Mexico - Financial Sector Adjustment Loan

Document of The World Bank FOR OFCIAL USE ONLY Report No. 11638 PROJECT COMPLETION REPORT MEXICO FINANCIAL SECTOR ADJUSTMENT LOAN (LOAN 3085-ME) FEBRUARY 8, 1993 Country Operations Division I Country Department II Latin America and Caribbean Regional Office This document has a restricted distribution and may be used bv recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY UNIT - PESO (MEX$) On June 24, 1992 the exchange rate in the controlled market was US$1 = 3,131.40 the free market exchange rate stood at US$1 - Mex$3,120. ABBREVIATIONS ACF - Average Cost of Funds (see CPP for Spanish) ADRs - American Depositary Receipts AGROASEMEX - Agro Aseguradora Mexicana (Mexican Agro Insurer) ANAGSA - National Agricultural Insurance Company BANCOMEXT - Banco Nacional de Comercio Exterior (Foreign Trade Bank) BANOBRAS - Banco Nacional de Obras y Servicios Publicos (National Bank for Public Works and Services) BANPECO - Banco Nacional de Pequefio Comercio (National Bank for Retail Trade) BANRURAL - Banco Rural (Rural Bank) BNCE - Banco Nacional de Comercio Exterior, S.N.C. BdH - Banco de Mexico (Central Bank) CETES - Mexican Treasury Bills CNB - National Bank Cominssion CNBS - National Banking and Insurance Commission COI - Committee for International Operations CNV - National Stock Exchange Commission CPI - Consumer Price Index CPIR - Country Program Implementation Review CPP - Costo Promedio Porcentual (see ACF for English) EFF - Extended Fund Facility FSAL - Financial Sector Adjustment Loan FICART - Fideicomiso para Crddito en Areas de Riego y Temporal (Trust Fund for Credit in Irrigated and Rain-fed Areas) FIDEC - Fondo para el Desarrollo Comercial (Trade Development Fund) FlRA - Fideicomisos Instituidos en Relaci6n a la Agricultura (Trust Funds Related to Agriculture) FOMEX - Fondo de Fomento de las Exportaciones Mexicanas (Fund to Promote Mexican Exports) FONATUR - Fondo Nacional de Fomento al Turismo (National Fund for Tourism Promotion) FOVI - Fondo de Operacion y Financiamiento Bancario a la Vivienda (Trust Fund for the Operation and Bank Financing for Housing) GDP - Gross Domestic Product GIRA - General Interest Rate Agreement GNP - Gross National Product GOM - Government of Mexico IFC - International Finance Corporation IMF - International Monetary Fund INFONAVIT - Instituto Nacional para La Vivienda de Los Trabajadores (National Institute for Worker Housing) ISPL - Industrial Sector Policy Loan JEMIX - The Export-Import Bank of Japan NAFIN - Nacional Financiera, S.N.C. PACTO - Economic Solidarity Pact PCR - Project Completion Report PECE - Stabilization and Growth Pact PERL - Public Enterprise Reform Loan PRONASOL - Programa Nacional de Solidaridad REER - Real Effective Exchange Rate SEDUE - Secretaria de Desarrollo Urbano y Ecologia (Secretariat for Urban Development and Ecology) SEDESOL - Ministry of Social Development SHCP - Secretariat of Finance and Public Credit SPP - Secretariat of Programming and Budgeting VAT - Value Added Tax FISCAL YEAR January 1 - December 31  FOR OFFICIAL USE ONLY THE WORLD BANK Washington, D.C. 20433 U.S.A. Office of Director-General Operations Evaluation February 8, 1993 MEMORANDUM TO THE EXECUTIVE DIRECTORS AND THE PRESIDENT SUBJECT: Project Completion Report on Mexico Financial Sector Adiustment Loan (Loan 3085-ME) Attached is a copy of the report entitled "Project Completion Report on Mexico - Financial Sector Adjustment Loan (Loan 3085-ME)" prepared by the Latin America and the Caribbean Regional Office, with Part II contributed by the Borrower. This successful project aimed at restructuring the highly controlled financial sector, moving it towards a market based framework, while at the same time reforming the corporate and income tax system and tax administration. Implementation of the project was good with some targets, such as those in the fiscal area, being exceeded. While the supervisory and regulatory framework for banks and brokers was modernized, the number of banks and trust funds was reduced and measures to limit subsidies and transfers to agricultural financial institutions were introduced. The project has shown the possibility of introducing financial sector reforms in an inflationary environment when strong macroeconomic policies are adopted to redress the fiscal deficit, thereby succeeding in rapidly reducing inflationary pressures. The highly satisfactory performance of the project and its likely sustainability are convincingly highlighted in the PCR. At the same time, the PCR acknowledges that problems still exist in the areas of development banks and trust funds, which extend credit at subsidized rates to small enterprises and low income farmers. This adjustment operation will be audited. Attachment 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.   FOR OFFICIAL USE ONLY PROJECT COMPLETION REPORT MEXICO FINANCIAL SECTOR ADJUSTMENT LOAN (Loan 308S5-ME) TABLE OF CONTENTS PAGE NO. PREFACE .................................................... i EVALUATION SUMMARY ........................................ iii PART 1. PROJECT REVIEW FROM THE BANK'S PERSPECTIVE .... .......... 1 Project Identity . ............................................. 1 Background ................................................ I Project Objectives and Description ................................. 3 Project Design and Organization ................................... 3 Implementation of Reforms ...................................... 5 Fiscal Sector . ............................................. 7 Financial Sector . ........................................... 10 Development Banks ......................................... 13 Supervision and Prudential Regulations of Banks and Brokers ............... 18 Results . ..... .............................. ........ ..... 21 Evaluation of the Reforms and Remaining Agenda ........................ 24 Sustainability ............................................... 28 Credit Administration, Use and Coordination ........................... 28 Bank's Performance .......................................... 29 Borrower's Performance ........................................ 29 Lessons Learned . ............................................ 30 Project Documentation and Data ................................... 30 PART 11. PROJECT REVIEW FROM THE BORROWER'S PERSPECTIVE .... ...... 33 PART 111. STATISTICAL INFORMATION .............................. 37 1. Related Bank Loans ........................................ 37 2. Project Timetable ......................................... 37 3. Loan Disbursements ........................................ 38 4. Project Costs and Financing ................................... 38 5. Use of Bank Resources ...................................... 38 This document his 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.  ANNEXES 1. Policy Matrix . ............................................. 39 11. Evolution of Revenues of Federal District ........................... 45 Ill. Assets of Financial Institutions and their Relative Importance ............... 46 IV. Main Components of Assets and Liabilities of Commercial Banks .... ........ 47 V. Commercial Banks: Assets, Employees, Branches and Privatization .... ...... 48 VI. Development Banks and Trust Funds .............................. 49 VIl. Interest Rates: Development Banks and Funds ........................ 50 VIII. Composition of Credit Stocks by Economic Activity .................... 51 IX. Credit Flows by Funding and Economic Activity ...................... 52 ATTACHMENTS 1. Comments from IMF ........................................ 53 2. Comments from EXIM Bank of Japan .............................. 54  PROJECT COMPLETION REPORT MEXICO FINANCIAL SECTOR ADJUSTMENT LOAN (LOAN 3085-ME) PREFACE This is the Project Completion Report (PCR) for the Financial Sector Adjustment Loan to Mexico (Loan 3085-ME) in an amount equivalent to US$500 million approved on June 13, 1989. The adjustment component of the loan has been fully disbursed. A small undisbursed balance under the Technical Assistance component in the amount of US$1.6 million remains and the loan is expected to be closed on June 30, 1993. The PCR was prepared by the Mexico Country Operations Division (LA2C1) in the Latin America and the Caribbean Regional Office (Preface, Evaluation Summary, Parts I and III) and the Borrower (Part H). The Export-Import Bank of Japan and the IMF provided comments on the PCR (Attachments 1 and 2). Preparation of this PCR was started in November 1991 and is based, inter-alia, on the Report and Recommendations of the President, the Loan and Guarantee Agreements; supervision reports; correspondence between the Bank and the Borrowers; internal Bank memoranda and financial sector work performed by LA2C1.  I  - Hii - PRQJECT COMPLETION REPOR MEXICO FINANCIAL SECTOR ADJUSTMENT LOAN (LOAN 3085-ME) EVALUATION SUMMARY 1. Objectives. The Financial Sector Adjustment Loan was part of three sector adjustment loans of US$500 million each, presented to the Board simultaneously in June 1989 to support the Government of Mexico's sectoral adjustment program and debt reduction efforts. The other two loans supported public enterprise and industrial sector policy reforms. The three loans together provided a comprehensive reform package combining macroeconomic policies with micro adjustments in key areas. The focus of the FSAL was to support fiscal and financial sector policies consistent with economic stabilization and the resumption of growth. The objective of the program was to help provide a policy framework conducive to increased private sector investment (paras. 6-7). 2. Implementation Experience. Overall implementation was exemplary. In many areas implementation went beyond what was agreed under the program. The fiscal targets were exceeded. Major changes to improve tax revenues were introduced. The reforms ranged from changes in the corporate and income taxes to increasing penalties for tax evaders. The policy reforms were accompanied by a complete overhaul of the tax administration apparatus. Tax reforms were not only introduced at the Federal level but also in the Federal District (paras. 12-26). 3. In the financial sector, in a very short period of time, Mexico shifted from a highly controlled to a financial system based largely on market forces. All non-prudential controls on commercial banks were lifted. At the same time, a remarkable reform and modernization of the supervisory and regulatory framework for banks and brokers was implemented. The development banks and trust funds were reduced in number and size and the Government introduced measures to limit subsidies and transfers to agricultural financial institutions (paras. 27-63). 4. Operationally, implementation was excellent. The loan was signed two days after Board approval and became effective the same month. The second tranche was released in February 1990, i.e. two and a half months later than originally planned. The fast disbursing component has been fully disbursed. The Loan is expected to be closed at the end of June 1993, two years behind schedule because the Government requested more time to complete disbursements of the technical assistance component. The audit reports and accounts for the Loan have been received on time and have been fully satisfactory (paras. 95 and 96). 5. Results. While it is difficult to separate the effects of the measures supported by this loan from the effects of other policy changes implemented at the same time, it can be concluded that the loan made a positive contribution to the achievement of its ambitious objectives. There was a remarkable improvement in economic stability (inflation dropped from 90% over 1982-88 to 23% over 1989-91). The sharp increase in private sector investment (more than 12% per year over 1989-91) and the  - iv - resumption of growth (GDP grew by 3.7% over 1989-91) suggest that the goal of establishing a framework conducive to private sector investment was achieved (paras. 67-70). 6. In the financial sector, the disintermediation process was reversed. Monetary aggregates relative to GDP increased rapidly. The decline in banking sector lending to the private sector was also reversed. Banking sector credit to the private sector increased in real terms by 35% per year over the 1989-91 period. The improvement in the prudential regulatory framework and bank and broker supervision helped establish an important pre-condition for the privatization of the banks by ensuring that Government would be able to adequately oversee a private banking system. The privatization of the commercial banks, which was not part of the FSAL, is proceeding well and is expected to be concluded in July, 1992. There has been a sharp increase in foreign capital inflows and Mexico has regained access to voluntary lending. The importance of directed credit in the financial system was reduced and Government transfers and subsidies to development banks and trust funds were decreased (paras. 71-77). Sustainability 7. Mexico has successfully implemented a program of sweeping reforms. The GOM's full commitment to the reform process is evidenced by the continuing deepening of the stabilization efforts, the recent reforms of the financial system and the opening of the economy. The commitment of the GOM to the reform of the financial sector is evident with the privatization of the banking system. The integration of the financial system to international capital markets envisioned under the Free Trade Agreement, currently under negotiations with the United States and Canada, is expected to further consolidate the reform effort. The GOM and the private sector have adopted new roles. The private sector has taken the lead in the economy and the Government is concerned with the provision of macroeconomic stability and a rational incentive framework. Therefore, it is very unlikely that the reforms in the fiscal and the financial sectors will be reversed (paras. 88-89). 8. The one area where further reforms are needed but which may suffer some backsliding is the area of the development banks and trust funds. There continue to be significant functional overlap among these institutions and the bulk of directed credit is priced somewhat below market to various degrees. One of the Government's main concerns is to assist the majority of the Mexican population to participate in the general economic gains from the economic reform. The Government plans to use the development banks and trust funds, in particular NAFIN, to assist small and micro-enterprises and BANRURAL and FIRA to assist low-income farmers. The Government's concern is very valid, however, it is not apparent that directed credit is the best way to achieve the Government's objective. In lending to small and medium enterprises, it has not been convincingly shown that there is a market failure that could be improved through Government intervention. In agriculture credit market where there are market failures that warrant Government intervention, the form of intervention has to be properly designed to succeed in reaching the small farmer. Past experience suggests that large, cumbersome development banks are ill suited to reach targeted groups (paras. 36-38, 44 and 83). Lessons Learned 9. The main lesson derived from the experience of the FSAL is that financial sector reforms can be introduced successfully in an inflationary environment if the reforms are part of a credible economic package. The financial sector reforms took place in the context of consistent macroeconomic policies, in particular, the fiscal sector accounts had been brought under control and strict fiscal targets were consistent with available financing and inflation targets. At the micro-level, reforms that aimed at  - v - eliminating price distortions and improving factor mobility, including foreign investment, were being introduced simultaneously and a far-reaching trade reform was already in place. The reforms in the financial sector were also part of a consistent package that placed strong emphasis on the strengthening of the prudential regulatory and supervisory framework. The success of the reform was possible because of Government's commitment and elevated implementation capacity (paras. 97-98). 10. In the area of tax administration the Mexican experience again shows that it is possible to improve the tax system if there is a strong political will and implementation capacity (paras. 20-22). 11. In retrospect, the program could have benefitted from more time for preparation in some areas. With more time, a careful review of all program components may have resulted in the exclusion of the component dealing with State finances or a better design of the conditionality attached to it. A more detailed evaluation could have enhanced the effectiveness of the technical assistance component. The reluctance of the Government to allow significant Bank involvement in financial sector work prior to appraisal of this loan may have been a factor in the design and implementation difficulties encountered in the area of development banks and trust funds. This, however, has to be counter-balanced with the benefits of the timeliness of the Bank's assistance. The Bank's quick response to the GOM's request for support to its adjustment program helped propel and consolidate the reform momentum (paras. 10-1 1). 12. Conditionality could have been strengthened by relying less on action plans and more on concrete measures, particularly with respect to the restructuring of the development banks and trust funds. This was in part a result of lack of up-to-date first-hand knowledge of the sector prior to project appraisal. Although the preparation of the Action Plans themselves was a good vehicle to conduct policy dialogue in critical areas, there was little follow-up on implementation after the second tranche was released. A follow-up operation to support remaining reforms was envisioned when the FSAL was designed. It never materialized, however, because further progress than expected was made in some areas and the Government did not wish to press forward in others. Also, the subsequent improvement in Mexico's external position eliminated the need for further balance of payments support (para. 100).   PROJECT COMPLETION REPORT MEXICO FINANCIAL SECTOR ADJUSTMENT LOAN (LOAN 3085-ME) PART I: PROJECT REVIEW FROM THE BANK'S PERSPECTIVE Project Identity Name : Financial Sector Adjustment Loan Loan Number 3085-ME RVP Unit LAC Region Country : Mexico Type of Loan Sectoral Adjustment Loan Background 1. Faced with the aftermath of the debt crisis of 1982, Mexico broke with earlier policies of protection and state regulation and adopted an outward oriented and private sector-led economic strategy. In 1983, an IMF-supported stabilization program was launched. The program succeeded in reducing the fiscal and current account deficits and a fragile economic recovery started in 1984-85. However, two major external shocks, the Mexico City earthquake of 1985 and the collapse of oil prices in 1986, necessitated a more profound transformation of the economy. A new adjustment program was adopted in July 1986. In addition to tough austerity measures, the program sought a greater integration of the Mexican economy with the rest of the world and fresh resources from foreign creditors. While the program helped achieve large non-interest current account surpluses, inflation climbed from 64% in 1985 to 106% in 1986. Economic stagnation and triple digit inflation continued until 1987. A stock market plunge in October triggered a run on the peso and a financial crisis. The Government responded with the "Economic Solidarity Pact" (PACTO). Under the PACTO, in return for commitment to strict fiscal discipline and continued structural reform, labor and business agreed to temporary controls on wages and selected prices, in particular the freezing of the nominal exchange rate against the U.S. dollar through the end of 1988. The PACTO was a success: by 1988, inflation dropped to 52% and GDP grew a modest 1 %. 2. From 1982 to 1988 the financial sector was extremely restricted. In September 1982 the commercial banks were nationalized and the constitution was amended to reserve banking to the state. At the time many banks were insolvent as a result of a deterioration in the quality of their portfolios in an inflationary environment and interest rate controls which had reduced their margins. The Government merged and closed 60 nationalized banks forming the present structure of 20 banks', and in 1986 instituted a Fund to help rehabilitate and modernize the banks. The brokerage firms remained privately 1 Including two banks that were never nationalized. One being the subsidiary of Citibank and the other a bank owned by a workers union,  - 2 - owned and became increasingly important intermediaries as they were not subject to restrictive controls. It was not until the drastic decline in equity prices in October 1987 that dubious practices and allegations of widespread fraud surfaced. Insurance companies were very small, and the annual premiiia they collected was less than I % of GDP compared to between 6 to 9% of GDP in countries with similar per capita income. There were in existence 8 development banks and 21 government financial trust funds (see Annex VI). The development banks rivaled the commercial banks in asset size. During this period the government's budget deficit garnered much of the economy's savings, and what was leti for the private sector was poorly allocated because commercial banks were forced to lend their funds to favored sectors at less than market interest rates. As a result, intermediation through banks had diminished in real terms, while institutional brokers and the intercompany market channeled a growing share of the money market. 3. The reform efforts were strengthened in 1988. The economic strategy was to stabilize the economy, to reduce the role of Government and to restore growth. Continued fiscal retrenchment was needed to achieve lower inflation targets, therefore the private sector was to become the engine of growth. Consequently, the policy measures sought to provide the framework for the increase in private sector investment. In this context, the Mexican government recognized that a well functioning financial system was essential for renewed private sector growth and started a far-reaching financial refoirm. 4. The World Bank supported the Government's reform strategy with a series ot adjustment loans during fiscal year (FY) 1987-91 for a total of US$5.2 billion. During fiscal year FY87 and 88, the Bank approved 5 adjustment operations with quick disbursement components totalling US$1.6 billion. The Financial Sector Adjustment Loan was part of a package of three adjustment operations, for a total of US$1.5 billion approved in June 1989. The other two loans were the Industrial Sector Policy Loan (ISPL) and the Public Enterprise Reform Loan (PERL). The broad objective of the three FY89 loans was to restore private sector based growth within the constrains set by external creditworthiness. These loans were linked to the Interest Support Loan for US$1.26 billion approved in FY90 which sought to reduce Mexico's transfers to foreign commercial credits by supporting the Government's debt reduction plan. Another three adjustment loans were approved in FY90 and 91 in the areas of agriculture, export promotion, and telecommunications and transportation, for a total of US$0.8 billion. The Bank's role in supporting the Government's adjustment efforts was to act as a catalyzing agent for a process of renewed growth by relaxing the external constraint and signalling that fresh resources would indeed trigger increased investment. The Export Import Bank of Japan (JEXIM) strongly supported Niexico's adjustment efforts. JEXIM's total financial support for debt and debt service reduction operations amounted to US$1.9 billion. This support included cofinancing of the FSAL for US$300 million as well as for the ISPL and PERL. 5. Since the start of its adjustment lending in Mexico, the Bank has collaborated closely with the IMF. Most of the Bank's sectoral adjustment lending was carried out concurrently with IMF programs. Since 1982, Mexico has benefitted from an extended arrangement (EFF) for SDR 3.4 billion, a special emergency drawing for SDR 291 million after the 1985 earthquake, a stand-by for SDR 1.4 billion in 1986. In 1989, Mexico obtained a drawing of SDR 453 million under the compensatory facility and a SDR 2.8 billion EFF that ran through 1992. The EFF was augmented to SDR 3.2 billion in January, 1990 for interest support in connection with debt and debt service reduction operations. In May, 1992, the EFF was extended to a fourth year and further augmented by SDR 466.2 million. The Mexican authorities have agreed not to draw the additional resources barring unforseen adverse developments. Mexico's performance under the on-going EFF arrangement has been exemplary.  - 3- Project Objectives and Description 6. The FSAL was part of a program of Bank support to the Mexican Government's efforts to stabilize the economy and resume growth. The FSAL was prepared in parallel with the ISPL and the PERL. The three loans together provided a comprehensive reform package combining macroeconomic policies with micro adjustments in key areas. The ISPL aimed at modernizing the industrial sector by deregulating important industrial sectors and by increasing factor mobility, in particular, by facilitating direct foreign investment, technology transfer and research and development and labor mobility. The PERL aimed at improving the efficiency of public enterprises whose poor performance accounted for much of Mexico's financial problems and at reducing the heavy burden that they imposed on the Government budget. The focus of the FSAL was on macroeconomic stability and financial sector reforms. 7. The FSAL supported fiscal policies and external financing plans consistent with macroeconomic targets that would help achieve macroeconomic stability. The reforms in the financial sector were expected to: (i) increase competition in the system which would gradually reduce unusually high intermediation costs; (ii) modernize the financial system, improving the quality of services and expanding the array of financial services available; and (iii) deepen the financial system, thus increasing the volume of resources available to finance the productive sectors of the economy. In addition to deregulating financial markets, the reforms also sought to overhaul the prudential regulatory frariework and strengthening bank supervision (Comision Bancaria). These improvements were critical because prudential regulations and supervision become especially important when there is greater competition in the financial markets. It was expected that the strengthened prudential regulatory framework would result in healthier banks with higher capitalization levels. 8. The program included a range of macroeconomic and financial sector measures. To achieve stability the policy actions envisioned were: (a) the adoption of a macroeconomic program consistent with the objective of stabilization and growth, including progress towards more flexible price adjustments; and (b) the implementation of a consistent fiscal policy. This in turn had two dimensions: (i) consistency of operational deficits with inflation targets and availability of foreign financing; and (ii) consistency of deficit targets with existing expenditures and revenue plans. To strengthen fiscal performance the program included measures to reform the tax system and to improve tax administration; to strengthen public investment planning; and to improve state and local finances. In the area of financial reform the emphasis was on liberalization of the banking system, strengthening prudential regulations and supervision, redefining the roles of development banks and trust funds and reducing interest subsidies and transfers to those institutions. IFC took the lead on the reforms in the supervision of brokerage houses. Other areas such as contractual savings institutions were not included in this phase of the financial sector reform. The program also had a technical assistance component to support program implementation in the area of tax administration and public expenditure programming. The measures are detailed in Annex I which updates the original project document with the implementation experience in each area. Project Design and Organization 9. Overall the program was well designed. The policy reforms supported by the program were part of a comprehensive and coherent reform strategy. The reforms were complemented by sectoral reforms that were to be implemented at the same time, such as the reforms in public enterprises and in industrial deregulation. The reforms supported by the FSAL provided an important basis for the successful renegotiation of the foreign debt and for the re-privatization of the banking system. The  - 4 - conceptual framework for further fiscal reforms, for liberalization of the financial system, for strengthening the supervision and prudential regulation of the banking system, and for limiting subsidies to development banks and trust funds was clear and well understood by all parties. The future role of the development banks and trust funds is one area which still would benefit from a further exchange of views between the Bank and Mexico despite attempts to reach an agreement. The importance of the proposed reforms in State finances was not well substantiated and this was reflected in the inadequate design of the conditionality in this area. 10. The timing of the program was impeccable but because of time constraints project preparation was limited in certain areas. The Government requested Bank assistance to support its reform program through three adjustment loans at the time of the IMF/Bank annual meetings in September 1988. Initial agreement on the scope of the adjustment operations was reached, and for the first time the Government of Mexico agreed to include financial sector reforms. The appraisal mission for the three adjustment operations took place less than two months later (October/November 1988). Although there was very little time for preparatory work, this was not a major problem in those areas where the Bank had been actively involved, such as overall macroeconomic and fiscal sector issues. In parts of the financial sector, however, the Bank had limited up-to-date first-hand knowledge because the Government had been reluctant to allow Bank involvement in that area2. A major input for the preparation of the financial sector component was a report prepared for SHCP (Secretariat of Finance and Public Credit) with the involvement of external consultants. Some of the relevant economic and sector work to, k place in the context of project implementation, after the project was approved. The lack of previous knowledge may have influenced the design of the conditionality. Second tranche release conditionality often was not the implementation of specific pre-defined actions but the adoption of action plans in the areas of supervision and regulation of banks and brokers and in the redefinition of the role of the development banks and trust funds. 11. The program was very successful in the area of macroeconomic stability and fiscal reform, in the liberalization of the banking system, in overhauling the supervision and financial regulations of banker and brokers, in reducing the subsidies to the development banks and trust funds and improving transparency in their funding, and in improving the finances of the Federal District. Progress was less satisfactory in improving the finances of States and in redefining the role of the development banks and trust funds. The main reasons for the overall success was the commitment and conviction of the Government that the reforms were essential to transform the economy according to the Government's new development strategy, private sector led growth. The Government was committed to stabilize the economy and the control of the fiscal deficit was a key element in achieving this goal. In the area of financial reform the Government intended to privatize the banks at a later stage and the reforms were a prerequisite for privatization. The performance in the area of State finances reflected the fact that the complex issue of State finances was not the focus of the program. The conditionality attached to this goal was "reduce non-matching grants to the States". The condition could not be directly quantified as the necessary data was not available. In the area of redefining the future of the development banks, two factors contributed to insufficient progress. First, the Bank did not have sufficient elements to identify a well defined set of specific actions during project negotiations, and second the lack of a clear framework for the Bank and the Government to agree on the appropriate roles for some of those 2 Since the mid-80s the Bank had discussed with the SHCP the need to address certain deficiencies in the operation of the domestic financial sector but SHCP was reluctant to include conditionality on this sector in the sectoral adjustment initiatives, partly because it did not wish to discuss the experience with the nationalized banking system.  -5 - institutions. Implementation of Reforms 12. Macroeconomic Framework. The FSAL supported the Government's macroeconomic program embodied in the PACTO. As indicated before, the PACTO was a combination of orthodox and heterodox policies. Under the PACTO, in return for commitment to strict fiscal discipline and continued structural reform, labor and business agreed to temporary controls on wages and selected prices, in particular the pre-determination of the nominal exchange rate. It was recognized that ultimate success of the PACTO would require the implementation of measures that would allow the economy to emerge from the PACTO with the controls removed but its anti-inflationary gains intact. The most difficult issue was the exchange rate, as there was concern that a significant exchange rate realignment would lead to matching wage claims and additional pressure on nominal price controls. The exchange rate would be monitored in the context of the IMF's EFF. A second-tranche condition of the FSAL was that the Government's macroeconomic program would be consistent with the objectives of stabilization and growth, including progress towards more flexible price adjustments. As discussed below, this condition was unequivocally met. 13. By all accounts there has been remarkable improvement in the overall macroeconomic framework. Table I shows a few key statistics that indicate the degree of success of the prograrms. The sharp reduction in fiscal deficit and tight monetary policies have brought inflation down, reduced interest rates, spurred private investment and growth. Far reaching trade reforms have encouraged non-oil exports and a successful debt deal have made the economy less vulnerable to external shocks. 14. GDP growth and private investment surpassed the projected levels (see Chart 1). Inflation also declined sharply although somewhat less than targeted. The fiscal primary surplus exceeded the targeted level by 0.9% of GDP in 1989 and by 0.8% in 1990. Aided by lower real interest rate payments, the operational deficit4 was lower than programmed at 1.8% in 1989 and turned into a surplus of 2.3% of GDP in 1990. The reduction in real interest rates, from a peak of 36% in June 1989, was partly a result of the favorable conclusion of the debt reduction deal in mid-19895 which boosted the credibility of the adjustment effort. 15. The PACTO has been highly successful. Inflation in 1991 was less than 20% and the prices of about 90% of private production are free of regulation. Adjustment in the nominal wage has consistently lagged behind inflation and has resulted in a 17% reduction in the real minimum wage since December 1988. Average manufacturing real wages however, have been increasing and the minimum wage is progressively becoming less representative of private sector wages. The rate of depreciation of the peso has been gradually reduced from I peso per US Dollar per day, 40 cents per day and to 20 cents per day (or 2.4% per year) from November 1991. In real terms, the peso appreciated by 15% from 1989 3 These results reflect not only the measures taken under the FSAL but the overall adjustment effort. 4 Primary balance minus foreign and (real) domestic interest payments. 5 The basic agreement was reached in mid-1989 although the legal implementation was delayed until the first quarter of 1990.  - 6 - CHART No. 1 CHANGES IN REAL GDP AND INVESTMENT (Percentage change ovef same quarter) 25- 20 10- CHART No. 2 .MONTHLY INFLATION-CETES RATES (ANNUALIZD) 400% 20%. *200 500% 45%t so 87 an as 90 91