Mexico - Second Decentralization and Regional Development Project

Document of The World Bank Report No. 13032-ME STAFF APPRAISAL REPORT mEico SECOND DECENTRALIZATION AND REGIONAL DEVELOPMENT PROJECT AUGUST 19, 1994 Natural Resources Management and Rural Poverty Operations Division Country Department II Latin America and the Caribbean Regional Office  CURRENCY EQUIVALENTS Currency Unit = Mexican New Peso (N$) US$1 = N$3.37 N$1 million = US$296,735 (June 1994) FISCAL YEAR January 1 - December 31 WEIGHTS AND MEASURES I meter (m) = 3.28 feet (ft) 1 kilometer (km) = 0.62 mile (mi) I hectare (ha) = 10,000 m2 = 2.47 acres I square kilometer (km) = 0.38 square miles (m?) = 100 ha I metric ton (m ton) = 2,205 pounds  ABBREVIATIONS AND ACRONYMS BANOBRAS National Public Works Bank (Banco Nacional de Obras y Servicios) CDS Social Development Agreement (Convenio de Desarrollo Social) CNA National Water Cornmission (Comisi6n Nacional del Agua) CONAPO National Population Council (Consejo Nacional de Poblaci6n) CONASUPO National Food Supplies Company (Compafi(a Nacional de Substancias Populares) COPLADE State Planning Commission (Comite para la Plant del Desarrollo) DRD Decentralization and Regional Development (Descentr, '-aci6n y Desarrollo Regional) ED School Rehabilitation Program (Escuela Digna) FONAES National Solidarity Business Fund (Fondos Nacionales de Empresas de Solidaridad) FMS Municipal Funds Program (Fondos Municipales de Solidaridad) FRS Indigenous Regional Fund (Fondos Regionales de Solidaridad) GDP Gross Domestic Product ICB Intemational Competitive Bidding IDB Interamerican Development Bank (Banco Interamericano de DesarroUo) INEGI National Institute of Statistics, Geography and Information anstituto Nacional de Estadistica, Geografta e lqformdtica) INI National Indigenous Institute (anstituto Nacional Indigenista) ITG Interstate Technical Group LCB Local Competitive Bidding MES Women in Solidarity (Mujeres en Solidaridad) MSC Municipal Solidarity Council MSU Municipal Support Unit MPWG Municipal Presidents Worling Group NAFIN National Finance Institution (Nacional Financiera, S. N.C.) NGO Nongovernmental Organization O&M Operation and Maintenance  OECD Organization for Economic Cooperation and Development PIDER Integrated Rural Development Program (Programa Integral para el Desarrollo Rural) PLANAT National Assistance Plan for Rainfed Areas (Plan Nacional para la Agriculkura Temporal) PPE Project Physical Performance Evaluation PROCAMPO Trade Liberalization and Direct Producer Income Support Program PRODERITH Program for the Development of Humid Tropica (Programa de DesarroUo Rural Integral para el Tr6pico Humedo) SARH Secretariat of Agriculture and Hydraulic Resources (Secretarfa de Agricufrura y Recursos Hidrdulicos) SHCP Secretariat for Finance and Public Credit (Secretarfa de Hacienda y Credito Pdblico) SCT Federal Highway Administration (Secretarfa de Comunicaciones y Transportes) SECOGEF General Secretariat of Comptroller of the Federation (Secretarfa de la Contralorfa General de la Federaci6n) SEDESOL Secrtariat of Social Development (Secretarfa de DesarroUo Social) SOLIDARITY National Solidarity Program SWA State Water Agency SRA. State Road Agency TOR Terms of Reference  MEXICO SECOND DECENTRALIZATION AND REGIONAL DEVELOPMENT PROJECT TABLE OF CONTENTS Page No. LOAN AND PROJECT SUMMARY ......................... i I. RURAL DEVELOPMENT AND DECENTRALIZATION IN MEXICO .1 A. Poverty in Mexico . B. Decentralization .2 C. Regional Equity .4 D. Poverty Alleviation and the National Solidarity Program .4 E. RURAL DEVELOPMENT AND DECENTRALIZATION STRATEGY . 7 A. Introduction. 7 B. SEDESOL's Strategy for Strengthening Capacity of Rural Municipalities. 7 C. SEDESOL's Strategy for Rural Water Supply .9 D. SEDESOL's Strategy for Rural Roads Rehabilitation and Maintenance .10 E. SEDESOL's Pilot Strategies to Increase Income Earning Potential .11 F. Lessons Learned from Past Operations .14 HII. THE PROJECT .16 A. Origin of the Project .16 B. Rationale for Bank Involvement ..16 C. Project Objectives ..17 D. Project Description and Components ..19 1. Overview of Institutional Aspects .19 2. Municipal Investment and Institutional Development Component .20 3. Rural Water Supply Component .24 4. Rural Roads Rehabilitation and Maintenance Component .27 5. Income-Generating Component .30 6. SEDESOL Institutional Strengthening and Project Coordination .30 E. Environmental Assessment ..31 F. Poverty Category ..31 This report is based on the findings of a World Bank appraisal mission which visited Mexico in February-March 1994. The mission was composed of Messrs./Mmes. Andrea Silverman (Tak Manager), Jean Claude Sallier, Fernando Aguilar, Maria Correia, John Glenn, Victoria Rodriguez, Sergei Soares, and Rudy Van Puymbroeck. Peer reviewers are Messrs. Hans Binswanger, Tun Campbell, Jean Delion, and Antonio Pereira. The Division Chief is Michael Baxter and the Department Director is Edilberto Segura.  TABLE OF CONTENTS (continued) Page No. G. Project Costs and Financing ...................................... 32 1. Costs ........................................... 32 2. Financing ........................................... 32 H. Project Organization and Management ..32 1. Implementing Agencies .32 2. Procurement .37 3. Disbursements .40 4. Accounts and Audits .43 5. Monitoring of Project Implementation and Bank Supervision .43 6. Project Physical Performance Evaluations and Mid-term Review .44 I. Project Benefits and Economic Evaluation .. 45 J. Participation of Indigenous Groups and Women .. 46 K. Project Risks ............................................... 47 IV. AGREEMENTS REACHED AND RECOMMENDATIONS ...................... 47 ANNEES ANNEX A Socio-oconomic Data for Mexico and eight Project States ANNEX B Project Costs ANNEX C Project Monitoring, Evaluation and Reporting ANNEX D SEDESOL Strengthening and Project Coordination Component ANNEX E Application of Lessons Learned from the first DRD Project ANNEX Municipal Investment and Strengthening Component ANNEX 0 Rural Water Supply Component ANNEX H Rural Roads and Maintenance Component ANNEX I Income-Generating Component ANNEX J Supervision Plan ANNEX K Estimated Schedule of Bank Disbursements ANNEX L Government Policy Letter ANNEX M List of Documents in the Project File MAPS: IBRD No. 25680: Mexico - Second Decentralization and Regional Development Project. Project States. IBRD No. 25681: Mexico - State of Chiapas. Second Decentralization and Regional Development Project. Rural and Urban Municipalities Participating in Municipal Funds Program IBRD No. 25682: Mexico - State of GuMr=ero. Socond Decentralization and Regional Development Project. Rural and Urban Municipalities Participating in Municipal Funds Program IBRD No. 25683: Mexico - State of Hidalgo. Second Decentralizaion and Regional Development Project. Rural and Urban Municipalities Participating in Municipal Funds Program IBRD No. 25684: Mexico - State of Michoacan. Second Decentralization and Regional Development Project. Rural and Urban Municipalities Participating in Municipal Funds Program  IBRD No. 25685: Mexico - State of Oaxaca. Second Decentralization and Regional Development Project. Rural and Urban Municipalities Participating in Municipal Funds Program IBRD No. 25686: Mexico - State of Puebla. Second Decentralization and Regional Development Project. Rural and Urban Municipalities Participating in Municipal Funds Program IBRD No. 25687: Mexico - State of Veracruz. Second Decentralization and Regional Development Project. Rural and Urban Municipalities Participating in Municipal Funds Program IBRD No. 25688: Mexico - State of Zacatecas. Second Decentralization and Regional Development Project. Rural and Urban Municipalities Participating in Municipal Funds Program   MEXCO SECOND DECENTRALIZATION AND REGIONAL DEVELOPMENT PROJECT LOAN AND PROJECT SUMMARY Borrower: Nacional Financiera, S.N.C. (NAFIN) Guarantor: United Mexican States Executing Agencies: Secretarfa de Desarrollo Social (SEDESOL); Municipalities; Water Supply, Rural Roads and Agriculture Agencies of the eight states of Chiapas, Guerrero, Hidalgo, Michoacan, Oaxaca, Puebla, Veracruz, and Zacatecas. Beneficiaries: Poor communities of the eight project states, including a total population of 25.9 million and a primary target of 14.4 million rural population. Loan Amount: US$500 million equivalent. Terms: Repayment in 15 years, including a five-year grace period, at the standard variable rate. Project Objectives: The overall objective of the project is to increase access of rural poor and indigenous communities to basic social and economic infrastructure (especially roads, water supply and schools), and to income-generating activities and thus alleviate poverty. The project would continue efforts initiated under the first Decentralization and Regional Development (DRD) project to strengthen the participation of poor, rural communities in local government investment planning and implementation and to strengthen the institutional capacity of state and local governments to support rural development efforts. The specific objectives are to: (a) improve basic infrastructure and support income- generating investments in poor rural areas of the eight states; (b) strengthen institutional mechanisms and capacity at the federal and state levels to plan, supervise, monitor, and evaluate rural water supply, rural roads and other rural development strategies with the participation of municipalities and beneficiary communities; and (c) strengthen the capacity of rural and semi- rural municipalities to finance, plan, implement, and operate rural infrastructure investments, using appropriate technologies and participation of affected communities. Project Components: The project would have five components: (a) Municipal Investment and Institutional Development (US$737 million). This component would finance small-scale community selected and managed works, for water supply development, rural roads, school rehabilitation, productive activities, and other small infrastructure works of priority to rural communities, through SEDESOL's Municipal Funds and school rehabilitation (Escuela  -ii - Digna) programs. The component would also develop the fiscal, administrative and technical capacity of rural and semi-rural municipalities, through studies, technical assistance, training, and support for legislative and regulatory reforms at the state level. Individual infrastructure investments in this component would not exceed US$50,000. Communities would be required to provide 20% of total project cost in cash or kind. Approximately 54,000 small investments would be implemented in the eight states under the project. (b) Rural Water Supply (US$178 million). This component would provide potable water to small rural localities (between 500 and 5,000 inhabitants), by financing investments whose technical complexity and cost make them inappropriate or ineligible for the Municipal Funds program. The component would also improve the capacity of state water agencies and municipalities to manage water supply investment and operations and maintenance efficiently and effectively. Subprojects would be selected and contracted by state water agencies, using established investment selection criteria and standard parameters for engineering design. The average water supply sub-project investment would be approximately US$120,000, with approximately 1,300 rural water supply systems to be constructed or rehabilitated under the project. (c) Rural Roads Rehabilitation and Maintenance (US$133 million). This component would finance the rehabilitation and maintenance of priority sections of the rural roads network, while developing the capacity of state road agencies and municipalities to do so efficiently and effectively. Rehabilitation investmnents would be managed by state road agencies, selected based on an established set of criteria, and designed according to standard engineering parameters and costing on average US$7,000 per kilometer. Municipalities and communities would have an active role in implementation, with labor intensive works contracted to municipalities through inter-governmental agreements. A municipal maintenance program to cover roads rehabilitated would also be financed. Approximately 15,600 km of rural roads would be improved and included in a municipal maintenance program under the project. (d) Income-generating Component (US$12 million). This component would provide technical assistance, training, and limited investment to develop and pilot new strategies to support income-generating projects in rural areas, by strengthening income-generating activities in the Municipal Funds program and by supporting the development of income-generating programs by state agriculture agencies in one or two pilot states.  -4ii - (e) SEDESOL Institutional Development and Project Coordination (US$35 million). SEDESOL's capacity to manage the project- financed programs would be strengthened. Financing would be provided for a program of institutional development technical assistance and training, contracting of technical expertise required for the supervision and review of each component, and continued development of the project information and monitoring system. Annual project audits would also be financed. Benefits: Project investments would result in an improved standard of living for approximately 10 million individuals living in relatively isolated rural areas, with the improvement of access roads, water supply, educational and other basic infrastructure. The rural water supply component investments will result in raising access to water of rural population in the eight states from 48 percent to 63 percent. Of the 50,000 kilometers of earthen, rural roads in the eight states, 29 percent (or 15,600 km) will receive spot improvement and maintenance, resulting in greater access of approximately 4 million rural dwellers to social services and economic activities. Approximately 10 million individuals are expected to benefit from the estimated 60,000 Municipal Funds and Escuela Digna investments to be implemented during the project. More importantly, the project will strengthen the capacity of municipal government and communities to work together to define and address priority needs in poor rural areas. ERR: Not applicable, as the project finances small economic and social infrastructure in poor rural areas, depending either on community participation mechanisms or subproject eligibility criteria to ensure selection of high priority and least cost solutions. Risks: Possible risks arise from: (a) the relatively weak institutions at state and municipal levels, sometimes leading to insufficient technical input in subproject selection and design; (b) number of institutions involved in project execution leading to overly heavy supervision burden; and (c) the extent to which general criticisms of Solidarity may reflect on the credibility of the project. To address these risks, the project limits investment to technically simple, but highly economic works (e.g., spot improvement of roads, small water supply schemes, etc.) for which simple selection criteria have been designed and agreed during project preparation. In addition, targeted programs of technical assistance have been designed for each project component to strengthen the state line agencies. To make project supervision easier and improve the project management, inter-state technical groups would be formed and would meet quarterly. In addition, the number of sectors to be supported by the Second DRD project has been reduced from ten covered in the first DRD project, to four, with strict criteria for subproject eligibility. The computerized monitoring system deve!oped during the first DRD project would continue to be upgraded by SEDESOL and used to provide timely analysis of implementation progress and issues in each state. To maintain the credibility of the project, the project will use clear and rational sets of  -iv - subproject selection criteria, and will monitor implementation closely, analyzing for possible biasing of investments based on other than poverty and efficiency criteria. Poverty Category: PA - Poverty Alleviation; Program of Targeted Interventions. Project investments will be targeted to the poor rural areas of eight of the poorest states of Mexico. Targeting to the rural poor will be achieved through: (a) the kinds of projects financed (e.g., small, inexpensive projects for water supply, earthen roads, and school classrooms); (b) implementation by community groups, avoiding the selection of investments not responsive to community priorities; (c) payment of laborers for rural road rehabilitation and maintenance works, resulting in employment generation for the poor; and (d) distribution of resources by formula to provide greater funding to poor rural areas. Indigenous communities and women's groups are to be specifically targeted within the income-generating component.  -V - Estimated Project Financing by Componenti (US$ Million) Project Components | Local Foreign Total I. Municipal Investment & Institutional Dev. 549 149 697 II. Rural Water Supply 120 49 168 m. Rural Roads Rehabilitation & Maintenance 92 34 125 IV. Income-Generating Component 8 3 12 V. SEDESOL Inst. Strength. & Project Coord. 27 6 33 Total Baseline Costs 796 240 1036 Price Contingencies 45 14 59 Total Project Costs 841 254 109S - _Financing Plan 1 Local 1'Foreign_ Total IBRD 246 .254 S00 Federal and State Governments 443 0 443 Beneficiaries 152 0 152 Total 841 254 109S 1 Figurs nay not add up due to rounding.  -vi - Estimated Project Financing by Componentli/2 (US$ Million) SEDESOL | Benefici- Total -% Total Component IBRD and State | aries I Base Governments | j Cost I. Municipal Inv.fInst. 299 266 133 697 67% Investment 265 265 133 663 Tech. Assist./Inst. Dev. 33 1 - 34 H. Rural Water Supply 81 78 10 168 16% Investment 78 78 10 165 Institutional Dev. 3 012 - 3 m. Rural Roads 64 61 - 125 12% Spot Improvement 55 55 - 109 Municipal Maintenance 6 6 - 12 Institutional Dev. 4 0 - 4 IV. Income-generating 8 2 1 12 1% Component Investment 2 2 1 6 Institutional Dev. 5 0 6 V. SEDESOL Strengthen. 21 12 - 33 3% & Project Coord. Total Baseline Cost 473 419 144 1036 100% Price Contingencies 27 24 8 59 Total 500 443 152 1095 Estimated Disbursements (USSmillion): Bank FY I l99 1997 1m22 1 9 1 Annual 8012 91 116 147 66 Cumulative 80 171 287 434 500 /Fiures may not add up due to rounding. 2/Less than .5 is rounded to 0. 3/lncludes an initial deposit to the Special Account of USS40 million and up to USS40 million in retroactive financing for eligible expenditures incurred after Febnrary 1, 1994.  MEXICO SECOND DECENTRALIZATION AND REGIONAL DEVELOPMENT PROJECr I. RURAL DEVELOPMENT AND DECENTRALIZATION IN MEXCO A. Poverty in Mexico 1.1 As Mexico joins the OECD and gradually moves into the ranks of the industrialized countries, poverty remains a major problem affecting almost half of its population. Mexico's National Statistics and Geographical Information Institute (INEGI) estimated that in 1992, 44 percent of Mexico's 84 million people were living in poverty, with 16 percent living in conditions of extreme poverty. Although the majority of Mexico's population (66%) live in urban areas, extreme poverty continues to be disproportionately a rural phenomenon, whose impact is greatest on the country's indigenous people. In 1992, INEGI estimated that 56 percent of the extreme poor lived in rural areas' and were engaged in agricultural activities. The eight disadvantaged states, which are the focus of the proposed project, include 32 percent of Mexico's population, but contain approximately 54 percent of its poor and 69 percent of its extreme poor.2 1.2 Poverty increased dramatically in Mexico with the onset of the 1982 macroeconomic crisis, as per capita GDP and public expenditures declined considerably. Between 1982 and 1988, real per capita GDP dropped by 10 percent from US$4,162 to US$3,723. Federal expenditures dropped by S percent while rural development expenditures (excluding social sector expenditures) dropped by 38 percent between 1983 and 1989. Reflecting the overall decrease in expenditures, targeted poverty alleviation programs developed in the 1970s (including the Bank-supported Integrated Rural Development Program, PIDER, 1975-1988) were severely curtailed. As a result, from 1984 to 1989, INEGI estimates that the total number of poor grew from 30 million to 38 million, while the population living in extreme poverty grew from 11 million to 15 million. 1.3 Since 1989, the overall economy has begun to recover and per capita GDP has risen slightly to US$3,961 in 1992, although it still remains below its 1982 level. In addition, expenditures on health, education and poverty programs have increased sharply and the rate of extreme poverty in Mexico has declined almost to its 1984 level. Nevertheless, regional differences remain very strong, with the poverty rate in the poorest states being ten times that of richer states. The greatest differences are seen between the states of the center and north which are either industrialized or have large expanses of irrigated agriculture and those of the southeast which have little industrial development and depend on rainfed agriculture. Regional differences are also clearly apparent in illiteracy rates, infant mortality, access to potable water supply, and other basic services (see Annex A). 1. Based on INEGI analysis of 1992 Household Survey; for the purposes of this survey, rral ares are defined as areas where no locality exceeds 15,000 population. All other uses of the term umi in this report refer to individuals living in localities of 5,000 or less popubtion. 2. These figures ae based on World Bank analysis of the 1989 INEGI Household surv.  1.4 Rural poverty has been aggravated by the low level of growth and productivity in the agriculture sector. GDP growth in the sector has been very uneven, averaging 2 percent since 1983, while the productivity of agricultural labor has also remained poor, improving only marginally during the last three decades. During the past decade, agricultural profitability has declined with the removal of many input and output subsidies combined with the decline in world prices for many crops. It is not yet clear what immediate impact the recent ejido land reform will have on rural poverty, as gains are expected to be seen over the long term and principally in the more productive regions of the country. The phased elimination of the guarantee price supports for maize and beans in exchange for direct income payments to producers (the PROCAMPO program) will extend benefits to poor farmers who previously did not have a market surplus. Again, because this program was only recently initiated, the extent of its impact on poverty it is not yet clear how much impact it will have on rural poverty. Moreover, the elimination of guarantee support prices and the shift to equivalent wvrld market prices under NAFTA may possibly have a short-term, negative impact on the sector and reduce the demand for rural labor. 1.5 The Mexican Government under the Salinas administration is addressing the issues of poverty alleviation and development of poor regions using several strategies. During the past five years it has: (a) begun to reorient agricultural research and services to place higher priority on rainfed agriculture; (b) increased decentralization of investments and services, strengthening the participation of state and municipal government and communities; (c) modified the fbrmula for distributing federal revenue sharing, making the per capita distribution more equitable and increasing resources going to poorer states; and (d) provided new sources of public investment targeted to poor areas through regional development programs and the reorientation of social sector investments in health and education. The reorientation of public investment in agriculture is being addressed in the Agriculture Technology Project (Ln. 3465-ME, 1992) and in the recently signed Rainfed Areas Development Project (Ln. 3778-ME, 1994). The improved poverty targeting of educational and health services is addressed in the Second Primary Education Project (Ln. 3722-ME, 1994), the Initial Education Project (Ln. 3518-ME, 1993), and the Basic Health Project (Ln. 3272-ME, 1991). The following sections summarize Government's poverty alleviation efforts as they relate to increasing decentralization, improved regional equity in resource transfers, and the use of the National Solidarity Program ('Solidarity') to carry out poverty alleviation activities across sectors. B Decentralization 1.6 In spite of being a federated system, national govermnent in Mexico collects and manages the greatest share of public resources. Currently, the federal government (excluding the Federal District) collects approximately 93 percent of aggregate public sector revenue from taxation and users fees, of which approximately 15 percent is transferred back to the 31 states and municipalities' through revenue-sharing. The largest source of state revenue in all states comes from federal revenue-sharng (79%), with only 5 percent coming from taxation, 4 percent from user fees, and 12 percent from all other sources. 1.7 Increasing decentralization and strengthening the authority and capacity of state and local government to manage public finance, establish investment priorities and provide services have been a 3. Municipalities are local jurisdictions which are often a mixture of runal and urban areas; they ae similar to 'districts, or counties' in other countrieL.  central goal of the last two presidential administrations of Miguel de la Madrid and Carlos Salinas. The goal of decentralization has been to increase the efficiency and effectiveness of public services, and to provide greater opportunity for citizen participation. During the past decade these administrations have taken several important steps in this direction, including: (a) the constitutional reform of 1983 increasing the authority and responsibility of locally elected municipal governments; (b) deconcentration of federal agencies; (c) increased use of coordinated investments by federal agencies with state governments; and (d) actual devolution of responsibilities in some sectors to state agencies and local governments. 1.8 The sweeping constitutional reform of Article 115 in 1983 gave municipalities responsibility for providing water supply and sewage, streets, public lighting, sanitation, and slaughterhouses, and for collecting and retaining property taxes and user fees for such services. In practice, however, most municipalities remain dependent on state government for financial, technical and administrative support, and must receive State Congress approval for municipal budgets, establishment of local tax rates and tariffs, and other local laws. State governments continue to collect local property taxes on behalf of most municipalities. For rural municipalities, property taxes, however, are not a significant source of revenue, and these municipalities depend on monthly revenue sharing transfers received from the state for approximately 90 percent of their revenue. 1.9 Some progress in strengthening municipalities has been made, however, in the ten years since the 1983 constitutional reforms. For larger, more urbanized municipalities, local initiative combined with technical assistance provided by the private sector, the National Public Works Bank (BANOBRAS) and the National Water Commission (CNA) have resulted in better local revenue generation through property tax collection and increased cost recovery for municipal services. For rural municipalities, the principal support has been provided through the municipal programs of Solidarity as well as efforts of the State Secretaries of Finance, supported in part by the first Decentralization and Regional Development (DRD) project (Ln. 3310-ME, 1990) (see paras. 2.3 to 2.6). 1.10 Since 1984, there have been reductions in the size of the federal bureaucracy and reforms designed to increase the role of state and local governments in the allocation of resources within an overall regulatory framework provided by the federal agencies. First, the input of state and local governments in the allocation of federal resources was expanded. The federal government increased its use of coordinated investmnent programs, investments which are agreed with state government and where the state provides a share of the financing. This, when combined with the initiation of the Solidarity federal-state matching grant program at the end of 1989 (see paras. 1.15 to 1.24), means that state governments now have a much greater influence regarding and, potentially, accountability for the investments that are made in their states. Second, state and municipal authorities are gradually receiving more direct responsibility for and autonomy over public investment and services in certain sectors. In education, the states are assuming the primary responsibility for many functions in the sector, and federal resources are being transferred to the states to cover these expenditures. For water supply, local semi-autonomous water companies, established at a municipal level, are now managing systems previously managed by CNA. In the road sector, state road administrations have been established to manage the network of secondary roads recently transferred to the states from the Federal Highway Administration (SCr). In addition, authority over rural roads is to be transferred from the federal to state governments, although this transfer has been delayed in most states due to a disagreement between the tuo regarding the transfer of federal resources to states for maintenance and rehabilitation.  - 4 - 1.11 The result of this decentralization effort is that state governments now have much more influence, and in some cases direct control, over public investment and services in their states. Municipal govermnents, particularly in the better-off states, are also beginning to assume greater responsibility for local services. While these changes do not guarantee improvements in the public sector, they are an important step toward more responsive and efficient government. C. Regional Equity 1.12 Prior to 1990, federal revenue sharing was distributed to states based on a fbrmula negotiated at the time of the tax act of 1980 (Ley de Coordinacion Fiscal), based on their individual tax collection efforts. The result of this formula was that the poorer states received, on average, one- third the per capita amount received by richer states. To provide greater equity, the Ley de Coordinacidn Fiscal was revised in 1989 in a way that would result in the redistribution of resources from richer to poorer states. Forty-five percent of the funds would be distributed according to the total state population, another 45 percent would be distributed according to the historically determined formula adjusted each year to reflect changes in state tax collection effort, while the remaining amount would be distributed in an inverse proportion to the state's participation in the other two components of the formula (population and tax collection). The stepwise implementation of this fDrmula resulted in a 64 percent real increase in federal transfers to the four poorest states (Chiapas, Guerrero, Hidalgo, and Oaxaca) during the period of 1989 to 1992, while the remaining states received an average increase of 20 percent over the same period. The overall effect this reform has been that the ratio of transfers to the 3 richest entities4 as compared to the 6 poorest states has been reduced from 3:1 in 1989 to 2:1 in 1992. Such differences will be reduced further in the 1994 fiscal year, when this new formula comes completely into effect. 1.13 Federally financed capital investments in the states are nearly twice that of revenue-sharing funds, and unlike those funds, are not formula-driven. On a per capita basis, the disparity in federal investment received among states is great, with a few states and the Federal District receiving three times the average level of investment per capita of the rest of the states combined. This has a significant effect as 70 percent of all public investmnents in the states are federal. 1.14 In the allocation of both revenue-sharing and federal investment, there is a great need for further reforms which would: (a) increase the resources managed diecly by states and municipalities either by increasing transfers, or, preferably, reforming the tax assignment structure in order to increase revenues collected by these levels; and (b) direct greater resources to the poorer states to meet their greater needs for basic social and economic infrastructure and to compensate for lack of a strong tax base. It is also anticipated that, as Mexico increases the decentralization of the functions of its central line ministries, related transfers will necessarily become formula-driven, based on a measure of need for services and local ability to py for them. D. Poverty Alleviation and the National Solidarity Program 1.15 Mexico has a wide-ranging experience in poverty alleviation efforts. In rural and regional development programs, Mexico's experience includes the Bank-assisted PIDER projects (1975-1988), the National Assistance Plan for Rainfed Areas (PLANAT, Ln. 1945-ME, 1980) the Program for the 4. Tle sAab of Nuew Le6n and Baja Califomia and the Federal District.  - 5 - Development of Humid Tropics (PRODERITH I and II, Lns. 1553-ME and 2658-ME, 1978 and 1986, respectively), and now the National Solidarity program, which receives support from the first DRD project. 1.16 The National Solidarity Program has been the central effort of the current government to reduce poverty and to address the gap in social services that had widened in the 1980s; it was initiated by President Salinas at the beginning of his administration in December 1988. Solidarity is managed by the Social Development Secretariat (SEDESOL) and funded through a single federal budget line (Ramo 26) which is combined with state funds based on the annual Social Development Agreement (CDS) signed every year by SEDESOL with each state. The CDS establishes the broad framevwrk for federal-state cooperation, within which budgetary allocations for each Solidarity program and specific investments are agreed between SEDESOL and the state Planning Committee (COPLADEs) each year. 1.17 Solidarity includes over 30 different sub-programs to target health, education, nutrition, employment, infrastructure, and income-generating projects to the poor. Federal financing for Solidarity, provided as a grant to states and municipalities, has grown from US$500 million in 1989 to US$2.2 billion in 1993, with each state government adding from 25 percent to 50 percent as counterpart finance. For large infrastructure projects, Solidarity funds are mixed with credit provided by national development banks (BANOBRAS and NAFIN), either to municipalities or to producers' organizations. 1.18 What distinguishes Solidarity investments from those financed by the budgets of federal or state line agencies are the following set of principles and guidelines: (a) community participation in project selection and implementation through Solidarity Committees; (b) poverty targeting; (c) decentralization and shared responsibility for Solidarity programs with state and municipal governments; and (d) sharing of program costs among the federal government, states, municipalities, and beneficiary communities. While these concepts are central to Solidarity, how they are applied varies among the different Solidarity programs. 1.19 Although Solidarity covers a broad range of investments, it is not by itself a comprehensive poverty alleviation program. Rather, the individual Solidarity programs are often designed to complement and strengthen normal sector investments. In education, for example, Solidarity has provided at least US$600 million in additional financing for the rehabilitation and construction of educational facilities in poor communities since 1989. It has also financed a program of small grants to individual poor students (Nflos en Solidaridad). In health, Solidarity funds have been used to rehabilitate or build and equip new health posts, but not to provide medical services. In water supply and drainage, Solidarity has provided additional financing to responsible line agencies, targeted to poor urban neighborhoods and rural areas. 1.20 Solidarity is also supporting investment in agriculture through a number of distinct programs. It is providing financing for agriculture-related investments identified by the COPLADEs and implemented by state and federal agencies. Although the total investment is small compared to the investment programs managed by the Secretariat of Agriculture and Hydraulic Resources (SARH), Solidarity funds constitute a significant portion of state investment in agriculture in the four DRD project states. In addition, Solidarity supports investments in income-generating projects by the new National Solidarity Business Fund, Fondos Naclonales de Empresas de Solfdaridad (FONAES, see paras. 2.21 - 2.23), the provision of small production credits by municipalities (Fondos de  - 6 - Solidaridadpara la Producci6n), a special program to provide production credit and grants to small coffee producers through the National Indigenous Institute (INI), and revolving credit funds managed by indigenous organizations (Indigenous Regional Funds, FRS). 1.21 The impact of Solidarity on the poor is difficult to measure because it has financed everything from large water supply schemes to individual scholarships for poor elementary school students, and because many of its programs have yet to develop an effective monitoring system.5 Nevertheless, it is clear that certain Solidarity programs, especially the Municipal Funds program, financed by the first and proposed Second DRD project, are contributing in a number of important ways. The Municipal Funds program has successfully increased the amount of financing available for infrastructure in poor rural communities, doing so by involving those communities and their municipal governments in establishing priorities for investment and ensuring that they are implemented. Other Solidarity programs focused on rural areas, such as rural water supply, rural road rehabilitation, and Escuela Digna, also supported by the tw projects, have provided important additional resources to rural areas, increasing the level of public investment significantly. 1.22 As a very highly visible government program, Solidarity has attracted both criticism and praise. Some of the most frequently cited strengths of Solidarity include: (a) providing a vehicle for greater citizen participation in government decision-making through the Solidarity Committees and Municipal Solidarity Councils, especially in programs managed at the municipal level; (b) effective mobilization of citizens to contribute to the planning and implementation of public works and social programs in their own communities; (c) implementing in a cost effective manner a large number of badly needed small infrastructure projects in a short period of time; (d) promoting greater decentralized control over public investment decision-making by states and municipalities; and (e) providing a mechanism for getting investment to rural areas. 1.23 The criticisms vary by the kind of Solidarity investment. However, some Solidarity programs have been criticized for the following: (a) that some investments may have been selected based on considerations other than poverty and need; (b) having very limited community involvement in some programs and works, especially those implemented by government agencies or contractors; (c) bypassing grassroots organizations by working exclusively with Solidarity Committees established for each small work; (d) presence of technical problems affecting the quality of implementation; and (e) lack of attention to operation and maintenance (O&M) issues. The experience of the current Bank financed first DRD project, which is supporting Solidarity investments in the four poorest states, is reviewed in paras. 2.27 to 2.34 and Annex E. 1.24 The Solidarity Program therefore, should not be seen as a unitary program, but rather as a general approach to poverty alleviation and regional development and an umbrella for many different programs. Because of that, both the first and proposed second DRD projects are designed to support only specific initiatives within Solidarity which best target poor populations and which best advance decentralization and the strengthening of local institutions. 5. While the se of exftme rural poverty, as measured by INEGI, has decreased from 28 percent to 26 percent ftom 1989 to 1992, it is not possible to draw a relationship betwen this decrease and Solidarity.  -7- II. RURAL DEVELOPMENT AND DECENTRALIZATION STRATEGY A. Introduction 2.1 Through its management of Solidarity, SEDESOL has undertaken the central role in developing national policies and program strategies for rural development, including the decentralization of investment in rural areas to state and municipal governments and community groups. The articulation of these strategies, until recently, have been confined to broad program documents,6 the Manual Unico de Solidaridad, and the operational manuals and technical guidelines for its individual programs (see references in Annex M). During the implementation of the first DRD project and the preparation of the follow-up, Second DRD project, SEDESOL has further defined strategies for improving the targeting and quality of implementation of investment programs and for strengthening state and local institutions involved in rural development and rural poverty alleviation. SEDESOL's general strategies for supporting poverty alleviation activities of state and local government and communities are presented in the Policy Letter (see Annex L) signed by the Secretary of SEDESOL. Its more specific strategies relating to the program areas to be supported by the project (i.e. municipal development, small community investments, rural water supply, rural roads, and income-generating investments) are presented in the draft Project Operational Manual, which was completed prior to project negotiations. The contents of this manual are to be finalized as a condition of loan effectiveness (see para. 4.1(a) and 4.2(a)). SEDESOL's strategies for supporting rural development and decentralization are summarized in the four sections below (sections B through E). B. SEDESOL's Strategy for Strengthening Capacity of Rural Municipalities 2.2 Rural municipalities suffer from a series of important limitations: (a) nearly complete dependence on external resources, mainly revenue-sharing distributed monthly by the state government; (b) requirement that municipal legislation be approved by the State Congress; (c) complete change in elected and nonelected municipal officials every three years, resulting in lack of technical capacity and continuity in development activities; (d) lack of services provided by state and federal agencies, as there are few incentives for civil servants to provide outreach to rural areas; and (e) sufficient resources are not available to support priority public investment in basic services. 2.3 Solidarity is a significant provider of investment funds for rural municipalities. Solidarity programs managed by municipalities include: Municipal Funds, School Rehabilitation (Escuela Digna), Production Support Funds (Fondos de Solidaridad para la Producci6n), and Children of Solidarity (Ninos en Solidaridad). The two latter programs, Fondos de Solidaridad and NMbos en Solidaridad, are transfer programs designed to assist poor producers and poor school children, respectively. Because the project focuses on strengthening local capacity to manage local investment activities, especially rural infrastructure, SEDESOL's strategy for these twv areas is not addressed here. 6. For exmple, La Solidaridad en cl Desarrollo Nacional, La Nueva Relacion entre Sociedady Gobierno, SEDESOL, March 1993.  2.4 Municipal Funds and Escuela Digna each provide investment funds that are to be used by municipalities in conjunction with community Solidarity Committees. In the case of Escuela Digna, these investments are limited to school rehabilitation. In the case of Municipal Funds, funds can be used to finance a wide range of small subprojects. In both programs, subprojects are managed directly by communities, with the communities contributing unskilled labor, local materials, and cash, equivalent to at least 20 percent of the total investment cost. In many rural municipalities, the Municipal Funds program alone has more than doubled the amount of investment resources available to the local jurisdictions. 2.5 Together, the Municipal Funds and Escuela Digna programs constitute an important step toward simplifying and making more responsive the planning and implementation of public investment in rural communities. Municipalities can use these resources to respond rapidly to communities' requests for water supply, the rehabilitation of a section of rural road, paving of the streets of the town center, or reconstruction of a dilapidated school building. However, because these investments are implemented by the communities themselves, the program is most successful in financing projects requiring a minimum of technical input. 2.6 In addition to targeting Solidarity programs to poor municipalities, some state governments have modified their formulas or coefficients for distributing federal revenue-sharing to target a greater proportion of these resources to poor municipalities,' or have initiated their own matching grant programs to support municipal investment.' lb strengthen the quality of municipal investment, SEDESOL and the state governments are providing technical assistance and training for municipal officials, through their regional offices' within each state, although the coverage and effectiveness of these efforts vary by state. In addition, many states are undertaking other municipal development efforts, such as improving property tax collection and financial management systems, and legislative reforms to increase local autonomy. While these reforms may benefit rural municipalities, their effect is greatest on urban areas. 2.7 SEDESOL is committed to working with state governments to strengthen rural municipalities and communities through the following actions, which wvould be supported by the proposed project (see paras 3.20 and 3.21): (a) Improving the reliability and targeting of public funds to poor municipalities by linking the allocation of Municipal Funds to a distribution formula; (b) Promoting activity by the states to review and rationalize their formula for distribution of revenue sharing resources to municipalities; (c) Improving financial management activities by strengthening municipal tax codes and tax collection effort, and basic accounting systems. 7. For example, Hidalgo, Michoacan and Puebla. 8. For eample, Veracruz. 9. Each of the eight prject stats re divided into 10 to 12 reions. Both fdemal and state personnel from a range of line and central agencies are located in regional offices.  -9- (d) Strengthening community participation in municipal investment planning, by promoting participatory decision-making within the Municipal Funds and Escuela Digna programs; (e) Providing municipalities access to technical assistance and training to assist them to plan and implement simple infrastructure works; and (f) Supporting municipal efforts to make local services more self-financing and cost- effective by improving cost recovery for O&M (especially for water supply) and identifying ways to reduce energy costs and consumption. C. SEDESOL's Strategy for Rural Water Supply 2.8 Access to potable water is a major problem in Mexico's rural areas. Although 79 percent of Mexicans have access to potable water, 44 percent in localities under 5,000 do not. Of the 17 million Mexicans without accessible water supply, 72 percent live in localities with under 5,000 inhabitants, and of these 12.3 million individuals, 7.4 million (60%) live in the eight project states. In the eight states, 35.6 percent of the total population of 25.9 million are without accessible water supply, of which 78 percent live in localities under 5,000 population. 2.9 The tvo principal consequences of inadequate water supply are increased health costs, including the transmission of cholera and other intestinal diseases, and the cost of time spent carrying water to the household. Health is negatively impacted not only because of poor water quality, but also because high transport cost reduces the use of water for sanitary purposes. Women are the principal transporters of water in rural Mexican societies, frequently spending tuoo t three hours per day bringing the minimum requirement of water to the household. Making potable water supplies more accessible, through either a nearby standpipe or in-house plumbing, allows women to devote more time to economic activities, as well as to attend to other demands. 2.10 While from a legal point of view, water supply is a responsibility of the municipality, many rural municipalities in these states lack the technical and financial capacity to meet this responsibility. At the same time, federal and state institutions do not have sufficient capacity or incentives to meet this need because of the great number of small, geographically dispersed, wvrks required. 2.11 Government devotes most of its water supply investment to urban areas, where the establishment and strengthening of semi-autonomous water companies is a major goal. To resolve problems of water supply in rural areas, Government relies on the normal state investment programs, supplemented with funding targeted to poor areas by Solidarity. These supplementary program investments may occur through state and municipal water agencies or through Municipal Funds, which involve communities in project implementation and operation and maintenance. 2.12 SEDESOL:s strategy for meeting the demand for rural water supply involves working directly with state water agencies (SWAs) to: (a) Strengthen the capacity of SWAs to address the needs for water supply in rural areas through the establishment of a rural water supply intestate technical group (IM) and of municipal support units (MSUs) (see para. 3.29);  - 10 - (b) Assist municipalities to achieve full recovery of O&M costs, provide adequate routine maintenance, and deliver potable water by improving the quality of systems and strengthening management capacity; and (c) Increase the impact of investment in rural water supply by improving the selection of subprojects, using economic efficiency criteria. D. SEDESOL's Strategy for Rural Roads Rehabilitation and Maintenance 2.13 Mexico has approximately 210,000 km of roads, including a federal netwurk of 49,000 km, another 61,000 km which were recently transferred from the federal to state governments to create a state netvurk, and 100,000 km of feeder and rural roads for which responsibility is yet to be transferred from the federal government to state and local governments. In addition, there is a network of 32,000 km of tracks (brechas) where responsibility is shared by states and local governments. The entire network is in poor condition, with about 60 percent of the federal network and 65 percent of the state highways needing rehabilitation. The rural road system is in even worse condition, suffering from the greatest neglect and lack of rehabilitation and maintenance activities. The poor condition of these roads limits the access of rural families to social services, as well as to inputs and markets for their economic activities. 2.14 This situation has led Government to articulate a national strategy to revitalize and rebuild the country's roads and ensure proper maintenance. The Government's strategy seeks to: (a) focus investmnent in the rehabilitation and maintenance of the existing road netwvrk, activities which will bring higher economic returns than new construction; (b) encourage greater decentralization of responsibilities to lower levels of government; and (c) support institutional reforms required for improved road management practices to be implemented and sustained. Both the Bank-financed Highway Rehabilitation and Safety Project (Ln. 3628-ME, 1993), focusing on the federal highway network, and the MDB-financed Rural Roads Project, focusing on the secondary road netuvrk, also support the achievement of these objectives. Institutional strengthening activities for these new state agencies is to be partially supported by the MDB-financed project. 2.15 As part of a federal decentralization strategy, responsibility for 61,000 kn of secondary roads was transferred to the states in 1990. The federal government has also sought to transfer the rural road network. In most states, however, responsibility for rural roads has not been accepted by state governments, which have complained about their poor condition and the states' lack of resources and adequate institutions to undertake needed rehabilitation and maintenance activities. 2.16 As part of the strengthening of the new state road agencies (SRAs), important institutional adjustments are necessary, including establishing investment priorities to favor more economically sound investments in rehabilitation and maintenance rather than new construction, developing road maintenance planning and management systems, relying more systematically on the more efficient private contractor industry rather than on the state administration for the implementation of works, and creating partnerships with municipal governments, which in the medium term will likely be given responsibility for parts of the rural network. 2.17 SEDESOL's strategy for strengthening the rural road network to be supported by the proposed Second DRD project is consistent with and complementary of the strategies being pursued in  - 11 - the strengthening of the federal highway and state secondary networks, supported by the Bank and IDB-financed projects and includes the following: (a) Road Rehabilitation. Priority would be given to the rehabilitation of critical sections of rural roads over new construction. Appropriate construction technology would be used to rehabilitate Type E and F rural roads (single lane) at minimal cost, thereby serving the maximum rural population with limited investment resources. Design standards and engineering would be kept simple, and works would be limited to elimination of critical sections (spot improvement), giving priority to the concept of access as opposed to the concept of comfort or speed of transport. However, a balanced rural road strategy would be developed by each state, including planning for construction of priority new roads as well as rehabilitation and maintenance. (b) Planning. Rural roads rehabilitation and maintenance activities need to be based on reliable and updated information about the condition of the road network. An information and monitoring system, and related decision-making criteria, would be developed to help in the definition of priorities and allow technical activities to be planned. Because almost all roads present a similar, very poor condition, interim planning will be based on a simple prioritization criteria (density of population per kilometer of road) that gives priority to roads with a low cost per beneficiary, in order to obtain the maximum use of limited resources. (c) Municipal Participation. Tl prepare the way for the eventual transfer of maintenance responsibilities to municipalities, and to exploit the comparative advantage of municipalities to manage labor intensive works in rural areas, municipalities would be contracted to undertake important aspects, principally drainage works, of the rural roads rehabilitation and maintenance program. (d) Boad Management. SRAs would be strengthened in their capacity to manage the road network, to supervise contracted activities, and to provide technical assistance to municipalities. In order to support and manage the institutional strengthening program, emphasis will be given to the development of a rural roads 1TG and MSUs in each SRA (see para. 3.39). E. SEDESOL's Pilot Strategies to Increase Income-Earning Potential 2.18 Rural areas in the poor states lack economic stimulus, new investments in income-generating ventures, and employment opportunities. This is due not only to the difficulty in identifying economically &asible investments, but also the lack of technical assistance and investment capital available to rural producers and potential entrepreneurs. Problems are exacerbated by poor physical infrastructure and poorly developed systems for marketing and distribution. Prior to the recent adjustment and liberalization policies, Government's strategy in rural areas had been to support the producers of basic grains by providing subsidized inputs, including credit and other agricultural inputs, and price guarantees. In addition, since the 1970's, Government has provided targeted investment money for agriculture in poor rainfed lands, through its regional development programs,  - 12 - first the PIDER programs and then Solidarity'