Mexico - Eighth Agricultural Credit Project

oCUMent o The World Ban FOR OMCIAL USE ONLY R*pst N.. P-3843-M ]REPORT A1D RECO1 kTTOIIS Pr}F; aF n UIIEATIOIAL BANK FCR DCOISTmCTION AIID IIEVEOPE EXECUTIVE DIRTORS CaN A P-OSnED LAN IL AN ANwUT EQIALrNT To uTso mILLIOLI TO NAIO?AL FLN1MERA, LSA. WIT WELE GUA&IEE OF UNITED NEICA SMTLTES FOR AN EIGHTE AGRICUIIURAL CEEDIT PROJBT Jue 4, 1984 Thb jow a resfteiggd dbftz.ul md my be w& by rcipi Om only in the peeh mme of their eseh duls. I P Is may w4 edwwie be dsqiumd whow WwMdink _,bim..  Currency Unit -Peso (ex S) On May 31, 1984, the exchange rate in the controlled market ws US$1 - Nex$L63.61; the freemarket exchange rate stood at US$1 Nex$181.73. Both exchange rates are currently sliding at a rate of 1ex$0.13 per day agatist the US dollar. Fiscal Tear January 1 to December 31 SrIGHIS MAD MEASURES 1 hectare (ha) 10,000 R2 - 2.47 acres 1 kilometer (kmZ) 0.62 miles 1 square kiLometer (km2) 0.39 sq. miles 100 ha I kilogram (kg) 2.20 pounds 1 liter (1) O.Z6 gallons 1 cubic meter (i3) 35 cubic feet 1,000 kg.-- 1 metric ton 0.98 long ton ABBREVIA7IONS ACF - Index of Average Cost of Funds to Multipurpose Banks BANIURAL - National Rural Credit Bank CECADE - Economic Development Training Center CONASUPO - National Marketing Corporation EDI - Economic Development Institute FEFA - Secial Agricultural Credit Trust Fund FEGA - Technical Assistance and Loan Guarantee Trust Fund FIDEC - Trust Fund for Marketing Development FIRA - Agricultural Trust Funds in Bank of Mexico FONDO - Trust FuTd for Crop, Livestock and Poultry Credit FONEI - Industrial Equipment Fund ICB - International Competitive Bidding IDB - Inter-American Development Bank IFAD - International Fund for Agricultural Development IFC - International Finance Corporation IMF - International Monetary Fund NAFINSA - Nacional Financiera, S.A NDP - National Development Plan SAN - Mexican Food Progra& SAEH - Ministry of Agriculture and Water Resources SOE - Statement of Expenditure  FOR OFFICL USE ONLY EIGHIH AGRICULTURAL CREDIT PROJECT Loan and Project Summary Borrower: Nacional Financiera, S.A. (NAFINSA) Guarantor: United Mexican States Beneficiary: Agricultural Trust Funds in the Bank of Mexico (FRAR) Amount: US$300 million equivalent, including a capitalized front-end fee of US$748,130. Terz=: Fifteen years , including three years of grace, at the standard variable interest rate. Relending Terms: Funds would be provided to FIRA as equity. The proceeds would be relent by FIRA on terms and conditions that vary with the income level of the beneficiaries and purposes of the subloans, as specified in the General Interest Rate Agreement negotiated recently with the Government. Project Description: The project is a credit program which would seek to increase agricultural productivity and production with a view to increasing exports, self-sufficiency in food and real farm income. It would continue to develop FlRA's institutional framework for efficient allocation of financial resources and assist to improve agricultural policies through the reduction of interest rate subsidies. The low-income producers' component would comprise about one-half of the total investment program. A program of training and demonstration would provide support to credit operations. About 105,000 families or 580,000 beneficiaries would benefit from the project. Project Risks: Since FIRA is a reasonably efficient and mature institution, the project presents no special risk in terms of the technical and financial soundness of various investment opportunities that would be financed under the program. The main risk would be that political pressures would Impede progress in eliminating interest rate subsidies, especially in the case of a resurgence of inflation causing a furtber deterioration of FIRA's financial position, a continued drain on Government budget resources, and a continued misallocation of production factors. This document hu a esicted disntbution and may be used by recipients only in heean of theiw officiad duties Its contents may not othewis be disdised witbout world Bank authoiiton.w  - ii - Estimated Cost: Local Foreign Total JSS mion 1. Investment Program Crop Investments 103 129 232 Livestock Investments 120 39 159 Agroindustrial Investments 33 27 60 II. Working Capital 137 60 197 Subtotal 393 255 648 III. Productive Support 12 3 15 IV. Project Cost 405 258 663 V. Price Contingency 59 41 100 VI. Total Investment 464 299 763 VII. Front-end Fee on Bank Loan - 1 1 TOTAL 464 300 764 _ - Financing Plan: Local Foreign Total =-- U4S$ mllion Participating Banks 102 102 FIRA 260 260 Bank 300 300 Beneficiaries 102 102 TOTAL 464 300 764 Estimated Disbursements: Bank FY 1985 1986 1987 1988 1989 US$ mIllion Annual 80 75 80 60 5 Cumulative 80 155 235 295 300 Staff Appraisal Report: Report No. 5014b-ME dated June 4, 1984. Economic Rate of Return: Economic Rates of Return for subloan investments range from 19% to over 100%.  REPORT AND RECOIMENDATION OF THE PRESIDENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED IOAN TO N&CIONAL FINANCIERA, S.A. WI THE GUARMAEE OF UNITED EXCAN STATES FOR AN EIGHTH AGRICULTURAL CREDIT PROJECT 1. I submit the following report and recoendation on a proposed loan to Nacional Financiera, S.A., (NAFI1SA.) with the Guarantee of Urited Mexican States for the equivalent of US$300 million to help finnce an Eighth Agricultural Credit Project to be carried out by the Agricultural Trust Fund (FIRA). The loan, which includes a capitalized front-end fee of 0.25 percent on the Bank loan, would be repaid over 15 years, including 3 years of grace, at the standard variable interest rate. Final beneficiaries would pay interest rates floating with the ACF index (average cost of funds to multipurpose banks) as specified in the draft General Interest Rate Agreement which is being distributed together with the project documents. The Government would bear the foreign exchange risk. PART I: THF ECONOMY 1/ 2. An economic report on Mexico (Mexico: Recent Economic Developments and Prospects, No. 4996-ME) was distributed to the Executive Directors on May 14, 1984. The report's m-an conclusions are summarized below. Background 3. After almost three decades of relatively stable and high economic growth, Mexico experienced a serious financial and economic crisis in 1976 and an even more serious one six years later, in 1982. When the Bank's previous economic report was prepared in 1980 and early 1981, an underlying trend towards structural economic imbalance was already evident, and the potential dangers were recognized. However, the issues were Lot addressed by the outgoing Governoent with the vigor that was required as oil revenues and external loans had temporarily eliminated foreign exchange constraints to development. 4. Today, Mexico is struggling to emerge from a crisis worse than any other in its modern history, and faces a severe resource constraint. In this struggle, the Government cannot afford to delay implementation of corrective policies on a broad front. Moreover, the prospects for a resumption of economic growth depend more than ever on favorable international conditions. The path leading to Mexico's economic recovery is a narrow one, with limited options and little room for maneuver in domestic policy. Developments During 1977-1982 5. The stabilization measures initiated in 1977 and the discovery and exploitation of large oil resources in the aid-1970g allowed the Lopez Portillo 1J This section is substantially unchanged from the President's Report for the Lazaro Cardenas Industrial Ports Project (P-3837-ME of May 31, 1984).  - 2 - Administration (Jan. 1977 - Dec. 1982) to overcome the serious financial crisis of 1976 and to start working on structural, social and economic problems, includ- ing poverty, income and wealth inequality, unemployment. regional imbalances and relatively slow agricultural growth. In the early years of that Administration (1977-1980) GDP growth was high (8.5 percent a year), 2.5 mllion jobs were created, domestic consumption recovered. and the share of investment and savings in GDP surpassed historical levels. 6. Rapidly rising public expenditures unmatched by revenues led to ir- creasing public deficits and an overheated economy. Although inflationary pres- sures mounted, the exchange rate was not adjusted. By mid-1981, the economic situation began to mirror the scene prevailing before the 1976 financial crisis. The appreciation of the real exchange rate contributed to a current accouat defi- cit of 5.8 percent of GDP, while the deteriorating international oil market conr ditions caused large revenue shortfalls with respect to budget expectations. The public sector deficit rose to just under 15 percent of GDP. External borrowing was used to finance part of the domestic fiscal deficits and to defend the ex- change rate. Mexico's foreign debt increased rapidly, at a time of high and rising international interest rates. A stabilization program initiated by the Government in mid-1981 was not sufficient to redress the growing fiscal imbal- ance, the high cost of foreign loans and the increasing private capital flight fueled by the public's anxiety over Mexico's financial troubles. 7. The crisis came to a head in 1982. In February, as capital flight intensified, the Bank of Mexico had to stop supporting the peso, which then experienced a 40 percent devaluation in dollar terms. A large wage adjustment granted in March 1982, which tended to undo the effects of the devaluation, and continuing slack in the oil market kept the balance of payments under strain. Under the circumstances, the international banking community was unwilling to commit new funds to Mexico, in the amounts required. These factors led to a second devaluation of the peso in August 1982, while the acute shortage of foreign exchange forced the Government to suspend the anortization payments of most of Mexico's external public debt pending a broader agreement on Its refinancing. Capital flight continued as private sector confidence was shaken by the nationalization of the banks in September 1982, and the mandatory conversion of US dollar deposits into pesos. Also put into effect were a generalized system of exchange controls and strict external trade restrictions. Recent Developments 8. The Administration of President de la Madrid, that began its term in December 1982, lost no time in taking steps to deal with Mexico's grave economic situation. The EFF agreement, approved by the IMF in December 1982, laid the basis for the re-negotiation of that part of Mexico's public external debt on which amortization payments had been discontinued in August 1982. Commercial banks agreed to restructure some US$19 billion of public sector debt and provide US$5 billion in net new loans for 1983. All obligations falling due between August 23, 1982 and December 31, 1984 were restructured over an eight year period, starting from January 1983, with a grace period of four years and at an interest rate of 1-7/8 percentage points over LIBOR (or 1-3/4 over the New York prime rate). The US$5 billion syndication had a 6-year maturity, with a 3-year grace period, at a spread of 2-1/4 over LIBOR (2-1/8 over prime). The restructir- ring exercise included an understanding that the international banks would  3 3- maintain their exposure to the Mexican banks that had been nationalized. At the same time, it provided a mechanism that would eliminate 1982 private sector interest arrears and facilitate payment of the rescheduled principal on such debt. 9. A new two-tier exchange rate system was introduced, with a controlled market for imports, most proceeds from merchandise exports (except those of in-bond industries) and debt related transactions, and a free market for all other transactions including those relating to tourism. The controlled rate was originally set at Mex$95 = US$1, a depreciation of some 35 percent in relation to the previously prevailing ordinary rate of Mex$70 per US dollar. It has been depreciated at a rate of Mex$0.13 per day, and is currently about Mex$164 per dollar. The free market rate had remained at about mex$150 per dollar until September 1983, when the authorities decided to let it slide at the same rate as the controlled rate, and is now about Mex$182 per dollar. The differential between the two rates, which in December 1982 stood under 60 percent, is now down to 11 percent. Although inflation continred to be high (about 81 percent in 1983), the real effective exchange rate in the controlled market remains competi- tive, and non-oil exports have risen considerably. 10. Under the IMF Agreement, the Administration committed itself to a dras- tic reduction of the public sector deficit, from 18.0 percent of GDP in 1982 to 8.5 percent in 1983, 5.5 percent in 1984 and 3.5 percent in 1985. SuaDstantial progress was achieved during 1983 in meeting the program objectives. The public finances were strengthened considerably and the public sector deficit in 1983 remained at all times below the ceilings established under the program. The brunt of public expenditure cuts in 1983 was borne by public investment. The cuts were made virtually across the board, but the authorities gave priority to completing projects that were already far advanced and to those that were import- ant for employment, equity, or foreign exchange earnings. Overall, public investment excpenditures are estimated to have declined in 1983 to about 7.4 per- cent of GDP, from 11.7 in 1982. The fiscal performance of 1983 was also aided by significant price increases for nearly all public goods and services, including petroleum products, electricity rates, food, etc. The Government has committed itself to a substantial reduction and eventual elimination of most subsidies, including those provided in the form of low interest rates. 11. The balance of paymenats experienced a major turnaround, the current ac- count moving from a deficit of almost US$5 billion in 1982 to a surplus of US$5.5 billion in 1983. The strength of the current account and the availability of e- ternal finance permitted Mexico to replenish its international reserves while paying a large part of the arrears that had accumulated in 1982. The net use of foreign financing by the public sector was US$4.2 billion for the year-below the ceiling of US$5 billion under the stabilization program. The errors and omis- sions account of the balance of payments dropped from US$11 billion in 1982 to an estimated US$0.4 billion in 1983, largely reflecting the decline in unrecorded capital outflows. The swing in the current account was mainly the result of a very sharp contraction of merchandise imports, to US$7.7 billion representing a decline of about US$7 billion from their 1982 level. The recession, the large devaluation of the peso and the quantitative restrictions all contributed to this. The performance of non-oil exports which had been poor in the earlier part of the year, improved considerably in the second half and showed an increase of 10.6 percent in dollar terms for the year as a whole. Growth in tourism and in- bond industry was particularly strong, and helped in alleviating unemployment.  The Government's stabilization program, together with a moderate incomes policy helped bring down inflation; it averaged 70 percent (annualized rate) in the last quarter of 1983 compared to 125 percent in the first quarter. The flow of savings into the banking system was in line with the projections of the program, reflecting both the exchange rate and interest rate policies. The impact of the severe and sudden adjustment of public expenditures and imports on economic growth has been serious; GDP is estimated to have declined by close to 5 percent in 1983. However, some signs of economic recovery have appeared in recent months: the demand for credit in the private sector has increased, and employment in the modern sector has risen somewhat. 1Z. The nev Government took steps to regain the confidence of both domestic- and foreign private investors. These included efforts to deal with the problems of private external debt, procedures to compensate owners of nationalized banks, and a more flexible application of the foreign investment law. Negotiations are now being completed with commercial banks and other private creditors for the refinancing of a total of US$11.6 billion of private sector obligations at stretched out maturities varying between 6 and 12 years, with 3- to 4-year grace periods. Moreover, the Government undertook the restructuring of Mexican private sector obligations guaranteed by official credit agencies abroad. The Government recently announced a program to transfer back to private sector ownership most of the 400 private firms that were controlled by the commercial banks prior to their nationalization. These measures and announcements have been beneficial, but much more remains to be done to restore full confidence of Mexican entrepreneurs and foreign investors. The Government fully realizes that this is an issue of the greatest importance as economic recovery beyond the current stabilization period will depene critically on the resumption of vigorous private investment. Short-term Economic Outlook 13. The Administration's stabilization policies will continue in 1984. The authorities expect a gradual resumption of economic growth and a further re- duction in inflation, while maintaining a strong balance of payments. Real GDP in 1984 is projected to grow by about 1 percent, -hile inflation is expected of- ficially to decline to about 40 percent, on a December-to-December basis, com- pared to 81 percent the year before although that may turn out to be somewhat op- timistic. The increase in economic activity is to be based mainly on a revival of the private sector and a small increase in public investment. Total employ- ment should continue to rise as the authorities proceed with the implementation of an emergency program to create and maintain between 700,000 and 800,000 addi- tional jobs in 1983-84. Declining domestic inflation (combined with the steady slide of both the controlled and the so-called free market exchange rates - see para. 9) is expected to provide adequate incentives to export development and ef- ficient import substitution. The Government expects merchandise imports to inr- crease to US$14 billion in 1984, partly as a result of recent measures reducing the restrictiveness of the import licensing system, and merchandise exports to US$24 billion (from US$22 billion in 1983) with most of the increa_e coming from nonr-oil exports. The current account surplus for the year is expected to be about US$0.7 billion in 1984. For 1984, the growth in public sector debt out- standing and disbursed is to be limited to US$4 billion. An important source of external financing for the year will be a US$3.8 billion syndicated loan from commercial banks. This loan will have a 10-year maturity, with a 5-3/4-year grace period, comparing favorably with the 1983 US$5 billion loan of 6-year matu- rity and 3-year grace. Further, the spreads on the new loan are 1-i percent over LIBOR (1-1/8 over prime), down from 2-1/4 over LIBOR (2-1/8 over prime) in 1983.  -5- Nediumr-term Prospects 14. The Government's strategy, as outlined in the National Development Plan (NDP) for 1983-1988, combines special efforts to recover from the present crisis with a longer-term perspective on regaining balanced and stable growth to over- come structural problems. The main structural problems facing Mexico in the years ahead include the very high rate of population growth (2.6 percent estimated for 1983) together with an even higher rate of labor force growth (a little under 4 percent), slow growth in agriculture, poverty, a highly skewed incerpersonal and interregional income distribution, and an overly oil-dependent economy with a manufacturing sector that has been inward looking for too long. 15. The medium-term strategy presented in the NDP focuses on the need for structural changes in the economy including a greater export orientation of the industrial system, poverty alleviation through basic needs policies and improve- ment in labor absorption, decentralization of economic activity, revision of external trade policies and modernization of the commercial structure. The basic elements of policies to address structural problems are mentioned in the NDP and it is expected that further details on specific programs and schedules for policy adjustments will be provided in the sectoral plans which are now under preparation. 16. Mexico's medium-term prospects for recovery and stable economic growth are good, provided economic management continues to be prudent, private sector confidence is restored, and the international environment remains favorable. Adequate domestic policies include inter alia continued efforts to reduce the fiscal deficit, liberalize trade and minimize price distortions. Restoration of private sector confidence is cr'icial since only a strong and dynamic private sector will be able to raise investment from the present depressed levels and to supply the increasing non-oil export surplus required for the resumption of growth. Success in this regard will depend critically on the quality and the effectiveness of Government's policies. As regards the external environment, the commercial banks are expected to maintain their exposure in Mexico in real terms, and foreign markets to be open to Mexico's nonr-oil exports. Mexico's prospects would benefit from a continuing fall in interest rates in the world financial markets (a one percentage point drop would mean a savings of about US$800 million in overall interest payments) and rising petroleum prices (a one dollar change in the price of a barrel of oil would alter export receipts by $550 million for the year). 17. Under favorable external and domestic conditions, Mexico's economic growth could reach 6 percent a year--the historical average for Mexico -towards the late 1980s. This growth would materialize through a sustained recovery of the commodity producing sectors. Contrary to the recent experience with public expenditure-led growth, Mexico's future economic performance will depend critically on the recovery of private sector investment. External Debt and Creditworthiness 18. Mexico's external public debt increased by about US$4 billion during 1983 and is expected to rise by a similar amount this year. With an expected net new borrowing of some US$3 to US$4 billion a year, the ratio of external debt to GDP would decline steadily from 41 percent in 1984 to 33 percent by 1990. The  - 6 - debt service ratio (32 percent in 1984 after rescheduling) would peak at about 60 percent in 1987-as amortizations on new borrowing and the rescheduled debt fall due-and would decline thereafter to below 40 percent by the end of the decade. The ratio of public debt outstanding to exports of goods and non-factor services would fall from 2.5 in 1984 to 1.5 in 1990. 19. As its debt repayment schedule implies large gross financing needs during the 1980s, Mexico will need to count on the continued cooperation of the international financial community in refinancing amortization payments and providing some additional net new borrowing. Such cooperation is already evident from the favorable terns of the US$3.8 billion jumbo loan from the commercial banks for 1984 (see para. 13), reflecting the Improvement in Mexico's external position. At the end of 1982, the last year for which a comprehensive external debt report is available at this time, the Bank's share in Mexico's debt was 5.3 percent. The Bank share in Mexico's total public external debt service payments during that year was 3.7 percent. In view of the good medium and loug term potential of its economy and the prospect of continued pursuit of sound economic policies by the present Administration, Mexico is considered creditworthy for IBRD borrowing. pART II - BANK GROUP OPERATIONS IN MEXICO2/ Bank Operations 20. As of March 31, 1984, Mexico had received 82 loans from the Bank amounting to US$6,486 million, net of cancellations and terminations; of these, 53 loans totalling US$2,887 million were fully disbursed. The Bank held US$5,335.9 million, of which US$2,327.4 million had not yet been disbursed. Some 42 percent of Bank lending has been for agriculture and rural development, 23 percent for industry, 11 percent for power, and 13 percent for transportation; the remaining 11 percent has been for water supply, tourism, urban development, vocational training and pollution control projects. Annex II contains a summary stat.ment of Bank loans as of March 31, 1984. 21. Of the US$6.48 billion total lending, about US$3.2 billion was for establishing or strengthening institutions for channelling credit to areas where credit supply was deficient or non-existent, and setting up in the com- mercial banking system the ability to carry out project-related appraisal of investments in agriculture, industry and tourism. These credit programs have facilitated lending to low-income farmers and small- and mediumrscale industrial and tourism enterprises based on productive investment plans, rather than credit granted on the basis of collateral. 22. The Government arranged adequate budget financing in the years 1978 to 1981, which significantly improved project implementation. Government and Bank officials met periodically to review project implementation, and greater attention was focused in Mexico on project monitoring. As a result of these measures, most of the Bank-assisted projects were being implemented satisfacto- rily until mid-1982 and disbursements rose from US$91 million in FY78 to US$448 2/ This section is substantially unchanged from the President's Report for the Lazaro Cardenas Industrial Ports Project (P-3837-ME of May 31, 1984).  - 7 - million in FY82. However, the present financial crisis is again causing delays in the provision of counterpart funds, consequently, disbursements in FY83 declined to US$389 million. A Special Action Program (SAP) was established in early 1983 to help the Government by alleviating the counterpart funding cons- traints on development projects, and 18 Bank financed projects are receiving support under the Program. Partly as a result of the SAP, disbursements during the first three months of 1984 improved significantly and, at US$195 million, almost equalled thrice the amount disbursed in the same period of 1983. IFC Operations 23. As of March 31, 1984, IFC had made investment commitments in 23 companies in Mexico, for a total of US$730.4 million, of which US$542.8 million had been sold, repaid or cancelled. A summary statement of IFC investments is presented in Annex II. IFC has been working together with the Bank in preparing proposals to establish a facility for provision of foreign exchange financing to private sector companies for the importation of machinery, equipment and spare parts required for production of exportable products, for efficient import substitution and for improvements in the utilization of their existing productive capacity. IFC approved a US$100 million facility (including funds mobilized from foreign commercial banks) in 1983, which is providing finance for fixed investments of a larger size than those assisted under the Bank loan for an Export Development Project. Bank Strategy 24. The main objectives of Bank lending in Mexico in the past eight years have been to: (a) support policies and programs leading to a wider distribu- tion of the benefits of economic growth; (b) help finance projects that, di- rectly or indirectly, contribute significantly to output and employment; (c) help reduce Mexico's urbanr-regional imbalances; and (d) help free bottlenecks which prevent rapid growth. More recently, however, in response to Mexico's requirements following tbhe 1982 economic crisis, the Bank, in close cooperation with the IMF, also supported the Government's stabilization program through asr- sistance for export promotion and intensified and broadened economic and sector work. As for medium term prospects, the volume and composition of Bank lending to Mexico would be related to progress in the implementation of policy reforms needed for structural economic adjustments, through broad policy conditionality affecting the entire lending program or important parts of it. Specific policy reforms that would be pursued through a dialogue with the Government, to be conducted in parallel with the processing of lending operations, would cover priority macro-economic and cross-sectoral issues, such as interest rate policy, energy pricing, subsidy reduction and export development. 25. Because of the difficult structural problems of agriculture and the sector's crucial importance for the one-third of the nation's population living in the rural areas, the Bank has made agriculture the leading sector for its lending. The Bank's agricultural lending program in Mexico has four goals: first, to help increase productivity of presently cultivated lands in general; second, to give emphasis to improving the productivity of small farmers; third, to complement infrastructure investments with support services, such as extenr- sion, marketing programs and credit; and fourth, to promote employment-generat- ing investments in rural areas. The Bank has made 13 loans in FYs78-83 total- ling US$1,829.4 million for irrigation, rural development and agricultural,  - 8 - agro-industrial and livestock credit programs. A US$175 million loan for a rural development project and a US$180 million loan for an irrigation rehabili- tation project were approved by the Executive Directors in FY82, and a US$138.4 million loan for San Fernando rainfed agricultural development was approved in early FY83. A US$115 million loan for marketing perishables was approved by the Executive Directors in April 1983. Projects for rainfed agriculture and regional development are in preparation. 26. Bank lending for industry has aimed at: (a) reduction of the balance of payments deficit; (b) decentralizing industrial activities away from the major, increasingly congested, urban areas; and (c) promoting greater employ- ment. 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 promote the development of small- and mediumrscale industrial enterprises, to finance expansion of small- and medium-scale mining, and to support an industrial equipment fund (FONEI) were approved by the Executive Directors in FYs78-80. A loan for a vocational training project was approved by the Executive Directors in July 1981; it is assisting a program to increase the supply of skilled workers and technicians. A US$152.3 million loan for development of a capital goods industries project and a US$60 million loan for pollution control were approved by the Executive Directors in FY82. A modification in the capital goods project was approved by the Executive Directors in early 1983 to set up a pilot export development fund to help satisfy the foreign exchange needs of Mexican exporters. A US$350 million loan for an Export Development Project and a US$175 million loan for a Third Small and Medium Scale Industry Development Project were approved by the Executive Directors in FY83. 27. Bank lending for physical infrastructure has been focused on regional development and strengthening of institutions and sector policies. A highway sector project (FY79) and the fourth railway project (FY81) support these goals. The first and second medium-size cities water supply and sewerage pro- jects (FY76 and 81) reinforce the planning, management and finance of spe- cialized water supply and sewerage institutions at the federal and municipal levels, and contribute to the establishment of tariffs more closely related to costs; a third project was approved by the Executive Directors on May 17, 1983. 28. The Govern ent has adopted a National Urban Development Plan that spells out its regional development priorities in operational terms. A project to assist in the development of the Lazaro Cardenas urban area was approved by the Executive Directors in FY78, and a second urban project for oil-producing southeastern Mexico was approved by the Executive Directors in FY81. A loan for the preparation of a deconcentration program for the Mexico City Region was approved by the Executive Directors in August 1982. 29. The Economic Development Institute (EDI) is assisting CELADE (Centro de Capacitacion de Desarrollo Economico under the Secretariat of Programming and Budgeting) in training Government staff in project preparation, monitoring and evaluation. EDI assistance is directed at courses on urban and regional development, agriculture, rural development and agro-industries. The Bank has also assisted the Mexican authorities in training peiionnel for managing water supply and industrial credit projects.  30. The Inter-American Development Bank (IDB) is the second largest source of multilateral aid to Mexico. The IDB has made loans to Mexico totalling US$3.1 billion as of March 31, 1984. Over 50 percent of the total has gone to agricultural and rural development projects, and the balance to transportation,. industry, water supply and sewerage, tourism infrastructure, education, municipal development, and pre-investment. The TDB and the Bank have coordinated their assistance on several projects. Each has made loans for the national integrated rural development program (PIDE) ), agricultural and livestock credit, small- and mediumr-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 administering the loan. 31. Bank-supported power, steel, fertilizer and tourism projects in Mexico have been co-financed by several bilAteral export credit agencies and cocmercial banks. nl January 1982, Mexico borrowed US$500 million from commercial banks to provide complementary financing for Bank-assisted projects where project specific co-financing would have been difficult. FARr III. THE AGRICULTUAL SECTOR Ari,culture in the Economy 32. Mexico's agricultural sector contributes about 1OZ of the gross domestic product, employs about one-third of the country's active labor force and contributes about 6Z to the country's exports. Between 1945 and 1955, annual agricultural production growth rates averaged about 6%, but declined to about 4.4Z between 1955 and 1965, and to less than 3% between I965 and 1980. During the latter period, production increases from newly irrigated land slowed down and agricultural terms of trade gradually worsened. However, agricultural production increased at an annual rate of about 8.5X in both 1951 and 1982. The increase was the combined result of favorable weather conditions, higher farm-gate prices and large input subsidies under the Government-sponsored Mexican Food Program (SAM). 33. The reduced agricultural production growth before 1981, coupled with increasing internal demand, resulted in Increased food imports and deterioration in the agricultural trade balance. In 1979 the country experienced its first agricultural trade deficit, and in 1981 the deficit was over US$1 billion. However, since 1982 the agricultural trade deficit has reversed primarily due to reduced imports influenced by substantial devaluations. Since 1970, corn, wheat, soybeans, sorghum and powdered milk have been the principal food imports, representing about 7.6% of total imports in 1980. During the same period, cotton, coffee, fruits, and vegetables constituted the main exports. Production Trends and Past Agricultural Policy 34. Mexico's basic crops, which include maize, beans, wheat, rice, sorghum, soybeans and sugarcane are produced on about 75% of the cultivated area. Production has varied strongly from year to year with a basic growtb trend of 1.5% to 2.5% over the 197IO, i.e., well below the population growth rate. Government intervention in the price setting and marketing of these crops gradually grew  - 10 - stronger over the decade. With the pressure to protect the consumer agaist increased food prices during a period of gradually increasing inflation, the terms of trade worsened. As a result, imports of these crops increased strongly, i.e., maize imports increased from 736,000 tons in 1970 to 3.8 million tons in 1980 and sorghum imports from 10,900 tons in 1970 to 2.8 million tons in 1981_ From 1980 to 1982, the Government attempted to reverse this trend, by substantially increasing farm-gate prices and introducing a range of input subsidies in the context of SAMY Farmers responded positively but, as consumer prices for the basic products were adjusted more slowly than producer prices, consumer subsidies increased and the Government progrma became too costly to maintain after 1982. 35. The production of export crops (mainly coffee, fruits and vegetables), which has remained relatively free from Government intervention in trade and prices, showed an annual average growth of about 12% between 1975 and 1979. In the ensuing three years, exports of these crops stagnated, mainly due to an inreasig overvaluation of the Mexican currency. However, indications are that since I982, growth has resumed. Rgarding livestock activities, beef production grew at an annual rate of 7% between 1975 and 1982, and pork, poultry =eat and eggs production at even higher rates, between lot and 12Z annmally over the same period. These growth rates were sufficient to cover increased domestic demand and Mexico's traditional beef exports were basieally maintained. Milk, however, which is produced under controlled prices, grew at only about 1.8% per annum during this period. Milk imports In the ten years before 1982 rose at an anmmal rate of about 07., and presently equal about 16Z of total production in fluid equivalent. 36_ Growth In related sectors has been mixed: (a) the agroindustries subsector grew rapidly through the decade of the 1970s (1(% per annum), and in 1979 accounted for about 18% of the industrial sector's output; (b) the forestry sector which comprises about 21 million ha of comercial wood is underexploited, producing only about 9 million m3 of wood products In 1981; and (c) the fisheries subsector has shown significant growth in recent years risin from an annual catch of about 0.25 mlllion tons in 1970 to about 2 million tons in 1982. Approximately 30% of the value went into exports (mainly shrimp) and about 5UZ of the total catch into fish meal. Present Government Agricultural Strategy 37. At the end of 1982, when the new Goverrment took office, there was an urgent need to reassess and reorient agricultural development policies. After substantial devaluations, domestic farm-gate prices had deteriorated in real terms. Strong price increases, especially for the basic comodities * were required if farmers were to maintain and increase production levels. On the other hand, in order to suppress inflation there was a need to contain food price increases. Also, in view of high public sector deficits, the Government's agricultural subsidy policy needed to be overhauled. 38. The Government's strategy, as outlined in the National Development Plan for 1983-1988, aims at accelerated agricultural growth. The policy emphasizes the importance of agriculture in increasing Mexican exports and production of import substitutes. The stated policy over the medium-term is to guarantee farm prices which are consistent with international prices. Hbvever, in the short-term, emphasis is being placed on adequate compensation for the increased cost of production and a reasonable profit margin to producers to determine price levels. Prices for basic crops (i.e., mostly the controlled sector) increased about 120%  - 11 - in nominal terms during 1983 and further increases, averaging around 35%, have been made in 1984. The basic staples, such as maize and wheat, are nw priced at current international levels- Input subsidies have been strongly reduced- Subsidized prices for key inputs (i_e-, fertilizer and seeds) are mow only available for rainfed-mafze production to small farmers halding less than 20 ha each. Interest rates on agricultural subloans, which until now were fixed and generally negative in real terms, will be made variable and are to approach positive levels gradually in accordance vith a timetable that forms part of the General Interest Rate Agreement between the Government and the Bank. The movement in rates will be referenced to the latest average cost of funds to multipurpose banks (AC?)3-1 Irrigation water rates were increased on an average about 2OM during 1983 and further adjustments are expected to be made towards tne stated goal of achieving operation and aintenance costs recovery under a geveral strategy to improve the use and management of Mexico' s water and soil resources. Improvement and rehabilitation projects will be undertaken in existing irrigation areas, and new investments will be decided on selectively, stressing smail and medium-scale irrigation projects in regions with a lesser degree of development_ The Government is also taking steps to decentralize planning, programming and Implementation of rural development projects to state and local levels and to improve interagency coordination. Agricultural policy dialogue between the Government and the BaTnk has been intense in the recent past, and both have agreed to a continuous policy dialogue in the future- Agricultural Credit 39. Within the context of its agricultural development policies, the Government has used credit as an important instrument for achieving growth and equity objectives. First, it has encouraged growth in agricultural lending by making public funds available (through the Bank of Mexico or from the budget) to various financing agencies, such as the Agricultural Trust Funds (FIRA), to discount subloans made by Mexican banks. Second, it has significantly promoted credit to low-Income producers by (a) financing operating subsidies of the state-owned National Rural Credit Bank (BAZIRURAL); (b) providing technical assistance and loan recovery guarantees to comercial banks that lend to low-income producers; (c) obliging such banks to bold part of their legal deposits in the Bank of Mexico in low-income producer loans; and (d) since 1976, increasingly, financing subsidized interest rates on loans to such farmers. The result has been a dramatic growth in outstanding agricultural credit from the commercial and public banks from Nex$17.7 billion in 1970 to Mem$218.5 billion In 1981-an average annual increase of 10.4Z in real terms. Low-income producers accounted for about 50% of the total loan portfolio in 1981. 40. While agricultural credit grew continuously up to 1981, growth came to an abrupt end in 1982, when institutional credit to agriculture fell nationwide by about Z8Z in real terms; again in 1983 it fell by about 25Z. The decline occurred because (a) as a result of high inflation, recuperations on the existing loan portfolio were inadequate to cover the demand for funds; and (b) the Government was unable to finance the large subsidy required to bridge this gap. In addition, because of strong devaluations, many traditional US sources of short-term 3/ The weighted average of interest rates paid by financial institutions on bonds, notes, and certificates of deposit, excluding checking and savings accounts. This rate is published monthly by the Bank of Mexico.  - 12 - finan ing outside the domestic banking system disappeared. In 1983, the banking system could not satisfy all of the demand for agricultural credit. 41. FlRA. The Bank of Mexico is the trustee for the three agricultural trust funds, which are integrated for management and accounting purposes and administered as FIRA: (a) the Trust Fund for Crop, livestock and Poultry Credit (FOEDO), which discounts to participating comercial and public banks short-term subloans for crops, livestock and agroindustry; (b) the Special Agricultural Trust Fund (FEFA), which discounts medium- and long-term subloans for crops, livestock and agroindustry; and (c) the Technical Assistance and Loan Guaranree Trust Fund (FEG&) ,which defrays to participating banks part of the cost of subloan evaluation and technical assistance for low-income producers, and guarantees the commercial banks' contribution to these subloans. 42_ FIRA and the Bank have a long and good relationship, having satisfactorily completed six projects with the ongoing seventh agricultural credit project substantially on schedule (providing a total financing of US$925 million). In addition to being one of the main providers of financial resources to the Mexican agricultural sector, FIRM provides significant technical assistance to coumercial banks and to farmers, through its training programs and demonstration centers. Throughout the years, FIRA has earned a good reputation, and its management is experienced and of high quality. However, some fine tuning of its operations will be needed, especially in the field of mediumrterm planning, in order to optimize use of scarce resources. Moreover, FIRA's technical assistance program needs to be expanded, to promote producers' adoption of new and improved technology and to strengthen its monitoring and evaluation procedures. 43. Until end-1981, FIRA's annual operating profits were sufficient to avoid decapitalization of its equity. This position vas reversed when inflation rose to 99Z in 1982 and 81Z in i983, while interest rates on subloans were fixed. In addition, prevailing rates for current lending were not raised sufficiently to adjust to the high inflation levels of the period. However, the decapitalization of the loan portfolio was largely absorbed by the Government through (a) Bank of Mexico rediscounts of about 60Z of FIRA's discounts at varying rates of interest, allowing FIRA a fixed margin of 3Z to 3. 5; and (b) Government guarantees which absorb exchange losses on almost all foreign indebtedness. At end-1983, the accumulated losses (1981 to 1983) on existing FIRA foreign indebtedness to be absorbed by the Government amounted to about Mex$70 billion (US$437 million). After deducting the Government subsidy, FIRA suffered decapitalization at an average of about 30Z per year during 1982 and 1983. 44_ For the next four-year period (mid-1984 to mid-1988), FIRA has adopted an overall lending target of about US$3,556 million. This would allow it to increase its level of lending by 5Z per annum in real terms. FIlA's proposed lending program would be financed partly by Bank of Mexico financing, equivalent to about 40Z of its total lending. The remaining balance would be generated from FIRA's own resources and through external borrowlngs. During the period 1984-88, FIRA's financial gap, after allowing for the repayment of US$442 million of foreign indebtedness becoming due, would be US$790 million. The Bank's proposed loan of US$300 million would allow FIRA to reduce this gap to US$490 million. 45. BANRURAL. BANRURAL, a public entity and the largest bank in Mexico, incorporates 12 subsidiary regional banks with 630 branches. Its lending operations, which increased from Mex$24 billion in 1970 to Mex$74 billion in  - 13 - 1981 and Me3$ 169 billion in 1983, consist mainly of short-term credit (82X of 1983 lending) primarily to low-income producers (about 90% of total). BANRURAL's operating costs are high (about 16Z of loan portfolio) and a high percentage of its loans are in arrears or unrecoverable; as a result, the bank is heavily subsidized. In 1981, the Government allocated from its budget about Hex$54 billion (US$2.2 billion), consisting of an equity contribution of Mex$ 14 billion and an operational subsidy of Hex$40 billion. While BADRURAL as a financial institution is considered too weak at this time for direct Bank financing, it is allowed to participate in FIRA's discounting system because FIRA exercises, through its own control mechanism, sufficient selectivity and supervision to obtain good performance. 46. Commercial Banks. The commercial banks, which were nationalized on September 1, 1982, continue to operate in a manner similar to their previous role as private banks. Because of the support extended by FIRA in terms of funds, training of staff and other support services, many commercial banks have established agricultural credit departments with agricultural technicians, who are graded and authorized to evaluate and approve subloans at varying levels. Lending operations by commercial banks traditionally concentrated on commercial producers and agroindustries. Consequently, the Bank of Mexico, in order to encourage lending to low-income producers, stipulated that 0.7Z of total deposits of multipurpose banks and 2Z of deposits in cammercial banks must be held in the form of agricultural loans to low-income producers. In addition, FEGA provides guarantees (about 802 of subloans) and reimburses technical assistance for subloans to low-income producers. Lending by commercial banks tbrough FIRA to low-income producers now averages about 28% of total subloans discounted as compared to about 102 in 1980. The commercial banks discounted about Mex$109 billion of subloans with FIRA in 1983, representing 83Z of FIRA's total discounts. Previous Bank Projects 47. In the past ten years (FY1974-83), Bank participation in the agricultural sector amounted to US$2,523 million distributed among 19 projects, of which three were credit proiects (FIRA V, VI and VII) with Bank financing totalling US$765 million. In December 1982, the Bank issued a combined completion report on the Fifth and Sixth Credit Projects (Report No. 4240). The overall conclusions were as follows: (a) FIRA's performance has been impressive and has had a strongly positive impact on agricultural production and institution building; (b) specific components set aside in Bank loans for low-income producers have helped to focus lending more on this farmer category. Also, lending, which was initially mainly for livestock, has become progressively more diversified; (c) FIRA, supported by the Bank, was in the process of developing a monitoring and evaluation system to measure lending impact, and has over the past three years effectively decentralized its lending operations, as a result of which most of its field offices have a reputation for excellence;  - 14 - td) the gap (since 1976) between FIRA's interest rates and commercial interest rates progressively widened as no provisions were made for periodic adjustments during implementation. This caused (i) an accelerating demand for credit; and (ii) a slow deterioration of FIRA's financial position; and (e) FIRA's capabilities for sectoral analysis, planning and programming and internal control of subloans was inadequate in the face of strongly expanded demand. 48. The Seventh Project, which is expected to be completed in mid-1984, was designed taking into account the experiences and lessons gained through the previous projects. There is a significant improvement in quality control of subloans financed through FIRA. An Operating Regulations and Procedures Manual and a data base system have been developed and a monitoring and evaluation system has been satisfactorily organized. FIRA's capabilities for in-depth sectoral analysis and medium-term planning and programming could, however, still be improved. In addition, interest rate adjustments have not been sufficient to cover the gap between agricultural on-lending rates and inflation. 49. Completion reports on two irrigation projects (Panoco, Loan 969-ME, and Sinaloa, Loan 970-ME) have been issued. The lessons learned from these projects, which have been confirmed by the audits are: (a) the evaluation of irrigation projects should consider the alternative of developing rainfed agriculture; (b) a strong extension service is necessary for the development of agriculture; Cc) projected agricultural production targets should be based on tested models; (d) large civil works components require advanced preparation before appraisal; and Ce) phasing should be considered for projects with long implementation periods. 50. Implementation of ongoing projects is currently slow because of limited counterpart fund availability. In addition, disbursements have lagged substantially because of insufficient budget and because the Government's financial control and reimbursement procedures are cumbersome. The Government,, is reassessing some of the ongoing projects and, in cooperation with the Bank, is reviewing the financial control procedures for simplification. Ia 1982 and 1983, high devaluation induced the inflation and severe budgetary constraints further slowed down execution of ongoing projects and disbursements. As indicated in para. 22, the Bank is implementing a Special Action Program to ease budgetary constraints and facilitate project implementation. PART IV. TEE PROJECT Introduction 51. A Staff Appraisal Report (No. 5014-ME) dated June 4, 1984, is being distributed separately. The proposed project was appraised in November 1983. Annex III contains a timetable of key events in processing the project and a description of the special conditions of the proposed loan. Negotiations on the proposed loan were concluded in Washington, D.C. on June 4, 1984. The Mexican negotiating team was headed by Lic. Luis Nava Hernandez of NAFINSA, and included representatives from the Ministry of Finance and FIRA.  - 15 - Project Objectives and Description 52. In accordance vith the Goverrment's overall development plan of promoting agricultural growth and reducing fiscal deficits, the objectives of the proposed project uld be to: (a) increase agricultural productivity and production with a view to (i) Increasing exports. (ii) Inproving food self-sufficiency, and Ciii) increasing farm income; (b) contnue to strengtben FI1ls intitutional framework for efficient allocation of financial resources; and (c) improve agricultural sector policies by reducing literest rate subsidies and restrict them to special target groups. 53. In order to achieve these obJectives, the proposed project would provide: (a) investment credit and short-term loans to farmers for crops, live- stock and agroindustries, representing a credit line of about 21% of FIRA's total lending program (the ptoposed loan would represent about 8Z of the total lending program); (b) technical assistance to farmers to enable appropriate transfer and adoption of improved technology; Cc) support services to continme the training of technical staff from FIRA and participating banks and strengthen IERA's mediu- and long-term development planning; and Cd) policy changes for Ci) the introduction of a more reallstic definition of subloan beneficiaries, and (ii) a gradual reduction and eventual eldiInation of subsidized interest rates, except for low-income farmers. 54. The proposed project would be carried out over a four-year period, and most project requirements. including interest rates, subproject appraisal and supervision, preparation of investment programs, and monitoring and evaluation, would apply to FIRA's total lending program. About 502 of loan proceeds would be directed to low-income producers. Investment subloans to beneficiaries would, as in the past, be based on technically and economically sound development plans, and constitute approximately 70Z of the total credit line. Because of the increased demand for working capital credit, incremental short-term financing would also be provided. constituting about 3aZ of the total credit line. About 52Z of the investment portion of the credit line would be for annual and perennial crops, 35Z for livestock and 13% for agroindustries. 55. Crop Lending Program. Investment lending for crops would cover the complete range of production types from annual to perennial cropping under rainfed and irrigated conditions in the country. Crop investment subloans would Include a wide diversity of loan size, type of borrower and ecological conditions. Invest- ment items for the crop lending program would include, inter alia, land improve-  - 16 - sent, equipment and machinery purchases, civil works construction, including supporting infrastructure for irrigation and storage, and establishment of fruit orchards and industrial crop plantations. 56. Livestock Lending Program. Of the Investment lending for livestock, about 55% would be for beef and dual-purpose production, 15Z for dairy production, and 30% for other livestock operations. As in the case of crop investment sub- loans, there would be a wide diversity of loan size, type of borrower and ecologi- cal conditions in livestock subloans. Investment items would include purchase of breeding stock, renovation andlor establishment of pastures, construction of buildings, fences and handling facilities and provision of water supplies. 57. Agroindustries Lending Program. About 13Z of FIRA's investment lending would be to the agroindustrial sector, particularly to small- and mediumr-scale producers. The portfolio of agroindustrial investments would continue to vary widely, including sawmills, fisheries, feedmills grain elevators. milk processing plants, and slaughterhouse facilities. Hbwever, the project would not finance marketing components of sub-projects as these would be financed under the Agricultural Marketing Project (Loan 2262-ME). 58. Short-term Lendlg Program. Short-term subloans under the project would be provided for the entire range of crop, livestock, and agroindustrial activities. Furthermore, as a large proportion of Mexico's low income producers are unable to take up investment loans, but do require working capital support to procure essential cash inputs, the project would provide at least 6oz of project-financed short-term subloans to this group. The project would finance only incremental short-tern lending, with incrementality defined as additional over PlLM's total short-tern lending of the previous year (draft Loan Agreement, Schedule 1; draft Project Agreement, Schedule 2, Part 11, para. 3). 59. Technical Assistance. FIRA's well-run technical assistance program would be expanded to promote the adoption of new and improved technology among farmers and to maximilze the effectiveness of on-farm credit. Direct trainion of farmers would focus primarily on the transfer of new technology through FIDA's demonstration centers and FIRA's and participating banks' technical staff visits. The number of demonstration centers would increase from 88 to lGB at full devedLop- ment. Since the centers are the focal point for trafIIng farmers, the new centers would be established in strategic locations close to major production areas. Project financing to support the new centers would include civil works, land improvement and development, crop and forage establishment, agricultural machinery and equipment and livestock. Support Services 60. Support services provided under the project would include training of technical staff, development of planning and progra"ming and the provision of consultants. FIMA would continue to maintain a strong training program under the project for its staff and technical personnel of the participating banks. The primary focus of training would be to educate trainers through formal courses with effective follow-up to revise course content and teaching methodology. It is anticipated that 2UZ of the technical staff to be trained under the project would be from FIRA, 40% from participating banks and 40X from other sources including SAREI.  - 17 - 61. In view of existing and predicted scarcities in lending resources, FIRA would develop its longer-term planning to efficiently allocate available funds within the framework of the Government's investment priorities and needs of the sector. Priorities for investments would be viewed in terms of products, producer groups and regions The project would provide a total of about seven staff-months of consultant support in monitoring and evaluation (four staff-months) and planir ing and programming (three staff-months). The monitoring consultant would be required to assist FIRA in simplifying the technique for gathering and computing information, making it more readily usable for managers, and reviewing and advising on related training procedures. The planning and programming consultant would assist FIRA, including the training of its staff, in its in-house exercise to strengthen its capabilities in analyzing and developing medium- and long-term development plans - Project Costs and Financing 62. Project costs are estimated at US$764 million, including price contingencies and the Bank front-end fee, of which US$520 million would be for mediumr- and long-term lending, US$227 million for short-term lending and US$16 million for productive support. About US$300 million, or 39Z, represents the estimated foreign exchange component. 63. The proposed Bank loan of US$300 million would cover the entire foreign exchange cost. Financing to be provided by FIRA, participating banks, and the beneficiaries would amount to 34%, 14%, and 13%, respectively. The proposed loan would be made to Nacional Financiera, S.A. (NAFINSA) a Government agency designated to borrow from the Bank, at standard terms for Mexico. The proceeds would be transferred to FIRA as equity and NAFINSA would repay the principal amount of the Bank loan together with interest and other charges. While this would partly offset the erosion of FIRA's equity, FIRA is expected to suffer an accumulated cash shortfall of US$490 million, during the project period, mainly the result of US$442 million of foreign indebtedness falling due for repayment. The Government has provided assurances that it will (a) require participating banks to finance from their own funds the agreed percentages of subloans; (b) cause participating banks to lose eligibility for subproject participation where arrears of loans discounted by FIEA are in excess of 15%; (c) ensure that the proceeds of the Bank loan would be transferred to FIRA as equity; and (d) provide the necessary resources to offset FIRA's cash shortfall (draft Project Agreement, Schedule 2, Part IB, para. 2 and Section 2.02(d); draft Loan Agreement, Section 3.01(b); and draft Guarantee Agreement Section 2.02(a)(ii) and 2.02(c)). Procurement 64. Bulk purchasing under International Competitive Bidding (ICB) would not be feasible, since the agricultural lending activities would be implemented over a four-year period, be widely distributed geographically, cover a variety of farm and ranch investment activities, and involve a large number of sub-borrowers. An adequate selection of machinery, tractors and other agricultural equipment and inputs is available to sub-borrowers through local and international suppliers. As in earlier projects, FIRA would require sub-borrowers to obtain quotations from several sources of supply, whenever practicable, for goods, civil works and imports of breeding livestock to be financed under subloans. Vehicles and equipment (US$1 million) for the demonstration and technical assistance programs  - 18 - would be procured through local competitive procedures. These procedures are known and generally acceptable to the Bank. The services of consultants to be financed under the project would be arranged in accordance with Bank guidelines. Machinery and equipment for agroindustries would be purchased by private producers or groups of producers through commercial channels (draft Project Agreement, Sections 2.02(a)(ii) and 2.06)). Disbursements 65. All project subloans would be committed during three and one-half years, and proceeds of the Bank loan would be disbursed over approximately four years. The Bank would reimburse FIRA (a) 63% of its discounts for disbursed project subloans; and (b) 20X of the total cost of the support services component. A special revolving account of US$30 million would be established in Bank of Mexico to assist in project implementation and facilitate disbursements. Disbursements against statements of expenditures under FIRA loans have been satisfactory. As the proposed project would be a continuation of the Bank's support to FIRA's lend- ing program, the Bank would retroactively finance subloans discounted by FLRA after full disbursement of the ongoing seventh loan, to a maximum of US$20 mil- lion, provided that these subloans are in compliance with the conditions of the proposed loan. The four-year disbursement period is based on the Bank's experi- ence with FLRA over seven credit projects. Through six projects, FIRA has disbursed on time or ahead of appraisal estimates, consistently above the regional average for credit projects. The seventh project, which was appraised for completion within 3 years, is expected to be completed in 3 112 years. Project Execution 66. FIRA would be responsible for project execution and would channel funds through participating public and commercial banks. FIRA has established a good reputation for its organization and technical competence through seven previous Bank-financed projects. The proposed project would continue to support FDRA's institution building by strengthening its delivery of technical assistance, development planning, and its monitoring and evaluation capabilities for measuring the impact of its lending. Sublending Procedures 67. Beneficiary Categories. Currently, agricultural producers are classified for credit purposes in three groups: (a) low-income producers whose principal income is derived from farming: their total annual income, including income from other sources, should be less than 1,000 times the relevant regional minimum daily rural wage; (b) medium-income producers whose total annual income is between 1,000 and 3,000 times the minimum daily rural wage; and (c) other producers whose total annual income is in excess of the upper limit for medium- income producers. Using the above income thresholds, the percentage of farmers included in the low-income producers category is high, embracing approximately 78% of the farmers throughout the country. As low-income producers would continue to receive an interest rate subsidy, it is necessary to ensure that this category would include only the poorest farmers, so that the total cost of this subsidy would fall within the Government's proposed overall limit for agricultural subsidies. As a part of the General Interest Rate Agreement, a study of beneficiary categories would be carried out, by mid-January 1985, to form the basis for a revised definition after discussion with the Bank (draft General Interest Rate Agreement, Section 3.02(iii)).  - 19 - 68. Interest Rate Structure. The Government's interest rate policy for agriculture, which is designed to spur investments and assist low-income producers, carries a high level of subsidy for certain groups of beneficiaries. Both the commercial and public banks adhere to the same on-lending rate structure, differentiated into the three categories by income groups as outlined above. The rates are linked to ACF and adjusted periodically. Currently the on-lending rates for medium- and long-term investment credit are: (a) low-income producers, 27.5%; (b) mediur-income producers, 36%; and (c) commercial producers, 62%, with a preferential rate of 45.5X if they produce -basic products.' Where the credit is short-term, 1% is added to each of the above rates. Credit for agroindustrial purposes attracts another 0.5%. Agricultural credit rates became strongly negative in 1982 and 1983, as inflation was 99Z and 81% respectively. The 1984 inflation rate is projected in the range of 5oz to 60% and is expected to decline to about 25% in 1985 and further down thereafter. The current level of interest rate subsidies, as measured by the difference between ACF and the nominal rate charged to ultimate borrowers, amounts to about 50Z for lou-income producers, 35% for mediumr-income producers and 17% for commercial producers of 'basic products". Interest rates are positive for other commercial producers. The Government is aware of the distortions and risks associated with negative real lending rates, including (a) artificial escalation of the effective demand for credit; (b) erosion of the capital base of the lending institutions; (c) misallocation of resources; and (d) increase in the substitution of funds at the producer and institution levels. However, the Government maintains that it would be undesirable to raise aU agricultural lending rates to the level where they would be positive in real terms, as in periods of high inflation, that would place an intolerable burden on the cash flow of borrowers of term loans and deprive the Government of one of the few instruments it has available to assist low-income farmers through interest rate subsidies. 69. The Bank and the Government have negotiated a General Interest Rate Agreement covering the ongoing credit-related projects financed by the Bank in various sectors. This Agreement provides for the gradual adjustment of existing interest rates so as to reduce subsidies and move towards positive rates. It will replace the existing interest rate covenants under several Bank loans and will provide a conceptual uniformity and a structured operational framework for policy dialogue. Under the General Interest Rate Agreement, the Government and the Bank will consult periodically on the accounting for interest rate subsidies and to correct any future distortions in the interest rates that may result from unforeseen changes in the economy. The applicable interest rates for agricultural credit included in the Agreement would be variable and would progressively increase as a percentage of ACF as shown below. With the ACF expected to range close to inflation levels during the project period, and with interest rates moving progressively towards positive real levels, FIRA would earn operating profits sufficient to slow down decapitalization in the short term, and to avoid it in due course. As a result, a major source of Government subsidy outlays would be progressively reduced.  - 20 - Structure and Adjustment of Onlending Interest Rates by Category of Producers for Medium- and Long-Term Subloans4/ Category of Producers Low Medium Commercial Revision Dates Income Income Basic Products5/ Other Rates as a Percentage of ACF6/ / July 1, 1984 50 67 85 ACF+2 October 1, 1984 60 80 85 ACF+2 January 1, 1985 65 85 90 ACF+2 July 1, 1985 67 87 95 ACF+2 January 1, 1986 70 90 ACF ACF+2 July 1, 1986 75 95 ACF ACF+2 January 1, 1987 80 ACF+1 ACF+1 ACF+2 70. As a part of the General Interest Rate Agreement, the appropriateness of the ACF as a central reference rate would be reviewed in a special technical study that will be one of the bases for consultation in February 1985. Interest rates will conform to the rates stipulated in the General Interest Rate Agreement (draft Project Agreement, Schedule 2, Part I B, para. 6 and draft Guarantee Agreement, Section 3.05). 71. Currently, participating banks are allowed a discount margin between the or-lending rate to the sub-borrower and that paid to FIRA, ranging from 2X to 6.5Z. This margin, which is currently adequate, vill be reviewed together with interest rates every six months. Margins allowed to the participating banks would require discussion and agreement with the Bank before revision (draft Project Agreement, Schedule 2, Part IB, para. 6). 72. Subloan Appraisal and Supervision. Over the years, FIRA has developed sound subloan apprais.; and supervision procedures. Subloans would be evaluated and approved by FIRA and participating bank technicians subject to FIRA's approval for subloans above prescribed limit. Under the proposed project, FIRA would be required to obtain prior approval from the Bank for project subloans in excess of 4/ For short-term subloans, an additional 2% would be added to the equivalent nominal rates and an additional 1Z for all agroindusrrial subloans. 5/ Basic products for Bank financed projects would only include maize, Wheat, sorghum, beans and rice. 61 Rates as a percentage of ACF, or as ACF plus additional points.  - 21 - US$800,000 equivalent, which also applies to individual subloans resulting from group activity. No subloan would be made for on-farm investment if the amount of the proposed subloan, together with the aggregate amount outstanding under previous FIRA-financed subloans to such a borrower, exceed Mex$ 30 million (US$187,500). FIRA's recently introduced Operating Regulations and Procedures Manual provides the guidelines. Assurances have been obtained that FIRA will adhere to the above subloan appraisal and supervision procedures (draft Project Agreement, Section 2.04 and Schedule 2, Part IB para. 4). Reporting Requirements 73. FIRA has developed an efficient system of timely reporting to the Bank. Quarterly progress reports summarizing project performance, subloan disbursements by categories and FIRA rediscounts are routinely submitted to the Bank no later than 60 days after the end of each quarter. Detailed reports are prepared semi- annually and submitted to the Bank no later than three months after the end of each six-month period. FIRA would continue to adhere to Bank reporting require- ments and to submit a Project Completion Report within 12 months of the Closing Date. Accounts and Audit 74. FIRA has consistently presented timely annual audited accounts. The accounting system of FIRA trust funds is satisfactory. FIRA would maintain separate project records, as established for the ongoing Seventh Credit Project. FIRA's accounts have been audited during recent years by external auditors, and all audit reports of its accounts have been unqualified. An audit, satisfactory to the Bank, would be made of the accounts, statements of expenditures submitted to the Bank, and financial statements of FIRA for each fiscal year. The audit would be in accordance with sound auditing principles consistently applied by independent and qualified auditors appointed by the Controller GeneraJl and the Bank of Mexico. Certified copies of the statements audited, together with the report of the auditors, which would also comment on the SOEs, would be submitted to the Bank no later than six months after the close of each fiscal year. Adequate accounts and records would also be maintained within all the participat- ing banks so as to identify all transactions pertaining to FlTA rediscounted subloans. Project Benefits 75. It is projected that 105,000 families, or about 580,000 beneficiaries, would benefit directly from the project. Secondary benefits would also accrue from processing and agricultural service activities. At full development, it is estimated that, based on previous experience, annual incremental production of basic crops (maize, beans, wheat, rice and sorghum) would increase by about 0.9 million metric tons; cotton, soybeans, and safflower by 100,000 tons; milk by 16 million liters, beef and pork by 120,000 tons, and eggs by 110,000 tons. The incremental production of basic crops alone would amount to foreign exchange savings of about US$140 million per annum at full development. Likewise, increased production of export crops would contribute to annual foreign exchange earnings in excess of the above savings on incremental basic crops. The project would cause an increase of net cash income to beneficiaries. Most investment  - 22 - plans are expected to have a financial rate of return in the range of 18% to 35%, with economic rates of return ranging from 19X to over 100%. The economic rates of return are higher because domestic producer prices for several products are below border price levels. This is consistent with findings of the completion reports of the Fifth and Sixth Credit Projects. 76. The project would assist institution building. Strengthening FIRA's analytical and medium- and long-term planning capabilities would allow a better allocation of investment resources over the longer term. Expanded technical assistance would emphasize the promotion and adoption by farmers of available improved technologies. Further support to the Monitoring and Evaluation Division would increase FIRA's capabilities to measure impact needs, including the adoption rate of available technology. Project Risks 77. Since FIRA is a reasonably efficient and mature institution, the project presents no special risk in terms of the technical and financial soundness of various investment opportunities that would be financed under the program. The main risk would be that political pressures would impede progress in eliminating interest rate subsidies, especially in case of a resurgence of inflation causing a further deterioration of FIRM's financial position, a continued drain on the Government budget resources, and a continued misallocation of production factors. However, the Government has given assurances that it would adhere to the General Interest Rate Agreement, and thus significantly reduce these risks. PART V - LEGAL INSTRUMENTS OF AUTHORITY 78. The draft Loan Agreemer.c between the Bank and Nacional Financiera, S.A., the draft Guarantee Agreement and draft General Interest Rate Agreement between the United l.exican States and the Bank, the draft Project Agreement between Bank of Mexico and the Bank 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. 79. Special conditions of the project have been described in Part IV of this Report and are listed in Section III of Annex III. 80. I am satisfied that the proposed loan would comply with the Articles of Agreement of the Bank. PART VI - RECOMMENDATION 81. I recommend that the Executive Directors approve the proposed loan. A. W. Clausen President Attachments June 4, 1984  - 23- Annex I TASLE 3. Page 1 of 5 _ CIAL , 3.Icarms Da 3E MEAL C -LQM ur . 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