Mexico - Interest Support Loan Project

Document of The World Bank FOR OFICIAL USE ONLY Report No. 11640 PROJECT COMPLETION REPORT MEXICO INTEREST SUPPORT LOAN (LOAN 3159-ME) FEBRUARY 8, 1993 Mexico Country Operations Division Country Department II Latin America and Caribbean Region This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS On December 12, 1989, the exchange rate in the controlled market was US$1 - Mex$2,620.00; the free market exchange rate stood at US$1 - Mex$2,642.00. ABBREVIATIONS DDSR - Debt and Debt Service Reduction EFF - IMF Extended Fund Facility GDP - Gross Domestic Product IBRD - International Bank for Reconstruction and Development IDB - International Development Bank IECDI - Debt and International Finance Division IMF - International Monetary Fund IRR - Internal Rate of Return LIBOR - London Interbank Offering Rate NAFTA - North America Free Trade Agreement PCR - Project Completion Report PECE - Pact for Stabilization and Growth SDR - Special Drawing Rights FISCAL YEAR January 1 to 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 - Interest Support Loan (Loan 3159-ME) Attached is a copy of the report entitled "Project Completion Report on Mexico - Interest Support Loan (Loan 3159-ME)" prepared by the Latin America and the Caribbean Regional Office, with Part II contributed by the Borrower. This is an excellent PCR on a very complex and successful project, the first of its kind in the Baank. The Interest Support Loan was part of the Bank's support for the Debt and Debt Service Reduction (DDSR) plan of the Government of Mexico. The loan included exchange of old debt for new--partially guaranteed debt carrying a discount in the principal or below market interest rates--and it aimed at covering Mexico's external financing requirements, thus helping support the Government's adjustment program. The PCR rightly indicates that the efficiency gains of the project, i.e., its impact on the growth prospects of the country, were far more significant than the pure financial gains measured by the internal rate of return on the enhancement funds. In fact, in 1989, following a long period of economic stagnation, economic growth resumed led by a strong recovery in private investment. In addition the DDSR plan also contributed to reduce nominal interest rates and thus realize government savings on domestic debt service. Sustainability of the project is evidenced by the current outstanding fiscal performance of the country accompanied by a sizable reduction of domestic and foreign debt during 1990-92. At the same time, the deterioration in the current account of the balance of payments has been more than compensated by large private capital inflows leading to strong build up of foreign exchange reserves. Finally, one should stress that the Bank, for this operation, did not impose as condition of effectiveness or disbursement any upfront policy conditionality. Instead, the operation is based on the country's proven commitment to adjustment reforms under the ongoing Bank's adjustment program and IMF's EFF. An audit of this adjustment operation is planned. 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 INTEREST SUPPORT LOAN (LOAN 3159 ME) TABLE OF CONTENTS PREFACE .i... . . . . . . . . . . . . . . . . . . . . . . . . . . . . EVALUATION SUMMARY .... . . . . . . . . . . . . . . . . . . . . . . PART I. PROJECT REVIEW FROM THE BANK'S PERSPECTIVE .1 1. Project Identity . 2. Background 1.. A. The 1982 Debt Crisis .... . . . . ..I.... . . . . . . B. Domestic Adjustment and the Evolving Debt Strategy . . . 2 C. Stabilization and Structural Reform: Preconditions of the 1989-90 Debt Restructuring . . . 3 3. Objectives: Restructuring Debt to Support Sustainable Economic Growth .. 5 A. External and Public Finance Requirements . .5 B. The Case for Debt Relief .... . . . . 6 C. Objectives .. 6 4. Project Description and Implementation: The Debt Agreement . 6 A. Debt Negotiations: Role of Creditor Governments 6 B. World Bank Contribution: the Interest Support Loan . . 9 C. Terms of the Agreement .11 D. Outcome ..... . . . . . . . . . . . . . . . . . . . . 13 E. Special Features: Novation, Free Riding and Recapture Clause .... . . . . . . . . . . . . . 16 5. Results .17 I. Nominal Debt Relief ..17 A. Short- and Medium-Term Cash-Flow Relief .18 B. Long-Term Debt Relief .19 C. Efficiency of Debt-Enhancement Funds: the Internal Rate of Return Approach .20 II. Debt Relief at Market Prices .22 A Debt Relief at Market Prices: an Example.23 B. Market Valuation of the New Instruments .24 C. Market Valuation of the Debt Package: Did Mexico Obtain a Good Bargain? .26 III. Debt Management Issues ..27 A. Burden Sharing ..27 B. Flexibility of Debt Management .29 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.  IV. Efficiency Gains: Domestic Impact . . . . . . . . . . . . 30 A. Was There a Debt Overhang? . . . . . . . . . . . . . . 33 B. Better Creditor Coalition . . . . . . . . . . . . . . 34 C. A Lower Internal Transfer . . . . . . . . . . . . . . 35 D. Reduced Domestic Uncertainty . . . . . . . . . . . . . 36 6. Impact on Sustainability .38 7. Summary of Findings and Lessons from Experience . . . . . . . 38 PART II. PROJECT REVIEW FROM BORROWER'S PERSPECTIVE . . . . . . . . . 41 PART III. STATISTICAL INFORMATION ... . . . . . . . . . . . . . . . . 47 1. Project Timetable . . . . . . . . . . . . . . . . . . . . 47 2. Cumulative Loan Disbursements FY90 . . . . . . . . . . . 47 3. Adjustmeent Operations ... . . . . . . . . . . . . . . 47 4. Mission Data ... . . . . . . . . . . . . . . . . . . . 48 TABLES A. Fiscal Accounts ... . . . . . . . . . . . . . . . . . . . . 49 B. National Accounts ... . . . . . . . . . . . . . . . . . . . 53 C. Balance of Payments ... . . . . . . . . . . . . . . . . . . 55 D. Debt Structure ... . . . . . . . . . . . . . . . . . . . . 56 E. Collateral Accounts ... . . . . . . . . . . . . . . . . . . 58 F. Mix of Options Chosen by Commercial Banks . . . . . . . . . . 59 ANNEXES 1. The 1982-83, 1984-85 and 1986-87 Debt Reschedulings . . . . . 63 2. Macroeconomic Stabilization ... . . . . . . . . . . . . . . 64 3. Structural Reforms in Mexico ... . . . . . . . . . . . . . 66 4. Pre-Deal Debt Structure and Medium-Term Finance Requirements ... . . . . . . . . . . . . . . . . 68 5. The Interest Support Loan and Bank Support for the Debt and Debt Service Reduction Plan . . . . . . . . . . . 70 6. Terms of the 1989-90 Debt Agreement . . . . . . . . . . . . . 71 7. Calculation of Market Value of Mexican Claims . . . . . . . . 76 8. Foreign Debt Factors Behind Exchange Rate Uncertainty and Private Investment . . . . . . . . . . . . . . . . . . 81 ATTACHMENTS 1. Comments from IMF ... . . . . . . . . . . . . . . . . . . . 84 2. Comments from EXIM Bank of Japan . . . . . . . . . . . . . . 87  PROJECT COMPLETION REPORT MEXICO INTEREST SUPPORT LOAN (LOAN 3159-ME) PREFACE This is the Project Completion Report (PCR) for the Interest Support Loan to Mexico (Loan 3159-ME) in an amount equivalent to US$1.26 billion. The loan was fully disbursed on February 16, 1990 and closed on May 31, 1990. The PCR was prepared by the Country Operations Division of Mexico (LA2C1) in the Latin American and the Caribbean Regional Office (Preface, Evaluation Summary, Parts I and III) and by Bancomext, the Borrower's Agent (Part II). On March 31, 1992 the Bank sent to the Borrower and to the Cofinanciers, the IMF and the EXIM Bank of Japan 1', Parts I and III for comments. Cofinanciers, the IMF and the EXIM Bank of Japan, provided comments (Attachments I and 2). Preparation of this PCR was started in December 1991 and is based, inter-alia, on the Report and Recommendation of the President, on the loan and guarantee agreements, on internal Bank memoranda and on the Memorandum to the Board "Analytic Aspects of Debt and Debt Service Reduction Operations" (January 1992). Preparation of this report has also benefitted from support provided by the Debt and International Finance Division (IECDI). 1/ Strictly speaking the Japan Exim Bank (JEXIM) was not a cofinancier to the Interest Support Loan. JEXIM did, however, cofinance with three World Bank sector adjustment loans (which were part of the 1990 debt deal) and lend Mexico in parallel with IMF's Extended Fund Facility.   - iii - PROJECT COMPLETION REPORT MEXICO INTEREST SUPPORT LOAN (LOAN 3159-ME) EVALUATION SUMMARY 1. Objectives (paras. 10-14). The Interest Support Loan was part of the Bank's support for the Debt and Debt Service Reduction (DDSR) plan of the Government of Mexico; it provided funds for enhancement of interest of the new bonds issued in exchange for old commercial debt. DDSR operations comprised the exchange of old debt for new, partially guaranteed, debt which either carried a discount in the principal or a below market fixed interest rate. DDSR operations were aimed at covering Mexico's external financing requirements, thus, helping support the Government's adjustment program, further structural reforms and the resumption of sustained economic growth. The reduction in required net transfers to creditors was expected to have a direct beneficial impact on Mexico's fiscal situation and, thus, on investment and output growth. Indirect or "secondary effects" through renewed private sector confidence were expected to play an equally important role in supporting sustainable economic growth. 2. Description (paras. 29-33). The DDSR agreement with Mexico's commercial creditors consisted of a menu of financing options which included two debt and debt service reduction facilities and four new money facilities. The debt and debt service reduction facilities consisted of exit bonds with the principal securitized by zero-coupon US Treasury bonds (or equivalent bonds depending on the currency of denomination of the bond) with a maturity date matching that of the Mexican bonds. All bonds would be repaid in a single installment on December 31, 2019. In addition, interest payments would be partly secured by a pledge by Mexico of cash or permitted investments in the relevant currencies for an amount equal to 18 months of interest payments due. 2/ Both par and discount bonds were offered in the menu; discount bonds carried a 35% discount and an interest rate of LIBOR plus 13/16, and par bonds carried a fixed 6.25% interest rate (or equivalent rates if bonds were not dollar-denominated). Lenders who did not commit to the par or discount bonds had to reschedule existing debt and lend an additional 25% of that amount over the 1990-92 period. The new money option carried a 15 year maturity and 7 years grace and had to be disbursed in six semi-annual tranches. Banks that have chosen discount or par bonds were 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, 2/ That is, covering three semi-annual interest payments.  - iv - however, would not exceed in any year 3Z of the nominal value of the debt exchanged. 3. Role of the Bank (paras. 24-28). Since 1986 the Bank had made major contributions to policy reform in Mexico providing support to the maintenance of a consistent macroeconomic framework and deepening structural reforms aimed at creating the preconditions for economic recovery. In the years immediately preceding and following the DDSR agreement fiscal adjustment was strengthened and structural reforms deepened. Macroeconomic conditionality set under World Bank Sectoral Adjustment Loans and an IMF Extended Fund Facility (EFF) was met in excess for most targets. Under the agreement signed with Mexico for the Interest Support Loan the World Bank helped Mexico through measures that explicitly support debt and debt service reduction. To implement Mexico's credit enhancement scheme for the discount and par bonds, it was necessary for the Government to obtain limited waivers of the restrictions against giving security on (other) external debt -- the negative pledge restrictions -- contained in agreements that Mexico had entered into with the Bank, IDB and other external creditors including the commercial banks. The Bank did consent to waive the negative pledge restriction up to an amount equivalent to $7.5 billion for the principal and interest payments on the discount and par bonds. The Bank also restructured the $750 million guarantees under "Facility 2" and "Facility 3" of the 1987 Multi-Facility Agreement. 4. The World Bank played a key advisory role to Mexico on the design, formulation and evaluation of the menu options in the DDSR plan, e.g., on the pricing of the oil recapture clause and fixed interest options. And it advised the Government of Mexico during negotiations with the Commercial Bank Advisory Comittee. There were operational lessons as well. The Interest Support Loan was the first operation of its kind. Its implementation required the development of new internal procedures and documentation: it was the first World Bank loan which was an advance rather than a reimbursement for imports/expenses. Thus, to ensure that the loan financed the purchase of collateral the World Bank had to reserve the right to require prepayment of the loan if such proceeds were not used to achieve debt-debt service reduction or if, having the resources been allocated to debt-debt service reduction, the collateral was released. Another unique feature of the Interest Support Loan was that the Bank did not impose as a condition for effectiveness and disbursement any upfront conditionality. This was fully because the level of existing conditionality was already considered high and because Mexico's past track record was excellent. With the benefit of hindsight, it was correct not to impose on Mexico extra conditionality. 5. Implementation and Project Outcome (paras. 24-38). Under the agreement signed with Mexico for the Interest Support Loan the World Bank lend $1.26 billion for financing collateral in respect of interest payments on discount and par bonds to be issued by Mexico for DDSR. In addition, the Bank provided $750 million of set asides from existing Bank loans to be issued for reducing the stock of commercial bank debt of Mexico. Funds for credit enhancement also came from Mexico's own reserves, $1.37 billion, the IMF, $1.68 billion, and the Government of Japan, $2.05 billion. Since the IMF and Japan did not frontload all of their contributions (i.e., did not disburse their contributions at the time of the debt exchange) a $1.09 billion credit line  -v- from commercial banks temporarily covered the needs to purchase the collateral for the debt exchange. A total of $7.12 billion was needed to secure the DDSR instruments subscribed by Mexico's commercial creditors; the availability of enhancement moneys (after the $1.09 billion line of credit was cancelled) was as follows: IBRD, $2010 million; IMF, $1688.5 million; Japan, $2050 million; and Mexico, $1373.6 million, i.e., a total of $7.12 billion. 6. As a result of the debt agreement, a total of $45.3 billion of commercial bank debt was restructured (excluding Mexican creditors) of which 49.5% was committed to the par bond, 40.5% to the discount bond and 10.1% to the new money option and uncommitted money. Including Mexican creditors, none of which chose par bonds, a total of $48.2 billion of commercial bank debt was restructured of which 46.5% was committed to the par bond, 42.6% to the discount bond and 10.9% to the new money option and uncommitted money. 7. Debt Relief (paras. 41-45 and paras. 50-58). Mexico's annual interest relief brought about by the debt deal ranges between $1.1-$1.5 billion over 1990-95 depending on the level of debt service refinancing assumed as a counterfactual, i.e., the level of principal and interest refinancing that would have occured in the absence of the DDSR agreement. Cash-flow relief, given that $4 billion of the loans for debt enhancement were additional (i.e., loans which in the absence of the debt agreement would have not been granted), and that 100% of the principal would have been refinanced in any case, averages $1 billion per annum over 1990-95. Debt relief, defined as the reduction in the present discounted value of expected payments as a percentage of the face value of outstanding debt, for the actual mix of par bonds, discount bonds and new money chosen by non-Mexican creditors was 29.5% (26.8% if the oil recapture clause is included). An alternative view on how to evaluate a debt package like the Mexican focuses on the pre- and post-deal market value of Mexico's commercial debt. Since creditors always have the option not to negotiate in such a voluntary approach, one cannot expect the market value of the claims to go down as a result of the negotiations unless a third party is willing to offset the impact of nominal debt relief on market value by enhancing, in one form or another, the market value of the new claims to be created after the negotiations. In this view, there is debt relief if the market value of the claims without the enhancements goes down or if the market value with enhancements does not go up by more than the value of the enhancements, i.e., if the enhancement resources accrue at least in part to Mexico. 3/ Mexico indeed obtained most of the value of the enhancement moneys, i.e., the market value of debt inclusive of enhancements went up by only a small fraction of the enhancements (1.4%). 8. Rate of Return of the Proiect (paras. 46-48). The internal rate of return of enhancement funds, calculated considering as net benefits the reduction in scheduled cash flow over the next thirty years, was in a 16%-40Z range depending on how much debt refinancing could have been obtained in the absence 3/ This approach assumes that the market value of debt is a good measure of expected repayments by the country; although an effort was made to control for other factors affecting secondary market debt prices a margin for error due to omitted factors remains.  - vi - of the DDSR agreement and on whether the oil recapture clause is included or not. This range is well above the cost at which Mexico borrowed the enhancement funds, or the rate of return that Mexico could have obtained for the foreign exchange reserves devoted to the package (around 8%). 9. Efficiency Gains (paras. 68-73). The domestic or indirect effects of the debt agreement proved to be far more important than purely financial gains. In 1989, after a long period of economic stagnation, Mexico resumed per capita income growth. Economic growth, averaging 3.5% per annum over 1989-91, was led by a strong recovery of private investment. The return of private sector confidence was also reflected in large private capital inflows including substantial capital repatriation. While it is not possible to ascribe Mexico's economic success to DDSR alone, it is clear that, at a minimum, DDSR has paved the way for the success of other deep structural reforms implemented during the period. The DDSR plan contributed to reduce domestic nominal interest rates to record low levels for the decade. While part of this impact is ascribable to fiscal alleviation implied by a reduced external transfer to commercial creditors a far more important part of it stemmed from a smoother and more predictable external transfer associated, in turn, with greater stability in foreign exchange markets as well as in other dimensions of economic policy. From a strictly fiscal point of view the indirect effects of the debt agreement were clearly more important than the direct effects: based on the 20 percentage points reduction in domestic nominal interest rates that occurred within weeks following the announcement of the agreement, savings on domestic debt service were equivalent to about 4% of GDP, that is, 8 times larger than the savings on external interest service. Renewed investor confidence may have also been derived from: i) the signalling effects of the support provided by the World Bank, IMF and creditor governments; ii) a reduction in the possible disincentives to structural adjustment and investment resulting from expected higher future taxes; and iii) reduced uncertainty about future repayments derived from a better coordination between Mexico and its creditors and reduced exposure to foreign interest rate fluctuations. 10. Impact on Sustainability (paras. 74). Mexico's fiscal performance remains outstanding and was reflected in sizable reductions of domestic and foreign public debt in 1990-92. Although the current account has deteriorated sharply in 1990-91, this is mainly the result of a private sector investment boom and has, in any case, been overfinanced by large private capital inflows (primarily portfolio and direct foreign investment) leading to strong reserve accumulation of over $10 billion in 1990-91. The attainments of the program and the sustainability of the project thus are not at risk, particularly, in view of the projected improvement of public sector creditworthiness indicators. 11. Main Findings and Lessons Learned. Mexico's success in negotiating favorable agreement with its commercial creditors can be traced to the;( effective way in which it managed to prevent free riding by any private creditor on the debt relief granted by others. A tax payer financed creditor bail-out was thus avoided. The concerted nature of the agreement, and the sizable political support, most notably from the US, that made it possible, were thus essential to this success. Equally important was the menu of  - vii - options offered to commercial creditors, which helped to accommodate the diverse needs and expectations of banks facing different regulatory and tax environments. The success of the Mexico's global debt restructuring can also be traced back to good burden sharing between official and private creditors: 1990-94 scheduled net repayments to private and official creditors dropped respectively 9.4-9.5% between 1989 and 1990 (measured as a percentage of their original debt stocks). The oil recapture clause, by allowing the banks to recover part of their losses if oil prices increased above $14 per barrel (inflation-adjusted), made possible a larger amount of debt relief as banks obtained in exchange for their existing claims a more valuable (contingent) claim. While there was no contingency financing, partly because US regulations prevented direct issue of commodity-indexed instruments, interest guarantees added substantial downside protection. And the conversion of about half of Mexico's commercial debt into fixed interest instruments (par bonds) reduced Mexico's exposure to foreign interest rate volatility, thus, providing an implicit insurance against possible increases in foreign interest rates. 12. The above findings about design and implementation of DDSR operations provide useful lessons for future operations of this kind. The World Bank played a key advisory role to Mexico on the design, formulation and evaluation of the menu options in the DDSR plan, e.g., on the evaluation of the oil recapture clause and the pricing of the fixed-interest (par bond) option. The World Bank also advised the Government of Mexico during negotiations with the Commercial Bank Advisory Comittee. Operational lessons from the World Bank involvement in the DDSR plan were also important. The Interest Support Loan was the first operation of its kind in the World Bank and its implementation required developing new disbursement and legal procedures to ensure that the loan financed the purchase of collateral. For example, the World Bank reserved the right to require prepayment of the loan if such proceeds were not used to achieve debt-debt service reduction or if, having the resources been allocated to debt-debt service reduction, the collateral was released (if Mexico repurchases its debt). The World Bank, as the IDB and commercial creditors, had also to consent to the waiver of the negative pledge restriction allowing the government to purchase collateral up to $7.5 billion for the principal and interest payments on the discount and par bonds. The World Bank did not impose as a condition for effectiveness and disbursement of the Interest Support Loan any upfront conditionality. This was due to the existence of substantial second tranche conditionality set by the World Bank adjustment loans and conditionality set under the IMF's EFF, and to Mexico's excellent track record on policy reform and on achieving macroeconomic policy targets. With the benefit of hindsight the perception that Mexico was committed to adjustment and reform was correct and so the World Bank did well in not imposing on Mexico extra conditionality. 13. The DDSR agreement brought about substantial short-term interest relief but, more important, prevented a liquidity crunch stemming from the need to load upfront debt enhancement resources. The outflow of resources required to purchase collateral was mostly funded from additional borrowing, i.e., funds which were not going to be available in the absence of the deal. The critical difference between traditional debt rescheduling and DDSR, though, emerges over the long term. Long-term debt relief (defined as the reduction in the discounted value of debt service as a percentage of the face value of  - viii - outstanding debt) resulting from the actual mix of options chosen by non- Mexican creditors was 29.5Z. Furthermore, the enhancement moneys have not only achieved nominal debt relief, they also achieved effective market value debt relief, i.e., the market value of the debt without enhancements dropped after the deal. The post-deal market value with enhancements went up but only slightly above the pre-deal market value. Thus, banks were only marginally better off implying that Mexico obtained most of the value of enhancement resources. 14. Efficiency gains derived from the deal were far more important than purely financial gains from debt relief. Efficiency gains, reflected in lower domestic interest rates and higher private investment, stemmed from the favorable impact of a smaller, smoother and more predictable transfer to foreign creditors on exchange rate devaluation expectations/uncertainty and, thus, on macroeconomic policy stability in general. Although more analysis is required to identify and measure efficiency gains derived from the debt deal it is clear that in the absence of the other deep and widespread structural reforms that Mexico underwent during the period the above gains would not have materialized to the extent that they did. 15. All expectations about the loan's benefits at the time it was approved (as stated in the President's Report) were met. In particular, expectations about the impact of the debt agreement on economic growth were fulfilled, i.e., the materiality test was satisfied. It is difficult to ascertain whether the design of the DDSR agreement could have been improved upon to increase benefits and/or reduce risks. However, given the resources available for debt enhancement and the fact that commercial banks would not enter into an agreement which would make them worse off, Mexico obtained as much debt relief as it conceivably could have expected. In other words, the DDSR agreement efficiently achieved Mexico's debt relief objective.  PROJECT COMPLETION REPORT MEXICO INTEREST SUPPORT LOAN (LOAN 3159-ME) PART I: PROJECT REVIEW FROM THE BANK'S PERSPECTIVE 1. Proiect Identity Name : Interest Support Loan Loan Number 3159-ME RVP Unit LAC Region Country Mexico Type of Loan Sectoral Adjustment 2. Background A. The 1982 Debt Crisis 1. 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 finance. At the same time, a decline in private savings incentives (real interest rates turned sharply downward) prevented a matching increase in private savings; external debt thus increased, increased oil revenues notwithstanding. The period of single digit inflation ended in 1973, the real exchange rate-l started to appreciate and the accumulation of external debt accelerated above the GNP growth rate. A serious, but comparatively brief, financial and economic crisis in 1976 ended following major oil discoveries in 1977. The ensuing prosperity lasted until 1982, when soaring domestic inflation, falling international oil prices, rising world interest rates and massive capital flight ($21 billion in 1981-82 according to recent estimates) 5/ led to a refusal by external creditors to 4/ The real exchange rate is defined as the price of foreign goods relative to domestic goods. Appreciation means a decline in this relative price. 5/ See Harald Eggerstedt, Rebecca Brideau and Sweder van Wijnbergen, "Measuring Capital Flight in Mexico", mimeo, 1991, World Bank.  roll over the principal of about $8 billion of Mexico's external public debt and a subsequent suspension of Mexican external debt service payments. B. Domestic Adiustment and the Evolving Debt Strategv 2. 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). Despite the severe fiscal adjustment, 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. 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. In that context, a speculative run on the peso in late 1987 prompted a large peso devaluation and triple-digit inflation. Nonetheless, and despite the sharp fall in oil prices, between 1981 and 1987 the primary deficit (non- interest public expenditure minus public revenues) of 8% was transformed into a surplus of 5.6% of CDP and the $6 billion trade deficit was transformed into a $10 billion trade surplus. 3. Domestic adjustment came along with three major commercial debt reschedulings, respectively in 1982-83, 1984-85 and 1986-87 (Annex 1). These major reschedulings were linked with three debt restructurings agreed with Paris Club creditors. As a consequence the average maturity of Mexico's foreign debt debt increased from 8 years in 1981 to 14 years in 1987 and the spread over LIBOR was reduced from 2 and 1/4 to 13/16 points. 61 However, despite a substantial drop in the average interest rate on foreign debt (from 14.9% in 1981 to 7.7% in 1987, due mainly to lower international interest rates), the average annual net transfer to creditors over 1983-86 averaged $5.5 billion, or about 4% of GDP. As a consequence Mexico's foreign debt was unchanged (in real dollar terms) between 1983 and 1987. However, economic growth ground to a virtual halt over 1982-87 along with a sharp deterioration of living standards, a deteriorating infrastructure, high inflation, and a loss of investor confidence. 4. Concerned about the lack of growth in highly indebted developing countries the then Secretary of the US Treasury, Mr. James Baker, in late 1985 proposed a new plan which required commercial banks to lend up to $20 billion of new money and higher levels of multilateral lending in exchange for a comprehensive package of structural reforms in eligible debtor countries. New financial resources were needed to bridge the gap between the short term costs and long term benefits of adjustment. Domestic conditions in Mexico had severely deteriorated as a consequence of the large transfer to foreign creditors but also the 1985 earthquake in Mexico City and the sharp decline in international oil prices in 1986. In the context of the Baker Plan the IMF and World Bank supported Mexico with $1.7 billion and $2.3 billion of new 6/ See World Bank Debt Tables, World Bank, 1991.  - 3 - money, respectively, to be disbursed over 1986-87, conditional on commercial banks providing $6 billion of new money. The 1986-87 package of loans also included contingency financing by both the IMF and commercial banks and the rescheduling of $52.3 billion of commercial loans at lower spreads over LIBOR (Annex 1). 5. In late 1986 a new stage of Mexico's debt strategy took hold: market- based debt reduction schemes began to complement the traditional debt resceduling and new money approaches. Mexico started to take advantage of the deep discount at which its sovereign debt was trading in secondary debt markets, reflecting Mexico's inability to fully service its debt in the absence of involuntary debt reschedulings and new borrowings. About $3.6 billion of foreign public debt was cancelled through a debt-equity swap program between June 1986 and April 1988. However, the program was discontinued in April 1987 to avoid the adverse fiscal and potentially inflationary impact of debt-equity swaps (the swap amounts to a pre-payment of public debt at a discount). After the debt-equity swap program was discontinued secondary market discounts skyrocketed, and prompted a rush to repurchase private debt. In a relatively brief period about $3 billion of private debt was prepaid at a heavy discount ranging from 30Z to 55Z. The resulting demand for foreign exchange was one of the factors contributing to the speculative run on the peso in late 1987. 7/ In 1988 the government broadened its commercial debt reduction strategy through a collateralized debt exchange organized by the Morgan bank. The Morgan deal was concluded in February 1988. The Mexican government exchanged, through an auction system, $3.7 billion of existing commercial debt (bids submitted amounted to $6.7 billion) for new 20 year bonds carrying a face value of $2.6 billion dollar with its principal secured with zero-coupon US Treasury bonds. Although the spread over LIBOR of the new bonds was twice as high as on the existing debt the discount implied $1.5 billion dollar in interest savings over the life of the bonds (assuming full debt service in the absence of the deal). 11 While the 1988 debt exchange did not reduce Mexico's debt service obligations substantially it set the precedent for the 1989-90 debt restructuring under the Brady initiative. C. Stabilization and Structural Reform: Preconditions of the 1989-90 Debt Restructuring. 6. Towards the second half of the 1980s a series of measures were taken to reverse Mexico's economic decline. Their most important goals were: macroeconomic stability and a rationalized set of incentives for private sector investment. In each of these areas (discussed respectively in Annexes 2 and 3) the Mexican Government has achieved notable progress. Progress in 7/ See Allen Sanguines, "Managing Mexico's External Debt: the Contribution of Debt Reduction Schemes", January 1989, LAC Discussion Paper, World Bank. 8/ See Sanguines (previous footnote) and Jose Angel Gurria, "La Politica de Deuda Externa de Mexico, 1982-1990", Segundo Seminario para Administradores de Deuda Externa, 1991, World Bank.  these fronts, in turn, was required to negotiate a credible financing plan with foreign commercial creditors from a strong bargaining position and to be able to reap the benefits derived from the debt deal thereafter. 7. In late 1987 the Government announced and begun implementing the "Economic Solidarity Pact" (Pacto), an agreement between business, labor, and government which 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. The Pacto was renewed, with important modifications, by the new Mexican Administration under the name of "PECE" (Pact for Stabilization and Growth). Under the PECE and its succesive renewals (the latest one in November 1991) public tariffs, minimum wages were revised, controlled prices were revised and most were de facto liberalized, and a daily adjustment of the peso exchange rate against the U.S. dollar was introduced (one peso a day in 1989 which gradually was reduced to 20 centavos a day in 1992). Contractual wages in the private sector were liberalized as early as 1989. 8. On almost every target that is under direct or indirect governmental control, performance under the "PECE" has been exemplary, in some instances going far beyond what was originally planned. Inflation dropped from 159% in 1987 to an average of 23% in 1989-91. At the same time, the economy has shown encouraging signs of economic recovery, led by a strong resurgence of private investment and to a lesser extent private consumption. Output growth was 3.2% in 1989, 3.9% in 1990 and is estimated around 3.6% for 1991. Confidence in the economy was boosted by overall macroeconomic policy consistency and an array of structural reforms including trade, financial and fiscal reforms, the 1990 debt agreement described in this report, the privatization of the telephone and steel companies and commercial banks (whose substantial proceeds were allocated mainly to domestic debt reduction in 1991) and, more recently, advanced discussions on a North America Free Trade Agreement (NAFTA) and the flexibilization of the collective rural land tenure system ("ejido"). NAFTA and, associated with it, a likely profound transformation of the agricultural system, is crucial both because it would deepen the structural reform process and make it more irreversible. Reflecting improved confidence in the economy nominal interest rates have declined to record low levels for the last 15 years and Mexico received massive private capital inflows, on average $9 billion in 1989-90 and an estimated $17 billion in 1991. The current account balance has deteriorated since 1988 but this is largely due to higher imports caused by accelerating private sector investment and, to a lesser degree, lower private saving. In short, while structural adjustment is by no means complete, the progress which has already been achieved augurs well for a period of sustained growth. 9. It is likely that without the deep and widespread structural adjustment measures in place commercial banks would not have embarked on concerted debt and debt service reduction (DDSR) operations. By making the adjustment upfront and by sustaining and strengthening it even under the most adverse circumstances Mexico signalled to its creditors a convincing commitment to reform.  3. Objectives: Restructuring Debt to Support Sustainable Economic Growth A. External and Public Finance Requirements 10. Despite the far reaching reforms implemented in Mexico, international capital markets were not prepared to provide the resources needed to bridge the period between the current costs and the future benefits of the reform program. This was reflected in a projected $23.5 billion financing gap over the 1989-94 period, based on existing debt commitments, on a projected non- interest current account surplus of 2.4% of GDP consistent with 4% GDP growth (Annex 4 and President's Report and Recommendation for the Loan Report No. P- 5235-ME). This included amortization on commercially held debt ($12.7 billion). Therefore, the corresponding net financing (assuming existing commercial debt was rolled over) required from debt service reduction, new money and return of Mexican flight capital was $10.8 billion. 11. Since more than 90% of Mexico's US$100.8 billion foreign debt outstanding at the end of 1988 was public or publicly-guaranteed, pressures for reaching a satisfactory agreement with foreign creditors were at least as pressing for public finances as for the country. Foreign public interest payments averaged around 4Z of GDP in 1986-89. High and volatile external transfers generated uncertainty about whether the future transfer burden could be met. This generated increased uncertainty about future exchange rate developments which, in turn, was translated into high domestic interest rates on domestic debt. "Ex post" real interest rates were almost 50% in the weeks before the debt accord was reached and, despite a 20 percentage points drop following its announcement, they averaged 30% in real terms during 1989. With domestic public debt at approximately 20% of GDP in 1989 this implied that the government needed more than 6% of GDP in revenues for domestic debt service alone. Thus, even the unprecedently large positive primary fiscal balance attained in 1989 fell short of real domestic and foreign interest payments; as a consequence, in 1989 there was an operational (inflation-adjusted) fiscal deficit of close to 2% of GDP. 12. In this context, a foreign debt accord was necessary not just to reduce the transfer to foreign creditors but also to induce a reduction of domestic interest rates. The latter could occur if the debt accord produced a general increase in private sector confidence and reduced devaluation expectations and exchange rate uncertainty by lowering, smoothing and making more predictable the required transfer to foreign creditors. But for such expectational factors to came into play, the deal needed to be of a medium-term nature. Hence the imperative was not only to reach a solution, but a solution that would likely forestall debt problems for the foreseeable future. With such a comprehensive solution, the 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.  - 6- B. The Case for Debt Relief 13. Because of the high domestic costs of continuing uncertainty international support could make a substantial difference only if it was based on an unequivocal, medium-term commitment by the foreign creditors. Commercial debt relief offered the most certain way to reduce not only current debt service flows but also future net transfers for a long time to come, i.e., it not only freed resources for investment but it also improved incentives for domestic investment (as future transfers to creditors acted like a tax on future output thus encouraging capital flight). Since most foreign debt was public, debt relief would simultaneously bring fiscal relief. It thus created headroom for reversing a declining trend in public investment and, associated with it, a deterioration of social and physical infrastructure. However, at least as important was the potential impact of the DDSR agreement on foreign exchange markets: by making the external transfer smaller, smoother and more predictable it could lead to greater stability in foreign exchange markets and, possibly, other dimensions of economic policy. There were additional arguments, both political and economic, which stressed the need for debt relief, as opposed to the provision of new money only. In terms of Mexico's domestic politics, Mexicans had made such enormous adjustments and accepted such a large reduction in living standards, that any package without a visible contribution by external creditors would have not been acceptable domestically. Another economic argument for debt relief was related to the likely time horizon of new money commitments in the current international environment. Such commitments were unlikely to go beyond three or four years, possibly not enough to see a process of economic growth firmly established. C. Obiectives 14. The conclusion from the above analysis is clear: Mexico needed external debt relief. The Government had the structural policies and domestic fiscal measures in place for sustainable economic growth to take off. What was missing was a sufficiently long period during which external creditors would allow this inherently sound economic program to get off the ground. It was also clear that DDSR was the best means to support the Government's adjustment program, further structural reforms and the resumption of sustained economic growth. By providing funds for enhancement of interest of the new bonds issued in exchange for old commercial debt the Interest Support Loan supported the DDSR plan of the Government of Mexico. 4. Prolect Description and Implementation: The Debt Agreement A. Debt Negotiations: Role of Creditor Governments 15. The perception that debt reduction should become part of a credible and successful debt restructuring of highly indebted countries was shared in early 1989 by creditor governments, particularly, the US government. In March 1989 the U.S. Treasury Secretary, Mr. Nicholas Brady, officially endorsed this  -7- view. In early April the Brady Initiative received support from the Group of Seven and twenty highly indebted countries were initially included in the list of eligible countries. The Brady Initiative went beyond formalizing market- based reduction schemes already in place. It called for a concerted effort by creditor governments to get commercial banks involved in debt reduction and/or new money in countries that have already shown a commitment to adjust. In exchange creditor governments commited resources, through international financial institutions, to enhance new debt and introduced regulatory and tax incentives to induce banks to participate. 16. Even before the Brady announcement Mexico sought agreements with the IMF and, later on, the World Bank and the Government of Japan about a major package of support measures. In May 1989, Mexico and the IMP reached agreement on an Extended Fund Facility (EFF) for SDR 2.8 billion (about $4.1 billion) covering three years and an optional fourth one. At around the same time, the World Bank and Mexico successfully concluded extensive negotiations covering three Sectoral Adjustment Loans for $0.5 billion each, plus a commitment by the World Bank to a lending program of about $2 billion per year for the period 1990-92. Both the IMF and the World Bank supported Mexico's claim that a reduction in the debt burden was called for in one form or another if growth was to recover in Mexico. 17. Prior to any negotiations with commercial creditors, Mexico sought to reduce net transfers to its official creditors, and in addition, sought their support for the principles underlying subsequent negotiations with commercial creditors. An agreement was reached with the Paris Club, representing creditor Governments, covering $2.6 billion of official principal and interest payments falling due in the period 6/89-5/92. All amortization over the three year period was rescheduled over ten years with 6 years grace. Also rescheduled were 100% of interest payments due in the first year, 90% of interest payments in the second, and 80% of interest payments due in the third. Access to import financing of up to $2 billion per annum was also secured. 18. Negotiations with commercial banks were extraordinarily complicated right from the outset. One complicating factor was the number of banks involved (more than 600). This problem was dealt with through the formation of a Bank Advisory Committee with representatives of some 15 creditor banks. Negotiations between Mexico and the Bank Advisory Committee began in New York in early April, 1989. The initial skirmishing was about Mexico's financing needs for growth to recover, in which both the World Bank and the IMF played an advisory role. When the negotiations moved on to debt relief, initial positions were far apart, with Mexico asking for 55% debt relief and the committee offering only 15%. Although various counterproposals between Mexico and the commercial banks brought the parties somewhat closer, negotiations in New York seemed to stall at the beginning of summer and were escalated to a higher level. The final negotiations, in Washington DC, involved the Mexican Minister of Finance and Public Credit, Mr. Aspe, the U.S. Treasury Secretary, Mr. Brady, the chairmen of the most important banks involved, and senior officials of the World Bank and the IMF. This phase was successfully concluded with the announcement of an agreement in principle on July 23, 1989 (Section C and Annex 6).  - 8 - 19. After the Brady Initiative was launched the IMF and the World Bank moved quickly to provide support to Mexico for specific debt and debt service reduction (DDSR) operations. In January, 1990 the IMF allowed set asides of 30Z of quota for debt reduction operations. On January 29, 1990 the Executive Board of the Fund approved an augmentation of the EFF by the equivalent of 40% of quota (SDR 466 million) for interest support in connection with DDSR operations. In June 13, 1989 the World Bank agreed to parallel enhancement support. And in November 9, 1989 the Government of Japan made available to Mexico $2.05 billion through the Exim Bank of Japan. These funds would directly or indirectly facilitate the use of freed reserves for credit enhancement. Of the total Japanese contribution, $1.0 billion equivalent was to be lent to Mexico through parallel lending with IMF's EFF, $1.05 billion through cofinancing with World Bank (including $150 million of cofinancing for an environmental project which materialized after the debt deal). Some $1.4 billion of the total Japanese contribution was to be disbursed at the time of implementation of the DDSR agreement. 20. However, because Mexico was the first country to benefit from the Brady initiative, many new procedures and approaches had to be developed, e.g. the establishment of the escrow accounts (to guarantee interest) and the purchases of zero-coupon bonds (to collateralize the principal) in several currencies. The bondholders appointed the Federal Reserve Bank of New York as collateral agent to hold the collateral for discount and par bonds denominated in any of the eligible currencies. The collateral agent opened the collateral accounts where cash and securities for the interest guarantees were deposited. Interest earned on these funds are released to the Government of Mexico. The eligible currencies were U.S. dollars, Japanese yen, Dutch florins, Italian lire, German DM, Swiss francs and French francs. Fixed interest rates in the par bond option varied according to the currency of denomination: 6.25% for the dollar, 3.81% for the yen, 5.01% for the DM, 6.63% for the French franc, 10.75% for the Italian lire, 3.75% for the Swiss franc and 5.31% for the Dutch florin. Separate collateral accounts were opened for discount and par bonds denominated in each currency and in some cases where more than one series were offered, e.g. dollar denominated par and discount bonds, a corresponding number of collateral accounts were opened. !1 21. As a result of the complexities involved in this first time operation, the final agreement was only reached in February 4, 1990 and the debt exchange finally materialized on March 28 1990. Between July 1989 and February 1990 commercial debt eligible for debt reduction dropped from about $52 billion to about $48 billion. This was due to debt prepayments and amortizations of goverDnment guaranteed private debt, debt equity swaps and cross-currency fluctuations. 22. Regulatory, tax and accounting treatments of sovereign debt were altered in several creditor countries in response to the introduction of new instruments (the collateralized bonds) and the change in debt strategy in general. The general outcome of the changes was to make it easier for 9/ More details are provided in the President's Report and Recommendation of the Interest Support Loan (paras. 40-44 and 75-80).  -9- commercial banks to participate in DDSR options. In the US, for example, accounting rules were changed such that under certain conditions the cost of DDSR options (for accounting purposes) was allowed to be spread over the lifetime of the bond. In the UK, the Bank of England ruled that the discount bonds will initially not require any additional reserve provisioning, but the par bonds will require the same level of provisions as the pre-deal Mexico debt. New money required in the UK the same amount of provisions as existing credits. In France, both bonds were exempted from the normally unfavorable treatment applied to losses on securities. Most other OECD countries also enacted changes which made it relatively more attractive for banks to choose DDSR options. 23. Political pressures from creditor countries on commercial banks were a particularly important factor in preventing free-riders, i.e., banks that do not participate in the DDSR agreement but nevertheless expect to benefit from it (e.g., if the secondary market price increases), and in concluding the deal relatively quickly. B. World Bank Contribution: the Interest Support Loan 24. Since 1986 the Bank has made major contributions to policy reform in Mexico providing support to the maintenance of a consistent macroeconomic framework and deepening structural reforms aimed at creating the preconditions for economic recovery. Under the agreement signed with Mexico for the Interest Support Loan (Annex 5) the Bank helped Mexico through measures that explicitly support debt and debt service reduction. The new money was provided through a $1.26 billion loan for financing collateral in respect of interest payments on discount and par bonds to be issued by Mexico for reducing commercial bank debt and debt service. In addition, the World Bank provided $750 million of set asides from existing World Bank loans to be used for reducing the stock of commercial bank debt of Mexico. The $750 million of set asides amounted to 25% of all adjustment and hybrid loans the Bank made to Mexico in the three-year period FY89-91. The $1.26 billion interest support operation accounted for 22% of the $5.8 billion Bank's lending program for Mexico in FY89-91. 25. The World Bank also played an advisory role to Mexico on the design and formulation of the options in the DDSR plan. In particular, World Bank staff helped Mexican authorities to evaluate debt-debt service relief implied by the different options in the menu offered to commercial banks including the pricing of the oil recapture clause. This analysis played an important role in assessing how the DDSR plan could help to meet Mexico's medium-term external financial requirements. The World Bank also advised the Government of Mexico during negotiations with the Commercial Bank Advisory Comittee, initially favoring a more demanding posture vis a vis commercial banks than the one Mexico finally took.