Mexico - Small and Medium Scale Industry Development Project

Document of The World Bank FOR OFFICIAL USE ONLY Report No. 181lb-ME FILE COpy MEXICO STAFF APPRAISAL REPORT SMALL AND MEDIUM SCALE INDUSTRY DEVELOPMENT PROJECT April 3, 1978 Projects Department Latin America and Caribbean Regional Office This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  MEXICO SMALL AND MEDIUM SCALE INDUSTRY DEVELOPMENT PROJECT CURRENCY EQUIVALENTS Currency Unit Peso (Mex$) US$1 Mex$22.70 1/ Mex$1.0 = US$0.044 Mex$l million = US$44,052 GLOSSARY OF ABBREVIATIONS ACF - Index of Average Cost of Funds to Financieras CANACINTRA - Camara Nacional de la Industria de Transformacion CENAPRO - Centro Nacional de Productividad CEPSE - Centro Empresarial de Perfeccionamiento Socio-Economico, A.C. CONACYT - Consejo Nacional de Ciencia y Tecnologia CONCAMIN - Confederacion de Camaras Industriales FIDEIN - Fideicomiso de Conjuntos, Parques y Ciudades Industriales y Centros Comerciales FIRA - Fideicomisos Instituidos con Relacion Agricultura FOGAIN - Fondo de Garantia y Fomento a la Industria Mediana y Pequena FOMIN - Fondo Nacional de Fomento Industrial FONATUR - Fondo Nacional de Turismo FONEI - Fondo de Equipamiento Industrial FONEP - Fondo Nacional de Estudios de Preinversion IMCE - Instituto Mexicano de Comercio Exterior IMIT - Instituto Mexicano de Investigaciones Tecnologicas INFONAVIT - Instituto de Fomento Nacional de Vivienda para los Trabajadores INFOTEC - Servicio de Informacion Tecnologica NAFINSA - Nacional Financiera, S.A. Program - Integrated Small and Medium Scale Industry Program SAHOP - Secretaria de Asentamiento Humano y Obras Publicas SMI - Stiall and Medium Scale Industry 1/ The exchange rate was US$1 = Mex$12.5 until August 31, 1976. The peso is now floating. The exchange rate for US$1 in recent months has been fluctuating between Mex$22.65 and 22.75.  FOR OFFICIAL USE ONLY MEXICO SMALL AND MEDIUM SCALE INDUSTRY DEVELOPMENT PROJECT Table of Contents Page No. I. SMALL AND MEDIUM SCALE INDUSTRY IN MEXICO The Economic and Industrial Setting .. ........... .. I Small and Medium Scale Industry 2 Industrial Policies . 4 Financing SMI ooo... o..o.. -o...7 Interest Rates and Inflation . 8 Technical Assistance ........ . ........ 9 The New Integrated Program to Support SMI Develop- ment .10 II. THE CREDIT AND GUARANTEES SUBPROGRAM Objectives ...12 Institutional Background . 12 Organization, Management and Staffing of FOGAIN 13 FOGAIN's Past Operations ... 14 FOGAIN's Past Financial Performance . 15 Interest Rates and Onlending Terms .16 Operational and Financial Projections and Resource Requirements.. .-.o. ... 17 Project Evaluation and Follow-Up 17 Procurement and Disbursement Procedures 19 Accounting Procedures and Auditing Arrangements 20 The Credit Guarantee Scheme 20 III. THE RISK CAPITAL SUBPROGRAM ....21 Objectives - .. . . ... 21 Role, Management and Organization of FOMIN 21 FOMIN's Past Operations .. .... ....22 Investment Policies and Procedures of FOMIN 24 Operational and Financial Projections and Resource Needs ..28 This report is based on the findings of an appraisal mission that visited Mexico between July 24 and August 24, 1977. The mission comprised Messrs. Cook, Challa and Hutcheson (LCPID) and Mr. Goderez (IDFD). 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.  TABLE OF CONTENTS (Continued) Page No. IV. THE INDUSTRIAL ESTATES SUBPROGRAM .................. 29 Objectives ............. ............................ 29 Institutional Background ..... ...................... 29 Process of Creating and Operating Industrial Estates ............ .........................*.. 30 Organization and Staffing of FIDEIN and the Fideicomisos ................................................... 31 Operating and Financial Performance to Date ........ 32 Evaluation of the Industrial Estates Development ... 32 Description of the Subprogram ................... ... 33 Execution Schedule and Cost Estimates .............. 34 Financing Arrangements ............................. 34 Financial Projections .................... .......... 36 Organizational and Other Requirements .............. 36 V. OVERALL PROGRAM IMPLEMENTATION AND THE TECHNICAL ASSISTANCE SUBPROGRAM .............................. 37 The Coordinating Committee and Secretariat .... ..... 37 Industrial Extension Agents ..... ................... 39 Cooperation with Specialized Technical Assistance Institutions . .................................... 40 Financing of Preinvestment Studies and Technical Assistance ... ................ .................... 42 Resource Allocation ...... .................. ... ....... 42 VI. THE OVERALL PROGRAM AND THE PROPOSED BANK LOAN The Size of the Program and of the Bank Loan ....... 42 Disbursement Mechanism ............................. 44 Description of the Loan Components .............. ... 45 Channelling of the Bank Loan ....................... 46 Repayment Terms of the Bank Loan .. ................. 47 Free Limits ....... ................................... 47 Disbursement, Procurement and Auditing ............. 48 Project Benefits and Risks ......................... 49 VII. RECOMMENDATIONS ....... ...................... 50 ANNEXES Annex I Estimated Quarterly Disbursement Schedule Annex 2 The ACF Index Annex 3 Supporting Tables and Charts  TABLE OF CONTENTS (Continued) TABLES T-1: Indicators of Resource Mobilization and Credit Availability from the Mexican Banking System T-2: Analysis of Total Credit Authorizations by FOGAIN during 1967/77 T-3: Analysis of Fixed Asset Credits (Refacionarios) authorized by FOGAIN T-4: Total Approvals, Disbursements and Repayments of FOGAIN's Credits T-5: Past and Projected Balance Sheets of FOGAIN T-6: Past and Projected Income Statements of FOGAIN T-7: Analysis of FOGAIN's Guarantee Operations, 1971-76 T-8: Summary of FOMIN's Investments, Cumulative up to December 31, 1976 T-9: Sectoral Distribution of Firms Supervised by FOMIN's Portfolio Control Department as of December 31, 1976 T-10: Status of Firms in FOMIN's Portfolio T-11: FOMIN's Audited Income Statement for 1976 T-12: FOMIN's Balance Sheet as at December 31, 1976 T-13: Equity Contributions needed to Support FOMIN's Expected Level of Investments, 1978-82 T-14: FOMIN's Sources and Applications of Funds T-15: FOMIN's Projected Income Statements and Balance Sheets T-16: Operating Results on the Industrial Estates (As of June 1977) T-17: Summary Balance Sheets for FIDEIN and the Fideicomisos Especiales as of December 31, 1976 T-18: Execution Schedule of the Industrial Estates Subprogram T-19: Capital Cost Estimate of the Industrial Estates Subprogram T-20: Cash Flow Projections for Lease and Sale of Factory Buildings T-21: Computation of the Foreign Exchange Cost Content of Program Financing T-22: Locations of NAFINSA's Regional Offices and FOGAIN's Field Representatives CHARTS C-1: Organization Chart of FOGAIN C-2: Organization Chart of FOMIN C-3: Organization Chart of FIDEIN C-4: Map of Mexico Annex 4 Supporting Documents and Data Available in Project File   I - SMALL AND MEDIUM SCALE INDUSTRY IN MEXICO The Economic and Industrial Setting 1.01 For two decades up till 1974 Mexico enjoyed sustained high economic growth with GDP growing by almost 7% annually. For most of this period the balance of payments was in equilibrium and inflation averaged less than 5% per year, allowing a stable exchange rate of 12.5 pesos to the US dollar. Industry was one of the most dynamic sectors of the economy, with manufactur- ing output growing by 9% p.a. in the 1960s and about 7% p.a. in the early 1970s. By 1974 manufacturing industry accounted for 23% of GDP, gave employ- ment directly to about 17% of the total labor force, 1/ and supplied 43% of merchandise exports. This performance has been facilitated by an active entrepreneurial class, the relatively large and rapidly growing domestic market, proximity to the high income US market and favorable government policies. 1.02 In 1974 and 1975 the economy was increasingly affected by rising domestic inflation, the effects of the oil price rise and the deepening recession in world trade. The GDP growth rate fell to 4.2% in 1975. Measures adopted to control inflation, and reduce balance of payments and fiscal defi- cits led to a further slowdown of GDP growth to 2.0% in 1976. Although the trade balance improved somewhat in 1976, continuing high inflation (averaging 16.5% in 1975 and 22% in 1976) forced the abandonment of the fixed parity in September 1976, since when the floating peso has decreased in value by approxi- mately 45% in US dollar terms. Growth in manufacturing output declined to 4.7% in 1975 and 2.6% in 1976 as industry was increasingly affected by the slow growth of the domestic market, the growing overvaluation of the peso and the uncertainties caused by the eventual devaluation. 1.03 The rapid rate of population growth (averaging 3.3% p.a.) and con- tinuing migration to the major cities have given rise to higher levels of urban unemployment and underemployment in the last few years as the rates of economic growth and industrial expansion have declined. Open unemploy- ment, which was estimated at 4% in the 1970 census, has risen and, based on surveys in the 3 largest cities, stood at around 6% in mid-1976. Contribu- ting to the unemployment problem was the decline in the rate of growth of industrial employment from 3.4% in 1965-70 to under 2% in 1970-75. An even more serious problem is underemployment, reflected in more than 40% of workers being engaged in part time or low productivity jobs in which they earn Less than the minimum daily wage. Rising underemployment and unemploy- ment have resulted in a progressive decline in the real incomes of the poorest sections of the population since 1974. 1.04 Faced with a very difficult economic situation, the new Government that took office in December 1976 moved rapidly to introduce measures designed to stabilize the economy, stimulate more rapid economic growth, restore investor confidence and increase employment. The strategies it has adopted 1/ These figures are taken from the Industrial Census of 1960 and 1975. They exclude petroleum refining, basic petrochemicals and extraction of minerals. The Population Census uses a broader definition of manufacturing and therefore indicates a higher contribution of the sector to total employment.  - 2 - of controlling the fiscal deficit, raising interest rates to stimulate private savings, encouraging new investments and maintaining a realistic exchange rate have begun to bear fruit in a number of areas. Both the balance of payments deficit and inflation are declining. Resource mobilization by the banking system is improving and the substantial capital flight that took place at the time of devaluation has now stopped allowing credit to the private sector to be increased. In agreements signed with groups of industrial enter- prises early in 1977, the authorities undertook to assist the private sector in carrying out long-term investment plans aimed at increasing production in various fields, and reassured it of the Government's commitment to create an environment favorable to the development of private initiative, comple- mented by public enterprise. As part of the Alliance for Production, agree- ments between the public and private sectors have been reached to promote investments totalling over US$4.4 billion equivalent in priority projects in industry, agriculture and tourism. Tax remissions equivalent to 10 percent of the value of investments are also being considered in an effort to quicken the pace of investment. The decline in industrial output has apparently bottomed out with production increases recorded in the second and third quarters. Particularly encouraging was the increase of 21% in manufactured exports in the first quarter of 1977 over the first quarter of 1976. 1.05 Given a continuation of appropriate policies, prospects are good for a progressive acceleration of economic growth. The Government's targets to get the economy back to a high growth path by 1979 and to reduce inflation to international levels in the next 2-3 years appear feasible based on the progress achieved during 1977. Rapidly rising petroleum output and exports are already having an important influence in strengthening the balance of payments and stimulating the economy. Industry can play a leading role in achieving these targets provided that sufficient funds are available to finance the necessary investments in productive capacity. Small and Medium Scale Industry 1.06 According to the 1975 Industrial Census Mexican manufacturing industry comprised some 120,000 enterprises, approximately the same number shown in the 1970 census. The detailed results of the 1975 census have not yet been published and thus the following analysis of the structure of industry by size of firm has been based primarily on the 1970 figures. Analysis of Manufacturing Enterprises According to Employment (1970) (Mex$ millions) Number of No. of Total Capital Gross Value Total No. Paid Employees Firms Invested Production Added of Employees None 57,568 742 1,631 674 91,963 1 - 5 39,222 2,181 4,995 2,069 107,016 6 - 10 708 2,208 3,578 1,514 58,450 11 - 25 6,485 6,759 10,434 3,961 106,739 26 - 50 3,532 9,604 13,811 5,123 126,643 50 - 100 2,492 16,725 22,683 8,345 176,829 100 - 250 1,796 30,935 41,838 15,995 283,163 More than 250 1,065 87,263 113,435 44,700 630,444 Total 119,963 156,416 212,404 82,383 1,581,247  1.07 The above table shows that there are some 58,000 firms with no paid employees, which rely on family labor. These firms, which contribute less than 1% of mantfacturing value added, and have invested capital equivalent to less than US$1,000 per firm, have traditionally been regarded as artisan enterprises and not part of the organized industrial sector. If small and medium sized industrial firms (SMI) are defined as those with I to 250 paid employees, then SMI accounted for some 61,000 firms which provided 45% of 1970 gross manufacturing output and 54% of employment in manufacturing. The 1065 large industrial firms contribute 54% of manufacturing output but only 40% of employment. 1.08 Further analysis of the census data classifying firms with 1-25 employees as small and those with 26-250 workers as medium sized indicates a number of differences between small and medium sized firms. The small firms on average have only 4 or 5 employees compared with 75 in the medium sized firms. The latter, although they represent only 10% of SMI firms, contribute nearly 80% of value added and output by SMI firms and 60% of employment, and are, therefore, a very important part of SMI. Both small and medium sized enterprises are quite labor intensive. Converted to 1977 prices and then to US dollars, the revalued assets per employee of the average small firm would be US$8,000, and that of medium sized firms, US$14,000. These figures indicate a relatively high labor intensity of the production processes of SMI. In nearly all industrial subsectors small enterprises predominate by number of firms, and in subsectors producing items of mass consumption (i.e. food products, garments, furniture and wood products, leather goods, etc.), small firms play a very prominent role. Over 75% of small firms and 60% of medium sized ones are located outside Mexico City, Monterrey and Guadalajara, the three largest metro- politan areas. 1.09 Taking into account differences in capital intensity, the majority of small and medium sized enterprises operate quite efficiently and compete effectively with large firms. 1/ On average they appear reasonably profit- able, reporting earnings of 10% on sales and 18% on equity capital in 1974. Nevertheless, in common with enterprises of a similar size in other countries, many SMI enterprises have deficiencies in accounting, administration, produc- tion or marketing which stem from this small size and lack of specialization of their management. They also encounter greater difficulties in securing adequate financing from commercial sources and suffer from a tendency of industrial policies to favor the larger enterprises. These problems tend to restrict the growth of SMI firms and are particularly serious for the smaller firms, more than 90% of which are organized as sole proprietorship family businesses or partnerships. 1.10 In view of their important role in manufacturing, their relative labor intensiveness and their predominance outside the three big cities, SMI can clearly make a major contribution to achieving national goals for employ- ment creation and regional development. Furthermore, SMI enterprises provide the seed bed for the development of entrepreneurial talent and for upgrading 1/ If a 10% cost of capital is assumed, then value added per unit of labor cost plus capital cost is approximately the same for SMI firms as for large firms.  - 4 - the skills of the labor force and, by their linkages with large industry and agriculture, they can help stimulate growth in other sectors of the economy. Since they also produce a large precentage of mass consumption goods, increasing their output and improving their productivity would also contribute to future price stabilization. Industrial Policies 1.11 A detailed review of Mexico's industrial policies is contained in the report of an industrial sector mission that visited Mexico in late 1976 (Report No. 1671-ME) 1/ The new administration is currently in the process of reassessing industrial policy and has already taken actions in several policy areas that are in line with the recommendations of the report. The areas of particular relevance to SMI are summarized below. 1.12 Protection. Until 1970, Mexico's industrialization strategy gave primary emphasis to import substitution, and protection for local manufac- turing remains a major feature of industrial policy. A system of import licensing has been used to restrict progressively the importation of manu- factured goods once domestic production becomes feasible. The proportion of imported items subject to licensing rose from about one third in 1950 to about four fifths in 1976. Tariffs have generally played a secondary role in protection, and, while a few import classifications have been subject to tariffs as high as 100%, most tariffs have been in the range of 10-30%. In addition, numerous tariff exemptions have been allowed, particularly in the case of public sector imports. Overall, protection for domestic production has not been excessive and its effects have been mitigated by internal competition and the difficulty of avoiding smuggling if differentials between domestic and international prices become too great. The protection policy was quite successful in inducing indus- trialization in Mexico and by 1970 imports contributed only 10% of the total supply of manufactured goods. Nevertheless, it has resulted in higher domestic prices for locally manufactured products and intermediate goods, which were about 15-20% above international levels in 1975. Price and exchange rate movements since the 1976 devaluation indicate that average industrial prices are now close to international levels. 1.13 The system of protection has generally had more influence on the output prices of larger firms, since the smaller ones are subject to much greater competition in the domestic market. On the other hand, the appli- cation of the quantitative restrictions on imports has tended to create difficulties for the smaller enterprises in securing an adequate and timely supply of reasonable quality production inputs. These problems also affect larger enterprises, but are more acute for the smaller firms which have weak purchasing power, limited resources to finance high inventories and more difficult access and less leverage when applying for import licenses. The Government's time-phased plan to substantially reduce the proportion of products subject to import licensing and to rely mainly on moderate tariff protection in future should benefit most SMI firms. As a first step in the implementation of this plan several product classes were freed from import license requirements during the course of 1977. 1/ Report entitled MEXICO - Manufacturing Sector: Situation, Prospects and Policies, dated May 1, 1977.  - 5 - 1.14 Export promotion. Since 1970 increased emphasis has been given to promoting manufactured exports. Responding to the introduction of export incentives in 1971, comprising rebates of indirect taxes, duty exemptions on imports and increased credit at concessionary terms for financing export production and sales, manufactured exports grew at 38.7% annually between 1970 and 1974 compared to 11.9% p.a. in the previous five years. Excluding exports by border assembly industries (maquiladoras), manufactured exports reached US$1,240 million in 1974. More favorable treatment granted after 1971 to export-oriented assembly plants in the free zone and border areas also stimulated a rapid growth in their exports from US$215 million in 1970 to US$1,030 million in 1974. In 1975 and 1976 the world recession and increasingly overvalued peso led to a significant decline in manufactured exports measured in constant prices, but since the devaluation in late 1976 and the economic recovery that is now starting, manufacturing export performance should improve noticeably. MEXICO: Manufactured Exports 1971-1977 /1 (in millions of 1970 US$) 1971 1972 1973 1974 1975 1976 1977 (6 months) GeneraLl Manufactures 454.2 574.9 837.9 1242.9 1069.3 1191.1 675.2 Assembly Plants /2 270.0 426.2 651.2 1032.9 1020.6 1168.1 553.5 Total 724.2 1001.1 1489.1 2275.8 2089.9 2359.2 1228.7 /1 Eixcludes primary non-ferrous metals, petroleum and sugar. /2 EBstimated value of total production. 1.15 While many SMI firms produce goods that are potentially competitive interrnationally, comparatively few are exporting. The bulk of exports come from the large firms, although in some sectors such as food, apparel and foot- wear, a significant proportion of exports do come from medium sized firms. SMI enterprises find it difficult to get adequate information regarding demand, prices, quality and style requirements in external markets and to make appro- priate contacts with foreign buyers. In addition the smaller enterprises often do not: produce in sufficient quantities to interest prospective buyers and lack confidence in their own ability to operate successfully in the more exacting world of export markets. To help overcome these problems, increased attention is beiing given to strengthening the role of industry associations and trading companies in intermediating between SMI enterprises and their potential export markets, and to the development of large scale commercial centers in the northern border areas. In addition, Instituto Mexicano de Comercio Exterior (IMCE) is giving increased attention to the information and technical assist- ance needs of small exporters. 1.16 Employment and wage policies also put SMI firms at a relative dis- advantage. Because SMI is generally much more labor intensive than large industry, labor costs and employment regulations have a much more important  influence on their production costs. However, there is a tendency for employment and wage policies to reflect the situation and payment capacity of large firms because of the latter's greater visibility and the greater strength of the unions representing their workers. Average real wages in manufacturing grew by about 4.2% per year between 1960 and 1976. The real minimum wage grew slightly faster at 4.9% yearly. Since SMI have a higher proportion of unskilled workers receiving the minimum wage, the effects of these trends were more serious for SMI than for large firms. In addition, the larger firms were better able to absorb these increases in wage costs by improving labor productivity through increased automation. For many SMI enterprises increases in social and other non-wage benefits for workers, which now add about 50% to direct labor costs, have also had a significant impact on production costs. Other aspects of labor legislation such as job security, severence pay and minimum hours of work further reduce the flexi- bility of SMI firms. The combination of these factors has tended to make SMI firms cautious about expanding their labor force to take advantage of market opportunities, and encourages them to switch to more capital- intensive methods as they expand. Furthermore, a number of small firms do not appear to be complying fully with minimum wage and other labor legislation and are, therefore, inhibited from applying for financial or technical assistance from public institutions. Some measures to reduce the impact of the above factors on SMI growth are currently under review, including the possible transfer of responsibility for paying some non-wage benefits from individual companies to general fiscal revenues. In addition, the authorities are considering measures to restore a more appropriate balance in the relative prices of labor and capital, which in the past have been biased in favor of capital as a result of duty exemptions on imported machinery and equipment and other investment incentives, and an overvalued exchange rate. 1.17 Industrial decentralization and regional development. In recent years the Mexican Government has become increasingly concerned about the rapid growth and heavy concentration of population, industry and income in the three largest urban centers of Mexico City, Monterrey and Guadalajara. At its current rate of growth the population of Mexico City would reach 35 million by the year 2000 but the cost of providing municipal services, particularly water, are already posing severe problems. In 1970-72 incentives were introduced for decentralizing industry. For this purpose the country was divided into three zones: Zone 1 comprising the three big cities; Zone 2 the areas adjacent to the big cities plus Puebla, Cuernavaca, Toluca and Queretaro; and Zone 3 the rest of the country. 1.18 In addition to the differentiation of minimum wages by region and reinforcement of the successful border assembly industry program already in force, fiscal incentives were introduced for firms locating in Zones 2 and 3 comprising reductions of 50-100% in income taxes, sales taxes, import duties on equipment and raw materials and other miscellaneous exemptions. Fideicomiso de Conjuntos, Parques y Ciudades Industriales y Centros Comerciales (FIDEIN) was established in 1970 to plan and implement a program of new indus- trial parks and industrial cities (large estate developments with residential and commercial zones) at selected locations in Zones 2 and 3 to assist in the decentralization process. 1.19 Despite the high level of these decentralizaton incentives, their impact has been rather disappointing to dates, particularly in terms of employ- ment generation. SMI does not seem to have been strongly influenced by the  incentives or to have derived much advantage from them. The fiscal incentives are mostly subsidies to capital and these favor the larger, more capital- intensive firms. About 16% of SMI firms have received some benefits from these incentives, but it is doubtful whether many SMI enterprises based their locational decisions on the availability of the incentives or whether the incentives significantly influenced their creation or viability. FIDEIN has sold lots on its estates to a significant number of SMI enterprises, but comparatively few medium sized firms and fewer small firms have so far been able to obtain the needed financing for factory construction. The decentrali- zation program may also have suffered from a dilution of efforts and resources caused by trying to do too much too quickly in too many different locations. The program is currently under review and is expected to focus more clearly in future on slowing down the growth of the Mexico City area and encouraging development in a restricted number of regional locations that have the potential to become alternative growth poles. In addition, increased atten- tion is being given to improving access to financial and technical assistance to firms located in the provinces via the proposed project. Financing SMI 1.20 Mexico's well developed banking system, comprising more than 200 public, private and mixed ownership institutions, has been the primary source of outside financing for industry as a whole, including SMI. Commercial banks and investment banks (financieras) make industrial loans and investments primarily from resources they mobilize via current and savings accounts, deposits and the issue of certificates and bonds, but they also have access to discounting facilities 1/ with public sector trust funds administered mainly by the Banco de Mexico (the Central Bank) and Nacional Financiera (NAFINSA), the main public sector development bank serving industry. Fondo de Garantia y Fomento a la Industria Mediana y Pequena (FOGAIN) is the most important trust fund discounting bank loans to SMI. During the late 1960s and early 1970s the banking system developed rapidly with the volume of outstanding credit growing faster than GDP and average term of credit lengthening. Mexico's open financial system allowed free flow of capital into and out of the country, and the long period of exchange rate stability encouraged US deposits in Mexican banks and foreign borrowings by Mexican firms. Generally credit was readily obtainable by industrial firms that were judged to be a reasonable credit risk by virtue of their size, reputation or the collateral they could offer. Nevertheless the smaller firms had some difficulty in securing credit because of banks' conservative attitude to risk and high collateral require- ments, frequently exceeding 200% of the loan amount. 1.21 Since 1973 accelerating inflation and tighter monetary control have slowed down the growth of the financial system and reduced credit availability. By 1974 access to credit had become a serious problem for SMI, with about 30% of firms having to supplement bank credit or substi- tute for it by borrowing from money lenders and other unofficial sources. 1/ Strictly speaking, intermediaries do not discount loans with these trust funds since they continue to bear the full credit risk. However, they can obtain resources from these trust funds to enable them to finance up to 100% of a loan provided that the lending terms and conditions and the nature of the project to be financed meet the requirements of the trust fund.  -8- The recent major peso devaluation has accentuated this trend. Not only are companies' needs for working capital much greater, but there has been a substantial decline in the volume of resources mobilized by the banking system in relation to the GDP (see Annex 3, T-1). In addition, large companies which previously relied on foreign loans have now switched to domestic borrowing, further accentuating the problems of SMI. While the policy of the new administration to allow interest rates to rise (see para. 1.24) has resulted in better resources mobilization by the banks, industrial credit seems likely to remain in very short supply for the next 2 to 3 years. In these circumstances SMI enterprises are finding it very difficult to gain access to term financing from banks unless the latter can discount the loan with FOGAIN, which is now experiencing resource constraints. 1.22 The stock market is not well developed in Mexico and has not been a very important mechanism for industrial companies to raise equity finance or sell long term bonds to the public. Comparatively few, mostly large, companies are listed and most trading is in relatively short term instruments (6-month to 2-year certificates) issued by financial institutions. The avail- ability of high yielding and highly liquid debt instruments offering, until recently, real returns to savers reduced their interest in long term risk investments. While large companies have circumvented this problem in part by developing interlocking relationships with investment banks, SMI firms find it very difficult to raise risk capital from new investors and have to rely mainly on reinvested profits and new subscriptions by existing shareholders. Recognizing these problems, the Government created Fondo Nacional de Fomento Industrial (FOMIN) in 1972 to help in the creation and expansion of SMI firms by investing, on a temporary basis, up to one third of the equity capital required. In its four years of operation to date FOMIN has had rather limited resources and had to develop its own expertise in this rather difficult investment field. It has so far had a useful, but relatively minor, impact on SMI's equity financing problems. 1.23 Other trust funds. Three other trust funds, which are designed to serve industry as a whole, also provide some financing to SMI for specialized purposes. Fondo de Equipamiento Industrial (FONEI), a Banco de Mexico fund, provides financing for export projects and new import substitution projects. I/ Its clients are comparatively large, but about 40% of its financing has gone to medium sized firms. Fondo para el Fomento de Exportaciones de Productos Manufacturados (FOMEX), also a Banco de Mexico fund, provides short term financing for export production and sales. Fondo Nacional de Estudios de Preinversion (FONEP), which is administered by NAFINSA, finances feasibility studies for new industrial projects. To date these funds have not had a very significant impact on meeting the broad financial needs of SMI. Interest Rates and Inflation 1.24 Following the stabilization measures introduced by the new admin- istration, inflation has been declining steadily from the 33% annual rate experienced in the first three months of 1977, averaging 21% for 1977 as a whole. It is projected to progressively decline to international levels over the next 3 years. To boost peso denominated savings and reverse 1/ FONEI received two World Bank loans in 1972 and 1975 totalling US$85 million.  - 9 - capital flight, in May 1977 investment bank and mortgage banks were authorized to offer higher maximum interest rates on time deposits ranging from 7% on short term deposits to 18.5% on 2-year certificates of deposit. 1/ Should inflation not decline as rapidly as expected, further adjustments may be made to the maximum permitted rates. On the lending side, banks and financieras have been switching progressively to a system of floating interest rates on medium and long term loans to reflect their increased uncertainties about their future cost of funds, which have relatively short average maturities, and to avoid a situation in which companies are inhibited from investing through fear of being locked in to high interest rates when inflation declines. Most banks are now relating their interest rates to the index of the average cost of borrowed funds to financieras (ACF) which is published monthly by the Banco de Mexico (see Annex 2). 1.25 Between May 1977 and February 1978, this index has increased from 11.9% to 14.7%. Banks are currently charging their clients margins of 3-7 points higher than this index (i.e. interest rates of 18-22% at present). The margins are expected to be reduced somewhat in the coming year once the banks overcome the problem of funding low fixed interest loans made in previous years. Onlending rates of government trust funds, which have usually been set a few points below commercial rates, are also under review. For example, FONEI now applies fully floating interest rates, and FONATUR 2/ is planning to do so shortly. For loans they finance through these trust funds, intermediary banks pay a rate approximately equal to the ACF index and relend to their clients at a rate I to 3 points higher. In connection with the proposed Bank projec:t, FOGAIN is proposing to adopt a system whereby its interest rates would be adjusted periodically to keep in line with general trends in interest rates (see para. 2.12). Technical Assistance 1.26 SMI enterprises in Mexico tend to suffer from a wide range of managerial and technical problems apart from limited access to finance. Indeed, it is often these other problems that give rise to the need for external financing, while reducing the firm's creditworthiness in the eyes of a prospective financing source. These problems tend to be associated with enterprise size and the background of the entrepreneur and are not fundamentally different from those facing SMI in other industrialized and semi-industrialized countries. They may include (1) inadequate financial management and accounting; (2) lack of control of product quality; (3) dif- ficulty in keeping up with technological developments; (4) limited knowledge of how to tackle new markets and exports; and (5) management weaknesses in purchasing, inventory control, production, labor management, etc. 1.27 There are large numbers of agencies, institutions, trade associations and public as well as priviate consultancies in Mexico offering a wide range of technical assistance services to industry, usually of a rather limited and 1/ After withholding taxes, time deposits yield effective rates of 5-16%. 2/ Fondo Nacional de Turismo (FONATUR) finances tourism infrastructure and hotel construction.  - 10 - specialized type. There is no institution offering a comprehensive service to SMI, but five important institutions offer services that are relevant to SMI's needs. These are Consejo Nacional de Ciencia y Tecnologia (CONACYT), Instituto Mexicano de Investigaciones Tecnologicas (IMIT), Centro Nacional de Productividad (CENAPRO), Instituto Mexicano de Comercio Exterior (IMCE), and Servicio de Informacion Tecnologica (INFOTEC). 1.28 CONACYT has the primary task of formulating and coordinating national policies for science and technology. Since 1974 it has started to establish some regional advisory centers for industry on production and technology matters at locations where there are concentrations of particular types of industrial activity. It also created a technical information and advisory service for industry, which has now been made a separate agency under the name of INFOTEC. IMIT carries out research and development work to help improve products and production processes, and also helps its clients to formulate and evaluate industrial investment projects. CENAPRO was estab- lished in the early 1960s, mainly to provide management training courses. Since then it has spread its activities to include training programs for management personnel of all levels, and vocational training courses for technicians and skilled workers in diverse areas. IMCE is a large, well- staffed institution that was created to stimulate exports by providing inform- ation and advice to exporters and by organizing trade fairs and promotions. Recently IMCE has been focussing more attention on the problems of small exporters, and is providing courses on exporting and helping SMI firms design their products for export requirements and exhibit them at trade fairs. 1.29 Despite the existence of these and other institutions, at present comparatively few SMI enterprises appear to be receiving the assistance they need, and this is particularly true of the small enterprises. Many small enterprises are unaware of their managerial and technical shortcomings, and receive little outside assistance in diagnosing them. Moreover, the small entrepreneur is often unaware of what sources of assistance are available and, in any case, has no readily available funds or sources of credit to finance such assistance. Existing technical assistance institutions direct their attention more to the larger companies and the content and cost of their services is often inappropriate to the small enterprises. Furthermore, most of these institutions concentrate their activities in the three largest cities, and are not known to, or easily accessible by SMI enterprises in the provinces. A survey by Nacional Financiera indicated that 48% of SMI firms questioned had received no technical assistance from any source. Of those that had received assistance, 60% had received aid on production matters mainly from equipment suppliers, 35% had received some assistance in training their work force and only 10% had received assistance in marketing matters. The proportion receiving assistance in general management and financial matters was negligible. The New Integrated Program to Support SMI Development 1.30 Recognizing the economic importance of promoting growth of SMI firms, the scarcity of financing they are currently experiencing, and the deficiencies in the present system of institutional support for SMI, NAFINSA, which has a close administrative or other relationship with the more important  - 11 - SMI: institutions, has designed and is now preparing to implement, with support from the proposed Bank loan, a comprehensive 'Integrated Program' 1/ of financial and technical assistance for SMI. The Program would make fulT use of the extensive institutional framework that already exists in Mexico, and would have the following main objectives: (a) to foster more rapid growth in output and employment by encouraging and helping to finance additional private sector investments in new SMI enterprises or expansions of existing SMI enterprises; (b) to promote and facilitate the achievement of national plans for industrial decentralization and regional development by making financial and technical assistance more readily avail- able to firms located or wishing to locate outside the main metropolitan areas; (c) to create a more comprehensive and effective system of support for SMI by coordinating more closely the activities of existing financing and technical assistance institutions, improving access of small firms to these institutions, and expanding the volume and range of services they provide; and (d) to help in developing a mechanism to (i) ensure that the special problems and needs of SMI enterprises are adequately taken into account in formulating national industrial policies and programs and (ii) better orient the institutional support to SMI towards the achievement of national industrial develop- ment goals. 1.31 This Program, which would be administered by NAFINSA, would comprise four major components or 'Subprograms': credit and guarantees to be provided by FOGAIN via commercial banks; risk capital to be provided by FOMIN; financing for facilities on industrial parks and equipment leasing provided by FIDEIN; and technical assistance to be provided mainly by extension agents recruited and trained by NAFINSA and by specialized institutions such as CENAPRO, INFOTEC and IMIT. The Program would aim to assist SMI enterprises as presently defined by FOGAIN, i.e. those enterprises having equity capital between Mex$25,000 and Mex$35 million. 2/ Special features would be incorporated to increase support for 'small' enterprises defined as SMI firms with equity capital below Mex$3.5 million. 1.32 The Program would be implemented in several stages. During the first stage, of about 3 years, it would have an experimentai character because of the need to (i) test out and perfect several new approaches to assisting SMI; (ii) implement operational improvements in several of the participating 1/ Henceforth referred to as the 'Program'. 2/ This definition of SMI corresponds approximately to enterprises having between 1 and 250 paid workers. Artisan enterprises having equity capital below Mex$25,000 would not be financed under the Program since their needs are quite different and alternative institutional arrange- ments outside NAFINSA are used to support them.  - 12 - institutions; and (iii) develop and staff a suitable organizational framework for carrying out the rather complex project. Resources channeled to partici- pating institutions in this stage would enable them to expand and diversify their activities. In later stages the scope of the Program would be broadened, building on the experience of the first, and may include additional institu- tions and the provision of additional services. The remainder of this report describes the first stage of the Program, which is intended to be financed by the proposed Bank loan. II. THE CREDIT AND GUARANTEE SUBPROGRAM Objectives 2.01 This subprogram would aim at increasing the amount of credit made available by the banking system to SMI subprojects in accordance with the objectives of the Program (para. 1.30). It would be implemented by FOGAIN, which would use Program resources of about Mex$1,240 million (in constant 1977 pesos) for discounting loans made by intermediaries to finance fixed asset expansions by SMI firms that (a) involve new productive capacity or expansions of existing capacity; or (b) represent a relocation in accordance with national decentralization policies. In general, firms selected for assistance in this subprogram will be those requiring, or likely to require, integrated support from more than one of the various mechanisms to be made available under the overall Program (i.e., credit plus risk capital, facilities on industrial parks, credit guarantees or technical assistance). To increase the interest of commercial banks and other intermediaries in lending to small enterprises this subprogram would also include the improvement and extension of FOGAIN's credit guarantee scheme involving an initial capital outlay of about Mex$10 million (constant 1977 pesos). Institutional Background 2.02 FOGAIN, the oldest and best known of Mexico's institutions support- ing SMI, was established in 1954 as a government trust fund administered by Nacional Financiera. It can rediscount up to 100% of credits granted to SMI enterprises by financial intermediaries, mainly commercial banks and finan- cieras but also including credit unions established by groups of smaller enterprises. Enterprises with equity capital between Mex$25,000 and Mex$35 maillion 1/ are eligible for FOGAIN discounts. To support its operations FOGAIN receives government equity contributions and loans from Banco de Mexico, and is also authorized to contract loans (via NAFINSA) from other domestic or foreign sources. 2.03 FOGAIN's operating regulations authorize it to finance SMI enter- prises in three ways. First, it can discount loans (normally of up to 10 years' maturity) made by intermediaries to SMI for working capital (up to Mex$3.5 million per enterprise), fixed assets (up to Mex$4.5 million) and debt restructuring (up to Mex$7.0 million) provided that total financing of all 1/ In practice FOGAIN uses a maximum limit of Mex$30 million for its credits, except in special cases such as export-oriented projects.  - 13 - three types to a single enterprise does not exceed Mex$10.0 million. Second, it can provide partial credit guarantees to banks on SMI loans, but due to various restrictive conditions and lack of active promotion of this facility, FOGAIN has made few guarantees in the past. The revised guarantee scheme to be established under the Program is designed to remedy this situation (see para. 2.25). Finally, FOGAIN can subscribe to bonds issued by SMI enterprises through intermediaries; this facility too has practically never been used by FOGAIN, due to the lack of interest among the intermediaries in bonds of SMI enterprises involving only a general security on the total assets of the enterprises (rather than specific collaterals), absence of a potential market for such bonds and the higher interest rates to the final borrower they are likely to involve. FOGAIN's operating regulations also specify that its total liabilities including guarantees and other contingent liabilities cannot exceed 10 times its equity. Organization, Management and Staffing of FOGAIN 2.04 The governing body of FOGAIN is its Technical Committee, composed of representatives from the Ministry of Finance, the Ministry of National Patrimony and Industrial Development, Confederacion de Camaras Industriales (CONCAMIN) 1/, NAFINSA, Banco de Mexico, FOMIN, Camara Nacional de la Industria de Transformacion (CANACINTRA), 2/ and Centro Nacional de Productividad (CENAPRO). The representative of the Ministry of Finance usually acts as the Chairman of the Technical Committee. The Committee, which takes a very active interest in directing FOGAIN's activities, meets about twice a month to make decisions on FOGAIN's policies, procedures, financial plans and budgets, and to approve discounting and other operations larger than Mex$2 million, based on recom- mendations from FOGAIN's staff. FOGAIN's Director is authorized by the Technical Committee to approve discounting operations of up to Mex$2 million (accounting for about 70% of FOGAIN's total credits). 2.05 An indicative organization chart of FOGAIN is shown in Annex 3, C-1. FOGAIN's staff of about 100 (including about 40 professionals) is mostly based at its head office in Mexico City, but includes regional representatives stationed are each at 11 of NAFINSA's 15 regional offices (see Annex 3, T-22). FOGAIN's Director, Mr. Sabas Francia Garcia, has had more than 20 years' experience with FOGAIN, and is well known to most SMI institutions and banks in Mexico. FOGAIN's staff is generally well qualified and has the required experience; however, there are gaps in the middle management level which appear to be preventing the utilization of the staff's full potential. For instance, the positions of the managers of the Department of Credit and the Department of Administration are vacant, and at present the heads of each individual section under these departments report directly to the Director. The hierarchical organizational relationships are not very clearly defined leading to an overly centralized management structure. 1/ Confederation of chambers of commerce representing industry as a whole. 2/ Chamber of commerce representing SMI.  - 14 - 2.06 FOGAIN has already developed outline plans to strengthen its internal organization, but has been hindered from finalizing and implemen- ting these plans by budget and other factors. To enable FOGAIN to cope with the increased volume and scope of operations implied in the implementa- tion of the Credit and Guarantees Subprogram, some strengthening of FOGAIN's management structure and increases in its staffing, will be needed. During loan negotiations FOGAIN confirmed that it would engage suitable consultants to review its future organizational and staffing needs and to take appropriate action based on their recommendations. FOGAIN's Past Operations 2.07 Since 1954, FOGAIN assisted more than 12,000 SMI enterprises through nearly 24,000 loans totalling Mex$9 billion in nominal terms. During 1961-71 FOGAIN's level of operations became relatively static at about 750 loans per year. From 1972 on, operations began to increase rapidly as FOGAIN became more promotional and liquidity became an increasingly important constraint to direct lending by banks. FOGAIN's loan portfolio has grown at an annual rate of 33% over the last 4 years (in nominal terms), to reach a substantial level of Mex$2.2 billion (about US$100 million equivalent) by June 30, 1977, distributed among about 6,100 credits and operated through nearly 140 intermediaries. 1/ 2.08 Annex 3, T-2 analyzes the credit authorized by FOGAIN during the last year, according to the size of credit, size of enterprise supported, location, type of financing and type of activity. More than three quarters of the number of credits and about 40% of the total amount of credit authorized by FOGAIN last year went to "small" enterprises (enterprises with equity capital of up to Mex$3.5 million). Loans of less than Mex$2.0 million accounted for the great majority (about 85%) of the total number of credits. More than half of the credit was for projects in Zones 2 and 3 (that is, outside the three major metropolitan areas of Mexico City, Guadalajara, and Monterrey); about 40% of the credit was to support acquisition of fixed assets. The activities most often supported by FOGAIN's financing were metal working and fabrication, and manufacture of food, clothes, footwear and furniture. A similar analysis of all the fixed asset loans provided through FOGAIN over the last four years indicates a generally parallel pattern (see Annex 3, T-3). Maturities on FOGAIN's financing have generally varied from I to 3 years in the case of working capital loans, and 3 to 8 years in the case of fixed asset loans and debt restructuring loans. 2.09 FOGAIN's position as a second-tier institution enables its financing to reach a large number of SMI enterprises in all geographical regions without making FOGAIN's administrative burden excessive since, under the discounting scheme, the primary responsibility for promoting FOGAIN's services, evaluating credits and administering approved loans to the final borrowers lies with the participating intermediary. However, since FOGAIN's margins for the inter- mediaries are fixed at 3% regardless of the size of the final beneficiary, the 1/ The five intermediaries with the largest participation accounted for about one third of FOGAIN's total loan portfolio as of June 30, 1977; beyond this the portfolio is widely and relatively uniformly distri- buted among a large number of intermediaries, including commercial banks, investment banks, credit unions and other financial institutions.  - 15 - commercial banks and other intermediaries have tended in the past to prefer lending to medium rather than small sized enterprises because of the higher administrative costs, less adequate collaterals and higher perceived risks associated with making small loans to the smaller enterprises. To correct this bias, in connection with the proposed loan FOGAIN has undertaken to carry out, before the end of 1978, a study of the adequacy of its margins to the intermediaries, focussing on the possibility of offering slightly higher margins to the banks when discounting their loans to the smaller enterprises. The second-tier status of FOGAIN has also severely limited its ability to identify and provide the technical assistance needs of its clients. Its recently established Technical Assistance and Promotions Department is small, with only 3 professionals other than the 11 field representatives who devote their attention mainly to promotional activities. So far its main achievements in the technical assistance area have been to produce short courses given through audiovisual presentations to explain the types of financing available from FOGAIN to banks and potential clients and to intro- duce basic accounting principles to their smaller client enterprises that need help in preparing lcan requests. Under the Program the task of providing technical assistancet to FOGAIN's SMI clients will be undertaken primarily through the team of extension agents to be recruited by NAFINSA. Thus FOGAIN's representatives will be able to devote their attention mainly to promoting its services with regional industry groups and bankers. FOGAIN's Past Financial Performance 2.10 Tables T-5 and T-6 of Annex 3 include comparative balance sheets and income statements (audited except for 1976/77) of FOGAIN for the last four years. They show an acceptable overall financial position reflecting rapid growth in its operations. FOGAIN's portfolio of outstanding loans has been financed mainly through equity (21% as of June 30, 1977), certificates of participation issued through Banco de Mexico (48%) 1/ and a series of loans from the Inter-American Development Bank (28%). 2/ Total debt to equity ratio, which increased to about 3.4:1 by June 1977, is still at a very acceptable level given that FOGAIN is a second-tier discounting fund, and is below the maximum 10:1 ratio specified in FOGAIN's operating regulations. The current ratios have been high, reflecting the large current portions of its loan port- folio; such high liquidities are, however, not unusual for discounting funds and are necessary to cover FOGAIN's undisbursed commitments of similar mag- nitudes. FOGAIN incurred small losses equivalent to about 0.2% and 0.3% of average total assets during the fiscal years 1974/75 and 1975/76 because increases in its financial costs were not offset by increased lending rates. 1/ The certificates of participation issued until June 1977 carried an interest rate of 8% but, in order to take account of the increase in inflation, Banco de Mexico recently raised the rate on new certificates issued for FOGAIN to 10%. 2/ FOGAIN was the recipient of 7 IDB loans totalling US$53 million over the past 15 years, at interest rates of 4-8%. The borrowings from IDB, which are denominated in foreign exchange, show a sudden increase in 1976/77 as a proportion of FOGAIN's total liabilities, due to the major devaluation of the Mexican peso in September, 1976 and subsequent changes in the floating exchange rate.  - 16 - Although FOGAIN raised its lending rates in early 1977 (para. 2.12), it suffered a higher loss of about 2.1% of average total assets during 1976/77, since the increased interest rate on new loans was insufficient to cover fully the higher principal and interest payments due on the IDB loans following the substantial devaluation of the peso. Administrative and general expenses as a percentage of average loan portfolio ranged from 1.0% to 1.5% in the past, which is reasonable in view of FOGAIN's small median loan size. 2.11 Reflecting its position as a second-tier financial institution operating through banks and other intermediaries who bear the credit risk, FOGAIN suffered virtually no losses on its loan portfolio during the many years of its operation. Arrears on loans correspond to only about 0.4% of its current loan portfolio, and few of these have been in arrears for more than three months. Interest Rates and Onlending Terms 2.12 FOGAIN raised its fixed interest rates by 2 points in early 1977 to 12-14% per annum, depending on whether the project is located in Zone 1 (14%), Zone 2 (13%) or Zone 3 (12%), in all cases including a margin of 3 points for the intermediary bank. However, FOGAIN now needs to make further adjustments to its interest rates to reflect movements in the general level of interest rates since early 1977 and to take into account increases in its own cost of funds. During the loan negotiations FOGAIN confirmed its intention to review its interest rates at least annually and make appropriate adjustments, to reflect the changes in the index of the average cost of funds to financieras (the ACF index referred to in para. 1.24 and calculated monthly by Banco de Mexico as outlined in Annex 2) and changes in its own borrowing costs. Specifically, the average interest rate of the final beneficiaries on FOGAIN's new subloans would be set at 1 to 3 percentage points above the level of the ACF index applicable at the time of the latest annual adjustment. Thus FOGAIN's interest rates to the final borrowers would be comparable to those of FONEI (para. 1.25), but would be fixed during the life of a subloan. The above system would give FOGAIN the flexibility to differentiate interest rates to the final borrowers depending on their location in Zone 1, 2 or 3, and to vary in the future its margins to the intermediaries depending on the size of the borrower (para. 2.09), as long as the weighted average of the final interest rates on its loans falls within 1%-3% above the ACF index. As the first step in changing to this new system, FOGAIN agreed that the average interest rate on its new subloans would be increased to 16% before it would submit any applications for withdrawal from the proceeds of the proposed Bank loan. Following this, FOGAIN would complete the first review and appropriate adjustment of its interest rates along the above lines before the end of 1978; further reviews and adjustments would be made once per year thereafter or more frequently if the ACF index changes by more than two points between two annual adjustments. 2.13 The above proposals would represent a significant improvement in FOGAIN's interest structure. The ACF index is considered a reasonable measure of the present cost of raising domestic resources and the Government has announced its intention to permit adjustments in financieras' borrowing interest rates in the future to ensure adequate domestic resource mobilization. Current expectations are that the ACF index will move only gradually over the next 3-4 year period and settle down at a level a few points higher than the  - 17 - inflation rate (Annex 2). FOGAIN's average lending rate to its borrowers over that period is expected to exceed by a slight but increasing margin the projected annual inflation rates of 16% for 1978 and 1979, 14% for 1980, and 11% for 1981. Operational and Financial Projections and Resource Requirements 2.14 Annex 3, T-4 presents the projections of FOGAIN's credit operations for the next 5 years. Total credit authorizations are projected conservatively to grow at an average annual rate of about 25% in current terms, 1/ reflecting a continued high demand for FOGAIN's financing, which is expected to result partly from the activities of the industrial extension agents promoting SMI investments in the field and a closer coordination among the various agencies supporting SMI expected to be achieved through the Program. The corresponding projected balance sheets (including the projected net additional resource requirements) and income statements are shown in Annex 3, T-5 and T-6. 2.15 The projections show that over the next five years, FOGAIN's loan portfolio as well as total assets would grow at an average annual rate of approximately 30% over the projection period to reach about Mex$8.9 billion (estimated to be more than US$220 million equivalent) by mid-1982. In addi- cion to Program resources of about Mex$1.8 billion in current terms 2/ (including about Mex$1.0 billion from the proceeds of the Bank loan, Mex$0.55 billion from Banco de Mexico and Mex$0.25 billion in the form of budgetary contributions to FOGAIN's equity) expected to be made available to FOGAIN, the above expansions in FOGAIN's credit operations would require additional resources in the form of net new borrowings of about Mex$5.8 billion over the 5-year period. These are expected to be procured mainly in the form of additional certificates of deposit issued through Banco de Mexico and potential borrowings from IDB and other external institutions. Although long term borrowings would increase substantially to support the above growth, FOGAIN would be able to maintain an acceptable financial structure, with the long term debt to equity ratio rising gradually from 3.4:1 in 1977 to about 6.8:1 in 1982, which would not be excessive for a rediscounting fund such as FOGAIN. With the expected revision of FOGAIN's average lending rates along the lines discussed (para. 2.12) and some economies of scale with respect to adminis- trative expenses, profitability is expected to improve, enabling FOGAIN to achieve a small net profit averaging about 1% on the average total assets (7% on average equity) during 1979-82. Overall, FOGAIN's financial position can be expected to be acceptable throughout the forecast period. Project Evaluation and Follow-Up 2.16 Intermediaries evaluate the creditworthiness and future potential of the client enterprises for purposes of their own decision making before sub- mitting them for discounting with FOGAIN. FOGAIN then analyzes the loan 1/ Although this projected growth rate is lower than that in the past, it is a reasonable estimate in view of the much larger overall size of FOGAIN's operations compared to a few years earlier and the expected decline in the inflation rate. 2/ That is, about Mex$1.25 billion in constant 1977 pesos.  - 18 - applications to verify their eligibility for discounting under its operating regulations and policies, and to assess the projects supported from admin- istrative, financial, technical, marketing and environmental viewpoints. The intermediary is obliged to furnish to FOGAIN any further information it may require on the projects submitted. 2.17 FOGAIN classifies all its credit applications 1/ received into "creditos menores" (up to Mex$2 million) and "creditos mayores" (more than Mex$2 million) and uses slightly different procedures to process the two categories of applications. Its procedures for "creditos menores" concentrate on an analysis of the organizational and market aspects and a simple financial ratio analysis of the client enterprise, and do not include an internal financial or economic rate of return calculation for the investment project. For credits of up to Mex$l million among the "creditos menores", FOGAIN further helps expedite loan processing by allowing intermediaries to disburse on the credits using funds from "lines of credit" opened by FOGAIN in favor of the individual intermediaries; the intermediary can thus obtain speedy reimbursement although such reimbursement subsequently has to be authorized by FOGAIN. 2/ In the case of "creditos mayores", an internal financial rate of return calculaticn is included, but this is generally carried out on the basis of projected cash flow of the enterprise as a whole, rather than on incremental cash flow generated by the investment project. FOGAIN has also been carrying out an economic rate of return (ERR) calculation in the case of its "creditos mayores" involving fixed asset investments of more than US$50,000, but the procedure for this calculation suffers from some defi- ciencies; in particular, domestic prices rather than international border prices (or shadow prices) are used for all inputs and outputs. Perhaps as a result of the absence of an appropriate incremental cash flow analysis of the project, the maturities and grace periods of the loans granted by FOGAIN appear to be somewhat stringent and may be restricting the expansion poten- tial of some profitable firms obtaining financing through FOGAIN. 3/ 2.18 Responsibility for following up an FOGAIN's credits rests primarily with the participating intermediaries. The intermediaries engage in follow- up activities with varying intensities, concentrating mainly on cases of loan arrears. FOGAIN periodically carries out a relatively comprehensive statistical analysis of the characteristics of credits authorized by it. However, it has not thus far indulged in a systematic follow-up of its individual projects to compare the performance with anticipated results. FOGAIN recently assigned 1/ FOGAIN processed nearly 400 applications per month on average during 1977, of which more than 300 per month were ultimately authorized. 2/ FOGAIN authorizes a "line of credit" upon the specific request of the intermediary; the size of the line of credit is determined by FOGAIN depending on the financial position and volume of discounting opera- tions of the concerned intermediary. As of June 30, 1977, about 100 intermediaries were making use of the line of credit facilities and credits approved under the lines of credit accounted for about 19% of FOGAIN's total loan portfolio. 3/ FOGAIN's total processing times average about two weeks for "creditos menores" and 6-7 weeks for "creditos mayores," indicating relatively quick processing overall.  - 19 - this responsibility to its Programming, Budgeting and Control Department, but is yet to define clearly the particular approach to be adopted for the follow- up activity. 2.19 As a first step in strengthening FOGAIN's project evaluation pro- cedures, the Bank would require an incremental cash flow analysis indicating the adequacy of maturities and grace periods, and internal financial rate of return calculation following standard Bank guidelines on all FOGAIN "creditos mayores" submitted for financing from the Program resources. In the case of the "creditos mayores" in 3 selected subsectors 1/ with high levels of protec- tion, FOGAIN would be required to carry out, on an experimental basis, an ERR calculation following standard Bank guidelines for DFCs. Further improve- ments in project evaluation procedures would be discussed with FOGAIN once it has gained sufficient experience in implementing the above changes. FOGAIN would also be required to carry out a follow-up of its projects on a sampling basis in order to assess whether or not the goals of its financing are being achieved and to consider any corrective actions required. The Coordinating Committee (para. 5.02) of the Program would have the overall responsibility for ensuring, on a continuing basis, that any reforms required in FOGAIN's evaluation and follow-up procedures in connection with the Program are adequately implemented. Procurement and Disbursement Procedures 2.20 Due to the unsophisticated nature of FOGAIN's smaller client enterprises and the relatively small average loan size, it is often not practical for FOGAIN to insist on price quotations from several suppliers. However, FOGAIN takes adequate steps to ensure as part of its project appraisals that the prices paid by client enterprises for goods and services acquired using FOGAIN's financing are reasonable. Where necessary, espe- cially in the case of fixed asset loans exceeding Mex$2.0 million, FOGAIN requests additional information from the borrower on the justification for the selection of the particular equipment and the corresponding purchase price. These procedures for procurement are satisfactory, especially in view of the relatively low level of protection in Mexico for industrial inputs (para. 1.12). 2.21 Disbursement procedures are adequate. The participating inter- mediaries are held responsible for ensuring that FOGAIN's financing is used for the purposes intended. Disbursements are made by FOGAIN to a partici- pating intermediary under the condition that it submits satisfactory docu- mentation within a specified time (usually a few weeks) as evidence of the purchase of goods or services authorized. If this condition is not met, the intermediary would have to return to FOGAIN any disbursements already made. Satisfactory documentation in the case of fixed asset loans comprises purchase invoices and import documentation, if any; for construction loans, the intermediary or its agent (for example, a civil engineering consultant) has to certify that construction is proceeding according to the specifica- tions agreed; in the case of the working capital loans, the intermediary is responsible for ensuring (through plant visits, if necessary) that the items purchased are as per the agreement with FOGAIN. 1/ Namely textiles, chemicals, and metal products and machine fabrication.  - 20 - Accounting Procedures and Auditing Arrangements 2.22 FOGAIN maintains an adequate accounting system. Its accounts are generally up to date and are audited annually as of June 30. For the last four years the auditors have been Mancera Hermanos y Compania, S.C., an established Mexican auditing firm of acceptable quality. In each of those years FOGAIN received an unqualified audit report. The Credit Guarantee Scheme 2.23 An important aim of the Integrated Program is to provide access to credit to small industrial enterprises that do not currently have such access because of lack of sufficient collateral to offer the banks. In order to achieve this aim, it will be necessary to revise and extend FOGAIN's guarantee facility, which has been little used so far. Over the past six years it guaranteed only 46 loans totalling Mex$9.2 million, of which only about Mex$3.7 million was covered by the guarantees (see Annex 3, T-7). 2.24 There appear to be two main reasons for the minimal use of FOGAIN's existing guarantee authority. First, the authority has been severely restricted both in terms of risk coverage and loan size. In Zone 1 FOGAIN's guarantee could not exceed Mex$200,000 or 50% of the loan, whichever is lower. In Zones 2 and 3 the guarantee could go up to 75% of the loan, but not exceed Mex$112,500. Perhaps more importantly, FOGAIN itself was not enthusiastic about using its guarantee authority because it had not received sufficient allocation of funds to provide a reserve against possible losses. Consequently, FOGAIN did not promote the guarantee idea and never spelled out clearly important aspects of the scheme in its publications, and as a result, banks did not submit many guarantee applications. 2.25 Upon the request of the Mexican authorities in connection with the proposed project, the Bank provided the services of a consultant to examine the existing guarantee scheme and suggest methods of correcting its deficiencies. Based on the consultant's recommendations and the mission's discussions with the Mexican officials, FOGAIN is proposing to expand and improve the features of its guarantee facility. FOGAIN has already modified its operating regu- lations to increase the maximum guarantee that it can grant on a SMI loan to Mex$750,000 or 75% of the loan amount, whichever is lower provided the total loan size does not exceed Mex$1 million. In addition, during the loan nego- tiations, the Mexican delegation informed the Bank that FOGAIN's capital reserve will be increased by about Mex$10 million as required to cover possible losses incurred in operating the guarantee facility. This is ex- pected to be sufficient to support credit guarantees of about 10 times, i.e. about Mex$100 million (about US$4 million equivalent). It may later be supplemented by further government equity allocations to FOGAIN to enable expansion of the scheme, depending on the demand for guarantees and the success of the scheme. A guarantee premium would be charged with the aim of making the scheme self-financing in the long run; a premium of 1.5%-2.0% per annum on the outstanding guarantee amount is contemplated initially, but this would be adjusted as necessary in the future to take account of the administrative and financial costs of the scheme. 2.26 During the initial 2-3 year period of the Program FOGAIN would rely mainly on the industrial extension agents to be recruited by Nacional Financiera under the Technical Assistance Subprogram (para. 5.05) to identify and recommend enterprises that would need assistance from the guarantee  - 21 - scheme. However, it would also consider requests for loan guarantees received from banks without the intervention of an industrial extension agent. Prior to the end of 1978, FOGAIN, with assistance as necessary from the Secretariat of the Integrated Program (para. 5.02), would prepare a detailed procedures manual for the operation of the guarantee scheme, including claims and recovery procedures and the obligations of the participating bank in following up on loan recoveries. The Coordinating Committee of the Integrated Program would be responsible for periodically reviewing the parameters of the scheme and for helping FOGAIN in imple- menting any appropriate revisions. III. THE RISK CAPITAL SUBPROGRAM Objectives 3.01 The Risk Capital Subprogram, to be executed through FOMIN, aims to encourage and facilitate the creation or expansion of economically sound and financially viable SMI enterprises by helping to fill the gap in the availability of risk capital. FOMIN would be allocated approximately Mex$400 million of Program resources of over a 3-year commitment period to enable it to substantially increase the number and volume of its investments in SMI enterprises. Initially, these investments would be made primarily in the form of subscriptions to common or preferred shares, but FOMIN would also experiment increasingly with the use of debt instruments with equity features (e.g., subordinated and/or convertible loans) to enable it to broaden the range of its potential clientele, design investment packages tailored to the particular characteristics and needs of individual enterprises, and to improve FOMIN's own income position. As in the case of the Credit Subprogram, firms with equity ranging between Mex$25,000 and Mex$35 million would be supported by this subprogram for implementing investment projects that (a) involve new productive capacity or expansion of existing capacity, or (b) represent a relocation of productive capacity in accordance with national decentralization policies. Most of the firms selected would be those requiring, or likely to require, integrated support involving assistance from one or more of the other elements of the overall Program (i.e. credit, facilities on industrial parks, technical assistance, etc.) also. Role, Management and Organization of FOMIN 3.02 FOMIN is a comparatively new institution that is undertaking an important but rather difficult task in the industrial promotion field. It was established in November 1972 as a trust fund of the Federal Government under the administrative supervision of NAFINSA to assist in the implementation of national plans for industrial diversification and regional development. Its role, as specified in its operating regulations, is to help in the creation of new SMI enterprises or the expansion or strengthening of existing ones by subscribing up to one third of the equity capital required, and to promote development of the capital market. Its investments are intended to be temporary and tco be sold once the associated company achieves a satisfactory financial position. FOMIN thus serves to bring together groups of investors, enabling enterprises to have access to greater capital, and permitting them to operate on a larger and more economic scale. Its participation frequently helps firms start the transition from a closed family enterprise, in which management is  - 22 - not specialized, to a corporation in which professional managers bring their expertise to bear on all aspects of the firm's operations. FOMIN gives priority in the selection of investments to projects in the less developed regions of the country and those designed to increase employment and output, utilize local natural resources, develop indigenous technology, address environmental problems, or create new export opportunities. Only in exceptional cases may FOMIN invest to help reorganize financially a firm in difficulty. FOMIN takes active interest in the management of the firms it invests in, and provides advice as appropriate for strengthening the financial structure of the firms. 3.03 Responsibility for the overall direction of FOMIN is vested in its seven-man board (called the Technical Committee). The board is chaired by the Director General of NAFINSA and comprises high-level representatives from NAFINSA, the Ministries of Finance, National Patrimony and Industrial Develop- ment, and Programming and Budgeting, a representative of the Banco de Mexico, plus two representatives from the private sector selected by the main indus- trial associations, CONCAMIN and CANACINTRA. As appropriate, outside experts and the Directors of FOGAIN and FIDEIN may be invited to participate in board meetings to assist in reviewing particular investments or problems. The board usually meets once a month to approve operating programs and budgets, set investment policies and guidelines, consider individual investment proposals and set conditions for FOMIN's participation, and generally oversee FOMIN's operations. 3.04 FOMIN's day-to-day operations are managed by its Director, who is appointed by the board. Mr. Cano, Director since 1974, has substantial experience in industry and in the management of trust funds. He has been delegated authority by the board to approve small investments up to Mex$500,000 after consultation with the board chairman. Reporting to the Director are a manager responsible for the Legal and Project Appraisal departments and an assistant manager responsible for the Portfolio Control and Investment Sales departments and also for administrative services (see organization chart in Annex 3, C-2). Both are qualified and experienced professionals. In August 1977 FOMIN had 49 employees, of whom 24 were professionals. Morale is high among the relatively young but capable staff. Turnover has been low and most staff members know their jobs well. FOMIN's Past Operations 3.05 Resources. To date all of FOMIN's financial resources have been provided by the Government in the form of contributions of FOMIN's own equity capital. FOMIN was provided with starting capital of Mex$50 million to be used for making investments and deflaying administrative and operating costs. Annually, FOMIN is required to submit to the Ministry of Finance for approval an investment and operating cost budget, on the basis of which additional capital contributions are decided. Actual contributions made to FOMIN's capital have been rather sporadic and have not matched the budgetary requests. FOMIN received Mex$50 million in 1973, Mex$75 million in 1974, Mex$50 million in 1975, and Mex$25 million in 1976, giving a grand total of Mex$250 million at year-end 1976. For 1977 an additional capital contribution of Mex$100 mil- lion was authorized. While it is expected in the longer run that portfolio sales and dividend receipts will provide a substantial proportion of the funds required for new investments, thus far their contribution has not been very significant since FOMIN is still growing and the majority of the investments have not yet matured (see para. 3.08). Uncertainties regarding the size  - 23 - and timing of government contributions created by the annual budgeting process made it difficult for FOMIN to plan its future operations and inhibited its promotional efforts. This problem would be alleviated under the Program, since FOMIN would have the assurance that a substantial volume of resources will be available to finance its investments over the next three years. 3.06 Investment activity. FOMIN made a rapid and rather impetuous start to its investment activities, approving investments totalling Mex$232.5 million in 113 companies by June 1974, several of which never became effective. Following the appointment of the present Director in 1974, the pace of invest- ment slowed down while efforts were made to strengthen appraisal and follow-up procedures and improve internal accounting. During the next 2-1/2 years, FOMIN approved a further Mex$149 million in 33 other companies, and by year- end 1976 had made investments totalling Mex$210 million in 81 companies (see Annex 3, T-8). As of that date, investments in 14 companies had been sold compLetely, two investments had been sold in part, and 3 companies in which FOMIN invested had been liquidated. Thus, its portfolio of investments at December 31, 1976 amounted to Mex$181.9 million invested in the shares of 64 companies. Annex 3, T-9 analyzes the sectoral distribution of 69 companies being supervised by the Portfolio Control Department as of December 31, 1976, which were engaged in wide range of industrial activities in many different states. 1/ Twenty of the 69 firms were newly organized. Only one firm would be cLassified as large, having equity capital of more than Mex$35 million before FOMIN's investment. Of the remaining portfolio 84.6% of the investment is in 37 medium sized companies and 8.7% in 31 small ones. By its partici- pation in these companies FOMIN helped to mobilize additional equity invest- ments totalling Mexll9.9 million from other shareholders and Mex$162.3 million in credit from banks and other sources. 3.07 Investment performance. To date FOMIN has not been able to generate an operating surplus from its investment activities. Of the 16 investments sold to date, including 2 partial sales, 12 have been sold at premiums averaging 17% above FOMIN's investment cost, 2 have been sold at par, and 2 at a capital loss averaging 30%. Overall the Mex$20.6 million of investments sold have yielded a net profit of Mex$1.05 million, equivalent to a 5% return on invest- ments over a holding period averaging about two years. Dividends received annually, averaging about 1% of portfolio, have not significantly increased the return on investment. Moreover, losses of Mex$8.4 million on the three companies that were liquidated exceeded substantially all gains from port- folio sales and dividend receipts. 3.08 Since sales and liquidations to date represent only about 12% of FOMIN's investments, the quality of the portfolio still held is a more important indicator of investment performance. During 1975 and most of 1976 there had been an improvement in the results of the companies in which FOMIN had invested (see Annex 3, T-10). At the beginning of 1975, 20 companies representing 29% of total investments were operating profit- ably, but by September 1976 this had increased to 26 companies representing 50% of total investment. FOMIN's clients were adversely affected by the aftermaths of devaluation and the fall in the industrial activity in early 1977 and, despite a slight recovery, by September only 20 firms representing 41.6% of FOMIN's investment were again operating profitably. 1/ The Portfolio Control department begins supervising firms before the investment in it has been finalized.  - 24 - Based on a review in September 1977 by the Portfolio Control Department, 10 firms (24% of investment) of the 19 operating at a loss (40% of invest- ment) appear to have overcome their most serious problems and can be expected to show profits within 1-2 years. The other 9 firms have reasonable prospects in the medium term. The remaining 26 firms are classified as being in a "special" situation. Of these, 17 firms, accounting for 12% of the investment have quite serious problems and some may have to be liquidated or reorganized under new management. Of the remaining firms, 1 was in installation and 8 were in process of being sold for an estimated 35% premium. 3.09 Bearing in mind the generally poor performance of industry in 1975-77, the priority FOMIN gives to investments in new enterprises and those located in less developed areas, and the fact that it is a relatively young institution that has had to develop its experience and expertise in the venture capital field, its investment performance to date has been reasonably satisfactory. In its early years FOMIN adopted a highly promotional view of its role and placed too much emphasis on the social desirability of a project and too little on its financial viability and prospects. Most of the investments in firms now in serious difficulty and in the three firms liquidated at a loss were made during these early years. Investments made more recently appear to have better prospects for having been analyzed more thoroughly and decided on the basis of more conservative judgements. Nevertheless, if FOMIN is to achieve its objective of maintain- ing the value of its investment capital and earning sufficient return from its investments to cover its administrative costs, it will need to take some further steps to strengthen its investment practices as explained below (paras. 3.11 and 3.12). 3.10 Overall results. To date FOMIN's total income (which includes dividends and capital gains on the sale of investments as well as return on short term investment of available liquid funds and interest from sales of investments on credit terms) has fallen substantially short of its operating and administrative expenses (including fees charged by NAFINSA for its personnel and other services), which have averaged about 7.5% of FOMIN's investment portfolio (see Annex 3, T-11 and T-12). Part of the reason for this has been that due to resource constraints in the last few years, FOMIN has not been able grow as fast as planned, being left with a considerably higher staff capacity than is needed to handle its current volume of opera- tions. Administrative expenses as a proportion of FOMIN's portfolio should decrease in the future as its operations grow. FOMIN has, however, been able establish itself over the last few years as an effective mechanism to support SMI enterprises in priority lines of activity through its equity participa- tions, to help them raise significant amounts of complementary financing, and to effect improvements in their financial structure and management. Investment Policies and Procedures of FOMIN 3.11 Policies. FOMIN has over the years developed a set of investment policies that takes account of both its unique role in supplying risk capital and the characteristics of the firms in which it invests. However, FOMIN's past inability to promote itself actively (para. 3.05) resulted in its dependence on the state development committees and enterprises with NAFINSA investments for a large portion of its investment proposals, and has not allowed FOMIN to define its investment policies in sufficiently concrete  - 25 - terms or to achieve good diversity and selectivity in its investments. In connection with the expected expansion in FOMIN's operations under the proposed loan, upon the request of the Mexicans, the Bank provided the services of a consultant to examine FOMIN's investment policies and practices. Based on the consultant's recommendations, discussions with the appraisal mission and its own analysis, FOMIN has recently formulated a more concrete definition of its investment policies. 3.12 Most importantly, FOMIN has set for itself as financial goals: (a) earning sufficient revenues in the short term to cover its admin- istrative costs, and in the medium term to maintain the value of its equity in constant prices; and (b) holding a diversified portfolio of investments whose benefits accrue in both the short and long term and whose risks of loss are compensated by possibilities of commensurate gains. In connection with the latter, FOMIN would limit its maximum exposure (including invest- ments through equity as well as other instruments) in a single firm to 10% of FOMIN's equity, and its total exposure in 2 or more firms belonging to the same industrial group to 15% of FOMIN's equity. During the loan nego- tiations FOMIN also specified its policies concerning the kinds of firms that FOMIN will invest in, the types and terms of its investment instruments, and evaluation, supervision, and sales of investments. The following para- graphs include a more detailed discussion of these policies. The most important elements of FOMIN's policies, namely those concerning its financial goals mentioned above and the use of new investment instruments (para. 3.13), have recently been incorporated into FOMIN's operating regulations through appropriate modifications. Under the proposed loan, any further changes in the operating regulations would have to be acceptable to the Bank. 3.13 Investment instruments. Until this year FOMIN's investments were virtually all in the form of purchasing new issues of common stock of its investee enterprises. Partly as a result of technical assistance provided during project preparation, FOMIN has recently begun using preferred stock as well. 1/ Institutions making risk capital investment in other countries even with well-developed equity markets, have found it advantageous to use a wide variety of subordinated and convertible debt instruments in addition to common and preferred shares. Common stock has the disadvantage that it exposes FOMIN to the full risks of loss but, in part because of the limited market for shares of SMI enterprises, FOMIN is not usually able to gain commensurately when the firm is successful. Preferred stock can help FOMIN to a minimum return and to negotiate a better selling price but has the disadvantage to the firm that preferred dividends paid are not tax deductible. 3.14 Given the current state of the Mexican capital market, it probably would not be possible to carry out FOMIN's new investment policy without extend- ing the range of investment instruments beyond common and preferred shares. Therefore, FOMIN plans to start using subordinated and convertible loans experi- mentally and, if successful, extend their use to a substantial portion of its operations. These new instruments would permit FOMIN to earn a higher and more certain current income from its portfolio as well as negotiate better terms of sale. As FOMIN's staff has no experience in using these instruments, its Director has requested Bank and IFC assistance in arranging training for several of its staff members. The needed training would be made available under the proposed Program. 1/ In cases of exceptional urgency, FOMIN can make a temporary loan in anticipation of its investment.  - 26 - 3.15 Appraisal. All investments above Mex$50,000 undergo FOMIN's thorough appraisal procedure which analyzes satisfactorily the technical and financial characteristics of the project FOMIN's investment will help finance. Smaller investments have a simplified treatment which is adequate in the circumstances. The appraisal, however, needs to be strengthened in assessing: (a) the pros- pects of the investment enterprise and the business and administrative abilities of its management; and (b) the desirability of the investment from FOMIN's (rather than all shareholders') point of view. The latter point will become increasingly important as more investments will be undertaken using instru- ments other than common stock. FOMIN would also have to evaluate more real- istically future dividend and interest paying ability and the conditions of disinvestment, in order to decide which investment instrument is the most appropriate. The management is aware of these shortcomings and is taking steps to correct them. FOMIN has in the past done little economic analysis of its projects beyond ensuring that the project falls within one of the priorities established by the Technical Committee. In the future, FOMIN would calculate an economic rate of return on all investments using more than US$150,000 in Bank funds, that is, on about half of its future operations (para. 6.10). 3.16 FOMIN also intends to concentrate the evaluation process on projects with a good chance of being implemented if approved. In the past some projects have been evaluated too early, before definite sponsors were found. In addition, FOMIN would review carefully the conditions that are attached to approval of projects, since this is another cause of approved investments not becoming effective quickly. Strengthening appraisals in these ways will require a closer coordination between the Evaluation Department and the Portfolio Control and Sales Departments. At present the Evaluation Department tends to work in isolation and thereby lacks sufficient feed-back from closely observing firms it has evaluated. 3.17 Supervision. FOMIN supervises its investments by appointing at least one voting member of the board and a shareholders' representative 1/ in each firm in which it invests. The board member is often the local representative of NAFINSA but the shareholder representative is invariably from the Portfolio Control Department. This practice enables FOMIN to keep abreast of developments within the investment enterprise. Although, as a minority shareholder, FOMIN cannot always effect changes to correct problems it has detected, it has at times, in concert with other stock- holders, helped bring about basic changes in the management of a firm in difficulty. 3.18 Disbursement and procurement. FOMIN's disbursement procedures ensure that its resources are applied to the purposes intended. After the first 20% of FOMIN's investment is disbursed when the firm has met all the formal conditions set by FOMIN, the remainder is disbursed against a timetable agreed with the firm. This timetable normally implies that FOMIN's subscrip- tions are made pari passu with or slightly later than those of the other shareholders. Regardless of timing, it is not feasible, in general, to assign specific items to the contribution of different shareholders in an equity investment. The Program, therefore, would reimburse FOMIN's disbursements 1/ It is common practice in Mexican corporations for minority shareholders to name a shareholder representative (comisario) to monitor the firm's operation and protect the minority's interests.  - 27 - for qualifying investments towards purchases of fixed assets and related permanent working capital against proof of acquisition of the shares or other investment instrument, and a description of the project including a list of goods and expenditure schedules (para. 6.12). Investments made for debt substitution would not be financed under the Program. 3.19 FOMIN has not paid sufficient attention in the past to procurement questions related to its projects, but now recognizes that this practice is inadequate for a minority shareholder. FOMIN is therefore planning to estabLish procedures for ensuring the technical adequacy and price reason- ableness of items procured in all projects financed by it in the future. 3.20 Sales and disinvestment. As a temporary investor FOMIN attempts to turn over its portfolio as conditions permit. Although FOMIN seeks to broaden stock ownership by selling its shares to outside investors, because of the underdeveloped state of the capital market, it often has had little alternative but to resell its investments to majority stockholders. In principle, FOMIN sells its stock when the firm has overcome its difficul- ties and is operating profitably, but is prepared to sell earlier at the initiation of the other shareholders. In negotiating the sale price it has taken the book value of the shares as a starting point, usually obtaining a small premium. A substantial portion of its sales has been on credit terms of 2-3 years. 3.21 The proposed use of new investment instruments should enable FOMIN to realize its investments on more favorable terms by using common stock purchase primarily in those cases where the prospects of the firm and the eventual terms of sale appear particularly favorable. FOMIN would in the future attempt to negotiate sales and disinvestment conditions that would allow it to meet its financial goals (para. 3.12). Its asking price for common stock would be based on the firm's expected earnings as well as the shares' book value and the yield to FOMIN of their sale. 3.22 Accounting procedures and audit. Until 1974 FOMIN had no independent accounting system, its accounts being kept by NAFINSA on a "fund basis". This did not separate current from capital income (and expenditure), and was inade- quate for judging FOMIN's performance. The situation has improved since FOMIN began to keep its own accounts. However, FOMIN adopted the practice of account- ing for stock dividends received as income. Although this practice is often used in Latin America, it is not in line with the generally accepted accounting principles, and could lead to substantial overstatement of income. On the balance sheet, investments are adjusted taking into account changes in retained earnings (including retained earnings converted into shares through stock dividends) and reevaluation of the fixed assets. 3.23 In 1976, in preparation for the proposed loan, FOMIN contracted an external audit for the first time. The firm, Despacho Garcia Coronado, S. C., a reputable financial auditor, objected to FOMIN's treatment of stock dividends and other minor matters which were corrected in the 1976 audited financial statements. Agreement that FOMIN would continue to be audited by reputable firms according to accepted accounting principles was obtained at negotiations (para. 6.13). The 1977 audit also would include a detailed reconciliation of FOMIN's operational and financial statistics and would recommend a system for maintaining consistency between the two.  - 28 - Operational and Financial Projections and Resource Needs 3.24 Recent changes in the Mexican economy are creating new needs for FOMIN's services. Tight liquidity in the banking system and unbalanced liability structures of manay firms are making them increasingly interested in FOMIN's equity participations and/or subordinated and convertible debt invest- ments. 1/ For example, between February and August 1977, FOMIN received 36 applications and, although about half were fairly preliminary, 17 of them indicated a demand for Mex$110.4 million, which is more than FOMIN would be able to invest this year. With the establishment of the Program, effective demand for FOMIN investments should increase substantially. Closer coordi- nation with the Credit and other subprograms should lead almost immediately to more firms coming to FOMIN from these sources. NAFINSA's industrial extension agents would also promote FOMIN's investments with firms that FOMIN could not reach directly. Moreover, by making available a specific volume of investment funds over a 3-year period, the Program would enable FOMIN to undertake systematic promotion, which it has not been able to do in the past because of uncertainties in the annual budgeting cycle. 3.25 Overall, if resources are not a major constraining factactor, FOMIN's investments per year can be expected to grow rapidly over the next few years. The number of projects studied in depth is expected to rise from about 20 during 1977 to an average of about 50 a year during 1978-81; correspondingly, the value of FOMIN's investments would more than triple in real terms during 1977-81, reaching a level of about Mex$300 million a year by 1981. To support this level of operations, FOMIN would need total equity contributions of about Mex$800 million (in 1977 pesos) during 1978-81 (see Annex 3, T-13). Of this, the Government can be expected to contribute up to about Mex$400 million in the absence of the Program, indicating a need for additional financing of an equal amount. Program resources including the Bank loan would fill this resource need. 3.26 More detailed financial projections of FOMIN's operations, including the use of the Mex$400 million of Program resources, and the assumptions used are presented in Annex 3, T-14 and T-15. However, they are only indi- cative since a large degree of uncertainty is inevitable in projecting opera- tions of an equity fund, especially over a period when it plans to modify its investment policies and expand the volume of its operations substantially. To highlight FOMIN's medium-term objective of maintaining the real value of its equity, the projections are presented in terms of 1977 pesos. 3.27 As a result of the rise in its operations, FOMIN's investment port- folio, comprised of both stocks and new investment instruments, would rise from an estimated Mex$280 million in 1977 to almost Mex$930 million by 1981. The amount of medium-term loans resulting from term sales of the investment portfolio would also rise substantially to just over Mex$100 million by 1981. Program resources would finance nearly half of FOMIN's investments during 1978-81. FOMIN would also step up sales of its investments to generate additional resources for new investments. FOMIN's total equity would stand at about Mex$1,150 million by 1981. After an initial adjustment period, income would start to rise sharply in 1979 as a result of the maturation of FOMIN's 1/ Although FOMIN must still overcome the reluctance of many private enterprises to accept participation of what they view as a government agency.  - 29 - investment portfolio, more selective investments that would be possible under conditions of high demand, and the use of the new instruments. Reflecting FOMIN's current excess capacity to appraise projects, little real increase would occur in administrative expenses. These developments would allow FOMIN to be making profits in nominal terms by 1979-80 and in real terms by 1981. In overall operational terms, FOMIN would over the next few years be able to consolidate its position as an effective tool to help create and btrengthen SMI enterprises engaged in priority industrial activities, exert a healthy influence on their management and financial structures, and help them mobilize domestic and foreign resources complementary to FOMIN's own financing. IV. THE INDUSTRIAL ESTATES SUBPROGRAM Objectives 4.01 The Industrial Estates Subprogram would be executed through FIDEIN and would introduce some new services designed to assist SMI to establish themselves on, or relocate to, one of FIDEIN's industrial estates. FIDEIN would receive resources under the Program to enable it to (a) finance directly or through loans to the 'Fideicomisos Especiales' (the legal entities running the individual estates) the construction of small, standard factory buildings on one of the industrial estates for lease to SMI enterprises, and the construction and lease of common facilities to provide services to groups of enterprises on the estates (for example, specialized water treatment plants, maintenance and repair shops, and warehousing); (b) loans to equipment leasing agencies approved by FIDEIN for leasing of equipment to SMI enterprises. Total Program resources of about Mex$200 million (in constant 1977 pesos) are contemplated for this subprogram. SMI enterprises with equity capital of up to Mex$35.0 million would be eligible for financing. Institutional Background 4.02 FIDEIN was established in 1970 as a government trust fund admin- istered by NAFINSA to plan, promote and help implement a national system of industrial estates, as part of the Government's strategy to promote decentral- ization of industry. The estates promoted by FIDEIN cater to industrial enter- prises of all sizes and types, although very large and natural resource based industries are generally excluded. Specifically, FIDEIN is authorized to promote three types of facilities falling under the general heading of indus- trial estates: "parques industriales" (industrial parks), which provide sites and infrastructure facilities such as water, power and sewage disposal; "ciudades industriales" (industrial cities), in which an industrial park with the above facilities is supplemented by housing, commercial sections and social infrastructure (schools, hospitals, recreational facilities, etc.); and "conjuntos industriales", which are centers offering common service faci- lities (for example, central purchasing and warehousing) to groups of SMI enterprises engaged in similar or complementary activities and located on the same industrial estate or close to it. Through a 1972 Decree the Government broadened the activities authorized for FIDEIN to include promotion of "centros comerciales" (commercial centers), which may comprise physical facilities for warehousing, retail and wholesale trade, general business offices and, in some cases, recreational centers aimed at the tourist market.  - 30 - 4.03 Thus far FIDEIN's activities have been concentrated mainly on industrial parks and cities. 1/ Based on detailed studies conducted by Secretaria de Asentamiento Humano y Obras Publicas (SAHOP) and FIDEIN, 20 locations had been approved by the Government by mid-1977 for the establish- ment of industrial parks or cities, taking into account the Government's regional and sectoral priorities, and the demand for the services and finan- cial viability of the estates. The first stage of construction has been completed at 13 of these locations (see Annex 3, T-22 and C-4 for the loca- tions), and construction at the other locations is in progress. To date FIDEIN has been involved in the promotion of only one commercial center (at Mexicali) and work on establishment of common service centers is still only at a planning stage. Process of Creating and Operating Industrial Estates 4.04 During the initial stages of planning, design and construction of the estates, for which SAHOP has been assigned the overall responsibility, FIDEIN works in close cooperation with SAHOP, particularly in selecting the locations of the industrial estates and carrying out the financial and market feasibility studies of the projects. Once the location of an industrial estate (or commercial center) is approved by the Government, SAHOP typically acquires a site of about 500 ha. at the location and, in consultation with FIDEIN and the local authorities, prepares overall layouts for the site. It then develops, as part of the initial phase of the estate development, about 20 ha. of the site including leveling, grading, laying access roads, and installing power, water and sewage disposal facilities. The entire site and other assets are then turned over to a local "Fideicomiso Especial," a legal entity which thereafter owns and manages the estate and is responsible for all its future expansions. 4.05 The decentralized Fideicomisos Especiales 2/ have considerable autonomy in their day-to-day operations, but are subject to monitoring and overall coordination by FIDEIN, NAFINSA's agent in administering the Fideicomisos. FIDEIN provides the Fideicomisos with assistance and advice on a continuing basis covering a number of aspects of their ongoing opera- tions such as: promotion and marketing of their lots; accounting and finan- cial control including preparation of annual budgets and financial statements; eliciting the cooperation of the state government concerned, industry asso- ciations and other local bodies; and administrative and legal matters such as design of standard legal contracts for agreements with client enterprises and preparation of administrative and operational manuals. FIDEIN has also been providing small amounts of short term credits (akin to an overdraft facility) to the Fideicomisos to help smooth variations in their cash posi- tion. In the future, FIDEIN is also expected to assist the Fideicomisos in planning and organizing common service centers, where appropriate, and in providing the clients with any technical support and advice required in that connection. Finally, FIDEIN provides advice to the relevant govern- ment agencies, including the Ministries of Finance and of National Patrimony and Industrial Development, on matters such as allocation of budgetary and other resources to the Fideicomisos. 1/ In most cases, implementation of the projects starts with the establish- ment of an industrial park; but all of them are expected to develop eventually into industrial cities. 2/ Henceforth referred to only as "Fideicomisos".  - 31 - 4.06 Assets of a newly created Fideicomiso include the value of undevel- oped land contributed as equity by the state government, the value of land development, preinvestment studies and assistance through FIDEIN provided as equity by the Federal Government, and, in some cases, land contributed by the municipality or other local bodies in exchange for equity or a note issued by the Fideicomiso. Additional funds required for ongoing land development and working capital are obtained from banks using the real assets of the Fideicomiso as collateral and to a limited extent from FIDEIN in the form of overdrafts. Organization and Staffing of FIDEIN and the Fideicomisos 4.07 The highest decision making body of FIDEIN is its Technical Committee, which is chaired by the Secretary of SAHOP and also includes representatives of NAFINSA, FIDEIN, the National Chambers of Commerce and Industry, the National Workers' Housing Fund (INFONAVIT) and the relevant ministries. 1/ Meetings of the Committee are arranged whenever important policy, administrative or other matters affecting FIDEIN arise. 4.08 FIDEIN cucrently has a total professional staff of 15 2/ headed by its General Manager, and is divided among five departments organized by function. An organization chart of FIDEIN is included in Annex 3, C-3. FIDEIN's staff appears adequately qualified and well motivated. Mr. Avendano, the General Manager, provides able leadership for the staff, and has recently been devoting particular attention to ways of further improving and diver- sifying FIDEIN's institutional capabilities and the services offered by it. 4.09 Each individual Fideicomiso is directed by its own Technical Committee, which is chaired by the Governor of the state in which the estate is located. Each Committee also includes representatives of SAHOP, FIDEIN, NAFINSA, the Ministries of Finance, and of National Patrimony and Industrial Development, and, in some cases, representativs of the municipal authority and other local or national bodies that may own part of the Fideicomiso's assets. The State Governor and the representatives of SAHOP and FIDEIN tend to be the most active members of the Technical Committees of the Fideicomisos. 4.10 The staff of an individual Fideicomiso typically consists of a manager, and about three other staff members including an accountant and a manager of sales and promotion. Although the managers of the Fideicomisos are under the formal direction of their respective Technical Committees, they work closely with FIDEIN's General Manager and seek FIDEIN's assistance on a variety of matters (para. 4.05). FIDEIN also assists the individual Technical Committees in selecting the managers and other staff of the Fideicomisos and later orienting them towards the industrial estates program. 1/ Namely the Ministries of Finance, National Patrimony and Industrial Development, Agriculture, and Programming and Budgeting. The Directors of FOGAIN and FOMIN are also invited to attend Technical Committee meetings to improve coordination among FOGAIN, FOMIN and FIDEIN. 2/ Including 4 accountants, 3 economists, 2 business administrators, 2 industrial engineers, 1 civil engineer, 1 architect, 1 lawyer and I public relations specialist.  - 32 - Operating and Financial Performance to Date 4.11 By mid-1977, first stages of industrial parks/cities in 13 of the 20 approved locations were fully operational and had been turned over to their respective Fideicomisos; 7 others currently under construction are expected to become operational by the end of 1978. To date some 8,500 ha. have been acquired and more than 6,000 ha already transferred to the individual Fideicomisos. Annex 3, T-16 presents salient data as of mid-1977 on land sales, progress on construction, and the investment and employment characteristics of the occupant industries at each of the 13 operating Fideicomisos. Thus far, lots totalling more than 400 ha have been sold to about 600 firms and negotiations are under way for the sale of an additional 100 ha of lots. The program is clearly gaining momentum, and sales are expected to accelerate in the near future. 4.12 Analysis of the size distribution of investments on the estates of a sample of 223 firms that purchased lots in FIDEIN's industrial estates indicates that a majority of the firms are likely to fall within the SMI category, and a significant proportion of these would be "small" under the Program's definition. Estate-based projects have been fairly labor intensive, with capital investment per incremental job estimated to be of the order of about US$13,000 equivalent (in 1977 prices). In selecting the occupant industries of the estates, the Fideicomisos ensure that they are consistent wiLh the spatial, sectoral and environmental priorities of the region they are located in. 4.13 Annex 3, T-17 presents summarized balance sheet data for FIDEIN and for all the Fideicomisos together (consolidated) as at year-end 1974. FIDEIN's own total assets are relatively small, reflecting its current role of primarily a promotional and advisory institution. The balance sheets of the Fideicomisos reflect their strong equity position based on government contributions, indica- ting that they can incur substantial additional debt obligations as needed for future expansion of their activities. By the end of 1976, the federal and state governments had invested about Mex$560 million 1/ in acquiring and developing land, at a cost of about Mex$765,000/ha which in nominal terms exceeds the average selling price (about Mex$700,000 per ha.) of the land sold to date. Taking into account the administrative costs of FIDEIN and the Fideicomisos, net operating losses on sales would be about 11%. However, FIDEIN considers the losses as transitory and normal in the early stages of mounting a program of this nature since estate land may have to be sold at a discount in order to attract the initial group of enterprises. The Fideicomisos are currently adjusting the selling prices of land upward to levels more closely comparable to market prices and are expected to generate appropriately positive margins on most of their future land sales. Evaluation of the Industrial Estates Development 4.14 After a slow start, the national industrial estates program is beginning to show the positive results anticipated at its inception. Land sales as well as the resultant industrial investment and job creation are 1/ Including about Mex$36 million contributed by the state governments in the form of undeveloped land, Mex$452 million invested by the Federal Government through SAHOP for developing the land, and an additional Mex$78 million channeled through FIDEIN by the Federal Government.  - 33 - accelerating, and the estates are becoming increasingly popular with SMI enter- prises. The FIDEIN-Fideicomiso two-tier structure has proved to be an effective mecharnism, and has successfully enlisted and integrated the support of central and state governments as well as the private sector. As the staff of FIDEIN and the Fideicomisos gain more experience in the planning, promotion and administration of the industrial estates, the program's effectiveness can be expected to increase further. Rather than start additional industrial estates at new locations, FIDEIN and the Government intend to focus their efforts over the next two years on completing and consolidating the work started on the locations already approved (see para. 1.19) and on supporting the growth of the individual Fideicomisos into viable institutions catering effectively to the needs of local industrial enterprises. The proposed improvement and diversification of services to the occupant SMI enterprises contemplated under the Industrial Estates Subprogram is consistent with this strategy. 4.15 While the recent performance is encouraging, a much higher rate of estate land sales and of factory construction must be achieved if this program is to have a significant long-term effect on industrial decentraliza- tion. To date, FIDEIN and the Fideicomisos have been able to provide term financing only for sale of the land. Also, the data of Annex 3, T-16 indicate a serious lag in factory construction. 1/ Investigations in the field by the appraisal mission confirmed FIDEIN's own belief that the key constraint the estates' development has been the lack of long-term credit needed by SMI companies to finance building construction. The smaller firms find it particularly difficult to obtain the amounts and terms of financing needed to acquire suitable physical facilities. Description of the Subprogram 4.16 The major component of the Industrial Estates Subprogram would be oriented towards helping SMI enterprises locating on the estates overcome the credit constraint discussed above through financing of the construc- tion of small factory buildings that would be offered for sale, straight rentaL or lease with option to purchase on suitable terms. Two smaller experimental components would provide additional services to help the compara- tively smaller client enterprises. These would provide: common service facilities to groups of small enterprises engaged in similar or complementary production activities to increase accessibility and reduce unit costs of these services; and facilities for leasing or hire-purchase of industrial equipment, to help small enterprises overcome the credit constraint in finan- cing their equipment needs. All the resources the Industrial Estates Sub- program would be channelled through FIDEIN, which would use them over a period of about four years to finance the above three components. The details of the three components, which are based on the expected demand for the facilities, are given below: (a) Factory buildings. Construction of about 80 standard factory buildings (expected to range in size from 600 to 2,000 sq. m.) to be offered for sale, rental or lease with option to buy. The building design would be modular to facilitate expansion by adding bays as needed. The number and sizes of buildings 1/ C1f the 589 firms that purchased lots, only 83 were operating and 92 were under construction as of mid-1977.  - 34 - constructed at each estate would vary depending on effective demand as well as the implementation capabilities of the local Fideicomiso. While as many as 6 or 8 units may be built at well-established estates, only I or 2 are expected at the newer estates. The smaller factory buildings would be offered for single occupancy and the larger buildings would be subdivisible internally to provide working areas (say up to 500 sq. m.) for rental to smaller firms. Total cost of this component is estimated at about Mex$130 million in constant 1977 prices. About 5,000 workers are expected to be employed by SMI enterprises occupying these facilities. (b) Common service facilities. Construction of common service facilities at two, and possibly three, locations is contemplated, as determined by FIDEIN based on the demand for such services and their financial and economic viability. 1/ Typical common services may include one or more of: maintenance and repair shop; central warehousing, quality control and material testing centers; worker training centers; and offices including staff for bulk purchase of raw materials and assistance/advice in accounting, marketing and promotion. (c) Equipment leasing. Up to Mex$10 million of Program resources would be channelled to finance equipment leases to eligible SMI enterprises located on the industrial estates. The leases would either offer the client enterprise a purchase option (perhaps in the case of general purpose equipment such as trucks and simple machine tools) or require purchase as mandatory before the expiration of the lease contract (particularly in the case of specialized equipment not easily usable by other firms). About 40-60 equipment leases are expected to be financed through this component. Execution Schedule and Cost Estimates 4.17 Annex 3, T-18 shows the projected schedule of the construction of the factory buildings and common service facilities, and equipment leasing. Annex 3, T-19 shows the corresponding cost estimates. As shown in the projections, construction of factory buildings is expected to proceed relatively uniformly throughout 1978-82, while construction of common service facilities and equipment leasing is not expected to start until 1979 because of the need to make additional administrative arrangements and to organize groups of similar enterprises. Financing Arrangements 4.18 FIDEIN would promote, receive and evaluate applications from the individual Fideicomisos and from equipment leasing agencies for financing of 1/ FIDEIN has drawn up a list of about 8 potential locations. The most promising among them appear to be: Aguas Calientes and Merida for two groups of up to 50 clothing manufacturers; Durango for a group of 20 woodworking firms; and Leon for some 70 small shoe factories.  - 35 - to support SMI enterprises as discussed above. FIDEIN's evaluation would cover the administrative and financial impact of the subprojects on the client enterprises supported by them, their potential decentralization, employment and other economic effects in line with the overall objectives of the Program, (para. 1.30) as well as the impact of the proposed sale/lease projects on the financial position and profitability of the concerned Fideicomiso. 4.19 FIDEIN would use Program resources to finance approved subprojects through loans on appropriate terms to the Fideicomisos for construction of the factory buildings and common service centers, and to the leasing companies 1/ for purchase of the equipment to be leased. However, in cases where the local Fideicomiso lacks the necessary financial or administrative capability, FIDEIN would be prepared to finance and administer the factory buildings and common service centers subprojects directly. The average maturity of the loans to the Fideicomisos for construction of factory buildings and common service facilities is expected to be 12 years (maximum 15 years as specified in the banking legislation) including 2 years' grace, while loans for equipment leasing would have maturities of about 5 years on average including grace periods of 6 months to 1 year; the Fideicomisos and the leasing companies would be expected to use the financing to provide lease/sale contracts covering similar periods (after allowing for construction time) to their client companies. 4.20 Client enterprises would be offered the buildings and equipment, either (a) on a straight rental basis, with the rent being reviewed and adjusted periodically to take into account effects of inflation and other factors, or (b) on a rental with option to purchase the building or equipment at any time during the lease period at a price equal to its estimated replacement value minus a proportion of the rent already paid by the enterprises. The estimate of the replacement value used under the second arrangement would be arrived at based either on the appraised market value at the time of sale, or on the initial cost of the facilities adjusted for inflation using an agreed- upon formula. 2/ It is expected that the straight rental arrangement would be used for most standard factory buildings that are subdivided into smaller 1/ Only leasing companies approved by FIDEIN would be used for channelling the equipment leasing component. The leasing company most often ued for this purpose is likely to be Arrendadora Internacional, which is a subsidiary of Banco Internacional, S.A., which in turn is majority owned by NAFINSA. Arrendadora Internacional is one of the larger and better known institutions in Mexico engaged in equipment leasing; as of June 30, 1977, it had a total portfolio of lease contracts (value of lease payments due until the end of the contract period) of about Mex$380 million (about US$16.7 million). During 1976/77, 579 new rental contracts totalling about Mex$150 million (about US$6.6 million) were effected, implying an average value of about US$11,400 per lease contract. 2/ Experience in other countries including the US indicates that rents under the second arrangement should be 15-20% higher than under the first to compensate for the restriction on the owner's freedom to sell or mortgage the asset.  - 36 - bays for the use of small enterprises, while the rental with option to purchase would be the more common arrangement in all other cases. The legal, tax and insurance ramifications would differ depending on the particular arrangement chosen, and would be taken into account by FIDEIN in designing the standard contract forms. The common service facilities may be offered under the either one of the above arrangements to cooperatives of the respective groups of SMI enterprises, or to other SMI enterprises willing to provide such services on the estates at a reasonable charge to the users. 4.21 FIDEIN would onlend Program funds to the Fideicomisos and the equipment leasing agencies at a rate similar to that charged by FOGAIN to its intermediaries. The Fideicomisos and the leasing agencies would be required to set rents and/or purchase prices at a level that would enable them to cover their financial and administrative costs and recover the real values of the capital invested. This is expected to result in imputed interest rates from the sale/lease contracts at least equal to the interest rates paid by final borrowers on credit channelled through FOGAIN. These arrangements and under- standings about the interest rates and rental contracts have been confirmed during negotiations. Financial Projections 4.22 Annex 3, T-20 presents projections of the revenue build-up, net income and cash flow of the Fideicomisos from the construction and lease of factory buildings, using assumptions consistent with the above discussion. They also assume that factory buildings are financed entirely by FIDEIN loans to the Fideicomisos, with the value of the occupied land representing the Fideicomisos' participation (equity), and that three quarters of the client enterprises exercise the purchase option for buildings (generally in about the fifth year of the lease). The projections show large surplus cash inflows from operations during the middle years (1983-86) of the projection period, as is typical for industrial estate projects with high sales components. When financing flows are also included, net cash deficits begin to show in 1987, but decline gradually as debt service obligations decline. From 1994 on, when the FIDEIN loans would be completely amortized, cash surpluses are once again achieved. The surpluses generated in the earlier years should be adequate to cover the deficits during 1987-93. However, to ensure adequate provision for debt service, each Fideicomiso would have to retain sufficient portions of its earned surplus to cover the deficits expected in later years; any additional cash surpluses could be reinvested in additional buildings. Organizational and Other Requirements 4.23 FIDEIN would have to expand its role and capabilities substantially in order to implement the Industrial Estates Subprogram along the above lines. In effect, FIDEIN would have to convert itself from a primarily promotional and advisory trust fund to a specialized DFC-type institution capable of evaluation, administration and supervision of medium-term loans to the Fideicomisos and leasing companies. FIDEIN's technical capabilities to assist the Fideicomisos would have to expand, particularly in regard to: preparation of standard factory designs appropriate to the needs of various types of SMI enterprises; financial, economic and technical evaluation of the subprojects; preparation of standard lease/sale contract forms; and monitoring of subproject execution including procurement of civil works contracts and equipment, construc- tion schedules, and progress in leasing or sale of the facilities.  - 37 - 4.24 FIDEIN has already made the appropriate modifications in its operating regulations in order to facilitate its development into a financing trust fund along the above lines. During loan negotiations FIDEIN confirmed that it would expand its professional staff as necessary for implementing this Sub- program, and that it would prepare an "operations manual" as an annex to its operating regulations, specifying in detail the types of operations it would finance, maximum amounts and maturities of its financing, and the criteria to be applied in the evaluation of subprojects and in designing the leasing contracts of the Fideicomisos and the leasing companies. The specifications in FIDEIN's operations manaual would be consistent with the financing arrange- ments discussed in paragraphs 4.18 to 4.21. Any subsequent changes in FIDEIN's operating regulations would have to be acceptable to the Bank and FIDEIN, in cooperation with the Secretariat of the overall Program, would also prepare and submit to the Bank prior to the end of 1978, a procedures manual describing the detailed procedures for promotion, selection, evaluation and follow-up of the subprojects under the Industrial Estates Subprogram. V. OVERALL PROGRAM IMPLEMENTATION AND THE TECHNICAL ASSISTANCE SUBPROGRAM 5.01 To provide the necessary mechanism for implementing the overall Program, NAFINSA has recently extablished a high level Coordinating Committee under the chairmanship of the Director General of NAFINSA, which will be assisted by a small Secretariat of permanent staff responsible for carrying out the day-to-day activities of the Program. The Secretariat will also be responsible for executing the Technical Assistance Subprogram and in this connection, will cooperate as necessary with CENAPRO, IMIT, INFOTEC and other specialized institutions. This Subprogram would involve (i) creation of a corps of industrial extension agents based mainly at NAFINSA's 15 regional offices; (ii) support to and cooperation with the specialized technical assistance institutions to help them develop services better oriented towards the needs of SMI and to promote such services among SMI enterprises; and (iii) provision of term credit by FONEP to help SMI firms finance preinvestment studies and technical assistance contracted from consultants or specialized institutions. It would also serve to integrate and promote the operations of the other subprograms designed to provide additional resources to SMI firms. SMI firms throughout Mexico would be eligible to receive technical assistance support, but priority would be given in deployment of extension agents and in the strengthening of the specialized institutions, to the smaller enterprises, firms located outside Mexico City and those involved in subsectors where SMI enterprises can be expected to operate efficiently and compete with larger enterprises. The Coordinating Committee and Secretariat 5.02 The Program Coordinating Committee comprises, in addition to the Director General of NAFINSA, the heads of the main participating trust funds and technical assistance institutions, and representatives of the Ministries of Finance and of National Property and Industrial Development, and of Banco de Mexico. The duties and responsibilities of the Committee include (a) setting the policies and priorities for Program operations and the use of Program resources; (b) reviewing subproject eligibility for financing  - 38 - under the Program; (c) coordinating the activities of various participating institutions and encouraging desirable improvements in their operations in line with Program objectives; (d) monitoring the success of the more experi- mental aspects and making appropriate adjustments; and (e) analyzing the impact on SMI of national programs and policies for industrial development and making proposals to the relevant government departments for desirable modifications. During the initial stages, the Committee would also oversee and ensure the timely execution of several detailed tasks that need to be completed before all aspects of the Program can be successfully implemented, including the recruitment and training of the industrial extension agents, and the preparation of manuals and procedures for implementing the various subprograms. In discharging its responsibilities the Committee will be assisted by the Secretariat, whose full time technical staff under the overall direction of a Technical Secretary will manage the day-to-day operations of the Program. During the loan negotiations the Mexican delegation confirmed that the Coordinating Committee and the Secretariat will remain in existence and continue to carry out their functions as needed for the purposes of the Program. 5.03 NAFINSA has prepared proposals for the organization and staffing of the Secretariat and the budget for the first three years of Program operations. Under these proposals, which have already been reviewed and approved by the Coordinating Committee, the Secretariat would include 15-25 qualified profes- sionals for the Secretariat, divided among four subdepartments, responsible respectively for Program financing and operations, technical assistance, promotion and subprogram operations, and Program evaluation and policy review. The first subdepartment would be responsible for the control of subproject financing requests and disbursements, preparation of financial statements and statistics, and liaison with the Bank and other financing sources. The second subdepartment would be responsible for recruitment, training and operational control of the corps of extension agents, liaison with specialized technical assistance agencies and FONEP, and preparation and dissemination of promotional materials and technical assistance aids. The third would be responsible for the review of financing applications under the various sub- programs, the preparation of procedures manuals, and liaison with, and the provision of operational assistance to FOGAIN, FOMIN and FIDEIN. The last subdepartment would be responsible for evaluation of the Program's operations in relation to its objectives and recommendations for future changes in policies and procedures. 5.04 NAFINSA has already recruited well-qualified and motivated pro- fessionals for some of the senior positions of the Secretariat, including the Technical Secretary, who participated in the loan negotiations. During the negotiations NAFINSA confirmed that 12 of the Secretariat's professional staff would be recruited during 1978, with about 10 more expected to be recruited in the following year. These staff would be given a special training course comprising about three weeks of orientation to the Program's objectives and operational details and the activities of each of the participating institu- tions, and a 2-month course to be organized by CENAPRO on all aspects of the operations and needs of SMI enterprises in Mexico. About 5 staff members of the Secretariat are also expected to visit (for 4-6 weeks) other countries to study alternative mechanisms for technical assistance and industrial extension service. The training of the first group of the Secretariat's technical staff is expected to be completed by the end of June 1978. Through an official  - 39 - letter as a sequel to loan negotiations NAFINSA submitted to the Bank a comprehensive Project Implementation Document including a detailed description of all components of the Program, and a plan and timetable for completing all outstanding tasks required before the Technical Assistance Subprogram as well as the other Subprograms can be implemented. This includes, for example, the preparation of manuals specifying the detailed procedures to be followed for implementing each Subprogram. These arrangements are adequate to ensure the timely execution of all the tasks required in the initial stages of the Program's implementation. Industrial Extension Agents 5.05 The most important new development under the Technical Assistance Subprogram would be the creation of a corps of industrial extension agents, which would serve as the arm of the Program in reaching the smaller enter- prices within the SMI sector. The role of the extension agents would be to (a) make small industrialists aware of the sources of financial assistance available under the other subprograms and help them with the mechanics of requesting support; (b) provide directly some basic technical assistance, for example, basic diagnostic services related to accounting, markets, etc., and help in preparation of financial statements; and (c) help the enterprises in identifying any further technical assistance needed and in obtaining it from one of the specialized technical assistance institutions cooperating in this Subprogram. 5.06 Some 40-50 extension agents are expected to be recruited during the 3-year period, starting with about 20 during the first year covering the first phase of the Program. Typically, they would have an engineering, accounting or business administration background, with some previous work experience with small firms. In order to provide the extension agents with the necessary orientation and familiarize them with the objectives and scope of the Program, they would be initially trained through a short (about 8 weeks) training program given mainly by Secretariat staff and CENAPRO. The detailed curriculum of the training program, which is now being prepared, is expected to concentrate heavily on the characteristics and special needs of small firms, institutions providing financial and technical assistance to SMI, and the operating procedures of the various subprograms. Some foreign training of supervisory level personnel may be desirable and direct foreign exchange expenditure for this purpose would be eligible for financing from the Bank loan. 5.07 The extension agents would be based in the 15 regional offices of NAFINSA (see Annex 3, T-22 and C-4), focussing initially on locations where there is already a concentration of SMI firms, and where rapid growth of SMI can be expected, such as Monterrey or Guadalajara, and the intermediate growth centers on the Queretaro-Leon corridor and the Gulf coast. Eventually, agents would be located in all 15 of NAFINSA's regional offices as well as Mexico City. NAFINSA recognizes the need for rapid progress in developing the corps of extension agents, and has confirmed during loan negotiations satisfactory arrangements including the timetable for the recruitment, training and deploy- ment of the extension agents. The training of the first group of extension agents is expected to be completed by the end of August 1978.  - 40 - 5.08 Private and mixed banks would also be encouraged to form teams of extension agents similar to NAFINSA's, in order to provide additional support to SMI. The banks would be invited to send their staff to participate in the training courses organized for NAFINSA's own extension agents. In addition, the possibility of making arrangements to partially reimburse banks for the costs of their extension agents, along the lines of the reimbursement for bank agricultural extension agents provided by FIRA, 1/ is being examined. Because of the need to determine experimentally the most effective ways of involving the private banks in the Technical Assistance Subprogram, only the "mixed" banks (banks with mixed government-private sector ownership), namely Banco Internacional, Banco Mexicano-SOMEX, and their affiliates, are expected to participate initially in forming teams of extension agents. Cooperation with Specialized Technical Assistance Institutions 5.09 As part of this Subprogram, support would be provided to various specialized technical assistance agencies, including primarily CENAPRO, IMIT, CONACYT and INFOTEC, through (a) financing of equipment and other facilities, and the cost of designing courses, seminars, etc., that would help these institutions orient their programs more towards the needs of SMI enterprises; and (b) meeting part of the additional costs incurred by these institutions in providing services to the Program's target SMI enterprises. 5.10 CENAPRO is the oldest and largest of the spcialized agencies. It was established in the 1960s with the objective of improving efficiency of Mexican firms through appropriate training programs, and offers training programs for personnel of all levels and disciplines in the industrial sector. Under its ARMO program, approximately 25,000 workers have received vocational training in many areas over the last 5 years, and more than 10,000 profes- sionals have thus far been trained through its middle management programs. CENAPRO also offers periodically special courses for senior management. 2/ On-the-job training is an integral part of many of its courses. However, an overwhelming majority of the participants in its courses thus far have been medium and large size enterprises, because the course contents tend to be overly sophisticated relative to the needs of the smaller enterprises, and perhaps also because participants have to bear a large portion of the costs of the courses. As part of the Technical Assistance Subprogram, however, CENAPRO has indicated its readiness to organize courses more suitable to the needs of the managers and workers of SMI firms. It has the necessary experience in developing curricula and organizing courses suited for the special needs of SMI, as may be identified by the extension agents and other Program staff. 5.11 IMIT is a government-supported, but independent institution carrying out research and development work to help improve products and production processes. It is also heavily involved in formulating and evaluating indus- trial projects, and in the course of this work provides advice and assistance to firms on technical, marketing an financial matters. It employs a highly 1/ FIRA is the trust fund administered by Banco de Mexico for providing agricultural credit. 2/ It organized two such courses in cooperation with FOMIN for the top management staff of FOMIN's client enterprises.  - 41 - qualified staff whose cost is recovered from fees charged to its clients, thus far mainly large public and private sector enterprises. IMIT is, however, currently developing a cost- and risk-sharing program whereby it would evaluate the proposed projects of SMI firms in a series of stages so that clients whose projects are found uneconomic at an early stage would not be charged the full cost. This program has promise of allowing IMIT to be of greater assistance to SMI. 5.12 CONACYT, the national body coordinating science and technology policy, has been operating Regional Service Centers ('Centros Regionales') that provide a range of services, primarily to SMI enterprises, in technical matters rele- vant to the most prominent subsectors in each locality. It has already estab- lished three centers--at Oaxaca for food processing industries, at Leon for leather products, and at Guadalajara for jewelry and handicrafts--and is considering proposals to start additional centers at other locations. The centers are partly supported by local governments and industry associations. Technical services provided by the centers typically include laboratory testing facilities for raw materials as well as the finished products, and technical advice and training related to the production process. Program resources would be made available to finance purchases by the Regional Service Centers of laboratory testing and other equipment that enable them to expand their services to SMI enterprises. The proposed Bank loan would cover any direct import content of such equipment. Also, the industrial extension agents would actively promote the services of existing centers and provide feedback on the demand for such centers at new locations. 5.13 INFOTEC is a trust fund of CONACYT administered by NAFINSA. It specializes in searching for technical information to help firms improve their business and is largely supported by fees paid by the firms subscribing to these services. Services provided by INFOTEC include regular visits by its engineers to the plants of the clients to determine their information require- ments, and technical reports covering manufacturing techniques and processes, technological alternatives, suggestions for improvement of product quality, and whereabouts of suppliers of appropriate technologies. INFOTEC also provides a telephone inquiry service (free of charge for enquiries involving up to 2-3 hours of INFOTEC staff's time) to answer quickly enquiries of a technical nature from SMI enterprises, and brings out a news "bulletin" periocdically, abstracting technical information from current foreign and Mexican journals. INFOTEC's clients are mostly small or medium sized. However, its promotional efforts with SMI enterprises have been limited by its location in Mexico City. The extension agents would be able to help in correcting this deficiency by making SMI enterprises outside Mexico City aware of INFOTEC's services. Resources under the Technical Assistance Subprogram would also be available to INFOTEC to meet the costs (for example, for addi- tional equipment, books, etc) of providing technical information suitable for SMI; the directly imported portion of such expenditures would be eligible for financing under the Bank loan. 5.14 The list of potentially cooperating technical assistance institutions mentioned above is not exhaustive. IMCE is considering a special program of suitable promotion activities and dissemination of information to assist SMI enterprises oriented towards exports. With its well-organized regional offices and the system of commercial counselors who could provide specific information regarding exports requirements and prospective customers, IMCE is  - 42 - well equipped to provide such a service. Most of IMCE's activities, however, are likely to be oriented to the medium scale enterprises under the Program. Other private bodies already engaged in industrial extension work, such as CEPSE 1/ and Fundicion Mexicana para el Desarollo may participate in the implementation of the Subprogram, mainly by providing, where necessary, extension services to target enterprises on a subcontracting basis until NAFINSA has trained an adequate number of its own industrial extension staff. Financing of Preinvestment Studies and Technical Assistance 5.15 FONEP, a NAFINSA-administered trust fund, was established in 1967, mainly to finance preinvestment studies of enterprises of all sizes. However, its charter also allows it to finance technical assistance activities, including training of technical staff or hiring consultants. Its financing is on concessionary terms, 10% p.a. in pesos, 3 to 8 years of maturity and up to 2 years of grace. As noted, most of the agencies providing technical assist- ance charge fees to cover most of their costs and this has been an impediment to SMI in obtaining assistance. Under the Program, SMI firms can obtain financing from FONEP to pay for the costs of preinvestment studies and techni- cal assistance whether from one of the aforementioned institutions or from private consultants. Resource Allocation 5.16 About Mex$200 million of Program resources would be tentatively allocated to the Technical Assistance Subprogram. Of this, it is estimated that about Mex$70 million would be required for the initial training and the direct and overhead costs of employing the industrial extension agents 2/ and advisory staff within the Program's Secretariat over 1978-82. About Mex$100 million are expected to be used to finance eligible activities of the cooperating specialized technical assistance institutions and to share the portion of their operating costs that represent subsidies on technical assist- ance to SMI enterprises. An additional Mex$30 million would be provided to FONEP to finance preinvestment studies and technical assistance. The above allocations are tentative and are subject to review during the Program's implementation. Total direct foreign exchange content of the cost of this Subprogram is estimated at about US$2 million. VI. THE OVERALL PROGRAM AND THE PROPOSED BANK LOAN The Size of the Program and of the Bank Loan 6.01 NAFINSA, with assistance from the participating institutions, has estimated that, during the initial 3-year experimental stage, the total financial resources required for the Program involving financial and technical assistance to SMI will amount to just over Mex$2 billion in 1977 pesos (US$91 million equivalent). This estimate is based on conservative judgment regarding (i) the likely demand for financing under the various subprograms; 1/ Centro Empresarial de Perfeccionamiento Socio-Economico, A.C. 2/ Based on estimates of about 20 extension agents in the first year, 30 in the second year and 45 in the third year of Program implementation.  - 43 - (ii) the resources currently available to the executing institutions and their capacities to expand their activities in line with the Program objectives; (iii) an appropriate balance between the amount of resources allocated to the various subprograms; and (iv) the lead time required to bring into full operation some of the newer elements of the Program (e.g. the credit guarantee and 'Leasing schemes). Taking into account contributions by the sponsors to individual subprojects, the total amount of investment in SMI enterprises encouraged and assisted under the Program would amount to almost Mex$3 billion. To help finance the Program, NAFINSA requested a Bank loan of US$47 million, which would be committed over a period of 3 years and disbursed in four years. The table below shows the proposed allocation of Program financing between Subprograms and between the various sources of financing. During the loan negotiations, the Mexican delegation confirmed that the local counterpart resources to complement the Bank Loan will be made available from fiscal resources of the Federal Government or from the Banco de Mexico substantially in the proportions shown in the table below. Allocation of Program Resources (All amounts in millions of constant 1977 Mex$) Private Total Total Sector Program World Govern- Banco Subprogram Investment Financing Financing Bank ment de Mexico 1. Credit and Guarantees 1,656 410 1,246 - Credit 1,646 410 1,236 680 156 400 - Reserve for Guarantee 10 - 10 - 10 - 2. Risk Capital 913 500 413 227 186 3. Industrial Parks 205 - 200 I - Factory Buildings . 185 - 185 102 83 - Common Services 10 - 10 5.5 4.5 - Equipment Leasing 10 - 10 5.5 4.5 4. Technical Assistance 225 25 200 - Extension agents, etc. 75 5 70 70 - - Specialized assistance 120 20 100 45 55 - - FONEP loans 30 - 30 30 - Total constant 1977 Mex$ 2,999 935 2,064 1,065 599 400 US$ equivalentl/ 132.2 41.2 91.0 47.0 26.4 17.6 1/ US$1.00 - Mex$22.7 6.02 The proposed loan of US$47 million would be used to finance about 1,000 subloans, 80 equity investments, construction of about 80 factory build- ings,40 equipment leases and other facilities on industrial estates, and a general program of technical assistance. It would finance about 52% of the total resources made available through the Program during the period and 35%  - 44 - of the total cost of the investments supported through the Program. The terminal date for submission of requests for subproject financing would be June 30, 1981 and the closing date would be June 30, 1982. 6.03 Based on an analysis of samples of subprojects that would be eligible for financing under the Program, drawn principally from the recent experience of FOGAIN, FOMIN and FIDEIN, the overall foreign exchange component of investments as defined in the above table would be approximately 59% of Program financing, i.e., about US$55 million (see Annex 3, Table 21). Thus the proposed Bank loan of US$47 million would cover about 85% of the estimated foreign exchange cost. This would provide sufficient flexibility to allow a reallocation of resources between Subprograms, which may well be required in an experimental program of this nature, without the Bank loan exceeding the Program's overall foreign exchange content. 1/ Disbursement Mechanism 6.04 In view of the large number, relatively small size and varied nature of the individual subprojects, it would be very cumbersome to attempt to determine the foreign exchange content of each individual subproject under the Program. Furthermore, in the case of equity investments by FOMIN, it is difficult to distinguish exactly which subproject expenditures are financed by FOMIN's investment and which by the other shareholders. A standard 55% of the individual subloans or investments made by FOGAIN, FOMIN and FIDEIN under the Program would therefore be financed under the proposed loan. This procedure would also ensure a reasonable Bank participation in their activities and that commitment fees and other charges not be too onerous for any individual trust fund. With regard to the rather few expenditures expected to involve foreign exchange costs under the Technical Assistance Subprogram, the Bank would finance the specific foreign exchange component of the individual investments. The table following shows the expected time distribu- tion of approvals and disbursements of the Bank loan over period of 4 years using this 55% disbursement percentage. 2/ 1/ The foreign exchange content of the underlying investments to be financed varied among the subprograms, and is esimated at 101% of Program financing in the case of the Risk Capital Subprogram, 61% of Program financing for the Credit and Guarantees Subprogram, 12% for the Industrial Estates Subprogram and 23% for Technical Assistance. Accordingly, the overall foreign exchange content of the Program would be rather sensitive to changes in the allocation of resources between Subprograms. 2/ The estimated quarterly disbursement schedule of the Bank loan is shown in Annex 1.  - 45 - APPROVALS AND DISBURSEMENTS (Millions of 1977 Mex$) 1978 1979 1980 1981 1982 Total Disburse- Disburse- Disburse- Disburse- Disburse- Approvals and Subprogrm Approvals ments Approvals ments Approvals ments Approvals ments ments Disbursements Credit 110.0 60.0 225.0 225.0 225.0 225.0 120.0 ' .O 55.0 680.0 Risk Capital :,0.0 22.7 85.0 68.1 92.0 111.5 20.0 24.7 227.0 Industrial Parks 10.0 - 30.0 30.0 43.0 43.0 30.0 30.0 10.0 113.0 Technical Assistance 5.0 - 15.0 15.0 15.0 15.0 10.0 10.0 5.0 45.0 Total 155.0 82.7 355.0 338.1 375.0 394.3 184.0 179.7 70.0 1065.0 Millions of uS$ equivalent 6.8 3.7 15.0 14.9 16.5 17.4- 8.1 7.9 3.1 47.0 Description of the Loan Components 6.05 The Bank loan would initially be allocated among four components as follows: US$30 million for FOGAIN to support the Credit and Guarantees Subprogram; US$10 million for FOMIN to support the Risk Capital Subprogram; US$5 million to be channeled through FIDEIN to implement the Industrial Estates Subprogram; and US$2 million to be used directly by NAFINSA to implement the Technical Assistance Subprogram. However, in view of the experimental nature of the Program, these initital allocations and other related loan features would be reviewed and revised as necessary during the commitment period as agreed between NAFINSA and the Bank. Subloans under each of the above components would be made in accordance with the operating regulations of the respective implementing agencies and would be required to satisfy the eligibility criteria specified for the respective Subprograms. Since a multi-tier approval system of the nature proposed for this project 1/ may involve relatively long processing times, subproject expenditures up to 180 days prior to receipt by the Bank of the financing application would be eligible for Bank financing. 6.06 The specific terms of financing under each of the loan components would be as follows: (a) The credit component of US$30 million would finance 55% of FOGAIN's credits for fixed assets (credits of up to Mex$4.5 million) and associated working capital (credits of up to Mex$3.5 million) for qualifying subprojects. Subloans are expected to have maximum terms of 10 years including 2 years of grace. The average lending rate to the final borrowers on FOGAIN-discounted subloans made prior to January 1, 1979 would be at least 16 percent; thereafter the average lending rates would be 1.0 to 3.0 percentage points above the ACF index calculated by Banco de Mexico and would be reviewed and adjusted if necessary at least once per year to reflect any changes in the ACF index and FOGAIN's financial costs, and whenever the ACF index differs for a period of three consecutive months by 2 percentage points or 1/ Including the Coordinating Committee, the participating trust fund (FOGAIN, FOMIN or FIDEIN), and the intermediary, if any.  - 46 - time of the last adjustment (see para. 2.12). Interest rates to the final borrowers may vary depending on their geographical location to help promote industrial decen- tralization, provided that the average interest rate charged is in the above range (para. 2.12). Margins to the inter- mediaries would be about 3%, but may differ slightly depending on the size of the enterprise to provide additional incentive for the intermediaries for lending to the smaller enterprises (para. 2.09). (b) The equity investments component of US$10 million would finance 55% of FOMIN's equity and equity type investments to support the fixed assets and associated working capital needs of qualifying subprojects. (c) The industrial estates component of US$5 million would finance 55% of (i) direct expenditures by FIDEIN or FIDEIN's credits to the Fideicomisos managing the individual industrial estates for construction (and rental) of single factory buildings or larger buildings that can be subdivided into smaller working areas, and common service centers on the industrial estates; and (ii) FIDEIN's credits to leasing companies for the purchase of equipment to be leased to qualifying SMI enterprises. FIDEIN would relend the funds to the Fideicomisos and the leasing companies at interest rates approximately equal to FOGAIN's interest rates to the intermediaries. 1/ (d) The technical assistance component would finance the direct foreign exchange content of the cost of training the extension agents and the central staff of the Programs Secretariat, and of the equipment needed for specialized technical assistance (para. 5.09). Channelling of the Bank Loan 6.07 A special Program Account would be established in NAFINSA to record the channelling of all Program resources, including reimbursements to the indi- vidual trust funds and other participating institutions for qualifying sub- projects and expenditures, and any debt service payments received from them. Program staff would claim reimbursement from the Bank for the portion of the Program disbursements that is eligible for financing under the Bank loan (para. 6.04). As the Borrower, NAFINSA would make the debt service payments to the Bank. However, it may recover from the respective participating institutions all or part of such debt service payments, depending on the Subprogram. 2/ 1/ The Fideicomisos and the leasing companies in turn wold be expected to set rents and purchase prices of factory buildings at rates that would enable them to fully cover their financial and administrative costs and recover their capital invested (para. 4.21). 2/ The Government intends to reimburse NAFINSA for all debt service payments made by NAFINSA that are not covered by payments into the Program account by FOGAIN, FOMIN and FIDEIN.  - 47 - 6.08 While NAFINSA would have flexibility in fixing the precise details of these channelling arrangements, it has agreed that the Program resources (inc:Luding the proceeds of the Bank loan) would be channelled in pesos to FOGAIN, FOMIN and FIDEIN on terms that reflect the characteristics of their respective financing operations and their resultant repayment capacities, and in any case would at least be as favorable (that is, maturities at least as long and interest rates at most as high) as their respective onlending or investment terms to the final beneficiaries. During loan negotiations, NAFINSA has confirmed that the following principles would be adhered to in designing the channelling arrangements: (i) FOMIN would not be required to pay interest on the amounts of the Bank loan used for its subprojects; (ii) FIDEIN would not be required to pay interest on the amounts of the Bank loan used for its financing operations until such time as it was generating sufficient income, net of operating expenses, from its financing operations to pay such interest; (iii) FOGAIN would pay interest on the amounts of the Bank loan used in its operations, but the levels of such interest charges would be set so as to enable FOGAIN to have a spread between its borrowing and onlending rates adequate to cover its operating costs; (iv) When FOMIN, FIDEIN, and FOGAIN recover the principal amounts of the Bank loan used for individual investment, lending or leasing subprojects, they would be required to repay such amounts to Nacional Financiera for reuse in the Program, or to themselves reuse such amounts for purposes similar to those of the Program. Repayment Terms of the Bank Loan 6.09 A fixed amortization schedule would be used for repayment of the proposed loan because (a) two of the principal implementing agencies of the project, FOMIN and FIDEIN, have, by the nature of their operations, uncertain cash recovery schedules; (b) the large number of subprojects expected 1/ makes it cumbersome for the Bank to use a composite amortization schedule, and (c) NAFINSA, rather than the individual trust funds would be responsible for principal repayments to the Bank. As the vast majority of the subprojects would have maturities of 12 years or less, and they may be approved up to the end of the commitment period, the Bank loan would be repaid over a period of 15 years including 4 years of grace (the expected period to complete dis- bursements). Free Limits 6.10 The Bank's role in the review and approval of subprojects to be financed under the proposed loan would vary among the different Subprograms 1/ About 1,000 subloans, 80 equity investments and 120 leasing subprojects, addition to common service centers and technical assistance subprojects.  - 48 - to reflect the substantial differences in the numbers and characteristics of the subprojects to be financed by FOGAIN, FOMIN and FIDEIN, the experience and capability of the respective institutions in subproject appraisal, and the presence of the technical staff of the Program as each an intermediate screening level between the institution and the Bank. Accordingly, free limits would be set as follows: (a) FOGAIN's subprojects would not require prior Bank approval in view of their large number and relatively small size (average US$50,000 and maximum US$200,000 equivalent), FOGAIN's ample experience, and the need for such subprojects to be approved at 3 levels before being eligible for Bank financing; (b) all equity investments by FOMIN involving more than US$150,000 in Bank financing would be subject to prior review and approval by the Bank (i.e., about one third of FOMIN's investments); (c) prior Bank approval would be required the first five factory leasing subprojects, the first common service center and the first two equipment leasing subprojects to enable close monitoring in the initial stages of the development of the appropriate appraisal procedures within FIDEIN; and (d) all applications to use Bank funds to finance specialized technical assistance would require prior Bank approval. 6.11 In order to enable monitoring and ex-post evaluation of the appraisal procedures and decision making under the Program, the Bank would undertake periodic review, on a past-appraisal basis, a representative sample (about 10-15 percent) of the subprojects not subject to the Bank's prior review and approval and would take up important points during supervision missions. Disbursement, Procurement and Auditing 6.12 Disbursement of the Bank loan would be made for 55% of disbursements made on subloans by FOGAIN, FIDEIN and FOMIN and 100% of foreign expenditures for the Technical Assistance Subprogram (para. 6.04). Disbursement for the subloans, investments and leasing operations would be made against certificates of expenditure issued by the respective trust funds; the detailed documentation evidencing the final expenditures on productive fixed assets or related perman- ent working capital would not be submitted but would be retained by the Borrower and be available for inspection by the Bank during the course of project supervision missions. Disbursement for subprojects financed through FOMIN and FIDEIN would in addition be required to be consistent with a brief description of the subproject, including a list of items financed and an estimated schedule of expenditures and disbursements, which would be required to be submitted to the Bank prior to Bank authorization of the subproject. 1/ Disbursement for the Technical Assistance Subprogram would be made against fully documented foreign exchange expenditures, or for 70% of the domestic price of imported goods when c.i.f. prices cannot be established (tariffs, local taxes, domestic freight and mark-up represent about 30% of the domestic purchase price on average). 6.13 The Borrower would also make satisfactory arrangements for a full audit 2/ of the individual trust funds, as well as of the Program Account 1/ While these disbursements procedures are not the same as those used for normal DFC projects in which the number of subprojects is relatively small, they are similar to the procedures used in other Bank operations involving financing of large numbers of rather small subprojects. 2/ By reputable auditors following accounting principles acceptable to the Bank.  - 49 - to be submitted to the Bank annually (see also para. 3.23). NAFINSA, together with F'OGAIN, FOMIN and FIDEIN would apply suitable procedures either directly or through the intermediaries to ensure that goods and services procured using Program financing are competitive in quality and price, and are appropriate for the needs of the client enterprise. Project Benefits and Risks 6.14 NAFINSA's new Program is complex in design and ambitious in scope, involving many diverse institutions and a large number of components and subcomponents. A key factor for its success is that most of the important institutions are under the administrative supervision of NAFINSA, which has the human resources and institutional capability to carry out the Program. The Program represents an imaginative and sound approach to tackle some of the major deficiencies that have limited the effectiveness of the present system of institutional support for SMI and to enable SMI enterprises to more fully realize their growth potential. 6.15 The proposed loan would support economically and financially viable SMI projects with a significant impact on both output and employment. The underLying subprojects would create 15-18,000 long-term jobs, with the capital investment per job estimated at US$7-10,000; three-quarters of the subprojects financed are expected to involve small enterprises with 25 or less employees. 1/ 6.16 The.project would also achieve major institution-building objectives oriented towards an integrated and balanced development of SMI in Mexico. It would create for the first time the institutional framework and procedures required for a closer coordination and complementarity in the activities of numerous SMI financing and technical assistance institutions in Mexico. In addition, it would help fill gaps in the availability of important services to SMI by promoting needed improvements and new activities in the participating institutions, including: strengthening FOGAIN's internal organization and its evaluation procedures (paras. 2.06 and 2.19); helping FOMIN to further upgrade its portfolio selection and investment sales procedures and to introduce new investment instruments (paras. 3.12, 3.14 and 3.21); developing FIDEIN's role as a specialized financing institution (para. 4.23), particularly in the design and evaluation of schemes for factory and equipment leasing; and creating a new industrial extension service capable of providing direct assistance to SMI enterprises (para. 5.05). 6.17 The major risk to be considered in the implementation of the pro- posed project is that it may not take off as quickly as is hoped since the Program involves many diverse elements and requires the cooperation of many institutions. This makes the effective functioning of the Program's Coor- dinating Committee and its Secretariat the key to the Program's success. However, tile actions already taken and the detailed plans shown in the Project Implementation Document (para. 5.04) suggest that this risk is not high. The only other important risk is a macro-economic one: there is the possi- bility that the Government may not succeed in reducing the rate of inflation 1/ These figures are based on an analysis of subprojects assisted by FOGAIN, FOMIN and FIDEIN during the last few years.  - 50 - as rapidly as expected, thereby causing uncertainties in the investment climate. While this may result in a lower rate of investment in SMI, it is unlikely to reduce demand for Program financing since it would probably be accompanied by a lower rate of domestic resource mobilization by the banking system. VII. RECOMMENDATIONS 7.01 During the loan negotiations, agreements were obtained, or under- standings reached, on: (a) a plan and timetable for completing all the outstanding tasks towards the implementation of each of the Subprograms (para. 5.04); (b) the allocation of the proceeds of the loan among the various components of the project, and arrangements for reviewing such allocation during the loan commitment period (para. 6.05); (c) availability of local counterpart resources of about US$44.0 million from fiscal resources or from Banco de Mexico to complement the resources from the Bank loan in executing the project, and their distribution among the various subprograms (para. 6.01); (d) arrangements for channelling the proceeds of the Bank loan and the counterpart resources to the participating trust funds (para. 6.07); (e) onlending terms including FOGAIN's interest rates to the final beneficiaries and margins to the intermediaries (para. 6.06), and financial criteria to be applied in designing FIDEIN's leasing contracts (para. 4.21); (f) free limits (para. 6.10) and project evaluation procedures (paras. 2.21 and 3.16); (g) satisfactory auditing arrangements for FOGAIN, FOMIN, FIDEIN and the special Program Account (para. 6.13); (h) procedures for disbursement (para. 6.12) and procurement (para. 6.13); and (i) substance of the various institutional improvements required in the operations of FOGAIN, FOMIN and FIDEIN for implemen- tation of the Program (para. 6.16); 7.02 The proposed project constitutes a suitable basis for a Bank loan of US$47.0 million with a term of 15 years including 4 years of grace on conditions outlined in Chapter VI.  ANNEX 1 Estimated Quarterly Disbursement Schedule IBRD Fiscal Year and Quarter Disbursements Cumulative Disbursements (Ending Date) during the at the End Quarter of Quarter (US$ millions) (US$ millions) 1978/79 September 30, 1978 1.5 1.5 December 31, 1978 2.0 3.5 March 31, 1979 3.0 6.5 June :30, 1979 3.5 10.0 1979/80 September 30, 1979 4.0 14.0 December 31, 1979 4.5 18.5 March 31, 1980 4.5 23.0 June 30, 1980 4.5 27.5 1980/81 September 30, 1980 4.5 32.0 December 31, 1980 4.0 36.0 March 31, 1981 3.0 39.0 June 30, 1981- 2.0 41.0 1981/82 September 30, 1981 1.5 42.5 December 31, 1981 1.5 44.0 March 31, 1982 / 1.5 45.5 June 30, 1982- 1.5 47.0 a/ Terminal date for submission of subprojects. b/ Closing Date.  ANNEX 2 Page 1 The ACF Index The average cost of funds to financieras 1/(ACF) is a rate calculated monthly by Banco de Mexico in order to determine how much to pay financieras for required reserves kept with Banco de Mexico. Thus, it is a ready-made indicator of financial costs. It is a weighted average of gross (of tax) interest rates paid on financial bonds and certificates, promissory notes, and the newly-created certificates of deposit, instruments whose maturity varied from sight to one year. The ACF excluded checking accounts, savings deposits and mortgage bonds and certi- ficates issued by commercial banks and mortgage banks even though in practice the latter paid rates approximately equal to rates paid by financieras. Movements in the ACF are determined chiefly by the rates paid on various classes of deposit instruments and changes in the volume of savings attracted by different instruments. Maximum rates that banks can pay on each instrument are set by Banco de Mexico to avoid excessive fluctuations in rates and undesirable large movements in deposits between financial institutions or between instruments with different term characteristics. Nevertheless, through 1972 rates were set high enough to attract substantial real increases in resources and the banking system was growing faster than GDP. During that time, the ACF at around 10% was 5-7 points greater than the inflation (See table below). During 1973-76, the inflationary period leading up to the abandonment of the fixed parity of the peso in relation to the US dollar in September 1976, the ACF rose to near 12Y as deposit rates were raised seve- ral times but never by enough to exceed inflation (except for brief periods). Resource mobilization, consequently, suffered and the financial system shrank when measured in constant prices. The new administration has announced a policy of setting interest rates which, in relation to inflationary expectations, would promote the renewed growth of resource mobilization. The first step in this policy was taken in May 1977 when interest rates on the longest term deposits (2 years) were increased from 15.17% to 18.52% (12.75% to 16% after tax) as a result of which the ACF reached 14.30% in December, 1977. A secondary determinant of changes in the ACF is changes in the relative amounts held in the various instruments. On at least two occasions changes in those relative amounts have importantly affected the ACF. In late 1976, deposit rates were raised but the ACF did not rise because the public, due to general uncertainty, shifted a larger portion of its deposits into financial bonds paying lower rates but withdrawable at sight. On the other hand, the effect on the ACF of the May increase mainly in longer term deposit rates was reinforced by a relative shift from shorter to longer term depo- sit instruments. The increase in deposit rates in May 1977 accompanied by a decline in inflation from 23.0% p.a. in the first semester to 16.4% in the second, has led to an encouraging increase in the volume of peso denominated financial savings. 1/ Financieras are the term lending arms of banking conglomerates, now formally fused with commercial and mortgage banks into multipurpose banking institutions--multibanks. Resources mobilized by the financing divisions continue to be the main source of term loans from multibanks and to be subject to their own regulating regime.  ANNEX 2 Page 2 It is likely that the spread between the ACF and the rate now paid by the borrower is higher today than in 1974 since the scarcity of peso credit intensified following devaluation. However, the rates being paid in May 1977, around 20% p.a. or roughly 8 points above the ACF of 11.93%, at that time, have increased little in the second semester as the ACF climbed to 14.7% in February, 1978, implying a decrease in the spread. If the recent rapid growth in deposits is sustained, there may be no immediate changes in deposit rates and the ACF may remain near its February level. Therefore, in the projections it is assumed that this level of ACF will prevail in the 1978-82 period which would be consistent with the assumption of inflation/gradually declining from 16% to 7% p.a. If, however, progress in controlling inflation were significantly less successful, the monetary authorities could be expected to raise deposit rates producing a further rise in the ACF. It is likely, therefore, that a lending rate set 1 to 3 points above the ACF would be positive in real terms over the life of a subloan, perhaps starting in 1978. There is, of course, no guarantee that deposit rates and the ACF would not again become negative in real terms as they were in 1973- 76, but having had such a clear, recent example of the damage this does to the finan- cial system, the authorities are not likely to controvene their stated policies by permitting this to occur again. Deposit Rates, the ACF and Inflation Inflation during Highest Deposit quarter, annualized Year Quarter Rate ACF rate 1971 1 11.48 10.53 4.9 2 11.11 10.41 3.9 3 11.11 10.30 4.3 4 11.11 10.19 4.2 1972 1 10.60 10.03 7.7 2 10.60 9.97 4.1 3 10.60 9.91 5.8 4 10.60 9.90 4.6 1973 1 10.60 9.87 13.6 2 10.88 9.87 14.6 3 12.71 10.41 29.9 4 12.71 10.65 28.5 1974 1 12.78 10.88 29.9 2 13.74 11.35 13.1 3 14.21 11.57 15.7 4 14.21 11.88 24.5  ANNEX 2 Page 3 Deposit Rates, the ACF and Inflation Inflation during Highest Deposit quarter,annualized Year Quarter Rate ACF rate 1975 1 14.21 11.86 10.4 2 14.21 11.89 16.7 3 14.21 11.91 9.9 4 14.21 11.97 8.3 1976 1 13.91 11.78 21.0 2 13.91 11.76 7.4 3 14.63 11.74 22.8 4 15.17 11.99 64.0 1977 1 15.17 11.99 32.7 2 16.28 12.59 15.4 3 18.52 13.83 21.7. 4 18.52 14.30 13.9  ANNEX 3 SUPPORTING TABLES AND CHARTS   Table 1: INDICATORS OF RESOURCE MOBILIZATION AND CREDIT AVAILABILITY FROM THE MEXICAN BANKING SYSTEM (as at year-end) 1970 1971 1972 1973 1974 1975 1976 (1) Non-monetary peso Liabilities of Banking system a/ Mex$ billions 119.9 139.4 162.5 178.5 208.3 258.4 258.7 as % of GDP 28.6 30.8 31.7 28.8 25.6 25.8 22.0 (2) Total Banking System Credit Outstanding (peso denominated) Mex$ billions 130.1 154.0 173.5 192.5 232.2 .290.8 392.2 as % of GDP 31.1 34.0 33.9 31.1 28.5 29.1 32.1 (3) Banking System Credit to Private Sector Mex$ billions 93.5 109.7 116.4 124.9 153.4 183.2 223.1 as % of (2) 71.8 71.2 17.0 64.9 64.1 63.0 56.9 as % of GDP 22.3 24.2 22.7 20.2 18.9 18.2 18.3 (4) Banking System Credit to Manufacturing Industry Mex$ billions 33.3 38.5 40.0 42.6 55.5 71.2 98,1 as % of (2) 25.4 25.0 23.0 22.1 24.0 24.5 25.0 (5) Banking System Credit to Private Manufacturing Industry Mex$ billions 27.2 31.8 30.2 32.5 42.4 48.7 63.7 as %,of (2) 20.9 20.6 17.4 16.9 18.3 16.7 16.2 a/ The term 'non-monetary liabilities' is used in this context to refer to all liabilities of the banks except checking X accounts and other demand deposits.  Table 2: ANALYSIS OF TOTAL CREDIT AUTHORIZATIONS BY FOGAIN DURING 1976/77 By Amount of Credit (in 'OOOMS) Number of % Amount % By Type of Financing Number of % Amount % (Mex$'000) Credits (Mex$ '000) Credits (Mex$ '000) Up to 50 331 9.1 12.7 0.6 Fixed Assets Loans 1,337 36.6 919.2 39.7 50 to 100 480 13.1 41.7 1.8 100 to 200 583 16.0 96.2 4.2 Working Capital 2,183 59.7 1236.0 53.3 200 to 500 1,125 30.8 415.4 17.9 For debt restructuring 135 3.7 161.3 7.0 500 to 1,000 602 16.4 495.8 21.4 Total 3==5 100.0 e2^=6. 100.0 i,ooo to 2,000 321 8.8 537.5 23.2 2,000 to 5,000 210 5.7 698.3 30.1 By Location 5,000 to 10,000 3 0.1 19.0 0.8 Total 32655 100.0 2=31 66 100.0 Zone 1 1,211 33.2 1,025.4 44.2 Zone 2 245 6.7 179.1 7.8 By Equity Capital of the Enterprise Zone 3 =2=;