Mexico - Second Small and Medium Scale Mining Development Project

Document of The World Bank FOR OMCIAL USE ONLY Repwt No. P-4048-ME REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN IN AN AMOUNT EQUIVALENT TO USM1D5.0 MILLION TO NACIONAL FINANCIERA, S.A. WITH THE GUARANTEE OF UNITED MEXICAN STATES FOR A . SECOND SMALL- AND MEDIUM-SCALE MINING DEVELOPMENT PROJECT April 30, 1985 Thi docment n a re*tbied dItibuio msd nmy be used by recipients only in the perfomance of tedr omEda dutieL lbs cntents may not otherwise be dtsclosd witbout Wod BDnk autburlutlon.  Curwney Unlt P- so NWS) On March 31, 1985, the exchange rate in the controlled market was US$1 Mex$208.79; the freemarket exchange rate stood at US$1 - Mex$226.85. Both exchange rates are currently sliding at a rate of Mex$0.21 per day against the US dollar. Piscal Year January 1 - December 31 WeiEhts and Measures Metric: British/US Equivalent 1 meter tm) = 3.28 feet (ft) 1 kilometer (km) = 0.62 mile (mi) 1 kilogram (kg) - 2.20 pounds (lbs) 1 metric ton (MT) = 2,205 pounds 1 liter (1) = 0.26 gallons (gal) Abbreviations ACF Index of Average Cost of Short-Term Borrowing to the Banking System CFM Comision de Fomento Minero (Mining Development Commission) CRM Consejo de Recursos MKnerales (Mineral Resources Council) FNM Fideicomiso de Minerales no Metalicos Mexicanos (Trust Fund for Non-Metallic Minerals) GIRA. General Interest Rate Agreement NAFINSA Nacional Financiera, S.A. PECAM Programa Especial Complementario de Apoyo a la Pequena y Mediana Mineria (Special Complementary Program for SMM) PEMEX Petroleos Mexicanos, S.A. (Mexican Oil Company) SEMIP Secretaria de Energia, Minas e Industria Paraestatal (Secretariat of Energy, Mines and Parastatal Industries) SHCP Secretaria de Hacienda y Credito Publico (Secretariat of Finance and Public Credit) SECOFI Secretaria de Comercio y Fomento Industrial (Secretariat of Commerce and Industrial Development) SMMs Small- and Medium-Scale Xining Enterprises SPP Secretaria de Programacion y Presupuesto (Secretariat of Programming and the Budget)  FOR OMCLCL USE ONLY S"LL- AMD VzD31W-CALX Rm= D LNT PROJECT Loan and Proect Borroemr: Nacional Financiera, S.A. (NAFINSA) Guarantor: United Mexican States Prodect Programa Especial Complementario de Apoyo a la Pequena y 4Mediana Mineria (PECAN) AgENcies: Comision de Fomento Minero (CFM) Fideicomiso de Minerales No-Netalicos Mexicanos (FNK) Comision de Recursos Minerales (CRM) Amount: US$105.0 million equivalent. Terms: 15 years, including three years of grace, at the standard variable interest rate. Mulending NAFINSA would pass on US$102 million to CFM, FNM, and CRM, Who Terms: would, in turn, relend US$76 million in pesos to SMN enter- prises, through subloans with terms of up to 12 years, including a grace period of up to three years, and floating interest rates based on the average cost of funds to the banking system (ACF), in accordance with the tervm of the General Interest Rate Agree- ment (GIRA) between the Government and the Bank. CEM and FNM would onlend a part of these funds through commercial banks, which would retain a spread of between 2.5 and 3.0 percentage points. CFM would also lease equipment to SMs for up to eight years, including a grace period of one year, with financial charges as specified in GIRA. CFM, FNM and CRK would repay the amounts they borrowed under the loan to PECAN, and the Govern- ment-through NAFINSA--would repay the Bank loan, including interest, and bear the foreign exchange risk. Project The proposed project hae been designed to support the Govern- Description: ment's sector development strategy, building and expanding upon the accomplishments of the first Bank project in Mexico's SM sector. by means of a comprehensive program of technical and financial assistance. It would finance evaluative exploration, mine development and exploitation; strengthen the capabilities of the major institutions supporting SNMs; and improve coordina- tion within the SMM sector. Commercial bank lending to SMMs would be encouraged under the project, which would help build up the second-tier credit operations of two key sector agencies- CIF and FIM. Thisdocument haanotiesbdistribution and maY beused by fedipbteno in theporfonnuse o m offichEd dutas. Its contento maynot otherwu bediscksed whhout WorldBank authofizoWn.  - il Prolect lisk: Although the proposed project faces no special risks, lower than expected commercial bank participation and low mineral prices might affect its implementation. However, in view of PM's satisfactory experience with commercial banks recently and the adequate spreads allowed, the probability of the first risk is low, and, given the broad range of minerals mined by SKNs and the record low international metal prices, which are unlikely to further drop sharply, the second risk is acceptable. Estimated Cost: (In US$ Millions Equivalent) Local Foreign Total Investments by SlOs: 99.0 60.0 159.0 ITaestuset by CPR, FNW and CM, fort Equipment Leasing 8.0 5.0 13.0 Regional Beneficiation Plants 14.0 10.0 24.0 Laboratories 2.0 4.0 6.0 Exploration Equipment 1.0 3.0 4.0 SUBTOTAL 25.0 22.0 47.0 T.ebnil Assistance: 2.0 4.0 TOTAL . 126.0 84.0 210.0 Finacing Plan: 'World Bank 21.0 84.0 105.0 Government 76.0 - 76.0 PECAM 9.0 - 9.0 Sifs 20.0 - 20.0 TOTAL 126.0 84.0 210.0 Estimated (Bank FY/US$ Millions) Disbursements:_ 86 87 88 89 90 91 92 Annual 6.3 19.4 26.4 24.6 16.8 9.0 2.5 Cumulative 6.3 25.7 52.1 76.7 93.5 102.5 105.0 Rate of All subprojects should have a minimum FRR of 12%. Calculation of Return: ERR would be required only for subprojects that involve Bank financing in excess of US$0.5 million equivalent; in such cases, a minimum ERR of 12% would be required.  - ii.i- Staff Deport: No. 5454b-1IE, April 26, 1985.  TNTDJAIONL BAN FORCOSTUCTION D 9DRM REPORT AND RE(XIEHUDhTIOE OF THE PRESIDENT OF THE IBRD TO TE EKWECUTLYE DIRECTORS ON A DRPOSED LOAK TO EACIONAL FINANCIERA, S.A. WITD THE GUARANTER OF UNITED LMXICAN STATES FOR A SECOND SHALL- AND NEDIIK-SCALE mDIENG DEVELODKEW PROJECT 1. I submit the following report and recommendation on a proposed loan to X Nacional Financiera, S.A., (NAFINSA) with the Guarantee of United Hexican States for the equivalent of US$105.0 million to help finance a Second Small- and Medium-Scale Mining (SMM) Development Project. The loan would be repaid over 15 years, including 3 years of grace, at the standard variable interest rate. About US$76 million equivalent would be relent in pesos to small- and medium-scale mining enterprises, through subloans with maturities up to 12 years, including 3 years of grace, and variable interest rates based on the ACF, in accordance with the General Interest Rate Agreement (GIRA) between the Government and the Bank. Financial intermediaries would earn a margin of between 2-1/2 and 3 percentage points. The balance of the loan would be for investments in support services to SMN enterprises and for technical assis- tance. The Government would repay the Bank loa- through. iAFINSA and bear the foreign exchange risk. PART I - THE ECOiy 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 main conclusions and recent economic developments are summarized below. 3. Following an import-substitution growth strategy, Mexico experienced some two decades of high and stable growth after the early 1950s. By the late 1960s, however, Mexico had largely exhausted the "easy and efficient possibil- ities for import substitution, and faced a choice between outward-oriented growth or continued inward-directed growth led by expansion of public sector expenditures and rising subsidies and protection of inefficient domestic production. By 1972, the choice was made to pursue the latter course. Public sector expenditures as a percent of GDP more than doubled between 1970 and 1982, from 18.8% to 42.5% (Report No. 4996-ME, p. 114). By 1976, Mexico expe- rienced a serious financial and economic crisis, followed by an even more serious one six years later. The discovery of large oil reserves in the mid- 1970s led Mexico to a quick economic recovery, but it also removed the urgency of policy reforms. Primary among these was the need to reduce protection and the anti-export bias of the trade regime to thereby move over time toward greater efficiency and international competitiveness. Oil revenues also tempo- rarily helped finance the public sector deficit and reduced the need for greater fiscal restraint. 1/ Parts I and II of this Report are substantially unchanged from the corresponding sections in the Presitdent's Report for the Chiapas Agricultural Development Project (Report No. P-4023-ME of March 29, 1985).  -2- Develojmeutm during 1977-1982 4. The stabilization measures initiated in 1977 and the discovery and exploitation of large oil resources in the mid-1970s allowed the Lopez Portillo Administration (January 1977-December 1982) to overcome the serious financial crisis of 1976 and to start working on structural, social, and economic prob- lems, including poverty, income and wealth inequality, unemployment, regional imbalances, and relatively slow agricultural growth. In the early years of that Administration (1978-80), GDP growth was high (8.5Z a year), 2.5 million jobs were created, domestic consumption recovered, and the share of investment and savings in GDP surpassed historical levels; but the economy became increasingly overheated. 5. Rapidly rising public expenditures unmatched by revenues led to increas- ing public deficits. While inflation rose, no significant pressure was felt to adjust the exchange rate, thanks to the oil earnings and the relative ease of obtaining foreign finance. By mid-1981, the economic situation began to mirror the scene prevailing before the 1976 financial crisis. The current account deficit of the balance of payments reached 5.2Z of GDP, while the deteriorating international oil market conditions caused large revenue shortfalls with re- spect to budget expectations. The public sector deficit rose to just under 15% of GDP. Non-oil exports dropped, and the trade deficit reached record levels. External borrowing was used to finance part of the domestic fiscal deficit and to defend the exchange 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 grow- ing fiscal imbalance, the high cost of foreign loans, and the increasing pri- vate capital flight fueled by the public's anxiety over Mexico's financial troubles. 6. The crisis came to a head in 1982. In February, as capital flight intensified, the Bank of Mexico had to stop supporting the peso, vhich then experienced a 40Z devaluation in US 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 became reluctant to commit new funds to Mexico in the amounts required. These factors led to a second devaluation of 35Z in August 1982, while the acute shortage of foreign exchange forced the Government to suspend the amortization 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 nation- alization 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 quantitative trade restrictions covering an unprecedented 100% of imports. Recent Developments 7. The Administration of President de la Madrid, that began its term in December 1982, lost no time in taking steps to recover domestic and external  -3- confidence, and stabilize the public sector and external finances. The Govern- ment's stabilization program, supported by an EFF agreement approved by the IMF in December 1982, laid the basis for restoring economic stability and for the renegotiation of that part of Mexico's public external debt on which amor- tization 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 inter- est 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 restruc- turing exercise included an understanding that the international banks would 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. 8. 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 MexS95 = US$1, a depreciation of some 35Z in relation to the previously prevailing ordinary rate of Mex$70 per US dollar. The free market rate had remained at about Mex$150 per dollar until September 1983, when the authorities decided to let it slide as much as the controlled rate. The differential between the two rates, which in December 1982 stood close to 60%, is now down to less than 10%. Over the past two years, the peso has gradually appreciated in real terms as inflation in Mexico remained high. The Government increased the rate of slide of the peso from 13 centavos a day to 17 centavos in December 1984, and to 21 centavos early March 1985, in order to bring it closer to the expected inflation differential between Mexico and its trading partners. Domestic deposit interest rates were also raised in early March 1985 from an average of about 45% to nearly 50%. 9. Under the IMF Agreement, the Administration committed itself to a dras- tic reduction of the public sector deficit, from 18.0% of GDP in 1982 to 8.5% in 1983, 5.5% in 1984, and 3.5% in 1985. Substantial progress has been made during the past two years in meeting the program objectives, although the tar- gets for 1984 were not fully met. The public finances were strengthened con- siderably and the public sector deficit was reduced to 8.7% of GDP in 1983 and an estimated 7.4% in 1984. The main reason for the higher budget deficit than the 1984 target was the much higher than expected interest payments on the domestic debt. Curbs on expenditures were wide ranging. However, recent esti- mates suggest that real public investment-encompassing states and local governments--may have been well in excess of the targets for 1984. The author- ities have given priority to completing projects that were already far advanced and to those that were important for employment, equity, or foreign exchange earnings. Nonetheless, public investment expenditures are estimated to have declined to about 7Z of GDP in 1983-84, well below the 1982 level of 11.7%.  -4- The fiscal performance 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. 10. The balance of payments experienced a major turnaround in 1983 with the current account moving from a deficit of almost US$5 billion in 1982 to a surplus of US$5.5 billion. The strength of the current account and the avail- ability of external 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 pro- gram. The errors and omissions account of the balance of payments dropped from US$8 billion in 1982 to an estimated US$1.4 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 balance of payments remained strong in 1984, with a current account surplus of US$3.7 billion; and a further US$2.5 billion were added to the nation's foreign exchange reserves, which at the year's end are estimated at a-bout 7-1/2 months of imports. Although imports recovered considerably, a rapid rise in non-oil exports, particularly in the first quarter of 1984, ensured that the trade surplus remained at the same level as in 1983, i.e., about US$13 billion. Growth in tourism and in-bond industry was also strong, and helped in alleviating unemployment. These favor- able external trends during late 1983 and early 1984 weakened in mid-1984, owing to an appreciating real exchange rate. 11. Fighting inflation remains the pivot of the Government's stabilization program. Although the Government's own inflationary targets have been missed by wide margins, the rate of inflation continued to decline through mid-1984. It declined from a rate of about IOOX in 1982, to 80Z and 59Z in 1983 and 1984, respectively. The main factors in this were restrained fiscal and mone- tary policies and moderate wage adjustments. The flow of savings into the banking system continued to rise, reflecting the beneficial influence of the exchange rate and interest rate policies. The impact of the severe and sudden cuts in public expenditure and imports on economic growth in 1983 was serious when GDP declined by over 5Z. However, the economic recovery in 1984 was stronger than the Government's expectations: GDP is estimated to have risen by about 3.5Z, compared to the earlier estimate of only 1%. Since the latter half of 1984, fiscal, monetary, and external trends have signaled a possible resurgence of inflationary pressures. 12. The Government also took steps to regain the confidence of both domestic and foreign private investors. These included efforts to deal with the prob- lems of private external debt, procedures to compensate owners of nationalized banks, and a more flexible application of the foreign investment law. Nego- tiations with commercial banks and other private creditors have been completed  -5- for the refinancing of nearly half of the 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 re- structuring of Mexican private sector obligations guaranteed by official credit agencies abroad. The Government has also transferred back to private 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 more remains to be done to restore the confidence of Mexican entrepreneurs and foreign investors. The Government realizes that this is an issue of the greatest importancp, as economic recovery beyond the current stabilization period will depend critically on the resumption of vigorous private investment. 13. The general improvement in the Mexican economy has been widely noted, particularly by the international banking community. Mainly for this reason, the Government's 1984 borrowing of US$3.8 billion from commercial banks carried much more favorable terms than the borrowing in 1983 (10 year maturity, 5-3/4 year grace period, and a spread of 1-1/2% over LIBOR or 1-1/8Z over prime). The negotiations between the Government and foreign commercial banks on the rescheduling of foreign debt have been virtually completed. The draft agree- ment, covering close to US$50 billion, has been submitted by the Banks' Advi- sory Group (consisting of the 13 largest lenders) to some 500 smaller regional banks for their acceptance. Under the proposed terms, the previously unre- scheduled debt (amounting to about US$20 billion), which is due for repayment in 1985-90, will have its maturities stretched over 14 years. The maturities of the previously rescheduled debt coming due in 1987-90 will be stretched over 11 years. The 1983 syndicate loan of US$5 billion will be restructured, after prepayment of US$1 billion, to carry terms identical to the 1984 syndicate loan. In summary, the pending rescheduling agreement will stretch maturities of US$50 billion public debt in such a way that the debt service remains vir- tually constant between 1985-1998, in contrast to the present situation, where 75% of the debt service is due in 1986-89. The banks will have the choice of LIBOR, a domestic reference rate, or a fixed rate. These terms are based on the understanding that the Government will continue to adhere to prudent eco- nomic policies. The rescheduling agreement covering US$29 billion of Govern- ment debt was signed on March 29, 1985. Another US$19 billion in loans to Mexican Government agencies will be refinanced between now and June. This followed the approval on March 25 by the IMF of a third-year Extended Fund Facility. Nedium-Term Prospects 14. The Government's strategy, as outlined in the National Development Plan (NDP) for 1983-88, 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 problems facing Mexico in the years ahead include the still very high rate of population growth (2.6% estimated for 1983) together with an even higher rate of labor force growth (a little under 4%), slow growth in agriculture, poverty, a highly skewed interpersonal and inter- regional income distribution, and an overly oil-dependent economy with a strong anti-export bias.  -6- 15. The medium-term strategy presented in the NDP focuses on the need for structural changes in the economy, including a greater export orientation through revision of external trade policies, poverty alleviation through basic needs policies and improvement in labor absorption, and decentralization of economic activity. The basic elements of policies to address structural prob- lems are mentioned In the NDP, and further details on specific program and schedules for policy adjustments are provided ln the sectoral plans which were prepared subsequently. 16. Mexico's medium-term prospects for recovery and stable economic growth are reasonably good, provided economic management continues to be prudent, pri- vate 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 crucial, since only a strong and dynamic private sector will be able to raise investment from the present de- pressed levels and to supply the increasing non-oil export surplus required for the resumption of grcwth. As regards the external environment, the commercial banks are expected to maintain their exposure in Mexico in real terms, and for- eign markets, to be open to Mexico's non-oil exports. Mexico will benefit directly from a continuing fall in interest rates in the world financial mar- kets (a one percentage point drop means a savings of about US$800 million in overall interest payments, which compares to a loss of US$550 million in gross export revenues that would result from a one dollar drop in the export price of oil). 17. Under reasonably favorable external and domestic conditions, Mexico's economic growth could reach a sustainable 6% a year-the post-WW3I average for Mexico-towards the late 1980s This growth would materialize through a sus- tained redirection of the economy toward a more outward-oriented growth pat- tern. Fiscal discipline, in the absence of improved domestic efficiency and export development, is likely to entail a prolonged period of slow growth, characterized by insufficient labor absorption in internationally competitive activities, domestic price distortions, and a continued need for subsidies. External Debt and Creditworthiness 18. Mexico's external public debt increased by about US$4 billion during 1983, and by about a similar amount in 1984. With an expected net new borrow- ing of some US$3 to US$4 billion a year, the ratio of external debt to GDP would decline steadily from 41% in 1984, to 33% by 1990. The debt service ratio, after the proposed rescheduling, is projected to peak at 47Z in 1988; thereafter, it gradually declines to about 25% in 1995. 19. At the end of 1983, the last year for which a comprehensive external debt report is available at this time, the Bank's share in Mexico's debt was 4.3% (excluding undisbursed). The Bank share in Mexico's total public external debt service payments during that year was 4Z. In view of the good medium- and long-term potential of its economy and the prospect of continued pursuit of sound economic policies by the present Administration, Mexico is considered creditworthy for IBBD borrowing.  -7- PART II- MAN GROUP OPERATIONS IN MEXIO hunk Operations 20. As of March 31, 1985, Mexico had received 85 loans from the Bank, amounting to US$6,831.3 million, net of cancellations and terminations; of these, 58 loans totalling US$3,495.2 million were fully disbursed. The Bank held US$5,465.6 million, of which US$1,948.9 million had not yet been disbursed. Some 42Z of Bank lending has been for agriculture and rural devel- opment, 23% for industry, 11X for power, and 13Z for transportation; the re- maining llX has been for water supply, tourism, urban development, vocational training and pollution control projects. Annex II contains a summary statement of Bank loans as of March 31, 1985. 21. Of the US$6.83 billion total lending, about US$3.5 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 medium-scale indus- trial 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 atten- tion was focused in Mexico on project monitoring. As a result of these mea- sures, most of the Bank-assisted projects were being implemented satisfactorily until mid-1982, and disbursements rose from US$91 million in FY78, to US$448 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 con- straints on development projects, and 18 Bank-financed projects are receiving support under the Program. Partly as a result of the SAP, disbursements during 1984 improved significantly at US$528.87 million or 35% over disbursements in 1983. IYFC Operations 23. As of March 31, 1985, IFC had made investment commitments in 27 compa- nies in Mexico, for a total of US$753.9 million, of which US$562.5 million had been sold, repaid or cancelled. A summary statement of IFC investments is pre- sented 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 urban/regional imbalances; and (d) help free bottle- necks which prevent rapid growth. More recently, however, in response to Mexico's requirements following the 1982 economic crisis, the Bank, in close cooperation with the IMF, also supported the Government's stabilization program through assistance 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 are being pursued through a dialogue with the Government, conducted in parallel with the processing of lending operations, cover priority macroeconomic 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 sec- tor'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 lend- ing. 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 extension, marketing programs and credit; and fourth, to promote employment-generating investments in rural areas. The Bank has made 14 loans in FYs78-83 totalling US$1,829.4 million for irrigation, rural development and agricultural, 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 rehabilitation project were approved by the Executive Directors in FY82, and a US$138.4 mil- lion 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, and a $300 million Eighth Agricultural Credit Project in June 1984. A US$90 million loan for a Chiapas Agricultural Development Project, together with a Chiapas Rural Roads Project, was approved by the Executive Directors on April 30, 1985. Projects for tropical agricul- ture, irrigation rehabilitation, extension and research, seed multiplication, and agricultural credit are in various stages of 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 empleyment. A steel project, which the Bank helped structure and finance, is now operatiug in  -9- 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 medium-scale industrial enterprises, to finance expansion of small- and medium- scale mining, and to support an industrial equipment fund (FONEI)--were ap- proved by the Executive Directors in FYs78-80. A US$90.0 million loan foz a vocational training project, which is assisting a program to increase the sup- ply of skilled workers and technicians, a US$152.3 million loan for the devel- opment of a capital goods industries project, and a US$60 million loan for pollution control were approved by the Executive Directors in FY82. A modifi- cation 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 for- eign 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 F.83. A follow-up vocational training project is expected to be presented to the Board in Late May 1985. 27. Bank lending for physical infrastructure has been focused on regional development and strengthening of institutions and sector policies. Two higbvay sector projects (FY79 and FY84), the fourth railway project (FY81), and an industrial ports project (FY84) support these goals. The first and second med7um-size cities water supply and sewerage projects (FY76 and 81) reinforce the planning, management and finance of specialized 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 che Executive Directors on May 17, 1983. A fifth railway project is expected to be presented to the Board also in late May 1985. 28. The Government 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 CECADE ("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 personnel 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$3.4 billion as of March 31, 1985. Over 50% of the total has gone to agricultural and rural development projects, and the balance to transportation, industry, water supply and sewerage, tourism infrastructure, education,  - 10 - municipal development, and pre-investment. The IDB and the Bank have coordi- nated their assistance on several projects. Each has made loans for the national integrated rural development program (PIDER), agricultural and live- stock credit, small- and medium-scale industries development, and hotel devel- opment 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 cofinanced by several bilateral export credit agencies and commercial banks. In January 1982, Mexico borrowed US$500 million from commercial banks to provide complementary financing for Bank-assisted projects where project specific cofinancing would have been difficult. pART LII - TEM ININ S=OR 2/ background 32. Mining is an ancient activity in Mexico and has been at the core of the nation's development throughout most of its history. Endowed with significant mineral resources,3/ Mexico has a broad human resource base of mine workers and well trained engineers and managers. Traditionally, mining has played a dominant role in the Mexican economy, supplying raw materials to local industry and earning foreign exchange from exports. Until the late 19309, mining was one of the most dynamic sectors of the economy. It accounted for about 4% of GDP in the 1930s, but this share declined to 1.3% by the late 1970s, mainly because of inadequate domestic policies and the country's petroleum boom. The sector is, however, one among the few that have grown recently in real terms, despite the country's severe economic crisis: in 1982-1983, mining output grew by 0.2% and 1.3%, respectively, while the economy as a whole contracted by 0.2% and 4.7%. Mineral production reached about US$2.5 billion equivalent in 1983, with metallic minerals accounting for 66% of the total. Foreign exchange earn- ings from mining amounted to US$980 million, being only third in importance after oil and tourism, and representing a growth of 13Z over the 1982 level. 33. At present, over 5,000 mines operate in the country, providing jobs for about 210,000 persons, or roughly 1X of the labor force. Ownership and opera- tion of the mines are classified into three groups: Parastatal Enterprises: consisting of over 40 medium and large size companies, fully owned and controlled by the Government, which produce 2/ All statistics and analyses of the mining sector presented in this report exclude figures for petroleum and related hydrocarbons. 3/ Mexico currently occupies first place in world production of silver, fluorite and arsenic and is among the top five producers of celestite, antimony, bismuth, graphite, mercury, sulphur and six other minerals.  - 11 - 35-39Z of Mexico's total mining output. Parastatals were created to develop strategic minerals4/ or to make investments considered too large for the private sector. Large Private Enterprises: comprising six large corporations, either fully privately-owned or with a minority Government participation. They account for about 46-49X of the nation's mineral production, and operate mainly in precious and industrial metals. Small- and Medium-Scale Mining Enterprises (SMHs): including some 5,000 units, which range from one-family mines to companies that compare in size and output to a division of large private enterprises. Government participation in this segment of the sector is not significant. Mining Legislation and Pblicies 34. In response to the sector's relative decline after the 1930s, a new Mining Law was passed in 1975. This Law has: (a) assigned responsibilities to the various agencies; (b) regulated concessions, exploration, processing and trading of all minerals; (c) set Mexican majority ownership as a requirement for all mining enterprises; and (d) defined discretionary powers for the Gov- ernment, such as declaring certain zones to be state mining reserves. The Law levied a production tax on the ex-smelter market value of the minerals, estab- lished tax credits for re-investment in exploration or development, and allowed import duty exemptions of up to 75X on mining equipment. 35. To increase the sector's efficiency and to strengthen its competitive edge internationally, the Government introduced two major tax changes in 1983: (a) the mineral production tax was eliminated and replaced by a new -right-to- exploit" payment on the net smelter value, which, in effect, reduced the cost to miners;5/ and (b) the dividend tax was raised from 21% to 55X. Further- more, in early 1984, the import tax exemption--the last specific subsidy to the sector-was also eliminated. In addition, internal prices for metallic miner- als have been allowed to follow international price levels, while for non- metallic minerals, the prices are generally determined by domestic supply and demand. 36. Mining concessions to SMMs do not hinder their development. Minerals underground belong to the state, but surface deposits belong to the landowner. * Mining concessions to SMNs for exploration or exploitation are transferable, and can be now used as collateral for loans. Underground deposits can be claimed anywhere in Mexico, but require specific authorization of the Ministry of Energy, Mines and Parastatal Industries (SEMIP). Concessions for explora- tion are granted for up to three years, covering a maximum of 50,000 hectares; for mining exploitation, they are granted for 25 years (renewable for another 4/ Iron ore, coal, sulphur, phosphate, fluorspar and potassium are classified as National Mining Reserves. Radioactive substances are governed by the Law of the National Institute of Nuclear Energy. 5/ 1983 tax reform: 'right-to-exploit- payments of 7% for gold, silver and sulphur; 2% for coal, iron ore and manganese; and 5 for all others. This represents a reduction of 2 percentage points in all cases.  - 12 - 25), and up to 500 hectares. The law allows mining enterprlses--whose explora- tion concession does not exceed 20 hectares-to start exploiting part of their reserves, while the exploration program is still in progress, thus helping the small miners to self-finance exploration works. NatIonal MIning Progra 1984-1988 37. To strengthen the country's mining sector, the Government issued a National Mining Program for 1984-1988, which set the following objectives: (a) exploiting the full potential of the sector to provide raw materials for other priority programs in the industry, food and energy sectors; (b) spurring economic growth through increased exports; (c) creating jobs; (d) contributing to the development of some of the least advanced regions; and (e) strengthening the coordination between the mining sector and the economy as a whole. High priority is assigned to SMMs under this program, for which the Special Comple- mentary Program for SMMs Development (PECAM) provides the required financial and institutional support. The 1984-1988 National Mining Program is expected to have a significant impact on the mining industry's growth over the next several years. Small- and Mediuw-Scale Mining (SW) 38. For operational purposes, PECAM and the Bank classify SMMs as small- or medium-scale mines whose annual production values do not exceed US$3 million and US$15 million, respectively, provided, however, that their daily production capacity is less than 200-300 tons a day for small, and 1,000-1,500 tons a day for medium-sized metallic or non-metallic mines, respectively. SMfs operate with adequate profitability, and no major subsidies. This is possible because of special geological and economic factors, such as: (a) tle high quality and abundance of mineral deposits, and a generally temperate climate with favorable rainfall conditions; (b) the high grade of narrow vein deposits typically exploited by SMMs, and their flexibility to adapt to market conditions; (c) low labor costs; and (d) the long history of small mining "culture' in the coun- try. SMMs are relatively labor-intensive; the average capital investment cost per job created in most SNMs is likely to be in the US$10,000-30,000 equivalent range, as compared to US$100,000-200,000 equivalent in large mines. Fiancing and Technical hssistance for S s 39. Mexico has a well developed banking system, comprising some 200 institu- tions, most of them publicly owned since 1982. While large mining enterprises are able to cover, to some extent, their financial needs, either through credit or internal cash generation, the availability of credit to SMMs has been lim- ited in Mexico. Given the country's industrial and commercial growth, and the relative difficulty in assessing the viability of SMM investments or related risks, the banking system has not been interested in lending to SMMs, unless meaningful collateral is available. Even so, most commercial bank lending has been for working capital needs, or through PECAM, since 1980. Financial assis- tance to SMMs from the Mining Development Commission (CFM), the Mexican Trust Fund for Non-Metallic Minerals (FNM), and the Mineral Resources Council (CRM)-  - 13 - all supported under the previous Bank loan (1820-ME) for PECAM-has alleviated the SMMs' shortage of funds. The assistance from these institutions, however, while satisfactory in quality, has catered only to a limited number of SMMs. Rnvironmental Impact and Safety 40. Mining enterprises operate subject to federal environmental and safety standards. In processing ores, the beneficiation plants mainly use neutral materials with no harmful content. For gold concentration, most beneficiation operations utilize the flotation process where cyanide is used, but in such small quantities (if at all) that it decomposes naturally in the tailings ponds and does not cause any adverse environmental consequences. In the small number of plants where the cyanide process is used, the contaminated wastes are recycled after settling out the tailings solids, without cyanide discharges to the environment. Additionally, in most beneficiation operations, tailings solids are reprocessed for metal recovery. To help ensure that contamination problems are not caused by SMHs, PECAM would carry out an environmental impact study of such operations, under the proposed project. SMMs generally do not present significant safety problems because they work under favorable condi- tions, such as mining normally vertical and narrow veins that are embedded in hard rock and can be ventilated adequately by simple methods. Mine safety regulations are enforced by the Government. Safety is also provided for in the contracts between the Syndicate of Mine Workers and mining enterprises. Union representatives frequently cooperate with the mines to ensure careful monitor- ing of safety standards. Under the previous Bank-supported mining project, PECAM would carry out a study to improve further the safety coaditions of SMMs. Its conclusions are expected to be available by mid-1986. Overall Potential, Viability, and Development Constraints of SMs 41. About a 1.8 million km2 area shows potential for mining, but to date- despite the country's longstanding tradition in mining--only about 15,000 km2, have been designated as mining areas. In exploiting these resources, SMMs have an important role to play. During the past decade, the SMM sector has grown at annual average rates of 4-5% in real terms, despite recent economic difficul- ties and ebbing international metal prices. This performance was possible because of the sector's comparative advantages (para. 38) and reasonable returns on investments. Investments by SMMs in 1979-1984 amounted to approxi- mately US$100 million each year. With stable international prices and a real- istic exchange rate, it is expected that SMMs would maintain this level of annual investments, especially as increasing emphasis is being placed by the Government on exploration, new mining development, and promotional activities through PECAN, CRM, CFM and FNM. In line with these expectations, the ceiling for subproject size under the proposed project would be raised, which in itself would spur credit demand by medium-sized mines. 42. In addition to a shortage in financing (para. 39) and still insufficient exploration work, the main constraints for the development of SMMs in Mexico at present include: (a) lack of nearby mineral concentration facilities, which increases crude mineral costs on account of long hauling distances; (b) tech- nical and administrative difficulties of SMMs; and (c) some shortcomings in the  - 14 - institutions providing support under PECAM, especially in areas of long-term planning for mine development, and technical and financial assistance. The various components of the proposed project would address these constraints. Past Dank Experience and Sector Strat5a 43. PECAM and its participating institutions generally performed well under a US$40 million Bank loan (Ln. 1820-HE) made in 1980. The achievements of the first Bank loan include: (a) inducing the Government tr establish a coordinat- ed policy for developing the mining sector and SMMs; (b) spurring regional and mine development through subprojects and creating some 1,800 new jobs; (c) pro- viding, mainly through CFH and PFM, otherwise scarce term lending to SPM4s; (d) developing FNM into a financial institution and preparing CPM to become one gradually; and (e) initiating beneficial institutional upgrading, which would serve as a basis for further assistance under a follow-up Bank operation. 44. The Bank's assistance strategy for the mining sector aims at : (a) sup- porting Mexico's export drive to earn foreign exchange; (b) promoting regional development; and (c) generating employment. While the SMiMs have played a cen- tral role in the Bank's pursuit of these objectives, recent sector work has identified other investment opportunities suitable for Bank financing, such as those required for mining sulphur, phosphate rock, and coal, new exploration work, and efficiency improvements in large private mines. In addition, the Bank's involvement in mining also lends support to the implementation of the General Interest Rate Agreement (GIRA), helping to reduce progressively the Government's subsidy outlays. PART IV - THE PROJCT 45. In mid-1984, the Government indicated its interest in obtaining further Bank support for the small- and medium-scale mining sector, in order to build and expand on the accomplishments of the first Bank loan (1820-ME), assisting PECAM. A Bank preparation mission visited Mexico in September 1984, followed by an appraisal and a post-appraisal mission in November 1984 and January 1985, respectively. The Bank also conducted an overview of the mining sector in November 1984, which helped complete the sectoral setting of the proposed oper- ation. Negotiations took place in the Bank in March/April 1985, and the Mexican negotiating team was headed by Lic. Arturo Galan de la Barreda, Manager of IBRD Banking Operations in NAFINSA, and included Lics. Luis Willars Andrade, Antonio Cervera Sandoval, Clemente Licon Avila, and Luis Macedo, representa- tives of PECAM, CFM, FNM, CRM; and Lics. Luis Nava Hernandez and Federico Patino of NAFINSA in Washington, D.C. A Staff Appraisal Report (No. 5454b-ME of April 26, 1985) is being circulated separately. Annex III provides supple- mentary data on the project. Project Desription 46. The proposed project has been designed to support the Government's sec- tor development strategy, aimed at building and expanding upon the accomplish- ments of the first Bank project in this sector. It would also strengthen the  - 15 - three project implementing agencies and improve coordination within the small- and medium-scale mining sector. Commercial Bank lending to S?Ms under the project would be encouraged, and the project would help build up the second- tier credit operations of two key sector agencies--CFM and FNM. Specifically, the proposed project would consist of the following major components: Credit to SiK enterprlses for: 1) Investments in fixed assets, including beneficiation and concen- tration facilities, permanent working capital, and technical assistance; snd 2) Exploration activities. Credit to the Participating Institutions for: 1) Acquisition, by CFM, of mining machinery and equipment, for leasing to SMMs; 2) Construction and/or expansion, by CFM, of some six regional bene- ficiation plants providing service to S4Ms; 3) Acquisition, by CEM, of mineral exploration machinery and equip- ment to assist SMMs' exploration activities; and 4) Expansion and modernization of the regional laboratories of CFM and CRM, and construction of new laboratories by FNM. Comprehensive Action Plan: Carrying out a comprehensive Action Plan for institutional development and specific studies by PECAM and the three participating institutions, including the acquisition and utilization of office equipment. The project would be carried out during the period of July 1985-June 1991. Project Costs and Financing 47. The project's costs are estimated at US$210 million, representing about two-fifths of all SMM investments in Mexico in 1985-1988. The proposed loan of US$105 million would finance 50% of project costs, extending the Bank's cost- sharing arrangements under the SAP and financing local costs up to about 10% of total project costs. Counterpart funds, equivalent to US$105 million, would be provided by the Government, PECAM, and the three participating institutions, as well as by the beneficiary enterprises, who would provide about 15% of their investments. Assurances were obtained during negotiations that the Government would make available counterpart resources for carrying out the project (Section 2.02 of the draft Guarantee Agreement).  - 16 - 48. NAFINSA would be the Bank's Borrower, and would, on behalf of the Government, pass on the proceeds of the loan to PECAM and its participating iustitutions, in accordance with contractual arrangements which would be satis- factory to the Bank. CFM, FNM and CRM would repay the amounts they borrowed under the program to PECAM, who would retain the funds for its assistance to SMN8 (Section 3.01 (b) of the draft Loan Agreement). The Government-through NAFINSA--would repay the Bank loan, including interest charges, and bear the foreign exchange risk. Execution of the contractual arrangements would be a special condition of the loan's effectiveness (Section 8.01 (a) of the draft Loan Agreement). Special Complementary Progrm for SHK (P=CAN) 49. The proposed project would be part of the Government's assistance pro- gram for the SMM sector. Following adoption of a new Mining Law in 1975, the Government established PECAM with the Bank's support in 1980, as a second major step to revive Mexico's mining sector. PECAM's objectives in assisting SMMs are reflected in the 1984-1988 National Mining Program (para. 37). PECAM reports to the Secretariat of Energy, Mines and Parastatal Industries (SEMIP), and is overseen by a Coordinating Committee, headed by the Under Secretary. To carry out its routine work, PECAM set up a Technical Secretariat, comprising a small, part-time working group. In order to cope with expanding PECAM opera- tions, SEMIP has taken administrative measures to upgrade the Secretariat's work force to a full-time staff, headed by an experienced manager. An agree- ment was reached during negotiations that PECAM would maintain the Technical Secretariat with adequate staff for carrying out its activities (Section 3.01 (b) of the draft Guarantee Agreement). i<ning Development Caomission (Cil) 50. CFM, the largest and oldest of the three project implementing agencies, was created in 1934, and works mainly with metallic minerals. Its share in implementing the proposed project would be the largest, accounting for about one-half of total costs. Its objectives are: (i) to serve as the Government's holding company and executing agency for large mining projects; (ii) to own and operate mines, and beneficiation plants; aad (iii) to provide financial and technical assistance to SMMs. 51. Organization. CFM's overall policymaking body is its Board of Direc- tors, headed by the Secretary of SEMIP and including representatives from key State Secretariats, NAFINSA, CRM, FNM, and the private sector. Operations are managed through 19 regional offices by a permanent staff of 2,553, including 610 professionals. The-staff is generally well qualified, but needs further training in management, finance, and economic evaluations, to cope with stepped-up promotion of, and lending and technical assistance to, SMNs. 52. Operations, Policies. Although keeping its role as a public holding company, CFM has expanded, in recent years, its credit operations to SMMs. More than 90X of its credit went to private companies for mine exploration, develepment, and exploitation. In addition, CFM leased equipment to SMMs, and  - 17 - invested in regional beneficiation plants. Investments for SMMs reached about US$14 million a year in 1981-1983, and about US$24 million Ln 1984. Under the proposed project, CFM would finance SMMs also as a second-tier institution, and-to achieve this objective--would encourage commercial bank lending to the sector. 53. Finance. The financial standing of CFM is satisfactory, with more than 90% of its assets financed through equity--mainly Government contributions. Its holding in 39 subsidiaries and affiliates amounted to about US$49 million equivalent at cost, representing about 53% of total assets at end-1984, down from 55% in 1981. Given this financial structure, CFM is planning to increase its lending, which is expected to bring down this percentage to 43% by 1988. Its loans in arrears declined from 35% of its total outstanding in 1981, to 18% by the end of 1984. To reduce this arrearage further, supervision responsibil- ities would be emphasized in CFM's Action Plan (para. 63). After years of operating losses, the agency made a profit in 1983 and 1984. 54. Regional Beneficlation Plants (fBPs). CFM currently operates some 20 RBPs, with capacity at each ranging from 100-600 tons a day. The installation of mini-sized plants at each mine is not feasible, but an RBP can process the ores of several small mines economically. This is the underlying rationale for CFM's RBP operations. The majority of the plants, 14 in all, serve small mines, charging a toll to the users. Traditionally, private investors enter this type of business only when they supply their own mineral, thus having some control over the capacity utilization of the concentration facilities. Other- wise, the private sector has been reluctant to invest in this type of business, mainly because of the lack of control over ore supplies, the difficulties involved in operating service plants in isolated areas, the need to provide technical assistance to small miners, and the existence of attractive invest- ment alternatives in larger mines, including concentration and smelting facili- ties. Therefore, SMMs will continue to depend upon CFM's regional plants in the medium term, and the proposed project would provide financial assistance for some six new plants. 55. CFM almost breaks even on its RBP operations. The tolls cover opera- tional costs, including depreciation, and--in the case of the only plant that was financed with debt--financial charges too. This practice contains an element of subsidy, although the small loss of US$170,000 by all RBPs in 1983 was more than offset by the total value of US$20 million of the products traded by the mines that used those RBPs. But, this practice is not fully consistent with CFM's policies to recover the costs of RBPs, and to ensure that the pri- vate sector is not discouraged by low tolls to invest in RBPs. Therefore, CFM would, under its Action Plan, by September 30, 1986: (a) carry out a study of the profitability of existing RBPs as well as of the mines being serviced; (b) review the RBPs' accounting system; (c) determine what adjustments, if any, in tolls should be introduced; and (d) furnish to the Bank the studies' recom- mendations. An agreement was also reached during negotiations that, CFM would: (i) charge toll rates for plants financed out of the proceeds of the loan, at a level sufficient to generate, starting in the third full year of operation of  - 18 - each plant, an annual rate of return on the average current net value of fixed assets of not less than the interest rate applicable to credits to small miners on the date when the plant is put into operation, provided, however, that the above return would not be less than 70X of the above specified level in the second full year of operation; and (ii) furnish to the Bank for comments the recommendations of, and proposed follow-up actions based on, a study of tolling rates for regional beneficiation plants included in CFN's Action Plan, and sub- sequently take action to improve the tolling rates for the plants (Section 2.01 (c) of the draft CFM Project Agreement). Trust Fund for Non-Netallic Minerals (FNN) 56. FNM's share in implementing the proposed project would be the second largest, accounting for about two-fifths of total costs. This agency was set up as a trust fund of NAFINSA, to help develop Mexico's non-metallic mineral resources by providing credit and technical assistance, promoting processing plants, and opening "ejido" land for exploration and development. Its govern- ing body is a Technical Committee, presided by a SEMIP official. FNM operates from nine regional offices, with a total staff of 139, which is expected to expand to 212 by end-1985, in order to increase its credit to SMMs. The Fund's technical staff is qualified, but requires some training in the areas of management, finance, and economic evaluations. 57. Finance. FNM's overall financial position is satisfactory. About 44% of its assets were financed through equity in 1984, and the balance, through debt instruments. Its loan portfolio grew below inflation in 1981-1983, but current plans call for an annual real growth of about 20% in 1985-1988. Arrears in its loan portfolio deteriorated in 1982-1983, representing as much as 17% of its total outstanding. But, as a result of improved recovery and a growing loan portfolio, the arrears dropped to 3.3% in 1984. FNM showed losses consistently in 1981-1983, but, for the first time, profits in an amount of US$670,000 are estimated for 1984. FNM would, by continued reductions in administrative costs, maintain a profit in 1985-1988, mainly through improved project processing and portfolio management. 58. Operations. FNM channelled one-fourth of its lending through commercial banks in 1981-1984. It lent US$19 million to SMMs in 1984. The Government's objective is now to increase further the Fund's lending to SMMs through commer- cial banks, for which its second-tier operations would be strengthened under this project. Mineral Resources Council (CDI) 59. The Council would have a small share in implementing the project, repre- senting about 4% of total costs. CRM was set up in 1955, to: (a) carry out geological surveys and exploration; (b) advise the Government in general on the exploration, exploitation, and preservation of mineral resources; and (c) coor- dinate geological studies and research by public sector entities. The National Mining Program 1984-1988 gave CRM a special mandate to explore sites with high mineral potential and to intensify its support to SMMs through credit, techni- cal assistance, and field laboratory services.  - 19 - 60. Organization. CRM is responsible to a Board of Directors, chaired by the Secretary of SEMIP. It has deployed nearly two-thirds of its 2,440 employ- ees in the field offices. While generally well-qualified, ite staff requires further training in management and finance of exploration projects. 61. Finance. CRM's financial position is strong, with about three-quarters of its assets financed through equity in 1984. Government contributions cur- rently also cover part of its operating expenditures. A roughly tenfold in- crease in debt financing--which CRM first undertook in 1981-is expected to continue, and CRM would, by 1988, finance nearly one-half of its assets through borrowing. Comprehensive Action Plan 62. To address some of their urgent needs discussed above, PECAM and the three project implementing agencies would undertake a comprehensive Action Plan. PECAM would have overall responsibility for the Action Plan, and carry out directly a small but significant part of the project's technical assistance program, which would acccount for about 2Z of total costs. More specifically, to help upgrade its Technical Secretariat, PECAM would: (a) upgrade its review system for subloans and prepare a manual; (b) prepare an operating document for the collection, processing and distribution of project informa.ion; (c) design a technical assistance program for its participating institutions; and gd) determine its staff requirements, including a review of job descriptions. In addition, PECAM would, under the Action Plan, carry out studies required to support SMMs and set sectoral policy. 63. While the project appraisal and supervision procedures of CFM, FNM, and CRM are generally satisfactory, improvements are needed to ensure more systema- tic project evaluation, including cash flow analysis, and a closer monitoring of subprojects, especially in the period when the investments are being made. FNM should strengthen the market evaluation, and C1RM should emphasize overall project feasibility beyond a survey of geological aspects in project apprai- sals. Given the expected increase in commercial bank participation, their supervision responsibilities and those of the regional offices should be spelled out in greater detail, including the monitoring of problem projects, subloans with payments in arrears, and periodic reporting requirements on proj- ect and subloan status. Therefore, as part of the Action Plan, CFN, FNM, and CRM, would prepare revised appraisal/credit processing and supervision manuals. 64. In addition, to bring about the required improvements in their opera- tions, the project implementing agencies would: (a) prepare overall institu- tional strengthening plans; (b) propose medium-term planning systems to deal with institutional strategy, and operational and financial targets and resource financing; (c) modernize their accounting system; and (d) draw up specific training programs. Training would be provided to the staff of PECAM, partici- pating institutions, and commercial banks, covering problem areas discussed in paras. 51, 56 and 60 and, in a larger sense, helping implement the comprehen- sive Action Plan. In all, some 350 technical staff would be trained under the project.  - 20 - 65. During negotiations, an agreement was reached on a list of the activi- ties that would be covered by the comprehensive Action Plan. Approval by PECAM, CFM, FNM and CRM of their respective Action Plans, in terms satisfactory to the Bank, would be a special condition of effectiveness (Section 8.01 (c) of the draft Loan Agreement). To carry out the Action Plan, the project would provide consultant services, including Mexican and international specialists, at a total cost estimated at US$2 million. Computers and equipment would also be financed, to help improve operations in PECAM's Technical Secretariat, CFM, FNM, and CRM. Project Implewentatlon 66. The project, as a whole, would be carried out in accordance with PECAM's Operational Guidelines, which has been under review by PECAM and its partici- pating institutions. Agreement on the substance of the Guidelines was reached during negotiations, and their formal adoption would be a condition of effec- tiveness (Section 8.01 (b) of the draft Loan Agreement). 67. The maximum amount of financing for any investment project or RBP, in- cluding any outstanding amounts, would be limited to US$5 million equivalent, and the plants would have a capacity of between 100 and 500 tons a day. Financing for any leasing operation would be limited to US$1 million equiva- lent; up to US$7 million would be available to finance leasing operations; and US$12 million, in the aggregate, would be provided for working capital. Prior Bank approval would be required for all subloan proposals requesting Bank financing in excess of US$800,000, all subloans to enterprises in which CFM or FNM have a controlling interest, and all RBPs. On the whole, the Bank is expected to review roughly one-fifth of all subprojects, representing about two-fifths of loan resources. All subprojects would have a minimum financial rate of return of 12%, and those involving Bank finance in excess of US$500,000 would also have to demonstrate a minimum economic rate of return of 12% (Schedule 4 of the draft Loan Agreement and Sections 2.01 (b) of the draft CFM and CRM Project Agreements). Relending and Leasing Terms 68. Subloans would be denominated in pesos, with a floating interest rate based on a percentage of the average cost of short-term borrowing by the bank- ing system (ACF), in accordance with the terms of the General Interest Rate Agreement (GIRA) between the Government and the Bank. The ACF, which is a monthly index, has in general followed inflationary expectations in Mexico. Recent studies confirmed that it is an adequate benchmark for setting interest rates. The Government is committed to gradually reducing the interest rate subsidy that is presently extended to SMM enterprises-which is justified by its contribution to the balance of payments, employment, and regional develop- ment goals--and to reducing the dispersion between rates charged to various classes of borrowers. These objectives are reflected in GIRA. In 1985, ini- tial interest rates would be at a level equivalent to 80% and 90% of the ACF for small- and medium-scale mines, respectively, currently equivalent to 38% and 43% p.a. Lessees of equipment would be charged a monthly financing fee  - 21 - equivalent to 90X of the ACF (Section B, Schedule 4 of the draft Loan Agree- ment). Under the framework of GIRA, the rates for small- and medium-sized mines would gradually be adjusted upwards, to a standard margin of up to 2 percentage points above ACF over 1985-1987, and maintain consistency with those charged to small- and medium-scale industry. Disburwements 69. Loan funds would be disbursed against 65X of disbursements under each subloan approved or authorized by the Bank, or of expenditures made by partici- pating institutions, provided, however, that the percentage of disbursements would be reduced to 45% when the aggregate total of subloans approved, added to disbursements for the investments of the participating institutions, shall have reached US$52.5 million (one-half of the loan amount). To speed up disburse- ments, a Special Account in an amount of US$8 million would be established in NAFINSA. Disbursements for subloans or investments costing less than US$50,000 would be made against statements of expenditures. The loan would be disbursed over six-and-one-half years, and the Closing Date would be December 31, 1991. Retroactive financing of eligible expenditures incurred after April 1, 1985, is included up to an amount of US$5 million. Auditing 70. The accounts of PECAN, FNM, CFM and CRM would be audited once yearly, according to standards satisfactory to the Bank. The statements of expendi- tures would be covered by these annual audits (Sections 6.01 (b) and (c) of the draft Loan Agreement, 3.05 (b) of the draft Guarantee Agreement, and 3.01 (b) and (c) of the draft CFM and CRM Project Agreements). The Special Account would be audited separately, in accordance with terms satisfactory to the Bank (Section 6.04 of the draft Loan Agreement). Procurement- 71. Procurement procedures for goods and services of SMM enterprises would follow those customary for industrial development finance operations and for items costing more than US$100,000, three quotations would be required. Goods and civil works packages procured by PECAM's participating institutions costing in excess of US$1.5 million, or US$500,000 in the case of single items, would be procured through international competitive bidding procedures, in accordance with Bank guidelines, and local suppliers of goods would be entitled to a mar- gin of preference of 15% or the applicable import duties, whichever is lower. Below these limits, goods and civil works would be procured in accordance with a local procedures which are satisfactory. Consultants financed from the loan would be employed on terms and conditions satisfactory to the Bank (Schedule 2 of the draft Loan Agreement). Project Benefits and Risks 72. The proposed project would have a strong impact on Mexico's SMM sector. Credit and services provided through the project would help some 200 SMN enter- prises across the country, generating an incremental output valued at US$110  - 22 - million per year, 40Z of which is expected to be in foreign exchange. Since it takes about US$20,00 of investment to create a new job in the SKM sector, the proposed investment outlays would cre&te 5,000-6,000 permanent jobs, mainly aemon low-income groups, including some in the least developed regions. The rate of return test--which is mandatory in the Operating Guidelines to be fol- lowed under the project-would ensure that the project's development impact materializes. In addition, the project would have a strong institution- baild- Ing effect, and it would encourage commercial bank lending to SMNs in Mexico. 73. The proposed project does not face any unusual risk. However, two un- certainties may materialize during project execution: first, commercial banks may not step up lending to SMM enterprises, particularly for metallic minerals; and second, some mineral prices, especially that of silver, may fall below cur- rent levels, possibly postponing investments under the project. Given FNM8s satisfactory experience recently with commercial banks and the adequate spreads allowed 2nder the project, the probability of the first risk is low. In view of the broad range of minerals mined by SMM enterprises in Mexico and the al- ready record low metal prices which are unlikely to show further drastic drops, the second risk is acceptable. PART V - LEGAL INTUMCENTS AND AUTHORITY 74. The draft Loan Agreement between NAFINSA and the Bank, the draft Guarantee Agreement between United Mexican States and the Bank, the draft Proj- ect Agreements between CFM and CIRM, and the Bank, and the report of the Commit- tee provided for in Article III, Section 4 (iii) of the Articles of Agreement are being distributed to the Executive Directors separately. Special condi- tions of the project are listed in Section III of Annex III. Three special conditions for loan effectiveness would be that: (a) contractual arrangements for passing on funds from NAFINSA to the implementing agencies, have been executed (para. 48); and (b) the Action Plans of the four project implementing agencies (para. 65) and (c) Operating Guidelines (para. 66), have been formally adopted. 7s. I am satisfied that the proposed loan would comply with the Articles o. gr^emDnt of the Bank. PART VI-RE I HKENDATIONS 76. I recommend that the Executive Directors approve the proposed loan. A. W. Clausen President Attachments April 30, 1985  -23- ANNEX I Page 1 of 5 ':'~ ~ ~ ~ ~ ~ ~ ~ ~~~"M 'I' .LIn COUii llW) i,@aL i,7oL1. msuau. ma.aa^m ca ap Am, (6*DH3|lI q. *() - -OTAL 1972.5 1972.5 1972.5 AORZIULIr *3.2 97e.a 979.3 Gw m cai" Cal) 360.0 730.0 2270.0 215.6 2345.3 m a.uutin M CAIn (CIORAf 0 OIL 1OlwUAn) 539.0 713.0 1340. 995.5 uL2.s NUUAUWO AM VrTL SYTBA27= IoUrXUOU.uh2-um (ZUS U5) 37073.0 5107.0 73122.0 on"rB Ca o TOTAL) 50.6 59.0 66.0 66.5 PO)UATION PIOJETtORU POPULATION IV VAl 2000 (HItLL) 109.4 STArZOMArI ropuAnmo (KELL) 196.5 UoVULDTIOU WfitU.9 FOAULTtO D-ITT FR SQ. a5. 16.6 25.9 36.1 3.67 2.9 MR SQ. M. ALIR. LAN 37.7 52.4 72.6 92.4 1s.9 FOIL&TKO MM sT3 CZ) 0-14 nRS 45.6 46.5 44.3 39.9 31.6 15ff4 us 51.0 50.0 52.2 51.0 61.1 65 MM ADM 3.4 3.5 3.4 4.1 7.1 1OPJIATIOII GROMT RATZ CZ) TOTAL 3.0 3.2 3.0 Z.4 1.6 131Am 4.6 4.7 4.2 3.6 3.7 CRUDE Ram aE (MR TONS) 65.4 63.6 33.9 31.3 23.4 cobs DEAT RATE (Pn 300s5) 12.2 9.7 7.1 *.1 5.5 GROSs REPRODCTIONI RATE 3.3 3.2 2.2 2.e l.6 1A1LLU PLAINKNG ACCEPTORS. AAL (TUS) .. 25.1 11650 1 SERS CZ OF HARRIED R) *- *- 39.0 INDEX OF rooD PRO. PIC CAPITA (19W971-100) 97.0 100.0 104.0 114.3 114.5 MRI CAPITA SUPPI.! OF CALORIE (1 Or p1IENTS) 117.0 112.0 121.0 110.6 L29.S POINS (GS PER DAY) 69.0 6s.0 74.0 67.3 69.7 OF MIICH ASUA AND PULJS 29.0 27.0 26.0 Id 34.1 34.5 0111. (AeS 1-4) DUTR RATE 10.3 6.5 4.0 5.7 5.2 LIFE ElECT. AT um11 (lEADS) 57.0 61.3 65.4 64.7 67.4 INANT WI=. RATE (PER TIOS) 91.1 73.6 52.9 60.6 54.2 ACMsSS TO SAFE HAUl (CPOP) TOTAL 23.5 49.0 is 56.0 1.65.6 URBAN .. u.s 6S.4 W 7?.1 RURAL .. 71.07 5i.eoT 46.2 ACCSS TO EBCRETA DISPOSAL CZ OP POLATION) TOTAL .. 37.0 /a 3B.0 la 52.9 UDAN .. 60.0 7 50.1 7m 67.0 AL .. 4.0 13.0 7W 24.5 L POPULATION MR ?ratICI 1830.0 1510.0 .. 1917.7 1065.8 POP. FRI NJSN PERSON 3650.0 1590.0 ..