Mexico - Second Contractual Savings Development Program (CSDP II) Adjustment Loan Project

Document of THE WORLD BANK For Official Use Only Report No. P 7239-ME REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED SECOND CONTRACTUAL SAVINGS DEVELOPMENT PROGRAM (CSDP II) ADJUSTMENT LOAN OF US$400 MILLION TO BANOBRAS, S.N.C. WITH THE GUARANTEE OF THE UNITED MEXICAN STATES May 13, 1998 Finance, Private Sector and Infrastructure Country Management Unit 1 Latin America and the Caribbean Regional Office This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS Currency Unit = Peso (P$) US$1.00 P$8.4 (February, 1998) FISCAL YEAR January 1 - December 31 ABBREVIATIONS AND ACRONYMS AFP Administradoras de Fondos de Pensiones (Pension Fund Administrator - Chile) AFORE Administradora de Fondos para el Retiro. (Pension Fund Administrator) BANOBRAS Banco Nacional de Obras y Servicios Publicos, S.N. C. CNBV Comision Nacional Bancaria y de Valores. (National Banking and Securities Commission) CNSF Comisi6n Nacional de Seguros y Fianzas. (National Insurance and Bonding Commission) CONSAR Comision Nacional del Sistema de Ahorro para el Retiro. (National Commission of the Retirement Savings System) FOVI Fondo de Operacion y Financiamiento Bancario a la Vivienda. (Housing Financing Trust Fund) FOVISSSTE Fondo para la Vivienda de los Trabajadores del ISSSTE. (Government Workers' Housing Fund) FTAL Financial Sector Technical Assistance Loan IMSS Instituto Mexicano del Seguro SociaL (Mexican Social Security Institute) INFONAVIT Instituto del Fondo Nacional de la Vivienda de los Trabajadores. (National Workers' Housing Fund Institute) ISSSTE Instituto de Seguridad y Servicios Sociales de los Trabajadores del Estado. (Institute of Security and Social Services for Government Workers) IV Seguro de Invalidez y Vida (Disability and Life Insurance) IVCM Invalidez, Vejez, Cesantia en EdadAvanzada, y Muerte (Disability, Old age, Severance, and Death Insurance Coverages) RCV Seguro de Retiro, Cesantia en Edad Avanzada, y Vejez (Old Age and Severance) MPG Minimum Pension Guarantee PROCAPTE Programna de Capitalizacio n Temporal (Temporary Capitalization Program) SAR Sistema de Ahorro para el Retiro (Retirement Savings System) STPS Secretaria de Tranajo y Prevision Social SECOFI Secretaria de Comercio y Fomento Industrial SHCP Secretaria de Hacienda y Credito Publico. (Ministry of Finance and Public Credit) SIEFORE Sociedad de Inversiones Especializadas de Fondos Para el Retiro (Specialized Pension Fund). Vice President: Shahid Javed Burki (LCRVP) Country Management Unit Director: Olivier Lafourcade (LCC1IC) Sector Management Unit Director: Krishna Challa (Acting, LCSFP) Task Manager: Gloria M. Grandolini (LCSFP)  FOR OFFICIAL USE ONLY MEXICO SECOND CONTRACTUAL SAVINGS DEVELOPMENT PROGRAM LOAN (CSDP ID TABLE OF CONTENTS Page No. LOAN AND PROG,RAM SUMMARY ................................................................ Hi I. MACROECONOMIC CONTEXTAND FINANCING REQUIRE'MENTS .......................................I II THE GOVERNVMENT'S CONTRACTUAL SAVINGS REFORMPROGRAM .................................3 A. Genesis and Objectives of the Pension Reform ................................................................3 B. The Government's Medium-Term Program ................................................................4 C. World Bank Stupport: A Phased Reform Approach ................................................................6 D Key Accomplishments under the First Phase of the Contractual Savings Reform ...........................7 I11 THE SECOND PHASE OF THE CONTRACTUAL SAVINGS PROGRAM . ................................. 11 A. Implementation and Consolidation of the 1997 Pension Reform ....................................................... 11 Regulatoiry Framework ................................................................ 11 Operation and Efficiency of the New Pension System ............................................................... 13 Transfer of SAR 92 balances ............................................................... 22 Investment Policies and Risk Management ............................................................... 23 Supervision and Enforcement ................................................................ 27 Disability and Life ............................................................... 29 Update of Fiscal Costs of the Transition ............................................................... 31 B. INFONAVIT ............................................................... 33 C. Preparatory work for the Public and State Pension Systems .............................................................. 38 D. Public Information ............................................................... 40 E. Complementary Financial Market Reforms ............................................................... 41 Banking Sector ............................................................... 41 Mutual Funds ............................................................... 41 Voluntary Pension Plans ............................................................... 42 Development of Long-Term Instruments and Financial Services ............................................ 42 IV. BANKASSISTANCE STRATEGY ..43 A. Overall Assistance Strategy ...................................... 43 B. Coordination with IMF ...................................... 44 C. Coordination wiith IDB ...................................... 44 V. THE PROP0OSED LOAN ...................................... 45 A. Loan Size and Proposed Tranche Conditionality ...................................... 45 B. Technical Assistance ...................................... 46 C. Disbursement and Auditing ...................................... 47 D. Lessons Learned ...................................... 47 E. Monitoring and Reporting ...................................... 48 F. Benefits and Risks ........................ 48 G. Program Objective Categories ........................ 50 VL RECOMMENDATION ......................... 51 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.  - ii - ANNEXES I. Letter of Sector Policy II. Matrix of Policy Actions III. Technical Annex IV. Investment and Risk Management in the Reformed System V Complementary Financial Sector Reforms VI. Economic Indicators Vil. Balance of Payments VIII External Capital and Debt IX. Status of Bank Group Operations in Mexico X. Mexico at a Glance XI. Supplementary Data Sheet Project Team: Gloria Grandolini (Team Leader - LCSFP); John Stein (Deputy Team Leader), Miguel Navarro, P.S. Srinivas, Truman Packard, Baralides Alberdi, Cara Zappala (LCSFP); Fernando Montes-Negret, Paulo Vieira da Cunha, Joost Draaisma (LCC 1 C); Rudy Van Puymbroeck (LEGLA); Olivia Mitchell (Consultant - Wharton School); Steve Weisbrod (Consultant) Peer Reviewers: Estelle James (DECRG); Afsaneh Mashayekhi Beschloss (IMDDR) 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.  MEXICO SECOND CONTRACTUAL SAVINGS DEVELOPMENT PROGRAM LOAN (CSDP II) PROPOSED LOAN AND PROGRAM SUMMARY BORROWER: Banco Nacional de Obras y Servicios Puiblicos, SNC (BANOBRAS). GUARANTOR: United Mexican States. AMOUNT: US$400 million TERMS: The loan is proposed to be a fixed rate single currency loan in US dollars, with a maturity of up to fifteen years. OBJECTIVES: The proposed loan would support the second phase of the Government's Contractual Savings Development Program (CSDP), which is designed to: (a) increase the equity, efficiency, and sustainability of the old age security system and gradually lead to greater effective coverage; (b) implement a financially viable pension system; (c) limit the fiscal impact of the current pension system; (d) raise the level of institutional savings and improve the allocative efficiency of domestic savings; and (e) enhance capital market development by stimulating greater private financial intermediation. DESCRIPTION: The first phase of the reform focused on the establishment of the legal, regulatory, and institutional framework for the reform of the country's old age security system. The second phase concentrates on the actual implementation of the reformed pension system. Specifically, the second phase of the CSDP supported by the proposed loan (CSDP II), included: (a) implementing, consolidating, and fine-tuning the reformed system for private sector workers by: (i) ensuring a flexible and responsive regulatory framework; (ii) initiating operation of the reformed system and increasing its efficiency; (iii) transferring SAR92 balances from the Central Bank to individual AFORE accounts; (iv) fine-tuning investment policies and improving risk management; (v) strengthening supervision and enforcement; and (vi) initiating payment of disability and survivors benefits by private insurers; (b) updating estimates of the fiscal costs of transition; (c) deepening reforms to INFONAVIT to ensure adequate returns on the housing sub-account; (d) advancing in the technical preparatory work for the reform of the public pension systems; (e) sustaining public confidence through education and information; and (f) advancing in the implementation of complementary financial market initiatives.  - iv- BENEFITS: Overall, the program will lay the basis for a marked increase in the volume of institutional savings and provide the institutional basis through which domestic savings can be channeled to productive investment. It will also lead to the creation of a new class of institutional investors and a new set of longer-term instruments. Pension and social security reform will move the actuarially bankrupt defined-benefit system to a fully funded defined contribution scheme. Public confidence will be strengthened, as workers will no longer view their contributions as a tax to provide benefits to current pensioners; instead, they will view these contributions as a means to build personal wealth. The separation of the pension and health sector schemes will result in pressure for greater efficiency in the delivery of public health benefits. Reforrns in the insurance industry will create a larger class of insurance products such as annuities, life and disability and pre-paid medical insurance. Reforms to improve Mexico's legal framework for mutual funds, secured lending and asset backed securities will deepen the capital market over time and broaden the base for domestic savings. In addition, over the longer term, as pension funds increase their equity fund investments, they will become major catalysts for improved corporate governance. RISKS: The reform could lead to higher fiscal costs if the savings generated from defined wage contributions do not earn an adequate real rate of return. These fiscal risks arise from the Government's continued guarantee of a minimum pension benefit to everyone participating in the social security system at the time of retirement. Without the housing fund component earning a positive real rate of return, these risks are high, making INFONAVIT reforms key to the scheme's sustainability. Given the legal limitation on investment in foreign securities, the success of domestic capital market reforms are also crucial to the success of the pension reform especially because of the weakened state of the banking system, which is currently the only major private source of financial assets. Low real rates of return on the average pension fund's assets are also likely to increase the moral hazard associated with providing a minimum pension guarantee by encouraging contributor preference for high risk pension investments. The risks of political pressures to reverse fiscal management policies will always exist but are mitigated by Mexico's growth potential over the medium term. On the banking side, specific programs are in place to increase the capitalization of the banking system while the overall level of supervision has improved markedly. CNBV's strengthened supervisory role for INFONAVIT should ensure the viability of its operational and financial restructuring program. All the above factors will be important for improving the likelihood that pension funds will earn reasonable real rates of return, thus reducing moral hazard concerns.  POVERTY CATEGORY: Not Applicable. ESTIMATED DISBURSEMENT: The proposed loan will be disbursed in a single tranche of US$400 million upon loan effectiveness (October 1998).  REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED SECOND C'ONTRACTUAL SAVINGS DEVELOPMENT PROGRAM LOAN TO BANOBRAS WITH THE GUARANTEE OF THE UNITED MEXICAN STATES 1.1 I submit for your approval the following Report and Recommendation on a proposed Loan to the Banco Nacional de Obras y Servicios Pzublicos, SNC (BANOBRAS) with the guarantee of the United Mexican States, in the amount of US$400 million to support the second phase of the Government's Contractual Savings Development Program (CSDP II) which focuses on the implementation of the legal, regulatory, and institutional framework for the reform of the country's old age security system. The loan would be single currency loan at the Bank's standard fixed rate, with a maturity of up to 15 years, and would be disbursed in a single trariche of US$400 million. I. MACROECONOMIC CONTEXT AND FINANCING REQUIREMENTS 1.2 Recent Economic Developments and Prospects. The Mexican economy rebounded in 1996-97, following the financial crisis of end-1994 and the severe recession of 1995 when GDP fell by 6.2 percent and domestic investment dropped by an excess of 30 percent. In 1996, real GDP rose by 5.2 percent reflecting continued export expansion and a strong recovery in investment. The implementation of tight financial policies led to a near halving of inflation, a significant lowering of nominal interest rates, and a greater stability of the peso. Investor sentiment improved, leading to a substantial rise in foreign direct investment, a marked improvement in Mexico's access to international capital markets, and a substantial increase in international reserves. Preliminary data suggest a consolidation of the economic recovery in 1997, while inflation continues to decline. Real GDP growth reached 7 percent in the year with another healthy expansion of investment in excess of 20 percent. 1.3 As other ermerging market economies, Mexico was jolted by the events in Southeast Asia in the second half of 1997. But, in Mexico, the contagion effects from Southeast Asia were so far relatively small when compared to events in other emerging market economies. Areas of vulnerability of the Mexican economy to adverse external developments are likely to be found in (i) the international oil price, (ii) capital flows to emerging markets and (iii) trade competitiveness. 1.4 Mexico's external accounts experienced a marked improvement since 1994. Exports boomed in 1995 prompted by the large change in the exchange rate and by the contraction in domestic demand; and these same forces led to an opposite impact on imports. With the expansion of domestic output and demand as of 1996, imports recovered rapidly whereas export growth was reduced to more sustainable levels. The trade balance observed a surplus in 1995 and 1996, of 7.1 and 6.5 billion dollar respectively, which diminished rapidly to 0.6 billion dollar in 1997 and is likely to become negative over the next few years.  2 PREsIDENT7SREPORT 1.5 A steady appreciation of the real exchange rate has been observed over the past two and half years and can be attributed mainly to a resumption of capital flows. The combination of an appreciating real exchange rate and growing domestic absorption contributed to a reversal in the trade account and an increasing deficit on the current account. In 1997, the deficit in the current account exceeded US$ 7.3 billion, and it is expected that it will continue to expand in 1998. Nevertheless, on balance, the level of the deficit (at about 2-3 percent of GDP), and of external borrowing, is prudent and consistent with a solid long-term creditworthiness position. 1.6 Underlying the strong performance of the external accounts and of private sector has been the supportive role of government. The operations of the public sector resulted in an increase in the primary surplus from 2.2 percent of GDP in 1994 to 4.5 percent of GDP in 1995-1996, in a context of overall fiscal balance which was prolonged in 1997. Despite declines of government expenditures reflected in transfers to public enterprises, lower spending on wages and salaries, and a rephasing of some capital projects, expenditure on social programs was safeguarded. Monetary policy has supported the fiscal stance and has focused, primarily, on disinflation. Monthly rates of inflation have been on a declining trend since end-1995 and, as a result, the annual rate of inflation has fallen from 52 percent in 1995 to 28 percent in 1996 and to less than 16 percent in 1997. 1.7 The short- and medium-term prognosis for the conduct of macro policy, hence for the economy as a whole, is positive. In 1998, real growth is expected to slow down to a more sustainable rate of about 4.8 percent with continued expansion in investment and progress in disinflation. However, the public sector balance is expected to deteriorate for structural and policy-induced reasons, even as the fiscal authorities come under increasing political pressure for authorizing expenditure increases and/or revenue reductions. 1.8 Justification for Adjustment Lending. The recent decline of international oil prices has led to additional pressures on public sector revenues, with oil income responsible for an average of 38 percent of total public sector revenue. The lower levels of oil prices observed in particular as of December 1997, prompted the Government to announce expenditure reductions of an amount of 0.7 percent of GDP for 1998 in order to maintain its public deficit target at 1.25% of GDP. While the estimated public revenue reduction to date has been mainly on account of external sales and those domestic sales that are contractually tied to price developments on world markets (e.g. natural gas and fuel-oil), a longer lasting weakness of international oil prices will increase pressures to reflect part of the international price decline in other oil related products sold on the domestic market, such as gasoline and diesel. 1.9 The contractual savings reform program as implemented by the Mexican government as of 1997, adequately addresses one of the major areas of public contingent liabilities. The reform, covering workers in the private sector, is causing a near term pressure on public finances with an estimated annual fiscal cost of 1.5 percent of GDP. Furthermore, other quasi-fiscal losses and contingent liabilities were allowed to expand and will require additional fiscal outlays in the near future. These losses arise mainly from the successive bailouts and/or rescheduling of the debts held by private banks, firms, households (mortgages and credit card debt), tollways operators, etc., in the wake of the 1995 financial crisis. The total cost of the financial sector rescue  MEXco - SECOND CONTRACTUAL SAVINGS DEVELOPMENTPROGRAM(CSDP II) 3 programs are now estimated at 14 percent of GDP, or a near term annual pressure on public finances of at least another 0.6 percent of GDP. 1.10 Admittedly, at the level of 40 percent of GDP, Mexico now holds one of the lowest levels of public debt among OECD countries. Yet it also faces the unique challenge of providing an adequate social and productive infrastructure for its expanding and aspiring population, and for its increasingly competitive firms. Public investment now stands at about 3 percent of GDP per year, and this may be insufficient to meet future challenges. Moreover, an overhaul of the fiscal-federalist system is overdue, with a significant shift in the relative balance of fiscal capabilities between the federation and the states. The combination of greater pressure on expenditure with an unavoidable recognition of contingent losses could threaten the medium term fiscal prograin. 1.11 In these conditions, maintaining fiscal discipline is essential as is the policy of sustaining a careful balance between domestic and foreign sources of funding of the fiscal deficit. Given the success of its recent macroeconomic performance, and the credibility of its policies, Mexico again enjoys an arnple access to international financial markets and, thus, did not face a funding constraint for its balance of payments requirements. Nevertheless, the current account deficit for 1998 is expected to be approximately 3% of GDP, and could in fact be higher. Hence, maintaining adequate access to medium-term financing as provided by IBRD is an essential element of the Government's strategy. Moreover, the Government faces a seriously binding fiscal constraint. rhe current program of reforms would exacerbate the difficulties to be faced by the government in abiding to this constraint. World Bank support would allow the authorities more room to maneuver. It would safeguard the limits of domestic borrowing and improve the overall quality of the medium-term fiscal response. II. THE GOVERNMENT'S CONTRACTUAL SAVINGS REFORM PROGRAM 2.1 This section presents the genesis and overall objectives of the Government's contractual savings reform and its medium-term program. This section also highlights the main characteristics of the World Bank's support through a phased reform approach. Finally, it summarizes accornplishments in the initial stage of contractual savings reform. A. Genesis and Objectives of the Pension Reform 2.2 Since coming into power, the Zedillo administration recognized that Mexico's contractual savings system suffered from several weaknesses. These have significant economic consequences that limit the viability of the social insurance system, constrain the development of the country's financial sector, and limit prospects for sustainable economic growth. The Government of Mexico has embarked on a major and important reform of the old age security system which should prove beneficial both to individuals, through the opportunity to obtain increased retirement income, and to Mexico's economic growth prospects over the medium and long term. 2.3 Demographic changes, rising health costs, as well as an increased level of benefits not properly backed in sufficient actuarial reserves indicated that the public pay-as-you-go (PAYG) pension system operating in Mexico, would become financially unsustainable by the end of the  4 PRESIDENT'SREPORT decade. A limited and failed attempt at reform was made in 1992 by establishing a mandatory individual retirement savings account (Sistema de Ahorro para el Retiro - SAR92) - with mandatory 2% defined contribution individual accounts - and by raising the contribution quota to the Mexican Social Security Institute (Instituto Mexicano de Seguridad Social - IMSS). The worsening financial situation of IMSS, labor market distortions, unfairness linked to the benefits' scheme, and the need to generate higher domestic savings - particularly after the December 1994 crisis - led to a growing consensus for pension reformn. 2.4 The reform of contractual savings is one of the key goals in the Government's National Development Plan (1995-2000). It is a medium-term program aimed at: * increasing the equity, efficiency, and sustainability of the old age security system gradually leading to greater effective coverage; * implementing a financially viable pension system; 1 limiting the fiscal impact of the current pension system and ensure transparency of the fiscal costs of transition; * enhancing financial market development and reducing volatility by stimulating greater private financial intermediation and increasing the array of financial instruments and contracts available; and l contributing to enhance the allocative efficiency of domestic and, in the longer-term, to raising aggregate savings. B. The Government's Medium-Term Program 2.5 The initial stage of reform. The shift of a country's pension system to a more equitable and financially sustainable one and the implementation of complementary financial sector reforms, is a long-term process. The Mexican Government could not afford - financially and politically - to tackle all aspects of the reform in one fell swoop. Also, the fine-tuning of the reform depends on the outcome of the implementation of the initial phase. The Government decided to initially focus its efforts towards the reform of the old age insurance scheme for private sector workers. During 1995-96 the Government implemented a number of policy actions that resulted in shift from a public PAYG, defined-benefit system to a privately managed, defined-contribution system. Also, the Government set up the supervisory framework for the private pension fund administrators and issued the investment rules to be followed by the pension funds. Section C below summarizes the key accomplishments of this initial stage of reform implemented during 1995-1996, and supported by the World Bank's fist Contractual savings development Program Loan (CSDP I). 2.6 The remaining agenda. Full realization of the objectives of the reform depend on the consolidation and fine-tuning of the reforms initiated during 1995-96, on maintaining the necessary flexibility to cope with implementation challenges, as well as addressing a number of design limitations. The remaining agenda needs to address the following strategic issues: c Increase the efficiency of the reformed system to lower administrative costs and augment the amount of funds available for investment. This challenge entails: the successful operation of the AFORE industry, including authorization, affiliation, and switching;  MEaCO - SECOND CONTRACTUAL SA vINGSDEVELOPMENTPROGRAM (CSDP 11) 5 * the smooth and efficient operation of the new centralized system for collection, individualization of accounts, and record-keeping; * The development of pension performance benchmarks for investment return and pension plan service. * Ensure that CONSAR continues delivering: * A flexible regulatory environment - able to respond to the changing needs of the reformed system. Key short-term actions include the issuance of rules relating to: (i) switching among AFOREs (traspasos); (ii) disclosure; (iii) transfer of SAR 92 balances into individual accounts; and (iv) orderly consolidation of the industry; and * A strong supervisory framework with enhanced enforcement capacity. 1 Create the conditions for adequate risk-adjusted returns for AFOREs. Critical to contain fiscal costs for transition generation and to ensure adequate retirement income to new generations. The focus should be on: * fine-tuning the investment regime and expanding investment opportunities; and * Strengthening risk management systems. D Design and implement mechanisms to ensure a competitive return to the contributions channeled to the housing sub-account (INFONAVIT). The reform will not fully succeed unless adequate returns can be assured on the 5% contribution to INFONAVIT - which represents 37% of total contribution for a worker earning the average wage. > Improve the efficiency of the provision of life and disability insurance and foster continued delvelopment of the insurance industry and annuities markets. Disability and life continues to be provided by IMSS with a fixed charge of 2.5% of payroll. The cost is high compared to that observed in other Latin American countries that have opted for allowing competition by pension fund mangers and the purchase of the insurance from an insurance company. * Continue monitoring of fiscal cost estimates, including sensitivity analysis. The Mexican plan is riskier on the fiscal side than the approach followed in other Latin American countries because the Government's liability is uncertain. The reformed system allows for a lifetime switch between the old and new system for every transition worker. Mexican fiscal costs, as compared to Chile's, for example, could be (i) higher, if returns on individual contributions (AFORES + INFONAVIT) are not high enough to ensure that a large number of transition workers choose, at retirement, the new system, but could be (ii) lower, because Mexico is saving the cost of recognition bonds if the market value at retirement of individual accumulated balances exceeds accrued benefits under the old PAYG system. Also, the Government did not restructure the current PAYG system as part of the 1997 reform and it continues to be a nominal system with many structural weaknesses that make the results of the reform program very sensitive to the future rate of inflation. * Sustain the public confidence in the system by building public support and confidence in the new pension system so as to avoid evasion and attract informal workers. * Accelerate complementary financial sector reforms to ensure an adequate supply of quality financial assets available for pension fund investment and support the development of financial infrastructure needs (such as custody services and rating agencies).  6 PRESIDENT'SPREPORT * Expand the reform to Public Sector workers. The current reform did not contemplate changes to the ISSSTE, PEMEX, other parastatals, armed forces, and the state pension plans. Hence, the portability constraint across private and public sector workers' pension plans will remain for now an issue along with the financial disequilibrium to be faced in the future by these pension funds. * Expand coverage. One of the longer-term objectives of the Mexican reform is to extend coverage and minimize the incidence of old-age poverty. Even in Chile, where the AFP system has been in full operation for nearly 16 years, that portion of the economically active population that is informally employed has increased from 49.9% in 1990 to 51.2% in 1995. This suggests that the removal of labor-market distortions via pension reform, may be a necessary but not sufficient condition either for formalization of the factors of production, or for widespread participation in the privatized pension system. * Allow investment in equities and in foreign securities. The explicit legal prohibition on investment in foreign securities was introduced by Congress as an amendment to the draft legislation proposed by the Executive branch. This prohibition is based on the argument that it would not be desirable to channel abroad long-term savings required by the domestic economy. However, this prohibition restricts the possibility of diversifying the investment portfolio and inhibits diversification of country risk. C. World Bank Support: A Phased Reform Approach 2.7 The World Bank's support in the area of contractual savings in Mexico began in 1990 with the preparation of an economic report, which provided a detailed analysis of contractual savings issues. The proposed loan is the outcome of a close dialogue between the Bank and the Government on the development of Mexico's financial sector and the need to improve the allocation of financial resources and set the basis for the effective channeling of domestic savings. The Bank's participation accelerated in late-1994 with the provision of advice and technical support in the area of pension reform and capital market development. This culminated with the decision to support the Mexican Government's reform objectives through a series of one-tranche adjustment operations. 2.8 To provide a strategic framework, this section highlights: (i) policy actions supported under the first Contractual Savings Development Program Loan (CSDP I) - approved in December 13, 1996; (ii) policy actions supported by the proposed CSDP II; and (iii) the key benchmarks of further progress in addressing remaining issues (para. 2.6) which could be supported in follow-up operation (s). The Policy Matrix in Annex II provides additional details on the medium-term framework.