Mexico - Second Industrial Equipment Fund (FONEI) Project

Document of FILE COPY The World Bank FOR OFFICIAL USE ONLY CIRCULATING COPY TO BE RETURNED TO REPORTS DESK ReportNo. P-1749-ME REPORT AND RECOMMENDATION OF THE PRESIDENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO NACIONAL FINANCIERA, S. A. WITH THE GUARANTEE OF THE UNITED MEXICAN STATES FOR A SECOND INDUSTRIAL EQUIPMENT FUND (FONEI) PROJECT January 21, 1976 This document has a restricted distribution and may be used by recipients only In the performance of their officlal duties. Its contents may not otherwlse be disclosed without World Bank authoriation.  Currron Unit - Peso (Meg) US$1.00 a Mox$12.50 Me4$.00 - US$ 0.08 Nea$t million - US$80,000 Fiscal Year - January 1 to Decmber 31  FOR OFFICIAL USE ONLY INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVEIWPMENT REPORT AND RECOMMENDATION OF THE PRESIDENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO NACIONAL FINANCIERA, S. A. WITI THE GUARANTEE OF THE UNITED MEXICAN STATES FOR A SECOND INDUSTRIAL EQUIPIfNT FUND (FONEI) FROJECT 1. I submit the following report and recommendation on a proposed loan to Nacional Financiera, S. A. with the guarantee of the United Mexican States for the equivalent of US$50 million, to finance the foreign exchange component of the lending operations of the Industrial EAuipment Fund (FONEI)..over the coming two years- The loan would have a term of 16 years, including three 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 Mexicos A Basic Report" (192-ME), distributed to the Executive Directors on June 26, t973s short-run trends in 1973-75 were covered in "Mlexico: Current Economic Position and Prospecta", distributed on September 27, i974. 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 Me dcan 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 oid-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 dDllar value of the peso was maintained at the level fixed in 1954. 11. 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 eooi2omic 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 emphasis of public and private investaent was reflected in changes in the structure of output and employment and particularly in the expansion of manufacturing industry. Agriculture, This document has .a restricted distribution and may be used by recipients only in the perlormance ot their oficial duties. Its contents may not otherwise be disclosed without World Bank authorization.  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 1960's - and, until fairly recently an emphasis on import substitution in industry, have prevented an adequate absorption of the labor force in productive eamployment. 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 Mexico's 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 manufacturing exports on a large scale - the system of drawbacks on domestic taxes paid on exports and the "border industries" 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 raral poor, and has launched a number of ambitious initiatives in this direction.  - 3 - 8. The attempts which have been made by the present adcinistration (1970-76) to alleviate the poverty of the countrysiLde and to redress some of the imbalances between rural and urban Mexico have several dimensions. They include a revised Agrarian Reform Law (i971) 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 fooderops. 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 signLificant 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 rurail 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 progran which has been financed with a five 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 managment. 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 extem al 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 eapansion of real credit was used to finance part of this deficit while net external borrowing of US$102 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). II. 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 -Ates had been reestablished by the end of the year. Credit was not hcodever 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, moreover, 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 Goverment'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 refonus, 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 GPD, the public sector deficit is expected to be equivalent to 7.8 percent of GDP, quasi-money growth is ps'ected 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 exected 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 oxpenditures0 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 GD?, which represents an important achievement in resource mobilization. The relatively high rate cf expected inflation and the relatively modest level of projected growth oi qursi-money are closely inter-related, although the growth of quasi- maney is aiso 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 ecuilibrium. 14. On December 31, 1974, Mexico's 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. 150 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 197L. 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 tc 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. Mexico's debt service ratio was 20.5 percent in 1974; 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  payments, credit and fiscal policies and, above all, maintains a favorable climate for export expansion; its recent statements concerning economic policies for 1976 suggest it intends to do so and it is our intention to continue to monitor developments in close contact with the Authorities. 17. In order to meet its financing needs to assure continued growth with equity in the future, Mexico will have to strengthen its fiscal effort and supplement that effort with substantial external borrowing. Given that the countryls diversified industrial structure is capable of supplying a good part of its capital goods requirements, some local cost financing by external agencies is necessary. Bank loans in such sectors as power, transport and industry are traditionally tied to the foreign exchange cost of projects. Some local currency financing is Justified in other sectors with characteristically low foreign exchange requirements, especially for high priority and institutionally complex projects like agricultural development in which there are substantial economic and social benefits and which call for strong institutional support by the Bank. PART II - BANK GROUP OPERATIONS IN MEICO Bank Operations 180 Including the recently signed loan for a water supply and sewerage project, the Bank had made 42 loans to Mexico for a total of US$237.7 mil14on net of cancellations; of these, 25 loans, totalling US$1,239.9 million, were fully dtsbursed as of November 30, 1975. During FY66-70 disbursements averaged some US$70 m4ition per year, increasing to about US$123 mllion per year over the period FY71-75- Some 35 percent of Bank lending to Mexico has been for agriculture and rural development (13 loans for close to US$781 dl.lion), 32 percent for power (11 loans for some US$71 5 mllion), and 20 percent for transportation projects (11 loans for US$448 million); the remaining 13 percent of Bank lending has been for industry and water supply. The execution of Bank financed projects has, on the whole, been satisfactory0 A mnmber of problems relating to financial management of the power, railways and ports sectors, on which I reported to you in earlier Presidentts Reports, have now largely been resolved. Annex II contains a suimary statement of Bank loans as of November 30, 1975, and notes on the execution of ongoing projects. IFC Operations 190 As of November 30,, 1975, IFn had made 13 investent comitnents in Mexico, for a total of US$6909 zillion, of which US$36.4 million had been solds repaid or cancelled0 The balance held by the Corporation, US$33.5 million, consist of US$27.8 million in loans and US$5.7 million in equity. A suwmary statement of IwC investments as of November 30, 1975 is presented in Annex 11.  -7- Bank Strateas 20. The main objectives of Bank lending in Mexico have been to: (i) support policies and programs leading to a wider distribution of the benefits of economic growth; (ii) strengthen policies and programs leading to continued economic growth, by helping to finance projects that would, directly or indirectly, make significant contributions to output and employment and by supporting institutional changes that would contribute to more effective management of key sectors of the economy; (iii) help resolve critical adjustment problems induced by Mexico's continued economic growth; and (iv) complement Mexico's domestic savings by helping to finance economic and social investments in a framework of internal and external financial stability. In the light of Mexico's short- and medium- term prospects, we intend, during this and the next fiscal years, to pay special attention to projects that would: (i) make relatively limited demands on the Government's budget; (ii) help generate public enterprise revenues and savings; and (iii) have a positive impact on the balance of payments, either in the form of additional exports or efficient import substitutions, where Bank participation can play a catalytic function. 21. Bank lending to Mexico has evolved over the last few years to the goals outlined above, as manifested in its sectoral mix and policy emphasis. A Bank loan of US$70 million, made for the Las Truchas ateel mill in FY74, for instance, was designed to further the country's industrial growth as well as to support the Government's policy of industrial decentralization. Likewise, a fertilizer project, for which the Bank made a loan of US$50 million in Fr75, was intended to enable Mexico to become independent of imported urea fertilizer in the medium term and to provide support to the fostering of new poles of development in the resource-rich southeast region and north central area. 22. The Bank has, however, put special emphasis on agriculture by making it the leading sector of its lending. Our lending is aimed at strengthening and expanding irrigation and agricultural credit programs to meet the denands of the rapidly growing population and generate foreign exchange earnings, raising the standard of living amd incomes of the rural poor through a combination of dlrectly productive, social infrastructure and productive support investments, strengthening Mexico's institutional capability to use agricultural resources and inputs more efficiently, Specifically, the Rio Bravo/Rio San Juan irrigation project, for which a US$150 million loan was approved in FYr5, will help bring agricultural production back in line with domestic and foreign demand and benefit directly more than 100,000 people through intensive agriculture and livestock operations on more than a quarter of a million hectares, thereby quadrupling the incomes of small-scale farmers in the area.  The Papaloapan and the second integrated rural development projects, approved in FY75 for US$50 million and US$110 million loans respectively, are designed to improve the living conditions and productivity of close to 1.5 million people. Another rural development project, an agricultural project and two irrigation projects are now being prepared for possible Bank financing. In addition, we are exploring the possibilities for a lagoon fisheries project and a tropical agricultural research and development project which would lay the foundation for the future development of hitherto untapped and sizable resources. 23. As to infrastructure, the Bank's focus has been on the provision of needed investments in key areas of the country, and the premotion and implementation of institutional reforms and sector policies, including the establishment of suitable pricing mo anisms to mobilize resources to help finance investments. The Mexico CGty water supply project, where a loan of US$90 million was made in FY73, was instrumental in the establishment of a specialized institution for the efficient management of water resources in the Mexico Valley, cutting across existing functional and administrative boundaries, and in the pricing of water to levels more closely related to costs. An airports development project, approved in FY74 for a loan of US$25 million, is supporting the Government's policy of regional integration. Similar aims have been sought through projects in the railways, ports, roads and electric power sectors. Further projects are being prepared in all these areas, and will be presented in due course. 24. The proposed project fits the objectives of Bank operations in Mexico. Through it, additional resources will be channeled to a sector in which investment must expand rapidly. Through the project, institutional improvements among participating intermediaries are sought, and the Government will be supported in its efforts to strengthen its industrial sector policies to exploit fully the opportunities to export. The proposed loan will be the second to Mexico in FY76. In addition to this loan, we plan to present to the Executive Directors for consideration during the current fiscal year loans for the railways and an agricultural credit program. PART III - THE INIUSTRIAL SECTCR 25. Over the last 30 years, Mexico has cone to place a heavy reliance on industrial expansion to achieve its economic growth targets. The thrust of Goverment industrial policies has been to pronote employment opportunities to absorb surplus labor, increase foreign exchange earnings thzough a rapid expansion of manufactured exports, strengthen intra- and  inter-industry linkages to improve their competitiveness, and intensify efforts at a wider regional dispersion of industrial investment. Since 1971, the Goverruent has introduced policies which farther emphasize investments in export-oriented projects and the estsblishment of a geographically balanced industrial structure. 26. M1nuf acturing industry represents today one of the most dynamics sectors of the Mexican economy, accounting for 28 percent of GDP (as compared with 19 percent in i940), absorbing nearly a fourth of gross domestic investment and proviiding employment for 23 percent of the total labor force. Both domestic and export market demands have contributed to the relatively rapid growth of manufactured output with the most important product groups in recent years, in terxs of annual rates of growth of output, being textiles and wearing apparel, engineering goods, metals and metal products, chemical and petrochemioal products. The growth of output in the last three of these product groups points to a changing structure of the sector, from consumer goods to capital and intermediate goods. Nevertheless, measured in terms of the value of output in 1974, consumer goods industries - led by processed food products - still dominate the sector with an estimated share of about 57% of manufacturing value added. 27. Although initially Mexican industry grew up under substantial protection, the growth of manufactured output from the mid sixties onwards has been aocompanied by rapidly increasing industrial exports. These exports, which stood at about US$200 million in 1965, rose to some US$1,300 million in 1974 (excluding exports of assembly industries along the U.S.-M4exican border), accounting for nearly 46 percent of total merchandise exports. Most notable gains in manufactured exports between i970-73 have occurred in the categories of textiles, apparel and footwear followed by non-traditional items, such as machinery, electronics and automotive parts which, in part, reflect the growing integration that has developed between Mexican parts suppliers and the U.S. industry and the success of the export promotion policies instituted since 1971. Industrial and Trade Policies 28. Its growing export orientation notwithstanding, manufacturing in Mexico is geared primarily to producing for the domestic market; less than 4 percent of the manufactured output in 1974 was exported. This is attributable to an industrialization strategy, which. has placed much emphasis on import substitution, resulting in a domestic market protected by both direct import.controls and tariffs. Increased impetus to manufactured exports came in 1971 at a time when export growth as a whole was sluggish and there was a mounting pressure on the balance of payments, threatening to slow down the pace of economic growth. Consequently,  - 10 - special legislation was introduced to permit duty free temporary imports of equipment and materials for export-oriented assenbly plants in the free zone and border areas (maquila industries). Since October 1972, firms in the interior of the country, outside the central zones, are also eligible for maquila status. Thus, by the end of 1973, 5