Mexico - Second Export Development Project

oni ant of The World Bank FOR OMCIuL USE ONLY Report No. P-4298-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 USt250.0 MILLION TO BANCO NACIONAL DE COMERCIO EXTERIOR, S.N.C. WITH THE GUARANTEE OF UNITED MEXICAN STATES FOR A SECOND EXPORT DEVELOPMENT PROJECT December 19, 1986 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  Currency Unit - Peso (Mex$) On December 15, 1986, the exchange rate in the controlled market was US$1 = Mex$887.90; the free market exchange rate stood at US$1 = Mex$889.00. Fiscal Year January 1 - December 31 Weights and Measures Metric: British/US Equivalent 1 meter (m) = 3.28 feet (ft) 1 kilometer (km) = 0.62 mile (mi) 1 kilogram (kg) = 2.20 pounds (lbs) 1 metric ton (MT) = 2,205 pounds I liter (1) = 0.26 gallons (gal) Abbreviations ACF Average Cost of Funds - Costo Promedio Porcentual (CPP) BANRURAL Banco Nacional de Credito Rural, S.N.C. BdM Banco de Mexico BNCE Banco Nacional de Comercio Exterior, S.N.C. CONASUPO Compania Nacional de Subsistencias Populares DGPI Direccion General de Promocion Industrial EDI Economic Development Institute ERR Economic Rate of Return FIFE Programa de Financiamiento de Inversiones Fijas para las Exportaciones FOMEX Fondo de Fomento a las Exportaciones de Productos Manufacturados FOMIN Fondo Nacional de Fomento Industrial FONATUR Fondo Nacional de Fomento al Turismo FONEI Fondo de Equipamiento Industrial GDP Gross Domestic Product GIRA General Interest Rate Agreement ICB International Competitive Bidding IDB Inter-American Dt.velopment Bank IMF International Monetary Fund IMCE Mexican Foreign Trade Institute LDC Less Developed Country NAFINSA Nacional Financiera, S.N.C. NIC Newly Industrialized Country PROFIDE Programa de Financiamiento de Exportaciones en Divisas PRONAFICE National Industry and Foreign Trade Development Program PROFIEX Integrated Export Development Program PVP Present Value Payment System - Sistema de Pagos al Valor Presente R&D Research and Development SAP Special Action Program SECOFI Secretaria de Comercio y Fomento Industrial SEMIP Secretaria de Energia, Minas e Industria Paraestatal SHCP Secretaria de Hacienda y Credito Publico SOEs Statements of Expenses SPP Secretaria de Programacion y Presupuesto SVIR Standard Variable Interest Rate  FOR OMCIAL USE ONLY IIOD ScKCoD IEPORT DEVEloPtrT LO"N Loan and Project Sury Borrower: Banco Nacional dt Comercio Exterior, S.N.C. (BNCE) Guarantor: United Mexican States Beneficiaries: Fondo de Fomento a las Exportaciones de Productos Manufacturados (FOMEX) Fondo de Equipamiento Industrial (FONEI) Fondo Nacional de Fomento al Turismo (FONATUR) Amount: US$250.0 million equivalent Terms: 15 years, including three years of grace, at the standard variable interest rate. Relending Terms: BNCE would relend in U.S. dollars up to an estimated-88Z of loan funds to FOMEX, FONEI, and FONATUR for the project's working capital and fixed investment components. It would on-lend, without intermediaries, the remaining 12X of the loan for fixed investments. BNCE would charge to FOHEX, FONEI and FONATUR, on all amounts relent, interest rates on a par with the first Export Development Project, currently equivalent to the Bank's standard variable interest rate plus one-quarter of a percentage point. The financial intermediaries would be guaranteed a minimum spread current- ly equivalent to one-and-one-half of a percentage point on U.S. dollar-denominated subloans, and two percentage points on peso-denominated subloans, as under other Bank-financed lines of credit to industry. Maturities would be up to I year for working capital subloans, and up to 13 years, including 3 years of grace, for fixed investment subloans. The foreign exchange risk would be borne by the Government on all principal repayments, and by the project executing agencies on interest payments. Project Description: The objectives of the proposed project-the Bank's second to support the development of Mexico's exports-would be to help increase and diversify the country's non-oil exports by supporting reforms of the policy framework for export devel- opment, assisting institutional development, and providing finance to exporters. These objectives would be achieved through three specific project components, which include: expansion of FOMEX's working capital financing of direct exporters and introduction of finance for indirect export- ers; provision of finance for the fixed investment require- ments of exporters, including tourism; and support for a technical assistance program for specific studies and training. This document has a restricted distribution and may be used by recipients only in the perfornance of their official duties, Its contents may not otherwise be disclosed without World Bank authorization.  - ii - Project Risks: The project faces risks in four specific areas which could ad- versely affect Mexico's non-oil export performance: (i) delays in economic stabilization and inadequate exchange rate manage- ment; (ii) a slowdown in trade liberalization; (iii) insuffi- cient progress in institutional/administrative improvements; and (iv) rising trade protectionism in Mexico's principal trading partners. Policy and administrative measures taken by the Gov- ernment already and actions proposed for further liberalizing trade and promoting non-oil exports, including institutional arrangements, combined with the industrial restructuring poli- cies supported by the recently approved Industrial Recovery and Industrial Technology Development Loans, should improve Mexico's non-oil export performance. A comprehensive review process under the project, combined with the proposed measures, would enhance the success of Mexico's export development strategy and afford the Bank and the Government an opportunity to consider additional policy and administrative measures needed to deal with any of the risks that may materialize. Financing Pla: Cofi- Executing Agencies nancing (BNCE, FONEI, FONATUR, (Ex/la FONEX) and Mexican Bank of Bank Co-werclal Banks Japan) Investors TOTAL USS millions Equivalent PROFIDE Fund (Pre- Shipcent Working 175.0 50.0 - - 225.0 Capital Financing) FIFE Fund (Fixed 74.5 22.0 240.0 87.5 424.0 Asset Financing) Technical Assistance 0.5 0.5 - - 1.0 and Studies TOTAL 250.0 72.5 240.0 87.5 650.0 Estimated (Bank FY/US$ Millions) Disbursements:1/ 87 88 89 90 91 Annual 15.0 116.5 86.5 28.5 3.5 Cumulative 15.0 131.5 218.0 246.5 250.0 1I Since a majority of loan funds will be disbursed for working capital financing of exporters, the standard IDF disbursement profile does not apply. The above profile is based on perfor- mance under EDP-I (Loan 2331-ME).  - iii - Staff Report: This is a combined Staff Appraisal and President's Report.  INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPENT REPORT AND RECOOENDATIE OF THE PRESIDENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO BUNCO NACIONAL DE COMERCIO EXTERIOR, S.E.C. WIT THE GUARAnTEE OF UNITED MEXICAN STATES FOR A SECOND EXPORT DEVELOPMENT PROJECY 1. I submit the following report and recommendation on a proposed loan to the Banco Nacional de Comercio Exterior, S.N.C. (BNCE) with the Guarantee of United Mexican States for the equivalent of US$250.0 million to help finance a Second Export Development Project. The loan would be repaid over 15 years, including 3 years of grace, at the standard variable interest rate. The BNCE would relend in U.S. dollars up to an estimated 88% of loan funds to FOMEX, FONEI, and FONATUR for the project's working capital and fixed investment components. It would on-lend the remaining 12% of the loan for fixed invest- ments without intermediaries. On all amounts relent, the BNCE would charge interest rates on a par with the first Export Development Project, currently equivalent to the Bank's standard variable interest rate plus one-quarter of a percentage point. The financial intermediaries would be guaranteed a minimum spread currently equivalent to one-and-one-half of a percentage point on U.S. dollar-denominated subloans, and two percentage points on peso-denominated subloans, as under other Bank-financed lines of credit to industry. The Gov- ernment would repay the principal of the Bank loan, while the implementing agencies would pay only interest and other charges. Foreign exchange risk would be borne by the Government on all principal repayments and by the agencies on interest payments. PART I - THE ECONOMY 2. An Economic Report on Mexico (Mexico: Recent Economic Developmentsand Prospects, No. 4996-ME) was distributed to the Executive Directors on May 14, 1984. An updating Country Economic Memorandum is scheduled to be issued later this year. Recent economic developments and a provisional assessment of the consequences for Mexico of the recent sharp decline in oil prices are discussed below. Country data are provided in Annex I. Background 3. Mexico experienced three decades of high and stable growth from the 1940s to the 1960s, based on an inimrd-looking groutb strategy. By 1970, how- ever, Mexico had largely exhausted the early and efficient possibilities for import substitution, and the economy started to slow down. The Government at- tempted to foster growth through expansion of public sector expenditures, rising subsidies, and the protection of high-cost domestic production. Public sector expenditures as a percentage of GDP increased by more than half between  -2- 1970 and 1976, from 20.9% to 31.9Z. This strategy failed to sustain sound economic growth, and in 1976 Mexico experienced a serious financial and eco- nomic crisis. New oil revenues led Mexico to a quick economic recovery in 1977, but these additional resources removed the urgency of policy reforms. Starting in 1980, rapidly rising public expenditures unmatched by revenue growth led to increasing public sector deficits. While inflation rose, no significant pressure was felt to adjust the overvalued exchange rate, thanks to the oil earnings and the relative ease of obtaining foreign finance. But the balance of payments deteriorated as imports increased rapidly and non-oil ex- ports declined. An appreciating exchange rate and lagging domestic interest rates encouraged capital flight. 4. The crisis came to a head in 1982. Public sector expenditures reached the unprecedented level of 40.1Z of GDP, while the deficit reached nearly 18% of GDP. In February, the Bank of Mexico stopped supporting the peso, which then experienced a 40% devaluation. A large wage adjustment and continuing slack in the oil market tended to undo the effects of the devaluation and kept the balance of payments under strain. Inflation nearly quadrupled, from 29Z in 1981 to 99Z in 1982. Commercial banks, which had granted Mexico substantial credit in past years, declined to commit new funds in the amounta required. These factors led to a second devaluation of 35% in August 1982 and the suspen- sion of amortization payments on most of Mexico's external public debt. Capi- tal flight continued as private sector confidence was shaken by the nationali- zation of the banks in September 1982 and by the mandatory conversion of U.S. dollar deposits into pesos. Exchange controls were introduced, and quantita- tive restrictions (QRs) were extended to control all imports. 5. Beginning in late 1982, with the support of an Extended Fund Facility from the 1IMF, Mexico undertook a stabilization program based on drastic con- traction of domestic demand through fiscal, exchange rate, and monetary poli- cy. The peso depreciated to an unprecedented new low in real terms, and import controls were tightened. Public sector expenditure (excluding interest pay- ments) in relation to GDP declined over the period 1983-85, from the high of 40.1% in 1982 to about 30% by 1985. Public sector investment was cut from about 1OZ of GDP in the late 1970s to 6.6%, a 10-year low. The public sector deficit declined from 18% of GDP in 1982 to 10% in 1985. Real wages fell 20- 25% between 1982 and 1984. Most public sector prices were raised in real terms. 6. The stabilization effort during 1983-84 was impressive. Imports fell 25Z, non-oil exports (including border industries) rose 40%, and the trade bal- ance showed unprecedented surpluses in 1983-84. Despite declining oil prices, net foreign reserves increased from a negative US$2.0 billion to US$6.5 billion between the end of 1982 and the end of 1984. A massive foreign debt restruc- turing was successfully negotiated. The balance of payments strengthened in 1983 and most of 1984, but the real exchange rate was rapidly deteriorating, leading to difficulties ahead. The optimistic reaction to Mexico's success in 1983-84 overlooked the short-term focus of the stabilization program and the absence of long overdue structural reforms. Optimism turned to disenchantment a year later, when it became clear that stabilization in the absence of more fundamental structural reforms could not restore Mexico's creditworthiness and that sustainable economic growth would not be possible without such reforms.  7. Despite tighter fiscal and monetary policies, inflation in both 1983 and 1984 turned out to be much higher than had been projected by the IMF and the authorities, with consumer prices rising by 80% and 59%, respectively. The fiscal deficit fell substantially in 1983 to 8.5% of GDP, but then levelled off in 1984. GDP fell in both 1982 and 1983 (by 0.5% and 5.3Z, respectively), and recovered only partially in 1984 (by about 3.5%). GDP per capita by 1984 remained below the levels of 1980. By late 1984, as the Government prepared for the mid-term Congressional elections of July 1985, fiscal policy began to ease, and public sector borrowing increased substantially. Monetary policy became accommodating, the exchange rate appreciated further in real terms, and the fiscal deficit rose well above program targets, primarily as a result of higher-than-expected inflation and, hence, higher interest payments on the domestic debt of the public sector. The brief recovery of growth in 1984-85, after two years of contraction, was accompanied by rising inflation, and turned out to be short-lived. 8. Most program targets were missed in 1985. The fiscal deficit rose to 9.9%, inflation increased to 63.8%, non-oil exports declined by over 10% from their 1984 levels, and most components of the balance of payments deteriorat- ed. Net foreign reserves declined by more than US$2.4 billion. While external public debt did not change much during 1985, the domestic debt of the public sector surged. As a result, crowding out of the private sector in the credit markets was severe, as the share of the public sector in total credit reached an unprecedented high, in excess of 75% in 1985. The brief spurt of GDP growth between mid-1984 and mid-1985 came quickly to a halt in late 1985. 9 Both short-term measures and structural reforms were introduced during 1985 to deal with the emerging new crisis. These included removing import licensing requirements from an additional 40% of merchandise Imports, thus reducing the share of imports subject to QRs to 37% of total imports, down from 100% in 1983. The controlled exchange rate was devalued by almost 20% in real terms, and the system of preannounced fixed daily crawl was replaced by a more flexibly managed float. Important economies were announced in the public sec- tor, including the elimination of some 25,000 full-time positions and plans to turn 230 small state-owned companies over to the private sector. The Govern- ment also started to rationalize parastatal operations. Further, aggressive adjustment of the controlled exchange rate and a consequent narrowing of the margin between the controlled and free rates, combined with tight domestic credit, brought capital flight to a virtual halt in the latter part of 1985. Recent Developments 10. The 1986 budget was initially drafted with the aim of inducing a drastic correction of the public sector deficit so as to compensate for the 1985 over- runs. However, in early 1986 the economy was severely affected by the sharp drop in international petroleum prices and the consequent fall in national income, export receipts and public sector revenues. Mexico's loss from lower oil prices during 1986 has been estimated at about 6.5 percentage points of GDP, and has resulted in greatly increased pressures on the balance of payments and higher inflation (estimated at an average of 85%), notwithstanding tighter credit policies and a continued real depreciation of the currency, reaching nearly 50% between mid-1985 and mid-1986. Output is expected to drop by about 4% for the year.  - 4 - 11. The Mexican Government has responded to these deteriorating conditions with a strong economic program of growth-oriented adjustment and structural reform. The program has been framed in a medium-term horizon to encompass both the demand management measures required to deal with pressing domestic and external imbalances and the supply-oriented structural policies necessary to foster economic efficiency and thus reinforce the country's growth prospects in the longer term. 12. The most fundamental policy reform in this economic program is the shift from decades of inward-directed growth behind high protectionist walls, towards a more outward-oriented development strategy based on gradually declining pro- tection, to improve the efficiency and export competitiveness of the economy. In addition to the trade liberalization measures discussed earlier (para. 9), Mexico has recently joined GATT and announced a calendar which calls for a further lowering of tariffs to a maximum of 30% by October 1988. 13. A second fundamental structural change is the decision to reduce the size of the public sector, improve efficiency of public sector firms, and cut back on subsidies throughout the economy. Along these lines, the Government has intensified its efforts in divestiture-selling, merging, closing, and/or transferring non-strategic and non-priority firms-and industrial reconver- sion. Furthermore, the authorities are strengthening the public finances through a combination of changes in the structure of the tax system, adjust- ments in the prices and tariffs of public enterprises, and reductions in public expenditure in relation to GDP. 14. Other major reforms relate to the following areas: In agriculture, sec- toral reforms will include, inter alia, liberalization of external trade in agricultural commodities, internal marketing and price deregulation, reduction of credit subsidies, and improved contro'l and targetting of remaining subsi- dies, and cutting back on input and consumer subsidies. In the area of foreign direct investment, the Government is taking further steps to streamline the administrative procedures for initiating and approving foreign investment proj- ects, so as to increase the flow of foreign capital to selected sectors. The Government has also launched a process intended to improve public investment management. 15. The success of the economic program will critically depend on the com- plementary framework of macro policy management. In this regard, the program includes pursuing flexible interest and exchange rate policies. The former will ensure a competitive yield on domestic savings and greater reliance on interest rates to promote an efficient utilization of financial resources and increase credit availability to the private sector. Maintaining a stable exchange rate, on the other hand, will help protect Mexico's external competi- tive position, build international reserves, and facilitate the liberalization of commercial policy. 16. The reforms being implemeted are vital not only-or even primarily-to the improvement of Mexico's external creditworthiness. Even if Mexico had no external debt problem, the reforms now being implemented would still be neces- sary for Mexico to recover employment growth commensurate with the growth of the labor force, since the most employment-generating activities in Mexico are in exports. Mexico exhausted the opportunities for sustained inward-directed  - 5 - growt.h and employment by the late 1960s--well before the external debt became a problem. Mexico's export performance has been steadily eroding over four decades, so that today Mexico has one of the lowest export-to-GDP ratios in the world, and has continually lost its share in world exports over that period. 17. The program is being supported by the international financial community through a comprehensive financial package that could provide over US$12 billion in net new disbursements through the first quarter of 1988. A key element of this package is an 18-month IMF Stand-by arrangement that will disburse SDRsl.4 billion. In addition, the financing package includes substantial increases in the exposure of multilateral (in particular, the World Bank) and bilateral (Japan, CCC) creditors and about US$6 billion from commercial banks. The financing package is very closely linked with the structural reforms being undertaken (as well as their pace) by the Government: for example, the trade liberalization measures are being supported by the US$500 million Trade Policy Loan recently approved by the Board. 18. The package also contains several contingency facilities--to be funded by the commercial banks and the IMF--that may provide an additional US$2.4 bil- lion. These contingency facilities would ensure that public sector investment would not fall below levels targetted in the program, in the event of lower oil prices, and permit an increase in selected public sector capital outlays, if the economy does not appear to be overcoming the present recession by the end of the first quarter of 1987. Among other components of the financial package are modifications in the terms of existing commercial bank debt, rescheduling of US$1.8 billion in Paris Club debt, and agreement in principle to refinance previously restructured private sector debt (US$11.2 billion), as well as main- taining existing credit lines with the Mexican banks. Further details on the financing package are provided in Annex 1. Mediu.-Term Prospects 19. Mexico's medium-term prospects for recovery and stable economic growth should improve, provided the Government is persistent in pursuing its current stabilization program, accompanied by the major structural adjustment policies described in the preceding paragraphs; private sector confidence is restored; and the international environment remains reasonably favorable, including open markets for Mexico's non-oil exports. Restoration of private sector confidence is crucial, since only a strong and dynamic private sector will be able to raise investment and production from the present depressed levels and supply the increasing non-oil export surplus required for the resumption of growth and the attainment of sound balance of payments prospects. As regards the external environment, the international financial community should be prepared to pro- vide continued financing in support of sound, growth-oriented economic policies. 20. The fundamentals for future recovery look promising. First, Mexico has a rich natural and human resource base and close proximity to the wt "'s largest market; second, the drastic fall in the terms of trade is unlikely to continue, and should begin to turn around on even conservative assumptions about the future world price of oil-any improvement in the terms of trade will have significant salutary effects on fiscal, financial, and balance of payments  - 6 - performance, as well as directly on growth, investment, and, hence, employment; third, the 30-40% drop in real wages since 1982 appears to have brought Mexican unit labor costs to internationally competitive levels, even below those cf Southeast Asia. 21. Under moderately favorable external and domestic conditions, Mexico's economic growth could reach a sustainable 4-5% a year toward the late 1980s. However, without continued progress in the areas of fiscal discipline, domestic efficiency, and non-oil export development, Mexico could enter into a period of prolonged stagnation, or negative growth, characterized by insufficient labor absorption, falling standards of living, high inflation, and continued balance of payments difficulties. External Debt and Creditworthiness 22. Mexico's external public and private debt increased by about US$9 bil- lion during 1983-84, and by less than US$1.0 billion in 1985, to US$94.2 bil- lion. The net new borrowing requirements are expected to average some US$5-6 billion per annum during the remainder of the decade, with the debt service ratio remaining around 70%. 23. At the end of 1985, the Bank's share in Mexico's public debt was 5.1%. The Bank's share in Mexico's total public external interest payments was 4.3%. The Bank's exposure in Mexico as of September 1986 amounted to 7.39% of its total portfolio. As the Bank moves forward with its expanded assistance program to Mexico, these ratios are expected to rise significantly by the end of this decade. In the expectation that sound economic policies will be pur- sued in the future and that the external environment will remain favorable for the execution of these policies, Mexico is considered creditworthy for this loan. PART II - BANK GROUP OPERATIONS IN MEXICO Bank Operations 24. As of September 30, 1986, Mexico had received 98 loans from the Bank, amounting to US$8.99 billion, net of cancellations and terminations; of these, 62 loans totalling US$4.1 billion were fully disbursed. The Bank held US$7.08 billion, of which US$3.10 billion had not yet been disbursed. Some 35% of Bank lending has been for agriculture and rural development, 19% for industry, 8% for power, and 16% for transportation; the remaining 16% has been for water supply, tourism, urban development, and vocational training. Annex II contains a summary statement of Bank loans as of September 30, 1986. 25. Of the US$8.99 billion total lending, about US$4.7 billion was for establishing or strengLhening institutions for channelling credit to areas where credit supply was deficient or non-existent, and setting up in the com- mercial 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 indus- trial and tourism enterprises.  26. 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 atten- tion was focussed 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 US$448 million in FY82. However, the 1982 financial crisis again caused delays in the provision of cou&,terpart funds; consequently, disbursements in FY83 declined to US$389 million. A Special Action Program (SAP) was established in early 1983 to help the Government by alleviating the counterpart funding constraints on develop- ment projects, and 18 Bank-financed projects (including the US$350 million first Export Development Loan approved in mid-1983) are receiving support under the Program. Partly as a result of the SAP, disbursements during FY84 improved significantly at US$528.87 million, or 35% over disbursements in 1983, and increased further by about 49% in FY85 to US$787.93 million. However, dis- bursements went down by about 18% to US$656.2 million in FY86. This decline is attributed mainly to the acute shortage of counterpart peso funding, lack of credit demand, and the delays in declaring effectiveness of a number of projects. IFC Operations 27. As of September 30, 1986, IFC had made investment commitments in 27 com- panies in Mexico, for a total of US$765.8 million, of which US$623.2 million had been sold, repaid, or cancelled. A summary statement of IFC investments is presented in Annex II. IFC has been workiLig together with the Bank to: Ci) identify investment opportunities which would best suit the needs of the Mexican private sector in the current phase of the stabilization program, and (ii) assist the Government in reviewing the requirements of the country's capi- tal markets, both through economic sector work and specific proposals for ven- ture capital operations. The IFC has carried out three operations in the motor vehicle and cotton seed business. The provision of foreign exchange and export production have been the principal objectives of these operations. Bank Strategy 28. The Bank's major objectives in Mexico prior to the 1982 crisis were to: (a) support policies and programs leading to a wider distribution of the bene- fits of economic growth; (b) help finance projects that, directly or indirect- ly, contributed significantly to output and employment; (c) help reduce Mexico's urban/regional imbalances; and (d) help free bottlenecks which prevent rapid growth. These continue to be important objectives of Bank assistance to Mexico. However, following the '982 economic crisis and a reassessment of the Bank's role in Mexico, the Bank Management concluded that: (a) increased Bank lending, critical to Mexico's recovery, must be linked to central policy re- forms; and (b) the Bank should play a central role in assisting Mexico's return to voluntary lending. To prepare itself for this new role, the Bank has inten- sified and broadened its economic and sector work. Specific policy reforms that are presently being pursued through a dialogue with the Mexican Government cover priority macroeconomic and cross-sectoral issues, such as trade liberali- zation, rationalization of preferential credit systems, improvement in public sector pricing, and investment and subsidy reduction. Traditional lending incorporating project- or sector-specific policy issues will be conducted in parallel with policy dialogue on cross-sectoral or macro policy issues.  - 8 - 29. As a result of these initiatives, the Bank is expected to be in a posi- tion to contribute to Mexico's external financing needs in 1986-87 in a very substantial way. Net disbursements for this two-year period have been target- ted at US$2.3 billion (including about USS180 million, representing the net present value of guarantees), which would be achieved through continued project lending and new quick-disbursing operations in support of policy reforms and structural adjustment in key sectors. The Bank's annual commitments would be raised to US$2 billion over the next two years, assisting Government initia- tives in the agriculture, industry, transport, and urban sectors. To lend broader support to Mexico's adjustment process, the Bank has, in addition and with the Board's authorization, initiated negotiations in October to put in place guarantees for the commercial banks' cofinancing and growth contingency facilities up to a total of US$750 million. These are the principal elements in the current phase of the Bank's assistance strategy to Mexico, which are considered critical to the success of the country's stabilization efforts and resumption of sustainable economic growth. 30. Because of the difficult structural problems of agriculture and the sec- tor's crucial importance for the one-third of the nation's population living in rural areas, the Bank has made agriculture the leading sector for its lending. The Bank's agricultural lending program in Mexico aims at: (a) a more effi- cient and rational use of natural resources to increase production; (b) produc- tivity improvements of cultivated lands, with emphasis on the productivity of small farmers; and (c) promotion of employment-generating investments in rural areas. To support these goals, infrastructure investments in Bank-assisted projects have been complemented with support services, such as extension, mar- keting programs, and credit. The Bank has made 12 loans in FYs8O-86 totalling US$1,855.0 million, for irrigation, rural and agricultural investment projects, and agro-industrial and livestock credit programs. A loan for a Second Tropi- cal Agricultural Project was approved by the Executive Directors on March 4, 1986. Projects for irrigation rehabilitation, extension and research, fores- try, agro-industries, and agricultural credit are in various stages of prepara- tion. Special emphasis has been placed in recent years on the development of rainfed areas. 31. Bank lending for industry between FYs8O-86 amounted to US$1,145.3 mil- lion, covering areas of small- and medium-scale industry, mining, vocational training, capital goods industries development, and export development. After the 1982 crisis, a US$350 million loan was approved to assist in Mexico's non- oil export sector. The loan contributed to an intensive and continuous policy dialogue between the Bank and Mexican authorities regarding: (a) export promo- tion and trade liberalization policies; (b) administrative and institutional aspect of export promotion; and (c) financing of non-oil exports. Based on the lessons of experience under that sector adjustment operation and broad economic sector work, a new comprehensive assistance strategy has been formulated to guide the Bank's lending work for industry. This strategy supports: (a) trade policy reform to move towards greater uniformity of incentives and greater international competitiveness; (b) complementary financial sector policies to raverse the prolonged contraction experienced by Mexico's financial system, including its securities market; and (c) measures required to encourage ade- quate supply responses, particularly through export promotion and industrial restructuring.  -9- 32. Bank lending for transport has focussed on regional development, strengthening of institutions, and rationalization of public investment outlays and pricing policies. Between FYs8O-86, six loans amounting to US$753.7 mil- lion were approved, including two in each of the following three subsectors: highways, railways, and ports. Additional projects to support the above goals were undertaken in the urban sector. During FYs8O-86, eight loans were approved in the urban sector totalling US$1,013.5 million, in the fields of water supply and sewerage and urban development. A Municipal Strengthening Project, a Solid Waste Pilot Project, and an Earthquake Rehabilitation Project were approved by the Executive Directors on March 25, 1986. Additional proj- ects are under consideration in the transport and urban sectors, aiming at strengthening the various institutions in the areas of planning, management, and finance. 33. The Economic Development Institute (EDI) is assisting Mexico through various courses/seminars dealing with policy alternatives and institutional reforms. EDI training is specifically directed at courses/seminars on water supply and sanitation sector management, transport policy, agricultural policy, industrial development and finance, and macro policy analysis. 34. 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$3.44 billion as of September 30, 1986. Over 50% of the total has gone to agricultural and rural development projects, and the balance to transportation, industry, water supply and sewerage, tourism infrastructure, education, munici- pal development, and preinvestment. 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 cred- it, small- and medium-scale industries development, and hotel development projects. The IDB is also providing a program of assistance for earthquake rehabilitation and reconstruction, and two loans in the health sector, total- ling US$41.3 million, were approved on June 27, 1986. The International Fund for Agricultural Development (IFAD) has approved a loan of US$22.0 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. PART III - BANK SUPPORT FOR TRADE REFORM AND INDUSTRIAL SECTOR DEVELOPMENT 35. To assist the Mexican Government in its endeavor to implement an export- led growth strategy, the Bank has, since the 1982 crisis, placed particular emphasis on strengthening the country's external and industrial sectors. This approach focusses on the required policy reforms, but, at the same time, sup- ports specialized programs designed to intensify the industrial sector's response to policy reform. The Bank engaged the Government in a dialogue con- cerning trade policy and prepared a US$500 million Trade Policy Loan, which was recently approved by the Board, and would support Mexico's multiyear trade adjustment program for 1986-88, designed to rationalize the tariff system and reduce non-tariff barriers. The proposed project and the Trade Policy Loan are mutually complementary. It would make little sense to concentrate on non-oil export development without comprehensive trade liberalizatlon that gradually deepens the reforms which will shift Mexico's economy towards greater unifor- mity of incentives and greater international competitiveness. And, the Trade  - 10 - Policy Loan assures that the Government's commitment to trade reform is put into effect according to a satisfactory timetable. The full benefits of trade liberalization would, in turn, not materialize unless Mexican exports were promoted by a broad export development strategy, which the proposed project would support. 36. Other specialized programs assisting industry in its adjustment to poli- cy reforms and structural changes are also necessary to round out the economy's supply response. To achieve that and to complement the objectives of the pro- posed loan, as well as those of the Trade Policy Loan, the US$150 million Industrial Recovery Loan and the US$48 million Industrial Technology Develop- ment Loan, would help strengthen the financial position and expand the produc- tion of industrial enterprises and support technology development at the enterprise level, as well as improved technology services to industry. These objectives would be achieved through the provision of finance, institutional measures, and technical assistance. 37. Based on the experience acquired under ongoing industry projects and broad economic sector work undertaken with greater intensity in the recent past, the Bank has, jointly with the Government, also assessed the need for the physical and financial restructuring of key industrial sectors and specific enterprises, with a view to making these more efficient and internationally more competitive. Ways in which financial and other Bank assistance could be provided are also being explored, both for the public and private sectors. Bank lending is now being expanded to provide some of the key ingredients re- quired to achieve the restructuring objectives of the industrial sector. Gov- ernment initiatives are being introduced in: (a) public expenditure planning and budgetting; (b) subsector and enterprise evaluation for restructuring; and Cc) implementing Mexico's new parastatal law that was adopted in Hay 1986, in order to enhance the efficiency of parastatal enterprises, through increased management autonomy and accountability. A Fertilizer Sector Adjustment Loan, the policy conditionality of which is currently under consideration by the Government, could be the first major industrial restructuring operation to be supported by the Bank. It may be followed by lending for other key public industrial sectors, the restructuring of which has been programmed in the Government's 1986 budget, including in particular segments of the steel and capital goods sectors. 38. An "industrial reconversion" loan is under active consideration by the Mexican authorities and the Bank. This operation would be designed to provide Bank lending and assistance to Mexico's industry sector for structural adjust- ment during the remainder of the present Presidental term, which expires in end-1988. It would, in addition to setting basic sector policy targets, lay the groundwork for broad financial support to both private and public enter- prises, including financial restructuring through the provision of associated risk capital and other forms of innovative financial instruments, physical restructuring, and modernization measures. Such broad-based support, together with the necessary sector policy reforms, is necessary to maximize industry's competitiveness and response to the Government's efforts to increase industrial efficiency.  - 11 - PART IV - THE EXPORT SECTOR Past Performance 39. Mexico's exports have fluctuated in the range of 8%-13% of GDP during most of the past four decades, in spite of repeated albeit short-lived attempts at liberalizing trade and promoting exports. The predominance of an import- substitution economic growth model throughout this period, the persistent inward-looking attitude of entrepreneurs and policymakers alike because of the country's rich resource endowment, and the relatively large domestic market explain the substantial anti-export bias of the incentive regime and the country's modest export performance. 40. Initially, the share of manufactured products in total exports was low. Aided by fiscal incentives, institutional support, and other complementary measures, it grew from 0.25% in the late 1960s to about 50% by 1975. In the mid-70s, however, when petroleum resources became the dominant source of eco- nomic growth in Mexico, the pattern of the economy as well as of the external sector changed radically: crude petroleum's share in merchandise exports grew from 11% in 1975 to 74% in 1982. The balance of non-petroleum merchandise exports comprised 142 of manufactures and 12% of primary products, such as cof- fee, cotton, fresh fruits and vegetables, and minerals. The portion of domes- tic manufacturing output that was exported had peaked in 1978 at 5.5% and declined to less than 4% in 1982. The decline was caused, among other factors, by a continually expanding domestic market, worsening world market conditions in the 1970s, and a rising inflation in Mexico well in excess of the inflation experienced by its principal trading partners in 1978-82, coupled with a gradu- ally appreciating exchange rate. A rise in total exports in relation to GDP from about 8% in 1970 to slightly over 13% in 1982 was due to a tenfold increase in oil exports in the same period. 41. Mexico's non-oil exports have a broad basis, including products for which the country has a comparative advantage because of natural resources or relatively abundant labor (e.g., processed foods and minerals, chemicals and petrochemicals, and wood products), and others for which the availability of skilled labor, quality control, and technology are critical (e.g., designer clothing and footwear, steel rolling mill equipment, small electric motors, automotive parts, and foundry casting). The proximity of sizeable markets in the Western and Southwestern U.S.A. offers considerable advantages to Mexican exporters. As a result, more than 70% of Mexico's manufactured exports reach the U.S.A. Although Mexico's exports are diversified, which reflect the broad structure of Mexican industry, the bulk of the growth in manufactured exports during 1983 and 1984 came from four subsectors, namely, petroleum derivatives, chemicals, steel, and automotive parts. Only 35 products account for two- thirds of Mexico's non-petroleum exports. Initial Government Strategy after 1982 42. Upon taking office in late 1982, the present Administration set out to reverse the unfavorable trend in Mexico's non-oil export performance. More- over, its 1983/84 policy measures were designed to ensure that the country's productive installations survived the crisis and that the combined impact of massive devaluations (para. 5) and drastic drops in domestic demand upon enter- prises heavily indebted in foreign exchange was adequately alleviated. Strict  - 12 - foreign exchange controls were introduced in Mexico for the first time, and non-tariff trade barriers were raised to an all-time high level (paras. 4-5). Coordination between foreign exchange and trade controls was also introduced. 43. Efforts at export promotion succeeded in the short term, mainly because of the massive devaluations of 1982, depressed domestic markets in the wake of the 1982 crisis, emerging recovery in the U.S.A., and the adoption of policy and institutional measures for the promotion of non-oil exports. In response to these stimuli, non-oil merchandise exports grew by 32.5Z in 1983, while manufactured exports rose by 52%. This new trend continued through the first semester of 1984, when both total and manufactured exports grew at annual rates of about 40%. Because of similarly high growths in tourism, border transac- tions, and transformation services (the so-called "maquila"), Mexico earned in foreign exchange an additional 28-30% of its total non-oil export revenues in 1983-84. 44. As domestic recovery emerged in the second semester of 1984, however, the growth in merchandise exports began to slow down. A traditional attitude of complacency towards exports by Mexican entrepreneurs only aggravated this process. Unabated domestic inflation, coupled with a gradual appreciation of the peso in 1984, increased the temptation for under-invoicing exports, while strict foreign exchange controls remained in place. In the second semester of 1984, total non-oil merchandise exports grew 18.4% annualized, while manufac- tured exports grew 18.9%. Export performance declined further during the first nine months of 1985, in part because of underreporcing of export sales, and non-oil merchandise and manufactured exports actually dropped by 11.8% and 10.4%, respectively, over the 1984 levels. Second Phase of the Government Strategy - PROFI 45. By late 1984, it appeared that Mexico's financial crisis had been large- ly controlled, and the Government began to turn its attention to medium-term structural problems, particularly in the trade policy and export promotion areas, in order to overcome external imbalances and to reduce the structural distortions which had emerged in the early 1980's and led to the 1982 crisis. Reforms were needed to resume sustainable growth. In July 1984, the Government launched the national program of industrial development and foreign trade (PRONAFICE) for 1984-88, which touched on the broad objectives of rationalizing Mexico's protective system to shift towards efficient import substitution and export development, and outlined a policy framework and specific measures required to develop non-oil exports. 46. Yet the decline in non-oil export performance in the second half of 1984 (para. 44) raised concerns about the viability of an export-led growth strate- gy, unless effective measures were taken to regain the growth momentum of non- oil exports that had been registered in 1983 and in early 1984. Indeed, as domestic demand rose significantly in the second half of 1984 and the first half of 1985, many marginal exporters were lured back to the domestic market because the basic export incentive framework was not sufficiently corrected, even though the conceptual framework for policy reform in this area had been laid down in the 1983-1988 National Development Plan, and subsequently, in PRONAFICE in 1984.  - 13 - 47. In particular, the Administration recognized that the anti-export bias of the incentive regime had to be reversed and that supportive macro policies liberalizing the trade regime and managing a realistic exchange rate were pre- requisites for any basic change in the attitude of Mexican companies towards exports. The Government also recognized, however, that its macroeconomic poli- cy measures would have to be complemented through specific, export-oriented action programs, to achieve improvements in export performance over the medium term. 48. The Integrated Export Development Program (PROFIEX), issued in the second quarter of 1985, spells out the Government's medium-term export develop- ment program. The program envisages growth and diversification of Mexico's non-oil export base, primarily by means of export policy reforms, further trade liberalization, encouragement of industrial efficiency, and improvements in public sector support for export development. Mexico's export sector is capa- ble of responding positively to the incentives under PROFIEX, and non-oil exports are expected to grow at annual rates of 15%-18Z over 1986-89. The early results under PROFIEX are promising. Non-oil exports grew by 30% in the first half of 1986, over the same period of the previous year. The prominent features of PROFIEX are discussed in the following paragraphs. 49. Creating a Free Trade Status for Exporters. The most important measure in the Government's export development strategy is the creation of a "free trade zone" environment for all exporting companies, which would expand and improve the temporary import regime and the value-added tax rebate mechanism. The trade liberalization process that the Government has now begun will take several years to be completed, so that the negative impact of price distortions for exporting companies will only slowly dissipate. The free trade status envisaged in PROFIEX provides for an expansion of the temporary import regime and a modification of the tax rebate procedures to enable the tax-free importa- tion of inputs for export production, thus putting Mexican exporters on an equal footing with competitors of other exporting countries. 50. Moreover, the free trade status will not be limited to direct exporters, but will also include indirect exporters-i.e., companies that supply inputs to directly exporting companies. The main vehicle for the inclusion of indirect exporters into the free trade status will be the recently introduced "domestic letter of credit," a document issued by the direct exporter to the indirect ex- porter, certifying his role as a supplier. In addition, to ensure that import movements will be adequately monitored, PROFIEX also envisages an upgrading of Custom's administrative capabilities under the Secretariat of Finance and Public Credit (SHCP), including computerization, to ensure adequate control of import and export movements. 51. Simplifying Export-Import Procedures. The simplification of export- import procedures is another important element in the future export promotion strategy. Improvements had already taken place after the 1982 crisis, but despite some achievements, administrative procedures for foreign trade contin- ued to be highly bureaucratic, causing delays in general and constituting a deterrent for smaller firms, which are relatively new in the export business and have no administrative infrastructure to deal with these problems. PROFIEX now stresses the need to eliminate administrative and legal obstacles that hamper foreign trade operations, especially in the area of export permits.  - 14 - 52. Improving Export Finance and Insurance. Before the 1982 crisis, Mexican exporters, particularly larger firms, had sufficient access to foreign and domestic credit to finance the production and sales of exports. Pre- and post- shipment financing was provided through the "Fondo de Fomento a las Exportacio- nes de Productos Manufacturados (FOMEX)," a rediscounting facility that operated up to 1983 as a Banco de Mexico Trust Fund, as well as through selec- tive credit schemes rediscounted directly by the Banco de Mexico. The transfer of FOMEX from the Banco de Mexico to the BNCE strengthened the institution of the latter, and was the first step in simplifying institutional arrangements in Mexico's export sector. Traditionally, FOMEX's interest rates carried a sub- stantial subsidy. The foreign exchange crisis in 1982 and the ensuing controls posed a new challenge to Mexican exporters, mainly by the sudden disruption in external financing flows and the lack of convertibility of the peso. Peso- denominated domestic financing schemes to support exports--mainly the so-called "1.2%" and "1.6%" lines funded from the Banco de Mexico's reserve require- ments-continued after 1982 and provided heavy interest subsidies. Interest subsidies began to be phased out gradually in 1984, followed by more aggressive adjustments after a major bilateral trade accord was reached between Mexico and the U.S.A. in 1985 (Annex VII). 53. Additional steps were taken in 1986, based on the recommendations of a high-level Committee that was set up in late 1985 to consolidate all export financing facilities. Management of the so-called "1.6% line" has now been transferred from the Banco de Hexico to the Banco Nacional de Comercio Exterior, S.N.C. (BNCE). The Government also began to focus on a series of issues affecting performance of the nation's export sector, such as the ade- quacy of insurance and guarantee schemes available to exporters, linkages between pre-shipment working capital and fixed investment financing, mechanisms required for making finance available to indirect exporters and trading compa- nies (including, in particular, introduction of the domestic letter of credit), and the expansion of FOMEX financing from the manufacturing sector to all non- oil exporters, regardless of ownership and sectoral specialization (Annex VIII). 54. The Bank's previous project was effective in assisting various Govern- ment agencies to study the experience of successful East Asian exporters and to adopt financial schemes that helped ensure "free trade" status for exporters, as well as suppliers who generate value added in export products. As a result, the domestic letter of credit-previously not used for export finance in Mexico--was introduced in early 1986, and a joint policy insurance is being adopted to cover the commercial and political risk of BNCE, FOMEX, and the financial intermediaries, through COMESEC--a private insurance company that has undertaken to enter this market, possibly with increased public sector participation in its equity base. 55. Providing Non-Financial Services. PROFIEX also assigns a key role to trading companies in future export development. To this effect, it envisages the conversion of some of the existing export consortia--mainly consolidated export departments of several exporting companies-into fully operational trad- ing companies that buy domestic goods at their own risk for foreign market- ing. In addition, considerable economic and sector work has been carried out in Mexico in the recent past to assess the export potential of specific prod- ucts and subsectors and to advance specific recommendations for market penetra- tion abroad. Some of the studies-financed by the previous Bank loan (Ln.  - 15 - 2331-ME)--were detailed enough to provide useful inputs to firms for making decisions about their export strategies. Further studies are needed in areas of finance, marketing, administrative procedures, productivity efficiency, and marketing of selected products to groups and policy reform, in order to imple- ment the Government's overall export development strategy designed to establish neutral status for exporters and to boost non-oil export performance. 56. Streamlining Institutional Responsibilities. Several specialized insti- tutions share responsibility for Mexico's export sector. Trade policy and related plans and programs are formulated and implemented by the Secretariat of Trade and Industrial Development (SECOFI). Its Under Secretariat of Foreign Trade has capable and experienced staff, particularly in trade and price con- trols and related administrative processes. The Customs agency is a Direc- torate General of SHCP, and exercises physical control of merchandise move- ments. BNCE and FOMEX provide the bulk of export financing, although credit for fixed investments is also intermediated by FONEI and FONATUR and commercial banks. 57. Non-financial services were, since the early 1970's, provided by the Mexican Foreign Trade Institute (IMCE), which helped organize industrial fairs, undertook export promotion missions, provided market information to potential Mexican exporters, and prepared subsectoral studies to identify product groups with comparative advantage and a potential to penetrate foreign markets. IMCE maintained 25 foreign offices and 8 regional "delegations" within Mexico to gather and provide information to exporters. However, IMCE was ineffective in building up its services and technical assistance to individual exporters, partly because of an excessive concentration of its staff, some 900 in all, in Mexico City. Also, IMCE's attempt to install the so-called "single window" facility, which was designed to consolidate into one step all administrative requirements for processing the documentation of imports and exports, did not succeed because the other sectoral institutions with primary responsibility for the functions involved were reluctant to delegate authority to IMCE as appropriate. 58. By late 1985, the Government decided to streamline the somewhat ineffec- tive and dispersed institutional structure characterizing the nation's export sector, responding to the need for clear responsibilities and effective support to exporting companies. In particular, the Government implemented the following measures: a) Redistribution of INCE's Responsibilities. Because of the ineffective- ness of IMCE in providing support to exporters, the Government decided to dismantle the institution and reassign its responsibilities to SECOFI and BNCE. The former has absorbed most administrative tasks, among them the streamlined management of export permits and certification of export products, including management of the "single window" facility. The BNCE, whose principal responsibility previously was limited to the provision of finance, has taken over responsibility for non-financial assistance to exporters and export promotion. Both SECOFI and BNCE are expected to rationalize and streamline administrative services, to provide more efficient support to Mexican exporters in the future; b) Improved Coordination among Government Agencies. To better coordinate the numerous institutions responsible for the Government's policies,  - 16 - financial and non-financial services, and administrative procedures for exports, a high-level Ad Hoc Committee was established in late 1985 to prepare specific proposals for Mexico's medium-term non-oil export development. The Committee, which was composed of the Secretary of SECOFI, the Director General of the BNCE, and the Director General of one of the two largest commercial banks, proposed in early 1986 suitable policy instruments designed to broaden Mexico's non-oil export base and achieve the growth target of the Government's Export Development Strategy-especially through encouragement for first-time exporters and small- and medium-sized manufacturers. Because of its success in ini- tiating action, this Ad-Hoc Committee was transformed into a permanent policymaking committee, discussed below. c) New Charter for BNCE. In November 1985 the Government also submitted a new Charter for BNCE to the Legislature. It was passed by Congress in late December 1985, and constitutes the first comprehensive law regulat- ing BNCE's operation since its establishment in 1937. The most signifi- cant change introduced by the new law is BNCE's participation in deci- sions concerning trade policy. That has been achieved through the establishment of a high-level Foreign Trade Promotion and Development Committee, chaired by the Secretary of SECOFI and comprising the Secre- taries of Finance and of Foreign Relations, as well as the Director Generals of the Banco de Mexico (BdM) and BNCE. BNCE's staff is serving as a secretariat to the Committee. Its mandate is to design, propose, and put in place policies and measures for export promotion, mainly in the areas of finance, insurance, and guarantee schemes, and the provi- sion of technical assistance, including promotion and the carrying out of studies for non-oil exports. Past Bank Assistance For Export Development 59. The Bank has had considerable involvement in Mexico's export sector since establishment of the US$100 million pilot PROFIDE fund under the Bank's Capital Goods Industry Development Project (Ln. 2142-ME) in April 1983. In June 1983, the Executive Directors approved a US$350 million Export Development Project (Ln. 2331-ME) to help Mexico recover from the financial crisis of 1982 and overcome the chronic foreign exchange shortage. While the pilot PROFIDE fund had the single objective of providing urgently needed foreign exchange to exporters, the export development project had the broader objective of support- ing the Government's export development strategy, including policy reforms, streamlining of administrative procedures, and institution building. The lead agency under the project was BNCE/FOMEX. Fixed investments in industry and tourism were channeled through FONEI and FONATUR respectively, two specialized Trust Funds. 60. Performance under the first Export Development Project, including dis- bursements, an assessment of the loan's impact among Mexico's exporters, and the project's contributions to the policy dialogue between the Bank and the Mexican authorities, are summarized in Annex IV. As explained in the Annex, loan commitments and disbursements were slow initially because subsidized finance from other sources was available and the requirement for submitting annual export plans under PROFIDE were perceived by borrowers as an unwarranted intrusion into confidential company information, curtailing real demand for  - 17 - credit. Both issues were addressed in 1984-85. Interest subsidies on other credit lines are being phased out (para. 52), and requirements for annual ex- port plans have been simplified (Annex IV). As a result, commitments and dis- bursements have expanded at a satisfactory pace since early 1985. At this time, virtually the full loan is committed, and disbursements amount to US$181 million, accounting for 50% of the loan amount. In view of the above, dis- bursement projections for the proposed loan now can be based on actual perform- ance under Ln. 2331-ME. 61. The loan's impact was especially critical in helping prepare measures to improve the basic incentive framework for exporters, strengthen the temporary import regime, and expand preferential administrative arrangements and avail- ability of finance to indirect exporters. In essence, the previous Bank proj- ect assisted the Mexican authorities in adapting the Government's export development strategy to evolving economic/financial circumstances, and provid- ing studies and assistance required for measures which the proposed loan would support further. The first Export Development Project achieved its major objectives and provided critical inputs for preparing the proposed loan. Export Strategy Paper 62. The proposed Second Export Development Loan would support implementation of the Government's export development strategy, as spelled out in the PROFIEX documents. Proposed policy reforms and the instruments required to implement them, together with a detailed timetable, have been prepared by the Government to ensure that additional actions for promoting non-oil exports, including those contained in a second PROFIEX document issued in March 1986, will be put into effect. To assure timely actions and coordination in carrying out the above program, the Government has submitted to the Bank a Letter of Export Development Policy, which is satisfactory; it is reproduced in Annex V. 63. The central theme of the Gcvernment's Policy Letter is the creation of neutral status for exporters in Mexico. Specific actions and a timetable for these actions have been designed to expand the "free trade status" to indirect exporters and trading companies; streamline the temporary import regime; sim- plify indirect tax reimbursement procedures and maintain flexibility in the application of foreign exchange controls to exporters; extend financial support to all activities generating value added for exports; and simplify and compu- terize the customs procedures. It also formally confirms the transfer of the management of the "1.6%" line of credit to BNCE, and reiterates the Govern- ment's intention to put in place a joint-policy insurance for exporters and to maintain in operation the domestic letter of credit for indirect exporters. A program of action in the above areas would be supported by the proposed loan. It would be complemented, however, by additional measures, which would be undertaken by the various Government agencies for amending the PROFIDE Operat- ing Regulations (para. 70) to allow financing of indirect exporters and trading companies. 64. To monitor closely implementation of the Government's export development strategy and coordination among the various agencies, the Bank would, as part of the proposed project's supervision, review with BNCE (the Borrower), SECOFI, and other relevant agencies, progress in carrying out specific policy measures, introducing administrative reforms and institution building to implement the  - 18 - policy reforms. The timetable contained in the Government's Letter of Export Development Policy would serve as a basis for Government and Bank monitoring during implementation of the proposed project. The reviews would afford the Bank and the Government a timely opportunity to consider additional export trade policy measures and new administrative or institutional arrangements which may be necessary to ensure that the project's objectives are met. Given the formal consultation process that would take place between the Government and the Bank regarding trade policy, under the Bank's Trade Policy Loan, super- vision missions for the proposed project would be scheduled immediately follow- ing each semi-annual trade policy consultation. This would provide a linkage between issues affecting foreign trade in general and exports in a narrower sense. 65. In addition to monitoring progress under the Government's export devel- opment strategy, the periodic reviews would also cover specific project-related matters, such as the performance of loan disbursements, and, when necessary, reallocation of loan funds among the various categories, including, in parti- cular, the funds allocated for indirect exporters, who would borrow for the first time under Bank-financed credit programs; the adequacy of interest rates charged to loan beneficiaries; implementation of the planned measures for indirect exporters and trading companies; and execution of studies and the project's technical assistance program. PART V - THE PRoPosED PROJECer 66. In late 1984, the Bank initiated a broader trade policy dialogue with the Government and introduced some adjustments in the design of the first Export Development Project (Ln. 2331-ME). Discussions with Mexican authorities about the Bank's continued support of non-traditional export development began at that time, and a preparation mission for the proposed project visited Mexico in April 1985. A pre-appraisal mission followed in September 1985, and the project was appraised in November the same year. Negotiations were held in Washington, D.C. during the period September 23-30, 1986. The Mexican delega- tion was headed by Lic. Ricardo Penaloza Webb, Financial Adviser in BNCE, and included Lic. Antonio Cervera Sandoval, Head of the Industrial Sector Projects Department in SHCP. There is no separate Staff Appraisal Report. Annex III provides supplementary data on the project. Objectives 67. Rapid expansion of non-oil exports is essential to Mexico's resumption of sustainable economic growth and effective balance of payments management. The Bank's continued involvement in export development through the proposed project would contribute to the growth and diversification of non-oil exports, as well as the structural base of these exports, by supporting Mexico's expanded export development strategy (paras. 62-63). These objectives would be achieved by: (a) providing finance to exporters through comprehensive financial services by the Borrower; and (b) strengthening, streamlining, and expanding the non-financial incentive framework for exporters.  - 19 - Project Description and Loan Components 68. A Bank loan of US$250 million is proposed to support the project's objectives, which would be achieved through three specific components, as follows: (a) Provision of working capital finance for the imported raw materials, components, spare parts, and services of exporters; (b) Provision of long-term finance for fixed investments by exporters, con- sisting of the establishment, expansion or improvement of the export capacity of exporters and the construction, rehabilitation, or expansion of hotels generating predominantly foreign exchange revenues; and (c) A technical assistance program for studies designed to improve the financial and administrative support system to exporters and the produc- tivity and efficiency of selected product groups and for supporting indirect exporters. 69. Working Capital Component (PROFIDE). The amount of US$175 million, accounting for 70% of loan funds, would be allocated to provide short-term pre- shipment finance for the imported input requirements of export enterprises. Essentially in line with arrangements under the Bank's first Export Development Project, any enterprise established in accordance with Mexican law and engaged in manufacturing, processing, agro-industry, tourism, and trade, or in the pro- vision of services, but excluding petroleum extraction or any related produc- tion process, would be eligible for working capital financing, provided that the enterprise can show an export plan, export order, or foreign and/or domes- tic letter of credit proving the enterprise's commitment for generating value added for goods and services to be exported. 70. Indirect exporters and trading companies would have access to short-term financing under the Bank loan for the first time, on condition that arrange- ments for channelling funds to them efficiently, in a manner satisfactory to the Bank, are in place. In addition, as a condition of the Bank's approval of subprojects, indirect exporters would have to submit copies of their production plans and agreements with final exporters, domestic letters of credit, bills- of-exchange, proof of import requirements, and/or any other document or infor- mation that may be necessary to establish that the enterprise's production will generate value added for exports. To cover the estimated needs of indirect exporters, some US$75 million of the total of US$175 million available under the project's working capital component, would be specifically allocated for these end-users. 71. Finance for pre-shipment working capital would be channelled by BNCE/ FOMEX Through commercial banks co eligible export enterprises. The PROFIDE Fund--set up with Bank financial assistance in early 1983 and operated by FOMEX--would implement this loan component. The amount of the outstanding bal- ance under any line of credit granted by PROFIDE, including any balance under previous Bank loans, would be limited to 100% of the exporter's estimated an- nual export earnings-or, in the case of indirect exporters, up to 100% of the value of goods supplied to final exporters for sales abroad as evidenced by the appropriate documentation, or US$10 million equivalent, whichever is lower.  - 20 - The Bank would finance up to 100% of the subloans. FOMEX would approve credit applications on a first-come-first-served basis to any eligible exporter or indirect exporter; it would have the right not to authorize a line of credit for any enterprise that has adequate alternative sources of finance. Should the need for rationing PROFIDE funds arise, FOMEX would give priority to enter- prises with proportionally the highest domestic value added, but would, in addition, take into account the relative amounts of foreign exchange generated by the enterprises. PROFIDE's operations are governed by its Operating Regula- tions, which were agreed between the Bank and FOMEX under the first Export Dev- elopment Project. To allow indirect exporters and trading companies timely access to PROFIDE funds, these Regulations would be amended, as a condition of the loan's effectiveness, in a manner satisfactory to the Bank. 72. Fixed Investment Component (FIFE). The amount of US$74.5 million, accounting for nearly 30% of loan funds, would be allocated tu provide long- term finance to eligible exporters, indirect exporters, and trading companies, as well as hotel enterprises generating foreign exchange revenues. It would cover the fixed investment requirements of establishing, expanding, or modern- izing the export capacity in manufacturing, processing, agroindustry, tourism, and mining, but excluding petroleum extraction or any related production pro- cess. The proceeds of the Bank loan would cover the foreign exchange component (estimated at 55%) of eligible subprojects up to an amount equivalent to the expected incremental foreign exchange earnings from exports or tourism, or--in the case of indirect exporters-the value of parts and components incorporated into the final export products, which are attributable to the proposed invest- ment over the first four years of the project's operation, or US$15 million equivalent, whichever is lower. 73. Bank financing to any enterprise, however, including any balance under PROFIDE or FIFE, would be limited to a cumulative total of US$20 million. To strengthen this limitation, BNCE would--as a condition of the proposed loan's effectiveness-amend its Operating Regulations to ensure that single company exposure is limited to 5% of the PROFIDE fund and 10% of FIFE funds, at any given time. Subloans would finance up to 80% of subproject costs, with the remaining 20% to be financed by the investors. In line with FONEI's Operating Regulations, however, its share of financing would be limited to 70%. Subproj- ect appraisal and supervision criteria adopted by BNCE in its Operating Regula- tions for FIFE under the first Bank project have proven to be satisfactory, and would be applied in implementing the proposed project. 74. Similar to the arrangements under the first Bank-financed Export Deve- lopment Project (Loan 2331-ME), BNCE would wholesale FIFE funds to FONEI and FONATUR, except for an estimated US$30 million (accounting for 12% of loan funds), which BNCE would relend, without financial intermediaries, directly to enterprises for fixed investments in industry, agroindustry, and mining. FONEI would be responsible for subprojects in the manufacturing and processing sec- tors, with an estimated US$20-30 million of loan funds expected to be used for this purpose, and FONATUR would handle subprojects in the tourism sector, with US$15-20 million expected to be used for hotel investments. Allocation of funds among BNCE, FONEI, and FONATUR would be reviewed between the Bank and the Borrower in the framework of project supervision, and adjustments would be made as required by the evolution of effective demand for credit in the various sectors.  - 21 - 75. Technical Assistance Component. This component, for US$u.5 million of loan funds, would provide for consultant services, training, and the related equipment and facilities of the project implementing agencies, thus helping to carry out the Government's export development strategy more effectively. Specific studies would be done on the: (i) development of comprehensive finan- cial packages for export industries; (ii) implementation of an administrative system for providing non-financial export incentives to indirect exporters and trading companies; (iii) customs procedures and the need for improvements, including the introduction of computerized systems; (iv) productivity, effi- ciency, and marketing of selected product groups enjoying significant export potential; and (v) technical and marketing assistance to indirect exporters regarding, among others, their product design and quality control. A satisfac- tory plan of action for implementing these studies, including a timetable and institutional arrangements for each, has been received by the Bank. Borrower and Relending Term 76. BNCE would be the Borrower of the Bank loan and would relend an estimat- ed 882 of the loan funds in U.S. dollars to FOMEX, FONEI, and FONATUR for the project's working capital and fixed investment components, under separate contractual arrangements with each implementing agency and the Government. Evidence of satisfactory contractual arrangements for the transfer of loan funds to FOMEX, for the project's working capital component, would be a special condition of loan effectiveness. Evidence of satisfactory contractual arrange- ments for the transfer of loan funds to FONEI and FONATUR, for their respective share of the project's fixed investment component, would be a condition of disbursement. The remaining 12% of the loan would be used by BNCE to finance the fixed investment requirements of enterprises and the project's technical assistance activities. BNCE's financial performance and sLructure have, in general, been satisfactory, with a growing capital base (Annex IX). 77. As under the previous Export Development Loan (Ln. 2331-ME), BNCE would charge interest to the project implementing agencies on all amounts relent at rates equivalent to the Bank's standard variable interest rate plus cne-quarter of a percentage point. Banks as financial intermediaries would be guaranteed a minimum spread comparable to those allowed under other Bank-financed credit programs, which currently amount to one- and one-half of a percentage point on U.S. dollar-denominated subloans, and two percentage points on peso-denominated subloans (paras. 79-80). Banks would be free to set their spread above these minimum levels, according to the credit risk of the subproject or the benefi- ciary enterprise. The foreign exchange risk would be borne by the Government on all principal repayments and by the project implementing agencies on interest payments. 78. To further strengthen the financial structure of BNCE, the Government would repay the principal of the Bank loan, thus increasing BNCE's equity base; the Government would, in addition, bear the related U.S. dollar/peso exchange risk, as well as the risk arising out of fluctuations of the exchange rates between the U.S. dollar and the currencies in which the Bank loan is repay- able. However, interest payments and the associated foreign exchange risk would be borne by each implementing agency and BNCE, when they perform as a first-tier institution. In addition, the Government and BNCE intend to explore other ways of increasing BNCE's capitalization in the short run. The resulting  - 22 - increase in BNCE's capital is expected to reduce its gearing ratio, which is high though not excessive, given BNCE's role as a financial agent of the Gov- ernment, which implies that the vast majority of its assets are guaranteed by the Government and, therefore, dces not represent a real credit risk of its own . Terms and Conditions of Pre-Shipment and Fixed Invstment Financing 79. PROFIDE subloans for pre-shipment working capital of exporters and trad- ing companies would be denominated in U.S. dollars. Interest would be set at rates not less than the effective interest rate at which 180-day Bankers' Acceptance maturities are traded in the New York market (the nominal Bankers' Acceptance rate quoted on the market is a discount rate) plus one percentage point. This covers the spread of the commercial banks. All PROFIDE subloans would have maturities to cover the exporter's production cycle up to 360 days. A commitment was received during negotiations that FOMEX would keep the repay- ments from working capital subloans in the PROFIDE account and use the proceeds of this fund in financing the working capital requirements of exporters throughout the life of the Bank loan. 80. Investors under FIFE would have an option to denominate their fixed investment subloans: (a) in U.S. dollars, and pay interest at rates not less than the Bank's standard variable interest rate plus two-and-a-half percentage points; or (b) in Mexican pesos, and pay interest at rates not less than the ACF plus two percentage points. Both rates adequately cover the spread of the commercial banks. Interest rates on subloans denominated in pesos would be set in accordance with GIRA. The peso option may be particularly attractive to indirect exporters whose revenues are in local currency, although it would be available to final exporters and trading companies too. Fixed investment sub- loans would have maturities of up to 13 years, including a maximum grace period of three years. Financing Plan and Initial Allocation of Loan Funds 81. The table below summnrizes the initial allocation of loan funds, which is based on current estimates of demand for the various programs under the pro- posed project. At the initiative of the Mexican Government, discussions have been held with the Export-Import Bank of Japan in respect of a cofinancing package designed specifically to support investments under the proposed proj- ect. Final agreement on cofinancing arrangements is expected to be reached by the parties in the near future. The Executive Directors would be informed of the outcome in due course. Complementary financing by BNCE, the implementing agencies, the commercial banks, and investors to cover the full resource requirements would be as follows: Cofi- Executing Agencies nancing (BNCE, FONEI, FONATUR, (Ex/Im FOMEX) and Mexicen Bank of Bank Commercial Banks Japan) Investors TOTAL US$ Millions Equivalent PROFIDE Fund (Pre- Shipment Working 175.0 50.0 - - 225.0 Capital Financing)  - 23 - Cofi- Executing Agencies nancing (BNCE, FONEI, FONATUR, (Ex/Im FOMEX) and Mexican Bank of (Continuation) Bank Commercial Banks Japan) Investors TOTAL --