Mexico - Agricultural Credit Project

Documenatof The World Bank FOR OFFICIUL USE ONLY Repoit No. f4125-M a 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 USt180 MILLION TO NACIONAL FINANCIERA, S.A. WITH THE GUARANTEE OF UNITED MEXICAN STATES FOR AN AGRICULTURAL CREDIT PROJECT June 28, 1985 This dcuanet h a raddcted dltbud_ mad may be wed by reipknts idy i the perfomiace d t,dr .add im In emsm's may mme lmir be dIdEsed widtot Wor ld k 11 orhtieu  Currency Unit - Peso (Mex $) On March 31, 1985, the exchange rate in the controlled market was US$ = Mex$208.79; the freemarket exchange rate stood at US$1 = Mex$226.85. Both exchange rates are currently sliding at a rate of fex $0.21 per day against the US dollar. Fiscal Year January 1 to December 31 WEIGHTS AND MEASURES 1 hectare (ha) = 10,000 m2 = 2.47 acres 1 kilometer (km2) = 0.62 miles 1 square kilometer (km2) = 0.39 sq. miles = 100 ha 1 kilogram (kg) 2.20 pounds 1 liter (1) = 0.26 gallons 1 cubic meter (m3) = 35 cubic feet 1,000 kg. = 1 metric ton = 0.98 long ton ABBREVIATIONS ACF - Index of Average Cost of Funds to Multipurpose Banks BANRURAL - National Rural Credit Bank CECADE - Economic Development Training Center CONASUPO - National Marketing Corporation EDI - Economic Development Institute FEFA - Special Agricultural Credit Trust Fund FEGA - Technical Assistance and Loan Guarantee Trust Fund FICORCA - Fideicomiso para la Cobertura de Riesgos Cambiarios FIDEC - Trust Fund for Marketing Development FIRA - Agricultural Trust Funds in Bank of Mexico FONDO - Trust Fund for Crop, Livestock and Poultry Credit FONEL - Industrial Equipment Fund GIRA - General Interest Rate Agreement ICB - International Competitive Bidding IDB - Inter-American Development Bank IFAD - International Fund for Agricultural Development IFC - Internatlonal Finance Corporation IMF - International Monetary Fund NAFINSA - Nacional Financiera, S.A NDP - National Development Plan SAM - Mexican Food Program SARH - Secretariat of Agriculture and Water Resources SHCP Secretariat of Finance and Public Credit (Hacienda) - SOE - Statement of Expenditure  FOR OFFICIAL USE ONLY MEXICO AGRICULTURAL CREDIT PROJECT Loan and Project Summary Borrower: Nacional Financiera, S.A. (NAFINSA) Guarantor: United Mexican-States Beneficiary: Agricultural Trust Funds in the Bank of Mexico (FIRA) Amount: US$180 million equivalent. Terms: Fifteen years, including three years of grace, at the standard variable interest rate. Relending Terms: Funds would be provided to FIRA as equity. The proceeds would be relent by FIRA on terms and conditions that vary with the income level of the beneficiaries and purposes of the subloans, as specified in the General Interest Rate Agreement. Project Description: The project is a credit program which would seek to raise agricultural productivity with a view to increasing food production, agricultural exports, and real farm income. It would assist to improve agricultural policies through the reduction of interest rate subsidies. The low-income producers' component would comprise about one-half of the total investment program. About 62,000 families or 350,000 beneficiaries would benefit from the project. Project Risks: Since FIRA is a reasonably efficient and mature institution, the project presents no special risk in terms of the technical and financial soundness of varlous investment opportunities that would be financed under the program. The main risk would be that political pressures would impede progress in eliminating interest rate subsidies, especially in the case of a resurgence of inflation causing a further deterioration of FIRA's financial position, a continued drain on Government budget resources, and a continued misallocation of production factors. liT document ha a resuicted distribution and may be used by recipients only in the performance | of their official duti Its contents may not othewi be disclosed without Workd Dank authoriaion.  - ii- Estimated Cost: Local Foreign Total US$ million -- Investment Program Low-income producers 3 crops, livestock and agroindustries 141 90 231 Medium-income producers crops, livestock and agroindustries 125 80 205 Other producers crops, livestock and agroindustries 27 10 37 293 180 473 Financing Plan: Local Foreign Total US$ million Beneficiaries 71 71 Participating Banks 71 71 FIRA 151 151 Bank - 180 180 TOTAL 293 180 473 Disbursements: Loan proceeds will be disbursed in: Bank Ft 1986 1987 -US$million- Annual 150 30 Cumulative 150 180 Economic Rate of Return: Economic Rates of Return for subloan investments range from 18X to 35Z. . - Appraisal Report: None  INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT REPORT AND RECOMMENDATION OF THE PRESIDENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO NACIONAL FINANCIERA, S.A. WITH THE GUARANTEE OF UNITED MEXICAN STATES FOR AN AGRICULTURAL CREDIT PROJECT l. I submit the following report and recommendation on a proposed loan to Nacional Financiera, S.A. (NAFINSA) with the Guarantee of United Mexican States for the equivalent of US$180 million to help finance an Agricultural Credit Project to be carried out by the Agricultural Trust Funds (FIRA). The proposed loan is to provide interim financing for FIRA from the closing of the ongoing Eighth Agricultural Credit Project until preparation and commencement of a new and broader agricultural credit project. The loan would be repaid over 15 years, including 3 years of grace, at the standard variable interest rate. Final beneficiaries would pay interest rates floating with the ACF index (average cost of funds to multipurpose banks) as specified in the draft General Interest Rate Agreement which is being distributed together with the project documents. The Government would repay the Bank loan through NAFINSA and bear the foreign exchange risk. PART I - THE ECONOMY 2. An economic report on Mexico (Mexico: Recent Economic Developments and Prospects, No. 4996-ME) was distributed to the Executive Directors on May 14, 1984. The report's main conclusions and recent economic developments are summarized below. 3. Following an import-substitution growth strategy, Mexico experienced some two decades of high and stable growth after the early 1950s. By the late 1960s, however, Mexico had largely exhausted the 'easy' and efficient possibilities for import substitution, and faced a choice between outward-oriented growth or continued inward-directed growth led by expansion of public sector expenditures and rising-subsidies and protection of inefficient domestic production. By 1972, the choice was made to pursue the latter course. Public sector expenditures as a percent of GDP more than doubled between 1970 and 1982, from 18.8% to 42.5% (Report No. 4996-ME, p. 114). By 1976, Mexico experienced a serious financial and economic crisis, followed by an even more serious one six years later. The discovery of large oil reserves in the mid-1970s led Mexico to a quick economic recovery, but it also removed the urgency of policy reforms. Primary among these was the need to reduce protection and the anti-export bias of the trade regime to thereby move over time toward greater efficiency and international competitiveness. Oil revenues also temporarily helped finance the public sector deficit and reduced the need for greater fiscal restraint.  -2- Developments during 1977-1982 4. The stabilization measures initiated in 1977 and the discovery and exploitation of large oil resources in the mid-1970s allowed the Lopez Portillo Administration (January 1977-December 1982) to overcome the serious financial crisis of 1976 and to start working on structural, social, and economic problems, including poverty, income and wealth inequality, unemployment, regional imbalances, and relatively slow agricultural growth. In the early years of that Administration (1978-80), GDP growth was high (8.5Z a year), 2.5 million jobs were created, domestic consumption recovered, and the share of investment and savings in GDP surpassed historical levels; but the economy became increasingly overheated. 5. Rapidly rising public expenditures unmatched by revenues led to increasing public deficits. While inflation rose, no significant pressure was felt to adjust the exchange rate, thanks to the oil earnings and the relative ease of obtaining foreign finance. By mid-1981, the economic situation began to mirror the scene prevailing before the 1976 financial crisis. The current account deficit of the balance of payments reached 5.2% of GDP, while the deteriorating international oil market conditions caused large revenue shortfalls with respect to budget expectations. The public sector deficit rose to just under 15% of GDP. Non-oil exports dropped, and the trade deficit reached record levels. External borrowing was used to finance part of the domestic fiscal deficit and to defend the exchange rate. Mexico's foreign debt increased rapidly, at a time of high and rising international interest rates. A stabilization program initiated by the Government in mid-1981 was not sufficient to redress the growing fiscal imbalance, the high cost of foreign loans, and the increasing private capital flight fueled by the public's anxiety over Mexico's financial troubles. 6. The crisis came to a head in 1982. In February, as capital flight intensified, the Bank of Mexico had to stop supporting the peso, which then experienced a 40% devaluation in US dollar terms. A large wage adjustment granted in March 1982, which tended to undo the effects of the devaluation, and continuing slack in the oil market kept the balance of payments under strain. Under the circumstances, the international banking community became reluctant to commit new funds to Mexico in the amounts required. These factors led to a second devaluation of 35% in August 1982, while the acute shortage of foreign exchange forced the Government to suspend the amortization payments of most of Mexico's external public debt, pending a broader agreement on its refinancing. Capital flight continued as private sector confidence was shaken by the nationalization of the banks in September 1982, and the mandatory conversion of US dollar deposits into pesos. Also put 'lnto effect were a generalized system of exchange controls and quantitative trade restrictions covering an unprecedented 100% of Imports. Recent Developments 7. The Administration of President de la Madrid, that began its term in December 1982, lost no time in taking steps to recover domestic and external confidence, and stabilize the public sector and external finances. The Government's stabilization program, supported by an EFF agreement approved by  -3- the IMF in December 1982, laid the basis for restoring economic stability and for the renegotiation of that part of Mexico's public external debt on which amortization payments had been discontinued in August 1982. Commercial banks agreed to restructure some US$19 billion of public sector debt and provide * US$5 billion in net new loans for 1983. All obligations falling due between August 23, 1982 and December 31, 1984 were restructured over an eight-year period starting from January 1983, with a grace period of four years and at * an interest rate of 1-7/8 percentage points over LIBOR (or 1-3/4 over the New York prime rate). The US$5 billion syndication had a 6-year maturity, with a 3-year grace period, at a spread of 2-1/4 over LIBOR (2-1/8 over prime). The restructuring exercise included an understanding that the international banks would maintain their exposure to the Mexican banks that had been nationalized. At the same time, it provided a mechanism that would eliminate 1982 private sector interest arrears and facilitate payment of the rescheduled principal on such debt. 8. A new two-tier exchange rate system was introduced, with a controlled market for imports, most proceeds from merchandise exports (except those of in-bond industries) and debt related transactions, and a free market for all other transactions including those relating to tourism. The controlled rate was originally set at MexS95 = US$1, a depreciation of some 35% in relation to the previously prevailing ordinary rate of Mex$70 per US dollar. The free market rate had remained at about Mex$150 per dollar until September 1983, when the authorities decided to let it slide as much as the controlled rate. The differential between the two rates, which in December 1982 stood close to 60%, is now down to less than 10%. Over the past two years, the peso has gradually appreciated in real terms as inflation in Mexico remained high. The Government increased the rate of slide of the peso from 13 centavos a day to 17 centavos in December 1984, and to 21 centavos early March 1985, in order to bring it closer to the expected inflation differential between Mexico and its trading partners. Domestic deposit interest rates have also been raised since early March 1985 from an average of about 45% to nearly 54% by May. 9. Under the IMF Agreement, the Administration committed itself to a drastic reduction of the public sector deficit, from 18.0% of GDP in 1982 to 8.5% in 1983, 5.5% in 1984, and 3.5Z in 1985. Substantial progress has been made during the past two years in meeting the program objectives, although the targets for 1984 were not fully met. The public finances were strengthened considerably and the public sector deficit was reduced to 8.7% of GDP in 1983 and an estimated 7.4% in 1984. The main reason for the higher budget deficit than the 1984 target was the much higher than expected interest payments on the domestic debt. Curbs on expenditures were wide ranging. The authorities have given priority to completing projects that were already far advanced and to those that were important for employment, equity, or foreign exchange earnings. Nonetheless, public investment expenditures are estimated to have declined to about 7% of GDP in 19B3-84, well below the 1982 level of 11.7%. The fiscal performance was also aided by significant price increases for nearly all public goods and services, including petroleum products, electricity rates, food, etc. The Government has committed itself to a substantial reduction and eventual elimination of most subsidies, including those provided in the form of low interest rates.  - 4 - 10. The balance of payments experienced a major turnaround in 1983 with the current acoount moving from a deficit of almost US$5 billion in 1982 to a surplus of US$5.5 billion. The strength of the current account and the availability of external finance permitted Mexico to replenish its international reserves while paying the arrears accumulated in 1982. The net use of foreign financing by the public sector was US$4.2 billion for the year-below the ceiling of US$5 billion under the stabilization program. The swing in the current account was mainly the result of a very sharp contraction of merchandise imports, to US$7.7 billion, representing a decline of about US$7 billion from their 1982 level. The recession, the large devaluation of the peso, and the quantitative restrictions, all contributed to this. The balance of payments remained strong in 1984, with a current account surplus of US$3.7 billion; and a further US$2.5 billion were added to the nation's foreign exchange reserves, which at the year's end are estimated at about 7-1/2 months of imports. Although imports recovered considerably, a rapid rise in non-oil exports, particularly in the first quarter of 1984, ensured that the trade surplus remained at the same level as in 1983, i.e., about US$13 billion. Growth in tourism and in-bond industry was also strong, and helped in alleviating unemployment. 11. Fighting inflation remains the pivot of the Government's stabilization program. Although the Government's own inflationary targets have been missed by wide margins, the rate of inflation continued to decline through mid-1984. It declined from a rate of about 100% in 1982, to 80% and 59% in 1983 and 1984, respectively. The main factors in this were restrained fiscal and monetary policies and moderate wage adjustments. The flow of savings into the banking system continued to rise, reflecting the beneficial influence of the exchange rate and interest rate policies. The impact of the severe and sudden cuts in public expenditure and imports on economic growth in 1983 was serious when GDP declined by over 5%. However, the economic recovery in 1984 was stronger than the Government's expectations: GDP is estimated to have risen by about 3.5%, compared to the earlier estimate of only 1%. 12. The Government also took steps to regain the confidence of both domestic and foreign private investors. These included efforts to deal with the problems of private external debt, procedures to compensate owners of nationalized banks, and a more flexible application of the foreign investment law. Private sector debts totalling approximately US$12 billion have been registared under a special Central Bank restructuring facility (FICORCA) at stretched out maturities varying between 6 and 12 years, with 3- to 4-year grace periods. Moreover, the Government undertook the restructuring of Mexican private sector obligations guaranteed by official credit agencies abroad. The Government has also transferred back to private ownership most of the 400 private firms that were controlled by the commercial banks prior to their nationalization. These measures and announcements have been beneficial, but more remains to be done to restore the confidence of Mexican entrepreneurs and foreign investors. The Government realizes that this is an issue of the greatest importance, as economic recovery beyond the current stabilization period will depend critically on the resumption of vigorous private investment.  13. The general improvement in the Mexican economy up to mid-1984 was widely noted, particularly by the international banking community. Mainly for this reason, the Government's 1984 borrowing of US$3.8 billion from commercial banks carried much more favorable terms than the borrowing in 1983 (10 year maturity, 5-3/4 year grace period, and a spread of 1-1/2 over LIBOR or 1-1/8% over prime). The negotiations between the Government and foreign commercial banks on the rescheduling of foreign debt have been virtually completed. The draft agreement, covering close to US$50 billion, has been submitted by the Banks' Advisory Group (consisting of the 13 largest lenders) to some 500 smaller regional banks for their acceptance. Under the proposed terms, the previously unrescheduled debt (amounting to about US$20 billion), which is due for repayment in 1985-90, will have its maturities stretched over 14 years. The maturities of the previously rescheduled debt coming due in 1987-90 will be stretched over 11 years. The 1983 syndicate loan of US$5 billion will be restructured, after prepayment of US$1 billion, to carry terms identical to the 1984 syndicate loan. In summary, the pending rescheduling agreement will stretch maturities of US$48 billion public debt in such a way that the debt service remains virtually constant between 1985-1998, in contrast to the present situation, where 75% of the debt service is due in 1986-89. The banks will have the choice of LIBOR, a domestic reference rate, or a fixed rate. These terms are based on the understanding that the Government will continue to adhere to prudent economic policies. The rescheduling agreement covering US$29 billion of Government debt was signed on March 29, 1985. This followed the approval on March 25 by the IMF of a third-year Extended Fund Facility. The balance of US$19 billion in loans to Mexican Government agencies is expected to be signed soon. Recent Policy Measures 14. Mexico has experienced some deterioration in its economic performance since late 1984, with signs of domestic overheating of the economy and 4eclining non-oil exports. In response, the Government has, during recent months, taken a series of corrective measures, and will have to take further measures during the remainder of 1985. In the last quarter of 1984, public sector expenditures rose in excess of the target of the EFF program. Consequently, the 1985 budget, which had been approved by Congress in late 1984, with a deficit of 5.1% of projected GDP, was cut in February and May 1985 to 4% of GDP, and a contingency reserve of 0.5% was dropped. In March 1985, the Government announced a program to reduce import licensing to cover 55-65% of total imports, as compared to 100% in 1983. As mentioned in para. 8, the exchange rate crawl was also twice adjusted, in December 1984, and again in March 1985, to stem the loss of competitiveness of Mexican exports. Medium-Term Prospects 15. The Government's strategy, as outlined in the National Development Plan (NDP) for 1983-88, combines special efforts to recover from the present crisis with a longer-term perspective on iegaining balanced and stable growth to overcome structural problems. The main problems facing Mexico in the years ahead include the still very high rate of population growth (2.6% estimated for 1983) together with an even higher rate of labor force growth  (a little under 4%), slow growth in agriculture, poverty, a highly skewed interpersonal and interregional income distribution, and an overly oil-dependent economy with a strong anti-export bias. 16. The medium-term strategy presented in the NDP focuses on the need for structural changes in the economy, including a greater export orientation through revision of external trade policies, poverty alleviation through basic needs policies and improvement in labor absorption, and decentralization of economic activity. The basic elements of policies to address structural problems are mentioned in the NDP, and further details on specific programs and schedules for policy adjustments are provided in the sectoral plans which were prepared subsequently. 17. Mexico's mediumrterm prospects for recovery and stable economic growth are reasonably good, provided economic management continues to be prudent, private sector confidence is restored, and the international environment remains favorable. Adequate domestic policies include inter alia continued efforts to reduce the fiscal deficit, liberalize trade, minimize price distortions, and maintain a competitive exchange rate. With regard to the latter, there is some concern that the continuing higher than projected domestic inflation rate, and the slow progress of the Government's trade liberalization program, have hurt Mexico's non-oil export performance. Restoration of private sector confidence is crucial, since only a strong and dynamic private sector will be able to raise investment from the present depressed levels and to supply the increasing non-oil export surplus required for the resumption of growth. As regards the external environment, the commercial banks are expected to maintain their exposure in Mexico in real terms, and foreign markets, to be open to Mexico's non-oil exports. If interest rates on world financial markets continue their downward trend, Mexico will benefit substantially, while she will lose export revenue if oil prices continue to decline. A one percentage point drop means a savings of about USS800 million in overall interest payments, which compares to a loss of US$550 million in gross export revenues that would result from a one dollar drop in the export price of oil. 18. Under reasonably favorable external and domestic conditions, Mexico's economic growth could reach a sustainable 6% a year-the post-WWII average for Mexico--towards the late 1980s. This growth would materialize through a sustained redirection of the economy toward a more outward-oriented growth pattern. Fiscal discipline, in the absence of improved domestic efficiency and export development, would likely entail a prolonged period of slow growth, characterized by insufficient labor absorption in internationally competitive activities, domestic price distortions, and a continued need for subsidies. External Debt and Creditworthiness 19. Mexico's external public debt increased by about US$4 billion during 1983, and by about half as much in 1984. With an expected net new borrowing of some US$2 to US$4 billion a year, and assuming that the Government implements policy adjustments, as needed, particularly in the area of trade policy, the ratio of external debt to GDP should decline steadily from 41% in 1984, to 33% by 1990. The debt service ratio, after the proposed  - 7 - rescheduling, is projected to peak at 47% in 1988; thereafter, it gradually declines to about 25% in 1995. 20. At the end of 1983, the last year for which a comprehensive external debt report is available at this time, the Bank's share in Mexico's debt was 4.3% (excluding undisbursed). The Bank's share in Mexico's total public external debt service payments during that year was 4%. In view of the good mediumr- and long-term potential of its economy and the prospect of continued pursuit of sound economic policies by the present Administration, Mexico is considered creditworthy for IBRD borrowing. PART II - BANK GROUP OPERATIONS IN MEXICO Bank Operations 21. As of March 31, 1985, Mexico had received 85 loans from the Bank, amounting to US$6,831.3 million, net of cancellations and terminations; of these, 58 loans totalling US$3,495.2 million were fully disbursed. The Bank held US$5,465.6 million, of which US$1,948.9 million had not yet been disbursed. Some 42% of Bank lending has been for agriculture and rural development, 23% for industry, 11% for power, and 13% for transportation; the remaining 11% has been for water supply, tourism, urban development, vocational training and pollution control projects. Annex II contains a summary statement of Bank loans as of March 31, 1985. 22. Of the US$6.83 billion total lending, about US$3.5 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 mediumrscale industrial and tourism enterprises based on productive investment plans, rather than credit granted on the basis of collateral. 23. 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 satisfactorily until mid-1982, and disbursements rose from US$91 million in FY78, to USS448 million in FY82. However, the present financial crisis is again causing delays in the provision of counterpart funds; consequently, disbursements in FY83 declined to US$389 million. A Special Action Program was established in early 1983 to help the Government by alleviating the counterpart funding constraints on development projects, and 18 Bank-financed projects are receiving support under the Program. Partly as a result of the SAP, disbursements during 1984 improved significantly at US$528.87 million or 35% over disbursements in 1983.  -8- IFC Operations 24. As of March 31, 1985, IFC had made investment commitments in 27 companies in Mexico, for a total of US$753.9 million, of which US$562.5 million had been sold, repaid or cancelled. A summary statement of IFC investments is presented in Annex II. IFC has been working together with the Bank in preparing proposals to establish a facility for provision of foreign exchange financing to private sector companies, for the importation of machinery, equipment and spare parts required for production of exportable products, for efficient import substitution, and for improvements in the utilization of their existing productive capacity. IFC approved a US$100 million facility (including funds mobilized from foreign commercial banks) in 1983, which is providing finance for fixed investments of a larger size than those assisted under the Bank loan for an Export Development Project. Bank Strategy 25. Prior to the 1982 crisis, the Bank's major objectives in Mexico were to : (a) support policies and programs leading to a wider distribution of the benefits of economic growth; {b) help finance projects that, directly or indirectly, contributed significantly to output and employment; (c) help reduce Mexico's urban/regional imbalances; and Cd) help free bottlenecks which prevent rapid growth. These continue to be important objectives of Bank assistance to Mexico. More recently, however, in response to Mexico's requirements following the 1982 economic crisis, the Bank, in close cooperation with the IMF, has attempted to broaden its support for the Government's stabilization and recovery program through assistance for effective export promotion and intensified and broadened economic and sector work. As for the future, the volume and composition of Bank lending to Mexico will be related to progress in the implementation of policy reforms needed for structural economic adjustments. Specific policy reforms that are being pursued through a dialogue with the Government, conducted in parallel with the processing of lending operations, cover priority macroeconomic and cross-sectoral issues, such as trade policy and export development, interest rate policy, public sector pricing and investment, and subsidy reduction. 26. Because of the difficult structural problems of agriculture and the sector's crucial importance for the one-third of the nation's 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 help increase productivity of presently cultivated lands in general; second, to give emphasis to improving 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 14 loans in FYs78-83 totalling US$1,829.4 million for irrigation, rural development and agricultural, agro-industrial and livestock credit programs. A US$175 million loan for a rjral development project and a US$180 million loan for an irrigation rehabilitation 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, and a $300 million Eighth Agricultural Credit Project in June 1984. A  -9- US$90 million loan for a Chiapas Agricultural Development Project, together with a Chiapas Rural Roads Project, was approved by the Executive Directors on April 30, 1985. Projects for tropical agriculture, irrigation rehabilitation, extension and research, seed multiplication, forestry, agroindustries, and agricultural credit are in various stages of preparation. 27. Bank lending for industry has aimed at: (a) reductiou of the balance of payments deficit; (b) decentralizing industrial activities away from the major, 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 industrial equipment fund (FONEI)--were approved by the Executive Directors in FYs78-80. A US$90.0 million loan for a vocational training project, which is assisting a program to increase the supply of skilled workers and technicians, a US$152.3 million loan for the development of a capital goods industries project, and a US$60 million loan for pollution control were approved by the Executive Directors in FY82. A modification in the capital goods project was approved by the Executive Directors in early 1983, to set up a pilot export development fund to help satisfy the foreign exchange needs of Mexican exporters. A US$350 million loan for an Export Development Project and a US$175 million loan for a Third Small- and Mediumr-Scale Industry Development Project were approved by the Executive Directors in FY83. A US$105 million second small- and medium-scale mining development project was presented to the Executive Directors on May 21, 1985, and a second technical training project, on May 28, 1985. In response to the current needs of the industrial sector, several projects to support non-oil export development, acquisition of modern technologies, financial restructuring of enterprises and industrial recovery and growth are in various stages of identification and preparation. 28. Bank lending for physical infrastructure has been focused on regional development and strengthening of institutions and sector policies. In transport, two highway sector projects (FY79 and FY84), an industrial ports project (FY84) and a recently approved railways sector loan support rationalization of public investment outlays and pricing policies, and improvement of the finances of the implementing sector agencies. Additional projects to support these goals are under consideration. In urban infrastructure, the first and second medium-size cities water supply and sewerage projects (FY76 and FY81) 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; a third project was approved by the Executive Directors on May 17, 1983. Projects for solid waste disposal, small cities water supply, urban transport, and municipal strengthening, which are in various stages of preparation, would further support these objectives in respective subsectors, while assisting the Government in its decentralization efforts.  - 10 - 29. 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 urban 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. A low-income housing project is in advanced stage of preparation. 30. The Economic Development Institute (EDI) is assisting CECADE ("Centro de Capacitacion de Desarrollo Economico" under the Secretariat of Programming and Budgeting) in training Government staff in project preparation, monitoring, and evaluation. EDI assistance is directed at courses on urban and regional development, agriculture, rural development and agro-industries. The Bank has also assisted the Mexican authorities in training personnel for managing water supply and industrial credit projects. 31. 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$3.4 billion as of March 31, 1985. Over 50X of the total has gone to agricultural and rural development projects, and the balance to 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. 32. Bank-supported power, steel, fertilizer, and tourism projects in Mexico have been cofinanced 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 projects where project specific cofinancing would have been difficult. PART III. THE AGRICULTURAL SECTOR Agriculture in the Economy 33. Mexico's agricultural sector contributes about 10% of the gross domestic product, employs about one-third of the country's active labor force and contributes about 6Z to the country's exports. Between 1945 and 1955, annual agricultural production growth rates averaged about 6%, but declined to about 4.4% between 1955 and 1965, and to less than 3% between 1965 and 1980. During the latter period, production increases from newly irrigated land slowed down and agricultural terms of trade gradually worsened. Agricultural production again increased in both 1980 and 1981 at an annual  - 11 - rate of about 6.5%. The increase was the combined result of favorable weather conditions, higher farm-gate prices and large input subsidies under the Government-sponsored Mexican Food Program (SAM). In 1982, when prices lagged behind the high inflation rate of that year, the value of production experienced a 0.4% negative growth rate. However, the economic sltuation has since improved, and the real value of production has increased by about 2.62 per annum for the years 1983 and 1984. 34. The reduced agricultural production growth before 1981, coupled with increasing internal demand, resulted in increased food imports and deterioration in the agricultural trade balance. In 1979 the country experienced its first agricultural trade deficit, and in 1981 the deficit was over US$1 billion. However, since 1982 the agricultural trade deficit has decreased primarily due to reduced imports influenced by substantial devaluations. Since 1970, corn, wheat, soybeans, sorghum, and powdered milk have been the principal food imports, representing about 7.6% of total imports in 1980. During the same period, cotton, coffee, fruits and vegetables constituted the main exports. Production Trends and Past Mricultural Policy 35. Mexico's basic crops, which include maize, beans, wheat, rice, sorghum, soybeans and sugarcane are produced on about 75% of the cultivated area. Production has varied strongly from year to year with a basic growth trend of 1.5Z to 2.5% over the 1970s, i.e., well below the population growth rate. Government intervention in the price setting and marketing of these crops gradually grew stronger over the decade. With the pressure to protect the consumer against increased food prices during a period of gradually increasing inflation, the terms of trade worsened. As a result, imports of these crops increased strongly, i.e., maize imports increased from 736,000 tons in 1970 to 3.8 million tons in 1980, and sorghum imports from 10,900 tons in 1970 to 2.8 million tons in 1981. From 1980 to 1982, the Government attempted to reverse this trend, by substantially increasing farm-gate prices and introducing a range of input subsidies in the context of SAM. Farmers responded positively, but, as consumer prices for the basic products were adjusted more slowly than producer prices, consumer subsidies increased and the Government program became too costly to maintain after 1982. 36. The production of export crops (mainly coffee, fruits and vegetables), which has remained relatively free from Government intervention in trade and prices, showed an annual average growth of about 12% between 1975 and 1979. In the ensuing three years, exports of these crops stagnated, mainly due to an increasing overvaluation of the Mexican currency. However, indications are that since 1982, growth has resumed. Regarding livestock activities, beef production grew at an annual rate of 7% between 1975 and 1982; pork, poultry meat and egg production grew at even higher rates, between 10% and 12% annually over the same period. These growth rates were sufficient to cover increased domestic demand and Mexico's traditional beef exports were basically maintained. Milk, however, which is produced under controlled prices, grew at only about 1.8% per annum during this period. Milk powder imports in the ten years before 1982 rose at an annual rate of about 20% and presently equal about 16% of total production in fluid equivalent.  - 12 - 37. Growth in related sectors has been mixed: (a) the agroindustries subsector grew rapidly through the decade of the 1970s (10% per annum), and in 1979 acccanted for about 18% of the industrial sector's output; (b) the forestry sector which comprises about 21 million ha of commercial forests is underexploited, producing only about 9 million m3 of wood products in 1981; and (c) the fisheries subsector has shown significant growth in recent years rising from an annual catch of about 0.25 million tons in 1970 to about 2 million tons in 1982. Approximately 30% of the value went into exports (mainly shrimp) and about 50% of the total catch into fish meal. Present Government Agricultural Strategy 38. At the end of 1982, when the new Government took office, there was an urgent need to reassess and reorient agricultural development policies. After substantial devaluations, domestic farm-gate prices had deteriorated in real terms. Strong price increases, especially for the basic commodities, were required if farmers were to maintain and increase production levels. On the other hand, in order to suppress inflation there was a need to contain food price increases. Also, in view of high public sector deficits, the Government's agricultural subsidy policy needed to be overhauled. 39. The Government's strategy, as outlined in the National Development Plan for 1983-1988, aims at accelerated agricultural growth. The policy emphasizes the importance of agriculture in increasing Mexican exports and production of import substitutes. The stated policy over the medium-term is to guarantee farm prices which are consistent with international prices. However, in the short-term, emphasis is being placed on adequate compensation for increases in cost of production and a reasonable profit margin in determining price levels. Controlled producer prices for most important crops, including basic staples such as maize and wheat, have been raised significantly in real terms since the beginning of 1983, so that nearly all of those prices are currently at or close to international levels. Further periodic adjustments to compensate, at least for domestic inflation, are expected in line with recent practice. Input subsidies have been strongly reduced. Subsidized prices for key inputs (i.e., fertilizer and seeds) are now only available for rainfed-maize production to small farmers holding less than 20 ha each. Interest rates on agricultural subloans, which until now were fixed and generally negative in real terms, will be made variable and are to approach positive levels gradually in accordance with a timetable that forms part of the General Interest Rate Agreement between the Government and the Bank. Irrigation water rates were increased on average about 200% during 1983, and further adjustments are expected to be made towards the stated goal of achieving operation and maintenance costs recovery under a general strategy to improve the use and management of Mexico's water and soil resources. Improvement and rehabilitation projects will be undertaken in existing irrigation areas, and new investments will be decided on selectively, stressing small- and medium-scale irrigation projects in regions with a lesser degree of development. The Government is also taking steps to decentralize planning, programming and implementation of rural development projects to state and local levels and to improve interagency coordination. Agricultural policy dialogue between the Government and the Bank has been intense in the recent past, and both have agreed to a continuous policy dialogue in the future.  - 13 - Agricultural Credit 40. Within the context of its agricultural development policies, the Government has used credit as an important instrument for achieving growth and equity objectives. First, it has encouraged growth in agricultural lending by making public funds available (through the Bank of Mexico or from the budget) to various financing agencies, such as the Agricultural Trust Funds (FIRA), to discount subloans made by Mexican banks. Second, it has significantly promoted credit to low-income producers by (a) financing operating subsidies of the state-owned National Rural Credit Bank (BANRDURAL); (b) providing technical assistance and loan recovery guarantees to commercial banks that lend to low-income producers; (c) obliging such banks to bold part of their legal deposits in low-income producers loans; and (d) since 1976, increasingly subsidizing interest rates on loans to such farmers. The result has been a dramatic growth in outstanding agricultural credit from the commercial and public banks from Mex$17.7 billion in 1970 to Mex$218.5 billion in 1981-an average annual increase of 10.4Z in real terms. Low-income producers accounted for about 50% of the total loan portfolio in 1981. 41. While agricultural credit grew continuously up to 1981, growth came to an abrupt end in 1982, when institutional credit to agriculture fell nationwide by about 28% in real terms; again in 1983 it fefl by about 25%. The decline occurred because (a) as a result of high inflation, recuperations on the existing loan portfolio were inadequate to cover the demand for funds; and (b) the Government was unable to finance the large subsidy required to bridge this gap. However, in 1984 institutional agricultural credit grew by about 17% in real terms. In spite of this renewed growth, the banking system could not fully satisfy the agricultural credit demand. In addition, because of the debt crisis, many traditional US sources of short-term financing outside the domestic banking system disappeared. 42. FIRA. The Bank of Mexico is the trustee for the three agricultural trust funds, which are integrated for management and accounting purposes and administered as FIRA: (a) the Trust Fund. for Crop, Livestock and Poultry Credit (FONDO), which discounts participating commercial and public banks short-term subloans for crops, livestock and agroindustry; (b) the Special Agricultural Trust Fund (FEFA), which discounts mediumr- and long-term subloans for crops, livestock and agroindustry; and (c) the Technical Assistance and Loan Guarantee Trust Fund (FEGA), which defrays to participating banks part of the cost of subloan evaluation and technical assistance for low-income producers, and guarantees part of the commercial banks' contribution to these subloans. 43. FIRA and the Bank have enjoyed a long and good relationship, having satisfactorily completed seven projects with the ongoing Eighth Agricultural Credit Project substantially ahead of schedule (providing a total financing of US$1.2 billion). The Eighth Loan is expected to be fully disbursed by July 1985 (except US$1 million remaining for technical assistance and support services) over two years ahead of -schedule. The main reasons for the accelerated disbursements were the following: First, FIRA, responding to a  - 14 - buoyant demand for credit, increased its lending by 16% in real terms over 1983 levels. Second, the increase in lending was even greater when stated in US dollars (50X) because the 1984 inflation rate (59%) was higher than the 1984 devaluation rate of the peso (20%). Third, while the Bank of Mexico provided the funds projected for FIRA, it was unable to contribute additional funds in line with FIRA's increased credit demand. As a result, the percentage of Bank funds utilized represented about 26% of FIRA's 1984 lending, compared to an average of 8% initially estimated for the life of the loan. 44. In addition to being one of the main providers of financial resources to the Mexican agricultural sector, FIRA provides significant technical assistance to commercial banks and to farmers, through its training programs and demonstration centers. Throughout the years, FIRA has earned a good reputation, and its management is experienced and of high quality. However, some fine tuning of its operations will be needed, especially in the field of medium-term planning, in order to optimize use of scarce resources. Moreover, FIRA's technical assistance program needs to be expanded, to promote producers' adoption of new and improved technology and to strengthen its monitoring and evaluation procedures. This becomes increasingly important as FIRA continues to provide more funds to low-income producers. 45. FIRA has continued to be a relatively sound financial institution. Its consolidated financial statements at end-December 1984 showed assets amounting to about Mex$232 billion (US$1.2 billion). These assets were financed mainly by the Bank of Mexico rediscounting, from external loans for which the Government absorbed the foreign exchange risk, and by equity. FIRA's loan portfolio at the end of 1984 amounting to Mex$224 billion (US$1.1 billion) represents about 96% of its total assets, about the same as the 1983 level in real terms. During the five-year period 1977-1981, FIRA increased its lending to agriculture at an annual average rate of over 20% in real terms. However, lending fell in 1982 and 1983. Lending in 1983 of about Mex$123 billion (US$767 million) was about 23X below the 1981 level in real terms. The situation has since been reversed and in 1984, FIRA increased its lending over 1983 by 16% in real terms. All subloan repayments are recuperated on due dates from participating banks through the Bank of Mexico's current accounts; as a result, FIRA suffers no arrears. Arrears to participating commercial banks on subloans discounted by FIRA are estimated to be less than 4%. FIRA's 1984 lending comprised about 69% for short-term credit and 31% for medium- and long-term credits. Low-income producers received 41%, medium-income producers 35%, and other producers 24%. Of the total lending, 49% was for crop production, 37% for livestock, 9% for agroindustries and 5% for other activities. 46. FIRA has consistently earned annual profits in nominal terms. In 1984, FIRA's average interest income on its average loan portfolio was 25.4%, compared to the 1984 inflation rate of 58%, and its cost of funds 18.8%, providing a net financial income of 6.6%. FIRA's operating costs before recoveries, comprising technical assistance, demonstration centers and administration consistently averages about 2.8% of average loan portfolio. Recoveries derived from production income of demonstration centers and from Government compensation to FIRA for technical assistance reduced operating costs in 1984 to 1.7% of average loan portfolio.  - 15 - 47. Until end-1981, FIRA's annual operating profits were sufficient to avoid decapitalization of its equity. This position was reversed when inflation rose to 99% in 1982 and 81Z in 1983, while existing subloans were at fixed interest rates and the prevailing rates for current lending were not raised sufficiently to adjust to the high inflation levels of the period. However, the decapitalization of the loan portfolio was largely absorbed by the Government through (a) Bank of Mexico rediscounts of about 50% of FIRA's discounts at varying rates of interest, allowing FIRA a fixed margin of 3% to 3.5%; and (b) Government guarantees, which absorbed exchange losses on almost all foreign indebtedness. After deducting the Government subsidy, FIRA suffered decapitalization at an average of about 30% per year during 1982 and 1983. However, the position improved in 1984, when FIRA's equity increased by 75% in real terms, due to an annual profit for the year amounting to Mex$8.9 billion (US$47 million) and external liabilities amounting to Mex$33.3 billion (US$173 million) assumed and capitalized by the Government. Key financial information on FIRA's operation is included in Annex IV. 48. For the Eighth Project, FIRA had estimated its lending for the four-year period (mid-1984 to mid-1988) at US$3,556 million. This would have allowed it to increase lending by 5% per annum in real terms. However, because of the higher inflation rate than devaluation rate (para. 43), FIEA's 1984 lending actually increased in US dollar terms by 50%. FIRA's proposed 1985-86 lending program would be financed partly by Bank of Mlexico financing. The balance would be generated from FIRA's own resources, the undisbursed balance of the Eighth Project, and through other external borrowings. FIRA's cash shortfall for 1985 and 1986 is expected to be about US$570 million. The proposed loan, which would be fully disbursed in mid-1986, would reduce this gap to US$390 million. 49. BANRURAL. BANRURAL, a public entity and the largest Bank in Mexico, incorporates 12 subsidiary regional banks with 630 branches. Its lending operations, which totalled about Mex$303 billion (US$1.6 billion) in 1984, consist mainly of short-term credit (about 82%) primarily to low-income producers (about 90% of the total). The most recent information made available to the Bank showed BANRURAL's operating costs to be high (about 16% of the loan portfolio), with a high percentage of its loans in arrears or unrecoverable; as a result, the bank was heavily subsidized. In 1981, the Government allocated from its budget about Mex$54 billion (US$2.2 billion), consisting of an equity contribution of Mex$14 billion and an operational subsidy of Mex$40 billion. While BANRURAL as a financial inscitution has been considered to date to be too weak for direct Bank financing, it is allowed to participate in FIRA's discounting system because FIRA exercises, through its own control mechanism, sufficient selectivity and supervision to obtain good subloans. However, FIRA's lending to BANRURAL has steadily declined from about 16% in 1980 to 6% in 1984. 50. Commercial Banks. The commercial banks, which were nationalized on September 1, 1982, continue to operate in a manner similar to their previous role as private banks. Because of the support extended by FIRA in terms of funds, training of staff and other support services, many commercial banks have established agricultural credit departments with agricultural  - 16 - technicians, who are graded and authorized to evaluate and approve subloans at varying levels. Lending operations by commercial banks are traditionally concentrated on commercial producers and agroindustries. Consequently, the Bank of Mexico, in order to encourage lending to low-income producers, stipulated that 0.7% of total deposits of multipurpose banks and 2% of deposits in commercial banks must be held in the form of agricultural loans to low-income producers. In addition, FEGA provides guarantees (about 80% of subloans) and reimburses technical assistance for subloans to low-income producers. Lending by commercial banks through FIRA to low-income producers now averages about 34% of total subloans discounted as compared to about 10% in 1980. The commercial banks discounted about Mex$210 billion (US$1.1 billion) of subloans with FIRA in 1984, representing 94% of FIRA's total discounts. Previous Bank Projects 51. In the past ten years (FY1975-84), Bank participation in the agricultural sector amounted to US$2,013 million distributed among 21 projects, of which four were credit projects (FIRA V, VI, VII and VIII) with Bank financing totalling US$1,065 million. In December 1982, the Bank issued a combined completion report on the Fifth and Sixth Credit Projects (Report No. 4240). The overall conclusions were as follows: (a) FIRA's performance has been impressive and has had a strongly positive impact on agricultural production and institution building; (b) specific components set aside in Bank loans for low-income producers have helped to focus lending more on this farmer category. Also, lending, which was initially mainly for livestock, has become progressively more diversified; (c) FIRA is in the process of developing a monitoring and evaluation system to measure lending impact, and has over the past three years effectively decentralized its lending operations, as a result of which most of its field offices have a reputation for excellence; (d) the gap (since 1976) between FlRA's interest rates and commercial interest rates progressively widened as no provisions were made for periodic adjustments during implementation. This caused (i) an accelerating demand for credit; and (ii) a slow deterioration of FIRA's financial position; and Ce) FIRA's capabilities for sectoral analysis, planning and programming and internal control of subloans was inadequate in the face of strongly expanded demand. 52. The completion report for the Seventh Agricultural Credit Project is currently being prepared. This project was designed taking into account the experiences and lessons gained through the previous projects. There was a significant improvement in quality control of subloans financed through  - 17 - FIRA. An Operating Regulations and Procedures Manual and a data base system was developed, and a monitoring and evaluation system has been satisfactorily organized. Whilst FIRA's capabilities for in-depth sectoral analysis and medium-term planning and programming had improved, further improvements were still necessary. In addition, interest rate adjustments were not sufficient to cover the gap between agricultural on-lending rates and inflation. The Eighth Project has substantially fulfilled its objectives. It continued to provide funds to support FIRA's good record of credit delivery, technical assistance to the producers and further improved its sectoral analysis, planning and programming. Loan commitments were substantially in accordance with the initially agreed program of lending, with low-income producers receiving over 50% of subloans under the project. In addition, it contributed to the improvement of agricultural sector policies through the conclusion and implementation of a general interest rate agreement, which reduced interest rate subsidies. 53. During the past year, completion reports were issued on the Papaloapan Rural Development Project (Loan 1053-ME), the Bajo Rio Bravo Irrigation Rehabilitation Project (Loan 1111-ME), and the Tropical Agricultural Development Project (Loan 1553-ME). The combined lessons learned from these projects are: (a) projects in new areas, especially where experience and knowledge are limited, should be modest in scope and design. In determining the number of components, consideration should be taken of institutional capacity and local experience; (b) the completion of thorough basic studies and the substantial completion of detailed design work are prerequisites to appraisal and approval of projects with major infrastructure components; (c) shifts in cropping patterns are not only dependent on technical consideration but also on Government price and support policies; and (d) an initial high level of extension coverage is necessary for the adoption of new technology, particularly in underdeveloped zones. 54. Implementation of ongoing projects is currently slow because of limited counterpart funds. This slowness and the fact that the Government's financial control and reimbursement procedures are cumbersome, had caused disbursements to lag. The Government, in consultation with the Bank, has reduced the scope of and cancelled loan funds for some of the ongoing projects and has reviewed the financia'l control procedures and introduced some simplification. The recent high devaluations (since 1982) contributed to the budgetary problems, which further slowed down execution of ongoing projects and disbursements. However, the Bank's implementation of a Special Action Program (para. 23) has eased the budgetary constraints and facilitated project implementation. PART IV - THE PROJECT 55. The proposed loan of US$180 million would provide interim financing for FIlA from the closing of the ongoing Eighth Agricultural Credit Project until preparation and commencement of a new and broader agricultural credit project. It is based on the appraisal of the Eighth Project which is described in Staff Appraisal Report No. 5014-NE, dated June 4, 1984. The Eighth loan will be fully disbursed in mid-1985, over two years ahead of  - 18 - schedule (para. 43) except US$1 milliun remaining for technical assistance and support services. Without the proposed interim finance, FIRA would have to curtail its lending program, with negative consequences for agricultural production and rural incomes. Meanwhile, the Bank and the Government would have sufficient time to: (a) fully review the current status of credit in Mexico; and (b) design a follow-up project in support of further institutional and policy reforms in agricultural credit, including possible assistance to other agricultural credit institutions and producer pricing. Annex III contains a timetable of key events in the processing of the project and a description of the special conditions of the proposed loan. Negotiations of the proposed loan were concluded in Washington, D.C. on May 29-30, 1985. The Mexican delegation team was headed by Mr. Luis Nava of NAFINSA, and included representatives from the Secretariat of Finance and FIRA. Project Objectives and Description 56. As in the Eighth Project and in accordance with the Government's overall development plan of promoting agricultural growth and reducing fiscal deficit, the objectives of the proposed interim project would be to: (a) raise agricultural productivity with a view to increasing food production, agricultural exports, and real farm income; and (b) improve agricultural sector policies by reducing interest rate subsidies and restricting them to special target groups. 57. In order to achieve these objectives, the proposed project would: (a) provide for investment credit to farmers for crops, livestock and agroindustries; and (b) continue to support policy changes for (i) the introduction of a more realistic definition of subloan beneficiaries, and Cii) a gradual reduction and eventual elimination of subsidized interest rates, except for low-income farmers. 58. The proposed project would be implemented over a one-year period. It wonld include finance only for investment credit. Most project requirements-including interest rates, subproject appraisal, supervision and preparation of investment programs, and monitoring and evaluation-would apply to FIRA's total lending program. About 50% of the proposed loan proceeds would be directed to low-income producers, 44% to medium income producers, and 6% to other producers. Investment subloans to beneficiaries would, as in the past, be based on technically and economically sound development plans. Investment lending would be for annual and perennial crops, livestock and agroindustries. 59. Thne remaining balance of the technical assistance component included in the ongoing Eighth Project would continue to strengthen FIRA's institutional framework enabling FIRA to allocate financial resources  - 19 - efficiently. To achieve the above, FIRA will continue to provide: (a) technical assistance to farmers to enable appropriate transfer and adoption of improved technology; and (b) support services to continue the training of technical staff from FIRA and participating banks and strengthen FIRA's medium- and long-term development planning. 60. Crop Lending Program. Investment lending for crops would cover the complete range of production types from annual to perennial cropping under rainfed and irrigated conditions. Crop investment subloans would include a diversity of loan size, type of borrower and ecological conditions. Investment items for the crop lending program would include, inter alia, land improvement, equipment and machinery purchases, civil works construction, including supporting infrastructure for irrigation and storage, and establishment of fruit orchards and industrial crop plantations. 61. Livestock Lending Program. The investment lending for livestock would be for beef and dual-purpose production, dairy production, and other livestock operations. As in the case of crop investment subloans, there would be a diversity of loan size, type of borrower and ecological conditions in livestock subloans. Investment items would include purchase of breeding stock, renovation and/or establishment of pastures, construction of buildings, fences and handling facilities and provision of water supplies. 62. Agroindustries Lending Program. Investment lending to the agroindustrial sector would go particularly to small- and medium-scale producers. The portfolio of agroindustrial investments-sawmills, fisheries, feedmills, grain elevators, milk processing plants, and slaughterhouse facilities would continue to vary widely. However, the project would not finance marketing components of subprojects, as these would be financed under the Agricultural Marketing Project (Loan 2262-ME). Project Costs and Financing 63. The cost of the project is estimated at US$473 million, and is designed for medium- and long-term investments only (Annex 5). About US$180 million, or 38%, represents the estimated foreign exchange component. The proposed project would represent about 34% of FIRA's total lending program during the project period. 64. The financial arrangements would be similar to those under the Eighth Project. Financing to be provided by FIRA, participating banks, and the beneficiaries would amount to 32%, 15%, and 15%, of the project cost, respectively. The proposed loan would be made to Nacional Financiera, S.A. (NAFINSA), a Government agency designated to borrow from the Bank, at standard terms for Mexico. The proceeds would be transferred to FIRA as equity and NAFINSA would repay the principal amount of the Bank loan together with interest and other charges. This contribution to equity would assist FIRA in avoiding an erosion of capital. However, with FIRA having revised and increased its lending program, it will suffer an accumulated cash  - 20 - shortfall to end-1986 of about US$390 million. The Government has provided assurances that it will (a) require participating banks to finance from their own funds the agreed percentages of subloans; (b) cause participating banks to lose eligibility for subproject participation where arrears of loans discounted hy FIRA are in excess of 15%; (c) ensure thac the proceeds of the Bank loan would be transferred to FIRA as equity; and (d) provide the necessary resources to offset FIRA's cash shortfall (draft Project Agreement, Schedule 2, Part B, para. 2 and Section 2.02(d); draft Loan Agreement, Section 3.01(b); and draft Guarantee Agreement Section 2.02(a)(ii) and 2.02(c)). Procurement 65. FIRA would require sub-borrowers to obtain quotations from several sources of supply, whenever practicable, for goods, civil works, and imports of breeding livestock to be financed under subloans. Machinery and equipment for agroindustries would be purchased by private producers or groups of producers through commercial channels (draft Project Agreement, Sections 2.02(a)(ii) and 2.06). Bulk purchasing under International Competitive Bidding (ICB) would not be feasible, since the agricultural lending activities would be widely distributed geographically, cover a variety of farm and ranch investment activities, and involve a large number of sub-borrowers. An adequate selection of machinery, tractors and other agricultural equipment and inputs is available to sub-borrowers through local and international suppliers. Disbursements 66. All the subloans under the project would be committed and proceeds of the proposed Bank loan disbursed over approximately one year. The Bank would reimburse FIRA 55% of its discounts for disbursed project subloans. A Special Account of US$30 million would be established in NAFINSA to assist in project implementation and facilitate disbursements. As the proposed project would be a continuation of Bank support to FIRA's lending program, the Bank would retroactively finance subloans amounting to US$18 million made by FIRA after June 1, 1985. Disbursements against statements of expenditures under FIRA loans are expected to continue to be satisfactory. The above disbursement period is based on the Bank's experience with FIRA, having implemented eight credit projects consistently above the regional and Bank averages for credit projects. Project Execution 67. FIRA would be responsible for project execution. Funds would be channeled through participating public and commercial banks. Formulation, evaluation, approval, and supervision of investment development plans would be carried out primarily by FIRA-approved participating bank technicians, with support from FIRA staff. During the period of the proposed project, funds remaining from the Eighth Loan would continue to support FIRA's institution building by strengthening its delivery of technical assistance, development planning, and its monitoring and evaluation capabilities for measuring the impact of its lending.  - 21 - Sublending Procedures 68. Beneficiary Categories. Currently, agricultural producers are classified for credit purposes in three groups: (a) low-income producers whose principal income is derived from farming: their total annual income, including income from other sources, should be less than 1,000 times the relevant regional minimum daily rural wage; (b) medium-income producers whose total annual income is between 1,000 and 3,000 times the minimum daily rural wage; and (c) other producers whose total annual income is in excess of the upper limit for medium-income producers. Minimum daily wages are established for over 100 economic regions throughout the country and currently range between US$3.3 to US$4.5 equivalent. While the above classification of low-income producers (about US$700 per capita income compared to the national per capita income of US$2,270, is reasonable, the percentage of farmers included in this category is high, embracing approximately 78% of all farmers throughout the country. As low-income producers would continue to receive an interest rate subsidy at a high fiscal cost to the Treasury, the Government has agreed under the General Interest Rate Agreement, described below, to carry out a study to evaluate and redefine low-income producers. The first phase of the study was carried out in 1984 and focused on development of the criteria required for allocation of subsidies to low income beneficiary groups. The second phase of the study, which is currently in progress, will redefine the subloan beneficiary categories after taking into account the experience of the implementing agencies. Because of the complexity of this issue and the time-consuming nature of the administrative process of conversion to a new definition of beneficiary categories, it is not feasible to introduce such changes as part of this proposed project. 69. Interest Rate Structure. The Bank and the Government signed a General Interest Rate Agreement (GIRA) on August 7, 1984. GIRA is a master agreement which covers interest rates in individual loans for credit programs. It provides for the linking of the interest rates to a central reference rate (an index of average cost of funds to multi-purpose banks- ACF), a systematic accounting of subsidies, a gradual phasing-out of remaining subsidies for most beneficiary categories, periodic adjustment of rates and a reduction in the dispersion of interest rates. It also provides a framework for financial sector work, and an agenda for a structured policy dialogue and periodic consultations. The proposed project would support the implementation of GIRA and additional financial performance conditionality is not needed. 70. The period4c adjustment of interest rates provided for under GIRA would allow existing rates to gradually become positive by January 1, 1987, except for subloans to low-income producers who would receive only a small subsidy after the above date, as shown below. The Agreement also provides that new subloans would have variable interest rates. FIRA would suffer some decapitalization (para.47) because: (a) of its existing fixed interest subloans; and (b) the fact that the movement to positive rates is gradual. However, the adoption of increased and variable rates would allow FIRA to gradually increase its profits, so that within a period of about eight years, it would be able to kaintain its equity in real terms entirely from profits.  - 22 - The problem of FIRA's decapitalization is related to Mexico's economic and financial crisis of 1982. It is a consequence of the Government's inability to raise all nominal interest rates to a level that would have been required to keep them positive in real terms. The decapitalization of FIRA is therefore a relatively new and temporary problem that will be resolved through the combined effect of gradual rate adjustment, as provided for under GIRA, and a decline in inflation. Structure and Adjustment of On-lending Interest Rates by Category of Producers for Medium- and Long-Term Subloans a/ Category of Producers Low Medium Commercial Revision Dates Income Income Basic Products D/ Other -- --Rates cJ / Current - revised April 1, 1985 63 80 99 ACF+5 September 1, 1985 67 87 99 ACF+2 January 1, 1986 70 90 ACF ACF+2 July 1, 1986 75 95 ACF ACF+2 January 1, 1987 80 a/ For short-term subloans, an additional 2% would be added to the equivalent nominal rates and an additional 1% for all agroindustrial subloans. bl Basic products for Bank financed projects would only include maize, wheat, sorghum, beans and rice. cl Rates as a percentage of ACF, or as ACF plus additional points. 71. Under GIRA, the Government and the Bank consult periodically on the accounting for interest rate subsidies to correct any future distortions in the interest rates that may result from unforeseen changes in the economy. The first such consultation was made in December 1984 and the second is planned for July 1985. The next adjustment is to be determined in the July consultations, for effectiveness on September 1, 1985. The Government has begun to introduce a system of variable interest rates for some sectors; i.e., small- and medium-mining, industrial equipment financing, and in agriculture for subloans discounted by FIRA. 72. The April adjustment has brought the Government substantially in compliance with GIRA. This adjustment raised the levels of interest rates for medium- and long-term investment credit as follows: (a) low-income producers, 30%; (b) medium-income producers, 38%; and (c) commercial producers, 52%, with a preferential rate of 47% if they produce 'basic products-. Where the credit is short-term, 2% is to be added to each of the above rates. Credit for agroindustrial purposes attracts another 1Z. The current level of interest rate subsidies, as measured by the difference between ACF and the nominal rate charged to alternate borrowers, has been reduced from the December 1984 levels and now amounts to about 37% (1984, 502) for low-income producers, 20% (1984, 35%) for medium-income producers, and 1% (1984, 17Z) for commercial producers of -basic products-. Interest rates are positive for other commercial producers.  - 23 - 73. As part of the General Interest Rate Agreement, the appropriateness of the ACF as a central reference rate was reviewed and accepted, based on a special technical study prepared by the Mexicans and presented to the Bank in December 1984. Interest rates will conform to the rates stipulated in the General Interest Rate Agreement (draft Project Agreement, Schedule 2, Part B, para. 6 and draft Guarantee Agreement, Section 3.02). 74. Currently, participating banks are allowed a discount margin between the on-lending rate to the sub-borrower and that paid to FIRA, ranging from 2% to 7%. This margin, which is currently adequate, would be reviewed together with the interest rates every six months. Margins allowed to the participating banks would require discussion and agreement with the Bank before revision (draft Project Agreement, Schedule 2, Part F, para. 6). 75. Subloan Appraisal and Supervision. Over the years, FIRA has developed sound subloan appraisal and supervision procedures. Subloans would be evaluated and approved by FIRA and participating bank technicians subject to FIRA's approval for subloans above prescribed limits. Under the proposed project, FIRA would be required to obtain prior approval from the Bank for project subloans in excess of US$800,000 equivalent, which also applies to individual subloans resulting from group activity. No subloan would be made for on-farm investment if the amount of the proposed subloan, together with the aggregate amount outstanding under previous FIRA-financed subloans to such a borrower were to exceed the equivalent of US$260,000 for each subloan beneficiary. FIRA's recently introduced Operating Regulations and Procedures Manual includes the guidelines for subloan evaluations, the level of authority for subloan approval, and the proper utilization of subloan proceeds. Assurances have been obtained that FIRA will adhere to the above subloan appraisal and supervision procedures (draft Project Agreement, Section 2.03 and Schedule 2, Part B, para. 4). Reporting Requirements 76. FIRA has developed an efficient system of timely reporting to the Bank. Quarterly progress reports summarizing project performance, subloan disbursements by categories and FIRA rediscounts are routinely submitted to the Bank no latcr than 60 days after the end of each quarter. Detailed reports are prepared semi-annually and submitted to the Bank no later than three months after the end of each six-month period. FIRA would continue to adhere to Bank reporting requirements and to submit a Project Completion Report within six months of the Closing Date. Accounts and Audit 77. FIRA has consistently presented timely annual audited accounts. The accounting system of FIRA trust funds is satisfactory. FIRA would maintain separate project records, as established for the ongoing Eighth Credit Project. FIRA's accounts have been audited during recent years by external auditors, and all audit reports of its accounts have been unqualified. An audit, satisfactory to the Bank, would be made of the accounts, statements of expenditures (SOEs) submitted to the Bank, and  - 24 - financial statements of FIRA for each fiscal year. The audit would be in accordance with sound auditing principles consistently applied by independent and qualified auditors appointed by the Controller General and the Bank of Mexico. Certified copies of the statements audited, together with the report of the auditors, which would also comment on the SOEs, would be submitted to the Bank no later than six months after the close of each fiscal year. Adequate accounts and records would also be maintained within all the participating banks so as to identify all transactions pertaining to FIRA rediscounted subloans. Project Benefits 78. It is estimated that additional project benefits would accrue in direct proportion to the percentage increase in the size of the original project. The project would benefit an estimated additional 62,000 families, or about 350,000 additional beneficiaries. Secondary benefits would al3so accrue from processing and agricultural service activities. At full development, it is estimated that, based on previous experience, annual production of basic crops (maize, beans, wheat, rice and sorghum) would increase by about 0.6 million metric tons; cotton, soybeans, and safflower by 60,000 tons; milk by 9 million liters; beef and pork by 70,000 tons; and eggs by 70,000 tons. The incremental production of basic crops alone would amount to foreign exchange savings of about US$80 million per annum at full development. Likewise, increased production of export crops would contribute to annual foreign exchange earnings in excess of the above savings on incremental basic crops. The project would cause an increase of net cash income tc beneficiaries. Most investment plans are expected to have financial and economic rates of return in the range of 18% to 35%. 79. Funds remaining from the Eighth Project would continue to assist institution building by: (a) strengthening FIRA's analytical and medium- and long-term planning capabilities allowing a better allocation of investment resources over the longer term; (b) expanding technical assistance for the promotion and adoption by farmers of available improved technologies; and (c) further supporting the Monitoring and Evaluation Division to measure project impact, including the adoption rate of available technology. Project Risks 80. Since FIRA is an efficient and mature institution, the project presents no special risk in terms of the technical and financial soundness of various investment opportunities that would be financed under the program. The main risk would be that political pressures would impede progress in eliminating interest rate subsidies, especially in case of a resurgence of inflation causing a further deterioration of FIRA's financial position, a continued drain on the Government budget resources, and a misallocation of production factors. These risks are limited by the Government having recognized the need to reduce subsidies and having committed itself, through the General Interest kate Agreement, to gradually adjusting interest rates towards positive levels, and to have FIRA become self-sufficient.  - 25 - PART V - LEGAL INSTRUMENTS AND AUTHORITY 81. The draft Loan Agreement between the Bank and Nacional Financiera, S.A., the draft Guarantee Agreement and General Interest Rate Agreement between the United Mexican States and the Bank, the draft Project Agreement between Bank of Mexico and the Bank 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 separately. 82. Special conditions of the project have been described in Part IV of this Report and are listed in Section II of Annex III. 83. I am satisfied that the proposed loan would comply with the Articles of Agreement of the Bank. PART VI - RECOMMENDATION 84. I recommend that the Execut've Directors approve the proposed loan. A. W. Clausen President Zccachments June 28, 1985  _26_ ANNEX I Page 1 of 5 TABLE 36 MExICO - SOCIAL IurICnarts ITA suEm MEXICO REFORE GROUS (HEIGTD AVEGS) rDST (NM smur ESTIHArE) lb caUmsCI I S mamI u w DItm issa!!! 197 ESmDIATELb. LAT. AIIRRCA4 CAR EURE AM TONa SQ. M) TOTAL 1972.5 1972.5 1972.5 AGICULTURAL 985.2 976.4 979.5 430, Q CAPT (131U) 360.0 730.0 2270.0 2108.6 2345.3 -RO aNUMTION PM CAlMa (KILOGRAMS OP OIL EQUIVALENT) 539.0 773.0 1340.0 995.5 1122.5 III^LTIX AM trTAL SfAIT POPULAfTON*HIb-TEAR CTHOUAIS) 37073.0 51176.0 73122.0 URBAN PopuLATiO (2 or ToTAL) 50.8 59.0 68.0 66.5 46.8 POPULATION ROJECTIONS POPULATION IN TA 200 CHILL) 109.4 STATIONARY POPATION (HILL) 196.5 PoPULArIoN noszuimi 1.9 POPULATION DENSITY PER SQ. i. IB.B 25.9 36.1 35.7 82.9 PER Sq. IN. ACRI. LAND 37.7 5Z.4 72.8 92.4 150.9 POPULATION AGE SRUCTURE (I) 0-14 US 45.6 46.5 44.3 39.9 31.6 15-64 URS 51.0 50.0 52.2 56.0 61.1 65 AND ABV 3.4 3.5 3.4 4.1 7.1 POPUIATION QOUTH RATE (C) TOTAL 3.0 3.2 3.0 2.4 1.6 URBAN 4.8 4.7 4.2 3.6 3.7 CRUDE BIRTH RATE CPEU THOUS) 45.4 43.4 33.9 31.3 Z3.4 CRUE DeATH RATE (PR TlOS) 12.2 9.7 7.1 8.1 8.8 GROSS REPRODUCTION RATE 3.3 3.2 2.2 2.0 L.6 FREELY PLANUING ACCEPTORS, ANNUAL (THOUS) .- 25.1 1145.0 /C USERtS (2 F MARAIUD UN) * * 39.0 T 40.3 FOOD AM NIrZ INDEX OF FODO PROD. PER CAPITA (1969-71-IS0) 97.0 100.0 104.0 134.3 L14.5 PER CAPITA SUPPLT OF CAIORIES (I OF REQUIRNIENTS) 117.0 112.0 121.0 110.6 126.6 PROTEINS (CANS PER OAY) 69.0 6b.0 74.0 67.3 89.7 OF WH1C0 ANIMAL AD PULS! 29.0 27.0 28.0 Id 34.1 34.5 CHILD (AGES 1-4) DEATH RATE 10.3 6.5 4.0 5.7 5.2 LIFE EXPECT. AT BIRTH (ARS) 57.0 61.3 65.4 64.7 67.4 INFANT NORT. IRATE (PER THOUS) 91.1 73.6 52.9 60.6 54.2 ACCESS IU SAFE WATER (2POP) TOTAL 23.5 49.0 Io 58.0 /. 65.4 URWA . 68.5 1. 61.4 /. 78.1 RURAL .. 21.071 5i.07r 46.2 ACCESS TO ErETA DISPOSAL (Z OF POPULATION) TOTAL . 3 7.0 le 38.0 Ie 52.9 U .. 60.07; 50.1 7. 67.0 RURAL . 4.0 7 13.07; 2 4.5 POPULATION PEA PSlISCLAN 1830.0 1510.0 . L917.7 lOb15. POP. PER NURSXC PERSON 3650.0 1390.0 .- B15. 764.4 POP. PER HSPrTAL BED TUTAL 590.0 970.0 . 3b6.2 32b.3 URBN 570.0 /f 1170.0 .- 611.5 201.5 RURAL - 1370-0 2636.3 AINUSSIONS PE HOSPITAL ED .. .. 27.3 20.0 I-C AVERACE SIZE OF HOUSENOLD TOTAL 5.4 5.7 IRBAN 5.7 5.7 RUAL 5.2 5.8 AVERAGE NO. OF PEtSONSIROON TOTAL 2.9 2.5 URBN 2.6 2.2 RURL 3.4 3.2 ACCESS TO ELECT. (Z OF WELLIVCS) TOTAL .. SI.9 URBAN .. 80.7 RURAL .. 27.8  - 27 - ANNEX I TA I L 3A Page 2 of 5 mcO - SOCa. TNDICATOfS DATA S MEXICO REPERENCE GROUPS (wEICHTED AVAES) a ST (NOSYRET RUM ESTIMIA) lb RGCENT MIDDLE INCOME MIDDLE INCOME 196v&! 1970f! xESTIMATzLb LAT. AMERICA GU cUa1uon ADJUSTED ENROLLMT RATIOS PRDIARY: TOTAL 80.0 104.0 121.0 105.4 101.1 MALE 82.0 106.0 122.0 106.3 105.5 FEMIAE 77.0 102.0 120.0 104.5 96.7 SECONDARY: TOTAL 11.0 22.0 51.0 43.2 59.1 .IALE 14.0 26.0 54.0 42.3 66.9 FEKALE 8.0 17.0 49.0 44.5 50.6 VOCATIONAL (Z OF SECONDARY) 23.6 26.7 11.6 33.6 21.6 PUPIL-TEAGNER RATIO PRDINY 44.0 46.0 37.0 30.1 25.1 SECONDARY 13.0 16.0 16.0 16.9 20.5 ADULT LITERACY RATE (2) 65.4 74.2 82.7 79.5 75.6 PASSENGER CARS/ OUSMD POP 12.9 24.1 61.3 46.0 54.7 RADIO RECEIVERS/THOUSAND POP 89.0 273.7 295.4 225.6 164.9 TV RECEIVERS/7HOUSAND FOP 17.5 56.5 108.1 107.2 1Z3.8 NEUSPAPER (-DAILY GENERAL :NTERESr) CIRIILATION PER THOUSAND POPLATION 73.3 .. 64.5 63.5 96.3 CINEMA ANNUAL ATTENDANCE/CAPITA 9.8 4.9 4.4 Ir 2.8 2.9 TOTAL LABR FORCE (THOUS) 11191.0 14722.0 Z1398.0 PEMALE (PERCENT) 15.2 17.4 20.0 23.2 34.5 AGRICULTURE (PERCENT) 55.1 45.2 35.6 31.5 40.7 INDUSTRY (PERCENT) 19.5 22.9 25.8 23.9 23.3 PARTICIPATION RATE (PERCENT) TOTAL 30.2 28.8 29.3 32.2 42.9 ML 51-1 47.4 46.7 49.3 54.7 FEMALE 9.2 10.1 11.7 15.2 31.0 ECONOMIC DEPENDENCY RATIO 1.6 1.7 1.6 1.4 0.9 INCOM DISTIIBUTIOE PERCENT OF PRIVATE INCOME RECEIVED BY HIGHEST 52 OF HOUSEHOLDS .. HIGNEST 201 OF HOUSEHOLDS 61.1 /b 60.7 57.7 /d LOWEST 2CO OF HOUSEHOLDS 3.4 7ii 3.3 2.9 7d* LO6EST 40: OF HOUSEHOLDS 9.8 7h 9.9 c.9 7d. POWERT! TAr GPOWS ESTLMATED ABSOLUTE POVERTY INCCME LEVEL (USS PER CAPITA) URBAN .. .. .. 288.2 RURAL .. .. .. 184.0 ESTIMATED RELATIVE POVERT IXNCME LEVEL CUSS PER CAPITA) URBAN .. .. 471.0 Ic 522.8 RURAL .. .. 471.0o 7 372.4 ESTIMATED POP. BELOW ABSOLUTE POVEiRT INCOME LEVEL (2) URLAN . . . .. RURAL .. OWT AVAILTI.E NOT APPLICABLE N O T 8 S /a Tbe group averages for each lndicator are population-weighted aritbmetic means. Coverage of coutrlea aong the Indicators depends on availabilLty of data and is wt uniform. /b Unless otherwise noted -Dta for 1960- refer to any year between 1959 and 1961; -Dta for 1970' between 1969 and 1971; and data for -Moet Recent Estimate between 1980 and 1982. /c 1979; Id 1977; /e Served from water supply and sewage; /f 1962; Ig 1976; lh 1963. JUNE. 1984  -28- ANNEX I msotin m ..~~~~ Page 3of 5 Il545.. U1msl 54 *4. deeM IS.. 5.05 j-sslII I1: 1.4-5 4555544 5* S1454. U .5*4 ld8 A- 55.4 -110 5445 to" 555p l . kw55 1. 4- 55.5 i.ote-I0l.