Mexico - Public sector investment review : a joint report

CONFIDENTIAL Report No.6371-ME MEXICO PUBLIC SECTOR INVESTMEN, REVIEW - A JOINT REPORT August 5, 1986 Government of Mexico Mexico Programs Division Latin America and the Caribbean Regional Office World Bank This document was prepared jointly by the Mexican authorities and World Bank staff. It is based on work done during the summer of 1985. The document has a restricted distribution and may be used by recipl4nts only in the performance of their official duties. Its contents may not otherwise be disclosed without the authorization of the Government of Mexlco or the Latin America and the Caribbean Regional Office of the World Bank.  Acknowledgewknt his report would not have been possible without the support of Undersecretaries Francisco Suarez Davila (SHCP) and Pedro Aspe Armella (SPP). The report is based on the joint work of a Mexican inter-agency team and a World Bank mission that visited Mexico in May 1985. The Mexican team was coordinated by Mbssrs. Jesus Reyes %roles (Director Geaeral of Financial Planning, SHCP) and Jose Curdoba Monutoya (Director General of Economic and Social Policy, SPP). They were assisted by Messrs. MNriano Ruiz-Funes, (Director, SHCP) and Jose Luis 'Iriegas (Director, SPP). The World Bank mission consis:ed of Messrs./Mesdames Landau (mission chief), Oskan (deputy mission chief), Yuravlivker (macroeconomics), Dussan, Lambertini, Wilberg (power), Babelon, Okudaira, Pearson, Wood (fertilizers and chemicals), Simon, Mangan (steel), Bentjerodt, Maraboli (mining), Gutman (transport), Wellenius (communications), Norton, Coeis (ari culture), Briggs, Fuller (education), Andreu (health), Yepes, Pereira, Mbi (water and sewerage), Flora, Thornhill (urban transport), Guarda, Augusto (housing), Nalatinszky, Petrei, Shir?.ey, Johnson, (institutional), Garn, (Federal District). We would also like to thank Messrs. Jose Angel Gurria, (Director General of Public Credit, SECP) and Jose Luis Flores (Director for International Financial Organizations, SHCP) for the overall support they provided throughout the project.  MIEXICO PUBLIC SECTOR INVESTMENT REVIEW - ~ ~ ~ - ------ Table of Contents Page No. Preface Smmary and Conclusions i-xii Introduction 1. The Macroeconomic Framework 1 I1. Sectoral Investment Programs for 1985-1988 13 A. Energy 13 (i? Oil and Gas 16 (ii) Power 23 B. Industry 32 (i) Fertilizers and Chemicals 32 (ii) Steel 4u (iii) Mining 56 C. (i) Transport 63 (ii) Communications 78 D. (i) Agriculture 87 (ii) Marketing and Storage 106 E. (i) Public Health 111 (ii) Education 118 F. Urban 131 (i) Urban Transport 131 (ii) Water supply and Sewerage 145 (iii) Housing 161 III. Institutional Aspects of Public Investment 167  Preface What follows is a review of Mexico's mediumrterm public investment program prepared jointly by the Mexican authorities and World Bank staff. The review is basefd on work done during the summer of 1985 and therefore does not reflect the effects of the September earthquake or the oil-shock of early 1986. The main objective of the report was to formulate a considered opinion on the investment program and its major components. The strategy was to start out w_th the "unrestricted" sectoral investment programs proposed by the relevant agencies/institutions and then point out areas of high priority and provide candidates for cuts/deferrals in case of tighter budgetary ceiliugs. This approach proved to be rather useful when the economic and financial constraints of early 1986 indeed required further cuts in public sector expenditures/investment. The aiproach taken also ensured that the general thrust and conclusions still remained valid some nine months after its prelaration. It should be stressed however, that both the macroeconomic framework and the investment figures provided in this report, for the period 1986-1988, are by now out-of-date. The present report is an interim output of a longer-term work progam on public sector investment and will be followed by in-depth sector work in selected areas. Amoug areas where such work is currently being undertaken are steel and capital goods industries, fertilizers, and agriculture -- some of the key sectors where the Government is focusing its restructuring efforts.  Summary and Conclusions Overview 1. In early 1985, the Mexican Government and the Bank agreed on undertaking a joint review of public sector investment. This draft report Fresents the findings of the first phase of that review. Tti-Z9baed1-bonl-the aialysis7-doniE-during the summer of 1M85 by sectoral working groups that included both Mexican officials and Bank staff. The present study does not take account of the September earthquake or the oil shock of early 1986. The investment figures provided for 1986-1988 are based on the macroeconomic outlook assumed at the time (summer of 1985) and may no longer be considered realistic. 2. The economic adjustments of 1983-84 required large reductions in public expenditures, the brunt of which was borne by public investments. The latter fell to 6.5% of GDP in 1984, from an average of 102 during the previous sexenio. The investment cuts were made largel.y across the board, without a clear definition of priorities. This trend appears to have contintied through 1985 with investment falllng below its 1984 level, despite an upward surge in overall public expenditures (and the fiscal deficit), Moreover, resources for public investment may be further constrained in the coming year. As a result, the review of the public investment program has become more urgent. 3. In general terms, the review found that the broad thrust of the public sector investments (controlled or supervised by the Federal Government), as amended recently in line with the country's financial constraints, is reasonable and consistent with the country' more urgent development needs. However, while some sectors and public entitities have well-defined multi-year investment programs (e.g., power, transport, mining), this is not generally true throughout the public sector. Thus, agriculture, water supply, public health, education and urban transport are examples of sectors where the review group was not able to obtain detailed investment programs. (This study did not review in any detail the investment plans of PEMEX). One of the findings of the review was that, as a result of the high levels of public investment realized prior to the 1982 crisis and of the sharp reduction in growth that is being experienced by the Mexican ecocomy, there is widespread excess capacity in many sectors. Therefore, there is now a potential to cut back investmenii txpenditures for a few years without creatIng excessive bottlenecks. In the present difficult economic 6onditions, Mexico is at a crossroads. Instead of continuing an economic strategy based on _. large government participation in the economy, together with deficit financing and high levels of industrial protection, the authorities have indicated their intention to create more favorable conditions for private investment, to reduce the public sector deficit and to enhance the competitiveness of the industrial sector by opening up the economy to foreign trade. In these circumstances, it should be possible to sustain the targetted growth rates with a lower level of public investment than in the past. This review found that the aggregation of the investment plans (explicit or implicit) of the various sectors and public entities implies an annual level of investment of US$14.8 billion (in 1984 prices). This level is likely to exceed substantially the Government's financial capabilities during the rest of the sexenio. But there is considerable scope for savings and rationalization in most sectors, particularly if the new  - ii - Government strategy is rapidly implemented and is complemented by institutional improvements and by other sector policies along the lines discussed in the report. As a tentative illustration, the report suggests that an average annual level of US$12 billion (in 1984 prices) could be consistent with attainment of the Government's objectives for social and economic development for the next three years. Sector Reviews 4. In the sectoral reviews that follow, the strategy is to start out with the investment programs prepared by the relevant agencies/institutions and then point out areas of higher priority and possible candidates for cuts/deferrals in case of tighter budgetary ceilings. In these reviews the sectoral priorities and issues are also highlighted. 5. In the energy sector, Government's first priority is increasing production/generation capacity to meet overall demand (includes demand for 1.5 mbd of crude exports). Other key Government objectives include energy conservation, diversification and adequate valuation of energy products. Critical to energy conservation will be energy pricing policies; investments aimed at reducing energy loss in power distribution and flared gai; and incentives and support for energy conserving investments by industries, the transport sector and households. The largest potential for diversification is in electricity generation where efforts would focus on reducing the share of hydrocarbon based plants. However, improvement in this area in the medium term will be slow given the large share of oil based generation plants in ongoing investments. With respect to pricing, the Government has taken some big steps in implementing a more realistic hydrocarbons pricing policy, but there is still room for improvement, especially in the areas of LPG and fuel oil. Pricing, however, will be most crucial for improving the financial situation of the power subsector, where the low level of tariffs necessitate large federal transfers. In this regard, there is an urgent need for a thorough review of both the average levels and structure of electricity tariffs. 6. In oil and gas, the next few years will be a period of consolidation for Pemex, in which distortions resulting from the unbalanced dev.elopment of the previous Sexenio are corrected. This will require investment in basic infrastructure such as storage and loading facilities, improvement in the pattern of refinery output so that it better matches the composition of product demand, and managing its network of gas gathering/ processing/transport facilities as a "system". It is also crucial that exploration and development of new oil fields and secondary recovery from existing fields are not restricted by a lack of investment, so that PEMEX can meet reasonable increases in internal demand and at the same time maintain the targetted volume of petroleum exports. The 1985-88 investment plan for PEMEX, as outlined in the energy plan, is some Mex$2.2 trillion (in 1984 pesos).1/ This plan has not been analyzed for the pr -,nt report. 7. In power, the investment program prepared by CFE is over Mex$1.2 trillion for the 1985-1988 period, growing at a rate of 11% per annum. This 1/ The investment plans are expressed in 1984 Mex$. The average exchange rate for 1984: US$1 Mex$167.8 (roughly, Mex$1 trillion - US$6 billion, Mex$1 billion - US$6 million).  - iii - investment program, however, is based on a relatively high demand scenario (7.5% per annum), which does not appear to take account of an expected real tariff increase of some 40% over 1985-1988 and a conservation program that will reduce energy losses in power generation/distribution; and does not consider the viability of a continued distribution effort in the context of the sectors' resources and priorities. Furthermore, despite the expected tariff increases and the conversion by the Government of some of CFE's debt into equity, the power subsector will not be able to generate any savings to finance its investment program and will continue to require large federal transfers through 1988. Taking into consideration the huge financing implications and the potential of lower demand growth, there is room for reduction in the power sector investment. Although the consequences of establishing precise investment priorities would require formulation of a new expansion plan and detailed analysis of the reliability of the power system, the following general comments on this matter can be given. If cuts are to be made, the first step would be to cut back on distribution investments in non-priority areas and to delay start-up of new generation projects; and second, to slow down construction of ongoing projects. The impact of reduced investments on the reliability of supply could be lessened through improvements in the efficiency of the power system. 8. In fertilizers, priority should be given to making the industry more competitive by international standards through improving the efficiency of production and distribution. This will require a rationalization program that may involve the closing of uneconomic plants and the relocation or rehabilitation of existing facilities. Other issues that should be addressed are the separate planning of ammonia and urea facilities by Pemex and Fertimex, and fertilizer pricing policies which have in particular, increased dependence on Government contributions to sustain operations, to invest and to service debt. Formulation of a financial restructuring package could help rationalize Fertimex operations, and allow the company to become self-reliant. The investment program recommended for the period 1985-88 is some Mex$100 billion. Though of a composition somewhat different from the investment program approved by SPP, these amounts are comparable to amounts approved so far, for new projects. With respect to the three major new investment proposals, there is little doubt that the output from the two urea plants would be needed to cover the projected deficit ia nitrogen by 1990, although it would be advisable to limit such capacity to meeting domestic demand only. The construction of a new sulfuric and phosphoric acid plant in the Pajaritos area, however, is unlikely to be economically viable. 9. In secondary petrochemicals, it may be worthwhile to reconsider the rationale for Government involvement. Depressed world price- and markets and general over-capacity makes any venture primarily based on exports doubtful at the moment. In addition, this is typically a sector where the private sector is efficient as long as a competitive environment is maintained. 10. In steel, a restructuring of Sidermex production facilities and of the whole Mexican steel industry appears to be urgently necessary. Planned investments should be further reviewed in this context. Beyond Sidermex, an in-depth study of the whole Mexican steel sector should identify the products for which the country has a comparative advantage, the technological  - iv - improvements required, and a package of policies that would ease transition of the industry towards a more optimal product and technological base. Such restructuring is needed if Mexico is to be successful in its efforts to export manufactured and semi-manufactured steel-based products, and desires to maintain/acquire reasonably advanced technology, and more generally to improve the international competitiveness of the industrial sector. Of the Mex$77 billion investment program (excluding SICARTSA II), at least the AHMSA rehabilitation, a portion of the AHHSA debnttlenecking, and perhaps the rehabilitation and debottlenecking at Sicartsa I should continue as scheduled. Debottlenecking of the AHMSA open hearth furnace system and the investments at FUMOSA -- except those absolutely necessary to maintain existing levels of production -- could be postponed until the review and studies recommended in the steel chapter are undertaken. Thus, between 1/4 to 1/3 of the proposed total of Mex$43 billion for 1985-86 should be the subject of careful review. 11. Mining investments proposed for this period translate into a total of 176 billion pesos. First priority would be given to preservation of production capacity of viable operations and basic mineral exploration effort necessary to preserve the growth potential of the subsector over the medium and long term. Second priority would be given to the program of credit assistance to private SMM (Small and Medium Mining), to MICARE's Carbon II project, which is designed to feed a thermal power plant falling into the power sector's least-cost development program, and to the fertilizer minerals program. Of lowest priority are the Sidermex expansion program in coking coal and the Sidermex iron ore program. For the former, part of the investment program could be postponed to later years with no substantial economic loss. In the latter case, some balancing and optimization investments for existing facilities would be sufficient. 12. In transport, the present administration has taken concrete actions to reorganize and consolidate the sector under a single secretariat; to direct its limited resources more towards maintenance and rehabilitation of transport facilities and the completion of high priority works rather than initiate new works; and to rationalize pricing practices and reduce unwarranted subsidies to the sector. Level of investment for 1985 is Me,$224 billion. Investment levels projected for 1986-88 are based on completing ongoing projects initiated in the 1979-1981 period and beginning some priority works in 1987-88. This would require real increases of 8-15% per year over 1985 budgets. However, if budgets remain restrictive, there are a number of options to reAuce investment without severely affecting transport service. For the higlhways, such a reduction would lead to scaling down SCT's new construction and modernization program, while increasing reconstruction and maintenance efforts to meet immediate needs. In the case of railways, again the main area for possible cuts would apply to new rail infrastructure investments. In ports, major investments should be postponed, except for those which are needed to serve the immediate needs based on firm commitments of specific industrial clients. 13. In communicatious, the proposed investment program for 1985-1988 is Mex$674 billion in 1984 prices, on an annual basis some 80% higher than the average actually achieved in 1983-84. This is indeed an ambitious investment program and several components could be reduced or postponed without impairing service. The bulk of the reduction would come from a smaller  - v - expansion of the local telephone system: limiting the number of new lines to 200,000 per annum rather than the targetted 375,000 would result in savings equivalent to 27% of the proposed program. In addition, SCT's proposed second earth-station for satellite communication through the INTELSAT system, and the purchase of a direct broadcasting satellite could be deferred. Similarly, the project to install about 600 earth stations can be revised down to reduce costs. 14. Agriculture has performed better than the rest of the economy during the crisis years 1981-84. The recent high growth rates of output of basc crops could be attributed, at least in part, to the producer pricing policies of the Government. While producer prices have begun to approximate the corresponding international levels, consumer prices for basic foods remain well below such levels. Emphasis of the present administration is quite different from the emphasis of earlier administrations on large-scale irrigation projects: there is a redirection of resources from irrigated areas and toward rainfed areas. There is also a realization that future growth in production will have to be based on improvements in yields as much as on increases in cultivated areas. Fulfillment of these priorities will require relative shifts in the agriculture budgets toward current expenditure, away from the investment budget, and an intensification of programs of research, seed multiplication and extension. 15. In agriculture, there was no comprehensive investment program. However, alternative scenarios were prepared for expenditure by SARH and its associated parastatal agencies. These aggregate 1985-88 expenditure budget scenarios are in the range of Mex$1.1-1.3 trillion. Taking share of investment at some 60% of overall expenditure -- slightly below its historical share - these figures would translate into yearly investment figures of some Mex$190 billion (1984 pesos). These budgets show a strong priority given to four areas. They are, in order, small scale irrigation, technical assistance, forestry programs, and infrastructure in rainfed zones. The lowest priorities are given to river control works, large-scale irrigation, and public administration and planning in the sector. If budaretary stringency becomes tighter, then technical assistance and forestry programs begin to get cut, and rainfed infrastructure and small-scale irrigation emerge as the top priorities under a skeletal budget. 16. Total expenditure in public health stood at 1.8% of GDP in 1984 - with about 10% of this total in capital expenditure -- and will remain under 2% of GDP in the mecium term in view of the less than favorable economic and fiscal prospects and larger than expected demands of pension-related obligations of IMSS. Equity and efficiency goals must, therefore, be pursued in the context of limited additional fin.-ncing, and will need to take advantage of the potential for improving capacity utilization in existing services. The ongoing decentralization of health services from SSA and IMSS/COPLAMAR to the states; and the adoption of specific health service packages by the individual states are additional factors bearing on equity and efficiency. The only investment plans available are those of SSA and do not appear to satisfy the sector's needs. First, the planned investments would make heavy demands on operating resources in times of fiscal stringency. Second, they emphasize the expansion of physical infrastructure as opposed to the improvement of existing capacity. Third, the proposed investments do not provide evidence of ljeing integrated into state  - vi - development plans and being related to specific health care models. Therefore, a reassessment of the nation's operational public health plan is of high priority. 17. In the education sector, the main priorities are meeting rising demand for schooling, improving quality and efficiency, addressing inequities in access to schooling, raising worker productivity through vocational and on-the-job training, and decentralizing administration of the basic school system. Addressing all these priorities during a period of declining resources -- education expenditure fell from 5.5X of GDP in 1982 to under 3.8% of GDP in 1985 - will be difficult. Projections for 1986-88 indicate that education spending will remain at around 4% of GDP, with about 8% of the total in capital expenditures. The absence f a specific investment/ expenditure plan makes difficult an assessment of program priorities and investment alternatives. Nevertheless, the stated government education objectives combined with the current fiscal situation do suggest some recommended policy priorities for the next few years. These priorities are: (a) continue to meet enrollment demands, particularly at the primary school level. Investments in primary education both yield high economic returns (relative to other types of education) and reduce inequities between income groups and geographic areas; (b) improve school quality through selective investments, especially in primary education. Two factors that could contribute to the quality of education would be increase in the share of overall expenditures directed to instructional materials and programs aimed at upgrading of teacher qualifications; (c) improve equity by reducing public subsidies to relatively affluent students in upper secondary and higher education and using the public savings to increase spending and educational quality in primary education; and (d) reduce regional disparities through increased spending in less developed areas. 18. In urban transport, the main problems identified are: (i) high concentration of investment in the Federal District -- virtually all of public expenditure for urban transport occurs within the Federal District; (ii) high operating subsidies -- there is virtually no attempt to recover costs from users - fares provide only 3% nf operating costs; (iii) distribution among modes of transport - almost half of expenditures are committed to the subway system, with over one third of the total going to 3ystem expansion; (iv) size of the future investment program -- on an annual basis, roughly double the 1985 levels; and (v) adequacy of the institutional structure - although there is a high level of expertise in the design and quality of transport projects, planning and prioritizing projects is less well developed and more coordination is needed among agencies responsible for the different modes of transport. 19. There has been a substantial financial commitment to build and operate Mexico's urban transport systems: an estimated total expenditure of some Mex$210 billion in 1985 (in 1984 prices). Based on current plans, this could increase by nearly 50% by 1988. Nearly all of the money is slated for the Mexico City region (92%), a very large portion of which is used to subsidize opotrating expenses. In the Federal District, over 1/2 of all expenditures are committed to the subway system, with over 1/3 of the total going for system expansion. The proposed investment program for the period 1986-1988 for Mexico City's urban transport system is an equivalent of  - vii - Mex$410 billion, on an annual basis roughly double the 1985 levels. These amountI axe excessive: not only they imply huge financing requirements, but also they would encourage the continuation of excessive growth in the capital region and further expansion of the system would obligate future administra- tions to commit larger and larger sums to finance growing operating deficits. In this regard, the extension of the Nexict. City metro system warrants careful review. 20. During 197(-1983, water supply service levels rose from 49Z of the population to 662. Sewerage and waste disposal service levels increased from 242 to 43Z of the population during the sakle period. The goal is to reach some 10 million new users with water and sewerage services by 1988. Attainment of these goals will be costly and require improvements in two key areas: pr,cing and institutional policies. The NDP (Jational Development Plan) called for pricing policies that reflect the real cost of water and would permit the sector to become more financially self-reliant. In practice, however, continued availability and indiscriminate use of extensive grant financing have not only discouraged the intentions reflected in the IDP, but has also encouraged grandiose and not always sound investment choices. The absence of a cohesive framework for sector planning an; consequent lack of consolidated investment plans has resulted in the emphasis on development of new water resources. In this regard, there is insufficient coordination with some state and iocal programs leading to duplication of efforts, waste, and low priority investments. Alternatives such as reduction of water losses and improved efficiency among sector operating entities have not been considered. 21. The official projections called for an annual investment of Mex$270 billhn. That level of investments (more than 4 times the historic levels), is unrealistic from the standpoints of both implementation capacity and economic constraints. The working grolip estimates for investment required (annually) to achieve the water and sewerage geals would be Mex$125 billion (in 1984 prices) for 1985-1988. As it might prove difficult to obtain even this level of resources, a thorough analysis of ongoing projects - to eliminate/postpone/redesign uneconomic ones - is essential. Further, more efficient use of existing infrastructure - through rehabilitation and improved maintenance procedures - should be emphasized. 22. Much of the investment in the Federal District (DDP) has been in the areas of urban transport and water and sewerage. If these sectors were to keep their historical shares in total DDF investment, the investments proposed by the corresponding sectoral agencies imply an unrealistically high level of investment in the DDP during the 1986-88 period - on average, roughly 601 higher than the investment levels of 1977-82. The expenditure plans for DDE will have to be substantially scaled down if total investment in the DDP are to be held to sustainable levels. In fact, the projections of the public investment working group in this area are for zero real growth in investments for the DDE (investment remaining at Mex$210 billion (in 1984 prices) and no substantial shift in sectoral emphasis. The expectation is for completion of existing projects, rather than initiation of major new projects over the study period. 23. Housing programs will have a central role in policies aimed at economic recovery with rapid employment growth. The share of public  - viii - investment in housing will be close to 2% of GDP annually during the 1986-1988 period. However, most of this investment is funded through the banking system and payroll contributions; resources directly drawn from the federal budget are about 6% of the total. Main issues in public housing are the following: (i) the average rate of capital recovery is very low: 40% durlng the period 1977-1982; (ii) the proliferation of activities and variety of credit terms and conditions applied by existing housing institutions challenge the stated objective of controlling and budgeting the subsidy element involved in preferential credit and in making it more transparent; and (iii) most of the programs remain beyond the reach of the poorest and the neediest population. Summing Up 24. L For the most part, the 1985-88 investment plans that are available - as prepared by the sector enterprises/agencies -- are reasonable. The exceptions are water and sewerage, urban transport, and communications, where the investment programs proposed by these agencies are some two to four times as large as the corresponding levels for 1977-82, thus providing large potential for savings.\ There is room for investment cuts in other sectors as well. Savings could be substantial in the areas of power--where demand for electricity could be substantially lower than currently projected; agriculture -- where there is now less emphasis on large scale irrigation projects which have in the past required large capital expenditures; and transport--where new construction and modernization programs could be scaled down. Although there is also room fGr cuts in the industry sector --chemicals, steel, and mining--their impact on total public investment would be relatively small. In education and health, cuts would not. be recommended in light of the small share of investment in total expenditure in these sectors and the negative impact such cuts would have on the quality of services which have already shown some deteriorafion. However, there is a need to redefine the operating programs for those two sectors. Similarly, in housing, cuts are not recommendable since the size of direct federal contributions are small and this sector is of high priority from the standpoints of both employment generation and income redistribution (the distortionary effects of subsidized housing credits should be carefully reviewed, however). Finally, a crucial area is the DDF (some 70% of total investment in urban transport and water and sewerage) where real increases in investment would not be required provided more efficient use of existing infrastructure is made through rehabilitation and improved maintenance. Further, such increased investments would have negative impact on concentration around the District and place future financial burden on federal resources given the very low rates of cost recovery for services provided in the metropolitan area. All the suggested cuts could be carried out without creating major bottlenecks to growth in the next 3-4 years. 25. The aggregate sector investment programs proposed by the various Government agencies and enterprises - or implicit in their development plans - are summarized in Table 1. They imply an average volume of investment of Mex$2,479 billion p,a. in 1985-1988, at 1984 prices (equivalent to US$14.8 billion at 1984 prices) or about 7.7% of GDP. Quite likely, it will not be feasible for the public sector to acommodate such large outlays during the present sexenio. To illustrate the possible shape that the public investment program could take if it had to be constrained to a smaller  Table 1: AGGREGATION OF SECTORAL INVESTMENTS s - (Billions of 1984 pesos)!/ - 9 . Shares Average Shares ( -) --- ------------Actual ------------ Proposed by Covernment Agencies pAr Sa) - 1971-76 1977-82 1971-76 1977-82 1983 1984 1985 b/ 1986 1987 1988 85-88 85-88 PEMEX 18.2 30.3 233 806 586 469 490 521 554 590 539 21.7 CFE 13.4 13.6 17i 362 262 260 256 313 324 352 311 12.6 Chemicals 1/ 0.5 1.1-- 6 29 24 31 51 51 51 51 51 2.1 Steel 2/ 4.9 2.5 63 66 77 64 14 29 20 14 19 0.8 Mining . . - 1.5 - 40 32 40 35 42 47 52 44 1.8 Transport 17.4 8.2 222 219 245 204 224 241 265 306 259 10.4 Communications 5.8 4.0 74 106 85 102 138 158 188 190 169 6.8 Agriculture 3/ 15.2 12.8 194 340 224 163 175 188 203 218 1'36 7.9 Uealth 4/ 4.4 4.0 57 106 b4 57 50 50 50 50 50 ?.( ,Education 4.5 3.1 61 80 68 60 64 60 65 73 66 2.6 Water & Sewerage 5t - 1.4 - 38 50 50 147 186 195 204 183 7.4 Housing 6, - 0.9 - 24 33 27 30 30 30 30 30 1.2 D0F 7/ 7.2 7.8 92 207 218 210 229 428 312 290 315 12.7 Total explained 91.5 91.2 1169 2423 1942 1815 1903 2297 2304 2420 2231 90.u (Share in CDP) 6.3 9.1 6.8 6.1 6.3 7.3 7.0 7.0 Total Pub. tnv.8/ 10.0 l(U.0 1277 2660 2164 1920 2114 2552 2560 2688 2479 100) Share in GODP 6.9 10.0 7.6 6.5 7.0 8.1 7.8 7.8 GDP 18,461) 26,600 28,450 29,500 30,469 31,688 33,145 34,902 a/ US$1 = Mex$167.8 bJ Does not take account ot recent cuts made for 1985 investment programs 1/ Fertilizers only except for 1985-1988 2/ For 1985-1988, SICAKTSA not included 3/ After 1983, SARH only 4/ For 1985-1988 estimates of the working group 5/ DDF not included / Includes direct federal contributions only 7/ For 1985-1988, DDF investment is estimated based on pxroposed investments for urban transport and water and sewerage taking into account their historical shares in overall DDF investment. 8/ For 1985-1988, estimated by using the historical relationship between total explained' and 'total pu6tic i0V-SttnX-stt.  Table 2: AN ALTERNATIVE SCENARIO FOR PUBLIC INVESTMENT (1985-1988) - (Billions of 1984 pesos) Average Shares p.a. (%) 1985 1986 1987 1988 85-88 85-88 PEMEX 490 521 554 590 539 26.8 CFE 256 260 278 298 273 13.6 Chemicals 32 32 27 24 29 1.4 Steel 14 17 20 14 16 0.8 Mining 35 41 43 44 41 2.0 Transport 224 224 241 259 237 11.8 Telecommunications 101 105 112 120 110 5.5 Agriculture 175 175 187 200 184 9.2 Health 50 50 55 60 54 2.7 Education 64 60 65 73 66 3.3 Water & Sewerage 50 55 60 65 58 2.9 Rousing 30 35 40 45 38 1.9 DDF 210 210 210 210 210 10.5 Total explained 1731 1785 1892 1982 1848 92.4 (Share in GDP) 5.7 5.7 5.7 5.7 Total Public Inv. 1881 1941 2057 2154 2008 100.0 (Share in GDP) 6.2 6.2 6.2 6.2  - xi - magnitude, Table 2 has been compiled on the basis of the recommendations andflndings of this report. The lower program would be equivalent to Mex$2,008 billion p.a., or US$12.0 billion p.a. (all in 1984 prices)2/ or 6.22 of GDP. These lower investment levels are believed to be eompatible with the current economic growth projections of the Government, provided that they are accompanied k-y appropriate macro, sector and institutional policies, along the lines suggested in this report. These magnitudes, however, have not been linked to specific investment projects in the present exercise; this is a task that remains to be done. Management of Public Investment 26. The PIR also looked at the resource allocation and budgetary process in the public sector. Some of the problem areas tiat can be strengthened are the following: 27. In the budgetary process, it would be useful to introduce a multi-year framework that would include uniform macro-economic guidelines (that spell out resource prospects), realistic expenditure ceilings for the sectors and a 'core program" of projects. For example, a multi-year rolling investment program could replace the present single-year budgeting system. In such a system, expenditures for the first year only are approved, while second and third year estimates serve to indicate likely spending requirements. This allows prior financial planning so that overcommitment to projects is avoided and recurrent expenditure implications are taken into account. Definition of a "core program" of projects could help separate priority projects - that could be fully funded each year in line with the amounts needed for efficient implementation - from "reserve" projects that would go ahead if and when additional resources become available. Such a system of priorities could help avoid across-the-board cuts of funding for ongoing projects at times of budgetary stringency. 28. With respect to parastatal management, the system of regulation and detailed budgetary control, appears to create severe constraints for parastatal operations. In spite of existing over-abundant reporting requirements, performance is not adequately followed-up. Among the possible measures that could be taken to improve the operations of the parastatals, one consideration would involve providing more flexibility and autonomy in the management of enterprises. Parastatals could be managed principally through controls over performance and financing, rather than through the budget or ex-ante approval of purchases and salaries. This would require elaboration of a system of performance evaluation for the companies and their managers. One approach would be through gradual generalization of the restructuring agreements (physical and financial) between the federal government and the parastatals - similar to the agreement on railroads. 29. Project preparation and evaluation should be improved and the information so generated be geared to budget needs. For this purpose, the SPP could set norms for technical, financial and economic appraisal and determine the basic parameters to be used for economic analysis. In this 2/ Again, the reader should be reminded that these figures are based on the resource outlook assumed during the sumer of 1985 and may no longer be realistic.  - xii - regard, existing project evaluation units (such as the ones in SPP, Semip) could be strengthened through broad training programs. Also helpful would be the establishment of a system to monitor and overlook the implementation of projects. 30. The recently announced trade liberalization measures present a unique opportunity to improve the quality and cost effectiveness of investments in tCAe public sector. To t'ke full advantage of the new -nphasis on international competitiveness and promotion of non-petroleum exports, it would now be necessary to modify accordingly the procurement procedures of government agencies. To the extent that these agencies are permitted to purchase equipment internationally, on the basis of price and quality considerations, they will be able to install less expensive and more appropriate equipment. This, in turn, would permit them to lower the dowestic price of the goods and services that they provide and to reduce the need for subsidies. 31. The share of investment projects planned and carried out by the states - frequently financed from Federal revenues -- is growing. Also, the states are playing an increasing role in regional planning and inter-agency coordination concerning local investments of the Federal Government. However, the quality of planning and budgeting for these local investments is uneven: quite advanced in a few states, but weak in others. Thus, it is important to improve the coordination of investment plans between states and the Federal Government to avoid duplication of efforts and the possible allocation of resources to low priority projects. In this regard, the revenue sharing dnd transfers could be linked to specific measures to be taken by the states for improved investment management.  INTRODUCTION 1. In early 1985, the Mexican authorities and the Bank agreed to carry out a joint public sector investment review. This report presents the findings of the first phase of that review. It- -w prepared -J w L *ri Th _cu. iiii dd~.,sti6i~ and r iuan~iial -ef#e~to--of- thvrezent--e&athquake ov the 2. The economic adjustments of 1983-84 required large reductions in public expenditures the brunt of which was borne by public investments. The latter fell to 6.5% of GDP in 1984, from an average of 10% during the previous sexenio. The investment cuts were made largely across the board, without a clear definition of priorities. This trend appears to have continued through 1985 with investment falling below its 1984 level, despite an upward surge in overall public expenditures (and the fiscal deficit). Moreover, reso s for ic investment may be further constrained in the coming year. , he review of the public invesppnt programias4 become more ur -/c( 0L Wta/ V 3. There ott consists of three chapters: V Chapter I provides an overview of the recent economic developments and a macroeconomic framework for the period 1985-1988. The latter is based on the -propetiHoni-prdd"-by the Mexican Government to the international banking community in June 1985. Chapter II comprises the sectoral reviews. Each secteral piece provides an overview of the sector,iicIuiding its institutional structure, sectoral issues and objectives, and examines the investment program for the period 1985-1988. The strategy is to start out with the "unrestricted" investment programs prepared by the relevant agencies/institutions and then point out areas of higher priority and possible candidates for cuts in case of tighter budgetary ceilings. /tA-v Chpter III discusses the institutional aspects of budgeting and investment planning.  CHAPTER I The Macroeconomic Framework * A. Introduction 1. The present Public Investment Review (PIR) is a joint study by the Mexican Government and the World Bank. The macroeconomic framework was provided by the Secretariat of Finance and Public Credit (SHCP). The projections in this framework are similar to those included in the periodic update of economic statistics supplied by the Mexican Government to the international banking community in June 1985. These projections serve in the PIR as a common point of reference for the various working groups preparing the sectoral investment plans. The macroeconomic framework is presented below following a brief discussion of the main developments in the Mexican economy in the period leading to the 1982 crisis and during the adjustment process thereafter. B. The Macroeconomic Background 2. The Mexican economy is still in the process of adjiustment trig- gered by the 1982 crisis. Although several external shocks precipitated the crisis, internal developments in the late 1970s increased the wvlnerability of the economy to external factors. Those developments were set in motion by the discovery of the large oil resources in the mid 1970s and skyrocketing oil production and exports. Oil exports climbed from US$1 billion in 1977 to almost US$15 billion in 1981 (three-quarters of total merchandise exports that year), bringing about an increase in public sector revenues as a share of GDP from 24 percent to 28 percent over that period. Public expenditure, however, went up even faster (from 30 percent to more than 40 percent of GDP), generating a growing public sector deficit which was financed by bor- rowing abroad and from the domestic banking system. The resulting monetary expansion led to an acceleration of domestic inflation to over 25 percent a year in 1980 and 1981. Since the nominal exchange rate was held constant, the real exchange rate appreciated, contributing to a steep increase in imports and mounting trade and current account deficits [Table 11. 3. The year 1981 was critical for the Mexican economy. Already highly dependent on oil revenues and on foreign borrowing, the country faced a sluggish oil market, a steep rise in interest rates and a deep rece'ssion in the industrial countries. The Government tried to maintain a high level of economic activity by sharply increased foreign borrowing: the external debt of the public sector rose by 60 percent, to US$53 billion in 1981. This allowed public expenditures, including public investment, to rise, bringing the economic deficit of the public sector to an unprecedented 13.6 percent of GDP. While imports continued to rise rapidly, non-oil exports reversed their upward trend and declined by almost 40 percent. Deteriorating public finances and balance of payments, as well as the mounting external debt, triggered a massive capital flight which put additional pressure on the Mexican peso and on the economy as a whole. * This chapter, as the rest of this report, was prepared during the summer of 1985. For up-to-date macroeconomic projections, please refer to the statistical addendum provided for the Trade Policy Loan approved on July 29, 1986.  - 2 - Table 1: MEXICO - RECENT ECONOMIC DEVELOPMENTS 1977 1978 1979 1980 1981 1982 1983 1984 GDP Growth rate 3.4 8.2 9.2 8.3 7.9 -.5 -5.3 3.5 Gross Capital Formation (% of GDP) 22.8 23.6 25.9 28.1 29.0 21.3 20.2 18.0 Foreign Savings (X of GDP) 2.0 2.6 3.6 3.6 4.9 -1.0 -4.3 -2.4 National Savings (X of GDP) 20.8 21.0 22.3 24.5 24.1 22.3 24.5 20.4 Rate of Inflation (Tyg.% change) 29.1 17.5 18.2 26.3 27.9 53.9 101.9 65.5 Real Exchange Rate - 128.5 127.5 116.5 103.4 91.0 139.9 127.7 99.6 Public Sector (% of GDP) 2/ Total Revenues 24.2 25.5 26.2 28.5 27.5 30.2 34.4 32.0 PEMEX 3.8 4.5 5.6 8.4 7.6 10.9 14.8 12.8 Total Expenditures 29.5 31.0 32.2 35.5 41.1 46.4 42.7 38.0 Invest nts 7.6 9.3 10.1 11.2 12.8 10.8 7.9 6.2 Deficit i/ 5.4 5.5 6.0 6.9 13.6 16.3 8.3 6.0 Balance of Pay nts (US$b.) A. Current anc'ount Balance -1.6 -2.7 -4.9 -7.2 -12.5 -4.9 5.3 3.9 1. Trade Balance -.9 -1.8 -3.2 -3.7 -4.5 6.8 13.7 12.8 Merchlandise Exports 4.6 6.1 8.8 15.1 19.4 21.2 22.3 24.1 Oil 1.0 1.9 4.0 10.4 14.6 15.6 16.0 16.6 Non-oil 3.6 4.2 4.8 6.7 4.8 4.5 6.3 7.5 Merchandise Imports 5.7 7.9 12.0 18.8 23.9 14.4 8.6 11.3 Public Sector 2.1 2.9 4.0 7.1 8.8 5.3 4.3 4.8 2. Non Factor Service Balance 1.2 1.4 1.4 1.1 -.7 -1.4 .6 1.0 3. Factor Service Balance -1.9 -2.4 -3.4 -4.9 -7.5 -10.3 -9.0 -9.9 B. Capital Account Iitlance 2.3 3.3 4.5 11.9 21.9 8.6 -1.1 -1.6 C. Errors and Omisions 0.( -.1 .7 -3.6 -8.4 -8.4 -0.9 -0.1 D. Change in Reserves .7 .4 .4 1.2 1.0 -4.7 3.3 2.2 External Debt (DoD) (US$b.) 29.7 33.9 40.2 50.7 74.9 87.3 93.6 94.2 Public Sector 22.9 26.7 29.7 33.8 53.0 59.7 66.6 69.4 Nationalized Banks 1.8 2.0 2.6 5.1 7.0 8.5 6.9 6.3 Private Sector 5.0 5.2 7.9 11.8 14.9 19.1 19.1 18.5 Source: Lndicadores Economicos (Banco de Mexico) and SHCP. 1/ December Index (1970-1980=100.0). The real exchange rate index represents the purchasing power parity between K.exico and nine mejor trading partners. The index uses WPIs, and an increase represents a real depreciation of the peso. 2/ Subject to budgetary control. 3/ Excluding financial intermediation.  - 3 - 4. The crisis occurred in 1982. The peso was devalued by almost 70 percent in February, but that did not stop capital flight. Rising inflation and the absence of a comprehensive economic program raised the level of uncertainty even further. Foreign borrowing continued in the first half of the year, but in August Mexico's access to international capital markets was drastically curtailed; consequently, the country suspended servicing its external debt. The authorities withdrew from the exchange market (bringing about a steep devaluation), and in September they introduced generalized exchange controls and nationalized the banking system. In the last quarter of 1982 the economy entered into a severe recession, inflation rose to 10-11 percent per month, and external payments arrears aczumulated while international reserves almost disappeared. Real GDP fell by 0.5 percent in i982, and public expenditures rose to 47.3 percent of GDP, largely due to high interest payments and exchange rate losses.1/ Public investment, on the other hand, reversed its rapid growth path of the late 1970s and fell to less than 10 percent of GDP, starting a downward trend that has continued throughout the adjustment process.2/ Nevertheless, the overall public sector deficit increased in 1982 to over 17 percent of GDP. S. In December 1982, the Mexican administration announced a compre- hensive economic program -- supported by a 3-year IMF extended fund facility -- that had the following objectives: a) to lower the rate of inflation; b) to reduce foreign borrowing and generate trade surpluses to meet external debt commitments; and c) to improve the efficiency of public expenditure and investment as a basis for future economic growth. To achieve these object- ives, the program called for: a) reducing the public sector deficit by raising taxes and tariffs of public goods and services, but mainly by cutting the volume of public expenditures; b) devaluing the peso to improve the competitiveness of domestic producers in international markets; c) rescheduling external debt. 6. The adjustment effort in 1983 was remarkably successful. There was a complete turnaround in the external accounts following a 100 percent devaluation in December 1982, the adoption of a pre-announced crawling peg, a deceleration in the rate of monetary growth, and a drastic cut in the public sector deficit. The current account of the balance of payments moved from a deficit of US$5 billion in 1982 to a surplus of over US$5 billion in 1983 -- the first current account surplus in Mexico since 1955. This switch resulted mainly from a reduction of imports to one third of their 1981 peak. Furthermore, there was substantial progress in the fight against inflation, which declined in the second half of the year Lo an annual rate of 65 percent, and also on the external debt front, where public sector obligations of US$19 billion were rescheduled, and agreement was reached on the principle of restructuring private debt. 1/ The interest payments in 1982 were equivalent to 8.9 percent of GDP and the exchange rate losses to 4.6 percent of GDP. 2/ Total public investment includes the investment of the Federal Government, budget controlled state enterprises, and entities outside budgetary control (including Telmex, Metro and DDF).  - 4 - 7. The immediate costs of this adjustment, however, were high: GDP fell by 5.3 percent in 1983, with the manufacturing and the construction sectors bearing the tightest contraction. Real wages deteriorated by 20 percent. The reduction in public expenditures was achieved largely by cutting down public investments to less than 8 percent of GDP, a proportion roughly similar to the pre-boom year 1977. 8. Economic growth picked up in 1984. Non-oil exports grew by nearly 20 percent, and the overall balance of payments remained strong, with a current account surplus of nearly US$4 billion. Both the rate of inflation and the public deficit, however, exceeded their policy targets. The real exchange rate appreciated by over 20 percent. Although public investment was further cut in 1984, current expenditures increased in the latter part of the year due to higher interest payments and higher outlays for goods and services. This looser fiscal discipline was accompanied by a somewhat weaker monetary policy, which put pressure on domestic prices and on the external accounts. 9. These negative effects carried over to the first half of 1985. The real exchange rate appreciated by an additional 7 percent. The appreciating peso and the increase in economic activity resulted in a 34 percent rise in imports and a 16 percent drop in non-oil exports compared to the same period in 1984. A sagging international oil market put additional pressure on the economy: following a sharp drop in oil exports, Mexico announced price cuts in June and July to restore export volume; however, the combination of lower exports in the first half of 1985 and lower prices in the second half of the year could result in an annual loss of over US$1 billion in oil revenues. These effects are partly offset by lower than expected interest rates and debt service payments: since effective interest rates on the external debt are roughly 1.5 percentage points below the 12.0 percent originally assumed, interest payments would be lower by over US$1 billion this year. However, these balance of payments developments, summarized by the loss of about US$2 billion of international reserves in the first half of 1985, were adding pressure to the already difficult situation generated by higher than planned inflation and public sector expenditures. 10. These developments triggered several rounds of policy measures to regain fiscal discipline, slow down the economy and reduce the rate of inflation. Reducing public sector expenditures is again essential for the success of the adjustment effort; hence the importance of improving the allocation and efficiency of public investment, using the limited available resources to build up a solid base for renewed economic growth. C. The Macroeconomic Framework 11. Tables 2-4 present the main projections for 1985-88. The driving variable of the model that generated these projections is the deficit of the public sector. That is, the size of the public deficit was predetermined as a policy target -- roughly 4 percent of GDP for 1986-88 --  Table 2 Macroeconomic Framework _ Basic Projections - ------Projected - - - -- 1982 1983 1984 1985 1986 1987 1988 Real GDP growth -0.5 -5.3 3.5 3.0 4.0 4.6 5.3 Inflation Rate - 61.2 92.1 66.0 59.0 42.7 32.3 23.0 Z of GDP: 3/ Public Sector Deficit - 16.2 8.2 6.0 6.8 4.3 4.0 3.8 Gross Capital Fo ation 21.2 20.2 18.0 19.2 20.4 21.8 23.3 Foreign Savings - -1.0 -4.3 -2.4 0.0 0.6 0.8 0.9 National Savings 22.2 24.5 20.4 19.2 19.8 21.0 22.4 memo GDP (billions of 1984 pesos) 30,026.9 28,442.2 29,438.9 30,322.1 31,534.9 32,985.6 34,733.8 GDP deflator 31.4 60.1 100.0 159.0 226.9 300.2 369.3 Exchange Rate (average) 57.4 120.1 167.8 292.0 304.2 377.7 442.2 Devaluation (Dec. to Dec.) 267.8 49.2 33.1 38.5 28.2 20.9 13.9 CPI (Dec. to Dec.) 98.9 80.8 59.2 58.5 37.0 28.0 20.0 Source: SHCP 1/ Projections provided by the Mexican government 2/ Based on GDP deflator 3/ Excludes financial intermediation 4/ Corresponds to current account balance as estimated in the framework of national accounts. This is very close to the current account balance in the IMF Balance of Payments data, except for 1982 where there Is a difference corresponding to 4 percent of GDP.  Table 3 Public Sector Deficit and Savings (% -of GDP) ---- Projected- - 1982 1983 1984 1985 1986 1987 1988 Revenues 30.2 33.9 32.4 31.3 31.5 31.7 31.8 Budget sector - 29.0 32.6 31.1 30.0 30.1 30.2 30.2 Pemex 6.0 8.0 7.0 5.3 5.2 5.1 4.9 Other 23.0 24.6 24.1 24.7 24.9 25.1 25.3 Enterprises not included in federal budget 1.2 1.3 1.3 1.3 1.4 1.5 1.6 Expenditures 46.4 42.1 38.4 38.1 35.8 35.7 35.8 Budget sector 1/ 43.6 40.0 36.3 36.1 33.9 33.7 33.5 Enterprises not included in federal budget 2.8 2.1 2.1 2.0 1.9 2.0 2.1 Budget deficit 14.7 7.5 5.2 6.1 3.8 3.5 3.3 Deficit of enterprises not included in federal budget 1.5 0.7 0.8 0.7 0.5 0.5 0.5 Overall deficit 16.2 8.2 6.0 6.8 4.3 4.0 3.8 Foreign financing 3.7 3.0 1.3 0.2 1.3 1.6 1.4 Domestic financing 12.5 5.2 4.7 6.6 3.0 2.4 2.4 Public sector current s ings 2/ -5.3 -1.1 0.1 0.2 2.1 2.9 3.5 Federal government _ -7.4 -4.1 -2.9 - -0.9 -0.3 0.3 Sudget-controllid state enterprises 4 -0.6 0.6 0.6 - 1.3 1.7 1.9 Pemex 1.6 3.8 3.1 - 2.3 2.4 2.4 Other -2.2 -3.2 -2.5 - -1.0 -0.7 -0.5 Memo: Fed. Govt. transfers to budget- controlled state enterprises 2.7 2.4 2.4 - 1.7 1.5 1.2 Source: SHCP 1/ Includes federal government and budget-controlled state enterprises. 2/ Consolidated figures exclude federal government transfers to budret-controlled state enterprises. 3/ Expenditures include current transfers to budget-controlled state enterprises.  Table 4 The External Sector (US$ billions) ---------Projected-