Mexico - Pollution Control Project

Documient or The World Bank FOR OFFICIAL USE ONLY L~~- J 5t-1 Report No. P-3302-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 POLLUTION CONTROL PROJECT I.ay :, 1982 This durment has a restrited distributiona and may be used by rec,ipients ovity in the peifonnance of their official duties. Its contents may not otherwise be dsclosed without World Darik authorization.  CURRENCY EQUIVALENTS The Central Bank withdrew from the exchange market on February 18, i982. Prior to that date, the rate of exchange was 26.9 pe',os to the US dollar. In recent weeks the Peso is being traded around 46 to the dollar. FISCAL YEAR January 1 co December 31 GLOSSARY OF ABBREVIATIONS ACF Index of Average Cost of Funds to Multipurpose Banks FONEI Industrial Equipment Trust Fund (Fondo de Equipamiento Industrial) GMCA Greater Mexico City Area NAFINSA Nacional Financiera, S.A. PEMEEX = Mexican Petroleum Company (Petroleos Mexicanos) PPAR = Project Performance Audit Report SA1HOP Secretariat of Human Settiemenes and Public Works (Secretaria de Asentamientos Humanos y Obras Publicas) SAPFH Secretariat of Agricuture and Water Resources (Secretaria de Agricultura y Recursos Hidraulicos) SMA Subsecretariat for Environmental Improvement (Subsecretaria de Me;Aoramiento del Ambiente) SSA Secretariat of Health and Public Welfare (Secretaria del Salubridad y Asistencia) WHO Woild Health Organization WQCD Water Quality Control District  FOR OFFICIAL USE ONLY MEXICO POLLUTION CONTROL PROJECT Loan and Project Sulamary Borrower: Nacional Finan.iciera, S.A. Guarantor: United Mexican States Beneficiary: Industrial Equipment Trust Fund (FONEI) Amount: US$60 m .' on equivalent, including capitalized front.-end fee. Terms: Fifteen years, including 3 years of grace, at an interest rate of 11.6 percent per annum. Onlending Terms: FONEI would receive loan funds at an interest rate equal to that of the Bank loan. FONEI would retain the proceeds of the loan as additional government equity. Project Description: The project would: (a) finance industrial enterprises' acquisition and installaticn of pollution control equipment, process changes or plant relocation; (b) finince private automobile garages' acquisition of vehicular t-mission testing and diagnostic equipment; (c:) finance local and federal authorities' acquisition and installation of pollution monitoring equipment, laboratory facilities, and emission testing and diagnostic equipment for automobile inspection stations; (d) train technical staff of implementing agencies, financial institutions and industries, and automobile mechanics; (e) support studies and technical assistance to help develop long-term contro' strategies and emissions standards. Project Risk: The most important risk is inadequate monitoring and enforce- Ftent of pollution control regulations. Th-te high priority attached by the government to this program and its commitment on a project execution paper, with a detailed action program, suggest that this risk is not high. This document has a restricted distritution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  - ii Estimated Cost: Local Coreign Total ----- US$ millions------ Air Pollution Control 91.0 39.3 130.3 Industrial Source Control 82.8 35.2 118.0 Automobile Inspection 5.8 2.0 7.8 Air Quality Monitoring * 0.2 1.8 2.0 Trai;ning and Studies * 2.2 0.3 2.5 Water Pollution Control 35.9 18.3 54.2 Industrial Source Control 35.0 18.0 53.0 Training, Studies, and Monitoring Equipment * 0.9 0.3 1.2 Salid Waste Control * Z.2 0. 2.5 Industrial Solid Waste Inventory 1.8 0.2 2.0 Feasibility Studies 0.4 0.1 0.I Health Impact Studies * 1.8 1.2 3.0 Front-End Fee - 0.9 0.9 TOTAL 130.9 60.0 190.9 Financing Plan: Local Foreign Total -------US$ millions FONET. 84.3 - 84.3 Industries and Banks 38.0 - 38.0 Government 8.6 - 8.6 Bank - 60.0 60.0 TOTAL 130.9 60.0 190.9 Estimated Disbursements: -----------------US$ millions----------- Bank FY 1983 1984 1985 1986 1987 1988 1989 Annual 2.4 10.5 15.5 :5.1 10.0 5.0 1.5 Cumulative 2.4 12.9 28.-; 43.5 53.5 58.5 60.0 Rate of Return: Not applicable. Staff Appraisal Report: Report No. 38165-ME dated April 28, 1982. * Costs of these items include physical contingencies of 5 percent and price contingencies of 8 percent for 1982 and 1983, 7.5 percent for 1984 and 7 percent for 1985.  INTERNAIIONAL 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 POLLUTION CONTROL PROJECT l. I submit the following report and recommendation on a proposed lcan to Nacional Financicra, S.A. with the Guarantee of United Mexican States for the equivalent of US$60 million to help finance a pollution control project. The loan includes a capitalized front-end fee of US$0.9 million. Approximately US$55 million of the loan would be onlent through the Industrial Equipment Trust Fund (FONEI) for the purchase of pollution control equipment by industrial enterprises and for purchase of automobile emissions testing equipmeat by private garages. FONEI would receive these funds at an interest rate equal to that of the Bank loan, and would retain them as additional government equity. The final borrowers would receive loan funds at a variable interest rate not lower than three points below the cost of funds to multipurpose banks (ACF). Subloans would have a maximum amortization period of 13 years including 3 years of grace. The government would assume the foreign exchange risk and the responsibility to repay tne Bank loan. The loan would be repaid over 15 years, including 3 years of grace, with interest at 11.6 percent per annum. PART I: THE ECONOMY 1 2. The Mexican economic situation and major issues of economic policy were analyzed in "Mexico: Development Strategy - Prospects and Problems" (3605-ME), distributed to the Executive Directors on August 31, 1981. Country data sheets are attached as Annex I. Background 3. For the last thirty years, the Mexican economy recorded a high rate of growth: on average, GDP grew at 6 percent per year, in real terms, between 1950 and 1980, allowing output per capita to increase by 3 percent per year over the same period. Sustained growth brought about rapid industrialization: especially after 1955, industry has been the most dynamic sector of the economy, growing at an average rate of 7.5 percent per year, while agricultural output grew at 3.5 percent per year; thus, the share of the industrial sector in GDP went up from 26 percent in 1950 to 38 percent in 1980. A similar change took place in the structure of foreign trade, with manufactured products accounting for an increasing share of total exports between 1950 and 1975. Finally, the last thirty years w'tnessed the passage from a rural tc , lar&gely urban society: in 1980, the fraction of total population living in urban areas was estimated to exceed 60 percent, while it was less than 30 percent in 1950. 1/ This section is substanti-Lly unchanged from the President's Report for the Capital Goods Industries Development Project (P-3284-ME of April 22, 1982). Hlowever some minor changes have been introduced in paras. 10-15.  5~~~~~~~~~~~~~~ 4. Successful exploitation of profitable opportunities by a dynamic private sector has been the main engine of growth in the Mexican economy; but the market mechanism, left to itself, would have done little to correct the effects of an uneven distribution of resources on the relative position of the poorer segments of the population and of the less favored areas of the country; hence the government na3 had to play a critical role in balancing the neod to provide resources and 'ncentives for growth against the demands for a fair distribution of its benefits. 5. In the early seventies, the government sought to build up infrastructure, expand basic industries, stimulate agricultural output and implement massive social programs. The difficulties it encountered in mobilizing enough resources to attain all these aims simultaneously led to excessive public sector deficits, while domestic supply rigidities caused a large part of aggregate demand to spill over into imports. Efforts to redress financial imbalances by strengthening public revenues fell short of their goal, and, in Septamber , 1976, the hitherto fixed parity of the peso was abandoned, while the government imposed a strict stabilization program on the economy. Economic Performance, 1976-1981 6. The Administration of President Lopez Portillo, whict took office in December, 1976, saw the c^ntrol of inflation and the improvement of the current account balance as its most urgent tasks; it succeeded in reducing the rate of increase of domesti: prices by half bet~ween 1977 and 1978 while, at the same time, the current account deficit decreased by over 40 percent. In 1978, the economy resumed its path of rapid growth. One of the major constraints on economic growth - the availability of foreign exchange - had been greatly relaxed by the successful exploitation of Mexico's oil reserves; these, which at the end of 1981 stood at 72 billion barrels (with potential reserves estimated at 200 billion brarrels), enabled the economy to finance the purchases of raw materials and eapital goods needed to sustain high GDP growth, while the revenues from federal taxes on oil exports prov'ded the Government with resouices, on a hitherto unprecedented scale, to pursue some of its long-standing policy goals. 7. In 1978-1981, output grew at an annual rate exceeding 7 percent, above what would have been needed to absorb the new entrants into the labor force; open unemployment is estimated to have fallen to 4-5 percent of the labor force in the modern sector although under2mployment is likely to remain I ~ high in the medium run. The Administratior. succeeded in achieving investment growth of over 16 percent per year, strengthen'.ng its support to agriculture, reversing the trend towards a worsening trade balance on basic foods, containing to some extent rural migration and providing small farmers with access to more efficient production methods. Finally, a combination of fiscal incentives and administrative regulations 'together wfth the increas- Lng costs of congestion) had a positive effect on spatial decentralization, one of the major policy objectives of the Administration. 8. A marked increase in the size of the budget has been the first result of the government's new commitments: the expenditure budget grew, in real terms, 20 percent per year between 1979 and 1981; furthermore, actual expenditures exceeded budget figures by, significant amounts (by as much as 12 percen. in 1981). Revenues have gTown more sLowly, and, as a result, the public sector deficit amounted to over 14 percent of GDP in 1981. DesDite a  3- high rate of mobilization of private savings into the financial system - made possible by a scheme of adjustable rates on peso deposits - the government had to resort increasingly to foreign borrowing. By 1980, moreover, the side-effects of rapid CDP growth were making themselves felt; aggregate demand - with total investment growing at over 16 percent per year, in real terms, since 1979 - was exerting pressure on prices, and domestic inflation reached 26 percent, while the nominal exchange rate had remained practically stable since 1977; as a result, non-oil exports were decreasing in real terms, while imports - encouraged to some extent by a more lioeral trade policy - had grown by 30 percent per year since 1979. At the end of 1980, the current account deficit amounted to 4 percent of GDP, as it had in 1976. Recent Developments 9. In 1981, the need to bring dcmestic inflation under control and to help restore the competitiveness of non-oil exports became obvious. The Administration opted for a policy of gradual adjustment, counting on slower demand growth in 1982 - brought about partly by a deceleration of public expenditures - to moderate inflation, and allowing a faster rate of float of the peso to reduce the gap between domestic and foreign prices over a two- year period. With a favorable outlook for oil exports, no major problems were expected in the external sector, and a path of gradual adjustment to a rate of growth of 6-7 percent appeared sustainable in the long run and was considered to be less costly in terms of inflation and unemployment than more drastic stabilization measures. Thus, the Administration attempted to reduce the extent of public overspending, while at the same time reintroducing import licenses on 80 percent of imports, tightening public procurement procedures and allowing the float to proceed at a faster pace. 10. This program suffered a setback when, in the second half of 1981, it became apparent that oil sales would not reach their target: actual oil revenues, at US$14 billion, turned out to be 25 percent below what had been forecast. The public sector had to increase its foreign borrowing by US$4 billion, and the current account deficit reached an estimated US$11.3 bil- lion, or 8 percent of GDP, at the end of the year. The exchange markets reacted by increasing the downward pressure on the peso, and, in early 1982, two events combined to make a guided float increasingly costly to maintain: on the one hand, it seemed likely that oil sales for the year would again fall short of expectations; on the other, the 5 percent increase in domestic prices in January - due in part to the rise in domEstic fuel prices decreed in December, 1981, and in part to a 34 percent raise in the minimimum wage for 1982 - suggested that inflation, which had reached 28.7 percent in 1981, might well. accelerate further in 1982. OrLce more, the exchange markets reacted unfavourably, and, in order to stop the steady drain on reserves required for maintaining the float, the authorities withdrew their suppc;-t of the peso on February 18. Since then, the exchange rate has stabilized at about Mex$46 to the dollar, amounting to an adjujtment OL 70 percent (40 percent in dollar terms). Simultaneously, the Administration announced a stabilization program whose main components are a 3 percent cut in the 1982 budget - which, at the current rate of inflation, shows a decrease in real terms with respect to 1981 - the imposition of temporary price controls, the liberalization of certain necessary imports (basic foodstuffs, raw materials and capital goods) and the granting of financial support to firms affected by the parity change. Finally, a wage raise of 30 percent for the lower  -4- echelons of the Administration was announced, with higher employees receiving increases of the order of 10 percent; labor has been urged to limit its demands So what would be necessary to restore the pre-devaluation real purchasing power of wages. Prospects 11. The rate of inflation for 1982 has been forecast at 40 to 45 per- cent, while output is expected to grow at 4-4.5 percent. Both figures are plausible, but sensitive to unpredictable circumstances. A 45 percent rate of inflation can be expected under a wage adjustment aimed at restoring the pre-devaluation purchasing power of wage incorne since, given the low import coefficient and *he still lower share of imports in consumption, such an adjustaent could be significantly lower than the parity change. A 4.5 per- cent rate of GDP growth is compatible with a slight fall in imports of around 5 percent which would bring about a substantial improvement in the current account balance. But a larger wage increase may result in higher domestic prices, and, if oil revenues fall short of their expected target of about US$17 billion, an improvement in the current balance might require a sharper fall in Imports which would, in turn, force a lower rate of GDP growth. 12. The Mexican Administration has sought to minimize the disruption caused by the stabilization measures so as not to jeopardize the remarkable growth of the past years. In doing so, it has opted for a policy of gradual adjustment whose effects will be apparent only in the medium run. Inflation may well exceed 40 percent in 1982, and this will offset pa:c of the effects of the devaluation on the competitiveness of non-oil exports. OrL the other hand, the external sector can improve, in the short run, only to the extent that imports show a substantial deceleration, since, even though the adoption of a more realistic parity has removed a major obstacle to non-oil exports, the stimulus to foreign sales is unlikely to have a significant effect on aggregate exports in the next few months since oil accounts for three-fourths of total export revenues. Finally, the Administration has little margin to reduce its expenditures during this fiscal year. The only item in which substantial cuts can !)e effected in the short run is public investment: general expenses (38 percent of the expe.iditure budget), debt service (21 percent) or transfers and subsidies are virtually fixed for the duration of the budget. But if the Administration adheres to a strict budgetary policy, thereby contributing to moderate the rate of domestic inflation, significant improvements are likely to appear by the end of 1983: non-oil exports, led by tourism and certain consumer goods such as clothing, footwear and appliances, will probably grow substantially. A reduced public sector borrowing requirement (new net foreign financing is scheduled at US$11 billion for 1982, down from US$15-17 billion in 1981) will reduce the pressure on the pcso, and, by 1984, Mfexico could reach a sustainable rate of GDP growth of abort 6 percent on averagc, while mainiLainirg the current account deficit within manageable limits. Lastly, the Administration has an opportunity to overhaul the entire system of transfers and subsidies, reducing their levels and improving their cost-effectiveness. 13. The country still faces structural problems in the years to come, related mainly to poverty and unequal interpersonal and inter-regional distribution of income. Efforts were made in the past to improve the living  -5- conditions of tie poorer segments of the population. A family planning program startea in 1972 brought the growth rate of the population to an estimated annual averaze of 2.6 percent, down from 3.5 percent in the 1970s. To tackle the problems of malnutrition and increasing dependence on foreign food, the present Administration launched the SAM (Mexican Food System) Program, aimed at increasing self-sufficiency in basic foods, providing for minimum nutritional needs of the poor and increasing rural employment. The Administration also placea greater emphasis on the promotion of small scale irrigation, rehabilitation of underutilized existing irrigation works and provision of credit and technical assistance for the development of rainfed agriculture. 14. The main urban-regional problems are: growing congestion, pollu- tion, high cost of services (especially water) and other management problems that stem from the continued growth of Mexico City (already the third most popalous metropolitan area in the world and moving rapidly to become the first) and Monterrey and Guadalajara, located in the dry, densely popul]ted central plateau; and retarded development, poverLy and great difficulty in providing better jobs or adequate public services to the one-third of all Mexicans who live in small, scattered centers in rural areas. The present government took many positive steps to confront these problems, including an administrative reorganization and the elaboration of a comprehensive National Urban Plan in 1978 and of a National Industrial Development Plan in 1979 which reLlected the preoccupation of the present Administration with the long-term prospects of the industrial sector and their implications for the correction of the employment and regional imbalances probleas. 15. The high rate of growth experienced by the Mexican economy in recent years has provided the strongest weapon to tackle the long-term problems mentioned above. At the present time, Mexico is in the midst of an adjustment process which may bring about higher unemployment, albeit from relatively low starting levels, thanks to the recent record of high GDP growth. Lower growth, on the other hand, will afford an opportunity to reappraise many of the past years' goals and policy instrunments, in particular the level and structure of subsidies, and there is evidence that the Administration after having adopted unpopular decisions ia a politically difficult year, intends to carry out such a reappraisal. 16. Mexico's public and publicly guaranteed debt service ratio has been increasing over the recent past and peaked at 69 percent in 1979. This high ratio reflected the still relatively low level of exports to GNP and the high proportion of Mexican borrowing from commercial banks. The public debt service ratio declined to around 30 percent in 1980, not only as a result of rapid increases in petroleum exports,but also because some of the debt con- tracted on the least favorable terms had been prepaid; but it had risen again to an estimated 43 percent by the end of M81. Debt service on Bank loans amounted to about 3.2 percent of public debt service in 1980 this ratio is projected to remain about the same during the mid-1980s. The Bank currently holds about 5.7 percent of Mexico's total medium and long-term public debt, and this ratio is not likely to change significantly over the next few years. Mexico is creditworthy for borrowing on conventional terms.  -6- PART II - BANK GROUP OPERATIONS IN MEXICO 2| Bank Operations 17. As of March 31, 1982, Mexico had received 72 loans from the Bank amounting to US$5,218.1 millio:- net of cancellations and terminations; of these, 44 loans totalling US$2,438.6 million were fully disbursed. The Bank held US$4405.3 million, of which US$1,942.9 million had not yet been disbursed. 3/ Some 46 percent of Bank lending has been for agriculture and rural development, 14 percent for industry, 13 percert for power, and 15 percent for transportation; the remaining 12 percent has been for water supply, tourism, urban development and vocational training projects. tnnex II contains a summary statement of Bank loans as of March 31, 1982 and r.tes on the execution of ongoing projects. 18. Of the US$5.2 billion total lending, about US$2.5 billion was for establishing or strengthening institutions for channeling credit to areas where credit supply wa, deficient or -non-existent, and setting up in the commercial banking system the ability to carry out project-related appraisai of investments in agricilture, industry and tourism. These credit programs have facilita-ed lendirgr to low-income farmers and small- and medium-scale industrial enterprisaE based on productive investment plans rather than collateralized credit., 19. Implementation of most Bank-financed projects was delayed during the period of economic difficulties in the mid-1970s and during the period of stabilization that followed the September 1976 devaluation of the peso. Since then, the government has arranged adequate budget financing and has significantly improved project implementation. Four projects which had important structural constraints were modified and rephased to acconlnt for the changed circum.stances. Government and Bank officials have met periodi- cally to review project implementation, and greater attention has been focused in Mexico on project monitoring. As a result of these m.easures, -ost of the Bank-assisted projects are be-ing implemented sat!.sfactorily and dis- bursements have risen from US$91 million in FY78 to US$413 million in FY81. IFC Operations 20. As of March 31, 1982, IFC had made investment corn .tments in 23 companies in Mexico, for a total of US$551.2 million, of whic US$404.1 million had been sold, repaid or cancelled. A summary .,tatenent of IFC investments is presented in Annex II. 2/ This section is subst.,ntialiy uncha.nged from rile ?resident 's Report for the Capital Goods Industries Development Project (P-3284-ME of April 22, 1982). However, some minor changes have been introduced in para. 23. 3/ These totals do not include a $180 million lcan for agricultural development approved in Ma-rch 1982, but not yet signed.  -7- Bank Strategy 21. The main ob < ives of recent Baik lending in Mexico have been to: (a) support policies and > rams leading to a wider dl;stribution of the benefits of economic growth; :) help finance projects that make, directly or indirectly, significant contrib u ons to output and employment; (c) help reduce Mexico's urban-regional imb a nces; and (d) help break bottlenecks preventing rapid growth. 22. Because of the difficult structural problems of agriculture and the sector's crucial impoihtance foi- tne one-third of the national population living in the rural avdeas, the Bank has made agricultuLe the leading sector for its lending. The 1Bank's agriculturai lending program in Mexico has four goals: first, to inciXease productivity of presently cultivated lands; second, to improve the| productivity of small farmers; third, to complem,ent infrastructire investT nts with suDport services, such as extension, mark2ting prograns an(, credit; and fourth, to promote eiaployment generating investments In rural ceas. The Bank has made eleven loans in FYs76-81 totalling IJS$1,466 mi lion for irrigation, rural development and agricul- tural, agro-indastrial and livestock credit programs. A US$175 million loan for a rural develupmen: project and a US$180 million loan for an irrigation rehabilitation project hIave been apprc 7ed by the Executive Directors in EY827 Several proje.:ts for rainfed agr'culture, rural development, irriga- tion, fisheries, and support services are irn preparation. 23. Bank lending for industry has aimed at: (a) reduiction of the balance of payments dzficit; (b) promoting greater employment; ana (c) decen- tralizing industrial activities away from the major and increasingly con- gested urban areas. A steel project which the Bank helped structure and finance is now operating in a previously underdeveloped area on the west coast of Mexico, and the city in which it is located, Lazaro Cardenas, is developing into a new growth pole. Four loans for industrial projects to pronote the development of small- and miedium-scale industrial enterprises, to finance expansion of smaii- and medium-scale mining, and to support an indus- trial equipment fund (FONEI) were approved by the Executive Directors in FYs78-80D They offer support to the private sector at a time of rapid expan- s'on and are directed at all three goals m- itioned above. A loan for a voca- tional training project was appr ved by tll Executive Directors in July 1981; it is assisting a program to incrcase the supply of skilled workers and tech- nicians. A loan for a capital gooOs industries development projecr is under consideration of the Executive Dire tors. 24. Bank lending for physical J\nfrastructure has been focused on regional development and strengthening of institutions and sector policies. A highway sector oroject (FY79) and he fourth railway project (FY81) support these goals. The first and sec- nd medium sizc cli,ies water supply and sewerage projects (FY76 and 81) rai i orce the planning, management and firance of specialized water supply and ' werage institutions at the federal ani municipal levels and contribute to th\ establishment of tariffs more closely related to costs; a third project ;as been appraised and is expected to be presented -ro the Executive Directors in the coming raonths.  O ~~~~~~~8 25. The government has adopted a National 'urban Development Plan that spells (ut its regional development priorities in operational terms. A project to assist in the development of the Lazaro Cardenas coniurbation area was approved by the Executive Directors in FY78, and a second project for oil-prcducing soGutiieastern Mexico was approved by the Executive Directors in FY81 . 26. Tie Economic Development Institute (EDT) is assisting CECADE (a sliilar institute under the Ministry of Programming and Budget) in training Government staff in project preparation, monitoring and evaluation. EDT assistance is directed at urban and regional development, agriculture, rural development and agro-industries courses. The Bank has also assisted the Mexican authorities in training personnel for managing water supply and industrial credit projects. 27. The nter-American Development BanK (IDB) is the second largest source of multilateral aid to Mexico. The IDB has made loans to Mexico totalling US$2,697.1 million as of March 31, 1982. Over 60 percent of the total has gone for agricultural and rural development projects, and the balance for transportation, industry, water supply, and tourism infrastruc- ture. The IDB and the Bank have coordinated their assistance on several projects. Each has made loans for the nationol integrated rural development program (PIDER), agricultural anl livestock credit, small- and medium-scale industries development, and hotel development projects. The International Fund for Agricultural Development (IFAD) has approved a loan of US$22 million for a rural development project in the state of Oaxaca which was appraised by the Bank's staff and for which the Bank is acting as cooperating institution for auministaring the loan. 28. Bank-supported po-wer, steel, fertilizer and tourism projects in Mexico have been co-financed by several bilateral export credit agencies and commercial banks. The capital goods credit project, which will be presen-ted to the Executive Directors shortly, will be co-financed with commercial banks and export credit agencies. In January 1982, Mexico borrowed US$500 million to provide complementary financing for Bank-assisted projects whrore project specific co-financing would be difficult. PART III. ENVIRONMENTAl POLLUTION ANL ITS CONTROL Background 29, Mexico's industrial growth has averaged over eight percenit per year for the past three decades. Industrial growth, larger employment and market opportunities and superior infrastructure facilities available in the urban centers, have led to high -oncentrations of populations. The Creater Mexficc City Area (CEiCA) accounts Lor nearly one quarter of the country's total population, more than one-third of the industrial production, and about one half of the country's estimated seven million motor vehicles. With estimated populatioii of nearly 15 million, CMCA stands among the three or four most highiv por-" aced LmtropolitaA areas in the world. Rapid industrial anid urban  growth have create,l high levels of pollution of the air, water and land in GMCA and some otner urban areas. Corrective measures have assumed critical importance. The Government has issued legislation tc regulate levels cf contaminants from industrial, vehicular, and other sources and is now irn the process of implementing a comprehensive en-ironmental protection program. Nature of the Pollution Problem "0. Air Pollution. 1ndustrial activities and combustion of high sulfur fuel oil account for nearly all of the particulate end sulfur dioYide emissions in GMCA, abol,t one quarter of the hydrocarbon emissions, and two-thirds of the nitrogen oxides. Motor vehicles account for most of the carbon monoxide emissions and three quarters of the hydrocarbon emissions. Very high levels of these pollutants have been observed in GMCA's atmosphere in recent years. GI4CA's air pollution problems are intensified by its loca- tion in a sheltered valley at a high altitude (over 2,200 meters), with high solar radiation, poor ventilation, and noor combustion conditions. The maxi- mum daily concentration. levels of the four major contaminants substantially exceed World Health Organization (WHO) standards, 4/ 31. Other areas of the country with significant air pollution problems `nclude Guadalajara and Monterrey, the next two largest urban and industr-,al centers in thie country, and the Coatzacoalcos-Minatitlan area which is tht home of the country's rapidlv growing petroleum industry. Particulates and sulfur dioxide emissions, predominantly frou industrial sources, represent the major air quality problem in these areas. Air pollution levels for sus- pended particulates at some locations in these areas exceeded even the highest daily averages recorded 4n GMCA. 32. The daily emission rates of the various air pollutants will increase in the coming years unless rigorous corrective actions are taken. Installation of pollution control equipment, changes in industrial processes, use of natural gas (instead of oil) as fuel, and strict motor vehicle inspec- tion and maintenance programs are being contemplated as corrective measures. 33. Studies in GMCA have indicated adverse health effects, including signifiant increases in the incidence of respiratory iilnesses (with childrern showing a two-fold increase), and increased carboxyhemoglobin levels in the blood (which could cause ad-verse systemic effects, reduced maximum work capacity and visual impairments). Poor visibility conditions occur frequently in GMCA, mainly due to the htigh levels of ozone and particulates. Ozone is known to produce irritiation of tharoat, nose and eyes, and could increase asthmatic attacks and pulmonary dysfunctions. Lacreases in respira- tory ard cardiovascular diseases, adverse effects on the human nervous system, loss in visibility and aesthetics, as well as damage to structures and local vegetation due to atmospheric pollutants have been documented at lower concentrations than .nose found is Mexico City. 4/ The contamination levels as a percentage of WHO prescribed limits are: 600 percent for ozone, 490 percent for total suspended particu- lates, 230 percent for carbon monoxide and 130 percent for sulfur dioxide.  -10- 34. Water Pollution. Industrial effluents are a major source Df the country's water pollution; discharges of organic matter, ceic chemicals, detergents, heated liquids and other matter are recognized to have had harmful effects, including contamination of drinking and other waters, spread of water-borne diseases, and adverse impact on aquatic life. Such contamin- ation can be particularly crippling in a water-short country such as Mexico. Water pollution problems are made more acute by the fact that much of the domestic and waste indiustrial waters are discnarged without any treatment. 35. In 1973, the Secretariat of Agriculture and Water Resources (SARH) began a study of the couatry's hydrological basins, with a view to establish- ing priorities for water pollution control. The results of the study were used to group the 218 water basins according to their priority for pollution control action. The top priority group contains 11 basins containing 54 percent of the population and producing 77 percent of Mexico's GDP. These include the water bodies connected to GMCA, the Toluca-Lerma urban industrial corridor, the Guadalajara and Monterrey metropolitan areas, the Cuernavaca valley, and the Coatzacoalcos-Minatitlan petroleum producing zone. 36. Solid Wastes Polltution. Mexico's rapid urbanization and Industrial growth has led to vast increases in the amounts of solid wastes generated by its population and industry, as well as to significant changes in the charac- teristics of such wastes. More importantly, the rapid industrialization has led to generation of large quantities of toxic and hazardous industrial eolid wastes, which at present are simply discarded as part of municipal refuse. Sdch wastes if inadequately treated threaten to cause long-lasting damage to the environment, primarily through the percolation of rain waters which carry contaminants into the groundwater table. At present no reliable information is available on the amount of toxic and hazardous wastes generated by Mexican industry, their physical and chemical characteristics, location of sources and disposal sites, treatment and disposal practices being followed, and the environmental and public health consequences, To correct this and provide the basis for systematic monitoring and formulation of strategies to control industrial solid wastes, comprehensive studies would be undertaken under the project. Institutions 37. The Secretariat of Health and Public Welfare (SSA) has the overall responsibility for coordinating the environmental protection and regulatory efforts of various government agencies. SSA has direct responsibility for monitoring air and land pollution and formulating and implementing protection and control measures for these media. Direct responsibility for water pollution monitoring and control to a large extent lies with the Secretariat of Agriculture and Water Resources (SARH). SARH collaborates with SSA on issues involving public health formulation of standards and sanctions against violation of the standards. The Secretariat of Public Works assists state and local agencies in public works execution, including in executing or supervising the construction of local water supply and sewerage systems. 38. A Subsecretariat for Envllronmental Improvement (SMA) was estab- lished within SSA in 1972 to be in cGi;irge of its environmental protection responsibilities. SARH's iat-r poll.tion monitoring and control activities are organized under its Directorate General for Ecology Protection and  'sS ~~~~~~~~- 11 - Management (DGEP). In August 1978, the government also created, through a Presidential decree, an Interministerial Commission i Environmental Improve- zent to facilitate coordination at a high level of 2 country's overall pollution control strategies. Coordination at the operational level among the a;.,Rncies would need to be strengthened in the future to overcome some existing gaps and ambiguities. Pollution Control Legislation * 39. The Federal EnvironmenCal Protectior Law became effective in February 1982, superseding a 1971 law. The new law retains emission standards set in 1972-1973 under the former law, but substantially increases the penalties for non-compliance and streamlines the enforcement process. It ;s an important first step in the strengthening of Mexico's pollution control efforts. Pollution Control Standards and Enforcement 40. Induitrial Air Emissions. Air pollution regulations issued in 1972 specify limits on particulate emissions. from stationary sources such as industrial and electric power plants. While these emission standards have served to address some of the most critical dust and smoke emission problems in Mexico they need to be refined to take accotunt of the degree of congestion in the respective areas, fraction of respirable particulates, and the toxic content of particula'as emitted. Also at present there are no prescribed standards for gaseous emissions from stationary sources--a critical gap since some of the most important pollutants from industrial sources are gaseous. As part of the pollution control activities undertaken to complement the proposed project, the government is expected to issue modified emission standards to correct the above gaps. Enforcement efforts have also becn hindered bv lack of adequate air monitoring equipment and by deficiencies in knowledge of the sources of emissions. In connection with the proposed project, SMA would take steps to upgrade its air emissions inventory, develop its air pollution modelling capabilities and carry out a number of studies to be able to refine standards and emission control strategies in the medium term. 41. Starting in 1977-78, SMA's staff has been carrying out an inspec- tion program for particulate emissions from the major stationary sources, particularly in GMCA. While a reasonably intensive program of inspection visits has been carried out, effectiveness of the enforcement effort has been severely hampered by low limits on penalties for non-compliance. To help correct this, the 1982 law raised the ceiling to 10,000 times the minimum daily wage rate in Mexico City (corresponding to about US$80,000 equivalent presenLly) per offense, with doubling or further increases for repeated non-compliance. 42. Vehicular Emissions. Starting in 1971, the government has been implementing a program to control emissions from new motor vehicles which has resu-lted in a 60 to 70 percent reduction in hydrocarbon and carbon monoxide cnissions for the latest model cars in comparison with the pre-1971 uncontrolled vehicles.  -12 - 43. The legislation provides adequate control authority for vehicles in circulation, as well as new ones. The government has announced a mandatory vehicle inspection and maintenance program for GMCA. implementation of this program would be undertaken by the government in connection with the proposed project which woould provide financing and technical assistance to private automobile garages and the governmentt's inspection stations for the purchase of emissions testing equipment. 44. Water Effluent Control. The law requires all industries to register with SARH all liquid discharges. SARH has the responsibility for setting discharge standards for each registered source so that overall quality for a body of water can be maintained. Such discharge standards apply to iniustries, municipalities, and agricultural users of water. 45. The regulations provide for discharge inspections and for fines and other penalities, including plant closure, for violators. However, plant inspections nave averaged only about 350 per year in the last 3-4 years. Individual discharge conditions have been established only for about 3,000 discharge outlets out of about 93,n00 registered with SARH. To date SARH''s strategy has been to focus on the largest water polluting sources or cn situations where there is a strong public pressure for prescribing discharge conditions. While this has been an effective initial scrategy, a more systematic priority setting in terms of the water basins and type of dis- charges (e.g., toxic substances), and an accelerated and consistent setting ef individual discharge conditions in the selected areas for priority action i, now needed. 46. The main reasons why enforcement of standards has not been very effective are: (a) entities discharging into municipal sewer systems are not supervised by SARH nor are municipalities enforcing water quality standards; (b) effluent standards for rmunicipal discharges have not been adequately enforced by SARH; (c) maximum fines for pollution offenses were too low under tihe old law (maximum of US$2,000 equivalent); (d) control effort was con- strained by limited staff and budget resources for inspection and enforce- ment; and (e) a medium term strategy in water pollution control was not clearly defined. 47. Water Quality Control Districts. SAPH is establishing Water Quality Control Districts (WQCDs) to facilitate the reductioTL of water pollu- tion in priority zones. Comnmon wastewater treatmernt plants would be con- structed for groups of industries and ml nicipalities wfthin a given WQCD. While SARH's proposal to establish WQCDs seems attractive, further experience with the technical, organizational and cost recovery problems involved in operating common wastewater treatment Dlants is needed. To facilitate a decision on a national WQCD program which involves large investment costs, the Goveramenu is considering construction of pilot common wastewater treatment plants in one or two selected high priority basins and has sought the Bank's assistance for this experimental program. A pilot project is being studied for possible Bank assistance. Incentives for Pollution Control Related Investments 48. As part of its strategy to reduce urban and industrial rencentra- tion, the Government is providing fiscal incentives to encourage location of industry away from the most congested and polluted urban areas. The incentives include 10 to 20 percent tax credits on investment- plus  I IF -13- additionel credit proportional to the number of incremental jobs created by the investments. Similar tax and employment incentives are available for industrial enterprises relocating out of the GMCA to other parts of Mexico. Th le Government has also established fiscal incentives equivalent to 20 percent of the investment cost plus additional employment incentives for companies purchasing pollution control equipment, as well as those manufacturing such equipment in Mexico. Pn' lution control equipment is also eligible for accelerated depreciation. Finance for Pollution Cont-ol Investments 49. The main source of fir-.ncing for Mexican industry is its banking system comprising private and -xed public-private banks which offer a combi- nation of commercial bankinp investment banking and other financial services. The Mexican government has established trust funds to channel additional finance through the commercial banking system for investment in priority areas. The Industrial Equipment Trust Fund (FONEI) established in the Bank of Mexico is the most important fund providing finance for pollution control investment by private industries. 50. FONEI has had considerable experience in appraising and financing i3dustrial investments. It has maintained high standards and has developed sound relationships with majot commercial banking chains in Mexico. In 1981, FONEI approved loans totaling about US$300 million for 110 projects. Under the Bank-supported FourTh Industrial Equipment Fund Project, FONEI began e. finance pollution control investments. FONET has gained useful experience in pollution control finance, and its performance has been satisfactory. So far, about US$23 million (representing some 54 percent of total investment costs of the projects) have been loaned to projects for control of emissions from metallurgical, cement, textile and chemical industries. Industrial enterprises have shown considerable demand for credit for pollution control investments. In 1981, FONEI financed 12 projects totalling about US$18 million rquivalent as compared to 4 in 1980 and l in 1979. Pollution control projects now account for 6 percent of FONEI's total lending. Most of the projects are in the GMCA, Monterrey, Guadalajara and Toluca. This growth in demand is expected to continue as a result of the greater enforcement of the law being undertaken by SSA and SARH. Experience under Previous Projects 51. The Fourth Industrial Equipment Fund (FONEI) project, assisted by Bank Loan 1712-ME of July 30, 1979, includes an experimental pollution control component of US$6 million (para. 50). The majority of the funds provided to FONFI under the four Bank loans has financed investments in export-oriented or import substituting industries. Execution of these four projects has progressively improved (para 53): sibprojects have been well prepared and properly appraised. Most subprojects have been carried out successfully with actual output, exports, and employment exceeding anpraisal projections. Appraisal estimates of economic rates of return for subprojects, mostly in the range of 20 to 40 percent, appear to have been met in practice in the majority of cases. 52. A Project Perfor-mance Audit Report (PPAR) of the First and Second Industrial Equipment Fund (FONEI) Projects (SecM79-535) of June 1979 commented on two important aspects of FONEI's early operations: I  - 14 - (a) FONEI's londing mostly benefitted large and well-established borrowers; and (b) FONEI made little progress towards achieving its objective, set under the second Bank loan, of encouraging the intermediaries to use project appraisals as a major input to their lending decisions, rather than lending primarily on the basis of loan collateral. At the same time, the report acknowledged that FONEI financed sound investments that resulted in substantial foreign exchange savings. 53. The difficulties noted in the PPAR are in large part due to the fat that FONEI, in the period covered by the PPAR, was a new institution. Ea of these difficulties has been addressed in the Third and Fourth pr(jects subsequently approved by the Bank. FONEI's onlending rates have sirt e been increased and are nov on a floating basis linked to the ACF index (para. 61). Interest rate spreads to participating banks have been increased to reasonable levels to provide an incentive for banks to assume greater lending risks in the utilization of FONEI rediscounts and to participate more actively in the appraisal and supervision of investment projects. Recent evidence indicates that these measures, together with changes in the banking law. have helped to reduce banks' collateral requirements and to increase appraisal-based lending. PONEIT's lending is also becoming increasingly diversified, with a lower prcportion of the subloans going to th.: largest clients. FONEI's loan portfolio at year-end 1981 was distributed among 270 companies of which 86 borrowed from FONEI for the first time in 1981. PART IV. THE PROJECT 54. A report entitled "Pollution Control Proje t" (No. 3816b-ME dated April 28, 1982) is being distributed separately. Neg tiations for the Loan took place in Washington, D.C. on April 15-23, 1982. The Mexican delegation was led by Mr. Luis Nava of NAFINSA. Objectives and Project Description 55. The proposed project is part of Mexico's long run program to reduce pollution levels. The principal objectives of the project are to: (i) introduce more effective pollution control strategies and enforcement procedures; and (ii) encourage and help finance investments by industrial firms aimed at reducing amospheric ar.d water poliution. 56. To help achieve these objectives, the project would: (a) provide cred4t to industrial enterprises undertaking investments involving: (i) installation of equipment to control air or water pollution from stationary sources; (ii) changes in production process or technology to re.duce such pollution; (iji) relocation of plants from congested areas to more decentralized locations; and (iv) conversion of fuel oil combustion facilities to natural gas;  - 15 - (b) provide credit to private automobile garages for th