Mexico - Interest Support Loan Project

Documnt of The World Bank FOR OMCiAL USE ONLY At! 3ArX'- M6 Repot No. P-5235-ME REPORT AIND RECOMMENDATION OF THE PRESIDENT OF THE INTRuTIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED NTREST SUPPORT LOAN IN AN AMOUNT EQUIVALENT TO US$1.26 BILLION TO SANCO RACIONAL DE COMERCIO EXTERIOR, S.N.C., -WITH THE GUARATEE OF THE UNITED MEIDCAN STATES AND ON RELATED MEASURES TO SUPPORT THE DEBT REDUCTION PROGRAM OF THE UNITED MEXICAN STATES JANUARY 18, 1990 This document has a restcted ditribution and may be used by recipients only In the performance of their offcial duties. Its contents may not otherwise be disclosed without Wold Bank authorization.  CURRENCY UNIT - PESO (MEX$) On December 12, 1989, the exchange rate in the controlled market was US$l - Mex$2,620.00; the free market exchange rate stood at US$1 = Mex$2,642.00. FISCAL YEAR January 1 - December 31 WEIGHTS AND MEASURES 1 hectare (ha) = 10,000 square meters (m2) = 2.47 acres (a) 1 kilometer (km) = 0.62 mile (mi) 1 square kilometer (km2) = 0.39 square miles = 100 ha 1 kilogram (kg) 2,205 pounds (lbs) 1,000 kilograms = 1 metric ton (t) - 0.98 long ton 1 liter (1) = 0.26 gallons (gal) ABBREVIATIONS BANCOMEXT - Banco Nacional de Comercio Exterior CCFF - IMF Compensatory Facility DFI - Direct Foreign Investment EFF - IMF Extended Fund Facility FERTIMEX - Fertilizantes Mexicanos, S.A. GDP - Gross Domestic Product IBRD - International Bank for Reconstruction and Development IDB - International Development Bank IFC - International Finance Corporation IFI - International Financial Institutions IMF - International Monetary Fund IR - Interest Reduction LIBOR - London Interbank Offering Rate NM - New Money PECE - Stabilization and Growth Pact PEMEX - Petroleos Mexicanos PR - Principal Reduction SDR - Special Drawing Ri-rts  FOR omCAL USE ONLY INTEREST SUPPORT LOAN TABLE OF CONTENTS Page LOAN AND PROGRAM SUMMARY . . . . . . . . . . . . . . . . . . . . . . . . . i PART I - THE ECONOMY . . . . . . . . . . . . . . . . . . . . . . . . . . 2 A. Background ..... . . . . . . . . . . . . . . . . . . . . 2 Macroeconomic Stabilization . . . . . . . . . . . . . . . . . 2 C. Rationalized Private Sector Incentives . . . . . . . . . . . 4 D. Reorientation of Public Spending . . . . . . . . . . . . . . 5 E. Medium-Term Finance for Growth . . . . . . . . . . . . . . . 6 PART II - DEBT RELIEF AND MEDIUM TERM FINANCING PLAN . . . . . . . . . . 7 A. The Case for Debt Relief . . . . . . . . . . . . . . . . . . 7 B. Structure of the Debt and Pre-Deal Financing Gap . . . . . . 8 C. Financing Requirements and Financing Plan 1989-94 . . . . . . 9 PART III - THE DEBT AGREEMENT BETWEEN MEXICO AND THE COMMERCIAL BANKS . . 10 A. Terms of the Agreement . . . . . . . . . . . . . . . . . . . 10 Debt-Equity Conversion . . . . . . . . . . . . . . . . 13 Recapture Clause . . . . . . . . . . . . . . . . . . . 13 Oil Contingency Facility . . . . . . . . . . . . . . . 13 Credit Enhancement ............. .... . 14 B. Evaluation of the Agreement . . . . . . . . . . . . . . . . . 17 Debt Relief . . . . . . . . . . . . . . . . . . . . . . 17 Impact on Financing Gap and Creditworthiness . . . . . 19 Impact on Growth - Materiality Test . . . . . . . . . . 20 PART IV - PROPOSED BANK SUPPORT . . . . . . . . . . . . . . . . . . . . . 23 A. Set Asides . . . . . . . . . . . . . . . . . . . . . . . . . 23 Implementation Arrangement . . . . . . . . . . . . . . 25 B. Interest Support Loan .26 Funding Level . . . . . . . . . . . . . . . . . . . . . 26 Implementation Arrangements . . . . . . . . . . . . . . 27 Transfer of Funds and Effectiveness . . . . . . . . . . 28 Disbursements . . . . . . . . . . . . . . . . . . . . . 28 C. Waiver of the Negative Pledge . . . . . . . . . . . . . . . . 29 D. Restructuring of IBRD Guarantee under the 1987 Multi- Facility Agreement . . . . . . . . . . . . . . . . . . . . . 29 E. Guarantee for Oil Contingency Facility . . . . . . . . . . . 30 F. Cofinancing with the Export-Import Bank of Japan . . . . . . 31 G. Monitoring, Reporting and Auditing . . . . . . . . . . . . . 32 H. Burden Sharing ..................... 33 I. Creditworthiness . . . . . . . . . . . . . . . . . . . . . . 35 J. Benefits and Risks . . . . . . . . . ... . . . . . . . . . . 35 PART V - BANK GROUP OPERATIONS . . . . . . . . . . . . . . . . . . . . . 37 A. Country Assistance Strategy .37 B. Sectoral Composition of Bank Lending . . . . . . . . . . . . 39 Agriculture .................... 39 Trade . . . . . . . . . . . . . . . . . . . . . . . . . 30 Industry and Finance . . . . . . . . . . . . . . . . . .0 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.  2 Infrastructure . . . . . . . . . . . . . . . . . . . . 40 Housing and Others ...... ........... 41 Social Sectors and Environment . . . . . . . . . . . . 41 C. IFC Operations ........ . .............. . 41 PART VI - COLLABORATION WITH THE IMF . . . . . . . . . . . . . . . . . . 41 PART VII- SUMMARY OF RECOMMENDATIONS ................. . 42 Table 1: Basic Macroeconomic Indicators Table 2: Key Economic Indicators with a Debt Package in Place Table 3: Balance of Payments with a Debt Package in Place Table 4: Projected Foreign Exchange Requirements with a Debt Package in place Table 5: Sources and Needs of Financing With > Debt Package in Place Table 6: Sources and Needs of Financing Without a Debt Package in Place  MEXICO INTEREST SUPPORT LOAN LOAN AND PROGRAM SUMMARY Borrower: Banco Nacional de Comercio Exterior, S.N.C.. (BANCOMEXT) Guarantor: United Mexican States Amouat: US$1.26 billion equivalent Terms: Repayment in 17 years, including five years of grace, at the standard variable rate. Objectives: The proposed loan is part of the Bank's support for the Debt Reduction Plan of the Government of Mexico, putting in place funds required for credit enhancement, in connection with the Debt Reduction Plan. The external financing requirements of the Government would be covered through the Debt Reduction Plan for 1989-94, thus, helping support the Government's adjustment program, further structural reforms and the resumption of sustained economic growth. Description: The proposed loan and related measures for the Debt Reduction Plan of the Government would provide for: (a) US$750 million in set asides for collateralizing discount bonds; (b) US$1.26 billion in collateral for interest payments of discount and par bonds; (c) Waiver of the negative pledge restriction up to an amount equivalent to US$7.5 billion; and (d) Restructuring of IBRD guarantees of US$750 million under the 1987 Multi-Facility Agreement. Benefits and The proposed loan and related measures would help achieve a Risks: debt relief of 242 after the interest recapture allowance, measured as a reduction in the discounted value of the debt service as a percentage of the face value of the outstanding debt. This is achieved by reducing both amortization and interest payments. Reduced net transfers abroad would enable the Government to recover sustainable growth, while concluding the stabilization and adjustment programs. As a result, a protracted deterioration in living standards would be stemmed, jobs would be generated, targeted and cost effective social sector programs would be expanded, and the country's environmental conditions would be gradually improved. Mexico's growth program faces several risks, including declining oil prices, rising interest rates and protectionist trends in the trade policies of its major trading partners. Any, or a combination, of these risks could adversely affect the balance of payments and seriously compromise the Goverrnent's growth objectives. To help deal with these risks, the Government may relax the targeted reserve buildup and tighten fiscal measures under the EIF program of the IMP. These arrangements would provide a short term breathing space to implement new  policies, in order to deal with the consequencea of the external risks. But, more importantly, the commitment of the Government to stay the course in macroeconomic and adjustment policies would suggest that a derailment of the program has a low probability. In any case, the substantial conditionality of the Bank's adjustment loan portfolio provides for early warning signals on any worsening trend in domestic policy or the country's external environment and would thus enable the Bank to consider timely measures to protect its portfolio and longer term interests in Mexico. Disbursements: The proceeds of the set asides and the proposed interest support loan would, unless the Bank otherwise agrees, be disbursed concurrently upon compliance with the conditions of effectiveness and disbursement, for the purpose of acquiring collateral. It is expected that the Bank's set asides and interest support will be fully disbursed by March 31, 1990. Rate of Return: Over 36Z Appraisal Report: Not applicable  INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT REPORT AND RECOMMENDATION OF THE eRESIDENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED INTEREST SUPPORT LOAN TO BANCO NACIONAL DE COMERCIO EXTERIOR, S.N.C., AND ON OTHER MEASURES TO SUPPORT THE DEBT REDUCTION PLAN OF THE UNITED MEXICAN STATES 1. I submit the following report and recommendatitn for a series of proposed measures to support the Debt Reduction Plan of the United Mexican States. The proposed Bank measures would include the following elements: (a) Release of set asides of US$ 375 million, consisting of US$125 million under each of the Financial Sector Adjustment Loan (3085-ME), Public Enterprise Reform Loan (3086-ME) and the Industrial Sector Policy Loan (3087- ME), all of which loans were approved by the Executive Directors on June 13, 1989, for financing collateral on disco, t bonds to be issued for reducing the stock of commercial bank debt of the Un;_ed Mexican States; (b) Allocation and release of additional set asides totalling US$375 million, consisting of $150 million under the Fertilizer Sector Loan (2919- ME), US$ 175 million under the Agricultural Sector Loan (2918-ME) and US$50 million under the Steel Sector Adjustment Loan (2916-ME), which loans were approved by the Executive Directers in March 1988, for fina-.cing collateral on discount bonds to be issued for reducing the stock of commr cial bank debt of the United Mexican States; (c) Approval of an Interest Support Loan to the Banct. Aacional de Comercio Exterior, S.N.C. with the guarantee of the United Mexican States for the equivalent of US$1.26 billion for financing collateral in respect of interest payments on discount and par bonds to be issued "r reducing the stock of commercial bank debt and debt service payments of che United Mexican States; (d) Waiver of the negative pledge restriction in existing loan and guarantee agreements between the United Mexican States and the Bank to permit a pledge of up to US$7.5 billion equivalent by the United Mexican States as collateral for the principal or interest payments of discount and par bonds to be issued for reducing the stock of commercial bank debt and debt service payments of the United Mexican States; (e) Restructuring of the Bank's guarantees of US$750 million under 'Facility 2" and "Facility 3" of the 1987 Multi-Facility Agreement.  2 PART I - THE ECONOMY A. Background 2. Between 1950 and 1974, Mexico enjoyed a remarkable period of high growth, low inflation and moderate external debt accumulation. Real growth averaged 6.4%, and inflation was in single digits throughout the period, in line with the prudent fiscal policies followed. This era of fiscal conservatism came to an abrupt end in the early seventies. Government involvement in the economy expanded rapidly, and increased public expenditure pushed up aggregate demand and the rate of economic growth. However, the higher government expenditure was not matched by rising public sector revenues. As a result, the inflation tax and external debt became increasingly important sources of public finarce. At the same time, a decline in private savings incentives (real interest rates turned sharply downward) prevented a matching increase in private savings; extern.i debt thus increased, increased oil revenues notwithstanding. The period of single digit inflation ended in 19i3, the real exchange ratell started to appreciate and the accumulation of external debt accelerated above the GNP grow.h rate. A serious, but comparatively brief, financial and economic crisis in 1976 terminated following major oil discoveries in 1977. The ensuing prosperity lasted until 1982, when soaring domestic inflation, falling international oil prices, rising world irnterest rates, and massive capital flight led to a refusal by external creditors to roll over Mexico's short-term debt and a subsequent suspension of Mexican payments of interest on its external debt. 3. Over the 1982-88 period, economic growth ground to a virtual halt. This was accompanied by sharply falling living standards, a deteriorating infrastructure, high inflation, and a loss of investor confidence. Towards the second half of this period, a series of measures was taken to reverse Mexico's declining fortunes. Among the most important goals were: (a) macroeconomic stability; (b) a ratlonalized set of incentives for private sector investment; (c) reallocation of public spending to support private sector-led growth, improved social services and the environment; and (d) a credible financing plan to remove the unsustainable overhang of external debt. In each of these areas, the Mexican Government has achieved notable progress. B. Macroeconomic Stabilization 4. The onset of the financial and economic crisis of 1982 brought in its wake explosive inflationary and balance of payments difficulties. Initial strong fiscal and monetary adjustment efforts were alternately not sustained for a sufficiently long period (1983-85) or undermined by external shocks such as the collapse in international oil prices (1986). Inflation, rather than slowing down, accelerated, partially in response to the sharp real devaluation of the exchange rate necessitated by the 1986 downturn in the terms of trade. 1/. The real exchange rate is defined as the price of foreign goods relative to domestic goods. Appreciation means a decline in this relative price.  3 The subsequent de facto targeting of the real exchange rate, together with an increase in the frequency of wage and cost adjustments, introduced an element of inherent instability into the system, culminating in a run on the peso in the last quarter of 1987 and triple-digit inflation. 5. The Government responded with the "Economic Solidarity Pact' (Pacto), an agreement between business, labor, and government. This agreement called for accelerated structural reform, further tightening of fiscal and monetary policy, a freeze of minimum wages and of basic public and private sector prices, and, the cornerstone of the 'Pacto", a freeze of the nominal exchange rate against the U.S. dollar. This partial freeze was extended at three- month intervals tlhrough the end of 1988, and renewed, with some modifications, by the new Mexican Administration under the name of "PECE" (Pact for Stabilization and Growth) through July 1990. The main adjustments brought about under the PECE initially were one-off catch up increases in selected public sector tariffs and in prices of key inputs, a two-stage 26% cumulative adjustment in the minimum wage, and a daily aijustment of the exchange rate of about one peso against the U.S. dollar. More recently, it has been announced that public sector prices will be adjusted more regularly but by smaller amounts, in line with general inflation targets. In addition, there has been substantial progress towards more flexible pricing, most recently in agriculture. The current policy stance is thus more flexible and more in line with current actual inflation than it was one year ago; arguably the FECE's ,soft landing" has been achieved. 6. On almost every target that is under direct or indirect governmental control, performance under the "Pacto" and "PECE" has been exemplary, in some instances going beyond what was originally planned. For example, after adjusting for changes in world oil prices, interest rates, and gross external financing, Mexico satisfied all of the first half 1989 performance requirements set out in the new Extended Agreement with the IMF, often by substantial margins. In trade, the Government had originally committed to a three-year program of reforms supported by the Bank. These reforms were designed inter alia to lower the maximum import tariff to 30% ad valorem by the end of 1988. In fact, during the first month of the Pacto, December 1987, tariffs were lowered such that no tariff excecded 20%, i.e., 10 percentage points lower than originally agreed and one year ahead of schedule. 7. The fiscal measures, backed by the temporary exchange rate freeze and an array of formal and informal wage and price controls, have had a dramatic success in reducing the rate of inflation, from 159% in 1987 to 20% in 1989. At the same time, the economy has shown encouraging signs of economic recovery, led by a strong resurgence of private investment. Industrial production was 6% higher in the first half of 1989 than in the same period a year earlier, and the economy has grown by an estimated 3% in real terms for the year as a whole. Interest rates, although still high by historical standards, declined by about 20 percentage points within days after the announcement in July 1989 of a debt reduction agreement between Mexico and its commercial bank creditors. The sharp drop stems, in all likelihood, from an improved climate of confidence in the consistency of the economic program and the prospects for renewed growth. The same factors have also led to more than US$2 billion in returned flight capital and increased foreign investment.  4 8. The current account balance has deteriorated from a 1988 deficit of US$3 billion to an estimated deficit of about US$5 billion in 1989. This is largely due to the increased imports drawn in by accelerating private sector investment and a drought-induced decline in net agricultural exports. Manufactured export growth continues at an annual rate of about 10%. International reserves experienced a sharp recovery in July and August, rising by over US$1.5 billion during that period. In short, while adjustment is by no means complete, the progress which has already been achieved augurs well for a period of sustained growth. C. Rationalized Private Sector Incentives 9. Mexico has transformed itself into one of the most open economies in the world through a trade reform supported by four policy-based loans provided by the Bank. Trade liberalization to date has lowered the percentage of domestic (non-oil) tradeable production covered by import quotas from 100% in 1984 to less than 17% at present. Maximum import tariffs were cut by similar magnitudes. Non-oil merchandise exports, which represented less than one- third of total exports in 1984, have doubled their share since then. 10. These "core" reforms have been complemented by many others. Recognizing that the era of public sector-led growth had passed, the Government took a number of measures to stimulate greater private investment. In May 1989, foreign investment regulations were considerably relaxed and made more transparent. A long-standing prohibition against majority foreign ownership was removed, the lishing, petrochemical, and mining sectors were opened to foreign investors for the first time, the licensing of proposed investments under US$100 million was made automatic in those sectors, and approval of larger investments became automatic following a 45-day waiting period, unless the Government interposed formal objection within that waiting period. Since 1986, the tax system underwent a series of reforms bringing marginal tax rates more in line with levels in major industrial countries, encouraging the repatriation of flight capital, and increasing the sanctions for tax evasion. Also, profits are for tax purposes now adjusted for the effects of inflation on assets and liabilities, and the grevious bias against equity finance has been reduced substantially. 11. To encourage improved mobilization of domestic savings, the Government initiated a parallel process of financial market liberalization, supported by a Financial Sector Adjustment Loan from the Bank. Commercial banks no longer face any ceilings on the deposit interest rates they can charge; the system of forced allocation of commercial credit towards favored sectors has been abolished and credit subsidies through official development banks have been reduced significantly. The principal development and agricultural banks in the public sector are in the midst of significant managerial and financial restructurings, designed to consolidate institutions, clean up balance sheets, and reform lending practiceL. 12. To reduce the role of the public sector in production, over 750 state- owned enterprises were sold, transferred, or liquidated from 1983 to the present. Many large-scale enterprises underwent major financial and partial  5 managerial restructurings. More recently, the Government announced plans to sell the country's largest airline and its telecommunications company. It also placed in receivership for eventual sale or liquidation the country's largest mine. An action plan for initiating widespread deregulation hes been approved. A radical deregulation of the transport sector has already been implemented. Such deregulation is useful in its own right, but it also increases the efficiency gains from the trade reforms undertaken earlier. D. Reorientation of Public Spending 13. Since 1982, a major retrenchment of public expenditure has taken place. Non-interest spending declined by 36% in real terms. The composition of the cutbacks was, perhaps, not ideal from the standpoint of growth. Real investment expenditures were cut more deeply than current outlays, posing the risk, now that growth is underway once again, that infrastructural bottlenecks in areas such as roads, communications, urban services, and skilled manpower availability might impose constraints on potential growth. 14. Also, some of the gains in reducing illiteracy, infant mortality, and nutrition during the seventies are threatened by the sharp cutbacks in public expenditures for social programs. The social sector's budgetary share declined from 20% or more in the years preceding the 1982 to around 13% currently. This trend is probably unsustainable, given the already sharp reduction in real wages, widespread unemployment, ai.d worsening inter-personal and inter-regional income disparities. 15. As for the environment, it is widely recognized thac the cumulative effects of past growth, combined with generations of public indifference about ecological issues, has resulted in severe degradation of Mexico's air, soil, water, and forestry resources. Mexico City is now one of the world's most seriously polluted cities, but many medium-size cities suffer from problems nearly as grave. The Salinas Administration recognizes the urgency of broad- based efforts to clean up the environment and welcomes the assistance of international agencies. 16. In recent years, two successive administrations have sought to soften the blow of reductions in social expenditures. Global consumer subsidies for basic food items have been replaced by less expensive, but more targeted, subsidies to the poor. Last year, a new "National Solidarity Program" has set aside US$400 million to coordinate the activities of existing agencies and provide limited additional budgetary support for productive agriculture, infrastructure, and social programs in Mexico's ten poorest states. For example, title to 300,000 urban plots Is to be regularized, 150,000 hectares )f semi-arid arable land rehabilitated, and tubewells, irrigation works, and rural infrastructure extended. It is hoped that the program can be tripled in 1990. Another US$200 million is being channeled into a revitalized federal program of primary health care in 12 states. And, starting in June 1989, a program to rehabilitate 25,000 primary and secondary schools began, with an expected cost of nearly US$220 million. 17. Given the severe fiscal constraints, the need to rebuild crumbling roads, bridges, and other infrastructure is at present only partially met.  6 Resources are found by shifting public expenditure away from activities which could be better carried out by the private sector, such as telecommunications. to areas like transport infrastructure, where the state's role is more easily justified. However, the restoration of sustainable growth will require a gradual increase in public Investment over the next few years, particularly for agriculture, the environment, transportation, energy, %nd the social sectors. E. Medium-Term Finance for Growth 18. Despite the far reaching reforms implemented in Mexico, international capital markets have not provided the resources needed to bridge the period between the current costs and the future benefits of the reform program. Continuing high external transfers generated uncertainty about whether the rapidly growing transfer burden could be met. This, in turn, generated increased uncertainty about future exchange rates, taxation, and financial regulation. Thus, to forestall further capital flighc, Mexico had to pay unsustainable interest rates on its domestic debt. "Ex post' real interest rates were almost 50% in the weeks before the debt accord was reached. 19. Real interest rates so far above the real growth rate of the economy are explosive under any circumstance; however in Mexico there is an additional complication in that the government is in the middle of a stringent economic stabilization program in which fiscal retrenchment plays an important role. Between 1981 and 1989, the primary deficit (non-interest public expenditure minus puhlic revenues) of 7% was transformed into a surplus of 8.4% of GDP. At historical levels of domestic real interest rates and at the current level of internal debt (20% of GDP), this is more than enough to avoid unsustainable debt accumulation, even at the current low rate of inflation. However at a 30% real interest rate (the average level for most of the past year), the current fiscal stance is far out of line with the stated inflation target of 18-20 percent. The reason is th-^., at 30% real interest rates on domestic debt, the government needs more _.aan 6% of GDP in extra revenues for domestic debt service alone. The uncertainty caused by future transfer problems, through its impact on domestic real interest rates, was thus a direct threat to the survival of the still highly successful stabilization program. 20. Moreover, the fiscal impact of high interest rates forced sharp reductions in public sector investment, to a share of GDP lower than at any time in the past fifty years. The consequences for the provision of public services and for public sector infrastructure, an important complement to private sector capital formation, are worrisome. The same external debt problems have also delayed the private sector's adjustment to the new incentive structure. Revival of private investment and a cautious increase in public sector capital formation are among the most important benefits one can expect from the now successfully-concluded external debt negotiations. 21. Thus, the impact of reduced uncertainty and renewed confidence will go much beyond the direct fiscal effects of the lower costs of domestic debt service. Reduced uncertainty is likely to have a substantial impact on private investment and direct foreign investment beyond the direct impact of lower interest rates. Moreover, reduced uncertainty will also have an impact  7 on the potential of capital flight reversal. Some of that is already taken into account since a shift by the private sector from dollar into peso assets is really what allows lower interest rates, but increased direct investment is also a likely channel for the return of flight capital. 22. Thus the beneficial domestic effects of the debt package will follow as much from reduced uncertainty and improved expectations about future policies as from the direct fiscal impact of any reduction in net transfers to foreigners. But for such expectational factors to come into play, the deal really needs to be of a medium term nature. Hence the imperative not only to reach a solution, but a solution that would likely forestall debt problems for the foreseeable future. With such a comprehensive solution, t e domestic impact of removal of the uncertainty related to external debt is likely to be as important as the direct effects of any debt relief granted. The almosc 20 percentage points drop in nominal interest rates immediately after the details of tbe deal became known bears ample testimony to that. Z/ PART II - DEBT RELIEF AND MEDIUM TERM FINANCING PLAN A. The Case for Debt Relief 23. Against the background sketched so far, Mexico initiated the debt negotiations to seek international support for its far-reaching adjustment program and recovery of economic growth. The Government has already demonstrated its strong commitment to the program, but its continued success depends on the availability of external support. Because of the high domestic costs of continuing uncertainty, the required international support can mike a substantial difference only if it is based on an unequivocal, medium term commitment by the creditors. Therefore, Mexico has pressed in the negotiations for a multi-year financing package. 24. The need for debt relief, in the case of Mexico, needs to be seen from this perspective. It is not so much the level of the country's debt, but the current flow of debt service payments that is too high, and causes too much uncertainty to allow growth and sustainability of adjustment. The need for debt relief has to be seen ir. this context. Debt relief offers the most certain way to reduce future net transfers for a long time to come. If accompanied by a recovery of growth, as projected, it would also be most effective in improving Mexico's debt indicators. 25. There are more arguments, both political and economic, which stress the need for debt relief, as opposed to the provision of new money only. In terms of Mexico's domestic politics, Mexicans have made such enormous adjustments, accepted such a large reduction in living standards, that any package without a visible contribution by external creditors would not be acceptable domestically. An economic argument for debt relief is related to the likely Z/ Nominal interest rates have since then rebounded 4 percentage points.  8 time horizon ot new money commitments in the current international environment. Such commitments are unlikely to go beyond three or four years, possibly not enough to see a process of economic growth firmly established. 26. The conclusion from the above analysis is clear: Mexico needs external acc mmodation. The Government has the structural policies and domestic fiscal measures in place for sustainable growth to take off. What has been missing was a sufficiently long period during which external creditors would allow this inherently sound economic program to get off the ground. But Mexico's successful debt renegotiations now provide the elements for a well structured debt reduction plan, a plan which is expected to allow the Government to achieve its growth objectives. B. Structure of the Debt and Pre-Deal Financing Gap 27. At the end of 1988, Mexico's external debt was at $100.4 billion. Of this total, most is held by commercial creditors (see Table 1), with the remainder held by official creditors. Among official creditors, the Bank holds $7.4 billion and the IMF $5 billion. Of the commercially held debt ($70.6 billion), a small amount ($5.1 billion) has never been rescheduled. The bulk of this $5.1 billion consists of PEMEX liabilities ($3 billion) that traditionally have oeen rolled over automatically. Table 1: MEXICO: EXTERNAL DEBT BY CREDITOR AS OF END OF 1988 (US$ billion) Commercial banks: 70.6 of which to: Public Sector 65.1 of which: Rescheduled 37.9 New Money 14.8 non-rescheduled 5.1 Inter-Bank 7.3 Private Sector 5.5 Other Creditors: 29.8 of which to: Public Sector 28.8 of which IBRD 7.4 IMF 5.0 Bilaterals 8.7 Bonds 3.7 Others 4.0 Private Sector 1.0 TOTAL 100.4 28. The new financing package covers the sum of the $37.9 billion that was rescheduled during 1986/1987 and the $14.8 billion of new money that was provided in the previous two rescheduling exercises (1983/1984 and 1986/1987).  9 This total ($52.7 billion) has since been reduced to $48.4 billion because of cross-currency exr'hange rate changes, debt-equity swaps and cancellation of debt held by Mexican institutions. Thus the basis covered by the debt package is $48.4 billion. A certain amount of sovereign debt is held by Mexican owned banks. Those claims will either be brought under the new money option described below, or will not receive enhancements if debt or debt service reduction options are chosen. C. Financing Reguirements and Financing Plan 1989-94 29. Mexico's total gross financing needs over the next six years amount to $51.1 billion (Table 2). This level of financing would accommodate a growth target of an average 4% over the next six years, provided, however, that the non-interest current account would generate a surplvs of 2.4% of GDP on average. At current interest rates and for the given structure of the country's debt, this leads to a cumulative current account deficit of around $23 billion (around 1.5 percent of GDP on average). In addition, reserves are expected to increase by $3.1 billion, as stipulated under the currently operative IMF Extended Fund Facility, raising the total to $26 billion. Total financing requirements include, in addition, the scheduled net amortization payments to commercial banks, bondholders, suppliers and holders of private non-guaranteed debt, which is currently estimated at US$18.3 billion over the same period. Table 2: MEXICO'S FINANCING NEEDS AND SOURCES 1989-1994 (bUSS) Needs Sources Current Account deficits Direct Foreign Investment 21.9 and reserve changes : 26.2 International Financial Institutions 3.4 Net Scheduled Amort.: 18.3 of which: of which to: IBRD: 4.93I Comm. Banks 12.7 IMF :-1.3/ Bonds 1.2 Bilaterals 2.3 Priv.Non- ---------------------------_ Guar.Debt 4.3 Subtotal 27.6 Suppliers 0.1 Other Capital Outflow 6.52/ FINANCING GAP 23.5 Total 51.1 Total 51.1 Notes: 1/ Totals may not add up due to rounding error. 2/ "Other Capital Outflows" is the bookkeeping counterpart to the current account item "imputed interest earnings on private assets held abroad." 3/ This does not include additional disbursements of USS 950 million and US$ 600 million under the Interest Support Facilities of respectively the Bank and the IMF.  10 30. To meet the above needs, funding is expected to be available from net lending by bilaterals and the international financial institutions. In addition, substantial direct foreign investment (DFI) is projected to take place in response to the sound economic reforms and consistent policies of the current Government, including the recent liberalization of the foreign investment regime. However, Table 2 indicates that funds available from these sources fall short of gross financing needs: the financing gap is projected at $23.5 billion cumulatively over the period ending in 1994, or almost $4 billion per year. This includes amortization on commercially held debt ($12.7 billion). Therefore, the corresponding net financing required from debt service reduction, new money and return of Mexican flight capital would be $10.8 billion. 31. This scenario is sensitive to developments in the world environment. Every dollar decrease in world prices for Mexican oil costs Mexico $0.5 billion in foregone export revenues per annum. Thus if oil prices are two dollars lower than assumed, Mexico would lose up to $6.0 billion over six years.2' The financing gap would increase correspondingly. Of course unanticipated increases in the price of oil would reduce the financing gap. Similarly, a one percentage point increase in international interest rates would increase the cumulative current account deficit by close to $6 billion over the period, with a matching increase in the financing gap. This sensitivity to international interest rates highlights the potential benefits of fixed interest debt instruments. PART III - THE DEBT AGREMNT BETWEEN MEICO AND THE COMRCIAL BANKS A. Terms of the Agreement 32. On September 15, 1989, the Government of Mexico and the Bank Advisory Committee representing the commercial bank creditors reached agreement on a financing package covering the period 1989-92, restructuring approximately US$48.4 billion of Mexico's external debt. The agreement consists of a menu of financing options which includes two debt and debt service reduction facilities and four new money facilities. On the same day, the Government of Mexico disseminated a term sheet to all of its commercial bank creditors and invited them to participate in the financing operation. The following are the summary terms of the financing options offered by Mexico to its commercial bank creditors under the 1989-92 Financing Package: Debt and Debt Service Reduction Options Option A: Collateralized Floating Rate Discount Bond Exchange. ./ Oil export volumes are projected to remain constant for the next six years. The oil prices mentioned refer to the average price of Mexico's oil exports. Recently, this price has stayed about $3.50 US$ below the price for West-Texas Intermediate.  11 Creditors may exchange eligible debt for new collateralized floating rate discount bonds issued by the United Mexican States in a principal amount equal to 65% of the principal amount of the elegible debt offered for exchange. The new bonds will be in registered form, will mature in a single installment on December 31, 2019 and will bear interest at a rate of 13/16% per annum over the six-month LIBOR rate for the currency in which the bonds are issued. (Bonds will be issued in: Canadian and U.S. Dollars; Belgian, French and Swiss Francs; Deutsche Marks; Dutch Guilders; Italian Lire; Japanese Yen; and Pounds Sterling). Payment of the full principal amount of the Discount Bonds on December 31, 2019 will be secured by a pledge by Mexico of zero-coupon U.S, Treasury obligations (or other comparable collateral for other currencies). Payment of interest will be secured by a pledge by Mexico of cash or permitted investments in the currency of the bonds in an amount equal to eighteen months' interest (calculated at a constant interest rate of 10% per annum in the case of discount bonds issued in US dollars). Option B: Collateralized Fixed Rate Par Bond Exchange. Creditors may exchange eligible debt for Collateralized Fixed Rate Par Bonds issued by the United Mexican States in a principal amount equal to 100% of the principal amount of eligible debt offered for exchange. The Fixed Rate Par Bonds will also be in registered form; will be issue' in the same ten currencies as under Option A above; and will mature in one maturity on the same day as the Floating Rate Discount Bonds. The interest rate payable on the Fixed Rate Par Bonds will be 6.25% per annum for those issued in U.S. dollars and corresponding rates for those issued in other currencies. Principal and interest payments on the Fixed Rate Par Bonds will be secured in the same fashion as for the Floating Rate Discount Bonds, except that instead of using the assumed constant interest rate concept, the interest payments on the Fixed Rate Par Bonds will be secured to their full contractual levels. New Money 0Rtions Option C: 1989-92 New Money Credit Agreement. Lenders may elect to commit to lend up to 100% of their New Money Commitment (defined as 12.5% of Facilities 2 and 3 advances under the 1987 Multi-Facility Agreement and 25% of all other eligible debt) in the New Money Credit Agreement which will provide the United Mexican States (with an undertaking by Banco de Mexico to provide foreign exchange) with a 15 year (7 years grace) loan at an interest rate of (a) 13/16% over LIBOR, or (b) 13/16% over the three months Certificate of Deposit rate or (c) a fixed rate calculated to provide a comparable yield to maturity as the floating rate options. The loans will be made in the same currencies as the Debt and Debt Service Reduction Bonds, except that European Currency Units can also be lent under the New Money Credit Agreement. Amounts under this Agreement will be available for disbursement in six semi-annual tranches commencing on December 1, 1989 and concluding in July 1992. The first tranche will permit the  12 disbursement of 40% of the loans and each subsequent tranche will permit the withdrawal of 12%. Option D: New Money Bonds. Each creditor may elect to purchase New Money bonds in an amount up to 50% of its New Money Commitment, although not more than $500 million of New Money bonds will be issued in total. New Money Bonds will be issued by the United Mexican States; they will be in registered form, issued in U.S. dollars; and will bear interest at the rate of 13/16% over LIBOR. They will be issued on the date of the borrowing of the first tranche under the New Money Credit Agreement, and will be repayable in equal semi-annual installments beginning in 1997 and ending in 2004 (15 year maturity, 7 year grace). Option E: Onlending Facility. Up to a limit of 20% of its New Money Commitment, each creditor may elect to make advances to a trust established by Mexico (with Banco de Mexico as trustee) for the purpose of onlending funds to Mexican public sector borrowers with the guarantee of the United Mexican States. These advances will bave the same repayment schedule as the loans made under the New Money Credit option (15 years maturity, 7 years grace), at an interest rate of (a) 13/16% over LIBOR, or (b) 13/16% over the three months Certificate of Deposit rate. Advances made under the Onlending Facility may be in any of the currencies permitted under the New Money Credit Agreement; and the same restriction on availability applies as the one on lcans under the New Money Credit Agreement. Option F: Medium-Term Trade Credit Facility. Up to a limit of 20% of its New Money Commitment, each creditor may elect to make advances to a trust established by Mexico (with Banco de Mexico as trustee) for the purpose of financing certain eligible trade credits (e.g., unguaranteed portions of bilateral trade credits to Mexican public sector borrowers, or trade credits to Mexican private sector borrowers for transactions approved by Mexico). The Medium-Term Trade Credit Facility will have the same primary terms and conditions as the Onlending Facility. 33. Creditors holding claims in their home currency can, if that home currency is not the US dollar, choose whether to maintain the original currency denomination or switch into US dollars. If they choose to remain in their non-dollar home currency, the total funds devoted to enhancement will not exceed what would have to be provided for an equivalent dollar claim. 4/ Banks holding Mexican obligations contracted in the 1983-88 period will reschedule them to 7 years grace with 15 years maturity to the extent they are i/ There is one exception to this rule. Up to 5% of the Yen-denominated debt held by Japanese creditors is eligible for full collateralization of principal through zero coupon bonds and 18 months of interest coverage.  13 not swapped for par or discount bonds. Mexico's external creditors would provide all the necessary waivers to make feasible the issue of new debt and debt service reduction instruments with credit enhancement. 34. The Government would be entitled to buy back any of the newly issued discount or par bonds if (a) it is current on interest payments, and (b) the collateral account for interest support is either not drawn upon or replenished. This latter restriction lapses after end-1994. 35. Mexico would continue to service the interest on its existing loans on their contractual terms until the signing of the 1989-92 financing agreement. However, the terms of the agreement would, upon signing, be implemented with retroactive effect from July 1, 1989. For the new money commitments, this implies that at the time of the signing, participating banks would disburse immediately all the installments due until and at that time, subject to the satisfaction of certain conditions precedent (which include the issuance of the discount and par bonds). Similarly, once the discounted and par bonds are issued, Mexico would deduct from the initial interest payments the amounts of interest paid on the exchanged loans in excess of the interest due on the new bonds, after July 1989. This clause was introduced to eliminate any possible perverse incentive on the part of the banks to delay the signing of the agreement. Debt-EauitX Conversion 36. Banks participating in the 1989-92 financing package will have access to a debt/equity program which would be authorized up to $1 billion per year. This program would be limited to public sector companies that are being privatized and to qualified infrastructure projects. The lower limit of discount would be 35% on par bonds, new money and eligible old debt, and the conversion of discount bonds would not be higher than the face value. Recaeture Clause 37. Banks that have chosen discount or par bonds are eligible to recover some of the money given up through a "recapture clause". Under this clause, beginning July 1996, 30% of the additional oil revenues Mexico gets if the price of oil rises above $14 per barrel (to be adjusted for US inflation), will accrue to the banks that have granted debt and debt service relief. The total amount to be recaptured, however, would not exceed in any year 3% of the nominal value of the debt exchanged for debt reduction instruments at the time of the exchange (i.e. there is no indexation of this cap). Furthermore, the amount available under this clause will be scaled back by the percentage of the total debt brought under the two debt reduction options. Oil Contingency Facility 38. Furthermore, arrangements are under negotiation for contingent financing in case of a decline in the price of oil; these are to be provided in a separate package. A small group of banks has been approached to put up contingency financing for the event that oil prices might fall below a trigger  14 level which is to be determined. These funds would be made available in addition to the new money option and are expected to take the form of a revolving three year credit line of up to US$500 million. Mexico could draw on these funds during the period 1990-92, if oil prices went below the trigger level, and would need to repay if oil prices rose above another, higher, trigger level, also yet to be negotiated. At the end of the three years, any outstanding advance would be converted into a 7-year loan with a four year grace period. An important feature of this arrangement is that the contingent nature of the facility ensures that commercial funds would become available in circumstances under which it might be difficult to obtain lending on a commercial basis. 39. Preparation of this facility is unlikely to be completed by the time the Executive Directors consider the proposals contained in this report because Mexico and the Bank Advisory Committee decided to complete the financing package first. So far, commitments totalling US$150 million have been received from two major banks, and some ten additional banks are expected to come in. The Government has submitted to the Bank a 1htter, signed jointly by those two banks, setting out their commitment to take the lead management of the facility, provide the amount specified above and make a best effort to fully fund the facility. Credit Enhancement 40. All discount and par bonds would be repaid in a single installment on December 31, 2019. The principal would be secured by the pledge of zero coupon US Treasurv obligations (or other comparable securities for bonds in other currencies) with a maturity date matching that of the Mexican bonds. In addition, interest payments would be partly secured by a pledge of cash or permitted investments in the relevant currencies for an amount equal to 18 months of interest payments due. 11 The securities and cash pledged as collateral will be held in special collateral accounts, to be managed by the Federal Reserve Bank of New York, as collateral agent.11 Creditors' debt service would be paid out of these collateral accounts in case the Government failed to make interest payments for longer than 30 days, for as long as there are funds in the accounts. To enable establishment of the special collateral accounts, waivers of the negative pledge restrictions are necessary and have been received from Mexico's commercial bank creditors. As discussed in para. 82, it is recommended that the Bank would also provide a similar waiver. l/ That is, covering three semi-annual interest payments. J More than one account may be needed to secure interest payments denominated in different currencies.  15 Table 3 ENHANCEMENT FUNDS REQUIRED (US$ billions) T T Discount Par Total Bond Bond Principal collateralizaton: 1.16 2.18 3.35 Interest Coverage 1.80 2.11 3.90 Total 2.96 4.29 7.25 Note: Based on a 6 months based 30 year bond yield of 7.925%, or a cost of 9.7 cts per dollar, a debt base of $48.4 billion, and a mix of 46% Par Bond, 38% Discount Bond and 16% New Money. Debt held by Mexican banks is not included in the calculations. Totals may not add up due to rounding errors. 41. According to the term sheet, a total of at least $7 billion is needed to secure the debt and debt service reduction instruments subscribed by Me.ico's commercial creditors, and more if at the mix chosen $7 billion is not enough for full collateralization of principal and 18 months interest coverage. As of January 11, 1990, with almost 99% of the commitments obtained, 49% of the debt not held by Mexican agencies has been committed to the par bond, and 41% to the discount bond, with the remainder going towards the new money option. Based on current information on the likely choice of the remainder of the non- Mexican creditors, and placing Mexican creditors in the new money option for purposes of the calculations, results in a mix of 46.4% par bond, 38.1% discount bond and 15.5% new money. This mix would require $7.25 billion (Table 3), $0.25 billion more than has been committed sofar. The calculation is based on the long term bond yield at which the US Treasury has agreed to sell 30 year zero coupon debt instruments to the Mexican Government. 42. The commitments and timing of the various sources are shown in Table 4 below. The Table outlines which of the various commitments will be available in February/March 1990 and the extent to which bridging facilities will be needed. 43. Credit enhancement is scheduled to be implemented in February/March 1990. Collateralization of principal through purchase of discount bonds requires availability of the full amount of enhancement money on or prior to the time when the bonds are issued. Moreover, although it is possible to think of arrangements where interest coverage would be provided gradually, in line with accumulating interest obligations, such a gradual release would clearly reduce the value of the coverage unless at least the discounted value of interest payments during a period equal to the amount of coverage provided is available up front. Any other arrangement would diminish the effectiveness of the enhancement operation. Therefore, to be useful, enhancement money for interest payments too needs to be available up front. As a result, the full  16 amount of the set asides and the interest support loan must be made available to the collateral agents by February/March 1990. Table 4 AVAILABILITY OF ENHANCEIENT MONEYS (US$ millions) MF4/ IBRD Mexico Japan Total Available Feb/March 1990 Interest support 6063/ 12603O Scheduled Set Asides 272 375 Advancing 1990 IF Set Asides to Feb/March 90 3643' Advancing a Portion of IBRD 1990 Set Asides to Feb/March 90 3753/ Japanese Parallel financing and Cofinancing 14001.21 Enhancements Available Feb/M1rch 90 1242 2010 1243 14001/ 5895 Enhancements available later 455 6501/ 1105 Total Enhancements 1697 2010 1243 2050"/ 7000 Available Total Enhancements Required 250 Total Available for Debt Reduction Only (IMF and Bank Set Asides) :1841 Total Available for Interest Support Only; Interest Facility IMF and Bank:1866 Notes: 1/ Japanese money includes cofinancing for $1.25 billion, which is not directly available for credit enhancement purposes, and a bridge loan of US$150 million by Japanese conmmercial banks. 2/ Of which $900 million is conditional on compliance with the second tranche conditions of Bank adjustment loans. 3/ Subject to Board approval. 4/ The dollar value of the IMF contributions has been calculated on the basis of a SDR value of US$1.30. 44. To meet the enhancement requirements by February/March 1990, the Bank, the Export-Import Bank of Japan Zl/ and the IMF have committed themselves to 1/ EXIM Bank loans are for cofinancing and are not direct available for credit enhancement purposes.  17 front load their contributions to the extent possiblo. The table above shows the degree to which front loading by each party is feasible. As the front loading obtained provides only 'JS$5.9 billion by the target date, available funds fall short of the required US$7.25 billion. The Government has therefore approached a group of commercial banks for a bridge loan to provide Us$1.1 billion towards filling the gap. Furthermore, to cover the remaining US$240 million, an agreement has been reached to provide only the discounted value of interest enhancement funds up front, to be placed in safe securities in such a way that the full amount will become available in line with growing interest payment obligations. This is estimated to reduce up front requirements by US$205 million, leaving an estimated shortfall of some $40 million. The Government will fund the remaining shortfall from reserves. To ensure that the debt exchange can go through as scheduled, the Government would, as a condition of the proposed loan's effectiveness, submit a sound financing plan to the Bank, confirming that the full amount of the required enhancement funds will be available on time. B. Evaluation of the A4reement Debt Relief 45. Given the current status of subscriptions to the 1989-92 financing package, it is now expected that debt and debt service reduction instruments totalling almost US$41 billion, and new money instruments of about US$7 billion (inclusive of debt held by Mexican banks) would be secured upon signature of the agreements.