Mexico - Second Industrial Equipment Fund (FONEI) Project

Report No. 943a-ME FILE COPY Mexico FIECP Appraisal of a Second Industrial Equipment Fund (FONEI) Project January 15, 1976 Projects Department Latin America and Caribbean Regional Office Not for Public Use Document of the World Bank This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS Currency Unit = Mexican Peso US$1 = Mex$12.50 Mex$1 = US$0.08 Mex$1 million = US$80,000 ACRONYMS CANACINTRA Camara Nacional de la Industria de Transformacion CEDI Certificado de Devolucion de Impuestos Indirectos CONCAMIN Confederacion de Camaras Industriales de Mexico FOGAIN Fondo de Garantia y Fomento a la Industria Mediana y Pequena FOMEX Fondo para el Fomento de la Exportacion de Productos Manufacturados FOMIN Fondo Nacional de Fomento Industrial FONEI Fondo de Equipamiento Industrial FONEP Fondo Nacional de Estudios de Preinversion IMCE Instituto Mexicano de Cosercio Exterior IMIT Instituto Mexicano de Investigaciones Tecnologicas NAFIN Nacional Financiera UNDP United Nations Development Program GOVERNMENT OF MEXICO FISCAL YEAR January 1 to December 31  FOR OMCLIL USE ONLY MEXICO APPRAISAL OF SECOND INDUSTRIAL EQUIPMENT FUND (FONEI) PROJECT Table of Contents Page No. SUMMARY ....................................................... i - ii I. INTRODUCTION .................................................. 1 II. THE INDUSTRIAL SECTOR ......................................... 1 General .................................................... 1 Trade Policy ............................................... 3 Protection ............................................... 3 Export Incentives ........................................ 3 Manufactured Exports ....................................... 4 Concentration of Manufacturing Activity .................... 5 III. THE FINANCIAL SYSTEM .......................................... 5 General .................................................... 5 The Stock Markets ........................................ 6 Improvements to the Financial System ..................... 7 Availability of Credit and the Interest Rate ............... 7 IV. FONEI ......................................................... 8 A. The Institution ............................................ 8 FONEI ...-................................................. 8 Objectives and Policies .................................. 9 Board .................................................... 9 Management, Organization and Procedures .................. 9 Project Appraisal and Procedures ......................... 10 Project Supervision ...................................... 10 Technical Department ..................................... 11 Procurement and Disbursement Procedures .................. 11 Audit .................................................... 12 Relations with the Government ............................ 12 Resources ................................................ 12 Types of Project Loans ................................... 12 Terms and Limits of Financing ............................ 13 V. B. Operations ................................................. 13 Loan Approvals ........................................... 13 Loan Portfolio ........................................... 14 Participating Intermediaries ............................. 14 Financial Results ........................................ 1 FONEI's Performance Under the First Loan ................. 15 FONEI's Interest Rate Under the Proposed Loan ............ 15 This report was prepared by Messrs. Patricio Reich and Thomas Hutcheson following visits to Mexico in January/February 1975 and October 1975. 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.  Page No. V. THE PROJECT .................................................. 16 FONEI's Future Role ....................................... 16 Transfer of Appraisal to Intermediaries ................... 16 Promotion ................................................. 18 FONEIfs Prospects ......................................... 18 Operations Forecast ..................................... 18 Resource Requirements ................................... 18 Projected Financial Results ............................... 19 VI. PROPOSED BANK LOAN .19 Retroactive Financing .20 FONEI Relending Rates .20 VIII. RECOCTrDATIONS. .20 LIST OF ANNEXES Annex 1 - Man of Mexico Annex 2 - MEXICO: Size Distribution and Other Indicators of Mexican Industry Annex 3 - hEXICO: Profile of Mlanufacturing Sector, 1970 Annex 4 - MEXICO: Profile of Manufacturing Sector, 1970: Averages per Firm Annex 5 - IMXICO: Manufacturing Value Added by 3conomic Classification Annex 6 - MEXICO: Nominal and Effective Protection Annex 7 - MEXICO: Tariff Schedules before and after July 1975 hevi$ion Annex b - MEXICO: Subsectoral Distribution of Manufactured ELxports Annex 9 - IEXICO: Geographical Distribution of Manufacturing Activities, 197C0 Annex 10 - MEXICO: Financial Institutions and Intermediation in Mexico Annex 11 - hEXICO: Sectoral Distribution of Credit Annex 12 - hEXICO: Small- and Medium-Scale Industry - Consolidated Percentual Balance Sheets and Income Statements by Industrial Groucs Annex 13 - MEXICO: Comparison of Percentual Consolidated Balance Sheets for Small- and hedium-Scale Industry - hexico, Colombia & U.S. Annex 14 - MEXICO: Average Cost of Deposits to the Financieras Annex 15 - FONEI: Operating Regulations of the Industrial Equipment Fund (FONEI) Annex 16 - FONEI: Board (Technical Committee) Annex 17 - FONEI: Organization Chart Annex 1b - FONEI: Characteristics of Loan Approvals from Inception to September 30, 1975 Annex 19 - FONEI: Breakdown of FONEI's Operations by Financial Intermediaries as of September 30, 1975 Annex 20 - FONEI: Audited Income Statements (1972-74) and Projected (1975-79) Annex 21 - FONEI: Past (1972-74) and Projected (1975-79) Balance Sheets as of December 31. Annex 22 - FONEI: Past (1972-74) and Projected (1975-79) Sources and Uses of Funds Annex 23 - FONEI: Approvals, Commitments, and Disbursements - Actual (1973-74) and Projected (1975-79) Annex 24 - FONEI: Resource Position (1972-First Quarter 197b) Annex 25 - FONEI: Assumptions for FONEI's Financial Projections (1975-&0) Annex 26 - FON -E: Estimated Disbursement Schedule for Proposed Loan  NKCO APPRAISAL OF SECOND INDUSTRIAL EQUIPMENT FUND (FONEI) PROJECT SUMMARY AND CONCLUSIONS i. This report appraises a second project to assist the Fondo de Equi- pamiento Industrial (FONEI), a Government trust fund in Banco de Mexico, the central bank. FONEI, created in 1971, finances through intermediaries the fixed asset costs of industrial export and import substitution projects having reasonable export prospects. In 1972 the Bank extended a US$35 million loan to F'ONEI, after collaborating with the Government in its establishment. This report proposes a second loan of US$50 million. ii. Manufacturing industry, which accounts for about 28% of GDP, was one of the leading sectors until 1970; since then, it has merely kept pace with the economy. Since the 1971 introduction of export incentives, manufactured ex- ports have grown at about 39% p.a. but in 1975 still account for a very modest 3.8% share of manufactured output. The 1971 export incentive program incluaes (a) the reimbursement of indirect taxes paid by exported manufactures, calcu- lated as percentages of their value, and (b) the duty-free importation of in- puts, for export products. The program has beeri gradually modified and im- proved, most recently in July 1975 when, because of balance of payments problems, this already successful export promotion program was extended significantly. iii. The growith of the Mexican economy has been aided by a well developed financial system. Large amounts of savings (over 4% of GDP in some years) have been channeled through financial intermediaries because of sound interest rate policies. Also, the system has intermediated between the public's prefer- ence for short-term assets and the needs of investment projects for medium- and long-term funds. Furthermore, Banco de Mexico, through the reserve mechanism, has channeled substantial amounts of credit to sectors to which the Government attached priority on social or economic grounds. However, the system's development was unbalanced. Fixed-return securities mobilized savings without a parallel development of the stock market. The stock markets are thin, information is scarce and there are minimal disclosure requirements for publicly traded firms. The banking legislation has impeded the development of the stock markets by allowing financieras to hold equity investments larger than their own equity. The authorities are concerned about these problems and are gradually introducing measures to correct these shortcomings. iv. Since 1973, higher inflation has set back the financial system's * development: non-monetary liabilities as a percent of GDP fell to their 1965 level because of negative real interest rates. As authorities began to take measures to control the high inflation, credit to industrial firms became scarce. This raised the general level of interest rates and caused credit to be allocated to the larger, better connected firms, particularly those af- filiated with financial groups, notwithstanding that these firms are highly leveraged in contrast to smaller ones which are in a position to absorb substantial amounts of debt. v. Management problems, lack of promotion and substantial liquidity in the banking system prevented ONEI from extending any loans during its first year of existence. A more active promotion by a new management and a rise in  - ii - the general level of interest rates made the first FONEI subloans pos- sible during the second half of 1973. Since then, FONEI has financed ef- fient projects of high priority to the Mexican economy. Mcreover, these projects have a significant impact on the balance of payments because of the emphasis placed on exports by IFONEI's Board of Directors. Once the projects financed so far by FONEI reach full capacity, they will generate about US$65 million per year of additional exports. vi. Since FONEI's relending rate was far below other rates, most of its funds were allocated to borrowers offering the best guarantees, many of whom possibly could have secured alternative financing on adequate terms. The concessional rates may have played a useful promotional role initially, but it is expected that gradually FONEI will become sufficiently accepted to make it possible to reduce or eliminate interest subsidies. Therefore, to improve the allocation of FONEIT's funds and to maintain its relending rates in line with changes in the cost of alternative funds, FONEI would have, under the proposed loan, higher and variable interest rates. The initial rate would be 13.5%, adjustable to fully reflect changes of at least O.25 percentage points in the average cost of deposits with financieras, as calculated monothly by Banco de Mexico. Final borrowers would be able to choose between two regimes: (a) a variable interest rate which would change every semester, if necessary, to reflect changes in the average cost of deposits with financieras, or (b) a flat rate throughout the life of the loan, determined as the interest rate prevailing at the time of loan approval. vii. Under the proposed project, FONET would play two important roles in the economy, namely: (a) financing industrial projects with a substantial impact on the balance of payments, and (b) encouraging financial intermediaries to include project appraisals among their lending criteria. The performance of FONEI's Technical Department would be crucial under the proposed loan and its capabilities would be improved substantially. To this end several measures are proposed,including an initially heavier-than-usual involvement of Bank staff. FONEI's financial projections, which are based on reasonable growth assumptions, indicate that the Bank loan would be fully committed by early 1978. Total assets would increase more than seven times in the period 1975-79. viii. The proceeds of the loan would cover the c.i.f. cost of imports or a maximum of 70% of the domestic price of imported goods purchased troff-the- shelf" when the c.i.f. price cannot be determined. Expenditures made up to 180 days prior to the Bank's reception of subloans for approval would be eligible for Bank financing. The limit for projects not requiring prior Bank approval (the "free limit") would be raised from US$500,000 under the first a loan to US$750,000 in view of IFNEI's increased experience. As requested by FONEI, the loan would include provision for retroactive financing for up to US$5.0 million equivalent. ix. The project is suitable for a Bank loan of US$50 million, with a term of 16 years including three years of grace, on conditions customary for Bank loans to development finance companies.  I. INTRODUCTION 1.01. Banco de Mexico, Mexico's central bank, has applied for a second Bank loan to assist one of its trust funds, the Fondo de Equipamiento Industrial (FONEI) in its operations. FONEI, a second tier institution, fi- nances through intermediaries (commercial banks and investment banks) the cost of fixed assets for the efficient production of industrial goods and services that either supply export markets or substitute imports, thereby generating and/or saving foreign exchange. The proposed US$50 million loan, to be guaranteed by the United States of Mexico, would be made to Nacional Financiera S.A. (NAFIN) who would make arrangements with Banco de Mexico, for the transfer to FONEI of the proceeds of the Bank loan. 1.02 In 1971, the Bank collaborated with the Mexican Government in establishing FONEI. To support FONEI's operations, in mid-1972 the Bank made a US$35 million loan now fully committed, the objective of which has been largely accomplished: the financing of economically sound projects that will have a significant impact on Mexico's balance of payments. 1.03 In addition to filling a gap in the availability of industrial long-term development credit, the proposed project is designed to achieve two important objectives namely: (a) to support the Government's program for expanding exports while still financing efficient import substitution; and (b) through FONEI, to encourage intermediaries to lend on the basis of project appraisal (appraisal banking) rather than primarily in relation to collateral to: (i) ease the access to Bank funds for medium-sized firms, and (ii) improve the allocation of domestically mobilized resources. 1.04 This report is based on the findings of an appraisal mission in January/February 1975 and an updating mission in October 1975, both by Messrs. Reich and Hutcheson from the Bank. II. TIE INDUSTRIAL SECTOR General 2.01 Manufacturing industry is one of the most dynamic sectors of the Mexican economy, accounting for 28% of the 1974 GDP, up from 19% in 1940; absorbing nearly a fourth of gross domestic investment and employing about the same fraction of the total labor force. This performance has been facili- tated by an active entrepreneurial class; the relatively large and growing domestic demand; the proximity of the high income US market; the absence of serious labor-management conflicts and favorable government policies. During  - 2 - the last 15 years the thrust of Government industrial policies has been to promote employment to absorb surplus labor, reduce foreign exchange expenditures through import substitution, increase foreign exchange earnings through a rapid expansion of manufactured exports, strengthen intra- and inter-industry link- ages and, intensify efforts for a wider regional dispersion of industrial activity (para. 2.15). Since 1970, the Government has shown increasing com- mitment to investments in export-oriented projects. 2.02 According to the 1970 industrial census, Mexican manufacturing industry consisted of 119,000 firms 1/. Firms in the food processing sub- sector were most numerous (56,000, about 46% of the total) and had the largest subsectoral output (Mex$39 billion about 19% of total output), while those in the chemical products subsector showed the largest investment (Annexes 2 to 4). 2.03 The census data also show that small- and medium-firms play an important role in the manufacturing sector. An arbitrary dividing line between large- and medium-sized firms set at 250 employees results in more than 98% of Mexico's industrial firms (excluding those without paid workers) being categorized as small- and medium scale. These firms accounted for 46% of the 1970 gross manufacturing output and about 54% of manufacturing employment (average employment of 14 workers per firm). Investment per worker in small- and medium-industry averaged about US$6,500, which is about half of the average in the larger firms. The role of the smaller firms is particularly prominent in the more traditional labor-intensive industries, producing items of mass consumption (wood, furniture, leather products, apparel, etc). 2.04 With small- and medium-scale firms requiring less capital invest- ment per job than larger industries, their expansion would have significant employment generation effects. This is a particularly important goal for Mexico given its young and rapidly growing labor force, especially in the urban areas. The proposed Bank loan is expected to assist mainly industrial firms with less than 250 workers. 2.05 Since 1950 there has been a gradual shift in the structure of mn-ufacturing output from consumer to capital and intermediate goods, re- flecting the Government's policy to broaden and diversify the country's industrial base. However, in 1974 consumer goods still made up about 56% of manufacturing value added while intermediate goods contributed 38% and capital goods 6% (Annex 5). The fastest-growing subsectors have been trans- port equipment, textiles, and wearing apparel, engineering goods, metal and metal products and chemicals, while the food and beverages subsector ex- perienced the slowest rate of growth. 1/ Includes about 60,000 firms that had no paid employees. About 90,000 people worked in these firms, only contributing about 1% to total manufacturing output.  -3- Trade Policy 2.06 Protection. Protection of manufacturing as an explicIt pollcy goes back at least to the 1930s with the Law of New and Necessary hn:4ustries. 1/ The balance-of-payments problems which emerged after World War II led to the reinforcement of the protection policy with higher tariffs and the imposition of import licensing (quantitative restrictions). 2.07 The most recent comprehensive study of protection in Mexico 2/ esti- mates an average of 25% nominal protection and 28% effective protection, one of the lowest in any developing country. In spite of the low average, protec- tion shows considerable variation between subsectors of manufacturing (Annex 6); consumer durables had the highest effective protection at 101%, while con- struction materials had the lowest protection at 1%. If the food, beverages, and tobacco and construction materials subsectors are excluded from the compu- tation, average nominal protection rises to 28% and average effective protec- tion jumps to 43%. 2.08 Nominal protection has increased in recent years as indicated by the faster rate of price increase in Mexico than in the United States, its malor trading partner. The number of import items subject to licensing increased from 26% of all imports in 1956 to around 75% in 1974. In July 1975, reacting to large balance-of-payments deficits, the authorities made all imports subiect to licensing. As part of the same measures, tariffs were raised, increasing the average tariff rate from 18% to 22% (Annex 7), and the export incentive program was expanded. 2.09 Export Incentives. The "Certificado de Devoluci6n de Impuestos Indirectos" 3/ (CEDI) program was instituted in 1971 to encourage exports by offsetting the high costs to exporters of domestic intermediate goods through indirect tax rebates granted as non-transferable certificates usable only for paying taxes. This program has been gradually expanded and improved. Following the July 1975 revision, manufactured goods with more than 60% of domestic content 4/ receive a rebate of 11% of their export value, a rebate of 7.0% for products with 50 to 60% domestic content and a rebate of 5.5% for products with 40 to 50%. A special 15% rate is allowed for goods with more than 60% domestic content exported by trading companies. The Law of New and Necessary Industries raises the effective protection to industries qualifying as "'new and necessary" by lowering tariffs on capital goods and intermediate goods purchased by the qualifying industries. 2/ "The Structure of Protection in Mexico," Bela Balassa and Associates, The Structure of Protection in Developing Countries, 1971. 3/ Certificates of Indirect Tax Reimbursement. 4/ "Domestic content" is defined as domestic inputs, direct wages and depreciation. Overhead costs and profits are left out.  - 4 - 2.10 The export incentive program, which also permits duty-free "tempo- rary imports" of inputs for products that will be exported, was extended in July 1975 to products with 20% of domestic content (down from 40%). Tempo- rary imports require prior authorization by the Finance Ministry, after receiving the opinion of the Ministry of Industry and Commerce. Before July 1975 they were difficult to obtain (a 3 months' delay being common), and many applications were denied. As part of the July 1975 measures both ministries are seeking ways to streamline the process. Most manufactured exports with more than 50% domestic content are also eligible for short-term concessionary financing by "Fondo para el Fomento de la Exportacion de Productos Manufacturados" (FOMEX) at concessionary rates. 2.11 The July 1975 revisions to the CEDI and temporary import systems, mark a further improvement of the successful program of export incentives. Manufactured Exports 2.12 Responding to the 1971 introduction of export incentives (para. 2.09) manufactured exports grew at 38.7% p.a. in 1970-74, compared to only 11.9% p.a. in 1965-70 (Annex 8). These exports which stood at about US$200 million in 1965 rose to about US$1,300 million in 1974 (excluding exports of assembly (maquila) industries), accounting for nearly 46% of total merchandise exports. Despite this rapid increase, manufactured exports in 1974 accounted for only about 3.8% of total manufacturing output. The export surge has been led by textiles, apparel, and footwear, followed by non-tradional items such as machinery, electronics and automotives parts, which in part reflects the growing integration that has developed between Mexican part suppliers and the US automotive industry. 2.13 In 1971, as part of the Government's policies for increasing exports, the special treatment of duty-free temporary imports of equipment and materials granted to export-oriented assembly plants in the free-zone and border areas was formalized in legislation. Since October 1972, firms in the interior of the country, outside the larger urban areas, are also eligible for maquila status. Thus, by end-1973, 51 firms in the interior had been given maquila status compared with 454 such firms in areas contiguous with the US. The results of these concessions have been spectacular as estimates of exports for 1973 from these sources amount to US$577 million in value and US$272 mil- lion in domestic value added compared to practically nil in 1965. 2.14 Manufactured exports are finding wider markets. Between 1965 and 1971, the share of manufactured exports to the US declined from 70.5% to 62.9% and sales to Central America declined from 7% to 5.7% while exports to the Latin American Free Trade Association (LAFTA) countries increased from 12.1% to 15.3% and the share directed to Europe and other countries outside the Western Hemisphere increased from 10.4% to 16.6%. This trend is likely to continue as Mexico promotes its manufactured exports in new markets.  -5- 2.15 Concentration of Industrial Activity. Mexico's industry, employ- ment and income are heavily concentrated in Mexico City, which accounts for 25% of the firms, 32% of the employment, and 33% of the output of the manu- facturing sector (Annex 9). Compounding the problem of Mexico City's popu- lation of 11 million are its 6.5% annual rate of growth, air and water pollu- tion, and the costs of providing water to a city located in an arid valley, 7,400 feet above sea level. 1/ These factors make it desirable to encourage growth elsewhere. 2.16 In 1972 the Government instituted a fiscal incentives plan for locating industry outside the capital and the two other largest cities, Guadalajara and Monterrey. The plan, however, suffered shortcomings: its impact on Mexico City was reduced by including Guadalajara and Monterrey where the concentration problems are not so acute as in Mexico City; and, by lowering the duties on imported capital goods, it provides more incentives to decentralize capital-intensive than labor-intensive industries. The Govern- ment, however, is considering other steps to decentralize the economy. 2.17 The Bank will soon complete two studies, Spatial Development in Mexico and the Economic Development of Southeast Mexico, dealing with the concentration problem. Both have been discussed with the Government. The first confirms the desirability of encouraging growth outside of the Mexico City area. The second indicates that the Gulf coast of the Isthmus of Tehuantepec is one of the most promising growth poles. II. THE FINANCIANL SYSTEM General 3.01 The growth of the Mexican economy has been aided by a well- developed, although unbalanced (para. 3.03) financial system consisting of almost 200 banks of public, mixed, and private ownership, with the central bank as its apex. The system is dominated by 11 large groups, each consisting of commercial banks, investment banks (financieras) and mortgage companies (hipotecarias). Encouraged by the authorities, the groups are becoming multi- banks offering a wide spectrum of financial services. For a detailed descrip- tion of Mexico's financial system see Annex 10. 3.02 Mexico's financial system traditionally has been able to mobilize large amounts of savings (over 4% of GDP in some years) because of a sound interest rate policy which maintained positive real interest rates up to 1972. It also has been able to intermediate successfully between the public's preference for short-term assets and the needs of the investment projects for medium-and long-term funds. Moreover, Banco de Mexico, through the reserve requirements mechanism, has channeled substantial amounts of credit to socially 1/ The Bank is the executing agency for a UNDP-financed project to study Mexico's water resources (Plan Nacional Hidraulico) and has carried out a water supply sector survey jointly with the Pan American Health Organization.  and economically desirable activities. To this end the Government has esta- blished several special purpose funds, five of which lend primarily to in- dustry. 1/ Since 1973, increased inflation has set back the system's develop- ment. Non-monetary liabilities, which stood at 35% of GDP in 1972, fell to 27% in 1974 and in 1975 appear to have fallen further to 25%, almost their 1965 level. This is the result of the system's inability to adjust its interest rates rapidly to the appreciable increase in inflation (from an average of 4-5% p.a. in the 1960s to 20% p.a. in 1973-74). 3.03 The development of the financial system has been unbalanced. Fixed return instruments mobilized large amounts of resources, without a parallel growth of the stock markets (para. 3.05). In this context, and aided by the Mexican tax legislation which favors debt over equity, the leading finan- cial groups merged with large industrial groups. This allowed the latter to pyramid 2/ their firms and still have ready access to credit, as witnessed by the high leverage of larger firms (para. 3.09). 3.04 The Mexican banking system traditionally has allocated credit more on the basis of guarantees offered by the investors and on the latter's rela- tionship with the lending institutions (para. 3.07) than on the merits of the proposed projects. This allocation of resources has diminished the efficiency of the system's financial intermediation by reducing the amount of funds that the system can transfer to sound projects whose sponsors cannot fulfill the intermediaries' guarantee requirements. If the Mexican banking system -an be encouraged to start lending on the basis of project appraisals, one of FONEI's objectives under the proposed loan (para 4.02), the efficiency of the entire industrial sector could be improved. 3.05 The stock markets. The development of the stock markets has lagged behind that of the financial system. In 1974, only 5% of the Mex$135 billion transacted on the three security exchanges 3/ was in stock, the rest being fixed-return securities. Several reasons account for this retarded develop- ment. The stock markets are thin, considerably decreasing the stocks' liquid- ity. Information on transactions is scarce since a large proportion of transactions take place through the commercial banks without public disclosure of prices and volume. Disclosure requirements for publicly traded firms have been minimal, lowering the public's confidence in investing in stock. 3.06 The banking legislation has impeded the development of the stock markets by allowing the financieras to make equity investments of up to 25% 1/ Fondo de Garantia y Fomento a la Industria Mediana y Pegue7na (FOGAIN) lends to small and medium industries, Fondo Nacional de Fomento Industrial (FOMIN) makes temporary equity investments, Fondo de Estudios de Pre- inversi6n (FONEP) finances preinvestment studies, and Fondo para el Fomento de la Exportaci6n de los Productos Manufacturados (FOMEX) extends pre- and post-export financing, at consessionary rates, for manufactured goods. The other fund, FONEI, is described in Chapter IV. 2/ Process of making intercompany loans, the proceeds of which are used to make equity investments in each other. 3/ Mexico (the largest), Monterrey and Guadalajara.  - 7 - of the sum of their own equities plus their liabilities to the public. 1/ This allows the financieras to convert deposits from the public into equity investments, generally for firms in the same group, considerably diminishing the firms' need to raise equity funds in the stock markets. This has con- tributed to concentrating the ownership of industrial firms. 3.07 Improvements to the financial system. The authorities, concerned about the system's weaknesses, are taking steps to correct them. To strength- en the stock markets, a new Securities Markets Law was enacted in January 1975. The purpose of they law is to provide the securities markets with a mechanism to disseminate information on the features of traded securities and their supply, the demand, and trading thereof, and to provide speedy and efficient contact between buyers and sellers. The law regulates the activi- ties of commercial banks vis-a-vis stock transactions and enlarges the disclosure requirements for publicly traded firms. The authorities are also encouraging the consolidation of the present multitude of financial insti- tutions into 10-20 multi-banks, which would operate independently from non- financial groups, thereby improving the allocation of credit. FONEI's intro- duction of appraisal banking would contribute to this latter objective. The process of de-pyramiding the large industrial groups, although of great importance, must be carried out gradually since it requires a parallel de- velopment of the stock markets. Availability of Credit and the Interest Rate 3.08 Between 1969 and 1973 domestic credit grew slightly faster than nominal GDP. In 1974, the monetary authorities, attempting to control inflation, allowed credit to grow by only 20.5%, less than the 28.5% increase in nominal GDP. As large amounts of credit were preempted by the public sector, credit to the private sector became scarce and the general level of interest rates increased accordingly. The share of manufacturing in total credit fell from 25.5% in 1969 to 23.9% in 1974, with the subsectors' shares remaining relatively stable (Annex 11). 3.09 About 46% of domestic credit outstanding in Mexico has terms of one year or more. Detailed information on term credit is not available since statistics aggregate all transactions with terms over one year. Financial data on industrial firms are also limited. A study of small- and medium-scale firms (equity of less than US$2 million) shows that manufacturing firms are hardly leveraged at all. On average, the small- and medium-scale Mexican industrial firms have a term-debt/equity ratio of 0.08:1 while their total debt/equity ratio is 0.3:1. Comparable firms in Colombia and in the U.S. show term-debt/equity ratios of 0.3:1 and total debt/equity of 1:1 (Annexes 12 and 13). Therefore, small- and medium-scale Mexican industrial firms can, on the whole, absorb substantial debt while still maintaining a sound capital 1/ Since the banking legislation allows a 22.5:1 debt/equity ceiling on financieras, theoretically they could have equity investments 5.9 times their own equity.  structure. In contrast, a recently published study 1/ has shown that larger 2/ firms are highly leveraged, as a reflection of their ready access to credit (para. 3.04). Thus, large firms are estimated to have a debt/equity ratio of about 2.7:1. This figure, however, could be still grossly underestimated because of pyramiding (para. 3.03). Once this is taken into account, their debt/equity ratio could be as high as 5:1. 3.10 Medium and long-term industrial loans to better borrowers, have interest rates that range from 14 to 18% p.a., depending on the relationship between borrower and banker. Short-term rates are higher at about 19% p.a. During 1975 the average cost of funds to the financial system has risen as interest paid on deposits increased and as the public shifted its deposits into higher yielding instruments. Lately, lending rates have fallen slightly reflecting the lower demand for credit because of the current Mexican reces- sion. 3.11 The large and better connected industrial firms in Mexico also have access to foreign credit. Loans are made at interest rates of 1-1/2 to 2-1/2 percentage points above the London Inter-Bank Offer Rate (LIBOR) or the U.S. prime rate--depending on the foreign bank's base--with the rates periodically adjusted. In October 1975 such loans were available at about 8.5 to 9.5% p.a. 3.12 In late 1974 financieras began to use variable interest rates for their medium-term lending to public sector enterprises. The loans carry an interest rate two points above the weighted average cost of deposits to the financieras, as calculated monthly by the Banco de Mexico. In December 1975, the average stood at about 12.0% after increasing from 9.9% in early 1973 (Annex 14), reflecting the increase in the general level of interest rates (para. 3.08). Given the flexibility afforded by variable interest rates loans, and since they are becoming more familiar to industrialists, under the proposed loan FONEI would give its final borrowers the option of secur- ing variables interest rates loans (para. 4.29). IV. FONEI THE INSTITUTION 4.01 FONEI, a trust fund of Banco de Mexico is a second tier institution that promotes new or expansion industrial projects and finances them through financial intermediaries. Commercial banks and investment banks (financieras) in compliance with Mexican laws and regulations are eligible for FONEI's operations and thus may become one of its financial intermediaries. 1/ See "Relacion entre Estructura Fiscal, Politica Financiera de las Empresas y Equidad Tributaria" by Lic. Francisco Gil Diaz (Banco de Mexico, S.A.), in Contaduria Publica, August 1975. 2/ Firms that report taxable profits in excess of Mex$500,000 (US$40,000).  -9- Obiectives and Policies 4.02 Under the proposed project FONEI would have two objectives; namely, (a) to finance export-oriented and efficient import substitution industrial projects with reasonable export prospects (para. 4.18) and (b) to encourage intermediaries to lend on the basis of project appraisal (para. 5.02). FONEI's Operating Regulations have been revised (Annex 15) to reflect the loan's objectives and to adapt them better to FONEI's future operations. The approval by FONEI's Board (Technical Committee) of revised Operating Regula- tions would be a condition of loan effectiveness and future changes in the Operating Regulations would be possible only through consultation with the Bank. Board 4.03 FONEI's Board (Technical Cormittee) is composed of nine members, six of whom are appointed by the Government and the rest represent Chambers of Industry (Annex 16). The Board, which usually meets once a month to discuss policy issues and to approve loans, is presided over by Mr. Hector Hernandez, General Director of Economic Studies, Ministry of Finance. The most active member of the body is Mr. Ernesto Fernandez Hurtado, Director of Banco de Mexico. A senior official of Banco de Mexico was recently designated coordinator of the activities of the various trust funds of Banco de Mexico (Annex 10) and in this capacity he attends FONEI's Board Meetings. One of the Board members, Mr. Deschamps, heads IMIT, FONEI's most used consultant (para. 4.07), which creates a potential conflict of interest. His presence at the Board is beneficial given his knowledge of Mexican industry. During negotiations the Bank obtained assurances that the representative of IMIT will abstain from voting on IMIT-appraised projects. 4.04 FONEI's Board has taken an active participation in directing the allocation of FONEI's credits. For this purpose the Board has vested in Mr. Fernandez Hurtado the power to screen loan applications before the start of the appraisal of proposed investments. Based on a project profile prepared by FONEI's technical staff, the export orientation of the proposed investment, or the efficiency and desirability of the proposed import substitution are checked. At this stage export projects are given preference over import substitution projects; this qualitative preference is reinforced during the projects' appraisals with the more stringent economic criteria applied during appraisal to import substitutions projects (para. 4.18). Management, Organization and Procedures 4.05 FONEI has had two chief executives since its inception. The first, appointed to set up the institution and get it started, was succeeded by Mr. Lajous, who has demonstrated great leadership abilities, which were crucial to the fast comnitment of the first Bank loan. He has promoted FONEI, with both the industrial and banking communities and maintains a good working relationship with the Board.  - 10 - 4.06 The rapid growth in lending volume (para. 4.22) left FONEI with an unsuitable organization that lacked operating procedures and clearly defined responsibilities thus decreasing the organization's efficiency. Recognizing these weaknesses, FONEI's chief executive engaged in early 1975 a management consultant of Banco de Mexico to propose a better organization, rationalize FONEI's systems, and draft a procedures manual. The consultant's study is almost finished and some of its recommendations are already being implemented (Annex 17 shows FONEI's new Organizations Chart). Project Appraisal and Procedures 4.07 Under the first loan all projects were appraised by several consul- tants selected by FONEI. Lately, FONEI has relied increasingly on IMIT, 1/ which produces some of the better appraisals. The quality and depth of the appraisals have been uneven--reflecting the consultants' different capabili- ties--although there has been a clear overall improvement in the appraisals through time. The appraisals should pay more attention to the projects' organization and management, soundness of the marketing efforts and, to the financial and economic analyses of the projects. These short-comings, however, may be explained by the consultants' lack of guidance from FONEI on appraisal matters (para. 4.11). To remedy this deficiency and to unify technical criteria, the Bank held, at FONEI's request, a one week seminar attended by leading FONEI consultants. The impact of this seminar proved positive. 4.08 FONEI's present coordination of the work between consultants and final borrowers has three undesirable results. First, by the very minor role played by the intermediaries, the impact of the appraisals on their lending decisions is greatly diminished. Second, the intermediaries lose project appraisal experience valuable for the introduction of appraisal lending. Third, FONEI uses a large proportion of the scarce manpower in its techni- cal department in dealing directly with final borrowers and consultants in- stead of devoting itself to evaluating project appraisals. 4.09 Recognizing the shortcomings of the above system, some intermedia- ries have shown interest in getting more closely involved in project appraisals to use them as an additional lending criterion. To this end, they have con- sidered setting up appraisal units, but have been discouraged from doing so because of cost considerations. The proposed loan includes provisions to help intermediaries to fund the cost of appraising projects. (para. 5.02) Project Supervision 4.10 Until the intermediaries develop the institutional strength to conduct effective project follow-up, FONEI has agreed to carry out this function by establishing a standard follow-up procedure. To this end, a financial analyst 1/ Instituto Mexicano de Investigaciones Tecnologicas, a research and con- sulting institution jointly sponsored by Banco de Mexico and NAFIN.  - 11 - was hired in July 1975. By September, after devising a supervision plan, nine projects had been visited already. The field visits are well prepared on the basis of the projects' appraisals and on the periodic reports that the final borrowers are requested to submit. A staff member of the project's inter- mediary is required to participate jointly with FONEI's staff in the super- vision visit. Shortly thereafter FONEI issues a report, copied to the inter- mediary, including when necessary, recommendations for action. FONEI's present project supervision procedures are adequate. Technical Department 4.11 Although FONEI's capacity for guiding borrowers and consultants in project appraisal and supervision matters has improved considerably, the Technical Department's overall performance still requires improvement. During a long period FONEI was unable to impress on the consultants the basic concepts and methodology of project appraisal. Also, appraisal reviews mainly concen- trated on minor project details instead of focusing on broader issues. This unsatisfactory performance may be explained by the staff's lack of experience and of proper internal guidance, since the Technical Department has had in- adequate leadership and has been without a head during the last six months. The hiring of a qualified head for the Technical Department may prove diffi- cult because of PONEI's non-competitive remunerations and limited career potential. 4.12 The Technical Department capabilities would have to be considerably improved so that it can discharge its increased responsibilities under the proposed loan. To this, end, several measures have been agreed upon with FONEI, namely: (a) further training for several technical staff members at the Bank, including attendance at EDI courses, (b) strengthening of FONEI's Technical Department by the recruitment of one or two well qualified profes- sionals, and (c) filling of the now vacant position of head of the Technical Department by a well qualified professional. During negotiations agreement was reached with FONEI on all necessary steps to ensure the improvement of FONEI's technical staff. 4.13 Bank supervision of the proposed project would initially have to include a heavy technical assistance component. To this end, supervision mission, longer and more staff intensive than usual, would mainly concentrate on providing guidance and technical assistance to FONEI, especially in its role as outlined in para. 5.05. Procurement and Disbursement Procedures 4.14 FONEI relies on the prospective borrower's judgment, experience and self-interest to select equipment that is competitive in price and quality and appropriate for the purpose in view. The procedures and checks regarding dis- bursements for goods procured are thorough and ensure that payments are made only for approved machinery, equipment, and services. FONEI, after a short learning period, is disbursing the proceeds of the first Bank loan smoothly.  - 12 - Audit 4.15 FONEI's accounts are audited by both Alfonso Ochoa Raviza, a reputable Mexican auditing firm, and by Banco de Mexico's internal auditors. None of their reports on FONEI's accounts has had qualifications. The present arrangement is satisfactory. Relations with the Government 4.16 While maintaining a close working relationship with the Ministry of Finance, FONEI has been able to preserve its autonomy and to resist political influence. The composition of FONEI's Board (para. 4.03) ensures its close coordination with other Government agencies in related activities, such as the Instituto Mexicano de Comercio Exterior (IMCE), which promotes Mexican products abroad, FDMEX, which provides comercial credit for exports, and FONEP, which provides funds at concessionary terms for preinvestment studies. Resources 4.17 The Mexican Government initially funded FONEI with a non-repayable contribution of Mex$125 million (US$10 million) and in mid-1972 the Bank made a US$35 million loan to FONEI, to be repaid by the Mexican Government to increase FONEI's equity. The Government, furthermore, undertook to make available to FONEI additional funds of at least Mex$375 million (US$30 million) with a minimum maturity of 20 years. For this purpose, in October 1974, Banco de Mexico authorized FONEI to issue five-year, renewable obliga- tions with a 9% p.a. interest rate which are being subscribed by financial institutions for meeting their reserve requirements. Banco de Mexico has assured the Bank that the obligations will be rolled-over for at least 20 years. Types of Project Loans 4.18 FONEI finances, through financial intermediaries, the cost of fixed assets of export-oriented and efficient import substitution industrial pro- jects with reasonable export prospects. Besides the qualitative preference given by FONEI's Board to export projects (para. 4.04), more stringent economic tests are imposed on projects that initially substitute imports. In addition to an acceptable economic rate of return, their product prices must be no higher than 125% of the c.i.f. value of comparable imports. The application of these criteria have oriented FONEI's operations decisively towards the financing of export-oriented projects. 4.19 FONEI also finances feasibility studies, including final engineer- ing in which case FONEI has to approve the consultant and his term of refer- ence. Should a feasibility study lead to a project, the cost is consolidated with the project loan; otherwise FONEI absorbs part of the cost and the client the rest.  - 13 - Terms and Limits of Financing 4.20 FONEI's minimum loan is Mex$3.5 million (US$280,000); its maxi- mum is Mex$37.5 million (US$3 million). Loans have a maximum term of 13 years, with up to three years of grace. These limits, which are appropriate, would be maintained but may be changed by FONEI's Technical Committee, in consulta- tion with the Bank. 4.21 Within the above mentioned limits, FONEI participates jointly with the intermediary and the final borrower in the financing of fixed assets costs of projects. FONEI's financing may cover up to 65% (new projects) or 72% (expansion projects) of the fixed asset costs. The financial intermediary's participation has to amount to at least 11% of FONEI's financing. In addition, the intermediary must ensure that the projects have adequate working capital financing. The final borrower has to finance at least 25% (new projects) or 20% (expansion projects) of the fixed assets cost. For feasibility studies, FONEI's participation amounts to a maximum of 80% of their costs, with the industrial enterprise financing the remainder. These percentages, which are reasonable, may be changed by FONEI's Technical Coinittee, in consultation with the Bank. B. OPERATIONS Loan Approvals 4.22 Because of managerial problems, lack of promotion and high liquidity in the banking system, FONEI did not make any loans during 1972, its first year of existence. More active promotion by a new management which took over in early 1973, together with an increase in the general level of interest rates which made FONEI's 11% p.a. relending rate more attractive, enabled FONEI to extend its first loans during the second semester of 1973. Durirng this period FONEI's Board approved loans totalling Mex$210 million (US$17 mil- lion) and in 1974 approvals had increased to Mex$480 million (US$38 million). During 1975, FONEI's approvals would decrease considerably to an expected level of about Mex$375 million (US$30 million) because of the impact of the current world recession on the Mexican economy. By September 1975 FONEI had approved ( 6 loans totalling Mex$987 million (US$79 million) of which five loans (Mex$1.5 * million) were for feasibility studies. The proceeds of the first Bank loan, which was fully commriitted by June 1975, were distributed among 41 projects. As of year-end 1975, the Bank had disbursed about US$23 million compared to the appraisal's estimate of the whole US$35 million. This lag is explained, however, by FONEI's initial delay in approving projects. 4.23 An analysis of FONEI's loan approvals 1/ is shown in Annex 18. The loan size distribution has a mean of Mex$21 million (US$1.7 million) and is skewed towards the larger loans. About 41% (69% of the lending volume) are larger than Mex$25 million (US$2 million). Only about 15% (of both loans and 1/ Loans in the financing of which the Bank has participated.  - 14 - volume) went to finance new projects. FONEI's strengthened promotion (para. 5.07) should increase this percentage under the proposed loan. Leading sectors in FONEI's operations were metallurgical products with 22% of all approvals, chemicals with 16%, and non-metallic products with 14%. All of FONEI's borrowers benefitted from loan terms designed to match the cash generation of their project: about 85% of FONEI's loans have terms between 6 and 13 years. In contrast, loans of financieras are usually for shorter terms. Loan Portfolio 4.24 FONEI's loan portfolio stood at Mex$565 million (US$45.2 million) as of September 30, 1975. This portfolio is virtually risk-free since the finan- cial intermediaries are liable for the timely payments to FONEI of interest and principal, irrespective of the final borrowers' servicing of the debt. Most of FONEI loans are still in either their disbursement or grace period; final borrowers have serviced on time the interest payments due to the inter- mediaries. FONEI, agreed to include in the standard loan agreement with its intermediaries a clause requiring them to report arrears on FONEI 's loans and ary other critical information, so that FONEI receives early indications of problems that the projects may be facing. Participating Intermediaries 4.25 By September 1975, FONEI had operated through 17 intermediaries which are affiliated in 10 financial groups (Annex 19). FONEI's loans have been made through their banks or financieras, depending on their resource availabilities. Six leading financial groups have intermediated 40 of the 56 FONEI operations and hold, therefore, about 72% of the value of FONEI's portfolio. These six financial groups, given their managerial and financial strength, wide geographic coverage, and better qualified staff, would con- stitute the main target of FONEI's efforts towards introducing appraisal banking in Mexico (para 5.03). Financial Results 4.26 Annexes 20 to 22 show FONEI's audited financial statements from inception through December 31, 1974. FONEI's revenues increased from Mex$5.8 million in 1972 to Mex$19.0 million in 1974 as funds were shifted away from low-yield deposits with Banco de Mexico to FONEI's higher-yield loan portfolio. FONEI's expenses have been minimal, so that net income amounted to Mex$2.1 million in 1972 and Mex$2.8 million in 1973, a 1.7% and 2% return on average total assets, respectively. During 1974, however, the payment of consultant appraisal fees (Mex$1.3 million) lowered net income to Mex$2.4 million, a 1% return on average total assets. Provisional results for the first three quarters of 1975 indicate that FONEI's profitability has dropped further to about 0.8% return on average total assets. This trend would be reversed by the higher interest spread that FONEI is expected to have under the proposed loan.  - 15 - FONEI's Performance Under the First Loan 4.27 FONEI has financed efficient projects of high economic priority with significant impact on the balance of payments and has contributed to the Government's decentralization efforts. The priority and efficiency of FONEI's projects are indicated by their high average economic (40%) and financial (18%) real rates of return. These projects will also directly generate about 4300 new jobs once they reach capacity. Reflecting FONEI's export emphasis (para. 4.18), once these projects reach their full capacity annual exports by companies undertaking them are expected to be about 400% above their 1973 level, generating about US$65 million p.a. of additional exports. Moreover, about 15% of the incremental output of FONEI's projects would be exported compared to only about 3.8% of total industrial output in 1974. FONEI's contribution to the industrial decentralization effort is shown by the fact that only 20% of FONEI's financing has gone to the Mexico City area. 4.28 Although FONEI has financed economically sound projects it has not yet played its proper role in the Mexican financial system beyond transferring resources to Mexico. From the time it began operations up to mid-1973, credit was easily available and, although FONEI's relending rate of 11% p.a. to the final borrower was slightly below the cost of alternative funds, intermediaries having excess reserves discouraged prospective borrowers from using FONEI funds. In mid-1973 credit began to be tight and intermediaries became willing to use FONEI funds. In 1974-75 FONEI's relending rate was well below that of alternative funds (para. 3.08), creating a situation of non-price credit rationing. Intermediaries therefore had every incentive to allocate FONEI's funds to borrowers offering the best guarantees --generally the larger borrowers and particularly those within the same financial industrial group. This re- sulted in part of FONEI's loans going to borrowers who might well have secured alternative financing on adequate terms. FONEI's Interest Rate Under the Proposed Loan 4.29 To improve the allocation of FONEI's funds and to maintain its relending rate in line with future changes in the cost of alternative funds, FONEI would have higher and variable interest rates. Under the proposed loan, FONEI would initially charge a 13.5% p.a. interest rate to the final borrowers. This interest rate would be adjusted, whenever necessary, to fully reflect changes of at least 0.25 percentage points of the average cost of debt funds to the financieras, as calculated monthly by Banco de Mexico (para. 3.12). 4.30 Final borrowers would be able to choose between two interest rate regimes; namely, (a) a variable interest rate which would change every semester, if necessary, to reflect changes in the Banco de Mexico average, or (b) a flat interest rate, throughout the life of the loan, determined as the interest rate prevailing at the time of loan commitment. Under both interest rate regimes FONEI would give to the financial intermediaries an interest rate spread of two percentage points.  - 16 - 4.31 The proposed interest rate mechanism for FONEI would be functionally linked to the average cost bf debt funds to the financieras. Since Mexico, an open economy, has to follow a monetary policy which ensures the maintenance of interest rates in line with those in major financial centers, the average (made up by the different interest rates paid to depositors) would vary with changes in financial conditions and would, in the long run, be positive in real terms. FONEI's relending rates, about 1.5 percentage points higher than this average would therefore, be positive in real terms and remain in line with the cost of alternative sources of domestic financing. V. THE PROJECT FONEI's Future Role 5.01 Under the proposed project, FONEI would play two important roles in the Mexican economy; namely, (a) the financing of industrial projects with a subs- tantial impact on Mexico's balance of payments and, (b) the encouragement of financial intermediaries to lend on the basis of project appraisal. Given Mexico's pressing needs to increase its foreign exchange earnings, FONEI in its first role would increasingly pursue its marked orientation towards export projects (para 4.18). Moreover, as FONEI becomes better known and gains further acceptance by both the business and financial communities it is likely to become a more important source of term funds and to be in a better position to focus its lending on priority sectors of the economy. The impact of FONEI would be further strengthened by the role it would play in Mexico's financial sector: the introduction of appraisal banking. As intermediaries begin to appraise projects their exacting collateral requirements may gradually be lowered. This, together with the proposed increase in FONEI's relending rates, would enable FONEI to finance, on adequate terms, sound projects that presently are not being implemented because of lack of financing. Transfer of Appraisals to Intermediaries 5.02 To encourage intermediaries to appraise projects a two-step approach would be used. As a first step, the responsibility for the coordination, during project appraisal, between final borrowers and consultants, would be transferred from FONEI to the intermediaries. As a second step, FONEI would induce inter- mediaries to set up in-house appraisal units (para. 5.04). In both cases FONEI would contribute towards the costs of appraising projects by (a) reimbursing intermediaries for the consultants' costs and/or (b) paying intermediaries a reasonable fee for appraisals made by their in-house appraisal units. 5.03 The transfer of appraisal responsibility from FONEI to the inter- mediaries would be achieved by: (i) requiring intermediaries to assume responsibility for the appraisal of projects that need FONEI loans larger than Mex$30 million (US$2.4 million). Under the first Bank loan, about 27% of FONEI loans were larger than Mex$30 million and over  - 17 - 80% of these loans were intermediated by the six financial groups which are the target of FONEI's effort towards introducing appraisal banking (para. 4.25). The intermedia- ries, when required to be responsible for a project appraisal, would have to choose a consultant--initially from a list of consultants supplied by FONEI, to coordinate the work between final borrower and consultant, and to be responsible for the quality and thoroughness of the appraisals. (ii) persuading intermediaries with smaller loans to gradually assume the appraisal responsibility. The extent of FONEI's involvement in these appraisals would be determined by the intermediaries' capabilities. In both cases, to ensure that appraisals become more relevant documents in the intermediaries' lending decisions, FONEI would request them to prepare, even for projects in whose appraisal the intermediary did not participate, a short project summary which would have to be initialed by one of its high ranking officers. This summary, besides helping to show to the intermediaries' manage- ment the advantages of project appraisal, would serve as a basis, complemented by the whole project appraisal, of FONEI's Board lending decision. 5.04 The second step towards having intermediaries appraise projects would be to have FONEI pay to those intermediaries which establish appraisal units a reasonable fee for individual project appraisals. This fee would compcnsate the intermediaries for costs incurred in appraising the project, and thus help fund their in-house appraisal units. A basic appraisal unit would be formed by three to four people with expertise in financial analysis, management, marketing and economics. Since the range of industrial project is wide, the intermediaries would be encouraged to use consultants for technical aspects of the projects. To qualify for the appraisal fee, the intermediary's project appraisal would have to be comprehensive and include both the financial and economic analyses of the projects. The economic analysis would be performed by the intermediary so that it knows whether a particular project meets all of FONEI's requirements in this regard. 1/ 5.05 Intermediaries, as they begin appraising projects, should start receiving guidance on appraisal methodology and concepts through FONEI's reviews of their project appraisals. PONEI's role towards intermediaries would be similar to the Bank's towards its first tier DFCs 2/. This necessi- tates, therefore, a different Bank approach vis-a-vis FONEI. The Bank will need to concentrate on strenghtening FONEI's capability to carry out its future role towards intermediaries, rather than on further developing FONEI's own project appraisal capability. This emphasis would be appropriate also since projects come to the Bank for approval when most of the investnent and financing decisions already have been made, considerably limiting the influ- ence that the Bank could have on the projects. Developing the required 1/ The intermediaries and FONEI are expected to follow the Bank's "Guide- lines for Calculation of Economic Rates of Return on DFC Subprojects." 2/ Typical DFCs that perform their own project appraisals.  - 18 - capabilities in FONEI will demand closer contacts between Bank and FONEI staff, in particular, more frequent and longer supervision missions (para. 4.13). 5.06 During negotiations agreement was reached with FONEI on the proposed transfer of project appraisal to the intermediaries, on the reim- bursement to intermediaries of appraisal costs, and the payment of a reason- able fee for individual project appraisals to those intermediaries which establish in-house appraisal units. Promotion 5.07 The expected reduction in the intermediaries' collateral require- ments--as they begin to appraise projects--together with the increase in FONEI's relending rates--which would discourage large borrowers with alter- native sources of financing from seeking FONEI funds--, would enable FONEI to direct its lending towards smaller and less sophisticated borrowers than in the past. These are the industrialists who traditionally have not been able to secure financing, on adequate terms, for their sound projects because of lack of collateral. FONEI should strengthen its promotional efforts to make more of these industrialists aware of its existence and thus increase the potential demand for its funds. For this demand to materialize, however, the intermediaries' top management and operational staff should become familiar with FONEIts operations. FONEI, therefore, should continue its dialogue with the financial groups' top management but should also undertake a new promotional effort, concentrated on the intermediaries' operational staff, to explain FONEI's activities and modus operandi. FONEI has agreed to take steps for a coordinated promotional effort directed towards indus- trialists and intermediaries. FONEI's Prospects 5.08 Operations Forecast. A forecast of approvals, 1/ commitments and disbursements for 1975-79 is given in Annex 23. During 1975-76 approvals are expected to be lower than their 1974 level as a reflection of (a) a significant slowdown in investment in Mexico, particularly for export-oriented projects, due to the world economic situation; (b) a decreased demand for FONEI's funds since borrowers with alternative sources of finance would rather seek financing elsewhere; and (c) the gradual adjustment by intermediaries to their new role. However, as a result of the expected improvement of the world economy, the stronger promotional effort by FONEI and a better working FONEI-intermediary system, loan approvals are expected to increase at a rate of 10% p.a. from 1977 on. This growth rate seems attainable. 5.09 Resource Requirements. Based on its projected level of loan approvals of Mex$1,200 million (US$96 million) through the first quarter of 1978, FONEI would have a resource need of Mex$1,105 million, of which 1/ Since FONEI is a second-tier institution, its approval gives rise to an intermediary's commitment. Moreover, the Bank authorizes sub-projects on FONEI's approval. FoUowing analyses, therefore, are on an "approval" instead of the usual "commitment" basis.  - 19 - Mex$600 (US$48 million) would be in foreign exchange (Annex 24). The domestic currency needs would be covered by (a) internal cash generation, including loan collection, in the amount of Mex$137 million, and (b) at least. Mex$500 million (US$40 million) to be made available to FONEI by the Mexican Govern- ment. For this purpose the Government has expressed its intention to allow FONEI to issue bonds carrying at most a 10% p.a. interest rate and having a maturity of at least the life of the Bank loan. These bonds would be subscribed by financial institutions for meeting their reserve requirements. During negotiations the Government undertook to make available to FONEI such funds as shall be needed under the project, through arrangements satisfactory to the Bank. The proposed Bank loan of US$50 million would cover FONEI's foreign exchange needs during the next two years. 5.10 Projected Financial Results. Since FONEI's relending interest rate would be variable under the proposed loan, its financial projections and hence its financial results would be subject to a high degree of uncertainty. How- ever, even assuming a decline in FONEI's relending interest rate (Annex 25), its net income would still be satisfactory. Return on average total assets would increase from about 1% in 1974 and a still somewhat lower level in 1975, to an average of 1.4/ during 1978-79 because of the relative fall in administrative expenses, which include appraisal fees paid to intermediaries and consultants. Such expenses would remain relatively constant between 1975 and 1979, at 0.3% of average total assets. Total assets would increase more than seven times in the period 1974-79: a 50% p.a. growth rate (Annexes 20 to 22). VI. PROPOSED BANK LOAN 6.01 The proposed US$50 million loan to assist FONEI for the next two years in covering its foreign exchange requirements would be on terms and conditions usual for Bank loans to development finance companies, including the standard commitment charge. The borrower would be NAFIN. As under the first loan, Banco de Mexico would sign the Project Agreement and the Mexican Government would guarantee the loan. NAFIN would make arrangements with Banco de Mexico, satisfactory to the Bank, for the transfer of the pro- ceeds of the Bank loan. The proposed loan would be renaid by the Mexican Government to further increase FONEI's equity. Interest and other charges on the proposed loan would be paid by FONEI. 6.02 The Bank loan would cover the c.i.f. cost of imports, including goods purchased 5'off-the-shelf" from domestic distributors if c.i.f. prices can be established, or alternatively, a maximum of 70% (tariffs, local taxes, domestic freight, mark-up, etc. add up to an average of about 30% of the price) of the domestic price of imported goods. Only expenditures made up to 180 days prior to the date on which the Bank receives a subloan for approval would be eligible for Bank financing. The Bank's normal 90-day limit would be waived because of FONEI's double intermediation, a longer process. The terminal date for submission of subprojects under the loan would be June 30, 1978; the clos- ing date for disbursements, December 31, 1979 (Annex 26).  - 20 - 6.03 Retroactive financing. As requested by FONEI, the Bank loan would include provision for reimbursing FONEI for approved disbursements up to US$5 million equivalent, made between October 1975, when the new interest rate regimes were implemented and the date of the Loan Agreement. The projects eligible for retroactive financing (they must carry an interest rate of at least 13.5% p.a. to the final borrower) were agreed with FONEI during nego- tiations. 6.04 FONEI relending rates to final borrowers--and intermediaries--would be variable, as described in para. 4.29. The financial intermediaries would have an interest rate spread of 2%. The interest rate level, the formula, and the interest rate spread may be modified, however, in light of experience in consultations between Banco de Mexico and the Bank. FONEI's free limit would be raised from US$500,000 to US$750,000, in view of FONEI's increased experience. This limit implies that about 45% of the subprojects financed under the loan would require prior approval by the Bank. VII. RECOMMENDATIONS 7.01 During negotiations agreement was reached: (i) with the Government on: (a) FONEI's relending rate (para. 4.29); (b) provision of domestic currency resources for FONEI (para. 5.09); and (c) arrangements for the transfer to FONEI of the proceeds of the Bank loan (para. 6.01). (ii) with FONEI on: (a) consultation with the Bank on future change in its Operating Regulations (para. 4.02); (b) the abstention of IMIT's representative on FONEI's Board from participating in Board decisions involving IMIT appraised projects (para. 4.03); (c) steps and measures to improve the Technical Department staff (para. 4.11); (d) the transfer of project appraisal to the intermediaries, the reimbursement to intermediaries of appraisal costs, and the payment of a reasonable fee for individual project appraisals to those intermediaries which establish appraisal units (para. 5.06); and  - 21 - (e) list of projects eligible for retroactive financing (para. 6.03). 7.02 Approval by FONEtI's Board (Technical Committee) of acceptable Oper- ating Regulations for FONEI would be a condition of loan effectiveness (para.4.02). 7.03 The proposed project would constitute a suitable basis for a Bank loan of US$50 million to FONEI, as outlined in Chapter VI. To improve the country's external debt profile, the proposed loan would have a term of 16 years including three years of grace. LCPDF January 1976   If X ~ BRD -i0415 14~~ ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~66 '0 766760