Mexico - Industrial Recovery Project

Docmment of The World Bank FOR OFFICIAL USE ONLY Report No. P-4364-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 US9150.0 MILLION To NACIONAL FINANCTERA, S.N.C. WITH THE GUARANTEE OF UNITED MEXICAN STATES FOR AN INDUSTRIAL RECOVERY PROJECT July 10, 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 1rc4) On July 10, 1986, the exchange rate in the controlled market was US$1 = Mex$588.00; the freemarket exchange rate stood at US$1 - Mex$627.00. Fiscal Year January 1 - December 31 Weights and Measures I hectare (ha) = 10,00D square meters (m2) = 2.47 acres (a) 1 kilometer (km) 0.62 mile (mi) I square kilometer (km2) = 0.39 square miles = 100 ha 1 kilogram (kg) = 2,205 pounds (lbs) 1,000 kilograms = I metric ton (t) = 0.98 long ton I liter (1) = 0.26 gallons (gal) Abbreviations ACF Average Cost of Funds (see CPP for Spanish) BANCOMER Banco Comercial, S.A. BANCOMEXT Banco Nacional de Comercio ExteriDr, S.N.C. BANPAIS Banco Nacional del Pais BdM Banco de Mexico [Central Bank] CEPROFI Certificado de Promocion Fiscal CETES Certificado de Tesoreria CPP Costo Promedio Porcentual (see ACF for English) EFF Extended Fund Facility ERR Economic Rate of Return FICORCA Fideicomiso para la Cobertura de Riesgos Cambiarios FIRA Fideicomisos Instituidos en Relacion con la Agricultura FOGAIN Fondo de Garantia y Fomento a la Industria Mediana y Pequena FONEI Fondo de Equipamiento Industrial FRR Financial Rate of Return GDP Gross Domestic Product GIRA General Interest Rate Agreement [CB International Competitive Bidding IMF International Monetary Fund NAFINSA Nacional Financiera, S.N.C. PEMEX Petroleos Mexicanos PRONAFICE Programa Nacional de Fomento Industrial y Comercio Exterior PVP Sistema de Pagos al Valor Presente QRs Quantitative Restrictions  FOR OFFICIL USE ONLY MEICO- nmusna conroa INDUSTRIAL RECO0VERY PROEC Loan and Project Suuaary Borrower: Nacional Financiera, S.N.C. (NAFINSA) Guarantor: United Mexican States Beneficiary: Fondo de Equipamiento Industrial (FONEI) Amount: US$150.0 million equivalent Terms: 15 years, including three years of grace, at the standard variable interest rate Relending Ten=s: NAFINSA would pass on loan funds to FONEI on the same terms as the Bank loan. The Government would repay the principal of the Bank loan, pay interest, and bear the foreign exchange risk. FONEI would relend funds tu intermediaries at rates not less than the average cost of funds to the banking system (CPP) plus one percentage point. The spread intermediaries would charge on fixed investment subloans would vary between a minimum of one and a maximum of four percentage points; there would be no upper limit on the spreads for working capital subloans. Maturities would vary between 3 and 13 years for equipment loans, 3 and 7 years for working capital subloans, and 3 and 10 years for the rediscounting of equity investments. The grace period would not exceed 3 years for equipment and working capital subloans, and 5 years for the financing of equity investments. FONEI would offer, as an option, the 'Sistema de Pagos Variables al Valor Presente (PVP)," in order to ease the cash flow of borrowers. Project Description: The proposed project would improve the quality and broaden the scope of financial services to medium-sized ai;d large private industrial companies. More specifically, it would: (i) intro- duce a repayment mechanism for long-term credit, which better matches debt service with cash generation; (ii) promote develop- ment of the capital market by introducing, on a pilot basis, the financing of equity and quasi-equity investments by commercial banks; and (iii) develop corporate finance capabilities within FONEI to offer comprehensive financial packages and related technical assistance. The project would provide: (i) finance for fixed investment and working capital, and, as a pilot program for the restructuring of overleveraged companies, equity and quasi-equity investments, and (ii) technical assistance to FONEI. This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  - ii - Project Risks: The loan is expected to disburse quickly, given FONEI's current project pipeline and expected industrial Einancing needs. However, commitments could slow down because of slow economic recovery or reluctance by financial intermediaries in accepting new financial instruments that will be introduced under the proposed project. To minimize these uncertainties, the loan amount is based on conservative demand estimates, and the amount allocated to equity finance is relatively small (US$20 million). Estimated Cost: Local Foreign Total --------- US$ Millions ------- Equipment Subloans 70.6 86.4 157.0 Working Capital Subloans 80.0 20.0 100.0 Equity Investments 22.1 17.9 40.0 Technical Assistance 2.0 1.0 3.0 TOTAL 174.7 Financing Plan: World Bank 24.7 125.3 150.0 FONEI/Goverrment 104.3 0.0 104.3 Intermediaries/Beneficiaries 45.7 0.0 45.7 TOTAL ZLL. 1 AL 320.0 E.timated (Bank FY/US$ Millions) Disbursemente: 87 88 89 90 91 92 93 Annual 7.0 28.0 39.5 39.0 20.5 13.0 3.0 Cumulative 7.0 35.0 74.5 113.5 134.0 147.0 150.0 Rate of Return: Subprojects would have to have FRRs and ERRs of at least 10% in real terms. Staff Appraisal Report: No. 5904-ME, dated July 10, 1986.  INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE IBRD TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO EACIONAL FINANCIERA, S.N.C. WITH THE GUARANTEE OF UNITED MEXICAN STATES FOR AN INDUSTRIAL RECOVERY PROJECT 1. I submit the following report and recommendation on a proposed loan to Nacional Financiera, S.N.C. (NAFINSA), with the Guarantee of United Mexican States, for the equivalent of US$150 million, to help finance the recovery of medium-sized and large industrial firms. The loan would be repaid over 15 years, including 3 years of grace, at the standard variable interest rate. NAFINSA would pass on loan funds to FONEI on the same terms as the Bank loan. The Government would repay the principal of the Bank loan, service interest charges, and bear the foreign exchange risk. FONEI would relend funds to intermediaries at rates not less than the average cost of funds to the banking system (ACF), plus one percentage point. The spread intermediaries would charge on subloans for equipment would vary between a minimum of one and a maximum of four percentage points; there would be no upper limit on the spread for working capital subloans. Maturities would vary between 3 and 13 years for equipment loans, 3 and 7 years for working capital loans, and 3 and 10 years for financing equity investments. The grace period would not exceed 3 years for equipment and working capital loans and 5 years for the discounting of equity investments. FONEI would offer to borrowers, as an option, the "Sistema de Pagos Variables al Vlalor Presente (?VP)" for the repayment of subloans. PART I - THE ECONOMY 1 / 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. A new Country Economic Memorandum is scheduled to be issued in two or three months. 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. Following an inward-looking growth strategy, Mexico experienced some three decades of high and stable growth from the 1940s to the 1960s. By 1970, however, Mexico had largely exhausted the early and efficient possibilLties for import substitution. Against the expectation of rapidly rising petroleum earn- ings, the Government attempted to foster growth through expansion of public sector expenditures, rising subsidies, and the protection of high-cost domestic production. Public sector expenditures as a percent of GDP increased by more 1/ Part I of this Report is identical to that in the President's Report for the Industrial Technology Development Loan (P-4365-ME).  than half between 1970 and 1976, from 20.9% to 31.9%. In 1976, Mexico expe- rienced a serious financial and economic crisis. Although an increase in oil revenues led Mexico to a quick economic recovery in 1977, it also removed the urgency of policy reforms. Starting in 1980, rapidly rising public expen- ditures unmatched by revenue growth led to increasing public sector 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. 4. The crisis came to a head in 1982. Public sector expenditures reached the unprecedented level of 40.1% of GDP, while the deficit reached nearly 18% of GDP. In February, as capital flight intensified, the Bank of Mexico stopped supporting the peso, which then experienced a 40% devaluation in U.S. dollar terms. 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. Consumer price inflation nearly quadrupled, from 29% in 1981 to 99% in 1982. The international banking community declined to commit new funds to Mexico in the amounts required. These factors led to a second devaluation of 35% in August 1982 and the suspension of amortization payments on most of Mexice's external public debt. Capital flight continued as private sector con- fidence was shaken by the nationalization of the banks in September 1982 and by the mandatory conversion of U.S. dollar deposits into pesos. Also introduced were exchange controls and quantitative restrictions (QRs) covering all imports. 5. Beginning in late 1982, with the support of an Extended Fund Facility from the IMF, Mexico undertook a stabilization program based on drastic con- traction of domestic demand through fiscal, exchange rate, and monetary poli- cy. The peso was depreciated to an unprecedented new low in real terms, and import controls were tightened. Public sector expenditure in relation to GDP declined over the period 1983-85, from the high of 40.1% in 1982 to about 33% by 1985. Non-interest expenditure declined to about 22% of GOP by 1985, a 10- year low. Public sector investment was cut from about 10% of GDP in the late 1970s to 6.6%, again a 10-year low. Non-interest current expenditure also declined, though more modestly, and remained still at the levels of the late 1970s. Real wages fell 20-25% between 1982 and 1984. Most public sector prices were raised in real terms. 6. The stabilization effort for 1983-84 was impressive. Imports fell 25%, non-oil exports (including border industries) rose 40%, and the trade balance 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. The 1983-84 performance was hailed by the international financial community as a model for other coun- tries. A massive foreign debt restructuring was successfully negotiated. Total net foreign borrowing for the three-year period 1983-85 amounted to US$4.5 billion, for an actual decline in the overall debt, in real terms, of about 4%. But the optimistic reaction to Mexico's success in 1983-84 over- looked 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 funda- mental structural reforms could not restore Mexico's creditworthiness, nor would sustainable economic growth be possible without such reforms.  - 3 - 7. Despite tight fiscal and monetary policies, inflation in both 1983 and 1984 turned out to be much higher than had been projected by the authorities, consumer prices rising by 80% and 59%, respectively. The fiscal deficit fell substantially in 1983, to 8.5% of GDP, but then leveled off in 1984. GDP fell in both 19B2 and 1983 (by 0.5% and 5.3%, respectively), and recovered only par- tially in 1984 (by about 3.5%). GDP per capita by 1984 remained below the lev- els of 1980, and income per head lower still. 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 turned accommodating, the exchange rate appreciated further in real terms, and the fiscal deficit rose well above program targets. The demand-led growth spurt that resulted, accompanied by higher than projected inflation, was unsustainable and short-lived. Recent Developments 8. Most program targets were missed in 1985. The fiscal deficit rose to 9.8%, 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. Foreign reserves declined by nearly US$3.5 billion. While external public debt actually declined during 1985, the domestic debt of the public sector surged back up toward the level of 1982. As a result, crowding out of the private sector in the credit markets was severe as the share of the public sec- tor 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. In response to the emerging new crisis, the Government adopted during the course of 1985 a series of important corrective measures, including remov- Ing import licensing requirements from an additional 40% of merchandise im- ports, thus increasing the share of imports not subject to QRs to 63% of total imports. 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 flexible managed float. Important economies were announced in the public sec- tor, including the elimination of some 25,000 full-time positions and plans to privatize over 230 small state-owned companies. The Government also started to rationalize parastatal operations. Further, aggressive adjustment of the con- trolled 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 late October. 10. In spite of the reconstruction needs created by the September earth- quakes (estimated at US$4 billion), the authorities preoared an austere budget for 1986. This budget signalled the commitment of the Administration to renewed demand-management efforts to recover internal and external balance and move on to a sustainable growth path by the late 1980s. The budget aimed at halving the fiscal deficit to 4.9% of GDP, through sharp cuts in transfers and subsidies, smaller reductions in public investment, a surcharge on upper-income taxpayers, and large adjustments in official prices and tariffs. The 1986 pro- gram also stressed the importance of continuing policies to liberalize trade and pushing ahead with other major reforms, such as the restructuring/privati- zation of some parastatal companies and the easing of remaining restrictions to foreign investment.  11. However, the recent instability in the world oil markets has dramatical- ly altered the Government's fiscal and balance of payments targets for 1986. The 1986 budget that is now being revised will undoubtedly reflect a larger public sector deficit and larger external financing requirements than original- ly planned. For the fiscal deficit, part of the loss from oil taxes will be offset by further trimming of subsidies and public expenditures. Similarly, the increase in foreign borrowing requirements will be smaller than the actual drop in oil export receipts, as a result of foreign interest rates, imports, and the build-up in reserves, all expected to be lower than the original budget assumptions. Hence the picture for external financing needs, although somewhat more difficult, should remain manageable, barring further major declines in Mexico's oil export prospects. 12. The expectation of lower prices and volume of oil exports for this year, despite its negative fiscal and balance of payments implications, has not affected the Administration's resolve to continue with the stabilization cum structural reform policy. In fact, many of the policy measures/reforms pro- grammed for 1986--highlighted in the previous paragraph--have already been addressed. In the area of trade reform, on April 30 the Government announced a multiyear calendar for the reduction of tariffs. With respect to restructur- ing/privatization of parastatal enterprises, the authorities have: (i) closed down the nation's second largest steel plant as part of an overall restructur- ing plan for the subsector; (ii) closed eight sugar refineries that were un- profitable; (iii) talarn a first step in getting out of the textile sector by selling one such enterprise; (iv) sharply curtailed subsidies on food items marketed by CONTASUPO; (v) drawn up a 10-point plan for the rationalization of BANRURAL, the nation's largest bank specialized in agricultural lending; and (vi) put into effect a major law that will set the stage for increased auton- omy, efficiency, and accountability in public sector enterprises. ,Finally, the Government has specified investment cuts totalling US$l billion. Medium-Term Prospects 13. Mexico's medium-term prospects for recovery and stable economic growth remain good, provided the Government is persistent in pursuing its current stabilization program accompanied by major structural adjustment policies (including trade liberalization cum non-oil export promotion and restructuring! privatization of parastatal companies), 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 provide financing in support of sound, growth-oriented economic policies. 14. Under moderately favorable external and domestic conditions, Mexico's economic growth could reach a sustainable 4-5% a year toward the late 1980s. However, should a more outward-oriented growth pattern comprising fiscal disci- pline, improved domestic efficiency, and non-oil export development fail to materialize, Mexico could enter into a period of prolonged stagnation, charac- terized by insufficient labor absorption, domestic price distortions, and continued balance of payments difficulties.  -5 Ixterual Debt and Creditworthinesu 15. Mexico's external public and private debt increased by about US$6 bil- lion during 1983-84, and fell by US$1.5 billion in 1985 to US$92.8 billion. With an international oil price of US$20/barrel, the net new borrowing require- ments are expected to average some US$2-3 billion per annum during the remaind- er of the decade, with the debt service ratio remaining a little over 50%. With an oil price of US$15/barrel, the net borrowing requirements would be an average of US$4-5 billion per annum during the same period, while the debt service ratio would be around an average of 55%. 16. At the end oE 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 end-1985 amounted to 7.6% of its total. In view of the expectation that sound economic policies will be pursued in the future, Mexico is considered creditworthy for this loan. PART II - BANK GROUP OPERATlONS IN NEXICO 2, Dank Operations 17. As of March 31, 1986, Mexico had received 95 loans from the Bank, amounting to US$8.29 billion, net of cancellations and terminations; of these, 6L loans totalling US$4.0 billion were fully disbursed. The Bank held US$6.63 billion, of which US$2.68 billion had not yet been disbursed. Some 40X of Bank lending has been for agriculture and rural development, 20% For industry, 91 for power, and 18% for transportation; the remaining 13% has been for water supply, tourism, urban development, and vocational training. Annex II containis a summary statement of Bank loans as of March 31, 1986. 18. Of the US$8.29 billion total lending, about US$4.7 billion was for establishing or strengthening institutions for channelling credit to areus 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. 19. The Government arranged adequate budget financing in the years 1978 to 1981, which significantly iproved project implementation. Government and Bank officials met periodically to review project implementation, and greater atten- tion war 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 counterpart 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 alIhviating the counterpart funding constraints on develop- ment projects, and 18 Bank-financed projects 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. The FY85 disbursement figure is US$787.93 million, 49% over 1984 or 100% over projected. 2/ Part II of this Report is identical to that in the President's Report for the Industrial Recovery Loan (P-4364-HE).  -6- IFC Operations 20. As of March 31, 1986, IFC had made investment commitments in 27 compa- nies in Mexico, for a total of US$753.9 million, of which US$580.2 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 to: (i) 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 Covernment in reviewing the requirements of the country's capi- tal markets, both through economic sector work and specific proposals for ven- ture capital operations. A US$100 million capital goods facility, approved in 1983, has yet to be used, and is, therefore, under review. Subsequently, the IFC has carried oat 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 21. The Bank's Lajor 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 1982 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. 22. 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 Eor 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 omphasis 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 10 loans in FYs8O-85 totalling US$1,566.0 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 Harch 4, 1986. Projects for irrigation rehabilitation, extension and research, seed multiplication, forestry, agro-industries, and agricultural credit are in va- rious stages of preparation. Special emphasis has been placed in recent years on the development of rainfed areas.  -7- 23. Bank lending for industry between FYs80-85 amounted to US$947.3 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 drive. Based on tho lessons of experience under that sector adjust- ment operation and broad economic sector work carried out with the Government recently, a new comprehensive assistance strategy was 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 interna- tional competitiveness; (b) complementary financial sector policies to reverse ths prolonged contraction experienced by Mexico's financial system, including its securities market; and (c) measures required to encourage adequate supply responses, particularly through export promotion and industrial restructuring. 24. Under the above strategy, the Bank is responding to the current needs of Mexico's industrial sector. A US$500 million Trade Policy Loan, that has just been negotiated and would be presented for Board consideration together with the proposed project, is aimed at supporting the trade liberalization process through further reform measures and the provision of quick-disbursing finance that is expected to facilitate the mobilization of commercial bank funds for Mexico's external financing needs in 1986. A US$48 million Industrial Technol- ogy Development Loan is also scheduled for distribution to the Board, which would help support technological innovation at the enterprise level and improve technology services. The Bank has already appraised a Second Export Develop- ment Project, which would continue Bank assistance for increased non-oil exports and policy reforms and provide finance to exporters. In addition, substantive preparation work has been undertaken to assess the need for finan- cial and physical restructuring in key industrial sectors and explore the ways in which the Bank could support both parastatal and private enterprises. Discussions are most advanced for Fertilizer Sector Adjustment and Public Sector Management Technical Assistance operations. 25. Bank lending for trasn--ort has focussed on regional development, strengthening of institutions, and rationalization of public investment outlays and pricing policies. Between FYs80-85, 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 FYsBO-85, four loans were approved in the urban sector totalling US$408.5 million, in the fields of water supply and sewerage and urban development. Two urban projects were recently approved by the Executive Directors: a Municipal Strengthening and a Solid Waste Pilot Project. An Earthquake Rehabilitation Project was also approved on March 25, 1986. Additional projects are under consideration in the transport and urban sectors, aiming at strengthening the various institutions in the areas of planning, management, and finance. 26. 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. 27. The Inter-American Development Bank (IDB) is the second largest source of multilateral aid to Mexico. The IDB has made loans to Mexico totalling  -8- US$3.4 billion as of March 31, 1986. Over 502 of the total has gone to agri- cultural 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 madc loans for the national integrated rural development program (PIDER), agricultural and livestock cred- it, small- and medium-scale industries development, and hotel development proj- ects. The IDB is also providing a program of assistance for earthquake rehabilitation and reconstruction. The Internasional Fund for Agricultural Development (IFAD) has approved a loan of US$22.0 million for a rural develop- ment project in the State of Oaxaca, which was 2ppraised by the Bank's staff and for which the Bank is acting as cooperating institution for administering the loan. PART III - THE INDUSTRIAL AND FINANCIAL SECTORS strialSector-Background 28. Over the past three decades, manufacturing developed into one of the leading sectors of the Mexican economy: its share in GDP rose from 17% in 1950 to 24% in the early 1980s; manufactured exports grew even faster, now contrib- uting about 29% to total exports; and the manufacturing sector creates about 13% of all jobs in the country. These growth trends look even more impressive when taking into account the discovery of huge petroleum reserves, which became the dominant source of economic growth since the mid-1970s. The composition of manufacturing had shifted gradually over the years. During the 1960s and early 1970s, manufacturing concentrated on light industrial goods (textiles, apparel, and wood products), which represented more than two-thirds of manufacturing value added in 1960. Twenty years later, this share had fallen below 40%, while the share of heavier industrial products (metal works, machinery, and equipment) rose from 23% in 1960 to 30% in 1980. 29. As a result of the economic and financial crisis, however, industrial growth came to an abrupt halt in 1982. Production dropped 11% from its 1981 level, and gross domestic investment as a proportion of GDP fell from a peak of 29% in 1981 to 16.5% in 1983. Many Mexican companies came close to bank- ruptcy. To avoid massive defaults, the banks had to reschedule the large-scale debt of their corporate customers. To alleviate their foreign exchange risk, the Government set up FICORCA ("Fideicomiso para la Cobertura de Riesgos de Cambios") in 1983, with a long-term currency and interest swap mechanism that enabled private companies to pay their foreign debt in pesos at domestic inter- est rates and, at the same time, to capitalize a portion of the interest pay- ments. Government agencies, such as FONEI ("Fondo de Equipamiento Indus- trial"), provided emergency liquidity to affected companies through special assistance programs. Also, the Government introduced an accelerated deprecia- cion scheme allowing a 75% write-off against new investments in 1984 and a 502 write-off in 1985, which continued in 1986. 30. The industrial sector began to recover in 1984, especially during the second half of the year. Industrial production grew by 4.8%, as opposed to a decline of 9% in 1983; manufacturing output rose by 4.7%; and construction activities also rose by 3.8%. Electricity and cement production were up by  5.9% and 8%, respectively. The recovery was led by a revival of capital goods and consumer durables, which had suffered particularly severe contractions in the preceding two years. Also, a 50% rise of the share of manufactured exports in total exports in 1984 contributed to growing output. The increases in pro- duction and exports reduced widespread overcapacity observed over the last two years, and gave rise to an expansion in fixed capital investments. Recovery c*ontinued into the first half of 1985, during which the industrial sector grew at an annualized rate of 9%. In the second half of 1985, however, economic growth, and with it industrial expansion, slowed down as a result of the Government's efforts to limit inflationary pressures and restrict public spending. Industrial growth for the year as a whole was 5%. Development Constraints 31. Despite the 1984-85 recovery, however, serious problems remain. A sud- den growth in manufactured exports in 1983-84 was the result of a suppressed domestic market and a drastic currency devaluation, and not of increased international competitiveness or export orientation. Mexican companies, in general, have not introduced lasting improvements in their competitiveness. I. addition, the financial situation of many companies remained precarious: high financial costs limit profitability, and improvements in liquidity after 1983 have been only temporary, afforded by postponed interest payments under the FICORCA mechanism. 32. Insufficient Export Orientation. Through decades, the Mexican Govern- ment has fol'u'ed an import-substitution strategy in industrial policies. High protective barriers, combined with tax breaks and subsidies, have nurtured domestic industries, many of which are simply not competitive in the world markets. As a result, the export base in manufacturing has remained limited. The number of important exporters is small, and most companies view export ventures only as a residual effort to complement slackening domestic sales. Manufactured exports have been concentrated in chemicals and petrochemicals, as well as transport equipment and automotive parts. Diversification is only beginning now. As 70% of manufactured exports go to the U.S. market, there is a potential for growth in export possibilities to other markets. 33. Weak Financial Condition of Firms. The structural weakness of Mexico's industrial secLor is compounded by the difficult financial condition of many enterprises. The massive devaluations sharply increased the debt burden of companies that had accumulated a high foreign debt exposure. In 1983, for instance, some 30% of all industrial companies had a debt/equity ratio of more than 2:1; 10% of the companies had a ratio exceeding 5:1. Although the finan- cial structure of the industrial sector improved during 1984, many companies remain financially weak. Recent increases in domestic interest rates further elevated financial costs. Within the next two years, company liquidity will deteriorate further, because the grace period under the Government's FICORCA scheme, which had assumed that industrial growth would recover by 1986, is now coming to an end. Government Policies 34. Recognizing the limits of an import-substitution strategy and Mexico's limited foreign exchange availability, PRONAFICE, the Government's isndustrial  - 10 - development plan announced in 1984, emphasizes the need for structural changes in industry. A first step in this direction was a trade liberalization package in July 1985, consisting of a reduction in quantitative import restrictions and a devaluation. Despite this change in the import protection system, the actual level of effective protection has not been lowered. In some cases, tariffs have been temporarily increased and ofEicial reference prices introduced in order to compensate for the loss of quantitative restrictions. But the Govern- ment has recently announced multiyear calendars for a tariff program signifi- cantly reducing tariffs by 1988 to 0-30%, for phasing out official reference prices by end-1987, and for additional quantified reductions in non-tariff bar- riers, such as quantitative restrictions. Breaking with its economic policy of the past two decades, Mexico has also applied for membership in the GATT. At the same time, the Government has already provided further incentives to exporters, including an expansion of the temporary import scheme, the simplifi- cation of rebate procedures for the value added tax on imported inputs, the partial elimination of export permits, the reduction of export taxes, and the maintenance of a realistic exchange rate. 35. The Government is aware, however, that these recent measures will have to be complemented with improvements in financial services to industry and the financial structure of companies. To be able to compete internationally, industry will have to invest more in plant, equipment, and working capital. But many companies with an over leveraged financial structure cannot afford to borrow because of the high financial costs and negative cash flow created by high nominal interest rates. Thus, in addition to a general need for term credit, many companies require equity, especially enterprises with healthy operations and good business prospects. But equity finance is not available in sufficient amounts. The Financial Sector - Background 36. Mexico's nationalized banking system comprises the Banco de Mexico (BdM, the Central Bank), 19 multibanks (general purpose commercial banks), and a num- ber of development banks, of which two (Nacional Financiera, S.N.C., NAFINSA, and the Banco Nacional de Comercio Exterior, BANCOMEXT) provide financing to the industrial sector. The commercial banks are sophisticated and efficient institutions in traditional banking services, but they are highly concentrated: the two largest multibanks account for almost 50% of total banking assets. Two banks are still privately held and are operating under "grandfather" clauses. A number of Government trust funds ("fideicomisos") provide credit, often through the banking system, to priority activities. Non-banking financial services are being offered through the stock exchange with 30 brokerage houses and 4 independent brokers. 37. The current institutional setup is the result of drastic changes in strecture and ownership of Mexico's financial system over the last decade. Private and mixed-ownership banks numbered 132 in 1978, declining to 76 in 1980, and to 59 in 1981. In September 1982, the commercial banks were nation- alized, and by year-end, they numbered only 51. The remaining specialized banks were merged into multibanks in 1983, and currently 19 multibanks are in operation. At the same time, the number of branches of the nationalized bank- ing system slowly increased from 3,719 in December 1980 to 4,429 in early 1986.  - 11 - Development Constraints 38. Drastic changes in economic environment over the last years also affect- ed financial sector development. The 1982 debt crisis had a profound impact on the balance of supply and demand of domestic and foreign financial resources. In addition, the increases in domestic inflation, from the 15-25% range in the late 1970s to above 70% currently, contributed to a drastic decline in the availability of adequate long-term finance. New lending and deposit instru- ments that are suitable for a high-inflation environment have not been intro- duced, and the long-term bond and equity markets have remained too small to serve as an effective complement to commercial bank credit. 39. Declining Supply of Financial Resources. Traditionally, only a limited portion of the resources mobilized through the banking system has been allocat- ed to industry without restrictions. Until 1984, some 48% of total banking deposits was subject to reserve requirements of the Banco de Mexico and used to finance the public sector deficit. Another 27% was directed to official credit programs, leaving the balance--only 25%--for free lending to interested cus- tomers. Policy reforms, initiated at the beginning of 1985 to limit Government access to Central Bank resources and increase the private sector share in com- mercial bank credit, were effectively reversed in the second half of 1985 to meet the funding requirements of a sharply rising domestic debt. This has led to further crowding out of the private sector (para. 44). Horeover, the deposit base itself has eroded as a result of a persistent disintermediation process over recent years. The ratio of MI/CDP steadily declined from 1979 (9%) to 1985 (5.5%), and banking system assets declined from 80% of GDP in 1982 to 65% in 1984, and recovered to only 70% in 1985. In addition, access to incremental foreign borrowing has all but collapsed since 1982. 40. Lack of Adequate Long-Term Financing. AS in many high inflation econo- mies, the availability of long-term finance has declined dramatically in Mexico. Although the maturity structure of the commercial banks' assets is not known, a relative decline in long-term deposits shows the increasing difficul- ties of banks ir funding maturity-matched long-term loans. The shortage of long-term financing is compounded by the negative cash flow effects of high nominal interest rates. While many Latin American countries have introduced indexing to adjust the outstanding principal for inflation, Mexico has opted, until now, to compensate for inflation through high nominal interest rates. High nominal interest rates, however, effectively shorten the maturity of a long-term loan, because the effects of the declining real value of principal repayments are more than offset by high interest payments. The resulting repayment stream, if calculated in real terms, implies that most of the loan is being repaid within two to three years--imposing a debt service burden which exceeds the cash flow generated by most fixed asset investments. To help over- come these difficulties FONEI proposed, and the Government agreed, to introduce a new repayment mechanism for borrowing from commercial banks--"Sistema de Pagos Variables al Valor Presente (PVP)," the use of which the proposed loan would encourage (para. 62). 41. Changing Structure of Real Interest Rates. Real interest rates have shown wide fluctuations over the last several years. During 1979 and 1980, the effective cost of the average term deposit to the commercial banking system,  - 12 - even if compounded monthly, was negative in real terms: after dropping to about -5% in 1980, it recovered to 1% in 1981, before plummeting again to a low of -22% in 1982. Since 1983, however, the average cost of funds (compounded monthly) to the banking system (ACF) has become positive and reached an annual average of 5% in 1984 and 6% in 1985. Consequently, interest rates which are set at or above the ACF have also become positive, averaging about 14% per year in 1984 and increasing further in 1985. This encouraged financial rather than productive investments, which will be necessary as industries try to adapt to a more open trade regime. To maintain a reasonable level of resource mobiliza- tion through the banking system, Mexico is expected to continue to allow term deposit rates to be positive in real terms. This should ensure that lending rates for large- and medium-sized industries are high enough to promote sound investment decisions. Continued movement towards a more realistic exchange rate and action to curb the fiscal deficit is central to achieving a sustainable, but not excessive, level of irterest rates. 42. Small Size of the Bond and Equity Narkets. Neither the money nor the long-term bond markets have yet developed into effective complements to commer- cial banking credit. Over 90% of the money market is accounted for by CETES ("Certificados de Tesoreria"), which were introduced in 1978. Commercial paper and bankers' acceptances accounted for the remaining 10% of the money market. Gross emissions in the bond market totalled a mere Mex$35 billion in 1984 (about US$210 million), with PEMEX's "Petrobonos" accounting for almost 60% of the total. 43. Mexico's equity market is still in the early stages of development. It is limited to only a few enterprises, and has remained small. Only about 160 companies are currently listed on the stock exchange, representing a decline from previous years; many registered companies were not actively traded. The commercial banks, originally holders of sizable equity portfolios, had to sell off their investments after the 1982 nationalization. The market for private placements is limited to a few well-known names, but inaccessible to most of the medium-sized companies. And, venture capital funds that could fill the institutional gap do not yet exist. The aversion of many Mexican industri- alists to "go public" appears to be one of the main reasons for the infancy of the equity market, because it involves the partial surrender of company con- trol, public scrutiny of financial and operational performance, and increased exposure to tax auditing. Also, potential investors are reluctant to associate themselves with companies that are not registered at the stock exchange. To initiate action for building up the equity market in Mexico, the proposed proj- ect has been designed to include a pilot equity component that would provide finance to over leveraged companies, and studies of the long-term financing needs of industrial enterprises and the factors affecting the supply of equity (paras. 52-54). Governent Policies 44. In a legislative reform of the financial sector in 1985, the Government took initial steps to fill some of the institutional gaps and clarify the role of existing financial institutions. In particular, the reform restricted Banco de Mexico to monetary regulation; limited Government access to credit, thus forcing the Government increasingly to borrow in the financial market through  - 13 - CETES; aimed at funding the developing banks through bonds and long-term bor- rowing from the commercial banks; and confirmed the role of commercial banks as competitive, profit-oriented institutions. However, the Government's stabili- zation efforts during the second half of 1985 effectively overrode some of these reform objectives. To limit credit expansion and force the repatriation of Mexican capital abroad, the Government froze private sector credit at its nominal July 1985 level, thus diminishing private sector credit in real terms and raising marginal reserve requirements to 100%. Changes in the auctioning process of CETES, and discretionary ceilings set on their yield, have reduced their market acceptance and further increased direct Banco de Mexico credit to the Government. The Government is aware that these measures are not sustain- able in the long run, and is expected to address these issues in the context of the 1986-87 stabilization and external financing plan. 45. One of the key objectives of Mexico's financial sector development is the strengthening of its risk capital markets, thereby improving the financial structure and growth potential of the industrial sector. The Government has expressed its commitment to this objective in the National Program for Devel- opment Financing (PRONAFIDE), launched in 1984. PRONAFIDE, among others, emphasizes the need to form risk capital funds and to foster the participation of institutional investors in the primary and secondary equity markets, assign- ing a leading role to the private sector. To provide special incentives for the development of the securities markets, capital gains on securities traded on these markets are tax exempt. While the nationalized commercial banks are now excluded from the stock brokerage and insurance business, they would have, through temporary and limited equity investments in industry, an important promotional and catalytical function in this process, drawing on their long experience with equity investments as well as their long-standing connections with private industry. Long-term financing, provided on favorable terms under the proposed project, would encourage the commercial banks to build up their equity portfolio within the limits established by the new law (para. 63). The new financial legislation has also established a legal framework for the opera- tion of venture capital companies, but some of its provisions are considered as overly restrictive and the development of this type of institutional investor is likely to remain limited. Notwithstanding the new incentives, which are expected to have a significant favorable impact on the supply of equity financ- ing, the equity market may fail to attract substantial financial resources as long as it has to compete with a large supply of Government securities, gener- ally perceived as lower-risk investments and currently yielding high real interest rates. A planned gradual reduction in the fiscal deficit would, therefore, make a very important contribution to equity market development. Bank Assistance 46. The Bank has assisted Mexico's industrial sector with a number of opera- tions. Four of these (Lns. 824-, 1205-, 1560-, and 1712-ME) provided term financing through FONEI. The first three loans are fully disbursed, and the fourth is expected to be disbursed shortly (para. 56). Subsequently, the Bank expanded the range of its industrial credit operations with projects addressing the problems of specific industrial target groups, such as the small- and medium-sized industry (Lns. 1552-, 1881-, and 2325-HE), capital goods producers (Ln. 2142-HE), and efforts to reduce environmental contamination (Ln. 2154- ME). This strategy recognizes that sectoral policy issues and institutional  - 14 - problems are best addressed through subsectoral assistance programs. While the first three loans are meeting their objectives, demand for capital goods has suffered because of the economic crisis, and inadequate enforcement of regula- tions has resulted in low utilization of credit for pollution control investments. 47. Given the current needs of the industrial sector, export development has become a top priority in the Bankts lending program since 1983. A first Export Development Project (Ln. 2331-ME) assisted the Government in improving export incentives, reducing the anti-export bias of policies, and introducing a tempo- rary import scheme. The loan is now almost fully committed, and is expected to be disbursed by end-1986. 48. These operations have focussed on delivery of credit and industrial sec- tor issues. The Bank's assistance to the financial sector has largely been concentrated on improvements of individual financial institutions. A broader approach was initiated through a dialogue with the Government on interest rate policies, which led to a General Interest Rate Agreement (GIRA), which commits the Government to phasing out gradually interest subsidies. Since 1984, all Bank lending to Mexico involving financial intermediation has been subject to CIRA's requirements. The proposed project would put additional emphasis on financial sector development, help reestablish an adequate supply of long-term funds, and upgrade the corporate banking capabilities of participating finan- cial institutions. Thus, the project is also expected to set the stage for a future financial restructuring operation. PART IV - THE PROJECT 49. In December 1984, the Government, together with FONEI, showed interest in Bank support to the industrial recovery process. A credit project was iden- tified jointly with FONEI in early 1985. A Bank pre-appraisal mission visited Mexico in April 1985, followed by an appraisal mission in June 1985. Negotia- tions were held in January 1986; the Mexican delegation was headed by Lic. Luis Nava Hernandez, NAFINSA Executive Representative in Washington, D.C., and included Lic. Hector Flores Santana, Manager of IBRD Banking Operations in NAFINSA, Lic. Jesus Villasenor Gonzalez, Director General of FONEI, and Lic. Antonio Cervera Sandoval, Chief, Industrial Projects Department of the Secre- tariat of Finance and Public Credit (SHCP). A Staff Appraisal Report (5904-ME) is being distributed to the Executive Directors separately. Annex III provides supplementary data on the project. Project Objectives 50. The proposed project is aimed at improving the quality and broadening the scope of financial services to medium and large industrial companies, which represent the bulk of FONEI's clientele. Given the over leveraged Einancial structure of many companies, the availability of comprehensive financial pack- ages for their long-term needs and of financing instruments that ease their cash flow in high inflation will be as critical as continued access to tradi- tional project/equipment financing. In some measure, Mexico's industrial recovery and return to sustainable growth also depend on such new financing arrangements. Therefore, the project's objectives would be to:  - 15 - - Adapt lending terms to a high-inflation environment through the introduction of a new repayment mechanism; - Promote development of the capital market by introducing, on a pilot basis, the use of additional financial instruments, such as equity and quasi-equity, by the commercial banking system; and - Develop corporate finance capabilities within FONEI to offer comprehensive financial packages and provide financial restructuring assistance to over-leveraged companies. Project Description and Design 51. To achieve the above objectives, the project would include financial as well as technical assistance components. It would provide credit for equipment and working capital requirements, finance for equity and quasi-equity invest- ments of industrial enterprises, and a technical assistance program. 52. Credit for Equipuent and Working Capital. This would be the project's largest component, accounting for about 86% of the loan. It would provide long-tenm financing to industrial enterprises, covering plant improvements or construction and acquisition of equipment--for which FONEI's clientele has had the greatest demand in the past, and providing for the long-term working capi- tal requirements of eligible companies. The inclusion of working capital financing not associated with plant and equipment investments would, under currently prevailing circumstances, stimulate output by improved capacity utilization in industry. 53. Equity and Quasi-Equity Investments. A pilot component representing some 13% of the loan amount would provide finance for the purchase of equity and quasi-equity instruments by intermediating commercial banks. Such instru- ments would include, inter alia, common or preferred stock, convertible securi- ties, or subordinated debt, which could be used either alone or packaged in combination with debt. Through this pilot component, FONEI would be able to offer, for the first time, comprehensive financial packages designed to meet the long-term needs of companies that are operaLionally healthy but suffer from a weak financial structure and prevailing high financial costs. This project component, together with the technical assistance program outlined below, would enable FONEI and the commercial banks to build up institutional capabilities in comprehensive corporate analysis and financial restructuring. Favorable repay- ment conditions of equity loans to be financed from the loan would encourage temporary equity investments and promote a secondary equity market through incentives of the law regulating the sale of stocks and securities. Given the recently introduced tax break on capital gains from trading on the equity market, commercial banks are expected to encourage enterprises in which they invest to Let listed on the local stock exchlange. 54. Technical Assistance. The project's technical assistance component would be its smallest, accounting for 1% of the loan. It would complement the provision of finance through: (i) improvements in FONEI's technical capabili- ties by designing and implementing a promotion campaign and a staff training and development program, and by upgrading FONEI's internal information and con- trol systems; (ii) financial market studies, assessing the financial situation  - 16 - and long-term financing needs of industrial enterprises, the supply of equity and quasi-equity to the industrial sector, and the use of direct borrowing instruments (such as bonds) by industrial companies; and (iii) specific assist- ance in the design of restructuring packages for final borrowers. Consultant services and computer equipment, including the development of software, would be financed by the proposed loan. Executing Agency and Kzperiemce Witb Past Lending 55. FONEI would be the project executing agency. Founded in 1971 as a trust fund of the Banco de Mexico, FONEI has become an important source of industrial tern lending in Mexico, highly regarded by both commercial banks and the pri- vate sector. Today, FONEI is administering a wide variety of industrial financing programs, and it has become an important source of technical assis- tance, offering training programs for project analysis and supervision. FONEI has developed guidelines for the design, evaluation, and supervision of proj- ects for its own use, as well as for the participating financial intermediaries and borrower companies. Over the years, FONEI has maintained a sound financial structure and satisfactory operating results: it showed a 28% return on equity in real terms in 1984, despite an increase of equity's share in its total assets from 4% in 1979 to 452 in 1984; its total assets grev at 6% per annum through 1983, but then began to decline in real terms due to high domestic inflation; FONEI's operation is adequately supervised by a qualified and expe- rienced staff, as shown, for instance, by a low arrearage affecting only 2.7Z of its current portfolio--a comendable achievement under current financial and economic conditions in Mexico. 56. The Bank has made four loans to FOEI. In addition, FONEI is partici- pating as one of the executing agencies in Bank-supported projects for capital goods development, export promotion, and pollution control. The first two FONEI loans (US$35 million, 1972; US$50 million, 1976) helped to consolidate its institution and establish basic project evaluation capabilities. Building up project appraisal capabilities in the financial intermediaries, however, turned out to be more difficult than expected, and two subsequent operations (US$100 milliont 1978; US$175 million, 1979) continued to assist industrial enterprises and commercial banks in these areas. Loan funds financed sound subprojects, according to a project performance audit report (PPAR)3/, and had a substantial foreign exchange and employment impact. Loan Amount and Terms 57. A US$150 million loan is proposed, with a maturity of 15 years, includ- ing 3 years of grace, and the Bank's standard variable interest rate. As in previous operations with FONEI, NAFINSA would be the Borrower, as an agent of the Mexican Government; the Government would guarantee the Bank loan. Under contractual arrangements satisfactory to the Bank, NAFINSA would pass on the proceeds of the loan to FONE0, and formal execution of such arrangements would be a special condition of the proposed loan's effectiveness. The Government would repay the principal of the Bank loan and pay interest charges, as a means of building up FONEI's equity, and would also be responsible for the associated foreign exchange risk. The recoveries of the loan and the Government's 31 See Report No. 2594-HE of June 29, 1979.  - 17 - counterpart resources would be accumulated in FONEI to strengthen its financial base, and FONEI would use these resources for purposes similar to those of the proposed project. Financing Plan 58. The project's cost is estimated at a total of US$300 million equiva- lent. The proposed US$150 million loan would finance 50% of the costs of eli- gible equipment and working capital subprojects, which would be committed over 1986-90. As the foreign exchange component is estimated at US$125.3 million, representing 42% of total costs, the proposed US$150 million loan would also finance US$24.7 million in local costs. Financing of local costs is justified in view of Mexico's continued difficulty in stabilizing the public sector's fiscal performance. Given the Government's commitment to deep cuts in the 1986 budget, the Bank's increased cost sharing would help keep priority investments on schedule, which is a precondition for sustained growth. The remaining half of project costs would be covered by FONEI, which would, depending on the individual subproject, finance up to 90% of subloans made by financial interme- diaries, as well as from funds provided by the financial intermediaries and subborrowers. Relending Terms and Conditions 59. The project would finance technically, financially, and economically sound investment subprojects of industrial enterprises. Subprojects would have to yield financial and economic rates of return of not less than 10% in real terms. Interest rates charged to final beneficiaries would conform to the requirements of GIRA. Equity investments would be expected to yield an after tax return on equity of at least 12% in real terms. FONEI's financing of sub- projects or equity investments by commercial banks would not exceed US$1O mil- lion equivalent, when added to any other subloan or equity investment to the same enterprise. 60. On-lending Rate of FODEI to Intermediaries. FONEI would on-lend project funds to financial intermediaries at an interest rate of not less than ACF plus one percentage point. This would assure FONEI that it can cover its own financial costs, including interests on its borrowing from the Banco de Mexico, as well as its administrative costs in support of the proposed project. Assuming a rational foreign exchange policy over the medium term, this on-lending rare also includes an adequate allowance for the foreign exchange risk to be assumed by the Government. Given the relative openness of Mexico's financial markets and a generally positive ACF since 1983, an interest rate based on this index should, in the long run, be equivalent in real terms to rates prevailing in international financial markets. The proposed on-lending rate is also in line with the marginal financial costs of commercial banks, which are estimated to be above the ACF. 61. On-lending Rate of Intermediaries to Subborrovers. The financial inter- mediaries would add to FONEI's on-lending rate an additional spread of at least one percentage point so that the minimum rate to the final subborrower would be not less than the ACF plus 2 percentage points, as provided for in GIRA. The maximum spread that intermediaries could charge on equipment subloans would be  - 18 - 4 percentage points. No maximum would be established for working capital sub- loans. Variable spreads would be introduced by FONEI for the first time, allowing the financial intermediaries flexibility in assessing risks and dif- ferences in creditworthiness, or covering administrative costs associated with individual clients. More importantly, this mechanism is expected to increase competition among the intermediaries who would bear the full credit risk of each subloan made. Linking rates to the ACF is expected to ensure that they continue to be positive in real terms and broadly in line with rates charged on other commercial bank lending. 62. Repayment Mechanism, Maturities, and Crace Periods. To diminish the cash flow implications of high nominal interest rates, subborrowers, with the agreement of their commercial banks, would have the option of choosing the "traditional" repayment schedule or one based on the PVP scheme. By capital- izing interest payments, this scheme greatly reduces the cash drain on borrow- ers during the early part of the maturities. Consequently, it is likely to induce borrowers to undertake investment projects in the prevailing unfavorable climate of high nominal interest rates. The maturity of investment and uorking capital subloans would vary from 3 to 13 years and 3 to 7 years, respectively. Equity and quasi-equity investments would have maturities ranging between 5 and 10 years. The maximum grace period would be 3 years for equipment and working capital subloans and 5 years for equity and quasi-equity investments. No grace period would be granted under PVP subloans, since the initial payments under a PVP subloan would still be lower than the interest payments during the grace period of a "traditional" subloan. 63. Special Conditions for the Equity Component. To be eligible for financ- ing, equity and quasi-equity investments would have to be used for purposes similar to term credit, including plant improvement or construction, acquisi- tion of equipment, and permanent working capital requirements. Project funds, however, could not be used for the refinancing of existing debt. Equity in- vestments by commercial banks to be financed with loan funds would be restrict- ed to a maximum of 25% of the share capital of any company, and investments exceeding 10% of a company's capital would not be held for more than five years, after which the investing commercial bank would have to reduce its equi- ty holding to below 10% of the company's total equity. This scheduled reduc- tion would be reflected in the respective subproject proposals and subloanl investment agreements. The above restrictions not only are in line with cur- rent legislation and would help keep the risks within reasonable limits, but they would also promote a secondary equity market. The risk of equity invest- ments would be borne by the financial intermediary, as FONEI would merely finance the equity holdings according to agreed guidelines, which are reflected in FONEI's revised Operating Regulations. Project IL.. lementatico 64. FONEI, as the executing agency, would on-lend project funds to partici- pating commercial banks to finance their clients' long-term plant, equipment, and working capital needs, or make equity or quasi-equity investments. Commer- cial banks would be responsible for subproject appraisal and supervision. FONEI would review the documentation submitted by the commercial bank for sub-  - 19 - project approval. It would take some five-and-one-half years to implement the project, and the commitment period for subprojects would end on December 31, 1990. 65. Except for subloans made to commercial banks under the equity component, the Bank would not carry out a prior review of subprojects, but would review samples of subprojects costing in excess of US$2 million. Based on these re- views, Bank supervision missions would discuss with FONEI changes in the evalu- ation procedures, if so required. In case a subloan would not have met agreed eligibility criteria, the Bank would not finance the subproject, and FONEI, if it had withdrawn funds from the project's Special Account for the purpose, would be obligated to reimburse the Special Account in the same amount. The proposed procedure is justified because FONEI has now become sufficiently expe- rienced in subproject evaluation and supervision (para. 55) and has a good track record under previous Bank loans. Under the previous FONEI loan (Ln. 1712-ME), the Bank approved every single subproject proposal, which confirms FONEI's appraisal capabilities. However, since FONEI's equity financing pro- gram is new, the Bank would have prior review of the first three equity invest- ments, as well as all other equity investments which would exceed 10% of the company's total capital or US$2 million, whichever is lower. FONEI's Operating Regulations, originally developed with Bank assistance, have now been amended to help carry out the proposed project and are satisfactory to the Bank. Procurement and Disbursement 66. Procurement procedures for goods and services financed with loan funds would comply with those customary for industrial development finance opera- tions. FONEI has had extensive experience with these Bank requirements, and it would, during project implementation, ensure the competitiveness of items procured in terms of price, quality, and their suitability Eor the purposes intended. Consultants financed from the loan would have qualifications and terms and conditions of employment satisfactory to the Bank, and related equip- ment would be purchased through local procurement procedures which have been reviewed and found satisfactory. 67. To simplify management of the loan account, the Bank would disburse against 100% of FONEI's loans to financial intermediaries up to 50% of total investment coBts of borrowers. The Bank would disburse to cover 50X of the cost of consultant services, staff training, and related computer equipment. A Special Account with an initial deposit of US$15 million would be established at NAFINSA to finance the Bank's share of FONEI's operations, thus helping prompt project execution. Withdrawals from the loan account would be made on the basis of statements of expenditures, and NAFINSA would maintain all sup- porting documentation and make it available for review upon the Bank's request. NAFINSA would submit to the Bank a monthly statement of the transac- tions oE the Special Account. Upon FONEI's request, retroactive financing for up to US$15 million, accounting for 10% of the loan amount, is recommended for expenditures incurred after September 30, 1985. This wiLl help bridge FONEI's financing gap between the date when funds under the previous Bank loan (1712- ME) were fully committed and when the proposed loan is expected to be signed. The Government is unable to cover this gap fully because of its fiscal constraints.  - 20 - Accounting and Auditing 68. The accounts of NAFINSA and FONEI, including those kept for the purposes of the project, the Special Account, and statements of expenditures, would be audited annually by independent auditors acceptable to the Bank. The audit reports, including an opinion regarding the supporting documentation for dis- bursements based on statements of expenditure, would be submitted within six months after the end of NAFINSA's and FONEI's fiscal year. Benefits and Risks 69. The proposed project is expected to improve the quality and breadth of financial services available to medium and large industrial companies. Aside from providing scarce term financing, the project would benefit Mexico's finan- cial system by introducing a subloan repayment mechanism that is suitable in a high inElation environment. The pilot equity component would enable FONEI to offer comprehensive financial packages, covering the long-term financing needs of its industrial clients. Together with the project's technical assistance program, they would enable FONEI to establish the financial and institutional mechanisms required for in-depth corporate financial restructuring that will have to be addressed through a broader program in the future. By encouraging the financing of equity by commercial banks, this component will make a modest, but significant, contribution to the solution of overindebtedness in industry. Because of their size and intimate knowledge of their clients' business, com- mercial banks are the only viable source of increased equity investment in the immediate future. A lasting solution to the financial problems of enterprises will require the mobilization of savings from other institutions and individ- uals, and the means for achieving this would be studied under the project's technical assistance component. 70. FONEI has developed into a reasonably efficient and mature financial institution. Therefore, the project presents no special risk concerning the soundness of the subprojects financed. However, it may take longer than ex- pected to implement the project if economic recovery is slower than projected or if the Government would slow down its trade liberalization process, thereby taking off pressure from the enterprises to modernize. In addition, the extent to which commercial banks and their clients will use the new financial instru- ments proposed is uncertain. Although FONEI intends to strongly promote the new PVP repayment scheme, which--at times of high nominal interest rates--is more favorable to clients than the traditional repayment methods, they may be reluctant to respond. The local market for equity is small and relatively undeveloped in Mexico. This is not expected to change fundamentally during project implementation, in part because owners of privately held companies may remain reluctant to allow the recently nationalized commercial banks to hold shares in their companies, if only for a limited period of time. To deal with these uncertainties, the loan size has been set for conservative demand projec- tions, and the US$20 million allocated for equity and quasi-equity instruments is relatively small. If this allocation proves too optimistic, the Eunds would be reallocated for traditional credit operations.  - 21 - PART v - RUOIUKUATIOIS 71. 1 am satisfied that the proposed loan would comply with the Articles of Agreement of the Bank, and recomend that the Executive Directors approve the proposed loan. Barber B. Conable President Attachments July 10, 1986  -22- ANE t . PaLe L of S T * L . 1.3 eas hSSWfZIobt tAr tLI feaT iteSu t EN04.to4 Na l.&una - VtAV .t*ttW wms M NUT ( IW) * 204. 27 -,o,uucumouCAnM.u (KOPL or OS2 1313 v2000 (ILL).0 I0 "0.9. mem A tL wn=r I"tA,ttc FLIS xt A (M LS3 L 7 .0 )LT7. 99110.0 OWAtIOU (IVa4N 1.9 POPULATIOS 0W53TM unR I. a. 11. ls.9 15.0 s.0 4. Mn . M. AcGI. UAS 37. 11.4 14.1 91.1 1o.0 POPULAITUM ACK SRUMUCT (2) a-s& us 39J 11. 0-14 13 &i.& '4.' 43.. 384