Document of The World Bank FOR OFFICIAL USE ONLY Report No. 4398a-ME STAFF APPRAISAL REPORT MEXICO THIRD St-ALL AND MEDIUM SCALE INDUSTRY DEVELOPMENT PROJECT May 31, 1983 Projects Department Latin America and the Caribbean Regional Office This document has a restricted distribution and may, be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization. CUKKJNCY EQUIVALENTS Currency Unit Peso (Mex$) Since December 20, 1982, Mexico has the following exchange rates: (i) a sliding controlled rate for priority imports, most exports and service payments on foreigrn debt; this was set at 95 pesos per dollar on December 20 and was about 115 on May 20, 1983 (used in this report); and (ii) a free exchange rate for all other transactions; in recent days the free peso has been trading around 148 per dollar. LIST OF ABBREVIATIONS ACE Index of Average Cost of Funds to Multipurpose Banks BANXICO Banco de Mexico, S.A. CANACINTRA Camara Nacional de la Industria de Transformacion CEDI Certificado de Devolucion de Impuestos CENAPRO Centro Nacional de Productividad CEPROFI Certificados de Promocion Fiscal CEPSE Centro Empresarial de Perfeccionamiento Socio-Economico, A.C. CONACYT Consejo Nacional de Ciencia y Tecnologia CONCAMIN Confederacion de Camaras Industriales DGCP Direccion General de Capacitacion y Productividad DGE Direccion General de Empleo EFF Extended Fund Facility FIDEIN Fideicomiso de Conjuntos, Parques y Ciudades Industriales FIRA Fondo Instituido en Relacion con la Agricultura FISOMEX Fomento Industrial SOMEX FOGAIN Fondo de Garantia y Fomento a la Industria Mediana y Pequena FOMEX Fondo para el Fomento de las Exportaciones de Productos Manufacturados FOMIN Fondo Nacional de Fomento Industrial FONATUR Fondo Nacional de Turismo FONEI Fondo de Equipamiento Industrial FONEP Fondo Nacional de Estudios de Preinversion GDP Gross Domestic Product IDB Inter-American Development Bank IMCE Instituto Mexicano de Comercio Exterior IMF International Monetary Fund IMIT Instituto Mexicano de Investigaciones Tecnologicas INFONAVIT Instituto de Fomento Nacional de Vivienda para los Trabajadores INFOTEC Servicio de Informacion Tecnologica IPADE Instituto Panamer4cano de Alta Direccion de Empresa NAFINSA Nacional Financiera, S.A. PAI Programa de Apoyo Integral a la Industria Mediana y Pequena SDR Special Drawing Rights SECOFIN Secretaria de Comercio y Fomento Industrial SEDUE Secretaria de Desarrollo Urbano y Ecologia SEPAFIN Secretaria de Patrimonio Nacional y Fomento Industrial SFB Standard Factory Building SMI Small and Medium-Scale Industry SNE Servicio Nacional de Empleo SOE Statement of Expenditure SOMEX Sociedad Mexicana de Credito Industrial STPS Secretaria de Trabajo y Prevision Social FISCAL YEAPR January 1 - December 31 FOR OFFICIAL USE ONLY MEXICO - THIRD SMALL AND MEDIUM SCALE INDUSTRY DEVELOPMENT PROJECT STAFF APPRAISAL REPORT TABLE OF CONTENTS Page No. 1. THE INDUSTRIAL AND FINANCIAL SECTORS AND MEDIUM SCALE INDUSTRY. 1 A. Introduction ........................................ I Recent Economic Events .............................. 1 B. Manufacturing Sector Performance and Policy ......... 1 Growth and Structure ...................... . .1 Imports ........... .................................. 2 Exports ... .......................................... 3 Employment ......... ................................. 3 The Industrial Development Plan and Industrial Incentives ........................................ 3 Small and Medium Industry ........................... 4 C. The Financial Sector ............................ 5 Institutional Structure ............................. 5 Credit Availability and Interest Rate Policy ........ 6 SMI Financing ....................................... 7 D. Prospects, Policy and the Project ................... 8 Prospects .......................................... 8 Policy .............................................. 8 The Project ............ 9 II. THE INTEGRATED SMALL AND MEDIUM SCALE DEVELOPMENT PROGRAM (PAI) ................ . 11 Introduction ........................................ 11 PAI's Organizational Structure ...................... 11 The Industrial Extension Service .................... 12 This report was prepared by Messrs. Claudio J. Joseph, and George Faillace, Ms. Judith Press, LCPI2; Ms. Michelle Pilon, LCP; and Mr. A. Cabral de Andrade, (Consultant), following two missions to the field in September/October, 1982 and January 1983, respectively. | 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. - ii - Table of Contents (Continued) Page No. Specialized Technical Assistance Institutions ....... 13 - INFOTEC . .13 - Direccion General de Capacitacion y Productividad . .14 - Direccion General de Empleo . . 14 - Other Specialized Technical Assistance Institutions ................. ................ 14 Participating Lending Institutions .... .............. 15 A. Fondo de Garantia y Fomento a la Industria Mediana y Pequena (FOGAIN) ........................ 15 - Organization, Management and Staffing 15 - Operating Regulations and Policies .16 - Onlending Interest Rates . .16 - Participating Intermediaries . .17 - Past Operations and Impact . .17 - The Credit Guarantee Scheme . .18 - Past Financial Performance . .18 - Project Appraisal and Supervision . .19 - Procurement and Disbursement . .19 - Accounting Procedures, Data Processing and Auditing Arrangements . .20 - Projected Demand. 20 - Operational and Financial Projections . .21 B. Fondo Nacional de Fomento Industrial (FOMIN) . ....... 22 - Background and Objectives . .22 - Organization, Management and Staffing . .22 - Investment Goals . .23 - Investment Instruments . .23 - Past Performance ................. e..... 24 - Portfolio Quality . .24 - Project Appraisal and Supervision . .25 - Procurement and Disbursement . .25 - Accounting Procedures and Auditing . .25 - Financial Position and Projections . .26 C. Fideicomiso de Conjuntos, Parques y Ciudades Industriales (FIDEIN) .26 - Background, Objectives and Organization 26 - Organization, Management and Staffing . 27 - Past Performance ........................... . 27 - New Program . .28 - Project Appraisal and Supervision . .28 - Procurement and Disbursement . .29 - Accounting, Credit Control and Auditing 29 - Financial Situation and Projections . .29 - iii - Table of Contents (Continued) Page No. III. THE PROJECT AND THE PROPOSED BANK LOAN ........................ 31 Experience Under Previous Bank Loans ..................... 31 Focus of Proposed Third Project .......................... 31 Size of Program and Proposed Loan ........................ 32 - The Credit Component .32 - Working Capital Subprojects .34 - Investment Subprojects .34 - Common Facilities Subprojects .34 - The Risk Capital Component .34 - The Industrial Estates Component .35 - The Technical Assistance Component .35 Loan Channelling and Repayment Arrangements .... .......... 35 Procurement and Disbursement ............................. 36 Approval Limits .......................................... 37 - FOGAIN .............................................. 37 - FOMIN ............................................... 37 - FIDEIN .............................................. 37 - Technical Assistance ................................ 37 Auditing ................................................. 37 Project Benefits and Risks ............................... 37 - Risks ............................................... 38 IV. AGREEMENTS REACHED AND RECOMMENDATION ......................... 39 A. Agreements and/or Understandings Reached .... ........ 39 B. Recommendation ...................................... 40 LIST OF ANNEXES Annex I - The Average Cost of Funds (ACF) Index Annex 2 - Estimated Quarterly Schedule of Bank Loan Disbursements Annex 3 - Project Execution Document - iv - Table of Contents (Continued) Annex 4 - Supporting Tables T-1 Structure of Gross Value of Industrial Production by Type of Goods (Current Pesos), 1970-1980. T-2 Structure of Gross Value of Industrial Production by Type of Goods (Constant Pesos), 1970-1980. T-3 Structure of Value Added by Type of Goods (Current Pesos), 1970-1980. T-4 Structure of Value Added by Type of Goods (Constant 1970 Pesos), 1970-1978. T-5 Structure of Industrial Imports by Type of Goods (Current Pesos CIF), 1970-1978. T-6 Structure of Industrial Exports by Type of Goods (Current Pesos FOB), 1970-78. T-7 Summary of Principal Fiscal Incentives for Industrial Investment Under Original 1979 Decrees. T-8 Alternative Incentive System for Employment Generation. T-9 Value of Investment Approved Under Investment Incentive Laws by Priority Classification. T-10 Manufacturing Industries CEPROFIs Issued for Actual Investment, 1979-1981. T-11 Number of Industrial Establishments, Employment and Value Added by Manufacture, According to the Number of Employees, 1970 and 1975. T-12 Structure of Manufacturing Industry, 1970-1975. T-13 Organization Chart of FOGAIN and PAI Secretariat. T-14 Integrated Small and Medium Scale Industry Program (PAI) Financial Statements. T-15 Estimated Breakdown of Technical Assistance Component by Institution for the Proposed Project Loan. T-16 Analysis of FOGAIN's Total Credit Operations, 1954 to 1982. T-17 FOGAIN's Balance Sheets and Income Statements Audited and Unaudited, 1980-1982. T-18 FOGAIN's Projected Sources and Uses of Funds. -v- Table of Contents (Continued) Annex 4 - Supporting Tables (Continued) T-19 FOGAIN's Projected Balance Sheets, 1983-1987. T-20 FOGAIN's Projected Income Statements, 1983-1987. T-21 FOGAIN's Current Interest Rate Structure. T-22 Summary of FOMIN's Investments, 1978-1982. T-23 Economic Activity of Firms Supervised by FOMIN, 1978-1982. T-24 FOMIN's Equity Investment Held. T-25 FOMIN's Convertible Credit Operations. T-26 Revenues from FOMIN's Disinvestments, 1980-1982. T-27 FOMIN - Audited and Projected Balance Sheets, 1980-1987. T-28 FOMIN - Audited and Projected Income Statements, 1980-1987. T-29 FOMIN's Sources and Applications of Funds, 1983-1987. T-30 FIDEIN - Audited and Projected Balance Sheets, 1980-1987. T-31 FIDEIN - Audited and Projected Income Statements, 1980-1987. T-32 Resources Needed for Support of FIDEIN's Expected Level of Operations, 1983-1986. Annex 5 - Selected Documents and Data Available in the Project File MEXICO - THIRD SMALL AND MEDIUM SCALE INDUSTRY DEVELOPMENT PROJECT I. THE INDUSTRIAL AND FINANCIAL SECTORS AND SMALL AND MEDIUM SCALE INDUSTRY A. Introduction 1.01 Recent Economic Events. The discovery and exploitation of significant petroleum reserves was a major contributor to the rapid expansion of the Mexican economy during the four years from 1978-1981. Similarly, the recent oil glut has been the immediate, though not the underlying, cause of Mexico's current recession. Petroleum exports, coupled with Mexico's large borrowings abroad, enabled the Government to maintain the peso at a level inconsistent with the differential between foreign and domestic inflation rates, which grew progressively as a result of the Administration's liberal demand management and investment policies 1/. The sums borrowed abroad amounted, by the end of 1982, to some US$80 billion; new debt was contracted increasingly on a short-term basis after June 1981. The exchange rate and the very high level of investment - which grew by 15% in real terms in 1981 - contributed to a strong increase in merchandise imports (20% in real terms in 1981). The world-wide recession contributed to the recent oil glut which, with the resultant shift in expectations, precipitated adjustments in exchange rate and demand management policies from February 1982. As the situation continued to deteriorate, the Mexican authorities introduced exchange controls in early August 1982 and again devalued the peso; on September 1, 1982, the private banks were nationalized. 1.02 Since the change in Administration on December 1, 1982, further austerity measures have been announced, and new national and sectoral development plans are under preparation (see paras. 1.27-1.29). The peso was devalued for the third time in less than a year in December 1982 and a dual exchange rate policy was introduced; the official rate has been depreciated on a daily basis since then to reflect the differential between domestic and international inflation rates. The exchange rate in mid-May, 1983 was around 115 peso3 to the US dollar for official transactions, and around 148 for free transactions, as opposed to 26.90/US$ before the February 1982 devaluation. A SDR 3.6 billion Extended Fund Facility was approved by the IMF in late December 1982; a further US$7 billion in net new financing is estimated to be required to support the stabilization program in 1983. An agreement was reached on March 4, 1983 for US$5 billion of this amount from Mexico's commercial creditors, and the remaining US$2 billion is being sought from official sources, including resource transfers from the multi-lateral banks. At the same time, the banks refinanced Mexico's US$20 billion of debt maturing through December 31, 1984. B. Manufacturing Sector Performance and Policy 1.03 Growth and Structure. Recent growth rates for both the economy as a whole and manufacturing in particular are summarized in Table 1.1. While this table highlights the impressive growth in GDP and employment during 1977-81, it also reveals the very high real growth in imports over the same period. 1/ Mexico's inflation rate was 28.7% in 1981, accelerating to 98.8% in 1982, while the public sector deficit reached 15% of GDP in 1981, increasing to 18.5% in 1982. - 2 - Table 1.1: Growth Rates of Key Indicators, 1971-1981 Average Annual Real Growth Rates 1971-74 1975-77 78-81 (%) Economy Mfg. Economy Mfg. Economy Mfg. GDP (V.A.) 6.8 7.4 4.4 4.1 8.5 8.7 Employment 4.1* 3.8* 4.1* 3.8* 5.7 6.8 Imports (Goods & Services) 10.2 10.6 -3.1 -7.2 25.6 28.1 Exports (Goods & Services) 11.3 8.7 6.8 0.6 8.9 7.4 * These data are for 1971-77. 1.04 Table 1.2 summarizes the changes in the structure of manufacturing value-added between 1970 and 1980. In particular, there has been a slight decline in the share of traditional goods, and a corresponding increase in the share of modern industrial goods. Table 1.2: Structure of Value-Added in Manufacturing a/ (in percentages) 1970 1980 Traditional Goods 51.5 46.4 Food, Beverages and Tobacco (27.9) (24.1) Other Traditional Goods (23.6) (22.3) Intermediate Goods 24.7 25.0 Modern Industrial Goods 20.1 24.0 Petroleum and Petroleum Products 2.7 1.6 a/ Excluding petroleum refinancing; see Annex 6, Tables 3 and 4 for detailed breakdown for 1970-1981. 1.05 Imports. During 1977-80, a policy of import liberalization was followed; thus in 1979 nominal protection for 24 out of 27 comparable manufacturing subsectors was lower than in 1970. After 1980, as the peso became increasingly overvalued, this policy was progressively reversed. This was to staunch the flow of imports: the growth of manufactured imports had averaged 32% annually (in real terms) over the three years 1977-1980 (Annex 4, Table 5). While liberalization made it possible, this growth in imports was primarily due to the high growth in the economy as a whole. Most of the increased imports were intermediate goods, such as certain petrochemicals and - 3 - basic metals, and capital goods required by the substantial investment boom. Imports of manufactures represented 12.8% of domestic consumption of manufactures in 1980, as opposed to 9.7% in 1970. 1.06 Exports. Manufactured exports grew significantly between 1976 and 1979, peaking in 1978 at 5.5% of the gross value of manufacturing output, as compared to 3.8% in 1970. However, declines were recorded in both 1980 and 1981; in 1980 manufactured exports represented 3.7% of the gross value of manufacturing output. While external market conditions have played a fundamental role in the development of exports, the decline in 1980 and 1981 reflected the growing loss of competitiveness due to the appreciation of the real exchange rate. Until December 1982, the CEDI (Certificado de Devolucion de Impuestos) system provided fiscal incentives to exporters; financial incentives continue to be provided through FOMEX (Fondo para el Fomento de las Exportaciones de Productos Manufacturados). The subsector which showed the most dynamism during the 1970s was the engineering industries, comprising metal products, machinery and equipment, whose share in manufactured exports rose from around 11% in 1970 to 28% in 1980 (Annex 4, Table 6). These products are not in general resource-based, and their export reflects growing technological mastery as well as the relatively inexpensive skilled labor which is available in Mexico. 1.07 Employment. Employment generation from 1971 to 1981 was substantial, particularly from 1978 on (see Table 1.1 above). The results after 1977 can be attributed in part to the macroeconomic strategy followed by the Lopez Portillo Administration, which relied on high GDP growth to generate sufficient employment. In fact, although productivity was still increasing, productivity growth declined in manufacturing during this period, as in most other sectors, and thereby contributed significantly to employment generation. 1.08 This decline in productivity growth was not altogether surprising, despite the fact that much new investment coming on-stream was capital-inten- sive. The rapid growth in the manufacturing labor force during the four years 1978-81 meant that, by the end of 1981, almost one in four of the total work force had been hired during that period. In the case of the Machinery and Equipment subsector, this ratio was almost one in three. It is difficult to see how such a large number of new workers could be adequately trained, either prior to hiring or on-the-job, to enable productivity growth rates to be maintained. This was also corroborated by circumstantial evidence sug- gesting increasing difficulties in obtaining skilled labor and even, in certain cases, unskilled labor. It seems, however, that the strength of aggregate demand, together with the industrial protection policies which enabled firms to sell as much as they could produce, encouraged the continued hiring of new workers, even as marginal productivity declined. 1.09 The Industrial Development Plan and Industrial Incentives. The Industrial Development Plan of 1979 set out the Government's basic sectoral objectives, including: accelerating the generation of employment opportunities through rapid growth, promoting industrial investment in accordance with regional priorities, increasing the real income of the population, orienting industrial production towards external markets and promoting indigenous technological growth in industry. The public sector's role in achieving these objectives was set out in the Plan, including direct investment in strategic subsectors and in economic and social infrastructure. - 4 - 1.10 For the private sector, the main policy instrument was the industrial investment incentive system, with fiscal incentives in the form of tax rebate certificates (CEPROFIs) for additional investment and employment generation. Annex 4, Table 7 summarizes the system, and shows how these incentives varied in accordance with the regional and subsectoral priorities. Small enterprises received higher investment incentives (25%) than any other type of industry, but no employment incentive. In addition to the fiscal incentives, special prices for certain energy-related inputs supplied by public sector enterprises were offered to favor the location of new industries in the priority development areas, comprising four industrial ports. 1.11 Traditional investment incentive schemes have generally contained no incentive to employment; the Government had recognized this shortcoming, and therefore included employment incentives in the CEPROFI system. The magnitude of these incentives was not sufficient, however, to overcome the anti-labor bias of the traditional system, let alone the anti-labor bias implicit in other policies. Although there has been no study examining the capital-intensity of total new investment since 1979, data on CEPROFIs authorized and issued (Annex 4, Tables 9 and 10), suggest that the bulk of investment took place in the more capital-intensive sectors. In view of these problems, the CEPROFI system was revised in March, 1982 introducing, as an alternative, a scheme providing no investment subsidy, but an increased employment incentive (Annex 4, Table 8). The revised system is favorable to industries which are either quite capital-intensive or quite labor-intensive, but leaves those with intermediate capital/labor intensities at a disadvantage; it also displays a bias in favor of fixed capital as opposed to working capital. 1.12 Small and Medium Industry. There are indications that small and medium industry 2/ (SMI) has been able to participate in the recent growth and that a number of former SMI enterprises have moved into the category of large industry during this period of expansion. Table 1.3 is based on the 1970 and 1975 industrial censuses 3/; while the total number of establishments remained slightly above 23,000, total employment grew from under 1.4 million to over 1.5 million between 1970 and 1975. Given the overall trends in employment generation between 1975 and 1981, SMI employment may have increased by more than 600,000 during this period. 2/ Establishment with between six and 250 employees. 3/ The results of the 1981 census are not yet available. Table 1.3: CHARACTERISTICS OF INDUSTRY CLASSIFIED BY SIZE OF ESTABLISHMENT a/ (Percentages) Distribution of Value-Added Establishments Employment (millions of pesos) 1970 1975 1970 1975 1970 1975 6-50 workers 76.9 75.9 21.1 18.3 13.3 11.1 51 - 250 workers 18.5 18.8 33.3 30.5 30.6 27.6 Over 250 workers 4.6 5.3 45.6 51.2 56.1 61.2 Total 100.0 100.0 100.0 100.0 100.0 100.0 a/ The group of enterprises with up to 5 employees has been omitted from these comparisons. About half of the employees in this group are unremunerated family members. SOURCE: Industrial Census for 1970 and 1975. 1.13 The 1975 industrial census suggests important changes in the size structure of industry. In common with other industralizing and industrialized countries, there has been a tendency towards increasing the average size of industrial establishments. A comparison of the 1970 and 1975 censuses show that even in this relatively short period large industry increased its share of overall employment from 45.6% to 51.2% and its share of value-added from 56.% to 61.2%. 1.14 Within SMI there have been significant changes in output structure (Annex 4, Tables 11 and 12). Between 1970 and 1975, the share of the traditional consumer goods industries in the total value-added by SMI (excluding mining) declined from 41.3% to 35.8% for food, beverage, tobacco, textiles, clothing and shoes. The share of modern industrial goods (para. 1.04) grew from 16% to 24%, over this period. While this trend is typical for an industrialized country, these changes within the SMI grouping were more marked than those of industry as a whole (Table 1.2). This change has important implications for future growth patterns, since these modern industrial goods are very likely to be the most dynamic group as the indus- trialization process accelerates, particularly following the recent devalua- tions and the decline of imports, if advantage is taken of the opportunities further to substitute imports of these goods. There are also new opportunities for manufactured exports, which can be expected to increase with the world recovery. C. The Financial Sector 1.15 Institutional Structure. On August 31, 1982, Mexico's banking system comprised some 76 financial intermediaries, including the Central Bank (Banco de Mexico), other public banks, and commercial and mixed-ownership -6- banks. The number of financial intermediaries had been declining steadily from over 200 in 1978, due to a change in the Banking Law that year encourag- ing the consolidation of specialized banks into multipurpose "multibancos". Other financial institutions included insurance and guarantee companies, credit unions and the securities market, and jointly accounted for about one quarter of total financial intermediation. 1.16 The commercial banks made industrial loans and investments primarily using resources mobilized via current and savings accounts, deposits and the issue of certificates and bonds; however, they also had access to resources through the public sector trust funds, which were set up to channel additional financial resources to sectors the government considers a priority. These funds derived their resources principally from the reserve requirements of the banking system, although several have also received loans from local and international sources, including the Bank. The most important trust funds providing financing to the industrial sector are among those managed by Nacional Financiera (NAFINSA) and Banco de Mexico. 1.17 Among the public sector banks, NAFINSA is by far the most important one supporting the industrial sector; as well as administering several Gov- ernment trust funds, it has fulfilled a combination of development banking, commercial banking and industrial promotion activities and acted as an agent of the Government in obtaining external borrowings. The main NAFINSA- administered trust funds supporting industrial activities are FOGAIN (credit to small and medium scale industry), FOMIN (equity and quasi-equity financing to small and medium scale industry), and FIDEIN (promotion and development of industrial parks). The principal industry-related trust funds administered by Banco de Mexico are FONEI, which finances relatively large export and efficient import substitution projects in the industrial sector, and FOMEX, whose main activity is pre- and post-export financing. 1.18 Although it has grown rapidly following a series of reforms in the mid-1970s, Mexico's securities market is still relatively small and has not yet developed into a very important mechanism to finance industrial firms. In 1980, new issues of shares and fixed interest securities accounted for only 4.2% of the country's total financing through financial intermediaries. Comparatively few, mostly well-established and large, companies are listed in the organized securities market. Recognizing the limitations of the existing securities market, the Government has been providing equity and quasi-equity financing through direct investments undertaken by NAFINSA, FOMIN and FISOMEX (holding company wing of the mixed-ownership bank SOMEX). 1.19 On September 1, 1982, the privately-owned commercial banks were nationalized. While it seems that this action is irreversible, the Adminis- tration which took office on December 1, 1982 has declared its intention of allowing the system to operate in an autonomous manner, as in the past. The issue of a changed role for organizations such as NA.FINSA has nevertheless been raised, and the ramifications of the nationalization for the financial sector as a whole are not yet entirely clear. 1.20 Credit Availability and Interest Rate Policy. In 1981, credit availability was high, although domestic credit to the non-banking private sector remained almost constant in real terms. Foreign currency financing to this sector through the domestic banking system increased by almost 48% in - 7 - real terms in 1981, for a total private sector real increase (domestic and foreign currency) of some 7.3%, as compared to a 12% increase in 1980. Financing to the public and private sector together increased almost 22% in real terms in 1981, up from 6.4% in 1980. The net outstandings of the manufacturing sector increased by 12.3% in real terms in 1981, and represented about 16% of the total net increase in outstandings. In 1982, as Mexico's economic situation deteriorated, credit availability declined significantly in real terms, by about one-thrid. 1.21 Although interest rates on deposits were positive in real terms during 1981, they became negative in real terms during 1982, as inflation surged following the major devaluations. The new Administration, however, has stated its intention to allow deposit interest rates to rise to levels that would encourage a positive flow of capital to Mexico. Based on the stabilization program being implemented with IMF support, deposit rates should be reasonably in line with expectations with respect to inflation by the end of 1983. Lending interest rates are also negative in nominal terms at present, but effective rates are considerably higher, and positive in real terms, due to banking practices which involve monthly compounding of interest payments, prepaid interest and compensatory balances. Since trust fund loans do not allow the use of these banking practices, but still wish to advertise rates that are competitive in nominal terms, their lending rates have also been negative in real terms. 1.22 Since 1977, practically all term loans have been made at floating interest rates, using as an index the average cost of deposit funds (ACF) to investment banking departments of intermediaries 4/. Since December 1979, the ACF index has been based on the average cost of all term resources (3 days to 2 years) to the commercial banking system; it is thus a broad and good indicator of the cost of these funds in the Mexican financial system. The May, 1983 ACF index of 58.14%, represents a considerable increase over the 36.26% ACF of May, 1982. 1.23. SMI Financing. Small and medium industry has always had some difficulty finding financing due to the considerable collateral requirements generally imposed by the banking system. FOGAIN's outstandings at end-1981 represented some 5% of total banking system outstandings to manufacturing; while SMI receives financing from other parts of the banking system, it is estimated to be of the order of only some 15% of total credit to manufactur- ing. Thus, SMI's share of financing still falls well below its approximately 35% share of value-added. FOGAIN has estimated that as many as two out of three SMIs in Mexico may never have used credit from the banking system; this could be a major factor in inhibiting more rapid growth in SMI value-added and employment generation. 1.24 SMI's need for financing has also increased in the last year as the economic situation has deteriorated. As a result of the foreign exchange shortage, imports have been closely controlled; when they are available they are much more costly than previously, due to the severe devaluations. These 4/ The index is a weighted average of interest rates paid on bonds, notes, and certificates of deposit, and excludes checking and savings accounts. - 8 - increased costs are reflected in higher inventory costs for the many SMIs which require imported inputs, particularly since such inputs may have to be purchased whenever they are available rather than as required. Also, many enterprises had contracted significant US dollar-denominated debt which assumed increasing importance in peso terms as the exchange rate fell; while comparatively few SMIs had such debt, most have been indirectly affected by the consequent liquidity squeeze. Thus, precisely because they are small, SMIs find it difficult to resist pressure to keep their accounts payable current, at the same time that they find their accounts receivable collection period considerably extended. Inflation has also put direct pressure on SMIs, which cannot always immediately pass on higher prices. In response to this liquidity shortage faced by much of the economy, and in particular SMI, the Mexican government in September 1982 authorizEtd Mex$50 billion (about US$500 million) in emergency funds, to be distribttted through four trust funds. Half of this amount was allocated to FOGAIN9 and was committed and largely disbursed in the last quarter of 1982. D. Prospects, Policy and the Project 1.25 Prospects. Mexico is currently undergcing a major recession requiring significant structural adjustment. Wtfhile an Extended Fund Facility (EFF) was approved by the IMF in December 1982, projecting stagnant GDP in 1983 and a slow resumption of growth from 1984 on, the recent further decline in world oil prices may tend to deepen and prolong Mexico's recession. In either case, it is clear that Mexico will be operating under dual constraints during the next few years with, on the one hand, the need for fiscal restraint and for significant inflows of external resources and, on the other hand, the need to maintain social stability, with one key element being the adequate absorption of new entrants to the labor force, who currently number in excess of 800,000 per annum. 1.26 It is clear that industry has a critical role to play in assisting Mexico to return to a stable growth path: industry can contribute to the alleviation of both the external constraint, through increased exports, and the domestic constraint, through improved labor absorption. Small and medium industry can be expected to make an important but somewhat smaller contribution than larger enterprises to the first goals due to some of the inherent disadvantages that small production volume causes for the export of some products. But SMI can make a proportionally greater contribution to the second objective since SMI tends to be more heavily concentrated in the more labor-intensive branches of industry. In order to be able to fulfill this role, however, SMI will require adequate working capital to overcome the current difficulties and to respond to the new opportunities. 1.27 Policy. The new Administration is revising both the macroeconomic and the industrial sector policy framework to take account of these new realities. The main elements of the macro-framework for the short to medium-term are already in place, and largely reflect the EFF agreement: the public sector deficit is to be considerably reduced, and a flexible exchange rate policy is being followed. The Government is currently preparing the longer-run macro policy framework, which is expected to be made explicit in the Plan Nacional de Desarrollo (National Development Plan) for 1983-1988, due to be published in late May 1983. According to recent speeches by the President, employment and exports will be two major focal areas (paras. 1.28 - 9 - and 1.29 below). In addition, maintenance of an adequate supply of low cost basic consumption goods remains a high priority, but emphasis will be placed on efficient production and marketing rather than on direct price controls as means to this end. Encouragement of industrial decentralization and regional development will continue, with greater delegation of responsibility for implementation from the Federal Government to state governments. 1.28 The detailed sectoral policy framework is likely to take longer to become explicit: the sectoral plans deriving from the Plan Nacional are not due until late September 1983. The general objectives and main lines of industrial policy have already been determined, however. The recent changes in foreign exchange policy have already resulted in a shift in relative prices towards tradeables, thus favouring both exports and efficient import substitution. There nevertheless remain significant disincentives to exports, largely because exporters are subject to cumbersome administrative requirements, as well as other barriers, relating to imperfect knowledge of international production norms and standards and other similar problems. Trade policy will be directed to overcoming these disincentives and barriers. 1.29 The second major area of concern in industrial sector policy will be employment. Short-term measures have already been announced in the context of the Programa para la Defensa de la Planta Productiva y el Empleo. Longer-term measures will largely involve further changes in the relative price of capital and labor. The largest single cause of the artificially low price of capital in the last few years was the increasingly overvalued exchange rate, which has now been corrected. Other contributing factors related to interest rate policy and energy pricing policy, which have also been addressed by the new Administration. Further changes in relative prices may be achieved through a revision of the investment incentive (CEPROFI) scheme, possibly to a system which gives only employment incentives; such a revision is currently under consideration. In addition, the Administration was concerned that the system of labor-and employment-related data collection and analysis was not adequate given the importance of these matters for policy formulation. It has therefore strengthened the institutional struc- ture for this work, and an improved system to provide timely and reliable data, with wider coverage, is now being implemented. 1.30 The Project. The reorientation of Mexico's industrial strategy, as outlined above, is in the directions advocated by the Bank and deserves con- tinuing Bank support. In particular, a further lending operation to support the PAI program appears well justified in view of: (i) the effectiveness of the program so far in respect of employment creation and regional develop- ment; (ii) the strong support for PAI expressed by both the outgoing and incoming Administrations; and (iii) the useful role that the Bank can play in helping PAI further to develop and adapt its activities to reflect the evolving industrial strategy. Processing this project has also provided further opportunities for an effective dialogue with the Government on employment issues: the Mexican authorities have prepared a policy statement on employment in the context of the project. This statement clarifies the types of measures the Government has taken, and plans to take, to encourage the growth of more labor-intensive activities, and to improve the system for monitoring employment and labor market developments during the period of economic adjustment, along the lines mentioned in para 1.29 above. - 10 - 1.31 The project also seeks to support some concrete actions in various areas. In particular, provision has been made in the technical assistance component to support, through financing consultant studies and equipment acquisition, implementation of the improved labor- and employment-related data collection and analysis system mentioned in para. 1.29 above. The technical assistance component also includes an element designed to improve SMI access to the labor markets. In addition, through the industrial extension service, the project seeks to assist SMI working in collective action groups that wish to improve their worker training capabilities and to develop exports. - 11 - II. THE INTEGRATED SMALL AND MEDIUM SCALE INDUSTRY DEVELOPMENT PROGRAM (PAI) Introduction 2.01 The PAI program was established by Nacional Financiera (NAFINSA) in 1978 (with Bank support) to strengthen and make more effective the extensive framework of institutions providing financial and technical assistance to SMI. The program has the following main objectives: (a) to encourage more rapid growth in output and employment in SMI; (b) to promote and facilitate the achievement of national plans for industrial decentralization and regional development; (c) to foster a more comprehensive and effective system of finan- cial and technical assistance support for SMI; and (d) to develop a mechanism which would allow SMI assistance programs to be adapted to reflect national industrial development goals. 2.02 The principal participants in the PAI program are: (i) a credit and guarantee fund (FOGAIN) which channels resources through the commercial banking system; (ii) a risk capital financing fund (FOMIN); (iii) a credit and tech- nical assistance fund (FIDEIN) which supports the development of industrial estates; (iv) an extension service group which helps SMIs to identify their financial and technical assistance needs and to obtain such assistance from one of the above funds or from specialized agencies and technical institutions; and (v) a Coordinating Committee with a Technical Secretariat, which oversees the working of the PAI program as a whole. 2.03 The first two Bank projects to assist small and medium industry supported the initiation and rapid expansion of the PAI program and its parti- cipants. The proposed third project would build on the results achieved to date by expanding some elements of the program and helping to consolidate or better to focus others. Following the recent nationalization of the banking system, the government has expressed its intention to consolidate and redefine the roles of some financial institutions in order to achieve better coordination, reduce duplications and realize some economies of scale. This is expected to affect NAFINSA and possibly some of the trust funds participating in the PAI program, but the detailed changes have not yet been decided. At the same time, it is desirable that some elements of the PAI program be redirected and streamlined to take into account past experience and the changing needs of the economy. A Project Execution Document, covering NAFINSA's intentions regarding the future development of the various elements of the PAI program, was agreed by NAFINSA and the Bank during negotiations. Particular points covered in this document, which is attached as Annex 3, are described later in this chapter as part of the discussion of individual elements of the PAI program. PAI's Organizational Structure 2.04 PAI is governed by a Program Coordinating Committee, which is headed by the Director General of NAFINSA and includes the heads of all the participating institutions as well as the representatives of the Ministry of Finance (SHCP), the Ministry of Commerce and Industrial Development (SECOFIN), and Banco de Mexico. The Committee's responsibilities include setting policies and priorities for PAI operations and for the use of PAI resources, reviewing the results of PAI's operations, including the general characteristics of - 12 - subprojects submitted for financing, and coordinating the activi'les of the various participating institutions. In addition, there is a working level Technical Coordinating Committee, which coordinates the efforts of the various participating lending and specialized technical assistance institutions. 2.05 The Technical Secretariat, which reports to the Program Coordinating Committee, provides the administrative mechanism necessary to implement PAI, and is responsible for the execution of the technical assistance and promotion subprograms through its extension services and for linking up with other institutions that provide services for SMI (see diagram). To date, the posts of Technical Secretary and Director General of FOGAIN have been assigned to the same person, to whom two deputy directors report, one responsible for the PAI Secretariat and the other for FOGAIN. In order to achieve economies of scale, a number of administrative functions are shared between PAI and FOGAIN, PAI Coordinating Committee PAI Secretariat Technical (Technical Secretary) Coordinating _ l 1 ~~~~~~~~Committee | 1 ~~~PAI Extension| Services Len ding Specialized Technical Institutions 1 | Assistance Institutions5/ FOGAIN INFOTEC FOMIN Direccion General de Empleo FIDEIN Direccion General de Capacitacion y Productividad The Industrial Extension Service 2.06 A central feature of the PAI program has been the creation of an industrial extension service which currently operates 26 branches, grouped into eight regions, with a staff of 117 professionals. Because the qualifications of the extension officers are quite high and salaries have been competitive, the extension service has had high administrative costs, but in the past these costs have been recovered through the margins and commissions earned from the financing channelled to FOGAIN and FOMIN by the extension agents. Nevertheless, the PAI service has been conscious that their work needs to be cost-effective. From making the program and its services known to local entrepreneurs initial- -ly, the extension officers' primary task has increasingly become the provision 5/ Herein considered as institutions, although they are two separate departments of the Labor Ministry (STPS). - 13 - of direct technical assistance to SMIs. As the agents gained in experience, they increasingly realized the high cost of providing only individual technical assistance; as a result, the extension service has recently been experimenting with ways to provide technical assistance to groups of SMIs rather than individual firms. One form of group action has been through training courses, held for both industrialists and commercial bank officials. Most of these training courses have been carried out by the local branch offices themselves, although in some cases they have been helped by other regional staff or CENAPRO, which has now become part of the new Direccion General de Capacitacion y Productividad in the Ministry of Labor. More significantly, PAI has developed an innovative program for clustering together firms in the same geographical area and with similar product lines (say, shoes or textiles, etc.), and imparting technical assistance to the group. The preliminary results of the work undertaken in late 1981 and 1982 with collective action groups were very promising, and considerable expansion in these types of programs took place in 1982. 2.07 The success of PAI's methods suggests that further work in estab- lishing and assisting collective action groups should be encouraged under the proposed project. However, given the considerable investment of staff time required, the costs and benefits of the program would need to be studied care- fully before embarking on an expanded program. During negotiations, agreement was reached with PAI and Government officials on the terms of reference and timetable for undertaking such a cost-benefit analysis, which should be completed by December 31, 1983. 2.08 As the extension service has evolved, the nature of referrals to the specialized technical assistance institutions has also changed, and coordina- tion with these institutions becomes more important, as their assistance becomes increasingly complementary to the extension services work. Specialized Technical Assistance Institutions 2.09 The experience obtained during the second SMI project with the different specialized agencies has made it possible to formulate more specific PAI-related programs for each specialized agency than in the past. A substantial portion of technical assistance funds under the project would be allocated to the three specialized agencies whose services are more closely linked to PAI's own activities, viz INFOTEC, the Direccion General de Empleo and the Direccion General de Capacitacion y Productividad (previously CENAPRO), which would enter into collaboration agreements with PAI. Technical assistance funds would also be available to support the Government agencies implementing the improved labor market-related statistical system (see paras. 1.29 and 1.31). The remaining technical assistance funds would not be allocated in advance, but would be available to be used on an ad-hoc basis for institutions whose assistance is required only occasionally or which may develop over the life of the loan. 2.10 INFOTEC (Fondo de Informacion y Documentacion para la Industria) has worked closely with PAI from the outset of the program. INFOTEC's services include an industrial information service, technical advice and courses on industrial technology. It now has a staff of about one hundred, most of whom are professionals. In the past INFOTEC has assisted PAI's SMI clients by providing information services via PAI's extension agents and also, although to a much lesser extent, through direct technological assistance in the field. The precise mix of services which INFOTEC will offer PAI's clients - 14 - in the future will vary; however, in general terms, it is expected that INFOTEC would increase its direct technological assistance in the field, and expand the information services that it has provided up to present, making material available in a form which is more understable by small and medium industrialists. In addition, INFOTEC would initiate three new activities: it would (i) develop regional data banks to help firms make decisions with regard to plant location and relocation and generally help small and medium industries know local markets better; (ii) establish and operate a quality control program through extension agents and collective action groups; and (iii) establish a program of industrial audits of FOMIN's investee firms in order to detect weaknesses which require action by their management (para. 2.47). 2.11 The Direccion General de Capacitacion y Productividad (DGCP), in the Ministry of Labor, was established in the 1960s as CENAPRO-ARMO to help train and develop managers as well as to provide vocational training programs for workers. In the past, CENAPRO assisted PAI in training its extension agents and has also provided materials for SMI managerial development. Under the proposed project, it is expected that DGCP would: (i) train PAI extension agents to become instructors in management development courses and also make the necessary material available to them; (ii) advise collective action groups that wish to set up their own training centers, covering both legal and organizational aspects and the development of training programs; and (iii) develop more appropriate training for SMI entrepreneurs and managers. 2.12 The Direccion General de Empleo (DGE), in the Ministry of Labor, coordinates the Servicio Nacional de Empleo (SNE), and the Directorate for Employment Planning. The Servicio Nacional de Empleo comprises the policy unit, with the individual State Employment Services as the operating units. SNE's current role is primarily as a labor exchange and, in order to carry out this task more effectively, it routinely prepares regional studies to evaluate the labor markets and general labor needs. In view of PAI's potential role in helping small and medium industry address the present problems of employment maintenance and generation, a joint work program for PAI and the DGE is being developed. Under this program, it is expected that SNE would help SMIs identify their labor needs, preselect suitable candidates, and help define the training needs of potential employees. 2.13 The new Administration's concern with employment policy has been reflected in the raised hierarchical level of DGE (to Direccion General from Direccion) in the context of the restructuring of the Ministry of Labor. Measures to strengthen the technical capability of the State Employment Services are also planned. Financing for DGE to carry out some of its PAI-related activities would be included under the technical assistance component of the proposed project. 2.14 Other Specialized Technical Assistance Institutions expected to be brought in as required to provide technical assistance to SMIs through PAI include FONEP (Fondo Nacional de Estudios de Preinversion), CONACYT (Consejo Nacional de Ciencia y Tecnologia), IMCE (Instituto Mexicano de Comercio Exterior), and CEPSE (Centro Empresarial de Perfeccionamiento Socio-Economico, A.C.). All of these agencies have cooperated with PAI in the past, but since their services are fairly specialized and are used only as required, no special programs would be developed with PAI. - 15 - Participating Lending Institutions A. Fondo de Garantia y Fomento a la Industria Mediana y Pequena (FOGAIN) 2.15 FOGAIN, the most important financial institution for small and medium industry in Mexico, was established in 1954 as a government trust fund administered by NAFINSA. FOGAIN is a second-tier institution, rediscounting credits for equipment, machinery, civil works and working capital made by banks, credit unions and other financial intermediaries to SMI 6/ enterprises to add new, and/or expand existing, productive capacity. 2.16 Organization, Management and Staffing. FOGAIN's highest decision- making body is its Technical Committee which is headed by a representative from SHCP, and includes representatives from SECOFIN, Secretaria de Programacion y Presupuesto (SPP), Banco de Mexico, NAFINSA, Confederacion de Camaras Industriales (CONCAMIN), Camara Nacional de la Industria de Transformacion (CANACINTRA) and FOMIN. The committee decides matters of policy, procedure, financial plans and budgets, and approves credit operations, on the basis of recommendations made by FOGAIN's staff. FOGAIN's Director General is authorized by the Technical Committee to approve credit operations of up to Mex$11 million (US$95,650). 2.17 The previous Director General (1979-82), Mr. Gonzalez Hinojosa, reorganized its structure by delegating greater authority to middle management and consolidating certain functions and responsibilities, and streamlined administrative and operational procedures, upgraded middle management and promoted decentralization of staff to regional offices. This structure coupled with greater autonomy of regional offices7/, facilitated a rapid growth in FOGAIN's activities, particularly outside the Mexico City Metropolitan area. Presently, FOGAIN is a mature and dynamic organization staffed with experienced personnel. The new Director General for FOGAIN and PAI, Mr. Sergio Mota Marin is focussing his attention on strengthening FOGAIN's management information systems and further development of PAI's collective action groups by upgrading the extension service's technical support to SMI enterprises. 2.18 FOGAIN and PAI staff share the same Director General, regional office management and also some technical, administrative and financial areas. This dual character of PAI-FOGAIN has been generally positive. As of year-end 1982, FOGAIN's professional and semi-professional staff num- bered about 150, a 30% increase over year-end 1979. Salaries have been generally attractive, permitting FOGAIN to hire qualified professionals. 6/ Small-scale enterprises supported by FOGAIN are defined as firms with total equity between Mex$50,000 (US$435 equivalent) and Mex$15.0 million (US$130,000 equivalent). Medium enterprises have equity between Mex$15.0 million and Mex$90.0 million (US$782,600 equivalent). 7/ Regional credit representatives have the authority to approve FOGAIN's credits up to Mex$6 million (US$52,200). - 16 - 2.19 Operating Regulations and Policies. FOGAIN's regulations and policies allow industrial financing for: (i) working capital (up to Mex$20.0 million with terms between 1-1/2 and 3 years); (ii) fixed assets (up to Mex$20.0 rmillion with terms betwseen 3 and 6 years), and, (iii) debt consolidation (for up to Mex$12.0 million with terms between 4 and 7 years). The total amount of credit that FOGAIN can grant any single enterprise was raised to Mex$45.0 million (US$391,300 equivalent) on September 275 1982. FOGAIN's operational policy statement would be modified under the proposed project to include financing of industrial buildings in industrial estates (para. 2.59) and common service facilities (para. 3.06) During negotiations agreement was reached with the Governmnent and NAFINISA on the revised regulations and policy statement lFormal approval by FOGAIN's Technical Committee is a condition of loan effectiveness. To encourage rapid processing, FOGAIN grants special credit lines to some participating banks, permitting automatic rediscounts for credits up to Mex$5 mill-on (US$43,500 equivalent). FOGAIN reserves the right to cancel ex-post an-y subLoan found to be ineligible or not in accordance with FOGAINs regulations. C-ea-- line limits are adjusted periodically based on FOGAIN's experience w-ith individual banks. 2.20 Onlending Interest Rates, FOGAIN's iterest rate structure, which under the Second SMI Project (Loan t881-ME) consist:ed of twelve different rates varying by geographic zone, size and priority of inciustrial enterprise, has been recently simplified to six rates (Annex 4, Table 21), Interest rates are now variable and adjusted quarterly on the basis of movements of the ACF 8/ index which is the average interest rate paid by Mexican banks for term-deposits (para. 1.22). Interest rates are adjusted suen that their average equals ACF+1. The ACF index (58.14% in May 1983) is expected to remain an appropriate basis for setting on-lending interest rates under the new Administration's interest rate policy. As mentioned in para. 1.21 above, the Mexican authorities have affirmed their intention, in connection with the IMF agreement, to adjust deposit interest rates as needed to ensure adequate resource mobilization in the economy. 2M21 Several improvements are still needed in FOGAIN's interest rate structure. Because FOGAIN has used the average ACF for the previous 12 months as a basis for its quarterly adjustments, its interest rates have lagged seriously behind current deposit rates during the recent period of rapidly rising interest rates. Second, FOGAIN has not fully implemented its variable interest rate scheme, partly because of computer system and administrative problems and partly because of the very difficult cash flow situation of SMIs in Mexico (para. 1.24). Third, the basis for setting individual interest rates had not been clearly defined with the result that: (a) protracted negotiations took place each quarter; and (b) the dispersion between the lowest and highest rates became too large. Therefore, agreement was sought with the Mexican authorities on: (i) fully implementing the variable interest rate system with quarterly interest rate adjustments; (ii) having an average interest rate equal to at least ACF+1, based on the average ACF for the last three months (ACF); (iii) relating each of FOGAIN's interest rates to the ACF by a constant, to be specified in FOGAIN's interest rate structure; and (iv) reducing the dispersion between the highest and lowest rates. The first two 8/ See Annex 1. - 17 - points are reflected in the loan agreement and the third and fourth would be reflected in the interest rate schedule to be presented to the Bank before loan effectiveness. 2.22 Participating Intermediaries. The nationalization of the Mexican private banking system on September 1, 1982 is not expected to affect the proposed third SMI project significantly. While some consolidation of the banks by absorption of smaller banks and reduction of competing branches may take place, no significant changes are expected in the nationalized banking system, since the Mexican Government has expressed its intention to transform it into a mixed ownership banking system with shares traded in stock exchanges, and gradually increasing private sector participation. Presently, FOGAIN channels funds through about 54 bank groups and 38 credit unions authorized and inspected by the National Banking and Insurance Commission. Spreads for intermediaries range between 2.0 and 3.5 points. 2.23 Past Operations and Impact. From the beginning of its operations in 1954 until year end 1982, FOGAIN has assisted about 39,462 enterprises with more than 60,834 credits amounting to Mex$41.3 billion. FOGAIN provided an estimated 10.7% of total banking system credit to industry in 1981 (about 33% of total credits to the SMI sector). FOGAIN's operations have increased from 4,420 credits amounting to Mex$4.7 billion in 1979, to 7,911 credits amounting to Mex$23.2 billion in 1982, at an average annual growth rate of 70% in nominal terms and 14% in real terms. 2.24 About 89% of FOGAIN's credits (75% by amount) in 1982 were directed to enterprises with less than 50 employees. Small scale industry (equity of up to Mex$10 million) accounted for 81% of the credits (53% by amount) of its 1982 operations. In addition, FOGAIN's operations have contributed to regional development and decentralization. An estimated one-half of industrial value added in Mexico comes from enterprises located in areas of low priority (e.g., Zone III - Mexico City Metropolitan and surrounding areas). During 1982 FOGAIN directed 93% of its credits by number and 88% by amount to industrial priority zones located outside Zone III. 2.25 The three most important subsectors financed by FOGAIN have been metal processing and machine fabrication (18%), food products (18%) and manu- facture of footwear and other leather products (13%). SMI's manufacturing activities tend to be relatively labor intensive, and firms supported in 1982 had an estimated cost-per-job ratio of about US$12,000 (at 1981 prices), which is satisfactory. About 55% of the enterprises supported by FOGAIN in 1982 (compared to 60% in 1979) used its credit facilities for the first time, indicating that FOGAIN is still expanding its clientele. FOGAIN has emphasized fixed asset financing in recent years for expansion of the productive capacity of SMI enterprises. However, due to the increasing need for working capital- financing, fixed asset financing accounted for only 39% by amount in 1982, (compared to 54% in 1981). 2.26 Under the Second SMI Project, FOGAIN conducted an ex-post evalua- tion in 1981 of a representative sample of its operations supported by the Bank. The rates of return of the subprojects averaged almost 38% (financial) and 51% (economic) suggesting that FOGAIN has been an important element in - 18 - fostering the SMI sector's growth according to objectives and policies established by the Mexican Government. A similar ex-post evaluation of a representative sample of Bank-financed subprojects would be conducted by December 31, 1983. Agreement has also been reached with the Mexican authorities on conducting periodic surveys of the impact of the evolving economic situation on SMIs. 2.27 The Credit Guarantee Scheme. FOGAIN's guarantee scheme has had very limited use since it has not been provided with sufficient allocations to cover possible losses, and its guarantee coverage was restricted to no more than Mex$200,000. Since these operating regulations were included in FOGAIN's Statutes, amendment requires Congressional approval. A new credit guarantee program has been designed which would overcome the above-mentioned limitations, and which would include the following: (i) only small enterprises and common service facilities would be eligible; (ii) the guaLrantee would not exceed 75% of the value of a credit, which would not exceed Mex$3 million; (iii) a premium of at least 1.5% p.a. of the guaranteed amount outstanding 9/ to be paid by the sub-borrower; and (iv) the initial capitalization of the guarantee fund would be increased by the premiums paid and by additional capitalization. The revised Guarantee System is expected to encourage banks to lend to the substantial number of small enterprises in Mexico which do not have access to bank credit because of inadequate collateral. During loan negotiations agreement was reached on the Guarantee Fund policy regulations that would be followed after Congress amended the law that created FOGAIN; these draft regulations are included in the Project Execution DocuLment (Annex 3), 2.28 Past Financial Performance. FOGAIN's loan portfolio has grown at an explosive rate of 25% in real terms in the 1979-82 period. By December 31, 1982 the total loan portfolio stood at Mex$33.6 billion (US$336 million). FOGAIN's portfolio, which represents 95% of its assets, at year-end 1982 was financed mainly by loans from Banco de Mexico (347), NAFINSA (18%), IDB (11%), equity (25%) and PAI (12%), including 7% from the Bank. BReflecting its position as a second-tier institution, FOGAIN has sufferred virtually no losses on its loan portfolio during its many years of operation. While FOGAIN does not incur any substantial credit risks v4s-a-vis its sub-borrowers in its operations, it is exposed to foreign exciange risks oni several 1DB loans and on one NAFINSA dollar-denominated loan. FOGAIN's accounting practice has been to defer the foreign exchange losses, amortizing them as principal and interest payments became due, rather than to record exchange losses or gains during the year, even when the transaction is not settled in rhe same accounting period as that in which the losses or gains are provisioned. In part to offset these losses and to strengthen FOGAIN's equity base, given its past rapidly growing portfolio, the Government has been capitalizing FOGAIN through anrual contributions and has been capitalizing the principal repayments of Bank funds channelled through PAIT FOGAIN's debt/equity ratio in December 31, 1982 stood 9/ It is expected that this premium would be sufficient fully to cover the fund's losses, as each credit operation is to be evaluated on its own merits prior to submission by the participating intermediary. Additionally, FOGAIN would rely on the advice of PAI's extension service regarding the clients concerned. - 19 - at 2.7:1. Subtracting from FOGAIN's equity the deferred exchange rate losses would cause the debt/equity ratio to rise to about 6:1, which is within the 10:1 limit of its operating regulations. At year-end 1982, arrears on loans represented less than 0.1% of total porfolio. A survey of the portfolios of a sample of participating intermediaries indicated that payments, on FOGAIN subloans, overdue by more than 90 days represented less than 0.8% of their outstanding balances by year-end 1982. 2.29 FOGAIN's income statement showed a moderate profit in 1980 (Annex 4, Table 17). During 1981 FOGAIN incurred losses of some Mex$68 million (US$2.6 million) and in 1982 losses of Mex$1.7 billion (US$17 million equivalent). FOGAIN's present portfolio is earning an average peso interest rate of about 18% compared to its average cost of funds, excluding its equity base, of about 30%. Since 1979, FOGAIN's subloan contracts have allowed it to adjust interest rates on outstanding loans, but FOGAIN has not done so (para. 2.21). While the average interest rate of its portfolio is expected to rise to about 25% during 1983 (as old loans with very low interest rates mature), losses almost double those incurred in 1982 can be expected (due to the negative spreads) unless appropriate adjustments to the interest rates are made (Annex 4, Table 20). During negotiations, agreement was reached with the Mexican authorities on a timetable for adjusting the interest rates of FOGAIN's outstanding loans to bring them into line with the revised interest rate structure for new subloans (para. 2.21). 2.30 Project Appraisal and Supervision. Intermediaries evaluate the creditworthiness and prospects of client enterprises before submitting sub- loan requests for FOGAIN's review and approval. Given the generally small size of FOGAIN's credits (para. 2.24), and the need for fast processing of these loans, Bank review of FOGAIN subprojects is only made ex-post on a sample basis. However, FOGAIN's appraisal procedures for fixed assets subloans are satisfactory. FOGAIN requests sub-borrowers to supply careful justification in the case of working capital loans, based on a detailed cash flow analysis covering salary payments, inventories, accounts payable and receivable. Revised criteria for appraising permanent working capital subloans have been agreed with the Bank, which would take into account the increased peso prices of inventories of raw materials, intermediate products, components and spare parts, using the applicants' 1981 and 1982 production levels and prices as a base. Follow-up of FOGAIN credits is adequately performed by the participating intermediaries, in addition to FOGAIN's own supervision. During the past three years FOGAIN's supervision unit, composed of seven experienced professionals, has performed a satisfactory supervision of a representative number of beneficiaries and intermediaries. 2.31 Procurement and Disbursement. Due to the nature of FOGAIN's sub- borrowers and the relatively small average loan size, it is often not practical for FOGAIN to insist on price quotations from several suppliers. However, as part of the credit evaluation, FOGAIN and its intermediary banks check that prices paid by sub-borrowers for goods and services to be financed are reason- able since, in many cases, the goods financed will be pledged as part of the collateral for the subloan. 2.32 The participating intermediaries are held responsible for ensuring that FOGAIN's financing is used for the purpose intended, and if any irregu- - 20 - larity is found, FOGAIN's loan is immediately fully reimbursed by the inter- mediaries. Disbursements are made by FOGAIN to participating intermediaries once they certify possession of purchase invoices, import documentation, or certificates of completion of structural and civil works. Generally, in cases of civil works and equipment installation, intermediaries establish disbursement schedules pari-passu with construction schedules, and confirmed by periodic visits to the job site. Based on samples from FOGAIN's supervision unit, disbursement documentation for subprojects appears to be generally acceptable. 2.33 Accounting Procedures, Data Processing and Auditing Arrangements. FOGAIN maintains an adequate internal accounting system, and is carrying out improvements in its portfolio control and information systems, using technical assistance funds under Loan 1881-ME. FOGAIN also intends to implement a larger data processing system to support the increasing needs of its operational area (particularly in respect of variable interest rates) and to permit development of more sophisticated monitoring and control systems, and financial projections. 2.34 The internal auditing of FOGAIN is provided adequately by a special unit of NAFINSA. Additionally, FOGAIN has been independently audited for 1981 by De la Paz, Costemalle y Asociados, an established auditing firm of acceptable quality, after four years of satisfactory audits performed by Mancera Hermanos y Asociados, S.C. 10/ The audit report for 1981 was unqualified, and arrangements made for the 1982 audit are satisfactory. 2.35 Projected Demand. Preliminary results of FOGAIN's 1983-85 credit demand study 11/ by industrial subsector show an average resource need of about US$320 million for fixed asset financing per year. Given the recent economic developments in Mexico, it is expected that demand for financing capacity expansions would be relatively low through 1984, but should increase as the economy recovers. Initially, demand for fixed asset financing is expected to be mostly for equipment replacement and modernization. On the other hand, demand for increased permanent working capital financing is strong as a result of recent high inflation and the changes in relative prices and increased cost of foreign borrowings resulting from the major devaluations. 10/ Independent auditors are designated every year by SPP, under a procedure of selecting and monitoring auditors performance which has been shifted during 1983 to the recently established "Secretaria de la Contraloria General de la Federacion" (Government Controller's Office), in accordance with Government-established rules. 11/ A separate study was carried out by FIDEIN to determine the credit demand for industrial building construction and infrastructure in industrial estates. The results of their study are included in FOGAIN's total estimated resource needs for the 1983-87 period. - 21 - 2.36 Operational and Financial Projections. FOGAIN's operations over 1983-87 are expected to show very slight real growth, considerably less than in the past few years (Annex 4, Table 18). Nonetheless, given the large amount of funds (US$250 million equivalent) recently provided by the Banco de Mexico through FOGAIN (para. 1.24), disbursements in 1983 are expected to show a real growth of about 40%. During 1983-87 FOGAIN would orient its lending operations towards: (i) regions outside Mexico City and its surrounding areas; (ii) fixed and working capital financing, the latter particularly to small clients affected by the recent economic situation; (iii) manufacturing subsectors designated as priorities in the National Industrial Development Plan. In addition to its internal mechanisms (e.g. differentiated margins and interest rates), FOGAIN intends to rely heavily on the PAI extension service in order to focus its operations on priority activities. Given the present situation and expected slow resurgence of economic activities, FOGAIN's projected disbursements appear quite realistic. 2.37 FOGAIN's projected requirements to meet expected credit disbursements during 1983-86 amount to US$1,388 million equivalent, 12/ which it expects to finance with the following resources: Table 2.1 - FOGAIN's Financial Resources Requirements 1983-86 US$ millions (equivalent) % Government 69.2 5.0 PAI (Excluding Bank) 81.3 5.9 Bank (1881-ME) 25.0 1.8 IDB 135.0 9.7 BANXICO 273.7 19.7 NAFINSA 42.6 3.1 Other Sources 611.0 44.0 Bank (SMI III) 150.0 10.8 TOTAL SOURCES US$1,387.8 100.0 2.38 The projected income statements (Annex 4, Table 20) show a net loss of about US$30 million in 1983, if no adjustment of interest rates on the 12/ See Projected Sources and Uses of Funds Statement (Annex 4, Table 18). - 22 - existing portfolio takes place. This loss could be reduced to one half, if appropriate adjustments are made on a timely basis. Provided FOGAIN implements its variable interest rate scheme, its financial spread is expected to remain positive throughout the 1984-86 period. B. Fondo Nacional de Fomento Industrial (FOMIN) 2.39 Background and Objectives. FOMIN was established in April 12, 1972 as a Government trust fund ("Fideicomiso") to assist in the implementation of national plans for industrial diversification and regional development. Previously administered by SHCP (through NAFINSA), it was shifted to SEPAFTN13/ when PAT was created. FOMIN's role is to stimulate the creation of new SMI--nterprises or the expansion or strengthening of existing ones by subscribing up to 49% of the equity capital required, and to promote deVelopment of the capital market. FOMIN's equity participation can also include debt instruments with equity features, which permit adequate flexibility in designing investment packages. Its investments are intended to be temporary and to be sold once the investee company achieves a satisfactory financial position. FOMIN thus serves to bring together groups of investors, enabling enterprises to have access to additional capital and permitting them to operate on a larger and more economical scale. Its participation frequently helps firms make the transition from a closed family enterprise to a more widely-owned corporation with professional management. 2.40 FOMIN has substantially expanded its investment instruments and stepped up its promotional efforts, and demand for its assistance has become quite strong; however, the supervision of a large number of investments throughout Mexico is putting a heavy strain on FOMIN's organization and staff. Thus, in order to continue expanding throughout Mexico, FOMIN has been encouraged by the Bank to examine the possibility of promoting the formation of Regional Venture Capital Corporations, in which it would participate on a Vininority basis with State Governments and possibly IFC, with the majority of shares being held by private sector interests, 2.41. Organization, Management and Staffing. The governing body of FOMIN is its Technical and Funds Disbursement Committee formed by representatives from SECOFIN, SHCP, NAFINSA, Banco de Mexico, plus two representatives from the private sector selected by the main industrial associations CONCAMIN and CANACINTRA. FOMIN's day-to-day operations are managed by an experienced Director General, Mr. Sergio Luis Cano Luebbert, who has been in this position for nine years. At present, FOMIN's staff totals 45, including some 30 professionals. In view of its expansion, a reorganization within FOMIN would take place under the proposed project aimed at greater delegation of authority to middle management, consolidation of related functions and responsibilities, and reduction of the number of managerial levels in order to permit more efficient supervision and portfolio control. During negotiations, agreement was reached with the Mexican authorities for the preparation of a plan of 13/ SEPAFIN's industrial arm was incorporated into the Commerce Ministry in January 1983, now renamed SECOFIN, and SEPAFIN has been renamed Ministry of Mines, Energy and State-Controlled Enterprises. - 23 - action for this reorganization and the required manpower needs, which would be presented to the Bank by September 30, 1983 (Annex 3). 2.42 Investment Goals. Eligible SMI enterprises include those with total equity ranging from Mex$50,000 to Mex$225.0 million 14/. Cost and risk factors, along with certain provisions of its charter (such as the requirement for external auditing), generally preclude FOMIN from having a significant role in financing small firms. Therefore, FOMIN's assistance is focussed primarily on medium (equity usually over Mex$10.0 million), and some larger, enterprises. As a general policy, FOMIN does not invest in firms to help them reorganize financially 15/, but focusses on creation or expansion of financially viable SMI enterprises with good growth prospects. A strong demand for FOMIN's participation has permitted better portfolio diversification and more selectivity than initially. As a result of the economic situation, FOMIN is currently experiencing a strong demand for financing increases in permanent working capital. FOMIN has established 10% of its equity as its maximum exposure (including investments through equity as well as other instruments) in a single firm and 15% of its equity as its maximum total exposure in two or more firms which belong to the same industrial group. 2.43 Investment Instruments. Initially FOMIN's investments were mostly in the form of new issues of common stock. As a result of the introduction in early 1981 of investments in preferred shares and convertible credits, with the encouragement and assistance of the Bank and IFC, FOMIN has broadened the range of its potential customers and is better able to design investment packages in accordance with an enterprise's cashflow and individual needs. 2.44 The use of preferred stock and convertible credits has allowed FOMIN to achieve a more stable and predictable income. Furthermore, compared with common stock, both have the advantage of receiving priority in liquidation. Common stock exposes FOMIN to the full risks of loss but usually does not reward FOMIN satisfactorily when the firm is successful, given the thin mlarkets for minority equity investments. Convertible credits have been favored to preferred stock by investee firms, because preferred dividends16/ are not tax deductible (as opposed to interest on convertibles). FOMIN utilizes common stock purchase primarily in those cases where the prospects for eventual divestiture appear particularly favorable. 14/ FOMIN evaluates in each case whether there is need to revalue the assets of the firm where equity participation is being considered. For eligibility purposes FOMIN considers the value of the firm's equity at the time of request for risk capital participation. 15/ Except for some investments made during its initial years. 16/ Preferred dividends are equivalent to 50% of NAFINSA's interest rates for priority industries. Adjustment is made annually. - 24 - 2.45 As of year-end 1982, FOMIN had completed -1 -o-Iertibie credit opera- tions (Annex 4, Table 25) in firms having total equities between US$150 thousand and US$1.5 million equivalent. FOMIN's convertible credits are for terms ranging between 6 and 8 years (including 2 to 3 years of grace). FOMIN has the right to exercise the option to convert (totally or partially) during the period of amortization of the principal. The inter-est rate for convertible credits used prior to option is the average ACF index for the previous quarter minus three percentage points. If the option to convert is not exercised by a stipulated date, the interest rate is increased by 4 points. 2.46 Past Performance. FOMIN's policies give priority to investments in SMI enterprises located in less developed areas. Although FOMIN has made sig- nificant progress in supporting regional development., by participating in the proposed Regional Venture Capital Corporations (para. 2.40), FOMIN could have an even greater impact in the future. Presently about 39% of FOMIN's invest- ments are for enterprises located in Zones III (Mexico City Metropolitan and surrounding areas) with the remainder of its investmients distributed in Zones I and II, (51% and 10% respectively). FOMIN's present portfolio of Mex$2.0 billion (US$17.4 million) has grown annually by 70% in nominal terms and 14% in real terms since 1979. The substantial growth which has taken place, particularly outside the metropolitan areas, is a result of the promotional program undertaken and the close support FOMIN received from PAI's extension agents. Industries supported by FOMIN present an estimated average cost per direct job created of US$14,000 equivalent (at 1981 prices), reflecting the relatively high employment impact of these enterprises. 2.47 Portfolio Quality. The quality of FOMIN's portfolio improved pro- gressively during the last six years, due primarily to FOMIN's growing expe- rience and to its success in attracting a much larger number of potential clients allowing greater selectivity in investments. However, several of FOMIN's clients have begun to experience serious problems resulting from the economic events of 1982. As of December 31, 1982, 54 companies representing 47% of FOMIN's total portfolio were operating profitably, and 43 firms repre- senting 36% of FOMIN's portfolio were experiencing some financial difficulties, many as a result of exchange losses and working capital shortages following the September 1, 1982 devaluation. A remainder of 13 firms with about 17% of FOMIN's portfolio were in the preoperating stage (Annex 4, Table 24). FOMIN has drawn up a plan of action to address its overall portfolio control needs with assistance from INFOTEC; this plan is reflected in the PAI Project Execution Document (Annex 3). 2.48 Results of equity sales have steadily improved over the past six years (Annex 4, Table 26). Out of equity in 35 firms sold by FOMIN during the past three years, only one resulted in capital losses, if investments are valued at historical costs. Although FOMIN's return on equity sales had increased substantially for the period 1979 to 1982 ('36% return in 1979 com- pared to 52% in 1982, in nominal terms), its results in real terms 17/ for 1981 and 1982 have been merely breaking even. A similar pattern is-expected for equity sales in 1983 and a modest gain in real terms would be expected 17/ Considering variation of the ACF index as the discount factor to account for time value of money. - 25 - after 1984 as industry recovers. Since SMI enterprises do not have an easily measuirable market value, in determining the sales price FOMIN has usually considered the book value of shares plus a premium reflecting revaluations of assets according to current replacement value as a starting point for divesti- ture. FOMIN intends to make further use of estimates of firms' projected future earnings to help establish appropriate share sale prices. 2.49 Project Appraisal and Supervision. FOMIN's project appraisals are carried out competently under the supervision of a well-qualified and motivated team of ten analysts/supervisors. Three additional professionals are expected to be employed during 1983, to deal with the technology and marketing oriented issues of FOMIN's increasing project sophistication. Additionally, FOMIN would hire two professionals specialized in evaluating firms' management capabilities and providing management support to investee firms. FOMIN's subproject appraisal of permanent working capital investments would be carried out in line with procedures described in para. 2.30 for FOGAIN, as reflected in the PAI Project Execution Document. FOMIN's supervision is carried out by the same analysts in charge of project appraisal. Supervision has not been fully adequate due to staff shortages and FOMIN's rapid portfolio growth. Therefore, FOMIN intends to establish a separate unit responsible for the supervision and portfolio evaluation and control on a continuing basis (para. 2.41). 2.50 Procurement and Disbursement. Disbursement policy provides for the first 20% of FOMIN's investment to be disbursed when the firm has met all formal conditions set by FOMIN. The remainder is disbursed against a sched- ule agreed with the firm, which provides that FOMIN's subscriptions are made at the same pace as, or sometimes after, those of the other shareholders. The description of each project includes a list of goods and expenditure schedules for disbursement purposes. As a general policy, FOMIN requires price quotations from several suppliers and focusses on the quality and the technical adequacy of goods purchased. 2.51 Accounting Procedures and Auditing. FOMIN maintains an accounting system using accounting principles generally accepted in Mexico. FOMIN's audit reports have been prepared in satisfactory detail, but have been quali- fied since the audited statement of some investee firms have been received after FOMIN's audit is completed, and FOMIN has been unable to adequately assess the value of its portfolio on a timely basis. FOMIN requires the assignment of independent auditors, and the use of accounting systems to FOMIN's satisfaction, by each firm in which it makes its investments. These audit firms are requested to forward, for shareholders' information, a report on internal control and accounting procedures for each of the enterprises, together with the annual certified financial statements. During negotiations agreement was reached that FOMIN would incorporate a complementary report to its audited financial statements on its consolidated portfolio by July of each year, as well as on a schedule for monthly reporting of key financial indicators by these firms. Annex 4, Tables 27 and 28, presents summarized year-end audited balance sheets and income statements of FOMIN for the years 1980, 1981, and 1982. - 26 - 2.52 Financial Position and Projections. After incurring losses in preceding years, FOMIN's revenues for the years 1980, 1981 and 1982 rose significantly due to the rapid growth of its portfolio, implementation of convertible credits and a more profit-oriented equity sales policy. Net revenues have covered operating and administrative expenses for the past three years, as shown in Table 2.1. While stock dividends have risen constantly for the period 1979 to 1982, these tend to reflect more fixed assets revaluations and adjustments of book value than retained earnings. Annex 4, Table 29, shows the importance of internally generated funds in financing FOMIN's future portfolio. Table 2.1: Operating Profits by Year 1979 1980 1981 1982 Summarized Income Mex$ US$ Mex$ US$ Mex$ US$ Mex$ US$ Statement mil. equiv. mil. equiv. mil. equiv. mil. mil. Net Revenues a/ 18.3 0.8 40.4 1.6 151.3 5.6 256.2 2.6 Operating and Administrative Expenses 26.9 1.2. 34.5 1.4 61.4 2.2 80.7 .8 Net Profit (Loss) (8.6) (0.4) 5.9 0.2 89.9 3.4 175.5 1.8 a/ Includes profit made on equity sales and excludes stock dividends. (Negligible amounts of cash dividends were declared by investee firms). 2.53 FOMIN's allocation of US$10 million under the first SMI loan was fully disbursed by the second quarter of 1982 and the US$12 million allocated under the second SMI loan (Loan 1881-ME) are expected to be fully committed by year-end 1983. Under the proposed project, US$18 million would be allocated to FOMIN, which are expected to cover 36% of FOMIN's total financing needs for the 1984-86 period. C. Fideicomiso de Conjuntos, Pargues y Ciudades Industriales (FIDEIN) 2.54 Background, Objectives and Organization. FIDEIN was established in 1970 as a Government trust fund administered by NAFINSA to plan, promote and implement a national system of industrial estates, as part of a comprehensive program of industrial decentralization and regional development. Initially, FIDEIN's role was principally to act as a central promotional and advisory institution to the "Fideicomisos Especiales", the legal entities owning and operating the individual regional public industrial estates. Subsequently, as part of the expansion of its role in implementing the Industrial Estates - 27 - subprograms under PAI, and with Bank assistance under the first and second SMI Projects, FIDEIN was expected to finance directly: (a) the construction of factory buildings on industrial estates to rent, lease with option to purchase, or sell to SMI enterprises, (b) construction and leasing of common facilities to provide services to groups of SMI enterprises on the estates, and (c) equip- ment and machinery leasing to SMI enterprises operating in these industrial estates. These activities were designed both to support new productive enter- prises and to meet the expansion and/or relocation needs of existing SMIs. 2.55 Organization, Management and Staffing. FIDEIN's overall policy- making body is its Technical Committee, headed by the Minister of Urban Development and Ecology (previously the Minister of Human Settlements and Public Works). The Committee includes representatives of SHCP, SECOFIN, Institute of Agrarian Reform, National Institute for Workers' Housing Development (INFONAVIT), NAFINSA, plus two representatives from the private sector selected by CONCAMIN and CANACINTRA. The present Director General, Mr. Gustavo Varela Ruiz, has implemented some significant organizational changes in FIDEIN to correct a series of technical and administrative problems. While these recent changes have been positive, the frequent changes in management and staff contributed in the past to a loss of continuity and momentum in the institution. Under the previous acting Director General, the direct construction of standard factory buildings (SFBs) initially accelerated but quickly got bogged down as a result of FIDEIN's inadequate technical and operational management capabilities in this area. 2.56 At the time, management sought to resolve these deficiencies by rapidly increasing total staff, from about 43 (including 27 professionals) in late 1980 to 84 employees (including 38 professionals) by December 1982, but this only served further to aggravate FIDEIN's operational problems since many of the new staff were not qualified. Under FIDEIN's revised program (para. 2.59) a careful review of its manpower needs, training and outside technical assistance would be established in accordance with a plan of action reflected in the Project Execution Document (Annex 3). 2.57 Past Performance. Under FIDEIN's construction program, a total of 48 SFBs 18/ were built in a period of about two years (1981-82), with sizes ranging from 1,100 to 2,400 square meters in 13 industrial estates. The infra- structure work of almost all of the 20 industrial estates in FIDEIN's program (for which FIDEIN acted in its advisory capacity) has been completed and most have been in operation for a few years. It is not planned that additional estates will be developed by the Federal Government, as the responsiblity for eleveloping new estates and for further developing existing ones has been assigned to the State Governments since June 1982. While FIDEIN's SFB construction program has been a valuable promotional device, the need for such promotion is diminishing at many of the estates. Given the difficulties for 18/ As of February 28, 1983, firm sales contracts had been signed for 24 SFBs, and there were option agreements for sale for 10 SFBs, leasing agreements with option to purchase for 3 SFBs, 3 SFBs for sale and 8 SFBs under construction and expected to be completed by mid-1983. - 28 - FIDEIN to continue carrying out the construction of iidus;;cidj bi ildings country-wide and, recognizing that most SMIs now prefer to obtaiin credit to construct their own buildings and facilities, FIDEIN is planning to: (i) transfer lending operations for SFBs to FOGAIN; (ii) finalize SFB sales and transfer the complete loan portfolio to an intermediary bank trust account for collection and overall administration. In this manner it is !xpected that the remaining balance allocated for FIDEIN under the second loan, aud to be channelled through FOGAIN, would be committed by June 1984. 2.58 With respect to common service facilities and equipment leasing, originally covered under the Second SMI project, the results have also been disappointing. No common service facilities have been financed under the second SMI loan, due to lack of active promotion by FIDEIN coupled with the fact that some of the industrial estates are not yet sufficiently developed to require common service facilities. Three machinery and equipment leasing operations have been concluded by FIDEIN, requiring a total FIDEIN investment of about US$449,000, with US$247,000 of Bank financing. In view of that very limited success of these operations and FIDEIN's limited experience, no further leasing operations would be planned under the proposed project. While the full allocation of US$5 million under the First SMI Project has been disbursed to FIDEIN, only US$2.3 million out of US$8.0 million have been committed under the Second SMI Project. 2.59 New Program. The Government has developed a new strategy for FIDEIN. The focus of FIDEIN's new role would be to help rationalize the development and operation of private, as well as publicly-owned, industrial estates (with due account taken of their environmental impact), and to provide SMIs with centralized information on the characteristics of the industrial estates in the country. At the same time, FIDEIN would continue to provide promotional and advisory support to industrial estates. Based on a survey of 24 of the estimated 110 private industrial estates in the country, a potential demand for credit and technical assistance by industrial estate developers has been estimated at Mex$1.7 billion (US$12.8 million equivalent) and Mex$234 million (US$1.8 million equivalent), respectively, over the 1983-86 period in constant 1983 terms. Annex 4, Table 32 shows FIDEIN's resources needed for its operations from 1983 to 1986. FIDEIN's future financing operations would be limited to infrastructure development in industrial estates. Under the proposed project, US$4.6 million of Bank funds would be allocated to FIDEIN for this purpose. 2.60 Project Appraisal and Supervision. FIDEIN's performance in project appraisal has been uneven, reflecting the lack of experience of its staff. FIDEIN is in the process of improving its project evaluation procedures to adjust to the new orientation of its operations, which will focus on technical assistance and infrastructure financing. In particular it plans to prepare its technical staff to cover more thoroughly the technical, administrative, marketing, financial, economic, and credit aspects of urbanization sub- - 29 - projects. Thus, with this specialization, the quality of FIDEIN's appraisals is expected to evolve satisfactorily. While FIDEIN's supervision activities have sufferred considerably, mainly as a result of inadequate past leadership, during the past year FIDEIN has opted to subcontract construction supervision to private engineering consultants located in their widely dispersed project areas, charging the client a supervision fee of 10% of project costs. This approach has proved very successful so far, and would also be used for urbanization projects. The revised operational regulations and procedures for approval of infrastructure development in industrial parks, were reviewed with the Mexican authorities during negotiations. Formal approval by FIDEIN's Technical Committee would be a condition of loan effectiveness. 2.61 Procurement and Disbursement. In view of the widely dispersed loca- tions, the existence of many competitive domestic civil engineering and construction firms, and the relatively small subproject size (average investment cost of US$800,000 required at each industrial estate site), only local competitive bidding would be used. Nevertheless, the beneficiary industrial estate would be required to announce planned construction in advance through advertisements in Mexican regional newspapers of wide circulation, and a minimum of three competitive bids would be required. For all subprojects above US$500,000 equivalent, the Bank would review subproject tender documents, and the subsequent award proposal, as well as the draft contract between the beneficiary and the winning contractor. 2.62 Disbursement of the credit proceeds are governed by FIDEIN's opera- tions manual (in Project File) and by provisions contained in each construc- tion contract between FIDEIN and the winning contractor. Bank disbursement would be made in line with the physical progress of construction, two weeks after certification by FIDEIN's supervising engineer or architect. If necessary, FIDEIN would obtain technical assistance from SAHOP. 2.63 Accounting, Credit Control and Auditing. FIDEIN's accounting system has improved considerably; it has carried out the Plan of Action, to improve its accounting and internal controls, which was agreed during the negotiations for the Second Loan. While the collection system remained weak until recently, substantial improvements have been made in this regard and arrearages of over 30 days now represent only 14% of its total portfolio. Nevertheless, with a view to reducing administrative costs, during negotiations agreement was reached with FIDEIN and the Government to eliminate FIDEIN's credit control operations by transferring this function to FOGAIN, to be managed on FIDEIN's account, and FIDEIN's loan portfolio to an intermediary bank trust account for collection and overall administration, as reflected in its reorganization plan (para. 2.56). 2.64 Financial Situation and Projections. Annex 4, Tables 30 and 31 present a summary of FIDEIN's audited financial statements for 1980, 1981 and - 30 - 1982 (unaudited). During 1982 FIDEIN had a loss of Mex$21.8 million'9/ compared to Mex$0.1 million for 1981. A Mex$120 million book profit is expected for 1983, primarily due to the sale or lease of the remaining factory buildings constructed by FIDEIN. Projected income statements show acceptable growth in FIDEIN's income for the period 1983 to 1987, provided administrative and operating costs are streamlined. 19/ This loss is primarily due to the administrative costs incurred by FIDEIN in the supervision and support of the "Fideicomisos Especiales" for which FIDEIN receives budgetary support from the Government rather than charging fees. - 31 - III. THE PROJECT AND THE PROPOSED BANK LOAN Experience Under Previous Bank Loans 3.01 The PAI program of integrated financial and technical assistance to the SMI sector was initiated and expanded under two previous Bank loans. The first Loan (1552-ME) for US$47 million was made in June 1978. The credit component was committed and disbursed by December 31, 1980, somewhat faster than projected during appraisal, while the smaller components were disbursed in line with appraisal estimates 20/. The second loan (1881-ME) for US$100 million was 79.0% committed and 71.8% disbursed as of May 31, 1983. The credit component of this loan is expected to be fully committed during the first half of 1983 and the other components by year-end 1983. Table 3.1: UTILIZATION OF LOAN 1881-ME RESOURCES AS OF MAY 31, 1983 Subprograms Bank Funds Committed Disbursed (US$ million) (US$ million) % (US$ million) % Credit (FOGAIN) 78 69.5 89.1 63.5 81.4 Risk Capital (FOMIN) 12 6.2 51.7 5.8 48.3 Industrial Estates (FIDEIN) 8 2.3 28.8 1.5 18.8 Technical Assistance 2 1.0 50.0 1.0 50.0 TOTAL 100 79.0 79.0 71.8 71.8 Focus of Proposed Third Project 3.02 In view of the tight resource availability of PAI and the substantial demand for credit by SMI, the Mexican authorities have asked the Bank to continue to support PAI through a further loan. While the proposed project would build on the successful results achieved by the two previous operations, it would also help to refocus PAI's operations to respond to the needs of SMI in the present economic situation. In particular, the project would be geared to helping SMIs maintain production and employment levels by ensuring adequate access to credit and investment resources, and to foreign exchange to cover production inputs such as raw materials, components, spare parts, and critical equipment needs. Initially, the project would finance the strong demand for incremental permanent working capital arising from the 20/ The remaining funds of Loan 1552-ME for the risk capital and industrial estates components were fully disbursed by late 1982. - 32 - surge in inflation and the increased relative cost ol ii;y,lrts anid foreign borrowings arising from the major devaluation. The smaller fixed asset financing demand foreseen for the first 12-18 months of the project would be mainly for replacement, balancing and modernization equipment, but as the economy recovers increasing demand to finance expansion projects is expected. 3.03 NAFINSA would be the borrower for the proposed loan and would channel proceeds to the various participating institutions and handle project administration and accounts. As in the case of the two prior loans, the pro- posed loan would support a credit and guarantee subprogram through FOGAIN, a risk capital subprogram through FOMIN, an industrial estates subprogram through FIDEIN and a technical assistance subprogram through the PAI exten- sion agents and special technical assistance and training institutions. As explained in the previous chapter and highlighted below, the individual sub- programs would differ somewhat from those financed under the previous project, reflecting the increased emphasis on working capital financing and on meeting other urgent needs of SMI in the present economic situation. However, the allocations of loan funds to working capital and fixed investment, as well as to the various trust funds, would be reviewed on the basis of the first year of project implementation and the evolution of the economic situation. Free-standing working capital financing by FOGAIN and FOMIN would be provided only in respect of expenditures incurred by December 31, 1985. Size of Program and Proposed Loan 3.04 On the basis of demand projections for the participating institu- tions, a Bank loan of US$175.0 million is proposed (including US$436,409 for the capitalized front end fee). This loan, together with additional PAI program resources of US$64.6 million equivalent, to be provided from govern- ment sources to the participating institutions, would support investment and technical assistance activities totalling US$349.2 million, with the balance of US$110.0 million being provided by subproject sponsors and intermediary banks. The proposed allocation of resources among the various subprograms is shown in Table 3.2. 3.05 The proposed loan would cover about 73% of the financing extended by the PAI program and 50% of the total expenditures on investments and tech- nical assistance activities supported. Since the the overall foreign ex- change content of the total expenditures is estimated to be US$106.0 million, the Bank loan would be financing US$68.6 million in local expenditures. This is justified in view of the very difficult economic situation currently being faced by Mexico. 3.06 The credit component of US$150 million would finance 73% of FOGAIN's credits for qualifying subprojects. Interest rates to final borrowers would be variable and would be adjusted quarterly to reflect move- ments in the ACF index. FOGAIN would use six different interest rates depending on the size and location of the ultimate sub-borrower but, on aver- age, interest rates would be equal to at least ACF+1. Margins for inter- mediary banks would range from 2.0 to 3.5 percentage points to provide incentives for banks to lend to small enterprises and those located outside Table 3.2: Allocat'o f Ra Psources Sources of Fianclrg Content of Fin g b/ Total Additional Furds Total World lDcal Exchange Foreign Exchange Bank's Local Subprogram ITvestnent Bereficiaries/Internediaries Program Financing Bank Covernment [ Content Content Cost Financing 1. credit 301.4 95.4 206.0 150.0 56.0 210.6 90.8 59.2 2. Risk Capital 36.3 11.6 24.7 18.0 6.7 25.3 11.0 7.0 3. lidustrial Parks 9.3 3.0 6.3 4.6 1.7 6.5 2.8 1.8 4. Technical Assistance 2.2 - 2.2 2.0 0.2 0.8 1.4 0.6 TUOAL 349.2 110.0 239.2 174.6 c/ 64.6 243.2 106.0 68.6 _= - == I _= % Participation 100.0 31.5 68.5 50.0 18.5 70 30 20 a/ US$1 = hx$115 b/ Considers that one half of the total investnent is allocated to permarent wrkirg capital reeds anxd assues 20% of foreign exchange content for working capitalI component. c/ Front-end fee of US$0.4 million not included. 1CPI2 May 1983 - 34 - Mexico City. Small enterprises would be eligible under the Credit Guarantee Scheme (see para. 2.27). Three types of FOGAIN credits would be eligible for financing through Bank subloans as follows: (a) Working capital subprojects: US$75 million of the Loan's credit component would be available for financing FOGAIN credits for pure permanent working capital subprojects. Such subprojects would help cover increases in permanent working capital requirements arising from increased costs of materials, components, spare parts and other production inputs. FOGAIN would finance up to 80% of estimated additional working capital needs using 1981 as a base year for determining normal production levels and cal- culating price changes. Beneficiaries would finance the remaining 20%. The maximum FOGAIN credit would be about US$390,O00.21/ Maximum credit and sub- loan terms would be six years with up to two years of grace. Beneficiaries would undertake not to reduce working capital below an agreed level during the term of the subloan. (b) Investment subprojects: US$70 million of the credit component would be for financing fixed asset investment subprojects of SMIs (including machinery, equipment, civil works, and industrial buildings) and increases in permanent working capital related to any increase in production capacity involved. FOGAIN credits for such subprojects would be limited to about US$390,000 per enterprise, based on FOGAIN's Operating Regulations, and would cover up to 80% of the total costs of the subproject. These credits would have a maximum term of six years, including two years of grace. (c) Common facilities subprojects: US$5 million would be avail- able to finance common service facilities to be used by groups of enter- prises. These may be firms located in industrial estates or groups of enter- prises constituting a collective acti6n group outside an industrial estate. In either case, the enterprises would need to organize themselves as a legal entity able to contract debt and service such debt from members' dues. Typical common services that might be required by such groups of enterprises would include maintenance and repair shops, central warehousing, purchasing and distribution centers, training facilities, quality control and materials testing centers, accounting and data processing centers, and canteens. FOGAIN credits would be for a maximum term of six years and would cover up to 80% of the cost of the common facilities, subject to a maximum credit of US$300,000 per subproject. The credits would bear the interest rates applic- able to small enterprises in the particular location and would be eligible for coverage under the guarantee scheme. 3.07 The risk capital component of US$18 million would finance 73% of FOMIN's investments through common and preferred shares, subordinated con- vertible loans and other equity-type instruments. Such investments would be to finance either (i) the acquisition of fixed assets and related increases in permanent work capital, or (ii) increases in permanent working capital requirements arising from increases in the prices of raw materials, components, parts and other production inputs. No more than US$10 million would be used for investments purely in working capital. The size of FOMIN's 21/ Expressed as 45 million pesos in FOGAIN's Operating Regulations. - 35 - investments would be such as to ensure that FOMIN would not be the majority shareholder either immediately or on conversion of subordinated loans. FOMIN 's investments eligible for Bank financing would be those whose total assets prior to FOMIN's investment do not exceed the asset limitation on eligibIlity for FOGAIN financing. Prior to exercising the convertibility oDption, subordinated convertible loans would carry a variable interest rate that is not more than 3 points below ACF. If FOMIN decides not to excercise the convertibility option by a specified date, the interest rate would be raised to at least ACF+1. 3.08 The industrial estates component of US$4.6 million would finance 73% of FIDEIN's credits to private and public industrial estates to support infrastructure and urbanization investments. In accordance with FIDEIN's revised Operating Regulations, such credits would be for a period of up to 12 years, including up to 3 years of grace. Interest rates would be adjusted each quarter to be equal to at least ACF plus 1 point. 3.09 The technical assistance component of about US$2.0 million would finance 75% of local expenditures and 100% of foreign expenditures for: (i) training PAI extension agents and staff in participating technical assistance institutions; (ii) consultants; and (iii) facilities and equipment needed under the program. In view of the large number of technical assistance activities and the possibility that their financing needs would change during project implementation, the initial allocation of the subprogram (Annex 4, Table 15) would be reviewed and revised, as necessary, during the commitment period, by agreement between NAFINSA and the Bank. 3o10 The trust funds would have to introduce substantial increases in interest rates to final borrowers, since their current rates are substan- tial[Ly lower than those required by the covenants under the proposed loan (Annex 4, Table 21). This would require some time, so that interest rates may be increased in stages. Onlending interest rates are expected to be increased by about 10 percentage points, to an average of 48%, in July, 1983, as a first step, and additional adjustments would be made subsequently, as necessary, in order to reach full compliance with covenanted interest rates under the proposed loan. In view of the urgent need for finance of small and medium-scale industry, up to US$50 million would be disbursed through December 31, 1983 at interest rates below those covenanted, for onlending for FOGAIN or FIDEIN loans, provided that all such loans carry variable interest rates, and that interest rates are adjusted, according to an agreed program, to reach the covenanted levels. Loan Channelling and Repayment Arrangements r, eI 1 1 NAFINSA would channel the loan proceeds in pesos through a Program Account (established in NAFINSA) to PAI, the individual trust funds and other participating institutions for qualifying subprojects and expenditures. In view of the trust funds' cashflow shortages due to a decrease in Government contributions, and in order to reduce the interval during which the trust funLds must finance the Bank's share of subloans with their own resources, an initial deposit of US$17.5 million will be disbursed from the Bank's loan zccount to a Special Account, to be set up in the Banco de Mexico for the Program (para. 3.14). All debt service charges (principal, interest and commitment fees) related to the Bank loan would be paid by NAFINSA to the liank in accordance with a fixed 15 year amortization schedule including 3 - 36 - years of grace. Participating institutions, with the exceptisn of technical assistance institutions, would pay back PAI resources as funds are recovered from subloan repayments and sales of investments. 3.12 FOGAIN and FIDEIN would be expected to repay to the PAI account both principal and interest on the amounts lent to them. The interest rate paid by FOGAIN and FIDEIN would be 2 percentage points below their onlending rate to final borrowers; this spread would cover their operating costs. FOMIN would repay PAI the net amount recovered from divesting its equity investments, 50% of any realized capital gains, plus an agreed percentage of interest received by FOMIN on convertible credits. Resources paid back by the participating trust funds to the PAI account that are not required to service the Bank loan would be utilized by PAI for purposes similar to those under the proposed project. As a condition of disbursement to each of the trust funds, channelling arrangements would be agreed by NAFINSA and the respective trust fund on terms and conditions acceptable to the Bank. Procurement and Disbursement 3.13 NAFINSA, through the PAI secretariat, together with FOGAIN and FOMIN would apply suitable procedures either directly or through the inter- mediaries to ensure that goods and services procured are competitive in quality and price, and are appropriate for the needs of the client enter- prise. Procurement procedures applied in the past are acceptable to the Bank and comply with standards for DFC operations. Infrastructure and urbaniza- tion of industrial estates financed by FIDEIN would require detailed review by the Bank of LCB procedures for all subprojects above US$500,000 equiva- lent. Ex-post reviews would be conducted on FIDEIN subprojects below that limit. Full ICB would not be required given the small average size of sub- projects (US$800,000) and the availability of many competitive construction and civil engineering companies in Mexico. Consultants hired through the technical assistance component of the proposed loan would be engaged in accordance with Bank guidelines. 3.14 Disbursements for the subloans and investments would be made against Statements of Expenditures (SOE), issued by the respective trust funds, for specific industrial subprojects. Bank reimbursement based on NAFINSA's withdrawal applications would then replenish the Special Account in the Banco de Mexico. Conversion from dollars into pesos wculd be made at the official rate of exchange that prevails on the date payment is made by the Program's Special Account to the trust funds. Detailed documentation evidencing final expenditures on machinery, equipment, civil works and permanent working capital would be retained by the respective trust funds and would be available for inspection by the Bank. In addition, disbursement requests by FOGAIN for common service facilities would include a detailed list of items financed, and an estimated schedule of expenditures and disbursements, which would be submitted to the Bank prior to Bank authorization of the subproject. Since approvals under the multitier system may involve relatively long processing times, expenditures up to 180 days prior to receipt by the Bank of the financing application would be eligible for Bank financing, as under the previous PAI projects. Annex 2 includes the estimated disbursement schedule for the proposed loan. This disbursement schedule was prepared assuming a somewhat faster disbursement rate during the first two years than the average profile for IDF loans, as a result of the faster disbursing permanent working capital component. - 37 - Approval Limits 3.15 The approval limits would be as follows: (a) FOGAIN: While Bank approval would not be required for FOGAIN's fixed asset financing to industries, the Bank could review at its discretion any withdrawal request prior to disbursement. The Bank would also review periodically a representative sample of subprojects on an ex-post basis during supervision missions. Bank approval would be required for the first 3 subloans for permanent working capital, and for all common service facilities subprojects. (b) FOMIN: Investments requiring more than US$400,000 equivalent in Bank funds would require Bank approval. (c) FIDEIN: Bank approval for infrastructure projects would be required for all subloans to finance infrastructure and urbanization of public and private industrial estates. Bank approval of procurement for FIDEIN projects would follow the procedure described in para. 3.13. (d) Technical Assistance: All use of Bank funds under this component would require Bank approval. Selection of, and contract terms for,consultants would also require Bank approval (see Annex 4, Table 15). Auditing 3.16 The Borrower would make arrangements for a full audit of the individual trust funds, as well as of PAI's Program Account, to be submitted to the Bank annually and according to standards satisfactory to the Bank. Contracts and working programs for external auditors should include a requirement for commenting on important deficiencies in internal control. Such comments from the auditors in a letter to management would be copied to the Bank. Furthermore, the Borrowers would also present to the Bank satisfactory audit of SOEs. Procedures for reporting the results of the review of FOGAIN's and FOMIN's SOEs would be incorporated into independent auditor terms of reference by each institution. Project Benefits and Risks 3.17 The proposed project is designed to address the urgent financial needs of SMI enterprises under present economic conditions. One half of the proceeds of the Loan are expected to be used to finance increased permanent working capital needs to help SMIs make effective use of their production capacity and maintain employment levels. The remainder of the Loan would be used initially to cover financing of equipment for modernization and replacement and later, as the economy recovers, expansions in production capacity, but the allocations to each component would be reviewed after the first year of project implementation. About 2,500 individual enterprises would be assisted by FOGAIN during 1983-86. Some 150 enterprises would be assisted through the Risk Capital Subprogram by FOMIN and 10-12 industrial estates would receive FIDEIN's financing assistance. Finally, the Technical Assistance Subprogram of PAI is expected to provide assistance to several - 38 - hundred SMI enterprises. An estimated 10,000 jobs at various levels, including unskilled labor, would be generated in 1983-86 through investments financed from the proposed loan. A further 20,000 to 30,000 jobs would be preserved through helping to provide firms with adequate working capital. Economic rates of return on subprojects financed under the first SMI Project were estimated to average around 50% on the basis of a sample of firms supported through the project; while the proposed project would include an increased proportion of working capital financing, similar economic rates of return are expected. 3.18 The project would also have an important institution-building impact by helping the PAI system maintain its dynamism and relevance to the evolving needs of SMI by: (i) consolidating and redefining the roles of some financial institutions taking into account past experience and the changing needs of the economy; (ii) improving the access of small firms to credit through implementation of the guarantee scheme; (iii) expanding the volume and range of technical services to SMIs through closer coordination between PAI and the various specialized institutions; (iv) expanding risk capital financing through the possible development of the regional venture capital companies; (v) strengthening the links between the PAI program and the National Employment Service. In addition, technical assistance provided through the proposed project is expected to support implementation of an improved labor-and employment-related data collection and analysis system, thus providing additional inputs for policy formulation and decision making. 3.19 Risks. The major risks in this project are of two kinds. There are institutional risks related to the considerable changes in managers and some professionals that have taken place following the change in the Administration. This could prove to have a destabilizing effect on the future development of the PAI program and the various institutions involved in the program. However, such a risk should not be too serious since a project execution document has been jointly prepared with PAI, and was agreed during loan negotiations. This document spells out the objectives and priorities of the PAI program and the roles and action programs of the participating institutions. 3.20 The other risk is that social and political pressures and further external shocks may prevent the Mexican authorities from adhering fully to the stabilization program on which they have embarked with IMF assistance. The determination shown by the present Administration so far suggests that their chances of successfully managing such pressures are quite high. While delays in achieving economic stabilization may prolong the period of recession and reduce investment demand somewhat, the need for working capital financing is likely to increase in such circumstances. - 39 - IV. AGREEMENTS REACHED AND RECOMMENDATION A. Agreements and/or Understandings Reached 4.01 During loan negotiations, agreements or understandings were reached: (a) With the Government on: (i) the policies to be followed with respect to the relative prices of labor and capital in order to encourage a more labor absorptive pattern of industrial growth (para. 1.30); (ii) the measures to be undertaken to improve the coverage and timeliness of labor market statistics (para. 1.29). (b) With the Mexican Government and NAFINSA on: the Government's and NAFINSA's responsibilities for servicing the loan, and providing counterpart funds of US$64.6 million and the arrangements for channelling loan and counterpart resources to the participating trust funds through the Program's Special Account (paras. 3.04, 3.11 and 3.14). (c) With NAFINSA (in its own capacity and as the trustee for the participating trust funds) on: (i) review by PAI's Secretariat, not later than December 31, 1983 of the PAI extension agent system and the results of PAI's cost and benefit analysis (para. 2.07). (ii) auditing arrangements for PAI's Program Account and the participating institutions, including a full audit of Statements of Expenditures (para. 3.16); (iii) a Project Execution Document explaining NAFINSA's intentions regarding the future development of PAI and the role of the various institutions involved in the program including the following points: a. FOGAIN's subloan policies for factory building and common service facilities financing, and operation of the credit guarantee fund (paras. 2.19 and 2.27); b. measures to be taken by FOGAIN to avoid erosion of its equity base, including a timetable for adjusting the interest rates of its existing portfolio (para. 2.29); c. procedures for appraising permanent working capital subloans and investments (paras. 2.30 and 2.49); - 40 - d. major points to be included in a plan for strengthening FOMIN's organization and staffing, which would be prepared not later than September 30, 1983 (paras. 2.41); e. FOMIN's plan of action for improving its portfolio control and auditing (paras. 2.47, 2.49 and 2.51); f. a plan and timetable to implement a reorganization of FIDEIN's structure (para. 2.56); g. FIDEIN's revised operational regulations and procedures for approval of infrastructure development in industrial estates (para. 2.60); h. specific subprograms of Specialized Technical Assistance Institutions (INFOTEC, and DGE and DGCP in STPS) to support PAI's activities, to be reviewed by the Bank not later than September 30, 1983 (paras. 2.10 to 2.13). (d) With NAFINSA and FOGAIN, FOMIN and FIDEIN on: onlending terms and conditions, including application of variable interest rates to the final beneficiaries and, in the case of FOGAIN, margins to the intermediaries (paras. 3.06 to 3.08). 4.02 Conditions of Loan Effectiveness would be: (i) formal approval by Technical Committees of FOGAIN and FIDEIN of agreed changes in their Operating Regulations (paras. 2.19 and 2.60); (ii) presentation to the Bank of a satisfactory schedule of interest rates to be applied by FOGAIN (para. 2.21). 4.03 Conditions of disbursement of loan allocations to each trust fund would be: (i) receipt by the Bank of documents attesting that satisfactory arrangements have been made for channelling loan proceeds to FOGAIN, FOMIN and FIDEIN (para. 3.12); (ii) implementation of an agreed program to adjust present FOGAIN and FIDEIN onlending interest rates to reach covenanted levels (para. 3.10). B. Recommendation 4.04 With the above agreements, the proposed project constitutes a suitable basis for a loan of US$175 million to NAFINSA with a maturity of 15 years, including 3 years of grace, subject to the conditions outlined in Chapter III. - 41 - ANNEX 1 MEXICO - THIRD SMALL AND MEDIUM SCALE INDUSTRY DEVELOPMENT PROJECT THE AVERAGE COST OF FUNDS (ACF) INDEX The ACF index is calculated as a weighted average of interest rates paid on all term funds and deposits by Mexican banking system. Changes in the ACF index below reflect adjustments in interest rates paid on deposits, and in the term distribution of funds. Table 1: ACF index, Highest Interest Rates on Deposits and Inflation Rates Highest Deposit Rate (End-period) ACF Index Annual Inflation Year Quarter Month Nomnal Effective Rate (CPI) Compounded (Avg.) (Avg.) (End Qt) 1975 14.2 11.8 15.1 1976 14.4 11.8 15.8 1977 17.1 12.9 28.9 1978 16.0 15.3 17.1 1979 18.5 20.0 16.5 18.4 1980 I 18.5 22.6 II 20.2 25.1 III 29.3 32.6 21.0 28.4 IV 23.2 28.9 1981 I 26.0 28.0 II 27.3 28.4 III 35.0 41.2 29.5 26.8 IV 31.6 28.6 1982 I - - 33.2 32.7 34.7 II - - 36.8 44.3 49.4 III 44.8 52.9 45.8 65.5 73.9 IV 57.9 71.2 45.9 89.0 99.8 1983 January - - 50.3 110.1 February - - 54.2 113.5 March 65.8 83.8 56.2 115.8 115.8 April 57.2 117.6 May 58.1 LCPI2 May 1983 - 42 - ANNEX 2 MEXICO - THIRD SMALL AND MEDIUM SCALE INDUSTRY DEVELOPMENT PROJECT Estimated Quarterly Schedule of Bank Loan Disbursements (US$ million) Disbursements Cumulative IBRD Fiscal Year and Quarter in Quarter Disbursements 1983-84 September 30, 1983 - December 31, 1983 10.0 10.0 March 31, 1984 12.0 22.0 June 30, 1984 14.0 36.0 1984-85 September 30, 1984 14.0 50.0 December 31, 1984 16.0 66.0 March 31, 1985 16.0 82.0 June 30, 1985 18.0 100.0 1985-86 September 30, 1985 20.0 120.0 December 31, 1985 15.0 135.0 March 31, 1986 12.0 147.47 June 30, 1986 10.0 157.0 1986-87 September 30, 1986 8.0 165.0 December 31, 1986 a/ 5.0 170.0 March 31, 1987 3.0 173.0 June 30, 1987 b/ 2.0 175.0 a/ Last date for submission of subprojects for Bank financing. b/ Closing date. LCPI2 February 1983 Page 1 of 27 - 43 - TRANSLATION MEXICO - THIRD SMALL AND MEDIUM SCALE INDUSTRY DEVELOPMENT PROJECT THE INTEGRATED SMALL AND MEDIUM INDUSTRY DEVELOPMENT PROGRAM (PAI) THIRD STAGE - (PAI-III) PROJECT EXECUTION DOCUMENT I. Institutional Aspects 1. Stage III of the Integrated Small and Medium Industry Development Program (PAI) will be undertaken in the framework of the Programa para la Defensa de la Planta Productiva y el Empleo (Program for the Defense of Productive Capacity and Employment), and its main objective remains to contribute to the recovery, strengthening and development of small and medium industry through appropriate and timely channeling of financial resources and technical assist- ance services. This support will be furnished in the form of loans and guarantees, through FOGAIN--Fondo de Garantia y Fomento a la Industria Mediana y Pequena (Guarantee and Development Fund for Small and Medium Industry); of risk capital, through FOMIN--Fondo Nacional de Fomento Industrial (National Industrial Development Fund); of loans for infrastructure and urban develop- ment of industrial parks, through FIDEIN--Fideicomiso de Conjuntos, Pargues y Ciudades Industriales (Industrial Estates Trust Fund); and of technical assistance services, through the PAI extension system, specialized technical institutions (INFOTEC, etc.) and the General Directorates of Employment and of Training and Productivity of the Ministry of Labor and Social Welfare. 2. In pursuit of the object of rationalizing the Mexican financial and banking system, activities are being developed aimed (a) at strengthening coordination among the various entities and trust funds that support medium and small industry, and (b) at tightening the links between their respective action programs and the guidelines and directives of industrial development policy. With these goals in mind, Nacional Financiera, in its capacity as Industrial Development Bank and Trustee of the development trust funds,has been implementing a series of measures, including in particular the establish- ment of a Small and Medium Industry Development Department. In this context, any future changes in operational systems or organizational structures will pay particular regard to the aim of fully complying with the targets and goals laid down for Stage III of the Integrated Program (PAI). 3. The PAI Technical Assistance Program for 1983-84 will be submitted to the World Bank by May 31, 1983. This Program will be designed to ensure continuity of the major actions undertaken under the provisional program, currently under way, so as to avoid either diminishing its dynamism or interrupting integral support to small and medium industry. The new Program will use a variety of means, such as the promotion of industrial clusters and joint action, all aimed at strengthening the capacity of small and medium enterprises to cope with the new economic situation and to contribute more efficiently to the achievement of economic policy goals in the areas of job creation, regional devlelopment, export promotion and import sub- stitution. ANNEX 3 Page 2 of 27 - 44 - 4. With the particular aim of evaluating the effectiveness of the support granted under the Program and drawing conclusions and recommendations for increasing the operational efficiency of the various support activities, the PAI Technical Secretariat will carry out the following three studies, based on the terms of reference and timetables given in Annex I of this document: (a) Cost-benefit analysis and evaluation of three of the major promotional and technical assistance programs: (i) establishment of industrial clusters; (ii) formation of new enterprises; (iii) regional decentralization of enterprises. (b) Ex-post analysis and evaluation of a representative sample of industrial enterprises assisted by FOGAIN with Program resources, with the particular aim of measuring the impact of this support on, and its effective contribution to, the structure and operation of the enterprises. (c) Survey of a representative group of enterprises assisted with FOGAIN resources, with the aim of evaluating, and deriving conclusions about, the impact and repercussions of the new economic situation on medium and small business. To achieve this objective, this study will be updated periodically, as necessary. 5. The Technical Secretariat of the PAI will conclude technical assis- tance agreements with INFOTEC and the General Directorates of Employment and of Training and Productivity of the Ministry of Labor and Social Welfare. These agreements, together with the specifications and specific execution timetables for each cooperation subprogram, will be opportunely submitted to the World Bank,and such that they are satisfactory to the Bank, by September 30, 1983 at the latest. 6. During execution of Stage III of the Program, PAI intends to foster even more strongly the linkage of small and medium industry operation to economic policy priorities. To that end it will be necessary to step up the promotional and technical assistance efforts, particularly the establishment of new collective aciton groups and strengthening of the industrial clusters already in operation. The Technical Secretariat of PAI will therefore carry out a study of the operation of the Program's industrial extension system, in accordance with Section 3.11 of the Loan Agreement. The purpose of this study will be to derive conclusions and recommendations as the basis for, among other actions, strengthening the structure and operation of the ex- tension system itself, with special emphasis on the incorporation of per- sonnel specialized in various disciplines (technological processes, market- ing, financial planning, etc.) and industrial subsectors. Where appropriate, the technical strengthening of the extension system will aim to improve co- ordination with the agencies responsible for execution of the technical assis- tance subprograms. ALNNtA J Page 3 of 27 - 45 - LOAN AND GUARANTEE PROGRAMS--(FOGAIN) 7. Loans. - FOGAIN's operating norms and procedures will include criteria with regard to the financing of projects for incremental permanent working capital,defined as that increment in working capital used to purchase inventory of raw materials or other items (such as spare parts) and other production inputs to maintain or reach necessary production levels. These credits will follow the terms and limits established by FOGAIN for working capital operations in general. However, a full project appraisal will be presented, to include historical and projected cash-flows, taking into account inventory price increases in Mexican peso terms, using 1981 and 1982 pro- duction levels and prices of the beneficiaries as the basis for calculations, for those subprojects totalling more than US$50,000. In all cases, the analysis will be supplemented by an annex presenting the details of the initial inventory, goods purchased during the various periods,and final in- ventory, together with a projection of estimated production volumes, for a two-year projection period. 8. Guarantee program. - FOGAIN is promoting legal and administrative adjustments which will allow it to provide guarantees for 75% of the amount of loans to small enterprises,and also to medium-sized enterprises in the case of common services. A draft of the operating rules and criteria for the Guarantee Program which, if appropriate, will enter into force as soon as the pertinent authorizations are given, is appended as Annex 2. 9. Portfolio control. - With the object of significantly improving its asset management system and achieving capacity to perform the operational tasks deriving from Stage III of the Integrated Program with the necessary efficiency, FOGAIN will set up a portfolio control subsystem which will make it possible, inter alia, to obtain the operational results set forth in Annex 3. To operate this subsystem FOGAIN will have available the necessary data computation facilities and programs and will carry out a specific sub- program of basic and advanced training for technical personnel of its Finance Department. The terms of reference and timetable are included in the said Annex 3. RISK CAPITAL PROGRAM--FOMIN 10. To enable FOMIN to continue to carry out with the necessary efficiency the activities arising from a growing volume of operations, and in particular its active participation in Stage III of the Integrated Program, its organiza- tion will be restructured to improve its technology and industrial process appraisal and portfolio control capacities. The corresponding program will be submitted to the Bank by September 30, 1983 at the latest. As part of this effort to strengthen its institutional structure and operational pro- ductivity, FOMIN will implement a permanent subprogram of human resource training and development. ANNEX 3 Page 4 of 27 - 46 - 11. In connection with FOMIN's investment portfolio, a plan of action including the following components will be implemented: (a) Addition to the portfolio control system of a mechanism for capturing information making it possible, through monthly analysis of the financial indicators, to identify the situa- tion, behavior and evolution of the associated enterprises. (b) From September 30, 1983, preparation of a periodic report on the specific situation of the enterprises that figure in FOMIN's portfolio problem, which will include--where this is merited--necessary rehabilitation actions and measures. In cases in which a recovery effort is not justified, the report will detail the steps that will have to be taken for winding up and liquidation. (c) Incorporation into FOMIN's audited financial statements of a supplemental consolidated report (Investment Portfolio Evaluation), in the month of July of each year, reflecting the situation of the enterprises in which FOMIN holds shares. (d) Implementation of a program of technical assistance for firms associated with FOMIN, based on support for consulting ser- vices, with the object of contributing to the improvement of the enterprises' administrative, financial, production, and marketing activities and, in general, all activities related to their efficiency and productivity, as described in Annex 4. 12. In the case of convertible loans or equity contributions to be applied exclusively to permanent working capital, the appraisal methods will include the criteria referred to in paragraph 7. INDUSTRIAL ESTATES PROGRAM--FIDEIN 13. During Stage III of the Integral Support Program, FIDEIN's work will have to focus basically on the goal of promoting and providing integral support for preinvestment, execution and operational phases of establishing and devel- oping industrial estates, both public and private. To enable it to perform the related tasks with the necessary efficiency, FIDEIN will make the necessary adjustments to its scheme of operations and its organizational structure. The program of activities and execution timetable are appended as Annex 5. 14. After FIDEIN's Plan of Action has been in operation for 18 months, an evaluation of the results achieved will be made and will be submitted to the World Bank. 15. In order to award contracts for works to be financed with World Bank resources, the norms referred to in Annex 6 will be applied. With regard to contracts totalling over US$500,000 equivalent,FIDEIN will, prior to the award, present to the Bank for its approval: ANNEX 3 Page 5 of 27 - 47 - (a) The document which will form the basis for the bidding; and (b) The corresponding award proposal, including the background and basis for said proposal. With regard to contracts amounting to less than US$500,000 equivalent, FIDEIN will submit to the World Bank, within 30 days of the contract award at the latest, the terms on which the respective contract was awarded and the back- ground materials which were considered in.making the award. Should the Bank determine that a contract was not awarded in conformity with the norms of the said Annex, it will notify FIDEIN of such circumstances in order that FIDEIN apply the corresponding sanctions under its contract with the Beneficiary. ANNEX 3 Page 6 of 27 - 48 - ANNEX 1 TECHNICAL ASSISTANCE PROGRAM EVALUATION OF SUPPORT PROGRAMS CONTENTS A. COST-BENEFIT EVALUATION OF MAJOR TECHNICAL ASSISTANCE PROGRAMS. B. EVALUATION OF ECONOMIC IMPACT THROUGH EX-POST ANALYSIS OF FIRMS ASSISTED BY FOGAIN. C. EVALUATION OF THE IMPACT OF THE ECONOMIC SITUATION AND THE NEEDS OF SMALL AND MEDIUM INDUSTRY. ANNEX 3 - 49 - Page 7 of 27 A. COST-BENEFIT ANALYSIS OF MAJOR TECHNICAL ASSISTANCE PROGRAMS CONTENTS Background Purpose and scope Methodology I. BACKGROUND There have been two main phases in the implementation of the technical assistance activities of PAI. In the first phase the work of the industrial extension agents emphasized individual technical assistance. On the basis of the knowledge acquired and experience with the problems of small and medium industry in the various regions of the country, emphasis was placed during a second phase on the preparation and implementation of special programs geared to the level of industrial development of the different regions of Mexico. The results of these activities have been successful on the whole, and the extension services provided have gradually become more efficient. Although information has been gathered periodically on the results of the work done, there are some inconsistencies and/or shortcomings in the manner of recording and analysis, both as regards the effort invested in implementation itself and as regards the various aspects that should be taken into account for a full knowledge of the outcome of the technical assistance activities. Because of this situation, a project must be undertaken to remedy the shortcomings mentioned above, and which covers the major technical assistance programs. II. PURPOSES AND SCOPE The purpose of this internal project is to make as accurate a determination as possible of the results of the various technical assistance programs. The study should identify and evaluate results from both the qualitative and quantitative standpoints, to permit an evaluation of the costs and benefits of each program and of the indirect benefits that were produced for the development of firms, entrepreneurs and the country in general. In the design of the study, as well as in its findings, an effort will be made to identify the most important aspects with the minimum of time and effort, and to produce, as a final result, an objective evaluation that can be applied to the various technical assistance activities. III. Methodology and timetable for implementation Periods of No. Stage Activities Implementation 1. Determination of the sample of firms and selection Analysis of localities in which there 2 weeks of localities in which the study will be conducted have been programs of industrial decon~centration, establishment of industrial clusters and formation of new enterprises. Determination of the sample of firms. 2. Preparation of questionnaires Design of questionnaires required to 1 week evaluate the programs of: - industrial deconcentration - industrial clusters - formation of new enterprises - individual technical assistance 3. Test of questionnaires Sending of questionnaire to selected 3 weeks localities for pilot testing. 4. Revisions and approval of questionnaires Revisions of questionnaires with the 1 week proposed changes 5. Gathering of information Gathering of information in the selected 6 weeks localities. 6. Compilation, analysis and interpretation of Collation of questionnaires from the 1 week sample data. selected communities for the purpose of: - arranging data - analyzing data - selecting required data 7. Preparation and distribution of preliminary On the basis of the information selected, 4 weeks m X document for discussion and approval. preparation of the basis document for 0 L discussion and/or approval.
Groupe de la Banque mondiale · Staff Appraisal Report
Mexico - Third Small and Medium Industry Development Project
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