Mexico - Third Industrial Equipment Fund (FONEI) Project

Document of FILE Copy The World Bank FOR OFFICIAL USE ONLY Report No. P-2295-ME REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO NACIONAL FINANCIERA, S.A. WITH THE GUARANTEE OF UNITED MEXICAN STATES FOR A THIRD INDUSTRIAL EQUIPMENT FUND (FONEI) PROJECT April 19, 1978 This document has a restricted distribulon and may be used by recipients only In the performance of their official dutdes. Its contents may not otherwlse be disclosed without World Bank authoriztion.  Currency Unit - Peso (Mex$) The fixed exchange rate of US$1 = Mex$12.50 which had prevailed since 1954 was abandoned on September 1, 1976 and the Mexican Peso has been floating since then. The rate of exchange has fluctuated in the range of Mex$22-23 to the US dollar for several months. It was traded at Mex$22.75 per US dollar on March 30, 1978. Fiscal Year January 1 to December 31 Abbreviations and Acronyms ACF = Index of the average cost of borrowed funds to financieras (investment banks); this index stood at 14.9 in March 1978. FOMEX = Fondo de Fomento a las Exportaciones de Productos Manufacturados (Trust Fund for Promotion of Exports of Manufactured Products) FONEI = Fondo de Equipamiento Industrial (Trust Fund for Industrial Equipment) NAFINSA - Nacional Financiera, S.A. PEMEX = Petroleos Mexicanos, S.A.  FOR OFFICIAL USE ONLY MEXICO - THIRD INDUSTRIAL EQUIPMENT FUND (FONEI) PROJECT LOAN AND PROJECT SUMMARY Borrower: Nacional Financiera, S.A. <NAFINSA). Guarantor: United Mexican States. Project Executing Agency: F'ondo de Equipamiento Industrial (FONEI) a Federal Government trust fund managed by the Banco de Mexico. Amount: US$100 million equivalent. Terms: Seventeen years including four years of grace at an interest rate of 7.5 percent per annum. Relending Terms: Industrialists would receive loans in pesos and interest charges would be two points above the index of the average cost of funds to financieras (the ACF index); interest rates would be adjusted every six months to reflect changes in this index. (The ACF index stood at 14.9 in March 1978.) Project Description: FONEI would provide medium and long term financing to industrial enterprises through the commercial banking system to help finance machinery, equipment and other fixed assets for projects which would improve Mexico's balance of payments by increasing exports of goods or services or by substituting imports efficiently. The Bank loan would finance the foreign exchange component of FONEI's financing over a period of about two years. Estimated Cost: US$ million Total cost of subprojects 425 Sources of Financing: US$ million % ]?roject sponsors 133 31.3 Participating intermediaries 67 15.8 Other local or foreign banks 58 13.6 FONEI 167 39.3 of which: Internally generated funds and local borrowing (67) (15.8) Bank loan (100) (23.5) 425 100.0 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  - ii - Disbursements: The loan is expected to be disbursed as follows: (in US$ million) Fiscal Years 1979 1980 1981 1982 Annual 7.6 37.6 38.8 16.0 Cumulative 7.6 45.2 84.0 100.0 Staff Appraisal Report: 1941b-ME of April 11, 1978.  INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT REPORT AND RECOMMENDATION OF THE PRESIDENT To THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO NACIONAL FINANCIERA, S.A. WITH THE GUARANTEE OF UNITED MEXICAN STATES FOR A THIRD INDUSTRIAL EQUIPMENT FUND (FONEI) PROJECT 1. I submit the following report and recommendation on a proposed loan to Nacional Financiera, S.A. (NAFINSA) with the guarantee of United Mexican States for the equivalent of US$100 million to finance the foreign exchange component of the Industrial Equipment Fund's (FONEI's) financing over a period of about two years. The loan would bear interest at 7.5 percent per annum and would have a repayment period of 17 years, including 4 years of grace. Resources would be onlent in pesos at a fully adjustable interest rate two points above the average borrowing rate of financieras. Repayment terms would be of up to 13 years including 3 years of grace. The Government would carry the foreign exchange risk. PART I: THE ECONOMY 1/ 2. Some of the major features of the Mexican economy were analyzed in "An Updating Report on the Economy of Mexico" (1110-ME), distributed to the Executive Directors on March 23, 1976. An economic mission visited Mexico in April-May 1977 and its report is now in preparation. The discussion which follows reflects the preliminary findings of the mission. Past Performance 3. For most of the three decades preceding the mid-seventies, Mexico was outstandingly successful in achieving rapid economic growth while main- taining stability in prices and the balance of payments. From 1940 to 1970, average GDP growth exceeded 6 percent per year in real terms, inflation averaged less than 5 percent per year from the mid-1960s to 1972, and the dollar value of the peso, fixed in 1954, was maintained until the September 1976 devaluation. The Government's role in this achievement was to carry out direct investments in infrastructure and in key industries such as power, steel and petroleum, while creatingta stable regulatory and institutional framework, as well as good profit prospects, to induce private sector growth. 4. This strategy produced rapid growth, but led to a sharpening of contrasts within the Mexican economy. While land redistribution under the reform of 1915 was continued, most of the peasants who received land could not improve their economic status in the absence of basic infrastructure, credit, and technical assistance. Rapid population growth made social equity even more difficult to achieve. Population growth in Mexico accelerated steadily, primarily as a result of reduced death rates, and reached 3.5 1/ Part I is substantially unchanged from the President's Report for the Tourism Development Project (R78-35 of February 16,. 1978).  -2- percent per year by 1970. Despite economic growth, the high demographic growth rate made adequate absorption of the labor force in productive employ- ment difficult. Some 40 percent of the labor force is either relatively unproductive and poorly paid, or openly unemployed. 5. During the 1970s, Mexico experienced increasing public sector deficits, inflation, large balance of payments deficits, capital flight and a marked slowdown in the real rate of growth of GDP, which dropped to 2 percent in 1976-- the lowest annual growth rate experienced by Mexico since the mid-thirties. On September 1, 1976 the authorities abandoned the fixed exchange rate of 12.50 pesos per dollar that had remained unchanged since 1954 and let the peso float; in recent months it has remained rather stable at rates fluctuating between 22 and 23 pesos per dollar. Following the devaluation, Mexico obtained major support from the IMF. In the last quarter of 1976, Mexico was able to draw on the Fund for US$480 million. For 1977-79, an Extended Fund Facility accompanied by a comprehensive three- year stablization program was negotiated which could provide as much as an additional US$861 million once the increase in Fund quotas becomes effective. Thus, total IMF support for the Government's program may exceed US$1.3 billion. The new Government ratified the agreement with the IMF shortly after taking office on December 1, 1976, and to date has complied with the program agreed upon with the IMF. Current Economic Policy 6. The present Government inherited a difficult situation upon taking office on December 1, 1976. High inflation, large public sector deficits, in- creasing foreign indebtedness and lack of confidence in economic management indicated a need for economic stabilization. However, the situation also called for more expansionary policies; economic activity had slowed down, net private investment was virtually nil, and the gap between new job creation and growth of the labor force was increasing. High world prices for petroleum offered profitable investment opportunities in the petroleum sector; indeed, increased production for export of these products seemed by far the best way to meet a large part of Mexico's high debt service requirements in the coming years. 7. Faced with these conflicting needs and opportunities, the Mexican authorities are adopting a mixed strategy aimed at reducing lower-priority public expenditures and increasing public revenues, while proceeding with petroleum and other high-priority investments. The objectives of the Govern- ment's program include progressive control of inflation together with a return to high rates of economic growth by the end of 1978. Better manage- ment of public sector expenditures, more rational pricing and cost control in public sector enterprises, promotion of private savings, limiting wage increases to justifiable levels, and more effective cooperation with the private sector are important parts of the Government's economic strategy. 8. The measures instituted by the new Administration have already produced good results. Inflation in the twelve months of 1977 slowed to 20.7 percent (January-December) as compared to an annual rate of 60 percent in the last three months of 1976. The deficit in the current account of the balance of payments has been reduced, and is estimated preliminarily at  -3- US$2.2 billion for 1977, compared to US$3.5 billion in 1976. Total public sector financial requirements dropped from 10.3 percent of GDP in 1976 to 7.9 percent in 1977. Mobilization of savings by the banking system is increasing. Perhaps most importantly, there is a general feeling of increased confidence in the Government's economic policy. 9. The stabilization effort during 1977 was necessary, but its price has been the continuation of economic stagnation; for a second year in a row GDP grew only by about 2 percent in real terms, implying a further decline of real per capita income. While control of inflation will remain as the overriding short-term objective--the Government's announced target is to reduce inflation to about 12-15 percent during 1978--the 1978 economic program aims at a simultaneous recovery of economic activity through a recovery of private and public investment. Increased public sector savings, further strengthening of the financial system and therefore in- creased availability of credit to the private sector, and continuation of a carefully managed wage policy (the annual increase in minimum wages agreed upon in January 1978 averaged about 14 percent) are the main means the Government will rely upon to attain the above objectives. Economic Issues and Prospects 10. As Mexico looks ahead, the key problems that its economic policies must address would seem to include the following: (a) Many Mexican families have not participated in the sustained economic growth of the last several decades. As of 1975, about 4,600,000 Mexican families--45 percent of the total-- receive incomes equal to less than one-half the national average. The members of most of these families work--more than half of them in agriculture--but they produce little and receive little. Mexico's labor force is now growing even more rapidLy than in the past--it will grow at about 3.6 percent per year over the next decade, which implies an average annual Lncrease by some 670,000 workers during 1978-82; during the 1960s the growth rate was 2.7 percent per year. The challenge of providing productive jobs for both new entrants and existing under-productive workers is an awesome one. (b) Crop and livestock production in Mexico, which had grown by 6 percent per year during 1945-55 and 4.2 percent per year during 1955-65, grew at only 2.1 percent per year during 1965-75. This near-stagnation of agricultural production signals the end of the strategy in which growth of agricul- tural production came from newly irrigated land, while rain- fed agriculture was relatively neglected. The continued expansion of large-scale irrigation, so successful from 1945 into the 1960s, has brought lower and lower returns as the works became costlier and easily accessible export markets for high-value crops became more nearly saturated. New approaches are required now to assure both production growth, and increases in income for Mexico's poor rural families.  (c) The size and role of the State in the economy has been a subject of much discussion in Mexico in recent years. During 1970-76, private investment slowed down, and virtually stagnated since 1975. This was, in part, a consequence of the pre-emption of credit by the public sector (during the six-year period, the share of the public sector in the economy grew from 15.0 to 21.5 percent), combined with infla- tionary financing and accompanied by what some perceived as an "anti-business" attitude. Public statements by the present Administration indicate that it wants to reverse this trend. (d) The present large foreign debt and sizable public finance deficit are mainly the direct outcomes of past public sector inability to mobilize adequate financial resources. By the early 1980s, large increases in export revenues, mainly from petroleum and related products, should make both the foreign debt problem and public finances much easier to manage. In the meantime, however, larger public sector savings are required to reduce inflationary pressures and to release credit for the private sector. (e) The rapid growth and heavy concentrations of people and production in Mexico City, and the scarcity of employment opportunities and services in rural areas, are important challenges which have to be confronted. Both equity and efficiency considerations imply a need for diversion of some of Mexico City's future growth to other regions, as well as the provision of basic public services and enhanced employment opportunities in selected villages and small towns. 11. In the medium term the prospects for resumption of economic growth with relative price stability are good. Poverty will remain a problem but the Government is taking steps to address it. The alleviation of the external constraint on growth brought about by the expected petroleum earnings (para. 14), together with the Government's efforts to increase public sector savings and to stimulate private investment could produce economic growth of 7 to 8 percent per year in the remaining five years of the present Administration. Resumption of economic growth combined,with the intensification of the Government's family planning program (on October 28, 1977 President Lopez Portillo announced the ambitious goal of reducing the population growth to 2.5 percent per year by 1982, then progressively to 1.8 percent by 1988, 1.3 percent by 1994, and 1 percent by the year 2000), the new emphasis on rainfed agriculture, and the implementation of specific programs aimed at increasing productive employment should help to address the structural problems mentioned above. 12. In agriculture, the Government's quick action to defuse tensions created by land invasions and expropriations at the end of 1976, and its decision to review the legislation concerning land and water use, should reduce uncertainty and induce a better use of the available land and water resources. In addition, the new emphasis on rainfed agriculture--which had  - 5 - been relatively neglected in the past--should lead to an increase in the production potential of vast areas currently under-exploited and to a reversal of the past trend towards larger income disparities between the modern and traditional agricultural subsectors. Development of intensive agriculture in the tropics and of a nationwide program to construct tropical small irrigation and drainage works are also new features of the Government's agricultural policy. These initiatives, together with the more realistic exchange rate and remunerative support prices, promise a resumption of growth of production for both domestic and export markets and increase the possibilities of an improvement in the living conditions of the rural poor. 13. Industry has potential for considerable growth in many sectors, including efficient import substitution in chemicals, petrochemicals and capital goods as well as exports of many different manufactured products. Increases in tourism export earnings are also expected. 14. Among the benefits of recent public sector investments are the new possibilities opened to the Mexican economy through the recent discover- ies of rich petroleum fields. The Government has decided to use these large hydrocarbon resources to help manage Mexico's heavy debt service burden and to enhance the country's over-all development prospects. To meet this objective, PEMEX (Petroleos Mexicanos, the State-owned oil monopoly) has launched an ambitious six-year investment program amounting to US$17.0 billion in 1977 prices (about 25 percent of total public investment). This program would: (a) almost triple the production of oil and condensates, from 292 million bbl/yeaLr in 1976 to 818 million bbl/year in 1982; (b) more than double the country's primary distillation capacity, from 270 million bbl/year in 1976 to 577 million bbl/year in 1982; (c) substantially increase production of primary petrochemicals (ammonia, ethylene, benzene, etc.) as well as downstream products (styrene, vinyl-chloride, polyethylene); and (d) enable export of natural gas at a rate of 2.0 billion cubic feet/day by 1982. Under this program, the value of exports of oil and related products would increase over ten times, from about US$0.9 billion in 1977 to more than US$10.0 billion in 1982. If this program were to be carried out on schedule, and incentives maintained for non-petroleum exports, the balance of payments on current account would shift from a deficit of US$2.1 billion in 1977 to a surplus of about US$3.0 billion in 1982. 15. The prospect oE rapidly rising petroleum exports, as well as pre- viously mentioned prospects for increases in tourism earnings, recovery of agricultural production and exports, and resumption of growth of manufactured exports, have greatly strengthened the balance of payments outlook. Even on the basis of somewhat more conservative projections of petroleum production and exports than those m,entioned above, the current account deficit can be expected to decline steadily over the next several years and become slightly  -6- positive by 1982, thus reducing Mexico's external borrowing requirements (Annex I). Mexico's debt service ratio has been increasing over the recent past and reached 46 percent in 1977. This comparatively high debt service ratio is more a reflection of the low level of exports relative to GNP and the high proportion of Mexican borrowing from commercial banks than it is an indication of a high level of external debt relative to the size of the economy. When middle income developing countries are ranked by the ratio of external public debt to GNP, Mexico appears about average. The debt service ratio is expected to peak at slightly over 50 percent in 1979 and, mainly as a result of the rapid expansion of petroleum exports, then decline sharply to levels of around 30 percent in the early 1980's. Debt service on Bank loans amounts to about 4 percent of public debt service; this ratio is projected to decrease over the next two years and to increase to some extent afterwards. The Bank currently holds about 8 percent of Mexico's total medium and long term public debt, and this ratio is likely to increase to some extent over the next few years. Mexico remains creditworthy for borrowing on conventional terms considering the country's strong medium-and long-term potential and the comprehensive economic strategy which the Government has adopted to realize it. PART II - BANK GROUP OPERATIONS IN MEXICO 1/ Bank Operations 16. As of February 28, 1978, Mexico had received 50 loans from the Bank amounting to US$2,624.4 million net of cancellations and terminations; of these, 33 loans totalling US$1,486.4 million were fully disbursed. As of February 28, 1978, the Bank held US$2,142.2 million of which US$787.2 million had not yet been disbursed. Some 35 percent of Bank lending has been for agriculture and rural development (15 loans for US$923.4 million), 27 percent for power (12 loans for US$704.8 million) and 21 percent for transportation projects (12 loans for US$546.7 million); the remaining 17 percent has been for industry (US$205.5 million), water supply (US$130 million) and tourism (US$114 million) projects. Mexico is carrying out a stabilization program and because of scarcity of counterpart funds, some projects fell behind schedule in 1976 and 1977. Following review with the Government, a steel loan was terminated (Sec M77-258 of April 5, 1977), the scope of an irrigation project was reduced and US$100 million from the original US$150 million loan were cancelled (R77-305 of December 13, 1977) and the scope of several other projects has been modified. Other projects under implementation and affected by the stabilization program are being reviewed by the Government and further discussions will be held with the Bank shortly. By and large, adequate budget support for the ongoing projects has now been secured. Annex II contains a summary statement of Bank loans as of February 28, 1978 and notes on the execution of ongoing projects. IFC Operations 17. As of February 28, 1978, IFC has made 13 investment commitments in Mexico, for a total of US$69.5 million, of which US$38.3 million had been sold, 1/ Part II is substantially unchanged from the President's Report for the Tourism Development Project (R78-35 of February 16, 1978).  -7- repaid or cancelled. The balance held by the Corporation, US$31.2 million, consists of US$26.2 million in loans and US$5.0 million in equity. A summary statement of IFC investments as of February 28, 1978 is presented in Annex II. Bank Strategy 18. The main objectives of Bank lending in Mexico have been to: (i) support policies and programs leading to a wider distribution of the benefits of econo- mic growth; (ii) strengthen policies and programs leading to continued economic growth by helping to finance projects that are to make directly or indirectly significant contributions to output, exports, and employment; and (iii) help resolve critical adjustment problems that Mexico is currently facing. The Bank is preferentially supporting projects that make relatively modest demands on budgetary resources and have a strong positive balance of payments effect, projects of high social priority that help the rural or urban poor, projects that promote higher levels of employment and those that help to decentralize economic activity. The project under consideration meets the first two of these criteria and in addition is expected to have a significant employment impact. 19. In view of the difficult structural problems of Mexico's agriculture and the sector's crucial importance to the country's further development, the Bank has made agriculture the leading sector for its lending. Consistent with the overall framework of country and sector objectives, a three-tier approach has been developed. First, to strengthen infrastructure development and agri- cultural credit programs so as to meet the demands of a rapidly growing popula- tion more adequately and to generate the foreign exchange needed for rising import requirements. Second, to raise the incomes of the rural poor and improve their standards of living through a combination of directly productive, support and social infrastructure investments. Third, to strengthen Mexico's institutional capability to use scarce agricultural resources more efficiently. In support of this strategy, the Bank has made seven loans over the past four years, totalling US$579 million, for irrigation, rural development and agri- cultural and livestock credit programs. In FY77, the Executive Directors approved a US$120 million loan for an Integrated Rural Development Project-- PIDER II--under which some 46,000 poor farm families will benefit from directly productive activities. This fiscal year, an agricultural develop- ment project focusing on the humid tropics was recently approved by the Executive Directors and an agriculture credit project has been appraised and will be submitted to the Executive Directors in the coming weeks. 20. Bank lending for industry has been aimed at assisting the Govern- ment's efforts to reduce the balance of payments deficit and decentralize industrial activities away from the major (and increasingly congested) urban areas. Thus, a major steel project which the Bank helped finance has recently started operating in a previously underdeveloped area on the west coast of Mexico and the Executive Directors approved a US$50 million loan in FY75 to support a fertilizer project which promotes new poles of development in the resource-rich southeast region and the north central area. A small- and medium-scale industry development project was recently approved by the Executive Director and a fertilizer project is currently being processed for submission to the Executive Directors in the coming months. 21. As regards infrastructure, the Bank's operations have been focused on investments in key areas of the country as well as on institutional reforms and sector policies aiming, inter alia, at suitable pricing mechanisms to  - 8 - help generate additional resources for investment financing: the Airports Development Project (FY74) was designed to support the Government's policy of regional integration; the Third Railway Project (FY76) supported improve- ments of institutional aspects and financial management of the sector. The Mexico City Water Supply Project (FY73) has been instrumental in the estab- lishment of a specialized institution for efficient supply of bulk drinking water in the Mexico Valley, and in the pricing of water at levels more closely related to costs. 22. The Government and the Bank have long recognized the regional economic disparities prevailing in Mexico. In June 1976 the Government adopted the Law of Human Settlements to provide a new institutional framework to deal with the pressing problems of over concentration of economic activi- ties in the larger metropolitan areas, and several projects are now being prepared to meet the needs for basic urban services for poor families in selected priority cities. A project to assist in the development of the conurbation zone of Lazaro Cardenas was recently approved by the Executive Directors. 23. The Government, pressed to reduce the external deficit on current account, is giving emphasis to the tourism sector to generate higher foreign exchange earnings and promote employment. In support of this policy, the Bank has granted three loans for tourism projects in Mexico; two to provide infra- structure in new poles of tourism and one, approved by the Executive Directors this year, to help finance tourism superstructure. PART III - THE INDUSTRIAL SECTOR Background 24. Over the last decades, manufacturing has grown rapidly in Mexico and has played an important role in providing employment opportunities. 1/ It directly employed about one quarter of the new entrants to the labor force between 1950 and 1969. In 1970, manufacturing accounted for approximately 23 percent of gross domestic product, directly employed 17 percent of the labor force and probably provided indirect employment through related activi- ties to a similar proportion. Growth in the volume of manufacturing sector output was 9 percent per year during the 1960s, considerably more rapid than the 7 percent per year growth in gross domestic product. This impressive performance was fostered by a large and active class of entrepreneurs, a comparatively large and growing domestic market, favorable government policies and the availability of investment financing. During 1970-1975 manufacturing growth slowed somewhat to 6.2 percent per year, but was still above the annual GDP growth rate of 5.7 percent. Development of the sector has followed a pattern common to several other large industrializing countries, with import 1/ A full review of the industrial sector of Mexico may be found in "Mexico: Manufacturing Sector - Situation, Prospects and Policies" Dated May 1, 1977, Report No. 1671-ME.  - 9 - substitution almost complete in consumer goods, and to a lesser extent in intermediate goods. However, development of the capital goods sector is less advanced in Mexico than in comparable countries. 25. Manufacturing is highly concentrated. The Federal District and the surrounding State of Mexico accounted for 52 percent of all manufacturing production in 1975; Nuevo Leon and Jalisco, the states where Monterrey and Guadalajara are located, had 9.7 and 5.2 percent respectively, with none of the remaining 29 states having more than 4 percent of the national total. This concentration is not unusual in industrializing countries because, during the initial phases, the necessary support services to entrepreneurs are available mostly in the main cities. Nevertheless, the extent of concentra- tion is already presenting serious difficulties, particularly in Mexico City where problems of transport, water supply, and air pollution are becoming increasingly difficult t:o resolve. The Government has adopted policies to encourage decentralizatiLon of future industrial development away from Mexico City, including higher rates for services such as water supply in the Federal District. 26. Public enterprises, firms owned by domestic entrepreneurs and foreign- owned companies co-exist: in Mexico. The public sector's stake in industry increased rapidly during the 1970s; public investment in manufacturing increased from 20 percent of totaL industrial investment in 1971 to 59 percent in 1974, while the private domestic sector's share in new investment declined. Because of the private sector's hesitancy during the latter years, and because of in- creasingly scarce credit, this period was atypical. At the same time, the Government invested substantial resources in a few key industries such as steel, petroleum, chemicals and fertilizers to assure domestic sources of supply at low prices so as to infLuence production costs in industries which depended on these inputs. Foreign owned enterprises have made an important contribution to industrial production and expansion in Mexico and have been instrumental in transferring technology. Despite regulation of foreign ownership and of payments for foreign technology, patents and trademarks introduced in 1973, foreign private investment remained buoyant from 1973 to 1975. In 1976 and 1977 the pace of both domestic and foreign investment slackened because of recessionary conditions and the uncertainties caused by the peso devaluation, but the investment climate has now improved significantly. Protection 27. Mexico's industrialization strategy has emphasized import substitu- tion, and protection for local manufacturing remains an important feature of industrial policy. Protection was given both by tariffs and, more importantly, by quantitative restrictions. Although some tariffs are as high as 100 per- cent, most lie in the 10-30 percent range. Moreover, tariffs have been subject to numerous exceptions, especially for imports of capital goods. Quantitative restrictions on the other hand became more widespread as the process of import substitution progressed. However, levels of realized protection have not been excessive for most products, and the industrial sector has developed with reasonable efficiency. With import substitution almost complete in many industrial subsectors, government policy is now encouraging improvement in  - 10 - efficiency in those subsectors where prices are still above international levels, and in areas where there are significant opportunities for further import substitution such as the mechanical engineering, capital goods and basic and secondary chemicals. The trend towards stricter import licensing was reversed in 1977. To promote increased efficiency of manufacturing industry, licensing requirements are being relaxed and tariffs are being rationalized. Exports 28. Since 1970, increased emphasis has been given to promoting manufac- tured exports. Export incentives were introduced in 1971 and included rebates of indirect taxes, duty exemptions on imported inputs and increased credit to finance export sales. These measures resulted in manufactured exports growing at 39 percent annually in dollar terms between 1970 and 1974, compared to 12 percent annually in the previous five years. Excluding exports by border assembly industries, manufactured exports reached $1.2 billion in 1974, or 20 percent of total goods and service exports. During 1975 and 1976, the world recession and the increasing over-valuation of the peso led to a decline in manufactured exports measured in constant prices, but with the devaluation in late 1976 and the economic recovery that is now starting manufactured export performance should improve noticeably. The Government has successfully avoided an acceleration of inflation following the large devalua- tion in 1976, and moderate cost increments as well as adjustments in the exchange rate since then have enabled most exporting firms to remain competi- tive. The bulk of exports come from large firms, though in some sectors such as food, apparel and footwear, a significant proportion is produced by medium sized firms. Increasing attention is being given to the role of industrial associations and trading companies in promoting exports by smaller companies. Industrial Financing 29. Mexico's well developed banking system, comprising more than 200 public, private and mixed ownership institutions, has been the primary source of financing for industry. Commercial banks and investment banks (financieras) make industrial loans and investments primarily from resources they mobilize in the private sector via current accounts, deposits, and the issue of certificates and bonds, but they also have access to discounting facilities with public sector trust funds. During the late 1960s and early 1970s, the banking system developed rapidly and the volume of outstanding credit grew faster than GDP. Mexico's open financial system allowed a free flow of capital, and the long period of exchange stability encouraged foreign deposits in Mexican banks and foreign borrowings by Mexican firms. Credit was readily obtained by industrial firms judged to be a reasonable credit risk. Nevertheless, certain structural weaknesses were apparent by the early 1970s. One was an excessive conserva- tism in credit allocation. Guarantees substantially in excess of the legal minimum (133 percent of credit granted) were required, and even credit for projects requiring term financing was decided primarily on the basis of the collaterals offered, rather than on the basis of appraisals of the merits and income earning characteristics of investment projects. The excessively short-term structure of the banking system's non-monetary liabilities resulted from insufficient interest rate premiums to savers for longer term deposits. This limited the amount of longer term financing that banks could provide.  - 11 - 30. To improve the amount and nature of credit available to industry, the financial authorities developed a system of trust funds, which provide partial financing to banks for term loans for projects meeting eligibility requirements. Trust funds are in two groups; Nacional Financiera S.A. administers three which are designed to support the development of small and medium scale industry, while the Banco de Mexico administers two other closely related trust funds: Fondo de Equipamiento Industrial (FONEI) and Fondo de Fomento a las Exportaciones de Productos Manufacturados (FOMEX). FONEI provides medium and long term financing for investment projects designed to increase exports or efficiently substitute imports, and FOMEX provides shorter term export sales financing and has recently been given additional resources to finance the sale of domestic capital goods to Mexican buyers. FONEI, which has received two previous Bank loans, will be the executing agency for the proposed project. A Bank loan to assist small and medium industry through the aforementioned trust funds administered by Nacional Financiera was recently approved by the Executive Directors. 31. Since 1973, increased inflation and tighter control of credit expansion and interest rates have slowed down the growth of the financial system and reduced credit availability, particularly longer-term credit. An insufficient differential between domestic and foreign interest rates, together with growing exchange rate uncertainty led to a fall in the volume of resources mobilized by the banking system. Excluding demand deposits, the value of peso denominated s,avings captured by banks declined as a propor- tion of GDP from 32 percent: in 1972 to 22 percent in 1976 while the deepening public sector deficit further reduced credit available to the private sector, which fell from 23 percent of GDP in 1972 to 18 percent in 1976. As their resources declined, banks reduced the average maturity of credit so that by 1976 few loans with terms of more than 5 years were being granted except with trust fund resources. The 1976 peso devaluation accentuated the problems of credit scarcity; in the months before and after the devaluation financial savings contracted sharply and capital flight accelerated, while the larger companies, which previously relied on borrowings from foreign commercial sources, suffered heavy losses due to the devaluation and started to rely increasingly on domestic borrowings. 32. To boost savings and reverse capital flight, investment banks and mortgage banks were authorized to offer higher interest rates to savers in May 1977. This has had a positive impact on the volume of savings captured by banks. The Mexican authorities have declared their intention of allowing further adjustment in rates so as to make a healthy growth of financial savings possible. 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 increased uncertainties about the future cost of funds. Most banks are now relating their interest rates to the index of the average cost of funds borrowed by the financieras (the ACF index), which is calculated monthly by the Banco de Mexico. Between May 1977 and March 1978 this index has increased from 11.9 percent to 14.9 percent in response to the increased interest rates paid to savers. Changes have also been made in the on-lending rates of the trust funds, several of which are now relating their rates to the ACF Index.  - 12 - Industrial Employment and Expansion Prospects 33. While the administration concentrates its efforts on restoring economic stability in the short term, priority is being given in the medium term to regaining a rapid rate of industrial growth in order to increase employment, reduce the trade deficit and stimulate growth in other sectors. The Government has indicated that emphasis is to be placed on taking advant- age of remaining opportunities for efficient import substitution, diversifying and expanding manufactured exports, and promoting more rapid development of industrial and related activities outside the present areas of geographic concentration. In agreements signed with groups of industrial enterprises 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 reaffirmed the Government's commitment to create an environment favorable to the development of private initiative, complemented by public enterprise. 34. The Government appears firmly committed to a policy of increasing employment opportunities, particularly in urban areas, through an expansion of industrial activity. In view of the success achieved by the new administration during 1977 in stabilizing the economy and restoring private sector confidence, and considering the favorable industrial policies being followed by this admin- istration, prospects appear good for industry to regain by the early 1980s the high rates of growth achieved in 1960s. Industrial output is expected to grow as rising petroleum output and exports reduce the foreign exchange constraint and stimulate the economy. There are substantial opportunities for growth in a number of industrial subsectors. Given the Government's policy of improving efficiency by liberalizing the import licensing system and ration- alizing tariffs, and the large demand for machinery and equipment resulting from the expansion of the petroleum industry and basic and secondary petro- chemicals, the capital goods industry is presented with an excellent oppor- tunity to expand. Mexican industry also has an excellent opportunity to continue building on the successful export performance of the early 1970s and to substantially expand the volume and range of goods exported, provided the Government continues its present policies of maintaining a realistic ex- change rate and improving industrial efficiency. The proposed project is oriented towards partially filling the financing needs of export and efficient import substitution projects that are also expected to have substantial employ- ment impact. PART IV - THE PROJECT Background 35. The proposed loan's main objectives are to (a) support the Govern- ment's efforts to stimulate an increased level of industrial investment, (b) improve Mexico's balance of payments through providing term credit to industrial projects that lead to exports or substitute imports efficiently, and (c) promote industrial efficiency by encouraging industrial enterprises to prepare detailed  - 13 - feasibility studies of their projects and banks to base their lending decisions on a careful appraisal of the projects. A brief project description may be found in the Loan and Project Summary at the beginning of this report. The staff appraisal report (No, 1941b-ME dated April 11, 1978) entitled "Third Industrial Equipment Fund (FONEI) Project" is being distributed separately to the Executive Directors. 'Che project was appraised in November 1977 and negotiations for the Loan took place in Washington in April 1978. The Mexican negotiating team was headed by Mr. Fernando Torres, representing NAFINSA as financial agent for the Government, and included Mr. Villase'nor, Director of FONEI. 36. The Bank participated actively with the Government in establishing FONEI in 1971 as a trust fand of the Federal Government administered by Banco de Mexico, designed to reinforce Mexico's balance of payments by providing term financing, through commercial and investment banks, to enterprises to produce industrial goods and services for export markets or to substitute imports efficiently. To support these objectives the Bank made a US$35 million loan to FONEI in 1972 which is now fully disbursed. FONEI also received a capital contribution equivalent to US$10 million from the Government and the equivalent of about US$30 million in the form of renewable medium term borrowings from the Banco de Mexico. The Bank made a second loan to FONEI in January 1976 for US$50 million. In spite of the industrial recession expe- rienced in Mexico over the past two years, this loan as well as the counterpart local resources of about US$40 million equivalent are now fully committed, slightly ahead of schedule. The Institution 37. FONEI's Operating Regulations indicate how it seeks to pursue its objectives. It partially rediscounts loans granted by credit institutions to finance productive fixed assets. Preference is given to export projects but import substitution projects are also financed provided they are efficient and also have reasonable prospects of producing for export in the medium-term. In order to ensure efficiency, FONEI insists on economic and financial tests in appraising its projects. The minimum amount of financing provided by FONEI for a single investment project is Mex$ 4.5 million (about US$200,000 dollars equivalent), and the maximum is Mex$ 100 million (US$4.4 million equivalent), though in exceptional cases FONEI can approve financing in excess of the maximum limit for projects in priority sectors. Within the above limits, FONEI's financing may cover up to 6t percent of the fixed assets costs for projects involving new productive capacity, and 72 percent of such costs for those involving expansions of existing capacity. The final borrower has to finance from its own resources at least 25 percent of the fixed assets cost in the case of new projects and 20 percent for expansion projects, with intermediaries and other banks financing the balance of the cost of assets. FONEI subloans may be made for a term of up to 13 years with a grace period of up to 3 years. Assurances, have been obtained that the Bank will be consulted when changes are made in FONEI's Operating Regulations (Section 2.01(c) of the draft Project Agreement). 38. As of October 31, 1977 -- the time of appraisal -- FONEI had approved 91 subloans totalling Mex.$ 2.5 billion. Analysis of these operations confirms that FONEI has financed economically sound projects that will have a positive  - 14 - impact on the balance of payments. A majority have been export projects, or combined export and import substitution projects. FONEI has supported mainly medium sized and larger industrial firms, since the bulk of Mexican exports come from such firms and because other institutional mechanisms are available for supporting the smaller industrial enterprises (see para 30). Approximately 45 percent of FONEI's credit has gone to new firms and a significant proportion of the remainder has gone to established firms with new product lines. The industrial activities benefitting most from FONEI operations have been mecha- nical and electrical engineering (51 percent of total financing) and chemical products (25 percent). When fully operational, subprojects financed by FONEI in the past are expected to export goods worth US$180 million equivalent and substitute about US$440 million of imports each year. They are also projected to create about 11,000 new jobs at an average cost of about US$26,000 per job. FONEI has also been quite successful in encouraging decentralization of industrial investments, with nearly 80 percent of its financing going to enterprises outside Mexico City. On average, projects financed by FONEI in the past are estimated to yield financial and economic rates of return of 20 percent and 29 percent respectively. 39. FONEI's Board ("Technical Committee") which is responsible for the formulation of policy and approval of loans, is composed of ten members, including high level officials of the various economic ministeries, Nacional Financiera, Banco de Mexico and the chambers of commerce and industry. FONEI is headed by capable managers who are supported by a qualified and motivated professional staff. Following the change of Administration in late 1976, FONEI experienced a substantial turnover in its professional staff, especially in the Technical Department. However, it has now overcome these difficulties and has recently streamlined its organizational structure. In order to meet the expected expansion in its level of operations, FONEI is planning to increase the number of its professional staff over the next few years. 40. FONEI's financial position is sound. Since it is a second tier financial institution discounting loans to established banks, its credit risks are minimal. By assuming the responsibility for repayment of the previous Bank loans from budgetary resources, the Government has made satis- factory arrangements for gradual capitalization of FONEI as the latter's operations grow. FONEI is responsible, however, for paying the interest and other charges on Bank loans. While FONEI achieved modest profits each year until 1975, it incurred losses in both 1976 and 1977, mainly as a result of the peso devaluation; since almost all of FONEI's outstanding subloans carried fixed interest rates denominated in pesos, FONEI's spread was reduced drastically. This adverse trend is expected to be reversed with FONEI's adoption of fully floating interest rates for subloans; FONEI is expected to be profitable again from 1978 on. Subproject Appraisal and Supervision 41. Since few banks have adequate technical staff to carry out detailed project appraisals, and since it would not be feasible for FONEI to employ a large technical staff including specialists in diverse subsectors, FONEI has  - 15 - used outside consultants to appraise subprojects. The quality of appraisals is generally good, and finaincial, marketing, technical and economic aspects of subprojects are coverec adequately. FONEI has attempted to involve partici- pating intermediaries n lore closely in the appraisal process and to encourage them to make their lending decisions on the basis of project appraisals rather than relying primarily on collaterals for security. However, the relatively long time taken for appraisal has limited FONEI's success in this endeavour. FONEI has recently taken several measures to streamline appraisal procedures and manage the work of consultants more closely; this has reduced FONEI's total project processing time over the past two years. FONEI is continuing its efforts to further reduce the time required to process projects, and has reaffirmed its willingness to reimburse intermediaries for the costs of appraisals carried out by them directly or through outside consultants. 42. FONEI's project supervision activities slackened somewhat during the last two years due to the rapid growth in its portfolio and the resulting heavy work load on its technical staff. FONEI has recently taken steps to correct this through the creation of the new Supervision Department and by increasing its technical staff. FONEI also intends to increase the direct involvement of intermediaries in supervision activities. Future Development of FONEL 43. FONEI has stepped up its promotional activities over the last two years in order to achieve a better geographical distribution of its clientele and to increase the proportion of loans to medium-sized enterprises. In spite of the generally cautious attitude towards investment, FONEI's loan commitments grew substantially in both 1976 and 1977. In total, 28 banks have participated as intermediaries in FONEI's operations to date. More recently, the recovery in industrial investment has resulted in a substantial increase in requests for FONEI financing. 44. While FONEI's primary focus is on projects designed to increase the production of manufactured goods, the Government has recently requested FONEI to assist selected projects designed to expand exports of services from Mexico's northern border zone. Accordingly, FONEI is examining the possibility of financing, on an experimental basis, mainly three types of service exports projects in the northern border areas: (i) the construction of factory buildings for lease to industries, some of which would be owned by foreign companies which are not permitted under Mexican Law to own real estate in the border areas. Such companies frequently wish to take advantage of the relatively low labor cost and other incentives available in Mexico; (ii) con- struction of large scale commercial centers designed to sell Mexican goods to visitors from across the border, and (iii) facilities for enterprises such as automobile repair centers that can sell services to visitors. FONEI is in the process of developing detailed criteria for the selection and evalua- tion of these service export projects. 45. FONEI expects demand for its resources to rise rapidly over the next two years as industrial investment recovers and as a result of FONEI's promotional efforts. Based on estimates of likely demand, FONEI would require additional resourc:es of about US$145 million equivalent to meet expected commitments over the next two years. The proposed US$100 million  - 16 - loan would cover the foreign exchange component of FONEI's financing over these two years. The Bank of Mexico would provide counterpart resources of about US$45 million equivalent to enable FONEI to carry out the project. 46. The principal amount of the proposed loan would remain in FONEI as equity and FONEI would be charged interest and other charges on the Bank loan only. The Government will carry the foreign exchange risk on the principal amount and FONEI would carry the risk on interest and other charges (Section 3.01(b) of the draft Loan Agreement). The proposed loan would be repaid to the Bank on the basis of a fixed amortization schedule of 17 years including 4 years of grace; no link is called for between the amortization schedule of the Bank loan and the composite of the amortization schedule of FONEI's subloans since the Government would provide NAFINSA with the funds required to repay the principal of the loan. On-Lending Terms and Conditions 47. For the Second Bank loan, FONEI agreed to adopt an interest rate structure to reflect better the trends in interest rates being charged by banks on term loans made with their own resources. FONEI's interest rate to final borrowers was linked to the ACF Index, which is considered a realistic measure of the cost of domestic resources (para 32). Final borrowers were offered the option of either a fixed interest rate, equal to the FONEI's interest rate prevailing at the time of signing the subloan, or a floating rate adjustable every six months to match FONEI's prevailing interest rate. Reflecting continued trends in the banking system towards the use of freely floating interest rates based on the ACF index, FONEI further modified its interest rate structure in April 1977. Since then, its interest rate has been set at 2.0 percentage points above the ACF index and is adjusted every six months for both new and outstanding subloans. This mechanism to determine interest rates to final borrowers would apply for purpose of the project (Section 2.02 of the Draft Project Agreement). As of March 1978, FONEI's prevailing interest rate under the above mechanism was 17 percent. 48. To ensure a reasonable diversification of Bank resources, the total amount of the Bank loan proceeds that could be onlent for a single subproject would normally be limited to US$5 million (Section 2.02(c)iv of the draft Loan Agreement). The Bank would be prepared to consider exceptions in the case of subprojects with high economic merit which do not have access to alternative sources of finance on adequate terms. Free Limits 49. Expenditures for subprojects designed to expand service exports (para. 44) would be eligible for Bank financing under the loan. Given the experimental nature of these operations the Bank would review all service export subprojects until satisfactory criteria for their evaluation had been evolved with FONEI for each main type of service export subproject,as evidenced by reviewing its appraisals. Unless the Bank should otherwise agree, the  - 17 - cumulative amount of the loan proceeds available to finance service export subprojects would.be limited to US$10 million (Section 2.02(c)iii of the draft Loan Agreement). 50. All other subprojects requiring more than US$1.5 million of Bank financing would be subject to prior review and approval by the Bank (Section 2.02(b) of the draft Loan Agreement). This represents a doubling of the free limit that was applicable under the Second FONEI Loan and is justified because the average project size FONEI is expected to finance will increase as a result of inflation and because of FONEI's greater experience in project evaluation. It is expected that the Bank would review about one third of the industrial goods subprojects; these and the service export projects which would be re- viewed would represent about half the amount of the proposed Bank loan. Procurement 51. Procurement wou:Ld follow standard Bank guidelines for DFC operations. In carrying out subproject appraisals, FONEI verifies that goods and services procured are competitive in price and quality -- it considers various offers, both national and foreign -- and that they are suitable for the purposes intended. In addition, FONEI ensures through documentation procedures and plant visits by its own staff, or the staff of the intermediary bank, that the proceeds of its financing are only used for the list of goods and services authorized by FONEI at the time of subloan signing. FONEI would give special attention to procurement in the larger subprojects. Disbursement and Auditing 52. Disbursement of the loan would be made for the fully documented CIF cost of direct imports and imported goods purchased "off-the-shelf" from domestic distributors if CIF prices can be established; where CIF prices cannot be determined, disbursements would be made for 70 percent of "off-the- shelf" costs of the imported goods, the estimated foreign exchange cost. In the case of locally manufactured machinery and equipment and local payments for installation and industrial construction, disbursement would be made for 25 percent of FONEI's financing of fully documented expenditures, which is a conservative estimate of the foreign exchange cost of such expenditures. As in the past, FONEI's accounts would be audited annually in a form accept- able to the Bank (Section 3.03 of the Project Agreement). Project Benefits and Risks 53. By increasing resources available to FONEI to finance industrial projects leading to exports or substituting imports efficiently, the proposed project would help the recovery of industrial investment and would have a substantial impact on Mexico's balance of payments. The proposed loan would help FONEI partially finance about 80 subprojects involving aggregate invest- ments of about Mex$ 9.7 biillion. Based on the characteristics of the FONEI's past operations, subprojects financed under the loan are expected to lead to net annual foreign exchange earnings, or savings, of about US$130 million equivalent at full capacity; they would also have a substantial employment impact, generating 13,000 to 16,000 new jobs at an average investment cost of US$26,000 to US$33,000 equivalent per job.. A significant proportion of FONEI's financing is expected to support projects outside Mexico City, thus helping the Government to decentralize industrial development.  - 18 - 54. The project would also help FONEI achieve a number of important institutional improvements, including an increased reliance on sound appraisal techniques in lending by Mexican banks and strengthened project supervision procedures. The scope of FONEI's operations and promotional activities would be broadened and the capacity of FONEI's staff would be expanded through appropriate recruitment and training. 55. As the third Bank operation with FONEI, which has developed a capable management and sound operating policies and procedures, the project presents no special risk. Should the recovery in industrial investment, which began in the second half of 1977, not maintain its momentum, the loan would be used at a slower rate than expected, but this is not likely in view of the attitude taken by the present administration to restore the private sector's confidence. PART V - LEGAL INSTRUMENTS AND AUTHORITY 56. The draft Loan Agreement between the Bank and NAFINSA, the draft Guarantee Agreement between the United Mexican States and the Bank, the draft Project Agreement between the Bank and the Banco de Mexico, and the Report of the Committee provided for in Article III, Section 4 (iii) of the Articles of Agreement are being distributed to the Executive Directors separately. Special conditions of the project are listed in Section III of Annex III. 57. I am satisfied that the proposed loan would comply with the Articles of Agreement of the Bank. PART VI - RECOMMENDATION 58. I recommend that the Executive Directors approve the proposed loan. Robert S. McNamara President Attachments April 19, 1978  ANNEX I Page 1 of 4 pages TABLE 3A NIEXICO - SOCIAL INDICATORS DATA SHEET LAND AREA (TfOU KM2)-