Document of The World Bank FOR OFFICIAL USE ONLY Report No. 13257 PERFORMANCE AUDIT REPORT MEXICO FIRST SMALL AND MEDIUM SCALE INDUSTRY DEVELOPMENT PROJECT (LOAN 1552-ME) SECOND SMALL AND MEDIUM SCALE INDUSTRY DEVELOPMENT PROJECT (LOAN 1881-ME) THRID SMALL AND MEDIUM SCALE INDUSTRY DEVELOPMENT PROJECT (LOAN 2325-ME) JUNE 30, 1994 Operations Evaluation Department 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 Currency Unit - Mexican Pesos (Mex$) - 100 cents Average Exchange Rates 1978 US$1 - 22.8 1979 US$1 = 22.8 1980 US$1 - 23.0 1981 US$1 * 24.5 1982 US$1 - 57.4 1983 US$1 = 120.2 1984 US$1 = 167.8 1985 US$1 - 257.0 1986 US$1 = 611.8 1987 US$1 - 1,378.2 1988 US$1 = 2,273.1 1989 US$1 = 2,461.5 1990 US$1 = 2,812.6 1991 US$1 = 3,018.4 1992 US$1 = 3,094.9 1993 (April) US$1 = 3,095.5 ABBREVIATIONS AND ACRONYMS USED ACF - Index of Average Cost of Funds CENAPRO - Centro Nacional de Productividad DGCP - Direccion General de Capacitacion y Productividad ERR - Economic Rate of Return FRR - Financial Rate of Return FI - Financial Intermediary FIDEIN - Fideicomiso de Conjuntos, Parques y Ciudades Industriales (Trust Fund for Industrial Parks Development) FOGAIN - Fondo de Garantia y Fomento a la Industria Mediana y Pequefia (Guarantee and Small and Medium Industry Development Fund) FOMIN - Fondo Nacional de Fomento Industrial (National Fund for Industrial Development) GATT - General Agreement on Tariffs and Trade GIRA - General Interest Rate Agreement IDB - Inter-American Development Bank IMF - International Monetary Fund INFOTEC - Servicio de Informacion Tecnologica NAFIN - Nacional Financiera S.A. (Government's National Industrial Development Bank) NAFTA - North American Free Trade Agreement PAI - Programa de Apoyo Integral a la Industria Mediana y Pequefia (National Program for SMI Development) PCR - Project Completion Report PCR I - Mexico - First and Second SMI Project, PCR, Report No. 7552 PCR II - Mexico - Third SMI Project, PCR, Report No. 11484 PFI - Participating Financial Intermediary QRs - Quantitative Restrictions SAR - Staff Appraisal Report SECOFI - Secretaria de Comercio y Fomento Industrial (Ministry of Trade and Industrial Development) SFB - Standard factory building SHCP - Secretaria de Hacienda y Credito Publico SMI - Small and Medium Scale Industry SHE - Servicio Nacional de Empleo TA - Technical Assistance FISCAL YEAR January 1 - December 31 FOR OFFICIAL USE ONLY THE WORLD BANK Washington, D.C. 20433 U.S.A. Office of Director-General Operations Evaluation June 30, 1994 MEMORANDUM TO THE EXECUTIVE DIRECTORS AND THE PRESIDENT SUBJECT: Performance Audit Report on Mexico First to Third Small and Medium Scale Industry Development Projects (Loans 1552. 1881. 2325-ME) Attached is the Performance Audit Report on Mexico - First, Second and Third Small and Medium Scale Industry Development Projects (Loans 1552, 1881, 2325-ME) prepared by the Operations Evaluation Department. The objectives of the three projects were to provide financial and technical assistance to small scale enterprises, and to strengthen the financial intermediation role of the institutions concerned. The resource transfer objective was met but the impact of the projects on improving organizations supporting loan and investment operations was very limited. Rating differences among the projects are minor. The first two are rated marginally unsatisfactory, and the third marginally satisfactory, mainly because under the third project Mexico's need for resource transfers was greater, interest rates on new and outstanding subloans were more appropriate, implicit subsidization of SMI was lower, the institutional performance of one intermediary better, and the operations of the industrial extension service were more cost-effective. For all three projects, sustainability is rated as uncertain and the institutional development impact as modest. The PAR ratings differ slightly from the ones of the PCRs which, on balance, consider the three projects as satisfactory. In designing these projects, Bank staff attempted to introduce new appraisal techniques and technical assistance delivery programs--with meager results. Lack of coordination among executing agencies and poor sub-project monitoring hindered progress. Bank supervision focused on resource transfer; not enough attention was paid to institutional development and technical assistance. In addition, the audit points out that these projects were undertaken without adequate sector studies and, especially in the case of the first two projects, implemented during a period of extreme macroeconomic instability and major distortions within the financial and industrial sectors. Government policy favored the subsidization of term lending through trust funds and the apex arrangement was not conducive to proper accountability in appraisal and supervision tasks. Robert Picciotto by H. Eberhard Kdpp Attachment This document has a restricted distribution and may be used by recipients only in the performance of their ofrocial duties. Its contents may not otherwise be disclosed without World Bank authorization. FOR OFFICIAL USE ONLY PERFORMANCE AUDIT REPORT MEXICO FIRST, SECOND AND THIRD SMALL AND MEDIUM SCALE INDUSTRY (SMI) DEVELOPMENT PROJECTS (LOANS 1552-ME, 1881-ME, AND 2325-ME) TABLE OF CONTENTS PAGE NO. PREFACE . . . . . . . . . . . . . . . . . . . . . . . . . . . . .i BASIC DATA SHEET . . . . . . . . . . . . . . . . . . . . . . . .iii EVALUATIONSUMMARY . . . . . . . . . . . . . . . . . . . . . . . xiii I. BACKGROUND.................... . . . 1 Macroeconomic Situation.. ............ . 1 Industrial Policies. . ........... . . . . 3 Financial Policies.. ........... . . . . 4 II. PROJECT OBJECTIVES, DESIGN AND RELEVANCE..... . . . . . . 7 Objectives................... .. . 7 Assessment of Objectives.. ........... . 7 Project Design................. . . 8 Relevance of Project Components. ......... . . .10 III. PROJECT OUTCOME, ASSESSMENT AND SUSTAINABILITY..... . . .11 Project Outcome............. .... . . .11 Resource Transfer . . . . . . . . . . . . . . . . . 11 Technical Assistance . . . . . . . . . . . . . . . 14 Institutional Development and Financial Performance 15 Project Assessment............ ... . . .20 Sustainability.............. ... . . .22 Institutional Sustainability. ........ . . .22 Sub-Project Sustainability. ........ . . . .23 Sustainability of Bank SMI Lending..... . . . .23 This report vas prepared by Nicolas Mathieu (Task Manager) and Derek White (Consultant) who audited the projects in October 1993. Jasmine Mason-Anderson provided word processing assistance. 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. TABLE OF CONTENTS (CONT'D) PAGE NO. IV. BANK AND BORROWER PERFORMANCE ............ . 24 Bank Performance . . . . . . . . . . . . . . . . 24 Borrower Performance......... ... . . . . . 25 V. CONCLUSIONS AND LESSONS OF EXPERIENCE...... . . . . . .26 Conclusions ..................... . 26 Project Identification . . . . . . . . . . . . . . 26 Project Design . . . . . . . . . . . . . . . . . . 27 Project Implementation . . . . . . . . . . . . . . 28 Audit Rating of the Projects. .......... . . .28 Leasons of Experience........... .... . .29 ANNEXES I Institutional Development 1978-1989 . . ... . . . 31 II FOGAIN - Subsidy Dependence Index 1983-1985..... . .34 III Comments from Ministry of Finance and Nacional Financiera, S.N.C......... . . .35 PERFORMANCE AUDIT REPORT MEXICO FIRST, SECOND AND THIRD SMALL AND MEDIUM SCALE INDUSTRY (SMI) DEVELOPMENT PROJECTS (LOANS 1552-ME, 1881-ME, AND 2325-ME) PREFACE 1. This is a Performance Audit Report (PAR) for three loans extended by the World Bank to Mexico during the 1978-89 period: the First, Second and Third Small and Medium Scale Industry (SMI) Development Projects (Loans 1552, 1881, 2325-ME). 2. The first SMI project was approved on April 27, 1978, fully disbursed, and closed on September 30, 1982, as scheduled. The second project was approved on June 24, 1980, fully disbursed, and closed on June 30, 1985, about six months later than originally planned. The third SMI project was approved on June 23, 1983, also fully disbursed, and closed on September 30, 1989, more than two years after the original closing date. 3. This PAR was prepared by the Operations Evaluation Department (OED). It is based on the Staff Appraisal Reports, the Loan Agreements, the Project Completion Reports (PCRs), the official files of the projects and discussions with World Bank staff. In addition, an OED mission visited Mexico in October 1993 and discussed the effectiveness of Bank assistance with Government officials, the Nacional Financiera, S.N.C (NAFIN) and representatives of the business and financial communities. Their kind cooperation and invaluable assistance during the mission are gratefully acknowledged. 4. The PCRs (Report No. 7552 for the first two projects and No. 11484 for the third project) were prepared by the Latin America and Caribbean Regional Office, with Part II contributed by the Borrower for the third project. The PCRs concluded that the projects were successful in transferring resources. However, it was recognized that the impact of the projects on institutional strengthening was limited. The PAR extends the investigation into the institutional capabilities of the implementing agencies to deliver loans and technical assistance efficiently. The PAR gives some new insights on the subsidy issue and discusses the sustainability of SMI lending operations. 5. The draft PAR was sent to the Borrower for comments. The comments received from Ministry of Finance and Nacional Financiera are reproduced as Annex III to the PAR. - iii - PERFORMANCE AUDIT REPORT MEXICO FIRST SMALL AND MEDIUM SCALE INDUSTRY (SMI) DEVELOPMENT PROJECT (LOAN 1552-ME) BASIC DATA SHEET LOAN POSITION (Amounts in US$ Million) As of March 31, 1994 Loan Original Disbursed Cancelled Repaid Outstanding 1552-ME 47.0 47.0 - 47.0 CUMULATIVE ESTIMATED AND ACTUAL DISBURSEMENTS FY78 FY79 FY80 FY81 FY82 Appraisal Estimate (US$M) 10.0 27.5 41.0 47.0 47.0 Actual (US$M) - 27.2 39.9 45.3 47.0 Actual as Z of Estimate - 98.9 97.3 96.4 100.0 Date of Final Disbursement: December 6, 1982 PROJECT DATES ORIGINAL ACTUAL Board Approval 04/27/78 04/27/78 Loan Signing 05/04/78 05/04/78 Effectiveness 10/01/78 01/12/79 Completion of Commitments 06/30/81 09/30/81 Loan Closing 06/30/82 09/30/82 SUPERVISION RATINGS (Form 590) Evaluation Development Legal Management Availability Year Overall Obiectives Covenants Performance Funds 1980 1 1 1 1981 1 1 2 1 1982 1 1 2 1 1983 1 1 2 1 - iv - STAFF INPUT I7 F8 F FY79 Y80 FY81 FY82 FY83 FY84 FY85 FY86 FY87 TOTAL Preappraisal 51.3 0.8 52.2 Appraisal 63.2 1.4 64.6 Negotiation 10.8 10.8 Supervision 0.1 7.5 7.7 5.9 2.7 0.1 10.7 6.4 41.2 Other 1.4 2.2 0.1 1.0 0.1 4.9 Total 51.3 74.9 9.0 9.9 6.0 3.7 1.5 0.1 10.7 6.4 173.6 MISSION DATA No. of No. of Date of MonthlYear Persons Staff Weeks Report Pro-appraisal 01/77 3 52.21' 09/77 Appraisal I 08/77 4 64.61' 04/78 Supervision 1 11/78 3 .1 12/78 Supervision II 02/79 1 3.5 03/79 Supervision III 11/79 4 4.0 12/79 OTHER PROJECT DATA Borrower/Executing Agency: Nacional Financiera S.N.C. Follow-on Projects: Project: Second Small and Medium Scale Industry (SMI) Development Project Loan No.: 1881-ME Amount: US$100.0 Million Board Date: June 24, 1980 Project: Third Small and Medium Scale Industry (SMI) Development Project Loan No.: 2325-ME Amount: US$175.0 Million Board Date: June 23, 1983 Project: Fourth Small and Medium Scale Industry (SMI) Development Project Loan No.: 2858-ME Amount: US$185.0 Million Board Date: June 25, 1987 Report writing included. - v - PERFORMANCE AUDIT REPORT MEXICO SECOND SMALL AND MEDIUM SCALE INDUSTRY (SMI) DEVELOPMENT PROJECT (LOAN 1881-ME) BASIC DATA SHEET LOAN POSITION (Amounts in US$ Million) As of March 31, 1994 Loan Original Disbursed Cancelled Repaid Outstanding 1881-ME 100.0 99.54 0.46 72.63 26.90 CUMULATIVE ESTIMATED AND ACTUAL DISBURSEMENTS FY80 FY81 FY82 FY83 FY84 FY85 Appraisal Estimate (US$M) 8.0 41.0 71.0 85.0 88.0 - Actual (US$M) 24.0 46.0 72.0 92.5 100.0 - Actual as % of Estimate 300.0 112.2 101.4 108.8 113.6 - Date of Final Disbursement: July 24, 1985 PROJECT DATES ORIGINAL ACTUAL Board Approval 06/24/80 06/24/80 Loan Signing 09/29/80 09/29/80 Effectiveness 12/22/80 12/22/80 Completion of Commitments 12/31/83 12/31/84 Loan Closing 12/31/84 06/30/85 - vi - SUPERVISION RATINGS (Form 590) Evaluation Development Legal Management Availability Year Overall Oblectives Covenants Performance Funds 1980 1 1981 1 1 2 1 1982 2 1 2 3 1983 1 1 2 1 1984 1 1 2 1 1985 1 1 2 1 1986 2 1 2 1 1987 2 1 2 1 STAFF INPUT FY77 FY78 FY79 FY80 FY81 FY82 FY83 FY84 FY85 FY86 FY87 TOTAL Preappraisal 23.3 23.3 Appraisal 47.3 47.3 Negotiation 6.7 6.7 Supervision 7.1 8.0 3.3 4.1 4.0 11.8 6.8 45.1 Other 2.1 0.1 2.2 Total 79.3 7.2 8.0 3.3 4.1 4.0 11.8 6.8 124.6 MISSION DATA No. of No. of Date of Month/Year Persons Staff Weeks Report Appraisal II 02/80 7 47.31' 05/80 Supervision I 06/80 2 3.7 07/80 Supervision II 09/80 1 4.0 10/80 Supervision III 01/81 1 6.0 02/81 Supervision IV 10/81 4 7.0 12/81 Supervision V 06/82 3 10.7 08/82 Supervision VI1 09/83 1 3.3 11/83 Supervision V112/ 03/84 1 4.1 07/84 Completion 05/86 2 5.0 06/87 li Report writing included. It Includes supervision for Loan 2325-ME. - vii - OTHER PROJECT DATA Borrower/Executing Agency: Nacional Financiera S.N.C. Follow-on Projects: Project: Third Small and Medium Scale Industry (SMI) Development Project Loan No.: 2325-ME Amount: US$175.0 Million Board Date: June 23, 1983 Project: Fourth Small and Medium Scale Industry (SMI) Development Project Loan No.: 2858-ME Amount: US$185.0 Million Board Date: June 25, 1987 - ix - PERFORMANCE AUDIT REPORT MEXICO THIRD SMALL AND MEDIUM SCALE INDUSTRY (SMI) DEVELOPMENT PROJECT (LOAN 2325-ME) BASIC DATA SHEET LOAN POSITION (Amounts in US$ Million) As of March 31, 1994 Loan Orizinal Disbursed Cancelled Repaid Outstanding 2325-ME 175.0 174.98 0.02 109.34 65.64 CUMULATIVE ESTIMATED AND ACTUAL DISBURSEMENTS FY83 FY84 FY85 FY86 FY87 FY88 FY89 Appraisal Estimate (US$M) 36.0 100.0 157.0 175.0 175.0 175.0 175.0 Actual (US$M) - 38.5 124.9 149.1 172.8 173.6 175.0 Actual as Z of Estimate - 38.5 79.6 85.2 98.7 99.2 100.0 Date of Final Disbursement: October 16, 1989 PROJECT DATES ORIGINAL ACTUAL Identification 06/10/82 06/10/82 Appraisal Missions let Mission 09/20/82 09/20/82 2nd Mission 01/10/83 01/10/83 Loan Negotiations 04/20/83 04/20/83 Board Approval 06/23/83 06/23/83 Loan Signature 08/25/83 08/25/83 Loan Effectiveness 09/27/83 02/27/84 Loan Closing 06/30/87 06/30/88 09/30/89 - x - SUPERVISION RATINGS (Form 590) Evaluation Development Legal Management Availability Year Overall Obiectives Covenants Performance Funds 1984 2 1 2 1 1985 2 1 1 1 1986 2 1 2 1 1987 2 1 2 1 1988 2 1 2 1 1989 2 1 1 2 1 1990 2 1 1 2 1 STAFF INPUT* Stage of Proiect Cycle Staffweeks Preappraisal 17.2 Appraisal 65.4 Negotiation 9.9 Supervision 125.7 Others 12.1 Total 251.0 MISSION DATA No. of No. of No. of Date of Month/Year Persons Weeks Staff Weeks Report Appraisal 06/82 4 4 16 05/83 Post-Appraisal 01/83 3 3 9 05/83 Supervision** 08/83 1 2 2 11/83 Supervision 11/83 1 1 1 12/83 Supervision 12/83 1 1 1 02/84 Supervision** 03/84 1 2 2 06/84 Supervision 04/85 1 2 2 07/84 Supervision 06/85 1 2 2 10/85 Supervision** 07/85 2 2 4 11/85 Supervision 02/86 1 1 1 02/86 Supervision** 12/86 1 2 2 01/87 Supervision** 09/87 2 2 4 11/87 Supervision** 10/88 2 1 2 11/88 Supervision 02/89 2 1 2 02/89 PCR 02/91 1 2 2 04/91 (draft) * Only subtotals are available from the Time Recording System. ** Combined with supervisions of other projects. - xi - OTHER PROJECT DATA Borrower/Executing Agency: Nacional Financier& S.N.C. Follow-on Proiectsa: Project: Fourth Small and Medium Scale Industry (SMI) Development Project Loan No.t 2858-ME Amount: US$185.0 Million Board Date: June 25, 1987 - xiii - PERFORMANCE AUDIT REPORT MEXICO FIRST, SECOND AND THIRD SMALL AND MEDIUM SCALE INDUSTRY (SMI) DEVELOPMENT PROJECTS (LOANS 1552-ME, 1881-ME, AND 2325-ME) EVALUATION SUMMARY Introduction tion of a range of detailed government controls. However, in 1985, recog- 1. Economic Background. The three nizing the need for basic improvements SMI projects were prepared and dis- in economic efficiency and more rapid bursed during an extremely turbulent and sustainable long-term growth, the period in Mexico's economic history Government slashed QRs, cut tariffs in that culminated in a fundamental re- half, and eased controls over non- orientation of government economic manufactured exports. Mexico subse- policies. The macroeconomic situation quently joined the GATT. These steps featured growing economic stagnation were followed by substantial disman- in the early to mid-seventies, an oil tlement of the sector programs, wide- boom in the late seventies, and a spread economic deregulation and the major financial and balance-of-pay- negotiation and signing of the NAFTA. ments crisis in 1982. This was fol- lowed by partial recovery in 1984-85 3. Financial Policies. The finan- and a further financial crisis, accom- cial system was traditionally a vehi- panied by exploding inflation, in cle for the pursuit of the 1986. A sustainable recovery, based Government's development policies. on massive cuts in government spend- Instruments employed included govern- ing, began in 1987. The public sector ment controls over interest rates, the deficit was eliminated and inflation direction of credit through the com- reduced to single digit levels by mercial banks (which were nationalized 1993. From 1985 on, the Government in 1982) and the allocation of subsi- carried out sweeping reforms designed dized credit through a network of to transform the Mexican economy into public development banks and trust one that is efficient, market-respon- funds. This system responded only sive and outward-oriented. imperfectly to market forces. In particular, interest rates lagged 2. Industrial Policies. Industrial behind inflation, particularly on policy encouraged import substitution longer term credit instruments and after the mid-fifties. This was government loans through the public achieved initially through the imposi- network. From the early eighties tion of higher tariffs on imports. until 1986-87, increasingly onerous However, during the seventies, mandatory interest-earning reserve increasing resort was made to QRs on requirements, imposed on the crmer- imports. Following the 1982 crisis, cial banks to assure the financing of QRs were imposed on all imports. public expenditure, crowded many pri- During the early eighties, attempts vate firms out of the formal financial were made to foster priority sectors system. in manufacturing through the imposi- - xiv - 4. During the early eighties, the NAFIN/PAI assumed the exchange risks. structure of interest rates in the public system was gradually made more 6. The overall PAI program was coor- responsive to market forces. In the dinated by a committee chaired by late 1980s, a financial sector reform NAFIN. FOGAIN and FIDEIN were each to was carried out. It involved the receive a margin sufficient to cover rewriting of the legal framework for their costs, paying the rest of their the financial sector, the liberaliza- interest receipts to PAI. FOMIN was tion of interest rates, the abolition to repay PAI the net amounts recovered of forced investments by the commer- from its equity investments but to cial banks, rationalization of the keep half of its capital gains and 20 network of public institutions, and percent of the interest received on reprivatization of the commercial its convertible loans. (PAI thus coy- banks. Under the NAFTA, the financial ered FOMIN's losses on bad invest- sector will be opened up to foreign ments.) The PFIs, which were to as- competition. sume the credit risks and undertake the initial appraisals of the sub- Prolect Obiectives and Design projects, were to receive a margin (initially 3 percentage points) to 5. The main objectives of the three cover their costs. projects were to provide a range of financial services, together with 7. Credit to SMI under SMI I and II technical and managerial support, to was at fixed rates, initially, 16 per- SMI, and to promote regional decen- cent but averaging the banks average tralization. There were four main cost of funds (ACF) plus 1 to 3 per- components: (i) credit, provided centage points after January 1, 1979. through a trust fund, FOGAIN, which, Under SMI III, subloans were made at acting as a second-tier lender, chan- variable rates based on the ACF; fur- nelled funds to SMI through partici- thermore, arrangements were made to pating PFIs; (ii) equity, preferred apply variable rates to FOGAIN's out- share and convertible debenture fi- standing portfolio of fixed-rate nancing, provided directly to SMI loans. through FOMIN, another trust fund; (iii) construction and leasing of Project Implementation factory buildings, leasing of machin- ery, and construction and leasing of 8. Following start-up delays, dis- common facilities, all on industrial bursement was rapid under the first estates, undertaken, for SMI, by two loans because of the boom condi- FIDEIN, a third trust fund; and (iv) tions prevailing during the late-sev- industrial extension services for SMI enties to very early eighties, coupled provided by a newly created corps of with low interest rates. However, agents under PAI, a technical secre- slow economic growth after the mid- tariat taking its name from the over- eighties delayed disbursement of the all SMI support program. PAI was third loan. established under NAFIN, a state de- velopment bank serving the industrial 9. Provision of Credit. Under the sector. FOGAIN, FOMIN and FIDEIN were first and the second projects, the administratively also under NAFIN. FOGAIN credit component reached its Each project loan involved an alloca- target group of SMI, and financed tion of funds to the four components. subprojects with high estimates of ex NAFIN transferred the proceeds of the ante ERRs and FRRs. A subsequent sur- loans to the trust funds in pesos and vey of a small sample of the sub- - xv - projects showed, however, a somewhat was absorbed by RAFIN. less satisfactory Ax post performance, mainly as a result of depressed eco- 12. Technical Assistance. PAI's in- nomic conditions, inflation, and high dustrial extension agents focussed financing costs. With regard to the initially on the promotion of FOGAIN third project, the SAR for the fourth loans, operating on a one-on-one basis project concluded that the SMIs ap- vis-a-vis SMI, but subsequently were peared to operate with positive ERRs reoriented towards the provision of and FRRs. more broadly based technical assis- tance to clusters of small enterpris- 10. Equity Financing. FOMIN equity es. The TA components of the Bank and quasi-equity financing went mainly loans, managed by PAI, went mainly to to medium-sized companies, some be- INFOTEC and other institutions provid- longing to larger conglomerates, as ing services to SMI, rather than to small companies were reluctant to have the three implementing agencies. A the government as an equity partner. large proportion of the funds was used The investments were overwhelmingly for general purposes only indirectly oriented towards the domestic market. related to the loans' objectives. Although the sub-projects showed good ex ante and ex post rates of return, Institutional Strengthening most enterprises financed under the first two loans were encountering 13. FOGAIN grew rapidly, matured and problems by 1985, with only 17 percent grew stronger under the three loans operating profitably. Most of FOMIN's but its subloan appraisal capability share sales either involved no real evolved slowly and it made little gains or entailed real losses, effort to promote subproject evalua- reflecting poor investments, a weak tion by the F. FOMIN also grew divestiture policy, and limited FOMIN substantially. It initially placed bargaining power. The projects failed inadequate emphasis on managing its to establish a secondary market for portfolio but this improved through SMI shares, as hoped, and less than time. FIDEIN suffered, under SI I and half of the investments were rated II, from serious management problems, satisfactory when FOMIN was absorbed financial irregularities, changes in by NAFIN and liquidated in the late- role, and disappointing results. Its eighties. performance improved considerably in its changed role under SMI III. 11. Industrial Estate Construction and Leasing. FIDEIN's performance was Institutional Financial Performance disappointing, the demand for its standard factory buildings less than 14. PAI was set up with US$ 22.5 expected, and it experienced difficul- million in government seed capital and ty in disposing of its inventory of received the principal of the Bank buildings. However, it reached mainly loans as additional capital. It also SMI, a large proportion new. Under received government subsidies to cover the third project, its role, apart its operating expenses. However, from providing extensive technical PAI's capital was quickly eroded, as assistance, was restricted to the FOGAIN kept most of the interest it financing of infrastructure, plus in- was to have paid PAI. At the same dustrial buildings run by leasing time, PAI had to pay interest on its companies. Almost a third of its foreign borrowings, on which it in- clients were in arrears or facing curred large exchange losses, plus judicial proceedings at the time it high interest payments on its - xvi - borrowings from the Bank of Mexico and because they are made in terms of NAFIN. Moreover, PAI realized losses gross (as opposed to net) employment both on FOMIN's investments and from additions. Moreover, the recessionary repayments of principal by FOMIN and aftermath of external shocks and poor FIDEIN in nominal terms during a peri- government macroeconomic policies was od of high inflation. Its receipts to leave many firms in difficulty and from its share in FOMIN's capital realized rates of return below antici- gains were small. A consequence of pated levels. Regionalization objec- these developments was that, by 1986, tives were partly achieved and PAI its assets in dollar terms were less achieved modest success with its tech- than 20 percent of the original amount nical and managerial assistance and invested by the Government. the extension service, although the latter may not have been cost-effec- 15. Although making losses prior to tive. However, in its coordinating 1984, FOGAIN was able to lend at sig- and allocative roles, PAI was an in- nificantly below market rates and make stitutional failure. The Bank TA a profit over 1984-86 because it was components were loosely designed, able to borrow from PAI and other poorly administered and supervised, sources at very considerably below the and did not serve the loans' objec- ACF and was absolved from exchange tives well. losses. Part of the improvement in its position was at the cost of 18. FOGAIN did not ensure adequate decapitalizing PAI. Despite FOGAIN's appraisal and supervision of its sub- below-market borrowings, its onlending projects but otherwise performed rea- rate was so low that it earned a re- sonably well. FOMIN, although innova- turn on its equity below the opportu- tive, lacked a real role, was finan- nity cost of capital. cially unsuccessful and failed to reach SSEs. FIDEIN's activities under 16. FOMIN's financial performancewas the first two projects were poorly apparently satisfactory from 1980 on managed and unsuccessful but improved but it was implicitly heavily subsi- notably under the third. FIDEIN was dized by PAI and also contributed to also financially mismanaged and proba- its decapitalization. Finally, al- bly unprofitable. A clear success for though very limited information is the three projects was to contribute available concerning FIDEIN's finan- to the rationalization of Mexican cial performance, it also repaid prin- interest rates. However, their con- cipal in nominal terms to PAI and tribution to institutional develop- contributed further to its decapitali- ment, apart from that inherent in zation. FIDEIN's income over 1979-84 better trained people, was negligible. was only significantly positive in 1981-82, despite its inclusion of Sustainability government subsidies as income. 19. The institutional unsustainabi- Proiect Assessment lity of the projects is attested to by the eventual abolition of PAI and the 17. Overall, the credit component was separate trust funds under the Govern- successful in reaching SMI, financing ment's 1988-92 financial reform pro- projects with satisfactory ERRs and gram. As now established under NAFIN, FRRs, and, in the case of SMI III, the provision of credit to SMI for transferring resources to Mexico at a investment and credit or technical difficult time. Claims of substantial assistance for industrial estates, employment creation appear overstated infrastructure and buildings appears - xvii - to depend either on the persistence of The technical assistance component was significant market imperfections al- poorly defined and inadequately super- lowing NAFIN to occupy a transitorily vised. Supervision in general, al- profitable niche or on continuing though adequate in volume, left large public subsidies. NAFIN is likely to gaps. find it difficult to operate without subsidies in the increasingly competi- Borrower Performance tive financial services environment resulting from the NAFTA. As far as 21. Shortcomings on the borrower side the sustainability of the sub-prolects include NAFIN's ineffectual coordina- is concerned, there will probably be tion, failure to ensure PAI's finan- winners and losers as the restructur- cial viability, failure to maintain ing of Mexican industry gathers momen- accessible records, and lack of com- tum in response to recent and continu- pliance with some provisions of the ing changes in relative prices result- loan agreement. FOGAIN failed to ing from the liberalization of trade comply with the projects' provisions and widespread domestic deregulation. regarding the allocation of interest These changes will tend to benefit spreads, apparently did not fully larger-scale and more specialized protect the interests of SMI vie-a-vie production. Bank support for SMI as the commercial banks, devoted insuffi- carried out under this project is not cient attention to sub-project likely to be sustainable if existing appraisal and supervision, and did not credit market imperfections, currently maintain sufficient information relat- justifying a role for NAFIN, disap- ing to its sub-project portfolio. pear. Nonetheless, the objective of financ- ing economically sound SMI sub-pro- Bank Performance jects was met and it accepted the gradual rationalization of subloan 20. In retrospect, the performance of interest rates. FOMIN was slow to the Bank was less than satisfactory. improve its divestiture performance, The identification of the three pro- profitability and appraisal techniques jects under the macroeconomic and but performed well in meeting its sector conditions that prevailed ini- clients' needs. FIDEIN performed tially, particularly when there was no poorly under the first two loans but need for resource transfers, is ques- improved substantially under the tionable. It is not clear why policy third, although it failed to adhere to reform to address the underlying caus- some agreements and a loan condition. es of inadequate financing for SMI investments (inflation, controlled Conclusions interest rates, directed credit, etc.) was apparently not pursued as an al- 22. The identification of the pro- ternative. The lack of adequate jects under the prevailing conditions knowledge of the needs of SMI contrib- constituted an implicit endorsement uted to a poorly identified role for of poor government policies, possibly FOMIN. PAI was ill-conceived, given helped delay needed reforms, tended to the existing institutional environ- undermine the coherence of the Bank's ment, and its emerging deficiencies policy dialogue, and entailed credit not sufficiently forcefully addressed risks, although it may have strength- during supervision. The cost-effec- ened the Bank's influence over inter- tiveness of the industrial extension est rate policy. The lack of adequate service was not initially given ade- prior Bank sector knowledge contribut- quate weight and remains uncertain. ed to design flaws: particularly, - xviii - overestimation of the need for equity the ACF, so as to cover NAFIN's ex- financing and standard factory build- change risks. Even then, the NAFIN ings. Initial slowness in securing coordinating committee, despite its prompt adjustment of onlending rates prior ineffectiveness, was retained to ACF-based levels led to significant and the basic problems of administered real resource transfers from lenders interest rates, directed credit, and to borrowers. forced commercial bank investments remained unresolved. 23. While it was appropriate for NAFIN/PAI to be assigned responsibili- 25. On the plus side, the credit ty for the systematic foreign exchange components financed sound SMI invest- risks (as distinct from the cross- ments, some PFIs built up their pro- currency risks) arising from ject appraisal capabilities, disburse- lender/borrower inflation differen- ments under the third project provided tials and appropriate for sub-borrow- resources at a difficult time, and era implicitly to cover these risks by interest rates became more market- being required to pay ACF-based inter- related. Overall, the first two pro- est rates reflecting domestic infla- jects are rated marginally unsatisfac- tion, FOGAIN should not have been tory and the third, marginally satis- permitted to retain more of the inter- factory (para. 89). est that it received from PFI than the 2 percentage points allocated to cover Lessons of Experience its administrative costs, since this left PAI with major uncovered interest 26. The following principal lessons obligations, and contributed to its may be learnt from experience with the decapitalization. FOMIN and FIDEIN three projects: should have been required to repay capital to PAI in inflation-adjusted Interest rate policy changes are terms. more effectively negotiated across all projects than on a 24. PAI was not properly integrated project-by-project basis; into the institutional framework rep- resented by NAFIN and the trust funds Credit operations to finance SMI and its addition to the chain of sub- investments are risky when gov- loan approval lengthened and delayed ement overspending is courting an already cumbersome process. PAI's severe future macroeconomic in- financial deterioration was allowed to stability; persist for too long. FOGAIN's opera- tions were implicitly subsidized by When lending in an inflationary low borrowing rates and subnormal environment, it is important to returns on equity and, after 1984, by identify which institution will lack of exposure to exchange risks. bear the foreign exchange risks Some of the subsidies intended for SMI and to ensure that arrangements were apparently captured by the com- have been made to provide that mercial banks through the imposition institution with adequate compen- of side conditions. It was not until sation; the fourth project that some continu- ing problems were addressed by abol- Complex projects should not be ishing PAI, directly funding technical launched without adequate prior assistance to FOGAIN, FOMIN and sector work; FIDEIN, and effectively linking FOGAIN's interest payments to NAFIN to iCare should be taken not to fur- - xix - ther complicate an already over- - The responsibilities of each tier complicated institutional situa- of a two-tier operation, inclu- tion by adding yet another insti- ding the provision of informati- tutional layer (such as PAI); on, should be clearly defined and effectively monitored; - Organizational strengthening is inappropriate if the organiza- - Bank supervision of credit pro- tions themselves are inappropri- jects undertaken in a complex ate and thus unlikely to survive institutional and policy envi- in the long term; ronment should provide for a fortified mission during the - Subsidies intended for final early stages of each project, in borrowers can end up in the hands order to identify sectoral, in- of financial intermediaries; stitutional, and organizational problems that otherwise typically 27. Other lessons of experience, that tend to be overlooked or ignored; have been drawn elsewhere with respect to SMI projects, are as follows: - The Bank should strengthen its mechanisms for learning from its - Technical assistance should be as mistakes, which are frequently carefully designed and supervised repeated in follow-on projects. as any other part of a project; - Effective onlending rates to sub- borrowers and effective spreads to PFI should be closely monitored; PERFORMANCE AUDIT MEMORANDUM MEXICO FIRST, SECOND AND THIRD SMALL AND MEDIUM SCALE INDUSTRY (SMI) DEVELOPMENT PROJECTS (LOANS 1552-ME, 1881-ME, AND 2325-ME) I. BACKGROUND Macroeconomic Situation 1. Following a period of growing economic stagnation in Mexico accompanied by rising public sector deficits, a serious crisis erupted in 1976, leading to a major devaluation of the peso, which had been fixed vis-a-via the dollar since 1954. By then, it had become increasingly apparent that economic expansion based on import-substitution and public enterprise-led growth had run its course and that fundamental measures were needed to spur efficiency, raise productivity and restore growth. 2. However, large oil discoveries in 1977, at a time of rising world oil prices, substantially boosted public revenues, raised expectations of future revenue increases, and enabled the Government to put off socially painful basic policy reforms. Public spending increased, the public sector deficit rose to over 15 percent of GDP by 1982, and the Government borrowed heavily domestically and abroad, substantially increasing the public debt. Despite the increasing flight of domestic capital, the peso appreciated strongly in real terms. 3. Declining oil prices, rising interest rates on the external debt, and an accelerating flight of capital led to another major crisis in 1982 and necessitated further, severe depreciation of the peso. Strong government measures to deal with the crisis included an additional, 100 percent depreciation, the imposition of QRs on all imports, cutbacks in public expendi- ture, tax reforms, increases in public enterprise tariffs, and accelerated divestitures of public enterprises. 4. Although these measures enjoyed considerable short-term success in curtailing imports, boosting exports, and increasing output, the Government nonetheless recognized the need for more basic, structural reforms. In 1985, it initiated a program that included reductions in QRs, the divestiture of a large number of public enterprises, and the rationalization of some parastatal operations. However, inflation continued at high levels (Table 1), fiscal discipline again slipped, and the public sector deficit, exacerbated by weakening oil prices, climbed to over 14 percent of GDP in 1986-87. Monetary growth exploded and inflation increased to 159 percent in 1987. Table i: MACROECONOMIC INDICATORS - 1977-1989 (Percentages) 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 GDP Growth 3.4 8.3 9.1 8.3 8.0 -0.6 -4.2 3.6 2.6 -3.8 1.9 1.2 3.3 Public Sector Deficit/GDP 6.9 5.7 6.9 7.8 14.7 15.6 8.1 7.1 8.0 14.5 14.4 9.3 4.8 12 Money Supply 116.0 33.1 35.8 36.7 49.0 58.0 61.6 70.1 46.3 94.4 141.0 42.2 43.0 CPI Changell 21.0 16.2 20.0 29.8 28.7 98.9 10.8 59.2 63.7 105.7 159.2 51.7 19.7 Interest Rates (ACF) 12.9 15.1 16.4 20.7 28.6 46.1 56.4 47.5 65.7 95.3 104.3 45.5 40.1 Public Consumption Growth -1.1 9.9 9.5 9.5 10.1 2.0 2.7 6.6 0.9 1.5 -1.2 -0.5 -0.1 Public Investment Growth 7.8 9.5 10.2 10.9 11.7 -18.8 -36.0 4.1 0.9 -14.2 -12.3 -4.2 3.6 Private Investment Growth 11.8 11.6 13.2 13.3 14.0 -15.1 -22.1 7.9 12.2 -10.4 6.4 10.2 7.5 Year end over year end. Source: Bank of Mexico and Industrial Financial Statistics Yearbook 1993. - 3 - 5. The incoming Salinas administration faced the need, in 1988, both to implement a far more decisive and permanent stabilization program than had been undertaken previously and to extend the reform program initiated by the de la Madrid government into a thoroughgoing and irreversible restructuring of the Mexican economy. Its overall program, virtually unprecedented in its speed, scope and decisiveness, has included severe expenditure cuts, tax increases, sweeping trade reforms, comprehensive industrial and service sector deregulation, measures to speed up the transfer of foreign technology, and major financial reforms. Mexico's ratification of the NAFTA has consolidated and extended the trade reform and will open up the Mexican economy to foreign investment and competition in services such as banking and trucking. 6. The three SMI projects reviewed in this report were disbursed over 1978- 89, clearly one of the more turbulent periods in Mexico's economic history and one that has witnessed the transformation of a state-led, inward-looking, and highly regulated economy into one that is now private sector-led, market- oriented, and one of the most open in the western hemisphere. Industrial Policies 7. From the mid-fifties, Mexico's industrial policies, which were intended to build up Mexico's industrial capacity, emphasized import substitution and export promotion. Tariffs were raised, apart from a brief reversal over 1977-79, from 1956 throughout the sixties and seventies until 1981. QRs became the main instrument for promoting the domestic production of manufactured goods during the early to mid-seventies. Although import licensing requirements were briefly eased over 1977-79, they increased rapidly over 1979-81. 8. Efforts to increase manufactured exports included the introduction of the maquiladora program of in-bond manufacturing in 1965. Activity under the program grew rapidly and maquiladora exports (25 percent Mexican value added) accounted for two-thirds of Mexico's total exports in 1992. Additional measures to promote exports, introduced in 1971, produced strong export growth over 1970-74, but overvaluation of the peso and world recession led to declines over 1975-76. Efforts to promote exports were further intensified after the 1982 crisis, with the aid of World Bank export promotion loans. However, prior to the liberaliza- tion of imports beginning in 1985, the structure of industrial incentives remained heavily biased against exports. Non-manufactured exports were limited from the fifties on, initially in order to provide stable inputs at low prices to favoured sectors, but from the mid-seventies, also to offset inflationary pressures. 9. The 1982 crisis led to the temporary imposition of QRs on 100 percent of imports. These were eased slightly in 1983-84. During the early eighties, in an effort to alleviate balance-of-payments problems and promote certain sectors, the Government established a number of priority sector programs, the most important covering the automotive, pharmaceutical, petrochemical and computer subsectors. These programs featured import restrictions, tax incentives, entry restrictions, domestic content requirements, mandatory export quotas, import/export balance requirements, and, in some cases, price controls, in an effort to achieve the Government's objectives. 10. Following the initiation of serious trade reform in 1985, the Government slashed QRs over 1985-88, and cut average tariffs in half (Table 2). Export licensing, which had covered 49 percent of tradeable goods production in 1982, was reduced to 25 percent by mid-1988, at which time, export taxes applied to only 2.4 percent of exports. Many of the restrictions imposed under the priority sector programs were lifted, with Bank support under the 1989 Industrial Sector Policy Loan, and have since been further reduced. Mexico acceded to the GATT in 1986 and subsequently ratified the NAFTA, which went into effect in January, 1994. It provides for the elimination, over a ten-year period, of most tariffs and NTBs on American and Canadian products. Table 2: TRADE LIBERALIZATION, 1985-1991 Jun85 Jun86 Jun87 Jun88 Dec89 Dec90 Dec91 Import 92.2 46.9 35.8 23.2 20.3 17.4 17.4 Licensinge Referenpe 18.7 19.6 13.4 0.0 0.0 0.0 0.0 Prices! Tariffs-Maximum 100.0 45.0 40.0 20.0 20.0 20.0 20.0 -Average- 23.5 24.0 22.7 11.0 12.8 12.4 12.4 Export Controls- n.a. n.a. n.a. 23.4 17.9 17.6 17.4 a/ Percentage coverage of production of tradeables; 1986 weights. b/ Weighted by production of tradeables; 1986 weights; excludes 5 percent surcharge. Source: World Bank, Country Economic Memorandum. Financial Policies 11. Financial policies and institutions were also used as instruments of state development policy. Deposit rates were set by the Government, credit was directed to favoured sectors through the commercial banking system, and subsidized credit was similarly directed through a network of state development banks and trust funds. Prior to the reform of the financial system in 1988, there were 8 state development banks and 21 state trust funds, including FOGAIN, FOMIN and FIDEIN, the three trust funds dealing with small and medium industry (SMI). 12. Under this closely controlled system, interest rates, particularly on funds channelled through the development banks and trust funds, were not immediately responsive to changes in the supply of, and demand for, credit, and tended, particularly on longer-term instruments, to lag behind changes in the rate of inflation (Figure 1). This was partly the consequence of a deliberate attempt by the authorities, in setting interest rates, to dampen inflationary expectations. Symptomatic of the system's significant disregard for market forces was growing inefficiency within the formal banking system, financial disintermediation during periods of rising inflation, and the evolution of a more market-responsive system of credit allocation outside the formal banking system. 13. After 1982, the Government nationalized the entire private banking system, which thereafter increasingly became a mechanism for financing public expenditure - 5 - and providing credit to preferred sectors. Government financing was secured by requiring the commercial banks to maintain very large, interest-bearing reserves involving rates that were frequently negative in real terms. Many private firms were crowded out of the formal financial system as comercial bank lending to the private sector dropped from 40 percent of total bank credit in 1980-81 to only 20-25 percent in 1986-87. 14. With accelerating inflation after 1982 and delayed adjustment of the banks' ACF, real interest rates became negative from early 1982 to early 1984 (Figure 1), leading to real resource transfers from lenders to borrowers that were magnified in the case of the less market-sensitive lending undertaken by development banks and trust funds. This became an increasing source of concern for the Bank, which pushed the trust funds through which it was lending to link interest rates to final borrowers more closely to the current level of the ACF, Mexico's closest approximation to a market-determined rate. These efforts culminated in the negotiation of the General Interest Rate Agreement (GIRA), an umbrella agreement covering all World Bank loans to Mexico's state credit agencies. The GIRA linked average subloan interest rates to the ACF and reduced the degree of dispersion associated with government subsidization of favoured activities. However, the Central Bank still influenced the ACF through its power to set deposit rates. Figure 1 120 Interest Pates & I nf I at -on 100 s0 60 40 20 90.1 81.1 82.1 83 1 84.1 85.1 88.1 ACF AdJ uTed N+on controI Ied I c Source: World Bank, PCR No. 7552, Annex page 89. 15. The sweeping financial sector changes introduced by the Salinas adminis- tration over 1988-92 included reforming the legal framework for financial services, rationalizing the system of development banks and trust funds and reducing overstaffing, liberalizing deposit and lending rates, eliminating - 6 - mandatory, interest-bearing bank reserve requirements, and abolishing forced investments in treasury bills. FOGAIN and FIDEIN were absorbed into NAFIN and FOMIN was disbanded. The commercial banks were reprivatized over 1991-92. Notwithstanding these later reforms, during the period of approval and disbursement of the three SMI loans, the Mexican financial system remained heavily regulated and the allocation of credit highly distorted, although there was gradual improvement in the market responsiveness of subloan interest rates. - 7 - II. PROJECT OBJECTIVES, DESIGN AND RELEVANCE Obiectives 16. The stated objectives of Loan 1552 ME (SMI I) were to: (i) foster growth and employment by providing specialized financial services to SMIs wishing to increase their productive capacity; (ii) promote decentralization of economic activity by focussing on SMI outside the main urban areas; and (iii) develop, and promote the use of, an improved system of technical and managerial support to SMI that was to include the development and deployment of a corps of industrial extension agents. Underlying these aims was a desire to address the apparent failure of the commercial financial system to provide adequate access by SMI to long-term credit and equity financing. Strengthening the institutional apparatus for achieving these basic aims was an important, related objective. The objectives of Loan 1881 - ME (SMI II) and Loan 2325 - HE (SMI III) were essentially the same. SMI III additionally allowed for the financing (through FOGAIN) of common service facilities managed by groups of enterprises and provided for expanded financing of permanent working capital. Assessment of Obiectives 17. In the specific context of preparing and processing the three loans, the Bank essentially took the economic environment, government industrial and financial policies, the institutional framework for the financial sector, the Government's regional diversification policies, and its support for, and policies towards, SMI as given. It took little account (e.g., in the Presidents' Reports) of the potential effects of macroeconomic instability, distorted incentives, and the misallocation of credit on the subsequent economic performance of the subprojects to be financed. This may have been in the belief that, despite these potentially damaging influences, economically sound subprojects could be identified through the assiduous application of ERR and FRR criteria. 18. The Bank's extremely active subsequent involvement in the restoration of macroeconomic stability in Mexico, as well as in reforming the interest rate, trade, regulatory, and financial systems, indicate that these matters were, in fact, at the forefront of its concerns. The SMI loans' limited objectives and the project documents' uncritical acceptance of government policies were, from this perspective, surprising, giving, as they do, the appearance of a Bank operating out of a number of separate compartments. 19. The suggestion that the projects would "create" new jobs was misleading and inappropriate. It failed to take account of the fact that new investment typically entails shifts of workers from less to more productive jobs, without necessarily creating net new employment, and also failed to recognize that the level of aggregate employment depends essentially on the macroeconomic situation and the efficiency of the labour market. While net job creation is a valid policy goal at times of significant unemployment, attempting to create new jobs by expanding demand during a period of excess aggregate demand is not. Under SMI I and the initial disbursement period for SMI II (1978-81), Mexico's GDP growth was averaging well over 8 percent a year and inflation was rising. Proleot Desixn 20. The loans each covered four main components: (a) The main component was funding for a credit discounting facility under FOGAIN, operating as a second-tier lender through the commercial PFI (with the PFI assuming the credit risk and undertak- ing initial sub-project appraisals) to finance SMI fixed and permanent working capital investments; (b) The direct provision, through FOMIN, of temporary, minority equity financing for SMI in the form of FOMIN purchases of equity instru- ments (initially common shares but subsequently, in addition, preferred shares and convertible debentures); (c) The construction and leasing, through FIDEIN, either directly or through intermediaries, of factory buildings on FIDEIN's industrial estates, the leasing of machinery and equipment to enterprises on FIDEIN estates unable to obtain financing to purchase these items, and the construction and lease of common facilities on estates-/ and (d) The provision to SMI, through a network of NAFIN industrial extension agents operating out of RAFIN's regional offices, of information about the integrated overall support program (PAI) plus general financial and technical information and advice. Part of the estimated foreign exchange costs of the first three components and the direct foreign exchange costs of training and equipment for the project under the technical assistance component were to be provided by the Bank's loans. 1/ FIDEIN's role was modified under SMI III. It withdrew from the direct construction of factory buildings and the leasing of machinery and equipment and transferred to FOGAIN responsibility for the provision of credit to firms wishing to finance their own buildings and facilities. Its role thereafter was to be to: provide information relating to industrial estates; support, and provide advice to, industrial estate developers; and provide specialized technical services. It was to expand its role in financing infrastructure and housing for industrial estates by covering private, as well as public, estates. !I Under SMI III, this component was extended to include support to, and training and services to SMI through, PAI and, inter alia, the following specialized technical assistance institutions: INFOTEC (technical information and occasional assistance), DGCP (training to increase productivity), and SNE (national employment service). - 9 - 21. The proposed distribution of the proceeds of the three Bank loans among these components is shown in Table 3. Table St DISTRIBUTI N OF SMI LOAN PROCREDS AHON: COMPOWENTS US$ millions SMI I SMI III FOGAIN (Industrial Credit) 30.0 70.0 150.0 FOHIN (Equity & Quasi-Equity) 10.0 16.0 18.0 FIDEIN (Industrial Estates Activities) 5.0 12.0 4.6 Technical Assistance 2.0 2.0 2.0 Total 47.0 100.0 174.6 22. The PAI program was to be coordinated by a committee chaired by the Director General of NAFIN, assisted by a small secretariat headed by a Secretary. The Committee was to determine operating policies and priorities, coordinate the activities of the institutions and agencies involved in the project (or, more generally, in assisting SHI) monitor progress of the more experimental features of the project, and approve individual subloans and investments. 23. NAFIN/PAI, the borrower, assumed the foreign exchange risks under each project and the obligation of repaying the loans, which were guaranteed by the Government. NAPIN transferred the peso equivalent of the loan proceeds to the trust funds. FOGAIN and FIDEIN were each to receive an interest margin of 2 percent from NAFIN (PAI) to cover their operating costs. FOMIN was required to repay NAFIN (PAI) the net amount recovered from its equity investments, half of any capital gain realized, and 20 percent of the interest received from convertible loans. PFIs were to receive a spread of 3 percentage points from FOGAIN to cover their costs-1. FOGAIN undertook, under the first loan, to consider offering wider margins to PFIa for loans to SSEs. Loan recoveries were to be repaid to NAFIN, placed in a separate account, and recycled by NAFIN (PAI) in accordance with the projects' objectives. 24. Lending by FOGAIN (at fixed rates) to final borrowers initially averaged' 16 percent under SHI I, but the average was to be adjusted after January 1st, 1979, to ACF plus I to 3 percent. Under SMI II, this arrangement was retained and the authorities agreed to revise rates once a year (more frequently in the event of ACF levels three percentage points above the level at the last This was adjusted to two to three and a half percentage points under the third project. 4t There was a substantial variation around this average, reflecting the differentials favouring small enterprises and priority regions and activities and vice versa. - 10 - adjustment for three consecutive months) to reflect the average ACF over the preceding 12-month period. Under SMI III, sub-borrowers were for the first time charged variable rates, adjusted quarterly to reflect changes in the ACF. Furthermore, a schedule was agreed to for adjusting interest rates on loans in FOGAIN's existing portfolio to the appropriate variable rate levels by January 1, 19851. Variable interest charges on FIDEIN and FOMIN investments were also to be adjusted quarterly, based on the average ACF for the three preceding months, plus 1 percentage point for FIDEIN loans and minus 3 percentage points in the case of FOMIN convertible loans. However, in the event FOMIN did not exercise its option to convert its loans into equity, it was to charge at least the ACF plus one percentage point. Relevance of Proiect Components 25. The loans were relevant in the sense of meeting part of the needs of SMI for term financing in the context of the prevailing system, which was characterized by a highly distorted allocation of financial resources, resulting in the inadequate availability of term financing for SMI. However, they were not relevant in the sense of meeting Mexico's real needs which were for basic and comprehensive financial and economic policy reforms. The FOMIN and FIDEIN components were not very closely related to the real needs of SMI, even under the prevailing conditions. The extension sub-components of the TA component of the PAI program was broadly relevant but, particularly at the beginning, not very effective. The Bank-financed TA sub-component was only partly directed to uses furthering the loans' objectives (para. 41). See Loan Agreement, Third Small- and Medium-Scale Industry Project, Schedule 3. - 11 - III. PROJECT OUTCOME, ASSESSMENT AND SUSTAINABILITY Proiect Outcome Resource Transfer 26. Disbursement Performance. Disbursement of SMI was initially delayed for a year due to the Government's failure to formalize the agreement reached with the Bank with respect to interest rates to be charged to FOGAIN sub-borrowersi/. However, once agreement was reached to set these rates at between one to three percentage points above the ACF, booming conditions in the economy ensured that the loan disbursed quickly. Disbursements under SMI II began in FY80, initially faster than projected because of the continuance of boom conditions, and were completed in FY 84, as planned. Disbursement of SMI III began in FY84 but, with real interest rates climbing and a recession in 1986 followed by slow growth in 1987-88, sub-lending was slower than anticipated and the loan closed over two years later than initially projected. 27. Disbursements tended to be far more rapid, under SMI I and SMI II, for the credit (FOGAIN) component than for the other components. FOMIN disbursements were slow because of FOMIN's cautious investment policy and the need to satisfy demanding requirements for information. FIDEIN's were slow mainly because of its limited capacity to implement projects- . Slow sub-project processing was characteristic of all three components but improved under the third project. 28. Allocation and Use of Loan Proceeds. The number of subprojects financed under the various components of the three projects, and the overall amounts involved, are summarized in Table 4.1i 1/ Disbursement experience under the loans is presented in detail in paras. 4.01 - 4.03 of the PCR for SMI I and SMH II (Report No. 7552) (PCR I) and pares. 5.1 - 5.9 of the PCR for SMI III (Report 11484) (PCR II). I/ NAFIN notes that the slow disbursement was due to slow maturing projects (see Annex III). Detailed project results, including the characteristics of the subprojects under the four components, are provided, for SMI I and SMI II, in PCR 1 (paras. 4.04 -4.25) and, for SKI III, in PCR 2 (paras. 6.1 - 6.13). - 12 - Table 4: SUBPROJECT FINANCING (Numbers of subprojects and US$ millions) Credit Equity and Industrial TA (FOGAIN) Quasi-Equity Estate (FOMIN) Activities (FIDEIN) No. Amt. No. Amt. No. Amt. Amt. SMI I 864 53.7 29 15.3 22 9.6 2.4 SHI II 2019 68.0 61 16.1 27 3.9 0.9 SMI III 7235 144.4 78 12.6 43 14.6 2.7 29. Provision of Credit. FOGAIN did not keep separate accounts for the Bank- financed part of its portfolio. However, a sample survey of subloans financed with Bank resources under SMI I showed that 83 percent of the enterprises involved had 10 or fewer employees and that the subloans were widely distributed by industrial sector. Only 18 percent were in the highest priority development zone. Subloans achieved satisfactory results in terms of associated employment. Based on a sample e 21 analysis, 80 percent had an average initial ERR of 47 percent. Sample data relating to SMI II showed that 46 percent of the subloans were in the highest priority zone. Ex ante ERRs were in the 4 - 385 percent range and FRRs in the 7.6 - 387 percent range. No ex post FRR and ERR data are available. 11 30. Under SMI III, demand for working capital was lower than projected and the unused part was reallocated to FOGAIN fixed asset credits, FIDEIN and technical assistance. No information is available regarding subloan characteristics such as ERR, FRR, employment creation, distribution by geographic zone, and average investment per job. 31. Overall, the Bank loans probably achieved their credit objectives in terms of reaching SMI and financing projects with high expected and initially realized economic and financial rates of return, although ex post performance was indicated by a subsequent survey to be less satisfactory. 32. Regarding onlending rates, commercial banks, at least at certain times, charged rates of interest to SMI similar to those being charged other customers, despite the granting of a large part of the total subloan by FOGAIN at a heavily subsidized rate (relative to general market rates). The banks accomplished this by charging a considerably higher interest rate on the portion of the loan provided out of their own funds, by introducing monthly compounding, and by 1i A small follow-up survey to SKI I and II by the PCR mission found that: all of the subloan recipients were then suffering from working capital shortages because of the severe restrictions on commercial bank credit; none had received technical assistance in project preparation or management; and anticipated ERR and FRR proved overoptimistic on an ex post basis, partly due to inflation, high financing costs, and depressed economic conditions. - 13 - requiring compensatory balances to be maintained by the enterprise that effectively reduced the size of the loan."-L1 The effect df these practices was on occasion to more than double the effective interest rate charged on an SMI subloan compared with a simple weighted average of the FOGAIN and PFI rates. 33. To the extent that these practices were commonplace throughout the duration of the three projects, the Government's efforts to provide special support to SMI were significantly undermined and instead contributed to substantial subsidization of the commercial banks. Unfortunately, no time series are available showing effective overall interest rates paid by sub-borrowers on their combined Bank/PFI loans in relation to the cost of FOGAIN funds to the PFI. 34. Equity Financing. About three-quarters of subprojects under the first two loansL1 involved medium-sized companies. Smaller companies mostly relied on their own equity and were reluctant to have a government agency as a partner. FOMIN funds were used mainly to expand or restructure existing enterprises. In some cases, the firms involved belonged to larger conglomerates. This ran counter to FOMIN's objectives of fostering the creation of new SMI and diversifying its portfolio. Over three-fifths of FOMIN's investments were in the two high-priority zones and over 90 percent oriented towards the domestic market. 35. At the end of 1985, only 17 percent of the enterprises were operating profitably. This reflected the effects of losses on foreign borrowings resulting from the 1982-83 exchange rate depreciations, the post-1982 period of slow growth and instability, working capital shortages and management deficiencies. However, the subprojects financed showed good ex ante (averaging 33 and 38 percent, respectively, under SMI I and SMI II) and e post rates of return and it was judged that about half of the enterprises experiencing financial difficulty could be rehabilitated. Most of FOMIN's equity sales under SMI I and SMI II either yielded no real gains or entailed real losses. .Lt See Staff Appraisal Report, Fourth Small and Medium Scale Industry Project, Report No. 6539-ME, World Bank, June 2, 1987, para. 1.04. The existence of such practices was apparently not picked up by Bank supervision missions, perhaps because these practices were less prevalent than they had become by the time the fourth project was appraised. However, even in the context of the SAR for the fourth project, the main concern expressed was that the resulting high cost of funds was restricting SMI demand for credit rather than that the capturing of government subsidies by the commercial banks was subverting one of the (main) purposes of the loans. Li Under SMI I, about three-quarters of the investments were in shares and most of the rest in convertible loans. In the case of SMI II, about two-thirds of the investments were in shares and the rest in convertible loans or mixed share/convertible loan packages. .L2/ PCR I (para. 4.22) concludes that this performance indicates "poor investment and a weak divestiture policy characterized by sales of shares to existing owners, with limited bargaining position in the hands of FOMIN". As of December, 1985, arrears on convertible loans represented 11 percent of the total - 14 - 36. In the case of SMI III, a little over 60 percent of the investments financed fixed assets and the remainder, permanent working capital. About 70 percent was in the form of equity participation and 30 percent in the form of convertible loans. The project was unsuccessful in encouraging the emergence of new minority investors and establishing a secondary market for FOMIN's share portfolio. The 3-4 year buyback period was probably too short. At the time FOHIN was taken over by NAFIN and liquidated in 1989, of 102 investments outstanding, only 44 were reasonably satisfactory. Overall, there was little demand for FOMIN financing from SSEs, a large proportion of the enterprises financed experienced subsequent difficulties, FOMINwas an unsuccessful investor, and there was little market for its portfolio of shares. 37. Factory Building and Equipment Leasing. Under SMI I, FIDEIN financed 31 factory buildings and 3 equipment leasing operations and, under SMI II, 24 factory buildings and 3 leasing operations. Over 80 percent of the factory buildings were sold to small companies- ; nearly 60 percent of assisted enterprises were new companies; and nearly 70 percent were established on industrial estates in the highest priority area. Loans were mainly for four to five years and 70 percent had already been repaid when the PCR for SMI I and II was prepared (December, 1988). In 48 of 50 subprojects surveyed (about 80 percent of all FIDEIN projects) the firms involved were still in business and using the factory buildings for their intended purposes. Notwithstanding this, FIDEIN's performance was disappointing and the demand for its standard factory buildings less than expected. 38. Under SMI III, FIDEIN's activities involved 113 industrial parks and included feasibility, pre-investment and engineering studies, technical assistance, and infrastructure financing. Reflecting its changed role under SMI III, FIDEIN financed 43 infrastructure subprojects for US$ 14.6 million, of which 76 percent involved privately owned estates. Only infrastructure was financed by the Bank loan. FIDEIN's extensive program of technical assistance was financed from its own resources. It included the administration of industrial towns constructed by state governments and the supervision of state construction projects. At the time of its absorption by NAFIN, 8 percent of FIDEIN's portfolio was in arrears and for 23 percent of total operations clients were awaiting judicial proceedings. Technical Assistance 39. PAI Program. A key feature of the NAFIN (PAI) program was the establishment of a corps of extension agents to advise SMI as to the sources and forms of financial assistance available and refer them to specialized technical assistance institutions participating in the program. By end-1981, the corps comprised 117 professionals. The staff were of high quality, well trained and highly motivated during the early years, but management changes and a deterioration in conditions of employment led to high turnover after 1983. lent, indicating, again, a rather unsatisfactory performance. L / NAFIN notes that this percentage is too good to justify describing FIDEIN performance as disappointing (see Annex III). - 15 - 40. Up to 1983, while FOGAIN and PAI were under the same management, extension activities focussed on the promotion of (subsidized) FOGAIN credit, which was used to encourage entrepreneurs to accept technical assistance and management training. After 1984, extension activities entailed a less promotional role vis- a-vie FOGAIN, provided more balanced technical assistance and emphasized group over individual assistance. "Clusters" of entrepreneurs in the same area and industrial activity were organized, so as to benefit not only from technical assistance but from group purchasing, credit unions, and other forms of cooperative effort. 41. The Bank Loan Technical Assistance Component. Under SMI I and II, the Bank loans were to finance the foreign exchange costs of equipment and specialized training. Assistance was intended to be widely distributed among PAI, INFOTEC, CENAPRO, FOGAIN, FOMIN, FIDEIN, and various other institutions. In fact, most went to INFOTEC (for a computer system, publications, patents and consultant services) while FOGAIN and PAI used most of the rest, largely for office equipment and facilities. FOMIN and FIDEIN received less than 1 percent between the two funds. The Audit Mission confirms the findings of the PCRLi that: the technical assistance component was loosely defined; funds were not well allocated in terms of the loans' objectives; inadequate amounts went to the main implementing agencies (FOGAIN, FOMIN, and FIDEIN); T.A. was poorly supervised; and PAI should have been encouraged to develop a monitorable, forward-looking program. 42. Under SMI III, of the US$ 2 million allocated to T.A., nearly half went to INFOTEC and 30 percent to fund a national survey of SMI. PCR II notes (para. 6.12) that T.A. under the project is difficult to evaluate, since its objectives were unclear, it was not monitored, and Bank supervision missions did not assess it or propose remedial measures. Institutional Development and Financial Performance 43. PAI's role was to provide and coordinate technical assistance to SMI and recycle the proceeds of recoveries of principal from loans and equity investments among the credit, equity and industrial estate components. It was, as noted, responsible for repaying interest on the Bank loans (although repa ment was guaranteed by the Government) and assumed the foreign exchange risks- . It was to have received the interest paid by final borrowers under the credit component net of the fixed percentage point margins assigned to the PFI and FOGAIN to cover their costs (para. 24). This meant that, when the average interest rate paid by See PCR I (para. 6.11). 5/ I PAI was set up with US$ 22.5 million in seed capital and received the principal of the Bank loans as additional capital, with the Government assuming responsibility for the repayment of principal to the Bank. PAI was responsible only for meeting the interest payments on the $30 million FOGAIN portion of the first loan. Whether this was also the case for SMI I and II is unclear. - 16 - final borrowers was linked to the banks' ACF, PAI would implicitly be largely compensated for its assumption of the foreign exchange risksn 44. However, PAI was required to cover FOMIN's losses while receiving only half its capital gains. Furthermore, FOMIN's capital borrowings were repayable to PAI in nominal terms (i.e., unadjusted for inflation). This meant that PAI was being decapitalized in real terms by being repaid only half of that part of the deemed capital gain that represented inflation rather than a real gain. FIDEIN also repaid principal in nominal terms only, with similar consequences. It was to pay interest only when it was earning sufficient income to make it possible'. 45. The roles of PAI and the coordinating committee did not evolve as intended. The committee stopped meeting after 1982 and the position of PAI, a new institution among larger, entrenched institutions, was weakened. It had little leverage over FOGAIN, which received only 20 percent of its resources through PAI. FOGAIN did not honour its financial commitments to PAI, paying only 35 percent on its outstanding balance with PAI over 1983-86, although the ACF ranged between 46 and 95 percent. It also retained recoveries of principal. 46. PAI not surprisingly became a large money-loser, requiring heavy government subsidiesui. PAI's income statement (PCR I, Annex 26) shows that exchange rate losses constituted the main expense item in 1985-86, accounting in the latter year for 57 percent of total expenses and absorbing over 85 percent of its (reduced) interest income. This left inadequate amounts to cover its large interest obligations to the Bank, the Bank of Mexico, and NAFIN, and led to significant losses (about US$ 3.6 million in 1986). The incurring of nominal losses in a highly inflationary environment in which income should have risen very sharply, so as to compensate for inflation, had major consequences. By 1986, the value of PAI's assets was less than 20 percent of the original dollar value of the capital invested in PAI by the Government. PAI was abolished under the fourth SMI project and its TA program taken over by NAFIN. 47. In retrospect, it seems clear that the continuing problems with PAI resulted from the insertion of an additional, weak institution into a complex and .L / This was because the ACF tended to reflect (with a lag) the rate of domestic inflation and a persistent differential between the Mexican rate of inflation and the average rate of inflation in the lending countries would, cet. par., be the main cause of depreciation of the Mexican peso. !ZU The Borrower notes that FIDEIN did not assume the operational risk as financial intermediaries currently do with NAFIN (see Annex III). .i / Financial information relating to the operation of PAI and the trust funds is incomplete. PCR II contains very little information relating to institutional financial performance and does not provide income statements or balance sheets. The audit mission was unable to obtain such information from the Mexican authorities. The fragmentary information provided in this report, covering mainly 1978-85, is derived from PCR I and its annexes and from the SAR for the Fourth Project. Little information is available for the post-1986 period. - 17 - entrenched institutional structure. Improved coordination of the trust funds' activities and a more appropriate allocation of capital and income would probably have been better accomplished by instead simplifying the institutional structure and strengthening the central authority, as was eventually done." 48. FOGAIN grew rapidly, matured and grew stronger under the three loans but its subloan appraisal capability evolved slowly and it made little effort to promote subproject evaluation by the PFI. Subloans were approved largely on the basis of the sub-borrowers' collateral. Supervision was mainly in the hands of the PFIs, which focussed mainly on sub-projects in arrears, and FOGAIN failed to maintain an adequate data base on the status of the PFIs' loan portfolios. As noted, FOGAIN was assumed by NAFIN in 1989, as part of the reorganization of the state banking system to improve its efficiency and reduce overemployment. 49. FOGAIN's total assets rose from US$ 327 million in 1980 to US$ 449 million in 1985, while its loan portfolio rose from US$ 318 million to US$ 424 million. Its financial performance was poor over 1979-83 but showed marked improvement from 1984 on (PCR I, Annex 17). During the earlier period, interest income was limited by the overhang of earlier loans to sub-borrowers at fixed interest rates at a time when FOGAIN's own costs of borrowing were rising and it was experiencing significant exchange rate losses (on its IDB borrowings). From 1984, FOGAIN's interest earnings soared, as interest rates on both new and outstanding loans were adjusted, under the agreement with the Bank, to reflect the average cost of funds to the banking system, while its average interest payments remained very substantially below market rates. Furthermore, it was absolved from responsibility for exchange rate losses after 1984. FOGAIN's administrative costs were acceptable, at under 2 percent of total assets. 50. Over 1980-85, FOGAIN's equity rose very substantially in relation to its total liabilities, while its debt/equity ratio dropped sharply, from 2.6 in 1980 to .89 in 1985, placing the fund in a strong financial position. Return on current equity was 22 percent. Part of FOGAIN's improved financial positionwas clearly at the expense of PAI, although PAI provided only a small fraction of FOGAIN's financial resources. 51. FOGAIN's ability to borrow at below-market rates and to tolerate a below- market rate of return on its equity mean that conventional measures of financial performance are suspect and difficult to interpret. One measure of the extent to which a financial institution is failing to operate in a fully market-oriented fashion is to calculate its Subsidy Dependence Index (SDI)L'. In constructing Lt / However, on the plus side, the creation of PAI represented an acknowledgement of the fact that, prior to its creation, the trust funds had operated largely independently, even when dealing with the same enterprise. NAFIN now recognizes and accepts the need for a coordinated approach and has established "one-step shopping" facilities and (unsubsidized) training facilities for SMI. PAI laid the foundation for the present system. L0/ See Jacob Yaron, Assessing Development Finance Institutions, World Bank Discussion Papers, No. 174, August, 1992 for details on methodology. This ratio has been used on several occasions in Bank economic and financial analysis. See, - 18 - a SDI, it is necessary to calculate (i) the amount by which the institution's return on equity is below what it would be if it equalled the rate of return on competitive market instruments (approximated by the banks' ACF); and (ii) the amount by which the institution's actual borrowing costs are below what they would be if it had to meet the average market cost of borrowing (again given by the ACF). In this case-y, the SDI is the ratio of the sum of these two amounts (the total subsidy) to the actual interest income received by the institution on its loan portfolio. 52. This index can be used to indicate what the institution's onlending rate (to the PFI) should be to eliminate the subsidy. Table 5 indicates that, for 1983, 1984 and 1985, the interest rates charged by FOGAIN on its loan portfolio would have had to be 17, 12 and 36 percentage points higher, respectively, than they in fact were, in order to eliminate the element of subsidy. They would also have had to be well above the banks' ACF. The latter reflects the fact that FOCAIN needed, if it was to operate in an unsubsidized way, not only to cover the opportunity costs (the ACF) of its borrowed funds but to cover its administrative costs and, in addition, earn a competitive rate of return on its equity-1. Table 5: FOGAIN SUBSIDY DEPENDENCE INDEX (SDI) (Percentages) 1983 1984 1985 Subsidy Dependence Index (SDI) 37.9% 28.1% 77.4% Current average On-lending Rate 43.7% 42.4% 46.2% Increase of On-lending Rate to Eliminate Subsidy 16.6% 11.9% 35.7% Required Subsidy-free onlending rate 60.3% 54.3% 81.9% Note: Detailed calculations are provided in Annex II. Source : Appraisal Reports Fourth SMI Project, Annex 9, Tables 7 to 9 and Third SMI project, Annex 4, Table 19, and OED mission estimates. from the same author, What Makes Rural Finance Institutions Successful? Research Observer, Vol. 9, No.1, January 1994, for numerical applications. SDIs have also been calculated for OED Audits on Korea Industrial Finance and SMI projects (Reports No. 12072, page 18, and No. 12125, pages 24 and 27). LU / In its general formulation, the subsidy dependence index can include other subsidy related items. (See Jacob Yaron, o2. cit.) 1_i As a corollary, the rate of onlending to SMI should have been still higher, since PFIs' spreads also needed to be covered. This implies that onlending to SMI at the ACF plus 1 percent represented a highly subsidized activity. - 19 - 53. In short, despite FOGAIN's apparently satisfactory post-1984 financial position, as conventionally measured, it was heavily dependent on implicit subsidies and thus unsustainable in the long run. 54. FOMIN also grew substantially. It initially placed inadequate emphasis on managing its portfolio but this improved through time. It also diversified from common stock purchases to the acquisition of preferred shares and convertible debentures, which suited some clients' needs better and gave FOMIN a more stable income. FOMIN improved its project appraisal capabilities under the first two projects and the Bank was able to raise its free limit under the third project. 55. FOMIN's portfolio rose from US$6.2 million in December, 1977, to US$22.3 million in 1985 (PCR I, Annex 22). Over the period, it received major capital infusions from the Government. These, together with financing from PAI and a rise in retained earnings, constituted the main sources of its asset growth in real terms. FOMIN was profitable from 1980 on, with net interest income on its marketable securities and convertible credits, profits on equity sales, and dividend income well in excess of operating expenses. 56. However, this performance did not necessarily reflect a fundamentally efficient and profitable operation. As noted, losses on portfolio equity sales were absorbed by PAI, while, on profitable sales, FOMIN only repaid PAI the borrowed capital in nominal terms, together with half the (nominal) capital gains. With high inflation, only a small portion of PAI's capital was being repaid in real terms, implying that FOMIN was being implicitly subsidized at the cost of decapitalizing PAI. FOMIN also received a 2 percent spread on its interest-bearing assets and assumed no exchange risks. In relation to its portfolio, FOMIN's operating expenses in 1985, at 4.8 per cent, appear very high. FOMIN's balance sheets did not adequately reflect appropriate revaluations of its equity portfolio and estimates of its equity were thus suspect. The abolition of FOMIN in 1989 implies that institution-building efforts relating to it were a failure. 57. FIDEIN suffered, under SMI I and II, from serious management problems, financial irregularities, changes in role, and disappointing results. Although expected to act as a second-tier lender, it dealt directly with SMI with regard to renting, sales and leasing- . Its facilities encouraged little industrial relocation and clients preferred individually designed to standard buildings.L L3i NAFIN notes that the internal changes suffered by FIDEIN during implementation of SMI I and II represented a learning cost of handling loans of this type (See Annex III). L4t In its early efforts, The Ministry of Human Settlements and Public works (SAHOP), in order to promote regional development, built industrial parks in unsuitable locations. ( NAFIN notes that the zones were not unsuitable in themselves; rather the demand for establishments of industrial estates was low (see Annex III) ]. With significant Bank training assistance, this problem was resolved by paying much greater attention to the economics of industrial location and conducting in-depth, feasibility studies. The Bank also helped FIDEIN - 20 - Its performance improved considerably in its change role under SMI III. FIDEIN was also, as noted, absorbed by NAFIN in 1989. 58. Financial information relating to FIDEIN is limited and valuing its assets extremely difficult. The PCRs provide no balance sheet data and the audit mission was unable to obtain data from NAPIN. The income statement (PCR I, Annex 25) covers only 1979-84. It includes government subsidies as income but indicates significant profits only in 1981-82. FIDEIN's financial arrangements with PAI called for principal repayments from the proceeds of sales and for FIDEIN to pay interest on the borrowed amounts only when it was generating enough income for it to be able to do so. With high inflation over 1978-89, repayment of principal in nominal terms implied large-scale transfers of real resources from PAI to FIDEIN. FIDEIN's failure to record significant profits in these circumstances, despite the inclusion of government transfers as income, appears to imply substantial losses on its operations. These were not primarily attributable to subloan repayment arrears, which were quite moderate. PCR I notes (para. 5.15) that FIDEIN's equity remained constant in nominal terms and thus declined in real terms. Proiect Assessment 59. The three projects' main explicit objectives (para. 17) were to: (i) foster economic growth and employment by supporting SMI; (ii) promote regional decentralization; and (iii) improve the system of technical and managerial support to SMI. Underlying objectives were to overcome market failure to provide adequate credit to SMI and to establish a more market-sensitive and less distorted structure of sub-project interest rates. The extent to which these objectives were achieved is as follows: (a) Financing Sound Sub-Projects. High ex ante ERRs for the sub- projects undertaken under SMI I and II indicate that the objective of fostering economic growth through the achievement of higher SMI productivity was at first likely to be realized. However, the 1982 crisis and its aftermath left many firms in difficulty and output increases less than expected or potentially realizable. While ERR data are not available for the sub-projects carried out under SMI III, the reported achievement or overachievement of its targets implies that substantial enhancement of SMIs' productive potential was also realized by the project. The audit mission visited project sites in the North (Leon), the central area (Guadalajara) and the South (Merida) in October 1993, discussed project outcomes with beneficiary enterprises, found the benefits substantial and the operations sustainable. (b) Employment Creation. Substantial additional or "preserved" employment is reported as associated with the three projects. Claims of substantial employment "creation" appear overstated. To the extent that the employment reported as associated with the leverage its funds more effectively and helped change the focus of state agencies. - 21 - projects represented shifts of workers from lower to higher productivity jobs, no net job creation would have taken place. (c) Regional Decentralization. The objective of decentralizing SMI activity was not well realized under SMI I but was achieved to a greater degree under SMI II. The degree of success under SMI III is unclear. (d) Technical Assistance. The objective of providing improved technical and managerial support to SMI was only partly achieved. The extension service focussed initially mainly on promoting FOGAIN credit activities. Subsequently, PAI was obliged to abandon its one-on-one approach to SMI as inefficientL". On the positive side, many SMI found the assistance provided useful and indicated willingness to pay a moderate price for further assistance. The technical assistance components of the Bank loans (as distinct from PAI's overall TA program) were poorly focussed, much of the assistance was not used as intended, and an inadequate share was funnelled to the three main implementing agencies. The TA components were loosely designed and poorly supervised and monitored. (e) Overcoming Market Failure. The underlying objective of overcoming market failure by providing credit to SMI through FOGAIN was essentially achieved." However, equity financing through FOMIN went mainly to medium-sized enterprises; few of the enterprises were profitable; FOMIN, without subsidies, would probably not have been profitable; and it was unsuccessful in creating a broader equity market. The provision of standard factory buildings by FIDEIN was a failure, but its technical assistance activities relating to the location of industrial parks, and its financing and development of infrastructure had a major impact and generated strong demand. (f) Rationalizing Interest Rates. With regard to the promotion of a more rational interest rate structure for lending to SMI, each project made a contribution. Market-based, variable rates were adopted under SMI III and consolidated under the GIRA. (g) Developing Institutions. Finally, with regard to institutional development, PAI, the major institutional innovation under the three projects, did not play the important coordinating and allocative role that was envisaged and the substantial turnover of PAI and FOMIN staffs implied significant loss of institutional expertise. These developments, coupled with the eventual disappearance of PAI, the absorption of FOGAIN and FIDEIN into NAFIN, and the liquidation 2Si The cost-effectiveness of extension activities was questioned by the Bank but a recommended study was not carried out. L6t However, market failure was itself a product of inappropriate government policies. - 22 - of FOMIN lead to the conclusion that the contribution of the three projects to useful and sustainable institutional development was negligible U, notwithstanding the absorption of much of the staff of the trust funds by NAFIN. While the industrial extension service continues to be operated by NAFIN, its cost-effectiveness remains uncertain. Sustainability Institutional Sustainability 60. It is apparent that, as initially conceived, the main institutional features of the three projects were not sustainable. With the metamorphosis of the trust funds into departments of NAFIN, the issue of institutional sustainability is now whether NAFIN, in carrying out its current role of redressing market imperfections pertaining to the financing of SMI investments, technological improvement and environmental protection, can survive over the long term, without subsidization, in a liberalized private banking system that will become increasingly competitive as it is opened up to foreign banks and other financial institutions under the terms of the NAFTA. 61. Senior Mexican Government officials are virtually unanimous in the belief that significant market failure continues, for the time being, to justify public intervention via NAFIN in the areas mentioned - particularly the financing of SMI investment. If this is the case and SMI investments offer attractive economic returns, NAFIN, if it is efficient, should be able to operate profitably, without subsidies, at least for a while. The audit mission visited branches of NAFIN in the North (Leon), the central area (Guadalajara) and the South (Merida) in October 1993, and had positive impressions on the quality of management and the professional experience of loan officers. 62. As the financial system becomes more competitive, however, existing market imperfections are likely to be progressively reduced. In such an environment, an unsubsidized NAFIN, unless operating highly efficiently, along fully commercial lines, perhaps as a private or artly private institution, is likely to find survival increasingly difficult.28 63. Despite the disappearance of the separate institutions through which the three projects were carried out, the absorption into NAFIN of staff (particularly from FOGAIN) specialized in SMI development has been of considerable benefit and is expected to contribute importantly to NAFIN's continuing role in providing financial and technical support to SMI. Again, despite the fact that the initially conceived modus operandi of the PAI extension service had to be modified in the light of experience, the system for providing technical and Details on the institutional development of the trust funds are provided in Annex I. With the reprivatization of the commercial banks and the passage of NAFTA, there is increasing recognition by the banks of the commercial importance of SMI financing. - 23 - managerial support and training to SMI would not have reached its present level of effectiveness without the evolution that took place under the three projects. Similarly, as a consequence of PFIs' familiarization with SMI financing and their experience of low default rates with it, some have integrated SMI financing into their regular activities. Sub-Project Sustainability 64. Limited sample surveys of sub-borrower and PFI experience indicated that, while some were experiencing difficulties attributable to inflation and poor growth, most of the subprojects financed were either profitable or potentially so. Their longer-term sustainability depends on how well the enterprises involved adapt, in terms of scale and technology, to the changed incentive regime resulting from the liberalization of trade and the deregulation of industrial production that have taken place since 1985 and that is acquiring further momentum under the NAFTA. Mexico's traditional import substitution policies encouraged the proliferation of small companies. Under liberalized trade and the NAFTA, increased scale and specialization will probably be called for, implying fewer small companies. There are likely to be both winners and losers among the enterprises and sub-projects that received assistance under the three SMI projects. Sustainability of Bank SMI Lending 65. Bank lending to support the provision of highly subsidized financial and technical assistance to SMI, as carried out under these three projects, appears unsustainable in the long run. Furthermore, the justification that SMI did not have adequate access to term financing through the commercial banking system is no longer as valid as it was, with the decline in inflation, the accompanying financial reintermediation, the elimination of directed credit, greater availability of term funds, and increased PFI involvement in lending to SMI. Moreover, NAFIN now has adequate access to commercial financing. The fourth SMI project was the last Bank SMI project in Mexico. - 24 - IV. BANK AND BORROWER PERFORMANCE Bank Performance 66. The performance of the Bank was less than satisfactory in several areas. First, given Mexico's inflationary macroeconomic environment, heavily biased system of industrial incentives, overregulated and inefficient economy, subsidized and distorted interest rate regime, and cumbersome, duplicative and inefficient structure of public financial institutions, the initial identification of what was to be primarily a credit operation was questionable. The transfer of resources was not a valid objective under the first two projects and only fortuitously so under the third. The prime motivation for the loan appears to have been the strong institutional momentum within the Bank to lend. 67. Second, partly because the Bank's knowledge of the financial system and the needs of SMI was very limited, the projects were designed to provide equity financing through FOMIN and standard factory buildings through FIDEIN for which there was limited demand from small firms. Third, PAI was ill-conceived, given the context of entrenched institutions into which it was inserted. Moreover, when its shortcomings in discharging its coordinating and allocative roles and in covering its financial risks, including its exchange risks, became apparent, little effective action was taken to address them. Its unsatisfactory situation persisted under the second and third projects. Fourth, the creation by PAI of an elaborate and extensive industrial extension service was apparently not based on prior study of its cost effectiveness nor on any pilot program. It had to be substantially reoriented as its deficiencies became apparent. Fifth, the technical assistance components of the first two projects were loosely defined and inadequately supervised. Finally, FOGAIN's lack of attention to subproject evaluation and supervision was allowed to persist for too long. 68. On the positive side, as noted, the Bank was instrumental in inducing FOGAIN to adopt a market-based system of subloan onlending rates that helped improve FOGAIN's financial viability. Nonetheless, FOGAIN's operations remained implicitly heavily subsidized and nominal onlending rates to SMI were markedly below those that would have obtained under an unsubsidized system. 69. The Bank devoted almost a full staff year to supervision missions under the first two projects and about half a staff year under the third. This was adequate in terms of volume and the supervision missions contributed significantly to the technical competence with which the projects were carried out. However, supervision was not effective in bringing about necessary basic changes, such as: improving coordination among the funds; preventing the decapitalization of PAI; inducing FOGAIN to adopt, and foster among the PFI, improved subloan appraisal, supervision and follow-up procedures; and ensuring compliance with important provisions of the loan agreement under the third project. Supervision focussed excessively on disbursement performance and subproject visits and inadequately on PAI's financial position, the PAI training program, coordination among the executing agencies, and proper reporting. - 25 - Borrower Performance 70. There were also significant shortcomings in the performance of the borrower. NAFIN did not ensure effective coordination of the operations of the trust funds through PAI and did not pay adequate attention to PAI's financial viability, particularly in light of the foreign exchange risks that it was called upon to assume. It was inadequately concerned with the cost effectiveness of the industrial extension program and did not use the technical assistance funds provided under the three projects in such a way as to maximize technical assistance to SMI. NAPIN's failure to preserve adequate information pertaining to trust fund and subproject performance following the absorption of the trust funds into NAFIN has limited the effectiveness of ex post review of the three projects. NAPIN did not carry out provisions of the Loan Agreement covering the third project calling for a study of the cost-effectiveness of the extension service program and for ex post evaluation by PAI of subprojects carried out under SMI I and II. On the other hand, NAFIN did ensure that the subloans were made in accordance with the loans' objectives and that subproject lending was generally sound and met the criteria established. 71. FOGAIN appears to have responded only reluctantly to the new institutional and financial arrangements resulting from the establishment of PAI and not to have concerned itself adequately with the actual financing terms confronting sub- borrowers. The latter issue should have been of serious concern to FOGAIN and should have prompted it to collect data permitting it to monitor effective terms of onlending and effective spreads to the PFI on a continuing basis. 72. FOGAIN also devoted insufficient attention, under SMI I and II, to fostering sound subproject appraisals, collecting information about subproject performance and arrears, ensuring the quality of PFI portfolios and improving subproject supervision. Its supervision improved during the third project following the replacement of paid supervisory consultants by an arrangement under which the PFI undertook their own supervisions, subject to sample review by FOGAIN. However, information on PFI subloan portfolios remained inadequate. Finally, FOGAIN did not implement an agreed loan guarantee program with Bank funds. 73. Notwithstanding these shortcomings, FOGAIN developed and matured under the three loans and the broad objectives of the credit component in terms of financing economically sound SMI investments were met. 74. FOMIN realized only limited success in identifying and financing sound investments and promoting a secondary equity market but the unstable and inflationary economic climate was partly to blame. Implicit subsidization by PAI obscured its financial performance. FOMIN was also slow to improve its divestiture performance and profitability. Furthermore, its appraisal techniques emphasized traditional credit evaluation rather than the venture capital aspects of proposed subprojects. It initially caused delays in the approval of projects above the free limit by failing to provide adequate information to the Bank but this problem was effectively addressed under the third project. It also did not comply with a loan agreement requirement to conduct a study of its clients' problems. However, given the difficult nature of its role and the limited demand - 26 - for government equity participation in business, it otherwise performed well and showed considerable imagination and adaptability in meeting its clients' needs. 75. FIDEIN did not perform well under SMI I and II. It suffered from an initial misdirection of effort, subsequent changes of direction, conflicts between NAFIN and the Ministry of Public Works, management problems, inadequate training of its staff to meet the financing role it was assigned, and inadequate attention by the Government and the Bank. Under SMI III, its technical and professional performance improved very considerably and its lending role expanded beyond that initially envisaged. However, it did not transfer management of its credit operations to FOGAIN, nor its loan portfolio to a trust fund for collection and administration, as agreed at negotiation, and did not comply with the covenant in the loan agreement calling for it to evaluate its overall operations. V. CONCLUSIONS AND LESSONS OF EXPERIENCE Conclusions Proiect Identification 76. As noted in paras. 17, 18, the basic premises for identifying all three projects were questionable. Since the problems confronting PFI were largely the result of inappropriate government policies , addressing them through project lending was a second-best solution that implicitly endorsed, and supported the continuance of, those policies and may even have contributed to delaying both needed reforms in financial policy and rationalization of the institutional framework. The counter-argument that Bank involvement permitted it to influence Mexico in the direction of reform is less convincing. Considerable Bank experience has demonstrated the difficulties involved in achieving reforms through project lending when there is no prior government commitment to reform and no firm meeting of minds on the program to be carried out. 77. Bank lending for SMI investment under the circumstances existing at the time the loans were approved also tended to undermine the coherence of the Bank's overall policy dialogue. Moreover, it entailed significant risks, since the viability of the subprojects financed was vulnerable to the effects of inflation, recession, possible future credit shortages, and basic changes in the incentive framework. However, while, on balance, the a priori case for Bank involvement was weak, it must be conceded that, in the event, the Bank did exert a positive influence on the Government's interest rate policy through its projects in Mexico. Furthermore, the three loans did provide needed credit to SMI, even when the government subsidy involved was captured by the commercial banks. 9/ For example, overspending, leading to inflation; controlled interest rates, leading to financial disintermediation and a shortage, in particular, of term funds; lack of competition in the commercial banking system; and non-market allocation of credit. - 27 - 78. The Bank developed the three projects without adequate prior work in the industrial and financial sectors and without a proper understanding of the needs of SMI, essentially because it was excluded by the Government from significant involvement in the financial sector until the late eighties. The lack of adequate prior sector work contributed to deficiencies in the design of the projects. Finally, when presenting the two follow-on projects to the Board, the staff tended to gloss over problems with the preceding projects. It was not until the fourth project that some of the continuing problems were addressed by abolishing PAI, directly funding technical assistance to FOGAIN, FOMIN and FIDEIN, and effectively linking FOGAIN's interest payments to NAFIN to the ACF, so as to cover NAFIN's foreign exchange risks. Even then, the NAFIN coordinating committee, despite its prior ineffectiveness, was retained and the basic problems of government controls over interest rates, directed credit, and forced commercial bank investments remained unresolved. Project Design 79. The main design problem was the failure, under the first two loans1 to establish a fully satisfactory arrangement for promptly adjusting interest rates on new and outstanding subloans for inflation. This led, until corrected, to windfall gains to sub-borrowers-t on top of subsidized interest rates. These subsidies and inflation windfalls were at the expense of the trust funds and PAI and contributed to their poor financial performance and need for government transfers. 80. Second, the demand for public equity financing was not well identified and, consequently, overestimated. As a result, FOMIN experienced difficulty in establishing a viable role. Furthermore, the arrangement permitting repurchase of shares by the issuing companies, coupled with the limited marketability of such shares, enabled a number of companies to use the issuance of shares simply as a cheap form of borrowing. 81. Third, FIDEIN's initial role was defined without sufficient understanding of SMI's needs and it was not adequately set up to discharge its financial responsibilities. FIDEIN performed its refocussed responsibilities under the third project well. 82. Fourth, the industrial extension service was designed without adequate prior analysis of SMIs' needs, the probable costs and benefits of the service, and the way in which it would operate vis-a-vis existing institutions. 83. Fifth, the TA components of the first two loans were loosely defined. The TA component of the third project was more strictly defined, with monitorable objectives. L01 The loans were disbursed prior to the coming into effect of the General Interest Rate Agreement in August, 1984. 31/ And, to an unknown extent, the commercial banks. - 28 - Prolect Implementation 84. First, the overall institutional arrangements for channelling the Bank funds were too complex, involving in the case of credit, a chain of institutions extending from the Bank through NAFIN, PAI, FOGAIN, and the PFI to the final sub- borrowers. The system resulted in processing delays and conflicts of objectives and authority, particularly between PAI and FOGAIN. 85. Second, PAI was not fully integrated into the administrative structure of NAFIN. Its intended role as a financially sound recipient and allocator of the proceeds of the Bank loans, subloan principal recoveries and its share of interest earnings did not materialize as expected. This appears attributable primarily to the fact that the existing institutions were large and well entrenched before the establishment of PAI and NAFIN was not really committed to changing the status quo. FOGAIN was able to use its dominant and entrenched position to borrow at highly negative real interest rates from PAI, bolstering its financial position at PAI's expense. Provision should have been made for principal repayments to PAI by FOMIN and FIDEIN to be indexed to inflation. 86. Third, the FOGAIN credit component largely succeeded in meeting its objectives of reaching SMI, financing sound investments, and, to a somewhat lesser extent, contributing to regional industrial diversification, although the latter probably involved an economically sub-optimum allocation of credit. Many PFIs have built up their capacity to evaluate investment projects. Disbursements under the third loan assisted in the transfer of resources to Mexico at a difficult time and helped sustain SMI operations during a period of depressed output. 87. Fourth, FOGAIN's lending was heavily subsidized in real terms. There were as many as three elements of subsidy. First, certain classes of sub-borrower were entitled to borrow at ACF minus several percentage points. Second, FOGAIN's average lending rates were not adjusted promptly to ACF-based levels. Third, competitive market rates were as much, at times, as ACF plus 20 percentage points. It is unclear to what extent SMI sub-borrowers benefitted from these layers of subsidy and to what extent they were captured (or more than captured) by the commercial banks through the practices mentioned earlier (para. 32). What is apparent is that, for some of the time, at least, there was very considerable diversion of subsidized funds into the hands of the commercial banks and a consequent undermining of the Government's objective of aiding SMI. 88. Fifth, much of the expertise built up in the trust funds is now contributing to NAFIN's operations. Similarly, part of the experience gained by the extension service is also supporting NAFIN's current activities. Audit Rating of the Proiects 89. As noted above (para. 66), it appears that there was no need for additional resource transfers under the first two projects, and the macroeconomic and sectoral policy environments were unsupportive. Moreover, the trust funds were heavily subsidized, the levels of onlending interest rates to SMI were inadequate, and PAI became a large money loser. Institutional performance of FIDEIN, FOMIN and the PAI coordinating committee was poor, and the TA component - 29 - ineffective. Thus, the SMI I and II projects are rated marginally unsatisfactory, despite the fact that FOGAIN financed investments with high ex ante ERRsl 90. Under SMI III, many of these problems persisted. The industrial and financial sector policy environments at first remained unsupportive, and the financial sector institutional environment continued to be unsatisfactory. However, Mexico's need for resource transfers was greater after 1982, interest rates on new and outstanding subloans more appropriate, implicit subsidization of SMI less, the institutional performance of FIDEIN better, and the operations of the industrial extension service probably more cost-effective. SMI III is rated marginally satisfactory. Lessons of Experience 91. The following principal lessons may be learnt from the Bank's experience with these three projects: - Investment sub-projects that are carried out at a time when the government is pursuing unsustainable expenditure policies run the serious risk of being subsequently undermined by inflation and slow growth. - Launching a complex project with insufficient prior knowledge both of the sectoral policy and institutional environments and the needs and characteristics of the target group invites poor results. - Care should be exercised not to further complicate an already complex institutional situation by adding another bureaucratic layer, as was done with PAI. Improved coordination may be better served by simplifying the existing institutional structure and strengthening the central authority. - Organization strengthening is not an end in itself. If the existing organizational structure is inappropriate to begin with, efforts to strengthen it will be misdirected. It was a mistake for the Bank to focus on supporting the trust funds rather than on reforming the system - something that was necessary but eventually undertaken by the Government itself, without Bank prompting or significant involvement. If it was deemed necessary to provide interim support to the trust funds (or NAFIN), the Bank should have had an exit strategy in mind. - Schemes involving significant subsidies lend themselves to manipulation for financial advantage and, not infrequently, corruption. Subsidized lending to SMI through PAI/FOGAIN/PFI led Financing sound investments may have led to a marginally satisfactory rating, in spite of substantial institutional shortcomings, if macro and sector policies issues would have been addressed to support a more sustainable financial and industrial development during the 1978-82 period. - 30 - to gains for FOGAIN at the expense of PAI, and gains for PFI at the expense of SMI, PAI and, ultimately, the Government. 92. Additional lessons of experience, drawn also from other SMI projects, are that: - Technical assistance, typically rather loosely defined, needs to be planned and supervised as carefully as the central elements of a project, if it is to be successful. - Where lending is undertaken through a second-tier institution, such as FOGAIN, there is a need continuously to monitor both PFI/sub- borrower spreads and second-tier lender/PFI spreads, so as to ensure that intended financial outcomes are being realized. - To ensure a successful two-tier operation, it is necessary clearly to define the responsibilities of each tier for sub-project appraisal and supervision and to ensure that those responsibilities are carried out. - Bank credit project supervision should provide for a "fortified" mission during the early stages of implementation of each project, in order to identify frequently overlooked sectoral, institutional, organizational and other problems that might compromise its success. - The Bank needs to strengthen its ability to learn from its mistakes, so that the same problems do not persist through a string of follow- on projects. - Bank credit project proposals prepared by financial sector specialists should be screened by economists able to provide a broadly based assessment of government policies and the merits of implicitly supporting them through the project. This could be done by having the country and sector economists contribute an independent sub-section to the "Project Benefits and Risks" portion of the President's Report. - 31 - ANNEX I Institutional Development 1978-1989 93. PAI. The integrated support program for SMI (PAI) was to be directed by a high-level coordinating committee headed by the Director-General of NAFIN (PCR I, paras. 3.01 -3.03). A technical coordinating committee with a secretariat was established to run the program. PAI was to set up and run the extension service, coordinate technical assistance activities with other participating agencies, and allocate resources among FOGAIN, FOMIN and FIDEIN out of the proceeds of loan recoveries. PAI provided counterpart funds for the Bank loan and assumed the foreign exchange risk. 94. The PAI secretariat was a new institution. FOGAIN had been in existence twenty-four years, FOMIN six, and FIDEIN, eight. FOGAIN, the largest of the SMI trust funds, received four-fifths of its funding from sources other than PAI. In these circumstances, the arrangement giving PAI control over extension activities and the allocation of loan recoveries was an awkward one that could only work if the coordinating committee exercised firm control over the trust funds from the outset, provided a clear and consistent sense of direction, and fully supported a strong PAI. This did not happen. In fact, the large and unwieldy coordinating committee stopped meeting after 1982, leaving responsibility for the program in the hands of the technical secretariat. PAI was merged with NAFIN over 1980-83 but separated again in 1984. Thus, PAI's role kept shifting, depending partly on how its director at the time interpreted it, as well as on the actions of the three trust funds. 95. FOCAIN refused to honour its financial commitment, withholding transfers of loan recoveries to PAI and paying only a small part of its interest spread to PAI. This, together with the failure to establish, particularly during the early years, adequate interest rates for FOGAIN, a profitable basis of operation for FOMIN, and inflation adjustments for the repayment of FOMIN's and FIDEIN's principal redemptions, undermined PAI's financial position, given its responsibility for the projects' exchange losses, and it became a large money- loser, requiring heavy government subsidies. Despite all the problems, PAI's institutional role remained unchanged under all three projects. Under the fourth SMI project, it was abolished and the trust funds financed directly. 96. PAI's extension service underwent a number of transitions, with its modus operandi evolving from an expensive, limited, one-on-one approach to SMI, largely directed, initially, to the promotion of FOGAIN loans, to a more cost-effective and broadly based group approach involving close cooperation with educational, training and technical institutions. The latter approach has continued with the absorption of the SMI institutions into NAFIN. The initial approach to developing industrial extension services was probably not cost-effective and too limited in coverage. The Bank, in preparing the fourth SMI project, suggested that an assessment be made of the effectiveness of the TA delivered by the extension service, but it was not undertaken by PAL. The focus of PAI's wide- ranging seminar activities was also unclear. PAI's TA program was taken over by NAFINSA when PAI was abolished in 1987. - 32 - 97. FOGAIN. Under the three loans, FOGAIN grew rapidly, matured and became stronger. However, it remained, in 1988, overcentralized. Under SMI I and II, FOGAIN focussed on the financial viability of subloan applicants and on whether the purposes of the subloans met the Government's policy objectives. Its subloan appraisal capability evolved only slowly and it made little effort, under S1MI I and II, to promote subproject evaluation by the PFI. At the start of SMI III, FOGAIN was itself undertaking appraisals of all projects above Mex$3 million (US$10,000), seriously delaying subloan approval and causing withdrawals of credit applications. This led, in 1985, to an increase in the PFI free limit level and a speed-up in loan processing. The basis of FOGAIN's sub-project appraisals was the adequacy of collateral. It was not until 1985 that the Bank reached an agreement with FOGAIN/NAFIN/PAI/SHCP to have ex ante and ex Post IRRs calculated for sub-projects. In 1986, FOGAIN was requested by the Bank to calculate IRR for each project over Mex$15 million but FOGAIN failed to comply. 98. Supervision of subloans was left mainly to the PFI, which, in turn, focussed primarily on subprojects in arrears. Although, in 1984-85, FOGAIN strengthened its supervision efforts, hiring outside consultants to assist, it did not focus on problems being encountered by subborrowere and failed to maintain an adequate data base, under all three projects, on the status of its PFI loan portfolio, including data on arrears. It was not until the fourth SHI project that the Bank made provisions, under the TA component, for FOGAIN to develop an adequate sub-project data base. 99. FOMIN. FOMIN also grew under the three loans, with the number of employees rising from 49 in 1978 to 106 under SMI III. Initially, FOMIN placed inadequate emphasis on managing its portfolio (as opposed to evaluating new clients) but, after 1982, the two functions were separated and FOMIN strengthened its supervision. Staff training was limited by the lack of domestic expertise and restrictions on staff visits to experienced foreign risk-capital institutions. A reorganization under SMI III reduced the number of management levels, strengthened middle management, and improved specialization. 100. Although, initially, FOMIN's investments were limited to the purchase of new issues of common stock, in early 1981, FOMIN began to invest in preferred shares and convertible subordinated credits. This diversification attracted more customers, met customers' needs better (convertible loan interest payments were tax deductible), and generated a more stable income for FOMIN. Following the 1982-83 debt crisis and recession, FOMIN was obliged to become more involved in financial restructuring, which it had hitherto avoided, and in the provision of working capital. The cost of assessing the risks of investment in small firms, the requirement that assisted firms use acceptable accounting systems, and small firms' limited interest in a government equity partner resulted in FOMIN's focussing primarily on medium-sized firmest 101. FOMIN's project appraisals and the appropriateness of its financial packages improved under SMI I and SMI II. ERRs began to be calculated for projects using more than US$250,000 in Bank funds but appraisals still underemphasized the ability of the entrepreneur and market prospects for the 11i NAFIN notes that the perception underlying the judgement of a "disappointing" performance of FIDEIN is incorrect (see Annex III). - 33 - products. Supervision was tightened up, with outside consultants employed on a continuing basis from 1983 on, and a monthly report on the financial status of FOMIN's portfolio permitted the preparation of an action plan to deal with problem investments. Under SMI III, the Bank approved an increase in FOMIN's free limit from US$400,000 to US$600,000. 102. FIDEIN. FIDEIN suffered, under SMI I and SMI II, from serious management problems, financial irregularities, major changes in its role, and disappointing results. The quality and management of its program remained poor throughout. It had previously been engaged in the promotion and development, in collaboration with special local trust funds and the ministry of public works, of a system of industrial estates, under a national industrial decentralization program. Under SMI I, in view of a perceived lack of adequate financing for SMI construction of factory buildings, it was reoriented towards the provision of financing for the construction of standard factory buildings (SFBs) and common facilities, and to the leasing of machinery and equipment to SMI. 103. Although expected to act as a second-tier lender, FIDEIN arranged direct contracts with client firms relating to rent, sales and leases. The results of its activities under the three new tasks assigned to it were disappointing. The new facilities encouraged very little relocation of existing production and clients preferred custom-made to standard buildings. FIDEIN had difficulty selling the standard structures and its inventory was not finally liquidated until 1986. 104. Under SMI II, FIDEIN was to construct, for demonstration purposes, at least one or two factories per estate. The results were again disappointing. Under SMI III, the three financing tasks introduced under the first loan were terminated and FIDEIN's role confined to that of providing technical assistance, financing infrastructure, and financing industrial buildings run by leasing companies. Its technical and professional performance improved considerably. In retrospect, it is clear that, while FIDEIN had acquired expertise in the location and design of industrial estates and the execution and supervision of civil works, its financial analysis and project appraisal capabilities were deficient to begin with and were never brought up to satisfactory standards! 105. Summary. It must be concluded that institutional development under the three projects, particularly in light of the eventual abolition of PAI and FOMIN and the absorption of FOGAIN and FIDEIN into NAFIN, was minimal. NAFIN notes that, in light of the progress made under SMI III, the statement that FIDEIN never achieved the necessary capability to perform its financial analysis and project appraisal to satisfactory standards is incorrect (see Annex III). - 34 - ANNEX II FOGAIN SUBSIDY DEPENDENCE INDEX, 1983-85 The table below provides details of the SDI calculations of Table 5, Chapter III, with related sources and notes. MEXICO: SMI II AND III PROJECTS FINANCIAL INSTITUTION: FOGAIN RETURN ON EQUITY AND SDI (Pesos millions) 1983 1984 1985 RETURN ON EQUITY Net Income (P) a/ (359) 3,089 12,609 Average Equity (E) b/ 7,756 12,188 24,835 Return on equity -4.6% 25.3% 50.8% SUBSIDY DEPENDENCE INDEX (SDI) Market Interest Rate to be paid by FOGAIN (M) c/ 56.4% 47.5% 65.7? Average Cost of Borrowing (C) d/ 57.9% 41.1% 30.5% Average Amount of Borrowing (A) e/ 20,657 39,194 55,471 Subsidy on Borrowing (M-C)*A (317) 2,504 19,535 Net Subsidy on Equity (E*M)-P 4,734 2,701 3,708 Interest Income (ILP) f/ 11,659 18,519 30,044 Subsidy Dependence Index SDI=((M-C)*A+(E*M)-P)/ILP g/ 37.9% 28.1% 77.4% Total Loan Portfolio (LP) h/ 26,661 43,698 65,041 Current Average On-lending Rate LR=(ILP/LP) 43.7% 42.4% 46.2% Increase of On-lending Rate to Eliminate Subsidy IR=LR*SDI 16.6% 11.9% 35.7% Required Subsidy-free onlending rate (LR+IR) 60.3% 54.3% 81.9% Source and Notes: a/ Appraisal Report Fourth SM1 Project, Annex 9, Table 7. b/ Appraisal Report Fourth SMI Project, Annex 9, Table 8. c/ Nominal ACF (Bank of Mexico). d/ Except for NAFIN "Single Credits" to FOGAIN, the cost of borrowings of FOGAIN was below market rates during 1983-85 (see Appraisal Report Fourth SMI project, Annex 9, Table 9). The total cost of subsidized borrowings has been approximated by the ratio of interest expenses to total liabilities. Appraisal Report Fourth SI Project, Annex 9, Tables 7 and 8. e/ Appraisal Report Fourth SMI Project, Annex 9, Table 8. f/ Appraisal Report Fourth SMI Project, Annex 9, Table 7. g/ SDI calculation based on two year average for end year data on assets and liabilities and calculation of subsidy through reserve requirements omitted because of data limitations. 1981 and 1982 data on assets and liabilities for 1983 calculations are from Third SHI Appraisal Report, Annex 4, Table 19. Data from Fourth SMI project Tables are in US$ equivalent. They have been converted back to Pesos using exchanges rates from IFS (end year for stocks and mid year for flows). For details on SDI methodology, see Bank Discussion Paper No. 174. h/ Appraisal Report Fourth SMI Project, Annex 9, Table 8. - 35 - ANNEX III SECRETARIAT OF FINANCE AND PUBLIC CREDIT DEPARTMENT OF INTERNATIONAL FINANCIAL ORGANIZATIONS PRODUCTION AND INFRASTRUCTURE PROJECTS DIVISION Mexico, June 2, 1994 Juan Manuel Izquierdo Sosa Director of International Financial Organizations - NAFIN I refer to the draft audit report sent by the World Bank regarding the implementation of the three stages of the Small and Medium Scale Industry Development Program, PAI, (Loans Nos. 1522-ME, 1881-ME and 2325-ME), the aim being to incorporate comments by the various Mexican agencies and institutions that were involved in these projects. I would like to ask you to send the following comments to the Bank: The Bank states that disbursements under the first two phases of the program were rapid because of the prevailing economic conditions in Mexico at the end of the 1970s and the beginning of the 1980s, and that as a result both the economic and financial rates of return on the projects presented for financing were adequate; however, disbursement of the third stage coincided with a difficult period owing to the economic crisis. We would like to point out that while it is understandable that the third project encountered greater difficulties owing to the economic instability that developed towards the end of 1982, it is worth stressing the efforts made to achieve project objectives. It is also important to note that the difficulties confronting lending operations at a time of high inflation were adequately dealt with. As regards the sustainability of the program, the Bank believes that it will be difficult for NAFIN to operate without subsidies, given the growing competition in the area of financial services that will result from the TLC (Tratado de Libre Comercio). The Bank also believes that the current restructuring of Mexican industry as a result of general trade liberalization and economic deregulation will promote larger companies and companies with more specialized product lines. On this point, Mexican industry will indeed face growing competition, but it is not clear that this should affect only small and medium companies. In our view the issue is not one of size but of the ability of firms to adopt the new technologies that will enable them to compete adequately in their different sectors. - 36 - Finally, the Bank states that the PAI will be unsustainable in the long term as a result of the imperfections in the credit market that result from subsidization, which will no longer justify NAFIN's current role in the provision of credit to small and medium enterprises. In response we would note that the justification for NAFIN is that it promotes flows of resources to enterprises that otherwise would have no access to new funds. Yours etc (signed) Moises A. Pineda Padron - 37 - June 3, 1994 NACIONAL FINANCIERA, S.N.C. COMMENTS OF THE PROJECT EXECUTING SIDE ON THE PERFORMANCE AUDIT REPORT FOR LOANS 1552-ME, 1881-ME and 2325-ME The object of the Performance Audit Report (PAR) on the loans made to help finance the first three stages of the National Program for SMI Development (Programa de Apoyo Integral a la Industria Nacional Medians y Pequena--PAI) is to assess the performance of the then executing agencies of the resources, each within its specific area of activity, in terms of achievement of the project objectives. These agencies are the Guarantee and Small and Medium Industry Development Fund (Fondo de Garantia y Fomento a la Industria Medians y Pequefa--FOGAIN), the National Fund for Industrial Development (Fondo Nacional de Fomento Industrial-- FOMIN), the Trust Fund for Industrial Parks Development (Fideicomiso de Conjuntos, Parques y Cludades Industriales--FIDEIN) and the PAI itself. The comments expressed in the PAR come down essentially to a series of criticisms on the following points: 1. Government policy for the development of small and medium industry. 2. Goals and objectives planning. 3. Real needs of these industrial strata. 4. Administrative and appraisal capacity of the project executing agencies. 5. Information availability. 6. Extent of the project's impact on industrial development in Mexico. It is from this standpoint that we offer the following comments on the PAR. During the period of implementation of the program Mexico was experiencing an economic crisis that affected every sector of the economy. This situation, which was noted in the PCRs for each of the three projects, meant that the only way enterprises could subsist in this turbulent environment was by means of financial and technical assistance, targeted especially to small and medium enterprises, which only the development institutions could provide. - 38 - It was against this background that the first priority for Government action was defined: the grant of financing at a preferential interest rate and at long term, these being essential requirements for development projects. The long-term lending requirement was met in large measure through external borrowing by Mexico in the form of both loans obtained from various international financing agencies and bilateral loans at the country level. The preferential interest rate requirement was met through the use of subsidies, particularly from the late 1970s to the mid-1980s. Experience with this option was not very encouraging in that, owing to the lack of an entrepreneurial culture in Mexico, many entrepreneurs--even though aware of the difficult economic situation the country as a whole was experiencing--did not conform to the requirements of the support the Government tried to offer, in terms of strict utilization of the resources for the purposes for which they were requested and also owing to deficiencies in the administration of their enterprises. This situation soon led to defaults in repayment of the loans they received. This aggravated the Government's problem due to Mexico's debt, since it did not receive enough income to meet its external debt-service obligations. For all these reasons, from the mid-1980s until the present time the Government's policy to escape from this vicious circle has been based on rehabilitating the public finances by divesting itself of parastatal enterprises, abolishing the great majority of subsidies and boosting its operational efficiency by slimming down agencies, while in addition placing great emphasis on training of the staffs of the public-sector institutions and encouraging similar action in the private sector. For this reason we also feel that the assistance in financing the first three stages of the PAI had a much greater impact than stated in the PAR on loans 1552-ME, 1881-ME and 2325-ME. Without this support it would not have been possible to undergo the learning process through which Mexican enterprise was enabled to survive and grow stronger. In the private sector, it is stressed that the PAI laid the groundwork for increased knowledge of the real needs of industry, a knowledge that has been developed and fine-tuned in each stage of the program. From the mid-1980s, subsidies were reduced to the minimum and at the same time the entrepreneurial sector was urged to consolidate its survival and development by striving to be more competitive and efficient. This objective was among those to which the PAI devoted major attention, through its industrial extension policy. This was one of the first experiences in Mexico of furnishing comprehensive support to the enterprises, comprising not only financial support but also refresher training and technical assistance in promoting the development of their businesses. This action acquired such a scale that Nacional Financiera has now resumed that first initiative, multiplying its impact from the position of second-tier - 39 - bank through the Entrepreneurial Development Network (Red de Desarrollo Empresarial--RDE) it has since set up. The RDE network is based on a number of agreements NAFIN has concluded with a whole series of educational institutions in Mexico with the object of providing refresher training and technical assistance of all kinds, through the agencies of these institutions around the country, whereby it has been able to reach a larger number of enterprises. The industrial development process in Mexico has also demonstrated the need to strike a happy medium in promotional work: while the subsidies were abolished, the development loans continued to be made at a preferential rate, lower than that on commercial bank loans; this does not, however, mean that they are subsidized. Today the development banks are required to perform their function without ceasing to be profitable but at the same time without seeking to enrich themselves at the expense of industry. Similarly, while the technical assistance and training are not free of cost, the recovery quotas the Development Banks apply for those purposes cover solely their own expenses and nothing more. We repeat that this is only part of the much that was learned through implementation of the PAI. It was through the accumulation of knowledge about all these situations that the technicians that made up the staffs of the project executing agencies during those years developed their special skills. This knowledge moreover is still expanding and improving at the present time, evidence of the continuity that marks this process. Moreover, the reference in the PAR to lack of information with respect to these loans seems to us to be incorrect: during the implementation period the Bank was kept fully informed about the progress of the project and was provided with financial information. Similarly, the PAR omits all mention of the experience of the Bank's Operations Evaluation Department mission of October 1993, whose program of activities included interviews with former officials of all the executing agencies for these loans and also with entrepreneurs in a number of cities who had received support financed out of the resources of these loans. - 40 - NACIONAL FINANCIERA, S.N.C. COMMENTS ON THE PROJECT PERFORMANCE AUDIT REPORT OF IBRD'S OPERATIONS EVALUATION DEPARTMENT FOR LOANS 1552-ME, 1881-ME and 2325-ME RESPONSE CONCERNING THE PERFORMANCE OF FIDEIN EVALUATION SUMMARY Page (xv), para. 11 While the demand for industrial estates under loans SMI I and SMI II was indeed low, it should be made clear that, with respect to the part implemented by FIDEIN, project performance was not disappointing but instead lower than expected. The experience gained in the implementation of SMI I and II is being turned to practical account under SMI III; as the PAR itself mentions, important improvements can be noted, beginning with SMI III, in the administration of FIDEIN, reflected in better management and utilization of the loan resources. These improvements were due in large part to the specialization of FIDEIN's role as Industrial Estates Development Trust, something which should be seen not as a criticism but as better focussing on the objectives assigned to it as an institution. An example is the fact that under SMI III FIDEIN no longer granted loans chiefly to the final users of the industrial factories but instead to industrial promoters (construction companies) which assumed responsibility for building the industrial estates and placing the factories among the final users. This change was made in light of the experience noted among the users of the industrial factories. Not being factory construction experts, they often contracted their construction to private engineers or architects. In many cases this resulted in a substantial increase in the construction cost originally agreed on. This incremental cost was passed on to the purchasers of this service. For their part, the latter neglected their own production processes to see to the progress of construction of their factories. Moreover, FIDEIN's delinquent portfolio did not amount to one third of the total--or anything like it--at the time it was absorbed by NAFIN. The delinquent portfolio was 6 or 7 percent at most. This reflected the situation of a loan made to Industrial Murua of Tijuana, B.C., in which the enterprise assigned rights over its assets to NAFIN owing to default in payment. - 41 - That loss was reflected in FIDEIN's balance sheet but not the addition of that asset to the Trust Fund's net worth, which would have significantly reduced the delinquency percentage. Page (xvi), para. 16 While it is true that payments to the PAI were made irregularly during implementation of SMI I and II, they were regularized and strictly enforced during SMI III. Page (xvi), para. 18 While shortcomings did occur during implementation of SMI I and II, it must be stressed that there was no timely orientation on the part of the Bank with respect to the methodology for appraising the projects being presented to it. At the time of these statements, the Trust Fund had practically no rejections by the Bank for implementation of SMI III. This situation was made possible by the training received by the Trust Fund's technical staff, provided by Bank experts during the third stage of the PAI. Page (xvii), para. 21 The report needs to spell out FIDEIN's shortcomings with respect to failure to adhere to some agreements and loan conditions. Page (xviii), para. 23 The repayments made during implementation of SMI III and IV did take account of inflation, since the interest rate charged was based on Average Cost of Funds (ACF) and the parameters used to calculate the ACF included domestic inflation. PROJECT OUTCOME, ASSESSMENT AND SUSTAINABILITY Page 11, para. 27 The slow disbursement of resources through FIDEIN was not due to limited capacity to implement projects but to the fact that the projects appraised by that Trust Fund were slow-maturing projects. This necessitated the preparation of at least three main studies: - Prefeasibility - Feasibility - Technical Engineering These studies reflected the policy in effect at that time with respect to financing for the construction of an industrial park. - 42 - Page 14, para. 37 It is stated in this paragraph that about 80 percent of the subprojects financed by FIDEIN out of PAI loan resources were surveyed and that the firms involved are still using the factory buildings for the purposes for which their financing was requested. In our view that percentage is too good to justify describing FIDEIN's performance once again as "disappointing." Page 14, para. 38 At the end of this paragraph the report states that at the time of its absorption by NAFIN, only 8 percent of FIDEIN's portfolio was in arrear and stresses that of that percentage 23 percent represented clients awaiting judicial proceedings. The wording of the report needs to be changed to make it clear that this 23 percent refers to FIDEIN's total operations. Page 15, para. 44 When an enterprise ceased to pay, FIDEIN in turn passed this situation on to PAI because FIDEIN did not assume the operational risk as the Financial Intermediaries currently do with NAFIN. Moreover, when repayments were made to PAI they were not made in only nominal terms, since the calculation of the interest charged based on the ACF takes account of inflation. Page 19, para. 57 The internal changes suffered by FIDEIN during implementation of loans SMI I and II represented the learning cost of handling loans of this type, reflected in outstanding performance under SMI III, which was due also to greater closeness on the part of the Bank. Moreover, FIDEIN never acted as second-tier bank and in fact was never expected to do so. Page 19, footnote 20 The first industrial estates to which the footnote refers were not developed by FIDEIN but by the then Ministry of Human Settlements and Public Works (Secretaria de Asentamientos Humanos y Obras Pdblicas--SAHOP), now the Ministry of Social Development (Secretaria de Desarrollo Social--SEDESOL). Moreover, these zones were not unsuitable in themselves; rather, the demand for establishment of industrial estates was low. This was one of the lessons learned during implementation of the loans: the establishment of an industrial estate does not by itself generate a demand for industrial infrastructure; the industrial estate must be established where the necessary conditions exist. - 43 - This was noted in a number of studies done by FIDEIN, which demonstrated that enterprises located in industrial parks developed better than those located elsewhere. Page 32, paras. 99 and 100 The report reiterates the statement made in earlier paragraphs concerning FIDEIN's "disappointing" performance and the expectation of it acting as a second-tier bank. We stress that the perception underlying these judgments is incorrect. Page 32, para. 101 The report states several times that FIDEIN underwent outstanding development under SMI III. In our view, therefore, the statement that FIDEIN never achieved the necessary capability to perform its financial analyses and project appraisals to satisfactory standards is incorrect.
Groupe de la Banque mondiale · Project Performance Assessment Report
Mexico - First, Second and Third Small and Medium Scale Industry Development Projects
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Organisation
Groupe de la Banque mondiale
Type de document
Project Performance Assessment Report
Pays
Mexique
Source
Banque mondiale