Mexico - Third Medium-size Cities and Sinaloa State Water Project

Document of The World Bank i FOR OFFICIAL USE ONLY Report No. P-3532-ME REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN IN AN AMOUNT EQUIVALENT TO US$100.3 MILLION TO BANCO NACIONAL DE OBRAS Y SERVICIOS PUBLICOS, S.A. WITH THE GUARANTEE OF UNITED MEXICAN STATES FOR A THIRD MEDIUM SIZE CITIES AND SINALOA STATE WATER PROJECT April 21, 1983 This document has a restricted distribution and their official duties. Its contents may not oth  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 foreign debt; this was set at 95 pesos per dollar on December 20 and was about 110 on April 14, 1983; and (ii) a free exchange rate for all other transactions; in recent days the free peso has been trading around 150 per dollar. Fiscal Year January 1 to December 31 Acronyms BC Beneficiary Cities Water Supply and Sewerage Companies BANOBRAS National Bank for Public Works (Banco Nacional de Obras y Servicios Publicos, S.A.) CEAPAS Sinaloa State Water Board (Comision Estatal de Agua Potable y Alcantarillado de Sinaloa) DIGESAPA General Directorate of Water Supply and Sewerage Systems (Direccion General de Sistemas de Agua Potable y Alcantarillado) FIFAPA Investment Fund for Water Supply and Sewerage Works (Fondo de Inversiones Financieras para Agua Potable y Alcantarillado) ERR Economic Rate of Return SAHOP Secretariat of Human Settlements and Public Works (Secretaria de Asentamientos Humanos y Obras Publicas) SARH Secretariat of Agriculture and Hydraulic Resources (Secretaria de Agricultura y Recursos Hidraulicos) SEDUE Secretariat of Urban Development and Ecology (Secretaria de Desarrollo Urbano y Ecologia) SHCP Secretariat of Finances (Secretaria de Hacienda y Credito Publico)  FOR OFFICIAL USE ONLY MEXICO MEDIUM SIZE CITIES AND SINALOA STATE WATER PROJECT Loan & Project Summary Borrower: Banco Nacional de Obras y Servicios Publicos, S.A. (BANOBRAS). Guarantor: United Mexican States Beneficiaries: Autonomous water supply and sewerage companies at the state or municipal level, and the Sinaloa Water Board (CEAPAS) Amount: US$100.3 million equivalent, including capitalized front-end fee. Terms: Fifteen years, including 3 years of grace, at the standard variable interest rate. Relending Terms: The beneficiaries would receive the peso equivalent of the loan and would repay FIFAPA, the Trust Fund for Water Supply and Sewerage Works of BANOBRAS, in 15 years after a grace period equal to the shorter of the construction period or 4 years, at an interest rate of 25 percent per annum. The Government would bear the foreign exchange risk. Project Description: The project consists of three components: (a) a construc- tion program and a pilot program for the Sinaloa State Water Board including an institutional development program and a health education program in Sinaloa that could be replicated in other states throughout the country; (b) provision of new and improved water supply facilities, laboratory equip- ment, transmission pipelines, domestic and production metering facilities, sewer interceptors and outfalls, sewage pumping stations and sewage treatment plants in medium-size cities; and (c) institutional support to SEDUE and FIFAPA. Project Risks: The risks are associated with the institutional aspects of the pilot program, namely, the Sinaloa Water Board and the five Regional Companies under the Board, and with the possible reluctance of some of the appraised municipalities to borrow from FIFAPA at the new 25 percent interest rate. To reduce these risks, the Sinaloa Water Board component is proposed to be closely monitored by SEDUE, that has acquired experience in providing technical assistance programs under the previous loans, and water projects are being prepared in a number of medium-size cities that could replace any eventual drop-outs from the already appraised sub-projects. 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 - Cost of Project: Local Foreign Total -----(in million US$)---------- State Water Company 31.4 32.0 63.4 Medium Size Cities 55.0 55.5 110.5 Institutional Support 2.1 1.0 3.1 Total Base Cost 88.5 88.5 177.0 Price Contingencies 4.5 11.5 16.0 Project Cost 93.0 100.0 193.0 Front-end fee on Bank loan - 0.3 0.3 Total 93.0 100.3 193.3 These costs include the value added tax, VAT, but exclude US$53.7 million in interest during construction, which would be financed by FIFAPA . Detailed project costs are given in Annex IV. Financing US$million % Plan: IBRD 100.3 52 Federal Government 93.0 48 Estimated (US$ million equivalent) Disbursements: Bank Fiscal Year FY84 85 86 87 88 89 90 Annual 7.2 25.1 39.0 16.8 8.2 2.0 2.0 Cumulative 7.2 32.3 71.3 88.1 96.3 98.3 100.3 Rate of Return: An aggregate ERR of 17 percent has been estimated for the appraised subprojects. Staff Appraisal Report: Report No. 4007-ME, dated April 19, 1983.  INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT REPORT AND RECOMMENDATION OF THE PRESIDENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO BANCO NACIONAL DE OBRAS Y SERVICIOS PUBLICOS, S.A. WITH THE GUARANTEE OF UNITED MEXICAN STATES FOR A THIRD MEDIUM SIZE CITIES AND SINALOA STATE WATER PROJECT 1. I submit the following report and recommendation on a proposed loan to Banco Nacional de Obras y Servicios Publicos, S.A., (BANOBRAS) with the Guarantee of United Mexican States for the equivalent of US$100.3 million to help finance a Third Medium Size Cities and Sinaloa State Water Project. The loan would have a term of 15 years, including 3 years of grace, at the stand- ard variable interest rate. The Government would bear the exchange risk. The Peso equivalent of the loan would be re-lent to the beneficiary water companies, which would repay in 15 years, after a grace period equal to the shorter of the construction period of the subproject or 4 years, with interest at 25 percent per annum. PART I: THE ECONOMY1/ 2. The Bank's last economic report on Mexico, "Mexico: Development Strategy - Prospects and Problems" (3605-ME), was distributed to the Execu- tive Directors on August 31, 1981. Since then the Mexican economy has faced severe economic and financial strains. An economic mission to undertake an in-depth analysis of the macro-economic developments and prospects for the economy, visited Mexico in February 1983. Country data sheets are attached as Annex I. Background 3. Mexico's GDP grew at an average rate of 6 percent a year in real terms between 1950 and 1980, yielding an increase of 3 percent a year in output per capita. This rate of expansion was somewhat better than the experience of other middle income LDCs. The GDP growth was composed of a satisfactory balance between agriculture (which grew at 3.5 percent a year) and industry (which grew at an average rate of 7.5 percent). The sustained and rapid industrialization resulted in the rise of the share of the indus- trial sector in GDP from 26 percent in 1950 to 37 percent in 1980. A similar change took place in the structure of foreign trade, with manufactured products accounting for an increasing share of total exports until 1975. Finally, the last thirty years witnessed the passage of Mexico from a rural to a largely urban society. In 1980, the fraction of total population living in urban areas was estimated at two-thirds, while it was less than 30 percent in 1950. 1/ This section is substantially unchanged from the President's Report for the Agricultural Marketing Project for Perishables (P-3504-ME of March 31, 1983). However, some minor changes have been introduced in paras. 6 and 13.  - 2 - 4. The dynamic private sector was the main engine of growth in the Mexican economy even though the public sector continued to account for well over one-third of domestic capital formation until the mid-1970s, i.e. before the rise of the oil sector that greatly enhanced the resources available to the Government. The public sector's role in Mexico was seen both to set the pace and pattern of economic growth and to help correct the effects of an uneven distribution of resources on the relative position of the poorer segments of the population and of the less favored regions of the country. The Government's success in this regard, however, was only partial. While the living standards of many Mexicans experienced considerable improvement, the income of the poor farmers and marginal urban dwellers lagged behind. Consequently, contrasts within the Mexican economy remain conspicuous. 5. In the early seventies, the Government sought to build up infra- structure, expand basic industries, stimulate agricultural output and implement massive social programs. The difficulties it encountered in mobilizing resources to attain all these aims simultaneously led to excessive public sector deficits, while domestic supply rigidities caused a large part of the aggregate demand to spill over into imports. Efforts to redress financial imbalances by strengthening public revenues fell short of their goal and, in September 1976, the Government abandoned the fixed parity of the peso and imposed a strict stabilization program on the economy in the context of the Extended Facility arrangements with the IMF. Economic Performance, 1976-1981 6. The last Administration, which took office in December 1976, saw the control of inflation and the improvement of the current account balance as its most urgent tasks. It succeeded in reducing the rate of increase of domestic prices by half between 1977 and 1978 while, at the same time, the current account deficit decreased by over 40 percent. In 1978, the economy resumed its path of rapid growth. One of the major constraints on economic growth - the availability of foreign exchange - had been greatly relaxed by the successful exploitation of Mexico's oil reserves, which at the end of 1982 stood at 72 billion barrels. Oil not only contributed directly to foreign exchange earnings and Government revenue, but it also enabled the country to carry a much larger external debt. The additional resources enabled the purchase of raw materials and capital goods needed to sustain a high GDP growth, and allowed the Government to embark on an ambitious expenditure program. 7. The public expenditure grew in real terms 20 percent a year between 1979 and 1981. Revenues grew more slowly, thus causing the public sector deficit to rise rapidly. As a proportion of GDP, the deficit rose to 15 percent in 1981, compared to a ratio of around 7 percent in the preceding several years. Despite a high rate of mobilization of private savings into the financial system, the Government had to resort increasingly to foreign borrowing. Although public sector foreign indebtedness, as a percentage of GDP, had fallen from 31 percent in 1977 to 20 percent in 1980, it rebounded again to more than 30 percent in 1981. By 1980, the rapid rise in aggregate demand was beginning to exert pressure on prices, and domestic inflation reached 26 percent. Since the nominal exchange rate had remained practically stable since 1977, the higher Mexican inflation resulted in an appreciation  of the peso in real terms. By 1980 the competitive edge gained after the 1976 devaluation had been lost. This made non-oil exports progressively less attractive, while imports rose rapidly at 30 percent a year. 8. On the positive side, the economic growth rate accelerated to over 7 percent during 1978-81, and resulted in an improvement of the labor market. Conditions were created not only to absorb the new entrants into the labor force, but also to lower open unemployment, which is estimated to have * fallen to 4-5 percent of the labor force in the modern sector. The Adminis- tration also strengthened its support to agriculture, reversing the trend towards a worsening trade balance on basic foods, containing to some extent rural migration, and providing small farmers with access to more efficient production methods. Finally, a combination of fiscal incentives and adminis- trative regulations had a positive effect on spatial decentralization, one of the major policy objectives of the Administration. Recent Developments 9. The state of the Mexican economy witnessed a progressive deteriora- tion since about the middle of 1981, and the Government's actions could be seen as responses to, instead of guiding, the events. By 1981, the need to bring domestic inflation under control and to help restore the competitive- ness of the non-oil exports had become apparent. The Administration chose to follow a policy of gradual adjustment, and expected the deceleration in the growth of demand, to be brought about through slowing the rise in public expenditures, would reduce inflation. With a favorable outlook for oil exports, no major problems were expected on the external sector, and a path of gradual adjustment to a rate of growth of 6-7 percent appeared sustainable in the long run and was considered to be less costly in terms of inflation and unemployment than more drastic stabilization measures. Thus, the Admin- istration decreed a 4 percent cut in its expenditures, reintroduced import licenses on 80 percent of imports, tightened public procurement procedures, and allowed a more rapid depreciation of the peso. 10. Unfavorable external circumstances as well as the ineffectiveness of the policies adopted were at the root of the deteriorating economic condi- tions in 1981-82. On the one hand, the prospects for the world oil market worsened in the second half of 1981, and the actual oil revenues, at US$14 billion, turned out to be 25 percent below what had been estimated in the budget. There was also the tightening of the international financial market, with a steep rise in the interest rates, which greatly increased the debt servicing burden, since the bulk of Mexico's external borrowing had been contracted at variable interest rates. By the end of 1981, the current account deficit reached $11.3 billion, or 4.5 percent of GDP. But the Government also failed to control public expenditures, which continued to rise faster than revenues right through 1982, resulting in an unprecedented high public sector budget deficit, estimated at 16.5 percent of GDP. In 1981, half of the financing gap could be met through external funds. Net new borrowing in that year amounted to US$18 billion (53 percent higher than the previous year) of which half consisted of short-term debt. During 1982, the foreign commercial lenders became progressively wary of extending new loans or rolling over the past ones as the country's financial and economic condition worsened.  - 4 - 11. Although the budget approved for 1982 was a moderate one, showing virtually no real increase in expenditures, the belief that the oil market would remain slack and doubts about financial discipline in the public sector fueled the expectation that the Government would not succeed in reducing the deficit and bringing down the rate of inflation. In fact, the general expectation was that inflation would worsen. Raising the minimum wage rate by 34 percent in December 1981 and the award of a 24 percent wage increase to public employees did little to improve the confidence in the management of the economy. The exchange markets continued to react unfavorably, despite the authorities allowing the peso to depreciate in February 1982 by some 70 percent, from Mex$28 to Mex$47 to the US dollar. 12. The Administration also announced an adjustment program following the devaluation. On April 19, 1982, a 17-point stabilization program was decreed, with further cuts in public expenditures, increases in public goods and service prices, and a ceiling on domestic deficit financing. The announcement of these measures failed to assuage the fears of the interna- tional financing community, and capital outflows persisted. On August 5, the shortage of foreign exchange forced the Bank of Mexico to withdraw once again from the exchange market. Following this a series of policy and institution- al changes were introduced, the most salient of which included a rigorous control of foreign exchange transactions, a dual exchange rate system (of Mex$50 and Mex$70 to the US dollar), nationalization of the domestic commercial banks, and the elimination of the US dollar accounts held in Mexico (the so-called Mex-dollar accounts) as they matured. The Government also requested the commercial banks to roll over principal repayments on public debt falling due during 90 days from August 23, 1982 (amounting to US$12 billion). Shortly thereafter, the Government approached the IMF for the granting of an Extended Facility, which was finally approved in the amount of SDR 3.6 billion on December 23, 1982. 13. As part of the agreement with the Fund as well as on the initiative of the new Administration of President Miguel de la Madrid (installed on December 1), several reforms have been instituted. The new Government has committed itself to a drastic reduction in the public sector deficit, to 8.5 percent of GDP in 1983, with further reductions intended for the following two years. The public sector prices, especially for petroleum products, have been raised drastically. The regulations governing foreign exchange have been modified. There continue to be two basic exchange rates (a controlled crawling rate of about Mex$110 per US dollar for specified transactions and a floating rate for all other transactions). In addition, an accounting rate of Mex$70 for the US dollar is used primarily for servicing public debt. As regards the external debt, the Government has reached an agreement with the foreign commercial banks on the restructuring of US$9 billion of the short- term public debt and $10.6 billion of medium and long-term debt due for repayment up to the end of 1984; rescheduling documents are now being executed between the borrowing agencies and their lenders. Prospects 14. It is particularly difficult at this stage to predict the course the Mexican economy will follow in the next few years. It is, however, clear that the period ahead will be one of austerity and sacrifices on the part of  the Mexican population. The factor which helped to postpone difficult policy decisions in the past - the abundant foreign exchange - cannot be expected to provide a cushion in the future. Although the Mexican economy can count on substantial natural resources, an educated and skilled labor force, and well-developed institutions, the prospects of growth in the short and medium-term will depend basically on: (i) the deflationary effects of the proposed sharp reduction in the budget deficit; (ii) the constraint on resource availability imposed by the need to service the large external debt; and (iii) the specific measures the Government adopts to stimulate production and exports of agricultural and manufactured products. 15. The recent budget deficits, a substantial part of which was financed by external sources, cannot be sustained in the future. In the absence of a quick recovery of the oil market - the chances for which are slim - the Government will have drastically to reduce expenditures and to raise revenue through increases in taxes and prices of public goods and services. But such deflationary measures will also likely affect production. Under generally favorable conditions, a reduction of the budget deficit to 8.5 percent of GDP - the target under the IMF agreement - could mean no growth at all in the national output in 1983, with a fair chance that it might actually decline. This should, however, considerably lessen the inflationary pressures in the economy. Once a reasonable budget balance has been established, and it may take some time, the economic health of the economy would be restored, and conditions favorable to steady growth would have been created. 16. The constraint on economic growth imposed by the external debt is likely to be longer lasting. Total external public debt amounted to $53 billion ($11 billion in short-term) at the end of 1981 and over $57 billion ($9 billion in short-term) by August 22, 1982. The private debt is estimated at $22 billion. The public debt service is estimated at $14.4 billion in 1982, and the interest payments alone could amount to $12 billion in 1983. For 1982, the debt service ratio is estimated at almost 50 percent, and the ratio of the external debt to GDP of about 45 percent. Mexico is estimated to require over $8 billion in foreign borrowing for 1983 to meet its foreign exchange needs and obligations. The IMF facility is expected to provide $1.3 billion, official sources $2 billion, and a $5 billion commitment has already been signed with commercial banks. 17. To avoid another financial crisis in a few years, there is need to ensure that the country's debt servicing capacity improves quickly. A critical element in this is the growth of the non-oil economy, specifically agriculture and industry, which are the principal earners and savers of foreign exchange. Although, a reduction in the budget deficit is likely to impose limits on the overall growth of the economy, appropriate incentive policies are needed to stimulate the growth of agriculture and manufacturing, which are largely private sector activities. 18. The country would continue to face structural problems in the years to come, related mainly to unemployment, poverty and unequal interpersonal and inter-regional distribution of income. Efforts were made in the past to improve the living conditions of the poorer segments of the population. A family planning program started in 1972 assisted in bringing the growth rate  - 6 - of the population to an estimated annual average of 2.6 percent, down from 3.5 percent in the 1970s. To tackle the problems of malnutrition and increasing dependence on foreign food, the previous Administration launched the SAM (Mexican Food System) Program, aimed at increasing self-sufficiency in basic foods, providing for minimum nutritional needs of the poor and increasing rural employment. The new Administration has abandoned the SAM strategy and is eliminating many of the producer's subsidies included in the Program, which were very costly and of questionable efficiency. In the last few years, the Government has placed greater emphasis on the promotion of small scale irrigation, rehabilitation of underutilized existing irrigation works and provision of credit and technical assistance for the development of rainfed agriculture. 19. The main urban-regional problems are: growing congestion, pollu- tion, high cost of services (especially water) and other management problems that stem from the continued growth of Mexico City (already the third most populous metropolitan area in the world and moving rapidly to become the first) and Monterrey and Guadalajara, located in the dry, densely populated central plateau; and retarded development, poverty and great difficulty in providing better jobs or adequate public services to the two-fifths of all Mexicans who live in small, scattered rural centers. Several steps have been taken in the past to confront these problems, including an administrative reorganization and the elaboration of a comprehensive National Urban Plan in 1978 and of a National Industrial Development Plan in 1979. 20. Restoration of a high and sustained rate of growth will provide the strongest weapon to tackle the long-term problems mentioned above. At present, Mexico is going through a period of adjustment, which dictates lower real growth and employment generation in the next few years. However, this will afford an opportunity to reappraise many of the past years' goals and policy instruments, and provide a sounder basis for Mexico's development. The new Administration has shown already its ability to take difficult and politically unpopular decisions. 21. The external debt problems have been described in para 16. The current debt service ratio is below the peak of 66.2 percent reached in 1979, but still very high. With the restructing of the external debt, the debt service ratio is expected to remain around 45 percent until 1987, when the first repayments of the restructured loans would start. Thereafter, the debt service ratio would start rising unless steps are taken to foster a rapid growth of export earnings. Debt service on Bank loans amounted to about 3 percent of public debt service in 1981; this ratio is projected to remain about the same during the mid-1980s. The Bank currently holds about 6 percent of Mexico's total medium and long-term public debt, and this ratio is not likely to change significantly over the next few years. In view of the medium and long term potential of the economy and provided that the new Administration continues to address forcefully the challenges outlined before, Mexico is considered creditworthy for borrowing on conventional terms. In view of the country's estimated foreign exchange needs over the next few years, financing of ongoing and new projects should include some local costs.  PART II - BANK GROUP OPERATIONS IN MEXICO 2/ Bank Operations 22. As of March 31, 1983, Mexico had received 77 loans from the Bank amounting to US$5,749 million net of cancellations and terminations; of these, 50 loans totalling US$2,724.6 million were fully disbursed. The Bank held US$4,795.8 million, of which US$2,085.0 million had not yet been dis- bursed. Some 46 percent of Bank lending has been for agriculture and rural development, 17 percent for industry, 12 percent for power, and 14 percent for transportation; the remaining 11 percent has been for water supply, tourism, urban development, vocational training and pollution control pro- jects. Annex II contains a summary statement of Bank loans as of March 31, 1983, and notes on the execution of ongoing projects. 23. Of the US$5.7 billion total lending, about US$2.6 billion was for establishing or strengthening institutions for channelling credit to areas where credit supply was deficient or non-existent, and setting up in the commercial banking system the ability to carry out project-related appraisal of investments in agriculture, industry and tourism. These credit programs have facilitated lending to low-income farmers and small- and medium-scale industrial enterprises based on productive investment plans rather than collateralized credit. 24. The Government arranged adequate budget financing in the years 1978 to 1981 which significantly improved project implementation. Government and Bank officials met periodically to review project implementation, and greater attention was focused in Mexico on project monitoring. As a result of these measures, most of the Bank-assisted projects were being implemented satisfac- torily until mid-1982 and disbursements rose from US$91 million in FY78 to US$448 million in FY82. However, the present financial crisis is again causing delays in the provision of counterpart funds, and proposals for special actions are under preparation to help the Government ease the coun- terpart funding constraints on the implementation of projects. IFC Operations 25. As of March 31, 1983, IFC had made investment commitments in com- panies in Mexico, for a total of US$551.2 million, of which US$411.6 million had been sold, repaid or cancelled. A summary statement of IFC investments is presented in Annex II. 2/ This section is substantially unchanged from the President's Report for the Agricultural Marketing Project for Perishables (P-3054-ME of March 31, 1983). Changes have been introduced in paras. 22-25, 27, 28 and 32.  -8- Bank Strategy 26. The main objectives of Bank lending in Mexico in the past six years have been to: (a) support policies and programs leading to a wider distribu- tion of the benefits of economic growth; (b) help finance projects that make, directly or indirectly, significant contributions to output and employment; (c) help reduce Mexico's urban-regional imbalances; and (d) help break bottlenecks preventing rapid growth. Under the present circumstances, the Bank also intends to support the Government's stabilization program through quick disbursing operations and assistance to increase non-oil export earnings, and to participate in an intensive macro and sector policy dialogue to support design and implementation of appropriate development policies. 27. Because of the difficult structural problems of agriculture and the sector's crucial importance for the one-third of the national population living in the rural areas, the Bank has made agriculture the leading sector for its lending. The Bank's agricultural lending program in Mexico has four goals: first, to increase productivity of presently cultivated lands; second, to improve the productivity of small farmers; third, to complement infrastructure investments with support services, such as extension, marketing programs and credit; and fourth, to promote employment generating investments in rural areas. The Bank has made 13 loans in FYs77-82 totalling US$1,834.4 million for irrigation, rural development and agricultural, agro- industrial and livestock credit programs. A US$175 million loan for a rural development project and a US$180 million loan for an irrigation rehabilita- tion project were approved by the Executive Directors in FY82, and a US$138.4 million loan for San Fernando rainfed agricultural development was approved in early FY83. A US$115 million loan for marketing perishables was approved by the Executive Directors in April, 1983. Several projects for rainfed agriculture, regional development and rural credit are in preparation. 28. Bank lending for industry has aimed at: (a) reduction of the balance of payments deficit; (b) decentralizing industrial activities away from the major and increasingly congested urban areas; and (c) promoting greater employment. A steel project which the Bank helped structure and finance is now operating in a previously underdeveloped area on the west coast of Mexico, and the city in which it is located, Lazaro Cardenas, is developing into a new growth pole. Four loans for industrial projects to promote the development of small- and medium-scale industrial enterprises, to finance expansion of small- and medium-scale mining, and to support an indus- trial equipment fund (FONEI) were approved by the Executive Directors in FYs78-80. A loan for a vocational training project was approved by the Executive Directors in July 1981; it is assisting a program to increase the supply of skilled workers and technicians. A US$152.3 million loan for development of a capital goods industries project and a US$60 million loan for pollution control were approved by the Executive Directors in FY82. The capital goods project has been revised to set up a pilot export development fund to help alleviate the current foreign exchange shortage confronting Mexican exporters. A follow-up small- and medium-scale industries project and an export development operation to help Mexico to promote its exports are being processed.  - 9 - 29. Bank lending for physical infrastructure has been focused on regional development and strengthening of institutions and sector policies. A highway sector project (FY79) and the fourth railway project (FY81) support these goals. The first and second medium size cities water supply and sewerage projects (FY76 and 81) reinforce the planning, management and finance of specialized water supply and sewerage institutions at the federal and municipal levels, and contribute to the establishment of tariffs more closely related to costs. 30. The Government has adopted a National Urban Development Plan that spells out its regional development priorities in operational terms. A project to assist in the development of the Lazaro Cardenas conurbation area was approved by the Executive Directors in FY78, and a second urban project for oil-producing southeastern Mexico was approved by the Executive Directors in FY81. A loan for the preparation of a deconcentration program for the Mexico City Region was approved by the Executive Directors in August 1982. 31. The Economic Development Institute (EDI) is assisting CECADE (a similar institute under the Ministry of Programming and Budget) in training Government staff in project preparation, monitoring and evaluation. EDI assistance is directed at courses on urban and regional development, agricul- ture, rural development and agro-industries. The Bank has also assisted the Mexican authorities in training personnel for managing water supply and industrial credit projects. 32. The Inter-American Development Bank (IDB) is the second largest source of multilateral aid to Mexico. The IDB has made loans to Mexico totalling US$2,974.3 million as of March 31, 1983. Over 50 percent of the total has gone for agricultural and rural development projects, and the balance for transportation, industry, water supply and sewerage, tourism infrastructure, education, municipal development and pre-investment. The IDB and the Bank have coordinated their assistance on several projects. Each has made loans for the national integrated rural development program (PIDER), agricultural and livestock credit, small- and medium-scale industries development, and hotel development projects. The International Fund for Agricultural Development (IFAD) has approved a loan of US$22 million for a rural development project in the state of Oaxaca which was appraised by the Bank's staff and for which the Bank is acting as cooperating institution for administering the loan. 33. Bank-supported power, steel, fertilizer and tourism projects in Mexico have been co-financed by several bilateral export credit agencies and commercial banks. In January 1982, Mexico borrowed US$500 million from commercial banks to provide complementary financing for Bank-assisted pro- jects where project specific co-financing would be difficult.  - 10 - PART III - THE WATER SUPPLY AND SEWERAGE SECTOR 34. Mexico has an unusual mismatch between water resources and popula- tion concentration. Rainfall ranges from 100 mm per year in dry areas to 5,000 mm in the tropical low lands. Population is scarce in areas with heavy rainfall, while dry areas are heavily populated. About 82 percent of Mexico's surface water resources are found below 500 meters of elevation, but 76 percent of the population is located, and 80 percent of the industrial output is produced, above this level. 35. The 1980 population of Mexico was 67.4 million of which 44.6 mil- lion, or 66 percent, lived in urban centers and 22.8 million in rural areas. Population growth has declined from 3.5 percent p.a. in the early 1970's to 2.6 percent p.a. at present. The Government is trying to improve the pattern of population distribution through the policies put forward in the National Urban Development Plan and the National Industrial Development Plan. Service Levels and Past Investments 36. The percentage of total population with access to water supply systems increased from 49 percent in 1970 to 58 percent in 1981. Sewerage service levels increased during the same period from 37 percent to 38 per- cent. An estimated 30 million people remain without access to safe water supply, while about 43 million people lack access to sewerage facilities. 37. Water service coverage through house connections in urban areas other than Mexico City, however, decreased from 65 percent in 1970 to 55 percent in 1981, and sewerage service levels decreased from 55 percent to about 43 percent over the same period. These decreases were offset by rural increases in access to water services from 21 percent in 1970 to 51 percent in 1981 (44 percent through house connections and the remainder by public standpipes). Rural sewerage service levels increased during the same period from 4 percent to 13 percent. 38. During 1974-1980, annual investments in the sector totalled Mex$8 billion (US$320 million in 1980 prices). Investments in rural areas increased from 34 percent to 50 percent of total sector investments in 1977-1980. On average, Federal funds financed 50 percent of total sector investment. These funds were provided as grants or loans. Most of the loans were interest free, with repayment periods of 10-20 years, and in practice many were never repaid. The Banco Nacional de Obras y Servicios Publicos (BANOBRAS) is the main financial agency for the sector outside the capital city. Its Trust Fund for Water Supply and Sewerage Works (FIFAPA) has financed 7.2 percent of total federal investment in the sector. FIFAPA is being supported by the Bank through loans 1186-ME and 1913-ME, and would receive financing under the proposed project. FIFAPA's role in the sector is particularly important because it has permitted pressure on the federal Government for grant funds to be reduced and has introduced on a large scale the concept of cost recovery in water supply and sewerage projects. As a result, in 1983 the Government intends to channel through FIFAPA about 80 percent of the federal funds for the sector, and thereby significantly decrease grant funds for water supply and sewerage works.  - 11 - Government Objectives and Strategy 39. The Government's specific water supply and sanitation objectives are to provide, by the year 2000, 95 percent of the urban and 70 percent of the rural population with piped water, and 80 percent of the urban and 42 percent of the rural population with sewerage or sanitation services. The intermediate targets for the year 1990 are to extend water service to about 83 percent in urban areas and 58 percent in rural areas, and sewerage service to about 62 percent in urban areas and 27 percent in rural areas. Although these goals appear feasible from the point of view of the institutional capacity of the sector, financial constraints might affect the realization of these targets. Sector Organization 40. Since 1976, the Secretariat of Human Settlements and Public Works (SAHOP) was in charge of planning, construction, supervision, operation and maintenance of the water supply and sewerage works in urban centers other than Mexico City and in rural areas. In late 1980, the responsibility for operation and maintenance of the water supply and sewerage systems was trans- ferred to the states. In December 1982, the new Administration established the Secretariat of Urban Development and Ecology (SEDUE) and assigned to it responsibility for the planning and supervision of all water supply and sewerage systems in the country, except for those in Mexico City. At that time, responsibility for construction of new systems or improvement of existing ones was legally transferred to the states. However, the Government has decided that SEDUE will continue to be in charge of construction during a transitional period until the states are able to handle their new responsi- bilities. SEDUE also provides technical assistance to the states. 41. The states created water and sewerage companies to operate and maintain the systems transferred to them. The scope of responsibilities entrusted to these new companies range from those with state-wide responsi- bilities to those responsible for a single system only. Some local water supply and sewerage systems have not yet been established as autonomous entities and continue to be operated by the municipal departments in charge of these services. The proposed project includes a strong institutional development component for one of the state companies, the Sinaloa State Water Board (CEAPAS) and its five Regional Companies with a view to set up a model to implement the decentralization plans of the Federal Government. Bank Role and Strategy 42. The Bank has been assisting Mexico with the implementation of water supply and sewerage projects since 1973. Loan 909-ME of June 1973, helped finance a US$155 million bulk water supply project for the Mexico City metropolitan area. The project was completed in 1981, after delays due to inadequate preparation and institutional problems. The Project Completion Report and the Project Performance Audit Report indicate that the main project objectives were broadly achieved. The Bank has made two loans to FIFAPA to finance water supply and sewerage projects for medium-size cities (Loans 1186-ME of January 1976 and 1913-ME of January 1981). Both loans are  - 12 - fully committed, and the financial and operating performance of the benefi- ciary water and sewerage companies has been satisfactory. To comply with the financial covenants in 1983, further action on tariff increases will be required in four of the thirteen cities included in these projects by the end of the year. 43. The Bank has also financed water supply and sewerage works under several projects in tourism, urban and rural development. Implementation of these has been satisfacotry. 44. Bank support to the FIFAPA scheme should permit sector lending in the forthcoming years, to support the implementation of the Government's plans to decentralize sector responsibilities and apply sound financial policies. Technical assistance to the sector's institutions, introduction of low-cost technologies and acceleration of provision of basic services to the low-income population of Mexico's growing urban centers would be the corner- stone of this strategy. Emphasis would also be given to pollution control, solid waste disposal and rural water supply and sanitation as the objectives in medium-size cities and state water companies are progressively achieved. PART IV - THE PROJECT 45. The proposed project was identified by a Bank mission in April 1981, and was prepared by BANOBRAS and SAHOP with the help of local consul- tants and Bank missions. The project was appraised in March 1982 with post-appraisal in February 1983, after the new Administration confirmed the sector's priority. Negotiations took place in April, 1983, and the Mexican delegation was headed by Mr. German Sandoval, of BANOBRAS. An appraisal report, "Staff Appraisal Report - Medium-Size Cities and Sinaloa State Water Project" (Report No.4007-ME) is being distributed separately. Project Objectives 46. Water supply and sewerage programs have been accorded high priority in Mexico even at a time of budget austerity, on grounds of employment generation and social impact. The proposed project would support the Government's goals in the sector, improve the environmental and health conditions of the population, strengthen the Sinaloa State Water Board (CEAPAS) and the Regional Companies under its control by improving their managerial, administrative, financial and technical procedures, and extend water supply services to about 1.4 million and sewerage services to about 1.2 million additional people. The project objectives will be achieved through the implementation of three components, described below. The CEAPAS Component 47. The objective of this component is to help CEAPAS develop into an institution that would serve as a model for establishing efficient water supply and sewerage companies at the state level. This component accounts for about 36 percent of the total project costs and would include the following programs:  - 13 - a) An institutional development program aimed at analyzing the organization and managerial procedures of CEAPAS and at promoting changes that would develop CEAPAS into an efficient, financially self-sufficient institution able to assume the responsibility for construction. The program would provide support for improving the water and sewerage companies in other states in the future. b) A construction program in the cities of Culiacan, Los Mochis, Topolobambo and Mazatlan (see attached Map IBRD 16393) that would benefit about 400,000 people and would consist of increased water production, treat- ment, storage, distribution facilities, new house connections, extension of the sewerage network, outfalls and construction of a sewerage treatment plant. c) A pilot health education program to promote better sanitation habits among the population in the areas where new facilities would be built under the project. This program would be carried out by consultants. d) A maintenance of equipment program, including purchase, opera- tion and maintenance of meter repair shops, topography equipment, excavators, water quality control laboratories, and leak detection and communication equipment for CEAPAS and the Regional Companies. The Medium-Size Cities Component 48. The medium-size cities component would support the Federal Govern- ment's strategy of promoting the development of basic infrastructure in medium-size cities for improving population distribution in the country and develop basic infrastructure for industrial growth. The program would improve the water supply and sewerage systems in medium-size cities outside the State of Sinaloa. Four subprojects accounting for about 22 percent of the project costs have been appraised for the cities of Celaya, Colima, Ciudad Guzman and Tapachula (see attached Map 16393). Additional subprojects would be selected by FIFAPA/SEDUE for financing under the loan before December 31, 1984, with the concurrence of the Bank. 49. Works in the four appraised medium-size cities are representative of this component and include the following elements: (i) provision of new production facilities and improvement of existing ones to meet demand through 1995; (ii) chlorination of water supplies to provide bacteriologically safe water and provision of laboratory equipment to control water quality; (iii) construction of transmission pipelines from the new production facilities to the distribution systems, and provision of additional storage capacity; (iv) extension of the water system to areas without service and improvement of the water distribution system to increase delivery capacity;  - 14 - (v) installation of new metered house connections and provision of meters for currently unmetered connections to cover 95 percent of all connections; (vi) purchase and installation of production meters and meter repair shops, and implementation of leak detection surveys and leak detection and control programs to reduce unaccounted- for water to about 25 percent by 1986; (vii) construction of sewer interceptors and outfalls to eliminate sewage discharge in populated areas; (viii) extension of sewer pipes to areas without sewerage services; (ix) construction of sewage pumping stations, where topographic conditions preclude the use of gravity systems; and (x) construction of sewage treatment plants where downstream use requires improvement in water quality. Institutional Support 50. The third component consists of a technical assistance program, including the purchase of support equipment, for SEDUE's General Directorate for Water Supply and Sewerage Systems (DIGESAPA) and FIFAPA. This component includes studies to establish the best solutions for the sector problems, and would aim at improving the efficiency of the sector institutions. The com- ponent includes the revision of SEDUE's guidelines for project preparation. The Borrower 51. The Borrower will be BANOBRAS, which is also the Borrower in the first and second Bank-financed water and sewerage projects for medium-size cities (Loans 1186-ME and 1913-ME). The federal Government controls its policies and directs its borrowings and lending activities. BANOBRAS' normal credit operations carry interest rates of 6 to 15 percent less than the ACF (average cost of borrowed funds), but it also lends for water sup- ply and sewerage works through a soft window, the Municipal Development Fund (Fondo Fiduciario Federal de Fomento Municipal) at 5 percent per annum, and through FIFAPA. BANOBRAS' 1981 lending program amounted to about US$2.1 billion, its net worth was US$334.7 million equivalent and its net profits after taxes were US$37.58 million equivalent. 52. FIFAPA is a trust fund under BANOBRAS that finances water and sewerage investments in medium size cities. FIFAPA has been instrumental in introducing the practice of cost recovery and in helping the Federal Government reduce its grants to the water supply and sewerage sector (see para. 38). FIFAPA is partially funded by the Bank through Loans 1186-ME and 1913-ME and would serve as the channel for the proposed Loan. FIFAPA has since its beginning kept a satisfactory financial situation. To date, FIFAPA has lent the equivalent of US$478 million. FIFAPA will receive the proceeds of the Bank loan as equity contribution, and will reimburse BANOBRAS for interest on the loan expressed in local currency. BANOBRAS would repay  - 15 - the loan to the Bank. The Government would bear the foreign exchange risk. FIFAPA would onlend the proceeds of the loan to the beneficiaries (see para. 54) under terms and conditions described in para. 63. The Executing Agency 53. The project will be executed by SEDUE through its General Direc- torate of Water Supply and Sewerage Systems (DIGESAPA). The newly created Secretariat is staffed with qualified managers formerly with SAHOP, and has experience in implementing the two previous loans. SEDUE, through DIGESAPA, will be in charge of project execution. Since the Government intends to transfer the responsibility for construction to the states, the legal docu- ments allow for the possibility that SEDUE would delegate the responsibility for the execution of the relevant components to water supply companies complying with technical and administrative criteria satisfactory to the Bank (Section 3.01(b) of the draft Guarantee Agreement). After the transfer, SEDUE would maintain responsibility for project supervision. SEDUE will also provide assistance to all beneficiaries in management, accounting and all areas of administration. The Beneficiaries 54. The beneficiaries of the proposed loan will be Autonomous Municipal Water Companies (BC's) in medium-size cities, similar to those benefitting from two earlier loans, and CEAPAS. BC's will be in charge of administering and operating the water supply and sewerage systems. At the time of apprais- al four medium size cities and four cities under CEAPAS had already been selected. Subprojects to be implemented in these cities account for about 60 percent of the project costs. The remaining beneficiaries will be selected before December 31, 1984, with the approval of the Bank (see para. 63), and will also be autonomous companies. 55. The financial performance of the appraised cities varies substan- tially. Working ratios range between 0.5 and 1.1. Three of the cities show a negative net income before interest. The financial record is only preliminary since fixed assets have been neither revalued, depreciated, nor recorded properly. These accounting deficiencies would be corrected in the course of project implementation. 56. CEAPAS, organized in September of 1981, is an autonomous public entity in the State of Sinaloa, that acts as a regulating and coordinating authority for the activities and investments of five semi-autonomous Regional Water and Sewerage Companies (Rio Humaya, Rio Fuerte, Rio Baluarte, Rio Evora and Rio Sinaloa - see Map IBRD-16392). The Bank was consulted in the prepa- ration of the by-laws of CEAPAS, which were recently approved by the State legislature. Since the enforcement of the by-laws requires their publication in the official gazette of the state of Sinaloa, such publication has been made a condition of loan effectiveness (Section 7.01(b) of the draft Loan Agreement). The Regional Companies own and eventually will operate all water and sewerage systems in the state. Less than 40 percent of the water and sewerage systems in the state are presently under the Regional Companies' management. The Government aims at integrating all the state systems under the CEAPAS Regional Companies by December 31, 1987 and a covenant to this  - 16 - effect has been included in the legal documents (Schedule 4, para. B(ii) (2) of the draft Loan Agreement). 57. Only three Regional Companies (Rio Humaya, Rio Fuerte and Rio Baluarte) are currently under the authority of CEAPAS. The other two Regional Companies (Rio Evora and Rio Sinaloa) are still in the process of incorporation. As a condition of disbursement of loan proceeds for the CEAPAS component, the five Regional Companies should have been incorporated, their organization should have been established and their key personnel appointed. (Schedule 1, para. 3(b) (iii) of the draft Loan Agreement). At present, CEAPAS lacks experience and competent manpower to properly regulate and control the Regional Companies. The present organization of the Regional Companies is also weak, but it is considered sufficient for the project because of the technical assistance to be provided by SEDUE. The institu- tional development program mentioned in para.47(a) would correct the existing deficiecies. Project Execution 58. Construction of the works will be carried out by SEDUE and/or the BC's. SEDUE will supervise project implementation through DIGESAPA, that will be properly staffed at all times (Section 4.02 of the draft Guarantee Agreement) and will be in charge of preparing bidding documents and tender analysis, and monitor project execution and compliance with subloan agree- ments by the beneficiaries. SEDUE will provide technical assistance to the BC's and CEAPAS, including training (Sections 3.01(c) and 4.03(a) of the draft Guarantee Agreement). For this purpose, the material already prepared by the former SAHOP in all areas of management and accounting will be used. The project would be completed by December 31, 1989. 59. The role of SEDUE will be particularly important in the imple- mentation of the CEAPAS component. DIGESAPA will be in charge of the implementation of the institutional development program in Sinaloa, for which terms of reference have already been prepared. The hiring of acceptable consultants to implement this part of the project would be a condition of disbursements for the CEAPAS component (Schedule 1, para. 3(b)(i) of the draft Loan Agreement and Section 3.02 of the draft Guarantee Agreement). As part of the institutional development program, SEDUE will review the financial aspects of CEAPAS and will prepare a scheme of fees to be paid by the Regional Companies to CEAPAS. The establishment of such scheme, satisfactory to the Bank, will be a condition of disbursements for the subprojects in the State of Sinaloa (Schedule 1, para 3(b) (ii)of the draft Loan Agreement). SEDUE will present to the Bank for comments the diagnosis of CEAPAS institutional problems by June 30, 1985, and a program satisfactory to the Bank, for implementing the required changes by December 31, 1987. Thereafter, this program would be put into effect to the satisfaction of the Bank (Section 3.01(f) of the draft Guarantee Agreement). 60. The condition of the water supply and sewerage network is deficient in many cases. SEDUE estimates that about 40 percent of the urban systems and 70 percent of the rural systems are in urgent need of rehabilitation. The level of unaccounted for water is estimated at between 30 and 50 percent. In order to reduce this proportion, SEDUE will carry out a leak  - 17 - detection and control program in all beneficiary cities where unaccounted for water represents more than 30 percent of total production (Section 3.06 of the draft Guarantee Agreement). 61. Since CEAPAS and its Regional Companies lack the expertise required to prepare the monitoring indicators, these indicators will be prepared and submitted to the Bank by DIGESAPA before December 31, 1984 (Section 3.05 of the draft Guarantee Agreement). The indicators will specify for each year the targets in terms of percentage of population served with water and sewerage services, the number of connections, volume sold, percentage of unaccounted for water, number of employees per 1000 connections, average tariff per cubic meter and working ratio. 62. SEDUE will approve subprojects to be carried out in the Regional Companies with a total cost of up to US$5 million equivalent. All other subprojects to be financed out of the loan would be sent to the Bank for approval, and will include the proposed cost, project description, feasibi- lity study, and all other information required to enable the Bank decide on the suitability of the project (Section 3.03 of the draft Loan Agreement). The presentation to the Bank of satisfactory engineering designs for treat- ment plants would be a condition of disbursement for the plants (Schedule 1, para. 3(d) of the draft Loan Agreement). Subloan Agreements 63. FIFAPA would relend the proceeds of the Bank loan and Government contribution to the BC's and CEAPAS. The conclusion of satisfactory subsid- iary loan agreements between FIFAPA and each sub-borrower will be a condition of disbursement for the respective subproject (Schedule 1, para 3c (ii) of the draft Loan Agreement). An acceptable legal opinion on the validity of each agreement in accordance with the Mexican law would also be a condition of disbursement (Schedule 1, para c(iii) of the draft Loan Agreement). The subloans would be guaranteed by the corresponding State Government, who will pledge its shares in Federal taxes to cover any eventual defaults in repay- ment of the subloans (Schedule 4, para.B(ii)(1)of the draft Loan Agreement). The subloans would finance subprojects selected according to priority criteria agreed upon with the Bank and described in Annex V (Annex to Schedule 2 of the draft Loan Agreement). The FIFAPA subloan would cover the cost of construction and consulting services, the corresponding VAT, and interest during construction on the subloan. Subloan agreements eligible for financing under the project should be signed before December 31, 1984 (Section 3.02(b) of the draft Loan Agreement). 64. Each subloan would carry an interest of at least 25 percent p.a. and a term of up to 15 years after a grace period equal to the construction period but not greater than 4 years (Schedule 4, para A of the draft Loan Agreement). Although the proposed 25 percent interest rate on subloans is lower than the cost of capital in Mexico, and negative at current rates of inflation (see para. 66), efficiency in resource allocation would be ensured by the criteria used by FIFAPA in the selection of subprojects financed under the proposed loan (see Annex V) and the requirements of the revenue covenant of the subloan agreement (para.65(a)). A higher rate would result in an increased pressure from local authorities to obtain interest free funds from the Federal Government, a trend being reversed under the present Administra- tion.  - 18 - 65. All subloans would be secured by contractual agreements between FIFAPA/SEDUE, the beneficiaries and the Government of the respective states, and would include conditions aiming at: (a) ensuring financial soundness through revenue covenants whereby each company would generate sufficient revenues to cover operating costs, working capital needs, minor works and the larger of the debt service or depreciation on net revalued assets (Schedule 4,para.B(x) of the draft Loan Agreement); (b) implementing an adequate accrual accounting system and revaluation of fixed assets (Schedule 4,paras.B(vii) and (viii) of the draft Loan Agreement); (c) creating specific programs to implement administrative and operational improvements including the reduction of accounts receivable to a maximum of 3 months of billing, the prepara- tion of indicators to monitor subproject execution and to put into effect the recommendations of the respective feasibility studies (Schedule 4,paras.B(iii, iv, v and vi) of the draft Loan Agreement); and (d) monitoring of their operation by external auditors (Schedule 4, para.B(xi) of the draft Loan Agreement). Project Cost and Financing 66. The estimated total cost of the project, including taxes and excluding financial charges during construction, is US$193.3 million equiva- lent, with a total foreign exchange cost of US$100.3 million (52 percent). Interest during construction would be financed by FIFAPA. The average physical contingency assumed for civil works was 10 percent, 15 percent for water or sewage treatment plants, and 5 percent for supplies and equipment. Physical contingencies of defined subprojects have been incorporated in their base costs, and no physical contingencies have been estimated for the 40 percent of the total project cost not allocated to specific works. The base costs are expressed in prices of December, 1982. Price contingencies were based on a 6-year construction program for the project, starting in 1984. Price contingencies for the local component were based on estimates of the Mexican inflation: 70 percent in 1983, 50 percent in 1984, 30 percent in 1985 and 20 percent from 1986 until project completion (1989). Price contin- gencies for the foreign component were based on international inflation forecasts of 8 percent in 1983, 7.5 percent in 1984, 7 percent in 1985, and 6 percent from 1986 to 1989. Variations in the exchange rate were assumed to compensate for the difference between local and international inflation rates. Engineering and administration expenses have been estimated at 7 percent of the investment cost. The project is expected to require approxi- mately 1,429 staff months of consultant services, of which only 31 man-months are expected to be foreign. The average estimated cost for local consult- ants, including all overheads, is US$2,400 per staff month. For foreign consultants, the estimated cost is US$13,600, including subsistence and travel.  - 19 - 67. The commitment by the Government to increase FIFAPA's equity by US$100 million equivalent to allow the transfer of the proceeds of the loan to FIFAPA as equity increase, would be a condition of loan effectiveness (Section 7.01(a) of the draft Loan Agreement). The Government will provide the required counterparts funds. The BC's would finance minor works and replacements out of their internal cash generation. The Bank loan would finance the US$100.3 million foreign exchange component of the project, including the front-end fee. Procurement and Disbursement 68. All goods and services would be procured in accordance with Bank guidelines. To the extent practicable, civil works, materials and equipment would be grouped so as to make them attractive for international competitive bidding (ICB). Before bids are invited, and as a condition of disbursement for each individual subproject, SEDUE would present to the Bank for comments the list of the contracts it intends to award for the subproject, and would revise the list as suggested by the Bank. (Schedule 1, para 3c(i) of the draft Loan Agreement). Contracts for civil works for less than US$2.5 million but over US$250,000, or less than US$500,000 but over US$150,000 for the purchase of equipment would be procured on the basis of local competitive bidding, for which the procedure is satisfactory. Contracts of less than US$250,000 for civil works and less than US$150,000 for materials subject to a maximum aggregate of US$8 million (4 percent of total project cost) could be procured directly on the basis of a minimum of three quotations. No force account works are envisaged. Given the advanced degree of development of the civil works construction industry in Mexico, all civil works contracts are expected to be won by local contractors. Goods manufactured locally and procured under ICB would be allowed a preference of 15 percent of the CIF price or the level of import duty, whichever is lower, over foreign goods. 69. Bank financing of the foreign component (52 percent of project cost) would be achieved by disbursing 70 percent of all payments to contractors (net of value added tax) in the first two years of project implementation, and thereafter reducing the percentage for the remaining years so as to disburse no more than the foreign exchange component of the project. BANOBRAS would also be reimbursed 55 percent of the sum paid to consultants for engineering designs, construction supervision and technical assistance. The closing date would be June 30, 1990. Auditing 70. BANOBRAS will send to the Bank, not later than June 30 each year, the audited reports on FIFAPA's accounts and financial statements (Section 4.02 of the draft Loan Agreement). All BC's are audited by state or municipal authorities every two years. Because of its recent creation, CEAPAS has never been audited, nor have the Regional Companies. The subsidiary loan agreements would require that all BC's and CEAPAS have their accounts audited every year by qualified auditors, and that such audits be furnished to the Bank for review no later than five months after the end of each year (Schedule 4, para. B(xi) and Section 5.01(ii)(a) of the draft Loan Agreement).  - 20 - Cost Recovery 71. Tariffs constitute the bulk of the operating revenues of the beneficiaries. In most cities, water and sewerage tariff levels and structures are inadequate. Minimum consumption allowances are often too large, and there is not sufficient progressivity to allow cross-subsidiza- tion. The charges include a connection fee that is paid by new consumers, and a charge (cuota de cooperacion) based on the area of the lot. CEAPAS does not have a uniform tariff level for all the state systems, and each municipality sets its own tariffs. CEAPAS aims toward a uniform tariff in each Regional Company that would permit cross-subsidization among consumers of different income levels. A framework tariff study is being completed by SEDUE and will establish the basic guidelines and criteria to resolve deficiencies in the tariff levels and structures. Within this framework study, specific tariff studies will be prepared in the BC's and Regional Companies (Section 3.07 of the draft Guarantee Agreement). The tariff studies will define tariff structures to be implemented in each city that will allow compliance with the revenue covenants mentioned in para 65(a) and will aim at the recovery of the economic cost of providing the services. 72. Distortion in investment decisions or in financial management of local institutions would be avoided through compliance with the criteria for selection: (a) that the least cost alternative is adopted; (b) that while consumers in the lower income brackets receive the benefit of the subsidies implied in the onlending rate and water charges for basic volume consumption are kept at levels affordable to the poor, all consumption above this basic volume is charged at above the long range average incre- mental cost of the services. Economic Justification 73. The project would provide water supply through house connections to about 800,000 additional inhabitants and sewerage to about 550,000 additional inhabitants by the end of the construction period. About 46 percent of the additional population to be served with water supply and 40 percent of the additional population to be served with sewerage are estimated to belong to the urban poverty target group, defined as people earning less than one-third of the annual national per capita income (or about Mex$11,050.00 or US$442.00 in 1980). On the basis of the appraised cities and the additional feasibility studies prepared by SEDUE, it is estimated that as a result of the project about 1.4 million and 1.2 million additional inhabitants will be connected to the water supply and sewerage systems respectively by 1991. Water supply coverage for the urban poor will increase from 58 percent in 1983 to 88 percent in 1987, while the sewerage coverage will increase from 35 percent to 65 percent during the same period. 74. The economic rate of return (ERR) for the appraised subprojects has been calculated using convenanted tariff levels as proxy for economic benefits. Economic rates of return were estimated by city for project investments and complementary works in water supply and water supply and sewerage combined. They range from 15 percent in Colima to 20 percent in Culiacan. The estimated aggregate ERR for the appraised subprojects is about 17 percent. The rates of return indicate that water and sewerage  - 21 - tariffs on average will be close to long-run average incremental costs, estimated on the basis of the same investment programs. Benefits such as improvements in public health, increases in labor productivity, and environ- mental improvements are either not reflected or only partially reflected in the tariff paid for these services. Families earning less than one monthly minimum salary, most of which have access only to unsafe water purchased from private vendors, would spend a maximum of 3 percent of their monthly income (including connection fees, monthly payments) for minimum consumption. Therefore, services should be affordable to the whole population of the benefitted cities. Project Risk 75. Since the project is the third Bank operation with FIFAPA, the main risk is associated with the implementation of the new component, i.e., the pilot program of CEAPAS and the Regional Companies in Sinaloa State. However, the improvements that have taken place in the organization of SEDUE and the expertise already acquired in providing assistance to water and sewerage companies should diminish the risk to a great extent. The 25 percent on-lending rate recently approved for the FIFAPA subloans might discourage some of the beneficiaries of the subprojects to borrow under this loan. However, the shortage of grant funds to finance works in the water supply and sewerage sector will be an incentive for the cities to participate in the project, and SEDUE has a long waiting list of potential beneficiaries, thus minimizing this risk. The project risks are more than compensated by the benefits accruing to the beneficiaries and to the sector with the intro- duction of a new organization scheme in the State of Sinaloa which could be replicated in other states. PART V - LEGAL INSTRUMENTS AND AUTHORITY 76. The draft Loan Agreement between the Bank and BANOBRAS, the draft Guarantee Agreement between the Bank and United Mexican States and the Report of the Committee provided for in Article III, Section 4 (iii) of the Articles of Agreement are being distributed to the Executive Directors under separate cover. 77. The following will be conditions of loan effectiveness: (a) the commitment by the Federal Government to increase FIFAPA's equity in an amount equivalent to US$100 million (Section 7.01(a) of the draft Loan Agreement); and (b) the publication in the official gazette of the State of Sinaloa of the by-laws of CEAPAS (Section 7.01(b) of the draft Loan Agreement). 78. For the CEAPAS component, no disbursement will be made until (a) the Bank is satisfied that the consultants to carry out the institutional development program have been employed in accordance with Bank Guidelines for the Use of Consultants (Section 3.02 of the draft Guarantee Agreement and Schedule 1, para. 3(b)(i) of the draft Loan Agreement); (b) a scheme of fees to be paid by the Regional Companies to CEAPAS has been established (Schedule 1, para. 3(b)(ii) of the draft Loan Agreement); and (c) each Regional Company has been incorporated and organized, and their key staff has been apppointed (Schedule 1, para.3(b)(iii) of the draft Loan Agreement).  - 22 - 79. No disbursements will be made for any subproject until the corre- sponding subsidiary loan agreement has been duly signed, a legal opinion on the validity of the agreement has been furnished, and a list of contracts to be awarded under the respective subproject has been sent and approved by the Bank (Schedule 1, para. 3(c) of the draft Loan Agreement). No disbursements will be made for any water and sewerage treatment plant until the Bank has been furnished with a satisfactory final engineering study for such plant (Schedule 1, para. 3(d) of the draft Loan Agreement). 80. Additional conditions of special interest are mentioned in Section III of Annex III. 81. I am satisfied that the proposed loan would comply with the Articles of Agreement of the Bank. PART VI - RECOMMENDATIONS 82. I recommend that the Executive Directors approve the proposed loan. A. W. Clausen President By E. Stern Attachment April 21, 1983  -23- ANNEX 1 TABLE 3A Page 1 of 5 MEXICO - SOCIAL LNDICATORS DATA SHEET MEXICO REFERENCE GROUPS (WEIGHTED AVE AGES AREA (THOUSAND SQ. KM.) - MOST RECENT ESTIMATE)- TOTAL 1972.5 MOST RECENT MIDDLE INCOME MIDDLE INCOME AGRICULTURAL 977.2 19bO /b 1970 /b ESTIMATE lb LATIN AMERICA 6 CARIBBEAN EUROPE GNP PER CAPITA (US$) 470.0 860.0 2090.0 1902.0 2323.9 ENERGY CONSUMPTION PER CAPITA (KILOGRAMS OF COAL EQUIVALENT) 712.7 1066.5 1534.6 1259.9 2107.4 POPULATION AND VITAL STATISTICS POPULATION, MID-YEAR (TIIOUSANDS) 36881.0 51187.0 69752.0 URBAN POPULATION (PERCENT OF TOTAL) 50.8 59.0 66.7 65.7 47.9 POPULATIUN PROJECTIONS POPULATION IN YEAR 2000 (MILLIONS) 115.0 STATIONARY POPULATION (MILLIONS) 202.6 YEAR STATIONARY POPULATION IS REACHED 2075 POPULATION DENSITY PER SQ. K.M. 18.7 25.9 24.3 35.2 83.3 PER SQ. KM. AGRILULTURAL LAND 36.9 52.4 69.3 92.5 155.4 POPULATION RGE STRUCTLUE (PERCENT) 0-14 YRS. 45.6 46.5 45.1 39.7 31.1 15-.4 YRS. 51.0 50.0 51.4 56.1 61.2 65 YRS. AND ABOVE 3.4 3.5 3.4 4.2 7.7 POPULATION GROWTH RATE (PERCENT) TOTAL 3.2 3.3 3.1 2.4 1.6 URBAN 4.9 4.8 4.3 3.8 3.5 CRUDE BIRTH RATL (PER THOUSAh'D) 45.2 42.9 37.0 31.4 23.6 CRUDE DEATH RATE (PER THIOUSAND) 11.7 9.4 7.4 8.4 9.2 GROSS REPRODUCTION RATE 3.3 3.1 2.5 2.1 1.6 FAMILY PLANNING ACCEPTORS, ANNUAL (THOUSANDS) .. 25.1 842.0/c USERS (PERCENT OF MARRIED WOMEN) .. ,. 40.0 F'OOD AND NUTRITION INDEX OF FOOD PRODUCTION PER CAPITA (1969-71=100) 97.0 100.0 103.0 10.0 116.0 PER CAPITA SUPPLY OF CALORIES (PERCENT OF REQUIREMENTS) 117.7 110.5 112.9/c 108.4 125.1 PROTEINS (GRAMS PER DAY) 69.1 64.7 65.2/c 66.0 92.7 OF WHICH ANIMAL AND PULSE 28.8 26.7 27.17T 34.0 35.9 CHILD (AGES 1-4) MORTALITY RATE 10.3 6.5 3.7 5.6 9.2 HEALTh LIFE EXPECTANCY AT BIRTH (YEARS) 57.7 61.7 65.4 64.2 67.6 INFANT MORTALITY RATE (PER THOUSAND) 91.1 73.6 56.0 64.2 65.1 ACCESS TO SAFE WATER (PERCENT OF POPULATION) TOTAL 23.5 54.0 62.0/d 65.6 URBAN .. 71.0 70. 0Td 78.9 'RAIA .. 29.0 49.0/d 43.9 ACCESS TO EXCRETA DISPOSAL (PERCENT OF POPULATION) TOTAL .. .. 59.3 UKBIL .. .. . 7 5 3 RURAL .. 13.0 14.0/d 30.0 POPULATION PER PHYSICIAN 1823.4 1506.3 1255.7/e 1617.3 1105.4 POPULATIui PER NURSING PERSON 3b34.1 1640.2 1423.6Th 1063.5 634.4 PFPI LATIoN rEh HOSPI TAL BED TO'AL 585.7 844.8 866.3/e 477.4 286.8 URBAN .. 1012.1 1080.0T7 679.8 192.0 HJUAL *- 1294.3 1121.1/e 1903.4 ADMISSIONS PFR HOSPITAL BED .. .. .. 27.3 20.0 HBO SING AVERAGL ,ILN OF HOUSFHOLD TOTAL 5.4 5 7 .. . URBAN 5.7 5.7 RURAL 5.2 5.8 AVFRAGE NUMBER OF PERSONS PER ROOM TOTAL 2.9 2.5 URBAN 2.b 2.2 RLURAL 3.4 3.2 ACCESS TO ElJ(1TRICIrY (PERCENT OF DWELILINGS) TOTAL .. 58.9 UiRBAN . 80.7 .. RURAL * * 27.8 ..  -24- ANNEX 1 TABLE 3A Page 2 of 5 MEXICO - SOCIAL INDICATORS DATA SHEET MEXICO REFERENCE GROUPS (WEIGHTED AVERA9ES - MOST RECENT ESTIMATE) - MOST RECENT MIDDLE INCOME MIDDLE INCOME 1960 /b 1970 /b ESTIMATE /b LATIN AMERICA & CARIBBEAN EUROPE EDUCATION ADJUSTED ENROLLMENT RATIOS PRIMARY: TOTAL 80.0 104.0 124.0 104.3 102.4 MALE 82.0 107.0 127.0 106.4 107.1 FEMALE 77.0 102.0 122.0 103.3 99.0 SECONDARY: TOTAL 11.0 22.0 45.0 41.3 60.2 MALE 14.0 27.0 49.0 40.4 66.4 FEMALE 8.0 17.0 41.0 41.8 54.0 VOCATIONAL ENROL. (% OF SECONDARY) 23.6 26.7 8.9 33.7 31.6 PUPIL-TEACHER RATIO PRIMARY 44.0 45.9 40.7 29.9 25.8 SECONDARY 13.1 14.5 17.0 16.7 22.2 ADULT LITERACY RATE (PERCENT) 65.4 74.2 81.0 79.1 75.9 CONSUMPTION PASSENGER CARS PER THOUSAND POPULATION 12.9 24.1 42.0/c 42.8 51.0 RADIO RECEIVERS PER THOUSAND POPULATION 89.5 273.6 295.2 270.5 157.2 TV RECEIVERS PER THOUSAND POPULATION 17.6 58.5 110.7 107.7 123.7 NEWSPAPER ("DAILY GENERAL INTEREST") CIRCULATION PER THOUSAND POPULATION 73.7 . . 64.5/f 63.7 112.3 CINEMA ANNUAL ATTENDANCE PER CAPITA 10.0 5.0 4.1 2.7 4.0 LABOR FORCE TOTAL LABOR FORCE (THOUSANDS) 11132.7 14724.8 20187.7 FEMALE (PERCENT) 15.2 17.4 19.5 24.4 36.6 AGRICULTURE (PERCENT) 55.1 45.2 35.6 31.3 38.7 INDUSTRY (PERCENT) 19.5 22.9 25.8 23.9 25.9 PARTICIPATION RATE (PERCENT) TOTAL 30.2 28.8 28.9 33.6 44.5 MALE 51.1 47.4 46.4 50.4 56.3 FEMALE 9.2 10.1 11.4 16.8 32.8 ECONOMIC DEPENDENCY RATIO 1.6 1.7 1.7 1.3 0.9 INCOME DISTRIBUTION PERCENT OF PRIVATE INCOME RECEIVED BY HIGHEST 5 PERCENT OF HOUSEHOLDS .. .. HIGHEST 20 PERCENT OF HOUSEHOLDS 61.1/g 60.7 57.7/c LOWEST 20 PERCENT OF HOUSEHOLDS 3.4/g 3.3 2.9/7 LOWEST 40 PERCENT OF HOUSEHOLDS 9.8/g 9.9 9.9/c POVERTY TARGET GROUPS ESTLMATED ABSOLUTE POVERTY INCOME LEVEL (US$ PER CAPITA) URBAN .. .. RURAL .. .. .. 184.1 ESTIMATED RELATIVE POVERTY INCOME LEVEL (US$ PER CAPITA) URBAN .. .. 471.0 518.0 RURAL .. .. 471.0 371.1 406.6 ESTIMATED POPULATION BELOW ABSOLUTE POVERTY INCOME LEVEL (PERCENT) URBAN .. .. RURAL .. .. Not available Not applicable. NOTES /a The group averages for each indicator are population-weighted arithmetic means. Coverage of countries among the indicators depends on availability of data and is not uniform. /b Unless otherwise noted, data for 1960 refer to any year between 1959 and 1961; for 1970, between 1969 and 1971; and for Most Recent Estimate, between 1978 and 1980. /c 1977; /d 1975; /e 1974; /f 1976; /g 1963. May, 1982  -25- ANNEX I ORTINXTIXI OF W4 =C=18Page 3 of 5 N...a iklhghocitu hdot a.. .. re f-e -os.ia gonoraly judged the -en aetho-itti- and rClieble. It Should .100 he -et that they - oat b. Iae-- _oI-,olly coo-ooelo bccoa of the loo of atndaOdL.no daf intiat Be. -Pont. -Wa by tiffo....t counui. . intlcotgt. duta, ma data r. o th. I.... osfu1 to det-iheorer f antd.ieitia . tract.. aa ohneel. .ert.. nelor. diff--nce We-n cenetele.. Tha refer..., grus toe, Ci) tha eec -cutry group of the .,ohIoct -ta"r act (2) . co Cty group i0th ..neebo higher -.eage Oao. thdd tha nuntey grou.P of th nbec outyLeLetfo _.ih[no 0L &epoCCen .r.P060 "KId4le 1neo nrItk Aft ito an tiddl. Ao.t' L. oboes hecos of C..e.e auc -Lto 1C-ciue fotl..ttereeee group dote th. -vge r peguItinto seightod arith-ctic -at Ior .-h io4d-ceeoe. We - b.. oy ab- aejority of tke --L..o to o goup M.a d.to fr that ioAl.cCo. Sinc- the co.-,.P of coorfea.. the jodilot... d.Peto on the ...ellbiligy of det. ar id o afrg ato Sctb eacd ia r.tLc