Mexico - Decentralization Adjustment Loan

Document of The World Bank FOR OFFICIAL USE ONLY Report No. P 7343 ME REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED DECENTRALIZATION ADJUSTMENT LOAN IN THE AMOUNT OF US$606.07 MILLION FOR BANCO NACIONAL DE OBRAS Y SERVICIOS PUBLICOS, S.N.C. (BANOBRAS) WITH THE GUARANTEE OF THE UNITED MEXICAN STATES November 30, 1999 Mexico Country Management Unit Latin America and the Caribbean Region This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  MEXICO-FISCAL YEAR January I-December 31 CURRENCY EQUIVALENTS (as of 1 November 1999) Currency Unit = Peso 9.53 Pesos = US$1 WEIGHTS AND MEASURES Metric System ABBREVIATIONS AND ACRONYMS BANCOMEXT Banco Nacional de Comercio Exterior, S.N.C. BANOBRAS Banco Nacional de Obras y Servicios Publicos, S.N.C. CAS Country Assistance Strategy CNBV Comisi6n Nacional Bancaria y de Valores DAL Decentralization Adjustment Loan FOBAPROA Fondo Bancario de Protecci6n al Ahorro FDI Foreign Direct Investment FY World Bank Group's Fiscal Year GDP Gross Domestic Product GOM Government of Mexico IDB Inter-American Development Bank IMF International Monetary Fund IPAB Instituto para la Protecci6n del Ahorro Bancario NAFIN Nacional Financiera, S.N.C. NAFTA North American Free Trade Agreement PBSS Paquete Basico de Servicios de Salud PAC Programa de Ampliacion de Cobertura PROGRESA Programa de Educaci6n, Salud y Alimentaci6n PROMAD Programa de Manejo Ambiental y Decentralizaci6n SECODAM Secretaria de Contraloria y Desarrollo Administrativo SEDESOL Secretaria de Desarrollo Social SEMARNAP Secretaria de Medio Ambiente, Recursos Naturales y Pesca TALD Technical Assistance Loan for Decentralization TDU Technical Decentralization Unit WBG World Bank Group IB:RD Vice President David de Ferranti Chief Economist: Guillermo Perry Country Director: Olivier Lafourcade Lead Economist/Manager: Marcelo Giugale Task Manager: Marcelo Giugale Operation's Lead Specialists: Steven Webb Fernando Rojas William Dillinger Team Production Support: Michael Geller This operation was prepared by a World Bank team composed of Messrs/Mimes. Dillinger, Rojas (LCSPS); Webb (LCSPE); Marquez (LCSHH): Brizzi, Giugale, Nguyen, Velez, Everhart, Draaisma, Ordonez, Duval, Urbiola, Geller, Toxtle (LCC1C); Genta-Fons (LEGLA); Sherman and Vetter (consultants). The team was led by Mr. Giugale (Lead Economist, LCC1C), and worked under the general guidance of Mr. Olivier Lafourcade (Director, LCC1C).  FOR OFFICIAL USE ONLY MEXICO DECENTRALIZATION ADJUSTMENT LOAN TABLE OF CONTENTS LOAN AND PROGRAM SUMMARY ..................................................... i I. INTRODUCTION AND RATIONALE . ..............................1..................... I II. MExICo's DECENTRALIZATION PROCESS ........................ ............................. 3 A. Overly Complex System of Transfers ............................ ......................... 3 B. Sub-optimal Taxation at the Sub-national Level ...................................... ............ 4 C. Unclear Spending Responsibilities ...................................................... 5 D. Missing Institutional Infrastructure ..................................................... 5 E. Inadequate Framework for Sub-national Borrowing ............................................. 6 III. THE GOVERNMENT' s RECENT ACHIEVEMENTS IN DECENTRALIZATION .. 8 IV. TBE PROPOSED DECENTRALIZATION ADJUSTMENT LOAN (DAL) ................. 9 A. Objective ..................................................... 9 B. Content ..................................................... 10 C. Risks ..................................................... 15 D. Poverty Impact ..................................................... 17 E. Terms and Conditions ..................................................... 18 V. THE MACROECONOMIC FRAMEWORK FOR THE PROPOSED DAL .. 19 A. Recent Economic Developments .................... ................................. 19 B. Macroeconomic Prospects ..................................................... 20 C. External Financing Requirements ..................................................... 22 VI. BANK STRATEGY ..................................................... 23 A. The CAS and The Proposed DAL ..................................................... 23 B. Complementarity with Other Operations by the World Bank .............. ............... 23 C. Complementarity with Operations by Other Institutions ..................................... 24 VII. RECOMMENDATION .. 26 TEXT TABLES Table 1. Mexico-Decentralization Adjustment Loan (DAL) Matrix of Policy Commitments for Tranche Release .. 11-12 This document has a restricted distribution and may be used by recipients only in the performance of teir official duties. Its contents may not otherwise be disclosed without World Bank authorization.  FOR OFFICIAL USE ONLY ANNEXES A. INDIcAToRs Al. Mexico at a Glance ............................. 27-28 A2. Mexico Social Indicators ......................... 29 A3. Key Economic Indicators ......................... 31-32 A4. Balance of Payments.............. ........... 33 A5. Key External Debt Indicators, ............................. , 35 A6. External Financing Requirements and Projected Sources of Financing ............................. 37 A7. Total IBRD Debt Flows and Stock ............................. 39 A8. Status of Bank Group Operations .................41....... 41 A9. Statement of IFC's Committed and Disbursed Portfolio .43 B. ENVIRONMENT-RELATED DECENTRALIZATION POLICY COMMITMENTS ..................... . 45 C. HEALTH-RELATED DECENTRALIZATION POLICY COMMITMENTS ................................ 49 D. LETTER OF DEVELOPMENT POLICY (ORIGINAL IN SPANISH) ............ 51 English Translation of Letter of Development Policy .. . 57 MAP 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 MEXICO DECENTRALIZATION ADJUSTMENT LOAN (DAL) LOAN AND PROGRAM SUMMARY Borrower: Banco Nacional de Obras y Servicios Puiblicos, S.N.C. Guarantor: The United Mexican States Implementing Agency: Secretaria de Hacienday Credito Puiblico (SHCP) Amount and Terms: US$606.07 million fixed spread, US dollar denominated loan, with 10 years of grace period; bullet repayment due on December 1, 2009. Commitment charge: 0.85 percent for first four years, and 0.75 percent thereafter. Front-end fee: 1 percent of the loan amount, capitalized. Description: The operation will directly support the Mexican Government's efforts in bringing market-driven order and accountability to the country's rapidly moving decentralization process. In particular, the DAL will support four immediate policy objectives-imposing hard budget constraints on federal resources provided to states and municipalities; reducing moral hazard in sub-national borrowing; increasing the transparency and public accountability of sub-national fiscal and financial management; and setting up pilot mechanisms to enhance efficiency in decentralized expenditures (with emphasis on environment- and health-related expenditures). The DAL-supported measures, which will provide a sub- national level complement to the authorities' conservative fiscal and monetary policies in the run-up to the presidential transition of December 2000, will be implemented in the context of an on-going IMiF Stand-by operation and will exploit strong synergies with related lending by the IDB. The DAL will be a key tool in delivering World Bank support for the three objectives that drive the current CAS (as discussed by the Board of Executive Directors on June 8, 1999): effective public governance, growth and macroeconomic stability, and social sustainability. The operation was envisaged in the CAS, both in scope and timing, and its amount lies within previously projected exposure limits and adjustment lending envelopes. This document has a restricted distribution and may be used by recipients only in the perfornance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  FOR OFFICLAL USE ONLY Risks and Benefits: Several types of risks will be operative: i) the election calendar will make consensus around necessary reforms difficult to achieve; ii) there remains a possibility that some states or municipalities would refuse to adopt recommendations or respond to incentives that they may perceive as federal imposition; iii) even if agreement is reached among the branches and levels of government, the new administration might choose not to sustain the new rules, institutions or procedures put in place by the decentralization program supported by the DAL; iv) it is theoretically possible that a politically and fiscally desperate state might ignore the new regulatory structure and associate with a rogue bank to borrow excessively; v) financial-sector-related technical difficulties may jeopardize the program's objectives; and vi) increased transparency may, in itself, present an implementation risk for this operation (by severely dampening, on impact, credit rating grades). While real, these risks have been taken into account in the design of the DAL operation, which puts emphasis on avoiding the need for new legislative action (outside the regular budget submission) and seeking to create incentives for the various stakeholders to want to abide, by the new decentralization rules. The DAL operation will carry two broad, core benefits -it will start to put Mexico's rapid decentralization process on a more sustainable path (unlocking that process' long-term promise of better quality in public service delivery, more transparent governance and greater citizen participation) and it will greatly contribute to preventing undue sub- natio:nal pressure on the federal fiscal accounts and, more generally, on the country's macroeconomic framework, especially in the period leading to the upcoming presidential transition. Both benefits will assist in protecting the Mexican poor. Schedule of Disbursements: The full amount of the loan (US$606,070,000) is expected to be disbursed in FY00 in two tranches (US$306,070,000 upon effectiveness, and the remaining loan amount as a second tranche about four months after Board approval). Closing Date: June 30, 2001 Project ID Number: MX-]E-P066867 This document has a restricted distribution and may be used by recipients only in the performnance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  MEXICO Decentralization Adjustment Loan I. INTRODUCTION AND RATIONALE 1. Mexico is progressing rapidly toward more autonomy and fiscal responsibility at sub- national levels of government. This process is being driven by heightened political competition and by the desire of the federal authorities to include decentralization in their program for broadening political participation and enhancing fiscal efficiency. The Federal Congress has reinforced these trends by enhancing municipal autonomy and local resources, as well as by strengthening control institutions. However, the country is not yet realizing all the potential benefits of decentralization. It lacks a cohesive overall model of decentralization and an appropriate institutional infrastructure for the management of sub-national spending, taxes, transfers, and borrowing. These are important shortcomings not only because they reduce the efficiency with which public services are delivered to final users, but also because they have major implications for Mexico's fiscal and, thus, macroeconomic stability-states now spend close to half as much as the federal government, and the municipal share of public expenditure is known to be growing fast although up-to-date aggregate figures are not available. 2. Those shortcomings may be especially critical in the upcoming period of presidential elections, when local political expedience may weaken sub-national fiscal discipline. Discipline in decentralization is in fact seen as a critical, real-side complement to the so-called "financial armoring" (blindajefinanciero) of the economy announced by the Government in June 1999 as a precautionary strategy to avoid a repetition of the so-called end-of-sexenio crises that have affected Mexico in the past. Under that armoring effort, an international loan package of some US$24 billion was planned, to ensure the financial stability of the economy in the period preceding the Presidential elections. The three-year package is led by a 17-month IMF Stand-by program (US$4.2 billion) and envisages lending from the World Bank, IDB, and international private lenders. 3. More fundamentally, underpinning macroeconomic stability through sustainable sub- national finances would serve as a means to protect the poor. Available analytical work shows that end-of-sexenio crises can have a devastating impact on the poor (notably, the 1994/95 crisis fully reversed the ten percentage point reduction in the poverty headcount that had been achieved since 1984). That protective effect would be additional to the benefits accruing to the poor from more transparent and more efiTcient financial management at the local level, especially in regards to decentralized expenditures that directly affect the poor (in the environment and health sectors, among others). 4. Aware of the urgent need to bring order and accountability to the decentralization process, the federal government requested, in December 1998, technical and financial assistance 1  from the World Bank in the form of (i) a comprehensive Policy Agenda for Decentralization (delivered in April 19991) and (ii) a US$600 million adjustmcnt operation in support of that agenda's implementation. The core purpose of the operation will be to establish a coherent structure of market-based incentives across the three levels of govern-ment (federal, state, municipal) as a first step toward ensuring discipline in all aspects of sub-national fiscal management. The loan would take place in the framnework of, and WOuid cornmlement, the above-mentioned 1IF Stand-by Arrangermient currently under irruipemnentaticn. 5. This Memorandum of the President explains the objectives, content, and risks of the proposed Decentralization Adjustment Loan (DAL), and seeks the approval of Worid Bank's Board of Executive Directors to proceed -vvith the operation. Thle loan was envisaged in, and is a central component of, the Country Assistance Strategy (CAS) for Mexico disciussed by the Board of Executive Directors on June 8, 1999, as it will directly support the three pillars of that strategy-effective public governance; growth and mnacroeconomic stabilityv and social sustainability. 6. At the outset, it is imperative to underscore the uncertain contex- and the coverage limits of this adjustment loan, for three main reasons. First, with presidertial elections scheduled for the year 2000 and a Congress in which the governing party has no majority (for the fi-st ttire in seven decades), the likelihood of gathering sufficient consensus around new legislative initiatives is negligible. Thus, the design of this opelration does not depen d on additional legal action (new laws or amendments) before the elections, except for the budget law package for the year 2000 (to be submitted in November 1999). Second, to ensufe _count-ry ownership, no policy commitments have been programmed to span into the next presidential ernm. y their nature, however, many needed decentralization-related reforms would take severai years to implement (for examnple, in the institutional development area. Third, the proposed operation will focus on the overall regulatory and institutional framework for decentralization, but will stop short of addressing the array of pending sector-specific decentralization issucs, except for pilot "performance agreements" in the environment and health sectors. Aithough relevant for the design of the overall agenda,2 most of the sectoral issues are deemed t-o be better addressed through sectoral investment operations and technical support (for example, through the Decentralized Rural Development II Loan, currently under restrucfuring) 7. While the above-mentioned constr-aints currently are preventing comprehensive policy actions in some important decentralization-related areas (notabl! s'. national taxation and transfer formulae), the reform package to be supported by the -croposed DAL will put in place strong incentives for that action to take place during the next admrinist,-ation (especially through the discontinuation of discretionary federal transfers and the imposition of rigorous market discipline on subnational borrowing). A complementary, lonager-hauL} technical assistance effort, to be launched as part of the government's overall decentralization program ,3 and the option of a successor policy-based operation by the World Bank 'wil provide a panal b.idge between 1. Coincident with the delivery of the Policy Agenda, a related presentation was made for Mexico s Minister of Finance and his three undersecretaries on April 6, 1999. 2. In preparing the proposed DAL, an informal "steering conm=itte&' involving all sectors i5 the Mexico Country Tean, as well as expert staff in other parts of the Bank, has a,nd wRill conitinue to be regl-arly consulted. 3. A US$400 million line of credit has recently been granted by IDB to support that techncal assistance effort. See Section VI. 2  presidential administrations. Equally important, the observed commitment of the current government officials to a legacy of fiscal order at both the federal and sub-national levels has proved, and will continue to prove, instrumental in the design and implementation of reforms that will be sustainable beyond the up-coming elections. 1I. MEXICO'S DECENTRALIZATION PROCESS 8. Mexico's decentralization efforts are hampered by problems in five main areas- intergovernmental transfers; tax assignment and collection; spending responsibilities; institutional infrastructure; and sub-national borrowing and debt management. This section presents a summarized diagnosis of those problems, while the next section elaborates on the authorities' efforts thus far to tackle them. a) Overly Complex System of Transfers 9. There are five broad types of federal to sub-national transfers in Mexico (their value as percent of 1999 GDP is shown in brackets): (i) the participaciones (2.9), as laid out in the fiscal pact of 1980 between the federal government and the states (through the Ley de Coordinaci6n Fiscal of 1980, its ensuing Sistema Nacional de Coordinacion Fiscal, and various subsequent reforms) whereby states receive their formula-driven share of the federal tax collection not subject to conditions or earmarking; (ii) transfers of Ramo 23 (0.1) determined unilaterally by the federal branch (in the past Ramo 23 was directly allocated by the President of the Republic) for the general purpose of bolstering state and municipal revenue and with no specific earmarking; (iii) the aportaciones (2.8) of Ramo 26 (especially up through 1997) and Ramo 33 (1998 onwards)4, through which the federal government allocates Congressionally approved funds to states and municipalities for these to spend within certain predetermined functional areas (partial earmarking) like education, health and municipal strengthening; (iv) pari-passu or matching- grant programs (0.1) negotiated between federal and state governments to pursue specific projects of mutual interest; and (v) a series of other discretionary or non-discretionary transfers (0.6) arranged by federal line-ministries with states or municipalities (notably in the areas of education, roads and health). 10. Both states and municipalities are highly dependent on those transfers-in the aggregate, two thirds of municipal governments' net revenues are accounted for by transfers; the proportion is even larger among states. While not all transfers carry attached spending responsibilities (or "mandates"), there is a general perception among sub-national authorities that the states receive considerably more mandates than funding, and municipalities (especially small ones) receive more funding than mandates. 4. Conceptual differences exist between Ramo 26 and Ramo 33 funds. Under the former, resources are transferred according to the discretion of the local delegations of SEDESOL (regulated by federal law and under SECODAM's control) and returned to the federation if unused. Under Ramo 33, transfers are made on a formula driven basis; are spent under state laws (and controlled by the local Contralorias and Contadurias Mayores); and remain with the state or municipality if unspent. 3  11. The objectives of the transfers are unclear. There are at least 10 major transfer programs in the 1999 budget, up from three in 1997. Each program addresses multiple objectives, and each objective is addressed in several programs. This makes it harder than necessary for states and municipalities to know how much money they will receive and for the federal government to determine how well the transfer system is addressing its objectives. The territorial allocation of these federal resources is not reported clearly. Nor are the matching-grant requirements, which are negotiated state-by-state. 12. The complexity of the transfers system flaws the implicit structure of incentives for both state and municipal governments, on five main accounts. First, at least up until 1999, the availability of ad hoc transfers for politically favored states undermined the incentives for good management of spending and enhancement of revenue. Second, complexity effectively forces the federal government to distribute more resources than necessary to achieve its objectives, benefiting sub-national governments whose accounts are relatively less transparent. Third, many transfers are based on historical or current costs, rather than using costs per capita or per potential recipient, rendering the system inequitable and discouraging effort to improve efficiency at the sub-national level. Fourth, lack of clear rules for allocation leads to mutual mistrust among levels of government and t;o ensuing over-reliance on earmarking and matching- grant requirements, something that, in turn, leaves states and municipalities with little autonomy for improving efficiency or adjusting their expenditures to meet local needs. Finally, the overall uncertainty associated with the yearly transfer decisions renders sound budget planning at the sub-national government all but impossible. b) Sub-optimal Taxation at the Sub-national Level 13. In general, Mexican states and municipalities underexploit their taxing potential, and inefficiently manage the collection of the taxes which they do impose. At present, taxes represent less than five percent of the total revenues of states (other than the Federal District) and less than a fifth of revenues of municipalities (who collect property taxes). While states typically have their own fees, payroll taxes (23 of the 32 federal entities), and taxes on automobiles, they have no legal power to tax income and are restricted from most sales taxes. 14. More fundamentally, most states and municipalities seem to lack the incentive to tax more or collect taxes more efficiently, since they have had too little control over how they spend revenues and relatively too much opportunity to negotiate discretionary transfers or obtain credit with, effectively, a federal guarantee. This is not a minor problem for Mexico's fiscal sustainability, as the ratio of non-oil-related tax revenue to GDP in the federal budget stood below 10 percent in 1998. 15. Uneven sub-national tax administration adds to the problem. While for most states the payroll tax offers substantial opportunities to increase own revenues and to reduce compliance costs for tax payers, the necessary homogenization and cooperation with the federal government (especially in terms of data exchanges) has not yet materialized. Similarly, administration of the municipal property taxes is highly unequal across the country. Some small and medium size municipalities leave the administration of the tax to the states; others administer the tax themselves, often without the support of the state government. The federal government provides no support specifically for property tax collection. 4  c) Unclear Spending Responsibilities 16. While the boundaries of responsibility between a large federal government, 31 states, some 2,400 municipalities, and a large Federal District are, in practice, difficult to clarify ex-ante with precision, Mexico's decentralization is especially hampered by two critical uncertainties. First, the role of the states in the allocation, monitoring and control of the Ramo 33-related transfers to municipalities has not been clearly defined in law or in court. Some states feel responsible for, and therefore entitled, to play, a significant role in the way municipalities manage these resources while others leave ample room to municipal decisions. 17. Second, the distribution of spending and, to a lesser extent, taxing responsibilities between the Federal District, the federation, and the states and municipalities that surround the Federal District is not clearly defined either. This is leading to inefficiency in investment because the involved governments under-invest in sectors that they do not consider of their own purview or over-invest in services that they perceive as their exclusive responsibility. (Such inefficiencies have been particularly acute in the areas of water and public transportation). 18. The poorly defined lines of responsibility also impair the sub-national governments' incentive to pursue further decentralization, because an overwhelming proportion of their own aportaciones is often de facto committed to federall-mandated expenditures (something that converts "decentralization" into "deconcentration"), and because the federal government negotiates (and does not report) the territorial allocation of its own expenditure. d) Missing Institutional Infrastructure 19. Mexico's drive toward decentralization started before an adequate institutional framework could be established. First, there is a need to strengthen the mechanisms for monitoring the overall process, and reporting accordingly. As demonstrated by the experience of other countries, such an institution is a pivotal force for enriching the discussion of and promoting a long term perspective on the complex, inter-disciplinary issues at the core of decentralization policies. Given the prevailing political nature of federal and state congresses, such monitoring institutions serve frequently as "think-tanks" for law reform proposals and negotiations across levels of government. They are also one of the pillars for linking public policies to civil society, building consensus and ensuring continuity. An institution that plays this technical role is all the more important in contemporary Mexico, as the country is experiencing increasing inter-party competition, congressional alliances and multiple centers of power at all levels of government. 20. Second, municipal governments are receiving transfers (Ramo 26, Ramo 28, and Ramo 33) in spite of evidence of insufficient management capacity at many-probably most- municipalities. Moreover, the subsidiarity principle-that would call for substituting state or federal management in weak municipalities where sufficient capacity has not been clearly established-is being applied in a confusing manner that diminishes accountability at both the federal and local levels. The federal government does not collect the information it is entitled tc, on the use of Ramo 33 transfers to municipalities. As a result, different states have different practices, some more and some less actively involved in municipal strengthening. Although 5  federal transfers allocate some resources to municipal capacity building, there are no clear patterns (by municipal size or otherwise) nor systematic monitoring and evaluation of the impact of these earmarked transfers. Neither do present arrangements stimulate alternative, more efficient approaches to strengthening of small- and medium-size municipalities, such as association of municipalities, public-private alliances or outsourcing. The wealth of experiences with capacity strengthening, within and o-utside the country, remains largely unknown to local and regional authorities. 21. Third, fiscal accountability at sub-national levels is often lacking. At present, control is largely restricted to ex-post verification of "formal" compliance, that is, verification that monies allocated to a category of expenditure (for example, health) are actually used within that category. This falls short of assessing quality and impact of earmarked transfers and pari passu programs; of checking against pre-defined performance indicators of fiscal management; and of assuring transparency in procurement and personnel decisions. The federal government and some state governments still lack the most basic control indicators on the Ramo 33 transfers (which account for about 3 percent of GDP in the 1999 national budget)-a telling example of this accountability problem. 22. Fourth, there are no uniform accounting and reporting standards across, or within each of, the three levels of government. Moreover, sub-national governments have resisted inter- government communication and coordination both as a way to assert their constitutional autonomy and as a natural response to repolting requirements that do not differentiate according to tne fiscal size of territorial units (thereby imposing an excessive burden on smaller states or municipalities). The federal government's own inconsistent performance in reporting back to the state and municipal authorities has only worsened the situation (and has prevented the use of earmarked and pari-passu funding as a positive incentive to exact better reporting from the subnational governments). 23. Finally, the timing of the preparation of the national budget limits the states' and municipalities' ability to plan and budget their expenditures, as they do not have reliable estimates of forthcoming fiscal transfers (of aportaciones in particular) until very late in the previous fiscal year or in the early part of the concurrent one. e) Inadequate Framework for Sub-national Borrowing 24. Sub-national debt in Mexico has so far not been a national macroeconomic problem (as it has in, for example, Brazil), but it could rapidly become one. In 1997, the recorded stock of state and municipal debt was equivalent to about 2 percent of Mexico's GDP (and about 6 percent of total public debt). By comparison, sub-national debt amounts to 5 percent of GDP in Argentina, almost 20 percent in Canada, and somewhat above that in Brazil. In addition, the Mexican constitution prohibits states from borrowing in foreign exchange or from foreign creditors. However, behind Mexico's relatively comfortable sub-national debt statistics lie three potential destabilizing factors-moral hazard, limited actual servicing capacity, and contingent liabilities. 25. Both states and their lenders have witnessed many federal bailouts in the past and come to expect them, making borrowing a means through which states can obtain extra federal 6  resources, transferred to them directly or through their creditors. All states received bailouts in the wake of the 1995 crisis, and a -few states have received bailouts since then when guarantees came due on large infrastructure projects. Perhaps more importantly, the federal practice of accepting state mandatos (mandates) to act as a trustee in servicing state debt that has been collateralized with participaciones has de facto become a pre-condition for states to have access to credit markets, not just because of the value of the collateral but because of the perceived blessing and guarantee by the federal government. 26. In general, Mexican states have much less disposable income to service debt than usual accounting would suggest. This is because much of their current expenditures is "tied" to de facto inflexible commitments (notably salaries). The ratio of debt stock to disposable revenue, the latter defined as own taxes plus untied transfers, ranges from a maximum of 1.8 (in Sonora) to a minimum of 0.02 (in Hidalgo). By that measure, the eight most indebted states are Sonora, Nuevo Le6n, Mexico, Queretaro, Quintana Roo, Baja California Sur, Jalisco, and Sinaloa, all with a ratio of debt stock to disposable revenue greater than 1, which is taken to indicate excessive indebtedness. In principle, abstracting for the moral hazard problem mentioned above, the limited debt servicing capacity of Mexican states should be identified, and priced in, 6 by prospective lenders. Th e credit rating of Mexican sub-national governments is being distorted, however, by private "fiscal management" ratings commissioned by the states themselves, which neither are connected to a particular loan nor measure the states' repayment capacity. 27. While precise data are scarce, pension benefits to state employees are probably the largest contingent liability of Mexican states, and one that goes largely unrecorded. The contingent nature of the pension debt is not in its expected value-the states' pension systems operate in an unfanded, pay-as-you-go basis, and few states will have the fiscal capacity to service them once their labor force matures. [A partial account of the states' pensions liability reached P$167 billion in 1997. that is, about 6 percent of national GDP.7 Among the 25 states with sufficient data to estimate the year in which the system would run out of reserves (given adequate actuarial and financial parameters), five were already in deficit in 1998 and seven more were projected to be bankrupt in 1999-2002.1 Rather, the contingent nature of this liability arises because the legal responsibility For this debt remains unclear. Most state governments see the pension liability as a legacy left from the pre-1990 practices, when state governments were under the complete domination of the federal government in Mexico City and many state employees (for example, teachers) worked originally for the federal government. Consequently some state govermments view pensions as a liability of the federal government, not their own. The lack of clear 5. The Fader Distiict, othug it has the highest absolute debt among Mexican sub-national govements, is ranked amnong the least-indebted federated entities relative to debt-servicing capacity, because it collects substantial revenue of its own. 6. Much of the sub-national borrowing has been from Banobras (a federal-governmnent-owned development bank) which reviews -le fiscal and financial status of borrowers and can refuse or reduce loans when it sees problems. Although Banobras does not disclose state lending data, it is known that states with high debt ratios and a repeated hstory of needirg bailouts still receive loans from Banobras. This suggests that its evaluations are less stringent th:an t.ey would be urthout federal ownership of the bank and without the federal mandate to deduct debt service from transfers. Banobras's cost of funds is higher than that of commercial banks, which are gradually getting more of the sub-national business. 7. This calculation was for 16 states (plus the Federal District) employing about half of the state employees. 7  assignment gives both sides an incentive not to make adequate provisions, hoping that the lack of preparation will result in the other side bearing more of the cost in the end.8 m. THE GOVERNMENT'S RECENT ACHIEVEMENTS IN DECENTRALIZATION 28. The federal authorities are well aware of the weaknesses in the framework within which decentralization is currently proceeding in Mexico. They have therefore implemented a number of policy initiatives that, while perhaps still insufficient, provide a good platform for the reform initiative to be supported by the proposed DAL. 29. On the institutional front, the recent constitutional reform of Article 115 will strengthen the autonomy of municipalities and make them more transparent and more accountable for the earmarked federal transfers they currently get. As a clearly distinguished level of government, municipalities will be in a better position to negotiate with other levels of government and be made responsible for legal and contractual obligations. This constitutional reform also establishes the basis for a clear division of responsibilities between states and municipalities vis- a-vis the Ramo 33 transfers. The federal congress has given high priority to preserving the independence and strengthening the capacity of the Contaduria Mayor de Cuentas de la Uni6n, and the Contaduria is pursuing coordination with and strengthening of the state contadurias. The Programa de Homologaci6n was launched with a view to introducing uniform rules and practices on accounting, budgeting and reporting. Unfortunately, the program has not been adequately implemented by several states, which had neither a legal obligation nor an economic incentive to abide by it, and has been effectively on hold since the end of 1998. In parallel, and with more encouraging results, the Contaduria de Cuentas de la Uni6n, and some of the state Contadurias and Contralorias are currently developing programs to collect information on and/or audit Ramo 33 spending. As part of that Ramo 33, the federation has also introduced earmarked resources for strengthening municipal capacity. A number of federal secretaries have signed agreements among themselves and with regional and local governments to share information and resources with a view to coordinate expenditure in the territories. 30. Some progress was also recorded in clarifying spending responsibilities. Perhaps to avoid ex-post legal liability for increasing municipal borrowing, states have recently shown interest in clarifying roles and accepting precise accountability in the management of the aportaciones that go to municipalities. The federal government took the initiative to provide more fiscal and political autonomy to the Federal District. For its part, the Federal District is preparing legal and constitutional reform proposals aimed at clarifying fiscal relations with the federation and neighboring states. 31. Initial steps to grant more tax autonomy to the states rendered limited results. In the 1999 budget proposal, the federal government offered states the option of introducing up to a 2 percent tax on final retail sales, but virtually all states declined. Their reasons related to both political cost and perverse incentives (more own tax revenue, less federal transfers), and the 2 percent option was dropped from the finally approved budget. At the level of municipalities, more is 8. The state of Nuevo Le6n is, perhaps, the exception, as it has independently proceeded with some limited reform of its pension system. 8  happening, particularly with the property tax-some large municipalities and particularly the Federal District have strengthened that tax's collection through better assessment and administration. In other cases, like the state of Puebla, the state supports the modernization of the cadastre and the overall tax administration while municipalities collect the revenues. In a few cases, municipalities, particularly rural municipalities, have completely delegated to their respective states the administration of the property tax. 32. While, as explained earlier, the system of transfers remains overly complex, the authorities have recently simplified it by doing away with extra-ordinary transfers almost entirely (a large portion of those transfers were part of the bail-out packages granted to the states in the aftermath of the 1995 crisis). In addition, the Secretaria de Hacienda is active in disclosuring the rules to access the pari passu programs, thereby strengthening the signals and incentives and leveling the field for equal state access to this type of federal grant. 33. Relatively less progress has been made in establishing a sound framework for sub- national borrowing. Following the 1995 crisis, the ministry's of finance (Secretaria de Hacienda y Credito Puiblico; SHCP) entered annual fiscal adjustment and disclosure agreements with each of the states (except the Federal District) that included specific borrowing parameters, as a pre- condition to deliver additional extraordinary transfers of funding. With those transfers now discontinued, no substitute mechanism to enforce state fiscal and borrowing discipline has been put in place. IV. THE PROPOSED DECENTRALIZATION ADJUSTMENT LOAN (DAL) a) Objective 34. The previous sections have shown that Mexico's decentralization process is unfolding at high speed but lacks an efficient policy framework to set the process on a sustainable path. The core objective of the proposed DAL is to support the federal government's efforts to introduce such a framework. This is an urgent task, if decentralization is not to translate into fiscal mismanagement of spending, taxes, transfers, and borrowing, rendering the business of government less, rather than more, transparent and accountable to citizens. The DAL will also play an important macroeconomic role, as it will help the Government reduce Mexico's vulnerability to external financial shocks and loss of confidence that in the past have been associated with the country's presidential elections. On the one hand, the fast-disbursing feature of the Bank's structural adjustment lending, of which the DAL is the principal component during FYOO, is a key part of the precautionary external financing package that the Mexican authorities are putting in place to avoid balance of payments difficulties in the period surrounding the upcoming election. On the other hand, this loan reduces the possibility that state-level fiscal deficits will undermine the prudent fiscal policy of the federal authorities. By reducing Mexico's vulnerability to external and fiscal crises, the Bank's support aims at avoiding the social and economic costs (particularly in terms of poverty increases) that are usually associated with these crises. 9  35. Making decentralization more efficient and accountable to democratic control will require a substantial set of reforms, some of which need to wait until the next administration. These include revamping tax and transfers systems and revising the assignments of spending authority, as discussed earlier. As the election will not take place until July 2000 and the new incumbent will not take office until December 2000, the elections effectively mean that no policy initiative requiring legislative action (apart from the annual budget law) can be realistically expected until around mid-2001. In addition, undertaking policy commitments under the DAL that span into the next presidential term would not guarantee ownership by the entrant policymakers. The decentralization framework and its supporting operation will, therefore, include no new laws (apart from the budget law for the year 2000) and its implementation will be programmed for completion by approximately April 2000. 36. While the proposed loan will not directly address the full set of required reforms, it will build institutional capacity, open up information and, critically, set hard budget constraints on sub-national finances. These will create the capability and motivation for the stakeholders to take the next steps in 2001 and thereafter. The DAL should thus be seen as a first but significant step in a chain of support, to be complemented by the federal government launching, as part of its overall decentralization efforts, a technical assistance program for states and municipalities; by strong synergies with other sector-specific operations with decentralization-related components both by the World Bank and by other institutions (see Section VI); and by the option of a successor World Bank adjustment operation under the next presidential administration. 37. More fundamentally, the current aLuthorities' proven commitment to a legacy of fiscal discipline underpins the design and implementation of decentralization-related reforms that will proved sustainable beyond the upcoming elections. If fully implemented, the DAL would enable the public as well as the federal government to monitor most of the transfers, would hold governments more accountable and fiscally responsible, would convey positive incentives to sub-national governments, and would strengthen their relative autonomy. Taken altogether, these benefits would begin to ensure tlhe cohesiveness and long term sustainability of decentralization in Mexico. b) Content 38. The operation will be based on the Government's broad decentralization program, as presented in the attached Letter of Development Policy, and from which a core subset of key policy actions have been selected as commitments for respective tranche disbursements (and effectiveness). Those actions are listed in Table 1; a summary explanation of their economics is provided below. 39. The selected policy commitments have four main targets: imposing hard budget constraints on federal resources provided to states and municipalities; reducing moral hazard in subnational borrowing; increasing the transparency and public accountability of subnational fiscal and financial management and of the overall decentralization process; and setting up pilot mechanisms to enhance efficiency in decentralized expenditures. 10  Table 1. Mexico-Decentralization Adjustment Loan (DAL)-MATRIX OF POLICY ACTIONS FOR TRANCHE RELEASE BOARD PRESENTATION (unless otherwise indicated) SECOND TRANCLE (expected December 1999) (expected by April 2000) 1. The federal budget proposal submitted for fiscal year 2000 will not include discretionaiy transfers to state and 1. SHCP wil provide the Bank: a) a report detailing any municipalities (and their organismos descentralizados) in excess of 0.15 percent of total federal expenditures.' discretionary transfer approved in the Federal Budget; and 2. SHCP announces, through the publication of the DAL's Letter of Development Policy (see Action 11 below), a new policy the aggregate aount ofalldiscreionaryltrasfe, ta on mandatos whereby: (i) effective March 31, 2000, SHCP will no longer accept mandatos to act as a trustee for the executed by the Federal Government until March 31, collateralization of borrowing by states and municipalities (and their organismos descentralizados); and (ii) from January 1 2000, does not exceed the total amount approved in the to March 31, 2000, mandatos will only be accepted if their effectiveness does not extend beyond March 31, 2000 and the federal budget for such transfers. soliciting state or "large" municipality2 (or organismo descentralizado) is, at a minimum, in the process of obtaining two global local-currency scale "issuer"3 credit ratings performed by credit rating agencies registered with the CNBV4, as 2. The Federal Government has been implementing its evidenced by the presentation of the relevant contracts between the borrower and those credit rating agencies. [Any policy of abolishing its practice of mandatos on a basis mandatos for borrowing by states and "large" municipalities (or their organismos decentralizados) contracted between consistent with the DAL's Letter of Development Policy. Board presentation and December 31, 2000 will be subject to the states' existing budget laws and associated borrowing 3. Capital-risk-weighting requirements for commercial and programs for fiscal year 1999.] development bank lending to state and municipalities (and 3. Issuance of regulation ("Modificaci6n a las Reglas sobre la Diversificaci6n de Riesgos en las Operaciones Activas a que their organismos descentralizados) have become effective se Refiere el Articulo 35, Fracci6n II de la Ley Reglamentaria del Servicio Publico de Banca y Credito") by SHCP and are being implemented in a manner consistent with revoking the "regimen de excepcion" (exemption regime) of exposure-concentration hmits for bank loans made after the relevant regulation. November 30, 1999 to states and municipalities (and their organismos descentralizados). 4. Regulations setting requirements for registration in 4. Issuance of regulations ("Modificaci6n a las Reglas para los Requerimientos de Capitalizaci6n de las Instituciones de SHlCP's Registro de Obligaciones y Emprdstitos de Banca Multiple " and 'Mod1ifcaci6n a las Reglas para los Requerimientos de Capitalizacion de las Instituciones de Banca Entidades Federativasy AMunicipios have been issued and de Desarrollo") by SHCP whereby the commercial and development bank debt of states and "large" municipalities (and have been implemented in a consistent manner. their organismos descentralizados) contracted after March 31, 2000 would: (i) if not registered with SHCP, be subject to a 5. Banobras, and any other development bank which has 150 percent capital risk weighting; and (ii) if registered with SHCP, be subject to a differential capital-risk-weighting grid provided loans to sub-national governments since March based on two, current, published, global-scale local-currency credit ratings performed by credit rating agencies registered 31, 2000, have issued and implemented intemal lending with the CNBV5 (for loans of US$20,000,000 or less, either "issuer" or "issue,6 credit ratings will be used; for loans of regulations regarding loans to states and "large" more than US$20,000,000 "issue" ratings will apply). This policy action wil be considered a condition of loan municipalities (and their organismos descentralizados) in effectiveness. accordance with SHCP's relevant of cio. 5. Issuance by SHCP of appropriate regulation whereby, effective January 1, 2000, it will register (in the Registro de 6. SHCP has published the regulations governing eligibility Obligaciones y Emprdstitos de Entidades Federativas y Municipios) new state, municipal, or subnational organismo criteria for the use of funds and detailed amounts of each descentralizado loans only when (i) the state or municipality in question is current7 on its publication of debt and fiscal pari-passu program approved in the federal budget for the statistics from the preceeding semester's final accounts, and on all of its debt service obligations toward the Govermnent's year 2000. development banks; and (ii) when the organismo descentralizado is current on all its debt service obligations toward the 7. SHCP has established and is operating the Government's developmnent banks. decentralization committee in a manner consistent with 6. Issuance by SHCP of an appropriate oficio instructing the federal Government's development banks with legal mandate to the relevant oficio. lend to states and municipalities to issue internal rules (in accordance with the applicable regulations) whereby, effective 8. SHCP has published the state-by-state allocation of March 31, 2000, they will make new loans to states and "large" municipalities (and their organismos descentralizados) federal expenditures and other explicit transfers to sub- only when the loan in question (i) qualifies for registration with SHCP; and (ii) requires a capital risk weighting of less national governments m the education and transport than 100 percent. Development banks can make loans to sub-national governments and their organismos descentralizados sectors, as approved in the federal budget for the year with a capital risk weighting of 100 percent or more only if the loan in question contains an institutional development 2000. component that is funded by an international development agency. 1i  7. SHCP has developed jointly with the states and announced an action plan to assist states and municipalities (and their 9. Relevant funds, as approved in the federal budget for the organismos descentralizados), at their request, in improving their accounting, auditing, budgetinig, revenue and debt year 2000, have been made available to states for the management, and reporting practices as well as in achieving other goals that the states and municipalities (and their execution of environmental and health "performance organismos descentralizados) may identify in their own institutional development programs. At least one government agreements". development bank has issued internal lending regulations to make credit available to states and municipahties for 10. Overall progress under the Government's Decentralization institutional development purposes. Program as specified in the DAL's Letter of Development 8. Issuance by SIHCP of an appropriate intemal instruction (oficio) appointing an intemal decentralization committee (Comite Policy is satisfactory to the World Bank. para la Coordinacion Hacendaria), with participation of and rotating chairmanship by SllCP's three sub-secretanias and with a permanent technical secretariat. The committee's functions wil include (i) strategic and policy analysis and recommendations in the area of decentralization, (ii) consolidation of available data and information in that area, and (iii) promotion of the publication of federal and sub-national fiscal and financial statistics. The committee will supervise the federal program for technical assistance to states and municipalities in the area of decentralization. 9. Inclusion in the federal budget submission for fiscal year 2000 of a program in support of "performance agreements" (Convenios de Desempeflo) between the federal and state govemments to elicit improvements in state-level legal frameworks for environmental protection and development of the states' environment-related institutions. 10. Inclusion in the federal budget submission for fiscal year 2000 of a program in support of "performance agreements" (Convenios de Desempeilo) between the federal and state governments to foster institutional development (training and monitoring capacity) at the state level that can facilitate the expansion of basic health coverage under the Programa de Ampliaci6n de Cobertura (PAC). 11. Pubhcation in major national media of the DAL's Letter of Development Policy. 12. Overall progress under the Government's Decentralization Program as specified in the DAL's Letter of Development Policy is satisfactory to the World Bank. 1/ As used in this table, "discretionary transfers" are transfers of federal resources to states or municipalities (and their organismos descentralizados) that are not allocated in accordance with specific amounts, distribution formulas or conditions for subnational access. 2/ A "large" municipality (and its organismo descentralizado) is defined as over 500,000 inhabitants. 3/ "A Standard & Poor's 'Issuer' credit rating is a current opinion of an obligor's overall financial capacity (its creditworthiness) to pay its financial obligations. This opinion focuses on the obligor's capacity and willingness to meet its financial commitments as they come due. It does not apply to any specific financial obligation, as it does not take into account the nature of and provisions of the obligation." Standard & Poor's web page, Issuer Rating Services: Issuer Credit Ratings, September 22, 1999 (w.standardandooors.comnratings/defnitions/issuer.html). 4/ As per infonnation provided by the Mexican authorities, all four credit rating agencies currently registered with CNBV are affiliated with intemationally reputable credit rating agencies. 5/ Should the two ratings lead to different risk weightings in the grid, a suitable decision nrle (e.g., average of the two ratings/weightings) will apply. 6/ "Issue" ratings are done for each loan or bond based on: (a) likelihood of payment independently of guarantees ("unsecured issuer rating"), that is, the capacity and willingness of the obligor to meet its financial comnnitment on an obligation; (b) nature of provisions of the obligation, and (c) protection afforded by guarantees and other legal arrangements. 7/ In this context, "current" means semester data published within six months of the close of the previous semester. (This means that during January-June of a given year, data would need to be published for the period up to June 30 of the previous year, and during July-December of a given year, data would need to be published for the period up to December 31 of the previous year.) 12  40. Hard budget constraints will begin to come about as rules rather than discretion start governing subnational expenditure, transfers and borrowing.9 Discretionary transfers to states- and municipalities will be discontinued (except for minute expenditures where accounting and other practices require a certain degree of discretion). All large pari-pasu programs will operate with transparent rules and will be available to all states that qualify according to published criteria. 41. Rules on discretionary financing from the federal government will be complemented with efficiency-enhancing, market-based incentives in sub-national borrowing, something that will both harden budget constraints and reduce moral hazard. Specifically, the federal government will, as of March 31, 2000, cease accepting mandatos from states to collateralize their loans with participaciones. States and their creditors will thus have to make alternative private fideicomiso or equivalent arrangements that do not carry an implicit guarantee by the federal treasury. SHCP will no longer be directly involved in the sub-national borrowing process. To make the transition to the new no-mandatos system as smooth as possible, during the first quarter of 2000 the federal government will accept mandatos only for states that are in the process of obtaining credit ratings from reputable international agencies (see below). 42. In parallel, bank regulation (and its impact on loan pricing) will be employed to foster both more efficient and more transparent borrowing programs and financial management by states and municipalities, and sounder, moral-hazard-free sub-national risk assessments by their bank lenders. In particular, the existing regimen de excepci6n, whereby all sub-national lending is exempted from normal exposure concentration limits, will be formally abolished. Bank loans to states and municipalities will be subject to a punitive capital risk weighting ratio (150 percent) if they are not registered with SHCP, a process that will in turn be made conditional on the borrower being current in its publication of debt and fiscal data and in all its debt service obligations toward the Government's development banks. More fundamentally, registered loans will be subject to a differential capital risk weighting "grid" that will link the capital backing requirements for (and, thus, the pricing of) sub-national debt instruments to the borrower's credit rating, as measured by two, current, published, global-scale local-currency credit ratings performed by credit rating agencies registered at CNBV (the four agencies currently registered are partner/affiliates of intemationally reputable credit rating agencies). 10 43. To be complete, the hardening of budget constraints and the reduction in moral-hazard will require a new lending framework for the public development banks, as they are not currently subject to the same corporate governance and market pressures as commercial banks. Thus, all regulatory and supervision standards applicable to commercial banks will be imposed 9. By liniting the discretionary power of the federal authorities, the prevalence of rules will also directly support on-going Congressional efforts to grant more independence to sub-national governments, including recent amendments to Article 115 of the Constitution. 10. This link between credit ratings and regulatory standards is in line with a recent consultative paper issued by the Basel Conmmittee on Banldng Supervision ("A New Capital Adequacy Framework", Basel Committee on Banking Supervision, Basel, June 1999). More generally, linking regulation to credit ratings is a common practice in the financial sector of many countries (including Mexico), for example, in regulating corporate bond issues or insurance companies' investments (see Annex VI of RIM 119991 International Capital Markets- Developments, Prospects and Key Policy Issues, World Economic and Financial Surveys, in www.inif.org/external/pubs/ft/icmIl999/index.htm). 13  on the development banks, including the above-mentioned differential capital risk weightings. In addition, and as a matter of corporate policy, the federal government (who owns the development banks) will only allow development banks to grant loans to sub-national governments if the borrower holds credit ratings that require capital risk weightings of less than 100 percent.1' 44. Increasing the transparency of decentralized fiscal management will be the third objective of the policy package to be supported by the DAL, as a means to increase the public accountability of both federal and subnational governments. The federal government will establish a high-level Decentralization Committee within SHCP that will play a continuing strategy setting, policy analysis and public information'2 role, based in part on the statistical disclosure generated by the incentives mentioned earlier. The Committee, which will be served by a permanent technical secretariat, will be responsible for technical analysis of the evolution of the decentralization process in order to guide federal policy on the matter. SHCP will also commission and publish a study of the state pension liabilities including state-level estimates of them. A more consistent process of institutional development for decentralization will be put in motion. Beyond the efforts of the above-mentioned Committee, a program of institutional training and strengthening at the state and municipal levels, covering accounting, budgeting, monitoring, reporting, auditing, and debt and revenue management, will be made available on- demand. This program will capitalize on on-going federal efforts (for example, homogenization of accounting practices) and will count on the financing of a recently-approved US$400 million loan from the IDB (see Section VI). 45. Finally, the DAL-supported policy package will include initial steps toward sub-national expenditure efficiency. Performance agreements between federal ministries and states will be piloted, primarily as a signal that, in the future, sub-national governments will be held more accountable for the sector-specific funds they receive through decentralization. To start, pilot performance agreements in a standard form for all states will be written and implemented for the environment and health sectors (these sectors appear particularly suitable for the performance agreement pilot as they enjoy a solid reform record, strong ownership, and ongoing decentralization agendas). 46. The performance agreement for environment will offer a one-time federal matching grant, included in the proposed budget for year 2000, to go into a fund that each participating state would set up and contribute to with its own resources. The fund would finance development of the state's institutional capacity for environmental management, including technical training, regulatory and monitoring capacity, and reporting for intergovernmental coordination. Once the program is approved in the budget, the Ministry for the Environment, SEMAR:NAP, will sign individual agreements with the states that choose to participate and agree to the conditions of the program. During FY00 and beyond, SENMARNAP will monitor and evaluate the effectiveness of this program and, based on that, design the next steps. This program is a pilot to demonstrate what a relatively small incentive can accomplish in terms of 11. An exemption to the internal, additional credit-rating requirement will be made for loans that carry an institutional development component funded wikh resources from international development agencies, as this may help improve a state's credit rating (especially among low-rated states). 12. While making decentralization-related information available to the general public may seem an innocuous undertaking, it represents a major break from past practice in Mexico, and one that is likely to generate a new set of political incentives for sound, decentralized governance. 14  mobilizing states' efforts in an area with national as well as state-wide externalities. Annex B provides more detail on the objectives, content, implementation and risks of the program. 47. The performance agreement for health will offer to participating states a matching grant to support development of states' training and institutional capacity to facilitate and monitor the expansion of coverage of basic health services. One of the government's principal objectives is to extend basic health-care coverage to the estimated 10 million people who currently lack access. To help achieve this, the federally funded Program for the Expansion of Coverage (PAC) pays for state health workers in 19 target states with high poverty indexes, in addition to the regular Ramo 33 funds that go for the health sector, which was decentralized to the states in the early 1990s. A major weakness of the Program for Expansion of Coverage at present is the lack of skills of state-level workers. The new program would address this problem and finance technical and managerial training, monitoring and reporting capacity, and other institutional development. This will be important for assuring that the general decentralization of the health care sector brings the expected benefits to the poor. Annex C provides more detail. 48. It is worth emphasizing that, because of the design constraints mentioned earlier (which primarily relate to the political calendar), there are important areas where no policy initiatives are planned at this time and should be pursued with the next administration, through separate sector operations, technical assistance and, possibly, a successor adjustment operation. Chief among those areas are further institutional development at the municipal level; continued refinement in transfer formulae; constitutional and legal changes to allow direct and indirect taxation at the state level; and a program for comprehensive reform in the states' pension systems. c) Risks 49. The election calendar will make consensus around necessary reforms difficult to achieve, even though both the administration and Congress want to continue progress on decentralization (indeed, it has been the interaction between the two branches of government that accelerated the process in recent years). On the other hand, the do-nothing-until-after-the-election alternative is not attractive-in the year until a new government comes into office, decentralization would go farther without an adequate policy framework in an uncoordinated and sometimes contradictory fashion, possibly causing irreversible damage to an otherwise-beneficial process. Thus, the DAL policy commitments do not require legislative action, with one exemption-the already- scheduled budget submission for the year 2000. The DAL-supported program calls for only one policy within that submission, which is very unlikely to be rejected by opposition parties, namely, the elimination of the federal executive's power to make discretionary transfers to the states and municipalities. 50. Even if government and Congress reach the necessary consensus, there remains a possibility that some states or municipalities would refuse to adopt recommendations that they may perceive as federal imposition. The proposed structure of incentives makes this improbable, as incentives have been crafted in a positive vein and failure to adopt those recommendations would limit the sub-nationals access to financial markets. Still, it is theoretically possible that a politically and fiscally desperate state might associate with a rogue bank and borrow excessively; that banks eager for the non-credit business of sub-national governments may not transfer to 15  interest rates the higher funding cost of lending to uncreditworthy state and municipalities; or that states that are denied bank credit resort to floating domestic-currency bonds in the capital_ markets (a form of sub-national borrowing that, while currently non-existent, is not contemplated in the proposed reform package). These scenarios are, however, unlikely. Under the new more transparent framework, especially with published credit ratings, unsustainable financial behavior by either sub-national governments or their lenders will be immediately known to the market and to the regulators, and will become unfeasible (at least on a continuing basis). 51. Similarly, even if agreement is reached among the branches and levels of government, the new administration might choose not to sustain the new rules, institutions or procedures put in place by the decentralization program supported by the DAL. Or the new administration might not proceed with the next steps in reforming intergovernmental relations and completing the longer-term program which is the underlying rationale for this operation. While these risks are indeed real, each is substantially mitigated by the same historical process that is bringing about decentralization in Mexico and by the reforms supported with this proposed loan. Legally, the measures taken over the life of this loan could be reversed, at least after budget year 2000. Practically this is unlikely. Disclosure of information by the federal executive and strengthening the accounting and auditing branch of the Congress will open up information and create expectations for follow up information and reforms, e.g., of pension systems. With the federal executive no longer in full control of Congress (stronger opposition parties since 1997 and less discipline in the ruling party), the irreversible release of information provides leverage for Congress to insist on continued reduction of executive discretion and even more disclosure in the future. The peer pressure for equal treatment will grow, as any state will and can protest if it gets less than the most favored treatment. The federal government is hardening the budget constraint on itself, of necessity, and the federal bureaucracy seems to have widespread interest in passing that discipline along to the next level. Hardening the budget constraint on federal and financial sector resources for states and municipalities will increase the incentives for them to raise more of their own taxes, to get control of their personnel costs, and to rationalize the transfer system, because negotiation with the federal government will no longer be a quick and painless way to raise more resources. 52. There is also a risk that financial-sector-related technical difficulties may jeopardize the program's objectives. Prime among those risks is that the bank regulatory authority (CNBV) might not be able to implement the new rules for sub-national lending and, more generally, might not enforce a sound regulatory framework for banking. While CNBV's record in that regard is mixed (particularly in the aftermath of the 1995 banking crisis), major reforms are currently under implementation. ]Following the establishment of the EPAB (in place of FOBAPROA) and the gradual unfolding of a new, more efficient deposit-insurance mechanism, the authorities announced in September 1999 a program of capital-related regulatory reforms that will, over a period of time, correct important flaws in the Mexican banking industry (most notably, the imposition of limits on deferred tax capitalization; removal from Tier 1 capital of equity investments in non-traded, non-financial companies; new provisioning methodology; new valuation programs for fixed assets; etc.). These reforms are being implemented in the context of the previously-mentioned IPX Stand-by, and will be supported and furthered by a proposed World Bank "Bank Restructuring" operation. 16  53. Increased transparency may, in itself, present an implementation risk for this operation. As market forces and new rules drive the states and municipalities to disclose, directly or through credit ratings, more complete information about their debt positions (especially in regards to pension-related contingent liabilities), lenders may refrain from sub-national lending altogether. While such a credit freeze, if it takes place, may have short-term costs, it will be both a temporary prelude of a rationale market diversification of sub-national risk and a strong incentive for states and municipalities to maintain prudent financial management practices. 54. Finally, sub-national institutional capacity may present a constraint to reform implementation. While, for efficiency reasons, technical assistance to states and municipalities (over and above existing federal programs) will be provided only upon demand, there is a general assessment in Mexico that sub-national governments have a genuine interest in seeing their institutional capacity up-graded. In fact, allocated federal funding may prove insufficient, especially given the overall fiscal restraint being exercised to protect the macroeconomic framework. As mentioned earlier, the funding associated with the recently-approved US$400 million 1DB loan (see Section VI) will substantially cover those needs. d) Poverty Impact 55. The proposed DAL operation would have important effects on poverty. On the one hand, by supporting the maintenance of viable fiscal accounts at the three levels of government, it will directly protect the poor, especially the extreme poor, from the potential effects of major macroeconomic fluctuations. 3 Such fluctuations have in the past erased the country's achievements in poverty reduction (especially during the 1994/95 crisis). On the other hand, by augmenting the institutional efficiency and transparency of sub-national finances, it will help improve administration and delivery of the array of social expenditure programs that are currently decentralized.14 The DAL's support for pilot performance agreements in the environment and health areas will be an important first step in that direction (e.g., an enhanced implementation of the PAC will bring immediate, tangible benefits to the most needy). 56. While the DAL-supported reform package will carry major poverty-related benefits, it also has potential risks for the poor. In particular, it is conceivable that imposing hard budget constraints on sub-national governments may lead to a reduction in social expenditures at the state and municipal level, rather than to an increase in expenditure efficiency, a contraction in spending on non-priority items, or invigorated revenue collection efforts. This risk is mitigated by three factors. First, like the federal authorities, sub-national governments also face democratic processes of their own and are therefore sensitive to social sector needs. The increased transparency sought by the DAL-supported reforms will enhance that sensitivity. 13. As part of its extensive poverty-related analytical work (spearheaded by an ongoing poverty assessment), the World Bank is producing a policy note that will focus on poor households' responses to negative macroeconomic shocks. 14. It should be noted that, although the DAL will help improve the administration of decentralized social programs (almost 100 at the federal level), it will not seek to address the efficiency with which each of those programs is actually executed, except for the health and environment programs described in Annexes B and C. Support for those programs will be delivered under the World Bank's large portfolio of projects and advisory services in the social sectors (health, education, social protection, program evaluations associated with the ongoing poverty assessment, policy dialogue on gender, and the like). 17  Second, any additional resources that might reach sub-national governments if "soft" budget constraints are left in place would not necessarily go to social needs, rather than to non-priority expenditures. Third, the federal government itself runs core social assistance programs for the poor, notably PROGRESA, a targeted cash-based system of transfers to the poor, conditional on their demonstrating consumption of specific goods and services (e.g., infant vaccination, school attendance, and so forth). e) Terrms and Conditions. 57. Loan Amounts, Conditions, and Arrangements. The proposed US$606,070,000 million DAL in the form of a fixed spread, US dollar denominated loan will be made to Banobras S.N.C. with a guarantee from the United Mexican States. Disbursements under the proposed DAL will be made to an account ("Deposit Account") of Banobras, S.N.C. established at the Banico de Mexico for this purpose. The loan will have a 10 year grace period, and a bullet repayment due on December 1, 2009. The commitment charge will be 0.85 percent for the first four years, and 0.75 percent thereafter. The front-end fee will be 1 percent of the loan amount capitalized. 58. Disbursement and Procurement. Loan disbursement will be made under simplified disbursement procedures. Proceeds will be disbursed against satisfactory implementation of the adjustment program, including compliance with stipulated tranche release and effectiveness conditions. In accordance with the Operational Directive on the Simplification of Disbursement Rules under Structural Adjustment and Sectoral Adjustment Loans (February 8, 1996), disbursements -will not be linked to specific purchases and, hence, there will be no procurement requirements. Upon notification by the Bank of loan effectiveness and of second tranche release, the proceeds of the first and second 1-ranche, respectively, of the loan will be deposited by the Bank into the Deposit Account at the request of the Borrower. If after deposit in this account, the proceeds of the loan are used for ineligible purposes as defined in the Loan Agreement, the Bank will require the Borrower to either: (a) return that amount to the account for use for eligible purposes; or (b) refund the amount directly to the Bank (in which case the Bank will cancel an equivalent undisbursed amount of the loan). 59. Loan Management and Monitoring. Loan administration will be the responsibility of a loan manager employed by Banobras, S.N.C. The loan manager will be responsible for preparing the withdrawal applications, maintaining the Deposit Account and arranging for its timely audit (if requested by the Bank.), and monitoring overall loan implementation. The loan manager will also be responsible for coordinating the preparation of the Borrower's contributions to the Implementation Completion Report and for writing those sections relating to loan administration. 60. Accounts and Audit. The loan manager will maintain separate records for all transactions under the loan. Upon the World Bank's request, the Borrower will have the Deposit Account audited by independent auditors acceptable to the World Bank and in accordance with standard World Bank requirements. 61. Environmental Assessment Requirements. In accordance with the Bank's Operational Directive on Environmental Assessment (OD 4.00, Annex A), the proposed operation has been placed in Category "C" and will not require an environmental assessment. 18  V. THE MACROECONOMIC FRAMEWORK FOR THE PROPOSED DAL a) Recent Economic Developments 62. The Mexican economy has in recent years achieved a solid growth record, in spite of an adverse external framework. International capital market uncertainty stemming from successive crises in Asia (second half of 1997), Russia (August 1998) and Brazil (January 1999) led to reduced and more expensive access to external financial resources. In addition, the collapse in international oil prices towards the end of 1997 and the historically low level of oil prices prevailing throughout 1998 and the first quarter of 1999 had a severe negative impact on Mexico's public finances and to a lesser extent on the country's terms of trade. Annual real GDP growth in 1998 fell to 4.8 percent (after averaging 6 percent during the 1996-97 period), a remarkably resilient performance by that year's regional standards. 63. The real-side resilience to external shocks was underpinned by conservative fiscal and monetary policy, coupled with a flexible exchange rate regime. Three consecutive public expenditure reductions (totaling 0.7 percent of GDP) managed to keep the fiscal deficit at its targeted level of 1.25 percent of GDP in 1998. Tightening of monetary policy on several occasions during 1998 could not, however, avoid a rapid pass-through to inflation of a higher than anticipated nominal depreciation of the peso. Consumer prices increased by 18.6 percent compared to the original target for the year of 12 percent. 64. A further slowdown in the expansion of economic activity during 1999 to about 3 percent had been anticipated on the basis of an expected lack of access to international capital markets, low oil prices and the impact of the above-mentioned fiscal and monetary policy adjustments on domestic consumption and investment demand. (The contraction of domestic absorption as of the last quarter of 1998 has had a dominant impact on growth performance during the first half of 1999, leading to an annualized growth rate of only 2.5 percent.) Nevertheless, against initial expectations, improved international liquidity and access to international capital markets, a higher level of oil prices and higher non-oil exports due to the strength of the U.S. economy are contributing to a recovery of domestic demand and economic growth during the second half of the year. The recently released third quarter GDP growth rate (year-on-year) of 4.6 percent has raised estimates for 1999 annual economic growth to about 3.4 percent. 65. Lower international oil prices contributed to an increase in the trade and the balance of payments' current account deficit in 1998, with the latter increasing to US$16 billion (3.9 percent of GDP). Weaker domestic demand and the increase of oil prices experienced during the first half of 1999 are, however, likely to reduce the current account deficit to some US$13 billion (2.8 percent of GDP) this year. Manufactured goods exports and total imports continue to grow at rates above 10 percent, and total trade flows already more than doubled under the NAFTA over the past five years. The economic integration in the NAFTA area is also reflected in the continued high level of Foreign Direct Investment (FDI), financing over two-thirds of the annual current account deficit. 66. Monetary policy is conducted in the context of a floating exchange rate regime adopted as of the 1995 crisis. Although the volatility of the peso-US-dollar exchange rate has been modest in comparison with other currencies over the past four years, adjustments in the exchange 19  rate have neither been gradual nor continuous, and long periods of stability have been followed by sharp variations in the nominal exchange rate. Such adjustments are closely related with capital flows and the international financial markets' perception of Mexico's country risk, especially in the wake of the various external crises (Asia, Russia, Brazil). The turbulence in the global financial situation during the second half of 1998, particularly for emerging economies, was thus reflected in a sharp depreciation of the peso. Since early 1999, however, increasing differentiation in the international investors' perceptions of developing countries risk has led to an improved access for the Mexican public and private sector to international capital markets and, together with other favorable external developments (oil price, U.S. economic strength), has driven a modest nominal appreciation of the peso. This contributed to the gradual appreciation trend observed in the real exchange rate over the past four years (whether measured on the basis of consumer price inflation differentials or unit labor costs), a phenomenon that, while requiring close monitoring, has neither translated into a marked loss of competitiveness (udging by the speed of non-oil export growth) nor been accompanied by a domestic financial "bubble" or excess domestic absorption (no boom in the stock market, surge in real estate prices, acceleration in credit expansion, or major deterioration in the balance of payments' current account). 67. Tight monetary policy has also caused a substantial increase in domestic interest rates. Ex-post real interest rates on Mexican treasury bills went up from an average of 6 percent in 1997 and the first half of 1998 to approximately 13 percent at present. Banks' real lending interest rates have reached levels of almost 20 percent over the past few months. The renewed emphasis on inflation reduction emanating from the monetary authorities' policy statements is likely to maintain the current high levels of interest rates throughout the upcoming political transition period. b) Macroeconomic Prospects 68. The government's 1999 and 2000 targets for real growth (3 415 and 4.5 percent), inflation (13 and 10) and fiscal deficit as proportion of GDP (1.3 and 1.0), albeit ambitious, seem attainable under the present, improving external climate and make up the base scenario for this operation's economic and external financing requirement projections (see Annex Tables A3-A5). A continuation of the main thrusts of present macroeconomic policies, emphasizing fiscal discipline and a gradual but determined reduction in inflation, is assumed even beyond the term of the present administration. Economic growth, largely driven by a gradual recovery of consumption and investment, would lead to an increasing, though still manageable, balance of payments' current account deficit (<up to 3.7 percent of GDP in 2002). Continuously tight monetary policy should also contribute, through its inflation dampening impact, to a slowdown in any further appreciation of the real exchange rate. 69. While the impressive recovery in private investment observed since the 1995 crisis (from about 13 percent of GDP in 1995 to over 22 percent in 1999) will level off, that investment will remain strong (bolstered by a flow of FDI that may reach some US$15 billion in 2002). In turn, 15. The real growth target in the economic program for 1999 was initially set at 3.0 percent. In the presentation of the budget and economic program for 2000, the estimate for GDP growth in 1999 was revised upwards of 3.4 percent in view of the favorable developments experienced this year. 20  consumption (both private and public) is expected to remain in check, hovering around 77 percent of GDP. 70. Those macroeconomic projections assume that Mexican policy-makers (current and forthcoming) will succeed in addressing the economy's two most critical structural needs- assuring the solvency and efficiency of the banking sector, and reducing the oil dependency of the fiscal accounts. Those needs are closely inter-related. The total cost to the public sector of debtor support programs, bank bail-outs and interventions implemented as of 1995 is now estimated at MX$ 873 billion (US$ 93 billion or 19.3 percent of 1999 GDP). Interest accruing, non-tradable bonds issued by the government's bank deposit insurance agency (earlier FOBAPROA, replaced in 1999 by IPAB) make up the larger part of this cost. In order for IPAB to cover at least the real component of its total interest obligations, annual fiscal transfers of about one percent of GDP are required. Recent efforts to strengthen the financial sector (the creation of IPAB; its issuing of regulations for the conversion of Fobaproa bonds for new, tradable securities; the gradual limitation of deposit insurance coverage; and various new rules for bank capital calculation and capitalization) are steps in the right direction that will need furthering in the medium term. 71. Similarly, the experience over the past two years showed again the high vulnerability of Mexican public finances to the level of international oil prices. The shallowness of the non-oil tax base (worth under 10 percent of GDP) results in fiscal over-reliance on oil, as a third of total non-financial public sector revenues are currently oil-related. Each dollar of variation in the average annual international price of oil leads, in the absence of compensating policies, to an estimated variation in the public sector's balance worth some US$660 million'6 (or 0.14 percent of GDP). This is further complicated by the inflexibility of expenditures in the federal budget. Over 70 percent of total federal government spending (or 16 percent of GDP) is already committed either to interest payments on domestic and external public debt, fiscal revenue sharing (participaciones) with sub-national governments, pension and social security reform costs, bank and debtor support programs, and social expenditure transfers to sub-national governments. However, while there is a general recognition of the need for comprehensive fiscal reform focussed on broadening the tax base, no political consensus is expected until the next administration. 72. Beyond banking and fiscal risks, this operation's macroeconomic scenario will be strongly affected by the performance of the US economy (and of its financial markets) and by the evolution of domestic political process in the run-up to the presidential elections and transfer of the administration in December 2000. A one percentage point increase in the average international interest rate faced by Mexico is estimated to cause a first-year increase in the country's total external interest payments worth approximately US$1 billion (0.2 percent of GDP), of which about half would be on account of the public sector. 16. And to an estimated variation of the trade and current account deficits of some US$ 550 million (0.11 percent of GDP) 21  c) External Financing Requirements. 73. One of the elements that contributed to the severity of the 1994-95 crisis was the amount of short-term dollar-indexed public debt (Tesobonos) contracted in the period that immediately preceded the crisis. Therefore, in addition to prudent fiscal and monetary policies and a flexible exchange rate regime, the administration has put particular emphasis on external public debt management that reduces repayments and refinancing needs over the 1999-2001 period, as a crucial element in maintaining stability in financial markets during the political transition. 74. In this regard, the Mexican authorities announced in June 1999, on occasion of the publication of the Letter of Intent for the previously-mentioned Stand-By Arrangement with the IMF, a broader three-year external financing program totaling US$23.7 billion. The package consists of US$16.9 billion in credit from international organizations (IMF US$4.2, World Bank US$5.2,17 IDB US$3.5 and US-Exim US$4.0 billion) and US$6.8 billion in contingent, crisis- management credit arrangements with the US and Canadian monetary authorities. 75. Details on Mexico's external financing requirements and projected sources are presented in Annex Table A6 (based on the contractual situation of the external debt at the end of June 1999). Total public and private sector external financing requirements are estimated at US$27, 35, and 34 billion for the second half of 1999, and the years 2000 and 2001, respectively. These amounts include typically shorter term trade financing (publicly guaranteed and private) obligations of US$8.6, 3.4 billion and 1.5 billion respectively for each of these periods. These are likely to be rolled-over continuously thereby reducing the need for longer term financing. 76. The foreign private sector is expected to remain the main source of external financing for Mexico. By 2001, three quarters of the country's total financing requirements will be served by either private investment flows or private non-guaranteed debt. It is important to note, however, that, due to its strategy of reducing refinancing obligations during the upcoming political transition, the public sector will face important external debt amortization requirements over the 2002-2004 period. Maintaining adequate access to longer-term financing as provided by the IBRD and other international financial organizations will thus be an essential element in improving the maturity structure of Mexico's external debt and in reassuring private investors of the viability of its external accounts. Notably, various international credit rating agencies upgraded Mexico sovereign risk rating after the announcement of the above-mentioned official financing program. 77. Annex table A7 reflects total annual IBRD debt flows and stocks with Mexico. With annual repayments of almost US$1.4 billion, a modest positive net flow of resources is maintained through average annual disbursements of US$1.7 billion over the next few years. The proposed fast-disbursing adjustment operation contributes to keep such a net flow at a critical time of the transition of administrations. IBRD debt outstanding with Mexico will stabilize at about US$12 billion and continue to fall as a share of the total IBRD portfolio, staying well within the historically employed and recently proposed country exposure limits of 10 percent and US$13.5 billion, respectively. 17. The World Bank contribution in the external finance package announced by the Mexican authorities refers to the FY99-01 lending program of the CAS presented to and discussed by the Board on June 8, 1999 22  VI. BANK STRATEGY a) The CAS and The Proposed DAL 78. The DAL will be a key tool in delivering World Bank support for the three objectives that drive the current CAS (as discussed by the Board of Executive Directors on June 8, 1999): effective public governance, and growth and macroeconomic stability, and social sustainability. The operation was envisaged in the CAS, both in scope and timing, and its amount lies within previously projected exposure limits and adjustment lending envelopes. b) Complementarity With Other Operations by the World Bank 79. The World Bank has been active for some time in decentralization issues at the sectoral level. The proposed DAL's design has benefited, and will continue to benefit, from those sectoral experiences and, in turn, will facilitate further sector decentralization operations by providing an adequate overall policy framework. Specifically, the Bank has been present in the financing of the municipal infrastructure funds since 1990 through SEDESOL. Access to basic services especially in the poorest areas has been a priority shared between the Government and the Bank and has translated into two loans to promote the provision of municipal social infrastructure and capacity building (Decentralization and Rural Development I and II-DRD- of $350 and $500 million, respectively, with about $150 million undisbursed). The creation of the Ramo 33, in January 1998, and the ensuing decentralization of a number of social programs (including the social infrastructure fund within Ramo 33) directly to sub-national governments has opened-up new opportunities to support the decentralization effort in key sectors, but has also created new challenges to the Bank's lending in support of fiscal transfers to states and municipalities. 80. Thus, the World Bank has recently reordered its decentralization-related efforts around four pillars. First, supporting decentralization-related policy reform through adjustment lending (this DAL and its possible successor) and continuing sector-specific investments (DRD II, currently under restructuring). Second, designing feasible channels for directing World Bank investment lending, possibly in roads, water, sanitation, and urban infrastructure, to the states (through the State Infrastructure APL, at present under preparation). Third, providing "just-in- time" technical assistance as required by the authorities (notably, through the production of the Policy Agenda for Decentralization delivered in April 1999 and through upon-request technical advice to state governments on, among others, water issues, education, health, and public administration). Fourth, supporting institutional development, primarily through the DRD loans. 81. The on-going work in restructuring the DRD II project (ointly with NAFIN) exemplifies the synergy between the Bank's sectoral operations and the proposed DAL. The successful reactivation of DRD II will depend on: i) the establishment of state-level systems of monitoring and information flow, something the DAL will directly foster, and ii) budget availability for the financing of the independent audits required by the Bank. Subject to the resolution of these issues, the Bank would resume and complete disbursement of the DRD II loan during FY00 and initiate preparation of new sectoral operations under that framework (for social infrastructure, institutional strengthening, and Desarrollo Integral de la Familia). 23  82. The World Bank Institute has developed in partnership with the Monterrey Institute of Technology a very successful distance learning program for municipal officials. In its first year operation the program has been offered twice (January 16-March 20 and September 11 November 13, 1999) training ove:r 3,000 municipal officials in 65 remote-learning ccnters in Mexico, plus eight in other countries of Latin America. The course relies on fees to cover the delivery and transmission cost, and it will be offered at least annually during the next three years. Demand for the course has been growing and specialized national programs for mayors will be set up in Mexico (and Guatemala) during 2000. This will complement the DAL by making municipalities better able to comply with new requirements for reporting, creditworthiness, and participation in the pari-passu programs. 83. Finally, as mentioned earlier, the DAL policy objectives are consistent with, and mutually-supportive of, the planned "Bank Restructuring" loan. While the DAL will enhance efficiency and soundness among sub-national borrowers (a branch of banking business that is very likely to expand rapidly in tandem with the decentralization process), the Banking Restructuring loan, combined with the IMF Stand-by, will attend to the broader solvency and regulatory needs of the Mexican banking industry. For the DAL, an important component of the improved banking regulations will be the gradual tightening of the definition of capital, which will gradually increase the incentive effects of the differential capital-risk weighting scheme for subnational debt to banks. c) Complementarity With Operations by Other Institutions 84. As mentioned before, the DAL will take place in the context of a SDR 3.1 billion (US$4.2 billion), 17-month, IMF Stand-by operation which was approved in July 1999 and will provide the macroeconomic underpinning for the implementation of the new decentralization framework. At the same time, the DAL-related actions will contribute to the sustainability of Mexico's fiscal accounts, a direct target of the Stand-by. In that sense, the operations are mutually reinforcing. The Fund arrangement includes periodic progress reviews of both quantitative quarterly performance criteria on fiscal and monetary policy and indicative targets for measures to strengthen the banking sector, to enhance tax policy and administration (as introduced in the 1999 budget), and to improve the external debt monitoring system. The program has been on track since its inception. Continuous coordination between the IMF and the Bank takes place in the review of economic policy and the preparation of respective operations. 85. The DAL will also exploit strong synergies with decentralization-related operations by the Inter-American Development Bank (IDB). The bulk of IDB's sub-national involvement will soon be channeled through a hybrid loan-US$400 million in fast-disbursing funding and US$ 400 million in a line of credit through Banobras. For the fast-disbursing part, the first tranche (expected by December 1999) commitments correspond to measures already taken by the government over the last two years-mainly the reforms of intergovernmental fiscal relations contained in the budget laws of 1998 and 1999 (particularly adherence to the approved schedule of Ramo 33 transfers to states and municipalities). The second tranche commitments (expected in Spring 2000) are primarily associated with the reform of Banobras, especially its internal management capacity, and with the federal government rationalizing the rules under which states use participaciones as collateral for their borrowing. The new regulatory framework for sub- 24  national borrowing to be supported by the DAL provides such rationalization (through, among others, the elimination of mandatos and their replacement by private fideicomisos or equivalent arrangements where SHCP plays no role). 86. The IDB-supported reforms in Banobras, a key player in Mexico's sub-national lending market, will significantly add to the efficiency of this market, a core objective of the proposed DAL. Those reforms will include the development of sounder, internal credit policies with emphasis on more efficient norms for risk management at the level of each borrower (inter alia, to determine whether and how much a potential client can borrow) and on monitoring systems to follow up on client performance. In parallel, the rules for states to access the line of credit part of IDB's operation require that those states be in the process of implementing acceptable institutional strengthening programs, including improved accounting systems and the setting of borrowing ceilings according to rules spelt out in the "Program's Manual". The line itself will be available to finance the wide-range of technical assistance activities that may be needed to carry out those programs. Access requirements to the line of credit are more lenient for financing purely institutional development, in contrast to infrastructure financing that is contingent on institutional improvements. Thus, even states with weak capacity and creditworthiness can get help to improve. This would directly facilitate the implementation of the new lending policy framework for commercial and development banks that the DAL will support, as it will foster the progressive "graduation" of low-rated states. 25  VII. RECOMMENDATION 87. I am satisfied that the proposed loan complies with the Articles of Agreemert of the Bank, and I recommend that the Executive Directors approve it. James D. Wolfensohn President By Sven Sandstrom Managing Director Washington, D. C. November 30, 1999 GIUGALEIWEBB/ROIAS/D1LL1NGER MSG 26  Annex Al Mexico at a glance 10/27/99 Latin Upper- POVERTY and SOCIAL America middle- Mexico & Carib. income Development diamond* 1998 Population, mid-year (millions) 95.9 502 588 Life expectancy GNP per capita (Atlas method, US$) 3,970 3,940 4,860 GNP (Atlas method, US$ billions) 380.9 1,978 2,862 T Average annual growth, 199248 Population (%/6) 1.8 1.6 1.4 Labor force (%) 2.6 2.3 2.0 GNP Gross Most recent estimate (latest year available, 199248) per primary capita enrollment Poverty (% of population below national poverty line) .. enrollment Urban population (% of total population) 74 75 77 Lffe expectancy at birth (years) 72 70 70 Infant mortality (per 1,000 live births) 31 32 27 Child malnutrition (% of children under 5) 14 8 -. Access to safe water Access to safe water (% of population) 95 75 79 Illiteracy (% of population age 15+) 10 13 11 Gross primary enmllment (% of school-age population) 115 113 108 - Mexico Male 116 .. .. Upper-middle-income group Female 113 _ KEY ECONOMIC RATIOS and LONG-TERM TRENDS 1977 1987 1S97 1998 Economic ratiose GDP (US$ billions) 87.4 140.2 401.7 410.3 Gross domestic investment/GDP 21.6 19.2 26.0 24.4 Trd Exports of goods and services/GDP 8.6 19.5 30.3 31.2 rade Gross domestic savings/GDP 20.6 25.3 26.0 22.4 Gross national savings/GDP 18.2 21.8 24.1 20.6 Current account balance/GDP -2.2 3.0 -1.9 -3.9 Domestic Interest payments/GDP 1.8 5.5 2.1 2.5 stInvestment Total debt/GDP 35.7 78.1 37.3 39.0 Savings Total debt servicelexports 57.4 40.1 32.4 19.1 Present value of debt/GDP . . 36.0 37.8 Present value of debt/exports .. .. 110.3 110.7 Indebtedness 1977-87 1988d8 1997 1998 1999-03 (average annual growth) GDP 2.2 2.9 6.8 4.8 4.6 Mexico GNP per capita 0.3 0.6 6.0 3.0 3.3 Upper-miedle-income group Exports of goods and services 9.4 12.3 10.8 9.7 5.9 STRUCTURE of the ECONOMY 1977 1987 1997 1SS8 Growtb rates of output and Investment 1%) (% of GDP) 40 Agriculture 10.2 8.6 5.7 5.4 Industry 30.7 35.9 28.5 29.1 20-_ Manufacturing 22.4 25.7 21.4 21.9 3. Services 59.1 55.5 65.8 65.5 -20- 93 94 se 97 9S Private consumption 69.6 65.9 64.1 68.2 go General govemment consumption 9.8 8.8 9.9 9.4 - GDI i GDP Imports of goods and services 9.6 13.4 30.4 33.2 1977-87 198848 1997 1998 Growth rates of exports and imports (%) (average annua/ growth) Agriculture 2.2 1.6 0.2 0.5 40 Industry 2.7 3.5 9.3 6.6 30 Manufacturing 2.3 3.9 10.0 7.4 20 Services 2.1 2.7 6.4 4.4 10 Private consumption 2.2 2.5 6.4 6.4 0 93 94 \SE s 57 ss General government consumption 5.2 1.8 2.9 -1.3 -i1 - 9 ,0 Gross domestic investment -4.6 4.1 25.0 8.4 -20 Imports of goods and services -1.3 12.1 22.8 14.2 rExports Imports Gross national product 2.6 2.4 7.9 4.7 _ Note: 1998 data are preliminary estimates. The diamonds show four key indicators in the country (in bold) compared with its income-group average. If data are missing, the diamond will be incomplete. 27  Annex Al Mexico PRICES and GOVERNMENT FINANCE 1977 1987 1997 1998 Inflation (%) Domestic prices (% change) 40T Consumer prices .. 131.B 20.6 15 9 t30 Implicit GDP deflator 25.6 137.3 17.7 13.8 20 (% of GDP, includes current grants) Current revenue - 29.5 23.0 20.6 93 94 ss 96 97 98 Current budget balance -10.3 3.1 2.3 GDP deflator CPI Overall surplus/deficit -15.0 -0.7 -1.3 TRADE (US$ miltions) 1'977 1987 1997 1998 Export and import levels (USS millions) Total exports (fob) .. 22,093 110,431 117,500 140,0W - Oil 8,630 11,323 7,147 120,ODO Agriculture 1,543 3,828 3,954 100,DW oo Manufactures 11,344 94,802 105,933 80,000 Total imports (cif) 13,305 109,808 125,242 00,D00 Consumer goods 768 9,326 11,108 40,000 Intermediate goods 9,907 85,366 96,805 20,000 Capital goods 2,631 15,116 17,329 0 92 93 94 0s ss 97 08 Export pnce index (1995=100) 93 101 99 Import price index (1995=100) 80 101 103 sExports r Imports Terms of trade (1995=100) 115 100 96 BALANCE of PAYMENTS (LUS$ millions) 1977 1987 1997 1998 Current account balance to GOP ratio I%) Exports of goods and services 7,792 27,509 121,701 129,387 0 Imports ofgoodsand services 7,665 18,387 121,608 137,859 -1 Resource balance '127 9,121 94 -8,473 ,2 Net income -2,151 -6,801 -12,790 -13,497 t Netcurrenttransfers 88 1,919 5,247 6,012 -4 Current account balance -1,936 4,239 -7,448 -15,958 Financing items (net) 2 558 1,861 17,942 18,095 7t Changes in net reserves .622 -6,100 -10,494 -2,137 -s Memo: - Reserves including gold (USS millions) . 12,590 28,815 29,032 Conversion rate (DEC, local/US$) O 02 1.4 8.8 9.6 EXTERNAL DEBT and RESOURCE FLOWS 1977 1987 1997 1998 (USS millions) Composition of total debt, 1998 (USS millions) Total debt outstanding and disbursed 31,179 109,459 149,690 159,962 A 4 IBRD 1,374 7,347 11,356 11,514 0G:27,506 A:C11514 , 0 IDA 0 0 0 0 Total debt service 4,715 12,083 42,452 26,778 IBRD 152 1,072 2,102 2,024 E:5,961 IDA 0 0 0 0 | Composition of net resource flows Official grants 9 75 Official creditors 299 888 -4,563 -776 Private creditors 4,407 2,891 6,003 12,219 Foreign direct investment 556 3,246 12,478 10,238 Portfolio equity 0 0 3,215 -66 World Bank program F: 100,952 Commitments 162 1,695 530 2,212 A-IBRD E-Bilateral Disbursements 202 983 995 1,283 8 - IDA 0 - Other multilateral F- Private Principal repayments 50 567 1,311 1,257 I C-IMF G-Short-term Netflovs 152 416 -316 26 Interest payments 102 505 791 767 Net transfers 50 -89 -1,107 -741 Development Economics 10127/99 28  Annex A2 Mexico Social Indicators Latest single year Same regionflncome group Latin America & Upper-middle- 1970-75 1980-85 1992-97 Caribbean income POPULATION Total population, mid-year (millions) 59.1 75.5 94.3 493.9 574.0 Growth rate (% annual average) 3.1 2.2 1.5 1.4 1.3 Urban population (% of population) 62.8 69.6 73.8 74.2 73.8 Total fertility rate (births perwoman) 6.5 4.2 2.8 2.7 2.5 POVERTY (% of population) National headcount index .. .. Urban headcount index .. .. Rural headcount index .. .. INCOME GNP per capita (US$) 1,980 2,160 3,700 3,940 4,540 Consumer price index (1995=100) 0 3 162 123 117 Food price index (1995=100) .. 4 169 INCOMEICONSUMPTION DISTRIBUTION Gini index .. .. 53.7 Lowest quintile (% of income or consumption) 3.3 .. 3.6 Highest quintile (% of income or consumption) 60.7 .. 58.2 SOCIAL INDICATORS Public expenditure Health (% of GDP) .. .. 2.8 2.8 3.0 Education (% of GNP) 3.5 3.9 4.9 3.7 4.8 Social security and welfare (% of GDP) 3.4 2.2 3.0 7.4 7.9 Net primary school enrollment rate /a (% of age group) Total .. 100 101 91 94 Male Female Access to safe water (% of population) Total 62 82 95 75 Urban 70 95 .. 83 Rural 49 50 .. 36 Immunization rate (% under 12 months) Measles .. 64 97 93 92 DPT .. 40 83 82 82 Child malnutrition (% under 5 years) .. .. 14 8 - Life expectancy at birth (years) Total 63 68 72 70 70 Male 60 64 69 66 67 Female 65 71 75 73 73 Mortality infant (per thousand live births) 69 47 31 32 30 Under 5 (per thousand live births) 110 74 38 41 38 Adult (1549) Male (per 1,000 population) 246 205 166 189 193 Female (per 1,000 population) 188 121 83 116 116 Maternal (per 100,000 live births) .. .. a. Ratios exceeding 100 indicate discrepancies between the estmates of school-age population and reported enrollment data. 29   Annex A3 Mexico Decentralization Adjustment Loan Key Economic Indicators National accounts (as % GDP at current market prices) Gross Domestic Product 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 Agriculture8 5.7 5.5 6.3 5.7 5.4 5.2 5.0 4.9 4.8 Industry8 26.9 27.9 28.4 28.5 29.1 29.3 29.2 29.3 29.5 Services' 67.4 66.6 65.4 65.8 65.5 65.6 65.8 65.7 65.7 Total Consumption 83.1 77.5 74.7 74.0 77.6 76.9 76.7 76.7 76.4 Gross Domestic Investment 21.7 19.8 23.2 26.0 24.4 24.3 24.5 24.7 24.9 Government investment 3.8 3.3 3.0 3.1 2.4 2.0 2.0 2.2 2.2 Private Investment 15.6 12.8 14.8 16.4 18.9 22.3 22.5 22.6 22.8 Increase in Stocks 2.4 3.7 5.4 6.6 3.1 2.7 2.4 2.4 2.4 Exports (GNFS)b 16.8 30.4 32.1 30.3 31.2 31.0 32.2 32.5 33.1 Imports (GNFS)b 21.7 27.8 30.0 30.4 33.2 32.1 33.4 34.0 34.5 Gross Domestic Savings 16.9 22.5 25.3 26.0 22.4 23.1 23.3 23.3 23.6 Gross National Savingsc 14.7 19.2 22.5 24.1 20.6 21.5 21.3 21.1 21.3 Memorandum items Gross Domestic Product 420,776 286,167 332,909 401,682 410,302 473,033 506,677 545,311 587,464 (US$ million at current prices) Gross National Product per 4,590 3,800 3,650 3,700 3,970 4,460 4,710 5,090 5,380 Capita (US$, Atlas method) Real Annual Growth Rates (%, calculated from 1993 prices) GDPatmarketprices 4.4 -6.2 5.1 6.8 4.8 3.4 4.5 5.0 5.0 Gross Domestic Income 4.5 -7.9 5.3 7.7 4.2 3.9 4.4 4.9 4.9 Real Annual per Capita Growth Rates (%/o, calculated from 1993 prices) GDP at market prices 2.5 -7.8 3.3 4.9 3.1 1.0 2.7 3.1 3.1 Total Consumption 2.5 -10.0 0.1 4.1 3.6 0.3 2.3 3.0 2.6 Private Consumption 2.7 -11.1 0.5 4.6 4.6 0.5 2.2 3.0 2.3 (Continued) 31  Annex A3 Mexico Decentralization Adjustment Loan Key Economic Indicators (Continued) Public finance (as % of GDP at current market prices)d Current revenues 22.8 22.8 23.0 23.0 20.6 21.3 21.9 21.9 21.6 Current expenditures 19.2 19.6 19.2 19.9 18.3 19.4 19.5 19.5 19.2 Current account surplus(+) 3.5 3.2 3.8 3.1 2.3 1.9 2.4 2.4 2.4 or deficit (-) Capital expenditure 3.7 3.2 3.9 3.7 3.4 3.2 3.4 3.4 3.4 Overall Balance -0.1 0.0 0.0 -0.7 -1.3 -1.3 -1.0 -1.0 -1.0 Monetary Indicators M2/GDP (at current 28.6 29.1 26.5 28.4 27.2 ... ... ... ... market prices) Growth of M2() 19.3 31.7 25.3 34.6 14.2 ... ... ... Private sector credit growth! 1.4 -0.3 -3.3 -8.4 0.3 ... ... ... ... total credit growth (%) Price indices (1993=100) Merchandise exportprice index 108.0 114.0 115.9 114.8 108.0 114.4 116.9 119.5 122.2 Merchandise importprice index 102.5 108.1 108.5 109.2 108.4 110.7 113.5 116.3 119.3 Merchandise terms of trade index 105.3 105.5 106.8 105.1 99.6 103:4 103.0 102.7 102.4 Realexchangerate(LCUIUS$)e 105.3 152.9 134.5 113.9 112.5 103.8 103.8 103.8 103.8 Consumer price index 7.0 35.0 34.4 20.6 15.9 15.4 10.5 9.1 7.2 (% growth rate, period average) Consumer price index 7.1 52.0 27.7 15.7 18.6 13.0 10.0 8.0 6.0 (% growth rate, end of period) GDP deflator 8.3 37.9 31.0 17.7 13.8 13.2 9.7 8.0 6.0 (% growth of rate) a. GDP components estimated at factor cost, as a % of GDP at factor cost. b. "GNFS" denotes "goods and nonfactor services". c. Includes net unrequited transfers excluding official capital. d. Consolidated non-financial public sector e. "LCU" denotes "local currency units". An decrease in LCU/US$ denotes appreciation. 32  Annex A4 Mexico Decentralization Adjustment Loan Balance of Payments Balance of Payments (UIS$ m) Exports (GNFS)a 71,184 89,207 106,779 121,701 129,387 146,680 162,916 177,498 194,644 Merchandise FOB 60,882 79,542 96,000 110,431 117,460 134,231 149,518 163,079 179,110 Imports (GNFS)8 91,616 81,454 99,700 121,608 137,859 152,056 168,999 185,217 202,633 Merchandise FOB 79,346 72,453 89,469 109,808 125,373 139,222 155,253 170,422 186,695 Resource balance -20,432 7,753 7,079 94 -8,473 -5,376 -6,083 -7,719 -7,989 Net current transfers 3,782 3,960 4,531 5,247 6,012 5,881 6,176 6,487 6,812 (including official current transfers) Current account balance -29,662 -1,577 -2,330 -7,448 -15,958 -13,101 -15,908 -19,811 -21,579 (after official capital grants) Netprivateforeigndirect 10,973 9,526 9,186 12,830 10,238 11,000 12,100 13,310 14,641 investment Portfolio investment 1,858 -13,340 3,708 3,800 -452 1,000 1,500 2,500 3,500 Long-term loans (net) 4,630 16,344 4,442 1,440 11,443 5,046 4,554 5,328 5,355 Official -585 10,352 -7,681 4,563 -776 -1,262 781 84 231 Private 5,214 5,992 12,123 6,003 12,219 6,308 3,773 5,244 5,124 Other capital (net, including -4,986 -13,504 -11,184 3,312 -2,071 -769 -766 -632 -636 errors and omissions) Net use of IMF resources -1,204 12,144 -2,052 -3,439 -1,063 -3,147 -951 -55 -1,077 Change in gross reserves 18,391 -9,593 -1,768 -10,494 -2,137 -30 -529 -639 -204 Memorandum items Resourcebalance(%of -4.9 2.7 2.1 0.0 -2.1 -1.1 -1.2 -1.4 -1.4 GDP at current market prices) Current account balance -7.0 -0.6 -0.7 -1.9 -3.9 -2.8 -3,1 -3.6 -3.7 (% of GDP at current market prices) Real annual growth rates (%) (1993 prices) Merchandise exports 17.3 30.6 20.7 15.0 6.4 14.2 11.4 9.1 9.8 Merchandise imports 21.4 -8.7 23.5 22.7 14.1 11.2 11.5 9.8 9.5 a. "GNFS" denotes "goods and nonfactor services". 33   Annex A5 Mexico Decentralization Adjustment Loan Key External Debt Indicators Total debt outstanding and 140,002 166,780 157,848 149,690 159,962 164,532 167,969 173,210 177,452 disbursed (TDO) (US$m)a Net disbursements (US$m)a 6,491 26,466 -4,843 -3,560 10,380 4,399 3,853 5,548 4,581 Total debt service (IDS) 21,941 26,886 40,792 42,452 26,778 39,072 39,342 37,025 47,310 (US$m)a Debt and debt service indicators (0/6) (%)C TDO/XGSb 187.5 179.6 142.2 118.3 118.5 107.8 99.3 94.1 88.1 TDO/GDP 33.3 58.3 47.4 37.3 39.0 34.8 33.2 31.8 30.2 TDS/XGSb 29.4 28.9 36.7 33.5 19.8 25.6 23.3 20.1 23.5 IBR3D exposure indicators (%) lBRDDS/publicDS 15.0 13.8 8.1 6.6 11.8 9.2 8.7 11.2 8.8 Preferred creditor/ 30.9 27.4 19.5 20.9 24.7 36.6 25.8 18.0 18.3 public DS (%)C IBRD DS/XGSb 2.7 2.6 2.1 1.7 1.5 1.4 1.3 1.1 1.1 IBRDTDO(US$m) 13,475 14,295 13,078 11,906 12,109 11,233 11,839 12,040 12,548 Present value 437 472 510 550 595 429 116 0 0 of guarantees (UJS$m) ShareofIBRDportfolio(%) 11.9 12.0 11.5 10.5 9.3 8.5 8.6 8.5 8.6 IFC (US$m) Loans 534 550 528 495 338 ... ... ... ... Equity and quasi-equitye 51 57 65 76 78 ... ... ... a. Includes public and publicly guaranteed debt, private nonguaranteed, use of IMl credits and net short-term capital. b. "XGS" denotes exports of goods and services, including workers' remittances. c. Preferred creditors are defined as IBRD, IDA, the regional mltilateral development banks, the IMF, and the Bank of International Settlements. d. Includes present value of guarantees. e. Includes equity and quasi-equity types of both loan and equity instruments. 35   Annex A6 Mexico External Financing Requirement and Projected Sources of Financing (in millions of U.S. dollars) Financing requirements: 1. Current Account Deficit 7,072 15,908 19,811 2. External Debt Amortizationa 19,869 18,438 13,898 a. Public and Publicly Guaranteed 10,207 10,989 6,384 of which IMF 2,998 2,894 52 of which IBRD 698 1,368 1,294 b. Private 9,662 7,449 7,514 3. Change in gross reserves (-decline) 11 529 639 4. Gross Financing Requirements 26,951 34,875 34,349 (1 + 2 + 3) Sources of Financing: 5. Private Investment Flows (Net) 6,061 13,600 15,81 D 6. External Debt Contracteda 20,890 21,275 18,539 Public and Publicly Guaranteed 8,490 11,275 5,539 Multilateral and Bilateral Gross 3,418 4,936 2,508 Disbursements of which MF 2,100 2,100 0 of which IBRD 362 2,090 1,924 Private Creditors 5,072 6,339 3,032 Private Non-Guaranteeda 12,400 10,000 13,000 7. Total Sources of Financing 26,951 34,875 34,349 (5+6) a. Includes short-term external debt amortization and refinancing during 1999-2nd half and part of 2000, except for interbank credit lines of the commercial banking sector of an amount of US$ 15,524 millions. Source: Bank staff estimates, SHCP. 37   Annex A7 Mexico Decentralization Adjustment Loan Total Debt Flows and Stock with IBRD (US$ million) Debt Outstanding 14,951 13,322 12,251 11,363 11,540 11,858 11,942 12,190 of which guarantees 462 499 539 572 424 429 116 0 Share of IBRD portfolio (%) 13.3 11.9 11.3 9.8 9.2 9.0 8.6 8.5 Comllmitments 2,387 527 485 1,767 950 1,700 1,900 1,500 Disbursements 1,113 1,473 943 1,024 1,309 1,698 1,740 1,667 Repayments 1,223 1,461 1,363 1,268 1,285 1,385 1,343 1,302 Net Disbursements -110 12 -421 -244 24 314 396 364 Interest 948 937 892 750 816 789 814 841 Net Transfer -1,058 -925 -1,313 -994 -793 -475 -417 -476 1/ As per information available as of December 1999 Source: Bank staff estimates 39   Mexico Decentralization Adjustment Loan Status of Bank Group Operations in Mexico Operations Portfolio As of 23-Nov-99 Difference Between expected Original Amount in US$ Millions and actual Last PSR Fiscal disbursements a/ Supervision Rating b/ Project ID Year Borrower Purpose IBRD IDA Cancel. Undisb. Orig Frm Rev'd Dev Obj Imp Prog Number of Closed Projects: 121 Active Projects MX-PE--7667 1992 NAFINSA IRRIG SCTR 400.00 0.00 0.00 30.70 80.70 4.00 S S MX-PE-7723 1993 BANOBRAS HWY RHB & SAFETY 480.00 0.00 0.00 84.20 42.60 0.00 S S MX-PE-7648 1993 BANOBRAS MEDIUM CITIES TRANSP 200.00 0.00 23.00 113.70 123.00 47.10 S S MX-PE-7725 1994 NAFIN PRIM.EDUC.II 412.00 0.00 0.00 110.30 154.30 93. 30 HS S MX-PE-7710 1994 BANOBRAS N. BORDER I ENVIRONM 368.00 0.00 0.00 65.40 306.40 39.30 S S MX-PE-7707 1994 BANOBRAS WATER/SANIT II 350.00 0.00 0.00 171.50 171.50 0.00 S S MX-PE-7701 1994 NAFIN ON-FARM & MINOR IRRI 200.00 0.00 0.00 60.40 85.40 13.70 S S MX-PE-7612 1994 BANOBRAS SOLID WASTE II 200.00 0.00 53.10 1.50 -4.50 1.50 S S MX-PE-34490 1995 NAFIN TECH EDU/TRAING 265.00 0.00 0.00 142.70 170.00 6.30 S S MX-PE-41811 1995 NAFINSA FINANCIAL SEC T.A. SUPPLM 14.00 0.00 0.00 9.80 0.00 0.00 f MX-PE-7702 1995 SEDESOL SECOND DECENTRALZTN 500.00 0.00 0.00 144.10 144.10 126.70 S U MX-PE-7713 1996 GOM WATER RESOURCES MANA 187.00 0.00 0.00 152.70 44.80 6.20 S s MX-PE-7689 1996 NAFIN BASIC HLTH II 310.00 0.00 0.00 164.00 89.20 64.30 HS MS . MX-PE-7732 1997 GOVERNMENT RURAL FIN. MKTS T.A. 30.00 0.00 0.00 28.30 26.00 12.30 U U MX-PE-7726 1997 GOVERNMENT AQUACULTURE 40.00 0.00 0.00 39.10 8.80 0.00 U U MX-PE-7700 1997 GOVT OF MEXICO COMMUNITY FORESTRY 15.00 0.00 0.00 9.30 1.30 0.00 S S MX-PE-43163 1997 BANOBRAS FEDERAL ROADS MODZTN 475.00 0.00 0.00 475.00 146.70 0.00 HU U MX-PE-55061 1998 BANOBRAS HLTH.SYSTEM REF. TA 25.00 0.00 0.00 23.00 6.40 0.00 S S MX-PE-49895 1998 MINISTRY OF FINANCE HIGHER ED. FINANCING 180.00 0.00 0.00 180.20 23.90 0.00 S S MX-PE-44531 1998 GOM KNOWLEDGE & INNOV. 300.00 0. 00 0.00 278.70 4.10 0.00 S S MX-PE-40199 1998 MEXICAN GOVERNMENT BASIC EDC. DEV. 115.00 0.00 0.00 99.90 8.40 0.00 S S MX-PE-7720 1998 8ANOBRAS HEALTH SYSTEM REFORM 700.00 0.00 0.00 350.00 116.70 0.00 S S MX-PE-7711 1998 NAFIN RURAL DEV. MARG.AREA 47.00 0. 00 0.00 41.50 12.20 0.00 S S MX-PE-48505 1999 NAFIN AGRICULTURAL PRODUCT 444.00 0.00 0.00 366.00 11.90 0.00 5 S MX-PE-7610 1999 BANOBRAS FOVI RESTRUCTURING 505.00 0.00 0.00 505.00 161.70 0. 00 S S Total 6,762.00 0.00 76.10 3,637.00 1,935.60 414.70 Active Projects c/ Closed Projects c/ Total c/ Total Disbursed (IBRD and IDA): 2,460.79 21,404.70 23,865.49 of which has been repaid: 122.08 12,731.48 12,853.56 Total now held by IBRD and IDA: 5,543.73 9,173.74 14,717.47 Amount sold 0.00 92.34 92.34 Of which repaid : 0.00 92.34 92.34 Total Undisbursed : 3,205.02 52.82 3,257.84 a. Intended disbursements to date minus actual disbursements to date as projected at appraisal. b. Following the FY94 Annual Review of Portfolio performance (ARPP) , a letter based system was introduced (HS - highly Satisfactory, S - satisfactory, U = unsatisfactory, HU - highly unsatisfactory) : see proposed Improvements in Project and Portfolio Performance Rating Methodology (SecM94-901), August 23, 1994. c. As of 31-Oct-99, 00   Annex A9 Mexico Decentralization Adjustment Loan STATEMENT OF IFC's Committed and Disbursed Portfolio As of 31-Aug-99 (In US Dollar Millions) Committed Disbursed IFC IFC FY Approval Company Loan Equity Quasl Partic Loan Equity Quasi Partic 198891192/93/95 Apasco 14.40 0.00 0.00 57.60 14.40 0.00 0.00 57.60 1994/96/98 Aurum-Heller 0.00 0.82 0.00 0.00 0.00 0.82 0.00 0.00 1998 Ayvi 10.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 1990/92/96 BANAMEX 100.00 0.00 0.00 71.06 44.33 0.00 0.00 71.06 1997 Banco Bilbao MXC 80.00 0.00 30.00 0.00 76.10 0.00 30.00 0.00 1992 Banorte-SABROZA 3.00 0.00 0.00 0.00 3.00 0.00 0.00 0 00 1995/96 Baring Mex FMC 0.00 0.03 0.00 0.00 0.00 0.02 0.00 0 00 1995/99 Baring Venture 0.00 2.73 0.00 0.00 0.00 0.00 0.00 0.00 1998 CIMA Mexico 0.00 4.80 0.00 0.00 0.00 4.80 0.00 0.00 1998 CIMAPuebla 7.00 0.00 0.00 0.00 3.50 0.00 0.00 0.00 1994 CTAPV 4.18 0.00 2.53 0.00 4.18 0.00 2.53 0.00 1997 Comercializadoma 3.50 0.00 2.50 7.50 3.50 0.00 2.50 7.50 1990/91 Condumex 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 1993 Derivados 4.40 0.00 0.00 6.02 4.40 0.00 0.00 6.02 1997 Fondo Chiapas 0.00 5.00 0.00 0.00 0.00 0.31 0.00 0.00 1998 Foria Monterrey 13.00 3.00 0.00 13.00 13.00 3.00 0.00 13.00 1991/96 GIBSA 24.34 0.00 10.00 81.86 24.34 0.00 10.00 81.86 1993 GIDESA 8.75 8.00 0.00 12.75 8.75 8.00 0.00 12.75 1996 GIRSA 27.00 0.00 9.29 110.00 27.00 0.00 9.29 110.00 1993 GOTM 1.09 0.00 0.00 0.66 1.09 0.00 0.00 0.66 1997/98 Gen. Hipotecaria 0.00 1.20 0.00 0.00 0.00 0.00 0.00 0.00 1998 Grupo Calidra 12.00 6.00 0.00 10.00 12.00 6.00 0.00 10.00 1989 Grupo FEMSA 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 1997 Grupo Minsa 20.00 10.00 0.00 30.00 20.00 10.00 0.00 30.00 1992/93/95196/99 Crupo Posadas 0.00 15.00 0.00 0.00 0.00 15.00 0.00 ).00 1992/96/97/98 Grupo Probursa 0.00 1.32 0.00 0.00 0.00 1.32 0.00 D.00 1998 Grupo Sanfandila 10.00 0.00 0.00 5.00 6.67 0.00 0.00 3.33 1994 Interceramic 10.00 0.00 6.00 7.00 10.00 0.00 6.00 7.00 1993 Masterpak 4.80 0.00 0.00 6.48 4.80 0.00 0.00 6.48 1998 Merida III 30.00 0.00 0.00 73.95 22.42 0.00 0.00 55.28 1984/87194/96 Metalsa 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 1995/99 Mexplus Puertos 0.00 1.41 0.00 0.00 0.00 1.41 0.00 0.00 1996 NEMAK 0.00 0.00 6.00 0.00 0.00 0.00 6.00 0.00 1990 Petrocel 2.60 0.00 1.20 1.40 2.60 0.00 1.20 1.40 1998 Punta Langosta 4.00 1.00 0.00 7.00 2.76 1.00 0.00 4.84 1988/94/95 Sigma 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 1997 TMA 4.87 0.00 0.00 9.60 4.87 0.00 0.00 9.60 1992 Toluca Toll Road 7.39 0.00 0.00 0.00 7.39 0.00 0.00 0.00 1991/92 Vitro 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 1991 Vitro Flotado 8.26 0.00 0.00 3.45 8.26 0.00 0.00 3.45 1998 ZN Mxc Eqty Fund 0.00 25.00 0.00 0.00 0.00 0.00 0.00 0.00 Total Portfolio: 414.58 85.31 67.52 514.33 329.36 51.68 67.52 431.83 Approvals Pending Comnmitment l,an Eadtv O"asi Partic 1997 ALTAMIRA 17.80 0.00 1.00 38.00 1999 BANAMEX LRP II 50.00 0.00 0.00 0.00 1999 BARINGBMPEFFMC 0.00 0.06 0.00 0.00 1998 CIMA HERMOSILLO 7.00 0.00 0.00 0.00 1999 CORSA 13.00 3.00 0.00 0.00 1999 GRUPO POSADAS V 25.00 0.00 10.00 35.00 1999 NEMAK RI 0.00 0.00 0.70 0.00 2000 NEMAK RI n 0.00 0.00 0.83 0.00 Total Pending Comnmitment: 112.80 3.06 12.53 73.00 43   Annex B Policy Commitments on Environment-related Performance Agreements Explanatory Note First Tranche: Inclusion in the federal budget submission for fiscal year 2000 of a pari- passu program, acceptable to the World Bank, in support of '7performance agreements" between the federal and state governments to elicit improvements in state-level legal frameworks for environmental protection and development of the states' environment-related institutions. Second Tranche: Overall progress under the Government's Decentralization Program as specified in the letter of Development Policy is satisfactory to the World Bank. 1. Background/Rationale. As a new administrative sector in Mexico, the environment is so far less decentralized or deconcentrated than the traditional sectors of health, education agriculture or infrastructure. In spite of some progress in the legal-regulatory environment,' the responsibilities of each level of government could not, to a large extent, be implemented in practice. The states must still adapt and adjust their legal environment to the new decentralized environment that is being put in place at the federal level. As in other sectors of the Mexican administration, further progress in decentralization requires, as a sine qua non condition, the strengthening of inter-government monitoring and reporting procedures and practices for which the federal government and the states are not yet prepared. Besides further definition of responsibilities, inter-government coordination mechanisms are urgently required for identification of priorities, co-financing and evaluation of shared responsibilities. State and municipal administrations often lack the necessary technical and management capacity for environmental protection matters. 2. SEMARNAP has put forward a proposal for the creation of state environmental funds. Besides being a financing mechanism, these funds would play a significant role in inter- government coordination through co-financing and strengthening capacity in the areas of planning, monitoring, reporting and evaluation.2 Theparipassu program that will be included in the federal budget for FYOO and supported by the DAL will help prepare the ground for the state environmental funds. It will introduce an incentive for institutional development at the sub- national level, geared towards the states' development of an adequate regulatory environment, training and technical capacity building, and monitoring and reporting for inter-government evaluation and coordination. Since the institutional development needs vary from state to state, the incentive offered by the federal government will consist of core instruments and activities for environmental management and a menu of institutional development options from which the states will choose. Institutional development priorities identified by the states themselves will then be aligned with those of the federal government and negotiated with SEMARNAP in terms of specific performance and impact indicators. 1. In particular, LGEEPA and Ley Forestal. 2. See "Propuesta de un Mecanismo de Financiamiento para la Gesti6n Ambiental Local. Resumen Ejecutivo." SEMARNAP, September 21, 1999. 45  Annex B 3. As part of the strategy for establishing and financing the state environmental Funds, it is also contemplated that SHCP may agree to the implementation of a gasoline surcharge by the states on a voluntary basis, as an instrument to enhance states' revenue earning capacity for the environment. If, as requested by SEMARNAP, SHCP (ingresos) agrees that the states can implement such surcharge (of no rnore than Mex$ 0.04 per liter) on the gasoline excise tax, the pari passu agreement will require that participating states effectively apply this surcharge and apply its revenues to the proposed state environmental funds. If this is indeed the case, the additional state revenues earmarked for the environment will be made part of the inter- government agreements, the implementation, and the impact evaluation of this pari passu programs. 4. In terms of connection with broader institutional development strategies for decentralization of environmental protection services, the pari passu program will directly contribute to the objectives of thie "Programa de Manejo Ambiental y Descentralizaci6n", PROMAD, as developed by SEMARNAP with support from the World Bank. That objective is to build efficient and effective environmental management systems by strengthening capacity at the federal, regional and local levels and mobilizing additional resources for the sector. Seen in connection with other institutional development objectives of this DAL, the pari passu program for the environment sector will facilitate collection and reporting of regional and local data on decentralization and inter-governrment coordination, as required by SHCP's Decentralization Committee. The program will also stimulate confidence building and negotiations among levels of government. 5. Expected Impact. The pati passu is a pilot to demonstrate what a relatively small incentive can achieve in terms of mobilizing additional resources, strengthening capacity and developing ownership for sustainable institutional development at the state level. The incentive will be a one-time matching grant contribution from the federal government, targeted on key measures that eliminate bottlenecks or otherwise further institutional development for decentralization of environmental protection. The agreement by SHCP that the states can implement a gasoline surcharge on a voluntary basis would be an additional incentive for the states to sustain their effort in addressing environmental priority issues after the one-time support is over. As a one-time action for achieving institutional development objectives goals, the sustainability and medium term impact of the pari passu will depend on further actions that consolidate the decentralized/deconcentrated institutional framework envisioned in Mexico. As a pilot program, this pari passu will provide lessons on institutional capacity building for decentralization and inter-government coordination. It will also provide lessons as to the size and cost-effectiveness of incentives for inter-government negotiation of priorities through pari passu programs. 6. Implementation. The SHCP will include in the budget bill for FY00 a program that offers matching resources to states that agree with SEMARNAP on reaching specific institutional development benchmarks, and reach them. This pari passu program will be specified in the budget, and detailed regulations issued by SEMARNAP in January 2000 will specify the institutional development objectives that can be financed, the amount of federal resources available, the rules of access by the states, the corresponding matching contributions required from the states, and the indicators to measure state performance and impact of the program. 46  AnnexB 7. Once the program is approved as part of the budget for FY00 (December 31, 1999, at the latest), SEMARNAP will sign agreements with the states whereby the individual institutional development objectives, the matching contributions, the various other commitments for the implementation of the program (as indicated above), and the evaluation indicators for each state program will be specified in detail. 8. Since the pari passu program is being introduced for the first time in FY2000, and it requires preparatory activities at the state level before the states actually sign the inter- government agreement, it is expected that only a limited number of states will be in a position to participate during the first year. 9. The federal contribution to each individual state will occur only once, afler the state has signed the inter-government agreement and otherwise demonstrated its commitment to the program. Indicators of satisfactory progress, for the DAL second tranche commitment, are: (i) publication by SEMARNAP of the Operational Manual of the pari-passu program, and (ii) preparatory work performed at the federal and state level for signing of the agreement between SEMARNAP and the participating states. Preparatory work for signing the pari passu agreement is necessary at the state level as participating states commit themselves to: a) up- dating of the state environmental legislation and regulatory framework; b) executing actions leading to capacity building at the sub-national level; c) issuing state environmental action plans that spell out the state's environmental, institutional, and investment priorities; d) creating a state environmental fund; e) allocating resources for the state financial contribution to the environmental fund to match the pari passu program, possibly including proceeds from the gasoline tax surcharge, the state's other own resources, donations and grants, private sector contributions, or municipal participation. 10. During FY00 SEMARNAP will monitor and evaluate the performance and impact of this pari passu program and will pursue further institutional development strategies at the state level that capitalize on the results of this pari passu. As part of its monitoring responsibilities, SEMARNAP will report to the SHCP on the performance and impact indicators and will submit an evaluation of this federal spending program. 11. Supervision. Supervision of compliance with this commitment will be in two phases: (i) inclusion of the pari passu in the budget bill for FY00; (ii) monitoring and evaluation of progress between the first and second tranches of the DAL on the basis of the number of inter-government performance agreements signed, disbursement of federal matching funds and preparation of SEMARNAP for monitoring and evaluation of the program. 12. Stakeholders. The GOM-SHCP, insofar as evaluation and rationalization of fiscal transfers and public expenditure efficiency is concerned. The GOM-SEMARNAP, as it is highly committed to advancing PROMAD and other strategies for strengthening capacity with a view to decentralization of the environment sector. The GOM, both SHCP and SEMARNAP, as the two secretaries are committed to strengthening inter-sector coordination for enhancing efficiency in public expenditure through decentralization. The sub-national entities that are demanding additional resources, incentives and technical assistance that enable them to assume new responsibilities for the protection of the environment. Civil society organizations and communities concerned with a more participatory and decentralized approach to environmental 47  Annex B protection. Other federal and state secretaries that will closely observe the performance of this pilot paripassu to draw lessons for decentralization in other sectors. 13. Risks and RiskMitigation. There is always the risk of the incentives being insufficient to mobilize the active commitment of the states. This risk is already being minimized through the participation of the states in the selection of their own institutional development priorities. Besides, SEMARNAP has for somne time been working with the states on and announcing support for institutional development at the state level. 14. The risk of SEMARNAP not actively promoting, monitoring and rigorously evaluating the pari passu is highly mitigated by the demonstrated commitment of the present SEMARNAP administration to decentralize the sector effectively and to put in place mechanisms for inter- government reporting and coordination. 15. The risk of the federal congress rejecting the government proposed pari passu program - although it exists-is estimated as low. 48  Annex C Policy Commitment on Health-related Performance Agreements Explanatory Note First tranche: Inclusion in the federal budget submission for fiscal year 2000 of a pari- passu program, acceptable to the World Bank, in support of "performance agreements" between the federal and state governments to foster institutional development (training and monitoring capacity) at the state level that can facilitate the expansion of basic health coverage under the Programa de Ampliacion de Cobertura (PAC). Second tranche: Overall progress under the Government's Decentralization Program as specified in the letter of Development Policy is satisfactory to the World Bank. 1 Background and Rationale. As part of the process of government decentralization, the federal government has made significant transfers to states and municipalities. Some, such as revenue sharing (ramo 28) are block grants. Others are earmarked for specific purposes, such as education and health. These earmarked transfers are not always supported by effective mechanisms for monitoring and evaluation. Therefore the federal government often lacks the necessary information to evaluate and adjust earmarked transfers and transfer mechanisms, develop adequate sector regulations or otherwise strengthen inter-government coordination. Neither is the federal government in a position to determine whether states are fully capable of performing the functions that have been decentralized to them. 2. The decentralization of health services in Mexico can be best characterized as a devolution of some revenues and responsibilities to state and municipal governments, with continued predominant federal control over policies and programs. One of the principal objectives of the current administration is to extend basic health services to the estimated 10 million people who lack either access to public health facilities. and health insurance. To achieve this goal, the Government's Health Sector Reform Program 1995-2000 defines a package of 13 low-cost, high-impact interventions, termed the Paquete Basico de Servicios de Salud (PBSS). These are to be delivered by state health workers in 19 target states, with funding from the federal Program for the Expansion of Coverage (PAC). (A complementary program-el Programa de Municipio Saludable-is now operating in 1,306 of the 2,426 municipios in the country.) To monitor progress toward universal coverage, the federal Secretariat of Health (SSA), with the support of the Panamerican Health Organization/World Health Organization (PAHO/WHO), has devised a system of 39 indicators which will measure the quality and quantity of basic health services in each target state. PAHO/WHO will be responsible for officially certifying states that have achieved the universal coverage target. 3. One of the main weaknesses in the implementation of the PAC is a deficiency in the specific skills required to deliver the PBSS effectively. To address this deficiency, the government intends to establish a matching grant program (pari-passu) to finance training, monitoring, reporting, and institutional development. The training program will cover technical and managerial aspects of PBSS delivery, as well methods for monitoring and reporting PAC impacts. 49  Annex C 4. Expected Impact. The proposed pari-passu program will strengthen participant subnational governments' capacity to deliver the PBSS. A required state capacity-building plan will stimulate regional ownership of partially devolved responsibilities and provide the basis for increasing state autonomy in planning and execution of health programs. Training in monitoring and reporting will enhance inter-government coordination and extend capacity and ownership of the PAC at local and community levels. Monitoring and reporting on actual PBS service actions and impact indicators will further elevate the PAC goals in terms of coverage and range of services. The pari-passu program will be selectively offered to a few PAC-participating states, as a pilot program that can be extended to other states later on. Strengthening the PAC will help it achieve its goal of improving the access of the poor to health care services. 5. Implementation. Federal finds allocated to this program will be specified in the budget bill for FY00. Eligibility requirements, criteria, and formula for distribution will be specified as part of the publication of all pari-passu rules and state-by-state allocation due for second tranche disbursement. The federal matching funds will be distributed to states in two tranches during fiscal year 2000: the first tranche upon signature of the pari-passu agreement, the second upon satisfactory completion of the commitments stated in the performance agreement. Signature of the pari-passu agreement will inter alia require each state to present an institutional strengthening plan for the health sector for FY2000. (Terms of reference have been prepared by SSA and are in the project files.) 6. Supervision. For first tranche, the Bank will review the inclusion of this new pari-passu program in SSA's budget bill for FY2000. For second tranche, program specifications must be acceptable to the Secretariats of Finance (SHCP) and Health (SSA) and the World Bank. The Bank will review the pari-passu agreements signed with individual states and the initial flow of funds to participating states. 7. Stakeholders. The Secretariat of Finance is a major stakeholder in this activity, given its interest in evaluating and rationalizing fiscal transfers and in improving the overall efficiency of public expenditure. The Secretariat of Health is a second stakeholder, given its interest in strengthening health service delivery. The states have a stake in strengthening their own capacity for service delivery and coordinating with the federal and municipal governments and civil society. 8. Risks andRiskMitigation. There is some risk that states might divert funds from this pari- passu program to ongoing training and personnel costs, rather than the allocating them to its intended purpose. This risk will be mitigated in three ways. 9a. First, SSA will explicitly warn the states and make it explicit in the pari-passu agreement that this is a one-time program aimed at achieving universal coverage in the year 2000; 9b. Second, SSA will enforce the requirement that each state present a plan for institutional development, monitoring and reporting; 9c. Finally, SSP will commit itself to monitor and evaluate the program's impact on coverage and on the range of Paquete Basico de Servicios offered through the PAC. The World Bank is prepared to finance and provide technical assistance for the design and implementation such a monitoring and evaluation mechanism. 50  G.H 1 SECRETARIA DE HACIENDA Y CREDITO PUBLICO Oficio 101.- - SECRETARIA CE HuACIENOA ' CRO1TO PUSLICO MkxicoD.F.a 26 de noviembre de 1999 Sr. James D. Wolfensohn Presidente Banco Mundial Washington. D.C. 20433 Estados Unidos Estimado Sr. Wolfensohn; En relaci6n con el prestamo en apoyo al Programa de Fortalecimiento a Estados y Municipios a ser contratado con el Banco Muniial (8M), mediante el cual se apoyara el prooeso de descentralizaci6n que se ileva a cabo, me permito hacer de su conocimiento algunos aspectos relevantes de ia economta mexicana, asl como de la politica macroecon6mica seguida por el Gobiemo de Mexico, en particular de las acciones realizadas y las que se llevar6n a cabo para continuar con el proceso de descentralizaci6n, i. Situaci6n Macroecon6mica En los uiltimos anos, la economf a mexicana ha logrado mantener la recuperaci6n y consolidaci6n de las bases para el desarrollo sostenido y con estabilidad de precios gracias a la aplicaci6n de un programo economico sustentado en la disciplina fiscal y monetaraa, asi como en el sano financiamiento del deficit de la cuenta corriente y los oportunos ajustes en el gasto p6blico. Asimismo, se ha llevado a cabo un programa de reformas estructurales, que incluye la desincorporaci6n de aeropuertos y ferrocarriles: reformas al sistema financiero y al sistema de seguridad social, en particular al sistema de pensiones. Estas acciones han influido en el compoftamiento de diversas variables macroecon6micas. El crecimiento del Producto Intemo Bruto (PIB) registr6 un crecimiento anual promedio de 5.6 por ciento en el periodo 1996-1998. Para 1999 se estima que podria registrarse un crecimiento ligeramente superior al 3 por ciento. a pesar de las condiciones intemacionales adversas como son ta desaceleraci6n en la tasa de crecimiento de Estados Unidos, la volatilidad de los precios del petr6leo y el limitado acceso a los mercados de capital. Con base en el mantenimiento del programs econ6mico de la actual Administraci6n, para el afto 2000 el crecimiento del PIB podria alcanzar un nivel de entre el 4 y el 5 por ciento. Por otra parte, en 1998 y 1999 el Banco de Mexico ha aplicado en diversas ocasiones una politics monetaria restrictiva con el fin de contrarrestar el efecto inflacionario de la depreciaci6n del tipo de cambio producido por eventos eXtemos desfavorables. Por ello, a pesar de los efectos negativos de la volatilidad de los mercados financieros intemacionales sobre el regimen de tipo de cambio flexible, la tasa de inflaci6n en los (ittimos afios ha caldo por debajo de la inflaci6\n observada en 1996 (27.7 por ciento), alcanzando 18.6 pOr ciento en 1998. La tendencia decreciente en la tasa de inflaci6n continuar6 en 1999, ano en que se espera terminar muy cerca de la meta programada del 13%, mientras que para el anio 2000 se proyecta en 10 por ciento. 51  G.H. 1 SCRETARIA OE 4ACIENOA Y CAEOITO PJBLICO Por su parte, la cuenta corriente presento en 1998 un deficit de 3.5 pOr ciento del PIS, cifra que se estima en 2.2 por ciento para fines del aho en curso y 3.2 por ciento para el 2000. Aproximadamente tres cuartas partes del financiamiento de este deficit proviene de inversi6n extranjera directa, lo que permite mayor estabilidad a las cuentas extemas. Asimismo, con el sustancial recorte de Jos gastos piblicos en 1998, que represento el 0.7 por ciento del PIB derivado de la caida de los ingresos petroleros, se mantuvo el deficit publico en 1.25 por ciento del producto, y se espera mantenerlo por debajo de esa cifra en 1999 y cerca de 1.0 por ciento en el afio 2000. Conjuntamente con el mantenirniento de un programa economico s6lido, el Gobiemo Mexicano ha otorgado especial atenc!6n al desarrollo de los sectores sociales. En este sentido, a pesar de las restricciones presupuestales impuestas en los ujttimos anos, y auin con los ajustes importantes de gasto que se efectuaron en 1998, el Gobierno ha incrementado, como proporci6n del proclucto, el gasto publico destinado a salud, educaci6n, capacitaci6n, seguridad social, servicios basicos como aqua potable, drenaje, eiectricidad y apoyo para areas rurales. En 1998 casi 60 por ciento del gasto federal se destino a programas sociales, manteniendo esta tendencia en 1999 y se estima que continuara en el 2000. Por otra parte, se tomaron medidas para fortalecer el sistema bancario mexicano. Se creo el Instituto de Proteccion at Ahorro Bancario (IPAB) y se est6 ajustando el marco regulatorio del sistema financiero. El IPAB emiti6 regulaciones que limitan la cobertura del seguro de dep6sitos bancarios e inici6 programas para eliminar los activos improductivos y convertir los bonos vencidos en valores negociables. Como acci6n complementaria se esta fortaleciendo el regimen regulatorio de los bancos, de manera que se incluya el uso de estandares mAs en linea con los intemacionales para la definicion del capRal. Cabe sefialar que nuestro proposito es mantener la linea de la politica macroecon6mica actual, enfatizando la disciplina fiscal y la reducci6n de la inflaci6n con el fin de asegurar la estabilidad econ6mica durante la transici6n politica que experimentara nuestro pais en el aino 2000. It. Politica de Descentralizacion A partir de estos avances y con el prop6sito de consolidar las bases para alcanzar un crecimiento sostenido y distribuir responsabilidades en los distintos niveles de gobiemo, en los ultimos anos se ha llevado a cabo un amplio proceso de descentralizaci6n. Ademas del tradicional sistema de participaciones utilizado deade 1980, el Gobiemo Mexicano ha delegado a los estados la responsabilidad sobre educacion y salud asf como sus correspondientes transferencias; asimismo, se han aumentado las transferencias a loS municipios Esto ha favorecido a las entidades ya que ahora tienen la capacidad de predecir el monto de sus recursog y c6mo distnbuirlos. 2 52  SECRETARIA OE HACIENDA Y CREDITO PU8LICO Esto se logr6 mediante la adecuaci6n de la Ley de Coordinaci6n Fiscal con el fin de que los gobiernos subnacionales respondan mAs adecuadamente a las necesidades locales. Asimismo se amplih, como parte del Presupuesto Federal, el Ramo 33 (Aportaciones Federales para Entidades Federativas y Municipios), mediante el cual se han fortalecido las haciendas locales y se ha avanzado en lo establecido en el Programa para un Nuevo Federalismo, en materia de coordinaci6n hacendaria y de descentralizaci6n fiscal. Este Ramo esta conformado por siete fondos: 1, Fondo de Aportaciones pars la Educacion Basica y Normal 2. Fondo de Aportaciones para los Servicios de Salud 3. Fondo de Aportaciones para la lnfraestructura Social 3.1 Fondo de Aportaciones para la Infraestructura Social Estatal 3.2 Fondo de Aportaciones para la Infraestructura Social Municipal 4. Fondo de Aportac*ones para el Fortalecimiento Municipal 5, Fondo de Aportaciones Miltiples 5.1 Asistencia Social 5.2 Infraestructura Educativa 6. Fondo de Aportaciones para la Educaci&n Tecnol6gica y de Adultos 7. Fondo de Apartaciones para la Seguridad Publica En general, los recursos otorgados a estados y municipios se distribuyen conforme a criterios claros y transparentes, y en los casos de infraestructura social, fortalecimiento municipal y seguridad pWblica, de acuerdo a f6rmulas que consideran factores como la poblaci6n objetivo y el grado de marginaci6n. De esta frima, se asegura la transparencia en la distribuci6n y destino de los recursos, y se evita su transferencia discrecional. De esta manera se institucionaliz6 una via complementaria para el traslado del gasto federal a los gobiernos estatales y municipales, asumiendo el Gobiemo de Ia Repcablica el compromiso de fortalecer el proceso de descentralizaci6n con lo cual se avanza hacia una mejor distribuci6n de recursos y responsabilidades en los tres niveles de gobiemo. Cabe senialar que en 1994, de cada peso del Presupuesto Federal ejercido pOr la Federaci6n, 51 centavos correspondian a gasto ejercido por estados y municipios, mientras que a la fecha esa proporci6n se aproxima a I peso con 43 centavas y en el presupuesto para el pr6ximo ato se espera que aumente en seis centavos mis. Como resultado de estos esfuerzos, se ha logrado disminuir considerablemente el nuimero de Estados con deficit primario y financiero, y consecuentemente una reducci6n en el saldo de la deuda puiblica total asi como del impacto de la deuda sobre el ingreso total de los estados. Es importante destacar que en ttrrninos reales la deuda estatal total disminuy6 23.5% durante el penodo 1l994-1999, y salvo en el caso de 3 excepciones, la deuda real disminuy6 en todas las entidades. Asimismo, se increment6 el n(imero de entidades federafivas que reforn6 o actualizo el marco juridico de las finanzas pCsblicas contando la mayoria de elias con Ley de Deuda Publica, Ley de Presupuesto e informes trimestrales de flnanzas p6blicas. 3 53  Gh. SECRETARA DE HIACIENDA Y CAENTO PUBLfCO Cabe senialar que la actual Administraci6n continua trabajando, en la agenda de'la estrategia de descentralizaci6n para los pr6ximos anios con el fin de ampliar y profundizar dicho proceso. Algunas medidas solo se podrian Ilevar a cabo en el mediano plazo. por lo cual serfa facultad de la pr6xima Administracion. Las reformas que se instrumentaran en el corto plazo persiguen cuatro objetivos principales~ i) incrementar aun mas la transparencia en la asignaci6n de transferencias a estados y municipios; ii) establecer un esquema de endeudamiento subnacional que promueva el endeudamiento responsable y prudente de estados y municipios: iii) aumentar la transparencia y responsabilidad de los gobiernos subnacionales respecto a las finanzas publicas; y iv) desarrollo institucional que permita mejorar la administraci6n y coordinaci6n entre los distintos niveles de gobiemo. Transparencia en la asignaci6n de recursos. La estrategia elimina casi por completo las transferencias discrecionales con el fin de aumentar la transparencia en la asignaci6n de recursos a los gobiemos subnacionales y mantener la estabilidad fiscal a nivel federal. Como parte de este esfuerzo, se reorganizaron los recursos para cubrir gastos de emergencias en un fondo con reglas claramente establecidas para disponer de los recursos s6lo en caso de desastres naturales y evitar el flujo de transferencias discrecionales. Con esta estrategia, se incentivara a los estados y municipios a asignar el gasto publico de manera mrAs adecuada. En 1999 las transferencias discrecionales representaron menos del 0,15 por ciento del gasto total y para el aiio 2000 se espera mantenerlas por debajo de dicha cifra. Esquema de endeudamiento subnacional. Un elemento central sera la introducci6n de un esquema de endeudamiento subnacional basado en mecanismos de mercado que incentive un comportamiento prudente entre las instituciones financieras otorgantes de crddito y los gobiernos subnacionales como tomadores del mismo. El esquema de endeudamiento requerirA la calificaci6n de la deuda subnacional por parte de dos agencias calificadoras, autonzadas por las dependencias regulatorias y de supervisi6n. De acuerdo con estas calificaciones se establecerA Is tasa de capitalizaci6n ai crudito otorgado por los bancos. De esta forma se incentivari la adecuada evaluaci6n de riesgos entre proyectos y entidades federativas. y por consiguiente, Ia correspondiente diferenciaci6n del precio del credito. Del mismo modo, se promovera que la inversi6n p(iblica subnacional se destine a proyectos de alta rentabilidad economica y se identifique la fuente de pago del financiamiento. Con estos elementos se fomentari un mayor rigor en el anilisis de la situaci6n financiera de las entidades estatales y municipales, lo que a su vez propiciara la necesidad de fortalecer sus sistemas de contabilidad, presupuestaci6n y planeaci6n de inversiones. En este marco, el analisis y tratamiento de sus pasivos contingentes es un punto que merece especial atencion, por lo que el Gobiemo Federal trabaja en coordinaci6n con los gobiemos estatales con el prop6sito de identificar con mayor precisi6n la problematica que se enfrenta y, en su caso, encontrar alternativas de soluci6n. Por otra parte, se hara imperativo fortalecer la capacidad recaudatoria de los estados y municipios asi como establecer con mayor clandad sus prioridades pars la asignacion del gasto. En el mediano plazo, este nuevo esquema propiciari la profundizaci6n de los mercados de deuda subnacional creando productos financieros inexistentes actualmente. 4 54  SECAETARIA MACIENDA v GREDITO PU8LICo De manera especifica, en el marco de la reuni6n del Grupo de Trabajo de Deuda de Funcionanos Estatales realizada el pasado 11 de octubre, esta Secretaria de Hacienda y Credito Puiblico anunci6 los elementos centrales del nuevo esquema de endeudamiento: i) despues del 31 de marzo del afio 2000 la SHCP terminara la practica de aceptar mandatos para colateralizar la deuda de estados y municipios; ii) con el prop6sito de dar tiempo a los gobiernos subnacionales para adecuarse al nuevo esquema, se establece un periodo de transici6n entre el 1V de enero y el 31 de marzo del ano 2000, durante el cual solo se aoeptar6n mandatos cuando su efectividad no se extienda mas alla de este periodo de transici6n y cuando el gobierno solicitante, ya sea a su nombre o en representaci6n de un tercero. se encuentre en el proceso de obtener dos calificaciones de credito. Adicionalmente, para fines del registro de la deuda estatal, a partir del 1 de enero del ano 2000 la Secretaria de Hacienda y Crtdito Pcblico estableceri como requisitos: 1) que el gobiemo subnacional este al corriente en la publicaci6n de su informaci6n fiscal y de deuda, la cual tendra que publicarse en por lo menos un peri6dico local y uno nacional ( estar al corriente se define como la informaci6n mas reciente que se disponga, sea esta la correspondiente al primer semestre del ano calendano la correspondiente al a no calendario precedente, en el entendido de que en ningCin caso Is informaci6n debera tener un rezago de mas de seis meses Sin embargo, para el periodo entre el primero de enero y el 15 de febrero se considerari como corriente la informaci6n correspondiente al 31 de diciembre de 1998 ); y ii) que el gobiemo subnacional este al corriente en el pago del servicio de su deuda con los bancos de desarrollo. En pr6ximas reuniones del Grupo de Trabajo de Deuda de Funcionarios Estatales se afinarcn los detalles a fin de que las acciones descritas esten operando a partir de la fecha sefialada. Conforme se adecule"la regulaci6n de la banca comercial para financiamiento de estados y municipios, se ajustara la regulaci6n del Banco Nacional de Obras y Servicios Piblicos, S.N.C. (Banobras) y otros bancos de desarrollo que otorguen cr6dito a gobiemos subnacionales de forma que observen los mismos estXndares que la banca comercial respecto a limites de la exposici6n al riesgo como porcentaje del capital. En el caso de los pr6stamos que reciban un nivel de capitalizaci6n igual o mayor al 100%. a fin de que sean financiados por la banca de desarrollo sera necesario que cuenten con los componentes de desarrollo institucional que sean fondeados por organismos financieros intemacionales. Este trataniento especial es con el fin de que Banobras apoye a los estados y municipios a mejorar su capacidad crediticia. Transparencia en la informaciun de las finanzas subnacionales. Se desarrollaran diversos programas para incrementar la transparencia en asuntos fiscales subnacionales. Muchos estados y municipios han llevado a cabo mejoras en este aspecto. Sin embargo, a fin de facilitar el acceso de las entidades al financiamiento, es necesarlo contar con mns y mejor informaci6n sobre su situaci6n fiscal. En este prop6sito las nuevas normas pare el registro de deuda subnacional promoveran el mejoramiento de la informaci6n fiscal y de endeudamiento. asi como su divulgacifn. Ademas, se promovera mayor responsabilidad en el ejercicio del gasto a traves de programas presupuestales vinculados a desempeno. Este serA un proyecto de largo plazo que se iniciara con la introducci6n de programas piloto de convenios de desempeiio en el presupuesto del aiio 2000 pars los sectores ambiental y salud. 55 s  bAAt SECR&TARIA DE AlEca U* CREOITO b6IUCo Desarrollo Institucional. Se establecera un mecanismo de coordinaci6n y seguimiento de las acciones que realizan las diferentes areas de la Federacion, que al mismo tiempo disemine informacion sobre las relaciones fiscales intergubernamentales, incluyendo las responsabilidades respecto al gasto, endeudamiento y transferencias, 111. Apoyo del Banco Mundial A la fecha son significativos los avances logrados en materia de descentralizacion. No obstante, existen algunas areas en las cuales deberan redoblarse los esfuerzos a fin de fortalecer el desempeAo de las finanzas subnacionales. Con tal proposito, debera continuarse trabajando para mejorar el sistema de transferencias utilizado actusalmente, fortalecer el sistema de recaudaci6n fiscal a nivsl subnacional. asi como definir con mayor claridad las responsabilidades de los estados y, en particular, de los municipios, con respecto al ejercicio de los recursos publicos. La consolidaci6n del Federalismo es un proceso irreversible y que complementa el programa de reforrnas economicas. En este marco, la ampliacion y consolidacion del proceso de descentralizaci6n requiere de la aplicaci6n de medidas en el corto y largo plazos. En este contexto, Mexico solicita el apoyo tecnico y financiero del Banco Mundial para la realizaci6n del Programa de Fortalecimiento a Estados y Municipios con el fin de apoyar el proceso de descentralizacion aumentando la autonomia, responsabilidad y transparencia de los gobiemos subnacionales en las decisiones de asignaci6n de recursos, mejorando el desempeno de los mercados de cr6dito a nivel estatal y municipal, y reforzando la capacidad de gesti6n financiers de los recursos publicos de los gobiernos subnacionales, La asistencia del Banco Mundial contribuira a fortalecer el proceso de descentralizaci6n en Mexico. Atentar mente SUGRAGIO EFECTIVO. NO REELECCION El Secretar:o, JoS6 Angel Gurria 56  MINISTRY OF FINANCE AND PUBLIC CREDIT Mexico City, Federal District Mr. James D Wolfensohn President World Bank Washington DC, 20433 USA Dear Mr. Wolfensohn, With respect to the Decentralization Adjustment Loan to be contracted with the World Bank in support of the program now underway for strengthening states and municipalities, I would like to bring to your attention some relevant aspects of the Mexican economy and of the macroeconomic policy followed by the government of Mexico, in particular the efforts that have been and will be made to continue the decentralization process. I. Macroeconomic situation In recent years, the Mexican economy has managed to recover and consolidate the foundations for sustained development, and price stability has been restored, thanks to an economic program based on fiscal and monetary discipline, and on a sound approach to financing the current account deficit and making timely adjustments to public expenditure. Also, a program of structural reform has been carried out, which has included spinning off the airports and railways and reforming the financial and the social security systems, in particular the pension system. The effect of these efforts can be seen in the behavior of various macroeconomic variables. The country's gross domestic product recorded an annual growth rate of 5.6 percent over the period 1996-1998. For 1999, it is expected to grow at slightly more than 3 percent, despite adverse international conditions, which include a slowdown in the rate of growth of the U.S. economy, volatile oil prices and limited access to capital markets. Assuming continuation of the current administration's economic program, GDP growth should reach a level between 4 and 5 percent for the year 2000. During 1998 and 1999 the Bank of Mexico has imposed a restrictive monetary policy on several occasions, in order to counteract the inflationary effect of depreciation in the exchange rate, caused by unfavorable external events. Despite the negative effect of international financial market volatility on the flexible exchange-rate regime, the inflation rate in recent years has fallen below that recorded in 1995 (27.7 percent), dropping to 18.6 percent in 1998. This declining trend in inflation will continue in 1999: inflation is expected to end the year very close to the planned goal of 13 percent, while it is projected to fall to 10 percent for the year 2000. The current account showed a deficit of 3.5 percent of GDP in 1998, a figure that is estimated to be 2.2 percent by the end of this year and 3.2 percent for the year 2000. Approximately three- quarters of this deficit is being financed by means of foreign direct investment, which allows for greater stability in the country's external accounts. Similarly, with the substantial cutbacks in public spending in 1998, representing 0.7 percent of GDP, occasioned by the drop in oil 57  revenues, the public sector deficit was held at 1.25 percent of GDP. We expect to maintain it below that level in 1999, and to bring it near one percent in the year 2000. Together with its pursuit of a sound economic program, the Mexican government has given special attention to development needs in the social sectors. In this respect, despite the budgetary restrictions imposed in the last few years, and even with the major expenditure adjustments that were made in 1998, the government has succeeded in increasing public spending, as a proportion of GDP. on health, education, training, social security, basic services such as water supply, drainage and electricity, and support for rural areas. In 1998, nearly 60 percent of federal spending was devoted to social programs, a trend that is being maintained in 1999 and is expected to continue in the year 2000. Furthermore, measures have been taken to strengthen the Mexican banking system. The Bank Savings Protection Institute (IAB) has been created and the regulatory framework governing financial transactions is being amended. The IPAB has issued regulations limiting bank deposit insurance cover and has launched programs to eliminate nonperforming assets and to convert overdue bonds into negotiable instruments. As a complementary action, the bank regulatory system is being strengthened, including a definition of capital that is more in line with international standards. Our commitment is to maintain the current approach to macroeconomic policy, emphasizing fiscal discipline and inflation reduction, in order to ensure economic stability during the political transition that will take place in our country in the year 2000. II. Decentralization policy On the basis of this progress, and for the purpose of consolidating the foundation for achieving sustained growth and redistributing responsibilities among the various levels of government, a broad process of decentralization has been launched in recent years. In addition to the traditional revenue-sharing system in place since 1990, the Mexican government has delegated responsibility to the states for education and health, and has accompanied this with the corresponding fiscal transfers; it has also increased transfers to the municipalities. As a result, these entities are now in a position to forecast the amount of their revenues and to plan their distribution. This was achieved by amending the Fiscal Coordination Law so that subnational governments could respond more appropriately to local needs. Furthermore, as part of the Federal Budget, Section 33 (Federal Contributions to States and Municipalities) has been expanded, with the result that greater resources have been transferred to the states and municipalities, thereby increasing the discretion of local government over the allocation of expenditure. 58  This Section consists of the following seven funds: 1. Basic and normal education fund. 2. Health services fund 3. Social infrastructure fund 3.1 State social infrastructure fund 3.2 Municipal social infrastructure fund 4. Municipal strengthening fund 5. Multi-use fund 5.1 Social assistance 5.2 Educational infrastructure 6. Technological and adult education fund 7. Public safety fund The resources provided to states and municipalities are now distributed according to an established formula that takes into account such factors as population and levels of poverty. In this way, transparency in the distribution of funding is assured, and the element of discretion over such transfers is eliminated. This approach has provided a complementary means for transferring federal expenditure to the state municipal governments, under which the federal government has assumed a commitment to strengthen the decentralization process, and to move towards a better distribution of resources and responsibilities among the three levels of government. It should be noted that in 1994, for every peso spent by the federal government under its budget, 51 centavos were spent at the state level, while today the latter proportion has increased to one peso and 48 centavos. As a result of these efforts, there has been a considerable reduction in the number of states with primary and financial deficits, and a consequent reduction in the total public debt and in the impact of that debt on total state finances. It is important to mention that total state debt declined 23.5 percent in real terms during the period 1994-99, and except in three cases the real debt declined for all of the states. Also, a growing number of states have reformed or updated the legal framework of their public finances, and most of them have adopted a public debt law, a budget law, and quarterly reporting on the status of public finances. It should be noted that the current administration is working, with assistance from the World Bank, on a strategic agenda of decentralization for the coming years, in order to broaden and deepen this process. Some of the measures included in the agenda can only be carried out over the medium term, which means that the strategy will have to be pursued by the incoming administration. The reforms to be undertaken in the short term involve four major objectives: (i) further improving transparency in the allocation of transfers to the states and municipalities; (ii) establishing a framework for subnational borrowing that will encourage a responsible and prudent approach to debt on the part of the states and municipalities; (iii) increasing the transparency and accountability of subnational governments with respect to their public finances; and (iv) institutional development to improve administration and coordination between the different levels of government. 59  Transparency in the allocation of resources. The strategy puts a virtual end to discretionary transfers, in order to increase transparency in the allocation of resources to subnational governments and to maintain fiscal stability at the federal level. As part of this effort, funding for emergency expenditures has been reorganized into a fund with clearly established rules that will make resources available only in the case of natural disasters, thereby avoiding discretionary transfers. With this strategy, the states and municipalities will have an incentive to allocate public spending more appropriately. In 1999 discretionary transfers represented less than 0.15 percent of total expenditure, and for the year 2000 they are expected to be below that figure. Subnational borrowingframework A key element will be to introduce a framework for subnational borrowing based on market mechanisms that will provide an incentive to prudent behavior, both by financial institutions in terms of their lending and by subnational governments in terms of their borrowing. The framework calls for the debt issued by subnational governments to be classified by two credit rating agencies that are authorized by the regulatory and supervisory authorities. These ratings will be used to establish the capitalization rate for the loans granted by the banks. This move will serve to promote proper risk assessment of projects and states, and will lead to a corresponding differentiation in the pricing of credit. Similarly, it will encourage subnational governments to direct public investment into projects with a high economic return, and to identify clearly the source of repayment for such financing. These elements will lend greater rigor to analysis of the financial situation of state and municipal entities, which in turn will pose: the need to strengthen their accounting, budgeting and investment planning systems. Moreover, it will be essential to strengthen the revenue-generating capacity of states and municipalities, and to establish clear priorities for expenditure allocation. Over the medium term, this new scheme will promote a deepening of the market for subnational debt and will generate financial products that do not exist today. To be specific, in the context of the meeting of the Debt Working Group of the State Functionaries on last October 11, the Ministry of Finance and Public Credit (SHCP) announced the central elements of the new framnework for borrowing: i) after 31 March 2000 the Ministry will end the practice of accepting niandatos to collateralize the debt of states and municipalities; ii) in order to give the subnational governments time to become accustomed to the new framework there will be a period of transition between 1 January and 31 March 2000 during which mandatos will only be accepted if their effectiveness does not extend beyond this transition period and if the soliciting government, whether in its own name or that of a third party, is active in the process of obtaining two credit ratings. Furthermore, after 1 January 2000, new state debt will have to meet two requirements in order to be registered at the Ministry of Finance and Public Credit: i) that the subnational government is current in the publication of its fiscal and debt information, which it will have to published in at least one local periodical and' one national (to be current is defined as with a delay of no more that one semester after the close of a, semester; for the period of 1 January to 15 February 2000, however, information will be considered current if it corresponds to 31 December 1998); and ii) 60  that the subnational government is current in its payment of debt service to the development banks. In the next meetings of the Debt Working Group of the State Functionaries the details will be finalized so that the actions described will be operating by the dates indicated. At the same time as banking regulations for financing states and municipalities are being adjusted, amendments will be made to the rules governing the National Bank for Public Works and Services (BANOBRAS) and other development banks that provide credit to subnational governments, to ensure that they observe the same standards as those that apply to commercial banks with respect to provisioning and to limits on risk exposure as a percentage of capital. In the case of loans that receive a capital risk weighting equal to or greater than 100 percent, in order for them to be financed by the development bank it will be necessary that they include components for institutional development that are funded by international financial agencies. The purpose of this special treatment is for Banobras to assist the states and municipalities in improving their creditworthiness. Transparency in financial information at the subnational level. Programs will be undertaken to increase fiscal transparency at the subnational level. Many states and municipalities have already made improvements in this respect. Nevertheless, greater efforts are needed to increase access to financing for these entities: the new rules for recording debt and publishing information on the fiscal and debt situation will help in this regard, by increasing the degree of accountability and transparency. In addition, steps will be taken to encourage greater accountability on the spending side, through budgetary programs that are linked to performance. This will be a long-term undertaking and will be initiated by introducing a pilot program of performance agreements for the budget year 2000, in the areas of environment and health. Institutional development. A mechanism will be established to coordinate and monitor efforts at the various levels of the Federation, while at the same time disseminating information on intergovernmental fiscal relations, including responsibilities with respect to expenditure, indebtedness and transfers. III. World Bank support Significant progress has already been achieved in the decentralization program. Nonetheless, there are several areas where efforts need to be strengthened further in order to improve the performance of public finances at the subnational level. To this end, measures are required to improve the current system of transfers, strengthen revenue collection at the subnational level, and define more clearly the responsibilities of the states and, in particular, of the municipalities, with respect to the control and use of public resources. Consolidating federalism is an irreversible process and one that is directly complementary to the economic reform program. In this context, expanding and consolidating the decentralization process will require both short-term and long-term measures. 61  I  MAP SECTION  I  IBRD 23547 'ION, - - F5uEO8Q L9, "sS7ESOF XX ~~~M E X I C O 4s' m? 95Ono >62/ r--- i30 f _ t C 1J \ e e '+ ">& / ti!>' o ,,,, ,,I . ,, or towns~~~~~~~~~~~~~~~~~~~~~10 sot.~apto ,AiA d Ok,, I- 0 A H --- -N ivAP AT -~~~~~~~~~~~~~~~~~~~ -~~~~~~~~~~~ --D~~~~~~~~~~~~~isided highways CA lIfORNIA & ~ 5n4 Selected min rOads - ifn Arztf< j-. Railroads