Mexico - Industrial Recovery Project

Document of The World Bank FOR OFFICIAL USE ONLY Report No. 13063 PERFORMANCE AUDIT REPORT MEXICO INDUSTRIAL RECOVERY PROJECT (LOAN 2746-ME) MAY 20, 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 1986 US$ 1 = Mex$ 613 1987 US$ 1 = Mex$ 1,378 1988 US$ 1 = Mex$ 2,273 1989 US$ 1 = Mex$ 2,462 1990 US$ 1 = Mex$ 2,813 1991 US$ 1 = Mex$ 3,018 1992 US$ 1 = Mex$ 3,095 ABBREVIATIONS ACF - Average Cost of Funds FONEI - National Trust Fund for Industrial Equipment GDP - Gross Domestic Product GIRA - General Interest Rate Agreement IRP - Industrial Recovery Project NAFIN - Nacional Financiera S.N.C. OED - Operations Evaluation Department PAR - Performance Audit Report PCR - Project Completion Report PFI - Participating Financial Intermediary PVP - Sistema de Pagos Variables al Valor Presente QR - Quantitative Restrictions FISCAL YEAR January 1 to December 31 FOR OFFICIAL USE ONLY THE WORLD BANK Washington, D.C. 20433 U.S.A. Office of Director-General Operations Evaluation May 20, 1994 MEMORANDUM TO THE EXECUTIVE DIRECTORS AND THE PRESIDENT SUBJECT: Performance Audit Report on Mexico Industrial Recovery Project (Loan 2746-ME) Attached is the Performance Audit Report on Mexico - Industrial Recovery Project (Loan 2746- ME) prepared by the Operations Evaluation Department. The project played an important, albeit small, role in reducing the disruptive impact of the economic crisis prevailing in Mexico during 1987-88 by providing critically needed funds for industrial recovery. Without this financial support, many of the investments to improve existing capacity and modernize may not have been made. Some firms, even though viable in the longer run, may have failed. While the project contributed to the process of industrial recovery, it did not support institutional or financial sector development, even though these were important objectives. In this respect, project design was impaired by the lack of adequate knowledge of the financial sector. The audit agrees with the main findings of the Project Completion Report. Overall, the project outcome is rated as marginally satisfactory, its sustainability as likely, and the institutional development impact as negligible. Two important lessons of experience drawn from this audit are that: (a) projects must be based on a proper understanding of sectoral issues to ensure better project design and to avoid the perpetuation of any existing policy shortcomings or institutional inefficiencies; and (b) directed credit schemes can serve an important function during periods of macroeconomic instability and credit scarcity by providing critically needed funds for industrial recovery. However, as in the case of Mexico, there needs to be a credible program to stabilize and structurally adjust the economy, particularly through trade reform, otherwise there is a real risk that these schemes will support inefficient and/or unviable industries. Attachment This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  FOR OFFICIAL USE ONLY PERFORMANCE AUDIT REPORT MEXICO INDUSTRIAL RECOVERY PROJECT (LOAN 2746-ME) TABLE OF CONTENTS PAGE NO. PREFACE ........................................... i BASIC DATA SHEET .................................... iii EVALUATION SUMMARY ................................ vii I. INTRODUCTION .................................. 1 II. PROJECT OBJECTIVES AND DESIGN ................... 3 III. PROJECT IMPLEMENTATION ........................ 4 Characteristics and Performance of Subloans and Subprojects . . .. 6 IV. EVALUATION AND SUSTAINABILITY .. ................... 7 Contribution to Industrial Recovery .................... 7 Contribution to Financial Sector Development .............. 9 Institutional Development .......................... 10 Role of the Bank ............................... 11 Sustainability .................................. 12 IV. CONCLUSIONS AND LESSONS OF EXPERIENCE ........... 13 V. ANNEXES ...................................... 16 Annex 1: Bibliography............................. 16 Annex 2: Summary of Main Project Terms and Conditions ..... 18 Annex 3: Comments from Nacional Financiera ............. 19 This report was prepared by Moina Varkie (Task Manager) and Derek White (consultant) who audited the project in October 1993 and 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.  PERFORMANCE AUDIT REPORT MEXICO INDUSTRIAL RECOVERY PROJECT (Loan 2746-ME) PREFACE 1. This is a Performance Audit Report (PAR) of the Industrial Recovery Project to Mexico (Loan 2746-ME) amounting to US$150 million. The loan was approved on March 15, 1986 and closed on December 31, 1992. The last disbursement was made on January 28, 1993. 2. The PAR was prepared by the Operations Evaluation Department (OED) and the Project Completion Report (PCR) was prepared by the Latin America and the Caribbean Regional Office. The PAR is based on the PCR, the Staff Appraisal and President's Reports, the loan documents, staff files, an OED study on Mexico/Bank relations, and discussions with Bank staff. An OED mission visited Mexico in October 1993 and discussed the effectiveness of the Bank's assistance with Government officials, the Nacional Financiera, S.N.C (NAFINSA) and representatives of the industrial and financial communities. Their kind cooperation is gratefully acknowledged. 3. The PCR provides a good account and candid assessment of the project's design issues and the implementation experience. The PAR focuses on the project's contribution to industrial and financial sector development and the performance of the Bank. 4. A draft PAR was sent to the Borrower. Comments were received and incorporated in this report, as appropriate.  - iii - PERFORMANCE AUDIT REPORT MEXICO INDUSTRIAL RECOVERY PROJECT (LOAN 2746-ME) BASIC DATA SHEET LOAN POSITION (Amounts in US$ Million) As of March 31, 1994 Loan Original Disbursed Cancelled Repaid Oustanding 2746-ME 150.0 150.0 - 56.07 93.93 CUMULATIVE ESTIMATED AND ACTUAL DISBURSEMENTS (US$ Million) FY87 FY88 FY89 FY90 FY91 FY92 FY93 Appraisal Estimate 7.0 35.0 74.5 113.5 134.5 147.0 150.0 Actual 29.1 45.0 115.5 134.8 138.3 148.7 150.0 Actual as % of Estimate 415 129 155 119 103 101 100.0 Date of Final Disbursement: January 28, 1993 PROJECT DATES ORIGINAL ACTUAL Appraisal Mission Departure 06/17/85 06/17/85 Start of Negotiations 12/10/85 01/29/86 Board Approval 03/15/86 07/29/86 Signing 08/08/86 08/08/86 Effectiveness 10/29/86 10/29/86 Closing Date 12/31/92 12/31/92 - Iv - SUPERVISION RATINGS (Form 590) Evaluation Development Legal Management Availability Yar Qveail Objectives Covenants Performanc Funds 1987 1 1 - 1 1 1988 1 1 - 1 1 1989 1 1 1 1 1 1990 1 3 1 1 1 1991 1 2 1 1 1 1992 1 2 1 1 1 STAFF INPUT EY85 FY86 FY87 FY88 FY89 EY90 FY21 FY92 TOTAL Preparation 34.0 - - - - - - - 34.0 Appraisal 2.7 10.5 - - - - - - 13.2 Negotiations - 2.4 - - - - - - 2.4 Supervision - - 2.3 11.9 2.4 8.5 4.9 1.3 21.3 Total 36.7 12.9 2.3 11.9 2.4 8.5 4.9 1.3 70.9 MISSION DATA No. of No. of Total Date of Month/Year Weeks Persons Weeks Appraisal 06/85 2 4 8.0 07/86 Supervision I 12/87 2 3 6.0 01/88 Supervision II 06/89 .4 1 0.4 08/89 Supervision III 06/90 1 1 1.0 07/90 Supervision IV 11/90 1 1 1.0 11/90 SPN/Completion 08/92 2 2 4.0 09/92 - OTHER PROJECT DATA Borrower/Executing Agency: Nacional Financiera S.N.C. Follow-on Projects: Project: Industrial Restructuring Project Loan No: 3047-ME Amount: US$250 million Project: Financial Sector Adjustment Loan Loan No.: 3086-ME Amount: US$500 million  - vii - PERFORMANCE AUDIT REPORT MEXICO INDUSTRIAL RECOVERY PROJECT (LOAN 2746-ME) EVALUATION SUMMARY Introduction provided a complementary package of Bank assistance and demonstrated the Bank's 1. The Industrial Recovery Project (IRP) substantial support for Mexico's reform was prepared in 1985 at a time when the program and resource mobilization efforts. economic climate in Mexico was one of high They were followed by a number of sectoral instability and uncertainty. Although adjustment loans in support of, inter li , stabilization measures had been initiated further trade reform, domestic deregulation, following an economic crisis in 1982, fiscal public enterprise reform and financial sector discipline slipped, high inflation prevailed, adjustment. and the structural problems facing an economy that had followed import substitution-led Prject Objectives and Design policies for decades remained largely unaddressed. At the micro level, firms were 3. The IRP was the fifth line of credit to highly leveraged, particularly with foreign the National Trust Fund for Industrial debt, and faced serious cash flow problems Equipment (FONEI), a Government trust fund due to the massive devaluations of the peso in under the Bank of Mexico, which functioned 1982 and 1983. Credit for the private sector as an apex institution channelling credit to the through the banking system was scarce and private sector through participating financial the bond and equity markets had not yet intermediaries (PFIs). The stated objectives developed into effective complements to of the project were to improve the quality and commercial credit. broaden the scope of financial services to medium- and large-scale industrial enterprises. 2. Against this background, the IRP was In addition to a traditional line of credit designed to support the recovery of the (which financed fixed assets and permanent industrial sector by improving the availability working capital), the project included of financial resources, permitting it to respond innovative components aimed at: to the envisaged new regime of trade incentives, and by strengthening the financial adapting credit repayment terms to the structure of individual enterprises. The inflationary environment by introducing a project was presented to the Bank's Board in repayment mechanism which better matched July 1986, along with the first Trade Policy debt service with cash generation; Loan (Loan 2745-ME) and the Industrial Technology Loan (Loan 2747-ME). The three facilitating corporate financial loans, together amounting to US$700 million, restructuring by developing FONEI's - viii - capabilities to offer restructuring advice and since they were not fully up to market instruments to clients; and determined levels. Most of the enterprises supported were well established firms. While * building up an equity market in Mexico the performance of these enterprises is not through the provision of finance for known, it is likely that they are performing investments by PFIs in firms' equity. satisfactorily, because: subprojects were carefully appraised, based on economic 4. These innovative components, although analysis; the enterprises are operating in a of a pilot nature and accounting for only a considerably improved economic and policy small percentage of the loan, became the main environment; and their loan repayment rate is justification for the project. The project also reported to be high. supported financial market studies and was expected to set the stage for a financial 7. The audit mission was unable to obtain restructuring project. adequate information on the performance of subloans and subprojects from NAFIN. This Project Implementation is mainly due to the fact that, with the dissolution of FONEI, most of the project 5. The project was implemented over the files were misplaced, lost or sent to period 1986 to 1992, when the Mexican inaccessible archives. economy was going through a dramatic turn around. Far-reaching economic and policy 8. While the credit line was fully changes, which brought about inter alia, disbursed, the more innovative project greatly improved macroeconomic stability components were hardly utilized. The new (particularly a drastic decline in inflation and repayment mechanism was difficult to interest rates), structural reforms (most administer and not well understood; as a importantly, trade liberalization) and a more result, it was chosen by only 5 percent of the competitive and autonomous financial system, subborrowers. Only 5 equity investments inevitably affected project implementation. were made, primarily because the tax system One of the most important changes was the was still biased in favor of debt versus equity rationalization and consolidation of numerous instruments and conservative attitudes of both schemes for directing credit through lenders and borrowers reduced the supply of, specialized institutions, including the and demand for, this component. absorption of FONEI into Mexico's largest Furthermore, FONEI lacked experience in development bank, the Nacional Financiera, promoting such components. The proposed S.A. (NAFIN), in 1989. technical assistance relating to corporate financial restructuring did not materialize 6. Most of the project funds were because, initially, there were disagreements on disbursed within three years of project the timeliness of the envisaged training effectiveness through the line-of-credit component, and eventually, it was not component, which supported a total of considered necessary and therefore abandoned US$307 million worth of investment by 261 following the absorption of FONEI by industrial enterprises. The lending rates to NAFIN. The financial market studies were these enterprises were linked to the banking not carried out because, as noted in the PCR, system's average cost of funds, but contained the Government was reluctant to allow the some element of subsidy in the early years, Bank to get deeply involved in a sector which - Ix - was considered politically sensitive at the public sector deficit. Monetary growth time. It was not till 1989 that the Bank exploded, inflation climbed to triple digit provided support for major policy reforms in levels in 1987 and 1988, and nominal interest this area. rates (represented by the banks' average cost of funds) reached a high of 104 percent in 9. Several reallocations of the loan 1987. In this environment, it was difficult for proceeds resulted in the line of credit banks to attract term deposits for onlending. component eventually accounting for 97 percent of the total loan amount, with the 13. Furthermore, the private sector was equity component accounting for the crowded out of the commercial credit market remaining 3 percent. A substantial portion (31 by onerous controls and regulations imposed percent) of the subloans were repaid as less on the banking system to ensure adequate costly sources of credit emerged through the financing for public expenditures. In the face banking system, following a drastic decline in of tight credit conditions in Mexico, many of inflation and reforms in the financial sector. FONEI's clients could not turn to the international financial community because Evaluation access to funds from abroad had been virtually cut off. 10. A basic assumption underlying the IRP was that industrial recovery in Mexico was 14. Thus, FONEI's funds were critically constrained by a scarcity of credit. It was needed in these years. Without this financial argued that, with the start of trade support, many of the investments to improve liberalization, firms needed to compete existing capacity and modernize would not internationally, but that the credit needed to have been made. Some firms, even though invest in plant and equipment, in order to viable in the longer run, might have failed, modernize and expand, was not available in delaying Mexico's industrial recovery and adequate amounts through the banking system. exacting high transition costs. By end 1988, however, the Government started to initiate 11. Perceived market failures also provided financial sector reforms, which led to an partial justification for the previous FONEI increasing flow of resources to the private loans, but the audits of these loans found that sector from the banking system. Thereafter, FONEI's funds had, in fact, served as cheaper the availability of FONEI funds was less substitutes for alternative sources of critical. investment financing. The question, then, is whether the experience under the IRP was any 15. While the project contributed to the different. process of industrial recovery, it did not support institutional or financial sector 12. Over 70 percent of the project funds development, even though these were were disbursed during 1987 and 1988, when important objectives. In fact, the project (and the highly inflationary environment was preceding FONEI loans) tended, inimical to the provision of term credit. unintentionally, to perpetuate the problems of Although the Government's stabilization the financial sector, since FONEI formed part program had started, a slippage in public of an elaborate system of directed credit financial discipline and weakening oil prices in schemes, which were duplicative, inefficient 1986 had resulted in a large jump in the - X - and contributing to the aggravation of the established industrial enterprises that were financial market and the fiscal burden. FONEI clients. Role of the Bank 18. While the passage of NAFTA gives permanence to many of the reforms, it will 16. Although the provision of credit also bring some change to the profile of through this project proved timely and winners and losers (some of whom may be important, the Bank's role in the preparation FONEI clients) in the industrial sector. and supervision of this project was Inefficient firms will have to adjust to the disappointing. Project design was impaired by realities of integration and firms will have to Bank staff's limited knowledge of the financial adapt to new environmental standards. sector and general acceptance of the status Sustainability will depend on the success of qu1. The latter may have reflected the Bank's these efforts and the continuing political conclusion that fundamental financial reforms commitment to address the outstanding would have to come at the initiative of the economic, environmental and social issues. Government and not at the urging of the Bank. However, the fact that five loans 19. NAFIN now largely operates as a through FONEI (amounting to US$510 second-tier institution and has reoriented some million) were made despite inadequate sector of its activities towards support of new knowledge suggests that the desire to maintain priorities, such as infrastructure development, an easy and proven lending vehicle also technology, environment, and micro- and played a significant role. The quality of the small enterprises. The sustainability of Bank's project supervision was deficient in NAFIN will, to a large extent, depend on how terms of the frequency of missions, the successful these new, riskier ventures are. reporting of project progress, advice to NAFIN's future role in financing medium- FONEI, particularly during the time of the and large-scale industrial enterprises, such as merger with NAFIN, and attention to the those supported under this project, becomes achievement of the project's development more questionable as commercial bank objectives. financing becomes increasingly available to these clients as a result of reforms and Sustainability increased competition. 17. The general outlook for the Conclusions sustainability of subprojects financed under the IRP seems positive. As a result of the 20. Mexicoses dramatic reforms, fundamental reforms implemented over the particularly the macroeconomic stabilization last few years, Mexico's industrial sector is and trade reforms, succeeded in restoring the now free from major policy distortions and is confidence of the private sector and bringing operating in an environment that is much about increased private investment. The RP more stable, with well structured incentives complemented these repforms by providing the for growth. The reforms in the financial finance needed for many of Mexico's medium- sector have revitalized the banking system and and large-scale industries to adapt to a more the securities market and are likely to assure internationally competitive structure of the future financing needs of the larger, well incentives and to increasing foreign competition. Thus, the project played an - xI - important, albeit small, role, in reducing the pilot schemes, studies, or technical assistance. disruptive impact of the economic This gives rise to false expectations as to environment in 1987-88 and in assisting the probable project achievements. When such process of industrial recovery. The project's components are included, special efforts must contribution to the industrial recovery process be made to secure firm local commitment to is also highlighted by the fact that 98 percent their implementation and to ensure proper of the subloans were for the expansion or supervision by Bank staff. modernization of existing enterprises and 44 percent were for export-oriented projects (a Directed credit schemes higher share than in previous FONEI loans). (notwithstanding their potential for As noted in the PCR, there was also an misallocating resources) can at times (such as important political dimension to the project: during periods of macroeconomic instability the availability of credit during these years and credit scarcity brought about by helped diffuse opposition from powerful adjustment policies) serve an important industrial groups to the trade reforms. function by providing a lifeline of support to industrial firms trying to weather the difficult 21. Notwithstanding these positive times. However, as in the case of Mexico, contributions, it must be recognized that the there needs to be a credible program to IRP served as a partial substitute for tighter stabilize and structurally adjust the economy, public sector financial discipline and particularly through trade reform, otherwise improvements in the financial system's ability there is a real risk that these schemes will end to allocate resources efficiently. Instead of up continuing to support inefficient and/or attempting to correct poor policies directly, unviable industries. In addition, these the IRP was directed towards alleviating their schemes should be carefully targeted and symptoms. The project's attempts to assist appropriately priced so that they are not used institutional and financial sector development by favored borrowers as cheaper substitutes failed. In view of this, the project is rated as for alternative commercial sources. marginally satisfactory. 22. In conclusion, one of the most Lessons of Experience important lessons derived from this project is that Bank staff must take account of the + As noted earlier, project design was lessons of the past. Audits of the previous affected by the lack of a proper understanding FONEI loans had concluded that: inadequate of the macroeconomic and sectoral context in sectoral knowledge impaired project design; which the project would be implemented. poor supervision affected project Projects must be based on a thorough analysis implementation; and, most importantly, the of sectoral issues in order to: assure their loans did not reach the intended beneficiaries, relevance; avoid overlooking preferable, more but rather well-established, favored borrowers fundamental solutions; ensure better project who had access to alternative commercial design; and avoid the perpetuation of any sources of finance. A more systematic existing policy shortcomings, institutional incorporation of lessons learnt might have led inefficiencies and allocative distortions. to more careful targeting in subsequent projects and improved the Bank's net * The major objectives of a project contribution to Mexico's industrial should not be expected to be achieved through development through the FONEI loans. relatively minor project components such as  PERFORMANCE AUDIT REPORT MEXICO INDUSTRIAL RECOVERY PROJECT (LOAN 2746-ME) I. INTRODUCTION' 1. The Mexican economic crisis of 1982 was amongst the most severe the country had ever experienced. It was triggered by a fall in oil prices and an increase in international interest rates, and was characterized by soaring fiscal and balance of payments deficits, accelerating inflation and massive capital flight. It led to the refusal of Mexico's external creditors to roll- over the public debt and eventually to the Government's decision to suspend external debt service payments. 2. The crisis forced the Government to adopt a drastic stabilization program and to seek external debt relief. It also changed the Bank's perspective on its role in Mexico. For the rest of the decade, the Bank's strategy would be to act as "lead lender" as it sought to: (a) assist in the design and implementation of sound economic policies; (b) transfer substantial resources; and (c) act as a catalyst for the mobilization of private foreign capital. 3. The Industrial Recovery Project (IRP) was prepared in 1985 at a time when the Mexican economy's difficulties were exacerbated by a further fall in oil prices and a destructive earthquake. Economic reforms and stabilization efforts were still at an early stage and the prevailing economic climate was one of uncertainty. Despite a temporary economic recovery in 1984/85, the structural causes of low productivity, resulting from decades of import substitution-led policies, remained largely unaddressed and high inflation prevailed. 2 At the micro level, industrial enterprises were highly leveraged, particularly with foreign debt. The massive devaluations of 1982-83 had sharply increased their debt service obligations, exposing them to serious cash flow problems. 4. The financial sector was also faced with many problems resulting from years of excessive regulations and controls. The main issues in the sector were: (a) extremely limited and misallocated credit to the private sector; (b) inefficient financial intermediation and insufficient price competition because of deposit rate controls; (c) unclear and overlapping roles for development banks and Government trust funds (there were 8 development banks and 21 trust ' For further details on macroeconomic, industrial and financial developments in Mexico during the 1980s see the Bank documents listed in Annex 1. 2 Industrial recovery at the time was led by a revival of capital goods and consumer durables production. A 50 percent rise in the share of manufactured exports in total exports contributed to growing output. However, this was mainly the result of a suppressed domestic market and a drastic currency devaluation, and not of increased productivity and efficiency. -2- funds); and (d) inadequate supervision and prudential regulation of banks. Furthermore, the bond and equity markets had not yet developed into effective complements to commercial credit. 5. Against this background, the IRP was designed to support the recovery of the industrial sector by improving the availability and quality of financial services and strengthening the financial structure of enterprises. The National Trust Fund for Industrial Equipment (FONEI), the vehicle through which the Bank had provided long-term finance to Mexico's larger industrial enterprises for much of the 1970s, was used as the apex institution to on-lend IBRD funds through participating financial intermediaries (PFIs). This was consistent with the Bank's previous efforts to assist Mexico's industrial sector through line-of-credit operations, which largely focussed on the needs of specific industrial target groups. It was also consistent with previous assistance to the financial sector, which was largely confined to channelling funds through, and improving, individual trust fund operations through these credit lines.' In 1984, a General Interest Rate Agreement (GIRA) was reached, which basically aimed at raising the overall level of interest rates towards market levels while reducing their dispersion and the implicit credit subsidies.4 Beyond this, however, the policy dialogue with the Government on the financial sector had been limited. From 1984 onwards, the Bank had attempted to discuss the need for addressing certain issues in the financial sector, but since it was considered highly sensitive politically, the Bank was not allowed any substantive involvement.' It was not till 1989, that the Bank provided support for major policy reforms in this area. 6. The IRP was presented to the Board in July 1986, along with the first Trade Policy Loan and the Industrial Technology Loan. It was consistent with the Bank's strategy at the time, which was to support trade policy reform, complementary financial sector policies, and measures to encourage adequate supply responses, particularly through support for export promotion and industrial restructuring. The three loans together amounted to about US$700 million. They were followed by a number of sectoral adjustment loans in support of, inter alia. further trade reform, domestic deregulation, public enterprise reform, and financial sector adjustment. During the FY86-90 period, the Bank's loans to Mexico totalled almost US$9.5 billion, demonstrating major support for Mexico's stabilization and restructuring efforts. The IRP must, therefore, be seen as an element in an integrated program of Bank support for the Government's economic reform efforts. ' Over the years, about US$1.9 billion of Bank loans provided support to the industrial sector. These loans provided support to small and medium-scale industries (US$ 507 million); the capital goods industry (US$152.3 million); industrial development promotion through the Export Development Loans (USS600 million); industrial technology (USS48 million); environmental improvements (US$60 million) and medium and large-industries through FONEI (US$510 million). ' GIRA sought to relate all interest rates to a referential rate - the average cost of funds borrowed by Mexican banks. After 1984, all Bank lending to Mexico involving financial intermediaries was subject to GIRA requirements. 5 As noted in the PCR, "...The issues involved in the sector had a heightened political sensitivity as one of the final and controversial acts of the previous Administration in 1982 was nationalization of the banks. As it was felt that the Bank would support reprivatization of the banks and this would appear to impinge on Mexico's sovereign rights, the Government did not want Bank involvement in sector analysis at this time." -3- II. PROJECT OBJECTIVES AND DESIGN 7. The Bank's relationship with FONEI dated back to its origins in 1971, when it was established as a Government trust fund administered by Banco de Mexico (Mexico's central bank) to facilitate the financing of investment in the industrial sector. The first line of credit was approved by the Bank in 1972. The IRP was the Bank's fifth and last line of credit to FONEI. 8. The project was jointly identified by the Bank and FONEI. The stated objectives of the project were to improve the quality and broaden the scope of financial services to medium- and large-sized industrial enterprises. Therefore, in addition to providing a traditional line of credit and technical support for FONEI's institutional development, the project aimed at adapting financial instruments to the exigencies of the economic and financial situation of the country at the time. Given the over-leveraged structure of companies, it was felt that the availability of comprehensive financial packages and instruments to ease cash-flow requirements was as critical as the availability of traditional financing. Accordingly, the project included innovative components designed to: * Adapt lending terms to a high-inflation environment by introducing a repayment mechanism (Sistema de Pagos Variables al Valor Presente - PVP) which better matched debt service with cash generation;' * Facilitate corporate financial restructuring by developing the capabilities within FONEI to assist clients; and * Build up the equity market in Mexico by introducing, on a pilot basis, the financing of equity and quasi-equity investments by commercial banks.' 9. Through this project, the Bank also expected to set the stage for a future financial restructuring project by supporting financial market studies. 10. The Nacional Financiera, S.N.C. (NAFIN), the main development bank in Mexico and the financial agent of the Government, was the borrower of the loan and carried the foreign exchange risk. The loan included: credit for equipment and working capital, representing 86 percent of the loan; a pilot component for the purchase of equity and quasi-equity instruments by financial institutions, amounting to some 13 percent of the loan; and technical assistance for 6 This payment mechanism essentially capitalized interest payments separately for each annual repayment of principal. Annex 2 contains a detailed discussion of the system. 7 In 1984 the National Program for Development Financing (PRONAFIDE) was launced which emphasized the need to form risk capital funds and to foster primary and secondary equity markets. In early 1985 new legislation was enacted, which, inter alia, allowed commercial banks to invest in equity. -4- FONEI, including consultant services for the development of training and promotion programs, financial market studies, and the design of restructuring packages for final borrowers, accounting for 1 percent of the loan. III. PROJECT IMPLEMENTATION 11. The project was implemented over the period 1986 to 1992, when the Mexican economy was going through a dramatic turn-around, as shown in Table 1. The fundamental economic and policy changes taking place in the country inevitably affected the project's implementation and performance. Important factors were the achievement of greatly improved macroeconomic stability (particularly the drastic decline in inflation and interest rates),' trade reform, and financial sector reform, which in addition to substantially deregulating the sector, resulted in the rationalization and consolidation of the development banks and trust funds, including the absorption of FONEI into NAFIN in 1989. Table 1: MACROECONOMIC INDICATORS (Percentages) 1985 1986 1987 1988 1989 1990 1991 1992 Real GDP Growth Rate 2.6 -3.8 1.9 1.2 3.3 4.4 3.6 2.6 M2Growth 46.3 94.4 141.0 42.2 43.0 46.2 47.2 20.0 Government Expenditure/GDP 39.2 44.9 44.9 39.7 34.2 31.9 26.9 25.3 Public Sector (Deficit) Surplus/GDP -8.0 -14.5 -14.4 -9.3 -4.8 -2.2 -0.3 1.6 Private Fixed Investment/GDP 12.5 12.9 13.2 14.2 13.4 13.7 14.9 17.4 Public Fixed Investment/GDP 6.6 6.5 5.2 5.1 4.8 4.9 4.6 4.1 Consumer Price Index Change 53.8 91.0 131.8 116.8 18.6 26.7 22.7 15.5 Bank's Nominal Av. Cost of Funds 65.7 95.3 104.3 45.5 40.1 29.2 20.0 22.8 Credit to Public Sector/GDP 28.9 39.3 32.3 28.1 25.1 20.4 16.5 11.5 Credit to Private Sector/GDP 11.5 11.1 9.4 9.8 13.9 17.3 22.1 24.0 12. Although the project was implemented over five years, most of the loan funds (over 80 percent) were disbursed by 1989, within three years of project effectiveness. The project closed on time after disbursing US$150 million through 20 PFIs for 261 subprojects. The subprojects amounted to a total investment of US$307 million. From the available documents it would appear that all loan conditions were complied with (Annex 2). Table 2 shows the actual ' In December 1987, the Mexican Government implemented a series of agreements with representatives of business, labor and farming on the key elements of a far-reaching price stabilization program which was called the "Economic Solidarity Pact" (PACTO). Subsequently, in December 1988 it was renamed the "Economic Stabilization and Growth Program" (PECE). -5- allocation of loan proceeds. The original allocation is shown in Annex 2. 13. The more innovative aspects of the project, i.e., the PVP mechanism and the equity component, were hardly utilized. The PVP option was chosen by only 5 percent of sub- borrowers and only 5 equity investments were made, for a total investment of US$5.0 million, compared to the US$20 million expected at appraisal. The PCR notes that only in one case did the provision of equity assist an over-leveraged company. The prevailing economic climate and conservative attitudes on the part of both lenders and borrowers affected the supply of, and demand for, these components (para 30). 14. Following the closing of a Pollution Control Loan (Ln. 2142-ME), the credit component of the project was modified in order to allow for the financing of pollution control subprojects. Only US$9 million was disbursed for this purpose because there was little demand for investment in pollution control equipment, largely due to the lax enforcement of pollution standards. 15. The technical assistance component was a non-starter. The Bank and FONEI disagreed initially on the timeliness of the training component, which was designed to develop corporate financing capabilities within FONEI and to offer financial restructuring assistance to over leveraged companies. The financial market studies were not carried out because, as noted in the PCR, the Government was reluctant at the time to allow the Bank to get deeply involved in a sector that was considered politically sensitive.' In the end, with the implementation of financial sector and institutional reforms, the technical assistance component became irrelevant and was abandoned. Table 2: ALLOCATION OF LOAN PROCEEDS No. of Amount Subloans % (US$'000) % Investment Type SubloansY 256 98 145,000 97 Equity 5 2 5,000 3 Total 261 100 150,000 100 Repayment Type Traditional 249 95 138,000 92 PVP 12 5 12,000 8 Total 261 100 150,000 100 1/ Includes permanent working capital loans, which amounted to US$40 million. A similar study was commissioned by FONEI with an international consulting firm using FONEPs own resources. -6- 16. The credit line was not seriously affected by the merger of FONEI, because most of the project funds were disbursed by then, but project monitoring and evaluation weakened. The audit mission was unable to obtain adequate information, particularly on the performance of subloans and subprojects, from NAFIN. 17. Several reallocations of the loan proceeds resulted in the credit component accounting for 97 percent of the total loan amount, with the equity component accounting for the remaining 3 percent. The resource transfer objectives of the project were achieved, but the objectives aimed at institutional and financial sector development and at providing improved financial services to clients, were clearly not. Characteristics and Performance of Subloans and Subprojects 18. As under previous FONEI loans, the IRP funds carried an element of subsidy to the final borrower. However, as a result of the umbrella agreement represented by the 1984 GIRA, which reduced interest subsidies on Bank projects, onlending rates were considerably more market responsive compared to the rates prevailing under earlier FONEI loans. 19. Project onlending rates to the final borrowers were variable and set at the average cost of funds plus 2 to 5 percentage points, depending on the type of loan. (For administrative simplicity, the margins provided to the PFIs were established as fixed percentage point spreads rather than as percentages of the average cost of funds.) There was an element of subsidy, particularly during the early years of the project because the mark-up over the average cost of funds was not always adequate to bring interest rates to final borrowers fully up to market- determined levels (in 1988, the average commercial bank lending rate was about 8 percentage points above the ACF). "0 Since this mark-up was expressed as a fixed percentage over the ACF, it also meant that the subsidy disappeared, and in fact, the real costs to the subborrowers rose sharply, as inflation declined and the ACF dropped. This led to a wave of subloan repayments (about 31 percent of the subloans were prepaid) as less costly sources of credit emerged. 20. In contrast with previous FONEI operations, the majority of subloans and subprojects under the IRP were small. About two-thirds of the subloans were below US$600,000 and the average subloan was US$687,000 (compared to US$1.1 million under the previous two loans). As under previous loans, many of the beneficiaries were well established medium and large enterprises. There was a relatively wide distribution of credit among industrial subsectors and industrialized regions within Mexico. The chemicals and metal products subsectors accounted for about 25 percent of the number of subloans. o It should be noted that subloans were denominated in either local currency or U.S. dollars and the Government (through NAFIN) assumed the foreign exchange risk. Since onlending rates were below market rates (which would have included some implicit premium that reflected market expectations in regard to inflation/exchange rate changes) for some years, there was an element of foreign exchange risk that the Government had to bear. There was also the cross currency risk, attributable to the appreciation of the weighted average of the currencies in the basket constituting the Bank loan vis-a-vis the U.S. dollar. -7- 21. The audit mission was able to gather little information on the economic and financial performance of the subprojects financed. This is mainly due to the fact that, with the dissolution of FONEI, most of the project files were misplaced, lost or sent to inaccessible archives. Aside from this, an apex institution's knowledge of ex-post subproject economic viability and impact tends to be limited, since there is no direct link between the institution and the end user. The PFIs, mainly commercial banks, who do have a direct link, are not particularly interested in this information. However, given that: most of the subloans were made at a time when the economy was opening up; the subprojects were carefully appraised, based on economic analysis; the dramatic reforms undertaken during the project implementation period enabled the suprojects to operate in a considerably improved economic and policy environment; and the repayment performance of the subloans is reported to be very good; one can conclude that most of the subprojects are performing satisfactorily. " IV. EVALUATION AND SUSTAINABILITY Contribution to Industrial Recovery 22. A basic assumption underlying the IRP was that industrial recovery in Mexico was constrained by a scarcity of credit. It was argued that, with the start of trade liberalization, firms needed to compete internationally, but that the credit needed to invest in plant and equipment, in order to modernize and expand, was not available in adequate amounts through the banking system. Perceived market failures also provided partial justification for the previous FONEI loans, but the audits of these loans found that FONEI's funds had, in fact, served as cheaper substitutes for alternative sources of investment financing. They concluded that, due to FONEI's low lending rates relative to market rates, FONEI funds were in high demand, and that many of the firms that benefitted (they included some of Mexico's largest firms) could have found other sources of financing, both domestically and abroad, based on their connections with industrial and banking groups. 23. The question, then, is whether the experience under the IRP was any different. Did the project provide critically needed funds for industrial recovery or were the project funds just a cheaper substitute for alternative financial resources? 24. Most of the project funds (over 70 percent) were disbursed during 1987 and 1988, when condititions in the Mexican economy were highly inimical to the provision of long-term credit. Although the Government's stabilization program had started, a slippage in public financial discipline and weakening oil prices in 1986 had resulted in a large jump in the public sector deficit. Monetary growth exploded and inflation climbed to triple digit levels in 1987 and 1988. Nominal interest rates (represented by the banks' average cost of funds (ACF)) reached a high " This is confirmed by the ex-post results of a small sample of 41 subprojects obtained by the project completion mission. The results of the sample subprojects are discussed in the PCR. -8- of 104 percent in 1987 (Table 1). In this environment, it was difficult for banks to attract term deposits for onlending. 25. In addition, although the Government had initiated some basic structural reforms (with a substantial reduction in the coverage of QRs, the divestiture of several hundred small state- owned companies, and the rationalization of the operations of some major parastatals), controls over the banking system remained and served to crowd out the private sector from the credit market." To limit credit expansion and force the repatriation of Mexican capital abroad, the Government had frozen private sector credit at its nominal July 1985 level, thus diminishing private sector credit in real terms, and raising marginal reserve requirements to 100 percent. Graph 1: Credit Granted to the Graph 2: Annual Inflation Rates vs. Public and Private Sectors Growth of Real Credit 100100 1986 -9-7--98------1990-1991-Ii- I I--- -- -- - I--- -- -- - I- 120 ---------- -0------ 50 100 1- - - - -I - .--- - - -- .. . . 0 -- ----- -G0 4 0 - - - - - --- - - - - - -10 20l 0--a 1986 1911 1988 1989 1990 1991 20 6 Ei r Ob 7 8 9 9 1 42 20 63 64 6 06 07 06 09 90 91 92 I.8 Yer Source: Baring Securities. Report on Mexican Financial Groups, September 1992. Banco de M6xico and Baring Securities estimates. 26. During 1987 and 1988, credit to the private sector as a percentage of GDP declined to 9.4 and 9.8 percent respectively (Table 1). In the face of tight credit conditions in Mexico, many of FONEI's clients could not easily turn to the international financial community, because access to funds from abroad had been virtually cut off." Subborrowers and commercial bankers interviewed for this audit confirmed that FONEI's funds were critically needed in these years and that, without FONEI, many of the investments to improve existing capacity and modernize would not have been made. Some Mexican officials interviewed for this audit held the view that, without access to FONEI funds, some firms, even though viable in the longer run, would have failed, delaying Mexico's economic recovery and exacting high transition costs. By 12 The controls included forced lending schemes, interest rate controls and high reserve requirements. " The extent to which some of the larger and more well known of FONEI's clients lent surplus funds to each other through an "inter-company" market, and obtained access to funds through brokerage firms' placement of commercial paper, is unknown. In any case, these funds typically are of short maturity. -9- end-1988, however, the Government started initiating fiscal and financial sector reforms, which led to an increasing flow of resources to the private sector through the banking system. Contribution to Financial Sector Development 27. While the project contributed to the process of industrial recovery, it did not support financial sector development, even though this was an important objective and selling point for the project. In fact, the project (and preceding FONEI loans) tended unintentionally to perpetuate the problems of the financial sector. As discussed earlier, at the time the IRP was prepared, although progress had been made -notably through the negotiation of GIRA - in making the structure of interest rates under Bank loans more responsive to economic conditions and market influences, the financial system was still highly repressed and the earlier proliferation of development banks and trust funds continued to aggravate the segmentation of the financial market and to pose a fiscal burden. The latter through a need for continual Government transfers and through wasteful duplication of effort.14 (For example, FONEI funds were in direct competition with NAFIN's similar funds, which were cheaper and easier to access.) 28. The failure to take more explicit account of these issues may have been due to the Bank's limited access to, and knowledge of, the financial sector. It may also have reflected the Bank's recognition that fundamental financial sector reforms would have to come at the initiative of the Government and not at the urging of the Bank. However, the fact that five loans through FONEI (amounting to US$510 million) had been made, despite inadequate sector knowledge suggests that the desire to maintain an easy and proven lending vehicle also played a significant role. In the case of the IRP, an incentive to ignore these issues may also have been due to the overriding and urgent need to transfer substantial financial resources to Mexico. 29. It should be noted, however, that the FONEI loans did make some contribution to financial sector development through the demonstration effect of FONEI's training and technical assistance. FONEI was able to convince many PFIs of the merits of project appraisal over the placing of sole reliance on personal connections and collateral in making lending decisions. This is reported to have led some banks to gradually lower collateral requirements on FONEI loans because of better access to project information." However, this contribution cannot be ' The Ministry of Finance (SHCP) calculations show that transfers to development banks and trusts represented 4.2 percent of GDP in 1986, while subsidies, ignoring loan collection problems, amounted to 3.2 percent of GDP. Subsidies were measured by the difference between the rates charged to the final borrowers and the prevailing market lending rates. (Source: Internal Bank memorandum dated November 30, 1988 on the financial sector.) " The audit report of the previous two FONEI loans showed the results of a sample, taken by FONEI, of average collateral (in relation to loan amount) on FONEI subloans from 1977 to 1988. This confirmed the gradual reduction of collateral requirements for FONEI projects as shown below: 1977-1981 8:1 1982-1984 4:1 1985-1988(July) 2:1 - 10 - attributed to the IRP, but to previous FONEI loans. 30. The IRP intended to explicitly support financial sector development through a pilot equity scheme, which was to help build up a capital market in Mexico. This was clearly not achieved. A proper assessment of the financial sector would have led to the conclusion that the promotion of commercial bank equity participation stood scant chance of success. Legislation enacted in 1985, which, inter alia. provided a framework for risk capital funds, was restrictive and insufficient to stimulate an equity market, the tax system was still biased in favor of debt versus equity instruments, and the equity market, in the early years, was competing with a large supply of low-risk Government securities yielding high returns. It was, therefore, unlikely to attract substantial resources. Furthermore, the commercial banks were not particularly interested in promoting potentially risky investments in an environment of high uncertainty and instability (especially since they had large portfolios of shares, acquired through restructuring litigation and bankruptcy, which they wanted to sell) and large Mexican industrial enterprises were not particularly keen to have nationalized banks as shareholders. The poor response to the equity component and its apparent use, where employed, essentially as a type of cheap short-term loan (by virtue of an enterprise's option of subsequent repurchase) confirms that the component was premature. 31. The Bank was not entirely unaware of these drawbacks to the effective promotion of equity instruments, some of which were recognized in the project documents. The main issue was one of presentation. Although the equity component was to be carried out only on a pilot basis, it (along with the small technical assistance component) became an important rationale for the project, underpinning the project's objectives of improving the quality and broadening the scope of financial services in Mexico. It would appear, as concluded in the PCR, that these broader objectives were tacked on to an otherwise traditional line-of-credit operation primarily for marketing purposes within the Bank. Institutional Development 32. When the IRP was prepared, FONEI was considered a well-managed, efficient, second- tier development finance institution and a model of its kind. Over the years, it displayed flexibility and creativity in responding to the changing needs of the industrial sector by increasingly diversifying its portfolio (from equipment loans to other loans, supporting, int alia, technological development, pollution control and permanent working capital) and developing new financial instruments (including variable interest rates and the PVP system). In addition, as discussed earlier, it developed a good technical capability to appraise and supervise projects and some of this expertise was transferred to NAFIN and the commercial banks." However, if FONEI is viewed in perspective, as one element of an elaborate network of '6 With the merger of FONEI with NAFIN a number of staff were transferred, while some chose to move on to more lucrative positions in the banking system. The skills acquired were therefore not entirely lost. - 11 - development banks and trust funds that was duplicative and inefficient, the institutional improvement of FONEI itself must be seen as a very limited and inadequate objective. 33. The IRP aimed at consolidating the institution-building efforts of the previous loans by developing FONEI's capabilities to: provide financial restructuring assistance to over-leveraged companies; carry out financial market studies; and upgrade internal information and control systems. As discussed earlier, these institution building efforts did not materialize and were effectively abandoned with the merger of FONEI into NAFIN. Role of the Bank 34. Upstream Activities. The quality of the Bank's performance during preparation and appraisal of the project was deficient. Project design was impaired by Bank staff's limited knowledge of the financial sector and general acceptance of the status Quo. It was particularly disappointing that: + The institutional context of lending through specialized trust funds was taken for granted without their raison d'etre, inefficiencies and potential for aggravating the segmentation of the market being addressed; * The provision of equity finance was accepted as contributing to capital market development without a proper analysis of the underlying causes inhibiting such development; * The technical assistance component, particularly the financial market study, was loosely defined, without a proper commitment on the part of the Government or FONEI to implement the component; and * The technical aspects of the project were not carefully designed. The PVP system was too complicated to administer, and on-lending rates (based on fixed percentage points above the ACF) did not take into account the possible effects of a less inflationary environment. 35. The Staff Appraisal Report and the President's Report did not indicate that the absorption of FONEI into NAFIN was in the offing and a possible risk to the achievement of the project's objectives, even though during the early stages of project preparation (as far back as the initiating project brief stage) the merger was under consideration by the Government. Furthermore, the financial strength of FONEI was not fully discussed, even though at the time the project was prepared, its financial sustainability was in question because of its inability to maintain the real value of its assets and equity. 11 Since the Bank was unable to place this 17 The audit of the third and fourth FONEI loans concluded that, over the period 1980 to 1986, FONEI suffered a real capital erosion of about two-thirds. Capital transfers from the Government helped to compensate for FONEI's capital erosion. This erosion was not due to portfolio losses, but rather due to interest rates that were negative in real terms and to FONEI's - 12 - project and its predecessors in a proper context, its role was limited to temporarily relieving the symptoms of distorted Government policies, rather than to addressing the underlying, more fundamental problems. 36. Downstream Activities. The quality of the Bank's supervision was deficient in terms of the frequency of missions, the reporting of project progress, advice to the implementing agency and attention to the achievement of the project's development objectives. The first supervision was conducted one year after effectiveness, the second mission, which lasted two days, was one- and-a-half years later, and the third mission a year after that. During this time, the macroeconomic environment was rapidly changing and fundamental decisions affecting the design and institutional development objectives of the project (such as the merger of FONEI with NAFIN) were being taken without the involvement of the Bank. There is no evidence of recommendations by the Bank on how to handle the impact of these changes; instead supervision missions focussed mainly on the disbursement of funds and the line of credit component. After the merger, a supervision mission reported that both FONEI and NAFIN were in considerable turmoil, but stated that the mission was not able to learn much about the scope of the reorganization. Although the Bank's relationship with FONEI dated back to its creation, the Bank's advice was not sought in its dissolution. The Bank's performance during supervision leads one to conclude that the Bank was largely a bystander during project implementation. Sustainability 37. The general outlook for the sustainability of benefits derived from the subprojects financed under the IRP seems positive. As a result of the fundamental economic and structural reforms implemented over the last few years, Mexico's industrial sector is now free from major policy distortions and is operating in an environment that is economically stable, with well structured incentives for growth. The reforms in the financial sector have revitalized the banking system and the securities market, and are likely to assure the future financing needs of industrial enterprises. 38. The passage of NAFTA gives permanence to many of the Government's reforms, but it also brings change to the profile of the industrial sector as new winners and losers (some of whom may well be FONEI clients) emerge. Inefficient industries, including those that have invested in worker training and new technology, will have to adjust to the realities of integration. Furthermore, industrial firms, including some of FONEI clients, will have to adapt to new environmental standards. Sustainability will depend on the success of these efforts and the continuing political commitment to address the outstanding economic, social and environmental issues. 39. NAFIN now largely operates as a second-tier institution and has reoriented some of its activities towards support of new priorities, such as infrastructure development, technology, absorption of the foreign exchange risk on past foreign loans. For a detailed discussion, see Project Performance Audit Report, Mexico: Third and Fourth Industrial Equipment Projects, June 13, 1989, Report No. 7859. - 13 - environment and micro- and small enterprises. This continued role is justified by Mexican officials on the grounds that adequate financing for these activities is not forthcoming through normal commercial channels. The sustainablity of NAFIN will, to a large extent, depend on how successful these new, riskier ventures are. Strengthened supervision of both first-tier and final borrowers will be of critical importance. NAFIN's future role in financing medium- and large-scale industrial enterprises, such as those supported under this project, becomes more questionable as commercial bank financing becomes increasingly available to these clients as a result of reforms and increased competition, including competition from foreign banks under NAFTA. It should be noted that at present, there are only two ongoing Bank projects that involve line-of- credit operations with NAFIN: The Industrial Restructuring Project (Ln.3047- ME) and the Fourth Small- and Medium-Scale Industry Project (Ln. 2858-ME). There are currently no plans for similar operations in the future. IV. CONCLUSIONS AND LESSONS OF EXPERIENCE 40. Mexico's dramatic reforms, particularly the macroeconomic stabilization and trade reforms, succeeded in restoring the confidence of the private sector and bringing about increased private investment, as shown in Table 1. 1s The IRP complemented these reforms by providing the finance needed for many of Mexico's medium-and large-scale industrial firms to adapt to a more internationally competitive structure of incentives and to increasing foreign competition. Thus, the project played an important, albeit small, role, in reducing the disruptive impact of the economic environment in the early years and in assisting the process of industrial recovery. 19 The project's contribution to the industrial recovery is highlighted by the fact that 98 percent of the subloans supported the expansion or modernization of existing enterprises, and 44 percent supported export-oriented projects (a higher share than in previous FONEI loans). There was also another important political dimension to the project, as mentioned in the PCR: the availability of financing for restructuring helped mitigate opposition by industrialists to the ongoing trade liberalization process. 41. Nonetheless, it needs to be recognized that the shortage of funds - particularly term funds - for private investment was itself the product of excessive public spending and a repressed financial sector. The IRP, therefore, served to partially substitute for tighter public sector financial discipline and a more market-determined and economically rational allocation of credit. In effect, instead of attempting to correct poor policies directly, the project was directed towards alleviating their symptoms. " The scale of investment in industry can also be inferred from the fact that capital goods imports more than tripled between 1987 and 1991. " As the PCR points out, the contribution of the project to the industrial recovery process was limited by its dimensions: US$307 million equivalent of total subproject investments corresponds to less than 5 percent of annual private investment in the industrial sector. - 14 - 42. The project made no significant contribution (directly or indirectly) to financial sector development or institutional development even though these were important objectives. The more innovative aspects of the project, including the technical assistance, which could have addressed these objectives, were poorly designed, without adequate sectoral knowledge. In the end, these components became irrelevant as reforms overtook their usefulness. 43. Through the IRP and the two other projects approved concurrently, the Bank was able to provide substantial financial resources to Mexico at a time of crisis. The Bank's role was important in this respect. However, its role in designing and supervising the project was disappointing. Having poorly prepared this project, the Bank was content to be a bystander during its implementation. For the Government, as emphasized in their contribution to the PCR, the central point of the project was to support the financial recovery of the industrial sector through the granting of long-term credits at a time when credit was scarce. For the Bank, the objectives were clearly broader. In view of the project's failure to meet these broader objectives, the outcome of this project is rated as marginally satisfactory. Lessons of Experience 44. This project offers a number of lessons of experience, which are summarized below: Project Objectives and Design + Projects must be based on a proper understanding of the macroeconomic and sectoral contexts in which they will be implemented, in order to: assure their relevance; avoid the potential aggravation or perpetuation of any existing policy shortcomings, institutional ineffiencies and allocative distortions; and ensure better project design. * The major objectives of a project should not be expected to be achieved through relatively minor project components, such as pilot schemes, studies or technical assistance. This places false expectations on potential project achievements. When these components are included, special efforts must be made to secure firm local commitment to their implementation at the outset and to ensure their proper supervision by Bank staff. Financial Intermediation * Directed credit schemes (notwithstanding their potential for misallocating resources) can at times serve an important function (such as during times of macroeconomic instability, economic uncertainty and credit scarcity brought about by adjustment policies), by providing a lifeline of financial support to industrial firms trying to weather the difficult times. However, as in this case, there needs to be a credible program to stabilize and structurally adjust the economy, particularly through trade reform, otherwise there is a real risk that these schemes will end up supporting inefficient and unviable industries. In addition, these schemes should be carefully targetted and priced appropriately so that they are not used by favored borrowers as cheaper substitutes for alternative commercial - 15 - sources. * Financial intermediation projects must ensure that the subproject appraisal and monitoring process includes criteria for reviewing and enforcing environmental standards. Role of the Borrower and the Bank * The Government's full cooperation and commitment, its willingness to participate in frank discussion, and its preparedness to give the Bank access to relevant background information is critical to successful project design and outcome. * Supervision missions should be proactive and not only focus on loan disbursements but assess the impact of macroeconomic and sectoral changes on the attainment of project objectives, with a view to taking corrective action, if necessary. * Project documents should include franker discussions of the problems encountered in preparing a project (such as inadequate access to sector information or limited Government interest in the Bank's involvement). In addition, if second-best solutions are adopted (such as intervention due to market failure) they need to be clearly justified and a remedial course of action to address the underlying problems should be discussed. 45. In conclusion, one of the most important and obvious lessons is that successive loans to an institution must take into account the lessons of the past. The audits of the third and fourth FONEI loans concluded that inadequate sectoral knowledge impaired project design and poor supervision affected project implementation. Unfortunately these same conclusions must be drawn for this project. 46. The audits of the preceding four projects also concluded that the FONEI loans did not reach the intended beneficiaries, but, rather, well-established, favored borrowers who had access to alternative sources of finance. Therefore, one might conclude that, with the exception of brief periods of real credit shortage, the Bank's support of FONEI resulted in the transfer of substantial resources (at varying levels of subsidy) to a class of favored borrowers in the industrial sector, who could have availed themselves of alternative resources through the banking system. A more systematic incorporation of lessons learnt might have led to more careful targetting in subsequent projects and hence improved the Bank's net contribution to Mexico's industrial development through the FONEI loans.  - 16 - BIBLIOGRAPHY Annex I World Bank. Economic Report, Mexico - Recent Developments in Mexico's Exchange Rate Policy, Report No. 11991, June 1993. World Bank. Economic Report, Mexico - Private Sector Assessment, Report No. 11823, April 1993. World Bank. Economic Report, Mexico - Mexico in Transition: Towards a New Role for the Public Inter, Report No. 8770, May 1991. World Bank. Economic Report, Mexico - Tax Reform for Efficient Growth, Report No. 8097, November 1989. World Bank. Economic Report, Mexico - Towards Growth. Structural Reform and Macroeco Stability in Mexico, Report No. 7525, December 1988. World Bank. Economic Report, Mexico - Trade Policy Reform and Economic Adjustment, Report No. 7314, August 1988. World Bank. Economic Report, Mexico - After the Oil Boom: Refashioning a Development Strategy, Report No. 6659, June 1987. World Bank. Economic Report, Mexico - Public Sector Investment Review: A Joint Report, Report No. 6371, August 1986. World Bank. Economic Report, Mexico - Recent Economic Developments and Prospects, Report No. 4996, May 1984. World Bank. Internal Discussion Paper, No. 29. "Managing Mexico's External Debt: The Contribution of Debt Reduction Schemes," January 1989. World Bank. Internal Paper, No. 178. "Economic Prospects and Policies in Mexico," May 1986. World Bank. Internal Paper, No. 70. "Economic Development and the Labor Market in Mexico," August 1981. World Bank. Internal Discussion Paper, No. 41. "Growth, External Debt and the Real Exchange Rate in Mexico," May 1989. World Bank. Journal Article, No. 281. "Trade Policy in Mexico," March 1983. World Bank. Policy Research Working Paper, No. 257. "Growth, External Debt and the Real Exchange Rate in Mexico," August 1989. World Bank. Policy Research Working Paper, No. 183. "Private Investment in Mexico: An Empirical Analysis," April 1989. - 17 - World Bank. Sector Report, Mexico - Industrial Policy and Regulation, Report No. 8165, August 1990. World Bank. Sector Report, Mexico - Selected Policy Papers, Report No. 7813, June 1989. World Bank. Sector Report, Mexico - Trade Policy, Industrial Performance and Adjustment, Report No. 6215, June 1986. World Bank. Sector Report, Mexico - Industrial Energy Rationalization Program, Report No. 5782, July 1985. World Bank. Sector Report, Mexico - Country Industrial Sector Strategy Paper, Report No. 5686, May 1985. World Bank. Sector Report, Mexico - Future Directions of Industrial Strategy, Report No. 4313, May 1983. World Bank. Sector Report, Mexico - Industrial Decentralization, Report No. 3449, April 1981. - 18 - Annex 2 Summary of Main Project Terms and Conditions Loan Amount: US$150 million Borrower: Nacional Financiera, S.N.C. (NAFIN) Terms: 15 years, including 3 years of grace at the Bank's standard variable interest rate and charges. Allocation: Category 1: US$78.5 million for investment subloans Category 2: US$50.0 million for permanent working capital subloans Category 3: US$20.0 million for equity investments Category 4: US$1.5 million for consultant services, staff training and computer equipment Relending Terms: NAFIN would pass on loan funds to FONEI on the same terms as the Bank loan. The Government would repay the principal of the Bank loan, pay interest, and bearing the foreign exchange risk. FONEI would relend funds to intermediaries at rates not less than the average cost of funds to the banking system (ACF) plus one percentage point. The spread intermediaries would charge on fixed investment subloans would vary between a minimum of one and a maximum of four percentage points; there would be no upper limit on the spreads for working capital subloans. Maturities would vary between 3 and 13 years for equipment loans, 3 and 7 years for working capital subloans, and 3 and 10 years for the rediscounting of equity investments. The grace period would not exceed 3 years for equipment and working capital subloans, and 5 years for the financing of equity investments. FONEI would offer, as an option, the "Sistema de Pagos Variables al Valor Presente (PVP), " in order to ease the cash flow of borrowers. Prior Review of Subprojects: Prior review required for first three subprojects that involved an equity investment. For the following subprojects, prior review required for all equity investments exceeding US$ 2 million or 10 percent of the company's total capital, whichever was lower. Procurements: Goods to be procured on the basis of competitive bidding, advertised locally, in accordance with procedures satisfactory to the Bank. - 19 - Annex 3 NACIONAL FINANCIERA Multilateral Finance Department Our ref: BBL-214-IV-94 April 4, 1994 Mr. Manuel Pefialver Chief, Country Policy, Industry and Finance Division Operations Evaluation Department The World Bank Washington, D.C. In the matter of World Bank Loan No. 2746-ME, which funded Mexico's Industrial Recovery Program and is now in the reimbursement phase, I wish to acknowledge receipt of your letter of February 22 last, to which was attached the draft version of OED's Project Performance Audit Report in this case. Set out below are the observations which Nacional Financiera, in its capacity as executing agency for the Program, wishes to make on the PPAR: 1. The statement that following the absorption of FONEI by NAFIN the monitoring of subprojects weakened is considered to be without merit. Although the extent of FONEI discounts was not comparable to that of NAFIN discounts, supervision and follow-up mechanisms were similar and geared toward the same objective. In addition, in the specific case of the subprojects that benefited under this Program, all information requested by PCR and PPAR mission members was provided. Both missions requested information on computation of the economic and financial rates of return on a sample of subprojects so as to be able to compare ex ante and actual data, but it was explained in both cases that neither FONEI nor NAFIN procedures made it possible to respond to this type of request. However, all other information requested was provided, and in a number of instances it was even necessary to obtain material from General Archives (inactive matters). - 20 - 2. It is merely superficial to underrate the results of the Program by blaming "excessive public spending" and "a repressed financial sector" for the shortage of funds for private investment. It should be remembered that this loan was negotiated and signed during a period of dramatic structural changes that were the outcome of an economic adjustment policy agreed upon with the international financial community, of which the Bank is an important member. It may also be noted that the explanation given for the causes and impact of the crisis of 1982 is incomplete and particularly simplistic. 3. With regard to the pilot project to introduce financing of equity and quasi-equity investments by commercial banks, it is important to note that FONEI lacked experience in implementing programs of this type since at that period NAFIN incorporated a trust fund (FOMIN) which had been responsible since 1972 for promoting industrial growth and development with contributions of risk capital. It may be assumed that during the early years of the Program execution period there was competition between two funds being financed from the same source. Despite the foregoing, the disappointing results of this pilot program do not indicate that instruments of this type are premature, but that the mode of implementing them followed in Mexico does not fit in with World Bank requirements. This fact not only impeded implemen- tation of this particular component of the Program, but also caused problems with its other components, although they were carried through. 4. Regarding the Bank's opinion on the PVP (pagos al valor presente) repayment mechanism, the fact it was hardly utilized was a not a matter of its being difficult to administer or not well understood, but that it meant the capitalization of interest. Given the prevailing general uncertainty in the economy, businessmen were particularly uneasy about the market for their products and preferred to use the conventional modes of payment. As to the technical assistance component, the fundamental reason why it was a "non-starter" was that the merging of FONEI with NAFIN made it unnecessary, since the latter had, and still has, special technical assistance programs on a larger scale. 5. It is important to point out that the firms which benefited from this Program were actually those targeted by the loan, since the group included large as well as medium-sized firms. Given the economic conditions prevailing in Mexico at the time, there was no other, alternative source of financing, a situation which by now has been fully overcome. -21 - 6. Finally, the assertion that the financial market studies were not carried out because "of the Government's reluctance to allow the Bank to get involved in a sector that was considered politically sensitive" is not only unfounded and irresponsible but also reflects a serious lack of knowledge of the relationship between the Bank and the Government in recent years. Yours, etc. /s/ Juan Manuel Izquierdo Sosa Director CC: Rafael Rodrfguez Islas, SHCP (Secretariat of the Treasury and Public Credit) Mois6s Pineda Padr6n, SHCP Timoteo Harris Howard, NAFIN (Nacional Financiera)