Mexico - Fourth Small and Medium Scale Industry Project

Document of The World Bank FOR OFFICIAL USE ONLY 9s Al. }k StW N Report No. 6539-ME STAFF APPRAISAL REPORT MEXICO FOURTH SMALL AND MEDIUM SCALE INDUSTRY PROJECT June 2, 1987 Projects Department Latin America and the Caribbean Regional Office This document has a restricted distribuion and may be used by recipients owly in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authoization.  CURRENCY EQUIVALENCES Currency Unit - Peso (Mex$) On May 12, 1987, the exchangu rate in the controlled market was US$1 = Mex$1,218.3; the free market exchange rate was at US$1 Mex$1,214.0. Fiscal Year January 1 - December 31 Weights and Measures 1 hectare (ha) - 10,000 square meteres (m2) - 2.47 acres (a) 1 kilometer (km) = 0.62 mile (mi) 1 square kilometer (km2) = 0.39 sr'uare miles = 100 ha 1 kilogram (kg) = 2,205 pounds (lbs) 1,000 kilograms = 1 metric ton (t) = 0.98 long ton 1 liter 0.26 gallons (gal) Abbreviations ACF Average Cost of Funds BDM Banco de Mexico (Central Bank) CEPROFI Fiscal Certificates for Industrial Promotion CETES Certificado de Tesoreria (Treasury Certificates) CPP Costo Promedio Porcentual (ACF) FIDEIN Fideicomiso de Conjuntos, Parques, Ciudades Industriales y Centros Comerciales FOGA1N Fondo de Garantia y Fomento a la Industria Mediana y Pequena FOMIN Fondo Nacional de Fomento Industrial FRR Financial Rate of Return GDP Gross Domestic Product GIRA General Interest Rate Agreement IDB Inter-American Development Bank INFOTEC Servicio de Informacion Tecno Logica NAFIN Nacional Financiera PAI Programa Apoyo Integral de la Industria SECOFI Secretaria de Comercio y Fomento Industrial SMI Small and Medium Scale Industry SOE Statement of Expenditures  FOR 0MCAL US ONLY STAFF APPRAISAL REPORT MEXICO FOURTH SMALL AND MEDIUM SCALE INDUSTRY PROJECT TABLE OF CONTENTS Page No. PROJECT SUMMARY .. .....*.. *** .. . .. .. i I. THE INDUSTRIAL AND FINANCIAL SFCTORS .................... 1 Economic Crisis and Industrial Recovery .I........... 1 The Small and Medium Scale Industry Sector ............ 1 Structure and Growth ...................... 1 Development Constraints .................. ... . 2 Market Limitations and International Competi,ivene,, s ....................... 0... 2 High Financing Costs .......... ................... 2 The Financial Sector3............................. * 3 The Institutional Setting.........3.... ............ 3 Development Constraints.......................... ..... 4 Supply Constraints and Directed Credit............ 4 Lack of Appropriate Lending Instruments..*##...... 5 Highly Risk Averse Commercial Banking Sector...... 5 Commercial Bank Portfolio Management.............. 5 Recent Macro-Economic Policy Initiatives.......... 6 Government Objectives in the Sector............... 6 II. THE PROJECT.ance .......................*... 7 Project Objectives and Description......*............. 8 The Credit Component .................a.....**** 8 The Risk Capital Component ... .................... 8 The Financial Restructuring Component 9............ 9 The Factory Buillding and Industrial Park De7elopment Program9........................... .. 9 The Pilot Micro-Enterprise Component ............. 9 The Technical Assistance Component ............... 9 Executing Agencies and Past Implementation Experience. 10 FOGAIN oooo*................ lO Participating Financial Intermediaries............ 10 FOMIN ... 11 l FIDEIN . 12 This report was prepared by Messrs. Owaise Saadat (LCPI2), Rodolfo Hommes, Rene Jarquin, Jacob Levitsky, George Philippatos, Eduardo Saucedo (Consultants), following a mission to Mexico In October 1986. Mr. Samaniego (Consultant) contributed to the Sector Analysis during Pre-Appraisal. This document has a restricted distribution and may be used by recipients only in the performanco of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  - li - TABLE OF CONTENTS (Continued) Page No. Final Beneficiaries0......................... 13 Cost and Financing ............................ 13 Relending Terms and Conditions.titions............ 14 Rellending Terms ..... ......... 14 Special Conditions for Restructuring Component.... 15 Subloan Repayment Ter m s 15 Maturities, Grace Periods and Free-Limits..$***.. 15 Project Implementation Arrangements..... . . ....... 16 Program Coordination ........... .. ............ ... 16 The Credit C6mponent ........... .......... ..... ... 16 The Risk Capital and Financial Restructuring Component. . ......... ............. ........ . . 17 The Factory Building ane Industrial Parks Com.ponent....... ............. . .......... .... 17 The Micro-enterprise Component.........O........ 17 The Technical Assistance Components .............. 18 Procurement. .. .a............... X......... .. .... 18 Disusemnt u rsoo*oo,e m en*oooooteo 18 Accounts, Auditing and Reporting.orting......... 19 Benefits and Rss19 BII. AGREEMENTS and.................. 20 ANNEXES 1. Outline for the Technical Assistance Program 21 2. Operations of the Fondo Garantia Desarrollo de Industria (FOGAIN) ................................................. 29 3. Operations of the Fondo Nacional de Fomento Industrial 4. Guidelines for the Restructuring Component..*******,,**,,,, 46 5. Review of Ongoing Micro-enterprise Programsgrams#*......... 51 6. Experience under Past Lending ............................. 54 7. Key Indicators for Project Implementation ................ 64 8. Estimated Schedule of Bank Loan Disbursements 66 9. Supporting Tables Industrial and Financial Sector T-1 Index of Manufacturing Production, 1975-85 .... 67 T-2 Industrial Concentration by Firm Size (G985)... 68 T-3 Employment by Subsector and Size of Firm******* 69 T-4 tionetary Aggregates, 1970-85 ................... 70 T-5 Banking System Credit by Sector, 1980-85....... 71 T-6 Structure of Interest Rates (August 1986) ...... 72 FOGAIN: T-7 Ipcome Statement, 1982-85 ...................... 73 T-8 Balance Sheets, 1982-85 ....................... 74 T-9 Weighted Average Cost of Funds, 1981-85........ 75 T-10 Total Commitments by Program Type.............. 76 T-11 Commitments by Financial Intermediary, 1981-85 77 T-12 Total Commitment by Firm Size ................. 78 T-13 Portfolio by Maturity Schedules .....0.......... 79 T-14 Staffing by Profession and Department.......... 80 T-15 Projected Income Statement, 1987-1990 ......... 81 T-16 Projected Balance Sheets, 1987-1990 ,.......... 82  - iii - TABLE OF CONTENTS (Continued) Page No. FOMIN: T-17 Hietorical and Projected Income Statement, 1979-86 ...... ............................. 83 T-18 Historical and Projected Balance Sheets, 1919-86 .............. 0 ............................. 84 Micro-enterprises T-19 Lending by State Guarantee Funds .............. 86 T-20 Financial Analysis of Sample Subprojects *..... 87 T-21 Structure of Interest Rates, Mid-August 1986... 88 10. Selected Data and Documents Available in the Project File 89 11. Summary Status of Current Industrial Loans to Mexico 90 CHARTS 1 Organization Chart - Fund for Industrial Development for Guarantee (FOGAIN) ............ 91 MAPS IBRD 15553 Mexico  MEXICO STAFF APPRAISAL REPORT FOtURTH SMALL AND MEDIUM SCALE INDUSTRY PROJECT LOAN AND PROJECT SUMMARY Borrower: Nacional Financiera, S.N.C. (NAFIN) Guarantor: United Mexican States Executing NAFIN in its own right and as trustee for Fondo de Garantia y Fomento a la Industria Mediana y Pequena (FOGAIN), Fondo Nacional de Fomento Industrial (FOMIN), Fideicomiso de Conjuntos, Parques, Ciudades Industriales y Centros (FIDEIN) and Secretaria de Comercio y Fomento Industrial (SECOFI) Loan: US$185 Million equivalent to be repaid in 15 years, including three years of grace, at the standard variable interest rate R_ending The Borrower on behalf of the Guarantor would relend US$100.0 Terms: million of the loan proceeds to FOGAIN at a rate linked to the ACF for onlending to industrial enterprises through participating financial intermediaries for investment in fixed assets and working capital. Another US$45.0 million would be onlent to FOMIN for providing equity and quasi-equity to private sector companies and financing for the restructuring component. FOMIN would, as in the past, share the capital gains on an equal basis with NAFIN, and for subordinated credits pay NAFIN 20% of its interest earnings. FIDEIN would receive as equity US$10.0 million to implement the industrial buildings and park development program. NAFIN would retain US$10.0 million for the micro-enterprise credit program. PFIs would bear the credit risk; and the Government would bear the cross currency risk and be responsible for interest and principal repayments of the loan to the Bank. Since the Mexican capital market is highly open, the interest rates structure as measured by the ACF (average cost of funds) reflects investors perception of the relative return to assets denominated in foreign and domestic currencies. Because the interest rates under 'he project are linked to the ACF, the foreign exchange risk will be implicitly borre by the final borrowers. ,Project The proposed project would provide a broad range of financial and Description: technical assistantce services to micro, small and medium size industrial enterprises. More specifically, it would provide: (a) medium to long-term credit to finance fixed investment and working capital; (b) equity and quasi-equity to finance fixed asset investment and working capital needs of new or expansion projects; (c) funds for institutional and financial strengthening of FOMIN and the commercial banks to restructure overleveraged flrms through debt equity swaps, lengthening of debt maturities and replenishing working capital; (d) credit for construction of industrial buildings by leaseholders in approved industrial parks and the  - ii - modernization/expansion of existing industrial parks; (e) fixed asset and working capital subloans for miero-enterprises in the informal sector; and (f) technical assistance to improve and expand the industrial extension service, strengthen credit unions as channels of credit, develop export promotion programs for SMIs, and carry out studies to improve the policy framework for SMI development. Projer*P Regarding the traditional credit and equity financing programs, no Risks: special project implementation risks exist given the satisfactory performance of FOGAIN, FOMIN and FIDEIN under the three earlier projects. Delays in resuming economic growth and stability, high nominal intterest rates may dampen fixed asset demand. In addition, the financial restructuring component could encounter a difficult start up because of the newness of the program and reluctance of commercial banks to write off their losses. To minimize these uncertainties, the credit amount has been based on conservative demand estimates with no real growth from 1984-86 FOGAIN disbursement levels, and the amount allocated to the restructuring component is relatively small (US$25 million). Estimated Cost: Local Foreign Total __----US$ Millions----- Credit Program 106.0 84.0 190.0 Equity/Quasi-Equity Component 22.5 16.0 38.5 Industrial Restructuring 45.0 25.0 70.0 Industrial Buildings/Parks 10.0 7.0 17.0 Micro-enterprises 7.0 5.0 12.0 Technical Assistance 2.5 5.8 8.3 Unallocated - 14.5 14.5 TOTAL 193.0 157.3 350.3 Financing Plan: World Bank 28.0 157.0 185.0 FOGAIN 25.0 - 25.0 FOMIN 30.0 -- 30.0 FIDEIN 2.0 --- 2.0 Intermediaries/Beneficiaries 104.5 -- 104.5 NAFIN 3.0 --- 3.0 SECOFI 0.8 - 0.5 UNDP - 0.3 0.3 TOTAL 193.0 157.3 350.3 Estimated (Based on Average Profile for IDF Bank Loans in Region) Disbursements: -----o ----US$ million---- 88 89 90 91 92 93 94 Annual 5.0 37.2 46.1 37.0 27.0 20.0 13.0 Cumulative 5.0 42.2 88.3 125.3 152.3 172.3 185.3 Rate of Subprojects would have to have FRRs and ERRs of at least 10% in real Return: terms.  STAFF APPRAISAL REPORT MEXICO FOURTH SMALL AND MEDIUM SCALE INDUSTRY PROJECT I. THE INDUSTRIAL AND FINANCIAL SECTORS The Industrial Sector 1.01 Economic Crisis and Industrial Recovery. Over the last three decades manufacturing developed into one of the leading sectors of the Mexican economy with its share of GLP rising from 17% in 1950 to 24% in the 1980s; it accounts for 25% of total exports and employs 13% of the economically active population. The severe economic and financial crisis of 1982, however, brought industrial growth to an abrupt halt and reversed the period of sustained growth. Production dropped by 11% from its 1981 level, and gross domestic investment as a proportion of GDP fell from a peak of 29% in 1981 to 20.2% in 1983. As a result of these developments, many medium to large-scale Mexican companies came close to bankruptcy, and even though small- and medium-scale industries (SMIs) showed more resilience because of their ability to adapt their output to the low demand situation, they reduced their capacity utilization significantly. During the second half of 1984, the industrial sector began to recover, with the capital goods and consumer durable subsectors providing the lead in the recovery. An additional boost was provided by manufactured exporrs which in 1985 attained a level 50% higher than in 1982. The recovery proved shortlived, however, and in late 1985, notwithstanding an overall production increase of 5.8%, a new period of economic slowdown set in, following the disruptive effects of weakening oil prices and the September 1985 earthquake; industrial growth in 1986 was negative. The Government is aware of the critical role of the industrial sector in the recovery of the economy and it has recently undertaken several important broad policy initiatives (para 1.11) which would improve the performance of this sector. Several other sector-specific reforms are needed, however, to ensure a sustainable adjustment and growth of the sector. The elements of a strategy to improve industrial performance and suggestions for policy reform are contained in the Sank's recent Industrial Sector Report (6215a-ME) dated June 24, 1986. The Small and Medium Scale Industry (SMI) Sector 1.02 Structure and Growth. Industrial statistics are quite poor in Mexico with the last industrial census dating back to 1975. Available data shows some 111,803 industrial establishments of which 85,000 are registered (Annex 9, Table 2); of these establishments, 97.8% are SMIs which account for 51% of industrial employment (2.6 million) and AQ% of industrial value added. The composition of production from SMIs is concentrated in food industries, clothing, printing materials, textiles, furniture, plastics and rubber products, shoes and leather, and non-electrical machinery; (Annex 9, Tables 2, 3). Since disaggregated data on manufacturing sector performance is unavailable, the performance of the SMI sector has been assessed by comparing the overall manufacturing sector growth to the performance of subsectors dominated by SMIs. The highest concentration of Mexican SMIs is in consumer goods (mainly non-durables) and the intermediate goods subsector. While the annual average rate of growth of physical production  - 2 - in the manufacturing sector was 3.6% for the period between December 1975 and June 1986, consumer goods grew at an annual rate of 3.7%, and intermediate goods at an annual rate of 4.2X. Within the consumer goods industries, however, the physical production of non-durable consumer goods (preponderantly SMIs) grew by 3.6% annually whereas durables (mainly produced by large scale industries) grew by 1.9%. Another important feature is that wlien compared to the overall growth of the manufacturing sector, the growth of both the non-durable consumer goods and intermediate gooda subsectors has been much faster during the upswings, and the reductfr:n in growth during the recessionary periods has been more moderate (Annex 9, Table 1). In sum, SMIs are concentrated in sectors with a smaller downward risk when compared with the manufacturing sector as a whole, a factor which explains their resilience during the 1982/83 crisis. Development Constraints 1.03 Market Limitations and International Competitiveness. The basic structure and growth pattern of the Mexican industrial sector is a direct product of the highly protective economic policies pitsued by Government for the last 30 years. Until the 1982 economic crisis, policy makers did not fully realize the vulnerability of supporting an industrial sector which is heavily dependent on a protected domestic market. While the domestic market still offers good possibilities for an efficient import substitution, the external markets for direct and indirect exports represent a more important development possibility in the medium and long run, mainly in thvse subsectors in which SMIs have clear competitive advantages. A recent analysis of the international competitiveness of Mexican industry measured by domestic resource cost ratios (DRC) indicates that the competitiveness of subsectors in which SMIs predominate is higher than the average for the economy. For example, in 1982, producers of consumer gcods, such as food (excluding processed meat and condensed milk, which are traditionally large-firm industries), beverages, textiles, wood aid glass products had DRC ratios well below one, indicating a high degree of international competitiveness. Despite this, in the face of the opening up of trade policy, there is no scope for complacency and supportive measures have to be taken to enable SMIs to become even more efficient. This not only entails the maintenance of a competitive exchange rate during the adjustment period but a rationalization of the existing fiscal incent!%is, particularly the tax rebate system (CEPROFI), which as currently constituted mainly benefit large scale and specific industrial sectors which have besn pre-selected for promotional purposes. Another important area of reform is the easing out of existing price controls on key SMI products and liberalizing importation of inputs; the latter is particularly important (at least in steel) since smaller producers normally buy from intermediaries and cannot take full advantage of importing inputs at international prices and are unaffected by benefits from import duty exonerations. 1.04 High Financing Cost. Real interest rates have shown wide fluctuations over the last several years; during 1979 and 1980 the average cost of funds (ACF) index (compounded monthly) to the banking system  - 3 - remained negative. Since 1983 however the ACF became positive and reached an annual average of 5% in 1984 and 6% in 1985. Lending interest rates which are closely linked to the ACF Index also became positive. Recent rapid increases in domestic interest rates (Annex 8, Table 21) have, however, elevated the financial costs of industrial enterprises to unsustainable levels and have affected the demand for investment credit including that for FOGAIN (the SMI credit institution) credit, which has shrunk by 40% in nominal terms in 1986, compared to 1985 levels. The Government has tried to protect classes of borrowers it considers important through preferential credit programs which enable commercial banks to rediscount their lending at subsidized ites to priority sectors such as the SMIs. In practice, the preferentt ' credit lines, however, provide little relief in the face of the high tfctive interest rates charged, on these very lines, by commercial banks tiirough a disguised system of compensatory balances (up to 20% of the total credit) and monthly compounding of lending rates and charges of 5 to 20 points above the Average Cost of Funds Index (ACF) for their own counterpart resources. For example, while the nominal interest rate for a typical FOGAIN subloan is 82% when it is structured in the following way; (i) FOGAIN funds; 89% at 95% of ACF;!/ (ii) commercial bank funds; 20% at ACF+5%, if account is taken of the practice of monthly compounding of subloans and of the requirement of compensatory balances, the effective nominal rate would be in the order of 167.4%. This rate compares with the free market lending rate when calculated on a ACF + 20 point basis and including the effect of monthly compounding. The factors contributing to high interest rates are discussed in para 1.06 and 1.09. At the prevailing high real interest rates, no enterprise can afford to finance more than a small proportion of its operations and if industrial investment is to take place, measures are needed to bring prevailing interest rates to realistic levels. The Government in aware of this problem and is committed to breaking the inflationary trend through a flexible exchange rate policy and through stringent monetary and fiscal measures. At the same time, fiscal measures have been introduced (para. 1.05) to offset the bias in favour of credit resources and to promote increase use of equity. The Financial Sector 1.05 The Institutional Setting. Mexico's nationalized banking system consists of Banco de Mexico (the Central Bank), 19 multi-banks (which are a product of the' merger of 51 commercial banks in 1983), 8 national development banks and 12 regional rural credit banks. Two of the national development banks, the Banco Nacional de Comercio Exterior (BANCOMEXT) and Nacional Financiera (NAFIN), provide funds to the industrial sector. A number of Government trust funds (Fideicomisos) provide special credit, often through the banking system, to priority activities. Among them, the three which have received Bank assistance under the three previous SMI projects are: FOGAIN, FIDEIN (Fideicomiso de Conjuntos, Parques y Ciudades Industriales), and FOMIN, which provide credit to SMIs, promote and develop industrial parks, and provide equity and quasi-equity financing to SMIs, respectively. Non-banking financial services are being offered through the 1/ The level of ACF prevailing in August 1986 was 84.6 percent, while the annualized rate of inflation was 81.8%.  stock exchange (Bolsa Mexicana de Valores), with 30 brokerage houses (Casa de Bolsa) and four independent brokers. Mexico's equity market is still in the early stages of development, and the market for private placements is limited to a few well known names, but practically inarcessible to SMIs. Venture capital funds that could supplement high cost commercial bank funds do not exist as yet, and FOMIN is the sole institutional source of equity financing for SMIs. However, the recent reform of the corporate income tax law is aimed at promoting equity financing and reinforcing the trend towards reduced loan finaacing set in motion by high interest rates (para. 1.06). Actually, the new tax system will restore neutrality to firms' financing decisions by gradually reducing the deductibiiity of the inflationary component of net interest payments. Consequently, the demand for loanable funds wil] be lower while that for equity funds is likely to increase. At the same time, the proposed prcject would help fill some of the institutional gaps in Mexico's equity and quasi-equity market by not only supplying equity funds, but by actively promoting joint equity financing between FOMIN and private and public sector venture capital companies and Casas de Bolsa (para. 2.04). Development Constraints 1.06 Supply Constraints and Directed Credit. Faced with mounting pressures from the growing fiscal deficit and declining external credit availability, in July 1985, the Government drastically restricted the already tight credit flows to the private sector -- the marginal reserve requirement of commercial bank liabilities to the private sector was raised to 90%. The Government has tried to ensure adequate flows of credit to priority sectors through its directed credit pro-ram which requires commercial banks to lend up to 27% of resources to prioritv sectors including 3.5% for the SMI sector. Despite such measures the net result of the tight credit policy has been a sharp decline in banking sector resources for the private sector--in relation to GDP, the flow of financing to the private sector declined from 6.8% in 1984 to 4.3% in 1985, and declined further in 1986. While the reduction in the supply of credit to the private sector has had serious consequences for credit availability for the manufacturing sector (Annex 9, Table 5), it affected SMIs dispropor- tionately, mainly because of the segmentation of the credit market, shortage of guarantees from SMIs, and the relatively higher unit costs of administering small loans. Commercial banks have tried to increase their loanable resources by placing bankers' acceptances (in July 1986, outstanding bankers' acceptances represented 49% of commercial bank capital land 5.8% of their liabilities), but these also benefit larger firms. 1.07 Lack of institutional credit at appropriate terms is a binding constraint on the investment plans of the SMIs, The FOGAIN rediscount line, which is the major source of SMI credit, iepresents only 3.9% of the total outstanding credit from commercial banks to the manufacturing sector, and about 13.5% of the 1evelopment bank credit co the sector. Another outcome of the high reserve requirements has been to push up interest rates on the banks' "free funds"; commercial banks have tried to compensate for the fact that a large proportion of their portfolio is frozen at moderate to low interest rates owing to the directed credit regime and obligatory purchases of Government paper by pushing up the free market interest rates  - 5 - on the remaining proportion of free funds. While positive interest rates are necessary to maintain a reasonable level of resource mobilization through the banking sector, and to promote sound investments, continued efforts towards a more realistic interest rate level is central to achieving higher levels of investment by SMIs. 1.08 Lack of Appropriate Lending Instruments. With persistently high inflation rates and accompanying high financial costs (pars. 1.04), there is an urgent need to develop lending instruments which are suitable for a high inflation environment. While many other countries have introduced a loan indexing mechanism to adjust outstanding principal for inflation, Mexico has opted, until now, to compensate for inflation through high nominal interest rates. These, however, effectively shorten the maturity of a long-term loan, because the effects of the declining real value of principal repayments are more than offset by high interest payments. The resulting repayment stream, if calculated in real terms,implies that most of the loan is being repaid within two to three years-imposing a debt service burden which exceeds the cash flow generated by most fixed asset investments. To help overcome these difficulties, it is pro'iosed to introduce a relatively new and more appropriate repayment mechanism -- known as Sistema de Pagos Variables al Valor Presente (PVP) - for borrowing from comme'cial banks (para. 2.22) which is already being used for the larger enterprises under the Bank's Industrial Recovery Loan (Loan 2746-ME). 1.09 Highly Risk Averse Commercial Banking Sector. The potentially high arrears, high reserve requirements and relatively moderate operating profits of the Mexican commercial banking sector are factors constraining their lending capacity; making them highly selective in their lending and pushing up the cost of financing investments. Officially commercial bank arrears, as a proportion of their loan portfolio, have been oscillating around 4% since 1984; in June 1986, this proportion was about 5%. this figure disguises, however, a more serious situation which is the amount of rolled over credit or refinanced debts, that are being recorded as normal credit. The level of such credit as a proportion of the banks' loan portfolio can, in some cases, be as high as 30% to 40%. And given that the officially reported arrears represent 73% of the capital and reserves of the commercial banks, even if a small proportion of the rolled over loans were to become delinquent, the banks could have their capital and reserves disappear rapidly. When this situation is combined with the relatively low profitability of Mexican banks (the ratio of their net profits to total assets was about 1.3% at the end of December 1985) there is little scope for flexibilit, in lending practices, which are highly restrictive to SMIs requiring collateral ranginF from 135% to 200% of the ;orrowed amount. Under these conditions the preferential credit lines set up by Government play an important role in supplying credit to the high priority sectors such as SMIs. 1.10 Commercial Bank Portfolio Management. An appropriate and prompt resolution of the issue of non-performing assets of the commercial banks' portfolio (para 1.09) is particularly important for ensuring the overall viability of the banking sector, and for restoring the profitability of a large number of financially distressed firms, the majority of which are part of the banking sector's affected portfolio. In the absence of a  - 6 - strong regulatory enforcement the nationalized commercial banks are free to accrue interest on their affected portfolios and to roll over doubtful debts. The preferred solution would be to subject the banks to stronger regulatory pressure to work out their non-performing assets. In cases where commercial banks have refinanced some of their troubled SMI clients, the financial situation of these enterprises has been complicated further by increasing their indebtedness. The proposed restructuring componeat (para 2.05) is intended to provide an interim solution to this problem while the Government works out a program of regulatory reform as part of the financial sector studies they are currently planning. Accordingly, during negotiations an assurance was obtained from Government that its ongoing financial sector studies program would include a study on the formulation of proposals to strengthen banking regulations and supervision with particular reference to the management of portfolio quality. 1.11 Recent Macro-Economic Policy Initiatives. The two major factors affecting the nature and level of investment in the manufacturing sector derive from elements of the macroeconomic policy framework, namely, the exchange rate and trade policies. For more than thirty years, industrial policy in Mexico has consisted of a set of Government actions intended to shift more resources into industry, both directly through the budget and indirectly through the incentive system as determined by quantitative trade restrictions, tariffs, and the maintenance of a fixed exchange rate regime. Following the 1982 economic crisis, the Government initiated the implementation of a flexible exchange rate policy and within that context began the gradual reduction of existing trade barriers. While considerable progress has been made in the area of trade reform, some 39% of 1984 imports or 49% of 1983 production are still covered by quota restrictions and, together with reference prices, about 61% of dcmestic production is still subject to non-tariff trade barriers. The Government is aware of the remaining distortionary aspects of the trade regime, and is planning to undertake further gradual reforms with the support of a series of Bank trade policy loans. Part of the planned reform is the reduction of non-tariff barriers to about 40% of production, with maximum tariff rates to be reduced from the current 40% to about 30% by October 1988, and the phasing out of official reference prices by end-1987. Within the existing macro-economic policy environment, the prospects for SMIs look promising over the medium term given the positive outlook for their sales growth related to the expected economic recovery and the inherent ability (para. 1.03) of SMIs to take advantage of increasing possibilities for export and efficient import substitution. In this context, the maintenance of a competitive exchange rate, and further trade liberalization during the adjustment period, should contribute to the growth of the SMI sector. 1.12 Government Objectives in the Sector. The Government's broad objectives for the SMI sector are to expand production, employment and regional development. The development of the SMI sector is considered to be critical not only because of its importance to employment generation, but because it provides the seedbed for the development of entrepreneurial talent and for upgrading the skills of the labor force. More recently, the Government has come to perceive an important role for SMIs in the promotion of manufactured exports, where SMIs have a comparative advantage because of their 'abor intensity. The strategic role of SMIs in the process of  - 7 - industrial recovery and restructuring was explicitly recognized in a specific SMI development program (dated April, 1985) entitled Integral Development Program for SMIs (PIPMI). Under PIPMI a National Consultative Subcommission was set up to ensure that: (i) highest priority is given by the banking sector and through budgetary support in the allocation of credit resources for SMIs; and (ii) the productivity of SMIs is improved by upgrading their technological and management base with a more focussed support from national technology and training institutions. Bank Assistance 1.13 To date, the Bank has assisted Mexico's industrial sector with a number of operations, three of which (Loans 1552, 1881, and 2325-ME) provided support for SMI development through the Government's Integrated Support Program known as PAI. The first two SMI loans (US$147.0 million) are fully disbursed and the third (US$175 million) is expected to be disbursed shortly. Experience with the execution of the three projects has been good; allocation of resources was economically efficient, and most institutional development objectives were achieved. A detailed analysis of the experience under previous S4I loans is contained in Annex 6 and Annex 10 contains a brief description of the status of other Bank loans for industry which are currently under implementation. Given the current needs of the economy to increase manufactured exports, Bank lending strategy is emphasizing an approach which combines policy-oriented, quick-disbursing loans--which will ensure an improvement in the overall economic environment--with conventional lines of credit providing financial and technical assistance to industrial companies. The Trade Policy Loan (Loan 2745-ME), the Second Export Development (Loan 2777-ME)and the proposed Industrial Restructuring Loan are all part oa the new lending emphasis. 1.14 The Bank's involvement in the proposed project would complement the Government's trade liberalization measures by enabling industrial enterprises to restructure their production units to become more competitive internationally. To minimize the "pain of transition in moving from a highly protected environment to one which is internationally competitive, the Mexican industry would need, inter alia, adequate long term finances at attractive terms -- the proposed project would provide these resources in the form of long-term credit and badly needed equity funds. At the same time, the proposed project would upgrade the financial engineering capabilities of the participating financial institutions by developing for the first time: (i) the institutional and financial capacity for restructuring overleveraged firms which are underutilizing installed capacity and whose poor performance is threatening the portfolios of the commercial banking sector; and (ii) a credit program to suplort micro-enterprises in the informal sector which are operated by low income producers, primarily women entrepreneurs. II. THE PROJECT 2.01 In February 1986, the Government/NAFIN presented to the Bank a proposal for financing a Fourth SMI project. The preappraisal mission,  - 8 - which visited Mexico in July 1986, helped develop a pilot financial restructuring and micro-enterprise credit component. Appraisal was completed in October 1986, and negotiations were held during May 4 zo 8, 1987; the Mexican delegation was led by Lic. Arturo Galan and Luis Nava Hernandez, both of NAFIN. Project Objectives and Description 2.02 The proposed project is aimed at improving the quality and range of financial and technical assistance services to SMIs whose financial viability is currently being seriously undermined by the high inflation environment and whose future prospects will be affected by the increased competitive pressure following the Government's recently introduced trade liberalization measures. Accordingly the proposed project would: (a) enable private small and medium scale investors to make their existing units more competitive by investing in the balancing, modernization, and expansion of existing units, and helping them establish new enterprises; (b) revive production of existing SMIs which are operationally viable but are overleveraged, through establishing an institutional and financial framework to plan, implement and support restructuring strategies for selected firms; (c) help disadvantaged segments of the industrial sector-- --informal micro-enterprises mainly managed by women entrepreneurs-through a pilot credit and training scheme; and (d) improve the policy framework for SMI development by broadening the understanding of the potential and constraints of SMIs through a series of studies. The proposed loan of US$185.0 million would include the following financial as well as technical assistance components. 2.03 The Credit Component (US$100 million) accounts for about 54% of the loan. Of the total loan funds, at least US$50.0 million will be for financing fixed asset investments, covering plant and machinery purchases, associated working capital needs and related civil works. Up to 50% of the credit funds (US$50.0 million) could be applied to financing free-standing permanent working capital requirements of eligible firms. Inclusion of this type of financing is considered particularly critical under prevailing circumstances since it would stimulate and maintain employment by raising capacity utilization. 2.04 The Risk Capital Component. (US$20 million) would support and broaden the scope of FOMIN's ongoing equity and quasi-equity investment program, which finances planned expansions by existing firms and venture capital type investments by new entrepreneurs. For the first time, FOMIN would offer joint financing opportunities with private sector (Sociedades de Inversiones); Casa de Bolsa and state-owned venture capital companies. As in the past, FOMIN financing would support investments in fixed assets and related permanent working capital. The latter would be restricted to no more than US$10.0 million. FOMIN's total stake in an enterprise, either in the form of common and preferred shares and/or subordinated convertible loans, will be such as to ensure that it will not be the majority shareholder.  - 9 - 2.05 The Financial Restructuring Component (US$25.0 million) would be operated by FOMIN on a pilot bastis The component would offer comprehensive financial packages including debt/equity swaps, lengthening of accumulated commercial bank debt and fresh working capital and fixed asset investment resources, all designed to meet the long-term needs of companies that are operationally healthy and have good prospects, but currently suffer from a weak financial structure. An integral part of the financial support program would be the technical assistance (para. 2.08 (ii)) which is aimed at developing the institutional capability and associated skills for restructuring firms by FOMIN and the commercial banks, which would take the lead role in preparing the restructuring workouts. As part of the restructuring exercise the commercial banks will consider partial write-offs as well as conversion of existing debt to equity. Bank funds would finance fresh working capital and fixed assets needs of restructured companies, while FOMIN's own funds may be used to refinance existing assets in exceptional cases. In such cases FOMIN's counterpart resources would help acquire up to half of the newly converted equity, possibly at a discount. Efforts would be made to offer the converted debt to other interested parties including foreign investors holding Mexico's external debt. 2.06 The Factory Building and Industrial Park Development Program (US$10.0 million) includes financing for the construction of factory buildings by lease operators within industrial parks in the high priority industrial zones. In addition, credit would be available on a selective basis for the expansion and/or modernization of industrial estates in the private or public sector, and establichment of new industrial parks primarily in the export processing zones including those for location of in-bond maquila industries. The Bank would review all subloans under this component and for each subloan, a comprehensive feasibility study including economic and financial 4ustification and an assessment of the environmental aspects for the investment would be presented. 2.07 The Pilot Micro-Enterprise Component (US$10.0 million) would build upon the successful experience with ongoing small business programs (Annex 5) and would provide financing for fixed asset investment and long-term working capital needs of micro-enterprises which are unable to borrow through the normal banking channels for want of collateral. NAFIN would onlend to public and private sector promotional agencies which have a-ctive micro-enterprise lending programs. At least 50% of the loan resources will be channelled through Non-Governmental Organizations (NGOs). 2.08 The Technical Assistance Component (US$5.5 million) accounts for about 3% of the loan. A breakdown of technical assistance costs and description is in Attachment I and it is detailed in Annex 1. Consultant services and equipment, including micro-computers, audio-visual equipment, and software development, would be provided for: (i) further improving the technical and institutional capabilities of FOGAIN and the commercial banks by designing and implementing simplified loan evaluation, portfolio control, and supervision systems; (ii) supplementing FOMIN's existing staff skills with outside experts in financing instruments and legal issues related to fin.acial restructuring; (iii) strengthening FIDEIN operations in the area of credit evaluation, supervision and approval through staff  - 10 - training programs combined with efforts at reorganization; FIDEIN would also undertake studies to assess the feasibility of developing industrial parks in selected States, within high priority zones; (iv) on-the-job training for NAFIN staff responsible for quality control of subprojects; (v) gradually expanding PAI's extension service and initiating new support programs for credit unions, indirect exporters, and subcontracting arrangements between SMIs and large-scale producers including multinationals; (v) strengthening the operations of the promotional agencies responsible for implementing the micro-enterprise component; and (vi) enabling SECOFI to undertake key subsector studies to identify development constraints and to formulate policies to promote SMI development. The objectives ar.d the detailed implementation program of the technical assistance program jointly drawn up during appraisal was confirmed during negotiations (para. 3.01 (d)). Executing Agencies and Past Implementation Experience 2.09 FOGAIN. FOGAIN is one of the main executing agencies under the project utilizing about 54% of the loan funds. Founded in 1953 as a NAFIN trust fund, FOGAIN has become the most important source of long-term credit available to SMIs thrbugh commercial banks and credit unions. Today, FOCAIN is administering a wide variety of industrial financing programs using loan resources from the Bank, IDB, Banco de Mexico, NAFIN and Grovernment credit funds for special credit programs. Details of FOGAIN's lending and financial operations are presented in Annex 2. In 1985, FOGAIN made 12,759 credits to 9284 firms representing a credit disbursement of US$399.0 million. About 90% of the subloans, representing 75% of loan funds, were for small-scale industries - the average size of FOGAIN subloans in 1985 was US$31,300. FO^,AIN intends to maintain its emphasis on making relatively smaller size subloans under the proposed project. Overall FOGAIN maintains a sound financial structure and has shown satisfactory operating results; in the last three years its profits have increased impressively from US$18.4 million in 1983 te US$41.3 million in 1986, which translates for 1985 to a rate of return on equity of 22%. The high profit levels are mainly attributable to the relatively low administrative costs (about 1.0% of total assets), variable interest rate policy pursued by FOGAIN since late 1982, and the substantial increase in its intermediation margins following the increase in the ACF level. FOGAIN is currently paying a flat 55% interest rate on the amounts it receives from NAFIN on the Bank loan. The Government treats the relatively high interest rate spread as a vehicle for capitalizing FOGAIN, and as a substitute for its annual budgetary transfers. In 1986 FOGAIN did not receive any direct budget support because of its strong liquidity position. This situation will be continuing in 1987, and it is expected that under the proposed project FOGAIN would meet all its counterpart obligations from its internal resources. 2.10 Participating Financial Intermediaries (PFIs). FOGAIN's Operating Regulations describe a participating financial intermediary as any commercial bank or credit union that, inter alia, maintains a satisfactory financial condition, including control and provision for arrears, and employs an adequate number of staff capable of managing the portfolio using FOGAIN rediscounting facility. All nationally owned commercial banks are eligible to apply for FOGAIN rediscounts, but in 1985,  - 11 - five banks represented more than half of FOGAIN rediscounts (Annex 9, Table 11). A major shortcoming of the existing two-tier rediscount scheme is the diffusion of loan monitoring responsibility between FOGAIN and the commercial banks. The latter manage their rediscounted portfolios in the same manner as the rest of their operations, minimizing credit risk through collateral requirements, interest compounding and compensatory balances. FOGAIN, on the other hand, is concerned with the accounting control of the use of its funds. The result is a lack of information on the quality and development impact of subproject portfolio. Data on subloan arrears was found to be particularly deficient at both the FOGAIN and PFI level. FOGAIN does not monitor arrearages of the commercial banks on the grounds that it takes no credit risk and besides considers this a "highly sensitive" issue wihich could damage their business relationships with the commercial banks. 2.11 A qualitative survey of FOGAIN portfolio, however, carried out by the appraisal and recent PCR missions at some selected commercial banks, showed that arrears for subloans financed with FOGAIN resources were less than 2% of outstanding balances by July 1986, below the 5% average for the overall portfolios of the commercial banks. These figures should be interpreted cautiously, however, in light of the arrearage situation discussed at para. 1.09. Under the technical assistance component of the proposed project, information systems on loan recovery status would be developed further and a more systematic review of the implementation eyperience of the subprojects would be carried out by NAFIN in conjunction with the executing agencies. During negotiations, agreement was obtained to a time bound plan for initiating an improved portfolio management reporting system. This would be the first instance when FOGAIN would begin to collect information on arrearages, and it expects the process to mature gradually over the implementation life of the project. 2.12 FOMIN. FOMIN was establishea in 1972 as a trust tund under SHCP, and later transferred to SECOFI when the PAI program was created. As an equity investment organization, FOMIN is mandated to subscribe, on a temporary basis, up to 49% equity capital in both new and existing private sector companies. FOMIN has been associated with the Bank almost from inception, and has been developing into a mature institution with good quality staff. The 1982-83 financial crisis provided FOMIN with considerable opportunity to provide bail-outs but FOMIN acted prudently and continued to apply strict selection criteria. FOMIN maintains a fairly diversified portfolio which has grown from Mex$3.7 billion in 1983 to Mex$6.9 billion (US$25.4 million) in 1985. As of December 1985, FOMIN had 124 active investments, of which eight were in the pre-operating stage, 29 were reporting profits, 12 companies, representing 2.2% of the portfolio, were in bankruptcy proceedings and the rest showed operating losses at the end of 1985. 2.13 Recently FOMIN has initiated several measures to improve the performance of its firms, including the appointment of voting directors on the boards of some sick companies, and the quality of its portfolio is showing some improvement. FOMIN's equity sales have also improved compared to the last two years, owing to its deliberate policy of divestiture. During 1984 and 1985 it sold off its interest in 17 companies, with an  - 12 - original investment cost of Mex$300 million at Mex$660 million making a nominal profit and breaking even in real terms. In addition, over the last three years, FOMIN has made operating profits which increased from US$1.3 million in 1984 to US$3.3 million in 1986. These profits resulted primarily from the steadier interest income received from subordinated credits. While FOMIN has developed into a fairly efficient organization with reasonable operating costs and a good cadre of professionals, because of the long gestation period and the inherent riskiness of its investments, it still has to depend for its seed capital on Government funding. Under the existing financing arrangements FOMIN shares its losses and capital gains equally with the Government; an arrangement which allows FOMIN a fair degree of tlexibility and results in capitalizing the institution. n.14 FIDEIN. FIDEIN was estabiished in 1980 as a NAFIN trust fund with responsibility for planning, promoting and implementing a national system of industrial estates to help industrial deconcentration and at the same time to promote regional development. During the first and second SMI projects FIDEIN engaged itself directly in construction of standard factory buildings and infrastructure development in seventeen industrial estates belonging to state entities specifically created to manage these industrial estates. This earlier operational phase, however, showed mixed results in that while the standard factory buildings served as a valuable promotional device FIDEIN was less successful in operating these buildings as a commercial venture, and could not sell them until recently. At the same time, the concept of developing self-contained industrial estates as part of a city development concept proved to be too ambitious, and in the later years FIDEIN concentrated on developing industrial space within the eEtates. In 1983, the Government redefined FIDEIN's objectives restricting i direct construction role and entrusting it essentially with the respons4bility of helping rationalize the development and operations of both private and public industrial parks. As such FIDEIN was to concentrate its future lending operations to financing urban infrastructure development, including the construction of industrial buildings in industrial parks. Accordingly FIDEIN transferred ownership of industrial estates to the State Governments and undertook a vigorous program to sell its inventory of industrial buildings -- the last three of these buildings were sold in early 1986. 2.15 FIDEIN's financial performance has been improving gradually reporting profits in the last two years after suffering operating losses during 1983 (US$0.3 million), and in 1984 (US$0.2 million). The large part of the profit was due to increase in the volume of its business and due to the increased interest rate spread for its operations. FIDEIN has always suffered from a weak management structure and high staff turnover, and its performance in project evaluatior. work was considered to be unsatisfactory at the time the Third SMI project was appraised. Several measures to improve this and other aspects of operation were agreed in the context of earlier projects, but most recommendations were not implemented. As a result FIDEIN subprojects were often found lacking analytical background information and several reviews were needed before Bank approval could be given. Recently, FIDEIN has taken several concrete steps to strengthen its staff capability through both hiring of experienced staff and through training of existing credit staff. In addition, it has carried out an internal reorganization creating, among other things, a Planning Unit  - 13 - specifically to carry out investment studies. Further changes in FIDEIN's operating structure would be introduced during implementation. For this purpose, two key studies are included under the project, which would propose organizational changes including the possibility of FIDEIN acting as a second tier credit institution. Final Beneficiaries 2.16 FOGAIN would finance technically, financially and economically sound investment subp ojects of micro-, small- and medium-scale enterprises which are defined by Government as follows: (a) formal sector micro- enterprises employing up to 15 persons and having annual sales of up to 40 million pesos (US$47,000); (b) small-scale enterprises employing 16 to 100 persons and with annual sales not exceeding Mex$500 million (US$590,000); and (c) medium-scale enterprises employing up to 250 persons with annual sales not exceeding Mex$1,100 million (US$1.3 mfllion). FOGAIN's maximum financing for any one enterprise world be US$1.0 million equivalent, including any outstanding amounts from previous subloans, and US$500,000 for free-standing permanent working capital subloans. It is expected that FOMIN subprojects would mainly comprise medium scale enterprises as these are more suitable for minority equity investments. To be eligible for financing under the informal micro-enterprise component, managed by NAFIN, prospective beneficiaries are defined as low-income entrepreneurs who: (i) have a family income not exceeding three times the minimum annual salary (currently around US$1,000), and who are unable to obtain credit through other preferential credit schemes; (ii) are directly engaged in production and the enterprise represents the major source of income; (iii) have a net worth of not more than 20 times the prevailing annual minimum salary; (iv) have fixed asset investments not greater than 12 times the annual minimum salary; and (v) employ less than 10 persons. The foregoing eligibility criteria are incorporated in the Operating Regulations of the respective executing agencies and were confirmed during negotiations. Cost and Financing 2.17 Total project cost is estimated at US$350.3 million of which about US$157.3 million represents foreign exchange. The proposed Bank loan of US$185.0 million would finance about 100% of the foreign exchange requirements and US$28.0 million equivalent in local costs. Financing of local costs is justified in view of Mexico's continuing difficulty in stabilizing the public sector's fiscal performance and the need to ensure priority investments in the SMI sector, particularly the relatively high level of Bank financial support planned for the micro-enterprise and the financial restructuring components. About US$104.9 million of the project costs would be financed by the PFIs and the beneficiaries from their own resources. The remaining project costs about US$60.4 million equivalent would be covered internally by FOGAIN (US$25.0 million), FOMIN/Government (US$30.0 million), FIDEIN (US$2.0 million), NAFIN (US$3.0 million) for the PAI technical assistance program and the micro-enterprise credit program, and SECOFI (US$0.5 million). The total cost of the technical assistance (US$8.3 million) would be financed by the Bank loan(US$5.5 million), a UNDP grant of US$0.3 million and the remaining US$2.5 million by NAFIN and the three executing agencies.  - 14 - Relending Terms and Conditions 2.18 The Loan. NAFIN would be the Borrower.; the Governinent would guarantee the Bank loan. NAFIN would pass on US$156.7 million equivalent of the loan proceeds relating to the credit, risk capital, industrial park program, and technical assistance components to FOUAIN, FOMIN, and FIDEIN. Because of the pilot nature of the financial restructuring components and the micro-enterprise credit program, an unallocated amount of US$14.5 million is being provided, which can be reallocated to any of the components. Under the proposed loan FOGAIN would receive funds from NAFIN at a rate which is linked to the ACF, instead of the flat 55% per annum interest rate it currently pays on outstanding balances due to NAFIN (para. 2.09). FOMIN would continue to receive Bank and counterpart resources on existing terms (para. 2.13). FIDEIN will receive US$10.0 million from NAFIN as a capital subscription. A signed agreement for transferring these funds from NAFIN to the executing agencies and the terms and conditions of such transfer would be a special condition for loan effectiveness (para. 3.02). NAFIN would retain about US$13.0 million to be allocated as followe: the micro-enterprise credit component (US$10.0 million equivalent), PAI technical assistance activities (US$2.2 million equivalent), technical assistance for micro-enterprise component (US$0.4 million equivalent), and NAFIN project review and disbursement unit (US$0.2 million equivalent). The remaining US$0.6 million equivalent of the loan amount would be transferred to the Government for the SECOFI technical assistance program. The Government would bear the cross-currency risk and be responsible for repaying the principal and interest charges on the entire Bank loan. However, since the ACF index includes, inter alia, an element for the cost of foreign borrowing the foreign exchange risk will be implicitly borne by the final beneficiaries. 2.19 Onlending Terms. FOGAIN would relend US$100.0 million of the project's credit funds to the PFIs for onlending to sub-borrowers at interest rates which conform to General Interest Rate Agreement (GIRA) between the Bank and the Mexican Government, and which would be variable over the life of the subloans. At present, these rates range from 85% of ACF for subloans to micro-enterprises (in the formal sector) to ACF+5 for lending to non-priority medium-scale industries. As in the past, the PFIs would be allowed to retain up to a five percentage point spread to cover intermediation costs. Henceforth, the onlending rate for industrial buildings, located in priority Zones I and II would be 95% of ACF until June 1988, and thereafter ACF; however, all subloans for investment in Zone III-B (meant for consolidation and improvement of infrastructure within existing parks) will be at ACF+2. Subloans for industrial estates, would be at 85% of ACF until June 1988 and 90% of ACF thereafter. Equity investments by FOMIN would be expected, on average, to last for six years with an option for the owner to purchase the equity at its estimated market value. The equity investments are expected to yield an after tax rate of return of 12% in real terms. FOMIN's financing of equity investments in any single enterprise would not exceed the 10% limit of its own equity base. These conditions would also apply to FOMIN investments under the restructuring component (para. 2.05).  - 15 - 2.20 The onlending rates for the micro-enterprise credit component in the informal sector would be initially at 75% of ACF increasing to 80% after June 1988. From its interest NAFIN wiuld deduct two percentage points for its overall coordination of the micro-enterprise program. In addition, the promotional agencies would retain five percentage points from the interest earnings to meet their administrative costs and to bear the credit risk. The balance of the interest earnings would be credited to a special micro--enterprise credit fund to be established in NAFIN. An understanding was reached at negotiations to include onlending interest rates under this loan within the provisions of a proposed subsidy control and budgeting agreement presently being discussed between Mexico and the Bank, when such agreement is reached. 2.21 Special Conditions for the Restructuring Component. While the precise financial arrangements and terms of the restructuring would be established on a case by case basis, some broad investment guidelines which have been developed are summarized here and described further in Annex 4. In general, eligible industrial companies would have to be operationally viable but have tight debt eervice ratios due to overindebtedness. The joint participation of FOMIN and the commercial banks in a restructured firm would not exceed 49% of the share capital of the company, while FOMIN (with its own funds) will acquire only up to 50% of the newly converted equity (from debt). These restrictions are to ensure a fair risk sharing between FOMIN and the commercial banks, and to maintain at all times a minority equity participation by FOMIN and the commercial banks. Bank funds would only be used to finance increases in working capital and fixed assets involved in these restructurings. Subloan Repayment Terms 2.22 Maturities, Grace Periods and Free-Limits. In accordance with the Operating Regulations of the participating institutions (FOGAIN, FOMIN, FIDEIN and NAFIN) the following terms and conditions for subloans were agreed during negotiations. The maturity of FOGAIN fixed asset investments and working capital subloans would be up to 13 years and seven years respectively. The maximum grace period would be three years for fixed asset credit and one year for working capital subloans. There would be no grace periods for the PVP subloans, since the initial payments under this scheme would be substantially lower than the interest payments during the grace period of a "traditional" subloan. The maturities of micro- enterprise subloans would be determined by the promotional agencies within the following limits: subloans for fixed assets and working capital would have maturities of up to five and two years respectively, including grace periods up to 12 months and six months respectively. The maximum working capital subloan amount would be MEX$6.0 million (currently US$8,000); for fixed asset credits the amount would be MEX$12 million (US$16,000) and for a combination of working capital and fixed assets MEX$15 million (US$20,000). Training for credit recipients would be an integral part of the credit operations. For FOMIN's regular equity and quasi-equity investments, as in the past, a flexible divestment policy would be adopted, with an average holding period of six years. Under the restructuring component commercial banks are required to divest their newly acquired shares within five years.  - 16 - 2.23 Given the very small amounts involved in the bulk of FOGAIN's credit subloans and the mandatory evaluation requirements proposed under the project (para. 2.25), the Bank would not carry out a prior review of FOGAIN's credit subprojects, but as part of its field supervision it would review samples of subprojects costing in excess of US$300,000. For FIDEIN's industrial buildings and park subloans all subprojects will, however, be subject to prior Bank approval. Reg&rding FOMIN's regular equity and quasi-equity investment program, the free limit would be US$700,000. For FOMIN's pilot financial restructuring program, however, the Bank would have prior review of the fiIat three restructuring proposals, irrespective of size as well as all of the investment proposals which would exceed US$500,000. NAFIN would send to the Bank for review and approval the evaluation of the first two micro-enterprise promotional agencies from the public sector and two from the private sector. All proposals for the T.A. activities including terms of reference for consultant studies would be subject to prior Bank approval. Project Implementation Arrangements 2.24 Program Coordination. Under the proposed project the implementation arrangements followed under the previous three projects would be streamlined to allow maximum financial and administrative autonomy to the executing agencies (Annex 6, para 6) and to ensure an overall direction by a high level committee. Accordingly, the Government has decided to set up a high level, but small, Project Coordinating Committee presided over by the Sub-Secretary of the Ministry of Finance (SHCP) and with the following members: NAFIN's Director General and the two other NAFIN Directors, and the Director Generals of Credit and Development Banking in SHCP. FOGAIN, FOMIN and FIDEIN would participate in the Committee as non-voting memberu. The Committee's responsibilities include setting policies and priorities for Program operations and the use and allocation of Program resources, reviewing the results of operations, and closely monitoring the progress of the more experimental project aspects. The Coordinating Committee is to be assisted in its day-to-day operations by a small Technical Secretariat of permanent staff which would no longer manage a common financing fund, as under earlier SMI projects. The Coordinating Committee would meet at least semi-annually. 2.25 The Credit Component would be managed by FOGAIN, which would on-lend project credit resources to PFIs which would be responsible for subproject appraisal and supervision. FOGAIN would review the documentation for subproject approval. While the methodology for subproject evaluation by the PFIs would depend on the size of the subloan, for FOGAIN financing of more than US$50,000 a financial rate of return would be calculated. In addition, an evaluation of market potential as well as the technical and managerial capacity of enterprises would have to be carried out. For financing subloans of less than US$50,000, only a cash flow analysis of the enterprise would be undertaken. All approved subprojects would have rates of return of at least 10% in real terms. During negotiations, it was agreed thaet the appraisal criteria for FOGAIN subloans agreed upon during a supervision mission dated June 21, 1985, would be applicable to subloans processed under the new loan.  - 17 - 2.26 The Risk Capital and Financial Restructuring Component would be implemented through FOMIN which will review all subproject proposals for its regular equity and quasi-equity investment program. During implementation FOMIN would also supervise its portfolio and attend the Board meetings of its client firms. For investments under the financial restructuring component FOMIN will work closely with the commercial banks which will play a leading role in identifying eligible firms and preparing their financial workouts using FOMIN consultant services financed under the project. In cases where there is more than one creditor bank, a lead bank would be appointed by the creditors and company owners. Once a restructuring proposal has matured, it would be submitted to FOMIN for participation. The lead bank will be responsible for supervising the subproject and, as such, would also be responsible for securing the loan documents, security sharing and supervising increases in capital. FOMIN supervision, which will be closely coordinated with the commercial banks, would be quite intensive and could even entail the appointment of a FOMIN representative to the management team of the restructured company. 2.27 The Factory Building and Industrial Parks Component. This component would be implemented by FIDEIN which will evaluate the technical and financial aspects of the subproject proposals and submit them to the Bank for review. FIDEIN has developed a reliable supervision system for monitoring particularly the construction quality and price aspects of its subprojects, and this system would continue to be applied in the case of the new subloans. To reduce FIDEIN's direct involvement in the credit aspects, a study would be carried out under the technical assistance comronent to explore the possibility of FIDEIN acting as a second tier institution rediscounting loans made by the commercial banks. In the short term, however, FIDEIN's credit functions (loan disbursement and collection) would gradually be transferred under the management of NAFIN's credit department. An agreement has already been concluded between NAFIN and FIDEIN regarding loan recoveries. 2.28 The Micro-enter2rise Component would be implemented by NAFIN in a decentralized fashion directed through both private and publicly supported non-profit promotional agencies with special programs to assist micro- enterprises. Formal credit institutions, including credit unions and commercial banks with special programs for micro-enterprises, may also participate. To be eligible for participation each promotional agency would provide proof of its legal status and prepare an investment plan including estimates of credit demand and training needs of microenterprises in each specific tegion. The agencies will also be required to demonstrate that they are legally constituted and that they have the resources and technical capabilities to carry out the planned program. NAFIN as a second-tier institution would carry out an evaluation of the promotional agencies and approve their credit lines, which will operate revolving funds to be renewed or increased by NAFIN, depending on the loan demand and recovery performance of each agency. NAFIN would ensure that the loan funds are used by the promotional agencies for the purposes for which they were granted. The promotional agencies will be the main contact point with the beneficiaries, evaluating their eligibility in accordance with the criteria described in para 2.16.  - 18 - 2.29 The Technical Assistance Components would be implemented by each executing agency. The general support activities for SMIs, such as the extension service and assistance to the credit unions, would, however, be implemented by the PAI technical assistance unit now part of NAFIN's Directorate of Industrial Promotion. UNIDO would be the executing agency for the joint Government/UNDP technical assistance program for SECOFI. To avoid duplication of effort in areas to be studied under the proposed project and under other ongoing Bank-assisted ,rojects, all proposals for studies would be screened by a small steeiring committee to be set up under the chairmanship of the Director General of SMI in SECOFI and comprising members from SHCP, SPP, end NAFIN. UNIDO's work program would be reviewed in annual meetings among representatives of the Bank, UNIDO, and SECOFI. The initial meeting to discuss the annual work program would be held three months after effectiveness. This arrangement ie included in the UNDP Project Execution Document. 2.30 Procurement. NAFIN as Coordinator of the Program would have overall responsibility for ensuring that all executing agencies apply suitable procurement procedures either directly or through the PFIs to ensure that goods and services procured under the project are competitive in quality and price, and ere appropriate for the needs of the client enterprises. Procurement procedures applied in the past by the executing agencies have complied with the standard for Bank IDF type operations. ICB would not be required, given the relatively small average size of subprojects proposed to be financed (the average subloan size for FOGAIN credits is currently US$30,000 equivalent); however, the corresponding institutions would assure themselves that the main sources of supply have been canvassed and that the purchasing is from the most advantageous sources. Consulting services would be open to international recruitment selected in accordance with Bank Guidelines for the Use of Consultants. Wi'Ale the records of the procurement process during subproject implementa- tion would be maintained by the PFIs, the executing agencies would be responsible for ensuring that the intermediaries comply with the procurement guidelines. 2.31 Disbursement. The final date for submission of subloan proposals would be December 31, 1991 and the closing date December 31, 1993 according to the average profile for IDF loans in the region, even though faster disbursement is expected, given the experience under the previous two loans (Annex 6). Retroactive financing has been included for expenditures of up to US$9.0 million, incurred between October 1986 and the date of effect- iveness. Such a provision is justified to enable financing for the two pilot components, namely FOMIN's financial restructuring investments and subloans to micro-enterprises. The Bank would disburse up to 80% of FOGAIN and FIDEIN credits for qualifying subprojects. For the FOMIN regular equity and quasi-equity program the Bank would disburse up to 80% of FOMIN's investments. FOMIN investments in restructured companies would, however, be disbursed at a rate of 100% of any new working capital resources and for fixed asset financing. In the case of micro-enterprises, the Bank loan would finance 90% of the total credits approved by NA1IN for the beneficiaries. For technical assistance, the Bank would disburse for 100% of total cost. To facilitate rapid project execution a Special  - 19 - Account would be established at NAFIN with an initial deposit of US$15 million representing about four months of disbursement requirements. Withdrawals from the loan account would be made on the basis of statements of expenditures (SOEs), and NAFIN would maintain all supporting documentation and make it available for review upon the Bank's request. Furthermore, NAFIN would submit to the Bank a monthly statement of the transactions ofthe Special Account. Since a two-tier credit system requires a longer period between expenditure by the sub-borrower and disbursements by the executing agencies than is normal for non-IDF projects, the Bank would disburse for expenditures incurred up to 180 days prior to the receipt of a disbursement request. 2.32 Accounts, Auditing and Reporting. As with previous projects, the accounts of NAFIN and the executing agencies (FOGAIN, FIDEIN, FOMIN and the PAI technical assistance unit) including the Special Account, and SOEs, would be audited annually by independent auditors acceptable to the Bank. The audit reports, including an opinion regarding the supporting documentation for disbursements based on SOEs, would be submitted within six months after the end of thie fiscal year of the respective executing agencies. Under the p.evious projects, the audits were carried out by qualified external audit firms which issued reports on the financial statements of the executing agencies on a timely basis with no major reservations beyond technical problemo of accounting for FOMIN's equity investments. Audit reports on Special Account and SOEs have been delayed because of lack of enforcement by NAFIN but this is expected to be remedied for the accounts relating to calendar year 1986. PAI would prepare for the Bank's review semi-annual progress reports on its technical assistance activities. NAFIN would consolidate all progress reports for transmittal to the Bank. The auditlng and reporting requirements described were agreed upon during negotiations. Benefits and Risks 2.33 The proposed project would complement the Government's trade liberalization and industrial restructuring efforts, by providing scarce long-term investment resources (credit and equity) to enterprises needing to either restructure or expand their businesses to become internationally competitive. More specifically, while the quelity and breadth of financial services available to the SMI sector would be improved, the project would introduce increased flexibility in the lending terms, permitting sub- borrowers to use a repayment mechanism that would tend to reduce their debt servicing burden during the earlier phases of the investment helping address the overindebtedness problem facing industries in Mexico, the financial restructuring component would ensure the more efficient utilization of existing industrial assets and would maintain employment. The project would broaden the scope of the ongoing program by supporting a pilot micro-enterprise credit scheme which would provide finance and technical assistance to low-income producers, primarily women entrepeneurs, who are engaged in highly labor intensive acti\vities. According to available estimates, 35% of Mexico's active labor force is engaged in informal sector activities. Tlhe informal sector is expected to play an increasingly important role in the futttre in absorbing, at low investment cost per job, displaced skilled and unskilled workers from other sectors.  - 20 - Finally the project's strong institution-building program would result in improved and more efficient provision of technical and financial services to the industrial sector, including the continued development of credit discipline. 2.34 The fact that FOGAIN and FOMIN, the two main executing agencies, have developed into reasonably efficient and mature financial institutions reduces both overall implementation risk and the risk related to financial and economic efficiency of resource allocation. Experience under the two past and ongoing SMI projects (Annex 6) shows that on balance the sub- projects financed had a positive impact and on average FOGAIN subprojects had economic rates of return in the range of 15 percent to 20 percent. The demand for FOGAIN investment credit would, however, be sensitive to slow improvements in the macro-economic developments, particularly to the high inflation levels and pace of economic recovery. To minimize the dampening affect of high nominal interest rates on credit demand the project would offer, as an option, a subloan repayment mechanism that is suitable in a high inflation environment. In addition, the overall size of the credit component has been set for conservative demand projections, and assuming no real growth over the last three years' actual credit disbursements by FOGAIN. The implementation of the financial restructuring component could be delayed due to the reluctance of commercial banks to participate, parti- cularly if they perceive their own financial sacrifice as disproportionate to that of the other participants. To deal with this uncertainty, the restructuring scheme is predicated on the principle of equal sacrifice and benefit for all participants including commercial banks and the entrepreneurs who would be converting a family owned company to outside participation. III. AGREEMENTS 3.01 During negotiations, agreement was confirmed upon: (a) the project's objectives and its description (paras 2.02); (b) the Droject cost, loan amount, financing as well as arrangements for channelling the resources to the various participating agencies and _ the accumulation of project resources in FOGAIN, FOMIN and NAFIN micro- enterprise fund (paras. 2.17, 2.18); (c) on-lending interest rates, spreads, maturities, grace periods and free limits (paras. 2.19, 2.22, 2.23); (d) planned technical assistance activities (para. 2.08); (e) subproject appraisal, procurement, disbursement, accounting, auditing and reporting arrangements (paras. 2.30, 2.31, 2.32). 3.02 Conditions of loan effectiveness whereby NAFIN will duly execute subsidiary loan agreements with FOGAIN, FOMIN and FIDEIN outlining the terms and conditions for the transfer of the loan proceeds (para. 2.18); 3.03 The proposed project constitutes a suitable basis for a Bank loan of US$185 million equivalent on the terms and conditions outlined in Chapters I and II.  - 21 - Annex 1 Page 1 of 6 MEXICO FOURTH SMALL AND MEDIUM SCALE INDUSTRY PROJECT The Technical Assistance Program 1. The technical assistance component of the proposed project is a comprehensive program covering a three-year period, which would encompass activities to: (a) strengthen the operations of the four institutions (FOGAIN, FOMIN, FIDEIN and NAFIN), which would act as apex institutions. Technical assistance will also be extended to the first tier participating financial institutions (PFI's), namely the commercial banks, credit unions and promotional agencies providing credit to micro-enterprises. (b) support the PAI industrial extension program and (c) assist the Directorate General of SMI's in the Ministry of Trade and Industry (SECOFI) to undertake key policy studies and to develop an information base on SMI's which can help design policies and programs in support of SMI development. The core of the technical assistance program would comprise funding for consultant services and equipment in support of the program. The total estimated cost of the technical assistance program is US$8.3 million,l/ of which US$5.5 million would be financed with Bank resources. While a - detailed breakdown of technical assistance activities and costs, as well as an implementation timetable is available in the Project Files, the main components of the program are discussed in the following paragraphs and the cost estimates are in Attachment 1. PAI-Technical Assistance Unit (PAI-TU) 2. The PAI-TU component is the largest of the five subcomponents, with an estimated foxeign cost of US$2.3 million. Within this subcomponent the support for the industrial extension program represents the key activity, followed by assistance to the credit unions which act as channels of credit to the SMI sector. It is anticipated that under the technical assistance program the PAI extension service would be expanded increasing its staff from 94 at present to 160 at the end of 1988. The newly recruited staff as well as existing PAI extensionists would receive on-the-job training and would also attend short seminars and courses in techncial areas. The assistance for credit unions would be confined to improving their management and accounting practices, loan recovery procedures, and project evaluation practices. Where necessary, NAFIN's TA unit would provide micro-computers and associated training to enable credit unions to improve their data base system. The technical assistance for PAI also includes: (a) a pilot program to identify and train new entrepreneurs, mainly young graduates with business aptitude; (b) assistance for stimulating the increase of SMI exports and the greater use of subcontracting, as well as improvements in productivity and quality control. The latter would include technical assistance to a group of enterprises in areas of project engineering, export marketing and subcontracting; (c) support to regional research institutes for the resolution of specific technical problems identified by the extension service or referred by SMIs; and (d) improvement of the statistical data base for the extension service and of PAI's promotional activities. I/ Includes US$0.3 million UNDP contribution.  - 22 - Annex 1 Page 2 of 6 Credit Program (FOGAIN) 3. A technical assistance component with an estimated foreign cost of about US$0.9 million equivalent would help strengthen FOGAIN operations. Speifically this package would: (a) strengthen FOGAIN and the PFI's in areas of project preparation, evaluation and supervision through short-term seminars as well as on-the-job training by experts who would review FOGAIN's existing evaluation guidelines and loan processing manuals; (b) support and speed up FOGAIN's program to decentralize its loan approval and control activities, and in this regard, develop the data base at the regional level linked to the system at headnuarters; (c) strengthen the current credit control and information system including assistance for sub-project follow-up, particularly in managment and portfolio control, aimed to monitor the quality of FOGAIN-financed portfolio at the PFI level; (d) develop the installed capacity in financial planning and programming as a basis for operational and financial projections; (e) accelerate the subproject processing procedures cutting down subloan approval time through the establishment of special project technical assistance units and revolving accounts in selected commercial banks; and (f) carry out more aggressive promotional activities based on a well-articulated mid-term strategy and an annual promotion program. The technical assistance support for FOGAIN also includes financial provisions for the acquisition of micro-computers, audio-visual equipment and the development of related software. About US$0.2 million has been earmarked for computerization of regional offices, but this sum would be available for use after a diagnostic study is completed to ensure that there is no duplication with the computerization planned under the recent IDB loan. Risk Capital - Restructuring Component (FOMIN) 4. The subcomponent for FOMIN is estimated to have an external cost of US$0.9 million equivalent and would: (a) provide assistance to FOMIN for strengthening its current investment analysis capacity with emphasis on training staff in carrying out an investment analysis for equity-type operations; (b) create the institutional capacity for FOMIN to implement the financial restructuring component. Since this would require a high level of expertise in varied areas consultant funds have been provided to enable FOMIN to seek the required expertise form consultant firms in Mexico or outside. It is envisaged that FOMIN consultants would work closely with commercial banks in developing restructuring workouts (Annex 4) and in this way also help build up the institutional capabilities of the participating banks, (c) help enterprises increase their production and product quality. In this regard FOMIN would finance studies covering specific areas such as improvements in production processes, market analysis and a diagnosis of companies' organizational problems; and (d) strengthen the existing management information system including subproject data. 5. Industrial Parks and Buildings Program (FIDEIN). The FIDEIN technical assistance component has been designed with two basic objectives namely, to strengthen the institutional aspects particularly credit evaluation and supervision and to enable FIDEIN to carry out special pre-investment studies. It is envisaged that FIDEIN would undertake special training programs for its staff in areas of project evaluation and  - 23 - Annex I Page 3 of 6 supervision. During the first year of operations, FIDEIN will carry out a study to determine the possibility of lending through commercial banks acting as a seccnd tier institution. Another study would help assess FIDEIN's staffing needs and propose any organizational changes, if necessary. After 18 months of operations under the proposed project, FIDEIN would commission a study which would review its lending operations and the overall performance of the Institution. The technical assistance program also includes financing for carrying out detailed pre-investment studies for industrial park development in 11 states. Similarly, standard building designs would be developed for factories to be constructed by private constructors wanting to locate businesses in high priority industrial zones. Micro-enterprise credit component (NAFIN) 7. In view of the pilot nature of the micro-enterprise component, technical assistance has been designed both for the apex institution (NAFIN) and the promotional agencies responsible for implementing this program. The estimated external cost of this component is US$0.3 million which would support the following: (a) strengthening the subdirectorate in NAFIN responsible for selection and screening of promotional agencies. There is a need to develop a central information and control system which would be supported by a computerization and management information program. (b) direct assistance to the promotional agencies in the form of training programs for their personnel and the development of subloan evaluation criteria, loan recoveries and supervision practices; and (c) studies for the identification of training needs for the final beneficiaries including the development of training programs to be implemented by selected training institutions; and (d) promotional activities including purchase of videos and the production of didactic materials, pamphlets and other promotional material. Subproject Review (NAFIN) 6. A major problem in the implementation of the previous projects was the delays in subloan approvals at each stage of processing, particularly for above the free limit subprojects, needing the Bank's approval. The underlying problem was the lack of conformity with Bank appraisal standards. It is planned that under the proposed project the responsibility for approving projects above the free limit be gradually transferred to a responsible and competent unit in NAFIN. In addition, there is the need to centralize the information requirements of the Bank in a single unit. Accordingly, it is planned that these responsibilities be carried out by NAFIN's Directorate of International Organization (which is the primary point of contact with the Bank), Since the Directorate of International Organizaton is not only responsible for the Bank's SMI projects but projects in several other sectors, its institutional strengthening would benefit the implementation of several Bank-assisted projects. The technical assistance package designed jointly with NAFIN is estimated to cost US$0.2 million and would be aimed to strengthen the quality control functions of NAFIN. Specifically three basic types of assistance are envisaged: staff training, procedural review and reporting. The training activities would be concentrated on upgrading the capacity of existing staff in areas of subproject review in the light of the agreed  - 24 - Annex 1 Page 4 of 6 Bank eligibility criteria. The main thrust of the training would be to provide on-the-job training and the development of guidelines for reviewing subprojects. The funds for computer equipment would be used to develop central information system for financial and operational information generated by the executing agencies. Key Sector Studies (SECOFI) 8. To date the Bank-assisted SMI projects have operated without direct linkages with the policymaking body, namely the Directorate of Small and Medium Scale Industries in the Ministry of Trade and Industry. The Directorate is responsible not only for developing the overall incentive proposals/schemes for the SMI subsector but also for developing the Government's overall policy for the sector. Recognizing the importance of adequate policies on the successful implementation of credit programs the project includes direct technical assistance to strengthen the operations of SECOFI's SMI Directorate to assist it in formulating or recommending policies for the promotion of SMI's. The technical assistance program for SECOFI would be part of a joint program between UNDP/Bank to be executed by UNIDO. The Bank's assistance is estimated to cost US$0.5 million while the UNDP component, which is mainly directed to development of the information base of the Directorate, is estimated to cost US$0.6 million. The Bank's technical assistance program would include the carrying out of special studies which would be followed up by specific action plans in areas requiring improvements. Areas to be studied are: (a) the existing regulatory framework constraining investment in the SMI subsector; (b) subsector studies aimed at determining the investment possibilities in the light of available production techniques and market prospects including export possibilities; (c) development of mechanisms for promotion of subcontracting taking into consideration the experience in other developing countries; and (d) strengthening the support of the Directorate to the technological development institutes like CONACYT and INFOTEC. Since several ongoing Bank-assisted projects include studies which may overlap with those proposed under the project, a small steering committee would be set up to screen proposals for the studies to be undertaken by SECOFI's SKI Directorate. The steering committee would be chaired by the Director General of the SMI Directorate in SECOFI and would have as members representatives from NAFIN, SHCP and SPP. Implementation Arrangements for the TA Component 9. The Technical Assistance program under the proposed project has been designed differently from the previous three SMI projects where the entire technical assistance program was managed and coordinated by a central authority, namely PAI. Under the proposed project, there are two types of technical assistance activities: first, those which are intrinsic to the executing agencies (FOGAIN, FOMIN, FIDEIN and NAFIN), and hence would be managed directly by them; second, those related to the entire project, as well as to the SMI sector, which would be handled by PAI in its role of a technical assistance provider and by SECOFI as an SMI policy- making body. Both types of TA packages would be executed in accordance with the detailed implementation plan, prepared jointly by the Bank and each institution during appraisal, and which is available in the project file. To ensure a smooth implementation and close interdepartmental  - 25 - Annex 1 Page 5 of 6 coordination, it is envisaged that each institution would nominate a high level official wich adequate support staff to be solely in charge of all TA activities within the respective agency, including contacts with the Bank. All progress reports on TA activities would be prepared under the coordination of the rnominated person. SECOFI's technical assistance program has been designed as an integrated package for a joint UNDP-UNIDO and Bank technical assistance project. UNIDO would be the executing agency for this component while the Bank would periodically review the progress of the program through tripartite meetings between SECOFI/Bank/UNDP. In addition, the annual work program for the technical assistance component would be discussed with the Bank. Both the annual review and semi-annual meetings would provide the Bank opportunities to monitor this important component. The Project Execution Document to be prepared by SECOFI for this component, would include, inter alia, the arrangements for implementation and review of the project. Technical Assistance Program Priorities 10. Even though the above TA activities for each participating institution (NAFIN, SECOFI, FOGAIN, FIDEIN and FOMIN, and FIDEIN) reflect their institutional, financial and operational aspects of the institutions which are considered high priority, the following activities are considered especially critical for project success. (a) PAI's industrial extension programs would be carried out in a way to ensure adequate strengthening through training of 30 existing extension staff and recruitment of 30 new extensionists annually. The recruitment and training program for extensionists would commence in the first implementation year. (b) During the three implementation years about 15 credit unions would be strengthened and project technical review units would be set up in a least three selected commercial banks. (c) Decentralization of FOGAIN operations represents a high priority for project execution as a means to speed up its loan approval time and to make the entire operation more effective. In this regard, terms of reference to carry out a diagnostic study about the current status and design of an action plan should be submitted for Bank consideration within the first semester of the project execution. (d) The strengthening of FOGAIN's Control and Information System, which includes the portfolio management, especially to know the quality and status of the PFI's project portfolio, including loan recoveries, is the key element of FOGAIN's institutional development and work on this activity would commence in the first phase (Qtr) of project implementation. (e) The TA activities related to both FOMIN's pilot component of financial restructuring, and NAFIN's technical assistance for the execution of the informal micro-enterprise credit component, should be initiated in the project's first implementation year and completed by year three.  - 26 - Annex 1 Page 6 of 6 (f) The TA for SECOFI, such as the studies related to incentives, and the simplification of the procedures required to enhance or set up a new enterprise, are important as the basis for developing new policies and strategies to promote the SMI sector. Accordingly these activities would be given priority within SECOFI's overall technical assistance program. The results of all studies should be made available within two and a half years of implementation. (g) FIDEIN's technical assistance activities will give the highest priority to staff strengthening through training programs in credit evaluation and sub-project preparation. In addition, FIDEIN would commission two key studies, namely that to determine its staffing and organizational needs and that to help It act as a second tier credit institution.  Attwdiunt 1 - 27 - I%jeIof2 P0El UIL MJI DtUm 5IEIX XNIiDffk 1 Etimatod Costs sd In Yrm for TWdwhial Asestae PN (h4At for 3 Yeaz) PART I Ihtenal 1oa Totfl PAi T?edo icd istaoe tdt Cost Cost Coat Ob*ivcti (MO thm1s t a) Stietrng t am .ihe tho aurnnt oapaoity of the Irustrial Ertuiou 7M).0 85.7 1,1RX.7 S& loo for 91'e, as ll as to devlop a training progm for parllel extawonitaU in the bwks and ttes. b) Pzcte the cretion of and amist Credit Uniorm to bo r.ore 49).0 *54.3 944.3 effective I'e. CoRuter equipeAnt will aIo b providd to support Crdit Unrion operatioos. O) Daevlop aed L^lpent an 41tmpmmertal Dewlopwint Prmv. 2X).0 9Q.S 312.8 d) Strengthan PAVs eurrent opity to assist Regimo Reerch 177.0 50.5 227.5 Irntitutes to rewolve taecndeal pmzblei faced IV 5I'4 in selected sub-esotora. a) Aeistance to oarry out pzgee for stimulating increas exports fcc 162.0 20.5 182.5 sr, mote subotrcting and enhnced prodaotivity/quality control. f) Pntide PAI with equipent for peO,tional and techd l asistanw 371.0 175.2 546.2 aUtivities (audio-visal); enpater equipunt to streNgthen both the Headquartere and the Regional Offices. WM PAl T.A. 2,00.0 1,619.6 3,819.0 PART Ul Gu*nte_ Fund for Iaiitial Cziit (FJOG) a) To iat FKAI in deoentriization thnh MeIsolUtion of its o.0 29.4 109.4 oaWter syte IV a netw* oreetirg of 7 eglonral Offices. b) To sttwtu loan's and m's eru-t oapwoitr on project 160.0 26.7 115.7 pftpttim an gwalujation e tugh short-term ssdlas wd on-tib-Job trding oarried cut tb XWAt as viol as thro* oemeX sponsorsd IV reticMI SW riatioAtl iiutitUtioaS. e) To iqzoe N:AIN'e subprojeot foflU up, idch inolxle ex-poet 70.0 12.2 8.2 proeasing of the finavial end seiO infoition, an subprojects, as well asimprove F 'Is lawledge of PVT's portfolio. d) To aeist ADI in designing a fwainl prousdg psts4, in order 62.0 8.9 to irjl*mt f huil pro3otions, penently end xpet itaily. a) Assist gX2: in ourrt out an action plan to estAblish in the PM's 42.0 2.3 44.3 Teniial Unit to pmoce and spervise subproJects swre effectively. f) &,Wrt PlADN's pnotaal activities izoluding the slaborsticv of a 31.0 Z2.5 53.5 aid-ten and an am1al prwtion progzi. g) Povide MM ccstar equipeont. and sippor otitwe ant twinini 435.0 394.0 819.0 for opiretiGw in thl R1eginl Offioes. PT 12 arteranl l l 'otl Neticeai. Xrtutrial% at a!l (KI) Cost Cost Coct Objectivet Lm thuans) a) Sulgte KMD's aursMt oepoity in pmject pa'em tion am 175.0 77.7 252.7 melwtion Smatuvisioa activitis. b) Assit hOI to detorodne invwtlt altewativ and to iarov the 126.0 24.5 150.5 productivity of the oamies financed I it. c) Asist MIU in p nDUOi activities dsed to feailierift 69.0 13.6 82.6 autmprmwt, dehb of iihmtries asnd b s with R( proga- d) StrsgUmrisg LIn oPeMial nd tadbiOa asPcs require to 36.0 36.3 421.3 iqlmmt tthe aw Coawnt of nmciea Ret btuarI hWay q-Ufied Oltmrts imld be hid prtiwamrli for c.ry l uS fit WIl aerirt ,ftdg nai vith *= WISl bam. 0) Ait KW1in &M sdstion of oms ae d audio.d Ial Sdipwnt, a8 115.0 0 115.0 Wel - vebic to soprt its operatinas, sperviion dan prortoMl activities. laBlTJW~~~~~~~~~~~~~~~~~~~~. 1581 0 , ; C  - 28 - Pop 2 of 2 8rtsnul Loal Total PAR IV cost Cost Cost Nacionl (iu~.a m(AI) (U.M thouamds) Objectives: a) Strentm NAPIN's International and Trawsy Dirctorate in ares of 90.0 24.8 114.8 geesral project follof up. b) Strethu the Current Inforution and Control ystem of NAFDl's 8.0 4.2 92.2 Internaticel and Treaay Directorate, that ould be repcmible for mual Project alinistration. c) StrwWthm NAF's operating capacity aa of prmtional gencies to 272.0 64.5 336.5 iql.it the na credit ooqwmt for infouml adcro-enterprisms. tails Aznex 5). TUDAL NAM T.A. 450.0 93.5 543.5 PART V Seoreteriat of Trade and !trtal Devlopmnt (S37I) Objectives: a) Asiat 3D0PI's Directorate Gerel for YIdium and Small Nnterprisee 48.5 11.6 60.1 (DISDI), to car out studies aiead at identi*irng ansm to simuplify existig idustrial reglation. b) Carry out stbies about the impact and effectiveres of oarnt ficl 84.5 14.2 98.7 inctivie and other types of ineentives for S1 developemit. e) Carry out a st* to deterine oca provm betmen the national 48.0 24.1 72.1 industrial reearch institute, SEnI AND OAMC. d) Unbertake spciel and sector stUdies covering topics suih as intaled 72.0 6.5 78.5 capacity, nm*et linittiaow, production, product quality, tedmo1o oeotrain-a and other aspet. heee stui vzuld act as giides to dei new policies and inveswett strateges for MI's. e) Prwte the usw of subcontracting beteen the lare and wall-scale 96.0 16.4 112.4 enterpTie, as well as attazlate tbe creation of inter-enterprise orgsaticns to implamt ths above nucha. f) ILmne WIMP's infomtimn base trogh icmrocaipter eispnnt ea 251.0 7.3 258.3 atdio-vial equipmt. TDI!AL SXMFI T. 60.0/ .1 680. PART VI Funt for Indtrial$sfjvelomopmt (F3Mi) Objectives: a) Carsy out studies for tme Estates to determine investist priorities; 264.0 27.0 291.0 design policies and strFtegies for industrial pase developt, to also ewluate the ipwot of tim exdsting and onoing operatio. An eninerin stubdy for deeloplng stard indutrial buildinro. b) Carry out a dMsostic atudy about II'a institatioral and operting 107.3 31.2 138.5 procedure to determne orgniatice2l adjustbt and staff requirumnts. The desdi of a ecmd flcor bik naurde for TII'IN. Stregthen FIM 's staff; aad sd-temr proJect emaution evaluation of F]IEDI's perfomnce. 128.7 100.1 228.8 c) Pratiml Activities to ineraa FlMl's operations and to enoa the use of the Industri Parks' facilities. 500.0 158.3 658.3 TOAL FEW T. A. 5,50'.0 2,589.0 8,089.0 MMID TOL T. A. - - - 1 boljese a gnat of tS,OO0 frzu UNDP/ONMDI.  Annex 2 Page 1 of 8 MEXICO FOURTH SMALL AND MEDIUM SCALE INDUSTRY PROJECT Guarantee Fund for Small and Medium Scale Industry (FOGAIN) The Credit Component 1. Perspectives. FOGAIN was founded in 1953 as a NAFIN trust fund, to act as a second-tier-credit institution rediscounting loans to micro-, small and medium industries (SMIs) for equipment, machinery, working capital and debt consolidation (industrial mortgages). From time to time FOGAIN has also been entrusted by Government with the implementation of several ad hoc programs, such as the DICONSA Suppliers' credit scheme and the emergency SMI credit program (US$500 million) created after the 1982 economic crisis. FOGAIN financing enables SMI firms to expand existing capacity, add new lines of products, as well as undertake new investments. Today FOGAIN lends through several participating financial intermediaries (PFIs), such as commercial banks and credit unions. 2. Effective from May 1, 1986, FOGAIN clients are classified on the basis of net sales and number of employees, as follows: (a) "Micro-industries which may be individuals, corporate bodies, or cooperatives, which employ up to 15 persons and whose net sales total less than Mex$40 million/year"; (b) 'Small-scale industries are units that do not fall within the previous category, have up to 100 employees, and show sales not exceeding Mex$500 million/year." (c) "Medium-scale industries are units that do not fit into either of the previ,us categories, have up to 250 employees, and show sales not exceding Mex$1.1 billion/year." (The New Operating Regulations (July 1986) Governing FOGAIN Operations Through the National Banking Systems are available in the Project File.) Past Financial Performance 3. FOGAIN's past financial performance covers the three year period 1983-85 and the first eight months of 1986. This period coincides with the implementation of the Bank-financed Third SMI project. Wherever meaningful, the 1983-85 performance is compared with results for the immediately preceding three-year period (1980-82). 4. Profitability. During the past two years, FOGAIN has demonstrated a good financial performance and maintained a sound financial structure. Operating profits have increased steadily over this period, and, in fact, the pattern of losses sustained between 1976 and 1983 was reversed (only in 1980 was there a moderate profit, US$167,698 equivalent). As will be seen from the past financial statements in Annex 9, T-7, T-8, FOGAIN's profits for 1984 amounted to Mex$3,408.7 million (US$18.4 million equivalent), which translate to a rate of return on total assets (ROA) of 3.6% and on average equity (ROAE) of 13.9% The profits for 1985 were even higher amounting to Mex$15,230 million (US$49.1 million equivalent), which translate to a ROA of 12% and a ROAE of 29.6%. It should be noted, however, that the dollar value of FOGAIN's asset base declined between 1984 and 1985 by 13.8%, thus making the adjusted ROA for 1985 equal to 10%. The above rates of return on total assets and on equity are considered satisfactory.  - 30 - Arneax 2 Page 2 of 8 5. The main reasons for FOGAIN's good performance during the 1983-85 period are: (i) the favorable interest rate margin in its balance sheets; the weighted average cost of FOGAIN funds increased much more slowly that its weighted average lending rates. This margin stood at 22.5 percentage points at the end of 1985 and increased to 24.1 percentage points in July 1986 (see Annex 9, T-9); (ii) the institution of variable interest rates charged on its subloans, tied to the weighted Average Cost of Funds, while FOGAIN's liabilities have, until now, represented low cost fixed rate refinancing instruments; (iii) the fact that FOGAIN's portfolio did not have any significant losses in its subloan portfolio (from accounts in arrears); (iv) a significant reduction in the growth of long-term liabilities (from 230% in 1980-82 to less than 4% in the 1983-85 period), except for obligations to PAI. This resulted in a reduction of interest costs in 1985 by 29%; (v) nominal increases in administrative and salary costs generally below the growth in the General Price Index. 6. Arrears. As a second-tier institution FOGAIN bears no credit risk except for its direct lending to credit unions. Thus, FOGAIN makes no provision for bad debts. Subloans in arrears (or uncollectibles) represent a very small proportion of the total loan portfolio, despite an increase from nearly 0% in 1983 to .02% in 1984. At present, FOGAIN does not receive periodic reports on status of arrears from the financial intermediaries. This is a major shortcoming and would be remedied under the proposed project, which would not only require such reporting, but the preparation of an action program based on these reports. The data on subloan portfolio is severely deficient, both at the FOGAIN and PFI level, but visits to three leading participating commercial banks showed that they placed their FOGAIN-financed subloans in arrears at their level, to between 2% and 5% of total loan portfolio. This figure conforms with the arrear position reported by the IDB appraisal mission in February 1986. While the low levels of arrears could be due to the conservative credit screening processes and high collateral requirements which prevent high defaults by selecting the lowest risk category, their real level may be masked by the commercial bank practice of rolling over outstandings (Main Report para 1.10). 7. Asset, Liability Structure, and Net Worth. In US$ terms, FOGAIN's asset base (85% of which is its loan portfolio) decreased between 1983-85 by 8.5% (from US$461.0 to US$422.0 million equivalent), principally due to inflation and the rapid devaluations. However, in this period FOGAIN's net worth increased by 112.0%, due to the plowback of increased earnings in 1984-85. The value of the loan portfolio also increased moderately (by about 7.0%). The foregoing developments are in contrast to the adverse developments during the previous 3-year period (1980-82), when both FOGAIN's net worth decreased by about 21.0% and the value of its loan portfolio decreased by 42.0% due to the severe economic and financial difficulties. A discussion of FOGAIN's loan portfolio is in para 10. 8. The level and composition of FOGAIN's liabilities also changed radically during the 1983-85 period. Total debt as a percentage of net worth has changed from 340.3% in 1983 to 78.4% in 1985, providing FOGAIN a greater capacity for future borrowing and permitting it to meet its counterpart funding requirements increasingly from its internal resources. In fact, no direct budgetary support for FOGAIN was provided in 1986.  - 31 - Annex 2 Page 3 of 8 Funding of domestically-financed credit programs, as a percentage of total debt, has decreased by 51%, while the external debt portion (representing Bank/IDB resources) of total indebtedness has increased by 217%. This is partly explained by the tight resource position in the market and mainly by FOGAIN's preference to use IDB/Bank resources which are relent to it by Government at fixed rates, free of currency risks and hence ch aper to service. It is not surprising that the latest (1986) IDB loan of US$180.0 million represents a quantum jump from its penultimate loan of US$0.0 million. Within this pattern, the contribution of Bank funds to FOGAIN's total debt has increased from 13.7% in 1982 to 57.1% in 1985, indicating the increased significance of the Bank's financing to FOGAIN's operations. 9. Portfolio Growth and Composition. During the 1983-85 period, as expected, FOCAIN's loan portfolio represented 85% of its total assets, growing significantly in nominal terms (from Mex$56.2 billion to Mex$123.7 billion). In US dollar terms, however, its value increased only by about 7.0% for the entire 3-year period (from tlS$374.0 million to US$399.0 million equivalent), as shown in Annex 9, T-8. The portfolio was financed as follows: 62.8% by FOGAIN's own resources, 13.7% by internal credit, 9.5% by external credit, 7.8% by the Bank of Mexico, and 6.2% by the Federal Government. The cumulative distribution of maturities in FOGAIN's subloan portfolio exhibited some rather significant changes during the last six years (see Annex 9, T-13). For example, the average annual proportion of maturities classified as 24-months or less increased to 53.5% of the portfolio during the 1983-85 period compared to 28.9% for the 1980-82 period. These averages are the result of an uninterrupted pattern since 1981 that portrays FOGAIN's portfolio being heavily weighted toward working capital subloans due to the severe effects of liquidity squeeze in the banking sector. The shortening of maturities can be explained also by the change in the size composition of FOGAIN's subborrowers. Specifically, the proportion of very small firms, which typically borrow for working capital needs, increased from 58% of all firms and 31% of total financing in 1984 to 91% of all firms and 75% of total financing in 1985 (see Annex 9, T-12). The increases in the average annual proportion of maturities for 24-months or less during 1983-85 were made possible at the expense of similar proportions for intermediate maturities (37-84 months) that decreased to 29.3% of the portfolio, compared to 44.7% in the 1980-82 period. While, under the proposed project, a conscious effort will be made to encourage longer term maturities, and, above all, measures have been introduced to ensure that commerical banks allow maturities to suit the cash flow requirements of enterprises, it is likely that the bulk of the credit resources will continue to be onlent for relatively short term working capital loans. Lending Strategy 10. FOGAIN perceives its mission to be the financing of SMIs that are primarily privately owned or have a majority private ownership. In all of its operations, FOGAIN acts as a second-tier institution, rediscounting loans of approved commerical banks and credit unions inspected by the National Banking and Insurance Commission. Presently, it channels its funds through 27 banking groups and 31 credit unions, that make loans to enterprises for working capital, equipment, machinery, and debt-consolidation purposes (industrial mortgages). The characteristics of FOGAIN's past and current lending operations are contained in Annex 9,  - 32 - Annex 2 Page 4 of 8 T-10, 11 and 13, while the description of its experience with the three Bank-financed projects is recounted in Annex 6. 11. Product Line and Range of Lending. In the past FOGAIN has concentrated on financing of working capital requirements (54.6% of total loans), equipment (38% of total loans), and debt consolidation operations (7.4% of total loans). From the beginnin, of its operations in 1954 to the end of 1985, FOGAIN has provided credit financing to 66,925 enterprises, of which 80% were small-scale and 20% were medium-scale industries. In the more recent time period, FOGAIN's operations have increased from 5,926 credits in fiscal 1980 amounting to Mex$9.0 billion to a record of 12,759 credits in 1985 totalling Mex$124 billion, at an average annual growth rate of 69.0% in nominal terms but less than 1% in real terms (Annex 9, T-10)~ 12. The performance of the Fund's portfolio in 1984 provided the first turnaround in real terms since the precipitous declines in 1982 and 1983 caused by the inflation and the major devaluation. Another interesting feature in portfolio growth was that, although FOGAIN's loan volume in real terms grew by only 2.3% during the entire period of 1980-85, the number of loans increased by 115%, leading to a corresponding reduction in average loan size from US$65,800 in 1980 to US$31,300 equivalent in 1985. The decline in loan size can be attributed to two causes: (a) the aucceqsive devaluations that reduced FOGAIN financing in US$ terms; and (b) the 1983-84 recession that found FOGAIN financing a larger proportion of expansion projects, with smaller costs per project compared to new projects. 13. Price Policy. After charging fixed interest rates on its portfolio until late 1982, FOGAIN adopted a system of variable interest rates adjusted monthly and tied to the CPP. Currently FOGAIN charges four different rates -- based on the type of firm and on priority classification. The range of interest rates charged by FOGAIN is between 85% of ACF and ACF+5. From the interest rate spread, FOGAIN allows intermediaries a margin of between 2 and 5 points. In addition, FOGAIN plans to pay one percentage point to intermediaries whose staff include "industrial extension agents." FOGAIN's weighted lending rate (net of intermediation margins) shot up from 47.5% in December 1985 to 65.1% in December 1985, and further to 87.7% in October 1986 (Annex 9, T-9). The advantages of adopting a variable interest rate policy became apparent when the continuous operating losses of 1980-83 period began to be converted into profits. Business System 14. Over the years, FOGAIN has developed policies and operating procedures that are sound and meet the current requirements of the Fund's lending strategy. The main elements of the business system - promotion, subproject appraisal and supervision -- have, in the past, been sufficient to support FOGAIN's role as a largely second-tier rediscounting institution for short- and intermediate-term financing. Nevertheless, in the future FOGAIN must place greater emphasis on delegating its routine loan processing and supervision responsibilities to the PFIs, and assisting the 'irst-tier level agencies in streamlining their operations and in ensuring the quality of the subprojects they finance.  - 33 - Annex 2 PaRe 5 of 8 15. Loan Processing and Acquisition. The PFIs ensure the gathering and evaluation of the proper information before forwarding subloans to FOGAIN. Such information includes, among other documents: (1) the letter of request from the intermediary, giving particulars of the loan to be discounted; (2) the completed application form for the class of enterprise under consideration; (3) the final version of the contract and deposit certificate prepared by the client; and (4) the necessary credit analysis that focuses on the feasibility of the project, particularly the combined financial commitments of the applying firm and its projected income. The PFIs reportedly take, on average, 2.5 months to process a loan application, while FOGAIN takes another 0.5 months to review and release disbursements. Measures are to be int, )duced under the proposed Droject to reduce the relatively high lapsed cime between loan application and disbursement. 16. Subproject Appraisal and Preparation. By now, FOGAIN has beco.sie an experienced institution in subproject financing and is cooperating with financial institutions in standardizing the evaluation and supervision of investment projects. While these two phases of its business sytem are well-developed and generally meet the standards established by the Bank for project appraisal, there is room for further improvement. 17. FOGAIN's subloan evaluation procedures have been developing gradually and PFIs have begun to carry out ex-ante analysis of the subloans it finances. Until 1985, FOGAIN did not carry out these evaluations systematically however, as these were not explicitly required under the Bank's earlier projects. In February 1985, a departure was made from this practice when the Bank and PAI/FOGAIN agreed that for credits larger than US$100,000 equivalent (authorized by the Regional Technical Committee or the National Technical Committee), the Financial Rate of Return should be computed before the decision is made on the loan application. In order to improve appraisal procedures further, it was agreed that under the proposed loan FOGAIN will ensure that the following appraisal criteria are met by PFIs or itself: (1) for projects up to US$100,000 equivalent, decisions should be made to streamline cash flow projections and analysis, at the level of financial intermediaries where such loans can be authorized; (2) For projects worth more than US$100,000 but less than US$300,000 equivalent, the financial rate of return should be utilized as a benchmark; (3) for projects in excess of US$300,000 equivalent, both the financial and the economic internal rates of return should be computed. The above appraisal criteria will be incorporated in FOGAIN's revised Operating Regulations. 18. Credit Supervision and Monitoring. FOGAIN's supervision process improved markedly after the establishment of a special Directorate of Credit Analysis in July 1985, wiose Subdirectorate of Credit Monitoring designed and implemented a sound and effective program of credit supervision. Under this program, in 1985, some 25 part-time independent consultants were employed to augment FOGAIN staff (10 at present), to visit a rather large sample of 2,739 firms. The sample for supervision is chosen mainly from medium-scale enterprises that have received credits between July 1983 and July 1985. Since the supervision effort can be diffused by the rather large sample of monitored firms (12.5% of total sub-borrowers, it was agreed that in future firms would be stratified according to meaningful credit-checking criteria with small samples in the range of  - 34 - Annex 2 Page 6 of 8 1%-3X drawn from each class for proper supervision. In addition, FOGAIN would in future focus its attention on subloans that are in arrears. The FOGAIN technical assistance component (Annex 1) includes provisions for the development of a computerized portfolio control system, which should help identify problem projects. 19. The existing procedure of credit monitoring is unduly focused on the proper use of FOGAIN's funds, as defined contracturally in the loan application. Moreover, since the large sample of firms visited changes every year, it limits the ability of FOGAIN's staff to measure financial and eonomic performance ex post. This is a critical area, which needs improving as FOGAIN is unable to precisely measure the impact of its lendinig at the beneficiary level and also compare its ex-ante projections with actual results. Under the Third SMI loan (2325-MH), several recommendations were made to improve portfolio control and about one half of these are already implemented. It is further recommended that under the proposed project, FOGAIN should broaden the scope of its monitoring and supervision activities to include: (a) the economic impact of the subprojects; (b) their repayment potential; and (c) the decomposition of operations at PFI level by source of financing (Bank/IDB/Banco de Mexico). Institutional Profile 20. Organizational Structure. Although administratively FOGAIN reports to the Ministry of Finance (Hacienda) it is governed by its legislative Charter and by the policy and procedural rules issued by the National Technical Committee, its highest decision-making body. The National Technical Committee composed of representatives from the Ministries of Finance and Industry, Banco de Mexico, the Chambers of Commerce and Industry (CANACINTRA), establishes overall strategy, policy, and procedures, and make operational decisions on the basis of recommendations by FOGAIN's staff regarding financial plans, budgets, and credit operations. The organizational restructuring that began in 1984 has resulted in the creation of the Subdirection of Administration, the Subdirection of Credit Monitoring, the Department of Internal Auditing, and the Department of Legal Affairs (Organization Chart). These changes have considerably streamlined FOGAIN's organization making it more responsive to its present functions at the home office level. 21. Management Team. The existing FOGAIN management team is headed by its Director General, who was appointed to this post in October 1986. At present, the management team consists of six Directors, eight Subdirectors and 29 managers. Institutionally, the outgoing management had directed its energies toward: (i) expanding operations; (ii) strengthening its critical administrative areas (e.g., Credit Analysis, Finance, etc.) and (iii) creating new departments and units to streamline the organizational structure (para. 22). 22. Staffing and Training. FOGAIN has built up a cadre of qualified and experienced professionals at all levels. The high calibre of FOGAIN staff can be attributed to the adequate career prospects FOGAIN offers to its professional staff. Although the FOGAIN salary packages are less attractive than those of commercial banks and the private sector, it has positioned itself as an attractive first employer for outstanding  - 35 - Annex 2 Page 7 of 8 university graduates interested in a long-term career in finance. In this role, FOGAIN offers excellent on-the-job tvaining and a good reference point for prospective private sector employers. As of October 1986, FOGAIN's sthff totaled 436 with 410 in Mexico City and 26 in the regional offices. An additional 13 positions are budgeted that will bring the staff to 449 people. The breakdown of staff number by profession is in Annex 9, Table 14. A, present there is an imbalance in the allocation of human resources between the home office and the regional branches, and FOGAIN's management has agreed to prepare a three-year decentralization plan to move gradually additional personnel to the regional branches. Under the project, technical assistance has been included to strengthen FOGAIN's regional operations through computerization of information and through special staff training programs. 23. Management Information Systems and Accounting Procedures. FOGAIN's current management information system (MIS) is still in its early stages of development. While basic raw data is now generally available on computers, evaluation of this data is still rudimentary and does not allow a comprehensive decision-oriented evaluation of operations. A simple example is that the existing credit control records cannot readily reveal operations under different financing lines and sources, and it has been most difficult to identify the impact of subloans financed with Bank resources. The development of the MIS suffered a severe setback during the recent earthquake, when computer equipment and records were lost. The technical assistance component under the recent IDB loan supports FOGAIN's plans to restore and improve its computer center. The proposed project would complement this investment by specifically catering to FOGAIN's needs at the regional level (Annex I). 24. Auditing Arrangements. Responsibility for bookkeeping and the preparation of FOGAIN's Financial Statements rests with the Accounting Department -- one of four under the Subdirection of Finance. The accounting procedures are mechanized but not yet fully automated. The system of accounts classification employed by FOGAIN meets the standards of the National Banking Insurance Commission, which is a Govenrmental agency charged with the responsibilty of overseeing the financial sector of the country. For purposes of internal control and auditing, FOGAIN created the Department of Internal Control in February 1984. In addition, the Controller-General of the Federal Republic approves the choice of FOGAIN's outside auditors. During 1981-83, FOGAIN's Financial Statemens were audited independently by the Accounting Firm of De la Paz Costemalle y Asociados. Similar external audits were performed for 1984 and 1985 by the Accounting Firm of Horacio Ojeda Paullada y Asociades, L.C. In all cases, unqualified opinions have been given by the auditors. Audited xinancial statements were submitted to the Bank on time as agreed. Future Operations and Funding Requirements 25. Projected Commitments. Given the present condition of the Mexican economy, the demand for financing expansions of productive capacity is likely to be relatively low through 1987, but it is expected to increase as the overall economy improves under the impetus of the financing package recently agreed upon with commercial banks/Bank/Fund. Among subloan categories, the demand for financing permanent working capital is likely to  - 36 - Annex 2 Page 8 of 8 be relatively strong due to the: (i) coolinued higii inflation, and (2) the sliding devaluation of the Mex$ that has increased the cost of foreign borrowing. FOGAIN's projected commitments both on a global scale and on the proposed project for the period mid-1987 to mid-1990 are shown in Annex 9, T-15 and T-16. The projections are made on the basis of a scenario that shows no real growth in demand for the overall period, and are adjusted partially for the pattern of overestimation experienced with the pro forma forecasts for the PAI III program. The overall cost of the proposed credit program is estimated to be US$190 million equivalent, and assuming a Bank participation of about 50% in FOGAIN's future commitments under the proposed PAI IV Program, the Fund would require about US$100 million equivalent in addition to its own internal resource generation and the financial contribution of intermediary institutions and beneficiary firms. 26. Pro-forma financial statements are shown in Annex 9, T-15 and T-16.These financial projections are based on a conservative estimate of credit disbursements (para 25); and a cost of funds equalling 55% of outstanding balances due to NAFIN. The exchange rates (US$1uMEX$964 in 1987; US$1-MEX$1,539 in 1988 and US$1-MEX$2,406 in 1989) are based on BANCO MEXICO projections. The interest rate income is estimated on the basis of an average spread on annual estimated disbursements by FOGAIN taking into account the credit ceilings and estimated disbursements based thereon approved by its Board and adjusting for past performance. FOGAIN's projected Balance Sheets and Income Statements for 1987-1990 (see Annex 9, T-15 and T-16) show considerable and increasing profits, coupled with healthy financial ratios. Net profits are expected to grow from US$78.8 million equivalent in mid-1987 to US$100 million equivalent in mid-1990, at an annual real rate of 9.2%.  - 37 - Annex 3 Page 1 of 9 MEXICO FOURTH SMALL AND MEDIUM SCALE INDUSTRY PROJECT Fondo Nacional de Fomento Industrial (1OMIN) The Risk Capital Sub-Program A. BACKGROUND AND OBJECTIVES 1. FOMIN was established in April 12, 1972, as a Government trust fund ("Fideicomiso") to provide risk capital to small and medium size enterprises (SMIs) which planned to either diversify their investments, or undertake new ventures. FOMIN was originally administered by the SHCP (through NAFINSA), and was shifted to SECOFI when PAI was created. Both new and existing firms are assisted by FOMIN, which subscribes up to 49% of the equity capital or quasi-equity, which permits adequate flexibility in designing investment packages. FOMIN does not seek a direct management involvement in its investee firms, and above all, its investments are intended to be only temporary, being divested once the companies achieve a satisfactory financial position. FOMIN's participation frequently helps companies make the transition from a closed family enterprise to a more widely owned corporation with professional management. 2. Traditionally, FOMIN has had a difficult role to play since SMIs have, in the past, found the effective cost of equity higher than debt -- interest on the latter was fully tax deductible. More importantly, there was a widespread reluctance in Mexico on the part of corporate groups to dilute their equity interest, particularly through the participation of a government-owned entity like FOMIN. The high inflation rates and the accompanying increase in debt servicing costs, however, forced companies to seek relief through equity injections. Even so, companies have preferred q'asi-equity instruments such as preferred shares or subordinated colivertible credits (para 8). To further expand its services to a growing market, FOMIN has: (i) stepped up its promotional efforts, including exploring possibilities of financing with newly established Regional Venture Capital Corporations, (two letters of intent with such Corporations have already been signed); (ii) commenced its active promotion of venture capital type investments, by contacting universities and technical centers to identify and pre-evaluate investment ideas submitted by "first time' entrepreneurs who intend using a new technology; and (iii) initiated preliminary discussions with the newly authorized private sector Venture Capital companies (Sociedades de Inversiones) and Casa de Bolsa, offering them also the possibilty of discounting or joint participation in selected enterprises. All these initiatives have already translated into increased pre-application requests, which has allowed FOMIN to screen them for sound projects.  - 38 - Annex 3 Page 2 of 9 B. ORGANIZATION, MANAGEMENT AND STAFFING 3. The highest governing body of FOMIN is its Technical Committee comprising representatives from SECOFI, SHCP, NAFIN, Banco de Mexico, plus tworepresentatives from the private sector, selected by the main industrial associations, CANACITRA and CONCAMIN. FOMIN's day-to-day operations are managed by the General Director, Mr. Gustavo Varela Ruiz, an experienced and prominent economist, who was previously the head of FIDEIN. The management team includes two sub-directors, the Administrative and Technical Subdirector. In line with the Bank's recommendations during the appraisal of PAI III, FOMIN has restructured its technical area, which is now divided into two departments, the Promotion and Analysis Department and the Investment Control Department. 4. At present, FOMIN's staff totals 82, of which 42 are professionals. Most of the professional staff is young and well motivated with degrees in accounting, business or economics, but is rather new in the organization as FOMIN's salary structure prevents paying attractive salaries to competent staff, and trained staff often leave for jobs in the private sector. The Government's austerity measures in 1985 affected FOMIN by reducing personnel, at a time when its work load was increasing due to active promotion campaigns. FOMIN has made up for this by effectively relying on outside help with consultants from INFOTEC and GESTEC to carry the analysis of certain projects. However, budget limitations often restricted the use of this resource, and under the proposed project, t.a. funds have been provided for FOMIN to obtain additional consultant services to implement the financial restructuring component (Annex 4). In general FOMIN's staff is adequately competent, but needs further training to help broaden their knowledge of equity operations elsewhere. Accordingly, under the proposed project, FOMIN would expand its staff training program which would, among other things, allow staff to take courses in local universities; specialized short term overseas courses would be arranged to enable FOMIN staff to be exposed to operations of other investment or venture capital firms. C. INVESTMENT AND DIVESTMENT POLICIES AND INSTRUMENTS 5. FOMIN's financial policies were basically developed in cooperation with Bank/IFC and are considered acceptable jor an organization mandated to promote and provide equity to private sector companies. The small demand for FOMIN's participation in its early years of operation prevented it from placing special emphasis or priority to participate in given industrial sectors or regions. Over time, however, FOMIN investments have evolved reasonably well, with priority to SMIs located in less developed areas. More recently, the demand for FOMIN financing has increased due to the financial crisis. The increase demand has permitted FOMIN even more selectivity in the investments than before. FOMIN has always pursued a cautious investment policy, which was guided by two basic fInancial goals: (a) that it maintain adequate liquid resources (about 20% of its total resources) to cover its administrative costs, and (b) in the medium term to maintain the value of its portfolio in constant terms. Consequently, the liquid resources have in the past been essentially generated from the quasi-equity instruments, which seem to have been preferred by FOMIN over pure equity.  - 39 - Annex 3 Page 3 of 9 6. Eligibility. In line with the national definitions of small and medium size enterprises, eligible firms include those with total sales of less than Mex$1,100 million (about US$2.0 million equivalent). However, cost and risk factors, along with certain provisions of its charter (such as the requirement of external auditing), generally preclude FOMIN from financing very small firms. FOMIN's assistance is primarily concentrated in medium size enterprises (equity over US$250,000 equivalent), and some larger enterprises. To diversify its risk, FOMIN has established 10% of its equity as its maximum exposure (including investments through equity as well as other instruments) in a single firm, and 15% of its equity as a maximum exposure in two or more firms that belong to the same industrial group. Up to 1983, as a general policy, FOMIN did not invest in firms to help reorganize them financially, but focused on the creation or expansion of financially viable enterprises with good growth prospects. However, as a result of the country's severe economic crisis, FOMIN experienced a strong demand for restructuring or financing increases in permanent working captial, rather than in the creation or expansion of existing enterprises. Accordingly, FOMIN gained some experience in restructuring firms in financial difficulties. 7. Investment Instruments. Initially, FOMIN's investments were mostly in the form of new issues of common stock of its investee enterprises. Since 1981, however, with the encouragement and assistance of the Bank and IFC, FOMIN has broadened the range of its investment instruments with preferred shares and convertible credits. For the subordinated credits, FOMIN charges the companies CPP less 1, 2 or 3% depending on the company's location plus a no-conversion premium of 5%, applicable to the outstanding balance, if FOMIN fails to exercise its option to convert the credit into share capital. For FOMIN the advantages of using preferred shares and convertible credits are that they: (i) have allowed FOMIN to widen its potential customers and design packages to suit a customer's investment needs; (il) allow FOMIN to achieve a more stable and predictable income; (iii) both receive priority in liquidation; and (iv) for the thin market for minority equity investments, preferred shares have a higher appeal to outsie investors. Given these advantages, FOMIN attaches preference to the utilization of these instruments over common shares which are primarily used in cases where the prospects for eventual divestiture appear particularly favorable. Preferred shares have a cumulative dividend equivalent to 50% of the CPP. 8. From the clients' point of view, convertible credits are also more attractive than either common or preferred shares. Tbe two reasons for this are: (i) preferred dividends are not tax-deductible (as opposed to interest on convertibles) and to the owners of a small firm, payment of a 50%-after tax dividend is equivalent to paying a CPP credit; and (ii) the small firms hope to avert having FOMIN become a shareholder by duly paying on time the interest and maturities of the convertible credit. The mutual benefit to FOMIN and clients has resulted, however, in some overuse of the convertible credit instrument, and FOMIN is assessing its need solely based on the cash flow position of each enterprise. The new tax laws (favoring equity investments and lower permissible interest payment setoffs on debt) are likely to rectify the imbalance between equity and debt-type (quasi-equity) instruments.  - 40 - Annex 3 Page 4 of 9 9. Divestment Policy. FOMIN's investments are of a temporary nature, and its investment policy is guided by the likely prospects for liquidating investments. The typical time horizon to divest its interests is 5 years; however, in the past, FOMIN has continued to retain in its portfolio the good investment yielding returns to compensate for those experiencing problems. In future, FOMIN intends to pursue a more concrete divesture policy with its outside limit of a holding of up to 8 years. Within this timeframe, FOMIN would evaluate the following divestment avenues: (i) as in the past, the resale of shares to the current owners of the company; (ii) sale of shares by private placement to third party investors, who may have a natural synergistic interest in the particular affiliate; and (iii) sale to institutional investors like pension funds and insurance companies. D. Past Operations and Portfolio 10. As of December 31, 1985, FOMIN had active investments in 124 enterprises, in some of which FOMIN has made repeated investments or has both credit and equity financing. As of that date, the value of its portfolio was Mex$6.9 billion, with 39.7% as common shares, 40.1% as preferred shares and thedifference as convertible credits. Relevant data f the portfolio is in the Project File. 11. Portfolio Growth and Quality. FOMIN's portfolio has been growing from Mex$3.7 billion in 1983 , Mex$5* billion in 1984, to Mex$6.9 billion in 1985. rhe 1985 figure still needs to be restated to reflect the proportional gain for revaluation of assets or gains (or losses) of the invested companies (given the different fiscal years used by the companies; the figures are still unavailable). The portfolio has grown 51.3% from 1983 to 1984, and 23% from 1984 to 1985, when expressed in pesos. The figures expressed in dollars, however, show a decline from US$22.7 million in 1983 to US$15.9 million in 1985, due to the high rate of devaluation experienced recently. During 1985, the Technical Committee approved investments in 26 companies totalling almost Mex$2.6 bllion (US$5.8 nillion), and approved disbursements for the same companies of almost Mex$1.6 billion (US$3.8 million). In addition, the Committee approved the sale of the ownership held in 15 enterprises, with an investment value of Mex$256 million, for Mex$636 million. As of December 31, 1985, the sale of eleven of those investments had been concluded. 12. Since sales of portfolio in the last three years represent only a small portion of the investments (less than 8%), the quality of the portfolio still held is a more important ind'cator of the investment performance. Of the 124 companies, only 29 of the companies reported profits at the end of 1985, representing 23.4% of the companies and 21.8% of the portfolio; and 8 companies representing 6.4% of the companies and 9.3% of the portfolio were in pre-operating stage; twelve of the companies, representing 2.2% of the portfolio were in bankruptcy proceedings. The rest of the companies reported losses during the year 1985. Companies reporting losses represented 28%, 46% and 49% of FOMIN's portfolio in 1933, 1984 and 1985, respectively. However, the number of companies in bankruptcy proceedings has decreased from 18 to 12 (2.2% of the portfolio)  - 41 - Annex 3 Page 5 of 9 in the same period, reflecting a somewhat better selectivity of investment alternatives. The poor performance of FOMIN's companies during 1982-83 is reflective of the general economic and financial crisis which commenced in late 1982 and adversely affected the performance of the industrial sector across the board. Available datal/ on performance of industrial firms during the 1983-85 period show that, on aggregate, they suffered severe liquidity problems and the significant drop in domestic demand seriously affected their profitability. 13. Portfolio Distribution. The geographical distribution of FOMIN's portoflio has been quite balanced and supports the Government's policy of promoting investments outside the high concentration zones. At present FOMIN has outstanding investments with adequate coverage by priority zones. Of those investments, 35 are in Zone I (maximum governmet priority); 25 in Zone II (local state priority); and the difference, or 64 investments, have been made in Zone III, of which 2 are in Mexico City. In the last two years, only 31% of the new investments were in Zone III. FOMIN investments cover a wide range of industrial subsectors, and at present include investments in pulp and paper, wood products, food processing, steel, metal-mechanics, chemicals, and pharmaceuticals. Appraisal and Supervision Procedures 14. Appraisal. Since FOMIN is typically both the promoter and investor of the projects it invests in, its project processing cycle tends to be long, running, in some cases, 18 months from the initial contact stage to the initial disbursement of an investment. FOMIN's project evaluations are carried out by competent staff or by consultants hired by FOMIN (the cost is borne by the company). Although the appraisals adequately analyze the marketing, technical, financial, economic and administrative aspects of the project, the analysis often resembles more a standard project analysis than an investment evaluation. Missing are elements like comparison of strengths and weaknesse of the company and the competition; in-depth market analysis; optimization of the allocation of credit and share captial; sensitivity studies; and, analysis of rate of return for FOMIN. FOMIN at times lacks technical expertise to analyze technical specifications or equipment requirements and under the proposed project would utilize outside technical consultants where needed. In addition, the technical assistance program for FOMIN discussed in Annex 1, para 4, includes specific activities to strengthen the above-mentioned operational aspects of FOMIN. 15. Prior to the presentation of the appraisal report for the consideration of the Technical Committee, the financial arrangements are pre-negotiated with the sponsors. These negotiations include a definition of the amount to be invested as equity, and the corresponding ownership sought by FOMIN; the terms and conditions of the subordinated convertible credit, if any; and the terms of the repurchase agreement for the stock being acquired by FOMIN. The pre-negotiations are not always successful, resulting in a dropout ratio of about 20%, attributed mainly to the fact / Financial data on a large sample of firms was analyzed as part of the Bank's Industrial Sector Report (6215-ME) dated June 24, 1986.  - 42 - Annex 3 Page 6 of 9 that only during negotitations do the shareholders become aware of cost (dividend distribution or repurchase agreement); and (ii) FOMIN may impose 'tough conditions' to cover high risks associated with the project or its overall portfolio. 16. Following the Technical Committee approval, the project is turned over to the Control Department for its follow-up, disbursement and supervision. The Control Department is also responsible for additional investments in the same enterprise, if needed. A staff member of the Control Department, specialize in the particular industrial sector, is assigned to supervise the project. Faced with staff constraints, the staff member becomes the company's commissioner and even a member of the Board of Directors. In the last year, FOMIN has begun to rely on outside consultants to act as commissioners for particular industries. This arrangement has been useful since the cost of these consultants is borne by the company, while FOMIN has been able to gain access to a wide expertise which is sometimes lacking in its own staff. 17. Supervision. In the past supervision procedures have been a constant concern of Bank supervision missions. The small number of supervisors, the scattered location of the investment and the types of expertise needed to oversee a varied portfolio complicates a continuous and effective supervision of the investments. The quality and frequency of FOMIN visits made to the participating companies and statistical information on firms has improved following the institutional separation of analysis and supervision responsibilities, and the utilization of outside consultants for supervision. There is still considerable scope for improvement given that FOMIN is an influential shareholder and should be ready to provide invaluable technical and managerial assistance to the participating firms to resovle day-to-day problems. The technical assistance component of the project includes provisions to strengthen FOMIN's supervision role by helping FOMIN build up a good monitoring base for its firms. 18. Procurement and Disbursement. The use of FOMIN funds is subject to the same restrictions imposed by IBRD. Purchases for relatively large amounts requirecompetitive bidding and initial conditions of disbursement must be met prior to the first withdrawal from FOMIN's resources. For subordinated credits, FOMIN reimburses the enterprise against the presentation of invoices or shipping documents, while for the equity FOMIN disburses 20% of the committed amount initially and the difference against the progress of the investment plan. The provisions mentioned above allow FOMIN to adequately monitor the procurement or disbursements. 19. Accounting Procedures and Auditing. FOMIN has maintained an adequate accounting system following generally accepted accounting principles in Mexico. In addition, FOMIN requires the appointment of independent auditors and the utilization of generally accepted accounting principles in each firm where FOMIN participation is considered. The auditors are required to forward to FOMIN, in addition to the audited financial statements, a report on internal control, accounting and managemert practices of the company. The Secretaria de la Controloria  - 43 - Annex 3 Page 7 of 9 appoints FOMIN's independent auditors. The use of different auditors every year makes year to year comparisons more difficult, since the quality content of the auditing reports varies. The quality of the 1985 auditor's report was less than satisfactory in that it provides a very summarized statement of its financial position. The auditors have always qualified FOMIN's financial statements, due to the difficulties of obtaining the proportional equity net worth for companies with different fiscal years, which FOMIN is unable to assess on a timely basis. Past Financial Position 20. Financing Arrangment. Under the three previous SMI projects, FOMIN reimbursed PAI for all its recoveries of subordinated credit and sale of shares, but retained 20% of the interest collected and 50% of the profits accrued through the sale of shares. FOMIN is required (under a contract with PAI) to pay PAI both the recoveries of the share capital invested and the assumed profits, at the time the sale is made; even the sponsors are given up to 5 years to pay for the shares acquired from FOMIN. The interest generated by the installment sale are kept by FOMIN (outstanding portfolio of installment sales as of December 1985 represented Mex$350 million). In addition to its interest income, the Federal Government provides FOMIN a direct subsidy to cover its administrative expenses, which has declined from Mex$596 million (US$2.9 million) in 1983, to Mex$552 million (US$1.6 million) in 1984 and further to Mex$45 million (US$0.1 million) in 1985, against a requested amount of Mex$915 million. 21. Financial Performance. Results of equity sales have improved dramatically over the last two years, as a result of an extraordinary effort divest a portion of the portfolio. During 1984, FOMIN sold its participation in six companies, with a recorded investment of Mex$106 million for Mex$312 million or a 194% profit; and, during 1985, sold participation in 11 companies with investment value of Me.,$186 million for Mex$350 million, or 88% profit. A summary of FOMIN's key past financial data is given below, and is detailed in Annex Table 17 and 18. FOMIN - SUMMARY OF FINANCIAL STATEMENTS (Mex$ million) Year 1979 1980 1981 1982 1983 1984 1985 Interest Incomel/ 18.3 40.4 151.3 256.2 296.7 459.6 1307.6 Net Revenues 18.3 40.4 151.3 256.2 350.7 589.8 1465.9 Operating Expenses 29.9 34.5 61.4 80.7 142.1 230.3 391.5 Net Income (8.9) 5.9 89.9 175.5 207.3 360.6 1109.0 / Does not include income from stock dividends deriving mainly from revaluation of assets. 22. After experiencing losses in the past, FOMIN was able to report its first profits ever in 1980. The profitability has increased substantially both in nominal and real terms since 1980, as a result of a  - 44 - Annex 3 Page 8 of 9 growing portfolio, the utilization of convertible credits, interest income from term sale of shares and a more aggressive divestiture strategy. Future Investment Strategy and Financial Projections 23. Investment Strategy. Wh'le FOMIN's target market would still remain the SMIs, its investment strategy, under the proposed project, would begin to emphasize a distinct shift in favor of assisting newer enterprises, particularly those which intend using innovative technology and are export-oriented. The key element of FOMIN's future investment strategy would be to structure an investment portfolio which is well-balanced not only in sectoral or regional terms, but also in the degree of risk assumed and consequent expected return. In practice, strategy translates into balancing risky venture capital-type investments, (greenfield projects using innovative technology in the Mexican context) with investments in going, more mature concerns familiar with their markets and the technology involved. FOMIN participation in ongoing concerns would assist these companies to either enter a new market niche and/or become more efficient and more profitable. The capital gains from investments in existing companies are obviously going to be relatively modest, but this is likely to be compensated by the prospect of receiving a current yield through interest or dividend payment. The planned participation with private sector venture capital companies could provide FOMIN with good opportunities to identify and assist innovative investments. 24. Financial Projections. For the financial projections, a conservative approach has been taken. FOMIN expects to make 26 to 29, investments in 1986, 40 investments in 1987, 48 in 1988 and 53 in 1989, with an average investment per company of Mex$100, 170, 270, and 430 million, respectively. The breakdown investments is assumed to be 25% as subordinated credit ano 75% as share capital. The projections assume that the existing portfolio will be gradually divested producing a profit of 140% in nominal terms, and that new investments will be sold starting after the 4th year. While a summary of financial prospects is shown on the table below, Annex 9, T-17 shows the detailed results of the financial projections. FOMIN - SUMMARY OF FINANCIAL PROJECTIOS (Mex$ '000) Year 1986 1987 i988 1989 Interest Income 3,016.0 4,194.6 6,520.1 10,631.4 Profit on Sale of Shares 469.0 656.6 1,047.2 2,076.2 Other Income 15.6 20.3 32.9 43.9 Total Income 3,500.5 4,871.5 7,600.5 12,751.5 Reimbrusement to NAFIN Interest 1,288.1 2,021.4 3,198.5 5,334.9 Equity 234.5 328.3 523.6 1,038.1 Other Expenses 851.5 1,388.0 2,312.6 3,825.2 Total Expenses 2,374.1 3,737.7 6,034.7 10,198.2 Net Income 1,126.4 1,133.9 1,565.7 2,553.3 Total Portfolio 10,115.9 16,196.7 27,771.8 48,219.7 New Investments 4,000.0 6,800.0 12,960.0 22,790.0  - 45 - Annex 3 Page 9 of 9 25. Despite a substantial increase in the portfolio, the profitability of FOMIN is expected to remain relatively flat in the near future, as the income from portfolio sales (140% in nominal terms) is not very attractive. However, with the experience accumulated by FOMIN and the possibility of selecting from several investment alternatives, it is expected that the profits attained by the sale of porfolio held will rise in the future. 26. Funding Requirements. As shown in the table above, the investment program requires Mex$6.8, 13.0 and 22.8 billion (US$7.1, 8.4 and 9.5 million equivalent) for 1987, 1988 and 1989/90, respectively, totaling US$25.0 million equivalent. To finance this investment program, FOMIN will receive from IBRD US$20 million, or 80% of the investment program. Based on the assumptions discussed above, a conservative summarized cash flow statement is shown below: FOMIN - PROJECTED CASH FLOW (Mex$ million) Year 1987 1988 1989 Initial Balance 1,234.4 1,511.6 1,907.8 Income from Operations 1,350.0 1,620.0 1,945.0 Direct Counterpart 6,800.0 12,960.0 22,790.0 Disbursements from IBRD 4,111.9 7,303.0 12,733.9 Principal Repayments, Other 13,496.3 23,394.6 39,376.7 Total Sources Total Applications New Investments in Shares 5,100.0 9,720.0 17,200.0 New Investments in Credits 1,700.0 3,240.0 5,590.0 Reimbursements to NAFIN 3,237.0 5,168.4 9,048.4 Operational Expenses 1,073.0 1,756.0 2,870.0 Other 2,109.1 3,114.0 4,755.0 Total Applications 13,219.1 22,998.4 39,463.4 The need for fresh funds could be reduced, if FOMIN is made an autonomous institution by capitalizaing disbursement under the proposed loan and FOMIN is also allowed to retain the recoveries from the investments made to date. With this scenario, if the financial projections materialize, the need for fresh funds for FOMIN would be reduced to Mex$2.1 billion (uS$2.2 million) in 1987, Mex$5.5 billion (US$3.6 millin) in 1988 and Mex$10.2 billion (US$4.3) in 1989, or about US$10 million for the three year program.  - 46 - Annex 4 Page 1 of 5 MEXICO FOURTH SMALL AND MEDIUM INDUSTRY DEVELOPMENT PROJECT Guidelines for the Restructuring Component 1. The high inflation rates and the massive devaluations of 1982-83 (which sharply increased the debt burden of companies with foreign debt exposure) have brought to surface the risks inherent in overleveraging companies at times when credit was relatively easy to obtain and when debt was preferred over equity for reasons of tax benefits, etc. Available figures show that the debt/equity ratio for the industrial sector in Mexicol/ climbed from about 1.7:1 in 1980 to more than 3.2:1 in 1983, while the debt/service ratio fell from 2.6 to -0.2 over the same period. Although the financial structure of industrial companies reportedly improved during 1984, partly on account of the Government's scheme to convert foreign debt into pesos (FICORCA) and a temporary upturn in demand, company liquidity is likely to deteriorate further in the next year in view of the projected high inflation rates and because repayments under FICORCA will become due. An important part of the strategy to revive growth and investment in Mexico's industrial sector would therefore be to put in place a program of financial restructuring for firms which are operationally profitable and economically efficiernt but are unable to service a bloated debt. While the preferred solution for the financial problems of companies is for the creditor banks to systematically review their performance and work out restructuring strategies, to date the nationalized commercial banks have not felt any pressures to undertake restructuring schemes on a systematic basis. The existing regulatory body does not strictly enforce the requirements of portfolio and bad debt management and there is need to tighten banking supervision. It is therefore proposed that Government initiate a study to identify weaknesses in the regulatory functions of the Superintendency of banks and based on the study to introduce improvements in the system. 2. In the interim, it is proposed that FOMIN, in close collaboration with the commercial banks, initiate a pilot program of financial restructuring for firms in financial distress. An acceptable restructuring plan under the proposed scheme would, however, need to encompass not only an assessment and resolution of financial aspects but it would need to address other underlying causes for the financial problems such as inadequate management, inappropriate production mix, misplaced marketing strategies, and inappropriate or obsolete technologies. To avoid giving the impression of a Government bail-out, the restructured firms would bc selected on a case by case basis. The Bank together with FOMIN (the Government risk capital trust fund) identified a pilot financial restructuring component with a total cost of US$50.0 million including Bank financing of US$25 million. The pilot restructuring component is expected to benefit the enterprises by helping them increase production and, at the same time, the commercial banks would be able to improve their portfolios. Above all, it is expected that FOMIN's participation would further promote / Based on a sample of enterprises whose financial returns were analyzed in the Trade Policy, Industrial Performance and Adjustment Sector Report, (6215a-ME), June 24, 1986.  - 47 - Annex 4 Page 2 of 5 the development of capital markets through the sale of securities belonging to SMI's. The detailed Operating Regulations for the restructuring component which were developed by FOMIN and the Bank during pre-appraisal were confirmed at negotiations. The broad operating guidelines are discussed below. Restructuring Instruments and Arrangements - Restructuring Instruments. The underlying principle of the restructuring component would be to make the debtors and creditors share equally any losses resulting from the proposed financial workouts. Since the nationalized banks in Mexico have to be offered an incentive to take s:ock of their losses, and give up the practice of showing book profits by accruing interest payments and other charges, FOMIN would provide from its own resources to purchase up to 50% of the shares acquired by the creditor bank as part of a debt to equity swap for the restructured firm. In the typical case, in addition to debt/equity conversion, additional fresh funds will be needed to finance working capital and fixed asset investment. The typical corporate workout would thus include the following: (a) writing off part of the accumulated bank penalties, charges, etc.; (b) converting part of the debt into equity;(c) rescheduling the remaining debt with maturities that span over medium to long term; (d) replenishing working capital and (e) investing in new fixed assets. Bank financing would only support investments in (d) and (e). - Preconditions for Restructuring. The banks and the current owners Nust agree on a base balance sheet, reflecting the real net worth of a company, taking into consideration an adquate reevaluation of assets and confirmed outstanding liabilities. The company must be agreeable to disposing of non-essential assets to reduce its outstanding debt and to cater for fresh working capital. The creditor banks should commit in principle to consider reducing their claims on the firm's cash flow by condoning all outstanding penalty charges and fees related to the debt in default, and converting part of the unserviceable debt into equity or quasi-equity. Existing owners would have to agree to the proposed debt/equity swaps and the subsequent sale of equity through private placements or other means. - Restructuring Plan. Each workout proposal would have four basic elements, namely, management, marketing, production and financial plans. (i) The management plan would review the existing managerial capacity and suggest a formal organization which is often lacking in family businesses. The need for specialized staff and technical training would also be identified. (ii) The marketing plan would be aimed at increasing the firm's revenues through emphasis upon the more profitable products and customers, product redesign, quality and packaging improvements, and geographic coverage; (iii) the production plan would be devised to fill the needs identified under the marketing plan and could  - 48 - Annex 4 Page 3 of 5 include measures to curtail productive capacity or, alternatively, for a fuller utilization of existing capacity; and (iv) a financial plan, the elements of which are discussed below. Each restructuring proposal would Include an independent legal opinion confirming the beneficiary firms' controlling interest and that the proposed refinancing scheme was legally binding and enforceable. Covenants limiting future borrowings by the company would be included in the overall financing agreement. - Incorporation and Ownership. The company to be restructured would be a duly incorporated entity in accordance with Mexican laws, and its activities would be concentrated in the industrial sector. Preference would be given to exporting companies. The controlling interest in the company would be clearly defined. The direct or indirect participation by FOMIN and the commercial banks would be less than 50%; this will put a limit on the amounts eligible for debt/equity swaps. - Required Copany Performance. While the restructuring exercise would essentially concern itself with an evaluation of future profitability the following broad guidelines would determine the eligibility of participating companies. Compar.ies should be operationally viable but due to overindebtedness, unable to fully service their existing debt. After the proposed restructuring and based on reasonable projections, these companies should be financially viable. - Limits of Participation, As in the case of its regular program, FOMIN's participation in any single enterprise would n-ot exceed 102 of its share capital (currently this participation is expected to be less than US$1 million). FOMIN would not acquire more than 50% of the equity converted from debt. Insofar as workouts provide a rare opportunity to reduce concentration and create ownership structures consistent with more active capital market development, FOMIN would try to solicit buyers for the converted (debt to equity) shares. Nevertheless, to protect its financial interest it would enter into a repurchase agreement with the banks, with FOMIN thus acquiring the right to sell them at a minimum guaranteed price (in real terms) the shares originally purchased from the banks. The minimum expected return on FOMIN's investments would be the same as under its regular and quasi-equity investment program. Determination of Debt Service Capacity. In determining the amount of debt to be serviced by the restructured company the guideline would be to determine a principal amount outstanding which car. be serviced over a period of ten years taking into account the projected cash flow of the company; however, prior to defining the debt the banks and the company must agree on the treatment to be given to the depreciation, and the amount of funds the firm would retain to increase working capital or replace equipment. Provisions for prepayment of debt would be included.  - 49 - Annex 4 Page 4 of 5 Implementation Arrangements - Preparation of Restructuring Proposals. The commercial banks would play a lead role in identifying potential companies and in drawing up restructuring prtQosals for FOMIN's review. It is expected that the involved banks would do a better job of aiding restructuring because of their knowledge of industrial companies, and they will be seeking to improve their own portfolios. In the case of more than one creditor bank an agent or lead bank would be appointed to carry out the restructuring exercise including negotiations with the company. The lead commercial bank would regularly supervise the subprojects in close coordination with FOMIN to see if the subloans are utilized for the purposes intended and that the financial and other conditions affecting operating performance are progressing satisfactorily. Supervision visits would be coordinated with FOMIN who would also have the right to visit the beneficiary enterprises. Commercial banks would submit semi-annual reports to FOMIN on the performance of the portfolio financed out of the loan proceeds. These understandings would be part of the legal contract between all parties to the restructuring exercise. - FOMIN's Evaluation and Supervision. FOMIN, as the executing agency, would manage the funds for this component and would be responsible for approving all restructuring proposals to be financed under the project. In addition to the traditional project analysis and documentation requirements for equity financing, FOMIN's review would place particular emphasis on the analysis of the company as a whole, including its management effectiveness, production strategy and future market prospects and prospects for liquidating its own equity or quasi-equity within a specified timeframe. Since skilled financial appraisal is needed to diagnose the underlying problems of the enterprise, and considerable knowledge of products and markets is needed to determine expected long-run financial viability, the institutional capacity has to be developed to carry out these tasks. Accordingly, the technical assistance funds under the proposed project include provisions for experienced consultants to assist both the creditor banks and FOMIN to prepare restructuring proposals and review for FOMIN the viability of financial projections in light of the assumptions in the marketing nad production plans. While the banks would have primary responsibility for supervising the restructured company, FOMIN would be associated in that supervision and, moreover, it would make random checks and stand ready to provide its clients technical and management assistance. Eligible Expenditures. Project funds would primarily be used for breaking production bottlenecks and financing fresh permanent working capital. FOMIN subloans for equity investments would be used to finance the same expenditures (plant, equipment and permanent working capi.al) as under FOMIN's regular financing program. However, under the financial restructuring program 100% financing would be provided for permanent working capital loans.  - 50 - Annex 4 Page 5 of 5 This percentage of participation is to enable FOMIN to use its own resources to finance the conversion of debt into equity. A transfer of existing shares from current owners to creditor banks would not be eligible for financing, with Bank resources.  - 51 - Annex 5 Page 1 of 3 MEXICO FOURTH SMALL AND MEDIUM SCALE INDUSTRY PROJECT Review of Ongoing Micro-Enterprise Programs Experience Under Existing Programs 1. A start was made in supporting micro-enterprises in the informal sector through five small project loans financed by IDB (the maximum IDB loan to one promotional agency is US$500,000). The first of the IDB programs was initiated in 1982 when 4' assisted private agencies in Monterrey (ADMIC-Asesoria Dinamica a Microempresas)l/ and in Chihuahua. At the same time programs were implemented through NAFIN using State-supported agencies in Hidalgo (Impulsora), Michoacan (FFOMICH--Fondo Mixto para Desarrollo Industrial) and Puebla (Promotora). To date these five agencies have disbursed close to US$2 million in credits ranging from Mex$0.2 to 7.0 millions (i.e., and US$300 to US$10,000). Recently some agencies (Impulsora and Promotora) have increased their loan size to Mex$12 million (around US$16,000). 2. All credit programs have been using highly subsidized interest rates ranging from 40 tc 50% of ACF. While the information on the impact of the existing programs with the private agencies is scanty, the loan recovery performance is reportedly good. The promotional agencies themselves have expanded their activities outside their original locations which indicates the successful nature of the operations. Two of the agencies, ADMIC and Desarrolo de Chihuahua, had submitted formal proposals to the Bank appraisal mission for a special line of credit amounting to US$4 million for micro-enterprise lending. NAFINSA has drawn up a list of 20 other promotional agencies which have expressed interest in participating in the program and it is estimated that the demand over the next three years (1986-89) will be the equivalent of over US$30 million--enough to absorb the projected loans of US$20 million from IDB and the proposed US$10 million Bank component, under the Fourth SMI Project. State Guarantee Funds (Fondos Estatales) 3. Recognizing that lack of collateral requirements has been a major problem for micro-enterprises, the State Governments have set up ?6 State Guarantee funds (Fondos Estales) since 1983. These funds were capitalized with State budget resources for a total amount of Mex$1,905 million (approximately US$2.5 million). Each State Fund can provide guarantees up to 10 times itscapitalization and up to 80% of each loan. The Funds were created with the objective of providing guarantees under the old definition of micro-enterprises as used by FOGAIN (i.e., those in the formal sector and receiving credits through the banking sector) but under the pilot program they will play an important role in guaranteeing credits to micro-enterprises in the informal sector. 1/ ADMIC which has been operating since 1980 and which received its first IDB loan for US$300,000 in 1982, gave out 380 credits for MEX$76 millions in 1985 and 144 dredits for MEX$50.775 millions in the first three months of 1986.  - 52 - Annex 5 Page 2 of 3 4. As may be seen from Annex 9, T-19, the use of the State Funds until now has been relatively slow. Up to the end of August 1986, only 825 guarantees have been approved for an amount of Mex$1,727 million (US$2.2 million)--only 9% of the maximum amount of guaranteed loans authorized; 560 (66%) of these guaranteed loans were given by NAFIN, but there has been a start in the use of the Funds by other banks. It is expected that the use of the Funds by the commercial banks will increase in the next year as their existence becomes more widely known. Proposed Program 5. Rationale. Micro-enterprises will provide Jobs for a large proportion of the newcomers to the labor force and for displaced workers. It will also represent an important source of income for poor families and help mobilize private savings. A recent Labor Secretariat survey estimates that more than 35% of the labor force is employed in the informal sector micro-enterprises. In manufacturing, the relative contribution of micro-enterprises is greatest in domestic resource based industries such as furniture, metal parts, assembly operations, bakery products, etc. Although the evidence is fragmentary, micro-enterprises on the whole appear to use factors of production more efficiently relative to large firms and with greater employment-creating effects. In recognition of the important role micro-enterprises play in employment generation and their present preponderance, it is proposed to include a free-standing micro-enterprise credit component under the project (Main Report, para. 2.07). 6. Proposed Credit and Participating Agencies. The US$10 million component will finance credits to micro-enterprises for both fixed asset and working capital investments. The maximum amounts for fixed asset financing would be US$16,000 and up to US$8,000 for free-standing working capital loans. The cumulative amounts under the two categories would be restricted to US$20,000. Training of credit recipients described in para. 10 would be an integral part of the credit program. 7. Both state-managed programs and those run by non-Governmental organizations would be financed through the proposed pilot credit component for micro-enterprises. It is expected that 50% of the credit resources would be used by private sector agencies. The overall responsibility for managing the program would be that of a Coordinating Committee in NAFIN which will, among other things, have responsibility to review credit applications from promotional agencies and approve special lines of credit for them. The Coordinating Committee will also develop credit policies and review the progress of this pilot program. The progress of the program and other supporting work would be carried out for the Committee by a small technical secretariat. More specifically, the technical staff would supervise on a sample basis the performance of the subloans at the beneficiary level, and prepare progress reports and draft policies and regulations for consideration by the Coordinating Committee. The promotional agencies would be the main contact point with the beneficiaries, bearing the credit risk and evaluation individual subloan applications. For subloens above US$5,000 a special local credit committee is proposed to be established on which the local NAFIN representative would be a member. At the NAFIN (HQ) level the documentation and administration of subloans would be managed by NAFIN's Credit Directorate, which will also use its supervision staff to carry out periodic spot checks to supervise  - 53 - Annex 5 Page 3 of 3 the use of credit resources at the beneficiary level. For nonitoring purposes, loan recoveries will be made through NAFIN's regional branches, with information linkages to the technical secretariat's micro-computer system to be set up with the project's t.a. funds. 8. To qualify as a promotional agency, each organization would submit a financing proposal to NAFIN which would include: (a) a survey of the number and type of micro-enterprises in the geographical area to be served; (b) demand estimates and types of financing intended to be provided; (c) specific training proposals in areas discussed in para 10; and (d) evidence of State Government's support. The Bank would review and approve for financing, the first two inestment proposals (in the private and public sectors) screened by NAFIN each year. 9. Technical Assistance for NAFIN and Promotional Agencies. In the technical assistance component provided by the project, about US 300,000 will be provided through NAFIN to strengthen the micro-enterprise support program. The amount will be broken down as follows: (a) consultancy services for NAFIN technical staff responsible for monitoring the program and in selecting and screening of promotional agencies: US$50,000; (b) credit control systems through the acquisition of micro-computers and accessories together with required software: US$100,000; (c) assistance to participating agencies in carrying out surveys and studies of micro-enterprise credit and t.a. needs and drawing up of submissions to NAFIN: US$100,000; (d) preparation of case studies, training manuals and didactic material including videos for micro-enterprise training programs: US$50,000. Requests for use of the technical assistance funds will be channeled through NAFIN and submitted to the Bank for evaluation, and approval. 10. Proposed Training Programs. An intrinsic part of the micro-enterprise support program will be the provision of technical assistance and management training for participants. Those receiving credit will be required to receive training in bookkeeping and financial management only if enterprises are unable to show that they have the basic accounting systems in place. Some basic simplified courses in production management and marketing will also be given. Each agency will make suitable local arrangements to provide training and technical advice to micro-enterprises in their area, especially to those receiving credits. While each promotional agency would submit to NAFIN its training proposals including the names of the training institutions proposed to be involved, the following national training institutions are likely to play a lead role: CONALEP (Colegio Nacional de Educacion Tecnica Profesional), PAI, CONACYT (Scientific and Technical Nadional Council), SEP (Educational Secretariat) and INFOTEC. The training activities would be financed from a portion of the interest rate spread retained by NAFIN in a Special Micro-Enterprise Credit Fund to be established by NAFIN and to be capitalized initially from the interest earnings from the subloans, and later with loan recoveries. The training funds would be allocated once NAFIN has approved the training plan submitted by the agency as required under para. 8(c) above.  - 54 - Annex 6 Page 1 of 10 MEXICO FOURTH SMALL AND MEDIUM INDUSTRY CREDIT PROJECT Experience under Past Lending 1. The Bank has made three loans in Mexico to support the "Integrated Support Program for Small and Medium Scale Industries" known as PAI. The first SMI loan (US$47 million) was approved in April 1978; the second SMI loan (US$100 million) was approved in June 1983. The first loan helped establish and support the PAI program which was implemented through a high-level Coordinating Committee in NAFIN and a technical secretariat. All three projects helped support the lending activities and institutional development of three Government trust funds serving SMI's, namely, FOGAIN (the credit institution), FOMIN (the risk capital financing institution), and FIDEIN (the industrial buildings and park development agency). In addition, the three projects helped finance the expansion of PAI's Technical Secretariat, and its extension service, and strengthening of the services of national technical assistance agencies like INFOTEC, CONACYT, and CENAPRO. 2. The recent PCR of the first two projects and a sample survey of subprojects finianced under the third loan show that in general Bank funds under the previous loans were allocated to sound subprojects which had a substantial employment impact and were geographically well dispersed. The experience under the previous projects is discussed in the following paragraphs, while a discussion of the more recent institutional development of the PAI executing agencies (FOGAIN FOMIN) is in Annexes 2 and 3. Loan Commitment and Disbursement Speed 3. The first SMI loan (1552-ME) became effective January 12, 1979 and was fully committed by 30 September 1981, only three months after the original termination date for the submission of subprojects. However, during the initial implementation phase disbursements were at a standstill, mainly because the Mexican authorities and the Bank could not agree on the interest rates to be applied under the project. Once this issue was resolved, disbursements moved rapidly and by end FY79 amounted to US$27.2 million, about 155% more than estimated at appraisal. The rather impressive rate of loan utilization under Loan 1552-ME can be attributed to the investment boom in Mexico during the 1979-80 period. The experience with the utilization of the second SMI loan (1881-ME) was equally positive, with almost 50% of the loan funds (US$46 million) committed during the first year of implementation. Total accumulated disbursements under this loan reached US$92.5 million (out of a loan of US$100 million) in the fourth year of implementation. The closing date of the loan was extended, however, for six months to June 1985 to allow additional time for remaining disbursements.  - 55 - Annex 6 Page 2 of 10 4. The third SMI project (2325-ME) became effective June 16, 1984 and after a relatively slow start, disbursements moved rapidly at the end of 1984. Within the loan categories the FOGAIN credit component has been utilized at a fairly rapid pace, while the FIDEIN resources had to be augmented with a reallocation of US$8.0 million to enable lending for industrial buildings. The FOMIN equity investment component has been the slowest moving, mainly due to the somewhat conservative subproject selection criteria and the preference of FOMIN to fully utilize its budgetary resources to avoid a cut in its level in the next budget year. The pending subloans and pipeline as well as joint financing agreements with State Venture Capital Funds are expected to accelerate use of the remaining US$7.0 million loan funds. As of March 1987, US$155.0 million have been disbursed and the remaining loan balance is expected to be fully committed by June 30, 1987, that is six months after the original closing date. 5. The serious economic situation in Mexico, particularly the persisting high levels of inflation, combined with the US$180 million IDB loan approved in January 1986, indicates that the loan utilization under the proposed fourth SMI project may be less rapid than in the past. Consequently, the appraisal mission pared down the total loan amount from the US$245.0 million requested by NAFIN to US$185.0 despite the fact that two new components costing US$35.0 million were added to the project. Furthermore, loan categories were made flexible to allow a quick reallocation of resources to those programs which move relatively faster. The disbursement profile of the proposed project (Annex 8) has been based on the average profile for LAC industrial finance projects, which is more conservative than experience under earlier Mexican SMI projects. Experience with PAI Program Coordination 6. In recognition of the need to streamline the several financing and technical assistance schemes for the SMI's, NAFIN created in 1978 a comprehensive 'Integrated Support Program for SMI" called PAI. This Program was to be financed through a specially created project financing Fund which was initially capitalized with a Government contribution of US$22.5 million. Additionally a special credit line of US$19 million from Banco de Mexico was made available to meet the counterpart financing requirements of the Bank-assisted credit schemes which were part of the whole PAI program. In fact, the Bank's first SMI project provided the operational basis for the Program, and the recoveries from all Bank- assisted SMI projects were to further capitalize the PAI Fund. To provide policy guidance to the various participating institutions, a central authority in the form of a Coordinating Committee was created in NAFIN. The Committee was chaired by the President of NAFIN and had as its members the joint directors of NAFIN as well as representatives from the Ministries of Finance, Industry and Urban Development. Other members included representatives from the Chambers of Commerce and the Directors General of the participating institutions. In sum, the Committee was unwieldy and too large to be effective. In discharging its responsibilities, the Committee was to be assisted by a Secretariat with a full-time technical staff, which was also responsible for onerating an SMI extension service and soliciting the support of several technical assistance institutions engaged in the  - 56 - Annex 6 Page 3 of 10 industrial sector. Within the foregoing structure, another processing level was the NAFIN Directorate of International Organization which became a filter for all communications with the Bank including the forwarding of subprojects. The channel of subprojects was thus: executing agencies- PAi--NAFIN--Bank. 7. During the implementation of the three projects, the PAI Coordinating Committee took a peripheral interest in project affairs and in the last three years even failed to meet in the capacity as PAI's policy making body. Parallel to this development was the assumption of a more direct responsibility by the PAI technical secretariat in coordinating and financing the Program. This unplanned role or 'interference" was strongly resisted by all executing agencies, but mainly by FOGAIN 'which felt responsible to its own Executive Board and did not like their atautonomy" to be reduced especially when PAI resources only represented 30% of FOGAIN's overall lending program. To avoid friction and to increase the linkages between PAI's extension services and the credit program a complete merger was carried out of the PAI staff with FOGAIN (from 1980-83). However, the two institutions were separated again in 1984, which again gave rise to the problems mentioned above. 8. The experience with the PAI Fund was equally disappointing with PAI making operating losses during each year of its existence, because of the following main reasons: (i) PAI borrowed high-cost funds from the market to finance the counterpart fund requirements for all participating institutions (on average 27% of the investment cost), while it received inadequate margins from the institutions out of the interest rate spread; (ii) the foreign exchange risk on interest repayments to the Bank was borne by PAI; this was a severe drain during the 1982-83 devaluations; and (iii) the unprecedented expansion of PAI's operations and extension staff from a mere 12 at inception of the Program to 246 as of December 1985. To compound PAI's problems FOGAIN (the largest user of PAI's funds) refused to transfer loan recoveries to the Fund, leaving PAI to raise its funds from the open market at effective interest rates as high as 90% per annum. The design of the proposed project takes into consideration the institutional experiences discussed above. And, in discussions with Government/NAFIN officials it has been agreed to make implementation arrangements which ensure: (a) a strong coordinating role by an effective high-level Coordiuating Committee with clearly defined responsibilities towards the program in NAFIN; (b) adequate capitalization of trust funds-through retention of loan recoveries, exemption of exohange risk, and adequate interest rate margins-to make them self-financing in the medium term; and (c) flexibility in the loan components, allowing the Coordinating Committee to reassign the loan resources to components which show greater promise during implementation. Lending Profile 9. Quality of Data on Portfolio. While data on overall FOGAIN operations at the subproject level is readily available, wore specific data on the operations relating to the Bank financed subprojects is not obtainable. The OGAIN information system was never programmed to provide e for the lack of information at the commercial bank level. The project  - 57 - Annex 6 Page 4 of 10 includes technical assistance funds to help develop the information and control system both at the FOGAIN and commercial bank levels. To compare the characteristics of FOGAIN's overall lending with that under the Bank- assisted projects a sample was undertaken of 85 subprojects for the first SMI loan and 245 for the second SMI project. (Project File). The lending characteristics under the Bank-financed subprojects were found to be generally in line with the overall operations. The discussion on FOGAIN's lending characteristics, therefore, is based on the entire universe of subprojects financed by FOGAIN. For the economic anti financial impact of the subprojects the results of the sample subprojects are analyzed. 10. Characteristics of FOGAIN Subprojects. Data on the major subproject characteristics is shown in Annex 9, Tables 10 to 13. In its 31 years of operation, FOGAIN has concentrated on financing working capital requirements for SMI's (54.6% of total lending), fixed asset (38% of total loans), and debt consolidation operations which represented 7.4% of total lending. To date FOGAIN has made about 66,925 credits to about 35,000 enterprises of which 80% were small scale industries. The total amount of financing for the period was MEX$298.0 billion, of which 56% was allocated to small scale and the rest to medium scale enterprises. In the more recent period, FOGAIN's operations have increased from 5,926 credits in 1980 to a peak of 12,759 credits in 1985 totalling MEX$124.0 billion, at an average annual growth rate of 69.0% in nominal terms but less than 1% in real terms. In US$ terms, FOGAIN's portfolio was US$396.0 million equivalent in 1984 increasing to US$399.0 in 1985. An interesting feature of FOGAIN's lending operations was that while the loan volume in real terms grew by only 2.3% during the entire period of 1980-85, the number of loans increased by 115%, leading to a corresponding reduction in the average size of subloans from US$65,800 in 1980 to US$31,300 in 1985. The decline in loan siize can be attributed to two causes: (a) the successive devaluations that reduced project costs in US terms; and (b) the recession of 1982-83 which found FOGAIN financing a larger proportion of expansion project and working capital credits; both types of credits require on average lesser financing than new projects. 11. Regional Focus. Although the regional composition of FOGAIN's portfolio has followed the general pattern of industrial concentration in Mexico, the largest number of enterprises financed were in Mexico City, Monterrey and Guadalajara. Over the last six years FOGAIN resources have been increasingly directed to supporting investments in the high priority Zone I. Whereas in 1979 only 32.5% of FOGAIN-supported industries were located in this zone, in 1984 this figure Jumped to 71%. More recently, FOGAIN's 1986 Operating Regulations actually exclude financing in Zone III. 12. Sectoral Distribution. FOGAIN has distributed its resources widely in several subsectors. Traditionally the four most important subsectors financed were food and beverages (19.5%), metal mechanics (9.0%), chemicals (7.9%), and textiles and apparel (6.2%). Overall 44.2% of FOGAIN financing went to the consumer goods industries; S3.7% for intermediate goods and only 12.1% for capital goods. However, more recently the financing share of capital goods has shown an increasing trend (from 10.7% of total financing in 1983 to 11.3% in 1985).  - 58 - Annex 6 Page 5 of 10 13. Financial Intermediaries. While almost all commercial banks have discounted their loans with FOGAIN, five banks (BANCOMER, BANAMEX, BANCO INTERNACIONAL, NAFIN, and BANPAIS) accounted for more than 50% of lending and 90% of total commitments in 1983. The rediscounting pattern .las, however, shown a marked shift in favor of two intermediaries, NAFIN and its sister organization BANCO INTERNACIONAL which together received 23.8% of FOGAIN credits in 1982, rising to 38.7% in 1985, and increasing further to 53.2% in the first six months of 1986. This shift is attributed to the more liberal collateral policy of the two institutions as well as the fact that until 1985 NAFIN (as a specialized industrial development bank) enjoyed a higher autonomous loan approval limit than the other commercial banks. In addition, recently the commercial banks have shown some reluctance to use FOGAIN's rediscount facilities, claiming that they find it difficult to meet the requirement to provide the increasing financial contribution (up to 35% of total amount of subloan), in the face of a tight liquidity situation and, moreover, that FOGAIN borrowing involves "heavy bureaucratic paperwork". The technical assistance component of the project is designed to simplify the loan processing procedures both at the FOGAIN and PFI levels, ensuring that FOGAIN's second tier operations benefit from the 5500 branch network established by all commercial banks. The aim, over the life of the proposed project, would be to broaden the use of FOGAIN funds amongst the several commercial banks, and to reward (through higher subloan autonomous limits, etc.) those PFI's which introduce adequate measures to improve evaluation and supervision of its subloans. Characteristics of FOMIN's Portfolio 14. FOMIN has financed 89 subprojects under the first two loans, of which 63 were direct equity pariticipations and the rest took the form of convertible subloans. The total cost of FOMIN investments was US$31.4 million, including US$18.5 million of Bank funds. Seventy percent of the subprojects under the first SMI project and 79% under the second SMI project were concentrated in medium scale enterprises. Only 4 subprojects received the maximum financing permissible under the project, with the average size of FOMIN investments during Loan 1552-ME of US$530,000 and during Loan 1881-ME US$264,000. Of the 89 investments only 7 were to new enterprises; this figure increases o 35 if new projects of existing enterprises are included. FOMIN investments cover a wide range of industrial subsectors such as food processing (which received 23% of subprojects and 39% of resources) and basic metals (20% of subprojects and 21% of resources); other areas of investment were pulp and paper, wood products, chemicals and servicing industries. The geographical distribution of FOMIN subprojects has been improving; under the first SMI project 39% of the subprojects were located in the low priority Zone III. At present, only 20 investments out of 125 are in Zone III. Subproject Performance Impact of FOGAIN Subprojects 15. FOGAIN's monitoring of its subprojects during implementation has been less than satisfactory, albeit improvements have been noted over the implementation of the three projects. Major reasons are the large volume  - 59 - Annex 6 Page 6 of 10 of business (average lending of US$300 million a year), the numerous clients (average 11,000 credits a year as of December 31, 1985) and the resistance of the PFIs to replace collateral financing with that based on project analysis. In addition, the computerization of FOGAIN operations, supported by the Bank, suffered a severe setback during the September 1985 earthquake. All this notwithstanding, there is need to further streamline the subproject follow-up procedures, enabling FOGAIN to better assess the impact of its financing at the beneficiary level. The technical assistance component under the proposed project is designed to assist FOGAIN and its financial intermediaries to develop a standard and reliable data base on its sub-borrowers with an objective of carrying out a regular performance assessment of the investments it finances. 16. At the outset it needs to be noted that in the past FOGAIN had no standard requirement to calculate ex-ante rates of return (let alone ex-post rates of return) for its subloans. This shortcoming was first seriously addressed by the Bank's supervision mission in February 1985 when an Agreement was signed between Bank/FOGAIN/NAFIN/PAI/HACIENDA requiring both ex-ante and ex-post financial rates of return for Bank-financed subloans. Economic rates of return were to be calculated for selected subprojects. Consequently while the impact of the subproject can be derived from the sample of subprojects analyzed, it is not possible to draw conclusions about the quality of projections or the basis for FOGAIN approvals of subloans--clearly the yardstick was collateral offerings. All these shortcomings are being addressed under the proposed project, which includes technical assistance funds to improve the monitoring of subloans during both the investment and post-investment phases. 17. As part of the PCR of the first two SMI loans, FOGAIN/PAI carried out an ex-post analysis of a sample of about 350 subprojects financed covering different sizes and subsectors. These surveys were cross-checked through mission visits to 12 randomly selected enterprises. Finally, to qssess the more recent developments under the ongoing Third SY'I project, financial analysis was carried out by the appraisal mission for 32 subprojects (provided by FOGAIN) and 17 others provided by PAI, which had data on both "with" and "without" project financing. The results of this analysis are in para 18. According to the sample of subprojects analyzed, FOGAIN has been financing economically and financially sound investments. For example, the average financial rate of return (in constant terms) for the sample of subprojects authorized under the two SMI projects was 47%; the average economic rate of return (in constant terms) for 70X of the sampled subprojects was 55%. These results suggest that FOGAIN has been an important element in fostering the growth of sound investments according to the general objectives and policies established by the Government for the SMI sector. The employment effects of the subprojects are quite positive, generating 4,300 new jobs at an average cost of US$9,000 in 1982 constant terms. 18. Financial Performance of Sampled Subprojects. Results of the analysis of subprojects sampled (32 FOGAIN and 17 sampled by PAI), contained in Annex 9, Table 20, show the following characteristics: (i) while the sampled subprojects are relying heavily on short-term credit  - 60 - Annex 6 Page 7 of 10 (80% of their total debt), their current ratios reflect a fairly liquid situation; (ii) the operational profit of these SMIs is high when compared with their financial costs, reflecting a risk averse financial policy by the entrepreneurs, which may also explain the resiliency of SMIs during periods of economic downturn; (iii) the profitability of the firms examined is very high. Since their net worth has been revalued the net profit/net worth ratios reflect real returns on equity which are of the order of 20% each year. This could be attributed to the very high gross sales margins--an indication of lick of competition, and to the correspondingly high operational margins; (iv) the low sales/assets ratios of the sample firms reflect excess capacity, a phenomenon which was confirmed by the entrepreneurs during the interview with the mission; and, lastly, (v) the very small-scale firms in the sample showed moderate levels of indebtedness which confirmed the fact that they mainly relied on their own resources for financing investments or borrowed from supplies credit which did not accrue interest, according to the practice, if paid between 30 to 60 days after delivery. The mission compared the data from the sampled firms with a larger sample of SMIs surveyed in 1982 by the office of the Economic Advisors of the President. The survey also showed that SMIs were moderately leveraged (52% of total assets); that their liabilitites were short-term (between 80 and 90% of total debt); and their liquidity high (current ratios of 1.5). Regarding profitability, the PAI-FOGAIN sample shows company profits to be considerably higher than those in the large sample. This could have occurred because the FOGAIN/PAI sample was pre-selected to include only creditworthy firms. Overall the SMIs financed by FOGAIN seem to operate with comfortable profit margins and positive ERRs and FRRs. Quality of FOMIN's Portfolio 19. Quality of FOMIN's Portfolio. During the first two loans, FOMIN's portfolio grew from 64 enterprises totalling MEX$181.9 million (December 1977) to an aggregate investment of MEX$6,777.4 million in current terms as of December 1985. In real terms FOMIN's portfolio increase is somewhat less impressive, increasing from US$6.2 million in 1977 to US$22.3 million in 1985, thus showing a growth in real terms of 18% per annum. An assessment of the profitability of the firms assisted by FOMIN was undertaken as part of the PCR. In general, FOMIN-financed subprojects--as the industrial sector in general--were affected by the economic crisis. Because of sharply increasing inflation and a slump in domestic demand, a substantial number of FOMIN equity investments suffered from cost overruns and unsatisfactory sales leading to operating losses. As of December 1985, of all the investments or credits approved under both previous loans, 17% were operating with profits, 46% with losses, and 30% were sold or liquidated with capital gains. To some extent the weak performance of FOMIN companies is owing to the lack of managerial expertise. For the sample of subprojects reviewed by the PCR mission the ex-ante rates of return ranged between 15 and 80% with an average of 53% for projects financed under PAI I and 38% for projects under PAI II.  - 61 - Annex 6 Page 8 of 10 Evaluation of FIDEIN Industrial Estates/Building Program 20. Earlier Development Strategy. The FIDEIN Industrial Estate Program has been an integral part of the Bank assisted SMI credit projects. During the implementation of the first two SMI projects FIDEIN's mandate was to act principally as a central promotional and advisory institution to the "Fidecomisos Especiales' that is the legal entities owning and operating th4 individual regional industrial estates. The FIDEIN program was originally meant to finance the operations of the "Fidecomisos Especiales" for the following activities (a) the construction of factory buildings on industrial estates for rqnt, lease with option to purchase or sale to SMI enterprises, (b) construction and lease of common service facilities to provide services to groups of SMI enterprises in the estates (for example, warehouses, maintenance and repair shops, quality control and material testing laboratories), and (c) equipment and machinery leasing to SMI enterprises operating in these industrial estates. In 1983 the Government reoriented FIDEIN's overall development strategy requiring it to divest itself of its direct investment role and henceforth be responsible for the development of industrial estates through the provision of financing for infrastructure work and construction of industrial buildings for lease and/or with sale contracts. 21. Program Implementation Under the First and Second SMI Projects. During the implementation of the first and second SMI Loans FIDEIN began to finance direct sales, rent and lease operations of all physical installations other than land development which was the responsibility of "Fidecomisos Especiales." Once land was developed by the Fidecomisos, FIDEIN acquired part of the land to construct Standard Factory Buildings (SFB's) and to create other types of supporting ipfrastructure. During implementation of the two projects, however, FIDE-IN became directly involved in developing the industrial parks. As part of its program FIDEIN developed 17 industrial estates and constructed 46 SFB's ranging in size from a minimum of 500 square meters to 2,400 square meters. In addition it constructed one common service facility (at Mexicali) which included maintenance and repair shops, central warehousing, worker training centers, marketing and promotion centers etc. The effectiveness of FIDEIN programs can be evaluated taking into account its main operating objectives namely preventing industrial concentration and promoting regional development. As of December 1979 FIDEIN sold 1,080 hectares of land (in the 17 estates it developed) to 607 firms which were all located in the high priority development Zones (i.e., away from the main industrial cities). More recent information shows that on average the industrial estates have achieved an occupancy rate of about 802 with only about 2 estates being closed out altogether. In fact, one of these Estates is being reactivated (at Nayarit) and FIDEIN has recommended major changes in the administration of the authority managing the Estate. 22. On balance, the development of industrial parks has played an Important role in industrial location. There were very few cases of relocation of existing units since the majority of the enterprises financed by FIDEIN were new and in some cases subsidiaries of existing firms located in the highly concentrated industrial zones (Mexico City, Monterrey, and GuadalaJara). FIDEIN's standard factory building program proved to be less  - 62 - Annex 6 Page 9 of 10 successful as a business venture. Public interest in such buildings was limited -- investors preferred custom made industrial buildings instead of SFB's. As a result, FIDEIN was unable to market its SFBs and its inventory was finally liquidated in early 1986. The data on the characteristics of the buildings program are: 1) over 80% of the SFB's were sold to small companies with equity less than Mexican $25 million (in 1985 prices), nearly 70% of these were located in Zone 1 which is the highest decentralization priority. A survey of the SFB's during the recent PCR shows that only two factory buildings are closed and unused. With respect to common service facilities, only one such operation was financed (para, 21) It is currently being operated as a profitable commercial venture by the State Industrial Park Authority. 23. Programs under the Third SMI loan. At the time of the Third SMI project, FIDEIN's operational strategy had undergone a radical change in that it withdrew from its direct investment role and began to act as an advisory body providing information and assistance on technical, and marketing aspects of industrial park development to private sector investors and some state governments. At the same time, FIDEIN commenced financing infrastructure development in industrial parks. The change in FIDEIN's operating strategy was a positive development and under the ongoing Third SMI project FIDEIN began, with the Banks concurrence, to finance industrial buildings by lease operators. Since then FIDEIN has concentrated its lending mainly on financing industrial buildings in either the export zones near the border or in industrial parks which are operating efficiently. During 1983-86, FIDEIN financed 96 subprojects for industrial buildings developing industrial space of 264,638 m3. It is estimated that the industries located in theoe buildings during 1983-86 employed 21,300 workers. At the same time, the development of new industrial parks per se, dropped from a high number of eight parks in 1984 to three in 1986. The de-emphasis on park development reflected the excess capacity (para. 24), available in existing parks. 24. By late 1985 FIDEIN had fully utilized its loan allocation of US$4.6 million and another US$8 million was reallocated to enable it to meet the strong demand for industrial buildings. On an ex-ante basis, the investment in industrial buildings show good financial rate of returns and the companies managing the buildings enjoy high profitability. FIDEIN also has a sound portfolio position -- its total outstanding subloans under all three previous SMI projects amounts to Mexican$7461.2 million, of which only 1% is in arrears for over 90 days. 25. Future Prospects. Due to the liquidity problems of existing enterprises and their reluctance to invest large amounts in fixed assets such as buildings, and beeause of the interest of overseas investors (particularly in the Maquila industries) there is currently a high demand for industrial building space within the industrial parks. Regarding the development of new estates, at present there are 89 industrial parks in Mexico which have 1,849 developed hectares still available for sale. However, occupancy rates within the industrial parks are highly varied and a considerable number of parks are facing strong demand for expansion and modernization particularly those close to the frontier area. Under the proposed project, the industrial estate program would be strictly limited  - 63 - Annex 6 Page 10 of 10 to existing parks to make them more efficient and to increase their capacity utilization. For this purpose, among other things, a promotion program has been designed as part of FIDEIN's technical assistance program. Above all, new industrial parks would only be initiated in the export processing and border zones and in cases where a clear demand is demonstrated for the need of such facilities. For this reason, and given the need to strengthen FIDEIN's credit evaluation aspects, the Bank has retained the right to review and approve all of FIDEIN's investment programs approved. 25. Implementation Capacity. As an institution FIDEIN's performance under the three Bank-assisted SMI projects has been uneven reflecting the lack of experience of its staff and the high turnover at the management level, particularly in areas of credit evaluation and management. FIDEIN started off as a technical assistance operation with a heavy bias toward engineering aspects; over the years it has essentially remained such an institution. The changes in the scope of FIDEIN from a construction-type operation to a banking institution were not accompanied by hiring of qualified personnel with experience in credit operations. Under the Third SMI Project recommendations were made to strengthen the technical, marketing, financial, economic and credit aspects of FIDEIN's operations but the results were less than satisfactory. It was also envisaged that the credit operations of FIDEIN would be transferred to FOGAIN, to be managed on FIDEIN's account, and its loan portfolio was to be transferred to an intermediary bank trust for colle_tion and overall administration. None of these measures were initiated and FIDEIN continued to produce substandard investment proposals with significant delays in their approval by the Bank for want of relevant information. 26. FIDEIN has recently (July 1986) introduced some measures to strengthen its staffing and to improve the quality of its subprojects. It also carried out an internal reorganization redefining the responsibilities of the finance division into credit evaluation and accounting units; and a special planning division was created to prepare pre-investment feasibility studies. Under the technical assistance program of the proposed project, provision has been made to further strengthen FIDEIN's operational aspects through training programs for existing staff. Above all, it is proposed to gradually reduce FIDEIN's role as a first tier financing agency allowing it to concentrate on the technical aspects of industrial park development. Accordingly, a study would be carried out in the initial year of implementation to make recommendations for FIDEIN to act as a second tier institutions transferring most of its credit responsibilities to the commercial banks. As a preliminary step, following the Banks recommendation, FIDEIN has transformed to NAFIN's credit department the responsibility for its portfolio management. To assist in FIDEIN's long-term institutional building effort, two dated studies have been agreed to devellop FIDEIN into a second tier institution and to strengthen its management structure further.  - 64 - Annex 7 Page 1 of 2 MEXICO FOURTH SMALL AND MEDIUM SCALE INDUSTRY PROJECT Key Indicators for Project Implementation A. To enable the Bank to monitor the fulfillment of the project objectives (main text, para. 2.02), during project implementation, FOGAIN, FOMIN, FIDEIN, and NAFIN would prepare the following minimum information. - Subproject Lending Performance (annually): . Number of subprojects and their Financial Composition . Total Investment Costs (Projected and Actual) . Sales (Projected and Actual . Implementation Delays , Current Project Pipeline (quarterly) , Status of Loans Outstanding (quarterly) - Socio-economic Impact (annually): Commitments and Disbursements by , Loan Type and Size of Enterprise , Sector " Region , Financial Intermediary , Incremental Jobs Created and Cost per Job - Technical Assistance Program