Mexico - Water Supply and Sewerage Project

CIRCULATING COPY FILE COPY' BE RETURNED TO REPORTS DESK DOCUMENT OF INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT Not For Public Use Report No. P-1727-ME REPORT AND RECOMMENDATION OF THE PRESIDENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO BANCO NACIONAL DE OBRAS Y SERVICIOS PUBLICOS, S. A. WITH THE GUARANTEE OF THE UNITED MEXICAN STATES FOR A MEDIUM SIZE CITIES WATER SUPPLY AND SEWERAGE PROJECT December 4, 1975 This report was prepared for official use only by the Bank Group. It may not be published, quoted or cited without Bank Group authorization. The Bank Group does not accept responsibility for the accuracy or completeness of the report.  Currency Unit - Peso (Me4) US$1.00 . Me'c$12.50 Mex$1.00 - Us$ 0.08 Mex$1 million - US$80,000 Fiscal Year - January 1 to December 31  INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT REPORT AND RECOMMENDATION OF THE PRESIDENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO BANCO NACIONAL DE OBRAS Y SERVICIOS PUBLICOS, S.A. WITH THE GUARANTEE OF THE UNITED MEXICAN STATES FOR A MEDIUM SIZE CITIES WATER SUPPLY AND SEIERAGE PROJECT 1. I submit the following report and recommendation on a proposed loan to Banco Nacional de Obras y Servicios Publicos, S.A. (BNOSP) with the guarantee of the United Mexican States for the equivalent of US$40 million, to help finance a medium size cities water supply and sewerage project. The loan would have a term of 20 years, including four years of grace, with interest at 8-1/2 percent per annum. PART I - THE ECONOMY 2. Some of the major structural features of the Mexican economy - past,present and future - were analyzed in "The Economy of Mexico: A Basic Report" (192-ME), distributed to the Executive Directors on June 26, 1973; short-run trends in 1973-75 were covered in "Mexico: Current Economic Position and Prospects"., distributed on September 27, 1974. Another updating report on the economy is now being prepared by a mission which visited Mexico in July this year. Country data sheets are contained in Annex I. 3. For the three most recent decades, the Mexican economic system measured in terms of GDP growth, has been outstandingly successful. Since 1940, the annual average growth rate has exceeded 6 percent. And from the mid-1950's to 1972, Mexico was among the few countries in the developing world to combine sustained and rapid growth with monetary and balance of payments stability. Inflation averaged less than 5 percent a year and the dollar value of the peso was maintained at the level fixed in 1954. 4. Rapid and sustained growth was the product of successful policies affecting the mobilization and use of both private and public sector resources. The role of Government in promoting economic growth was expressed on the one hand in the development of strategic infrastructure and major utility industries and, on the other, in policies which featured price support, import control and agrarian reform measures in the agricultural sector and external protection and the provision of fiscal incentives in the industrial sector. 5. The sectoral emphasi of public and private investment was reflected in changes in the structure of output and employment an6 particularly in the expansion of manufacturing industry. Agricultur-e,  nevertheless, continued to be the chief source of livelihood for much of the population and in 1970 accounted for almost 40 percent of total employment. 6. In spite of rapid and sustained economic growth over this long period, the combination of a high demographic growth rate - rising to about 3.4 percent per year in the 1960s - and, until fairly recently an emphasis on import substitution in inaustry, have prevented an adequate absorption of the labor force in productive employment. Industrial growth has been quite rapid - about 8 percent annually since the mid- fifties - but could have been even faster if industrial and trade policies had been primarily focused on exploiting Mexicots unique export opportunities based on its contiguity to a large industrial market in which labor costs are much higher than those in Mexico. It was only in the early seventies that some important steps were taken to develop manufacturingexports on a large scale - the system of drawbacks on domestic taxes paid on exports and the "border industriest" regime were introduced at that time, and these have been so highly successful as to suggest that a lot more could still be done. As it is, 40 percent of the labor force is estimated to be still engaged in marginal occupations - relatively unproductive and hence poorly paid - or to be openly unemployed. 7. The Mexican strategy for development has, in the past, relied on a combination of public action and private profit. The Government has played a highly important role in this process, both in promoting key industries, such as power and petroleum, and in creating a regulatory and institutional framework within which private and social groups could compete and contend, but which was both firm enough and flexible enough to ensure overall continuity and stability. As a formula for growth, this system has served Mexico well; it has however also led to a sharpening of contrasts in income and wealth between people and among regions. This was not entirely an incidental by-product of the process of growth; the share of the Government in the economy was kept down quite deliberately for many years, and the scope of redistributive policies was necessarily limited as long as the tax ratios remained under ten percent - among the lowest in the world. The Government played a crucial role in the development of private commercial agriculture through irrigation and credit policies and of industry through the provision of infrastructure, education, social legislation and financial policies, but it did not concern itself primarily with the problems of the poorest sections of the population. While the process of land reform based on the 1915 legislation was sustained, the absence of abundant fiscal resources made it impossible to develop major programs to improve the economic status of its beneficiaries. The present Government, however, came to power on a program of combining past growth policies with much greater efforts in favor of the rural poor, and has launched a number of ambitious initiatives in this direction.  - 3 - 8. The attempts which have been maae by the present administration (1970-76) to alleviate the poverty of the countryside and to redress some of the imbalances between rural and urban Mexico have several dimensions. They include a revised Agrarian Reform Law (1971) and a new Federal Water Law (1972), both of which are intended to promote a more equitable distribution of basic agricultural resources. These measures have been complemented by changes in the sectoral allocation of agricultural credit in order to increase the share of low-income farmers and ejidatarios (members of ejidos. which are a form of collective land tenure based on usufruct), and the introduction of higher support prices for basic foodcrops. The Government has also increased outlays for agricultural research, training and extension services, with particular regard to the needs of peasant farmers. Perhaps the most significant innovation has been a new program for integrated rural development with which the World Bank has been associated from an early stage. 9. The social and economic needs of the rural sector have not monopolized government attention; those of urban-industrial development have also been stressed in the form of heavy public investment in basic industries - delayed during the 1960's - and an innovative low-income housing program which has been financed with a f4ve percent payroll tax. Productive investment has thus been complemented, in the urban as well as the rural economy, by institutional changes and public expenditures designed to improve the living conditions of the poor. This parallel effort has, however, generated several problems of short-run economic management. 10. In 1971, after monetary and balance of payments pressures had emerged during the previous year, the (then new) Government took stringent action to control demand with the effect that the GDP growth rate fell to 3.7 percent by comparison with a decade average of 7.1 percent in the 1960's. In 1972, renewed expansion was stimulated by public expenditure and the GDP growth rate rose to 7.4 percent. There was another year of rapid growth (7.6 percent) in 1973 - but this time associated with an increase of 21 percent in the GDP deflator which was strongly associated with the impact of external inflation. Inflation was not the only novelty; private domestic financial savings, which in the past had helped finance sustained growth increased by only 11 percent, compared with an average annual rate of increase of 18 percent in 1965-71; the inflow of private capital was replaced by a net outflow; and private investment - particularly in the industrial sector - slackened, reflecting some uncertainty on the part of the business community and a declining interest rate differential vis-a-vis those prevailing on financial savings instruments in the United States. In the public sector, the fiscal deficit amounted to 5.6 percent of GDP by comparison with an average of 2.7 percent in 1965-71. A major share of the limited expansion of real credit was used to finance part of this deficit while net external borrowing of US$1.2 billion (2.4 percent of GDP) was deployed to finance the rest. These trends were inevitably reflected in the balance of payments, where the current account deficit rose to 3 percent of GDP (by comparison with an average of 2.0 percent in 1965-71).  - 4 - 11. Noting these trends, the authorities had, by mid-1973, adopted a restrictive monetary and credit policy and complemented this with what was originally intended to be an austere public finance program for FY74. Taken together, these measures were expected to restrict demand and to reduce both inflation and the size of the current account deficit in the balance of payments. The results for the year indicate that whereas the former objective was achieved, the latter was not. Monetary and credit policies were, on the whole, carried out as planned; the rate of increase of prices decelerated from April onwards, and a positive differential between Mexican and foreign interest rates had been re- established by the end of the year. Credit was not however allocated as originally intended because the public sector again pre-empted a large part of the available expansion. Higher than planned public expenditures and lower than expected revenues meant, moreoverp that the fiscal deficit was larger than foreseen as were the growth rates of aggregate demand and of real imports. The deficit in the balance of payments on current account thus amounted to 4.2 percent of GDP rather than the intended 2.8 percent. Net public external borrowing of more than one year rose to US$2.4 billion. 12. During 1975, the Government's original objective was to achieve sustained economic growth under what were expected to be adverse conditions associated with the world recession. The public finance program called for an increase in public expenditures, which was to be partly financed with a substantial increase in public revenues based on tax reforms, and it was expected that the public sector deficit could be reduced to 4.3 percent of GDP by comparison with 5.6 percent in 1974. Given this, and assuming only a moderate growth of imports in real terms, a decline in the resource gap and in the current account deficit in the balance of payments were anticipated. With a modest level of public internal borrowing and an expected recovery in quasi-money deposits the intention was to maintain a restrictive monetary policy while allowing a modest increase in real private credit and on this basis to achieve a substantial reduction in inflation. 13. In the light of provisional results for the first half of 1975, and likely trends for the remainder of the year, it is now clear that the objectives of this program will not be fully realized. The real GDP growth rate is expected to be of the order of 4.0 percent, the current account deficit in the balance of payments is projected at the equivalent of 4.9 percent of GDP, the public sector deficit is expected to be equivalent to 7,8 percent of GDP, quasi-money growth is projected at 11 percent over the year, and the annual rate of inflation is expected to be approximately 18 percent. In accounting for these trends, it is clear that the growth of the public sector deficit is a significant factor. It is also clear however that the world recession has had a much greater than expected impact on the economy and has moreover been one of the factors that has led to the growth of the public deficit because the Government has attempted to counteract the slowdown in economic growth with increased  public expenditures. The increase in public sector revenues has been somewhat smaller than expected but will nevertheless amount to an increase of about 1.8 percentage points of GDP, which represents an important achievement in resource mobilization. The relatively high rate of expected inflation and the relatively modest level of projected growth of quasi-money are closely inter-related, although the growth of quasi- money is also associated with a narrowing differential in the second half of the year between Mexican and foreign interest rates. The discrepancy between the original targets of the 1975 economic program and its likely outcome is expected to have a constraining influence on economic management in 1976 and it is expected that the authorities will make a major effort to control public expenditures and to limit the size of next year's public deficit. It is also expected that money, credit and balance of payments policies will be designed to reduce this resource gap. In recent discussions with Bank staff, the authorities have stressed their determination to take whatever action may be necessary to reduce inflation, and to restore financial and balance of payments equilibrium. 1X. On December 31, 197L, Mexicots outstanding and disbursed public debt of more than one year was US$7.5 billion. Net medium- and long- term public borrowing in 1974 of US$2.2 billion reflected heavy reliance on external as well as internal capital to finance the fiscal deficit and some borrowing - as in 1973 - to offset private capital movements. 15. During 1975, it is expected that net public external borrowing of more than one year will be of the order of US$2.8 billion, which will amount to 3.1 percent of estimated GDP compared with 2.7 percent in 1974. Both in 1974 and 1975 a very large proportion of new borrowing has been in the form of financial credits. Mexico's level of indebtedness is consistent with the country's projected capacity to service interest and amortization payments given the expected growth of real exports in the medium term. The behavior of petroleum exports is an important element in these projections. After allowing for the growth of domestic consumption, the rate of growth of crude output and the export surplus will continue to rise through 1980 by which time net exports of crude and petroleum products are conservatively projected at US$1,000 million. YMexico's debt service ratio was 20.5 percent in 197L; the estimate for 1975 is 24.5 percent. The debt service ratio will probably be higher than this in the remainder of the 1970's and early 80's but can be expected to decline to about the present level by the mid-80's. The actual level of debt service payments will, of course, depend on the management of the balance of payments. The Bank's share of the public debt outstanding and disbursed at the end of 1974 was approximately 12.9 percent and its share in debt service payments was about 8.5 percent. These shares are expected to fall during the remainder of this decade. 16. Mexico is creditworthy for borrowing on conventional terms provided the Government exercises due restraint in monetary, balance of  pqae;iS, Credi.t acd a,