Mexico - Third Industrial Equipment Fund (FONEI) Project

Document of The World Bank FILE C 0jY FOR OFFICIAL USE ONLY Report No.194 lb-ME MEXICO STAFF APPRAISAL REPORT THIRD INDUSTRIAL EQUIPMENT FUND (FONEI) PROJECT April 11, 1978 Projects Department Latin America and the 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 THIRD INDUSTRIAL EQUIPMENT FUND (FONEI) PROJECT Currency Equivalents Currency Unit = Mexican Peso (Mex$) US$1 Mex$ 22.70 1/ Mex$ 1 US$0.044 Mex$ 1 million = US$44,142 GLOSSARY OF ABBREVIATIONS ACF Index of average cost of borrowed funds to financieras FIDEIN Fideicomiso de Conjuntos, Parques y Ciudades Industriales, y Centros Comerciales FOGAIN Fondo de Garantia y Fomento a la Industria Mediana y Pequefia FOMEX Fondo para el Fomento de las Exportaciones de los Productos Manufacturados FOMIN Fondo Nacional de Fomento Industrial FONEI Fondo de Equipamiento Industrial FONEI-I Bank Loan 824-ME, signed in June 1972 FONEI-II Bank Loan 1205-ME, signed in April 1976 IMCE Instituto Mexicano de Comercio Exterior IMIT Instituto de Investigaciones Tecnol6gicas NAFINSA Nacional Financiera, S.A. UNIDO United Nations Industrial Development Organization Government of Mexico Fiscal Year January 1 to December 31 1/ The exchange rate was US$1 = Mex$ 12.50 until September 1, 1976. The peso is now floating. The exchange rate per US$1 has fluctuated in recent months between Mex$ 22.65 and 22.75.  FOR OFFICIAL USE ONLY MEXICO THIRD INDUSTRIAL EQUIPMENT FUND (FONEI) PROJECT TABLE OF CONTENTS Page No. I. INDUSTRIAL DEVELOPMENT IN MEXICO ..... ............... 1 The Economic Setting ................................ 1 The Manufacturing Sector .*------ . 1 Industrial Policies and Priorities. 3 II. INDUSTRIAL FINANCING ........................- 6 The Banking System ........................- 6 The Trust Funds ..................................... 7 Trends in Credit Availability ....................... 8 Financial Policy and Interest Rates ............ 8 III. THE INDUSTRIAL EQUIPMENT FUND (FONEI) .... ........... 9 Objectives, Management and Organization .............. 9 Operating Policies and Procedures of FONEI ........... 12 Past Operations and Performance ..... ................ 19 Financial Results ........ ........................... 21 IV. FONEI'S FUTURE OPERATIONS AND RESOURCE NEEDS .... .... 22 Operational Priorities .............. ................ 22 Operations Forecast ................ ................. 23 Resource Requirements ............ .. ................ 24 Projected Financial Results .-- . ...................... 25 V. THE PROPOSED PROJECT AND THE BANK LOAN .... .......... 26 The Proposed Bank Loan and its Features .... ......... 26 Project Justification and Risks ..... ................ 30 VI. RECOMMENDATIONS ........ ............................ 31 This report is based on the findings of an appraisal mission which visited Mexico between November 2 and November 18, 1977. The mission comprised Messrs. Cook, Hutcheson and Challa (LCPID). | 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 (Cont'd) ANNEXES Annex 1 Variable Interest Rates and the ACF Index Annex 2 Operating Regulations of the Industrial Equipment Fund (FONEI) Annex 3 FONEI's Development Strategy Paper Annex 4 Estimated Quarterly Schedule of Bank Loan Disbursements Annex 5 Estimation of the Foreign Exchange Component of Domestic Fixed Assets Financed by FONEI Annex 6 Supporting Tables T-1: Imports as Ratios to Domestic Demand 1967-1974 T-2: Manufactured Exports 1965-1976 T-3: Indicators of Resource obbilization and Credit Availability from the Mexican Banking System (as at year-end) 1970-1976 T-4: Characteristics of FONEI Approvals T-5: FONEI's Income Statement and Balance Sheet 1972-1977 T-6: FONEI: Operations Projections 1978-1982 T-7: FONEI: Loan Commitments and Resources 1978-1982 T-8: FONEI: Resource Position 1978-1982 T-9: FONEI: Past and Projected Sources and Applications of Funds T-10: FONEI: Past and Projected Balance Sheets T-ll: FONEI: Past and Projected Income Statements T-12: FONEI: Principal Assumptions Used in the Financial Projections T-13: Projected and Realized Exports of a Sample of Enterprises Financed by FONEI Annex 7 Selected Documents and Data Available in the Project File  MEXICO THIRD INDUSTRIAL EQUIPMENT FUND (FONEI) PROJECT I. INDUSTRIAL DEVELOPMENT IN MEXICO The Economic Setting 1.01 Prior to 1974 Mexico had sustained a high rate of economic expansion for more than two decades with GDP growth averaging 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. In 1974 and 1975 the pace of growth slowed down as the economy was increasingly affected by rising domestic inflation, shortage of credit to the private sector, and the impacts of the oil price rise and the deepening recession in world trade. The GDP growth rate fell to 5.9% in 1974 and 4.2% in 1975. Measures adopted to control inflation and reduce the mounting balance of payments and fiscal deficits led to a further slowdown of GDP growth to 2.0% in 1976. Although the trade balance improved somewhat, continuing high inflation (averaging 16.5% in 1975 and 22% in 1976) led to the abandonment of the fixed parity in September 1976; since then the exchange rate has been floating and has increased by approximately 80% in US dollar terms. As a result of slower economic growth since 1974, unemployment and particularly underemployment have increased significantly, and high inflation has had an adverse impact on the real incomes of the poorer sections of the population. 1.02 Faced with a very difficult economic situation, the new Government that took office in December 1976 moved rapidly to introduce a package of measures designed to stabilize the economy, rekindle economic growth, restore investor confidence and increase employment. The strategies adopted of controlling public sector expenditures, raising interest rates to stimulate private savings, encouraging private sector investment and maintaining a floating exchange rate are having a positive impact on the economy. Inflation, which was running at an annual rate of almost 60% in the first 3 months following devaluation in September 1976,has declined steadily during 1977 and averaged about 21% for the year as whole. The balance of payments is improving partly as a result of an increase in exports of petroleum and manufactured products. Resource mobilization by the banking system is recovering 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. Given a continuation of appropriate policies, prospects are good for a progressive acceleration of economic growth. Based on progress achieved during 1977 and rapidly rising petroleum output and exports, the Government's targets to get the economy back on a high growth path (i.e. 6-7% p.a.) by 1979 and reduce inflation to international levels shortly thereafter appear feasible. The Manufacturing Sector 1.03 During the period of rapid economic expansion until 1974 industry was one of the most dynamic sectors. Between 1960 and 1974 manufacturing output increased on average by 8.3% per annum, and manufacturing increased its contribution to GDP from 19.2% to 23.8%. Its share of total employment has  -2- reached 17%, and its share of merchandise exports, 43%. 1/ This impressive performance was fostered by an active class of entrepreneurs, the comparatively large and growing domestic market, proximity to the high income US market, favorable government policies and the availability of investment finance. 1.04 Industrial development has followed a pattern common to several other large LDCs, with primary emphasis being placed on import substitution during the fifties and sixties. By 1970 Mexico had achieved a substantial degree of import independence with manufactured imports accounting for about 10% of domestic demand. Almost all nondurable consumer goods and 89% of intermediate goods were supplied domestically, but about 30% of nondurable consumer goods and capital goods were still imported. By 1974 imports were significant only for basic and secondary chemicals, synthetics and plastics, capital goods (particularly mechanical machinery and transport equipment) and the miscellaneous category (see Annex 6, T-1). After 1970 increased emphasis was placed on promoting manufactured exports, which grew from US$353.5 million in 1970 to 1,242 million in 1974. 2/ 1.04 Recent performance. Even before 1974 the pace of industrial expansion was beginning to slacken as opportunities for further efficient import substitution became fewer and more difficult to realize and exports, while growing quite rapidly, still represented only about 4% of gross output. The rate of growth of manufacturing output averaged 6.6% in 1970 to 1974, compared to 9.1% in the previous decade. The mounting economic difficulties of 1974 to 1977 accentuated this trend as industry was increasingly affected by tighter credit, slow growth of the domestic market, the world trade recession, the growing overvaluation of the peso and the uncertainties caused by its eventual devaluation. Manufacturing output growth fell to 4.7% in 1975 and 2.6% in 1976. During the early months of 1977 output declined in real terms, but growth resumed during the last three quarters of the year as the policy measures introduced by the new administration began to restore economic stability and private sector confidence and the more realistic exchange rate facilitated export growth. Over the year, a modest growth of 2-3% is estimated to have occurred, about equal to growth in GDP. 1.05 Employment and wages. Between 1950 and 1969 employment in manufacturing grew by 4.9% p.a., significantly faster than the labor force was growing (2.4% p.a.) Thus, manufacturing industry was able to provide employment to 20-30% of new entrants to the labor force during this period. But from 1970 to 1975 manufacturing employment grew by only 2% p.a., and since 1975 there has been almost no growth in manufacturing employment. With the slower rates of industrial and economic expansion in the last few years, unemployment and underemployment have increased. Open unemploy- ment, which was estimated at 4% in the 1970 census, had risen to about 6% by the end of 1976 and has worsened since then. An even more serious problem is under- employment, as more than 40% of workers are being engaged in part time and low productivity activities for which they earn less than the minimum daily wage. 1/ These figures are taken from the industrial censuses of 1960 to 1975. They exclude petroleum refining, basic petrochemicals and the 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/ These figures exclude exports by border assembly plants, and exports of sugar, primary non-ferrous metals and petroleum products.  -3- 1.06 Between 1960 and 1976 the average industrial wage, which is higher than that of most other sectors, increased by about 4.2% annually in real terms,led by minimum wages that grew slightly faster (at 4.9% p.a.). Over this period, and particularly after 1972, average wages rose faster in Mexico than in the United States, and Mexico lost some of its comparative advantage. Average Wages in Manufacturing 1960-76 (dollars per hour) Dec. 1960-65 1966-70 1971-72 1973 1974 1975 1976 Mexico .49 .70 .87 1.0 1.28 1.45 1.18 USA 2.43 3.03 3.69 4.07 4.40 4.79 5.40 Mexico/USA (%) 20 23 24 25 29 30 22 Output per worker in Mexican manufacturing grew somewhat faster than wages, at 5-6% per annum. Such a high rate of growth of labor productivity was attributable more to a shift towards more capital-intensive processes than to a shift towards more capital-intensive products, which was encouraged by an increasingly overvalued exchange rate. The peso devaluation in 1976 restored Mexico's comparative advantage in labor costs to the level established in 1966-70, and the maintenance of a realistic exchange rate should avoid excessive distortions in the relative cost of capital and labor in the future. Industrial Policies and Priorities 1.07 While the new Mexican administration concentrated 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 is currently in the process of reviewing and revising its industrial policies, but has indicated that emphasis is to be placed on taking advantage of remaining opportunities for efficient import substitution (particularly in the capital goods and chemicals sectors), diversifying and expanding manufactured exports, and promoting more rapid development of industrial and related activities outside the present areas of industrial concentration. The proposed project is designed to support these objectives by helping industrialists to design, and obtain adequate financing for, export projects and efficient import substitution projects, with increased promotional attention being given to projects outside of the Mexico City area (para. 1.12). 1.08 Efficient import substitution. Until 1970 Mexico's industrialization strategy emphasized import substitution, 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 were as high as 100%, most lay in the 10-30% range and became subject to numerous exceptions,especially for public sector imports of capital goods.  -4- Quantitative restrictions on the other hand have tended to become more widespread as the process of import substitution progressed, with the proportion of imported items subject to license rising from one third in 1950 to four fifths in 1976. However, levels of realized protection have been held down by internal competition and the possibility of smuggling, and were further reduced during the mid-1970s by the overvaluation of the exchange rate. With some exceptions, the industrial sector has developed with relative efficiency. In 1970 industrial prices were only about 15% higher than international levels, and only 19% higher in 1975.1/ Effective protection averaged 30% to 40% in the 1970-1975 period. Price and exchange rate movements since 1975 indicate that average industrial prices in 1977 were close to international levels and that effective protection had been reduced substantially. 1,09 With import substitution almost complete in many industrial subsectors, Government policy is focussing on two main themes: encouraging improvements in efficiency in those subsectors where prices are still above international levels; and tackling the two remaining areas where there are significant opportunities for further import substitution, namely the mechanical engineering and capital goods subsectors, and basic and secondary chemicals and related products. To encourage greater efficiency in new and existing industries, the Government plans to reduce progressively the number of products subject to import licensing (400 products were freed from licensing during 1977) 2/and to rely in future more on the maintenance of a realistic exchange rate and moderate tariff protection. In addition, steps are being taken to remove some of the obstacles to domestic capital goods production (e.g. procurement policies and procedures of key public sector agencies which are unfavorable to domestic manufacturers, and shortage of sales financing on adequate terms) that have restricted the growth of this subsector. Finally, a substantial proportion of future public investment is being earmarked for the petroleum and basic petrochemical subsectors, which should open up greater opportunities for the private sector in down-stream production of secondary chemicals, plastics and synthetics. 1.10 Export axpansion. Because of its proximity to the United States, a well developed and reasonably efficient industrial sector, and abundant natural and human resources and comparative advantage in labor costs, Mexico has considerable potential as an exporter of manufactures. Prior to 1970, however, manufactured exports developed rather slowly mainly because the rapidly growing and protected domestic market appeared to offer more profitable and less risky opportunities to industrialists under prevailing government policies. Responding to the introduction of export incentives in 1971, comprising rebates of indirect taxes, duty exemption on imports, and increased credit at concessionary terms to finance export production and sales, manufactured exports grew at 36% p.a. between 1970 and 1974 compared to only 5.6% p.a. in the previous decade. While there was an increasing diversification in the range of goods exported and in trading partners during this period, exports tended to be concentrated in comparatively few sectors (automotive parts; textiles, garments and footwear; food products and basic chemicals accounted for 73% of exports by value) and the United States continued to be the most important trading partner, absorbing about 70% of manufactured exports. More favorable treatment granted after 1971 to foreign companies establishing assembly plants in the border areas to supply the US market also stimulated rapid growth in their exports from US$215 million in 1970 to US$1,030 million in 1974. However, despite this rapid growth in exports by Mexican manufacturing companies and by assembly plants, by 1974 the total value added in all manufactured exports, including assembly industries, still represented only 4.7% of total value added in manufacturing, 1/ These figures are net of estimated peso overvaluation of 3% in 1970 and 1B% in 1975. 2/ Products freed from licensing so far do not represent a very substantial proportion of manufactured imports but the Government has announced its intention to remove licensing for the majority of imported products over the next 4-5 years.  - 5 - leaving substantial scope for further export growth (Annex 6, T-2). In 1975 and 1976 the world recession and increasingly overvalued peso led to a slight decline (-2.1% p.a.) in the US dollar value of manufactured exports, but since devaluation export growth has resumed. With present policies of maintaining appropriate export incentives and a realistic exchange rate, prospects are good for continued rapid expansion of manufactured exports to provide a major stimulus to industrial and economic growth. 1.11 Industrial decentralization and tegional development. In recent years concern has increased about the heavy concentration of industry and employment in a few large metropolitan areas, particularly Mexico City,and the growing disparities in employment opportunities and incomes between these areas and the rest of the country. At its present rate of population growth Mexico City would surpass 35 million by the year 2000 but pollution levels and the cost of providing municipal services, particularly water, are already posing severe problems. In 1970-1972 industrial decentralization incentives were introduced. For this purpose, the country was divided into 3 zones defined as follows: Zone I - the metropolitan area of Mexico City, Guadalajara and Monterrey; Zone II - the areas adjacent to Zone I and several intermediate cities near Mexico City; Zone III - the rest of the country. Firms locating or expanding in Zones II or III receive reductions on income and sales taxes and partial or full exemptions from import duties on capital goods and other production inputs. 1.12 Despite the high level of these incentives, results have been disappointing. The most noticeable impact has been in Zone II, where some firms have been established just across the zone limit contiguous to Zone I. Moreover, the incentives are mostly subsidies to fixed investment leading to comparatively little decentralization of jobs. The failure to provide greater incentives to Guadalajara and Monterrey as counter attractions to Mexico City has also been questioned. In addition, the current legislation did little to reduce the substantial advantages for locating in Mexico City represented by suverior infra- structure, proximity to markets, and federal subsidies to transport and education costs available only in the capital. Currently, decentralization policy is under review to better focus the incentives on a restricted number of localities with potential to become growth poles, to eliminate their bias in favor of capital- intensive investment, and to increase the range of policy instruments used. Of particular relevance to the proposed project is the intention to speed up the development of the Isthmus of Tehuantapec region based on the efficient import substitution opportunities offered by the rapidly expanding petroleum, natural gas and basic petrochemical industries, and to further develop the production of exportable goods and services in the northern border areas to take greater advantage of opportunities offered by the proximity to major US markets. Outlook for Industry and for Industrial Investment 1.13 In view of the success achieved by the new administration during 1977 in stabilizing the economy and restoring private sector confidence and the generally favorable industrial policies being followed by this administration, prospects appear good for industry to regain by the early 1980s the high rates of growth achieved in 1960s. Industrial output is expected to rise by 4% to 5% in 1978 and to grow faster in subsequent years as rapidly rising petroleum output and exports reduce the foreign exchange constraint and stimulate the economy to 6-8% growth  -6- rates in 1979-1980. There are substantial opportunities for growth in a number of industrial subsectors, including basic and secondary chemicals, plastics and synthetic fibers, extraction and processing of metals and minerals, processing of agricultural and seafood products, mechanical engineering and the production of capital goods. Furthermore, Mexican industry now 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. 1.14 After several years in which private investment in industry has been virtually stagnant, an increased rate of industrial investment will be required to support future growth. During the 1960s private investment grew at about 9% annually in real terms, almost exactly the same rate as manufacturing output was growing. Between 1970 and 1976 private investment grew at only 3.2% p.a. while manufacturing output growth averaged more than 5% p.a. over the same period. During the second half of 1977 some recovery of industrial investment was apparent and this trend is expected to strengthen during 1978. In the next 2-3 years investment is projected to grow by 8-10% p.a. in real terms. However, the achievement of these rates of investment will be dependent on industry's access to sufficient volumes of credit at suitable terms since profit margins and corporate savings have declined significantly during the recent recessionary period. II. INDUSTRIAL FINANCING The Banking System 2.01 Mexico's well-developed banking system, comprising almost 200 private, mixed and publicly owned institutions, with the Banco de Mexico (the Central Bank) at its apex, has played a major role in financing the development of industry and the other productive sectors of the economy. Private and mixed financial institutions are of three main types: some 97 commercial banks which, as of November 30, 1977, had deposits of around US$5.6 billion equivalent from the public primarily through checking and savings accounts; 71 investment banks (financieras) which had around US$6.2 billion equivalent in short and medium term bonds and certificates of deposit, and are able to make longer term loans than commercial banks; and 21 mortgage ba-nks (hipotecarias) which had about US$1.8 billion equivalent raised in a similar way to investment banks but used mainly for financing residential and commercial construction. Eleven large financial groups--each made up of one or more commercial banks with branches throughout the country, an investment bank and a mortgage bank-- account for more than three quarters of banking deposits and credits. In recent years the authorities have been encouraging the consolidation of the smaller banks into new medium-sized financial groups, and the transformation of these groups into multibanks able to offer a full range of financial services through their branch offices. The reasons for this are to simplify administration of the reserve require- ment system, increase the financing capacity of the medium sized groups and improve their competitive position, and improve access to the full range of financial services outside the biggest cities. 2.02 During the 1960s and early 1970s the banking system developed rapidly, with the volume of outstanding credit growing faster than GDP and the 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  -7- encouraged US deposits in Mexican banks and foreign borrowings by Mexican firms. This process was facilitated by sound interest rate policies, maintaining positive real interest rates and a small premium of Mexican interest rates over those offered on US dollar deposits. Nevertheless, certain structural weaknesses were apparent by the early 1970s. One was excessive traditionalism in credit allocation. Guarantees substantially in excess of the legal minimum (133% of credit granted) were required, and even credit for projects requiring term financing was decided primarily on the basis of the financial strength and reputation of the sponsoring enterprise and its owners,rather than on the basis of an appraisal of the merits and income earning characteristics of the investment project. Another weakness was the excessively short-term structure of the banking system's liabilities brought about in part by the liquidity preference of savers in a situation where insufficient interest rate premia were offered for longer term savings. As a result, banks were both limited in the amount of longer term financing they could provide and forced into a rather high degree of term transformation. Because of the above weakness, there was a tendency for credit, particularly term credit, to be concentrated in firms and sectors that were already well established,to the detriment of new firms and more innovative activities. The Trust Funds 2.03 To overcome the weaknesses mentioned above, the financial authorities progressively developed a system of trust funds, whose resources come mainly from the legal reserves of the banking system, to allocate credit on appropriate terms to priority activities in the fields of agriculture, industry and tourism. Banks are able to obtain partial financing from these trust funds for term loans they make for projects which meet the eligibility requirements and lending terms and conditions of the appropriate trust fund. The five trust funds designed to support industry can be divided into two groups. Nacional Financiera S.A., the main public sector development bank, administers three trust funds which are designed to support the development of small and medium scale industry; 1/ Banco de Mexico administers two other closely related trust funds: Fondo Nacional de Equipamiento Industrial (FONEI) and Fondo para el Fomento de las Exportaciones de los Productos Manufacturados (FOMEX). The former provides medium and long term financing for investment projects designed to increase exports or efficiently substitute imports and the latter shorter term financing for export production and sales. In addition, in order to support the domestic capital goods industry, FOMEX has recently been authorized, and provided additional resources, to finance the sale of domestically manufactured capital goods to Mexican buyers. FONEI, which has received two previous Bank loans, will be the executing trust fund for the proposed project. A separate Bank project to assist small and medium industry has been prepared which involves the aforementioned trust funds administered by Nacional Financiera. 1/ These trust funds are: (1) Fondo de Garantia y Fomento a la Industria Pequefia y Mediana (FOGAIN) which discounts bank loans to small and medium sized industrial firms; (2) Fideicomiso de Conjuntos, Parques y Ciudades Industriales (FIDEIN) which is charged with developing industrial estates and financing factory buildings and other equipment for firms locating in these estates; and (3) Fondo Nacional de Fomento Industrial (FOMIN) which makes minority risk investments in small and medium sized firms.  -8- Trends in Credit Availability 2.04 Since 1973 increased inflation (averaging 20% from 1974-1976) 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). Failure to increase interest rates sufficiently and maintain an adequate premium of Mexican rates over foreign rates, together with growing exchange rate uncertainty led to a fall in resource mobilization by the banking system and non- monetary peso liabilities 1/ of the system fell from 32% of GDP in 1972 to 22% in 1976. In addition, the deepening public sector deficit forced Banco de Mexico to raise reserve requirements, further reducing credit availability to the private sector which fell from 23% of GDP in 1972 to t8% in 1976 (Annex 6, T-3).2/Furthermore, as resource mobilization declined, banks reduced the average maturity of their credit so that by 1976 few loans of more than 5-year terms were being granted except with trust fund resources. 2.05 The 1976 peso devaluation accentuated the problems of credit scarcity. In the months surrounding the devaluation financial savings contracted sharply and capital flight accelerated. While the financial policies followed by the new administration (see para. 2.07) have resulted in a sianificant recovery of the financial system during 1977, term industrial credit seems likely to remain in very short supply for the next 2 to 3 years. Credit scarcity is compounded by the fact that the larger companies, which relied increasingly on borrowings from foreign commercial sources during 1974 to 1976, suffered significant losses as a result of devaluation and are now reverting to borrowing in the domestic market. 2.06 The trust funds have a vital role to play in the recovery of the financial system and the alleviation of credit shortage. Over the next several years they must provide a significant proportion of the term credit needs of the sectord in which they operate. To augment the resources made available to these funds from banking system reserves, the Mexican authorities are seeking additional loans from international agencies. Bank loans have been requested for the trust funds serving agriculture, tourism, and small and medium industry in addition to the proposed loan for FONEI. In the longer run, an important role of the trust funds is to influence the banking system in its allocation of credit that does not flow through the funds themselves. For example, one of FONEI's objectives is to encourage the banks to take their lending decisions on the basis of project appraisals rather than relying mainly on the amount of collateral offered, in order to improve the allocative efficiency of the system. Financial Policy and Interest Rates 2.07 With the continuation of prudent demand management implied in the recent budget, the inflation rate is expected to fall from 21% in 1977 to around 16% in 1978-79 and to decline progressively to international levels by 1981 or 1982. To boost peso denominated savings and reverse capital flight, in May 1977 investment banks and mortgage banks were authorized to offer higher maximum interest rates on time deposits ranging from 7% for call money to 18.5% on 2-year certificates of deposit.3/ The introduction of these new rates has had a very positive affect on increasing overall resource mobilization by the banks and on improving the term structure of bank liabilities. Depending on the future course of domestic and world inflation and general trends in international interest rates, the 1/ The term non-monetary peso liabilities is used to refer to all liabilities other than checking accounts and other demand deposits. 2/ As of February 28, 1977, total outstanding banking system credit to the private sector stood at Mex$ 229.7 billion (about US$10.1 billion equivalent) including ' Mex$66.3 billion (about US$2.9 billion equivalent) to manufacturing industry. 31 Actual interest rate received by Investors range from 5.6% p.a. to 16' p.a. after taking into account withholding taxes.  - 9 - authorities have announced their intention of making further adjustments in maximum permitted rates so as to sustain a healthy growth in financial savings. In a parallel move to avoid concentration of scarce credit in the largest and safest borrowers, stricter limits have been placed on the amounts that individual banks can lend to a single firm or group of related firms. 2.08 On the lending side, banks and financieras have been switching increasingly to a system of floating interest rates on medium and long term loans to reflect the increased uncertainty about their future borrowing costs and to avoid a situation in which companies are inhibited from investing for 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 (the ACF Index), which is computed monthly by the Banco de Mexico (see Annex 1). Between May 1977 and March 1978 this index has increased from 11.9% to 14.9%, a level which is approximately equal to the annual rate of inflation recorded in the last quarter of 1977. Banks are presently charging their clients rates of 3-7 points higher than this index (i.e. 18-22% p.a.), but the banks margins are e