, we would particularly stress the importance of the following for Mexico: 10. Continued focus on poverty reduction. We commend the government's efforts to maintain or expand social expenditure, but gains in efficiency and targeting of services are critical, especially to ensure. that the indigenous and poorest populations are effectively protected and, more importantly, gain new economic opportunities. (In this regard, lack of access to credit, among other handicaps, seriously inhibits economic mobility and self-reliance of the poor.) The CAS places new emphasis on improving the situation of the urban poor. While we agree that this is important, we would note that the rural poor have suffered the greatest deterioration in consumption standards since 1994. Thus, we welcome the assurances that we have received in conversations with staff that the Bank will continue to support the government's efforts to broaden economic options for the rural poor. In several places, the CAS refers to possible Bank assistance for the government's efforts to strengthen social protection. In this regard, we would urge emphasis on development of ex ante, or on-going, policies and programs to strengthen vulnerable populations' resilience to economic and financial crises rather than a focus on emergency, cns1s response measures per se. The ongoing Poverty Assessment, together with the Public Expenditure Review, should serve as important sources for designing a strategy in the next CAS update. 11. Financial sector strengthening. We agree that resolution of the problems of the banking sector is essential to sustainable development. As several Directors commented during the Board's June 3 discussion of the IFC's investment in Grupo Posadas, Mexican companies face constraints on their access to long-term domestic finance. Unfortunately, progress on policy reform has been disappointing in this sector. Unless Mexico takes advantage of the Bank's readiness to support fundamental policy and structural reform in this key sector, including non-bank financial institutions, the Bank must reappraise its engagement. 12. Removing impediments to private sector development. The fact that SMEs continue to lack access to finance -- despite 56 federal programs to assist small and medium-sized enterprises (SMEs) and hundreds more at the subnationallevel --underscores the urgency of fundamental structural reforms to remove barriers to establishing and running SMEs. The Bank should direct its efforts to supporting creation of a policy, regulatory, legal and judicial environment conducive to private sector decision-making and investment rather than supporting schemes that funnel finance through government channels to SMEs or industrial sectors. We agree with the CAS that improvements in competition policy, contract enforcement, bankruptcy and insolvency regimes, and corporate governance could contribute significantly to an improved environment for private sector investment and job creation. Broad deregulation and elimination or streamlining of the numerous licensing requirements that entrepreneurs must satisfy to establish businesses in the formal economy is needed. More rapid growth of the formal economy will have beneficial effects, inter alia for urgently needed increases in government revenues. 13. More effective public governance. We wholeheartedly support the CAS's emphasis on measures to build institutional capacity at all levels of government, particularly subnational levels. Accountability mechanisms must be strengthened as decentralization proceeds. We also encourage Mexico to take advantage of the Bank's willingness to help it strengthen judicial and tax administration systems and combat corruption, which erodes social consensus and creates economic inefficiencies. Progress in these areas is essential both to creation of an improved environment for private sector development and to ensure that tax collections, low as a percentage of GDP in Mexico compared to levels in many other countries at comparable levels of development, are sufficient to sustain social and other needed public expenditure programs. 14. Environmental protection. We concur with the urgent need, stated in the CAS, to protect the environment, but again are unclear what the Bank offers as solutions. Water shortages, deforestation, atmospheric contaminants, and inadequate waste treatment are all serious challenges. We are concerned by recent reports that industrial sites in northern Mexico (Torreon, Monterrey, and Chihuahau) have atmospheric and other ambient concentrations of lead, cadmium, and arsenic greatly in excess of levels normally considered acceptable. Government efforts to remove impediments to private sector development must give due regard to promulgation and enforcement of appropriate industry environmental atandards. The Bank's efforts to promote environmental protection in Mexico should be "mainstreamed" across a range of lending and non-financial services rather than treated as a stand-alone activity. We also welcome Mexico's emphasis on prevention in its efforts to improve its disaster management capacity. The experience of our own Federal Emergency Management Agency (FEMA) demonstrates that cost-effective prevention measures can do much to reduce the severity and costs of natural disasters. Mix of Financial and Non-financial Services 15. We find it difficult to answer the CAS question, "Is the mix of financial and non-financial services planned in the CAS adequate, and does it reflect and exploit the WBG (IBRD and IFC) capabilities and comparative advantages?" The CAS contains no information regarding the scale of the proposed individual lending operations in Table 2, nor does the CAS indicate even in notional terms the cost of the non-lending services summarized in Annex B4. Such information should be included in every CAS. 16. Taken individually, the proposed non-lending services are generally satisfactory. Taken together, the list looks too ambitious and in need of much greater selectivity. The Bank should not self-initiate non-lending services as an optimistic device for persuading the government of the need and urgency of reform in any particular area. This approach is unlikely to produce research affecting policy outcomes. Instead, we believe that the Bank should undertake such services either in response to specific requests from the government for assistance in devising strategies Jn areas where clear commitment to reform already exists, or for the purpose of controlling its portfolio risks (e.g., Public Expenditure Review, Poverty Assessment, Country Procurement Assessment Report, and Country Financial Accountability Assessment.) 17. In line with our comment regarding the desirability of the Bank's focusing on the legal and regulatory framework for private sector development rather than on industrial promotion programs per se, we believe that the proposed study of decentralization of industrial promotion could be dropped altogether. And several proposed studies appear ones which the IMF should undertake or at least be consulted on: the policy note on management and prevention of external shocks; the study of the tax regime; and studies of the financial sector, such as the proposed update on the Mexican banking system, the nonbank fmancial institutions study, and the capital markets study. The OECD, of which Mexico is a member, may also have valuable information and an important perspective on these issues, as well as on matters such as the proposed studies of corporate governance of conglomerates, regulatory constraints to private sector development, training mechanisms, and labor markets. Why aren't the IMF or OECD taking the lead in at least some of these areas, which would leverage the Bank's resources more effectively? 18. We expect further attention to governance in the Bank-Mexico dialogue. We are pleased to see the Country Procurement Assessment Report proposed for FY 00 and the public governance policy note proposed for FY 01. However, we hope that the government might come to see the merits of accelerating the timetable for these studies and of undertaking governance assessments at both the federal and state levels. Annual Public Expenditure Reviews (starting with a broad macro PER and moving to state and sectoral PERs) and a CFAA would be appropriate to identify sustainable spending patterns and adequate fiscal control mechanisms. 19. We were disappointed that the CAS lacked explicit information about where the Bank believes its comparative advantage lies. The only area where the CAS cites the Bank as lacking expertise is in "political process". We recognize that Mexico has large development needs, that bilateral donors have a minimal presence, that the IDB is the only other significant source of official finance, and that, therefore, "hay campo para todos". Nonetheless, the CAS should have contained at least a table of the IDB's outstanding and planned loan operations and further explanation of the substantive and geographic division of labor between the Bank and the IDB. 20. We were pleased that the Private Sector Strategy aims to exploit the comparative strengths of the IBRD and the IFC. We agree with the general division of labor proposed, with the Bank focus on the policy, legal and regulatory framework and on provision of quality infrastructure for private sector development and the IFC focus on transactions. We agree generally with the priorities that this strategy outlines, with the caveat that the Bank should eschew support for industrial and SME promotion programs in favor of concentrating on policy issues. The CAS notes the importance of reforms to sustain external private debt finance. We agree; however, it is even more important to redress the institutional, regulatory, and market structures and incentives that promote recourse to external debt finance instead of external equity finance, and recourse to foreign credit instead of domestic credit. 21. Increased foreign direct investment flows and the expansion of long-term domestic credit are essential to development of Mexico's private sector. The IFC is not, nor should it be, large enough to fill the gaps created by deficiencies in Mexico's domestic financial markets and institutions, although we agree that it should undertake well-chosen investments to help Mexican companies access long-term finance. We particularly encourage IFC support for privately financed infrastructure, for financial institutions strengthening, and for innovative private participation in social services. 22. We were surprised not to see any reference to MIGA in the private sector strategy and would appreciate information about how MIGA sees its role in Mexico. Implementation Risks 23. The most serious risks are domestic rather than external. Policy slippages or drift on crucial reforms in the run-up to the elections and the post-election transition would significantly diminish the level of financial and other support Mexico could receive from the BanJc These risks are largely within control of the government and the political parties in the legislature. While Mexico remains vulnerable, like many other economies, to turbulence in foreign financial markets, it can through its own domestic reforms strengthen the resilience of its financial sector and social protection schemes. Flexibility 24. The CAS provides ample flexibility. The Bank needs to be able to focus its lending and non-fmancial services on areas where the government's commitment to reform and capacity to deliver change are strongest. This said, a flexible strategy of responding to targets of opportunity, as they arise, is one that can be carried too far. Despite the political risks to implementation of the CAS --indeed, because of these risks-- explicit goals, funding levels, and benchmarks are needed. The more standard CAS with these elements does not preclude change. It does, however, require that changes be explicitly acknowledged and explained. This is important, particularly as the CAS indicates that the Bank's portfolio may be experiencing increasing difficulties. 25. In sum, the proposed $5.2 billion three-year lending level is not an entitlement. In bilateral conversations, staff have assured us that they do not see it as such. If the government's commitment to, or capacity to deliver, the reforms required for effective lending lessens, the overall lending level should shrink. On this basis and understanding, we support the unusually flexible approach in this CAS. We do expect, however, as indicated in our opening comments, that the Bank will review the strategy with Mexico after the elections and will update the Board.